Richard Koo of Nomura is out with a new report. The note from The famed economist, who authored Balance Sheet Recession: Japan’s Struggle with Uncharted Economics and its Global Implications, and The Holy Grail of Macroeconomics: Lessons from Japan’s Great Recession, mostly discusses QE and we have some interesting excerpts on that topic. Also see some other excerpts from Richard Koo via Matthew Boesler of Business Insider.
See the prior missive from Richard Koo here- Richard Koo ‘China May Not Have 15–20 Years’
According to an 18 April IMF publication I cited in an earlier report, the resulting losses to the central bank could be very substantial.
The IMF piece estimated that Fed losses in the most likely interest rate normalization scenario would amount to about 3% of GDP, or $500bn.
This represents the cost to the Fed of raising interest rates without mopping up the excess reserves created under QE.
Richard Koo: Fed may also require capital injection
The capital losses would be a one-time event, and actual losses could be avoided if the Fed held the bonds until maturity since the principal would be returned in full. But it is not difficult to envision a scenario in which the market deems the Fed to be technically insolvent, with serious implications for its faith in the US dollar.
If the Fed actually succeeded in ending QE and was able to sell its bonds on the open market, it would have to book an actual loss of $500bn.
To prevent a corresponding loss of confidence in the Fed among market participants and the general public, the government might then have to inject capital into the Fed, which of course would add to the fiscal deficit.
Moreover, the need to pay interest on excess reserves would continue until the funds supplied under QE were mopped up. It should be remembered that this is a cost that would never have to be borne if the central bank had not engaged in quantitative easing in the first place.
The question, of course, is whether one views these costs as being high or low. Apparently the Fed is willing to pay them. But the risk is that they will develop into a political issue at some point since the fiscal deficit will increase by an equal amount.
Richard Koo: What comes next in saga of quantitative easing?
We can see that the story of quantitative easing is in fact a saga—its adoption during the balance sheet recession was merely the first chapter.
The second chapter began in May when the Fed started talking about winding down the program. That has not led to serious strains in the market yet because private demand for loans in the US remains relatively weak.
However, Chapter 2 is where the Fed falls into the QE “trap” of being unable to wind down quantitative easing because attempts to do so send long-term interest rates sharply higher and arrest the economic recovery.
The situation worsens as the private sector completes its balance sheet repairs and businesses and households start to borrow money again, which leads us to Chapter 3:
“Monetary tightening.” Here the Fed is forced to pay a high rate of interest on the excess reserves it has created and also faces huge capital losses on the long-term bonds it has purchased.
If the Fed fails to tighten policy, the risk that excess reserves equal to 19 times statutory reserves could inflate the money supply sparks fears of hyperinflation and sends longterm rates even higher.
Meanwhile, raising rates leads to heavy capital losses on the bonds purchased under QE, possibly rendering the Fed technically insolvent. Speculation that the Fed would never undertake tightening resulting in a $500bn loss could then fuel talk of a dollar collapse and hyperinflation. Something must be done in response.
Richard Koo: Talk of capital injection could emerge if Fed is held to account
The most desirable outcome in this situation would be for the US Congress to move quickly to defuse the crisis by injecting capital into the Fed and declaring it will remain solvent no matter how much policy is tightened. However, I suspect efforts to hold the Fed to account for the mess would have already begun at that point, complicating the situation.
In particular, I think the many politicians—mostly Republicans—who have opposed quantitative easing from the start would begin bashing the Fed, threatening its independence.
Richard Koo: Cost of QE cannot be calculated until end of Chapter 4
Only after this crisis is overcome will we enter the fourth and final chapter of this saga, where the Fed concludes that it must mop up the troublesome excess reserves as quickly as possible. At that point, the Fed may work with the Treasury Department and pursue a course of action that I outlined in an earlier report—namely, reducing the duration of its bond portfolio with a reverse Operation Twist and using the short-term bonds obtained in that operation to mop up excess reserves, much like the BOJ did in 2006.
While interest rates would still rise, I suspect the monetary authorities—having just survived a life-threatening crisis in Chapter 3—would place first priority on winding down quantitative easing.
Richard Koo: Real cost of quantitative easing
I suspect it will be several years before Chapter 4 comes to an end, and only then will we be able to calculate the full cost of QE.
Those calculations should compare the situation then with a case in which the Fed had not engaged in QE and the economy had recovered smoothly without having to consider the problem of what to do with the excess reserves.
I suspect economists will conclude that while undertaking QE in Chapter 1 may have hastened the recovery slightly, that benefit was more than offset by the crisis and turmoil of Chapters 2–4, and from Chapter 2 onwards the recovery itself was delayed substantially compared with a scenario of no QE.
Finally, I think economists will come to the conclusion that (highly unusual) balance sheet recessions should be addressed using fiscal policy, and that it was the US authorities’ decision to employ monetary policy that created the huge side effects of Chapters 2 through 4.
Richard Koo: QE was driven by politics
Responsibility for the saga of quantitative easing appears to lie first with the Democrats, who allowed it to happen. However, a look at the history of QE shows that QE2, Operation Twist, and QE3 were all next-best measures carried out because Republicans prevented the mobilization of fiscal policy.
QE2 was adopted the day after the Republicans—with their overwhelming focus on cutting the deficit—took control of the House of Representatives with a commanding victory in the 2010 midterm elections. Operation Twist was unveiled soon after the crippling debate over the federal debt ceiling in the summer of 2011. QE3, meanwhile, was intended as a backup policy in the event the US was unable to avoid the fiscal cliff in January 2013.
In explaining its recent decision to delay tapering, the FOMC also cited the extremely hostile budget negotiations between the two parties in Congress and the issue of the federal debt ceiling, which will soon need to be raised.
Richard Koo: Rift in Congress continues to deepen
Over the past few weeks the antagonism between the two parties has become increasingly acute. In particular, the Republican leadership’s loss of control over the party’s deficit hawks—symbolized by the Tea Party—is complicating everything.
The hawks seek “small government” and are willing to bet their political careers on overturning Obamacare, which they see as a symbol of big government. Moreover, they have a well-deserved reputation for being unwilling to compromise.
Government shutdown would tip US economy back into recession
The US was able to avoid premature fiscal consolidation in part because of the Fed chairman’s repeated warnings about the fiscal cliff. The US economy has outperformed Europe’s precisely because it did not fall off the fiscal cliff.
Now, it seems, politicians have let the recovery go to their heads. The ongoing antagonism between the two parties not only risks sending fiscal expenditures to zero if government shuts down but creates the danger of a default on the government’s obligations just a few weeks later.
If the US continues down this path, it risks repeating the mistakes of Japan’s Hashimoto government in 1997, when premature fiscal consolidation sparked five straight quarters of economic contraction that subsequently took more than a decade to recover from.