Tuesday, August 10, 2010

Krugman Calls for Protests Against Fed

Here's Paul Krugman's reaction to today's announcement by the FOMC that they will began to reinvest payments received from their earlier purchases of MBS and other instruments:

The FOMC has spoken. What’s my reaction? The Fed’s current policy is grossly inadequate, logically bizarre, and slightly — but only slightly — encouraging...

What we need to do now is keep up the pressure, so that at the next FOMC meeting the members are once again confronted by the reality that not changing course would be seen as dereliction of duty. And so on, from meeting to meeting, until the Fed actually does what it should.
I know: it’s a heck of a way to make policy. In a better world, the Fed would look at the state of the economy and do what was right, not the minimum necessary. But wishing for that kind of world is like wishing that Ben Bernanke were running the place.
Krugman is correct that the policy is logically bizarre, but the problem is not what Krugman thinks it is. Krugman doesn't understand that the Fed's reinvesting is not simply maintaining the status quo. As I explained earlier, the Fed making open market Treasury purchases is adding new money to the system, something the money didn't do when the Fed just bought directly from banks that then put the money with the Fed as excess reserves. 

What is bizarre about the Fed's program is that it is completely unknowable as to how significant of an impact the move will have. It is partly based on how much prepayment  money the Fed receives and partly how much of a money multiplier impact there will be. This is mad scientist Bernanke at his maddest. Instead of using the old tools of controlling the money supply (which worked just fine) via the reserve requirement, the discount rate and the Fed funds rate, Bernanke has gone off and created a moneymaking tool that has the potential to be very unstable and is an unknown quantity in terms of what it will actually do to the money supply.

Noble prize winner Krugman is not alone in failing to understand what Bernanke is attempting to do here, but it is a said commentary on the state of the economics profession when you have a Fed chairman doing bizarre things with the money supply, and at the same time you have critics so off the mark that they don't understand step one of Bernanke's  new tool.


  1. Great work on this. This stuff is vitally important and you are the only person I have found who has a consistent approach on this. I still don't quite understand how money injected into the economy works without loan demand quite well enough.

    Also, I just don't get how when the Fed first bought these 1.25T in mortages, how did this not have a similar affect on the eoonomy. They bought them from GSE's, so they couldn't park that money in excess reserves. How did the initial purchase not turn into "supermoney?"

  2. I have to re-read this later to digest it better because I still don't get it all. Really, I just don't get the Fed's strategy. I agree the reserve requirement tool makes more sense. Even with Bernanke's incorrect theoretical framework, it doesn't make sense to do this.

    Maybe I'm making a leap here, but does anybody know how this plays (or does not play) with the strange trillion dollar accounting move the Fed has made recently?