A Qualified Defense Of The Inflationistas

Yesterday Paul Krugman once again attacked people who predicted that Fed policy would result in inflation. His claim is that, unlike himself, these people just can’t admit they were wrong.

Now it’s obvious there hasn’t been runaway inflation and it definitely makes people who made inflation predictions look really bad. Still, the gloating by Krugman and others doesn’t seem justified to me. Certainly not at this point. They claim that the facts vindicate their Keynesian model while demonstrating the “wrongness” of their opponents model. But what model is that? I’m not aware of any model that suggests the demand for money will not have an effect on the price level. In fact the model most free market economists use suggests that if an increase in the demand for money outstrips the increase in supply, prices will fall. Not any different from the Keynesian model.

So it seems to me that the inflation predictions were more about what would happen to the demand for money. It wasn’t unreasonable to think at the time that the demand for money wasn’t going increase enough to offset the trillion of dollars the Fed was printing. How could someone have been so confident that it would have? After all, increases the monetary base by that amount are largely unprecedented in the western world. The few times it had been done historically, it resulted in hyperinflation. Here’s what happened to the monetary base:

Monetary Base

Critics will say, “Yes but we were in a liquidity trap! It doesn’t matter how much money is printed. In a liquidity trap the banks wont lend it into circulation. They should have known that!” To the extent that is true, the liquidity trap was very short lived. Except for about eight months in 2009 inflation has been positive through almost all of the recovery. Since 2009 the official measure of the price level has risen by 8.7%. That hardly suggests a liquidity trap to me.

But aren’t we at the Zero Lower Bound? Sure, but that is largely a byproduct of the Fed printing $85 billion a month while simultaneously paying interest to keep the banks from lending that money into circulation ― another unprecedented policy. My guess is if the Fed were to stop paying interest, a good chuck of the reserves would flood into the economy producing some serious inflation. That’s partially why I find the notion that we are constantly teetering on the edge of deflation to be laughable.

Now of course those who predicted inflation did so knowing full well that the Fed was paying interest on excess reserves, but I think it mostly came down to a matter of confidence in the Fed. How likely was it that the same economists who completely missed the housing bubble and who told us that lending standards were “spectacular” would be able to effectively manage trillions in excess reserves and prevent inflation?

Those who opposed the inflation predictions did so, I suspect, largely because of a (most likely unjustified) confidence that the Fed would be able to use its policy “tools” to manage reserves and keep inflation low. But were those predictions a byproduct of a superior understanding of economics or largely the result of luck?

So far the Fed has been able to keep the juggling act going. Inflation is still low and excess reserves are still growing. At some point, however, it seems the banks are going to want to draw down on their reserves and it remains to be seen how the Fed will handle it.

In my opinion it would be more appropriate to judge who was ultimately right after the Fed unwinds its balance sheet. In the mean time I suspect the gloating from Krugman and friends will continue.

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