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The Fed Is Quantitatively Easing Americans Out of Their Jobs

Sunday 5 May 2013

By Louis Woodhill

As the months go by, it is becoming clear that the Federal Reserve’s "QE3" program, which is supposed to be "doing something" about unemployment, is having the exact opposite effect. We can only wonder how long it will take Fed Chairman Ben Bernanke to realize this.

Friday’s "Employment Situation" report from the Bureau of Labor Statistics (BLS) was really, really, really bad. The reported 0.1 percentage point decline in the "headline" unemployment rate (from 7.7% to 7.6%) fooled no one. Total employment actually fell by 206,000. The only reason that the reported unemployment rate went down was because 496,000 Americans gave up on looking for jobs.

The most striking feature of President Obama’s so-called "economic recovery" has been the exodus of Americans from the labor force. The unprecedented 2.5 percentage point decline in labor force participation under Obama amounts to 6.2 million Americans being pushed out of the job market.

If labor force participation had remained at the level it was when George W. Bush left office (65.8%), the unemployment rate for March would have been reported at 11.1%, up 0.2 percentage points from February. This amounts to a 3.1 percentage point rise during Obama’s presidency, 1.4 percentage points of which occurred since the start of our so-called "economic recovery" in June 2009.

So, March was not a pretty picture on the jobs front. Now, let’s turn our attention back to the Federal Reserve and QE3.

On September 13, 2012, the Fed announced that it would buy $40 billion/month of mortgage-backed securities until the unemployment rate fell below 6.5%, or the expected inflation rate rose above 2.5%. The Fed’s new program was universally referred to as "QE3," for "Quantitative Easing, Part 3." It was bold and unprecedented for the Fed to publicly target a real variable, unemployment, rather than a nominal quantity such as an interest rate or the size of a monetary aggregate.

In their QE3 press release, the Fed expressed frustration with the slow pace of improvement in labor market conditions. Over the 14 months after QE2 (the Fed’s previous $600 billion attempt to "do something") had ended on June 30, 2011, the "headline" unemployment rate declined from 9.1% to 8.1%. However, most of this apparent improvement was the result of Americans dropping out of the labor force. Adjusted to the labor force participation rate when Bush 43 left office, the "true" unemployment rate had only dropped by 0.2 percentage points, from 11.5% to 11.3%.

The unemployment rate didn’t improve during the first two months of QE3, so on December 12, 2012, the Fed more than doubled the size of QE3 by adding the purchase of $45 billion/month of longer-term Treasury securities. This brought the scale of the Fed’s monetary jihad against unemployment up to $85 billion/month, or more than $1 trillion/year. Let’s call the Fed’s expanded QE program "QE3 Full Throttle."

So, how is Ben Bernanke’s latest attempt to "do something" working for us so far? Let’s look at what happened during 1Q2013, which comprised the first three months of QE3 Full Throttle.

In 1Q2013, the Fed increased the size of its balance sheet by $285 billion, or 9.8%. The reported unemployment rate did decline by 0.2 percentage points, to 7.6%. Unfortunately, this improvement was pure illusion, the product of a 483,000 drop in the labor force. The number of Americans with jobs actually fell by 19,000 during the quarter, and the "true" unemployment rate increased from 10.9% to 11.1%.

So, what went wrong?

QE3 is intended to provide the economy with "monetary stimulus." Like fiscal stimulus, monetary stimulus is supposed to reduce unemployment by increasing aggregate demand (nominal GDP). Unlike fiscal stimulus (e.g. Obama’s $862 billion government spending orgy in 2009), which can never work because it is based upon Keynesian superstition, monetary stimulus can help in certain circumstances.

A money economy needs money to operate. In this sense, our economy is like a car engine, which needs both fuel and air to produce power. In this analogy, nonresidential produced assets (the real capital used to produce our GDP) are like air, and money is like gasoline.

Every automotive engineer knows that, in terms of getting power out of an engine, the big challenge is airflow. Perhaps 99% of the weight and cost of an engine relates to the movement of air. In contrast, delivering the gasoline that the engine needs is a relatively trivial undertaking. However, if this task doesn’t get done, the engine won’t run.

The analogy between our economy and a car engine holds in another important way. The power output of an engine is governed by controlling the airflow into the engine. A well-designed fuel injection system simply reacts to changes in airflow, spraying in the precise amount of gasoline required to match the mass of air moving through the combustion chambers. From the standpoint of power and efficiency, too much gasoline is just as bad as too little.

In the case of an engine, the idea of an active, ad-hoc, discretionary "fuel policy" would be crazy. The engine would keep stalling, as it alternated between flooding and lean misfiring. Similarly, the very idea of a discretionary monetary policy is insane. Money cannot drive economic growth any more than gasoline input can determine the power output of an engine.

A good monetary control system would be purely reactive, just like a good automotive fuel injection system. It would automatically respond to shifts in the need for money, based upon events in the real economy. It is America’s lack of such a system that made possible the housing bubble of 2001 - 2006, the financial crisis of 2008, and our current "Pretty Good Depression."

An economy with a well-designed monetary control system would never get itself into a situation where it could benefit from monetary stimulus (e.g., QE3). However, it is possible for a discretionary monetary regime to create a situation where the economy doesn’t have the amount of money that it needs to operate efficiently. In such circumstances, changing monetary policy to better match the supply of money to the economy’s demand for money would make things better. This was probably the concept behind QE3.

The proximate problem is that, even by its own misguided standards, QE3 is not working. In fact, it is producing the opposite effect of what the Fed’s theories would predict. QE3 Full Throttle seems to be actually depressing the economy.

If nothing else, the counterproductive (by the standards of monetary stimulus) nature of QE3 can be seen in the price of gold. QE3 is intended to be inflationary, and yet the gold price actually fell by 10% during the first two calendar quarters of QE3.

This suggests that QE3, and especially QE3 Full Throttle, is actually having the effect of tightening monetary conditions. "Tight money" (the economy finding that it has less money that it expected to have) is known to produce the symptoms that we are now experiencing (falling gold prices; worsening labor market conditions).

How could something like QE3 Full Throttle, which increased the size of the Fed’s balance sheet by almost 10% in a single quarter, possibly do this? The problem is that what the Fed is actually doing to implement QE3 is exchanging newly created, interest-paying bank reserves for federally guaranteed mortgage-backed securities and Treasury bonds. In so doing, the Fed is increasing the size of the monetary base, and therefore "printing money."

However, for monetary stimulus to work, the new monetary base must be transformed into the kinds of "money" that are actually used to do transactions. This does not appear to be happening.

During the 3 months prior to the start of QE3, the monetary base actually contracted by 0.95%. However, M3, a broader measure of the money supply, increased by 1.53%. In contrast, during our 3 months of QE3 Full Throttle, the Fed increased the monetary base by 10.83%, but M3 went up by only 0.49% (the M3 numbers are taken from Shadow Government Statistics).

The movements in the monetary aggregates, like the falling gold price, and like the darkening jobs picture, suggest that QE3 Full Throttle is having the opposite effect of what Bernanke must be intending. This is not a good thing.

Analysis by Jeff Snider, who also writes for RealClearMarkets, suggests that the problem is that the Treasury bonds that the Fed is buying up are needed by the financial markets to collateralize the transactions by which monetary base is transmuted into the broader forms of money. If Snider is correct, the more QE the Fed does, the worse things will get.

If this whole thing sounds crazy to you, it’s because the whole notion of a discretionary monetary policy is crazy. What Bernanke is doing right now makes as much sense as your getting your friends together for a meeting every six weeks to vote on how much gasoline the fuel injectors in your car’s engine should be spraying into the cylinders.

The ultimate solution to our monetary mess is a gold standard system that would simply and automatically supply the amount of monetary base needed by the economy at a given moment, while keeping the value of the dollar constant. Meanwhile, we can only hope that Chairman Bernanke wakes up and realizes that his current policies are quantitatively easing Americans into unemployment.

Louis Woodhill (louis@woodhill.com), an engineer and software entrepreneur, is a Forbes contributor.

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