Author Archives: dslavin

(Revised) Can QE* Be an Effective Long Term Policy? Yes, and Here’s How.

The Fed’s decision to implement quantitative easing and other unconventional monetary policy in December 2008 sparked a blaze of heated discussion amongst economists that has been burning to this day. The questions of if and how these new measures affect economic growth have become the focus of countless blog posts and editorials, and have become an integral part of many university Econ courses. The beginning of QE tapering in December 2013 added even more fuel to the fire, but it also gave many traditional economists a sense of relief. It finally looked like there was an end in sight to these unfamiliar and controversial policies. To the dismay of these traditionalists, however, recent research by the Brookings Institution (paper #1 and paper #2) suggests that there are significant benefits of pursuing unconventional monetary policy in the long term. A recent Economist article, “Staying Unconventional,” emphasizes some of the most important results of this research and raises a provocative question: Can QE and forward guidance, or some alternate forms of these policies, be combined to create an effective long term policy?

Based on my reading of the research papers that the article cites, I am inclined to say yes. It may not be the QE policy currently being rolled back, but I can see an alternate form of such a policy (hence the * in the title) being effective in the long term. Not only does unconventional monetary policy not cause riskier financial behavior, but it also provides a substantial boost to economic growth. In this blog post, my goal is to defend the bolded argument by highlighting some of the key findings of the research papers I mentioned earlier.

1.    Unconventional Monetary Policy Does NOT Cause Financial Instability

The argument commonly used to refute long-term implementation of QE is that it encourages individuals and financial institutions to pursue riskier investments, thereby reducing financial stability. The prediction is that long periods of low interest rates incentivize investors to ‘reach for yield’ and take on more credit risk, duration risk, and/or leverage. The research by Gabriel Chodorow-Reich of Harvard University confirms this prediction but emphasizes that the story is not so cut and dry. Although the Fed’s low interest rate policy has caused financial institutions to take on some riskier investments, it has also boosted the value of these institutions’ portfolios, making them less risky and strengthening the stability of the U.S. economy. Most importantly, Chodorow-Reich’s analysis shows that the stabilizing effect of QE has been stronger than the destabilizing effect caused by ‘reaching for yield.’

Chodrow-Reich determined the magnitude of each effect by evaluating the effect of the Fed’s policies on four categories of financial institutions: life insurers, commercial banks, money market funds, and defined benefit pension funds. Together, these institutions manage $24 trillion in assets. The effects are nicely summarized in the graphic provided in the abstract of the paper:

unconventional MP_1

As Chodrow-Reich states, “In the present environment, there does not seem to be a trade-off between expansionary [monetary] policy and the health or stability of the financial institutions studied.”

If the biggest argument against long-term use of QE (investors reaching for yield) is nullified, perhaps the Fed should think twice about continuing to taper. There is, however, the problem of surprising the market with such a change in policy. A possible solution to this is to continue the taper, but then start buying a constant level of bonds again after the taper is complete. If the Fed warns the public of such a long term policy change in advance, it could dampen the volatility the move would create in the markets.

2. Unconventional Monetary Policy Boosts Immediate Economic Growth and May Have Substantial Long-Term Growth Benefits As Well

The research conducted by Joshua K. Hausman (University of Michigan) and Johannes F. Wieland (University of California, San Diego) examines the success Abenomics has had in boosting Japanese GDP and gives insight into how such unconventional monetary policy can sustain amplified GDP growth in the long term.

Named after Japanese Prime Minister Shinzo Abe, ‘Abenomics’ is the name used to refer to Japan’s current three-pronged economic stimulus policy, which consists of a combination of monetary policy expansion, fiscal stimulus, and structural reform. It is the only real and current example of long-term unconventional monetary policy, and is thus viewed by economists as an important test of its validity.

So far, Abenomics has stood up to the challenge. The Japanese stock market has risen, the exchange rate has depreciated, and Japan’s GDP has jumped by up to 1.7%. Hausman and Weiland claim that one percent of this GDP growth has been directly caused by the monetary policy shift. Furthermore, Abenomics’ effect on the Japanese money supply has been much more effective than that of previous QE policies. The below graphic from the Economist article provides a nice summary of the effects of Abenomics:

unconventional MP_2

Hausman and Weiland attribute the superior effectiveness of Abenomics to the change in inflation expectations it has caused. Japan has set a new 2 percent inflation target and because Abenomics was announced to the public as a permanent change in policy rather than a temporary measure to boost GDP, inflation expectations increased for both the short and long terms. Both short and long-term borrowing appeared cheaper as a result. This, in turn, caused borrowing to increase across the board, stimulating increased consumer spending.

One should not go all-in on Abenomics quite yet, though. Both the article and research paper emphasize that Abenomics is still in its initial stages and has yet to prove itself as an effective catalyst for long term growth. When discussing the long-run outlook of Abenomics, Haussman and Weiland assert:

The research shows that the Bank of Japan is achieving its intermediate objective of higher expected inflation, but that the inflation target itself ‘remains imperfectly credible,’ with long-run inflation expectations below 1.5 percent.  Thus the modest estimates of Abenomics’ effects reflect in part that the Bank of Japan has not yet fully convinced the public that inflation will be two percent.

If the Bank of Japan could somehow more strongly convince the public of a future two percent inflation rate (perhaps through a public announcement reinforcing its intention to pursue the policies of Abenomics), the effects could be substantial. Hausman and Weiland estimate that “the output effects of Abenomics could as much double if inflation expectations rose to the 2 percent level.

In summary, based on the results presented by Gabriel Chodorow-Reich about the positive effects of QE on financial stability, and Hausman and Weiland’s estimates of past and future Japanese output growth as a result of Abenomics, I am convinced that unconventional monetary policy can be used effectively in the long term. If the Fed can convince the public that inflation will be steady at two percent and interest rates will remain low, whilst continuing to purchase assets and pursuing fiscal stimulus, it can achieve both strong economic growth and increased financial stability.

Lessons From the Past: What Alibaba Can Learn From the Google IPO (Part 2)

This is a continuation of my previous blog post about the Google IPO. There has been a lot of talk in the media recently about the upcoming Alibaba IPO, so I thought it would be interesting to analyze another very publicized IPO that happened about ten years ago– the Google IPO. Tech IPOs as big as Alibaba’s or Google’s don’t happen often, so Alibaba could learn some valuable lessons by looking to the past. The previous blog post described the structure of the Google IPO and this blog post will discuss the result + some of the successes and shortcomings of the IPO.

The Result of the Google IPO

In traditional book-built IPOs, large financial service providers (usually banks) partner with the company wanting to pursue an IPO and assess its worth in order to determine a share price for the IPO. These banks (referred to as underwriters) have an incentive to underprice the IPO offering price in order to guarantee that all shares will be sold.

Google, at least within the public eye, wanted to eliminate this tendency to underprice by using the auction format (discussed in previous post). Some good evidence for this exists in Google’s initial S-1 filings which read, “Buyers hoping to capture profits shortly after our Class A common stock begins trading may be disappointed” (Google Form S-1, note 238).  Ultimately however, the results of the Google IPO auction were not analogous with Google’s stated goals. After uncertainty about the IPO grew due to concerns brought up by the SEC, Google adjusted its original price range of $108-$135 to $85-$95 per share, and later established a final price of $85 per share. Rather ironically, after the first day of trading had completed, Google’s share price rose from $85 to $100.34. Despite its unique structure, the results of the Google IPO seemed very similar to what would have occurred if Google had simply pursued a traditional book-built IPO.

Possible Alterations

After seeing the somewhat disappointing results of the Google IPO it is natural to ask what could have been done differently. Traditional game theory asserts that an auctioneer’s aims in an auction are five-fold: (1) to extract as much revenue as possible, (2) to allocate ‘prizes,’ or shares efficiently, (3) to gather accurate information about bidder’s valuations, (4) to encourage new bidders to participate in the auction, and (5) to attract attention to the auction. Based off of the results observed, it seems that Google only succeeded in achieving the fifth goal.

One possible improvement that could have been made is electing to enlist one experienced underwriter to lead the underwriting syndicate, rather than two inexperienced underwriters. Google chose Credit Suisse First Boston LLC and Morgan Stanley & Co. Inc., two of the leading investment banks in the U.S., to lead their underwriting syndicate. Unfortunately, neither of these banks had any experience with auction-based Internet IPOs. Electing one leading underwriter with more experience could have led to better communication between Google and the underwriter as well as increased efficiency in Google’s attempts to increase the pool of potential investors.

Conclusion: Same Result, More Hype

In conclusion, I think that Google’s goal for the IPO was to create more public excitement for the company. By using an untraditional IPO auction structure, Google was able to generate increased media attention and use its IPO as not only a catalyst for company revenue, but also as a largely effective marketing tool. Despite achieving similar results to traditional book-built IPOs, Google may have profited more from its IPO in the long run by generating new potential users and customers.

Furthermore, it is worth noting that Google did succeed in two of its initial goals: one, offering the shares to a larger group of people including private investors versus just financial institutions, and two, Google succeeded in paying a lower percentage to underwriters than experienced in traditional book-built IPOs. For a big tech company like Alibaba it may be wise to follow in some of Google’s footsteps as it prepares to hold its own IPO within the next month.

Lessons From the Past: What Alibaba Can Learn From the Google IPO (Part 1)

There has been a lot of talk in the media recently about the upcoming Alibaba IPO, so I thought it would be interesting to analyze another very publicized IPO that happened about ten years ago– the Google IPO. Tech IPOs as big as Alibaba’s or Google’s don’t happen often, so Alibaba could learn some valuable lessons by looking to the past. This blog post will be dedicated to describing the structure of the Google IPO and the next blog post will discuss the result + the things Alibaba can learn from the Google IPO.

Introduction and Context

Google filed for its initial public offering on April 29, 2004. The goal of going through with an IPO is the same for practically any company—to raise capital from the sale of shares in the company ownership. Google’s goal was no different, but after seeing how technology companies had faired using standard book-building IPOs, especially during the dot-com boom of the nineteen nineties, Google’s executives decided to change things up and use what is known as an auction IPO. In theory, an auction IPO is supposed to limit the underpricing of and restricted access to initial stocks typically experienced in a standard book-building IPO.

Structure of Google IPO Auction and Comparison to a Pure Dutch Auction

From the outside, the structure of the Google IPO auction seemed very similar to that of a standard pure Dutch auction. The general public had an opportunity to bid on shares in Google before the shares actually got released, and the auction format was used to determine which bidders actually got to buy the shares. Because an initial public offering is done once, this auction is an isolated occurrence. The auction is run once, allocating the company shares to specific bidders. After, these bidders can trade these shares amongst each other. Google can, in principle, sell more shares of its company in the future, however this sale would not be considered an IPO anymore.

In a standard Dutch auction (as related to an IPO) a company initially determines a price range and a maximum number of shares that can be sold during the IPO. Bidders then submit bids based on their localized demand, stating a price within the established price range and the number of shares they want to purchase at that price. The company then evaluates all the submitted bids and establishes what is known as a clearing price. The clearing price is the maximum price within the established price range at which all the designated amount of shares can be sold. After the clearing price is established, all winning bidders are sold their desired amount of shares at the clearing price. This bidding structure allows the company to maintain more control over price and allocation than in a standard book-built offering, in which the ‘clearing price’ is determined by an underwriter’s evaluation of the worth of company shares. It also is supposed to limit the underpricing of shares and establish a fairer offering price because the clearing price is a direct result of bidder competition. The larger the demand for the shares, the greater the clearing price, and vice versa.

There was one significant characteristic of the Google IPO auction that made it different from a traditional Dutch auction. Unlike the Dutch auction, in which the clearing price is determined solely by the bids submitted, Google executives maintained the option to rule out or ignore bids they deemed speculative. This essentially meant that the actual clearing price of the auction would not necessarily be the ultimate offering price. Google executives could adjust the price upwards or downwards depending on their own or their underwriter’s judgment. Thus, the main characteristic of the Dutch auction that allowed it to establish a more accurate or fair market price than the traditional book-building method was thoroughly undermined by Google.

Low Fixed Income Returns and What it Means For the Future

Usually when I see the words ‘fixed income’, I immediately think two things: low risk and low return. From what I have learned and extrapolated in my finance classes, bonds and other such fixed income securities are used as safe assets in investors’ portfolio, ‘guaranteeing’ (I use that word loosely) a steady, relatively low level of income. As I found out to my surprise today though, the low level of income may only be the case for individual investors. The buying and selling of bonds, currencies, and commodities (collectively known as FICC) have accounted for more than half of investment banks’ revenue in recent years! Take a look at the following graph:

investment_banks_fi_revenue

 

Unfortunately for investment banks, however, that fraction has been dropping since 2009.  As a recent article in the Economist, “The Engine of Investment Banking is Spluttering,” explains,

In 2009 the world’s big investment banks earned nearly $142 billion from FICC—63% of their total revenue, according to Coalition, a data firm. By last year that had halved to nearly $74 billion, accounting for slightly less than half of revenue (see chart). In 2013 alone revenues from FICC fell by almost 20%.

The article goes on to point out that this trend has not stopped in 2014. Across the world, investment banks’ fixed income revenues have fallen and this drop has been most prominent in Europe:

Huw van Steenis, an analyst at Morgan Stanley, reckons Europe’s leading investment banks gave up about five percentage points of market share in FICC to the three leading American banks last year.

A valid question to ask is why is this happening?

There seem to be two main reasons. The first is a cyclical argument, justifying the drop in FI revenue because of current economic policy. The second reason is related to increased financial regulation. I will discuss both of these reasons below.

The Cyclical Argument

From an economic policy perspective, the first four months of 2014 have been characterized by the Fed’s QE tapering and adoption of forward guidance, which is the name given to the Fed’s recent efforts to keep long term interest rates low. This effort is mostly driven by the Fed’s economic forecasts and communications with the public. So how does this relate to low fixed income revenues? Stable and low interest rates make for slim bond trading profits. Low interest rates mean that bond prices are relatively high and stability means that banks have less chance to take advantage of price changes.

The Regulation Argument

Although this argument relates more to Europe (Swiss banks are especially stringent), it is also relevant to the rest of the world. Generally speaking, financial regulation is becoming more restrictive globally. Banks are required to hold more capital in order to trade, the U.S. has banned banks from trading on behalf of their clients, and there has been a global effort to move derivative trading to central clearing houses. All of these things force investment banks’ profits down.

I think the main effect this decrease in fixed income revenue will cause is a shift on the part of investment banks toward equities. However, I don’t think this shift will last very long because once the Fed starts raising interest rates again fixed income will once again be attractive because spreads will be higher.

The Russian Economy: Why Natural Resources Are Its Only Hope (Part 2)

This is a continuation of my previous post about the adverse effects that the Russia/Ukraine conflict has had and will continue to have on the Russian economy. I will elaborate on two more of these negative effects and argue that Russia’s natural resource industry is one of the only bright spots in an otherwise grim view of the future for the Russian economy. As a recent Economist article, “From Bad to Worse,” emphasizes, the three most notable negative effects of the Russia/Ukraine conflict are: (1) Sanction tightening, (2) a cut off of foreign lending + investment into Russia, and (3) a fall in the value of the ruble. Having examined sanction tightening in the last post, I will take a closer look at the last two effects in this post.

2.    Cut off of Foreign Lending + Investment into Russia

Political instability in Ukraine is causing foreign investors to doubt whether or not their investments and loans to Russian firms are safe bets. As I have discussed numerous times before in previous posts, availability of credit drives business cycles (both short and long term), so a credit tightening in Russia would have many unfavorable consequences including plummeting asset prices, a drop in productivity, and decreased incomes. Unfortunately, these potential effects are already becoming realities. As the article states,

With capital flight hitting $60-70 billion in the first quarter of this year alone, investment in domestic production—what the spluttering economy needs most of all—will be even harder to come by.

It is worth noting that the main concern is not about existing investments and loans, but new ones. Many of the investments into Russian firms are under long term contracts, which make them difficult to get out of, but new financing is unlikely to come rushing in after the conflict in Ukraine. Although Russian banks have expressed enthusiasm in replacing the role of their foreign counterparts, their ability to do so is doubtful because many of these banks rely on western loans. If further sanctions and investor doubt forces these western loans to stop flowing in, Russian banks may be in an even worse position than the Russian firms relying on foreign imports (discussed next).

3.    Fall in the Ruble

The ruble has plummeted as a result of the conflict in Ukraine. Although there is some argument about whether or not a weak ruble is good or bad for Russia, I would argue that the costs clearly outweigh the benefits. A weak currency makes imports more expensive, and with many Russian firms not only relying on foreign loans, but also on foreign imports of supplies, a weak ruble is not something to celebrate.

In conclusion, I have laid out a detailed summary of some of the negative consequences the Ukrainian conflict will bring upon the Russian economy (sanction tightening, cuts in foreign lending, and a fall in the value of the ruble). Furthermore, I have argued that Russia’s natural resource industry will likely survive these troubles because of two reasons– Europe’s dependence on natural gas and the prospect of new, long term deals between Russia and China.

The Russian Economy: Why Natural Resources Are Its Only Hope (Part 1)

In my last two posts I discussed Europe’s dependence on Russian natural gas and I argued that it is unlikely that this dependence will disappear anytime soon. By focusing on Russia’s prospering natural gas and oil industry I think that the past two posts downplayed the negative effects that the Russia/Ukraine conflict has the potential to bring upon the Russian economy. In this post and the next one I will elaborate on some of these negative effects and argue that Russia’s natural resource industry is one of the only bright spots in an otherwise grim view for the future of the Russian economy. As a recent Economist article, “From Bad to Worse,” emphasizes, the three most notable negative effects of the Russia/Ukraine conflict are: (1) Sanction tightening, (2) a cut off of foreign lending + investment into Russia, and (3) a fall in the value of the ruble.

1.    Sanction Tightening

Although the sanctions placed on Russia as a result of the Ukraine conflict have been minimal (mostly because gas-dependent Europe refuses to risk endangering its natural gas supply), their potential negative effect is magnified by what Alexander Kilment of Eurasia Groups calls the ‘scare factor.’ The scare factor is essentially the idea that trade sanctions cause investors to expect further sanctions and trouble in the future. Shares of Russian companies that do business abroad, especially shares of those with administrative officials whose names are on the sanctions list, have fallen greatly. What makes this even worse is that the effects of the scare factor have been hitting the Russian economy where it hurts most: its energy companies. As the article states,

Shares in Novatek, a gas producer, fell sharply when the restrictions were announced, on fears it might struggle to do deals with foreign partners or raise capital abroad because Gennady Timchenko, a friend of Vladimir Putin’s named on the American sanctions list, owns 23% of the company and sits on its board.

The article suggests that this effect could spread to other large Russian energy firms such as Rosneft (an oil company) if the American government sanctions Igor Sechin, Rosneft’s current boss.

Even given these potential drops in shares, however, I have confidence that Russian energy firms will thrive. Apart from the European dependence reason I have discussed in previous posts, another key international player has entered the Russian energy game as a result of the sanctions: China. China is taking advantage of the sanctions by urging Russian firms to sign long term trade contracts that would quell some of China’s ever-growing natural resource demand. Gazprom, for example, is on the cusp of signing a deal to sell gas to China. In the next post I will elaborate on the other two negative effects: cuts in foreign lending and a drop in the value of the ruble.

Europe’s Thirst for Russian Gas: An Addiction Unlikely To Wane (Part 2)

This post is a continuation of my previous post about Europe’s dependence on Russian natural gas. After reading a recent Economist article, I am convinced that Europe’s addiction to Russian gas will remain strong in both the short and long term. The combination of (1) an already developed infrastructure, (2) a lack of viable alternatives, and (3) a growing European demand for gas reveals that a large enough economic incentive can successfully overshadow political conflict. Having analyzed the infrastructure point last time, I will elaborate on points 2 and 3 in this post.

2.    Poor Alternatives

Even if European leaders were to overlook the infrastructure problem and tap into all the alternative sources of natural gas at their disposal, they would only have enough to cover about half of Europe’s gas demand. In order to see this more clearly I will elaborate on the main alternative sources Europe could use and the problems associated with each one:

  • Gas from other European countries (i.e. Norway, Netherlands, Britain): Although Norway and the Netherlands combined have enough gas to provide about one eighth of Europe’s yearly gas demand, environmental concerns (carbon emissions and earthquakes) and negative public opinion create domestic political barriers.
  • Shale Gas from European countries: Although tapping into local supply provides an effective hedge from international political risk, the problem with local shale gas is, once again, environmental. Many countries, such as France, the Czech Republic, and Bulgaria have banned shale gas extraction.
  • Gas from Africa (i.e. Libya, Algeria): These sources have generally been unreliable due to political unrest and increased local demand. As the article points out: “Italy’s imports from Libya, once a reliable supplier, were down by 11.9% in 2013; supplies from Algeria (where local demand is booming) were down by 40%.
  • Liquefied Natural Gas (LNG): The main problem with LNG is its inelastic supply. Due to the cost of the plants that liquefy the gas and the steadily growing demand from China and Japan, Europe would not be able to attain the LNG for a reasonable price.
  • Shale Gas from America: The lack of U.S. export facilities means that there would be large startup costs to begin importing, and even once the facilities were built, Europe would have to compete with the high prices China will be offering for the shale gas.

An interesting statistic to conclude and drive the point home: if Europe were to employ all of these alternative sources it would not only be short about half of its demand, but it would also spend $50 billion more on gas per year!

3.    Growing European Demand For Gas

The final argument is a short, but important one– European demand for gas is expected to grow for the next ten years: According to AT Kearney, a consultancy, imports are set to climb from 327bcm today to 413bcm in 2020.” A growing demand for gas would mean that gas from alternative sources would be even more expensive, making Russian gas that much more attractive.

In summary, the past two blog posts have developed a detailed argument for why European dependence on Russian gas will remain strong despite political concerns in Ukraine. The already developed infrastructure between Russia and Europe, the unjustifiably high cost of alternative gas sources, and a growing demand for gas has put European leaders in a tough position– a strong and expanding Russia is not in their best interest, but Russia’s cheap gas has chained Europe’s leaders onto the political sidelines until an economically viable alternative is found.

Europe’s Thirst for Russian Gas: An Addiction Unlikely To Wane (Part 1)

The Russia/Ukraine conflict has been a topic of growing concern for the Western World in the past month, especially for Europe. Vladimir Putin has discovered a chink in his western neighbors’ armor and is now exploiting it to his advantage. Europe’s severe dependence on Russian natural gas, a majority of which is supplied through the Brotherhood pipeline that runs through Ukraine, has allowed Putin’s annexation of Crimea to go largely unpunished. If Russia were to suddenly cut off the supply of gas to Ukraine, European gas prices would skyrocket, hurting households and firms across Europe– a risk that European leaders are unwilling to take. Even though Putin has little incentive to cut supply off in the long term (the EU’s purchases of Russian gas make up 3% of Russia’s total output), it is not stopping him from using it as an effective short-term threat while the conflict with Ukraine unfolds.

In a previous post, I discussed some of the potential long-term effects of the crisis, predicting that Europe will make an effort to rely less on Russian gas in the future by increasing demand from alternative sources (Norway, Algeria, and LNG). However, after reading a recent Economist article,  “Conscious Uncoupling,” I am convinced that Europe’s addiction to Russian gas will remain strong in both the short and long term. The combination of (1) an already developed infrastructure, (2) a lack of viable alternatives, and (3) a growing European demand for gas reveals that a large enough economic incentive can successfully overshadow political conflict.

1.    The Infrastructure Problem

The transportation of gas from one region to another requires a significant amount of infrastructure. Everything from pipelines to processing plants to storage facilities need to be built and then maintained regularly. An already developed natural gas transportation infrastructure between Europe and Russia is the primary reason Europe will continue to buy Russian gas. It is simply too costly for European countries to stop using the already built pipelines, especially when, as is the case for Lithuania, Estonia, and Latvia, these pipelines are the country’s only source of natural gas:

natural_gas1

Adding to the infrastructure argument is that even if Russia were to completely cut off supply to the Brotherhood pipeline, its workload would likely be redirected to other pipelines that run from Russia to Europe. As I mentioned in my previous post on this topic, the Nord Stream pipeline through the Baltic Sea to Germany and the Yamal pipeline through Poland and Belarus offer the EU alternative methods of importing gas from Russia.

Furthermore, many alternatives to Russian gas, such as American shale gas, face infrastructure concerns as well. As the Economist article points out, investors may be wary of the large, potentially unjustified startup capital necessary to begin importing shale gas into Europe:

Private-sector investors may be chary of putting money into costly terminals that risk not being used if Europe slips back into accepting more cheap Russian gas.”

And even if European demand for shale gas was guaranteed, lobbyists in the U.S. government could attempt to stop the export of shale gas in an effort to keep domestic prices low.

In the next blog post I will analyze two other reasons for Europe’s long term dependence on Russian gas: a lack of economically viable alternatives and a growing demand for gas in general.

Can QE* Be an Effective Long Term Policy? Yes, and Here’s How (Part 2)

The research conducted by Joshua K. Hausman (University of Michigan) and Johannes F. Wieland (University of California, San Diego) examines the success Abenomics has had in boosting Japanese GDP and gives insight into how such unconventional monetary policy can sustain amplified GDP growth in the long term.

Named after Japanese Prime Minister Shinzo Abe, ‘Abenomics’ is the name used to refer to Japan’s current three-pronged economic stimulus policy, which consists of a combination of monetary policy expansion, fiscal stimulus, and structural reform. It is the only real and current example of long-term unconventional monetary policy, and is thus viewed by economists as an important test of the policy’s validity.

So far, Abenomics has stood up to the challenge. The Japanese stock market has risen, the exchange rate has depreciated, and Japan’s GDP has jumped by up to 1.7%. Hausman and Weiland claim that one percent of this GDP growth has been directly caused by the monetary policy shift. Furthermore, Abenomics’ effect on the Japanese money supply has been much more effective than that of previous QE policies. The below graphic from the Economist article provides a nice summary of the effects of Abenomics:

unconventional MP_2

Hausman and Weiland attribute the superior effectiveness of Abenomics to the change in inflation expectations it has caused. Japan has set a new 2 percent inflation target and because Abenomics was announced to the public as a permanent change in policy rather than a temporary measure to boost GDP, inflation expectations increased for both the short and long terms. Both short and long-term borrowing appeared cheaper as a result. This, in turn, caused borrowing to increase across the board, stimulating increased consumer spending.

One should not go all-in on Abenomics quite yet, though. Both the article and research paper emphasize that Abenomics is still in its initial stages and has yet to prove itself as an effective catalyst for long term growth. When discussing the long-run outlook of Abenomics, Haussman and Weiland assert:

The research shows that the Bank of Japan is achieving its intermediate objective of higher expected inflation, but that the inflation target itself ‘remains imperfectly credible,’ with long-run inflation expectations below 1.5 percent.  Thus the modest estimates of Abenomics’ effects reflect in part that the Bank of Japan has not yet fully convinced the public that inflation will be two percent.

If the Bank of Japan could somehow more strongly convince the public of a future two percent inflation rate (perhaps through a public announcement reinforcing its intention to pursue the policies of Abenomics), the effects could be substantial. Hausman and Weiland estimate that “the output effects of Abenomics could as much double if inflation expectations rose to the 2 percent level.

In summary, based on the results presented by Gabriel Chodorow-Reich about the positive effects of QE on financial stability, and Hausman and Weiland’s estimates of past and future Japanese output growth as a result of Abenomics, I am convinced that unconventional monetary policy can be used effectively in the long term. If the Fed can convince the public that inflation will be steady at two percent and interest rates will remain low, whilst continuing to purchase assets and pursuing fiscal stimulus, it can achieve both strong economic growth and increased financial stability.

Can QE* Be an Effective Long Term Policy? Yes, and Here’s How (Part 1)

The Fed’s decision to implement quantitative easing and other unconventional monetary policy in December 2008 sparked a blaze of heated discussion amongst economists that has been burning to this day. The questions of if and how these new measures affect economic growth have become the focus of countless blog posts and editorials, and have become an integral part of many university Econ courses. The beginning of QE tapering in December 2013 added even more fuel to the fire, but it also gave many traditional economists a sense of relief. It finally looked like there was an end in sight to these unfamiliar and controversial policies. To the dismay of these traditionalists, however, recent research by the Brookings Institution (paper #1 and paper #2) suggests that there are significant benefits of pursuing unconventional monetary policy in the long term. A recent Economist article, “Staying Unconventional,” emphasizes some of the most important results of this research and raises a provocative question: Can QE, or some alternate form of it, be an effective long term policy?

Based on my reading of the research papers that the article cites, I am inclined to say yes. It may not be the QE policy currently being rolled back, but I can see an alternate form of such a policy being effective in the long term (hence the * in the title). Not only does unconventional monetary policy not cause riskier financial behavior, but it also provides a substantial boost to economic growth. In this blog post and the next one, my goal is to defend the bolded argument by highlighting some of the key findings of the research papers I mentioned earlier. The remainder of this post will be dedicated to discussing the first claim:

1.    Unconventional Monetary Policy Does NOT Cause Financial Instability

The argument commonly used to refute long-term implementation of QE is that it encourages individuals and financial institutions to pursue riskier investments, thereby reducing financial stability. The prediction is that long periods of low interest rates incentivize investors to ‘reach for yield’ and take on more credit risk, duration risk, or leverage. The research by Gabriel Chodorow-Reich of Harvard University confirms this prediction but emphasizes that the story is not so cut and dry. Although the Fed’s low interest rate policy has caused financial institutions to take on some riskier investments, it has also boosted the value of these institutions’ portfolios, making them less risky and strengthening the stability of the U.S. economy. Most importantly, Chodorow-Reich’s analysis shows that the stabilizing effect of QE has been stronger than the destabilizing effect caused by ‘reaching for yield.’

Chodrow-Reich determined the magnitude of each effect by evaluating the effect of the Fed’s policies on four categories of financial institutions: life insurers, commercial banks, money market funds, and defined benefit pension funds. Together, these institutions manage $24 trillion in assets. The effects are nicely summarized in the graphic provided in the abstract of the paper:

unconventional MP_1

As Chodrow-Reich states, “In the present environment, there does not seem to be a trade-off between expansionary [monetary] policy and the health or stability of the financial institutions studied.”