Ten Economic Pieces Worth Reading: December 28, 2009
On the Definition of a "Taylor Rule"...

In Which Mark Thoma Defends Ben Bernanke...

Mark Thoma writes:

Is Criticism of the Bernanke Fed Justified?: >[T]he employment problem is big enough to justify a wide spectrum, aggressive approach. Thus, while I do worry about our ability to undo quantitative easing later without causing an inflation problem — something that would be a big blow to employment down the road — and while I’m not convinced quantitative easing will do much to generate new output and jobs right now, we should try everything that has a reasonable chance of working. That means quantitative easing, new spending on infrastructure, tax cuts to encourage investment and hiring, make work programs, whatever it takes to get both the economy and people working again...

This is, I think spot on. I endorse it without any quibbles.

But he says some other things that I annot buy into:

[T]he Fed is largely flying blind right now. It does not have the models it needs to truly understand what policy approach is best in the present environment. I have not been a strong advocate of quantitative easing, i.e. targeting, say, a 3 percent inflation rate, but I cannot claim that my view is informed by a theoretical model of the crisis I believe in, [for] such a model does not yet exist. My view is based on empirical evidence suggesting the relative impotency of monetary policy in recessions, but that evidence comes from regular recessions, not a severe recession like we are having now and the evidence may not apply. Because of this, i.e. because of the considerable uncertainty over what policy is best, I have emphasized a portfolio approach involving both monetary and fiscal policy in the hopes that one or the other will get the job done. My concern lately is that all the talk about Bernanke and the Fed has distracted our attention away from fiscal policy, but perhaps another stimulus package isn’t politically viable.... But as I’ve said before, that doesn’t mean I will give up pushing this point... fiscal, not monetary policy, is the best response right now.

For those who are making strong statements about what policy should be, and beating up Bernanke and the Fed for not following those policies, I ask you to do one thing: Produce a theoretical model that can explain the crisis and justify your policy response. It’s certainly possible to start with, say, a liquidity trap and move on from there to justify quantitative easing, but if the liquidity trap arises in a New Keynesian sluggish price adjustment model, or some other model that does not capture the essence of this particular crisis, should we take it seriously?  There are some models that can justify quantitative easing, but I don’t think those models fully capture the factors that caused this particular crisis. It’s very good to ask these questions, and perhaps quantitative easing is, in fact, the way forward, but until we have better models, we just don’t know for sure....

Mark's second paragraph--well, I think that the only model that is of any use right now is basic Hicks-Hansen, with the short=term safe nominal interest rate on Treasuries on the vertical axis and nominal spending on the horizontal axis. Only I prefer to call it Fisher-Wicksell. Irving Fisher, you see, focuses on one equilibrium condition: supply-and-demand in the money market. Given the price of liquidity--the difference between the return on cash and the return on short-term safe nominal bonds--is the flow of nominal spending at the right level to make businesses and households happy holding all of the economy's cash? Knut Wicksell focuses on another equilibrium condition: the flow-of-funds through financial markets. Given the level of spending, is the configuration of interest rates and asset prices such that the flow of savings into financial markets matches net uses of funds by businesses seeking to expand?

Normal monetary policy by altering the quantity of money changes the equilibrium level of spending conditional on the price of liquidity. In normal circumstances the Wicksellian flow-of-funds is an annoyance: it induces changes in interest rates that shift velocity to partially crowd-out effects of conventional monetary policy.

The problem is, as Mark Thoma says, the liquidity trap. In the liquidity trap more-or-less any level of money balances is consistent with a low level of spending. Policy has to get you out of the liquidity trap--which means affecting the Wicksellian flow-of-funds in such a way that investment exceeds savings even when the short-term safe nominal interest rate is zero. Quantitative easing is a tool to shift the Wicksellian flow-of-funds--to make businesses think that the future course of nominal prices is likely to be such that their wealth is better held in the form of yet more excess capacity than in the form of cash.

But, as Mark says in his first paragraph, there are no guarantees and we should be trying anything. And, as he does not note, the very thing that promises to make quantitative easing effectiving in the present is that it will generate expectations of the future inflation that would pose a policy problem in the future.

This is not rocket science. This is more difficult than rocket science. Ben Bernanke does not have an easy job.