Can there be such a thing as an “orderly” restructuring?

As EU and IMF officials set about to negotiate their second rescue package to a eurozone member in a year, more and more voices are calling for the “orderly restructuring” of peripheral countries’ debt as an integral component of a crisis resolution framework.

The idea is that, when the debt dynamic is unsustainable under most doable fiscal consolidation scenarios, pouring more official money into the problem amounts to “kicking the can down the road” rather than begetting a permanent solution.

A key advocate of this view has been Nouriel Roubini, who in a recent paper called for an “orderly, market-based approach to the restructuring of Eurozone sovereign debts” to deal with any insolvencies now, avoid the deferral of tough choices later and contain moral hazard.

My objective here is not to challenge the “kicking the can down the road” argument, which is of course correct. Neither am I going to discuss whether Greece , Ireland or, indeed, Italy are illiquid or insolvent. Instead, I want to examine whether it is at all possible to achieve the “orderly” restructuring that Nouriel and others propose in the specific case of the eurozone.

The focus on the eurozone matters: It is not particularly constructive, nor relevant, to evoke (as Nouriel does) the experiences of Pakistan, Ukraine, Uruguay or the Dominican Republic in order to shed light on what might happen if Greece or Ireland decided to “bail in” the private sector. These countries’ GDP is tiny, and so was the debt they restructured. To give you an idea, Pakistan restructured $608 million (with a “m”), the DR $1.5bn, Ukraine $3.3 billion and Uruguay around $5.5bn 1/. Greece ’s $420bn of public debt is far more prone to a disorderly outcome by virtue of its size and also due to Greece’s association with other fiscally vulnerable eurozone members.

Second, manageable initial debt-to-GDP ratios in those countries meant that sustainability could be achieved with only a small NPV reduction: Per the IMF, the NPV reduction was just 2% for the DR, 5% for Ukraine and 8% for Pakistan. In Uruguay, which had a comparable (though still smaller) debt-to-GDP ratio to Greece’s 133%, the NPV reduction was 13%. But I should point that Uruguay achieved fiscal surpluses of the order of 3-4% immediately, rather than 3 years into the IMF program, which is what is envisaged for Greece (IF ever feasible).

Let's also note that where the necessary NPV reduction was large (Argentina: 75%; Russia: 44%), the restructuring was not exactly an “orderly” one—and neither was it pre-emptive.

So much for the precedents. What can we say about the potential for an orderly restructuring in the eurozone today? First, let’s define what we mean by orderly, which, in my view, requires three elements:

1) Participation should be largely voluntary. A high degree of investor coercion can lead to a larger number of hold-outs that makes the process lengthier and messier. More importantly, a precedent of coercion in one eurozone member could prompt wary investors to stampede out of other vulnerable members, turning one country’s crisis into the self-fulfilling eurozone domino everyone dreads. This potential for contagion (through trade and financial linkages and/or by association) cannot be overstated when talking about eurozone members in my view.

2) The restructuring, along with the policy mix adopted by the debtor country, should restore debt sustainability under reasonable macroeconomic scenarios. It should also help achieve a prompt return to market financing.

3) The NPV reduction in the debtor country should not shift the crisis elsewhere in the eurozone (e.g. via the banking system).

Clearly these elements are usually conflicting—and more so in the eurozone. For a largely voluntary restructuring, the NPV reduction offered must be attractive compared to the alternative. In this context, Nouriel suggests that a restructuring be “market-based” (ie reflecting the going market value of the debt): after all, with Greece’s long-term bonds already trading at 50-something cents on the dollar, investors should voluntarily accept a 40-50% NPV reduction and do so in an orderly way, right?

In my view, such a “market-based” offer is not at all a guarantee for an orderly restructuring. First, because the “market value” can change swiftly once restructuring becomes a certainty (see what happened to peripheral spreads once Angela Merkel began to talk about bail-ins). Second, the threat of contagion cannot be overstated. What looks like a sustainable debt level in Spain (or Italy ) today might not be tomorrow, if the market decided to turn its attention there.

Third, many of the holders of the debt are banks that have yet to mark-to-market their sovereign debt holdings. Here, Nouriel’s proposal is an exchange offer that preserves the debt’s face value but prolongs the maturity and reduces the coupons. This would surely help these banks avoid immediate write-downs and the concomitant capital adequacy problems; but it would also “lock” their balance sheets with assets they cannot sell for years to come (unless they are ready to take the losses), preventing them from using their capital to lend to the productive sector. This might be “orderly” from a short-term financial-stability perspective, but it’s certainly suboptimal for the eurozone’s growth outlook.

So under what circumstances can we then have an “orderly” restructuring in the eurozone? In my view, a “pre-emptive” and “orderly” restructuring is only possible if the likes of Germany and France are ready to provide a credible commitment to backstop all the fiscally vulnerable eurozone members either directly (through a generous fiscal transfer that helps achieve debt sustainability) or indirectly (through an explicit capital backstop to their own financial sectors, which are the main holders of peripheral debt).

Note that I am *not* calling for a pre-emptive restructuring for Portugal, Spain or Italy here; nor am I talking about the establishment of a European Sovereign Debt Restructuring Mechanism or Credit Resolution Mechanism which, as Nouriel argues, is not necessary. I am talking about a credible and comprehensive backstop to cover the losses of any necessary debt restructuring, across the board, by the financially stronger governments.

Such a backstop might be anathema to the Germans, but the economic case for holding their nose and plunging into the “cesspool” can be compelling: German banks’ exposure to the PIGS (“I” for Ireland ) is around $500 billion (BIS data); that of French banks is around $400bn. This sets a clear ceiling as to the potential liability borne by the taxpayers if the crisis is contained to the PIGS.

In contrast, in the event of a piecemeal approach that leads to a systemic crisis, the size of their taxpayers’ burden becomes indeterminate: Not only will the likes of Italy be vulnerable (talking about “systemic”); but the negative wealth effects from a collapse of Europe’s financial markets would be extremely adverse for the growth outlook, especially as the global economy is still at a very fragile state.

Bottom line, it is wishful thinking to talk about an “orderly” debt restructuring when that involves a piecemeal, country-by-country approach that leaves the rest vulnerable to speculative attacks. It is also wishful thinking to talk about “market-based” approaches, given the flimsy nature of market values and the implications for the health of eurozone banks. An orderly restructuring is indeed achievable, provided it is backed by a credible backstop by the financially stronger governments. It is also desirable: the alternative won’t be pretty for anyone…

1/ Source: “Cross country experience with restructuring sovereign debt and restoring debt sustainability”, IMF 2006

The “misoverestimated” surpluses and the tax-cuts debate

One of the most stunning statements in George W Bush’s recent memoir, “Decision Points”, is his response to accusations that he squandered the budget surplus he inherited from the Clinton administration. According to an MSNBC report, Bush writes:

“Much of the surplus was an illusion, based on the mistaken assumption that the 1990s boom would continue. Once the recession and 9/11 hit, there was little surplus left.”

The irony runs deep: Back in 2001, the projected “surpluses” had been the very premise underlying the Bush tax cuts, which, supporters argued, would serve to refund to Americans the over-charge on their taxes.

But with the surplus premise now defunct even by the tax cuts’ own creator (let alone by the glaring misery of America’s fiscal outlook), are there any arguments left to support their extension beyond their scheduled expiry at year-end?

Obviously, the #1 argument made by frightened policymakers from both the right and the left is that the economic recovery is still at too fragile a stage to engage in contractionary fiscal policies such as the repeal of the Bush tax cuts. But the argument is misplaced. First, because the stimulative effect of the Bush tax cuts—as designed—is not as obvious as their multi-billion dollar cost would suggest; and second, because the alternative does not have to be the absence of any other stimulus measure.

Expanding on the first point, it is useful to consider the arguments made by William Gale and Peter Orszag in a 2004 paper, which assessed the impact of the Bush tax cuts, including as a stimulus against the 2001 recession.

The authors argued that the tax cuts were poorly designed as a stimulus measure for a number of reasons, many of which continue to apply today: First, they had a regressive nature—i.e. they were not primarily targeted to the (lower-income) households with the highest marginal propensity to consume.

Second, some of the provisions (e.g. estate tax repeal, and increases in tax-free savings allowances) were designed to increase saving, not consumption.

Third, by contributing to a large fiscal hole (to the extent they are not offset by spending cuts), they generate uncertainty about the government’s finances, which could undermine future investment by increasing volatility in capital markets.

Finally, the authors cite research by Economy.com that estimated that the measures with the highest “bang for the buck” (always from a stimulus perspective) were the extension of unemployment benefits, the aid to state governments and measures that targeted low- and moderate- income households, including the child tax credit rebate and the acceleration of the 10% bracket.

In short, the call to keep the Bush tax cuts out of fear of undermining the economic recovery has shaky economic foundations, and certainly does not stand when made by those who consider a fiscal “stimulus” as anathema. Further government support to the economy (to the extent it is politically desired) can be provided by alternative measures that are better targeted, temporary and cheaper (ie with a bigger bang for the buck).

A second argument for maintaining the Bush tax cuts is that lower revenues encourage spending restraint. Well… if only! In fact, not only is this argument disproved by the spending track record of the previous administration; steps to reduce spending can be made politically difficult by the fact that the prime beneficiaries of the tax cuts are not the same as those affected by the potential spending cuts. In other words, the bargaining game on how to restore fiscal discipline is easier when spending cuts can be “traded” for selected tax increases.

A final argument has to do with efficiency: lower taxes tend to foster incentives to increase labor supply, saving and investment. But, as argued by Gale and Orszak, the Bush tax cuts, as designed, were not ideal from an efficiency perspective. Labor supply incentives tend to increase with decreases in a worker’s marginal tax rate and, per the authors estimations, this did not change for some 40% of taxpayers. The latter is partly because the nominal cuts in the tax rates are irrelevant for households subject to the alternative minimum tax (AMT).

In addition, the Bush tax cuts have not provided a stepping stone for a true, fundamental reform of the tax system—one that is geared towards a consumption (rather than income) tax, one that broadens the tax base, one that addresses the “double taxation” on corporate profits, one that treats the interest income and expense equally, and so on. Such reform will have to wait until Congress is ready for a constructive debate on the tax code. It has little to do with the Bush tax-cut extension.

In light of the above, it is pretty baffling that voices from both the right (who supposedly care about tax efficiency, fiscal discipline, etc) and the left (who supposedly care about equity, progressive taxation, social spending, etc) have been “terrorized” into maintaining a set of measures that is faithful to none of their respective “credos”. And it will be unfortunate (and potentially explosive) if the debate on government finances does not manage to graduate into a cooler, economics-driven discussion in the months ahead.

What do the Fed's policy and poker have in common?

It is no accident that, at the last FOMC meeting, one of the “outsiders” present was NY Fed economist Gauti Eggertsson, of Eggertsson and Woodford (2003) fame—the paper he co-authored with Michael Woodford discussing a central bank’s policy options when nominal interest rates are near the zero bound.

Two of the paper’s conclusions could point to the Fed’s thinking in the months ahead, in my view. First, that quantitative easing is redundant as a tool for preventing deflation, over and above central bank commitments with regard to the interest-rate path. (Although some of the assumptions they make can be challenged, especially for situations like 2008/09, where markets were dysfunctional). In the words of the authors,

“neither the extent to which quantitative easing is employed when the zero bound binds, nor the nature of the assets that the central bank may purchase through open-market operations, has any effect on whether a deflationary price-level path will represent a rational-expectations equilibrium. Hence the notion that expansions of the monetary base represent an additional tool of policy, independent of the specification of the rule for adjusting short-term nominal interest rates, is not supported by our general-equilibrium analysis of inflation and output determination.” (my emphasis)

Second, rather than quantitative easing, the optimal policy consists of a commitment to a “history-dependent” rule driven by the price level (i.e. not the rate of inflation of the consumer price index). Under that rule, the central bank commits to a given path for the level of the price index, and undertakes to make up for past inflation shortfalls (which would drive the price level below the target) by allowing future inflation to be sufficiently higher to bring prices back up towards the target path.

The motivation behind a rule like this is to bestow the central bank the ability to manage inflation expectations (and, thus, control the level of the real interest rate), even when the nominal rate is stuck at the zero bound. By raising inflation expectations, the Fed could provide stimulus by lowering real interest rates, as well as penalizing cash holders, thus forcing them to put that cash to alternative uses—consumption or investment.

While conceptually appealing, the proposed rule is vulnerable to lack of credibility. This is because, in order to conduct policy, a central bank needs not only a rule but also a tool to implement that rule. But here, the rule and the implementation tool virtually coincide: The rule is the central bank’s intention to allow higher inflation in the future in the event of past inflation shortfalls; and the tool is simply the verbal expression of that intention.

This makes monetary policy akin to bluffing in poker: If the market buys the bluff, inflation expectations rise, real rates fall, cash gets spend, aggregate demand recovers. But why would the market buy the bluff, if, for example, it suspects that the central bank will renege on its “promise” of higher inflation in the future, and that it will “cheat” by raising interest rates once aggregate demand picks up?

In short, how can a central bank demonstrate its commitment to higher inflation, besides simply stating that this is its intention?

A number of economists have sought to address this question, including Eggertsson and Woodford (E&W) in their 2003 paper. One approach, proposed by Lars Svensson involves a price-level targeting rule combined with the pegging of the domestic currency to a foreign one after it has been depreciated by a certain amount. By pegging to the currency of a trading partner that is experiencing (positive) inflation, the central bank can demonstrate that it is serious about generating inflation at home.

Clearly, while this might be a tool available to countries like Japan or Sweden (the latter being the only country to have actually experimented with price-level targeting in the 1930s, and one that involved an eventual peg to the British pound), it is not a policy available to the Fed today.

A dollar devaluation would be unacceptable to any one of the three major economic areas (the EU, the UK and Japan), given that they face a similar economic quagmire to that of the US. And of course, a peg to a basket of emerging market currencies is not credible, given that the size of foreign asset purchases the Fed would have to make would be too large compared to the size of these markets—not to mention the capital controls (see China) that prohibit the entry of foreign players into domestic markets.

So is the Fed powerless? Not entirely. But the solution rests on calling a spade a spade—or, in the current context, calling the Fed’s large-scale asset purchases of (domestic) Treasuries (or LSAPs) “debt monetization.” In this way, the LSAPs can serve as the tool with which the Fed can make its commitment to higher future inflation credible. E&W make this point:

“[T]he tax cut can be financed by money creation, because when the zero bound binds, there is no difference between expanding the monetary base and issuing additional short-term Treasury debt at zero interest. This is essentially the kind of policy imagined when people speak of a "helicopter drop" of additional money into the economy, but here it is the fiscal consequences of such an action with which we are concerned.

[I]f the central bank also cares about reducing the social costs of increased taxation—whether because of collection costs or because of other distortions—as it ought if it really takes social welfare into account, the result is different. As Eggertsson has shown elsewhere, the tax cut will then increase inflation expectations, even if the government cannot commit to future policy.”

The bottom line here is one I’ve been arguing all along: that the only real way to boost aggregate demand at this stage is through a fiscal operation—one that is targeted towards safeguarding the economy’s productive capacity and/or facilitating the deleveraging of companies and households that remain overwhelmed with debt. (Mind you, this is not necessarily something that I, as a taxpayer, would be crazy about—I am talking strictly on economic grounds.)

The Fed’s role in this operation would be to facilitate its financing and, in the process, raise inflation expectations and help the economy avoid falling in (or escaping from) a liquidity trap. In other words, the stated motivation behind any LSAPs should not be the so-called “portfolio balance” effect (whose impact is doubtful at this juncture) but the outright monetization of government debt.

How likely is that the Fed will come out and say so on November 3rd? Don’t hold your breath—especially with a pretty nasty US midterm election a day before! In which case, the Fed’s policy will continue to resemble bluffing in poker for a little while longer.

Ben’s new rabbit: Inflation expectations

Once again, we find ourselves holding our breath for a new fluffy rabbit coming out of Ben’s hat on November 2nd (the day of the next FOMC meeting). In previous pieces I have discussed the limitations of unconventional measures (QE in particular) in stimulating aggregate demand. Here, I want to revisit this discussion in light of Bernanke’s new magic trick: that of managing inflation expectations.

The starting point is the two principal factors restraining aggregate demand currently: First, the ongoing balance-sheet repair by a certain segment of households, corporates and banks; and second, the fact that economic agents that are cash-rich maintain a strong preference for liquidity. Put differently, those with little cash and lots of debt can’t spend; and those with lots of cash and little debt won’t spend.

So the question is: What tools does the Fed have available for addressing these two problems? Pre-empting my conclusion, Large-Scale Asset Purchases (or LSAPs) of US Treasuries are an ineffective—indeed, a counterproductive—tool for addressing any of the two problems above; the kind of LSAPs that would work are *not* available to the Fed in the current political climate. But there is certainly hope in the Fed’s intention to manage inflation expectations. The issue there is where exactly inflation expectations should be guided towards, and how best to achieve that.

Starting with balance-sheet repair... I have argued before that the Fed’s LSAPs of mortgage-backed securities (MBS) and US Treasuries (ie "QE 1.0") have not been an effective tool for tackling the problem. This is because, by design, they fail to target those segments of the economy undergoing balance sheet repair.

As an example, the drop in mortgage rates that followed the Fed’s MBS purchases helped prompt an increase in mortgage refinance activity. But the cash boon from lower mortgage payments only benefited people who could afford to refinance—ie those with jobs, income and positive equity in their home, instead of the cash-strapped households facing foreclosure. Meanwhile, foreclosures kept on rising as recently as September 2010.

Ditto for corporates: Large firms with access to capital markets benefited from higher investor demand for “safer” fixed-income assets such as high-grade corporate bonds (arguably triggered by the LSAPs). But small firms with no capital market access continue to face tight lending standards.

Against this backdrop, for any new LSAPs to work, the Fed would have to be far more adventurous in terms of the assets it purchases (for more on this see here and the comments on that piece). Unfortunately, in the current US political climate such an “adventurous” LSAP program is not an available policy tool—esp. since it would require the cooperation of the Treasury. So what’s left?

Come out the new rabbit—the guidance of inflation expectations. There are two issues here: First, how does the management of inflation expectations help stimulate aggregate demand? Second, what should “managing inflation expectations” mean at this juncture and how can the Fed best achieve it?

Starting from the first question, there are two ways in which the guidance of inflation expectations can help aggregate demand at this juncture. First, by preventing real interest rates from increasing to undesirable levels: with nominal interest rates at record lows, sustained declines in inflation expectations would translate into rising real interest rates—a rise that the Fed would be unable to “fight” by cutting the nominal interest rate further. Hence the need to work on the inflation-expectations front.

But the *appropriate* management of inflation expectations can go further in my view. It can help address the second problem I mentioned in the beginning—agents’ preference for liquidity.

Currently, with inflation (and inflation expectations) at low levels, holding cash is “cheap” because of the low opportunity cost. But an increase in inflation expectations would make holding cash expensive, provided it is accompanied by a Fed commitment to keep nominal short-term rates low even if inflation eventually exceeds the Fed’s medium-term “target”. Note that in the absence of such a commitment, agents would expect the Fed to raise short-term rates as inflation moves higher. This which would in turn preserve their real return on cash, eliminating the incentive to switch into less liquid investment instruments, consumption and/or hiring (in the case of corporates).

Put simply, in order to facilitate a switch away from cash, the Fed has to commit to allowing inflation to go above its medium-term projection. Now, before you accuse me of pushing the Fed into some treacherous territory, check out what Ben said on Friday:

Recognizing the interactions between the two parts of our mandate, the FOMC has found it useful to frame our dual mandate in terms of the longer-run sustainable rate of unemployment and the mandate-consistent inflation rate.

Repeat: “mandate-consistent.”

Later in that the same speech, Bernanke added that

“The longer-run inflation projections in the SEP indicate that FOMC participants generally judge the mandate-consistent inflation rate to be about 2 percent or a bit below.”

Now that’s for the “longer-run”—i.e. beyond 2012. In my view (and that’s just *my* view), the “mandate-consistent” inflation in the nearer-term is above that level, precisely for the reason I mentioned above: Economic agents with lots of cash at hand need an incentive to part with their cash.

So much about the economic rationale. How about implementation? In my view, hints of such an approach were given by Bernanke on Friday:

A step the Committee could consider, if conditions called for it, would be to modify the language of the statement in some way that indicates that the Committee expects to keep the target for the federal funds rate low for longer than markets expect [my emphasis]. Such a change would presumably lower longer-term rates by an amount related to the revision in policy expectations.

The problem with Ben’s specification however is that “longer than markets expect” does not condition the period of low rates on the inflationary path. As such, it falls short of achieving the liquidity-preference objective I mentioned above.

But there is also a second problem (read “systemic risk”) with the Fed’s overall policy framework—one that brings me back to reiterating (for the nth time) my aversion to the LSAPs. This is the inconsistency between the Fed’s attempts to “force down” long-term yields to levels that are misaligned from the Fed’s own medium-term targets for inflation and growth!

Basically, it’s one thing to intervene in order to correct a misalignment of asset prices from fundamentals (like the Fed did with its liquidity interventions in 2008). It’s another thing to intervene in order to engineer a misalignment of asset prices away from fundamentals—the very fundamentals you (Fed) are trying hard to achieve! This latter is not only non-credible; it is also dangerous, as it creates bond-market bubbles that can unwind with potentially disruptive effects for the financial system (it’s no accident that the hot topic at the IMF meetings last weekend was when will the bond bubble burst).

So with all that in mind, my call to Ben would be “a little more inflation and a little less LSAPs please”. LSAPs of Treasuries or MBS have little power to stimulate aggregate demand but carry too many risks for the financial system. Instead, the FOMC should find the language to convince the world that a little more inflation in the near-term is the way to go.

QE and its unintended consequences

In raising the possibility of QE2 at his Jackson Hole speech, Ben Bernanke mentioned two potential costs that would have to be assessed against any benefits of a QE - round #2, before the Fed makes a decision to that effect.

One had to do with the potential rise in inflation expectations due to perceptions that the Fed would have difficulties unwinding its vastly expanded balance sheet in the future.

The second had to do with economists’ insufficient understanding of the exact impact of central bank asset purchases on financial conditions (let alone aggregate demand). As Bernanke put it, “we do not have very precise knowledge of the quantitative effect of changes in our holdings on financial conditions. […]. [U]ncertainty about the quantitative effect of securities purchases increases the difficulty of calibrating and communicating policy responses.”

Here, I want to add a few more potential risks into the list: Are there any unintended consequences of the Fed’s asset purchases (and low-for-long interest rates more broadly), other than a possible spike in inflation expectations? For the sake of brevity I’ll just keep a list format, with the intention to elaborate on each one of the issues separately in future pieces.

So the first concern has to do with the potential systemic risks associated with the behavior of institutions such as insurers and pension funds in an environment of low (and falling) long-term interest rates. For starts, falling interest rates have increased the net present value of their liabilities (and have lengthened their duration). This does not have to have a negative balance sheet impact, provided that the asset side of these institutions benefits from matching capital gains as interest rates fall.

However, news reports and market talk suggest that this is not what has happened: Before the Fed’s hint of QE2, expectations that long-term rates had to go up from record low levels saw many institutions holding conservative duration exposures on the asset side of their balance sheet. The result has been a smaller gain on the asset side (with the concomitant increase in the funding gap) and a recent push towards long-duration positions to address the duration mismatch between assets and liabilities. The “systemic” risk here is that, if and when long-term yields begin to rise, the unwinding of these positions can lead to a much sharper rise in yields and volatility in the bond market.

A second concern has to do with the hedging behavior of mortgage/MBS investors. Low interest rates increase the probability of refinancings and, as a result, reduce the expected duration of MBS securities (and the underlying mortgages). MBS investors hedge against this prepayment risk by holding instruments of long duration, such as long-term Treasuries or interest rate swaps. Once again, if and when interest rates start going up, unwinding these positions can become destabilizing, as everyone enters the market in the same direction. (The impact of this is of course mitigated by the fact that the Fed itself holds a substantial chunk of the mortgage market).

Third on the list is the potential build-up of leveraged positions (or “carry trades”) “thanks” to the Fed’s promise of low-for-long interest rates. The risk is that crowded carry positions can unwind fast once Fed rates begin to rise, especially since the earlier leverage build-up has pushed asset valuations to stretched levels.

Now, unlike many pundits out there, I do not believe there is an empirically established causality from the Fed's policy rates to investors’ leverage. For example, the academic literature has failed to find a definitive link between the level of advanced economy interest rates and emerging market spreads (which would be obvious beneficiaries of carry trades). What does matter is investors’ risk appetite (e.g. proxied by the VIX).

And here is the challenge for the likes of the Fed: Economists do not have a complete understanding of how monetary policy affects investors’ risk-taking behavior (the so-called “risk-taking channel"). But this does not mean that it’s something to ignore, simply because it doesn’t fit into some well-established theoretical framework. More so since the framework supporting the Fed’s asset purchase program (the “portfolio balance channel”) has little to say about the build-up of leveraged positions and any associated risk from their unwinding.

A final concern—and maybe the least interesting—is the impact of low interest rates on the viability of money market funds (MMFs). Low-for-long nominal rates, combined with new regulations to increase the liquidity and reduce the maturity and riskiness of MMF investments has been squeezing the sector’s profitability. Add to that the fixed expense ratios of around 0.2-1% of assets, and the low rates can force at least some of the less efficient MMFs to closure.

The reason this is the least interesting problem in my view is that the economic impact is unlikely to be meaningful. Users of MMFs tend to be high-quality corporate borrowers who could easily tap bank or capital market financing. True, the costs of borrowing might be marginally higher, but this is most likely dwarfed by the impact of record-low interest rates thanks to the Fed's policy.

Still, I thought I should mention it, first because some economists have raised this issue in the past, and second because I was personally amused by Bernanke’s own take on this concern. Here is Ben in 2004:

“In thinking about the costs associated with a low overnight rate, one should bear in mind the message of Milton Friedman's classic essay on the optimal quantity of money (Friedman, 1969). Friedman argued that an overnight interest rate of zero is optimal, because a zero opportunity cost of liquidity eliminates the socially wasteful use of resources to economize on money balances. From this perspective, the costs of low short-term interest rates can be seen largely as adjustment costs, arising from the unwinding of schemes designed to make holding transactions balances less burdensome. These costs are real but are also largely transitory and have limited sectoral impact.”

That’s right… Bernanke (then-Fed Governor) responded by going philosophical, citing a supposed structural argument (something like, “MMFs are probably not that useful and zero interest rates can help eliminated them”), grounded on a much-debated theory (Friedman’s rule) to support a policy that is strictly cyclical in nature!

Anyway.. A mini-diversion from the main point, which is that the potential costs from further QE, and low-for-long yields more broadly, go beyond the possible rise in inflation expectations and the threat to the Fed’s credibility. Against this backdrop, any cost-benefit analysis should consider not only policymakers’ uncertainty over QE’s impact on aggregate demand but also their uncertainty about the potential risks for global financial stability.