A few months ago, the Internet sensibly zeroed in on the real question posed by the second Hobbit movie. “The Desolation of Smaug” clearly refers to the gigantic monetary disturbances brought about by the greedy lizard. CNBC and Slate were amongst many who followed up on Frances Woolley’sobservation about the depression Smaug caused over Middle earth when he took away so much currency.
After 150 years of scarce currency and falling prices, Bilbo and his dwarf friends would clearly cause a massive nominal shock by releasing such a huge stash of gold onto the depressed Laketown economy. Gold that over the decades had become far more valuable would see its value obliterated by the onrush of new currency, causing a massive inflation. Upon realising what was about to happen, any merchant with some small stash of gold would immediately buy everything he can get his hands on: goatskins, houses, fishing rights, you name it. Anything to get rid of something that is about to collapse in value.
Given the depression the effect is likely to be electric in real terms. With rapid rises in prices and wages, any outstanding debts would become easier to service. Bills would be paid with great eagerness, new working capital sought out. New investments would look far more attractive. Asset prices would boom.
Would it make any difference if there was no bank credit, because Smaug had incinerated the bankers? Or if the few banks remaining didn’t understand relationship lending? Or if Laketown had very low interest rates owing to the depressed state of trade and high risk aversion? Or even if the Laketown authorities were on an austerity drive?
I should think not. Sluice the economy down with enough gold and there will be a huge stimulus. And this would be the case even if none of it was owned by the people of Laketown. Even if the dwarves gave none of it away, their huge potential purchasing power would have a massive effect. Even if they were total misers, and spent little of it, what would you think if you were that merchant? You would not want to hold gold at the same price. That dwarf gold will come out somehow.
The debate about the potency of monetary policy in a depressed economy is a perennial; not least since the Crash, but going back at least 50 years to the monetarist counter revolution. Mishkin in his tome distinguishes two types of evidence in this debate. ”
Reduced Form” evidence resembles Underpants Gnome thinking: step one: lots more money, step two: ????, step three: higher NGDP. The mechanisms don’t matter. The evidence accumulates by people observing how prices and money supply move together.
“Structural Model” evidence tries to specify mechanisms. It it a bit like what the Bank attempted when it first explained QE and monetary policy in general. It talks about lower rates, higher asset prices, that sort of thing.
Thinking about Smaug leads me to prefer the former way of thinking. How would all his gold boost Laketown? The honest answer is “somehow”. Would it be lower rates, higher asset prices, more consumer spending, expectation of higher prices elsewhere, a wealth effect, a balance sheet effect, a cheaper currency helping exports, banks becoming more eager to lend? The right answer is: I don’t know, but it would happen. Just as it happened when FDR went off gold (devaluing dollars). It worked through some channels, but not others. It is probably doing the same in Japan right now.
I am not normally a fan of Underpants Gnomes, nor of the Bank’s reasoning. But in this case I would back it against the criticisms of those who say “My model says QE can’t work”. In extremis, permanent money injections clearly work, whatever the other circumstances. I have no doubt QE could have been done better; it could clearly have been communicated better. But the Bank’s confidence seems well founded. The only problem is that for long periods they have implied that QE would be extremely temporary, which changes everything.
Mishkin ends this specific chapter with clear “lessons for monetary policy”. He chooses:
- Don’t associate the easing of monetary policy with a fall in nominal rates
- Other asset prices than short term debt convey important information about the monetary policy stance
- Monetary policy can be highly effective in reviving an economy even when short term interest rates are near zero.
Fancy that. He doesn’t even say you have to kill a dragon first.