The Fed Has Not Done Enough and it Has Not Fired Most of its Ammunition

These are difficult times.  The sudden collapse of stock prices is not creating panic so much as despair, a despair voiced by Joseph Stiglitz in his column in the Financial Times today in which he correctly observes:

The Fed’s announcement that it will keep the target federal funds rate near zero for the next two years does convey its sense of despair about the economy.  But, even if it succeeds in stopping the slide in equity prices, it won’t provide the basis of recovery: it is not high interest rates that have been keeping the economy down.

Joseph Stiglitz is a brilliant economist, richly deserving the Nobel Prize he won in 2001, but it is shocking that he would assert that monetary policy can promote recovery only by reducing interest rates.  Evidently, that idea has been repeated so often and with such conviction that even an economist of Professor Stiglitz’s stature can unthinkingly parrot it without embarrassment.

Does Professor Stiglitz believe that if US monetary authorities decided to buy foreign exchange with dollars driving down the value of the dollar against other currencies, dollar prices would not rise?  And if foreign governments responded by purchasing dollars with their own currencies does he believe that prices in terms of those currencies would not rise?  Competitive devaluations would require no reduction in interest rates to be effective and would produce an immediate increase in money supplies and prices.  So it is clearly within the power of central banks, if they had the will to do so, to achieve any desired increase in the price level.  That the Fed and other central banks have not done so means only that they have not tried.

Stiglitz continues:

Corporations are awash with cash, but banks have not been lending to the small and medium-sized  companies that are the source of job creation.  The Fed and Treasury have failed to get this lending restarted, which would do more to rekindle growth than extending low interest rates though 2015

He is right that the Fed and Treasury have failed to get lending restarted, but fails to mention the primary reason: banks are being rewarded for holding reserves with a higher interest rate than they could earn by holding short-term Treasuries.  Returning to a zero-interest-rate policy on reserves or even imposing a tax on excess reserves would certainly change banks incentives, inducing them to reduce their holdings of reserves and to seek alternative ways, like lending to businesses and consumers, to generate income.

A similar sense of futility, though reflecting a profoundly different economic outlook from that of Professor Stiglitz is evidenced in The Wall Street Journal in its August 9 editorial on the FOMC’s announcement.

This is what a central bank does when it wants to appear to do something to help the economy but has already fire most of its ammunition.

But within two paragraphs, the Journal sharply pivots in its characterization of the Fed’s statement.  After noting the dissents of three FOMC members, regional bank presidents not appointed by President Obama, the Journal conjectures that:

the policy statement may have been a compromise, and that others on the committee would have gone further, perhaps so far as to start a third round of quantitative easing.

So the Journal itself seems to imply that the Fed’s statement ought to have been characterized as follows:  This is what a central bank does when it can’t agree to use the ammunition that it has.

The Journal, like Professor Stiglitz, pronounces the Fed’s quantitative easing a failure because all it accomplished was to “[push] investors into riskier assets (stocks and commodities).  But the prices of those assets have since fallen back down to what investors think they’re worth.”  It is almost surprising to read that the Journal believes that the Fed has power to push investors into anything, but readers of the Journal editorial page are no longer so easily surprised.  Investors make judgments, which may or may not be correct, on their own based on the policy signals emitted by the Fed.  If asset prices rose as a result of the Fed’s policy, it was because that was what investors, given the information they then had, felt the assets were worth.  If the assets fell in price later, that was because investors revised their expectations, presumably in light of new information, including new information about the Fed’s policy intentions, as well as the intentions of other relevant policy makers.

The Journal presumes that QE2 was intended to produce wealth effects that would increase consumer spending.  In this presumption, the Journal actually has some support from unfortunately inaccurate explanations of how the program would work by Mr. Bernanke himself.  But such wealth effects were, in the Journal’s view, offset by the negative “income effects” occasioned by the commodity-price bubble induced by QE2. 

Economic growth has decelerated over the past year despite QE2, so we wonder what good Mr. Bernanke thinks it did.  We’re hard pressed to see what good QE3 would do as well.

We know that QE2 was intended to prevent inflation expectations from falling to dangerously low, even negative, levels, as they seemed about to do last summer.  And in this it was successful.  The deceleration in growth was associated with a series of unfortunate one-off events: severe winter weather, a spike in oil prices as a result of the Libyan uprising against Colonel Ghaddafi, and the tsunami and nuclear disaster in Japan.  But rather than accommodate these supply shocks by allowing prices to rise as would be natural in the face of a supply shock, pressure built to tighten monetary policy to counter the supply-driven rise in prices, with results that are now becoming all too evident:  rapidly falling inflation expectations and real interest rates.

The correct explanation of how QE2 was supposed to work is that it would raise the cost of holding liquid assets that would lose value as prices rose.  That is why, within a few months after QE2 was initiated interest rates actually rose along with stock prices, contrary to the Journal’s story about “pushing investors into riskier assets.”  This would have induced business to shift some of their cash holdings into real investment rather than watch their idle cash lose value and to induce consumers to shift depreciating cash into consumer durables.

The notion that QE2 was undermined by a commodity price bubble is nothing but an urban legend.  I apologize for being unable to reproduce the graph on the blog, but if you go to here, you will find the Dow-Jones/UBS commodity index and you will see that that at the peak of the so-called commodity price bubble in April 2011, the index was at the same level it was at in September 2005 and 20% less than it was in July 2008.  The jump in food prices was largely the result of bad wheat harvests and US ethanol subsidies that have driven up the price of corn to unprecedented heights and caused farmers to shift production from other crops to corn.

The Journal then delivers the following piece of wisdom:

The larger error is to assume that monetary policy will save the economy from its current malaise.  That’s the latest mantra from the same economists who told us that $1 trillion in spending stimulus was the answer in 2009.  Since that has failed, we are now told the economy needs a bout of extended inflation to reduce our debt burden.  Harvard’s Kenneth Rogoff says the Fed should allow “a sustained burst of moderate inflation, say 4-6% for several years.”

That may be the mantra of Keynesians, but it is also the policy advice that has consistently been given by monetary economists of various stripes who have warned since 2008 that an overly tight monetary policy would produce a recession and that Fed policy, because of its payment of interest on reserves, has not been the least bit expansive despite the rapid increase in the Fed’s balance sheet.  Fiscal policy may have failed, but monetary policy has yet to be tried.

The Journal concedes that inflation can erode the value of money and debt, a truism too obvious for even the Journal to dispute.  But the Journal counters with the withering observation that Argentina tries this every few years, as if Argentina were the model that Rogoff and others advocating a rapid but limited increase in the price level were offering for emulation.

“The middle class,” warns the Journal, “pays a huge price in a debased standard of living.”  But the standard of living depends primarily on the real level of output and employment.  And there are powerful theoretical reasons to expect that a substantial rise in prices would trigger a large increase in output and employment, restoring living standards to levels not seen in years.  In addition, the historical example of FDR’s devaluation of the dollar in 1933 provides striking empirical evidence that for an economy with very widespread unemployment a period of rapidly rising prices can induce a substantial increase in output and employment.  In the four months following FDR’s devaluation of the dollar, wholesale prices rose by 14 percent, and industrial output rose by 56%, while the Dow Jones average doubled, the fastest increase in output and employment in US history.

“Once you encourage more inflation, it’s hard to stop at 4%,” asserts the Journal as if it were laying down a law of nature.  But there is no economic theory to support such a proposition.  If the Fed announced a specific price level target, there is no reason why it could not reach the target, and, having reached the target, no reason why it could not remain there or revert back to a sustainable long-run price-level path.

“If monetary policy by itself could conjure growth, or compensate for bad fiscal and regulatory policy,” the Journal reasons, “we’d already be booming.”  The Journal simply fails to grasp an elementary distinction: the difference between, on the one hand, the long-run potential rate of growth of an advanced economy, roughly 3% a year over long periods of time, a rate determined by real forces including the incentives provided for investment in the stock of human and physical capital, a stable legal system and efficient tax and regulatory policies, and, on the other, the job of restoring an economy to a long-run growth path from which it has lapsed.  With the former, monetary policy, indeed, has little to do; for the latter, as F. A. Hayek recognized in The Road to Serfdom (p. 121) monetary policy is preeminently responsible.

There is, finally, the supremely important problem of combating general fluctuations of economic activity and the recurrent waves of large-scale unemployment which accompany them.  This is, of course, one of the gravest and most pressing problems of our time. . . . Many economists hope, indeed, that the ultimate remedy may be found in the field of monetary policy, which would involve nothing incompatible even with nineteenth-century liberalism.


17 Responses to “The Fed Has Not Done Enough and it Has Not Fired Most of its Ammunition”

  1. 1 Bill Woolsey August 11, 2011 at 4:08 am

    Shifting from holding reserves to making consumer loans and business loans is a shift from less risky to more risky assets.

    Shifting from holding “cash,” presumably bank deposits, T-bills, and other safe and short assets, to purchasing capital goods is a shift towards more risky assets.

    And, shifting from “cash” to longer term bonds, corporate bonds, and stocks, are shifts from less risky to more risky assets.


  2. 2 David Glasner August 11, 2011 at 6:05 am

    Bill, My point was that the shift toward riskier assets was not caused by the Fed “forcing” them to hold assets that they didn’t want to hold, but that people chose to hold them because of expectations of increasing returns. In an absolute “liquidity trap,” asset holders will not shift out of money under any circumstances.


  3. 3 Morgan Warstler (@morganwarstler) August 11, 2011 at 8:41 am

    First, I’m still waiting for a real answer here:

    Second, you make the same mistake that Sumner makes – perhaps your jobs keep you from being able to step up to the plate and swing for the fences.

    There is no neutral monetary policy. Ultimately, the most important thing is that it looser monetary is ONLY granted to provide cover for aggressive fiscal cuts.

    Think of it as tit for tat.

    Categorically, the recent growth of govt in Obamacare, regulations, etc. will NOT BE REWARDED with truly aggressive monetary policy.

    And that is a natural thing. After all, there is no such thing as an economist with the Conscience of a Liberal. Economics is not social policy. It is brutal, it is amoral, it is about what free men do at trade.

    As such, the large bulk of economists that inform fed decision making – they themselves have innate biases in favor of the free market and against growth of government.

    There is a REASON the Fed is owned by banks.

    It is thus NATURAL and INGRAINED for them to feel far more nervous when they confront a Democrat President, and they find comfort when Bill Clinton says in 1993 he will not invest in anything, and to be terrified when Obama viewed 2008 as a crisis of capitalism.


    The point is David, that you and Sumner both have to shit or get off the pot.

    Arguing for QE! QE! QE!

    Is fine in the spirit of Milton Friedman who so hated government that everyone KNEW he’s only support it if didn’t empower pro-government advocates.

    it is not fine to quote anyone and everyone from both side of the aisle as if anyone who say QE! is good.

    Sumner says today

    “But I’m afraid Wolfers has violated one of my favorite maxims: Never reason from a price change. It does matter why rates fall.”

    Similarly is does matter WHY someone wants QE.

    The conservatives have the power and the floor, if you want QE, you will side with them and shout down the left and their FISCAL spending at every and all opportunities.


  4. 4 Benjamin Cole August 11, 2011 at 11:47 am

    Excellent first-rate blogging. Superb. Keep up the good work–let’s just hope someone in DC is listening.


    Here is a list of federal employees by agency. Will you point out to me to agencies that that modern-day “conservatives” want to cut?

    Department of Defense 3,000,000
    Veterans Affairs 275,000
    Homeland Security 250,000
    Treasury 115,000
    Justice 112,000
    Energy 109,000
    USDA 109,000
    Interior 71,000

    Labor 17,000
    HUD 10,000
    Education 4,487

    Ever notice that when “conservatives” bray about federal outlays, it is always entitlements (largely money returned to taxpayers), and not agency spending (money given to the gaggle of grifters and lobbyists that run DC)?

    Are you aware in the next 10 years we will spend $10 trillion on defense, VA and Homeland Security, and we have no military enemies of any stature? A few hundred terrorists at most?

    I am all for trimming entitlements, raising the retirement age, somehow cranking down on Medicare. SSDI needs a major cutback.

    But that ain’t the half of it. We are $4 trillion into Iraqistan and not done yet.

    The “conservatives” have no answers for that.

    Besides all that, it is a sideshow. This blog is about what the Fed is supposed to do.


  5. 5 David Glasner August 11, 2011 at 12:16 pm

    Morgan, I just responded to your question, though I doubt in a way that will be satisfactory to you, on my other blog post.

    On your second point, who is doing the granting here? As for your idea of what economics is, i prefer the term “value-neutral” myself, and I am not so sure that you are entirely value-neutral in your assessments. On the other hand, I haven’t been following your comments long enough to be sure one way or the other. Just out of curiosity, do you know any economists who work for the Fed? And my next question for you is: suppose Rick Perry is elected President in 2012 (I believe that I saw you say somewhere that he’s your guy). Do you think that he will come out in favor of monetary expansion after he is elected? If so, do you have any basis for that opinion other than your own exceptional insight into political economy?

    Benjamin, Thanks. It’s always a relief to hear that you approve.


  6. 6 Benjamin Cole August 11, 2011 at 3:08 pm


    Enjoy your blog–and it is important topic, to say the least. There is a small band of monetarists who have a way forward for the USA, and you are one of them. Keep up the blogging, and I echo your commentary around the web and elsewhere.


  7. 7 Morgan Warstler (@morganwarstler) August 11, 2011 at 3:22 pm


    Department of Defense 3,000,000
    Veterans Affairs 275,000
    Homeland Security 250,000
    Treasury 115,000
    Justice 112,000
    Energy 109,000
    USDA 109,000
    Interior 71,000
    Labor 17,000
    HUD 10,000
    Education 4,487

    1. Remove the soldiers from the DoD totals. End wars then reduce force levels.
    2. Immediately cut 4% of PAYROLL budget for 2012 for each department from 2011 levels. Announce you will do the same again each year until 25% cuts have occurred to 2011 levels.
    3. Institute policy that ALL future department payroll increases are contingent on 2.5% annual productivity gains which we will finally begin to measure (stopped in 1996 – always at about 1%).
    IF the Dept. of Justice wants to see budget increase, they have to hit 2.5% gains EVERY YEAR.
    4. The end result here is the PAY RAISES re funded by staff reductions.

    Get out of way. Because the the entirety of government will be remade in the image of the Internet. What has happened in white collar job market since 1996 will immediately be FORCED upon the public sector – pay raises dependent on staff reductions.


    Normal people, as in everyone who works in the professional private market, they are USED TO this kind of world. It is the status quo.

    David, that you are unable to hypothesize on how the stock market would respond to having taxes not go up, and suddenly not having to listen to the left moan about unemployment – speaks volumes.

    You think Milton Friedman would have no opinion?

    MONEY AND GOVERNMENT are both tools put to work for the private owners of hard assets,

    David, more on Rick Perry later. But can I remind you of Greenspan telling Congress that they had to cut taxes because the government couldn’t run a surplus?

    If you claim to be value-neutral, you have a liberal bias.


  8. 8 Benjamin Cole August 11, 2011 at 5:33 pm

    Remove solders? Why? They are employees now, except they get to retire after 20 years of service on full pensions and medical for the rest of their lives.

    I have a better idea: Wipe out all federal pensions, and let all federal employees finance their own retirement programs.

    Your other ideas I like. Except we could eliminate USDA entirely and immediately, and HUD too.


  9. 9 Morgan Warstler (@morganwarstler) August 11, 2011 at 5:57 pm

    “FEHB may exceed what the private sector does in certain areas,” said Anthony J. Vegliante, USPS chief human resources officer and executive vice president. “It may not meet what the private sector does in other areas. So cost may be above the private sector, while value may be below the private sector.”

    Bills that would rein in employee benefits or have workers pay more for the benefits have been introduced in Congress and met with vigorous opposition from federal employee organizations. Intentionally or not, the Postal Service’s proposal provides support for such legislative initiatives.

    The post office has the right attitude, when every division of government thinks this way, is treated this way – our economy will be FINE.


    Right now we could be saving $500B a year in Federal State and Local compensation annually.

    If we had taken this approach from 1999 on, we’d have a Federal Deficit of less than $8T, and state budget sin far better shape.

    So forgive me when a public employee decides to explain who we just need to print money to get over a crisis brought on by overpaying public employees / having too many public employees.

    SO IF YOU want to argue for printing money you better do it from the smaller government team side.

    Show us the scalps you win, the coup you count reliably against fiscal stimulus guys, and your voice will have a lot more boom.


  10. 10 David Glasner August 11, 2011 at 8:24 pm

    Benjamin, Your encouragement is greatly appreciated. Let’s see how long I can keep this up. I’m no Scott Sumner, you know.

    Morgan, Oh, so that was the hypothetical? I must have been distracted. Milton Friedman had an opinion about everything. I’m no Scott Sumner and I’m no Milton Friedman, though, the truth is that I like Scott better. I look forward to being enlightened about Rick Perry. And if you think that I am the least bit embarrassed to be called a liberal, Morgan, I am afraid that you don’t know me as well as you think. Actually, Morgan, since I have explained why owners of hard assets will be made a lot wealthier by inflation and a lot poorer by deflation, I should have thought that you would be prepared to overlook my ideological deviancy out of your own pure self-interest.


  11. 11 Morgan Warstler August 12, 2011 at 7:20 am

    David since you are so concerned with the holders of hard assets why not just agree we’ll print money and only give it to folks who have piles of money. Then there is no moral hazard.

    Oh I know you are a liberal… your unwillingness to examine this crisis as caused by the cost of public employees speaks volumes. Let me say that again… VOLUMES.

    Also I suspect Sumner has far less in common with you and far more in common with Friedman than you think…


  12. 12 David Glasner August 12, 2011 at 7:52 am

    Morgan, You misunderstood on two counts, I didn’t say that I am a liberal I said that I would not be embarrassed to be called one. Anyway, my conception of liberalism is probably very different from yours or of most Americans. Second, I didn’t say that I am so concerned about holders of hard assets. I said that since I have discovered what will make them richer, indeed save them from financial ruin, you, who are so concerned with them, should show me a little more gratitude and be more tolerant of me despite the liberal heresies that you suspect me of harboring. About Sumner and Friedman, Scott has a sentimental attachment to Friedman and sometimes those kind of feelings are hard to leave behind even if one knows better.


  13. 13 Morgan Warstler (@morganwarstler) August 12, 2011 at 11:30 am

    David, lets me make this clear: the hard assets will always be here. The buildings, the land, the utilities, the roads… that stuff STAYS.

    What changes is who “owns” it – so when the housing market crashes, and the banks (the current owners) are not bailed out by the Fed, the banksters go to poor house, and the guys with dry powder (the guys who got out EARLY) they buy up everything cheap… they become the NEW OWNERS, they become the landlords, and a large swath of people who NEVER should have owned a house, become renters – spend a far smaller piece of the income on housing.

    Now in that model, monetary policy that keeps NGDP level targeting going along at 3% no matter what happens – is a GOOD THING.

    More later, but here’s the first bit on Rick Perry:

    Remember if he gets elected, you have a good chance at being fired..


  14. 14 Morgan Warstler (@morganwarstler) August 12, 2011 at 1:00 pm

    OK, so before we go much further I want you to understand this bit of logic too:

    We can break home owners into three groups.

    1. Those with their house paid off.
    2. Those who bought before the bubble, say 2003, and did not refinance during the bubble.
    3. Everybody else.

    My contention is that right now everybody in 3 doesn’t matter. Worrying about them is for naught. By and large they were either foreclosed on or so underwater (in the real boom markets) that there is NOTHINGS TO SAVE.

    They have no equity. MEANING if they lose the hard asset to the bank and the bank has to liquidate the hard asset, that person hasn’t lost anything.

    It is true that they will have their credit dinged. BUT ONLY FOR SEVEN YEARS. And we are through 3 of those years already had we just liquidated the whole ball of was with normal bankruptcy at the start of Obama’s term.

    Moreover, as I’ve blogged elsewhere – we could have used the title mess to give people the ability to wipe the blemish from the credit – notice the important thing is NOT FORGIVENESS while they keep ownership, it is forgiveness after they lose the house, and bankers lose the hard assets – and their asses.

    So the question becomes AFTER the folks in 3 get gutted, we’re talking about 12M+ houses that have to get acquired for pennies on the dollar.

    And guess what David? Now finally after THREE YEARS of the banks being propped up, Obama is FINALLY letting go and letting Fannie Freddie FHA FDIC all dump “tapes” (hundreds of properties sold in bulk) – doing exactly what I and every Austrian wanted three years ago.

    So you need to argue what was gained by saving the banks, enriching the banksters, extending the suffering of those in #3, before we finally do what guys like me wanted to do all along.


  15. 15 David Glasner August 13, 2011 at 7:58 pm

    Morgan, Actually hard assets depreciate and require maintenance otherwise they fall apart. So if there are no incentives to invest, real wealth is lost. That does not mean that it would not be a good thing for banks to take a beating on their real estate investments. Actually, one of my first blog postings after the Lehman crash on the Becker-Posner blog and on was to recommend that instead of the TARP program banks should be required to sell all their toxic assets to the government for pennies on the dollar or else the underlying mortgages would be declared uncollectible. That would have solved the banking crisis in one fell swoop and we could have started from a clean slate. Unfortunately, nobody paid any attention to me either. About Rick Perry, I guess it’s a good thing that I started blogging.


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About Me

David Glasner
Washington, DC

I am an economist in the Washington DC area. My research and writing has been mostly on monetary economics and policy and the history of economics. In my book Free Banking and Monetary Reform, I argued for a non-Monetarist non-Keynesian approach to monetary policy, based on a theory of a competitive supply of money. Over the years, I have become increasingly impressed by the similarities between my approach and that of R. G. Hawtrey and hope to bring Hawtrey’s unduly neglected contributions to the attention of a wider audience.

My new book Studies in the History of Monetary Theory: Controversies and Clarifications has been published by Palgrave Macmillan

Follow me on Twitter @david_glasner


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