The Fed and the Recovery, or, QE not D

Lately more and more people seem inclined to congratulate the Fed for the great job it has done saving us from another Great Depression and getting the U.S. economy back on its feet. Frankly, I’m getting tired of it.

It’s not that I’m cock-sure that the Fed’s post-2008 actions haven’t achieved anything. It’s just that I’m pretty darn sure that all the people who claim that the Fed has done a bang-up job haven’t any solid reasons for doing so. They remind me of the characters in an episode of The Beverly Hillbillies who were certain that Granny had a concoction that could cure the common cold–certain, that is, until Granny told them that it took about ten days for the stuff to work.

Some point to Europe’s relatively feeble economy, and the ECB’s belated attempt to revive it by means of Bernanke-style Quantitative Easing, as proof of the Fed’s enlightened conduct. But that comparison may only prove that Europe’s central bank has bungled things even more than ours has. In fact, the comparison doesn’t even prove that much, since U.S. money market conditions appeared to offer better prospects for the success of quantitative easing than those that prevailed in Europe.

Apart from being better than Europe’s, our recovery offers precious little for Fed boosters to brag about. It has been remarkably slow—slower, according to some experts, than the severity of the crisis can itself account for. It has been remarkably incomplete. And it has landed us in a low low-interest-rate mire from which there’s no easy escape.

But surely, some may object, the Fed’s policies—all that Quantitative Easing and Twisting and Reverse-Repo-ing—have helped. Maybe. But proving the point isn’t just a matter—as some commentators seem to think—of pointing to improved economic numbers, noting that the numbers arrived after the Fed did this and that, and declaring Quod Erat Demonstrandum.

Why not? Because, first of all, economies tend to recover from slumps, if only very slowly and painfully, without the help of fiscal or monetary stimulus. The immediate cause of such slumps is a slow down or collapse of spending or “aggregate demand,” like the one that took place during the last half of 2008. When spending collapses, businesses generally can’t recover their costs. Nor can they hope to keep producing as before, unless the prices of their inputs decline enough to make up for their lower earnings. The ideal remedy is to get spending back up again—and fast—by increasing the total supply of dollars. But suppose you had a negligent central bank that first resisted creating new dollars, and then made sure that new dollars it did create piled up in bank vaults instead of being lent and spent. In that case, spending would remain depressingly low. [1]

What then? Well, eventually, people start to come to grips with the new reality. They stop hoping that spending will pick up again, and start thinking about getting by at a permanently lowered spending level. In economists’ fancy jargon, this means that “aggregate supply” schedules start dropping. In plain English it means that workers start to accept pay cuts they wouldn’t have considered before, while firms settle for lower product prices.

Downward supply-schedule shifts aren’t pretty. No one likes making them—and I’m certainly not recommending them. (I also promise to track-down and give a noogie to anyone who suggests otherwise.) But make them they will—eventually—if the alternative is not selling their services and goods at all. The adjustments might be delayed for a long time, and it might take much longer for them to succeed in getting the economy back to full employment. They might even take more than six years to do so. But it’s hardly likely that they would not have achieved some considerable measure of recovery during such a long stretch of time, unless it was because monetary (or fiscal) authorities discouraged needed adjustments by repeatedly promising to revive spending, and then failing to deliver on those promises.

The last observation brings me to my second point, which is that central bank actions—including some superficially expansionary ones—can delay as well as promote recovery. Policy announcements that end up giving a bigger boost to aggregate demand expectations than to aggregate demand itself are one example. (I continue to be perplexed by all the chatter since 2008 concerning the need to raise, not the actual, but the expected rate of CPI inflation–as if doing that would not have the effect of further raising supply schedules that are already too high.) And although Quantitative Easing necessarily increases the nominal supply of bank reserves, it doesn’t necessarily increase that supply more than it increases demand: as St. Louis Fed economist Li Wen has observed, when real interest rates on riskier assets are already low relative to the return on reserves, QE can cause some investors “to switch from interest-earning assets to money,” and so can actually end-up reducing instead of increasing an (already excessively low) equilibrium price level.

All of which is a long way of saying that determining the Fed’s actual contribution to the recovery takes some fancy statistical work—so fancy, indeed, that no one is quite sure how to do it. Instead we have, so far, numerous studies reaching different—and sometimes dramatically different—conclusions. (Here is another review of some of them.)

Many of these studies do find that the Fed’s policies succeeded to some degree. But “succeeded” in most of them means succeeded in lowering long term interest rates, which though perhaps a step in the right direction is not at all the same thing as boosting employment or real output. Those studies that attempt to measure the effect of the Fed’s interventions on output or employment generally report modest gains only, if not negligible ones (see, for instance, the studies by Wen and by Chen, Cūrdia, and Ferrero). Finally, even some of the larger estimates supply only very meager grounds for celebration. One recent Federal Reserve Board study, for example, has the Fed’s combined Large Scale Asset Purchases achieving a 1.2 percentage point peak reduction in the unemployment rate by early 2015. Though large compared to other estimates, this reduction in the unemployment rate is less than half as large as that attributable to the post-2008 decline in labor force participation. Also, because the actual unemployment rate in January 2015 was 5.7%, with 9,000,000 unemployed and an implied labor force of 157,894,737, the gain amounts to only about one job for every $2 million in Fed asset purchases!

Don’t get me wrong: I’m not claiming that the new jobs attributable to Fed asset purchases weren’t worth it: creating money to combat cyclical unemployment isn’t the same as spending it in a state of full employment, so the numbers I mentioned don’t amount to any sort of cost-benefit calculation. What I am saying is that its worth pondering whether, had it handled things differently, the Fed might have created a lot more jobs, without having had to create nearly as many dollars. Suppose, for instance, that, instead of engaging in sterilized direct lending, the Fed had taken steps to expand the monetary base as soon as demand started flagging (or, better still, that it had expanded preemptively, as it had done on some prior occasions when markets were badly rattled). Suppose that it had refrained from paying interest on bank reserves just when the economy was starving for want of lending and spending. Suppose that instead of trying by hook and crook to preserve an obsolete interest-rate target, it had been targeting NGDP growth all along. Suppose, to go a bit further back, that it had not rescued Bear Stearns, or that, having rescued it, it made clear that it did so for reasons that would not entitle larger investment banks to similar aid?[2] Suppose, finally, that instead of “rolling the dice” (as the New York Times put it recently), the Fed had stuck to a tried-and-true monetary rule, or that it had been obliged to follow a novel but potentially superior rule, and that it had also obeyed Walter Bagehot’s sound advice for last resort lending? Is is not possible that by doing some or all of these things it might have allowed the U.S. economy to recover at least as rapidly as it has, if not considerably more rapidly, without having to purchase trillions of dollars worth of assets?

What difference does the extent of the purchases make? Plenty. First, the wealth redistribution effects of the Fed’s policies might have been smaller and correspondingly less unpalatable. Second, the Fed might not have undermined to the extent that it has its ability to tighten money by means of conventional open-market sales. The Fed claims it can instead manage by means of a combination of reverse repos and a higher interest rate on bank reserves; but there are good reasons for being less-than-sanguine about these alternative “exit” strategies: for one thing, to the extent that they succeed in reducing banks’ excess reserve holdings, they do so by permanently increasing the Fed’s share of total financial intermediation (and correspondingly reducing the efficiency of investment), and (so far as repos are concerned) by inadvertently propping-up Money Market Mutual Funds at the expense of commercial banks.[3] Finally, by boosting the prices and lowering the term premium on low-risk assets, the Fed has given an artificial fillip to riskier ones, increasing in like measure the risk of a major correction.[4] In short, after more than six years worth of Fed experiments, we haven’t yet heard the last monetary-policy shoe drop.

Am I suggesting that the Fed could not possibly have done worse? Of course not. Only someone with a severely defective imagination could suppose so. Whatever his shortcomings, Ben Bernanke was far from being an incompetent central banker. In suggesting that we might have done better than Bernanke’s Fed did, I don’t mean that we could have used a better discretion-wielding central banker. I mean that we might have been better off avoiding seat-of-the-pants-style central banking altogether.

I struggle, moreover, to understand why more people don’t take the same view. For if it takes a stunted imagination to suppose that things couldn’t have been worse, it takes a no-less defective one to suppose that we couldn’t possibly improve upon the presently-constituted Fed. Far for supplying grounds for celebration, or warranting complacency, the events of the last decade or so ought to make it more evident than ever that our monetary system is very far from being the best of all possible alternatives.

[1] If you wonder why any monetary authority would encourage banks to hoard reserves in the middle of a spending crunch, the answer in the Fed’s case is that they did it precisely because they didn’t want Quantitative Easing to lead to increased bank lending and, thence, to a general increase in spending. “It is important to keep in mind,” a Fed source informs us, “that the excess reserves [generated by Quantitative Easing] were not created with the goal of lowering interest rates or increasing bank lending significantly relative to pre-crisis levels. Rather, these reserves were created as a by-product of policies designed to mitigate the effects of a disruption in financial markets. In fact, the central bank paid interest on reserves to prevent the increase in reserves from driving market interest rates below the level it deemed appropriate given macroeconomic conditions. In such a situation, the absence of a money-multiplier effect should be neither surprising nor troubling.” Got that?

[2] Here, for once, the FCIC got things right:

The lesson taught by the rescue of Bear was that all large financial institutions—and especially those larger than Bear—would be rescued by the government. The moral hazard introduced by this one act irreparably changed the position of Lehman Brothers and every other large firm in the world’s financial system. From that time forward, (i) the critical need for more capital became less critical; the likelihood of a government bailout would reassure creditors, so there was no need to dilute the shareholders any further by raising additional capital; (ii) firms such as Lehman that might have been saved through an acquisition by a larger firm or an infusion of fresh capital by a strategic investor drove harder bargains with potential acquirers; (iii) the potential acquirers themselves waited for the U.S. government to pick up some of the cost, as it had with Bear—an offer that never came in Lehman’s case; and (iv) the Reserve Fund, a money market mutual fund, apparently assuming that Lehman would be rescued, decided not to sell the heavily discounted Lehman commercial paper it held; instead, with devastating results for the money market fund industry, it waited to be bailed out.

[3] This fear that it might trigger such a correction is of course one reason for the Fed’s reluctance to absorb excess liquidity by selling any substantial share of the assets it has acquired.

[4] Actually only 94 MMMF’s are so favored. As Bob Eisenbeis points out, they all belong to a relatively small number of U.S. and foreign financial institutions.

[Cross-posted from]