Counterthoughts

QE2

by Steve Landsburg November 18, 2010

Some Q&A about quantitative easing, with a somewhat higher ratio of economics to cartoon characters than we had yesterday:

What is this quantitative easing stuff? What exactly is the Federal Reserve (a/k/a “the Fed”) doing?
They’re creating 600 billion new dollars and using those dollars to pay down the government’s debt.

They’re paying down the debt? I thought they were buying bonds.

It’s the same thing. Last year, Huey McDuck lent the government a dollar and received a bond. (A bond is the same thing as an IOU.) Today the Fed buys Huey’s bond. Now the government owes a dollar to the Fed instead of to Huey.


"It's the same thing."

If the Federal Reserve is part of the government, and the U.S. Treasury owes money to the Fed, then our government owes the money to itself. In that case, it doesn't owe that money to anybody else, so I guess it doesn't even count as money owed. Makes sense to me...

Kind of by definition, the Fed is not part of the economy. So if the Fed has a dollar, that dollar is not "in" the economy. When the Fed buys something with that dollar, the dollar goes into the economy. And if the Fed sells something and receives that dollar in payment, the dollar comes back "out" of the economy.

So if the Fed buys something, the dollar goes into the economy and the something comes out. If they buy government debt, then that government debt should come out of the economy. It should "cease to exist" in the same way a dollar "ceases to exist" when the Fed receives it. That's what makes sense to me. But I never saw the story told that way, by somebody who really knows. Somebody like an economist.

If this is the right story, then a lot of things fit together and make sense for me. If a government debt ceases to exist, the government shouldn't have to pay interest on that debt. Or to simplify the paperwork, say, it could continue to pay interest on that debt but then get that money back at the end of the year, or whenever. Makes sense to me.

Of course, this all depends on accepting the view that the Fed is part of the government. I accept that view, but some people don't.

> SEE MILTON FRIEDMAN, MONEY MISCHIEF, P.206 (CLICK THE 'Page 206 »' LINK)
> SEE G. THOMAS WOODWARD ON 'PUBLIC OR PRIVATE'


But the government still owes someone a dollar!

Well, yes and no. Unlike Huey, the Fed is subject to a 100% tax on profits. So the government can pay its one-dollar debt to the Fed and then turn right around and swoop that dollar back up again. That’s just as good as not owing anything in the first place.


"The Fed is subject to a 100% tax on profits."

Almost.

1. G. Thomas Woodward writes: "Over its history, the Fed has paid to the Treasury approximately 95% of its earnings." So it's not 100 percent. It's 95 percent. But that's close enough for me.

2. The blogger Landsburg says the Fed is subject to a "tax." I don't think that's right. I think it's an oversimplification, the kind that leads to important misunderstandings down the road. The Fed turns it all over to the Treasury, not to the IRS. It's sorta like a husband and wife, both working, and they pool their funds. It's not like a tax at all.

> SEE G. THOMAS WOODWARD ON 'WHERE DO THE PROFITS GO?'
> SEE YAHOO ANSWERS


So in effect, the Fed is reducing the debt by 600 billion dollars. Does this mean taxpayers will have to cough up 600 billion fewer dollars in the future?

Yes.


This is a definitive answer to an ambiguous question. I think the question means, Is this $600B of debt that taxpayers won't have to pay back? If that's the question, the answer is easily a definitive yes, because the federal debt never gets paid back. Does this come as a surprise to you? It really shouldn't.

Oh, yeah, Clinton reduced the federal debt four times, and Nixon reduced it once. But basically, the debt never gets paid back. It used to be policy. These days, people get all bent out of shape about it.

> SEE TIME MAGAZINE OF 31 DECEMBER 1965 (NEXT-TO-LAST PARAGRAPH)


Sounds like magic! Why don’t they just do this over and over again until all the debt is gone?


That's not even a reasonable question. I don't think anybody would ask that, except maybe somebody writing a Q&A. Anyway, here is Landsburg's answer:

Because there is no such thing as magic. You can’t make the world a richer place just by creating dollars. Dollars are claims on wealth, but they’re not wealth. You can’t eat them, you can’t drive them, you can’t live in them...


Well, that's part of Landsburg's answer.

Landsburg says you can't make the world a richer place by creating dollars, because dollars are not wealth.

Fair enough. But as he points out, "Dollars are claims on wealth." So, there is a relation between wealth and dollars. That relation has to do with making claims on wealth or, as I would put it, it has to do with buying and selling.

If they print too many dollars it makes prices go up, yadda yadda. So we can say with some authority that the "relation" has to do with the quantity of money, and that too much money can be a problem.

Now, just naively, one would expect that not enough money could also be a problem. However, that is not something one hears people say. My collection of statements on money as the problem includes two from the 1600s which warn of problems resulting from a shortage of money, and an observation by Adam Smith that an increase in the quantity of money was beneficial in Scotland in the 1700s. No other observations on shortage of money, until mine of 1977.

You cannot make the world a richer place, Landsburg says, just by increasing the quantity of money. Adam Smith said you can. Smith said, "When paper is substituted in the room of gold and silver money, the quantity of materials, tools, and maintenance, which the whole circulating capital can supply [is] increased..." Production is increased, not because the money is paper, but because the use of paper permits an increase of the quantity of money.

Smith continues: "I have heard it asserted, that the trade of the city of Glasgow doubled in about fifteen years... and that the trade of Scotland has more than quadrupled" as a result of this increase in the quantity of money. It worked, because there had been a shortage of money. Just something to keep in mind.

The balance of Landsburg's answer:

...Paying down debt makes the taxpayers richer. But in order for taxpayers to get richer, someone else has to get poorer — unless the Fed finds a way to create real wealth. And that’s not so easy.


"Paying down debt makes the taxpayers richer."

A bold statement. Could be true. Or... the federal debtor could increase everybody's taxes and try to pay down debt that way. I don't know if it would work, but I do know it wouldn't make the taxpayers richer.

Okay, then. Who gets poorer?

When the Fed buys Huey’s bond for a dollar, Huey goes out to buy a blueberry muffin. This (ever so slightly) bids up the price of muffins and so (ever so slightly) reduces the value of everyone else’s money. Or maybe Huey lends that dollar to his cousin Dewey, who buys a muffin, or maybe the dollar takes a more circuitous route. But sooner or later someone tries to spend it, drives up a price, and drives down the value of existing money. We can even figure out the size of that effect: Since the taxpayers got a dollar richer (through the reduction of the national debt) and since the world as a whole is neither richer nor poorer, the moneyholders must have gotten exactly a dollar poorer. Do that 600 billion times and the taxpayers will be 600 billion dollars richer and the moneyholders will be 600 billion dollars poorer.


$600 billion poorer. That is quite a calculation. By Landsburg's measure, if Huey spends one new dollar, it "ever so slightly... ever so slightly" reduces the value of everyone else's money. But if 600 billion Hueys do it, moneyholders end up "exactly" 600 billion dollars poorer.

"There is no such thing as magic" when the Fed creates dollars. But there seems to be some magic in Landsburg's numbers. Besides the sleight-of-hand, Landsburg totally discounts the effect that economic growth would have on his numbers.

If output has been held below its "natural" level by a shortage of money, as in Adam Smith's Scotland, increasing the quantity of money can result in an increase of output rather than prices. Granted, such a state of affairs is alien to our experience. But the "printing money causes inflation" argument makes the most sense in its most complete form, which includes the possibility of a shortage of money.

>SEE MILTON FRIEDMAN, MONEY MISCHIEF; MONEY USUALLY MORE SIGNIFICANT


Aren’t the taxpayers and the moneyholders largely the same people?

Largely, but not completely. Bill Gates pays a lot of taxes, but he might not hold a lot of money. Odds are most of his wealth is tied up in other assets, like Microsoft stock.


The question is a general one, covering many people. The answer is a specific one, considering only one person. I cannot analyze this answer further.

I would point out, however, that pretty much everybody has their money tied up one way or another, in assets or in bills or what-have-you.

Are there any other downsides to all this?

Yes. The taxpayers are relieved of a 600 billion dollar debt burden. That’s 600 billion dollars worth of good. The moneyholders see the value of their money reduced by 600 billion dollars. That’s 600 billion dollars worth of bad. So far, at least from the perspective of the-world-as-a-whole, that washes out. But there are additional costs. For one thing, people will scurry around trying to convert their money into other assets so they’re not holding money when it loses value. That’s a lot of effort that serves no real social purpose. For another, it’s harder to do financial planning when the value of the currency is subject to unpredictable change. So on balance, the world is actually a poorer place.


Not according to Adam Smith.

Well, that’s terrible.

Compared to what? In the absence of this Fed action, we’d still have to pay that debt off someday. We’d do it by raising $600 billion in taxes — with all the accompanying disincentive effects. That’s kind of terrible too. It’s not clear whether the Fed’s action is better or worse than the alternative.


Oh there ya go. "It’s not clear whether the Fed’s action is better or worse than the alternative." Landsburg must be an economist. He cannot reach a conclusion.

Are there any ways in which printing dollars can enrich the world?

Well, maybe, if people are sufficiently idiosyncratic. Take Huey’s Uncle Scrooge, for instance. Unlike Huey, who (like most of us) values money only for what it can buy, Scrooge values money as a thing in itself: He likes to fill his vault and swim in it. I said earlier that dollars aren’t wealth because you can’t eat them, drive them or live in them. But they’re wealth if you like to nuzzle them. Buying bonds from Scrooge increases the world’s stock of nuzzlables, and that makes the world a richer place.

Where does the extra wealth go?

Well, not to Scrooge, really, because he’s got to trade away his bonds to get those beloved dollars. But consider: When the Fed buys Scrooge’s one-dollar bond, it retires a dollar of debt and makes taxpayers richer — just like buying Huey’s bond. But Scrooge, unlike Huey, never spends his new dollar. So prices never get bid up and our money retains its value. That’s a gain for the taxpayers at no cost to anyone. By creating something of value — a dollar for Scrooge to cherish — the Fed can make the taxpayers a dollar richer at no cost to anyone.


So... Landsburg is saying what we need is a way to reduce the federal debt, but without increasing the quantity of money.

This interests me because Landsburg apparently sees an imbalance between the quantity of federal debt and the quantity of money. I see a similar imbalance, between the quantity of total debt and the quantity of money.

Of course, there are differences. I see the imbalance as a recurring long-term trend that repeatedly results in Depression. Landsburg sees the imbalance as a problem because it makes our taxes high.

There is a problem with Landsburg's view, because his focus is on the federal debt. The problem arises because our money is backed by federal debt. Every dollar the Fed puts into circulation gets there because the Fed uses that dollar to buy some Federal debt. So, how can they take federal debt out of the economy, without putting money in?

1. The Fed can buy federal debt, but this means the Fed is putting money into the economy. It's what they usually do, but Landsburg doesn't like it.

2. The Fed can buy non-government debt, as opposed to federal debt. And, interestingly, that is exactly what they did in the first Quantitative Easing. But again, the Fed is putting money into the economy.

3. At some point perhaps, the Fed can swap the non-government debt it bought during QE1 for federal debt held in the private sector. This will reduce the federal debt without increasing the quantity of money. That might satisfy Landsburg.

It does not satisfy me, because I don't think federal debt is the problem. I think private-sector debt is the problem that holds our economy down.

So buying a bond from Huey means paying down the debt at the expense of the moneyholders, while causing some auxiliary damage that might or might not be greater than the auxiliary damage you’d cause if you tried to pay down the debt some other way. But buying a bond from Scrooge means paying down the debt at no expense to anyone.

Correct.


"...at no expense to anyone."

Okay, I'm rememberin that one. I'm gonna say stuff like Anyhow, as Landsburg says, it doesn't really cost anything when the Fed spends money.

Sounds like we need more Scrooges! Do they exist outside of comic books?

Probably not too often. More’s the pity.


"More's the pity."

Wow. My differences with Landsburg until now have been minor. This one is huge. Uncle Scrooge is hoarding money. Landsburg is telling us we need more hoarding. I'm saying, we don't. Hoarding is a problem.

In a normal economy, hoarding is what the Fed does when it sells something. It doesn't spend the money it receives in exchange; it hoards. That's the real reason we say that money is "out" of the economy when the Fed has it.

In today's economy, hoarding is what the banks are doing, with their vast quantity of excess reserves. The Fed put all that extra money into the economy, but the banks are sitting on it like Uncle Scrooge. So that money is effectively out of the economy.

If the Fed is putting trillions of dollars into the economy, maybe the only way to avoid inflation is to increase the hoarding. But that doesn't help the economy recover.

But all that hoarding, that is the reason the Fed has been increasing the quantity of money -- to keep the quantity in circulation from dropping as hoarders snatch money out of circulation and stuff it under the mattress or into reserve accounts.

I think our true objective is economic recovery. Preventing inflation by cloning Scrooge the Hoarder may be better than hyperinflation. But recovery is better yet.

Anything else we should know?

Keynesian economists (like Paul Krugman) have various theories about how buying bonds from guys like Huey could help get us out of the recession. I’m skeptical of those theories, though you should treat my skepticism with a grain of salt, because I am not really an expert on macroeconomics. (Though neither, come to think of it, is Paul Krugman.) But even if those guys are right, I’m largely unimpressed, because I don’t think recession fighting is a terribly important goal compared to enriching the world in the long run. And as far as that goal goes, I think I’ve covered the key issues here, though I’m sure readers will let me know if I’ve left something out.


"I don’t think recession fighting is a terribly important goal compared to enriching the world in the long run."

Sentences like that always make me thing about the Dark Age. And I have to wonder whether the guy who says it thinks the fall of Rome somehow enriched the world.