04 Oct 2014

One More Point on Krugman vs. Gross on QE2

Economics, Federal Reserve, Krugman 11 Comments

I’m like Columbo. I notice just a slight turn of phrase that other investigators would consider innocuous, yet I realize it shines a spotlight on the killer.

Remember: Krugman is now saying that Gross et al. were wrong about QE2 because they suffer “liquidity trap denial” (his actual term lately). That is, these people were just-so-sure that the government’s big budget deficits were going to send interest rates up, that when it failed to occur, they desperately fumbled about for an excuse, and landed on, “Aha! The Fed’s QE programs are holding down Treasury yields!”

Now since this is the way Krugman is framing what happened, you can understand why he himself is now painted into a corner where he has to say that QE2 didn’t have much of an impact on interest rates at all, and that’s why the end of the program didn’t make long-term rates go up. Again, the problem (as Krugman now frames it) is that Gross et al. didn’t realize that long-term rates were low because of the liquidity trap.

That’s why Krugman’s March 2009 post, on the launch of the first QE program, is so revealing. Here are the relevant parts again:

The big policy news this week has been the Fed’s decision to buy $1 trillion of long-term bonds, going beyond the normal policy of buying only short-term debt. Good move — but it’s probably worth pointing out that yes, this does expose the Fed, and indirectly the taxpayer, to some risks…

The Fed is…creating a new liability: the monetary base it creates to buy these bonds. In effect, it’s printing $1 trillion of money, and using those funds to buy bonds. Is this inflationary? We hope so! The whole reason for quantitative easing is that normal monetary expansion, printing money to buy short-term debt, has no traction thanks to near-zero rates. Gaining some traction — in effect, having some inflationary effect — is what the policy is all about.

[I]f and when the economy recovers, it’s likely that long-term interest rates will rise, especially if the Fed’s current policy is successful in bringing them down…

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.

Look at the passages I’ve underlined, and in particular the last parenthetical remark where Krugman complains about terminology. For the Krugman vs. Gross debate, that parenthetical throw-away line is actually the murder weapon.

Why is Krugman complaining about terminology here? He’s arguing that the big deal with QE isn’t how much money the Fed is creating, but rather the assets it is buying with that money. Hence the Fed’s purchases have changed qualitatively, not quantitatively.

With that distinction in mind, go review again the other things I underlined above. Now do you see it?

Krugman is quite clearly saying (my paraphrase of course): “The Fed has bought short-term Treasuries and pushed down short-term rates to zero. That is a dead end; we’re in a liquidity trap, after all. Since it hit a wall, the Fed is going to try buying long-term Treasuries, to push down long-term Treasury rates. This might work, but if it does, there will be risks of capital losses if rates rise suddenly. I’m OK with those risks, but let’s not ignore them.”

Does everybody see that? And so, is it really accurate or fair for Krugman to now be claiming that Gross was in “liquidity trap denial” for thinking that QE2 had pushed down long-term Treasury rates?

NOTE FOR PURISTS: Krugman famously pointed out a theoretical mechanism in the late 1990s by which a central bank could still “gain traction” when short-term rates were 0%, by credibly promising to be irresponsible in the future. However, that is a different mechanism from what Krugman seems to be arguing above. Krugman’s late 1990s advice for the Bank of Japan didn’t involve changes in asset purchases right now, instead it involved credible words right now to convince the public about what the Bank of Japan would do in the future. So please don’t tell me that Krugman’s talk of “inflation is the goal” in the above is an invocation of his Bank of Japan unconventional policy stuff; it’s not.

11 Responses to “One More Point on Krugman vs. Gross on QE2”

  1. Darien says:

    I’ve always thought of you as the Columbo of economics. Hans-Hermann Hoppe is clearly Poirot: relentless deductive reasoning leads him right to the killer every time. Krugman I think is more like Quincy: once the guy is already dead, he’ll cut the body to bits and then claim it proves what he knew to begin with.

    And Walter Block is Father Dowling. Why? Because Tom Bosley is awesome is why.

    • Tel says:

      Daniel Kuehn would make a good Inspector Clouseau.

  2. Keshav Srinivasan says:

    Bob, having read a few different Krugman posts, I think I now see where Krugman is coming from, in terms of diagnosing the ultimate cause of Gross’ failed prediction as “liquidity trap denial”.

    In Krugman’s view, Gross’ reasoning in 2011 went roughly as follows: “In the absence of quantitative easing, you would expect long-term rates to be relatively high right now, especially when you consider budget deficits and things like that. But long-term rates are really low right now. So that must mean that QE2 is what is keeping long-term rates so low. Thus as soon as QE2 is lifted, long-term rates will go up a lot.” And Krugman’s response to that would be “No, we’e in a liquidity trap, so even without quantitative easing you would actually expect long-term rates to be relatively low right now. So QE2 can’t be having that big of an effect, and thus the removal of QE2 won’t cause a significant rise in long-term rates.”

    So I think the disagreement between Krugman and Gross wasn’t whether the removal of QE2 would cause a rise in long-term rates at all, but rather whether they’d cause a massive rise in long-term rates. In Krugman’s view Gross thought that long-term rates would go up a lot right after QE2 was over, where Krugman thought the only time rates would go up a lot is if and when there was an expectation that the liquidity trap would be over.

    • Bob Murphy says:

      OK Keshav, what you’re saying is reasonable on the face of it, but I remind you that you earlier said:

      “By the way, you’re right, if Gross was talking about long-term rates, then Krugman has no justification for attacking Gross…”

      I actually thought this was one time in recorded history when someone who was initially supportive of Krugman would consider my position then change his mind. But it was not to be.

      (Incidentally, do you think Gross “bet against Treasuries” by buying deeply out of the money options, such that Treasury yields had to spike in order for his clients to win? No, that’s not what happened. It’s because yields *fell* that he got crushed. Go look at DeLong’s post.)

      • Keshav Srinivasan says:

        Haha, yeah, I was initially agreeing with you, but then I read more of Krugman’s posts and I realized why he was connecting Gross’ views on long-term rates and “liquidity trap denial”: it’s because if you’re in a liquidity trap, there would be no need to explain the fact that long-term rates are so low, so Krugman is saying that the very fact that Gross feels a need to come up with an explanation like “the Fed is keeping rates low” is due to the fact that he denies/does not understand the nature of liquidity traps.

        • Bob Murphy says:

          OK but…if rates had returned to where they were in March 2009–when Krugman knew the US was in a liquidity trap and said QE might bring down long-term rates–Gross would’ve been a hero and gotten a fat bonus.

          Did you go find Gross saying all the words Krugman put in his mouth? I looked at two of his articles, and it wasn’t even obvious that Gross was *for* ending QE2. He said the economy might not handle the end of Fed liquidity injections well, meaning stocks could fall, and that interest rates would rise, “perhaps significantly.” Note the “perhaps.”

    • skylien says:

      Keashav, what is massiv for you, or for Krugman?

      Here what Gross said summarized:

      “Gross says that is about a point and a half below what he takes to be its normal level, judging by history. He says the 10-year Treasury normally carries an interest rate that’s about the same as the current forecast for U.S. economic growth.

      With forecasters predicting that the economy will expand about 5% in nominal terms, unadjusted for inflation, Gross says, it is clear that the price on government bonds has considerable room to fall.”


      At least to me that doesn’t sound massiv, it is significant, but not massiv.

      • skylien says:

        BTW. I checked since it is interesting in this context. Nominal GDP growth was 4.7%. in 2011.

        Isn’t that quite close to what Sumner argues for is ideal?

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