A cartoon has been making the rounds (e.g., Forbes, Zero Hedge, and Real Clear Politics) in which cartoon characters (bunnies maybe? or perhaps some other life form) ask questions about quantitative easing. I would have provided slightly different answers than did the didactic character in the cartoon, so I thought it might be fun to interject myself as a third character in the bunnies’ conversation.
The cartoon begins with a discussion of quantitative easing.
Bunny: What does that mean?
JDH: It means that the Fed is going to buy some more long-term Treasury securities. The idea is that by buying a large amount, the effect will be to increase the price of those bonds, which would make the interest rates on those and other bonds lower. Lower interest rates might help make more loans available to small businesses and create better opportunities for households to refinance. By depreciating the dollar, the move may also encourage U.S. exports and discourage U.S. imports.
Bunny: Why do they call it the quantitative easing? Why don’t they just call it printing money?
JDH: Actually no money is going to be printed. The Fed will pay for these purchases by crediting accounts that banks have with the Fed. Although it is true that banks could ask to withdraw these funds in the form of green currency, they currently are showing no interest in doing so. And before banks did start to want to withdraw these funds as money, the Fed plans to sell the assets off to bring the reserves back in. There is no plan now or in the future to “print a ton of money”.
The bunnies then go on to note correctly that one of the goals of quantitative easing is to prevent deflation.
Bunny: Isn’t [deflation] good? Doesn’t that mean people can buy more of the stuff?
JDH: It would if your nominal income stayed the same. But that’s exactly the problem. In episodes of deflation, people’s wages go down, and many lose their jobs and can’t find new ones. A decrease in the price of what we buy sounds good to us, but a decrease in the price of what we sell (namely, a decrease in our salary) does not. The experience of countries in which wages and prices are falling has been very painful, and the Fed wants to avoid this.
Bunny: But aren’t food, gas, health care, and tuition prices higher than a year ago?
JDH: Yes, though items such as clothes and furniture are lower. But if we wait until deflation is established more broadly before acting, measures like the ones the Fed just announced would likely be less effective.
Bunny: Aren’t bond prices higher than a year ago?
JDH: Bond prices don’t enter into consumer’s budgets. In fact, the higher bond prices are one indicator that deflation is a greater risk today than it was a year ago.
Bunny: Has the Fed ever been right about anything?
JDH: A study by Christina and David Romer published in the American Economic Review in 2000 found that Federal Reserve forecasts of inflation were significantly better than those generated by the Blue Chip survey of economic forecasters, the Survey of Professional Forecasters, or Data Resources, Inc. A study by Jon Faust and Jonathan Wright published in the Journal of Business and Economic Statistics in 2009 found the Fed’s forecasts of inflation were significantly better than those generated by a battery of state-of-the-art time-series forecasting techniques.
The bunnies then get into a discussion of the mechanics of bond purchases by the Fed.
Bunny: If the Ben Bernank wants to buy the Treasury bonds with the American people’s money, he does not buy them from the Treasury, he buys them from the Goldman Sachs?
JDH: Goldman Sachs is one of 16 different dealers from which the Federal Reserve Bank of New York solicits competitive bids. That’s the way it’s been done for a century, and it would be illegal for the Fed to do as the bunnies propose. From U.S. Monetary Policy and Financial Markets, 1998, Chapter 7:
The Federal Reserve makes all additions to its portfolio through purchases of securities that are already outstanding. The Federal Reserve Act [of 1913] does not give the [Federal Reserve] System the authority to purchase new Treasury issues for cash. Over the years, a variety of provisions had permitted the Treasury to borrow limited amounts directly from the Federal Reserve. Options for such loans existed until 1935. Temporary provisions for direct loans were reintroduced in 1942 and renewed with varying restrictions a number of times thereafter. Authority for any kind of direct loans to the Treasury lapsed in 1981 and has not been renewed.
The reason that the Fed has always been required to buy bonds from private dealers rather than the U.S. Treasury is that the process of money creation needs to be institutionally separated from the process of financing the public debt. In fact, the potential blurring of those boundaries is one of the most important legitimate criticisms of quantitative easing.
And here is the original cartoon, in which you’ll see that the bunnies’ own answers are much funnier than mine.