By Sung Won Sohn
Sunday,
December 7, 2008
Most economists are predicting a slow recovery beginning sometime during the second half of 2009. If the forecasts go awry, the global economic growth will be much worse than predicted.
Over the next two years, the Obama administration plans to spend an additional $500 billion to $700 billion to stimulate the U.S. economy. The Federal Reserve is in the process of pursuing "big-bang monetary policy" itself.
In this global economic tsunami, the risk of doing too little could be catastrophic.
The Federal Reserve has studied when the Bank of Japan fought deflation for almost a decade. The central bank already has launched a pre-emptive strike on a prolonged recession and possible deflation — a long period of declining prices — by going down the path of so-called "quantitative easing."
The quantitative easing can include three stages.
First, the federal funds rate is set to zero. Banks can borrow money from each other at zero interest rate. Longer-term interest rates can be higher depending on credit risk and maturity. The Bank of Japan managed to bring the rate down to 0.001 percent.
In the second stage of the quantitative easing, the central bank announces that the interest rate will remain at zero either for a set period of time or until the inflation rate rises to a specified rate. The market participants must believe the interest rate would remain at zero for an extended period in order for them to have higher inflation expectations and spend money. In short, the sharp decline in the interest rate must have some expectation of permanence.
In April 1999, the Bank of Japan promised to maintain a zero interest rate until deflationary concerns are dispelled. The zero interest rate was “abandoned” in August 2000 when the economy grew 3.3 percent between the third quarters of 1999 and 2000.
The third stage of the quantitative easing is to set the amount of long-term securities, including Treasuries, private debt and equities, the central bank will buy from the marketplace. Each year, for example, the Bank of Japan announced the amount of long-term debt it would buy from the market. Liquidity is pumped into the economy, lowering long-term interest rates.
The Federal Reserve has announced it is purchasing more than $600 billion of private debt, including commercial paper, mortgage-backed securities and other asset-backed securities. In order to cover the possible credit loss from the purchases, the U.S. Treasury agreed to set aside $20 billion out of the $700 billion authorized by the Congress. The Bank of Japan even purchased private equities from banks.
The three stages of the quantitative easing help the economy through at least three channels. They lower deflationary expectations. With deflationary expectations, people postpone purchases because they believe prices will fall, hurting economic growth and employment. With inflation expectations, people tend to spend now because waiting could mean higher prices.
The purchases of the long-term debt do at least a couple of things. Lower long-term interest rates have a much more significant effect in stimulating the economy than short-term interest rates. For example, lower long-term rates are likely to encourage more capital spending than lower short-term rates would.
The quantitative easing also can lower the value of the dollar or the yen as the supply of the currency increases. With weaker currency, exports tend to rise and imports are discouraged, creating demand for labor and goods.
The central bank can create an unlimited amount of money by purchasing both public and private securities, a significant advantage. Furthermore, the actions do not need the difficult process of congressional approvals. What securities it does purchase or accept as collateral in case of loans are flexible as well. Sometimes this is called the "doorknob policy." If the central bank so chooses, it can accept your doorknob from your bedroom as collateral.
A possible disadvantage of monetary policy by the central banks is that the excess liquidity does not necessarily lead to spending. This is the reason why fiscal policy — tax cuts, government spending and loan guarantees — needs to accompany the quantitative easing.
Sung Won Sohn is a professor of economics and finance at California State University, Channel Islands.
A little Christmas missive.
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