Paul Krugman’s reaction to the results of The Great Market Monetarist Test has created some confusion. Some of his supporters tried to convince me that 2013 wasn’t a good test of MM. You don’t have to convince me, I already believe that. For years I’ve been preaching that there is “no wait and see.” It’s Krugman who claimed that 2013 was a test of market monetarism. He’s the one you have to convince. BTW, Alex Tabarrok, David Beckworth, Bill Woolsey, and Bob Murphy all have excellent posts on this topic.
Obviously it was a sort of crude test, and it’s better that the ex post results came in as we predicted, than otherwise. But the real test is how policy initiatives affect expected NGDP growth. And we (should) know that right away.
Now that we’ve “won,” there’s been some discussion about exactly what “market monetarism” is. There are clearly many issues where we overlap with new Keynesians (NKs), indeed even more so now that Romer, Woodford, Frankel, etc., have endorsed NGDPLT. So why not call it market Keynesianism? After all, we agree that wages and prices are sticky. We agree that temporary monetary injections are not effective. We don’t want to target the money supply. So what distinguishes MM?
I suppose there are a number of possible answers, starting with why the hell is NK not called “new monetarism?” But I think a good place to start is with monetary policy. Unfortunately the terminology in this field is vague. In the NK model is the monetary base the instrument, the fed funds rate the short term target, and inflation the policy goal? Or is the fed funds rate the instrument? I’m going to trying to sidestep linguistic disputes by describing the process without referring to “instruments.”
As far as I can tell NK goes something like this:
1. The Fed sets a policy goal. Let’s assume 2% inflation for simplicity, although it’s actually inflation plus the output gap.
2. The Fed targets the fed funds rate at a position where they believe the gap between the fed funds rate and the Wicksellian equilibrium rate is most likely to lead to on-target inflation, based on their structural model of the economy. The gap between the fed funds rate and the Wicksellian equilibrium rate is a sort of policy indicator; it describes the stance of monetary policy. The fed funds rate is traditionally adjusted via changes in the base, although changes in the interest rate on reserves can also work, and may be used in the future.
How does market monetarism differ?
Some people might point to the fact that I talk much more about the base than do the NKs. But I don’t think that’s the key. Like old style monetarists we don’t see the base as indicating the stance of policy. Unlike old style monetarists, we don’t think any monetary aggregate is a reliable indicator of the stance of policy, although some MMs think broad aggregates are more useful than I do. So it’s not the base. I may define the base as “money,” but fundamentals never hinges on definitions.
I think the key is that MMs see market forecasts of NGDP growth as playing roughly the role that the fed funds rate minus the Wicksellian equilibrium rate plays in the NK model. It’s the indicator of the stance of policy. It’s easier to explain this difference using inflation targeting, however, so let’s start there first.
NKs would adjust the base in order to move interest rates to a position where their structural model predicted on-target inflation (using Lars Svensson’s target-the-forecast approach.)
MMs would adjust the base in order to move the TIPS spread to a position where the market predicted on-target inflation.
Thus in an inflation targeting world it’s actually pretty easy to explain the difference between NK and MM. The NKs use interest rates as an intermediate target, and they rely on structural models. The MMs use TIPS spreads as an intermediate target, and rely on the market, not structural models.
Things get a bit trickier when we shift over to the preferred target of the MMs (and increasingly the NKs), which is NGDPLT. Now we don’t have a market indicator such as the TIPS spread. What do we do in that case? The first answer is that we should obviously create and subsidize trading in a NGDP prediction market. That’s a big part of my agenda. In the absence of that market, we try to estimate the market forecast of NGDP by looking at a wide range of asset prices (including TIPS spreads) as well as (perhaps) the consensus of private forecasters. Unfortunately this is a very imprecise process, and that fact obscures what is really going on. It’s easy for me to explain that a market price such as TIPS spreads is the MM equivalent of the fed funds target. But the “shadow” market NGDP growth forecast is a much fuzzier concept, which makes MM seem more like NK than it really is. It’s easy for NKs to mistake the shadow NGDP forecast as a sort of Svenssonian policy goal, whereas it’s actually the intermediate target, which can be “measured” (actually merely estimated) in real time, just like the fed funds rate.
Because NKs rely on an interest rate intermediate target, they worry a lot about the zero bound, and this also makes them more optimistic about fiscal stimulus when at the zero bound. In contrast, there is no zero bound on TIPS spreads, and would not be a zero bound on NGDP futures prices, if such a market were created. But that leads to another problem, which economists haven’t thought through clearly enough. Does the fact that TIPS spreads have no zero bound really take away the “liquidity trap” problem? Can it really be that simple?
Yes and no. It takes away the direct problem of not being able to lower interest rates below zero, but not the problem lurking in the background, which is that the central bank might have to buy so much stuff to hit the TIPS target than monetary policy bleeds over into fiscal policy. I think that problem is grossly exaggerated. The mistake NKs make is that they see central banks buy a lot of stuff, fail to hit their target, and then assume that under MM policy they’d have to buy much more stuff. Actually they could get by with buying much less, but that’s hard to prove to the satisfaction of NKs. Thus in desperation they end up discussing extreme policy innovations, such as Miles Kimball’s proposal of negative interest on money. That policy would work, but is unnecessary in my view.
One area where NKs and MMs seem to agree is that there is an inflation target or NGDP target path that is high enough to make the zero bound problem go away. I think we both agree that in that sort of world the fiscal multiplier is roughly zero and MMT is nonsense. But it’s hard to be certain because NKs like Larry Summers can be very hard to read. Joe Stiglitz would certainly not agree.
In my view the now famous Krugman “test” of market monetarism is an indication of the pathetic state of modern macro. We are still in the Stone Age. Future generations will look back on us and shake their heads. What were they thinking? Why didn’t they simply create a NGDP futures market? They’ll look back on us the way modern chemists look back on alchemists. It’s almost like people don’t want to know the truth, they don’t want answers to these questions, as then the mystical power of macroeconomists with their structural models would be exposed as a sham. Remember when the Christian church produced bibles and sermons in a language that only the priesthood could understand? That’s macroeconomics circa 2013.
To summarize this overlong post, the nonexistence of an active NGDP prediction market is why people have so much trouble understanding what MM is. If that market existed then the concept of MM would be far easier to explain. Indeed quite simple.
HT: This post was motivated by a Kevin Donoghue comment and a tweet by Andy Harless.