The Fed turns on the money spigot again, but will it work?

The Federal Reserve’s recent decision to throw at least $600 billion into the money supply (dubbed “QE2″ as in the 2nd round of “quantitative easing”) has caused a firestorm around the globe . . . and a debate among economists as to its wisdom.  At present, the debate centers on whether the late Milton Friedman, champion of Monetarism, would approve.  After examining the arguments, I would say Friedman would oppose it, and so do I.

Interestingly enough, it wasn’t John Taylor or Allan Meltzer (in the Wall Street Journal, albeit behind subscription wall) – both of whom are certain Friedman would have opposed QE2 – who convinced me, but rather (accidentally) David Beckworth, in his attempt to argue Friedman would favor it. 

One of Beckworth’s arguments is that Friedman would have reminded us about the entire Monetarist equation that he made famous, namely MV=PQ (for the uninitiated, V is the velocity of money; P is the price level; Q is the level of economic output; and M is, of course, the money supply).  Friedman always counseled for a steady rate of money supply growth on the assumption that stability would keep V and P relatively stable, while Q would grow.  Beckworth argues that V has not been stable lately, but has fallen during the Great Recession, and thus, Friedman would want that countered with actions such as QE2.

There’s only one problem: Beckworth doesn’t consider why money velocity (V) fell.  In fact, his own charts reveal that the decline in V could very well have been in response to the first round of “qualitative easing” (now known as QE1) in 2007-9.  In fact, V seems to have levelled off around the end of QE1.  This means either (1) given how Beckworth calculated money velocity, it was mathematically too dependent up money growth, meaning his model is flawed, or (2) the American people responded to QE1 not by spending, but by saving/reducing net borrowing, meaning QE2 will have the same effect.

Beckworth might not notice this, but Friedman certainly would have.  History has repeatedly shown us that the American people do not respond to temporary fiscal policies (I would submit that half the reason the growth in the “aughts” was so weak and uneven was that the tax cuts that partly fueled them had expiration dates).  The Great Recession and Japan’s “lost decade” are evidence that temporary monetary policies have the same impotence.

In other words, it is far more likely that the only effect of “QE2″ is lack of confidence in the dollar, greater concern over the the deficit being “monetized” (i.e., solved by printing money), foreign currencies depreciating in retaliation, and inflation – the very things Friedman opposed during his entire career.  This tells me he’d be with Messrs. Taylor and Meltzer (and yours truly) in opposing QE2.

Cross-posted to BD

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11 Responses to The Fed turns on the money spigot again, but will it work?

  1. [...] The Fed turns on the money spigot again, but will it work? « The right-wing liberal says: November 7, 2010 at 2:41 am [...]

  2. Ken Reynolds says:

    Isnt the problem the lack of velocity that almost threw us under the bus in 2008? And the economy is now on the re-bound thanks to the fiscal and monetary policies put in place since then?

  3. D.J. McGuire says:

    That’s only if you assume the first QE didn’t *cause* the velocity drop, which it may well have. There is also the question of whether or not the economy was damaged by the events of September 2008 itself or (my view) that expectiations plummeted after the panicked reaction to said events from bernake and Paulsen, thus tanking an already weak but not disastrous economy.

  4. Ken Reynolds says:

    Panicked reaction?? My view is that the right wing normally sits on the sidelines and criticizes the Democratic Party that usually inherits the problems and seeks ways to address them? This is a classic case…….and the nation is working itself out of the near-depresssion, despite the volumes of hot air from the right!!! No matter what we do, it is wrong!!

  5. D.J. McGuire says:

    Yes, panic. That’s exactly what I saw in the fall of 2008. Pure, unadulterated panic.

    I do find it interesting that you are so partisan and defensive that you forgot that Paulsen was Bush’s Treasury Secretary, and that my criticism was of both parties, not just the Democrats.

  6. Ken Reynolds says:

    YES, i am defensive when i see the republicans getting away with so much when they were there and caused most of the damage in the first place. What bothered me the most was the incredible drop in the Dow Jones averages and accompanying drop in pension values……..AND, would drop further unless something was done??? And yes, Paulsen was there and did try to do something and the Democrats that followed continued much of what Paulsen started…….one thing i do wonder about is the degree to which theREpublican leaders will rely on staff to implement new policies? OR will they simply sit there and continue ot block things further?

  7. D.J. McGuire says:

    I disagree; remember the Dow dropped like a stone *despite* “something” being done. There are times when it’s better to keep your powder dry and not spread the panic. There were ways to address what happened in the fall of 2008. I firmly believe TARP actually made things worse economically.

    You have to recognize that I simply do not subscribe to your interpretation of events. What you think fixed the economy, I think broke it.

    Until you’re prepared to accept that, you’ll never even understand me.

  8. Ken Reynolds says:

    I guess we could go on and on……..but apparently you think that all of the improvements since 2008 just kind of happened…..including the increase in the DJ and improvement in the number of jobs. I believe it is generally agreed that TARP did not come up to expectations………….which is another point………not everything that was tried worked, BUT something had to be done, and now things are better, and getting better every day!!!

  9. D.J. McGuire says:

    Actually, they did “just happen.” It’s called recovery, and I believe it happened despite TARP (and would have been stronger without it). Moreover, numerous economists are finding that the “stimulus” had a negligeable effect on the economy. Nearly all “improvment in the number of jobs” came from the public sector. Private sector job growth has been anemic. We’re in what I call “slowth”: a period of weak recovery that isn’t recession, but doesn’t lead to enough new jobs in the private sector to keep up with labor force growth. The last “slowth” lasted five years (Mar 1991-spring 1996).

  10. [...] is price level; Q is quantity/output). Using Keynesian verbiage helps Beckworth avoid the question I posed to him when he tried to defend QE2 in the Monetarist tongue: namely, what if velocity fell in reaction to [...]

  11. [...] price level; Q is quantity/output).  Using Keynesian verbiage helps Beckworth avoid the question I posed to him when he tried to defend QE2 in the Monetarist tongue: namely, what if velocity fell in reaction to [...]

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