The Dangers of Quantitative Easing

Delivered by Senator-Elect Pat Toomey, (R-PA), on December 11th, 2010, to the Pennsylvania Manufacturers' Association.

This speech can come in handy. Imagine for a minute, you’re on an airplane and a guy takes a seat next to you and he won’t shut up—he just keeps talking. I promise you, you talk about monetary policy, you’ll put him to sleep in thirty seconds – problem solved!

More seriously, I think the recently-announced decision by the Fed to pursue another round of massive monetary easing is actually a very big deal. It’s very worrisome to me, and I wanted to share some of my concerns and I look forward to your input on this topic.

The Fed has described this new round of quantitative easing, this huge creation of new money, as QE2. Someone suggested it’d be better named the Titanic. I hope that quip does not turn out to be prophetic. But it is $600 billion in the creation of new money that they will use to buy Treasuries. It’s going to expand the monetary base dramatically. It will explicitly monetize something like three-quarters of all the new debt created by next year’s government deficit. And this is all in addition to something like $2 trillion of monetary easing that was done a couple of years ago.

Now, let me state very clearly, I believe Chairman Bernanke is a very smart guy. He’s a great scholar, a student of economic history and monetary policy, and he understands the risks he is taking. But I think he feels compelled to do something that he shouldn’t feel compelled to do, and I want to discuss that in a moment.

But first, let me run through a couple of the arguments that we sometimes hear in favor of this massive quantitative easing and tell you why I’m skeptical about these arguments.

One is that this huge new supply of money will have the effect of devaluing the dollar and that will make our exports more competitive so we’ll have an export surge and corresponding economic growth. I am very skeptical about that scenario. I think QE2 might very well lead to a devaluation of the dollar, but it seems to me that there is not a strong historical correlation between a declining currency and a surge in exports, and if it were to occur, it would probably be temporary. Think about it: Obviously, if we diminish the value of the dollar, all the inputs are going to become more expensive and that tends to offset the advantage from the decline in the dollar’s exchange rate.

But maybe even more compelling as a reason why that’s not likely to be very effective is that everyone else can play that game too. We can devalue our currency and everyone else can do likewise. And then, we have a global round of competitive devaluations that gets us absolutely nowhere but can be enormously disruptive to the economy.

The second notion, and this I think is closer to what the Fed itself has suggested about this, is that they’re actually worried that inflation is too low—which is a little counterintuitive to me—but that’s one of their concerns. So they want to raise inflation expectations, and obviously, a huge new supply of money can do that. At the same time, they want to use the money to buy treasury bonds in the hopes that that will keep interest rates low. So let’s think about this: You’re telling the world we’re going to have higher inflation, thereby eroding the value of bonds, and we expect bondholders to settle for a lower return? It’s rather unlikely that this going to work. Professor Alan Reynolds had a very persuasive argument about how ineffective that strategy is likely to be in a recent Wall Street Journal op-ed.

Maybe the best argument for QE2 is that what it really amounts to is an effort to reflate asset prices, which, obviously declined dramatically during the recent financial crisis. This is meant to have several effects. The first is the idea that you can recreate the “Wealth Effect” whereby stocks go up and people feel wealthier. They become more willing to spend money and this helps the economy. Maybe equally important in the eyes of many, if you have broad inflation, you increase the value of the collateral supporting loans on the balance sheets of banks. So for banks that have problem loan portfolios, the problems diminish to the extent that the dollar loses value. Some might describe that as kind of a backdoor bailout for banks with problems because you inflate the value of their collateral.

You can argue that this reflation has been occurring already. Some would suggest that the recent rise in stock prices might be attributed, at least in part, to the expectations of the coming monetary easing. I think it’s hard to quantify that, but in any case, the big problem is that you can’t control this process. I think the Fed would acknowledge that their ability to decide which assets go up and how much they go up is notoriously impossible to control and very difficult to predict, and therefore, it can be very destabilizing.

The big mistake in this whole approach is that the problems facing our economy are not fundamentally monetary in nature. The big problem is not that we don’t have sufficient money supply. In fact, M1, M2, and M3 have all grown. So clearly, that’s not the problem. And by the way, I thought the first round of quantitative easing was the right thing to do. When we had a financial crisis, when we had a contraction in the bank balance sheets, I thought the appropriate textbook response of the central bank was to provide liquidity, to provide easing, and they did that. That was the right thing to do.

We are not in those circumstances anymore. We have a weak economy, but we do not have a severe financial crisis happening right now. We do not have a huge liquidity crisis, and I would argue we don’t need this huge quantitative easing. I think the problems that we do have really fall into two broad categories.

One, the lingering effects of too much leverage – the deleveraging process that we are still going through, especially at the personal and the family level. A lot of the corporate level balance sheets are in much better shape.

The other big problem is that we have misguided fiscal, tax, and regulatory policies coming out of Washington which have had a chilling effect on investment. Those are, I think, the real problems with this subpar economic recovery.

So if you ask me, QE2 is the wrong tool. It’s like using a hammer when you need a wrench, and that’s not a good way to turn a nut. I think what we’re seeing right now is an effort to use the wrong tool to solve our economic problems.

Here are some of the serious dangers that worry me about pursuing this.

Ultimately, the big one is inflation. We always think of inflation as rising prices, but really, it is the declining value of the currency in which everything in our economy is denominated. And it’s happening already, maybe not in CPI, but look at commodities. Gold is at record highs; silver is at a 30-year high; soft commodities; cotton; grains; and other foods – all at very high prices. Oil is pretty high and gasoline prices are now starting to reflect that.

So I would argue strongly that there are a lot of warning flags out there. It may not be manifested in CPI yet, but CPI increases usually lag behind commodities. So this is pretty worrisome.

Second, the idea that we should be looking to diminish the value of our currency is very counterintuitive. If we diminish the value of our currency, it makes us all poorer. This is the currency of our savings. This is the currency in which everything that we do and produce is denominated. And obviously, if we diminish its value, everything costs us more.

Another particular problem is that asset reflation is never uniform. This happens in an erratic fashion which can be very disruptive. And the people who are hardest hit by this – if we do have a surge in inflation which I think would follow – are the people who are least able to manage the crisis, least able to diversity and find ways to adapt.

Imagine a union worker whose compensation is a tied to a multi-year contract. If inflation comes along at a high level, it’s going to erode the value of that worker’s earnings long before there is an opportunity to negotiate a new contract. This is just one of many examples.

Third, of course, if we have serious inflation, is the potential devastation to anybody who is a saver. Think of how unfair this is. Take our senior citizens who chose throughout their working lives to defer consumption, and instead of consumption, they saved in the hopes that when they reached retirement they would be able to consume or they’d be able to pass on their savings to their kids. Those savings just get devastated, to the extent that we have inflation, and I think that’s terribly unfair.

Fourth, this course could lead to a global trade war. That could take the form of competitive devaluations or other efforts to diminish trade. That’s worrisome to me.

Finally, among the most worrisome consequences are just the effects of higher interest rates that inevitably follow. Imagine: inflation starts to really take hold—that’s what the Fed wants to induce—and if that happens, then the higher interest rates that will almost certainly follow mean higher costs to consumers, higher mortgage rates, higher costs for business, and higher expenses for everybody.

Now, as worrisome as I find that whole scenario, I would argue it’s even more dangerous to do this at a time when we have this terrible fiscal imbalance. When we’re running huge deficits and we’re accumulating record amounts of debt as we are, this is very dangerous and here’s why I’m particularly concerned.

If you accept the views of most private economists, or the CBO, or anyone who is looking at this, we are on a trajectory to have the federal government’s debt exceed the total size of the American economy, over 100% of GDP, by roughly 2020.

Mind you, that should be frightening enough. All the problems that we read about in Greece occurred at a time when the Greek debt was 113% of GDP. We’re on a fast trajectory to get pretty much there. So as we approach that, let’s assume that they pursue QE2, and let’s assume that they’re successful in raising inflation expectations, which I think they will be. Now if that happens, I think it’s inevitable that interest rates go up. So today, the federal government’s average interest rates are historically low at 2.2%. If those rates simply revert to their historical norms – the last 20 years, they’ve averaged almost 6% – then think about where that leaves us. Debt is at 100% of GDP; average interest on that debt is at, let’s say, 6%. So our annual interest on our debt is 6% of GDP.

That’s more than we spend on the entire defense budget, including waging two wars. In fact, it’s almost a third of all revenue the federal government takes in. Historically, over the past 20 years, the government takes in something like 18% of GDP in revenue. Can you imagine if we had to devote a third of all that just to debt service? And by the way, that assumes that interest rates will just go back to their historical norm. But if we experience an unprecedented expansion of money supply through QE2, I don’t think it’s very far-fetched to imagine that interest rates will go higher than their recent historical average.

So I just think this is a very dangerous path that the fed is pursuing. And I think we should have a very vigorous debate about this, and not just academics, but economists, businesspeople, and members of Congress. We really ought to discuss this.

Now some have suggested that a critique such as mine amounts to an inappropriate politicizing of the Fed. I disagree. (For the record, I’m not suggesting that Congress start to wield a veto over routine Fed operations. That’s not the direction I’m advocating.) But the fact is, the Fed has enormous power and influence over our economy, on a scale that can sometimes dwarf whatever else the government does. Yet, is has remarkably little accountability. So, I’m suggesting we take a serious, hard look.

One of the things we ought to look at is the dynamic that leads the Fed to make a decision like this, and historically, has led the Fed to err on the side of easy money. I think that is a direct result of the mandate that Congress puts on the Fed – a legislative mandate to do two things.

The first is to maintain price stability. The second is to maximize employment. Well, the former – price stability – is clearly a fundamental responsibility of any central bank. That’s why we created a central bank. Interestingly, when the European Union decided to create the Euro, the central bank that they established to manage that Euro was given a single mandate – price stability. It was the only mandate. To this day, there is no ECB mandate to maximize employment.

But we took a different approach. We have these two simultaneous mandates on our central bank, one to maintain price stability, and the other to maximize employment. I would argue that in order to comply with the latter, the Fed feels from time to time, such as at this moment, compelled to pursue what is really I think inappropriate monetary policy – a policy that will create the illusion of growth, the illusion of activity, but not true growth. It’s been well documented that flooding the economy with money doesn’t create any wealth, doesn’t create any new productive output, doesn’t achieve what we’re really looking for – true increases in output, and actually, can be harmful.

So you have this paradox, where in an effort to achieve the second part of this mandate – the maximization of employment – the Fed actually undermines its ability to execute its first mandate – price stability. And in the end, price instability makes it impossible to maximize employment because it’s just too disruptive.

Now, of course, we all want to maximize employment. The question is whether it’s the proper mission of the Fed, and I’m increasingly coming to the view that we should reconsider that. History is clear. Efforts to monetize debt and efforts to reflate assets are often tempting but usually don’t end well. Perhaps, the Fed should focus on a single mission of maintaining price stability – which would be its greatest possible contribution to maximizing employment.