John Cochrane is a tremendously talented economist and professor of finance @ Chicago’s Booth School of Business.  He’s probably forgotten more arcane financial reasoning than I know; but that doesn’t stop us from critically examining his thinking.  In today’s WSJ, Mr. Cochrane cheers the Fed’s balance sheet expansion as a good thing for the economy.

As Federal Reserve officials lay the groundwork for raising interest rates, they are doing a few things right. They need a little cheering, and a bit more courage of their convictions

As a note, the Fed’s balance sheet at the beginning of the financial crisis was ~$800B; it has ballooned to over $4.3T.  While this unprecedented increase greatly troubles many economists, Mr. Cochrane sees the bright side:  by creating a liability (an asset on the bank’s balance sheet) in the form of bank reserves (which necessarily happens in the Fed’s expansion of its balance sheet), the banks are much safer–more reserves on the banks balance sheet (as opposed to additional loans) makes them inherently safer.  But what if the banks loan out all those reserves, won’t that be inflationary?  Cochrane correctly responds:

Reserves that pay market interest are not inflationary. Period. Now that banks have trillions more reserves than they need to satisfy regulations or service their deposits, banks don’t care if they hold another dollar of interest-paying reserves or another dollar of Treasurys. They are perfect substitutes at the margin. Exchanging red M&Ms for green M&Ms does not help your diet. Commenters have seen the astonishing rise in reserves—from $50 billion in 2007 to $2.7 trillion today—and warned of hyperinflation to come. This is simply wrong as long as reserves pay market interest.

Yet is there truly a free lunch here?  Have we increased financial stability at no cost?  I think not….

First we need to consider the nature of the Fed’s balance sheet expansion.  Surely the Fed’s large expansion has created the almost zero interest rate the U.S. Treasury pays on its debt issuance.  The Fed has facilitated the massive increase in our national debt; when you pay no interest, it is an invitation to spend money.  The Fed’s artificial stimulus has created a massive bubble–but this time the bubble is in government finance.   Rinehart and Rogoff* have shown us pretty conclusively where this ends–and it will not be pretty–albeit it may be years off.

And this gets to another problem with Mr. Cochrane’s analysis–everything will be ok as long as the Fed pays a market interest rate on reserves.  I think he is broadly correct here (ignoring my previous concern of the government finance bubble), but he is crucially ignoring the mismatch between assets and liabilities that the Fed has incurred.  At some point, the short term market interest rate will rise, and when it does the Fed’s balance sheet is loaded with fixed long term assets paying low interest rates.  If an inflationary premium gets baked in, this could be really ugly (think 1970s short term interest rates).  If we are concerned with Bear Stearns having short term liabilities and long term assets, do we not have any concern with the Fed doing the same thing?

The final concern we have is that this policy only works by the Fed’s continued financial repression of most American’s.  We are systematically being taxed ~2-3% annually on our cash holdings, and further the Fed has driven yields down to absurdly low levels, with the stated intent to drive us into riskier assets.  And it has worked–the stock market rise is unabated.  And that leaves those sucked into the market in pursuit of yield vulnerable to another crash when the liquidity stops.

As Hayek says,

We shall not grow wiser before we learn that much that we have done was very foolish

I continue to believe that the best policy for the Fed at this point is to just stop.  Don’t do anything.  Let the assets on the balance sheet run off.  Begin an orderly return to more normal interest rate policy (say a 3% short run rate).  First do no wrong…

* I’m talking about the broad undisputed conclusion of their book This Time is Different; that countries that continue increasing their debt ultimately either debauch or default on their debt.  What the exact tipping point is unknown and irrelevant for our purposes–simply we know that what cannot continue forever will not.