December 1, 2010


The Conservative Case for QE2: A spike in the demand for money has significantly hampered spending, and quantitative easing can help to fix it. (David Beckworth, 12/01/10, National Review)

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.

Trying to explain tight money to the gold-bug Right is futile. For them, the notion that inflation must accompany big government is ideological.

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Posted by Orrin Judd at December 1, 2010 6:13 AM
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