. . . I couldn’t resist.  This is from Krugman’s March 1 post:

A quick response to Scott Sumner

OK, I see that Scott Sumner has written an open letter to me. But I’m puzzled. He writes:

“I think you have acknowledged that there is some level of quantitative easing that would boost demand. If I am not mistaken you are concerned that if such a policy boosted inflation expectations sharply, the Fed would have to quickly sell off these assets, suffering massive capital losses.”

Um, you are mistaken. I’ve never said such a thing. Did you mean to address this letter to someone else?

And here is something from his blog 19 days later:

My back of the envelope calculation looks like this: if the Fed buys $1 trillion of 10-year bonds at 2.5%, and has to sell those bonds in an environment where the market demands a yield to maturity of more than 5%, it will take around a $200 billion loss.

I’m not complaining; I think quantitative easing (it’s really qualitative easing, but I give up on trying to fix the terminology) is the right way to go. But we should go into it with our eyes open.

Any Krugman defenders wish to comment?

There were a lot of interesting comments on my political art piece, and since I don’t have time to do a new topic today, I thought I would develop the idea a bit further, and also comment on a very recent article that illustrates some of the strengths and weaknesses of political art.  Next Sunday I hope to have something new ready.

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This has been a very busy week.  But I’m not complaining, as I got what I wanted—lots more people paying attention to my views.  I’d like to correct one thing I said in my previous post, it is not true that Earl Thompson has given up on macro.  He has done quite a bit of work that I was not aware of, and you can link to many of his papers by going to his website.  He has some very unconventional views that combine monetary policy, fiscal policy, and politics into an overarching model.

My previous post was my final attempt to sell my view of the crisis.  In the future I will spend more time responding to commenter requests, discussing current events, and other miscellaneous topics.  One request was for more graphs, which might buttress my argument.  Hence today’s post.  Soon I hope to respond to a request for a post on 1932, and then a request for something on monetary policy options in other countries.

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I was originally going to entitle this entire post “Why me?”  But I thought that would be too self-indulgent, even by the standards of this blog.  What I would like to do here is trace the development of my research into monetary economics since 1986, so that you can see things through my eyes.  Almost no one accepts my view that a tight money policy by the Fed caused the crash that occurred in late 2008.  I hope that if you better understand the development of market-based monetary policy proposals, you will come to see my hypothesis as natural, even inevitable.  If you’ve ever read Murders in the Rue Morgue, you might recall a scene where the detective walks silently through the streets of Paris with a friend, observing all the things his friend notices along the way.  Then he suddenly breaks into his friend’s (silent) internal monologue, as if they had been conversing all along.  That’s what I hope to do here.

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[I call this "part 2," because if you plan on reading the previous post, do that one first.]

I’ve always had a cynical attitude toward overtly political themes in art.  Some of this comes from reading movie reviews, which often provide preposterous political interpretations.  Thus New York magazine says last year’s Wall-E, a film about a society where a government-run corporation controls 100% of the economy, is a critique of “free markets.”   Films about the Three Gorges Dam (which epitomizes Maoist economics) are critiques of capitalism.  I know this is like shooting ducks in a barrel, but coverage of political art isn’t really any better at more highbrow publications, such as the New York Review of Books.

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[I should first explain the "part 1."  The hope is that you will read this before the political art post which follows.  They are separate issues, but the second is easier to understand if you read this first.  Mankiw visitors:  I do off-topic posts every Sunday, early next week I'll do a monetary post that gives you an idea of my views on the crisis.]

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I use the efficient markets hypothesis in my research and in my blog.  Once I started looking at the world through the EMH lens, I found it much easier to understand the relationship between policy and the financial markets—particularly in my research on the Depression.  Here I’d like to do three things; indicate why I believe markets are more efficient than they seem, acknowledge that there are events that look like market inefficiency, and then argue that those perceived inefficiencies, even if real, don’t have the policy implications that many people assume they have.

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If markets are efficient then the expected loss on Fed purchases of long term debt is roughly zero.  On the other hand if the Fed has inside information about its future policy, then the Fed could use that information to make expected profits or losses.  In a post today, Krugman argues that the Fed may be using the inside information in a perverse way, to generate expected losses.  His argument (which is technically correct and which I discussed here in an earlier post) is that the Fed might actually persevere and produce more inflation (and I would add more real spending growth as well) than the markets currently expect.  Because markets are skeptical about the ability or willingness (probably the latter) of the Fed to carry through on a reflationary policy, long bond yields do not currently price in the sort of inflation or nominal spending growth that the Fed presumably wants.  What do we make of this?

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I haven’t had a chance to fully digest yesterday’s Fed action.  However since I have received many comments from people who think I should be enthused, I feel obligated to throw a little cold water on the celebration.

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Soren asked why I don’t think predictive accuracy is necessarily the best way to test whether someone is a good economist.  First let me point out that economic theory itself predicts that it should almost impossible to make unconditional predictions of asset prices, or to predict the business cycle beyond a few months.  So the fact that Irving Fisher didn’t predict the stock market crash, for instance, is totally irrelevant to his ability as an economist.  But there is certainly something to Soren’s point.  If economic models cannot make at least conditional predictions, what use are they?

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It’s Sunday and thus time for another break from monetary economics.  Because of heavy grading early this week, I may not post anymore for 3 or 4 days.  But I have a couple interesting ideas for later in the week.

A New York Times article once reported that economists in academia tend to vote about 3 to 1 Democratic, whereas other academics vote about 7 to 1 Democratic.  Of course the general public tends to split about 50/50 between Democratic and Republican voters.  What should we make of this pattern?  A few years ago I began thinking about this issue and came up with a hypothesis that is based on the distinction between worldviews and values.  I think economists tend to be people with liberal values and a right wing worldview.  BTW, I haven’t had time to do much research in this area, so I claim no originality for the ideas here.  (Indeed, I believe that Bryan Caplan is far ahead of me in exploring the worldview issue that I discuss here.)  However in future posts on issues like political art, I think I might be able to make some original observations.

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I don’t have much to say about the initial financial crisis, other than lots of bankers made lots of bad decisions.  And through experience I have found that virtually nobody finds that bland explanation satisfactory.  At the same time I have always had a nagging feeling that moral hazard played a bigger role in the financial crisis than was apparent at first glance.   A very interesting recent post by James Hamilton shows how moral hazard contributed to the crisis.  He described the insurance giant AIG as a sort of hedge fund, which made an enormous bet insuring mortgage-backed bonds, even though:

AIG lacked the financial resources to make good on those contracts in the event that the housing downturn became as severe as it has now proved to be.

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When I discovered Nick Rowe’s blog a few days ago, I told Nick it was nice to find someone who approached monetary issues from a similar perspective.  I had no idea how similar.  I was all set to write a post today on the distinction between temporary and permanent monetary injections, and also Krugman’s expectations trap, when I noticed that yesterday Nick had already done so here.  Because I agree with what he has to say (and he says it in a much more straightforward way than I will), I’ll try to approach the issue from a slightly offbeat perspective in the hopes that readers will benefit from both posts.

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Before beginning this post I should mention that I don’t have Selgin’s most important book on deflation (Less than Zero) in front of me, rather I am reacting to a recent article from The American Conservative that George sent me.  Even so, given all the comments that I have received about the relative merits of inflation and deflation, I thought it would be worth discussing his ideas.

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I hope someone can telling me what I am missing, because the debate over quantitative easing seems to be taking on an increasingly surreal quality.  A recent Goldman Sachs study concludes that it would take another $7 to $11 trillion dollars of asset purchases by the Fed to achieve the necessary 6 percentage point reduction in the real interest rate implied by the Taylor Rule formula.  Lucas Critique anyone?

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I just discovered a very good blogger that shares some of my ideas (and has actually been blogging much longer than I have.)  The blogger, Nick Rowe, has a couple of very interesting posts on monetarism here and here.  (He also linked to my blog, but I have been so busy that I only now noticed.)  Mr. Rowe indicates that he was a student of David Laidler, and before talking about Nick’s ideas, I’d like to say a few things about Mr. Laidler.

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Note:  Because Christina Romer and I have both done research on similar topics, I know quite a bit about her views on monetary policy during the Great Depression.  Ironically, I was planning this post for today before two things happened:

1.  There was an announcement that Obama’s economic team would meet with Bernanke.

2.  Several commenters including Dilip and R McGarry sent me a link to a paper with her views.  I presume it was in the news today.

In any case, here is the post that I had already planned:

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Last Sunday I did an offbeat post on Denmark, today I thought I’d pick another Nordic country—Iceland.  This will be lighter and shorter and probably completely forgettable, but I’m burned out after two long monetary posts this weekend.

Here’s my thought; Iceland is to the Nordic mainland what America is to Europe.  I got this idea watching a Lars von Trier film called “The Boss of Them All.”  I don’t agree with his politics, but at least Von Trier’s satiric films don’t insult your intelligence and pander to your prejudices.  In the film there was a scene where a group of visiting Icelandic businessmen were portrayed as having a very gruff and aggressive style.  Later when I started reading about the Icelandic banking crisis, I noticed frequent descriptions of the men who had built these financial empires as being aggressive, swashbuckling figures, so I’m going to assume that there is some reality behind this stereotype.  What lesson can we draw from this?

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You may recall that in a recent blog post Krugman disagreed with the idea that unconventional monetary stimulus could help boost the economy.  He also denied ever supporting that view.  Well, you’ll be happy to hear that Krugman does now support unconventional monetary stimulus.  Here is the quotation from his blog:

The problem, of course, is that you can’t cut interest rates below zero (if you try, lenders will just hoard cash.) So the Fed simply can’t do what the rule says it should.

This is why we need a huge fiscal stimulus, unconventional monetary policy, and anything else you can think of to fight this slump. Quite literally, the usual rules no longer apply.

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Drudge highlighted an Obama request that Americans not “stuff money in mattresses.”  Here is the article it is from.  I know he’s talking about consumer demand, not money demand, but the Depression-era rhetoric may get people thinking about the need for monetary stimulus.

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