Economics of Recovery in 2010

I wrote this to my sister, Mary in December in an attempt to give her what little knowledge I have about the Fed and its plans:

Well Mary, what we call Quantitative Easing (QE) is similar to an Open market Purchase by the Fed. An OMP is where the Fed buys Treasury Securities from Open Market Trading Desks (i.e. not the Treasury) and increases the money supply giving them their cash reserves for the T-Bills and/or T-Bonds. With QE the Fed does the same Open Market Purchase but does not use its cash reserves but rather purchases the T-Bills with freshly printed money from the Treasury. This is called “monetizing the debt” and in better times would be considered inflationary.

One of the smartest guys I know, Dr. Ed Dolan (Ph.d. from Yale in Econ) says that this move is to try and provide easy money to the economy by increasing its supply and hence exerting downward pressure on interest rates. You seem concerned that the money the Fed is using could go to better use and that is an interesting point.

First of all, though the Fed is using its money (reserves) to purchase Treasuries, it is really only changing its investment position from cash to Treasuries. No real consumption is going on; they can’t really use their reserves for anything other than investments. They are to be held for Open Market operations and recently to invest in Mortgage Backed Securities (MBS) that are presumably under-performing.

Of late the Fed has rebated the interest they have earned on T-Bills purchased back to the Treasury because I believe the Fed’s aim is not to make money on its reserves but rather to execute monetary policy.

Dr. Dolan is ok with the QE which is now called QE2 since it is the second round of QE in 2010. I feel that it is ok but we must remember interest rates are very low for businesses and banks so I would expect QE2 to have very little effect. It seems to me that intuitively one really can’t influence interest rates to move below zero.

Dean Baker, another economist I follow, is fine with the monetary policy attempts of QE2. I believe he thinks it is entirely appropriate. His disgust is palpable though for the deficit hawks and economists who did not recognize the devastating global real estate bubble. It is further maddening that the press is treating it as a non-event. Dr. Baker wants all economists held accountable for their part in the worst economic crisis in decades.

Dr. Baker blames the Fed for the world’s economic woes because they fueled the Real Estate fire. He believes that Greenspan and Benanke have not been the least bit contrite about it and the whole Board of Governors should be terminated!

Both Dr. Dolan and Dr. Baker are good economists and they are openly against the deficit fear-mongering by the likes of Peter Peterson, the Washington Post and to a lesser extent the New York Times. Oh, and lets not forget Fox News….yuck!

So that’s my take on current monetary policy and then there is fiscal policy (i.e. spurring demand through government spending). I wrote a very unpopular comment to a post by a Wall Street Investment Adviser on Seeking Alpha. The Adviser was saying that fiscal policy does not work and that the government should not engage in such policy (i.e. stimulus). This was around October I believe. My point was why would Seeking Alpha readers listen to an investment peddling Chartered Accountant on the economic effectiveness of fiscal policy when there are several well qualified economist contributors to the site (such as Mr. Dolan)? Presumably the investment adviser thinks Wall Street should be forever bailed out but fiscal stimulus for the rest of the economy will not work!

Dr. Baker is beside himself about TARP and he feels the Wall Street firms should have been allowed to go broke. Instead they recover due to our huge cash infusions and they pay themselves bonuses. Dr. Baker says that even though the money is paid back, there was a real cost to us for bailing them out and that is the greedy little idiots are still at the helm.

Dr. Dolan would probably agree that TARP was necessary to allay panic in the financial sector. I don’t think it is an either/or proposition. I believe we could have bankrupted them in a civilized manner and avoided any panic.

The real and current threat is, according to Dr. Baker, the deficit hawks who suddenly wanting to fix the deficit in a downturn. Not the time. Let’s budget as well as we can now but when there is little private investment (business not spending on growth needs) then there needs to be public investment (government spending on infrastructure, research, incubation etc) to get people back to work.

The strange thing is that these deficit mongers want the middle-class to “get austere” and basically leave the rich to do whatever they want. They are even proposing to cut social security benefits even though it’s a trust that people have paid into with their own money over the years. Is that not confiscation? The Congressional Budget Office, according to Dr. Baker, says Social Security is fine now and will not experience unfunded liability for 23 years. Dr. Baker says, and I agree, that in 15 to 20 years we can increase contribution rates to adjust with no need to cut benefits.

Dr, Baker believes that if we can get control of health care costs with drug patent reform we will eliminate the deficit very quickly (healthcare including medicare is a large portion of our budget). Too much of our per capita health care costs are for drugs. However drug patent reform is a tough road because drug companies have a lot of money and we need independent politicians with strength to get it done.

I would add that getting out of Afghanistan and Iraq would go a long way towards reducing the deficit as well. No need to raid the Social Security trust fund.

Much love, John

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