Bernanke's QEII Worked: Here's Why

Ramesh Ponnuru National Review April 7, 2011

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Ramesh Ponnuru

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April 6, 2011 4:00 A.M.

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More important — and more disturbing — is that it is not at all clear that we have learned from the mistakes of the 1930s. Those central bankers believed that money was easy because interest rates were low and the monetary base (the supply of money under the Fed’s control) had expanded. They worried that further easing would reduce confidence in the dollar. British economist R. G. Hawtrey, writing in the late 1930s, described the climate of opinion in his country at the start of the decade: “Fantastic fears of inflation were expressed. That was to cry ‘Fire! Fire!’ in Noah’s Flood.” The economy was actually deflating, not inflating. Under the influence of the “real-bills doctrine,” some central bankers believed that the money supply should respond only to traders’ need for credit. Anything else would only fuel speculative excess. Today’s inflation hawks employ the same reasoning that those firefighters did. And they are not wholly wrong. Easier money can lead to a destabilizing run on the currency. Inflation can be associated with low real interest rates and an expanded monetary base. But not always: Not in the 1930s, and almost certainly not today, either. The late Milton Friedman, perhaps the most famous inflation hawk of his generation, spotted the fallacy in his analysis of 1990s Japan: Low interest rates can also be a symptom of an excessively tight monetary policy that has choked off opportunities for growth. A looser policy, by increasing expectations of future economic growth, could actually raise real interest rates. To see why changes in the monetary base are also an unreliable guide to whether money is loose or tight, I’m afraid it’s necessary to look at an equation. Friedman and others familiarized us with the equation of exchange: MV=PY. What that means is that the money supply (M) times the speed with which money changes hands (V, for velocity) must equal the price level (P) times the size of the real economy (Y). If velocity holds constant and the money supply goes up, either prices must go up or the economy must expand or both. If, on the other hand, velocity drops — if people have an increased desire to hold money balances — then either prices must drop or the economy must shrink or both. And prices, especially wages, are sticky. They won’t automatically and evenly fall in response to a shock. So at least some of the reduction in PY, and maybe a lot of it, will have to come from real economic contraction. What this suggests is that if velocity drops unexpectedly, stabilizing the economy will require increasing the money supply to make up for it. Another way of putting it is that if the demand for money balances increases, the money supply has to grow to accommodate it. If the Fed does not increase the money supply, its inaction in the face of changing economic conditions amounts to passive tightening. The money supply is itself the product of the monetary base (B) and the “money multiplier” (m), which measures how changes in the base are being converted into changes in commonly used monetary assets such as checking and money-market accounts. So — I promise this is the last equation — BmV=PY. David Beckworth, a conservative economics professor at Texas State University who maintains a blog, has shown that at the height of the financial crisis in late 2008, velocity dropped significantly and the money multiplier fell off a cliff. The monetary base grew a lot too: The inflation hawks are right about that. But it grew enough to offset only the fall in the money multiplier. It didn’t offset the fall in velocity. 1 | 2 | 3 | Next >

COMMENTS 38

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Old Hickory

04/06/11 22:51

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NR's sad descent into Establishmentarianism continues. Ponnuru ignores the role of loose money in creating the crisis of 2008, ignores the need for the economy (especially the housing sector) to correct itself, ignores the inflation that surges all around us (gas up directly in tandem with QE2 - so predictable), ignores the role of tax and regulatory policy in promoting or inhibiting economic growth, one-ups Humphrey-Hawkins by seeming to imply the Fed's main focus should be promoting growth, asserts that the Fed should seek to centrally plan the rate of that growth and even trots out the banal, discredited Phillips Curve with this whopper: "But a modest uptick in inflation that helps to bring nominal income back to trend is better than staying below trend." And on his way to making this litany of mistakes, Ponnuru defends the hyper-political Bernanke and even finds time to trash conservatives. NR has lost its way.

Javawerks

04/06/11 17:03

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Yet another clueless NR commentator, not knowing the history of the Fed, CFR, IMF, WB, BIS and Rothschilds. Classic NR!

William P

04/06/11 15:23

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Why, if we don't trust the government with healthcare, would we trust the government with interest rates?

And does anybody else suspect that perhaps Mr. Ponnuru doesn't really understand what an interest rate represents?

04/06/11 15:21

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Can't agree with JasonC. Short reason, look at world markets, helicopter Ben has set off commodity inflation wildfire, that will cause another recession. StagFlation, it's 1979 all over again. From CNBC: External Link

JasonC

04/06/11 15:09

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I mostly agree wholeheartedly with the article, but a few quibbles.

No, the crash wasn't made worse by the Fed being too tight in 2008. The Fed was properly cutting aggressively from the fall of 2007 - against a chorus of criticism that is was loosening too soon, I might add (see the blow phase of in oil).

And it properly arranged the Bear bailout.

The fundamental cause of the severity of the recession was the housing crisis and the failure of the GSEs. credit losses on mortgages rose 20 fold over the average of the previous 15 years, and 3 times their worst previous recession peaks, staying there for years. This wrecked the underwriting model of the GSEs and of private mortgage insurers, who all blew out their capital, sending potential mortgage losses upstream in the chain of collateral.

The ordinary logic of financial crisis was then in place. That logic is that unassigned losses are felt about 10 times as heavily as assigned ones. By an unassigned loss I mean a shortfall in value from expectations or plans that everyone recognizes must and will occur, but that has not yet found a home, because those directly liable for that loss are incapable of bearing the full hit.

Unassigned losses destroy credit and lead to value destroying scrambles to get out of the legal path of loss assignments. This has happened in every financial panic since the 17th century, it isn't the fault of the Fed or of any policy. It is simply a recurring element of financial crisis.

The correct solution to such panics is known, from long practical experience. The losses must be allocated as soon as possible, without much regard for the merits or long run moral hazard concerns but instead focus on saving total value. And a lender of last resort must restore the liquidity that the collapse of credit is making evaporate, by lending freely on sound collateral.

Before we had a Fed, this is exactly what the strongest bankers and banking consortiums did in a crisis, and the Fed was created precisely to do this, in such crises. Congress believed that the fate of the financial system should not rest on the fortitude and preparedness of one private citizen like JP Morgan, as it had in the crisis of 1907.

The GSEs failing was the biggest part of the crisis, and the treasury backstopping their liabilities prevented a complete collapse. If you look at the data you will find that foreigners fled agency securities in a trillion dollar run in the summer and fall of 2008. This could have destroyed the credit of the entire country; it was properly not allowed to do so.

However, the Treasury received enourmous criticism for the "bailout" of the agencies. The libertarian sentiments of the financial press and their inflation fears united in full cry to oppose any bailouts in the future.

The Treasury very unwisely reacted to this criticism and pressure, and took it much more seriously than it ought to have done. When Lehman went down, they let it fail messy, with losses to creditors running to 85%, to avoid the opinion that they would prevent any failures.

This was a collosal mistake. It set off the heightened wave of panic that endangered the money funds, shut down the corporate bond market, brought down AIG, etc.

This and not any putative excess tightness by the Fed earlier in 2008, was the policy error in the whole episode.

It was a direct violation of Bagehot's dictum to never starve a panic.

A similar though lesser error was committed in the failure of Washington Mutual. The FDIC sought to reduce the cost to itself and the Treasury by conveying assets away from the corporate parent, effectively stiffing senior bondholders of that parent with a higher loss than they were legally responsible for. This was foolish - it caused the rates on bank debt in the secondary market to leap to 12-15% in a matter of days and effectively shut down the bond market for financial firms for about 6 months.

The message being sent in both episodes was that unallocated losses would be dumped on the secured creditors wherever possible.

As Kindleberger said of a similar episode in much earlier times, "from today's perspective it is inconceivable that (the authorities) would let it fail". These punitive attempts at anti-bailout "virtue" duly blew up and had to be replaced by much larger lender of last resort operations.

The specifically monetary actions of the Fed were fine, both before those autumn 2008 blow ups and during the crisis period itself.

Arguably the Fed was somewhat too tight in the middle half of 2009 (March to October). The market was recovering and its emergency loans were being repaid. It prevented a fall in the money supply by reinvesting the repayments in mortgage securities and treasuries, and this was absolutely necessary. The Fed was however unsure of the longer term effects of its huge late 2008 intervention and so it was reluctant to allow broad money to grow.

Before QE II, in fact, the Fed held the size of its sheet basically at the November 2008 level. This may count as slightly too tight. They may be forgiven for being cautious about it, given the huge scale of the immediately preceding expansion of the sheet and known lags in monetary policy effects. In retrospect, a modest 5% annual rate of increase in the sheet then, would have been preferable.

That basically accounts for the weakness seen in mid 2009 - coincident with the European debt crisis but not caused solely by foreign factors.

QE II is the first sustained increase in money supply since November 2008.

It is possible QE II is somewhat overdone, but it was correct to loosen from the level of tightness during 2009.

That the overall operation was not overdone before then can be seen in the series for financial sector total debts (in the Fed Z.1 flow of funds dataset), which has contracted $3 trillion since the end of 2008.

Mostly this is the asset backed securities market being cut in half. Combined with no net mortgage issurance, this was and is a huge swing from trend in broader money creation, from the private not the public sector.

My last quibble is related to the previous point. Even the commentators the author cites are too fixated on public policies by public official actors, and not looking enough at the private sector drivers they are reacting to. That includes money demand but it also includes the institutional reactions of the private financial sector.

It remains a deflation, driven by private sector forces not public policies. Policy is has been correcly loose in response to those conditions, and has thereby spared us another great depression.

Allesnarf

04/06/11 14:55

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"Finish a basic course in banking and money before trying to sounding off."

Why? Ramesh didn't.

JPK can defend himself, but typically when one puts a word like "borrowed" in quotes it indicates that the word isn't meant in its literal sense. The point is that money does not equal value, and it can't store value that doesn't exist yet.

alannyc

04/06/11 14:50

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Centex kid is wrong. First, "injecting currency now increases economic activity now". If this is true, why not add $10 billion per day of new money? Why stop at $3-$4 billion? Milton Friedman had it right - increases in the money supply do not lead to sustainable increases in real economic activity. On the contrary, inflation is the inevitable result of too much money chasing too few goods. Second, we were "very very close to a deflationary disaster"...."worse than the Great Depression". Based on what evidence? The Fed was part of the problem. By keeping interest rates extremely low in the 2003-2005 time period, when economic growth was strong, the Fed had a major hand in creating the credit and asset bubbles that ultimately burst. The unwinding of excess leverage is very painful, as we have seen

Skeptic20

04/06/11 14:23

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Two comments: 1. By definition, banks can't "lend out" their reserves. It's the Fed's policy of paying interest on member banks' excess reserves that's questionable. 2. One would think that the Fed would endeavor to increase, not decrease, m as well as B to offset the fall in V.

Centex kid

04/06/11 14:14

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JPK - "Remember, that money hasn't yet been earned. It is being "borrowed" from future incomes not yet realized. In otherwords, he is taking furure money and injecting it into our economy now. Whether Ramesh believes it or not, the velocity of money is occuring -from future incomes to the present."

Finish a basic course in banking and money before trying to sounding off. The Fed creates the money (currency) out of nothing. By injecting currency now, it increases economic activity NOW. It has absolutely nothing to do with borrowing from the future, though refusing to stilumate a depressed economy now will result in less productivity now and in the future. Yes, The Fed's largest injection of currency is via purchasing government dept on the open market, though they can also use their lending window to banks or they can purchase new dept being issued or rolled over. On a broader level, money enters the economy when the government spends more than it taxes. (All of it done with currency the Fed creates from nothing, ie not taxes.) The current economy is around 12 trillion. To just keep a normal economy of this size running requires annual injections of over 300 billion dollars (I feel like Carl Sagan), not counting the economic activity outside the US (oil, for example) that is traded in US dollars. So, adding 3 - 4 billion per day, over a limited period of time, sounds about right till people decide they can risk spending (not just investing) their money again.

We came very, very close to a deflationary disaster, one that could have made the crash of the 1880s (much worse than the Great Depression) seem like a cake walk. The Fed fed just enough to get us through it.

Mr. Kane

04/06/11 13:47

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myrtledr has it right:

"No, no, no! Central planning of any commodity ALWAYS fails."

Read your Hayek folks.

04/06/11 12:54

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Sam Ritter and JPK are also spot on. cdscott? Oi Vey!

JPK

04/06/11 12:33

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@CarolinJimbo

"I don't understand how QE2 increased the money supply."

Someone must buy the debt that the federal government spends. Currently the federal government is spending $3-4 billion per day more than it takes in via taxes (ie money that exists but is being transfered from private to public sectors). Whoever is slated to recieve the money that has been borrowed must at sometime be paid. The Federal Reserve covers those costs buy purchasing T-Bills. In other words, the Fed is providing QE by other means. Bernecke is litterally expanding our monetary base by $3-4 billion a day.

Remember, that money hasn't yet been earned. It is being "borrowed" from future incomes not yet realized. In otherwords, he is taking furure money and injecting it into our economy now. Whether Ramesh believes it or not, the velocity of money is occuring -from future incomes to the present.

cdscott1968

04/06/11 12:15

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I think Ben Bernanke has done a stellar job as Chairman of the Federal Reserve. He has been dealt the worst possible hand and has managed to help the U.S. avoid another depression. Many conservatives are way off base when they criticize Mr. Bernanke.

Thank you Mr. Ponnuru for writing this article.

Sam Ritter

04/06/11 12:13

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I follow what you are saying and agree for the most part. I have always felt that like military might, the monetary might of the FED should be wielded like a big stick. Often the implied threat of intervention, makes the intervention unnecessary. I felt that Greenspan's baby stepping interest rates failed to properly intercept the boom/bust of the tech bubble. I'd rather see a FED that appears willing to act decisively. Otherwise, what good is the FED - Congressional committees can act at a glacial pace instead.

Part of the problem of perception may be Bernanke's rep as an inflation hawk and that this seems to be contrary. I think the real issue has been that Bush allowed the value of the dollar too lapse too low even when the economy was expanding. With the value of the dollar already low, a move that appears to devalue it even further seems counterintuitive.

Key will be for Bernanke to find ways to tighten the money supply properly as the economy begins to expand. Interest rates will need to rise too. It will be a tightrope, but the problem still flows from the monetary policy of the late 90's and the 2000's.

I don't think any of this eliminates supply-side tactics though. Cutting taxes and reducing government spending still will allow more money & capital to remain active in the economy rather than be tied up in non-productive government usage. Putting money in one pocket while removing from another is counter-productive for a recovery.

Of course, what do I know?

cicero

04/06/11 12:01

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Let me see. . . how many angels can dance on the head of a pin? Sept., 2008, the bankers all bet the wrong way on derivatives, based on their computer programs. Since they are stuck with mark to market accounting, when they refuse to loan money to one another on their mortgage backed assets, those assets are all market down to zero. They are all broke. The government jumps in and bails them out, instead of pointing to the bankruptcy court, where the gamblers would have been forced to face their day of reconning. Fast forward to March, 2009. The gocernment tells the banks that they can go back to standard accounting reconning. Now their mortgage backed assets are valued at their face value. Our friendly bankers rush to the Fed and borrow against their newly valued mortgage securities (9 to one), and the game begins again. No one (bankers) are hurt. No one has to cough up their bonusses. And only the american taxpayer is left holding the bag (14trillion of debt). The current architect in chief is now on the hunt for at least a billion in campaign funds so he can stay in his new digs. Guess where he will go for the first round of fund raisers.

Jimi in Mich

04/06/11 11:55

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Mr. Ponnuru has some excellent observations here, but what troubles me is the nature of the causes in the drop in V and m: Governmental fiscal actions (and the resulting distorted economy and markets) that scare the public away from innovation and investment. Can the Fed really correct that with M, and in any accurate or well-timed way? The Money Supply debate may simply be peripheral to the policy actions of Hoover/Roosevelt and Bush/Obama. (Amity Shlaes may disagree with Ramesh.) I would like to hear Kevin Williamson weigh in on this one, if we promise not to use the word "Socialist" loosely.

04/06/11 11:42

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alannyc and CarolinaJimbo are absolutely correct. I am glad to see such geographically diverse men can both think straight. You may want to stick to politics Ramesh, this foray into economics/finance/monetary policy was not so good. That's OK though, Ben B. is a genius and he screwed the pooch here.

David James

04/06/11 11:41

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I cringe when I see economists classified by their political views (i.e. a conservative economist). The sad fact is that economics is far too politicized, so much so I don't think most readers even notice anymore. How about a conservative physicist, a liberal chemist, a moderate biologist? Sounds a bit odd, no? Get the politics out of it, what works...works. Truth is truth, left, center or right. And the sad truth is that economists are the handmaidens of politicians.

CarolinaJimbo

04/06/11 11:32

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Moreover, Since traditional purchasers of U.S. Treasury Securities are running for the hills (e.g. Pimco), the Federal Reserve stepped up to the plate.

CarolinaJimbo

04/06/11 11:30

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I don't understand how QE2 increased the money supply. The money the Fed created wasn't used to give borrowers (besides the U.S. Treasury Dept.) loans. It was used to finance deficit spending. It was used primarily to "monetize the debt."

myrtledr

04/06/11 11:23

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Was the Soviet Union successful in centrally planning the price and quantity of wheat to be produced? No, of course not. Were they not successful because they had the wrong central plan, or because central planning always fails? I would imagine you would say it's because central planning always fails.

Yet in your article you exhibit the fatal conceit that we can have economic success if we do the "right" central planning of the price and quantity of money. No, no, no! Central planning of any commodity ALWAYS fails. You completely ignore the fact that it was the Fed's poor central planning that inflated the bubble up to 2008, with disastrous results culminating ultimately in the election of the worst president in our history. These are bad, bad, BAD outcomes.

It's time to put a leash on the Fed. No more central planning, period.

JefH

04/06/11 11:05

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I don't understand any of this. What I do understand is that I'm one of those senior idiots that kept money in a bank account thinking that, any day, interest would rise. TARP and the QEs kept interest low. Great! I won't be a sucker and part of it next time. The only good thing about low interest for us savers is you don't have to pay taxes on it, which of course, adds to the deficit.

alannyc

04/06/11 10:57

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There are three huge flaws with your piece. First, monetary policy has no medium or long term effect on real economic growth (the "Y" in your equation). Therefore, to use monetary policy to try to manage nominal GDP growth is folly. Real economic growth is a function of hours worked multiplied by output per hour. The former is largely driven by demographics and the latter is productivity. Monetary policy has no impact on productivity. Second, how can anyone say monetary policy is tight when every indicator is flashing red? Gold is up. Commodities are up. Long term interest rates are up. Why do you think PIMCO is no longer buying treasury bonds? The Fed has a brutal choice come June. If they stop buying treasuries (i.e., monetizing the debt), then interest rates will skyrocket as the Fed has been buying 70% of the new bond issuance according to PIMCO. If they keep printing money, inflation will break out. Third, velocity has been down because the demand for money has been tamped down by all the uncertainty around Obama's policies. Who would want to borrow and invest in the face of Obamacare, an EPA run amok and massive federal borrowing speeding us towards insolvency?

PrincetonAl

04/06/11 10:47

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How convenient, a superficial analysis of two financial crises that completely omits the entire Austrian Economic viewpoint, the only school of economic thought that grew out of the failure of traditional economics to predict these financial recessions.

I would suggest that NRO get themselves an Austrian economist on the editorial committee pronto.

Those who ignore history are condemned to repeat it. (In the case of economic history, follow Japan off the cliff.)

For those who want a legitimate analysis, try Mike Shedlock at External Link .

One of the top individual economic blogs in the world, followed by billionaires and the individually concerned alike.

04/06/11 10:36

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Hmm... thoughtful analysis. Two things though: 1. No mention of the Fed's purported reasoning for QE-- i.e reduce long-term rates to help the US housing market and improve US homeowner balance sheets; and 2. No mention of US National debt. Those omissions are telling. Firstly, long-term/mortgage rates are up since QE especially QEII-- so if that was the real reason, QE has been epic fail. Second, QE would have been a fabulous idea IF, it was done in conjuction with Merkel style gov't budget cuts in Germany. It wasn't, it was done in connection with massive federal government debt spending. So in the end, the Bernanke's QE was nothing more than a cynical dollar debasement play to cheat US Debt creditors by paying them back with cheaper dollars. That's all. The critics are right, this is nothing but Ben printing money because he can, to sustain deficit spending. This is our Central banker? Jeez.

Breaker of Horses

04/06/11 10:03

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It occurs to me that the most important point in the whole piece (which is very well done, btw) is that "experts" are still debating a chicken and egg question 80 years after the fact, the parties not able to even agree generally on which chicken and which egg, while at the same time applying the "wisdom" gleaned from such discussions to the raucous, chaotic hen-house of the present, filled as it is with many chickens, many eggs, several well-fed foxes and tired, self-satisfied roosters, and what might just be a goose in a chicken suit. Perhaps the problem is not with this or that policy (he said trying and failing to artfully drop a tired metaphor) but rather that we are relying on these "experts" in the first place. I get the feeling a groundhog could manage our economy and have about as good a chance of "getting it right" (whatever that means) as our financial overlords. Would we be better off advocating for a real money economy, back by gold or silver (or both)? Or platinum? Or aged cakes of tea? Or perhaps a tchotchke-standard? My wife's Grandfather's place is full of them; I'd be filthy rich.

Derbosphere

04/06/11 09:50

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Persuasive piece. Ramesh's approach is really balanced - it lays out the facts in an interesting way without resorting to pushing readers' emotional buttons (as my man Derb is known to do at times).

One thing this article doesn't mention is that now, more than ever, this freshly printed money instantly starts ricocheting around Colombia, Russia, China...and then when it gets unwound, we could be pulling the rug out from someone who could trip us up as well (pardon the mixed metaphors).

Patrick J

04/06/11 09:44

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When trying to use the history of the 1930s as a guide for what to do and not to do, it's important to keep the differences as well as the similarities in mind. Even if Ramesh is right about what Hoover's and FDR's economists should have done, it doesn't follow that a similar prescription makes sense today.

In 1935, increasing the money supply meant injecting savings into the economy. But all the money, new and old, was real (gold-backed). Today, increasing the money supply means printing more fiat currency. Apples and oranges. You can release funds to boost the economy without causing inflation when the money is real. When new money is just a dilution of current money, you're causing inflation by definition.

William P

04/06/11 09:43

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I simply cannot understand how/why NRO continues to hold water for the Fed. Yes, Milton Friedman famously condemned the Fed for being too tight, and causing the Depression. Friedman's Monetarism had its hay day, was tried in Britain and the United States. Thatcher abandoned the policy. Friedman backed off and reversed course.

This wasn't accidental. There is simply no way that statistical surveying can convey the aggregate time preferences of an entire nation. Price information that is used for economic decision making is generated by exchange, not by prognostication, or reading the statistical tea leaves.

Inflation does nothing but distort prices and redistribute wealth. Smart money is smart for a reason - it can, better than others, predict growth and inflation expectations. The argument, so utterly naive and dismissive of reality, that consumers and other "economic agents" need their outlook readjusted by the Fed and its machinations overlooks the fact that most consumers have no idea what the Fed does, much less the tactics it is implementing. Consumers (that is, not businesses) are all but totally ignorant of the Fed, and they make up 70% of the economy.

NRO should follow not Friedman in this regard, but Hayek, who spent much of his career criticizing centralized decision making, particularly as to how to it affects the information contained in prices. Mr. Ponnuru, usually so thoughtful and considered, does not appear to recognize that once QE2 terminates, interest rates will necessarily rise, as "pump priming" is the only thing keeping these rates perpetually low. (One is tempted to call this an amateur error, but in a world where even the financial press doesn't quite "get it" it's hard to lambaste Ramesh.)

These higher rates will again endanger the pyramid of credit. At that point we can either pursue QE3, or face the liquidation and bankruptcy which we've put off for so long.

Hayek famously wrote, I paraphrase, that there's no wonder we have such money problems. The money selected by the free market - gold (and other precious metals) - has scarcely been given a chance to function as money without incessant government intervention. Reviewing a millennium or two of economic history tends to confirm Prof. Hayek's conviction. The history of money is inseparable from the history of rule. Only for a brief period of ~100 years did the Western world keep to a relatively straight gold standard. The other 4,900 years of human history are littered with fiat money schemes, debauchment, interest rate manipulation, and monetization of debt.

HankRearden

04/06/11 09:36

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Once again, the theoretician instructs the practitioner.

This wrongheaded article explains a whole lot (including my decision to allow my 15 year NR subscription lapse).

An over-leveraged economy (and government) simply needs more credit, huh?

Go explain that to the Chinese! I'm sure they'll clamor for head of the line privileges to purchase US debt denominated in shrinking dollars.

Again, this article explains a WHOLE lot!

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Bernanke's QEII Worked: Here's Why

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