Thursday, December 27, 2012

Trickle-Down Monetary Policy

From Fed’s $4 Trillion Rescue Helps Hedge Fund as Savers Hurt:
Bernanke said last year that the Fed aims “strictly to do what’s in the interest of the broad public.”

He said last week that the policies are intended to “try and create a stronger economy, more jobs, so that folks across the country, including places like the one where I grew up, will have more opportunity to have better lives for themselves.”

Bernanke said last week the central bank will purchase $85 billion of assets a month next year “to increase the near-term momentum of the economy.”

Purchasing assets removes those assets from the economy and replaces them with new money. But what is an asset? An asset is somebody's liability.

I buy a house. I get a mortgage to buy the house. The house is my asset and the mortgage is my liability. Forget about the house.

I get a mortgage. I get an asset (the house. Forget about the house), and the lender gets an asset. The asset the lender gets is my promise to pay back the loan.

My promise to pay back the loan is my liability. It influences all my spending decisions for the next 30 years.

My IOU is an asset to the person I am paying, and it is a liability to me because I am paying. The fact that I'm paying is what makes the IOU an asset to the other guy.

Along comes the Fed, giddy buyer of assets. The Fed buys my IOU from my lender and pays the lender with the-ink-is-still-wet money.

The... what do they say? The "composition of the bank balance sheets" has changed. Yeah, okay, fine. The guy that used to have my IOU now has cash. He got satisfaction. He got what he expected to get, eventually, for the IOU. But there is more to the story than that.

The Fed buys the IOU from my lender. The lender gets cash. And I get to make the same payments I made before, except now I pay somebody else. That really doesn't do much for me. It doesn't do much for the economy, either.

Purchasing assets removes those assets from the economy, replacing them with money. But the liabilities remain as they were: draining income, depressing demand, hindering economic growth.

If I'm just squeakin by, barely getting from paycheck to paycheck or maybe not even, I don't give a rat's ass if I'm paying the original lender or the asset-buyer of last resort. I have more pressing concerns.

Those concerns are not addressed by the Fed's asset purchase policy.

Now, if the Fed bought my IOU and cancelled it, it would remove a liability from the economy. This is what needs to be done to bring our economy back to life: Reduction of liabilities, not assets.

Remember back when this whole thing started, the word of the day was "deleverage". People wanted to reduce their debt: People wanted to reduce their liabilities.

The catch-phrase at the time was "toxic assets". What is a toxic asset? Something like my IOU if I'm failing to make the payments. Toxic assets are liabilities going bad.

What the Fed did was, it started buying the toxic assets. Started buying the bad IOUs. It took bad IOUs out of the economy and replaced them with new money. But the IOUs still exist, and they are still iffy. Meanwhile, we are still trying to make the payments, and this is still undermining demand and hindering economic growth.

See the problem?


Joshua Wojnilower said...


Spot on with this analysis. A couple things I might add:
1) The Fed buys the IOU from lenders at current market prices, which don't necessarily include expected full return of principal or interest payments. In this manner the Fed actually earns profits, reducing net interest income to the private sector. This is why some people argue QE is actually monetary tightening.
2) In theory the Fed could cancel liabilities, but IMO that is explicitly crossing the line into fiscal policy. Do we really want unelected officials determining which individuals will have their liabilities cancelled? I'm not ready to go that far.

DIego Espinosa said...

"Now, if the Fed bought my IOU and cancelled it, it would remove a liability from the economy"

Maybe. Currency is one type of liability. It is a "perpetual zero coupon" one. Meaning it has infinite duration. I can see how the PV of this liability is zero.

Bank reserves are another type of liability. It is a perpetual, callable, coupon-paying one. Because the IOR is adjustable at will, bank reserves have overnight duration. The PV of bank reserves is >0.

If the Fed cancels all its Treasuries, this would have no effect. The Fed has already issued an o/n-duration liability -- bank reserves -- to fund U.S. government current spending. "Cancelling" the debt is merely an intragovernmental redistribution. That is, it prevents Treasury from having to pay interest to the Fed that is then remitted back to Treasury. Perhaps, one could say cancellation has the effect of making bank reserves non-callable and therefore more likely to be converted into currency.

In any case, the major impact of QE has to do with changing the duration of liabilities issued by the consolidated Fed/Treasury balance sheet: from 5yrs+ duration (ranging to infinite for currency) to o/n.

The Arthurian said...

Joshua, you know I think you're gonna be the Fed Chairman someday :)

1) I assume there are stats on how much of a bargain the Fed is getting, and estimates of how much asset prices are propped up (or pushed up) by Fed purchases.

Wait... are you saying the extra interest the Fed earns from these asset purchases is interest income not paid to the private sector? Just that straightforward??

To gauge whether QE is monetary tightening, one would have to compare the interest paid to the Fed, versus the principal that comes out of circulation because the liabilities behind the Fed's MBS purchases have NOT been cancelled, versus the money the Fed paid to SAVERS when it bought the MBS. (Giving money to savers does little or nothing to fortify the spending stream.)

Add to that, that the interest income NOT received by the private sector (because of the Fed's asset purchases) is probably not-received by SAVERS, not spenders. (Are there stats on this???)


2) I see people saying such things. I have a simple (Adam Smith would say "rude" :) view: If the Fed does it, it's monetary policy. If the tax-and-spender does it, it's fiscal policy.

BTW, perhaps you never heard this: The "fisc" in "fiscal" and the "fisc" in "confiscate" have a shared origin. (Oh, I'm putting that into a post.)

I think the right question is not "Do we really want unelected officials determining which individuals will have their liabilities cancelled?" but rather "Shall we choose to eliminate the impediment to growth?"

If there are any "moral hazard" issues in that, they are best worked out by creating better policy early in the next boom.

John Atten said...

re: "If the Fed does it, it's monetary policy. If the tax-and-spender does it, it's fiscal policy."

You forgot one - " . . . and if the citizen does it, it's a crime."

Nice post! Consider me subscribed.

Joshua Wojnilower said...

Art, thank you for the excellent compliment. It made my day.

1) As I understand it, the Fed buys and sells securities through an auction so that actual prices paid and received are very close to current market prices. The question of whether banks front-run Fed actions is a good question but far more difficult to measure.

My point however was as simple as stating the Fed's annual profits are forgone interest income of the private sector.

Regarding the principal of securities purchased, I'm not sure exactly how defaults were treated. My guess is the Fed took some losses that would have otherwise been absorbed by private sector banks. I imagine there are details on this in Fed reports but am unaware of any specifics at this point.

2) I had not heard about the origin of fiscal before but am glad you brought it up. Looking forward to a post on that topic.

You make a good point about the distinction between monetary and fiscal policy. A good follow up inquiry would be to find out whether the Fed is legally permitted to modify or cancel liabilities.