by Cullen Roche
There’s been a bit of a spat in the last 24 hours between Paul Krugman and Richard Koo. The two have disagreed on QE since its inception with Koo saying it would do nothing and Krugman maintaining faith in the policy. This is nothing new though. This spat has been going on for decades now. Richard Koo was an early critic of QE in Japan when a young(er) American economist named Paul Krugman went over to Japan to lecture the Japanese on their policy options as deflation dug its heels in. Dr. Krugman was a very vocal advocate of the policy saying that it could alter expectations and generate positive economic growth. Koo maintained that, in a balance sheet recession, the policy would fail to generate any sort of substantive effect on the real economy. Of course, Koo ended up being right about QE in Japan and he’s now being proven right again about QE in the USA.
Now, I have to admit that I am a bit biased in this fight because I’ve been siding with Koo since QE began, but the facts are the facts. QE does not appear to have done a single positive thing for the economy. A few of us (myself and Richard Koo) were particularly vocal critics of the policy from its onset and not for the reasons that most others were (inflation, money printing, debt monetization, etc). It’s now clear that QE didn’t result in hyperinflation, excessive money supply growth, debt monetization and merely generated a margin squeeze on the entire economy, resulted in no real growth and actually resulted in lower real GDP. Thus, it would appear that Koo was right and Krugman was wrong.
But Paul Krugman isn’t having it. Unfortunately, he’s making the same argument he made 9 months ago. He says he wasn’t wrong. He merely claims that he was an advocate of the Fed trying all options and that he was also calling for greater fiscal policy. Let’s review what he actually said:
“I believe that given the grim economic situation, all players in the game should be trying to do whatever they can. There are other things the Fed can do; they would help; uncertainty about how much they would help shouldn’t be a reason not to try.
But it would be a big mistake to count on monetary policy alone. The zero lower bound on short rates really does matter, even if longer-term rates are positive. The Fed cancontrol short-term interest rates, it can influence long rates — there’s a world of difference between those two statements. So it’s not safe to assume that the Fed can, for example, hit any target for nominal GDP that it chooses.
What that means is that while the Fed should be doing more, so should other actors: unconventional monetary policy should go along with fiscal stimulus. The Fed deserves to be chastised for not doing more; that’s not the same as saying that the Fed should be the only target of criticism.”
These comments are actually very similar to what Ben Bernanke said in 2003 regarding QE and how the various arms of the government should work in tandem to achieve their objectives. Mr. Bernanke was an advocate of QE because he also said fiscal policy was necessary in Japan. Unfortunately, his understanding of the Japanese monetary system led him astray and resulted in a misguided belief that QE was necessary to help “finance” any fiscal policy. This is just not how a sovereign currency issuer’s monetary system functions, but that’s for another discussion (see here). I can’t be sure if Paul Krugman is advocating the same approach, but we already know he’s a bit confused about sovereign currency issuers so it wouldn’t be a big leap of faith to conclude as much….The two Princeton professors are very much on the same (wrong) page with regards to QE and have been for a long time.
With regards to trying all policy approaches…look, I’m a big fan of team efforts. Unfortunately, there are times when certain players need to just take a backseat and accept the reality that their participation is unlikely to help. In this case, the Fed was and has been out of bullets. But they continued to heave shots at the hoop with the hope that one of them would land in the basket and they could proclaim to have saved the economy. The Fed shouldn’t just be throwing shots up because they get the ball. That’s not a winning strategy. You have to diagnose the situation and maximize your best weapons in crunch time by ensuring that they’re the ones taking the shots. Richard Koo has been very clear about his position as have I. In a balance sheet recession monetary policy is notoriously ineffective and fiscal policy is the only real tool that can offset the de-leveraging. The history of Japan makes this abundantly clear. We shouldn’t have our least effective players heave shots at the hoop just because they want to try and help the team. But Paul Krugman continues to push the same failing argument he made in Japan in 1998. It was wrong then and it is wrong now.
In that 1998 speech he said:
“this argument against the effectiveness of quantitative easing is simply irrelevant to arguments that focus on the expectational effects of monetary policy. And quantitative easing could play an important role in changing expectations; a central bank that tries to promise future inflation will be more credible if it puts its (freshly printed) money where its mouth is.”
Well, expectations certainly changed. They changed so much that speculators scurried into commodities, causing cost push inflation and causing real GDP to decline as real growth failed to materialize. When Paul Krugman repeated these comments in October of last year I called him out and predicted exactly what would happen:
“Talking a big game about future inflation expectations is great and all, but talk is cheap. Ultimately, we need real positive change in the real economy – more jobs, higher wages, higher net worth. QE doesn’t provide that. You can alter public perception briefly by screaming in the streets, but ultimately, without some real world impact people just begin to ignore you. And this might just be the greatest problem with QE. Not only will it do little to nothing to solve the economic malaise, but it threatens the credibility of the Federal Reserve who has now gone “all in” on a policy tool that I believe Mr. Bernanke himself does not even fully understand. If it doesn’t work the Fed will be viewed as the emperor with no clothes and that will be one more notch on devil’s tool of discouragement. And ultimately, that will have the exact OPPOSITE effect that Mr. Krugman and Mr. Bernanke are hoping for.”
And this gets right to the crux of Dr. Krugman’s confusion regarding QE. He still thinks it’s about size and not quantity. His comments above regarding rates make this clear. He was a vocal advocate last October of “$8-$10B” of QE. But QE is never about size. It is always about price. This is another thing I explained last fall:
“The bigger problem here is not quantity, however. Mr. Krugman appears to believe that the apple (and no, this apple salesman is not selling iPads unfortunately) salesman can rush into the marketplace and scream and wave his hands regarding the new stock of apples he has that is 10X larger than his old stock. “Step right up ladies and gents! Fresh new apples right off the truck! We’ve got 10X more than we had yesterday!”. The problem with this thesis is that, while it might cause a stir in the marketplace (it might even cause a near-term boost in sales – or commodity and equity prices if you will), ultimately, sales will be determined by the willingness of the consumers to purchase. Therein lies the weakness in QE. Because it does not alter net financial assets in the private sector there is no reason to believe that it will alter the real economy in the long-term.”
If you’re a bit confused this explanation of mine from a few weeks ago sheds more light on the issue of price vs quantity and shows why Dr. Krugman is wrong to be discussing quantity:
“When I first discussed QE last August and why it would not contribute positively to economic growth I described how QE was akin to an apple salesman who can’t sell enough apples. So, instead of altering price he merely alters the number of apples on the shelves. Altering reserve balances at banks is perfectly analogous. Giving the banks more reserves does nothing because banks are never reserve constrained. But now all of the experts are trying to convince us that QE just wasn’t tried hard enough! If only the apple salesman had put more apples on the shelves – then his sales would have improved! No, that’s not how monetary policy works. And as I’ve said for many many months now, this obsession with size is entirely misguided. QE2 isn’t about size. It is about price.
QE2 was destined to fail before it ever started. Not because it wasn’t large enough, but because rates can’t be controlled through size. They are controlled by targeting price. The Fed controls the short end of the curve by setting the rate. They do not come out at the FOMC meetings and declare that they will buy $XXXmm in reserves. They announce that the short rate is X.XX%.
With regards to QE2 the Fed has come out and said they are going to buy back a specific number of bonds. And the bond market has yawned at the Fed. In fact, the bond market has spat in their face. Long rates are higher by almost 100 bps since QE2 started and there is no evidence that QE2 is helping to spur the lending markets as the Fed might have hoped. Can you imagine if the Fed set the overnight rate at 0.25% and the market just ignored them and took short rates right up to 1.25%? The Fed would be mocked as a meaningless institution. But in the case of QE2 we make all sorts of excuses about size, real rates, etc in order to shield their impotence.
Had the Fed hoped to control long rates they should have come out and directly stated their target rate. They should have done exactly what they do at the short end – stand guard at that rate and challenge any and all speculators to move the rate.”
QE was destined to fail before it ever began. Not only was it merely an asset swap, but it failed to control rates because it was implemented incorrectly. It altered expectations (as Dr. Krugman hoped), but only for the worse as the commodity surge appears to have negated the entirety of the positive effects from the $100MM tax cut. The fact that prominent economists continue to have so many misconceptions regarding the policy only goes to show that this is an incredibly dangerous policy tool to be swinging around.
But Richard Koo is not without fault in this whole debate. One place where I do agree with Dr. Krugman (and disagree with Richard Koo) is with regards to Koo’s position on the US Dollar. He says there is some risk that QE could cause a collapse in the dollar (he recently reiterated these comments). In his Holy Grail of Macroeconomics Koo states:
“a central bank can always generate hyperinflation by acting so as to lose the public’s trust, its ability to induce modest amounts of inflation depends on whether private businesses are in profit-maximization mode or not.”
Koo resorts to his neoclassical roots here by presuming that bank reserves are lent out and that the central bank can always create inflation if the economy is not in a balance sheet recession. This is factually incorrect. Banks never lend reserves. The fact that we are in a balance sheet recession gives the appearance that reserves are not being lent out, however, the balance sheet recession is only exposing the banking system for what it really is. Banks are never reserve constrained. They lend first and find reserves later. This is a simple reality of modern banking and has been shown in several Fed papers in recent years and is prominently discussed by MMT economists (who are just about the only ones who have these facts accurate).
Koo’s point here is to show that the central bank could potentially generate hyperinflation by being reckless with their policy and losing the trust of the public. I think this is a fundamental misunderstanding of the US monetary system. Helicopter drops (as Koo refers to them in the book) are always fiscal operations (see Scott Fullwiler’s excellent presentation here). The Fed did not monetize the debt. The Fed did not print money. And hyperinflation is a unique event whose historical episodes bear zero resemblance to the modern day United States. Therefore, I think Koo’s fears of a disorderly dollar collapse are totally unfounded. The very foundation from which he is working is fundamentally wrong. And ironically, his misunderstanding stems from the same place that Krugman’s misunderstanding stems from – a basic misunderstanding of the actual operations of a sovereign currency issuer with monopoly supply of currency in a floating exchange rate system.
So, I guess they’re both wrong….At least Koo got the policy right in the first place though…
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