QE 2 - Will it do more good than bad

[phattonez]

This is a HUGE misnomer, and I really wish people would understand what they are thinking when they write or say this. If you have debt, inflation will make paying back that debt harder. If your job is most similar to most people's jobs, then your paycheck is not tied to inflation. The gas to drive to work costs more. The food costs more. Clothes cost more... If you have debt tied to anything with a variable interest rate then as inflation goes up so to do the interest rates and minimum payments.

And don't forget the complaints it causes amongst lenders.

 

[phattonez]

Yes supply and demand can dictate price, but so can herd mentality, irrational exuberance, market manipulation, monopolies, and access to credit.

Herd mentality does not exist in the long run. Reality must hit at some point. Such is the case also with irrational exuberance and market manipulation. Monopolies do not exist, as everything competes for your money. Meat doesn't just compete with meat, it also competes with chicken, with fish, with rice, with fruit, etc. Access to credit can only be artificially manipulated for a short while. Eventually reality hits and access to credit is determined by what we've actaully put away. Besides, credit helps determine how much we invest in future production. I get the feeling that you don't understand the true importance of capital.

Also, there are some who argue whether supply creates the demand or whether demand creates the supply. But thats probably a discussion that needs a thread of it's own.

It's both, of course.

 

[drz-400]

When inflation is realized, people spend less of their total income proportionally. They try to save more to get their time preference to where they want it. During the inflation but before it is realized, yes production does increase because the available capital seems to increase. However it's not the case, and when that is realized what happens to capital markets?

That is most likely because the amount of capital does increase if output is increasing. Investment spending tends to have the largest swings over the course of the business cycle. As far as the "realization" of inflation, I think that is pure speculation as ones "time preference" is determined by personal preferences. Furthermore, inflation would result in a higher rate of return for capital investors as it decreases the real interest rate.

 

[phattonez]

That is most likely because the amount of capital does increase if output is increasing. Investment spending tends to have the largest swings over the course of the business cycle. As far as the "realization" of inflation, I think that is pure speculation as ones "time preference" is determined by personal preferences. Furthermore, inflation would result in a higher rate of return for capital investors as it decreases the real interest rate.

So the fact that the savings rate started ticking up after home prices fell was purely a coincidence? People lost the security that they thought they had in their home equity; of course they are going to save more after a loss like that.

 

[drz-400]

So the fact that the savings rate started ticking up after home prices fell was purely a coincidence? People lost the security that they thought they had in their home equity; of course they are going to save more after a loss like that.

No, peoples expectations about the economy changed. How can you fabricate that into, "inflation was realized?"

 

[phattonez]

No, peoples expectations about the economy changed. How can you fabricate that into, "inflation was realized?"

Why did people's expectations about the economy change? Because home prices fell. In this specific case it wasn't inflation perse that was realized, but the overproduction which eventually lead to a fall in price. If home prices didn't fall then you wouldn't have seen the rising savings rates.

 

[oldreliable67]

To paraphrase John Hussman's excellent piece, here, the much-anticipated QE II presumably has two operating targets. One is to directly lower long-term interest rates, possibly driving real interest rates to negative levels in hopes of stimulating loan demand and discouraging saving. The other is to directly increase the supply of lendable reserves in the banking system. The hope is that these changes will advance the ultimate objective of increasing U.S. output and employment, i.e., the Fed's dual mandate.

Hussman's analysis is quite compelling, so permit me to quote him:

"To assess whether QE is likely to achieve its intended objectives, it would be helpful for the Fed's governors to remember the first rule of constrained optimization - relaxing a constraint only improves an outcome if the constraint is binding. In other words, removing a barrier allows you to move forward only if that particular barrier is the one that is holding you back.

On the demand side, it is apparent that the U.S. is presently in something of a liquidity trap. Interest rates are already low enough that variations in their level are not the primary drivers of loan demand. Loans are desirable when businesses see opportunities to make profitable investments that will allow the repayment of the loan, without too much uncertainty. Similarly, loans are desirable when consumers see opportunities to shift part of their lifetime consumption stream toward the present (or to acquire durable items such as autos or homes which provide an ongoing stream of benefits), and where they also believe that their future income will be sufficient to service the debt.

Broadly speaking, neither businesses nor consumers are finding attractive borrowing opportunities, or have sufficient confidence that they will be able to repay the loans and end up better off. A few years ago, individuals did have the confidence to shift a portion of their lifetime consumption to the present because the values of their homes and other financial assets gave them the impression that their future consumption needs were well covered. Lax lending standards created a feedback loop of soaring mortgage debt, consumer debt, home values, and consumption. At the corporate level, the return on equity capital was progressively boosted by taking on increasing leverage, which eventually reached catastrophic levels in the financial sector. The subsequent collapse forced the recognition among consumers and businesses that their ability to service debt, based on expectations about the future value of their assets, was not as strong as they previously believed.

Instead, businesses and consumers now see their debt burdens as too high in relation to their prospective income. The result is a continuing effort to deleverage, in order to improve their long-term financial stability. This is rational behavior. Does the Fed actually believe that the act of reducing interest rates from already low levels, or driving real interest rates to negative levels, will provoke consumers and businesses from acting in their best interests to improve their balance sheets? "

On the supply side, a result of quantitative easing is an increase in the amount of lendable reserves in the banking system. As with the demand side, this is not a constraint that is binding. The liquidity to make new loans is already present. U.S. commercial banks already hold $1.066 trillion of reserves with the Fed, and another $1.626 trillion in Treasury and agency securities. The corporate sector also holds huge precautionary balances.

Hussman concludes:

"further attempts at QE are likely to have little effect in provoking increased economic activity or employment. This is not because QE would fail to affect interest rates and reserves. Rather, this policy will be ineffective because it will relax constraints that are not binding in the first place."

IMHO, Hussman is quite correct: quantitative easing in the form of direct purchases of U.S. Govt securities will likely not move the economy forward with respect to the Fed's dual mandate because it does not directly address the constraints currently holding the economy back.

 

[drz-400]

Why did people's expectations about the economy change? Because home prices fell. In this specific case it wasn't inflation perse that was realized, but the overproduction which eventually lead to a fall in price. If home prices didn't fall then you wouldn't have seen the rising savings rates.

Well, then if anything you should be arguing that when deflatoin (in housing prices) is realized then it results in a recession.

 

[phattonez]

Well, then if anything you should be arguing that when deflatoin (in housing prices) is realized then it results in a recession.

The overproduction was a result of inflation. Realization of inflation is that assets are worth less than you thought. Home prices were inflated, and to keep them inflated would have just made the crash worse. The bust was inevitable once home prices began to be jacked up.

 

[drz-400]

The overproduction was a result of inflation. Realization of inflation is that assets are worth less than you thought. Home prices were inflated, and to keep them inflated would have just made the crash worse. The bust was inevitable once home prices began to be jacked up.

Poeple's predictions of the future value of goods in the economy are not systematically wrong. For the economy as a whole, people's decisions are correct on average.

 

[phattonez]

Poeple's predictions of the future value of goods in the economy are not systematically wrong. For the economy as a whole, people's decisions are correct on average.

In general this is true, so why were people so wrong in this case?

 

[drz-400]

In general this is true, so why were people so wrong in this case?

Because people make decisions about the future based on the past. Housing prices haven't trended down since the early 80's.

 

[phattonez]

Because people make decisions about the future based on the past. Housing prices haven't trended down since the early 80's.

But they went down this time, which was due to overproduction (malinvestment) and bubble formation in this market. So what caused the formation of the bubble that was this mass delusion.

 

[oldreliable67]

The overproduction was a result of inflation. Realization of inflation is that assets are worth less than you thought. Home prices were inflated, and to keep them inflated would have just made the crash worse.

What, very low interest rates and lax mortgage lending standards didn't play a role?

When Paul Krugman, in a now somewhat infamous but seldom-mentioned column in 2002, declared: “Alan Greenspan needs to create a housing bubble to replace the NASDAQ bubble.” And all this time, we thought he did just that. But now you're saying it was inflation and only inflation that caused it?

 

[Moot]

Alright! Appeal to popularity! That's the way to do it!

Today, most mainstream economists favor a low steady rate of inflation.....
Hummel, Jeffrey Rogers. "Death and Taxes, Including Inflation: the Public versus Economists" (January 2007). p.56

AEAweb Journal Articles Display

Many people think that inflation makes them poorer because it raises the cost of what they buy. This view is a fallacy, however, because inflation also raises nominal incomes.....
Principles of Economics - Google Books

It appears that you are one of the many people who believe the fallacy mentioned above.

 

[Moot]

Herd mentality does not exist in the long run. Reality must hit at some point. Such is the case also with irrational exuberance and market manipulation. Monopolies do not exist, as everything competes for your money. Meat doesn't just compete with meat, it also competes with chicken, with fish, with rice, with fruit, etc. Access to credit can only be artificially manipulated for a short while. Eventually reality hits and access to credit is determined by what we've actaully put away. Besides, credit helps determine how much we invest in future production. I get the feeling that you don't understand the true importance of capital.

It's both, of course.

If your arguement had any validity, you wouldn't need to use an ad hominem fallacy to sum up your paragraph.

 

[Moot]

But they went down this time, which was due to overproduction (malinvestment) and bubble formation in this market. So what caused the formation of the bubble that was this mass delusion.

Predator lending and the irrational exuberance that home prices would continue rising up forever. Also, banks betting against the borrowers that they sold the predator loans to.

 

[phattonez]

What, very low interest rates and lax mortgage lending standards didn't play a role?

How do you get low interest rates? And of course lax mortgage lending standards played a role, but why did they happen?

When Paul Krugman, in a now somewhat infamous but seldom-mentioned column in 2002, declared: “Alan Greenspan needs to create a housing bubble to replace the NASDAQ bubble.” And all this time, we thought he did just that. But now you're saying it was inflation and only inflation that caused it?

Inflation sparked the bubble.

 

[phattonez]

Today, most mainstream economists favor a low steady rate of inflation.....
Hummel, Jeffrey Rogers. "Death and Taxes, Including Inflation: the Public versus Economists" (January 2007). p.56

AEAweb Journal Articles Display

Many people think that inflation makes them poorer because it raises the cost of what they buy. This view is a fallacy, however, because inflation also raises nominal incomes.....
Principles of Economics - Google Books

It appears that you are one of the many people who believe the fallacy mentioned above.

And let me guess, you're of the fallacy the deflation reduces real income? Explain growth in the Long Depression then.

 

[phattonez]

If your arguement had any validity, you wouldn't need to use an ad hominem fallacy to sum up your paragraph.

Price controls on goods makes supply run short, right? If the price cap is set below the market rate then you are going to get shortages. Why is it any different with the price of using capital (interest rates)?

 

[phattonez]

Predator lending and the irrational exuberance that home prices would continue rising up forever. Also, banks betting against the borrowers that they sold the predator loans to.

Predator lending? People agreed to it, so why did they agree? Why were so many homes built that it would ultimately cause a crash? How did the bubble form?

 

[drz-400]

But they went down this time, which was due to overproduction (malinvestment) and bubble formation in this market. So what caused the formation of the bubble that was this mass delusion.

The fact that housing prices had not fallen in a long time, imo. There was no reason to believe that housing prices were going to take a dive, so people kept investing. People kept investing, prices on houses kept rising, builders built more homes, lenders lent more money, etc. Kind of like when people were talking dow 16,000 in the late 90's.

 

[Moot]

Predator lending? People agreed to it, so why did they agree? Why were so many homes built that it would ultimately cause a crash? How did the bubble form?

Yes, predator lending.....

Predatory Lending and Its Common Practices

The bubble formed because first, the banks lobbied to remove the rules and regulations that protected borrowers and then they lent to the riskiest borrowers they could find and then they bet against those borrowers through a financial device know as a credit swap that they bought through AIG, and then when the borrowers started to default just like the banks knew they would, the banks threatened the US taxpayer with an economic collapse if they didn't bailout AIG. It was the biggest financial scam in history and the banks pulled it off brilliantly.

 

[phattonez]

The fact that housing prices had not fallen in a long time, imo. There was no reason to believe that housing prices were going to take a dive, so people kept investing. People kept investing, prices on houses kept rising, builders built more homes, lenders lent more money, etc. Kind of like when people were talking dow 16,000 in the late 90's.

But the building and speculating wouldn't have been possible to the extent that it was without low interest rates. Capital should have been shriveling up with the way homes were being built and people taking out loans to buy them. The price of capital was distorted so it's no surprise that a correction came about.

 

[phattonez]

Yes, predator lending.....

Predatory Lending and Its Common Practices

The bubble formed because first, the banks lobbied to remove the rules and regulations that protected borrowers and then they lent to the riskiest borrowers they could find and then they bet against those borrowers through a financial device know as a credit swap that they bought through AIG, and then when the borrowers started to default just like the banks knew they would, the banks threatened the US taxpayer with an economic collapse if they didn't bailout AIG. It was the biggest financial scam in history and the banks pulled it off brilliantly.

Yet people agreed to the loans. Furthermore, if the Fed was not in control of interest rates, then what do you think would have happened to interest rates as we got deeper and depper into the boom? Would they have fallen, stayed the same, risen? Tell me what you think would have happened.