DeLong Smackdown Watch: Tim Duy Comes to the Defense of and Explains Kansas City Fed President Esther George
Brad DeLong : There Is Something I Do Not Understand About Kansas City Fed President Esther George's Reasoning Here: The Fed's current Quantitative Easing ∞ program involves its buying risky bonds--thus diminishing the pool of risky assets that the private sector can hold. Esther George objects because… it does not make complete sense to me…. Because there is less in the way of risky assets for the private sector to hold--and because that pushes prices of risky assets up and returns on risky assets down--QE ∞ actually makes private-sector portfolios riskier? Is that the argument? It could be--the world is a surprising place, and lots of things can happen. But my first thought would be that a world in which the Federal Reserve takes risk off of private-sector balance sheets and onto the government's balance sheet is one in which the private sector is holding not more-risky but less-risky portfolios…
Tim Duy performs the smackdown:
Safe Assets and the Coordination of Fiscal and Monetary Policy - Tim Duy's Fed Watch: DeLong is looking at a continuum of assets from safe to risky, where cash anchors the safe end of the continuum. Right next to cash is the somewhat riskier Treasury… by exchanging cash for Treasury securities, you by definition must be removing risk… and thus the public's portfolio is now less riskier. But… this is obviously not how George views the situation…. George… believes that [Fed policies] are in fact making the public's portfolio more, not less, risky…. I think a way you can explain George's position if you consider Treasuries as less risky than cash…. [T]he Treasury bond may be perceived as a safer because it provides some return…. [F]or any given inflation rate, the Treasury bond will thus be a safer store of value [if held to maturity]. If you viewed the world from this perspective, then the Fed is increasing riskiness of the public's portfolio…. George appears to be saying that the Fed is eliminating (more accurately, removing) the safe assets that the public wants to hold. Suppose that this is true. Does this mean that the Fed should reverse policy to increase the proportion of safe assets in the public's hands? Or does it mean that another agency - perhaps a fiscal authority, hint, hint - should take action to increase the proportion of safe assets in the public's hands?
Once again, we come back to the issue of coordinating monetary and fiscal policy. If the public has a strong demand for noncash safe assets, monetary policy has something of a secondary role by providing an accommodative environment by which the fiscal authority can issue those assets. If the proportion of safe to risky assets is not "correct", the the fiscal authority should have a role in correcting that imbalance. In this world, then, it is not really the actions of the monetary authority that is creating the financial sector imbalances that concern George. It is the lack of action by the fiscal authority that creates those imbalances. George should be criticizing the fiscal authorities, not the monetary authority.
In other words, if a recession is the result of the public shifting to safe assets, the Fed is trying to respond by taking away the option of safe assets, leaving only risky assets. Instead, the Fed should view their role creating an environment (making clear that default is not an option) that allows the fiscal authority to issue more safe assets.
All of this, however, suggests that fiscal policy has a much greater role in stabilizing economy activity than conventional wisdom would hold. I suspect, however, that thinking along these lines is anathema to Federal Reserve officials who maintain that stabilization policy is the domain of monetary policy only. But if in fact there needs to be greater cooperation, and instead we continue to rely solely on monetary policy, then we will continue to experience less-than-satisfactory economic outcomes which will eventually endanger the cherished independence of central banks.
In short, I don't think you can have a discussion about the influence of monetary policy on the riskiness of the public's portfolio without including some discussion about the role of the issuer of those safe assets, the fiscal authority.
This is, I think, why I want the Fed's QE ∞ policies to take the form of buying genuine long-term risky securities more risky than Treasurys or MBS. If the point is to remove risk from the private sector balance sheet-if the point is to take Vienna--then remove risk from the private sector balance sheet--take Vienna! If the point is to expand the supply of cash to create expectations that interest rates will stay lower for longer, then it is better to buy assets the unwinding of which must by the nature of things be gradual and prolonged rather than buying assets positions in which can be unwound nearly costlessly in the blink of an eye. If the point of QE ∞ is neither to remove risk from the private sector balance sheet nor to back up guidance that interest rates will stay low for a long time, I do not understand what the point of the policy is.
And, of course, he is 100% right that expansionary fiscal policy by credit-worthy governments (or expansionary financial policy via loan guarantees) is the right policy to deal with a shortage of safe nominal assets leading economic agents to try to cut their spending below their income. This is, of course, the reason that I think a proper assessment of Tim Geithner's tenure at the Treasury would be a very harsh one indeed.
Tim's point that for an economic agent with a five-year horizon a five-year Treasury dominates cash is a good one, and I think it points to a flaw in my visualization of the Cosmic All that I do not know how to repair.
