The extremely sharp Jeremy Stein is correct here: we should be talking about positive portfolio balance effects rather than negative reaching for risk effects, unless you have concrete evidence that the people reaching for risks are assuming positions they are unqualified to evaluate:

Olivier Blanchard: “Have low interest rates led to excessive risk taking?”.... Jeremy Stein: “It seems pretty clear that the low interest rates (plus QE) of the last several years have led to significant downward pressure on a variety of risk premiums. Of course, all of this is to be expected, and was explicitly intended to be part of the transmission mechanism for low rates--the so-called 'portfolio balance' channel, which is a nicer and more politically correct euphemism than the 'risk-taking' or 'reaching for yield' channel...


...But they are all the same thing, and indeed, we have been fortunate that monetary policy has these risk-taking effects, because this gives it more potency per unit of funds-rate-cut, which is a crucial benefit near the zero lower bound..."

  • "Portfolio balance" connotes organizations that understand the risks responding to changing spreads by... rebalancing their portfolios... in a sensible way...

  • "Reaching for yield" connotes organizations that find their old business models unsustainable taking on risks they do not really understand and cannot evaluate well...

  • "Risk-taking" is in the middle...

Lawrence_Summers: "I think this is a serious concern. Especially at a moment like present I think Olivier is wrong to blame low rate primarily on QE. Term structure is pretty flat. Stock of long term debt markets have to absorb is high by historical standards.... I’m less confident than Olivier that risk premiums are low. For equities his judgement relies on assumption that super high earnings will be highly persistent. Commercial real estate,c ovenant lite lending, and credit spreads are along w emerging markets more alarming. Even if Olivier is right that high asset prices are justified by low Long rates that does not mean they are not a source of risk..."

I suspect that the right way to make the accurate point that this line of discussion is hunting for is to focus not on the amount of risk but on, rather, who is bearing the risk...

Think of it this way:

Let me first outline what is the wrong focus—on the quantity of risk being carried: In the financial market there is a demand for risk-bearing capacity by firms and others who want to borrow but who cannot guarantee that they will be able to repay. The higher is the price of risk—the greater the risk premium interest rate spread over short-term Treasuries they must pay--the less they will borrow. There is also a supply of risk-bearing capacity by savers and financial intermediaries who want to lend, and are willing to accept and bear some risk in return from getting more than the short-term Treasury rate. The higher is the price of risk—the greater the risk premium interest rate spread over short-term Treasuries they must pay--the more they will be willing to lend.

When the Federal Reserve undertakes quantitative easing, it enters the market and takes some risk off the table, buying up some of the risky assets issued by the U.S. government and its tame mortgage GSEs and selling safe assets in exchange. The demand curve for risk-bearing capacity seen by the private market thus shifts inward, to the left: a bunch of risky Treasuries and GSEs are no longer out there, as the government is no longer in the business of soaking-up as much of the private-sector's risk-bearing capacity. And this leftward shift in the net demand to the rest of the market for risk-bearing capacity causes the price of risk to fall, and the quantity of risk-bearing capacity supplied to fall as well. Yes, financial intermediaries that had held Treasuries and thus carried duration risk take some of the cash they received by selling their risky long-term Treasuries to the Fed and go out and buy other risky stuff. But the net effect of quantitative easing is to leave investors and financial intermediaries holding less risky portfolios because they are supplying less risk-bearing capacity.

How do we know that they are holding not more but less risky portfolios? We know because we know that supply curves slope up, and if they were holding more risky portfolios in total—supplying more risk-bearing capacity to the market—the price of risk would have not fallen but risen, and interest rate risk spreads would be not lower but higher, wouldn't they? At least, that is the case as long as the supply curve for risk-bearing capacity slopes up, like a good supply curve should.

Perhaps those who claim that there are big risks to quantitative easing regroup. Perhaps they claim that financial intermediaries are perverted, and that the lower is the price of risk the greater is the amount of risk-bearing capacity they supply to the market because they lose their jobs if they don't make at least three cents on every dollar of assets in a normal year in which risk chickens come home to roost. But in that counterfactual world, the Federal Reserve's adoption of quantitative easing policies triggered an enormous expansion of the quantity of risk-bearing capacity demanded by firms and households and a huge private-sector lending boom as firms issued enormous tranches of risky bonds and as firms and households took out risky loans. In that counterfactual world, employment in bond underwriting tripled as 85billionamonthinQEwasmore−than−offsetbyanextra 120 billion a month in private-sector bond issues. In that counterfactual world, we saw a rapid recovery of housing construction and a thorough equipment investment boom as far across the U.S. as they eye could see.

That didn't happen. So what are the risks of QE, really?

Let me now analyze what is the right focus::

  • Commercial banks traditionally accept deposits, put the deposits in long-term Treasuries or similar low-risk high duration assets, rely on the law of large numbers and on deposit insurance to allow them to always hold their long-term Treasuries or other low-risk high duration to maturity, and so have a profitable business model as long as they focus on what their core competence is: running a commercial banking business with branches, ATMs, and a well-collateralized loan portfolio.

  • When commercial banks cannot do this profitably, they need to find higher return assets to invest in. The problem is that they have no expertise in judging those higher return assets—hence they are highly likely to get adversely selected as they try to find them.

  • The result is that they are likely to lose money. And then somebody will have to eat the losses.

To the extent that organizations whose business models become unprofitable as a result of low rates and QE and so take on risks excessive for them because they have no expertise in judging such risks do so by investing government-insured deposits, this is not a source of systemic risk to the economy: it is only a source of financial risk to the Treasury.

To the extent that organizations whose business models become unprofitable as a result of low rates and QE and so take on risks excessive for them because they have no expertise in judging such risks do so by investing non-insured deposits, this could be a source of systemic risk to the economy depending on where the funds are coming from, and how highly leveraged the organizations that these funds are being drawn from are.

At least that is what I think a coherent and possibly accurate worry might be...