Nomura chief economist Richard Koo returned from a recent trip just in time for the government shutdown, and even though the government managed to avoid default, lost credibility could hurt the U.S. just as we need to deal with the coming QE trap.

Richard Koo

Richard Koo on government shutdown

“The actual damage and the loss of confidence caused by the shutdown of the US government for more than two weeks are significant, as they signify an increase in the risk premium involved when doing business with the government,” writes Koo. Even though Tea Party tactics have proven to be deeply unpopular, they have threatened to use them again, and hearing elected officials argue that a default wouldn’t be that big of a deal is worrying.

While Koo places some of the blame on Obama’s unwillingness to budge, he also thinks that “House Speaker John Boehner lost control of his party… A wide and unbridgeable gap has opened up between those who want to engage in the traditional process of government via compromise and the Tea Party members, who oppose large government in every sense of the word and are determined not to compromise.”

Emergence of the Tea Party

Aside from creating a dangerous political dynamic, Koo says the most recent episode demonstrates how “a reliance on big government fundamentally contradicts the principle of individual responsibility and self-reliance that underpins democracy, and the emergence of the Tea Party underscores that contradiction.” He continues, “I have noted in the past how difficult it is to sustain fiscal stimulus in a democracy during peacetime. Whether we look at Japan over the last two decades or the more recent case of the U.S., we can see that democracies are not well-equipped to deal with balance sheet recessions.”

Moving away from the controversy of the day, Koo sees the same problem manifest in the Fed’s approach to QE. He’s talked in the past about the possibility of a QE trap, and he was hoping to find some government official who could assure him that his misgivings were misplaced.

“At the Fed I hoped to hear a refutation of the QE ‘trap’ argument presented in my last report,” he writes.  “However, the official I met with was unable to say anything to ease my concerns.”

Quantitative easing trap

The QE trap is what Koo calls the process when a central bank is trying to end a QE program that involved buying back long-term government debt. As the market responds to expected central bank actions, demand in interest-sensitive industries falls off forcing the central bank to ease policies in response. This could create a feedback loop, which creates a long-term drag on the economy.

QE Trap 1013

Cost of the QE Trap 1013

“Moreover, I sensed the Fed’s full attention is now devoted to the question of whether and when to ‘taper’ its purchases of longer-term Treasury securities, leaving officials little time to think about long-term costs and scenarios. The same could be said for the market participants I met with in New York and Boston, where the typical response was ‘We haven’t thought that far ahead’ or ‘It’s tomorrow’s problem’.”

Suggestions that the QE trap could be avoided either with reverse repos or by paying a higher interest rate on excess reserves “would be sufficient in an ordinary world where excess reserves were only slightly in excess of statutory reserves, but they are unlikely to be sufficient in a situation like today’s where excess reserves amount to 19.5 times statutory reserves.”

Ironically, Koo told a Fed official that the best way to get out of this trap would be for them to convince everyone of their incompetence and declare QE to have been a failure that didn’t help the markets at all. Whether or not it’s true, as long as investors believe that it’s true they won’t be quite so nervous about tapering and the QE trap might not manifest at all.

“The official’s only response was to ask whether I really believed such an announcement would help curb the rise in long-term interest rates.”