Thursday, November 18, 2010

Queen Elizabeth 2

I recently finished Thomas Sowell's The Housing Boom and Bust (revised edition), which I had assigned to my intermediate macroeconomics class.  It is a decent overview of the housing portion of the recent financial crisis.  It doesn't aim to be a comprehensive overview of the whole crisis, but does a pretty good job asking why housing prices rose so much and then fell, and why this caused some problems in financial markets.  To give some idea of the flavor of the book, Sowell documents that during the boom, housing prices rose faster in areas with extensive restrictions on land use--with less land available on which to build houses in a given area, housing prices rose faster.  This is important, in Sowell's telling, because it implies that it was not simply the Greenspan Bubble causing a rise in housing prices, but other government failures combined with the Greenspan bubble.  Not surprisingly, then, Fannie Mae and Freddie Mac come in for quite a bit of abuse in the book.  The chief virtue of the book is that if one knew nothing about all this, it is written in a manner that explains part of the problem very well.  The chief disadvantage of the book is that if one knows quite a bit about the financial ciris, the book seems horribly incomplete.

And, I may as well take the opportunity to answer a question I get asked a lot these days.  What is QE2 and is it a good idea?  QE2 or Quantitative Easing 2 is simply the recent Fed decision to expand the money supply.  Rapidly increasing the amount of money is commonly known as an "easy money" policy, and thus the Fed is being Easy in providing a higher Quantity of money.  The only thing unusual about this is that they are not using the standard method of deciding how much more money to provide.  In normal times, the Fed would announce an easier money supply by announcing a lower target for the federal funds rate (the rate banks charge each other on overnight loans).  Once the target was lowered, the Fed would simply  increase the monetary base until that particular interest rate fell to the desired level.  However, right now the federal funds rate is near zero, so they can't announce the policy that way.  So, they announced that they will buy longer term assets and provide a certain amount of funds to the market.  They did this before; so this is the second time they have announced such a policy, hence the 2 in QE2.  Plus, it sounds a lot hipper and cooler to talk about QE2 than it does to say things like increase the monetary base.

What will be the effect of the policy.  Bernanke thinks that QE2 will provide enough new money to the market that interest rates will fall a bit and then firms will invest more and consumers will borrow more and the increase in investment and consumption will help kick economic growth into a higher gear.  There is an obvious concern that the long term effect of this policy will be higher inflation, but Bernanke is convinced the Fed can get the money back out of the economy in time to prevent inflation.  Critics of the policy come in two forms: 1) the mild critics think hat the policy won't actually do much good, that there is limited ability to lower the interest rates (they are already low), so the stimulative effect of the policy will be tiny;  2) the stronger critics agree that the policy won't do much good, but moreover, the Fed is unlikely to get the money back out of the economy in time to avoid generating high inflation.

There is really no way to forecast what will happen with respect to inflation--it is purely a matter of predicting whether the Fed will have the willingness and knowledge to act in time.  So, the big determination in whether one is a mild or strong critic is simply determining whether you think Ben Bernanke will have enough knowledge and will to pull off shrinking the money supply before inflation becomes unavoidable.  (I don't think anyone questions his motives here.)  You can put me down as a strong critic.  I really don't see the Fed stomping on the breaks in time to stop inflation from coming at the risk of generating another recession.  It can be done in theory, but I will be surprised if it works out well in practice.  I really hope I am surprised.

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