Economic Notes: Doing Nothing IS An Option
3/20/2009
Building its Balance Sheet: The Federal Reserve (Fed) announced that it will expand its balance sheet by more than $1 trillion through purchases of Treasuries ($300 billion) and mortgage-related bonds ($850 billion). Fed Chairman Ben Bernanke has described this strategy as “credit easing.”
The Fed’s plan is to buy bonds in order to: (1) increase liquidity and reduce interest rates; (2) making it attractive for households and businesses to borrow; thereby (3) stimulating the demand for goods and services; which will lead to (4) increased employment and earnings.
The sequence of events is quite plausible, but where does the Fed get the money to fund it?
Minting Money: As the minter of the nation’s currency, the Fed has a unique capability: it can create money out of thin air simply by adding cash to its balance sheet. But in the 21st Century, rather than printing a trillion one-dollar bills, it will issue itself a trillion-dollar gift card – for free!
The Fed will then use that gift card to buy Treasuries and mortgage-related bonds. As the new biggest buyer on the block, the Fed is looking to raise the price (i.e., lower the interest rate) on long-term paper. At some future date, it can reverse the process by selling its bonds. (Presumably, it would then reduce the limit on its magical gift card.)
Can it work? The record is mixed. In the early 1960s, when the Fed pursued a similar strategy (dubbed “Operation Twist”), the gambit was ineffective.
But circumstances were different then; the world’s economy was far more fragmented, the dollar was pegged to gold, and the U.S. was a net creditor (not the world’s largest debtor) and energy independent. So the 1960s experience may not be apposite to current circumstances.
During its lost decade (1990s), Japan’s initial success with a slightly different approach was aborted, largely by jittery fiscal policies. Consequently, we can only speculate as to the strategy’s long-term potential.
In the absence of relevant experience and reliable data, much of today’s policymaking is driven by the refrain that “doing nothing is not an option!” But does that mean that doing anything – regardless of the risk – is an option?
What are the risks? Credit easing has some clearly acknowledged risks. I’ll take a few short cuts to illuminate the most significant one.
The most pressing risk in credit easing is its eventual impact on inflation and, more immediately, the assessment by creditors, including other national governments, of the probability that those inflationary risks will be realized.
Even though the weakness in the global economy removes the near-term threat of inflation, creditors are focused on longer term (i.e., post-recession) prospects. And those with whom the U.S. trades and to whom it sells its debt are already expressing concern about potential dollar devaluation through inflation.
Should they begin to act on those concerns (i.e., cut back on the amount of U.S. debt they are willing to purchase or hold), the impact on the nation’s economy would be highly detrimental. Indeed, credit easing’s costs could overwhelm its benefits and worsen the current slump.
Were credit easing’s risks sufficient to forgo its use? Despite the unanimous approval of credit easing by the Fed’s Board, it was the wrong call. Not because current conditions do not warrant extraordinary action, but because there are some actions, particularly those predicated on erroneous assumptions, that have a greater potential for harm than good.
Chairman Bernanke has predicated his confidence in the Fed’s success on the assumption of sufficient “political will,” including the willingness to put our financial house in order. Indeed, his assumption regarding political will is the bedrock principle of credit easing’s potential. On the facts, it appears wrong.
Instead, we have a Federal government that proposes budget deficits that will average $700 billion per year for the next decade. We have counter-cyclic policies aimed at encouraging borrowing by already over-leveraged businesses and households.
In that context, credit easing is tantamount to holding temperance meetings in a tavern. Congress will order drinks for the house and expect the Fed to pay the bill with its magic gift card.
Absent a detailed plan to address the county’s fiscal and financial imbalances, that is, a roadmap to a sustainable economic trajectory, the Fed should have accepted that in the choice between credit easing and “doing nothing,” inaction was not only an option, it was the only option.
***
The statements, opinions, and conclusions contained herein are based solely upon the author’s own studies, research, and personal experience. Neither J.H. Cohn LLP nor the author makes any representation or warranty as to the accuracy or completeness of this information. J.H. Cohn LLP and the author expressly disclaim any liability for any loss or damage which may be incurred, of any kind whatsoever, as a result of or arising from the use of any of the information contained herein or reliance on the accuracy or completeness of it.
For more information, contact Patrick O’Keefe, director of economic research at J.H. Cohn, at pokeefe@jhcohn.com or 973-364-7724.