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Public Policy Brief No.117
05 April 2011
It’s Time to Rein In the Fed
AbstractScott Fullwiler and Senior Scholar L. Randall Wray review the roles of the Federal Reserve and the Treasury in the context of quantitative easing, and find that the financial crisis has highlighted the limited oversight of Congress and the limited transparency of the Fed. And since a Fed promise is ultimately a Treasury promise that carries the full faith and credit of the US government, the question is whether the Fed should be able to commit the public purse in times of national crisis.
Download Public Policy Brief No. 117, 2011 PDF (1.19 MB) -
Working Paper No.665
04 April 2011
Causes of Financial Instability
AbstractGiven the economy’s complex behavior and sudden transitions as evidenced in the 2007–08 crisis, agent-based models are widely considered a promising alternative to current macroeconomic practice dominated by DSGE models. Their failure is commonly interpreted as a failure to incorporate heterogeneous interacting agents. This paper explains that complex behavior and sudden transitions also arise from the economy’s financial structure as reflected in its balance sheets, not just from heterogeneous interacting agents. It introduces “flow-of-funds” and “accounting” models, which were preeminent in successful anticipations of the recent crisis. In illustration, a simple balance-sheet model of the economy is developed to demonstrate that nonlinear behavior and sudden transition may arise from the economy’s balance-sheet structure, even without any microfoundations. The paper concludes by discussing one recent example of combining flow-of-funds and agent-based models. This appears a promising avenue for future research.
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Working Paper No.664
31 March 2011
Can Portugal Escape Stagnation without Opting Out from the Eurozone?
AbstractThe creation of the Economic and Monetary Union (EMU) has not brought significant gains to the Portuguese economy in terms of real convergence with wealthier eurozone countries. We analyze the causes of the underperformance of the Portuguese economy in the last decade, discuss its growth prospects within the EMU, and make two proposals for urgent institutional reform of the EMU. We argue that, under the prevailing institutional framework, Portugal faces a long period of stagnation, high unemployment, and painful structural reform, and conclude that, in the absence of institutional reform of the EMU, getting out of the eurozone represents a serious political option for Portugal.
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Working Paper No.663
29 March 2011
Quality of Match for Statistical Matches Used in the 1995 and 2005 LIMEW Estimates for Great Britain
AbstractThe quality of match of four statistical matches used in the LIMEW estimates for Great Britain for 1995 and 2005 is described. The first match combines the fifth (1995) wave of the British Household Panel Survey (BHPS) with the 1995–96 Family Resources Survey (FRS). The second match combines the 1995 time-use module of the Office of Population Censuses and Surveys Omnibus Survey with the 1995–96 FRS. The third match combines the 15th wave (2005) of the BHPS with the 2005 FRS. The fourth match combines the 2000 United Kingdom Time Use Survey with the 2005 FRS. In each case, the alignment of the two datasets is examined, after which various aspects of the match quality are described. In each case, the matches are of high quality, given the nature of the source datasets.
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Working Paper No.662
28 March 2011
The Financial Crisis Viewed from the Perspective of the “Social Costs” Theory
AbstractThis paper examines the causes and consequences of the current global financial crisis. It largely relies on the work of Hyman Minsky, although analyses by John Kenneth Galbraith and Thorstein Veblen of the causes of the 1930s collapse are used to show similarities between the two crises. K.W. Kapp’s “social costs” theory is contrasted with the recently dominant “efficient markets” hypothesis to provide the context for analyzing the functioning of financial institutions. The paper argues that, rather than operating “efficiently,” the financial sector has been imposing huge costs on the economy—costs that no one can deny in the aftermath of the economy’s collapse. While orthodox approaches lead to the conclusion that money and finance should not matter much, the alternative tradition—from Veblen and Keynes to Galbraith and Minsky—provides the basis for developing an approach that puts money and finance front and center. Including the theory of social costs also generates policy recommendations more appropriate to an economy in which finance matters.
Download Working Paper No. 662 PDF (169.71 KB) -
Working Paper No.661
26 March 2011
Minsky’s Money Manager Capitalism and the Global Financial Crisis
AbstractThe world’s worst economic crisis since the 1930s is now well into its third year. All sorts of explanations have been proffered for the causes of the crisis, from lax regulation and oversight to excessive global liquidity. Unfortunately, these narratives do not take into account the systemic nature of the global crisis. This is why so many observers are misled into pronouncing that recovery is on the way—or even under way already. I believe they are incorrect. We are, perhaps, in round three of a nine-round bout. It is still conceivable that Minsky’s “it”—a full-fledged debt deflation with failure of most of the largest financial institutions—could happen again.
Indeed, Minsky’s work has enjoyed unprecedented interest, with many calling this a “Minsky moment” or “Minsky crisis.” However, most of those who channel Minsky locate the beginnings of the crisis in the 2000s. I argue that we should not view this as a “moment” that can be traced to recent developments. Rather, as Minsky argued for nearly 50 years, we have seen a slow realignment of the global financial system toward “money manager capitalism.” Minsky’s analysis correctly links postwar developments with the prewar “finance capitalism” analyzed by Rudolf Hilferding, Thorstein Veblen, and John Maynard Keynes—and later by John Kenneth Galbraith. In an important sense, over the past quarter century we created conditions similar to those that existed in the run-up to the Great Depression, with a similar outcome. Getting out of this mess will require radical policy changes no less significant than those adopted in the New Deal.
Download Working Paper No. 661 PDF (149.04 KB) -
Working Paper No.660
21 March 2011
Financial Markets
AbstractThis paper provides a brief exposition of financial markets in Post Keynesian economics. Inspired by John Maynard Keynes’s path-breaking insights into the role of liquidity and finance in “monetary production economies,” Post Keynesian economics offers a refreshing alternative to mainstream (mis)conceptions in this area. We highlight the importance of liquidity—as provided by the financial system—to the proper functioning of real world economies under fundamental uncertainty, contrasting starkly with the fictitious modeling world of neo-Walrasian exchange economies. The mainstream vision of well-behaved financial markets, channeling saving flows from savers to investors while anchored by fundamentals, complements a notion of money as an arbitrary numéraire and mere convenience, facilitating exchange but otherwise “neutral.” From a Post Keynesian perspective, money and finance are nonneutral but condition and shape real economic performance. It takes public policy to anchor asset prices and secure financial stability, with the central bank as the key public policy tool.
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Working Paper No.659
16 March 2011
Minsky Crisis
AbstractStability is destabilizing. These three words concisely capture the insight that underlies Hyman Minsky’s analysis of the economy’s transformation over the entire postwar period. The basic thesis is that the dynamic forces of a capitalist economy are explosive and must be contained by institutional ceilings and floors. However, to the extent that these constraints achieve some semblance of stability, they will change behavior in such a way that the ceiling will be breached in an unsustainable speculative boom. If the inevitable crash is “cushioned” by the institutional floors, the risky behavior that caused the boom will be rewarded. Another boom will build, and the crash that follows will again test the safety net. Over time, the crises become increasingly frequent and severe, until finally “it” (a great depression with a debt deflation) becomes possible.
Policy must adapt as the economy is transformed. The problem with the stabilizing institutions that were put in place in the early postwar period is that they no longer served the economy well by the 1980s. Further, they had been purposely degraded and even in some cases dismantled, often in the erroneous belief that “free” markets are self-regulating. Hence, the economy evolved over the postwar period in a manner that made it much more fragile. Minsky continually formulated and advocated policy to deal with these new developments. Unfortunately, his warnings were largely ignored by the profession and by policymakers—until it was too late.
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Working Paper No.658
15 March 2011
Keynes after 75 Years
AbstractIn this paper I first provide an overview of alternative approaches to money, contrasting the orthodox approach, in which money is neutral, at least in the long run; and the Marx-Veblen-Keynes approach, or the monetary theory of production. I then focus in more detail on two main categories: the orthodox approach that views money as an efficiency-enhancing innovation of markets, and the Chartalist approach that defines money as a creature of the state. As the state’s “creature,” money should be seen as a public monopoly. I then move on to the implications of viewing money as a public monopoly and link that view back to Keynes, arguing that extending Keynes along these lines would bring his theory up to date.
Download Working Paper No. 658 PDF (203.19 KB) -
Working Paper No.657
12 March 2011
What Does Norway Get Out Of Its Oil Fund, if Not More Strategic Infrastructure Investment?
AbstractFor the past generation Norway has supplied Europe and other regions with oil, taking payment in euros or dollars. It then sends nearly all this foreign exchange abroad, sequestering its oil-export receipts—which are in foreign currency—in the “oil fund,” to invest mainly in European and US stocks and bonds. The fund now exceeds $500 billion, second in the world to that of Abu Dhabi.
It is claimed that treating these savings as a mutual fund invested in a wide array of US, European, and other stocks and bonds (and now real estate) avoids domestic inflation that would result from spending more than 4 percent of the returns to this fund at home. But the experience of sovereign wealth funds in China, Singapore, and other countries has been that investing in domestic infrastructure serves to lower the cost of living and doing business, making the domestic economy more competitive, not less.
This paper cites the debate that extends from US 19th-century institutional doctrine to the approach of long-time Russian Chamber of Commerce and Industry President Yevgeny Primakov to illustrate the logic behind spending central bank and other sovereign foreign-exchange returns on modernizing and upgrading the domestic economy rather than simply recycling the earnings to US and European financial markets in what looks like an increasingly risky economic environment, as these economies confront debt deflation and increasing fiscal tightness.
Download Working Paper No. 657 PDF (273.70 KB) -
Strategic Analysis
10 March 2011
Jobless Recovery Is No Recovery: Prospects for the US Economy
AbstractThe US economy grew reasonably fast during the last quarter of 2010, and the general expectation is that satisfactory growth will continue in 2011–12. The expansion may, indeed, continue into 2013. But with large deficits in both the government and foreign sectors, satisfactory growth in the medium term cannot be achieved without a major, sustained increase in net export demand. This, of course, cannot happen without either a cut in the domestic absorption of US goods and services or a revaluation of the currencies of the major US trading partners.
Our policy message is fairly simple, and one that events over the years have tended to vindicate. Most observers have argued for reductions in government borrowing, but few have pointed out the potential instabilities that could arise from a growth strategy based largely on private borrowing—as the recent financial crisis has shown. With the economy operating at far less than full employment, we think Americans will ultimately have to grit their teeth for some hair-raising deficit figures, but they should take heart in recent data showing record-low “core” CPI inflation—and the potential for export-led growth to begin reducing unemployment.
Download Strategic Analysis, March 2011 PDF (2.96 MB) -
Working Paper No.656
05 March 2011
Money in Finance
AbstractThis paper begins by defining, and distinguishing between, money and finance, and addresses alternative ways of financing spending. We next examine the role played by financial institutions (e.g., banks) in the provision of finance. The role of government as both regulator of private institutions and provider of finance is also discussed, and related topics such as liquidity and saving are explored. We conclude with a look at some of the new innovations in finance, and at the global financial crisis, which could be blamed on excessive financialization of the economy.
Download Working Paper No. 656 PDF (169.85 KB) -
Working Paper No.655
04 March 2011
A Minskyan Road to Financial Reform
AbstractIn the aftermath of the global financial collapse that began in 2007, governments around the world have responded with reform. The outlines of Basel III have been announced, although some have already dismissed its reform agenda as being too little (and too late!). Like the proposed reforms in the United States, it is argued, Basel III would not have prevented the financial crisis even if it had been in place. The problem is that the architects of reform are working around the edges, taking current bank activities as somehow appropriate and trying to eliminate only the worst excesses of the 2000s.
Hyman Minsky would not be impressed.
Before we can reform the financial system, we need to understand what the financial system does—or, better, what it should do. To put it as simply as possible, Minsky always insisted that the proper role of the financial system is to promote the “capital development” of the economy. By this he did not simply mean that banks should finance investment in physical capital. Rather, he was concerned with creating a financial structure that would be conducive to economic development to improve living standards, broadly defined.
In this paper, we first examine Minsky’s general proposals for reform of the economy—how to restore stable growth that promotes job creation and rising living standards. We then turn to his proposals for financial reform. We will focus on his writing in the early 1990s, when he was engaged in a project at the Levy Economics Institute on reconstituting the financial system (Minsky 1992a, 1992b, 1993, 1996). As part of that project, he offered his insights on the fundamental functions of a financial system. These thoughts lead quite naturally to a critique of the financial practices that precipitated the global financial crisis, and offer a path toward thorough-going reform.
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Working Paper No.654
03 March 2011
Measuring Macroprudential Risk
AbstractWith the Great Recession and the regulatory reform that followed, the search for reliable means to capture systemic risk and to detect macrofinancial problems has become a central concern. In the United States, this concern has been institutionalized through the Financial Stability Oversight Council, which has been put in charge of detecting threats to the financial stability of the nation. Based on Hyman Minsky’s financial instability hypothesis, the paper develops macroeconomic indexes for three major economic sectors. The index provides a means to detect the speed with which financial fragility accrues, and its duration; and serves as a complement to the microprudential policies of regulators and supervisors. The paper notably shows, notably, that periods of economic stability during which default rates are low, profitability is high, and net worth is accumulating are fertile grounds for the growth of financial fragility.
Download Working Paper No. 654 PDF (494.14 KB) -
Working Paper No.653
02 March 2011
Financial Keynesianism and Market Instability
AbstractIn this paper I will follow Hyman Minsky in arguing that the postwar period has seen a slow transformation of the economy from a structure that could be characterized as “robust” to one that is “fragile.” While many economists and policymakers have argued that “no one saw it coming,” Minsky and his followers certainly did! While some of the details might have surprised Minsky, certainly the general contours of this crisis were foreseen by him a half century ago. I will focus on two main points: first, the past four decades have seen the return of “finance capitalism”; and second, the collapse that began two years ago is a classic “Fisher-Minsky” debt deflation. The appropriate way to analyze this transformation and collapse is from the perspective of what Minsky called “financial Keynesianism”—a label he preferred over Post Keynesian because it emphasized the financial nature of the capitalist economy he analyzed.
Download Working Paper No. 653 PDF (386.64 KB) -
Working Paper No.652
01 March 2011
The Dismal State of Macroeconomics and the Opportunity for a New Beginning
AbstractThe Queen of England famously asked her economic advisers why none of them had seen “it” (the global financial crisis) coming. Obviously, the answer is complex, but it must include reference to the evolution of macroeconomic theory over the postwar period—from the “Age of Keynes,” through the Friedmanian era and the return of Neoclassical economics in a particularly extreme form, and, finally, on to the New Monetary Consensus, with a new version of fine-tuning. The story cannot leave out the parallel developments in finance theory—with its efficient markets hypothesis—and in approaches to regulation and supervision of financial institutions.
This paper critically examines these developments and returns to the earlier Keynesian tradition to see what was left out of postwar macro. For example, the synthesis version of Keynes never incorporated true uncertainty or “unknowledge,” and thus deviated substantially from Keynes’s treatment of expectations in chapters 12 and 17 of the General Theory. It essentially reduced Keynes to sticky wages and prices, with nonneutral money only in the case of fooling. The stagflation of the 1970s ended the great debate between “Keynesians” and “Monetarists” in favor of Milton Friedman’s rules, and set the stage for the rise of a succession of increasingly silly theories rooted in pre-Keynesian thought. As Lord Robert Skidelsky (Keynes’s biographer) argues, “Rarely in history can such powerful minds have devoted themselves to such strange ideas.” By returning to Keynes, this paper attempts to provide a new direction forward.
Download Working Paper No. 652 PDF (234.09 KB) -
One Pager No.8
14 February 2011
It’s Time to Rein In the Fed
AbstractThe economic crisis that has gripped the US economy since 2007 has highlighted Congress’s limited oversight of the Federal Reserve, and the limited transparency of the Fed’s actions. And since a Fed promise is ultimately a Treasury promise that carries the full faith and credit of the US government, the question is, Should the Fed be able to commit the public purse in times of national crisis?
Download One-Pager No. 8 PDF (114.83 KB) -
Working Paper No.651
14 February 2011
Το μοναδιαίο κόστος εργασίας στην ευρωζώνη
AbstractΟι τρέχουσες εισηγήσεις σχετικά με την ανάγκη να μειωθεί το μοναδιαίο κόστος εργασίας (κυρίως μέσω δραστικών μειώσεων των ονομαστικών μισθών) σε ορισμένες χώρες της ευρωζώνης (ειδικότερα στην Ελλάδα, την Ιρλανδία, την Ιταλία, την Πορτογαλία και την Ισπανία) προκειμένου να βγουν από την κρίση οι εν λόγω χώρες μπορεί να μην είναι πανάκεια. Κατ\’ αρχάς, ιστορικά, δεν υπάρχει καμία σχέση μεταξύ της αύξησης του μοναδιαίου κόστους εργασίας και της αύξησης της παραγωγής. Αυτό είναι ένα καλά εδραιωμένο εμπειρικό αποτέλεσμα, γνωστό στη βιβλιογραφία ως «το παράδοξο του Kaldor». Δεύτερον, ο υπολογισμός του μοναδιαίου κόστους εργασίας χρησιμοποιώντας συγκεντρωτικά στοιχεία (συνήθης πρακτική) είναι μια δυνητικά παραπλανητική διεργασία. Το μοναδιαίο κόστος εργασίας που υπολογίζεται με συγκεντρωτικά στοιχεία δεν είναι απλώς ένα σταθμισμένο μέσο όρο του μοναδιαίου κόστους εργασίας των επιχειρήσεων. Τρίτον, το συνολικό κόστος εργασίας ανά μονάδα προϊόντος αντανακλά την κατανομή του εισοδήματος μεταξύ μισθών και κερδών. Αυτό έχει επιπτώσεις στη συνολική ζήτηση, οι οποίες έχουν παραμεληθεί. Από τις 12 χώρες που μελετήθηκαν, το ποσοστό εργασίας αυξήθηκε σε μία χώρα (στην Ελλάδα), μειώθηκε σε εννέα, και παρέμεινε σταθερό σε δύο. Εικάζουμε ότι αυτό είναι το αποτέλεσμα της αύξησης του μεριδίου στο σύνολο της οικονομίας των μη εμπορεύσιμων υπηρεσιών. Επίσης, έχουμε κατασκευάσει ένα μέτρο ανταγωνιστικότητας, το αποκαλούμενο μοναδιαίο κόστος κεφαλαίου, που προσδιορίζει την αναλογία του ονομαστικού ποσοστού κέρδους προς την παραγωγικότητα του κεφαλαίου. Αυτό έχει αυξηθεί και στις 12 χώρες. Συμπεραίνουμε ότι μια δραστική μείωση των ονομαστικών μισθών δεν θα λύσει το πρόβλημα που αντιμετωπίζουν ορισμένες χώρες της ευρωζώνης. Αν γίνει αυτό, οι επιχειρήσεις θα πρέπει να αναγνωρίσουν επίσης ότι το μοναδιαίο κόστος κεφαλαίου έχει αυξηθεί σημαντικά και ως εκ τούτου θα πρέπει να μοιραστούν το κόστος της προσαρμογής.
Download Επιστημονική εργασία υπό εξέλιξη (Working Paper) No. 651 PDF (1.36 MB)
Έχοντας αποκλείσει λύσεις όπως την έξοδο από το ευρώ, η λύση είναι να επιτραπεί στη δημοσιονομική πολιτική να διαδραματίσει έναν μεγαλύτερο ρόλο στην ευρωζώνη και να καταβληθούν προσπάθειες για την αναβάθμιση των εξαγωγών προκειμένου να βελτιωθεί η ανταγωνιστικότητα με τις πιο προηγμένες χώρες. Πρόκειται για μια μακροπρόθεσμη λύση που δεν θα είναι ανώδυνη, αλλά που δεν απαιτεί τη μείωση των ονομαστικών μισθών. -
Working Paper No.651
14 February 2011
Unit Labor Costs in the Eurozone
AbstractCurrent discussions about the need to reduce unit labor costs (especially through a significant reduction in nominal wages) in some countries of the eurozone (in particular, Greece, Ireland, Italy, Portugal, and Spain) to exit the crisis may not be a panacea. First, historically, there is no relationship between the growth of unit labor costs and the growth of output. This is a well-established empirical result, known in the literature as Kaldor’s paradox. Second, construction of unit labor costs using aggregate data (standard practice) is potentially misleading. Unit labor costs calculated with aggregate data are not just a weighted average of the firms’ unit labor costs. Third, aggregate unit labor costs reflect the distribution of income between wages and profits. This has implications for aggregate demand that have been neglected. Of the 12 countries studied, the labor share increased in one (Greece), declined in nine, and remained constant in two. We speculate that this is the result of the nontradable sectors gaining share in the overall economy. Also, we construct a measure of competitiveness called unit capital costs as the ratio of the nominal profit rate to capital productivity. This has increased in all 12 countries. We conclude that a large reduction in nominal wages will not solve the problem that some countries of the eurozone face. If this is done, firms should also acknowledge that unit capital costs have increased significantly and thus also share the adjustment cost. Barring solutions such as an exit from the euro, the solution is to allow fiscal policy to play a larger role in the eurozone, and to make efforts to upgrade the export basket to improve competitiveness with more advanced countries. This is a long-term solution that will not be painless, but one that does not require a reduction in nominal wages.
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Policy Notes No.1
11 February 2011
What Happens if Germany Exits the Euro?
AbstractLike marriage, membership in the eurozone is supposed to be a lifetime commitment, “for better or for worse.” But as we know, divorce does occur, even if the marriage was entered into with the best of intentions. And the recent turmoil in Europe has given rise to the idea that the euro itself might also be reversible, and that one or more countries might revert to a national currency. The prevailing thought has been that one of the weak periphery countries would be the first to call it a day. It may not, however, work out that way: suddenly, the biggest euro-skeptics in Europe are not the perfidious English but the Germans themselves.
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Working Paper No.650
19 January 2011
Fiscal Policy: Why Aggregate Demand Management Fails and What to Do about It
AbstractThis paper argues for a fundamental reorientation of fiscal policy, from the current aggregate demand management model to a model that explicitly and directly targets the unemployed. Even though aggregate demand management has several important benefits in stabilizing an unstable economy, it also has a number of serious drawbacks that merit its reconsideration. The paper identifies the shortcomings that can be observed during both recessions and economic recoveries, and builds the case for a targeted demand-management approach that can deliver economic stabilization through full employment and better income distribution. This approach is consistent with Keynes’s original policy recommendations, largely neglected or forgotten by economists across the theoretical spectrum, and offers a reinterpretation of his proposal for the modern context that draws on the work of Hyman Minsky.
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Working Paper No.649
18 January 2011
Fiscal Policy Effectiveness: Lessons from the Great Recession
AbstractThis paper reconsiders fiscal policy effectiveness in light of the recent economic crisis. It examines the fiscal policy approach advocated by the economics profession today and the specific policy actions undertaken by the Bush and Obama administrations. An examination of the labor market renders the contemporary aggregate demand–management approach wholly inadequate for achieving certain macroeconomic objectives, such as the stabilization of investment and investor expectations, the generation and maintenance of full employment, and the equitable distribution of incomes. The paper reconsiders the policy effectiveness of alternative fiscal policy approaches, and argues that a policy that directly targets the labor demand gap (as opposed to the output gap) is far more effective in stabilizing employment, incomes, investment, and balance sheets.
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Working Paper No.647
24 December 2010
Money
AbstractThis paper advances three fundamental propositions regarding money:
(1) As R. W. Clower (1965) famously put it, money buys goods and goods buy money, but goods do not buy goods.
(2) Money is always debt; it cannot be a commodity from the first proposition because, if it were, that would mean that a particular good is buying goods.
(3) Default on debt is possible.
These three propositions are used to build a theory of money that is linked to common themes in the heterodox literature on money. The approach taken here is integrated with Hyman Minsky’s (1986) work (which relies heavily on the work of his dissertation adviser, Joseph Schumpeter [1934]); the endogenous money approach of Basil Moore; the French-Italian circuit approach; Paul Davidson’s (1978) interpretation of John Maynard Keynes, which relies on uncertainty; Wynne Godley’s approach, which relies on accounting identities; the “K” distribution theory of Keynes, Michal Kalecki, Nicholas Kaldor, and Kenneth Boulding; the sociological approach of Ingham; and the chartalist, or state money, approach (A. M. Innes, G. F. Knapp, and Charles Goodhart). Hence, this paper takes a somewhat different route to develop the more typical heterodox conclusions about money.
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Working Paper No.645
14 December 2010
Quantitative Easing and Proposals for Reform of Monetary Policy Operations
AbstractBeyond its original mission to “furnish an elastic currency” as lender of last resort and manager of the payments system, the Federal Reserve has always been responsible (along with the Treasury) for regulating and supervising member banks. After World War II, Congress directed the Fed to pursue a dual mandate, long interpreted to mean full employment with reasonable price stability. The Fed has been left to decide how to achieve these objectives, and it has over time come to view price stability as the more important of the two. In our view, the Fed’s focus on inflation fighting diverted its attention from its responsibility to regulate and supervise the financial sector, and its mandate to keep unemployment low. Its shift of priorities contributed to creation of the conditions that led to this crisis. Now in its third phase of responding to the crisis and the accompanying deep recession—so-called “quantitative easing 2,” or “QE2”—the Fed is currently in the process of purchasing $600 billion in Treasuries. Like its predecessor, QE1, QE2 is unlikely to seriously impact either of the Fed’s dual objectives, however, for the following reasons: (1) additional bank reserves do not enable greater bank lending; (2) the interest rate effects are likely to be small at best given the Fed’s tactical approach to QE2, while the private sector is attempting to deleverage at any rate, not borrow more; (3) purchases of Treasuries are simply an asset swap that reduce the maturity and liquidity of private sector assets but do not raise incomes of the private sector; and (4) given the reduced maturity of private sector Treasury portfolios, reduced net interest income could actually be mildly deflationary.
The most fundamental shortcoming of QE—or, in fact, of using monetary policy in general to combat the recession—is that it only “works” if it somehow induces the private sector to spend more out of current income. A much more direct approach, particularly given much-needed deleveraging by the private sector, is to target growth in after tax incomes and job creation through appropriate and sufficiently large fiscal actions. Unfortunately, stimulus efforts to date have not met these criteria, and so have mostly kept the recession from being far worse rather than enabling a significant economic recovery. Finally, while there is identical risk to the federal government whether a bailout, a loan, or an asset purchase is undertaken by the Fed or the Treasury, there have been enormous, fundamental differences in democratic accountability for the two institutions when such actions have been taken since the crisis began. Public debates surrounding the wisdom of bailouts for the auto industry, or even continuing to provide benefits to the unemployed, never took place when it came to the Fed committing trillions of dollars to the financial system—even though, again, the federal government is “on the hook” in every instance.
Download Working Paper No. 645 PDF (482.22 KB)