The humbling of the Fed (wonkish)

Paul Krugman on the Paulson-Bernake bailout

A bit off the Paulson plan topic, but not entirely …
Not a day has gone by since this crisis began that I haven’t been thankful that Ben Bernanke is the chairman of the Fed; had events gone a bit differently (thank you Harriet Meiers!) the post might well have gone to some unqualified Bush loyalist.
That said, the Fed’s experience in this crisis has been humbling; getting traction has proved harder than BB himself suggested in his pre-crisis writings. Here are my thoughts on why.

So: we usually don’t think of it this way, but the Fed can be seen simply as one of many players in the financial market. It’s a very big player, but not that big compared with the market as a whole — the Fed has roughly $800 billion each of assets and liabilities, in a $50 trillion credit market. And conventional monetary policy consists, basically, of enlarging or contracting the Fed’s balance sheet. Why does the size of a financial player constituting less than 2 percent of the credit market matter?
The answer is that the Fed’s liabilities are special: nobody else has the right to create monetary base, which can in turn be used either as currency or as bank reserves. When the Fed expands the money supply, the key thing isn’t that it’s buying Treasury bills, it’s the fact that it’s doing so by expanding the monetary base, which increases liquidity to the economy as a whole.
But in March, and again this week, interest rates on T-bills fell close to zero — liquidity trap territory. What does that do to the Fed’s role?
You still see people saying, in effect, “never mind the zero interest rate, why not just print more money?” Actually, the Bank of Japan tried that, under the name “quantitative easing;” basically, the money just piled up in bank vaults. To see why, think of it this way: once T-bills have a near-zero interest rate, cash becomes a competitive store of value, even if it doesn’t have any other advantages. As a result, monetary base and T-bills — the two sides of the Fed’s balance sheet — become perfect substitutes. In that case, if the Fed expands its balance sheet, it’s basically taking away with one hand what it’s giving with the other: more monetary base is out there, but less short-term debt, and since these things are perfect substitutes, there’s no market impact. That’s why the liquidity trap makes conventional monetary policy impotent.
But why not purchase stuff other than T-bills? This can be thought of as changing the composition of the Fed’s balance sheet, rather than enlarging it; and Ben Bernanke, in happier days, thought that might be an effective policy in a liquidity trap.
There are, however, three reasons to be doubtful about this stuff:
1. The Fed is now trying to move a much bigger rock: it is, in effect, trying to raise the price of financial assets other than T-bills by selling T-bills and buying other stuff. There’s only (yes, “only”) $800 billion of monetary base. There are, by contrast, many trillions of stuff other thanT-bills, so the Fed has to make huge changes in its balance sheet to achieve any noticeable effect.
2. T-bills and other assets, such as long-term bonds, are probably much better substitutes for each other than T-bills are for monetary base — money is unique as a medium of exchange, whereas once you get past that you’re only talking about competing stores of value. So it should take much larger changes in relative supplies to get major changes in asset prices.
3. The reason T-bills are an imperfect substitute for, say, corporate bonds — to the extent they are — is risk. Therefore, the reason changing the composition of the Fed’s balance sheet can move prices, to the extent it can, is because the Fed is taking on risk. This isn’t a role the central bank is meant to play; you’re sliding over into fiscal policy.

Nonetheless, I guess the Fed had to try the “Bernanke twist.” And it did — the old Fed balance sheet, in which T-bills were the vast bulk of assets, is no more. But the effects have been disappointing, especially weighed against the risk, which I know is making Fed officials very nervous.
And now, with the Paulson plan — about which I have my doubts — responsibility is clearly shifting from the Fed to the fiscal authorities.
So Ben Bernanke came into his current position believing that central banks have the power, all on their own, to fight Japan-type problems. It seems that he was wrong.