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QE Is Untested and Ineffective

David Malpass | 11/16/2010
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These issues are the crux of the debate and should be argued thoroughly, especially since U.S. is not in a financial emergency. By undertaking large-scale purchases of long-term assets with very little equity behind it, the Fed is drastically expanding its role in the bond market and in the economy. Owning long-term assets financed by overnight deposits (as the Fed is now doing) is as far from garden-variety monetary policy as good banking is from bad.

Unfortunately, Dr. Blinder colors the debate at the outset, terming critics of the Federal Reserve “the economic equivalent of the Flat Earth Society” even though the Fed has suffered severe monetary and regulatory policy blunders over the years. Even after the housing bubble related to super-low Fed interest rates, the Fed has done little to rebuild confidence in its policy judgments.

In a garden variety monetary policy, the Fed owns short-term assets like Treasury bills, balanced by short-term borrowings from banks. Because the maturites are matched, interest rate increases would have little impact on the Fed’s earnings or net worth. This assures the Fed a great deal of latitude in pursuing price stability, giving investors confidence that the Fed can sell Treasury bills and allow interest rates to rise as needed without itself losing money.

By buying longer term assets, whose value will decline when interest rates rise, the Fed is engineering a fundamental change in the nature of U.S. monetary policy. This has undercut global confidence in the Fed, as reflected in high gold prices, dollar weakness, and large-scale investments abroad by U.S. companies and wealthy individuals.

Of equal concern, the Fed’s asset purchases interfere with prices in the bond market, at least temporarily increasing the value of the bonds the Fed buys. Wall Street loves this aspect of the Fed’s asset purchase program because it has been able to buy the assets before the Fed does, creating almost sure-fire profits. If the Fed were to expand into purchases of private securities, as Dr. Blinder has advocated, the potential for bond market distortions and opportunities to profit by buying ahead of the Fed would be even greater.

As for the Fed’s ability to foresee and combat inflation, a key question mark in the Fed’s program to expand its balance sheet, the Fed claimed a moderation in inflation to justify its ultra-low interest rate choices in 2003 and forward. Yet inflation frequently topped 4% in 2005-2008, with no evidence that the Fed has improved its crystal ball enough to avoid a repeat. Dr. Blinder says he’s sympathetic with the view that buying Treasury notes is a weak policy tool and therefore won’t be very inflationary, but this begs the question – why embark on a fundamental change in the Fed’s approach to monetary policy if the tools are weak?

One of the biggest complaints about the new Fed stimulus is that it directs the nation’s credit toward the government and corporations big enough to issue bonds. Since small businesses, especially new businesses, create the lion’s share of jobs, Fed asset purchases are likely to harm the nation’s job creation by underpricing capital for the government and corporations, at the expense of small businesses. In the Fed’s ultra-low interest rate experiment of 2003-2007, excess home building and auto production were subsidized by businesses that didn’t need cheap credit, causing a double harm when the housing bubble popped without strength in other parts of the economy. Already in this global expansion, plentiful credit is being channeled to emerging markets and commodities at the expense of savers and small businesses, a good opportunity for aggressive investors but a loss for the many businesses that don’t have access to cheap credit or have to compete with businesses that do.

Critics of the Fed’s $600 billion asset purchase program can draw parallels to the $800 billion 2009 fiscal stimulus program – both are major expansions of government that are far-removed from job creation. Dr. Blinder’s article turns this into a straw man, arguing that critics of Fed asset purchases are as clearly wrong as critics of government spending. He says government spending can’t kill jobs under present circumstances because there’s slack in the economy. Again, this is the crux of the debate – expansions of government, whether fiscal or monetary policy, discourage private sector jobs by undermining business confidence about future taxes, the stability of the dollar, and market interference by the government.

Dr. Blinder chose not to argue that Fed asset purchases are vital to the survival of the economic recovery or the financial system. In effect, he’s created a low bar for defending Fed asset purchases – they may not be very helpful but it’s OK to try them. I think there should be a higher bar -- unless Fed asset purchases are in some way necessary to the economy’s survival, the assumed harm from an expansion of government, which is at the core of our principles of limited government, argue against Fed asset purchases.

One of the messages from the November 2nd election was a demand from the people to the government to downsize spending, taxation, power and intrusion into America’s economy and culture. This is a hard message for Washington to accept because it means less power, less influence. Both fiscal stimulus and Fed asset purchases raise the same giant red flag. As the government expands its role in the economy, business confidence and hiring decline in the knowledge that there’s no free lunch.

David Malpass served as deputy assistant Treasury secretary in the Reagan administration and is president of Encima Global LLC.


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