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Economists on the Ineffectiveness of Fiscal Policy; Sh@t Is All F@#^ Up and Bullsh@t Weblogging

Costs and Risks of Central Bank Balance Sheet Expansion

People like Ben Bernanke talk about them a lot. What are they?

Two good arguments that extraordinary monetary ease has costs:

  1. Summers 2003: a Ponzi scheme or any form of over optimistic finance requires--unless your current clients are overwhelmingly stupid--that you show them the money. This means that you'll have to attract enough new clients each year to pay out at least the nominal interest rate to your old clients. That's when the nominal interest rate is 10% per year the only Ponzi schemes that are sustainable even in the short run are those that attract at least 10% new clients each year. But when the nominal interest rate is zero, it is much much easier for a Ponzi scheme to pass the payout hurdle. Let's finance becomes rife with fraud if nominal interest rate stayed too low for too long. (Note that this is an argument against zero interest-rate policies for any extended period of time, not an argument against balance sheet expansion.)

  2. Blanchard 1994: A large central-bank balance sheet--or a large national debt--may make central-bank claims of the low inflation target incredible. If inflation expectations lose their anchor, then the central bank may have to push the unemployment rate up above its natural rate and keep it there in order to attain its inflation target.

Two bad arguments that policies of extraordinary monetary ease have costs:

  1. The central bank will expand its balance sheet by buying assets when they are high, and when it normalizes its balance sheet it will have to sell assets when their prices are low. Thus the central bank will lose money. The appropriate response to this is: so what? A central bank is not a profit-making institution.

  2. When the central-bank starts to normalize its position by selling off its assets, momentum traders may tag along for the ride and dump a huge amount of assets on the market, thus pushing long-run bond prices below their fundamentals and causing a recession. The right response to this is: then don't sell so much. The point of unwinding the balance sheet is to return asset prices to their fundamental values after the crisis is over. If you do not need to fully unwind the balance sheet in order return asset prices to their fundamentals, then there is no reason to fully unwind.

Are there any other costs and risks to expanding the central bank balance sheet? Are there any other arguments--fallacious or not--that people make? If so, what are they?

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