The Federal Reserve Bank is about to undertake another round of quantitative easing, by purchasing up to $600 billion worth of U.S. Treasury bonds. The Fed gets to make up their own money—they don’t have to get that $600 billion from anybody else—so this is a way of expanding the overall money supply. The intent is to increase the price of U.S. Treasury bonds, thereby lowering their yield and making it more attractive for people with money to seek other forms of return. Seeking other forms of returns means investing elsewhere, and in particular it means making loans to businesses which use the money to create jobs.
On paper, there is no way that this can work. The problem with the U.S. economy right now is not a shortage of available money. In fact the interest rate on loans is quite low. The interest rate is so low that companies like IBM are selling bonds directly in order to borrow money at a low interest rate. In other words, this move by the Fed isn’t going to encourage IBM to invest any more: IBM can already get all the money it needs.
It’s small businesses which are having a harder time getting loans. They’re not having a hard time because the banks don’t have money to give them. They’re having a harder time because the banks are being more stringent on their loan requirements. The Fed is hoping that by making investing in Treasury bonds even less worthwhile, banks will start making more small business loans in order to increase their profits. This isn’t going to work for the big banks, which are scared because they still don’t know how much they have at risk during the slow moving unwinding of bad mortgages. They’re going to hold onto their cash. It could work for the small banks.
But even the small banks aren’t going to start loaning money to small businesses unless the small businesses start asking for it. And the small businesses aren’t going to start asking for it until people start spending more money. And people aren’t going to start spending more money until they feel that they have enough savings. The savings rate was very low for several years, around 1%, and is now up to a more respectable 6% or so. In the long run, more savings is good for the economy. In the short run, it means that people are not spending money, which means that small businesses are not starting up and hiring people.
What this means is that the Fed is pushing on a string. Increasing the money supply is a very indirect way of creating more jobs. On paper, the newly created money is just going to get saved, mostly by large banks to improve their balance sheets. In the current economy, the way to create jobs is obvious: give people money to spend. You can’t do with income tax cuts, because most relatively poor people—the people who would spend extra money rather than saving it—pay next to no income tax. You could do it with a payroll tax holiday.
Or you could do it with stimulus spending. However, the Fed isn’t doing that, because it can’t. The Fed isn’t allowed to just hand out the money they create. They can only do specific things with it, like buy Treasury bonds. The rest of the government could hand out money, but they are unable to due to political paralysis.
The recent election is not going to help in this regard, as the Republican platform appears to be extending the Bush income tax cuts and refusing to increase spending, neither of which is going to help the current economy at all. (In fact, of course, extending the Bush income taxes is going to increase the overall deficit far more than any plausible spending cuts, so the claims by people like John Boehner to be interested in deficit reduction without clearly describing the compensating spending cuts make no sense.)
So on paper the Fed’s move is going to be useless. It has only one prospect of working: by making it clear to investors that, despite the government paralysis, the Fed is going to keep expanding the money supply until something happens. If people come to believe that, then they will be that much more likely to start spending, companies will be that much more likely to start borrowing, and jobs will start to be created. It’s a very indirect way of working. I don’t personally think it is going to work. But it could happen.
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