Arnold Kling  

Megan McArdle's Plea to Monetary Policy Critics

Balan's Test... The Decline in Civil Liberties...

She writes,

There is no such thing as a perfect Fed; it's always going to err on one side or another. You said you wanted a Fed that didn't err on the loose side; now you have it. This is what that looks like.

My view of the Fed is as as follows.

1. I don't think that the Fed can fine tune the economy. I think that, at most, it can toggle between two regimes: a regime where inflation is high and variable; and a regime where inflation is low and stable.

2. I am not at all sure that (1) is the correct view of things. My views are certainly not mainstream. In case something closer to mainstream theory is correct, in which case expansionary policy might reduce unemployment, I would like to see the Fed try an expansionary policy now.

3. I think that the main effect of the Fed's "non-traditional policies" of the past two years has been to transfer wealth from ordinary citizens to bank shareholders and executives. I do not think that the bailouts undertaken by the Fed and the Treasury helped the overall economy. I think that the message of the markets to the financial sector in 2008 was, "Shrink!" The Fed has been doing its best to fight against that message, in part because of institutional bias in favor of big banks, and in part because of a misguided analogy with the 1930's, when the demise of banks hurt the economy. This is not 1932. In 1932, the banking sector shrank too much. In 2009, it shrank too little.

So, in the end, I do not blame Greenspan for the housing bubble. I don't buy into the argument that we had a housing bubble because Greenspan messed up the Taylor rule.

Nor do I blame Bernanke for the weak economy today. I think that there is a good chance that, even if the Fed tried to do something, they would fail. I am not convinced that toggling to the high-and-variable inflation regime would reduce unemployment.

What I blame Bernanke for is carrying out and supporting the bailouts. I hate the bailouts.

Incidentally, I was quite surprised to see Scott Sumner's answer in the comments to this post on a question of monetary theory. One of my three questions asked how the Fed could lower the long-term interest rate from 2.6 percent to 2.5 percent, and he responded,

If forced to come down one way or another, I'd say higher 10 year yields are bullish, so if the goal was lower 10 year yields, I'd tighten monetary policy and cross my fingers.

My bet is that Paul Krugman would give the opposite answer. So even two economists who agree that they would like to see the Fed do more to boost the economy might not agree on the mechanism by which open market operations affect long-term interest rates.

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CATEGORIES: Monetary Policy

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The author at Eli Dourado in a related article titled Are There Two Inflation Regimes? writes:
    Arnold Kling tentatively postulates that central banks can, at most, select between a low-stable inflation regime and a high-variable inflation regime. Bryan Caplan proposes a quick test, which I hereby supply. Below are some scatterplots of inflation ... [Tracked on August 28, 2010 3:06 PM]
COMMENTS (13 to date)
Megan McArdle writes:

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.

jb writes:

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.

fundamentalist writes:

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.

Philo writes:

"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.

Philo writes:

"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?

Arnold Kling writes:

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.

Philo writes:

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

ed writes:

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.)

Felix writes:

"expansionary policy might reduce unemployment"

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

123-TMDB writes:

"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.

Hyena writes:


How strong is your "might"?

Cyberike writes:

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?

azmyth writes:

"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.

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