Monday, November 22, 2010

Quantitative Easing

To clear up the debate over quantitative easing, there are only three relevant questions: (1) Should the Fed ease ever? (2) Should the Fed ease now? and (3) Is 'Quantitative Easing' the right strategy? If you disagree with the Fed about QEII, you have to say no to one or more of those questions.

Should the Fed Ease Ever?

This is a surprising one. If you would have talked to me a few years ago, I would have said that there is a widespread consensus around the idea that the Fed should loosen policy to make recessions easier (and ideally tighten in good times).

Yet now there has been an outpouring of anger at this idea -- led by intellectuals of many stripes, but politically primarily by Republicans. The concern is that "printing money" is not sufficient to handle "primarily structural" problems in the economy. The underlying idea here is that purely nominal changes reflecting the money supply can't have an effect on the real economy (according to Paul Ryan, they never have).

The other critique, bizarrely, enough, is that the Fed eased too much during the boom years, generating a "bubble," and more easing now might lead to runaway inflation. Sometimes, you hear both concerns from the same people. But let me focus first on the idea that monetary policy can't do anything.

As Christina Romer (former CEA Chair) has pointed out, the entire recovery the US had from the Great Depression can be accounted for by monetary stimulus -- in particular, the decision to get off the Gold Standard (which removed a huge constraint on how much money we could print). Vockler generated a huge recovery in 1983 by loosening policy. And as recently as 2000-01, the Fed’s easing prevented what were actually quite enormous real economic losses (comparable to subprime losses) from turning into worse outcomes.

The theory of how this happens has been explained by Milton Friedman, among others. Paul Krugman has a particularly good explanation of this using a parable of the baby co-op, that I'll provide a lengthy excerpt from:
A group of people (in this case about 150 young couples with congressional connections) agrees to baby-sit for one another, obviating the need for cash payments to adolescents. It's a mutually beneficial arrangement: A couple that already has children around may find that watching another couple's kids for an evening is not that much of an additional burden, certainly compared with the benefit of receiving the same service some other evening. But there must be a system for making sure each couple does its fair share.
The Capitol Hill co-op adopted one fairly natural solution. It issued scrip--pieces of paper equivalent to one hour of baby-sitting time. Baby sitters would receive the appropriate number of coupons directly from the baby sittees. This made the system self-enforcing: Over time, each couple would automatically do as much baby-sitting as it received in return. As long as the people were reliable--and these young professionals certainly were--what could go wrong?…
Now what happened in the Sweeneys' co-op was that, for co
mplicated reasons involving the collection and use of dues (paid in scrip), the number of coupons in circulation became quite low. As a result, most couples were anxious to add to their reserves by baby-sitting, reluctant to run them down by going out. But one couple's decision to go out was another's chance to baby-sit; so it became difficult to earn coupons. Knowing this, couples became even more reluctant to use their reserves except on special occasions, reducing baby-sitting opportunities still further.
In short, the co-op had fallen into a recession.
Since most of the co-op's members were lawyers, it was difficult to con
vince them the problem was monetary. They tried to legislate recovery--passing a rule requiring each couple to go out at least twice a month. But eventually the economists prevailed. More coupons were issued, couples became more willing to go out, opportunities to baby-sit multiplied, and everyone was happy….
Above all, the story of the co-op tells you that economic slumps are not punishments for our sins, pains that we are fated to suffer. The Capitol Hill co-op did not get into trouble because its members were bad, inefficient baby sitters; its troubles did not reveal the fundamental flaws of "Capitol Hill values" or "crony baby-sittingism." It had a technical problem--too many people chasing too little scrip--which could be, and was, solved with a little clear thinking.
Sometimes, your problems really are just monetary. When the demand for holding money shoots up, and we don’t respond by increasing the supply (we refuse to "debase our currency"); people start to hoard cash, and we get a recession.

But even if you don't buy that logic; clearly we can't go on with the same money stock that existed, say, in 1913. We need more money from time to time, and that happens through two channels -- (1) banks can do more lending, resulting in more privately generated money, or (2) the Fed can exchange bonds held by banks for cash, in effect giving banks a "licence" to print more money. In our system, the actual process of money generation actually happens through banks, but the government has a key role through monetary operations that allow or cancel what are in effect "money printing licences."

Again -- there really shouldn't be any debate over this. We need to print money from time to time. This is especially important when there is an excess demand for money -- at which point purely nominal changes can result in actual, large-scale effects in the economy. Room for reasonable debate starts at:

Should the Fed ease Now?

We have various statistics on governing monetary aggregates and indicators. Most of them suggest that money growth is below trend:

M2 is a basic standard of "money;" the one preferred by Milton Friedman. Here, you can see that growth in M2 is below recent trends:

M3 is another measure, that incorporates broader monetary items. According to Gary Gorton, it's a better measure of money in the modern world, where financial instruments -- like repos or Treasuries -- serve as money in financial markets. That's actually declining.

Then there is inflation. The most recent data show that “core” inflation is weighing in at .6%. If you were to better impute ongoing house price declines (or hedonistic quality improvements), that would be even lower. (It would be higher if you counted some commodities. But the price growth in those items is driven primarily by strong demand from emerging countries, not from monetary expansion in the US.)

Of course, low current inflation may be a temporary sideshow. Inflation could jump up in the future, as people have argued for several years now. But instead of relying on unfalsifiable fears or concerns -- I prefer to look at the markets. What do markets think about future inflation? The Cleveland Fed has the best figures; that show inflation expectations are low and falling:

So, by every possible measure, the money supply is low and trending lower. It’s projecting to be low in the future as well. If you think that money growth should be a little counter-cyclical to meet greater money demand, it's too low by far. Even if you think that the Fed should only have an inflation target around 2% — money supply is too low.

As you have probably heard, Japan spent a lost decade (really, now 18 years) going through a deflationary period enduring all sorts of economic pain. Here’s America relative to Japan on that path:

Deflation, in general, isn't necessarily a bad thing. America went through deflationary trends in the 1860s-1870s and the 1920s but did just fine. When deflation is driven by supply-side technological improvements that reduce secular prices, the Fed does not need to deliver inflation (arguably, this was the case in the 2000s; when trade and technology may have reduced prices on their own; and Fed intervention just led to a "housing bubble."). Deflation is a bigger problem when it’s driven by shortfalls in demand; and gets you a world like the baby co-op where all members are afraid to run down babysitting script for fear that they would be unable to pick one up later.

Deflation during times of economic stagnation is nothing short of catastrophic. The Japanese have been unable to generate enduring economic growth for, again, close to two decades now. High inflation is easy enough to end with central bank that cares about the issue -- but deflation on Japanese lines is near impossible to cure. In my view, the massive costs of persisting in a Japan-like ditch are sufficiently large (and the odds that it will happen are high enough); suggesting that we should be prepared to pay a high premium for an insurance policy against such an outcome. Fortunately for us, this is really a negative premium considering the benefits that inflation closer to target would have for us today.

If anything, our experience would be worse than Japan’s. As Michael Pettis points out, Japan had the fortunate chance of dealing with economic stagnation by undergoing domestic rebalancing. Though economic growth was slow, households earned a steadily larger share of the pie. America doesn’t have that option, given how large household consumption already is. American households in a deflationary environment would likely be hit by a double-whammy — as growth stagnated, households would readjust their consumption share downwards as they started to save.

If the costs of low inflation are high, the costs of dealing with high inflation are manageable. As Scott Sumner has argued; the Fed has many more tools to combat inflation that in the 1970s. Futures markets indicate market expectations about future inflation, ensuring that the Fed won't be caught off guard by unexpected rises in inflation. Plus, with economic slack and underutilized labor and equipment, rises in nominal spending would presumably manifest in the form of greater utilization, rather than higher prices. This allows the Fed a greater degree of cushion in setting policy.

The Fed also has a new tool — it’s policy of paying interest rates on bank excess reserves. Banks now have the option of holding extra money at the Fed and earn interest, instead of extending loans in the real economy or buying bonds. The Fed’s decision to undertake this policy explains in part why the traditional monetarist fears about a larger monetary base generating inflation haven’t panned out. The Fed’s (brand new) policy has short-circuited the normal process of money creation. The upside is that future increases in inflation will be easily curbed by the Fed if it is willing to use this tool.

Finally, there's the fact that while higher inflation is hardly a cure-all, the costs of having unprecdentedly low inflation right now make solving nearly every other problem in the economy much harder. It’s harder to rebalance global consumption (more savings in the US, more consumption elsewhere) while the dollar is strong. It’s harder to dig out of a housing debt overhang when inflation is lower than home buyers anticipated when they drew up contracts. It’s harder to deal with government debt if the Fed isn’t purchasing that debt. All of these are “real” economic problems, but they’re impossible to manage in the presence of deflation, and difficult enough when inflation is as low as it is.

While easing may generate the "risk" of inflation, it's worth considering what that means. There's no good economic evidence that inflation has any bad consequences until it hits the double digits. India, for instance, is managing 8% economic growth just fine even as inflation nears 10%. Inflation was around 4% when Vockler declared a victory against high inflation (subsequently, he was attacked by Republican officeholders for letting inflation fall below that — how times have changed).

Why QE?

To sum up; we have a deflationary environment; the Fed has ample tools to attack inflation in the future, and it has in effect a "magic ball" that allows it to anticipate changes in inflation before they happen. On top of that, higher inflation would, if anything, be good; while the costs of extended deflation could be quite bad.

The only reason to have a debate about this at all is that the traditional tool of monetary policy — the Fed purchasing short-term Treasury debt in exchange for money — has run out. With short-term interest rates near zero, banks simply take the money from any Fed asset purchases and send it right back to the Fed to earn comparable interest rates as excess reserves. Short-term asset purchases now simply change one low-interest bearing government asset for another.

But suppose, as Rortybomb and others have suggested, that we simply find that we are mistaken about interest rates, and the Fed actually could ease a little more through the conventional route. It’s tough to imagine that anyone would actually then oppose further easing. After all, the Fed bought a great deal of government bonds (lowered interest rates) in 2007-2008; a period of time during which growth was higher than now, inflation was higher, and growth in monetary aggregates was also higher. No one complained about debasing the currency then.

The entire debate thus revolves around the fact that the Fed, in trying to ease while short-term interest rates are zero, is going to purchase government bonds of slightly longer duration (quantitative easing). That's the only difference. You can call this an "unprecedented" or "risky" strategy if you like, but really it’s virtually identical to the policy we would all like to do if short-term interest rates were a few points higher.

There is one and only one new concern that QE raises, as Greg Mankiw points out:
If future events require higher interest rates, the Fed will end up making losses on its portfolio. And even if doesn't recognize these losses (by not marking to market), it could end up paying more interest on newly expanded reserves than it is earning on its newly acquired portfolio of long bonds. Such a cash-flow deficit could potentially undermine the Fed's political independence (which is already not very popular in some circles). Yet if the Fed tries to avoid these losses by failing to raise rates when needed, inflation could indeed become a problem down the road.
The issue is that, if higher inflation hits, the Fed will be forced to deal with that. If it contracts by selling the same long-term bonds it purchases today, it may be forced to realize a nominal loss. But losses from central banks are a little odd to think about. The Fed practically has a license to print money. It’s normal activities also generally produce a sizable surplus, which typically goes to the Treasury (but a greater proportion of which could stay with the Fed to counter realized losses). Bernanke considered this issue extensively in his speech to the Bank of Japan (in which he urged the adoption of various tactics to deal with Japan’s deflation and zero-rate problem), suggesting that:
In short, one could make an economic case that the balance sheet of the central bank should be of marginal relevance at best to the determination of monetary policy.
He also suggested a bond conversion (or interest-swap) proposal between the Bank of Japan and the Ministry of Finance (here, the Fed and the Treasury) that would protect the Bank of Japan (Fed) from any subsequent interest rate changes. This would, in effect, reduce the scary-sounding “quantitative easing” to normal monetary policy — on which there should exist broad consensus that we need to ease.

So, again, that's the only real "risk" that QE induces -- the risk that inflation will somehow jump up dramatically (even though money growth is trailing GDP, and markets don't expect it), that the Fed burns through trillions of dollars of short-term bonds in responding to that (bearing minimal losses); and that the Fed then somehow takes minor nominal losses on their long-term bond purchases. And we even have solutions to that if we can get the proper coordination between the Treasury and the Fed (bond conversion or the Fed keeping more of the money they make). When balanced against the risk of letting inflation expectations de-anchor from historical norms and lead to a deflationary spiral, I think that's a pretty fair tradeoff. Certainly I don't think this risk in any way justifies the sort of vituperative rage that has been directed against the Fed.

Plus, I don't think QE skeptics have fully thought through their position. It is entirely resonable, in my view, to suggest that the zero-rate bound should represent a real constraint on the actions of the Fed -- that the Fed should simply not purchase any long-duration assets. So if short-term interest rates are zero; tough luck.

But if you really believe that, the resulting low inflation means low (nominal) interest rates, which means that the Fed will run out of its traditional ammo and hit the zero-rate bound again and again, and be left paralyzed. This means that we really need insurance against hitting this bound, in the form of higher inflation that results in higher nominal interest rates.
Put differently -- if you want low inflation (ie, 2%); you also need to give the Fed the tools it needs to conduct monetary policy when interest rates hit zero, as they will frequently with inflation that low. Just complaining about printing money isn’t an option — everybody needs to believe in easing now (if you don’t think the zero-rate bound is a real barrier), or easing later (to generate higher long-term inflation).

The criticisms I take more seriously argue that QE will do little. I think the market responses to the anticipation and announcement of QE2 demonstrate that it can do some good; but I also think it won't do much.

But what we need to do then is pair it with policies that will do good. For instance, we can end the Fed policy of paying interest on excess reserves, and then have the Fed buy many more government bonds of all durations. That way, banks will take the money and put it somewhere in the economy. Even if they park it in other bonds, that will lower interest rates, push the seller to do something with the money, and at some point result in higher nominal spending. Or, the Fed could just eliminate this policy now, see what the current $1 trillion of parked reserves could do, and then think about future asset purchases.

Alternatively, the Fed could try to push money out by other ways. A combined Treasury-Fed operation is a commonly envisioned tactic -- this would work by having the government spend money in some way, and have the Fed foot the bill by buying the resulting additional government bond issuances. Even John Cochrane, who is skeptical of both monetary and fiscal policy, agrees that this would have some effect. So do the modern monetary theory guys. Bernanke, too, stressed this sort of monetary and fiscal cooperation in his speeches to the Japanese. Either his logic was wrong then, or it’s wrong now.

Finally, I'll say that for me, this issue is as much moral as it is purely practical. I was drawn to the bipartisan, technocrat economic management school not because of the patently unrealistic assumptions about human behavior, but because I saw it had real solutions to solve major economic problems. You don't have to suffer a Great Depression -- you just need to set your monetary policy correctly, etc.

Now, I'm worried that so many commentators have seemingly checked out of these debates. You see many people complaining about new policies, and worrying about supposed "risks" or "worries" that don't exist in data coming in statistics or financial markets. There are fewer and fewer people with tangible solutions on how to solve this mess. I think that erodes the moral legitimacy of capitalism. I think no economic system that tolerates 10% unemployment is acceptable; and something must be done. If you don't like QE; if you don't like the alternate options here; then what's your plan? What's your strategy for avoiding a Japan death trap/Mad Max world? For Krugman and Bernanke, it was frustrating to watch policymakers in Japan seemingly self-destruct in the face of difficult economic times. Turns out it's also frustrating to live in that world.


nazgulnarsil said...

the parable of the babysitters stupidly hoists itself by its own petard. it assumes a magically static value for the scrip that does not exist. in that scenario the value of the scrip would increase until equilibrium was again reached in people's desire to go out vs spending scrip.

the parable could be used to demonstrate stickiness, but in the form told by krugman is dangerously misleading.

Anonymous said...

"we simply find that we are mistaken about interest rates, and the Fed actually could ease a little more through the conventional route. It’s tough to imagine that anyone would actually then oppose further easing."

You do know that Hoenig wants to raise the target rate to 1%.

Did you See Nick Rowe looking into the background and writings of Fischer? My god: