Bryan Caplan  

Arnold's Solution to Sumner's Paradox: Is It Right?

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Sumner's spent a year or so trying to figure out what Bernanke's thinking.  Pre-crisis, Scott and Ben were in almost perfect agreement.  But when the crisis hit, Bernanke seemed to suddenly come down with amnesia.  What's up with that?

Arnold's solution to Sumner's Paradox:
The Fed has changed from a central bank to a piggy bank. Any economist who tries to interpret Fed policy from the standpoint of economic theory is playing a fool's game.
Bernanke's running the economy into the ground on purpose in order to help his new cronies?  Arnold's story fits the facts, but it just seems too conspiratorial.  Does anyone want to convince me, one way or the other?


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COMMENTS (12 to date)
david writes:

For comparison, here is Sumner's "best analysis of the Bernanke debate" (in Sumner's words): a post written by Brad DeLong, in which he disagrees with Paul Krugman (all those who only read blogs they agree with must now be wincing!).

I find it much more convincing than Kling's; Kling is postulating a super-rational Fed, very competent at serving a selected clique of cronies, that also manages to hide said competence from the public.

It doesn't just seem too conspiratorial: it is conspiratorial and has all the failings of conspiracy theories, especially that of unusually competent conspirators. Maybe Bernanke has harbored a secret evil side for his entire academic career. Maybe so! But suggesting that the rest of the FOMC are also now deploying their evil twins requires quite a leap of the imagination.

Cameron writes:

Firstly, who says Bernanke disagrees with Sumner? Fed policy isn't completely up to Bernanke. If he doesn't have agreement from other fed officials, it seems unlikely he has the influence/personality to get his way.

Second, it’s easy to be cynical about the current policy, but my guess is that the fed really thinks it's doing the right thing. A lot of people in the Fed are bankers and bankers are focused on banking. If they think the financial system is the problem then clearly that is what they are going to try to “fix” (versus simply increasing AD).

That being said, I completely agree with Sumner and think Fed policy has been awful since mid 2008. If the Fed had focused on conventional monetary policy and tried to simply keep inflation/unemployment stable while letting the banking system sort itself out, my guess is things would be a lot better than they are now. Focus on the financial system seemed to prevent the fed from concentrating on NGDP and aggregate demand, which resulted in a severe recession.

Niccolo writes:

To be fair about the conspiratorial stuff. It is very possible that Bernanke actually believes the US as a whole and even the taxpayers are better off if the banks have more money.


I don't think that he's evil. Just that he's so far in the forest of his own belief, he can't see the trees.

Daniel Kuehn writes:

I agree with Niccolo that there's a difference between wanting to recapitalize the banks for the sake of the economy and wanting to help out Wall Street.

I was intrigued by Arnold's post, but I think it's even simpler than that: it's very easy to come up with a plausible solution as an economist. It could even be plausible enough to stand firmly behind it. But when you're responsible for implementing it and you realize your more or less plausible solution is quite untested you're going to be a little hesitant to jump right in. He's not just presenting a paper or giving a speech anymore - he has no less than three hundred million livelihoods at stake. That's sobering and it SHOULD be. We don't want policy makers taking huge leaps on deductively derived conclusions - or, if empirically based at all, conclusions that have extremely limited empirical evidence. And honestly, I'd put most libertarian policy suggestions under this column too. I think people are far too hard on Bernanke. Sumner has the advantage of being a professor rather than being the guy ultimately held responsible for what happens.

Eli writes:

I'm opposed to the conspiratorial hypothesis. I think it's relatively easy to explain Bernanke's behavior in terms of his stated beliefs about monetary policy.

If you read Bernanke and Gertler's famous 1995 paper, you will see a clear statement of Bernanke's belief in the credit channel of monetary transmission in general and the bank lending channel in particular. Bernanke is behaving as if he believes the bank lending channel is extremely important, which means shoring up bank profits so that the channel remains strong.

Most other economists believe that the cash balances mechanism is far more important, and that there are many other institutions besides traditional banks that can act as financial intermediaries (venture capital, non-bank firms, etc.). This is why the rest of us think Bernanke is crazy or evil.

Lord writes:

I realize Scott believes expectations and believability can be established overnight, but Volcker couldn't end inflation overnight and I don't think Bernanke believes the economy can shift directions that fast.

Doc Merlin writes:

Of course they are doing it to keep banks alive, its not just "conspiracy theory" its what they believe is best for the country as a whole and for their member banks.

Elvin writes:

I agree with Lord. One person cannot change expectations cannot change overnight. (Though an "event" like 9/11 can.)

The first half of 2008 had two significant forces tugging at the economy. One force was much higher oil prices depleting consumers budgets and strangling profits in many businesses. This flowed through to headline CPI, so there was a lot of screaming at the time about doing something about inflation. I tried to argue with people at the time that this wasn't "real" inflation, but a sectoral induced one, since we didn't see inflaton in wages, housing, clothing, etc. The second force was the quiet collapse of overleveraged institutions and households. Bear fell in March, the auction-rate market collapsed in January, etc. We were learning about how leveraged the big banks were--who had ever heard of SIVs before August 2007? How many knew the about the CDO machine and the leverage in CDO-squared. Not many, but we were learning about it throughout early 2008. I realized after Bear that some of the banks were in peril--they might be solvent if the economy recovered and housing stabilized, but if it fell into recession, a real mess was in store.

So in July 2008 the Fed was in a real bind: the public concerned about inflation (go look at inflation expectation surveys at this time), but credit issues in finance, which are deflationary. Which way do you steer policy?

I think by August of 2008 the public had decided to cut back expenditures a lot and businees had put all investment on hold--there were too many uncertainties out there. Ben could have had a prime time telecast about printing money to make sure that nominal GDP would be 4% and it wouldn't have moved the public an inch.

In retrospect it was a slow motiion train wreck that culminated in October. Too many real imbalances had built up in the system--overconsumption and overleverage, trade deficits--for monetary policy to fix. Oh, maybe it could have kept the imbalances going for awhile, but 1% savings and 30-1 leverage equals a problem.

Blaming the Fed for the collapse is silly. We did it to ourselves.

Bob Murphy writes:

Bryan,

Let's start with something simpler. I am reading David Henderson's _The Joy of Freedom_ and he suggests that the government uses minimum wage and other laws which hurt workers in general, but help their union cronies.

Do you reject such crazy conspiracy talk?

Colin K writes:

I think a more subtle reading would be that the conspiratorial lens is a more useful model than the policy one, even if not quite true per se.

The argument, I think, is that the policy ("we must preserve these banks!") was decided ad hoc and based primarily on Kentucky windage, in an environment of severe cognitive capture. As all the policy decisions have come to light and been plotted on the chart, the line of best fit (i.e. the theoretical justification) keeps shifting.

Grant writes:

What would Robin Hanson say?

Humans seem to be very good at rationalizing favors for their ingroups. It seems very plausible that Bernanke things whats good for banks = whats good for America; i.e. what Niccolo said.

It isn't very conspiratorial to believe that many in Bernanke's ingroup are bankers, and that human nature means he rationalizes ways to help them over others not in his ingroup. He is very intelligent, so he is probably very good at rationalizing.

I'm not sure I wouldn't call this behavior evil. How many criminals don't rationalize their acts?

John writes:

Obi-Ben's a academic bureaucrat These people never change their minds (or opinions).

The country is running like a fine tuned watch. The smartest amoral scumbags are winning. We're just watching the only possible end-game of all competitive events (which is what Capitalism is, after all) and the best people of the Capitalist event have won (who else should have all the loot, the honest people?) The fact that they (the winners) didn't do it according to some goofy Libertarian rules (truth, justice, and all that), but instead did it the natural human way (cunning, sleaze, and power) doesn't mean they did something wrong.

All you Libertarians are going to have to figure out how to make the NEXT game have impartial referees. Otherwise, the outcome will be exactly the same. The smartest amoral scumbags win.

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