The Taper, Nick Rowe, Quantitative Easing, and Intellectual Coordination Failures: Wednesday Focus for August 27, 2014

Nick Rowe begs for North Atlantic central banks to do what he (and I) regard as their proper job, and writes:

Nick Rowe: Money, Prices, and Coordination Failures “The more interesting cases are…

…where a non-monetary coordination failure has spillover effects, and causes a monetary coordination failure. A worsening of asymmetric information problems in financial markets, which is a coordination problem in its own right, also causes an increased demand for money and a monetary coordination problem. Should we say that the problem in financial markets is the “root cause” of the recession, and one that should be addressed directly, if possible, by something other than monetary policy? No. Monetary policy should take the world as it is, warts and all, and do what it can do. And what it can do is eliminate that excess demand for money, even if it cannot eliminate that original problem that initially caused the excess demand for money. It does not matter, for the monetary authority, whether that increased demand for money was caused by some natural event like the weather, which nobody can change, or whether it was caused by some other problem, which the fiscal authority can and should fix.

Governance is itself a coordination problem…. An autonomous central bank targets inflation, or NGDP, just like Hayek’s user of tin targets his own profits or utility. And just as Hayek’s user of tin does not need to know why the price of tin has fallen, so the central bank should not need to know why inflation, or NGDP, has fallen below target. The whole point of having a good monetary policy target, just like the point of having a market system, is that the central bank can do what’s right without knowing everything about the economy, and do what’s right whether or not the rest of the government does what’s right in their jobs…

Not that I believe that what I am about to say has escaped him, but I think I should remind Nick Rowe that I do not believe his arguments have been found convincing by monetary policymakers. Nowhere in the North Atlantic is there a central bank committed to supplying money today and in the future on a path so that planned economy-wide spending equals projected economy-wide income at the NAIRU level of employment. Nobody at the Jackson Lake Lodge in Grand Teton National Park last weekend set out his point of view (although my (imperfect) visualization of the Cosmic All postdicts that Christina Romer came close).

Why not? My visualization of the Cosmic All tells me that:

1. Some denied that there was, today, any large shortfall of today’s level of employment from today’s NAIRU level.

2. Some claimed that there would be “immaculate deanchoring”: the measures necessary to convince workers, managers, savers, and investors of a higher nominal GDP path would–even though employment today is well short of the NAIRU level–immaculately de-anchor inflation expectations so that 100% of the rise would show up as higher inflation and 0% as higher real production and employment.

3. Some claimed that supplying enough money to satisfy the demand for money at a NAIRU-consistent level of employment would generate an unwise increase in the risks of financial instability.

The first of these simply flies in the face of everything we know. Consider what has happened to employment-to-population ratios for prime-aged males and females since 1980:

To make sense of this first would require that factors reducing the ability of employers to make a good match with 25-54 year-old males have accelerated from reducing the employment share of the 25-54 male population by 1%-point/decade in the 1980s and 1990s to a rate of 2%-points/decade between 2000 and 2007 and then a rate of 7%-points/decade between 2007 and 2014–without any similar acceleration in disemployment effects among 25-54 year-old women comparing 2000-2007 to 2007-2014. That makes no sense to me whatsoever. Moreover, the fact that the employment rate among 25-54 year-old females today is no higher than at the global recession trough in 2009 is, I think, a very powerful piece of evidence that there is still a lot of slack in the labor market: prime-aged females should, given the collapse in male employment, have a stronger demand for jobs today than they did back in 2007.

Thus let me give three cheers for Binyamin Applebaum’s assessment of David and Haltiwanger:

Binyamin Applebaum: On the Decline in Labor Force Participation: “Davis and Haltiwanger attribute [the decline in participation]… to… aging… decline in the creation of new companies… [rising] cost of training… partly because the share of all workers who require government licenses has grown… legal changes that have made it more difficult to fire employees… insurance as a reason that employees may stay put. In [their] view… the recession just made a bad situation worse…. But… [how] to reconcile the assertion that these trends were the dominant factors with the reality that the employment rate rose in the years before the recession[?]… [This,] like others of its genre… requires belief in a big coincidence… that the economy crashed at the moment that it was already beginning a [not so] gradual descent.

I think that hits the nail on the head.

To make sense of this second would require that the best analogue for the U.S. today be the only even semi-large economy that has ever been even mentioned as a possible candidate for “immaculate deanchoring”: France at the election of Mitterand. And the claim that even France then was such an example is strongly contested. I can see “immaculate deanchoring” being a thing in small very open economies, but not in large ones–especially not in large ones that issue reserve currencies.

And I continue to fail to understand this third point–largely because I have not yet found anybody who will spell it out to me in any depth or at any length. How, exactly, is taking risk off of the private sector’s balance sheet via quantitative easing supposed to increase risk? Every time I try to think about this issue, I find myself led back to this argument I made quite a while ago: In brief, while reductions in risk premia that spring from irrational exuberance or other increases in the supply of risk-bearing capacity by private agents who have no clue what they are doing can drive bubbles and provoke crises by increasing the amount of risk in financial markets, it is very hard to see how reductions in risk premia that spring from decreases in the demand for private-sector risk-bearing capacity that are driven by asset purchases by a solvent government can do the same, for such reduce the amount of risk in financial markets by transferring it onto taxpayers:

What Are the Risks of Quantitative Easing, Really?

In the financial market there is a demand for risk-bearing capacity by firms and others who want to borrow but who cannot guarantee that they will be able to repay. The higher is the price of risk–the greater the risk premium interest rate spread over short-term Treasuries they must pay–the less they will borrow.

In the financial market there is also a supply of risk-bearing capacity by savers and financial intermediaries who want to lend, and are willing to accept and bear some risk in return from getting more than the short-term Treasury rate. The higher is the price of risk—-the greater the risk premium interest rate spread over short-term Treasuries they must pay–the more they will be willing to lend.

When the Federal Reserve undertakes quantitative easing, it enters the market and takes some risk off the table, buying up some of the risky assets issued by the U.S. government and its tame mortgage GSEs and selling safe assets in exchange. The demand curve for risk-bearing capacity seen by the private market thus shifts inward, to the left: a bunch of risky Treasuries and GSEs are no longer out there, as the government is no longer in the business of soaking-up as much of the private-sector’s risk-bearing capacity:

And this leftward shift in the net demand to the rest of the market for risk-bearing capacity causes the price of risk to fall, and the quantity of risk-bearing capacity supplied to fall as well. Yes, financial intermediaries that had held Treasuries and thus carried duration risk take some of the cash they received by selling their risky long-term Treasuries to the Fed and go out and buy other risky stuff. But the net effect of quantitative easing is to leave investors and financial intermediaries holding less risky portfolios because they are supplying less risk-bearing capacity.

How do we know that they are holding not more but less risky portfolios? We know because we know that supply curves slope up, and if they were holding more risky portfolios in total–supplying more risk-bearing capacity to the market–the price of risk would have not fallen but risen, and interest rate risk spreads would be not lower but higher, wouldn’t they?

So when the intelligent and thoughtful Mark Dow tweets:

I, too, think risks [of QE] overstated, but they’re non-zero. Main ones r credit leverage buildup…

I am at a loss. As long as supply curves slope up, QE does not increase but reduces the leverage of private-sector financial asset holders.

And when the intelligent and thoughtful Mark Dow tweets:

I, too, think risks overstated, but they’re non-zero. Main ones r… outsized int’l capital flows

I am again at a loss. Yes, the Federal Reserve has taken some domestic risky assets off the table. Yes, U.S. financial intermediaries and savers will respond by buying foreign assets to so deploy some of their now-undeployed risk bearing capacity. Yes, they will now bear some exchange-rate risk. But, once again, the fact that QE pushes interest rate spreads down is very powerful evidence that these capital flows are not “outsized”–that the extra exchange-rate risk U.S. financial intermediaries have now taken onto their books is less than the duration risk that QE took off of their books.

At least, that is the case as long as the supply curve for risk-bearing capacity slopes up, like a good supply curve should.

Perhaps those who claim that there are big risks to quantitative easing regroup. Perhaps they claim that financial intermediaries are perverted, and that the lower is the price of risk the greater is the amount of risk-bearing capacity they supply to the market because they lose their jobs if they don’t make at least three cents on every dollar of assets in a normal year in which risk chickens come home to roost.

In that counterfactual world, the supply-and-demand graph would look like this:

And in that counterfactual world, the Federal Reserve’s adoption of quantitative easing policies triggered an enormous expansion of the quantity of risk-bearing capacity demanded by firms and households and a huge private-sector lending boom as firms issued enormous tranches of risky bonds and as firms and households took out risky loans. In that counterfactual world, employment in bond underwriting tripled as $85 billion a month in QE was more-than-offset by an extra $120 billion a month in private-sector bond issues. In that counterfactual world, we saw a rapid recovery of housing construction and a thorough equipment investment boom as far across the U.S. as they eye could see.

That didn’t happen.

So what are the risks of QE?

It really seems to be this:

• Commercial banks traditionally accept deposits, put the deposits in long-term Treasuries, rely on the law of large numbers and on deposit insurance to allow them to always hold their long-term Treasuries to maturity, and so have a riskless and profitable business model.
• When commercial banks cannot do this, they find some way to gamble with government-insured deposits.
• ????
• LOSS!!

But this is not a source of systemic risk: because the deposits they may be gambling with are government insured by the FDIC, no run on the banking system or the shadow banking system occurs when risks come due. It would be embarrassing, yes. And the proper response to thinking that commercial banks are running undue risks with government-insured money is to send in the bank examiners–not to undertake policies that raise unemployment.

So put me with Ryan Avent, who tweets:

[The] risk [is that] of not being considered a [very] serious person by peers [unless you claim to greatly fear the risks of quantitative easing]

It almost seems to me that all those who talk about how quantitative easing raises the risk of future financial crisis by causing financial intermediaries to “reach for yield” that they should not do have either failed to consider that a shock to the demand curve in the market for private risk-bearing capacity different from the shop to the supply curve in the market for private risk-bearing capacity, or failed to consider that they have implicitly committed themselves to believing in a supply of private risk-bearing capacity that slopes the wrong way and led every Treasury bond and mortgage-backed security withdrawn from the market via quantitative easing to have been matched and more than matched by a tsunami of private risky-asset issue that we simply did not see. Instead of enlarging their risky-asset holdings as Treasury and MBS duration risk were taken out of the market and triggering such an issue boom, financial intermediaries supplying risk-bearing capacity shifted some of their asset holdings into reserve deposits and whimpered at the decline in their rate of return.

Does anybody say otherwise?