At a recent book signing, commenter Marcelo asked Krugman why we shouldn’t focus on monetary policy, given the difficulty of getting fiscal stimulus through Congress.  Krugman responded, and then had this to say at about the 1:05:20 mark:

There are a handful of people, someone like Scott Sumner, who I would regard as in a lot of ways as the heir to Milton Friedman . . .

I’ll take that!

I won’t respond to the meat of his argument here, as I’ve already addressed that issue ad nauseum.  Instead I’ll just remind readers that over the last three years I’ve occasionally argued that Paul Krugman is in lots of ways the heir to John Maynard Keynes.

I’m done with Krugman bashing.  I’ve finally gotten over that slight from back in March 2009.  It’s all respectful disagreement from now on.

PS.  Let’s not see any spoilsport commenters claiming that Krugman meant I’m heir to Friedman’s policy views, and not his towering intellect and seminal contributions to macroeconomics.

PPS.  The first economics book I ever purchased was Friedman and Schwartz’s Monetary History of the United States, 1867-1960.  I remember pouring over all the data as a high school student.

PPPS.  I went to Chicago in September 1977 hoping to study under Friedman.  I liked his “partial equilibrium” approach to problems.  When I arrived I discovered that he’d left a few months earlier.  If he’d stayed it’s likely that he would have been my dissertation adviser.  As it was I had to “settle” for Lucas.

PPPPS.  I just opened a copy of my Monetary History, and found this letter from Milton Friedman inside (dated May 28, 1994–the day I got married in Beijing):

Dr. Mr. Sumner:

In cleaning up a pile of answered and unread material that had accumulated, I came across your letter of July 7, 1993 and the enclosed article.  I write now simply to apologize for not having acknowledged receipt of the article or having been able to provide you with any comments on it.

Sorry that that was the case,

Sincerely yours,

Milton Friedman

Senior Research Fellow

Hoover Institution

And people wonder why I answer the comments.

Early on I decided that it was very unlikely that Fed policy would rescue the economy.  The markets predicted that Fed policy would remain suboptimal, and the markets are usually right.  So what implications can we draw from this pessimism?

1.  Some argue that the Fed is too hawkish to change its policy, and even if it did the new policy wouldn’t be credible.  Thus we needed fiscal stimulus.

2.  Of course Congress is much too deficit-phobic to enact effective fiscal stimulus, and the Fed’s 2% inflation target would neutralize it even if they did.  So any sort of demand stimulus is futile.

3.  Some argue that this means we should focus on structural changes, supply-side reforms like a simple, loophole-free consumption tax.  But of course Congress is much too corrupt to ever do that, so there is no prospect of supply-side reforms.

4.  Some argue that there’s no point in even getting out of bed in the morning.  After all, life is just M iterations of N events with K degrees of intensity.  Life has no meaning.  In any case, we have no free will, so we are merely going to play out the motions that the atoms in our bodies are compelled to undertake according to the laws of physics plus quantum randomness.

Or . . .

Or we can pretend that the universe is charged with meaning.  That our actions do make a difference, that my blogging might lead Richard Fisher to have a road to Damascus experience, where he wakes up one morning exclaiming “Yes, I see the light, Scott Sumner has been right all along.”

I’ve spent my life studying the Great Depression, so I fully understand that my crusade will likely fail, at least in the short run.  If Keynes failed when he was alive, why should I expect to succeed?  So why keep blogging?  I suppose because if I stop blogging that means there is no hope for communicating with my fellow economists, indeed my fellow human beings.  In that case there really would be no reason to get out of bed in the morning.  I have to hope that someday, even if 100 years from now, these ideas will be accepted by the profession.  And when that happens, the monetary-policymakers will surely follow, as they always do.   The Fed has always stuck close to the consensus views of macroeconomists, and always will.

All this was triggered by a recent Tyler Cowen post sent to me by David Levey, which seems to confuse what will happen with what can happen:

4. The Fed, at least right now, is not able to make a credible commitment toward a significantly more expansionary policy for very long. Putting aside the more general and quasi-metaphysical issues with precommitment, just look at the key players. Bernanke leaves the scene in 2014 and is a lame duck at some point before then. Obama could be gone by the end of this year, and in any case is unlikely to be reelected with a thundering mandate. Romney’s actual views on monetary policy are a cipher. Either house of Congress could change hands. There is less public support for a consensus view of the Fed today than in a long time.

On this issue I feel Scott Sumner is insufficiently Sumnerian. He correctly stresses the role of expectations and credible commitments, but I still do not understand why he does not accept the implied pessimism in this, at least for May 2012. 2008-2009 was the time to act, in a Ludwig Erhard/Douglas MacArthur/Alexander Haig “I’m in charge now and we’re doing ngdp targeting try to challenge me in the chaos and confusion” sort of way.

Oh I do accept the implied pessimism, but I’m playing a much longer game.

Let’s return to this “quasi-metaphysical” issue of commitment.  Paul Krugman has famously argued that the BOJ can’t inflate, because any commitment to inflate wouldn’t be believed.  And why wouldn’t it be believed?  Because everyone knows they don’t want to inflate, and would renege on any promises at a future date.  OK, but what if they really changed their minds about the desirability of higher inflation?  Krugman would argue that the markets would not believe them.  Actually that’s wrong, as there’s all sorts of things they can do right now to show the “change of mind” (such as currency depreciation.)  And it’s wrong because the markets know the “mind” of the central bank much better than the central bank knows it’s own mind.  But let’s say he was right.  I’d still say he was confusing can’t with won’t.  The only solution to a central bank bound and determined to produce deflation is to change them (via change in attitude or change in mandate or change in personnel) into a central bank that isn’t bound and determined to produce deflation.  It does no good to throw up one’s hands and say “they can’t because they won’t.”  In legal terms that’s called “the insanity defense.”  Have we reached the point where we are going to judge monetary policymakers “not guilty due to insanity?”

If I had to summarize my blog in one word, it would be “j’accuse.”  (Or is that two words?)

I’m going to make 4 arguments for ignoring Tyler’s advice and charging ahead with my Fed/ECB/BOJ bashing:

1.  Public pressure is part of the policy process

2.  Failure is a matter of degree

3.  Educating the public

4.  Playing the long game

Some people have pointed to Fed officials indicating (sotto voce) that they’d like to do a bit more, but there’s oh so much public pressure from the inflation hawks.  This argument is apparently supposed to make me see that my crusade is futile.  But it does just the opposite.  If hawkish pressure is restraining the Fed from easing, then market monetarist and enlightened Keynesian pressure can push back the other way.  No one can deny that reporters are increasingly pressing Bernanke at his press conferences on the obvious inconsistency between the Fed’s unemployment objective of 5.6% and inflation objective of 2%, with a policy that is currently expected to undershoot on both jobs and inflation.  But there’s much more work to be done.  We still need to educate roughly 50% of economists, and President Obama, and much of Congress, all of whom support more stimulus but think the Fed’s out of ammo.

Even if we don’t “succeed” perhaps we’ll cause the Fed to fail a little less badly.  Tyler’s right that there are no longer $1 trillion bills lying on the sidewalk, as in 2008-9.

I still believe in a looser monetary policy, I just think that what we can get for that now is much much less (a fifth? a tenth?) of what we could have received in 2008-2009.

But that means there are still $100 billion bills lying around, well worth picking up.  Heck, I’m old enough where I still pick up non-copper coins.

Some people say “yes, we see your point, but there’s nothing that can realistically be done at this point.”  Actually, people don’t agree with me.  Few agree that tight money caused the recession.  Few agree that the fiscal multiplier is zero, although the idea is beginning to appear in unexpected places.  Few agree with me that saving is not contractionary.  Indeed here’s Tyler:

3. As banking and finance heal, debt overhang is less of an AD problem. The debt repayments get rechanneled into investment, rather than falling into a black hole.

Yes, saving can be deflationary under money supply or interest rate targeting, but that’s not Fed policy.  Bernanke is targeting inflation at 2%, with perhaps some weight given to employment.  Under inflation targeting saving is not contractionary, regardless of the weight given to jobs.

Many people wrongly think that monetary stimulus would hurt older people.  Not so, Social Security recipients are protected via indexing, and those living off capital will do better is a healthy economy where returns to capital are higher.  If part of the cause of our malaise is public pressure caused by false theories, then correcting those false ideas has real value.

And then there’s the long game.  My hope is to get market monetarist ideas into the textbooks, where they might influence the next generation.  (Soon I hope to be able to announce progress on that front.)   I’m shocked when people say that there’s no hope of convincing the world’s central banks that NGDP targeting is a good idea.  It was only a few decades ago that the economics profession convinced the world’s central banks that inflation targeting was a good idea.  Furthermore, many central banks already do “flexible inflation targeting,” which is really close to NGDP targeting.  Furthermore, until the interest rate hit the zero bound in 2008 the Fed has been doing something pretty close to NGDP targeting for 25 years.  Furthermore the idea of a single target that addresses both sides of the dual mandate has great appeal, as both the left and the right now agree that the discretion associated with the Fed’s current approach to the dual mandate leads to undesirable policy uncertainty.  Furthermore NGDP targeting has already been praised by lots of well known conservative economists and lots of well known liberal economists.  And after all this we are to believe it can never happen?  People need to use their imaginations a bit more.  Change is the only constant in the world of central banking.  Never say never.

Tyler also has this to say:

This will sound counterintuitive, but we should be debating real factors more and nominal factors less, all the more as time passes.

Circa 2012, monetary policy matters less every day. You might feel outraged by that reality, and by the policy omissions from the past, but still monetary policy matters less every day. That point follows from basic insights from Milton Friedman and Irving Fisher, or for that matter modern most mainstream neo-Keynesian models. By the way the labor force participation rate declined in the latest round of data, and will likely remain low for a good while, so I am not convinced by graphs which beg the question about the size of the output gap.

I also stress that I haven’t changed my views at all, not since 2008-2009, and not since my early column on Scott Sumner (someday I’ll do a post on why I wrote that column in terms of prices rather than ndgp). Same views, but I do see the clock ticking on the wall.

This entire point is hardest to grasp in a mental framework of “accumulated blame,” easiest to grasp within a disciplined, non-moralizing look at marginal products.

He doesn’t realize that he’s preaching to the choir (with me, not Krugman.)  I recently wrote in the comment section that Tyler hadn’t changed his views.  I have consistently argued that monetary stimulus becomes less effective as more time passes.  I’ve gone from recommending we go all the way back to the trend line to (more recently) only 1/3 of the way back.  I do occasionally post on supply-side issues, and agree that they are what really matters in the long run, what separates North and South Korea. But I have no special expertise in non-monetary areas of economics.

I only have two choices.  Keep focusing on those $100 billion bills on the sidewalk, or give up blogging and go back to being an obscure prof at Bentley, playing out the string while watching contemporary Asian art films.  M iterations of N events with K degrees of intensity.  A blob of buzzing sub-atomic particles in a universe too perplexing to understand.

So what shall I do, Tyler?

Angus expresses what seems to be the standard view among economists:

Second, the Bernank actually helped to save our asses back in the darkest days of financial panic.

Actually the Fed caused the recession with ultra-tight money, at least according Milton Friedman and Ben Bernanke’s view of how to ascertain the stance of monetary policy.  And no, it wasn’t merely “errors of omission”.  I know that’s the standard response when I make that claim, but that’s because most economists have never looked at the data.  The Fed brought base growth to a screeching halt between August 2007 and April 2008, triggering a recession.  Then the Fed raised real interest rates on 5 year bonds from 0.57% to 4.2% between July and November 2008.  Are those steps “concrete” enough?

Why does this matter?  Because now you have lots of people claiming that “easy money” is hurting the economy.  That it’s causing low interest rates and hurting savers.  Then there’s another huge group that argues the Fed’s current tight money policy is expressly aimed at helping older retired savers.  I view both arguments as silly, but I’ll address that issue in another post.  The point is that until we figure out whether we have easy or tight money, there’s no possibility of making sensible policy judgments.  If you believe that easy money is in effect now, then it’s only one small step to argue that it’s somehow associated with our current malaise.  And then it stands to reason that tighter money will boost AD (I kid you not–there are people making that argument.)

Update: I didn’t mean to imply Angus was one making that argument, he certainly is not.

Angus continues:

Third, these are the same folks who generally believe that wages are too low and workers don’t earn enough compared to capital. Yet their solution to the low growth / high unemployment problem is for the Fed to lower wages?

That confuses secular problems with cyclical problems.

Fourth, the Fed cannot automatically control the real interest rate. Do you think the Fed could set inflation or inflation expectations at 10% and simultaneously hold nominal rates at zero?

No one claimed it could, and no one supports that policy.  But if any increase in inflation expectations would merely raise nominal rates, then ipso facto we aren’t stuck at the zero bound, and the Fed should simply resume ordinary interest rate targeting.  In that case I wonder what Angus would propose.  At the end of his post he says he favors somewhat easier money.  Well wouldn’t it be nice if we could accomplish that with ordinary rate cuts?  Even Bernanke says he’d cut rates if he could.  So this fourth point, which at first glance seems a clever application of the Fisher effect, actually undercuts Angus’s entire argument.

Fifth, NGDP targeting is not some magic bullet that would solve our current problems. It relies crucially on a particular path for expectations. If you think it’s easy for an actor who can’t easily make credible commitments to control expectations,

Actually it’s incredibly easy to target a nominal aggregate along a particular path.  In the 1980s central banks all over the world started to buy into inflation targeting, and they all succeeded.  Because Americans never pay any attention to events outside our borders, we attributed this success to the “wizardry” of Alan Greenspan.  Boy, it sure was lucky that all the other developed country central banks also had Greenspan-like wizards at the helm!

No central bank has ever tried to inflate and fail, because it’s incredibly easy to debase a currency.  Markets are 1000 times smarter than central banks.  Believe me, if the central bank sets out to inflate the markets will know about the decision even before the central bank realizes it made the decision.

I personally support having the Fed try some additional unorthodox policies in the short run. Even if there’s only a .25 chance they significantly affect employment and growth, why not try? But I do not think the Fed is sitting on policies that will definitely cure our economic ills. The Fed is not close to omnipotent.

Let’s unpack this.  The Fed is close to omnipotent over nominal aggregates.  But it’s true that not all our problems are due to a nominal shortfall.  In fact, as Tyler Cowen pointed out in a new post; “monetary policy matters less every day.”  That’s an implication of the natural rate hypothesis.  When there are adverse demand shocks, the economy naturally self-corrects over time.  Some people ask me why it takes so long—haven’t wages and prices adjusted by now?  Not completely, but the problem goes far beyond sticky wages and prices, it also includes sticky government policies and perhaps some hysteresis.

I’m going to develop these ideas further in the next post, which addresses Tyler Cowen’s recent post.

HT:  Statsguy

Here’s Ryan Avent:

Yet it increasingly seems as though the fundamentals are not so important as what level of employment growth the Fed is willing to tolerate. As my colleague also notes, the Federal Reserve’s projections are consistent with job growth of 150,000 to 200,000 a month; over the past year, payrolls have risen by an average of 169,000 a month. America is getting exactly the recovery the Fed wants.

Should underlying fundamentals drive job growth forward at a faster pace in the months to come, one would expect the Fed’s inflation concerns to grow. When employment growth was healthier, at the beginning of the year, fed fund futures hinted that rate cuts might come earlier than the language in the Fed’s statements suggested. Markets, in other words, were taking the Fed’s late-2014 language as more conditional statement than commitment. Observed job growth was presumed to push up the date of expected rate increases. The Fed’s failure to stick rate-cut expectations firmly at the late-2014 date allowed policy to tighten a bit in response to better economic conditions. That reads as though the Fed made a mistake; I don’t think they did.

.   .   .

And so Mr Obama will be left biting his nails, pitching his efforts to the American people, and trying to explain why recovery hasn’t been any faster. Mitt Romney will put the blame for that squarely on the president. And the press will debate over who has the better argument. But Mr Bernanke is the wizard behind the curtain. Had Mr Obama managed to pass legislation preventing quite so many government jobs from being lost, the economy would have run hotter and the Fed would have been correspondingly less aggressive””leading, most likely, to no meaningful difference in the pace of job recovery.   America is getting the job growth the Fed wants, plus or minus a random error reflecting the fact that Mr Bernanke is not quite God.

Exactly.

If there is any silver lining in the current policy morass, it’s that at least we have a sort of clarity.  Back in 2009 I had to battle with people who insisted the Fed was out of ammunition, but really, really wanted to do lots more.  That argument never made much sense to me, and Bernanke’s recent comments pretty much drove a stake through any hopes for a fiscal end run around the Fed.  Core inflation is close to 2% and the Fed damn well intends to keep it there.

Time for some supply-side reforms?

BTW, that final allusion to Paul Krugman’s famous quip was just perfect; it put a big smile on my face.

My dream is that in a few more years I’ll be able to do a post entitled “We’re all zero fiscal multiplier, market monetarist, progressive consumption tax, supply-sider, neoliberal Yglesians now” so that I can retire to some place warm and sunny.

And now Sweden is reversing course and cutting rates, just another sorry example to add to our earlier list of premature ejections from ultra-low rates:

1.  In 1936 and 1937 the Fed raised rates slightly via higher reserve requirements.  Fed minutes show that by late 1937 they realized they’d made an awful mistake, but were unwilling to accept blame.

2.  In 2000 the BOJ raised rates, despite there being no inflation in Japan.  This disproved Krugman’s expectation trap theory, which argued the Japanese wanted to inflate, but just couldn’t get the hang of it.   Soon after the BOJ had to do a humiliating about face.

3.  In 2006 the BOJ raised rates and cut the monetary base by 20% despite no inflation, completely demolishing what was left of Krugman’s expectations trap argument for Japanese deflation.  Later the BOJ had to cut them back to zero again—and still no inflation.

4.  In the spring of 2011 the ECB raised rates twice, and soon after Europe plunged into a double dip recession.  Trichet wouldn’t admit his error, and Europe had to wait for a new ECB leader to do the humiliating about face.

5.  And now Sweden.  The Riksbank had raised rates steadily from mid-2010 to mid-2011, as Sweden was recovering faster than other European countries.  But being at the zero bound is kind of like lying in bed for a few days with a serious illness.  You start to feel fine and want to go out and play a game of golf.  But you weren’t really recovered and the exertion causes a relapse.

Here’s what happened in Sweden:

According to the National Accounts, GDP fell by 4.6 per cent in the fourth quarter, when calculated as an annual rate. Compared with the fourth quarter of 2010, GDP only increased by 1.1 per cent. The outcome was much weaker than anticipated.

So the Riksbank had to back-peddle, and cut rates in December 2011 and February 2012.  But as Lars Svensson points out, not enough:

The repo-rate path in the main scenario has been lowered compared with December, but according to these diagrams it has not been lowered enough to best stabilise inflation and resource utilisation. With the new repo-rate path, the forecast for CPIF inflation is still too low and the forecast for unemployment is still too high. Lowering the repo-rate path further would improve target fulfillment for both inflation and unemployment. Monetary policy is therefore not well balanced in the main scenario, according to Mr Svensson. He does not think that it is necessary to be an expert on monetary policy to realise this.

.   .   .

The section “Alternative scenarios for the repo rate” in Chapter 2 of the draft Monetary Policy Report includes several lines of argument for why the red repo-rate path should be better than the blue one. Mr Svensson said he found these lines of argument strange. One argument drifts back and forth between CPI and CPIF inflation. Having several targets and switching emphasis between these different targets from time to time is a well-known way of justifying a specific policy that is desired for other, unstated reasons, Mr Svensson pointed out.

.   .   .

According to Mr Svensson, a large and serious problem in the decision-making process is that, in practice, there is no scope for a serious, in-depth discussion of different policy alternatives. There should be at least two alternative repo-rate paths with attendant carefully-analysed forecasts for inflation and resource utilisation, together with discussions of target fulfillment for the various alternatives. Without this, the decisionmaking material is insufficient. How can the members of the Executive Board take reasonable decisions if the consequences of the alternative repo-rate paths have not   been properly examined?

Does any of that make you think of the Fed?  In contrast to Svensson’s razor-sharp logic, the hawks on the committee just talk in vague generalities, relying on hunches rather than clear and transparent reasoning.

Paul Krugman keeps saying that surely it should count for something if one has been consistently right.  Svensson has been consistently right about Swedish monetary policy, and yet he still can’t get a majority of the Board to listen to him.

Lars Svensson’s views are close to those of Ben Bernanke, which makes me think that what Svensson says is what Bernanke really thinks.   Recall how Bernanke keeps saying that monetary policy in the US is extraordinarily accommodative, despite the fact that his own 2003 criteria for judging the stance of monetary policy suggests it’s the tightest since Herbert Hoover was president.  Here’s how Svensson sees things:

Mr Svensson pointed out that, while the real interest rate is very low in a historical perspective, Figure 3 of the figure supplement he handed out shows that the nominal interest rate is historically high in relation to foreign interest rates. Furthermore, it is not obvious how we can measure how expansionary monetary policy is. It could be maintained that the most relevant measure is the gap between the real policy rate and the neutral interest rate, where a practical definition of the neutral interest rate could be the real interest rate that leads to a sustainable level of resource utilisation within a certain period, for example one year. According to Mr Svensson, the neutral interest rate is apparently very low and negative in Sweden, Europe and the United States.

If one reads the entire 32 page document, one can’t help thinking about Noah Smith’s recent post.  Noah discussed some ideas like inertia, and fear of risking your reputation by taking bold action.  But those don’t really fit Sweden very well, as the hawks sharply raised rates between mid-2010 and mid-2011.  But this comment from Noah perfectly fits the February 2012 Riksank report:

Why are all these people arguing for things like hard money and austerity? Do they believe in some model – some RBC variant, perhaps – that tells them that now is not the time for quantitative easing and fiscal stimulus? If so, they aren’t publicizing the fact. My guess is that it’s not really about models and theories at all – policymakers and pundits basically don’t buy into any macro model, and so are falling back on their own reflexive intuition.

For three years I’ve been arguing that this crisis was a disaster produced by macroeconomic policy makers relying on common sense rather than rigorous models and hard logic.  Now I am more convinced than ever.

PS.  You might wonder if a central bank ever waited too long to raise rates above the zero bound.  Yes the Fed in 1951, when they let inflation rise sharply.  But we aren’t even close to that scenario, and that inflation spike was quickly extinguished.

HT:  I thank Stefan Elfwing for the very helpful documents from the Riksbank.  He indicated that the right-leaning appointees opposed Svensson.  The Swedish right has done a great job fixing the structural problems in Sweden’s economy, but aren’t very good at monetary policy.