QE undone: quantitative easing can boost the stock market, but not the real economy--or even inflation.

• Author: Makin, John H.

The two pillars of post-crisis recovery policy doctrine-fiscal austerity (higher taxes and slower government spending growth) and quantitative easing (central bank bond buying to offset austerity and boost the economy)--are crumbling. We have seen austerity undone by political backlash, especially in Europe, against the unemployment and slow growth that follows it, coupled with doubts about the Reinhart and Rogoff claim that gross debt-to-GDP ratios above 90 percent are associated with slower growth. In the United States, the gross debt-to-GDP ratio stands above 100 percent, with no discernible harm to growth.

Now quantitative easing is under attack, first because it has not worked to boost growth, and second because many, both inside and outside the U.S. Federal Reserve, believe that quantitative easing will either cause higher inflation (which it has not done) or result in an economic/financial collapse when it is unwound (which has yet to occur). The focus here is largely on a current U.S. policy dilemma, though the issues raised are important for other economies with high debt levels and central banks concerned about growth.

From a theoretical standpoint, the undoing of both fiscal austerity and quantitative easing is no surprise. At the zero bound, with policy-set interest rates virtually at zero, the economy is stuck in a liquidity trap. Large increases in bank reserves are simply held, resulting in an absence of a money multiplier whereby increases in the monetary base boost the money supply. Rising cash assets of the public (households and firms) are largely held. The observable counterpart of the rise in cash holding by the public is a drop in velocity, the ratio of nominal GDP to the money supply, which measures the pace of transactions turnover of the money supply. U.S. velocity dropped sharply after 2008 and has continued to fall since 2011, even after QE2 and QE3 were implemented (see Figure 1).

In a liquidity trap, fiscal austerity reduces output and employment more than normal because austerity results in no reduction in the already-zero interest rate. The International Monetary Fund has acknowledged this in its last two World Economic Outlooks as it counsels a retreat from austerity. The awkward corollary for deficit hawks is that, in a liquidity trap, fiscal expansion results in an extra-large boost in output and employment because, with interest rates stuck at zero, there is no crowding out from the usual rise in interest rates that accompanies the actual/expected rise in the supply of government bills, notes, and bonds issued to finance more government spending.

The question of what happens next with austerity out of fashion and quantitative easing seen as ineffective is a difficult one. The United States has actually raised taxes by about $180 billion a year in the "fiscal cliff" deal and cut spending starting in 2014 by about $120 billion per year in the sequester. The Fed has begun to talk about how it will exit quantitative easing. The lower growth resulting from tighter fiscal policy could be offset by easier money were we not stuck in a liquidity trap. The Fed speaks as if it believes there...