I offer reactions to a Wall Street Journal review of a new book, How To Speak Money, by one John Lanchester, who is tellingly identified as a British novelist. Tellingly, because, as the reviewer makes clear, Mr. Lanchester is a novelist trying to explain economic theory, and the match-up is a mismatch. The reviewer, Daniel Shuchman, characterizes Mr. Lanchester’s views on “quantitative easing” (QE) as profoundly misleading, and so they are.
Mr. Lanchester reportedly defines QE as the process of “the government . . . buying back its own debt.” Apparently he thinks the US Treasury and the US Federal Reserve Bank are just two different agencies of the same branch of the federal government, as “he analogizes QE to an individual who has the power magically to add money to her bank account and uses it to ‘pay off’ her debts” (to quote the reviewer). As the reviewer indicates, Mr. Lanchester has made the twin mistakes of conflating Treasury and the Fed and believing that when the Fed engages in QE – when it buys government debt obligations (treasuries) – it is paying off that debt, causing that debt to cease to exist.
Mr. Lanchester is half-right: as he implies, the Fed is in fact creating new money (adding “money to her bank”) in the form of credits given to the reserve accounts of U.S. banks as payment for the Treasuries the Fed buys. But he is wrong on the more-important half: the debt represented by those Treasuries does not go away, it remains extant, interest obligations and all. The Fed, though creating money, is not paying off Federal debt. The Federal debt continues, undiminished; the Fed has created new money in order to make a particular kind of investment, but not to pay off government debt. Indeed, it has merely swapped one form of government debt (money) for another form (Treasuries).
The purpose of that investment, the reason for QE, is not to finance the federal government, it is to make it easier (in the Fed’s opinion) for the Fed to regulate economic growth by raising or lowering interest rates in the financial markets, while at the same time making the banks more stable and secure. (QE increases the level of bank reserves at the Fed, and the Fed thinks it can control market interest rates more easily by simply modifying the interest rate that it pays on those reserves, rather than by utilizing the traditional technique of engaging in open market operations.) Whether fiddling with interest rates at all, either through QE or through open market operations, actually affects economic growth (the avowed purpose of either technique), is another hot topic, but likewise a separate one. (If you are interested in that topic, watch what happens in Japan, now that their central bank has announced a major interest-rate cut.)
Mr. Lanchester’s mistake is a common one. Many people, including some conservatives, think that QE is a program through which the Fed accommodates the enormous federal deficits caused by the riotous spending of the Obama Administration. In other words, the Fed is seen as an enabler of the fiscal recklessness of this White House. But that is not what happens. When the federal government runs an annual deficit (when its expenditures exceed its revenues), it covers the shortfall by offering government debt-obligations (“Treasuries”) to the markets – to domestic and foreign financial institutions, individuals, and governments. So long as there are enough buyers, at high enough prices (that is, reflecting low-enough yields), the U.S. can keep chugging along, running up bigger and bigger annual deficits and a bigger and bigger cumulative national-debt. In Leftyworld, this scheme (sometimes blamed on Keynes) can be continued indefinitely, the total debt can leap toward infinity, with little real risk to the country, though that premise becomes shakier with each new deficit or other action that accelerates the decline of our international standing (including our creditworthiness).
But remember, it is not the Fed that is buying these Treasuries from the Treasury Department, it is the investing public. The Fed only comes in after the fact, after the Treasuries have already been floated. Under QE, when the Fed buys a Treasury, it is buying a debt obligation that is already out there in existence, in the market. The deficit the Treasury offering was designed to finance, has already been financed; the Fed is not creating money and delivering it to the Treasury Department to cover a deficit, as the bond market has already covered the deficit by buying the initial offering of the Treasury.
Yes, it is true that the Fed, in paying for the Treasuries it buys, is creating new money, and each such addition to the overall money supply does carry significant longer-term implications – e.g., if/when the U.S. finally starts to experience a real recovery from the ’08 recession, this overhang of idle money will complicate things; we might face a problem comparable to the one that President Reagan and Fed Chairman Volcker faced in the early 1980s. Would that we might have a Reagan and a Volcker to deal with it when that problem again arises.