Richard Koo on QE3

Mr ‘balance sheet recession’ himself holds forth on the follies of QE. Highly recommended reading…

As I spoke with investors in London and Geneva last week, markets were rocked by a resurgence of fiscal problems in Greece and a steep drop in the price of silver andother commodities.In London there was talk in the market that the drop in commodity prices had left a handful of investors facing serious losses. If true, it suggests that the preceding rise in commodity prices was driven by speculation and not by real demand.Another frequent topic of discussion was QE2, indicating that many investors established large positions based on the availability of substantial amounts of liquidity under this program.All these factors suggest that a number of markets have been transformed into liquidity-driven markets, and that asset prices in those markets may have risen to levelsthat cannot be justified by the real economy.

David Llewellyn-Smith
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  1. I always enjoy Richard Koo, but I wish Scribd would go back to using Flash. The new HTML5 viewer brings my browser to a crawl.

  2. Ranier Wolfcastle

    No problems with Firefox.

    One of the strange things about QE2 was, as he said, bond prices were expected to rise — I don’t think I read anyone who didn’t take that as a given at the time — however they fell (yields rose).

  3. Tech geeks..

    Anyways, the article was an enlightening read. I’m no economist, but I would have thought increasing incomes beget increasing asset prices, not the other way around. If Koo is right then the US may be in for trouble come June.

    Query: what does this mean for the AUD? If commodities burst after QE2, it would go down. However, if the US falls off a cliff will Australia’s higher rates and stronger public balance sheet see the carry trade maintain the AUD?

    • Ranier Wolfcastle

      My guess would be strengthening of the US dollar. Absence of the Fed being there as the ultimate buyer of treasuries means others will be buyers — where others IMO means an increase in overseas buyers relative to what we have seen over the last 6 months. Therefore demand for dollars. But that is a guess.

      Additionally there were misplaced fears about inflation in the US which wouldn’t have helped US dollar sentiment. Ending QE2 should ease those fears.

      There are limits to how much stronger the dollar can get though when you have a ZIRP.

      • But large, continuing US deflation is the game without QE…

        …why on earth would private investors buy USD admist significant deflation.

        For, IMHO, the USD is looking at medium term devaluation vs many currencies (esp precious metals), whether its economy enters outright inflation or deflation – it’s just a matter of the mode, not whether it (USD devaluation) will occur.

        As i life to say, “Inflation will do what deflation is not permitted to – just differently”.

        Hence, IMHO, the general nature of the outcome, macro-speaking, is fairly assured; just the timing, duration and nature of the “correction” is different.

    • Lighter Fluid

      Remember that in the height of the GFC the USD out-did even gold as a ‘safe-haven’ asset.

      This wasn’t because the USD was considered safe, It was merely because margins were being called and collateral was required – these contracts were all done in USD.

      When the leveraged players are forced to unwind their positions, they have to buy USD and/or short treasuries to settle their debts.

      Depending how tight the credit markets become, other entities who have borrowed in USD (ie the big 4) might face a similar difficulty and need to post collateral in USD.

  4. The timing of Koo’s paper is perfect, just prior to the ‘end’ of QE2 – enough time to digest the contents and the meme to spread.

    “Viewed objectively, the central banks are trying to push up asset prices using quantitative easing and the portfolio rebalancing effect. The resultant rise in asset prices based on this effect represented a potential bubble—or at least a liquidity-driven event—from the start. The question is whether the real economy can keep pace with asset prices formed in those liquidity-driven markets. If it cannot, higher asset prices will be considered a bubble and will collapse at some point. The resulting situation could be much more severe than if quantitative easing had never been implemented to begin with.”

    My take is this is a recommendation that QE3, in some form or other, be undertaken. Any decision not to continue would result in a potentially cataclysmic situation, certainly worse than pre-QE1. Continue stimulus, because although Bernanke’s ‘gamble’ has not succeeded to date, to end stimulus will ensure the economy crash and burn.

    Pretty much Koo policy, I would say -never shy to recommend massive government stimulus.

    Am I missing something?

          • Not explicitly. (Recommendation was my word, probably the wrong one.) What I meant when I said the timing was perfect – was the need to put this thread out there, have it discussed, absorbed – and accepted – before the official end of QE2. Koo is no lightweight, attention will be paid to this. It is probably preferable that it is not a direct recommendation, but an implicit one.

            A clever position – expresses no direct support and concedes QE2 a gamble that has not paid off. But the reader if left with the awful realisation that without stimulus, the economy will deteriorate even more severely. Allows others to come on board without coercion, to accept there is no alternative. Like that medicine you had as a kid, hated it, tasted terrible, but you knew it was good for you.

    • Ranier Wolfcastle

      I read as the exact opposite 🙂

      QE is bad because all it does is push up valuations and create bubbles without doing much at all for the real economy.

      • And you think those who have the power to make QE3 happen – and profit from it – actually *care* a hoot about who suffers from the very consequences you’ve rightly named?

        • Ranier Wolfcastle

          Not really. I’ve always thought of this as being about the banks not about main street. It does nothing for main street and therefore objectively, as an economic tool you shouldn’t have QE3. On the other hand it helps banks so wall street will want QE3.

    • Just took another quick look at Koo’s paper, have a slightly different slant on it.

      This paper was written starting with the assumption: the necessity for the continuation of QE, in some form. A supporting argument was developed around this premise, ostensibly to promote the portfolio/balance sheet rebuilding idea, a diversion from its real purpose, a red herring even.

      Koo has argued that the Fed’s QE has not resulted in global inflationary pressure, not increased the money supply, has potentially created bubbles in some assets classes but that an end to fiscal stimulus would affect these markets in a devastating fashion (worse than prior QE1). That the balance sheets of banks/institutions supporting these areas would suffer severe damage and as a result QE3 is the only alternative.

      In one fell swoop he conquers:

      – QE critics claims that QE causes global inflation
      – QE critics claims ‘Fed is flooding the system’ with money
      – QE critics opposed to Bernanke (subtle poke, Bernankes gamble didn’t pay-off)
      – Acknowledges development of asset bubbles, warns of potential cataclysm should they burst due to sudden withdrawal of stimulus
      – Argues that should these asset bubbles collapse, balance sheets of banks/institutions would be severely damaged

      …Which leads us back to where we are – if we wish to escape financial devastation, there is no alternative – there is only continued fiscal stimulus.

      Just a thought.

  5. Alex Heyworth

    Interesting article, although I think he has things the wrong way round wrt how banks lend. Surely these days they lend to anyone who will pay the interest rate and put up appropriate security. Then they go looking for the funding afterwards. I’m sure bank lending officers don’t have to enquire whether they have sufficient deposits before making a decision to approve a loan.

    • Ranier Wolfcastle

      Yes that is something Steve Keen often writes about. I don’t think it detracts from the overall analysis though. The main weakness (for me) was his assertion that bond prices rise, i.e. drawing on expectations of what *would* happen rather than what actually *did* happen.