Eugene Fama is right on QE

Eugene Fama of Chicago Booth School of Business is one of the three winners of the 2013 memorial Nobel prize in economics – and a rare winner of one of these softer prizes whom I consider extremely well-chosen (the efficient market hypothesis will be discussed later).

Yesterday, CNBC's Rick Santelli asked him about the quantitative easing.




The interview has sparked a controversy in a part of the economics blogosphere. Here is the video:



If you don't see any video above, find it on this page of Pragmatic Capitalist who liked Fama's fresh observations as much as I did. Note that in the mobile template, the rectangle only shows a part of the image because the whole video doesn't fit in; switch to the full green web template if it is a problem for you.




The exchange makes me think that the "economic science" journalists are equally deluded and suffer from the same kind of idiotic group think as most of the science journalists writing about the climate or high energy physics.

Well, Santelli's idea is that everyone agrees that the quantitative easing has been a wonderful thing with a miraculous curing effect on the economy and the only issue is that one must be careful while exiting it. Everyone has to agree with these theses, Santelli assumes, so the only thing that an economic Nobel prize winner may add are some irrelevant details, babbling that no one cares about and whose only point is to confirm the "consensus" of the journalists talking about the markets. Nobel prize winners are just decorative appendages on the journalists' neck.

However, Fama just doesn't agree. He looks at the thing analytically and classifies the whole operation as a simple example of "asset swapping". In effect, the American central bank is buying back some long-term debt and selling new short-term debt in order to have cash for the buybacks. This maneuver is expected – and arguably has the desired purpose – to lower the long-term interest rates but the price to pay is the increase of the short-term interest rates. The operation doesn't do much, Fama concludes.

Santelli obviously doesn't want to accept this insight so he acts as if he fails to understand plain English. For example, he's asking, if it's so inconsequential, why don't all the central banks do such a thing all the time? Fama is smiling because he has already provided the viewers with the answer. The central banks may do such things but they're pretty much inconsequential, neutral events, so it doesn't matter. The central bankers may also hug the trees every morning which still doesn't mean that the economy will triple every year.

It seems obvious to me that Fama's basic claim is right. There could be operations that dramatically change the inflation rate and other quantities – like dropping trillions in banknotes from the helicopters or stealing all treasuries from their owners in some way – but as long as such things are not being done, the Fed is just redistributing its assets and debts and moving piles across the room just isn't the most important maneuver for the economy.

If one reduces the long-term debt by issuing some other debt, it's clearly a neutral event. If the two debts have different maturity dates, such an operation will change the yields of the two kinds of debt in opposite ways. It will add a contribution that tries to lower the long-term interest rates but it will also add another contribution that raises the short-term interest rates.

However, there are also other contributions – other factors and pressures – that determine both interest rates (and the whole curve) so the final outcome may be different. It just happened that even the short-term rates were dropping for some other reasons and the Fed took credit for that trend. However, as Fama points out, the only rationally expectable consequence of the asset swapping for the short-term interest rates was their increase so it is preposterous for the Fed to take credit for these short term interest rates' decrease. The short-term interest rates dropped despite the Feds' efforts to the contrary, not because of them.

When Santelli mentions that some people are praising QE for their car loans, it's really preposterous because generic people with car loans can't have a clue about the actual causal relationships and mechanisms that operate in the economy.

Santelli asked Fama why central banks aren't doing such things all the time. Isn't it a great outcome to lower the long-term interest rates? Well, it wouldn't do much, Fama's arguments imply. If I elaborate on Fama's ideas how I understand them, the long-term debt isn't the only debt and those who buy treasuries may choose which kind of debt they decide to buy. If the short-term interest rates become high enough, the holders of treasuries will start to prefer the short-term debt which they may buy again and again. The nominally long-term debt will represent a lower percentage of the total debt than before. Much of the debt will be moved to nominally short-term debt that is "actually" a long-term debt because the bondholders are determined to buy it again and again. So the asset swapping will only change how often they have to renew some papers. It doesn't affect the essence much. The total debt is still the same number, it's just distributed differently, and the U.S. and others are pretty much paying the same average interest rates for the debt. Of course that you can't create miracles for the economy just by moving piles from one side of the room to another. The taxpayers own all the assets as well as liabilities as a whole, Sack und Pack or Sakum Prdum, as we say in Czech, so it doesn't matter if some terms in the balance sheet are canceled on the paper.

These are crystal clear arguments but some people – like Rick Santelli – just prefer their mindless group think over rational arguments. It's not just Rick Santelli who likes to turn their brains off. Economist Brad DeLong wrote a rant against Fama's explanation (via Pig). As far as I can see, DeLong's rant doesn't contain a tiny glimpse of an argument. It just claims that Fama is clueless.

Efficient market hypothesis

Well, in order to give DeLong the full credit and to praise every aspect of his knowledge and creativity, I must admit that the last word of his rant is "dumbass", too.

DeLong may say that Fama is a "dumbass" but I think that he realizes very well that when it comes to the brilliance in economics, he (DeLong) is just a tiny little wee wee if compared to well-known Chicago school economists, even third-wave Chicago school economists like Fama (the Chicago school was linked to Milton Friedman's monetarism through the 1970s which became replaced by "new classical economics" based on "rational expectations" but the thoughts kept on irritating leftists and Keynesians in the same way as monetarism because they are largely equivalent). In fact, Fama's main expertise is exactly the portfolio theory so questions whether some asset swapping matters are questions he has successfully (understatement) studied for 50 years.

The Chicago school of economics is a culture of economic thought that really makes sense, that puts the primary principles such as free markets to the center, and that's been repeatedly tested to be vastly superior in comparison with other general approaches (and yes, Chile has been a major example of that although some people find it politically incorrect to even talk about these successes).

Fama began to be influential in economics since his PhD thesis in the 1960s. He proposed nothing less than the efficient market theory. Well, we may sometimes talk about "market inefficiencies" but I surely think that the understanding why the markets are basically efficient and what it implies is as important for economics as the understanding of classical physics for a physicist.

Prices may fluctuate and resemble a random walk – well, the typical price may behave as \(\exp(R(ct))\) where \(c\) is a constant, \(t\) is time, and \(R(x)\) is a random walk function that tends to behave as \(\langle |R(x)|^2\rangle=\sqrt{x}\). The more they fluctuate, the greater profit the investor expects because he may get huge losses instead, too. In fact, even the expectation value of the profit should be higher for more volatile assets – the extra profit is a premium one gets for the risk.

But once the system exists, investors are spread over assets and none of them will really be a better investment than others – assuming that no one is an "inside trader" who has a "systematically better information" about the future behavior of the prices. A higher risk may bring you higher profits – or greater losses. Many people who claim special skills and knowledge that goes beyond the efficient market hypothesis are inside traders and charlatans who oversell their good luck or their morally questionable enhanced access to some tools of the markets and to the government as a talent.

The random-walk character of the prices was first modeled by Jules Regnault, a broker, in 1863, and Louis Bachelier, a French mathematician, in a 1900 thesis. But Fama went further. And in the 1990s, he constructed a more quantitative Fama-French three-factor model of portfolio's returns.

I don't want to go into details of Fama's work because this is not an economics blog. But if I return to the debate about quantitative easing, the main big-picture tension here seems to be the pro-government/anti-government intrinsically ideological debate. Keynesians like Brad DeLong want to attribute lots of miraculous powers to the government. If you move the piles of treasuries from one side of the room to another, you will make the economy prosper forever, and so on.

The reality is different and kind of simpler. There are no miraculous cures. The best thing that the government may do is to encourage sensible overall/average interest rates (e.g. by targeting inflation) which means to guarantee that the currency remains a good and predictable enough a unit of wealth and to avoid interventions into any of the relative prices which are optimally determined by the free markets.

Sometimes, a government may intervene into relative prices and it may distort these prices – and distort the market. It may help to create bubbles at particular places or to induce the opposite development, whatever is the right word for anti-bubbles. But in some cases, the distortion is pretty much inconsequential. In the case of quantitative easing as interpreted by Fama, the distortion just involves the increase of prices of treasuries using one color on the paper and the decrease of treasuries with another color. The bondholders owning the first color will be a bit lucky while the bondholders with the second color will be a bit unlucky because the central bank has effectively moved a part of their wealth to the pockets of the first group (which is something that shouldn't be done by the government) but the overall impact on the whole economy is pretty much zero. All of them still hold treasuries or debt of some sort. Its overall magnitude hasn't changed. And the overall magnitude of the debt determines the risk that America will default – and it determines the effective, average interest rates as a consequence.

The tense exchange between Santelli and Fama shows how much the actual top experts are being avoided by the media and how shocked the media folks inevitably are when one of them gets on the TV screen. The media are largely controlled by mediocre pseudoexperts such as Brad DeLong who have been trained to think that a few insults and the repetition of not quite coherent clichés (and flawed arguments that almost always overlook one side of the equation among two) may replace or beat evidence or a sensible argument that just works.