Over on Coordination Problem, Steve Horwitz explains why he opposed both QE 1 and QE 2. Basically, he is responding to attacks by Rothbardians claiming that he has shown excessive quasi-monetarist tendencies. (Really, the problem is that Horwitz has deviated from the plumb-line that any increase in the nominal quantity of money, other than an increase in the quantity of gold, is EVIL.)
What is quantitative easing?
Perhaps it is just wishful thinking, but to me "quantitative easing" refers to efforts to increase the quantity of money. Quantitative tightening would be efforts to decrease the quantity of money.
This is as opposed to interest rate targeting, where easing means lowering the target for the federal fund rate and tightening means raising that target.
When the target for the fed funds rate had been reduced to about 2 percent, and many economists, journalists, and politicians were saying monetary policy was out of ammunition (seeing zero so close,) and so we needed fiscal policy, it became clear that this tool of manipulating short term rates, that appeared to work well during the late eighties, ninties and the first part of the 2000s, was breaking down. It was time to focus on the quantity of money rather than interest rates.
I must confess that I have never liked interest rate targeting, but its apparent success during the Great Moderation led me to hold my tongue. I never favored the 2 percent inflation target either, but disinflation to zero just wasn't a priority for me. ( I did write Mark Sanford about it when he was in Congress.)
Unlike Horwitz, I don't support Bagehot's approach to lender of last resort. Rather than have the central bank lend to sound banks at a penalty interest rate if there is an increase in the demand for base money, I favor having the Fed make open market purchases of government bonds to accomodate the increase in the demand for base money. The base money would go to whatever banks sell the bonds, or whatever bank is utilized by the nonbank firms or households that sell the bonds. The market can handle moving reserves to sound banks that need reserves. Banks that cannot obtain reserves will have to default. They should be closed and reorganized. Rapidly.
I suppose I don't trust the Fed to follow rules about only lending to sound banks. Years ago, I was persuaded by Friedman's argument that the discount window should close. I don't think "penalty interest rates" should be part of the process. Interest rates should depend on market forces. If Fed purchases of governement bonds results in lower rates for government bonds, that should not be a worry. Whether the interest rates at which various banks can borrow on the market rise or fall should also not be a concern.
To some degree, my approach is that the Fed needs to offset changes in the money multiplier (in the currency deposit ratio or reserve deposit ratio) by changes in base money, to prevent changes in the quantity of money. However, I don't really favor stablizing the quantity of money, and believe that the quantity of money should change to offset changes in the demand to hold money.
Sometimes rather than break things down between base money, money multiplier, the quantity of money in the hands of firms and households, and the demand to hold that money, I just focus on the quantity of base money and the demand to hold it. It has some value. If the demand for base money rises, the central bank should increase the quantity to match. The market can determine the quantity of deposits people want to hold. On the other hand, the relationship between the quantity of deposits and the demand to hold them plays a key role in the process by which inbalances in the demand for base money and the quantity of base money actually impacts spending on output, prices, and production.
The actual policy of the Fed in 2008 was mostly focused on supporting loan securitization. It did involve an increase in base money, which was what was needed. But it also was directed at supporting markets where banks made loans, sold them, investment banks bundled them, and then sold asset backed securities to mutual funds and other investors. The theory was that the demand for these securities was low because they had become illiquid--they couldn't be sold. If the Fed jump started this market, then everything would go back to where it was before 2008. If people were confident they could sell the securities when they wanted, they would be willing to buy and hold them. If they would hold the securities, then the investment banks could sell them. If the investment banks could sell them, they would buy loans from banks. If the banks could sell the loans, they would make more loans.
From a monetary disequilibrium approach, this would work to solve the problem because people were holding money rather than these asset backed securities, perhaps indirectly through mutual funds. If they went back to holding the asset backed securities, then the demand for money would fall to pre-crisis levels.
The benefit to the Fed's approach had to do with lending markets. If banks hold loans on their balance sheets, regulations require that they fund it partly with capital. And so, by making loans and selling them, the loans can be funded by investors without banks (or anyone) providing capital.
The alternative would be for banks to make the loans, hold them on their balance sheets, fund them with deposits, and sell new stock to meet capital requirements. This process would take time, and in the meantime, lending would be disrupted. The price response to this would be high loan rates and low deposit rates. The increase bank earnings both provides an incentive for investors to purchase new issues of stock and allows banks to build capital with retained earnings.
Of course, banks held large portfolios of asset backed securities, particularly mortgage-backed securities. They suffered losses, and had less capital already, which further caused problems with lending. Because there is no capital requirement when banks hold reserves or government bonds, banks that have suffered losses and so have less capital can meet their capital requirements by cutting back commercial and consumer lending As old loans are repaid, they can hold reserves or purchase government bonds. This reduces their capital requirement.
So, there was method to the Fed's madness. But I was always skeptical that it would work. And it didn't. Asset securitization has not recovered, and the problem remains that the demand for money is extremely high by historic standards. The crash in the stock market also has resulted in a higher money demand. The extremely low interest rates on government bonds has raised money demand. So, there is more going on than just the collapse of securitization. Which is, of course, one reason why I think the Fed's focus on fixing that market was an error.
In the past, my view had been that the Fed should buy T-bills when there is an increase in the demand for base money. If the Fed bought all of the T-bills that exist, and there was still too little base money, they should start moving up the yield curve-- 2 year bonds, 3 year bonds, and so on. If they end up with the entire national debt, then start looking to agency debt, AAA municipal bonds, AAA private securities and so on. But I didn't expect to ever get there. It is difficult for me to imagine that a monetary base of $7 trillion or so would be too small.
Because of the crisis, I have changed my mind. When the yield on an asset gets so low that holding currency is better (which is probably slightly negative,) then the Fed should stop buying and move up the maturity curve to something that still has a positive yield. (I still have trouble imagining that $7 trillion could be too little, I just don't think the Fed should bother buying government bonds with really low yields.)
Also, it is embarrassing to admit this, but I didn't realize to what degree the Fed's asset portfolio was already heavy with longer term government bonds. Open market operations in T-bills was apparently something from textbooks.
So, I think the quantity of base money has been too low for the last several years. And I think the Fed should continue to purchase government bonds with positive yields (which all of them have, but the 4 week ones and even 6 month ones have pretty low yields.)
And so, I support quantitative easing. And, when the demand for base money falls, as I expect it will, and hope it will soon, I will support quantitative tightening.
As I, and all the quasi-monetarists have explained, quantitative easing would be much better in the context of an explicit target for the growth path of aggregate money expenditures. I favor final sales of domestic product. Further, the Fed should stop paying interest on reserve balances, and in fact, charge a bit for them to reflect the interest rate risk it is bearing on its asset portfolio. But the Fed should also stand ready to expand base money however much is needed to get money expenditures to target. And then to contract it again when the demand to hold base money falls.