QE2 and the undead homicidal zombie market

By Felix Salmon
November 16, 2010
Baruch has a fantastic new post up, which nails what I'm really worried about when it comes to quantitative easing.

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I know this blog has been way too heavy on the QE of late; apologies for that. But Baruch has a fantastic new post up, which nails what I’m really worried about when it comes to quantitative easing.

Essentially, says Baruch, the stock market rally is like the cat in Pet Sematary: it looks real, but it isn’t. And in fact it’s likely to turn out very harmful indeed.

Part of the problem is that QE has become, in part, a game of “kill all the shorts”—a game which a glance at IOC or OPEN or even UTA will tell you is being played very well indeed. Correlations are high, which is always a bad sign, and that weakens the raison d’être of the entire market, which is to allocate capital efficiently. Instead, the stock market becomes a place where people park their money in the hope that it will go up and in the expectation that if it goes down, the Fed will step in and rescue them.

But Baruch isn’t reassured:

Will we crash? Will we carry on straight up? Will we pause and rally? Who can say? We’re in a period where anything is possible, as I’ve said before, a world of unintended consequences coming down the pipe. Some may be good, and some may be bad…

I’m not saying we’re in an undead homicidal zombie market, though we may be. But here’s an example of what the Pet Sematary market is capable of in terms of unintended consequences: QE inflates all asset prices, including commodities. This pressures the Chinese consumer, who we are relying on to pull us all out of this mess, who can suddenly not afford his new LCD TV because his Moo Shu pork Big Mac and fries is costing 20% more than it used to. Changes in commodity prices have a much greater impact on his consumption than Joe Schmoe in Idaho. The BoC has to raise rates to offset the inflation this is causing, hurting Chinese growth even more, and global GDP growth drops 50bp. Bravo the Bernank. With your Quantitative Easing you just killed off the only good thing in this market which was working naturally without outside interference.

Baruch doesn’t think this is going to happen, necessarily — but the point is that neither he nor anybody at the Fed is remotely able to judge its probability, or, for that matter, the probability that QE will actually work.

Kevin Drum makes the very good point that we’re not actually arguing about something hugely important here:

Despite the scary sounding $600 billion number, the actual impact of QE2 is almost certain to be fairly small. With interest rates already so low, there’s simply not enough money involved to move markets substantially.

But the key word here is “almost”: QE might well end up making very little difference either way, but there’s no doubt that it’s made the tails fatter. Global markets have ramped up a lot since QE2 was effectively announced, and a sudden unwind of that move would devastate confidence. There’s lots of things that can go wrong, and the chances that the stock market has its valuations right have never been smaller. If you’re buying stocks right now, I hope you’re able to withstand a very bumpy ride. Because there’s a substantial chance that you’re going to get exactly that.


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I don’t understand how looking at IOC, OPEN and UTA makes the point that this is a short-covering move. Almost all stocks (correlation) look like that.

And it looks like the whole commodity play is over, so what Baruch is talking about is old news.

Posted by Bernanke | Report as abusive

Your logic makes no sense. Anytime the global markets think there is a better prospect of an American recovery, they will ramp up. Anytime they are disappointed, they will fall.

Your arguments against QEII, which is modest by any measure and has already been tried in Japan with small effect, are the same arguments against any type of stimulative measure — that it could possibly cause a bubble. Perhaps extra liquidity is ginning up the markets a lot, perhaps not. So should that fear justify doing nothing.

I guess the best way to avoid that is to have long, drawn-out depression. No bubble concerns there.

Posted by gpowell | Report as abusive

Do you have any argument here besides being afraid?

Posted by q_is_too_short | Report as abusive

I don’t want to be the ornery academic economist here, but both you and Baruch are in need of a lengthy primer on asset pricing. (And yes, I acknowledge that markets aren’t always perfectly rational and efficient, but that’s not the point here. You are not positing any strange behavioral dynamics on the part of investors — as far as I can tell, the vague and confused model you’re using does not incorporate any specific departure from rational responses to incentives. It just gets the responses wrong.)

This bizarre statement is a case in point:

“Instead, the stock market becomes a place where people park their money in the hope that it will go up and in the expectation that if it goes down, the Fed will step in and rescue them.”

How, exactly, does the Fed “rescue” them? There are really only two possibilities. First, the Fed improves the real economy and thus asset prices. Under this interpretation, the market currently believes that the Fed *could do significantly more* to boost the economy — which is inconsistent with essentially everything else you’re saying.

The other possibility is that the Fed lowers the real interest rate by increasing inflation expectations. The problem here is that it’s clear that real interest rates are currently *above* the equilibrium level; that’s why nominal spending has fallen so much in the first place, and it’s why a widespread increase in the supply of savings hasn’t translated into a boost in capital investment (which it ordinarily would — if not constrained by the zero lower bound, the real interest rate would fall until savings and investment reached equilibrium). By lowering the real interest rate, therefore, the Fed actually removes a distortion currently present in capital markets — which is again exactly the opposite of your claim.

From an asset pricing perspective, the claim that QE is causing the runup in commodity prices (or even a fraction of it) is also completely incoherent, except insofar as QE has lowered the real interest rate — which, again, is *removing* a distortion in markets, not creating one.

Posted by agradstudent | Report as abusive

What agradstudent said.

It is amusing that you have juxtaposed this post with one in which you muse about Tina Brown’s “reality distortion field.” That, at least, is a subject in which you have formidable expertise: the problem here is not that your blog has been “too heavy” on QE, but rather, too lightweight.

Posted by Greycap | Report as abusive

But this is a daft argument. Yes, we are in uncharted territory and we don’t know what QE2 will do — but there are good reasons to think it should help, so let’s give it a go. Your argument is basically just fretting that we don’t know it all.

Does this come down to a matter of temperament? Some people are inclined to act in a new, bad situation, and some are paralysed with nerves?

Posted by JDB | Report as abusive