Instead, businesses and consumers now see their debt burdens as too high in relation to their prospective income. The result is a continuing effort to deleverage, in order to improve their long-term financial stability. This is rational behavior. Does the Fed actually believe that the act of reducing interest rates from already low levels, or driving real interest rates to negative levels, will provoke consumers and businesses from acting in their best interests to improve their balance sheets?
On the supply side, the objective of quantitative easing is to increase the amount of lendable reserves in the banking system. Again, however, this is not a constraint that is binding. The liquidity to make new loans is already present. U.S. commercial banks already hold $1.066 trillion of reserves with the Fed, and another $1.626 trillion in Treasury and agency securities (thanks to Greg Weldon for the graph below). Many banks may very well be insolvent in the sense that their liabilities would exceed their assets if the remaining assets were booked at levels properly reflecting their fair market value, but bank liquidity is not a binding constraint on the U.S. economy here.
Meanwhile, the corporate sector is already holding large precautionary balances in cash and marketable securities. Yet aside from predictable upgrades of information technology, the use of this liquidity has been limited to acquisitions, which simply transfer the ownership of existing assets, do nothing to increase output, and may even result in reduced employment.
In short, further attempts at QE are likely to have little effect in provoking increased economic activity or employment. This is not because QE would fail to affect interest rates and reserves. Rather, this policy will be ineffective because it will relax constraints that are not binding in the first place.
Opacity masquerading as solvency
One of the arguments for quantitative easing is the notion that the Fed's purchase of $1.5 trillion of Fannie Mae and Freddie Mac debt somehow "pulled the U.S. economy back from the abyss" of a Depression. But a closer examination of the past 19 months suggests that a much more specific mechanism - suspension of truthful disclosure - was actually the key element. Unfortunately, the benefits of this suspension are also impermanent, because the underlying solvency problems have been left unaddressed.
