I’ve recently done several visits to Washington DC.  The first was a Mercatus conference called “Instead of the Fed,” and more recently a Cato conference with a similar theme.  I also met 5 Heritage staffers for a discussion of monetary policy.  The title of this post could refer to the growing NSA/CIA/FBI/INS/IRS/DEA/TSA/HHS octopus that has tentacles everywhere, or the vast right-wing conspiracy, depending on your ideology.

I was pleasantly surprised by many of my discussions.  Lots of people seemed interested in my ideas, more than I would have expected.  I was also surprised by how much I agreed with the speakers at the conferences.  The head of the Cato Institute (John Allison) gave a very good talk on banking, pointing out all the unforeseen side effects of banking regulation, and ended up suggesting that we abolish all banking regulation except minimum capital requirements.  Sounds good to me.

In addition to the radical agenda for deregulation, I also agreed with much of the criticism of the Fed. George Selgin gave a very good talk on how the Fed has mischaracterized the pre-Fed banking system in America.  Others discussed Bitcoins, etc.  I even agreed with the claims that the Fed is trying to do too much: interest on reserves, credit allocation, selective bailouts, policy discretion, etc, etc.  It’s drifted far from its previous Taylor Rule approach to keeping NGDP (or something closely related) growing on target.

Charles Plosser gave the opening talk at the Cato conference, and I agreed with virtually everything he had to say, except that he favored having the Fed focus like a laser on inflation targeting, and I favor having the Fed focus like a laser on NGDP targeting.

But . . . .

When it came to the stance of monetary policy, this group which had seemed so sensible on most issues suddenly seemed to be way off track.  Not so much because they thought money was incredibly easy, almost everyone thinks that, on both the left and the right.  Rather they seemed to think that current policy was highly inflationary, which it clearly is not.

Recall that my only disagreement with Plosser is that he supports inflation targeting.  But even if I was convinced to shift to that position, I’d still totally disagree with him about the current stance of monetary policy.  If the Fed should focus like a laser on its 2% inflation target and ignore unemployment (which seems to be Plosser’s preference) then they should adopt a far more expansionary monetary policy.  But he seems to favor a tighter policy.

One speaker after another talked about policy like we were back in the 1970s, instead of seeing the slowest growth in M* V since Herbert Hoover was president.  Why isn’t Bernanke a big hero on the right?  The Fed is producing very low inflation.  Talking to individual people didn’t help much, as there was a wide range of views. Some thought inflation was actually much higher than reported (it isn’t.)  Some pointed to asset price inflation (even though they had not cried “deflation” when asset prices were plunging in 2009.) Some thought the inflation would show up later (it clearly won’t.)  In fairness, some favor no inflation at all, or even mild deflation, so for them money really is too easy tight.

But my overall reaction is that the conservative/Austrian/monetarist/classical liberal/libertarian/RBC schools of thought are too influenced by a combination of massive deficits, massive QE, near-zero interest rates, and simply assume that with all this stimulus we must have high inflation, or else it’s just around the corner.  So they end up “crying fire, fire in Noah’s flood,” as Ralph Hawtrey described similar conservative fears in the 1930s.  Another period of near-zero rates, QE, big deficits, etc.  Another period where (in retrospect) conservatives were wrong.

Benn Steil and Steve directed me to an interesting comment by Janet Yellen during her testimony:

. . . certainly that [austerity] has been a headwind on the economy and something we’ve tried to offset . . .

It’s around the 1:03 mark.  Just to be clear I’m not claiming she’s a market monetarist.  She went on to caution that:

.  .  . our tools to do so are not perfect.

All along I’ve made several arguments:

1.  The degree of offset will depend on how well Fed officials do their job.  It will be time-varying.

2.  What matters is the expected multiplier, not the actual multiplier.

3.  The expected multiplier will be zero if the Fed is doing its job.

4.  You need to think about fiscal policy as a systematic regime, not as unpredictable shifts in policy.

5.  Fed officials will tend to deny monetary offset, partly because it sounds like sabotage (when policy is becoming more expansionary) and partly due to cognitive illusions.  Monetary offset doesn’t seem like monetary offset.  You might well get a different answer from a Fed official depending on how you asked the question:

a.  If Congress did more would you react by doing less, offsetting the stimulus effect?

b.  If Congress enacted austerity would you do your best to offset the drag on the economy?

These are identical questions, but I’d wager that many Fed officials would answer “no” to the first and “yes” to the second.

PS.  Kudos to Senator Mark Warner.  Right after he asked the question (framed as his support of monetary offset), he asked a question about cutting IOR to give banks an incentive to move the money out into the economy, citing Denmark. Yellen was noncommittal.

I often hammer Congressmen for their inept questions, so Warner deserves praise for two great questions.

PPS.  I have a post over at Free Exchange

. . . and when the essay is devoted to the Great Eurozone Depression of 2008 – ??

and when the ECB raised rates twice in 2011, despite a very weak economy,

and when the already feeble eurozone NGDP growth subsequently crashed,

and when eurozone unemployment subsequently soared,

and when eurozone inflation fell to 0.7%,

it might not be wise to omit all discussion of monetary policy in your essay.

Nor does this argument sound persuasive:

The key European problem, which Krugman persistently ignores, has long been constrained supply . . .

On the positive side:

1. Anders Aslund is right that the eurozone does have a huge problem of constrained supply, but it has nothing to do with business cycles caused by NGDP growth crashes.

2.  Anders Aslund is right that Krugman exaggerated the risk of a eurozone breakup, and exaggerated the cost of fiscal austerity.  But don’t throw the baby out with the bathwater.  The eurozone has a huge aggregate demand problem, and it’s the ECB’s fault.

PS.  There is a school of thought that provides a coherent explanation of the eurozone crisis.  It’s not Keynesianism and it’s not austerianism.  And there’s another school of thought that explains the eurozone’s long run supply-side problems, and it’s not American progressivism (anti-neoliberalism in Europe.)  Call me a supply-side market monetarist.

HT:  Tyler Cowen

Several people have asked me to comment on a new WSJ article by Andrew Huszar, who managed the Fed’s bond-buying program:

It wasn’t long before my old doubts resurfaced. Despite the Fed’s rhetoric, my program wasn’t helping to make credit any more accessible for the average American. The banks were only issuing fewer and fewer loans. More insidiously, whatever credit they were extending wasn’t getting much cheaper. QE may have been driving down the wholesale cost for banks to make loans, but Wall Street was pocketing most of the extra cash.

The Fed should not be trying to affect the supply of credit or the price of credit, so I’m glad to hear that it didn’t seem to have those effects.  The goal should be to stabilize the growth rate of NGDP.

From the trenches, several other Fed managers also began voicing the concern that QE wasn’t working as planned. Our warnings fell on deaf ears. In the past, Fed leaders””even if they ultimately erred””would have worried obsessively about the costs versus the benefits of any major initiative. Now the only obsession seemed to be with the newest survey of financial-market expectations or the latest in-person feedback from Wall Street’s leading bankers and hedge-fund managers. Sorry, U.S. taxpayer.

Huszar doesn’t seem to realize that financial-market reactions are the best indication of how these programs are working, indeed the only reliable indication. Everything else (such as borrowing costs) is meaningless without a counterfactual.

Trading for the first round of QE ended on March 31, 2010.  .  .  .

You’d think the Fed would have finally stopped to question the wisdom of QE. Think again. Only a few months later””after a 14% drop in the U.S. stock market and renewed weakening in the banking sector””the Fed announced a new round of bond buying: QE2. Germany’s finance minister, Wolfgang Schäuble, immediately called the decision “clueless.”

If you are going to criticize Fed policy, you really ought not mention any eurozone policymakers, especially German policymakers.  The Germans were the ones pressing the ECB to adopt a tighter monetary policy. How did that work out?  Well back in 2009 and 2010 the eurozone and the US had almost identical unemployment rates (close to 10%).  Since then the eurozone rate has risen to 12.2% while the US rate has fallen to 7.3%.  And what explains that vast difference in performance?  Mostly differences in NGDP growth, i.e. monetary policy.

[See David Beckworth and Lars Christensen for excellent posts on the US/eurozone divergence.]

And what explains the difference in monetary policy?  The Fed was doing one QE after another, with the avowed intention of boosting aggregate demand.  The ECB was raising short term interest rates in 2011 with the intention of reducing aggregate demand.  Both “succeeded.”

It’s certainly fair to point out that the US recovery has been weak, despite QE. But if you are going to criticize QE you need a counterfactual policy.  What should the Fed have done to boost NGDP growth? Huszar doesn’t say.  Quoting eurozone hawks isn’t going to convince anyone outside the WSJ editorial page, over on this side of the pond.  FWIW, I would have preferred NGDPLT and elimination of IOR, as an alternative to QE.

The article contains a lot of discussion about how QE is a subsidy to banks. There’s s tiny bit of truth in that claim, as the Fed does pay 0.25% interest on reserves.  And they should not do so.  But the $5 billion or so that flows to the banking industry via QE is peanuts compared to the $100 billion the Feds are taking from banks through extortion.

Others argue that low interest rates are a subsidy to banks, which makes no sense.  Interest rates are set in the free market.  Back in the old days when central banks did tight money the progressives cried that it was a subsidy to big bankers.  Now when the Fed does “easy money” progressives and many conservatives cry that it is a subsidy to big bankers.  Neither is a subsidy.

And the impact? Even by the Fed’s sunniest calculations, aggressive QE over five years has generated only a few percentage points of U.S. growth. By contrast, experts outside the Fed, such as Mohammed El Erian at the Pimco investment firm, suggest that the Fed may have created and spent over $4 trillion for a total return of as little as 0.25% of GDP (i.e., a mere $40 billion bump in U.S. economic output). Both of those estimates indicate that QE isn’t really working.

Actually if the bump is only $40 billion then QE is working.  Huszar makes the mistake of assuming the “cost” is the amount of bonds purchased.  But that’s not a sensible definition of cost, as the Fed is simply swapping one government liability for another.  A better measure of cost is the interest on reserves program, which has cost about $5 billion per year on average.  And even that is an exaggeration; earnings on the Fed’s bond portfolio offset it.  BTW, “a few percentage points” might be a million jobs, or more. Does Huszar think unemployment is not a big problem?

And how is Mr. El Erian an “expert” on the macroeconomic impact of QE?  What model does he use? Where does his expertise come from? When I went to grad school we were never taught how to model a QE/IOR program.  Did he study how to model these programs in grad school?  If so, which one?  I’m not trying to pick on Mr. El Erian, who I don’t know, my point is that it is not at all clear where one would get expertise in this area.  It’s very possible that El Erian knows more about QE than anyone else in the world, but is still not an expert.

In my view there is only one expert—the market.

HT:  Frank McCormick, Caroline Baum

This is a very good paragraph from Paul Krugman:

One last point: the Germans are very proud of their own adjustment between the late 1990s and 2007, during which they emerged from economic doldrums and became very competitive. But that adjustment, from a European point of view, looked like my first figure: German belt-tightening was accompanied by what amounted to a highly expansionary monetary policy, which led to fairly high inflation in Southern Europe. So when Germany asks why other countries can’t do what it did, it isn’t just forgetting that we can’t all run trade surpluses; it’s also insisting that other countries replicate its success while denying them the kind of external environment that made its success possible.

One small quibble, which I think even Krugman would accept.  Replace “highly expansionary monetary policy” with “relatively expansionary monetary policy.” Highly expansionary is 1965-81.  It was relatively expansionary compared with the post-2008 policy.

Krugman also seems to slightly modify his earlier claim that the zero-bound model has applied to the eurozone in recent years:

But as Wren-Lewis says, that’s not what has happened in Europe “” the ECB has in fact been very reluctant to pursue expansionary policies despite all that fiscal austerity, and now “” having waited too long “” it finds itself close to the zero lower bound.

That’s been my position all along; that the eurozone has not been at the zero-bound, but arrived there a few days ago, or at least is very close.

The point, which I guess we should all have been making more clearly, is that all the various things we talk about here “” the extreme slump in Southern Europe, Germany’s failure to narrow its current account surplus, and the slide of the eurozone as a whole toward deflation “” are really aspects of the same story. We have huge forced fiscal contraction in part of Europe, not at all offset by either overall monetary policy or fiscal expansion elsewhere.

So the ECB made a big mistake in 2011 by not offsetting fiscal austerity.  Krugman and I agree on that point.  The eurozone was not at the zero bound, so austerity should not have reduced demand, even using Krugman’s model.  One irony here is that Krugman may be partly right about the fiscal multiplier, but for essentially supply-side reasons.  One problem in 2011 was that inflation was running above target.  And that was partly due to various tax and fee increases designed to close the large budget deficits.  The ECB reacted to these tax increases by raising rates several times in 2011.  In an AS/AD model the tax increases shifted AS to the left, raising inflation and reducing output, and the ECB reacted by shifting the AD curve to the left.  So fiscal austerity was a mistake.

Or perhaps the real problem was the specific type of fiscal austerity.  My analysis, combined with the ECB’s insane preference for inflation targeting, suggests that demand-side fiscal austerity would have been desirable. Raise the employee-side payroll tax by 4 percentage points and lower the employer-side payroll tax by 2 percentage points.  That sort of fiscal reform would have lowered inflation and thus caused the ECB to cut rates in 2011, instead of raising rates.

But unless I’m mistaken, the Krugman/Eggertsson “paradox of toil” model suggests that my proposal to cut employer-side payroll taxes would be a mistake.

PS.  Ryan Avent also has a good post on the German opposition to “inflation.”