Quantitative Easing

The Federal Reserve Bank is about to undertake another round of quantitative easing, by purchasing up to $600 billion worth of U.S. Treasury bonds. The Fed gets to make up their own money—they don’t have to get that $600 billion from anybody else—so this is a way of expanding the overall money supply. The intent is to increase the price of U.S. Treasury bonds, thereby lowering their yield and making it more attractive for people with money to seek other forms of return. Seeking other forms of returns means investing elsewhere, and in particular it means making loans to businesses which use the money to create jobs.

On paper, there is no way that this can work. The problem with the U.S. economy right now is not a shortage of available money. In fact the interest rate on loans is quite low. The interest rate is so low that companies like IBM are selling bonds directly in order to borrow money at a low interest rate. In other words, this move by the Fed isn’t going to encourage IBM to invest any more: IBM can already get all the money it needs.

It’s small businesses which are having a harder time getting loans. They’re not having a hard time because the banks don’t have money to give them. They’re having a harder time because the banks are being more stringent on their loan requirements. The Fed is hoping that by making investing in Treasury bonds even less worthwhile, banks will start making more small business loans in order to increase their profits. This isn’t going to work for the big banks, which are scared because they still don’t know how much they have at risk during the slow moving unwinding of bad mortgages. They’re going to hold onto their cash. It could work for the small banks.

But even the small banks aren’t going to start loaning money to small businesses unless the small businesses start asking for it. And the small businesses aren’t going to start asking for it until people start spending more money. And people aren’t going to start spending more money until they feel that they have enough savings. The savings rate was very low for several years, around 1%, and is now up to a more respectable 6% or so. In the long run, more savings is good for the economy. In the short run, it means that people are not spending money, which means that small businesses are not starting up and hiring people.

What this means is that the Fed is pushing on a string. Increasing the money supply is a very indirect way of creating more jobs. On paper, the newly created money is just going to get saved, mostly by large banks to improve their balance sheets. In the current economy, the way to create jobs is obvious: give people money to spend. You can’t do with income tax cuts, because most relatively poor people—the people who would spend extra money rather than saving it—pay next to no income tax. You could do it with a payroll tax holiday.

Or you could do it with stimulus spending. However, the Fed isn’t doing that, because it can’t. The Fed isn’t allowed to just hand out the money they create. They can only do specific things with it, like buy Treasury bonds. The rest of the government could hand out money, but they are unable to due to political paralysis.

The recent election is not going to help in this regard, as the Republican platform appears to be extending the Bush income tax cuts and refusing to increase spending, neither of which is going to help the current economy at all. (In fact, of course, extending the Bush income taxes is going to increase the overall deficit far more than any plausible spending cuts, so the claims by people like John Boehner to be interested in deficit reduction without clearly describing the compensating spending cuts make no sense.)

So on paper the Fed’s move is going to be useless. It has only one prospect of working: by making it clear to investors that, despite the government paralysis, the Fed is going to keep expanding the money supply until something happens. If people come to believe that, then they will be that much more likely to start spending, companies will be that much more likely to start borrowing, and jobs will start to be created. It’s a very indirect way of working. I don’t personally think it is going to work. But it could happen.


  1. fche said,

    November 5, 2010 @ 8:08 am

    I agree with almost all you say. This part though:

    “Republican platform appears to be extending the Bush income tax cuts and refusing to increase spending, neither of which is going to help the current economy at all”

    The first part seems wrong entirely. The converse of “extending the tax cuts” is raising taxes, and it is a rare sort of economist who argues that this helps any economy.

    The second part is more fuzzy, but “refusing to increase spending” only fails to help the wealth-redistribution-based portion of the economy. It is at least neutral with respect to the rest of it, and probably positive (in conjunction with tax / spending cuts they’ll try to push).

  2. Ian Lance Taylor said,

    November 5, 2010 @ 8:12 pm

    Raising taxes can certainly help some economies, and I think any economist would agree with that. Otherwise one can only conclude that there should be no taxes, in which case there is, eventually, no government. For example, any society entering a war would normally raise taxes—in fact, a significant portion of the current federal deficit is due to the combination of starting a war while cutting taxes pursued by the Bush administration.

    That said I agree that raising taxes does not make sense in this economy. But a permanent extension of the Bush tax cuts, unless coupled with severe spending cutbacks, is going to lead to an increasing deficit which will cause serious difficulties down the road. Extending the Bush tax cuts for another two years or so would probably be the right move today.

    I don’t know what distinction you are trying to draw when you say the wealth-redistribution-based portion of the economy. Increasing spending now could well make people more willing to spend money, which is what is needed to start getting more jobs. The Republican refusal to do it will almost certainly extend the recession. I could see that as a reasonable position if they thought that the deficit took absolute priority—but if they thought that then they would certainly be willing to raise taxes by letting the Bush tax cuts expire, at least for the wealthy. Their current position is, as far as I can tell, completely inconsistent. The Democratic position, of letting the tax cuts expire for people who make more than $250,000, is also inconsistent with their stated goals of stimulus spending, but not as much since the evidence is that the wealthy people are saving their extra income rather than spending it.

  3. fche said,

    November 5, 2010 @ 8:19 pm

    “I don’t know what distinction you are trying to draw when you say the wealth-redistribution-based portion of the economy.”

    Sorry, it was just a flippant way of making the basic observation that when government spends, only those directly benefit who are its recipients. By nature and definition, that money must have been taken from someone else, for whom it is an anti-benefit — whether the money arrived in the form of taxes, new debt, or inflation.

  4. Ian Lance Taylor said,

    November 5, 2010 @ 8:25 pm

    Ah, yes, that is certainly correct. However, when the government is running a large deficit, as it is today, the government is taking money from people in the future to give to people today (the future people will pay in the form of interest on the bonds sold today). The theory is that this will cause the economy to grow, which will make the effective future cost lower, because it will be a smaller percentage of the overall economy. It has worked in the past, for some countries in some cases.

  5. fche said,

    November 6, 2010 @ 2:37 pm

    “It has worked in the past, for some countries in some cases.”

    It’s quite a bet though, isn’t it? If it’s wrong, the next generation will be both no better off in terms of economic activity *and* will have to pay off the debt due to our excesses.

    By the way, how would you judge this tactic “working”? To me, an intuitive method would be to show that such deficits are temporary, and the debts are quickly repaid. Yet, of all the last generation or two, only a few years in the 90s had a federal budget “in the black”, and of course you know how ridiculous the last bunch of years have been.

    I wonder what you’d accept as evidence for this tactic working – or not working. And if you don’t know, how would you justify arguing that the bet should be made ever larger?

  6. Ian Lance Taylor said,

    November 6, 2010 @ 9:37 pm

    It’s a bet either way. If you choose to not stimulate the economy, then the economy grows more slowly, and you run the risk that a steadily increasing number of people can’t find jobs and you sink into an unbreakable recession. That’s more or less what happened in Japan during the ’90s, and they are still having trouble growing the economy to meet the needs of their population. Keeping the deficit down now can cost trillions in the future in growth that didn’t happen. It would be nice if there were a sure prescription for what to do, but there really isn’t.

  7. fche said,

    November 7, 2010 @ 3:21 am

    “Keeping the deficit down now can cost trillions in the future in growth that didn’t happen.”

    I see why someone might think that. But at some point, can we find some sort of empirical test to confirm the value of this gambit? Because if not – if it is done just on faith that Keynes was righter than the others – the bet becomes essentially infinite, and the risks manifestly outweigh hypothetical benefits.

  8. fche said,

    November 7, 2010 @ 3:33 am

    And regarding Japan, their budgets have been in the red for all recent times, except a few years around 1990, so are you sure that’s a valid counterexample?

  9. Ian Lance Taylor said,

    November 9, 2010 @ 6:15 am

    I don’t know of a test other than the great Depression, which finally ended when the government started running large deficits. Also, it’s worth noting that many countries have run huge deficits without long-term problems.

    Japan failed to stop their depression when it started, and that it made it very hard for them to shake later. They certainly had other issues, too, such as a failure to force their banks to acknowledge the bad loans carried on their books.

  10. fche said,

    November 9, 2010 @ 6:26 am

    “I don’t know of a test other than the great Depression, which finally ended when the government started running large deficits.”

    That sounds a little like Krugman’s endorsal of world war II as an economic assistance measure. If that’s the best evidence *for* deficit-laden fiscal policy, I suspect people would pass.

    “many countries have run huge deficits without long-term problems”

    But it’s a cumulative problem! At some point, the even the mere interest becomes unsustainable, leading countries to default and/or inflate. Surely neither of those is a good plan.

  11. Ian Lance Taylor said,

    November 9, 2010 @ 9:22 pm

    I believe that World War II worked not because it was a war, but because everybody was completely convinced that the government was going to continue to run deficits for years to come. That encouraged everybody to invest.

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