Ben Bernanke published an influential article back in 1983, in which he argued that debt-deflation could worsen a depression by reducing bank intermediation.  He saw the reduction in intermediation as sort of “real shock,” which could not be completely addressed by easier money (otherwise his model would not have differed from Friedman and Schwartz’s.)

In 2008 he was given a chance few academics ever see—he was allowed to try out his theory on the US economy.  The Fed decided to focus on bailing out the banking system in the second half of 2008, rather than adopting an aggressive policy of monetary stimulus.  Indeed the famous interest on reserve program of October 2008 was implemented precisely to prevent the injection of funds into the banking system from ballooning the money supply and raising prices.  The Fed argued that without IOR the fed funds rate would have fallen close to zero.  (The ff target was in the 1.5% to 2.0% range at the time.)

Unfortunately, Bernanke’s theory is based on a misreading of the Great Depression.  The bank panics were problematic, but only because they led to monetary contraction.  The direct effects were trivial.  How do I know this?  Obviously I cannot be sure, but consider the following evidence:

1.  There were more than 600 bank failures each year during the Roaring Twenties, and yet the economy boomed.  Over 950 banks failed in 1926, a relatively prosperous year.

2.  The rate of bank failures did increase in the early 1930s, but they were mostly the same small rural banks that failed in the 1920s, and the share of deposits affected was a small fraction of the total banking system.

3.  There was one exception, during 1933 bank failures rose dramatically.  The deposits of failed banks were 11% of all deposits.  Much of the banking system was shut down for many months.

And what happened to the economy during this “mother of all bank panics?”  Prices and output soared (as I discussed in the previous post.)  This occurred because in 1933 (unlike 1930-32) the bank crisis was not allowed to lead to monetary contraction.

I would never argue that banking problems had zero impact on productivity, but the evidence from the booming 20s, and from 1933, suggests that as long as NGDP is growing, banking difficulties are not a major factor in the business cycle.  And we also know that banking problems don’t prevent NGDP from growing.  So it looks like Bernanke was relying on the wrong model of the business cycle, and fighting the wrong problem.

The Fed was not trying to raise the rate of inflation during late 2008.  Now they are trying to (modestly) raise inflation, up to around 2%.  They should have done that two years ago, and they are still likely to fall short of their goal.  How do I know?  The Fed’s own internal forecasters just issued a new set of macro forecasts, which are essentially telling Bernanke that $600 billion isn’t enough.  More is needed.

Part 2.  The battle of textbook co-authors

It seems to me that this post loosely relates to the recent back and forth between Tyler Cowen and Alex Tabarrok on the question of whether we’d be better off without the Fed.  I don’t have strong views on the question, partly because it’s not clear to me exactly what is being debated.  If the counterfactual to no Fed is that we go back to the gold standard, then I vote for the Fed.  I don’t wish to rehash the issue of whether the macro economy did better before WWI, or after WW2, and in any case I’m not sure that’s the right question (for instance, almost half the population were farmers in the 1800s–so how can one compare unemployment rates?)  Rather I’d like to point out that the Asian boom has just led to a big rise in real commodity prices.  If we returned to gold I doubt other countries would follow.  And I’m not willing to risk our monetary system on the assumption that somehow one country returning to gold would have prevented that commodity price boom from spilling over into higher real gold prices.  Of course a rise in the real value of gold means deflation for any country with a currency pegged to gold.

If the counterfactual is that the Fed is abolished in 2006, and instead the Treasury puts monetary policy on automatic pilot via a NGDP futures targeting scheme, then count me in.  Tyler might argue that we’d have been worse off without someone to rescue the banking system.  I guess you won’t be surprised to learn that given a choice between stable 5% expected NGDP growth (level targeting) combined with a banking crisis of uncertain size, and collapsing NGDP growth combined with the Fed doing its lender of last resort routine, I’ll take the NGDP target.

Part 3.  The paradox of really stupid monetary policy

People have asked me to comment on the new paper by Paul Krugman and Gauti Eggertsson.  I’ve just skimmed the paper, but much of it seems to revive the various “paradoxes” that I have often criticized.  Their innovation is to directly model the debt crisis.

There’s probably some value in focusing on the debt problem, but I see it as mostly reflecting tight money, not as an exogenous shock.  Their counter-intuitive policy advice (savings, wage flexibility are bad) comes from the assumption that the AD curve slopes upward when at the zero bound.  This means that if you have wage cuts (or more saving), both prices and output fall.  Which means NGDP falls.  There are certainly policy regimes where this can occur, and indeed it might have played a role in the 2008 recession.  For instance, if the Fed is pegging nominal interest rates and people suddenly try to save more (or invest less), then the Wicksellian equilibrium interest rate will decline.  If the Fed continues to hold rates fixed, the money supply will decline, as will NGDP.

But note that this assumes monetary policymakers are stupid.  Some might argue that they really are stupid, so the model applies.  I think it’s more reasonable to argue that they are occasionally a bit slow to respond, and they sometimes let AD fall more than they should.  But any serious discussion of macro stabilization policy that assumes the central bank is hopelessly incompetent is not likely to lead to any good policy options.  Who are we supposed to look to for wise policy advice—Congress?

I don’t think money was tight during the German hyperinflation and hence I don’t use interest rates as a benchmark of the stance of monetary policy.  I use expected growth in M*V, or NGDP.  So when I read Krugman and Eggertsson, I interpret them as saying that more saving or wage cuts might be bad at the zero bound, because it would cause the Fed to tighten monetary policy, i.e. it would lead to lower NGDP expectations.  I don’t think that view of the world is capable of providing useful policy advice.

I also don’t think the empirical evidence supports their view of monetary policy, or wage flexibility.  The 1921 recession (with flexible wages) ended quickly.  The 1930 recession (with very sticky wages) . . . not so well.  FDR’s NIRA was a complete disaster.   Industrial production had risen 57% in the 4 months before his high wage policy (due to an easy money policy), and then increased not at all for the next two years (until the NIRA was declared unconstitutional.)

I also disagree with Krugman’s interpretation of Japan, having argued many times that:

1.  The BOJ said they were opposed to inflation.

2.  The BOJ tightened policy to prevent inflation on several occasions during the 2000s.

3.  The BOJ succeeded in preventing inflation.

I’ve never understood how those facts show that a central bank cannot create inflation at the zero bound.  There are people at the BOJ who are currently warning about the danger of inflation, even as deflation has been accelerating.  I know, I’m not sophisticated enough to understand the subtle nuances of Japanese monetary policy.

If the Congress does more saving (i.e. fiscal austerity) the Fed should do more QE, or a lower IOR.  That’s the policy mix recently adopted by the British.  Is our system in America so inept that we must develop special macro models that rely on our central bankers being more incompetent that the Brits?

Don’t answer that question.

Seriously, part 3 of this post does seem inconsistent with part 1.  But don’t we have to work on policy approaches that assume some sort of rationality on the part of policymakers.  Yes, the Fed shouldn’t have let inflation fall to 1%, but at least they moved when it did.  And what’s our alternative?  Does anyone see Fiscal Stimulus II in the near future?  At least the Fed is doing something.

Update:  People complain that I am too tough on Krugman.  But Bob Murphy is even tougher.  Here he finds an amusing contradiction.

Robert Skidelsky has written a well-reviewed biography on Keynes.  Here he comments on FDR’s gold-buying program:

The gold-buying policy raised the official gold price from $20.67 an ounce in October 1933 to $35.00 an ounce in January 1934, when the experiment was discontinued. By then, several hundred million dollars had been pumped into the banking system.

The results were disappointing, however. Buying foreign gold did succeed in driving down the dollar’s value in terms of gold. But domestic prices continued falling throughout the three months of the gold-buying spree.

The Fed’s more orthodox efforts at quantitative easing produced equally discouraging results. In John Kenneth Galbraith’s summary: “Either from a shortage of borrowers, an unwillingness to lend, or an overriding desire to be liquid – undoubtedly it was some of all three – the banks accumulated reserves in excess of requirements. Reserves of member banks at Fed were $256 million more than required in 1932; $528 million in 1933, $1.6 billion in 1934, $2.6 billion in 1936.”

What was wrong with the Fed’s policy was the so-called quantity theory of money on which it was based. This theory held that prices depend on the supply of money relative to the quantity of goods and services being sold. But money includes bank deposits, which depend on business confidence. As the saying went, “You can’t push on a string.”

Keynes wrote at the time: “Some people seem to infer…that output and income can be raised by increasing the quantity of money. But this is like trying to get fat by buying a larger belt. In the United States today, the belt is plenty big enough for the belly….It is [not] the quantity of money, [but] the volume of expenditure which is the operative factor.”

I’m afraid that his analysis is both misleading and inaccurate.  The US gradually depreciated the dollar between April 1933 and February 1934.  During that period unemployment was nearly 25% and T-bill yields were close to zero.  Keynes argued that monetary stimulus would not be effective under those circumstances, and Skidelsky seems to accept his interpretation (which was published in the NYT during December 1933.)

[Note that Keynes certainly did believe in the “pushing on a string” theory–I frequently get commenters insisting that Keynes didn’t believe in liquidity traps.]

Unfortunately, Keynes and Skidelsky are wrong.  The US Wholesale Price Index rose by more than 20% between March 1933 and March 1934.  In the Keynesian model that’s not supposed to happen.  The broader “Cost of Living” rose about 10%.  Industrial production rose more than 45%.

And the gold-buying program was not an application of the quantity theory of money.  George Warren was an opponent of the QT, insisting that the quantity of money was not what mattered, that the price level was determined by the price of gold.  His views were much closer to Mundell than Friedman.  Keynes’s views on these issues were inconsistent and borderline incoherent.  Only a few weeks after Keynes argued that it was foolish to believe that currency depreciation could boost prices, FDR finally stopped depreciating the dollar.  How did Keynes react?  He congratulated FDR for rejecting the policy advice of the “extreme inflationists.”  By early 1934 prices were rising again.

The “disappointing” results that Skidelsky mentions come from cherry-picking a few misleading data points.  After the NIRA wage shock of late July, the real economy slumped and commodity prices started falling.  The value of the dollar also leveled off for a few months.  This led FDR to adopt the gold buying program in late October 1933. Despite the name, the actual “gold buying” was not large enough to be important–rather it was essentially a gold price raising program–a signal of future devaluation intentions.  This was well understood by the markets, and commodity prices tended to rise on days when FDR raised the gold price.  The broader WPI was relatively stable between September and December, and then started rising briskly again in early 1934.

It’s a mistake to focus on the tiny declines in the WPI during November and December 1933, which partly reflected sharply falling prices in Europe.  The key point is that the WPI and industrial production rose strongly during the period of dollar depreciation.

Skidelsky is a big fan of Keynes, but needs to read his hero’s writings with a more critical eye.  Other modern Keynesians like Krugman and Eggertsson have argued that FDR’s dollar devaluation program boosted the economy in 1933, and they are right.  They would also be horrified to see a Keynesian criticizing QE2:

Now the US, relying on the same flawed theory, is doing it again. Not surprisingly, China accuses it of deliberately aiming to depreciate the dollar. But the resulting increase in US exports at the expense of Chinese, Japanese, and European producers is precisely the purpose.

The euro will become progressively overvalued, just as the gold bloc was in the 1930’s. Since the eurozone is committed to austerity, its only recourse is protectionism. Meanwhile, China’s policy of slowly letting the renminbi rise against the dollar might well go into reverse, provoking US protectionism.

The failure of the G-20’s Seoul meeting to make any progress towards agreement on exchange rates or future reserve arrangements opens the door to a re-run of the 1930’s. Let’s hope that wisdom prevails before the rise of another Hitler.

I can’t see how depreciating the dollar against the euro would cause China to depreciate its currency against the dollar—I would have thought exactly the reverse.  What am I missing?  (Or was that a typo on Skidelsky’s part?)  And it wasn’t protectionism that led to the rise of Hitler, it was deflationary monetary policies in the US, France, and Germany.

PS.  Keynes is not my hero, George Warren is.  Anyone criticizing Warren in the blogosphere can expect a sharp rebuke from TheMoneyIllusion.

PPS.  His statement about the official price of gold being raised after October is also misleading.  The par value of gold rose all at once in early 1934.  The gold-buying price was already well above $20.67 by October 1933.  The focus should be on the market price of gold, which rose gradually over a period of about 10 months.

PPPS.  There is one strong similarity to late 1933; the conservative outrage over the gold-buying program forced FDR to stop it long before he reached his objective of reflating the price level to pre-Depression levels.  Now there are signs that conservative outrage over QE2 may be making it harder for Bernanke to achieve his inflation objectives, which are to return the inflation rate to pre-recession levels.  Plus la change . . .

HT:  JimP

Mark Thoma recently made the following comments on the Fed’s interest on reserve program:

There’s been a lot of talk lately about the Fed’s policy of paying interest on reserves with many claiming that this has caused banks to retain reserves that might have otherwise been turned into loans, and thus the policy has depressed aggregate activity. However, paying interest on reserves is a safety net for the Fed that allowed them to do QEI and QEII. If the Fed wasn’t paying interest on reserves, QEI would have likely been smaller, and QEII may not have happened at all.

First, on whether paying interest on reserves is a constraint on loan activity, the supply of loans is not the constraining factor, it’s the demand. Increasing the supply of loans won’t have much of an impact if firms aren’t interested in making new investments. Businesses are already sitting on mountains of cash they could use for this purpose, but they aren’t using the accumulated funds to make new investments and it’s not clear how making more cash available will change that.

Second, I doubt very much that a quarter of a percentage interest — the amount the Fed pays on reserves — is much of a disincentive to lending (market rates have fluctuated by more than a quarter of a percent without a having much of an impact on investment and consumption).

Third, this a safety net for the Fed with respect to inflation. Paying interest on reserves gives the Fed control over reserves they wouldn’t have otherwise, and control of reserves is essential in keeping inflation under control. If, as the economy begins to recover, the Fed loses control of reserves and they begin to leave the banks and turn into investment and consumption at too fast a rate, then inflation could become a problem.

But by changing the interest rate on reserves, the Fed can control the rate at which reserves exit banks.

I agree with much of what Thoma has to say, but would add a few comments.  Let’s start with the fact that without IOR a massive increase in the monetary base would eventually lead to high inflation.  I think that’s right, but it’s not really a reason for having a positive IOR right now, rather it’s a reason for having an IOR program in place.  (Indeed later in the post Thoma indicates that he holds the same view.)

In January and March 2009 I published a couple papers that suggested the Fed might want to implement a negative IOR.  The plan was adopted just a few months later.  Unfortunately, it was adopted by Sweden, not the US.  (And the Swedish plan had some loopholes.)

I agree that the existence of IOR made QE1 and QE2 more likely, but I wonder whether Thoma realizes the implication of the argument.  I’ve tirelessly argued that fiscal stimulus was unlikely to be very effective because the Fed probably would have mostly neutralized the effects by doing less QE (and other forms of monetary stimulus such as negative IOR, level targeting, etc.)  So if the Congress had done the $1.3 trillion stimulus that many liberals recommended it seems unlikely that the Fed would have done QE1.  And if they had done no fiscal stimulus, QE1 would almost certainly have been much bigger.  The Fed may be a bit slow on the uptake, but they do eventually notice inflation falling below their target, and take corrective actions.

I’ve never rigidly argued that fiscal policy can’t work, or didn’t have any stimulative effect in 2009, just that the monetary reaction problem made multiplier estimates highly unreliable.  Now Thoma says we also can’t rely on estimates of the impact of having no IOR, because without IOR there might have been no monetary stimulus.   And he may well be right–it’s essentially the same argument I use against fiscal stimulus.  The difference is that fiscal stimulus is quite costly, so the stakes are much higher.

I’d also point out that my monetary reaction argument is actually stronger for fiscal stimulus, than his argument is for QE1.  That’s because fiscal stimulus was done to boost the economy, precisely the same motivation as monetary stimulus.  On the other hand the original increase in the monetary base (which occurred in the fall of 2008) was aimed not at economic stimulus, but rather at rescuing the banking system by injecting liquidity.  Recall that the Fed decided against cutting the fed funds target on September 16, 2008, because they viewed the risks of recession and inflation as equally balanced.  But they might well have felt a need to rescue the banking system with some liquidity injections even if Congress had not given them authorization for IOR.

Sometimes I like to daydream and imagine a scenario where Congress refuses to authorize IOR, TARP, and all the other initiatives used to bail out the banking industry.  Bernanke would have had to go to the Fed and deliver the awful news:

Ladies and gentlemen, Congress won’t let us bail out the banks by any means other than good old-fashioned monetary stimulus.  We tried hard to get authorization for a program that would rescue banks without also boosting AD, but those morons on Capital Hill won’t go along.  I am afraid we have no choice but to do massive monetary stimulus, which unfortunately will boost NGDP growth.

Yes, they might have found that the only way to bail out the banks was to bail out the economy.  Wouldn’t that have been awful!

PS.  Whenever an economist thinks they’ve discovered a new idea, you can be sure someone else got there first.  I thought I was the first to discuss negative IOR, but Rodney Everson sent me the following quotation for an unpublished monograph written in 2001.

In essence, Japan will begin to immediately recover if its monetary authority charges each bank an interest penalty each week based on the amount of excess reserves reflected on its books at that time, assuming, of course, that they are farsighted enough to then provide the excess reserves.  This will make the potato “hot” once again, and excess reserves will no longer be held in hand.

Alternatively, they could raise the rate of overnight money to 1 or 2 percent which, of course, is impossible under current theory because it would be considered a “tightening.”  If you, the reader, now understand why such a “tightening” is necessary before an “easing” can be effected, then you have grasped the essence of this monograph.  You also should then understand the immediate danger we face under the current Federal Reserve policy of steadily driving the federal funds rate lower.

The quotation is from the monograph mentioned in this blog post.  BTW,  I think the second paragraph is wrong, but would be interested in what others think.

When I was young I thought I was experiencing a series of events.   Now I understand that I was experiencing the feeling of being young.  Sure you can go back and revisited a bunch of European countries, but it won’t seen the same as when you first tramped around Europe with a backpack, and the world seemed charged with mystery and meaning.

I think of public policy in similar terms.  Obviously there are cases where we can literally go back—the 21st Amendment restored the status quo ante of before the 18th Amendment.  But it’s never quite the same.  Indeed in just the last 10 years we’ve lost the ability to drink alcohol at our Bentley holiday party (I suppose due to fear of lawsuits.)

How I think about the past often depends on whether my mood is that of an ornery reactionary or a hopeful progressive.  Whether listening to talk radio or NPR.  Sometimes I think both the left and right miss something important when they visualize the past.  The right tends to romanticize a golden age that was ruined by statism, whereas the left sees a period of misery, which progressive legislation has lifted us above.  I believe the right has lots of blind spots, and the left often attributes change to legislation that actually reflects the fact that we are vastly richer than 100 years ago.

As a macroeconomist I often think of the spring of 1929 as a sort of golden age of policy, when there didn’t seem to be any significant macro problems and we had a pretty efficient policy regime.  But how should a pragmatic libertarian like me think about 1929 vs. today?  It’s not quite as obvious as you might think.  In some ways things have certainly got worse; Federal spending has grown from 3% to over 20% of GDP.  We have an alphabet soup of regulatory agencies that do more harm than good.  But there are also many changes for the better.  The rights of blacks, women, and gays are much better protected than in 1929.  And even many of the changes that would be vigorously opposed by more dogmatic libertarians, are somewhat ambiguous to a pragmatist like me:

1.  Social Security and Medicare really do help older people, but the systems were set up in a way that discourages saving.

2.  Some environmental regulations really do improve our lives, but they are often implemented in an inefficient way.

3.  We have lower tariffs, but many more non-tariff barriers.

4.  We’ve gained the right to drink alcohol, but also suffer from a new reign of paternalism

5.  We are more willing to tolerate immigration from non-European countries, but must suffer under the abominable TSA and INS.

6.  There is less regulation of transport pricing and entry, but more rent controls and minimum wages

7.  We have unlimited bank branching, but much more moral hazard in the system.

8.  There is more annoying paperwork today, but also less governmental corruption

I suppose for a dogmatic libertarian things are clearly worse, but for a pragmatist like me that’s not so clear.  Which finally brings me to monetary policy.  Are we better off today than in 1929?  How about compared to 1912?  I pick those dates because our monetary system has undergone two revolutionary changes in the past century; we’ve added a central bank and dropped the gold standard.  There’s only one thing I am really sure of; it’s a really, really bad idea to have both a central bank and a gold standard.  If you don’t believe me, check out the macro performance of the US between 1913 and 1941.  Both inflation and output were extraordinarily unstable.

In my view we are better off without the gold standard.  We can’t afford to leave the price level and NGDP to chance, where an increase in the demand for gold could cause severe deflation and depression.  Admittedly the worst example of this occurred under a gold standard that was far from pure (1929-33) but there are two strong arguments that cut the other way:

1.  The gold standard was also far from pure during the so-called classical period (up to 1914.)

2.  The whole point of the gold standard is that it’s supposed to work automatically, to protect you against foolish governmental decisions—indeed to prevent governments from printing too much or too little money.  If we need sensible government to make the gold standard work, then why not just attach the sensible government to a fiat regime, that will work even better (and did between 1983-2007.)

So far I’ve been emphasizing my progressive side, but now I’m going to do a 180 degree pivot.  I think a very strong case can be made that we’d be better off if the Fed had never been created.  Indeed a recent paper by George Selgin, William D. Lastrapes, and Lawrence H. White makes exactly that case.  It’s a very long paper and it marshals an impressive array of evidence against the Fed.  The focus in on two areas; whether the Fed has actually made the economy more stable (unlikely), and the effects of its regulatory actions,particularly in the recent crisis.  As far as I am concerned, their new paper becomes the definitive critique of the Federal Reserve System, which any academic researching the issue will have to address.

If you are a pragmatist like me, don’t write off the paper as a hopelessly utopian attempt to re-create a mythical gold age.  Their arguments are much more subtle and nuanced:

“Coming up with alternatives to the Fed today takes more imagination. Assuming that there is no political prospect of replacing the fiat dollar with a return to the gold standard or other commodity money system, for the dollar to retain its value some public institution must keep fiat base money sufficiently scarce. [..] [T]he Fed’s poor record calls for seriously contemplating a genuine change of regime. In particular it strengthens the case for pre-commitment to a policy rule that would constrain the discretionary powers that the Fed has used so ineffectively. Whether implementing such a new regime should be called “ending the Fed” is an unimportant question about labels.”

That’s exactly where I am on the issue.  It’s not a question of going back or staying where we are, it’s about moving forward.  Here’s an analogy.  The left and right have been debating whether we need a government-run postal service for decades.  Long before that debate is resolved technology will have eliminated the need for snail mail (except packages, which can be easily delivered by Fedex or UPS.)  It’s likely that long before we solve the problem of whether to use interest rate or money supply control, we will go to a cashless society with all electronic money.  That will make possible Robert Hall’s (1983) visionary scheme to index interest on reserves in such a way as to automatically stabilize the expected future price level (or NGDP.)  No Fed discretion is required.  Even Woodford once had nice things to say about the idea.

The debate over “ending the Fed” is pointless.  There will always be something called “the Fed.”  What we need to do is not to end it, but emasculate it.  Take away its discretion and simply give it a nominal mandate, and let the market implement the mandate.

I see the human race as like that runaway train in the new Hollywood film.   Technology is hurtling us rapidly toward a future that we can’t envision, and which would both horrify and dazzle us if we could.  (Just as the ancient Greeks would be both horrified and dazzled by our current culture.)  We don’t study the past to try to recreate the past, but rather to learn lessons that we hope will make the ride on this runaway train a bit smoother.

PS.  Thanks to William for sending me the quotation.  I’ll try to have more to say about other issues raised in the Selgin/Lastrapes/White paper when I have more time.  David Beckworth, Tyler Cowen, Alex Tabarrok, Bryan Caplan, and Arnold Kling also make comments.  I agree with some of the points made by Cowen, although I’d point out that while it’s true that if we’d had no Fed in 2008 there might have been a Great Depression, it’s also true that if we had no Fed in 2002 there would have been no sub-prime fiasco.  Banks don’t do that sort of thing without a safety net.  I will be at another conference this weekend, so blogging will again slow to a crawl.

This past May I pointed out that the euro debt crisis was increasing the demand for dollars and depressing AD in the US.  One sign was the dollar appreciating as investors fled to safety.  As I expected, this slowed the US economy in the second and third quarters, necessitating the Fed’s QE2 program.  QE2 did “work,” at least to a limited extent.  It raised the prices of assets such as stocks and foreign exchange.   Rumors of QE2 may have roughly offset the effects of the euro crisis, putting the dollar and expected NGDP growth back where they were in April.

Unfortunately, the euro crisis seems to be flaring up again.  Look at how the euro has recently slipped from 1.40 to 1.35.  As the dollar rises again, stocks start declining.  Let’s hope this is just a temporary blip; if the euro crisis became severe it could have a deflationary impact on the US economy–requiring still more QE (or better yet something more effective like level targeting or much lower IOR.)  Ironically all this occurs against a backdrop of relentless criticism of the Fed’s “inflationary” policies.

Readers of this blog might recall I often say “never reason from a price change.”  So why am I making such a big deal about changes in exchange rates?  In fact, it is very dangerous to draw conclusions from exchange rates alone.  You need to look at the news events that cause the changes, and look for confirmation in other asset markets such as stocks, commodities, commercial real estate and TIPS spreads.

The ECB doesn’t seem to realize that its policy is far too tight for most eurozone members; not just the PIIGS, but also major economies like France.  This is making the eurozone debt crisis even worse, although in my view they also face serious long term fiscal imbalances that go beyond the current recession.

The tight money policy in Europe causes the debt crisis to flare up and the euro itself depreciates as there is a flight to safety.  And guess which major exporter of machinery benefits from the weaker euro?  My Canadian readers might like this analogy: Suppose commodity prices plunge.  This might weaken the Canadian dollar, as Canada is a major commodity exporter.  But it might also help the manufacturing exporters in the Ontario region.

Currencies are not a zero sum game.  The tight money policy of the ECB makes eurozone NGDP growth decline, even if the euro depreciates during a debt crisis.  An exchange rate of 1.35 could represent easy money in both the US and Europe, or tight money in both regions.  With all the focus on exchange rates let’s not lose sight of the underlying monetary policies, which show up in expected NGDP growth rates in each region.  Get those right, and it makes little or no difference what happens to exchange rates.

PS:  A few posts back I linked to an amusing anti-QE video.  A commenter named “wkw ” animated it for me, and Greg Ransom was nice enough to colorize the animation.  (He doesn’t know that I prefer watching classic film is the original B&W version.)  If I knew people were going to be speaking my lines, I wouldn’t have used ungainly phrases like NGDP.