Be careful what you link to

Paul Krugman recently argued that Keynesian economics is alive and well, and linked to this paper by Greg Mankiw, which summarizes the principles of new Keynesian economics.  Unfortunately it was typed back in the Stone Age, so I can’t cut and paste.  And I’m too lazy to re-type, so I’ll summarize the gist of Mankiw’s explanation of new Keynesianism:

1.  It probably shouldn’t even be called Keynesian; don’t waste time with the General Theory.

2.  It uses lots of classical principles.

3.  Paradox of thrift?  Fugetaboutit.

4.  Similar to the economics of Hume and Friedman.

5.  Don’t do discretionary policies, follow a rule–preferably NGDP targeting.

6.  Don’t bother with fiscal stabilization policy, use monetary policy.

I will include one exact quotation from the 1991 paper:

For the purpose of analyzing economic policy, a student would be better equipped with the quantity theory of money (together with the expectations-augmented Phillips curve) than the Keynesian Cross.  In the United States today fiscal policymakers have completely abdicated responsibility for economic stabilization.  Their inability to cope with persistently large government deficits has left them unable to even imagine trying to reach consensus on countercyclical fiscal policy in a timely fashion.  All attempts at stabilization are left to monetary policy.  When a recession ensues, as it did recently in the United States, fiscal policymakers merely begin discussions of what the Federal Reserve did wrong.

Reading this brought tears to my eyes.  A mere 20 years ago we were in a golden age of macroeconomics.  Now a new dark age has set in, as the forces of old Keynesianism have made Mankiw’s vision seem like a distant dream.

PS.  Try to imagine Obama, Pelosi, and Reid in early 2009 sitting around discussing what the Fed did wrong in 2008.

PPS.  Krugman’s post contains this comment:

What actually happened in the 70s was that the Chicago guys stopped reading anyone who wasn’t a true believer, which meant that they missed the revival of Keynesian economics (pdf) (yes, that’s a paper by Greg Mankiw), and all that went with it.

I think some Chicago economists are guilty as charged.  But I wonder whether Krugman himself read Mankiw’s paper.  If so, is this his vision of Keynesianism?

HT:  JL


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65 Responses to “Be careful what you link to”

  1. Gravatar of Morgan Warstler Morgan Warstler
    3. January 2012 at 15:41

    this is a VERY strong post.

    “Try to imagine Obama, Pelosi, and Reid in early 2009 sitting around discussing what the Fed did wrong in 2008.”

    Bill Clinton did it right. Democrat handed a steep debt laden credit card, he did exactly what Greenspan wanted.

    Once Republicans learned the spend-it-all gambit, this is all Democrats can do. To truly respond in kind, Democrats have to adopt a Balance Budget Amendment mindset – truly let voters choose guns or butter. When wars have to be paid for with today’s taxes and war bond sales, we won’t have a Military Industrial Complex.

    But Dems are going to have to have a couple more Clintonian-style cycles before they figure it out.

  2. Gravatar of Invisible Backhand Invisible Backhand
    3. January 2012 at 15:47

    Off topic, but just listened to your interview with Russ Roberts. Loved it. Good job talking over Russ every time he tried to interrupt, he’d try to get you to say aggregate demand didn’t exist if you let him.

    You were a bit too charitable at one point, you merely said “the makers of monetary policy” were I would have said, “the rich and powerful” ;)

  3. Gravatar of Andy Harless Andy Harless
    3. January 2012 at 15:59

    I don’t think the Mankiw paper considers the possibility of the federal funds rate hitting the zero lower bound. The New Keynesian consensus it describes is basically conditional on the assumption that this would never happen (an assumption that, as I recall, seemed so reasonable at the time that it could go without saying). Once people realized it could happen (and different people realized at different times, many not until long after it was observed to happen in Japan), the consensus blew up (although the basic model was still the same), and New Keynesians were all over the map regarding the appropriateness of fiscal policy. I would say, though, that any New Keynesian who extrapolates from Greg Mankiw’s 1991 vision to the world we live in today would be likely to favor either fiscal policy or a higher inflation target (or a price level target that implies higher inflation in the short run).

  4. Gravatar of Brito Brito
    3. January 2012 at 16:02

    I don’t know about that Mankiw paper, but in general Mankiw’s version of New Keynesian economics is Keynesian in some senses, principally through nominal rigidities and monopolistic competition (remember price not being equal to MC is pretty much the start of the general theory).

    Still I’d agree Krugman isn’t really a New Keynesian, or at least, I don’t recall him contributing to the New Keynesian DSGE literature. He’s a neokeyensian of the Hicksian type.

    Where he DOES have a point is that RBC and New Classical theories caused some Chicago economists to think that government cannot stabilise the business cycle, whereas modern New Keynesian literature showed that they can, i.e. they were obviously wrong to think the economics was even close to settled.

  5. Gravatar of Patrick R. Sullivan Patrick R. Sullivan
    3. January 2012 at 16:04

    ‘I wonder whether Krugman himself read Mankiw’s paper.’

    I’m betting, no.

  6. Gravatar of david david
    3. January 2012 at 16:08

    Almost certainly this is Krugman’s vision of Keynesianism, or at least compatible with it; recall that Krugman is an international trade theorist, not a New Keynesian specialist like Mankiw. What Krugman cares about is that the broadly Keynesian relationships between aggregates hold, not the choice of microfoundations in particular.

    And from this perspective the difference between sticky-wages Hicksian IS/LM and sticky-prices New Keynesian macro a la Mankiw, Romer, or Yellen is not terribly large. The key is that both produce the desired dynamics: expansionary policy is expansionary, etc. The fiscal multiplier, in both, is non-zero.

    Remember that Mankiw himself has argued that fiscal policy may be optimal at the zero bound and an incredible central bank (with Matthew Weinzierl) – this is hardly different from Krugman’s own position, although the magnitudes almost certainly differ.

  7. Gravatar of Martin Martin
    3. January 2012 at 16:09

    Well you recently quoted (econtalk) Krugman back from 1999 arguing as much. The difference between then and now, is that Krugman has been doing some thinking on the notion of a liquidity trap and now argues that fiscal policy still has a role to play. Although you’ve seen him going back and forth between 1999 and now on the relative merits of fiscal and monetary policy.

  8. Gravatar of Integral Integral
    3. January 2012 at 16:16

    1. To be fair: NK economics is nothing more than RBC + product variety + Calvo pricing. It “looks very classical” because it is very classical.

    2. “the quantity theory + an expectations-augmented PC” sounds an awful lot like the typical Market Monetarist’s implicit model. Just saying.

    3. I thought Scott was joking when he made the aside about NGDP targeting, but nope: it’s right there in the paper, on page 9. I’m a little bemused.

  9. Gravatar of RN RN
    3. January 2012 at 16:42

    So you’re actually claiming Krugman didn’t even read that paper?

    Unbelievable how low you’ll stoop.

  10. Gravatar of ssumner ssumner
    3. January 2012 at 16:44

    Thanks Morgan,

    Thanks IB,

    Andy, I agree that the zero rate situation threw us off course (although rates never hit zero (yet) in Europe, so what is their excuse?)

    And the zero rate bound didn’t just mess up Keynesianism, it also messed up monetarism and Austrianism. That’s because when rates hit zero the demand for money soars, as does the supply (in most cases), and the old-line monetarists and Austrians think money is easy and high inflation is just around the corner. It pretty much messed up all of macro, which is why I got into blogging.

    Brito. I agree, although the classical economists also believed in wage and price stickiness, so there’s really nothing “Keynesian” about that idea. The NK model is roughly the model Keynes was rebelling against in the early 1930s.

    Patrick, I won’t take that bet!

    David, You said;

    “The fiscal multiplier, in both, is non-zero.”

    Unless the central bank is an inflation targeter, then it is zero.

    I don’t recall Krugman saying that students who want to understand economic policy should study the QT of M, and pay no attention to the General Theory, but I agree that he accepts much of this in the non-zero bound situation.

    Martin, Actually, he developed his liquidity trap model (the one he always cites today) back in 1998. So the 1999 paper did not reflect his pre-liquidity trap views.

    Integral. Seriously, this paper is basically my view of the economy. It’s market monetarism. I wasn’t joking about it being a sort of golden age, I really believe that.

  11. Gravatar of ssumner ssumner
    3. January 2012 at 16:45

    RN, I assume you are joking, I certainly was.

  12. Gravatar of david david
    3. January 2012 at 16:50

    “The NK model is roughly the model Keynes was rebelling against in the early 1930s.”

    This seems a little implausible, given Ch. 19 of General Theory, which openly asserts the equivalence of monetary policy and general wage adjustment if it is taken as given that expansionary money is expansionary (which the GT leaves as unknown).

  13. Gravatar of david david
    3. January 2012 at 17:11

    The “individual rationality, such-and-such aggregate outcomes” wasn’t even rigorously proven until Arrow et al came along, isn’t it?

  14. Gravatar of david david
    3. January 2012 at 17:15

    Mankiw pings back.

  15. Gravatar of marcus nunes marcus nunes
    3. January 2012 at 17:21

    Krugman must be thinking: “What the hell did I do”?

  16. Gravatar of Brito Brito
    3. January 2012 at 17:28

    “Brito. I agree, although the classical economists also believed in wage and price stickiness”

    Well the New Classical growth models I have been taught seem to assume perfect competition and no price/wage rigidity, so perhaps they believed it but didn’t model it, or perhaps I’ve been taught the wrong models.

    “so there’s really nothing “Keynesian” about that idea. The NK model is roughly the model Keynes was rebelling against in the early 1930s.”

    Wikipedia: “Keynesian economics argues that private sector decisions sometimes lead to inefficient macroeconomic outcomes and, therefore, advocates active policy responses”

    In New Keyensian economics price rigidity can lead output to deviate from its efficient and natural level, demand side policy can restore output back to its natural level. That sounds consistent with the above quote. Wiki:

    “Because of what he considered the failure of the “Classical Theory” in the 1930s, Keynes firmly objects to its main theory — adjustments in prices would automatically make demand tend to the full employment level.”

    Seems also consistent with NK. I’d agree that NK differs significantly from old Keynesian economics, but I wouldn’t say it’s entirely non Keynesian.

  17. Gravatar of K K
    3. January 2012 at 18:27

    Scott,

    “Paradox of thrift?  Fugetaboutit.”

    He most certainly does not say that. He says:

    “By contrast, few economists today believe that excessive saving threatens the economy”

    Bear in mind that he is writing in 1991. Rates were at 8%! And we hadn’t been near the zero bound for, what, 60 years? He is speaking of the context within which the demand for saving is well regulated by the CB through expectations of the short rate.

    Lower down he says:

    “rather than being concerned with excessive saving, most American economists fear that the US saving rate is inadequate to maintain Americas’s high standard of living”

    Do you think he is saying that the market can produce inefficiently low levels of saving but never inefficiently high ones?

    I am quite certain that Mankiw understands that it is exactly the paradox of thrift that acts to depress output in the context of an excessively high short rate, and that the possibility of a liquidity trap is currently very real. If you want evidence that he may now feel concerned look no further than his textbook which since 2003 has included discussion of both the liquidity trap and the paradox of thrift and if you want something more recent, how about this 2008 NYT article, the topic of which is “What would Keynes have done” and the first two paragraphs of which are the paradox of thrift and which include this quote: “IF you were going to turn to only one economist to understand the problems facing the economy, there is little doubt that the economist would be John Maynard Keynes. Although Keynes died more than a half-century ago, his diagnosis of recessions and depressions remains the foundation of modern macroeconomics. His insights go a long way toward explaining the challenges we now confront.”

  18. Gravatar of David S. David S.
    3. January 2012 at 18:33

    Scott,

    I don’t think the paper rejects the idea of a paradox of thrift. As I understand it, the paradox is basically a short-run argument, where people in general try to push their spending below their income and so aggregate income falls. Normally the interest rate adjusts to align things, but with the challenges of the zero lower bound, it’s not. In Mankiw’s piece it seems like he’s talking more about long-run investment and growth issues, which I think ignores the business cycle.

  19. Gravatar of W. Peden W. Peden
    3. January 2012 at 18:53

    Brito,

    “Keynesian economics argues that private sector decisions sometimes lead to inefficient macroeconomic outcomes and, therefore, advocates active policy responses”

    Surely too broad a criterion. I’m pretty sure that such a criterion would make us catergorise Milton Friedman as a Keynesian: the K% Rule and a NGDP rule differ in form but not in type. Ditto Fisher. In fact, you could argue that an inflation target and the Gold Standard + central bank are not SO different: one targets the price of money, the other targets the price of gold.

    Such a proposition is certainly a premise of Keynesianism, but it’s not a criterion of Keynesianism and it’s too common to really call “Keynesian”.

  20. Gravatar of Brito Brito
    3. January 2012 at 18:57

    W. Peden, what do you think the criterion should be then?

  21. Gravatar of Response to Brad De Long (Star Wars Themed) « Portrait of the Economist as a Young Man Response to Brad De Long (Star Wars Themed) « Portrait of the Economist as a Young Man
    3. January 2012 at 19:15

    [...] http://www.themoneyillusion.com/?p=12529 [...]

  22. Gravatar of W. Peden W. Peden
    3. January 2012 at 19:54

    Brito,

    A good question. Wasn’t it DeLong who said that the only thing in the General Theory that was unambigiously original was the liquidity trap?

  23. Gravatar of W. Peden W. Peden
    3. January 2012 at 19:55

    (Obviously, we’d end up with a set of criteria and even then I wouldn’t be surprised if they didn’t supply necessary & sufficient conditions for someone being Keynesian.)

  24. Gravatar of Brito Brito
    3. January 2012 at 20:44

    I remember one of my professors /I think/ saying that a model is New Keynesian when it has nominal price rigidity and real wage rigidity, and becomes Keynesian when it includes nominal wage rigidity on top of real wage rigidity. The problem is I can’t remember whether it was nominal rigidity on top of real rigidity or real rigidity on top of nominal rigidity.

  25. Gravatar of david david
    3. January 2012 at 20:48

    @Brito

    “Current” NK theory has all four possible combinations of real/nominal/price/wage rigidity, so…

    Ultimately it tends to boil down to some manner of Calvo equation anyway.

  26. Gravatar of Brito Brito
    3. January 2012 at 20:54

    @David

    Or Taylor or Caplin Spulber or Fischer or hybrid model etc… Calvo isn’t the only model of price stickiness, although admittedly it is probably the simplest to compute mathematically.

  27. Gravatar of Kevin Donoghue Kevin Donoghue
    4. January 2012 at 03:41

    Mankiw: “To some old Keynesians, new Keynesian economics may be hard to recognize as Keynesian at all. Indeed, new Keynesian economics may appear more similar to the classical economics of David Hume, or even to the monetarist economics of Milton Friedman.”

    I don’t think Krugman would dispute that at all. He rarely says anything harsh about Friedman’s economic theory (as opposed to his policies) and Hume is one of his heroes. Indeed one of his regular complaints about Lucasians is that they have abandoned Friedman.

    Of course Paul Krugman’s Keynes is a very different character from Joan Robinson’s Keynes. What would she say about Krugman and Mankiw calling themselves Keynesians? She would probably say that they are both new-fangled Bastard Keynesians, building on the tradition of Hicks and Samuelson.

  28. Gravatar of MostlyAPragmatist MostlyAPragmatist
    4. January 2012 at 04:29

    Three things:

    1. The paradox of thrift clearly has to do with monetary policy at the zero lower bound and Mankiw was pretty clearly (and understandably) not considering that in 1991.
    2. Mankiw agrees with Krugman on the importance of fiscal stimulus in 2008-2012, but as a Republican thinks it should mostly take the form of tax relief for higher earners.
    3. It’s not at all clear that Mankiw thinks Krugman misread his paper. In typical Mankiw fashion, he quotes Scott but doesn’t say that he agrees. He often does this when someone makes a point that’s helps his side (or criticizes his opponents) but that he can’t agree with for fear of damaging his reputation as an honest, accurate academic.

  29. Gravatar of K K
    4. January 2012 at 05:31

    MostlyAPragmatist: “The paradox of thrift clearly has to do with monetary policy at the zero lower bound and Mankiw was pretty clearly (and understandably) not considering that in 1991.”

    I agree with the substance of everything you are saying, but I think it’s important that the paradox of thrift is about excessive demand for savings at some given (excessive) level of the risk free rate. The liquidity trap occurs when that excessive rate happens to be zero. From that perspective I’d think the paradox of thrift was pretty relevant in 1991 as the Fed was busy using it to kill the US economy. I doubt that with the benefit of hindsight, Mankiw would disagree. And you really nail the essence of Mankiw as a public figure in your third point.

  30. Gravatar of ssumner ssumner
    4. January 2012 at 06:19

    David, The last place anyone should look for a description of “classical” economics circa the 1920s is the General Theory. It’s well known that Keynes totally misrepresents his opponents. The standard 1920s model included a sort of Phillips Curve, sticky wages and prices, and many favored price level targeting. That’s pretty new Keynesian.

    Marcus, I already know his response–”The zero bound changes everything.”

    Brito, There is no relationship at all between new classical and classical macro. The classical economists believed money was non-neutral because of wage and price stickiness.

    Don’t rely on Wikipedia, very few people have bothered to read classical economics, I’m one of them. As far as I know, all macroeconomic historians agree with me, sticky wages and prices was the standard assumption, pre-Keynes. This is certainly true of Hume, Fisher, Pigou, Hawtrey, Cassel, Wicksell, and many other famous economists.

    K, There is one big problem with your argument. In this paper Mankiw is discussing how NK economics differs from Keynesian economics. So obviously he doesn’t agree with you that their views on saving are the same.

    This post is discussing Mankiw’s views in 1991, not in 2008. I’ve consistently argued that almost all major economists moved away from their past writings in 2008. Mankiw just linked to this post, if he thought I misrepresented his views I’m surprised he didn’t say so

    David, Keynes also saw too much saving as a long run problem. That’s what I meant, and that’s clearly what Mankiw thought was different about NK.

    Kevin, Krugman said some very harsh things about Friedman’s theories right after he died. Especially his monetary view of the Great Depression. (While other Keynesians were praising Friedman.) Indeed Krugman said Friedman was intellectually dishonest, and right after Friedman died! I do agree, however, that Krugman likes Friedman more than he likes the modern Chicago school.

    Regarding Joan Robinson, she’d certainly say that about Mankiw, and the Krugman of 1999. I’m not quite so sure about the Krugman of 2009.

    Mostly a Pragmatist. I disagree with point 1 (see my 2nd answer to David), and agree with point 2 (but that point has no bearing at all on this post.)

    MAP and K, It’s obvious to anyone with half a brain that Krugman’s views on economics have changed radically from the 1990s, when he was a moderate. It’s obvious that Mankiw understands this, and is poking fun of Krugman with this fact in mind.

  31. Gravatar of herb jacobs herb jacobs
    4. January 2012 at 06:33

    Keynes versus tax cuts, it is my belief that when Obama took office, Christine Romer proposed tax cuts over deficit spending and Harry Reid and Nancy Pelosi said fine but we can’t give tax breaks to the rich, only to say the bottom 50% earners and Christine said then tax cuts won’t work because we need to increase discretionary spending and the top 20% account for maybe 50% of discretionary spending and the tax cuts died a painful death.

  32. Gravatar of Kevin Donoghue Kevin Donoghue
    4. January 2012 at 06:52

    Krugman said some very harsh things about Friedman’s theories right after he died.

    Yeah, really harsh:

    Friedman’s critique of Keynes became so influential largely because he correctly identified Keynesianism’s weak points. And just to be clear: although this essay argues that Friedman was wrong on some issues, and sometimes seemed less than honest with his readers, I regard him as a great economist and a great man.

    to say nothing of:

    Friedman’s theoretical work is universally admired by professional economists.

    (Would that that were true. I don’t believe Fama and Cochrane have read Friedman and I don’t see how they could agree with him if they did.)

    Okay, I admit I’m cherry-picking quotes here. Best to read the full essay, which I think can fairly be described as favourable to Friedman the theorist, but not to Friedman the policy wonk. Here it is:

    http://www.nybooks.com/articles/archives/2007/feb/15/who-was-milton-friedman/?pagination=false

  33. Gravatar of K K
    4. January 2012 at 07:19

    Scott: “In this paper Mankiw is discussing how NK economics differs from Keynesian economics. So obviously he doesn’t agree with you that their views on saving are the same.”

    I think you are being deliberately obtuse. Old Keynesians did *not* recognize the possibility of the economy (demand for savings) being fully regulated by the short rate, even away from the ZLB. NKs do. This is how OKs and NKs differ. That’s what Mankiw was talking about in ’91 when the ZLB was far out of sight.

    “This post is discussing Mankiw’s views in 1991, not in 2008. I’ve consistently argued that almost all major economists moved away from their past writings in 2008.”

    There is no reason, whatsoever, to believe that he changed his mind on the theory between 1991 and 2008. The NK explanation for the operation of rates on the economy was and still is the paradox of thrift. You are making a big mistake if you conflate that with the liquidity trap. The liquidity trap is the paradox of thrift at work *at the ZLB*. What changed between ’91 and ’08 is the nominal natural rate and that is why Mankiw is right to emphasize Keynes in ’08 and not in ’91. I would give him great credit for being very consistent in his theoretical approach over the entire period (probably more so than Krugman).

  34. Gravatar of Mike Sax Mike Sax
    4. January 2012 at 08:20

    So that’s your golden age? I never thought much of Mankiw-how much of a “Keynesian” could he be as Bush’s number one economist. If the Bush tax cuts were Keynesian it was a fairly bastaraderized version-much more simple supply side tax cuts than anything to do with Keynes even if he did try to sell it as a stimulus. Certainly he did a fine job of coping with Bush’s huge government deficits

    “Now a new dark age has set in, as the forces of old Keynesianism have made Mankiw’s vision seem like a distant dream”

    Who are these old Keynesians exactly? Surely you don’t mean Krugman, Romner, Delong, or Ygleias? who have all signed in on NGDP. I’m not saying your attacking straw men but a few names will be helpful.

  35. Gravatar of Lars Christensen Lars Christensen
    4. January 2012 at 08:41

    Frankly, we can not blame old Keynesians like Krugman for being Keynesians, but it is a lot more disappointing that today’s “Chicago” economists have learned nothing from Friedman…I don’t think it is a coincidence that all of the Market Monetarists that were educated at Chicago learned their economist in the 1960s or 1970s and not recently.

  36. Gravatar of K K
    4. January 2012 at 11:07

    Scott,

    I just reread my comment. I apologize for accusing you of deliberate obtuseness. It was totally uncalled for. I’m sure these are just genuine differences in our world views that make us see things so radically, but sincerely, differently.

    Sorry

  37. Gravatar of Brito Brito
    4. January 2012 at 11:28

    @Scott

    Whoops, misread you, for some reason I thought you said new classical when you said classical

  38. Gravatar of pat toche pat toche
    4. January 2012 at 11:59

    This short paper by Mankiw is a sort of stand-in for the famous two-volume with Larry Ball on New Keynesian Economics. As far as I can tell, that’s the point Krugman was making, he could just as well have quoted a paper by Blanchard for instance. The point is that the “bad guys” haven’t read New Keynesian Economics.

    The zero lower bound is post-Japan stuff, so not relevant to the New Keynesian Econ before about 1995. The point is that if you won’t read NKE, you won’t be equipped to think about the zero lower bound, fiscal policy and all that.

    The “bad guys” reference is to a paper by Barro entitled something like “The good bad and the bad guys.” Look it up. That’s where Barro and Cochrane and Fama and Mulligan are coming from. Imagine explaining a paper like Barro’s to real scientists…

  39. Gravatar of Cthorm Cthorm
    4. January 2012 at 12:53

    A bit off topic, but Gross has expanded on his editorial from last month. FT Alphaville has a good breakdown of it here.

    My favorite quote: “Deflation would reward the holders of ‘non-productive’ government debt, while inflation would reward the holders of tangible real assets. QE (or a lack of QE), meanwhile, could help tip the balance either way.”

    Which is a pretty clear endorsement of the need for inflation to bring the system back to normalcy.

  40. Gravatar of Randall Randall
    4. January 2012 at 12:54

    Harless makes a good point. Keynesian did’t consider 0 bound risk free rates. This issue is paramount to what is shaping the market now and into 2013. Im a banker not an economist and the market dynamics today have never been seen before. The markets risk free rate/10y Tbill is (-0)% which eliminate secondary market yeild, so banks hoard capital because the overnight security (paid by feds) is better than the market return even if adjusted for a 10% default with 80% recovery creating tight credit. Coupled with the EUs liqduidity crisis a flight to safety to the greenback. So sovereign treusurys buy into the market to cover and support their dollar denominated reserves. This is great for the US. The high demand at 2&10YR auctions has positioned the tresuary to sell more debt into the market to rollover older debt at near zero cost which will have a profound affect on our deficiet and my unfortuantely give Keynesian a false sense of security and encourage bad behavior. The near term zero0 US rate enviroment coupled with the EU liquidity barriers would ordinarily be dilutive to the dollar but give this market will become the 3rd leg of a self reinforcing market cycle. Reinforcing support in the 0 bound trade against any currency creating potentiall large tails in both directions. This is the issue PIMCO/Goss outlined. Its a new day for the carry trade, where developing markets once provided both growth and returns, they will be subjugated to growth yielding returns to US denominated equity and capital markets. To capture these returns and to the need for regulatory arbitrage, a dirth of new instruments are flooding the market. The US equity market VIX will bound trade 25-75 to 2013. The resultings tails will create our next shock.

  41. Gravatar of NotSureIfSerious NotSureIfSerious
    4. January 2012 at 13:02

    Yes yes these TOTALLY CRAZY “bad guys” haven’t read New Keynesian economics. Not like they’ve sat through 100000 seminars in which New Keynesian papers were presented and thoughtfully criticized* them. Hell, look at John Cochrane who gets more heat than most people:
    http://faculty.chicagobooth.edu/john.cochrane/research/papers/cochrane_taylor_rule_JPE_660817.pdf

    Oh look, it’s almost like he had to have read papers and attended seminars to obtain a reasonably solid grasp on the New Keynesian literature before writing that paper. Compare that to:

    “Rolnick: What was Paul Krugman’s opinion about those Princeton macro seminar presentations that advocated modern macro?

    Sargent: He did not attend the macro seminar at Princeton when I was there.

    Rolnick: Oh.”

    *Or angrily criticized them, as in Lucas’ response to Mankiw-Ball. I like Mankiw, but the paper was ridiculous and they were rightfully skewered for it:
    http://www.scribd.com/doc/77085319/Lucas

  42. Gravatar of MostlyAPragmatist MostlyAPragmatist
    4. January 2012 at 15:24

    Scott Sumner, thanks for responding.

    “Mostly a Pragmatist. I disagree with point 1 (see my 2nd answer to David), and agree with point 2 (but that point has no bearing at all on this post.)”

    I thought it was relevant that Mankiw has supported tax cuts as fiscal stimulus on two occasions (Bush’s tax cuts and the 2009 stimulus bill) because you claimed his paper says not to bother with fiscal stabilization policy, use monetary policy.

  43. Gravatar of Mike Sax Mike Sax
    4. January 2012 at 16:06

    Actually in reading Mankiw’s paper it turns out that he was discussing nominal GNP-I know that’s a little different from nominal GDP- as the best best for a policy rule back then in 1991.

    He suggested that if not that then a target for the nominal wage.

    I know about NGDP through you and the other other market monetarists, didn’t realize that was on the menu back then.

    The main thing Mankiw says that makes a lot of sense to me in this paper is he admits that involuntary unemploynment actually exitsts (!) Shocking revelation.

    You love to needle those who are not trained as economists as being clueless in their attempts to use common sense to understand economics yet it’s amazing to me that the trained economists took this long to figure out that it’s possilbe to be involuntarily unemployed, that it’s not always a case of “laziness.”

  44. Gravatar of Matt Waters Matt Waters
    4. January 2012 at 16:13

    To me, the issue with NK is not that it’s wrong. It’s basically, in broad strokes, the same as Keynesian. The difference is that Keynes wrote from the perspective of the Great Depression and NK was from the perspective of the 80′s and 90′s.

    For that reason, NK seems to think too small in many respects. It didn’t really envision a ZLB where the paradox of thrift, liquidity trap, deflation and all that could lead to such terrible outcomes. Instead, NK was about fine-tuning interest rates to where full output was maximized on an expectations-adjusted Phillip’s curve.

    That’s all good…outside of the ZLB. NK didn’t comprehend just how powerful the Phillip’s curve could be and that’s partly why there isn’t more of a dichotomy between Mankiw and more pure libertarian economists. And today there should be a really bigass dichotomy if Mankiw’s NK assumptions are true.

  45. Gravatar of Matt Waters Matt Waters
    4. January 2012 at 16:27

    “A bit off topic, but Gross has expanded on his editorial from last month. FT Alphaville has a good breakdown of it here.

    My favorite quote: “Deflation would reward the holders of ‘non-productive’ government debt, while inflation would reward the holders of tangible real assets. QE (or a lack of QE), meanwhile, could help tip the balance either way.”

    Which is a pretty clear endorsement of the need for inflation to bring the system back to normalcy.”

    That “Total US debt” graph should also really be logistic, not linear. Anything that grows geometrically looks like that graph.

    I can’t really blame Gross’s arguments though because he makes the same mistakes as most central bankers. Since they’re all involved in the debt market, they assume that the only way AD is increased by monetary policy is through decreasing interest rates. If that’s the case, then the ZLB does mean monetary policy is out of ammunition.

    He references that “when both yield and credit are at risk the mix can be toxic.” Indeed, which is why monetary policy can affect the credit side as well as the yield side. Setting future demand expectations higher improves the NPV of capital projects for debtors, just as lower interest rates improve the NPV of debt.

    Then if debtors are truly tapped out and even future demand expectations can’t get credit-worthy borrowers, monetary policy can move to the consumption side instead of the investment side, when those on the debit side of the “balance sheet recession” decide to actually spend their money. But the balance sheet recession thing is overblown anyway. What will in fact happen is that things will go back to the “old normal” if and when the old normal’s demand expectations still apply.

  46. Gravatar of Dan S Dan S
    4. January 2012 at 16:31

    Stupid comment, maybe, but NK sounds a heck of a lot like your own views on macro. Where exactly is your point of departure? The interest rate as the transmission mechanism?

  47. Gravatar of Brito Brito
    4. January 2012 at 16:35

    Mike Sax, the concept of involuntary employment has existed in economics for at least 2 centuries.

  48. Gravatar of Brito Brito
    4. January 2012 at 16:35

    Involuntary unemployment*

  49. Gravatar of Cthorm Cthorm
    4. January 2012 at 16:47

    @Matt Waters

    Gross is not at all guilty of making the assumption that interest rates or QE are the only levers of monetary policy. This was established in previous threads and clearly in his previous editorial. The real question was whether he favored a NGDP target to steepen the yield curve and get the debt market structure back to normal, regardless of short to medium term inflation. The answer is yes, as evidenced by his tweets and editorials like this (he uses the term reflation, but in his tweets he says NGDP target). H/T to 123 for finding that tweet by the way.

  50. Gravatar of Matt Waters Matt Waters
    4. January 2012 at 18:36

    Fair enough. At first glance it struck me as another “pushing on a string” argument, which is not true at all.

  51. Gravatar of Kevin Donoghue Kevin Donoghue
    5. January 2012 at 03:01

    “Hell, look at John Cochrane….”

    Brad DeLong did, in response to a demand from Kantoos:

    http://krugman.blogs.nytimes.com/2012/01/04/the-nonsense-problem/

  52. Gravatar of W. Peden W. Peden
    5. January 2012 at 09:28

    “Which is a pretty clear endorsement of the need for inflation to bring the system back to NORMALCY.”

    That’s one contribution of the 1920s that we can certainly do without.

  53. Gravatar of Mike Sax Mike Sax
    5. January 2012 at 13:38

    Brito it certainly doesn’t sound like the neoclassicals believe it nor did many at the time of Keynes.

    When Keynes introduced it in the General Theory it caused a lot of dissonance

  54. Gravatar of JL JL
    6. January 2012 at 00:18

    Wow, my first HT from Scott Sumner. When you get your Nobel*, I’ll be able to tell my children that I read and indirectly contributed to your blog.

    * The peace prize, for leading the way out of the Lesser Depression. At least it’s a REAL Nobel prize. :-)

  55. Gravatar of Morgan Warstler Morgan Warstler
    6. January 2012 at 07:24

    DeKrugman shows his mental panties here:

    http://www.nytimes.com/2012/01/06/opinion/bain-barack-and-jobs.html?_r=1

    JOLTS data CLEARLY shows that month-to-month we add jobs when the turn-over is higher. Get up over 5M quits / terminations / hires and we’re likely adding jobs.

    At 5.5M turn-overs we are for sure growing.

    At 4M we are losing jobs month-to-month.

    —-

    DeKrugman would like to say I have the causality reversed, that when times are good, more people quit – that’s because he likes to think of labor as the dominant part of the equation, it isn’t.

    What matters is new young growing companies crushing destroying old dying companies – the turmoil of creative destruction – that kind brought on by Romney’s time at Bain.

    When you have a floundering company, it is a GOOD THING that it very quickly have one last turn-around shot, get levered up and killed quickly if it fails.

    Zombies are TERRIBLE for the job market.

    There was just a great article in the NYT about zombie restaurants that stumble along in and out of bankruptcy protection. This country would be far better off with without Friendly’s. Perkins, etc.

  56. Gravatar of Doc Merlin Doc Merlin
    8. January 2012 at 02:10

    Why do people keep acting as if negative nominal interest rates can’t exist? We see negative rates in the real world all the time.

    1) Credit card kickbacks are short term negative interest rates. (You get paid for borrowing the money and only pay interest if you borrow past the month.)

    2) NY mellon was charging interest on savings deposits.
    3) In 2009 Sweden’s central bank had negative nominal rates.

    @Mick Sax:
    No, Bush’s tax cuts where Keynesian. They were nominal cuts across the board and not permanent. A supply side cut requires that the cut be permanent.

  57. Gravatar of Full Employment Hawk Full Employment Hawk
    8. January 2012 at 16:58

    “A mere 20 years ago we were in a golden age of macroeconomics.”

    Tweny years ago the New Classical Economics was the established orthodoxy in graduate teaching and the professional journals. And Real Business Cycle theory was the dominant version of the New Classical economics. Since, according to the New Classical Economics, prices and wages adjust instanteously and together, there was no room for any discretionary monetary policy. Since discretionary monetary policy would be anticipated, it would only result in instanteneous changes in the price level, and no changes in output and employment, even in a short run. At best unexpected changes in the money supply could change output (the Lucas model, for example). But according to Real Business Cycle theory, even such unexpected changes in the money supply would not affect output because output fluctuations are caused by disturbances on the supply side. This was certainly not a golden age for monetary policy and for macroeconomics. It was as anti-monetary policy as the period of naiive Keynesianism after WWII that Friedman had called the “anti-monetary terror.”

    New Keynesians were struggling against this orthodoxy by developing sticky price models in which changes in aggregate demand would affect output. These changes in aggregate demand could in principle be the result of either discretionary monetary or fiscal policy, but the preference at the time was definitely for monetary policy. But this was an insurgency against the established orthodoxy.

  58. Gravatar of Full Employment Hawk Full Employment Hawk
    8. January 2012 at 17:00

    “Why do people keep acting as if negative nominal interest rates can’t exist?”

    The Fed could charge a penalty on excess reserves, therefore creating a negative nominal interest rate on this very central interest rate.

  59. Gravatar of Full Employment Hawk Full Employment Hawk
    8. January 2012 at 17:10

    “Try to imagine Obama, Pelosi, and Reid in early 2009 sitting around discussing what the Fed did wrong in 2008.”

    The most serious mistake the Obama adminsitration made in the area of economic policy is that it failed to fill the vacancies on the BOG promptly with people who took the Fed’s mandate to achieve maximum employment seriously and understood that non-conventional monetary policy continues to be effective even when short-term treasury bills have hit a zero floor. Peter Diamond was therefore a bad choice. And after the Republicans started to obstruct, use recess appointments to fill the vacancies. That would have required nominating people after Diamond withdrew that the Republicans would reject, so that they could have been recess appointed at the same time the other recess appointments were made.

    Having two such people on the FOMC at the present time could still have made a significant difference in the performance of the economy by next November.

  60. Gravatar of Full Employment Hawk Full Employment Hawk
    8. January 2012 at 17:21

    “federal funds rate hitting the zero lower bound”

    The federal funds rate has not hit the zero bound. It is currently at 25 basis points and can be reduced to zero by the BOG any time is chooses to.

    25 basis points may not seem like much but is higer than the yield on short-term treasury bills. Lowering this rate to zero would give the economy a monetary boost as banks reduce their holdings of excess reserves. The best outcome would be that they make additional loans, but if they buy securities instead, the conomy still gets a monetary boost.

  61. Gravatar of Full Employment Hawk Full Employment Hawk
    8. January 2012 at 17:26

    When Mankiw wrote this paper, the possiblity that short-term government bonds would hit the zero lower bound, so that CONVENTIONAL monetary policy become ineffective was not considered a possibility. Keynesian economists therefore preferred monetary policy because of its greater flexibility.

    If was only after this bound was reached that many Keyensian economists, such as, for example, Brad DeLong started to support expansionary fiscal policy again. Even Krugman argues that fiscal policy is effective only when the economy is in what he calls a liquidity trap.

  62. Gravatar of Nick Rowe Nick Rowe
    9. January 2012 at 01:31

    FE Hawk: “Tweny years ago the New Classical Economics was the established orthodoxy in graduate teaching and the professional journals. And Real Business Cycle theory was the dominant version of the New Classical economics.”

    “New Keynesians were struggling against this orthodoxy by developing sticky price models in which changes in aggregate demand would affect output.”

    That’s not how I remember it. I thought it was the other way around. New Keynesians were the new orthodoxy, and New Classicals were the ones struggling against it. Though it probably varied from school to school.

  63. Gravatar of Julio Huato Julio Huato
    9. January 2012 at 04:31

    Krugman didn’t invoke Mankiw’s paper in support of all of his views. All he did was to link it while narrowly arguing that, after the 1970s, the Chicago people seemed to have missed what Mankiw called the 1980s “reemergence of Keynesian economics” (yeah, as a “reincarnation” but “reemergence” nonetheless).

    Mankiw’s paper draws a strong contrast between the “new” Keynesian and the “old” one, but there’s no rejection of the notion that *expansionary policies work* (in the short run). If Mankiw rejected that, then it wouldn’t be “reincarnation” or “reemergence,” but plain death.

    So, re-read Krugman’s blog post (http://krugman.blogs.nytimes.com/2012/01/02/hermetic-economic-cults-wonkish/) and tell me exactly where and how Mankiw’s paper undermines his argument.

  64. Gravatar of ssumner ssumner
    9. January 2012 at 07:33

    herb, I doubt a Keynesian like Romer would make that argument.

    Kevin, Talk about Cherry-picking!! He accused Friedman of being intentionally deceptive.

    K, I’m not sure what you mean by “the operation of rates on the economy.” Never reason from a price change. Interest rates don’t have any effect on the economy, they are the price of credit. Changes in monetary policy, propensities to save, etc, have effects on the economy. The Keynesian model allows for low rates to be associated with expansionary factors (easy money) or contractionary (too much saving.)

    Mike Sax, Old Keynesians believe the Fed is out of ammo–I’d say that’s at least 1/2 of all Keynesians in America.

    Bush’s “huge deficits”?!?!?

    Lars, That’s right.

    K, Don’t worry, I found the Keynesian model to be very confusing, so all my obtuseness is unintentional.

    Pat toche, So does that mean Krugman’s not a “real scientist?”

    Cthorm, Thanks for the link.

    Notsureifserious. Yes, and he also brags that he doesn’t read conservative blogs. That’s why he keeps making the same Econ101 errors over and over again. He doesn’t read my corrections.

    Mostly a pragmatist. The 2003 cuts were a supply-side policy. But I agree that in 2009 he moved away from these views.

    Mike Sax, Provide a quotation from an economist who thinks unemployment is always due to laziness. Or did you make that up too?

    The US converted from GNP to GDP a few decades back.

    Matt, I don’t think the old Keynesian model works at the zero bound either. Explain the big inflation of 1933-34 with the old Keynesian model (unemployment was 25% and interest rates near zero.)

    Dan S, Yes, that’s one of the big differences. I use the expected future hot potato effect.

    JL, Don’t hold your breath.

    Doc Merlin, You don’t see negative rates on cash held by the public–but it is possible on bank reserves, as you say.

    FEH, I agree with Nick, that’s not at all how I remember things. I do agree on the FOMC seats, however.

    Nick, I agree.

    Julio, So you don’t think it strange that Krugman bashes Cochrane, Lucas, etc for not knowing that fiscal stimulus can be effective, and then links to a Keynesian paper that argues fiscal stimulus is pretty much useless? Obviously you don’t share my sense of humor.

  65. Gravatar of Kevin Donoghue Kevin Donoghue
    9. January 2012 at 09:08

    Scott: “Talk about Cherry-picking!! [Krugman] accused Friedman of being intentionally deceptive.”

    Recall that your claim was that Krugman “said some very harsh things about Friedman’s theories right after he died.” That’s what I was disputing, not the fact that he said Friedman “sometimes seemed less than honest with his readers” — which is right there in my cherry-picked quote.

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