Modern Economists Misinterpret Quantitative Easing

Monday, 29 Nov 2010 07:02 AM

By Barry Elias

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If you are interested in promoting long-term, sustainable economic growth, I submit the velocity of money is more pertinent than the quantity of money (quantitative easing).

Apparently, many modern economists haven’t focused sufficiently on this economic parameter.

Simply stated, the velocity of money indicates how frequent monetary transactions occur. The same dollar, through multiple transactions, creates one dollar of income for multiple entities. Therefore, income can expand via numerous transactions while the monetary base (supply of physical currency, which excludes credit in the form of loans) remains constant. Hence, sustainable economic growth can be achieved with a stable supply of physical money.

The art is to create an environment that empowers monetary velocity to remain vibrant and grow.

The St. Louis Reserve Bank reports that monetary velocity fell 75 percent from mid-2008 to mid-2009, despite a 100 percent increase in the monetary base (from nearly $1 trillion to almost $2 trillion). An increase in the quantity of dollars is insufficient to generate the utilization of those dollars: they remain static in the form of excess reserves, available for transactions at some later date.

In 1978, MIT economist Nathan Mass developed a model to describe why excess liquidity in the form of monetary aggregates (capital) is insufficient in creating meaningful economic activity and growth. This scenario is referred to as the “liquidity trap.” He stated: “The weak impact of monetary stimulus on real activity arises because additional money has little force in stimulating additional capital investment during a period of general overcapacity.”

“Due to persistent excess capital, which cannot be reduced as fast as labor can be cut back to alleviate excess production, unemployment actually remains higher on the average following the drop in production."

Essentially, an increase in the monetary base exacerbates the overcapacity of capital. The excess supply of capital reduces its cost and provides less incentive to innovate and create investment opportunities. The excess monetary aggregates may be myopically consumed by endeavors with little future potential.

Ironically, higher borrowing costs (interest rates) provide additional incentive to generate more innovative, long-term investment opportunities. This enables an environment that fosters strong, sustainable economic growth (healthy transaction velocity with a more stable monetary base).

In analyzing a regression analysis of the monetary base and velocity in the United States, John Mauldin, president of Millennium Wave Advisors, demonstrates how a stable monetary base with nearly 0 percent growth can generate a growth in velocity and income of 6 percent (note: income equals quantity of money times velocity). The study also indicates that a percentage increase in the money base ironically causes a decrease in monetary velocity by an equal percentage. The net positive effect on economic growth is low, if any.

The same analysis for Japan is striking: it suggests a zero percentage gain in velocity with a stable monetary base of 0 percent growth. This reflects the ill-fated accommodative monetary policy in Japan for two decades, which solidified an intense liquidity trap. Monetary velocity for Japan would increase only if the monetary base contracts. Less available money may actually inspire innovative, entrepreneurial activity, which creates positive economic feedback: an environment that can sustain long-term growth.

The U.S. can avoid the liquidity-trap environment experienced in Japan by focusing less on the quantity of money (quantitative easing) and more on its velocity.

The Japanese phenomenon was unique in that quantitative easing (creation of monetary aggregates) was concurrent with a massive increase in debt issuance. During the U.S. depression of the 1930s, government debt as a percentage of GDP was reduced to 125 percent from 270 percent (a 50 percent decrease). However, total debt (private and public) in Japan tripled in the past two decades to 470 percent of income, according to a 2008 McKenzie study.

Debt issuance is highly inefficient in promoting economic growth. The level of debt required to generate a dollar of income quadrupled during the past four decades in the US: from $1.53 in 1960 to $6.00 in 2000. Moreover, studies by Dr. John Taylor, of Stanford University, suggest the velocity of money generated by government expenditures is roughly 50 percent of that for private expenditures, which translate to lower economic growth.

In addition, the structural and policy issues that precipitated the flawed monetary policy in Japan don’t exist for the U.S. Economic activity in Japan was predominantly focused on quality enhancement rather than creative and innovative enterprise. Diminishing economic returns set in after several decades of extraordinary economic growth following WWII. The business structure in Japan was also highly dependent on the domestic integration of horizontal and vertical supply chains, including capital financing.

Government policy exacerbated this dysfunction by protecting the export-oriented domestic industries with high import tariffs and instituting lifetime-employment contracts for workers. To remedy the artificially high trade surplus of Japan with the U.S. and the world, the1985 Plaza Accord coordinated a global currency intervention. The goal was to increase the value of the Japanese yen, thereby increasing demand for global imports and reducing demand for Japanese exports.

As export activity diminished, unemployment, income, and economic activity began to deteriorate. The Japanese had an extraordinarily high level of private savings. This capital was then diverted into real-estate and financial assets to provide a return to alleviate decreased earned income. These assets appreciated in price significantly. Sluggish economic activity couldn’t support these price levels, and in 1989 these markets began to experience a tremendous decline.

During the next two decades, total government debt outstanding tripled. As a percentage of GDP, government debt quadrupled to 200 percent and total debt (private and public) tripled to 470 percent. Ninety percent of the government debt was financed by private-sector savings. According to the Bank of Japan, the savings rate decreased from 11 percent of disposable income to 2 percent during the past decade.

Japan reduced long term interest rates during this time to 1.4 percent from 7.5 percent to keep debt service constant or declining, despite a sizable increase in the quantity of debt.

The Woodrow Wilson Center indicates the demographic composition in Japan portends future economic difficulties with 25 percent of the population age 65 or older (to 33 percent in several decades). This population generates lower income, greater public expenditures, and therefore more debt to finance. Overall, there will be less available savings and more debt issuance. To attract capital, interest rates will invariably rise.

Generally speaking, global macroeconomic factors suggest an increase in the supply of debt, greater associated risk of the debt, and a lower supply of available funds to finance this activity. This portends an increase in interest rates that offer a viable return on investment for risk-based capital.

In the U.S, since quantitative easing was formalized several weeks ago, the interest rate on 30-year U.S. Treasury bonds increased from 3.93 percent to 4.29 percent.

This result may be antithetical to that expected by the modern economist.

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