Quantitative Easing: Wacky Progressive Economics or Financial Annealing?
This post is based on playing around with some analogies to try to understand quantitative easing in my own mind. I can't decide if this approach is helpful or just wanking. I fear it is the latter, but if we banned all banned all intellectual wanking in blogs, my feed reader would be virtually empty.
I haven't really written much about the Fed's latest round of quantitative easing, dubbed QE2. Basically they plan to print some significant fraction (I see different numbers in different articles) of a trillion dollars and use the newly created money to buy government bonds (they don't actually print the money but create it out of thin air in the memory banks of computers). As I understand it, the theory is that this will boost the price (and thus reduce yields) on the government bonds on the balance sheets of private banks. This will in turn have two effects: improve (at least on paper) the balance sheets of banks, hopefully making it more likely to lend; and it will reduce the yield on the bonds on their balance sheets, hopefully making private loans look like a better investment in comparison.
I am not an economist, and so won't get embroiled in issues I don't understand, but it strikes me that even if one accepts the theory of QE, it will be difficult to have any measurable impact as long as Congress and the administration keeps generating new debt at astounding rates.
But what is really happening here is that the dollar is being devalued. This is one of the semantic quirks that make me laugh -- when Argentina or Zimbabwe do this, its called devaluation. When a western nation does it, it is called quantitative easing. Because, uh, we are much smarter or something. But I have to believe that a lot of progressives have hitched their wagon to QE2 out of the hope for some inflation (wow, the revenge of William Jennings Bryant). Because inflation and dollar devaluation would nominally achieve some of the goals they are hoping for, including:
- making Chinese imports more expensive, creating a wealth transfer from consumers to a few politically powerful exporters
- re-inflating the housing bubble while devaluing long-term fixed rate mortgages, creating a wealth transfer from creditors to debtors
- continuing the wealth transfer from average workers (who typically don't have COLA's) to government and union workers (who typically do have COLA's)
- acts as wealth transfer from individuals to government since it creates an effective income tax rate increase, as key income levels in the tax tables, particularly where AMT kicks in, are not indexed for inflation
It is impossible to argue that devaluing a currency is a path to wealth generation. It can't be, though progressives, as always, are willing to tolerate a total reduction of wealth as the price for the type of re-distributions discussed above.
But excepting the re-distribution arguments, it strikes me that the only possible argument for this devaluation is that the economy is somehow trapped in a local minima from which the escape energy is too high. This would make QE a bit like annealing in a metal, where metal that is heated up and cooled too fast can be hard and brittle. The only way to get it to be ductile is to re-heat it and then allow it to cool slower.
This is kind of a pretty comparison, but in large part it is probably BS. The economy is way, way, way more complex and multi-variate than crystallization in a metal. Even if we were trapped in a local minima, which by the way it is pretty much impossible to determine, we don't know what kind of energy should be applied to the system to move it out. In fact, if we wanted to use this analogy, it would make far more sense to me to remove barriers to entrepreneurship and wealth creation which likely form a large part of the energy barrier that keeps us in such a local minima. In fact, the annealing analogy would likely point one in the direction of decalcifying markets and increasing labor mobility rather than massive government interventionism. It is much easier for me to argue that the missing energy is entrepreneurship rather than liquidity. Apparently, the German finance minister agrees with me:
The American growth model, on the other hand, is in a deep crisis. The United States lived on borrowed money for too long, inflating its financial sector unnecessarily and neglecting its small and mid-sized industrial companies. "¦I seriously doubt that it makes sense to pump unlimited amounts of money into the markets. There is no lack of liquidity in the US economy, which is why I don't recognize the economic argument behind this measure. "¦The Fed's decisions bring more uncertainty to the global economy. "¦It's inconsistent for the Americans to accuse the Chinese of manipulating exchange rates and then to artificially depress the dollar exchange rate by printing money.
Update: Chinese bond rating agency downgrades US treasuries
The United States has lost its double-A credit rating with Dagong Global Credit Rating Co., Ltd., the first domestic rating agency in China, due to its new round of quantitative easing policy. Dagong Global on Tuesday downgraded the local and foreign currency long-term sovereign credit rating of the US by one level to A+ from previous AA with "negative" outlook.
Andrew Sarcus:
Don’t forget that inflation also bumps up effective capital gains tax rates because there is no deduction for inflation.
November 10, 2010, 11:11 amWill Sawin:
Our economy's normal level of inflation is about 2%. Currently it's lower, close to 0%. The goal of quantitative easing is to inflate somewhat faster than normal, to return price level to its previous trend. Progressive economist Paul Krugman said 5%. Nowhere near Zimbabwe/Argentina levels.
"Devaluation" also implies a primary focus on international trade, which isn't really the point of the policy. Instead, the Fed wants to create expectations of inflation so that domestic consumers and firms will save less money and spend more, and that money will go to hiring workers.
If you think debt is such a huge problem for low interest rates then, well, look at interest rates - they're low. Investors aren't worried about default, high inflation, or anything of the sort.
QE, by the way, is not very different from regular policy of interest-rate setting. They both involve bond market interventions. It's all a continuum. What do you think is the right level of inflation right now? 2%? 0%? -2%?
The 1st and 2nd reasons you gave are reasons I've heard from liberals, but the 3rd and 4th were produced by trying to read evil liberal's minds and figure out what's in them.
The reason for the first one is that a trade deficit is harmful when an economy is not utilizing its full capacity (such as unemployed workers).
The second one is because people who are in debt must cut back on their spending, while creditors are under no obligation to increase theirs, leading to a fall in overall spending and a balance-sheet recession.
This policy is sincerely advocated by liberals as a temporary method to get us out of this recession, not a long-term redistributionary strategy.
While inflation does not increase wealth, it doesn't reduce it either. Paper wealth such as bonds and stocks are exactly equal to liabilities, and inflation reduces the value of both by the same amount. The value of real wealth, such as physical and human capital, remains unchanged. Since the world holds more of our debt than vice versa it's something of a wealth transfer from them to us, however the wealth benefit of taking that wealth is outweighed by the consequent skeptical outlook they'd take to buying our debt in the future.
November 10, 2010, 11:12 amWont:
I'm laughing at this:
"This policy is sincerely advocated by liberals as a temporary method to get us out of this recession, not a long-term redistributionary strategy."
I'll probably be able to stop laughing when, for the first time, I hear a liberal argue that it's time to dial back one of these 'temporary' redistributionary strategies...
November 10, 2010, 11:30 amgadfly:
"As I understand it, the theory is that this will boost the price (and thus reduce yields) on the government bonds on the balance sheets of private banks. This will in turn have two effects: improve (at least on paper) the balance sheets of banks, hopefully making it more likely to lend; and it will reduce the yield on the bonds on their balance sheets, hopefully making private loans look like a better investment in comparison."
This all sounds reminicent of the much publicized Enron scandal. According to Wiki:
"In an article by James Bodurtha, Jr., he argues that from 1997 until its demise, 'the primary motivations for Enron's accounting and financial transactions seem to have been to keep reported income and reported cash flow up, asset values inflated, and liabilities off the books.'"
This, of course, resulted in a heavy dose government solutuions including Sarbanes-Oxly regulation and mark-to-market accounting which later collapsed the 2008 mortgage bubble. Now I know what "What goes around comes around" means.
This, in turn, begs the question, "Who oversees the overseers?"
November 10, 2010, 12:09 pmJoseph K:
The rationale behind inflating the money supply is to encourage banks to lend more and customers to borrow more. It's done by both increasing bank balance sheets and by driving down interest rates. The idea is that when people increase their debt, they increase their spending and then the increased spending will spur economic growth. The analogy that people who advocate think of is that the economy is like a car that's battery has died and just needs a jump start to get going (as opposed to a solar-powered car that's batteries have died).
There are two problems with this reasoning. First of all, increasing debt levels increases economic volatility. Just as a person who lives hand to mouth while paying down debt is in serious financial straits when they lose their job (whereas a person who has large savings can easily survive a period of temporary unemployment), an economy with high savings rate is very sensitive to economic fluctuations and thus can be easily plunged into a recession. Second of all, inflation isn't distributed equally. People who advocate inflationary policies essentially assume that inflation spreads instantly throughout the whole economy. The reality is that some people see the increased money before prices start to rise, whereas some people see it afterwards. Thus, inflation also acts a redistribution of money to those who create the new money and receive it first (the banks and their immediate borrowers) away from those who won't see the new money until later. Thus, it helps people at the expense of others.
November 10, 2010, 1:05 pmMark:
what many people don't realise, is when the fed reserve pumps in more dollars into the economy there is a multiplier effect, based on what banks hold in reserve (currently about 5% so 1/.05 ~20x) so if the fed puts out one extra dollar the multiplier effect turns that into 20. So when you read that the fed wants to put $600 billion into the economy through the purchase of bonds, they know that they are actually increasing the money supply by $12 Trillion. Yes $12 trillion. You can read about the bank money multiplier effect online.
The problem is that all this extra money needs to be absorbed somehow, and usually that causes inflation in the host country. But this time people do not believe it is worth investing in the USA, so the money is actually going overseas to exporting nations, like Brazil, and Hong Kong, and other countries that peg to the dollar, and are causing economic havoc with gross inflation.
November 10, 2010, 5:02 pmJohn Moore:
I think there's another issue here... there appear to be structural reasons that make deflation more damaging than inflation (we're not talking "hyper-" in either case). In a nation with lots of private debt, deflation leads to the sort of defaults we see in the housing bubble. Inflation does not. Inflation has been continuous since the Great Depression, so it is deeply built into the system at this point - removing it is the equivalent of changing the rules that drove huge amounts of investment.
Hence if one is to play with monetary remedies, inflation probably makes more sense than deflation.
Pne big fear is that the Fed has greatly increased the monetary base, without much effect (other than to enrich the banks). If things pick up and the Fed can't pull that money back out, the inflation could be severe.
The other big fear is that monetary policy has done all it can do, without being able to create inflation, which implies that we might be headed towards a deflationary spiral (as happened in the late 1920s and early 1930s).
Of course, the big lever that has not been tried is improved governance: smaller government, reduced uncertainty, reduced taxes. However, the Fed is not in a position to do that, and the current government wants to go in the other direction.
It's a mess.
November 10, 2010, 5:18 pmme:
I never understood the argument that a weaker dollar would reduce unemployment - the devaluation of the dollar required to make American workers competitive with Vietnamese or Chinese workers *and* incent investors sufficiently to rebuild production chains in the US is staggering.
I like the Chinese approach to an overvalued currency (buy as many commodities on critical industrial paths as possible) much smarter and more likely to succeed.
November 11, 2010, 1:06 ammm:
What Will Sawin said. Regardless of what you think the ideal rate of inflation should be, in reality it's been around 2% for 20 years and the economy has grown to expect that. All QE aims to do is get back to that 2% rate.
The actual dollar value of QE is irrelevant; it could be $10 million or $10 trillion. What matters is the effect these new dollars have on all the other dollars currently in existence. Currently the market (TIPS spread) believes that the 5-year inflation outlook is 1.75% -- still too low, even with QE!
I'm almost as libertarian as it gets, and I endorse QE.
November 11, 2010, 8:24 amMatt:
"Of course, the big lever that has not been tried is improved governance: smaller government, reduced uncertainty, reduced taxes. However, the Fed is not in a position to do that, and the current government wants to go in the other direction."
This is the key point. They're the federal reserve. Monetary policy is what they do, so if they see a problem, they have to either ignore it or find a solution in the realm of monetary policy. The fact that a quick solution to our current mess requires assassins, rather than bankers, is immaterial to them, since bankers are what they have.
November 11, 2010, 8:34 amIgnoramus:
We're running a federal deficit of over $1 trillion this year. Somebody has to buy the necessary IOUs -- It's Bernanke, because foreigners won't do it in sufficient numbers. Isn't this the simplest explanation for what's going on.
November 11, 2010, 4:36 pmcaseyboy:
Matt, Matt, Matt - I'm going to assume your use of the word assassins is figurative and that you want to kill our leaders in a political sense by defeating them and killing their careers. My greatest fear is that government institutions are already too powerful to reverse their momentum by political means. One of our Founding Fathers anticipated problems due to his understanding of the nature of man. Here are a couple on point.
"Experience hath shewn, that even under the best forms of government those entrusted with power have, in time, and by slow operations, perverted it into tyranny." --- Thomas Jefferson
"For a people who are free, and who mean to remain so, a well-organized and armed militia is their best security." --- Thomas Jefferson
November 12, 2010, 8:24 amMatt:
"I’m going to assume your use of the word assassins is figurative and that you want to kill our leaders in a political sense by defeating them and killing their careers."
That'd certainly be the preferred way. But the next opportunity to do that is in two years, and I specifically used the phrase "quick solution". :)
Note that I'm not _advocating_ the homicide of any particular elected official...but the fact remains that, without blood, the best we can realistically hope for between now and January of 2013 is for gridlock to keep things from getting even worse than they already are, not for improvement.
Is patience preferable to homicide? I think so. It'll be expensive, but ultimately I think time is on our side.
November 18, 2010, 8:15 amQuantitative Easing:
I never understood what quantitative easing is but after reading some blogs I got some idea about it. I came to know that it is a monetary policy used by some central banks to increase the supply of money by increasing the excess reserves of the banking system. Inflation jumps with capital gain tax.
December 4, 2010, 3:03 am