More Quantitative Easing is Not The Answer

The Fed seems poised to do some more quantitative easing—substituting reserves for longer maturity debt. Chairman Bernanke had long advanced the notion that even if overnight interest rates reach the zero bound, a central bank still has substantial weapons in its arsenal to stimulate a flagging economy. The Great Crisis offered him the chance to try a real world experiment. Since the financial collapse began over two years ago, the Fed expanded its balance sheet to $2 trillion by lending or “auctioning” reserves, through open market purchases of government bonds, and by buying the toxic waste banks wanted to unload. In the process, the Fed competed with private markets that were running to safe government debt, driving down returns on longer term US sovereign debt. This distorted yields, crushing savers who cannot find decent returns. And it has not generated any lending or recovery. In truth, the only thing that was beneficial was the purchase of risky assets from banks under the slogan of QE. Yes, taking risk off bank balance sheets and moving it onto the Fed's balance sheet helps banks to avoid recognizing losses if the Fed pays high enough prices. The long term consequences, however, will not be known for a long time. What happens when the Fed tries to sell some of these risky assets back to the banks? How will Congress react to losses at the Fed? Since the Fed turns profits in excess of a six percent return over to the Treasury, it will be Uncle Sam that absorbs the loss. And if QE is nothing more than shifting risks to Uncle Sam, then Congress ought to be consulted. There was a tremendous debate about the wisdom of having Uncle Sam prop up the auto companies (while that debate was confused—auto company problems had more to do with their financial arms than with car sales—at least the bail-out took place in public). But the Fed bail-out of financial institutions through purchases of toxic assets has mostly taken place behind closed doors. There are two fundamental misunderstandings behind the concept of QE. First, Bernanke and others do not understand that banks do not lend reserves. When the Fed buys assets, it credits the selling bank with reserves that pay a return slightly above zero. There is nothing that banks can “use” reserves for except to meet reserve requirements (banks in the aggregate have massive quantities of excess reserves, so they do not need reserves for this purposes), to clear accounts with one another (again, they have more than enough reserves already), to clear with the Fed (ditto), or to meet cash withdrawals (ditto, again). Reserves are simply an entry on the Fed's books—banks cannot lend these to households or firms for the simple reason that households and firms cannot have entries on the Fed's balance sheet. To paraphrase J.M. Keynes, the Fed can pump reserves into banks until it is blue in the face, but this will have no impact on lending. The second, more critical, mistake is the belief that if the Fed can push rates on safe assets to a sufficiently low level, banks will begin to make loans and that this will stimulate the economy. But lending takes two parties willing to tango—a willing borrower with a good project, and a bank willing to take the risk on that borrower. The problem is that no one is willing to go to the dance until the music starts playing again. No one is projecting that unemployment will fall for years to come. No one in her right mind believes that residential real estate markets will recover for years to come (it typically takes six to ten years for real estate to recover after a regional crash—and this is the mother of all real estate crashes). And only those drinking spiked cool-aid believe that retail sales are going to grow at a reasonable pace over the near future. Hence, the wise thing for banks and potential borrowers to do is to wait it out. And the historically low interest rates across the term structure have wiped out interest income. Further compression of spreads will just reduce income—both for savers and for financial institutions. This is not going to generate more spending and a recovery. The only thing that is going to help is job creation—something no one wants to admit. This will not come from the domestic private sector, and it is not going to come through US exports. The reality is that only the Federal government is going to create the jobs we need. But that is a reality that will not be recognized before, say, 2012. Ironically, if what the Fed really wants to do is to drive rates lower on longer-term sovereign debt, the same thing can be accomplished simply by having the Treasury stop issuing them. When the Treasury runs a budget deficit, its spending creates more bank reserves than are debited by tax payments. It then sells bonds as an interest-earning alternative to excess reserves in the banking system. Now the Fed buys those bonds to try to drive the interest rate toward zero—eliminating the advantage bonds hold over excess reserves! It would be far simpler to just leave the extra reserves in the banking system, paying near-zero interest on them, and foregoing the issue of bonds. QE simple demonstrates that neither the Treasury nor the Fed has any idea how monetary policy works.