Ask The Economist: Exploring Quantitative Easing

“Inflation everywhere is a monetary phenomenon,” said Milton Friedman, in his famous 1970 essay titled, The Counter-Revolution in Monetary Theory. What he meant is actually quite simple. Inflation (an overall increase in the price levels of an economy) only occurs when the amount of currency printed by the Federal Reserve exceeds the amount of goods being produced.

For example, let’s say a country only produces widgets, the market determines their price to be $1, and this creates demand for 1,000 widgets. Next, let’s assume that the supreme commanders of the country, Lords Krugman and Bernanke, decide to miraculously double the amount of money held in the bank accounts of the widget consumers. These consumers feel rich and start demanding more widgets.

 

However, nothing else in the economy has changed. Manufacturers are still producing just 1000 widgets. The resources and technology of the economy are completely unaffected by the appearance of more money. So if these “rich” consumers start demanding more widgets, but the manufacturers are producing the same amount as before, the price of widgets will start to rise. And suddenly we have inflation, with no increase in real Gross Domestic Product (GDP), the only real measure of actual production in an economy.

The same inflation occurs when the Federal Reserve simply adds currency to the US economy. This is exactly what the central bank has been doing with their controversial “quantitative easing” (QE) program, in their desperate bid to manufacture a recovery from the never ending recession of 2008.

The first phase of the ’08 bailout intervention - called “active monetary policy” - involved keeping short term interest rates artificially low, (by purchasing U.S. government bonds), and acquiring more public debt (in order to infuse more money, or in econ speak “liquidity”, into the market). However, this intervention proved impotent in the face of near 0 or even negative real short term interest rates, leaving no room for further economic “stimulation.”

So the Federal Reserve then adopted a measure called quantitative easing (QE). This involved targeting the longer term interest rates by purchase of financial assets from commercial banks. The Federal Government currently holds $2.054 trillion worth of such assets, but intends to taper off active purchases by October and let the existing assets expire as scheduled.

Two key questions surface: 

• GDP has not expanded significantly since the end of the recession, so why are we not seeing the inflation we would expect from so much additional money being dumped into the economy?
• What will the consequences of the end of this expansionary monetary policy be?

To answer the first question, the Federal Reserve Bank pays interest on reserves held by banks. It has cleverly set this payment at a rate marginally higher than what the banks can expect to make by lending money to consumers. Thus, the Fed has incentivized banks to sit on this additional liquidity and keep the currency from ever really seeing the actual economy. Thus, no hyperinflation.

Since it doesn’t “cost” the Fed anything to keep printing money and paying interest to these banks, this is likely to continue even when QE officially expires, in a bid to prevent the extremely high inflation that would occur if all these built up reserves were released into the economy. After October, the Fed will likely start selling its stock of government debt in the market to soak up this liquidity. What exactly was the point of this money shell game?  Even if we are doomed to end up where we started, the Fed evidently feels better to have been busy moving money around.

When the Quantitative Easing plan expires, the Fed has given the markets enough notice that we are likely to see a only a soft deflation in both asset prices and the stock market as people start pulling money out to take advantage of higher interest rates. This should not ultimately effect the real economy, since the infused liquidity was not actually in play in the first place. However, since markets and economies are affected by public perceptions in the short run, I would expect some negative but temporary swings throughout October.

---Abir Mandal, PhD Candidate, Clemson University Department of Economics and Palmetto Policy Forum Summer Fellow

Ask The Economist: Are Government Agency Banks a Good Idea?

People often associate capitalism with “Wall Street greed” and corporate fat cats getting special favors from government. The truth is, anytime the government is involved in the business of anything beyond protecting individual and property rights, it leads to a distortion of the free market and in fact detracts from authentic capitalism. We call this cronyism.

One of the most prominent examples of this phenomenon are government agency banks, such as the World Bank, Export-Import bank (Ex-Im), USAID and the International Monetary Fund. While the stated reasons for such institutions always sound noble, the numbers and perverse incentives they generate tell a different story.

Businesses often turn to such agencies when they are unable to raise enough funds for a project from the private capital markets at an attractive interest rate. The business then approaches the relevant bank to bridge the financing gap—either on the project side (such as to actually construct a factory) or the purchaser side (to finance the purchase of goods and services from the project). Either way, these government banks (and thus taxpayers) assume the risks that private financiers are unwilling to undertake.

Some businesses in the US and abroad claim they need this funding to stay in operation.  But this begs the question: if a business cannot exist without being subsidized by the government, wouldn’t the taxpayer dollars being used to prop it up be more efficiently allocated elsewhere by the free market? This would be true capitalism at work and the “creative destruction” that accompanies it. Unfortunately however, many well-connected (and often well-off) shareholders of such businesses continue to benefit from forced taxpayer “generosity.” This hardly seems fair.

Some of these agencies claim to be profitable—i.e. they bring in revenues in excess of what they take from the taxpayers. Even if this were true (and such claims are often doubtful when you account for documented cases of waste and fraud), these claims ignore the “opportunity cost” of the government allocating these funds. (This means we will never know the actual losses from such investments, because the alternative, potential use of this money will never see the light of day.)

For example, when you spend money you have earned, you have incentive to prioritize your spending to ensure that you get the biggest “bang for your buck” possible. You chose carefully, because a bad decision hits you in the wallet where it hurts! But when a government spends taxpayer money, it has no such compulsions since the risk of losses are socialized (ie - borne by you the taxpayer).

And in addition to having little incentive to make good investment decisions, these banks are put in the position of choosing winner and losers among American companies: who will get cheaper, government-guaranteed funds and who will have to play by the regular rules of the game?

Perhaps the most persuasive argument for the US government to back agencies like this is to “level the playing field” for American industries since other countries have similar crony-type institutions. However, if another country is intent on bad fiscal policy (which is what financing otherwise unprofitable ventures entails) this does not mean that the US should do the same.

Instead, the American government should just let its citizens enjoy the cheap products and services made available on the back of taxpayers of other countries and use the dollars saved on true government priorities (such as paying down our enormous debt) or never taking them out of the pockets of taxpayers to start with.

We should do the American people a favor and shut these banks down.

LEARN MORE:

This week, Forum Chairman Jim DeMint writes that only 2 percent of all exports involve Ex-Im assistance.  He also shared this helpful chart from the Mercatus Center at George Mason University showing the breakdown of who benefits from Ex-Im (note the “unknown” section:  Ex-Im routinely loses track of whom they’ve been helping.)

---Abir Mandal, PhD Candidate, Clemson University Department of Economics and Palmetto Policy Forum Summer Fellow

(Click on image to enlarge)

"Move On When Reading" = Good Education Policy!

Imagine trying to navigate the challenging waters of fourth, fifth and sixth grade science, social studies, and English unable to read. Unfortunately, this is the case for too many Palmetto State children, who are "socially promoted" based on seat time alone rather than proficiency. So how do we help ensure students have this fundamental tool for academic success? New research from Arizona supports one of our key initiatives that answers this question.

The Grand Canyon State has long been on the cutting edge of education transformation, and we could learn much from them. One innovative policy that Arizona recently implemented is called Move On When Reading. This is simply a benchmark requirement mandating that any third grade student without sufficient reading competency be prevented from advancing to the next grade until she is ready. While this change was met with the inevitable opposition, the results speak for themselves. When the law was passed, there were an estimated 4,300 third graders who would be retained based on the law. However, since its passage, the Move on When Reading mandate has caused school systems to focus on helping their students achieve the necessary competency through additional support like tutoring and summer school. Now it is estimated that the number of students likely to be held back is well under 750! This is a truly impressive educational triumph, and it came during a time when school budgets were decreasing. With our new Read to Succeed law, struggling young South Carolina students should finally get the help they need as well. Hopefully we will soon fill this space with Arizona-like results.

READ FULL ARTICLE HERE

Ask the Economist: Minimum Wage Laws or Minimum Skills Laws?

Infographic: American Action Forum http://goo.gl/ZuQC8N

     Many feel-good policies are ultimately disastrous. One of these, the concept of a government-mandated minimum wage, is particularly counterproductive. 

On the face of it, what could be so bad about guaranteeing the poorest workers in society receive wages high enough to ensure a minimum standard of living? (Especially since it only comes at the cost of "immoral corporate greed"?) 

     The answer is: a lot. No company will ever employ a means of production that costs more than the benefit it derives from said factor. Labor is no different. If the minimum wage is set at $10 an hour, the employees who get paid that much must at least provide that amount of returns to the employer. What about people whose lack of skills or education prevents them from producing enough value? They wind up suddenly unemployed, or, if they were unemployed in the first place, farther than ever from a much needed job. 

     Who are these people? They would be the least educated and, thus, the poorest members of society. These are the very individuals the Left says that minimum wage increases would help. History bears this out. Youth and minority unemployment always tends to increase the most when recessions hit. (Again, this is because as minimum wage laws curtail the adjustments the labor market needs to handle such downturn.) In effect, minimum wages only serve to make skills below a certain threshold untradeable in the job market. If a person is willing to trade his skills for low wages, even something like $5/hour, and is able to find someone willing to pay him that wage, the government has no business telling them that they cannot complete this mutually beneficial transaction. In this light, minimum wages make very little economic sense and essentially amount to arbitrary government restrictions on the free market. 

     These economic realities must be remembered in light of the ongoing debate over minimum wage laws so that our good intentions don't translate into bad policies that end up hurting the very people we want to protect.

---Abir Mandal, PhD Candidate, Clemson University Department of Economics and Palmetto Policy Forum Summer Fellow

Ask The Economist: Why Elasticity Means Soaking the Rich Won’t Work

In the history of civilization, income tax policies designed primarily to soak the rich have always failed. Why? Because of a basic concept of economics called elasticity. Imagine the price of gas goes up by $4 per gallon (to say, the European price). If you routinely buy 20 gallons of fuel a week for your “fun” car (maybe a BMW M3 or Chevy Corvette), would you, after this price hike, be likely to add an extra $80 a week to the coffers of the gas company? The answer is, of course, no. You observe the price of gas going up and cut your consumption. 

The percent change in the quantity demanded for a good or service  following a change in its price is called its price elasticity of demand. The same applies to supply. As the price received by suppliers of a good increases, they tend to supply more of the good to the market. The change in supply with a change in price is called the elasticity of supply. This holds both for a sales tax or an income tax—the income tax being the price you pay for the “privilege” of working. If governments tax a good higher, less of it is demanded. If you tax labor higher (by taxing income at a greater or graduated rate), you get less of it in the market. 

Thus, tax revenues will begin to plateau with increasing tax rates and will eventually start declining. This phenomenon, known as the “Laffer Curve,” was first articulated by Economist Arthur Laffer. 

Hopefully, now you understand elasticity, even if (some of) your elected representatives do not.

---Abir Mandal, PhD Candidate, Clemson University Department of Economics and Palmetto Policy Forum Summer Fellow