Pushing on a String?

Public Choice economist William Shughart criticizes quantitative easing. His argument? It is the old Keynesian argument that you can't push on a string. He writes:

The key assumption behind "QE2" is that credit markets are frozen - and lenders are reluctant to lend - because the financial system lacks sufficient liquidity. But banks are awash in loanable funds.

No, the key assumption behind QE2 is that real expenditures are less than the productive capacity of the economy, and that an increase in the quantity of money--the amount of money available for firms and households to hold--will result in an increase in money expenditures on goods and services. Whether credit markets are frozen or whether the financial system has sufficient liquidity is irrelevant.

When the Fed purchases government bonds it directly increases the money balances of those households and firms that sell the bonds. Unless the demand for money increases dollar-for-dollar with the increase in the quantity of money, the resulting excess supply of money will generate increased expenditures. While those selling the bonds may purchase other financial assets, what do those who sell those assets do with the money? At least some of the excess money is almost certainly spent on goods and services, which is the goal of quantitative easing.


When the Fed purchases bonds, it also increases the reserves of the banks. If the banks use those reserves to lend, then the quantity of money will increase by more than the value of the bonds purchased by the Fed. The operation of the money multiplier reduces the amount of bonds the Fed needs to purchase to generate the needed change in the quantity of money. While banks might make consumer or business loans, they can also "lend" by purchasing existing bonds. While having banks use increased reserves to expand lending is a possible consequence of quantitative easing, motivating banks to make more loans is not the purpose of quantitative easing and it is not necessary for quantitative easing to achieve its purpose--to expand spending on final goods and services.

Even if the Fed succeeds in reducing long-term interest rates, the economy will not necessarily be out of the woods. Artificially low interest rates induce businesses to undertake projects that otherwise would be unprofitable. Not to worry too much, though. Investors have been selling Treasury securities in anticipation of the Fed's buyback plan, raising yields to levels not seen for three months.

Admittedly, listening to Keynesian advocates of quantitative easing--it is supposed to lower real interest rates and stimulate real expenditure by a combination of lowering nominal interest rates and raising expected inflation-- can be misleading. However, it is sad when free market economists respond with the old-fashioned Keynesian critique of monetary policy--the banks already have plenty of reserves, they have plenty to lend, and no one wants to borrow. You can't push on a string--the traditional refrain of those who confuse money and credit.

Restricting government spending, tax reform and deregulation, would all help end the slow down in productive capacity shown by the CBO estimate of productive capacity. Perhaps such policies would result in a reduction in the demand for bank reserves or the demand for money, resulting in more spending on goods and services. However desirable such policies might be, they are not arguments against a monetary policy that does its job--adjust the quantity of money to meet the demand to hold money and keep money expenditures on output growing at a slow steady rate.