Moral posturing versus QE2
I've had a go at Allister Heath in this blog before. Looking back, I realise that it was on the same subject as today's post: quantitative easing.
As I read his column in City AM today, I wondered: when I disagree with someone this much, and yet he is so sure of himself, should I question my beliefs? So I questioned them, and read the column again, and realised: no, 90% of macroeconomists are right, and Allister Heath is wrong.
Heath argues with conviction that the Federal Reserve's "hubris" will cause inflation without helping the economic recovery. It's a version of the Austrian story: the economy must undergo a necessary recalculation, restructuring, reallocation of resources, before a recovery can happen. Stimulus will just paper over the cracks and maintain the distortions in the economy.
There are reasonable arguments that this may be true of fiscal stimulus (though on balance, I don't agree with them). But monetary stimulus (including QE) can hardly be accused of this. Monetary easing, in fact, is one of the main routes out of a distorted economy.
In an economy where prices and wages adjust instantly to changes in demand and supply, recessions would not happen - all economic corrections would take place right away, and no intervention would be needed from any kind of authorities (except to deal with externalities, public goods or other identifiable market failures). That is not the world we live in. Prices and wages are anchored to fixed points - by psychology, by menu costs, and by the imperfect transmission of supply and demand signals through imperfect markets full of asymmetric information and not-very-good negotiators.
Inflation is the easiest way we know to loosen these anchors, allow prices to adjust, and make the economy more flexible. This is because inflation gives people a reason to change their prices - and while they're changing them anyway, they may as well try to adjust them to the correct level. It provides a way for companies to reduce effective prices or wages without protest from suppliers or employees, so that they can adjust to new market realities. There are far fewer forces to stop wages from increasing than decreasing, so people in high demand will get higher salaries regardless. And people in low demand - construction workers, according to Heath - will automatically get lower wages in a time of inflation, and therefore will be more likely to keep their jobs.
Much of the theoretical work of macroeconomics over the last few decades has been about determining the strength of this effect: the Phillips curve, the concept of NAIRU and New Keynesianism are all based on the idea that inflation has an effect on growth and vice versa. Monetary policy can be seen as the optimal, market-based response to fix this market failure. The interest rate (combined with other monetary tools), exogenously set by the central bank, is the empirically determined price which society puts on the externality represented by inflation.
Monetary stimulus has another effect, which is to increase the price of assets relative to consumption (see last week's post about Nick Rowe) - which boosts investment. Investment in a recession is generally much lower than its optimal level - and if, as Heath claims, we "need to deleverage", it will be lower for many years yet. If monetary policy can combat this effect, it's a good thing.
An odd claim towards the end of the article:
"Alan Greenspan...cut rates to one percent to minimise what many wrongly saw as a risk of deflation. In the event...inflation rose from a low of 1.1%...to 2.4%"
The fact that a Fed action, intended to prevent deflation, was followed by no deflation is hardly an argument against it. We can have a debate about Greenspan's overall effectiveness, but inflation of just over 2% is a success, not a failure, of Fed policy.
Finally, Heath warns against "the huge dangers of engaging in further QE" but omits to mention what any of those dangers are - with one exception. He suggests there is "a bubble in emerging markets" - but if, as he also says, "elevated unemployment and weak growth are...unavoidable" then where else would Western investors put their money than in emerging markets? QE may have a stimulating effect on investment in those markets, but there is an almost unlimited capacity for it, and I don't think China, Brazil or India will be too worried about someone coming to build $50 billion more of factories.
To put this in perspectively, though, of the previous $1.7 trillion of QE, probably no more than $50-100 billion went outside of the US. The majority went either into the US Treasury or into Federal Reserve bank deposits, and is only slowly feeding out into private investment. Sensible macroeconomists wish it would go a bit faster, and the next phase of QE must help that process along. If Heath would prefer the economy - and millions of unemployed people - to suffer a few more years until his corrections are properly implemented, he is fortunately in a minority.