Thursday, November 18, 2010

Gregory Mankiw on QE2

Mankiw writes about QE2 here. It came as a surprise to me to learn, at one time, that Mankiw was a Republican, as I had assumed that hard-core Keynesians had to be Democrats. Of course, this should not have surprised me, as I know many hard-core new-classical types who are Democrats.

Like Krugman, Mankiw is worried about deflation, and he has a Keynesian view of how QE2 works, i.e. through interest rate effects on "aggregate demand." The interesting part is in this paragraph, where he nails some of the potential problems with QE2:
Moreover, I do see some potential downsides. In particular, the Fed is making its portfolio riskier. By borrowing short and investing long, the Fed is in some ways becoming the hedge fund of last resort. If future events require higher interest rates, the Fed will end up making losses on its portfolio. And even if doesn't recognize these losses (by not marking to market), it could end up paying more interest on newly expanded reserves than it is earning on its newly acquired portfolio of long bonds. Such a cash-flow deficit could potentially undermine the Fed's political independence (which is already not very popular in some circles). Yet if the Fed tries to avoid these losses by failing to raise rates when needed, inflation could indeed become a problem down the road. I trust the team at the Fed enough to think they will avoid that mistake.
He's basically in tune with some of the issues that Kocherlakota raises here. I like this paragraph, but disagree with the last sentence. The Fed is trustworthy, in some sense, but I don't think they will be able to withstand the pressure to do the wrong thing when the time comes to do the right thing.

11 comments:

  1. Professor, wondered if you were going to discuss at some point the new paper from Krugman and Eggertsson ?
    http://www.voxeu.org/index.php?q=node/5823

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  2. I haven't seen it. Thanks for the link.

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  3. Steve,

    Mankiw sez:
    "If future events require higher interest rates, the Fed will end up making losses on its portfolio. And even if doesn't recognize these losses (by not marking to market), it could end up paying more interest on newly expanded reserves than it is earning on its newly acquired portfolio of long bonds."

    I haven't read his full post, but I've had a question along these lines for a while. Namely, should we be at all concerned if the Fed takes a capital loss on its post-QE2 portfolio? After all, that'll only happen if a) inflation takes off without much economic recovery, or b) recovery takes off & causes inflation. I still haven't heard or read a plausible story for (a), from you or anyone. And if it's (b), then would that be so bad? After all, in that case the private sector would be on the winning side of the bet against the Fed, right? So as long as those gains flow back as, say, dividends, how are we worse off in the aggregate?

    PS

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  4. Noted econ blogger Paul Krugman has just written a paper with Gauti Eggertsson. I've checked and I don't see the word ISLM anywhere:

    http://www.princeton.edu/~pkrugman/debt_deleveraging_ge_pk.pdf

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  5. Pete,

    How does a recovery cause inflation?

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  6. "Such a cash-flow deficit could potentially undermine the Fed's political independence (which is already not very popular in some circles)."

    I believe this is what is happening with the People's Bank of China. Ok, granted the PBoC is not very independent to begin with. But it is facing a cash flow problem because the rate at which it issues sterilization bills (in order to neutralize inflation) is rising, whereas the rate that it earns on its US debt portfolio is flat. If this gets any worse it'll have to get some sort of recapitalization, the necessity of which effectively makes the PBoC more beholden to some other government body.

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  7. Kocherlakota: "The Fed cannot literally eliminate the exposure of the economy to the risk of fluctuations in the real interest rate. It can only shift that risk among people in the economy. So, where did that risk go when the Fed bought the long-term bond? The answer is to taxpayers.".

    I would say... either the taxpayers or currency holders or some combination of both take the risk described above (and in the case of semi-private central banks, shareholders might bear the risk).

    If the Fed takes a significant hit due to losses on risky assets, it'll need some sort of recapitalization. Most likely the tax payer will be called to provide the funds via the Treasury. So here I'd agree with Kocherlakota that - given a risky Fed strategy - that risk is borne by taxpayers.

    But if there is no explicit promise of a government recapitalization, then the Fed will be terminally crippled. This financial weakness will be borne by those who hold the Fed's existing liabilities; note holders and Fed deposit holders. The value of their investment will depreciate, ie. inflation will occur.

    In the case of the Fed, the government could force its shareholder banks to recapitalize the Fed. Here the risk of any strategy falls upon shareholders. What do you think, Stephen?

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  8. Apologies for the flood of post, but why are you and Kocherlakota some of the only economists I read (on the net, at least) talking about central bank capital losses? Most economists I read don't seem to care. What is it about the core of your brand of economics that finds relevance in this important issue?

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  9. JP,

    Yes, I agree with most of what you are saying. Another issue for the Peoples Bank of China is that a large fraction of its assets are denominated in US dollars, but of course its liabilities are in Renminbi. Of course they don't want a currency appreciation, as they run up against the same problem you are discussing. Why don't more people think about these things? Good question. It is useful to think about the central bank as just another financial intermediary. All that distinguishes it is the ability to issue some class of liabilities. Perhaps everyone does not think that way.

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  10. I have a question. Let say that the Keynes plan do work, and the help will heat the economy. If the first half of the industry path ( resources and base industry ) is in a foreign contry, this plan will just heat the other country economy, not the local country economy, right?

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