Finally, A Real Debate Over Monetary Policy

Scott Sumner is an original economic thinker and a particular expert in monetary affairs. So I sat upright when I saw his skeptical reply to the QE2 Skeptics.

Early this week a host of high-profile economists, investors, and thinkers, under the e21 banner, issued an understated but unusually critical “open letter to Ben Bernanke.” They urged him to abandon the $600 billion QE2 strategy, warning of uncertain but possibly very large downside risks compared to little reward even in the unlikely case it works.

Sumner, who favors a concept he calls NGDP (nominal GDP) targeting, says the Fed isn’t trying to spur inflation. It’s trying to boost national income. And who could be opposed to that?

Sumner says the Fed can move the AD (aggregate demand) curve to the right. “Whether that extra spending shows up as inflation or real growth,” he acknowledges, “is of course an important issue.” A very important issue. But critics of QE2 and the broader existing Fed framework aren’t necessarily worried about short-term inflation of the CPI type. No, we are worried about sinking Fed credibility, dollar debasement, possible asset bubbles, and international turmoil. And, yes, possible inflation down the road.

I think Sumner ignores a couple important factors that argue against the simple equation that more Fed easing yields a significant and quantifiable higher level of NGDP, and more importantly RGDP.

First, the transmission mechanism whereby increased bank reserves become credit isn’t working well. A trillion dollars of excess reserves sit on U.S. bank balance sheets. Small and medium sized businesses have found access to loans difficult. Consumers, too, even with historically low mortgage and personal loan rates, have not necessarily been able to access credit because of tighter lending standards and retrenched credit cards and home equity lines. If QE2 merely increases excess reserves further, without a more effective way to boost the supply and demand of actual credit, I don’t think the Monetary Ease –> More NGDP equation is so clear. A further complication: Large companies and the federal government find credit at historically low rates abundant and accessible. But this begs the second problem with the simple Ease –> NGDP equation.

In a world of closed economies, Sumner’s view that U.S. QE would directly translate into more U.S. AD (or his preferred national income) might work, at least temporarily. But we don’t live in a closed economy. Or as Robert Mundell long ago said, “There is only one closed economy — the world economy.” Companies, hedge funds, and other global entities can borrow cheap dollars and then go find opportunities across the globe.

An example is this Nov. 17 Bloomberg story: “Bernanke’s ‘Cheap Money’ Stimulus Spurs Corporate Investment Outside U.S.”

Southern Copper Corp., a Phoenix- based mining company that boasts some of the industry’s largest copper reserves, plans to invest $800 million this year in projects such as a new smelter and a more efficient natural-gas furnace.

Such spending sounds like just what the Federal Reserve had in mind in 2008 when it cut interest rates to near zero and started buying $1.7 trillion in securities to spur job growth. Yet Southern Copper, which raised $1.5 billion in an April debt offering, will use that money at its mines in Mexico and Peru, not the U.S., said Juan Rebolledo, spokesman for parent Grupo Mexico SAB de CV of Mexico City.

Southern Copper’s plans illustrate why the Fed’s second round of bond buying may not reduce unemployment, which has stalled near a 26-year high.

Or as Richard Fisher, CEO of the Dallas Federal Reserve Bank, said in an October 19 speech:

I have begun to wonder if the monetary accommodation we have already engineered might even be working in the wrong places.

I’m all for companies investing in the best opportunities around the globe. And some of that investment may benefit the companies’ American assets or workforce in direct or indirect ways over time. But that kind of long-term symbiotic growth is not what the Fed is aiming for or says it’s doing with QE2. When the Fed specifically targets the short-term U.S. economy and ends up pushing money overseas, that’s a direct failure of the mission. I believe the Fed should concentrate more on the dollar’s value as the world’s key reserve currency. But here we have a case of arbitrage — getting weak dollars the heck out of the country. We can see that much of ROW is growing faster than the U.S.

Beyond these transmission and international factors, it’s clear that Fed policy — now that we are beyond the panic of 2008-09 when Bernanke and Co. rightly filled an emergency monetary hole — is fueling the growth of government and giving Washington an excuse to continue with counterproductive anti-growth fiscal and regulatory policies.

Sumner tries to addresses this criticism:

7.  “Won’t monetary stimulus just paper over the failures of the Obama administration, allowing him to get re-elected?”

That’s an argument unworthy of principled conservatives.  After 30 years of major neoliberal reforms all over the world (even in Sweden!) it’s time for conservatives to become less defeatist about the possibility of making positive improvements in governance.  We need to do the right thing, and let the political chips fall where they may.  If monetary stimulus is tried, and succeeds in boosting NGDP (which even conservatives implicitly acknowledge can happen when they worry about inflation) then it would drive a stake through the heart of the Krugmanite fiscal stimulus argument (for future recessions.)

I think Sumner misses the point. Fed critics should of course root for the success of Bernanke and our other economic policymakers. But it’s not the case that QE2 is objectively the “right thing” and all critics are opposing it for political reasons. If critics think it is the wrong monetary policy — with the additional ominous factor that it is aiding and abetting (“papering over”) a harmful fiscal and regulatory path — then they are not required to bite their lips and “let the political chips fall where they may” as the economy continues to limp along. If mere monetary policy could solve all the world’s problems, then Mao’s China could have succeeded so long as Beijing printed enough money. That’s a severe reference, an exaggeration to make a point. But Bernanke himself has stated that the Fed cannot do everything, and it’s crystal clear historically that central banks often cause more problems than they cure, often when they are trying to compensate for other poisonous policies.

Despite the sluggish economy and these disagreements, I’m encouraged we are finally having a real, national (international!) debate over monetary policy — one I’ve urged for a long time. And I look forward to further offerings from Sumner . . . and many others.

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