It may be an overstatement to say that the world’s economy is in crisis, but if so it is only a slight overstatement. Unemployment in the United States is abnormally high, and it is substantially higher in much of Europe. Europe’s finances are in a terrible state, and its output is falling, contributing to economic slowdowns in China and other expanding economies, such as India and Brazil, and harming U.S. exports.
The Federal Reserve is under some pressure, both internal and external, to reduce interest rates in an effort to stimulate U.S. output and employment. The Fed can do this by buying securities, whether short-term Treasury notes—the traditional method of stimulating the economy—or longer-term obligations, including 30-year mortgages. By buying short-term securities for cash, the Fed increases the supply of money, which in turn reduces interest rates. There is an indirect effect, because of substitutability, on long-term interest rates as well. But by buying long-term securities, the Fed can reduce long-term interest rates slightly more. A reduction in long-term interest rates will reduce mortgage interest rates, which, since houses are bought mainly with debt, should increase the demand for housing, and hence home prices. At the same time, lower short-term interest rates will make credit card debt and other forms of consumer debt and by thus stimulating consumer borrowing will stimulate consumption. The lower long-term rates will increase personal wealth by raising housing values (a house being the most valuable asset owned by most families), reducing the savings rate and thus further stimulating consumption. The higher consumer spending is, the higher the production of consumer goods will be, as well as of capital goods to enable that higher production; and the higher production, the greater the demand for labor, so unemployment will fall.
In this way monetary policy can, in principle anyway, raise an economy from the doldrums, and in the current setting protect the U.S. economy against fallout from Europe’s economic crisis and from the downward global economic spiral that that crisis may be inducing.
But there are three reasons for doubting that the Federal Reserve’s using its monetary authority to reduce interest rates at this time is a good idea. The obvious ones seem to me weak: that the necessary measures would create serious inflation risk and that they would increase the already enormous federal debt. The rate of inflation is at present very low, and, judging from the interest rate (less than 2 percent) on long-term Treasury securities (for example, 10-year Treasury bonds), is expected to remain low for some years. This expectation is influenced by beliefs about whether the Fed will try to reduce interest rates; but since no one thinks the probability zero, it seems unlikely that the 10-year interest rate would be so low if action by the Fed to reduce interest rates were expected to cause inflation, which of course would raise interest rates. Moreover, as long as interest rates are low, increasing the federal debt is a low-cost proposition. At 2 percent, the annual cost of borrowing $1 trillion is only $200 billion. That is a large number, obviously, but only about half would be borrowed abroad, and $100 billion is a small fraction of the annual federal budget. The half borrowed from Americans would be an internal money transfer rather than a transfer of money abroad.
The more serious objection to the Fed’s pushing down interest rates is that it probably would have little effect on borrowing, consumption, production, and employment. The reason is that interest rates are already very low, yet borrowing is lackluster. One reason is that, in part because of pressure from regulators, banks have raised their credit standards, so that many individuals and firms, though they would like to borrow and would be willing to pay the current interest rates, cannot persuade banks to lend to them. Another reason is that household savings are still below historic standards because of the depression in housing prices (and as I said a house is the most valuable asset that most households have) and because of continued economic anxiety people want to increase their savings—and savings are the obverse of borrowing. And finally concerns with bank solvency and new federal regulations are inducing banks to increase their cash reserves, which is an example of hoarding rather than spending.
If banks are reluctant to lend and consumers to borrow, increasing the supply of money will not lead to a big increase in borrowing. Instead the banks will use the money to buy Treasury securities, which are riskless assets. The money will go in a circle: the Treasury will buy securities from banks, and banks will use the money to buy securities from the Treasury. Or the Treasury will buy securities from nonbank owners of them, who will deposit the proceeds in banks, which will use the additional cash to buy Treasury securities or increase cash reserves. This is an exaggeration, but can help one to see why increasing the money supply need not increase productive activity.
The idea that increasing the supply of money must stimulate economic activity, though mistakenly thought to be an idea of Keynes’s, is actually an echo of “Say’s Law,” which Keynes famously attacked, though he was not the first economist to do so. Say’s Law, rather confusingly paraphrased as supply creates its own demand, treats money as a medium of exchange and a standard of value, but nothing more. This is essentially a barter theory of the economy. But modern economies are not barter economists. In a modern economy, receiving money in exchange for some good or service doesn’t dictate that you exchange the money forthwith for some other good or service. You can save the money indefinitely. If you put it under your mattress, it makes no contribution to productive activity. Similarly, money can pile up in Federal Reserve Banks if people are disinclined to spend, without contributing to economic activity.
Largely for political reasons, there is no possibility of a different kind of attack on our sluggish activity, which would be for the Treasury to borrow a large amount of money at the current low interest rates and lend it to enterprises that would use it to increase production and with it employment. By raising wages such lending might increase incomes and economic confidence, leading to increased tax revenues and an eventual reduction in the federal deficit. But since that kind of economic stimulus spending is not in the cards and an increase in the money supply seems unlikely to have a significant stimulative effect, it seems that we shall have to be patient and let the economy recover under its own steam.