Nov 222013

With few exceptions, economics relies on soft evidence. So, for example, if we ask: Does Quantitative Easing work?, the answer cannot be: let’s take 20,000 recessions, do QE in half of them, and so on. We have to get by with what we have: a few, limitedly comparable historical episodes. This is why, apart from a few shared notions, disagreement among economists starts early, to the puzzled bemusement of other scientists, who share a vastly larger common ground, based on undisputed hard evidence.

Certainty in economics, and especially in economic policy, seldom comes from the accumulation of overwhelming confirmative evidence. Unfortunately, observational scarcity means that unexpected outcomes can quite easily be dismissed, explained away or otherwise dealt with, with little impact on basic presumptions. Something of this kind must have happened to the signatories of the 2010 open letter to Bernanke. After all, they were merely pointing out the risk of “currency debasement and inflation”, not predicting that it would necessarily happen – weren’t they?

I think this is a wrong and harmful attitude. With so few observations, we should treasure and adequately weigh up the ones we have, especially when they run counter to our convictions. Don’t be swayed by the tactful tone of the letter: you don’t write one unless you intend to warn about a clear and present danger. Look here to see what they really meant: they wanted a confession and an apology. And this is tame compared to the widespread cacophony of arrogant, crass, obtuse and offensive Bernanke bashing.

Do yourself a favour: rise above the claptrap and invest a few hours listening to or reading the Bernanke lectures:

Sometimes you hear that the Fed is printing money in order to pay for the securities we acquire. But as a literal fact, the Fed is not printing money to acquire the securities. And you could see it from the balance sheet here.

That layer is basically flat; the amount of currency in circulation has not been affected by these activities.

What has been affected is the layer above that, reserve balances. Those are the accounts that commercial banks hold with the Fed, assets to the banking system and liabilities to the Fed, and this is basically how we pay for those securities. The banking system has a large quantity of these reserves, but they are electronic entries at the Fed. They basically just sit there. They are not in circulation. They are not part of any broad measure of the money supply. They are part of what is called the monetary base, but they certainly are not cash (Lecture 4, at 19:10, or p. 106).

So next time you hear someone screaming about the Fed recklessly printing money and seeding hyperinflation tell them to shut up and listen. Here is another instructive paper.

An additional irony in all this is that, despite appearances, it is not a political issue: it has nothing to do with the liberal-conservative divide, or with Keynes vs. whatever debates.

Here is a quiz. This is an excerpt from an interview with a famous economist:

Economist: What is really needed to change the situation is for the US to start pulling itself out of recession.

Interviewer: How should it go about doing that?

Economist: By expanding its money supply. People will say “But how can it expand the money supply when the discount rate is only 0.5 percent and the long-term bond rate is around 1.2 percent?” The answer is that the central bank can buy up government securities. It can keep on buying them. It doesn’t matter whether the interest rate is 1.2 percent or 1.1 percent or 1 percent. If it buys those securities, it will increase the monetary base. It will increase the reserves in the commercial banks. It will do more in the short run to help the US resolve its banking crisis than any short-term reforms.”

Who is the economist? a) Ben Bernanke b) Paul Krugman c) Milton Friedman.

Ok, it is a bit of a loaded question. The right answer, of course, is the ‘surprising’ one: it was Milton Friedman, in a 1999 interview. He was talking about Japan, not the US, but that’s irrelevant. He was advocating QE (Abenomics: hallelujah!). The divide here is between economists worth their salt and people who should learn from them. So the real surprise among the signatories is not so much to see the likes of Jim Grant, Niall Ferguson or (alas) Seth Klarman, but to find respected academics, such as John Taylor, Ronald McKinnon and Kevin Hassett, who should know better: people rely on their authority.

I close with the latest words of wisdom from Larry Summers (this is also in response to Adam’s interesting comment to my previous post).

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