Let me start by saying that I do not support the loose monetary policy of Quantitative Easing by the Federal Reserve.
Supporters of QE say that it is required because there is so much slack in the economy. They say that we are far below the CBO projection of potential real GDP. Thus, the monetary policy must find a way to lower real interest rates to encourage investment. My problem with this view is that effective demand will put a limit on real GDP below the CBO projection of potential real GDP. (see prior post) In my view, the business cycle will end much sooner than economists think. The benefits they see from pushing loose monetary policy are much more than what I see as possible. The risks of QE are therefore relatively greater.
Supporters of QE also point to high unemployment. The implication is that we need to support business in any way possible to create jobs. I have a problem with this view too. From my calculation, unemployment will be between 6.5% to 7.0% on a quarterly basis when the effective demand limit is reached. Unemployment will stop declining at the effective demand limit. The perceived benefits of QE to lower unemployment below 6.5% are not attainable in my view.
On the other hand, people who do not support QE normally point to the danger of high inflation. I don’t agree with this view either. There simply isn’t enough wage growth to provide demand for higher inflation. Also there isn’t enough upside to capital utilization to support an increasing inflation. Capital utilization will also be limited at the effective demand limit in the 79% to 80% range.
So then what is my problem with QE? What harm can it do? I will refer to William Emmott for an explanation. He is a former editor for the Economist magazine. There is a short video of his view on the problem with QE. (link to video).
His view is this… Accommodative monetary policy “distorts investment decisions”. It “subsidizes certain forms of activity”… “In the long-run you get an inefficient allocation of capital”.
He talks about how low interest rates distorted investment in Japan leading to weak economic growth. He says that the United States has a better chance of escaping this problem than Europe, but the problem is still present.
Mr. Emmott says that “Zombie companies, zombie sectors, are being kept artificially alive by accommodative monetary policy” and that this is “slowing down the process of creative destruction”. I would do more than just point to certain zombie companies, I would say that even healthy companies have become more inefficient from low-interest rate subsidization and from doing business with the zombie companies. Loose monetary policy is a disease that is weakening the interconnected vitality of the economy overall.
These zombie companies are less productive, less marginally profitable, thus less able to raise wages at a time when wages need to be raised. Zombie companies justify lower wages for all companies. Keeping these zombie companies alive is a weight dragging down the demand side of most advanced countries.
At the end of this current business cycle (not the end of QE since the end of the business cycle will come before the end of QE), when the economy starts to contract, these zombie companies are going to present symptoms of a disease which will begin to affect other companies. That is when the recession will come.
QE is making the economy weaker by not allowing creative destruction.
Let me make an analogy of creative destruction to the physiological process of building muscle. Muscles are analogous to companies in business sectors. Here is a brief explanation of how we make our muscles stronger.
“The process starts with what is known as the ‘stimulus’ – this is the training itself. We stimulate the muscles, which causes ‘trauma’. This is the term for muscle damage – it is the breakdown of the skeletal muscle tissue. This breakdown forces the muscle to restructure and grow, returning bigger and stronger under the correct nutritional and recovery conditions.” (source Total Fit blog)
In order to make our muscles (business sectors) stronger, we must first be in training. Training means challenging our muscles on a continual and gradually tougher basis. During proper training, we will damage our muscles. We will traumatize them… break them down. Remember, what doesn’t kill us,
just makes us miserable, just makes us stronger.
In economics, we have to traumatize businesses in order to make them stronger. The crisis was a trauma… yes. My model shows that the Fed rate should have gone to zero % after the crisis. But the Fed rate has been near zero % too long now.
We should actually be in training to get stronger at this moment. We should be gradually challenging business to restructure, be more efficient and more productive. If we don’t, business will never be efficient enough to raise wages. Anyway, loose monetary policy has stopped the training. It took away an advantage of more efficient companies to compete with zombie companies. Muscles fibers (companies) that were breaking down have not been replaced by stronger muscle fibers. Companies have been “babied” by many policies, including tax policy.
Look at the reaction of business when they freaked out for a couple weeks over the Fed talking about maybe tapering QE later this year and China at the same time tightening its interest rates. The Fed backed off. Businesses and investors have hung their investment decisions on slack monetary policy. Investments in Zombie entities are not going to be challenged. and There will be adverse effects in the long-run from supporting this inefficient allocation of money.
Bottom line: We all want a strong and productive economy that can provide good-paying jobs. Good-paying jobs will revive demand. We are not going to get that by coddling business with accommodative policies at every turn. There is wisdom to challenging business through a creatively destructive process, which includes continually and gradually tightening monetary policy through the business cycle. Ultimately real wages will have a fighting chance to increase. The Fed needs the courage, the foresight, the backbone and the stomach to challenge zombie businesses.