Most people are probably pretty familiar with the idea that the Fed raises or lowers interest rates. Yet, how does it do that?

Well suppose the Fed wanted to lower interests rates. The Federal Open Market Committee – which Ben Bernanke heads – issues orders to the open market desk.

Traders at the open market desk are told to start buying bonds. As they do bonds go up and price and the yield or interest rate goes down. The traders are ordered to continue buying until the interest rate hits the committee’s target and then stop.

However, currently interest rates on short-term bonds are basically zero. What are the traders to do? Well, consistent with their orders they simply stopped, and the market halted where it was.

Now, the Fed is issuing a new kind of order. It used to say keep buying until you hit a target interest rate. Now it is saying keep buying until you have spent $75 billion per month. The traders will begin buying as ordered, and instead of stopping when they see a certain interest rate, they stop once they’ve spent a certain amount of money.

Economists like to think in terms of prices and quantities. Usually the orders from the FOMC come in the form of prices, in this case the price is called the interest rate. Now the orders will come in terms of quantities. This is why the whole thing is called quantitative easing. It is a quantity target instead of a price target.

Otherwise, it is the same.

Via Yglesias.

As you see, extending unemployment insurance benefits causes a temporary blip in deficit spending. But the effect of tax cuts is lasting and deep. And as Bruce Bartlett points out, the “Starve the Beast” theory—according to which diminishing revenues will force the government to curtail spending—simply hasn’t held up:

Starve the beast theory has been the subject of much recent academic research, all of it showing that there is no truth to it whatsoever. Indeed, the literature shows that the effect is actually perverse; leading to higher spending because the tax-cost is reduced by tax cuts. I provide links to a number of recent academic studies on this point in my Fiscal Times post [Wednesday, July 14].

The yellow line shooting up is the projected growth of the U.S. budget deficit (as a percentage of GDP) if current health spending trends continue. The light blue line drifting slowly downwards is what our budget outlook would look like if health cost trends in the U.S. were scaled down to match trends in other high-income OECD countries.

The Center for Economic and Policy Research declares, “The U.S. health care system is possibly the most inefficient in the world: We spend twice as much per person on health care as other advanced countries, but we have worse health outcomes, including a lower life expectancy.” If we want to fix the long-term deficit problem, we have to address the problem of exploding health spending. In the long term, there is no other deficit problem.

Via Austin Frakt.

Arjun Jayadev at New Deal 2.0 finds the mark of George W. Bush’s presidency etched into the picture of our national finances over the past decade. Literally. And I don’t mean Joe-Biden literally. But literally literally. That is, the literal letter “W” literally appears on the graph of total revenues over the last 10+ years (supplemented by projections of presumptive recovery).

This observation prompts Mike Konczal, writing at Ezra Klein’s place, to declare the past decade the “W years.” And so they were.

This is pie-in-the-sky, but I think that if Congress wants to get serious about supervising the Fed better what they ought to do is scrap the “dual mandate” in favor of something clearer. The nature of the dual mandate is that it’s impossible to say if the Fed is meeting its mandate, and thus impossible to hold anyone accountable. As an alternative, Congress could set a statutory nominal GDP trend target or a price level trend target and hold the leadership of the Fed accountable based on how good a job they do of hitting the target.

One thing the current system shows you is that it doesn’t take much for a statutory mandate to satisfy the Supreme Court’s “intelligible principle” standard (though I don’t believe the Supreme Court has specifically addressed the Fed’s mandate—no one has standing to challenge it). The Court has held that Congress may delegate power to an administrative agency—e.g., to conduct the nation’s monetary policy—only when Congress specifies an intelligible principle to guide the agency’s discretion in exercising the delegated power.

One perfectly intelligible principle for the Fed would be: Go forth and do open-market mumbo jumbo to achieve maximum employment. Another perfectly intelligible principle would be: Go forth and do open-market mumbo jumbo to stabilize prices. But to demand both at once is scarcely intelligible, and hardly a principle. Basically we’re leaving it to the Fed to decide how to balance inflation and unemployment. And I guess that’s what the Fed will always say it’s doing—no matter what policy direction it takes. 

Because of the Fed’s cherished “independence,” and because the Federal Open Market Committee (the Fed’s rate-setting arm) is stacked with regional Fed bankers, the Fed’s obscure, relativistic mandate is tantamount to untouchable regulatory capture. It’s not clear that auditing the Fed can change this underlying dynamic.

This pie chart from the IMF, via Ezra Klein, shows the various sources of new debt taken on by G-20 governments since the recession began. Stimulus spending and financial-sector bailouts account for a comparatively small portion. (Not sure though if U.S. figures would be in lockstep proportion with G-20 numbers here.) The bulk is just a consequence of the fall in tax revenues, which, of course, is a consequence of a drop in incomes. Klein writes:

A lot of people, understandably enough, assume that [the run-up in debt] is the product of government spending. The stimulus was expensive, and the bank rescues seemed expensive, and we just passed a health-care reform plan, and that must be why the deficit blew up.

The IMF, in a new report (pdf), explains that that’s not the case. “Of the almost 39 percentage points of GDP increase in the debt ratio, about two-thirds is explained by revenue weakness and the fall in GDP during 2008-09,” they write.

[...] This isn’t just an interesting explanatory point, though. It’s a reminder that the most important thing we can do to reduce the deficit in the long run is to do whatever it takes to get economic growth back up to speed. The more willing we are to accept permanently higher unemployment and permanently lower growth, the harder it’s going to be to get our debt under control.

12 U.S.C. § 225a.

The Board of Governors of the Federal Reserve System and the Federal Open Market Committee shall maintain long run growth of the monetary and credit aggregates commensurate with the economy’s long run potential to increase production, so as to promote effectively the goals of maximum employment, stable prices, and moderate long-term interest rates.

I guess that language is just enough of a jumble that it doesn’t really matter that there are actually three goals: maximum employment, stable prices, and moderate long-term interest rates. Maybe the third gets lopped off because we think of the Fed’s control of interest rates more as a means than as an end. And because employment and inflation are the two recognized poles of monetary policy.

In more ways than one, though, it seems that the statutory language takes a back seat in directing Fed policy priorities. The word maximum in “maximum employment” is understood to be implicitly limited by the need to stave off inflation, though the need to escape high unemployment doesn’t seem to imply complementary limits to the pursuit of stable prices. Also, the statute’s more direct mandate has to do with long-run growth tied to increased production; the other two (or three) goals are almost afterthoughts.

I’m not especially knowledgeable about any of this, but I’d just note that this is a statutory provision which, however it was intended, seems tailor-made to supply obfuscatory justification of whatever direction Fed policy happens to take. There’s a little bit of everything in there, and the Fed Board and Federal Open Market Committee have immense discretion in their control of what is probably the government’s most consequential role in the economy. And that’s why these nominations matter so much.

My first thought is: By the time the sun starts burning out, we will totally have this nut cracked! And my second thought is: I hope these three nominees are committed to raising the employment level.

Well, Janet Yellen, president of the San Francisco Fed and the nominee for vice chair of the Board of Governors, made some promising noises right out of the box today:

I am strongly committed to pursuing the dual goals that Congress has assigned us: maximum employment and price stability and, if confirmed, I will work to ensure that policy promotes job creation and keeps inflation in check.

Sounds good, maybe, I think. You know, in that deeply ambiguous monetary policy kind of way. Via Matt Yglesias.