Part of the U.S. Federal Reserve’s quantitative easing (QE) programs in the wake of the 2008 recession focused on purchases of mortgage-backed securities (MBS). While doing so helped revive mortgage finance lending, it also crowded out bank commercial lending to firms in other industries, leading to a decrease in business investments, according to a recent study coauthored by Wharton finance professor Itay Goldstein.
QE programs in the future could learn from that experience to have a more widespread impact, Goldstein noted in a recent interview on the Wharton Business Daily show on Sirius XM. “The MBS purchases caused unintended real effects and … Treasury purchases did not cause a large positive stimulus to the economy through the bank lending channel,” notes the study, titled “Monetary Stimulus and Bank Lending,” which was published in the Journal of Financial Economics. Goldstein’s co-authors are Indraneel Chakraborty, associate professor of finance at the University of Miami Business School, and Andrew MacKinlay, assistant professor in Virginia Tech’s department of finance, insurance and business law.
An edited transcript of the conversation follows.
Wharton Business Daily: What did you find out from your study that looked back at the impact of QE during the 2008 recession?
Itay Goldstein: We found that it depends on what assets you buy in QE. The whole idea of QE is you want to stimulate the economy. Usually you do it with monetary policy. You reduce rates. But central banks found themselves in a situation in the crisis where rates were already so low, they could not lower them anymore. So they started looking for other, more innovative ways to stimulate the economy, and QE was the highlight. Instead of reducing rates, they went out and bought assets, and this is how they wanted to stimulate markets. They wanted to encourage banks to do more lending and so on.
But what we found is that there are different effects for the different assets that you buy.
Wharton Business Daily: What were the elements that were considered – not only by the Federal Reserve, but by banking institutions around the world?
Goldstein: In the U.S., they bought treasuries and mortgage-backed securities. In Europe, they experimented with corporate bonds. In Japan, they experimented with equities. Buying mortgage-backed securities had peculiar effects, and this is something that central banks going forward would want to watch, before they design future rounds of [QE].
Unintended Outcomes
Wharton Business Daily: What were the impacts, then, over the course of time? We did see more lending eventually occur here in the U.S. because of the amount of mortgage-backed securities being purchased by the Federal Reserve.
Goldstein: The intended consequence of buying mortgage-backed securities was to encourage banks to give more loans in the real estate market – basically to encourage banks to give more mortgages.
“As central banks, and as policy-makers in general, we may want to be more focused on corporate investments because this is where real investment can develop the economy.”
The unintended, negative effect was that there was also crowding out of other types of lending. [It gave] banks the incentive to provide more mortgages, and to lend more to the real estate market. And they [achieved] that. But then what happens is that banks have limited resources, and they have to decide how to allocate those resources. If they allocate more resources to the real estate markets, they will allocate fewer resources to other industries. We found that banks that increased mortgage lending reduced other types of lending, in particular lending to corporations. That could have negative consequences for firms that depend on banks to finance their operations. They would find that difficult to cope with.
Wharton Business Daily: That probably had an impact on business investment over time.
Goldstein: Yes, absolutely. We had detailed data that allowed us to look at what kinds of lending banks were doing. We could also connect banks to firms, because banks have lending relationships with particular firms, and see whether those banks that were doing more mortgages were doing less by way of commercial and industrial loans. Then, we could look at the firms that are connected to these banks and see whether these firms were investing less as a result. Indeed, we could verify this whole chain.
Basically, there is a crowding-out effect. When we think about monetary policy, we don’t think about stimulating one area of the economy. Usually monetary policy is supposed to stimulate everything. But with QE, the Fed was choosing the type of investments that would be incentivized and promoted, and some types of investments could potentially be compromised. This is something that we need to take into account.
Wharton Business Daily: Why do you think it is so important to have that understanding moving forward, especially if we see QE being used again if we were to have another significant crisis down the road?
Goldstein: The focus on the housing market could be problematic. I understand where this focus came from. Obviously the core of the crisis in 2007 and 2008 was the decline in housing prices and the collapse of subprime mortgages and so on. So there was this attempt to revive the housing market and bring it back to usual.
However, at the end of the day, this is not where real economic activity happens. Many people are using the housing market to speculate. Sometimes you see bubbles forming in the housing market. Designing a policy that will just stimulate more investment in housing and more increases in housing prices could be problematic. As central banks, and as policy-makers in general, we may want to be more focused on corporate investments because this is where real investment can develop the economy.
Here, we identify a potential downside. If you incentivize more investment in housing, you might be crowding out more investment in the real economy, which is where long-term economic development could be coming from.
How QE Worked in Europe
Wharton Business Daily: How do you compare what we saw in the U.S. with what we’ve seen over the last several years in Europe with the use of QE?
Goldstein: It’s a multidimensional question. There are other differences between the U.S. and Europe. One aspect in the U.S. that you can say was favorable in terms of the way that policy-makers acted is that they did everything very quickly. They did the quantitative easing quickly. They revived the banking system fairly quickly. As a result, the overall consequences of the crisis were not as severe as in Europe.
In Europe, on the other hand, [central bankers] responded late. They did not help all banks. And you can see that some of the problems are still lingering. I’m not advocating that we should take lessons from Europe here, in that sense. At the end of the day, their policy was not as effective [as in the U.S.].
However, what we should think about is: Could we potentially make things here even better? When you design QE, you may want to make it a bit more balanced, and not necessarily buying mortgage-backed securities. [You could] potentially buy other assets that could also stimulate lending into the corporate sector, into the real sector.
The Next Crisis
Wharton Business Daily: Has QE become kind of a fallback that central banks will consider maybe at the top of their agenda now, should we see another severe economic crisis down the road?
Goldstein: I think so. QE is now part of the menu of tools that central banks will consider. Monetary policy has changed dramatically in the last decade. Traditionally, we used to have these [economic] cycles. Rates would go up, and then as economic activity slows down, you would start reducing rates and try to stimulate economic activity. This is how you would like to moderate business cycles and reduce the impact of recessions.
“There was this hope that if you do something to help the housing market, everything else will follow.”
What we see now, which is very peculiar, is that rates have been low for a very long time, even though economic activity has gone back and recovered following the crisis. Now, everyone is asking themselves: Suppose that there is another recession coming? What could central banks do? They don’t have much flexibility to continue reducing rates. Rates are already very low. Negative rates are indeed a possibility. (With negative rates, central banks charge banks to deposit money with them.) But even with negative rates, there is some limit. You can’t go too negative.
Central banks have to realize that they have limited use of the interest rate as a tool to affect economic activity going forward. They will have to continue using the other tools that they used during the Great Recession.
[The Federal Reserve also gave out] forward guidance. Instead of reducing rates, they gave out all sorts of signals with all sorts or language to say, “This will be our policy for the long future.” But that also has limited effect. The QE came up as kind of an innovative tool to say, “When we are limited on rates, then we will start buying assets, and this is how we can stimulate economic activity and stimulate markets.”
That is why I think QE is still very relevant. [However, it will entail] difficulties, and central banks have to revisit this and think about how to do it. Now that we have the data, [they could] go back and analyze how this policy worked in the past and what we should learn from it.
Wharton Business Daily: If there had been more of a focus on commercial and industrial lending, what potentially could have been the impact of that? Could it have resulted in a quicker bounce-back of economic growth?
Goldstein: Potentially, that could happen. It’s very difficult to quantify that, but that could have been a better outcome in the sense that there will be more investment, and as a result, greater growth after the crisis.
Wharton Business Daily: Why wasn’t there more of a focus on that?
Goldstein: Two things were going on. First, there was a great focus on the housing market because it was the core of the crisis. This is where it started. And there was this attempt to bring it back. But second — and this is where the results of our study are particularly interesting — there was this hope that if you do something to help the housing market, everything else will follow. [The hope was for] positive spillovers from the housing market to other parts of the economy. We have quotes from policy-makers saying, “You’re going to revive the housing market. House prices are going to go up. People are going to feel richer. They will spend more money. As a result, business activity will also improve, and everything will go in the same direction.”
“If you give banks clear incentives to originate more mortgages, securitize them, and so on, it doesn’t mean that they will also at the same time do more commercial and industrial loans.”
Our study shows that it doesn’t necessarily all go in the same direction. Sometimes there is crowding out. If you give banks clear incentives to originate more mortgages, securitize them, and so on, it doesn’t mean that they will also at the same time do more commercial and industrial loans. They could reduce them. And this is what [happened].
Wharton Business Daily: I would imagine that you and other experts who have looked at this area are looking also at the long-term impact of having the several rounds of QE.
Goldstein: Yes. This research is still being conducted. I’m not doing this myself. Thinking about the long-term impact is more difficult because when you’re looking at something over longer horizons, you have to ask yourself the question: Where is the effect coming from? There are so many other things that are changing over time, so it’s very difficult to say, “I did QE in 2008, and now in 2019, I see these effects.” What we studied was the short-term effect, looking at QE in a particular quarter and how banks [responded] in the following quarter. This is where we could identify this crowding out.
The Equities Option
Wharton Business Daily: We talked about QE in the U.S. and in Europe, but your paper notes that Japan decided to go with equities. Why did they make that decision?
Goldstein: I’m not sure what exactly they had in mind. [However], this could be highly problematic. You could imagine the Fed starting to buy corporate bonds of particular firms or equity of particular firms, and the backlash coming out of that would also be pretty big. It’s not like these issues are without controversy.
Wharton Business Daily: Are you still seeing impacts from the QE in the economic growth of the U.S?
Goldstein: I believe so. Again, generally, it’s difficult to say because a long time has passed, and it’s very difficult to track these effects over a very long horizon. We have to remember that the QE has not been unwound yet, because the Fed is still holding a lot of assets.
Whenever the Fed says, “We’re going to start unwinding and reducing the assets on our balance sheet,” the market immediately freaks out. So part of the reason the [stock] market right now is so high is that these assets are still being held by the Fed. Everyone fears that once the Fed unwinds [its QE holdings] and sells all these assets, then the negative consequences for the market will be pretty big.
