At the top of my Financial Times this morning reads the blurb: “Did Ben Bernanke Drop the Ball Over QE3?” This is reference to an editorial by Clive Cook. In examining the speech given by Fed Chairman Bernanke, Cook takes on the Financial Times essays published last week by Michael Woodford and Mohamed El-Erian that argued against the Fed implementing a QE3. Cook contends that Bernanke missed a “chance to jolt ailing America.”
I don’t believe that Bernanke dropped the ball. I don’t believe that a declared QE3 is necessary. Whereas Cook believes that a QE3 would “shock” America, I believe that a QE3 would be taken as ho-hum, more of the same. In this, I don’t believe that QE1 and QE2 were understood.
Woodford, the “good” academic, states in his essay: “The economic theory behind QE has always been flimsy.”
QE1 and QE2 were not a result of economic theory. QE1 and QE2, in my mind, were a response of real people to a desperate real world situation. In the first case, the financial markets were falling apart. In the second case, the economy was not growing. In both cases, the response of Bernanke and the Fed’s policy makers was to throw whatever they had against the wall to see what would stick. There is little in the way of theory behind this. Some of us believe that in the first case this was not one of Bernanke’s finest hours. In my mind, what was behind these actions was not theory but history; Bernanke is one of the premier students of the history of the Great Depression.
So what was behind QE1 and QE2? In the case of QE1, Bernanke was aware of the massive monetary history written by Milton Friedman and Anna Schwartz. The famous conclusion drawn from the Friedman/Schwartz history is that the Federal Reserve allowed the money stock of the United States to decline by one third over the 1929-33 period. Bernanke and the modern Fed were not going to allow this to take place. As a consequence, they threw everything they had at the wall. There was no theory in this. They were just human beings reacting in a situation in which there was extreme uncertainty and in which things seemed to be falling apart around them.
In terms of QE2, we can also go back into the history of the 1930s to get some instruction that might help us understand what the Federal Reserve has been attempting to do over the past year. The specific case here comes from the period 1937-38. The United States economy had been modestly recovering since 1933 but bank lending had not really picked up. Excess reserves at commercial banks became, for the time under review, excessive. Since the Federal Reserve’s policy makers did not want to have all these excess reserves around because they felt this reduced their control over the banking system, they raised reserve requirements so as to get rid of these “superfluous” reserves.
The consequence? There was another collapse of the money stock because the commercial banks “wanted” those excess reserves due to the uncertain times and the slow pickup in business activity. When the Fed took away the excess reserves, the banks reduced their lending activity even more to recover their “excess” reserves and the financial system declined once again. There was another depression following up on the “Great” one.
Bernanke and the Fed did not and do not want a repeat of the 1937-38 depression. As a consequence, QE2 was created. The thought behind QE2 was to throw enough against the wall so that something would stick. Economic growth was sluggish at best; bank lending was still declining in the summer of 2010; debt loads of businesses, and families, and governments were huge; foreclosures and bankruptcies were at record levels; and under-employment were at levels reached only in the 1930s. Banks had excess reserves, yet nothing much seemed to be moving. Bernanke and the Fed wanted to escape a replay of 1937-38.
There was little or no theory behind QE1 and QE2. These two programs were put into place by real people facing extreme situations who did not want to err on the side of not doing enough. They were people who would let history decide whether or not they acted correctly and let the theorists debate all they wanted to in their own little worlds.
What are we left with right now? A commercial banking system that has around $1.6 trillion in excess reserves and about $2.0 trillion in cash assets on its balance sheets. We are told that the central bank is poised to act in the future in any way needed to shore up the banking system and the economy. Furthermore, we are told that short-term interest rates are to stay around where they are for two more years.
Bernanke, who has overseen both QE1 and QE2, is not afraid to throw more “stuff” against the wall if needed. This, to me, is the state of monetary policy at the present time.