November 14, 2010
Why I Do Not Like QE2
Why I Do Not Like QE2-Becker
Other governments, and their central banks, have reacted vocally and negatively to the Federal Reserve's plan for another round of quantitative easing-which means that the Fed purchases long-term bonds. These negative reactions to QE2 outside the United States are presumably motivated by their self-interest, but I believe that another large-scale Fed purchase of bonds is also against American interests.
One justification frequently given for further Fed open market operations is that it will increase bank lending through raising bank reserves ("high powered" money). The reluctance of banks to lend has clearly been a factor in the slow down in the US recovery. Yet the Fed's creation during the past couple of years of well over trillion dollars in additional reserves through open market operations has not induced rapid increases in bank lending. Instead, banks have accumulated huge amounts of excess reserves; that is, reserves above the amount they are required to keep as collateral for their deposit liabilities.
Given that banks already are holding such large reserves that carry low interest rates, it is hard to see why creating additional reserves will stimulate much additional lending. The big constraint in the lending market is that both borrowers and lenders perceive considerable risk to investments. This is partly due to government policies, like the health care and the financial reform bills, and proposals to raise taxes on higher incomes and on capital gains that will raise costs of doing business, and lower after-tax incomes of investors. Perhaps that perception will change due to the recent election of many Congressmen who say they want to lower taxes and reduce the size of government, but this perception of a risky investment environment will not change because the Fed creates large quantities of additional reserves.
The eventual inflationary impact of QE2 is another reason to be skeptical about its desirability. Before too long the US economy is likely to recover at a faster pace, and bank lending will then increase by a lot. At that time, the reserves created by the Fed will be converted through increased bank lending to businesses and households into money, such as currency and demand deposits. This growth in the money supply will create far more inflation than the Fed desires, unless the Fed dampens the growth by large scale selling of much of the several trillion dollars of assets it accumulated during the financial crisis.
The Fed does have the tools to control the resulting increase in inflation through selling these assets and reducing bank reserves. However, it is problematical whether it will have the political will to do that. Any large effort by the Fed to sell assets and reduce reserves will not only dampen the inflation rate, but the real economy as well. As a result, the Fed will be under strong political pressure to reduce their open market operations. Whether the Fed succumbs to that political pressure depends on Chairman Ben Bernanke's willingness to fight the political battles. Perhaps he will, but my guess is that a compromise will be reached whereby the Fed will tighten but less than it would like. The end result will be a greater rate of inflation than is good for the economy.
Central banks and other participants in currency markets are expecting an eventual significant increase in prices in the United States. This is why they have been trying to reduce their holdings of dollar-denominated assets that would decline in real value with inflation. These efforts in turn lower the value of the dollar relative to the euro, yen, and other currencies. Until the inflation rate actually increases by a lot, this reduction in the exchange value of the dollar reduces the prices of US goods in the international market. This in turn stimulates the demand for US exports, and reduces the demand by American consumers for goods made abroad. However, once inflation actually takes off, the process will tend to be reversed: demand for US exports would decline, and American demand for imports would go up.
In justifying the planned purchase of hundreds of billions of dollars of long-term bonds, Chairman Bernanke indicated that the goal is partly to lower long term interest rates relative to short term rates- which are already close to zero- and thereby stimulate longer term investments. A large purchase of long-term bonds would indeed lower long term rates relative to short -term rates, but the effect is not likely to be large. The reason is that long -term interest rates are essentially a weighted average of current and expected short-term rates, adjusted upwards for the greater riskiness and lower liquidity of long-term bonds. That is to say, the long-term shape of the interest rate yield curve is mainly determined by these fundamentals, and it is much less affected by changes in the relative supply of short and long-term assets.
Fed Chairman Bernanke wrote in an article in the Washington Post on November 4th that "The Federal Reserve cannot solve all the economy's problems on its own." The slowdown in the recovery of the American economy is not the result of Fed policy, and cannot be cured by yet another bout of open market operations. This is why the Fed should curtail, and better yet, eliminate its plans for QE2.
Quantitative Easing—Posner
"Quantitative easing" is a pompous, uninformative term for a central bank's buying debt (bonds, mortgages, commercial paper, etc.) in quantity in an effort to depress interest rates in order to stimulate economic activity. Recently the Federal Reserve began buying $600 billion (for starters) worth of long-term Treasury bonds. It is buying them with money that it creates by a computer stroke. That money will expand the money supply relative to the output of the economy and thus (depending however on how rapidly the money circulates) increase inflation, which in turn will reduce the burden of fixed debt and, it is hoped, thereby encourage people to spend more. In addition, by increasing the demand for bonds, the program will increase their price, which in turn will reduce their return; bonds are fixed-income debt, so as the price of a bond rises, the interest it yields, being a fixed amount, becomes a smaller percentage of the price. So interest rates will fall, stimulating (it is hoped) borrowing and hence spending. Finally, by increasing the world supply of dollars, the purchase of bonds with cash newly created by the Fed will reduce the value of dollars relative to other currencies, thus making exports of American goods and services cheaper and imports of foreign goods more expensive. As Becker points out, anticipation of inflation leads owners of dollar-denominated assets to sell those assets, which further increases the amount of dollars in the world economy relative to other currencies.
The first and third effects are probably more important than the second, the effect on long-term interest rates. Those rates are low in part because short-term rates are very low and there is considerable substitution between short- and long-term loans. Moreover, the modest incremental effect on long-term interest rates of increasing the demand for and thus price of long-term bonds may be offset by the effect of enlarging the money supply in causing inflation expectations to rise, which in turn increases interest rates.
The first (inflation) and third (devaluation) effects of the new program are not emphasized by the Fed because of their sensitivity. Since the financial collapse of September 2008, the Fed has been pouring money into the economy, and as a result its total assets (mainly bonds of various sorts) have soared to $2.3 trillion. The new quantitative-easing program may push the total well beyond $3 trillion (remember that the $600 billion is just the initial implementation of the program). This will not necessarily cause an immediate increase in inflation, because much of the money supply is as a practical matter frozen because of uncertainty about the economic environment. The banks are sitting on $1 trillion in excess reserves (in effect, lendable cash); large corporations have large cash hoards as well; and the personal savings rate has increased severalfold in the last two years. Money that is hoarded rather than spent does not increase inflation. If the Fed creates $1 in money and the private sector responds by increasing the amount of saving by $1, there is no effect on inflation because there is no increase in the number of dollars that are chasing the goods and services produced by the economy.
Even if there is reluctance on the part of the private sector to spend the new money pumped into the private economy by the Fed's new program, there probably will be at least a small uptick in inflation because of expectations of a future increase in spending and hence in inflation. This can be a good thing by lightening fixed debt, such as mortgages that carry a fixed rather than adjustable interest rate. The less debt people have, the less they will save and so the more they will spend. Increased consumption will lead in turn to increased production and hence increased employment, resulting in higher incomes which in turn will spur more consumption.
Similarly, the devaluation of the dollar will increase the demand for U.S. exports, which in turn will spur production, and there will be a further effect of increasing production because of the reduction in imports; and some of that reduction, moreover, will induce increased domestic production aimed at satisfying demand formerly supplied by imports.
So "quantitative easing" is a rational response to a depressed economy with stubbornly high unemployment and very low inflation. But that doesn't mean it's a sensible response. There are three principal objections to the new program. The first is that the inflation that it aims to increase by a slight to moderate amount may get out of hand. Suppose businesses and consumers increase their spending, and the banks lend the $1 trillion they're holding in excess reserves (accounts in federal reserves banks, equivalent to cash). The ratio of money in circulation to goods and services will rise, and inflation will tick upward, perhaps more than desired. The Fed can reduce the money in circulation by selling some of its huge inventory of bonds, but by doing so it will raise interest rates (just as increasing the demand for bonds lowers interest rates, increasing the supply raises them), which may choke off the economic recovery. If it hesitates to sell bonds and retire the cash it receives from the sales, expectations of inflation may soar, and inflation rise to a dangerous level; and to bring it down the Fed will then have to sell bonds after all, draining money out of the private economy at a rate that brings on the kind of very sharp recession that the nation experienced in the early 1980s.
No one knows or can know whether the Federal Reserve can walk such a tightrope. Even if it can do so as a technical matter, political pressures may cause it to fall off the tightrope. The Fed will be subject to greater political pressures, beginning in the near future, as a result of the financial regulatory reform legislation passed earlier this year, which by giving the Fed regulatory authority over financial institutions that are not commercial banks is increasing its political exposure.
The second objection to the new program concerns its effect on the role of the United States in the global economy. Nations such as China, Germany, and Japan that are large exporters are irate at our devaluing our currency by increasing the world supply of U.S. dollars. They are capable of retaliating, and if as a result our trade balance does not improve significantly the program of "quantitative easing" may end up having no beneficial effect other than to increase inflation, which may as I said get out of hand.
Moreover, the U.S. dollar is the major international reserve currency. That is, it is the currency in which many international transactions not limited to transactions with U.S. firms are denominated because of the stability of the dollar. The status of the dollar as the international reserve currency requires foreign central banks to buy dollars in quantity so that firms in foreign countries can buy dollars for their international transactions. The dollars accumulated by central banks in turn are available to be lent back to the U.S. Treasury (by purchase of Treasury bonds from it) to help finance our huge national debt. If we manipulate the value of the dollar to improve our trade balance, we undermine confidence in the dollar's stability, and the demand for dollars as a reserve currency may fall.
The third and perhaps biggest objection to the program of quantitative easing is that it relaxes the pressure on our politicians to address urgent issues of economic reform. The politicians are sitting back and letting the Fed try to hoist us out of our current economic hole. The pressure to respond to the urgent need to put the health reform and financial regulatory reform programs on hold because of the debilitating uncertainty that they have injected into the business environment, and to take effective steps that will be politically painful (for they will include entitlements reform) toward increasing the rate of economic growth and reducing the rate of increase of the national debt, is being blunted.
These objections might recede in significance if "quantitative easing" could be expected to stimulate the economy. But that seems unlikely. Banks and corporations are awash with money. Their reluctance to lend because of the uncertainty of the business environment is unlikely to be overcome by a further and probably modest reduction in long-term interest rates—modest because of the substitution effect I mentioned earlier and because the bond-buying program will increase expectations of future inflation, which in turn will push up long-term interest rates.