Quantitative Easing and Market Distortions

January 7th, 2013 by Wayne Leighton

In yesterday’s post, I noted that members of the Federal Open Market Committee are starting to discuss the Fed’s latest quantitative easing, in particular the size and duration of a program that includes purchases of Treasury securities and mortgage-backed securities.

What really needs to be asked is

1) whether this policy is distorting the market rate of interest (which, if it is, will distort investment decisions and set the economy on the path to bigger problems in the future), and

2) whether the purchase of mortgage-backed securities (instead of a pure focus on Treasury securities) will exacerbate these types of distortions, particularly in the real estate market.

In chapter 6 of Madmen, Ed and I show links between the idea that home ownership should be vigorously promoted by government, the actions of madmen in authority taken to pursue such policies, and utlimately the erroneous decisions made by people across the economy that contributed to the 2008 crisis.

The idea that home ownership is part of the American dream has been embedded in the culture since at least the 1930s.

In response to this bottom-up demand for the American dream, and at times in an attempt to build on it for political or economic gain, politicians spent the better part of the last century trying to facilitate home ownership. Various institutions emerged, prompted by both political and market foreces. Indeed, it is hard to separate these two influences, as they are intimately linked.

The cast of characters among these institutions, and those affected by them, is long. They are star players in the biggest financial crisis since the Great Depression, and they include Congress, the White House, the Federal Housing Administration, Fannie Mae and Freddie Mac, the Federal Reserve, other federal agencies, independent financial ratings agencies, banks, and mortgage brokers–and, just as importantly, the homebuyers themselves. Everyone responded rationally to the incentives before them. In short, the rules that guided home ownership changed over time, which in turn changed the incentives of these actors. And bad things happened.

The “incentives matter” argument — how bad incentives distorted the real estate market and led to a crisis — is made nicely in a 2009 essay by Peter Boettke and Steven Horowitz, “The House That Uncle Sam Built.” Their argument in brief:

When central banks like the Federal Reserve inflate, they provide banks with more money to lend, even though the public has not provided any more savings. Banks respond by lowering interest rates to draw in new borrowers. The borrowers see the lower interest rate and believe that it signals that consumers are more interested in delayed consumption relative to immediate consumption. Borrowers then begin to invest in those longer-term projects, which are now relatively more desirable given the lower interest rate. The problem, however, is that the demand for those longer-term projects is not really there. The public is not more interested in future consumption, even though the interest rate signals suggest otherwise…

Eventually those producers engaged in the longer processes find the cost of acquiring their raw materials to be too high, particularly as it becomes clear that the public’s willingness to defer consumption until the future is not what the interest rate suggested would be forthcoming. These longer-term processes are then abandoned, resulting in falling asset prices (both capital goods and financial assets, such as the stock prices of the relevant companies) and unemployed labor in sectors associated with the capital goods industries.

So begins the bust phase of a monetary policy-induced cycle; as stock prices fall, asset prices “deflate,” overall economic activity slows and unemployment rises. The bust is the economy going through a refitting and reshuffling of capital and
labor as it eliminates mistakes made during the boom. The important points here are that the artificial boom is when the mistakes were made, and it is during the bust that those mistakes are corrected.

What mistakes are being made now by madmen in authority at the Federal Reserve? What might prompt a correction? Is a larger “structural” reform possible, and if so, under what conditions?