The Curse of Low Expectations

When many students reflect on why they are at Harvard, they will (or should) probably give their parents some credit for raising them well. The most important thing that our parents did for us was uphold very high expectations. Our economy is not so different from a student at times–its success depends on well-calibrated expectations, and often it is not operating at full potential because of low expectations. People don’t expect customers to buy their goods or major investments to have a high return, so they don’t hire new employees, and the economy is mired in a low-growth track. The Federal Reserve can change these expectations and have a profound impact on economic growth, and though they’ve finally started trying to do so, there is much more that they can do.

The Federal Reserve holds the keys to changing these expectations through monetary stimulus, and on Wednesday, the Federal Reserve finally announced its long-awaited expansionary program, “Quantitative Easing 2,” which it hopes will boost the lagging economy. The plan is long overdue and completely necessary, and must be followed by far bolder action by the Federal Reserve.

Normally, when the Federal Reserve wants to strengthen the economy, they lower short-term interest rates, an action that incentivizes corporations to spend. This can’t be done now, however, because interest rates have already been lowered to zero percent for quite some time. Thus, in “quantitative easing,” the Federal Reserve will buy $600 billion of Treasury bonds through open market operations, thus releasing a new batch of fresh cash into the economy.

QE2 should have a number of positive effects on the economy. The influx of cash into the economy should decrease long-term interest rates, which still have room to fall. This decrease will make long-term investment and borrowing more affordable. Inflation will also rise, which should encourage businesses to let go of their hoards of cash and invest in job creation. The dollar will weaken in relation to other currencies, which will strengthen American exports.

The Fed’s program will start to affect the economy in these ways—but there is much more that it must do. The Fed weakly acknowledges that inflation is not high enough, but this statement won’t do much to change expectations. If they instead explicitly said they would keep easing until inflation reached a target of four percent (the rate during Ronald Reagan’s presidency), it would do a great deal to get businesses spending again. A much larger set of bond purchases would also create significantly better outcomes, because as Paul R. Krugman noted, “$600 billion really isn’t a lot when you’re trying to move a $15 trillion economy.”

Many naysayers inexplicably argue that this could create runaway inflation. Such concerns are absurd when inflation has been far too low for years, and our country was growing just fine in the mid-to-late 1980’s, when inflation was around four percent. Others worry that QE2 might lead to bubbles in emerging markets such as China. China has a solution to that problem that the world might quite like: They can let the yuan appreciate. Finally, concerns about “currency wars,” in which everyone attempts to ease their currency, are completely misguided. “Competitive reflation” might actually be a boon to the global economy by providing stimulus the world over, as it did during the Great Depression.

The Federal Reserve is on the right path, but much more bold action is needed, because unless there is a truly massive change in expectations, the economy will continue to grow far below its potential.

Ravi N. Mulani ’12, a Crimson editorial writer, is an applied mathematics concentrator in Winthrop House.