Thursday, October 21, 2010

The QE 2 debate in perspective

Ben Bernanke's recent speech has set-off heightened speculation about a second round of quantitative easing (QE) being round the corner in the US.

The debate about QE represents the classic economic problem. On the one hand, the supporters point to an economic environment with idling resources - both capital (cash surplus businesses postponing investment decisions) and manpower (unemployed labor) - and weakened animal spirits. In the circumstances, restoration of market confidence can be done only through government interventions, either by way of direct government spending or incentives to encourage businesses to change their investment and consumers their consumption decisions.

On the other hand, such interventions result in increased deficits and debt stock. And this is where opponents draw attention to the danger of stoking inflationary pressures, which in turn puts upward pressure on interest rates. They also point to government borrowing ultimately (and through different channels) crowding out private borrowers and investments. And we know that all this will end up tipping the economy back into recession.

The supporters counter by arguing that all the aforementioned "Treasury View" arguments do not apply when the economy is facing the nominal zero interest rate and resultant liquidity trap. When faced with the zero bound and pervasive gloom, all conventional approaches loose traction, and only governments have the firepower to lift the economy back into a sustainable growth path.

They claim that the danger of doing nothing for fear of inflation and debt spiral is the real possibility of a long-drawn out deflation-induced recession, even a depression. And they highlight the case of Japan and the striking pre- and post-crisis similarities between the US now and Japan of the nineties. They say that Japan's nearly two-decade long troubles underlines the fact that a deflation-induced stagnation is much worse than an inflation induced recession.

Opponents see a slippery slope in this argument. They question the benefits of the earlier round of quantitative easing. They allege that far from saving the economy from any collapse, the TARP doled out tax payer money to bailout greedy bankers and their financial institutions, which they argue should have been allowed to fail. They also point to the fact that even after the $787 bn fiscal stimulus, unemployment rates and output gaps remain at historic highs.

They also argue that any further monetary accommodation and credit expansion will only exacerbate the process of resource mis-allocation in the financial markets, already evident from the rising stock markets. The QE way of stimulating recovery, they caution, carries the considerable risk of inflating another bubble with all its attendant market distortions. It only postpones the inevitable and necessary rebalancing required to wring out the excesses that had got built into the world economy. They therefore not only oppose further QE, but also calls for exiting monetary accommodation.

So who is correct? I am inclined partially to both sides. The fiscalians are correct that there exists the possibility of a long-drawn equilibrium of stagnation, which can be averted only with government intervention. The austerians are correct about the slippery slope and the dangers of a new bubble. The difficulty, even impossibility, of separating cause and effect (like in so many other areas of economic policy making) means that we will never be able to satisfactorily resolve the dispute about whether TARP and ARRA succeeded or failed, leave alone how much they contributed towards the present employment and output conditions.

As Nobel laureate Myron Scholes recently pointed out, a decision to proceed with expansion through policies like the QE has uncertain consequences. Though it lowers the uncertainty associated with government's commitment to keep interest rates low and stimulate the economy, going ahead it also engenders uncertainty about the economy, especially about the problems with exiting from QE and the possibility of inflationary pressures taking hold.

On the policy makers' third-hand, the challenge then is to reconcile these two apparently contradicting yet plausible positions and tailor policies that mitigate dangers without sacrificing the benefits of fiscal and monetary expansion. For a start, they could begin with interventions that deliver the greatest bang for the buck with the least macroeconomic distortions and adverse long-term consequences. Continuation of the automatic stabilizers and interventions like assistance to states are the least controversial of such policies.

The fears about crowding out and inflation taking hold are easily dismissed. Deflation and not inflation looks like the more important concern. The fears about crowding out looks positively out of place in an environment where business expectations are anemic and the credit markets are flush with funds.

Also, the fears of stimulus spending rocketing up deficits and debt stock are not borne out by facts. The stimulus expenditures - even with a large third round of stimulus - a very small proportion of the long-term debt projections. The deficits have exploded due to a stagnating economy and reduced revenues, and even without any spurt in government expenditures.

The more pertinent dangers are with resource mis-allocation. Is it possible to structure expansionary policies which have minimal resource mis-allocation possibilities? Should we raise sectoral capital adequacy ratios and their risk weights so as to disincentivize and limit resource flows into those sectors? Ultimately, debates about macroeconomic balancing reverts back into issues of appropriate regulation of the financial markets.

What should be the policy transmission channels and how should the recovery look like? The ideal outcome would be for the expansionary policies to stimulate aggregate demand without generating financial market distortions. Fiscal policy should employ idling labor resources and government spending should put money in the hands of people who are likely to spend and thereby boost aggregate demand. This in turn should increase business confidence and encourage businesses to go ahead with their investment and hiring decisions.

The unconventional monetary expansion should lower the cost of capital, especially long-term capital, for businesses and governments, and thereby encourage and bring forward business investment decisions and lower the real cost of the public debts run up to finance the fiscal stimuluses. It should also provide the time and opportunity for businesses and households to repair their badly bruised balance sheets. All the while, the aforementioned specific regulations should play their role effectively in preventing the build-up of financial market imbalances.

In other words, instead of debating the relative merits of the respective positions of fiscalians and austerians and fighting fictitious (and ideological) battles against inflation and debts, we ought to be discussing about having in place approppriate regulations to address the possibility of market distortions arising from the expansionary policies.

Update 1 (24/10/2010)
Paul Krugman questions the effectiveness of QE 2, since the net risk remains within the government. He writes that "QE2 amounts to a decision by the US government to shorten the maturity of its outstanding debt, paying off long-term bonds while borrowing short-term".

Taking the Treasury and the Fed as a single entity, any quantitative easing would merely involve redemption of long-term debt (through re-purchases by the Fed) using money generated by expanding the monetary base. sales of new short-term debt instruments. Given the fact that at close to the zero-bound, cash and T-Bills are close substitutes (both pay nearly zero interest rates), it is just as if Treasury sold 3-month T-bills and used the proceeds to buy back 10-year bonds.

Update 2 (17/11/2010)

Mark Thoma has an excellent post on QE II. He describes QE II as, "It is conventional monetary policy that operates at the long end of the yield curve through the buying and selling of long-term financial assets rather than through the more traditional buying and selling of short-term assets. The need to operate at the long end of the yield curve presently is not because the Fed has lost control of long-term rates... it’s because the Fed can no longer move rates at the short-end."

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