More QE Madness (Yes, It Worked)

It's not surprising that QE3 has emerged as a partisan topic. Although the positions against more monetary stimulus are varied, we'll address the comments that previous episodes of Quantitative Easing "did not work." The common complaint is that lending did not increase enough to justify the effort. This is partly true, but mostly misguided.

There's a lot of different places to look if you want to assess the effectiveness of QE, and lending is just one of them. You can look at the change in yields on different assets (like they did at Northwestern), and see a substantial effect.

QE1 bought treasuries and mortgage-backed securities, both saw serious drops in yields. In more layman's terms, the interest paid by the government and mortgage borrowers went down; you can see this in the decline in yields for Mortgage-Back Securities (MBS). No doubt. High-grade corporate debt also went down (since it is a somewhat similar market to treasuries), making it easier for them to borrow too.

QE2 was less effective, because it was more focused. They didn't buy MBS the second time around. Regardless, both of the previous QEs raised inflation expectations, which you could see by tracking TIPS (the inflation-protected version of US government debt). The same inflationary pressure was seen in Britain during the Bank of England's QE operations.

Because of QE efforts, the US government could actually borrow at negative (real) interest rates. In other words, the rate of interest was less than the expected rate of inflation. QE made things much easier for the government to spend some money, if it wasn't so gridlocked.

If you want to get more of the details on the current version of QE, you should check out Scott Sumner's FAQ, which describes nominal GDP targeting, a type of monetary policy that is very similar to what the Fed is currently doing. It's kind of odd, because NGDP targeting is very friendly to libertarians (and Scott is included), even though the Ron Paul variety are probably the last people to embrace this type of monetary activism. The idea is that the government should be ignored, and as least intrusive as possible. The Central Bank can create money-driven economic growth as much as it wants. I know it's a different strain of libertarianism (more Milton Friedman than Von Mises), but it's libertarian nonetheless.

So what makes this round of QE special? Well, it seems like they've been learning their lessons. They're buying the most effective asset classes for the kind of monetary stimulus they're looking for (in particular MBS). But more importantly, they're looking to change the expectations for inflation. While a target hasn't been set yet, Bernanke mentioned that they would be more accommodating of inflation if unemployment remains high. This is why the whole "open-ended" side of this round matters. They will continue to pump money, even after things start to get better. If you're sitting on cash, you're going to start losing money.

(And a quick aside on that theme. The Fed should also stop paying interest on reserves. They're currently considering it. It's just that the Fed moves at about the same speed as a glacier. It took three months of debate to get QE3, so be patient.)

I know I've said this before, but it's worth repeating. If you want unemployment to drop, you need to look to increase the inflation rate. Inflation hurts savers (and the rich in particular), in that it reduces the value of hard assets (like bonds), but it helps workers (and the poor, in particular). It makes debt easier to bear, and it encourages spending directly by creating incentives against holding cash. Both are good for attacking the unemployment.

But there's only so much growth you can get through inflation. Too much inflation (let's say 10 percent a year and higher) will cause all sorts of negative side effects. People will stop saving their money, for example. This is why the Fed has a dual mandate (employment and price stability). You have to strike a balance between the two.

It's also the angle that you'll see attacks on the Fed come from. The rich, and their financial representatives, will bitch and moan about the diminishing values of bond portfolios. They'll moan about the damage to "pensioners," conveniently forgetting that only a small portion of Americans own lots of bonds. Just ignore them. Their stake in all of this is obvious. They don't want a recovery; they just want to sit on their wealth. The Fed is making sure that they can't.