‘To economists reading this essay in 2010, perhaps the most remarkable single fact to note about monetary policy at the end of the interwar period” — the author, Columbia University economist Charles Calomiris, is of course also talking about the end of the Great Depression — “is that its architects were, for the most part, quite pleased with themselves. Far from learning about the errors of their ways during the interwar period, Fed officials congratulated themselves on having adhered to appropriate principles, and to the extent that they were self-critical, it was because they thought that they had been too expansionary.”
Almost all economists today agree that monetary policy during the Depression, especially its early stages, was disastrously tight, indeed that this contractionary policy is the principal reason the Depression became Great. But perhaps we should not judge the central bankers of America in the 1930s too harshly. For one thing, as Calomiris notes, smart economists are still arguing about the precise nature of the Fed’s policy mistakes. He himself presents evidence against the received view that the Federal Reserve precipitated the “recession within a recession” of 1937 by raising banks’ reserve requirements and thus discouraging lending.
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More important — and more disturbing — is that it is not at all clear that we have learned from the mistakes of the 1930s. Those central bankers believed that money was easy because interest rates were low and the monetary base (the supply of money under the Fed’s control) had expanded. They worried that further easing would reduce confidence in the dollar. British economist R. G. Hawtrey, writing in the late 1930s, described the climate of opinion in his country at the start of the decade: “Fantastic fears of inflation were expressed. That was to cry ‘Fire! Fire!’ in Noah’s Flood.” The economy was actually deflating, not inflating. Under the influence of the “real-bills doctrine,” some central bankers believed that the money supply should respond only to traders’ need for credit. Anything else would only fuel speculative excess.
Today’s inflation hawks employ the same reasoning that those firefighters did. And they are not wholly wrong. Easier money can lead to a destabilizing run on the currency. Inflation can be associated with low real interest rates and an expanded monetary base. But not always: Not in the 1930s, and almost certainly not today, either. The late Milton Friedman, perhaps the most famous inflation hawk of his generation, spotted the fallacy in his analysis of 1990s Japan: Low interest rates can also be a symptom of an excessively tight monetary policy that has choked off opportunities for growth. A looser policy, by increasing expectations of future economic growth, could actually raise real interest rates.
To see why changes in the monetary base are also an unreliable guide to whether money is loose or tight, I’m afraid it’s necessary to look at an equation. Friedman and others familiarized us with the equation of exchange: MV=PY. What that means is that the money supply (M) times the speed with which money changes hands (V, for velocity) must equal the price level (P) times the size of the real economy (Y). If velocity holds constant and the money supply goes up, either prices must go up or the economy must expand or both.
If, on the other hand, velocity drops — if people have an increased desire to hold money balances — then either prices must drop or the economy must shrink or both. And prices, especially wages, are sticky. They won’t automatically and evenly fall in response to a shock. So at least some of the reduction in PY, and maybe a lot of it, will have to come from real economic contraction. What this suggests is that if velocity drops unexpectedly, stabilizing the economy will require increasing the money supply to make up for it. Another way of putting it is that if the demand for money balances increases, the money supply has to grow to accommodate it. If the Fed does not increase the money supply, its inaction in the face of changing economic conditions amounts to passive tightening.
The money supply is itself the product of the monetary base (B) and the “money multiplier” (m), which measures how changes in the base are being converted into changes in commonly used monetary assets such as checking and money-market accounts. So — I promise this is the last equation — BmV=PY. David Beckworth, a conservative economics professor at Texas State University who maintains a blog, has shown that at the height of the financial crisis in late 2008, velocity dropped significantly and the money multiplier fell off a cliff. The monetary base grew a lot too: The inflation hawks are right about that. But it grew enough to offset only the fall in the money multiplier. It didn’t offset the fall in velocity.
We have had a short period of weak growth and you are declaring "mission accomplished" already? No. It is far too early to know if QE2 worked. There are signs of inflation everywhere.
1. No serious person still accepts the BLS BS inflation numbers.
2. The Swedish geniuses who give awards for coconuts also gave prizes to Gore and Obama.
3. "Almost all economists" is the first clue you have no clue. Read Money, Bank Credit, and Economic Cycles by Jesus Huerta de Soto.
Ponnuru makes the same basic error as the bloggers whose views he has apparently taken up: He assumes that the economy shrinking is always and everywhere a bad thing. He cites Friedman's equation and points out that if velocity drops, either the money supply has to increase or the economy has to shrink, as if this, if accepted, were a conclusive argument for increasing the money supply.
But if we're in the process of unwinding an economy's-worth of malinvestment, of course the economy's going to shrink. If, economy-wide, people increase their preference for reserves, that's the same as decreasing their preference for deploying their wealth in the economy at the moment. You can't simultaneously hoard your wealth and spend or invest it. When the malinvestment has been sufficiently unwound, and uncertainty has diminished, to the point where people again want to deploy their wealth in the economy, then velocity will increase, and the economy will grow again.
Instead of letting the market determine when that happens, Ponnuru's/Bernanke's solution tries to manipulate people into acting against their better economic judgment in order to goose short-term spending and GDP figures. In so doing, it brings about further malinvestment and sets the stage for the next crash.
Currency debauchment (AKA inflation) is a pitfall no doubt of sovereign debt monetization, but that is not the worst peril. Today, the sovereign debt situation is one of insolvency. Also the financial sector is insolvent. Yes you can buy time by pumping liquidity in, but if you walk away from the solvency issue, an even larger deflationary reset will occur in time. Better to re-organize and write down bad debt, take a recessionary hit and rebuild from there. Current monetary policy helps to delay and but not eliminate the final reckoning.
What is the mpact of QE2 on the value of the dollar? Also the impact of lower interest rates seriously impacts those whose savings were supposed to be a supplemental income in the retirement years. An entire spending source sector: the retirees who saved their money have had their incomes truncated because of poor return on on less risky investments. Economic recovery was at the expense of the most responsible members of society. Those who saved for a rainy day.
Believe me I can see a very dramatic impact upon my lifestyle as a retiree because of the low rate. We were the economic sacrifical lambs. That will get worse when the numbers of baby boomers increase. Only compensation or perhaps commiseration is the 1099s have smaller amounts on them. QE2 just makes the funny money just that more worthless.
The market collapsed in 2008 because there was never enough money to cover the historic losses in the derivative markets. The entire house of cards collapsed taking Bear Stearns and others with it. In a period of 6 months trillions of dollars in liquidity were wiped out. The real estate and mortgage markets collapsed, and there was real danger that a repeat of 1932 was at hand. It should also be noted that like 1932, 2008's deflationary crisis also brought on a collapse of oil and commodity prices, which were priced well above supply/demand.
TARP I and II was designed to correct the problems in the mortgage markets. But as we saw, the removal of the Mark-to-Mark rules of SARBOX did more to help the banks than either TARP did. And QE I and II was designed to stabilize our monetary system.
I give Bernecke high marks for acting boldy. I just think his actions were reckless. And I think he has put politics above many other considerations. QE I and II, despite what the "experts" say has resulted in trillions of dollars in new liquidity to be injected into our financial systems. Heck, the money flows directly from the Fed to the Treasury and back to the Fed again. In the mean time it is spent (ie injected into our economy), but that money has never been "earned"; it is borrowed from future earnings. Currently, $3-4 billion a day is being injected into our economy via the federal government. And as the Federal Reserve continues to monetarize our debt commodity prices are going up and up. All of that capital has to go somewhere, and Bernecke's Coup de Whiskey", like Strong's QE in 1929, is fueling speculation.
Bernecke along with Geithner are complicit in the staggering amount of debt (Quantitative Easing) that the President and his party racked up. The recovering of the DJIA, energy prices, commodities, etc mirror this debt accumulation. Last month alone, the federal government borrowed nearly $200 billion; over 180,000 jobs were created in March. That comes to nearly $400,000 of QE per job.
Let's see,
Gas is at $3.89 today at the station I filled up at, it was $3.57 last week.
I've received yet another notice from BCBS that my monthly premium will rise $103.15 this month (it increased $400 over the last two years)
On average my grocery bill has risen roughly $20/wk, and this includes increased coupons and more selective purchasing decisions.
There is a notice that my water bill will increase between 7 and 11 percent shortly.
Those numbers project out for the year as:
Gas up $1500
Ins up $1200
Food up $1000
Water up roughly $400
That's $4100/yr more for the same (or lesser) previous purchases.
That, my friends, means less disposable/discretionary income, and it is that income being infused in the economy that turns our situation around and grows it.
I simply cannot understand how/why NRO continues to hold water for the Fed. Yes, Milton Friedman famously condemned the Fed for being too tight, and causing the Depression. Friedman's Monetarism had its hay day, was tried in Britain and the United States. Thatcher abandoned the policy. Friedman backed off and reversed course.
This wasn't accidental. There is simply no way that statistical surveying can convey the aggregate time preferences of an entire nation. Price information that is used for economic decision making is generated by exchange, not by prognostication, or reading the statistical tea leaves.
Inflation does nothing but distort prices and redistribute wealth. Smart money is smart for a reason - it can, better than others, predict growth and inflation expectations. The argument, so utterly naive and dismissive of reality, that consumers and other "economic agents" need their outlook readjusted by the Fed and its machinations overlooks the fact that most consumers have no idea what the Fed does, much less the tactics it is implementing. Consumers (that is, not businesses) are all but totally ignorant of the Fed, and they make up 70% of the economy.
NRO should follow not Friedman in this regard, but Hayek, who spent much of his career criticizing centralized decision making, particularly as to how to it affects the information contained in prices. Mr. Ponnuru, usually so thoughtful and considered, does not appear to recognize that once QE2 terminates, interest rates will necessarily rise, as "pump priming" is the only thing keeping these rates perpetually low. (One is tempted to call this an amateur error, but in a world where even the financial press doesn't quite "get it" it's hard to lambaste Ramesh.)
These higher rates will again endanger the pyramid of credit. At that point we can either pursue QE3, or face the liquidation and bankruptcy which we've put off for so long.
Hayek famously wrote, I paraphrase, that there's no wonder we have such money problems. The money selected by the free market - gold (and other precious metals) - has scarcely been given a chance to function as money without incessant government intervention. Reviewing a millennium or two of economic history tends to confirm Prof. Hayek's conviction. The history of money is inseparable from the history of rule. Only for a brief period of ~100 years did the Western world keep to a relatively straight gold standard. The other 4,900 years of human history are littered with fiat money schemes, debauchment, interest rate manipulation, and monetization of debt.
When trying to use the history of the 1930s as a guide for what to do and not to do, it's important to keep the differences as well as the similarities in mind. Even if Ramesh is right about what Hoover's and FDR's economists should have done, it doesn't follow that a similar prescription makes sense today.
In 1935, increasing the money supply meant injecting savings into the economy. But all the money, new and old, was real (gold-backed). Today, increasing the money supply means printing more fiat currency. Apples and oranges. You can release funds to boost the economy without causing inflation when the money is real. When new money is just a dilution of current money, you're causing inflation by definition.
Persuasive piece. Ramesh's approach is really balanced - it lays out the facts in an interesting way without resorting to pushing readers' emotional buttons (as my man Derb is known to do at times).
One thing this article doesn't mention is that now, more than ever, this freshly printed money instantly starts ricocheting around Colombia, Russia, China...and then when it gets unwound, we could be pulling the rug out from someone who could trip us up as well (pardon the mixed metaphors).
It occurs to me that the most important point in the whole piece (which is very well done, btw) is that "experts" are still debating a chicken and egg question 80 years after the fact, the parties not able to even agree generally on which chicken and which egg, while at the same time applying the "wisdom" gleaned from such discussions to the raucous, chaotic hen-house of the present, filled as it is with many chickens, many eggs, several well-fed foxes and tired, self-satisfied roosters, and what might just be a goose in a chicken suit.
Perhaps the problem is not with this or that policy (he said trying and failing to artfully drop a tired metaphor) but rather that we are relying on these "experts" in the first place. I get the feeling a groundhog could manage our economy and have about as good a chance of "getting it right" (whatever that means) as our financial overlords.
Would we be better off advocating for a real money economy, back by gold or silver (or both)? Or platinum? Or aged cakes of tea? Or perhaps a tchotchke-standard? My wife's Grandfather's place is full of them; I'd be filthy rich.
Hmm... thoughtful analysis. Two things though: 1. No mention of the Fed's purported reasoning for QE-- i.e reduce long-term rates to help the US housing market and improve US homeowner balance sheets; and 2. No mention of US National debt. Those omissions are telling. Firstly, long-term/mortgage rates are up since QE especially QEII-- so if that was the real reason, QE has been epic fail. Second, QE would have been a fabulous idea IF, it was done in conjuction with Merkel style gov't budget cuts in Germany. It wasn't, it was done in connection with massive federal government debt spending. So in the end, the Bernanke's QE was nothing more than a cynical dollar debasement play to cheat US Debt creditors by paying them back with cheaper dollars. That's all. The critics are right, this is nothing but Ben printing money because he can, to sustain deficit spending. This is our Central banker? Jeez.
How convenient, a superficial analysis of two financial crises that completely omits the entire Austrian Economic viewpoint, the only school of economic thought that grew out of the failure of traditional economics to predict these financial recessions.
I would suggest that NRO get themselves an Austrian economist on the editorial committee pronto.
Those who ignore history are condemned to repeat it. (In the case of economic history, follow Japan off the cliff.)
For those who want a legitimate analysis, try Mike Shedlock at External Link.
One of the top individual economic blogs in the world, followed by billionaires and the individually concerned alike.
There are three huge flaws with your piece. First, monetary policy has no medium or long term effect on real economic growth (the "Y" in your equation). Therefore, to use monetary policy to try to manage nominal GDP growth is folly. Real economic growth is a function of hours worked multiplied by output per hour. The former is largely driven by demographics and the latter is productivity. Monetary policy has no impact on productivity. Second, how can anyone say monetary policy is tight when every indicator is flashing red? Gold is up. Commodities are up. Long term interest rates are up. Why do you think PIMCO is no longer buying treasury bonds? The Fed has a brutal choice come June. If they stop buying treasuries (i.e., monetizing the debt), then interest rates will skyrocket as the Fed has been buying 70% of the new bond issuance according to PIMCO. If they keep printing money, inflation will break out. Third, velocity has been down because the demand for money has been tamped down by all the uncertainty around Obama's policies. Who would want to borrow and invest in the face of Obamacare, an EPA run amok and massive federal borrowing speeding us towards insolvency?
I don't understand any of this. What I do understand is that I'm one of those senior idiots that kept money in a bank account thinking that, any day, interest would rise. TARP and the QEs kept interest low. Great! I won't be a sucker and part of it next time. The only good thing about low interest for us savers is you don't have to pay taxes on it, which of course, adds to the deficit.
Was the Soviet Union successful in centrally planning the price and quantity of wheat to be produced? No, of course not. Were they not successful because they had the wrong central plan, or because central planning always fails? I would imagine you would say it's because central planning always fails.
Yet in your article you exhibit the fatal conceit that we can have economic success if we do the "right" central planning of the price and quantity of money. No, no, no! Central planning of any commodity ALWAYS fails. You completely ignore the fact that it was the Fed's poor central planning that inflated the bubble up to 2008, with disastrous results culminating ultimately in the election of the worst president in our history. These are bad, bad, BAD outcomes.
It's time to put a leash on the Fed. No more central planning, period.
I don't understand how QE2 increased the money supply. The money the Fed created wasn't used to give borrowers (besides the U.S. Treasury Dept.) loans. It was used to finance deficit spending. It was used primarily to "monetize the debt."
Moreover, Since traditional purchasers of U.S. Treasury Securities are running for the hills (e.g. Pimco), the Federal Reserve stepped up to the plate.
