The Parallax Brief


Unrepentant Subjectivity on Economics, Politics, Defence, Foreign Policy, and Russia

The Fed’s Ten Trillion Dollar Problem

If anyone should have been prepared for the credit crunch it was Federal Reserve chairman Ben Bernanke (pictured right). Much of his academic reputation, which is immense, was built upon his work on the causes of depressions and, specifically, the Great Depression.

Although central bankers and economists assumed that advances in economic understanding — a significant portion of which came from Bernanke — had made depressions avoidable, Japan’s oft-discussed lost decade of deflation raised some uncomfortable questions.

Here was a nation not unlike the US and large Western European countries, with a powerful industrial base, sophisticated financial sector, and a modern, mature economy, which became mired in monetary quicksand, unable to exfiltrate itself from economic stagnation, despite following the playbook economists throught could avoid just such scenarios. Why?

Bernanke thought he had the answer: according to Paul Krugman, Bernanke and the Fed “have been gaming out what they would do if “it” happened here for years,” and had come up with a package of unconventional monetary actions with opaque names like ‘quantitative easing’, and ‘balance sheet expansion’, as well as the somewhat more explicit ‘use of the printing press’.

Whatever the names meant, the idea was simple. When interest rates are at zero, conventional monetary policy, which seeks to influence the economy by making credit cheaper or more expensive (and thereby making money more plentiful or scarce), reaches its logical limit. Interest rates cannot drop below zero, because nobody receives a fee to take a loan, or, the other way around, a creditor does not pay interest to the borrower.

But if interest rates are at or near zero, making credit as cheap as it possibly can be, and therefore money as plentiful as it possibly can be, yet the economy is still falling off a cliff, and inflation is still plunging toward negative figures, monetary policy must look for alternatives if it wants to gain leverage.

Which is where Bernanke’s opaque names make an appearence. Those alternatives are to expand the balance sheet, which involves the Fed buying government bonds to ensure long term interest rates remain low, and buying securities (bonds, or even stocks) to make sure markets are liquid. This is done by printing money, to make it more plentiful and therefore cheaper.

Bernanke believed that by aggressively enacting this program, he could help America avoid the calamity of a ‘lost decade’ of economic stagnation and deflation.

Not so fast, Mr Bond, says Noam Scheiber:

Today’s daily economic report from Goldman Sachs performs a fascinating exercise: It tries to measure the power of the Fed’s so-called “unconventional easing.”


Goldman tried to figure out is how much in the way of assets you’d have to buy up to replicate the effect of, say, another 1 percentage point drop in interest rates. Their answer: about $1 trillion to $1.6 trillion.

Now that sounds like a lot. And Goldman certainly thinks it is. They write: “These are clearly huge numbers, especially when compared with the Fed’s current balance sheet ($1.9 trillion, of which securities [asset purchases like the kind we’re talking about] held outright make up roughly one-third).””

This scares the bejesus out of Krugman:

“One thing Noam Scheiber doesn’t mention in his summary above is the extent to which this result, if true, strikes at the heart of Ben Bernanke’s strategy for dealing with the crisis.”

And a key element of the strategy was altering the composition of the Fed’s balance sheet — that is, unconventional easing.

But that tool isn’t proving very potent.”

In other words: it’s not going to work. And perhaps this explains why flooding the economy with liquidity is proving ineffective (what Keynes described as “pushing on a rope”).

At current levels, the Fed’s interest rate, according to Krugman, ‘should’ be at minus 6%, meaning the Fed would potentially have to expand its balance sheet by nearly USD10 trn (USD10,000,000,000,000) to have an effect equivalent to setting interest rates at the level the economy currently requires.

Houston, the Fed has a problem.

The conclusion that Krugman and Scheiber avoid (probably because they’ve already made it ad nauseum) is that fiscal stimulus is going to have to step into the breach.

Sorry Chicago School, but monetary policy has reached its limit. We’re all Keynesians now.


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