Is quantitative easing (QE) money printing?

An economics student with whom I’ve been corresponding recently relayed to me that his economics professor stated that the Federal Reserve’s policy of quantitative easing (QE) did not equate to printing money. This question causes a lot of confusion between economists and non-economists so it seemed like a good topic for a quick post.

So, should QE be considered money printing?

At first glance it should. In fact, if you Google the term “quantitative easing,” Google provides the following definition, “the introduction of new money into the money supply by a central bank.” Similarly, Wikipedia starts off its entry on quantitative easing with, “Quantitative easing (QE) is a monetary policy in which a central bank creates new electronic money in order to buy government bonds or other financial assets to stimulate the economy…”

Before we go further, let’s understand the basic mechanics of quantitative easing. In a nutshell, the Federal Reserve (or any other central bank) purchases long-term bonds from banks and other financial institutions using newly created money. Now, when we use the term “newly created money” we do NOT mean that the Fed prints a whole bunch of brand new Ben Franklins ($100 bills, for those of you reading this outside the U.S.). Instead, the Federal Reserve makes an electronic entry in its computer system, indicating brand new money.

Let’s say that the Fed purchases $1 million of bonds. On its balance sheet, the Fed records a liability of $1 million reflecting the brand new (electronic) money that it created and records an asset of $1 million reflecting the bonds it just bought. The Fed’s balance sheet is now larger by $1 million than it was prior to the purchase.

Now let’s look at the balance sheet of the bank that sold the bonds. On the asset side, the bank now holds $1 million of additional cash (in the form of reserves) courtesy of the Fed’s new money. Also on the asset side, it has decreased its holdings of bonds by $1 million. Hence, there is no change to the net value of the bank’s assets (and no change to its liabilities).

The simple answer to whether quantitative easing is printing money is clearly yes, since the Fed creates new money in order to purchase bonds. As we’ve seen, the Federal Reserve’s balance sheet increases by $1 million. The commercial bank’s balance sheet doesn’t change (the makeup changes but not the amount). So the net effect to the entire system is a $1 million increase. However, to economists, the story does not quite end here.

Economists argue that while the Fed is technically creating new money, it is not actually increasing the money supply. And here we find that the question of whether or not QE is money printing is really a semantic argument rather than a true economic argument. In essence, it boils down to whether “printing money” is the same thing as “expanding the money supply.”

The argument that economists make is that what the Federal Reserve is really doing is an asset swap. The Fed is merely swapping newly created money for bonds. The key point economists are trying to make is that once the Fed owns those bonds, they are not really part of the economy and should not be counted as part of the money supply. In essence what economists are saying is that ONLY the private sector banking system, by making a new loan, can expand the true money supply. The central bank cannot expand the money supply by creating electronic money.

Is this true? First, it depends on what your definition is of the “money supply.” There is no one agreed upon definition of the money supply and in fact economists have different measures of the money supply (e.g. M1, M2, M3). Ultimately, you must pose the question, “what is money?” The true meaning of money is equally important, complex and misunderstood and something I do not dare tackle here, but hope to in a future (and much longer) post. For now, I reiterate what I said earlier in this post, that whether quantitative easing is or is not money printing is really a semantic discussion, and not an important one.

There are much more important, and economic (rather than semantic) questions to discuss regarding QE, which we will turn our attention to shortly. However, before moving on, I want to add one point to the discussion. I would argue that when the Federal Reserve purchased bonds from the private sector financial system, it paid MORE than fair market value, given its massive size and status. Hence, by overpaying (compared to what others would have paid), QE was not exactly a one-to-one asset swap.

For example (and I’m making up numbers here) if the true market value of a bond was $80 and the Fed paid $100 then the $20 difference should indeed be considered “money printing” even if you take the position that QE is, otherwise, an asset swap. To be fair, not being a bond trader, I have no idea to what magnitude the Fed overpaid but I would bet that they did, especially for the mortgage backed securities (MBS) that the Fed purchased (the Fed purchased both US treasures and MBS in its three rounds of QE).

There’s an additional argument that some economists and commentators make with regards to QE not being money printing. They claim that even though the Federal Reserve expanded its balance sheet by trillions of dollars under QE (and ZIRP), because there was no meaningful inflation (not to mention poor GDP growth and poor employment figures), Fed policy cannot and should not be considered to be “printing money.” I’ve written previously (here) a post on why the Fed’s extraordinarily loose monetary policy hasn’t led to inflation. Briefly, however, I believe this line of argument is faulty for two reasons.

First, it is erroneous to equate expanding the money supply with inflation. This fallacy is, in my opinion, one of the reasons why the Fed (and other central banks) have caused so much damage to the world’s economies. I have and will continue to write about this topic elsewhere, but simply put, measures of inflation such as the CPI and expanding the Fed’s balance sheet are two different things. It is even less true to say that the money supply can be equated to economic growth or employment.

Second, and much more importantly is the counterfactual. How do we know what would have happened in the absence of QE? We know that the U.S. economy (and many others) was facing enormous deflationary pressure after the financial crises. This is precisely why the Fed along with other central banks resorted to unprecedented and extraordinary policy. It is certainly possible, and perhaps likely, that absent QE, the economy would have experienced substantially lower GDP, lower employment (higher unemployment) and even lower inflation (or deflation).

If true, then QE was certainly inflationary even if the CPI was ONLY 2%. In short, to state that a massive amount of QE cannot be considered inflationary (or be considered printing money) simply because the economy did not overheat is bad science and holds no water since we have no idea what would have happened without QE.

As I wrote above, I believe that the question of whether quantitative easing is technically “money printing” or not, is a semantic one and of little importance. What is important are the following three questions: 1) what was the purpose of quantitative easing, 2) did it work and 3) was it justified.

What was the purpose of quantitative easing?

At the highest level, the goal of quantitative easing was to help the economy. First, to help prevent the economy from falling into a depression and to help stave off deflation (both, real fears to central bankers after the financial crises).  Second, to help expand the economy faster, to reduce unemployment, grow wages and increase inflation.

Specifically, as we’ve already discussed, the Federal Reserve was buying long-term bonds (Treasuries and MBS) in order to reduce long-term interest rates. This was a new policy because historically the Federal Reserve only purchased short-term debt in order to target short-term interest rates. However, given that targeted short-term interest rates were already at zero because of the central bank’s zero-interest rate policy or “ZIRP,” the Fed decided to target long-term rates.

The stated goal of lower long-term interest rate was to encourage borrowing. For example (in theory), lower long-term rates should lead to lower mortgage rates, which should induce more people to buy new homes. Similarly, lower rates should make it cheaper and easier for businesses to borrow to build new factories or open new stores. The end result (again in theory) being more economic activity, higher GDP, more jobs and lower unemployment rates.

There were at least two other goals of QE, both significantly less talked about by central bankers, for what should be obvious reasons. One was to help members of the banking sector “repair” its balance sheets. The idea being that an unhealthy bank is unlikely to lend. A bank with a healthy balance sheet more likely to lend, and thus aid the economy. That’s the polite way of looking at it. The more cynical viewpoint is that QE represented further bailouts to the banking sector. (One of the reasons why, as I discussed above that I suspect that the Fed was paying above market prices, especially for MBS, whose value otherwise should have been marked down).

The second less discussed goal was to directly increase the price of financial assets. This idea is known in econ-speak as the “wealth effect,” an idea in which the Federal Reserve seems to believe. Other things equal, lower interest rates raise the value of all financial assets. The wealth effect posits that individuals whose financial assets have risen in value (and therefore have more wealth) will consume more. More consumption (other things equal) naturally leads to a faster growing economy, more investment and less unemployment.

Regardless of which of the Fed’s motives you believe were more important, in all cases the intent of QE was to spur lending in order to grow the economy faster (or prevent it from shrinking). And, as I stated above, every loan that the banking sector makes is considered an expansion of the money supply. So (and this is a key point), whether or not the act of quantitative easing by the central bank is technically “printing money” or not, the INTENT of QE is clearly to expand the money supply.

Did quantitative easing work?

Remember, the purpose of quantitative easing was to lower long-term interest rates in order to induce more lending, more investment, more jobs and more economic growth. Did it work? Well, after trillions of dollars of bonds bought by central banks, the answer is…wait for it…we have no idea. On the one hand, the U.S. economy (same story for other economies that experienced QE) did not experience very strong GDP growth, employment and wage growth, nor did headline inflation (CPI) reach the Fed’s target of 2%. On the other hand, economic growth, though weak, was at least positive, the employment rate did decline significantly and the economy avoided the Fed’s worst fears of deflation.

Economics is not a science primarily for the following reason: economists cannot run experiments. That is to say, economists cannot rerun the financial crises hundreds or thousands of times with and without quantitative easing to determine whether or not QE was effective. And as I stated above, we have no idea what the economy would have looked like in the absence of QE.

Personally, I would guess the following: quantitative easing was somewhat effective in preventing the worst effects of the post financial crises deflationary pressures and had somewhat of an effect on increasing GDP and reducing employment. I would further surmise that QE was nowhere near as effective as the Federal Reserve (and other central banks) had hoped.

Was quantitative easing justified?

Up until now, pretty much everything I’ve written would be considered mainstream economics. Here, in this final section, I will deviate. The question that remains, and the most important one in my mind, is SHOULD the Fed have engaged in quantitative easing.

It has become standard economics since Keynes in the 1930’s to focus exclusively on the short-term results of economic policy and to ignore the long-term effects. I’ve already stated that I believe that QE aided the economy in the short-term by increasing GDP and lowering unemployment. To mainstream economists, that is good enough. Not to me. The question that needs to be asked (but never is), is whether the long-term negative effects of quantitative easing outweigh the short-term benefits. I believe they do, and massively.

Quantitative easing (along with ZIRP) has re-inflated an asset bubble that has been trying to burst for 30 years and delayed the inevitable restructuring that must occur. It has bailed out banks and rewarded bankers that deserve, and need, to fail. It is has subsidized “investment” in non-productive financial activity such as M&A, stock buybacks and parasitic technology companies, all which destroy jobs, at the expensive of long-term job creating real investment. It has been the primary cause of increased income inequality, which if not reversed, will destroy liberty (and lives) throughout the world.

In the near-term some of us might be better off because of quantitative easing. In the long term, we are all worse off.

Why is the world so messed up?

Here’s another post inspired by the Trump election.  What the hell is going on in the world?  Why are people so angry? Why are the Brexits and the Trumps of the world winning elections? Why are extremists of the right-wing and the left wing, the populists, the isolationists, the politicians of anti-immigrant and anti-trade persuasion, the fascists and the socialists gaining power all across the western world?

It feels like in recent years that the world has taken a big step backwards.  The short-lived optimism brought upon by the end of the cold war has been replaced by fears of global terrorism and the anxiety brought upon by power-hungry dictators and empowered rivals such as Russia and China. Meanwhile, belief in a prosperous “age of moderation” was shattered by the global financial crises and by the indisputable evidence of surging income inequality.

Many smart people have tried to explain the various factors causing our world-wide angst. Capitalism. Wall Street. Globalization. Trade. Technology. Immigration. Terrorism. Some get parts of it right.  Some get none of it right. But few correctly see the larger picture, that is, the fundamental trends underpinning these trying times. We can do better.

I believe that the world is experiencing forces brought upon by a combination of two global trends: 1) massive financialization brought upon by short-sighted monetary policy, and 2) the growth of big government and its evil-twin, crony capitalism.  Together (and they do go together), these two decades-long trends have depressed productivity and economic growth, subsidized job loss due to technological disruption and excess international trade, and sown the seeds for global terrorism.

No institutions have done more damage to the global economy over the past several decades than the world’s central banks.  No idea has done more damage to the global economy over the past several decades than the belief that a centralized government agency can, and should, dictate the economy’s interest rates.  Led by the U.S.’s Federal Reserve, this monetary policy experiment has lead to a world in which money is in massive over-supply, risk is massively under-priced and the financial sector has grown to become a massive drain on productivity.

Low interest rates are supposed to encourage investment.  Financial bailouts are supposed to prevent disastrous depressions.  Perhaps a short-period of monetary stimulus and a once in a blue-moon bailout might not do too much economic damage.  But 30+ years of easy money and near-continuous bailouts of banks and the financial system have created such economic distortions that to categorize the U.S. economy as anything near a free market would be utterly wrong.

Of course, Wall Street is not the only entity in town that has grown substantially larger. Growth of federal governments has been almost as devastating to global economies. Marx thought that it was capitalism that was unstable and would inevitably collapse.  He was wrong. Regrettably, it is democratic government that seems ultimately unstable and prone to collapse by slowly, but inevitably strangling the economy.

Democracy’s fundamental flaw is that it is biased towards its own growth.  Growth of the government workforce, growth of regulation, growth of taxes, growth of disincentives, growth of monopoly.  The flip side?  Lack of productivity, lack of efficiency, lack of employment, lack of competitiveness, lack of growth, lack of freedom.  What began as more or less a free market, becomes, through the growth of government and the cradle-to-grave welfare state, a system of crony capitalism, less and less distinguishable from socialism.

Decades of easy monetary policy combined with the growth of big government have, among other things:

  • Encouraged speculation and short-term financial results at the expense of long-term productive investment in infrastructure, research and development and human capital.
  • Subsidized consumption at the expense of savings, fostering a culture of indebtedness and instant gratification and exacerbating worldwide trade imbalances.
  • Subsidized investment in vastly unproductive uses, creating serial asset bubbles in the process.  Nowhere is this more evident than in the technology industry where money losing companies funded with massive amounts of inexpensive capital that employ few disrupt profitable companies that employ many. This is not creative destruction, as some would claim.  This is subsidized economic suicide.
  • Subsidized large, publicly traded and monopolistic companies at the expense of small, privately-held and entrepreneurial companies because of easy access to capital markets, crony capitalism and an emphasis on financial engineering, M&A and private equity activity.
  • Caused enormous inflation in non-tradable goods such as healthcare, higher education and real estate.  Is it any wonder why the middle class is drowning in debt?  Is it surprising that young people can’t afford to pay for college, can’t afford healthcare and can’t afford to buy a house?
  • Destroyed the centuries-old business model of local, relationship-based banking and is in the process of destroying pensions, retirement savings and the insurance industry.  Collectively, these are the cornerstones of a capitalist economy.
  • Directly enriched the wealthy by funneling money through and to Wall Street and inflating financial assets, creating an enormous bifurcation of “haves” and “have-nots.”
  • Encouraged an entire generation of the best and brightest to become investment bankers, traders, venture capitalists and consultants, rather than scientists, engineers, doctors, and teachers.
  • Allowed governments (the U.S. in particular) to finance naive, adventurous wars in the middle east without the sacrifice of higher taxes, and thus without sufficient contemplation from the citizenry.  Further, easy money and big government has subsidized a military-industrial complex lobbying for arms sales, arms subsidies, arms grants and general armament of questionable groups, not to mention all sorts of military involvement and war. Needless to say, the predictable result has been anarchy, terrorism (often, facilitated with our own weapons), untold number of deaths, and the largest migrant crises since World War II.
  • Fueled a worldwide energy and commodities boom that enabled petro-dollar dictators like Vladimir Putin and Hugo Chavez to stay in power, and countries like Iran and Saudi Arabia to sponsor and finance global terrorism and religious extremism.
  • Subsidized internet and communications technologies that have led to a less-informed global citizenry, the decimation of more-or-less non-partisan media coverage in favor of the consumption and belief in “fake news” and conspiracy theories, as well as aiding in the planning and recruitment of terrorists.  Oh, and few if any productivity increases.
  • Destroyed entire manufacturing sectors because of regulation, tax policies, protected unionism, and the short-sighted policies of refusing to allow wages to fall.  The result being outsourcing, offshoring and global trade far beyond what would likely occur under a true global free market, and significant unemployment.
  • Completely divorced the healthcare industry from competitive forces, resulting in the worst of all worlds, the privatization of profits and the socialization of costs (just as the government did with the financial services industries).  The inevitable results being skyrocketing healthcare costs, a less healthy populace and monopolization within the entire healthcare vertical.
  • Created a bloated, wasteful and monopolistic education system that favors teachers, administrators and bureaucrats at the expense of students.  The result of which is an education system that neither produces the “good citizens” necessary for democratic government nor the job skills necessary for a competitive economy.
  • Fostered a culture of dependency, blame, over-sensitivity and selfishness rather than self sufficiency, responsibility and community.

The ramifications of poor economic growth and the slow-motion implosion of the welfare state

The upshot of decades of absurd and counterproductive monetary policy and an ever-growing government? Economies especially prone to speculative bubbles and financial crises. Economic growth and productivity far below potential. A bleeding and resentful middle class.  Easily financed and poorly planned wars with the terror and chaos that follows.  And income inequality the likes of which the world has probably not experienced since before industrialization.

But it gets worse. Combine poor economic performance with the enormous welfare state and you get a downward spiral difficult, perhaps impossible to break.

First and foremost, poor economies hurt those at the bottom of the food chain, most notably young people.  With job prospects few or nonexistent, young people delay or completely avoid forming households and having children.  You wind up with an aging population with fewer and fewer workers paying into the ponzi-like welfare system and ever greater number of aging retirees taking money out. This is playing out all over Western Europe, but even more obviously in Japan, a country in its third decade of economic depression.  (It is mainstream economics to blame Japan’s weak economy on its demographic challenges and aging population.  However, this gets cause and effect exactly wrong.  It is Japan’s weak economy and poor job prospects that causes its demographic challenges and aging population.)

Further, what happens when masses of unemployed and underemployed young people with poor prospects and little hope are further and further removed from productive society?  They turn to drugs (witness the opiate epidemic in the U.S.), crime, and in some cases terrorism.

Moreover, a stagnant or shrinking economic pie causes everyone within society to take a zero sum mentality.  That is, whatever government benefits you get, means less that I get. The result is a bifurcation of the populace into two groups: those within the system that are currently benefiting from the crony capitalist welfare state, and those outside it trying to get in.  Most notably, who’s in the “out” group?  The young and the immigrants. Naturally, this bifurcation leads to resentment and anti-immigration bias. It leads to a two-tiered society.  It leads to an unassimiliated underclass, as has occurred in many Western European countries.

So now you’ve got a slow death cycle.  The economy is weak and jobs are scarce. The young are unemployed. Immigrants are shunned.  The population ages and more and more money flows to entitlements, to pensions, to retirees, to healthcare.  Meanwhile local services, education, infrastructure and other forms of investment are cut.  More money to unproductive uses, less money to productive uses.  So the economy becomes even weaker, and the cycle continues. Yet the elite blame capitalism and ask for even more government.  Sooner or later, crises ensues. Pensions can’t be paid. Local governments go bankrupt. Then state governments. Then federal governments.  The implosion of the welfare state.  It is occurring in Western Europe.  Though less apparent and more slowly, it is occurring in the United States too.

The way forward:  optimism or pessimism?

As I’ve mentioned several times, the twin maladies of easy money and big government have led to a stagnating world economy, financial bubbles in nearly every asset class, excesses of trade and technology, unprecedented income inequality, global terrorism and anti-immigrant and anti-trade sentiment throughout the world.  Is there anything we can do? And are there any reasons to be optimistic?

First, we need to end the era of easy money.  We need to stop subsidizing financial markets. We need to let banks and investors fail if they deserve to fail. We need to allow market forces to set prices, whether of financial assets or labor, and allow those prices to decline. We need to let our economy reorient itself from its short-term and transactional focus back to one based on long-term investment and long-term relationships.

We cannot continue to subsidize large corporations at the expense of smalls ones, just because large companies have the money to lobby. We must find a way to reduce pensions at the state and local level. We must return healthcare to a market system and recognize that one way or another healthcare consumption must shrink.  We need to limit the power of the federal government, return power to local governments and reduce regulations that favor monopoly.

We must not turn our backs on global trade, but recognize, and acknowledge two truths.  Yes, trade will always have negative effects on a small portion of the population (while having less obvious, but more significant positive effects on a larger portion of the population).  And yes, there has been an excess of outsourcing, offshoring and foreign trade over recent years.  But this is due to the prevalence of easy money and crony capitalism, not because of free market forces.

Similarly, we must recognize that while entrepreneurship is fundamental to a strong functioning and growing economy, the vast majority of recent entrepreneurship, specifically from the technology sector, has been wasteful at best, and extraordinarily damaging at worst.  Only an end to stimulative monetary policy will fix this.

Finally, we must encourage not discourage immigration. Immigration is morally correct, is good foreign policy and is economically beneficial. Immigrants must be viewed as assets, which they are, not liabilities. And given aging populations and poor economic growth, population growth through significant immigration is the only chance to delay the inevitable implosion of the welfare state for another generation.

Are any of these things realistic given today’s toxic, and corrupt political system? Not a chance. There is absolutely no realization whatsoever among the economics profession, the mainstream media or the political community of the disastrous consequences of “modern” central banking. Nor is there any reason to believe that those in power who have benefited so much from decades of easy money will change their viewpoint.

Similarly, there is no political will to accept the near-term pain required of weaning the economy off of monetary stimulus and letting the economy restructure as needed. There is no political will to cut pensions. No political will to view healthcare as a consumer good, not an entitlement. No political will to end crony capitalism, to end the power of special interests.  In short, there is simply no incentive for politicians to favor a long-term outlook. And herein lies the paradox of democratic government:  it works until it grows too big to work.

So what happens next?  Perhaps the world stumbles on for a while. Populists continue to come to power. The rich stay rich, the powerful stay powerful and the poor stay poor. Trade suffers, immigrants are shunned.  Economic growth is weak. Capitalism continues to be viewed as the problem, big government as the solution. Maybe another financial crises that we can inflate our way out of. Maybe another financial crises that we can’t. Sooner or later the music stops.

About 100 years ago, the world sleepwalked into World War 1. Today the world sleepwalks into the next global disaster. Regrettably, I see few reasons to be optimistic.

A quick note on the election of Donald Trump

Like many who live in one of the elitist bastions of the United States (New York City, in my case), I am disappointed and dismayed by the election of such a simple-minded, volatile and enormously unqualified man as president. But two incredibly important points need to be made.

First, about half of what Trump said during the election cycle was absolutely correct, most notably that Washington is corrupt, needs to change and needs to shrink. The other half (the “Wall”, Mexicans, immigration, women, Muslims, etc) is frightening. Which half will come to pass over the next four years? Who knows. That uncertainty is also very frightening.

The second important point, and an undeniable message of the election, is that Trump, and many other of his populist leader brethren around the world, are speaking to a vast proportion of the populace that feels left behind by the so-called modern economy.  And they are right.

But what is even more scary to me than a Trump presidency is the backlash, not from college campus protestors, but from those on the left, pondering how this all happened. They will blame the rise of Trumpism on the failures of capitalism and free markets.  The prominence of ultra-liberals and socialists like Elizabeth Warren and Bernie Sanders will grow.  And just as the power of the Republican moderates has been neutered by the far-right, the Democratic moderates risk being made irrelevant by the far-left.

As I’ve written about elsewhere on this site, the middle class is not being failed by free markets.  The middle class is being failed by lack of free markets.  It is being failed by corrupt big government and crony capitalism, by monetary policy that subsidizes Wall Street to the detriment of Main Street, and by regulation and tax policies that favor monopolistic large companies over competitive, and job-creating small ones.  The “modern economy” is not a natural outcome of flawed capitalism but a natural outcome of flawed government.

Finally, I speak directly to the young people and college students reading this.  As much as we must fight the bigotry, racism and exclusionary tendencies of Trump, we must fight the anti-market and socialist tendencies of those that will oppose Trump.  Neither’s policies will make America great again.  To be honest, I don’t know how to do this.  Maybe it means supporting moderate Democrats and moderate Republicans.  Maybe it means a viable third-party.  But we must do something, and we must do something now.

As always, feel free to comment or get in touch.

Why hasn’t the Fed’s loose monetary policy since the financial crises led to inflation?

Since the financial crises of 2008, the Federal Reserve has expanded its balance sheet from about $850 billion to about $4.5 trillion. In other words, the Fed has created $3.6 trillion of new money, representing more than 20% of U.S. GDP.

Back in 2008 and 2009 lots of smart people assumed that money printing of that magnitude would surely cause serious inflation, if not hyperinflation. And yet, with all that new money, inflation, at least as represented by the Consumer Price Index (CPI) has remained below the Fed’s target of 2%. Why? Why hasn’t the Fed’s extraordinarily loose monetary policy led to significant inflation?

In no particular order, here are seven possible explanations. Which ones are true? All of them.

1. Banks have not lent the money

Of all the reasons for why the Fed’s extraordinary monetary policy hasn’t led to inflation, this one is both the most obvious and the least controversial.

The mechanism of monetary policy is for the Federal Reserve to buy securities (e.g. government debt) from banks with newly created money. This newly created money is then available for banks to lend to businesses and consumers. Since banks historically earned no interest income on this idle money (“excess reserves”), banks should have incentive to lend the money in order to earn interest income.

The fable told in economics textbooks is that of the money multiplier and the reserve requirement. The story goes that once reserves are created on a bank’s balance sheet, the bank will then lend out all of it except the portion it is legally required to hold. For example, if $100 of new money is created by the Fed and deposited in a bank, and if the reserve requirement is 10%, then the bank will lend out $90. But that’s not the end of the story.

That $90 can then be used to buy machinery or hire workers or build a house, and that $90 will ultimately be deposited back at another bank (or the same bank, it doesn’t matter) by the receiver of the money (the machinery vendor, the worker or the homebuilder). Now the banking system can lend out another 90% of that $90, or $81. This process continues indefinitely ($100+$90+$81+$73+$66, etc.) and ultimately, $1000 of money is created, equal to the original amount divided by the reserve requirement (in our example, $100/.01). In other words, the money multiplier is 10, since 10x the Fed’s original deposit is created.

If this was the way the world really worked, then the $3.6 trillion created by the Fed would have really led to something like $36 trillion of new money (the reserve requirement in the U.S. is 10% on most balances). This would equate not to 20% of annual GDP but 200% of GDP. With that amount of newly created money, it is a near certainty that inflation would have followed.

Clearly, that hasn’t happened. Massive inflation hasn’t followed because the banks haven’t lent the money. The so-called multiplier effect simply hasn’t occurred. Instead, banks have kept most of the excess reserves on their own balance sheets, to the tune of $2.5 trillion. There are a number of reasons why.

First, the Fed, beginning during the financial crises began paying interest to banks on excess reserves. Hence, since banks do earn some income on unused reserves, they have less of an incentive to lend. Second, thanks to extraordinarily low interest rates set by the Fed (the Fed is targeting an interest rate when it buys securities with newly created money), banks earn relatively little interest income on the funds that they do lend. Why earn only a little income on risky lending when you can earn only a little bit less income without taking risk?

Third, banks are still repairing their balance sheets that never fully recovered after the financial crises of 2008. And given the severity of the last financial crises, banks now realize that they had better keep more reserves ahead of the next (inevitable) crises. Fourth, the Fed and other bank regulators, through various regulations and “stress tests” have significantly increased the amount of capital banks are required to have, and curtailed the amount of risk banks can take.

Lastly, and most importantly, banks haven’t lent because they can’t find very many creditworthy borrowers that want to borrow. Consumers, as a group, are still over-indebted. And businesses are facing the twin hurdles of global oversupply and “disruption” from easy-money fueled technology companies. With this onslaught, it is no wonder why most businesses have no appetite to borrow and to invest.

Before we move on, let’s revisit the stated purpose of easy monetary policy: to encourage banks to lend. As I said above, that banks aren’t lending all the money that the Federal Reserve created is common knowledge. And as I also mentioned, the Fed and other government regulators are actively forcing large banks to reduce risk. Seems a bit contradictory, doesn’t it?

This begs the following question: what is the true purpose of easy money, if not to directly stimulate the economy through increased lending? To recapitalize (bail out) banks? To raise asset prices? To simply appear to be doing something to help the economy, so that you’re not blamed for the next downturn?

2. The money has flowed overseas

Textbook economics dictates that the Fed can at least influence, if not control the level of inflation. By lowering interest rates and printing money, the Fed can stimulate lending, which stimulates businesses activity, which results in increased employment, which results in increased aggregate demand, which puts pressure on wages and ultimately prices.

However, as we’ve already discussed, banks aren’t lending as much as the Fed would like to U.S. consumers and U.S. businesses. But perhaps they are lending the money overseas? This is what is known as the “carry trade.” Made famous over the past two decades involving the Japanese Yen, it applies equally well to the United States. Simply put, borrow where interest rates are low (e.g. Japan and the U.S.) and then lend the money in emerging market countries where both interest rates and growth prospects are higher. In other words, freshly printed (digitally, that is) Federal Reserve money winds up not in the U.S. as intended, but instead financing Spanish real estate or Brazilian mines or Chinese factories.

So perhaps the textbooks are correct that low interest rates and new central bank money will lead to higher GDP and ultimately inflation. But in a world of free-flowing capital, that higher GDP and even inflation can just as easily occur in other countries rather than the country in which the money was created. In other words, in the small, closed economies of the ivory tower, perhaps an all knowing central authority can indeed control inflation. In the real world, perhaps not.

3. The CPI is understated

Like all government created economics statistics, the CPI is an enormously complicated statistical measure that very few people understand. To quote Wikipedia, the CPI is “a statistical estimate constructed using the prices of a sample of representative items whose prices are collected periodically.” But what are those representative items? What I buy and what you buy might not be the same. And what prices should be used? Prices in New York? In Detroit? In rural Alaska? And how should we collect these prices? And how often?

Yet those are probably the easy questions. There are much harder ones. What about quality changes? How should new cellphone features be factored into the price index? How about safer cars? Or less legroom when flying? And how about substitution effects? If the price of steak goes up, I might switch to chicken, which is cheaper. Since I no longer buy steak, should the price index only account for chicken? But if I really prefer steak, isn’t that really a reduction in my utility, and hence similar to a quality decline in my food consumption?

Perhaps the most controversial input in the CPI is how it accounts for housing, the single largest expense for the average consumer, and thus the largest component of the CPI. Rather than directly include the change in the price of houses, like it does for other consumer goods, the CPI takes into account something called “owner’s equivalent of rent” (OIR). This is a measure, based on surveys, for how much monthly rent homeowners believe that could get if they were to rent out their homes.

Leading up to the financial crises, housing prices where increasing at a rate double that of OIR. Many have suggested that the Federal Reserve ignored the obvious signs of the housing bubble because they were focused on inflation indices such as CPI, which vastly understated the inflationary impact of rising house prices.

The CPI is truly a black box, and I will be the first to admit that I have little understanding of what exactly is contained in that black box, or how that black box is constructed. And to be fair and truthful, you can find plenty of economists who will argue that the CPI overestimates true inflation (mostly due to quality increases) rather than underestimates inflation.

However, one thing is undeniable. As much as I hate to sound like a conspiracy theorist, I would be remiss to point out that the government has a huge incentive to understate the CPI, for at least two reasons. First, because many government entitlement programs, most notably social security are tied to cost of living increases. The lower the official inflation rate, the lower the entitlement payments the government is obligated to make. Second, inflation is a key component of reported economic output (i.e. GDP). The lower the inflation rate (in this case the GDP deflator), the higher the headline real GDP figure. All the better for incumbent politicians.

Long story short, given the government’s bias for lower inflation, I would guess that true inflation is perhaps 1-2% higher than the reported CPI number. But whether I am right or not, here’s the most important thing to remember. Measuring inflation is enormously complicated and messy. Even without a bias, this is art not science. So why should a central bank rely on such a figure, a figure who’s margin of error is probably at least a full multiple of itself, to justify printing trillions of dollars? To me, this is unwise, unscientific, undemocratic and bordering on criminal.

4. Asset prices are inflated

Take someone off the street (Main or Wall) and ask them what they think of the Federal Reserve. Assuming they know what the Federal Reserve is, they might say the Fed is doing a good job or a bad job. They might say that the Fed should do more to help the economy or less. They might say that the Fed should lower interest rates further or raise them. But if you ask them, regardless of their economic beliefs, to state one criticism of the Fed, I’d bet most would say the following: the Fed contributes to rising asset prices and to asset bubbles.

Remember the discussion of owner equivalent of rent from above? Just in case you don’t, we said that the housing component of the CPI reflects an estimate of changes in housing’s rental price rather than its sales price. Why is that? Because renting a home is considered consumption while buying a home is considered investment. The CPI is meant to measure consumption. Not investment. And therefore, not asset prices.

The Fed won’t admit they they create asset bubbles. But they do. Easy money in the 1990’s led to the first tech bubble. Easier money in the 2000’s led to the worldwide real estate bubble. Even easier money now has led to a bubble in all financial assets. Stocks, bonds, real estate, art, wine, you name it.

Let’s talk finance 101. Mathematically, the flip side of a low interest rate (technically, a low cost of capital) is a high valuation. In fact, the Fed has explicitly stated that they believe in what is known as the “wealth effect.” If your stock portfolio is higher and the value of your house is higher, then you are more likely to spend money, which should help the economy. Whether or not this wealth effect is real is irrelevant here. What is relevant is that higher asset prices are both a mechanical consequence AND a desired outcome of central banking’s loose monetary policy.

While the CPI might not reflect inflation, asset prices do. And the more risky the asset, the more the asset has been inflated. If this sounds scary, it should. Sooner or later, asset bubbles burst. When they do, financial crises tend to follow.

What asset inflation also means is that investors are paying more today for income tomorrow. We see this looking at metrics like Price/Earnings on stocks (very high) or Capitalization Rates on real estate assets (very low). These two metrics (essentially inverses of each other, hence the opposite direction) reflect, respectively, the high price paid today for a dollar of earnings from public companies or a dollar of cash flow from real estate investments.

Said another way, paying a high price now means that future rates of return on financial assets will likely be much lower than they have been in the past. This is great for today’s sellers of assets, who are receiving very high (inflated) prices. Sellers can use that money to consume, theoretically helping the economy (another impact of the wealth effect). However, buyers of financial assets pay more now, and will receive lower cash flows later on, reducing future consumption. So, not only does asset inflation result in those dangerous asset bubbles, it also pulls consumption forward, meaning lower economic growth in the future. Not to mention, you’re killing the business models of insurance companies and pensions, which rely on investment income to meet future obligations. Truly a disaster waiting to happen.

Long story short, while the $3.6 trillion the Fed has printed (and the corresponding reduction in interest rates) may not have led to very high CPI figures, it has helped lead to asset inflation. And the riskier the assets, the more inflated they are. This has gotten the world into trouble before. It will do so again.

5. Inflation is much higher for the wealthy

When we were talking about the CPI, I mentioned that there are many assumptions that have to be made in order to construct such an index. For instance, what products to include. Also, who to survey. In reality, the government folks (the Bureau of Labor Statistics or “BLS”) who are responsible for publishing the CPI do construct several different indices based on who they survey. For example, they have separate price indices for urban consumers and rural consumers. They also have a price index for consumption by the elderly.

To my knowledge, none of those price indices show inflation levels that would worry the Fed. However, I believe there is a subset of American (and global, for that matter) consumer that is experiencing inflation on a level that should concern the central banks of the world. That consumer is the wealthy.

Whereas the CPI has been running under 2% for many years running, I believe that a properly measured index for wealthy consumers would show inflation running at somewhere between 6-10% annually. In other words, perhaps 3-5 times the CPI. And the richer the consumer, the higher the inflation.

What has happened to this segment of consumer is a classic wage/price spiral. In a textbook wage/price spiral, money printing heats up the economy causing prices to rise. Workers seeing prices rise, demand higher wages. Higher wages result in businesses raising prices to offset higher wage costs. Higher prices cause workers to demand even higher wages, etc, etc, etc.

In today’s world, that is what is happening but the money first flows through Wall Street, and then flows to the owners and operators of high risk assets, such as hedge funds, tech entrepreneurs and public company CEOs. Those “workers” see their cost of living go up (e.g. housing prices in Manhattan or Greenwich, CT) and demand higher compensation and the cycle continues.

I freely admit that I don’t have hard data to back up my contention. However, observation and intuition says that the annual increase in the cost of living in a “1%” city like New York or San Francisco has clearly increased well beyond 2%. So have the costs of eating in a 4-star restaurant, imbibing a grand cru burgundy, staying in a Four Seasons hotel, paying full-fare for an Ivy League education (or buying your kid’s way into Harvard) and many more such worldly pursuits.

To be clear, I’m not advocating that you feel sorry for the rich. Not at all. For incomes of the wealthy have increased correspondingly. Remember, the point of this article is to explain why the Fed’s loose monetary policy hasn’t led to inflation, at least as measured by the CPI. However, in my view, it has led to very high inflation for this subset of consumers. Moreover, the asset inflation that I talked about above, plays a large role here too. For who owns most of the financial assets in the world? The wealthy. So just as there is price inflation for the 1%, there is massive wealth inflation.

If this sounds to you like I’m blaming the Federal Reserve for the enormous increase in income inequality over the past few decades than you are exactly correct. Regardless of intention, good or bad, the money that the Fed, and other central banks have printed has, for the most part, not flowed to Main Street. And it has not flowed to the middle class. Instead, it has gone to the wealthy, the super-wealthy, and the uber-wealthy. It has gone to Wall Street and to New York. It has gone to Silicon Valley and to San Francisco. It has gone to hedge funders and investment bankers, to tech entrepreneurs and venture capitalists, to CEOs and star athletes and perhaps worst of all, to politicians or at least ex-politicians.

6. The Fed is chasing its own tail

The next explanation for why the Fed’s easy monetary policy hasn’t led to inflation is what I will call the Fed chasing its own tail. What I mean is that contrary to intention, cheap money actually leads to lower prices rather than higher prices.

Let’s once again review the textbook rationale for easy monetary policy. Printing money and lowering interest rates leads to more lending and borrowing, and therefore to more investment and more spending than would otherwise happen without easy money. The implicit assumption is that the economy is operating under capacity (i.e. there is unemployment) and therefore, that the additional spending and investment expands the economy until it reaches full capacity, at which time inflation should occur.

Other things equal, I agree that low interest rates and easy money leads to more investment and, especially to more riskier investment. However, like everything in the real world, other things are not equal. As I wrote about extensively here, I believe that a substantial portion of the investment fueled by easy money actually retards economic growth, lowers employment and reduces overall prices (though not to the wealthy, as discussed above).

The prime (get it?) example I used in my previous article was of Amazon (see, “Amazon Prime”???). Amazon is a company that absent cheap money would likely not exist since it has no ability to actually make money. Yet, it has “disrupted” traditional retailers, resulting in hundreds of thousands of lost jobs, a multitude of retail bankruptcies and yes, lower prices.

This trend is prevalent throughout the economy with few companies or industries spared from Fed subsidized tech disruption. In other words, easy money does indeed spur some (i.e. tech) investment. But when taking into account the disruptive secondary effects, we find that overall investment, employment and economic activity are actually lower. Prices are lower too, contrary to what the textbook models state. Consumers benefit from lower prices for the time being. But mostly, the benefits accrue to a handful of venture capitalists, tech entrepreneurs and highly skilled developers, all part of the 1%.

7. Deflation is winning

I now present to you one final explanation for why central bank money printing has not led to inflation: it is being offset by deflation.

Let us remember why the Federal Reserve and the other central banks of the world are pursuing extraordinary monetary policy, to the tune of trillions of dollars created and zero or even negative interest rates. They are doing these things in response to the financial crises of 2008 and the global “Great Recession” that followed. Governments and central banks were, and are, desperate to prevent falling prices. This fear has led to a money experiment never before seen in 5000 years of recorded history.

We need to ask ourselves why did the financial crises happen in the first place. Obviously many, many books have been written about the causes of 2008. Unfortunately, nearly all of them have been wrong. As briefly as possible I’ll try to summarize the true causes.

The financial crises, like all financial crises, was a natural, market reaction to an economic bubble fueled by cheap money, subsidized risk and the perverse, short-term incentives that stem from cheap money and subsidized risk. What made this crises worse than most in recent history was that the market was trying to correct not years of financial mismanagement, but decades.

Erroneously believing that monetary policy could (and should) smooth out the business cycle and prevent recessions, the Federal Reserve has repeatedly printed money, set interest rates below their market rate and bailed out banks and other financial services firms. Each time it has done this, it has led to an even larger asset bubble and further reinforced the message that risk takers will be bailed out. Naturally, each bailout has been larger than the one before. 2008 was very large. Yet, the Fed, continued and wildly expanded its playbook, still believing that the cure for too much money is more money.

Unfortunately, the cure for too much money is not more money. Money needs to be extinguished. Oversupply needs to be reduced. Companies without profitable business models need to disappear. Over-leveraged banks, regardless of size, need to fail. Investors who took stupid risks need to learn painful lessons. This is the only way a free market can work. And this is the only way an economy can grow over the long-term.

Even though the central banks of the world have created trillions of dollars of new money, that new money is still fighting against gravity. That gravity is a massive deflationary current worldwide stemming from decades of easy money. So in one sense, what the Fed is doing is working. Prices are not declining, and are, in fact not far from the Fed’s target of 2% inflation. Moreover, we are not, at least officially, experiencing “depressionary” conditions.

Why hasn’t trillions of new dollars caused inflation? It has, but we don’t notice in measures such as the CPI because it is fighting the gravity of deflation. Sooner or later, however, gravity wins. It always does.

Conclusion – what comes next?

The past eight or so years have seen the central banks of the world print trillions of dollars. We see negative interest rates in parts of Europe and in Japan, something that has never happened before in human history. Now we hear calls from many mainstream economists for central banks to raise their inflation targets even higher, and louder and louder shouts for “helicopter money.”

Yet, inflation remains “stubbornly” below the target set by the Federal Reserve and most of the world’s central banks. Meanwhile, the world’s economies are growing slowly, if at all. And while the stock market and other financial asset prices continue to rise, income inequality continues to worsen, as does the political unrest that income inequality fosters. We see unemployed young people with student loans they will never repay. We see unprecedented amounts of homeless on our city streets. We see anti-capitalist, socialist and fascist politicians worldwide gaining votes and gaining power.

From this mess there are two conclusions one can draw: either central banks aren’t doing enough or what they are doing isn’t working. Mainstream economists have concluded the former. Print and spend, is what they say. How much to print and spend? Until it works. What if it still doesn’t work? Then print and spend some more.

However, one need only look at Japan to see this folly. More than two decades of extraordinary money printing and extraordinarily low interest rates have done nothing to awaken Japan from a generation-long depression. Meanwhile, Japan’s population ages and shrinks, an effect, not a cause of a stagnant economy.

I said it earlier and I will say it again. Easy money and subsidized risk cannot solve the problem of an economy ailing from decades of easy money and subsidized risk. But central banks and politicians will continue to try it. Because they have no understanding of what truly ails the economy and know no other way.

So what happens next? With no end in sight to more money printing and continued low interest rates, is inflation ultimately inevitable? Not necessarily. The U.S. and the rest of the developed world can continue limping along with slow growth, low inflation, continued income inequality, worsening demographics. We are all Japan.

Sooner or later, another financial crises will hit. Perhaps months from now, perhaps years, perhaps even decades. Will the central banks be able to save us again? For sure, they will try. But eventually they will fail. Whether the endgame is massive deflation or hyperinflation is unknowable and probably immaterial.The result will be the same. Crises. Depression. Ultimately, a financial reset.

It will be very painful. But it is, unfortunately, very necessary. And just maybe, 100 years from now, historians will look back and ask themselves how could we have been so primitive, so unwise, so naive to think that printing money is a good idea.

Mainstream Economics Myth 3: Insufficient aggregate demand causes recessions

In this series of articles, I use the term “mainstream economics” to illustrate what I believe to be the consensus views of economists and the ideas taught at most universities and found it most economic textbooks. However, for this post, I want to be a bit more specific about what I mean by mainstream economics. Perhaps more than anything else, what defines a mainstream economist today is the belief in Keynesian economics, or more precisely a Keynesian explanation of economic downturns and a Keynesian solution to economic downturns.

This view has dominated mainstream economic thought since the 1930s with a brief interruption in the “stagflation” days of the 1970s.  Ever since the global financial crises of 2008-2009, the Keynesian view has effectively monopolized economics.  Certainly in the U.S., and in most of the world, virtually all tenured economics professors, columnists, political advisors and central bankers adhere to the Keynesian religion.

Before we go any further, let me very briefly explain the Keynesian (and mainstream) tale of economic recessions.  First, what do mean by the term “recession?”  Conceptually, let’s call a recession a widespread (or economy-wide) reduction in economic activity (i.e. GDP) accompanied by high or rising unemployment.

The economy is merrily galloping along at full employment and in equilibrium.  Economic growth is robust and everyone who wants a job has a job.  Then, BOOM, out of the blue comes some unpredictable “shock” to the economy.  This shock causes consumer confidence to decline, which results in consumers spending less money than they should, which results in businesses having to cut investment and layoff workers.  With fewer employed workers, consumers as a whole spend even less money, businesses invest even less, layoff even more and  there is a vicious spiral leading to poor (or negative) economic growth and high unemployment.

In econ-speak, the economy suffers from “insufficient aggregate demand.”  That is to say, consumers are not spending enough money to keep the economy running as it had been prior to the “shock.”  In contrast to a free market view of  a self-correcting economy, due to somewhat mysterious structural reasons, such as sticky wages, the Keynesian economy now gets “stuck” in an “equilibrium” of less than full employment.  Finally, the economy cannot get “unstuck” and back to full employment without the aid of government (fiscal and/or monetary) stimulus.

In the next post in this series, Myth #4, we’ll discuss the Keynesian viewpoint that government (especially through monetary policy) can both prevent recessions and get us out of them.  Here, however I want to focus on the first part of the story, the Keynesian myth that insufficient aggregate demand is the cause of recession.

Now, let’s return to the mainstream, Keynesian story of recession.  To believe the Keynesian explanation requires four major assumptions, all four of which are unsatisfactory and/or false.  The first assumption is that the “shock” to the economy, that is the proximate cause of recession, is unpredictable. The second assumption is that the post-shock amount of aggregate demand is below the “correct” or so called “equilibrium” level. The third assumption is that the reduction in aggregate demand is due to “confidence” issues.  The fourth and final assumption is that it is demand, rather than supply that is the key driver of the economy (at least in the short-term).

Let’s start with the first assumption, that the “shock” is unpredictable.  In a small or undiversified economy, it is reasonable to say that some unexpected event might cause an economy-wide downturn.  For example, an economy highly dependent on agricultural output might experience recession due to drought.  An economy dependent on a single commodity (oil, for example) might experience recession if there is a decrease in the global price of that commodity.

However, in a large, diversified economy such as the United States, recessions are not caused by some unpredictable, exogenous shock.  They are caused by an unsustainable expansion of money and credit leading to an unsustainable expansion of investment.  When the “unsustainable” becomes realized, you get a recession.   In the old days, much wiser people than today’s economists and politicians understood that what we now call “recessions” where part of a business cycle.  And not for nothing did they call it a “boom-bust” cycle.  You don’t have the bust without the boom.

The second key erroneous assumption made by mainstream economists is that in a recession, the level of aggregate demand drops below what had been the “natural” or “equilibrium” level.  Of course, there is no question that demand drops from previous levels in a recession. However, if you believe that modern recessions always follow credit and investment booms, as I do, then you should understand that the previous (boom) level of aggregate demand was actually higher than it should have been and not some natural or equilibrium level.  Incidentally, whether equilibrium even exists (preview:  it does not) is something we will cover in Myth #9.

The third foundation of the Keynesian view of recession is that aggregate demand is reduced due to issues of “confidence.”  To paraphrase Keynes himself, “animal spirits” of both consumers and businesses in an economic downturn are depressed.  No doubt this is true.  But poor confidence is a cop-out reason for weak economic activity.  For low confidence is a symptom, not a cause of recession.

The fourth and final problem with the Keynesian explanation of recessions relates to the focus on demand rather than supply.  As we’ve stated already, the “boom” part of the economic cycle is a result of an unsustainable expansion of money, credit and investment.  This investment boom results in over-supply, whether it be over-supply of houses or factories or stores or mines or social networking apps.  When the investment bubble bursts, as it inevitably must, this over-supply must be pruned before robust economic growth can once again return.  It is the painful pruning of over-supply, through bankruptcies, layoffs, closures and investment cuts that is the true driver of the recession part of the cycle.  Hence, it is far more intellectually honest to refer to the cause of recession as excess aggregate supply (stemming from the boom) rather than insufficient aggregate demand (stemming from low confidence).

Long story short, I believe that the mainstream or Keynesian explanation for recessions is positively wrong.  Recessions are not caused by some unpredictable shock which leads a positive feedback loop of poor confidence and low aggregate demand.  Instead, recessions are the inevitable result of an economic boom fueled by an expansion of money, credit and investment.  More or less, this is the story espoused by the non-mainstream economists known as the Austrian school, and in future posts, I’ll cover this explanation in much greater detail.

Finally, as we have done and will continue to do in each of the articles in this series of mainstream economic myths, let’s ask ourselves why this topic is of vital importance.  Once again, we answer that what matters is not so much the explanatory, but the remedies inferred from the explanatory.

If recessions are indeed caused by insufficient demand then government can “cure” recessions by artificially creating more demand (i.e. spending) through the use of monetary or fiscal stimulus.  This is exactly the Keynesian prescription and exactly what economists have advised, and governments have implemented since the Great Depression of the 1930s and in unprecedented scale since the financial crises of 2008/9.

However, if the true cause of recession is the inevitable aftermath of an investment boom fueled by money and credit, then further stimulus is exactly the wrong thing to do.  Stimulus, among many other deleterious things, exacerbates the problem of oversupply, delays the inevitable correction and encourages the kind of risk-taking that caused the boom in the first place.

So as I hope you can see, understanding the root cause of recession is of vital importance to the long-term health of the economy.  And unfortunately, today’s consensus explanation is utterly wrong, and has caused immeasurable damage to the global economy.  We must fight to remedy this.

Mainstream Economics Myth 2: Market failures are common

I freely admit that I have a faith in free markets that few possess.  Yet anyone who believes that markets are perfectly efficient or result in an optimal condition or some kind of utopia is utterly naive.  Such conditions don’t exist in the real world.  However, it is equally wrong to believe that market failures are common, an assumption made by mainstream economists today.

There are two problems with the mainstream view that market failures are common.  The first problem stems from the mainstream definition of a “market failure.”  Economists define a market failure as anytime an outcome is less than perfectly efficient.  Perfection is a pretty high bar.  And I’m sure you can also appreciate that equating the word “failure” to anything less than utter perfection is a little bit unfair, demonstrating both mainstream economics’s misunderstanding of markets and its inherent anti-free market bias.

The second problem is to identify a “market failure” in situations where no market actually exists.  As we’ll see in a minute, this is more frequently the case when discussing so-called market failures such as externalities and public goods.

What do economists mean by market failures?  There’s a number of broad categories and I’ll very briefly address the ones that are most common.  First, that individuals are irrational.  As I’ve already discussed in Myth #1, this is viewed as a market failure justifying government action.

A second type of market failure is what is knows as information asymmetry.  For example, if I am a used-car salesman and you are in the market to purchase a used car, I clearly have more information about the cars I have to sell than you have about the car you might buy.  That I might be less than scrupulous and sell you a lemon of a car is considered a market failure and justifies to most economics government involvement in this transaction through regulation.  Yet, there are plenty of free market solutions that do a much better job than the government of dealing with information asymmetries.  These include reputation, branding and marketing, consumer agencies, consumer reviews, civil/tort law and insurance.

Simply put, information asymmetry is the every day state of the world.  It is impossible (except in silly economic models) for all parties in a transaction to have perfect information.  But as long as a transaction is fully voluntary to all involved parties, information asymmetry does not represent a market failure.

Another commonly assumed market failure is the natural monopoly.  Monopoly is indeed the enemy of free markets.  Yet, in a free market, there is no such thing as a natural monopoly.  Over the long-term (and that long-term need not be very long), the free market will always provide incentives for innovation that will result in substitutes and break a short-term monopoly.  This is true even for industries requiring substantial investment and exhibiting substantial economies of scale, such as transportation (e.g. roads and railways), utilities and telecommunications networks.  The only monopolies that can subsist are those that are government created, government sponsored, government subsidized or government itself.

A fourth category of market failure about which economists are fond of speaking is externalities and public goods.  A prime example of an externality is over-fishing, which is sadly all too common in waters that have no ownership.  Paradoxically, inefficiencies cause by over-fishing is viewed by economists as a market failure when it should be viewed as a failure of government to create a market.  You cannot have a market failure when you have no ownership of the underlying assets.  Timber is a good example.  Where forests have no private ownership you see over-foresting.  Where forests are owned by private enterprises you do not.

There is no question that externalities such as over-fishing, environmental damage, pollution and global warming are big issues to communities large and small.  But to use these examples to shout “market failure” in the absence of a market is wrong and unfair.

That last type of market failure that I’ll briefly mention is the economy’s ability to recover from an economic downturn.  That the economy does not return to full employment is viewed by mainstream economists as another failure of free markets.  We’ll discuss this issue in greater depth later on, but as a preview, I note that this view incorporates three errors:  1) not understanding the true cause(s) of the downturn, 2) not appreciating that government intervention inhibits the market from recovering and 3) faith in a very silly economic concept called equilibrium.

Before I leave this post, I want to answer the question, “so what.”  Why does it matter whether something represents a market failure or a failure to have a market?  It matters not so much in the classification of economic phenomena, for that is semantic, but in the remedies proposed.

Anytime economists spot what they believe to be (correctly or more than likely incorrectly) a less-than perfect economic outcome, they immediately point to government as the savior, usually in the guise of more regulation.  They rarely ask themselves whether a much better outcome would be to create a market where none existed.  And even in cases where that might not be possible, they infrequently bother to ask, or properly analyze, whether the government “solution” would result in even worse efficiency or outcome than the supposedly market failure itself.  But that’s a story for another post.

Mainstream Economics Myth 1: People are irrational

I know what you are thinking.  Did I make a typo here?  Don’t most economists believe in perfect rationality?  So isn’t the myth that people are rational?  No and No.

It is true that up until 10 or 20 years ago, the assumption of mainstream economics was of rationality.  Yet thanks (or no thanks) to the explosion of the (sub)field of behavioral economics, mainstream economists today operate with the assumption that individuals make all sorts of “irrational” decisions.  And economics use this assumption of irrationality to explain all sorts of so called “market failures” (see Myth #2) and to justify all sorts of government intervention to counteract these irrationally fueled market failures.

The truth is that individuals are indeed rational, yet neither the economists of yesteryear nor the economists of today get it right because they both are using a poor definition of the word “rational.”  The correct definition of a rational decision is one that you believe will make you best off (to be technical, that you believe will maximize the present value of your future utility).  It is not necessarily the decision that you believe will maximize your income or wealth.  It is not necessarily the decision that you believe will maximize your current utility or happiness.  It is not necessarily the decision that will actually make you best off.  You may make a poor decision for lack of information, due to miscalculation, stupidity or any other reason, but as long as you believe you are making the best decision for you, you are acting rationality.

Virtually all of the so-called “anomalies” to rational behavior that behavioral economics have “discovered” in recent decades are not truly “anomalies” if you use the proper (and colloquial) definition of rationality.  In other words, behavioral economics, though sometimes mildly interesting, is hardly worthy of the attention it has received.

And by the way, financial bubbles (which can and do exist) have absolutely nothing to do with investor irrationality.  I’ll have a lot more to say about the subjects of utility and rationality in a future post, but in the meantime remember to be skeptical whenever you hear economists justify government intervention in markets due to “irrational behavior.”

10 Myths of Mainstream Economics – Introduction

I am of the opinion that mainstream economics gets most things wrong.  Mainstream economists pretend to be scientists when they are not, use unrealistic assumptions to create simplistic models, confuse correlation with causation, ignore history, are biased towards action over inaction and favor the short-term over the long-term.  Perhaps more importantly than anything else, mainstream economics has forgotten the lessons of Adam Smith and fails to appreciate what a free market really means, and does not mean.

My criticisms are not original.  In fact, many if not all of them are held, though not widely held, by those outside the economics community.  Naturally, if economists were like all other members of the social sciences, these criticisms would be, well, academic, just like economists are supposed to be.

But economists are not just academics.  To paraphrase Keynes, policy makers are, “usually the slaves of some defunct economist.”   Economists have escaped from the ivory tower and have become entrenched in both government and finance.  In fact, economists have come to influence our world more than members of perhaps any other profession.  Worse, they have become the policy makers, but with less oversight and more power.

This has not been to the world’s benefit. I will go as far to say that economists, especially through their role as central bankers, have done more damage to the world than anything since World War II.  And not because they are malicious or evil like Hitler or Stalin.  Economists mean well.  They believe they are helping.

No, it is because they are clueless.  Not simply clueless to the damage they have caused (for they will of course deny this), but clueless to even the power they possess. And not because they are dumb.  On the contrary, they are mostly smart.  In many cases very smart.

Modern society fetishizes intelligence.  We are educated to believe and thus take for granted that smart people make the right decisions.  This is wrong.  It is not high intelligence that is the making of good policy, but wisdom.

Wisdom requires self awareness.  You must know what you don’t know.  Wisdom requires humility.  You must be able to admit what you don’t know.  Wisdom requires an understanding of history.  You must be able to see and appreciate the bigger picture.  Wisdom requires an understanding of human nature.  You must be able to interpret what fundamentally motivates people.

Economists don’t lack intelligence.  But they do lack wisdom. They have a false understanding of what drives decision making.  They are required to learn no history in their economic studies.  They act before they understand.  And most importantly, they take for granted what they should question.  It is not simply that they rely on assumptions that are unrealistic or wrong.  It is that they make assumptions that they don’t even realize they are making.

Over the next ten posts, I will highlight, in no particular order, what I believe are the ten largest myths of mainstream economics.  These are assumptions that I believe economists get wrong because they are unwise.  And the world is much worse-off because they get these assumptions wrong.  On many of these myths, I will have much more to say in the future.  But for now, I ask you to settle for rather short explanations.

Myth 1: People are irrational

Myth 2:  Market failures are common

Myth 3:  Insufficient aggregate demand causes recessions

Myth 4:  Central banks can micromanage the economy and prevent recessions

Myth 5:  Deflation is always bad

Myth 6:  Moderate inflation is good

Myth 7:  Liquidity in financial markets is always good

Myth 8:  There is such a thing as fundamental value

Myth 9:  Equilibrium exists

Myth 10:  Entrepreneurship is always good

Bonus Myth:  “In the long run we are dead”

Does the Federal Reserve’s loose monetary policy actually hurt employment?

It goes without saying that the Federal Reserve’s monetary policy has been extraordinarily loose since the financial crises of 2008.  The Fed has had a zero interest rate policy (ZIRP) for 7 years now, not to mention its 3 rounds of quantitative easing (QE).  The Fed’s balance sheet has grown over this time period from approximately $800 billion to $4.5 trillion.  And even if the Fed raises rates 0.25% as it is expected to do in December 2015, it will be years (or perhaps generations) before we see anything like normal monetary policy.

There are many, many reasons to criticize the money printing policies of the Federal Reserve (and all the other central banks of the world).  They blow serial asset bubbles.  They create moral hazard.  They favor borrowers over savers.  They cause future inflation.  They bail out undeserved banks. They create “too big to fail” conditions.  They encourage risky investment and speculation.  They contribute to income inequality.

Even supporters of easy monetary policy, a group to whom nearly all mainstream economists and politicians belong, will admit to some, if certainly not all of these risks.  But, they would argue that these risks are worth it.  Worth it to help the economy recover from financial crises.  More specifically, worth it to help employment.

As you might know, when it comes to monetary policy,  the Federal Reserve has two congressionally mandated goals.  One is stable prices.  The other is maximum employment.  Since inflation, at least as measured by the Consumer Price Index (CPI), has been quite benign, the Fed has felt compelled, or at least free, to focus on helping employment.  Hence the policy of low interest rates and printing money.

Related post: Why does loose monetary policy help employment (the mainstream argument)?

Low interest rates and printing money should lead to more borrowing, more consumption, more investment and more jobs.  But, and this is a big BUT, what if that’s not what happens? Put simply, what if the Fed’s policy of easy money is actually destroying jobs, not creating them?  That’s what I think is happening.  Let me explain why.

The Subsidy to Growth

First, recall one of the most fundamental principles of finance: the value of any asset, such as a company or its stock, is inversely related to its cost of capital. In other words, the cheaper a company can access money, the higher its valuation. Since interest rates are the primary driver of a company’s cost of capital, the Fed’s loose monetary policy acts as an enormous subsidy to all companies and all asset classes.

But, the Fed’s valuation subsidy does not impact all companies equally.  By suppressing interest rates the Fed has encouraged and even forced investors to take on incrementally more risk.  Or in technical parlance, risk premia have been compressed. The higher the risk of the investment, the more that the risk premium has been reduced, and the greater the increase in asset value.  So while all assets have received a valuation “subsidy” due to easy monetary policy, high risk companies have received a proportionally larger one.

You may be thinking, how can the Fed “force” investors to take on risk. We live in a free country.  Nobody is forced to invest in risky assets, right?  Not exactly.  Consider an insurance company or pension fund that has future liabilities that it must fund.  If the insurer or pension fund cannot meet its necessary investment return from safer assets then it has no choice but to take on more risk. The same concept holds for any investor that requires investment income, either now or sometime in the future.  Need a 6% return but very safe assets pay nothing?  Take on more risk.

In fact, risk premia are compressed not only by artificially low interest rates.  They are suppressed even further by another central banking policy, known as the “Greenspan put.”  Simply put (no pun intended), the Federal Reserve has made it very clear, since at least the stock market crash of 1987, that it will provide liquidity to support asset prices in the event of market “dislocation.”  Hence, with the implicit promise of a bailout, risk premia are even lower and valuations even higher.

By encouraging risk and suppressing risk premia, the Fed has subsidized high risk companies.  Who are these high risk companies?  More than anything else, these are high growth tech companies.  We see this subsidy through the high public valuations and trading multiples of the Facebooks, Twitters and Amazons of the world.  We see it through the private valuations of the “unicorns” such as Uber, Airbnb and Dropbox.  And we see it through the basic business model of venture capital where a higher and higher valuation for a winning investment can support more and more losing ones.¹

Creative Destruction or Subsidized Disruption?

Why is it a problem that the Federal Reserve is subsidizing high growth, high risk companies at the expense of lower growth, lower risk companies? Isn’t that a good thing and isn’t that exactly what the Fed should be doing to help grow jobs?

Unfortunately, the answer is no. High growth/high risk companies, as best exemplified by the tech industry are not adding to overall U.S. employment. In fact, in today’s world, high growth companies are typically net destroyers of jobs, not creators.  To use the trendy term, tech companies are “disrupting” traditional employers.

There is no better example than the internet retailer, Amazon. Amazon is great (at least in the near-term) for consumers.  You can shop in your pajamas, pay rock bottom prices and get fast, free delivery. And certainly, Amazon’s stock performance has been great for its investors and its management. But has Amazon’s enormous growth really benefited the U.S. economy? In terms of employment, the answer is clearly no.

As you can see in the table below, Amazon had about $100 billion of revenue over the past twelve months and accomplished that with approximately 154,000 employees. So in one sense Amazon created 154,000 jobs, or about 1.5 jobs for each $1 million of revenue.

Sounds like that’s great for the economy, right?  But that’s not the whole story.  For the most part, Amazon’s revenues come at the expense of traditional retailers.  So the question to ask is how many people would traditional brick-and-mortar retailers have employed if they, and not Amazon had generated those revenues.

Again, looking at the following table, we can see that Amazon’s competitors, such as Walmart, Barnes & Noble and Toys R Us employ far more people for each dollar of revenue.  A simple average of this metric for 6 traditional retailers indicates about 4.9 employees per $1 million of revenue, far higher than Amazon’s 1.5.  And this figure is probably understated since smaller privately held retailers probably have even more employees per dollar of revenue.

So for each $1 million of Amazon’s revenue, around 3.4 jobs in the U.S. economy are lost or never created.  Based on its most recent twelve months of revenue, Amazon is directly responsible for the destruction of more than 300,000 jobs.


Amazon destroys jobs


Now you may be thinking, doesn’t this sound like capitalism at work, like creative destruction? Old companies and old technologies being replaced by new companies and new technologies? The automobile replacing the horse and buggy?  The digital replacing the analog?

In a proper world with normalized interest rates, you would be correct. Investors would make discriminating decisions on where to invest their money based on a company’s business model, its projected profitability and cash flows, and its perceived risks. Let the company with the better product or the more efficient operations win, and if that company happens to be more productive and employ fewer people, so be it.

But thanks to the Federal Reserve, we don’t live in such a world. We live in a world where the cost of capital especially for high growth companies is much, much lower than it should be. This is a world where companies are too easy to start and money is too easy to raise. A world where growth trumps profitability and where not even a plan for revenue, let alone actual revenue is a prerequisite for an IPO or a multi-billion dollar valuation.

This is a world where established companies with real business models and real profits are “disrupted” by an endless wave of companies, large and small, with full bank accounts and empty business models. Facing this subsidized onslaught, good companies, those that are profitable (or would otherwise be), forego hiring or worse, are forced to shrink or go out of business.

Amazon, with about 20 years of operating experience, has yet to show that it can be consistently profitable. Given the total absence of barriers to entry in Internet retail, it likely never will. Absent easy money, Amazon would probably not exist, and certainly would not be the disruptive retailing giant that it is.

But this phenomenon of Fed-subsidized job destruction is not limited to the retail sector. It is happening in nearly all sectors of the economy.

Profitless companies like Twitter and Pinterest along with a near infinite number of money-losing Internet content providers have decimated the journalism and print media industries with their free content to the tune of significant job loss.

So-called “sharing economy” startups like Airbnb, a company with a $25 billion valuation and a business model based substantially on flouting local occupancy laws is doing its Fed-subsidized best to disrupt traditional hotel companies such as Starwood and Hilton, companies that employ hundreds of thousands.

Stock market darling but profit-challenged Netflix, a company with about 2000 employees, having put video retailer Blockbuster (60,000 jobs) out of business some time ago now has its well-funded sights set on disrupting the TV and Cable industries.

These are just a few prominent examples of Internet companies that probably shouldn’t exist, fueled by cheap money, eliminating American jobs.


Traditional critics of the Federal Reserve’s extraordinarily loose monetary policy cite the blowing of serial asset bubbles, potential future inflation and “moral hazard” as cautionary tales. But as we’ve seen, the Fed’s actions have a much more direct and immediate effect on the economy. Current monetary policy is hollowing out the economy by subsidizing companies that destroy jobs, to the benefit of a few fortunate investors and entrepreneurs, and to the detriment of many working Americans.

Monetary policy is also an example of the failure of mainstream economics.  That is, the failure of mainstream economic models to reflect the complexities of the real world.  Textbook models assume that printing money encourages risk taking.  This is correct.  They further assume that risk taking will lead to investment and job creation.  This is also correct. But they fail to realize that much of this new investment competes with established businesses and many of these new jobs come at the expense of a substantially higher number of existing ones.

To be fair, normalizing monetary policy will be a very painful process. In the short-term, many startups and even large tech companies will fail. Asset prices, including real estate and the stock market will decline.  It is highly likely that the economy will fall into a recession. Politically this is very hard to stomach. But stomach it we must if we ever want to return to a vibrant economy with real and sustainable job growth.



¹ Assume a venture capital firm requires a 20% annual rate of return (IRR) and invests $1 million per company.  Further assume that after 5 years time, the VC firm can exit one successful investment and all the other investments fail with zero return.  If the successful exit has a valuation of $25 million, the VC can fund approximately 10 total investments.  If the exit has a $100 million valuation, the VC can fund about 40 investments.  If the exit is valued at $1 billion, then the VC can afford to fund more than 400 investments.


Why does loose monetary policy help employment (the mainstream argument)?

That low interest rates and printing money leads to higher economic growth, job creation and a reduced unemployment rate is both textbook economics and conventional wisdom.  Whether it is true or not is another story, but here’s the rationale.  There’s at least four related mechanisms at work.

First, low interest rates encourage businesses to borrow.  For businesses, projects that might have been prohibitively expensive to fund at higher interest rates and a higher cost of capital can get funded.  Business expansion will naturally lead to a need for more workers.  Similarly, entrepreneurs will have the ability to raise money to start companies that would not have been founded in a higher interest rate environment.  More new businesses will again lead to higher employment.

Second, consumers, like businesses, will spend and borrow more.  Low interest rates discourage savings, since a saver earns less interest income.  Less savings means more consumption.  Plus, consumers are more apt to borrow money to fund consumption of homes, cars and other items.  Higher consumption means greater demand for goods and services, which encourages businesses to expand and of course, hire.

Third, low interest rates encourages banks to lend by increasing the amount of lendable reserves on the balance sheets of banks.  The Fed does not technically set the key interest rate that banks lend to each other (the Federal Funds Rate), but targets a rate by buying and selling securities (e.g. government debt) from banks.  Buying securities from banks adds newly created money to bank reserves that can be lent out to businesses and consumers.   Since banks earn little or no income on these excess reserves, they have an incentive to lend them and earn more interest income.  More lending for consumption and especially for businesses investment leads to job creation.

Fourth, low interest rates raise asset prices, which encourages consumption through what is known as the “wealth effect.”  Other things equal, the lower a company’s cost of capital, the higher its valuation. And this is true for all financial assets, including stocks, bonds and real estate.  In fact, raising asset prices is a direct objective of easy monetary policy.  The idea being that individuals with fatter brokerage accounts will go out and spend more money, thus encouraging business investment and employment, just like we mentioned above.  Whether this “wealth effect” actually happens is not without controversy, but it has been supported by statements from Fed policy makers, including former chairman Ben Bernanke.