I was hoping to take it easy today and prepare for Hurricane Irene as it makes its way toward the East Coast, but Alan Reynolds, a very good economist (UCLA undergrad) whom I have known and liked for a long time, got in the way. Alan somehow has gotten the idea that monetary policy cannot stimulate a recovery, thus adopting the doctrine that kept the US from recovering from the Great Depression for over three years until FDR courageously devalued the dollar and took US off the gold standard. I thought that Alan understood this, especially because he read the manuscript of my book Free Banking and Monetary Reform as I was writing it, and seemed to have understood and accepted the argument I made about the monetary (i.e., the gold standard) cause and the monetary cure of the Great Depression. Alas, either I did not succeed as well in enlightening him as I had thought, or he subsequently reverted to some old mistakes, our interactions having become increasingly less frequent. So I take no pleasure in criticizing Alan, but, hey, a blogger’s gotta do what a blogger’s gotta do.
Alan, the creme de la creme of contributors to The Wall Street Journal editorial page, wrote an op-ed today accusing the Fed of having slowed down the recovery by adopting its program of monetary easing (QE2) last fall. This is a remarkable and, on its face, counter-intuitive claim. Nor does Alan provide much in the way of a theoretical explanation for why monetary expansion would would have slowed this recovery down, in contrast to other recoveries in which it hastened recovery, he suggests that by causing the dollar to depreciate, monetary expansion fueled a commodity price boom, thereby driving up costs and reducing the profitability of US businesses.
I don’t think that is a very plausible theoretical argument about how QE2 affected the economy. On the other hand, even Ben Bernanke has been unable to give a proper explanation for how monetary expansion would cause an economic recovery. Bernanke argues that monetary expansion reduces interest rates, already close to zero at the short end of the yield curve, at the long end of the yield curve. But Reynolds has no problem showing that long-term interest rates rose almost from the get go. To Alan this suggests that there was no stimulus, but on the contrary what the rise in long-term interest rates shows is how effective the stimulus was in improving expectations of future cash flows. The improving expectations of future cash flows fueled the rise in stock-market values starting in September (after a miserable August 2010 in which stocks fell by about 8 to 10%). (The S&P 500 rose from 1047.22 on August 26, 2010 to 1343.01 on February 18, 2011.) In my paper, “The Fisher Effect under Deflationary Expectations,” I provided evidence that the stock market, in contrast to what one would expect under normal conditions, has since 2008 gone up and down in close correlation with changes in inflation expectations. I discussed this phenomenon in a previous post.
Alan thinks that because the dollar fell against the euro from $1.27/euro to over $1.40/euro, and because commodity prices rose fairly sharply (perhaps by 25% in the six months after QE2 was announced) that there was no benefit from monetary expansion. Again, Alan has a bit of an excuse for his misunderstanding because those explaining the program, e.g., Christina Romer, Obama’s chief economist at the time (and a good one at that who should have known better), explained that a declining dollar would make US exports more competitive in world markets, failing to point out that there is a countervailing tendency. Alan correctly points out that a weaker dollar also makes imported products more expensive, so that the dollar cost of imported raw materials and capital equipment rises, diminishing the gain from a cheaper dollar to US exporters. However, US wages don’t rise (at least not without a very long lag) as a result of a falling dollar. And since, for most businesses, wages are the largest cost item, the falling dollar did in fact help to increase the profitability of US exporters, something Alan himself confirms when, in a different context, he reports that the operating earnings per share of S&P 500 companies were $24.86 on June 30, 2011 compared to just $20.40 a year earlier.
It is the increased profitability associated with increasing the prices of output faster than cost that is the primary (but not the only) explanation of how QE2 was supposed to stimulate a recovery. It was partially successful, as attested to by the increase in stock prices from September 2010 to February 2011. However, the recovery was stalled by a string of one-off events that disrupted and partially reversed the increase in production that was getting under way: a severe winter, a big runup in oil prices in February as a result of the shutdown of Libyan oil production, and the earthquake and Tsunami in Japan in March [update August 28, I failed to mention the effect of the European debt crisis which also began to worsen again at about that time].
I am sorry to say that Alan fudges a bit in discussing the increase in commodity prices in general and oil prices in particular. He attributes the entire increase in oil prices to quantitative easing. In fact between September and February oil prices rose about 20-25%, reflecting the increasing optimism of traders that a recovery was gaining traction. That increase in oil prices was in line with the increase in other commodities. The Dow Jones/UBS commodity price index increased about 30% between September 2010 and February 2011. Since commodity prices, including oil, had dropped sharply after the 2008 crisis, it is not surprising that an anticipated recovery would have caused a significant rebound in the prices of commodities in general, and especially oil demand for which is highly sensitive to overall economic activity. However, from February to April, crude oil prices increased another 20%, coinciding in the US with the spring changeover to higher ethanol requirements, driving gasoline prices to all-time records, thus dealing a blow to consumer confidence.
The first of the two charts below shows that although commodity prices increased sharply over the past year, they are still well below the levels reached in the summer of 2008 and about where they were in 2005. Concerns about commodity price inflation seem greatly overblown
The next chart shows a comparison between the movements over the past year in the entire DJ/UBS index and in the index of the Brent Crude benchmark. One can see that the DJ/UBS index increased between August and February and then leveled off, while Brent Crude increased sharply just when the broader index peaked. Only in May did oil prices moderate somewhat before falling sharply over the past month when markets began to take fright at the prospect of deteriorating economic conditions and policy paralysis. [Update August 28: a further fall in oil prices induced I think by the sudden success of the Libyan rebels, raising hopes of a restoration of Libyan oil production is particularly significant and I hope to follow up with a post on Libyan developments later this week.]
In short, my old friend Alan Reynolds blames everything bad that has happened over the last year on monetary causes, but can’t provide a coherent explanation for why monetary expansion would not stimulate the economy, something even Robert Barro was willing to concede as recently as January 22, 2009 in the Wall Street Journal editorial page.