Why Death Matters for Central Bank Policy

Noah Smith raises the question: can the Fed influence the interest rate? Although the answer may seem obvious, the question itself reflects a conundrum for neoclassical theory. It is representative of a related but more comprehensive question: does the asset composition of the central bank balance sheet matter?

Let me set aside, for now, the deep question: what is money? I will take for granted the fact that the liabilities of the central bank are special. Perhaps this is due to legal restrictions, as Neil Wallace has suggested, or perhaps it is a matter of social convention. My focus here is not on central bank liabilities; but on their assets.

Figure 1
Figure 1 is a stylized representation of the balance sheet  of the Fed. Like King Midas who turned everything he touched to gold, so the Fed turns everything it purchases into money. Commercial banks hold accounts at the Fed, and when the Fed purchases an asset, any asset, those accounts are credited with the creation of new money.

Historically, the asset composition of the Fed has consisted almost exclusively of short term Federal government bonds, the item in red on Figure 1. In September of 2008 two things happened. First, the size of the balance sheet increased. The RHS of the table in Figure 1 went from $800b to $2,000b overnight. Second, the composition of the asset portfolio changed dramatically.
Figure 2
Figure 2 is a highly stylized representation of what happened following the collapse of Lehman Brothers in the fall of 2008.  The Fed purchased a whole boatload of long-term government debt: And for the first time in its history, it bought mortgage backed securities (MBS). 

The fact that the asset side of the balance sheet went from $800b to $2,000b is referred to as quantitative easing. The fact that the fraction of liabilities held as short term treasury securities went from 94% (750/800) to 38% (750/2000) is referred to as qualitative easing.

Here's the puzzle for neoclassical theory. According to received wisdom (Michael Woodford's Jackson Hole paper is an excellent exposition of this idea) the asset composition of the Fed's balance sheet is irrelevant. If the Fed had bought more short-term government debt instead of intervening in the riskier MBS market; it would not have made one whit of difference to the economy.

Why is that? According to standard neoclassical models, all transactions are carried out by infinitely lived families who take into account the welfare of their descendants. The far sighted paternalistic patriarchs of these families trade assets with each other that are contingent on every possible future event.  

Because the price of long bonds reflects all known facts about the probabilities of future outcomes, central bank asset positions do not influence the market price of risk. When the government takes a new position in the asset markets, the private sector unwinds that position through its own open-market trades.

But that is not what happened. A wealth of evidence shows not just that quantitative easing matters, but also that qualitative easing matters. (see for example Krishnamurthy and Vissing-Jorgensen, Hamilton and Wu, Gagnon et al). In other words, QE works in practice but not in theory. Perhaps its time to jettison the theory.

Replacing all of neoclassical theory with an operational alternative is a daunting task. There is no lack of contenders. Perhaps people are irrational as the behaviorists have claimed. Perhaps the market is segmented and institutional constraints cause pension funds to favor safe assets. Perhaps there are borrowing constraints that prevent some trades from taking place. These are all possibilities and I do not want to suggest that they do not have merit. But there is a much simpler explanation for the failure of the irrelevance result. Human beings do not live forever.

The fact that our lives are finite has consequences for the efficiency of asset markets. Davis Cass and Karl Shell called this idea sunspots. Asset markets are volatile because we all, eventually, meet the grim reaper. And although governments are sometimes overturned, they have much longer horizons than individuals. That simple fact explains why the asset composition of the central bank matters.