Paul Krugman Gets, I Think, too Close to His Inner Hayek
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The Liqudity Trap, and Open Market Operations on the Risk Premium on a Pan-Galactic Scale

Conventional open-market operations work on the liquidity premium--they either relax a cash-in-advance constraint keeping aggregate demand low, or relax a relatively-safe-investments-look-unprofitable animal spirits constraint keeing investment and thus aggregate demand low. For the past year the problem has not been that safe interest rates have been low--far from it. The problem has been that risky asset values have been low (partly because a lot of risky assets are backed by investments that weren't fundamentally very profitable, and partly because risk premia are high because the supply of risky assets is great and the mobilized risk-bearing capacity of the private market is not that large).

So the natural answer appears to be open-market operations working not on the liquidity premium but on the risk premium--Operation Twist on a Pan-Galactic scale.

Paul Krugman has thoughts:

The humbling of the Fed: 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....

[T]he Fed... is 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.... 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?... [O]nce T-bills have a near-zero interest rate... the two sides of the Fed’s balance sheet become perfect substitutes.... [T]he 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....

  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....

  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.... 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.

Krugman's (2) seems to be wrong, for the reason he gives in his (3): T-Bills are not close substitutes for mortgage-backed securities. If they were close substitutes, we wouldn't have a problem. It's the huge risk premium that makes them fail to be close substitutes--if the risk premium fell, things would be very different.

But I am not sure that (3) is right: taking on risk doesn't seem to me to be well-described as fiscal policy any more than as conventional open-market operation monetary policy. It is something else. I'm calling it open-market operations on the risk premium, but that is not a very good name.

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