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George Selgin on Average Inflation Targeting and *The Menace of Fiscal QE*
Quantitative easing has taken on a new fiscal meaning over the past few years, and this development presents numerous new avenues for political imprudence.
George Selgin is the director of the Cato Institute’s Center for Monetary and Financial Alternatives and is a returning guest to Macro Musings. He joins again to talk about his views on the Fed’s new framework and his recent book titled, *The Menace of Fiscal QE.* Specifically, David and George discuss the Fed’s quantitative easing evolution, and how the move to a floor system helped pave the way for fiscal QE to become a more popular policy in the present.
Read the full episode transcript:
Note: While transcripts are lightly edited, they are not rigorously proofed for accuracy. If you notice an error, please reach out to [email protected].
David Beckworth: George, welcome back to the show.
George Selgin: It's great to be back again, David.
Beckworth: Well, George it's great to have you back on the show and just like the Fed, we are going to be practicing makeup policy today on the podcast. You are the reigning champ, you've been on a few times already. But you were on an episode that got permanently derailed because of the COVID crisis. So we're making up for that, this is our makeup policy. And we're going to have you back on. So this show was actually recorded before in February, right as the crisis was unfolding, and it got derailed as events moved beyond this pretty quickly.
Beckworth: So we're making this up to George, we had another podcast we did recently, same thing where we had lost the episode in the pipeline because of the crisis. So this is a great conversation on George's book. Again, his title is *The Menace of Fiscal QE.* We need some scary music when we say that title George, some ominous background tone, as we say that title.
Selgin: The background music from Jaws, perhaps.
Beckworth: Okay, there you go. Imagine that shark coming on you, that's *The Menace of Fiscal QE.* But it's a great book. I was looking at it again for the second time, as I prepared for the show. I actually listened to our previous podcasts, were recorded on it. And also you got some favorable reviews on it too, and we'll talk about those later. But before we do that, let's talk about the Fed's makeup policy. So this show is our makeup policy here at the podcast. Let's talk about the Fed's new makeup policy. And as you know, last Thursday, they had the big reveal that being the average inflation target that they announced, or chair Jay Powell announced at the Jackson Hole conference, and there were some big changes in there. They said they were going to commit to an average inflation target of 2% over time. Also, another big change in this policy is that they are looking for unemployment shortfalls not deviation.
Beckworth: So it's like they're taking the Phillips curve and just shooting it. They've given up on the Phillips curve and they're like, "Look, we're just aiming for this notion of long run price stability where we average 2% over time on average," which if they do faithfully follow would look a lot like a price level target. So let's talk about this new framework, George. First, I'm interested to hear your response to, let's first start with any positives you have on it and we'll move to maybe some concerns you have. But any positive responses to this new program?
Compliments, Concerns, and Criticisms of Average Inflation Targeting
Selgin: Well, yes, I think average inflation targeting could be a good step, depending on how they interpret it. And it could be so because there are times of course, as we've seen lately, when the Fed persistently undershoots inflation. And that can be problematical. It means that you have a price level that's wandering off course, so to speak. And that what you end up with in retrospect is an inflation rate that's different from the Fed's target rate. So that's what comes from having a purely forward looking inflation targeting strategy where you're always letting bygones be bygones. There's a mistake, but, oh, well.
Selgin: So with average inflation targeting, you could have a more predictable price level path and more than that, you can also have a more aggressive policy for getting out of a recession. And particularly, I think this is the most interesting part of average inflation targeting and all of these things go for price level targeting as well, it can be an automatic counter cyclical device that is useful for getting out of the zero lower bound problem because if it's working the way it's supposed to, it results in a higher expected future inflation rate coming out of a period of low inflation. And that amounts to a higher ideal policy rate setting, which means that if you're stuck at zero, the increase in inflation expectations is getting you closer to where you need to be without having to actually go below zero with your nominal rate target.
So with average inflation targeting, you could have a more predictable price level path and more than that, you can also have a more aggressive policy for getting out of a recession.
Selgin: So those are all the potential advantages of average inflation targeting. But there could be a huge gap between those theoretical advantages and what actually comes out of the Fed's plan depending on what sort of average inflation targeting we really are going to see. And the problem there is we have no idea. There have been no specifics. Just to put that in bold relief, we can think of two extreme versions of average inflation targeting, you might say limiting versions. At one extreme, the Fed is always going to make up for past deviations of the price level from its 2% trend, let's say. It's going to make up for all of it. And that means we're going to get back on that trend by hook or by crook, that would be the case where average inflation targeting really, it's a version that amounts to price level targeting, or its equivalent.
Selgin: At the opposite extreme, the window over which the average inflation target is to be achieved, the period of time involved can be so short, that effectively you're still engaged in ordinary inflation rate targeting and in that case, the change in policy isn't a change at all. Now neither Powell nor anyone else at the Fed has told us exactly what window they have in mind. So there's so much unknown about this change and we really can't say how much of a change it's going to be.
There's so much unknown about this change and we really can't say how much of a change it's going to be.
Beckworth: Yeah. And that's been a concern I've had with their announcement. And I'm trying to see this as a glass half full, trying to be optimistic here. Because this could be in practice something similar to nominal GDP level targeting. Not exactly the same, but a step in the direction and maybe one day create outcomes that mimic a nominal GDP level target. Also it would probably have avoided some of the mistakes we've seen in the past, 2008, 2009. Maybe some of the rate hikes in the past decade. Again, if it were credible. But your point is, it's not well specified, so we really don't know what they're going to do with it other than it gives them license to not worry or fret about inflation running above 2%. So what I wonder going forward is will they be able to bear the onslaught of public opinion and pressure from Congress and others when they do hit that threshold?
Selgin: Yes. Well, that's another problem. Let me say, by way of, I'm afraid emphasizing the empty part of that glass, that not only has the Fed not said exactly what inflation targeting they plan to engage in, but Powell in his speech did say that they were going to be flexible about it. In other words, they not only don't have any specific parameters that they're going to offer to us, they never planned to have any fixed parameters. Which means that lots of things are possible at some points they could be doing things consistent with a longer window or closer to price level targeting. And other times they could be doing the opposite.
Selgin: If you throw in the additional factor that there may be an asymmetrical component of their average inflation targeting because of the greater flak they'll get when it's time to undershoot the long run inflation target to make up for being over it in the past, what we end up with is so much scope for different kinds of Fed actions in the future. That it's tempting to conclude, and I think one could legitimately conclude that all the Fed has really announced is a willingness to have a more discretionary policy, that is greater… it has given itself a larger number of degrees of freedom to do whatever the heck it wants to do. Now, conceivably, it could improve things. But it's hardly obvious that it will.
Beckworth: Well, I'm going to take the glass is half full perspective and make the following case, why it may turn out better than we think. So I think one, it'll be easy for them to do make up policy on the downside. So I think that's pretty given if they see inflation below target, they're going to try to make up for that. The hard part is when it's above target. Do you create a recession to bring the price level back down? And the answer is probably no. That's going to be a tough call.
Beckworth: Now I want to believe that given the credibility the Fed has with inflation, and it's anchored well, that you probably won't see that happening anytime soon. What you will see will be supply shock inflation bumps. So let's say that is what we do see and if the Fed avoids those, because it's hard to do it or because it can see through them, it's effectively doing something that looks a lot like nominal GDP targeting. If it's responding to demand shocks on the bottom, it's preventing inflation overshooting because of too rapid demand growth and it's allowing supply shock inflation to pass through, then we're getting something that looks a lot like a nominal GDP target.
Selgin: Well, that would be the right way to win me over to the Fed's new strategy if I believed you. But we should keep in mind that NGDP targeting, let's speak of level targeting.
Selgin: Differs from price level targeting which is an extreme version of average inflation targeting where you never let bygones be bygones. They only differ in the case of supply when it comes to dealing with supply shocks, not demand shocks. Reaction is exactly the same with demand shocks, it's the same for both of those strategies. So if we talk about supply shocks, well, now we've got a new problem because now if there's an adverse supply shock that raises inflation above its target, that's a case where in NGDP targeting, you don't want the Fed to try to respond. You want to let the price level rise in response to the shock.
Selgin: So there is a practical difference, a clear, practical difference between the two policies. And it's one where NGDP level targeting would be more expansionary in response to an adverse supply shock. And I think that that would be a good thing. But again, in the case of average inflation targeting, the Fed would be committed to trying to deal with that adverse supply shock by making up for it. So I guess what you could say, David is, if the Fed really were unwilling to make up for excessively high inflation because of the flak it's going to get, then average inflation targeting could come closer to resembling NGDP targeting in the case of adverse supply shocks.
Selgin: In the case of adverse demand shocks, though, you would end up with the Fed deviating. I mean, positive demand shocks, you would end up with the Fed deviating from the ideal NGDP targeting strategy.
Beckworth: Yeah, no I agree. And that's why I think in practice, it's going to look a lot like a nominal GDP level target. Again, the real question is will... For me, at least the question is, will they get past inflation going above 2% when they need to make up? That to me is the real test of this. But I think in practical operational terms, what we'll see is they won't react to a supply shock, inflation, great. They'll do a good job of keeping demand inflation in line. And in practice, it probably won't be that much difference. Again, the key will be, will they actually have the ability to follow through with their promise to do the makeup policy? So I'm hopeful, I may be wrong.
Beckworth: One last thing on this though, before we move on to your book, it was interesting, so this morning I was on Twitter and Robin Brooks from the Institute of International Finance had a few interesting tweets where he pointed out that the Fed doing average inflation targeting moves it really well ahead of the Bank of Japan and the European Central Bank, where they can't do that, at least not yet. Maybe in the future. And so really, it's going to create some challenges, some wedges between what the Fed does and what these other important central banks do. It could affect exchange rates, it could be destabilizing for these other regions of the world until they have policies that maybe adapt.
Beckworth: So if that's the case, then maybe these other central banks will feel the pressure to follow and also start doing some make up policy, and George, before you know it, we end up in a world where all the advanced central banks are doing some form of nominal GDP level targeting. That is my dream, go ahead and pop the bubble for me now.
Selgin: Well, you are an optimist. Well, one reaction I have to that is that insofar as our policies are out of line with what other central banks are doing, and particularly the ECB, and therefore, you have exchange rate movements and things that are problematic from those other central banks point of view, well, they will also be somewhat problematic from the Fed's point of view and that too, may be a reason why the Fed is sometimes reluctant to actually do what it has to do to strictly reverse or make up for deviations of inflation from the target. So it could mean not just a move of the other central banks toward average inflation targeting, it could mean a softening of the Fed's own-
Beckworth: That's a fair point.
Selgin: ... targeting. So we might be in the middle of it too.
Beckworth: We have to wait and see. But your point is like in 2015, 2016, when the Fed was talking of rate hikes, they had to dial it back because the dollar got really strong and it destabilized the global economy and came back to bite them in the rear. And so they said, okay, slow down rate hikes. And-
Selgin: Yeah. So it's not just the other central banks that will have to move in that direction.
Beckworth: Right, right.
Selgin: It could be we don't go as far as the Fed might in pursuing this new targeting strategy.
Beckworth: Well, it'll be interesting to see the next year, I mean, what the Fed actually does, because presumably that will be part of the makeup period. We've been below target this year, they make the announcement this year, you assume they're going to make up for this year's misses. So let's see what happens over the next year or two.
Selgin: Yeah, that's hard to say. Hard to say. I mean, there are a lot of parameters here that aren't recognized. How far back do you look? How quickly do you want to get back to the path once you know how far back you want to go? That gives you the deviation you have to correct for. But then the other parameter is how quickly do you want to get back to make up for that deviation? All these things remain completely unspecified. And if you plug in the right values, you get the status quo ante no change at all. So who knows?
Beckworth: Who knows? Well, there's enough uncertainty there to keep us busy.
Selgin: Yeah. If they're expecting the public to make a radical change in its expectations in the future, then presumably they're expecting the market to plug in those parameter values. And my guess is that there's going a lot of noise in there and a lot of confusion about just what they must be.
Beckworth: Yeah. So it could go in many directions. I'm going to hope for the best here and encourage any Fed officials listening to the podcast, be bold, be courageous, and be fearless as you move forward. Now I know that's easier said than done, especially next year when we have potential drama in the Fed chair appointment process and stuff. But I will hope for the best.
Beckworth: Okay, let's switch to your book, *The Menace of Fiscal QE.* And I mentioned it was a recent book but it came out earlier this year and you really had some great endorsements, just looking at the cover you got Sir Paul Tucker, you got Darrell Duffie, you've got Peter Conti-Brown, you've got Peter Fisher, former Undersecretary of the US Treasury, some big names. And you had a great, great endorsement from Charles Goodhart. He did a review of your book in the Central Banking Publication. And he notes in there, he says, "Look, George Selgin's book is more relevant than when he first put it out." He made the case that, "What he wrote about is even more pressing today than a few months ago when it came out," back in, when was it? February, March when your book came out?
Selgin: I think it was February, yeah.
Beckworth: February, yeah. Right when these things happened. So this book is a very timely book. And I will also mention, this is what's interesting is, I got an email from a listener at one of our regional Federal Reserve banks who said, "Hey, I heard that you had George Selgin on a show, you recorded his book, *The Menace of Fiscal QE,* then you canned it because it got dated. I want you to get him back on the show." So you were specifically asked. Because they really liked your book and they wanted to hear your thoughts on it. So there's a lot of I think interest in this topic.
Beckworth: And finally, one last thing to motivate what we're going to talk about, Greg Ip from The Wall Street Journal had a great piece last week right before the big announcement, and the title of the article was *Mission Creep at the Fed.* And let me just read the first few paragraphs here. “In a much anticipated speech this week, Federal Reserve Chairman Jerome Powell, is expected to lay out a new framework for meeting its often elusive goal of 2% inflation. When he's done, he should keep his jacket on because the proliferation of other missions await. Full employment and low inflation are no longer enough. In recent years, the Fed has been asked to prevent financial crisis, shrink the trade deficit, tackle climate change, and now eliminate racial economic disparities, both the unemployment gap and the wealth gap.” So he goes on to outline, the bigger and bigger asks being given to the Fed. And they all speak to the challenge that you outline in your book. So let's dive into it. And let me begin George, first by throwing at you some terms and having you define them.
Beckworth: Now, I know our listeners will know some of these terms. But you have this nice classification of quantitative easing, because the title of your book is again, *The Menace of Fiscal QE.* So let's define what QE is, ordinary QE. And then you have a term quasi fiscal QE. And then you have fiscal QE, which is on top of the book. So walk us through those three definitions.
The Three Types of Quantitative Easing
Selgin: Right. So quantitative easing, as the term is used today is what the Fed prefers to refer to as a large scale asset purchases. And these are purchases of long term assets. And they're not ordinary Fed purchases. Ordinarily the Fed would purchase a certain amount of securities to accommodate growth and the demand for currency mainly, and also some growth in the real demand for bank reserves. But this is not meant to be a counter cyclical policy. QE with very large scale asset purchases becomes relevant for counter cyclical purposes when the Fed has exhausted its ability to stimulate economic activity by lowering short term interest rates. Typically when those are at or very close to zero.
Selgin: So the theory is that, in those circumstances a substitute for going negative might be buying larger amounts, having the Fed buy large amounts of long term securities with the intent of lowering the yields on those securities, and indirectly stimulating investment, etc, that way. It's a controversial approach, though becoming less so. And again, it's important to stress that so far it's only been used for macroeconomic purposes. So that's plain old quantitative easing.
Beckworth: Now George, who originated QE? Where did it start?
Selgin: Well, that's a good question. The phrase actually was first used by the Japanese, of course, the Japanese equivalent of the term quantitative easing in the early 2000s, when the Bank of Japan bought lots of assets, but they weren't long term assets. And so what the Bank of Japan did back then doesn't qualify as quantitative easing, according to the now accepted meaning of the term. That originated with the Federal Reserve during the 2008-09 crisis and was taken up by other central banks as well at that time. So the origins of quantitative easing, strictly speaking, I suppose that they trace to the Fed rather than the Bank of Japan.
Beckworth: Yeah, it's interesting because now it's ordinary a conventional monetary policy. When it first came out we called it an unconventional. And what we're going to talk about today is moving to the unconventional space. So it's fascinating to see the evolution of this idea. I mean, you mentioned Japan. Japan's emphasis, as you noted, was just increasing bank reserves. They were focused on the liability side of their balance sheet. Kind of a more of a monetarist view of quantitative easing where the Fed, and Bernanke was very clear about this. He said, "Look, we're not doing what Japanese did, the Bank of Japan did. We're doing credit easing.”
Beckworth: “They did quantitative easing, and we're doing credit easing, and we're focused on the mix of assets we're buying, we're focused on the asset side of our balance sheet, which affects spreads and risk taking and all those things." So we've seen an evolution of this idea, but in any case, it's a large expansion of the central bank's balance sheet. So that's basic QE. If we can call it basic or ordinary QE. What is quasi fiscal QE?
Selgin: So any central bank balance sheet expansion is going to have some fiscal implications, of course. But when I speak of a quasi fiscal quantitative easing, I mean quantitative easing that besides having a macroeconomic purpose which might be achieved just by having the Fed, for example, buy Treasury securities, the kinds of securities it would ordinarily buy, instead, there's an additional fiscal element consisting of the fact that the Fed is purchasing particular non Treasury securities, with the aim of achieving goals other than simple macroeconomic or monetary stimulus.
But when I speak of a quasi fiscal quantitative easing, I mean quantitative easing that besides having a macroeconomic purpose which might be achieved just by having the Fed, for example, buy Treasury securities...there's an additional fiscal element consisting of the fact that the Fed is purchasing particular non Treasury securities, with the aim of achieving goals other than simple macroeconomic or monetary stimulus.
Selgin: For example, to speak again about what happened back in the previous crisis, the Fed's long term asset purchases included substantial purchases of mortgage backed securities, agency securities, with the aim, yes, of contributing to the recovery, but also of stimulating the housing market. Now, as soon as you introduced this non macroeconomic goal, you're getting into fiscal quantitative easing, but in this case, it's quasi fiscal because the easing has a macroeconomic purpose, not just a fiscal purpose.
Beckworth: Well, George, how would you classify then the Bank of Japan when it buys ETFs? I mean, presumably it's doing it to hit its inflation target. Or the Swiss National Bank, they buy corporate securities, foreign exchange. I mean, that is getting into fiscal policy too, I think people would say that's fair. But it seems like they're doing it almost purely for price stability reasons. Is that right?
Selgin: Well, I can't be quite certain that's the case for all of the examples you have in mind, David. But there is certainly in those that you've mentioned specifically, an overarching macroeconomic purpose. In that case, you can say that there is still a fiscal component, there is still an element of quasi fiscal QE involved, because the central bank is propping up the prices of particular securities and aiding particular markets, even though it's doing so with a macroeconomic end in mind. So I suppose that the simplest way to understand quasi fiscal QE is that the central bank is trying to assist particular markets as it's also trying to facilitate recovery of the economy as a whole.
I suppose that the simplest way to understand quasi fiscal QE is that the central bank is trying to assist particular markets as it's also trying to facilitate recovery of the economy as a whole.
Selgin: It gets complicated, quasi fiscal QE, it's actually more complicated than straight fiscal QE. Because you also have cases like straight out debt monetization, where there's clearly a fiscal angle there. And you can have a case where the central bank is only buying the government securities to help it pay its bills, not to get out of a zero lower bound problem, for example. In that case, even though Treasury securities are involved, it's still fiscal QE. So sometimes it's the composition of the securities that matters, but most fundamentally, it's the intention or the goal of the program that's the most important distinguishing factor. And that isn't always obvious as some of the cases you referred to.
Beckworth: Yeah. So quasi fiscal QE, you're still largely trying to address business cycle concerns, but you're dipping your toe into fiscal policy as you're doing that. So look, why don't we define what pure fiscal QE is?
Selgin: Okay. Yeah, so just to summarize, basically, if you're at the zero lower bound, you can't have purely fiscal QE because the QE is clearly capable of serving a general macroeconomic purpose. In contrast, purely fiscal QE is when there's no need for an unconventional policy or QE as a way of generally loosening up credit. It is instead a case where the central bank is buying large quantities of assets for purely fiscal purposes, to help the government pay its bills, and also to help pay for specific projects, in some cases, in some versions of it. And that's where you're getting into the strictly fiscal QE.
If you're at the zero lower bound, you can't have purely fiscal QE because the QE is clearly capable of serving a general macroeconomic purpose. In contrast, purely fiscal QE is when there's no need for an unconventional policy or QE as a way of generally loosening up credit. It is instead a case where the central bank is buying large quantities of assets for purely fiscal purposes, to help the government pay its bills, and also to help pay for specific projects.
Selgin: The most obvious example would be, if well, probably the example that might come to mind most readily is if the Federal Reserve were to pay for the Green New Deal by buying certain Green New Deal investment securities, where the purpose has nothing to do with getting out of a recession, it's simply a way to pay for this very expensive government program. And we're hearing more and more proposals, though they've been around for a while, for having central banks use their quantitative easing powers for such non macroeconomic purposes. And that's what I mean by strictly fiscal QE.
Beckworth: Yeah. And it was a big issue, because when your book came out, it was prior to the pandemic part of the crisis. And we were reaching full employment, well beyond the downs of the business cycle and there was a lot of conversations about, wow let's use this space on the central bank balance sheet to finance certain opportunities, certain investment activities. Now, we'll come back to the crisis in a bit, but let's walk our way through the history that led us up to this conversation about doing fiscal QE. And you know in your book that it begins in the UK, at least the recent history of this begins in the United Kingdom 2010. You mentioned Richard Murphy and the Green New Deal convener, Colin Hines had proposed it and Jeremy Corbyn comes out with the people's QE. So talk about that.
The History and Path to Fiscal QE
Selgin: So the earlier proposals you mentioned were proposals for fiscal QE. So at first what happened is, you had plain old, non-fiscal QE. This was of course, what got the idea into some people's heads that, "Hey, maybe we can do some other things with this QE thing." And the original, the first proposals were for quasi fiscal QE, were what people were saying is, "Oh, while the Bank of England is buying securities to get us out of this recession, why shouldn't it buy these or those?" Or whatever other specific securities to pay for specific programs or in some cases the proposals were not for having the central bank buy securities of any sort, but for having it pay out right for certain programs, kind of helicopter money proposals. But again, the point wasn't to argue for using QE to get out of a crisis it was for directing the purchases that were taking place in certain ways that would help them fund certain programs. So that was the beginning.
Selgin: Now Corbyn's proposal was different. He had in mind, a long term program of Bank of England purchases to pay for various projects. And it was a 10 year program, I believe. So once you're talking about that kind of QE, it's no longer a counter cyclical proposal. Clearly this was about using the Bank of England to pay for stuff, regardless of whether it's doing so was helping to get the economy out of recession or not. So I would say Corbyn's proposal really marks the first clear proposal for strictly fiscal QE.
Beckworth: All right. So we have a fiscal QE proposal and discussion in the United Kingdom. And then just like the Beatles mania, it comes over to the United States. And-
Selgin: It does. Though we had our own homegrown developments that contributed to the idea of strictly fiscal QE. And one of the most important was the FAST Act, the Fix America Surface Transportation Act, where the government decided that to pay for fixing transportation infrastructure, it would raid the Fed's capital fund. It ended up doing this twice, actually, but that was the first time. So the Fed had something like $30 billion of capital and they grabbed 20, then they grabbed some more, till there was hardly anything left. Now, that's not quantitative easing, of course. They weren't asking the Fed to buy any securities or anything like that. But it's clearly a precedent because you can imagine people saying that this idea of raiding the Fed's capital is pretty neat because we don't have to raise the gas tax, we don't have to borrow etc, the Fed will just pay for it. But they only have so much capital, and we've taken most of it. So what next? Well, QE comes along and now there's this, the unlimited cornucopia of funds.
We had our own homegrown developments that contributed to the idea of strictly fiscal QE. And one of the most important was the FAST Act, the Fix America Surface Transportation Act, where the government decided that to pay for fixing transportation infrastructure, it would raid the Fed's capital fund.
Selgin: The Fed has quantitative easing capacity, which is connected, in part to its post 2008 operating procedure, which I'm sure we'll get to. Well, now you can tap that for any amount you like. Because while the Fed's capital is limited, its QE capacity is not. So you can see how the FAST Act can serve as a precedent that once QE really gets going, of course, QE had already taken place when the FAST Act was passed. But once people put the two concepts together, you can easily get out of that proposals for fiscal QE. Let's have the Fed pay for stuff not with its capital, but by buying securities for the purpose. And let's have it do so whether there's a crisis or not. Of course, that idea was later embodied in the Green New Deal proposals.
Selgin: There were other more minor proposals for fiscal QE before that, but the big one was, and the one that probably poses the greatest risk, I would say in the future is that the Fed would be dragooned into or convinced to expand its balance sheet, use its QE powers to pay for a very, very expensive Green New Deal. I'm indifferent, by the way as to what kinds of fiscal programs QE is used to. Whether it's building walls to keep out immigrants or anything else. I make a point in the book of saying I have nothing against any, I don't mean to venture any opinion about any particular government spending program. I do have strong opinions about using QE to pay for government programs as an alternative to ordinary borrowing or taxation or whatever. My criticism is aimed at that idea that-
Beckworth: Yeah. You're pretty clear in the book that this piggy bank that can be very tempting for politicians to raid is appealing to both sides of the aisle, meaning Republicans could use it to build the wall, you mentioned or the Democrats could use it to fund the Green New Deal. I mean, you mentioned some other examples. Senator Elizabeth Warren, I forgot about this, but in the book you mentioned in 2013, she wanted to use it to pay for student debt. And then the Green Party candidate Jill Stein in 2015, it was on her platform that the Fed would basically buy up all the student debt. So it has appeals on both sides. And I think the timing of it is pretty important. It comes out after everyone sees, oh, QE. The 2008, 2009 the Fed's QE was more than just about the Fed stabilizing the business cycles. That's what we want to see. But it opens the eyes, it sets a precedent. You mentioned others look at it and say, "Look, the Fed can expand its balance sheet without generating inflation. This is a free lunch. Let's go tap into it."
Beckworth: And let's use that as a segue to talk about that because this is where the choice of an operating system is very important for the Fed and other central banks. There's just big political economy consideration that's a part of your book, that it's not just about the Fed having an extra lever to pull. It creates these political potential costs that could weigh in on the Fed's independence. So I know we've had this discussion on here before and listeners may know this, but walk us through, why was the adoption of a floor operating system consequential to the movement towards fiscal QE?
The Fed’s Floor System as a Precursor to Fiscal QE
Selgin: Well, that's a really good question. And in fact, I'll start by stating boldly that strict fiscal QE is only possible with the floor operating system. Now I have to defend that statement. So before we had a floor operating system, unless you were at the zero lower bound of central bank, let's speak of the Fed, Fed security purchases would lead to easier monetary policy. And that meant that the bigger the Fed's balance sheet became other things being equal, the higher the price level would go. That's the simple point. So what did that mean in practice? It meant that if politicians importune the Fed, "Hey, why don't you pay for this program?" And then we're talking about really expensive things. "Why don't you just use your balance sheet so we don't have to issue bonds or raise taxes?" The Fed officials could say, "We can't do that, or we'll fail to meet our inflation targets. We'll exceed those targets."
I'll start by stating boldly that strict fiscal QE is only possible with the floor operating system.
Selgin: And of course, we know that the Fed in the past has exceeded its inflation targets by expanding its balance sheet too much to pay for government programs, that's what happened in the Great Society period and the Vietnam War in the '70s and '60s. So the Fed had a powerful answer to calls for it to use its balance sheet to just pay for stuff. And the answer was, "We can't do that. Because if we do that we will generate above target inflation." The only exception was in a crisis like 2008, rates were at their zero lower bound, it's precisely then that quantitative easing becomes a useful macroeconomic tool precisely because it doesn't lead to inflation of the same kind. You can't generate inflation so easily with asset purchases, you have to rely on very large scale purchases to lower those long term yields as a way of trying to get around the impotence of ordinary monetary policy.
Selgin: In that case, of course, the Fed can't say, "Oh, we're just going to have inflation go through the roof. If we use our balance sheet to buy a lot of stuff." On the contrary, the Fed has to do that, it's tempted to do that to generate enough inflation or to get the economy back on its feet. And that, of course, means that people can appeal to it for quasi fiscal QE but not ordinary.
Selgin: What a floor system does, is to create a circumstance where even when you're not at the zero lower bound, QE is always possible. And it also generally has non-inflationary consequences. So you can have a situation where the policy rate is two, 3%. That means the interest rate on reserves is somewhere in that neighborhood in an ordinary orthodox floor system, it would be the same. Balance sheet expansion in such a system itself doesn't affect spending very much. Doesn't create a growth in spending or lowering of interest rates or any of those effects. And so with a floor system, there's always a capacity for QE, non-inflationary QE. And in that case, the Fed doesn't have the ability to say we can't pay for all these programs by expanding our balance sheet because we'll miss our inflation target.
What a floor system does, is to create a circumstance where even when you're not at the zero lower bound, QE is always possible. And it also generally has non-inflationary consequences.
Selgin: So that's how the switch to a floor system creates an invitation for people to call for strictly fiscal QE because they can argue, quite legitimately, that the Fed still has the ability to limit inflation through its control of the interest rate on reserves. That growth in its balance sheet alone doesn't prevent it from achieving its inflation targets. So we're in an environment where the temptation for people to look to quantitative easing as a way to just pay for stuff is much greater than it would otherwise be. Because they know the Fed hasn't got a good answer. And because they may sincerely feel that if it's not going to cause undue inflation, why not? It looks like a cheap way to pay for stuff.
Beckworth: Okay, George, those are interesting discussions and points. How has the recent crisis exacerbated these concerns if at all?
Fiscal QE and the Current Crisis
Selgin: I think what the recent crisis has done is to substantially increase the importance of the prominence of quasi fiscal QE. That's what it's done. We can't possibly speak of strictly fiscal QE going on during this crisis because it's perfectly obvious that this is one of those occasions where QE has a macroeconomic function. It can be rationalized as a way to get around the zero lower bound problem, which prevails once again, and therefore, whatever else the Fed's large scale asset purchases are doing, they can also be helping to revive the economy.
I think what the recent crisis has done is to substantially increase the importance of the prominence of quasi fiscal QE. That's what it's done.
Selgin: So we don't have strictly fiscal QE, what we do see in the United States and in other places, too, is a lot more of quasi fiscal QE consisting of the Fed's purchasing of assets that it's purchasing to achieve specific, not necessarily macroeconomic ends. I think this includes providing a lot of relief to municipal governments or propping up certain corporate security values and that sort of thing.
Selgin: And so it provides further… this episode is providing a lot more precedent that could help to inform further calls for purely fiscal QE in the future. That is, people can say, look, if the Fed's quantitative easing powers are useful for helping this group or that group, if you can buy up corporate securities, why not pay off student debts? Why not fund the Green New Deal? These are all perfectly legitimate arguments, by the way, as far as they go. Because once the Fed crosses that fiscal Rubicon, where it's using its powers, not for strictly macro or monetary purposes, then it's legitimate for people to say, "Well, why should it help that group and not this group?" And so on? "Why should it direct funds that way and not this way?" Those are good questions.
Once the Fed crosses that fiscal Rubicon, where it's using its powers, not for strictly macro or monetary purposes, then it's legitimate for people to say, "Well, why should it help that group and not this group?" And so on? "Why should it direct funds that way and not this way?" Those are good questions.
Selgin: My concern isn't to say that those questions shouldn't be asked, they should. My concern is that the answer may end up being in practice that the Fed makes more use of its balance sheet for strictly fiscal ends, and that it does so even when balance sheet expansion serves no macroeconomic purpose at all. And I know we're going to get to it, David, but I want to stress that one reason why I think this is all very bad is because the quantitative easing is actually a rather bad way to pay for things. It's not fiscally prudent, but it gives the impression of being cheap, and thereby allows the scarce resources of society to be misdirected. Government priorities can be falsely rearranged in a way that makes people worse off by the illusion of being able to get something for nothing, if only you can get the Fed to use QE to pay for it. That can create a lot of waste. So that's where I'm going with all that.
Beckworth: Okay. So let me summarize as I understand it, two things coming out of this crisis that will affect this march towards fiscal QE, one is it provides further evidence that the Fed can expand its balance sheet rapidly and have no inflation and still control the stance of monetary policy. So we saw the Fed's balance sheet go from about four trillion to seven trillion. It's gone down a little bit, but roughly four to seven trillion, wow, inflation has actually dropped. The Fed's doing a great job containing inflation. So next year, we'll be out of this recovery, why not add a few extra trillion to pay for the Green New Deal? What difference could it make? So it creates this false sense of fiscal space, maybe this false sense of a way to fund activity. So I see that point.
Beckworth: The other one, though, I think you're pointing to is all of these programs under quasi fiscal QE are undermining the Fed's independence and ability to stay focused on what it's supposed to be doing, price stability and full employment. And if the Fed can go bail out a corporation, why not fund some other project? If it's going to pick winners and losers in one part of the economy, why not pick winners and losers somewhere else? And so both of those things, the ability to expand its balance sheet rapidly and the fact that it's already crossed the Rubicon of picking winners and losers, it's just the easy next step to fiscal QE.
The Negative Implications of Fiscal QE
Selgin: That's right. There are actually two things that are dangerous in all this. One as you say, is the threat to the Fed's independence because once it becomes acceptable to ask the Fed to use its balance sheet just to pay for different programs, once politicians decide that's an acceptable thing to do, then the Fed is placed right in the crosshairs of all kinds of political pressures. It's already there, we've already seen what the Fed has to contend with when it starts choosing which municipalities to support and which corporate bonds to buy.
Selgin: But in this case, you have the extra added element that because it's losing control of its balance sheet, it's also indirectly losing control of its interest rate target. Because now it has to compensate for whatever balance sheet growth it's forced to engage in, and whatever stimulus effects that has, it has to raise its interest rate on reserves to control inflation, it can always do that. That's why this doesn't have to lead to inflation. But it's losing a degree of freedom because the balance sheet is one of its instruments. The balance sheet side is still an instrument. It doesn't have the same changing, it doesn't have the effects that it would have in a non-floor system, but it's still an instrument of monetary control. Otherwise, we would never have had QE to begin with.
Selgin: And what happens is if you let fiscal QE become a normal policy measure where government officials are able to compel the Fed to use its balance sheet for that purpose, the Fed loses control of one of its instruments and then has to adapt its remaining instrument, the interest rate on reserves to whatever circumstances arise from the balance sheet being determined essentially by politicians, not by the Fed itself. This is not good.
If you let fiscal QE become a normal policy measure where government officials are able to compel the Fed to use its balance sheet for that purpose, the Fed loses control of one of its instruments and then has to adapt its remaining instrument, the interest rate on reserves to whatever circumstances arise from the balance sheet being determined essentially by politicians, not by the Fed itself. This is not good.
Selgin: The other consequence of fiscal QE, though, has to do with appropriations. The way our government is set up, the power of the purse is supposed to reside in Congress, and its responsibilities include setting priorities about how money is spent. And that's done through an appropriations process. By no means is that the case already that all spending has to go through that process. A lot of it is what is sometimes called backdoor spending where it's off budget sheet, you have agencies and things that fund themselves through bonds and all that.
Selgin: What fiscal QE would do, though, is to vastly increase the scope of such backdoor spending, which is spending where there doesn't have to be any setting of priorities, where it doesn't have to go through that appropriations process. Somebody can set up a program like a Green New Deal or otherwise, and put in the legislation that the Fed's going to fund this by buying these special Green New Deal securities and that means that real resources will be channeled into that program in greater quantities, and there's nobody in government who's saying, "Well, wait a minute, should that be our priority? How much of that do we want to do because it's the appropriations process has been sidestepped?" And this could have important implications.
Selgin: It certainly isn't a very democratic innovation, because it means to some extent, the democratic feedback process which is what Congress is supposed to be a part of, has been undermined. And so next thing you know, people are fighting about what the Fed does with its QE powers and the Appropriations Committee is just sitting there with nothing to do. And I'm not sure that this is how it's supposed to... I'm pretty sure this is not how it's supposed to work.
Beckworth: Yeah. So you want the body politic through the representatives, Congress voting on appropriations. You want this to be a democratic process. And if you rely more and more on fiscal QE, you're avoiding that. You're putting more and more power and decision making into the hands of a few players. And so that undermines the whole point of the appropriations process. Another concern you raised in your book, in addition to this backdoor spending, though, is it affects the debt structure of our nation's outstanding stock of government debt. So speak to that, why does that matter?
Selgin: Well, it matters first of all because it has to do with the question, is fiscal QE a good way to pay for stuff after all? Is it cheap? And I think there's a very popular misconception that fiscal QE amounts to something like a free lunch. Particularly if the nominal rate of interest on the securities involved is essentially zero, as would be the case if all the interests are repaid to the government by the Fed or if the bonds had zero, were zero coupon to begin with. So imagine a situation where somebody says, "Okay, we've got this program, it's going to cost $5 trillion, but the Fed's going to pay for it with QE. And it's going to pay for it by essentially giving government the money." And it could be just helicopter money or by exchanging, crediting the Treasury's account by $5 trillion. Did I say trillion before? I meant-
Beckworth: Yes. Yeah, you did.
Selgin: By $5 trillion. And the Treasury gives the Fed zero coupon bonds or it gives the Fed bonds that pay interest, but the Fed's going to rebate all the interest. Well, it looks like you're getting something, fair enough. Now there was a time again, at pre floor system where that might have been true. But it's not true anymore. Today when the Fed engages in quantitative easing, of course it's creating reserves, that much was true in the past as well. But the reserves bear interest. And the banks get that interest. It doesn't go back to the Treasury. So the actual interest cost of QE is the interest on reserves that are created in the process. And it's not clear at all that that's going to be cheaper in the long run than what the Treasury would pay if it issued securities. So that's one part of that fiscal fallacy here, this free lunch fallacy.
Selgin: Now then you get down to the question of whether the resort to fiscal QE might still be a cheaper way to fund the debt. It's not free. But maybe the Fed has an advantage with these short term securities, which are called reserves that it can issue and the Treasury can't. But generally speaking, it's very hard to make a case that that's fiscally cheaper. In fact, of course, under strict Ricardian equivalence, the structure of the debt doesn't make much difference. So we have to be out of that world, first of all before we can say that QE has any advantage. But to the extent that we consider relevant frictions, it's quite possible that it's more expensive to rely on short term debt. The literature on tax smoothing suggests that it's better for the government to borrow long than borrow short, for example.
Selgin: So the more you look into fiscal QE, the more apparent it is that there's no clear fiscal advantage in the strict sense of making it cheaper for government to afford things, to pay for things. I have to be careful what I mean by afford. Yes, it can always come up with the necessary means for paying for things but what I mean is that the overall interest burden would be lower. There's no obvious case to be made that that's going to be so. What is clearly so though is that it can look cheap, that fiscal QE can look cheap to people in the same way that in the past inflationary finance looked cheap because people didn't see the connection between the Fed buying all these securities and the price level going up. If they didn't make that connection, then inflationary finance is still cheap. Over time, people got better at seeing that connection, so it didn't look cheap anymore.
The more you look into fiscal QE, the more apparent it is that there's no clear fiscal advantage in the strict sense of making it cheaper for government to afford things, to pay for things. I have to be careful what I mean by afford. Yes, it can always come up with the necessary means for paying for things but what I mean is that the overall interest burden would be lower. There's no obvious case to be made that that's going to be so.
Selgin: Well, now, they still have to learn that fiscal QE isn't cheap, even though it looks that way. And the danger is that until they figure it out, politicians will want to take advantage of it, to do what politicians love to do, which is pretend to offer everybody something for nothing. And so all of this is, these are lessons we don't need to learn. And we'd be better off not having to learn.
Beckworth: Yeah. We had Peter Stella on the show, and he discussed with us how many other countries have learned these lessons painfully. So we don't want to have to go through that process. So the challenge is that fiscal QE creates a fiscal illusion, kind of like a money illusion, but this time on the fiscal space side and also, it's a backdoor way to do spending without the appropriate accountability to the public. It affects the debt structure. So what do you recommend we do moving forward? What are your policy fixes to get us out of this trajectory that we're moving in toward fiscal QE?
How Policy Can Direct Us Away From Fiscal QE
Selgin: So in the book I discuss a number of options for trying to, as it were, shut the door to fiscal QE. But the one that I ultimately concluded is the most reliable was to get out of the floor system. Now remember, I'm writing this in February when the balance sheet is only about four trillion. And at that point, I still believed it was desirable to try to wind down that balance sheet ultimately and get back to a situation of scarce reserves where there was an interest rate corridor and monetary balance sheet expansion once again had the old fashioned consequence of causing more inflation other things equal.
Selgin: Charles Goodhart in his very generous review that you mentioned, points out that this hardly seems like a practical solution today. We've gone so much deeper into floor arrangement with the vast post COVID expansion and the further expansion of the Fed's balance sheet. But I still think that a move to corridor system of sorts is the best safeguard against fiscal QE. What I would propose now as a compromise, a way of acknowledging just how big the Fed's balance sheet is, is that the Fed move, and that we encourage the Fed or do whatever we can to get the Fed to move towards a tiered system.
I still think that a move to corridor system of sorts is the best safeguard against fiscal QE. What I would propose now as a compromise, a way of acknowledging just how big the Fed's balance sheet is, is that the Fed move, and that we encourage the Fed or do whatever we can to get the Fed to move towards a tiered system.
Selgin: In a tiered system, what you have is a layer of reserves that pay a higher interest rate. And then you have beyond that, an upper layer that don't pay so high in interest rate, but instead pay an interest rate that is low enough for banks to bear an opportunity cost by holding excess reserves. And in this way, you can have a central bank that has a very big fat balance sheet with tons of reserves sloshing around out there, and yet at the margin, it's a corridor system. In the sense that the marginal interest rate on reserves is below the target policy rate setting, balance sheet expansion, therefore, because it's adding to that upper layer of reserves, it's beyond that threshold, is going to have inflationary consequences. In that world, you're back to having a central bank that can say, "Sorry, we can't do this because it undermines our inflation target." And I think that would probably be the best solution.
Selgin: There are tiered systems in operation around the world today. So this is hardly an unprecedented reform. Having the Fed fend off fiscal QE is also hardly the only reason for wanting to get to a marginal corridor system. I argue for that reform or argued for it a few years back when I wrote my previous book on the floor system. I think floor system is a lousy idea in all sorts of ways. This is just one more reason for wanting to get away from it.
Beckworth: Okay with that our time is up. Our guest today has been George Selgin. And his book is *The Menace of Fiscal QE.* Be sure to check it out. George, thanks for coming back on the show.
Selgin: Thank you, David.
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