Wednesday, January 20, 2010

Limits of quantitative easing?

The WSJ points to Andrei Shleifer's argument, made at the annual meeting of the American Economic Association, that "quantitative easing" can be successful only if the Fed or Treasury buys mortgage-backed securities and other private assets in large enough quantities that their prices rise so much that the banks find them no longer attractive investments. This arguement is made on the premiss that as the prices of securities deviate from fundamentals and hit the bottom, they become attractive investment options for reserves rich banks, who instead of making loans start buying securities. And once the prices rebound and arbitrage opportunities diminish, their attractiveness decreases. As Shleifer said,

"Because asset prices are out of whack, injecting capital into banks doesn’t restart lending. Banks simply use the money to buy underpriced securities... to speculate... Financing of new investment by banks [via lending to business] is always competing with speculation. If speculation is more attractive, it is going to draw the attention of banks."


So Shleifer's solution is to get the Fed or the government to buy a lot of securities, so many of them that the price rises and the banks no longer find them attractive for speculation and start using their money to lend instead. Shleifer proposes focussing on the highly rated securities instead of the toxic assets.

Ironically, coming as it does from Shleifer, this advocacy to make large purchases appears unconvincing. In a different but relevant context, Shleifer and Robert Vishny had made the important arguement that professional arbitrage, typically done by traders with other people's capital, "becomes ineffective (in bringing security prices to their fundamental values) in certain circumstances, when prices diverge far from fundamental values". Such extreme circumstances and the associated volatility exposes arbitrageurs to "risks of losses and the need to liquidate the portfolio under pressure from investors in the fund".

By a similar reasoning, it can be argued that under certain market conditions (and the sub-prime crisis surely was one of those), the prices of securities can deviate so far from their fundamental values that even with massive purchases, governments may not be abvle to get to the other side of the trade. This leaves governments saddled with cheap assets and large losses.

This applies not just to the toxic assets, but even triple A rated assets, many of which were found as the sub-prime crisis unfolded to have been wrongly assessed by the rating agencies. In an uncertain environment, rife with counter-party risks, there is no way of even making reasonable assessments of the worth of underlying securities, many of which were rendered worthless, and cannot be revived even with massive purchases, and may have to be effectively junked. As with all strategies that advocate purchasing securities to boost the markets, the challenge remains to identify the securities that can be purchased and whose prices can be revived.

To rephrase Shleifer and Vishny, do we have "limits of quantitative easing"?

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