Why Quantitative Easing Needs to Involve Securities Other than Government Securities - Grasping Reality with Both Hands
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Grasping Reality with Both Hands The Semi-Daily Journal of Economist J. Bradford DeLong: Fair, Balanced, Reality-Based, and Even-Handed Department of Economics, U.C. Berkeley #3880, Berkeley, CA 94720-3880; 925 708 0467; delong@econ.berkeley.edu.
Economics 210a Weblog Archives DeLong Hot on Google DeLong Hot on Google Blogsearch October 23, 2010
Why Quantitative Easing Needs to Involve Securities Other than Government Securities Paul Krugman writes: How To Think About QE2 (Wonkish): Still on the run, so no long posts. But with all the talk about further quantitative easing by the Fed — QE2, for quantitative easing, the sequel — I think it’s worth sharing one way of thinking about what’s on the table — and why you shouldn’t be too optimistic about its effects. This isn’t original, although I don’t know who deserves the credit. So, here it is: in effect, QE2 amounts to a decision by the US government to shorten the maturity of its outstanding debt, paying off long-term bonds while borrowing short-term. This should drive down long-term interest rates. But how much? How do we get to this view? Think first of the Fed’s balance sheet. The Fed’s liabilities are the monetary base — currency in circulation, plus bank reserves. Those bank reserves are essentially short-term borrowing: the Fed pays a small interest rate on them, which is comparable to the interest rate on Treasury bills. More broadly, in a near-zero-rate world, cash — an official liability that pays no interest — is essentially equivalent to T-bills — another official liability that pays more or less no interest. What happens when the Fed buys long-term government securities? If we consider the Fed and Treasury as a consolidated entity — which, for fiscal purposes, they are — then what happens is that some long-term federal debt is taken off the market, and paid for by issuing more short-term debt in the form of monetary base. It’s just as if Treasury sold 3-month Tbills and used the proceeds to buy back 10-year bonds. So the question to ask is, how much do we think federal management of its maturity structure matters for the real economy? I think if you put it that way, most people wouldn’t be terribly optimistic. Anyway, my jet-lagged thought for the day. I would put it differently. The point--from one point of view, the neo-Wicksellian point of view--behind quantitative easing is to reduce the interest rate that matters for private business investment: the long-term, default-risky, systemic-risky, beta-risky, real interest rates at which private businesses finance their capital expenditures. You can reduce this flow-of-funds equilibrium interest rate and raise the level of economic activity in any neo-Wicksellian framework in two ways: 1. Reduce the "safe" real interest rate on short-term, safe government bonds. 2. Reduce the various premia--duration, default, systemic risk, and beta risk--between the rates the Treasury pays to borrow in T-bills and the rates businesses pay to borrow. Conventional open-market operations that lower the nominal interest rate on T-bills accomplish the first. Once the nominal interest rate on T-bills has been pushed to zero, quantitative easing policies that create expectations of higher future inflation continue to lower the real interest rate on T-bills and thus help the situation. Suppose, however, that the nominal interest rate on T-bills is zero and that you cannot alter inflation expectations--cannot commit to keeping your quantitative easing permanent, cannot commit to an exchange rate path, whatever, you cannot do it and inflation expectations are immovable. Then what? Then, as Paul Krugman says, quantitative easing is working be altering the spread between the short-term safe T-bill rate and the long-term, systemic-risky, beta-risky, default-risky rate. How does it do that? Lloyd Metzler and James Tobin would say that it does so by altering relative asset supplies--by taking duration risk, systemic risk, beta risk, and default premia off of
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Why Quantitative Easing Needs to Involve Securities Other than Government Securities - Grasping Reality with Both Hands
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private savers' books and placing them on the government's books (and thus on the taxpayers, who are a very different group of people than are private savers). To the extent that quantitative easing thus involves assets whose risk characteristics are very similar--federal funds and two-year T-notes, say--we would not expect even a lot of quantitative easing to have much of an effect on anything. Thus a quantitative easing program that is going to have bite should involve Federal Reserve purchases of long-term risky private assets rather than merely long-term U.S. Treasuries. Hiring PIMCO as an agent to manage a long bond index portfolio naturally comes to mind--if one could avoid its front-running. And, of course, the most effective quantitative easing program of all would involve the Federal Reserve issuing reserve deposits and using that purchasing power to buy the assets that are the furthest away in their risk characteristics from short-term government bonds: bridges, dams, the human capital of American citizens, police protection, research and development. The best quantitative easing program of all is a money-financed fiscal stimulus, as Jacob Viner said back in 1933: It is often said that the federal government and the Federal Reserve system have practiced inflation during this depression no and that no beneficial effects resulted from it. What in fact happened was that they made mild motions in the direction of inflation, which did not succeed in achieving it.... [If] a deliberate policy of inflation should be adopted, the simplest and least objectionable procedure would be for the federal government to increase its expenditures or to decrease its taxes, and to finance the resultant excess of expenditures over tax revenues either by the issue of legal tender greenbacks or by borrowing from the banks... Brad DeLong on October 23, 2010 at 10:31 AM in Economics, Economics: Federal Reserve, Economics: Finance, Economics: Fiscal Policy, Economics: Macro, Obama Administration | Permalink Favorite
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Comments bakho said... Could the Fed buy State Bonds at very high price to deliver more money/ lower interest rates to the states? If states retired long term bonds at higher rates they could spend the interest savings. States could collect more revenue on other investments because state bonds are often tax free. Reply October 23, 2010 at 10:40 AM max said... Feh. It ate my comment. I left a comment on Krugman's blog this morning saying the much the same thing (albeit in shorter form). Thanks for confirming I had the right answer. "buy the assets that are the furthest away in their risk characteristics from short-term government bonds: bridges, dams, the human capital of American citizens, police protection, research and development." Or we could do helicopter drops for real via the USPS. ;) max ['The helicopters drops aren't known to work because they haven't been tried!'] Reply October 23, 2010 at 11:28 AM crf said... Maybe Government + Senate could try rebranding a new fiscal stimulus program as public/private partnership (PPP). Stable partnership of governments + private sector partners in long term (like 30 year) projects. Both put in capital to the project (although, in a side deal, government could finance or guarantee the private partner's stake, with the private partner paying the government back over time, in exchange for paying an upfront fee to government.) Projects could be things like bridges (revenue by tolls or fees from motorists), rail (revenue from fares), power plants (revenue from power bills). Businesses that have stable sources of revenue from PPP would have good capital, and banks might be willing to loan to them for their other activities. This would involve government picking "winners and losers". Sort of. Reply October 23, 2010 at 11:46 AM Matt Young said... Sounds a lot like choosing the best set of very lousy multipliers, the Fed ends up negotiating losses among the parties in
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aggregate bankruptcy. Reply October 23, 2010 at 12:46 PM save_the_rustbelt said... Banks do not want to lend, small business is leery of borrowing, consumers do not want to spend. Somebody has to go first. And for those of us in the accounting and consulting business, it would be nice to know future tax rates so we can calculate discounted future cash flows without being more nervous than we already are. Reply October 23, 2010 at 01:02 PM Robert Waldmann said... I note that Krugman wrote that he read the idea somewhere but doesn't remember where. I think it might have been here http://www.angrybearblog.com/2010/10/quantitative-easing-without-fed.html OK on substance, things have changed in the past two years. Risk premia are no longer immense. Aggregate demand is very low. Corporations with cash on hand are not investing it. I think that JBD style QE will not be as effective now as it was two years ago. I'd guess that Brad thinks that the level of, say Baa rated bond yields doesn't matter and that they can be pushed lower and that this will have some effect on fixed capital investment and it's the only game in town. I will have a Wicksellian type story such that no form of QE works. Consumers have decided that they have to deleverage. They feel they need to hold less debt. Therefore for given G and I and NX consumption will be low. Therefore even if corporations could borrow at very low interest rates, they won't invest. QE can't eliminate indebtedness. If consumers are just as worried about owing money to the Fed as to a private agent, then the Fed can only satiate their desire to deleverage by giving them money. The Fed can't do that without specific permission from congress -- money can be disbursed only as appropriated by Congress. The Fed can do pretty much whatever it wants with its balance sheet so long as it balances. If low consumption were purely due to housholds balance sheets (not the cost of debt service just the balance sheet) then the Fed can't legally do anything about it. There is excess demand for [not being in debt] an entity, which can loan but can't give, can't do much about it. I think the constitution says that we can't save ourselves unless the Senate cooperates, that is, the economy will be depressed for a long time. Now QE2 what the hell, it's worth a try. Better to light one small candle than to curse against the filibuster. Reply October 23, 2010 at 01:05 PM Rob said... From my understanding the Fed pretty much controls its internal budget correct? So why isn't there a huge rush to renovate Fed buildings? Fully update the computer systems, some nice landscaping, large statues, manicured gardens. And you'll need more security for the now statues and rose bushes so time to hire more guards. And now's great time to buy some overflow office and storage space. And no reason why there couldn't be say some economic scholarships for students in each banks region. Reply October 23, 2010 at 01:24 PM Omega Centauri said... It seems to me QE has a rather large downside. Exchanging risky debt, for taxpayer backed debt is just horrendoous optics. The sort of thing that might generate a teaparty rebellion. Maybe thats what the Republicans had in mind when they developed their filibuster strategy. Reply October 23, 2010 at 01:36 PM postescript said... That was a great explanation. Thanks Brad! But the Fed does seem to be considering an inflation target so that would alter the spread, right? Eichengreen said on Project Syndicate that the Fed can expand its balance sheet essentially without limit. Are you guys in agreement on these "unconventional" measures or does he have other ideas? Reply October 23, 2010 at 01:52 PM Comment below or sign in with TypePad
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