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.

 

 

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