Monday, November 22, 2010

Blinder makes Monetary Policy on the Moon

I eased off the topic of Quantitative Easing (QE) until now because there was so much being written about it. But then all this stuff about Prince William and Princess Kate hit the news and I realized two things. First, I am getting really old. Wasn’t Prince William playing in his crib last year? Second, you people need a little diversion from the Royal Family. And then to top things off Alan Blinder, a former Fed vice chairman, called QE2 a “garden variety monetary policy.”

Wow. Professor Blinder must be growing his artichokes on the moon if he calls QE2 garden variety. It is true that the Fed always does monetary policy by buying government bonds and by trying to influence interest rates. The buying of the government bonds washes the banks with new increased liquidity and reduces the pressure on the cost of bank borrowing. The general idea is that if the cost of bank funds decreases then banks will be willing to reduce interest rates on loans. The story continues – and then goldilocks lived happily ever after. Err, I mean the story goes that firms see lower interest rates and they jump in their Fords and drive down to the carry out window and borrow tons of money and spend it on new machines and workers. 

While I make a little fun with the story, the truth is that this sometimes works. The truth also contains the fact that most of the Fed's buying of government bonds is in bonds of short maturities. Therefore most of the direct impacts on interest rates occur at the short end of the term structure – on bonds that mature in two years or less. Of course, they hope that the reduction in short-term rates would bring about a decline in longer- term rates as well. To have the full or complete impact the story wants to have all rates decline. 

The above is garden variety monetary policy on planet Earth.

So what is different about QE2? First, it was invented in places like Japan and now the US where short-term interest rates are virtually zero so that the above story is no longer relevant. The Fed cannot reduce short-term interest rates and the cost of bank funds. So they decided that if they are going to make Mad Money (the TV show) on a regular basis they better come up with something cool and novel. If Nancy Pelosi cannot save the US economy, then maybe the Fed can.

Second, the Fed realized that even though they were able to drive short-term interest rates to zero (ta da!) rates on longer term assets were not coming down as much or as fast as they wanted. After all, to have the largest impact on spending it is important to impact loans with longer maturities. So QE is different – since it worries less about short-term rates and forcing even larger amounts of unused reserves on banks – and more on directly influencing long-term interest rates. While this has been tried by the Fed in the distant past, it is NOT DOING MONETARY POLICY AS USUAL.  And, of course, you wouldn’t have thousands of articles being written about QE if it were business as usual. 

Policy conservatives have plenty to chew on. QE and QE2 represent a broadening of the Fed’s tools or perhaps even its mandates. If policy conservatives want the Fed to focus its energies more narrowly (aiming only at inflation), then they are not going to sit around smelling incense as the Fed gets more active.  Moreover, policy conservatives might point out that QE1 already stuffed plenty of money into pillows and adding a second round is only asking for trouble. Professor Blinder can show you overhead slides of how easily it is to pull money back out of those pillows when necessary but what he can’t easily show you is how difficult that plan is to put in place in the real world right here on Earth.

Third, the difference in QE2 also relates to the business environment. Keynes convinced most of us that monetary policy is NOT the best tool to use when the recession is deep and when confidence is failing. Keynes and his legion of legally-obtained medical marijuana smokers have a preference for fiscal policy. Read recent articles by Krugman and Stiglitz to see why some activists prefer fiscal to monetary policy today. While you should not count QE2 out until the bell rings, it does not surprise me that most long-term interest rates rose – did not fall – once the Fed got serious about some of the details of QE2. As Keynes might say today, the Fed‘s flailing attempt to do something is doing nothing but creating a higher risk environment. Alan Blinder and some current Fed officials can say all they want – but markets are smarter than that. QE2 is not a good policy for the Earth at this time.


  1. Prof Larry,
    You lost me at Keynes and Krugman....especially Krugman.

  2. Dear Crash,

    In Keynes' book, the General Theory, he lays out why he would NOT use monetary policy in a severe recession. Bernanke and Blinder should have listened to Keynes. Some Keynesians have a more moderate view of money but acknowledge Keynes' point in what they call the liquidity trap. They model this as a flat LM curve in the infamous IS-LM Model. When the LM curve is flat, monetary policy has no impact on the economy but fiscal policy is effective.

    My view is that in today's economic situation NEITHER monetary nor fiscal policy is going to be very effective. Aggregate Supply Policy would be more useful.

  3. I may be missing something.....I usually am & it's part of my frontal lobe....but if people aren't working & earning, how is supply going to help w/o an equal/greater demand? We wind up w/ huge inventories w/ the businesses paying huge taxes on them & laying off more people because demand for all of this supply isn't there. My head hurts.

  4. Crash,

    Have you tried aspirin for your headache? It is a wonder drug. The long answer to your question is in my two posts about supply-side policy. The shorter answer is that today's current problem has more to do with supply than demand. The press has been pushing the idea that households won't spend because they either don't have a job or they are worried about losing one. I interpret this as a supply problem. If firms were more optimistic about the future then they would hire more workers and this would create both supply and demand. Supply-side policy is aimed at reducing tax rates, regulations and other factors that might be clouding the future.