Paul Krugman | Ignoring the Evidence, and Waiting for Inflation

Canon to right of me, canon to left of me – actually, scratch that, it’s all canon to right of me.

Noah Smith, a finance professor at Stony Brook University, recently wrote on his blog about the “finance macro canon.”

This is the view that money-printing and deficits lead inexorably to runaway inflation, plus assorted other arguments about why easy money is a terrible thing, even in a depressed economy.

And Mr. Smith is right – that view is still dominant on much of Wall Street. I’ve had several recent conversations with finance-industry people – including traders – who talk with some wonderment about the failure of high inflation and a plunging dollar to materialize, because “all the experts” told them to expect that outcome. When I found myself on CNBC’s “Squawk Box” with Joe Kernan in 2012, he described me as a “unicorn” – he couldn’t believe that there was anyone out there who didn’t believe that deficits and quantitative easing were going to lead to rapid doom.

Now, it’s interesting to note that the really smart Wall Street money doesn’t buy into this canon. Jan Hatzius, the chief economist at Goldman Sachs, and the rest of the economics group there are relying on an underlying macroeconomic framework pretty much indistinguishable from mine, and have consistently talked down the risks from easy money and deficits. But the great Armani-suited unwashed apparently don’t know that; they think that “everyone” shares their springtime-for-Weimar vision.

What makes this even more peculiar is the way the canon continues to dominate despite having failed the reality test in the most dramatic way possible.

The budget deficit as a percentage of gross domestic product and the rate of growth of the monetary base (currency plus bank reserves) in the United States both exploded to unprecedented levels in recent years – yet inflation went nowhere, and is in fact running below the Federal Reserve’s target.

So how can this disastrous a failure of the canon’s predictions have failed to make a dent in its dominance – especially when we unicorns were predicting exactly this result?

Actually, an aside on prediction failures: there are failures, and then there are failures. Some people seem to think that an event like Spain’s slight recovery this year – the best estimates now are that it may grow 1.5 percent – is as big a failure for the critics of austerity as the absence of runaway inflation is a failure of the finance canon. But many factors can cause the economy to grow a percentage point or two more or less than was forecast. On the other hand, if you believe that prices should move in proportion to the monetary base, there’s simply no way to rationalize triple-digit money growth associated with 2 percent or less inflation.

Anyway, what lies behind the canon’s continuing hold?

Class interest arguably explains the policy demands: tight money is what rentiers always want. But most of the consumers of this bad analysis are trying to make money, not influence policy, so what’s in it for them?

Mr. Smith suggests that it’s the need for the illusion of knowledge; but that in itself doesn’t explain why goldbug cranks should dominate so completely. Why haven’t the kind of people who listened to commentators like Peter “Hyperinflation by 2010” Schiff switched to, say, someone like the economist Warren Mosler?

It has to be in some sense political; the canon appeals to certain kinds of prejudices, in particular the prejudices of angry old white men with money to invest. But it remains amazing how little those prejudices have been dented by their failure to meet the most decisive real-world test you could imagine.