Insanity, according to an aphorism often attributed (probably erroneously) to Albert Einstein, is doing the same thing over and over again and expecting different results.
Last week Federal Reserve Chairman Ben Bernanke announced that the Federal Open Market Committee plans to purchase $600 billion in longer-term Treasury securities between now and the middle of next year. This move is not, as he admitted at a conference at Jekyll Island, Georgia, this past weekend, a substantive departure from what the Fed has been doing all along. The question is, what makes him think the results will be different this time?
The news media have dubbed this move QE2 — the QE stands for “quantitative easing” — implying this is the second time the Fed has done anything this dramatic. But it’s really just the same old story: the Fed is buying the government’s IOUs. The only difference this time is in their maturities.
The Fed has furiously been buying up government securities since the subprime mortgage meltdown in the fall of 2008, and presently is holding more than $2 trillion worth. What they are doing is accommodating the Federal Government’s huge deficits, turning government debt into bank reserves.
Theoretically, an increase in bank reserves will support an increase in the money supply that is several times the injection of the new reserves — if the banks lend the money. And here’s the catch: they aren’t.
The ratio of excess reserves — what banks are allowed to lend — to total reserves is presently over 93 percent (after seasonal adjustment), according to preliminary figures released last week by the Fed. To give you an idea of how high this percentage is, during the one-year period before the Fed started its aggressive security purchases in response to the subprime mortgage meltdown, the average ratio of excess to total reserves was just over four percent.
The system clearly does not need any more reserves. In fact, they are already at unprecedentedly and dangerously high levels.
No, injecting liquidity into the system — supposedly the Fed’s raison d’être — is not Bernanke’s goal. And short-term interest rates are already near zero, so he can’t drive them any lower than they already are.
What Bernanke is doing now is — to use the words of one commentator — throwing a Hail Mary pass, hoping to drive down intermediate and long-term interest rates by aggressively buying longer-term government bonds in an effort to drive up their prices.
What he is really doing is helping the Federal government impose a backdoor tax. Whenever the government increases its spending, somebody has to pay for it. Keynesian economists may try to tell you that in a recession, when there is unemployment and idle resources, government spending can be a free lunch, but don’t believe it. Some people have to do with less so the government can spend more.
Who pays when the government runs a deficit? It depends on whether the Federal Reserve monetizes the new debt by buying government securities. If they don’t, private businesses pay through higher borrowing costs. If they do (as they are in this case) people on fixed incomes or who depend on interest income, e.g., retirees, pay.
By suspending one’s moral sensibilities it might be possible to justify this backdoor wealth transfer — if it worked. But it hasn’t so far, and there is no reason to expect it to work if the Fed starts buying $600 billion in government bonds.
Banks aren’t lending the excess reserves they have now. Pouring more into the system won’t make them any more anxious to lend. In fact, since even long-term interest rates will start falling, they’ll likely have less incentive to make new loans.
Interest is charged on loans in part to cover the risk of being separated from one’s money for a time. The main risk, of course, is that the borrower may default on the loan. But there are two other risks, and they apply mainly to banks. One is interest rate risk. If interest rates rise, banks risk being stuck with paper that yields less than they have to pay for funds. The other is liquidity risk — the more loans they have outstanding, the fewer new loans they are able to make.
The biggest problem the economy is facing now is uncertainty, not a lack of liquidity. Interest rates are now so low — and longer-term rates will get even lower once the new easing kicks in — they are not sufficient to cover the risks of lending and investing.
In his General Theory, John Maynard Keynes raised the possibility of a “liquidity trap”, a situation in which interest rates fall so low that any injections of new money into the economy get absorbed into people’s cash balances and have no effect on economic activity. Most economists have regarded a liquidity trap as an intellectual curiosity rather than a real possibility; even if interest rates fell to zero, people would still spend their money even if they don’t lend it.
But the Federal Reserve, working in conjunction with the Federal government, has succeeded in creating an actual liquidity trap. It is not a Keynesian liquidity trap — which is based on the demand for money becoming infinite at some extremely low interest rate. This is a supply-side liquidity trap because, despite the Fed’s hyper-expansionary efforts, banks are not creating new money by lending their excess reserves.
The real danger in all this is not that the policy isn’t working. The danger is that it might work eventually. The enormous level of excess reserves in the banking system is a potential disaster just waiting to happen. If banks start lending their excess reserves, the money supply, in a short period of time, could balloon to several times its present level, triggering a hyperinflation that will make our present economic woes seem trivial.