Saturday, December 5, 2009

Hoisted from the Comments: Commenter Gabe

Commenter Gabe disagrees w/ my take on Bernanke:
The Fed has substantially expanded its balance sheet until 12/08 though. What you're saying is that the increase from a balance sheet of ~900 billion in March 08 to over 2000 billion in 12/08 and its stayed over 2000 billion since then. If something was going to cause inflation, that should have done it. I agree that Bernanke shouldn't have tapped the brakes, but its hardly being an inflation hawk.

In a liquidity trap, even QE won't matter. If the Fed buys assets and gives banks reserves, then they need to lend out those reserves to affect monetary aggregates and the price level. If the bank just puts those reserves back at the Fed, then this becomes excess reserves and has no effect on the money supply, and no effect on prices. QE might be worth it to monetize government debt, but if the intent is to increase money supply or lending, then it won't have an effect in a liquidity trap.

Also, if you want to get rid of Bernanke, who should he be replaced by? (I stick by De Long)

Also, how many reserves would be enough? The following chart should show that the Fed has been trying:

Sharp comments. I have a few quibbles, however. The Fed's Balance sheet did go below 2 trillion -- from about 2.35 trillion on the 12/31/2009 to about 1.8 trillion in March. That's a fairly substantial "tap on the brakes" given that the "normal" pre-crisis balance sheet contained about $800 billion in assets. It was also clearly, in my opinion, a mistake. Since March, the Fed has started its normal QE program and poured more money into MBS and agency debt, growing its total assets slowly, but has not gotten back up to its previous high. Back in February of this year, I (and many other economists) were still under the mistaken impression that the Fed was still pumping money into the system like mad -- turns out they were pumping money out of the system. It did not occur to the Fed to start QE on long-term bonds until March. That would certainly have been something I would have tried the previous fall, back in the throes of the financial crisis.

Secondly, I think the nearly $1.5 trillion Bernanke pumped into the economy did stave off the financial crisis. Until 12/31/2009, one might be able to argue that, as far as the Fed's balance sheet is concerned, Bernanke did everything right. (In actuality, I think he should have been more expansionary much earlier in 2008, once it became clear that the markets were spooked.) And perhaps his actions merely staved off deflation rather than actually ignite much inflation? Of course, it is impossible to know the counter-factual, but I can see several plausible channels by which dumping large amounts of cash into a variety of assets helps out the economy: 1) When the Fed dumps $850 billion into MBS, this does help out banks' balance sheets and profits, making them more likely to lend (and less likely to fail), 2) Lowering the yields on a variety of long-term bonds also reduces borrowing costs for the economy as a whole, although perhaps the effects are not as strong as when the Fed Funds rate gets lowered, 3) More money created, even if it just sits in banks' coffers, still should lower the value of the dollar, helping net exports (IS curve shifts right), and, as Gabe concedes, 4) there is the added benefit that QE helps the government's long-term fiscal situation, plus 5) all that extra money swishing around means higher asset prices generally, which might have a small feedback into consumer confidence.

And I'll go ahead and concede that most of these channels will not be very strong unless we start talking hundreds of billions of dollars. But we are talking in hundreds of billions... (And this is why the graph linked is misleading, since, historically, a $50 billion increase in the Monetary base is a big move -- but now it isn't.) Instead of doing $300 billion on Treasury QE over six months, they might have done $300 billion in October to December of last year, another $600 billion from Jan. to March, and, then, had we gotten labor market results similar to what we actually did get, then another $1.2 trillion from April to June, and then, had the economy continued to bleed jobs in that period (as it did), then add another $2.4 trillion through September. Had the Fed followed this strategy, I suspect we'd have turned a corner on the jobs front months ago, I suspect inflation would start to creep up, and I suspect we'd be expecting 7% unemployment sometime in 2010 rather than sometime in 2012. And, yes, I realize that Monetary Policy operates with lags -- if the Fed had expanded it's balance sheet to $4 trillion by now, and if we had enjoyed our 2nd or 3rd consecutive month of 100,000+ job growth, with inflation ticking upward, then the Fed would need to reverse course, and need to move quickly to reverse large chunks of that $4 trillion very quickly. But we are at least three months away from having that, so the Fed's balance sheet should still be expanding.

I'll concede, of course, that fiscal stimulus is a better option. There should have been more money for states, and that money should have been dispersed sooner. I'll also concede that the latest unemployment numbers make more action on QE less urgent than before, but more is still clearly needed.

As to the question of "who to replace Bernanke" -- how about Jon Corzine? One critique of academic macro people like Bernanke is that he (and they) probably know nobody personally who has lost his/her job or really been directly impacted by the increase in unemployment. It's just a statistic to them. Corzine actually did loose his job solely b/c of the crisis! On another level, I do not think it matters. Clearly the experiment with picking an academic macroeconomist did not go so well. I do not have confidence in Ben Bernanke, and I think there are a large number of people who can do better. The most important qualification are that whoever does get the job had better know how to handle the yahoos on the FOMC, like Plosser, who is truly an embarrassment. It would also be nice to have a Fed Chairman who does not see fit to reminding the Congress it has the power to repeal Social Security and Medicare.


  1. I agree with much of this. However, I still don't see the mechanism for increased reserves to translate to broader monetary aggregates or nominal GDP. I'm still a big believer in a Keynesian liquidity trap.

    I definitely agree about monetizing debt while you can. We'll see what happens when the economy recovers- talk about an exit strategy by the Fed is exactly *not* what the doctor ordered. Plosser should be ousted immediately. Maybe Yellen is more of an inflation dove, she seems like she would be. Bernanke's replacement?

  2. All I'm sayin' is that if you monetize *enough* debt, you'll at least get lower borrowing costs -- long-term bond yields aren't zero. And it would also put downward pressure on the dollar. Both are good. And, yes, we're talking hundreds of billions to have any impact -- Gagnon suggests $2 trillion.

    Jon Corzine for Fed Chair! And Gagnon to replace Plosser ASAP...


  3. As Scott Sumner is fond of pointing out, the Fed is also paying interest on those reserves: a contractionary policy in intent.

  4. Thor-Would you really get lower borrowing costs? How much did long term bond yields fall in Japan? From what I've read, not very much at all.

    If long-term bonds are the average of future short term bonds plus a term premium, would the term premium fall over time?

    For example, assume 3-month government debt is 0% and everyone assumes it will stay at 0% forever. Even in this case, long-term bond rates will be positive because of the term premium. I don't see any reason why QE would change the term premium. Now maybe the long-bond rate is still larger than the term premium because of expectations of future rate hikes, but still I am skeptical.

    Look up "Operation Twist" which happened in the Kennedy administration. Generally, the effect of Fed actions on long bonds was minimal in this case. Generally, the Fed is not seen as being able to affect long-term rates much.

    And why would more QE weaken the dollar? If the QE just ends up as excess reserves, i.e. as digits in the Fed's computer records, then this wouldn't affect the dollar. Usually the transmission mechanism for money to afffect exchange rates is through prices which then affect exchange rates through PPP holding. (Us price level up versus another price level->arbitrage->more dollars to buy the same foreign currency=dollar weakness). I think the dollar movement we're seeing is just people shifting in and out of US assets due to varying risk-aversion/fear.

    The literature on QE in Japan isn't very supportive of QE working. I assume you think that's becauase it was too small, but I'm still unconvinced. In the US case, I don't see why 1 trillion would have little effect and 2 trillion would have a large effect, but it's possible.

    vimothy- yes the Fed is paying interest on reserves, but the US in Great Depression and Japan recently have had excess reserves as well. The Fed paying interest on reserves is a *huge* mistake, but it's not a necessary condition to see excess reserves. I support a Sumnerian tax on reserves, but it would probably just mean more bond purchases or more vault cash.

    (Question: would a tax on reserves mean that 3-month t-bill rates could go negative? i.e. if you must pay 1/4 percent on reserves, 3-month bill rates would go to something like negative 1/8 percent? That would be weird. But if banks feel safer having money at the Fed than keeping it in their vaults, then I think it's possible)

  5. I meant Yellen as Fed replacement, just to be clear. I think she is on the left and more of an inflation dove than Bernanke. Corzine wouldn't be bad, though I don't know about anybody from Goldman Sachs....

    Anybody can replace Plosser. He reminds me of central bank presidents circa 1930.

    Gagnon seems like he's definitely got his head on straight, so actually, yeah, he can be Fed Chief.

  6. Gagnon estimated that $2 trillion would lower long-term yields by .75... I dunno if that's true, but $2 trillion isn't chickenfeed.

    Re: Japan. I haven't seen the literature on QE in Japan, but yes, the key is that they never really tried it. They just monetized $300 billion of an $8 trillion deficit, so could have done much more. They definitely succeeded in lowering some of their long-term rates, if memory serves, then yen did weaken, and they did restore inflation. Impossible to say if any of that was causal. And after things started to get better, the Japanese foolishly dumped their debt back on the market -- after which they had more deflation and another recession.

    Also, last week when the Bank of Japan announced very, very modest QE numbers, the yen fell. That's a fact. And that's a change in prices which has real effects -- it will boost Japan's net exports and make its exporters more profitable. Had they announced a QE package of $1 trillion instead of $100 billion, the yen would have tanked...