John H. Cochrane
In November, the Fed started its new “quantitative easing program.” The Fed will buy up to $600 billion of long-term government bonds, putting $600 billion of extra money in the economy. Defenders think this is the key to reducing unemployment and breaking the economy out of its doldrums. Though the Fed's motives were initially unclear, Chairman Ben Bernanke's Dec 5 interview on CBS 60 minutes made it clear that fighting unemployment is a crucial motivation. Critics think this is the first step to out-of-control inflation, dollar devaluation, and a trade war.
Neither is right. All of the arguments fall apart on one hard fact: Now that short-term interest rates are basically zero, money and short-term bonds are the same thing. A bank can hold reserves at the Fed, which pay 0.25% interest – this is the “money” we’re talking about. Or, it can hold one to three-month treasury bills. These are very easy to buy and sell and also pay about 0.25 % interest. Obviously, the bank really doesn’t care a bit which one it holds.
This fact is why the Fed is buying long-term debt in the first place. The Fed knows that its usual open-market operations – buying short-term debt from banks, and giving the banks more reserves in exchange – have no effect whatsoever. This is like taking your red M&Ms, giving you back green M&Ms. It has no effect on your diet.
But if exchanging money for short-term debt has no effect, it follows inescapably that giving banks more money is exactly the same as giving them short-term debt. All that QE does is to restructure the maturity of US government debt in private hands. Now, of all the stories you’ve heard why unemployment is stubbornly high, how plausible is this: “The main problem is the maturity structure of debt. If only Treasury had issued $600 billion more bills and not all these 5 year notes, unemployment wouldn’t be so high. It’s a good thing the Fed can undo this mistake.”
Of course that’s preposterous. The banking system is awash in liquidity. Banks used to hold about $2 billion dollars of excess reserves. Now, they have about a trillion. If they didn’t lend out this first trillion of extra cash, why would they lend the next $600 billion? Money or “liquidity” in the economy is like oil in a car. Not enough oil, and the car seizes. Once you have enough, you can’t make the car run faster with more oil.
So much for the claim that QE will revitalize the economy. What about the danger of inflation and devaluation? Sorry, that claim also falls apart on the same hard fact. Buying long-term debt and giving banks money, now that interest rates are zero, can have no more effect on inflation or devaluation than buying long term debt and giving banks short-term debt. The money is not “money,” which banks try hard to get rid of because they lose interest. Money now is the same thing as debt, held as an asset.
Yes, we have a lot of experience that says too much money leads to inflation. But all of that experience comes from times when interest rates were not zero, and people try to spend extra money rather than sit on it as they do government debt. That experience simply is irrelevant for the current situation, with zero short term rates and a trillion dollars of extra cash already lying around. If inflation and short-term interest rates perk up, the Fed can undo the entire operation overnight.
QE is not harmless however.
First, lots of short-term debt makes the US more vulnerable to bad news, just as it made Bear Stearns and Lehman vulnerable to bad news. Suppose a day of reckoning comes – perhaps with a default in California and Illinois, or a breakdown of long-term US deficit-reduction efforts. Investors lose faith in the US government, even temporarily, and want to dump its debt. If the US has sold a lot of long-term debt, long-term bond prices fall, but there is no crisis. There is time to address the issues, and reestablish a solvent government. If instead the US is constantly rolling over short-term debt, then we will be unable to borrow new money to pay off maturing bills. This is what happened to Greece. Our current moment of exceptionally low long term rates is a golden opportunity for the US to issue long-term debt, not to buy it back.
Second, QE distracts us from the real issues. Unemployment is not high because the maturity structure of government debt is too long, thank you, nor from any lack of “liquidity” in a banking system that is sitting on a trillion dollars of cash. It’s time to focus on the real, microeconomic, tax, and regulatory barriers to growth, not a policy that creates a lot of noise but no real effect.
Finally, if it did work, why is the Fed anxious to restore even 2% inflation? Whose definition of “price stability” is this? In every theory of inflation and unemployment, raising expected inflation just gives you stagflation, without any benefit to unemployment. If everyone knows inflation is coming, they raise prices and wages immediately and are not fooled into a little boost of output.
A sudden deflation is bad, because it hurts borrowers, just as a sudden inflation is bad because it wipes out savers. But zero inflation, or even a slow, steady, and widely expected deflation, are in fact much better in the long run. The financial system is much healthier with bundles of cash lying around, at no interest cost, than if everyone is engineering clever, but ultimately fragile, cash management schemes. The main argument for higher inflation and consequently higher nominal interest rates is that it gives the Fed more power to run the economy by occasionally lowering rates, i.e. to go back to driving the car by slightly starving it of oil, and then artfully adding a quart when needed. Given what a great success that’s been lately, maybe trading a more fragile financial system for greater Fed power isn’t such a good idea after all.
 John Cochrane is a professor of finance at the University of Chicago Booth School of Business.