What Quantitative Easing Couldn't Do

It staved off crisis. But the risk of "debt deflation" remains real.

Since the start of the subprime financial collapse in 2007, the Federal Reserve System has been engaged in an extended life support operation. Part of this effort has been focused on money and financial markets, part on trying to restore that necessary ingredient known as “confidence.” But now in its sixth year, the extraordinary efforts that have seen the Fed balance sheet triple in size are being wound down. The massive intervention in the markets for government and mortgage debt known as “quantitative easing” or QE is being slowly withdrawn. And as the Fed’s giant transfer from savers to debtors is ended, the question naturally arises: what do we do now?

Seen in historical context, the Fed’s actions were entirely appropriate. When the private sector fled from the debt markets starting in 2007, the central bank slowly but steadily filled the void with low interest rates and eventually QE, which included the purchase of hundreds of billions of dollars in debt. The great American economist Irving Fisher described the danger of "debt contraction deflation," where losses on bad debt overwhelm the markets and lead to a catastrophic contraction of private capital, consumer demand and economic activity. In a very real sense, Fisher and John Maynard Keynes both were saying the same thing in the 1930s when they advocated massive government action.

Using QE, the Fed avoided the terrible threat of deflation, but QE alone is not enough to restore real growth to the US economy. “QE cannot ever be considered a permanent replacement for private sector debt/equity,” notes one of America’s veteran securities lawyers. “It only creates a bridge until the private sector reabsorbs the investments; as fear subsides and investors move back into the market.” But sadly, even as the Fed has worked to repair confidence, Congress and others have done just the opposite. Deliberate acts of idiocy such as the Dodd-Frank Wall Street reform law, the Basel III capital rules and a general atmosphere of punitive regulation are discouraging private risk taking and stifling job and economic growth.

Private investors have crowded into havens of liquidity such as stocks and blue-chip debt, leaving vast portions of the US economy without capital. The lack of credit available to the US housing sector, for example, ought to cause national apprehension. Inside Mortgage Finance, for example, reports that issuance of all mortgage securities is down nearly 57 percent compared to a year ago, the lowest level in five years. Bank lending is shrinking. Despite QE, nearly one third of Americans still live in homes that are worth less than their mortgages.

The missing ingredient in national policy, sadly, is a determination to restructure the US economy and fine tune public policy in order to attract new capital and create opportunities for growth. The Fed has accomplished the first step by calming investor fears and restoring some degree of normalcy to global financial markets, but what is needed now is a careful and pragmatic approach to restoring incentives for private investment and growth while we bring federal spending under control. In order to achieve this, however, we must move cautiously, with one eye on the private debt markets and the other on the still-parlous state of the US economy.

The trouble with the current Fed policy of “tapering” QE is that it is an attempt to fulfill market expectations of a return to “normalcy” in the economy without doing any of the hard work. The Fed can and should raise interest rates if, and only if, the demand for money causes that to occur. But if we raise interest rates as an isolated policy that does not consider market responses, we will repeat the key mistake of the Great Depression and slide into a deflationary sinkhole.

First and foremost, Congress and the American policy community need to understand that many of the supposed “reforms” put in place since 2008 are actually making the economic situation far worse. The Dodd-Frank law, in particular, has cut millions of Americans off from mortgage credit, a terrible error that now threatens to force home prices downward in the coming year. Basel III is likewise an almost comical error in judgment, offering the palliative of higher capital for banks when the real problem behind the subprime crisis was securities fraud—as it was in the 1920s.

Second, the Fed’s obsession with protecting the ability of the Treasury to borrow ever more money needs to be replaced by a progressively more critical attitude towards our fiscally dissolute Congress. The massive borrowing and federal deficits of the past several decades, combined with low-interest-rate policies from the Fed to accommodate our collective fiscal recklessness, is the chief engine of instability in the US economy today. QE was first and foremost a bailout for Congress and the Treasury.

And third, we need to develop a combination of tax cuts and fiscal incentives to start to generate growth and encourage the private sector to become more engaged in the process of restructuring. My former boss Rep. Jack Kemp (R-NY) advocated lower taxes and sound money as the foundations for economic growth. But sadly the Republican-controlled governments in the 1980s and 1990s lacked the courage to fix America’s chronic fiscal problems.

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