America’s Strategy Vacuum

NEW HAVEN – Apparently, policymakers at the Federal Reserve are having second thoughts about the wisdom of open-ended quantitative easing (QE). They should. Not only has this untested policy experiment failed to deliver an acceptable economic recovery; it has also heightened the risk of another crisis.

The minutes of the January 29-30 meeting of the Fed’s Federal Open Market Committee (FOMC) speak to a simmering discontent: “[M]any participants…expressed some concerns about potential costs and risks arising from further asset purchases.” The concerns range from worries about the destabilizing ramifications of an exit strategy from QE to apprehension about capital losses on the Fed’s rapidly ballooning portfolio of securities (currently $3 trillion, and on its way to $4 trillion by the end of this year).

As serious as these concerns may be, they overlook what could well be the greatest flaw in the Fed’s unprecedented gambit: an emphasis on short-term tactics over longer-term strategy. Blindsided by the crisis of 2007-2008, the Fed has compounded its original misdiagnosis of the problem by repeatedly doubling down on tactical responses, with two rounds of QE preceding the current, open-ended iteration. The FOMC, drawing a false sense of comfort from the success of QE1 – a massive liquidity injection in the depths of a horrific crisis – mistakenly came to believe that it had found the right template for subsequent policy actions.

That approach might have worked had the US economy been afflicted by a cyclical disease – a temporary shortfall of aggregate demand. In that case, countercyclical policies – both fiscal and monetary – could eventually be expected to plug the demand hole and get the economy going again, just as Keynesians argue.