Econ 1: Fall 2010: Files for October 25 "General Equilibrium" Lecture
Liveblogging World War II: October 25, 1940

Department of "Huh?!": Where Is Joe Stiglitz Coming From? Edition

Joe Stiglitz joins... the Austrians, I think:

Joseph Stiglitz: Why Easier Money Won't Work: The Federal Reserve, having done so much to create the problems in which the economy is now mired... now wants to make a contribution to preventing the economy from sinking into a Japanese-style malaise... through large-scale purchases of U.S. Treasurys—called quantitative easing, or QE....

The problem is that, with interest rates already near zero, there is little the Fed can do to restart the economy—and doing the wrong thing can do considerable damage. In 2001, (then) record-low interest rates didn't reignite investment in plant and equipment. They did, however, replace the tech bubble with an even more dangerous housing bubble....

Large businesses are flush with cash, and small changes in interest rates—short-term or long—will affect them little. A banker rightly asks if such a business comes asking for money, "What's wrong with it?" But it is SMEs that are the source of job creation in most economies, including the U.S. Many of these enterprises are starved for cash.... They borrow from banks, and many of the smaller local and community banks on which they depend are in dire straits.... Yet even if the banks were willing and able to lend, lending to SMEs is typically collateral-based, and the value of the most common form of collateral, real estate, has fallen 30% to 40%. No wonder then that credit availability is so constrained. But QE in the form of buying U.S. Treasurys is not likely to affect this much....

QE may not even succeed in lowering interest rates, or lowering them very much. Given the magnitude of excess capacity, there is little risk of inflation today. But if the inflation hawks come to believe that the risk of future inflation is real, then... long-term interest rates, even now, may actually rise....

QE poses a third risk: The bursting of the bond market bubble that the Fed is seeking to develop—the sequel to the tech and housing bubbles—will clearly have adverse effects on the economy....

The advocates of QE point to another channel through which it will strengthen the economy: Lower interest rates may also lead to a weaker dollar, and the weaker dollar to more exports.... But this policy only works if other countries don't respond. They will and have, through every instrument at their disposal.... [A]s the U.S. lets forth a flood of liquidity... money is supposed to reignite the American economy... instead goes around the world looking for economies that actually seem to be functioning well and wreaking havoc there.

The upside of QE is limited. The money simply won't go to where it's needed, and the wealth effects are too small. The downside is a risk of global volatility, a currency war, and a global financial market that is increasingly fragmented and distorted. If the U.S. wins the battle of competitive devaluation, it may prove to be a pyrrhic victory, as our gains come at the expense of others—including those to whom we hope to export.

As I understand it, Joe Stiglitz adopts his standard segmented-capital-markets view and makes three claims:

  1. The problem is one of impaired capital on the part of small banks and impaired collateral on the part os small enterprises--a credit channel problem--and quantitative easing in Treasuries will not help that problem.

  2. Quantitative easing will raise expectations of inflation on the part of financiers--and so will raise long-term nominal interest rates--without raising expectations of inflation on the part of industrialists, and so it will raise the perceived cost of capital to businesses and so diminish investment.

  3. Quantitative easing will unleash a process of combined and uneven quantitative easing across the globe that will create dangerous exchange rate and trade volatility.

Therefore we should not do it.

I, by contrast, would say that to the extent that quantitative easing raises expected price levels ten years hence, it will raise the value of collateral. I would say that quantitative easing gives small banks a chance to sell assets to the Federal Reserve and so improve their capital. I would say that even a bond bubble--a topic I have a very hard time wrapping my mind around--is dangerous only if leverage means that the losses from its end are concentrated in key financial institutions. I would agree that quantitative easing is like the scene from Monty Python where they are trying to catch fish in the river by hitting them with a log.

But when you need fish, and when all you have is a log, you try to catch the fish by hitting it with a log.

Don't you?