The Federal Reserve has begun its second round of “quantitative easing” aimed at jump-starting an economy so anemic nearly one in 10 American workers remains unemployed, many for a year or more.
Announced recently by its chairman, Ben S. Bernanke, the Fed plans to buy $600 billion in Treasury securities from the banks and other financial institutions that currently hold them. By exchanging bonds for dollars, the purchases will expand the amount of credit available for lending, drive down long-term interest rates and provide incentives for private businesses to invest in new plant and equipment, recall laid-off workers, hire new ones and theoretically, restore economic prosperity.
Or so Mr. Bernanke hopes.
Fed Vice Chairman Janet Yellen told the Wall Street Journal that “I’m having a hard time seeing where [else] really robust growth can come from.” Even so, Ms. Yellen doesn’t see the economy returning to normal until 2013.
America’s central bank is playing a dangerous game. The key assumption behind “QE2” is that credit markets are frozen - and lenders are reluctant to lend - because the financial system lacks sufficient liquidity.
But banks are awash in loanable funds. When the Fed started its first round of quantitative easing in 2009, to help achieve its target of a near-zero federal funds rate (the interest rate banks charge one another on overnight loans), lenders simply sat on the extra reserves. They did so not because they didn’t want to use those funds profitably, but because the bursting of the housing bubble and the ensuing “Great Recession” sensitized them anew to credit risk.
Then, as now, the economy’s arteries were clogged with toxic assets, including mortgage-backed securities whose values are yet unknown because the real estate market hasn’t yet hit bottom.
In order to minimize credit risks, banks invested in safer Treasuries instead. The Fed now proposes to soak up an additional $600 billion of those assets.
Buying bonds will expand bank reserves once again, but it does nothing either to change underlying economic fundamentals or to resolve the uncertainty about future tax rates, the costs of Obamacare, regulatory “reform” of financial markets and other government policies that undermine the spending plans of private business owners and consumers alike.
It doesn’t take a rocket scientist to predict that banks still will hesitate to lend despite having an additional $600 billion in reserves, or to realize that if credit markets “unfreeze” at some future date, as they inevitably will, the disgorging of trillions of dollars in now-idle loanable funds is apt to produce much higher rates of inflation, unless the Fed reverses course quickly and reverts to a tight money policy.
Even if the Fed succeeds in reducing long-term interest rates, the economy will not necessarily be out of the woods. Artificially low interest rates induce businesses to undertake projects that otherwise would be unprofitable. Not to worry too much, though. Investors have been selling Treasury securities in anticipation of the Fed’s buyback plan, raising yields to levels not seen for three months.
Some commentators suggest that Washington’s fiscal and monetary responses to current economic events have been too timid. How much would be enough: $2 trillion, $3 trillion, more?
It’s fashionable on the left to argue that America should emulate Europe, especially with respect to social-welfare policies.
But Europeans - and many U.S. economists - are wising up. Coincident with the Fed’s latest initiative, the European Central Bank signaled that it will refrain from further monetary stimulus, at least for the time being. That policy of restraint, along with the fiscal austerity programs recently adopted by France, Germany and the United Kingdom, point down the path our own government should take.
William F. Shughart II is a senior fellow with the Independent Institute and professor of economics at the University of Mississippi.