Response to Readers

Many thanks to the dozens of readers who submitted questions and suggestions regarding my book. Sorry for the delay in responding; there were technical problems on our end. Below are responses and reactions to selected comments:

There were many questions about quantitative easing (QE) and quantitative tightening (QT). Some readers asked why QE after 2008 did not significantly increase the money supply. The answer is that QE did increase bank reserves and lower longer-term interest rates, but bank reserves are not part of most definitions of the money supply (for example, the popular monetary measure M1 is basically the sum of currency outstanding and checking accounts). QE increases the broader money supply only if banks lend out their reserves, which they were reluctant to do in 2008 and the next few years, largely due to post-crisis caution, uncertainty about possible regulatory changes, and (probably most important) the financial weakness of borrowers during the crisis and recession. (Notably, housing activity and thus mortgage ledning remained very low following the collapse of the housing bubble.) There is no support for the idea, sometimes heard, that the Fed's decision to pay bank one-fourth of a percentage point interest on ther reserves — a tiny return — inhibited banks from lending.

Why didn't the large amount of QE during and after the financial crisis spark inflation, as many critics expected? The QA lowered longer-term interest rates, as desired, which provided support for the economy. But, in an economy with an independent central bank (no "fiscal dominance"), inflation requires either an overheating economy (which was never the case in the years after the crisis) or big supply shocks (like the recent increases in food and energy prices associated with the Ukraine war), which also did not occur.

Another question was whether the effects of the currently ongoing QT will have effects on longer-term interest rates of the same magnitude as QE (with an opposite sign). I expect the effects of QT will be notably less (although note that some of these effects are already incorporated, via investor expectations, in longer-term rates). One reason is that investors absorb the increased supply of government securities that QT will provide. Remember also that because of the Fed's new "ample reserves" operating system, the Fed will likely reduce its balance sheet by only about one-third rather than to pre-crisis levels. Finally, an important mechanism by which QE works is by signaling to investors that new easing initiatives are likely. With QT, the Fed has made strong efforts to make the process highly predictable and to divorce it from rates policy, eliminating or greatly reducing the signaling effect.

There were questions about the relationship between QE and the government debt. QE does not reduce the aggregate liabilities of the government, defined as the Treasury plus the Fed, because QE is a swap of new bank reserves (a liability of the Fed) for Treasury (and GSE) securities, a liability of the Treasury. What QE really does is shorten the average maturity of government liabilities. It's true that QE makes government debt cheaper to finance in the short run (which may be a good thing, since periods of QE also tend to be periods when expansionary fiscal policy is helpful). However, the Treasury has outstanding debt with a wide range of maturities and must plan for period of both low and high interest rates. In the long run, if the interest burden of the debt gets very high, the government will face pressure to raise taxes, cut spending, or both to keep deficits under control.

A reader asks if there is a standard definition of a financial crisis. Probably not, but I think we know the symptoms. Gary Gorton and Ellis Tallman, in their (recommended) book Fighting Financial Crises, argue that crises are periods when investors are unwilling to hold anything but the safest and most liquid assets. This preference for liquidity may reflect uncertainty about the solvency of financial intermediaries generally (not just one or two firms) and breakdowns in the normal functions of credit markets. My 2018 paper in the Brooking Papers on Economic Activity ("The Real Effects of Financial Crisis...") shows that extreme financial crises, like the one in 2007-2009, can have severe effects on output and employment. My book argues that, while important progress has been made, regulators still have work to do to reduce the risk of a future crisis (the shadow banking sector being a prime example).

There were a number of useful corrections and amplifications. A reader noted that the conservatorship of the GSEs in 2008 implied government support of the companies but did not amount to a “full faith and credit” guarantee. Another reader pointed out that Congressman Ron Paul was from Texas, not Kentucky as I mistakenly wrote. There was an important typo on p. 415: The thrust of the mangled sentence was that Janet Yellen was the first female chair and Lael Brainard the third female vice-chair (after Alice Rivlin and Yellen).

Many people suggested adding more graphs and figures. Some readers are put off by too many figures, but I think overall this is a good suggestion for a future edition. More importantly, a new edition will have to give a much more detailed analysis of the inflation that began in 2021 (about the time the manuscript was completed). As the Fed realizes, the Great Inflation of the 1970s and Paul Volcker’s conquest of it contain many lessons for current policy and communication. Finally, readers asked for more on the international economy and on the factors (such as productivity) that determine long-run growth. Good ideas both.