While a lot of attention has been paid today to the "luminaries letter" in the Wall Street Journal urging the Fed to give up quantitative easing, a similarly aimed if better reasoned piece by federal judge Richard Posner seems to have escaped attention.
In his usual direct style, Posner begins by criticizing the term “quantitative easing” as “a pompous, uninformative term for a central bank’s buying debt (bonds, mortgages, commercial paper, etc.) in quantity in an effort to depress interest rates in order to stimulate economic activity.”
Posner goes on to discuss the problems with quantitative easing. His main objections: It runs the danger of creating runaway inflation; it threatens to upset our global trading partners, and it allows politicians off the hook for making serious economic reforms.
Most importantly, however, he says it won’t work.
So “quantitative easing” is a rational response to a depressed economy with stubbornly high unemployment and very low inflation. But that doesn’t mean it’s a sensible response. There are three principal objections to the new program. The first is that the inflation that it aims to increase by a slight to moderate amount may get out of hand. Suppose businesses and consumers increase their spending, and the banks lend the $1 trillion they’re holding in excess reserves (accounts in federal reserves banks, equivalent to cash). The ratio of money in circulation to goods and services will rise, and inflation will tick upward, perhaps more than desired. The Fed can reduce the money in circulation by selling some of its huge inventory of bonds, but by doing so it will raise interest rates (just as increasing the demand for bonds lowers interest rates, increasing the supply raises them), which may choke off the economic recovery. If it hesitates to sell bonds and retire the cash it receives from the sales, expectations of inflation may soar, and inflation rise to a dangerous level; and to bring it down the Fed will then have to sell bonds after all, draining money out of the private economy at a rate that brings on the kind of very sharp recession that the nation experienced in the early 1980s.
No one knows or can know whether the Federal Reserve can walk such a tightrope. Even if it can do so as a technical matter, political pressures may cause it to fall off the tightrope. The Fed will be subject to greater political pressures, beginning in the near future, as a result of the financial regulatory reform legislation passed earlier this year, which by giving the Fed regulatory authority over financial institutions that are not commercial banks is increasing its political exposure.
The second objection to the new program concerns its effect on the role of the United States in the global economy. Nations such as China, Germany, and Japan that are large exporters are irate at our devaluing our currency by increasing the world supply of U.S. dollars. They are capable of retaliating, and if as a result our trade balance does not improve significantly the program of “quantitative easing” may end up having no beneficial effect other than to increase inflation, which may as I said get out of hand.
Moreover, the U.S. dollar is the major international reserve currency. That is, it is the currency in which many international transactions not limited to transactions with U.S. firms are denominated because of the stability of the dollar. The status of the dollar as the international reserve currency requires foreign central banks to buy dollars in quantity so that firms in foreign countries can buy dollars for their international transactions. The dollars accumulated by central banks in turn are available to be lent back to the U.S. Treasury (by purchase of Treasury bonds from it) to help finance our huge national debt. If we manipulate the value of the dollar to improve our trade balance, we undermine confidence in the dollar’s stability, and the demand for dollars as a reserve currency may fall.
The third and perhaps biggest objection to the program of quantitative easing is that it relaxes the pressure on our politicians to address urgent issues of economic reform. The politicians are sitting back and letting the Fed try to hoist us out of our current economic hole. The pressure to respond to the urgent need to put the health reform and financial regulatory reform programs on hold because of the debilitating uncertainty that they have injected into the business environment, and to take effective steps that will be politically painful (for they will include entitlements reform) toward increasing the rate of economic growth and reducing the rate of increase of the national debt, is being blunted.
These objections might recede in significance if “quantitative easing” could be expected to stimulate the economy. But that seems unlikely. Banks and corporations are awash with money. Their reluctance to lend because of the uncertainty of the business environment is unlikely to be overcome by a further and probably modest reduction in long-term interest rates—modest because of the substitution effect I mentioned earlier and because the bond-buying program will increase expectations of future inflation, which in turn will push up long-term interest rates.
His blogging colleague Gary Becker is even more direct:
Fed Chairman Bernanke wrote in an article in the Washington Post on November 4th that "The Federal Reserve cannot solve all the economy's problems on its own." The slowdown in the recovery of the American economy is not the result of Fed policy, and cannot be cured by yet another bout of open market operations. This is why the Fed should curtail, and better yet, eliminate its plans for QE2.
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