Straight Talk about Quantitative Easing in the Face of Fiscal Austerity

Gerald Epstein

In Tokyo, during the recent IMF Annual Meetings, Federal Reserve Chair Ben Bernanke defended the Fed’s expansionary monetary policy – so-called QE1, 2, and 3 – against its critics. And critics there are – truckloads of them – from left, right and center. Some US right wing critics like Rick Perry, Governor of Texas and ex-presidential aspirant, threatened to “treat” Ben “pretty ugly,” in order to head-off at the pass any macroeconomic policy that could promote economic growth and jeopardize Republican victories in the election. This is all part of the Republican “political business cycle” strategy – strictly in reverse, of course. Others, like Ron Paul and his supporters, are conveniently delusional – seeing inflation lurking behind every sign-post of stagnation.

But it’s not just right-wingers who have become big Ben bashers. Leaders of all stripes from some “emerging market” countries have once again denounced the Fed for its counter-cyclical policy. The Finance Minister of Brazil Guido Mantega, called the Fed’s latest stimulus effort “selfish”, arguing that it leads to capital surges into Brazil, forcing up the value of the Brazilian currency in a beggar-thy-neighbor attempt to increase US exports. And, according to the The New York Times, the Russian finance minister, Anton Siluanov, told reporters in Tokyo: “For now, this excess liquidity is not contributing to inflation, but it could happen at some point.”

And many heterodox economists continue to feel uneasy about “Quantitative Easing”.  In his excellent Triple Crisis Blog piece,  “The Last Days of Pushing on a String “, Mark Blyth well describes the forces leading to an almost total reliance on monetary policy to fight the crisis in the US, the UK and Europe: the abandonment of counter-cyclical fiscal policy and the destructive move toward fiscal retrenchment and austerity by the governments in the US, UK and the Eurozone. As Blyth correctly notes, this has led to “pushing on a string,” to use Mariner Eccles graphic phrase, as an alternative.

Joseph Stiglitz calls the expansionary policies on both sides of the Atlantic largely “Monetary Mystification”. L. Randall Wray, in a blog post in August, declared:  “No matter what it does, [the fed} won’t matter much.”  In fact, Wray argues QE makes things worse by lowering short term interest rates close to zero and reducing incomes going to “savers”, which, according to Wray, has a negative impact on spending. Though many progressives are very pessimistic about the power of more quantitative easing, they are unwilling to completely shred it because with fiscal austerity taking the upper hand, QE style monetary policy seems to be the only expansionary macroeconomic policy in town.

The reasons the QEs are not having a larger effect are many and can be divided into demand-side factors and supply-side ones. On the demand side is the classic “pushing on a string” problem. Too few firms have profitable expansion opportunities given the short-fall in aggregate demand. So they either do not want to borrow, or appear too risky to banks to justify lending to them.

But there is another side to the problem: the financial intermediation system is broken. This has a number of dimensions. One is that many large banks still have toxic assets left over from the financial bubble and  crash; this toxic over-hang leads banks to hold on to excess cash to cover law-suits, write downs, and fines to angry borrowers and government investigators, timid as they may seem. All told, US banks are holding almost 1.6 trillion in excess reserves. Robert Pollin estimates that as much as 600 billion might be precautionary holdings for these types of possibilities.

Another key factor is that the large Wall Street banks have so much market power, that they are using the Fed’s low interest rate policy to pocket vast quantities of profits by borrowing at low interest rates, and then refusing to pass on the savings to borrowers. Even William Dudley, President New York Fed, recently complained about these banks. Much of the recent QE easing has involved buying Mortgage Backed Securities (MBS) to lower their interest rates; but the large banks have not passed on much of the savings to mortgage seekers. Wells Fargo, for example, initiates roughly a third of all mortgages in the US and saw its profit go up by 22% in the most recent quarter largely as a result of its ability to maintain high lending margins because of its market power as it initiates mortgages and refinancings.

Economists, including progressive ones,  have developed important proposals to transform monetary policy to make it more effective. Robert Pollin in a series of papers proposes a carrot and stick: tax excess bank reserves to induce banks to lend out more, while providing government loan guarantees for loans to small business to induce banks to lend more.

The Bank of England, recognizing the intermediation system is blocked,  has created a special lending scheme to induce banks to make more loans. Such proposals may well help and are worth trying.

These are good schemes. But there also needs to be direct action taken to write-down the massive debt over hang that is afflicting homeowners, students and others. With the banking system so broken, these actions have to be taken directly, by-passing the broken banking system all together.

Senator Jeff Merkely of Oregon has proposed, for example, a fund to buy-up underwater mortgages, and reduce the debt to manageable levels. This is modeled on the Depression era Home Owners Loan Corporation that was highly successful in keeping families in their homes.

The Fed could support a program like this by buying the bonds issued by the fund, reducing the costs of running the program.

It is this kind of direct intervention by the Fed, bypassing the broken and concentrated banking system, and offering targeted lending to directly help households and students who are facing massive debt over-hangs, that could help transform “pushing on a string” into a “bottom-up economic recovery”. By-passing the banks would also reduce the possible negative spill over effects the Brazilian finance minister and others complain about: these targeted Fed interventions would not increase liquidity in the financial markets generally, and therefore would be less likely to induce hoots and hollers from angry emerging market finance ministers.

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