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Friday, March 18, 2011

Here I go again. Matt Yglesias assumes that monetary policy must be effective when in a liquidity trap. I object.

Here is a very brief summary of his post.

In the latest issue of Democracy: A Journal of Ideas I have a piece about progressives, the Federal Reserve, and the need to confront the centrality of monetary policy to economic issues:


The members of the Federal Reserve Board of Governors and the presidents of the regional Federal Reserve banks, by contrast, are specifically tasked with the job of preventing giant recessions. They’ve failed. Utterly. And it’s a big deal.

Good proposal, bad appeal to evidence. The Fed is very important. It is not democratic. democrats* should address the issue. So should Democrats.

But the current recession does not prove that the current Fed is no good. You can equally argue that the stimulus failed so we should blame the Democrats. In each case, the relevant question is counterfactual. The sensible answer is that things are bad, but they could be much worse -- rich country industrial production was following the exact same path as in the great depression.

The current Fed is by far the most aggressively expansioinary Fed in history. You simply assume that they could have prevented the recession entirely.

Look another analogy. Medical doctors are no good at all. Their job is to keep us alive and we all die. Therefore the current approach to health care is no good at all and we should try something heterodox.

As far as I can understand from reading every word written on this blog, your proposal is quantitative easing. Your complaint is that the $900 billion in open market operations in 2010 weren't enough (even though they were larger than all pre-Bernanke open market operations put together).

So not enough of a good thing (like your critique and mine of the stimulus). There is a difference however -- the stimulus was followed by a dramatic turnaround in GDP growth. Output following the stimulus was higher than the forecast baseline. This is true also when the forecasts are based on VARs and atheoretical. The data show the stimulus worked as expected. The current state of the economy shows it was not enough of a good thing.

In contrast, there is no evidence (0 (zero)) that QE2 worked at all. The idea is that QE causes lower real interest rates either by causing lower nominal interest rates or by causing higher expected inflation. Real interest rates are now what they were last August (QE1.1 and Bernanke's statement that there would be some QE2). They are higher than they were when the actual QE2 purchases started.

My reading of the data

is that some people believed that QE2 would work, so they drove TIPS yields down expecting to profit when it was actually implemented. When QE2 was actually implemented, they took a bath and now everyone with money on the line is betting that QE is ineffective in the current liquidity trap. In other words, Paul Krugman was right and Milton Friedman was wrong (knock me over with a wrecking ball).

It is true that most people who are not bankers pay a whole lot more attention to congress than the Fed (and more to the President than to Congress). This is almost always a mistake, since the Fed is almost always very important. But not now.

* I think it is more important to distinguish supporters of democracy (small d democrats) from one party (large D democrats) than to conform to standard rules of capitalisation -- also "a rose is a rose is a rose."

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