May 10, 2016

Every day, every one of us makes numerous cost-benefit calculations that impact the way we live our life. We might not sit down with pen and paper or an excel spreadsheet to make these calculations: many of our decisions are based on intuition and gut feel. Nevertheless, nearly all our decisions involve weighing the benefits of a particular action against the cost.

In general, most of us are very good at this. Indeed, one might argue that human beings are perfect or near-perfect cost-benefit analysis machines. The process of evolution has created a biological system (the human being) that is fundamentally attuned to making quick and accurate decisions regarding its own self-interest.

However, while the process of evolution may have endowed us with the ability to make good individual decisions, it doesn’t seem to have endowed us with the ability to make good collective decisions. This problem is becoming more and more apparent as our societies becomes larger and as the barriers between our societies begin to erode.

Moreover, we are very poor at making collective decisions in matters where the benefits are clear and short-term in nature, while the costs are ambiguous and long-term in nature.

Nowhere is this more evident than the policy-behavior of the major Western democracies over the past twenty years.

Over the past twenty years, voters and policy-makers in the major Western democracies have consistently opted for short-term economic gain rather than genuine austerity and real structural reform, even if that short-term gain is almost certain to involve much greater long-term costs.

Government debt levels as a percentage of GDP have risen in every major Western democracy to levels rarely seen except in a time of major war. The chart below illustrates how government debt levels in the United States are back to the peak post-WWII, an extraordinary outcome when one considers the massive government spending that was required to win WWII.

Modern-day Keynesians will argue that government spending in a time of recession is critical to ensure a timely economic recovery. While this may or may not be true, there is a flipside to this Keynesian coin: government can not perpetually run massive government deficits. If society wants to spend in the bad times, then society must save in the good times.

Apparently, there have been few “good times” in the last thirty years. Most Western governments have run almost perpetual and significant budget deficits over that time, the one exception being the United States that actually managed to run a budget surplus in four of the past thirty years (during the epic technology-fueled boom of the late 1990s).

The fact that governments have run almost perpetual budget deficits over the past thirty years suggests that rather than there being few actual “good times” over the past thirty years, our definition of “good times”, at least from an economic perspective, is flawed.

In truth, most of us recognize that economic conditions during most of our lifetime haven’t been that bad, at least relative to the economic conditions that our grandparents and other older generations had to endure. So this raises the obvious question of what is really going on? Why do we keep pulling in the benefits and pushing out the costs?

The view of The Money Enigma is that while each of us are generally good at making cost-benefit decisions that relate to our own individual circumstances, we as society are particularly bad at conducting good cost-benefit analysis when it comes to major economic decisions. This is particularly the case when the benefits are clear and the costs are uncertain.

In the case of fiscal policy, it is not that difficult for the ordinary person to get their head around why there must be some limit on government spending. Most adults have to balance their own budget and recognize the broad principle that government should do the same. Nevertheless, there are still many “serious” economists today who argue that one shouldn’t worry about government debt or deficits, a phenomenon that has no doubt contributed to Western societies profligate fiscal behaviour.

However, in the case of monetary policy, it is very difficult for the ordinary person to understand the long-term costs associated with excessive and prolonged monetary stimulus. This lack of monetary education shouldn’t be surprising: most economists are themselves totally befuddled when it comes to this point. Indeed, the view of The Money Enigma is that modern economics fails to provide a sensible model of the process from “too much money” to “rising prices”.

If people can’t understand the costs of monetary policy, then it is impossible to have a sensible debate about the limits of policy. Given the extraordinary monetary excess of the past ten years, it is worth stepping through the cost associated with such excess and how that cost comes to be realized in a practical sense.

Before we discuss the costs, we shall also briefly discuss the benefits of easy monetary policy. Hopefully, readers will conclude, as I do, that the short-term benefits of such policy are not worth the severe long-term costs.

Quantitative Easing: The Cost-Benefit Analysis

In order to analyze the benefits and costs of highly accommodative monetary policy, it is helpful to define exactly what aspect of this policy we are focused on. In this case, we will focus on the benefits and costs of quantitative easing.

In essence, quantitative easing involves the central bank creating money (expanding the monetary base) and using this newly created money to purchase predominantly long-term, fixed-income government securities.

Why would a central bank do this? Well, creating money and using it in this way achieves something that is difficult to do with conventional monetary policy. Conventional monetary policy operates by manipulating the short-term interest rates. By manipulating the short-term interest rate, the central bank can influence the level of lending by banks. However, conventional monetary policy is limited in the sense that it has limited impact on long-term interest rates.

When the Fed ran out conventional monetary policy options in the financial crisis of 2008, it decided to adopt unorthodox measures. Most notably, it decided to begin manipulating the long-term interest rate by creating money and using it to purchase long-term government securities, a process also known as “quantitative easing”.

The benefit of artificially lowering the long-term interest rate is that it has a profound impact on the allocation of capital across the economy and, therefore, a marked impact on economic activity. More specifically, by artificially lowering the interest rate on long-term government debt, the Fed, in effect, artificially lowers the long-term required rate of return on risk capital.

In simple terms, QE forces investors to accept a lower rate of return on their capital and/or to take on more risk. As the Fed buys more low-risk government debt, investors must look elsewhere to achieve returns: government bond investors shift towards corporate bonds, corporate bond investors shift towards equities, and so on. At the margin, private investors are forced to take more risk for less return.

One “benefit” of this policy is that it encourages higher levels of speculation, i.e. asset prices rise and there is a “wealth effect” across the economy. Another way of saying this is that the rich get richer and spend more, at least theoretically.

The second and more profound benefit is that lowering the cost of risk capital does encourage new business formation and the expansion of existing businesses. In other words, this unorthodox form of monetary policy does, at least in the short term, allow more small businesses to start up and does lead to the creation of more jobs.

In summary, the net benefit of QE is that those with assets get richer and, at the margin, more jobs are created for everyone else. This may not be an ideal social outcome, but it does represent a real economic benefit for most in the short term.

However, QE does come with an economic cost. Unfortunately, the cost is policy-path dependent and, therefore, is not simple to assess. More specifically, the exact nature and timing of the cost depends upon whether the unconventional monetary policy is temporary or permanent in nature.

If the QE experiment is temporary, i.e. if the monetary base is quickly reduced after a short period of expansion, then the primary cost of QE is the impact on financial markets and economic activity that occurs when the long-term cost of risk capital rises.

Just as reducing the cost of capital leads to a rise in asset prices and an increased level of business investment, an increase in the cost of capital (as a result of unwinding QE) should predicate a fall in asset prices and a general decline in business investment and new business formation. As the cost of capital rises, asset prices fall and jobs are lost.

Clearly, none of this sounds much fun. So what is the other alternative? Well, policy makers could decide to leave the monetary base at historically high levels. In other words, this unorthodox and very aggressive monetary base expansion could become more permanent in nature.

While the Fed has generally argued that QE was always a temporary phenomenon, it is increasingly unclear when or if the Fed will reduce the monetary base. At the time of writing, the Fed has barely touched the short-end of the interest rate curve, let alone made any real effort to reduce the monetary base and raise long-term interest rates.

So, why not leave the monetary base at the current exceptionally high levels? Why not avoid the costs associated with reversing QE? Why can’t our society live with a higher level of base money, just as we seem to be living with a higher level of government debt?

The simple answer to this question is that, in the long run, growth in the monetary base that significantly exceeds growth in real output will lead to inflation. Unfortunately, while this there is significant historical evidence for this concept, the simple answer to our question doesn’t explain why this is the case.

Why Does Money Matter?

In order to understand why the amount of money created by the central bank matters, we need to step back and begin with two basic concepts: (1) money has value, and (2) as the value of money falls, the price level rises.

The money in your pocket possesses the property of market value. If it didn’t, then you wouldn’t accept it in exchange for your services and others wouldn’t accept money from you in exchange for their goods and services.

Moreover, the value of money is critical in determining the price of any good as expressed in money terms. For example, if a banana is twice as valuable as one dollar, then what is the price of bananas in dollar terms? Clearly, it is two dollars.

This price is a relative relation: it expresses the market value of the banana relative to the market value of the dollar. Importantly, this relative relationship can change for one of two reasons: either, the value of the banana can change, or the value of the dollar can change. For example, if the value of the banana is constant (in absolute terms) but the value of the dollar falls by 50%, then suddenly each banana is now four times more valuable than each dollar and the price of bananas in dollar terms is four.

Anyway, the key point is that the value of money is a key input into all prices as expressed in money terms. Moreover, if the value of money falls, then prices will rise.

This raises an obvious question: what determines the value of money?

The view of The Money Enigma is that money is governed by a social or implied contract. This contract, if it were to be written out, would state that each unit of the monetary base represents a proportional claim on the future output of society.

In essence, money is the equity of our society. Just as our society can issue fixed claims against future output (government debt), so it can issue variable claims against future output (the monetary base).

What determines the size of the variable entitlement to real output that each unit of money represents? The view of The Money Enigma is that the variable entitlement is determined by expectations regarding the long-term size of the monetary base.

In other words, if people believe that long-term monetary base growth will be restrained, then this supports the current value of money. In contrast, if people believe that the central bank has become reckless and long-term monetary base growth will not be tightly controlled, then this can lead to a sudden and severe decline in the value of money.

If this theory is correct, then expectations regarding whether QE is a temporary or more permanent phenomenon matter. If the market is correct and QE will be reversed in due course, then there is little reason for the value of money to decline sharply and for inflation to accelerate.

However, if the market suddenly begins to doubt the Fed’s intentions and starts to assume that QE is more permanent in nature, then the value of money could decline quickly and sharply, leading to a sudden acceleration in inflation.

Today, the Fed is trying to have its cake and eat it too. The Fed is trying to enjoy all the benefits of QE, while avoiding all the costs. The Fed can pull off this magic trick as long as it continues to convince the markets that QE will be reversed in the “near future”. However, if the markets begin to doubt the Fed’s sincerity in this regard, then the value of money could decline sharply. In this scenario, the Fed could find that things quickly spin out of control.