I’m not sure I fully understand the dispute between Paul Krugman and Nick Rowe on helicopter drops and Ricardian equivalence and the Pigou effect, but I’ll take a stab at it.  The bottom line is that I agree with Krugman on this one.  First a very simple example of what I see Krugman as doing here:

The government drops cash out of a helicopter.  But they don’t want there to be any inflation.  So it’s widely understood that the money will be removed from circulation before interest rates rise above zero (after which point the cash would be inflationary.)

How will the cash be removed from circulation?  At gunpoint, by the military.  And what is an X period zero interest rate loan worth during a period where the market interest rate is zero?  Nothing.  The public is not better off.  They fearfully put the cash in a lockbox to await the day when the soldiers show up at the door.  I see the “soldiers with guns” assumption (i.e. taxes) as being the Ricardian part of the exercise.

Now even Paul Krugman would admit that the example is quite far-fetched as stated.  Why would a conservative government with an inflation-phobia be dumping cash out of a helicopter in the first place?

They would not.  But they might well do a combined fiscal/monetary expansion—indeed the Japanese did essentially this in the recent past.  They built bridges to nowhere and paid in cash.  They printed money to pay the pensions of old people.  And then every so often they removed a lot of the cash from circulation (as in 2006) just to show they were serious about not allowing inflation.  I suppose Krugman’s model would predict some expansion from the first order effects of the bridge, but not much.  And none from tax cuts or benefit increases, if you assume extreme Ricardian equivalence.

Nick says that cash is not a liability in any meaningful sense.  I tend to agree, at least in a legal sense.  But the economic effects are similar to a currency that is backed by a commodity, if the central bank has a credible policy of not allowing inflation.  So I don’t see where the fact that cash is not legally a liability comes into play when considering the Pigou effect.  It’s all about what the public expects.  And Krugman believes the Japanese public expects the central bank to act as if the currency is backed by a basket of goods and services comprising the Japanese CPI.  They can only do that by removing the money at gunpoint at the point when interest rates are about to rise.

I see the Japanese situation as a beautiful illustration of Krugman’s claim that the helicopter drop approach doesn’t really solve anything if you already are having trouble inflating because of a “liquidity trap,” and if there is R.E.

So where do I disagree?  My only objection is that I don’t think it would be hard to credibly inflate; there are all sorts of easy techniques that can be used.  I think that central banks that promise to inflate are likely to carry through with that promise, and so I don’t see the liquidity trap as a problem in the first place.  But if it is, then Krugman’s right that a “helicopter drop” doesn’t solve the problem, as the Japanese case shows.  On the other hand I’m sure that even Krugman would agree that an actual helicopter drop (no quotation marks) would work, as it would be an extremely powerful signal that the central bank is determined to inflate.  Indeed the difference between a “helicopter drop” and a helicopter drop is a perfect example of the limitations of abstract macroeconomic models.  It’s also why macroeconomists underestimated the harm done by IOR.

PS.  Here’s another way of stating it.  It looks like the Fed’s problem is that they are having a difficult time creating higher inflation.  But the Fed’s real problem is that Ben Bernanke told Brad DeLong that the Fed was strongly opposed to 3% inflation, and meant it.  And that’s why the Fed will fail to achieve 3% inflation.  (I’d prefer to say succeed in avoiding it, as that’s what they are trying to do.)

Nick Rowe has a fascinating new post on monetarism.  It’s fairly long, but I think Nick is saying that throughout history we almost never observe stylized facts that are sharply at variance with monetarist theory.  He also argues that throughout much of history monetary policy was essentially unplanned, thus the correlation between money and prices cannot be due to explicit government policies.  He ends up by arguing that monetarist approaches to the transmission mechanism must be telling us something that is missed in IS-LM models, or else we would observe occasional cases of hyperinflation or hyperdeflation that seemed at variance with monetarism.

I have a lot of sympathy with this post, but would to offer a few suggestions:

1.  I’m not sure what Nick means by “monetarism.”  The old-style monetarism says that the supply of money is the key to modelling inflation.

2.  In my view the market monetarist approach says something closer to “looking the supply and demand for money is the most useful way to model the price level.”   (As compared to looking at interest rates, economic “overheating,” etc.)  Indeed I’d prefer using the term ‘medium of account’ rather than ‘money’ but I’m in the minority.

Consider the following claim by Nick:

Empirically we observe that if you don’t let the money supply explode to infinity the economy won’t explode into hyperinflation either; and if you don’t let the money supply implode to zero the economy won’t implode to zero either. Empirically we know that monetarism is at least roughly true. But theoretically we don’t know why it is true. We don’t understand the strong dark force that makes monetarism at least roughly true.

This makes me a bit uneasy.  Is it really true that all hyperinflations involve huge increases in M?  Maybe, but I could easily imagine one that didn’t.  Suppose the Confederate government was expected to collapse within a few weeks in 1865. Even if they hadn’t printed a lot of money, wouldn’t prices have soared in terms of Confederate money, as the demand for that sort of money plummeted?

At the other extreme, I could imagine the demand for base money soaring during deflation, and leading to a situation where prices rose far less than the money supply.  So I’d emphasize supply and demand.

Here’s how Nick ends up:

Or maybe, just maybe, it’s only hard to understand the strong monetarist dark force if you try to see it in a non-monetarist theoretical framework. Like ISLM, for example, where money only affects AD via its effect on interest rates. Or a neo-Wicksellian/”New Keynesian” framework, which doesn’t appear to have money at all. Maybe the liquidity preference theory of the rate of interest, according to which the rate of interest is (at least proximately) determined in “the money market”, by the demand and supply of money, is theoretically incoherent, because there is no such thing as “the money market”. Because every market is a money market in a monetary exchange economy. And so an “excess supply of money” does not just mean an “excess demand for bonds”.

Or you could stick by your theoretical framework, and ignore the empirical facts. And the historical falsity of the “keynesian” argument from design is one of those empirical facts.

I agree that the Keynesians focus too much on the terms of trade between cash and bonds, and not enough on the terms of trade between cash and stocks, or foreign exchange, or commodities, or real estate.  But more importantly I’d also like to see the Woodfordian “expectations channel” applied to the “hot potato effect.”  If we know that money is neutral in the long run because of the HPE, then expectations of long run money neutrality lead to changes in expected NGDP growth, which is probably the most powerful transmission channel of all.  It’s what Keynes meant by “confidence.”

No one is surprised when a big crop of apples causes NGDP in apple terms to suddenly double.  No one should be surprised when a big crop of currency in Argentina causes NGDP to double in currency terms.  No need to invoke mysterious forces; the transmission mechanism is right out of EC101.

Supply and demand.

PS.  Paul Krugman knew all this years ago; Patrick just sent me the following quote from 1998:

Because the traditional IS-LM framework is a static one, it cannot make any distinction between temporary and permanent policy changes. And partly as a result, it seems to indicate that a liquidity trap is something that can last indefinitely. But the framework here, rudimentary as it is, suggests a quite different view. In the flexible-price version of the model, even when money and bonds turn out to be perfect substitutes in period 1, money is still neutral – that is, an equiproportional increase in the money supply in all periods will still raise prices in the same proportion.

So what would a permanent increase in the money supply do in the case where prices are predetermined in period 1? Even if the economy is in a liquidity trap in the sense that the nominal interest rate is stuck at zero, the monetary expansion would raise the expected future price level P*, and hence reduce the real interest rate. A permanent as opposed to temporary monetary expansion would, in other words, be effective – because it would cause expectations of inflation.

My only quibble would be the central role given to the real interest rate. Expectations of higher future NGDP tend to raise current AD for obvious reasons. That might result in nothing more than inflation. But if wages are sticky you will also get some real growth as NGDP rises.

PPS.  And now I have to write a post taking Krugman’s side in his argument with Nick Rowe.

Matt Yglesias comments on Paul Krugman throwing in the towel:

I also find this disheartening, but I don’t really understand where it leaves us. Krugman says “the political economy of policy turns out to make an effective fiscal response to depression very difficult.” I agree. And he says “the Fed hasn’t ever been willing, or felt that it had sufficient political room, to do that experiment.” I also agree. So then he concludes:

At the very least it means that we need “macroprudential“ policies “” regulations and taxes designed to limit the risk of crisis “” even during good years, because we now know that we can’t count on an effective cleanup when crisis strikes. And I don’t just mean banking regulation; as the authors of the linked paper say, the logic of this argument calls for policies that discourage leverage in general, capital controls to limit foreign borrowing, and more.

A few months back I argued that Japan’s recent policy moves were effective, but not enough to reach their 2% inflation/3% NGDP growth targets.  I still believe that to be the case.  First the positives:

1.  The yen is down to around 97/$, well below the 79/$ level of mid-November 2012, when rumors of Abenomics first hit the market.

2.  RGDP growth was 4.1% in Q1 and 2.6% in Q2.  Unfortunately I don’t have NGDP numbers, but I’d guess they are positive.  (Trend NGDP growth in Japan is zero, so positive is good.

3.  Inflation rates are slowly increasing. (Actually deflation is ebbing)

4.  Unemployment is falling, down to 3.9% in July.

Now the negatives:

1.  Inflation still seems unlikely to hit 2%.

2.  The yen has been appreciating since it fell to 103/$ a few weeks back

3.  Q2 RGDP growth was below the 3.6% expectation.

4.  Japan will be hit by an adverse supply shock next year (higher sales tax rates) which will boost inflation–making it look like they will hit their 2% target.  Don’t be fooled.  When the effects wear off Japanese inflation will slip back below 2%. Because of Japan’s fiscal situation, it has no good options.  The sales tax increase will hurt the economy, but is needed.  I used to think they should delay it, but now I think they should bite the bullet and do it.

They got off to a good start, but need to do more.  I suggest another round of yen depreciation combined with more QE.  What they did helped a little – – – so do more!

Since I’ve criticized Krugman for his recent posts on monetary history, let me praise him for some recent positive statements he’s made about Milton Friedman. For example:

Friedman “” like Solow, in most of his work “” was in the habit of writing crisp papers with very clear morals. So while you can, on a careful read, see from S-S [Solow-Samuelson] why you should not in fact trust the Phillips curve to be stable, people didn’t actually get that until Friedman and Phelps laid out the point with stark clarity. Credit where credit is due.

But this is what I’d really like to focus on:

What caught me in the Waldmann piece, however, was the brief discussion of the Pigou effect, which supposedly refuted the notion of a liquidity trap. The what effect? Well, Pigou claimed that even if interest rates are up against the zero lower bound, falling prices will be expansionary, because the rising real value of the monetary base will make people wealthier. This is also often taken to mean that expansionary monetary policy also works, because it increases money holdings and thereby increases wealth and hence consumption.

And that’s where I came in (pdf). Looking at Japan in 1998, my gut reaction was similar to those of today’s market monetarists: I was sure that the Bank of Japan could reflate the economy if it were only willing to try. IS-LM said no, but I thought this had to be missing something, basically the Pigou effect: surely if the BoJ just printed enough money, it would burn a hole in peoples’ pockets, and reflation would follow.

But what I did was a little different from what the MMs have done this time around: I set out to prove my instincts right with a little model, a minimal thing that included actual intertemporal decisions instead of using the quasi-static IS-LM framework. [If you have no idea what I’m talking about, you have only yourself to blame — I warned you in the headline]. And to my considerable surprise, the model told me the opposite of my preconception: there was no Pigou effect. Consumption was tied down in the current period by the Euler equation, so if you couldn’t move the real interest rate, nothing happened.

One way to say this “” which Waldmann sort of says “” is that even a helicopter drop of money has no effect in a world of Ricardian equivalence, since you know that the government will eventually have to tax the windfall away.

Let’s review a few facts:

1.  I published an article claiming temporary currency injections have almost no effect on the price level 5 years before Krugman did.  His 1998 article is 100 times better, but it’s not like we market monetarists don’t get his point.

2.  I have several blog posts pointing out that (for Ricardian reasons) even “helicopter drops” don’t really solve the problem of liquidity traps, at least if you believe the liquidity trap is a problem.  (I don’t.)  I’ve cited Japan as an example. So (in my case) he’s preaching to the converted in the last paragraph.  I believe David Beckworth disagrees with me on this point.

3.  I don’t rely at all on the Pigou effect, and as far as I know other MMs don’t either.  I rely on the expected hot potato effect, plus asset price changes. Because money’s expected to be neutral in the long run, a injection that’s expected to be permanent will raise future expected NGDP, which is expansionary even in a Woodfordian model. And no, it’s not all mysterious hand-waving, unless you believe the trillions of dollars being earned in the Japanese stock market this year is monopoly money.

4.  In the past, Japan did not try to reflate during those episodes where Krugman claimed they did.  I think independent observers who have looked at the issue now agree I was right and Krugman was wrong.

5.  Point 4 was strengthened when the BOJ was pushed into a 1% inflation target a couple years ago, and then was dragged kicking and screaming into a 2% target more recently.  No one with a deep understanding of Japan seriously believes they were trying to create inflation back in 2006 when inflation was zero and they raised interest rates and cut the monetary base by 20%.  Thus proving the point of my 1993 paper that temporary currency injections are not inflationary.

6.  If rates are zero and expected to be zero forever then Krugman’s right.  But in that case buy up the entire national debt with currency, and start in on the debts of other countries too.  Call that fiscal policy if you like; it’s still monetary policy to me.

I think we differ because we envision QE much differently.  He sees it as a lever that might fail because it might not credibly change expectations of future monetary policy.  I see the policy itself as NGDPLT.  You credibly promise to do whatever it takes.  Then you figure out how much base money the public and banks want to hold at that expected NGDP growth rate, and do enough QE so that the market for base money is in equilibrium (plus cut IOR to zero.).  If you don’t know how, create an NGDP futures market.

NGDPLT is the policy, QE is the tool to make it work.  If you don’t want 5% NGDP growth (and the tapering talk strongly suggests the Fed does not) then there’s no point in even doing QE.

PS.  I can see how someone might have assumed I relied on the Pigou effect in the past, as I’ve argued that QE probably has a small effect above and beyond the expectations channel.  Cash and bonds are not perfect substitutes, even at zero rates.  But I’ve never emphasized this channel, and in any case it’s based on a (very weak) hot potato effect, not the Pigou effect.

PPS.  Let me end on a positive note.  I do believe the 1960s monetarists would have benefited from absorbing the message in Krugman’s 1998 paper.  But I also think it unfortunate that (without saying so) his writing style sometimes leaves his readers with the impression that this 1998 paper taught him that monetary policy was ineffective at the zero bound.  Krugman continued to favor monetary stimulus (in Japan) over fiscal stimulus in the late 1990s, and changed his view a few years later.

PPPS.  Krugman ends as follows:

 . . . modern Friedmanites are a very small group with no real constituency.

Maybe, but we’re coming on strong.

HT:  Edward