Why Has Monetary Policy Been So Ineffective?
How does the Fed stimulate the economy? It buys government securities from securities dealers, thus replacing one type of asset (Treasury securities) that investors may wish to hold (since it has a return) with another (money) that banks may wish to lend (since it lacks a real return). Lending thus rises and the economy is stimulated. Of course the Fed’s real target is the federal funds rate, the rate banks charge each other for overnight loans, mostly undertaken to meet reserve requirements. But the lever of monetary policy is the imperfect substitutability between Treasury securities and money. Fed purchases of Treasury bills and other government debt leave banks holding excess reserves (i.e., excess money). And banks normally push these out to the public, since it makes little sense to hold what one isn’t legally obligated to hold (such as required reserves) and that lacks a return.
But what if this premise of monetary policy should fail? Are there circumstances in which banks and investors would want to hold vast quantities of Treasury bills and money, not really caring which, since the two are seen as near-perfect substitutes? Unfortunately, the answer is yes. And now is such a time, a situation called a “liquidity trap.” A liquidity trap occurs when confidence in return-bearing assets is so low that banks, investors, and, to a lesser extent, consumers, mainly want to hold just riskless assets, i.e., cash and short-term Treasury bills. Monetary policy is then ineffective, since even as the nominal interest rate falls to zero, nearly all the liquidity the Fed throws at the economy disappears into hoards, rather than being lent or spent, as is painfully clear in this diagram:
The diagram reflects the dramatic expansion of the Fed’s balance sheet over the last year. The monetary base—coins, currency, and banks’ reserves (required and excess)—is the narrowest measure of the money supply, since it’s the most acceptable or liquid form of final payment. Normally as the monetary base expands, excess reserves are unaffected. Since September of last year, however, almost all of the increase in the monetary base (about 90 percent of it) has been absorbed into excess reserves, i.e., reserves that just sit on banks’ balance sheets rather than being used productively in the economy. Keynes likened this situation to “pushing on a string.” When you push on a string it slackens; and when the Fed pushes reserves into the economy, the reserves just move onto banks’ balance sheets where they remain. It’s a "trap" in the sense that nearly all the liquidity the Fed supplies to the economy gets "trapped" on the balance sheets of banks, making monetary policy ineffective.
Some have argued that the reason for the colossal increase in excess reserves is the Fed’s practice, begun in October 2008, of paying interest on reserves (ostensibly to provide a lower bound for the federal funds rate, making that rate more controllable). This may explain part of it, but not all. The interest rate on reserves is now just a quarter of a percent (it started at three-quarters). So clearly, by hoarding reserves, banks are foregoing potentially profitable lending opportunities. (It’s also possible that as competitive enterprises, banks are passing along their interest on reserves to depositors. If so, interest on reserves should have no particular economic effect.)
The increasingly widespread view that we’re in a liquidity trap clashes with macroeconomic orthodoxy, which says liquidity traps don’t exist—that since Keynes we’ve learned that monetary policy, done right, can always cheapen the currency sufficiently to stimulate aggregate demand and move us out of a recession. In a 2002 speech, then Federal Reserve Board governor Ben Bernanke told the following parable to illustrate why in a fiat money system “deflation is always reversible”:
“Suppose that a modern alchemist solves his subject's oldest problem by finding a way to produce unlimited amounts of new gold at essentially no cost. Moreover, his invention is widely publicized and scientifically verified, and he announces his intention to begin massive production of gold within days. What would happen to the price of gold? Presumably, the potentially unlimited supply of cheap gold would cause the market price of gold to plummet. Indeed, if the market for gold is to any degree efficient, the price of gold would collapse immediately after the announcement of the invention, before the alchemist had produced and marketed a single ounce of yellow metal.”
The moral is that because the Fed can create money ex nihilo, it can always cheapen the currency enough to compel people to spend or lend more rather than hold an asset (money) whose real value is falling. Indeed the Fed should be able to achieve this result merely by threatening to create more money, since if people believe prices will rise, they will spend and lend more to avoid holding dollars they expect will become devalued. Their actions thus occasion the very inflation they expect. Aggregate demand then rises, stimulating the economy away from recession.
The title of Bernanke’s talk was “Deflation: Making Sure ‘It’ Doesn't Happen Here.” A couple of points: (1) The “It” refers to a deflationary, liquidity trap-like scenario, like what we’re experiencing now. (2) The word “Here” rather than “Again” implies that the precedent Bernanke had in mind was not the Great Depression, but the “lost decade” of the 1990s and early 2000s in Japan, where—with an economy depressed despite nominal short-term interest rates at or near zero—something like a liquidity trap clearly existed. The Great Depression, on the other hand, most economists including Bernanke now believed (following Milton Friedman and Anna Schwartz), was not a liquidity trap but an ordinary recession turned into a depression by bad monetary policy (contractionary when it should have been expansionary).
“It,” Bernanke believed, was most unlikely to happen in the U.S. because of a “combination of strong economic fundamentals” and policymakers “attentive to downside as well as upside risks to inflation.” Since, however, “it” was happening in Japan, economists had to at least entertain the possibility that it could happen here. Indeed Bernanke in his academic work considered very seriously what actions the Fed could take if the federal funds rate were to hit the "zero lower bound." (See, for example, this.) In his 2002 speech he outlined some of them:
- Committing to maintaining the federal funds rate at zero for an extended time to lower long-term Treasury rates—the latter being an average of current and expected future short-term rates, plus a risk premium.
- Making unlimited purchases of longer-term Treasury securities (two years or longer) to enforce longer-term interest-rate ceilings.
- Purchasing agency debt (e.g., mortgage-backed securities issued by Ginnie Mae, the Government National Mortgage Association).
- Indirect lending to the private sector via lending to banks through the discount window (the Fed can’t directly lend to the private sector).
- Purchasing foreign government debt.
The intended effect is to stir inflation a bit, raising aggregate demand, and thus steer the economy away from recession. Some economists, of a monetarist/New Classical bent, still believe that monetary policy alone can achieve recovery.* Well, no one is claiming monetary policy is completely ineffective, even now. The massive expansion of the Fed balance sheet almost certainly is what stands between us and the still greater misery of deflation. But the fact that so massive a monetary expansion—on a scale that might normally be expected to cause Zimbabwe-like inflation—has left us with a consumer price index just below what it was a year ago, surely says what’s happening now falls outside the monetarist/New Classical theoretical framework.
So what is happening now? My interpretation is that it’s a combination of phenomena identified by the two Great Depression-era economists, Irving Fisher and John Maynard Keynes. Fisher hypothesized that the Great Depression resulted from a “debt-deflationary process,” a process rooted in “over-investment and over-speculation…conducted with borrowed money,” viz. a highly leveraged asset bubble. The bursting of the bubble, in Fisher’s analysis, leads to a lengthy “chain of consequences” that includes “distress selling,” “contraction of deposit currency,” a “slowing down of velocity of circulation,” “a fall in the level of prices,” “a still greater fall in the net worths of business,” “bankruptcies,” a “fall in profits,” “a reduction in output, in trade and in employment,” “pessimism and loss of confidence,” “hoarding and slowing down still more of the velocity of circulation,” etc.—essentially a self-perpetuating process that feeds on itself. The key dynamic is that through deleveraging (“distress selling”) money is withdrawn from circulation, which reduces aggregate demand, which further worsens the balance sheet conditions that started the process, which causes still more deleveraging, etc.—a downward vicious cycle.
Add to these dynamics the reverse multiplier effect discussed by Keynes, which causes the paradox of thrift, and Keynes’s notion of a liquidity trap, which explains why our normal response to a recession, monetary expansion, has been ineffective, and we have a fairly comprehensive account of the current crisis.
Bernanke in his speech alludes to the Fisherian debt-deflationary scenario, but in most of his analysis he fails to distinguish between different sources of falls in aggregate demand. However, the source of a fall in aggregate demand can make all the difference. If it’s caused only by excess capacity (a normal recession), then a sufficiently low federal funds rate should make the return on investment positive, enabling the economy to recover. If the source is a Fisherian debt-deflationary process (viz. the bursting of a highly leveraged asset bubble), however, then merely feeding liquidity to the economy, though necessary, may not stem the tide of deleveraging before the federal funds rate hits zero. The problem is that desired saving (or thirst for liquidity) is so high that all, or nearly all, liquidity gets absorbed into savings. Diagrammatically, the equilibrium or market-clearing interest rate (point of intersection between the investment and saving curves) is below zero, a state of affairs that both Paul Krugman and Greg Mankiw argue characterizes the economy now. Indeed the Federal Reserve itself now estimates that the “correct” interest rate, given current unemployment and inflation, is minus 5 percent.
It’s possible that the economy can recover by purely monetary means. If the Fed keeps supplying liquidity, that should ultimately slake the economy’s thirst, parly because increased aggregate demand will make the toxic assets on banks’ balance sheets less toxic, and partly because inflation will cause the real value of losses from toxic assets to fall. But this is a roundabout approach. The drawback of relying on monetary policy is that it doesn’t directly address the real problem, which is the self-perpetuating and mutually reinforcing dynamics of a debt-deflationary process, a reverse income multiplier, and a liquidity trap. And as we’ve seen, these processes are inherently resistant to efforts to address them by monetary means. To address the problem efficiently—and prevent a lot of carnage—more direct means, like expansionary fiscal policy, bailouts, and/or government takeovers of banks, are necessary.
Which isn’t to say a massive monetary response hasn’t also been necessary. Almost certainly it’s prevented a catastrophe. In response to the crisis, the Fed has had to step out of the box to confront phenomena not well recognized in orthodox macroeconomics. And fortunately the Bernanke Fed has more or less dropped ideology and responded pragmatically. We can at least be thankful that the Fed chairman, as a good academic, was intellectually prepared for the “it” he thought so improbable.
*It should perhaps be noted that there’s something deceptive about the idea that quantitative easing is a purely monetary response to the crisis. When the economy recovers, the Fed will have to withdraw the money it’s now creating, lest it prove inflationary. And it will seek to do so by reselling the securities it’s now adding to its balance sheet. The rub is that it will have to resell them at lower prices, since with recovery interest rates will likely rise and securities prices will likely fall. Hence these securities won’t fetch prices high enough to enable the Fed to withdraw all the money it’s now creating. To stave off inflation the Fed will therefore have to sell additional Treasury debt, which means the Treasury will have to issue additional debt. In other words, quantitative easing is to some extent de facto expansionary fiscal policy—a fact seemingly little known (though it’s noted by Krugman).
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Some Reality about Deficits
Armageddon: The Aftermath
The Hype
How to Explain It
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The Point of the Public Plan
The Context of Health Care Reform
Addendum
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What Americans Believe
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NBC-WSJ Poll
Inside the Asylum
More About Bubbles
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The Geithner Plan
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Economics: A Theoretical Divide
The New Deal and the Great Depression
Stimulus By the Skin of Our Teeth
The Interregnum
Postmortem
Obama and McCain on Tax Cuts and Health Care
Religion and the New Atheism
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