Megan McArdle's Plea to Monetary Policy Critics

Perhaps I should have made it clearer that you were not one of the critics I had in mind . . . I think there are fair criticisms of Greenspan, Bernanke, the Fed, the bailout, etc. I think you've made several of them.

But I think there are a bunch of commentators--many or most of them not economists--who want to have it both ways; they want to blame Greenspan for being too loose during the last recession, then they want to know why the Fed isn't being looser in this one! That doesn't mean I think all critics of the Fed should knock off; I just think they should pick a consistent viewpoint. Do you want the Fed to risk inflation during recessions, or don't you? I understand that you don't, which is fine, and entirely consistent, because you haven't been bashing Greenspan over the housing bubble.

Me, I think that the evidence that you can push down long term rates via the application of a single short-term rate has so far not convinced me, and that the people saying the Fed should have used its regulatory authority to shut down the housing bubble sound more than a little fuzzy on how that would actually have been accomplished. I'm not sure what I think about further QE yet. People I respect are on both sides of the issue, and I don't feel confident enough in my own genius to second guess any of them, including the Fed.

Take 1 and divide it by the product of Matt Yglesias's Pundit's Fallacy, times Hindsight Bias times 'Leader's Sheer Power of Will' and you get the probability that any of these prognosticators are correct.

The differences over monetary policy seem to fall along a continuum of how seriously you take the quantity theory of money. Some, like Sumner and Krugman, take MV=PQ literally and as if P is psychic and responds to thoughts about changes in M. (OK I exaggerated. I'm making fun of the inflation expectations people.)

Others don't take it seriously at all. They see no connection between money and the economy at all. I think Mises and Hayek had it right that the only position worse than ignoring the quantity theory is to take it too literally.

The quantity theory of money is nothing more than the theory of subjective value applied to money. That was Mises' expertise and reason for his fame before WWII. And Hayek was known as a monetary theorist. His first famous paper was "Monetary Theory and the Trade Cycle." But the theory isn't mechanical. It has different effects at different times and in different phases of the business cycle. Its effect depends on what people want to do at the time.

During a depression, people want to rebuild the savings they lost, so the quantity theory is almost powerless. At the peak of a boom, a small change in M can have an enormous effect on P. Zimbabwe found that out recently.

"I think that, at most, [the Fed] can toggle between two regimes: a regime where inflation is high and variable; and a regime where inflation is low and stable." This hardly makes sense. If the Fed is "toggling," that's *variation*--variation that includes periods of low inflation.

"My bet is that Paul Krugman would give the opposite answer." What Sumner is saying is that the surest way to lower long-term interest rates is to produce deflation and, thereby, depression. Why do you think Krugman would disagree?

Philo,
I interpreting Krugman as saying that the long rate is the geometric average of expected future short rates. So if the Fed bought some T-bills and lowered the short rate, this would lower the long rate a bit.

Lowering the short rate *now* wouldn't necessarily lower the short rate expected in the future, and. indeed, might well have the contrary effect.

I'm not sure why you hate the wall street bailouts so much. It appears to me that most or all of the money will be repaid (unlike the bailouts of Fannie, Freddie and GM.)

This all comes down to whether the banking crisis was primarily a solvency crisis or a liquidity crisis. Fed intervention in a liquidity crisis seems like a good idea, indeed that's one of the reasons we have a Fed at all. It is looking to me like you were wrong and this was more a liquidity crisis than a solvency crisis.

(AIG financial products division was certainly a solvency crisis, but that's why AIG wasn't really "bailed out," but rather AIGs creditors were bailed out and AIG insurance divisions which weren't insolvent were allowed to continue to operate. Perhaps the Fed was too generous here, but again the attempt was to prevent an even more severe liquidity crisis.)

"expansionary policy might reduce unemployment"

This idea sounds a bit like the assumptions that made stagflation so entertaining.

"I interpreting Krugman as saying that the long rate is the geometric average of expected future short rates. So if the Fed bought some T-bills and lowered the short rate, this would lower the long rate a bit."

No. If the Fed has lowered the short rate unexpectedly, market participants will revise their forecasts about future actions of the Fed, and geometric average might change in either direction.

123-TMDB,

How strong is your "might"?

I am obviously (and admittedly) not at the same intellectual level as most of the posters here. But I see the problems with the economy as being fundamentally different than what is being discussed here.

Suppose, for example, that Fed policy is stimulating demand in a fashion. Unfortunately, that demand is being satisfied by manufacturing in China and services from India (I am simplifying a bit) so that jobs and income (and further demand) are not following the expected path. Economies are being stimulated, just not here in the USA. What I am asking is, is it possible that the economic "truths" that our current policy assumes (and the models we use to formulate policy) no longer apply?

Somehow we have to take into account that automation and globalization have fundamentally shifted economic realities. I don't see that here, and in places I do read about those concerns there are no answers, only more questions. Am I totally off base?

"1." In normal times I would probably agree, but I think one of the most important goals of a central bank should be to match the market's expectations of inflation. Inflation hovered around 3% since the early 90's and I would guess that a lot of companies and workers indexed their contracts expecting that to continue. Inflation variance has spiked in the last 2 years increasing uncertainty. The Fed's lack of explicit policy goal makes the uncertainty much worse because firms can't know what inflation rate to index to. They've managed to come up with a policy regime that has created low and variable inflation.

Cyberike: If the Fed devalues the dollar that will make our exports relatively cheaper for foreigners and likely lead to an increase in exports.