Tyler Cowen recently had the following to say about QE:
I’m unhappy with claims that “we’re not doing enough” and that therefore this is no test of the idea of monetary stimulus. This is what QEII looks like, filtered through the American system of political checks and balances. And if it looks small, compared to the size of our problems, well, monetary policy almost always looks small compared to its potential effects. I’m willing to consider this a dispositive test and I am very curious to see the results.
Of course I am one of those claiming that we aren’t doing enough, but I’d like to focus on Tyler’s curiosity about the results. I think there are more layers to this question that most people assume—many more.
Let’s start with the distinction between real and nominal GDP. What would count as success? Should we focus on real GDP, nominal GDP, or both? That depends. I think most economists would say that the whole point is to raise RGDP, and that a rise in NGDP that was not accompanied by an increase in RGDP would constitute failure. But what happens if both RGDP and NGDP rise at rather modest rates, (which is quite likely.) In that case, would monetary stimulus have been shown not to work? Tyler Cowen has argued that much of the recession is real, and he has also expressed skepticism about “liquidity trap” models that say monetary policymakers cannot create inflation (or higher NGDP) at the zero rate bound. So perhaps Tyler is interested in whether a given increase in NGDP translates into higher RGDP.
For instance, let’s assume NGDP grows at 3%, RGDP at 2% and prices at 1%. I’d say monetary stimulus hasn’t really been tried. On the other hand if we had 6% NGDP growth accompanied by only 2% RGDP growth I’d say monetary stimulus had been tried, and failed to produce the predicted growth in RGDP. Does that mean it never should have been tried? Not necessarily, it depends on the Fed’s policy goals. I favor 5% NGDP targeting, level targeting, regardless of what is happening on the supply side of the economy.
On the other hand, as I read Tyler’s comment above, he’s setting the bar where 3% NGDP growth would constitute failure. Even if monetary stimulus, pursued a outrance, would certainly boost inflation and NGDP, he suggests that the recent QE announcement is about all that is politically feasible in the US. This is an argument that Krugman has made as well, and at some level I think he’s right. But that sort of failure would not change my message, because whereas Tyler views QE2 as a partially endogenous response from real world monetary policymakers, I consider TheMoneyIllusion.com to be a sort of exogenous shock, aimed at convincing policymakers that monetary stimulus that seems highly aggressive is actually quite modest. I’m trying to make more expansionary policies become more politically acceptable. Yes, that’s a rather grandiose objective, and I don’t realistically think I can have more than a tiny impact on the zeitgeist, but (as I argued earlier) even a tiny impact is important when the stakes are high.
We’ve considered the distinction between real and nominal GDP, and the distinction between what’s politically feasible and what is not. And yet we’ve haven’t really addressed the most important implications of Tyler’s curiosity. For instance, what would be the policy implications of failure? If NGDP rises fast, but unemployment stays high, then maybe we shouldn’t be trying to boost AD at all. If NGDP doesn’t rise, then maybe we should have tried fiscal policy. Or maybe not. It’s clear to me (from market reactions) that QE2 has already raised the expected rate of NGDP growth. I also think QE1 slightly boosted AD in 2009. Those who claim that fiscal stimulus should have been $1.3 trillion would have to show that the Fed would not have simply offset the effect of more fiscal stimulus by doing less monetary stimulus. Perhaps QE1 and QE2 never would have happened. After all, the Fed’s two forays into QE both seemed motivated by a macroeconomy that was under-performing in the months immediately preceding the policy initiatives.
Most importantly, I would argue that Tyler Cowen has no reason to be curious. We already know whether QE2 will work, we know the only effects that matter—the impact on NGDP growth expectations. OK, that’s slightly overstating things; we know it boosted 5 year inflation expectations by about 0.5%. Again, this shows the urgent need for a NGDP futures market. For the moment, let’s assume an NGDP futures market did exist–my hunch is that Tyler Cowen might still have been “curious” to see the effect of QE. Obviously I think that would be a mistake, and the only thing we will learn from observing the macroeconomy over the next 5 years is that part of NGDP growth that was not caused by QE.
Think of the TIPS market response as not just the optimal forecast of the effect of QE, but also the optimal estimate of the effect of QE. And not just the optimal ex ante estimate, but the optimal ex post estimate. How can that be? Surely we will eventually know much more about how much inflation was created than our current rather crude forecasts? Actually no. We still don’t know how much good Obama’s $800 billion fiscal stimulus did, because we don’t know the relevant counterfactual growth path.
Economics is all about the effect of X on Y, ceteris paribus. The TIPS market gives us the optimal forecast of inflation, ceteris paribus. The actual inflation rate that we observe over the next 5 years will differ from that forecast, but we have no way of knowing whether it differs because “other things weren’t equal” or because our original forecast was flawed. Without such knowledge, we have no reason to revise our estimate of how much QE2 raised 5 year inflation expectations. There’s no need to be curious Tyler; we know how much good QE2 did, about 0.5%/year more inflation over 5 years. Yes, we don’t know how much that will raise RGDP growth, but only because of the bizarre anomaly that the US government has never bothered to create an NGDP future market. Now are you guys seeing why I think this market is so important? If we had one, the market response (TIPS vs. NGDP futures) over the past 2 months would have basically settled the dispute between Tyler and myself about whether the recession is mostly nominal or mostly real.
I seem to recall Robin Hanson complaining that we won’t spend the money needed to redo the Rand health insurance experiment—the only one that really solves the identification problem. This is even worse, we are making enormous macroeconomic policy errors because we won’t create and subsidize trading in a simple NGDP futures market.
Let’s go one year forward and consider how my reputation will fare under different outcomes:
1. NGDP grows at only about 3-4%, and RGDP grows by only about 2%. I think QE2 will be seen as not working, and my reputation will suffer.
2. NGDP grows about 5%, and RGDP grows a bit over 3%. I think I’ll do alright. I said it was better than nothing and would slightly boost growth.
3. NGDP grows 7% and RGDP grows at 4-5%. I think people will see the result as strongly vindicating my policy proposals.
4. NGDP grows 7% and RGDP grows only 3%. I think people will think I was right about the potency of monetary policy, but wrong in assuming the recession was an AD problem. Tyler Cowen wins twice. Krugman loses twice. Kling wins on structural problems, but loses on the potency of QE.
But that’s not how I see things. I hope outcome #3 occurs, but I also think the credit that I predict I’d receive would be undeserved. I’m a “target the forecast” guy. The markets are saying QE2 helped, but nothing too dramatic. Outcome #3 would be more than I think the markets are forecasting, and hence would not be evidence in support of forecast targeting. My sense is that other people don’t particularly focus on the forecast targeting part of my message, however, and that they’d see it as vindicating my constant arguments for monetary stimulus. What do you think?
I bet you never realized there was so much complexity embedded in Tyler Cowen’s innocuous sounding comment “I am very curious to see the results.” I’m very curious to see how Tyler interprets the results that actually occur, but I have no curiosity at all about the nominal effects of QE2. The markets have already answered that question to my satisfaction, ceteris paribus. But I am curious to see the NGDP/RGDP split, if NGDP rises dramatically.
Tags: QE 2