QE Has Worked Before: My Reply to Paul Krugman

Paul Krugman appears to be responding to my previous post where I argued it was unfair of him to dismiss Milton Friedman's views based on what happened in Japan.  In his reply he continues to raise doubts about the efficacy of Friedman's monetary prescription for Japan in the 1990s and the United States in the early 1930s.  He then goes on to question those of us who have been calling on the Fed to target the level of aggregate spending through something like a nominal GDP target. Here is Krugman (my bold below):

I think it’s also important to note that Friedman was all wrong about Japan — and that you can argue that he was also wrong about the Great Depression, for the same reason. For what Friedman argued, both for Japan in the 1990s and America in the 1930s, was that all the central bank needed to do was more — push out those reserves into the banking system. This would raise the money supply, and a higher money supply would have the usual effects.

But the Bank of Japan tried that — and found that pushing more reserves into the banks didn’t even lead to rapid growth in the money supply, let alone end the problem of deflation... So, after 2000 the Bank of Japan engineered a huge increase in the monetary base; this was the original quantitative easing. And it didn’t even translate into a surge in the money supply! This is why I’m so skeptical of people who say that all the Fed has to do is target higher nominal GDP growth — in liquidity trap conditions, the Fed doesn’t even control money, so how can you blithely assume that it controls GDP?

Let me begin my response by encouraging Krugman and other monetary skeptics to have a little more faith in the power of monetary policy.  Here is why: QE has been done before in the United States and it worked incredibly well.  It was initiated in early 1934 when FDR and his treasury officials decided to (1) devalue the value of the dollar relative to gold and (2) quit sterilizing gold inflows.  Now this was a radical move at the time, much like QE2 is to many folks today.  The gold standard was viewed then almost as a sacred institution.  FDR was going to weaken it and allow prices to permanently increase.  How dare he! But that is exactly what was needed, a big permanent shock to inflation expectations that  served to stop the deflationary spiral, end the liquidity trap, and allow a recovery in aggregate demand.  Now this policy move was backed up with significant and permanent increases in the monetary base over time: it went from about $8 billion right before the policy change to about $24 billion by the end of the 1930s.  Below are two graphs that shows this remarkable QE program at work.  Here is the monetary base and M2 (Click on figure to enlarge.):

Note how the increase in the monetary base was followed by an similar increase in M2.  Monetary policy--in its unconventional form--was able to influence the money supply.  And note the slowdown in the monetary base in 1937 was followed by a slowdown in M2.  This is when the Fed decided to stall out FDR's QE program and in the process help create the recession of 1937-1938. (See Francois R. Velde for more on this recession.)  

What about total current dollar spending? Here too, FDR's QE program also served to stimulate aggregate spending as seen in nominal GNP:

Again we see that nominal GNP closely tracks the surge in the monetary base.  FDR's QE was a smashing success when it came to shoring up aggregate spending.  So those of us folks who want the Fed to increase and stabilize nominal GDP have a good reason to believe it is possible--it happened before.

So let's recap the highlights here:

(1) QE was tried before in the United States during a liquidity trap and worked incredibly well.

(2) QE not only worked well, but it did so in an economic environment far wore than that found in either Japan in the 1990s or the United States today.

(3) QE worked  because it (i) it reshaped inflation expectations and (ii) was backed up with meaningful increases in the monetary base.  

The Fed is more than able to do the same today.  It certainly can reshape inflation expectations.  Just look at what has happened to them over the last month or so when Fed officials started talking up QE2.  The Fed would be far more effective, though, at shaping inflation expectations by explicitly committing to some nominal target. Thus, the Fed needs to come out this week with more than an announcement that it is going to purchase say $500 billion assets going forward.  It also needs to shake up inflationary expectations and do so in a manner that creates certainty going forward.  The Fed, then, needs to (1) announce an explicit nominal target and (2) say it will do whatever is necessary to hit it (i.e. it will buy/sell as many assets as needed). I just hope it is a level target for total current dollar spending.

Update I: Josh Hendrickson reminds us that QE seems to be working rather well in the U.K.
Update II: The M2 and monetary base data come from Friedman and Schwartz (1963) while the nominal GNP data come from Balke and Gordon (1986).

What the GDP Report is Screaming to the Fed

There is a loud and clear message coming from today's BEA report on the U.S. economy:  it is time for the Fed to adopt an level target for total current dollar spending.  The report showed that final sales of domestic product grew at an annualized rate of only 2.4%.  This is far too weak of a growth rate in aggregate demand for there to be a robust recovery.  Moreover, it means that  that total current dollar spending is falling further below its long-run trend.   This can be seen in the figure below: (Click on figure to enlarge.)

The fitted trend puts final sales at about $16.5 trillion.  Actual final sales is around $14.6 trillion, a whopping $1.9 trillion shortfall.   That the Fed can let aggregate demand fall this far below trend is mind-boggling.  It is even more staggering when one considers that there were forward-looking indicators all along that were telling the Fed it was passively tightening monetary policy by allowing this development to happen.  This need for an aggregate demand target is further supported by the following two figures.  The first one shows the year-on-year growth rate of final sales of domestic product over the most of the postwar period.  It  shows how far aggregate demand has to go just to get back to a normal growth rate of about 5%. (Click on figure to enlarge.)

The next figure shows the key reason--other than the Fed's failure to act aggressively enough--why total current dollar spending is so depressed.  This figure shows that money demand, as measured by velocity, is still relatively high (note: velocity and money demand are inversely related). There is still a monetary disequilibrium problem out there: there is excess demand for highly liquid assets and the Fed has failed to offset it.This is a point made repeatedly by the us Quasi-Monetarists  (Click on figure to enlarge.)

Is it really that hard to get total current dollar spending back on path?  I think not, all that is needed is for the Fed to (1) announce an explicit nominal spending target and (2) then say it will do whatever is necessary to hit it (i.e. it will buy/sell as many assets as needed). Thus, I think calls for "shock and awe" by the Fed--such as Goldman Sachs claim that the Fed needs $4 trillion to be effective--are wrong. The Fed simply needs to convince the public it is committed to an explicit target and most of the heavy lifting will occur on its own in the market.  We see glimpses of this with the uptick in expected inflation associated with all the Fed chatter about QE2.  In this case, the Fed has done nothing official yet l the market is already pushing expected inflation up.  Just think how much more effective it would be if the Fed was explicit and publicly commit to a nominal anchor. Shaping expectations is key to the Fed's success here.

The question then comes back to why an aggregate spending target?  I have talked about this policy goal before, so let me draw from it:

[Though I want higher inflation now] I have never been enthusiastic about stabilizing inflation as an end in itself.  The reason being is straightforward: inflation is a symptom, not an underlying cause.  More generally,  the percentage change in the price level could be the result of shocks to  aggregate demand (AD), aggregate supply (AS), or both.  Currently, it seems clear that the drop in inflation expectations and the drop in core inflation are reflecting faltering aggregate demand.  Thus, it makes sense to talk about the need to arrest these drops.  However, it need not always be the case--low inflation could also be the symptom of a positive AS shock (e.g. productivity boom).   Imagine, for example, aliens land and give us new technology that makes our computers faster, gives us clean energy, and allows us to travel to  distant galaxies.  Such an alien encounter would create mother of all productivity booms.  Among other things, this productivity boom would imply a higher neutral interest rate, lower inflation rate, and robust AD growth (given  the increase in expected future income).  In such a case a rigid inflation target of say 4%, as some have proposed, would not make  sense here.  Most likely it would be too high an inflation rate to keep AD stable.   

Another way of saying all of this is that monetary policy should focus only on that over which it has meaningful control:  total current dollar spending or AD.  It should ignore AS shocks, both the good and the bad, because all it can do by responding to such shocks is to make matters worse  as alluded to above.   Focusing too narrowly on an inflation target--which assumes every shock is an AD one--can cause a central bank to make this very mistake.  I made this case before in  more detail in this post which got some play time in the economics blogosphere (e.g. Mark Thoma reposted it here).  My hope was that this post would help folks see that the stabilization of AD rather than inflation targeting should be the key  objective of monetary policy.   

So what kind of monetary policy would serve to consistently stabilize AD?  The answer is one that directly targets a stable growth path for AD. This could be a NGDP target or a final sales of domestic output target or any measure that directly aims to stabilize the growth of total current dollar spending.  Scott Sumner outlines its advantages in a recent post, but let me add a few thoughts.  First, an AD target is easy to implement.  All it requires is a measure of the current dollar value of the economy.  It does not require debates over the proper inflation measure, inflation target, output gap measure, and coefficient weights that plagued inflation targeting and the Taylor Rule.  Second, it can easily be made into a forward-looking rule by having the Fed targeting the market's forecast of AD.  This would require some innovations such as  NGDP futures market, but it is within the realm of possibilities as shown by Scott Sumner.  Finally, it could be easily communicated to and understood by the public by labeling it along the line of a "total cash spending target."

So FOMC officials take note: the BEA report is screaming to you it is time to get serious about stabilizing total current dollar spending.

Update: Yes, NGDP grew at about twice the rate of final sales in Q3.  But that is because there was a sizable buildup in inventories (i.e. NGDP - final sales = change in inventories).  For this reason, final sales is a better measure of actual aggregate demand than NGDP.  With that said, I would be delighted if the Fed started targeting the level of NGDP.  Any aggregate spending target would a big improvement in my view.

Milton Friedman, Nominal Income, and Paul Krugman

David Wessel has an article in the Wall Street Journal today where he considers what Milton Friedman would do now.  He comes to same conclusion Will Ruger and I did last week in our Investor Business Daily piece (PDF version here): Milton Friedman would support some form of QE2.  Though we reach the same conclusion, let me elaborate on two points raised by Wessel.  First, he notes that Friedman would want nominal income to be stabilized:

[Milton Friedman] would look at growth in income. "He considered stable nominal [unadjusted for inflation] income growth desirable because sudden swings in it (and thus in spending) cause huge macroeconomic disturbances when wages and prices fail to adjust quickly," says economist David Beckworth of Texas State University. Income is growing well below historical norms. POINT: For QE.

Will and I made this point in our Op-Ed and provide some discussion of it here.  The clincher for me, though, is this figure of  the growth rate of final sales of domestic product, a measure of aggregate demand (AD) (Click on figure to enlarge.):

The data in this figure runs through 2010:Q2.  It reveals that AD has a long ways to go before being stabilized. Milton Friedman wouldn't be please with the results shown in the above figure.  Because of this AD shortfall and other reasons, I personally would like to see the Fed target some measure of aggregate spending such as a NGDP level target.  Though probably low on the list of nominal anchors the Fed is likely to adopt, the FOMC actually discussed the possibility of a NGDP level target in its last meeting.

The second point I want to elaborate on is that Friedman would argue the Fed is not out of ammunition.  Here is Wessel:

Friedman would have scoffed at the notion that the Fed is out of ammunition. He believed in the potency of "quantitative easing," or QE—printing money to buy bonds. "The Bank of Japan can buy government bonds on the open market…" he wrote in 1998. "Most of the proceeds will end up in commercial banks, adding to their reserves and enabling them to expand…loans and open-market purchases. But whether they do so or not, the money supply will increase…. Higher money supply growth would have the same effect as always..."

Nowhere in this quote does Friedman say a temporary increase in the money  growth rate is the goal.  He says a higher money supply growth rate, period.  That is why I think Paul Krugman's comments on this piece are off.  Krugman says that Friedman's call for Japan to increase the monetary base in the above quote were insufficient because Japan tried it and it didn't work.  No, Japan did not try what Friedman suggested.  Rather, Japan only added temporary injections of montary base that were pulled out once price level stability was reached.  Thus, to argue Friedman's prescriptions for Japan were wrong one has to argue that he called only for  temporary increases in the monetary base. But he did not make that call.  Here is Scott Sumner on  Japan's approach to monetary policy:

What happened in Japan is precisely what proponents of QE in the US (such as Krugman and I) predict would happen. The BOJ adopted a policy of raising rates and reducing the money supply any time inflation rose above zero. (Bernanke mentioned this aspect of the BOJ's policy in his Jackson Hole speech.) This sort of policy will not result in inflation, because the monetary injections will be viewed as temporary. And indeed they were, the BOJ reduced the monetary base by about 20% in 2006, just as inflation was rising above zero. This prevented an outbreak of inflation. In Japan the CPI is still at 1993 levels, which is of course consistent with the BOJ's announced target--stable prices. By this standard the BOJ has been the most successful central bank in world history. Whether a stable CPI is good for the Japanese people is an entirely different matter.

It is unfair to attribute to Friedman the Bank of Japan's policy goals.  Krugman's claim that Friedman called for  "just printing notes" and nothing more like shaping expectations ignores the fact that Friedman actually understood the value of shaping inflation expectations.  It was Friedman, after all, that called for the Fed in the early 1990s to target the expected inflation rate implied by the spread between the nominal yield on Treasuries and the the real yield on TIPs.  Friedman knew the importance of managing inflation expectations.

Structural Problems Need QE2 Too

One argument against further easing by the Fed is that the main source of U.S. economic problems is structural in nature and cannot be addressed by monetary policy.  In particular, the balance sheets of households have collapsed and require a significant amount of painful deleveraging.   More monetary stimulus cannot  change that fact.  QE2, therefore, ultimately will be an exercise in futility.  This critique has been thrown at me a lot lately and so let me address it here.  

First, I agree that there are big structural problems with the household sector and that they are driving much of the problems elsewhere.  Households spent the past decade leveraging up and now they are having to reverse this buildup of debt given the collapse of the asset side of their balance sheets.  This household balance sheet problem in turn got  transferred to the government balance sheet and is also currently influencing aggregate spending choices. So yes, this is a structural problem and requires some radical structural solutions like swapping the underwater portion of mortgages for equity. Felix Salmon suggests some other structural solutions.

Now just because this is a structural problem it does not follow that monetary policy cannot contribute in a productive manner to the deleveraging.  In fact, monetary policy can actually make this structural adjustment easier to do.  How so?  There are two ways.  First, monetary authorities could push the price level back up to trend and reduce the real debt burden facing Americans.  During the past recession the price level actually fell and this deflation made it more costly to service existing nominal debt.  In other  words, the drop in dollar incomes  along with the drop in the dollar price of assets were not matched by similar drop in household dollar debt.  Moreover, this price level decline never returned to its (unofficial) 2% trend path and according to the FOMC's forecast is not headed back to it anytime soon.  Chicago Fed president Charles Evans made this point in a recent speech with this figure:

QE2, then, could help houesholds better cope with the deleveraging by pushing up dollar incomes and dollar prices of assets. 

The second way QE2 would provide support to deleveraging households is that it would increase total current dollar spending.  This development, in turn, would in the presence of sticky wages and prices increase real economic activity and boost the real income of households. For those who doubt the ability of the Fed to increase aggregate spending should look to the pick up in expected inflation coming from treasury bonds.   This increase in expected inflation is ultimately a signal that the bond market believes aggregate spending--the underlying cause of inflation assuming no big changes in aggregate supply--will pick up in the future.  And if aggregate spending and inflation are expected to pick up in the future this belief in turn will affect current spending choices. With higher real incomes, households will be better able to service their debts and deleverage their balance sheets.  Thus, QE2 by pushing the price level back to trend and increasing real incomes will provide much needed support to main structural problem facing the U.S. economy.   

P.S. I am not arguing we return asset prices to bubble levels, but that we simply return overall prices or the price level to the 2% trend.  This would imply some increase for asset prices too. 

P.S.S.  I would rather have QE2 return aggregate spending to its trend level rather than return the price level to its trend for reasons laid out here.  For now, though, I will settle for a price level target.

In Case Fed Officials Needed More Evidence...

They should look no further than the Macroeconomic Adviser's monthly nominal GDP series.  This is a monthly indicator of total current dollar spending or aggregate demand in the United States.  It shows for August that aggregate spending declined at an annualized rate of decline of  1.69%.  More worrying, though, is that there is a downward trend in aggregate spending over the entire year. This downward trend is consistent with the quarterly forecasts of the Survey of Professional Forecasters that show a drop in the NGDP forecast. Here is monthly NGDP (click to enlarge): 

 

Now these numbers only go through August.  I suspect all the recent QE2 talk--and its effect on   nominal expectations and thus on current spending--may have to some extent arrested  this downward trend in NGDP.  Still the Fed should not let its guard down come the November FOMC meeting.

What Would Milton Friedman Say About Monetary Policy Today?

That is a question William Ruger and I address in an article at Investor's Business Daily. William is a colleague of mine and has just finished a scholarly biography of Milton Friedman. Here is the introduction to our piece :

Four years after his death, Milton Friedman's thoughts on monetary policy remain as relevant today as they were 30 years ago. Even Fed Chairman "Helicopter Ben" Bernanke (whose nickname comes from Friedman's famous "helicopter drop" idea for overcoming deflation) has referenced the Chicago don as an inspiration for his actions.

However, Friedman's views may not be well understood even by those who would claim him as their intellectual fountainhead — which could be problematic for policy-making. So what would Milton Friedman say about our current monetary policy?

We make the case that Milton Friedman would be supportive of more aggressive monetary action at this time. We note that Milton Friedman argued (1) low interest rates do not necessarily mean monetary policy is accommodative, (2) the Fed should target expected inflation, (3) the Fed should do what is necessary to stabilize nominal income, and (4) the Fed is not out of ammunition. Points (1) and (4) are made by Friedman in this article.  Point (2) is outlined in Friedman's book Monetary Mishief.  Point (3) is pervasive throughout Friedman's writings, but here is a recent example.  Our article also draws from Scott Sumner who has made similar arguments  before  about Milton Friedman.  

Lessons from the 1930s

Doug Irwin has a great article and podcast on the gold standard during the Great Depression.   Among other things, he notes that the countries that left the gold standard the earliest--a radical policy move at the time--were the first ones to experience economic recovery.  The whole discussion of how the gold standard contributed to the Great Depression is an interesting one and is instructive for today's economic issues.   I wish folks like Stephen Gandel, Tyler Durden, and David Rosenberg who see the Fed's QE2 not only as ill-conceived but as also having the potential to incite civil unrest would look to this period before making such claims.  If they did they would see how monetary experiments far more radical than QE2 actually ended the Great Depression.  They would also see that had such programs been implemented sooner  it is possible World War II may have been avoided.  Although a world war  is not imminent, there is the rising threat of a trade war.  And yes, there are lessons from the Great Depression even for this development. Here is Doug Irwin and Barry Eichengreen:

Today, the United States is in the position of the gold-standard countries in the 1930’s. It can’t unilaterally adjust the level of the dollar against the Chinese renminbi. Employment growth continues to disappoint, and fears of deflation will not go away. Lacking other instruments with which to address these problems, the pressure for a protectionist response is growing. 

So what can be done to address the situation without getting into a beggar-thy-neighbor, retaliatory free-for-all? In the deflationary 1930’s, the most important way that countries could subdue protectionist pressure was to use monetary policy actively to push up the price level and stimulate economic recovery. The same is true today. If fears of deflation were to recede, and if output and employment were to grow more vigorously, the pressure for a protectionist response would dissipate.

The villain of the piece, then, is not China, but the US Federal Reserve Board, which has been reluctant to use all the tools at its disposal to vanquish deflation and jump-start employment growth. Doing so would help to relieve the pressure in Congress to blame someone, anyone – in this case China – for America’s jobless recovery. Where the Bank of Japan has now led, the Fed should follow.

QE2 would get exported to China and other economies that peg to the dollar.  Obviously, this presents  problems for China and it may resist QE2, as we saw with their interest rate increase yesterday. In the long run, though, QE2 going to China and other places should provide added global stimulus and may even help rebalance the world economy.