Just How Infamous Was that Infamous Open Letter to Bernanke?

There’s been a lot of comment recently about the infamous 2010 open letter to Ben Bernanke penned by an assorted group of economists, journalists, and financiers warning that the Fed’s quantitative easing policy would cause inflation and currency debasement.

Critics of that letter (e.g., Paul Krugman and Brad Delong) have been having fun with the signatories, ridiculing them for what now seems like a chicken-little forecast of disaster. Those signatories who have responded to inquiries about how they now feel about that letter, notably Cliff Asness and Nial Ferguson, have made two arguments: 1) the letter was just a warning that QE was creating a risk of inflation, and 2) despite the historically low levels of inflation since the letter was written, the risk that inflation could increase as a result of QE still exists.

For the most part, critics of the open letter have focused on the absence of inflation since the Fed adopted QE, the critics characterizing the absence of inflation despite QE as an easily predictable outcome, a straightforward implication of basic macroeconomics, which it was ignorant or foolish of the signatories to have ignored. In particular, the signatories should have known that, once interest rates fall to the zero lower bound, the demand for money becoming highly elastic so that the public willingly holds any amount of money that is created, monetary policy is rendered ineffective. Just as a semantic point, I would observe that the term “liquidity trap” used to describe such a situation is actually a slight misnomer inasmuch as the term was coined to describe a situation posited by Keynes in which the demand for money becomes elastic above the zero lower bound. So the assertion that monetary policy is ineffective at the zero lower bound is actually a weaker claim than the one Keynes made about the liquidity trap. As I have suggested previously, the current zero-lower-bound argument is better described as a Hawtreyan credit deadlock than a Keynesian liquidity trap.

Sorry, but I couldn’t resist the parenthetical history-of-thought digression; let’s get back to that infamous open letter.

Those now heaping scorn on signatories to the open letter are claiming that it was obvious that quantitative easing would not increase inflation. I must confess that I did not think that that was the case; I believed that quantitative easing by the Fed could indeed produce inflation. And that’s why I was in favor of quantitative easing. I was hoping for a repeat of what I have called the short but sweat recovery of 1933, when, in the depths of the Great Depression, almost immediately following the worst financial crisis in American history capped by a one-week bank holiday announced by FDR upon being inaugurated President in March 1933, the US economy, propelled by a 14% rise in wholesale prices in the aftermath of FDR’s suspension of the gold standard and 40% devaluation of the dollar, began the fastest expansion it ever had, industrial production leaping by 70% from April to July, and the Dow Jones average more than doubling. Unfortunately, FDR spoiled it all by getting Congress to pass the monumentally stupid National Industrial Recovery Act, thereby strangling the recovery with mandatory wage increases, cost increases, and regulatory ceilings on output as a way to raise prices. Talk about snatching defeat from the jaws of victory!

Inflation having worked splendidly as a recovery strategy during the Great Depression, I have believed all along that we could quickly recover from the Little Depression if only we would give inflation a chance. In the Great Depression, too, there were those that argued either that monetary policy is ineffective – “you can’t push on a string” — or that it would be calamitous — causing inflation and currency debasement – or, even both. But the undeniable fact is that inflation worked; countries that left the gold standard recovered, because once currencies were detached from gold, prices could rise sufficiently to make production profitable again, thereby stimulating multiplier effects (aka supply-side increases in resource utilization) that fueled further economic expansion. And oh yes, don’t forget providing badly needed relief to debtors, relief that actually served the interests of creditors as well.

So my problem with the open letter to Bernanke is not that the letter failed to recognize the existence of a Keynesian liquidity trap or a Hawtreyan credit deadlock, but that the open letter viewed inflation as the problem when, in my estimation at any rate, inflation is the solution.

Now, it is certainly possible that, as critics of the open letter maintain, monetary policy at the zero lower bound is ineffective. However, there is evidence that QE announcements, at least initially, did raise inflation expectations as reflected in TIPS spreads. And we also know (see my paper) that for a considerable period of time (from 2008 through at least 2012) stock prices were positively correlated with inflation expectations, a correlation that one would not expect to observe under normal circumstances.

So why did the huge increase in the monetary base during the Little Depression not cause significant inflation even though monetary policy during the Great Depression clearly did raise the price level in the US and in the other countries that left the gold standard? Well, perhaps the success of monetary policy in ending the Great Depression could not be repeated under modern conditions when all currencies are already fiat currencies. It may be that, starting from an interwar gold standard inherently biased toward deflation, abandoning the gold standard created, more or less automatically, inflationary expectations that allowed prices to rise rapidly toward levels consistent with a restoration of macroeconomic equilibrium. However, in the current fiat money system in which inflation expectations have become anchored to an inflation target of 2 percent or less, no amount of money creation can budge inflation off its expected path, especially at the zero lower bound, and especially when the Fed is paying higher interest on reserves than yielded by short-term Treasuries.

Under our current inflation-targeting monetary regime, the expectation of low inflation seems to have become self-fulfilling. Without an explicit increase in the inflation target or the price-level target (or the NGDP target), the Fed cannot deliver the inflation that could provide a significant economic stimulus. So the problem, it seems to me, is not that we are stuck in a liquidity trap; the problem is that we are stuck in an inflation-targeting monetary regime.



21 Responses to “Just How Infamous Was that Infamous Open Letter to Bernanke?”

  1. 1 Peter K. October 28, 2014 at 2:43 pm

    I agree with this post and feel both DeLong and Krugman would agree as well (if not about Hawtrey and the history of thought something of which I personally know nothing about and so remain agnostic).

    I am interested to see what Yellen will do. She has expressed a desire to see wage inflation and discussed inequality as a problem the other day (the latter causing much consternation). Will she allow inflation to drift upwards now that QE has ended?


  2. 2 Mike Sproul October 28, 2014 at 4:43 pm

    If the signatories had understood the backing theory of money, they would have known that huge open market purchases increase the fed’s assets right in step with the quantity of Fed-issued money. Thus the amount of backing per dollar is unchanged, and there is no inflation. After all, the Fed would have plenty of assets with which to buy back the new money.


  3. 3 jkb October 28, 2014 at 4:43 pm

    I think this is a cogent analysis, and I concur with most of it,particularly the nature of the mistake made by the letter writers. My own(admittedly untutored) analysis is that the problem has been compounded by the combination of the euro and the Chinese decision to hold massive amounts of Treasuries, which has effectively created a new (and deflationary) “gold ” standard. Would be interested in you thoughts on this.


  4. 4 TravisV October 28, 2014 at 7:24 pm

    Dr. Glasner,

    Of course I agree that a higher inflation target would be wonderful. But I truly wish you had added that NGDP target would be way way way better…….


  5. 5 Lorenzo from Oz October 28, 2014 at 8:28 pm

    Nicely put.

    Perhaps we could get folk to at least move to the RBA’s “average over the business cycle target”. It has an actual track record, and does not represent quite such a leap as NGDP targeting (which I support; my argument is one of pragmatics, not final preference).


  6. 6 Benjamin Cole October 28, 2014 at 10:05 pm

    Excellent blogging.

    I still think the “problem” with QE was that it was not forceful enough, and was not keyed on results. Ala, QE will start at $50 billion a month, and rise $10 billion monthly until the Fed sees 4% inflation or 4% unemployment.

    David Beckworth says the fed should make clear the balance sheet is permanent, and I agree with him.

    Also, I suspect lionizing inflation is a PR mistake; I prefer to say what I championing is growth strong enough to incur some bottlenecks that are resolved by price hikes. A robust economy generates some inflation. Boo-hoo. A small price to pay (and yes, wages are initially cut, but real wages go up in general, see the 1960s).

    Maybe shrink IORs.


  7. 7 Biagio Bossone October 29, 2014 at 3:16 am

    Dr. Glasner,
    a few observations:
    1) working on inflation expectations in the hope of stimulating demand confuses cause with effect. Inflation is like body temperature: it is the effect of accelerated body motion, not the cause of it. If, in a situation of economic depression, your policy instrument is effective in raising aggregate demand, then you would most probably also get some inflation as a result. But then you would aim at stimulating demand, first, and then you’d see what happens to prices depending on the output response. This is what happened after the Great Depression: policies were effective in stimulating demand and output; inflation followed. The body of the economy moved faster and its temperature (prices) rose as a consequence. Which leads to my second observation:
    2) Maybe it is simply the case that QE is not effective in stimulating demand: it might be the wrong instrument aiming at the wrong objective (ie. raising inflation expectations). QE is ineffective in stimulating demand because the newly injected money does not reach the people that would more likely spend it.
    3) Perhaps “helicopter money” (that is, monetary + fiscal policy) is really what you need, and what can be most effective, in some extreme cases like depressions. HM can stimulate demand, without creating new public debt, by affecting spending decisions directly not via expectations. Of course, expectations of rising demand might reinforce the mechanism.
    4) Perhaps, the current ZLB situation can be described as one where both the Keynesian liquidity trap and Hawtreyan credit deadlock co-exist: it is true that banks are not willing to lend, and it is also true that people do not wish to spend and stay liquid. By the way, at the height of the financial crisis in the US, banks themselves did actually hold liquidity and did not lend even to each other: a perfect example of liquidity trap and credit deadlock simultaneously at work within the same sector.


  8. 8 Marcus Nunes October 29, 2014 at 3:51 am

    David, at least one member of the Krugman fan club has a good grasp of your last paragraph:


  9. 9 dan October 29, 2014 at 4:54 am

    “Now, it is certainly possible that, as critics of the open letter maintain, monetary policy at the zero lower bound is ineffective.”

    There’s a zinger.

    But more basically, I am not quite so sure I agree with you. Because we now know that low interest rates do not call out all types of demand.
    Government spending has been a huge drag on demand, and this despite many arguing that low interest rates on treasuries are neon signs flashing ‘invest!’ from one end of Pennsylvania Ave to the other.
    The problem here is not a (counter) cyclical contribution to GDP, the problem is the structural requirement of the economy for government spending, or more precisely for those things the government is uniquely equipped to invest in that the private sector is dependent on for growth.

    Interestingly this controversial letter called out fiscal policy as a superior tool for responding to the problems of the day, they were certainly right on that one, though I suspect they have a very different fiscal policy in mind than I do.


  10. 10 Brad Lewis October 29, 2014 at 8:26 am

    Excellent column on the letter and on inflation generally. The signatories are an interesting group, including Kevin Hassett, who wrote the book Dow 36,000, which was conceptually flawed and incredibly off target.

    What’s also intriguing to me is that the signatories do not, apparently, understand the effect that institutional changes, including paying interest on reserves and targeting interest rates, have had on inflation prospects. For example, many commentators profess to be convinced that the increase in the Fed reserves held by banks must be inflationary because “eventually” banks will use those reserves to make more loans and create more deposits, thus starting a 70’s-style spiral. But starting in 2008, the Fed has paid interest on reserves, and if the federal funds rate is below that interest rate, banks will simply hold more excess reserves. So holdings of excess reserves are not an indicator at all of future inflationary potential. In addition, when the Fed started to target interest rates–when it stopped targeting the monetary aggregates, M1 and M2, quite awhile back, because changes in them did not have predictable consequences for inflation or output–it entered an era in which it could not set the quantity of reserves independent of the federal funds rate it wanted to control, which ultimately meant that banks have not been constrained by reserves, as they simply will borrow reserves if they need them to support profitable loans.

    What’s surprising is that you can find the effects of these institutional changes discussed in standard undergraduate texts, as well as the expanding literature on modern money theory. I talk about them myself in my financial markets and monetary economics undergraduate courses. Why don’t the “experts” seem to know them?

    And the signatories also cited, in 2010, the support of other central banks for their view–could those have included the ECB, which gave us, thanks to the Germans, the kind of controlled experiment pitting austerity vs. stimulus that we normally couldn’t hope to find in Economics? Or the Bank of England, while England was in the spell of Ricardian equivalence for awhile?

    And I wonder how many of the signatories would acknowledge that FDR’s going off gold and devaluing the dollar did so much so quickly, an excellent point made in the article.

    The “soundest” money comes in a fiat money system properly run, not a gold-backed money, not one with fixed exchange rates, and not one with an arbitrary target for monetary aggregates.


  11. 11 David Glasner October 29, 2014 at 10:03 am

    Peter, I am not sure what Krugman and Delong would say. They seem to waver between arguing that monetary policy is ineffective and acknowledging that Fed policy is accomplishing something, so I am genuinely confused about what their position is. It is also possible that they just wanted to make the signatories to the open letter look stupid, and thought that the easiest way to do it was to focus on the failure of the inflation prediction.

    I don’t have any particular insight about what Yellen and the FOMC will do, but they seem to be trying to slowly back out of what they mistakenly view as an aggressively expansionist monetary policy.

    Mike, Haven’t heard from you lately. Glad that you’re still out there. Remind me how the backing theory explains not only the real quantity of money outstanding, but also the value of an individual monetary unit.

    Jkb, Thanks. I have written a bit about Chinese monetary policy in posts about currency manipulation, search people’s bank of China or Chinese central bank for those posts. I have also discussed the euro as a kind of version of the gold standard. One post that I remember is the Economic Consequences of Mrs. Merkel, but there have been others.

    Travis, Just blame it on my stubbornness and perversity in wanting to establish a reputation as an inflationist and currency debaser. I admit it; I am terrible.

    Lorenzo, Thanks. That’s actually a good pragmatic suggestion, and not so bad in principle.

    Benjamin, I agree that the Fed has not been as aggressive as they could have been in buying up assets, but the combination of IOR and a 2% inflation target might well have overcome any program of asset buying. I don’t disagree with Beckworth, but I think committing to a permanent increase in the balance sheet might have been an even tougher sell than raising the inflation target. You are right about PR, but this is who I am.

    Biagio, Sorry, but I disagree about inflation. A devaluation under the gold standard produces a price effect that precedes the aggregate demand effect. The US money supply increased after FDR devalued the dollar not before. You have read too much Friedman. Everything he wrote on the Great Depression was badly distorted by his simplistic adherence to a simplistic form of the quantity theory of money. I am not opposed to using money creation to finance a budget deficit. Such a policy might have been effective, but political support for it quickly evaporated.

    Marcus, Thanks for the link. I think that as I pointed out to Peter above, they were just using the inflation warning as the most convenient way to discredit the letter and its signatories.

    Dan, I think the letter was referring to fiscal policy as a supply-side instrument not a demand –side instrument, at least that is how they would think about it.

    Brad, Thanks for your comments, which are all exactly on target.


  12. 12 Mike Sproul October 29, 2014 at 10:18 am

    The backing theory says that whether the Fed issues $100 backed by assets worth 100 oz, or $300 backed by assets worth 300 oz, each dollar is worth 1 oz either way. In ordinary open market operations, the Fed issues another $10 of base money in exchange for bonds worth $10, so assets move in step with money-issue, and the value per unit of money is unaffected. Note that it makes little difference if assets are denominated in oz. or in dollars. It’s underlying value that counts.

    The same is true of stocks and bonds. Say GM shares are worth $60 each. Then GM issues 10 new shares and sells them for a total of $600 cash. GM’s assets have risen in step with its stock issue, so GM’s stock price is unaffected.

    So on this theory, inflation is caused by money outrunning assets. For example, if the Fed pays $100 for bonds that turn out to be worth only $99, then the Fed took a 1% loss, and there is a potential for inflation.


  13. 13 Mike Sproul October 29, 2014 at 10:21 am


    PS: Here’s a link that explains the backing theory in the context of the law of reflux, which is right up your alley.



  14. 14 Philo October 29, 2014 at 3:19 pm

    “. . . the risk that inflation could increase as a result of QE still exists.” I suspect that QE did, indeed, increase the probability of high inflation: from almost-infinitesimal to still-almost-infinitesimal!


  15. 15 JKH October 30, 2014 at 1:58 am

    This may seem like an odd question, but:

    Can you reduce your previous belief that quantitative easing should have been more effective than was the eventual case to a particular category of actual economic transactions that might have occurred according to that belief but that didn’t occur?

    E.g. is it bank lending that didn’t occur as you expected?

    Or something else?

    Or is there no such category of actual transactions? Is it a diffusion of activity?


  16. 16 Biagio Bossone October 30, 2014 at 3:58 am


    On April 5, 1933, Roosevelt ordered all gold coins and gold certificates in denominations of more than $100 turned in for other money. It required all persons to deliver all gold coin, gold bullion and gold certificates owned by them to the Federal Reserve by May 1 for the set price of $20.67 per ounce. By May 10, the government had taken in $300 million of gold coin and $470 million of gold certificates. Two months later, a joint resolution of Congress abrogated the gold clauses in many public and private obligations that required the debtor to repay the creditor in gold dollars of the same weight and fineness as those borrowed. In 1934, the government price of gold was increased to $35 per ounce, effectively increasing the gold on the Federal Reserve’s balance sheets by 69 percent. The Federal Reserve recovered the use of fiat money. As creation of new fiat money was now possible, demand was stimulated, increasing output and increasing prices.
    The devaluation by itself did not produce an automatic adjustment of dollar prices or price effect (except via export). By the way, in any case where you have a price adjustment and no adjustment in money and/or velocity to support it, waht you get is a contraction not an expansion of demand. Again, you need additional energy to see body temperature rise, not viceversa.


  17. 17 dan October 30, 2014 at 5:11 am

    But David,
    You can talk about monetary policy all you want but how is it not logically inconceivable that monetary policy is by definition necessary but NOT sufficient?
    Something around 1/3 of the economy isn’t dependent, determined, or responsive to monetary policy.
    I don’t see strong evidence that monetary policy has been so poor or ineffective on that portion of the economy that is responsive to monetary policy. Consumers are spending and corporations are increasing their investment – though neither are at theoretically ideal levels, and perhaps both have taken longer to arrive where they are than might have been so with some superior policy. That will almost always be so.

    Just as a logical practical mathematical non-ideological matter – lets say you get your inflation and nominal GDP AND federal employment remains flat, investment in government provided services and infrastructure continues to decline and State and Local continue to grow substantially slower than the economy. Does that even work? is it sustainable in anyway? Is it a better outcome than the inversion, today’s inflation and no nominal gdp target but government spending continued at trendline from 2007?

    Ah well, you gave me a reading list, that addresses this question earlier, I suppose I should read it rather than bang on about my pet peeve.

    thank you


  18. 18 dan October 30, 2014 at 5:35 am

    Also, may I request a post topic? Milton Friedman, his ideas, the man and his legacy.


  19. 20 Benjamin Cole October 31, 2014 at 7:42 pm

    Excellent blogging.


  1. 1 Worthwhile Reads – November 3rd | Fix the Jobs Trackback on November 3, 2014 at 8:22 am

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About Me

David Glasner
Washington, DC

I am an economist in the Washington DC area. My research and writing has been mostly on monetary economics and policy and the history of economics. In my book Free Banking and Monetary Reform, I argued for a non-Monetarist non-Keynesian approach to monetary policy, based on a theory of a competitive supply of money. Over the years, I have become increasingly impressed by the similarities between my approach and that of R. G. Hawtrey and hope to bring Hawtrey’s unduly neglected contributions to the attention of a wider audience.

My new book Studies in the History of Monetary Theory: Controversies and Clarifications has been published by Palgrave Macmillan

Follow me on Twitter @david_glasner


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