QE2


I’m pissed off. Fed is taking MY role. I do Unreasonable Responses here, not Ben! Maybe I’d charge them for the IP.
Although, on second thought, Fed is doing what it has been doing for quite a while now, so maybe it’s not so unreasonable from its perspective. Maybe I can find a more unreasonable response – let’s try.

First, why is Fed’s QE unreasonable? It relies on too many transmission mechanisms, all of them working exactly as Fed wants.

Think of the current situation as a drought, where Fed can create water out of thin air – and downstream there are plenty of farms that sprung in desert few years back, when trucking water to them was cheap. Fed operates the biggest dam in the country, feeding pretty much every river.

Now, Fed believes that if it dumps more water into the dam, it will trickle down via the rivers and canals to all the farmers who need it downriver, who will use it to irrigate, which will mean some evaporation, and then eventually we will get rain again which will solve everyone’s problems.

The only problem is, the people who own the canals and smaller dams downriver don’t really believe that the drought is over and rain is over the horizon – and it has been scorching for the last few years, with only a few small clouds on the horizon now and then.

Instead of sending any water Fed puts into the dam downriver, they want to keep it, and build bigger reservoars themselves. Even the farmers water only the minimum they need, and build reservoars and stock the water instead. Letting water evaporate is wasting valuable resources.

Give it a few years, and we end up in Dune-like situation – no evaporation, no rain, more drought, people take even more careful approach to water, even less evaporation etc. etc. Manufacturing still-suits is going to be a big business!

Fed may try to solve this by putting more and more water into the dam. The problem is, that the canals and rivers may not be able to transmit all that is being put into them (regardless of how big they are to start with). At the same time, no-one is entirely sure what the system can cope with – too much water, and at one stage it may break, flooding everything downriver, carrying away the soil it’s meant to irrigate.

Now, what is an Unreasonable Response to this? Rename Ben B. to Ben “Rainmaker” B.If Fed can create water, bypass the transmission mechanisms and just go out and make rain directly. There’s nothing that will make people believe in rain as much as raining. He could even book some helicopters to drop it – how cool would be that? Of course, the next generation may think that it’s not clouds that make rain, but helicopters, but it may be worth trying. Steve Waldman of Interfluidity has a good post on this (and, thanks to Steve for comments on a draft of this post!)

A slightly less Unreasonable Response (am I allowed to do it?) takes me away from my metaphor. One of the goals of QE is to support (nominal) asset values. The asset values tend to be supported by flows the assets can generate, either directly, or as a future appreciation of the asset.

Like it or not, currently most assets are bought with debt. Thus, the debt used to buy the asset has to be sustainable (or at least believed to be sustainable). In the current situation, where the asset appreciation is more or less ruled out (I’m on purpose ignoring nominal rises induced by significant inflation here), it means that the debt burden has to be less than the income generated by the asset. A simple example is that your mortgage payments have to be comparable to the rent you’d pay for a similar house + any value you put on the emotional attachment and security of having your own place (or rather an illusion of. Until you discharge the mortgage, you’re effectively renting from the bank, albeit the tenant obligations are only financial, so it can be seen as less restrictive).

Low interest rates help, as they make the debt more affordable. Of course, the problem is that what is affordable on low interest rates become unaffordable when the rates go up. In addition to that, if QE leads to the dollar depreciation, most of the commodities go up, which immediately means that cost-of-living goes up and affordability of the debt goes down.

The ONLY way how to ensure affordability of the debt is to raise income (at least notional, preferably real). As I wrote earlier, QE attempts this, but with way too many transmission channels.
Rain rises the income, although if the only rain can be produced by Fed, then Fed will have to take on a permament role of a rain god.
Best way to guarantee the rain is to make the intermediaries to uncover their reservoars and let them evaporate. In a non-metaphor world, it means making the companies stop accumulating cash reserves and raise the wages they pay.

This in itself is not without its problems. First, even assuming the companies understand that it’s better when wages rise, they would like everyone else to do it, rather than themselves. And we have a free-rider problem. Second, uncovering only one reservoir will not get enough moisture into the air to get us rain. And lo, we have a coordination problem.
Now, if you ask a game theorist why we have governments, they say that it is to solve exactly these problems (and also break prisoner dilemmas). You need an external agency to solve them, the participants themselves cannot solve it.

Given that US companies are flush with cash, the right response of the administration would be to induce them to rise the amount of money they pay out in wages (which means either rising the wages to existing employees, or hiring new ones).
How? For example by legislating that amount of total compensation (including fringe benefits) paid to corporate officers cannot be more than x% of the total wages paid in the corporate. The x could be even set by the board. Or cap corporate officers pay rises to the lowest pay rise (percentually) in the workforce. Whatever. I’m sure people can come up with some interesting suggestions.

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