Sailing to a stronger economy on the QE2

One of the nice things I have discovered about doing jury duty is that when it is all over, the judge usually comes in to thank the jurors for their service (or for coming down to the courthouse, if they don’t end up on a jury).  When the judge discovered that I am an economist he immediately asked: “What is this thing that the Federal Reserve announced today that that it is going to do?  And will it help?”

The Fed announced that it will undertake a second round of “quantitative easing” (hence QE2) of about $600 billion.  The decision to go forward with QE2 did not come as a surprise.  It did lead to serious criticism.

German Finance Minister Wolfgang Schäuble dismissed the policy as “clueless” (the adjective he actually used is probably less dismissive, and can be better translated as “without any redeeming value”). China, Brazil, Thailand and other emerging economies have strongly criticized the decision.

What is quantitative easing and what will it do?

Ordinarily, the Federal Reserve monetary policy affects short-term interest rates.  However, with the target for the federal funds rate currently 0 to 0.25 percent, short-term interest rates can’t go much lower.  Under the policy of quantitative easing, the Fed buys longer term securities, lowering longer term interest rates (the yield on the ten-year Treasury note is currently about 2.5 percent).

The motivation for the policy is that lower long-term interest rates will encourage firms to invest in new plant and equipment.  Since these projects are typically undertaken with borrowed funds, making those funds cheaper should encourage more such investment projects which will promote economic growth and reduce unemployment.

What might go wrong and why are foreign governments complaining?

As with any monetary policy that increases the money supply, there is always the worry that it will result in inflation.  With low inflation and a sluggish economy, that is not a major consideration at the moment.  There is also reason to believe that the Fed has the tools to pull back on monetary expansion should inflation rear its head.

Emerging economies complain that the policy will put downward pressure on the dollar, leaving them facing two not-very-appealing options:

(1)  They can try to match the US monetary expansion, in order to prevent an appreciation of their currencies against the dollar.  The problem with this approach is that that it involves undertaking expansionary monetary policy, which heightens the risk of igniting speculative bubbles.

(2) They can allow their currencies to appreciate against the dollar, which will not do their export industries any good (the US government has been arguing that China’s renminbi is deliberately undervalued and should be allowed to appreciate).

Others are worried that the depreciation of the dollar will lead to a currency war, in which the industrialized countries will engage in competitive devaluations in order to gain the upper hand.  Barry Eichengreen suggests that the three main developed-country currency blocs (the Eurozone, Japan, and the US) undertake coordinated monetary expansion, which will help these countries and–their export industries–recover (he also has some suggestions about how the emerging market economies can cope with a lower US dollar).

Policy makers have only so many tools that they can use to help the economy recover.  Given the lack of political support for more expansionary fiscal policy, quantitative easing is the best tool we have.

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One Response to Sailing to a stronger economy on the QE2

  1. Colin says:

    Professor,

    Am I right in assuming that China is simply being contrary in this case? Any downward pressure on the dollar caused by QE shouldn’t affect the exchange rate with a country using such strict capital controls. While Brazil or Thailand are understandable, I would expect the most outspoken criticism from Germany [noted] and Japan.

    I agree completely that QE is our best bet for the time being, but in the yen’s case at least, couldn’t this be characterized as a beggar-thy-neighbor policy?

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