Martin Feldstein Is at It Again

Martin Feldstein writes in the Wall Street Journal (“The Federal Reserve’s Policy Dead End”)

Quantitative easing . . . is supposed to stimulate the economy by increasing share prices, leading to higher household wealth and therefore to increased consumer spending. Fed Chairman Ben Bernanke has described this as the “portfolio-balance” effect of the Fed’s purchase of long-term government securities instead of the traditional open-market operations that were restricted to buying and selling short-term government obligations.

Here’s how it is supposed to work. When the Fed buys long-term government bonds and mortgage-backed securities, private investors are no longer able to buy those long-term assets. Investors who want long-term securities therefore have to buy equities. That drives up the price of equities, leading to more consumer spending.

What Feldstein fails to ask, much less answer, is why anyone is willing to pay more for the stocks than they are worth (based on expectations of the future net cash flows generated by the underlying assets) just because they have excess cash in their pockets. Feldstein is covertly attributing irrationality to investors, although to be fair, he intimates, and has previously asserted explicitly, that the increase in stock prices since QE started was a bubble. And to be fair one more time, he is accurately characterizing Ben Bernanke’s explanation of how QE is supposed to work.

But despite the Fed’s current purchases of $85 billion a month and an accumulation of more than $2 trillion of long-term assets, the economy is limping along with per capita gross domestic product rising at less than 1% a year. Although it is impossible to know what would happen without the central bank’s asset purchases, the data imply that very little increase in GDP can be attributed to the so-called portfolio-balance effect of the Fed’s actions.

Even if all of the rise in the value of household equities since quantitative easing began could be attributed to the Fed policy, the implied increase in consumer spending would be quite small. According to the Federal Reserve’s Flow of Funds data, the total value of household stocks and mutual funds rose by $3.6 trillion between the end of 2009 and the end of 2012. Since past experience implies that each dollar of increased wealth raises consumer spending by about four cents, the $3.6 trillion rise in the value of equities would raise the level of consumer spending by about $144 billion over three years, equivalent to an annual increase of $48 billion or 0.3% of nominal GDP.

Again, all that is irrelevant, because the portfolio balance rationale for QE misrepresents the mechanism whereby QE can have any effect. That mechanism is primarily by preventing inflation expectations from dropping. Each one of the QE episodes has been initiated when expectations of inflation were dropping. In each instances, the announcement or even the expectation of QE succeeded in reversing the downward drift of inflation expectations, thereby contributing to expectations of increased profits and cash flows and thus allowing stock prices to recover from their deeply depressed levels after the 2007-09 downturn and panic. I explained the underlying theory in my paper “The Fisher Effect under Deflationary Expectations,” which also provided supporting empirical evidence showing of a strong positive correlation since 2008 between inflation expectations as measured by the TIPS spread and stock prices, a correlation not predicted by conventional theory and not observed in the data until 2008.

This 0.3% overstates the potential contribution of quantitative easing to the annual growth of GDP, since some of the increase in the value of household equities resulted from new saving and the resulting portfolio investment rather than from the rise in share prices. More important, the rise in equity prices also reflected a general increase in earnings per share and an increase in investor confidence after 2009 that the economy would not slide back into recession.

Earnings per share of the Standard & Poor’s 500 stocks rose 50% in 2010 and a further 9% in 2011, driving the increase in share prices. The S&P price-earnings ratio actually fell to 17 at the start of 2013 from 21 at the start of 2010, showing the importance of increased earnings rather than an increased demand for equities.

In other words, QE helped to improve earnings, thus validating the expectations that caused the increase in stock prices.

In short, it isn’t at all clear that the Fed’s long-term asset purchases have raised equity values as the portfolio balance theory predicted. Even if it did account for the entire rise in equity values, the increase in household equity wealth would have only a relatively small effect on consumer spending and GDP growth.

Feldstein continues to attack a strawman, albeit one presented to him by Ben Bernanke.

Mr. Bernanke has emphasized that the use of unconventional monetary policy requires a cost-benefit analysis that compares the gains that quantitative easing can achieve with the risks of asset-price bubbles, future inflation, and the other potential effects of a rapidly growing Fed balance sheet. I think the risks are now clear and the benefits are doubtful. The time has come for the Fed to recognize that it cannot stimulate growth and that a stronger recovery must depend on fiscal actions and tax reform by the White House and Congress.

Feldstein’s closing comment reminded me of a piece that he wrote two and a half years ago in the Financial Times entitled “QE2 is risky and should be limited.” Here are the first and last paragraphs of the FT contribution.

The Federal Reserve’s proposed policy of quantitative easing is a dangerous gamble with only a small potential upside benefit and substantial risks of creating asset bubbles that could destabilise the global economy. Although the US economy is weak and the outlook uncertain, QE is not the right remedy.

The truth is there is little more that the Fed can do to raise economic activity. What is required is action by the president and Congress: to help homeowners with negative equity and businesses that cannot get credit, to remove the threat of higher tax rates, and reduce the out-year fiscal deficits. Any QE should be limited and temporary.

I was not yet blogging in 2010, but I was annoyed enough by Feldstein to write this letter to the editor.

Sir, Arguing against quantitative easing, Martin Feldstein (“QE2 is risky and should be limited“, Comment, November 3) asserts that Federal Reserve signals that it would engage in QE, having depressed long-term interest rates, are fuelling asset and commodities bubbles that will burst once interest rates return to normal levels.

In fact, since Ben Bernanke made known his intent to ease monetary policy on August 29, longer-term rates have edged up. So rising asset and commodities prices are due not to falling long-term rates, but to expectations of rising future revenue streams. Investors, evidently, anticipate either rising output, rising prices or, most likely, some of both.

Why Mr Feldstein considers the recent modest rise in commodities and asset prices (the S&P is still more than 20 per cent below its 2007 all-time high) to be a bubble is not clear. Does he believe that with 15m US workers unemployed, expectations of increased output are irrational? Or does he believe the Fed incapable of causing the price level to increase? It would be odd if it were the latter, because Mr Feldstein goes on to insist that QE is dangerous because it may cause an “unwanted rise in inflation”?

Perhaps Mr Feldstein thinks that expectations of rising prices and rising output are inconsistent with expectations that interest rates will not rise sharply in the future, so that asset prices must take a hit when interest rates finally do rise. But he acknowledges that expectations of future inflation may allow real rates to fall into negative territory to reflect the current dismal economic climate. Since August 29, rates on inflation-adjusted Tips bonds have fallen below zero. Rising asset prices indicate the expectation of QE is inducing investors to shift out of cash into real assets, presaging increased real investment and a pick-up in recovery.

Why then is inflation “unwanted”? Mr Feldstein maintains that it would jeopardise the credibility of the Fed’s long-term inflation strategy. But it is not clear why Fed credibility would be jeopardised more by a temporary increase, than by a temporary decrease, in inflation, or, indeed, why credibility would be jeopardised at all by a short-term increase in inflation to compensate for a prior short-term decrease? The inflexible conception of inflation targeting espoused by Mr Feldstein, painfully articulated in Federal Open Market Committee minutes, led the Fed into a disastrous tightening of monetary policy between March and October 2008, while the US economy was falling into a deepening recession because of a misplaced concern that rising oil and food prices would cause inflation expectations to run out of control.

Two years later, Mr Feldstein, having learnt nothing and forgotten nothing, is urging the Fed to persist in its earlier mistake because of a neurotic concern that inflation expectations may soar amid massive unemployment and idle resources.

Well, that’s my story and I’m sticking to it.

26 Responses to “Martin Feldstein Is at It Again”

  1. 1 nottrampis May 9, 2013 at 6:56 pm

    I got you despite being late.

    Look at US articles.

  2. 2 Marcus Nunes May 9, 2013 at 7:08 pm

    David. What a coincidence. I had just posted on the Feldstein pice when the e-mail alerting to your post came through!

  3. 3 Greg Hill May 9, 2013 at 7:15 pm


    “What Feldstein fails to ask, much less answer, is why anyone is willing to pay more for the stocks than they are worth (based on expectations of the future net cash flows generated by the underlying assets) just because they have excess cash in their pockets.”

    Doesn’t QE raise bond prices, lower interest rates, and therefore reduce the discount rate applied to earnings? And doesn’t this increase the PV of net cash flows, and therefore the value of stocks? In addition, wouldn’t a Fed committed to QE reduce the risk of holding stocks by, in effect, providing insurance against falling sales revenue and profits?

    p.s. I agree with Brad Delong; you should be paid to write frequent posts on Keynes’s “Treatise on Money.”

  4. 4 Frank Restly May 9, 2013 at 7:37 pm

    Greg Hill,

    “Doesn’t QE raise bond prices, lower interest rates, and therefore reduce the discount rate applied to earnings?”

    Interest rates do not always move in unison. The discount rate that is applied to earnings is the interest rate that a company pays to borrow, NOT the the interest rate that the federal government pays to borrow. Does QE raise all bond prices? Only in the sense that bond funds must stretch for yield.

    BAA / Treasury Spread:

  5. 5 greghill1000 May 10, 2013 at 11:18 am


    Thanks for the reply. I was actually thinking of investors who purchase stocks rather than companies that are considering capital investments. And, for the former group, I doubt that a firm’s cost of borrowing plays any significant role in the investor’s choice of a discount rate. Although all interest rates don’t move in unison, the Composite Corporate Bond Rate has fallen from 5.88% in January 2010 to 4.06% in April 2013 ( p.s. I’m sure there’s a better index.

  6. 6 Frank Restly May 10, 2013 at 1:44 pm


    “I was actually thinking of investors who purchase stocks rather than companies that are considering capital investments.”

    Would you buy the stock of a company that just piled the money you gave them in a corner? I don’t think you can separate the two so easily. The discount rate applied to earnings must be that company’s cost of debt service because the company when facing a choice between funding an investment with debt or equity will typically choose the least expensive method. If it is less expensive for the company to issue equity relative to debt, this will tend to push equity prices down regardless of the interest rate that the federal government pays on its debt.

  7. 7 WNY-WJ May 10, 2013 at 5:14 pm

    It’s always a pleasure to see well-written reasoning with references to (sadly) oft-forgotten economists like Irving Fisher. His theory of debt deflation should never have been ignored or forgotten by so many economists in the last decades.

  8. 8 Diego Espinosa May 11, 2013 at 7:34 am

    You have an interesting thesis on inflation and profits, but I think it simplifies too much. The recovery in corporate profits has far outpaced that of income. While this is normal in a recovery, I the profits/wages ratio has seen a much steeper increase than in previous post-war recoveries. Thus, the rise in stock prices has been much more about the distribution of income (towards profits) than its expected growth.

    My point is that inflation often yields important changes in relative prices. In the case of this recovery, firm output prices seem to have gained even more than usual in relation to their inputs. The persistence of this phenomenon implies market power–oligopolistic competition. My view is that the Fed’s moves have allowed firms to increase profits without seeking market share growth. This, in turn, has held down business investment as firms are rewarded by shareholders for stingy capital expansion. This stinginess, in turn, has produced less competition between firms and higher margins. The result is a feedback loop of rising corporate profits, restrained investment/competition, and rising corporate profits. This helps explain high cash balances at large firms, and the higher large firm profitability relative to SME’s. Much of this has to do with Fed policy, but not through the “expected NGDP growth” channel that you cite.

    As an aside, I would say profits explained the stock market recovery quite well up to last year. Since then, the rate of profit growth has slowed dramatically, and it is much more likely that a “reach for returns” has taken over. This phenomenon is less a function of preferred habitat (the core assumption of “portfolio balances”) and more of agency effects.

  9. 9 Steve Roth May 12, 2013 at 3:26 pm

    “Why then is inflation “unwanted”?”

    Because an extra point of (“unexpected”) inflation transfers hundreds of billions of dollars in real buying power from creditors to debtors. Every year. Permanently.

    And we shouldn’t forget that the Fed is run by creditors.

  10. 10 David Glasner May 18, 2013 at 8:50 pm

    nottrampis, Thanks, much appreciated.

    Marcus, Great minds . . .

    Greg, I did not spell out the argument as fully as I should have. If QE raises bond prices through the portfolio balance effect, without increasing inflation expectations, the reduced yield will be reflected entirely in real interest rates. But real interest rates can’t fall very much if inflation expectations don’t rise, so the portfolio balance effect could not generate a very large increase in asset values that we have observed. If inflation expectations increase, then the real interest rate is depressed so that with constant expected real cash flows you can get a significant increase in asset values. On top of that I claim that there is some tendency for real expected cash flows to increase, though there is a puzzle because I would expect real expected future cash flows to be positively correlated with the real interest rate.

    It was flattering to see that suggestion from Brad Delong. Maybe in my next career.

    Frank, Agreed, but I think borrowing costs have been pretty much falling across the board.

    WNY-WJ, I don’t think that Fisher’s theory of debt deflation was ever forgotten, but it certainly deserves more attention than it has received.

    Diego, I don’t see the connection between Fed policy and the incentives of firms to increase market share. Also, could you explain how agency effects have influenced the relationship between stock prices and profits?

    Steve, Banks are creditors, but increasingly they are debtors as well, so it is possible that the incentives are not entirely transparent.

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About Me

David Glasner
Washington, DC

I am an economist in the Washington DC area. My research and writing has been mostly on monetary economics and policy and the history of economics. In my book Free Banking and Monetary Reform, I argued for a non-Monetarist non-Keynesian approach to monetary policy, based on a theory of a competitive supply of money. Over the years, I have become increasingly impressed by the similarities between my approach and that of R. G. Hawtrey and hope to bring Hawtrey's unduly neglected contributions to the attention of a wider audience.

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