The Fed: Paper Tiger?

Last week’s post “QE3: US1” may have over-stated the problems with Operation Twist, but also under-stated others. Some, including this helpful post at Econbrowser, contest the description of the Fed’s operation as ‘quantitative easing’ or QE3, (h/t Art Goldhammer, author of the excellent French Politics.) The argument is that, since the Fed is selling $400 billion of short-term Treasuries, and buying equal value amounts of long-term Treasuries, it is not ‘injecting liquidity’ (as we put it last week) because no cash is placed in any private accounts. The aim, rather, is to use the change in the Fed’s portfolio to buy up some of the existing supply of long-term Treasuries, and thus increase their price. As Econbrowser puts it, “The hope is by lowering interest rates, there would be slightly more opportunity for households and firms to borrow or refinance and perhaps increase spending a bit.”

Three separate points, made last week, are still relevant, as well as one new one. First, it is not illegitimate to say that monetary policies that facilitate the creation of private moneys are ways of increasing liquidity. That, we take it, is why folks like Perry Mehrling are willing to use the term QE3. The problem, in the case of Operation Twist, is that it is unclear that there is very direct mechanism by which it leads to the creation of private moneys. But the zero-interest rate policy, which allows for, among other things, carry-trades, certainly seems to be one method for QE3 private-style: “If you can borrow at zero, and can roll your borrowing for two years, then anything with a positive yield looks good.  If a hedge fund borrows at zero and buys MBS, that is QE1 private-style.  If a hedge fund borrows at zero and buys long-dated Treasuries, that is QE2 private-style.” So even if Operation Twist will have little effect on this, there is still a valid reason for arguing that some kind of QE3 mechanism is still in effect. But if one doesn’t like the QE3 moniker that doesn’t matter, since it is the form of monetary stimulus that matters.

Second, a problem both with this aspect of the zero-interest rate policy and with Twist (insofar as it is supposed to promote refinancing and borrowing) is that there is no saying what is done with the money that is actually borrowed. There is thus a very tenuous connection between these ‘stimulus’ measures and job-creating employment. And the redistributive effects of sparking any kind of inflation may be offset by inflating away earnings, (especially when the job-creating investments look less attractive than other speculative investments in gold, currencies, and so on) – leading households to turn to borrowing to maintain consumption.

Third, to the degree that Twist has any effect, it still looks like a system reboot. To requote, Econbrowser says the aim of Twist is “slightly more opportunity for households and firms to borrow or refinance and perhaps increase spending a bit,” and to requote Mehrling, “The rationale behind lowering long-term bond yields is that it will enable homeowners to cut their borrowing costs, encourage greater borrowing and investment, while pushing more investors to leave government bonds and buy riskier assets.” Cutting borrowing costs with the hopes of increasing debt-financed household consumption and speculation is, to say the least, a pretty unimaginative response to a crisis produced by, well, just that.

The one new thing we would add to last week’s points is that we are, in a way, dealing with a Paper Tiger problem. Pre-crisis, the Fed was lauded as the lynchpin of the neo-Keynesian Great Moderation, reducing volatility with careful management of the interest rate. Now, however, it appears powerless, inducing wonder at popular outbursts against it. Econbrowser says, “Indeed, some observers had quite a passionate response that I find hard to reconcile with the fundamentally modest nature of what the Fed has been doing. Using the tool of QE2 as a device for helping to manage expectations is in fact the main argument I can see for having the Fed rather than the Treasury be the agent responsible for announcing and carrying out the plan.”

Now it is true that Twist will likely have a negligible effect, and that there is little the Fed can do in the way of stimulus, especially now that interest rates are at zero. Plenty of economists have, at this point, argued we are facing stagnation that monetary policy cannot get us out of. But the ire at the Fed is not just an irrational outburst of people who have never taken a macroeconomics class. The Fed is, for one, a decidedly undemocratic institution, which makes major economic decisions for which it is extremely difficult to hold it to account. In addition, there are the problems with monetary stimulus that we have discussed before. But more immediately, the Fed, and a good amount of economic theory, spent the better part of two decades parading itself as the master of markets. It was the tiger keeping the jackals and hyenas in order. No wonder, then, that it is subject to populist ire, even as it helplessly flounders amidst a crisis/post-crisis stagnation that it helped create but can do little to improve.