The Grand, Underappreciated Implications of QE For Economic and Foreign Policy.

As Quantitative Easing has just ended after four years, consisting mostly of around $3 trillion worth of Federal Reserve purchases of U.S. Treasury bonds, many observers have not yet understood the extremely positive implications of the QE experiment for both economic policy and foreign policy. Once our economic policy makers catch on, there will no longer be deep recessions or periods of high unemployment, and no holding back on necessary infrastructure investments and defense expenditures so long as the unemployment rate is over 5% and capacity utilization has room to increase. There will no longer be any talk of our national debt being too high, of debt being passed on to future generations of taxpayers, of budget deficits necessarily being inflationary or inevitably crowding out private investment, of our not being able to afford increased defense, infrastructure, and research spending, of our having to patiently slog through recessions and endure periods of high unemployment. This may sound improbable and pie in the sky, but only to those who do not yet fully understand QE.

When our policy makers fully understand the nature of QE, QE will be used in a revolutionary way, not just as it has been over the past four years to stabilize the economy by financing otherwise unfinanceable enormous budget deficits, thereby keeping the economy from plunging into depression: QE-financed tax rebates will become the standard tool to stimulate the economy, allowing economic growth to reach its highest potential, recessions to always be very brief, unemployment to never be high, and the national debt to shrink. Even private sector indebtedness will shrink. The use of QE-financed tax rebates as the standard tool to stimulate a weak economy -as opposed to an easy monetary policy with ultra-low interest rates which have the negative side-effects of creating asset bubbles and of reducing interest income necessary for consumption- will be the economic equivalent of the invention of the wheel.

What is QE? It is, quite simply, the Fed printing money through the creation of virtual, not real debt, virtual debt which gets extinguished upon maturity and disappears into thin air. The virtual debt consists of newly issued Treasury bonds which the Fed purchases and keeps through maturity. Since the Fed is an agency of the U.S. government, at the end of each year it reimburses the Treasury for all interest payments received on the T-bonds it held, and it returns to the Treasury all principal payments it received on maturing T-bonds. So, T-bonds held by the Fed cost the Treasury absolutely nothing in terms of interest payments, and absolutely nothing in terms of capital repaid upon maturity. As for the money creation, it occurs when the Fed credits the Treasury’s checking account at the Federal Reserve for the dollar amount of newly issued Treasury bonds it purchases. (Such crediting is an instance of electronic printing of money.) Importantly, since all T-bonds held by the Fed get extinguished at maturity, the debt represented by those bonds vanishes and is not passed on to future generations of taxpayers. QE means free, new money for the Treasury and subsequently free, new money for the U.S. economy when the government spends it or passes it on to consumers through tax rebates.

Conventional economic theory, which has often proved mistaken, holds that printing money is necessarily inflationary. But the past four years of gigantic QE, about $4 trillion dollars worth, has not led to high inflation, not even to higher inflation. Inflation has held at extremely low levels despite enormous amounts of money printed by the Fed. That can only mean one thing, i.e., that printing money is not per se inflationary. Logic explains why. So long as newly printed money does not translate into excess aggregate demand (the situation of “too much money chasing too few goods”), the economy will not overheat and cause “demand-pull inflation”. Prices and wages rise when there is excess aggregate demand, i.e., when capacity utilization is very high and unemployment very low. So long as there is slack in the economy, inflation will not be a problem. That has been the situation over the past four years, with ample free productive capacity and employment well below full-employment levels. (Too many economists fail to distinguish between the two types of inflation, i.e., “demand-pull” and “cost-push” inflation, which have different causes and require different economic policy responses. The high inflation years of the 1970’s and early 1980’s were of the “cost-push” variety due to skyrocketing oil prices having nothing to do with excess aggregate demand.)

Consequently, whenever there is slack in the economy, a well-calibrated QE (one which does not cause excess aggregate demand) will not be inflationary, it will only help the economy grow. The reason the enormous QE implemented by the Fed over the past four years did not bring about a strong economic recovery is that the printed money was mainly targeted to help the financial sector avoid obliteration, and not also targeted to significantly increase personal income and consumption. The proper QE would have included a large QE-financed tax rebate, which would have gone straight into taxpayers’ pockets and led to strong consumption growth. With an $800 billion tax rebate (the same size as the Obama stimulus package of 2009), each taxpayer would have received a $5,000 check from the U.S. Treasury. A household with two taxpayers (v. husband and wife) would have received two checks of $5,000. Such a rebate would have immediately stimulated the economy which was suffering from insufficient consumption due to rising unemployment and over-indebted consumers unable to increase their borrowing no matter how low interest rates fell. It would also have stopped the housing crisis in its tracks, as households in financial difficulty would have suddenly had the means to keep current on their mortgages. The recession would have been ended overnight, and both public and private indebtedness would have declined substantially.

Since QE does not increase the nation’s indebtedness, it can be employed as often as needed. Well-calibrated QE-financed tax rebates should become the standard tool for stimulating the economy. Importantly, they are fair, since there is no discrimination, no favored categories of beneficiaries as unfortunately happened with the 2009 Obama stimulus which benefited only new cars buyers (“cash for clunkers”), new home buyers, state and local government employees, and selected companies awarded infrastructure contracts. With tax rebates, instead, all taxpayers benefit equally, receiving the exact same check from the U.S. Treasury. The combination of fairness and no-cost means that QE-financed tax rebates can be implemented whenever the economy slips into recession. No one will have reason to complain, since every taxpayer benefits equally and the national debt does not increase by one penny, in fact it decreases thanks to the cyclical economic recovery brought about by the rebates.

The proper use of QE-financed tax rebates means the end of prolonged recessions and high unemployment. It means higher sustained economic growth and lower national indebtedness, along with a stronger national defense and foreign policy largely free from budget constraints, without any significant increase in inflation. It means using an accurate tool for fine-tuning the economy, as the stimulative effects of tax rebates can be accurately estimated, which eliminates the risk of generating excess aggregate demand. (Of course, tax rebates can be partially reversed if found to be excessive through the imposition of temporary tax surcharges.) It means using a stimulative tool which does not create asset bubbles.

As for the widespread apprehension that the unwinding of the Fed’s balance sheet will cause interest rates to spike, it is mistaken. First, the Fed can dispose of its Treasury bond holdings as slowly as it wants in the bond markets or not at all, since it can simply hold on to all its QE-financed T-bonds until maturity, letting them evaporate. Second, the Fed’s enormous holdings of QE-financed T-bonds will not inevitably generate inflation since most of QE was targeted to cover the enormous losses of the financial sector, i.e., it served to avoid a bank sector implosion, it did not serve to greatly augment bank lending capacity which would lead to a lending boom. Therefore, there is no need for the Fed to reduce its balance sheet since there is no inflation risk inherent in the QE of the past four years. In any case, the best way to head off demand-pull inflation (which occurs only with a booming economy) is not through drastically higher interest rates (which have serious side effects, just as ultra-low interest rates have) but through temporary tax surcharges. In fact, the best monetary policy is a neutral one, one which targets the fed funds rate at the six-month trailing CPI on an ongoing basis. We should never have the fed funds rate far above the going inflation rate, as we did under Fed Chairman Paul Volcker in the 1980’s: that only served to greatly increase indebtedness, to slow economic growth, and to have a grossly overvalued dollar on a trade basis. It is no coincidence that we had record budget and trade deficits under Volcker’s tenure as Fed chairman.

QE-financed tax rebates may seem too good to be true, a magic trick to stimulate the economy without inflation. But they are simply a logical and instantly effective way to put idle productive resources back to work, to increase consumption to a level which ensures high capacity utilization and low unemployment, without increasing debt, indeed with public and private indebtedness decreasing as a result. Crucially, they are also a fair way to stimulate the economy, with all taxpayers benefiting equally. Large QE-financed tax rebates would have quickly ended the Great Depression of the 1930’s, whereas the various public works programs did not. Nor was World War II necessary to end the Depression. Large QE-financed tax rebates would have provided the necessary stimulus with no displacement of workers away from producing consumer goods and services towards the defense sector, therefore without causing demand-pull inflation.

One would expect that after three years of QE by the Federal Reserve totaling more than $3 trillion, there would be no more talk of the U.S. depending on foreign capital to finance our budget deficits. Incredibly, that mistaken theory still prevails today in the face of such overwhelming contrary evidence, and even ends up constraining our foreign policy due to our presidents feeling beholden to our largest foreign creditors, such as China currently. No Addiction to Foreign Capital, my May 3, 1985 article published by the Wall Street Journal, debunked the conventional economic wisdom that the U.S. depended on foreign capital (Japanese at the time) to finance its budget deficits. Since we have the Fed to do QE whenever necessary, it should be clear to everyone that the U.S. does not need foreign capital to finance its budget deficits, ever.

November 8, 2014

© Edward Sonnino 2014