Wednesday, August 01, 2012

More Contra Yglesias

I think extremely highly of Matthew Yglesias.

I mainly disagree on one topic and it is a disagreement of degree not of kind. We both think the Fed can and should do more to stimulate the economy. He tends to argue that this would be easy and all the Fed has to do is declare a higher inflation target plus maybe open ended QE3. He noted that Peter Diamond disagrees. He was impressed at his courage in debating a Nobel Laureate and has gone on to assume, in effect, that Diamond is so obviously wrong that he can be ignored.

The question is whether the Fed can achieve an inflation target of say 4%. Yglesias argued (no link) that it obviously can because it controls the money supply. Here I think the issue can be redefined (maybe I am being unfair to Yglesias here and still no link) as whether the Fed can achieve an inflation target of 4% if the only way it affects the economy is through expected inflation.

Note I haven't specified the existing inflation rate at the time the Fed announces its 4% target. I think this makes it clear why people significantly older than Yglesias find his posts on the subject incomprehensible. In 1980 the Fed had an inflation target of 4% (possibly importantly it wasn't stated at the time -- I infer this from later monetary policy). It achieved this target following an extremely severe recession. My recollection is that output remained low and unemployment high even after Volker's ruthless determination was made very clear to everyone who was paying attention.

Look at the Livingston Survey of Consumer Price Index forecasts (many pages go to CPI). In 81 and 82 you will see forecasts of increases on the order of 4 or 5%. Notice these are forecasts of prices 6 months ahead so correspond to expected inflation of 8 or 10%. This is after the Fed had a huge horribly painful effect on the real economy. The unemployment rate reached the highest level since WWII (not surpassed in 2009). This is a snip of median CPI forecasts

No one who lived through the early 80s can imagine that the Fed can control inflation expectations just because it controls the money supply.

The usual boring rant follows.

Yglesias thinks the Fed can stimulate a lot and I suspect it can stimulate not so very much, but not so very much better is better than current policy. We also disagree about how the Fed can most dramatically affect the economy. I think the main thing the Fed can do is bear (really hide) risk from investors reducing the supply of risky assets held by private agents and increasing their prices. So I think the key issue is first that there be QE3 and second that the Fed buy something risky. This means US Federal Agency issued mortgage bonds or bonds issued by not so credit worthy foreign governments (conflict of interest disclaimer some of those bonds are sold to get the money paid to me each month). These are the only risky asset it is allowed to buy. This is what QE1 was (and it worked). In QE2 the Fed tried unconventional monetary policy which was as close to conventional as possible and the effects were, in my view, not statistically significantly different from nothing.

1 comment:

JW Mason said...

Right. The modern monetarist argument that Yglesias has picked up somehow is really the same as the old monetarist argument -- that a "credible" central bank can control the inflation directly via expectations without any need for policy to be transmitted through the financial system into changes in aggregate demand. This was why monetarists in both the US and UK claimed it would be possible to end the late-70s inflation without a significant recession, and why monetarists elsewhere similarly claimed a "regime change" was enough to stabilize prices. Historically the monetarists were wrong every time, but as you say, Yglesias doesn't know any history.