Josh Hendrickson sent me this Youtube video on Don Luskin defending QE2.  I won’t say; “I couldn’t have put it better myself,” the fact is that I couldn’t even have put it as well myself.  If you are not interested in his defense of supply-side economics, skip ahead to the 5 minute point.

Luskin nails one point after another:

1.  QE2 was needed as the economy showed all sorts of signs of sluggishness in the summer.

2.  QE2 is working because asset prices (stocks, TIPS spreads) responded strongly to rumors of QE2 that began in late summer.

3.  The rise is interest rates is actually a good sign, indicating that inflation expectations are moving closer to an appropriate level, and real growth expectations are increasing.

4.  Money was actually too tight during the summer, despite near zero rates.

5.  Milton Friedman pointed out that nominal rates were an unreliable indicator of the stance of monetary policy.

6.  Luskin said you must look at other indicators, and they all showed money was too tight.

7.  QE2 is very consistent with laissez-faire economics, as we don’t want the Fed to maintain a steady interest rate or money supply, but rather to provide enough money to generate a stable macro environment (dare I say NGDP) for companies to operate in.

Back in late 2008 I never heard that sort of talk on TV.  Indeed that’s the main reason I got into blogging; frustration over the conversation of pundits, which seemed to be ignoring the elephant in the room.  If I knew pundits were going to get so smart I might have stayed out of blogging.  It turns out I wasn’t needed.

PS.  It took me one year to figure out how to post graphs on my blog.  Perhaps in another year I’ll learn how to directly post YouTube videos.

PPS.  Tyler Cowen has a very generous post on my NGDP targeting talk.  I will definitely comment at some point, but am too busy with grading right now to give it the attention it deserves.  Meanwhile, help me think up titles;  “Wittgenstein and me”?  I will also eventually comment on his recent inequality article, but that may take even longer.

PPPS.  Luskin also supports the “tax cut.”  I get annoyed by progressives always talking about how the Clinton-era top rate (39.6%) was fine.  Maybe so, but then why don’t they support this “tax cut,” which will return the top rate to 38.8%, once the health care tax kicks in?

I haven’t commented on Paul Krugman for a while:

Hiring plunged; job separations also mostly fell, but that was due to a fall in quits rather than layoffs, which rose during the worst of the crisis, then returned to normal levels.

In all such exercises, you’re looking for the “signature” associated with one or another story; and the signature here is clearly the one you’d expect with a general fall of demand. Keynes roolz.

He’s completely right of course, except for that last sentence.  What could he have been thinking?  All the data shows is that negative demand shocks cause unemployment.  Doesn’t everyone believe that?

1.  Friedman and Schwartz certainly argued that tight money causes unemployment.

2.  Hayek certainly believed that falling NGDP causes unemployment.

3.  Robert Lucas completely accepts Friedman’s and Schwartz’s monetarist interpretation of the Great Contraction, and suggested in a recent talk that falling velocity was a big problem in late 2008.

4.  All the old, new, and post-Keynesians believe demand shocks matter.

5.  RBC-types started out denying the importance of money, but latter added nominal shocks to better fit the data.

I’m not saying that there aren’t a few loonies out there who think if the Fed cut M in half and NGDP fell in half that there be no loss of jobs.  That wages and prices would fall just as fast as M.  But surely not more than a handful.

Here’s what everyone agrees on.  NGDP fell in 2009 at the fastest rate since 1938.   Big falls in NGDP cause lots of unemployment.  The only debate is over whether in addition to the demand-side unemployment, there are also some structural problems.  I think there are, although less than many other right-wing economists seem to believe.  But evidence showing that demand shocks cause unemployment tell us nothing about the relative merits of various business cycle theories.

Part 2.  Krugman and Wells need to consult Mishkin

In another recent post, Krugman makes this admission:

. . . finishing the redraft of the monetary policy chapter in Krugman/Wells 3rd edition (how the heck do we get quantitative easing in without totally muddying everything else?)

It’s easy if you have the right model.  Yesterday I taught Frederic Mishkin’s view of monetary policy at the zero bound, and I had the easiest class of my life.  Everything Mishkin has been saying for years came true in September-October 2010, on rumors of QE2.  I’m referring to his chapter 23, where he looks at unconventional monetary policy transmission mechanisms, which still work at the zero bound.  He lists 10.  Here are a few of the 10 he lists:

1.  Monetary stimulus raises stock prices, and hence the Tobin q, increasing the incentive to invest.  Check.

2.  Monetary policy raises inflation expectations, lowers real i-rates, and increases the incentive to invest.  Check.

3.  Monetary stimulus lowers real rates, depreciates the dollar, and boosts exports.  Check.

4.  Monetary stimulus raises asset prices, raises wealth, and hence increases consumption.  Check.

I would add that monetary stimulus raises commodity prices, and hence raises output in commodity industries.  And because it raises prices, it also reduces real wages.  He’s also got 5 credit view channels that I won’t even bother to discuss.

Of course Krugman’s often argued that QE doesn’t really do much more that change the term structure of government debt.  If that’s all it did, he’d be right to be skeptical.  But we now know it does lots of other things to various asset prices, even though the recent Fed move was far less than we needed.

I’d suggest Krugman and Wells just copy Mishkin’s chapter 23.  If doing so means “muddying everything else” up, then he might want to consider re-evaluating whether “Keynes roolz.””

I hope this is my last attack on conservative opposition to QE2, as I am getting sick of the topic.  I’ll try to summarize all their arguments here, to see if any are even slightly defensible:

1.  Inflation only seems low because the Fed ignores food and energy.

The core rate is only 0.6%, but even the overall CPI is only running 1.2%.  So that argument is flat out wrong.  Yet it doesn’t stop some people from making it.

2.  History shows that when central banks print lots of money, high inflation results.

Actually no.  History shows that when central banks print lots of money at the zero rate bound, one generally doesn’t get much inflation.  Japan has been printing lots of money for years, and has also run big budget deficits—thus they’ve been monetizing the debt.  And their price level is lower than in 1994.

3.  Japan is different.  When the Fed has printed lots of money we’ve had high inflation.

Actually no.  Again, when at the zero rate bound, printing money is not necessarily inflationary.  The Fed printed lots of money in the 1930s, indeed the monetary base nearly tripled.  Yet the price level fell during the 1930s.

4.  The gold market shows that high inflation is just around the corner.

Actually no, for reasons discussed in this earlier post.  Every direct indicator we have of inflation expectations shows very low inflation in the years ahead.  CPI futures markets, 5-year TIPS spreads, the consensus economic forecast, they all point to low inflation.

5.  OK, in the past printing money didn’t produce high inflation at the zero rate bound, and we don’t have high inflation now, and both forecasters and markets tell us not to expect high inflation in the future.  But I just can’t believe we can print that much money without eventually suffering from high inflation.  Monetarist theory tells us . . .

Monetarist theory has nothing to do with the current policy environment.  Monetarist theory is all about the impact of printing non-interest bearing money–aka “high-powered money.”  The reason it’s called high-powered is because it lacks interest, and thus is a sort of “hot potato,” an asset that everyone tries to get rid of, and the in process drives up prices.  Milton Friedman and Karl Brunner would be rolling over in their graves if they knew people were claiming monetarist theory meant than the issuance of reserves paying interest at rates higher than earned on T-bills was some sort of “high-powered money.”

6.  If the policy does raise NGDP, interest rates will also rise, causing the Fed to suffer capital losses on its large bond portfolio.

Conservatives presumably believe in efficient markets, and thus the expected loss is approximately zero.  The term structure of interest rates has already priced in the expected increase in rates that will occur as the economy recovers.  Yes, there is some risk, but far less than people think.  The Fed is mostly buying medium terms bonds, for which the price risk is rather low.  And if the recovery is much stronger than expected, the gains to the Treasury would far exceed the losses to the Fed.  This is NOT an argument for leaving millions of workers unemployed.  Especially given that the Fed took far greater risks to save the big banks.

7.  Yes, they are paying interest in reserves, and that prevents inflation right now, but when the economy recovers there will be tremendous pressure on the Fed to avoid raising the interest rate on reserves, and they will spill out into the economy. 

Even distinguished economists such as Becker and Posner are making this argument, but I find it the most perplexing and feeblest argument of all.

Right now the Fed is under tremendous pressure not to do more monetary stimulus, despite 9.8% unemployment and below target inflation.  There is little pressure on the Fed to do more.  Yet somehow we are to believe that when the economy recovers somewhat and inflation is much higher, and unemployment is lower than today, there will be tremendous pressure on the Fed to not raise rates?  And all this despite the fact that the Fed is almost universally blamed for holding rates too low for too long, and inflating the housing bubble?  That makes no sense.

Even worse, we need easier money to reduce that part of unemployment that is not structural; almost certainly a substantial share of the 8 million jobs lost in the recent recession was cyclical.  NGDP is not now growing fast enough to rapidly reduce unemployment.  I don’t expect the 11% NGDP growth we saw in the first 6 quarters of the (low inflation) Volcker recovery of 1983-84, but surely we can at least raise NGDP growth a bit higher than the current path?  How can we in good conscience tell the Fed not to do the right thing, and ease the enormous suffering caused by unemployment, solely because we fear they might do the wrong thing in the future?  Especially given that there is little political pressure on them to inflate now, when you’d think the political benefit of easy money would be greatest?  Obama didn’t even nominate three people for empty Fed seats for 15 months, which shows how little the liberal establishment cares about monetary policy.  And we are to believe that in the near future when the need for monetary stimulus is far less, Obama will suddenly morph into a latter day William Jennings Bryan and start pressuring the Fed?

So there you are.  The conservatives do not have a single good argument against QE2.  Every argument is based on bad logic, bad economics, a lack of understanding of history, or a lack of understanding of our political system.   There must be some reason why the conservative establishment hardly raised a peep when the Fed would cut rates when inflation was running 3% or 4% when Reagan was president, or when Bush was president, and yet are now up in arms over monetary stimulus when we have 1% inflation and 17 million people out of work.  There must be some reason.  But for the life of me, I can’t figure out what it is.

OK, I’ll get off this topic, and wait for conservatives to explain to me what’s going on.

And when we figure that out, then we can work on the even more bizarre opposition from certain voices on the left.  But perhaps I should leave it to Krugman to figure out what’s going on in the mind of that other outspoken, prickly, left-wing pundit and Nobel laureate.  Joe Stiglitz.

It seems like lots of commenters are insisting that QE2 is failing because interest rates have risen since the November 3rd announcement.  If course most of the interest rate effect was already priced in by November 3rd.  But they are also missing a more important distinction—higher rates can be good news, or more specifically a reflection of good news.

Take yesterday’s big move in the bond markets.  Five year T-note yields jumped 17 basis points, from 1.47% to 1.64%.  But the yield on 5 year TIPS only rose by 10 basis points, from -0.22% to -0.12%. Thus 5 year inflation expectations rose 7 basis points, from 1.69% to 1.76%.  That’s good news folks.

Now some people might say; “Sumner, you can’t have it both ways.  The QE2 proponents have been arguing that the falling rates of September and October showed QE2 was working.”  Actually I can have it both ways.  In the months before QE2 was announced TIPS yields fell much more sharply than nominal yields and thus 5 year inflation expectations rose from about 1.2% to 1.7%.

Message to QE critics (and proponents); stop focusing on interest rates.  Here’s what Milton Friedman had to say in 1997:

After the U.S. experience during the Great Depression, and after inflation and rising interest rates in the 1970s and disinflation and falling interest rates in the 1980s, I thought the fallacy of identifying tight money with high interest rates and easy money with low interest rates was dead. Apparently, old fallacies never die.

The stock market understands that message; they brushed of the higher interest rates and rose 2% yesterday.  And stocks also rose when rates fell on earlier rumors of QE2.

Then there is the argument that the rising dollar (against the euro) shows QE2 isn’t working.  I admit to arguing that the strong dollar was a sign of tight money in the spring of 2010.  But I wasn’t basing that argument solely on the movements in the exchange rates, which are always an ambiguous signal.  A rising dollar can reflect tighter money here, or easier money in Europe.  In the spring it seemed to reflect tight money in the US, as other asset prices were confirming that signal.  And my initial reaction was that the same was occurring in response to renewed problems in the eurozone.  But a good macroeconomist will never fall in love with an explanation.  It seems like the eurozone troubles may be becoming so severe that the ECB will have to become more accommodative.  If there is anything the ECB hates more than easier money, it would be a crisis that ripped the eurozone apart.  Here’s a recent story hinting that ECB easing may be necessary to save the euro:

NEW YORK (AP) — U.S. stock futures are rising, building on gains overseas as the European Central Bank meets to discuss its plans to support the euro zone.

Investors are hoping that the bank will take additional steps to prevent the European financial crisis from spreading to Spain and Italy.

I’m not saying I have high confidence in this explanation, but rather that one must always remember to look at a wide variety of variables when analyzing a situation.  Even the very best macroeconomists can become a little too obsessed with one variable, Milton Friedman with the money supply, Robert Mundell with exchange rates.  But where they differ from their followers is that they generally knew when to look beyond that one variable, and which other variables were relevant to the problem at hand.

Yesterday a commenter named Leo made this interesting observation:

Readers should not (as I’m sure you don’t) confuse Hayekian pragmatism for Misesian logic.

I can’t comment on Mises, but I do consider myself a pragmatist.  In any given macroeconomic situation there are at least 10 models and variables that need to be considered.  Some people will ignore 9 of the 10, and then methodically apply Cartesian logic to the one variable that they consider “the real problem.”  That’s not my style.

PS.  What am I monomaniacally focused on?  NGDP expectations?

Update:  This article has a bit more info on the ECB:

LONDON (AP) — The European Central Bank stepped up efforts to contain the continent’s government debt crisis, as bank president Jean-Claude Trichet announced it would prolong measures to provide ready cash to banks and steady the financial system.

Markets were initially disappointed Thursday when Trichet did not say the bank would go even further and increase its purchases of government bonds. The euro sagged almost a cent during his news conference.

But it quickly bounced back, trading higher on the day on market chatter that the bank might in fact be quietly buying bonds of financially troubled eurozone countries — despite Trichet’s reticence on the issue.

You’re probably getting sick of me arguing that the Fed should be talking about how it’s trying to raise national income, not the cost of living.  Here’s Jim Hamilton making the same point:

The strength of this opposition [to QE2] may puzzle some within the FOMC. Traditionally, the Fed faced a trade-off between the goals of trying to keep both unemployment and inflation low. But at the moment, unemployment is painfully high by anybody’s standards, even as inflation is lower than the Fed feels is consistent with its goal of long-term price stability. Why is the Fed finding that persuading the public that inflation is too low is such a hard sell?

As Ben McCallum recently noted, regular Americans will tell you, of course inflation is still too high, because the price of X has gone up over the last year. Somehow the ability to process numbers that way fits naturally into our cerebral wiring, whereas averaging over all our purchases does not. There is also a deep-seated distrust of the official government measures of inflation. More fundamentally, many Americans think of inflation as an increase in the price of things they buy (which of course sounds bad), as opposed to an increase in the price of the things that they sell (which by itself is not that unpleasant). Perhaps the Fed should consider referring more to its desire to see wages and incomes growing more solidly, rather than its desire to see inflation higher.

In late 2008 when everyone was wringing their hands saying there’s nothing the Fed can do, Hamilton said something to the effect that; “If they can’t create inflation, let me have a shot at it.  I’ll show them how.”  (Not his exact words.)  He was right then and he’s right now.

PS.  Don’t say it would be deceptive advertising to switch from inflation to income.  The Fed isn’t trying to boost inflation, they are trying to boost national income.  For any given increase in NGDP they’d prefer to have less inflation and more real income growth.  I’d be like a anorexic sumo wrestler saying he was targeting a higher fat level by eating big meals.  No he’d be targeting more weight, and hoping that any weight gain is mostly muscle and only a little fat.

I’d love to see the looks on the faces of ad execs on Madison Avenue if Bernanke explained that he was trying to raise nominal spending and income, and thought the best way to communicate this fact to the public was by announcing the Fed was trying to raise the cost of living.  A future satirist will have lots of fun picking over the wreckage of this crisis.

Update:  Leigh Caldwell sent me the following from Time:

And that’s what those two little cute Bernanke bashing bears don’t seem to get. It’s not that the Fed is trying to prevent falling prices, or at least that’s not what they are most worried about when it comes to deflation. The price of iPhones, flat screens and other gadgets fall all the time, and that’s not a problem. The real thing that the Fed is worried about is wage deflation. When we all make less money we spend less, and it becomes even harder to pay back our debts. That’s an economic spiral that is very hard to get out of. And rising commodity prices make that spiral more likely, not less.

That’s slightly better than inflation, but still not really correct.  The Fed doesn’t want higher wages, they want higher incomes.  It is true that higher wages would be an indication that stimulus is working, but for any given increase in national income, higher wages mean fewer jobs.  What we really need is more income.

It’s ironic that having to respond to those two little bears is making the intelligentsia come over to my side.   My God! (pundit whacks hand on forehead) . . . it’s not inflation, it’s higher income that the Fed has actually wanted all along.