QE2 Won’t Save Our Sinking Ship
by L. Randall Wray, Professor of Economics at the University of Missouri-Kansas City, Research Director with the Center for Full Employment and Price Stability and Senior Research Scholar at The Levy Economics Institute.
Fed Chairman Bernanke is signaling that a second round of quantitative easing will soon begin. In the first round, the Fed’s balance sheet nearly tripled to nearly $2.3 trillion as it bought $1.7 trillion in Treasury securities and mortgage-related securities. Since the Fed appears to want to unwind its position in mortgages, QE2 will probably target federal government debt.
During Japan’s long stagnation, Bernanke was famous for arguing that the Bank of Japan could have done far more to fight deflation. Since the BOJ’s overnight interest rate target was effectively at zero, the conventional policy of lowering its interest rate target was not an option. Hence, Bernanke advocated quantitative, rather than price, activity — the BOJ would purchase assets from banks, driving up their excess reserves, until they would finally make loans to stimulate spending that would reverse the trend of prices.
So when he had the opportunity, he put theory into practice in the US, driving short-term interest rates effectively to zero and filling bank balance sheets with excess reserves by purchasing their assets. So far, the impact has not been significantly different than Japan’s experience. Indeed, Bernanke has been publicly warning of the dangers of a Japanese-style deflation, as US inflation has dropped nearly to zero, well below the Fed’s informal target of two percent.
And so we are now set for round two of QE — more of the same old, same old.
In truth, the Fed has done only two helpful things. First, during the liquidity crisis of 2007 and 2008, it lent reserves to financial institutions that faced a liquidity crisis. To be sure, it took the Fed far too long to figure out that in a liquidity crisis you must lend to any financial institution, and you should not look too closely at the quality of assets submitted as collateral. The Fed’s bumbling made the liquidity crisis far worse than it should have been. But eventually we got through that phase.
We then moved on to the insolvency phase, as everyone discovered that banks were, and still are, holding assets whose value is far below the value of their liabilities. A flimsy “stress test” was concocted, designed to ensure that all institutions would pass. The government then injected a bit of capital into some of them and proclaimed the problem resolved. Next, banks cooked their books and showed healthy profits so that they could buy out Uncle Sam. More importantly, they wanted to party like it was 1999 so they could pay record bonuses to top management.
However, purchasing toxic assets from banks did help them — the second useful thing done by the Fed. The problem is that the Fed did not and cannot buy enough of the waste to make banks healthy. There is simply too much of it. When the crisis hit, the US debt to GDP ratio was 500%, and that has hardly come down. A lot of the debt was bad even before the recession, but far more of it is bad now that we have lost 10 million jobs and half of homeowners are either underwater in their mortgages or soon will be. And there are tens of trillions of dollars of derivatives deals. To resolve the insolvency crisis would require that the Fed buy tens of trillions of dollars worth of questionable assets — QE2 would have to be orders of magnitude larger than QE1. Putting a number on it is nothing but a guess, but it could be at least $20 trillion.
The Fed can certainly “afford” to buy up all the bad assets and take on any counterparty risk from the derivatives that might be triggered. As Bernanke has testified, the Fed buys assets by crediting bank accounts, through a simple keystroke, and there is no way the Fed can run out of keystrokes. But it is politically constrained in a number of ways.
First, there is no chance that inflation hawks would stomach Fed actions on that scale. They still believe that bank reserves generate loans that inevitably create inflation. Bernanke carefully tries to navigate these waters by agreeing with the hawks that in the long run, Fed creation of too many reserves would be inflationary, but argues that in current circumstances the greater danger is deflation. Still, he reassures markets that reserves creation is temporary, and that the Fed will “exit its accommodative policies at the appropriate time”. Yet, if the Fed buys junk assets that will never have any value, it will not be able to sell these back to markets later — so there is no way to remove the reserves it created when it buys trash.
Second, the Fed generally makes a profit on its operations and turns excess profit on equity over to the Treasury. Buying toxic assets will lead to losses, something Congress will not stomach. So the Fed is between the inflation rock and the hard place of losses. It cannot solve financial institutions’ solvency problem without buying on a politically impossible scale.
This should come as no surprise. It has always been the central bank’s role to deal with liquidity problems, and the Treasury’s role to deal with insolvency problems. The difference is that US Treasury spending is directly controlled by Congress and accounted for in the federal budget. Bailouts by Treasury — such as the rescue of the US auto industry — inevitably generate a public debate. By contrast, bailouts by the Fed take place behind closed doors, and usually only come to light after the fact. Still, Congress and the public are fed up with the Fed and will tolerate such shenanigans no longer. That leaves the Treasury as the only chance for action, but President Obama claims it has already “run out of money”. This is pure nonsense since Treasury also spends using “keystrokes”, but it is a widely accepted myth.
So the Fed is left with the only option available to a central bank that has already pushed short-term interest rates to zero: buy longer maturity treasury bonds in order to push longer rates toward zero. It certainly can do this. It could, for example, buy all 10 year Treasuries, bidding up their prices until their yields fall to zero. Historically, 30 year fixed rate mortgages have tracked 10 year bonds fairly closely, so such an action could conceivably lower mortgage rates. But they are already below 4%, so it is not clear what could be gained. Dropping rates still further is not likely to bring forth any buyers except hedge funds that have been buying foreclosed homes. The “foreclosuregate” scandal has at least temporarily killed that demand.
Other potential buyers are waiting for house prices to fall further, or for a real economic recovery to begin — one with job creation and rising wages. In short, the problem in real estate markets is not that mortgage rates are too high, but rather that prospects for real estate and job markets are too poor. The Fed is in a Catch 22: Interest rate policy will not spur borrowing until economic recovery is underway, but recovery will not begin until spending picks up. Only jobs and income will stimulate spending, but the Fed cannot do anything in those areas.
The Fed believes that it might spur bank lending by lowering returns on safe, liquid assets like Treasuries. If banks cannot generate sufficient returns by holding these assets, then they might have no choice but to take greater risks. But it takes two to tango — banks need good and willing borrowers in order to make loans.
Recent data indicate that banks are instead trying to increase revenues through “churning” — trading existing assets, which generates no new spending — and by increasing fees and penalties. Conventional wisdom is that it costs banks up to 400 basis points (four percentage points) to operate the payments system that relies on checking deposits and credit cards. If Treasuries are paying less than half that, and mortgages are below that, the only way that banks can turn a profit is by charging customers for their deposits, debits, and charges. That is why they have been busy jacking up their charges. Yet if Elizabeth Warren is effective, she is going to make it harder for banks to gouge customers.
No matter how mad at banks we might be, we have got to leave them with a way to return to profitability that does not rely on speculative bubbles, pump-and-dump schemes, and accounting fraud. Pushing returns on relatively safe assets toward zero is not the answer. Pumping banks full of reserves that pay very low interest will not help, either. What Bernanke might understand, but most in the mainstream media do not, is that banks do not and cannot lend reserves. Reserves are just an entry on the Fed’s balance sheet — a liability of the Fed and an asset of banks. Rather, banks make loans by accepting the IOU of the borrower and issuing a demand deposit. Only financial institutions have access to the Fed’s balance sheet, so it is literally impossible for a bank to lend out reserves.
So anyone who thinks that pumping banks full of reserves while driving interest rates toward zero is a way to encourage lending simply does not understand banking. (This also means, of course, that whether banks have $100 billion or $100 trillion of reserves has no implications for prospective inflation.)
Note that if we really wanted to use our central bank to resolve this economic crisis, it would be far better to have it directly buy houses and create jobs for the unemployed. But it makes far more sense to use our fiscal authorities for that.
QE2 does not represent a solution to our current quagmire. No, this Titanic is still headed underwater. The sooner that the Obama administration recognizes that what we need is jobs, more jobs, and mortgage relief, the sooner we can get this ship afloat.