Dan Kervick has, I think, done the best job categorizing QE3, calling it “shamanistic economics.” He wrote:
Here’s how it works in theory: Suppose there is something X the Fed would like to see happen. The Fed is supposed to make X happen by announcing that it intends to make X happen and that it is doing some other thing Y that is aimed at making X happen. The hope is then that a significant number of people thinkthat there is a causal connection between Y and X, and that Y causes X… What is important, the defenders of this approach say, is that people believe quantitative easing will cause a stronger recovery. They will then start to invest in production, hiring and consumption more readily because they are expecting improved conditions… It doesn’t really matter what quantitative easing would have accomplished on its own if people didn’t have these beliefs.
Especially in light of Arin Dube’s skepticism that Bernanke and the Fed actually has any ammo left to push up inflation at the zero lower bound and the effects this skepticism should have on inflation expectations, “shamanistic economics” nails what the expectations fairy is supposed to facilitate. So, as a term for thinking about what exactly QE3 is, shamanistic economics does a fine job.
I have a totally separate problem with this article: the idea that shamanistic economics is for some reason illegitimate. Kervick seems to believe that it’s possible to consider something like quantitative easing in a vacuum. Above, he mentioned “what quantitative easing would have accomplished on its own” (emphasis added). He later writes
All that matters is that apart from whatever actual causal connections exist between X and Y that operate independently of expectations, there are also a lot of popular beliefs about the connection between X and Y that cause people to act with the expectation that Y will cause X. (emphasis added)
What he’s after here is what the collection of actions called quantitative easing would do to an economy in which people’s expectations didn’t change, or in which people’s expectations didn’t affect economic outcomes. That goal is absurd and aligns almost identically with what Frederick Engels meant when he spoke about the scientist’s seizing “nature without any foreign addition,” and the same criticism should be made. As Francois George writes, “Far from preceding the scientific attitude, reality and the object were constituted by it,” which is to say that without a ready-made body of scientific theories and community of scientists, reality and the object would both be unintelligible (80, paid, sorry).
The same objection applies to economic policy/experiments — any economist claiming he has a good model of how the economy works outside of how people would react to it doesn’t have a good model of the economy works. This is, in a way, a post-modern extension of the Lucas critique. As Simon Wren-Lewis explains,
The classical example of the Lucas critique is inflation expectations. If monetary policy changes to become much harder on inflation, then rational agents will incorporate that into the way they form inflation expectations. A model that did not have that feedback would be ‘subject to the Lucas critique’.
In this description, the policy happens prior to the expectations adjustment, which is to say, unless we assume perfect and immediate adjustment everywhere, this is the chain of events: policy-makers make a real/objective change in economic conditions; real changes occur; expectations change; feedback from the expectations changes causes other real effects.
Now, though, the Fed can’t make real stimulative changes (though it could, presumably, ruin everything forever by making real contractionary changes). At the ZLB, its ability to cause inflation has been neutered, and it can no longer lower nominal interest rates. What the latest round of QE relies on is short-circuiting the Lucas critique. Rather than making real changes and arguing that the expectations feedback won’t undo them, the Fed is skipping the making real policy changes step. The Fed is skipping what’s supposed in a rational/objective universe to be a sequence of cause and effect, and is instead relying on subjective interpretations of future economic conditions to bring about those conditions.1
Kervick thinks this plan is stupid because it shouldn’t work in something like an objective economic reality. However, inasmuch as economic reality is comprised of people with expectations and that, without these people, “economics” as such doesn’t exist, the impossibility of proving the effectiveness of further easing in an objective economic reality is unconcerning.
This isn’t to say that the Fed policy should work. Even if unemployment turns around tomorrow, it will be unlikely that that change was in a strict sense “caused by” the Fed action.
The success of the Fed’s actions, Kervick writes, “depends on the perpetuation of false and superstitious beliefs among the public,” but, as roguishly as I could, I’d counter sure, but not “false” in the sense of “not true,” but of a different kind.
1 – For a literal, literary, and hilarious example of what this looks like in magic, see Jonathan Strange & Mr. Norrel, chapter 22