Last time we heard financial reporters say what QE2 is supposed to do. Truly these writers looked like “the blind men trying to describe an elephant.” Economists, on the other hand, are easily to be able to see the whole picture. Economists are nearly unanimous is feeling that this round of quantitative easing will accomplish next to nothing
Why is that? To see, let’s put together the pieces of QE that make up a whole elephant. Then let’s see why our elephant might not get us to here we want to go.
Why the Fed chose QE2 to rescue our elephant
Let’s start with the question of where the Fed wants our economy (our “elephant”) to go. The Feds are pretty clear about what they want to happen. They say they want to promote job growth while keeping prices stable, i.e., to avoid either harmful deflation or harmful inflation. This is actually the mandate by law for the Federal Reserve.
Where did this mandate come from? What exactly does it mean? The Fed’s mandate stems from a mathematical formula devised in the 1930s by a British Lord, John Maynard Keynes, in order to deal with the Great Depression. Keynes’ algebraic formula was designed to enable a national government, for the first time in history, to stimulate its economy out of a financial crisis.
Here, for those of you who learned it, is Keynes famous formula: G+C+I+(E-M) = Y
Each of these letters stands for something, e.g. G is for government spending, C is for private sector spending, I is saving, and E and M stand for total exports and imports. On the other side of this equation, Y stands for total national income, also called GDP (gross domestic product).
During the Great Depression, to stimulate our economy, our government substituted G, government spending, for the lack of C, i.e., private-sector spending. The government spent taxpayer money on “make-work” infrastructure projects such as the WPA. In 2008, many of us expected our government to promote job creation the same way by using direct government spending to promote entrepreneurial small business in America. We all understood that “Research shows that new businesses are the most important source of jobs…Without them there would be no net job growth at all… (“Few Businesses Sprout, With Even Fewer Jobs Wall Street Journal, 11/19/10 B1+B8)
Instead, the President and the heads of the Treasury, Fed and FDIC, chose to use indirect government spending via the financial sector to stimulate the economy. They reasoned consumers and businesses alike needed a healthy banking system to make loans in order for economic growth and employment to increase.
But the original “stimulus,” large as it was, failed to make that happen. Gillian Tett, a financial reporter for the Financial Times, suggests the Fed was not aware in 2008 that the “shadow banking” sector at $2o trillion was nearly twice as large as our $11 trillion financial sector. Shadow banking had also “seized up” in 2007 and affected the rest of the financial sector. The Fed could not and did not deal with the crisis in the shadow world of private investment and banking back then. (Road Map that brings shadow banking out into the open,” FT Nov. 19, 2010)
Whatever the reason for the original stimulus’ failure to stimulate banks to make loans, we now have nearly-stagnant prices and an unemployment rate of almost 10 percent. And this year entrepreneurs and small businesses are failing at a higher rate than ever before. Many small businesses and new entrepreneurs can no longer get loans from banks or from other sources they used in the past (i.e,. family and friends, credit cards, home equity loans, and venture capital “angels”).
Keynes and his followers have used their mathematical formulas to support their belief that the “normal” rate of unemployment is 5 to 6%. They calculate that if inflation were at a rate of 2%, our economy would have 5-6% unemployment. These are the precise goals our Fed is trying to achieve when they talk about promoting employment and price stability together. These are the goals that need to be met under the Fed’s legal mandate.
Having failed to meet its mandate with the original “stimulus,” the Feds are now trying an even more indirect method to stimulate the economy, QE2.
How the long tail of QE2 wags the economy
Here is the chain of events that must happen for QE2 to succeed:
- The Fed believes that buying back its own bonds will make these bonds scarce.
- The “law of supply and demand” in economics says that a scarcer product will rise in price (as long as demand for it does not decline.)
- When prices of scarce government bonds rise, yields (interest rates paid to buyers) on those government bonds fall.
- Lower yields paid out on government bonds mean the Fed makes more money from selling its bonds.
- With more money from its bond sales in its pockets, the Fed is able to lower the rate of interest it charges banks who need to borrow money from it.
- When the Fed lowers interest rates to banks, banks lower their interest rates for credit cards and loans to customers.
- Lower interest rates on credit and loans encourage consumers and businesses to borrow and spend more money.
- The rising demand that consumers and business create for more products and services leads to job creation.
That’s how QE2 is supposed to work.
According to the Keynesian formulas used by Fed economists, QE2 might create a bit of inflation, but not enough to worry us, because according to the Fed’s brand new method of measuring inflation, we’re only at 1% inflation right now. The Fed assures us it will carefully keep an eye on QE2 and make sure to slow or stop it if the rate of inflation takes off.
Why the long tail might not move the economy
Does this long chain of steps needed for QE2 to succeed show you why economists have so little faith in it? The assumptions that lie behind each one of these links in the QE2 chain of reasoning can easily prove false in the current situation. The Fed’s long QE2 chain of reasoning can be broken in any number of places.
Already, the second step of QE2 appears to be failing. The expected price increase foam QE2 is not happening. Instead, yields on 10-year Treasury bonds have zoomed from 2.46% to 3% since QE began a couple of weeks ago. (Fed must regain intiative from bond market, FT 11/20-21/10 p 17)
Even if this should change, and yields of long-term government bonds begin to decrease, the Fed would still have a long way to go before QE2 could succeed in bringing about 6% unemployment while holding inflation below 2%!
Given the loud barking of those who don’t believe in Keynesian economics and/or who don’t want to give up their more fortunate economic situations, our elephant may not have a chance in China of getting us (and the Fed) to where we want to go.
Copyright © 2010 Nancy K. Humphreys