Don't Try to Fix it Up, Tear it Up

WB is flacking for a David Einhorn argument against QE3 (our third bout of quantitative easing). I happen to not like QE3 much either, but for an opposite reason - it's far to feeble to do much good.

Let's start with a somewhat simplified economic identity Production = Consumption + Savings, or P = C + S. Call that conservation of economic stuff. Note that I neglect any fluxes, which is not locally valid, but close enough globally. Recessions and depressions occur when P stops growing or actually decreases. There are a lot of ways that can happen, including exhaustion of a critical resource (the Harappans?), troubles with those fluxes I neglected (think Spain) and other exogenous factors. Many, however, are like the current financial crisis, endogenous effects of non-linearity in the economy.

A common characteristic of these latter is that consumption drops making it unprofitable to produce much. The economy is saving so much of its production that it becomes a glut resulting in a collapse of demand, shrinking production and employment, and further depression of demand.

If there is considerable inequality in a society, most of the wealth becomes concentrated in those who aren't disposed to spend it, and that is likely to provoke lack of demand. There are a lot of ways to ameliorate that problem, and most advanced countries in Europe, including the most successful economies in the World, do a fair amount of wealth redistribution via taxes and social spending. 
Another popular method is fiscal stimulus, typically by deficit spending.

One way that talked about a bit these days might be called "pouring quantitative gasoline on the embers of the economy," or QGEE. Quantitative easing, you might recall, consists of the central banks buying up longer term federal debt. This puts more cash in the economy, but it also creates the threat that those bonds will eventually go back in the market, driving up future debt costs. In QGEE, you just take that national debt you bought and feed it to the flames. Goodbye to future debt sales and and borrowing costs, and, goodbye to all that nasty debt we used to owe.

So what's the downside? The downside is that you will create inflation, because you just printed money. Now if you believe, as Krugman and many other economists do, that a whiff of inflation is exactly the medicine that the economy needs, that method allows you to calibrate rather precisely how much inflation you are injecting.