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Is the Fed’s QE2 program a monetization of sovereign debt? And hence, does it enable more fiscal policy action?

Looking at it from its effectiveness as an enabler of private bank lending,QE2 falls short. Operationally, it is the purchase of long-term government bonds by the Fed. The largest holders of this security are commercial banks, who will essentially get cash, or in bank parlance-- additional reserves-- in exchange for their government securities.

Scott Fulwiller has given a convincing explanation for how banks do not lend their reserves. Put another way, banks do not need reserves to do their lending activities. If a bank is to grant more loans, it needs adequate capital, in order to buy risk-weight assets, and it needs to have credit-worthy borrowers. If it has both of these, it can always raise any deficiency in its reserves, i.e. deposit base, by borrowing in the interbank market, or from the Fed’s discount window. If it doesn’t have adequate capital, or a compelling borrower, no loans will be extended.

So QE2’s flood of new reserves into the banking system will not necessarily result in a flood of new loans. What can this be useful for? Well, you could look at it this way. Excess reserves may not fund more loans, but any excess will be put into more liquid marketable securities. If the natural buyers of government bonds suddenly have more cash, and lesser of the bonds, will they be more susceptible to buy bonds in the next auction? Yes.

The Fed, by its charter, is not allowed to buy government securities in auctions. It can only buy them in the secondary market, via open market activities (or QE) . Treasury, on the other hand, is not allowed to fund its deficits by printing money, it needs to float bonds to finance the deficit. The Fed, by buying the older issues of treasury via QE2, has given the banks, the natural buyers in Treasury auctions, a clean slate, so they can again be buyers in the government’s next auction. Because they have a clean slate, they will be ready to fund a higher government deficit, without raising borrowing costs for the government. So they can enable the government to undertake more pump-priming activities.

This can be tricky, though. The Fed should clearly show the market that its interventions in the bonds market will not make owning government bonds too penalizing (by causing zero to negative returns), or the banks will just stick to their cash, and not participate as actively in the next auction (thereby increasing government borrowing costs again).

Now, is QE2 necessary to ensure that funds are available for the next government bond auctions? No. Government deficits, or government spending, by their nature, create private sector income. It is this private sector income which can then be used for consumption in more private sector goods, and eventually result in private sector savings. These go into commercial banks as deposits, which causes bank reserves to increase, which makes banks buy more government securities.

No Fed easing required. QE2 only increases reserves, most of which will likely be kept within the banking system, and nowhere near the real economy, and it only increases the Fed’s balance sheet. It may result in some banks using the new reserves to speculate in risk assets other than loans (if they do have adequate capital, but still not enough credit-worthy borrowers). Some of it may be deployed into risk assets by credit-worthy borrowers who are not building businesses, but are building portfolio assets on margin. But that’s another story.

Our point here is-- does the Fed’s QE2 program enable further fiscal policy? You could say yes, but it is not necessary. Government deficits, which put money into the people’s pockets, who will then spend it in the economy, enables its funding by itself.

Source: Does QE Enable Further Fiscal Policy Action by Government?