What hath QE wrought? QE is the Federal Reserve’s regular purchases from its member banks of long- term bonds, mortgage- backed securities, and other assets. The Fed’s decision throughout the crisis to provide extraordinary amounts of liquidity to member banks has raised hackles among libertarian conservatives while stirring at least qualified hope on the part of influential liberals, including Paul Krugman. Both, however, misunderstand modern banking.
The liberal defense of both the direct bailout of banks through TARP and of the subsequent quantitative easing has been that the banking system was near collapse. Though an orderly bankruptcy with systemically vital creditors being paid off while firing bank officers and placing strict limits on compensation might have been desirable, such actions were not legally available. This excuse is questionable. Citing the Federal Reserve’s legal limitations becomes suspect in the face of quantitative easing itself, which clearly stretches the limits of the Fed’s authority.
Conservative fears regarding the inflationary impact of the Fed’s easing were equally misplaced. As Paul Krugman pointed out at the time and as history has born out, with interest rates already near zero, pouring more liquidity into the banking system could not drive interest rates lower. Therefore these purchases could not cause an avalanche of inflationary pressure. To his credit, Krugman has always been skeptical that with nominal rates already zero anything other than fiscal policy, direct government spending, would end the slump.
But Krugman’s understanding of the nature and role of contemporary banking is quaint. He underplays the role of investment banks in occasioning the volatility of the financial system. Krugman views banks as mere intermediaries between “patient savers and impatient borrowers.” However, the role of banks in lending money helped occasion a debt induced boom, and their fierce determination to cut back when debts seemed unsupportable exacerbated the decline. Banks—not government—have in essence printed money. As Australian economist Steve Keen puts it, lending by banks is a different phenomenon from one saver transferring his/her spending power to another with zero net impact. It involves creating new spending power via debt creation. CNBC contributor John Carney nicely summarizes this process: “the basic infrastructure of banking is not built on a foundation of a bunch of cash that is then lent out. It's built on the loans themselves, with capital and reserves raised to meet regulatory requirements.”
The willingness by banks to make and borrowers to take out loans can go on indefinitely. As private debt escalates crisis becomes more likely though one cannot predict exactly when, just as one cannot predict when an avalanche will occur. Krugman’s treatment of banks as mere passive agents removes an element of flux from his economic models. This move gives him more confidence in economics as a predictive science with equilibrium as an economy’s default state.
In the US, banking has had its own volatile history. It has coevolved in complex relation to industry and commerce. Hyman Minsky’s classic work points out that in the immediate post World War II period, banks, burned by the experience of the Depression, were cautious. They loaned only to sure things. But the very success of those loans in a growing economy led many to conclude that they had been too restrained. They responded by taking on more leverage and engaging in more speculative finance. Speculation included financing innovative industries and technologies. They helped fund the process of creative destruction celebrated by Joseph Schumpeter. These changes required far more than the funds of Krugman’s patient savers. But as success in such ventures further increases profits and opportunities, eventually all caution is thrown to the wind. What Minsky calls a “euphoric economy” with multiple instances of ponzi finance emerges. Ponzi financiers cannot pay interest on their loans through ordinary operating profits. They depend on sale of assets expected to appreciate via sale to other investors holding the same expectations. Eventually these debts cannot be paid, but the damage done goes far beyond the ponzi artists. Fire sale of their assets leads to deflation and increasing debt burdens even for more prudent investors. A vicious circle leading to deep depression is soon underway. Stability breeds instability.
Above all else the triumph and the tragedy of finance suggests that distinctions between finance and “the real economy,” Main Street versus Wall Street, do not fully hold. Each has had a powerful influence, both for good and ill, on the development of the other.
Finance today could be said to combine over caution via local commerce and industry with renewed exuberance in the creation and marketing of speculative instruments. As Naked Capitalism blogmaster Yves Smith argues, “The central bank has happily allowed banks to become fewer and bigger even before the crisis. But megabanks run their branches like stores, and allow managers little discretion. That means they don’t engage in character-based lending and aren’t able to use local market intelligence to inform small business lending decision.”
If quantitative easing has at best kept a moribund banking system from collapse, it has at worst laid the foundations for a future crash of at least as significant magnitude. Cheap money has not stimulated real business investment, which would depend on a healthier, less debt- ridden consumer. Nonetheless, it has spurred a renewed range of merger and acquisition, IPO, and corporate buyback schemes. As Wolf Richer, also blogging in Naked Capitalism, puts it “For the first time since 2009, the global top five were our too-big-to-fail friends on Wall Street. ...They’re all celebrating their phenomenal success in extracting massive fees from a wheezing economy… But it’s also a warning signal: Financial engineering looks good on paper for a while, and the markets love it, and the hoopla makes everyone feel energized, especially those who take the cream off the top, and it feeds off the nearly free money the Feds hands to Wall Street. But after these financial engineers are done extracting fees and altering the landscape, they move on, leaving behind iffy debt, shares of dubious value, wildly growing tangles of risk, and other detritus. And a lot of these financially over-engineered constructs won’t make it in an environment where money isn’t free anymore.”
To QE or not is hardly the question any more. The more ominous issue is the size and structure of the banking system. It has never been more imperative to reduce concentration in finance, to extend to student and home owner debtors the same forgiveness banks received, to spend on green infrastructure projects, to restore the Glass-Steagall separation of commercial and investment banking, and to change banker incentives.
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