Bernanke And The Shibboleths, by Paul Krugman: Everyone hates quantitative easing. The inflationistas believe that it’s the end of Western civilization (but as a correspondent points out, we want them to believe that; similar beliefs about the end of the gold standard helped recovery in the 1930s); meanwhile, the rest of the world is furious at the Fed’s actions.
Clearly, Bernanke must be doing something right. As Greg Ip says, all the objections currently being offered to QE would apply equally well to conventional monetary policy — and given high US unemployment and sagging inflation, how can you argue that monetary expansion is unjustified?
But what we’re seeing worldwide right now is an inability to think clearly about economics. In particular, the unconventional nature of our situation is making it clear how many people rely not on any model of how the economy works but rather on what the late Paul Samuelson called shibboleths — by which he meant slogans that take the place of hard thinking.
The basic situation of the world economy is simple: we have an excess of desired saving over desired investment, even at a zero interest rate. ...
How did this happen? The answer, mainly, is that over-borrowing in the past has left large parts of the world credit-constrained, forced to deleverage by cutting spending; and even a zero interest rate isn’t enough to persuade the unconstrained players to increase spending by enough to offset these cuts.
Yet interest rates can’t go below zero; which poses a problem. For the world as a whole, savings must equal investment, or, equivalently, spending must equal income. So this incipient excess of savings leads to a depressed world economy, in which income falls to match the amount people are able/willing to spend.
So what can policy do?
1. It can try to achieve negative real interest rates by creating expectations of inflation. ...
2. Alternatively, governments can step in and spend while the private sector won’t.
3. Finally, central banks can try to circumvent the zero lower bound by buying long-term debt. The point here is that we only have zero rates at the short end, and it’s possible, though not certain, that you can get at least some traction by buying those longer-term bonds.
But now that we’re in this situation, VSPs around the world are objecting to all of these possible actions. Inflation targets are horrible because we must have price stability. Fiscal policy is unacceptable because we must have balanced budgets. QE is outrageous because that’s not what central banks are supposed to do.
Notice that in each case the objection is based on a shibboleth. Price stability is treated as an absolute virtue, without any model to explain why. The same with budget balance. And those who are horrified at the idea of expansionary monetary policy have been inventing concepts on the fly to justify their position.
The simple fact is that we have a global excess supply of savings, which is doing terrible things to workers. The reasonable thing is to do something about it; it’s deeply unreasonable, and deeply irresponsible, to invent reasons not to act because you’re clinging to simplistic slogans.
Here's an example of someone worried that QEII will result in uncontrollable inflation. Steven Williamson has trouble being civil -- I suspect it's the frustration from thinking he's built a better theoretical mousetrap yet the world keeps beating a path to someone else's door -- so I'm sure this will bring some response about how stupid I am for not understanding this or that, and how stupid anyone who might disagree with him is. But his objections are hard to understand or, as Krugman predicted, left unexplained.
His first fear is that:
One possibility is that economic growth picks up, of its own accord, reserves become less attractive for the banks, and inflation builds up a head of steam. The Fed may find this difficult to control, or may be unwilling to do so.
If the economy begins growing so robustly that inflation breaks out, and as posited by Williamson, QEII has nothing to do with that growth ("growth picks up, of its own accord"), why, exactly, would the Fed be reluctant to remove reserves from the system? If the system is overheating due to high rates of growth, what harm will the Fed fear? If adding the reserves didn't stimulate the economy, how will removing them harm it? QEII didn't help, but ending it will harm the economy? I suspect Williamson has an asymmetric loss function of some sort -- creating inflation, or the expectation of it in the future, doesn't stimulate the economy but lowering it does harm -- but we aren't told what that story is. We're simply told the Fed "may find this difficult" or "may be unwilling." There are certainly stories one can tell about the harmful effects of reducing inflation, e.g. a standard Phillips curve model, but what story does he have in mind? I doubt very much that it's the New Keynesian Phillips curve story, but can't really say -- it's hard to evaluate an objection when you aren't told what it is.
(The reason I am saying that Williamson is assuming QEII will do no good at all is that he only identifies costs and objects on that basis. If there are benefits, then they ought to be weighed against the costs if you are doing an economic analysis. But he doesn't do that. That means he either thinks there are no benefits, as I've assumed, or that he is presenting a one-sided, misleading argument based only on costs to make his case.).
His second objection is that:
Even worse is the case where growth remains sluggish, but inflation well in excess of 2% starts to rear its ugly head anyway. Bernanke is telling us that he "has the tools to unwind these policies," but if the inflation rate is at 6% and the unemployment rate is still close to 10%, he will not have the stomach to fight the inflation.
But how does inflation pick up if aggregate demand remains stagnant? If the reserves are simply piling up in banks, how, exactly does the inflation occur? (Does he mean asset price inflation perhaps? Worried about a bubble maybe?). Waving your hands and saying the economy is sluggish, but there's inflation without explaining how that inflation happens is simply assuming the bad results you want. Maybe Williamson has a story in mind about how prices get driven upward without an increase in aggregate demand, and I expect a (less than civil) response detailing this, but we aren't told what that story is.
Williamson's final paragraph says:
My concern here is that, given the specifics of the QE2 policy that was announced, the FOMC will be reluctant to cut back or stop the asset purchases, even if things start looking bad on the inflation front. Once inflation gets going, we know it is painful to stop it...
This completely ignores Bernanke's clear statement that the Fed will reevaluate the program in light of changing economic circumstances. The Press Release announcing the QEII program was very clear about that, and Bernanke made sure to repeat it in his Washington Post editorial the next day. Williamson clearly does not believe the Fed will actually do what it says it will do since he thinks the costs of ending the QEII program prematurely or reversing it would be so large. But, again, what are those costs? To summarize my questions, why is it painful to stop inflation when the economy is overheating due to excessive demand? We're told the Fed may be "reluctant," but why would they be reluctant to temper inflation in an overheating economy? Why would reducing inflation be so harmful in the Fed's eyes in this case? And if the economy is not overheating, if demand remains stagnant, how exactly does the inflation occur to begin with?
Let me add one more thing. This statement made me chuckle:
Predictably, Krugman and this two buddies DeLong and Thoma think the asset purchase program should have been larger.
First, anytime anyone wants to put me in the same group with DeLong and Krugman, that's fine with me, even if it is to claim we're all idiots. I don't mind being told I'm as dumb as those two. If the phrase "Krugman, DeLong, and Thoma" catches on, as opposed to, say, just "Krugman and DeLong," no problem here. But the funny part to me is that in his desire to put the three of us into the same group so he can summarily dismiss two of us as nothing more than Krugman echoes, he seems to have missed that the three of us don't agree on how well QE will work. I guess pointing out that "predictably" we disagree on some aspects of quantitative easing sort of ruins his effort to undermine us, but at least it would be accurate.
Update: Please see my follow-up post on this: Williamson Responds to "Grumpy Thoma".