Taylor, Krugman and Quantitative Easing

November 17, 2010

by Chidem Kurdas

In two substantial New York Review of Books articles, Paul Krugman and Robin Wells offer their views on various explanations of the property bubble and ways to get out of the slump.  On the latter front, they advocate aggressive deficit spending by the federal government and  quantitative easing by the Federal Reserve— No surprise to anyone who reads Professor Krugman’s writings.

Regarding the causes of the bubble, they favor the “global savings glut” explanation.  This view absolves the Federal Reserve from having spiked the punch bowl at the intertwined credit and real estate parties—by keeping interest rates exceptionally low from 2002 to 2005. It is remarkable that Krugman and Wells dismiss the case against the Fed without even bothering to mention the work that argues and presents evidence for the Fed’s pivotal role in causing the crisis—namely, Stanford professor John Taylor’s book and articles, including a Wall Street Journal piece.  

Why does this matter? If the Fed fueled the twin bubbles, then its current actions may bring more of the same. Chairman Ben Bernanke is proceeding to inject money into the system via additional quantitative easing, possibly blowing new bubbles, whether in gold, junk bonds or some other asset.

What is more, if the Fed itself is a menace on that level, then we’re truly in danger as the same bureaucracy gets even more powers to do whatever it wants, thanks to the Dodd-Frank Act Congress passed this year.

If, instead, the past bubbles were caused by a global savings glut and the Fed is off the hook, then it is more plausible that QE2 is harmless, if not beneficial. Krugman and Wells cite the eponymous Taylor’s rule in defense of quantitative easing but ignore recent research by Professor Taylor.

Here is a quote from Taylor regarding the supposed global glut: “The main problem with this explanation is that there is actually no evidence for a global saving glut. On the contrary, … there seems to be a saving shortage. … the global saving rate – world saving as a fraction of world GDP – was very low in the 2002-2004 period especially when compared with the 1970s and 1980s.”

If you think about it, during the time in question some countries like China saved a lot but other countries, notably the United States, did not save. The savers were balanced by the non-savers. Certainly there was – and still is – global imbalance, but not an overall surplus.

What do Krugman and Wells say about the lack of evidence of a global glut? They don’t say anything. I suppose it is much easier to pretend no such question exists.

In any case, they write that the Fed could not have done otherwise in the years following the 2001 recession because recovery from that recession was too slow. Similarly, Krugman argues for aggressive policies now on the ground that the current recovery is too slow. Maybe recoveries are hampered by hangovers caused by the Fed’s serial stimulations. Yet more stimulation is like telling someone to have another drink when they wake up with a bad hangover. True, some people will do that, but it’s not really the way to recovery.

Fed chiefs, former and current, have espoused the global glut argument and Alan Greenspan  responded to Taylor’s critique. Jerry O’Driscoll showed the problems with Greenspan’s reply.  

Krugman and Wells are inclined to present government entities in the best light—they also defend mortgage buyers Fannie Mae and Freddie Mac. They criticize Raghuram Rajan, author of the one of the books they review – Fault Lines: How Hidden Fractures Still Threaten the World Economy –  for suggesting that these government-backed giants made mortgage credit easy. That, according to Krugman and Wells, is “a politically motivated myth.”

So, Fannie, Freddie and the Fed are innocent; the big bad global glut fed the boom which led to the crash. If you believe that, you’ll give me a government-backed mortgage for this bridge I’m buying in Brooklyn.

24 Responses to “Taylor, Krugman and Quantitative Easing”


  1. [...] Taylor, Krugman and Quantitative Easing, by Chidem Kurdas [...]

  2. Ryan Says:

    Sometimes I think Krugman should have his wishes granted and the Govt, run by him and people who think like him, assume control of the state’s machinery. Then he can have his falling out with those more forceful and persuasive than he, ultimately enjoying the same fate as Nikolai Bukharin. Poetic justice and all that.


  3. Perhaps it is overly simplistic but the “glut” that I hold most responsible is the housing glut, created by overbuilding by the nation’s merchant builders in complete disregard of underlying demand. Actions and non-actions by the federal government, the Federal Reserve, FHLMC and FNMA merely intensified the problems.

    This is further explained in a recent blog – http://www.residentialmarketingblog.com/2010/06/have-we-seen-the-death-of-common-sense-in-the-homebuilding-industry/

  4. Bogdan Enache Says:

    I think Krugman’s article was very predictable, including the fact that he he discounts all evidence against the savings glut hypothesys without offering an explanation of how exactly a saving glut, if one existed, would have triggered the crisis, and his critical opinion of such an insightful economist as Rajan (who is also a Professor as far as I know); however, the most surprising article the NYRB features is the one by Mark Lilla on Glenn Beck, of whom I personally know little, but I can now understand why it is such an important topic in the US (and what every-day English language speakers understand by using the pronoun “they” as a conversational short-hand for the subject of a sentence). It’s not every day that one can see such a widely-read intellectual who built his career on criticising the recklessness of great intellectuals of the past and on theorizing about political philosophy criticising popular intellectuals and popular political theologists. It’s really a treat!

  5. Troy Camplin Says:

    It seems to me that the Keynesian explanation is that recessions happen “by magic,” that there is no reason except for some mystical, collective change of mood. And of course if recessions are caused by magic, then magic will fix the problem: creationist approaches such as QE; intelligent design approaches such as regulations and bailouts.

    I have said before that much of Keynesianism is folk economics. It’s more than that. It’s animist economics. “Animal spirits” should have been the first clue.

  6. Lord Keynes Says:

    The missing element in your analysis is the fundamentally dysfunctional system of financial regulation that was created after 1980 in the US and in other countries, with the advent of New Classical economics, monetarism, and revived neoclassical macro-theory.

    The system that existed from the 1930s to the 1980s, by contrast, minimised bubbles and reckless lending:

    http://socialdemocracy21stcentury.blogspot.com/2009/11/financial-deregulation-and-origin-of.html

    Low interest rates occurred in the post-WWII era as well, but did the US system suffer massive bubbles and financial collapse? It did not.

    Further evidence that financial regulation is the key factor in the current mess comes from the fact that Canada’s banking system required no bailout and had no systemic crisis in 2008/9. In 2008, the World Economic Forum ranked Canada’s banking system as the soundest in the world. The US system was ranked at number 40, and Germany and Britain ranked 39 and 44.
    Canada’s banks were restricted by regulators from mass securitizing of mortgage debt, and prohibited from taking on high levels of leverage to make larger and riskier loans. The Canadian mortgage industry was regulated to maintain high lending standards, instead of lax ones allowing an explosion in sub-prime mortgages:

    http://www.nuwireinvestor.com/articles/canadas-highly-regulated-banks-helped-it-sidestep-the-financial-crisis-55555.aspx

    Further evidence that poorly regulated/unregulated financial markets are prone to bubbles and crises is that before the Federal Reserve even existed, the US suffered financial crises in 1857, 1873, 1893, and 1907, and notably contributing to, and exacerbating, recessions in 1873 and 1893.

    And need I mention the massive property bubble in Australia in the 1880s when that nation had a free banking system and no central bank? This led to a financial collapse and horrific depression in the 1890s:

    Charles R. Hickson and John D. Turner, 2002, “Free Banking Gone Awry: The Australian Banking Crisis of 1893,” Financial History Review 9: 147–167.

  7. Troy Camplin Says:

    You are apparently unaware of what happened in the 1970′s — the decade which discredited Keynesianism, at least, until recently.

    I won’t speak to the errors you make about the other dates, as there are others far more qualified than me to do so. But you don’t have to be a macroeconomist to know that the 1970′s was a dismal failure of rhe Fed and Keynesianism.

  8. Lord Keynes Says:

    You are apparently unaware of what happened in the 1970′s — the decade which discredited Keynesianism, at least, until recently etc.

    And what exactly does effective financial regulation have to do with Keynesian economics? The answer: none.

    An economy run on monetarist/supply side polices could still implement an effective system of financial regulation.

    Even if you believe that Keynesian macroeconomics was discredited by 1970s stagflation (which is, anyway, false), that would not demonstrate that financial regulation is ineffective.

  9. Troy Camplin Says:

    You claimed that there were no downturns during this period. Which is false — as the 1970′s demonstrates.

    The financial “deregulation” — which is nonsense, as it was merely one new set of regulations replacing another — in the early 80′s apparently took a long time to set in, as we didn’t have a real downturn until the tech bubble. And that seems to have had as much to do with ABCT as anything, even if the current one clearly has far more to do with it. I will note too that inflation started really taking off around 1980 too, suggesting that Fed action has been driving much of the instability — it was just of a different kind from the 1980′s on than it was in the 1970′s.

    Again, I am going to rely on people much more informed than myself in regards to the rest and the details, as I am not a macroeconomist beyond understanding that ABCT is the most logical explanation of a recession — and most based on the facts as I understand them to be — of any theory of recession out there. It’s certainly more sensible than the popular animist theory currently out there.

  10. Lord Keynes Says:

    You claimed that there were no downturns during this period.

    I did no such thing. This is a blatant straw man argument.

    The financial “deregulation” — which is nonsense, as it was merely one new set of regulations replacing another

    Yes, one set of regulations replaced another – a highly dysfunctional system of financial regulation (inspired by New Classical macroeconomics, the efficient markets hypothesis, and rational expectations) was introduced and replaced a much more effective system which existed 1930s-1980s, with further attacks on it on the 1990s (e.g., Clinton’s repeal of Glass-Steagall).

    I am not a macroeconomist beyond understanding that ABCT is the most logical explanation of a recession — and most based on the facts as I understand them to be — of any theory of recession out there.

    Then perhaps you should do more reading?

    Both Ludwig Lachmann and Joseph Schumpeter did not think that Hayek’s business cycle theory could be used to explain all business cycles (R. J. Batemarco, 1998. “Austrian Business Cycle Theory,” in P. J. Boettke [ed.], The Elgar Companion to Austrian Economics, Elgar, Cheltenham, UK. p. 222), and Israel Kirzner had rather candid criticisms of Hayek’s theory.
    Kirzner in his own words:

    KIRZNER: I’ve never felt that the Hayekian business cycle theory was essentially Austrian. In fact, Mises, who was the originator of this whole idea in 1912, didn’t see it as particularly Austrian either …. It goes back to the Currency School and Knut Wicksell. It’s certainly not historically Austrian. Further, I would claim that, as developed by Hayek, there are many aspects of it that are non-Austrian. I don’t believe that to be an Austrian you have to buy into the Hayekian view of business cycles …. I think the way Hayek developed it was not quite consistent with the way Mises laid it out in 1912

    http://mises.org/journals/aen/aen17_1_1.asp

  11. J Oxman Says:

    Canada’s mortgage system is significantly less politicized than the U.S. system. There is no Fannie Mae/Freddie Mac, who were the primary buyers of MBS. There is Canada Mortgage Housing Corporation, akin to FHA, but there is little evidence that they reduced their requirements over the years in terms of down payment and mortgage insurance.

    Furthermore, the banking system is populated by a few large banks thus they are much less fragile than most U.S. banks. They also have much more diversified assets. Most banks in the U.S. are overly exposed to real estate.

    Canadian banks have been always able to merge and compete across provincial lines. Also, unlike the U.S. until the 1990s, Canadian banks usually combined several services in one firm. Thus RBC had commercial, investment, and retail banking, and money management services all in one shop.

    Finally, the Canadian banking system has always been much less fragile than the U.S. banking system. Again, this is due primarily to the size of the banks and the diversification of the balance sheet.

  12. Bill Stepp Says:

    Global savings glut? When homeowners in the world’s largest economy were using their homes (i.e., home equity) as an ATM machine?


  13. By the way, in that quote of Kirzner, he is referring to the fact that Hayek continued to make use of Böhm-Bawerk’s concept of the “average period of production”. This had been (rightfully) abandoned by Mises.

  14. Troy Camplin Says:

    Lord Keynes,

    You said, “The system that existed from the 1930s to the 1980s, by contrast, minimised bubbles and reckless lending”. Since bubbles lead to recessions, and the 1970′s was recessionary, this suggests otherwise.

    I will say that the blog posting at the link shows a gross misunderstanding of what happened with globalization. Whenever there is a transition state, there is instability. Anyone who knows anything about complex systems knows that.

    Nobody said Hayek’s business cycle theory explained all downturns — only the Great Depression, the tech bubble, and the Great Recession. Which it no doubt does. No matter how Austrian it may or may not be. Other recessionary cycles are likely to have other causes. It is likely to be a natural element of any complex system where instabilities are natural (if not brought on by the magical animism suggested by Keynes — which just avoids the issue entirely).

  15. chidemkurdas Says:

    Lord Keynes–
    Re ” a highly dysfunctional system of financial regulation (inspired by New Classical macroeconomics, the efficient markets hypothesis, and rational expectations) was introduced and replaced a much more effective system which existed 1930s-1980s, with further attacks on it on the 1990s (e.g., Clinton’s repeal of Glass-Steagall).”

    I’m not sure what you’re referring to as the new system that replaced 1930s regulation. On the contrary, the 1933 Act and the other regulations that followed remain in place to this day.

    As for the repeal of Glass-Steagall, that had no relevance for the bubble-and-bust. Very few investment banks took advantage of it. Only one of those — Citi — ran into serious trouble in the 2008, and its problems had nothing to do with its taking deposits as allowed by the repeal. Lehman Brothers, the investment bank that failed, was not a depository institution.

  16. chidemkurdas Says:

    To expand on Troy’s point about the 1970s– inflation started to rear up in the 1960s, pushing up interest rates. Keynesian policies almost certainly played a role.

    By the 1970s this was squeezing banks and in particular thrifts, which had given mortgages at low rates. In response to their lobbying, Congress relaxed restrictions on their lending. That led to the Savings & Loans crisis. The government itself had decades ago created the structure that resulted in these developments. Nothing to do with New Classical macro, etc. that ‘Lord Keynes’ brings up.

  17. Lord Keynes Says:

    You said, “The system that existed from the 1930s to the 1980s, by contrast, minimised bubbles and reckless lending”. Since bubbles lead to recessions, and the 1970′s was recessionary, this suggests otherwise.

    Recessions in the 1945-1990 period were not caused by asset bubbles and debt deflation.

    They were mostly inventory recessions (and you can easily consult Glasner and Cooley’s “Business cycles and depressions: an encyclopedia” to get the evidence), just as people at that time noted:

    LIFE 14 Apr 1961.

    A few were caused by, and worsened by, external shocks, as in the 1970s oil shocks.

    The severe recession 1980-1981 was induced by Volcker’s disastrous and failed experiment with monetarism, when he switched to targeting money supply growth rates and let the Federal funds rate “float”.

    Nobody said Hayek’s business cycle theory explained all downturns — only the Great Depression, the tech bubble, and the Great Recession.

    This is precisely what ABCT theory does not explain. How does investment by business in higher-order capital goods explain reckless lending to consumers (2000s) or speculators (1920s), securitization (2000s), asset bubbles (1920s/1990s/2000s), and debt deflation?

    f not brought on by the magical animism suggested by Keynes — which just avoids the issue entirely

    Even Ludwig Lachmann believed that expectations and investment decisions are are essentially subjective, which is what Keynes’ meant by “animal spirits.”

    See, for example, Ludwig Lachmann, “John Maynard Keynes: A View from an Austrian Window,” South African Journal of Economics 51 (1983): 253–260.

  18. Lord Keynes Says:

    I’m not sure what you’re referring to as the new system that replaced 1930s regulation. On the contrary, the 1933 Act and the other regulations that followed remain in place to this day.

    No, they are not.
    Legislation and regulatory practice was modified significantly, producing a new system. The main legislative acts were as follows:

    Depository Institutions Deregulation and Monetary Control Act (1980)

    Garn–St. Germain Depository Institutions Act (1982)

    Riegle-Neal Interstate Banking and Branching Efficiency Act (1994)

    Financial Services Modernization Act of (1999), also called the Gramm-Leach-Bliley Act

    Commodity Futures Modernization Act (2000).

    The SEC’s Voluntary Regulation Regime for Investment Banks (2004)

  19. Rafael Guthmann Says:

    I think that it is true that government imposed restrictions on the expansion of credit can reduce the magnitude of bubbles.

    My argument is based on this line of thinking:
    In the present monetary system where the money base is determined by the government, banks always have the incentive to expand the supply of credit given their reserves.

    If the banks had perfect foresight they would tend to multiply the supply of means of payment, given their reserves, by an infinite number of times. That would be the equilibrium tendency. As the process of discovery takes place with the passage of time, with time banks learn how to optimize their utilization of reserves, increasing the multiplier. This process is a process of credit expansion.

    So, the operation of the market process naturally creates the tendency for the formation of bubbles, given this system were the monetary base is determined exogenously. Restrictive regulation that limits the proportion of the reserves that banks can loan can reduce the magnitude of credit expansion, reducing the size of the bubbles.

    In Brazil the banking system is regulated, and the monetary policy

  20. Rafael Guthmann Says:

    in the last decade was very conservative, with high interest rates and high reserve requirements. As result, credit expansion was quite limited, and with the crisis, our banking system wasn’t impacted.

    Hayek, in Prices and Production, said that during the process of credit expansion, the monetary base

  21. Rafael Guthmann Says:

    could be contracted as banks expanded credit. That could prevent the bubbles, but the technical problems involved in this “quantitative hardening” made Hayek advocate a gold standard system at the time.

    Perhaps, a system of competitive monies could work well enough to prevent bubbles.

    Sorry for the broken posts.

  22. chidemkurdas Says:

    Re “Legislation and regulatory practice was modified significantly, producing a new system. The main legislative acts were as follows:” etc.

    These were additions to existing regulation, not replacements. The 1933 act required companies to register and provide information before offering shares to the public remained intact. The 1934 Act followed up with the creation of the Securities and Exchange Commission. The SEC always had extensive powers over securities markets and has even greater powers now. Financial regulation grew, it did not shrink.

  23. chidemkurdas Says:

    Some of the laws listed by ‘Lord Keynes’ gave additional regulatory powers to agencies other than the SEC, as for instance the Commodity Futures Modernization Act and the Commodity Futures Trading Commission. Various regulatory bureaucracies grew through the 20th century and continue to grow now.

  24. John Papola Says:

    Lord Keynes, you surely have chose the right name as an avatar for your ideas. That much is certain. Your analysis of the 80-81 recession is classic hair-of-the-dog keynesianism. First, I don’t understand why you think a switch of policy approach from interest rate targeting to money growth targeting would induce a deep recession. Plus, how did we get the rapid recovery afterward, given that assertion? Did the fed change targets in 1982? I don’t believe there was any massive deficit-financed fiscal “stimulus”. Maybe I’m missing something.

    But more importantly, embedded in your assertion is the idea that 1970s stagflation was somehow unrelated to monetary growth. It’s as if the inflationary path was going to somehow reverse without a change in money growth. How? If Volker’s reversal in money growth was necessary to curb inflation, calling it a mistake is bizarre. Its keynesian perpetual-boom fantasy. The recession was inevitable and necessary to allow the mass of inflation-fed malinvestments to restructure. And as that happened, growth and employment emerged quickly.

    The oil shock explanation is dubious given that we can find sustained stagflation throughout the emerging market world right now despite no such “shocks”.

    Keynesianism suffers from a raft of problems that lead it to your faulty analysis and misunderstanding of the chain of causality. First, it’s over-aggregated, missing the crucial role of relative prices in resource allocation and macroeconomic coordination. there are no sectors or interconnecting markets in the keynesian model. Labor is “L”. Capital is absent. Time is ignored.

    Second, it’s ignorant of public choice, modeling government as saintly “G” while ignoring the rent-seeking, corrupt boondoggle machine it is in practice. A look at the actual makeup of stimulus spending bears out this naïveté.

    Third, keynesianism seems blind in practice to real outcomes, relying on assertions about the long impacts of policy while focusing entirely on the short run monetary changes. Printing money “creates” jobs in this worldview, immaterial of the sustainability of such short-run monetary effects. Keynes and Hayek both agreed that the quantity theory wasn’t true in the short run, but Keynesianism doesn’t seem to have an answer for how short run changes resolve into long run effects. We’re just in a never-ending series of short runs. That’s nonsense. Hayek called money a loose joint in the short run, but Keynes treats it like a broken joint.

    Then there’s the oddball stuff like “liquidity traps” and, worse, the idea that interest rates are determined by liquidity preference, not supply and demand for credit. I see no market process which can explain how people determine their cash holdings in a bidding process based on interest rates. The loanable funds model makes sense and can account for suppy changes due to mattress stuffing. But that’s still and credit demand/credit supply market process at work.

    Lastly, keynesianism has a set of downright goofy concepts. The circular flow where savings is a leak is just wrong in a world of functioning financial intermediation that translates savings into investment via changes in interest rates. And so, this “savings glut” theory offers nothing, not even an explanation of what constitutes a “glut” of savings. Now, in a world shaken by crisis, whose true causes are inexplicable by keynesianism beyond animal spirits, savings can get trapped in a broken banking system (see the “excess” reserves at the Fed). But this is not a “general theory” about the function of savings in an economy. It’s a symptom of a broken banking system, and other problems dampening credit demand.

    Increased money demand that goes unmet, could be the problem, but again the causes there are two steps back. Why is there an aggregate increase in money demand? Why is the supply not keeping up? “Animal Spirits” isnt an answer, it’s handwaving.

    Markets can and do fail all the time. The straw man trope about domination by EMH as the cause of our problems just doesn’t hold up to even slight scrutiny. The Greenspan Put wasnt EMH at work. Three decade of bailouts from the S&Ls to continental illious, to the post 87 crash Greenspan injection, to the mexican peso to LTCM are not signs of a free market at work. Real capitalism is a system of profit AND LOSS. A world guided by EMH or Austrian economics would have had a great deal more loss than what we got.

    (Excuse typos. I’m on my iPhone)


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