The fallout from Fed Chairman Ben Bernanke’s suggestion that the Fed would begin tapering of its QE3 program in September of this year was swift and vociferous. Yields on almost all Treasury notes continue to rise, and the Fed is now embarking on what many see as a remedial PR campaign to undo the damage caused by Bernanke’s comments. The general consensus among economists and investors is that Bernanke has made a terrible mistake that will substantially slow down US, and therefore global, prospects for recovery.
Paul Krugman attributes this change in attitude of the Fed to two possible factors: a fear of bubbles, and worries about inflation, which have been voiced loudly and often by many concerned conservatives. I wholeheartedly disagree. While human kind as a whole has a long history of fudging macro policy, I still find it hard to believe that the Fed would honestly see inflation as a real threat at this point. Even with all the money being pumped into the economy, it’s looking like a bit of a struggle just to keep inflation above 1%–it was 1.1% in April and shows no sign of rising to dangerous levels. And as Krugman has argued, a rate of 4 or 5% wouldn’t be the worst thing in the world, as it would inflate away some of the US’ debt, and would perhaps incite firms to let go of some of that hoarded cash we’ve been hearing so much about. Harm to savers would be minimal, as current personal savings rates are abysmal. (Yes, the St. Louis Fed really outdid itself with this page. All flash and no substance, guys!) And as for the bubble threat, there doesn’t seem to be any on the horizon. One of the classic signs of a bubble is a thriving economy–albeit, an artificial sort of thriving driven by an asset that is about to crash spectacularly–but there is no thriving of which to speak. I am of the mind that the Fed knows all this perfectly well.
So if bubbles and inflation are not a concern, then why would the Fed want to begin tapering QE? Quite simply, because it’s not helping those that it intended to help. The one bubble that there has been some concern about lately is a stock bubble–the words “record high” are tossed around with astonishing frequency these days, enraging the struggling masses who wonder when they will see the benefit of all that prosperity. The answer is probably never, and the Fed probably sees this. What seems to be happening is that firms are getting hold of all that cheap money and, instead of reinvesting it to create jobs and improve efficiency, opt to instead use it to inflate their share prices by way of share buybacks and dividend increases. This is good for investors, but bad for people who need jobs. Exacerbating this pooling of money at the top is the fact that investment income is taxed so lightly, the result being that shareholders, usually those with the most disposable income, benefit disproportionately. This chart pretty much says it all:
While one could tell a story about how lower tax rates have given investors increased incentive to seek out profits, as this blogger has, that is not my primary concern here. What I am seeing is a very little portion of society benefiting from the Fed’s QE program, perhaps in part due to low tax rates on capital gains that raise the stakes, giving added incentives for companies to placate investors in hard times while ignoring long-term growth. Indeed, share repurchasing is at a record high, according to the Financial Times. So, seen in this light, why would the Fed want to continue a policy that is not having its intended effect? Will doing it more help matters? I personally don’t think so–the flaw lies in the structure of our financial system, not in the attitudes of business owners and CEOs.
A report on cash-hoarding by the St. Louis Fed gives a number of reasons for companies’ reluctance to reinvest, and acknowledges that many firms prefer to keep earnings overseas to avoid repatriation fees. The report cites tax uncertainty in the US as the primary reason that firms are holding cash, as well as the looming threat of tightened monetary policy, which may make it more difficult for firms to get cash quick if needed. It observes that the ratio of cash to net assets has more than doubled in the past 20 years, and that it is mostly smaller firms that are holding cash.
This very clearly signals a need for legislators in the US to make more cash available to smaller firms, because they are best-positioned to return the US to its former status as innovator and land of opportunity. Of course, I don’t think the Fed’s stats tell the whole story–many larger firms such as Wal-Mart seem intent on increasing share prices, regardless of the long-term effects this may have.
So, the solution is two-fold: make more cash available to smaller firms, and discourage large firms from engaging in stock market tomfoolery which they will certainly regret later, anyhow. Another sound policy might involve a clearer and more predictable system of taxation that encourages corporations to bring profits to the US. The Fed itself has acknowledged that companies are holding money abroad to evade taxes: why is this acceptable?
Getting back to Bernanke’s actions in the past week: the reaction has been very extreme, but perhaps it was long-overdue. Interest rates on US Treasury notes were at all-time lows to begin with, and the US is still a long way from ever having to default. If Bernanke’s statements incite large firms to begin planning for a time when easy money will no longer be available, by, say, reinvesting instead of engaging in share repurchasing, then perhaps they will have had their intended effect. Interest rates will still be low, so small firms should not feel that they cannot take calculated risks as well.
Though Bernanke’s recent tactics seem wrong-headed to some, a closer look at just who was benefited by QE shows that perhaps there is some method behind the madness. The subsequent contradictions by other Fed officials only serve to highlight internal divisions and show the Fed’s weakness to corporate interests. With the enactment of the policies I have suggested above, however, I see no reason why the end of QE should be the death knell of the US economy.