Frequent readers might be familiar with a recurring series on the site, Economics for Lawyers. These posts represent ongoing attempts to take some of the economic concepts and theories that underpin many of the posts on the site and make them more understandable and accessible to some of Blawgconomics' most frequent visitors; individuals in the legal community.
Lawyers are not, of course dummies, at least not all of the time. However from observations in Corporate Law classes to discussions of Judge Posner's decisions to arguments on the roots of the financial crisis, it is fairly clear that the concepts of the economic world are no more comfortable to discuss for some lawyers than explaining the enigma of the Sphinxian silence of Justice Thomas would be for most economists. Therefore, as noted, the mission of these posts, and indeed perhaps the site as a whole, is to bridge the gap between these two fascinating worlds which can individually, and in combination, can go so far toward explaining so many of the intricacies of modern society.
To this point, we have focused on some of the simplest of concepts that one might find in an introductory micro- or macroeconomics text, some of the most well-known and widely discussed topics in the economics literature. Topics such as supply and demand and deflation were both useful and, in the case of the latter, continue to be timely. M3 money supply veered ever so slightly from the list of topics that most first or second year economics students might be familiar with, but the concept of money supply and why different measurements are important is nonetheless firmly rooted in the orthodoxy of economic theory.
Not so with today's topic. Today we are discussing something that is not likely to be found in anything but the most recent academic journals and newspaper articles. Something that, if effective, could well take its place among the first few chapters of any widely used macro book in the future, or otherwise could be consigned to the dustbin of economic history. In the meantime, it has proven to be a quite controversial topic, and with its lack of the aura of orthodoxy or even a track record to base assumptions on, this will necessarily be more of an opinion piece than previous economic posts. The topic, as indicated by the title, is the Federal Reserve Bank's experiment in stimulating the US economy with a tool called quantitative easing.
Essentially quantitative easing is an attempt by a central bank to increase the money supply via market purchases of treasury securities from member banks. In other words, it is putting more money into the economy through the asset transfer procedure of trading its dollars for Treasury securities (in the case of the US), hopeful that the extra money in the economy will stimulate growth causing activities such as lending and consumer spending. While it is true that the methods described in this post are used by central banks around the world on a regular basis, never before has a central bank attempted a proactive move on such a large scale with so much risk and so much at stake as America's Federal Reserve is embarking on over the next few months with its quantitative easing project.
The latest, widely anticipated round of bank action has been dubbed QE2 as it follows on the heels of a previous round of quantitative easing that occured in response to the pressures of the housing market collapse and which lasted a little over a year, including 2009 and small portions of both years sandwiching it. That operation is now referred to as QE1, much as WW1 only gained its modern name after WW2 made the addition of a numerical post-modifier useful. However, that was a reactionary move, made in response to the contemporary collapses of banks holding mortgage securities as well as the pressures of skipped payments and ultimately foreclosures.
Those familiar with economic theory will recognize the tools of the QE described above as what are referred to as open market operations. Typically, open market operation are used to regulate the money supply and therefore impact the interest rates of an economy. This is also known as monetary policy, and contrasts with fiscal policy which is the taxing and spending activities of the government. These tools are, of course quite common in themselves. Indeed, monetary policy is what the Fed is actually doing when it 'changes' interest rates. The central bank has no ability to actually fix the interest rates in the economy, but it can impact money supply. Through careful and systematic purchases or sales of Treasury securities, adding or subtracting dollars from the economy, it can impact overnight lending rates which are used as a guide by others in the economy who utilize interest rates, i.e. home and business loan lenders.
This is due to simple supply and demand pressures. For example, if the US economy is overheating, the Fed will sell Treasury securities, removing cash from the system (and also increasing the interest rate on those securities because a lower price on a bond means a higher yield, or effective interest rate) making banks and corporations more likely to hold cash. When an economy is contracting on the other hand, it will try to reduce lending rates by buying securities, putting more cash in the economy, and reducing the attractiveness of cash by reducing the rates on Treasury securities.
This, again, is all quite common, and is, along with setting reserve ratios, one of the more commonly used tools of the Fed. However, the economy is in a unique situation currently, as rates are already barely hovering above 0% and as deflation, rather than the more commonly discussed inflation, is presumed to be a key threat to growth. Additionally, and particularly with a Republican House of Representatives in place, the prospect of further fiscal policy actions seems slight at best. Therefore, in what some are viewing as the playing of its last card, the Fed is planning on buying securities with what is colloquially known as printed money in an attempt to reduce longer term rates interest rates, which will, according to the bank, stimulate the economy. According to standard monetary theory, this will also cause inflationary pressure on the economy. As keeping inflation low is one of the mandates of the Fed, it would presumably only court such action if it considered deflation to be a clear and present danger.
Therefore, this policy of purchasing $600 billion of Treasuries is a signal that the Fed believes that the economy is on the brink. If it is correct, and the policy works, it could be a masterstroke in creative thought and quick action which could go a long way toward ensuring that the end of the Great Recession isn't simply the beginning of the Second Great Depression. However, the strategy is also fraught with perils almost too numerous to list in a posting which is already dragging on a bit. Therefore, following are merely some of the most widely discussed and presently obvious dangers of the policy.
For one, low interest rates were at least a contributory factor in stimulating the housing bubble in the first place as low rates and easy money (as well as poor regulations) allowed homeowners to buy above their means and speculators to run rampant. It is not inconceivable that current policies are leading to the next great bubble. There is also the uncertainty surrounding what exactly the policy might result in and risks to the dollar's hegemonic status in global trade.
There are additional risks on the global front. For example, the US Government looks rather foolish when it tries to get other countries to be more responsible with currencies while its central bank essentially prints money, particularly right before a G20 summit where the big ask will be for reduced reserves and more flexible exchange rates. Also, there are significant risks of increased geopolitical tensions with developing nations (not least of all China) as the impact to currency exchange rates is unpredictable, and as those which hold US debt become increasingly disillusioned with the benefits of holding Treasury securities which are treated like domestic policy tools rather than debts.
Last, but not least, is the fact that recent economic data have been rather sturdy, suggesting that the action may not be necessary, and that it may not only result in the 'little bit of inflation' policy makers are searching for, but also a bit more than they can chew. Indeed, one vocal member of The Fed even suggested that rates should be increasing right now (notably, rates are on the rise in other large countries, while other developed countries, particularly in Europe, are slashing government budgets). However, jobs data remains unconvincing, and continuing weakness in the housing market, which could presage everything from additional foreclosures to reducing consumer spending, has led the Fed to its historic decision.
It is possible that QE2 will lead to a boost in the economy accompanied by the slight inflationary impact the Fed is seeking. It is also possible that it could lead to far more inflationary pressures than intended and an economic slow down right when prospects are looking up. In the meantime, it has already created tensions with major trading partners and rival economies and has decreased America's influence at the global bargaining table. Some have even suggested that the dollar's days of hegemony are over. Yes, it is true that this latest Fed interference in the economy could be good or bad; only time will really tell. However, despite the obvious downside, we should all hope that a few economists sitting in Washington got this right. Because, if they didn't, all that might be left for their colleagues to do is predict when the next great economic crisis will occur.