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Yet Another "Operation Twist"?

Mises Daily: Tuesday, July 10, 2012 by

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The US central bank announced recently 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. 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 from 2007 to present indicates that a decline in interest rates did nothing visibly to lift 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?

Figure 1

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's monetary pumping — increasing 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.

Because 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, however, when the pool of real savings comes under pressure (when it is either stagnating or falling). Then monetary pumping by the central bank cannot lift the rate of growth of the money supply, because 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 it will end up as nonperforming 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 nonperforming (i.e., bad) assets increases. Under this situation the Fed cannot do much, because 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 illusion is coming to an end.

Obviously the Fed can bypass the banks and lend money directly to the nonbanking sector, thereby boosting the growth momentum of the money supply — such as the "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, as it were. 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 toward future goods relative to present goods, this is manifested by a decline in interest rates.

Conversely, an increase in the relative preference toward 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 toward 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 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 a central bank 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 toward nonproductive activities, thereby diminishing the ability of wealth generators to grow the economy.

We can conclude that the latest policy of the Fed not only is not going to help the economy but, on the contrary, 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 is unlikely, however, to stop with its policies to "revive" the economy. In fact, 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." He 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 aggressively expanding its balance sheet — it will not work if the banks sit on the new cash and do not lend it out.

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So far, in June, banks excess cash reserves stood at $1.49 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 difficulty stimulating economic activity — i.e., generating illusory economic growth.

Summary and Conclusion

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. We therefore suggest that the latest extension of "Operation Twist" is going to make things much worse. Because 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.