For six years Paul Krugman has been engaged in an intellectual war against the forces of evil on the right. Those who claim that monetary stimulus would lead to high inflation. Over that same period I’ve been engaged in a three-way struggle; market monetarism against the forces of misguidedness on both the left and the right. (Unlike Krugman I believe my opponents are well intentioned.) Monetary stimulus won’t lead to high inflation, and it’s not ineffective. For once I’m the sensible moderate. Now the battle continues—and this time it’s Krugman’s post that needs correcting:
Switzerland has never paid interest on reserves — and lately it has taken to doing the opposite, charging banks 0.25 percent for the privilege of parking their money at the central bank. So has the Swiss National Bank’s huge increase in the monetary base, which dwarfs what the Fed has done, produced inflation?
Well, look at the included chart. Monetary base up by a factor of eight. Money supply up by much less, because banks didn’t lend the funds out. And consumer prices flat, indeed flirting with deflation.
This is all exactly what a basic liquidity trap model — the one I laid out in 1998 — predicted. So the inflationistas are finally going to concede their mistake, right?
As I’ve noted before, the 1998 model doesn’t say monetary policy is ineffective, indeed soon after it was published he was using the model to argue against fiscal stimulus and in favor of monetary stimulus in Japan.
In 2010 the Swiss franc had become too strong for comfort, and the Swiss National Bank was buying up lots of foreign assets to hold down its value. By then Krugman had become very skeptical of the effectiveness of monetary stimulus at zero rates:
Oh, and about the exchange rate: there’s this persistent delusion that central banks can easily prevent their currencies from appreciating. As a corrective, look at Switzerland, where the central bank has intervened on a truly massive scale in an attempt to keep the franc from rising against the euro — and failed:
Later I pointed out that even that claim was wrong, but at least it was plausible. Beginning in September 2011, however, the claim was no longer even plausible, as the SNB depreciated the franc sharply and then pegged its value to the euro. As I’ve argued many times, there is much in Krugman’s monetary analysis that is correct, and even ahead of his critics. But there is one fatal flaw, shared by many of my commenters. Krugman assumes that if a central bank has done X purchases of assets, and failed to hit its nominal target, then it would have to do more than X to hit its target. But in the Alice in Wonderland world of monetary economics, it’s exactly the opposite; the more ambitious your target, the less you have to do. And that’s equally true of exchange rate targets and NGDP targets. Among the developed countries, Australia had the most ambitious NGDP target in this century, and its central bank has had to do the least to hit it.
In 2012 Evan Soltas provided evidence that as soon as the SNB started pegging the exchange rate, they didn’t need to buy anywhere near as many foreign assets to hold down the value of the SF.
Its credibility is so powerful, in fact, that the SNB has stopped having to buy up foreign currencies with new swiss franc, which it did in earnest to prove its commitment in 2011, increasing its foreign exchange reserves by 177 billion from July to September. It hasn’t had to defend at all the value of its currency against appreciation since September, despite what should be enormous pressures. (See here and here for the data.) That is truly remarkable, when you zoom out for the macroeconomic big picture.
That is the power of credible monetary promises. And we can do the same thing with the price level path, of course, managing correctly the striking strength of market expectations. All it takes is the appropriate use of the expectational channel; re-establish 5 percent annual NGDP growth as did the SNB for its currency, and then the market will do the rest for you.
I found some monetary base data that is quite interesting. From January to September 2011 the Swiss monetary base soared from 79b SF to 253b SF. That’s Zimbabwean money printing, and it shows why Krugman is so contemptuous of the inflationistas. Switzerland got essentially zero inflation. But then something interesting happened; after the currency was depreciated and pegged at 1.2 SF/euro, the base actually fell to 215b by May 2012. Once investors stopped thinking the SF was going to move ever higher, they no longer had a strong incentive to speculate in that asset. It became easier to defend the currency.
Alas, there was one more attack in mid-2012, as eurozone investors worried about a collapse in the euro. Naturally, in that environment the SF would be attractive at even a zero expected rate of return. The base rose again to 349b SF in September 2012, at which point growth slowed sharply (it’s 376b today.) More importantly, the 1.2 SF/euro peg held. Krugman was wrong, currency depreciation is not difficult if it is followed up with a level targeting regime.
With the recent collapse of the Russian economy, the SNB imposed a negative 0.25% interest rate on reserves. So I suppose you could call that a “problem,” that is, if having the rest of the world be willing to pay you to accept their loans is considered problem. Personally, I can think of lots of other European countries that would be happy to trade places with Switzerland. Starting with Greece, and ending with . . . let’s face it, except for Norway wouldn’t any of them rather be in Switzerland’s shoes right now?
The recent success of the SNB and the BOJ in their attempts to depreciate their currencies is pretty conclusive evidence that the liquidity trappers are wrong. Yet Paul Krugman continues to trumpet his successes against the inflationistas, which quite frankly is like shooting ducks in a barrel, and ignore the monetary theory that is superior to both the crude quantity theory and crude liquidity trap Keynesianism. The only macro theory capable of explaining all of the major stylized facts of the past 6 years.
The theory that didn’t even have a label until Lars Christensen named it in 2010.