Denial, and Bernanke the Brave

Someone teased me about my recent post on Zero Lower Bound denial – can any disagreement on theory or evidence now be labelled by either side as denial? I admit that one of the negative aspects of blogging (for me at least) is that it can lead to an indecent attraction to neat catchphrases and rhetorical flourishes. However there was some method in my madness.

What I take as the characteristic of denial, whether it’s about climate change or macroeconomics, is that a strong position is taken not on the merits of the case, but because of a dislike of some  implication of accepting the proposition being denied. So climate change denial would come not from a consideration of the evidence, but distaste for the idea that it is an externality that requires government intervention to correct. Evidence that this form of denial exists comes from the clear correlation between climate change denial and a pro-market ideology (see Oreskes and Conway, 2010). In macroeconomics, demand denial may also come from dislike of the idea that state intervention (monetary policy) is required to ensure the aggregate economy stays on its efficient path, which is why those that keep suggesting our current problems are not about deficient demand also tend to come from the political right. We could call this bias or wishful thinking rather than denial, but the key point is that evidence on the issue appears to have no impact because the source of the belief lies elsewhere.

In the case of central banks, zero lower bound (ZLB) denial would be a belief that ‘unconventional’ monetary policy is almost as effective or reliable as conventional policy not on the merits of the case, but because the central bank must be seen to be in control. Now no one wants to hear a pilot tell passengers that they are no longer in control of the plane. However a better analogy here would be the pilot not telling the co-pilot, because fiscal policy can also be used to stabilise the economy. In the case of perhaps some economists, ZLB denial may be due to an aversion to the use of fiscal demand stabilisation, and hence the need to talk up the effectiveness of actual or potential monetary policy actions or regimes. But it was the central bank case that I really had in mind: hence my use of the quote from the Woodford paper about central bank wishful thinking.

To take the UK example, I have previously discussed (towards the end of this post) a speech made by George Osborne that stated that monetary policy was all you needed for stabilisation and appeared to ignore the ZLB, at the very moment that UK interest rates hit 0.5%. Now if I had been Governor of the Bank of England at the time, I would have said in private at least that the world had changed, and I was no longer sure I could achieve the Bank’s mandate. Perhaps this was said, and maybe one day we will find out. It was not the stance the Bank took in public.

Of course, my use of the term denial also signifies that I believe the idea that unconventional monetary policy is somehow on a par with fiscal policy in its reliability and effectiveness is fairly weak. I want to make two points here. First, I think it is important to distinguish between targets and instruments. My previous post asserted that nominal GDP targets in a world where unconventional monetary policy was ineffective would only reduce the impact of the ZLB, and not eliminate it. I think this is a useful case to consider because it helps clarify ideas: I still read people saying that nominal GDP targets in themselves would mean that large negative demand shocks would be less likely to take us to the ZLB, and I do not understand why this is.

               

Second, the key issue for me is not whether QE will or will not have some significant effect. My suspicion is that it can, and Woodford’s baseline case takes too idealised view of financial markets.[1] However our lack of knowledge about the extent of the deviation from Woodford’s idealised view mean that these effects appear of an order more uncertain than the impact of fiscal policy, which is why you have to use the latter, and why austerity during a recession is foolish.

Which brings me to the recent Bernanke decision. If the FOMC were ever in denial, they are no longer. What I think is significant about this decision is that it combines more QE with a suggestion that the Fed may at some point in the future allow inflation above target. I am often asked how we know that QE will be temporary – that central banks will claw back the reserves they have created when the economy recovers – and the easy answer is that they remain committed to their inflation targets. For central banks that have used QE, being seen to be totally committed to inflation targets is their way of showing that they are not permanently monetising government debt. Ironically I wonder whether QE has made central banks less willing to consider changes in the targeting regime, because doing so at the same time as printing lots of money would look too much like the prelude to significant monetisation. In that sense Bernanke and the FOMC have crossed an important psychological barrier, and hopefully the world will be better for it.

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[1] See for example Gagnon on markets in general, and Julian Janssen in a direct comment, and David Glasner here in relation to the FOREX market – see also this evidence. On selling currency to engineer depreciation there is of course the obvious point that this would not help a global economy at the ZLB, and as a result would not be received well by other countries.