QE2 or Titanic?

The question of the Quantative Easing Part 2 being done by the Federal Reserve is the Reserve printing money to buy US Treasuries through 3rd party resellers (like Goldman-Sachs) at a mark-up so as to try and get liquidity into the markets.  To this point in time easy credit policy has not 'stimulated' businesses and the business climate remains unsettled due to government policies being unknown on a day-to-day basis.  Such things like the cost of Healthcare Reform, the Financial Reform bill, and tax policy have all put forward an array of new federal agencies that will, perforce, eat up money and increase regulation while showing very little in return for their work.  Each piece of paperwork needing to be filled out in the private sector to meet some new government program or regulation is time spent not doing something productive.  With the threat of taxes going up, actually keeping a business afloat is a major problem as no one can forecast what taxes will look like even one year down the road.  On top of all of that Social Security is operating deeply in the red, cashing in its Treasury obligations, which takes money from both the federal government via direct payments (FICA and general revenues) and needing to pay for those cashed out Treasuries years before anyone expected them to be cashed out.

Thus the federal government is insolvent: it has burdens that it needs to meet that eat up all available cash and then needs to borrow more money at interest.

It is finding the borrowing climate hard as the economy is in the doldrums, and no one sees how the US can pay for all of its 'entitlements' or even just the few mandatory government functions necessary to run the National government.  There is, actually, cash for the latter, but only if you shed all the 'voluntary' parts of government at the federal level.

With no political willpower to do that, the un-elected Federal Reserve (which will get autonomous powers under the financial reform bill as Congress can no longer to its job) has decided to start buying some Treasuries to help keep things going in the name of liquidity: in order to try and pay for today we are devaluing our dollar in hopes that this will jump-start the economy.  There are, unfortunately, no success stories for that worth mentioning.  Thus this is a failed monetary policy with high-end risks and very few tangible rewards unless the idea is to survive until the next election to be thrown out of office to blame the incoming people for your mess.

Still this idea has its backers on the Right like Ramesh Ponnuru, at National Review Online and he points to others who are backing it under the ideas put forward by Milton Friedman and Friedrich Hayek. At one of the sites linked to, at Marco Market Musings is an article by David Beckwith on 08 FEB 2010 that a JMCB article by Larry White discussing this topic (pdf document here).  In that article is an analysis of Brad DeLong's look at Hayek's views on this... following this?  From Ponnuru to Beckwith to White to DeLong, about Hayek!

Right!  Lets take a look at the first summary point of White reviewing DeLong's work (boldface mine unless otherwise noted throughout):

(1) The Hayek-Robbins (“Austrian”) theory of the business cycle did not in fact prescribe a monetary policy of “liquidationism” in the sense of doing nothing to prevent a sharp deflation. Hayek and Robbins did question the wisdom of re-inflating the price level after it had fallen from what they regarded as an unsustainable level (given a fixed gold parity) to a sustainable level. They did denounce, as counterproductive, attempts to bring prosperity through cheap credit. But such warnings against what they regarded as monetary over-expansion did not imply indifference to severe income contraction driven by a shrinking money stock and falling velocity. Hayek’s theory viewed the recession as an unavoidable period of allocative corrections, following an unsustainable boom period driven by credit expansion and characterized by distorted relative prices. General price and income deflation driven by monetary contraction was neither necessary nor desirable for those corrections. Hayek’s monetary policy norm in fact prescribed stabilization of nominal income rather than passivity in the face of its contraction. The germ of truth in Friedman’s and DeLong’s indictments, however, is that Hayek and Robbins themselves failed to push this prescription in the early 1930s when it mattered most.

The 'liquidation' policy was that of putting failing banks to rest via letting them fail in the 1920's.

Things that pop out?

- Re-inflating price levels is questionable: that is trying to get price levels up to a sustainable level after bubble bursts.  In other words don't try to re-inflate the bubble.

- Corrections to money requires some allocative corrections when easy credit has inflated prices.

- The goal is to stabilize nominal income, not prices.

- All of this is done with a fixed gold parity money supply.

The last point is telling, and anyone trying to use Hayek or any other economist from history must review if they are talking about a 'stable' currency (that is gold, precious metal, or other substance backing) or a 'fiat' currency that has no fixed value and has only relative worth over time.  The prescriptions of Hayek for a fixed parity currency do not apply, necessarily, to a non-fixed value currency and any prescriptions for the former cannot be given to the latter as the monetary value of the currency means there is an absolute adjustment level for the fixed value currency and no absolute value to the non-fixed value currency.

With a non-fixed value currency when you attempt to 'stabilize' the currency by pushing bank notes into the system, you get nominal inflation of the currency, meaning it is worth less than it was before the printing of money.  From that inflation and deflation of non-fixed value currency cannot be definitively addressed by monetary policy alone: other adjustments need to be done so as to stabilize the value of the currency so that it has stability.  When more is printed and money is worth less over time, there is increased instability in the markets and pricing adjusts to meet the de-valued currency.

Can government spending on 'work' projects help?  This is point 2 that is examined:

(2) With respect to fiscal policy, the Austrian business cycle theory was silent. Hayek and Robbins did oppose make-work public programs, but they opposed them because they believed that the programs would misdirect scarce resources, not because the programs were financed by public-sector borrowing.

Governments get money via taxation or the printing press.  When money is taken from taxpayers it is not available in the economy to be used in an economic fashion to address the needs of individuals and businesses.  When money is printed the value of it is lessened when it is a non-fixed value currency, which creates additional instability for pricing and valuation of goods, services and income.  Thus government cannot 'stimulate' an economy as it is not utilizing funds in an economically efficient manner.  Non-economically efficient things can be done, yes, but that is a political case not an economic one that needs to be made, especially during times of downturns: they are not a 'cure' for an economic downturn and must meet some other need of the State.

Mr. White then goes on to look at Hayek's theory and monetary policy norm, and its a bit of a long section:

Hayek’s business cycle theory led him to the conclusion that intertemporal price equilibrium is best maintained in a monetary economy by constancy of “the total money stream,” or in Fisherian terms the money stock times its velocity of circulation, MV. Hayek was clear about his policy recommendations: the money stock M should vary to offset changes in the velocity of money V, but should be constant in the absence of changes in V.4 He accordingly lamented the shrinkage of M due to the public’s withdrawing reserve money from banks (as had occurred in 1929-33), referring (Hayek 1937, p. 82) to “that most pernicious feature of our present system: namely that a movement towards more liquid types of money causes an actual decrease in the total supply of money and vice versa.” He declared (1937, p. 84) that the central bank’s duty lay in “offsetting as far as possible the effects of changes in the demand for liquid assets on the total quantity of the circulating medium.”

To stabilize the volume of nominal spending, Hayek (1935, p. 124) urged that “any change in the velocity of circulation would have to be compensated by reciprocal change in the amount of money in circulation if money is to remain neutral toward prices.” Thus Hayek (1933b, pp. 164-65) held that an increased public demand to hold (i.e. to “hoard” or not spend) deposit balances would have undesirable deflationary consequences unless offset by deposit expansion:

Unless the banks create additional credits for investment purposes to the same extent that the holders of deposits have ceased to use them for current expenditure, the effect of such saving is essentially the same as that of hoarding [of base money] and has all the undesirable deflationary consequences attaching to the latter.5

Hayek (1937, p. 93) was as strongly opposed to contraction in nominal income as he was to excessive expansion:

Whether we think that the ideal would be a more or less constant volume of the monetary circulation, or whether we think that this volume should gradually increase at a fairly constant rate as productivity increases, the problem of how to prevent the credit structure in any country from running away in either direction remains the same.

Hayek’s ideal (ibid.) was not a do-nothing monetary policy but “an intelligently regulated international system.”6

Do note that when talking about the 1929-33 banking problems it is with a fixed value currency.  Thus a 'run on the banks' means that the currency is being taken out of circulation.  Thus both M (the amount of money) and V (its movement through the economy) are lowered simultaneously as there is less of it to lend as more of it moves back to the individuals that removed it from the banks.  Shifting some reserves from the vaults and into circulation makes sense with this, so long as it is still a fixed value currency as this is a replenishment of lending stocks.

This is a description of a liquidity problem.

Today there are investors not investing money, and individuals who are paying off debt (a good thing) so as to be more solvent in their daily lives.  There is plenty of money to lend, there are very few people wanting to borrow it.  The borrowing problems are from the instability, and if low cost loans are not an incentive to borrow money at its current value, then how will decreasing the value of it make it attractive to borrow?  In theory, yes because you will pay it off with devalued currency. That devaluation trend will shoot the original investment value to hell in short order: that investment you make in plant, equipment and materials will be worth less tomorrow and you will then have to charge more for what you are doing which causes an inflationary spiral.  Pumping money in to 'prime the pump' makes everything more expensive in the short and long run, and while loans can be 'paid back' your living standard declines unless your wages chase the increases in cost... which also add to the inflationary spiral.

This is the opposite of 'stabilizing' a currency which could only be done with a fixed value currency, and then in relatively small amounts.  With a non-fixed value currency the ability of all that money to have a real world value decreases, thus this is the effect of decreasing the value of M even when increasing the number of notes in circulation.  Worse, still, is if that amount then is not used for borrowing, because borrowers don't see how they can pay it back lacking things like jobs, and if employers don't borrow it because they have no idea what fiscal, monetary, tax, and social policies will do to them in weeks, months and years, then it just sits there without adding to V. 

During a major economic downturn with a non-fixed value currency, that downturn, itself, needs to be corrected for via the simple expedient of letting things continue via the rule of law: that adds stability to the markets as well known processes will continue and assured outcomes are understood.  Doing anything to try and 'prime the pump' with a non-fixed value currency runs the high risk of not encouraging economic growth (due to uncertainty) which means that you do not lower unemployment (via marginal production expansion) and that prices go up because of inflation.  The word coined for this: Stagflation.

And you get that when the government still has some solvency left to it, as was the case in the 1970's.  Today the US government is insolvent, and unable to make its bonds attractive due to the amount of debt and structural costs of government spending on entitlements, the military, and the entire federal bureaucracy that stretches from medication safety to subsidizing sugar producers to paying for entire Departments that can't improve the criteria of what they were made to do one iota, like Education.  That is why the government now has trouble selling bonds: we are overburdened with too much government trying to do too much and it is costing us all dearly.  A non-fixed value currency adds to that by giving an illusion that doing something to loan rates, changing criteria for lending, inflating money supply, indeed a host of things added in since 1911, will actually allow the government to better 'regulate' the economy.  By all of its activity, however, it has done just the opposite.

What will QE2 get us?  Stagflation, at best.

Why? The unsettled economic climate means no one can forecast the economy as those in government try to 'regulate' it from positions unattached to the economy for political reasons.

What is the answer? 

1. Announce a change to a fixed value currency, exchange current notes for gold backed ones on a 10:1 basis so everyone can just move the decimal point one place.  This will require new bills and coins, many struck from gold and silver.  At that point an ounce of gold might be around $100, which sounds about right for fractional quantities.
   
2. Keep 'entitlements' like SSA for those in the system, end it for those not in it, remove the 'retirement age' and admit that 'retiring' is best planned for by individuals not governments.  End FICA and fund the remains directly from tax revenues.  This is a major part of the insolvency problem.
   
3. Remove Medicare/Medicaid by adding them up, dividing by 2 and block granting that to the States and phase it out over 5 years as a payment.  Remove all subsidies for medical care via the tax code.  This is the other major part of the insolvency problem.
   
4. Stop the federal spending by shedding government agencies and functions wholesale and selling off the remains. What the government is actually required to have is short: State, DoD, Commerce, US Coast and Geodetic Survey, a Mint, USPTO for limited duration patents, copyrights and tracking trademarks, and a much downsized IRS.  This gets some liquidity into the system for government to operate and pay off our debts.   This includes the Federal Reserve, Fannie, Freddie, Ginnie, Sallie, SEC and a host of other 'regulatory' agencies that are nothing but political means to meddle in the economy.
   
5. A balanced budget amendment that requires the American People to directly sign off on deficit spending.

Then you can do all the fixed value currency analysis you like.

Yes, this would be wrenching to us, conceptually.  But it would offer firmness of process, an understanding that nothing is 'too big to fail', that the rule of law guides what happens at all points in the economy, that politicians should not try to 'regulate' things they don't understand and then 'fix' their 'regulations' with more ill-founded political beliefs, and that the best people to decide what to do in the economy are those that make it and run it at the lowest level.  Their election to do so was pretty simple: they got a productive job.  Politicians, not so much.