Sinking the QE2 and the False Monetary Policy -- Fiscal Policy Divide

For most of my life, QE has meant Queen Elizabeth. (An early-childhood thrill was being able to board the Queen Elizabeth I while it was docked at a New York harbor and have the opportunity to look around. This also was an age when trans-Atlantic passenger travel often was conducted on the water because flying still was prohibitively expensive.)

Today, QE2 means "Quantitative Easing, the second round," which is another way of saying the Federal Reserve System is supposed to find a way to convert the massive monetary base in banks into lots of new loans. However, as Paul Krugman and many others have pointed out, with interest rates close to "the zero bound," it does the Fed little or no good to use low interest rates to employ "Monetary Policy." (Krugman does favor devaluation of the US Dollar, as it would raise prices and cut real wages, which, according to Keynesians, would accomplish what the so-called Classical economists held: that unemployment occurs when wages are higher than what the labor market is willing to bear.)

As anyone who has taken a typical course in Macroeconomics, the supposed debate is between "Monetary Policy" and "Fiscal Policy" prescriptions for how government should deal with the economy. The debate between followers of John Maynard Keynes (Keynesians) and followers of Milton Friedman (Monetarists) centers around which kind of policy is effective in situations like the one we face today.

Keynesians say that when interest rates are extremely low, then government needs to take up the slack by borrowing and spending in hopes that the "stimulus" will "prime" the economy and get it moving again, the "traction" argument that Krugman often uses. On the Monetarist side, the Friedmanites say that Keynes was wrong in claiming that "money does not matter," and that the Fed really does have tools to get businesses to borrow once again.

Thus, we see the academic arguments spilling to editorial pages and onto the street, with the assumption that the Monetary Policy -- Fiscal Policy prescriptions take up the entire universe of macroeconomic prescriptions. However, what if there were a "third way" of viewing this matter, one that eschews both arguments?

Neither Keynesians nor Monetarists bring factors of production into the mix and specifically capital. Instead, if they do concentrate on prices, it is prices of final or consumer goods, but even there, the only "prices" that matter are those that are part of the "price indices," or the Consumer Price Index. (True, Friedman did speak out against price controls and he certainly had a better understanding of price theory than does Krugman, but nonetheless the macro arguments from both Keynesians and Monetarists ignore the micro-level system of prices.)

Likewise, both groups tend to view the macro economy as having homogeneous factors of production in which production pretty much automatically happens just as long as there is "enough money" by which to make the requisite transactions that will keep the goods moving. As noted before, they differ on the role of money, but also the nature of economic shocks.

The Keynesians hold that a market economy is internally unstable because individuals have a marginal propensity to save that sets off a cycle of under-consumption/overproduction that drags the economy down to a liquidity trap, which can last indefinitely. The Monetarists, on the other hand, hold that the market economy is stable and that the shocks are external, specifically coming when the monetary authorities at the Fed try to push too much money at one time into the economy. Thus, they argue that the Fed should have monetary growth targets. (Friedman even argued for a Constitutional amendment which instructed the Fed to permit the supply of money to grow about two percent annually.)

So, that supposedly is the crux of the Big Debate. However, as noted earlier, neither Keynesians nor Monetarists are willing to concede the Austrian point that during a boom, capital will be malinvested and the crisis occurs when lines of production are no longer sustainable, given the economic bubble has burst. In order for a recovery to occur, the malinvested capital must be liquidated or transferred to uses that can be profitably sustained. In the Austrian view, factors of production (and especially capital) are heterogeneous, not homogeneous, and that simply adding money or new spending to the mix only will further the malinvestments.

Now, in the current debate, I agree with Krugman and the Keynesians that simply easing loan terms will solve nothing, given that businesses are not going to borrow just for the heck of it. Entrepreneurs (who generally are left out of the macro discussions, since it is hard for these "economists" to find proper mathematical variables to depict them) must see the possibilities for economic profit, and in this current age with the White House spouting out anti-business rhetoric and the New York Times editorializing continuously for criminal prosecutions for "economic crimes," entrepreneurs are seeing the handwriting on the wall.

Furthermore, from what I can tell, Keynesians and the "Progressives" who now hold political power see entrepreneurs as being either evil and greedy or as being "socially useful" when they seek to build enterprises that depend upon government funding. To people like Krugman, production of goods is little more than a technological question that is answered by a production function. I doubt seriously that Krugman would even begin to understand the real role of entrepreneurs, given that I never have read any economic commentary from him that even recognized their existence.

So, in a nutshell, it won't do any good to increase bank reserves, but nor will it do any good for government to launch a massive, bond-fed "spending" program. Yes, some people will be employed and temporarily have money in their pockets, but the larger effects cannot and will not be sustainable.