Wednesday, October 3, 2012

The Theory of Quantitative Easing

Recently we received a series of questions about binary economics, i.e., what it is, what makes it different, what could be done from a binary perspective to turn the economy around, and so on. The first question concerned the recent decision by the Federal Reserve to engage in more "quantitative easing" and what we could expect as a result.

"Quantitative easing" is just a fancy way of saying "induced inflation." This is pure Keynesian theory. The idea is that printing money inflates the currency and redistributes wealth. This creates purchasing power, which in turn stimulates demand for marketable goods and services. Increased demand gives companies the incentive to create jobs to supply the goods and services. At the same time (so the theory goes), rising prices will cause consumers to reduce consumption, that is, effective demand. "Reduced consumption" is the Keynesian definition of saving.

The theory is, therefore, that inflating the currency both increases demand and decreases demand
at one and the same time! This sounds like nonsense, but it is the stuff on which Keynesian economics is built. Cf. the Keynesian "money multiplier," that claims new money magically appears by drawing checks on one bank, and depositing them in another . . . all the while ignoring the simple fact that no bank will accept a check unless it can be presented to the bank on which it is drawn for payment! (In other words, as Harold Moulton pointed out, there is no net increase in money, just a change in who has it.)

To return to the Keynesian concept of "forced savings," however, rising prices force consumers to consume less because they cannot purchase the same amount of goods and services as before. Keynes called this "forced savings" because consumers have no choice. They either have to pay the higher prices, or starve. Either way they reduce consumption — "save" in the Keynesian dictionary.

Ordinarily, saving benefits the one who reduces consumption. That is not the case with Keynesian forced savings, however. The benefit of forced saving does not go to the consumers who were forced to reduce consumption in response to higher prices, but to producers. The idea is that producers will presumably use the higher profits they realize to invest in new capital and create new jobs.

Thus, in theory, stimulus or "quantitative easing" only needs to be done once to "prime the pump," as they called it in the New Deal in the 1930s. The theory is that stimulus will be self-sustaining after a single large infusion of cash.

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