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Allan Meltzer: QE is a Mistake — a Big One

Allan H. Meltzer, Carnegie Mellon University and Hoover Institution

With $2.5 trillion sitting idle on bank balance sheets and more than $2 trillion additional sitting on corporate balance sheets, we should expect the Federal Reserve to ask: What can more quantitative easing—QE—do that banks and corporations cannot do without it? The right answer is NOTHING.

Continuing QE is a big mistake. Not only is it likely to roil world financial markets when it eventually unwinds, but it finances the massive federal budget deficit at low interest rates. Holders of bonds cannot all be nimble as rates rise. The sooner QE ends, the better off we will be, but ending QE quickly or slowly will not avoid international market disturbances.

The Fed tells a different story. The official line is that QE2 and 3 were in place to reduce the unemployment rate and increase the economy's sluggish growth rate. In his November 19 speech, then-Fed Chairman Bernanke expressed proper and overdue concerns about the effectiveness of QE. He concluded, however, that economic conditions favor continuation. Chairman Yellen said much the same in her confirmation hearing and her February testimony.

Neither Fed chair recognizes publicly that continuing QE just expands the huge future problem of withdrawing trillions of idle reserves. We saw recently that a small reduction in the rate of QE growth has major effects on capital flows to Brazil, Turkey, and many other countries.

The Fed deserves high praise for the first round of QE in 2008. However, the benefits ended long ago. More than 95 percent of the reserves that the Fed supplied under QE 2 and 3 sit idle on bank balance sheets. M2 money growth for the year to the end of January 2014 is less than 5.5 percent. There is no mystery about why inflation remains low.

The mistaken results of QE policy include Federal Reserve financing of outsize budget deficits. No one should require a tutorial about the longer-term consequences of using central banks to finance government deficits. Sooner or later the results are inflation, always and everywhere.

The Fed points to labor market benefits, but these benefits are almost entirely false. Data show that QE has had very little, if any, favorable effect on employment and output. The reason is that our economic problems are mainly real problems, not monetary problems. It is an elementary error to confuse real and monetary problems by claiming that QE purchases can alleviate current unemployment. In their first course in economics, students learn that jobs, productivity, and growth are real events. And they learn also that printing money has at best a temporary increase in jobs or output that soon vanishes.

Real economic problems cannot be improved by having the Fed print more reserves that sit idle on bank balance sheets. That is why more than $3 trillion of new reserves has had so little effect. True, interest rates are marginally lower because the Fed's purchases reduce the amounts of debt and mortgages that the market has to hold. But additional purchases will do little.

To those who would remind me that the measured unemployment rate has fallen from above 10 percent to 6.6 percent, I say look more carefully. Most of the decline in the reported rate reflects discouraged workers leaving the labor force. That is socially detrimental, not beneficial. And decisions to leave the labor force are real, not monetary decisions that QE does not help.

Current real economic problems are mainly a result of the administration's counter-productive fiscal and regulatory policies and actions. These raise current and future costs. The principle benefits of QE do not go to the unemployed. They go to investors in real assets that rise in price. In the 1960s, Chairman Yellen's teacher, James Tobin, and separately Karl Brunner and I, developed models in which rising asset prices are a principal means by which asset markets transmit monetary policy to output markets. Rising asset prices make investment in new capital relatively cheap compared to buying existing assets. Investment increases and creates employment.

That has not happened despite the large increase in equity prices. New investment remains low, and much of the investment that firms do is labor saving—robots and computer software—further evidence that current economic problems are mainly real, not monetary.

The Fed should rethink its strategy. It should ask what is the best, conditional, multi-year strategy to eliminate the massive overhang of idle reserves. I am sure the answer will not be to watch the noisy, frequently-revised labor market data on unemployment. It is long past time to announce a strategy that puts the Fed on a path that reduces the idle reserves at lowest social cost and gradually restores a pre-announced rule based monetary policy. The way to start that journey is to end QE.

Allan H. Meltzer is the Allan Meltzer University Professor of Political Economy at Carnegie Mellon University, Distinguished Visiting Fellow of the Hoover Institution, and author of A History of the Federal Reserve (University of Chicago Press, 2003 and 2009).

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Posted: February 13, 2014 Thursday 10:00 AM