Why is liquidity “passing through” the global economy in such a segmented, non-neutral fashion?

“It is fair to say that the Fed has created a marvellous environment for virtually all assets, even if this remains one of the weakest economic recoveries on record in the US and through virtually all of the developed markets,” wrote Deutsche Bank in a note.

European high yield, or “junk”, corporate bonds have fared best, producing total returns of more than 150 per cent. Among the few losers were owners of Greek shares.

And yet the eurozone may be approaching deflation and has exhibited weak nominal gdp growth.  From the FT there is more here.  You should be certain about the appropriateness of the taper — or not — only if you understand this issue better than any human being I have met or heard or read.  I wonder if that’s you.

Milton Friedman, some time ago, wrote that money was for the most part neutral, and that the new money rapidly mixes in with the old.  That made sense to me at the time, and it nudged me away from Austrian views, yet we have seen decidedly non-neutral effects from the various QEs and the periodic taper talk.

(Where does this non-neutrality come from?  Do liquidity injections swing to concentrated areas in financial markets when an underlying economy has not solved what Arnold Kling calls its “PSST problems“, and/or when rates of return are low?  That is speculation.)

Note that Michael Woodford supports the taper, and Stanley Fischer has called for the same (“It would be good to start“).  They are the leading experts on this question, along with Bernanke himself of course, and each also appreciates the potential benefits from monetary stimulus.  Donald Kohn wants to delay the taper but refers to it as a “close call.”

Here is another opinion:

“The best argument for tapering sooner rather than later?” Peter R. Fisher, senior director at the BlackRock Investment Institute, wrote in a recent analysis. “The Fed is running out of stuff to buy.” He estimated that if it maintained the current level of asset purchases, the Fed could soon be consuming all the new issuance of Treasuries and mortgage bonds.

Is this the methadone for withdrawal from QE?

Overall, we don’t have a very good understanding of the different ways in which economies can build up imbalances.  Unfortunately, we may soon learn more.

Update: There is indeed a new tapir.


This was my attempt at explaining the non-neutrality of money in terms a monetarist could accept: http://www.iwmonitor-digital.com/iwmonitor/20130102?pg=52#pg52. The gist of the argument is that there are varying degrees of "moneyness" for different assets and they are imperfect substitutes, not perfectly fungible. The Fed operates with a set of primary dealers. Monetary policy operates through these dealers and their custodian banks. They direct the flow of money, which creates waves and distortions. It's like pouring water into a bathtub. It's not like it uniformly seeps up from the bottom.

I'd read this - but do you happen to have a copy in a more usable interface :)?

Anyone confused about the effects of the taper has more than likely befuddled themselves out of the ability to see things clearly.

Unemployment is very high, labor force participation is low, and inflation is low. These problems tend to be solved by more money unless there is some supply-side constraint, especially in the energy sector, that would cause further monetary stimulus to be purely inflationary.

This is also a case where "use of wrong metaphor" is a pandemic memetic illness that is terminally crippling our ability to have this conversation. In recent years monetary stimulus has usually been phrased as the consumption of some short-term-pleasing but long-term-unhealthy substance to which the economic body begins building a tolerance, such as "sugar" or "heroin;" the latter especially harmonizes with the terminology prevalent in these discussions ("injection," "withdrawal"). Yet this is, in fact, a poor metaphor for monetary policy except in narrow circumstances distant from those we currently occupy.

The correct metaphor for monetary policy is the steam engine of a locomotive. There is a correct amount of fuel to add to the engine; too much and it overheats, too little and it sputters and remains in place. The question to be asking is always "are we above or below the optimal point?" The current question - "how do we exit QE?" - is leading us down a very ominous path. Why do we inherently want to exit QE? Because hopefully it would signal economic recovery. But that does not mean exiting QE can cause recovery.

Now, monetary policy is of course more complex than a steam engine; the better metaphor is one that imagines a self-aware steam engine that can anticipate how much fuel it will likely receive in the future and can therefore reserve some portion of current fuel for future rather than present consumption. If we see the engine reserving substantial portions of fuel even as it is going slower than we'd like, that is not an engine that is on the path to regain the momentum to which we aspire.

Nonsense. The steam that drives the economy is the innovation and competitive drive. Money and finance are akin to the grease that you had to put into the bearings so that they thing wouldn't seize up. Excessive grease just made a mess.

If you want to reframe that metaphor that way, certainly, but note it makes the consequences of vast inflation - large grease puddles - much less than those of even moderate deflation - machine seizes up.

If you prefer, take my metaphor and imagine "innovation and competitive drive" as the continual process of upgrading the train, making its maximum speed greater. Adding more fuel past a certain point won't make the train go any faster, it will instead cause overheating, another common metaphor for inflation. But no matter how many improvements you make to the train - innovations, new products, greater efficiencies, etc - the train will never obtain the higher speed it is now capable of if there is insufficient fuel in the engine.

My favorite metaphor for monetary policy is the soul.

For some of them say that the soul is fire, like Democritus; air, like the Stoics; some say it is the mind; and some say it is motion, as Heraclitus 2; some say it is exhalation; some an influence flowing from the stars ; some say it is number in motion, as Pythagoras; some say it is generative water, as Hippo; some say an element from elements; some say it is harmony, as Dinarchus; some say the blood, as Critias; some the breath; some say unity, as Pythagoras; and so the ancients say contrary things. How many statements are there about these things ! how many attempts ! how many also of sophists who carry on a strife rather than seek the truth!

...What then must we term these things? They seem to me, to be a prodigy, or folly, or madness, or rebellion, or all these together. If they have found out anything true, let them agree together about it, or let them join together, and I then will gladly listen to them. But, if they distract the soul, and draw it, one into a different nature, another into a different being, changing one kind of matter for another; I confess I am harassed by the ebbing and flowing of the subject. At one time I am immortal and rejoice; at another time again I become mortal and weep. Anew I am dissolved into atoms: I become water, and I become air: I become fire, and then after a little, neither air, nor fire: he makes me a beast, he makes me a fish. Again then I have dolphins for my brothers; but when I look on myself, I am frightened at my body, and I know not how I shall call it, man, or dog, or wolf, or bull, or bird, or snake, or serpent, or chimaera; for I am changed by the philosophers into all the beasts, of the land, of the sea, having wings, of many forms, wild or tame, dumb or vocal, brute or reasoning: I swim, I fly, I rise aloft, I crawl, I run, I sit. But here is Empedocles, and he makes me a stump of a tree.

And repeat:


My preferred analogy for QE is likening it to bullets for a gun. In this case a gun that kills lack of demand and deflation.

With this analogy the FED's purchasing all those MBS's is like Homeland security purchasing billions of bullets. Everyone is saying "holy cow, you can kill a lot of citizens/ lack of demand and deflation with all those bullets!" The actions of the FED and Homeland Security send a message to the people about their "seriousness" surrounding the issue. There is an affect on markets and citizens alike when they see this seriousness. So there are "expectations" effects going on there. What are those expectations? Bullets will be flying! That has been the primary affect of both policies -- so far.

However, as we've seen, buying bullets is not the same thing as firing the gun. In order for all the "printed" money to really affect the economy the banks must make more loans (fire the gun) -- monetary base must become money supply. The "printed" money from QE is meaningless if it just sits buried in the back yard (I mean the FED's computerized bank account) doing nothing. Unfortunately, QE has another affect (not so analogous to bullets) which is that it decreases the spread between long term and short term interest rates (all those purchases of long term bonds). This lowered spread means lower profits for banks on their loans. This lowers the incentives for banks to make loans (I mean fire the weapon.) So, at some point, accumulating bullets (QE) like this becomes counter-productive. Anyone that looks at a graph showing the size of the monetary base can see that we've reached that point.

The good news for us is that the British have recently gone through a hefty round of bullet purchasing (I mean QE) and when they stopped, and spreads increased a bit, the banks have been loaning and the economy is growing quite nicely. Stopping QE will be expansionary.

So far the market agrees with my final sentence.

"The Fed is running out of stuff to buy" seems like a really crappy reason to cut off QE.

If liquidity isn't passing through neutrally and the Fed is running out of stuff to buy, why not initiate a Basic Income to all US citizens? I'd love to hear Tyler's thoughts on this, since it's gaining huge popularity online.

QE is a subsidy to big banks- I think balance sheets are a lot healthier now.

QE supports the housing market by keeping a cap on rates. Housing is looking close to standing on its feet.

QE has helped erase the "2009 fear bubble" in the stock market. Valuations are again reasonable.

I'm ok with tapering baby steps. Can always reverse course if the economy falters.

On the news that consumer prices are unchanged due to lower energy, is the emergence of cheaper natural gas, on top of the market crash of 2008 and ensuing threat of a liquidity trap, causing a perfect storm where we can inject pretty much as much liquidity as we want into the economy without causing inflation?

It's much simpler than that, isn't it? With the middle class going extinct, no one is spending money on anything except speculative assets, so there is no mechanism through which inflation can flow.

If inflation is 'more money chasing fewer goods', what happens when the chasing stops?

For what it's worth, I think we're close to deflation, but I also think the tapering needs to happen. QE isn't propping up jobs; it's propping up asset bubbles. It's just making the rich richer and not coming close to solving the actual problems underlying the economy.

LOL at "middle class going extinct". Saying this is like saying Obama was born in Kenya, instant loss of credibility.

Yes, you win, you caught me speaking non-literally. The middle class is not going extinct, but its prevalence will be reduced.

Also, weird thing to say on a blog written by someone who just wrote a book on that subject.

Just because Tyler makes exaggerated claims doesn't mean you should exaggerate them further.

"Update: There is indeed a new tapir."

This comment must have come from Tyrone. ;)

"Milton Friedman, some time ago, wrote that money was for the most part neutral, and that the new money rapidly mixes in with the old."

Intuitively I would think that money becomes less neutral as interest rates approach the zero bound. The opportunity cost of hoarding cash rather than investing it immediately goes down. Skittish economic players can wait a year or longer before doing anything with their new money, and pay little cost. Thus the marginal velocity of newly created money is lower with lower rates.

What happens to the productive sector of towns that get casinos?

>Where does this non-neutrality come from?

I'm amused and amazed that this is even a question. Are economists, especially macro economists so detached from reality that they have to ask this?

To reuse a quote that is over used, Willie Sutton said when asked why he robbed banks, because that is where the money is.

What is easier? To discover or create a market, develop a product or service, develop the people you need with training and skills needed to service this market, and then to actually do it. You have the IRS, OSHA, EPA etc. folks either looking to stop you or looking to take what you have.

Or to place yourself in the stream of money emanating out of Washington or New York, money that seemingly has no cost but can buy the best at Tiffany's.

You have to be smart and resourceful to do either, but if you plot all the curves of the various costs structures the US is facing, you look at the cost performance of influence dollars, and look at the potential returns over the near future, the choice is obvious.

It is obvious to me. Why does the intellectual elite of the US not see it?

The second obvious thing is that if someone really is driven to do the hard work of developing a product and market they will do it elsewhere. We have been seeing that happen for a couple of decades already.

Really? Where elsewhere?

Had this argument with ssumner a while back. If you accept that appearance is reality, then possible explanations include:

1) Access to cheap credit is non-neutral; high asset value earns cheaper credit
2) Access to credit limits the instantaneous nature of asset valuations (why did market take so many months to ramp after QE even though QE was widely anticipated?)
3) Access to credit, and economic rewards of cheap credit, are non-equal (favoring existing wealth), so cheap credit (especially in a time of low asset valuations) favors wealth concentration, and wealth distribution has a non-trivial effect on total economic activity/growth

Maybe others...

Tyler is one of many economists who have created the fiction that has made money no longer "neutral".

He, along with most economists, have discarded the fundamental principle of microecon: an economy is zero sum.

Tyler sees no economic problem with what he describes in Average is Over.

Tyler sees only a world where 50% of the people have no job, but otherwise the economy is fantastic because more stuff than ever is produced with half the workers.

What Tyler ignores is that he is implying that 50% of people have no job, no income, and consume nothing produced by the economy, and the other half consume twice as much as they consume today, because they must consume the half once consumed by the workers who lost their jobs.

What we have today is government taking money created by the Fed and spreading it around with 10% of GDP in profits going to chase stocks and bonds, driving those prices up. The Fed is trying to get money chasing after existing real estate to drive up its prices.

None of the money is going to create jobs. Higher stock prices create lots of pressure to slash jobs, and Tyler thinks this is a good thing because less labor to produce the same quantity means higher profits and that means higher stock prices and more pressure to create more unemployed.

Tyler does not say that increased unemployment must result in less consumption and less consumption must mean less production, and less production means more unemployment, so Average is Over is the description of an economy in collapse.

He has failed to see how increased inequality must lead to economic decline.

"He, along with most economists, have discarded the fundamental principle of microecon: an economy is zero sum."


I call it Mulpanomics.

Yeah, but, he'll never stop. Has mulp ever REPLIED to a post? He just posts this same comment in every thread, then moves on to the next thread regardless of what anyone says in response.

Could be a 'bot.

Just to play devil's advocate, if you look at economics as the study of how people divide finite resources, instead of in utility terms, it's not that ridiculous of a statement.

I don't believe there is a respectable school of economics which sees a fixed amount of wealth in the world being pushed around. Demagogues don't count.

But that isn't what economics is. What it is is how people go about adding value to the resources nature provides.

I thought economics was solving the economizing problem, how to achieve the greatest utility with given resources, include knowledge, technology, labor, and others.

While economists focus on what changes could increase the rate of increase in utility, the propositions loose interest when the growth is collected among a smaller and smaller group of people in the economy. Theory is great until 30% of the population realizes they have no valuable skills, own no farm land, and can't afford more education. Or until we realize it.

Money is flowing to investments which offer either international diversification in their source of profits, or offer a legislative or IP moat protecting the margins of naturally growing businesses.

When the Treasury begins simply issuing new bonds and the Fed accepts that, roll-overs of T's, the end is nigh. If taper doesn't happen before that, faith will evaporate.

Why is everyone talking about tapering and exit strategies? Core inflation is at 1.7% and falling. It would be one thing if we had high inflation and low unemployment, but we don't. Does anyone ever look out the window?

Now, now, looking at basic facts and applying basic logic is for proles and bloggers, not the righteous solons who have to make the hard choices, for reasons.

because, bubbles?

"Core" inflation is useful to macro economists. Households aren't feeling the love.

It is natural to ask why, with the extensive QE, specialized money printing, inflation seems to be headed downward here and in the UK. Why is the US service economy being converted to a part-time labor force? Why do corporations embrace the concept of pushing employees out into a tax-payer or general population health insurance world? So many financial products which have been sold (GIC's etc) required that the equity market not go back to DOW 7000. That's what freaked Paulson completely, the collapse of financial companies implied by just a continuing low market. Fixing the equity market, then putting another prop under it by advancing the ACA as a corporate alternative for the health insurance cost problem, brightens the world of many, including me, but does nothing for the average family whose real income has been falling for twenty-four years.

It is very simple. Tapering will begin to work fine, as homeowners re-emerge from being underwater, and can ramp-up residential investment and consumer borrowing.

Because the banks can transfer their eyes from looking to find money in meeting daily obligations to each other, back to the regular business of making loans into the real economy.

This should not be difficult to understand. The entire sequence is not mathematically modellable, however. The reason is because there is an emergent property. In fact there are several emergent properties, and they are incommensurate.

To begin the story, the financial system is a subsystem within the domestic macro flowchart. The subsystems in macro are: finance, households, gov't, business. These each have emergent properties.

Finance has an emergent property that now must be maintained: The financial system has its own interior trades, trades which remain interior to the financial system, i.e. the other party in the trades is not acting at that moment from the real (i.e., "non-financial") economy. Yet these trades, entirely interior to the financial system, surpass the dollar size of the GDP. The biggest of these interior trades is the repo market, which itself is the size of the GDP if not bigger.

Now back up a second, to explain this. A simple deposit bank once got its overnight loans from the "federal funds market." (A "simple" deposit bank, parsed as "abstract" and "pedagogic".) These loans are from other banks; they are lending overnight to each other. These overnight loans are crucially necessary in finance, so banks can daily make their payments due on their other items of business.

The "repo" market is the analogous market to the fed funds market, for NON-depositories: the unregulated shadow banks. The repo market is huge.

Repo uses collateral, and in the beginning, the collateral used was largely Treasuries.

To jump to the end of the story, the call for higher interest rates is ALSO a call to drain the U.S. taxpayer of more disposable income. The taxpayer is going to pay more to redeem these Treasuries when interest rates go up. Why will this happen? Because the distinction "Depositories/ non-depositories" is becoming a disused distinction that was composed of, "No, cannot speculate in securities on their own behalf/ Yes, can trade 'for themselves'," and, "Protected by taxpayer/ Not protected by taxpayer."

But let's go back to the beginning. The unregulated repo market uses collateral. By 2008, AAA mortgage derivatives were used as repo collateral, maybe about half the time. Prior to this, the collateral was largely Treasuries.

Then, when housing crashed, a lot of mortgage derivatives weren't worth much of anything, as collateral or anything else. At that moment, there was not enough collateral for the repo market. Non-depositories could not do daily business.

Since that would immediately stop everything else in the real economy too -- payrolls, credit accounts, e.g. --- the gov't flooded it with money via Fed and the Treasury (TARP, etc.) to purchase securities and provide reserves. This money was NEVER going to be inflationary because it is just sitting, or going around interiorly, in the financial system.

Basically, the U.S. government has been propping-up the distribution of asset-ownership of most of the private sector, by preserving the system of unwinding the time-trades in the purely-interior bank markets. Quantitative easing gives them cash to buy more securities, and they are good to go!

And it need never be inflationary, because once the economy starts heating up, the Fed can increase reserve requirements, and valve-down the lending to the real economy.

The other reason the money has not so far leaked out of the financial subsystem to become inflationary in the real economy is the "liquidity trap". And that comes because of another emergent property, from an entirely different subsystem: Households. Household real consumption ("C") is still lacking $1 Trillion (or thereabouts) annually; called the "output gap". Why? Because part of household consumption follows upon residential investment (housebuilding), and residential investment fell with the mortgage derivatives. This reduced new borrowing. There has been much less new consumer and residential borrowing, so the money in the financial system has not leaked into the real economy enough to cause inflation.

Thus the answer to, "Why is liquidity “passing through” the global economy in such a segmented, non-neutral fashion?" is that not much of it has been getting into the global real economy. The gov't fixed bank borrowing, but did not fix household borrowing. Household borrowing was abandoned, to fix itself. Really, really stupid of everyone in Washington D.C.

Back to beginnings: Which came first? Overbuilding and corrupt mortgagemaking, together. Does it matter which came first, in a complex system with different subsystems? Not necessarily, because there are multiple causations, and prediction about each subsystem is not precise, due to non-linearities and incommensurabilities. In addition, each subsystem has its own forms of systemic risk.

Any holistic logic on the macro flowchart shows that we should have ramped up consumer demand via massive mortgage writedowns and government fiscal spending on infrastructure. We'd be in a lot better shape now, and we wouldn't owe the financial system so much future profit on so much static debt-holding.

This all follows from the fact that there is one (at least one) emergent idea property at the center of any intentional subsystem: in macro, those subsystems are: finance, household, gov't, business. The explanation therefore is partly holistic, not entirely, but partly, meaning dealing with WHOLE SUBsystems which must be saved by their own interior logic. This gets into looking at systemic risk, info-limitations, and non-precise predictability, for each subsystem. Systemic risk cannot be fully priced in as any form of smaller risk; it is logically different. This is true of any subsystem -- even households have forms of systemic real risk; war, climate, collapse of credit system -- not merely the financial system, although that is where the ideas originated as quantities to think about. I don't think the whole system can be math-modeled usefully, but it can be flowchart-modeled certainly, avoiding big mistakes. Sequence starts here: http://www.youtube.com/playlist?list=PLT-vY3f9uw3ADgyYqUVo2R8kxM4Agc3aw

Tapering will begin to work fine, as homeowners re-emerge from being underwater, and can ramp-up residential investment and consumer borrowing.

What the hell are you talking about--don't you remember what happened the last time everybody spent money they didn't have on granite countertops and big-screen TVs?

I mean, dude, this was only five years ago.

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Non-neutrality of money is a big topic, but some parts of it are simple. The Austrian point you're referring to was very simple and intuitive: there are always some people and activities closer to the money spigot than others. In the present case we're talking about US QE which is Fed purchases of public mortgage bonds and Treasurys.

Fed purchases of public mortgage bonds obviously affect housing prices and things near to them more than the rest of the economy, and indeed that's the point.

Fed purchases of Treasurys I think don't currently have any comparable affect, as they aren't facilitating increased US fiscal spending. Unless they facilitate increased fiscal spending, central bank purchases of sovereign bonds merely substitute issuance of currency for issuance of bonds. Elsewhere and at other times, when QE aka monetary emission facilitates increased fiscal spending, the recipients of that spending and those near them enjoy the non-neutrality effect described in Austrian theory.

As for why QE is causing general asset prices to rise, I think you need to turn to classic portfolio theory. When money supply grows, the value of money must fall relative to other assets, ie other asset prices must rise in nominal terms, until the price changes motivate sufficient desire to hold the additional cash.

I surmise that the question Tyler is trying to ask in his roundabout way is, why is QE pushing up specifically financial asset and land prices, and not those of consumer goods? Is this non-neutral money?

Outside the effect of public mortgage bond purchases I already mentioned, I think Fed purchases of Treasurys inflate asset prices without affecting consumer goods prices because they increase the money supply without increasing economic activity. That's not quite the same point as in Austrian theory and I don't know if you want to call it non-neutrality of money.

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