A Young Person's Guide to QE3

The Federal Reserve Building, DC.

As we all know, the QE3 is a Cunard cruise ship, but this abbreviation has also the vernacular as the latest installment of the Fed's quantitative easing program. Although the media was very good at reporting the details as far as the announcement went (see here or here for example), there is very little commentary on what QE3 will actually have the potential to do to the economy - so here I'll attempt to shed a little light on that without hopefully offending either political party.

The term "quantitative easing" is used when the Fed can no longer use conventional methods to ease monetary policy further - that is by lowering interest rates.  Interest rates in the US are now extremely low and the Fed has decided that it doesn't want to see them any lower - this is the so called "lower bound".  So the Fed instead resorts (as the Bank of Japan did before it) to unconventional methods, namely "quantitative easing" which occurs whenever the central bank buys bonds which are longer term government bonds or bonds not issued by the government.  When the central bank buys or sells short term government bonds (known as T-bills) this is known as "open market operations" and is the usual channel in which monetary policy operates.  So what were QE1 and QE2?  In late November 2008, the Fed started buying $600 billion in mortgage-backed securities (MBS) - these are pieces of paper that represent bundles of mortgages, and they result from banks packaging together mortgages in big bundles and then effectively selling them on so they can free up their balance sheets. By March 2009, the Fed held $1.75 trillion of bank debt, MBS, and Treasury notes, and this reached a peak of $2.1 trillion in June 2010. Further purchases were halted as the economy had started to improve, but resumed in August 2010 when the Fed decided the economy was not growing fast enough. This was "QE1". In November 2010, the Fed announced a second round of quantitative easing, or "QE2", buying $600 billion of Treasury securities by the end of the second quarter of 2011. 

Ben Bernanke from an Article in The Atlantic Magazine

The third round of quantitative easing, or QE3, which was announced by Fed Chairman Bernanke a couple of weeks ago, was completely different, not because of what the Fed would do, but because of how it would do it. This time the Fed is going to buy $40 billion of mortgage-backed securities (MBS) per month, until the US labor market improves.  Bernanke said essentially that this program would be open ended, and would continue until the economy is well on it's way to recovery. Now what does this mean exactly?  Well, for a start, the Fed is committing itself to buying securitized US mortgages, which as any undergrad student of economics knows will increase the demand for this type of bond, and so will increase price, which will reduce yield.  The immediate effect then of doing this will be to keep mortgage rates very low, as banks will be able to issue up to $40 billion of new mortgages per month without putting any upward pressure on mortgage interest rates.  This in turn, will be a big stimulus to the housing market, one of the key sectors in the US economy.  All well and good so far.

The main problem with the policy though is that the so-called "transmission mechanism" for this form of unconventional monetary policy is not entirely clear, and here's why.  Given that this stimulates mortgage lending (as banks know that they can easily package up the mortgages and sell them on as MBS), this will clearly stimulate both existing and new housing activity, which will mean more housing construction.  So that will, in turn, mean more construction workers will be hired, which should increase employment, and that in turn will boost payroll numbers and bring down unemployment.  But employment in construction, even at the height of the housing boom in 2006 only represented about 8% of total US employment, so that is not really going to have a huge impact on the labor market, plus, many of the hires that do occur for manual construction jobs tend to be illegal or undocumented workers, so this won't feed into the official statistics either.

Of course I cannot imagine what the Fed economists have in mind for the transmission mechanism for QE3, but the only thing I can think of is that a mini-housing boom causes house prices to rise, and that in turn gives rise to so-called "wealth effects". These wealth effects result from people feeling better off because they have a net profit in their property, so go out and and spend as they did back in the 2000s.  There are also likely to be wealth effects arising from the stockmarket as well, as obviously market sentiment has improved in the knowledge that the Fed has backstopped the economy for the moment, and so share prices should continue to firm.  But the danger here is that these mechanisms are very - how might I put it - inexact. Obviously imprecision is not an excuse for inaction, but on the other hand it really is sending the Fed into uncharted territory.

Now please don't get me wrong here - I'd rather the Fed did something rather than nothing, as we clearly need more stimulus from somewhere, but I'm just a little uncertain as to how well QE3 will work.  I guess only time will tell.

The NHS, Obamacare and the priorities of a US President

http://www.flickr.com/photos/48459298@N07/7658481768/in/photostream/

I just came back from the UK and as you know if you read my blog regularly, I was at the London Olympics but more importantly I was in the UK to soak up the Olympic spirit and the great atmosphere that settled on London.  Now I saw Danny Boyle's Olympic Opening Ceremony like many people on the planet and was, I confess, a little surprised that Boyle emphasized the NHS as one of the "firsts" that the UK should celebrate as a nation. Now most of my US friends don't know what the NHS, but the National Health Service as it is known in the UK is the state funded healthcare system that has been in force since it was introduced in 1948 in post-WWII UK under the most left-leaning UK government under Clement Atlee, as one of the consequences of a reconstruction of the UK after the terrible hardships suffered by the country during the war (see here for more).  Health Minister Aneurin Bevan introduced the NHS with the following principles - i) it meets the needs of everyone; ii) that it be free at the point of delivery and iii) that it be based on clinical need, and not the ability to pay.

Now as you can see on the left, the NHS isn't necessarily seen as the most wonderful institution by all concerned in the UK ( - here David Cameron (UK PM) and Boris Johnson (Mayor of London) - are seen grimacing) in the way Boyle was determined to celebrate the NHS as a real achievement using real NHS nurses and doctors.

But one thing I think that people not from the UK need to recognize is that even the right wing party in the UK, the Conservative party, is not about to scrap the NHS because it is a beloved part of the UK landscape and although most people complain about various facets of the system, in the UK the horror stories about the US healthcare system are such that most Brits have no wish to embrace a private healthcare system like the US's system.

Now to Obamacare. Paul Krugman recently noted on his blog (here) that references a CEPR blog article (here) that comments on an article that criticises President Obama for focusing so much on healthcare in his first term in office when in the opinion of the author he could have been focusing more on the economy.  But in my way of thinking reform of the US healthcare system will probably be one of the major accomplishments of the Obama Presidency.

My basis for making this statement is partly because healthcare costs are an extremely large part of the government budget and because also they are much higher as a percentage of GDP than for any other country in the world. Whether you like Michael Moore or not, one of his major contributions must be his film "Sicko", which points out how expensive and inefficient the US healthcare system is, considering the economic resources that are absorbed by the healthcare sector.

But also I can make this statement from a personal point of view as I have been a recipient of healthcare under the US, Canadian, UK, and Finnish healthcare systems - how many people do you know who can say that? Now admittedly I haven't been on the operating table in any of these systems, so I haven't gone through the whole GP, to specialist to operation procedure, but I have received treatment by doctors in all 4 countries, and received some basic tests (blood work or some other basic testing). These are my observations about the US compared to the other systems:
 - a doctor's visit in the US involves much more basic "triage" than elsewhere - which might yield some useful observations, but is likely to be superfluous in most cases.
 - US doctors have an incentive to give many more tests than in other countries as they can charge for these tests - but they are permitted to give these tests according to the HMOs and PPOs, so naturally, they do!
 - US doctors will not contact patients on the phone - but they do elsewhere.
 - the HMOs and PPOs really determine the charges and expense of the system - thereby setting the minimum prices for the system.

Critics of both the Canadian healthcare system and the NHS say that they are "socialist".  Certainly in the UK that cannot be further from the truth. The structure of the system has been to create decentralized NHS "trusts" which are given a budget and then tasked with delivering care as efficiently and effectively as possible. In both the UK and Finland there are private options if you want to pay, but everyone pays for the NHS through their taxes, so that leads to a minimum level of care. And when you go to the doctors in Canada, the UK and Finland, the doctor personally invites you into his or her office without all the "triage" tests, and basically gets straight down to business. This "personal touch", in my experience, sets these systems apart from the US system, in which lawsuits and rent extraction are the main foci.

So, what do I think of Obamacare?  I think it really comes up short compared to the "single payer" systems that I think work more efficiently than the US healthcare system, but it is certainly better than what the US has right now. Will the US ever get rid of the middlemen ( - the HMOs and PPOs)?  The answer is likely no - they have way too much power now and are completely entrenched in the system.

So did President Obama waste his time focusing on reforming the US healthcare system?  No, I don't believe he did - it was an important task to complete, and now ranks as one of his biggest achievements over the past 4 years.