Wednesday, December 1, 2010

QE Has Worked Before and It is Not Just About Lowering Interest Rates

Felix Salmon tries to defend his criticism of QE2:
I don’t think that we’re hysterically attacking QE2, so much as pointing out that it’s never been done before, that we don’t know whether it will work, and that, if it doesn’t work, we don’t know how it’s going to fail, either.
No, QE2 has been done before and it worked quite well.  As I showed in this post and as noted by Paul Kasriel, the original QE started in in late 1933 and was very effective at spurring a robust economic recovery.  And contrary to conventional wisdom, the key to making QE work then and now was not the lowering of long-term interest rates.  It was about addressing the excess money demand problem and thereby spurring a recovery in nominal spending.  Yes, interest rates may initially fall,  but if QE2 works according to plan there should ultimately be an increase in yields. In short, QE2's success is not contingent on a sustained lowering of interest rates.


  1. Moreover, interest rates on long term government bonds are influenced by all kinds of other factors than Fed purchases, such as confidence in the U.S. government, general willingness to save, supply of close substitutes, etc. Although these aren't likely to change much over the next couple of years, they help to remind us why the Fed has no business trying to determine particular interest rates.

    The Fed needs to satisfy changes in the demand for base money (and indirectly satisfy changes in the demand for broader measures of money). They should just let the market deal with particular interest rates in the same way it deals with other prices, right?

  2. Lee, you are correct. The real reason the Fed is going after long-term securities is because short-term securities have become near perfect substitutes for the monetary base. By purchasing long-term securities, portfolios will be out of balance and readjusting of it ultimately lead to more spending. All asset prices and yields will be affected to some degree.

  3. The so called QE that took place in 1933, if Paul Kasriel’s description is accurate, bears little resemblance to the QE taking place in 2010. The former consisted of raising the value of gold in dollar terms, which enabled the Treasury to create dollars out of thin air.

    The first crucial difference between the two is that the 1933 episode increased the private sector’s net financial assets, which doubtless induced this sector spend. In contrast, present day QE has no effect on the total worth of the private sector. To illustrate, if my $X worth of Treasuries are “eased”, I get $X: I’m no better off. Thus I have little inducement to spend (apart perhaps from buying some shares so as to return the “cash to investments” ratio of my portfolio to nearer where it was prior to my Treasuries being eased.)

    The second crucial difference is that the money created ex nihilo in 1933 seems to have been spent on the variety of items the Treasury funds (roads, the military, etc). I.e. this extra money will have found its way into the pockets of a wide variety of people, rich and poor. And the poor have a greater propensity to spend extra income than the rich. In contrast, present day QE just boosts the bank balances of those who hold government debt, and that tends to be the rich.

  4. I should have said in addition, that as an admirer of Abba Lerner and Modern Monetary Theory, I’d be all in favour of repeating the 1933 policy, except that with every country now being off the gold standard, gold is now irrelevant. That is, the government / central bank machine can (and in a recession should) create money ex nihilo and spend it on the normal items that governments fund (or they can cut taxes and make good with ex nihilo money). This policy is the essence of Modern Monetary Theory.