by John P. Hussman, Ph.D., Hussman Funds
With continuing weakness in the U.S. job market, Ben Bernanke confirmed last week what investors have been pricing into the markets for months - the Federal Reserve will launch a new program of "quantitative easing" (QE), probably as early as November. Analysts expect that the Fed could purchase $1 trillion or more of U.S. Treasury securities, flooding the financial system with additional bank reserves.
A second round of QE presumably has two operating targets. One is to directly lower long-term interest rates, possibly driving real interest rates to negative levels in hopes of stimulating loan demand and discouraging saving. The other is to directly increase the supply of lendable reserves in the banking system. The hope is that these changes will advance the ultimate objective of increasing U.S. output and employment.
Economics is essentially the study of how scarce resources are allocated. To that end, one of the main analytical tools used by economists is "constrained optimization" - we study how consumers maximize their welfare subject to budget constraints, how investors maximize their expected returns subject to a various levels of risk, how companies minimize their costs at various levels of output, and so forth. To assess whether QE is likely to achieve its intended objectives, it would be helpful for the Fed's governors to remember the first rule of constrained optimization - relaxing a constraint only improves an outcome if the constraint is binding. In other words, removing a barrier allows you to move forward only if that particular barrier is the one that is holding you back.
On the demand side, it is apparent that the U.S. is presently in something of a liquidity trap. Interest rates are already low enough that variations in their level are not the primary drivers of loan demand. Loans are desirable when businesses see opportunities to make profitable investments that will allow the repayment of the loan, without too much uncertainty. Similarly, loans are desirable when consumers see opportunities to shift part of their lifetime consumption stream toward the present (or to acquire durable items such as autos or homes which provide an ongoing stream of benefits), and where they also believe that their future income will be sufficient to service the debt.
Broadly speaking, neither businesses nor consumers are finding attractive borrowing opportunities, or have sufficient confidence that they will be able to repay the loans and end up better off. A few years ago, individuals did have the confidence to shift a portion of their lifetime consumption to the present because the values of their homes and other financial assets gave them the impression that their future consumption needs were well covered. Lax lending standards created a feedback loop of soaring mortgage debt, consumer debt, home values, and consumption. At the corporate level, the return on equity capital was progressively boosted by taking on increasing leverage, which eventually reached catastrophic levels in the financial sector. The subsequent collapse forced the recognition among consumers and businesses that their ability to service debt, based on expectations about the future value of their assets, was not as strong as they previously believed.
