Seven years ago, on November 15, 2010—less than two weeks after QE2 was announced—a group of prominent, nonconformist and thought-to-be forward-thinking economists, investors, and political strategists sent a letter to then Fed Chairman Ben Bernanke. They did not equivocate. The open letter, under the letterhead of the Hoover Institution, succinctly outlined concerns about undesirable side effects of QE. No attempt was made below to emphasize any words, phrases, or sentences that might distract the reader.
Open Letter to Ben Bernanke
We believe the Federal Reserve’s large-scale asset purchase plan (so-called “quantitative easing”) should be reconsidered and discontinued. We do not believe such a plan is necessary or advisable under current circumstances. The planned asset purchases risk currency debasement and inflation, and we do not think they will achieve the Fed’s objective of promoting employment.
We subscribe to your statement in the Washington Post on November 4 that “the Federal Reserve cannot solve all the economy’s problems on its own.” In this case, we think improvements in tax, spending and regulatory policies must take precedence in a national growth program, not further monetary stimulus.
We disagree with the view that inflation needs to be pushed higher, and worry that another round of asset purchases, with interest rates still near zero over a year into the recovery, will distort financial markets and greatly complicate future Fed efforts to normalize monetary policy.
The Fed’s purchase program has also met broad opposition from other central banks and we share their concerns that quantitative easing by the Fed is neither warranted nor helpful in addressing either U.S. or global economic problems.
The letter was not without its nongovernmental critics such as here.
The Fed’s response was cordial, prompt and self-assured (emphasis added):
As the Chairman has said, the Federal Reserve has Congressionally-mandated objectives to help promote both increased employment and price stability. In light of persistently weak job creation and declining inflation, the Federal Open Market Committee’s recent actions reflect those mandates. The Federal Reserve will regularly review its program in light of incoming information and is prepared to make adjustments as necessary. The Federal Reserve is committed to both parts of its dual mandate and will take all measures to keep inflation low and stable as well as promote growth in employment. In particular, the Fed has made all necessary preparations and is confident that it has the tools to unwind these policies at the appropriate time. The Chairman has also noted that the Federal Reserve does not believe it can solve the economy’s problems on its own. That will take time and the combined efforts of many parties, including the central bank, Congress, the administration, regulators, and the private sector.
Queried four years later by Bloomberg, the signatories to the original letter reaffirmed their warning of risks associated with quantitative easing.
Prescient Warning or Shortsighted Fear-Mongering?
So, here we are in late December, 2017, again asking ourselves whether the open letter was prescient or shortsighted. Headline employment growth (to say nothing of the steady drop in the monthly unemployment rate) and quiescent consumer prices have undoubtedly tilted sentiment toward the Fed’s justifications in 2010. In fact, the presumed success of the Fed’s monetary stimulus program is widely celebrated in both public and private sectors. And that’s what worries me and the signatories to the November 2010 letter.
Our apprehensions rest with forces that typically don’t make the headlines. Let’s begin with the wellspring of economic prosperity, growth in productivity. This metric is the amount of goods and services produced compared to the number of labor hours used in producing them. This is the 10th business cycle since 1947 and the fourth longest, but productivity has grown at a dispiriting 1.1% annually, less than half the 70-year average of 2.3%.[1] No prior cycle produced a lower gain in productivity.
The centrality of labor productivity cannot be understated. In a typical postwar cycle, robust gains in productivity have a multiplier effect throughout the entire economy. The economy is able to produce increasingly more goods and services for a given number of hours of work. These gains in efficiency make it possible to achieve growth in labor income, shareholder profits, and public-sector revenue. Growth in the productivity of labor allows these factors to increase simultaneously, without gains in one coming at the cost of another.
In this anemic cycle, subpar productivity gains mean real hourly compensation has grown at a record low of .07%. The long-term average is 1.7%. Likewise, growth in output (GDP) has been 1.4%, well below the average-cycle rate of 3.4%. It’s no consolation that hours worked have grown slightly faster than output.
Shareholder profits was italicized above for emphasis, as its link to the productivity of labor is not commonly understood. Just like income to labor, growth in corporate profits is dependent upon growth in the productivity of labor. According to the Bureau of Economic Analysis (BEA), the after-tax corporate profits component of GDP (using the income versus production approach) bounced back from the recession lows to $1.49 trillion by Q3 2010. Nearly 7 years later, in Q3 2017, profits reached $1.86 trillion, growing at an annual real rate of 3.22%. By contrast, over the same period, the S&P 500 rose 132% or 12.45% annually. Intentionally or inadvertently, I believe that the unprecedented expansionary Fed policy has created a Wall Street bubble and not a robust and enduring Main Street expansion. This is a clear indication of the antisocial misallocation of resources that results from managing the cost of money.
The Roots & Fruits of Low Productivity
Technology stagnation, capex starvation, and declining effectiveness of the labor force have been cited as root causes of subpar productivity growth since even before the Great Recession. It is impossible to wholly diagnose the causes of low productivity, but it is especially difficult to determine whether the post-crisis Fed policy has had any measurable impact on the productivity of labor, or even real wages, economic output, and corporate profits.
The consequences of low productivity are more predictable. Lower growth in the productivity of labor is likely to end recent historical trends toward real deflation in consumer goods and services—that which is driven by improvements in production, supply chain management and retailing technologies. As a result, real incomes will decline faster and fiscal and monetary systems around the world will be feeling the pain of these adjustments. On a long enough horizon, a structural slowdown in the growth of productivity can end up lifting inflation while continuing to depress economic growth. Intervention with monetary and fiscal policy can actually be counterproductive. Despite the high-fives around Washington, the tax law just signed by the President will surely exacerbate the problem.
As regards to the prices paid by consumers for goods and services, over the last 10 years the Consumer Price Index (CPI) has risen at an average of 1.9% annually. Energy costs, 0.2% (7.9% index weighting; used cars and trucks, 0.2% (combined CPI weight of 7.0%), and recreation, 0.5% (5.7%), had the most deflationary effect on the index although there were no outliers on the upside.
Meanwhile, runaway inflation has been the conspicuous norm in most classes of marketable securities, commercial real estate, collectibles and the like. While the signatories to the open letter worried about consumer price inflation, that did not happen. There may be a greater threat, however; a bubble in so-called risk assets. As the Fed unwinds years of monetary largess with a new and inexperienced captain at the helm, the consequences of a revaluation of asset prices may be uncomfortable indeed.
[1] According to the Bureau of Labor Statistics (BLS), a business cycle is measured from the peak of one expansion to the peak of the following. This cycle began in Q4 2007.