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.