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Myron Scholes, the Nobel Prize-winning retired Stanford University finance economist, contemplates the prospects for another round of Federal Reserve quantitative easing, and wonders if it’ll work as well as the Fed hopes.
Some possibilities: (1) Maybe in short run, QE reduces the risk premium and encourages investment. Encouraging investment is good. The problem is that this isn’t a rational argument. The risk premium can’t be affected by flows. Investors will sell risky assets to government and buy bonds. The Fed could end up holding all risky assets; investors will hold safe assets. The risk premium stays the same.
(2) If Fed purchases of safe assets move investors into risky assets, then the risk premium falls, encouraging investment. Wealth increases and so does consumption and employment. The problem: The Fed isn’t an independent, exogenous entity. U.S. persons own the Fed. If the Fed takes on more risk, society still has the risk. The risk doesn’t go away, any more than the risk of holding subprime mortgages went away before the crisis. We cannot structure the risk such that it disappears. Society still has the risk, and will want to hold safe assets if the Fed affects the risk premium.
(3) QE reduces uncertainty about government commitment to stimulating the economy and continues to provide liquidity. The problem: Uncertainty increases as to how the Fed is going to get out of QE and what effect the Fed might have on economy going forward when it stops QE. Actually, while savers have reduced the real interest rate in reducing the risk of their balance sheets the Fed QE moves might actually increase uncertainty, which counters their plan to reduce risk premiums.
A fundamental question: Can the Fed affect risk premiums at all? In the short run? In the long run? In the short run, yes, because investors bid up assets in anticipation of being able to sell them at inflated prices to the Fed. This action has no effect on investment, however, for most investments are of longer duration than six months.
(4) Is QE a little like Laffer curve of taxation? Increasing money massively might lead to the hyperinflation of Zimbabwe, Weimar Germany, Argentina, etc. Increasing money too little does nothing: The horse to water problem. But, this all means nothing. Expectations are key. Fed won’t go far enough to dump money into the system because Fed officials worry somewhat about becoming Argentina. And markets know this. They think that Bernake is rational and act accordingly. This is a rational game. If the Fed is irrational, the whole world breaks apart. The markets know that Fed isn’t so stupid as to increase money to Argentine levels. Therefore, the game theoretic approach is for the Fed to be very timid in undertaking QE (maybe just enough to monetize the incremental government debt.) The Bernanke Fed doesn’t want inflation expectations changed so dramatically that we will need new “Whip Inflation Now” buttons.
(5) Capital flows out of U.S., reduces the value of the dollar, stimulates exports, growth, etc. If QE scares foreigners who don’t understand (4) and are worried about crazy experiments and low rates, they repatriate money to home country; that depresses the dollar. If the European Central Bank is conservative and won’t play the game, the euro appreciates against the dollar (as would the currencies of Australia, Canada, Japan, Korea, China, etc.) Then, we must worry about responses, if any, of these other countries.
(6) A weaker dollar stimulates investment in the U.S. and gives time for domestic recovery to take hold. As the dollar depreciates against other currencies, QE might force other countries, China in particular, to act sooner than later. This might be the key. QE causes action now. We need action to realign currencies that are constrained by government policies or, more important, capital and convertibility constraints. QE might force a new accord and new equilibrium (that should have been in place anyway and was resisted by government policies) sooner. Early action might be better for the global society. This might be tough on China and its employment and export businesses. But better than sanctions. I do fear that Congress is salivating to move the blame to the next villain. Bush and Wall Street have become somewhat stale.
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I am breathing a sigh of relief after the myriads of ignorant comments issued by various economists and Fed officials.
This must be one of the most sophisticated commentaries I have seen on WSj RTE. The last time I felt like this is when Anna Schwartz wrote “Bernanke is fighting the last war”
Just about all the same considerations apply to the Fed’s adjustment of interest rates during normal times. Will they do their job? Will they be successful at it? They weren’t too successful previously or we wouldn’t be in this situation but one has to have faith they will eventually get it right.
Wait a minute isn’t Emperor Bernanke the guy who said subprime is contained? He does exactly what he’s told to do as the pimp point man for the NWO globalist Rothschild “Crooks Without Borders” crowd of criminals. Hey, he recently sent a slush fund payment of 18 billion in U.S. taxpayer free ATM funds ostensibly to keep the Greeks in suntan oil through the IMF graft tool and those funds have just disappeared and nothing is even said about it. This Nuremberg status criminal is just a machination master for the Bilderberger’s ( the gnomes of Zurich) and the lions of Liechtenstein AKA P.O. Box multi-national companies with secret bank accounts. Burn-them-key is a corrupt figure of an old evil graft syndicate founded by a bunch of nut job eugenicists but he keeps my 58,500 ton trenchers billowing the black smoke of American citizen economic burial plots. He always issues the same Wendy Gramm REPO 105 Enron accounting misdirection memos which make you think you’re back in 1950’s USSR Moscow reading a morning Pravda newspaper after a horrendous Vodka hangover. Audit and abolish the FED vote out all incumbents in a few weeks except for Ron Paul, and then try Bernanke, and the turbo tax cheat at the treasury Herr Oberfuhrer Geithner the architect of American fascist economic models and an Albert Speer protege in spirit for sedition and violation of every RICO statute known to man but revered by Government Sachs and then send them to a cell in San Quentin where “Lonely Bubba” waits to do to them what they have done to the country. Oooooooooh what a rush! Gee gold is at an all time high everyday thanks to the emperor, platinum. silver also and the dollar is going down like a bar of lead in the Mariann’s trench. Enjoy, have a bad weekend. My shadow is on the land. Tea anyone?
Interesting considerations. But come on. Make a call. Should or shouldn’t QE2 be done? The people at the Fed have to make that decision. We as citizens have to decide whether we should support it or not. How about you having the courage to do the same.
Real Time Economics offers exclusive news, analysis and commentary on the economy, Federal Reserve policy and economics. The Wall Street Journal’s Phil Izzo and Sudeep Reddy are the lead writers, with contributions from other Journal reporters and editors. Send news items, comments and questions to realtimeeconomics@wsj.com.
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