By Paul Kasriel
The Federal Reserveâ€™s second round of stimulus looks more promising than the first.
In November, the Federal Reserve initiated a second round of quantitative easing â€” the practice of purchasing securities in the open market to create a higher level of credit â€” the result of which will likely be more successful than the first round, initiated in late 2008. To assess why this effort will likely prove more successful than the previous, it is important to understand how quantitative easing works and why the first round did not deliver its intended outcome.
Quantitative easing refers to the practice of the Federal Reserve purchasing securities in the open market, not so much as to achieve a certain level of interest rates, but rather to more directly create a certain quantity of credit for the economy in order to stimulate the demand for goods and services. The Federal Reserve turns to quantitative easing when interest rates already have fallen to very low levels yet credit creation remains moribund and growth in the aggregate demand for goods and services is too weak to bring down an elevated unemployment rate. This atypical situation occurs when the commercial banking system is constrained in its credit creation, usually due to concerns about current or future capital adequacy.
The key to understanding the efficacy of quantitative easing is to appreciate the uniqueness of banking system credit creation compared with the credit the non-bank sector grants. When the banking system grants net new credit, no other entity in the economy needs to cut back on its current spending in order for the recipients of the credit to increase their spending. This is not generally the case when the non-bank sector grants net new credit. Here, the credit grantors postpone their current spending so that credit recipients can increase their current spending.
The Federal Reserve initiated a quantitative easing policy in late November 2008. This round of quantitative easing lasted 16 months, concluding in March 2010. During this period of quantitative easing, the Federal Reserveâ€™s holdings of securities owned outright increased by $1.5 trillion. Because other financial assets on its balance sheet declined, the Federal Reserveâ€™s total financial assets increased by only a net $199 billion in that 16-month period. Moreover, during this time frame, commercial banking system credit contracted a net $876 billion. So, the sum of Federal Reserve credit and commercial bank credit contracted a net $677 billion during the first phase of quantitative easing. As a result, the first round did little to stimulate the demand for goods and services.
The Federal Reserve announced on November 3, 2010, a second round of quantitative easing of $600 billion. This second round is likely to be more successful in stimulating the demand for goods and services than the first for a couple of reasons. Firstly, Federal Reserve credit has been relatively constant since March 2010. Thus, in contrast to the first round, other elements of Federal Reserve credit are unlikely to decline significantly as the Federal Reserve increases its holdings of securities in this second round. Secondly, commercial banking system credit has been increasing modestly in each of the four months ended October 2010. Unlike the first round, a contraction in commercial banking system credit is unlikely to offset the expected net increase in Federal Reserve credit.
With this second round expected to result in an increase in credit, there is a presumption that there also will be an increase in the growth of nominal spending in the U.S. economy. There will likely be increased spending on goods and services, some of which will be produced domestically and some of which will be imported. There also will likely be increased purchases of assets, some of which will be financial â€” stocks and bonds â€” and some of which will be â€śrealâ€ť â€” real estate and commodities. It is not possible, however, to predict a priori what form â€” goods, services, assets â€” the increased spending will take.