The Conservative Case for QE2

by David Beckworth

A spike in the demand for money has significantly hampered spending, and quantitative easing can help to fix it.

The Federal Reserve is back at it. After increasing the monetary base — currency in circulation and bank reserves — by about $1.2 trillion over the last two years, the Fed has decided to expand it again, by another $600 billion. This second round of “quantitative easing” or QE2 has many conservatives worried. They are concerned that these staggering increases in the monetary base have the potential to unleash a 1970s-type inflation and put the country on the path to economic ruin.

Because of this unease, QE2 has been widely criticized by conservative commentators — including Sarah Palin, Rush Limbaugh, and Glenn Beck — and has led Republican representative Mike Pence (Ind.) and Republican senator Bob Corker (Tenn.) to introduce legislation that would change the mandate of the Federal Reserve.

But in fact, if it works according to plan, QE2 will promote conservative principles.

One reason for this confusion is a failure by some conservative commentators to understand the real purpose of QE2. It is not solely about lowering interest rates, increasing bank reserves, and encouraging bank lending, though all of those will occur. Rather, it is about fixing a spike in the demand for money that has significantly hampered spending.

To better understand this excess-money-demand problem, consider the figure below, which is based on data from the Federal Reserve and the Survey of Professional Forecasters. It shows total current-dollar spending in the U.S. economy, as measured by nominal GDP, for the period 1993:Q1 through 2010:Q3; the consensus forecast for the series up through 2011:Q4; and the 1993–2007 trend. Note the 2008 drop in total current-dollar spending relative to its former trend. The gap between the trend and reality is projected to get larger through 2011. In fact, by 2011:Q4, total current-dollar spending will be about $2.14 trillion below its trend.

Why the drop in 2008, followed by a sustained slump? The easy answer is that the housing bubble popped and caused a financial crisis. The resulting uncertainty from this crisis curtailed aggregate spending, which continues to stay depressed because of the ongoing deleveraging cycle.

While there is some truth to this view, it is incomplete and ignores some basic issues. First, total current-dollar spending is the product of the money supply and how often it is spent. Because the monetary base has been increasing so rapidly and there has been very little inflation, it must be the case that demand for the money must be increasing even more. In fact, money demand has been so pronounced that even the previous $1.2 trillion increase in the monetary base was not enough to prevent outright deflation in 2009 or a sustained decline in core inflation (which shows the trend path of inflation) over the past two years. Thus, a significant portion of the money supply is being hoarded and not spent. This is the excess-money-demand problem.

Second, the explanation incorrectly assumes the entire U.S. economy is on a deleveraging cycle. It fails to recognize that for every debtor there must be a creditor. Thus, for every debtor who is cutting back on spending in order to pay off his debts, there is a creditor receiving money payments. In principle, these creditors should be increasing their money spending to offset the decline in money spending by the debtors — but if that were happening, there would have been no decline in overall total current-dollar spending. Instead, creditors are sitting on their money because they see an uncertain economic future. Creditor households are reluctant to buy new cars or get their kitchens remodeled lest they lose their jobs in the future. Creditor firms, meanwhile, are reluctant to build new plants since they cannot see how they would be able to sell all the new production coming from those plants. Similarly, creditor banks are not increasing lending as there is little demand for funds and few creditworthy borrowers.

If these creditor households, firms, and banks all simultaneously started spending their excess money balances, this would increase total current-dollar spending and in turn spur a real economic recovery. Moreover, knowing that the real economy would improve would feed back and reinforce current spending decisions by the creditors — creditor households would buy new cars and remodel their kitchens, creditor firms would build new plants, and creditor banks would increase lending. A virtuous cycle would take hold and push the economy back toward full employment. But this virtuous cycle is not taking off because creditors are still hanging on to their money balances. What is needed to kickstart this cycle is an entity powerful enough to incentivize all the creditor households and firms to start spending their money simultaneously.

Enter the Federal Reserve. It alone has the ability to provide these incentives through its control of monetary policy. The fact that total current-dollar spending has remained depressed for so long means that the Federal Reserve has failed to do its job and effectively has kept monetary policy too tight.

QE2, then, is a long-overdue attempt by the Federal Reserve to address the excess-money-demand problem. It will do so in two complementary ways. First, QE2 will increase inflation expectations, which should reduce the demand for money. Knowing that prices will be higher in the future will motivate creditor households, firms, and banks to start spending their money today while prices are lower. Second, QE2 will increase the monetary base, and this should begin to satiate excess money demand. Together, these developments should provide the catalyst needed to get the virtuous spending cycle started.

Note that lower long-term interest rates are not the key to QE2 working. Yes, long-term interest rates may initially drop as the Federal Reserve buys up long-term Treasury securities to increase the monetary base. But this effect will be fleeting if QE2 is successful. Once the economy starts recovering, interest rates will start increasing. Similarly, QE2 may initially cause the dollar to lose value, but by spurring a recovery QE2 will ultimately put upward pressure on the dollar.

So how does QE2 promote conservative principles? It does so by reducing the likelihood of further government spending on the economy. Currently, there are important structural adjustments occurring in the economy such as the retooling of workers and the deleveraging of debtor households. These adjustments would be easier and in some cases expedited if QE2 were successful in spurring economic growth. Workers, for example, would have greater opportunities to retool — on-the-job training, higher income, more educational and employment options — and debtors would have both higher incomes to support their debt repayment and lower real debt burdens. Obviously, QE2 would also address the weak-demand problem, which would further shore up employment and income growth. By supporting such a market-based recovery, QE2 would eliminate the need for further fiscal stimulus. Programs like extended unemployment benefits would disappear, and budget deficits would be harder to justify. The federal government would be put on a more solid path to fiscal solvency.

In fact, had the Federal Reserve fixed this money-demand problem two years ago, when total current-dollar spending originally crashed, the fiscal deficits would have been far smaller. Instead, monetary policy was effectively kept tight, and expansionary fiscal policy was used in its place. Something similar happened in the 1930s: As shown by Milton Friedman and others, monetary policy was kept too tight by the Federal Reserve. As a result, an ordinary recession got turned into the Great Depression. The severity of the Great Depression created a clamoring for something to be done. That something turned out to be increased government spending and involvement in the economy. Thus, whether it is the 1930s, the 2000s, or some other period, tight monetary policy will typically lead to more government intervention. Conservatives, therefore, should be supporting QE2.

Unfortunately, QE2 may not live up to its potential for several reasons. First, QE2 was not implemented in an optimal fashion. It should have been enacted in a rule-based fashion, with a clear, explicit objective. For example, the Federal Reserve could have announced a price-level target of 2 percent that would be maintained at any expense. This would have increased long-term certainty about the price level without requiring an explicit dollar commitment up front from the Federal Reserve. Instead, the Federal Reserve did the opposite. It committed to a large, ad hoc amount of $600 billion that will be used to maintain some vague inflation target. Second, the Federal Reserve continues to pay banks to sit on excess reserves, a policy that keeps money demand elevated at banks. Thus, on one hand the Fed is promoting an expansionary QE2 policy, while on the other hand it is promoting a contractionary excess-reserve policy.

Finally, the Federal Reserve is not immune to political pressures. It is possible the current criticism aimed at the Federal Reserve will make it more timid in implementing QE2.

Conservatives should not let this happen. They should throw their support behind the Federal Reserve while encouraging it to refine QE2 by tying the policy to explicit rules. Conservatives, especially, need QE2 to work.

— David Beckworth is a former economist with the U.S. Department of the Treasury and is currently an assistant professor of economics at Texas State University.