“Puffed up egos”

Recently Ryan Avent at the Economist blog wrote:

And then there is the Fed. Ben Bernanke has managed to innoculate himself against charges of doing too little, among much of the press anyway, by stepping in repeatedly when things look particularly bad. Yet the Fed bears the greatest responsibility for America’s pathetic recovery. Mr Bernanke has systematically avoided his own good advice about how to stimulate at the zero lower bound. The Fed’s interventions have been limited and seemingly designed to ignore the powerful expectations channel; at no point have breakevens shown inflation expectations steady at even pre-crisis levels when expectations above pre-crisis levels are what the current situation demands. Despite the obvious importance of inflation expectations for recovery at the ZLB, the Fed has behaved as if it’s operating under a 2% inflation ceiling, rather than a target. It repeatedly stops pushing the economy forward as soon as it seems likely that the economic trajectory will carry inflation toward 2%. With plenty of slack remaining in the American economy, this strategy inevitably produces a return to disinflation at the slightest breath of trouble from abroad.

To which Robert Waldman says:

Given the demonstrated (again) effectiveness of fiscal stimulus and the almost compete absence of any evidence that the Fed’s efforts since the crisis have had much effect, I have no idea how Avent can possibly think that the Fed bears greater responsibility than Congress. I can see an argument for more aggressive monetary policy on the grounds that it certainly won’t hurt, but I think Avent’s blind faith that it is as effective now as in normal times is based on a refusal to deal with the evidence.

I have no idea what Waldman means when he says “given the demonstrated (again) effectiveness of fiscal stimulus…” I didn´t know it had been demonstrated before, let alone now.

Contrary to what he says there´s a lot of evidence that the Fed´s actions have been limited and designed, not to ignore, but to avoid letting the powerful expectations channel to come into play. Both QE1 and QE2 raised inflation expectations which were dropping to dangerously low levels, but as soon as they reached the Fed´s “desired” level the QE button was “switched off”.

And that´s the reason behind the fact that for the past three years we´ve had moments when the ‘patient’ pepped up, but was quickly ‘tucked’ underneath the bed sheets again.

As Anon/Portly writes in the comments of this Scott Sumner post:

This is another amazingly insightful post, but I wonder if it doesn’t kind of underestimate the sociological dilemma of the smart Keynesians. Yes, it’s hard not to be suspicious that they like fiscal policy simply because of the win-win of stimulus and more G, but then think of all of the hand-wringing about not having foreseen the Great Recession. I mean all the “we didn’t see this coming/failure of Macro” stuff. It all focused on not having foreseen the financial crisis, not having read enough Kindleberger and Minsky.

Then market monetarism comes along and it turns out they all missed not only the significance of the NGDP drop, but its plain fact. So now not only their analysis but their meta-analysis are in tatters.

It’s not easy to have to admit something like that – if nothing else, what if not only your analysis and your meta-analyis but also your meta-meta-analysis turn out to be wrong? 3 strikes and you’re out?

But 80 years ago another President ‘bit the bullet’. As Mark Sadowski notes in his comment in the same post:

One can turn that on its head and ask where did Franklin Delano Roosevelt get the crazy notion that monetary stimulus was an option? Certainly based on Krugman’s interest rate reasoning a much stronger case could have been made in 1933 that fiscal stimulus was the “only game in town.”

Well, the short answer is that he got it from agricultural economist George Warren who sold Irving Fisher’s “compensated dollar plan” to FDR in early 1933. FDR was so taken with Warren’s ideas that he pursued his dollar devaluation plan over the strong opposition of many of those within his own administration, such as William Woodin, Dean Acheson (yes, that Dean Acheson), Oliver Sprague, James Warburg and Henry Morgenthau, all of whom, with the exception of Morgenthau resigned in protest.

It’s hard for me to imagine Obama fighting for monetary stimulus in opposition to all those puffed up egos much less going to the trouble of seeking out and listening to the seemingly hair brained schemes of a lowly rumpled bespectacled agricultural economist.

And Lars Christensen brings up this article by Matt O´Brien at the Atlantic. It´s an “ego killer”:

Central banks have a strong influence on market expectations. Actually, they have as strong an influence as they want to have. Sometimes they use quantitative easing to communicate what they want. Sometimes they use their words. And that’s where monetary policy basically becomes a Jedi mind trick.

The true nature of central banking isn’t about interest rates. It’s about making and keeping promises. And that brings me to a confession. I lied earlier. Central banks don’t really buy or sell short-term bonds when they lower or raise short-term interest rates. They don’t need to. The market takes care of it. If the Fed announces a target and markets believe the Fed is serious about hitting that target, the Fed doesn’t need to do much else. Markets don’t want to bet against someone who can conjure up an infinite amount of money — so they go along with the Fed.

6 thoughts on ““Puffed up egos”

  1. Pingback: The Jedi mind trick – Matt O’Brien’s insightful version of the Chuck Norris effect « The Market Monetarist

  2. Thanks for the link. I think the effectiveness of fiscal stimulus was demonstrated by the huge expansion during WW II. Also the smaller US expansions during the wars in Korea and Vietnam. So the positive GDP growth anomaly in 2009 demonstrates this again.

    OK I haven’t actually read your whole post, but I was struck by “the powerful expectations channel”. What evidence supports your claim that the expectations channel is powerful ?

    My sense is that faith in the powerful expectations channel caused many economists and policy makers to believe that a firm resolute approach to disinflation would have a small effect on output as expected inflation would fall along with actual inflation. The experience of the 80s strongly contradicted this prediction. This is one case in which faith in the strong expectations channel survived in spite of contrary evidence.

    I think all cases are such cases. Again I haven’t read the post, but I doubt that you can present evidence that the expectations channel is powerful. I believe this is true because it isn’t.

  3. I have now read everything in the post written by our host. I am back to clarify.

    My objection is to the word “powerful.” I agree that Bernanke believes he can influence expected inflation and has been trying to keep expected inflation low. I agree that this is a mistake. I question whether it is as damaging a mistake as Congress’s refusal to try more fiscal stimulus. My objection to Avent is

    I think that Marcus Nunes and I agree that WWII proves that fiscal stimulus stimulates. I fail utterly to understand the relevance of the recent wars in Iraq and Afghanistan. I wasn’t discussing the wisdom of fighting the Nazis. I do think it was necessary, but I considered the war only as a huge shock to public spending followed by a huge increase in GDP which had never before and has never again been so far above trend. In “he Fed bears the greatest responsibility for America’s pathetic recovery” I objected to the word “greatest”. It is a comparison. I agree with Avent that the Fed bears some of the responsibility. But his claim is a very specific claim about relative magnitudes, which I contest. The post contains no evidence or argument related to my disagreement with Avent.

    I agree that there is an expectations channel and that Bernanke has been careful to avoid letting the expectations channel come in to play. I see no evidence that it is powerful

    The only passage in the post which might have any relevance to the dispute is the observation that Roosevelt tried monetary policy as well as fiscal policy. Roosevelt tried everything. He also tried price fixing via the NRA. The case that the expectations channel is powerful is identical to the case that what we need is a new NRA with firms coordinating on prices. Oh and tough antitrust enforcement – FDR tried that too.

    The post does not address my arguments at all.

    • RW – Contrary to what you think, NIRA was a recovery stopper, maybe the strongest brake an economy has seen!. Between March 33 when FDR delinked from gold and indicated he wanted the price level to go back to the level before 1929 (a price level target) and June 33 when NIRA was signed, Industrial production went up by more than 50%! For the next two years, until NIRA was declared unconstitutional in May 1935, it stayed flat and picked up again after that. Also, in 1937 it was monetary policy, through higher required reserves and gold sterilization that gave rise to the recession within the depression. So no, “a new NRA, with firms coordinating on prices” would make things much worse and offset any expansionary expectational force.

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