Time for one more stab at QE, and then we’ll have a bit of (I hope) good natured fun with my favorite target in the blogosphere.
Paul Krugman has a new piece on the problems with QE, in both Japan and Britain. As usual, I agree with much of what he has to say, but have a slightly different take on things:
Actually, this has a moral beyond not to worry about inflation. It’s also a reminder that it’s hard to make monetary policy effective in a liquidity trap. There are some writers who suggest that all we need is more determination on the part of Bernanke et al; while I dearly wish the Fed would try harder, it’s not all that easy, because just pushing out money doesn’t do anything. You either have to buy lots of long-term assets — we’re talking multiple trillions here — or credibly commit not just the current FOMC, but future FOMCs, to pursuing higher inflation targets.
I agree that the key is expectations; if you don’t commit to higher inflation, you won’t get results from QE. But I’m not sure this makes monetary stimulus hard to do. Take a look at the graph he provides (and his comment after on the effects of QE):
Hmm. Deflation just kept on going.
Yes and no. The policy does get CPI inflation up to near zero percent during 2003-08. The deflator keeps falling, but my hunch is that the BOJ cares more about the CPI. Also note that unlike the Fed, which has a 2% inflation target, the BOJ has a target of zero inflation. I think you can make an argument that the policy succeeded, in the sense that they got the inflation rate they wanted. (Of course recent Japanese inflation has again fallen short of target, just as in most other countries.) Why do I think that the BOJ succeeded in its own terms? Because they acted like they had succeeded. Note the big drop in the monetary base in 2006 (below). Things like that don’t just happen for no reason. Krugman doesn’t discuss the decline, but I think the reason for the fall is fairly clear, indeed it is easily explained by Krugman’s own model of the liquidity trap.
In the late 1990s Krugman modeled an “expectations trap,” where at zero interest rates conservative central banks had trouble committing to higher long term inflation targets, because the public didn’t believe they would carry through with the policy once the crisis was over. And because prices are sticky, it’s hard to raise inflation in the short term. It might be easier to explain this idea with a numerical example. Suppose the nominal rate falls to zero, and the Fed decides to double the monetary base, in order to boost AD. In Krugman’s model that extra money might be hoarded, if the increase was not expected to be permanent. So why not announce that the increase will be permanent? That would work, but perhaps too well. If the public expected the liquidity trap to be over in 5 years, then a doubled monetary base might result in a doubled price level. But the public doesn’t believe a conservative central banker would allow such high inflation. OK, then how about promise to leave the money supply 10% higher in 5 years, so that we’d get 2% expected inflation? Or 15% higher for 3% expected inflation? The problem is that they can’t really even credibly commit to that, because velocity is unstable and so the Fed must, in the real world, reserve the right to move the money supply as needed.
OK, so why not just promise to leave enough money in the economy in five years time so that prices rise by the target amount. Bingo. And unless I am mistaken (and I usually am when interpreting Krugman) I think he would say this is the key—you need to credibly promise to create inflation. QE is just something that allows you to meet the promise, but it won’t by itself cause monetary stimulus to be credible. Of course technically Krugman’s model doesn’t say that QE won’t work, it says temporary injections don’t work. But given his model of conservative central bankers, this pessimistic assumption might be warranted.
So far it sounds like I mostly agree with Krugman, and in a technical sense I do. But let’s return to the big drop in the Japanese base in 2006—how are we to interpret that? In one sense a Krugmanite could say; “See, the Japanese currency injection was temporary, just as Krugman predicted.” [Notice I say a "Krugmanite," not Krugman--you'll see why later.] And again, I’d have to agree. But what is revealing isn’t the fact that the money was withdrawn, but the implicit inflation target it revealed. By 2006 they again had gained control of policy and were tightening. Why? Apparently because their inflation target really is 0%. Even worse, they don’t believe in level targeting, or catching up for past under-shooting. If we are going to judge the Japanese on how closely the CPI adheres to their 0% inflation target, they haven’t done that bad. I happen to think the target is a bit too low, as it exposes them to frequent liquidity traps. But they are basically hitting their target, as they see it. If they weren’t they would have waited until a 2% trend rate developed before withdrawing the QE, not stable prices. Indeed they also tightened in the year 2000, again with during a period of slightly negative inflation. So we have two “revealed preference” examples clearly indicating that Japan has an ultra-low inflation target.
So what does the Japanese case show? It shows that QE may fail to boost prices. And I think it also shows that QE may fail to boost prices because the public correctly understands that the conservative central banks will immediately withdraw the QE when the crisis is over. But, unlike Krugman, I don’t think it shows that monetary stimulus is hard when rates are at zero. Rather it shows that the BOJ has a really, really low inflation target, zero or even slightly negative.
Krugman does propose one solution, a higher inflation target. Then he notes, correctly, that central banks are too conservative to implement such a policy. Just today, Bernanke reiterated his opposition to the very sort of policy he recommended that the Japanese adopt. Of course I find this very maddening. But in a sense it’s even worse, as the Fed doesn’t even need to adopt a higher inflation target. Their implicit 2% target might be enough, under two conditions:
1. They adopted level targeting.
2. They got serious about it.
In a previous post I explained all this, and pointed out that it’s not my idea, its Bernanke’s. He recommended that as soon as the Japanese fell into a deflationary liquidty trap, they adopt level targeting, making up for any over- or undershooting. We entered a (mildly) deflationary liquidity trap around September 2008. Is it too much to ask for a conservative central banker to stick to the 2% target they claim to have, and make it level targeting in a crisis? The core CPI has fallen well below the 2% target path from September 2008, and more importantly is now expected to fall even further behind. A policy of 2% inflation targeting, level targeting, retroactive to September 2008, would dramatically raise inflation expectations over the next few years. Hitting that sort of target with 9.9% unemployment (i.e. fairly flat SRAS) would require much higher AD, much higher NGDP. As you know, I favor NGDP targeting, but even price level targeting would be much better than the current passivity. It would also inoculate us from the deflationary effects of the Greek crisis.
What does Krugman think of level targeting? I’m tempted to speculate, but last time I tried to decipher his beliefs the brilliant but prickly pundit called me a “damn liar.” Or maybe he didn’t. Maybe that accusation is itself a damn lie. And that’s the problem. I find him very elusive. The term “damn lies” appeared in the title of his post. And it was about how I had mischaracterized his views. But who knows? Which brings me to my next point.
I get tired of being slapped down for misinterpreting him. So perhaps I should refer to him by a codename. Odds are he hasn’t gotten this far in this overlong post, so he won’t know who I am referring to. Something like ‘the zen master.’ No that’s taken. The ‘gnomic one? ’ ”He who shall not be named?” I notice he just left for Morocco, site of the opening scene in The Man Who Knew too Much. So how about The Man Who Revealed Too Little?
Think I’m exaggerating? OK, let’s have some fun with this golden oldie from 2005:
And the backlash [against neoliberalism] has reached our closest neighbor. Mexico’s current president, Vicente Fox, a former Coca-Cola executive, is a firm believer in free markets. But his administration is widely considered a failure.
So what is Krugman saying here? You might think; “Isn’t it obvious? He’s saying that Fox implemented free market reforms and they failed.” If so, you underestimate the subtlety of Mr. Krugman. He didn’t say that Fox implemented any free market reforms at all. He said he was a firm believer in free markets. And who could dispute the proposition that mere belief in free markets, if not actually implemented, does not produce economic miracles? How dare you assume he claimed Fox implemented such policies!
By now you probably think that I am ready for the lunatic asylum. But let’s see who gets the last laugh. The fact is that Mr. Fox did not implement free market reforms. Why not? Because the Mexican legislature was firmly controlled by the opposition PRI, who had no interest in helping him. Yes, Krugman’s right that Fox was unpopular, as you’d expect of any leader who failed to get things done. Think about it. If you wanted to say economic reforms failed, why not just come out and say it. Why refer to a leader who believed in market reforms, when it takes no more ink to say a leader who implemented market reforms. (OK, ‘implemented’ is a couple extra letters—’enacted’ would do.)
Here’s another gem from the same article:
Latin Americans are the most disillusioned. Through much of the 1990′s, they bought into the “Washington consensus” – which we should note came from Clinton administration officials as well as from Wall Street economists and conservative think tanks – which said that privatization, deregulation and free trade would lead to economic takeoff. Instead, growth remained sluggish, inequality increased, and the region was struck by a series of economic crises.
At first glance you might think; “Aha Sumner, there’s your smoking gun. He does oppose the neoliberal agenda of privatization, deregulation and free trade, or at the very least thinks it failed. Just as you said. You’ve finally nailed him.” Not so fast. He didn’t say these policies were tried and failed, he said they were recommended by American officials, and he also said Latin America had not done well. But he never actually said the policies were tried and failed. Again, you might think I am being absurdly pedantic here. But I am quite serious. Indeed I think it is quite possible that Krugman actually favors neoliberalism–as many of his fans insist who write in the comment section of my blog.
As with the President Fox example, my interpretation also has the virtue of being true. In most of Latin American neoliberal policies are been tried only fitfully. Only one country in Latin America has enthusiastically embraced neoliberalism; Chile. And Chile also happens to be the only economic success story in South America. So the facts of the matter actually fit my interpretation, strange as it may seem. (BTW, Chile ranks 10 in the Heritage Index of Economic Freedom, the next highest South American country is Uruguay at 33, which I believe is the second most successful economy in South America.)
Now if you have an ounce of common sense you shouldn’t believe anything I just wrote. I understand that it is quite a reach to spin this sort of convoluted interpretation. But no matter how much it seems to defy common sense, I think it quite possible that my seemingly bizarre reading is the correct one. Here’s why.
Much as right-wingers like to pick on Krugman, and make fun of him, he has never moved so far left as to lose credibility. So think about this for a moment. A center left government takes over after Pinochet leaves office. Until the recent election, the leader of Chile was a respected moderate socialist. This government kept almost all the neoliberal reforms, and added some extra social spending. Suppose Krugman was called upon to advise Ms. Bachelet in 2006, soon after he wrote this article. Suppose she asked whether they should junk the entire neoliberal agenda and follow the Chavez strategy. My hunch is that Krugman would have told them to do exactly what they did–keep the neoliberal reforms and add a bit of social spending.
Now least you think I am incredibly naive, let me be clear about one thing. I understand that when Krugman’s chic fans on the upper west side of Manhattan read his columns, they don’t know about what really is going on in Chile. And I don’t doubt that they read his column as claiming that neoliberalism has brought misery to Latin America—which is of course exactly what they already knew from Hollywood films like the most recent James Bond pic. But does Krugman believe this? I’m not so sure. After all, it’s not true. And after all, Krugman’s a pretty smart guy. It’s a genuine mystery to me. Thus the title of this post.
Earlier I referred to him as a brilliant but prickly pundit. My right wing fans get angry when I say he is smart, and I suppose the left wing readers think I am mocking him. They would both be wrong. There is a nice anecdote in the recent New Yorker profile that illustrates why I think Krugman is so brilliant:
“What does it mean to do economics?” Krugman asked on the stage in Montreal. “Economics is really about two stories. One is the story of the old economist and younger economist walking down the street, and the younger economist says, ‘Look, there’s a hundred-dollar bill,’ and the older one says, ‘Nonsense, if it was there somebody would have picked it up already.’ So sometimes you do find hundred-dollar bills lying on the street, but not often—generally people respond to opportunities. The other is the Yogi Berra line ‘Nobody goes to Coney Island anymore; it’s too crowded.’ That’s the idea that things tend to settle into some kind of equilibrium where what people expect is in line with what they actually encounter.”
I know nothing about his work in economic geography, but he deserves a Nobel Prize just for boiling economics down to its essentials. He’s very good at using the revealing parable, like his babysitting co-op metaphor for a (nominal shock) recession. He is especially good at the folly of tight money policies, as revealed in this pointed but accurate critique of the right in the very same column that contained the nonsense about neoliberalism:
But the most dramatic example of the backlash is Argentina, once the darling of Wall Street and the think tanks. Today, after a devastating recession, the country is run by a populist who often blames foreigners for the country’s economic problems, and has forced Argentina’s foreign creditors to accept a settlement that gives them only 32 cents on the dollar.
Free market policies being blamed for recessions caused by tight money. Sound familiar?
So I am quite sincere about his brilliance. His economic intuition is off the charts. But then there is this, from the same New Yorker profile:
Krugman was bemused by the reactions. True, he had accused Chicago economists of espousing ridiculous ideas in part because of financial incentives—sabbaticals at the Hoover Institution, job opportunities on Wall Street. But when those economists responded with anger he was surprised. “There was no personal invective in what I wrote,” he says. “I never insulted anybody’s personality. It was always at the level of ideas.”
Ideas? Your opponents are in it for the money? I guess that’s the “idea” that they are intellectual prostitutes? Hmmm, why would they be annoyed by that?
So is he brilliant? Yes. But social intelligence? Let’s just say it’s “on the charts.”
If Krugman weren’t saying those awful things about neoliberalism he’d be one of my favorite economists, maybe my favorite living economist now that Friedman’s dead. But I just can’t overlook those quotations. I know full well how his readers interpret them, and I am pretty sure that he does as well.
But I always like to look on the bright side. The blogosphere would be a much impoverished place without him. There are lots of bloggers I enjoy more, but no one who seems so essential on the big issues.
Call me Ahab
In a recent research report on the euro area, economists at DeutscheBank, led by Thomas Mayer, said that euro area countries “can learn some valuable lessons from the Baltics’ experience over recent quarters.” Those countries survived drastic budget consolidation without devaluing their currencies.