After proponents of the Federal Reserve's second round of quantitative easing (QE2) abandoned the argument that QE2 would spur growth by bringing down interest rates (only after rates increased), the new defense became "we intended for rates to go up all along, as a result of increased inflation expectations." Since few would argue for increased inflation, or expectations of such, as an end in itself, the claim was that increases in inflation expectations would drive households to consume more, which would in turn causes businesses to hire more, bringing down the unemployment rate. But does this chain of reasoning withstand empirical scrutiny?
It turns out looking at the historical data on inflation expectations, as collected at the University of Michigan, that inflation expectations and household savings rates (the inverse of consumption rates) are positively correlated. Now of course correlation doesn't mean causality,but what the data suggest is that instead of consuming more when inflation expectations increase, households have actually saved more. This positive correlation also holds for the second half of the data series, so it's not simply the result of a downward trend in either inflation or savings.
To review, the latest argument for QE2: increase inflation expectations, which is assumed to increase consumption, which is hoped to increase employment. The problem I've had all along with this position is that the only thing we know for certain is the first part, QE2 would increase inflation expectations. The hope that it would increase consumption and hence employment was just that: hope. Given the disconnect we've seen between consumption and unemployment over the past 18 months, the third link in that chain is also a weak one. So what do we have at the end of the day: certain costs with fairly speculative and uncertain benefits. And here I was thinking that reckless speculation was the sole province of the private sector.
Within the Federal Reserve System, there is a tug of war over QE2 (2nd Quantitative Easing). Some, mostly outside the system, are calling for $1 trillion‐plus purchases of long‐term bonds. Within the Fed, there is little taste for purchases that large. I expect a compromise, with an initial purchase perhaps as low as $100 billion.
There is widespread doubt as to the efficacy of further purchases of long‐term bonds. They will supply additional liquidity, but liquidity isn’t what is needed. Businesses and banks are suffering from fear and uncertainty: new taxes, new regulations, new mandates, and, for financial services, the uncertainty of the Dodd‐Frank banking bill.
Lower interest rates on long‐term bonds will do nothing to diminish fear and uncertainty. Instead, QE2 will further inflate the bond bubble and the commodities bubbles.
As the Federal Reserve Federal Open Market Committee (FOMC) meets today, it is widely expected that the Fed will announce a new round of quantitative easing (QE). The first round began in March 2009, as the Fed started large‐scale purchases of Fannie and Freddie debt and MBS. The next round is expected to focus on purchases of long‐dated US Treasuries.
The objective of QEII would be to reduce long‐term interest rates, with the belief that such a reduction would spur investment and consumption, thus increasing employment. Estimated impacts on rates range from zero to 80 basis points (80/100s of one percent).
Given the large excess reserves in the banking system, it is likely that much of the monetary stimulus provided by QEII will simply be added to bank reserves, which would correspondingly have little to no impact on either lending or interest rates. So its likely that we will get very little bang out of QEII.
Even if QEII did lower rates as much as some Fed leaders claim, the impact would still be relatively small, under one percent. Given that mortgage rates have already fallen by that much over the last six months without changing the direction of the housing market, it is hard to see even a 1% decline in rates moving the economy. Quite simply, the major problem facing the economy today is not high interest rates.
The real impact, and the greatest risk, of QEII is that it changes expectations of inflation. It seems pretty clear that the Fed wants higher inflation than we have now. QEII sends the signal that the Fed will do everything possible to create that additional inflation. QEII also runs the real risk that the Fed ends up “monetizing the debt” — both reducing the political pressure to address our fiscal imbalances as well as undermining the dollar. I see these risks as easily outweighing what little bump one might get from a few basis points decline in long‐term interest rates.
Prof. Paul Krugman asserts in his New York Times column of May 31st that "Both textbook economics and experience say that slashing spending when you're still suffering from high unemployment is a really bad idea -- not only does it deepen the slump, but it does little to improve the budget outlook, because much of what governments save by spending less they lose as a weaker economy depresses tax receipts."
While Prof. Krugman and most other fiscalists believe this to be self-evident, it is not. Indeed, this fiscalist dogma fails to withstand the indignity of empirical verification. Prof. Paul Krugman's formulation fails to mention the state of confidence. This is an important oversight. As Keynes himself put it: "The state of confidence, as they term it, is a matter to which practical men pay the closest and most anxious attention."
By ignoring the confidence factor, economic theory can lead to wildly incorrect conclusions and misguided policies. Just consider naive Keynesian fiscal theory -- the type presented (as Prof. Krugman notes) in textbooks and embraced by most policymakers and the general public. According to Keynesian theory, an expansionary fiscal policy (an increase in government spending and/or a decrease in taxes) stimulates the economy, at least for a year or two after the fiscal stimulus. To put the brakes on the economy, Keynesians counsel a fiscal contraction.
A positive fiscal multiplier is the keystone for Keynesian fiscal theory because it is through the multiplier that changes in the budget balance are transmitted to the economy. With a positive multiplier, there is a positive relationship between changes in the fiscal deficit and economic growth: larger deficits stimulate growth and smaller ones slow things down.
So much for theory. What about the real world? Suppose a country has a very large budget deficit. As a result, market participants might be worried that a further loosening of fiscal conditions would result in more inflation, higher risk premiums and much higher interest rates. In such a situation, the fiscal multipliers may be negative. Fiscal expansion would then dampen economic activity and a fiscal contraction would increase economic activity. These results would be just the opposite of those predicted by naive Keynesian fiscal theory.
The extent to which government spending either complements or crowds out private investment has long been one of the most heated debates in economics (and politics). Generally economic theorists posit that an increase in government spending drives up interest rates, which increases the cost of private investment, accordingly reducing such investment. Most macroeconomic models are build on this relationship.
In an interesting new working paper, a trio of economists attack the question from a different angle. They measure the impact of increased earmarks on the local economy receiving those earmarks, and compare the impact to areas not receiving the increased earmarks, which allows them to control for the overall macroeconomic environment. Their finding: even in a setting where government spending is “free” to the recipients (but not free to the rest of us), such spending reduces private investment.
More specifically, the authors examine what happens to a state when one of its senators becomes a chair of a powerful committee. First, the obvious, upon taking a power chairmanship, the value of earmarks increase almost 50%. This results in roughly a $200 million annual increase to the state. But the authors find this is not simply a transfer from the rest of the country to the state, it also depresses private capital investment and R&D spending in the state. On average, once a state has a senator obtain a powerful chairmanship, state level private investment in capital expenditures decreases $39 million annually and state private R&D decreases $34 million annually.
For states seeking to get your senator into a powerful chairmanship: be careful of what you wish for. There’s no free lunch, even when someone else is paying.
Last week, after Rep. Barney Frank (D‑MA) said that holders of Fannie Mae and Freddie Mac’s debt shouldn’t be expected to be treated the same as holders of U.S. government debt, the U.S. Treasury took the “unusual” step of reiterating its commitment to back Fannie and Freddie’s debt.
If ever there was case against allowing a few hundred men and women to micromanage the economy, this is it.
Fannie and Freddie, which are under government control, are being used to help prop up the ailing housing market. If investors think there’s a chance Uncle Sam won’t back the mortgage giants’ debt, mortgage interest rates could rise and demand for housing dampen. Therefore, Frank’s comments caused a bit of a stir. However, with the government bailing out anything that walks or crawls, investors apparently weren’t too concerned with Frank’s comments as the spread between Treasury and Fannie bonds barely budged.
As I noted a couple weeks ago, the Treasury is in no hurry to add Fannie and Freddie’s debt and mortgage‐backed securities to the budget ($1.6 trillion and $5 trillion respectively). Congress certainly isn’t interested in raising the debt ceiling to make room. And as Arnold Kling points out, putting Fannie and Freddie on the government’s books would actually force the government to do something about the doddering duo.
All of which points to what an unfunny joke budgeting is in Washington. Take a look at what current OMB director Peter Orszag had to say about the issue when he was head of the Congressional Budget Office:
Given the steps announced by the Treasury Department and the Federal Housing Finance Agency on September 7, it is CBO’s view that the operations of Fannie Mae and Freddie Mac should be directly incorporated into the federal budget. The GSEs’ revenue would be treated as federal revenue and their expenditures as federal outlays, with appropriate adjustments for the manner in which credit transactions (like a mortgage guarantee) are reflected in the federal budget.
Note that Orszag wrote that statement less than two years ago. And since then, the bond between the government and the mortgage giants has only gotten tighter.
The same people that say Fannie and Freddie shouldn’t be on the government’s books are often the same people who once dismissed concerns that the two companies were headed toward financial ruin. In 2002, Orszag co‐authored a paper at Fannie’s behest that concluded that “the probability of default by the GSEs is extremely small.”
Another one of those persons, Congressman Frank, has his fingerprints all over the housing meltdown. In 2003, a defiant Frank stated that “These two entities – Fannie Mae and Freddie Mac – are not facing any kind of financial crisis.” Frank couldn’t have been more wrong. Yet there he remains perched on his House Committee on Financial Services chairman’s seat, his every utterance so important that they can move interest rates.
- A real stimulus: To create jobs, repeal the corporate‐income tax.
- As if times weren’t hard enough: The individual mandate on health insurance would impose high implicit taxes on low‐wage workers. For more on this, read the new Cato study on burdens the health care legislation will place on the poor.
- Hot off the press: New issue of Regulation magazine looks at lessons from the financial crisis and property rights.
- Even though the government is running massive deficits, interest rates and inflation are low. So, what’s the problem?
- Podcast: “Bernanke’s Conceit” featuring Mark A. Calabria.