Archive for February 2012


Did Krugman UNDERSTATE the fiscal multiplier?

That’s no typo, today I’ll argue that the fiscal multiplier might be bigger than Paul Krugman suggests.  Since I’m no Keynesian, this post is actually a sort of question for my Keynesian readers.  Here’s Krugman discussing Robert Hall’s work:

The Hall approach is to compare changes in real defense spending as a percentage of the previous year’s GDP with the actual percentage growth in real GDP. Over the period 1930-1962 “” no point going further, since there hasn’t been a good case since the Korean War “” it looks like this:

Clearly, expansionary policy is expansionary, and contractionary policy is contractionary. The apparent multiplier is only about 0.5, but anyone who knows a bit about the history realizes that this is likely to be an underestimate for current conditions: during World War II private spending was constrained by rationing, and postwar effects of the military contraction were partially offset by the pent-up consumer demand; the Korean War was paid for with tax increases amounting to around 4 percent of GDP.

I’ve never liked studies that use RGDP when looking for multiplier effects; it seems to me that the issue should be separated into two distinction questions:

1.  Does more G boost AD, and hence NGDP?

2.  Does more NGDP boost RGDP?

Those are actually unrelated questions.  The Keynesian model predicts that more G will boost NGDP, but also that the effect on RGDP depends on the slope of the SRAS curve.  Keynes assumed a sort of backward L-shape, where it becomes almost vertical at “full employment.”  Beyond that point more demand just leads to higher inflation, with no boost to output.  That’s now realized as being a bit too simple; the economy can temporarily go beyond full employment, as for example when housewives were put in munitions factories during WWII.

As you know, my skepticism about the fiscal multiplier has to do with point one (at least under certain monetary regimes like inflation targeting), not point two.

Now let’s look at the graph provided by Krugman.  I am no econometrician, but I recall being told that in this sort of graph the slope is mostly determined by the 4 points that are way off the Y-axis.  I’d guess the three boom years were WWII, and the big drop was 1946.  If I’m right, then Hall’s study might better be characterized as 1941-46, not 1930-62.  But perhaps there are now more sophisticated econometric techniques, which give more weight to small changes.

In any case, it seems to me that during WWII we were at full employment, so I’d expect the effect of more NGDP on RGDP to be much less than usual.  That’s a very different argument from Krugman’s “rationing” claim.  In other words, if I were Krugman I’d make two separate claims:

1.  The change in NGDP over the change in G is the fiscal multiplier.

2.  The multiplier model will usefully predict changes in RGDP when output is well below capacity (like right now.)

In that case Krugman could argue that the effect of more G on RGDP today might actually be greater than in 1943 and 1944, when we were already at full employment.

There are actually two ways of justifying the Keynesian multiplier, a real mechanism and a nominal mechanism.  The traditional Keynesian approach is basically nominal.  More G gives you more NGDP, and because wages and prices are sticky in the short run, you get more RGDP as well.  But there are also real models that don’t require any change in NGDP, especially those where the government output is quite different from private output.  Thus if the government spent lots of money on the military, it would increase RGDP unless private spending fell by an equal amount.  But a crowding out of private spending would make people “poorer” in terms of consumption, so they’d work harder to maintain their lifestyles.  This harder work would prevent complete crowding out.  (These real multiplier arguments don’t apply to lump sum tax cuts.)

I read Krugman as mostly relying on the traditional Keynesian nominal approach to the multiplier, augmented by an assumption that NGDP affects RGDP.

Since the evidence Krugman supplies is probably mostly based on WWII, here’s my take, FWIW:

1.  After mid-1940 the escalating war in Europe led to sharply higher US military output, and also probably raised expectations for future growth.  The monetary regime at the time was still linked to gold (as Christina Romer showed) and so it was very passive.  The stimulus seems to have boosted NGDP for very Keynesian reasons, as will happen if monetary policy is passive.

2.  Even if monetary policy had prevented any impact on NGDP (as under inflation targeting), I expect there still would have been some effect on RGDP for the “real multiplier” reasons I discussed above.  However in that case it’s unlikely (not impossible however) that Americans would have been better off in terms of living standards.

3.  Just to be clear, I do think Americans were made better off by the very fast 18 months of growth before Pearl Harbor, but that’s because NGDP did rise.  So to some extent we were overcoming suboptimal output due to sticky wages and prices.

To summarize, I think there are two arguments for a fiscal multiplier, both of which are somewhat problematic:

1.  The traditional Keynesian NGDP argument, which relies on incompetent central banks which fail to hit their nominal target (inflation or NGDP.)

2.  Real arguments that work to some extent under any monetary regime, but are more likely to raise RGDP than living standards.

Take the current situation in the UK.  If I’m not mistaken, the British political system is different from that in America.  British governments are basically elected dictatorships, with no checks and balances.  Even though the Bank of England is independent, the government can give it whatever mandate it likes.  If I’m right then both fiscal and monetary policy are technically under the control of the Cameron government.

So I read the UK austerity critics as saying:

Because you guys are too stupid to raise your inflation target to 3%, or to switch over to NGDP targeting, fiscal austerity will fail.  We believe the solution is not to be less stupid about monetary policy, but rather to run up every larger public debts.

Is that right?  Is that what critics are doing?

Some will argue that my views are naive, that Cameron would be savagely attacked for a desperate attempt to print money as a way of overcoming the failures of his coalition government.  Yes, but by whom?  Would this criticism come from Ed Balls?  Perhaps, but in that case he would essentially be saying:

“It’s outrageous that the Cameron government is trying to use monetary stimulus to raise inflation from 2% to 3%, whereas they should be using fiscal stimulus to raise inflation from 2% to 3%.”

I’m sorry to have to repeat this over and over again, but what 99% of pundits on both sides of the Atlantic are treating as a debate about “stimulus” and “austerity” is actually a debate about stupidity.  I’m not saying the pundits are stupid (Krugman certainly understands what I’m saying) but rather they are addressing their audience as if the audience was stupid.

Don’t talk down to Cameron and Osborne!  Don’t say “austerity will fail.”  Say “austerity will work, but only if the BOE becomes much more aggressive, otherwise it will fail.”  That sort of advice would be USEFUL.  Instead we are getting a bunch of pundits getting ego boosts because they can say “I told you so.”

Why are we few market monetarists the only ones to point out that the emperor has no clothes?

Update: The excellent commenter Britmouse says my UK argument was actually much stronger than I thought:

I did a post which touched on that. UK fiscal budget changes are subject to parliamentary approval, so there are “checks and balances”, especially given that we have a coalition government with a thin majority.

The legal mandate for the Bank of England only requires them to maintain “price stability”, where HM Treasury is required to define “price stability”, and can change it at will.

So to do a fiscal spending boost, Cameron/Osborne would have to go through parliament. To get a 3% inflation target, they would need only to send a single letter to Threadneedle Street, and the Bank of England would jump to it.


The argument against British austerity just vanished into thin air.  The Cameron government needs to ask for a higher nominal target over at the BOE.  Period.  End of story.

If the BOJ really wanted to . . .

There have been two views of the Great Japanese Deflation.  The standard view is that the Bank of Japan repeatedly tried all sorts of monetary stimulus, but nothing worked.  My view (and that of many other market monetarists) is that the Bank of Japan acted as if it didn’t want inflation, tightening policy in 2000 and 2006, despite no inflation.  In my view the press and many economists were somewhat naive in accepting the BOJ’s claim that there was little they could do to end deflation.  After all, the yen is a floating fiat currency.

Here’s the Financial Times expressing surprise at the BOJ’s new inflation target of 1%:

What’s less obvious, however, is why the BoJ’s policy board has opted for such a low target.

Inflation targeting is supposed to work by influencing expectations. Targeting inflation of 1 per cent will, therefore, do little to convince markets and the public that the central bank is hell-bent on boosting growth.

If the BoJ really wanted to signal its intent to fight deflation, then it would make a lot more sense for the Policy Board to begin by targeting inflation of above 2 per cent, before lowering it on signs that demand was recovering.

Yes, IF they really wanted inflation.  But they don’t.  There’s a reason why almost all central banks chose 2% inflation and the BOJ chose 1%.  These things don’t just happen by accident.

I used to wonder why the BOJ tightened so much in late 2006, raising interest rates and reducing the monetary base by 20%.  Another Financial Times story gives us the answer:

In recent years, the bank has tended to shrug off overt political pressure. A 1998 revision of the BoJ law strengthened its operational autonomy by removing the government’s authority to dismiss the governor and deputy chiefs.

Only under prime ministers with very solid popular support, such as Junichiro Koizumi between 2001 and 2006, has the BoJ appeared to bend to the government’s will. It has put up a particularly strong defence of its independence under Mr Shirakawa, promoted from deputy governor in 2008.

The difference now is twofold, say analysts. Firstly politicians are worried about their own job security, thanks to a persistently strong yen and the related “hollowing out” of Japan’s manufacturing sector.

.  .  .

“The linkage between the exchange rate and deflation is now clearer in [the] minds of politicians,” said Robert Feldman, senior economist at Morgan Stanley MUFG Securities. “As long as we have deflation the yen gets stronger.”

As of 7pm in Tokyo on Thursday, the yen had weakened about 1.5 per cent against the dollar since the BoJ announcement on Tuesday.

The second reason for the unusual degree of political pressure is that Mr Shirakawa’s five-year term expires in April next year. The governor, deputy governors and six members of the nine-member policy board are officially nominated by the cabinet, and approved by the Diet. Internal candidates from promotion will be anxious not to rule themselves out of contention by appearing too hawkish, say analysts.

“Senior BoJ officials are aware that the government could be trying to exclude them [from selection]. That is why they are trying to improve relations,” said Hiromichi Shirakawa (no relation), chief Japan economist at Credit Suisse.

.   .   .

But while the yen remains strong, and while the governor runs down his time in office, external pressure to ensure the bank’s policies do not jar with the government’s is unlikely to relent. And neither will the anti-deflation lawmakers.

Brad DeLong was right

[Warning, this post will initially seem sarcastic, but I’m dead serious.]

In July 2008 Brad DeLong made the  following astute prediction:

The chance that American taxpayers will actually lose any money if Ben Bernanke and Henry Paulson decide that Fannie and Freddie need government support is very low:

* The interest payments they have coming in are greater than the interest payments they have going out.

* Their government guarantee is itself a very valuable asset that they have made a lot of money off of in the past and will make more off of in the future.

* They are not even in liquidity trouble–unless they begin to have problems rolling over their discount notes…

* As long as it is generally understood that they are too big to fail, they should not even have liquidity problems–absent a depression that bankrupts many currently-solvent homeowners, that is.

I’d guess that 99% of readers would find DeLong’s prediction incorrect.  That’s because most people are excessively impressed by unconditional forecasts.  When dealing with business cycles and financial markets only conditional forecasts matter.  People win the lottery every day.  I’m no more impressed by an economist making an unconditional prediction that turns out correct than I would be if my plumber won the lottery.

DeLong correctly realized that a depression could push a lot of otherwise-solvent homeowners over the edge.  And of course that’s exactly what happened; the biggest drop in NGDP since the 1930s began the very month DeLong made the prediction.

I’ve had a hard time convincing people that much of the financial crisis was caused by falling NGDP.  Or that with better Fed policy the banking crisis would have been far milder.  I don’t know if DeLong agrees with me, but based on the logic of his prediction he ought to.  After all, the very same factor that caused the GSEs to end up much worse off than expected, also damaged the rest of the financial system.  That’s not to say that there weren’t many problem loans that were unrelated to the fall in NGDP, and I won’t deny that some banks (plus Greece) would have failed with even perfect monetary policy.  But the NGDP collapse made the crisis far worse than it should have been.

I’d guess DeLong made the same mistake as I did.  I suspect he assumed that a Fed chairman who has written papers criticizing the BOJ for not showing “Rooseveltian resolve” in fighting against inadequate NGDP growth, would be unwilling to preside over the greatest NGDP collapse since the 1930s.

I blame myself.  As Ball recently showed, the warning signs were there.  Ever since 2003 Bernanke was increasingly absorbed into Fed-think, which doesn’t allow for price level or NGDP commitments that might later embarrass the Fed.

HT:  123

PS.  After I completed this post I ran across Paul Krugman’s Playboy interview:

PLAYBOY: Were crimes committed here, and should people be in jail?

KRUGMAN: It’s hard for me to believe there were no crimes. Given the scale of this, given how many corners were being cut, some people must have violated laws. I think people should be in jail partly because I’m sure crimes were committed and partly because the lack of accountability is a serious problem. Something terrible happened and nobody has been held accountable. The public is angry, and a lot of the anger is being directed at the wrong targets.

I wonder how commenters will react to this quotation.  His answer reminds me of  the film “12 Angry Men.”   And also that if I’m a banker I don’t want Krugman on the jury.  But I do very much identify with the final sentence of that answer.  There are lots of scapegoats out there, and sometimes it’s easier to see the real villains in another culture, where you can be more dispassionate.  Krugman underestimates how much of our recession was caused by the Fed.  But there’s no doubt he knows who’s to blame for the eurozone recession:

PLAYBOY: Greece and Italy are in financial chaos. Are the euro and the European Union dead? Is that a good thing or a bad thing, or should we even care?

KRUGMAN: It’s on the edge. They need drastic action””basically printing a lot of money for the time being””and it looks highly doubtful that they’ll do it.

DeLong is right that much of our debt crisis is due to falling NGDP and Krugman’s right that the eurozone’s big problem is excessively tight money.

Now that both Keynesians and market monetarists agree on the problem, let’s start working on solutions.

PPS.  And don’t worry, the link is completely work-safe.  That is as long as you don’t live in a country founded by Puritans.

All hail Pete Klenow

Fifty elite economists were asked what I thought was a very simple question:

Because of the American Recovery and Reinvestment Act of 2009, the U.S. unemployment rate was lower at the end of 2010 than it would have been without the stimulus bill.

And only Pete Klenow got it right:

Agree.   Caveat: how much was it offset by less aggressive (than otherwise) unconventional monetary policy?

You might be thinking “Wait a minute Sumner, I thought you disgreed.”  You guys forget I’m a teacher.  I grade answers based on whether they used proper reasoning, not whether I happen to agree with the conclusion.  (Yes, I know some other professors don’t do things that way, but I do.)

Pete Klenow was the only one of 50 who seemed to understand the question.  They were asking if fiscal policy lowered unemployment, i.e. boosted RGDP.  But the standard model says that only occurs if it boosts AD.  And that only occurs if NGDP rises.  And the standard new Keynesian and monetarist and new classical models all agree that monetary policy drives NGDP.  So it’s really asking if the 2009 fiscal stimulus in some way caused NGDP to evolve differently than otherwise, which is inescapably a question about how monetary policy would have evolved in the absence of the ARRA.  And only one guy seemed to understand that.

The correct answer was; “What kind of question is that!  How the hell can I answer that if you don’t tell me the monetary policy counterfactual.”

Matt Yglesias recently made the following comment:

Doug Elmendorf, on the CBOBlog: “Slack demand for goods and services (that is, slack aggregate demand) is the primary reason for the persistently high levels of unemployment and long-term unemployment observed today, in CBO’s judgment.”

This is correct. Strangely the subsequent discussion completely neglects monetary policy as relevant to demand.

It may be strange, but we no longer should be surprised.  People who read economics blogs live in a sort of bubble, where there is widespread understanding of the failure of monetary policy.  But out in the real world things are very different.  Ever since NGDP collapsed in 2008, the profession has largely ignored monetary policy.  In the previous post I pointed out that our profession was to blame for the severe recession.  Every day that goes by brings more and more evidence supporting that sad conclusion.

PS.  I will go to my grave wondering why almost every macroeconomist in America wasn’t loudly calling for more monetary stimulus in late 2008.  Instead almost none were.  Epic fail.

PPS.  Commenter Liberal Roman in the previous post:

Recently, I have taken a break from Scott’s site and the whole market monetarist blogosphere just to see if anything has changed out there in the mainstream. And I am sad to report that nothing has. On the right, it’s the same old argument that companies and people aren’t spending because we have a Kenyan Nazi socialist as a President. And on the left, it’s people aren’t spending because we are not forcing companies to pay them enough so that they can spend. I have spent so much time engrossed in the market monetarist blogosphere that I felt like we actually are having some impact. But once you peek your head back out into the mainstream, we are barely causing a ripple. When I bring up NGDP targeting in comment threads, I get the worst response: nothing. No rants against me, just deafening silence.

Of course the good news is that we don’t have to convince the masses. As Scott points out, we just have to convince the average macroeconomist.

We see people like Krugman/Romer/Cowen/DeLong/Yglesias/etc saying good things about NGDP targeting, and think we are winning.  But we are surrounded by two much bigger groups.  Those who don’t see a need for more spending (wrong, but logically defensible), and those who see a need for more demand, but for some odd reason don’t see the key role of monetary policy in driving NGDP.  I fear the latter group represents the mainstream of our profession.  So we have our work cut out for us.

HT:  Marcus Nunes

Bernanke and Burns: Right in the mainstream

When Arthur Burns was named to head the Federal Reserve Board in 1970, the Great Inflation was already underway.  But when he left in 1978 the inflation problem had become even worse.  Indeed he presided over some of the most inept Fed policy of the entire 20th century.  Here’s Athanasios Orphanides discussing Burn’s views as an academic:

In his 1957 lectures on Prosperity Without Inflation, Arthur Burns eloquently explained that economic policies since the enactment of the Employment Act of 1946 had introduced an inflationary bias in the U.S. economy which had marred our nation’s prosperity in the post-war period” (p. v). By promoting maximum employment,” the Act encouraged stimulative policies which, by prolonging expansions and checking contractions, resulted in an upward drift in prices. Burns called for an amendment to the Act, a declaration by the Congress that it is the continuing policy of the federal government to promote reasonable stability of the consumer price level” (p. 71).

And here’s Lawrence White discussing how Burn’s views evolved after being named to the Fed:

In his Newsweek column of 2 February 1970, Milton Friedman enthusiastically cheered the previous week’s appointment of his former college professor and mentor Arthur Burns as Chairman of the Board of Governors of the Federal Reserve System. He lauded Burns as the first person ever named Chairman of the Board who has the right qualifications for that post.  Under Burns’s predecessor, the United States inflation rate had reached 5.5 percent in 1969, rising from only 1.2 percent in 1962. Friedman’s research had convinced him that inflation””persistently rising money prices of goods on average””was due to overly rapid growth in the stock of money, more dollars chasing each bundle of goods. As head of the central bank Burns would be in position to control the quantity of money in the American economy. Friedman encouraged Burns to produce growth in the money stock”•low enough to avoid renewed inflation.”–1

In only a few months Friedman had to choose between keeping his convictions and keeping friendship with Burns unimpaired.  As Fed chairman Burns began attributing the inflation he had inherited not to previous monetary policy, but to cost-push factors beyond the central bank’s control. In July 1971 Burns told a congressional hearing:  The rules of economics are not working in quite the way they used to. Despite extensive unemployment in our country, wage rate increases have not moderated. Despite much idle industrial capacity, commodity prices continue to rise rapidly. He called for federal wage and price controls to fight this supposedly new type of inflation””a policy response that in Friedman’s view was akin to fighting a Toyota’s runaway acceleration by taping down its speedometer needle.

In May 1970 Friedman sent Burns a lengthy handwritten letter criticizing Burns’s arguments and policy proposals. Edward Nelson relates that Burns was shaken by the letter and personal relations between the two deteriorated.2 The disagreement went public as Friedman in lectures, newspaper interviews, and writings challenged Burns’ views. At the December 1971 meetings of the American Economic Association, Friedman quoted and rebutted Burns’ July statement. Examining the data, Friedman found that inflation was in fact responding as usual to money growth. The economy was performing poorly because the Fed under Burns was pursuing erratic and destabilizing monetary policy [that] has largely resulted from the acceptance of erroneous economic theories.”–3 A sharper rebuke by a student of his former teacher, consistent with professional decorum, is hard to imagine.

As with Friedman and Burns, Bernanke was my first choice to head the Fed.  As with Friedman and Burns, I was disappointed to see Bernanke adopt the sort of passive policies he criticized the BOJ for pursuing.  As with Burns, Bernanke is following a policy close to what the “median economist” would prefer.  Some economists would prefer easier money, some tighter, but Bernanke is certainly right in the mainstream.  So was Burns.

Over the last few years I’ve occasionally argued that macroeconomists as a class are mostly to blame for the global economic crisis, not bankers or regulators.  Seeing what happened under Burns makes me even more convinced that we macroeconomists are to blame.

What does this tell us?  It tells us that it may not matter than much who’s in charge of the Fed, rather it depends what the median economist thinks is the appropriate policy.  As an analogy, domestic economic policy probably reflects the views of the median Congressman more than the views of the President.

PS.  Bryan Caplan has two good posts on Larry Ball’s paper on Bernanke (here and here.)  Caplan studied under Bernanke.

HT.  Thanks to the commenter Declan, who pointed out the connection between Burns and Bernanke.