Archive for the Category Praising Krugman

 
 

Brilliant Krugman, dumb leftists

In all of the discussion about how wrong the right has been about monetary issues over the past 7 years, it’s also worth pointing out some flaws on the other side.  But first let’s start with the good news.  To put the following Paul Krugman quote into context, he’s responding to a Ambrose Evans-Pritchard story (exposé?) that the Fed sees falling long term rates as a sign of monetary ease, calling for a bit tighter policy stance.  Here’s Krugman making the observation that a contractionary demand shock can actually lead to lower long term interest rates over time:

A first-pass way to think about this is surely to suppose that the Fed sets U.S. interest rates, so that an increased willingness of foreigners to hold our bonds shows up initially as a rise in the dollar rather than a fall in rates. This may then induce a fall in rates because the stronger dollar weakens both growth and inflation, affecting Fed policy – but this means that the rate effect occurs because the capital inflow is contractionary, and is by no means a reason to tighten policy.

It’s only one step from there to Milton’s Friedman observation that low interest rates mean that money has been tight.

Some of my liberal commenters make a big deal of the fact that Krugman, and other liberals bloggers (DeLong, Thoma, Duy, Yglesias, Wren-Lewis, etc.) have favored monetary stimulus, and that lots of silly right wing Congressmen have opposed these policies.

On the other hand the left has not exactly covered itself in glory.  President Obama has done essentially nothing over the past 6 years to promote monetary stimulus.  Ditto for European social democrats.  Elizabeth Warren suggested that ultra-hawk Paul Volcker would be a dream candidate for  Fed chairman (no, I’m not joking.)  And now we have the Finance Minister of Greece, a country fanatically opposed to any sort of meaningful supply-side reform, denigrating Greece’s only hope for a demand-side economic recovery:

The European Central Bank’s bond purchases will create an unsustainable stock market rally and are unlikely to boost euro zone investments, Greek Finance Minister Yanis Varoufakis warned on Saturday.

The ECB began a program of buying sovereign bonds, or quantitative easing, on Monday with a view to supporting growth and lifting euro zone inflation from below zero up towards its target of just under 2 percent.

Bond yields in the currency bloc have collapsed, but record low interest rates so far have not spurred investments that would support growth in recession-hit countries like Italy or Spain.

“QE is all around us and optimism is in the air,” Varoufakis told a business audience in Italy. “At the risk to sound the party pooper … I find it hard to understand how the broadening of the monetary base in our fragmented and fragmenting monetary union will transform itself into a substantial increase in productive investments.

“The result of this is going to be an equity run boost that will prove unsustainable,” he said.

I don’t know whether to laugh or cry.  As Tyler Cowen keeps saying, these are not serious people.

PS.  In the right column of this blog I’ve had a pathetically inadequate and useless set of “categories.”  I’m in the process of vastly expanding that list, although I’m still struggling with how to categorize monetary policy posts—there are too many.  This post will go into the new category “praising Krugman,” among others.  This revision process will take a long time, I’ve only recategorized about the first 100 posts, out of over 2800. So for quite a while these new categories will only include a tiny fraction of the relevant posts.  It’s actually part of a project to turn my blog into a book.

HT:  Luis Pedro Coelho

 

Paul Krugman is gaining a better understanding of market monetarism

Here’s Paul Krugman:

I would submit, by the way, that the quasi-monetarists “” QMs? “” have actually backed up quite a bit on their claims. They used to say that the Fed can easily and simply achieve whatever nominal GDP it wants. Now they’re more or less conceding that the Fed has relatively little direct traction on the economy, but can nonetheless achieve great things by changing expectations. That’s pretty close to my original view on Japan. But changing expectations in the way needed is hard, especially when the Fed (a) faces massive sniping from the right and (b) has a number of hard-money obsessives among its own officials.

Of course we’ve always focused on expectations; that’s why we’re called market monetarists.  When I wrote an open letter to Paul Krugman in 2009, I discussed the need for QE, lower IOR, and a NGDP target, level targeting.  That’s still my view.  If Krugman thinks we’ve moved in his direction, it’s because he never really understood our views until now.  Come to think of it, there’s a lot of evidence that he didn’t understand what we were saying.

In fairness, market monetarists have been supportive of QE2, as that seemed much more politically feasible than NGDP targeting, level targeting.  Indeed even more feasible than price level targeting.  So it may have appeared we thought that was the optimal policy, at least at first glance.  But Krugman also supported QE2.

My areas of disagreement with Krugman have always been over fairly subtle questions.  He sees Japan as an example of an expectations “trap,” I see the problem as simply a central bank that has the wrong policy objective–an excessively low inflation target.  Not a central bank “trapped” by forces beyond its control.  He sees expected inflation as being needed; I see higher expected NGDP growth as being needed (but not necessarily anything close to 4% inflation.)  He sees monetary stimulus working through the real interest rate transmission mechanism, I see the interest rate as a sort of epiphenomenon, and instead see the mechanism as excess cash balances driving NGDP higher in the long run (hot potato effect), and expectations of future increases in NGDP driving current asset prices and current AD in the short run.  Other market monetarists obviously have diverse views on this question.

Our areas of agreement have always been much more important:

1.  We both see a need for much more demand stimulus.

2.  We both see temporary currency injections as useless and monetary aggregates as unreliable policy indicators.

3.  We both believe that the key is to raise expectations of future monetary stimulus.

4.  We both agree (I think) that if QE2 worked at all, it probably worked partly by sending a signal regarding the Fed’s future policy intentions.

5.  We both like Gauti Eggertsson’s work on the Depression (AER 2008.)  If Krugman thinks I’m a Johnny-come-lately to his expectations hypothesis, he might take a look at the 3 papers I wrote that Gauti cited in 2008, which argued (among other things) that the Fed’s 1932 open market purchases failed (contrary to the claims of Friedman and Schwartz), and that the reason they failed is that the purchases were viewed as temporary because of the constraints of the gold standard.

One final point.  There is a difference between Krugman and the market monetarists in terms of how we approach the thought experiment of an increase in the money supply at the zero bound.  He assumes the increase is expected to be temporary, and we often assume it’s permanent.  Thus the debate is often people talking right past each other, as even Krugman agrees that a permanent monetary injection would be expansionary.  In favor of our assumption, standard quantity theory models generally assume a permanent, one time money supply increase, when thinking about the effect on the price level.  To see why, consider how Irving Fisher or Milton Friedman would have reacted if told the Fed planned to double the money supply, and then remove the new money 12 months later.  Would Fisher and Friedman have predicted that the price of homes would double, but then fall back to the original level 12 months later?  Obviously not.  On the other hand neither Fisher nor Friedman seems to have fully understood the importance of the distinction between temporary and permanent monetary injections.  So Krugman’s 1998 paper did a great service by showing just how important this distinction really was.

But here’s something I never see Krugman discuss.  Expectations aren’t just important at the zero bound, they are always important.  If interest rates are 5%, and the Fed suddenly announces that they will immediately double the money supply, but then remove the new money a year later, there is little impact on prices.  So the expectations approach doesn’t merely challenge the naive QTM models at the zero bound, it does so at positive interest rates as well.  Expectations always matter a lot.  So why does the problem seem more severe at the zero bound?  Nick Rowe has pointed out that the Fed becomes mute at the zero bound.  As long as rates are positive, they can send signals about their future monetary policy intentions by adjusting short term rates.  Once rates hit zero, they don’t know how to communicate their policy intentions to the public, and the price level becomes unmoored, drifting around aimlessly.  At least until they find other tools (like QE) to communicate their future policy intentions.

PS.  I’m having lots of computer problems, so blogging may slow down for a while.

The sad end of monetarism

Two years ago Allan Meltzer warned that the Fed’s policies would lead to high inflation.  Paul Krugman and I told him he was wrong.  In a new article in the WSJ he repeats this warning.  But today I’d like to focus on something more disturbing, the end of monetarism as a powerful intellectual movement that addresses our problems.  Here’s how Allan Meltzer begins:

Day traders and their acolytes tried to pressure the Federal Reserve to open the money spigots wider this week. They called for QE3, a third round of unprecedented quantitative easing. Fortunately, the Fed said no to QE3, at least for now. But it did vote to continue its super-easy, zero-interest-rate policy until mid-2013, well after the next presidential election.

Alarm bells are already ringing.  This isn’t monetarism at all.  Milton Friedman reminded us that ultra-low rates meant money had been tight.  And it wasn’t just Friedman.  In this (undated) paper, Allan Meltzer argued that Japan needed easier money at a time when interest rates were near zero and banks had plenty of reserves.  The argument that money is easy due to low rates is a Keynesian and Austrian argument.  Meltzer continues:

How can the Fed know now that a zero-rate policy will be required two years from now? It can’t. Yes, economic growth has slowed, and forecasts of future growth decline daily. But the United States does not have the kind of problems that printing more money will cure.

So what kind of problem do we have?

Banks currently hold more than $1.6 trillion of idle reserves at the Fed. Banks can use those idle reserves to create enormous amounts of money. Interest rates on federal funds remain near zero. Longer-term interest rates on Treasurys are at record lows. What reason can there be for adding more excess reserves?

This is odd for two reasons.  It doesn’t tell us what sort of problem we have (demand or supply-side.)  Given that NGDP has grown 4% over three years, whereas the trend rate would be about 15%, I would think a monetarist would see the problem as demand side.  Friedman often pointed to the slowdown in NGDP growth in Japan during the 1990s.  I’m also confused by the point of this paragraph.  It seems to imply that the US is in a liquidity trap.  But monetarists like Friedman and Meltzer denied Japan was in a liquidity trap, despite large levels of bank reserves.  This sounds more like Keynesianism.  Meltzer continues:

The main effect would be a further devaluation of the dollar against competing currencies and gold, followed by a rise in the price of oil and other imports. Inflation is now at the edge of the Fed’s comfort range, which is below 2%. Money growth (M2) reached 10% for the past six months, presaging more inflation ahead.

Now I’m totally confused.  If the US were in a liquidity trap, then adding more reserves would not devalue the dollar.  In the monetarist model there is no mechanism where monetary stimulus depreciates the dollar but fails to boost NGDP.  None.  This is the sort of argument made by Joe Stiglitz.  I’m very surprised to see Allan Meltzer make this argument.

I’m even more shocked by the prediction of more inflation ahead.  Oil prices have fallen sharply.  Tips spreads are low.  Stocks are falling.  We have 9.1% unemployment.  Where exactly is this high inflation going to come from?  Gasoline prices?  Rapid growth in wages?  I just don’t see it.  M2 growth was even higher in late 2008, leading to the previous false prediction by Meltzer (of high inflation ahead.)  But at least I can’t deny that using M2 is an application of old-style monetarism.  It’s also why us quasi-monetarists now focus on other indicators.  Skipping ahead a bit:

A large part of our current unemployment problem reflects the unsold stock of housing left from mistaken past housing policies. We cannot quickly convert most carpenters and bricklayers into computer operators. Short-term policy actions will not solve that problem. But population growth, falling housing prices and rising rents will eventually help by stimulating enough new construction to put many in the housing industry back to work.

This is the sort of quasi-Austrian argument that Friedman and Schwartz severely criticized in their Monetary History.  It’s also completely false, for many reasons.  First, the job losses in housing construction were far too small to significantly impact unemployment.  Roughly 70% of the decline occurred between January 2006 and April 2008, and yet unemployment merely edged up from 4.7% to 4.9%.  The big job losses occurred in late 2008 and 2009, as the sharpest fall in NGDP since 1938 (something monetarists should be very worried about) led to a decline in commercial construction, manufacturing and services.  Eventually even state and local government jobs were hit.  Housing construction over the past 10 years is far below previous decades, the empty homes are due to poverty and unemployment caused by falling NGDP, not excess construction.  Many young adults are jobless and still living at home.  Meltzer continues:

The U.S. also has to make a major transition from a consumption economy to one that exports more and grows consumer spending more slowly. That transition has started, but it will not occur quickly. Those who look to consumption spending to recover its old path are hoping for a past that should not return.

That might be true, but wouldn’t monetarists argue that any transitions would be easier if NGDP hadn’t fallen at the sharpest rate since 1938?  Meltzer told us that monetary stimulus would merely depreciate the dollar.  That’s not a monetarist argument, but let’s say it’s true.  Why would that be bad if we need to transition from consumption to exports?  And why did Meltzer argue that Japan should engage in additional monetary stimulus to depreciate its currency at a time when rates were near zero and banks had lots of reserves?  Why was currency depreciation a useful tool for Japan, but not the US?

Meltzer goes on to make lots of sensible arguments for structural reforms to boost productivity growth.  I certainly agree we have structural problems—indeed I’m increasingly sympathetic to Tyler Cowen’s Great Stagnation hypothesis.  But we also have a demand problem, which seems obvious to me when you look at data such as NGDP growth since mid-2008.  In an earlier post Kevin Donoghue made a very astute comment:

You might ask yourself why two people who differ as much in their politics as Krugman and Sumner end up sounding so similar. Could it be that empirical evidence played a part?

I think that’s right.  We both look at lots of empirical data, including forward-looking market forecasts.  These indicators have been consistently warning of too little AD since mid-2008.

It pains me to write this because monetarism has greatly informed my worldview.  Meltzer is probably one of the three most distinguished post-war monetarists (along with Brunner and Friedman.)  But it seems to me that this type of monetarism has reached a dead end.  It needs to be reformulated to incorporate the insights of the rational expectations and EMH revolutions.  It needs to focus on targeting the forecast, using market forecasts, not searching for an aggregate with a stable velocity.  And it must be symmetrical, with just as much concern for excessively low NGDP growth as excessive high NGDP growth.  It needs to offer answers for high unemployment, and advocate them just as passionately as Friedman and Schwartz argued that monetary stimulus could have greatly reduced suffering in the Great Depression.  Just as passionately as Friedman and Meltzer argued for monetary stimulus in Japan once rates hit zero.  Unemployment is the great tragedy of our time.  History will judge the current schools of thought on how seriously they addressed this issue.

HT:  Big thanks to Lars Christensen, who supplied both articles, and some ideas.

Update:  I slightly regret the post title.  Just to be clear, I meant that it’s sad that this once proud school of thought seems to be reaching the end of the road.  Not as a sort of insult to Mr. Meltzer.  I disagree, but there is nothing “sad” about his editorial.  I just think he’s wrong.

Where Krugman was magnificantly right

I feel bad doing 4 negative pieces in a row.  So let’s talk about where Paul Krugman was way ahead of everyone else, and is still ahead of almost everyone else.

During the late 1990s and early 2000s Krugman warned that what happened in Japan could also happen in the US.  He was referring to the zero rate trap, and the long period of economic weakness.  I was skeptical, for two reasons:

1.  The US inflation target (believed to be around 2%) was significantly higher than the Japanese target (closer to zero).  I am pretty sure that (prior to 2008) there are no examples in all of world history of countries stumbling into a liquidity trap with mild inflation (although one could have inflation after getting into the trap.)

2.  I believed Bernanke when he said the Fed had plenty of tools to use once rates hit zero.  Indeed I still believe this, as does Bernanke.  But I also inferred from this claim that the Fed would actually use those tools to keep AD on target.  Big mistake.

Most people see this crisis from the perspective of a single framework, which usually involves debt/bubbles/etc.  Instead we need two completely different frameworks, like two trains running on different tracks.  One framework is the supercycle in nominal interest rates.  They peaked in 1981 at about 15%, and have trended downward ever since.  When they hit 1% in 2003 I thought it was the bottom of the supercycle.  I still thought that in 2007, when they were much higher.  But the supercycle wasn’t over, by 2008 they had fallen close to zero.  Most people think this progressive fall in interest rates (both real and nominal) represents progressively more expansionary monetary policy.  They blame the Fed.  Krugman and I both see it as a fall in the Wicksellian equilibrium interest rate, to unusually low levels.  I attribute it to some combination of savings glut and lack of good investment opportunities.  It certainly wasn’t caused by easy money, as inflation has trended downward since 1981, reaching negative levels in 2009.

The second problem was real, factors such as the US banking/mortgage/GSE/regulation mess, which led to a housing crash in 2008.  And to a lesser extent the energy shock of early 2008, which hit autos hard.  These shocks (combined with an inadequate response from the Fed) put us in a recession in 2008, which drove rates to zero.  The moment the markets realized the Fed had no backup plan, when they realized the Greenspan/Bernanke puts were no longer operative, was the point where NGDP expectations plummeted.  The rest is history.  Asset prices collapsed, and the financial crisis got much worse.

The real factors are really easy to see, and hence 99% of pundits focus on those factors.  The nominal problem is much more subtle.  Indeed it never would have occurred if (like Australia) we’d had a 7% NGDP growth trend—a policy Krugman advocates in the form of a 4% inflation target.  The lack of effective monetary policy changes everything.  That’s one reason Krugman seems so much more Keynesian, so much more left wing, than in the early 1990s.  With a Bernanke put, there’s no need for fiscal stimulus, even in a recession.

And nothing has been solved.  The low interest rate supercycle is likely to last for decades, and indeed may get worse when China becomes another Japan.  The next recession is likely to drive interest rates right back to zero, unless the Fed has learned something from this cycle.  But they are telling us that they haven’t.  They tell us that they oppose higher inflation targets, or price level targeting, or NGDP targeting, or indeed every single policy that would prevent the zero rate trap.  They’ve worked hard in getting inflation expectations down to this level, and dammit they’re not going to give up those gains just because it makes monetary policy ineffective for the next 5 recessions in a row, and leads to so much fiscal stimulus and recessionary deficits that we end up like Greece.

Have a nice day.

Krugman 1998 . . . Sumner 1993

Paul Krugman and I both use a similar framework to analyze monetary policy.  Temporary monetary injections don’t have much effect; stimulus comes from injections that are expected to be permanent.  I thought it might be interesting to review just how similar our views are, given the small but important differences in how we interpret this framework.

This is from Krugman’s justifiably famous 1998 paper “It’s Baaack“:

One often hears, for example, that the real problem is that Japan’s banks are troubled, and hence that the Bank of Japan cannot increase monetary aggregates; but outside money is still supposed to raise prices, regardless of the details of the transmission mechanism. In addition to the problem of bad loans, one often hears that corporations have too much debt, that the service sector is overregulated and inefficient, and so on. All of this may be true, and may depress the economy for any given monetary base – but it does not explain why increases in the monetary base should fail to raise prices and/or output. One way to say this is to remember that the neutrality of money is not a conditional proposition; money isn’t neutral “if your banks are in good financial shape” or “if your service sector is competitive” or “if corporations haven’t taken on too much debt”. Money (which is to say outside money) is supposed to be just plain neutral.

So how is a liquidity trap possible? The answer lies in a little-noticed escape clause in the standard argument for monetary neutrality: an increase in the money supply in the current and all future periods will raise prices in the same proportion. There is no corresponding argument that says that a rise in the money supply that is not expected to be sustained will raise prices equiproportionally – or indeed at all.

.  .  .

Suppose that we start with a [flexible price] economy . . .  and then imagine an initial open-market operation that increases the first-period money supply.  (Throughout we imagine that the money supply from period 2 onwards remains unchanged – or equivalently that the central bank will do whatever is necessary to keep the post-2 price level stable). Initially, as we have already seen, this operation will increase the price level and reduce the interest rate. . . . But what happens if the money supply is increased still further – so that the intersection of MM and CC is at a point like 3, with a negative nominal interest rate?

The answer is clearly that the interest rate cannot go negative, because then money would dominate bonds as an asset. What must therefore happen is that any increase in the money supply beyond the level that would push the interest rate to zero is simply substituted for zero-interest bonds in individual portfolios (with the bonds being purchased by the central bank in its openmarket operation!), with no further effect on either the price level or the interest rate. . . .

A good way to think about what happens when money becomes irrelevant here is to bear in mind that we are holding the long-run money supply fixed at M*, and therefore also the long-run price level at P*. So when the central bank increases the current money supply, it is lowering the expected rate of money growth M*/M, and also – if it does succeed in raising the price level – the expected rate of inflation P*/P. Now what we know is that in this full employment model the economy will have the same real interest rate whatever the central bank does. Since the nominal interest rate cannot become negative, however, the economy has a minimum rate of inflation or maximum rate of deflation.

Now suppose that the central bank in effect tries to impose a rate of deflation that exceeds this minimum – which it does by making the current money supply M large relative to the future supply M*. What will happen is that the economy will simply cease to be cash-constrained, and any excess money will have no effect: the rate of deflation will be the maximum consistent with a zero nominal rate, and no more.

Great stuff.  In a 1993 paper on colonial American currency, I developed a similar idea.  Here’s a few passages from that paper:

[note (1=r)n and (1+r)x are meant to be (1+r) raised to the power of n or x.]

For example, suppose that at time=zero there is a nonpermanent currency injection that is expected to be retired at time=x.  Then, if the real return from holding currency has an upper bound of r, the ratio of the current to the end-period price level (Px-n/Px) cannot exceed (1 + r)n.  Furthermore, if real output is stable, it would not be expected that Px would be any different from Po.  Both price levels would be determined by the supply and demand for money as in the quantity theory.  The existence of a maximum anticipated rate of deflation (r) has the effect of placing a limit on the size of the initial increase in the price level.  No matter how large the original currency injection, the price level at the time of the currency injection cannot increase by more than a factor of (1+r)x.  Furthermore, these restrictions on the time path of prices can be established solely on the basis of the future time path of the quantity of money, without any reference to fiscal policy.  It is this quantity-theory model that is applicable to the colonial episodes of massive and nonpermanent currency injections. . . .

The impact of U.S. monetary policy during the period from 1938 to 1945 provides a good illustration of the preceding hypothesis.  Between 1938 and 1945 the currency stock increased by 368 percent while prices (the GNP deflator) increased by only 37 percent.  There was no depreciation in the dollar (in terms of gold.)  Although real output grew substantially, the ratio of currency to nominal GNP increased from .062 to .132.  Why was the public willing to hold such large real balances?

Although the U.S. did not experience deflation following World War II (as it had following previous wars), surveys indicate that deflation was anticipated.  During the entire period from 1938 to 1946, the three-month Treasury Bill yield never rose above 1/2 percent.  The fact that massive currency injections (associated with expectations of future deflation) were able to drive the nominal interest rate down close to zero, is at least consistent with the modern quantity-theory model I have described.

In both our papers the equilibrium real interest rate sets the maximum rate of expected deflation.  Krugman recognized that the equilibrium real interest rate might be negative (and thus we might have a liquidity trap at positive expected rates of inflation.)  Oh, and although my paper came first, his is 100 times better.

In future posts I’ll discuss why we interpret this framework differently.  But at least we agree that the quantity of money drives the price level in the long run.

And just so you won’t think there’s anything new under the sun, here’s some Congressional testimony from 1932 involving New York Fed President Harrison and Representative Goldsborough (proposing a price level targeting bill.)  Notice how it weirdly echoes Krugman’s discussion of Japan:

Harrison: [T]hat pressure [excess reserves] does not work and will not work in a period where you have bank failures, where you have panicky depositors, where you have a threat of huge foreign withdrawals, and where you have other disconcerting factors such as you have now in various sorts of legislative proposals which, however wise, the bankers feel may not be wise. You then have, in spite of the excess reserve, a resistance to its use which the reserve system can not overcome.

Goldsborough: [I]n anything like normal times, specific directions to the Federal reserve system to use its power to maintain a given price level will tend to decrease very greatly these periods, or stop these periods of expansion and these periods of deflation which so destroy confidence and produce the very mental condition that you are talking about…. I do not think in the condition the country is in now we can rely upon the action of the Federal reserve system without the announcement of a policy. A banker may look at his bulletin on Saturday or on Monday morning and see that the Federal Reserve system has during the previous week purchased $25,000,000 worth of Government securities. But that does not restore his confidence under present conditions because he does not know what the board is going to do next week…. If this legislation…were passed, the Federal Reserve Board could call in the newspaper reporters and say that Congress has given us legislative directions to raise the price level to a certain point, and to use all our powers to that purpose, and we want you to announce to banks and public men at large that we propose to go into the market with the enormous reserves we now have available under the Glass-Steagall Act and buy $25,000,000 of Governments every day until the price approaches the level of that of 1926…. [I]f the bankers and business men knew that was going to be the policy of the Federal reserve system,…it would restore confidence immediately….and the wheels of business would turn [italics supplied].

Note that FDR adopted price level targeting in 1933.

The entire quotation (including italics) is taken from an unpublished manuscript by Robert Hetzel.  You will be hearing a lot more about Hetzel’s work in the future.  I regard it as the definitive account of the Great Recession, comparable to Friedman and Schwartz’s Monetary History.