Stimulus Can Backfire: Monetary Policy

If Bernanke needs a break today, he should go to McDonalds like the rest of us.

The previous posting addressed how fiscal stimulus can backfire. This posting addresses monetary policy. Alan Blinder’s opinion piece, “Ben Bernanke Deserves a Break” from the WALL STREET JOURNAL September 28, 2011 is the point of departure.

The fiscal stimulus discussion, “Stimulus Can Backfire: Fiscal Policy,” and previous discussions of fiscal stimulus focused exclusively on how stimulus can fall short of, or fail to achieve, expected results. That was facilitated by the focus on the economic impact of the analysis being discussed. By contrast Blinder’s opinion piece spends a lot of time on the politics and optics surrounding monetary policy. It eventually does mention the economic aspect of operation twist. This posting will follow the same outline.

If one examines each of the pressures Blinder mentions, it is hard to see how one can seriously exempt Bernanke from some responsibility for creating the sources of most of the pressures. That is especially true of Blinder’s forays into politics and the optics. So, let’s deal with that first.

Blinder does not seem to realize that purchasing across the yield curve has always embroiled the Fed in politics. The Hedged Economist noted this cost of quantitative easing and TARP on July 19, 2011 in “A Clearer View Of The Fireworks.” As stated, “The entire issue of the Fed’s role probably could have been skipped except that it is going to explain why the Fed is going to lose any semblance of independence. Since I favor a relatively independent Fed, I consider that important.”

A number of examples of the political pressure on the Fed that are the inevitable result of trying to manage the yield curve are discussed below. They are from the period around the Fed / Treasury accommodation of the 1950’s. That period is used to confuse the partisans since many partisan roles were the opposite of today’s, although the methodological issues are often the similar.

Wall Street expectations of a twist are a curious issue. During the 1950’s they were viewed by some as a potential reason why the Fed should not buy long-dated bonds. Two concerns were 1) that bond buyers would game the Fed, and/or 2) it would reduce private sector markets for long-dated bonds. Often both arguments, although to some extent contradictory, were used by the same person. Now, Blinder views them as a pressure to implement a twist: just the opposite conclusion.

Wall Street expectations are an issue that seems totally irrelevant. What economic impact does whether Wall Street expected operation twist have? Little to none seems a reasonable answer. The most that Fed research staffs can come up with is that expectations may have a slight impact on timing. The pressure that Blinder thinks Bernanke felt due to Wall Street expectations would be totally of Bernanke’s creation.

Here’ a quote from an article: “Stocks jumped, then sank and then rose again, as investors tried to bet on whether the Federal Reserve is going to intervene again to support financial markets.” Without a reference, it could be any article (it also could have been about bond prices rather than stocks), but here’s the telling question. In what decade was it written and did the Fed act? Do a little research, and you will find it has been written in many different decades. You will also find that whether market participants’ expectations were accurate had NO relationship to future economic performance.

The real issue concerns more extensive price controls (which is what manipulating the yield curve is). The question is: Do price controls implemented through Fed purchases produce efficiency? Given the dislocations of wartime wage and price controls, this was a major issue during the 1950’s. Interestingly, in the 1950’s, justifying price controls was a major challenge for advocates because of potential adverse effects on investment. Currently that issue has been largely ignored. By contrast, some contemporary critics of purchasing longer-dated bonds point to negative impact on savers (e.g., pensions, retirees, and life insurers), an issue that could safely be acknowledged and then ignored back in the 1950’s due to the huge forced savings built up during wartime.

The divided vote among the Fed committee members is an issue where Blinder’s comments make him appear far less knowledgeable than he is (or should be). He almost certainly knows they are typical, and he has often been a party to such divisions. Let’s take one of many examples from the 1950’s where Blinder’s personal behavior isn’t at issue. Fed Chairman Martin, and the New York Fed Sproul are the best example. They are only one example, but one that was common, almost the norm.

The Martin-Sproul differences are informative currently. Two characteristics are very timely. First, the differences often originated from differences in what each individual thought should be the focus/objective of policy at the time. Yet, unlike the fictitious employment vs inflation tradeoff economists cling to despite lengthy periods of stagflation, their differences didn’t facilitate positions that were dogmatic. Blinder’s consistent advocacy of easier monetary policy wouldn’t fit into the Martin and Sproul discussions. Their differences weren’t one sided with each one always advocating the same policy.

As also exists currently, behind some of their policy differences there were significant differences in perceptions of how markets would react. Although the issues were different, the market-reactions issue is akin to the adaptive expectation-rational expectations issue. The current differences between those who rely on comparative statics verses those who believe market reactions are path dependent are also similar to the Martin-Sproul differences. There were fundamental differences in how the two parties thought markets behave.

Blinder just brushes aside the potential methodological/theoretical bases of policy differences. In an academic environment he may be more open minded. His reporting, however, leaves an impression of dogmatic refusal to question the current economic conventional wisdom. That’s unfortunate because it raises questions about whether he can actually view the policy issues objectively.

The partisan political pressure is also not new. One suspects that Blinder’s reporting it as unprecedented reflects his partisan leaning more than anything else. Democratic Senator Douglas was the highest profile congressional critic of the Fed during the 1950’s. While Douglas and the recent efforts Blinder notes represent a single chamber of Congress, surely Blinder knows that at times both chambers and the executive branch have historically pressured the Fed from time to time.

One pressure that belongs squarely with Bernanke (and those like Blinder who report and comment on the Fed) is reflected in every discussion of “bailouts.” Bernanke and maybe even Blinder understand that Fed policy represents two different issues depending upon whether the policy is designed to address a liquidity crisis, or a slow, tentative recovery. Bernanke hints at it with his “the Fed can’t do it alone” rhetoric, but he hardly helps by trying to defend current actions by referencing parallels between two very different policy imperatives.

During a liquidity crisis a central bank’s role is to add liquidity: Lend freely at usurious rates against good collateral. That will end the liquidity crisis. That was the origin of the October 2, 2010 posting, “TARP: A success not being acknowledged.” However, as the recent Republican presidential debates and the Occupy Wall Street campouts demonstrate, the Fed failed to go back and explain what they did and why.

Most of the economic pressures Blinder also notes seem like nonsense. The Fed’s role (i.e., monetary policy) is economic. Economic “pressure” is the only reason for having a Fed.

What is strange about Blinder’s argument that Bernanke deserves a break is that once he turns to economics, Blinder undermines the argument fairly effectively. He notes that all Bernanke has to offer is a “relatively weak weapon.” He goes on to say: “Any … influence of monetary policy on the economy was bound to be modest.” If any positive impact is expected to be modest, it would seem advisable to question whether the policy action should be taken. That is only reinforced by the widespread acknowledgement that the action has risks. Even Bernanke has often mentioned the risks.

That risk was mentioned even before the posting on TARP on September 15, 2010 in “Stimulus more or less? A failure not being acknowledged. PART 3.” The quote is: “One doesn't have to be terribly familiar with what is called a "barbell" portfolio strategy to understand that there is a rational way around this potential impact of having more equity on the balance sheet. Forcing banks to hold more of a conservative asset or a conservative liability can be offset by increasing the holding of an offsetting high risk item. The overall risk doesn’t change. In fact, it’s a rational response if one wants to maintain a given overall portfolio return. One just takes on a high risk, high return positions to offset the low risk, low return position; risk and return stay the same. If the reader doesn’t understand why, consult anything on portfolio theory. Or, …”

An interesting aspect of the quote was that it came up in 2010 in connection with efforts to force banks to reduce leverage and the associated risk. However, now it explains why Bernanke can’t force people into taking more risks. One can always adjust the weights across the barbell in order to maintain any given overall risk-return profile.

Between the postings “Speak Softly But Carry a Big Stick, Dr. Bernanke,” “Operation Twist, Or Is It the Logic That’s Twisted?” and “The Fed Cannot Force Investors to Shift to a Different Risk-Return Profile,” the potential that operation twist will backfire has been covered fairly thoroughly. This is not the dogma of some political figures nor a belief that the Fed or Bernanke are evil failures. Rather, it reflects the fact that TARP and the associated liquidity injections of the earlier period would succeed while operation twist will do little under current conditions. Furthermore, what it does accomplish may do more harm than good. What is worse whatever the result of operation twist, it wasn’t worth the price.

The point where Blinder’s comments get particularly telling is when he compares quantitative easing efforts. He states: “… I was a huge and enthusiastic supporter of QE1, which concentrated on MBS, but only a lukewarm supporter of QE2's Treasury purchases. (It was better than nothing.) Since then, a few scholarly studies have estimated that QE1 was indeed more powerful than QE2. So any move back toward dealing in MBS, or in other private-sector securities for that matter, is welcome."
This statement could easily be the subject of a separate posting. Just to summarize. First, the scholarly studies he cites lend no support to his conclusion about the current program. This blog has defended QE1 (and TARP) as highly effective. It defended QE2 as consistent with a reasonable interpretation of how monetary policy could contribute to economic recovery. In both cases the impact was in NO way dependent on what assets the Fed acquired. The results the studies identify are totally dependent on the economic environment at the time. (That realization has a lot to do with the dissention on current policy).

Blinder goes on to say: “Indeed, if we indulge ourselves in a bit of blue-sky thinking, we can even imagine the Fed doing QEs in corporate bonds, syndicated loans, consumer receivables and so forth.” This is perfectly consistent with my statement above: “In both cases the impact was in NO way dependent on what assets the Fed acquired. The results the studies identify are totally dependent on the economic environment at the time.” The big issue is monetary policy.

However, the hollowness of Blinder’s very argument strongly supports the contention that the Fed shouldn’t be free of supervision in deciding which types of assets it purchases. As pointed out, even purchasing across the yield curve has always embroiled the Fed in politics. That’s of questionable justification, but once the assets aren’t Treasuries, it is legitimate to argue that it should be political. It’s also why the Fed should avoid it whenever possible, and why the current operation twist, which may have no beneficial impact, isn’t worth the political cost.