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links for 2008-03-10

DeLong Smackdown Watch: Effects of Sterilized vs. Non-Sterilized Policy Moves

Paul Krugman writes:

Why sterilization matters: Brad DeLong, commenting on my last post, misses the point, I think:

Foreign exchange markets are so large that even big exchange intervention efforts look like a drop in the bucket. But domestic financial markets are even larger--so that even big open-market operations not just look like but they are a drop in the bucket. Yet open-market operations are highly effective in changing interest rates.

The reason open-market operations are highly effective is that they change the monetary base -- and the monetary base is only $822 billion (yes, "only" -- we are in the land of Very Big Numbers here). Whatis more, there are no close substitutes for monetary base. So there, an intervention of a few tens of billions of dollars has a big effect.

But a sterilized intervention means an intervention that doesn%u2019t affect the monetary base %u2014 swapping dollar t-bills for euro T-bills, or T-bills for mortgage-backed securities. And here the numbers are much bigger: $11 trillion in home mortgages, for example. And home mortgages are a better substitute for, say, long-term government debt than either is for green paper bearing portraits of dead presidents.

The point is that the effectiveness of conventional open-market operations offers very little reason to be optimistic about the super-TAF, or whatever they are calling the Fed's new role as pawnbroker of last resort.

I think a better guide is the failure of sterilized intervention in, say, the 1992 sterling crisis: $40 billion in intervention -- about 4 percent of GDP -- blown away by the markets in a couple of weeks. That's why I'm not optimistic about the Fed's plan.

I parry in sixte with the response that while there are no close substitutes for monetary base (in a world with no excess reserves) there are very close substitutes for the liquid bank deposits those reserves enable: drop my checking balance and raise my VISA limit by $1000 and my liquidity position is unchanged.

But Paul's point that it is harder to see how sterilized interventions matter is correct.

Touche...

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