09/20/2012 08:44 pm ET | Updated Nov 20, 2012

The Futile Search for Signs of Doubt Among Central Bankers

Central banks in the United States (the Fed) and Europe (the ECB) are running their printing presses overtime to create artificial demand for sovereign debts and thereby to reduce global interest rates. In doing so, they expect to stimulate demand and thereby bring about economic recovery. These are grand schemes hatched by mortals who, having donned the garb of masters of the universe, see no need to display doubt as to the correctness of their prescription for what ails the world or the certainty of achieving the outcomes they desire.

One intended effect of printing money to carry out these programs (Outright Monetary Transactions or OMT in Europe; Quantitative Easing or QE in US) is to drive up the price of capital assets in general and global equity markets in particular (up 16 percent ytd).

The Chairmen of the Fed and the ECB, Messrs. Bernanke and Draghi, have each been praised for "boldness." True enough, but boldness should never be equated with intelligent, restrained policies that admit to limits and uncertainties and weigh all possible adverse consequences, intended and unintended, with care, caution and complete transparency, so that the public understands potential risks as well as rewards. We have been treated to three rounds of QE, with the third now on-going. Here are quotes by Bernanke post QE2 and QE3. They make it perfectly clear that one direct intended result of QE is to drive stock prices up to levels that their prospects for future earnings would not support.

Post QE 3: "the tools we have involve affecting financial asset prices"; "to the extent that consumers will feel wealthier, they'll feel more disposed to spend... "

Post QE 2: "stock prices rose and long term interest rates fell when investors began to anticipate the most recent action... Higher stock prices will boost consumer wealth and help increase confidence, which can also spur spending. Increased spending will lead to higher incomes and profits that, in a virtuous circle, further support economic expansion."

The Fed has a dual mandate to achieve a stable dollar and a healthy level of employment.  There is no mandate to manipulate the stock market to achieve either of these goals. The existence of a mandate to achieve full employment shouldn't be construed to allow the Fed to do so "by any means," heedless of other effects. The unemployment problem we face could be, and should be, addressed through fiscal policies. The political deadlock makes this solution impossible to implement at the present time. This situation does not justify the Fed engaging in a program that could possibly, and in some well-informed opinions, is likely to, do more harm than good when its course is run.

There are risks, known and unknown, to the Bernanke-Draghi policies, although one wouldn't learn about them from their pronouncements. Faust was a brilliant early example of unintended consequences of bargaining with the Devil, in this case being tempted to print paper money notionally backed by gold that had not even been mined. At first happy results ensue across the land (which happens to be the Holy Roman Empire). As more and more money is printed, however, rampant inflation follows, destroying the economy. In a recent speech, Jens Weidmann, a lone voice from the Bundesbank in Germany, used Goethe's play to illustrate the core problem of today's paper-money monetary policy. He said OMT "was tantamount to financing governments by printing banknotes."  

What bad outcomes are possible? By driving down interest rates to the artificial rate of zero and below (in real terms), QE1, 2, and 3 are, in effect, imposing a tax on all holders of debt, including, importantly, savers, annuitants and retirees. In addition, artificially low rates of return on debt instruments make even banks with plenty of money to loan reluctant, because the spreads become too narrow to cover costs and a satisfactory return. And money market mutual funds are hurt because they can't offer returns without subsidization.

QE 1 and 2 fuelled a bubble in commodities and increased income inequality. There is good reason to suppose QE3 will do the same. Over the 16 months that QE1 was in effect, to March 2010, the CRB commodity price index rose 36 percent while food prices rose 20 percent and oil prices 59 percent. During QE 2, in eight months to June 2011, the CRB rose another 10 percent, food prices were up another 10 percent and oil prices were up another 30 percent.

These price movements offset whatever stimulative effects QE achieves from artificially lifting stock prices, at least to some significant extent. But the damage is worse than might appear because it's mainly the wealthy families who benefit from a rising stock market.  Families in the top 10 percent of income own 75 percent of all stocks. The middle and lower classes mainly experience the anti-stimulative effects of rising prices for the food and oil they must have to survive. There should be a study of the impact of QE 1, 2 and 3 on the lower and middle classes in this country. The Fed produces studies on many subjects but this subject is not likely to be one we'll see any time soon, even though it would surely have been done for internal use by the Governors before they embarked on the QE program. It is probably the lack of accountability of Central Bank Chairmen for what they do that enables them to proceed on a "trust me" basis without disclosing to the public the full range of risks, possible outcomes and unintended adverse consequences.

The record of accomplishment by Central Banks is mixed at best. Bernanke missed the real estate bubble that burst in 2008, leading to the severe conditions that followed and still persist, especially in regard to unemployment. As William White, former Economic Advisor and the Head of Monetary and Economic Department at the International Bank for Settlements, noted in an important paper titled Ultra Easy Monetary Policy and the Law of Unintended Consequences:

The unexpected beginning of the financial and economic crisis, and its unexpected resistance to policy measures taken to date, leads to a simple conclusion. The variety of economic models used by modern academics and by policymakers give few insights as to how the economy really works.

The WEO, published by the IMF in the spring of 2008, predicted real growth in the advanced economies in 2009 of 3.8 percent of GDP. The actual outcome was -3.7 percent, a forecast error of 7.5 percentage points of GDP. They were by no means alone in missing this dramatic turnaround.

The Fed has a tiger by the tail with its program. It is creating a giant bubble in capital asset prices, especially in our stock markets. To let the tiger go is to be eaten. Its balance sheet is swollen with government debt and to unload will mean rising interest rates to attract buyers. The same may be said of the ECB. All of which suggests a quip of long ago: the trouble with our times is that the future's not what it used to be.