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.

Most people agree that the Fed is a conservative institution. But conservative in what sense? Temperamentally, or ideologically? A temperamentally conservative Fed is reluctant to go out on a limb and try new techniques. An ideologically conservative Fed abhors greater than 2% inflation in much the same way that a vampire abhors sunlight. It turns out that it matters a lot whether the Fed is temperamentally conservative, ideologically conservative, or both.

In recent posts, Ryan Avent and Matt Yglesias have criticized the widespread view among Keynesians that the Fed is out of ammunition. People like Larry Summers are skeptical about whether the Fed could stimulate the economy, because doing so would require them to boost inflation. These Keynesians have tended to recommend fiscal stimulus as the only way to boost aggregate demand.

In my view there are two flaws with this argument. First, some Keynesians seem to believe that fiscal stimulus can work without raising inflation expectations, whereas monetary stimulus is only effective at the zero bound if the Fed succeeds in convincing the public that higher inflation is on the way.  But both fiscal and monetary policy work through higher AD.  And unless the SRAS curve is completely flat, higher AD means higher inflation. The markets know this; hence fiscal stimulus will be expected to work if and only if it boosts inflation expectations.  Yes, the early Keynesians believed the SRAS was flat when the economy had lots of slack, but after watching how sensitive oil prices are to growth expectations, I can’t imagine that anyone still believes in a flat SRAS curve.

So if fiscal stimulus is to work, it must boost inflation expectations. This is why we need to know the Fed’s motives. Will the Fed attempt to squash the higher inflation resulting from fiscal stimulus, or will they allow inflation expectations to rise?  Most Keynesians seem to have assumed the Fed was temperamentally conservative. That they were reluctant to make the sort of bold moves required to boost AD at the zero bound, but wouldn’t stand in the way of fiscal stimulus. And in fairness, there are statements by Bernanke that seems to support that assumption. But the actions of the Fed strongly suggest otherwise. Consider Fed policy since 2008:

1. The Fed started paying IOR for the first time in its history.

2. The Fed got involved in bailing out the banking system to an unprecedented extent.

3. The Fed got heavily involved in buying MBSs (QE1)

4. The Fed did QE2, with longer term bonds

5. The Fed did Operation Twist

That doesn’t seem like a timid or cautious Fed to me, that seems quite aggressive. Not at all temperamentally conservative. Now let’s consider evidence for ideological conservatism. Here’s Ryan Avent:

According to the Cleveland Fed’s estimates, 10-year inflation expectations haven’t risen above 2.1% since the end of 2008. At least three times during that span, the Fed has halted or reversed its easing, first by ending its initial asset purchases, then by allowing its balance sheet to contract naturally as securities matured, and then by ending the asset purchases known as QE2. Expectations have remained in check because the Fed has opted not to continue policies that would raise them. The myth of Fed helplessness is just that.

I think that’s exactly right. Ryan is describing a temperamentally ambitious Fed willing to try all sorts of unconventional policies, but which pulls back whenever inflation threatens to exceed 2%. My question to the Keynesians is:

How does fiscal stimulus overcome an ideologically conservative Fed?

I think they have in mind a scenario where the Fed won’t take affirmative moves to kill a recovery, such as raising interest rates. And that may be right. (We’ll see when we actually get a recovery—the FDR-era Fed, the BOJ, and the ECB all raised rates prematurely.) But that’s not the right question. The problem is that the Fed needs to do extraordinary things just to keep inflation from falling well below 2%. And it seems like when inflation rises to 2%, they stop doing those things. That’s ideological conservatism. It may be unintentional on the Fed’s part (I believe it is unintentional on Bernanke’s part) but it means the Fed is not just failing to do its part, it’s actually sabotaging fiscal stimulus.

PS. I’d also note that with an ideologically conservative Fed the most effective fiscal policies (for reducing unemployment) are not at all what progressives would like.  You’d need to lower employer-side payroll taxes, lower minimum wages, cut back on the maximum duration of UI benefits, in order to shift aggregate supply to the right. It’s interesting that a Fed dominated by Republicans does policies that make conservative fiscal policy the only effective option. Morgan Warstler’s fantasy.

This is from an excellent Matt Yglesias post entitled “Could A Determined Central Bank Fail To Inflate?”:

He quotes both former Federal Reserve Vice Chair Donald Kohn and former NEC Chairman Larry Summers as expressing skepticism that it would be possible for the Federal Reserve to generate higher inflation expectations under conditions of depressed demand and slack output. It’s difficult for me to know how we would prove this one way or another, but I believe this view is mistaken. What’s more, I think it’s noteworthy that administration officials who say they believe this seem disinclined to follow this line of thought to its logical conclusion.

For starters, a little throat-clearing about the burden of proof. Many of the inflation skeptics have impressive resumes. What they don’t seem to have are empirical examples of central banks determined to raise inflation expectations and failing to do so. We don’t, unfortunately, have a directly parallel case to the current U.S. situation. But on my side I’ll cite as evidence the successful implementations of exchange rate policy by Sweden, Israel, and Switzerland during the current recession. Those, however, are small economy. So I’ll also cite FDR’s gold policy in the 1930s. That, however, was a gold standard. Then there’s QE 2. I would say we have examples of small open economies with determined policymakers doing this successfully. I would say we have an example of a large economy with determined policymakers doing this successfully under different historical conditions. And I would say we have an example of the Federal Reserving acting with only weak determination and achieving weak results. In my view that means our overwhelming presumption ought to be that a determined Federal Reserve system could increase nominal expectations, especially if the president and the treasury secretary supported that goal.

What’s more, it’s important to get a better understanding of why this would help the economy. The Obama administration seems to have thought of higher inflation expectations as useful primarily because they would help with the debt-deleveraging problem. That’s true. But there’s something more profound happening. Higher expected inflation lowers real interest rates and encourages investment. Higher expected inflation, at the margin, spurs consumption among households who aren’t debt-constrained. Most of all, higher expected inflation coordinates expectations so that households and firms expect higher levels of nominal spending and nominal income in the future, which encourages more real economic activity.

Now flip this around. What if I’m wrong. What if Michael Woodford and Paul Krugman and Lars Svensson and Scott Sumner are wrong? What if the academic writing of Christina Romer and Ben Bernanke is wrong? What if there’s something different about the 1930s and Switzerland and Sweden and Israel that means that in the United States you can’t spur higher inflation expectations as long as there’s all this slack in the economy? Well that’d be a pretty wild scenario. I first started to hear about this scenario back in late 2008 from folks who regarded themselves as well outside the mainstream of the economics profession. Their wacky idea was that faced with a deep recession, the government should basically just finance itself by printing money and not bother with the whole taxes thing. The natural counter to that argument was and is that such a policy would be highly inflationary. Personally, I’m old-fashioned, and I think it would be inflationary for the central bank to just print money at random to finance government operations. But by the same token, I have no doubt that a determined central bank can create inflation expectations. So bringing this back around to where we began, I think the Obama team made a huge mistake here and that most of the key players continue to be making the same mistake. Worse, a large fraction of the progressive community keeps making it along with them. But either the Fed could be doing a lot more to fix the economy, or else some really strange fiscal policy ideas need to be adopted.

It’s interesting to compare Matt’s post to the Ryan Avent quotation discussed in the previous post.  It seems to me that there is growing acceptance of this view among thoughtful centrists and progressives.  As much as I’d like to give credit to us market monetarists, there was obviously a sort of historical inevitability to the increased focus on the Fed, especially after fiscal policy seemed to reach a cul de sac.  Still, I think it’s fair to say we’ve at least contributed some talking points, which allow others to make the case much more effectively than we can.

PS.  I don’t mean to suggest that Avent and Yglesias are recent converts to these views–they been discussing monetary stimulus for several years.  Rather that the issue recently seems to have taken on a new urgency, especially given the lackluster employment numbers.

PPS.  This is also an excellent post.

The entire article is excellent, but I especially liked the way Ryan Avent framed the issue of monetary policy:

What Mr Kohn and Mr Diamond are actually saying is not that the Fed can’t do more, it’s that it won’t. Why, indeed, would expectations change under current circumstances, given a central bank that is clearly uncomfortable trying to raise them? The right question for Mr Klein to ask of the Fed is why it has been reluctant. And it has. According to yields on 10-year TIPS, expectations for annual inflation over that timeframe haven’t risen to 2.7% during the whole of the recovery. According to the Cleveland Fed’s estimates, 10-year inflation expectations haven’t risen above 2.1% since the end of 2008. At least three times during that span, the Fed has halted or reversed its easing, first by ending its initial asset purchases, then by allowing its balance sheet to contract naturally as securities matured, and then by ending the asset purchases known as QE2. Expectations have remained in check because the Fed has opted not to continue policies that would raise them. The myth of Fed helplessness is just that.

The history presented in the Reinhart-Rogoff research suggests that excessive central bank caution is another common feature of post-crisis recessions. Japan, whose “self-induced paralysis” Mr Bernanke himself has criticised, is the most obvious example. And perhaps the story here is also one of political constraints; maybe central banks just aren’t that independent, and it’s therefore difficult for them to do what’s necessary to return an economy to full employment. And in fairness, Mr Klein mentions the Ron Paul and Rick Perry reactions to Fed easing.

But it’s important to get this story right. It would be one thing to forgive Fed caution because people don’t like the idea of using inflation to erode debts, and maybe the Fed is helpless anyway. It’s quite another to add to the list of policy failures the fact that the Fed sat on its hands when it might have returned the economy to full employment because it was reluctant to accept even 3% inflation. And frankly, the rest of it””the too-small fiscal stimulus or the too timid housing policy””is small beer by comparison. Just as the conduct of monetary policy was the crucial difference in the magnitude of the Depression and that of the Great Recession, the conduct of monetary policy has been the crucial difference between the present, disappointing recovery and one in which a long-period of cyclical unemployment is not a prominent feature. Not the only difference, but certainly the biggest.

It was announced today that Christopher Sims and Thomas Sargent will be awarded the Nobel Prize in economics.  A number of bloggers have discussed their contributions, with MarginalRevolution leading the pack.  I don’t keep up with the field enough to provide a comprehensive overview, but I thought I’d provide a few remarks:

1.  I was shocked to hear that Sargent won, because I’d assumed he must have already won the award years ago.  Sargent and Wallace did a lot of important work integrating rational expectations into monetary economics back in the 1970s and early 1980s.  This work may have contributed to Krugman’s paper on expectations traps.  I often argue that if we do eventually get high inflation, the cause will most likely be tight money over the past few years.  That argument comes directly from this paper by Sargent and Wallace.

2.  The Swedish academy provided a short paper explaining some of the contributions of each winner, and I thought I’d make a few comments on impulse response functions and VARs, since those innovations (due mostly to Sims) are being singled out as particularly important:

The difference between forecast and outcome – the forecasting error – for a specific variable may be regarded as a type of shock, but Sims showed that such forecasting errors do not have an unambiguous economic interpretation. For instance, either an unexpected change in the interest rate could be a reaction to other simultaneous shocks to, say, unemployment or inflation, or the interest-rate change might have taken place independently of other shocks. This kind of independent change is called a fundamental shock.

The second step involves extracting the fundamental shocks to which the economy has been exposed. This is a prerequisite for studying the effects of, for example, an independent interest-rate change on the economy. Indeed, one of Sims’s major contributions was to clarify how identification of fundamental shocks can be carried out on the basis of a comprehensive understanding of how the economy works. Sims and subsequent researchers have developed different methods of identifying fundamental shocks in VAR models.

This certainly sounds like a promising approach, and yet I’ve always been skeptical about its practical applicability.  To be honest, I don’t know if my objections hold water, perhaps some commenters can let me know.

When impulse response functions are estimated for monetary shocks, they typically show tight money leading to a near term reduction in output, lasting for several years.  They also show no near term impact on prices, with a slight decline after about 18 months (although it’s not clear if the results are statistically significant.)

I have several problems with this approach.  Researchers often use changes in the monetary base or (more often) interest rates as indicators of monetary shocks.  I don’t find these to be reliable indicators.  They also use macro data such as the Consumer Price Index, which I view as not only highly inaccurate, but systematically biased over the business cycle.  If monetary shocks are misidentified, then you have big problems.  For instance, are higher interest rates tight money, or a reaction to higher NGDP growth expectations?

I’ve noticed that when we do have massive and easily identifiable monetary shocks, as in 1920-21, 1929-30, and 1933, output seems to respond almost immediately to the shock, as does prices.  This makes me wonder about those impulse response functions.  Why would severe monetary shocks immediately impact prices, whereas mild monetary shocks only impact prices after 18 months or more.  That doesn’t seem intuitively plausible, but perhaps I’m missing something here.

Perhaps VAR models are misidentifying monetary shocks.  I’d argue we saw a severe negative monetary shock in the second half of 2008, and that this caused both prices and output to decline significantly between mid-2008 and mid-2009.  What do VAR models show?  Do they correctly identify this contractionary monetary shock?  If not, is there any way of telling why not?  What variables might have given off a misleading reading?

3.  Paul Krugman recently made this argument:

Most spectacularly, IS-LM turns out to be very useful for thinking about extreme conditions like the present, in which private demand has fallen so far that the economy remains depressed even at a zero interest rate. In that case the picture looks like this:

Why is the LM curve flat at zero? Because if the interest rate fell below zero, people would just hold cash instead of bonds. At the margin, then, money is just being held as a store of value, and changes in the money supply have no effect. This is, of course, the liquidity trap.

And IS-LM makes some predictions about what happens in the liquidity trap. Budget deficits shift IS to the right; in the liquidity trap that has no effect on the interest rate. Increases in the money supply do nothing at all.

That’s why in early 2009, when the WSJ, the Austrians, and the other usual suspects were screaming about soaring rates and runaway inflation, those who understood IS-LM were predicting that interest rates would stay low and that even a tripling of the monetary base would not be inflationary. Events since then have, as I see it, been a huge vindication for the IS-LM types

I certainly agree about the lack of inflation resulting from the tripling of the base, which I also predicted, but I don’t see it as having much to do with the shape of the LM curve.  Indeed Sargent and Wallace (1973) provide a much clearer explanation; the Fed publicly announced that the monetary injections would be temporary (although you could also view the IOR program as an explanation.)

Here’s why I don’t like IS-LM.  Suppose the Fed had instead announced that the tripling of the base would be permanent.  What does the IS-LM model predict?  Notice the LM curve is flat, which means the variable on the vertical axis is the nominal interest rate.  But saving and investment depend on real interest rates.  A tripling of the base that was expected to be permanent, would lead to a large increase in inflation expectations—probably to double digit levels.  This would shift the IS curve far to the right, to where it intersected the LM curve at a positive interest rate.  Easy money would make interest rates rise.

So there is no liquidity “trap,” just a promise by the Fed not to allow significant inflation, which they have kept.  From the Fed’s perspective, and even more so from the ECB’s perspective, it’s mission accomplished—inflation has stayed low.  So IS-LM doesn’t show that monetary policy “doesn’t work,” because it has worked out exactly as the Fed hoped; no breakout in inflation expectations.  Some people are under the illusion that the Fed tried to create higher inflation and failed.  But Bernanke explicitly indicated that he was very opposed to a 3% inflation target.  People need to pay more attention to the Fed’s announced objectives, as those objectives are a major cause of the Great Recession.  And Sargent and Wallace help us to understand why.

PS.  I do not favor having the Fed announce that monetary injections will be permanent.  Rather I favor an announced target trajectory for NGDP (or prices), with level targeting.  This would implicitly mean that the Fed was promising enough of the injections would be permanent to hit the nominal target in the future.