Interview with Joe Gagnon on Quantitative Easing, its Criticisms and the Argument for QE3.

In the wake of recent bad employment numbers, people are looking for options to boost the economy. Some have proposed another round of quantitative easing to get us back to the normal rate of growth. I interviewed Joe Gagnon, Senior Fellow at the Peterson Institute for International Economics, about this program. He recently spoke at the Future of the Federal Reserve conference, co-hosted by the Roosevelt Institute and New America Foundation, about what we need to do now to get the economy re-started. He outlines some basics about monetary policy, discusses whether the first rounds of QE worked, and address criticisms of the program and whether a third round of QE will help.

I: How Monetary Policy Works

Mike Konczal: What is a recession, and what does the Federal Reserve normally do in reaction to one?

Joe Gagnon:  A recession is when there isn’t enough spending in the economy to keep everyone fully employed. People are thrown out of work and inflation starts to trend downward. What the Federal Reserve does, what monetary policy does, is to lower interest rates to make it easier for people to borrow and less attractive for people to save, which encourages businesses to borrow and invest. That spending gets people working again.

Why does a lower interest rate help us recover from a recession?

If the interest rate, which is the cost of borrowing, is lower, then it is cheaper to borrow. That makes it easier for businesses to borrow. They are then more willing to borrow to build factories, hire workers and build stuff. It also means households are more willing to borrow to buy a house. It’s all about making it more attractive for people to borrow and spend. And conversely, it makes it less attractive for people to save, because they are earning less on their savings. So they are more likely to spend it.

If that’s the case, why doesn’t the Federal Reserve lower the short-term rate?

The short-term interest rate the Fed controls is essentially at zero now. It cannot make the interest rate negative because if you were a saver looking to put money in the bank, and the bank was offering you a negative interest rate, you would say, “No thanks, I’ll hold cash instead,” and stuff your mattress with dollar bills. Dollar bills earn a zero rate of return, and you’d be better off holding that.

Since the Federal Reserve is buying other assets, does QE have the same kind of effect regarding interest rates?

Yes it does. The way to think of monetary policy is that it tilts the playing field between savers and spenders. Normally it just works on short-term interest rates, which encourages corporations to invest more and savers to save less. Quantitative easing impacts longer-term interest rates, but this also has the same effect on savers and spenders. It makes it easier to borrow and less attractive to save.

So did QE2 work? And if so, how can you tell?

It did work. I think QE2 had two elements. One element was of moderate importance, one element was of minor importance. The moderate one is that QE2 convinced markets that the Federal Reserve would not allow deflation or a double dip recession to happen. This is good because it inspired confidence and kept inflation expectations from falling any further. That was the most important step, because it convinced financial markets that the United States wouldn’t turn into Japan, which they were worried about. The element of minor importance was that it lowered long-term bond rates a little bit. It takes a lot of purchases to move these interest rates even a little bit, and QE2 wasn’t big enough to move them dramatically. It’s not nothing, but it is small in the scheme of things.

Why is deflation bad, and what would it mean to be the next Japan?

The interest rate that matters for households and businesses is the real interest rate, which is the nominal interest rate minus the inflation rate. Why is that? Because when prices of everything are going up, when you pay back a loan at a certain interest rate some of that is just eaten up by inflation. The lender doesn’t get in real terms — in terms of goods and services — as much back as he lent because of this inflation. Higher inflation lowers the real rate of interest. Deflation raises the real rate of interest. If deflation gets big enough, when you hit the zero bound, you have a positive rate of interest and get into deflationary spiral, where the real rate of interest is choking the economy and choking the economy makes the deflation worse, which is a vicious cycle.

Japan has been in a mild version of that. It hasn’t accelerated, but it hasn’t gotten out of it either.

So how do you know that QE has worked? What kind of studies are conducted, and how do they draw their conclusions?

I have a paper that looked at two things. When the Fed made announcements on QE1, what happened to bond yields? Yields on the things the Fed was buying went way down, but yields on things the Fed wasn’t buying also went down. All yields went down. So that was one piece of evidence. As for the other piece of evidence, we looked back thirty years and ran a regression of how the government’s net supply of long-term bonds affects bond yields. We found when the government issues more long-term bonds, bond yields increase. When the government buys back long-term bonds, bond yields go down. QE, really, is like the Treasury buying back long-term bonds and issuing short-term bonds. There’s a long history of this, including in non-crisis times. So for both pieces of evidence, when the government buys long-term bonds and issues short-term bills, it can push down the yield curve.

So QE2 helped with the job growth of the past year?

It definitely contributed by relieving businesses’ fears of a double-dip recession and deflation. This helped with some growth in the economy. But really, not enough. The Fed has not been aggressive enough, it has been too timid.

II: Addressing Criticisms of Quantitative Easing

I want to talk about some criticisms of QE that have come up. There’s an argument that QE generally can provide a floor on how bad the economy will go, but can’t, by itself, get us back to full employment and trend growth. What do you make of that argument?

There’s no reason to think that there’s any limit to the effectiveness of quantitative easing or monetary policy. There’s no theoretical or practical reasons to think that monetary policy will stop working. They’ve just been too timid.

What about the argument that QE has caused massive inflation?

Look at measures of underlying inflation. Wage inflation is the most important thing. Think about slow-moving prices that are inside the US economy.

Wage inflation is not spiraling.

Right. Commodities have spiked, but oil has come back. If monetary policy was to respond to commodities, you’d have really unstable policy. You don’t want to ignore any price, but you want to smooth through the noisy ones. Wages are an important one. Monetary policy works through the labor market. If inflation is too high, we throw people out of work to cool the economy and keep wages low. And if inflation is too low, you want to hire more people to get the economy going faster. If you look at wages there’s no worry about any future inflation.

There are two other criticisms of QE2 that go in different directions. One is that the new capital has just sat on banks’ balance sheets and not impacted the recovery. The other is that, with rates being so low, QE just helps create asset bubbles. How would you address these?

They are both different. The first is rather easy. We know that the banks aren’t lending the money out. There’s little the Fed can do about that. So QE2 wasn’t aimed at the banks. It would be good if the banks lent that money out, because we wouldn’t then have to do so much QE. But the banks aren’t. Given that they aren’t, we need QE3 to push down other prices to work through the bond market or the foreign exchange markets.

Can you talk a bit more about these alternative channels?

The basic channel is the bond market. The Fed is buying up long-term bonds and that pushes interest rates down on those bonds. That’s what makes it attractive for people to borrow. The market then does some arbitrage. The equity market looks at the bond market and says “oh, well, long-term bond rates are low, so we are going to discount future dividends and profits differently.” This makes the value of stocks more attractive and raises their values. And this encourages businesses to invest. Also, international investors look at rates of return in other countries, and they say “these other countries have higher rates of return than in the U.S.,” so that pushes the dollar down. These aren’t direct channels of monetary policy, but they are linked.

Some might interpret that as saying QE deliberately creates a stock bubble, which makes them nervous.

Well, there’s two important things to keep in mind. First of all, the harm of a bubble arises almost entirely if it’s leveraged. We have to make sure, through financial regulations, that people are not borrowing to buy stocks. And they aren’t as far as we know. The tech bubble wasn’t leveraged, and when it burst it had little effect. The housing bubble was leveraged, and it had a major effect. If we have an equity bubble, and equities don’t seem to be priced unusually high, but even if we did, we’d want to make sure it wouldn’t cause harm when it unwinds.

The second is that it’s not clear that it is even a bubble if monetary policy is working through interest rates, as monetary policy always does. You need equities to be priced highly when there’s a recovery, you want to encourage people to invest. Moreover, by creating a healthier economy, monetary policy can increase the fundamental value of equities, which by definition is not a bubble.

Some like Raghuram Rajan and Thomas Hoenig have taken the concern about bubbles further and  argued that rates being “unnaturally low,” specifically short-term rates at zero for too long, creates conditions for moral hazard and distorts asset prices. How do you respond to this?

The cause of unusually low interest rates right now is two things: first, households and small businesses are repairing their balance sheets and do not want to borrow more; and second, developing economies — led by China — are funneling massive amounts of government money into the US and European economies. The correct response of monetary policy is to push interest rates as low as possible. Rajan and Hoenig are confusing cause and effect.

Recently, Rajan has argued the morality of monetary policy, saying that QE2 hurts “the patient and uncomplaining saver.” What do you say to the argument that QE (and monetary policy generally) is being too unfair to savers?

This is always an effect of monetary policy, which benefits borrowers when the economy is weak and savers when the economy is strong. Savers do not have any right to a specific rate of return and they are free to spend the money or invest in physical capital or equities if they want a higher rate of return. In any event, the distributional effects of monetary policy are much smaller than those of fiscal policy, which transfers from future generations to today’s generations.

One last argument against QE. The economist Richard Koo looks at the US recession and, comparing it to Japan and the Great Depression, says we suffer from a debt overhangthat  has devastated the balance sheets of households and firms.

I totally agree with him.

His critique then follows that QE, and monetary policy more generally, encourages people to take on more debt, but since everyone has too much debt, QE can’t help. Interest rates are at record lows, yet consumers are de-leveraging, implying that consumers want to shed debt regardless of how cheap it is. How would you address this?

People don’t want to borrow as much as they normally would. But QE helps by allowing people to repair their balance sheets. Households can refinance their debts into lower rates. Corporations are issuing long-term bonds at record-low rates. They are paying off older, higher-yield debts. This repairs their balance-sheets and increases their value. For households, if you can get a lower rate that reduces your payments. That’s a huge improvement to you.

Once you repair your balance sheet, you are prepared to spend sooner. So even if QE doesn’t immediately raise borrowing as much as it would in normal times, it is making it easier for you to repair your balance sheet and get the economy to a place where you’ll spend faster. It’s absolutely all the more essential because of the balance sheet nature of the recession. You want to raise asset prices to make people feel better off. You want to lower interest rates so people can refinance and repair their balance sheets. QE is the best way we have of addressing Richard Koo’s concerns.

III: The Potential for QE3

What should QE3 look like?

A lot of the benefit of telling the markets that you aren’t going to allow deflation is already out there. You could re-enforce that, but the major effect is out there already. They would need to do a bigger number. There’s no point in doing it unless it’s at least $1 trillion dollars.

The floor is set. The market is reassured against fears of deflation. Can QE3 return to trend and full employment?

While QE2 had good effects, it was too timid. A QE3 needs to be bigger than QE2 — you want to signal a larger amount. A trillion dollars sounds like a big number, but it isn’t like a trillion dollar tax cut. All it is is a swap of two different assets. Buying one kind, selling another.

Are the effects of QE3 amplified by a short-term stimulus in the form of infrastructure spending and employee tax cuts?

Absolutely. The end of the payroll tax cut, the winding down of the stimulus spending, and the termination of extended unemployment benefits are conspiring to create a large fiscal drag on the economy in 2012. I would recommend extending or even enlarging the payroll tax cut for 2012 and renewing extended unemployment benefits for at least 12 months. QE3 can help to ensure these actions have the best possible effect.

As for infrastructure spending, I think it needs to be analyzed in two categories. First, anything that can really be built (and not just planned) in 2012 could be viewed as near-term stimulus in place of (or in addition to) a payroll tax cut. Second, longer-term infrastructure projects (many of which I support) need to be based on long-term needs and in the context of a long-term fiscal plan to stabilize our national debt, not the near-term state of the recovery. The dividing line between the near term and the long term is probably 2013, with spending in 2013 still contributing usefully to near-term recovery.

Let’s say this all goes sideways. What kinds of risks is the Federal Reserve taking on by doing more QE?

We are not taking on a lot of risks. People see large numbers and they get scared. The only risk here is a small risk on future profits of the Federal Reserve. Because of QE1 and 2, they are making record profits. They are making these profits by buying bonds that yield 3 or 4% and funding them with near 0% money. They hand it back to the Treasury every year. Down the road, if this works, and the economy starts growing, then the Fed will have to ease off the accelerator and start raising interest rates. Then, in the new world that we are in, the Fed is going to have to fund these QE assets at the new higher interest rate. If short-term rates go high enough, the Fed could make a loss, but it would only be after years of excess profits. That’s the biggest risk, and it isn’t that big.

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34 Responses to Interview with Joe Gagnon on Quantitative Easing, its Criticisms and the Argument for QE3.

  1. David Beckworth says:

    Thanks Mike for doing this. It is a welcome reprieve from the all the QE2 out there now.

  2. JW Mason says:

    Savers do not have any right to a specific rate of return

    He doesn’t think so. You don’t think so. I don’t think so. But they sure seem to think so.

    The most stable, and the least easily shifted, element in our contemporary economy has been hitherto, and may prove to be in future, the minimum rate of interest acceptable to the generality of wealth-owners. If a tolerable level of employment requires a rate of interest much below the average rates which ruled in the nineteenth century, it is most doubtful whether it can be achieved merely by manipulating the quantity of money.”

  3. Dan Kervick says:

    So how do you know that QE has worked? What kind of studies are conducted, and how do they draw their conclusions?
    ….
    … Yields on the things the Fed was buying went way down, but yields on things the Fed wasn’t buying also went down. All yields went down. So that was one piece of evidence.

    Gagnon seems to be confusing techniques with ultimate ends here, and is apparently using a deflated definition of “worked”. The question isn’t whether QE and QE2 succeeded in lowering interest rates and yields. The question is whether doing those latter things had any significant impact on economic activity, employment and incomes. And so far, we are looking at something close to a big fat zero. The economy is still crap. Of course, the monetarists will never be convinced that their snake oil doesn’t work. They will just say we should apply more snake oil.

    • Joe Gagnon says:

      When driving on the highway you encounter a steep hill. You press down on the accelerator but the car still slows down. Do you 1) conclude that the accelerator and brake have switched positions, or 2) conclude that you should press harder on the accelerator?

      • Dan Kervick says:

        Relying on that analogy, Joe, requires the dogmatic theorist’s faith-based certitude that the connection between interest rates and economic activity in a deep balance sheet recession is as close as the connection between the accelerator pedal and engine RPM’s in a factory made car. What if it’s not? You were asked for evidence that QE and QE2 had worked to increase economic activity. But all the evidence you cited showed is that it probably lowered interest rates.

        Maybe most business people don’t care how cheap the capital is if there is no money to be made by expanding output, and maybe they are of the opinion that in the 2011 world of drowning consumers and a collapsing American dream, the only thing worth doing with extra money is to sit on it, or invest it in extremely safe assets – or puffed up assets that will give them some fast bubble-induced returns?

        If you want a car analogy, here’s mine:

        You crash your car into a telephone poll. You then try to start it and it doesn’t move. So you put a quart of oil in it, and it still doesn’t move. So you put another quart of oil in it, and it still doesn’t move. Now I suppose one kind of mind thinks, “I know from my reading that lubricants make engines move, so if my car isn’t moving, it probably just needs more lubricant. On to Quart-of-oil 3 and Quart-of-oil 4, etc. It’s bound to work eventually.”

        But maybe the problem with your car isn’t a lack of lubricant. Maybe it’s more profoundly broken. Similarly, maybe the problem with our economy isn’t a lack of monetary lubricant.

      • backwardsevolution says:

        “The smart way to keep people passive and obedient is to strictly limit the spectrum of acceptable opinion, but allow very lively debate within that spectrum – even encourage the more critical and dissident views. That gives people the sense that there’s free thinking going on, while all the time the presuppositions of the system are being reinforced by the limits put on the range of the debate.”
        - Noam Chomsky

        What we SHOULD be discussing is how to end the Federal Reserve (a privately-owned consortium of moneyed interests) whose sole purpose is to extract interest for the elite.

        That’s where the discussion needs to be.

  4. Laurence says:

    I don’t have a strong prior, but I think this needs closer interrogation:
    “In any event, the distributional effects of monetary policy are much smaller than those of fiscal policy, which transfers from future generations to today’s generations.”
    There are across time, and within time across persons distributional effects to both, and I would love to see a detailed scorecard, especially considering the biggest problem, employment.

  5. Hmmm …. hard to know where to start. Is this Kudlow?

    I’ll give Bernanke a break due to QE being harmless as well as useless. Central banks have lost the ability to make monetary policy. It’s Saudi Arabia’s oil minister and hundreds of millions filling their tanks every day who fix the price of money, now.

    I’ll even give Bernanke credit for the MONEY FLOW TO CHINA AND BRAZIL b/c of ZIRP and massive moral hazard + a boiling dollar carry trade, also keeping the Treasury mkt afloat.

    If the fuel price becomes high enough there will be a massively deflationary deleveraging event and Bernanke won’t be able to do anything but wring his hands. One reason why QE 2 has faded is because it had stopped doing anything: diminishing returns. That’s why no QE 3, It will make things worse. We are not Japan w/ positive trade balance (that it had).

    Mebbe the Fed can burn a witch, but there is nothing he can do to influence an energy crisis. High fuel costs have hamstrung the world economy, until Bernanke can print crude oil, the game has changed under him.

    Out with the growth and in with the shrinkth. Giving handouts to bankers and other speculators probably keeps them off the streets, robbing folks @ gunpoint and selling dope but accomplishes nothing else. I wish I had some better news but we’ve been too efficient as wasting what we needed to hang onto like Precious.

    Now it’s too late, Hope yr parachute works, cause the landing is a bitch.

  6. Thorstein says:

    Wow, what an interview. Mr. Gagnon exudes an impressive amount of confidence in his understanding of recent monetary history. Count me among those who side with the versions proffered by Raghuram Rajan, Richard Koo, Tom Hoenig, Larry Kotlikoff, Steve Keen, and James Grant.

  7. backwardsevolution says:

    Bruce Krasting’s article entitled, “QE: A Failed Policy”, shows that QE I and II have been dismal failures.

    http://brucekrasting.blogspot.com/2011/06/qe-failed-policy.html

  8. backwardsevolution says:

    Charles Hugh Smith’s article, “The Baseball Economy: The Fed Strikes Out”, again shows that speculators and banks have done well under the Fed, but it has done nothing for the average guy.

    http://www.oftwominds.com/blogmay11/baseball-economy5-11.html

  9. Brahe500 says:

    His major transmission mechanism seems to be that higher equity values will lead to higher investment. Could someone try expanding on this? Companies are cash rich. They are not funding real investments by raising capital on equity markets so higher equity prices may be desirable for shareholders but has very limited impact on real investment.

    • Pig says:

      What can companies do with cash? The options are:

      1. Invest
      2. Pay dividends
      3. Repay loans
      4. Buy back shares
      5. Keep the cash

      If the world has changed in that:

      - cash pays less interest,
      - loans are cheaper, and
      - shares are more expensive

      then companies are more likely to go for options 1 and 2. If they go for option 1, this gives you investment immediately. If they go for option 2, this puts the cash in the hands of others, who face the same set of constraints. This means they are more likely to consume or invest – both of which boost the economy.

      Finally, don’t ignore new capital raising so easily. You may have noticed some high profile new issues come to market recently. That would not have happened if the market had been in the pits.

  10. Ted K says:

    Joe Gagnon: “There’s no reason to think that there’s any limit to the effectiveness of quantitative easing or monetary policy. There’s no theoretical or practical reasons to think that monetary policy will stop working. They’ve just been too timid.”
    Joe Gagnon 2 seconds later: “We know that the banks aren’t lending the money out. There’s little the Fed can do about that. So QE2 wasn’t aimed at the banks. It would be good if the banks lent that money out, because we wouldn’t then have to do so much QE. But the banks aren’t.”

    Uuuuh, excuse me Mr. Gagnon, but the two statements are contradictory. I like how you can say that a policy wasn’t aimed at something, so that means the policy gets a free pass. I’m sure the drunk who bashed his wife’s head in was aiming for his mother-in-law’s picture on the wall, so really it’s not his mistake, eh??? Let’s let him take three swings, I’m sure he’ll get the picture next try. The fact is HUGE amounts of the QE1 and QE2 have gone directly to TBTF bank reserves and stayed there, and we have zero reason to believe QE3 will be any different in that aspect.

    Mike, it’s called “follow-up question”.

    • tlesinski says:

      The Fed currently pays interest on excess reserves to banks, which acts as an incentive to, well, keep reserves instead of lending out. Doesn’t this sterilize QE ? Shouldn’t we be talking about that more ?

      • JW Mason says:

        It’s a fair point. The current level of interest on reserves is too low to make much difference, but to the extent it does, it’s hurting rather than helping. We should be talking instead about taxing reserves — it’s the equivalent of a negative Fed Funds rate.

        It is important to realize, however, that the banks cannot change the aggregate volume of reserves. Eliminating interest, or taxing reserves, would increase lending at the margin (tho I agree with those who think that even unconventional monetary policy probably can’t accomplish much and we need more policies that directly raise final demand.) But these measures *cannot* reduce the total volume of reserves. Reserves and currency are the Fed’s only meaningful liabilities. Currency in circulation doesn’t change much, so as an accounting matter, changes in the Fed’s asset position have to show up as changes in the volume of reserves. Until 2007, the only assets on the Fed’s balance sheet were Treasuries. But over the course of the crisis, the Fed acquired over $1 trillion in private and GSE securities; this corresponds to the roughly $1 trillion excess reserves now held by banks. The excess reserves will go away only when those assets leave the Fed’s balance sheet. (Well, strictly speaking, if the Fed sold its entire holdings of Treasuries, that would be just about enough to mop up the excess reserves. But the Fed needs to hold a substantial stock of federal debt for its routine operations.) So while it is true that paying interest on reserves is counterproductive, it is not true, as people sometimes claim, that the existence of excess reserves is informative about whether monetary policy is working.

  11. Ted K says:

    Also I want to add:
    We are now paying for foreign bankers’ losses now. Does Joe Gagnon support QE for foreign banks???See here:
    http://www.zerohedge.com/article/exclusive-feds-600-billion-stealth-bailout-foreign-banks-continues-expense-domestic-economy-
    here
    http://www.bloomberg.com/news/2011-03-31/belgium-s-dexia-drew-most-from-discount-window-during-record-week-in-2008.html
    and here
    http://www.bloomberg.com/news/2011-03-31/libya-owned-arab-banking-corp-drew-at-least-5-billion-from-fed-in-crisis.html
    Interesting to note, when Jamie Dimon got to ask Bernanke his one question, he never asked about all that Fed money that goes to “recapitalize” (recapitalize= welfare checks for banks) foreign banks. I guess Jamie Dimon’s cool with large FOREIGN banks getting free money from the Fed. But lowering debit card fees to citizens of his OWN COUNTRY really pisses Jamie Dimon off to no end.

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  13. James Hudson says:

    Joe Gagnon says: “What the Federal Reserve does [in response to a recession], what monetary policy does, is to lower interest rates to make it easier for people to borrow and less attractive for people to save, which encourages businesses to borrow and invest.” So it encourages borrowers. But from whom do they borrow, given that saving is being discouraged? There is less saving–a lesser quantity of funds available for borrowing–unless the Fed also engages in money creation. But then *that* (money creation) must be the important action of the Fed, creating extra funds that might be borrowed, *regardless of interest rates*.

    He adds: “[A lower interest rate] makes it less attractive for people to save, because they are earning less on their savings. So they are more likely to spend it.” But, again, less saving means less, not more, investment.

    In short, it is fallacious to argue that a lower interest rate will lead to greater investment. It is *a larger money supply* that leads to greater investment; and, of course, it also leads to greater spending on consumption.

    He continues: “Quantitative easing impacts longer-term interest rates [by driving them down].” This ignores the Fisher Effect: loose monetary policy tends to increase inflation, and expected inflation is priced into the bond market, raising rates. QE2 seems actually to have *raised* interest rates, both short- and long-term.

    “We know that the banks aren’t lending the money out. There’s little the Fed can do about that.” This is an incredible statement. The Fed is paying interest on reserves! Banks are being encouraged to hold excess reserves, rather than making loans.

    • JW Mason says:

      Again, the volume of excess reserves tells us nothing about whether the Fed is succeeding in encouraging lending. Yes, when a bank holding excess reserves decides to make a loan, it replaces those reserves with a different assets on its balance sheet — but as a matter of accounting, the reserves just show up on another bank’s balance sheet. Total bank reserves plus currency in circulation always equals the total assets on the Fed’s balance sheet, and there is nothing that banks can do to change that.

      The rest of James Hudson’s comment is such a mass of confusion and faulty logic I can’t be bothered to untangle it all. But the claim that low interest rates -> less saving -> less investment, is equivalent to saying that if Saudi Arabia pumps more oil, falling oil prices will cause other producers to cut back, which will cause oil prices to rise. It’s the same argument and it’s just silly in both cases.

      • dilletaunted says:

        “Again, the volume of excess reserves tells us nothing about whether the Fed is succeeding in encouraging lending. Yes, when a bank holding excess reserves decides to make a loan, it replaces those reserves with a different assets on its balance sheet — but as a matter of accounting, the reserves just show up on another bank’s balance sheet. Total bank reserves plus currency in circulation always equals the total assets on the Fed’s balance sheet, and there is nothing that banks can do to change that.”

        banks don’t replace the excess reserves with other assets, they just convert the excess reserves to required reserves. the reserves don’t go anywhere (unless you’re talking about banks lending to other
        banks, which you may be, but this should be mostly beside the point)

  14. dilletaunted says:

    “It is important to realize, however, that the banks cannot change the aggregate volume of reserves. Eliminating interest, or taxing reserves, would increase lending at the margin (tho I agree with those who think that even unconventional monetary policy probably can’t accomplish much and we need more policies that directly raise final demand.)”

    @ JW Mason:

    the banks don’t lend the reserves out, so reducing IOR won’t cause them to use them for lending purposes. there isn’t an option between lending the reserves or keeping them to get the interest, it’s a nonexistent margin. what would happen if IOR was eliminated is that you would see some portfolio rebalancing as banks tried to make up for the lost returns, which maybe stimulative (if speculation can ever be stimulative). a tax on required reserves is nonsensical, just a drain on the banking sector’s liquidity

    the situation is similar in the excess reserves tax as to IOR, as the banks may then try to convert excess reserves to required reserves via making loans. the policy would then be to penalize banks for not making negative NPV loans.

    maybe a regime where there is a positive interest on required reserves and zero on excess reserves? i haven’t thought through that one. all this, though, is ignoring the reason why the private sector isn’t hiring, isn’t investing: a lack of demand.

    a helpful link perhaps:

    http://neweconomicperspectives.blogspot.com/2009/07/why-negative-nominal-interest-rates.html

  15. Joe Gagnon says:

    The evidence of monetary policy’s effect on the economy is enormous and no serious economist doubts it. A good place to start learning about it is the textbooks by Krugman and Mankiw, depending on whose ideological views you prefer. The question now is how monetary policy works after the short-term interest rate hits zero. Economists are only beginning to sort that out. All economists agree that IF monetary policy can lower the long-term interest rate, then it can work like it does in normal times. But some economists doubt that monetary policy can lower the long-term rate. The new evidence I and others are finding is that monetary policy IS able to lower the long-term rate.

    • dilletaunted says:

      i refer you to dan’s comment earlier concerning “deep balance sheet recessions”

    • Dan Kervick says:

      This is a unvarnished appeal to authority.

      “No serious economist doubts it.”

      “All economists agree that IF …”

      ” … the textbooks by Mankiw and Krugman.”

      The “serious” economists have failed utterly. Why should we be listening to them?

    • JW Mason says:

      Of course it is true that demand is much more important. Nonetheless, it remains true that (1) banks cannot change the aggregate quantity of reserves but (2) efforts by individual banks to reduce their reserve holdings will increase lending to the real economy. Nothing you said contradicts that, nor does the linked article, which explicitly concedes that a tax on reserves would reduce interest rates faced by nonfinancial borrowers.

      (The author you linked is one of those hilarious people who thinks “it reduces bank profits!” is a decisive argument against a policy.)

  16. JW Mason says:

    Hey Joe,

    It’s not just the binary choice of effect or no effect, tho, is it? What’s your take on the Old Keynesian conventional wisdom that “you can’t push on a string,” i.e. that high interest rates can choke off an inflationary boom but low interest rates cannot end a recession. Or as Keynes argued in the General Theory, changing expectations can lower the expected profit on new investment much further and fast than monetary policy can possibly reduce rates, so that in a severe slump you have to do something to raise the return on investment directly (or boost other components of demand), since you can’t lower the cost of capital enough to make a difference. Was Keynes just full of it, or was he maybe onto something?

    Also, what about the widely held view that the main channel through which monetary policy has worked in practice is the housing market, i.e. that housing investment is by far the most interest-sensitive component of demand? If that were true — and lots of smart economists think so — wouldn’t we expect monetary policy to be much less effective in the wake of a housing bubble than at other times, even if it can move long rates?

  17. seattlebruce says:

    “Commodities have spiked”

    The effect of QE and QE2 on the value of the dollar (trended down to dangerous levels) and on dollar denominated asset prices (corn, wheat, et al) has had massive impact on what the poor spend around the world for food. Because so much of the world’s poor spend such a high amount of their income on food (>50% often), what seems like not a big deal here (say a 25 or 30% rise on the 5% or 10% we might spend on food) is magnified 5 or 10 fold for a poor person like that. To say that wage inflation is the most important thing, may be true for 320 million Americans that benefit from the dollar’s current reserve currency position. But for 1 billion of the world’s poor, this reckless, American centric policy has resulted in massive heartache and hunger. Point your finger directly at the Fed and other central banks for that, as well as the merchants of debt that have us all in this debt box to begin with.

    And that’s not considered a ‘moral hazard?’ What banker’s drugs are you toking?

    Repeal the Federal Reserve Act of 1913. Take back control of our money creation according to Article 1, Section 8 of the US Constitution and unravel the massive debt ridden economy with a stable money supply that is accountable to the people and not some cabal of private manipulating bankers. Since the Federal Reserve (which is a private institution) was created, the dollar has lost 97% of its value.

    How’s that for a moral hazard?

  18. Pingback: Economist's View: Fed Watch: Fed on the Sidelines

  19. Brahe500 says:

    I have no doubt the Fed can lower long term interest rates by leveraging its balance sheet but it needs a very clear understanding of the transmission mechanism before it takes such risks. Possible transmission mechanisms in different circumstances might be:

    1) Encourage banks to lend given higher reserves but banks already awash with reserves.
    2) Enable corporates to borrow at lower rates but corporates (non-banks) have massive cash balances
    3) Depreciating dollar leading to export boost. Almost certainly the case but impact is small given limited size of US exports relative to GDP.
    4) Encourage higher equity prices leading to higher consumption. Again probably true but very limited given limited number of consumers hold equities directly and wealth impact from this source takes several years before impacting normal patterns of consumption.
    5) Lower long term interest rates will provide marginal support to housing via cheaper mortgages but impact is again limited given higher mortgage rates from banks fearing default . In any case problem is not that mortgages are too expensive but that purchasers fear further declines in capital values.

    Intervention from the Federal Reserve does not come from a desire to help financial markets but a desperate desire to avoid the errors of the 1930s. Their desperate desire to believe they can help is to their credit but simply not supported by the facts.

    Brahe

  20. Steve Roth says:

    If Jamie Galbraith is right that the interest on long government bonds (to the extent that it exceeds inflation) is simply a gift to banks/financial players, paying them interest on risk-free savings,
    http://www.levyinstitute.org/publications/?docid=1379
    Then the QE bond purchases are taking that gift away from the banks (“giving” it to the Fed/treasury, who arguably never should have given it away in the first place) — essentially moving us toward the MMT vision of no bonds at all, in which the only bills the government issues are zero-interest dollar bills.
    It’s no surprise that the Bill Grosses of this world object to it. It is more surprising to find the likes of Carmen Reinhart screeching about “financial repression.”

  21. Pingback: Joseph Gagnon explains monetary policy | Kajulew

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