Bernanke In Space

I call on Paul Krugman: return his Nobel Prize in economics.  My request is based on his article in the April 29 New York Times magazine.  Titled “Earth to Ben Bernanke,” the article actually supports many of Dr. Bernanke’s actions, specifically the quantitative easing program.  (Dr. Krugman, for some reason, does not like this name, calling it “This is the strategy that has come to be known, unhelpfully, as quantitative easing.”  Really?  Unhelpfully?

So what does Dr. Krugman believe the Fed should do?  I can summarize his proposal in one phrase: announce a higher target for long-term inflation.  Currently the Fed’s implicit inflation target is probably around two percent.  Krugman believes, with some empirical support, that raising the inflation target would cause people and businesses to increase their spending because they will expect the purchasing power of their money holdings to depreciate faster.  However, there is another point that Krugman overlooks that is at least as important as increasing velocity.

Higher inflation expectations mean higher nominal interest rates.  Krugman seems to be following the lead of Dr. Olivier Blanchard, now “Economic Counsellor and Director, Research Department” at the IMF.  Prof. Blanchard is currently on leave from M.I.T.  He once proposed that increasing the inflation target would increase interest rates, giving the central bank more room to — get this — lower interest rates.  Let me quote from my blog entry in March, 2010:

“Blanchard’s argument is that by raising the inflation target, nominal interest rates would be higher.  This, he proposes, would give central banks more room to reduce interest rates to stimulate the economy.

Unfortunately, Prof. Blanchard has made an error that should make him blush.  It is the real interest rate, not the nominal interest rate, that affects most economic activity.  The only way Prof. Blanchard’s model can work is by appeal to the long-discredited “money illusion” hypothesis.”

Spending depends on real interest rates, not nominal rates.  Increasing inflation expectations will indeed increase nominal interest rates and raise spending a bit by increasing the velocity of circulation of money.  But the increase in spending won’t be very large because real interest rates have not changed.

Dr. Krugman has one Nobel Prize, while Dr. Blanchard has none.  Krugman’s proposal today is no more valid than Blanchard’s was two years ago.  I call on Dr. Krugman to return his Nobel prize in economics for failing to see a fundamental flaw in his proposal.