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The following comment left by Matt Yglesias is a gold mine, which will generate a number of posts:

The state of the art thinking in DC, as I understand it, is that with interest rates and capacity utilization low monetary policy may not be able to boost NGDP by arbitrary amounts. Under the circumstances, to push it up non-trivially might require “crazy” steps that cause inflation expectations to become dangerously unanchored. So you need fiscal policy + monetary accommodation (i.e., bigger short-term deficit + Fed holds interest rates low) to produce the kind of moderate AD stimulus that’s wanted. Unclear to me where this model comes from, or what evidence people think they have for it. But it’s a popular view among professional staff at Treasury & Fed and is bouncing around in the heads of some important principals and “name” economists. See Peter Diamond’s remarks to Ryan Avent and what Donald Kohn and Joel Prakken told Dylan Matthews. To me this seems like what happens when a bunch of really bright people fuck up. Rather than admit that they fucked up, they’re devising clever theories to explain why they haven’t fucked up.

Matt’s very well connected, so I don’t doubt his facts. And his interpretation is also spot on. But I think it’s worth discussing all the reasons why the conventional wisdom is all wrong, just as the identical conventional wisdom from the 1930s is now known to be 100% false.

There are all sorts of problems with the conventional view, but they boil down 2 fundamental problems:

1. Grossly overestimating what the Fed has already done in terms of stimulus.

2. Grossly overestimating how hard it is to prevent excessive inflation when exiting a liquidity trap.

Those who wrongly think the Fed has already been very accommodative, who think ultra-low rates and large injections of interest-bearing reserves represent “easy money,” are naturally inclined to throw up their hands and think; “If even this did nothing, then imagine how much stimulus would be required to boost AD. And then think of the risk of hyperinflation.” The commodity price rise following QE2 probably exacerbated that fear.

But money isn’t easy, it’s very tight. Policies like Operation Twist were widely viewed as being almost a complete flop after it was tried in the 1960s; there was never any theoretical or empirical evidence that should have led the Fed to expect success by resurrecting that discredited tactic. QE2 does seem to have had some effect; certainly on markets, and maybe on the monthly jobs numbers in early 2011. But it was ended. And things have gotten even worse since the signals were sent out that the Fed was stopping the program.

Most importantly, the Fed has never done any of the things that would really be effective. The things Bernanke recommended the BOJ do, like level targeting. I’m sure the Very Serious People in DC don’t care at all what I think, but it should give them pause to consider that no less than Michael Woodford thinks level targeting is essential when rates hit zero. Better yet, level targeting is explicitly designed to prevent an outbreak of high inflation when a country is attempting to exit a liquidity trap. Peter Diamond may have a Nobel Prize, but he isn’t 1/10th the monetary economist that Woodford is. It makes no sense to say the Fed has already been aggressive, when they haven’t even tried state of the art ideas like level targeting, and they have done contractionary policies like IOR (which greatly reduces the effectiveness of QE.)

Fear of excessive inflation is even more unfounded. Let’s start with a list of all the countries in world history that exited a liquidity trap and ended up with excessive inflation:

1.

OK, now let’s discuss why it’s never happened. The most aggressive monetary policy during a liquidity trap was FDR’s dollar depreciation policy of 1933-34. It did produce rapid inflation during 1933-34, but not thereafter (except a brief burst in 1936-37, that was immediately reversed.) But it failed to achieve the policy goal; reflation to pre-Depression price levels. Not even close. And yet at the time all the Very Serious People said it was an inflationary time bomb, which would explode in a couple years. In fact, during 1934-40 the WPI rose by 5%, less than 1% per year. One of the Very Serious People was Keynes, who criticized the policy as being too inflationary in late 1933 (when gold prices rose above $28.) When FDR went back onto the gold standard in January 1934 (at $35/oz), Keynes congratulated FDR for rejecting the views of the “extreme inflationists.” That’s right; if Krugman wrote for the NYT back in 1934 he would even be criticizing Keynes.

I don’t even need to talk about Japan, which has made no serious attempt to escape the zero rate trap; indeed which tightened monetary policy in 2000 and 2006 when inflation was roughly 0%. And then went right back into deflation. Believe me, there is no way the Fed’s going to overreact, whatever they do will be too little, and will almost certainly be judged too little by future economic historians.

In addition, wages don’t move until inflation expectations rise. And the Fed can prevent that by monitoring TIPS spreads closely and not allowing 5 year spreads to exceed 3%. I’m not saying they’ll hit their inflation target perfectly, but any overshoot will be trivial compared to the devastation of US and European labor and debt markets by the relentless decline in NGDP growth. A few years ago 3% inflation didn’t even attract any attention.

Headline inflation is another story. A robust recovery will cause a sharp, one-time rise in world oil prices. Are we willing to pay that price, or do we prefer to keep 15 million unemployed so those with jobs can pay less for gas? If we were at full employment and had $5 gas, should we purposely create 9.1% unemployment in order to bring gas prices down? What do you think?

A recurring theme in this blog is that policymakers around the world are reacting to how things seem to be, not what history, theory, and logic tells us is actually going on. Woodford has the theory and logic, and I have the history. But most people don’t know the history, and few people have the deep understanding of monetary economics that Woodford has. So we are going with our hunches. But monetary economics is a very counter-intuitive field. Really tight money can look just like really easy money. And since policymakers rely on common sense, we are screwed.

Unfortunately, it increasingly seems likely that sound monetary policy won’t return until we can go back to targeting nominal rates. Our only hope is to create a robust enough recovery where we can have positive interest rates without those higher rates representing tight money. And every day that scenario recedes further and further into the future, partly due to the actions of the Fed itself.

Unless they change course dramatically, there is no light at the end of the tunnel—there is no 2% T-bill yield for as far as the eye can see. And that means no prosperity.

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Tags: Operation Twist

This entry was posted on October 05th, 2011 and is filed under Monetary History, Monetary Policy. You can follow any responses to this entry through the RSS 2.0 feed. You can leave a response or Trackback from your own site.



