Monday, December 7, 2009

Keynes's Guinea Pigs

Back in January of this year we wrote a post titled The Fed Will Buy All Treasury Bonds in Existence if Necessary.  The aim of that post was to settle an argument over whether the Fed would actually follow through with its threat at the time to buy long dated treasury bonds.  We argued that Ben Bernanke gave a speech in 2002 that covered the topic, and he explicitly stated that he believed the Fed could control both short and long term interest rate by outright purchasing treasury bonds.  Sure enough, on March 28, 2009, the Fed announced its program to buy $300 billion in treasury bonds over the coming months.  Since that time, the Fed has become the largest purchaser of treasury and agency debt in the world.  We still aren't quite sure why so many were unwilling to believe that the Fed would do this.

Moving on, in August, President Obama nominated Bernanke for a second term as Fed Chairman.  The word used over and over to describe Bernanke was "creative."  See the following quotes...
How creative has Bernanke been really?  After reading John Maynard Keynes, it becomes obvious that at least one of Bernanke's so called creative ideas should properly be credited to Keynes.

First, let's examine briefly what Bernanke said in his now famous 2002 speech:

So what then might the Fed do if its target interest rate, the overnight federal funds rate, fell to zero?

One relatively straightforward extension of current procedures would be to try to stimulate spending by lowering rates further out along the Treasury term structure--that is, rates on government bonds of longer maturities.

[One direct method] would be for the Fed to begin announcing explicit ceilings for yields on longer-maturity Treasury debt (say, bonds maturing within the next two years).

The Fed could enforce these interest-rate ceilings by committing to make unlimited purchases of securities up to two years from maturity at prices consistent with the targeted yields.

If this program were successful, not only would yields on medium-term Treasury securities fall, but (because of links operating through expectations of future interest rates) yields on longer-term public and private debt (such as mortgages) would likely fall as well.

Lower rates over the maturity spectrum of public and private securities should strengthen aggregate demand in the usual ways and thus help to end deflation. Of course, if operating in relatively short-dated Treasury debt proved insufficient, the Fed could also attempt to cap yields of Treasury securities at still longer maturities, say three to six years. Yet another option would be for the Fed to use its existing authority to operate in the markets for agency debt (for example, mortgage-backed securities issued by Ginnie Mae, the Government National Mortgage Association).

Bernanke held true to his words from 2002 and enacted these very programs in 2009.

John Maynard Keynes wrote similar thoughts all the way back in 1933, in his famous work The General Theory of Employment, Interest and Money:

Chapter 15, Section III
Perhaps a complex offer by the central bank to buy and sell at stated prices gilt-edged bonds [English government bonds] of all maturities, in place of the single bank rate for short-term bills, is the most important practical improvement which can be made in the technique of monetary management.

The monetary authority often tends in practice to concentrate upon short-term debts and to leave the price of long-term debts to be influenced by belated and imperfect reactions from the price of short-term debts; — though here again there is no reason why they need do so.

There is the possibility, for the reasons discussed above, that, after the rate of interest has fallen to a certain level, liquidity-preference may become virtually absolute in the sense that almost everyone prefers cash to holding a debt which yields so low a rate of interest. In this event the monetary authority would have lost effective control over the rate of interest. But whilst this limiting case might become practically important in future, I know of no example of it hitherto. Indeed, owing to the unwillingness of most monetary authorities to deal boldly in debts of long term, there has not been much opportunity for a test. Moreover, if such a situation were to arise, it would mean that the public authority itself could borrow through the banking system on an unlimited scale at a nominal rate of interest.

I am sure Keynes would be thrilled to know that a test of his ideas would eventually be enacted, with us modern day folks being the guinea pigs of this experiment.  It only seems appropriate to describe the current situation we are faced with by using a quote from Keynes himself:

Practical men, who believe themselves to be quite exempt from any intellectual influences, are usually the slaves of some defunct economist.

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