Counterfactual Thinking and Thinking Outside the Box

In his October 23rd EconoMonitor article, ‘Assessing QE: Why Counterfactual Thinking is Important’, David Beckworth recommends that readers consider what would have happened without QE in order to develop a more informed judgement about the utility of QE.  He then uses some modelling results to suggest that QE has secured apparently relatively large benefits for the economy.  As far as one can tell, these effects seem, on the face of it, much larger than the results reported by James Hamilton ‘Estimates of the Effects of the Fed’s Large-Scale Asset Purchases’, EconoMonitor, October 21), and the results reported by Avrind Krishnamurthy and Annette Vissing-Jorgensen in their draft of ‘Ins and Outs of LSAPs’), but only a fully thought-through comparison could clarify this aspect.

However, quite apart from modelling results about which there is great uncertainty, there are likely some important creases in the Beckworth logic and in the conclusion drawn from it.

First, the modelling analysis most likely fails to specifically account for the adverse side-effects of QE: mispricing of risk; asset price effects; income effects on those relying on safe fixed bond returns; and effects of increased risk-taking, etc.

Second, the Beckworth logic fails to take into account the fact that QE is not yet over and has not been unwound.  Any worthwhile analysis of the effectiveness of QE must take into account likely future effects deriving from unwinding.  If QE merely brought forward activity that activity might be reversed, and unwound over time, as the artificial stimulus is withdrawn.

More importantly, perhaps, the Beckworth logic does not go far enough in its enquiry.  The deeper question that must be asked to shed light on the relative utility of large-scale asset purchases is this: no matter what effects, if any, unconventional monetary policy may have had, could there have been a better way to deploy monetary policy over the years since the crisis erupted?

The issues at stake here have relevance not only to the United States but to other countries as well; particularly countries continuing to suffer from deep and prolonged recession/depression and high public debt.  And, in the broader context in which individual macroeconomic policies must be assessed, consideration needs to be given to the interaction, and degree of synergistic coordination, between monetary and fiscal policies.

Governments can finance on-going budget deficits by, inter alia, issuing new government bonds or by utilising new money creation.

When new bonds are issued to finance the deficit, public debt increases: consumers and investors then take into account the related higher market interest rates, and the need for likely future increases in taxation to repay the debt and pay interest on the debt.  On this basis, they are likely to lower their consumption demand to some extent.  However, if new money is used to finance the on-going budget deficits then there is no increase in public debt or interest rates, and no prospect of needed higher taxation.  Consumers and investors will, ceteris paribus, spend relatively more, and aggregate demand will be raised (relative to what would happen under bond financing).

At the same time, government’s have a choice between adopting a QE monetary policy — using new money to finance banks and financial institutions — and adopting Overt Money Financing (OMF) — using new money creation to finance on-going budget deficits and possibly reducing debt as well.

The economic implications and consequences of choosing between these two monetary policy approaches are profoundly different.

Under QE, base money increases but the money supply does not increase, or does not increase early or by much.  Under QE the new money results in higher asset prices and/or capital flows abroad, or goes into larger unproductive (interest paying) commercial bank reserve accounts at central banks.  Under QE the main beneficiaries are high wealth individuals or financial market participants such as banks, traders and speculators.  All these persons and entities have a relatively low marginal propensity to consume ordinary goods and services and multipliers are low: not only is demand not increased by much, but consumer prices (for countries suffering a deflationary tendency) are little impacted.

In contrast, under OMF the new money gets injected, through the budget deficit, directly into the real economy.  Under OMF the new money goes to the unemployed; to other disadvantaged individuals; and to infrastructure projects; all with a relatively high marginal propensity to consume ordinary goods and services.  As a consequence, aggregate demand is increased, multipliers are relatively high, and the effective money supply and credit are likely to expand: not unimportant implications in a demand-depressed economy.

Based on the above economic logic, then, OMF is likely to represent a relatively powerful fiscal and monetary policy combination: more powerful, for instance, than combining QE with conventional bond financing and austerity.  For countries suffering from deficient aggregate demand and high public debt in the context of zero-bound interest rates, OMF arguably represents the policy-makers’ preferred policy mix, particularly if monetary stimulus (currently in the form of QE) is planned to be withdrawn.

It is hoped that, by considering more generalised forms of the Beckworth logic, future policy discussions could be encouraged to break from the current orthodoxy and to develop in new directions for countries with depressed demand and high public debt.