Here’s Paul Krugman, in his pessimistic mood:
You might think that it’s a fundamental insight that doubling the money supply will eventually double the price level, but what the models actually say is that doubling the current money supply and all future money supplies will double prices. If the short-term interest rate is currently zero, changing the current money supply without changing future supplies — and hence raising expected inflation — matters not at all.
And as a result, monetary traction is far from obvious. Central banks can change the monetary base now, but can they commit not to undo the expansion in the future, when inflation rises? Not obviously — and certainly “credibly promising to be irresponsible”, to not undo expansion in the face of future inflation, is a much harder thing to achieve than simply acting when the economy is depressed.
Just to be clear, Krugman is not saying the central bank must promise a specific future money supply on a specific date, he’s saying the expected future money supply must be large enough to produce a specific expected future inflation rate (or price level.)
There are several possible solutions to the credibility problem. One that both Michael Woodford and I have discussed is level targeting. Suppose the central bank always falls short of its price level or NGDP target by 1%, due to a lack of credibility. You might argue that this describes the current situation in Japan, for instance. If the central bank has a level target, that shortfall only has significant macroeconomic effects in the very first year. After that the level of the target variable continues to fall 1% below target, but the growth rate of the aggregate (which is what really matters) is always on target (after the first year.)
A second solution is to adjust the monetary base as needed to peg the price of CPI futures, or NGDP futures. That will keep expected future growth in the nominal aggregate right on target. If that seems “to good to be true,” it’s because it exposes the fact that worry about “liquidity traps” is actually worry about something else—the size of the central bank balance sheet. But in the long run the central bank balance sheet will be smaller with a more expansionary policy, and perhaps (as the Swiss central bank showed a few years ago) even in the short run. If the central bank balance sheet is too big for comfort when you are hitting your target for expected future inflation, or expected future NGDP growth, then raise the Price level/NGDP target path or lower the rate of interest on reserves.
In my view this is where Krugman goes off course. He assumes that if the central bank has done a lot, and has still fallen short, it would have had to do even more to succeed—bleeding into fiscal policy. In fact, just the opposite is true. The central banks that succeed are those (like the Reserve Bank of Australia) that do the least. That’s because faster NGDP growth leads to a much lower desired ratio of base money to GDP, and hence smaller central bank balance sheets.
Just to be clear, I have supported QE in both Britain and the US, on the grounds that (a) central bank purchases of longer-term and riskier assets may help and can’t hurt, and (b) given political paralysis in the US and the dominance of bad macroeconomic thinking in the UK, it’s all we’ve got. But the view I used to hold before 1998 — that central banks can always cause inflation if they really want to — just doesn’t hold up, theoretically or empirically.
I seem to recall that Krugman was quite pessimistic about the ability of the BOJ to succeed in producing inflation, at least a few years ago. But when they raised their inflation target to 2%, they did succeed in moving from deflation to mild inflation (albeit still short of the 2% goal.) The good news is that we now know that the Japanese government can sharply depreciate the yen anytime it wishes to (something else that Krugman had originally doubted.) That means the BOJ can inflate–it’s just a matter of how committed they are to make it happen. In a sense this is also Krugman’s view (when he’s in the more optimistic mood), and he’d undoubtedly argue that the political push from Abe helped the BOJ. In the past Krugman seemed to think fiscal stimulus was an easier sell politically. That may be true in a few cases, but in Japan monetary stimulus has turned out to be the easiest part of the three-part reform project. And monetary policy doesn’t have to worry about fiscal offset, in the way that fiscal policy must worry about monetary offset.
On the other hand, my recent Econlog post on the ECB shows an almost Krugmanian level of pessimism. I just don’t see the institutional resolve at the ECB to raise inflation up to their 1.9% target. Europe badly needs to rethink everything they are doing, from the ground up.
HT: Ken Duda