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Extending Twist Won't Help US Economy

The Fed's extension of its Operation Twist program could do more harm than good...

THE FEDERAL RESERVE announced last week that it will expand its "Operation Twist" program to extend the maturities of assets on its balance sheet and also said it stands ready to take further action to put unemployed Americans back to work, writes Dr. Frank Shostak at the Cobden Centre.

The US central bank will prolong the program through the end of the year, selling $267 billion of shorter-term securities and buying the same amount of longer-term debt. The action should put downward pressure on longer-term interest rates and help make broader financial conditions more accommodative, so it is held.

The idea behind the move, nicknamed "Operation Twist" after a similar policy in the 1960s, is to push down long-term borrowing costs to encourage the housing market and other forms of economic activities. But why should a lowering of interest rates do all this?

For instance the data between 2007 to present indicates that a decline in interest rates did nothing to lift visibly housing starts. There is in fact a positive correlation between interest rates and housing starts since 2007. (A fall in interest rates is now associated with a downtrend in housing activity). Note that prior to 2007 there was negative correlation between housing starts and interest rates – so why is there a sudden break in the correlation?

Now, a fall in interest rates cannot grow the economy. All that it can produce is a misallocation of real savings. As a rule an artificial lowering of interest rates (which is accompanied by the central bank monetary pumping – increases commercial banks reserves) boosts the demand for lending and this as a rule causes banks to expand credit out of "thin air".

This in turn sets in motion the diversion of real savings, or real funding from wealth generating activities to non-wealth generating activities.

Since so called economic activity is measured in terms of money obviously the more money is created the greater the so-called economic activity is going to be, which is misleadingly interpreted as a strengthening in real economic growth. (Note that employing price deflators doesn't fix the problem of measuring real economic growth).

As long as the pool of real savings is still expanding the illusory policy of the central bank appears to be "working".

Trouble emerges when the pool of real savings is coming under pressure (when it is either stagnating or falling). Then monetary pumping by the Central bank cannot lift the rate of growth of money supply since banks don't employ the pumped money in boosting the expansion of lending.

Note that banks are just intermediaries, once the pool of real savings is not there any expansion of lending out of "thin air" runs the risk that this will end up as non-performing assets.  (Remember it is the expanding pool of real savings that makes real economic growth, i.e. real wealth expansion possible).

Obviously banks will not be interested in this. Observe that when the pool of real savings is expanding banks "can afford" to engage in inflationary lending without incurring too much risk.

However, as the pool comes under pressure the chances that banks will end up holding a large percentage of non-performing (i.e. bad) assets increases. Under this situation the Fed cannot do much since the banks will not expand lending out of "thin air". In short if the pool of real savings is in trouble, the Fed's ability to create illusions is coming to an end.

Obviously the Fed can bypass the banks and lend money directly to the non-banking sector, thereby boosting the growth momentum of the money supply – so-called "helicopter money". We suggest that if the pool of real savings is in trouble such pumping will not "work", in fact it will run the risk of destroying the market economy.

For those commentators who hold that an artificial lowering of interest rates could grow the economy we must reiterate that an interest rate is just an indicator. In a free market it would mirror consumer preferences regarding the consumption of present goods versus future goods. For instance, when consumers raise their preferences towards future goods relative to present goods this is manifested by a decline in interest rates.

Conversely, an increase in the relative preference towards present goods leads to the increase in interest rates.

As a rule, all other things being equal, an increase in the pool of real funding tends to be associated with an increase in the preference towards future goods i.e. a decline in interest rates. Note however that movement in interest rates has nothing to do with the generation of real wealth as such. The key for that is the increase in the capital goods. What makes this increase in turn possible is the expanding pool of real savings.

In a market economy interest rates instruct entrepreneurs (in accordance with consumer time preferences) where to channel their capital. A policy that artificially lowers interest rates only sends misleading signals to businesses thereby resulting in the misallocation of real funding.

If a lowering of interest rates could have created economic growth as the popular thinking has it, then it makes sense to keep interest rates at zero level for a long time.

The fact that we have already had such an experiment, which so far failed, should alert various supporters of low interest rate policies that something is completely wrong with the idea that central banks can grow an economy.

By now it should be realized that the artificial lowering of interest rates can only divert real funding from wealth generating activities towards non-productive activities, thereby diminishing the ability of wealth generators to grow the economy.

From this we can conclude that the latest policy of the Fed not only is not going to help the economy but on the contrary it is going to make things much worse. What is needed now is the curtailment of the Fed's ability to pursue loose monetary policies. The less the Fed does the better it is going to be for the economy.

The Fed however, is unlikely to stop with its policies to "revive" the economy. In fact the Fed Chairman Ben Bernanke said, "If we don't see continued improvement in the labor market, we will be prepared to take additional steps if appropriate". The Fed Chairman added, "Additional asset purchases would be among the things that we would certainly consider".

But then why should it work if it has failed so far? Even if the Fed were to boost its pace of pumping by introducing QE3 i.e. buying assets and expanding aggressively its balance sheet, it will not work if the banks will sit on the new cash and will not lend it out.

So far, in June, banks excess cash reserves stood at $1.490 trillion against $1.461 trillion in May. This means that if the pool of real savings is in trouble, which is quite likely, the Fed will have difficulties to stimulate economic activity, i.e. to generate an illusory economic growth.

The US central bank announced that it will expand its "Operation Twist" program by extending the maturities of assets on its balance sheet. So far this policy seems to have been ineffective in significantly reviving the economy. We suggest that this policy in fact only further distorts the economy. Hence we suggest that the latest extension of the "Operation Twist" is going to make things much worse. 

On account of still-subdued bank lending it is questionable whether the Fed can artificially stimulate the economy without the cooperation of commercial banks. We are doubtful that banks will agree to cooperate if the pool of real savings is in trouble.

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Built on anti-Corn Law radical Richard Cobden's vision that "Peace will come to earth when the people have more to do with each other and governments less," the Cobden Centre promotes sound scholarship on honest money and free trade. Chaired by Toby Baxendale, founder of the Hayek Visiting Teaching Fellowship Program at the London School of Economics, the Cobden Centre brings together economists, businesspeople and finance professionals to better help these ideas influence policy.

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