November 23, 2010
Although the economy appears to have finally turned the corner, most analysts foresee a very slow, agonizing recovery ahead, particularly for employment. In light of this, the Fed has initiated an additional round of quantitative easing to improve the prospects for recovery. However, many people — conservatives in particular — have expressed strong opposition to the Fed’s plan.
Why are conservatives so opposed to the Fed’s plan to help the economy? As is clear from the 23 economists who signed a letter protesting the Fed’s move, the main concern is inflation. Worries about inflation are also behind a proposal from Rep. Mike Pence of Indiana to change the Fed’s dual mandate of stabilizing both inflation and employment to a single mandate of price stability.
The Fed’s plan, called QE2, requires printing new money and using it to purchase long-term Treasury securities from the private sector. The increase in the money supply that results from these purchases is potentially inflationary.
However, inflation won’t be a problem until the economy recovers. So long as the economy continues to struggle, there will be little demand for loans to finance new investment or the consumption of durables, and the new money the Fed creates will simply pile up in banks as idle balances. This means that the inflation problems the GOP is worried about can be avoided if the Fed reverses its policies once the economy improves, something it has assured us it will do. The worry about inflation is really a worry that the Fed won’t reverse course and undo the quantitative easing once the economy begins doing better.
Thus, the expected costs of quantitative easing depend critically upon how much faith one has in the Fed. However, the evaluation also depends upon the expected benefits. How large are the benefits? I have been skeptical about how strongly business investment and the consumption of durables will respond to a fall in long-term interest rates brought about by additional quantitative easing. And I also doubt that foreign governments will allow a substantial devaluation of the dollar against their currencies, and hence do not hold a lot of hope that quantitative easing will stimulate exports. Nevertheless, I still think there is a good chance that some benefits will occur as a result of the policy, and any improvement right now would be very valuable.
But even if the direct benefits from falling long-term interest rates and falling exchange rates are not as large as hoped, there are also benefits from avoiding the deflation that threatens the economy. Presently, inflation is on a downward trajectory and the fear is that this could eventually turn into actual deflation.
Why would a period of falling prices — something that makes goods cheaper — be a bad thing? Falling prices are generally accompanied by falling wages, and in periods of deflation wages generally fall even faster than prices. So even though prices are falling, people can’t afford to purchase as much as before. In addition the amount people owe — their debts — does not fall, they simply have less income available to pay them and this creates an additional burden. Falling prices are also bad for businesses since it makes it more likely that they will sell goods for less than they paid for them, and as with households it raises the value of their debts. Historically, periods of falling prices have not been the best of times, and there are large benefits from avoiding this outcome.
I am confident that the Fed will not let inflation become a problem in the long-run. If anything, I worry the Fed is being too cautious presently, and that it will be too quick to raise interest rates in the future. However, even if inflation does occur, it won’t be as costly as the last time inflation rose to undesirable levels. Most of our experience with the costs of inflation comes from remembering the problems that inflation caused in the 1970s. At that time there was little automatic indexing of interest rates, wages, pensions, and so on to inflation, and when inflation hit the economy it had large unintended effects. However, since that time inflation has been largely institutionalized and there are now many automatic mechanisms such as variable interest rates and automatic income adjustments that kick in and prevent inflation from imposing the kinds of costs that we saw in the 1970s.
The bottom line is that I think those opposed to the Fed’s new round of quantitative easing have it wrong. The expected costs of the Fed’s plans are relatively low while the potential benefits, though not huge, are certainly large enough to justify the Fed’s choice to try to help the economy.