QE the Sequel: Putting Ben’s Money Where His Mouth Is

A consensus is emerging among Fed watchers that the Fed is set to embark on a fresh round of “quantitative easing” (QE), faced with a subpar employment growth and a lingering threat of deflation.

Abstracting from whether the economic outlook is such as to warrant further stimulus, I wanted to focus here on what kind of “QE” might be more effective this time round, if it were to happen.

Pre-empting my conclusion, let me say that my proposal will probably sound like the mother of unconventional measures, but it’s actually a variant of what the Chairman himself proposed back in 2002, at his famous “it” speech on deflation. But let’s start from the beginning.

First of all, “QE” means the purchase by the Fed of a certain quantity of risky assets, funded by the creation of bank reserves. The intended objective is twofold: First, to boost the price (/lower the yield) of the assets purchased (in the case of the Fed’s first round of QE, these would be US Treasury bonds, agency debt and mortgage backed securities (MBS)); and second, to affect the price of other risky assets through the so-called portfolio balance effect.

For details on how the portfolio balance channel is supposed to work you can read Brian Sack’s speech at the Money Marketeers last year (here), but here is an excerpt from that speech that sums it up:

“[T]he purchases bid up the price of the asset [being purchased] and hence lower its yield. These effects would be expected to spill over into other assets that are similar in nature, to the extent that investors are willing to substitute between the assets.” (my emphasis)

So against this theoretical backdrop, the key questions to ask when contemplating “QE, The Sequel” are two: What assets should the QE program target in order to be effective? And, critically, who should be buying those assets?

To answer the first question, we have to have in mind the endgame, which is the desire to boost aggregate demand. In other words, the true metric for success of an LSAP program is not whether it managed to lower the yield of the security targeted (e.g. mortgage rates) but whether those lower yields translated into a material increase in aggregate demand.

By that metric, the Fed’s past LSAPs have probably fallen short. Clearly, measuring the counterfactual is impossible, but there are reasons to believe that the impact on aggregate demand was small. Why? First, because the reduction in mortgage rates boosted refinancings only by people who could refinance—i.e. people with jobs and some positive equity in their home. Not exactly the most cash-strapped ones who would have spent the extra cash.

Second, the portfolio-balance effect of the LSAPs on the prices of assets like corporate bonds or equities is at best weak, if not counterproductive. The reason (which I explained in detail here) has to do with the fact that US Treasuries and MBS are not “similar in nature” to corporate debt and equities. Unlike the latter, Treasuries/MBS have more of a “safe haven” nature—so that removing them from investors’ portfolios create demand for more “safe” assets, rather than boosting the prices of equities, high yield bonds, etc.

The bottom line here is that, while the LSAPs may have helped boost the cash position of certain financially healthy households and corporates, (a) they were not targeted to achieve a big bang for the buck; and (b) they have failed to boost agents’ risk-taking behavior—in the form of stronger consumer spending or a meaningful pick-up in employment.

Put differently, the LSAPs in their first incarnation failed (as they did in Japan) to remove the right type of risk out of the market. So what should a sequel target then?

The answer is assets in the riskiest part of the portfolio spectrum—small business loans, foreclosed properties, toxic credit card debt, and so on. Now, before I have hundreds of copies of the Federal Reserve Act thrown at me, let me touch a bit on the logistics.

Logistic #1: The “QE” operation should not actually purchase the small business loans or foreclosed properties themselves from the banks. This would be a logistical nightmare for the Fed (which would have to administer those loans), as well as giving rise to unmitigated moral hazard (why would I ever pay back my credit card debt, if the Fed stood ready to buy it off for free?) Instead, the QE operation should aim at injecting capital to banks against mark-downs on existing distressed loans.

Logistic #2: Clearly, this walks and talks like a fiscal operation, right? Well, it is a fiscal operation, with winners and losers, capital allocation to “chosen” institutions and with costs to the taxpayer. As such, the Fed is not the right institution to be in charge—it should be the US Treasury instead. So what is the role of the Fed then?

Enters Ben Bernanke, 2002:

“In practice, the effectiveness of anti-deflation policy could be significantly enhanced by cooperation between the monetary and fiscal authorities. […] If the Treasury issued debt to purchase private assets and the Fed then purchased an equal amount of Treasury debt with newly created money, the whole operation would be the economic equivalent of direct open-market operations in private assets.” (my emphasis)

Call it debt monetization par excellence. You set up a “special purpose vehicle”, which funds targeted capital injections to banks with Treasury securities. The Fed then purchases an equal amount of Treasury debt, funded by bank reserves.

The advantages of this approach are that (a) it would remove the right type of risk out of the market, in effect accelerating the “deleveraging” of the economy; and (b) it would distance the Fed from the credit allocation business. A key disadvantage of course is that many people out there (myself included) loathe the idea that irresponsible bozos would end up getting bailed out of their mortgage debt with taxpayer money.

But this is precisely why “QE, The Sequel” (and any QE for that matter) should be the explicit responsibility of the fiscal authority—i.e. an elected governing body: So as to allow voters to ultimately decide the kind of path their economy should follow. This may sound like lunacy in the current political climate, but maybe another quote from that same Bernanke speech can help strike an optimistic tone:

“In short, Japan's deflation problem is real and serious; but, in my view, political constraints, rather than a lack of policy instruments, explain why its deflation has persisted for as long as it has. Thus, I do not view the Japanese experience as evidence against the general conclusion that U.S. policymakers have the tools they need to prevent, and, if necessary, to cure a deflationary recession in the United States.”

So there.. a chance for America to show that's it's not going to become Japan.