Quantitative Easing? I’m For It! (11/5/10)

November 5, 2010

Much commentary has been appearing about the Federal Reserve’s plans for quantitative easing, dubbed QE2 because of its being the second time around in the current recession/weak recovery.

With interest rates close to zero for short maturities, and at modern record lows all along the yield curve, little can be gained from even lower levels.  And with the Fed having full employment as part of its mandate, the central bank is in a “what do we do now?” dilemma.  The dilemma is accentuated by there being little political likelihood of any further fiscal stimulation to the economy.

The Fed’s answer is to pump additional bank reserves in to the system by open market purchases of longer-maturity government bonds, hoping to see a further decline in longer maturity yields, and an expansion of the money supply that will kill the deflationary forces that are holding back economic recovery, and hopefully even put some inflation back in the system.

Well, you can hear the screams from some of Wall Street’s prominent economists. They maintain that lack of money is not the problem; high unemployment is structural and needs to be dealt with as such. The Fed’s action, they say, will further assure an ultimate takeoff of serious inflation and trash the dollar, while doing nothing to stimulate the economy. What the Fed is hoping for, they claim, is to bolster asset prices, particularly stocks and real estate, which is a weak and unsustainable way to stimulate confidence and spending.  Some say it’s yet another case of the Fed promoting a bubble.  Others say it’s Japan all over again; it didn’t work there and it won’t work here. Leaders of emerging economies are complaining about a lower dollar adding to already booming economies.

The markets’ reactions so far seem to confirm these fears; the dollar has fallen, commodity prices have risen sharply, and the stock market has been strong. But wait a minute, isn’t this exactly what the Fed is trying to accomplish? A lower dollar stimulates exports and inflates import prices; higher commodity prices create a tad of inflation without beginning a wage/price spiral, and higher stock prices raise wealth levels and give confidence a boost. And all based only on the announcement of QE2, not its implementation. Sounds pretty good to me!

I agree that the unemployment problem is importantly structural in nature. Manufacturing activity is less and less reliant on labor in general and lower skilled labor in particular. Service industries are much the same; information technologies have reduced the use of people. Our education system is lousy. The growing efficiency of emerging economies is giving us stronger and stronger competition in an increasing array of products and services.

But these are not problems the Fed can address. Besides, the structural issues are not 100% of the problem. Cyclical forces holding back the economy are also at play.

It appears that the critics’ cynicism stems from watching the Fed make twin mistakes a decade apart.  In the mid to late 1990’s Greenspan and Co. shunned any actions to cool the dotcom stock market bubble. Then early in the current decade there was no recognition within the Fed of the housing bubble and the dangers it contained. Following the stock market bust of 2000-2001 interest rates were kept too low for too long, letting the financial engineers of Wall Street drastically over-exploit the new markets for securitized debt, especially mortgages.

I concur that the Fed made these two bad mistakes. But that was then not now. A new bubble growing out of the current economic environment seems highly unlikely to me. Utilization of both physical capacity and labor are simply too low to worry about any bubble/inflation for some time to come.

Conclusion: I don’t have perfect conviction that QE2 will produce significant results in terms of significantly goosing economic activity, but my education and rearing as a monetarist lead me to bet that way.  It’s the same bet I made in early 2009 based on the Fed’s quantitative easing. It worked. Just as I thought then that the Fed had taken a depression off the table, I now believe that we will be witnessing a stronger and more sustainable tone to the recovery, at least partly because of the Fed’s actions.

The key questions for the future, of course, are whether, how, and when the Fed reverses course.  Can they really take back out of the system the funds they will have put in? Can they time any such actions appropriately? These are bothersome and unanswerable. Not because the Fed doesn’t have the tools to reverse course. It does. But the questions bring threats to the Fed’s independence into sharp focus. I am considerably discomfited by the increasingly loud voices calling for inhibiting the central bank. A stark historical fact is that never in economic history has there been a case of hyperinflation in a country with an independent central bank. Let’s hope that our politicians recognize that.

The main ingredient still missing for the economy and markets is a credible plan for reducing the federal deficits. Let’s hope that the election brought at least a tough-minded beginning to that process.