Sunday, April 17, 2011

"Not Enough Money"

That's the title of this wonderful piece by Ramesh Ponnuru in the National Review. Sadly, it was written a couple of years late, but it's nice to see that some people in a conservative news organ are now trumpeting the ideas of Friedman, Beckworth, and Sumner-- namely that the Fed holds much of the blame for our current economic malaise as Bernanke & co. failed to keep NGDP growing at its normal, expected rate and pursued monetary policy that was too tight just before and during the recession. Viewing expansionary monetary policy through the lens of lowering nominal interest rates is a Keynesian and very dangerous error. QE2 was necessary and we probably need a QE3.

As I've repeated and linked to Sumner and Beckworth several times to explain, the Fed pursued a tight-money policy during the recession given the scope of the massive increase in demand for money. It allowed inflation expectations to fall throughout 2010, causing real interest rates to rise and growth to stagnate. Those economists are pushing for central banks to target NGDP instead of inflation. It looks like the Bank of England is privately pursuing this policy as they continue to expand the monetary base in the face of higher inflation. Real GDP and unemployment in England aren't doing so well. (The irony here is that the Bank of England is giving the Conservatives ammunition to cut government spending by countering with expansionary monetary policy. Rep. Paul Ryan and Gov. Tim Pawlenty want to cut U.S. government spending in the same fashion but blast the Fed for pursuing the expansionary policies that would make the spending cuts palatable).

The "quasi-monetarist" position of these economists is very simple: an increase in the demand for money (for safety or whatever reason) is a decrease in velocity, causing nominal GDP to fall. (M x V = P x Y). If your money supply is manipulated/controlled by a central bank, then it needs to increase the money supply in response to the increase in demand. Milton Friedman advocated this throughout his career in various ways. He pointed out that ultra-low interest rates aren't a sign of ultra-loose monetary policy, they are a symptom of too-tight monetary policy.

Marcus Nunes is an economist who has also joined the fray. This is a favorite post of his with 3 graphs that tell the story. Note the MZM measure of money and velocity at the bottom.

Why does all this matter? Well, the European Central Bank is in the midst of tightening money in response to respond to headline inflation. The result will well likely be a more rapid departure of Ireland, Greece, and perhaps other PIIGS from the Eurozone. Slower growth in Europe is bad for the rest of the world as well.

The U.S. also seems to have an endless supply of quacks like Glenn Beck who have been predicting hyperinflation since 2007. A friend sent me a forward of recent statements made by a California congressman that talks about interest rates and Fed policy:
"Once the Fed ends QE2, even if it doesn't reverse it, the markets will then have to absorb a new influx of long-term bonds at a time when our ability to pay them is in question. The Fed can cure a bunch of this simply by printing a lot more money. That, however, will result in an inflationary period with major wealth destruction and economic malaise."

There's a misunderstanding that the Fed engaging in QE2 is all about lowering long-term rates (probably because this is actually the official explanation of Bernanke and most Keynesian-leaning economists). But QE2 has been successful precisely because it has caused an increase in long-term rates. As David Beckworth has pointed out, inflation expectations fell off in 2010 and it was only when the Fed started pondering QE2 out loud that this reversed. Interest rates on 30 year loans are higher now than they were in November.

Why would we be happy about an increase in inflation expectations? Because inflation and economic growth are historically correlated. As incomes increase and unemployment falls, people buy more stuff. Velocity increases and prices rise. When actual inflation is less than what people were expecting when they originally borrowed and lent, wealth is essentially transferred from borrowers to lenders over the life of the loan, which has hurt household balance sheets in the recent downturn. The Fed had allowed both actual inflation and then inflation expectations to falter, just as they allowed the NGDP growth trend to falter, and they are now bringing those expectations back in line with the trend.

The Fed ending QE2 in a couple months won't cause long-term interest rates to rise unless the economic recovery is well-underway. Several economic forecasters have revised their growth projections for Q1 2011 to less than two percent, anemic growth that would cause unemployment to rise again. Inflation isn't a problem right now. An increase in gas prices does not equal inflation. Conservative and liberal economists can agree on this point: You can't have an upward spiral of inflation without wage increases, and wage increases don't appear to be forthcoming (so long as unemployment is just under nine percent, this isn't a concern).

If the Fed were to follow the ECB and start contracting the money supply (raising short-term interest rates), the result would likely be even lower NGDP growth projections, falling inflation expectations, falling interest rates while seeing a decrease in investment, and higher unemployment.

Right now, demand for money remains high. So long as our currency is controlled by a central bank, its duty is to increase the money supply right now. More money, please.

No comments: