Just What is Bernanke Up To?

On the eve of President Obama’s arrival to the G20 talks in South Korea, a growing chorus of voices is questioning the direction of U.S. monetary policy. Germany’s finance minister, Wolfgang Schaeuble, went so far as to scold Chairman Bernanke, saying “With all due respect, U.S. policy is clueless.” Some critics (with justification) have argued that America is guilty of the “currency manipulation” policy for which it castigates China. Others have argued that US policies are opening the door to a complete revision of the international monetary system based on the dollar. World Bank president Robert Zoellick appeared to even suggest a return to the gold standard when he talked of “employing gold as an international reference point of market expectations about inflation, deflation and future currency values.”

I already argued that QE2 is more of a slogan than a policy, and will not repeat those criticisms here. Rather, I will deal with the two most important issues and misunderstandings surrounding quantitative easing. The first concerns the consequences of injecting another $600 billion of excess reserves into the banking system. The second is associated with the Fed’s attempts to lower long-term interest rates through purchasing treasuries. Both of these issues are in turn connected to the belief that QE2 will devalue the dollar and threaten its status as the international reserve currency. That, however, is a topic for another column.

All developed countries’ central banks now operate with an overnight interest rate target (the fed funds rate in the US). To hit this rate, they must supply reserves more or less on demand. We can think of the supply of reserves as “horizontal”, that is, as an infinitely elastic supply at the target interest rate. The simplest way to operate such a system is to offer “overdraft” facilities at the central bank, lending on demand at the target rate (this is done in Canada). Knowing that they can obtain reserves any time they want, banks would never hold substantial excess reserves, since they could borrow them as needed.

The Fed has never explicitly operated this way, preferring to supply most reserves through its open market operations (purchasing treasuries) while imposing “frown” costs on banks that come to the discount window. Most of the time, this does not really matter. However, when the financial tsunami hit, the fed funds market froze up as banks refused to lend to one another, even on the basis of good collateral. There was a general run to liquidity, and no bank felt it could get enough reserves to see it through the crisis. The Fed played around with an alphabet soup of auction facilities rather than simply announcing that it would supply reserves on an unlimited basis to all comers. That cost the economy dearly by dragging out the liquidity crisis. Fortunately, the Fed finally stumbled upon the obvious: supplying reserves in sufficient quantity. The liquidity phase of the crisis passed, and the Fed got the short-term interest rates down to its near-zero target.

So here is where Bernanke’s pet, quantitative easing, came in. Conventional wisdom is that the once the central bank takes the short-term rate to zero, it has shot its wad. Nayeth, sayeth Bernanke — the Fed can continue by flooding banks with excess reserves, which they do not want to hold. Some commentators have said that banks would eventually begin to lend out the excess reserves, seeking a higher interest rate than the Fed pays them. One hopes Bernanke never made that mistake — banks do not lend reserves (except to one another), since they exist only as entries on the Fed’s balance sheet. Only an institution with a “checking account” at the Fed can hold reserves, so there is no way a bank can lend these to households or firms (which do not have accounts at the Fed). So Bernanke presumably understood that if for some reason holding excess reserves caused banks to want to increase lending, this would simply shift the reserves around the banking system while leaving the outstanding quantity unchanged. But that means that offering Canadian-like overdraft facilities, promising banks they can have reserves anytime they want them, would have had the same impact as quantitative easing. Rather than actually holding excess reserves, the banks would have been just as happy knowing that they were safely “locked up” at the Fed and available anytime they were needed. In other words, pumping about $1.5 trillion into the banks would be no different than telling them the Fed would supply any amount at any time.

In sum, adding excess reserves to bank portfolios will not, by itself, do anything if the overnight interest rate has already been driven down to its near-zero target. QE2 proposes to add another $600 billion of excess reserves — but whether banks have $1 trillion or $10 trillion in excess reserves will have no impact.

So why would QE have any impact at all? Because to get those excess reserves into the banks, the Fed buys something from them. What did the Fed buy? Good, safe (mostly short-term) treasuries, and bad, toxic waste: mortgage backed securities. Now, treasuries are effectively reserves that pay a higher interest rate; they are like a saving account at the Fed, rather than a checking account. So when the Fed buys treasuries from a bank, it debits the bank’s saving account and credits its checking account. This will have no appreciable impact on the bank’s behavior and thus will have no discernible economic effect.

But if the Fed buys trashy assets, and at a nice price, the banks are able to shift junk they don’t want off their balance sheets and onto the Fed’s. And if the Fed were to do that in sufficient volume, it could turn insolvent banks into solvent ones. In truth, the Fed did buy a lot of junk, but banks were left with trillions of dollars of toxic waste assets — probably much worse than the trash they sold to the Fed — so they are still massively insolvent. Thus, while QE1 was useful, it did not come close to resolving the insolvency problem. It bought time for some of the trashiest banks, which they devoted to ramping up their dangerous and largely fraudulent activities, digging the hole ever deeper — but that, too, is a story for another day.

With QE2, the Fed proposes to buy longer-term treasuries. Since these are not toxic, it will not help the banks. It is like transferring funds from CDs they hold at the Fed to their checking accounts, thereby reducing their interest earnings. I suppose the idea is that the Fed is going to reduce bank income, impoverishing banks to the point that they will finally throw caution to the wind and begin to make loans to struggling firms and households. It is simultaneously a strange view of banking and also a scary remedy to a financial crisis that was created by excessive bank lending to those who could not afford the loans. It’s sort of like sending a covey of nymphomaniacs to the hospital bed of a nonagenarian suffering from myocardial infarction initiated by an age-inappropriate tryst.

The only plausible scenario in which this can prove useful is that QE2 pushes up prices of long maturity treasuries, lowering their yields. This could cause other longer-term interest rates to fall through competitive bidding by banks seeking better returns in alternative assets. Now, mortgage rates are already at historic lows, and what is needed to spur real estate markets is not lower interest rates (which will only generate big problems later when rates rise, crushing the holders of legacy mortgages that earn well below 4%) but rather the recovery of real estate markets. Only when it is clear that home prices have reached bottom and turned up will real homebuyers step forward — that is, buyers other than the vultures making speculative purchases of blocks of homes at pennies on the dollar. So far as business borrowing goes, the problem is the market for firms’ output, not excessively high interest rates. So the “bang for the buck” in terms of inducing domestic spending by lowering long-term rates cannot be very large and may not even be positive, since reducing interest rates also reduces the income of savers, which could depress spending.

This brings us back to the international sphere, and the fear that QE2 really means to succeed by “beggaring thy neighbor”. Bernanke has talked openly of his desire to raise inflation expectations, and that, in combination with lowering interest rates, could make America a less attractive investment option. If so, the dollar could depreciate, increasing US competitiveness in traded goods and services. This could boost exports.

At the same time, international managed money would be looking for more attractive investments in strong currencies with higher interest rates — say, the BRICs (Brazil, Russia, India, China) — fueling appreciation of their currencies. In other words, QE2 would do for the US what Geithner claims Chinese currency policy is doing for China: cheapen our exports. At the same time, many developing nations are also facing destabilizing capital inflows, and worry about a reprise of the Asian crisis of the late 1990s when the flows reversed and wrought havoc on their economies. That is why they are threatening to drop the dollar, reduce capital mobility, and move to some sort of fixed exchange rate based on gold or a new international currency.

I do not have the space to completely address all of these issues, but I will just say that while much confusion surrounds the complaints thrown at the US, there is at least an element of truth in the claim that QE2 puts the burden of adjustment on other nations. The critics are certainly right to argue that so far as domestic policy goes, QE2 does nothing to get the US out of its crisis. In fairness to the Fed, Bernanke has argued that relying solely on monetary policy for stimulus is less than ideal, so one could argue that the Fed is just doing the best it can in the absence of stimulative fiscal policy. That is correct, up to a point — only fiscal stimulus will get us out of the recession.

But Bernanke is not dealing with the one area for which the Fed does have primary responsibility, and in which a strong Fed policy initiative would do a lot of good: dealing with bankster fraud. Indeed, I believe that even with a huge fiscal stimulus (which is not going to happen) we would not escape another financial collapse and a long and deep economic depression unless the biggest banks are foreclosed. Right now the fraudsters are the biggest barrier to recovery.

At best, QE2 is a diversion from the task at hand.