The ECONOMIST says QE2 is Necessary

America's economy Not by monetary policy alone

Another dose of “quantitative easing” is necessary; but it will not, by itself, revive America’s economy

Oct 28th 2010

ONE of the few people to come out of the economic crisis well is Ben Bernanke, chairman of the Federal Reserve, America’s central bank. He won acclaim for his decision to pump trillions of dollars into the American economy by providing liquidity to frozen financial markets and, from late 2008, by buying government bonds and mortgage-backed securities, or “quantitative easing” (QE). By common consent, these measures helped avert global economic disaster.

Now there is pressure for Mr Bernanke to work his magic again. Although America’s economy no longer looks on the point of collapse, it has failed to return to healthy growth. Unemployment, at 9.6%, is five percentage points higher than it was before the crisis and GDP is not growing fast enough to bring the jobless rate down. This economic slack is pushing inflation worryingly low. Core consumer prices rose a mere 0.8% over the past year. The Fed is therefore expected to announce a new round of asset purchases, widely known as QE2, at the end of its November meeting next week.

This round is unlikely to work as well as the last one. Financial markets are healthier than they were two years ago, so there is less scope for the Fed to give the economy a boost by providing extra liquidity. QE works in part by bringing down long-term interest rates, but the more you do, the less the incremental effect is likely to be. There are also potentially nasty side-effects. Fed purchases should help America’s economy by pushing asset prices up and the dollar down, but they may lead to a damaging rise in commodity prices and fuel asset bubbles in emerging economies. A big jump in the size of the Fed’s balance-sheet may also increase fears that quantitative easing could stoke inflation which could prove hard to control.

Despite these risks, QE2 is the right thing to do. Deflation is a bigger worry than inflation right now. Deflation would make it much harder for Americans to shake off their debts; and a combination of deflation and stagnation in America would be devastating for the world. Since underlying inflation is threatening to sink towards zero, the Fed is right to act pre-emptively.

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Rather than rely on Mr Bernanke alone, politicians should complement QE2 with more short-term fiscal stimulus. The first stimulus is now expiring and much of its contribution was cancelled out by the shrinking of state and local-government budgets. A new fiscal boost combined with targeted structural measures—encouraging banks to write down mortgage principal, for instance, so that homeowners with underwater mortgages can move house to look for work—would bring unemployment down faster. Yet Congress is reluctant to act because increasing the deficit is politically toxic.

Americans are right that government debt is a serious long-term problem. But growth is a serious short-term problem. The two can be addressed simultaneously, by adopting a credible medium-term deficit-reduction plan of the sort that Britain’s government has announced. Doing that will take courage, for it means coming up with a scheme for cutting entitlements to pensions and health care that will not go down well with voters. But if ever there were a moment for courage, this is it.

David Wessel says Friedman would support QE2

Channeling Milton Friedman

By DAVID WESSEL Wall Street Journal OCTOBER 28, 2010

Enough about John Maynard Keynes. We can be sure the 20th century British economic giant would advise more government spending to spur U.S. economic growth with consumers and businesses so hesitant and short-term interest rates at zero.

What would Milton Friedman, the University of Chicago champion of monetary discipline, do now? What would he say—reversing the charges when he returned a reporter's call, as he always did—if asked about Federal Reserve Chairman Ben Bernanke's imminent move to print hundreds of billions of dollars to buy more U.S. Treasury bonds to put more money into the economy?

We can't ask him. He died in 2006. "Friedman," says one of his eminent students, Robert Lucas of the University of Chicago, "was such an original thinker that one could never guess how he would react to a new question." Nevertheless, this seems a ripe moment to contemplate Friedman's views and those of his disciples—though they don't agree among themselves. Friedman believed in the power of money: the more money, the more income and, eventually, the more inflation. He didn't think the Fed could deliver full employment. He regarded interest rates as a misleading measure of whether the Fed was loose or tight. He favored flexible exchange rates, and would have lectured China against pegging its yuan to the dollar.

He didn't trust central bankers. He blamed the Bank of Japan for the deflation of the 1990s and the Fed for the Great Depression of the 1930s and the Great Inflation of the 1970s. He would, if his sharp-tongued co-author Anna Schwartz is any clue, have condemned the bank bailouts of recent years. "They should not be recapitalizing firms that should be shut down," she told the Journal in October 2008.

Friedman would have scoffed at the notion that the Fed is out of ammunition. He believed in the potency of "quantitative easing," or QE—printing money to buy bonds.

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But how would he decide if the Fed should buy bonds now?

He would look at the growth of the money supply, though he and his followers always had trouble identifying which measure was the right one. The Fed pumped up the monetary base (currency plus bank reserves), but broader measures are growing slowly. That bolsters the QE case. Still, the money supply is growing, not shrinking, Mr. Lucas notes. "If we had something like the Japanese deflation I'm sure Milton would say: Pour more money into the system. But we're not in that situation." POINT: Uncertain on QE.

He would warn, as he often did, about "erratic swings" in the money supply. For much of his career he said the Fed should let the money supply grow at a fixed rate. "Friedman did not believe in big discretionary changes in the money supply," says John Taylor, a Stanford University economist. "He would argue that we need to keep money growth stable, and if it slows, pick it up." But he wouldn't back massive bond-buying, Mr. Taylor insists. POINT: Against QE.

He would look at velocity, the number of times a dollar turns over in a given year, to gauge demand for money. "To keep prices stable, the Fed must see to it that the quantity of money changes in such a way to offset movements in velocity and output," he wrote in this newspaper in 2003.

When velocity is stable, the Fed should keep money growth steady. When velocity swings widely, the Fed shouldn't be passive. Velocity rose sharply from 1990 to 1997 and then plummeted; the Fed offset that and kept inflation stable, he said with praise. Velocity has been falling—which means each dollar the Fed prints has less oomph. POINT: For QE.

He would look at growth in income. "He considered stable nominal [unadjusted for inflation] income growth desirable because sudden swings in it (and thus in spending) cause huge macroeconomic disturbances when wages and prices fail to adjust quickly," says economist David Beckworth of Texas State University. Income is growing well below historical norms. POINT: For QE.

He would look at bond-market inflation expectations. In his 1992 "Money Mischief," Mr. Friedman said Treasury bonds with an interest rate tied to inflation would produce "a market measure of expected inflation" that would give the Fed "information to guide its course that it now lacks" and a way to "hold it accountable." It could even lead Congress to legislate an inflation target, he said with approval.

Today, we have inflation-tied bonds and what amounts to a Fed inflation target. Markets anticipated low and falling inflation—until Mr. Bernanke began talking about QE2 in late August, a sign that markets believe Fed's bond-buying will boost inflation, as the Fed desires. POINT: For QE.

Milton Friedman held unswervingly to his principles, but was more pragmatic than some of his modern-day followers. He was supremely self-confident, but, as Mr. Lucas puts it: "One of the many lessons I learned in Friedman's class was to work out my own views on questions, using economic logic as well as I can, and not to trust authority—even his."

The Friedman logic, though, makes the case for QE2.

Blinder says Keynes is not Dead

Our Fiscal Policy Paradox

Government's kitbag is overflowing with ways to spur demand. Yet fiscal policy sits idle, paralyzed by extreme partisanship.

By ALAN S. BLINDER Opinion Wall Street Journal OCTOBER 25, 2010

The practice of monetary and fiscal policy is fraught with difficulties, but the central concept is straightforward, compelling and, by the way, 75 years old: The government should push the economy forward when unemployment is high and slow it down when inflation threatens.

To do so, governments normally have two principal sets of weapons. Fiscal policy means moving some taxes or elements of public spending up or down to either propel or restrain total spending. In the United States, such decisions are made politically, by Congress and the president. Monetary policy normally (but not now) means lowering or raising short-term interest rates to either speed up growth or slow it down. That power, of course, resides in the technocratic Federal Reserve.

In 2008 and 2009, the U.S. government rolled out the heavy fiscal and monetary artillery to stave off Great Depression 2.0. Taxes were cut, spending was increased, and the Fed pushed the federal-funds rate all the way down to virtually zero. It worked.

But that was then and this is now. Today, the economy still needs a boost. But we seem to be trapped in what I call the paradox of macroeconomic policy: The policies that might work won't be tried, and the policies that will be tried might not work. If that sounds irrational, well, you've got the message.

There are plenty of powerful weapons left in the fiscal-policy arsenal. But Congress is tied up in partisan knots that will probably get worse after the election. On the other hand, the Fed stands ready—indeed, seems eager—to act. But it has already deployed its most powerful weapons, leaving only weak ones. That's the paradox.

How might fiscal policy speed up growth? As Elizabeth Barrett Browning once said, let me count the ways. Actually, let me not, because there are too many. Here are just three of my personal favorites:

• New jobs tax credit. ...
• Government hiring. ...
• Cut sales taxes. ...

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Don't get me wrong. The two main thoughts that are probably going through Mr. Bernanke's head today are, first, "I sure wish I could get some help from fiscal policy," and second, "I probably can't, so I'd better do whatever I can." He's right on both counts.

In a more rational world, it wouldn't be this way. Fiscal policy, which packs the power, would be doing the heavy lifting—by combining tax cuts and spending today with credible deficit reduction for the future. Monetary policy would take the back seat by keeping interest rates low. But we don't live in a rational world. And as Donald Rumsfeld might have said, you go to war against recession with the army you have. Right now, that's the Federal Reserve. The fiscal army is AWOL.

Mr. Blinder, a professor of economics and public affairs at Princeton University and vice chairman of the Promontory Interfinancial Network, is a former vice chairman of the Federal Reserve Board.