by Benjamin Studebaker
It has become fashionable on the political right to attack the Federal Reserve and its policy of quantitative easing, the process by which the Federal Reserve increases the money supply by purchasing assets owned by the private sector with cash that it prints. The right argues that quantitative easing encourages inflation and makes it easier for the government to borrow money, that it discourages saving, and that these are bad things. In contrast, these are very good things, and I shall endeavour to argue as to why.
The first thing you have to realise in order to understand why higher rates of inflation, more state borrowing, and less saving are good things is that the economy is not at present growing rapidly. Last quarter’s growth rate was an anaemic 1.3%–the average quarterly growth rate for the United States post-1947 is 3.3%, and given that the United States is emerging from a recession, we should expect the rate to be much higher. At the same time, US unemployment remains over 8%. As a result, the US economy is operating far beneath its potential output. As a result, we have what’s called an output gap, as Menzie Chin illustrates:
Now we have had another year to shrink that gap after this data ends, but persistent unemployment an slower growth in 2012 than we saw in 2011 indicates that the gap very likely remains significant. There is still some number of hundreds of billions of dollars in gap out there that could be employing more workers and purchasing more products. In other words, demand remains insufficient for the economy to reach its potential.
So this brings us to the three major right wing issues with QE:
- It increases inflation
- It encourages deficit spending
- It discourages saving
All of the claims the right is making here are true–quantitative easing does all of these things. However, these things all contribute to closing the output gap and restoring demand. Let’s take them one at a time.
QE Increases Inflation
QE tends to lead to inflation because it increases the money supply. Once that money begins to actually circulate, it produces inflation. Inflation is typically viewed as an immense evil by the right because it eats into capital gains. If you make a capital gain on an investment of say, 7% over the course of a year, but there’s 5% inflation during that same year, a substantial portion of the gain is lost to inflation. That’s unfortunate for you if you are an investor. However, inflation has an interesting impact on consumers–it makes them spend money. Anyone who was buying things during the seventies can tell you that when inflation is high, the incentive is always to buy everything now rather than later. If you know that waiting a few weeks or months to buy something will mean you have to pay more, you buy now. People do this even though inflation not only drives up prices, it also drives up wages (which means that people who do not possess savings or investments–the poor–are more or less immune to any negative impact from inflation). A higher rate of inflation will consequently drive up demand and help to close the output gap, as people spend now rather than deferring spending until later. With the current rate of inflation still under 2%, a slightly higher rate of inflation seems a small price to pay for shrinking 8% unemployment and augmenting 1.3% GDP growth. It is important to note that QE cannot produce inflation unless the extra money injected into the economy is actually spent. In other words, unless QE successfully increases economic demand, there will be no inflation rise.
QE Encourages Deficit Spending
QE encourages deficit spending by raising the rate of inflation such that the real interest rate on US Treasury bonds becomes more and more negative. This makes it very cheap and affordable for the government to borrow money, as it does not have to pay back the entire principle on its loans. Consequently, when spending by the government boosts economic performance and raises revenue, the loan becomes essentially free. The right takes issue with this because the right wants to cut government spending–but what is the point of cutting government spending if the government can easily get paid by investors to take their money? Senator Bob Corker of Tennessee explains the right’s objection in the WSJ:
the Fed’s easy money policies are taking pressure off Congress to address our fiscal problems, something that Chairman Bernanke and every economist agrees must happen to prevent a crisis.
His argument amounts to “everyone agrees there is a crisis, therefore there is a crisis”. It is a weak argument, but it is made even weaker once we realise that it is absolutely false. Two-thirds of the members of the National Association of Business Economists agree that both monetary and fiscal policy should be more stimulative in 2013–that means more QE on the monetary policy front, and more spending on the fiscal policy front. Even Mitt Romney’s own economic advisor agrees that QE is good policy.
QE Discourages Saving
QE discourages saving by raising the inflation rate, causing saved money to grow less valuable over time. However, during a time of slow economic growth and high unemployment, the last thing we want is for people to save money, because that’s demand that could be boosting the economy now being deferred until later. It is often argued that the real victims of inflation are the elderly who live on fixed incomes, but this is a myth–Social Security regularly receives COLAs, or “Cost of Living Adjustments”, as the Social Security Administration shows.
The only people who really suffer any negative effects from current Federal Reserve policy are people who derive large percentages of their income from capital gains or who squirrel away large amounts of money that they then proceed to do nothing with for extended periods of time, and these people will only suffer if the inflation rate actually rises, which it will only do if QE 3 actually succeeds in stimulating the economy and the banks who received money from the Federal Reserve spend more. In other words, if QE 3 is a failure, there will be no negative impact. If QE 3 is a success, unemployment will fall, growth will rise, and a small number of people whose incomes are not indexed to inflation will see their investments and savings eaten into.
That sounds like a fair trade to me, so why does it not sound that way to the right? The right is focusing on protecting the incomes of people who derive large portions of their income from capital gains–wealthy investors. What these people are overlooking is that a stronger economy produces higher profits for companies and higher returns on investments. If you make a 5% gain in the face of 2% inflation one year, and a 7% gain in the face of 4% inflation the next year, you are really no worse off than you were before. A successful US economy is to the benefit of more or less everyone, inflation or no inflation. The right’s opposition is the equivalent of refusing to receive a necessary medication because you are afraid of the sting of the shot. The shot itself does a trivial amount of damage to the skin, the medication it provides is far more valuable. A person who focuses on the shot is not looking at the right indicators and does not have the right priorities. It is the 8% unemployment rate and the weak economic growth that really harms people and damages our society, not the spectre of a couple points more inflation.