Hmm another Krugman Kontradiction? Possibly, though if so, not as bad as some of the others I’ve documented. When (understandably) running a victory lap recently about his predictions on US interest rates compared to the deficit hawks, Krugman said that they came up with a bunch of ad hoc explanations after the fact, for why their predictions of crowding out etc. were so wrong:
The apologists offer a series of special explanations; it was the Greek debt crisis driving investors into the dollar safe haven; it’s the Fed’s purchases; whatever. We’ll [see] what happens when the latter end at the end of this month, by the way.
Now just read that a couple of times. It seems to me that Krugman is arguing, “At the end of this month, QE2 will end, and I bet you interest rates don’t zoom up. So that will be one less excuse that the deficit hawks can use to wipe the egg off their faces.”
And yet, even if you thought Fed purchases of bonds drove down interest rates, you wouldn’t necessarily think that the end of QE2 would make them zoom back up. Apparently, there is a whole school of respectable economic thought that says the stock of Fed purchases matters, not the flow. You know who explained this the best to me? Paul Krugman, back in April:
I’ve been getting questions about what happens when the Fed wraps up QE2 — related especially to Bill Gross’s public view that interest rates will shoot up. This is related to the question of the extent to which QE2 has kept interest rates low. So a quick exposition of my theoretical position, which also happens to be more or less standard economics.
So: I basically think of asset prices in a Tobin-type stock equilibrium framework (pdf). People make portfolio choices, allocating their wealth among bonds, stocks, etc.. Asset prices – including the famous “q” – rise and fall to match these portfolio choices to the actual asset supplies.
On this view asset purchases matter because over time they change the stocks of assets available : by buying long term federal debt, the Fed takes some of that debt off the market, and hence drives up the price of what’s left, reducing interest rates. The flow – the rate of purchases – matters only to the extent that it affects expected returns.
On this view, the fact that the Fed is currently buying some large fraction of debt issuance is irrelevant; interest rates are determined by the willingness at the margin of private investors to hold the existing stock of debt, regardless.
I’d also add that if flows matter a lot — if it’s hard to persuade investors to buy a suddenly increased quantity of newly issued Treasuries per month, as opposed to being willing to hold the total amount of Treasuries outstanding — the big shift into budget deficits and the corresponding increase in Treasury issuance should have led to sharply rising interest rates. And as you may recall, some people did predict just that — and ended up not just with egg on their faces, but losing a lot of money for their investors.
So I don’t buy the notion that rates are low only because the Fed is doing QE2; if there were really a problem with the marketability of US debt, rates would be high regardless. And so I don’t expect rates to spike when QE2 ends unless there’s good economic news that gives us a reason to believe that the zero-rate policy on short-term rates will end sooner than expected.
I’ve included the full discussion to be fair to Krugman; his underlying position here has been consistent: He doesn’t think QE2 is a big reason for low interest rates. However, I’m pretty sure there are economists out there who think QE2 (and QE1) did push down interest rates–after all, that was one of the original justifications I heard for QE1. To wit: “We can’t push down short-term rates any more, because we’ve hit the zero lower bound. So the Fed should buy longer-term Treasuries to push down yields further out on the curve.”
(Note that this gets really nuanced really quickly. There are a lot of people–especially the quasi-monetarists–who have argued that a successful QE program would raise interest rates, as people start expecting stronger economic growth.)
So my point here is this: Somebody who believed in the original, standard justification for QE1 and QE2, could think that Treasury yields would be significantly higher if the Fed dumped its holdings next week. At the same time, such a person could think that yields wouldn’t zoom upward, just because the Fed stops adding to its stockpile at the end of June. And the reason for this view is the whole stock/flow analysis Krugman described above.
Last point: Am I missing something? I don’t see that there is a huge distinction between the stock/flow approach. Suppose Batman and Robin are tied up by the Joker’s goons, and are standing in a pool that’s being filled with water. Robin says, “Holy suffocation, Batman, that flow is pretty fast. We’re goners if you can’t reach your acid pack!” But Batman says, “Easy there, chum. Our impending death is no reason for imprecision. The flow of the water is irrelevant. It’s when the depth of the water equals our noses, that we need to panic.”