This is a friendlier version of an earlier post that was marked for economists.
Q: Everyone keeps saying that the government cannot boost the economy by increasing its spending because we need to reduce the amount of government debt. Now I know we have talked a lot about why this view is mistaken, but what is stopping the government paying for additional spending by just printing money?
A: Do you know the technical name for that idea?
Q: Money financed fiscal expansion rather than bond financed fiscal expansion? And didn’t Friedman have this idea involving a helicopter?
A: Good. And what is meant by Quantitative Easing, or QE for short?
Q: The central bank buying government debt by creating bank reserves?
A: That will do. And what does the term ‘monetary base’ or ‘high powered money’ mean?
Q: That is the amount of money created directly by the central bank, which is either cash held by the public, or reserves held by banks.
A: So if we have a policy that involves both bond financed fiscal expansion, and QE, what does that amount to?
Q: Ah! Is it the same as money financed fiscal expansion?
A: It looks that way. But to properly answer that question, we need consider another. Now what happens if a government spends like there is no tomorrow, and finances it all by printing money?
Q: We get inflation of course. But that is only because the government would be increasing demand even when we have got to full employment. Today when there is deficient demand and high unemployment, adding to demand should not cause an inflation problem.
A: I agree. But suppose money financed fiscal expansion, or bond financed expansion plus QE, works, and we get back to what you call full employment. What happens to all that money the central bank has created?
Q: Well now there would be too much money chasing too few goods, so the central bank would have to put QE into reverse. Otherwise we would get inflation.
A: OK. Would the world look any different after QE had been reversed, compared to a policy that had just involved bond financed fiscal expansion in the first place?
Q: So what you are saying is that bond financed fiscal expansion with or without QE looks just the same in the long run, as long as QE is reversed.
A: Well you have just said it, having gone down the path I have subtly led you down. Now what have I always told you about the time frame involved with issues involving government debt?
Q: I know I asked the first question, but now I’m doing all the answers. You really should be using different letters from Q and A, like maybe S and T.
A: Ah, the famous dialogs between Socrates and Theaetetus. How nice it is to teach Students in Tutorials who also study philosophy. But what is the answer to my question.
Q: That issues involving government debt are long term, not short term. So if using money to finance extra government spending just involves a temporary increase in money, and no permanent reduction in debt, what is the point?
A: Indeed. Now there might be some point if the government or central bank wanted to signal with QE that it did intend to raise inflation above the target level for some time, which is the same as saying that it would not reverse all of the QE.
Q: But haven’t both the Bank of England and Federal Reserve said they remain totally committed to their inflation targets?
A: Effectively yes, and recently they seem to be content to see inflation below target, so it would be very odd if they were using QE to signal the opposite.
Q: So does that make QE a complete waste of time? And why do you say there would be some point in having higher inflation in the future?
A: I think this is an excellent point at which to end things with some reading for next week. I suggest this paper that Michael Woodford has just written. After that have a look at these blogs (Bruegel, Kimball and DeLong, Serlin, Hamilton, Gagnon) on the effectiveness of QE, and this on nominal GDP targets and fiscal policy. (Try and keep the issues involving instruments, mechanisms and targets separate if you can.)
Q: Not another paper by Woodford! The last time you made us read one of his papers it went into maths just when it was getting interesting.
A: I’m tempted to say that without maths there can be no true knowledge, and this is just the exception that proves that rule.