Teaching the Fed as the hero
By Scott Sumner
Many people would regard my approach to teaching monetary policy during my final years at Bentley to be hopelessly “out of date”. Marginal Revolution University has a new video out that discusses new ways of teaching Fed policy in light of changes made during and after the Great Recession. Here I’d like to push back against this new view.
Early in the video, Tyler suggests that the Fed traditionally relied mostly on open market operations, and then during the Great Recession it discovered that it needed new tools to achieve its goals. Tyler mentioned quantitative easing, interest on bank reserves, and repurchase agreements (as well as reverse repurchase agreements).
But is there actually any evidence that the Fed needed new policy tools?
Tyler mentions that the Fed traditionally purchased T-bills in its open market operations, and that quantitative easing allowed it to purchase much longer-term bonds. But is that correct? This data suggests that even before the Great Recession, T-bills were only a modest portion of the Fed’s balance sheet:
In my view, “quantitative easing” is nothing more than big open market operations. You might quibble that the purchase of MBSs was something new, but since these bonds had already been effectively guaranteed by the Treasury, they were very close substitutes for the long-term T-bonds that the Fed already held in its portfolio. Instead of a brand new way of teaching money, we simply need to add a couple words on MBSs to the textbook definition of open market operations, which is the buying and selling of bonds with base money. Repurchase agreements have the same sort of impact on the monetary base, but it’s a technical innovation that isn’t really important for undergraduates. Rather you want them to focus on the essence of what monetary policy–exchanging money for bonds.
There is one new policy tool that is both distinctive and important—interest on bank reserves. While I’m no mind reader, I sensed that Tyler struggled with the question of how to explain this tool. At the beginning of the video, Tyler suggested that these new tools were instituted by the Fed to address the special problems that arose during the Great Recession. Then right before explaining interest on reserves, he noted that the Fed had trouble stimulating the economy during the long period of near zero interest rates after 2008.
I hope you see the problem. Interest on bank reserves is a contractionary policy, and does nothing to address the special problems associated with the sort of liquidity trap that was used to motivate the discussion. Indeed the Fed was provisionally granted permission to use IOR back in 2006 (with a 5 year delay), when interest rates were fairly high.
Just to be clear, Tyler doesn’t say anything about IOR that is incorrect. After motivating the IOR discussion with some comments on the zero bound issue making open market operations much less effective, the actual example of interest on reserves that he cites is from 2015, when the Fed raised IOR to prevent the economy from overheating.
In retrospect, the Fed clearly raised IOR too soon, but that doesn’t mean it’s a bad example to use. The 2015 example does illustrate how IOR works in a technical sense. My bigger complaint is that the video gives the impression that the Great Recession created a need for new policy tools, and there isn’t really any evidence that this is the case. Quantitative easing is not really a new tool, it’s an old tool used much more aggressively. And IOR is a highly contractionary policy, and thus whatever its merits its not something you want to start doing 10 months into the worst recession since the 1930s. But that’s exactly what the Fed did.
I sympathize with instructors. It must be confusing to teach the truth—that the Fed blundered in late 2008 (as even Ben Bernanke admitted in his memoir.) It’s much easier for students if you teach these new tools as logical innovations to deal with specific new problems. Unfortunately, the easy way to teach monetary policy doesn’t happen to be true.
PS. This critique is aimed at a new MRU video, but it’s equally applicable to many new economics textbooks, which treat the Fed as the hero of the story, not the villain.
PPS. If you want to teach about new expansionary policy tools for the zero bound, you should ignore the Fed and instead discuss the policy of negative IOR in Europe and Japan.