The paradox of over-production in a world of QE

The paradox of over-production in a world of QE

Izabella Kaminska

| Sep 20 17:40 | 14 comments | Share

The Fed’s taper no-show this week resulted in a plethora of commentaries and articles flagging the risks of the world’s collective addiction to QE. To name a few:

1) Felix Salmon noted the dangers of the growing QE multiple — the incremental sugar hit the market gets from every anticipated unit of QE.

2) Tyler Cowen didn’t like that very much either.

3) Gillian Tett, meanwhile, suggested that all that QE does in its current form is provides credit for existing infrastructure and capacity, rather for new investment.

4) And HSBC’s chief economist Stephen King argued that QE only exacerbates the conditions that lead to savings glut conditions, which arguably created the crisis in the first place.

Either way, the idea that the economy is now somehow dangerously addicted to QE is a pervasive theme, and QE bashing is becoming the definitive vogue in town. Nevertheless, there are some who vehmently disagree with the analysis. Brad DeLong, for example, made the following point in response to Cardiff’s argument that the downsides of QE are not trivial at all:

A world in which U.S. equities currently have an earnings yield of 6%/year does not appear to be a world in which there is ample risk-bearing capacity going begging in the marketplace. If there were, there might be an argument that the Federal Reserve’s pulling Treasury duration risk out of the marketplace increases the risk of bubbleicious overleverage by feckless risk-lovers. But if there are feckless risk-lovers, why haven’t they bid equities up to more substantial price-earnings multiples? I fear bubbles in real estate, in equities, and in commodities. But is Cardiff telling me that I should fear bubbles in… bonds, which have a terminal maturity date and value that pins down their value not in some infinite transversality-condition long run but in 2023?

DeLong, it has to be said, makes some excellent points.

Fundamentally, QE is all about derisking the economy — having the state take the risk so that the private sector doesn’t have to. Does that in itself fuel dangerous bubbles? Yes it can do.

Should these bubbles be feared? Well, it’s all relative to the downsides of not doing QE. Currently those downsides may be more dangerous.

Lacking alternative distribution mechanisms, QE is currently the best tool we have to support a monetary system that is still dependent on bank-created credit for redemption of real goods and services.

That is to say, this thing we call “money” is nothing more than a claim on the physical goods, services and resources of the economy at large.

Those claims may be fungible against each other, but in reality they are originated from many different sources.

In a simple system, where all money is issued and controlled by the state, the state has complete control over such claims; everything from the number of these claims in circulation to their distribution and longevity. The state is charged with distributing the claims equitably and in a way that encourages enough productivity to satisfy the redemption potential of all the claims in existence.

In our current system, however, that job has been partially outsourced to private enterprises called banks, who have the power to originate money (claims) in their own right.

Banks came into play because the state could not always be relied upon to distribute or allocate claims in a way that actually stimulated the growth needed to satisfy those claims. Bad allocation decisions are made, and the economy fails to produce enough growth to satisfy the claims that remain in circulation.

Private institutions on the other hand have an interest in transfering claims only to entities who have the definitive means to create more of the stuff that’s needed by the system. Those who are prepared to go without redeeming goods and services for the sake of creating more stuff, are rewarded eventually with the rights to even more claims than they started out with.

But there is a problem.

If the economy gets more productive and efficient as a result of these processes — fuelled by the basic desire to overcome scarcities or needs — it leads to the concentration of wealth in the hands of those who chose to allocate capital wisely. This seems fair enough, but in reality if the concentration is not compensated for by the issuance of new claims, the system runs dry because only one player is left with all the chips.

Think of it as a giant game of Monopoly. The game ends once everyone has run out of money, and no one has the ability to roll enough dice to pass go and collect £200. No one can get a bridging loan from a private bank either, because private banks know the odds are against anyone other than the existing owners of rent-collecting capital.

That’s kind of where we are now with QE.

QE represents the distribution of £200 regardless of where you are on the board. It’s not the ideal outcome, because most of the liquidity still flows in one direction to the owners of capital, but it does keep the system afloat. Indeed, providing the central bank can keep up the distribution of cash to participants in the game, the game can go on. And this serves the interests of capital owners, who would otherwise have no opportunity to extract rent.

Of course, it’s unlikley to solve the problem, which is that the owners of capital would rather not be taxed, and would rather be able to protect their relative advantage in the game for eternity onwards.

In that sense Monopoly QE is more akin to a real helicopter drop, equitably distributed to all players. In real QE, the £200 replaces pre-existing yield-bearing claims which are held mostly by capital owners. These entitle the entities to ever more goods over time, protecting them from the potentially debasing effects of £200 helicopter drops. They are, in many ways, intended to keep their relative wealth intact.

But real QE replaces yield-bearing savings with zero-yielding savings, in a hope that the owners of ‘Park Lane’ and ‘Mayfair’ will be inclined to spend some of those claims on the potentially productive assets of other players (or goods produced by those assets). This, or that they help to fund investments that overcome newly identified scarcities and economic needs.

Yet, if you add the paradox of over-production to that mix — and the fact that such scarcities are potentially limited — you realise that the owners of capital have no interest in spending those claims on anything other than rent-producing assets, resources and/or anything they believe can protect their relative advantage.

All QE does is forces them to reposition their advantage from one based in futureclaims over more bountiful goods and services into one based on rent-collection and monopoly-related control over infrastructure, capacity and resources.

In a world of plenty, relative advantage can only be guaranteed by tightening the rein on accessibility to abundance. Those who have access to abundance will consequently work hard to withhold it from the population so as to keep their relative standing in place.

Technological innovation that allows such monopolies to be busted — or for goods and capacity to leak out for free — will also be discouraged, since these goods cannot be absorbed by the economy unless a relative redistribution of wealth comes with it.

In that context, it’s arguably only right that the state should enforce a penalty, tax or “negative rate” to erode the soaring advantage capital owners develop over non-capital owners.

Indeed, without such a tax, we would only move to an ever more unequal world, or one where an ever greater portion of the economy begins to depend solely on ongoing £200 Go payments.

And on that basis, the only downside of more QE and the collateral crunch that comes with it, is that capital will either be encouraged to flee developed markets altogether or be directed into riskier projects and pursuits that can undermine the current status quo.

The point really is that a collateral crunch doesn’t do anything but punish savers — and that, in the relative scheme of things, is not necessarily a bad thing.

QE addiction on that basis is no bad thing.

It’s not a dissimilar situation to the one described by HG Wells in his analysis of the problems that led to the Great Depression. As he wrote (looking back retrospectively from an imagined future) in The Shape of Things to Come:

Long before the world breakdown became manifest, the experience of the ordinary consumer so far belied the sanguine theory that free competition was a mode of endless progress that he was still living in a house, wearing clothes, using appliances, travelling about in conveyances, and being fed with phrases and ideas that by the standard of the known and worked-out inventions of the time should have been discarded on an average [Hooker computes] from a quarter to half a century before.

There was labour unemployed and abundant material available to remedy all this, but its utilization was held up by the rent-extracting and profit-earning systems already in possession. The lag in modernization added greatly to the effects of increased productive efficiency in the disengagement of those vast masses of destitute unemployed and unemploying people which began to appear almost everywhere, like the morbid secretion of a diseased body, as the twentieth century passed into its third decade.