There hasn’t been inflation because the money supply has not grown, because the money supply is determined by the quantity of money multiplied by the velocity of money. If velocity is dropping, the money supply shrinks. Therefore, the Fed injects quantity into the system to try to maintain the aggregate supply.
There are many problems with doing this, however. For one thing, a huge quantity of money with low velocity is risky, because if velocity picks up the money supply can expand rapidly, leading to inflation. This means the Fed will have to unwind all that money somehow, by selling all the securities it bought, or by raising interest rates, or whatever. The problem is that it’s politically much easier to expand the money supply than it is to contract it. You run the risk of setting up a situation where any improvement in the economy will lead to a sharp uptick in inflation, which will force the fed to take actions which slow the recovery back down. Stagflation becomes a real possibility.
Another problem with QE is that it devalues the currency. On paper, this can have advantageous consequences, as it lowers the price of exported goods. However, as we can see from the last few days, this can also screw up your relationship with your trading partners, and when you rely on so much foreign debt to keep the economy moving it increases the risk that you either won’t be able to find buyers for the debt, or that you’ll have to raise interest rates to attract enough buyers.
A third risk is that since the fed is essentially monetizing the debt (printing money equal to the amount of borrowing), that the market sees it as a desperate attempt to keep an insolvent ship afloat, and uncertainty and risk pricing goes up. In the worst-case scenario (which we may be seeing), the increased liquidity is offset by a further drop in velocity, making the cash injection useless or even counter-productive.
Of course, there are potentially good effects from QE. I was in favor of the first round of QE because the money supply was shrinking rapidly back then, and the fed was out of interest rate bullets and QE seemed to be the only game in town to keep a very serious downward spiral from developing.
This time around, I’m not convinced that the situation was dire enough to warrant another round of QE, considering the various risks and drawbacks. And it seems to me that there is actually plenty of liquidity and that the problem is velocity, so adding more liquidity doesn’t seem to be an effective solution.
Finally, I believe the root problem in this recession is structural. The U.S. has essentially been engaging in Keynesian pump priming since the 1990’s. Greenspan held interest rates too low, Bush and Obama cut taxes and raised spending, all in an attempt to boost the economy with Keynesian stimulus. The result has been malinvestment, asset bubbles, low savings rates, and a gradual buildup of forces that have finally led to the current disaster. The only way out of this is to allow the economy to reset itself.
Stop meddling, stop trying to stimulate, and allow the malinvestments to clear the market, the toxic debt to be devalued, etc. It will likely mean a double-dip recession, and the government should focus on helping those most hurt by it (instead of say, using stimulus money to give 5% pay raises to upper-middle class government employees).
If the process of restructuring is thwarted or slowed by government borrowing and monkeying in the money supply, the result WILL be another ‘lost decade’. Increasing deficits will slow GDP growth, the economy will remain structurally inefficient, and the U.S. will limp along with 10% structural unemployment, GDP growth of 1-2%, and an ever-rising deficit.
If that environment continues until the entitlement crunch hits, the U.S. will be in for a much bigger disaster. Better to clear out the dead wood and the zombie companies now, get control of the debt, and get the economy on a healthy footing so it can better weather the next storm on the horizon.
