Monetary policy had a rare moment in the spotlight this week with Ben Bernake’s press conference. Granted, it took the stage right after Obama revealed his birth certificate and right before two people from England got married, but when is monetary policy ever going to get the nation’s attention?
Before the conference, the New York Times ran an article by David Leonhardt criticizing the Fed for not doing more to lower unemployment. His position is based on false premises, and there is no attempt to support them.
First, Leonhardt flatly assumes that more accommodative monetary policy can lower borrowing cost thereby lowering unemployment. I’m going to take a few minutes to explain how this works.
Generally, the Fed lowers borrowing costs by dropping its overnight bank lending rate. If banks can borrow cheaply, they can lend cheaply. People are encouraged to borrowing money from the banks, they spend or invest their dollars, the economy resumes its happy exponential growth for the rest of time, and businesses feel comfortable hiring again.
This strategy was exhausted during the financial crisis. The Fed has set the overnight rate at 0% for a while now. With the time value of money, no interest is better than free. Its a guaranteed profit.
When low rates did not get the economy going, the Fed decided to “supplement its policy tools” by engaging in “quantitative easing” (QE). QE is a fancy way of saying the Fed is buying US treasury bonds with money that did not exist before. You might know this as printing money.
QE is also supposed to lower borrowing costs. Banks use the US government’s interest rates to set its interest rates, most notably on mortgages. The interest rate on treasury bonds is determined by the demand for the bonds, and with the Fed inflating demand for the bonds, the treasury gets a lower interest rate. The banks pass on the low rate to everyone else.
It is possible in some circumstances that lowering the cost of borrowing could lead to lower unemployment, but America is not in those circumstances.
Public companies have the best access to capital markets and could hire using cheap credit, but they do not need the money. They are sitting on record amounts of cash and just experienced their most profitable quarter ever.* If there were opportunities to invest in human capital and generate returns, they would do so, and they wouldn’t even have to incur interest expense. So far, they have been content to squeeze more productivity out of existing workers.
What about small businesses and entrepreneurs? They could use the money and are responsible for the vast majority of job growth. Couldn’t they benefit from easier access to credit?
Yes, but financial institutions are not in a position to extend credit. Small borrowers create too much transaction costs to be worth the big banks’ time. Following a financial crisis brought about by reckless lending, banks have raised underwriting standards. There is much greater risk in lending to this segment, and with banks’ stability still somewhat tenuous, they can’t afford to take on these risks.
The answer to unemployment isn’t going to be as simple as printing more money. Unemployment is a result of structural changes to our labor market that cannot be addressed with loose monetary policy. Outsourcing has lowered demand for jobs outside the information economy, and most unemployed do not have the skills required to compete for good jobs in this market. There is no monetary silver-bullet that can bring our factories back or educate the workforce.
Leonhardt also claims that more extreme monetary policy interventions don’t risk high inflation because they have not caused inflation in the past two years. This logic is laughable. Its like saying, “I didn’t get in an accident yesterday, so there is no need to wear my seatbelt today.” Only drawing from a two year sample size out of the entire history of money borders on intent to mislead. A more thorough historical survey would frame the risks a little differently.
And even without further policy changes, there is good reason to expect more inflation shortly. Because the renminbi is pegged to the dollar, China imports our inflation, and their inflation is rampant. China produces most of our goods, and as the costs of production increase, these costs will be passed on to US consumers. Its taken a little while for inflation to pass through the supply chain, but the world’s largest retailer says its coming.
After looking at the assumptions, expanding QE is foolish by Leonhardt’s own calculus. The probability of improving unemployment through more aggressive monetary policy is low given where we stand economically. Anyone who buys gas can tell you the costs are starting to add up. I think we have no choice but to continue pursuing inflationary monetary policy (a subject for a later date), but don’t let anyone tell you it won’t hurt American’s purchasing power and will improve unemployment.
*Companies sitting on cash raises some troubling questions. The general rule in financial management is when your return on assets is greater than your borrowing costs, then taking on debt will increase profitability. Rates are low, companies are generating high profits on their assets, but they are still hording cash. Also, by not reinvesting cash flows, companies subject themselves to greater tax burdens. I can think of three possible explanations for this behavior: 1) there are no good investment opportunities right now, 2) companies have lost faith in the financial system’s ability to meet their needs for capital and have decided to become self-financing, or 3) companies don’t think they are out of the woods yet and want a cushion if this recovery thing doesn’t work out. I think 1) is doubtful given the relative health and opportunity for scaling in emerging markets, so its pick your poison on 2) or 3).