Monday, November 1, 2010

Bernanke's "Radicalism" is Already Working

Paul Krugman replies to my post on QE in the Great Depression. He then notes that Gautti Eggertson corresponded with him on this discussion:
Gauti Eggertsson writes in to follow up on my piece on quantitative easing in the Great Depression. He points me to a 2008 paper (pdf) in which he shows that the coming of FDR, combined with America’s exit from the gold standard, was seen by markets as a huge regime change; it was, said FDR’s own budget director, “the end of Western civilization.”
This regime change immediately shifted expectations of future inflation, well before there was any actual surge in monetary base. That, rather than the quantitative easing per se, is how monetary policy — or more accurately, expectations of future monetary policy — gained some traction in the 30s liquidity trap. Again, an important lesson — but how relevant is it to current circumstances? Bernanke, unfortunately, cannot convince people that he’s bringing the end of Western civilization.
Two remarks.  First, this is the point I was trying to make in my initial post: change inflation expectations and  follow up with actual changes, as needed to support those expectations, in the monetary base.  

Second, I don't understand Krugman's dismissal of this insight as relevant for today.  There are many folks out there who do think Bernanke is bringing an end to an important feature of Western Civilization today: the value and importance of the dollar. In fact, Krugman himself admitted just last week he was shocked to see such beliefs. It gets worse, there are some who believe Bernanke's QE2 could usher in civil unstrife and maybe even a civil war. As noted by Ryan Avent, Karl Smith, and others, this Bernanke radicalism is already being reflected in the markets.  Below is expected inflation rate from coming from the bond market. Note that after a nine-month fall it does a sudden turn around once the Fed starts talking up QE2 (Click on figure to enlarge):

What more does Krugman need to convince him that Fed is already shaping inflation expectations and can continue to do so if it plays its cards right? Again, have some faith in the efficacy of monetary policy.


  1. Is there some sleight of hand going on do you think? All the time the Fed has been talking up expectations of QE2, yet over the last 6 months the Fed's balance sheet has actually shrunk by 3% (it peaked in May).

  2. Has the Fed not been talking up inflation for two years now?

    We've seen this movie before. QE did not alter interest rates in the UK, Japan or USA. In fact, all three situations resulted in higher rates at the end of the programs. In addition, all three currencies rallied in trade weighted terms during QE1. Aside from a brief move in markets participants soon realized that the deflationary trends that caused this mess (household debt) was largely unchanged by the Fed's actions.

    This is not a supply side issue. It is a demand side issue. The Fed cannot make a bankrupt household take on more debt. This is QE's ultimate failure and all three historical cases show that QE did little to improve borrowing and trade.

  3. Mark S,

    actually no. Bernanke and the Fed have only been talking up their concerns about inflation since September. In fact, many of us observers were going perplexed as to why earlier in the year the FOMC minutes and Bernanke in his speech would make claims the inflation expectations were stable.

    You are right that the Fed cannot make a bankrupt household take on more debt. But it can make a non-bankrupt household, a cash-flushed firm, and cash flushed financial instutions start to spend or invest more of their money. There is an excess money demand problem now and the Fed is not addressing it. See here for more on this excess money demand problem.

    QE is working in UK (see Josh Hendrickson's
    post) and it worked according to what the Bank of Japan wanted. The BoJ did not want inflation, it simply wanted no deflation and a stable price level. It never really tried to reflate its economy. This was understood (and evidenced by withdrawals of the monetary base) and thus never led to a pick up inflation.

    So all the evidence DOES indicate QE can work if tried. The Fed can make a difference, it can shore up aggregate demand.

  4. ECB:

    Interesting question. Note also that broad monetary aggregates (M2, MZM) are increasing. Maybe the Fed is trying to encourage the growth of inside money while allowing some reduction of inside money.

  5. David,

    Thanks for the reply.

    If QE worked in the UK then why is demand for money via loans so weak? There has been no significant pick-up in borrowing. The same can be said of the USA after QE1 and it is certainly true of Japan. None of these cases resulted in sustained economic recovery and the evidence of higher AD or inflation as a result of QE is very weak at best.

    While inflation might be running higher in the UK it is still very very low by historical terms. The same is true in Japan and the USA.

    The BOJ has actually admitted that QE did nothing to increase prices or AD:

    The case in the UK looks eerily similar and the evidence once again points to no effects in the real economy due to QE:

    Here in the USA I think we can all agree that QE did little to generate higher inflation or AD. After all, we wouldn't be talking about QE2 if it had....

  6. MarkS,

    You are confusing money and credit. An excess demand for money, all else being equal, reduces the demand for credit. Why? Because an excess demand for money increases the burden of debt.

  7. Lee,

    We agree on that.

    But you do not explain to how QE will address the current problem and why history shows that is hasn't.

    QE's only real hope of working is via the lending mechanism and your comment appears to imply that you don't think that will happen which makes me wonder why you are defending QE....



  8. MarkS:

    Again, the BOJ never really tried to stimulate AD. All it tired to do is prevent deflation. This is widely understood. In the UK they recently had higher real GDP growth than expected along with relatively high inflation. Here is an excerpt from a WSJ article:

    The U.K. economy has now expanded 2.8% in the last year, a little above the average for the pre-crisis decade of 2.6%. Encouragingly, growth is broad-based across services, construction and manufacturing; the latter has now racked up annual growth of 5.3%, the strongest year-on-year rise for 16 years, Barclays Capital notes. Despite concerns, service-sector growth held up at 0.6%, the same pace as the second quarter. Indeed, worries that the U.K. is experiencing a particularly bumpy recovery are starting to look overdone. That should help unlock corporate spending and hiring

    The later part points to how QE would work: the expectation of higher prices will cause cash-flushed firms, households, and other entities to start spending more today. Note, that this has nothing to do with lending, yet. All it has done is drop the excess money demand. Now given the slack in the economy and stick prices, this pickup in spending will translate into real economic gains and encourage banks to start lending. On top of that, the higher expected inflation will drop the real interest rate and encourage more interest-sensitive spending. Next, we could consider the pick up in asset prices have a wealth effect on consumption. Finally, further depreciation of the dollar may spur exports. Bottom line is that there are multiple channels through which QE could work.

  9. What more we need is action, substance, to follow the Fed.s talk. If the action doesn't live up to the talk, the markets won't keep predicting higher inflation.

  10. There's a lot wrong in these comments.

    Of course they tried to stimulate AD. That is the whole purpose of QE. To say otherwise is sheer semantics and nonsense.

    You don't appear to want to confront the real evidence with regards to how QE functions. You argue that it results in an export boom. But all three historical cases showed little to no change in trade weighted FX moves and in fact rose. Therefore, it is incorrect to argue that QE somehow devalued the currency and resulted in an export boom.

    Interest rates on a 12 and 24 month basis were higher following all three cases. Therefore, it is incorrect to argue that cheaper financing resulted in a spending boom.

    So, we know that lower interest rates and a declining currency were not the cause of any supposed future growth.

    Without real change in asset price fundamentals there is no reason to believe that a "wealth effect" should last. You're encouraging investors to spend paper gains (hello housing bubble!!!!). That's Greenspan's admittedly "flawed model" all over again.

    You say say households and businesses are flush with cash. But you are looking at the asset side of the ledger while ignoring the liability side. In truth, corporate and household debts are near record highs. Your "cash on the sidelines" is a myth.

    You say banks are just waiting to lend. But banks are never reserve constrained. This should be abundantly clear after the last year.

    You appear to be arguing that you can scare an economy into spending. But you're approaching this from a theoretical perspective and a real world perspective. If the Fed decides to become "credibly irresponsible" as P Krugman would say that does not in any way entice business to spend more. In fact, all it is likely to do is drive input costs higher which will actually hurt corporate margins and reduce a corporations ability to respond to future needs.