Airs – Ian Lance Taylor

QE2

In private e-mail I got a pointer to one of the real goals of the Fed’s quantitative easing, one that we’re also seeing in other countries reactions to the Fed’s plans: to weaken the dollar in order to improve the U.S. trade deficit. This is a more plausible goal than the stated ones. By making it cheaper to borrow money in the U.S., the Fed is encouraging investors to borrow in the U.S. and invest the money abroad—the carry trade. This will tend to drive up prices abroad and in particular tend to drive up foreign currency relative to the U.S. That will make U.S. exports cheaper, and thus tend to reduce the U.S. trade deficit. This will tend to make U.S. exporters hire more people, improving the economy in the U.S.

This won’t work with China, of course, because the Chinese government controls their currency levels. But it will work with most of the other countries the U.S. is running a trade deficit with. Unless, of course, they respond in some way. The trick for them will be finding a way to respond which does not involve increasing their own deficit unsustainably and does not run them afoul of WTO rules.

It’s still a gamble by the Fed, but at least it’s one that might work. The biggest risk would seem to be a steady increase in subtle trade barriers, which will tend to hurt the entire world economy. There is a real sense in which China started the game of subtle trade barriers, and this may be the U.S. response.

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9 responses to “QE2”

  1. fche Avatar
    fche

    “to weaken the dollar in order to improve the U.S. trade deficit”

    IOW, to inflate, with all the benefits one might speculate that would bring. One hopes the well-known downsides of deliberately induced inflation may somehow be avoided, as may a currency war. Fun times. How different national financial tactics seem to be from those of prudent persons.

  2. jyasskin Avatar
    jyasskin

    See http://www.guardian.co.uk/commentisfree/2009/mar/17/g20-globalrecession. It doesn’t matter if other countries prevent the dollar from falling by printing their own currency; if the mutual currency-printing manages to raise the price level to what it would have been without the recession, that should fix a lot of the problem globally. It would be better to just print money and send it to people (i.e. http://voices.washingtonpost.com/ezra-klein/2010/11/the_helicopter_drop_a_number.html) rather than giving it to major banks to adjust interest rates, but this’ll be better than nothing.

    This was all standard monetary theory before the recession, but apparently recessions cause economists to forget their old positions.

  3. Ian Lance Taylor Avatar
    Ian Lance Taylor

    fche: U.S. inflation is extremely low and does not seem to be a serious risk right now. And, yes, you’re quite right that national financial tactics are different from those of ordinary people. Keynesian theory says that governments should act counter-cyclically: if governments do what everybody finds to be prudent, then you get caught in the paradox of thrift.

    Regarding inflation there is an interesting book, The Great Depression: A Diary, in which the author, a lawyer was steadily puzzled by the fact that there was no inflation despite massive government spending. Of course he missed the fact that the massive deleveraging was very deflationary, just as is happening today.

    jyasskin: Thanks for the reference, but I’m not entirely convinced. If everybody depreciates, we’re back to the situation in which every country is pushing on a string. The problem today is not a lack of investment capital. It’s a lack of desire to invest. Forcing people to invest by cranking up inflation is really the worst possible approach, because it punishes people who are being prudent.

  4. jyasskin Avatar
    jyasskin

    Pushing on a string is a risk that devaluing would simply be ineffective, not that it would be harmful. But doing something unusual is a more “credible commitment to be irresponsible” than giving up, so this should help some even if other countries devalue too.

    On punishing the prudent (which only happens if the Fed succeeds at fixing the economy, btw), think about the mechanism that pushes up inflation. The Fed prints more money; that money goes out into the economy through some channel; people spend it on stuff, increasing demand; higher demand with short-term-fixed supply causes higher prices. But that higher demand causes people to _want_ to invest because it makes the potential investments actually pay off. On the other hand, if the money never makes it out into the economy (say, it stays in bank reserves), then the inflation never happens and doesn’t punish anyone.

    It does matter how the money gets into the economy—sending it through banks is worse than giving it directly to the people—but as long as it gets out there, the largest effect still happens.

  5. Ian Lance Taylor Avatar
    Ian Lance Taylor

    It’s potentially harmful in this sense: the country owes another $600 billion which has to be paid back at some point. If the economy grows, paying that back is not a big deal. If the economy shrinks, it’s piling on the problem. That is, it’s harmful if it doesn’t work. And I think fche would argue that it is harmful regardless.

    Punishing the prudent happens in a more limited sense even if the Fed doesn’t fix the economy. Banks will have nothing to invest in, so they will pay even lower interest rates on savings accounts. People who save will get very low returns. This is, of course, part of the effort to encourage them to invest rather than save. However, if the economy does not pick up, and banks decline to invest, individuals will have nothing to invest in either. People who planned for their retirement expecting a certain rate of return on their savings will not get it. But you’re right that it’s not nearly as bad if inflation stays low.

  6. fche Avatar
    fche

    “even if the Fed doesn’t fix the economy”

    When did it become mainstream to think of an organ of government as having the (sole?) power to *fix* an economy? In normal capitalism, fixing an economy happens due to the aggregate efforts of its participants. Governments are not normal participants: they play a role somewhere between a parasite and a crazy old matchmaker. OK, once in a while something good comes out of it too.

    “People who save will get very low returns”

    But at least that rate would still be above zero. With inflation, you can get negative real rates of return on one’s savings.

  7. Ian Lance Taylor Avatar
    Ian Lance Taylor

    We can look back to the U.S. in the 1800’s to see what happens when the government does not attempt to fix the economy: a much sharper and shorter business cycle, with many more people thrown out of work with far fewer resources. Note that the most basic way that the government attempts to fix the economy is via unemployment benefits.

  8. fche Avatar
    fche

    “Note that the most basic way that the government attempts to fix the economy is via unemployment benefits.”

    That sounds rather like Pelosi’s famous quip. Even if that were true, it would have to be counter-cyclic instead of monotonically-increasing, no?

  9. Ian Lance Taylor Avatar
    Ian Lance Taylor

    Unemployment benefits are counter-cyclical in two ways. First, when more people are out of work, the government pays out more benefits. Second, when there is a recession, Congress normally does a temporary extension of the time that benefits are paid out. Both of these cause the government to pay out more money during a recession.

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