Perils of Quantitative Easing

            On Sept 13, 2012, the Federal Reserve announced it would begin a third round of “quantitative easing.”   This means they intend to expand the money supply again.   The Fed intends to begin purchasing $40 billion worth of mortgage backed securities per month, and continue to do so until unemployment comes down to an acceptable level.  And at some point, they may begin buying U.S. Treasury Bills again.   In the first round of bond buying, begun in March 2009, the Fed bought 1.25 trillion dollars worth of corporate assets.   And then in November of 2010, the Fed began buying U.S. Treasury Bills, pumping an additional 600 billion dollars into the economy. Where does the Fed get the money to make these purchases?  In effect, they just print it. 

            What are they doing and why are they doing it?  The Federal Reserve, like any central bank system, is simply trying to control the money supply, keeping the availability of dollars at a level which they hope will bring unemployment down to an acceptably low level, while still keeping inflation from rising to an unacceptably high level. These two things are what central banks try to do, and in the U.S., Congress has given the Fed a specific mandate to do both.

            Do I object to this action which the Fed is undertaking?  No—the unemployment rate is way too high, and something has to be done about it.  If it could be brought down to a normal level, then the increased tax collections and reduced welfare expense would, in and of itself, nearly balance the budget.  But I’m disappointed that we are using no tools other than monetary policy to do this, when a combination of fiscal policy and monetary policy would work infinitely better.  Fiscal policy could be used with surgical precision if we had a Congress with the will to do it.  But we don’t, so the whole task of bringing down unemployment is left to poor Mr. Bernanke, who has little more in his tool box besides the “sledge hammer” of monetary easing. 

            Before I explain what my real objection is, let’s take a moment to briefly consider just what monetary policy really is.   If a central bank wishes to add cash to the economy, they simply buy up “commercial paper,” that is, the kind of IOUs that banks and large corporations give to other banks.  By buying corporate bonds for cash, they take these bonds out of circulation and put more cash into circulation. That supposedly expands the money supply.  And if they wish to shrink the money supply, they sell some of the commercial paper from the vast hoard in their portfolio at any given time, and that takes money out of circulation.

               But there is just one problem.  Switching cash for corporate bonds may not change the money supply as much as you may think, because such bonds are in themselves a form of money.   Money is anything that can be used to pay a debt.  And if a bundle of bonds are written on blue chip companies, and are offered at an appropriate discount, most investment banks, in normal times, will accept them as cash.   In fact, an interest-bearing note from a credit worthy company is better than cash, because cash does not pay interest.  And in normal times, the overwhelming majority of the money in circulation is corporate paper—not U.S. currency. 

            Whenever there is a panic—a stock market crash, a war, or whatever--the market freezes up and banks temporarily stop accepting corporate paper for debt payment. They demand cash.  So then these assets cease to be liquid—they stop being money.    Of course, some of them, such as subprime real estate, should never have been money in the first place.  But when the crash of 2008 hit, banks not only stopped accepting questionable mortgages, they didn’t want good ones either.

             So this produced a liquidity crisis, as a lot of the money in circulation just stopped being money and stopped circulating. About 3 trillion dollars worth of liquidity instantly ceased to exist.  But the instruments, the bonds, mortgages, promissory notes, etc, still exist somewhere.  And if the economy ever fully recovers, banks will start trading them.  And all 3 trillion bucks worth will become part of the money supply.  And that’s why I get a little nervous about quantitative easing.  Just about the time that unemployment gets down to normal, all of the dollars that Mr. Bernanke has added to the economy will have some unexpected company, as this slug of commercial paper suddenly becomes liquid again.

            At that point, the Fed will try to shrink the money supply by selling off commercial paper in exchange for cash.  As they trade bonds for cash, this removes cash from circulation, but it might not really remove much money, because by then the bonds put back into circulation will have become money again.  And every month, even more of this money will be created as every corporation in the country begins issuing more corporate debt.   And it isn’t just corporations that do this. You and I can expand the money supply.  Some years back, my brother took out a home improvement loan, secured by a mortgage.  Over the time he paid it back, he ended up mailing interest and principle payments to a different bank every month.  He originally borrowed it form a local bank, but that note was traded to banks all over the country.  He had, in effect, increased the money supply.  

            I would suggest that we don’t even have a general agreement as to what “money” is.  If a credit card company informs you that you have an additional $10,000 line of credit, is that money?   Well, it would spend the same as money—wouldn’t it?  So how much control does the Fed have over the money supply when every man Jack can create the stuff?

            So far, monetary policy has not produced much result.  The stimulus did produce results. It is the reason that unemployment never got much above 10% rather than ballooning to 25%, as it did in the Hoover administration.  If we had a million businesses that had no access to credit but had customers banging on the door, then monetary policy might create a few jobs.  But right now, American corporations are sitting on 3 trillion bucks and they aren’t spending any of it. They do not need cash or credit—they need customers.  Business needs a whole generation of young people to begin entering the middle class, and not a generation of middle aged consumers falling out of it. Business needs the unemployed to have jobs—jobs secure enough that the workers are not afraid to spend what they earn—but even more important, business needs the underemployed to earn more discretionary income.

             The stimulus was large enough to keep unemployment from becoming disastrously worse, but not large enough to really cure it.  And none of the quantitative easing has cured it either. I suppose that if we were to dump enough dollars on the market, we would eventually bid down the value of the Dollar to where those who hold dollars would start panic buying, hoping to unload dollars while dollars can still buy something. But this is a pretty dangerous game. The main peril of relying on monetary policy alone, aside from the fact that it doesn’t work, is that it’s a lot easier to throw those dollars out there than to ever call them back.