Paul think the markets are over-reacting

But I really don’t understand this. Granted that QE2 will probably have some positive effect, hopefully bigger than analysis based on the debt-maturity equivalence suggests. Still, the prospect remains that we’ll face multiple years of high unemployment — or, if you prefer, a protracted large output gap(PLOG). And history is clear on what that means: declining inflation:

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My guess, then, is that the markets are overreacting; they’re thinking, “The Fed is printing money!”, while forgetting that this ultimately matters, even for inflation, only to the extent that it seriously reduces unemployment.

Market over-reaction is possible sure. On the other hand, how about the parsimonious view: Expected inflation drives down real interest rates, drives people out of cash and into profitable investments thereby increasing the rate of growth and lowering unemployment.

This is the perspective of our basic New Keynesian models and of many economists including of course Paul Krugman! Here is Paul himself circa 1998

Sometimes big problems have small causes; sometimes a simple technical fix can work miracles.

Last spring I decided to sit down and think seriously about Japan’s ills, putting aside conventional wisdom and my own prejudices, following the logic of economic analysis wherever it led. And it led to a surprising conclusion: that there is indeed a simple fix for Japan’s slump – and that the structural obstacles to a quick recovery lie not in the economy itself but in the minds of policymakers.

What is particularly remarkable about the debate over Japan is that it is a case where straightforward economic analysis and policy orthodoxy are in direct conflict. If you apply the most conventional of macroeconomic models to Japan’s unusual plight, you come up with recommendations that are anathema to central bankers and finance ministers. And in this case, I am firmly convinced that the models are right and the officials are wrong.

The models suggest a commitment strategy. The Fed should promise inflation. The whiteboard says it should work. The markets seem to be acting as if it is will work. Maybe it is working?

Now, I am the first to admit that it is easy to get sucked into confirmation bias. Obviously, I am tempted to see evidence for cash hoarding everywhere and likewise am tempted to see rising inflation expectations as implying strong future growth.

However, just because your are vulnerable to bias doesn’t mean you are wrong!

What would be helpful is specific counter-evidence showing that the communication strategy is not in fact working and that we will not begin to see cash moving out safe bank accounts and into productive investments.

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