that the Federal Reserve's Quantitative Easing policy is the problem - hardly so. Quantitative Easing, or "Printing Money" in simplistic terms, is doing two things for the economy that investors and businessmen LOVE. Just like a tax cut, QE reduces the interest rate, and thereby distributes wealth from the powerful banks and investment institutions to the businessmen and entrepreneurs. Or should I put it differently as diverting wealth from the powerful banks and investment institutions and into the businesses they own. Lower interest thereby reduces the expenses on businesses and consumers. It also reduces inflation - in the short term - by keeping prices moderated (businesses don't feel the need to increase prices when their expenses have been reduced), but at the same time stems deflation - which is absolutely the end all of economic disasters.
You may wonder how QE policy can put the spending power in the hands of businesses rather than banks. Steve will know the answer to this one. Businesses and businessmen look at the interest rate as an opportunity cost standard for whether a business should simply earn interest on a bond investment, or whether they should make a capital investment and wait for a future return. By reducing the interest rate (called "Printing Money"), the opportunity cost of capital investment is reduced, and the incentive to invest in a bond for future interest payments is reduced. Therefore businesses would rather spend money upgrading. It also has to do with present value of money. By reducing the interest rate to zero as the Fed has done, the future value of money in nominal terms will be the same as the present value. This is based on the equation Pv=S(1+r)N Where Pv is present value, S is the principle amount invested, n is the time in years, and r is the current interest rate.
Here's an example. The value of 10,000 dollars in three years at a 5% interest rate is:
=10000((1+.05)^3)
=11600
So in 3 years at a 5% interest rate, the value of 10,000 is 11600. So if your expected ROI on a 3 year investment is less than 11600, you should just put it in a bond at 5% and forget investing in capital. Also, this means that if 10,000 is worth 11600 in 3 years, it will theoretically take 11,600 to buy something that was worth 10,000 in today's current money value. But if the interest rate is closer to zero as it is now, 10,000 today is still 10,000 tomorrow, both in quantity and money value. This theoretically gives enormous incentive for investment in capital goods. And capital goods are the core drivers of our economy.
So this easing policy is much like a tax cut, but from the Fed rather than the government. However, the government should also be reducing taxes and expenditures while the Fed does this over the long term. Short term it may make sense for the government to spend more, since they can get cheaper bonds. The problem is the government already had enormous debt BEFORE the crisis. So spending any money they don't have is dangerous.
The only caveat to Quantitative Easing is that you have to be very good at judging when inflation is back to normal from zero, or when GDP is positive from negative. If you don't time it right, inflation will be more than normal. This is based on the Fed's money calculation MV=PQ. Increases in GDP raise the PQ side, and therefore to remain proportional, the Fed needs to increase the money site proportionally. V is a constant velocity of money, and P for prices in the economy normally should stay the same to avoid inflation. However, if GDP (prices or quantity) are decreasing, the fed can theoretically increase MV to force an increase in PQ. It is leaving the large amount of money on the table for too long that increases P too much, causing inflation.
Also, one has to take into account Gregory Mankiw's new theorem (Mankiw is a conservative economist at Harvard) that inflation is only a problem if it outpaces average raises in wages. Think of this: Businesses normally don't give raises based on performance. They have bonuses and promotions for that. Most raises are usually "in line" with or a bit above the interest rate. This means from year to year, the average worker maintains the same buying power, while GDP increases the quantity of selection as more and better products and services enter the market. This means that you have more to purchase tomorrow or next year with the same purchasing power (because the quantity of dollars available to you increased through a raise).
Currently, raises (if your company hasn't suspended them yet) are still outpacing inflation, which is somewhere near zero, or even slightly negative. Even if you got no raise, it is still in line with inflation since it is at zero. Once the economy recovers, most companies will give raises that are larger than normal to "make up" for the previous suspension, while hopefully the inflation rate stays below or around 4%, which will maintain a slight increase in purchasing power that we have been used to since Reagan.
Maintaining a 4% or lower inflation is the trick the Fed has to ensure.
Check out Mankiw's blog: http://gregmankiw.blogspot.com/ or this other blog by James Hamilton http://www.econbrowser.com/archives/2009/03/quantitative_ea_1.html
Now I want your dissertations and dissentions!
Tijs Limburg
Chairman and CTO of DMX - Digital Media eXceleron, Inc.
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