Barry Ritholtz linked a post in by Randall Forsyth in Barron’s that has interesting and important ramifications for whether we should use fiscal (Congressional spending) or monetary (quantitative easing) means to stimulate the economy.
The drawbacks to fiscal stimulus are well-known and obvious: it creates debt that must be paid off later, Congress is slow in acting so it usually shows up only when recovery has begun, and since it shows up late, it ends up creating inflation.
But we have been sold a narrative in which there are no consequences to Fed actions, as long as they are genuinely prudent on interest rates to avoid situations like the housing bubble created by Greenspan and a few million co-conspirators. Forsyth thinks that quantitative easing, by creating a bit of a bubble in commodities, is responsible for the current slowdown:
As notes long-time Fed watcher Lacy Hunt of Hoisington Investment Management in Austin, Texas, the unintended consequences of its policies have all but superseded their professed aims. For instance, QE2—the Fed’s purchase of $600 billion of Treasury securities completed in June—caused the current slowdown instead of giving the economy a boost, he writes in Hoisington’s Quarterly Review and Outlook. Real disposable income was lower in August than in December, in part because of the jump in commodity costs.
And there’s the possibility that banks will cease to lend (as if they already haven’t), because very low long-term interest rates means that they can’t make much money on lending:
But, Hunt points out, ultra-low interest rates could have the opposite effect. To earn a profit, banks have to cover their costs, from payroll, overhead, taxes and “elevated” fees to the Federal Deposit Insurance Corp. Then they have to earn a spread to compensate for the risk the borrower could default. At very low interest rates, there aren’t enough basis points left to lend profitably. The historical precedent is Japan, where banks would rather buy government bonds than make loans.
This doesn’t logically follow, since the whole point of Operation Twist was to lower rates on long government bonds, whereas rates for everything else is determined in the market. But it’s worth considering. If rates for everything fall to zero, there’s obviously no profit to be had. The closer they get to zero, the more compression there is. Ordinary people experience that in their bank accounts. If interest rates on CD accounts are 0.1%, the value in lending money to the bank is so low that one might as well keep it in cash. Even a $10,000 CD generates less return than the bookkeeping it costs to maintain it.
Fiscal stimulus is hard to do right. But it’s pretty clear that that–if coupled with major reforms– and not monetary stimulus is the only thing that will get us out of recession.