When is increasing liquidity or the monetary base not inflationary?

Two comments on an earlier blog of mine made the point that the Fed’s swap of Treasuries for MBS with the primary dealers had been motivated by the desire not to increase system-wide liquidity (monetise the MBS), but simply to allow existing pockets of liquidity to be mobilised more effectively. I commented on Miranda Xafa’s post but I had missed Alfred Smith’s remark that “The striking inpact of the Fed’s action is enhancing mortgage market depth without adding to the monetary base. In this respect, it has filled the role of lender of last resort while minimizing the inflationary bias of this role.” The statement is descriptively correct as regards the effect of the Fed’s action on the monetary base/liquidity but analytically wrong as regards the inflationary implications of monetising the MBS. It may be worth repeating the difference, in the context of the quantity of money, between a movement along the demand curve and a shift of the demand curve.

An increase in liquidity, or an increase in the monetary base that accommodates an increase in the demand for real liquidity (i.e. an increase in the demand for liquidity at a given general price level) is not inflationary. The accomodation, through an increase in the nominal quantity of liquidity (or base money) of an increase in the quantity of real liquidity demanded, instead avoids the need for deflation – a decline in the general price level.

The increase in the quantity of real liquidity demanded is a fact – a consequence of the liquidity crunch. What will be key is that, when markets normalise and the credit crunch vanishes, the Fed withdraws the liquidity it has injected, because this liquidity will at that point become inflationary. But that will be then. This is now, and the non-inflationary-if-properly-handled-in-the future increase in liquidity and the monetary base is needed now.

The Fed’s swap of Treasury bonds for MBS with the Primary Dealers substituted liquid Treasury bonds for illiquid MBS in the portfolios of Primary Dealers. If there were pockets of underutilized but mobilizable ultimate liquidity in the private sector (unused claims on central bank money in excess of what the private party holding them would want to hold if the alternative of Treasury Bills were on offer, but not in excess of what that same private party would want to hold if only MBS were on offer), then the Fed’s swap with the primary dealers would indeed increase effective liquidity in the system, by permitting the more efficient utilisation of these idle pockets of ultimate liquidity already out there.

I don’t know how many pockets of unutilised or underutilised ultimate liquidity are out there that could be mobilised by MBS being exchanged for Treasuries. I doubt whether they would make much of a collective dent in the liquidity drought we are experiencing. So, much better not to futz around, but instead to increase the quantity of ultimately liquidity (and of base money) in the economy either through collateralised loans from the Fed to the primary dealers against MBS or through the outright purchase of MBS by the Fed from the primary dealers and anyone else who wants to get rid of them. All this to be done at properly punitive prices for the MBS, topped with an appropriate hefty haircut to minimize moral hazard and to give the tax payer a fair crack at making some money on the deal. Life is beautiful.

Maverecon: Willem Buiter

Willem Buiter's blog ran until December 2009. This blog is no longer active but it remains open as an archive.

Professor of European Political Economy, London School of Economics and Political Science; former chief economist of the EBRD, former external member of the MPC; adviser to international organisations, governments, central banks and private financial institutions.

Willem Buiter's website