A Note on Paul Krugman's Reflections on Fiscal Aspects of Quantitative Easing (with Gratuitous Toy Story Reference)
Paul Krugman thinks about monetary policy:
Fiscal aspects of quantitative easing: The big policy news this week has been the Fed’s decision to buy $1 trillion of long-term bonds, going beyond the normal policy of buying only short-term debt. Good move — but it’s probably worth pointing out that yes, this does expose the Fed, and indirectly the taxpayer, to some risks. And in so doing, it blurs the line between fiscal and monetary policy.... The Fed is... printing $1 trillion of money, and using those funds to buy bonds. Is this inflationary? We hope so! The whole reason for quantitative easing is that normal monetary expansion, printing money to buy short-term debt, has no traction thanks to near-zero rates. Gaining some traction — in effect, having some inflationary effect — is what the policy is all about. The problem may come when the economy recovers... there will come a time when the Fed wants to withdraw that extra $1 trillion of money it created. It will presumably do this by selling the bonds it bought back to the private sector....
[W]hen the economy recovers... long-term interest rates will rise.... Suppose that the Fed has bought a bunch of 10-year bonds at 2.5% interest, and that by the time the Fed wants to shrink the money supply again the interest rate has risen to 5 or 6 percent.... Then the price of those bonds will have dropped.... My back of the envelope calculation looks like this: if the Fed buys $1 trillion of 10-year bonds at 2.5%, and has to sell those bonds in an environment where the market demands a yield to maturity of more than 5%, it will take around a $200 billion loss. I’m not complaining.... But we should go into it with our eyes open.
Paul thinks (correctly, I believe) that the prices of Treasury bonds are higher than they will be in the long run, and thus that the Fed is buying high and will be selling low. But, as I understand it, Paul also thinks (correctly, I believe) that the prices of private-sector bonds are too low--that is our problem: that firms that ought from a social-welfare point of view to be expanding can't expand because they cannot get financing on any but usurious terms. If true, then in the long run the prices of private-sector bonds will go up.
Since buying Treasury bonds and buying private bonds for cash should have similar effects on the overall structure of asset prices, this raises a natural question: why not have the Federal Reserve buy those assets that are undervalued (private bonds, because the risk discount right now is too high) rather than those assets that are overvalued (Treasury bonds, because the duration discount right now is too low)? In that case the Fed would be buying low and selling high--and making, not losing money for the Treasury in the long run.
The answer in normal times is that open-market operations in Treasuries do not play favorites among corporations (although they do play favorites among sectors, either penalizing or rewarding sectors whose capital or output is of long duration), just as revenge is not a concept believed in on Buzz Lightyear's planet. However, then Buzz Lightyear grabs Woody by the throat and says: "But we are not on my planet, are we?"
We are not in normal times right now, are we?
