Why I don't think QE2 will trigger any significant and persistant inflation

I originally posted a version of this as a comment to this blog post:

Why is the Fed doing this? on Econbrowser.com

I wouldn't worry too much about QE2. I don't think the Fed could cause inflation right now with any reasonable amount of QE. Here is my reasoning.

1. In an economy that is 70% consumer spending inflation cannot get very far without corresponding increases in nominal household income. If prices rise without corresponding increases in household income aggregate real demand will fall in proportion to price increases and quickly snuff inflation.

2. Thus, for QE2 to cause significant inflation there has to be some mechanism by which the additional money pouring out of the Fed turns into an increase in household income.

3. One possible mechanism would be that freshly printed money is used for real investment, that creates jobs and thereby creates increases in household income. However, interest rates are already at near record lows and companies are still not embracing real investment, so it seems unlikely that a few more tenths of a percent drop in the interest rate will stimulate significant increases in real investment.  Companies make the decision to invest based on the spread between probable profit from the investment and the cost of borrowing the money to make the investment and if an investment isn't already attractive its still not going to be very attractive after rates fall a bit more.

4. The additional money being used to bid up commodity prices is not likely to result in increases in household income as long as there is excess capacity and high unemployment. Commodity sellers will simply tend to pocket the extra profits from the higher prices and choose not to share those extra profits with their workers (what pressure is there to share with workers with unemployment so high?).

5. Higher commodity prices could result in increased commodity production, which could result in increases in household income. However, the increased commodity supply from increased production will tend to moderate the price increases at the same time that the higher household income is providing income to pay higher prices, so once again inflation will tend to be blunted over time.


Maybe bubbles are not the problem

The other day I was reading another Dean Baker post about how the Fed should have prevented the real estate bubble because the popping of the bubble caused of the recession (The Washington Post Praises Baby Sitter Who Burned Down the House: the Kids Survived).

As I commented on that blog post, Keynes didn't think preventing booms was the right answer. From The General Theory of Employment, Interest, and Money, Chapter 21 - Trade Cycle - Section III:
Thus the remedy for the boom is not a higher rate of interest but a lower rate of interest! For that may enable the so-called boom to last. The right remedy for the trade cycle is not to be found in abolishing booms and thus keeping us permanently in a semi-slump; but in abolishing slumps and thus keeping us permanently in a quasi-boom.
Read all of Chap 21, Section III, for the complete reasoning. Instead of preventing bubbles Keynes thought the key to managing the business cycle was to redistribute income to people who would spend it on consumption:
"Furthermore, even if we were to suppose that contemporary booms are apt to be associated with a momentary condition of full investment or over-investment in the strict sense, it would still be absurd to regard a higher rate of interest as the appropriate remedy. For in this event the case of those who attribute the disease to under-consumption would be wholly established. The remedy would lie in various measures designed to increase the propensity to consume by the redistribution of incomes or otherwise; so that a given level of employment would require a smaller volume of current investment to support it."
From The General Theory of Employment, Interest, and Money: Chapter 21 - Trade Cycle - Section III. In other words, the problem with a boom is that eventually over-investment results in over-supply of the popular assets at which point investors reduce investment spending, which reduces overall demand, which triggers a recession. However, the recession can be avoided if we shift income to consumers when the investors start reducing their investment spending so that overall demand (investment + consumption) doesn't fall.

Reading these arguments from Keynes reminded me of a recent post by Robert Reich who argued that no amount of monetary or fiscal stimulus would fix the recession because the problem is that the middle class has run out of ways to increase their consumption spending:
Ultimately, even if fiscal and monetary policy weren’t deadlocked, we’d still face the same conundrum. Say the White House and Ben Bernanke got everything they wanted to boost the economy. At some point these boosts would have to end. The economy would have to be able to run on its own.

But it can’t run on its own because consumers have reached the end of their ropes.
After three decades of flat wages during which almost all the gains of growth have gone to the very top, the middle class no longer has the buying power to keep the economy going. It can’t send more spouses into paid work, can’t work more hours, can’t borrow any more. All the coping mechanisms are exhausted.

Anyone who thinks China will get us out of this fix and make up for the shortfall in demand is blind to reality.

So what’s the answer? Reorganizing the economy to make sure the vast middle class has a larger share of its benefits. Remaking the basic bargain linking pay to per-capita productivity.
This in turn got me thinking: what if the current recession was a natural and inevitable consequence of the upward redistribution of income America has seen over the last few decades? If the middle class spends every extra dollar of income it receives, but the upper class saves most of every extra dollar it receives, then having most of GDP growth go to the upper classes will result in savings and investment steadily growing while consumer demand grows at a slower rate. Eventually this will result in a situation where the upper classes have fully invested in every existing profitable investment opportunity available at that level of consumer demand and there are few new opportunities for profitable investment because underlying consumer demand is not growing fast enough. At this point the upper classes will cut back their investment spending, triggering a recession unless some other sector (government, consumers, or exports) increases its spending by an equal amount.

You can look at the recent housing boom and bust through this paradigm. As the point of exhaustion of profitable opportunities was reached the financial system started shifting more and more of the excess savings of the upper classes to the middle class through mortgages that were easier and easier to obtain (read sub-prime). This resulted in growing middle class demand for housing which in turn resulted in full employment through growing construction employment. The problem was that because the excess savings were shifted to the middle classes through the mechanism of loans the process could not continue indefinitely. When the middle class could no longer afford to increase their debt service the flow of money from the upper classes to the middle classes abruptly stopped and the recession started.

How to avoid this cycle? It seems to me that the key for steady economic growth is to ensure that every dollar of GDP growth gets more or less distributed evenly on a per capita basis, i.e. if GDP grows by $100 the top 10% income bracket should receive only $10, and the bottom 90% should receive $90. This way consumer demand will steadily grow as GDP grows and the reduced income of the upper brackets will mean that there is a healthy shortage of capital for investment so that every additional dollar of upper bracket income will get spent on profitable investments.

But how to do this? One obvious way would be to make taxes more progressive (raise taxes on the upper brackets and reduce taxes on the middle class) so that middle class disposable incomes and upper class disposable incomes grow at equal rates. Another way would be raise taxes on the upper brackets and increase government spending. Or we could keep taxes low and have the government borrow the excess savings of the upper brackets and then use deficit spending to support demand. Or we could devalue the dollar to make our industries competitive in the global market and increase demand for exports. Of course it is easy to find flaws with each of these approaches, but doing nothing will result in a perpetually stagnant economy.