QE2, Trade and Black Box EconomicsCommentary by Bob McTeer
December 16, 2010
"The Fed is printing money, and Economics 101 tells us that if you increase the supply of something, ceteris paribus, its price falls. The Fed is devaluing the dollar."
This paraphrased line was used on me recently in a recent TV debate on the impact of QE2. I couldn't see the fellow in the other box, but I could hear his smile as he savored what he considered his knock-out punch.
It would no doubt come as a surprise to him that in my distant past I had run across Economics 101 and even had heard of ceteris paribus. In fact, my nose was rubbed into ceteris paribus in the context of our discussion: what happens when the money supply increases. I was an assistant to my money and banking professor, who coached me at length on how to grade his exams, which, coincidentally, always included the money question in the final. This professor was not only very high on ceteris paribus-assuming other things equal-including making all assumptions about other factors explicit and skipping no steps in the chain of reasoning. He wanted no black boxes.
Using the equation of exchange-MV=PQ-as the framework and Milton Friedman's quantity theory as the holy grail, he would not tolerate going directly from a change in M to a change in P, much less from a change in M to a change in the exchange rate for the dollar, which wasn't even part of his model.
The students had to make all their assumptions explicit, and they couldn't get away with a glib ceteris paribus reference and then jump directly from more M to more P. Full credit for the answer required full disclosure of the assumptions that got you to your conclusion, but the difference different assumptions would make on the conclusion. If M changed, for example, what might or might not happen to V-the income velocity of money-and why might V change? A decline in V could offset an increase in M, or an increase in V could augment the impact. Behind the scenes, of course, changes in V reflected changes in the demand to hold money (cash balances), k. If k represented the fraction of money income (PQ) that people preferred to hold, changes in k would cause inverse changes in V. What would cause k to change? Interest rates? Something else? The K , or demand for money, could be omitted by undergraduates without much penalty, but not so for graduate students.
Then assuming that your assumption about what happens to V gives you an assumption about what happens to MV (total spending), what happens on the other side of the equation? Does a higher MV always mean a higher PQ? If so, is the change mostly in P, or in Q? What conditions would affect the difference? Well, the answer to that depended largely on whether Q (real output) was pretty much maxed out, meaning running at or near full employment of labor and other resources, or whether there was significant slack in the economy that might be taken up by greater spending. The closer you are to full employment, the more likely M increases result in proportional P increases. In a deep recession, however, some expansion in Q was likely to take some pressure on P.
How the student ended up meant less than how he got there. He had to walk the talk of ceteris paribus, not just spout it out and then ignore it. My professor was definitely "no Keynesian"; so he was okay with too much money creation leading to more inflation, but you had to reason it out rather than just assert it. No black boxes.
But my honorable debate opponent, as well as many others over these past couple of years, didn't just make the leap from M to P without spelling out the assumptions and the process; he, along with others, jumped all they way from M to dollar depreciation. The usual line about QE2 is this: "It won't work to stimulate the economy, but it will cause inflation and tank the dollar." But how does that work? How can it cause increased inflation without any impact on a high-unemployed economy? What goes on in that black box?
If more M doesn't create more MV and if Q is limping along with low capacity utilization and high unemployment of labor resources, how can P rise without some rise in Q? And, before leapfrogging over to the dollar, don't you need to assume greater dollar demand for foreign currencies and/or lesser foreign currency demand for dollars? That's a pretty big load to take for granted and leave unmentioned.
Back to that Economics 101 course: I learned that there is a connection between the supply and demand for dollars in the foreign exchange market and the demand and supply respectively for foreign goods and services. Import demand gives rise to a supply of dollars and a demand for foreign currencies. Demand for our exports supplies foreign currencies and a demand for dollars. Debits in our balance of payments reflect the demand for foreign currencies and the demand for dollars. Credits in our balance of payments reflect the supply of foreign currencies and demand for dollars. This may or may not have much to do with the Fed buying long-term securities in the U.S. market under QE2.
The trade balance and the broader current account balance are obviously key to what happens to the dollar. How can every pundit on Cable TV talk endlessly about the fate of the dollar without ever even mentioning our balance of payments? Let me repeat that with emphasis. How can every pundit on Cable TV talk endlessly about the fate of the dollar without ever even mentioning the balance of payments? Talk about black box economics!
Back to the topic of QE2: It is needed in large part because open market purchases have led to the creation of too few dollars. We've been having trouble getting to the increase in M-even before worrying about the adverse consequences of an increase in M.
Don't those who make dire predictions have some obligation to let us peek into their black box to see if anything's there?