Why I hate Keynesian talk
The ongoing debate about what Robert Lucas really meant couldn’t get more annoying. The obvious solution is to do a Woody Allen/Marshall McLuhan, and just ask him. He’s not dead yet.
The latest entry is John Cochrane, who really annoyed me by starting a new blog that I’ll need to pay attention too, even though I’m already short of time. He criticizes this statement by Paul Krugman:
..think about what happens when a family buys a house with a 30-year mortgage.
Suppose that the family takes out a $100,000 home loan …. If the house is newly built, that’s $100,000 of spending that takes place in the economy. But the family has also taken on debt, and will presumably spend less because it knows that it has to pay off that debt.
But the debt won’t be paid off all at once “” and there’s no reason to expect the family to cut its spending right now by $100,000. Its annual mortgage payment will be something like $6,000, so maybe you would expect a fall in spending by $6000; that offsets only a small fraction of the debt-financed purchase.
. . .
How could anyone who thought about this for even a minute “” let alone someone with an economics training “” get this wrong?
Cochrane then argues Krugman is confused about Ricardian equivalence:
So, according to Paul, “Ricardian Equivalence,” which is the theorem that stimulus does not work in a well-functioning economy, fails, because it predicts that a family who takes out a mortgage to buy a $100,000 house would reduce consumption by $100,000 in that very year.
I don’t think Krugman is making that claim, I think he’s saying that Ricardian equivalence doesn’t apply to government output, just taxes and transfers. None the less I’m not especially impressed with Krugman’s example, partly for reasons outlined by Cochrane here:
Most likely, someone was saving money, and put it in a bank. If this family didn’t take out the loan, another family would have (perhaps at an infinitesimally lower interest rate) done so, and the economy would have built a different house. Or perhaps the money came from an investor in mortgage-backed securities, who would have built a factory instead. These are where the $100,000 offset in aggregate demand comes from, and why the family’s decision to take out the mortgage need have no effect on aggregate demand.
Can something go wrong in that process? Sure. That’s what real analyses of stimulus think about. But those like myself who, reading theory and evidence, come to the conclusion that stimulus doesn’t work well, do not come to that conclusion because we think the family will spend $100,000 less!
But I still think this misses the point. All this debate about the Keynesian multiplier is meaningless without a model of nominal GDP. You can make whatever assumptions you like and there’s no way to prove anyone right or wrong. Recall that the basic Keynesian model says autonomous expenditure shocks boost AD, and hence NGDP. Whether this boosts real output depends on whether the economy is currently at capacity. Lucas admits that a monetary stimulus might work, so we can assume he’s not coming from a strict RBC perspective. Instead, Lucas must be saying that fiscal stimulus won’t boost NGDP, unless accommodated by an increase in the money supply. Technically Lucas is wrong, but in a deeper sense he’s right. He’s right that monetary policy drives NGDP, and hence that the fiscal stimulus only boosts NGDP if the monetary authority accommodates it by allowing higher NGDP (or higher inflation if you prefer.)
All Keynesian debates seem mind-numbingly stupid to me, because they leave out the essential factor; the monetary policy response to the shock. Without knowing that we can say NOTHING about the impact of a spending shock on AD.
First I’ll provide Lucas’s actual statement, and then I’ll indicate what he should have said if he had known that dozens of economists would go over his off-the-cuff remarks with a fine tooth comb nearly three years later:
If the government builds a bridge, and then the Fed prints up some money to pay the bridge builders, that’s just a monetary policy. We don’t need the bridge to do that. We can print up the same amount of money and buy anything with it. So, the only part of the stimulus package that’s stimulating is the monetary part.
That’s technically incorrect, as deficits lead to slightly higher interest rates, and thus slightly higher velocity. But in practice the change in velocity isn’t all that important, because central banks tend to target things like inflation, not M2, and hence offset velocity changes. Here’s what Lucas should have said:
If the government builds a bridge, and then the Fed prints up some money to pay the bridge builders, that’s just a monetary policy. The same is true if the Fed allows slightly higher velocity to boost inflation. We don’t need the expensive bridge to do that. We can costlessly print up enough money to boost NGDP and buy anything with it. So, the only part of the stimulus package that’s stimulating is the monetary part.
But he didn’t say that, and hence this long pointless debate over Keynesianism by economists using completely different languages, talking right past each other.
Update: A blogger named Robert Kulick has an amusing take on the entire dispute. He comments on this post as follows:
I would describe it as a good example of “Hate the methodology, not the economist.”
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1. January 2012 at 12:53
Without knowing [the monetary policy response to the shock] we can say NOTHING about the impact of a spending shock on AD.
Cet. Par. over the supply of money?
I have seen your argument translated in third-hand accounts of the Scott Sumner Phenomenon as a breakdown into a separate real then monetary shock, which your own approach to summarizing ‘market monetarism’ tends to be similar to. In any case such breakdown militates against asserting that There Is No Such Thing As A Neutral Monetary Policy.
1. January 2012 at 13:22
Scott,
silly question perhaps regarding this whole Ricardian Equivalence debate, but doesn’t NGDP-targeting make the Ricardian Equivalence true?
Assume that the economy is in equilibrium at capacity and that the monetary authority ‘sets’ the ‘price of money’ (NGDP). The government increases spending – building pyramids – and issues bonds, some people switch some money for bonds, the government switches money for goods & services and some other people switch goods & services for money and add this to their cash balances. The composition of output has changed, a shift from I to G, but otherwise what one group has ‘invested’, another group has saved in its cash balances. The only way I can see it boosting output, is if the ‘price of money’ is changed.
How is this different from the situation where people foresee having to pay taxes for the deficits and save the money needed to pay taxes for the deficit spending? Sure the difference is in distribution, but in aggregate? And sure if you ask people whether they have saved because they expect they expect a tax in the future they’ll look puzzled, but a lumberjack will look just as puzzled at you when you ask him whether he cut down that tree so that a pencil can be made for a certain Scott Sumner at Bentley.
1. January 2012 at 13:49
@Martin: Ricardian equivalence says nothing about the effect of a change in G on the economy.
It’s a proposition about timing of payment for a *given* stream of G. Specifically, given a stream of government spending today and tomorrow, it does not matter for consumption, investment, interest rates, wages, or any other real variable whether one pays for that stream with a balanced-budget in both periods or with deficits today and taxes tomorrow.
Equivalently, for a given stream of G, switching from balanced-budget to a deficit today and taxes tomorrow has no real effects. A deficit-financed tax cut is a wash.
Now, with that aside, you are correct in that NGDP targeting has implications for the effect of an autonomous change in G on NGDP. Under (proper) NGDP targeting, a change in government expenditures leaves NGDP unchanged but affects the composition of NGDP.
—
@Scott: yet another example of “once you start thinking about policy in terns of NGDP, it’s difficult to think about it any other way.”
1. January 2012 at 14:03
@Integral, thanks for the correction and clarification!
So instead of increasing spending, it would be cutting taxes and it would be a shift from I to T with as a result that both decrease? And the monetary authority could then be described as to act in a way to give a signal – through the price of money – to the agents in the economy – as if – for future taxes?
1. January 2012 at 15:04
Doesn’t it just matter what you think the monetary reaction function is?
For example…
Sumner NGDP Fed: Fed commits to 5% NGDP growth and gets it. Deficit spending sterilized by monetary authority to keep 5% NGDP growth. Private spending has to fall proportionally for G to rise if 5% NGDP target is maintained.
ZLB-obeying Fed: Fed isn’t comfortable outside of traditional interest rate tool. When deficit spending puts upward pressure on interest rates, the Fed can accommodate this traditionally, buying the debt to prevent any rise in rates. A ZLB-obeying Fed insists that fiscal policy “says the magic word” to allow monetary expansion since it refuses non-traditional asset purchases.
So, fiscal policy only matters for NGDP if the Fed says it does. If Bernanke said that he’ll only do more open market purchases when Justin Bieber releases a new album, then we could gather evidence that Bieber albums are expansionary. Then we would talk about how House Republicans should be ashamed for disliking J. Bieb’s music and refusing to vote for more. Remember, the welfare effects of Bieber albums don’t matter since we just care about boosting AD.
1. January 2012 at 15:11
enforce your own policy and delete the parenthetical “or higher inflation if you prefer” its just nicer without it.
i tend to agree with you that the fiscal multiplier is zero under N targeting. but under inflation targeting, and granting the keynesians an under-utilised economy (for animal spirits) and a perfect functioning monetary authority lets say the government acts as employer of last resort and pays people to do whatever. it borrows from foreign banks to do this. surely this boosts N and R as these people are unemployed anyway (ok so the unemployed labor pool drops a bit and these people spend more rising prices a little but R probably jumps) the monetary authority cools M a little to address the higher prices but R has risen.
Australia sent everyone out $900 in the GFC and i was opposed to the policy but apparently it seemed to work. of course the government should have printed the $900 rather than borrowing it (money stimulus vs fiscal) but i wonder why more keynesians don’t talk about it (probably because they never heard of it)
1. January 2012 at 18:09
A couple of things
A)In the mortgage example it’s
A family gets $100,000 mortgage. This money is given to the seller who spends or invests it. Bank1 creates for itself a $100,000 asset. Bank1 wasn’t all that fussy about the borrower’s credit, because it doesn’t plan on keeping the mortgage, and high interest loans pay better.
The bank sells that asset to a CMO packager who puts it in a mortgage pool and gives the bank1 $100,000.
CMO manager massages the mortgages into tranches until enough of them have Feng Shui that is acceptable to a payed rater who pronounces the top tranches of the CMOs as AAA investment grade. We’ll leave how the B tranches are handled out of this for now. It may also pay some stooge company to guarantee the AAA CMOs with a credit default swap. This is money for nothing for the stooge unless the CMO’s go south, and the likelihood of a significant number of them doing so is ruled out by the “independent probabilities” buried inside its value at risk formula.
The packager takes a cut and sells the AAA CMOs containing the mortgage to Bank2 and recoups its $100,000 with a tidy profit.
Bank2 takes the CMO and Repos it for $100,000 Money Manager (ignoring a possible haircut). It splits the interest with money manager.
Bank2 takes it’s $100,000 and buys another $100,00 CMO, which it Repos in turn. Wash and repeat.
At the end the original $100,000 may have financed $2,000,000 of mortgages.
If this sounds strange, you don’t work on Wall Street. The issuing banks’ lending wasn’t constrained by their deposits or any Fed set multiplier, because the mortgages were no longer on their balance sheet.
This is the Readers’ Digest version. It gets more complicated but not more sane.
1. January 2012 at 19:42
Distressing:
http://www.nytimes.com/2012/01/01/business/from-6-economists-6-ways-to-face-2012-economic-view.html?scp=4&sq=romer&st=cse
Today in the Times Mankiw at least mentioned nominal targeting (in his careful non-committal way) – but Romer talked only about more fiscal – even though she knows full well that it wont happen and also that nominal targeting would be much more powerful. Distressing.
1. January 2012 at 19:50
David, I’m not sure I follow your question, other than the part about ceteris paribus over the supply of money. That makes no sense, as the money supply is almost never held constant.
Martin, NGDP targeting makes fiscal policy ineffective, but it doesn’t make Ricardian equivalence true, as people may not save 100% of tax cuts.
Integral, That’s right.
Alex, Yes, but Bernanke has shown that he’s willing to do monetary stimulus when the fiscal authorities drop the ball, as with the QE2 in 2010.
C8to, I don’t follow your argument. My zero multiplier argument applies equally to NGDP and inflation targeters. In both cases any tendency for stimulus to boost NGDP or inflation will be offset by less monetary stimulus.
The parenthetical statements are necessary to stop annoying commenters.
Peter, That’s all very interesting but it tells us NOTHING about AD.
1. January 2012 at 19:51
JimP, I saw that too–disappointing
1. January 2012 at 20:04
“That’s technically incorrect, as deficits lead to slightly higher interest rates, and thus slightly higher velocity.”
I am confused. Don’t higher interest rates reduce velocity by lowering the cost of holding money?
I had been under the impression that increasing the government’s holdings of the money stock was supposed to increase velocity because the government spends money at a faster rate than private agents?
2. January 2012 at 01:15
The attempt to say whether it’s fiscal or monetary policy that’s being used seems to me like an argument between whether it’s gasoline or the engine that makes the car go. Neither one can work very well on their own if the other isn’t shaped to match it. Fiscal policy can certainly fail if monetary policy is adjusted to counteract it (and, I think, the Keynesian assumption is that if the economy is sluggish the central bank will allow fiscal policy to work- that it will set a position and not suddenly tighten in response to fiscal stimulus, particularly when it has pretty explicitly asked for a fiscal response to match its monetary position)
On the other hand, a purely monetary response only works if there’s enough demand for loans to move the money without completely throwing out standards of creditworthiness and ability to pay to find borrowers that actually want to take the money. The bridge becomes important because it links the two together- monetary policy creates the money, the expenditure on needed infrastructure provides an effective borrower and pathway for the money into the economy while allowing for it to be effectively rolled over indefinitely without needing to pay it back. It’s only once AD picks up enough to overflow the ability of direct spending and investment to finance the necessary growth to meet that demand, that people begin to seek out more loans to make up the gap.
You have to pass through:
-“Is what’s being demanded readily available for free?”
-“Can I entice someone to provide it for me for free?”
-“Do I have the time and resources on hand to produce it myself?”
-“Do I have enough money on hand or revenue to directly pay for it?”
and, generally,
-“Can I find and investor willing to give me money for a share of future revenue or some other benefit relative to the return?”
before you finally get to
-“Can I take out a loan or find some other form of investment where the repayment terms are not scaled to the actual returns?”
So while monetary policy can make money available, it takes fiscal policy to provide the basic demand level to drive production needs through all of those initial steps until the private sector actually begins to demand loans at a significant enough rate to allow monetary policy to work more directly.
“The Fed will allow fiscal policy to work as intended” may not be a reliable assumption, but I think it’s a better one than “People will want to borrow money productively simply because it’s available to be lent” Fiscal policy is the only effective borrower that doesn’t need to worry about getting a near term positive ROI to be able to make payments on the money that it deploys. No one else will take out a loan- even at an effective 0 or negative rate, unless demand suggests that they’ll at least make enough revenue in exchange to make the payments on it. (And even fewer do if a large number of potential borrowers are already underwater or otherwise not reasonably creditworthy)
2. January 2012 at 02:19
scott: why?
2. January 2012 at 03:33
As an aside a nice bit of thinking here
http://silasx.blogspot.com/2011/12/broken-windows-part-i-pain-of-hard.html
2. January 2012 at 03:37
One of the reasons *I* hate Keynesian talk is that many of them speak out of both sides of their mouth. If you want to defend Paul Krugman, fine, but be careful to state clearly which Paul Krugman you are talking about.
Back in 2003, PK had a much different take on “fiscal imbalances and mortgages”. Here’s Paul, back in the days days of Bush in an Op-Ed piece entitled “A Fiscal Train Wreck”:
“With war looming, it’s time to be prepared. So last week I switched to a fixed-rate mortgage. It means higher monthly payments, but I’m terrified about what will happen to interest rates once financial markets wake up to the implications of skyrocketing budget deficits.”
http://www.nytimes.com/2003/03/11/opinion/a-fiscal-train-wreck.html?scp=1&sq=%22we're%20looking%20at%20a%20fiscal%20crisis%20that%20will%20drive%20interest%20rates%20sky-high%22&st=cse
It seems that Paul had a mild streak of Ricardo in him then, anticipating what might happen in the future as a result of government deficit spending. And, wasn’t this the same PK who more recently argued that perhaps the thing we need right now is another war (albeit against aliens rather than Iraqi’s) to perk the economy up a bit?
2. January 2012 at 08:07
“Martin, NGDP targeting makes fiscal policy ineffective, but it doesn’t make Ricardian equivalence true, as people may not save 100% of tax cuts.”
Scott, thanks. It seems obvious now: should’ve written down Y = etc.
2. January 2012 at 09:46
Thanks for the reminder, Vivian. Paul sounds then, a lot like Mark Steyn now.
2. January 2012 at 10:58
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2. January 2012 at 11:59
KRG
I have the same issue you are raising. That a fiscal approach seems more tangible and real than the monetary one.
The reply to this seems to be that a combination of the Fed committing to a NGDP or price level target and relentlessly buying financial assets until this is achieved will shock private individuals, professional investors and businesses into spending the enormous cash balances they are sitting on in the real economy for fear of coming inflation. Spending it either directly in the economy or indirectly through the purchase of corporate stocks and bonds.
Can you buy this? I’m skeptical about it.
Ultimately, this approach relies on being able to convince people in the private sector that the Fed can and will create a higher level of inflation, thus motivating them to reduce their cash balances and crank up their spending now.
It’s supposedly a better alternative to government (at whatever level depending on the program) doing the spending and investing, as it supposedly unleashes the private sector more directly, and importantly, is sustainable through time as the Fed commitment would not be subjected to political whims and pressures.
But either way (monetary or fiscal) it does seem to suggest a consensus is forming about the federal government using its power to print unlimited amounts of dollars to generate economic growth when the private sector falters. It’s just a question of which approach is more feasible and sustainable.
2. January 2012 at 18:25
W. Peden, No, the interest rate is the opportunity cost of holding money. As it rises, money demand falls.
KRG, You said;
“Neither one can work very well on their own if the other isn’t shaped to match it.”
Not true at all. The central bank can create high inflation without any budget deficits at all.
You said;
“On the other hand, a purely monetary response only works if there’s enough demand for loans”
Not true at all. Money can boost NGDP without any increase in lending at all. Indeed more money was inflationary before banks even existed.
C8to, Why what?
Thanks for the link Dave,
Vivian, Yes, we all know that Krugman’s been all over the map on these issues. I don’t see this post as defending him, I think he’s wrong on fiscal policy. I was simply pointing out that he’s not wrong in precisely the way Cochrane indicated.
Richard, You said;
The reply to this seems to be that a combination of the Fed committing to a NGDP or price level targeting and relentlessly buying financial assets until this is achieved will shock private individuals, professional investors and businesses into spending the enormous cash balances they are sitting on in the real economy for fear of coming inflation.”
I’ve challenged Keynesians 100 times to show me a fiat money central bank that tried to inflate and failed. So far my Keynesian opponents have offered zero examples. I assume that means they’ve given up.
BTW, the groups you mention aren’t sitting on giant cash balances, banks are.
2. January 2012 at 18:32
Scott,
Thanks for the correction. I had that totally the wrong way around in my head.
2. January 2012 at 20:21
hence this long pointless debate over Keynesianism
But the debate is not pointless; it is the central point.
Lucas, Cochrane (a Catoist) have agendas other than the best interests of the 99%
The comments are planned and intended disinformation, for the benefit of the 1% and the Right.
2. January 2012 at 22:08
Scott,
You say “Not true at all. Money can boost NGDP without any increase in lending at all. Indeed more money was inflationary before banks even existed.”
Of course true when money equals currency, but it seems a lot more complicated when you have broader and more diversified forms of money. For example, the Fed could buy Treasuries in the open market from banks. If the banks just kept the proceeds as ER with the Fed, it would increase MB but might have no impact on broader monetary aggregates… in other words no impact on MV (i.e. AD). Obviously the Fed purchase would push rates down a little but if there was no loan demand, it might not make any difference. Has anyone done a good synthesis on the relationship between money, credit and AD. I realize that market expectations play a big role here and frankly I have a hard time understanding how everything fits together.
Theoretically, I think you could run an economy on credit alone with no money.
3. January 2012 at 03:48
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3. January 2012 at 06:37
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3. January 2012 at 07:32
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3. January 2012 at 08:52
Hi Scott,
A basic question for you to help my understanding of economic stimuli if you don’t mind. In the question of building a bridge by government, versus the equivalent monetary sum of asset purchases by the Fed, such as buying T-bills, have you any recommendations on research about the leakages of either and particularly the latter? I guess this is a multiplier comparison between fiscal and monetary intervention. My main goal is to understand how effective or ineffective buying financial assets has been – my concern is that intervention on this level results in funds heading or repatriating overseas, particularly with such intergated global financial markets, resulting in the undermining of monetary policy’s QE tool. Thanks.
3. January 2012 at 12:55
JLD, Lucas voted for Obama. Was that to help the 1%?
dtoh, Yes, there have been economies without money, they are called barter. But the price system becomes very complex; for each good, there are millions of different prices, depending on what you plan to exchange.
When interest rates are positive banks won’t sit on ERs, even if there are no good loan prospects–they’ll just buy assets like T-bills.
John T, There is no stable multiplier between changes in the money supply and changes in total spending, so it’s not even worth investigating. In recent years the base has tripled, and NGDP hardly budged.
3. January 2012 at 17:11
Scott,
Yes, there have been economies without money, they are called barter. But the price system becomes very complex; for each good, there are millions of different prices, depending on what you plan to exchange.
I was actually thinking of a system, where buyers and sellers just exchanged IOUs. The IOUs would have to be denominated in something, e.g. dollars, but dollars wouldn’t actually have to exist for the system to work. Thus the question about what is the mechanism by which changes in MB effect changes in the broader M (i.e. NDGP/V). BTW is there an accurate way to define M other than as NDGP/V?
When interest rates are positive banks won’t sit on ERs, even if there are no good loan prospects-they’ll just buy assets like T-bills.
Not necessarily. It depends on the relative interest rates. If the banks are unwilling to buy other assets and are already sitting on Tbills, open market operations won’t work unless the Fed offers a price that induces the banks to switch out of Tbills into ERs (or cash).
4. January 2012 at 08:42
dtoh, If dollars don’t exist, there is no anchor for the price level. Prices could shoot up to infinity. Bennett McCallum has written about this issue.
I’m afraid you are wrong about the T-bills. They’ll just buy more, or something else. There is no history of banks holding substantial ERs at positive market interest rates. It simply doesn’t happen.
4. January 2012 at 17:48
Scott,
“dtoh, If dollars don’t exist, there is no anchor for the price level. Prices could shoot up to infinity. Bennett McCallum has written about this issue.”
Thanks for this. Just read a couple of McCallum papers. The math was a little above my level of pain tolerance so I’m not sure I completely understand what he is saying, but it seems to me (and maybe I am way off) that the price level could but does not necessarily need to go to infinity. In a non-money, non-barter economy, the MOA really becomes the credit of economic players and what determines the price level is the net amount of credit in the system and the creditworthiness of the borrowers. In a sense, our current system works the same way, there is no underlying MOA other than borrowing by the Fed (reserves) and what determines the price level is how much the Fed borrows (MB) and how credit worthy they are.
I’m afraid you are wrong about the T-bills. They’ll just buy more, or something else. There is no history of banks holding substantial ERs at positive market interest rates. It simply doesn’t happen.
I agree, but as you say we have seen an anomalous situation now, where ER have ballooned and presumably this could happen under different circumstances even if it wasn’t deliberate sterilization by the Fed. I agree though that mostly what will happen is that they’ll Tbills or something else. What I would like to understand though is what is the impact on MV(AD) if they for example buy Tbills versus issuing new mortgages. I’m not really debating, I would just like to better understand how the mechanics work. Presumably everything could just translate into asset price inflation with very little impact on AD.
9. January 2012 at 10:50
dtoh, It can’t be right that credit is a unit of account. both the US and Britain have credit, but no one would say we have the same unit of account. I agree that bank reserves can serve as a unit of account.
Asset price inflation has to happen for a reason. If there is no rise in NGDP, then there must be some other reason. More money is not a reason.
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