Sunday, March 8, 2009

Central Banks and "quantitative easing" to contain recession

Central Banks, driven to the zero-bound with interest rates and faced with prospects of liquidity trap, are resorting to "quantitiative easing" (and here), wherein they print money to buy longer-term treasuries or other assets, including commercial paper, with the aim of expanding the monetary base.

Liquidity trap makes conventional monetary policy impotent because during such times, when T-bills have a near-zero interest rate, cash (monetary base) and T-Bills - two sides of the Fed's balance sheet - become perfect substitutes. In that case, if the Fed expands its balance sheet, it’s basically taking away with one hand what it’s giving with the other - more monetary base is out there, but less short-term debt, and since these things are perfect substitutes, there’s no market impact.

Under the circumstances, Central Banks need to look at more unconventional monetary policy solutions. Ben Bernanke (working paper here) had earlier advocated that Central Banks expand their balance sheets with purchases of other assets in a liquidity trap scenario, and the Japanese authorities had resorted to such "quantitative easing" in a big way during its nineties crisis. The Monetarists led by Milton Friedman had long claimed that the Fed can expand and tighten monetary base to control money supply and thereby prevent recessions and depressions.

They claim that the Fed could have prevented the Great Depression if only it has been more aggressive in countering the fall in the money supply, an arguement, which as Krugman claims, "later mutated into the claim that the Fed caused the Depression"! But as the examples of Japan in the nineties and the US (banks' excess reserves have rocketed) during the recent crisis shows, this claim appears not to be grounded on reality.

Paul Krugman doubts the efficacy of trying to raise the price of financial assets other than T-bills by selling T-bills and buying other stuff by "quantitative easing", especially at times of such deep uncertainty, bordering on a depression. He quotes three reasons for his doubts

1. Given the size of the market, and the depths to which asset prices have dropped, the Fed may need to massively expand its balance sheet to achieve any noticeable effect on the markets. The enormity of the task is underlined by the fact that the total monetary base is only $800 bn, whereas there are many trillions of stuff other than T-Bills.

2. T-bills and other assets, such as long-term bonds, are probably much better substitutes for each other than T-bills are for monetary base — money is unique as a medium of exchange, whereas once you get past that you’re only talking about competing stores of value. So it should take much larger changes in relative supplies to get major changes in asset prices.

3. The reason T-bills are an imperfect substitute for, say, corporate bonds — to the extent they are — is risk. Therefore, the reason changing the composition of the Fed’s balance sheet can move prices, to the extent it can, is because the Fed is taking on risk. This isn’t a role the central bank is meant to play; you’re sliding over into fiscal policy.

Update 1
Paul Krugman has this excellent presentation that argues how the Japanese crisis and the present one have demolished the monetarist claims that the Fed could easily have prevented the Great Depression, that monetary policy is always effective, and that discretionary fiscal policy is unnecessary and usually counterproductive.

And this post nicely sums up the difficulty of the situation facing the US banking system now, even with the example of Japan behind us.

No comments: