Monetary economists have spent the past decade debating the pros and cons of the Fed’s “bloated $4.5 trillion balance sheet.” Does a large balance sheet make monetary policy more effective? Or should the Fed sell off its assets and return its more modest pre-QE balance sheet?
The Fed’s lingering love handles have only served to weigh down the economy and crowd out private investment.
Often overlooked in this discussion is the negative impact the Fed’s large balance sheet might have on bank lending to the private sector, and hence real economic growth. Both have been sluggish since 2008. And the Fed’s $4.5 trillion balance sheet is partly to blame.
Financial systems play a critical role in driving economic growth. Arguably the most important channel through which finance contributes to growth is through “financial deepening,” or enabling a larger share of the public’s savings to be intermediated by private financial institutions.
The intuition is fairly straightforward. Private banks are far better stewards of the public’s savings than governments or central banks (if you don’t believe me, consider the shoddy track record of countries that have nationalized their banking systems). They specialize in channeling savings into profitable investments. These investments lay the foundation for sustained economic growth and development. The share of private bank-issued money to central bank-issued money, therefore, provides a reasonable estimate of the financial depth of an economy. The higher the ratio, the greater the prospects for economic growth.
Unfortunately, this ratio has declined rapidly in the United States since 2008Q4, when the Fed began expanding its balance sheet. For the decade prior, financial depth in the US averaged around 87.89 percent. Since 2008Q4, it has averaged just 76.24 percent. Although there are many factors contributing to this decline, the Fed’s policy of paying member banks interest on excess reserves is perhaps the chief culprit. Simply put: the Fed encouraged banks to hoard excess reserves rather than make loans. This has allowed the Fed to maintain its bloated balance sheet so that it can allocate credit to favored sectors of the economy without unleashing the bottled up genie of inflation.
What kind of assets is the Fed investing in? As of December 2017, just over half (54.69 percent) consists of U.S. Treasury securities. Mortgage-backed securities make up another sizeable chunk (39.42 percent). Together, these two categories count for 94.11 percent of the Fed’s asset holdings – not exactly healthy ingredients for a weakened economy.
Economists shouldn’t be afraid to call the Fed out for its unhealthy and unsustainable diet. Adding a little fat might’ve been necessary amidst the financial whirlwind of 2008-2009. As Scott Sumner and others have pointed out, one of the reasons why the Great Recession was so “great” was because the Fed failed to act as a “lender of last resort” during the early stages of the credit crunch. By the time it did begin pumping reserves into the banking system, it was too late to avoid a major recession.
But nearly a decade has passed since the Fed’s major mishaps. And today, the Fed’s lingering love handles have only served to weigh down the economy and crowd out private investment.
Moving forward, economists shouldn’t be afraid to call the Fed out for its unhealthy (and unsustainable) diet. They should demand that it take the necessary steps to begin cutting the fat off its balance sheet. As the share of private bank-issued money in the economy returns to more reasonable levels, lending to the private sector will rise, and so too will rate of economic growth.