We agree that each further round of quantitative easing in form of buying Treasury debt and agency securities is likely to be less effective and could contribute to future inflation. However, we disagree with the broader conclusion that the Fed should consider becoming a developmental central bank. The more the Fed enters the domain of politicians, the more political pressure it will face. More political pressure will result in gradual loss of political independence. Loss of political independence, in turn, will make it more difficult for the Fed to deliver on one of its mandates – to maintain price stability, as historical experience shows. By pursuing such a path, the Fed would likely “win the battle, but lose the war”. The Fed’s latest announcement of QE3, which includes monthly purchases of mortgage backed securities, continues their movement toward “development central banking”.
Ben Bernanke has used the depressed state of the US economy to justify quantitative easing, but the same monetary expansion could have been achieved by purchasing government assets rather than buying mortgage backed securities. It is also a bit odd that a federal agency proposes to fine-tune the housing sector so soon after other Federal agencies contributed to the housing bubble that contributed to the Great Recession. Mian and Sufi and others have shown that Fannie Mae contributed to the bubble by subsidizing credit and lowering loan standards. Is there reason to believe that another venture into developing the housing sector will be more successful than the last one? If the economy recovers, and it is time for the Fed to reverse the monetary expansion, how anxious will the Fed be to sell mortgage-backed securities and slow housing expansion? In the US it has been far easier to add subsidies to housing than to withdraw them. Mortgage interest payments are tax deductible and their exemption is one of the largest loopholes in the federal tax code. The government is facing an immediate “fiscal cliff” and a longer–run debt crisis, but neither political party is willing to offer to withdraw the mortgage interest housing subsidy.
The Fed has a dual mandate of maximum employment and price stability. A discussion of whether the single mandate of the ECB generally makes it more effective than the Fed is beyond the scope of this post. However, in case politicians fail to do their part of the job, a single mandate is less dangerous, because it enables the central bank to put more pressure on politicians. This has apparently been the case in the Eurozone where the ECB, referring to its single aim to maintain price stability, keeps putting pressure on politicians to carry out reforms. When Mario Draghi says the ECB will do whatever is necessary to save the Euro, he adds a qualification, as long as it is “within the mandate” of the bank. The ECB also requires that debtors seeking ECB help must first apply to the European Financial Stability Facility or the European Stability Mechanism and accept strict conditionality.
While the Eurozone problems are not resolved yet, the path in the US now looks increasingly as follows: more procrastination on fiscal policy and more urging by Congress and the President for Chairman Bernanke and the Fed to take drastic and unconventional actions intended to solve the nation’s macroeconomic problems. Moreover, down the road that might also mean higher inflation. Ironically, the fatal flaw of the dual mandate of the Fed might be that those designing it failed to take into account the possibility of a prolonged failure by the politicians to implement a fiscal policy that complements monetary policy. Diaz-Bonilla also reminds us of the Tinbergen Rule that a government cannot attain two objectives with one instrument. If fiscal policy fails to contribute to macroeconomic stabilization, monetary policy remains the only policy instrument to deal with two goals. Can the Fed kill two birds with one stone?
References
Diaz-Bonilla, Eugenio. 2012. „Déjà Vu, All Over Again: QE3 and Developmental Central Banking”, EconoMonitor. September 13, 2012.
Mian, Atif, and Amir Sufi. 2010. „The Great Recession: Lessons from Microeconomic Data”, American Economic Review. May 2010.