Joe Public versus Ben Bernanke on QE

The title of this blog should really read “How Come Many in the General Community Appear to Be At Odds With the Thinking of Those in Orthodox Policymaking Circles?”

The answer is that the standard presentation of orthodox thinking on monetary policy that most glean from introductory textbooks or newspapers no longer even remotely reflects the state of knowledge of those orthodox economists working in the area of monetary policy.

The Standard Textbook Treatment

A. The Money Multiplier Theory

The textbooks have traditionally claimed that the Fed exogenously controls the money supply by making use of a supposedly stable money multiplier. It is claimed that when the Fed varies the level of reserves, it alters the amount that banks are able to lend and this causes a multiplied change in the money supply (defined as currency on issue plus demand deposits).

B. The Quantity Theory

The textbooks then claim that the alteration in the money supply results in variations in the general price level. This is because it is assumed that the economy is automatically at full employment, so that any increase in demand must result in “too much money chasing too few goods”.

The Orthodox Policymakers

Very few orthodox monetary policy specialists and policymakers would seem to adhere to the standard textbook treatment.

They understand that the Fed cannot exogenously control the money supply in accordance with the money multiplier theory. Increasing reserves does nothing to increase the capacity of banks to lend, and the orthodox policymakers realize this. There is no direct connection between reserves and the money supply. Reserves, themselves, are not part of the money supply (they are “outside money”), and alterations in their level have no predictable multiplier effects on the money supply. The orthodox policymakers know this, too.

When orthodox policymakers talk about monetary policy having an effect on the economy, they are therefore not referring to a direct effect from reserves to broader money. They are talking about an indirect effect through interest rates. The orthodox policymakers hope that a reduction in particular interest rates will stimulate demand in the real economy and that this will increase demand for loans from credit-worthy borrowers.

The orthodox thinking behind QE is that it can be used to reduce the interest rates that are traditionally considered to be the “investment rates”. It is hoped that lower longer-term rates will entice firms to increase investment.

We can compare the textbook transmissions mechanism with the one orthodox policymakers actually have in mind in relation to QE:

A. Textbook

Fed buys securities/increases reserves
=> Banks lend more
=> Money Supply expands

B. Orthodox Policymakers

Fed buys securities/increases reserves
=> Longer term interest rates fall
=> Investment demand of firms in the real economy increases
=> Demand for loans from credit-worthy borrowers increases
=> Banks can profitably extend more loans
=> Money Supply expands

The transmissions mechanism envisaged by the orthodox policymakers is much less direct and much less certain in its impact than the story told in the textbooks. For starters, the policy has to succeed in having the desired effect on longer-term interest rates. Next, private investment demand may be insensitive to interest rates, in which case the impact on demand for loans will be weak. Additionally, if general economic conditions remain depressed, then even if firms’ demand for loans increases, the banks may remain skeptical of profitability and reticent to lend. So, from the perspective of orthodox policymakers, there is no certainty that QE will ultimately have much effect on the money supply at all.

But let’s suppose there is some effect. Joe Public appears to be at odds with orthodox policymakers not only on the transmissions mechanism between reserves and broader money but also on the effects of any successful attempt to expand the money supply on prices.

In the standard textbook treatment, any expansion of the money supply is inflationary because the economy is assumed automatically to be at full employment. In fact, to this day, this remains the orthodox position in the “long run”. That is, orthodox policymakers – in contrast to Keynes influenced economists – are in agreement with the textbooks that the economy will eventually reach full employment if left to its own devices. They differ amongst themselves only on the speed of this supposed automatic adjustment.

Obviously, at the moment, the economy is a very long way from full employment. For this reason, the orthodox policymakers understand that an expansion in the money supply will not at first be inflationary but rather accommodate an expansion in real output and employment. It is only when the economy reaches full employment that monetary expansion causes “too much money to chase too few goods”.

When the economy does reach full employment – and for the orthodoxy it is a matter of when not if – further monetary expansion would need to be curtailed. Until then, orthodox policymakers view the inflation risk as minimal.

Examples of Orthodox Thinking Within Monetary Policy Circles

To gain an insight into current thinking in the orthodoxy, one good source is a paper published by the Bank of International Settlements on “unconventional monetary policies” (i.e. balance-sheet policies such as quantitative easing). I have linked to this paper previously. Another place to look are the statements made by Bernanke (for instance, in this Q&A session with university students). I also recommend this post by Bill Mitchell in which he discusses these two sources.

Consistent with what has been described in the preceding section, the authors of the BIS paper reject the notion that quantitative easing is inflationary on two grounds: (i) reserve expansion does not increase the capacity of banks to lend; and (ii) there is nothing uniquely inflationary about bank reserves when compared with other similar financial assets. For instance, the authors write:

The preceding discussion casts doubt on two oft-heard propositions concerning the implications of the specialness of bank reserves. First, an expansion of bank reserves endows banks with additional resources to extend loans, adding power to balance sheet policy. Second, there is something uniquely inflationary about bank reserves financing.

The authors then explicitly reject the money-multiplier theory – i.e. the notion that an expansion of bank reserves encourages bank lending and so causes a multiplied expansion of the money supply – in this passage:

… an extreme version of this view is the text-book notion of a stable money multiplier: central banks are able, through exogenous variations in the supply of reserves, to exert a direct influence on the amount of loans and deposits in the banking system.

In fact, the level of reserves hardly figures in banks’ lending decisions. The amount of credit outstanding is determined by banks’ willingness to supply loans, based on perceived risk-return trade-offs, and by the demand for those loans.

It is clear in this passage that the authors of the BIS paper take the view that the expansion of reserves does nothing in itself to encourage bank lending and so does nothing in itself to cause growth in the money supply.

In other words, in the view of the authors of the BIS paper, quantitative easing does not in itself cause an expansion of the money supply. On this point, Bernanke is clearly in agreement when he says in the linked video:

What the purchases do, is, if you think of the Fed’s balance sheet, when we buy securities, on the asset side of the balance sheet, we get the Treasury securities, or in the previous episode, mortgage-backed securities. On the liability side of the balance sheet, to balance that, we create reserves in the banking system. Now, what these reserves are is essentially deposits that commercial banks hold with the Fed, so sometimes you hear the Fed is printing money, that’s not really happening, the amount of cash in circulation is not changing. What’s happening is that banks are holding more and more reserves with the Fed …

Reserves are not part of the money supply. They are outside money, as has been mentioned. That is why Bernanke says “the amount of cash in circulation is not changing”. Also, there has been no change in net financial assets. One type of asset (securities) has been swapped for a near-equivalent (reserves). There is no more “firepower” in the system. There is just an alteration in the composition of financial assets and a corresponding alteration in the term structure of interest rates (yield curve). The authors of the BIS paper put it this way:

… we argue that the typical strong emphasis on the role of the expansion of bank reserves in discussions of unconventional monetary policies is misplaced. In our view, the effectiveness of such policies is not much affected by the extent to which they rely on bank reserves as opposed to alternative close substitutes, such as central bank short-term debt. In particular, changes in reserves associated with unconventional monetary policies do not in and of themselves loosen significantly the constraint on bank lending or act as a catalyst for inflation.

It is clear why the authors of the BIS paper think the focus on reserves is misplaced. Their reason is that the monetary policy transmissions mechanism is not a direct one from reserves to loans – as the textbooks have traditionally claimed – but an indirect one from the term structure of interest rates to the demand for loans. The appropriate way to formulate balance-sheet policy, in the view of these authors, is to consider how the composition of financial assets impacts on the yield curve and how this in turn affects the demand for different types of loans.

Needless to say, my own position – following MMT – which I’ve discussed here and here differs from that of the orthodox policymakers, and diverges even more from the standard textbooks. But I thought pointing out how the current thinking of orthodox policymakers differs from the standard textbook treatment might help to clarify the QE debate.