Paul Krugman recently discussed the charge that QE2 is stoking inflation in the developing world:

Oh, and what about Ben Bernanke? Well, to the extent that emerging markets are insisting on a fixed exchange rate against the dollar in the face of obvious overvaluation, that contributes to the boom and hence to demand. But I don’t think it’s reasonable to demand that the Fed stop fighting US unemployment in order to keep Chinese currency manipulation from leading to cotton hoarding by Chinese farmers.

He’s right, all the Chinese would have to do is raise the value of the yuan.  You might argue that this would slow their economy.  But if inflation is shooting upward they need to slow the (nominal) economy.

For China to blame the US for its inflation, when they refused to cut back on the number of Treasury bonds they bought as a way of tightening monetary policy and boosting the yuan, would be like the US blaming China for high unemployment, when we refused to buy more Treasury bonds to weaken the dollar and boost the prices of commodities, stocks, TIPS and foreign currencies.  Bernanke and company showed in November that they are quite capable of taking affirmative steps to solve our own problems (although I’d like to see even bigger steps.)  Now China needs to show the same can-do spirit, and stop blaming foreigners for its problems.

BTW, it’s good to see Krugman talking about how the Fed is “fighting unemployment.”  A clear message to all those old Keynesians who whine that there is nothing monetary policy can do once rates hit zero.  Their hero FDR didn’t whine that there was nothing he could do about deflation because rates were at zero.  He engaged in level targeting—set a goal of getting prices back up to 1926 levels.  And he got prices rising fast.

Paul Krugman recently started off a post as follows:

I’ve been watching with sympathy as David Beckworth and Scott Sumner discover that their updated monetarism actually puts them on my side of the great ideological divide “” cast into the outer darkness along with John Maynard Keynes and Milton Friedman.

But what does the other side believe? Someone, I don’t know who at this point, sent me to this post by Robert Murphy, which is the best exposition I’ve seen yet of the Austrian view that’s sweeping the GOP

I certainly understand the point Krugman is making, and in a sense I agree.  But I also think this slides over a much more important ideological divide; one I still don’t fully understand.

Suppose you asked the top 100 macroeconomists in America whether they were with the 5 economists in the first paragraph, or Bob Murphy.  My guess is that at least 90 would be with us (and yes, that even includes new classicals like Robert Lucas.)  So the “outer darkness” is not all that lonely a place.

But here’s what I don’t know.  Why weren’t those 90 macroeconomists out picketing the Fed in October 2008, demanding easier money?  Well 89 of the 90, the other is in the Fed.   Back in late 2008 and early 2009 a few of us quasi-monetarists were just about the only people insisting on the urgent need for much more monetary stimulus.  A tiny handful of others (including Krugman) half-heartedly agreed it was worth a shot, and almost everyone else completely ignored monetary policy.  One argument was they assumed we were at the zero bound.  Actually, we weren’t at the zero bound in October 2008, but let’s say we were close.  The main problem with the zero bound argument is that there was no general understanding that monetary policy was ineffective at the zero bound among the macro elite.  Indeed many of them (Bernanke included) argued forcefully that the BOJ needed to do much more in the late 1990s and early 2000s

I seem to recall Krugman once saying something to the effect that Bernanke discovered things were much harder than it looked from the outside, once rates hit zero.  Yes, that’s right, but the thing Bernanke found out was not that the ideas he gave the Japanese don’t work, he found out that it was difficult to get his colleagues to agree to implement those ideas (or at least that’s what I assume.)   But whatever you think of Bernanke, none of that explains the behavior of the 89 economists discussed above.  Why weren’t they speaking out?

The reality is that the Fed almost always does roughly what the broad consensus of macroeconomists thinks they should do.  In late 2008 and early 2009 those 89 macroeconomists didn’t think we needed more monetary stimulus, or if they thought so didn’t speak out (I’d guess Svensson would have agreed with me.)  Naturally the Fed didn’t provide the needed monetary stimulus.  If the consensus of the 89 had been that QE2 should have been adopted in November 2008, not November 2010, it probably would have been done then.

I still don’t think the views of Murphy have broad acceptance among elite macroeconomists (if they do God help us.)  They certainly didn’t in 2007.  The big mystery is not explaining wacky views of Austrian bloggers and GOP economists who hope to get a gig as Sarah Palin’s chief economic advisor, but the broad mainstream of Ivy League macroeconomists.  I just did a post showing that Charles Calomiris opposed QE2 even though his rationale suggested it was needed.  Earlier I did a post showing that Frederic Mishkin did not think Fed stimulus was inadequate in late 2008 and early 2009, even though the key insights of his textbook clearly and unambiguously suggest it was.  Indeed the explanation of the crisis added to the 8th edition of his textbook is completely contradicted by his 4 key insights into monetary policy, which come just one page later!  I recall a talk by Robert Lucas a couple years ago, where he mentioned how in this situation the Fed needed to boost the money supply to offset a fall in velocity, but then for some strange reason suggested he though Bernanke was doing a good job.  I could go on and on.

The big mystery Krugman should investigate is not why people like Bob Murphy hold wacky opinions, but why his fellow elite macroeconomists seemed to suffer from mass amnesia in late 2008 and early 2009.

Krugman makes this observation later on:

Why is there such a strong correlation between nominal and real GDP? Why is there overwhelming evidence that when central banks decide to slow the economy, the economy does indeed slow? And on and on.

I’d love to know why our elite macroeconomists were not loudly demanding that the Fed do something to prevent (in 2009) the biggest fall in NGDP since 1938.

BTW, I appreciate the support from Paul Krugman; despite our previous disagreements I consider him the most brilliant macroeconomist in the blogosphere.  But I was slightly bemused by his comment that I had just “discovered” I was on Krugman’s side regarding demand shocks.  I feel like I’ve been here all along.  I can’t help remembering when I tried to remind Paul Krugman that we were (should have been?) on the same side in March 2009.  As Matt Yglesias pointed out, on the issue of monetary stimulus it is others that need to do some soul-searching:

The Great Recession has revealed a lack of capacity for dealing with monetary issues to be a major institutional weakness of the progressive movement.

Matt himself doesn’t lack an understanding.  I’d like to think that’s partly because he reads quasi-monetarist bloggers.  You know, the ones who said that rumors of QE2 would depreciate the dollar, raise equity prices, and raise inflation expectations—months before rumors of QE2 actually did depreciate the dollar, raise equity prices, and raise inflation expectations.

I suppose this sounds like I’m being a poor sport.  Two positive mentions in a row from Paul Krugman!  Let’s celebrate that fact and not look back on unpleasant memories that are best forgotten.

🙂

Conservatives often complain that progressives, aka “liberals,” are insatiable.  Whenever they see unmet needs they call for more regulation, or new entitlements.

I’m not sure this criticism is fair, but I think conservatives see two particular problems with the “unmet needs” approach to policy:

1.  There will always be problems in society, and hence this approach would lead to a larger and larger role for government.  In other words it would put us on the road to you know where.

2.  Government regulations aimed at fixing one problem often create new problems.  Bank branching regulations were intended to prevent concentrations of financial power.  These laws resulted in bank panics in the US, which led to deposit insurance.  Deposit insurance created moral hazard, which led to reckless lending by S&Ls.  This led to re-regulation of S&Ls in the 1990s, etc, etc.  The same dynamic is underway in health care.

How does this apply to monetary policy?  As long as there are “unmet needs,” i.e. aggregate demand is short of target, the progressives should be calling for more monetary stimulus.  And in this case the conservatives should as well, as monetary stimulus is essentially costless.   (On average, the Fed might incur a capital gain or loss, but a non-stimulative policy is likely to create even larger gains or losses to the Treasury.)  And monetary stimulus is no more “interventionist” than non-stimulus, just as setting a steering wheel at NNW is no more interventionist than setting the wheel at WNW.

Here’s what puzzles me, why don’t progressives agree with me that the Fed caused the recession, not the bankers?

One answer is that in 2008 many progressives thought the Fed was out of ammo.  But in 2009 and 2010, progressives became increasingly critical of the Fed for not doing more to stimulate the economy.  Suddenly the Fed wasn’t out of ammo.

Do progressives apply the criterion of “unmet needs” to monetary policy?  I think the answer is yes.  Look at almost any Krugman column that is critical of the Fed for not being more aggressive.  He repeatedly cites data on inflation and jobs.  Krugman says there’s no excuse for the Fed to tighten as long as inflation and jobs are below the Fed’s implicit target.  And he keeps pressing the Fed to do more.  And more.  And more.  And he’s basically right (although I’d rely on NGDP, rather than inflation and jobs.)

I see that as an “unmet needs” approach to monetary policy.  Keep doing more until the expected growth in AD shows no “unmet needs” for more AD.  So if this is the progressive approach to monetary policy, doesn’t that mean that the Fed caused the big drop in NGDP between 2008 and 2009 by not following this criterion?

There are only a tiny number of economists who believe the Fed caused the Great Recession with an excessively tight monetary policy, relative to the needs of the economy.  Why don’t progressives believe this?

A.  They might have thought the Fed was out of ammo in 2008, because rates were only 2%.  But if so, why do they think the Fed is not out of ammo in 2010, despite zero interest rates.

B.  They might have understood the Fed could have pursued much more aggressive stimulus in 2008, but thought it was inappropriate.  But why did they think monetary stimulus was appropriate in 2010 when the economy was already recovering, but not in 2008 when it was falling off a cliff?  And why did they call for fiscal stimulus in 2008?

C.  They might believe that the Great Recession was not caused by a big fall in AD, but rather by structural problems, and/or Obama’s interventionist policies.  But then why do progressives criticize conservatives for making this argument?

It seems to me that the logic of the “unmet needs” approach to policy, combined with the obvious fact that progressives have become highly critical of the Fed for not doing more, points to tight money being the cause of the Great Recession.  So why does almost no one agree with me?

PS.  For new readers I should point out that it is generally understood that there is no absolute indicator of easy or tight money; interest rates and the money supply are both highly unreliable.  When I say “tight money,” I mean tight relative to the policy objective, which is the only meaningful way to talk about the stance of monetary policy.

On Monday I made this observation:

Lars Svensson is one of the few policymakers who will come out of this debacle with his reputation intact.  I’m surprised Krugman hasn’t mentioned him in his blog posts.  (They are colleagues at Princeton.)

Yesterday Paul Krugman made this observation.

In Sweden, my former colleague Lars Svensson, now at the Riksbank, is concerned about the desire of his colleagues to raise interest rates in the face of inflation far below target and an economy that is a long way from having fully recovered. But what does he know? He’s just one of the world’s leading monetary economists, having spent a great deal of time studying problems of monetary policy at the zero lower bound.

But that’s not the reason for this post.  This is:

Snark aside, the rise of the pain caucus is truly amazing – I’m a hardened cynic, yet even I didn’t see that one coming. As Posen points out, mainstream macroeconomics – which suggests that we need a lot more stimulus, monetary and fiscal – has actually held up very well in this crisis; it has, above all, made the right predictions about inflation and interest rates, while the doctrines underlying the pain caucus have gotten it all wrong. Yet “serious” policy makers are rejecting the theory that works in favor of theories that don’t.

Exactly.  And the same thing occurred in the Great Depression.  The most respected monetary theories going into the Great Depression were the more progressive price level/NGDP targeting views of people like Fisher, Keynes, Hawtrey, Cassel, Pigou, Hayek, etc.  And their predictions of the catastrophic implications of a big drop on the price level and/or NGDP were borne out.  And policymakers completely ignored their advice and went with their gut instincts.

Even though I spent much more time studying the Great Depression than Krugman, I was even more wrong about the response of monetary policymakers than he was.  (I.e., I was more optimistic.)  A triumph of hope over experience on my part.

In the previous post I suggested that Paul Krugman might have earned a bit of bad karma with his skepticism about monetary policy during late 2008 and early 2009.  But at least he favored monetary stimulus, no matter how much he suggested it was unlikely to occur and/or be effective.  In contrast, UC professor Raghuram Rajan is now advocating a 200 basis point increase in the Fed’s target rate.

Now I am all for higher rates, but I want them to rise as a result of expected economic expansion, not the liquidity effect.  Anyone with even a passing knowledge of the equities markets knows that this sort of move would produce  a stock market crash.  Not simply a fall in stock prices, but a world-wide meltdown of epic proportions.

I thought University of Chicago economists believed in efficient markets?  Sure, the stock market doesn’t precisely track social welfare.  But how often does a major stock market crash lead to good things?  What sort of confidence would you have to have in your policy “hunches” in order to advocate a policy likely to immediately destroy many trillions of dollars in wealth?  I’ll say this; I lack that sort of confidence, and I’m glad I do.

PS.  This is really scary:

He (William White) and Rajan will have the chance to make their case at the Fed’s annual symposium in Jackson Hole, Wyoming, this week.

HT:  Paul Krugman

Update:  A commenter named Ashwin pointed out that Rajan is concerned that low rates will bail out speculators.  Actually, low rates tend to be associated with falling asset prices.  I agree that higher rates would be desirable, but only if achieved through a more expansionary policy.  Rajan’s idea was tried in 1931.  We had experienced two straight years of job loses, and the Fed responded by raising rates by exactly the 200 basis points he recommends.  It helped turn a severe recession into the Great Depression.  And the Depression then forced rates down close to zero, where they remained for almost 20 years.  So his proposed policy wouldn’t even achieve the higher rates he envisions, just the opposite.