Quantitave Easing

I was fretting the other day that the American system of government might have too many veto points to grapple with the economic crisis in a decision way. Something that I should have thought of is that we have, quite smartly, set up a quasi-independent Federal Reserve system that’s able to take action without going through the veto point process. Instead, the script is flipped — congress can dictate to the Fed, but in order to do so it needs to pass through a large number of veto points so in practice the Fed can take decisive action in a crisis. Hence, things like today’s dramatic announcement of “quantitative easing”.

This is something most people don’t understand very well, but when you hear people talk about how the Fed “set” short-term interest rates at such-and-such a level, the people are being a bit inaccurate. What the Fed does is make decisions about how to target interest rates. Then it engages in a bunch of actual financial transactions — buying or selling of short-term bonds — to make the market prices move in line with the target. Ordinarily, you would fight a recession by lowering interest rates. Unfortunately, we’ve already lowered rates as far as they can go and yet there’s still a recession. Under such circumstances we turn to “quantitative easing” or “unconventional monetary policy” in which, basically, the Fed buys other stuff. In this case, long-term bonds, Fannie & Freddie securities, and some mortgage-backed securities. The goal here is to make interest rates on mortgages extremely low. That way homeowners will be able to refinance their loans at low rates and save on their monthly payments. That, in turn, will free up money that can be used to buy stuff, encouraging a return of production and retail jobs and a revival of business investment.

At any rate, that’s the theory. We’ve never before been in a situation where this is actually tried on a substantial scale.