Thursday, 19 October 2017


Saying Goodbye to Price Stability

Posted by
April 5, 2011
in Blog

America’s monetary policy has been going rogue ever since the Great Recession began. Mr. Bernanke, a man, whose position I by no means envy, has taken certain unprecedented steps, since the crisis, with the aim of helping get America’s economy back on track. I do not doubt Mr. Bernanke’s intentions (I know he means well); nor do I doubt his sincere belief, that the policies that are being pursued by the Federal Reserve, under his leadership, will help the Fed fulfill its mandate of maintaining maximum employment. However, there is more to making sound policies than just meaning well.

Mr. Bernanke’s purchase of long term assets—what we infamously call QE2—when explained in theory sounds, indeed, magnificent. A brief explanation of what the (perhaps, misnamed) QE2 is meant to achieve: according to Mr. Bernanke the purpose of the long term asset purchase is, not in any way to increase the monetary supply. Rather the purpose of the policy, at least, from the Federal Reserve’s perspective is to ease credit. The Federal Reserve believes that the purchase of these assets would decrease long term interest rates. Since interest rates have an inversely proportional relationship to prices, this would mean an increase in asset prices. According to the Fed’s reasoning, the low interest rate brought about by this policy would play two important roles: First, it would incentivize borrowers—inventors, industries, home owners, etcetera—to borrow. If people who do business can borrow and spend that money somewhere else, then that would help jump start the economy. Second, the increase in asset prices that result from this policy would increase the value of collaterals. The increase in the value of collaterals would allow for more lending in the money market. An ease in money market lending would allow banks to lend even more to borrowers. This is because, the Fed has reasoned, borrowers in the money market would be able to present these high valued collaterals for short term loans in the money market, should they become illiquid (this is what Mr. Bernanke calls the financial accelerator).

Alright, I know that the reasoning behind this policy—abstract though it seems—sounds kind of impressive; except, it just looks at one side of the equation—the credit side. I would not dispute the Federal Reserve’s claims that its policies would decrease interest rates and ease credit. In fact, it might. But that doesn’t necessarily mean that we are going to be better off. What the Fed has not sufficiently explained is how it is going to deal with the excessive increase in monetary supply that would ensue, should it fully follow through with this policy. As a student of financial history, I have not seen any time in history, where after a crisis, a Central Bank’s actions helped people get over their hesitation to borrow. People usually hesitate to borrow after a crisis because, having learned their lessons from the previous euphoria, they tend to be very cautious. And so do banks. Usually, in order for very robust lending and borrowing to begin after a crisis, there must be some exogenous force, a highly profitable venture, say, from which people believe they could profit. But the Federal Reserve cannot produce that profitable venture. It comes about, when, after slow and steady lending and borrowing, somebody comes up with some impressive idea, say, or an interesting product, which attracts investment, and induces people to get on the “money train”, before it gets too late (usually this leads to booms if it is not caught early, as it did with the housing market when the Federal Reserve failed to raise interest rates). Without that, growth usually tends to be slow, but eventually it comes around. As it is the American economy is experiencing that phase of growth already, albeit at a slow pace. But that is to be expected, given the severity of the recession. By pursuing policies that reduces interest rates, the Federal Reserve is risking inflation, despite the absence of a guarantee that the policies are going to work, for reasons aforementioned.

The Federal Reserve’s QE2 policy is unwise and needs to be halted immediately because, first, spending $600 billion on a policy– which is only a gamble, at best– is not worth the cost: inflationary pressure on the dollar. Second, the economy is gradually picking up, as it always does, slowly but surely; and if robust lending or borrowing is going to happen, it is going to happen because both lenders and borrowers see it to be mutually beneficial. It is not going to happen because a third party –the Fed– has established an artificial environment for it to happen. (Setting an environment for lending and borrowing to occur makes no sense if there are no profitable ventures out there, from which both investors and borrowers can—at least by their estimation –profit.)  Lastly, and most importantly, the Federal Reserve, in pursuing these policies, is sacrificing its price stability mandate in order to achieve another– the maximum employment mandate.

Sadly, however, it might fail to achieve either of those if it continues the current trend. The reason is this: it is hard to figure out how maximum employment can be achieved with a worthless currency.


  1. Henry April 14, 2011 1:23 PM

    I don't quite get your argument Dmitry. Both Tom and I agree that monetary supply would be increase through the Fed's QE2 policy.The question is which part are you focused, as an economist: is it the credit side or the monetary side.As I said the Fed is focused on the credit side. Tom and I, and perhaps you, are concerned about the monetary side, and that was the purpose of this blog in the first place–that there might be inflation as a result of the Fed's policy.

    What Tom and I seem to disagree on is whether an extra $600 billion is effectively going to increase borrowing, merely because interest rate decreases: the very reasoning behind the Fed's QE2 policy. On this, the substance of your argument seem to side with me. And so I am a little bit confused. But you make some compelling arguments nontheless

  2. Dmitry April 14, 2011 3:13 AM

    It appears that QE2 is exactly what Tom has mentioned, "money pumped into the system", rather than a method to "not in any way to increase the monetary supply". Keeping the interest rates low is achieved primarily through expansion of money supply – pumping money into the economy. In this case, the open market operations take form of massive purchase of private, rather than public, credit. Especially, and I perhaps misperceive, but how much lower can the near-zero interest rate go? Moreover, a strategy of easing the possibility to take credit through increased price of the collateral – housing – sounds a lot like the major cause for the recent recession. Is this a wise strategy to rise prices of housing artificially? Is that beneficial for the American people who are now – just recently and incrementally getting out of unemployment and finally earning sufficient income to afford mortgage – to raise housing prices? I don't see the logic for government intervention when individuals would eventually raise housing prices anyways by the means of market mechanisms. $600 billion is also a figure that barely adresses another crucial issue of the American economy – growing budget deficit. Why is fed so eager to assume a central stage in this gig? If we are speaking about a demand-side recession, it seems a lot more wise to achieve a rebound through increased federal spending on infrastructure that President Obama has eloquently promised – here's a place where $600 billion could come in handy. Finally, inflation should not be a central issue in this discussion. Unless we are speaking about significant figures (say 8%) it is not an issue. Rather inflation, resulting in depreciating dollar, will be beneficial for our stagnating export industry. So let me join the ranks of those who criticize the above policy – after all, it does give us at least 600 billion reasons to be critical of.

  3. Tom Duncan April 6, 2011 9:03 AM

    There is, of course, uncertainty in the market (caused by a variety of factors, including regulation, fiscal policy, military policy) that would make people hesitant to invest, but it may be possible to construct an argument that this hesitation is mostly on the supply side rather than the demand side. Even though there is enough money pumped into the system to theoretically push interest rates low, I may not wish to lend my money out onto a market where I think people are more likely to undertake incredibly risky ventures.

    • Henry April 6, 2011 11:53 AM

      Both of your arguments are not necessarily wrong. They are in fact valid. But first I will explain a few things: after a crash what usually happens is that there is a lack of credit. As Bagehot defines it: credit is "trust". If I say person A has a good credit, in essence what I am saying is if I give him X amount of money, I trust that he would pay me, as he has promised to, at time Y. After every recession the lack of credit result–it is in fact part of human nature to be hesitant after a particular euphoria comes to a spectacularly painful end. So I agree with u when you say that the hesitation could be on the supply side. However, to say that it is solely on the supply side is an argument that is hard to fathom at best. Here is why:For an investor to invest in something, he has to first know that that thing is going to yield some decent profits. I doubt that any serious investor would unhesitatingly go back, in our case, to invest millions in the housing market; in which case housing prices would have gone up desirably already(it has not).And it make sense because busts do not just happen–they happen because usually, as a result of the euphoria, the supply tends to be way in excess of demand. But we know that naturally, for the money supply to increase, or for interest rate to go down prices(especially of stocks and bonds) must go up. That is usually indicative that people are comfortable investing again, in which case banks and other financial institutions become incentivized to lend to more people in order that they can make profit. And so the supply and demand, in this case, are two sides of the same coin: You are incentivized to supply so long as you know that there are positive signs out there that suggest that there is going to be real demand– demand that does not have much risk attached to it. But we know that the decrease-in-interest rate policy that the Fed is pursuing right now is, as I have explained, to allow prices to go up, and encourage people to borrow. Thus the amount of money in the system is not mainly as a result of people investing, but rather the Fed is using it to get people to invest (which they believe would, in turn cause more borrowing). Now if you follow this argument, it becomes clear that this still doesn't change the fact that there is nothing seriously appetizing into which serious investors are interested . But since we know that growth had started already,albeit at a slow pace before QE2(and is still is) we could conjecture that the patterns of growth could have still been what it is, regardless of the Fed's policy. And our conjecture would be right because three years is usually how long it takes for an economy to grow after a recession. And usually robust lending and borrowing(and as a result growth) does not sprout overnight. So according to your argument, if the Fed's low interest rate would allow more people to borrow and invest; then perhaps growth in the economy should have been very robust already, and perhaps housing prices should have been flying high up in the skies; but it is not. This suggests that investors are waiting for the market to yield that thing that they would find profitable, and as of now the Fed has not been able to create that thing through its monetary policies.

  4. Tom Duncan April 6, 2011 9:01 AM

    While I am obviously not a fan of the Federal Reserve’s monetary policy, I would like to push you on a few points.

    How do you deal with the argument that the Federal Reserve is creating the illusion of profitable ventures by the very nature of interest rate manipulation? When the interest rate is pushed artificially low, then ventures that were unprofitable at the higher interest rate do become more profitable at the lower due to the differences. A return on the investment above the interest paid for borrowing is a strong incentive to produce. The venture does not have to be profitable in the long-run. Short-run gains could be enough to induce borrowing. If the borrower believes he can beat the odds, getting quick profits and then getting out before the next crash, then he has incentives to take the risk. Profitable ventures do not have to be exogenous, as the rate of return is dependent on the rate of interest at which one borrows.