In a post written on June 14th, I warned Krugman that it was foolish to play politics; he should just advocate the policy that is most effective:

As I read Krugman, his attitude seems to be something like the following (which is my interpretation, not his words):

“Ah, what a pity it is that these conservative central banks aren’t willing to commit to a modest amount of inflation.  That would be the easiest way to boost AD, and the least costly.  But as they aren’t willing to adopt effective policies, we can assume that monetary policy is ineffective.  Now let’s move right along and look at fiscal policy.”

At this point Krugman directs his moral outrage at the conservative knuckleheads in Congress who won’t accept anything bigger than a measly $800,000,000,000 stimulus package, which he thinks is woefully inadequate.

In my view Krugman is mixing science and advocacy in a very misleading and inappropriate way.  When he evaluates central banks, he seems to take a deterministic, scientific, and clinical attitude, as if studying a colony of ants.  (I assume that for entomologists there is no “should.” The only question is how ants behave.)  Central banks are assumed to be impervious to public pressure.  On the other hand his stance toward fiscal policy is much more normative.  Now he is an advocate, he’s part of the game, passionately calling for more stimulus.  But I don’t see how this makes any sense.  If we are going to take a deterministic view of things, it seems likely that Congress is also far too conservative to implement the sort of spending that Krugman advocates.  Indeed, hasn’t that already been shown?   Couldn’t one just as reasonably say: “Since Congress clearly won’t do what it takes, we must fall back on the Fed as our only hope for the sort of stimulus that the economy needs.”

I view my own role as that of an advocate; I am trying to change the consensus view of economists about the causes of this crisis, and the most effective solutions.  I want to describe the most effective solutions, not those I think are politically feasible.  We need to change the political climate, if that is the problem.  Indeed if policy is deterministic, then all hope is lost.  I hope that my ideas will eventually filter down to policymakers.

Krugman is 100 times more influential than I am.  With his NYT column, and his ideological allies in the White House, he is arguably the most influential economic pundit in the world.  And he is also known (for better or worse) for his moral outrage over perceived injustices.  In many cases I think he goes a bit over the top.  But here it is just the opposite.  I am outraged over Krugman’s lack of outrage over current monetary policy.
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The Financial Times is a very respected newspaper, so I guess there must be some logic to this column.  But I confess I have no idea what this Belgian professor is talking about.  First prize to someone that can explain this to me.

The dilemma for the US authorities now pops up in the following way. The US monetary authorities pursue a policy aimed at keeping inflation low. It’s not an explicit inflation target as in the case of the UK or the eurozone, but it is certainly an implicit one. This implicit inflation target is close to two per cent which implies that when the Federal Reserve issues dollars it gives an implicit promise that these dollars will buy a basket of US goods and services which is approximately constant (ie declines by only two per cent per year). Given that the US economy grows on average at a rate of close to three per cent per year, this implies that the yearly increase in the supply of dollars should be close to five per cent (two per cent inflation plus three per cent economic growth).

This price stability commitment however conflicts with the international role of the dollar. The worldwide demand for dollars increases at yearly rates that by far exceed the five per cent money supply growth rate that will keep prices in the US approximately stable.

Thus the US monetary authorities have to choose between a policy that accommodates for the high demand for dollars in the world, but then the supply of dollars will increase much faster than the one that will keep approximate price stability in the US. Alternatively, the US sticks to the inflation target, but this requires limiting the supply of dollars to a much lower level, frustrating the high demand for dollars worldwide.

If foreign demand for dollars is rising faster than US demand, doesn’t that mean that the Fed can increase the world supply of dollars at faster that 5% rate and still hit its target.  So what is the “dilemma?”

Even worse, if the Fed didn’t respond by increasing the supply of dollars by more than 5% a year, I still don’t see a problem.  Foreigners would still be free to accumulate all the dollars they wished, it would just mean that the dollar would tend to appreciate in nominal terms (but not real terms) over time.  So what’s the dilemma?

HT:  Marcus

Here is a long passage from pp. 33-36 of a November 2009 paper by Woodford and Curdia, which describes a 2003 paper by Woodford and Eggertsson (you’ll need to open the PDF):

Eggertsson and Woodford show that it can be a serious mistake for a central bank to be expected to return immediately to the pursuit of its normal policy target as soon as the zero bound no longer prevents it from hitting that target. For example, Figure 11 (reproduced from their paper) compares the dynamic paths of the policy rate, the inflation rate, and aggregate output under two alternative monetary policies, in the case of a real disturbance
(here interpreted as an exogenous increase in the probability that loans are bad, requiring intermediaries to increase the credit spread by several percentage points) that begins in period zero and lasts for 15 quarters, before real fundamentals permanently return to their original (“normal”) state.

Note:  I wasn’t able to copy the figure 11.  It is on page 61, and is worth looking at.  The dotted line shows a deep and prolonged recession with a policy of inflation rate targeting.  The solid line shows the economy avoiding a recession (and avoiding deflation) with a policy of targeting the price level.  Note that they are proposing an elastic price target, so it is actually quite close to NGDP targeting.  Of course the other difference is that they do not contemplate targeting the forecast, which I think would make it even more likely that a recession could have been avoided.
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1. I thought the weak Chinese yuan was stealing business from American firms:

Here’s today’s report on the rising US stock market.

NEW YORK (Reuters) – Blue chips rose for a sixth day, capping their longest winning streak since August on Wednesday, as an upbeat forecast from a top homebuilder and data from China pointed to a strengthening global economy.

BTW, the US stock rally started in March.  And the Chinese recovery?  It also began in March.
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You may recall that a week ago I made a sort of “Emperor has no clothes” accusation against the economics profession.  I claimed that economists are always talking about “easy money” and “tight money” without have any coherent definition, indeed not even knowing that they have no coherent definition.  In this post Bob Murphy challenges my dismissal of real interest rates as the proper indicator.  He makes some good arguments, which I will address as well as I can, but in the end I am still left with 4 reasons for dismissing the view that real interest rates provide a useful indicator of the stance of monetary policy.  Furthermore, I think that any one of these four arguments would be sufficient to prove my point:
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