Archive for the Category Liquidity trap


David Beckworth interviews Paul Krugman

Love him or hate him, there’s no denying that Krugman is a brilliant economist. David Beckworth’s interview with Krugman is probably my favorite so far in the series, even though on the policy issues I tend to agree more with earlier interviewees such as Bullard.  (Interestingly, these two agreed on a number of issues, despite being far apart on the political spectrum.)

There’s no transcript, so I’ll rely on memory, and then leave a few observations after each point:

1.  When discussing his famous 1998 paper, Krugman said the hard part was determining the implication of an “expectations trap” for policymakers.

This is a very good point, and most people underestimate this problem.  Krugman himself has changed his views as to the paper’s implication, in the years since it was published.

2.  He indicated that when trying to exit a liquidity trap, you don’t need to just convince the central bankers, you also need to convince the public.

I have a “build it and they will come” attitude here.  If the central bank adopts an effective policy response, I think the public will believe it.  The real problem has been the failure of central banks to be willing to adopt “do whatever it takes” policies.

3.  He suggested that price level targeting might not be enough—you might need a higher inflation target if the equilibrium real interest rate fell to very low levels, and stayed there.

Here my view is different.  A liquidity trap should not be viewed as zero nominal interest rates, but rather the zero bound on eligible assets that the central bank has not yet purchased.  Imagine a policy of targeting the price level with CPI futures. That policy will work regardless of how low the equilibrium interest rate falls, as low as the central bank has the ability to adjust its balance sheet to base money demand.  Ditto for exchange rate targeting (i.e. Singapore). Liquidity traps are not times when fiscal policy is needed, they are times when bigger central bank balance sheets are needed.

Krugman cites Japan’s falling population.  On the one hand that might reduce Japan’s equilibrium real interest rate.  But it also reduces aggregate supply, which is inflationary.

4.  Krugman noted that elite policymakers don’t think that an inflation target of higher than 2% is responsible.

My immediate reaction was “Hmmm, where did they get that idea.”  To his credit, Krugman later joked “I may have set back policy by decades with that credibly promise to be irresponsible remark.”

5.  The first QE in the US and Europe helped to restore confidence to economies that had been destabilized by private sector financial turmoil.

My reaction is that that financial turmoil was at least partly caused by bad monetary policy, which was causing NGDP growth expectations to plummet.

6.  Krugman points out that Congress would have objected to a higher inflation target.

I think that’s right, but other options like PL targeting and NGDP targeting we at least possibilities.  More importantly, the Fed could have kept the inflation target at 2% and done far more in the realm of “concrete steppes”.

7.  Krugman’s ideal policy back in 2009 would have been enough fiscal stimulus to get inflation up to 4%, followed by standard monetary policy to stabilize the economy after that (presumably something like policy during the Great Moderation, except with a high enough inflation target to prevent hitting the zero bound.)

That might work, but if you raised the inflation target to 4%, then I doubt you’d even need fiscal stimulus.

8.  On whether 2% was a target or a ceiling, Krugman actually seemed less cynical than David (which might surprise people given their personalities).

I tend to agree with Krugman on this point, but I also believe that David has the better argument, and this is one place where Krugman struggled a bit to refute it. He talked about central bankers wanting to go back to the old days of Volcker, when they fought a heroic battle against inflation, and he also talked about the Fed as an institution having a bias toward fighting inflation.  Of course you could view those observations as supporting David’s claim about 2% being a ceiling, and I sensed that Krugman saw that as well.

9.  Krugman suggested that he had mixed feelings about NGDP targeting, worrying that it might allow too much inflation volatility.

Here again, he struggled a bit in his reply.  At one point he tried to suggest a scary counterfactual of 1% RGDP growth and 4% inflation, and then immediately seemed to realize that a few minutes earlier he had advocated 4% inflation.  In my view Krugman missed the point here.  A period of 1% RGDP trend growth is precisely when you are likely to see the sort of low equilibrium real interest rate that Krugman himself thinks calls for 4% inflation target.  Admittedly I am relying a bit on a sort of “divine coincidence” of RGDP trend growth and equilibrium real interest rates moving together, but I also think there are strong labor market reasons to prefer NGDP targeting. Krugman said something about menu costs of inflation, but surely he cares more about unemployment than menu costs, and labor market stability is almost certainly more closely correlated with NGDP than inflation. Indeed an awareness of that fact (in my view) largely explains why central banks have “flexible” inflation targets.

Like most other mainstream economists, Krugman doesn’t seem aware of all the arguments for NGDP targeting made by market monetarists, and even earlier by George Selgin.  We still have work to do.

Overall a great interview.  Krugman said, “I don’t really know” more often than one might expect from reading his NYT columns, which is to his credit.

I used to think his bashing of the GOP was exaggerated, but now it seems on target.  I say he’s finally got it right, whereas Krugman would presumably say that Trump proves that he was right all along.


It was not “inability”

Over at Econlog, I have a post discussing Bernanke’s views on price level targeting.  Here I’d like to nitpick a couple passages from Bernanke’s post:

As price-level targeting and “make-up” policies are closely related, they could be combined in various ways. For example, by promising to return the price level to trend after a period at the zero lower bound, the Fed could use the language of price-level targeting to make precise its commitment to make up for its inability to respond adequately during the period when rates are at zero.

It was not inability to cut rates that prevented the Fed from acting after Lehman failed in September 2008.

It was not inability that caused the Fed to raise the interest rate on reserves in October 2008.

It was not inability that caused the Fed to refuse to cut rates to zero in November 2008.

It was not inability that caused the Fed to refuse to do negative IOR, when Sweden adopted the policy in 2009.

It was not inability that caused the Fed to prematurely end QE1 in late 2009.

It was not inability that caused the Fed to prematurely end QE2 in mid-2011

It was not inability that caused the Fed to prematurely talk about tapering in 2013.

It was not inability that caused the Fed to prematurely raise rates in 2015.

Now Fed policy is roughly appropriate.  But it was obviously too contractionary for many, many consecutive months and years, just as had been the case in Japan.  Just to refresh your memories, Bernanke’s paper that criticized the BOJ on almost precisely the same grounds as I criticized the Fed was entitled:

Japanese Monetary Policy:  A Case of Self-Induced Paralysis?

And the answer he gave was a resounding yes.  That’s not to say the Fed’s job is easy.  I might have done no better than Bernanke, if I were in his shoes.  There are all sorts of political pressures within the Fed and also from the outside.  It’s a very hard job.  But it’s never about inability; it’s about the Fed’s willingness to do whatever it takes.  It’s willingness to show what Bernanke once called “Rooseveltian resolve”.

One other quibble:

Support for a higher inflation target seems to be increasing along with worries about the ZLB. In a recent post entitled “The case for a higher inflation target gets stronger,” Stephen Cecchetti and Kermit Schoenholtz cite four arguments in favor:

  1. the persistent decline in normal interest rates;

  2. findings (like those of KR) that the frequency and severity of future ZLB episodes may be worse than previously thought, even given the low level of normal interest rates;

  3. some evidence, drawn from a study of the 1970s, that the costs of higher inflation might be less than previously believed; and

  4. calculations that suggest that standard inflation measures may overstate actual increases in the cost of living by more than had been understood.

I don’t have a big problem with this, but I don’t really like point four.  If higher inflation is a good idea, it has nothing to do with the fact that “standard inflation measures may overstate actual increases in the cost of living”.  There are several theories about the welfare cost of inflation, but none of them hinge in any way on the question of whether the BLS properly accounts for quality changes, or the substitution effect, or the new product effect.  The welfare costs of inflation have to do with things like menu costs for adjusting prices, or excess taxation of capital income when inflation is high.  Point four creates the misleading impression that economists want to control inflation so that consumers will benefit from a dollar that loses 2% of its purchasing power each year in terms of . . . what?  Utility?

I also disagree with this:

Second, although quantifying the economic costs of inflation has proved difficult and controversial, we know that inflation is very unpopular with the public. This may be due to reasons that economists find unpersuasive—e.g., people may believe that the wage increases they receive are fully earned (that is, not due in part to prevailing inflation), while simultaneously blaming inflation for eroding the purchasing power of those wages.

The thing that is unpopular with the public is called “inflation” by the man on the street, but it has nothing to do with inflation as defined by economists.  I talk a lot about how the American public in 1990 thought inflation was higher than in 1980.  But an even better example occurred in Europe, where polls showed that Europeans believed that inflation jumped dramatically after the euro was introduced.  I had European students tell me this with a straight face, back when I taught at Bentley.  I’m not sure what Europeans were annoyed about in 2002, but it was not “inflation” as the concept is understood by economists.  We need to stop trying to please a deeply confused public that doesn’t understand our terminology, and instead produce a macroeconomic environment with stable NGDP growth, stable growth in incomes, and stable employment growth.  They liked it in the 1990s, and they would like it now.

I vaguely recall reading that there were more complaints about inflation than deflation during the Great Depression.  (Can someone confirm?)

PS.  Here’s today’s headline from the FT:

Sign ‘Trumpflation’ sputtering as consumer prices fall

I’m still skeptical of the Trump reflation story.  Monetary offset is still in place, and supply side gains are likely to be a couple tenths of a percent at best, assuming he can get anything through Congress.

HT: rtd

Keynesianism as religion

If there is any intellectual framework that should have been discredited over the past decade it is old-style Keynesianism.  Unfortunately, just the opposite has happened.  Marcus Nunes directed me to a Noah Smith post that discusses the revival of old Keynesian ideas:

Another way of putting this is that Paul Krugman was right. Krugman has long advocated that macroeconomists learn to once again think in terms of simple simple Keynesian theory. And when more fully developed, complex models are needed, Krugman uses the kind of models that Christiano endorses.

As Christiano mentioned, the New Keynesian revolution isn’t so new. Even in the 1990s, economists like Greg Mankiw and Olivier Blanchard were arguing that monetary policy had real effects on demand. And at the same time, international macroeconomists were realizing that Japan’s post-bubble experience of slow growth, low interest rates and low inflation implied that demand shortages could last for a very long time unless the government rode to the rescue. Krugman, Adam Posen, Lars Svensson, and others were already referring to a Japan-type stagnation as a liquidity trap in the late 1990s, and warning that standard monetary policy of cutting interest rates wouldn’t work in that sort of situation. .  .  .

If economists gravitated toward anti-Keynesian theories, it was at least in part because evidence wasn’t strong enough to push them in the right direction. It’s just very hard to assess the impacts of fiscal stimulus. For example, Japan’s tremendous government spending binge in the 1990s looks to a casual observer like it had no effect, since the economy didn’t recover until years later — but government spending might have been the only thing saving the country from a deeper recession.

I certainly agree that Japan tells us a lot about the validity of old Keynesian thinking.  Here are some things it tells us:

1.  Depreciating the yen is a foolproof way of creating inflation.  Thus Keynes was wrong about monetary policy being ineffective at the zero bound.

2.  From 1993 to 2013 Japan ran up by far the largest peacetime fiscal deficits ever seen by a major economy.  And all that “stimulus” led to by far the worst growth in AD over 20 years ever seen by a major economy.  Roughly zero growth in NGDP over two decades.  And the Keynesian takeaway is that this was a great success, as it prevented an even more record-breaking fall in NGDP.  This is like a religious person who believes in the efficacy of prayer, prays for peace in 1939, and then later argues that his prayers prevented an even bigger war and Holocaust. Okaaaay . . .

3.  Then in 2013 Abe takes office and raises consumption taxes.  This fiscal tightening causes the debt to GDP ratio to level off at 250%.  Instead Abe relies on monetary stimulus, raising the inflation target.  And both inflation and NGDP growth actually increase, the opposite of the prediction of the old Keynesian model.

Of course I could go on and on.  There’s the letter signed by 350 Keynesians warning that the fiscal austerity of 2013 risked recession (growth actually sped up.) Or the fact that Keynesians don’t even know how to estimate the multiplier (as documented recently by Ryan Murphy.)

Smith points out that Paul Krugman realized in the late 1990s that the standard policy of cutting interest rates would no longer work at zero.  But he doesn’t tell you that everyone already knew that, even Milton Friedman.  AFAIK, not one economist in the entire world in the late 1990s thought that cutting interest rates when they were already zero would work. Perhaps you think I’m being too picky; what Smith really meant is that Krugman discovered that monetary stimulus no longer worked in Japan, and that fiscal stimulus was needed. Except that’s not true, in the late 1990s and early 2000s Krugman ridiculed the idea of using fiscal stimulus in Japan, and suggested that monetary stimulus was the obvious solution. Whatever “new facts” caused Krugman to revert to old Keynesianism more recently; it certainly wasn’t his famous 1998 study of Japan’s liquidity trap.  So what caused Krugman to change?  I’m not sure, but Smith hints at one possibility:

When evidence is sparse or inconclusive, things like sociology and politics often fill the gap.

Did the US cause the Great Japanese deflation?

Commenter Jim Glass provided another Paul Krugman op ed, this one from 2001 2011:

Nonetheless, Mr. Koizumi is right about one thing: Japan cannot go on like this. Swelling public debt will eventually threaten the government’s solvency; the festering financial problems of the banks will soon require a government bailout that will swell that debt even further. Something must be done. But the actions Mr. Koizumi has proposed could tip Japan into full-blown depression.

There is an answer to this dilemma, one that has become almost orthodoxy among economists who have tried to think seriously about Japan’s plight. This answer involves unconventional monetary expansion, with the Bank of Japan buying dollars, euros and long-term government bonds; it also involves accepting and indeed promoting mild inflation and a weak yen. I could explain why this would probably work, but what’s the point? It’s not about to happen.

For the real tragedy right now is that however innovative and open-minded Mr. Koizumi may be, he will fail unless other important players — mainly the Bank of Japan, but also the U.S. Treasury Department — are prepared to learn from Andrew Mellon’s mistake. And all the evidence is that they are not. The head of the Bank of Japan insists that the country’s continuing slump is the result of inadequate reform — that is, insufficient purging of the rottenness. And although the details are in dispute, the U.S. Treasury secretary, Paul O’Neill, appears to have warned Japan not to let the yen weaken too much.

Poor Japan. It is the victim of those who refuse to learn from the past, and thereby condemn others to repeat it.

So even three years after the famous 1998 liquidity trap paper, Krugman was still favoring monetary stimulus over fiscal stimulus for countries at the zero bound. But I’d like to focus on the comment regarding our Treasury officials.  Krugman’s right that they have consistently warned the Japanese not to engage in “currency manipulation”.  What our Treasury doesn’t understand is that all central banks manipulate currencies—-that’s their job!  The only question is how.  And don’t say “It’s OK to manipulate the purchasing power of a currency but not the foreign exchange value.”  If the manipulation is done via central bank policy, then the two types of manipulation are identical. For decades, the US Treasury has been (unknowingly) warning the Japanese not to manipulate their economy out of deflation.

Ironically, a healthier Japanese economy would also be good for the US, boosting our exports and creating good jobs.  Pity that we are so dense.

PS.  Over at Econlog you’ll find a Trump post that is perhaps a bit less “unhinged” than usual.  At least I hope so.

When did Krugman change? And why?

Paul Krugman frequently suggests that his famous 1998 article (“It’s Baaack, Japan’s Slump and the Return of the Liquidity Trap”) led him to rethink the role of monetary and fiscal policy.  He says that the “expectations trap” model in that paper convinced him that monetary policy might be ineffective at the zero bound, and that fiscal policy might then become necessary.

Previously I’ve pointed to a 1999 Krugman essay that advocated monetary stimulus for Japan, and was quite dismissive of the idea of fiscal stimulus.  While cleaning out my office, I came across a Krugman editorial from the year 2000, which made similar arguments:

Japan has the dubious distinction of being the first major nation since the 1930’s to experience a “liquidity trap,” in which even cutting the interest rate all the way to zero doesn’t induce enough business investment to restore full employment. The result is an economy that has been depressed since the early 90’s, and that in 1998 seemed to be on the verge of a catastrophic deflationary spiral.

The government’s answer has been to prop up demand with deficit spending; over the past few years Japan has been frantically building bridges to nowhere and roads it doesn’t need.

In the short run this policy works: in the first half of 1999, powered by a burst of public works spending, the Japanese economy grew fairly rapidly. But deficit spending on such a scale cannot go on much longer. Japan’s government is already deeply in debt (about twice as deep, relative to national income, as the U.S. was before our own budget turned around). For the policy to do more than buy a little time, the recovery must become “self-sustaining”: consumers and businesses have to start spending enough to allow the government to return to fiscal responsibility without provoking a new recession.

Carping critics (like me) warned that there was no good reason to think this would happen. Sure enough, it hasn’t; as the big public works projects of early 1999 have wound down, so has the economy. . . .

Although the Bank of Japan has already reduced the short-term interest rate to zero, Western economists have pointed out that there are other things it can and should do: buy longer-term bonds, announce a positive target for inflation to encourage businesses to borrow. Indeed, textbook economics tells us that to adhere to conventional monetary rules in the face of a liquidity trap is not prudent; it is irresponsible. (Full disclosure: I personally have been the most visible and vociferous advocate of inflation targeting).

But the current government has actually slowed the pace of reform, and the Bank of Japan — which only recently acquired Federal Reserve-style autonomy — has adamantly refused to do anything unconventional. (When I was in Japan in December, I witnessed an argument between former B.O.J. officials and current officials of the Ministry of Finance. The former declared that it would be wrong to do anything risky; the latter reminded them, to no avail, that the current policy of running up huge debts to finance public works is already very risky.)

Of course Krugman turned out to be absolutely correct.  The fiscal stimulus never got Japan out of the liquidity trap, and it was only in 2013 that Japan finally adopted a 2% inflation target—and then prices started rising.  Krugman was very worried about Japanese debt levels when their national debt was less than 150% of GDP—now it’s 250%.  All those “bridges to nowhere” were a monumental waste of money, when a 2% inflation target back in 2000 would have been far more effective.

Later in 2000, Krugman wrote more articles on Japan, which criticized the BOJ decision to raise rates.  Again, Krugman turned out to be completely correct—Japan fell back into recession and had to cut rates again.

So when did Krugman become “Krugman”?   It seems like the turning point was around 2002, when he started advocating fiscal stimulus for the US:

Not many people realize that in some ways Japanese economic policy responded quite effectively to a sustained slump. It’s easy to make fun of the country’s enormous spending on public works — all those bridges to nowhere in particular, highways with no traffic, and so on. Without question enormous sums have been wasted. But it’s also clear that all that spending pumped money into the economy, preventing what might otherwise have been a full-fledged depression.

So what will be the U.S. equivalent? Right now we are in effect following the reverse policy: slashing domestic spending in the face of an economic slump. Some of this is taking place at the federal level; the Bush administration is nickel-and-diming public spending wherever it can, shaving a billion here, a billion there off everything from veterans’ benefits and homeland security to Medicare payments. More important, the federal government is doing nothing to help as state and local governments, their revenues savaged by recession, make deep cuts in spending on everything that isn’t urgently necessary, and many things that are.

This is a radically different Paul Krugman from the 1999-2000 version:

1.  Now Krugman is making things up—for instance suggesting that Bush had adopted a contractionary fiscal policy, when Bush’s policy was actually quite expansionary (huge tax cuts, massive increases on federal spending on education, homeland security, Medicare drug benefit, military build-up.)  This is a more ideological Krugman than the neoliberal of 2000.

2.  Krugman says it’s easy to make fun of the Japanese public works, but doesn’t tell his readers that back in 1999 he was one of those people ruthlessly mocking the Japanese public works spending:

What continues to amaze me is this: Japan’s current strategy of massive, unsustainable deficit spending in the hopes that this will somehow generate a self-sustained recovery is currently regarded as the orthodox, sensible thing to do – even though it can be justified only by exotic stories about multiple equilibria, the sort of thing you would imagine only a professor could believe. Meanwhile further steps on monetary policy – the sort of thing you would advocate if you believed in a more conventional, boring model, one in which the problem is simply a question of the savings-investment balance – are rejected as dangerously radical and unbecoming of a dignified economy.

Will somebody please explain this to me?

One possibility is that Krugman turned left due to “Bush derangement syndrome.” In fairness, however, you could see a similar pattern in Ben Bernanke, who was a Republican during this period.  In 1999, Bernanke was also contemptuous of the view that the BOJ was out of ammunition, but by late 2008 Bernanke was also advocating fiscal stimulus.  Indeed right about the turn of the century there was a gradually shift to the left in many places.  Regulations started ramping up in the US (i.e. Sarbanes-Oxley).  The British Labour Party abandoned their fiscal austerity, as did the Dems in the US.  So perhaps Krugman was merely a part of this gradual change in the zeitgeist.  I haven’t changed, so I’m not well placed to understand what caused so many other people to become more sympathetic to fiscal stimulus and regulation.