Econ 101 and QE2

In Defense of Ben Bernanke

By ALAN S. BLINDER

15 November 2010.
http://online.wsj.com/article/SB10001424052748704658204575611052418939656.html

Ignorance is not bliss, especially when your economy is faltering and sound
policies are badly needed.

For months, we have witnessed the spectacle of people arguing that Keynes
was wrong. Somehow, additional government spending actually reduces
employment-even when the economy has huge amounts of spare capacity and
unused labor desperate for work; even when the central bank will prevent
interest rates from rising to "crowd out" private spending. Really?

One current catchphrase is "job-killing spending." Hmmm. How, exactly, does
more spending kill jobs when there is idle capacity and no threat of rising
interest rates? Stumped? So am I.

The anti-Keynesian revival has been disheartening enough. But now the
economic equivalent of the Flat Earth Society is turning its fury on Ben
Bernanke and the Federal Reserve. Critics ranging from German Finance
Minister Wolfgang Schauble to tea party favorite Sarah Palin-which is quite
a range-have spoken as if Bernanke & Co. have lost their marbles and are
embarking on a wild policy misadventure.

All in all, it looks like the nation and the world need an Economics 101
refresher. So let's start with the basics.

The Fed's plan is to purchase about $600 billion of additional U.S.
government securities over about eight months, creating more bank reserves
("printing money") to do so. This policy is one version of quantitative
easing, or "QE" for short. And since the Fed has done QE before, this
episode has been branded "QE2."

Here's the first Economics 101 question: When central banks seek to
stimulate their economies, how do they normally do it? If you answered, "by
lowering short-term interest rates," you get half credit. For full credit,
you must explain how: They create new bank reserves to purchase short-term
government securities (in the U.S., that's mostly Treasury bills). Yes, they
print money.

But short-term rates are practically zero in the U.S. now, so the Fed wants
to push down medium- and long-term interest rates instead. How? You guessed
it: by creating new bank reserves to purchase medium- and long-term
government securities.

That sounds pretty similar to garden-variety monetary policy. Yet critics
are branding QE2 a radical departure from past practices and a dangerous
experiment.

The next charge is that QE2 will be inflationary. Partly true. The Fed
actually wants a bit more inflation because, now and for the foreseeable
future, inflation is running below its informal 1.5% to 2% target. In fact,
there's some concern that inflation will dip below zero-into deflation. The
Fed, thank goodness, is determined to stop that. We don't want to be the
next Japan now, do we?

But might the Fed err and produce too much inflation? Yes, it might, leaving
us with, say, 3% inflation instead of 2%. Or it might err in the opposite
direction and produce only 1%. Neither outcome is desirable, but each is
quite tolerable. To create the fearsome inflation rates envisioned by the
more extreme critics, the Fed would have to be incredibly incompetent, which
it is not.

The final major charge, levied especially by a number of foreign officials,
is that the Fed's new policy amounts to currency manipulation: deliberately
lowering the international value of the dollar to gain competitive advantage
for U.S. exporters. Is there any truth to this? Not if words have any
meaning.

Economics 101 teaches us that one standard side effect of a central bank
reducing interest rates is a lower exchange rate. Actually, things don't
always work out that way in the real world; sometimes the stronger growth
pushes the currency up instead. This contradictory evidence notwithstanding,
it is commonly assumed that expansionary monetary policy depreciates the
currency. That's why some foreign governments, especially the more
mercantilist ones, are apoplectic. What's down for us is up for them.

But calling QE2 "currency manipulation" is a grotesque abuse of language.
After all, the U.S. dollar is a floating currency. Many factors, including
but certainly not limited to monetary policy, influence the exchange rate,
which changes every minute. But the Fed will not intervene to push the
dollar down. If the dollar should rise instead of falling, c'est la vie.

More important, the U.S. is a sovereign nation with a right to its own
monetary policy. So I was stunned when a top aide to the Russian president
suggested that the Fed should consult with other countries before making
major policy decisions. Come again? An independent central bank doesn't even
consult with its own government.

Finally, there's that old hobgoblin: consistency. Critics tell us that QE2
won't give the U.S. economy much of a boost but will lead to rampant
inflation. Both? How does that work?

If buying Treasurys is a weak policy tool, a view with which I have some
sympathy, then it shouldn't be very inflationary. There is no magic link
between growth of the central bank's balance sheet and inflation. People,
businesses and banks have to take actions-like spending more, investing
more, and lending more-to connect the two. If they don't, we will get
neither faster growth nor higher inflation, just more idle bank reserves.

What the Fed proposes to do is neither foolproof nor perfect. Frankly, it's
not the policy I would choose. As I've written on this page, I'd like the
Fed to purchase private securities and to reduce the interest rate it pays
on reserves, even turning it negative. The latter would blast reserves out
of banks into some productive uses.

But I don't run the Fed. Maybe Chairman Bernanke's ideas are better than
mine and, in any case, the planned QE2 is far better than doing nothing. It
is not a shot in the dark, not a radical departure from conventional
monetary policy, and certainly not a form of currency manipulation.

I know Ben Bernanke. Ben Bernanke is a friend of mine. And critics ranging
from Mr. Schauble to Ms. Palin are no Ben Bernankes.

Mr. Blinder, a professor of economics and public affairs at Princeton
University and vice chairman of the Promontory Interfinancial Network, is a
former vice chairman of the Federal Reserve.