Archive for the Category Monetary Theory


Endogenous money and the QTM (#4)

In the first three posts of the series I sketched out a simple model of inflation and NGDP growth.  For large persistent changes in the money supply, M dominates everything else.  But inflation reflects both money growth and changes in the real demand for money.  So real GDP growth raises real money demand, and hence is deflationary, while higher nominal interest rates reduce real money demand, and hence are inflationary.  The later point is not just NeoFisherism; higher interest rates actually cause inflation to be higher than what you’d get from money growth alone.  All my claims so far are supported by literally hundreds of money demand studies done in the 1970s and 1980s.  This stuff is not controversial for monetary economists who recall the 1970s.

Here in the final post I’ll consider the money/inflation correlation you’d expect when the money growth rate is endogenous. I’ll start with the case of Bretton Woods, which covers the first part of the period in Barro’s table.  Speaking of which, I erred in saying Barro used the monetary base; he actually used the currency stock.  But I’m quite confident that this distinction was unimportant for the period covered. (Today it would be very important.)  I also discovered that he got the data from the IMF.  Still not sure if he used differences of logs.

Under Bretton Woods, exchange rates were fixed and this tended to equalize inflation, due to Purchasing Power Parity.  But inflation rates were not completely equalized, as the real exchange rates would change over time, due to factors such as the Balassa-Samuelson effect.  There would also be gaps between money and inflation, due to differing patterns of real GDP growth and velocity growth.  And here’s the key point—there’s no logical reason to expect changes in real exchange rates to be strongly correlated with variations in money growth caused by all sorts of other factors.  This means that under Bretton Woods, the variation in inflation rates (which is identical to the variation in real exchange rates) will not be closely correlated with variations in money growth rates.

I had Patrick Horan do separate regressions for the top and bottom half of the data set, the 40 countries with the highest inflation rates and the 39 with the lowest. The top half regression had an R2 of over 98%. But here’s what he found in the bottom half:

Screen Shot 2015-08-13 at 8.29.29 PMA very low adjusted R2, below 10%.  About the best you can say is that the coefficients have the correct sign.

And the problem isn’t just Bretton Woods, the same thing happens under inflation targeting.  If everyone is targeting inflation at 2%, then any variation in inflation will simply represent central bank errors, and will likely not be strongly correlated with variation in money growth rates.

But don’t be fooled by the endogenous money correlations, or lack thereof.  Money growth is still driving inflation and NGDP; it’s just that the need to hit certain inflation/exchange rate targets is driving money growth.  If a country had decided to have 5% faster money growth, on average, then they would have had to leave Bretton Woods, and they would have had roughly 5% higher inflation and NGDP growth, on average.

Thus the entire “endogenous money” issue is often misunderstood.  It doesn’t mean that money growth is unimportant; it just means that if you are targeting something other than money, then money growth is determined by your target.  In other words, don’t say, “money growth didn’t cause X, as it’s endogenous”.  Your interest rate, or exchange rate, or inflation target caused money growth to cause X.  Money growth is still the “real thing”, even if you don’t see it in sophisticated models by Michael Woodford.

Conclusion:   A monetarist model that tries to explain NGDP growth and inflation by looking at money growth, real GDP growth and the opportunity cost of holding money does an excellent job of explaining the stylized facts of the Great Inflation, when there was enormous variation in inflation and NGDP growth.  And it does so in a way consistent with basic economic theory about how people behave, how they react to changes in the costs and benefits of holding real cash balances.  As far as I know, no other model can explain all of these stylized facts.  Indeed no other model comes close.  I’ll gladly convert to New Keynesianism or Austrianism, or Old Keynesianism, or MMTism, or Marxism, or New Classical economics, or RBC, or any other school of thought, if you can provide a coherent theoretical explanation for these stylized facts.  And if not, then please tell my why I shouldn’t keep on being a market monetarist.  I’ve got a model that works; why give it up for one that doesn’t?

The Quantity Theory at the extremes (#3)

Our initial look at the quantity theory was very positive.  Over long periods of time the growth rates of M and P are highly correlated, in a sample that includes high inflation countries.  Even better, some of the discrepancy is explained by growth in real GDP.  And better still, the coefficient on RGDP growth was approximately negative one.  Let’s use an example to think about what that means.

Suppose a country has 40%/year money growth.  Your first guess might be 40% inflation.  But now you find out that RGDP growth was 5%/year.  Now your best guess for inflation is 35%, as RGDP growth seems to reduce inflation roughly one for one.  OK, but then why not simplify the model by using NGDP as our scale variable instead of prices?  Instead of going:

inflation = money growth – RGDP growth + other stuff

We could have:

NGDP growth = money growth + other stuff

I had Patrick Horan do a simple regression of NGDP growth on money growth, and this is what he got:

Screen Shot 2015-08-11 at 10.39.20 PM

The adjusted R2 is better than for a simple regression of inflation on money growth, and almost exactly the same as when we regressed inflation on both money growth and real GDP growth (in the previous two posts.)

Let’s think a bit more about real money demand:

M/P = f(RGDP, other stuff)

The real GDP factor is obvious.  People have more demand for real cash balances as they get richer, and make more purchases.  That addresses the benefit of holding cash.  But what about the cost?  There are several ways of thinking about the opportunity cost of holding cash, such as inflation and nominal interest rates.  Inflation is the loss of purchasing power from holding cash and nominal interest rates are the foregone earnings from putting that wealth into an alternative asset. Fortunately, the Fisher Effect suggests these two variables will be highly correlated when inflation is extremely high.  So the “other stuff” could be proxied by either the inflation rate, or (better yet in my view) the nominal interest rate.

But real money demand assumes that the price level is the right scale variable.  If we shift over to NGDP, we get the following:

M/NGDP = f(i) = Cambridge K


NGDP/M = V(i) = Velocity

In the data set of 79 countries (in this post) there were 12 cases where inflation was higher than the money supply growth. In each case, real GDP growth was positive.  This meant that in those 12 cases the velocity of circulation grew faster than RGDP over a period of 30 or 40 years.  That’s actually pretty impressive, as most countries see considerable RGDP growth over 40 years.  If velocity grew even faster, then those 12 cases exhibit a pretty large total increase in V, which is a violation of the simple QTM assumption that velocity is stable.

Let’s suppose our models of money demand are correct.  What would it take for velocity to increase sharply?  The demand for money would have to decline sharply.  And that is mostly likely to be caused by a big increase in the opportunity cost of holding money.  So you’d expect to see a big rise in V in countries where the inflation rate/nominal interest rate increased very sharply.  Unfortunately the table doesn’t show the change in the inflation rate, just the average level.  But think about it, if the inflation rate rose very dramatically over that period, isn’t it likely that the average inflation rate would be rather high?  Not certain, but fairly likely.  You normally won’t see the inflation rate increase by 20% or 40% in countries like Switzerland and Germany, where the average rate of inflation was only about 3%.

The preceding view of money demand suggests that there should only be a few countries where inflation exceeded average money growth over 30 or 40 years, and that most of those cases would be countries where the average inflation rate is quite high.  And that’s exactly what we observe.  There are only 12 such countries out of 79, and yet they comprise 8 of the top 14 inflation rates.

So now we have our complete money supply model:

M/P = f(RGDP, i)

and delta M/P = delta Y – V(i)

Or to make the model even simpler:

NGDP/M = V(i)


delta NGDP = delta M + delta V(i)

Nominal GDP growth depends on two factors, money base growth plus the change in velocity.  And velocity is a function of the nominal interest rate.

This means that when the inflation rate rises very sharply, inflation will often be even higher than the money growth rate. But that’s not really a big problem for the quantity theory of money.  No one gets too upset if Argentina has 73% money growth and 76% inflation.  The problems come in the other directions, and for two reasons:

1.  When inflation slows, money growth is often higher than inflation, and sometimes even higher than before inflation slowed, for a brief period when there is a one-time adjustment in real cash balances.  That looks bad for the QTM.  This occurred briefly in the early 1980s, when inflation slowed from 13% to 4%, and the public then chose to hold larger real cash balances (and velocity fell.)  At low rates of inflation these discrepancy stand out more, and tend to discredit the entire QTM approach.

2.  This problem becomes especially severe at near zero interest rates.  Recall that base money is the world’s most liquid asset.  It has some really appealing qualities.  When interest rates fall to zero you are reducing the opportunity cost of holding this desirable asset all the way to zero.  So there can be enormous increases in base money demand.  This problem can also occur if the central bank foolishly chooses to pay market interest rates on bank reserves.

To summarize, at the zero bound the demand for base money can soar, and the money supply growth rate can vastly exceed the inflation and NGDP growth rates.  This is where the QTM looks worst.

But even in this case, money is what drives inflation and NGDP.  If the liquidity trap lasts forever then bonds become money, and the money supply gets redefined to include bonds.  In the far more realistic case where the liquidity trap is expected to be temporary, long term rate stay above zero, and permanent monetary injections still boost the price level and NGDP according to the QTM.

So far I’ve focused on exogenous changes in the money supply, which is the model that works best for the high inflation cases.  The next post will examine monetary regimes like Bretton Woods and the Taylor rule, where the money supply is endogenous.  We will see that the correlation between money and prices greatly weakens, despite the fact that changes in the money supply still cause in one for one changes in P and NGDP.

Why is growth deflationary? And why do we all think it’s inflationary? (#2)

In the previous post I sketched out the basic correlation between M and P, when M is changing really fast.  Here we’ll take a deeper look, and begin to explain why the correlation between M and P is not perfect.  Let’s start with an identity:

P = M/(M/P)

That’s a sort of stupid identity, because if you simplify you get P = P.  But it turns out to be pretty useful.  If you take rates of change you get:

inflation = (money supply growth rate) – (percent change in real money demand)

(Technically, all these equations should actually be expressed as first difference in logs.)  Where did I get the terms ‘supply’ and ‘demand’? It turns out that the central bank controls the nominal supply of base money, and the public controls how much real cash balances they want to hold.  So you can model inflation by modeling those two variables.

Now let’s return to the table in the previous post.  Notice that over 40 year periods the growth rates of M and P almost never differ by more than 10% (Libya’s the only exception.)  So one way of thinking about the correlations we see is to assume that there is some factor or factors causing the real demand for money to change, but their impact is rather modest, and doesn’t get bigger when the money growth rate gets really high.  So if real money demand is always changing by single digit annual rates over 40 year periods, then long run inflation will closely correlate with long run money supply growth, when the latter variable is growing really fast.  That’s why the QTM tends to do best in the high inflation cases, money demand changes pale by comparison.

Next let’s see if we can go a bit further, and explain the various discrepancies between money supply growth and inflation. We know that in an accounting sense it’s explained by changes in real money demand, i.e. real cash balances, but why would the public choose to hold more or less real cash balances?  What explains shifts in the real demand for money?

After Libya, two of the larger gaps are in East Asia, South Korea and Singapore.  In both cases money growth was much higher than inflation.  In an accounting sense that meant that the public in South Korea and Singapore were holding larger and larger cash balances.  Not just in nominal terms (as in Argentina) but even in real terms.  Their total holding of purchasing power rose by 9.3% per year in South Korea and 7.2% per year in Singapore, for many decades.  (The Singapore data is only for 1963-89.)  Why is that, why hold more purchasing power?  The answer is obvious—these economies grew very rapidly in real terms, and hence the real demand for money rose over time.  As the public became much richer and did much more shopping, they chose to hold larger real cash balances.

The sum of inflation and real GDP growth is NGDP growth.  If people hold larger real cash balances when real GDP grows, then perhaps the best way to think about the QTM is not to look at the correlation between money growth and inflation, but rather between money growth and NGDP growth.  In both Singapore and South Korea the money growth rate is much more closely correlated with NGDP growth than inflation. But if we insist on modeling inflation, then here’s what we have so far:

inflation = (Ms growth) – (real money demand growth)

Ms growth = f(Fed policy)

M/P growth = f(real GDP growth, other stuff)

Let’s try this conjecture.  When real GDP grows by X%, people choose to carry X% more real balances, to use for shopping, etc.  In that case, you’d expect the inflation rate to be equal to:

Inflation = Ms growth rate – real GDP growth rate + error term due to effects of other stuff

And that’s (almost) exactly what we found in the regression in the previous post.  Here I’ll first show a regression w/o real GDP growth, and then repeat the regression from the last post, with RGDP growth:

Screen Shot 2015-08-11 at 11.50.23 AM

Screen Shot 2015-08-10 at 7.46.02 PM

The coefficient on money growth is roughly one in both cases, and the coefficient on real GDP growth is roughly negative one in the second.  Growth is deflationary.  And the adjusted R2, which was already 95% in the simple regression of M and P, improves to over 96% when real GDP is added.

There is (or should be) nothing surprising about the finding that growth is deflationary, it’s the prediction of this very simple money demand model. It’s also the prediction of the AS/AD model—as the LRAS curve shifts to the right, the price level declines.  The only thing surprising is that so many people find this surprising.

By the way, suppose we label the “other stuff” with the letter V.  Then we have:

delta P = delta M – delta Y + delta V.

Look familiar?  It’s really just an identity; we need to explain the other stuff (V) to turn the Equation of Exchange into a model.

Let’s look for more hints in the data set.  Of the 79 cases, it seems like the vast majority show a money growth rate that is larger than the inflation rate.  That’s really not surprising, as almost every single country averaged positive RGDP growth over that period (except Guyana), and we’ve seen that positive economic growth holds down inflation, as the public desires to hold larger real cash balances.

Indeed the only surprise is that there were 12 cases where prices grew faster than the money supply, despite positive RGDP growth.  There were 12 cases where the inflationary impact of the “other stuff” was more than the deflationary impact of the real GDP growth.  We’ll model the other stuff in the next post, but first let’s briefly return to the issue of real GDP growth. Here are two questions:

1.  Can we assume that growth in M has no causal effect on Y in the long run?

2.  And if so, why are M and P positively correlated in the short run?

In the data set it looks like rapid money growth does not cause faster real GDP growth, at least in the long run.  The 10 highest inflation countries averaged 4.0% real GDP growth, and the 10 lowest inflation countries averaged 4.5% RGDP growth in the long run.  Money seems roughly long run superneutral, or perhaps hyperinflation is actually slightly negative for growth (as Mr. Ray Lopez has hypothesized.)

Then what’s going on in the short run?  Why does everyone think recessions reduce inflation and booms raise inflation? Here’s a hypothesis.  Suppose NGDP growth varies over time, due to monetary policy shocks.  And let’s assume that while money is long run superneutral, in the short run it has real effects–perhaps due to sticky wages and prices.  Thus in the short run, an increase in NGDP growth leads to both faster real GDP growth, and higher inflation.  In that case it would look like growth is inflationary, even though growth would actually be deflationary.  Thus if NGDP growth rose by 4%, and both RGDP growth and inflation rose by 2%, it would look like growth was inflationary.  But in fact the NGDP growth (i.e. monetary policy) was causing 4% higher inflation, ceteris paribus, and the extra 2% RGDP growth was holding down the inflation rate, limiting the increase in inflation to 2%.

If this is the way the world works then one might expect many cognitive illusions to form.  People would think growth was inflationary, whereas in fact it would be deflationary, as the regression in the previous post showed, and as our theoretical model predicts.  Procyclical inflation would reflect bad monetary policy (unstable NGDP growth) and inflation would be strongly countercyclical under a sound monetary policy regime (stable NGDP growth.)  If the central bank predicts that inflation will pick up during a boom period, they are predicting their own incompetence.

To summarize, it seems like the less restrictive version of the QTM is supported by the evidence.  If the money supply is increased by X%, this will lead in the long run to both prices and NGDP being X% higher than otherwise.  RGDP will be mostly unaffected.  But we’d still like to explain more of the discrepancies, the “other stuff.”  In the next post I’ll focus on those countries where inflation was higher than money growth, despite a growing real economy.  If you prefer to use the Equation of Exchange, then these are the rare cases where V rose by more than Y, over long periods of time.  We’ll also explain liquidity traps.

And in the post after that we’ll look at what happens when money supply growth rates are endogenous.  How does that affect the QTM?  It’s all there in the data set, if we look closely enough.  BTW, don’t think that this analysis has no implications for the low inflation world we live in today.  Monetary policy always and everywhere affects inflation and NGDP; we just need to figure out how to interpret what’s going on.

PS.  Some commenters pointed out that the data really should be first differences of logs.  That’s right, and I’m embarrassed to say that I don’t know if it is, or if it’s ordinary percentages (which is what I assumed when I had Patrick Horan calculate the NGDP growth rates.)  I’ll try to get an answer in a few days.

The best economics data set ever (#1)

Update:  People asked for a graph.  Marcus Nunes has one for a very similar (but slightly different) data set.

I’m working on turning my blog into a book, and in order to do that I need to give readers an idea of how I ended up where I am today.  One obvious need is to explain how I adopted a quantity theoretic approach to monetary analysis, rather than some alternative like the interest rate approach.  For me it all goes back to the Great Inflation of the 1960s to the early 1980s.

As an aside, the quantity theory can be defined in several ways:

1.  An X% rise in M will be associated with an X% rise in P

2.  An X% rise in M will be associated with an X% rise in NGDP

3.  An X% rise in M will cause both P and NGDP to be X% higher than otherwise, in the long run.

The third definition is probably the most accurate, and the first is the least accurate.

The following data set (from a Macroeconomics textbook by Robert Barro) is so rich in information, that we will spend many posts investigating all the implications.  It shows average inflation, money growth and real GDP growth rates over 30 or 40-year periods around 1950-90, for 79 countries:

Screen Shot 2015-08-10 at 11.02.02 AM

Right off the bat one notices the strong correlation between the growth rate of M (the monetary base) and P (the price level.) David Hume didn’t have this data set in 1752, but just using his brilliant mind he was able to figure out that if you double the money supply, the only long run effect is for prices to double.  Money is just a measuring stick.  For about 40 years Argentina and Brazil were doubling the money supply, on average, once every 14 months.  And prices were doubling just as Hume predicted.  All good, the Quantity Theory of Money (QTM) is triumphant.

Except it’s all downhill from here.  I’ve just provided the best possible data set for convincing you of the QTM.  Suppose I had only given you the bottom half of the data set?  Now the correlation is much harder to see.  Or suppose we’d looked at shorter time periods.  Again, not so good.  Or suppose we’d looked at countries at the zero bound?  Now the QTM would have major problems.

The key to understanding the QTM is to hold two thoughts in your mind at the same time.  In one sense the theory is logical, indeed blindingly obvious.  It’s incredibly powerful, incredibly true.  But in all sorts of situations it seems to fail.  That’s what we need to figure out.

Before moving on, let’s remind ourselves why it’s the bedrock of monetary theory, and why all other theories fall short.  In this data set we are doing the economic equivalent of when scientists expose objects to great heat, pressure, or speed, to get at the essential qualities.  We’re looking at what happens with very fast money growth

No other model can explain the correlations we see.  Yes, the growth in the money supply might have “root causes” elsewhere, such as budget deficits.  But you can’t figure out that Brazil and Argentina would have 75% inflation for 40 years, whereas Iceland would have 19% and the US would have 4% by looking at budget deficits, you need the money supply growth rates to even get in the right ballpark.  Note that some countries (the US in the 1970s) printed lots of money w/o big budget deficits.

Nor do interest rate models work.  Ironically the only interest rate model that would even come close is NeoFisherism, as the nominal interest rates in these countries would also be highly correlated with inflation.  But that model doesn’t tell you how you get those high nominal interest rates.  Again, you need money supply data.

Nor will an exchange rate model work.  Yes, the (depreciating) exchange rate for Brazil and Argentina was closely paralleling their inflation rate.  They saw the local currency price of US dollars rise at around 70% per year over those 40 years.  But that doesn’t explain how you cause the currency to depreciate so rapidly over 40 years. Again, you need money supply data. Both the Fisher effect and PPP are just appendages of the QTM.

Let’s finish today’s post with the first of several regressions that I’m going to give you–all provided by Patrick Horan of the Mercatus Center:

Screen Shot 2015-08-10 at 7.46.02 PMThis is the Mona Lisa of macro regressions.  The t-statistic on money growth is 45.2. Yup, I’d say there’s some truth to the QTM.  The P-value?  One over . . . umm . . . how many atoms are there in the universe?  And the coefficient is pretty close to one, within two standard errors.  When you raise the money supply at 75%/year for 40 years, you’ll get roughly 75% inflation.

Later we’ll see there’s a reason the coefficient is slightly greater than one.  Can you guess? (It’s a very hard question.) But let’s finish up by noticing the coefficient on real GDP growth (delta Y).  You’ve all been taught that economic growth is inflationary.  The people at the Fed tell us that inflation will rise as we approach full employment.  Maybe it will, but not because growth is inflationary.  As you can see from the regression, economic growth is deflationary, indeed almost exactly as deflationary as money growth is inflationary.  So are the Keynesians wrong?

Yes they are!  And they are wrong in an interesting way.  Let’s suppose their predictions turn out right, and inflation does rise as we approached full employment.  Will I admit that I’m wrong?  Of course not!!  I’m an arrogant economic blogger.  Instead I’ll claim that this bizarre outcome is proof of the Fed’s incompetence.  They so botched monetary policy that they made inflation procyclical.  Indeed they do this so often that some of my commenters think this is natural.  Poor Mr. Ray Lopez found a dictionary somewhere that says inflation naturally falls during recessions and rises during booms.

And it’s all a myth.  Don’t worry, we’ll explain the mystery of deflationary growth in the next post.  And we’ll explain why the coefficient on money growth was a little bit bigger than one in the post after that.  All our money/macro questions are answered in this data set, if we know where to look.  Put on your David Hume thinking hat, you have lots more info to work with than he had. Indeed Milton Friedman became the second most famous economist of the 20th century mostly by figuring out how this data set allowed us to go “one derivative beyond Hume.”

PS.  Here are the two “money quotes” (pun intended) from Friedman:

Double-digit inflation and double-digit interest rates, not the elegance of theoretical reasoning or the overwhelming persuasiveness of serried masses of statistics massaged through modern computers, explain the rediscovery of money.” (1975, p. 176.)

As I see it, we have advanced beyond Hume in two respects only; first, we now have a more secure grasp of the quantitative magnitudes involved; second, we have gone one derivative beyond Hume.” Friedman (1975, p. 177.)

Was it sensible to expect “this” back in 2009?

By “this” I mean sluggish growth, very low inflation, and especially near-zero interest rates.  Paul Krugman has repeatedly said “yes” and mocked people like Martin Feldstein, who expected a more conventional recovery with rising inflation and rising interest rates.  But Brad DeLong says he’s too tough on Feldstein:

Unlike Paul, I get why moderate conservatives like Feldstein didn’t find “all this convincing” back in 2009. I get it because I only reluctantly and hesitantly found it convincing. Feldstein got the Hicksian IS-LM and the Wicksellian S=I diagrams: he just did not believe that they were anything but the shortest of short run equilibria. He could feel in his bones and smell in the air the up-and-to-the-right movement of the IS curve and the upward movement of the S=I curve as investors, speculators, and businesses took look at the size of the monetary base and incorporated into their thinking about the near future the backward induction-unraveling from the long run Omega Point. My difference with Marty in 2009 is that he thought then that the liquidity trap was a 3 month-1 year phenomenon–that that was the duration of the short run–while I was much more pessimistic about the equilibrium-restoring forces of the market: I thought it was a 3 year-5 year phenomenon.

I’m somewhere in between, and also a bit off to the side.  DeLong has by far the best argument, and if you are only going to read one post, stop reading mine and read his instead.  But I’ll put in my 2 cents, FWIW.

I have a very low opinion of the IS-LM model; indeed I blame a lot of our policy failures on that model.  I think it led too many economists to write off monetary policy in late 2008, right when we desperately needed monetary stimulus.  But I reached the same conclusions as Krugman, for somewhat different reasons.

Since late 2008, I’ve consistently wanted more, more and more, but not for IS-LM reasons.  Rather I’m a market monetarist, and in my view the markets have been signaling a need for more, more and more.  I’m also a Lars Svensson-style, “target the forecast” guy, which means I always, at every single moment, want the instruments of monetary policy set at a position where expected NGDP growth equals desired NGDP growth.  Since 2008 we’ve consistently fallen short.

In contrast, Paul Krugman is much more skeptical of the market view:

Kevin O’Rourke has a post, What do markets want, raising the same issues I’ve been discussing about debt, austerity, etc.

But never mind all that: read the comments, specifically this one:

The markets want money for cocaine and prostitutes. I am deadly serious.

Most people don’t realize that “the markets” are in reality 22-27 year old business school graduates, furiously concocting chaotic trading strategies on excel sheets and reporting to bosses perhaps 5 years senior to them. In addition, they generally possess the mentality and probably intelligence of junior cycle secondary school students. Without knowledge of these basic facts, nothing about the markets makes any sense—and with knowledge, everything does.

That’s about as far from my view of markets as it’s possible to get, although I suspect that Krugman himself doesn’t really quite believe it.  Maybe it’s just my imagination, but on occasion I think I see him “peeking” at markets, to confirm his (often excellent) intuition about where things are going.  And when he fails to do so, as in early 2013, he pays a heavy price in lost prestige.

OK, so Krugman and I were right in 2009, but did we just get lucky?  Even now it’s hard to say.  DeLong spends a lot of time explaining why in a traditional macro model, even a traditional Keynesian macro model, you would not expect a recession to lead to 7 years of near-zero interest rates.  Not even a deep recession like 1982, when unemployment peaked at 10.8%.  So what happened this time?

On the other hand Krugman’s right that this isn’t actually unprecedented, we had near-zero rates from 1932 to 1951, and then again in Japan beginning in the late 1990s, and still ongoing.  So (he asks) why is anyone surprised?

In my view we had a perfect storm of shocks that just barely added up to zero rates for 7 years in the US, but not enough for Australia, and more than enough for Japan (and perhaps going forward, Europe.)  These included:

1.  A big negative AD shock.  Both a big NGDP drop in 2008-09, and an unprecedentedly slow recovery.  DeLong might argue that I am assuming the conclusion, that I need to explain this slow NGDP recovery.  I don’t quite agree, but I’ll circle back to this issue later.

2.  Bad supply-side factors.  In the US we have boomers retiring, fewer young people choosing to work, more people going on disability, and a crackdown on immigration. Then we had a 40% rise in the minimum wage right at the onset of the recession, and an unprecedentedly long extension of unemployment benefits (which DeLong correctly predicted (in 2008) would raise unemployment.)  By themselves, these factors weren’t that important, but together they had some impact.  For instance, after unemployment compensation returned to the usual 26 weeks in early 2014, job growth accelerated.

3.  A 30-year downtrend in the Wicksellian equilibrium real interest rate.  And the last step down after 2008 was aided by a structural shift in the US and Europe from investment to consumption, as an after effect of the housing bust and tighter lending standards.

In my view the weak NGDP growth is monetary policy.  Period, end of story.  But DeLong would want something more:

In the long run… when the storm is long past, the ocean is flat again.

At that time–or, rather, in that logical state to which the economy will converge if values of future shocks are set to zero–expected inflation will be constant at about the 2% per year that the Federal Reserve has announced as its target. At that time the short-term safe nominal rate of interest will be equal to that 2% per year of expected inflation, plus the real profits on marginal investments, minus a rate-of-return discount because short-term government bonds are safe and liquid. At that time the money multiplier will be a reasonable and a reasonably stable value. At that time the velocity of money will be a reasonable and a reasonably stable value. Why? Because of the powerful incentive to economize on cash holdings provided by the sacrifice of several percent per year incurred by keeping cash in your wallet rather than in bonds. And at that time the price level will be proportional to the monetary base.

So you can’t explain why the massive QE didn’t lead to a big growth in NGDP unless you can explain how interest rates stayed near zero for 6 years after the recession, holding down velocity.

My response is that, yes, back in 2009 it would have been hard to predict near-zero rates in 2015.  The markets didn’t expect that and neither did I.  We had that perfect storm described above.  But that doesn’t matter.  You take policy one step at a time.  The markets were also telling us that the policies that so many thought “extraordinarily accommodative” were in fact woefully inadequate.  That’s all we knew in 2009, but it’s also all that we needed to know in 2009.

Krugman sees traders as drug-crazed yuppies.  I see economists and Fed officials as stupid bulls that need a ring in their noses.  Then you attach the rings to the markets, and let those 22-27 year old drug-addled traders lead us to a glorious world where expected NGDP growth is always on target and where bailouts and fiscal stimulus aren’t needed.  A world where Say’s Law is true even though it’s not really true (I stole that last one from Brad DeLong.)

HT:  Marcus Nunes