09.30.10

Is the focus on QE2 distracting the Fed?

Posted in Economics, Politics and Policy at 8:40 pm

This week we saw a number of releases from the Fed discussing potential upcoming QE2 measures.

The issue continues to be framed in the traditional context of how to best expand the Fed’s balance sheet (i.e., what assets to purchase) and whether the primary effect will be via lowered interest rates on long term debt or through the expansion of bank reserves.

This seems to me to be missing the point.  Interest rates are already at historical lows.  Does the Fed really think that driving rates on 30 year fixed mortgages down by another 30-40 basis points will provide that much of an INCREMENTAL boost to aggregate demand?  Do they think that adding another $100 billion (or less) in reserves to a system that already has approximately $1 Trillion in excess reserves will stimulate further bank lending?

The problem is that the financial system itself is still broken.  Banks are still carrying too many non-performing and barely performing assets at inflated prices on their balance sheets.  The private securitization market is virtually non-existent.  Meanwhile, the consumer is facing a nearly 10% unemployment rate, home prices that are still declining in many areas, and a crushing debt load.  This translates into businesses facing reduced demand for their goods and services, along with their own debt problems.  At some point, private sector debt (consumer, financial business, and non-financial business) has to fall further.  This implies that public debt will have to rise by an offsetting amount.  Yet austerity is the talk of the day.  You can’t have it both ways.  There are going to have to be large writedowns, which means more banks are going to fail, and at some point we’re going to have to address the problem at a systemic level, something we should have done in early 2009.  The alternative is a series of QE half measures, attempts at premature fiscal restraint that actually worsen the budget position, and the institutionalization of zombie banks.  In other words, a repeat of Japan’s lost decade….err….two decades….err….you get the point.

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