The Fed’s decision to implement quantitative easing and other unconventional monetary policy in December 2008 sparked a blaze of heated discussion amongst economists that has been burning to this day. The questions of if and how these new measures affect economic growth have become the focus of countless blog posts and editorials, and have become an integral part of many university Econ courses. The beginning of QE tapering in December 2013 added even more fuel to the fire, but it also gave many traditional economists a sense of relief. It finally looked like there was an end in sight to these unfamiliar and controversial policies. To the dismay of these traditionalists, however, recent research by the Brookings Institution (paper #1 and paper #2) suggests that there are significant benefits of pursuing unconventional monetary policy in the long term. A recent Economist article, “Staying Unconventional,” emphasizes some of the most important results of this research and raises a provocative question: Can QE, or some alternate form of it, be an effective long term policy?
Based on my reading of the research papers that the article cites, I am inclined to say yes. It may not be the QE policy currently being rolled back, but I can see an alternate form of such a policy being effective in the long term (hence the * in the title). Not only does unconventional monetary policy not cause riskier financial behavior, but it also provides a substantial boost to economic growth. In this blog post and the next one, my goal is to defend the bolded argument by highlighting some of the key findings of the research papers I mentioned earlier. The remainder of this post will be dedicated to discussing the first claim:
1. Unconventional Monetary Policy Does NOT Cause Financial Instability
The argument commonly used to refute long-term implementation of QE is that it encourages individuals and financial institutions to pursue riskier investments, thereby reducing financial stability. The prediction is that long periods of low interest rates incentivize investors to ‘reach for yield’ and take on more credit risk, duration risk, or leverage. The research by Gabriel Chodorow-Reich of Harvard University confirms this prediction but emphasizes that the story is not so cut and dry. Although the Fed’s low interest rate policy has caused financial institutions to take on some riskier investments, it has also boosted the value of these institutions’ portfolios, making them less risky and strengthening the stability of the U.S. economy. Most importantly, Chodorow-Reich’s analysis shows that the stabilizing effect of QE has been stronger than the destabilizing effect caused by ‘reaching for yield.’
Chodrow-Reich determined the magnitude of each effect by evaluating the effect of the Fed’s policies on four categories of financial institutions: life insurers, commercial banks, money market funds, and defined benefit pension funds. Together, these institutions manage $24 trillion in assets. The effects are nicely summarized in the graphic provided in the abstract of the paper:
As Chodrow-Reich states, “In the present environment, there does not seem to be a trade-off between expansionary [monetary] policy and the health or stability of the financial institutions studied.”