The Problem with Printing Money
The Federal Reserve’s dramatic new intervention into the U.S. economy—a $600 billion purchase of Treasury bonds that was immediately branded with the nautical nickname of QE2—had barely gotten underway in November 2010 before the Fed itself began sending signals that it had a public-relations disaster on its hands. In a speech to European central bankers in Frankfurt only two weeks after the policy was announced, Fed chairman Ben Bernanke said he didn’t like using the term “quantitative easing”—much less “QE2” —because it didn’t precisely describe what the central bank was trying to do by running the printing presses overtime.
Technically, Bernanke had a point. “Quantitative easing” usually describes rare efforts by a central bank to pump money into the private banking system in hopes that the banks will then lend out the new funds to business. But that isn’t the main goal of QE2, nor of the Fed’s previous $2 trillion bond-buying effort (the original “QE”) that began in November 2008.
What Team Bernanke is trying to accomplish with its “large-scale asset purchases”—the chairman’s preferred but extraordinarily boring term—is far more complicated and economically elegant. It’s a quintuple-cushion bank shot that seeks to promote job and wage growth. By purchasing Treasuries from banks, the new plan intends to (1) lower long-term interest rates, which would in turn (2) raise the attractiveness and price of other assets such as stocks, which would then (3) boost household wealth, followed by (4) increased consumer spending, which would (5) finally lift employment by nearly a million jobs over the next two years.
All wonky reasons aside, Bernanke surely sought to put distance between his policy and the nickname QE2, because the moniker was the instant wellspring for snarky comments about sinking ships and hidden icebergs among all those skeptical that it could have a positive impact on a $13 trillion economy slowly crawling its way out of the wreckage of the 2007-09 financial implosion. Alas for Bernanke, rumors that this policy was going to be implemented began swirling around the markets in early September 2010, and he had a chance to gauge its effectiveness to some degree by the market and macroeconomic response to it even in its infancy. The portents were not good. Long-term interest rates remained flat. And while stocks were up 10 percent or so, most of that gain seemed to be due to the anticipation of the Republican triumph in the midterm elections. Following the vote on November 2, and the implementation of the new policy a few days later, stocks barely moved.
More important, the Fed has implicitly conceded that LSAP, or QE2, or whatever, isn’t going to make much of a difference for Americans suffering most profoundly from the economy’s woes. Its most recent economic forecast features sobering news on American employment. It foresees the nation’s unemployment rate remaining above 9 percent for the next year before declining to 8 percent at the end of 2012 and to 7.4 percent at the end of 2013—some four and a half years after the official end of the Great Recession. As recently as February 2008, the jobless rate was below 5 percent.
Should the Fed forecast conform to reality, QE2 will almost surely look to voters and their representatives like yet another example of government intervention into the economy that proved a spectacular failure. It will mirror the reaction to Barack Obama’s trillion-dollar stimulus, which two-thirds of Americans think was a bust despite the persistent White House argument that the downturn would have been far worse without it. A nation that has just experienced a generation-long economic boom will give scant applause to policies it judges unsuccessful in generating a full-scale return to prosperity. And the central bank will see its already battered reputation bloodied even further.
The Fed really can’t afford any further erosion in its standing. Not only has the central bank taken a host of unprecedented steps during the past two years, many economists—even some Fed members—blame it for the financial crisis altogether. As Kansas City Fed president Tom Hoenig recently told the Wall Street Journal: “When all these very important decisions were made in 2003 to bring interest rates to 1 percent, it was because unemployment was 6.5 percent and thought to be too high. As a consequence of that—not immediately but in time—we now have 9.6 percent unemployment.”
Even worse is the growing perception that the Fed has begun to work too closely with elected officials and executive-branch leaders. Independent central banks, of which the Fed is history’s foremost example, do a better job at keeping prices stable than central banks that appear to be taking cues from political bosses, rather like film directors getting notes from studio executives. Bernanke & Co. appear to be as vulnerable to political meddling as any Fed since the Nixon administration, which leaned on Chairman Arthur Burns to loosen monetary policy before the 1972 presidential election.
Typically, politicians want central banks to run the printing presses to boost economic growth. They fear unemployment more than inflation. In Washington, opinion is split along lines reflected in the Fed’s dual mandate, which is to keep prices steady and employment high. Democrats want the bank to do even more to create jobs, while Republicans would prefer it focus only on inflation. Members of the new GOP-controlled House, especially those with a libertarian bent or Tea Party support, may show Bernanke little deference when he comes to testify before them next year. The House Financial Services subcommittee that oversees the Fed will be run by Representative Ron Paul, who recently wrote on his website that “central banking is inherently incompatible with our Constitution and a free market economy.”
And it isn’t just Republicans who want to fuss with the Fed. Representative Barney Frank, the outgoing chairman of the House Financial Services committee, wants to exclude regional Fed bank presidents like Hoenig (there are 12 of them) from voting on monetary policy because they tend to be more inflation-averse than the presidential appointees who serve on the Fed board in Washington.
So the political heat shield around the Fed, built over a generation on the foundation of then-Chairman Paul Volcker’s steel-nerved determination to end the inflationary spiral in the early 1980s, is thinning quickly. Bernanke realizes this, which is why he’s been far more media-friendly than his predecessor, Alan Greenspan, and may even begin doing press conferences to explain Fed actions. The key Fed action in the near future will come when it chooses to begin shrinking the massive holdings on its balance sheet. Even before QE2, the Fed had $2.3 trillion of assets on that sheet, two and a half times what it owned before the financial crisis. Most of those assets are Treasury bonds, debt issued by Fannie Mae and Freddie Mac, or mortgage-backed securities issued by the two real-estate behemoths. The Fed simply cannot hold on to these assets, because at some point economic confidence will be high enough and business-loan demand robust enough that all those reserves the Fed created by buying bonds from banks will flood back into the economy, thus risking an inflation surge in which too much money is chasing too few goods.
Yet the Fed’s decision to shrink the balance sheet—which will grow even larger due to the purchase of bonds as part of QE2—will almost certainly come at a time when the economy still looks less than robust and inflation appears quiescent. Interest rates will rise as a result. There will be tremendous political pressure on the Fed from Washington and the American public to delay implementing this exit strategy. Even assuming that the Fed is nimble and skilled enough to time its move before inflation and even expectations of inflation rise—thus making sure it doesn’t contribute to the growth of inflation—its own political gamesmanship could lead it to stay its hand. And the longer the Fed waits, the more dramatic the eventual tightening phase will have to be to counter the flood of cash, putting a further drag on economic growth. The Fed also risks dramatically worsening the U.S. debt situation if higher inflation raises federal borrowing costs.
In an “Open Letter to Ben Bernanke” that appeared in the November 15 Wall Street Journal, a group of 23 economists and investors urged an end to the bond-buying program, charging that it risks “currency debasement and inflation, and we do not think [it] will achieve the Fed’s objective of promoting employment.” That had to sting. It’s one thing for a populist politician like Sarah Palin to offer this sort of critique in a Facebook posting. It’s quite another when one of the letter signers is Stanford University’s John Taylor1, who is on the very short list to serve as Bernanke’s successor if a Republican takes the White House in 2012.
The views expressed in the open letter actually reflect a considerable body of opinion inside the Fed itself. We learned this in the minutes from the November 2-3 meeting of the Federal Open Market Committee (the group of board members and regional Fed presidents that actually sets monetary policy). As the minutes note:
Some participants, however, anticipated that additional purchases of longer-term securities would have only a limited effect on the pace of the recovery…. Some participants noted concerns that additional expansion of the Federal Reserve’s balance sheet could put unwanted downward pressure on the dollar’s value in foreign exchange markets. Several participants saw a risk that a further increase in the size of the Federal Reserve’s asset portfolio, with an accompanying increase in the supply of excess reserves and in the monetary base, could cause an undesirably large increase in inflation.
Yes, key members of the Fed actually agree with Sarah Palin—not to mention the signers of the open letter, and a slew of foreign financial ministers.
Bernanke’s basic response, both in a recent Washington Post op-ed and in that speech to European central bankers, can be summed up this way: “Look, there is certainly no risk of inflation in the short term. If anything, the economy is tilted more toward deflation. Great Depression? Japan in the 90s? Ever hear of them? When the economy does pick up, the Fed will begin draining excess cash, no matter what crazy Ron Paul says about us wanting to control the world. And don’t forget that, unlike every other central banker on the planet, the American-elected politicians who have established the Fed’s mandate have ordered me to worry about prices and jobs both. If you hadn’t noticed, the U.S. labor market is a shambles. My bond buys will create 700,000 jobs over two years with little downside risk at a time when ideas for more fiscal stimulus are DOA in Congress. Anybody with a better plan, you know where to find me. One more thing: Germany and China, quit kvetching about the dollar. We’re not going to eat your exports. So anytime you want to boost domestic demand for your products, that would be super.”
So, in Bernanke’s view, QE2 will have a fair bit of upside (avoid deflation, create jobs) with little downside (some slight chance the Fed will be a tad tardy in withdrawing its stimulus).
The chairman’s calculations might be skewed by his own obsession with the possibility of deflation. Bernanke is the foremost academic expert of his generation on the causes of the Great Depression, which in his view might better have been dubbed the Great Deflation. A tremendous credit contraction and wave of bank failures led to a vicious downward spiral where prices fell by an average of 10 percent a year from 1930 through 1933. That is what he fears most and wishes to prevent. He is also well aware that less severe deflations, like that in Japan during the 1990s, can still trap an economy for years.
The problem for this analysis and the anti-deflationary prescription Bernanke is writing is that there are few signs of deflation at the moment. Although not a Reaganesque boom by any means, the economy is growing and jobs are being added. The Federal Reserve Bank of Cleveland reports that its latest estimate of 10-year expected inflation—using a model with a number of variables, including the rate on inflation-protected securities—is 1.5 percent. That’s not far off the unofficial Fed inflation target of 2 percent. (An inflation target is the rate a central bank considers optimal; the Fed doesn’t have one explicitly, but others do.) There is also little sign of deflation in real-time price data, where the only category still showing declines is housing.
For Bernanke, reducing unemployment constitutes the far less important second front in his economic war on deflation. If he is wrong about what he most fears, he might be the banking equivalent of those generals and military strategists who came of age during the Cold War and kept waiting for Russians to come charging through the Fulda Gap—and thereby missed the rise of militant Islam.
For most Americans, increasing employment should be the primary responsibility of all government officials. Of some 8.4 million U.S. jobs lost between the peak of the expansion and the end of 2009, only about 900,000 have been restored as of this writing. In fact, the Fed’s efforts to push interest rates even lower may result in many jobs being created overseas rather than in the United States, in an unanticipated consequence that economists call “leakage.” For example, the Phoenix-based Southern Copper raised $1.5 billion in an April debt offering. But the company is going to use that capital for its mines in Mexico and Peru, not in the U.S. In October, Walmart sold $5 billion in debt in its biggest bond offering in more than a decade. And although the company didn’t specify how it would employ the money, analysts speculated it would be used to fuel expansion in overseas markets.
Such corporate behavior hasn’t escaped the notice of Richard Fisher, president of the Dallas Fed. He recently said that in his “darkest moments, I have begun to wonder if the monetary accommodation we have already engineered might even be working in the wrong places…. Far too many of the large corporations I survey that are committing to fixed investment report that the most effective way to deploy cheap money raised in the current bond markets…is to invest it abroad where taxes are lower and governments are more eager to please.”
Even if the temptation to use cheaply borrowed domestic money in foreign climes could be avoided or prevented, there’s reason to doubt whether QE2 can actually create 700,000 jobs in the U.S. during the next two years. After the 2000-01 recession, unemployment decreased right along with an increase in the pace of job openings. But this downturn has been different. Starting in June 2008, unemployment rose much faster than would have been predicted by the decline in job openings. Research from the Minneapolis Fed points out that job openings rose by 20 percent from July 2009 through June 2010. But the unemployment rate was actually a tick higher a year later.
The explanation, says Minneapolis Fed president Narayana Kocherlakota, is that all those unemployed construction workers and mortgage lenders don’t have the skills employers need. He concludes that if the job market were operating as efficiently as usual, unemployment might be as many as three percentage points lower than its current level. Even if Kocherlakota is far off, continually enlarging the Fed balance sheet is hardly a sustainable way to boost employment in what the Fed itself admits will be a long, hard slog back to acceptable levels.
So, despite Bernanke’s conviction, the new policy represents a huge risk by further undermining Fed credibility and independence and thus limiting its ability to contain inflation. And that risk is being taken for little potential benefit—waving away a few wisps of deflation and perhaps temporarily knocking off a few tenths from the unemployment rate. No matter what it is called, QE2 or LDAP, it may be remembered as Bernanke’s Folly.
1 See Taylor’s piece, co-authored with John F. Cogan, in this issue on page 23—Ed.