Saying Goodbye to Price Stability
America’s monetary policy has been going rogue ever since the Great Recession began. Mr. Bernanke, a man, whose position I by no means envy, has taken certain unprecedented steps, since the crisis, with the aim of helping get America’s economy back on track. I do not doubt Mr. Bernanke’s intentions (I know he means well); nor do I doubt his sincere belief, that the policies that are being pursued by the Federal Reserve, under his leadership, will help the Fed fulfill its mandate of maintaining maximum employment. However, there is more to making sound policies than just meaning well.
Mr. Bernanke’s purchase of long term assets—what we infamously call QE2—when explained in theory sounds, indeed, magnificent. A brief explanation of what the (perhaps, misnamed) QE2 is meant to achieve: according to Mr. Bernanke the purpose of the long term asset purchase is, not in any way to increase the monetary supply. Rather the purpose of the policy, at least, from the Federal Reserve’s perspective is to ease credit. The Federal Reserve believes that the purchase of these assets would decrease long term interest rates. Since interest rates have an inversely proportional relationship to prices, this would mean an increase in asset prices. According to the Fed’s reasoning, the low interest rate brought about by this policy would play two important roles: First, it would incentivize borrowers—inventors, industries, home owners, etcetera—to borrow. If people who do business can borrow and spend that money somewhere else, then that would help jump start the economy. Second, the increase in asset prices that result from this policy would increase the value of collaterals. The increase in the value of collaterals would allow for more lending in the money market. An ease in money market lending would allow banks to lend even more to borrowers. This is because, the Fed has reasoned, borrowers in the money market would be able to present these high valued collaterals for short term loans in the money market, should they become illiquid (this is what Mr. Bernanke calls the financial accelerator).
Alright, I know that the reasoning behind this policy—abstract though it seems—sounds kind of impressive; except, it just looks at one side of the equation—the credit side. I would not dispute the Federal Reserve’s claims that its policies would decrease interest rates and ease credit. In fact, it might. But that doesn’t necessarily mean that we are going to be better off. What the Fed has not sufficiently explained is how it is going to deal with the excessive increase in monetary supply that would ensue, should it fully follow through with this policy. As a student of financial history, I have not seen any time in history, where after a crisis, a Central Bank’s actions helped people get over their hesitation to borrow. People usually hesitate to borrow after a crisis because, having learned their lessons from the previous euphoria, they tend to be very cautious. And so do banks. Usually, in order for very robust lending and borrowing to begin after a crisis, there must be some exogenous force, a highly profitable venture, say, from which people believe they could profit. But the Federal Reserve cannot produce that profitable venture. It comes about, when, after slow and steady lending and borrowing, somebody comes up with some impressive idea, say, or an interesting product, which attracts investment, and induces people to get on the “money train”, before it gets too late (usually this leads to booms if it is not caught early, as it did with the housing market when the Federal Reserve failed to raise interest rates). Without that, growth usually tends to be slow, but eventually it comes around. As it is the American economy is experiencing that phase of growth already, albeit at a slow pace. But that is to be expected, given the severity of the recession. By pursuing policies that reduces interest rates, the Federal Reserve is risking inflation, despite the absence of a guarantee that the policies are going to work, for reasons aforementioned.
The Federal Reserve’s QE2 policy is unwise and needs to be halted immediately because, first, spending $600 billion on a policy– which is only a gamble, at best– is not worth the cost: inflationary pressure on the dollar. Second, the economy is gradually picking up, as it always does, slowly but surely; and if robust lending or borrowing is going to happen, it is going to happen because both lenders and borrowers see it to be mutually beneficial. It is not going to happen because a third party –the Fed– has established an artificial environment for it to happen. (Setting an environment for lending and borrowing to occur makes no sense if there are no profitable ventures out there, from which both investors and borrowers can—at least by their estimation –profit.) Lastly, and most importantly, the Federal Reserve, in pursuing these policies, is sacrificing its price stability mandate in order to achieve another– the maximum employment mandate.
Sadly, however, it might fail to achieve either of those if it continues the current trend. The reason is this: it is hard to figure out how maximum employment can be achieved with a worthless currency.
