So Quantitative Easing in the eurozone is working, then?

A little inflation greases the economy

This isn't the problem currently in the eurozone of course. There it's the other way around, as I've previously noted. We think that V has fallen, fallen far below the normal level. That's going to lead to either P or Q falling. P falling is general deflation and we don't like that as it feeds upon itself. And Q falling is a fall in GDP: the very definition of a recession. So, to counteract V falling we can increase the amount of M around. And that's what Quantitative Easing is designed to do and does.

The central bank invents some money on its computers and goes out and buys bonds (no, not normally from banks and it's most certainly nothing to do with saving banks, they're bought from pension and insurance companies usually). Investors, thus, have loads more cash and will move along the risk curve in order to try to get a bit more income. That lowers long term interest rates and it, hopefully, in turn increases the joint product of M and V.

We want to create inflation in fact, but only just enough of it that we counteract deflation.

Which brings us back to our basic analysis of what we think is going wrong. We think we'd like to have a gradual expansion of the money supply to accommodate a growing economy. This is closely linked with the idea of targeting nominal GDP. That's the idea that we shouldn't try to target inflation or growth too much, just try to target the combination of the two and let the market sort out which we get.

We get much the same numbers from both systems. Nominal GDP targeting tells us that we want growth of about four per cent, or so. Inflation would be on target at two per cent and the long run growth rate of most advanced economies is thought to be about two per cent in real terms. So, add them together and you get that four per cent nominal growth.

By the way, yes, it might be true that we'd prefer entirely static prices but a little bit of inflation acts as a bit of grease here. We know that prices, most especially wages, are sticky downwards. We really hate to see our nominal wages go down.

But we'll accept, even if grumpily, real wages falling if nominal ones stay static. And there's always sections of the economy where real wages should be falling. So, it's easier to get people to accept that if there's a bit of inflation to hide it from them. Thus the grease of two per cent inflation.

If we look at the money supply then we'd like M3 or M4 to be expanding at again about that four or five per cent. Again this is what finances a generally expanding economy. And we're very certain that without that monetary expansion (which doesn't get out of hand!) then we're not going to get the expansion of the economy.

At which point, of course, we can lay AEP's concerns to rest. Because so far at least it looks like eurozone QE is doing exactly what it was meant to do.

Just look at the divergence between our two measurements of the money supply. That M1 is roaring away and that M1 is what is directly influenced by QE. M3 is, pretty much, M1 multiplied by our V. And our original analysis is that V has fallen but we don't want M3 to do so, we'd like it to expand at a rate consistent with allowing growth. And what is happening? M3 is growing about where we'd like it to be as a result of the slower than usual V impacting upon the M1 growth.

That is, QE is working. The time to worry is when M3 expands at that faster M1 rate. At which point, we stop the QE and eventually reverse it.

As I've said around and about before now the biggest economic lesson from the recent Great Recession is that one of the fundamental planks of Keynesian fiscal theory has been sawn through.

For one of those planks was that when interest rates did hit zero, the zero lower bound, then monetary policy was not going to be effective. Thus, the government must turn on the spending taps for only fiscal policy would be able to drag us out of recession. This eurozone QE is the third proof (after the US and UK experiences) that this isn't true.

Sure, there's still room for fiscal policy to be more effective, that's a nice argument to have. But it's obviously not true that monetary policy cannot be effective under such circumstances. And thus the inevitability of fiscal policy goes away to be replaced with a choice of policies.

I don't expect this to become generally accepted wisdom any time soon, but will confidently predict that in a couple of decades no one will believe that anyone could ever have thought differently. ®