Ben Bernanke's Made-Up Money
With its new round of quantitative easing, the Fed enters uncharted territory.
If one were to predict potential policy-driven political squabbles, a dust-up about monetary policy between Federal Reserve Chairman Ben Bernanke and Sarah Palin—conducted partially via Facebook—would likely be pretty far down the list.
Nevertheless, it happened. Last week, Bernanke announced that the Federal Reserve would expand the money supply by $600 billion over the next six months through a policy of "quantitative easing"—essentially creating new money and using it to buy up Treasury bonds—or QE2. President Barack Obama supported the move, which is intended to lower interest rates and, as a result, prod investors to spend more money now, while borrowing is cheap. Palin responded by arguing that the policy wouldn't increase lending, but might lead us into an inflationary spiral by flooding the market with extra dollars, thus devaluing the currency.
Not surprisingly, Palin got crucial details wrong. And no doubt she was motivated as much by political opposition to the president as a conviction about the proper role of the Fed. But Bernanke's new policy is risky and untested—and has already sparked legitimate inflationary fears at home and abroad.
One simplified way to describe how this round of quantitative easing will work is this: The Fed doles out $600 billion in made-up money to the world's biggest banks, who make a tidy profit on the sale and then split that profit up into bonuses. As Reuters financial blogger Felix Salmon writes, "We're not exactly helping the unemployed here."
The actual process is slightly more complicated, but not much more appealing. Once the members of the Federal Open Market Committee vote to buy additional bonds, the Fed schedules a series of sales, and notifies the banks on its list of primary dealers—18 very large banks. Those banks then buy up bonds with the intention of selling them at higher rates to the Fed. And then when the scheduled sales come around, they trade their store of bonds for money that the Fed has newly created, as The Washington Post explained, "essentially out of thin air." Interest rates go down. Inflation goes up. Investors, knowing that money is cheap now and might not be worth as much later, start to spend. The economy gets back in gear.
At least that's the idea. It's not the first time the Fed has pursued the QE strategy (hence QE2), and the first go-round wasn't an obvious success. When the financial crisis first landed, the Fed pumped $1.7 trillion into the system, yet failed to lift the economy out of its sluggish state. By the time this round of quantitative easing ends, the Fed will have added almost $3 trillion to the money supply—and that's if it quits with $600 billion. The Fed's first round was originally supposed to total just $1 trillion; the second round could easily expand beyond the initial plan as well.
One major worry is that all that extra currency will only lead to out of control inflation. That was the gist of Palin's argument against the Fed's decision. She declared that food prices "have risen significantly over the past year or so." As The Wall Street Journal's Sudeep Reddy has pointed out, that's wrong (food price inflation has been extremely tame over the last year), as was Palin's follow-up defense of her statement. But food prices, now growing at around 0.5 percent, are projected to grow more steadily in 2011—somewhere between 2 and 3 percent. That's not an unreasonable level. And so far, inflation has stayed on a manageable trajectory. But inflationary spirals don't tend to announce themselves at the door, and there are some signs that recent inflation in commodity prices is a result of Fed policy. The lone member of the Federal Open Market Committee to dissent from the policy did so in part because of worries about inflation. As economist Joseph Stiglitz recently told The Washington Post, the policy puts the U.S. in "uncharted territory." Long-run, the inflation picture is tough to predict.
In general, the outlook on this round of quantitative easing is anxious uncertainty. International reaction has been negative. China has been particularly peeved, with one Chinese ratings firm actually downgrading U.S. debt. And the usual ideological dividing lines aren't entirely holding up. Tyler Cowen, a George Mason economics professor with a libertarian bent, says that, although he's not sure it will work, it "may do some good." The Wall Street Journal's editorial board has speculated that Milton Friedman might have supported the policy. Meanwhile, economic historian Robert Higgs, a senior fellow at the Independent Institue, blames Bernanke for the "zombification of High Finance," and the Cato Institute's Alan Reynolds argues that Bernanke is "risking higher interest rates and inflated commodity costs in the pursuit of the contradictory objectives." Even some liberal economists of the more-stimulus-now school have suggested that it probably won't have a major stimulative impact. In short, there's no clear consensus on the merits of quantitative easing, but the Fed is moving forward with the policy anyway.
That lack of consensus may be why arguments in favor of the policy sometimes seem a tad bit self-justifying. When mathematicians—or at least grad student wannabes—put together proofs, they sometimes stick the letters QED at the end. It's an abbreviation for the Latin phrase quod erat demonstrandum, which roughly translates to "which was to be demonstrated." And if they're feeling particularly defiant, having perhaps proved a colleague wrong, they're sometimes known to add the word motherfucker at the end. More broadly, it's become a way for nerds to snidely exclaim, "See! I was right!"
There's a similar sentiment behind arguments for the Fed's new policy, a simplified version of which goes something like this: Quantitative easing is probably a good idea. Why? Because we need to do something to increase economic activity. Fiscal stimulus is off the table for political reasons (at least). Inflation has been running a little low, which makes it an obvious policy lever. Expanding the monetary supply—and thus spurring on inflation— may not do much, but it's what can be done. And that means that, well, quantitative easing is a good idea. QE2, motherfucker!
Peter Suderman is an associate editor at Reason magazine.