Sunday, December 28, 2008

Saint Nick Brings Good Economic Cheer This Holiday Season

Okay, it was not really Saint Nick but Nick Rowe who gave me some economic cheer this holiday season. He did so by addressing, in part, my concern about the deterioration of the Fed's balance sheet over at Econbrowser. There, Nick reassures me that this deterioration is nothing to fear, but is the equivalent of the now-needed helicopter money drop:
Let's compare the Fed's "gamble" with helicopter money.

With a "helicopter" increase in the money supply, the Fed's balance sheet shows a new liability, and no new asset.

That is equivalent to the Fed buying an asset, with newly-printed money, and then the asset turning out to be worthless.

In other words, if you believe that a "helicopter" increase in the money supply is what is needed to get the economy out of a liquidity trap, then the destruction of the Fed's balance sheet net worth is exactly what the Fed is trying to achieve.

The only difference between helicopter money and the Fed's buying a worthless asset is in who gets the money: the person who picks it up off the ground (i.e. the one who receives the government transfer payment); or the person who sold the fed the worthless asset.

Let me put it another way: if it lost the gamble, the Fed would be forced to print money to make the same monthly transfer to Treasury, and this would be inflationary. But the expectation of future inflation is exactly what the Fed needs to create now, to escape the liquidity trap. This is a gamble the Fed wants to "lose".

This is a very interesting take on the changes in the Fed's balance sheet, one that Nick Rowe further elaborates on over at the Worthwhile Canadian Initiative. He is beginning to give me hope that maybe there is a well-thought out plan behind the deterioration of the Fed's balance sheet. What would fully bring me peace is if Nick Rowe could also explain what the Fed will do once the recovery is secured and inflationary pressures loom.

Update: See the comment section for Nick's answer to my question on inflationary pressures.

4 comments:

  1. Thanks David!

    I am making the assumption that if the economy (and deflation) gets worse, the Fed's assets will be worth a lot less than the Fed paid for them; and if the economy recovers, and inflation returns to normal, then the Fed's assets will be worth as much or maybe more than what the Fed paid for them. I don't know if this assumption is true, but it seems plausible.

    If it is true, then if inflation returns to normal, the Fed's assets are worth a lot, and the Fed can then sell those assets again in an open market operation to shrink its balance sheet back to normal, and prevent inflation rising further.

    I have no idea whether this is Ben Bernanke's deliberate conscious plan. In one sense, it doesn't matter, since it can work regardless of whether he planned it. But in another sense it does matter, since if he announced it as the Fed's plan, this announcement would affect people's expectations (the only rational expectation would be to expect a return to normal inflation), and this expectation would help the economy return to normal. With no explicit announcement, people have to figure it out for themselves, and it may take longer for expectations to adjust.

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  2. That makes sense to me. Thanks for the reply.

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  3. A well-thought plan, eh? Aficianados of the brilliant BBC series "Blackadder" will be able to appreciate that Bernanke's "cunning plan" bears a striking resemblance to those of
    Baldrick.....

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  4. Nick and David, I have a few questions. You talk about the Fed's balance sheet in the article, my question is, how do really know anything about the Fed's balance sheet since it has never been audited? How can we have confidence in the financial statements issued by the Fed without an audit? I like to assume that they are on the up and up, but if the SEC requires a company to have an audit to be publicly traded, then why is it that the entity controlling our whole economy is not held to the same standards? The SEC requires a corporation to be audited to protect the "stakeholders" that rely on the company's financials (shareholders, creditors, vendors, etc.), well, aren't we all "stakeholders" in the Fed? I don't understand this system. Am I supposed to not think about these things because an audit would cause the system collapse like the house of cards that it is? I feel lost.

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