Thursday, September 2, 2010

Quantitative Easing Or Helicopter Drop? What Should Ben Bernanke Do?

A lonely nation turns its eyes to you, Ben Bernanke.

Double dip fears run rampant (despite a better than expected August ISM number). Fiscal stimulus is waning -- much of it undone by draconian cuts at the state and local level. Housing looks poised to go cliff-diving again now that the homebuyer's tax-credit has expired. And, of course, unemployment remains stubbornly high.

The high priests of economic orthodoxy assure us if we just embrace fiscal austerity or higher interest rates that we can ward off the dangers of debt deflation. Which is to say, they are incoherently grasping at any justification to foist contractionary policies onto a weak economy, all in order to fight the specter of incipient -- only in their minds -- inflation.

But with short-term rates up against the zero bound, what ammo does the Fed have left to support the fragile recovery? Here are the usual suspects of unconventional policy tools:

1) Resume quantitative easing. It's debatable how much banks substituting one non-interest bearing asset for another helps the real economy. Additional cash seems likely to either pile up as excess reserves, filter into the markets or get arbitraged via more Treasuries. Still, it's better than nothing.
2) Credibly commit to a higher inflation target in the medium-term. Targeting a 4% inflation rate over a prolonged period obviously not only makes holding cash less appealing, but also reduces real debt burdens. Of course, Messrs. Fisher and Hoenig would do everything in their power to undermine such a project to return to 1980s-level inflation.
3) Buy longer-dated Treasuries. Pushing down yields on longer-dated Treasuries makes other, riskier assets more attractive. Even just credibly threatening to buy up longer-dated Treasuries could be enough, if yields aren't already too low.
4) Eliminate IOER. The Fed currently pays out 0.25% on excess reserves, but why not cut that down to zero? Or even impose a penalty rate? Banks would pile into other short-term assets and increase their vault cash, but at least some of that otherwise idle money would leak into new loans (although there could be some unintended consequences vis-รก-vis money market accounts).

Those are just the more conventional "unorthodox" measures the Fed could pursue. Another option would be quantitative easing to non-banks, i.e. direct lending. This is where monetary and fiscal policy meet. The key is that it would entirely eliminate the excess reserves problem, though it would introduce the question of favoritism -- an issue the Fed would be loathe to raise given the recent assault on Fed secrecy.

Still, the radical idea of the Fed giving money to businesses and households rather than to banks liable to sit on it holds some appeal. The so-called helicopter drop would accelerate the deleveraging process, effectively papering over bad household debt. Indeed, from what we know about lump sum tax rebates, we would expect households to save/pay down debts with their one-time check from the Fed. So a good portion of this newly minted money would still end up at the banks, just as with quantitative easing, though it would come at the cost of reducing the banks' claims on households.

But wouldn't this debauch the currency? If the Fed gave away free money, essentially accepting anything as collateral, they wouldn't have the assets to sop up the excess liquidity and prevent out-of-control inflation on the other side. This is the issue some have raised with the Fed accepting MBS as collateral: the Fed is holding MBS at inflated values, so when it comes time to sell that paper, the Fed won't take out as much money as it put into the system -- hence, inflation.

This is where the Treasury comes in. As MIT professor Ricardo Caballero points out, the Treasury could simply transfer T-Bills to the Fed to sell, basically the reverse of monetizing the debt. The Fed would never countenance such extreme action but it's worth remembering that Ben Bernanke circa 2002 was correct: a determined Fed should be able to reverse deflation. Too bad he's not running things nowadays.

1 comment:

  1. Wow, you mean I could park my old lawn mower with the Fed? I kinda like that idea.

    The Fed would become a giant pawn shop with better rates! Woo Hoo!