Scott Sumner  

EconTalk Extra

Would Roland Fryer Be Better O... The Friedmans and Joseph Schum...

I'd like to make readers aware of a site called EconTalk Extra. There is a very good recent post by Amy Willis discussing my EconTalk conversation with Russ Roberts. Unfortunately I didn't respond to comments until this morning, as I just returned from a trip. So if you left a comment last week then go take another look.

It probably worth saying a bit more about the first comment, which pointed to the widely held perception that monetary stimulus has boosted asset prices without significantly helping the economy. There is a grain of truth in the asset price effects, but I believe people tend to overestimate the "Cantillon effects."

In recent years the demand for bank reserves has been very strong, mostly due to near-zero nominal rates, but also the 0.25% interest-on-reserves program. The QE injections have mostly served to prevent an even slower recovery. Here you might contrast the US with the eurozone, where the ECB did less monetary stimulus and the recession took a double dip after 2011.

So in my view the Fed's QE actually boosted asset prices by preventing a worse macro outcome. I do understand why people disagree with me; the recently soaring stock prices seem much too dramatic to explain by the modest economic recovery in the US. And that's because at the same time the Fed has been doing QE, the global economy has been buffeted by "stagnation" forces that seem to have depressed equilibrium real interest rates, even on very long-term bonds. And yet despite the weak economy, corporate earnings are pretty good. If you discount strong corporate earnings with low real interest rates, you end up with high asset prices. But the Fed plays only a very modest direct role in the low rates.

In 1928 and 1929 things were a bit different. The global economy still had relatively high short-term real interest rates, and then in the late 1920s the Fed raised them even higher, with the goal of popping the stock market bubble. In the end they "succeeded," but it's more interesting to consider the 18-month period when they failed, early 1928 to late 1929. Why did the continual increase in interest rates fail to pop stock prices until the fall of 1929? The answer seems to be that macro conditions are much more important than the short term interest rates that are affected by monetary policy. Stock prices plunged only when the economy began a sharp nosedive in the fall of 1929.

The real interest rate was much higher in the late 1920s than today, but in both cases we see asset markets responding more to macroeconomic events than to the (liquidity effect of) monetary policy. That's not to say monetary policy is not important, but it's mostly important to the extent that it impacts the key macro variables, not because it swaps one interest-bearing Federal government liability for another interest-bearing Federal government liability.

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CATEGORIES: Finance , Monetary Policy

COMMENTS (15 to date)
Hazel Meade writes:

I tend to avoid sites that involve audio or video, since it takes significantly longer to listen than it does to read.

Michael Byrnes writes:

@Hazel Meade

Transcripts of Econtalk episodes are available at the link. (And the "Econtalk Extra" posts aren't audio).


There's obviously a huge difference between what you are talking about here (economic outlook improves, thus expected returns from stocks rise, thus stock prices rise) with what others mean when they talk about "asset price inflation" (I think people mean something like an "asset hot potato effect" - more cash chasing fewer stocks thus stock prices rise).

Kevin Erdmann writes:

Michael, that's what's so frustrating about public discourse. It's all coming from Scott's effect, and none of it is from the asset "hot potato". I'd take it farther than Scott. The discount rate applied to expected profits isn't low and corporate debt is low. So low interest rates aren't even pushing equity values up. But this mistake causes people to mistake optimal Fed policy as some sort of Wall Street bailout or an unsustainable bubble. Even members of the FOMC do this.

Amy Willis writes:

Thank you, Scott!

Brendan Riske writes:


Thanks for getting back to us today. I guess my further question is how do you measure the cantillion effects of fed policy? I mean, QE and ZIRP are essentially unprecedented in size and duration, and the magnitude is enormous. I'm just curious because alot of your narrative starts here.

The EU didn't launch QE, but it was in far worse shape than the US anyway. Capital would flow back into the US naturally. Don't forget Draghi promised to launch QE which has kept European markets afloat until he finally confirmed it recently. I think its a false dichotomy between US easing and EU austerity. The fed just gave money to the banks to paper over their issues, without fixing the structural problems in the economy. The EU could get a QE program because of how the union was structured, until things got desperate and germany caved. But the EU countries, not the PIGS but as a whole, took on more public sector debt. No austerity there.

@Kevin Erdmann

I have no idea what your complaining about. Corporate debt is low? did you check the aggregate levels? Way higher than in 08. Of course low interest rates prop equities up! two ways: people move money from low yielding assets into higher yielding stocks. Also, they allow companies to issue debt cheap the proceeds of which are used to buy back stock. Seriously what are you talking about? Fed policy favors wall street over main street, its a simple fact. It has pushed money into equities causing a massive bubble. Truly a piece of corporate welfare, the banks would've gone under without fed support, not just money but guarantees. You are the one who is completely, mistaken.

Kevin Erdmann writes:

Corporate debt is as low as ever. What measure are you referring to?

"people move money from low yielding assets into higher yielding stocks."
Nobody goes to that restaurant any more because it's too crowded.

Scott Sumner writes:

Michael, This is a common misconception. The act of purchasing stock does not push up stock prices. Indeed on October 19, 1987, there was an all time record amount of stocks purchased, and the stock market plunged 22.8%.

Money doesn't go into markets, it goes through markets.

Kevin, How do you measure the discount rate on stock earnings?

Amy, And thanks to you as well.

Brendan, You said:

"QE and ZIRP are essentially unprecedented in size and duration, and the magnitude is enormous."

Not really, something fairly similar happened in the 1930s. Also look at Japan from 1996 to 2006.

You said:

"The EU didn't launch QE, but it was in far worse shape than the US anyway."

That's simply not true. Back in 2010 both the US and eurozone had roughly 9% unemployment. Then the eurozone rate went up over 12%, and ours fell below 6%.

Policy matters!

The ECB's tight money policy of 2011 was incredibly damaging.

You said:

"The EU could get a QE program because of how the union was structured, until things got desperate and germany caved."

I'm afraid you simply are not aware of what's been going on. Between 2008 and 2012 the eurozone was not even at the zero bound, they were doing ordinary monetary policy, raising and lowering interest rates. The tight money policy of 2011 was done by raising the interest rate target enough to slow NGDP growth. Lack of QE is not an excuse.

Obviously if the ECB is raising interest rates it makes no sense to use their supposed inability to do QE as an excuse. It would be like saying the car isn't moving because it isn't getting enough gas, at a time the transmission is in "park." (And by the way, they could have done QE whenever they wanted.)

Brendan Riske writes:

You are correct that something similar happen during the 1930s as well as in Japan.

I would say one only needs to took at the effects of QE in Japan to see what it leads to, long term depression as the real economy takes a back seat to the financial economy. Abenomics will go down as a major failure. The "third arrow (structural reforms for growth)" was never successfully implemented and that was the only part of his policy that could've helped. He has only succeeded in driving the yen down towards oblivion, and crushing the savers of his country.

The scale of QE this time is larger than either. The fed was authorized to buy government debt to the tune of $4 Billion from 1932-1936. It was done with specific congressional support and limitations. This time we have seen $4.5 trillion of asset purchases 2008-2015. It has also become a persistent market force. After each round has ended the fact is that another round was called for and received. If the US economy does not pickup soon or enters a contraction, another may be necessary (there have been hints by fed governors already at QE4).

In defense of my comments on Europe:

My basic point is Europe was structurally weaker than the US after the financial crisis. Demographically it was set to grow more slowly, and its regulatory structure has been stifling to growth. The US economy also had more access to natural resources than the Europeans, with our oil production vastly exceeding theirs.

This was the background to the ECB's decisions. Monetary policy is not an antidote for structural issues, and the ECB found out by 2012 that it could not hold the Eurozone together with interest rates alone. There was a major risk of the PIGS defaulting on their debts and leaving. The consensus was quantitative easing was necessary, as had occurred in the US and England. The only barrier was the Bundesbank, which was reluctant to pursue such an expansionary policy. So Draghi confirmed that he would do "whatever it takes" and the market expected QE from Europe. The stability fund was a way of demonstrating that commitment, as were the other government financing policies given to get the PIGS out of crisis. I don't argue that this was priced in. This helped stabilize the Eurozone and end the first debt crisis. The problem was it was too early, and Draghi did not have the political capital to implement a wider QE until conditions worsened again, say as Greece appears to be leaving.... Now we get 1.1 trillion euro of bond purchases. Pushing bond prices up, pushing interest on them negative.

Brendan Riske writes:

@Kevin Erdmann

That is an interesting graph you have there. Doesn't capture the whole picture at all. There is no serious commentator who thinks corporate debt levels are lower today than before the crisis. I've seen it quoted as an increase from 7.2 trillion in 2007 to over 9 trillion today, or 11 trillion to 13 trillion, depending on how you want to calculate it. They issue debt to buy back stock, take a look at the rate of stock repurchases lately to get an idea of how much debt they have issued.

as for the second part of your comment, i don't understand. People are still buying equities hand over fist. earnings multiples (in GAAP terms) are at pre-great depression levels, and valuations in technology and biotech are reaching bubble levels. No one cares, sovereign wealth funds are buying, central banks are buying, pension funds are buying, day traders are buying. Corporations are buying back record amounts of their own stock. There has been a greater fool to flip these assets to because any large portfolio has needed to purchase more equities to get its yield up. Its an easy trade, until it doesn't work. Savers are still being crushed on bank rates. HY debt is still being issues like wildfire, even in the shale sector. The global search for yield is real.

Kevin Erdmann writes:


Aswath Damodaran at NYU keeps the most popular estimate of expected equity returns that I know of.

Using CAPM, required returns to stocks are estimated by adding the risk free rate (he uses the 10 year treasury) and the Equity Risk Premium (ERP). He infers the ERP by using published growth expectations to estimate market expectations of cash flows.

What is interesting is that while it is common for everyone to discuss equities as some sore of mob driven by greed and fear, most of the changes in equity values are cyclical movements related to actual changes in cash flows. But the ex ante expected returns on stocks tend to be fairly stable. I'd say more stable than the risk free return on bonds. Here's a graph of long term nominal returns of bonds vs. stocks.

The lack of stationarity in ERP over long investment horizons is mostly from long term persistent changes in nominal bond returns. I did a series of posts a while back about how this makes nominal bonds a terrible hedge for equities.

And, that is the case now. The expected return on equities (treasuries + ERP) is about where it tends to stay. For the S&P 500 it's about 6% in real terms (8% nominal), and has been in that area at least since 1960, except for a brief bump up in the late 1970s, because of inflationary dislocations I assume.

So, when long term treasuries move up 2 or 3%, ERP will tend to move down by a similar amount. Of course, as you know, long term rates, which is what we are talking about here, won't necessarily move in the same direction as short term rates. The effect short term rates have on equities is practically all a product of its effect on nominal consumption, which is the main driver of cyclical equity fluctuations. As with most things in finance, there is much confusion about this because of causal density.

A writes:

Brendan Riseke,

It's not clear why debt fueled buybacks would inflate stocks. Even if you adjust Modigliani-Miller assumptions to include discount rates that have been highly reduced by liquidity support, that still leads you to level revaluation. You would expect the market to quickly reprice at a level where lowered future returns and income yields imply your suggested scenario. But take a look at this chart showing the relationship between cyclically adjusted P/E and interest rates:

There is not a simple relationship between nominal long term rates and P/E cycles.

A buyback is just a form of payout. Few people would argue that debt fueled dividends result in 6 year bull markets, but something about buybacks perpetuates this argument.

Brendan Riske writes:


I think its hard to argue Modigliani-Miller holds up in this environment. Companies have priced in the low interest rate environment into their decision to take on debt. They are not investing this in CAPEX or paying out more to employees in salary. It isn't debt based on the expectations of future earnings. It is debt strictly because their is plenty of cheap credit available right now, and its being used to pay shareholders. Great examples have been these huge failed M&A deals lately. The "market" prices nothing in, its more about how convincing can venture capital firms be that deals will work. When you boil it down it looks like they take out debt as long as this debt will inflate stock prices long enough for the principal holders (executives, hedge funds, banks) to cash out.

A buyback is a reward to shareholders. Which means it also rewards executives paid in stock. No one is arguing that debt fueled the entire recent bull market, but I would argue that it has been a major factor in boasting stock prices. It has been possible due to fed policy. Large companies have access to credit at a discount typically, and since the rate provided to banks has reached zero, the cost of borrowing for companies has also come close to zero. At this bound it makes perfect sense to issue a huge amount of debt and buy stock with it. The stock price gets a temporary boast from the increased demand, and the appearance of higher earnings per share, executives and shareholders can sell shares and cash out while value is high, and the interest on the debt is sustainable. But if interest rates rise, or the stock market tanks, these companies now have huge balance sheets and will have great difficulty generating the cash to pay their debts.

6 year bull markets are not caused by stock market buybacks. But they can be caused by fed policy. Greenspan started it, and Yellen has continued it. A nice series of booms followed by spectacular busts. I am not looking forward to the bust following this recent boom. Great moderation....

Scott Sumner writes:

Brendan, You said:

"I would say one only needs to took at the effects of QE in Japan to see what it leads to, long term depression as the real economy takes a back seat to the financial economy. Abenomics will go down as a major failure. The "third arrow (structural reforms for growth)" was never successfully implemented and that was the only part of his policy that could've helped. He has only succeeded in driving the yen down towards oblivion, and crushing the savers of his country."

We agree that the third arrow was the most important, was not fully implemented, and hence was a missed opportunity. And that Japan's prospects are not good. Otherwise I don't agree. You assume that money in Japan has been easy, whereas I agree with Milton Friedman (writing in 1998) that it has been tight. As Ben Bernanke says, neither the money supply nor interest rates are a good indicator of the stance of monetary policy. You need to look at NGDP growth and inflation.

QE is something central banks do when money has been too tight. That's why the central bank of Australia did no QE, they had easier money than the other central banks. Blaming QE for the long depression is like blaming umbrellas for rain. When Japan raised its inflation target to 2% in early 2013, the economy did pick up a bit, but with a rapidly falling population there is no prospect of rapid RGDP growth in Japan. Abenomics has created jobs, however, and reduced the Japanese unemployment rate. So at least Abenomics is better than what came before.

Regarding the Depression, the MB increased nearly 4 fold between December 1929 and December 1941, not too dissimilar from the recent increase, except over a longer period of time. At first economists viewed that as an easy money policy, but now they know better.

I completely disagree with your arguments on Europe. The structural issues you mention don't explain why the eurozone suddenly went from having about the same unemployment rate as the US in 2010, to twice the level. Yes, they have "regulation," but have always had regulation. And slower population growth obviously doesn't explain higher unemployment. Of course Draghi had to convince his colleagues, but that has no bearing on my claim that the ECB screwed up, it merely addresses the issue of which specific individuals were to blame for the screw-up.

Scott Sumner writes:

Thanks Kevin, I'm no expert, but here's what I see:

1. The required discount rate includes long term bond yields and the ERP.

2. Bond yields can be measured precisely, the ERP is very hard to estimate.

3. We know that bond yields have fallen substantially.

From those facts I'm not sure if I have much confidence in the stability of the discount rate for stocks. It might be stable, but it might well have fallen.

Kevin Erdmann writes:

Fair enough. I just thought you were under selling your point. To the extent that attempts to measure expected equity returns don't show a decrease, your point is even stronger than you make of it.

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