Quantitative Teasing

Back on November 15, 2010, I was one of the signatories of the following letter, addressed to the Chairman of the Federal Reserve, Ben Bernanke, which was published in the Wall Street Journal:

We believe the Federal Reserve's large-scale asset purchase plan (so-called "quantitative easing") should be reconsidered and discontinued. We do not believe such a plan is necessary or advisable under current circumstances. The planned asset purchases risk currency debasement and inflation, and we do not think they will achieve the Fed's objective of promoting employment.

We subscribe to your statement in The Washington Post on November 4 that "the Federal Reserve cannot solve all the economy's problems on its own." In this case, we think improvements in tax, spending and regulatory policies must take precedence in a national growth program, not further monetary stimulus.

We disagree with the view that inflation needs to be pushed higher, and worry that another round of asset purchases, with interest rates still near zero over a year into the recovery, will distort financial markets and greatly complicate future Fed efforts to normalize monetary policy.

The Fed's purchase program has also met broad opposition from other central banks and we share their concerns that quantitative easing by the Fed is neither warranted nor helpful in addressing either U.S. or global economic problems.

A number of people have written snide comments about this letter, including the author of these words:

… if you write about current affairs and you're never wrong, you just aren't sticking your neck out enough. Stuff happens, and sometimes it's not the stuff you thought would happen.

… I've been wrong many times over the years, usually on minor things but sometimes on big ones.

This of course is the man who used to boast that he had only ever made two mistakes - unlike us members of the "Always Wrong Club". But now it turns out he's been "wrong many times over the years". Amazing how memory plays tricks. Or perhaps someonejogged his memory.

Now, when someone of that caliber calls you out for having been wrong about the future path of inflation, you have a right to remind him that one of his "many mistakes' included … being wrong about the future path of inflation. Guess what? Predicting the future path of inflation is actually quite difficult, whether or not you have a Nobel Prize.

In any case, our 2010 letter did not make a prediction about inflation. What we said was:

The planned asset purchases risk currency debasement and inflation, and we do not think they will achieve the Fed's objective of promoting employment.

Note that word "risk". And note the absence of a date. There is in fact still a risk of currency debasement and inflation. The monetary base of the United States Federal Reserve has increased by a factor of 1.9 since we published our letter (and by a factor of more than 4 since the financial crisis began). The gross federal debt, meanwhile, has increased by 25%, from $13.8 trillion in November 2010 to $17.2 trillion. A rising share of that debt now sits on the Fed's balance sheet. It is true (as I wrote elsewhere in 2010) that "deflation is a bigger threat than inflation" in the short run. But can anyone with the slightest knowledge of financial history claim that there is no risk of inflation in policies that have so hugely increased the monetary base and the public debt in time of peace? Clearly, these things by themselves do not make higher inflation inevitable. That would take some combination of faster growth of broader monetary aggregates, higher velocity of circulation, changes in expectations, and so on. But to dismiss the risk of inflation after just three years is a bit like dismissing the case for global warming after three cool summers.

What about the doubt we expressed about the efficacy of quantitative easing (QE) in promoting employment? Since then, the unemployment rate has come down from 9.8% to 7.3%, to be sure. But few economists would claim this as a triumph. And none that I know would attribute all of the decline in unemployment to QE.

Larry Summers recently reignited the debate on the U.S. economy's poor performance by raising the specter of "secular stagnation". I think he is right about that, but wrong to attribute it to insufficient policy stimulus. As our 2010 letter said:

We think improvements in tax, spending and regulatory policies must take precedence in a national growth program, not further monetary stimulus.

That remains my view. It is an argument set out at length in my book The Great Degeneration.

Finally, we wrote as follows:

We disagree with the view that inflation needs to be pushed higher, and worry that another round of asset purchases, with interest rates still near zero over a year into the recovery, will distort financial markets and greatly complicate future Fed efforts to normalize monetary policy.

This worry seems as valid today as it was then - indeed more so.

Our letter was prompted by the announcement of QE2. We are now in the second year of QE3. How exactly the policy was supposed to work remains a matter for debate. The original idea was that large-scale asset purchases would stimulate the economy through the so-called "portfolio balance channel". More recently, Fed Governor Jeremy Stein has proposed an alternative "recruitment channel".

Whatever the mechanism, the most striking consequence of the policy has indeed been very rapid inflation - of asset prices. The S&P 500 has risen by 50% since the publication of our letter. Though generally regarded by a cause for celebration (even by those commentators who otherwise lament increasing inequality), this bull market has been accompanied by significant financial market distortions, just as we foresaw.

Even more prescient was our warning that more QE would make it difficult to normalize monetary policy. As recently as last October's International Monetary Fund meeting in Tokyo, Chairman Bernanke was still insisting that this was not the case and that ending QE would be straightforward. Raghuram Rajan and I begged to differ. In essence, our point was that, as a volatility-depressing policy, QE would be impossible to end without increasing volatility. What happened in the summer of this year bore out our critique. The very mention of a future reduction of Fed asset purchases caused a spike in ten-year yields, the ramifications of which were so alarming to Chairman Bernanke and his colleagues that the planned "taper" was postponed.

The Fed itself now acknowledges the potential costs and risks of QE. The March minutes of the FOMC set these out in some detail. More recently, in an important paper, three economists at the Fed have acknowledged the "uncertainty regarding the efficacy and costs associated with additional [large-scale asset] purchases". As they very correctly observe: "Since asset purchases are such a new policy tool, the historical record for judging such effects is limited." Quite so.

Contrary to what has been claimed here and elsewhere, there is therefore no need whatever for the signatories of that 2010 letter to retract a word of what we wrote. It is those who have willfully misrepresented our letter who should do the retracting.

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