On Eugene Fama and Fed QE

About one year ago, Professor Fama from Chicago caused quite a stir by stating that the impact of the Fed’s QE (or tapering) on the markets (and the economy) would be low and an exit from QE  possible in an orderly way. In other words, things (interest rates) would look pretty much the same with and without QE.  How did he arrive at this conclusion? Fama got his hands dirty by looking at the accounting impact QE has on the Fed’s balance sheet. The paper he wrote can be found here.

As Prof. Eugene Fama sums it up in this interview: the fed is merely exchanging assets with a low maturity (central bank reserves) with assets of a higher maturity (bonds) thereby affecting the relative interest rates between the curves – not the aggregate level! Fama comes to the stunning conclusion that short rates would even be lower without fed intervention, whereas long rates would be higher. Given the “high demand” for short them liquidity rates would go down, if the fed would not supply market participants with what they desire, whereas due to their selling of long-term bonds (the demand for money must come from somewhere), long-term bond yields would be higher if the Fed would not purchase them by issuing short-term assets (reserves). There is no free lunch: yes, the curve would be steeper, but the net effect on rates would be minuscule.

Three things spring out that I want to discuss in this post:

  • For Fama there seems not exist a fundamental difference between money and other (liquid) assets
  • Fama implicitly assumes a constant money supply
  • Only the steepness of the yield curve changes, but this does not matter

 From this interview an Austrian could conclude that Fama has no clue of monetary theory: money (monetary base) and money substitutes (deposits) have a feature that distinguishes them from other “highly liquid” assets (bonds): they can be used to make final payments, i.e. to extinguish debt, as Mises explained. If I buy bread at the bakery I can fulfill my obligation by paying him with base money (cash) or with deposits (card). If all I have are treasury bonds, I first have to SELL to somebody with money, to get money. Only then, the baker gets paid. Given this fundamental difference, you should be highly sceptical if somebody tells you that QE has no effect since it is merely shifting assets of different durations around.

Now, it is easy to see how Fama could come to this conclusion: it in good times when liquidity is ample this difference might not be perceived to matter. After all, bonds can easily be sold and turned into cash, so whats the difference?…”Let’s assume they are one and the same thing and make a regression analysis!”… just kidding. Market participants (not tenured professors apparently)  know that liquidity of an asset is relative:  good times usually do not last forever. In a crisis, for example, there IS a big difference between an asset and money. Heck, in a real crisis there is even a difference between money substitutes (deposits) and cold, hard cash, as many Cypriots have found not a long time ago. Summary: there is a fundamental difference and logic tells us it should matter.

Please also note, that Fama implicitly assumes a constant money supply, although we know – even by official sources – that this is not the case, not even desired. When he says that, without QE, interest rates would be lower at the short end and higher at the long end, therefore netting out somehow, he assumes that only what is sold (for money) can be used to buy things – which is true in a constant money supply world: if I want to buy more bread (thereby increasing its price at the margin), I have to spend less on other goods (driving down their price) – the aggregate effect (a dubious concept, anyway) should be negligible. However, in a world (such as ours), where the money supply grows, you can buy things without foregoing others. In other words, it is possible to sell your bonds to the fed thereby increasing the demand for money and lowering the short rates, without necessarily lowering the prices of the bond, as the supply of bonds is absorbed by an increased (base) money supply. Summary: with an expanding money supply there IS a free lunch for somebody. In times when economists really where theoreticians – and not merely statisticians – this was known as the “Cantillon-effect“. In our case the free lunch is enjoyed by banks and other bondholders: they can become more liquid (i.e. holding more reserves) without paying the price through lower prices on the bonds they are selling.

On the last point I partially agree with Fama: QE really does impact the slope of the yield curves. Contrary to Fama, however, I think this does have an impact. After all, if long-term and short-term assets can be interchanged without further consideration, we have to face the question of why yield curves, where different rates are quoted for different maturities, exist at all. For those familiar with “Austrian Business Cycle Theory” (ABCT) it will be no surprise when I state that the slope of the yield curve matters a lot to economic actors. Not just to carry traders, but to corporations in the “real economy” as well since they base their capital spending decisions on the price signals received from the yield curve. Summary: as expected, Fama is not familiar with ABCT. In best Chicago School tradition he assumes money neutrality, ignoring the lessons from the recent financial crisis.

I applaud Fama for his effort to tackle a real world problem. I do think that he tried to approach the problem in an objective, non-partisan way. Sadly, this is more than can be expected from most professors nowadays, who are either politically corrupt or who only write for other academics about irrelevant topics. Fama, however reveals a serious lack of knowledge of history of economic thought. In intellectually arrogant fashion,  typical for mainstream economists, he has tried to tackle the problem without even considering historical debates of similar problems.

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