QE3 Could Fail Due To A Liquidity Trap
The Fed’s announcement on Thursday caused a rally for stocks and a fall for bonds. However, data from the bond market didn’t make much sense; the long end of the curve was rising and the short end falling. I was confused the long end because traders were selling bonds quickly, whereas the Fed had promised to buy Mortgage Backed Securities (MBS) – so the long end should have been stable or falling.
Adding to the confusion, I read the Fed’s statement on its website and it wasn’t clear if it was going to buy bonds in the open market or if these purchases were going to be made just to add liquidity in the banking system. If it’s the latter, then I wouldn’t make much of this event as the US has been in a liquidity trap for a long time. New money from a round of QE would just become trapped again.
I’m not sure about how this printed money would impact the country’s GDP, but right now it’s a safe assumption that most of it will be going towards stocks. The rapid sale of bonds on the long end of the curve shows that investors are planning to use that money for stocks and commodities as they expect inflation. So, the Fed’s money will be going to institutional banks and would be reinvested. The point of all of this is that this money would not have a high velocity – an argument I made in my previous article.
Stocks and commodities will continue to rise, but that is not what the US needs. A liquidity trap is broken people’s fears subside, and they do so when uncertainty ends. The new money will flow from the Fed to the banks, who will invest it in stocks and metals, and it would end there. Money won’t flow into the broader economy, where its velocity could help GDP growth.
QE3 might not even provide a strong rally for the stock market. $40 billion a month could be absorbed by the enormous market capitalization of stocks.
In the end, the Fed’s success or failure will depend on whether fear and uncertainty is removed or not.
Examining the liquidity trap
Consumers are the real force behind economic growth. If they save money out of fear monetary policy won’t be able to stimulate the economy.
Keynes believed the government spending was the best way to break the liquidity trap. There were two other options available as well, which are mentioned below:
- The government could lower interest rates. However, in a recession people may be so unwilling to borrow or spend that it would become impossible to lower interest rates after a certain point, i.e. when they reach 0.
- The government could increase the money supply (print money). Theoretically, it would work as this money would go around the economy, allowing people to invest and consume more. However, when a recession creates uncertainty they tend to hoard the cash instead, and it doesn’t travel around the broader economy, i.e. a liquidity trap.
The US has been stuck in a liquidity trap ever since quantitative easing began. The chart below illustrates this fact:
The savings portion of M2 travelled along with M2 itself till 2007, and travelled much higher after 2008. This roughly corresponds with QE1 in November of 2008. While it cannot be said with certainty that quantitative easing was the reason why Americans started to save more, it’s safe to say that QE programmes didn’t do anything to address the public’s fears.
The following chart examines spendable cash in the economy since 2007, a key driver for growth.
Spendable cash is the key factor behind GDP growth. Note that it fell from $3.96 trillion in Nov 2008 to $3.59 trillion today. The Fed has spent $3 trillion since they started the quantitative easing rounds, and most of it has gone into savings. Had this money been circulating in the economy, it would have had a multiplier effect on GDP growth.
Unemployment is another way to measure this phenomenon. A reduction in spendable money supply is correlated with an increase in unemployment. The chart below shows the unemployment rate from 2008:
The unemployment rate started to climb when spendable money supply decreased.
All of this leads us to GDP growth:
When we look at the inflation adjusted GDP, we find out that there hasn’t been any growth at all since the recession. The conclusion is that QE rounds have not addressed the fear in the public and investors, which is hindering growth.
Even though we’ve long forgotten Keynes, some of his words still have some wisdom. On the liquidity trap, Keynes said:
If investment exceeds saving, there will be inflation. If saving exceeds investment, there will be recession. One implication of this is that, in the midst of an economic depression, the correct course of action should be to encourage spending and discourage saving.
Americans would get out of this problem once they boost their own confidence. Monetary and fiscal policies have not worked to end the fears so far. I could even argue that these measures are leaving the people worse than they were before; now, the people also have to deal with credit downgrades. When bonds start to reflect these downgrades, the country would have to carry even more costs than before.
Predictions for the stock market
I believe the market rally isn’t reflective of what’s going on, so it shouldn’t last that long. While the duration is analysed in another article, I support my argument by examining the current market situation. The country is experiencing a high amount of unemployment, there is a liquidity trap, the fiscal cliff exists, the eurozone is even worse off, China is experiencing a hard landing and debt is rising at an alarming rate.
In the end, QE3 is producing a short rally in stocks and commodities.
Update (20 Nov 12): The rally was short-lived, as the S&P 500 soon experienced a massive sell-off and reached a new low near 1340. QE3 is in the background now as the fiscal cliff looms.
More on Quantitative Easing:
- QE3 Part 1: Velocity of Money and Quantitative Easing
For further debate on the Fed’s policies, I recommend Ron Paul’s book: