Not another rant against monetary easing? Thoughts on encouraging risk

It has often been stated that a major objective of the QE2 monetary expansion is to encourage people to take on more risk, and to discourage them from hoarding money into savings. QE2 is meant to create an environment which creates incentives for people to put money into circulation via spending and investment. Well, as it happens, proponents of QE2 are setting up a straw man. Who needs to take on more risk? Companies? Individual savers? Institutional investors?

Monetary easing is a potent economic weapon, and just like an atom bomb, it doesn’t make a distinction of who its target is. It doesn’t care whether you’re rich or poor, whether you’re a consummate saver or you’re a consummate debtor. Monetary easing will always have one effect on you – take on more risk.

And so it has been since it was called a Greenspan put (now it goes by the updated name of Bernanke put). Whenever the economy starts to slow down, the solution has been to avoid incurring fiscal deficit at all costs (It increases government debt) and substitute it with activist monetary policy – which in the case of a slowdown means monetary easing.

During Greenspan’s time, the solution was lowering interest rate. Lower interest rate (or Fed funds rate, to be exact) is supposed to encourage more company investment. But the straw man also includes pension and money fund managers. You know them- the people you entrust your retirement savings to, with a mandate to ensure 10% annual yields (or better). They have promised to turn your savings into a nest egg that can fund your lifestyle in your retirement years. So what happens when rates are made lower, but their marching orders are still to generate 10% annual yield (or better)? That’s right. Take on more risk.

Well, let’s qualify that. They are supposed to safeguard the principal of their investors, because these are meant to be there when they retire. So, you look for yield while maintaining the illusion of safety.

During Greenspan’s time, the process became – lower interest rates – hunt for higher yield (more risk) – this leads to a bubble, turbocharged by leverage, which deflates – large losses, which, coupled with leverage, leads to a bigger downturn, as investors take stock of their losses and deleverage.

Now, during Bernanke’s time, the process is the same. A downturn leads to….well now that we are at the zero-bound as a starting point, the idea is to make interest rates negative in real terms. That means nominally increasing money supply, via QE2. So….. negative interest rates – hunt for higher yield (more risk) – this leads to a bubble, turbocharged by leverage, which deflates – large losses, which, coupled with leverage, leads to a bigger downturn, as investors take stock of their losses and deleverage.

During Greenspan’s time the investment of choice for the bravest and fiercest was leveraged mortgage bonds. It promised yield while maintaining the illusion of safety.

Fast forward to now, Bernanke’s time, the investment of choice seems to be commodities and emerging market debt. After all, when money is replicating faster than amoeba, the effect should be a turbocharged increase in the value of “scarce” resources, right? And so we see yield hungry investors fleeing into commodities and commodity-rich economies (and economies which are just now starting to develop).

But what happens when this leads to an inevitable bubble, which then bursts? What will save leveraged investors from falling price of commodities? (And why shouldn’t you eventually leverage up, when interest rates are negative?) What will save the economy from going into a bigger tailspin?

Well, if we are to believe the all-encompassing usefulness of monetary policy, monetary easing should do the trick. QE9? QE10? After all, there’s no problem that can’t be solved by throwing more money into it (No matter if it leads to the next, bigger problem). Just don’t let it lead to a fiscal deficit.