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There's More to QE Than Krugman Thinks

Noah Smith is a Bloomberg View columnist. He was an assistant professor of finance at Stony Brook University, and he blogs at Noahpinion.
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Nobel Prize-winning economist Paul Krugman says that quantitative easing was a test of macroeconomic theories. On one side, he says, Keynesian theories predicted that QE would have little effect; on the other side, a whole bunch of alternative schools predicted that there would be high  inflation. According to Krugman, the failure of inflation to materialize means that Keynesians prevailed, and this makes sense -- the theories that predicted inflation seem to be due for a re-examination, especially in light of Japan’s very similar experience in previous decades.

But some of the people who had predicted inflation did reconsider their ideas. Neo-Fisherism -- the idea that low interest rates cause low inflation or deflation in the long term -- was the most dramatic rethink possible, at least in terms of policy recommendations.

Yet Krugman thinks that the Neo-Fisherians are trying to deny the results of the macroeconomic acid test:

[Now] we have the neo-Fisherite claim that everything we thought we knew about monetary policy is backwards, that low interest rates actually lead to lower inflation, not higher...The neo-Fisherites are flailing about, trying to find some reason why the inflation they predicted hasn’t come to pass — but the only reason they find this predictive failure so puzzling is because they refuse to accept the simple answer that the Keynesians had it right all along.

This seems a bit unfair to me. “Flailing about” -- or, to put it more positively, casting about for new ideas -- is exactly what you’re supposed to do when confronted with unexplained phenomena. And I think Krugman vastly overstates the degree to which “more or less Keynesian” theories predicted the results of QE in Japan and the U.S. New Keynesian models -- the dominant type of “more or less Keynesian” models in academia -- tend to predict that monetary easing eventually raises both output and inflation.

Maybe the U.S. simply hasn’t gotten over the negative demand shock from the 2008 financial crisis. But to explain the failure of QE and ZIRP (zero interest rate policy) to generate inflation in Japan even after multiple decades, you have to modify New Keynesian models substantially. Michael Woodford at Columbia did this by adding the idea that QE affects the amount of collateral in the financial system. Harvard economist Larry Summers and Gauti Eggertsson, of Brown, did this by coming up with the “secular stagnation” hypothesis. In other words, these macroeconomists are “flailing about” -- exactly what they should be doing, and exactly what the Neo-Fisherites are doing too.

Meanwhile, bloggers have been having a very interesting debate about the Neo-Fisherian idea. University of Chicago economist John Cochrane has the clearest and most comprehensive post on the subject, which uses a series of simple graphs to demonstrate how Neo-Fisherian and New Keynesian ideas differ. The key is stability. According to New Keynesianism, if the Fed pegs the interest rate higher or lower than its natural value, it eventually sends the economy into either an inflationary or a deflationary death spiral: 

 Neo-Fisherism, on the other hand, says that eventually the real economy just starts ignoring the Fed, and inflation adjusts to more or less match the Fed’s interest rate peg: 

 Nick Rowe of Carleton University, taking the opposite side of the debate, agrees that this is the main question.

 Rowe contends that monetary tightening caused inflation to fall in Sweden. He might have also cited the example of Abenomics, where a blast of monetary easing led to a rise in inflation and inflation expectations.

But Neo-Fisherism doesn’t actually say this won’t happen. It’s a prediction about the long-term consequences of an interest rate peg, not about the short-term reaction when the peg is first established or is moved around. Cochrane points out that under Neo-Fisherism, monetary easing can cause a short bump of inflation, followed by a long grinding disinflation that basically never ends.

Here are Cochrane’s graphs:

If you flipped these pictures upside down, you’d get ZIRP. The “mild Neo-Fisherian” view predicts that the establishment of ZIRP causes a bump up in inflation, followed by a permanent dip of inflation below its pre-ZIRP level. If that’s right, then the inflation bump Japan has seen from Abenomics -- which has essentially implemented negative nominal rates and promised to keep monetary easing going indefinitely -- can be expected to fade in a year or two, sending Japan back into deflation.

 So it looks like we’re going to get a real acid test for the Neo-Fisherian idea. Instead of castigating the Neo-Fisherians for “flailing about,” I think we should try to understand their models, and wait eagerly for the results from the Bank of Japan’s bold experiment.

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