A toxic toolkit
Jul 23rd 2010, 18:07 by G.I. | WASHINGTON
[Greg Ip] Asked Wednesday what he’d do if the economy needed more stimulus, Ben Bernanke was noncommittal: “We are going to continue to monitor the economy closely and continue to evaluate the alternatives that we have.”
Mark Thoma (here and here) is dismayed that Mr Bernanke, given the time the Fed has had to study this, doesn’t seem to know what he’ll do. Robin Harding says Mark is unfair: what Bernanke does will depend on what happens, and then on developing a consensus with his colleagues.
Robin is right that what the Fed would do differs depending on whether it faces a liquidity crisis or a shortfall in aggregate demand and rising threat of deflation. Yet Mark is also right that this does not exonerate Mr Bernanke. That he knows what to do in a liquidity crisis (more lending to banks and shadow banks, more discount window loan auctions, etc.) is of small comfort since such a crisis is not in anyone’s forecast. To echo Mark, the question is, how will you deal wth the plausible forecast of inadequate demand, disturbingly high unemployment and low inflation bordering on deflation? That the Fed has a plan for when another fire breaks out on its drilling rig is fine, but where’s the plan for capping the well that’s already spewing oil into the ocean?
I think the reasons for Mr Bernanke’s reticence are two fold. First, he’s genuinely optimistic the economy will be okay, in part because he’s sanguine about the expiration of fiscal stimulus.
If it becomes clear in the current quarter that that optimism is misplaced, I think the Fed will swing into action quite quickly. Naturally, he didn’t say this week just what the Fed would do; Fed chairmen never do until after the FOMC votes. The FOMC’s internal divisions I think are not a deterrent. If Mr Bernanke wants to do more, the FOMC will fall in line in short order. Only a minority of FOMC members are opposed to more quantitative easing (QE), but because they’re so vocal, it gives the impression of more opposition than really exists.
I think Mr Bernanke himself, however, is ambivalent on the benefit of more QE. He’s not sure of the unintended consequences of printing all that money. And the next round of QE will have less impact than the first because the spread between mortgage rates and Treasury yields has collapsed since the first round of QE. So the benefits of more QE are smaller and the costs greater than they were a year ago.
The Fed is not helpless; it has two powerful tools left – but both are politically toxic. One is unsterilized foreign exchange intervention: buying foreign currencies with newly printed dollars, as the Swiss National Bank has done to hold down the franc. This would both stimulate net exports by pushing down the nominal value of the dollar, and alleviate deflation pressure by pushing up the price of tradable goods. (In theory, unsterilized intervention expands the money supply and ultimately, raises the price level, so the real exchange rate is unchanged even if the nominal exchange rate falls.) But the Fed won’t do this without the Treasury’s approval, which for its part doesn’t want the rest of the world accusing it of exporting its deflation.
The other tool is a money-financed fiscal expansion: the infamous helicopter drop of money. Buying bonds on the secondary market, as the Fed already has done, stimulates demand only by lowering interest rates. Unless the banks take the money they got in exchange for the bonds they sold to the Fed, then plough it into other, riskier assets (like loans), there’s no direct boost to boost aggregate demand. By contrast, buying newly issued bonds specifically to enable the federal government to spend more money would be a powerful boost to demand. But this needs the federal government to agree to a lot more fiscal stimulus and the Fed to set aside concerns about being the Treasury’s hand maiden. Neither looks likely.