We are in the third act of the theatre of the absurd.
In the first act, Chairman Bernanke created QE1, through which the Fed bought $1.75 trillion of assets from banks—mostly trashy mortgage backed securities, but also a lot of government debt.
This filled banks with a trillion dollars of excess reserves. It is extremely difficult to fathom just what result Bernanke thought this would have—but whatever that might have been, he is not happy. The NYFed estimates this unprecedented purchase of long term assets lowered long term interest rates by 50 basis points. A half of a per cent.
Obviously, even with very optimistic estimates of the interest rate elasticity of spending, even in the best of times that would have had such a small effect on spending that it would fall within the error term. And if Bernanke thought that pumping banks full of excess reserves might generate some incentive to lending, that is only because he has almost no understanding of the way banks operate. Banks do not lend excess reserves. And excess reserves do not incentivise them to lend.
So now we are in act two: QE2. Now the Fed will focus its attention entirely on purchases of longer term treasuries. Again, this seems to be predicated on two faulty propositions. First, if a trillion dollars of excess reserves won’t do it, then let’s give them another $600 billion.
Just what was that definition of insanity? Oh, right, if something does not work, keep doing it over and over. The second proposition is that this will lower long term rates. Ok, based on the NYFed’s estimates, the additional purchases might lower long term yields on treasuries by 18 basis points.
It is hard to see that as a useful goal even if it might be achieved. But if Bernanke’s goal were to lower long term yields, the most efficient and surest way to do that is to simply announce a target rate—say, 2% on 10 year treasuries—and then start buying them until the yield drops to the target.
Actually, it would almost certainly drop there before any purchase were made. Who wants to bet against the Fed? It has got its “checkbook” in hand, and as Bernanke has testified, it can buy as many assets it wants through keystrokes.
What exactly is QE2? The Treasury is running a large budget deficit, that will reach perhaps $1.4 trillion this year. Like the Fed, it spends through keystrokes, simultaneously crediting the demand deposit of some recipient, and also the bank reserves of the recipient’s bank. So, the deficit creates reserves exactly dollar for dollar–$1.4 trillion this year.
All of these will be excess reserves. Then the Treasury (and, normally, the Fed) sells treasuries to drain some of those excess reserves to offer a higher interest rate to banks. So, say it sells $1.4 trillion worth of treasuries. Banks are happy to get somewhat above 2% on treasuries rather than 25 basis points on excess reserves. Enter QE2. Bernanke buys back $600 billion of treasuries, removing the higher interest rate assets and restoring the excess reserves. And that is somehow supposed to save the banks and the economy?
Act 3. Congress is hysterical about the growing treasury debt, issued to drain excess reserves from banks. And then bought by the Fed to put the reserves back.
Solution: do not raise the debt limit. Stop selling treasuries. Leave the excess reserves created by budget deficits in the banks. Stop QE2.
Since reserves are not counted as government debt, the US government debt will stop growing. We can all find something more appropriate to worry about.
L. Randall Wray is a Professor of Economics, University of Missouri—Kansas City. A student of Hyman Minsky, his research focuses on monetary and fiscal policy as well as unemployment and job creation. He writes a weekly column for Benzinga every Thursday.
He also blogs at New Economic Perspectives, and is a BrainTruster at New Deal 2.0. He is a senior scholar at the Levy Economics Institute, and has been a visiting professor at the University of Rome (La Sapienza), UNAM (Mexico City), University of Paris (South), and the University of Bologna (Italy).
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