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.

The Fed Moves in, Queue the Inevitable Inflation Politics

The Fed's unprecedented monetary policy is the top economic news of the week. I'll let the New York Times do the busy work.

The Federal Reserve opened a new chapter Thursday in its efforts to stimulate the economy, saying that it intends to buy large quantities of mortgage bonds, and potentially other assets, until the job market improves substantially.

This is the first time that the Fed has tied the duration of an aid program to its economic objectives. And, in announcing the change, the central bank made clear that its primary reason was not a deterioration in its economic outlook, but a determination to respond more forcefully — in effect, an acknowledgment that its incremental approach until now had been flawed.

Tyler Cowen was one of the first to point out that this is Scott Sumner's revolution. We all are just privileged to live in it.  As he writes,

The Fed’s policy move today might not have happened — probably would not have happened — if not for the heroic blogging efforts of Scott Sumner. Numerous other bloggers, including the market monetarists and some Keynesians and neo Keynesians have been important too, plus Michael Woodford and some others, but Scott is really the guy who got the ball rolling and persuaded us all that there is something here and wouldn’t let us forget about it.

Although this blog cheers the new direction taken by the Fed, we're not here to discuss monetary policy in a lot of detail. I'm just not that good at it. Dr. Sumner's blog is a much better place for that. On the other hand, the Fed's actions have brought back the politics of inflation, sometime that's very close to my heart. The bullhorns were loud and clear over at CNBC.

Central bankers are “counterfeit money printers” and Federal Reserve Chairman Ben Bernanke should resign for messing up the U.S. economy so badly, Marc Faber, author of the Gloom, Doom and Boom, told CNBC on Friday.

He said Bernanke was one of the main proponents of an ultra-expansionist economic monetary policy that was to blame for the latest financial crisis.

“If I had messed up as badly as Bernanke I would for sure resign. The mandate of the Fed to boost asset prices and thereby create wealth is ludicrous — it doesn’t work that way. It’s a temporary boost followed by a crash,” Faber said.

So what's going on? As usual, the first place to look in these sorts of debates is motivated reasoning. Marc Faber, of course, is a hedge fund manager. And he, like many other wealthy people, has very good reason to fear inflation. It will quickly and sharply eat into his assets. Once you see this, all of his other proclamations of doom and gloom can basically be ignored. Faber stands to lose a lot of money if monetary policy gets especially loose. End of story.

And while many economists lament the silly public debate over this issue, there is almost no controversy among economists about the effects of moderate inflation on employment. expansionary monetary policy benefits poor people at the expense of rich people, especially those who derive their income from wealth, i.e. people like Marc Faber. As Coibion, Gorodnichenko, Kueng and Silvia explain in an IMF working paper,

Contractionary monetary policy shocks appear to have significant long-run effects on inequality, leading to higher levels of income, labor earnings, consumption and total expenditures inequality across households, in direct contrast to the directionality advocated by Ron Paul and Austrian economists. Furthermore, while monetary policy shocks cannot account for the trend increase in income inequality since the early 1980s, they appear to have nonetheless played a significant role in cyclical fluctuations in inequality and some of the longer-run movements around the trends. This is particularly true for consumption inequality, which is likely the most relevant metric from a policy point of view, and expenditure inequality after changes in the target inflation rate.

In other words, inflation is a tax on wealth-holders used to encourage more spending. This relationship and its mechanism have been known for quite some time, essentially since the creation of the Philips curve. In that sense, Ron Paul is right; he just conveniently forgets to mention who benefits and who loses. Moderate inflation, similar to the kind that the Fed is currently implicitly pursuing, will create demand and jobs, the things that America's workers actually need. The only real question among economists is how much you can reasonably sop the rich to do something like this. There has to be limits, which is why you don't want inflationary pressure when unemployment is already around ~5 percent.

This is discussed a lot in Larry Bartels' Unequal Democracy (and in this related in the post on this blog). Republican presidents have traditionally presided over monetary regimes that are contractionary, while Democrats have pursued something slightly more expansionary. Obviously, the relationship isn't completely perfect, since it's a small data state dominated by Reagan and Carter. Nonetheless, the relationship is there, and it becomes most apparent once we look at GDP growth by p 

Chart taken from the Lisco Report. The original can be found here.

That's why Republicans are good at ensuring decent growth in the incomes of rich people and more importantly, creating the incentives to build and hang on to wealth, as Bartels' data clearly points out. 

There's really no doubt about it. For anyone that considers 8 percent unemployment an big deal, today's action by the Fed is great news.