Wednesday, November 3, 2010

Helicopter Ben Goes Off the Deep End

News Alert
from The Wall Street Journal

The Federal Reserve unveiled a controversial new plan to buy U.S. Treasurys, hoping to spur growth in a slow U.S. economy.

After two days of discussions, Fed officials decided to go ahead with a much anticipated program, saying they will buy $600 billion of U.S. government debt over the next eight months. The Fed's policy-setting body said it stands ready to purchase more bonds if the economy's persistent weakness leads inflation to remain too low and unemployment too high.

No less than Martin Feldstein thinks this is bad monetary policy.  Feldstein notes,

"Under the label of QE, the Fed will buy long-term government bonds, perhaps one trillion dollars or more, adding an equal amount of cash to the economy and to banks’ excess reserves. Expectation of this has lowered long-term interest rates, depressed the dollar’s international value, bid up the price of commodities and farm land and raised share prices."

Read more about his take on it here.   

I agree with Martin Feldstein.  Let's see if we can figure out how the Fed's latest, greatest monetary policy action (a.k.a. "quantitative easing") will affect the economy.  

When the Fed purchases $600 billion of U.S. Treasurys, it will do so with newly created money.  That is, the Fed will write checks to the current owners of those U.S. Treasurys to pay for them, and the current owners of those U.S. Treasurys will deposit those checks in their bank accounts.  The Fed will add those U.S. Treasurys to its massive portfolio of federal government debt. Bottom line: the Fed will create $600 billion in new money.

Incidentally, the Fed's purchase of $600 billion will create room for the U.S. Treasury to create and sell new U.S. Treasurys.  In other words, the U.S. Treasury will attempt to borrow what has not yet been produced.  You can read here  and here  about how well that works out. 

Any new production of goods and services so far?  No.  Any new jobs created so far?  No.  Fortunately, that's not the end of the story.  If it were, everyone would surely understand that the Fed's policy will not help America shed its slow growth shackles nor help create new jobs. But the story is complicated enough that the wool can be pulled over our misplaced trusting eyes.  The Fed's been doing it for at least 98 years.

Next step.  What will the previous owners of those U.S. Treasurys do with the new money they now have? By the way, those previous owners could be lots of different folks.  They could be you or me, they could be some bank, they could be some Chinese bank, they could be some business, and they could even be the U.S. Treasury itself. They could be anyone at all who happens to own a U.S. Treasury of the maturity the Fed decides to buy.

Consider the possibilities for what the previous owners can do with the new money: (1) buy some real goods or services, (2) keep the new money in their bank accounts indefinitely, (3) change their minds and buy newly issued U.S. Treasurys after few days or weeks pass, (4) buy some other financial assets, such as corporate stocks or bonds, or (5) buy some real assets like a plot of land, a vacation home, a rare painting or maybe even gold! 

Choice (5) appeals to folks who fear the Fed's expansion of the supply of money will ultimately lead to higher inflation.  They hope the prices of real assets will protect their wealth.  They could be right. But option (5) will not lead to economic growth or new jobs.

In fact, choices (2) through (5) do not and will not directly result in new production of goods or services or new jobs created. 

Option (2) would increase commercial bank reserves, which could lead to banks expanding loans in the fullness of time, which could lead to production of new goods and services --- provided the new loans were made to businesses who want to expand productive capacity and hire more workers. 

But why would we expect that to happen, since commercial banks already have mountains of excess reserves and could already make all the new loans to businesses they wanted to make --- if only businesses wanted to expand productive capacity and hire more workers.  But they don't just now.  Why not?  They are afraid to expand capacity and increase cost of production in the current political-economic environment.  Can you blame them?

Of course, banks could extend new loans to households.  Presumably, those households would be borrowing to buy real stuff.  But how will those households pay back those loans?  

Consumers who borrow to finance current consumption will need future income to pay back both principal and interest.  How will borrowing consumers generate that future income?  They would need jobs or their own productive, value-producing business to do so.  

Consumers who borrow today to finance current consumption are betting on an uncertain future.  Lots of households did that during the housing bubble.  Those borrowers were not particularly good seers of the future, evidently.  Betting on the come is dangerous in poker and in consumption of goods and services, particular when the government is creating massive uncertainty about taxes and its own deficit spending.  

But new loans made to households who want to spend beyond their means will not generate new production or create new jobs.  Remember, we just tried that one; it helped cause the housing bubble, all those foreclosures, and the Great Recession.  

Incidentally, new loans made to consumers could cause inflation in the prices of consumer goods much sooner instead of later. New money chasing the same quantity of goods and services does lead to rising consumer prices.  I guess the Fed doesn't think that will happen. Or maybe the Fed just doesn't really care about that outcome.  You decide which is the case.

In the fullness of time, options (4) and (5) would cause the prices of financial assets like corporate stocks and bonds, and the prices of real assets like houses, rare paintings, or gold to rise.  But the official CPI numbers will not count that as inflation, since the Consumer Price Index does not include such assets in its market basket of goods and services purchased by a typical urban household.  Consequently, no increase in inflation  (a.k.a., loss in purchasing power of each and every dollar in existence) will be measured by the Department of Commerce.  Well, thank goodness; out of sight, out of mind.

With no rise in the CPI, the Fed will tell us that the new money it pumped into the economy did not cause a rise in inflation.  The Fed will be self satisfied, quite certain in it's collective minds that its policies are not causing inflation.  But wait. The story isn't over yet.

$600 billion is a lot of new money.  Do you suppose that such a huge amount of new money could fuel a bubble somewhere in some asset?  No?  Think again; that's exactly what happened with housing just a few years back.  Remember?  All that new money definitely must find a home somewhere.

Hey, if you can spot the next bubble before lots of other folks, get in early and get out before the bubble collapses, you can get rich!  Every cloud has a ..., you know the rest. 

Suppose the new money goes for option (5).  Since option (5) does not result in new production of real stuff, what do you suppose will happen eventually to the prices of consumption goods and services?  Eventually, maybe years from now,  the owners of the real assets like houses, rare paintings, or gold may want to purchase cheeseburgers, automobiles, and cloths. When they sell their houses, paintings, or gold to do so, then we could see the prices of cheeseburgers, automobiles, and cloths begin to rise.  Then we will see the CPI begin to measure the inflation that actually was present much earlier --- just unmeasured.

Of course, by the time consumer prices begin to rise, everyone will have forgotten the quantitative easing the Fed engineered.  And if everyone hasn't forgotten, the Fed will assure us that something else is causing the unexpected inflation --- certainly not its ancient policies.
Option (3) is a real doozy.  Option (3) is a round-about path for the Fed to simply hand new money over to the U.S. Treasury. Does that ever happen?  Sad to say, it does.  Of course, ANY purchase of U.S. Treasurys by the Fed ultimately finances U.S. Treasury spending, either immediately or later.  

We might actually be better off if the Fed Open Market Committee exercised its monetary policies through buying and selling a portfolio of houses instead of U.S. Treasurys.  At least then it would be builders who prospered when the Fed bought houses, instead of the U.S. Treasury.  Of course, if you like the way the U.S Treasury spends its funds, then you will prefer that the Fed buy U.S. Treasurys.

When the Fed buys newly issued U.S. Treasurys, it's obvious that the Fed is financing government expenditures with newly created money.  When the Fed buys seasoned (i.e., previously issued) U.S. Treasurys, the Fed creates space for issue of new U.S. Treasurys --- expanding federal debt.  The world has a large appetite for U.S. Treasurys, especially when the Fed is buying.

That leaves us with option (1) for the new money created by the Fed's purchase of $600 billion in U.S. Treasurys.  The previous owners of the Treasurys might actually buy real goods and services.  That could be a good thing, right?   That could lead to increased production and new jobs, right?  Yes, it could.  But will it?

Why would previous owners of U.S. Treasurys decide to buy real goods and services?  They could have bought real goods and services before the Fed created $600 billion in new money.  All they had to do was sell their U.S. Tresurys and spend the money on real stuff.  

Why would we think the Fed's creation of $600 billion in new money will motivate someone who owns U.S. Treasurys to buy goods and services, given that they could have done so before, but chose not to?  Evidently, Helicopter Ben thinks the previous owners of the U.S. Treasurys will change their saving ways and start spending --- just because the Fed pumps out new money.

This story has been a bit long, but if you have read this far, it's time for the punch line.  "You can't borrow what hasn't already been produced."  The U.S. Treasury can't borrow what hasn't already been produced either.  

Even if the Fed enables the U.S. Treasury to expand its borrowing by creating new money, that won't likely cause more goods and services to be produced.  But the Fed's new money will enable the U.S. Treasury to command a larger share of the U.S. economy.  The Fed's new money will enable the federal government to fight its wars.  The Fed's new money will take purchasing power out of your pocket and put it into the pocket of the U.S. Treasury.

Does the Fed's creation of new money sound something like stealing?  Maybe it will make you feel better about it if you just call it "the inflation tax."  Or maybe that term will just lead you to think about supporting Tea Party candidates next time around.

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