How to Tame the Effects of Quantitative Easing to Better Benefit the Real-World

Economy (and not just financial assets)

By Jonathan Ferry

The Problem:

Quantitative Easing (QE) is a very powerful tool utilized by central banks around the world (most
notably, the U.S. Federal Reserve) in an effort to provide support to the economy by encouraging
investment (e.g., risk-taking), which can lead to new employment and productivity.

The way QE is supposed to work, is that by buying low risk assets, such as treasury bonds, and mortgage-
backed securities, the Federal Reserve lowers interest rates. That lowering of interest rates, in effect,
reduces the cost of money, making liquidity more widely available which commercial banks,
corporations, and entrepreneurs should then invest into productive uses that will generate more
employment, greater productivity and higher wealth.

What really happens is that in QE, central banks do buy lower risk assets, and they do effectively lower
the interest rate, which does encourage speculation and an increase in financial asset (read: stocks,
bonds and real estate) to increase, sometimes drastically. But as 20 years of history and many, many
other papers have shown, which I will not elaborate on here, for sake of time, it has not resulted in
much new employment or productivity.

Why? A big part of the reason is that QE is not directed. And by Federal law, it really cannot be directed,
at least by the Federal Reserve. That is because the Federal Reserve is limited to only buying the risk
assets that are backed by the Federal Government (hence government bonds and mortgages). The
result is that after the initial displacement of cash that was invested in these lower risk assets, the
previous owners, who now have cash in hand, go off and look for another relatively safe place to invest
their cash. The next safest place is investment grade corporate bonds. So, the cash moves there, and the
rates on corporate bonds comes down. This entices companies to, in their own best interest, take
advantage of cheap borrowing costs to borrow as much money as their balance sheet can maintain. And
here, is where the money is supposed to go from the corporations to creating new employment and
new productivity. And it does happen to an extent. But only a tiny fraction of the money displaced by QE
ends up going to these ends. Instead, the lions’ share of the money ends up going into stock buybacks,
which is where companies replace their more expensive sources of capital (equity) with the now very
cheap source of capital (bonds/debt). That, in turn, drives up stock prices, and stock prices are
predominantly owned only by the very wealthy, so the wealth effect that is created ends up being
reinvested into more financial assets, rather than being invested in the real economy, and so a cycle is
created where this wealth from the Federal Reserve continues to circulate between institutions who sell
bonds and mortgages to the Fed, to Corporations, to stock holders, back to financial institutions who
then have to reinvest that wealth.

The breakdown, then, is a direct result of the money being directed into the above-described cycles and
not into the real economy. Why is this happening? The most likely reason that this is happening is
because companies do not have investment ideas that they can readily implement that will return a risk-
adjusted return that is higher than the return that they get by immediately buying their own stock,
which has, in theory, very little risk.
A Solution:

If we go back to the beginning of where the money from the Federal Reserve enters the economic
system, we see an initial limitation. That was, that they can only buy assets that are backed by the
Federal Government. The assets that are backed by the Federal Government, then, generate cash flows
that either go to supporting Federal Government expenditures (Gov’t Bonds) or the housing market
(mortgage-backed securities). Those are the only markets that the Federal Reserve can directly impact,
legally. Now, the Federal Government could then take those monies and direct them into uses that
would potentially generate more productivity and employment. But, aside from the New Deal, this has
been a difficulty for a large bureaucracy like the Federal Government to accomplish in the past. And,
even when they are successful, there is tremendous inefficiency, often, in their efforts, so that much of
the force of the monetary impact does not get felt on the street by the Average American.

There is, however, an economic development solution, here, that combines the powers of the Federal
Reserve, and the Federal Government, as well as local and state governments and the business
community, all together.

But there is one more point that needs to be addressed before we get to the financial solution. And that
is the barrier that currently exists that makes quality investment opportunities for the business
community so scarce. To be certain, there are many such barriers. But, I believe that the chief barrier
among them is the lack of broad-based skills in the labor force. That is, skills for a large subset of the
labor force are not keeping up with the demands of the economy and of businesses. This leads to less
innovation, which means less productivity and less demand for workers. (And even the demand for
workers that is there is often going unfilled in many key industries, such as manufacturing).

As mentioned, there are multiple barriers, and different financial tools could be created to try and
overcome each of them. But for now, I am going to focus on the problem of workforce skills.

I believe one solution that could make the power of quantitative easing work far better for the real
economy is if we had a type of financial security that was backed by the Federal Government, but
allocated by the free market, in conjunction with input from the state and local level and funded by the
Federal Reserve’s QE program.

The way that this could work would be through the creation, at the local and state level, of Workforce
Improvement Nodes (WINs). These nodes would be a type of special taxing district created by State and
local governments. The taxing district would be set up to add a payroll fee that would be added to the
payrolls of existing (and new) businesses within the WIN. The state and federal governments would also
contribute a portion of their income tax collections into the WIN as well. These monies would collect
into a fund that would then be restricted for use in workforce training to provide the skills that are
necessary to enhance the skills of American Workers. The states and municipalities who establish these
WINs can determine the rules that they want to follow as to how the monies can be spent. Those funds
can be spent, for example, when companies apply for funds in order to fund company or industry-
specific training programs. They can be allocated by states or cities to fund broader workforce programs,
such as the establishment of trade schools, or soft skills training for lower skilled workers. The funds
could even be used to provide childcare services within the district for workers with children, so that
they can better participate in the labor force. In other words, there is room for creativity, here. And
there is no one correct way to determine how the funds should be spent. That is why the local and state
agencies are so critical to the establishment of the WINs and the determination for their programming.

Where the Federal Government and the Federal Reserve come into play (because honestly, this program
could happen without them, but it could be supercharged with them), is if the Federal Government,
through the Department of the Treasury ratifies the creation of each Workforce Improvement Node,
much like they were involved in the creation and ratification of Opportunity Zones. In doing so, they
could issue federally backed securities that would be repaid from the combined cash flows coming from
the fee/tax imposed on businesses within the WIN and by the monies contributed by the State
governments. The Federal Government could then determine a set level that they are comfortable with
backing in each WIN, based on economic projections and past history (as the program matures). Those
then become a security that the Federal Reserve can purchase through their Quantitative Easing
program, which will ensure that there is ample liquidity to fund upfront workforce development
programs across the country.

The skills learned through these programs, then, will be what drives both productivity and wage growth,
which will be the biggest boost seen to the real economy from any Federal Reserve program ever
conducted to date.