Back from vacation and still alive. (Just missed a head-on collision in the Ted Williams tunnel last night–think about what that means.) I noticed that commenters sent me lots of Paul Krugman columns.
Part 1: Each week Krugman seems to inch a bit closer to adopting the ideas that I asked him to support in my open letter of March 2009. A few months back he endorsed Joe Gagnon’s call for QE plus eliminating interest on reserves—both of which were included in my open letter. And now he seems to endorse price level targeting. (In the past he generally discussed inflation targeting.) Level targeting was the third and final item in my post.
Unfortunately, Krugman still doesn’t seem to understand that we don’t need a very high inflation rate, just a figure slightly higher than the 1% we’ve recently been experiencing:
What am I talking about? Something like a commitment to achieve 5 percent annual inflation over the next 5 years — or, perhaps better, to hit a price level 28 percent higher at the end of 2015 than the level today. (Compounding) Crucially, this target would have to be non-contingent — not something you’ll call off if the economy recovers. Why? Because the point is to move expectations, and that means locking in the price rise whatever happens.
It’s also crucial to understand that a half-hearted version of this policy won’t work. If you say, well, 5 percent sounds like a lot, maybe let’s just shoot for 2.5, you wouldn’t reduce real rates enough to get to full employment even if people believed you — and because you wouldn’t hit full employment, you wouldn’t manage to deliver the inflation, so people won’t believe you. Similarly, targeting nominal GDP growth at some normal rate won’t work — you have to get people to believe in a period of way above normal price and GDP growth, or the whole thing falls flat.
As I wrote way back, the Fed needs to credibly promise to be irresponsible — at least from the point of view of the VSPs.
Krugman seems to think that you need high inflation in order to get real interest rates low enough to produce robust growth in aggregate demand. He should have gone to the Karl Brunner conference I attended in Dallas, where he would have learned that money affects all sorts of asset prices, not just T-securities. I suppose he would argue that QE would also fail to boost those other asset prices (because we are in a liquidity trap) unless the real interest rate falls low enough to significantly boost AD. But we know that is wrong for both theoretical and empirical reasons:
Empirical evidence: Haven’t we just seen stock and foreign exchange prices rise briskly in response to hints of Fed easing? And recall that an extremely modest program is being advocated (Krugman’s right about that), with every indication that Bernanke is not willing to go past QE and adopt level targeting. Just imagine how the markets would respond if the Fed said they’d do whatever it takes to raise core inflation expectations to 2.7% over 2 years (to catch up for the recent undershoot.) Unless I misunderstood Krugman, he seems to think there is no monetary policy capable of doing that—i.e. that policy would either under- or overshoot 2.7% inflation. It would need to produce high inflation expectations in order to get any serious boost to AD, and if we didn’t have high inflation expectations, we’d be stuck around 1% inflation.
Theory: Krugman’s theory ignores the fact that as the expected NGDP growth rate rises; the Wicksellian equilibrium real rate also rises. For instance, suppose that given the current expectation for weak nominal growth, it would take a minus 5% real short term rate to significantly boost AD. Now assume the Fed does enough QE to raise one year NGDP futures to 8% above current levels. Krugman himself argues the SRAS is currently quite flat, so this implies the 8% NGDP growth would be associated with only 2% or 3% expected inflation, and 5% or 6% expected RGDP growth. Krugman might argue that 2% or 3% inflation expectations are not enough to get the needed reduction in real rates. But if people really did expect 8% NGDP growth, then real rates would not have to fall nearly as far to boost spending—all sorts of other asset prices would be rising fast and that would help generate the required boost in AD
On many issues I disagree with most traditional monetarists. I think they put too much weight on the monetary aggregates, and I think some are too worried about an inflationary time bomb being embedded in current Fed policy. I think some are too enamored of the Austrian explanation for how we got in this mess, overlooking just how tight money was in 2008 (I’m of course exempting monetarists like Robert Hetzel.) But they are completely right about one thing; we’ll never get anywhere as long as we keep evaluating monetary policy solely in terms of an interest rate transmission mechanism. QE raises future expected NGDP, and that raises current asset prices and current AD. Which assets? Stocks, commodities, commercial real estate, foreign exchange, etc, etc. Given how flat the current SRAS is, we can do a lot more stimulus without triggering much inflation. Indeed back in 1993 (JEP) Robert King argued that in a rational expectations model monetary stimulus might well raise real interest rates, as a result of expectations of much higher levels of investment. Real interest rates are not the issue.
Part 2: Krugman’s completely correct in this post about why common sense doesn’t help much in macro.
Part 3: Krugman continues to insist Milton Friedman was dishonest in asserting that the Fed caused the Great Contraction, a charge he made in a NYR of B article right after Friedman died (a time when many of his fellow liberal economists were praising Friedman.)
You can see, by the way, why I get so annoyed with the vulgar-Friedman claim that the Fed caused the Depression, as opposed to, perhaps, failing to prevent it: monetary base actually rose substantially from 1929 to 1933.
I agree that the point is debatable, but given that eminent Depression expert Ben Bernanke agrees with Friedman, it’s a bit over the top to accuse him of dishonesty. And why the monetary base data? Since when is that an indicator of whether money is too easy or too tight? Neither Keynesians nor monetarists favor targeting the base, and the Fed was given the responsibility of being a lender of last resort, not base targeting. Even as far back as the 1930s prominent economists like Hawtrey and Fisher accused the Fed of abandoning NY Fed President Strong’s counter-cyclical policies after his death in late 1928. My own view is that both the Fed and the Bank of France played major roles in the Great Contraction. But the Fed’s role was particularly important between October 1929 and October 1930, when the US monetary base fell about 8%. This important episode of tight money is almost impossible to see on Krugman’s chart. Yes, the base did subsequently rise during the banking panics, but not enough to offset their effect on the multiplier.
This argument is actually about the merits of laissez-faire capitalism. Keynes argued that the Depression showed why laissez-faire was bad. Friedman and Schwartz showed that big government wasn’t needed, that laissez-faire would work fine as long as the central banks didn’t adopt deflationary policies. It’s not hard to see why Krugman doesn’t like that message; he shares Keynes’s preference for a big and active government that relies heavily on . . . well, smart economists who also believe in big and active governments.
Krugman also misunderstands the role of monetary policy in the recovery, but I’ll skip over that as Gauti Eggertsson already corrected him on that point.
He ends the post by arguing that our task is much more difficult than the one that FDR faced, as we need higher inflation, whereas they simply needed to return to the 1929 price level. But as I argued above, Krugman grossly exaggerates how much more inflation we actually need.
Part 4: Krugman likes to criticize conservatives who believe all poor people are welfare queens. So what are we to make of the fact that Krugman seems to approve of this idiotic statement which stereotypes financial asset market investors? (Note, the quotation is in a Krugman post, it is not his words.)
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 knowladge of these basic facts, nothing about the markets makes any sense—and with knowladge, everything does.
Yes, I get the fact that there are good reasons why it would be much more offensive to do this sort of stereotyping of poor people. But is it really any less stupid? Over the past three years these drug-addled traders have been much more accurate than the world’s central banks in their predictions about the macroeconomy. They saw the AD problem long before the Fed. And didn’t Keynes say our capitalists needed to keep their “animal spirits” revved up?
Part 5: In this recent post Krugman claims, with some justification, to have foreseen the current situation before the rest of us. So it’s a pretty good post. But there’s just one problem; when Krugman makes this statement:
The slide toward deflation despite huge increases in the monetary base hasn’t shaken either the paleomonetarists who still predict hyperinflation or the it’s-all-the-Fed’s-fault crowd.
he overlooks the fact that his own model says “it’s-all-the-Fed’s-fault.” They need to set a higher inflation target. They refuse to do so (just as the BOJ refused to shoot for even 2% inflation.) It’s not that they are powerless; it’s that they refuse to exercise the power they have.
Part 6: Here is Krugman arguing that the Bank of Japan was just spinning its wheels when it tried QE.
But the Bank of Japan tried that — and found that pushing more reserves into the banks didn’t even lead to rapid growth in the money supply, let alone end the problem of deflation. Here’s a chart of growth rates of the monetary base and of M2, Friedman’s preferred monetary aggregate:
We both agree that temporary currency injections are ineffective, and we know that the real demand for base money will rise when nominal rates fall close to zero. I’d be the first to agree that the “paleomonetarists” have not adequately addressed these issues. But notice the graph he uses stops at December 2005. Could that be because the monetary base fell about 20% in 2006, thus showing the increase was partly temporary? Remember, the BOJ needs to promise it will leave enough base money in circulation to produce a higher price level. It refuses to make that promise, and it refuses to actually do that policy. No surprise that QE hasn’t worked. I’ve debated Krugman on this issue before, and he certainly is aware of the 2006 data. Was the data left off because he wished to hide an “inconvenient truth?” Or was it merely a random decision to end his graph in December 2005? You make the call.
Part 7: OK, one more Paul Krugman post then I hope you Krugman-haters will be satiated. Here he scratches his head over the modest increase in inflation expectations that have occurred since the Fed started talking about QE2:
Financial markets seem convinced that quantitative easing will be highly effective at solving at least one problem: inflation running well below the Fed’s 2-percent-or-so target. The chart above shows the difference between interest rates on 5-year inflation-protected bonds (which are now negative) and rates on unprotected bonds; implicitly, the market forecast of inflation over the next five years has risen half a point.
But I really don’t understand this.
I’m not surprised he’s confused, given that (as we saw in Part 1) Krugman doesn’t think this is possible. He doesn’t think the Fed can create a modest increase in inflation expectations—it’s all or nothing. And don’t say he was talking about the level of inflation needed for a robust recovery in RGDP. He’s also on record arguing the SRAS curve is relatively flat right now.
PS. Apologies to fans of Krugman, but when I returned from vacation I found my commenters were demanding blood. And I did say one and two-thirds of his recent posts were excellent–how many right-wingers would have given him credit for those posts?
PPS. Apologies to other bloggers that I may have inadvertently plagiarized. I haven’t had any time yet to catch up on other blogs.
PPPS. My taxi driver rounded a bend last night in the TW tunnel, and some idiotic lady was coming right at us in our lane! Not more than 100 yards away.