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.

But in some ways, QE2 is nothing new. Yes, it is a departure from the traditional Fed purchases of only very short-term securities. And yes, it could lead to all the problems of which its new critics warn. But this is just the latest round in a long series of mistakes. The new worries are possible currency debasement, inflation, asset bubbles, international turmoil, and avoidance of the real burdens on the U.S. economy — namely fiscal and regulatory policy. These worries are real. But this would be a replay of what already happened in the lead up to the 2008 Panic. Or the 1998 Asian Flu. Or the 2000 U.S. crash.

Here was my warning to the Fed in The Wall Street Journal in 2006:

It is these periods of transition, where the value of the currency is changing fast, but before price changes filter through all commerce and contracts, when financial and political disruptions often take place.

That was two years before a Very Big Disruption. (I followed up with another monetary critique in the WSJ here.)

But over the last few decades, there was no common critique of monetary policy among conservatives, Republicans, libertarians, supply-siders, nor among Democrats, liberals, or Keynesians, etc. (Take your pick of labels: the point is there was no effective coalition with any hope of altering the American monetary status quo. There were, for example, just as many Republican backers of Greenspan/Bernanke, and of America’s weak-dollar policy, as there were detractors.) A silver lining today is that QE2 appears to have united and galvanized a broad and thoughtful opposition to the existing monetary regime. Hopefully these events can spur deeper thinking about a new American — and international — monetary policy that can build a firmer foundation for global financial stability and economic growth.

Columbia’s Charles Calomiris discusses his opposition to the Fed’s QE2

— John H. Cochrane, October 26, 2010

— Joseph Stiglitz, October 23, 2010

“Geithner is Exactly Wrong on China Trade” – The Wall Street Journal. January 26, 2009.

“An End to Currency Manipulation” – Far Eastern Economic Review. March 26, 2008.

“The Elephant in the Barrel” – The Wall Street Journal. August 12, 2006.

“Money and the Middle Kingdom” – September 24, 2003.

— The Wall Street Journal, October 1, 2010

Some excerpts:

Before saying the real problem is we are not providing enough monetary stimulus, should we not worry about why corporations did not invest then and what other problems will emerge as we  keep rates ultra-low while hoping corporations will see the light?

. . .

If the government raised taxes explicitly to provide the interest subsidy, everyone would scrutinize the use this money was being put to carefully. Because the Fed picks investors’ pockets silently and forcibly through its ability to set the short term interest rate, no one asks questions about cost.

. . .

Of course, the Fed now disingenuously claims that the worst excesses in the housing market were committed when it had already started raising rates, and therefore it is not responsible for the housing boom. But it was complicit in setting off the boom by keeping interest rates too low for too long before then!

I may disagree with Rajan’s take on “global imbalances” (as I wrote about here) but nevertheless think he has become one of the smartest academic analysts of today’s confusing economic landscape.

— Thomas Jefferson, 1784, as quoted by Judy Shelton

THE WALL STREET JOURNAL / January 26, 2009

Geithner Is Exactly Wrong on China Trade

The dollar-yuan link has been a great boon to world prosperity

by BRET SWANSON

Treasury Secretary-designate Tim Geithner’s charge that China “manipulates” its currency proves only one thing. Three decades after Deng Xiaoping’s capitalist rise, America’s misunderstanding of China remains a key source of our own crisis and socialist tilt.

The new consensus is that America failed to react to the building trade deficit with China and the global “savings glut,” which fueled our housing boom. A “passive” America allowed China to steal jobs from the U.S. while Americans binged with undervalued Chinese funny money.

This diagnosis is backwards. America did not underreact to the supposed Chinese threat. It overreacted. The problem wasn’t “global imbalances” but a purposeful dollar imbalance. Our weak-dollar policy, intended to pump up U.S. manufacturing and close the trade gap, backfired. Currency chaos led to a $30 trillion global crash, an energy shock, bank and auto failures, and possibly a new big government era. For globalization and American innovation to survive, we must first understand the Chinese story and our own monetary mistakes.

We’ve heard the refrain: China’s rapid growth was a mirage. China was stealing wealth by “manipulating” its currency. But in fact China’s rise was based on dramatic decentralization and sound money.

After 500 years of inward looking stagnation, Deng opened 1979 with a bang. He freed 600 million peasants with history’s largest tax cut. He emulated Hong Kong and Taiwan by establishing four Special Economic Zones on the sleepy southern coast. Before Beijing hard-liners knew it, mayors across China were demanding similar low-tax, local-control freedoms. By 1993, 8,000 of these of these entrepreneurial free trade zones had swept the nation. Two hundred fifty million people migrated to this “new China,” where tax rates were low and regulations few. Capital poured in from China and the world.

Township and Village Enterprises (TVEs) were an unexpected but powerful innovation. Fiercely competitive and locally owned, these quasigovernment entities escaped Beijing taxation. Propelled by local knowledge and a zero corporate tax rate, the TVEs by 2000 accounted for half of China’s output.

China needed an anchor for its complex transformation and in 1994 linked its currency, the yuan, to the U.S. dollar. The dollar-yuan link allowed a real price system to arise in China and created a single economic fabric stretching across the Pacific. Before long, the whole region had adopted what Stanford economist Ronald McKinnon calls the East Asian Dollar Standard.

The opposite of currency “manipulation,” this dollar standard was a victory for free trade and global growth. But U.S. economists missed its portent. The Fed and Treasury of the late-1990s did not supply sufficient dollars to match rapidly growing global demand. A scarce dollar shot higher, and hard assets fell. Oil plummeted to $10 a barrel, gold fell to $250 from $400, credit shriveled, and dollar debtors across Asia went bankrupt. With an appreciating dollar and a world in turmoil, capital flooded into the U.S. and especially our soft, intellectual assets — Cisco, Microsoft and dot-coms. The technology boom and bust was not a function of easy money but a scarce dollar.

In 2003, Alan Greenspan and Ben Bernanke identified an exotic threat: deflation. The Fed was seven years late. Mr. Greenspan’s post-9/11 liquidity had already ended the 1997-2001 deflation. Yet the Fed persisted with 1% interest rates through 2003-04 and easy money thereafter. Meanwhile, Treasury Secretary John Snow targeted China and its trade surplus as a big threat. He and his successor Hank Paulson agitated for a stronger yuan and thus a weaker dollar.

Treasury’s trade-deficit mania encouraged anti-China politicians. Messrs. Snow, Greenspan, Paulson and Bernanke several times talked Sens. Chuck Schumer and Lindsay Graham off the protectionist precipice. But the administration did not realize that the weak-dollar policy was itself protectionism.

China was imparting deep changes on the world economy. Yet in 2003 U.S. manufacturing was 50% larger than in 1994. U.S. knowledge industries were generating most of the world’s profits and wealth. American consumers were benefiting from low-cost imports. Meanwhile, many Asian goods were rerouted through China for final assembly. The U.S.-China trade deficit thus grew even as the total portion of U.S. imports from East Asia fell below 35% from 40% in 1990.

The real threat was a devalued dollar. In mid-2005, we finally forced China to delink from the dollar and mildly appreciate the yuan. Nevertheless, the trade deficit accelerated. Robert Mundell — Nobel laureate, China expert, father of the euro and supply-side economics — continued to warn that the trade deficit was perfectly natural. Worry about currency instability instead.

But other eminent economists urged a “more competitive dollar.” On May 13, 2006, this newspaper headlined: “U.S. Goes Along With Dollar’s Fall to Ease Trade Gap.” All these “more competitive” dollars had to go somewhere, and with amazing efficiency found their way into oil and subprime mortgages.

The weak dollar had the opposite of its intended effect. Cheap-dollar commodities exploded the trade gap. Conceived to make the U.S. “more competitive,” the policy channeled money away from technology innovators and into home-building and home-equity consumption. Inflation for a time does pump up demand, and so U.S. consumers bought, and Chinese growth shot even higher. Chinese, Russian and Middle Eastern foreign reserves grew, further depressing the yields of U.S. Treasurys.

Some credit indicators are now improving, but the Fed’s past destabilization policy will reverberate. The weak-dollar blunder helped scuttle the Doha Round of trade talks and will make the successful Bush tax cuts difficult to preserve. American interventionism could absolve Europe’s anti-innovation “antitrust” policy and excuse China’s worst intellectual property violations and “national champion” subsidies.

And yet, with sound-money advocate Paul Volcker in the Obama White House and Mr. Mundell plugged into Beijing, the monetary mayhem of the last decade could give way to a worldwide, sound-money revival in 2009 and beyond.

Mr. Swanson is a senior fellow and director of the Center for Global Innovation at the Progress & Freedom Foundation.

— Nassim Nicholas Taleb, AI5000, Jan/Feb 2010