Paul Krugman has been busy as a bee of late tearing into QE truthers and inflation hawks for their gross ignorance. How could they have been so stupid to believe that QE would cause inflation? he asks. Let me show you my IS-LM model, which clearly shows that QE cannot trigger inflation during a liquidity trap.
Before delving into the flaws of his argument, let’s be clear: he is right in some respects. When interest rates are at 0%, and full employment is nowhere in sight, QE will not cause inflation. Inflation can only occur when spending rises above the full employment level. And the central bank finds it difficult to boost spending when interest rates are already at 0%. So on this point Krugman is spot on: QE cannot cause inflation when the rate necessary to drive full employment (the ideal interest rate) is negative, which is the definition of a liquidity trap.
His self-congratulatory rants slip into fantasy when he claims that QE was never going to cause inflation. With this argument Krugman is making a fatal logical error: he is assuming that the US would be forever stuck in a liquidity trap. From this premise, it is correct to conclude that QE won’t cause inflation. But here’s the problem: the premise is flawed. If the ideal interest rate had suddenly jumped into positive territory (bringing an end to the liquidity trap), and the central bank hadn’t reacted fast enough, the US economy may well have have experienced inflation. It didn’t happen, but it could have. For Paul Krugman to dispel all QE truthers as moronic is equivalent to saying that he knew with absolute certainty that the ideal interest rate would remain negative for the (un)foreseeable future. In other words, he’s prophet.
Of course, he isn’t a prophet. No one is. A near-endless number of factors constitute the ideal interest rate, all of them beyond the prediction of us mortals. While Krugman could have made the argument (which he didn’t) that the US was entering a period of secular stagnation, he still couldn’t forecast, not with any certainty, that the US economy would remain in a liquidity trap forever.
At the core of this endless debate is a simple problem: the tools we use to manage the economy are imperfect. In our free market world we rely on central planners to set spending and interest rates in the hope that demand remains at the full employment level. And because central planners literally have no idea what the ideal interest rate is, and can only react to data, there’s always room for economists and politicians to argue that our policy actions can simultaneously risk both inflation and unemployment.
So here’s what I suggest: Paul Krugman, please stop arguing that QE was never going to cause inflation. It fills readers’ minds with unhealthy absolutism. As for QE truthers: please stop arguing that QE is unquestionably going to cause inflation. If you were less absolute, perhaps economists like Krug & Co would open their minds to the very real risks, however unlikely, that come with these unconventional policies.
The correct answer is always nuanced. In many respects economics is an art, not a science. It’s about time we accepted that.