Some Q&A about quantitative easing, with a somewhat higher ratio of economics to cartoon characters than we had yesterday:
What is this quantitative easing stuff? What exactly is the Federal Reserve (a/k/a “the Fed”) doing?
They’re creating 600 billion new dollars and using those dollars to pay down the government’s debt.
They’re paying down the debt? I thought they were buying bonds.
It’s the same thing. Last year, Huey McDuck lent the government a dollar and received a bond. (A bond is the same thing as an IOU.) Today the Fed buys Huey’s bond. Now the government owes a dollar to the Fed instead of to Huey.
But the government still owes someone a dollar!
Well, yes and no. Unlike Huey, the Fed is subject to a 100% tax on profits. So the government can pay its one-dollar debt to the Fed and then turn right around and swoop that dollar back up again. That’s just as good as not owing anything in the first place.
So in effect, the Fed is reducing the debt by 600 billion dollars. Does this mean taxpayers will have to cough up 600 billion fewer dollars in the future?
Yes.
Sounds like magic! Why don’t they just do this over and over again until all the debt is gone?
Because there is no such thing as magic. You can’t make the world a richer place just by creating dollars. Dollars are claims on wealth, but they’re not wealth. You can’t eat them, you can’t drive them, you can’t live in them. Paying down debt makes the taxpayers richer. But in order for taxpayers to get richer, someone else has to get poorer — unless the Fed finds a way to create real wealth. And that’s not so easy.
Okay, then. Who gets poorer?
When the Fed buys Huey’s bond for a dollar, Huey goes out to buy a blueberry muffin. This (ever so slightly) bids up the price of muffins and so (ever so slightly) reduces the value of everyone else’s money. Or maybe Huey lends that dollar to his cousin Dewey, who buys a muffin, or maybe the dollar takes a more circuitous route. But sooner or later someone tries to spend it, drives up a price, and drives down the value of existing money. We can even figure out the size of that effect: Since the taxpayers got a dollar richer (through the reduction of the national debt) and since the world as a whole is neither richer nor poorer, the moneyholders must have gotten exactly a dollar poorer. Do that 600 billion times and the taxpayers will be 600 billion dollars richer and the moneyholders will be 600 billion dollars poorer.
Aren’t the taxpayers and the moneyholders largely the same people?
Largely, but not completely. Bill Gates pays a lot of taxes, but he might not hold a lot of money. Odds are most of his wealth is tied up in other assets, like Microsoft stock.
Are there any other downsides to all this?
Yes. The taxpayers are relieved of a 600 billion dollar debt burden. That’s 600 billion dollars worth of good. The moneyholders see the value of their money reduced by 600 billion dollars. That’s 600 billion dollars worth of bad. So far, at least from the perspective of the-world-as-a-whole, that washes out. But there are additional costs. For one thing, people will scurry around trying to convert their money into other assets so they’re not holding money when it loses value. That’s a lot of effort that serves no real social purpose. For another, it’s harder to do financial planning when the value of the currency is subject to unpredictable change. So on balance, the world is actually a poorer place.
Well, that’s terrible.
Compared to what? In the absence of this Fed action, we’d still have to pay that debt off someday. We’d do it by raising $600 billion in taxes — with all the accompanying disincentive effects. That’s kind of terrible too. It’s not clear whether the Fed’s action is better or worse than the alternative.
Are there any ways in which printing dollars can enrich the world?
Well, maybe, if people are sufficiently idiosyncratic. Take Huey’s Uncle Scrooge, for instance. Unlike Huey, who (like most of us) values money only for what it can buy, Scrooge values money as a thing in itself: He likes to fill his vault and swim in it. I said earlier that dollars aren’t wealth because you can’t eat them, drive them or live in them. But they’re wealth if you like to nuzzle them. Buying bonds from Scrooge increases the world’s stock of nuzzlables, and that makes the world a richer place.
Where does the extra wealth go?
Well, not to Scrooge, really, because he’s got to trade away his bonds to get those beloved dollars. But consider: When the Fed buys Scrooge’s one-dollar bond, it retires a dollar of debt and makes taxpayers richer — just like buying Huey’s bond. But Scrooge, unlike Huey, never spends his new dollar. So prices never get bid up and our money retains its value. That’s a gain for the taxpayers at no cost to anyone. By creating something of value — a dollar for Scrooge to cherish — the Fed can make the taxpayers a dollar richer at no cost to anyone.
So buying a bond from Huey means paying down the debt at the expense of the moneyholders, while causing some auxiliary damage that might or might not be greater than the auxiliary damage you’d cause if you tried to pay down the debt some other way. But buying a bond from Scrooge means paying down the debt at no expense to anyone.
Correct.
Sounds like we need more Scrooges! Do they exist outside of comic books?
Probably not too often. More’s the pity.
Anything else we should know?
Keynesian economists (like Paul Krugman) have various theories about how buying bonds from guys like Huey could help get us out of the recession. I’m skeptical of those theories, though you should treat my skepticism with a grain of salt, because I am not really an expert on macroeconomics. (Though neither, come to think of it, is Paul Krugman.) But even if those guys are right, I’m largely unimpressed, because I don’t think recession fighting is a terribly important goal compared to enriching the world in the long run. And as far as that goal goes, I think I’ve covered the key issues here, though I’m sure readers will let me know if I’ve left something out.
From what I understand Post-Keynesians believe that prices effect the money supply, not the other way around like Friedman said. In a hunch, this means that Central Bank policy doesn’t matter and the government can just print money to cover debt. This argument seems as silly to me as it does to you although I may be vastly overstating it.
On a lighter note, Ben Bernanke’s pictures, including the one you’ve chosen, always make me want to sit on his lap and tell him what I want for Christmas.
This part is wrong:
“For one thing, people will scurry around trying to convert their money into other assets so they’re not holding money when it loses value. That’s a lot of effort that serves no real social purpose. For another, it’s harder to do financial planning when the value of the currency is subject to unpredictable change. So on balance, the world is actually a poorer place.”
The purpose of QE2 is to make the future value of currency more predictable. The Fed wants (and for a long time wanted) annual inflation in the range of 1.7-2.0%, but the current quantity of money is too low for this target.
How do you know what is the optimal return on holding money? Why are you so sure that the optimal real return on holding money is zero? I guess you oppose interest rate controls for other financial assets (current real yield on 5 year TIPS is negative – would you support a law that says that prohibits negative yield on TIPS?).
People scurry around trying to convert their NYSE investments into other assets so they’re not holding stocks that they believe will lose value. Would you agree with Lenin that this effort serves no real social purpose?
The current short term risk-free real interest rate that balances saving and investment is negative. Why should government provide financial assets (dollar bills) that provide above-market real yields? Would you support a Social Security program that promises return that is 1 percentage point higher than return on S&P500?
Steve Landsburg wrote, “But there are additional costs. For one thing, people will scurry around trying to convert their money into other assets so they’re not holding money when it loses value. That’s a lot of effort that serves no real social purpose.” The rate of inflation as measured by CPI is now about 1.2%. This is a low value compared to most of the past 40 years. Inflation is not a problem right now and actually there is a risk of deflation, which has problems of its own. If you have evidence that this action by the Fed is likely to cause price spikes or renewed inflation, please provide that evidence along with the expected magnitude of the effect. If you don’t have such evidence, it’s irresponsible to suggest that people will waste time and energy converting money into other assets. Also, you fail to discuss another expected benefit of this Fed action: that it is expansionary economically. Up to a point, more money in circulation can create demand for goods and services, which in turn can improve employment. This, in turn, means more tax revenues and less government spending on unemployment insurance and social safety net programs.
Here a good link about predictability of value of money:
http://macroblog.typepad.com/macroblog/2010/10/a-good-time-for-price-level-targeting.html
I see that you did say that some economists, including Krugman, say that this could help us out of the recession. So I apologize for saying that you failed to discuss that this Fed action is expansionary economically.
I think that QE in this situation is a good thing. Yes it would push up the prices a little bit in the medium run. But my intuitive way of thinking about this is that we are actually trading future consumption to today’s consumption. And (especially in a state like this) today’s consumption is more valuable than the future consumption. So what if consumption is lower in the future due to higher prices. What we need, is consumption today because of this slump. Effectively we are just smoothing consumption in the aggregate level. I’d say that is welfare enhancing.
Fed intervention does not make the future value of currency more predictable, intervention makes it less predictable.
To hell with the CPI…
Debasing the currency has led to a most predictable result: inflation. Inflation in food, oil, hard/soft commodities, etc.
Steve, money is a financial asset and a financial service. Bernanke has got financial asset and service pricing theory. You don’t.
You say that Huey buying a muffin with his dollar drives up prices ever so slowly, which reduces the value of everyone elses money.
But isn’t that what we want in a recession, that people go out and buy muffins? I think the only people who suffer are those who sit on large amounts of cash, and maybe that’s good in a recession.
I thought the Fed’s plan is to sell the treasuries it purchases back into the market, and not retire them. If they are sold back into the market then the total nominal debt would remain (assuming the Treasury new debt issue auctions don’t fail to produce buyers). Of course, if interest rates are higher when the Treasuries are sold the Fed will never be able to drain all the cash that it used to buy them, but that loss will not be reflected (or deducted) from the nominal amount of the debt which (I think) will remain.
Does Bernanke think that the banks with excess reserves are Scrooge-like? Are they printing money to pay off debt in hopes that ScroogeBank’s money hoarding prevents inflation?
My fear is what the Fed will do if ScroogeBank stops acting so Scroogey and starts increasing the velocity of money.
Nice overview. You did a great job of summarizing my concerns with macroeconomic wizardry in this paragraph:
—
“Because there is no such thing as magic. You can’t make the world a richer place just by creating dollars. Dollars are claims on wealth, but they’re not wealth. You can’t eat them, you can’t drive them, you can’t live in them. Paying down debt makes the taxpayers richer. But in order for taxpayers to get richer, someone else has to get poorer — unless the Fed finds a way to create real wealth. And that’s not so easy.”
—
Well played. I suppose the Fed’s actions might cause people to start creating more wealth, but the act of printing money to retire debt won’t do it on its own.
A little nitpick: After watching the cartoon, I now believe that any credible discussion of QE should make at least one reference to ‘the Ben Bernank’.
Well one point not addressed here is what effect does this have on foreign holders of USD? will this lead more of them to move away from holding large amounts of USD as reserves, and what effects would that have?
Thanks for the great post, I have a much better understanding now of the rationale underlying QE.
I am largely in agreement with the money demand blog, though for different reasons. I think the Obamacrats did this for two reasons, both entirely political. One was a shot across the bow of the Chinese, which I think succeeded. Although nothing much came of the G20, China in the past week has taken a couple of public measures to curb its own inflationary growth. I don’t know enough to say if those measures are going to have real effect or just be symbolic, but the Fed was definitely saying “Hey, China, you own a LOT of dollars and we can make them worth a good bit less if you don’t play ball.”
In addition, it was a subtle message to Congress saying “Well, you won’t consider another stimulus so we’re going to do this anyway and if you don’t like it how about we talk about the stimulus or at least some method of debt reduction other than pure cutting?”
I do not think that will be as effective as the first message, but I do think it’s part of their motivation.
Steve Wozniak (founder of Apple computers) could be a real-life Scrooge. Apparently, he loves $2 bills and buys uncut sheets of them for more than the face value of the bills. He (understandably) enjoys the novelty of tearing off the bills like a notepad and giving them as tips. Needless to say, he’s had to explain this behavior a few times.
Can we encourage this behavior? I think a Nobel Prize (or some other accolade) should be awarded to any economist or politician who can make a dent in the country’s debt by selling people money!
I am confused.
It seems to me that the $600B of QE2 does a couple of things.
1 – it is inflationary
2 – it depresses the value of the dollar
Is a little inflation a bad thing right now? I assume it is better to have a little more inflation today when it is very low than 30 years ago when inflation was 10%.
Is a lower dollar a bad thing right now? Again, it seems like a lower dollar might be a good thing since it would increase exports and decrease imports.
Isn’t QE2 similar to lowering interest rates?
This is probably the best post on QE2 that I’ve seen. To my extremely biased self, it appears relatively unbiased and written in a way that will make sense to just about everybody. Now if only normal news outlets went through the trouble of explaining things this well to the general population.
“Because there is no such thing as magic. You can’t make the world a richer place just by creating dollars.”
So what if Joe is unemployed. If Joe works he can produce $30,000 of goods. So we print $30,000 and pay Joe to work, the world now has $30,000 more goods. If the private market won’t come up with the money to pay Joe, why shouldn’t we print the money and pay him?
I thought Krugman has done a fair bit of work on international macro in addition to trade. Doesn’t that make him a macroeconomist of sorts?
“I’m largely unimpressed, because I don’t think recession fighting is a terribly important goal compared to enriching the world in the long run”
(1) How would your opinion change if you were unemployed?
(2) How do you measure the loss of future wealth caused by today’s unemployment? Those on the left talk about the harm to families caused by unemployment, and those on the right talk about strong families leading to future wealth. Do your models capture the loss in the future from unemployment today?
Thank you. I found this very helpful.
This part confuses me: “the Fed is subject to a 100% tax on profits. So the government can pay its one-dollar debt to the Fed and then turn right around and swoop that dollar back up again”, because it makes it sound as if there’s no way for the Fed to unprint dollars, and I was hoping there was a way for the Fed to do that when inflation gets too high.
The part about people who like to “nuzzle” dollars really hit a chord with me. It reminds me of my grandmother who fondly remembers the days of >15% CD interest rates. Of course the fact that inflation was running ~18% doesn’t matter to her, because she never spends the money (being a child of the depression her savings rate is astronomical). She’s just comforted knowing that there’s more money in her account.
QE2 is not much different than normal open market operations. Instead of buying short-term treasuries, the FED is buying medium and long-term treasuries instead. Many of your criticisms of QE2 could be applied to FED operations in general and central banking in general. However, given that we do have a central bank, what is the best policy it should be following now? I think the best policy would be to solve the excess demand for money problem we are facing. The excess demand for money is showing up as an excess supply for goods, high unemployment, and underutilitization of resource. An increase in the supply of money brought about by QE2 should help reduce excess money demand, get people spending money, and increase output.
Dan Grayson: The Fed can unprint dollars by selling bonds and destroying the dollars they collect. Those dollars are no longer part of their profits and hence no longer owed to the government.
“the Fed is subject to a 100% tax on profits.” Are bond principal payments considered “profits?” If I buy a 0 coupon bond for $100, then I don’t consider myself to have “profited” by $100 when I am repaid.
Also, you make it sound as if the Treasury has discretion as to whether or not to levy this tax (they “can”), is that true?
I’m wondering if QEII will actually behave like the traditional macro you explained so well in this post, or if something else will happen?
After all, between January 2007 and October 2010 the M1 money increased from $1.373 trillion to $1.779 trillion, 30% while the CPI only increased by about 8% (202.416 to 218.711.)
If I remember correctly, the Fed is paying interest on reserves now and banks are holding a much higher ratio of reserves to deposits. In January of 2007 banks were holding total reserves of $41.857 billion and had required reserves of $40.313 billion. In Oct 2010 total reserves are $1,040.455 billion with required reserves of $66.958 billion. That’s a 26 fold increase in reserves with only a 50% increase in required reserves which makes me think the money multiplier has plummeted.
So what’s another 33% increase in M1 going to do to price levels if nothing else changes? This looks like a really weak monetary policy move to me, at least much weaker than it would be in more normal economic times.
Also, what happens when banks start lending again? When the Fed stops paying interest on reserves or when the return rates on safe investments gets (enough) higher than the rate that the Fed is paying. Wouldn’t it be a much stronger move to reduce or end the interest on reserves to increase the money supply than printing some more?
I haven’t heard anything about bank reserves in the QEII discussions, and it seems like that should be pretty central. If banks continue hoarding cash like Scrooge, more quantitative easing doesn’t seem like it will have much of an effect. But if banks start behaving normally, we’re in for a LOT of inflation regardless of QEII. (In Jan 2007 monetary base was about 19.4 times total reserves, if that were the case in Oct 2010 monetary base would be $20.2 trillion instead of $1.964 trillion. This is scary, but I don’t know if it’s a reasonable calculation partly because the Fed uses a different measure for monetary base in their information on reserves than they use for M1.)
I’m using http://www.federalreserve.gov/releases/h3/hist/h3hist1.txt for reserves in relation to monetary base.
ftp://ftp.bls.gov/pub/special.requests/cpi/cpiai.txt for CPI.
And http://www.federalreserve.gov/releases/h6/hist/h6hist1.txt for M1.
Jonathan Campbell:
Are bond principal payments considered “profits?”
For simplicity, assume a zero interest rate.
If the Fed creates a dollar, uses it to buy a one-dollar bond, and then receives a one-dollar principal payment from the govt (retiring the bond) then at the end of the day, they’ve got an extra dollar in assets. Depending on your accounting system, I suppose you could say either that they profited by creating the dollar or that they profited by collecting the principal payment (but not both). Either way they’d pay a tax of $1.
This tax (unless I’m badly misinformed) is always paid. Whether the Treasury *could* choose not to collect it, I have no idea.
What would the negative aspects be of getting rid of our central bank? Positive?
“buying a bond from Scrooge means paying down the debt at no expense to anyone.
Correct.
Sounds like we need more Scrooges!”
Wait, if Scrooge never spends his dollar and never uses the fact that he owns that dollar, then it’s as if he didn’t have it. But in that case it’s as if the Fed just stole Scrooge’s bond without giving him anything in return. I’m assuming that not all Scrooges have a physical attraction to the actual dollar bill.
Does this statement:
“The Fed can unprint dollars by selling bonds and destroying the dollars they collect. Those dollars are no longer part of their profits and hence no longer owed to the government”
provide a contradiction to this one?:
“the government can pay its one-dollar debt to the Fed and then turn right around and swoop that dollar back up again”
I’m envisioning that at the end of the fiscal year, the dollar is no longer there to be swooped up by the Treasury because it’s been destroyed by the Fed. (Perhaps I don’t understand which of the Fed’s internally-held dollars are destructible.)
Isn’t inflation in the USA, right now, a good thing for the USA? For example, a programmer in the USA might earn $25 per hour. A programmer in Egypt might earn $5 per hour. Yet they are doing the same job. This means there are some inefficiencies going on, does it not? That the current situation is not pareto-optimal? If the value of the US dollar is brought down (relative to the Egyptian pound), wouldn’t this have the effect of reducing the inefficiency, and potentially making everyone better off?
Pietro: Scrooge is defined by his attraction to the actual dollar bill.
Dan Grayson: I’m not sure how the accounting works in terms of ends of fiscal years, etc., but destroying a dollar would add a negative dollar to the Fed’s profit and reduce its tax liability accordingly. So when the Fed creates a dollar and buys a govt bond, it’s equivalent to creating a dollar and using it to pay down the national debt. If the Fed destroys a dollar, it’s equivalent to undoing that action.
This sensible answer:
“So when the Fed creates a dollar and buys a govt bond, it’s equivalent to creating a dollar and using it to pay down the national debt. If the Fed destroys a dollar, it’s equivalent to undoing that action.”
also seems to provide a possible contradiction to this statement:
“the government can pay its one-dollar debt to the Fed and then turn right around and swoop that dollar back up again”
, because the destruction of the dollar, in the meantime, could prevent the government from swooping it up again. (Sorry to remain perplexed about the same exact thing, despite your answer.)
So money is a “store of wealth.” That’s fairly obvious I suppose, Since you can get people to do things for you if you give them money. But what’s not so obvious to me is why money is how this happened. Why are so many people today willing to do so much for money? My first guess is it became a store if wealth because you could exchange the dollars for gold at any bank. And gold of course has historically gotten people to do stuff of value to obtain it for whatever original reason…it’s beauty and rarity I suppose. I guess my question is…staying on the gold system was obviously not going to work, but why at that moment when you could no longer receive gold for your dollars did people continue to work for money?did they do so because everybody else did for the most part? It just seems like it would be a verg difficult thing to get a mass of people to value a paper currency, but it has happened throughout the world many times, so I guess it’s easier than I think.
Josh asks, “I guess my question is…staying on the gold system was obviously not going to work, but why at that moment when you could no longer receive gold for your dollars did people continue to work for money?did they do so because everybody else did for the most part?”
The first thing you have to realize is that the US government stopped redeeming dollars for gold in 1971. But more important than the dollar being a store of value, it is the medium of exchange. After the government refused to convert dollars for gold, your employer is still paying you in dollars, if you want to purchase goods and services you still need dollars, if you want to pay your taxes you are going to need to pay in dollars. So, even though in 1971, the government stopped converting dollars to gold, you are still going to need dollars as a medium of exchange. How many individuals were going to the government to redeem their dollars to gold before 1971? Refusing to convert dollars to gold didn’t really impact individuals in their daily lives.
Dan Grayson:
When the Fed creates a dollar, buys a bond, and holds the bond to maturity, the debt represented by the bond is effectively retired.
You’re right that until the bond matures, the Fed has the option of re-selling it, undoing its action and “unretiring” the debt. So in that sense, I agree that the debt is not really fully retired until the bond matures.
@Josh & Tom Dougherty – It’s also worth noting that Executive Order 6102 (May 1, 1933) and the subsequent Gold Reserve Act of 1934 made it illegal for US citizens to actually own gold.
So, although the US Dollar was convertible into gold, it was unlawful for US citizens to convert and then hold the bullion. This irony is sometimes lost on people who want to “return” to the gold standard.
The US went off the gold standard in 1971, and it was only in 1974 when President Ford lifted the limitation on private gold ownership.
Which brings us back to the fact that a dollar is worth whatever it can purchase, and creating more dollars should *eventually* result in higher prices. If one charts the Fed’s M2 Money Supply Figures against the Consumer Price Index, this relationship becomes crystal clear.
Rocky,
Thanks for that history lesson, although I think my point still stands that people use dollars (even though you cannot convert it to gold) because of the medium of exchange aspects of the dollar and not the store of value aspect of it.
If price adjustments don’t happen instantaneously, than Huey can buy things at old prices using new money, and he has some gain. This cost is born by people who spend their money once prices have adjusted. This is the point the video tries but fails to make when it argues that “the Goldman Sachs” will be a beneficiary of QE2 at the expense of other currency holders. (The video incorrectly calls the losers American taxpayers, when it’s actually American currency holders).
On an aside, I’ve long been curious about your views on the neutrality of money. I recall a paper you linked to on MR that found grocery prices are not sticky. I would love a blog post elaborating on this. (In addition to fulfilling my intellectual curiosity, it would be timely as well!)
I translated this post to japanese without your permission.
I have a question.
If USA fall into deflation,and had liquidity trap like japan.you think it is not a big problem?
In deflation process like japan,I think a lot of people would have money like scrooge.
Some additional remarks:
1. Fed officials have repeatedly said that Fed’s balance sheet will return to the previous size after the crisis. This means that QE2 will be fully reversed and QE1 will be mostly reversed. Unless you think that the Fed will break the promise, you should modify your analysis.
2. The Fed is paying interest on reserves at market levels. This means that QE2 is a debt maturity swap (with an average maturity of government debt reduced by one year), not a downpayment of debt.
3. The purpose of QE is to make the value of currency predictable. When QE2 was announced, both the internal Fed forecasts and market expectations (TIPS spreads) indicated that the inflation is expected to be below target for the next five years. If you disagree with market forecasts, you can purchase cheap inflation protection and send a market signal to the Fed.