Monday, December 1, 2008

Will Quantitative Easing Work?

Much has been made recently about the theme of quantitative easing. What is it? In short, quantitative easing (QE) is a central banking policy tool used when the rate of interest falls so close to zero that further reductions are either impossible or are having no effect on stimulating the economy or preventing deflation. The central bank is to create money (electronic money) out of thin air, and use it to buy government securities, although it could conceivably be used to buy anything. Done by any other person, this is a process known as "counterfeiting," but that is the very nature of our central banks. This is what Fed Chairman Ben Bernanke was referring to in his famous "helicopter" speech back in 2002, Deflation: Making Sure "It" Doesn't Happen Here.

It is a tool first used by Japan earlier this decade to stave off deflation, and has been, to say the least, a miserable failure. Why did it fail? For one, the money that was injected into the Japanese banking system didn't stay in Japan. It went elsewhere, fueling "carry trades." Secondly, the Japanese population was rapidly aging and asset prices were too high. They needed to fall further - and indeed they have. Lastly, deflation is partly a psychological condition. People in Japan knew that the inflated values of Tokyo apartments would fall further, so they were far better off to save their money and rent.

In his 2002 speech, Bernanke laid out his reasons that the Japan experiment with quantitative easing would be different from any American attempt.
The claim that deflation can be ended by sufficiently strong action has no doubt led you to wonder, if that is the case, why has Japan not ended its deflation? The Japanese situation is a complex one that I cannot fully discuss today. I will just make two brief, general points.

First, as you know, Japan's economy faces some significant barriers to growth besides deflation, including massive financial problems in the banking and corporate sectors and a large overhang of government debt. Plausibly, private-sector financial problems have muted the effects of the monetary policies that have been tried in Japan, even as the heavy overhang of government debt has made Japanese policymakers more reluctant to use aggressive fiscal policies (for evidence see, for example, Posen, 1998). Fortunately, the U.S. economy does not share these problems, at least not to anything like the same degree, suggesting that anti-deflationary monetary and fiscal policies would be more potent here than they have been in Japan.

Second, and more important, I believe that, when all is said and done, the failure to end deflation in Japan does not necessarily reflect any technical infeasibility of achieving that goal. Rather, it is a byproduct of a longstanding political debate about how best to address Japan's overall economic problems. As the Japanese certainly realize, both restoring banks and corporations to solvency and implementing significant structural change are necessary for Japan's long-run economic health. But in the short run, comprehensive economic reform will likely impose large costs on many, for example, in the form of unemployment or bankruptcy. As a natural result, politicians, economists, businesspeople, and the general public in Japan have sharply disagreed about competing proposals for reform. In the resulting political deadlock, strong policy actions are discouraged, and cooperation among policymakers is difficult to achieve.

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.

Boldface mine.

As can be easily seen, the problems facing Japan in the 90's that Bernanke referred to as different from the US, are now strikingly similar 6 years after Bernanke's speech. Yet he is persisting in the same policies anyway. I'm reminded once again of Einstein's definition of insanity (as I am almost daily): "The definition of insanity is doing the same thing over and over, yet expecting a different result."

Bernanke is clearly insane.

Similarities with Japan aside, others have pointed out for years that because the US Dollar is the reserve currency of the world, deflation is impossible in America. To that I would simply argue that it's reserve status can easily change. Regardless, it should be readily apparent that the US (and the UK - soon to be followed by the EU) is in deflation now. If you read Bernanke's full speech and the tools he said he would use to conquer deflation, it would also be readily apparent that Bernanke himself knows America is deflation (although he may not want to publicly admit it for self-perpetuating psychological reasons.)

So what now? Does America suffer from 18 years of alternating stagnant growth and deflation like Japan? Do they suffer the brutality of a 1930-33 style 10% a year deflation? Maybe it will be something in between, maybe something different entirely. There's not much on the precedent side of things when it comes to deflation - one of the few astute observations made in Bernanke's speech.

The only thing I know for certain, is that if left alone, the economy would heal itself much quicker than with all of this tinkering.


Matt Stiles said...

Bernanke used another one of the tools he mentioned in that speech today. He's buying long dated US Treasuries. Yields are getting crushed on the news. Japan 2.0.

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