So, in my previous diary entry I discussed some details about quantitative easing, and here I aim to show that it is a better alternative to TARP. The chief reasons that QE is better than TARP are 1) TRANSPARENCY and 2) MARKET NEUTRALITY.
Firstly, treasury bonds and government mortgage securities trade in very liquid markets, so fair prices are known at all times. A trader who overpays for a treasury bond by a tenth of a percentage point is going to get massively chewed out by their boss. If the Fed buys a bond, it buys it from the current owner who is willing to part with it for the least money. There’s no situation like I described in a recent comment in which the government official in charge of purchases takes a bribe in order to overpay for a hard to value security. If Martha Kent wants to sell her treasury bond to the Fed’s QE program, she gets to if she’s the cheapest seller.
Next, with regards, to market neutrality, QE may distort the government bond market, but it doesn’t directly pick winners and losers in private markets like TARP. Understanding how this is so depends on the following principle: conservation of financial assets. To the first order, the number of treasury bonds, and private bonds and shares of stock as well, is independent of the amount of cash in circulation. (If you want to argue that QE induces Congress to spend even more wildly and thus issue more treasury bonds, you’d probably have a good case, but that’s a second order effect!) So, if the Fed creates cash to buy a bond from an investor, the investor then has to do something with their money. Aside from stuffing the cash in their mattress (or taking the advice of ACORN’s Brooklyn office and burying it in the backyard), they have a few basic options: A) they can spend it on real asset or consumption goods, B) they can deposit it in the bank, or C) they can purchase a new financial asset. The Fed doesn’t dictate which of these things an investor will do, so it doesn’t pick winners and losers.
Now, let’s outline how former owners of treasury bonds pursuing options A), B), and C) will repair the economy if left to their own devices.
If an investor chooses to do buy real assets, this means that they are buying things like houses, cars, and equipment in addition to consumption goods and services such as restaurant meals and vacations. This stimulates the economy.
If an investor deposits their money in a bank, this improves the bank’s capital ratio, thus allowing the bank to make new loans. This partially alleviates the banking crisis.
If an investor uses the money to buy a risky financial asset such as subprime mortgage bond, then this drives up the prices of these securities. When the prices of toxic securities that banks own rebounds, this restores their financial health, so that they can lend again without government capital infusions. If they buy something less risky such a bond issued by General Electric, then the seller of that bond has to find something else riskier to buy, such as the aforementioned subprime security. This is basically an instance of the pigeonhole principle in finance!
Does this all seem like a pipe dream? The Fed actually bought around ONE TRILLION DOLLARS worth of treasuries and government mortgage securities this year through QE. Given the increased level of government borrowing due to the Porkulus spending bill and the budget, if the Fed hadn’t done any quantitative easing, it’s pretty plain that $1T fewer dollars would have been available for lending in the private markets. That would have basically meant that no businesses would have gotten any loans. This would have been an utter disaster.
QE isn’t a cure all. It still induces systemic moral hazard because it trains all players in the market to believe that there will be a macroeconomic rescue if everyone loses their shirt. It runs the risk of causing inflation if the money remains in circulation too long. It still seems a heck of a lot better than placing the bailout money directly back in the hands of the banking institutions that made these bad loans in the first place due to a combination of their shortcomings in risk controls, incentive structures, and government meddling via Fannie, Freddie, Ginnie, and the Community Reinvestment Act. It also precludes letting Congress and the White House have slush funds with which to pick other winners and losers, a situation that causes true economic paralysis, as a command economy saps the will of the individual to exert any effort until they know what share of the pie they’ve been allotted. I hope this doesn’t come across as a cheerleading essay for QE, as I really understand the extreme risks to an economy caused by rapid swings in the supply of money, but I surely believe that we’d have been a lot better off with an additional $787B + $700B in quantitative easing instead of Porkulus + TARP.