So, there continues to be much controversy with QE2, and in general with the Fed's monetary policy over the past two years. I've been paying close attention to this stuff because frankly this is the marker by which we will know when the current economic crisis is on it's way to closing. It's a complicated subject, though, mostly because you have to learn to cut through the economic jargon.
It's also become highly politicized, because ultimately this is tied to decisions made on the behalf of the government, impacting the deficit and taxes. Taxes are political for obvious reasons; people want to pay less in taxes, but that is balanced against maintaining a stable economy, which means sufficient employment and is tied to how much we all make. The politics is how I cam to the discussion, but over the past couple years I've learned a lot.
The Value of the Dollar
One thing your libertarian and conservative friends will pretty much as you as their 'gotcha' question on monetary policy is 'just what is a dollar worth?' This is supposed to be a barb against abandoning the gold standard, where the value of a dollar was fixed, in the abstract, to some amount of gold. $1 = X gms of gold, effectively. The follow up question, then, the real answer to the gotcha question, is a question itself-- if $1 = X grams of gold, then what is a gram of gold worth? If I have X grams of gold, how many eggs can I buy? How many grams of gold is an hour's labor worth?
What you're really talking about when you ask the value of the currency is what it can buy in terms of goods and services. The trouble is that the real value of goods and services change with respect to one another. A big example of this, recently, is the value of a house. In general, houses were considered to be of much higher value 3-4 years ago then they are today. You can make the argument that these McMansions were never really 'worth' what they were selling for, but that's not how the market determines value. A thing's value is really what you can get someone to pay for it, and 3-4 years ago you could get someone to pay a lot more for a house than you could today.
In the abstract, then, the value of a dollar, V, is then V=M/W, where M is the money supply, the total number of 'dollars' on the market, and W is the total wealth represented in the market. W is, in turn, a simple function of W=W0+P-D, where W0 is the basic amount of wealth already in the system, P is the total amount of wealth produced, and D is the total amount of wealth destroyed. An increase in V is 'deflationary,' meaning that you can buy more for a dollar-- prices fall, or 'deflate'. A decrease in V is 'inflationary,' meaning that you can buy less for a dollar-- prices rise, or 'inflate.'
In a deflationary cycle (V increases), P goes down, as people can afford less, so they are buying fewer new things, and so less new things are produced. Also, D goes up, for a few reasons. One is that more debt is defaulted on, as the value of the debt relative to the value of income goes up. Another is that producers are losing money in producing-- say there is an upfront cost of producing a widget, and it takes 3 months to produce the widget. In a deflationary cycle, as prices fall, the price the producer can charge goes down, and the value of the widget also falls in accordance, meaning that the producer sells the widget for less than a widget would have been worth when the producer paid the upfront cost of producing the widget. The producer eats that loss of value, and that value is taken out of the market. In a sufficiently deflationary cycle, producing widgets ceases to create value-- and generally then production of the widget stops, further reducing P. This then becomes a feedback loop-- V goes up. P goes down, D goes up, meaning W goes down-- and V goes up more. This is effectively the trap of a depression-- which ravaged the entire god damned world over the 30's.
An decrease in V is inflation-- prices rise. This is a big problem, though, because there is another relation between V, P and D. The trick is that P and D are also related to V on the flip side-- that inflation, where V goes down and prices inflate, can also negatively impact P and D, but mostly impact P. More money buys less, so less is produced. Less production leads to higher unemployment, which really pisses a lot of people off, but also lowers the value of labor (creating D). The cost of debt rises; as inflation goes up, so do interest rates to try to match or beat inflation. Eventually, somewhere in the system, something breaks, and a whole bunch of debt is defaulted on, and there is insufficient capital to lend to producers to make more stuff, so P goes down further, and more people are unemployed, leading to more D. Then you're back to V rising, and things balance out. Things stagnate around high unemployment. This was the lesson of the 70's, 'stagflation.'
Measuring Inflation
How, then, do you measure inflation?
Bankers value a dollar at how much they can make by lending that dollar, or interest rates. If they borrow money at x interest, they want to charge y interest, where y>x in re-lending it to someone else. They 'borrow' this money in two ways-- deposits, and from the Fed. If they can borrow money at a cheaper rate from the Fed then they can 'borrow' it in deposits, they do so, but generally speaking, they pay less in 'interest' on deposits-- in fact, most of them make money on deposits by charging fees for various services (overdraft fees, for example, ATM fees, for another). But there is only so much money that can be raised from deposits, and so banks borrow money from each other and central banks (like the Fed) to make money.
In the long term, banks set their interest rates (at least for loans made in dollars) against Treasuries. The proposition here is simple-- the US government is far less likely to default on a loan than any private banker. It is, after all, the government, with big guns and the power of taxation. But more, it prints the money in the first place, so it can just print more money. So if it can make x return by just buying Treasuries (which is where the government takes on debt), it will set the rate it charges, y, at x + it's cut + some sort of premium based on how risky they think the loan is + profit.
What rate they can get from Treasuries is set is as follows: Treasuries are sold in auctions in different denominations. They are basically promises that the government will give the holder the denomination in US dollars when the term of the treasury is up-- so a 5 year $10k note is an IOU from the government saying they'll pay you $10k in 5 years for the note. So, if you're buying a whole slew of 5-year $10k notes from the Treasury, you're not going to buy them for $10k dollars, you're going to buy them for $10k minus the interest you think you can make off of the money you're buying the notes with. This is effectively a market valuation of what the buyer thinks inflation will be over the period of the note and how much interest they think they can make over that period using that money by lending it to someone other than the US government. The banks then set their interest rates based on that market valuation, and that in turn impacts the prices of goods as producers set their prices in turn are based either on how much it costs them to borrow the costs of producing the goods, or how much that money could have made them if they'd simply invested with the bank.
This goes back to trying to determine the value of a dollar-- and savvy investors (and the Fed) use things like the Consumer Price Index to see how prices are changing relative to each other. The CPI is a big giant index of practically every good or service on the market, and price changes across those goods/services, and then an attempt to do a weighted average of all those price changes. So if a dozen eggs is now 10 cents cheaper, but a loaf of bread is 20 cents more, and a month's rent is more-- all of these are measurements of what a dollar is worth vs. a specific good. If a i dollars buys you 12 eggs today, and j dollars bought you a dozen eggs last month, then the change of the value of a dollar today vs. the value of one egg is i-j. Average that across a wide enough index of goods and services, and you arrive at a decent estimate of how much the value of a dollar has changed across all goods and services; in other words, how much the value of a dollar has inflated.
The Fed looks at these estimates of real inflation, then figures out how much money it wants to inject into the system and then sets the Fed funds rate. If the rate is less than real inflation, then the Fed is increasing the money supply relative to the increase of wealth, colloquially referred to as 'printing money.' If the rate is more than real inflation, then the Fed is reducing the money supply, which doesn't generally happen because everyone is trying to avoid deflation and the wealth-destruction cycle it creates. So it's really a matter of how much the Fed is undercutting real inflation, and whether it's hitting the sweet spot that keeps inflation not too cold (depression) and not too high (stagflation, where production ceases to match the increase of labor on the market).
Taking Down The Gold Standard
If you listen to certain libertarians, you are sure to hear about the Gold Standard, or for some of the hard nosed fiscal 'conservatives,' the notion of a 'hard' or fixed currency. This is the biggest of the straw men to knock down, which is why it's getting it's own section; knocking down the Gold Standard took the world a substantial period of time after it started recognizing the necessity of managing it's economy.
On the gold standard, then, M was 'fixed,' because the total amount of gold was and is finite. But it wasn't really fixed; Gold may be finite, but gold mines can be discovered, increasing the amount of gold. More, gold can come out of the market, as it is 'consumed' by people making jewelry or other goods out of it, or burying a bunch of gold coins in their back yard, for example. In olden days, ships carrying massive in transactions between major world governments would occasionally sink. The amount of gold, then, could be thought of as G = G0+Gp-Gr, where G0 is the amount of gold already on the market (a constant), Gp is the gold produced and Gr is the gold removed from the market, both time valued equations. Gp would be a function of gold mined and gold re-sold into the market (people melting down jewelry, digging up caches of coins, etc), and Gr would be the amount of gold consumed in various ways, through jewelry, decoration, etc. In reality, the gold standard wasn't simply a straight fix to gold-- governments also held massive stocks of silver, valued against gold, in reserve. So in talking about 'gold supply' they were also talking about silver supply, with the silver valued against gold.
The important bit here about the gold standard, though, was that there was no handle on the amount of gold. The problem with that, going back to the V=M/W equation, is that when wealth was destroyed, M stayed fixed. That meant that V increased. More, when W increased, V decreased, because again, M was fixed. On a fixed money supply, then, the economy, being dynamic, oscillates between inflation and deflation, and is not very stable.
But wait, you say, didn't I just say that on the gold standard M wasn't really fixed? True enough. But here's the thing-- you're talking about the gold available on the market. To keep V stable, you'd have to increase the amount of gold on the market when W decreases, but you can't just discover gold when you happen to have a major global destruction of wealth. Sure, as gold rises in value, more people will sell their jewelry. This will, across the market, result in a minor increase in Gp. Economic instability, however, will also induce people to hoard gold, effectively removing it from the market. So on the gold standard, facing deflationary pressure, Gp rises only a tiny bit as people sell their gold and silver, but Gr increases as people hoard their gold and silver for times when it will buy them more. Realistically, this increase in the supply didn't actually increase it sufficiently to counteract the hoarding and speculative buying.
More, add into this that gold is a commodity-- and so people can speculate in gold. They can make bets that some current economic troubles will lead to a destruction of wealth-- and then buy gold like gangbusters. So when an economy is merely on the verge of deflation, but hasn't actually crossed it-- speculation in the gold market, on the speculation that the market is going to crash, can contract the money supply, creating the crash itself, perhaps even overwhelming positive forces on the market that would otherwise have prevented the crash. Conversely they can sell gold off like gangbusters, on the presumption that W is about to increase substantially. That's a problem when they're wrong, and W doesn't increase enough to match the sell off; that creates inflation in the bad way. But more, when inflation is already in progress, they get out of gold to get into investments that get them higher returns, further increasing inflation.
In other words, the gold standard amplified the pressures of inflation and deflation, because the economic incentives were such that in a deflationary period people would hoard and buy up gold, reducing the money supply and making the depression worse, and in an inflationary period, people would sell gold to put their money in investments with higher returns thus increasing the money supply and making the inflation worse. Figuring this out was why pretty much the entire world abandoned the gold standard-- the gold standard was just a feedback loop.
Abandoning the gold standard was effectively abandoning the concept that the price of eggs (or other goods/services for that matter) should be tied exclusively to the value of gold-- that regardless of if a ship carrying .01% of the world's gold supply sinks in a storm, or, conversely, a discovered shipwreck adds .01% to the world's gold supply, an egg is still an egg and is still worth exactly one egg. So off the gold standard, then, the value of the dollar is valued, generically, on what a dollar will buy you, valued as what the market will sell you for a dollar.
More importantly, and the political force behind abandoning the gold standard, was that abandoning the gold standard also allowed central banks to counter inflationary and deflationary pressures, simply by printing more money or taking more money out of the market (though admittedly it wasn't until the 70's that they really understood that inflation could be as dangerous as deflation). Politically-- more people care about having a job that pays the bills than they care about the stability of the dollar. At least, most people, not bankers and investors who already have sufficient employment, for reasons we'll get to.
So the idea that increasing the money supply is bad in and of itself is ill founded-- these are people effectively arguing that the money supply should be fixed, but that is an argument that we should effectively let the economic cycle of a fixed money supply take hold. This an argument that economic depression is a good and necessary thing. If people own up to that-- ask them for an example of an economic depression that didn't feature large amounts of human suffering and really seriously high unemployment. These are people arguing (though they may not be aware of it) that the value of a dollar should matter more than the ability of some workers to put food on the table.
Straw Men Mutilation
We have gone through all of that to really start talking about QE2, and mutilating all the straw men arguments against it.
QE2 is another way for the Fed to increase the money supply, or M. The current trouble is that in order to avoid deflation (aka depression) the Fed needs to increase the money supply-- but it can't do enough of that by setting the Funds rate below inflation, because the rate is already effectively zero. So it has to find another way to put money into the system-- and it has settled on buying Treasuries from Treasury holders. They do this by printing money (more like issuing credit for cash, there's no physical press running off more cash) to banks holding Treasuries they bought from the government. Effectively, they are buying the Treasuries with money they are creating on the books by issuing credit for that money.
First off-- yes, printing money is an inflationary measure. In the V=M/W equation, it's increasing M. But remember that W = W0+P-D. So really, V=M/(W0+P-D). If D is increasing relative to P, then you need to add M just to keep V stable. Otherwise V will go up, which is deflationary, meaning lower prices and a wealth-destruction cycle that continues to lower P and D.
High unemployment has that effect on D, as does a high consumer debt to income ratio, for reasons discussed. So because so many people are out of work, and so many people borrowed more money than they could really afford, D could increase sufficiently to overwhelm P, and total wealth in the market would be destroyed. Technically, the market is still catching up to that effect-- again, over 10 trillion in value was wiped out in the Lehman crisis. So the simple answer to those without a real substantive reason for why they think the Fed taking this inflationary move is bad is to ask them just how high unemployment and high consumer debt ratios aren't sucking wealth out of the economy, or just where they see sufficient growth in production to offset this trend, not to mention counterbalance the wealth in the market already destroyed. There's no substantive evidence of sufficient growth in production to offset the current destruction of wealth induced by unemployment and high consumer debt; there is plenty of evidence of falling housing prices, foreclosures, and other debt default.
There is room for argument about just why the Fed isn't buying the Treasuries from the Treasury department, but rather from private buyers. The answer to that comes down to the fact that the Fed isn't just trying to increase the money supply generically-- it's trying to increase the money supply in a specific place in the monetary cycle, hopefully with the effect not only of keeping inflation stable, but also increasing employment. The Fed is specifically buying Treasuries in the 2-5 year range, because it wants to lower the rates on short-term debt in the 2-5 year range. That range is important for two reasons.
First, it's the range at which people buy 'durable goods,' i.e. stuff like cars and refrigerators and big-ass TV's on credit. Most people buy those purchases with financing-- on a two or three year term, or something similar. Or you buy your car on a car loan for about that much. Those things are all 'durable goods,' i.e. big ass honking things that take a fair amount of labor to make. The Fed wants to encourage the purchase of durable goods because the manufacture and sale of durable goods (which tend to be bulky and complex) employs more people.
Short-term debt in the 2-5 year range is also where most start-ups and other entrepreneurs borrow money against. Say you want to open a cafe; you need to get a lease. Business leases like that tend to operate in the 1-2 year range. You also need to buy all the kitchen equipment, and seating, tables, silverware, and the list goes on. Most people do this with a business loan-- which they pay off in the 2-5 year range. Similarly, say you have a new widget to sell, better than any of the other widgets. You have development costs, to make some of those widgets, and to have an initial supply to start selling to customers. Solution: again, buisiness loan in the 2-5 year range. All of that creates jobs. Lowering those rates makes it easier for people to take out those loans. So the Fed also wants to lower the rates in the 2-5 year range for people trying to start new businesses, to encourage people to start more business and hire workers.
The question here is whether the Fed more effectively lowers the rate on short-term debt by buying the Treasuries from the Treasury department, or as a secondary customer buying from the people who bought them from the Treasury department. And it's a good question-- buying from the Treasury would mean a lower supply of Treasury notes, and hence higher prices, meaning a lower return, hence lowering rates, according to supply and demand.
The substantive answer to the question, though, is again another question: could the Fed estimate as well as private buyers what the Treasuries it bought were actually worth? The Fed could pay more for the Treasuries than they were really worth, and lose money there without really helping the economy; buying as a second-tier customer ensures that the Fed gets market rates for the Treasuries and doesn't over-pay for them at auction.
You could argue that if anyone could hire the right people to buy these Treasuries at the right price it's the Fed, but the fact of the matter is that the institutional buyers of Treasuries are institutional for a reason-- it takes a lot of people with the right know-how to figure out how the CPI and all the other influences on inflation are turning out and make a good estimate. They'd effectively be hiring the people who work at Goldman Sachs to make these purchases in the first place-- only they'd be hiring on a temporary basis. Buying as a secondary buyer saves them the employment premium for that kind of contracting, and ensures they get the same rates as other buyers. The Fed isn't looking to be a permanent buyer of Treasuries, just a temporary one. Yes, Goldman Sachs makes money off of the deal-- but they were going to make that money anyway.
Someone was going to buy those Treasury notes, the question of whether Goldman is making more money with the Fed in the market or out of the market altogether. Likely, they would make more money if the Fed wasn't in the market, as prices would be lower and they'd get better returns on the resale.
Which is why all this hullaballo about QE2 is bunk, for the most part. Increasing the money supply is what the Fed should be doing; the question is whether it is doing so in the right place. Which we'll get to in the next post.
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