Two years have passed since the worst financial crisis since the 1930s dealt a body blow to the world economy. Among the Fed's responses was a dramatic easing of monetary policy - reducing short-term interest rates nearly to zero. The Fed also purchased more than a trillion dollars' worth of Treasury securities and U.S.-backed mortgage-related securities, which helped reduce longer-term interest rates, such as those for mortgages and corporate bonds.Big banks had over-extended themselves and gone bankrupt. Rather than turning them over to the FDIC for an orderly write-down, which would have repriced their toxic mortgage debt, unwound over $300 trillion in unquantified derivatives, and wiped away the financial stranglehold on the federal government, we decided to tough it out. The Fed immediately gave the banks zero interest rates, transferring all fixed income to the banks and making it possible for them to make billions of dollars on government interest payments on their debt. We thought that would shore up their balance sheets.
Unfortunately, the job market remains quite weak; the national unemployment rate is nearly 10 percent, a large number of people can find only part-time work, and a substantial fraction of the unemployed have been out of work six months or longer. The heavy costs of unemployment include intense strains on family finances, more foreclosures and the loss of job skills.
click to enlarge, double click to reduceOf course saving the banks prevented the market from repricing their assets and delayed economic recovery. The market has been attempting to write down those assets ever since. Our actions placed the entire responsibility of bearing the cost of those write-downs onto the taxpayer, and guaranteed all foreclosure costs and real estate loss would be born by home owners and taxpayers rather than the banks. Until those markets are repriced, we will see more of the same and a stagnant economy.
Maceration of Money by George Eastman House, on Flickr
Maceration of Money by George Eastman House, on Flickr
Today, most measures of underlying inflation are running somewhat below 2 percent, or a bit lower than the rate most Fed policymakers see as being most consistent with healthy economic growth in the long run. Although low inflation is generally good, inflation that is too low can pose risks to the economy - especially when the economy is struggling. In the most extreme case, very low inflation can morph into deflation (falling prices and wages), which can contribute to long periods of economic stagnation.
We have tinkered with the definition of inflation to better suit us. Banks like inflation because it guarantees our profits. Unlike say, the continued declining price of computers, which everyone sees as a good thing, we have convinced the public that lower prices due to technology and productivity gains is a bad thing for the economy. Printing money like we did drastically devalues the dollar. For the poor, that first shows up as increased prices on food and commodities where you already pay 60% of your income.
But bankers like inflated prices because it makes debt payments easier and tends to send signals that drive the stock market up, which people mistakenly believe are the signs of a strong economy. Falling real estate prices are the continued attempts by the market to reprice the assets we forced the taxpayer to save.
With short-term interest rates already about as low as they can go, the FOMC agreed to deliver that support by purchasing additional longer-term securities, as it did in 2008 and 2009. The FOMC intends to buy an additional $600 billion of longer-term Treasury securities by mid-2011 and will continue to reinvest repayments of principal on its holdings of securities, as it has been doing since August.
Unfortunately the economy continues to struggle to take on all the trillions of failed risk we transferred from the banks. And since we already gave them zero interest rates, we've decided to devalue the dollar even further and hopefully all the new money we inject into the economy will make enough people feel like spending some of it because they have a false sense that they are now rich.
This approach eased financial conditions in the past and, so far, looks to be effective again. Stock prices rose and long-term interest rates fell when investors began to anticipate the most recent action. Easier financial conditions will promote economic growth. For example, lower mortgage rates will make housing more affordable and allow more homeowners to refinance. Lower corporate bond rates will encourage investment. And higher stock prices will boost consumer wealth and help increase confidence, which can also spur spending. Increased spending will lead to higher incomes and profits that, in a virtuous circle, will further support economic expansion.
Printing money on this scale has never turned out well in any other country. But stock prices rose when we did it. We're hoping that is a good thing and will inspire confidence. Of course, just before the financial collapse, I insisted that a strong stock market meant a strong economy, and I was totally wrong. But I am sticking with that story because it is written in my Keynesian Bible and by now I am at a loss to explain exactly what I am doing.
Although asset purchases are relatively unfamiliar as a tool of monetary policy, some concerns about this approach are overstated. Critics have, for example, worried that it will lead to excessive increases in the money supply and ultimately to significant increases in inflation.
Critics say we are insane and that the underlying issue of the banks must be addressed. They state further that we are heading down the road to destruction. But we can not turn back now. We will look like fools.
Our earlier use of this policy approach had little effect on the amount of currency in circulation or on other broad measures of the money supply, such as bank deposits. Nor did it result in higher inflation. We have made all necessary preparations, and we are confident that we have the tools to unwind these policies at the appropriate time. The Fed is committed to both parts of its dual mandate and will take all measures necessary to keep inflation low and stable.
Using our tinkered inflation numbers, rising prices are hidden. Plus, we can act quickly if the huge global economy begins to unwind. It is not too complex for us to manage it! We will get you all back to work by playing with counterfeit money!
The Federal Reserve cannot solve all the economy's problems on its own. That will take time and the combined efforts of many parties, including the central bank, Congress, the administration, regulators and the private sector. But the Federal Reserve has a particular obligation to help promote increased employment and sustain price stability. Steps taken this week should help us fulfill that obligation.
Printing counterfeit money with no assets to back it up is not the only solution to our economic problems. Congress and regulators can spend more borrowed taxpayer money to make it look like the economy is OK and soften the crash landing of real estate prices that the market demands by drawing it the pain out over a longer period of time. But we are doing our part to save the banks. And what is good for the banks, is good for America.
More commentary here. Warning. This is painful to watch. Biggs and Betty: Epic fail: