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The US central bank announced
recently that it will expand its "Operation Twist" program to
extend the maturities of assets on its balance sheet and also said it stands
ready to take further action to put unemployed Americans back to work. The US
central bank will prolong the program through the end of the year, selling
$267 billion of shorter-term securities and buying the same amount of
longer-term debt. The action should put downward pressure on longer-term
interest rates and help make broader financial conditions more accommodative,
so it is held.
The idea behind the move, nicknamed
"Operation Twist" after a similar policy in the 1960s, is to push
down long-term borrowing costs to encourage the housing market and other
forms of economic activities. But why should a lowering of interest rates do
all this?
For instance, the data from 2007 to
present indicates that a decline in interest rates did nothing visibly to
lift housing starts. There is in fact a positive correlation between interest
rates and housing starts since 2007. (A fall in interest rates is now
associated with a downtrend in housing activity.) Note that prior to 2007
there was negative correlation between housing starts and interest rates — so why is there a sudden break in the
correlation?
 
A fall in interest rates cannot
grow the economy. All that it can produce is a misallocation of real savings.
As a rule, an artificial lowering of interest rates (which is accompanied by
the central bank's monetary pumping — increasing commercial banks'
reserves) boosts the demand for lending; and this, as a rule, causes banks to
expand credit "out of thin air."
This in turn sets in motion the
diversion of real savings, or real funding, from wealth-generating activities
to non-wealth-generating activities.
Because so-called economic activity
is measured in terms of money, obviously the more money is created the
greater the so-called economic activity is going to be, which is misleadingly
interpreted as a strengthening in real economic growth. (Note that employing
price deflators doesn't fix the problem of measuring real economic growth.)
As long as the pool of real savings
is still expanding, the illusory policy of the central bank appears to be
"working."
Trouble emerges, however, when the
pool of real savings comes under pressure (when it is either stagnating or
falling). Then monetary pumping by the central bank cannot lift the rate of
growth of the money supply, because banks don't employ the pumped money in
boosting the expansion of lending.
Note that banks are just
intermediaries: once the pool of real savings is not there, any expansion of
lending out of thin air runs the risk that it will end up as nonperforming
assets. (Remember it is the expanding pool of real savings that makes real
economic growth — i.e., real wealth — expansion possible.)
Obviously banks will not be
interested in this. Observe that when the pool of real savings is expanding,
banks "can afford" to engage in inflationary lending without
incurring too much risk.
However, as the pool comes under
pressure, the chances that banks will end up holding a large percentage of
nonperforming (i.e., bad) assets increases. Under this situation the Fed
cannot do much, because the banks will not expand lending out of thin air. In
short, if the pool of real savings is in trouble, the Fed's ability to create
illusion is coming to an end.
Obviously the Fed can bypass the
banks and lend money directly to the nonbanking sector, thereby boosting the
growth momentum of the money supply — such as the "helicopter
money." We suggest that if the pool of real savings is in trouble, such
pumping will not work; in fact, it will run the risk of destroying the market
economy.
For those commentators who hold
that an artificial lowering of interest rates could grow the economy, we must
reiterate that an interest rate is just an indicator, as it were. In a free
market, it would mirror consumer preferences regarding the consumption of
present goods versus future goods. For instance, when consumers raise their
preferences toward future goods relative to present goods, this is manifested
by a decline in interest rates.
Conversely, an increase in the
relative preference toward present goods leads to the increase in interest
rates.
As a rule, all other things being
equal, an increase in the pool of real funding tends to be associated with an
increase in the preference toward future goods — i.e., a decline in
interest rates. Note, however, that movement in interest rates has nothing to
do with the generation of real wealth as such. The key for that is the
increase in the capital goods. What makes this increase in turn possible is
the expanding pool of real savings.
In a market economy, interest rates
instruct entrepreneurs (in accordance with consumer time preferences) where
to channel their capital. A policy that artificially lowers interest rates
only sends misleading signals to businesses, thereby resulting in the
misallocation of real funding.
If a lowering of interest rates
could have created economic growth, as the popular thinking has it, then it
makes sense to keep interest rates at zero for a long time.
The fact that we have already had
such an experiment, which so far failed, should alert various supporters of
low-interest-rate policies that something is completely wrong with the idea
that a central bank can grow an economy.
By now it should be realized that
the artificial lowering of interest rates can only divert real funding from
wealth-generating activities toward nonproductive activities, thereby
diminishing the ability of wealth generators to grow the economy.
We can conclude that the latest
policy of the Fed not only is not going to help the economy but, on the
contrary, is going to make things much worse. What is needed now is the
curtailment of the Fed's ability to pursue loose monetary policies. The less
the Fed does, the better it is going to be for the economy.
The Fed is unlikely, however, to
stop with its policies to "revive" the economy. In fact, Fed
chairman Ben Bernanke said, "If we don't see continued improvement in
the labor market, we will be prepared to take additional steps if
appropriate." He added, "Additional asset purchases would be among
the things that we would certainly consider."
But then why should it work if it
has failed so far? Even if the Fed were to boost its pace of pumping by
introducing QE3 — i.e., buying assets and aggressively expanding its
balance sheet — it will not work if the banks sit on the new cash and
do not lend it out.
So far, in June, banks excess cash
reserves stood at $1.49 trillion against $1.461 trillion in May. This means
that if the pool of real savings is in trouble (which is quite likely), the
Fed will have difficulty stimulating economic activity — i.e.,
generating illusory economic growth.
Summary and Conclusion
The US central bank announced that
it will expand its "Operation Twist" program by extending the
maturities of assets on its balance sheet. So far, this policy seems to have
been ineffective in significantly reviving the economy. We suggest that this
policy in fact only further distorts the economy. We therefore suggest that
the latest extension of "Operation Twist" is going to make things
much worse. Because of still-subdued bank lending, it is questionable whether
the Fed can artificially stimulate the economy without the cooperation of
commercial banks. We are doubtful that banks will agree to cooperate if the
pool of real savings is in trouble.
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