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Quantitative Easing Leads to Inorganic Growth

| Friday October 15th, 2010 | 12 Comments

The term quantitative easing has been going around lately.  It is a big term, but it’s meaning is pretty straightforward: to artificially increase the money supply.  Recently released Federal Reserve notes hint that the Fed will be leaning toward utilizing more quantitative easing in the future.

What are the effects of an increased money supply? Is this merely short term stability at the cost of long term sustainability? Is quantitative easing economically sustainable?

The increase in the money supply is in attempts to inject liquidity into the economy. The idea is that the liquidity will spark investment and consumption amongst the population. (On a side note, as sustainability folk, don’t we want less consumption overall in the first place? Why would we want to stimulate that?)

It is strange that the Fed needs to stimulate the economy, even though we have been “out of a recession” for more than a year. One could argue that the Fed is attempting to prevent a double dip recession. But in doing so, I worry that it may be providing the seeds for a prolonged recession, or even the next recession.

Let me explain with a more concrete example. Take vegetables. We can either grow vegetables organically or inorganically:

With organic farming, vegetables grow at a modest yet natural rate. Care is given to the soil’s health to maintain its nutrients and longevity, and to ensure that it will be productive in future seasons. Yields will be less, at a higher quality, but the soil will be fertile and sustainable for the long term.

In an organic economy, their is no need for the Fed to stimulate the economy, as the economy is nurtured by its nature. Prices fluctuate accordingly and money will find its way to its best used purposes. Growth is slow and steady. Or to use our favorite word, growth is sustainable.

Now turn to inorganic or conventional farming. Artificial fertilizers and harmful pesticides are used to stimulate growth.  The fertilizers not only make their way into the vegetables, but the high growth they encourage harms the soil in the process. You may get higher yields today, but the loss of nutrients are stripped from the soil for tomorrow. Or you may get no yields because the fertilizers and pesticides are too strong. This is an unsustainable way to grow vegetables.

In an non-organic/conventional economy, the Fed forces the economy to grow beyond its natural rate. Forcing growth hinders sustainable growth. It may even cause outrageous growth. Prices inflate due to an increase in the money supply. (Inflation used to be defined as an increase in the money supply, but it has now come to mean increased prices.) Money is malinvested and over-consumption ensues. Growth is erratic, unnatural, and artificial, perhaps even leading to a bust.

Although the Federal Reserve may desire to stimulate the economy by an increase of the money supply, quantitative easing may do more harm than good in the long run. Sure we may have an abundant harvest now, investment and consumption now, but at the cost of the future. In order have a sustainable economy, we need to return back to growing the economy organically.


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  • http://auros.livejournal.com/ R.M. ‘Auros’ Harman

    Sigh. More flat-earth economics. Where to begin…

    “Inflation used to be defined as an increase in the money supply” No, it was never defined that way by any economist worth his salt.

    Let’s say that every worker is paid the same wage. Wages and prices are currently stable. The working age population grows by 1%; in order for wages and prices to remain the same, you either need to increase the money supply by 1%, so that the new workers can get paid, or you need to increase the velocity of money (moving dollars faster from people’s accounts, to purchases, to payments to more workers). The increase in the money supply is more likely — changing the velocity of money is quite difficult — and it is absurd to regard this as inflation when people’s actual purchasing power is not being affected. That Austrians apparently do regard this as inflation simply highlights the fact that they have no place in a serious policy discussion.

    As it happens, Quantitative Easing probably would be inflationary in terms of prices. But that’s the whole point of the exercise. Currently, we want to drive a little inflation.

    Recessions are not merely a process of adapting after malinvestment. Nobody denies that investment bubbles are possible. (Or at least, not anybody in the New Keynesian school; some of the hardcore neo-Classical / Real Business Cycle folks assert that short-term market prices are “correct” even over the long term.) If shifting capital and labor from one industry to another required high unemployment, you would see high unemployment during bubble growth, not just after.

    Regarding the current malaise, plenty of conventional economists have been discussing the sluggishness of modern recoveries for years. And it’s well-known that financial crises tend to be followed by an extended period of sub-trend growth, though the details of why are contentious. (I believe Koo‘s interpretation of Minsky — the “balance sheet recession” — provides the best explanation. A number of people, including Krugman, in the linked article, have argued that Koo’s work provides another reason to favor mild inflation — it accelerates the process of relieving the debt burden on firm and household balance sheets. This is basically a process of redistributing claims on production from creditors to debtors; but it probably benefits the creditors in the long run, more than they recognize, by reducing defaults and improving growth, providing them more profitable opportunities to lend in the future.)

    Recessions, and extended periods of slow growth, represent a shortfall of planned purchasing compared to what would be produced if everybody were employed. This includes a shortfall of demand for investment goods. Typically, monetary policy helps get us out of a recession: If you drive the real interest rate down, you persuade businesses to raise their planned level of investment — it’s cheaper to borrow, therefore they can accept more incremental, long-term payoffs.

    In an extremely severe recession, you can fall into a liquidity trap, a situation where even at zero interest, businesses are unwilling to hire and invest, for fear of not finding customers, and where creditors are unwilling to lend for fear of defaults. Lower interest rates / higher money supply just leads banks and companies to pile up mountains of cash. The interest rate that is consistent with jump-starting new hiring and investment is negative. In order to get a negative real interest rate, therefore, you need some inflation.

    • Jonathan Mariano

      I strongly beg to differ on the term historical usage on inflation. Here is an explanation of the evolution of the term:
      Federal Reserve of Cleveland

      Historical it referred to the money supply. Currently, in the mainstream, it refers to general price increase.

      Mr. Garsey below provides a good argument against QE…

      • http://auros.livejournal.com/ R.M. ‘Auros’ Harman

        Even when used in reference to money supply, it is used specifically about increases in money supply not commensurate with the quantity of goods and services. (Have a look at the very first quote in that Cleveland Fed article.) Money supply growth commensurate with the growth of economic capacity is not inflationary, and never has been. A fixed money supply, with a growing economy (even if the growth is either from increased efficiency — more service with the same physical throughput — or due to improved hedonic quality) is deflationary.

        • http://www.jonathanmariano.com Jonathan Mariano

          Whether we look at the Fed paper, or delve further into history, my point is that inflation has been defined as an increase in the money supply is “defined that way by any economist worth his salt.”

    • http://www.jonathanmariano.com Jonathan Mariano

      Auros, what do you think of the following equation:

      MV = PQ

      aka the quantity theory of money?

  • Jonathan Garsey

    Mr. Mariano’s article presents a creative, easy to understand way of viewing today’s economic turmoil. My understanding of Austrian economics allows a variable money supply to accurately reflect the relatively stable amount of wealth in any given country. The massive amount of QE is technical jargon that masks the ancient biblical sin of the rich oppressing the poor. Whoever touches the new money first (the well-connected) is able to acquire the most real assets. Whoever touches the money last, for example, poor widow living on fixed income, is swamped by price inflation. QE does not create wealth but it did allow people with easy access to new money to build brand new office complexes which are at least 50% vacant now. It seems to me in order for the physical world to reflect the fantasy of QE, millions of people would have to discover vast reserves of oil or gold on their property.

  • http://www.presidioedu.org/ Shripal Shah

    Interesting article. I have a question and a comment.

    Q: how would you define the term ‘natural growth of the economy’. It would appear that with or without federal reserve intervention, the idea of an organic/natural economy is still mythical given the number of different forces (both free market and various organizations) acting within a given economy.

    I’d also like to add that from a Sustainability standpoint, not all additional consumption is undesirable. For example, if the extra dollars are spent on consuming energy efficient products or using recycled material or organically produced items, then those extra dollars are being put to better use. My guess is that additional consumption topic is much more nuanced than simply being antithetical to sustainability.

    • http://www.jonathanmariano.com Jonathan Mariano

      Hi Shripal,

      Thanks for the Q.

      I would define the “natural growth of the economy” as growth that emerges from within the economy itself. It is a process of free exchange between individuals in an economy. It is decentralized. I know, this may sound a little vague.

      This is opposed to artificial growth, where the central bank comes from outside the market economy, changing the dynamic of exchange between individuals.

      IMHO, by doing so, the central bank intervention skews the picture to the average consumer, leading folks to buy things they would have not other purchased without the artificial inflation. This is what I would term artificial growth.

      As for Sustainability and consumption, I agree, it is much more nuanced. Not all consumption is “undesirable”. I draw the distinction between consumption and overconsumption.

      What is undesirable is having consumption forced upon a population when interest rates are artificially lowered by the central bank thus increasing the money supply. This leads to or is overconsumption, per se. Think of the housing boom, when money was cheap, and housing prices increased dramatically. People in general were over- consuming houses because of the cheap money. Thus leading to the housing crash.



  • cuchulain

    Garsey has it right. The inflation is in the money supply so that the banking system can use it to rebalance, at our expense later when the cost of everything rises due to devaluation of our money. The stock market & commodities, you notice, are kept aloft as things crumble due to this debasement of the dollar, not any increased value of the stocks. We don’t need any more Keynesians to blather at us. And we don’t need inflation. We need market forces to wipe out all the banks and legacy corrupt industries that have Congress doing their bidding, burdening innovation and small business formation and growth. And real estate needs to suffer the same fate; get it over with. Similarly then, people will come in who have saved & can afford the houses. New capital will form competitive ventures. The failed will… fail. The recession will be shallower but compressed & seem horrendous. But it won’t be intergenerational theft by the central banksters.

  • William Ray Yeager


    In your response to Shripal you do a good job of distinguishing what you refer to as natural and artificial growth but I’m not sure that you really answer his question. I too am curious as to what you mean by natural growth. It may be that you understand it very well but you haven’t yet articulated it clearly. When you say that the growth “emerges from within the economy itself” you make me think of someone pulling themselves up by their own bootstraps. If that’s what you mean I suggest you sit down on the ground and spend some time pulling on your boots. I assure you that this action will not help in getting you off of the ground. Sometimes getting off of the ground requires the helping hand of a friend (a “visible” hand works best). If you were not hinting at bootstrap logic then I apologize for the strawman.

    On the topic of growth, would you argue that what we need is deflation? As a debtor (I just bought a house with help from a bank) the idea is a little scary. From another point of view, I work in an industry where prices have been falling dramatically over the past few years (decades, actually). When I started selling solar panels three years ago $4 per Watt was considered a good price. For a similar solar panel today you wouldn’t have to pay more than $1.90/W (and some are as low as $1.30/W). Through all of this we’ve seen tremendous growth as an industry but, obviously, it can’t go on forever. Once the cost of solar energy is as low as the (also subsidized) cost of coal energy we’ll need to see prices stabilize. If, after reaching that stable state with minimal profit, we hit a recession it would be terrible for prices to fall further. In such an event I would welcome a little (just a little) inflation to incent consumers. Consumption of solar panels is desirable, right?

    On the topic of inflation I think you would enjoy a recent Planet Money podcast on the Brazilian economy. Check it out: http://www.npr.org/blogs/money/2010/10/01/130267274/the-friday-podcast-how-four-drinking-buddies-saved-brazil . The Brazilians had an innovative solution to their economic tragedy.

    As a final note, I think you need to work on your vegetable analogy. Metaphor is a powerful tool but it is important to pick comparisons that have some common thread. After reading your article a couple times I still fail to grasp the relationship between quantitative easing and chemical fertilizers. I understand the direction you’re headed but the connection is pretty weak.

    Kind Regards,


  • http://www.jonathanmariano.com Jonathan mariano

    Hi WIlliam,

    Thanks for your comments. Here are some thoughts:

    Natural Growth
    When I refer to natural growth, I refer to growth without the central bank artificially increasing the money supply. Some would argue this is impossible, as there would not be enough money to go around. I would say it is possible, but that prices would need to reflect the amount of money in circulation. The Federal Reserve, since 1913, is the third incarnation of the central bank in the United States. We were able to survive without a central bank controlling the money supply before, I think we will be able to do so again.

    Deflation can mean either monetary deflation or price deflation. Gathering from your example, I will take it to mean price deflation. My argument would be that prices of goods and services need to best reflect the available currency sans an artificial increase in the money supply. Some things would go up in price, but most some things would go down in price.

    With the solar industry power example, it appears that the price fluctuations main determinants are supply and demand, but not price deflation on the massive scale.

    Brazilian Currency
    Thanks for the link on the Real. If we examine the history of currency in Brazil, it has gone through 7 different iterations since 1942:
    Admittingly, I am not well versed in the currency history of Brazil, as I am with the US. However, I would conjecture that one of the biggest reasons why there was a devaluation of the currency was due to an significant artificial increase in the money supply, i.e. hyperinflation: http://en.wikipedia.org/wiki/Hyperinflation#Root_causes_of_hyperinflation.

    Analogy + Metaphor
    I agree, metaphor can be quite powerful. On the other hand, as with almost any analogy, the analogy itself is not the argument, but utilized for pedagogical purposes. The connection I was trying to make was that the economy will probably grow with the use of monetary policy. Vegetables will grow with the use of inorganic fertilizers. But such growth in either case is not sustainable, whether it be the economy or in agriculture. By any chance, any recommendations for an alternative analogy or metaphor that gets this point across? I was toying with cows and rGBH.


  • ben lam

    Thanks for the excellent posts by Jon and others.

    Talking about vegetable, I remember a few years back, I met a customer who works as a farmer. It was a very warm winter in the UK . I asked him if it was a good year to him because of the warm weather and more sunshine. Suprisingly, he said a cold winter was better because this year, the bugs survived and grew, so he needed to use more pesticides which was no good to the soil or vegetable itself. (sure we don’t want to eat veg with lots of pesticides)

    Sometimes, with our economic, would it be better with a cold winter ? company would then cut their cost, fix their problem (the bug) and make it a better company to prepare the next boom to come ?

    It is natural to have winter, why not recession?