Jury is still out on Quantitative Easing

St. Patrick’s Day is still just over a month away, but when Corporate America looked through its pockets it found just over $300 billion in magic money that the leprechauns had apparently left there for them.

The $300 billion is actually an unadvertised consequence of winding down the magical part of our monetary policy, Quantitative Easing.

The story began back in 2008 when the Federal Reserve and the U.S. Treasury Department stepped in and shored up the financial markets in order to avoid a complete collapse. The Fed did this by buying up dubious bank assets to clean up their portfolios and improve their capital positions — the maligned yet ultimately vindicated Troubled Asset Relief Program (TARP). The Fed also kept interest rates, including long-term rates, low and inflated bank reserves by buying the Treasury securities they held. This stabilized our financial system’s vital signs and stopped the housing industry’s free-fall. It kept our economy from plunging into the abyss and taking every other developed country along with us. It paid off, and in the end largely paid for itself. It was, as they say, “all good.”

Eventually, though, the financial crisis was over and the focus shifted to economic recovery and the jobs it would bring. Unfortunately, that’s when monetary policy encountered “Maslow’s Hammer.” Almost half a century ago, psychologist Abraham Maslow wrote that, “… it is tempting, if the only tool you have is a hammer, to treat everything as if it were a nail.”

The Federal Reserve believed that the housing industry was still so fragile that it needed low long term interest rates to support it. It also believed that low long term interest rates would stimulate commercial borrowing and growth in the rest of the economy, too. It all made sense, especially after the disappointing results from our other economic policy, the government deficit spending program known as Stimulus I.

In 2009, then, the Federal Reserve used more of the only tool it had, easy money. It began a program of Quantitative Easing (QE) in which it would buy financial assets, primarily longer-term Treasury bonds, from member banks. This kept downward pressure on long-term rates, which would, theoretically, help the housing industry to regain its footing, encourage business sector borrowing, and provide energy to the anemic recovery of the overall economy.

The U.S. economy did not respond immediately to quantitative easing, however, and continued its lethargic ways despite the gradual improvement in the housing industry picture. The Federal Reserve then expanded the program in 2010-2011, nearly doubling purchases in an effort, known as QE2 to breathe some life into the economy. Some might see political pressure behind the timing of the monetary expansion programs, but most likely it was standard, off-the-shelf government logic: if a program does not live up to expectations, double its budget.

In September, 2012 the Federal Reserve launched QE3, an expanded and accelerated monetary expansion that included purchasing mortgage-backed securities. This program lasted until late December 2013 when the Fed began winding down Quantitative Easing gradually— a process it called “tapering.”

We will have to wait a decade or more before we get a worthwhile assessment of how effective any or all of the Quantitative Easing programs were. The only thing we know for certain is that our financial markets quickly became dependent on regular, large purchases of federal government debt. We also know that the Federal Reserve’s Balance Sheet has now topped $4.1 trillion, which is a big number in anybody’s algorithm.

The Fed’s talk of “tapering,” along with other factors, did prompt an increase in both short-term and long-term interest rates last year. Generally speaking, that was not in the playbook but while it caused a few anxiety attacks on Wall Street, it also energized the leprechauns.

Interest rates have a profound effect on the value of financial assets and liabilities. By keeping interest rates low, the Federal Reserve maximized the pension fund liabilities of large corporations, which meant companies had to divert cash to keep the pension systems actuarially sound. Whether this cash drain had a significant effect on corporate investment isn’t known, but it certainly didn’t help the sickly economic recovery.

What happened on corporate balance sheets, though, was that the higher interest rates in 2013 meant they owed less to their pension funds — about $300 billion less — and a good portion of that will be available for companies to invest and grow.

It’s magic money, of course, a by-product of the accounting systems used to measure future liabilities such as pensions. Magic or not, though, it will provide a real, and much-needed, boost to the economy, and that is the best news we’ve had so far this year. Magic, yes. But, go leprechauns!

James McCusker is a Bothell economist, educator and consultant.

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