The Federal Reserve’s Relevance Test

John Maynard Keynes argued that monetary policy was ineffective during the Great Depression. Central banks are better at restraining markets’ irrational exuberance in a bubble – restricting the availability of credit or raising interest rates to rein in the economy – than at promoting investment in a recession. That is why good monetary policy aims to prevent bubbles from arising.

But the Fed, captured for more than two decades by market fundamentalists and Wall Street interests, not only failed to impose restraints, but acted as cheerleaders. And, having played a central role in creating the current mess, it is now trying to regain face.

In 2001, lowering interest rates seemed to work, but not the way it was supposed to. Rather than spurring investment in plant and equipment, low interest rates inflated a real-estate bubble. This enabled a consumption binge, which meant that debt was created without a corresponding asset, and encouraged excessive investment in real estate, resulting in excess capacity that will take years to eliminate.

The best that can be said for monetary policy over the last few years is that it prevented the direst outcomes that could have followed Lehman Brothers’ collapse. But no one would claim that lowering short-term interest rates spurred investment. Indeed, business lending – particularly to small businesses – in both the US and Europe remains markedly below pre-crisis levels. The Fed and the European Central Bank have done nothing about this.

They still seem enamored of the standard monetary-policy models, in which all central banks have to do to get the economy going is reduce interest rates. The standard models failed to predict the crisis, but bad ideas die a slow death. So, while bringing down short-term T-bill rates to near zero has failed, the hope is that bringing down longer-term interest rates will spur the economy. The chances of success are near zero.

Large firms are awash with cash, and lowering interest rates slightly won’t make much difference to them. And lowering the rates that government pays has not translated into correspondingly lower interest rates for the many small firms struggling for financing.

More relevant is the availability of loans. With so many banks in the US fragile, lending is likely to remain constrained. Moreover, most small-business loans are collateral-based, but the value of the most common form of collateral, real estate, has plummeted.

The Obama administration’s efforts to deal with the real-estate market have been a dismal failure, perhaps succeeding only in postponing further declines. But even optimists don’t believe that real-estate prices will increase substantially any time soon. In short, QE – lowering long-term interest rates by buying long-term bonds and mortgages – won’t do much to stimulate business directly.

It may help, though, in two ways. One way is as part of America’s strategy of competitive devaluation. Officially, America still talks about the virtues of a strong dollar, but lowering interest rates weakens the exchange rate. Whether one views this as currency manipulation or as an accidental by-product of lower interest rates is irrelevant. The fact is that a weaker dollar resulting from lower interest rates gives the US a slight competitive advantage in trade.

Meanwhile, as investors look outside the US for higher yield, the flood of money out of the dollar has bid up exchange rates in emerging markets around the world. Emerging markets know this, and are upset – Brazil has vehemently expressed its concerns – not only about the increased value of their currency, but that the influx of money risks fueling asset bubbles or triggering inflation.

The normal response of emerging-market central banks to bubbles or inflation would be to raise interest rates – thereby increasing their currencies’ value still more. US policy is thus delivering a double whammy on competitive devaluation – weakening the dollar and forcing competitors to strengthen their currencies (though some are taking countermeasures, erecting barriers to short-term inflows and intervening more directly in foreign-exchange markets).

The second way that QE might have a slight effect is by lowering mortgage rates, which would help to sustain real-estate prices. So QE would produce some – probably weak – balance-sheet effects.

But potentially significant costs offset these small benefits. The Fed has bought more than $1 trillion of mortgages, the value of which will fall when the economy recovers – which is precisely why no one in the private sector wants to buy them.

The government may pretend that it has not experienced a capital loss, because, unlike banks, it is not required to use mark-to-market accounting. But no one should be fooled, even if the Fed holds the bonds to maturity. The attempt to ensure that the losses are not recognized might tempt the Fed to rely excessively on untested, uncertain, and costly monetary-policy tools – like paying high interest rates on reserves to induce banks not to lend.

It is good that the Fed is trying to make amends for its dismal pre-crisis performance. Regrettably, it is far from clear that it has changed its thinking and models, which failed to maintain the economy on an even keel before – and are certain to fail again. The Fed’s previous mistakes proved extraordinarily costly. So will the new mistakes, even if the Fed strives to hide the price tag.

Joseph E. Stiglitz, a Nobel laureate in economics, is University Professor of Economics at Columbia University. The paperback edition of his book Freefall: Free Markets and the Sinking of the World Economy will be published this month.