Paul Krugman is dismayed that the conservatives he pays no attention to are not saying the things he’d like them to say if he did listen to what they said
Or something like that. As we all know, Krugman likes to brag that he doesn’t read any conservatives, as they have nothing interesting to say. But that doesn’t prevent him from being dismayed by their lack of intellectual honesty. Here Krugman discusses Allan Meltzer’s repeated warnings that inflation is coming:
Tests in economics don’t get more decisive; this is where you’re supposed to say, “OK, I was wrong, and here’s why”.
Not a chance. And the thing is, Meltzer isn’t alone. Can you think of any prominent figure on that side of the debate who has been willing to modify his beliefs in the face of overwhelming evidence?
Here’s Steve Williamson, who changed his mind about inflation:
Back in days of yore, my concern was that we could indeed get higher inflation. How? I had thought that the Fed had the ability to control inflation, but when push came to shove, they wouldn’t do it. Once people caught on to that idea, we could get on a high-inflation path that was self-sustaining. Of course, since I said that, I’ve continued to work on these problems, and stuff has been happening. In particular, we’re not seeing that high-inflation path.
And here’s an article discussing Arthur Laffer:
And in June of 2009, he penned an op-ed warning excessive quantitative easing would inevitably lead to higher inflation and interest rates.
…we haven’t ever seen anything like this in the U.S. To date what’s happened is potentially far more inflationary than were the monetary policies of the 1970s, when the prime interest rate peaked at 21.5% and inflation peaked in the low double digits …Gold prices went from $35 per ounce to $850 per ounce, and the dollar collapsed on the foreign exchanges. It wasn’t a pretty picture.
Obviously, nothing like that happened.
In an interview with Business Insider from his office in Tennessee, Laffer admitted that he was wrong. The old maxim that dictates increasing the availability of cash through lower interest rates will lead to higher prices, he said, may need to be reexamined.
I frequently meet conservatives who have changed their minds, and I frequently meet conservatives who have not changed their minds. I also meet Keynesians who didn’t change their minds about market monetarism after the famous 2013 “test.” In any case, don’t take this as a jab at Krugman; given that he doesn’t read any conservatives he can hardly be faulted for not knowing what they are saying.
Enough fun and games, now let’s focus on the much more important question: whither monetarism? (That’s the first time in my life I typed the word ‘whither’ and probably the last. I just don’t like that word.)
There have been lots of good critiques of Meltzer’s op ed, including friendly fire from monetarists like Marcus Nunes and Bob McTeer. Brad DeLong provides some not so friendly fire. I’d like to focus on what I see as the big problems, and the resulting implications for monetarism:
1. Meltzer confuses the monetary base with high-powered money. High-powered money is base money with a lower yield that T-bills. The recent injections of money by the Fed are mostly interest-bearing reserves, and hence are not high-powered money. So contrary to the claim of Meltzer, the Fed is not monetizing the debt. And that means that all previous cases of monetizing the debt have no bearing on the eventually outcome of QE1, QE2, and QE3.
2. There is no such thing as long and variable lags. Monetary policy affects assets prices like stocks and TIPS spreads immediately. Effects on the broader economy show up very quickly after asset prices change. A huge literature on long and variable lags grew up based on a fundamental misconception, that interest rates and/or the money supply are useful indicators of the stance of monetary policy. They aren’t.
3. The low interest rates of recent years represent the effects of a tight money policy by the Fed, not easy money (as Meltzer seems to imply in the op ed.) Milton Friedman understood this. So did Ben Bernanke (back in 2003, not today.)
On the third point, Keynesians make the same mistake. Here’s Menzie Chinn discussing the fiscal multiplier:
When output is contracting due to some aggregate demand shock, there is likely to be a lot of slack, such that a Keynesian model is more apt than a Classical model. In addition, monetary policy is likely to be accommodative.
Chinn, Meltzer and about 99% of other economists seem to believe that monetary policy has been accommodative since about 2008. Ben Bernanke agrees. But the Ben Bernanke of 2003 would not have agreed:
The imperfect reliability of money growth as an indicator of monetary policy is unfortunate, because we don’t really have anything satisfactory to replace it. As emphasized by Friedman (in his eleventh proposition) and by Allan Meltzer, nominal interest rates are not good indicators of the stance of policy, as a high nominal interest rate can indicate either monetary tightness or ease, depending on the state of inflation expectations. Indeed, confusing low nominal interest rates with monetary ease was the source of major problems in the 1930s, and it has perhaps been a problem in Japan in recent years as well. The real short-term interest rate, another candidate measure of policy stance, is also imperfect, because it mixes monetary and real influences, such as the rate of productivity growth. . . .
Ultimately, it appears, one can check to see if an economy has a stable monetary background only by looking at macroeconomic indicators such as nominal GDP growth and inflation. On this criterion it appears that modern central bankers have taken Milton Friedman’s advice to heart.
I believe old monetarism is effectively dead. The monetarists (including Allan Meltzer) made enormous contributions to our understanding of monetary policy. But their model has reached a dead end. I implore bright young grad students with an interest in monetary economics to take a look at market monetarism. Since 2008 we’ve been more accurate in our predictions than any other school of thought. We have a coherent model that incorporates rational expectations and efficient markets. Our views on policy lags do not conflict with market indicators. We understand the difference between the monetary base and high-powered money. We understand the difference between temporary and permanent monetary injections. We understand the importance of interest on reserves. We have a model that can explain market responses to QE and forward guidance surprises. We can explain the price level, not (like NKs) merely the rate of inflation.
What we don’t have is jobs at elite institutions. So if you are a bright young academic you have a golden opportunity to lead the movement—to become the next Milton Friedman. What’s stopping you?
We see one article after another demonstrate that the stylized facts simply don’t support NK sticky price models. This AER paper by Bils, Klenow and Malin is a recent example. On the other hand models that rely on NGDP shocks and sticky wages are very unlikely to be falsified. Don’t you want to base your research agenda on a rock solid assumption? NGDP shocks cause demand-side business cycles. Period. End of story.