Thu, 22 Sep 2011
Northern Trust Chief Economist Paul Kasriel makes the case for additional quantitative easing.
Jason Stipp: I'm Jason Stipp for Morningstar. As economic concerns intensify and policymakers debate possible solutions, the Northern Trust Chief Economist Paul Kasriel has an interesting proposition in a recent presentation that we need more quantitative easing. A controversial position. He's here with me to make the case today.
Thanks for joining me, Paul.
Paul Kasriel: My pleasure, Jason.
Stipp: So a lot of ideas have been floated out there about the current economic situation. A lot of folks are focusing on sovereign debt issues, the unemployment rate. People are talking about the consumer. But you made the case in your presentation recently that one solution that could help us has to do with credit, and credit is the thing that we should be focusing on. Why did you arrive at that?
Kasriel: Well from a study of history and a study of the Great Depression, there is a book recently published by Reinhart and Rogoff, and they document that whenever you've had a financial crisis, you've had very sluggish growth afterwards, and they did an excellent job of going back centuries and documenting the data, but they didn't explain the data. I think if you go back and look at the data, especially in the 1930s here and really we had a dress rehearsal for this in the early '90s, you see that contraction in what I call depository institution credit, essentially bank credit, is a factor that really has a big impact on the economic cycle.
We saw really quite severe damage done to our financial sector in this last recession. In fact, in 2008 versus '07, corporate profits for financial institutions contracted by 73%. To put that into perspective, in 1930 it was only 56%. Now fortunately we had a more aggressive Fed this time and that didn't degenerate into another depression. But since that time our banks, S&Ls, and credit unions have not been creating any new credit for the economy, and there is a very high correlation between the behavior of bank credit and the behavior of demand in the economy, and we are again not seeing very strong growth now.
Stipp: So I want to talk to you about demand in a moment, but before we get to that, you argue that we should consider more quantitative easing. Now this was a policy that the Fed followed a couple of times earlier in the recovery. Before we really get to your argument, though, I think that there's not a clear understanding of exactly the mechanism of quantitative easing and how it works and its relationship to that credit. Could you just walk us through that?
Kasriel: In its simplest terms, let's just have a little example, the Federal Reserve buys securities from a pension fund. The pension fund now has more cash, fewer securities. Where did that cash come from? Did it come from your account? Did it come from my account? No, it was like manna from heaven. The Federal Reserve created that cash. There is net new cash in the system.
Now, assuming that the pension fund wants to stay invested, it's going to go out and look for another asset to replace the one it sold to the Fed, and again to make things very simple, let's assume that there's a company that wants to buy some new computers at that time and is going to issue, let's say, a corporate bond to finance the purchase of those computers, and the pension fund buys that bond.
So what we have is a net increase in credit, a net increase in spending, and again it's a net increase in spending. You see if that bond were financed by a household, that household would be cutting back on its current spending, and that's called saving and transferring that purchasing power to the corporation, and that would just result in a change in the composition of spending, not a net increase in spending.
Stipp: Okay, so the quantitative easing program meant to make more of this "out-of-thin-air" credit available. We had two rounds of it [already], and some would say here we are with an economy that still seems to be stumbling. The quantitative easing didn't work, and you're saying we need more of it. So how do you bring those two thoughts together?
Kasriel: Well the first round of quantitative easing was that the Federal Reserve bought securities, but there's more to it. You have to look at the entire balance sheet of the Federal Reserve, and while it was buying securities, which was adding a credit to the economy, it was also contracting some of its other assets, like loans to commercial banks, loans to central banks. So when you look at the Fed's entire balance sheet during the first round of quantitative easing, there was actually a net decline in the Fed's balance sheet, so it didn't make a net increase in credit to the economy.
The second round did make a net increase, but when you look at combined Federal Reserve and commercial bank credit, the rate of growth in that combined credit was still quite modest compared to historical standards.
Now, this doesn't explain everything. There is still some unexplained movements in the economy like tsunamis in Japan that interrupted the shipment of parts to the United States for the production of cars, spikes in energy prices caused by geopolitical events. So, there are other things that can affect the economy, but based on historical relationships, things would've been even worse in the first half of this year had the Fed not engaged in quantitative easing.
Stipp: Since we're talking about the Fed, this week the Fed did come out with a plan known as "Operation Twist." This is not quantitative easing. Can you explain what this plan is and what effect you think it will have?
Kasriel: Well, for some reason economists believe that economic activity is affected by the behavior of long-term interest rates. So, I guess you can only get a 30-year mortgage. You can't get an adjustable-rate mortgage. So that's a myth.
And also, economists believe that falling long-term interest rates are a sign of easier monetary policy. If you look at the history, falling long-term interest rates typically are a sign of a weaker economy going forward.
But what the Fed is doing is it's simply changing the composition of its balance sheet. It's going to sell some shorter-maturity securities and use the proceeds to buy longer maturities, but it's going to keep its balance sheet, or Fed credit, constant. So it's not adding any net new credit to the economy.
Now, will this have a positive impact on the economy? Yes, the Fed's going to engage in more securities transactions. It's going to sell securities; it's going to buy securities, so, I expect that government securities dealers' profits will increase as a result of this, and that means that bar and restaurant sales in Lower Manhattan will be helped by this, but that's about it.
Stipp: I am sure the Fed was hoping for perhaps a wider-ranging improvement there.
Kasriel: I think it was, yes.
Stipp: So assuming that we did do another round of quantitative easing, created this credit out of thin air, as you say, some would argue that, "Okay, we have more credit, but the demand isn't there. People aren't looking for loans," and you mentioned a little bit before about a correlation between demand and credit. Can you say that the demand will be there if the credit is there?
Kasriel: Well, first of all we know there is one big demander out there. It's called the U.S. Treasury. It's borrowing $1.2 trillion at an annual rate. So there is a demander.
Housing today is more attractive as a purchase because of the very low mortgage rates and the decline in house prices. Housing is more attractive as a purchase than it's been in 50 years. There are people who in 1991 would have easily qualified for a mortgage. These are people with jobs who can make some down payment, have good credit records--who are being turned away today.
There are small businesses who've had long-term relationships with the banks, and they are now being refused credit, not because of any material change in their creditworthiness. You see, banks can't lend now because they're concerned about their future capital adequacy. They still have some residential mortgages that they're carrying on their books at inflated prices. They have some commercial real estate mortgages that they are carrying at inflated prices. If they use their capital today to support new lending, lend to that potential homebuyer, and tomorrow some of those previous loans go bad, then they're going to take a hit to capital, and they could be inadequately capitalized. So that's an issue.
The regulators now--I'm not faulting the regulators; I'm simply stating a fact--the regulators are going over your portfolio with much more scrutiny today, and the regulators know a lot of those loans are probably not at the value that you're carrying them at, but there is forbearance there.
And also the market demands that you be more highly capitalized. Again, going back to the regulators, if you're a bank and want to raise your dividend, want to buy back shares, or maybe increase salaries for top management, you have to get that approved by the regulators, and they are looking at capital. So I think that's the main constraint.
But in the interim while banks are in this process of healing, the Federal Reserve could step in and create some of the credit that banks ordinarily would have been creating.
Stipp: Last question for you: You gave some guidelines in your presentation about ways that the Federal Reserve could execute another quantitative easing program. Can you walk us through some of those steps?
Kasriel: Sure. You see, the way the Fed has operated in the first two episodes of quantitative easing is they said we're going to buy X hundred billion dollars of security over Y number of months. I don't know where they got those numbers from.
What they ought to do is say we are going to buy securities such that the growth in combined Fed and commercial bank credit is at some specified rate; let's say 4 1/2%, and I'm just using that as an example, although I happen to think that's probably about the right rate.
So what that means is if banks are not stepping up and maybe even pulling back, the Fed has to do more quantitative easing to get that combined growth rate up to 4 1/2%. And it also gives them an exit strategy because when banks are healed and they start lending again, then we're going to move above that 4 1/2%, everything else the same, and that's a signal to the Fed to pull back so that you don't violate the top of that range.
Stipp: Paul Kasriel, Chief Economist from Northern Trust, thanks so much for joining me today and for your interesting insights.
Kasriel: My pleasure.