Paul Krugman recently started off a post as follows:

I’ve been watching with sympathy as David Beckworth and Scott Sumner discover that their updated monetarism actually puts them on my side of the great ideological divide “” cast into the outer darkness along with John Maynard Keynes and Milton Friedman.

But what does the other side believe? Someone, I don’t know who at this point, sent me to this post by Robert Murphy, which is the best exposition I’ve seen yet of the Austrian view that’s sweeping the GOP

I certainly understand the point Krugman is making, and in a sense I agree.  But I also think this slides over a much more important ideological divide; one I still don’t fully understand.

Suppose you asked the top 100 macroeconomists in America whether they were with the 5 economists in the first paragraph, or Bob Murphy.  My guess is that at least 90 would be with us (and yes, that even includes new classicals like Robert Lucas.)  So the “outer darkness” is not all that lonely a place.

But here’s what I don’t know.  Why weren’t those 90 macroeconomists out picketing the Fed in October 2008, demanding easier money?  Well 89 of the 90, the other is in the Fed.   Back in late 2008 and early 2009 a few of us quasi-monetarists were just about the only people insisting on the urgent need for much more monetary stimulus.  A tiny handful of others (including Krugman) half-heartedly agreed it was worth a shot, and almost everyone else completely ignored monetary policy.  One argument was they assumed we were at the zero bound.  Actually, we weren’t at the zero bound in October 2008, but let’s say we were close.  The main problem with the zero bound argument is that there was no general understanding that monetary policy was ineffective at the zero bound among the macro elite.  Indeed many of them (Bernanke included) argued forcefully that the BOJ needed to do much more in the late 1990s and early 2000s

I seem to recall Krugman once saying something to the effect that Bernanke discovered things were much harder than it looked from the outside, once rates hit zero.  Yes, that’s right, but the thing Bernanke found out was not that the ideas he gave the Japanese don’t work, he found out that it was difficult to get his colleagues to agree to implement those ideas (or at least that’s what I assume.)   But whatever you think of Bernanke, none of that explains the behavior of the 89 economists discussed above.  Why weren’t they speaking out?

The reality is that the Fed almost always does roughly what the broad consensus of macroeconomists thinks they should do.  In late 2008 and early 2009 those 89 macroeconomists didn’t think we needed more monetary stimulus, or if they thought so didn’t speak out (I’d guess Svensson would have agreed with me.)  Naturally the Fed didn’t provide the needed monetary stimulus.  If the consensus of the 89 had been that QE2 should have been adopted in November 2008, not November 2010, it probably would have been done then.

I still don’t think the views of Murphy have broad acceptance among elite macroeconomists (if they do God help us.)  They certainly didn’t in 2007.  The big mystery is not explaining wacky views of Austrian bloggers and GOP economists who hope to get a gig as Sarah Palin’s chief economic advisor, but the broad mainstream of Ivy League macroeconomists.  I just did a post showing that Charles Calomiris opposed QE2 even though his rationale suggested it was needed.  Earlier I did a post showing that Frederic Mishkin did not think Fed stimulus was inadequate in late 2008 and early 2009, even though the key insights of his textbook clearly and unambiguously suggest it was.  Indeed the explanation of the crisis added to the 8th edition of his textbook is completely contradicted by his 4 key insights into monetary policy, which come just one page later!  I recall a talk by Robert Lucas a couple years ago, where he mentioned how in this situation the Fed needed to boost the money supply to offset a fall in velocity, but then for some strange reason suggested he though Bernanke was doing a good job.  I could go on and on.

The big mystery Krugman should investigate is not why people like Bob Murphy hold wacky opinions, but why his fellow elite macroeconomists seemed to suffer from mass amnesia in late 2008 and early 2009.

Krugman makes this observation later on:

Why is there such a strong correlation between nominal and real GDP? Why is there overwhelming evidence that when central banks decide to slow the economy, the economy does indeed slow? And on and on.

I’d love to know why our elite macroeconomists were not loudly demanding that the Fed do something to prevent (in 2009) the biggest fall in NGDP since 1938.

BTW, I appreciate the support from Paul Krugman; despite our previous disagreements I consider him the most brilliant macroeconomist in the blogosphere.  But I was slightly bemused by his comment that I had just “discovered” I was on Krugman’s side regarding demand shocks.  I feel like I’ve been here all along.  I can’t help remembering when I tried to remind Paul Krugman that we were (should have been?) on the same side in March 2009.  As Matt Yglesias pointed out, on the issue of monetary stimulus it is others that need to do some soul-searching:

The Great Recession has revealed a lack of capacity for dealing with monetary issues to be a major institutional weakness of the progressive movement.

Matt himself doesn’t lack an understanding.  I’d like to think that’s partly because he reads quasi-monetarist bloggers.  You know, the ones who said that rumors of QE2 would depreciate the dollar, raise equity prices, and raise inflation expectations—months before rumors of QE2 actually did depreciate the dollar, raise equity prices, and raise inflation expectations.

I suppose this sounds like I’m being a poor sport.  Two positive mentions in a row from Paul Krugman!  Let’s celebrate that fact and not look back on unpleasant memories that are best forgotten.

🙂

For decades the Fed has steered the economy along a path of two to three percent inflation.  The policy has not been controversial.  Sometimes they ease, and sometimes they tighten.

Recently inflation has run closer to 1%, and Bernanke has suggested pushing the rate back up to 2%.  Others at the Fed are more radical, calling for level targeting.  This would allow a bit above 2% inflation to offset periods of below 2% inflation.  Even those radical proposals are more conservative than the actual 2% to 3% average rate of recent years.  So how is the public reacting to monetary policy proposals that are more conservative that what actual occurred in recent decades?  According to Time magazine, they’re so angry it might lead to a civil war:

What is the most likely cause today of civil unrest? Immigration. Gay Marriage. Abortion. The Results of Election Day. The Mosque at Ground Zero. Nope.

Try the Federal Reserve. November 3rdis when the Federal Reserve’s next policy committee meeting ends, and if you thought this was just another boring money meeting you would be wrong. It could be the most important meeting in Fed history, maybe. The US central bank is expected to announce its next move to boost the faltering economic recovery. To say there has been considerable debate and anxiety among Fed watchers about what the central bank should do would be an understatement. Chairman Ben Bernanke has indicated in recent speeches that the central bank plans to try to drive down already low-interest rates by buying up long-term bonds. A number of people both inside the Fed and out believe this is the wrong move. But one website seems to believe that Ben’s plan might actually lead to armed conflict. Last week, the blog, Zerohedge wrote, paraphrasing a top economic forecaster David Rosenberg, that it believed the Fed’s plan is not only moronic, but “positions US society one step closer to civil war if not worse.” (See photos inside the world of Ben Bernanke)I’m not sure what “if not worse,” is supposed to mean. But, with the Tea Party gaining followers, the idea of civil war over economic issues doesn’t seem that far-fetched these days. And Ron Paul definitely thinks the Fed should be ended. In TIME’s recently cover story on the militia movement many said these groups are powder kegs looking for a catalyst. So why not a Fed policy committee meeting. Still, I’m not convinced we are headed for Fedamageddon. That being said, the Fed’s early November meeting is an important one. Here’s why:

Usually, there is generally a consensus about what the Federal Reserve should do. When the economy is weak, the Fed cuts short-term interest rates to spur borrowing and economic activity. When the economy is strong and inflation is rising, it does the opposite. But nearly two years after the Fed cut short-term interest rates to basically zero, more and more economists are questioning whether the US central bank is making the right moves. The economy is still very weak and unemployment seems stubbornly stuck near 10%.

In the past I’ve argued their mistake was to argue for more inflation, which sounds undesirable.  Contrast Fed policy with fiscal stimulus.  In early 2009 there was lots of criticism about the fiscal stimulus plan, but I don’t recall a single critic arguing that fiscal stimulus was a mistake, because it “might work.”  Instead, they argued it was a waste of money and would probably “fail,” which meant it wouldn’t boost AD.  It was taken as a given that more AD was desirable.  Now monetary policy has become so controversial that people are talking about civil war.  Why?  Because some of the more radical members of the Fed are proposing average inflation rates almost as high as what we have experienced over the last two decades.

What are some possible explanations:

1.  Higher inflation sounds bad–the Fed should have said it was trying to boost AD, or NGDP, or the average income of Americans.

2.  The monetary base has already exploded in size, so people are already worried that only “long and variable lags” separate us from Zimbabwe-style inflation—despite 2% bond yields and despite the fact that similar policies had no effect on long run inflation in Japan.

Today I’d like to suggest a different explanation.  Perhaps this crisis is a sort Waterloo for Keynesian interest rate targeting, analogous to the effects of 1982 on monetarism.  You may recall that in the early 1980s monetarist ideas were popular.  Slower money supply growth helped slow inflation.  But velocity seemed to decline sharply in 1982, so the Fed let the money supply rise above target, and went back to interest rate targeting.  (Indeed some claim they never really abandoned interest rate targets, but let’s put that aside.)

This crisis has put the economy into a position where the Fed’s normal interest rate mechanism doesn’t work.  It can’t steer the economy in the only way it feels comfortable steering the economy.  Maybe we need a new steering wheel.  And the search for a new steering wheel is what is so controversial.

If we had been doing NGDP futures target all along, nothing interesting would have happened in late 2008.   Expected NGDP growth would have stayed at 5%, nominal rates would have stayed above zero, and the monetary base might not have exploded (that is less clear.)  The severe financial crisis would have been far milder, if it occurred at all.  The Fed would have continued steering the economy in the same way it always had.  (BTW, the decline in house prices in bubble areas was already largely complete by late 2008—the second leg down was caused by falling NGDP.)

Instead, when rates hit zero the Fed stopped trying to steer the economy at all; it followed Stiglitz’s advice and stopped using monetary policy.  Of course they were still doing policy (and highly contractionary policy at that) but didn’t realize it, as their normal policy tool had jammed just as the wheels of the car were pointed toward a ditch called “recession.”  In the next post I’ll explain why it’s almost impossible to pry the Fed’s hands off the old steering wheel, even though it is now broken and not connected to the wheels.

Randall sent me a perplexing Financial Times piece by Joe Stiglitz.  He begins by comparing the proponents of monetary stimulus to the monetarists of the 1980s:

A quarter-century ago proponents of monetary policy argued, with equal fervour, in favour of monetarism: the most reliable intervention in the economy was to maintain a steady rate of growth in the money supply.

In fact, a better comparison would be with the Keynesians of the 1980s, or the Keynesians of today.  It is Keynesians that favor monetary stimulus in recessions, monetarists advocate stable money growth.  Stiglitz knows this, which makes me wonder why he is warning his fellow progressives that monetary stimulus is a dangerous monetarist idea.

This was followed by the discredited pushing on a string idea:

Traditionally, monetary authorities focus policy around setting the short-term government interest rate. But, leaving aside the fact that with interest rates near zero there is little room for manoeuvre, the impact on the real economy of changes in the interest rate remains highly uncertain. The fundamental reason should be obvious: what matters for most companies (or consumers) is not the nominal interest rate but the availability of funds and the terms that borrowers have to pay. Those variables are not determined by the central bank. The US Federal Reserve may make funds available to banks at close to zero interest rates, but if the banks make those funds available to small and medium-sized enterprises at all, it is at a much higher rate.

Then there is this:

It should be obvious that monetary policy has not worked to get the economy out of its current doldrums. The best that can be said is that it prevented matters from getting worse. So monetary authorities have turned to quantitative easing. Even most advocates of monetary policy agree the impact of this is uncertain. What they seldom note, though, are the potential long-term costs. The Fed has bought more than a trillion dollars of mortgages and long-term bonds, the value of which will fall when the economy recovers – precisely the reason why no one in the private sector is interested. The government may pretend that it has not experienced a capital loss because, unlike banks, it does not have to use mark-to-market accounting. But no one should be fooled.

So the Fed might suffer some modest capital losses if QE works, and promotes a faster than expected recovery.  Wouldn’t that be a tragedy!  And he ignores tax revenue gains to the Treasury from a fast recovery.  And what makes Stiglitz think he can predict the future movements of bond prices better than the market?  Is he telling me I’ll get rich if I short T-bonds right after QE2?  Should I believe him?

But all this is nit-picking.  Here’s what really bothers me about Stiglitz’s article.  It’s not that he favors a different monetary policy than I do; it’s that he seems to oppose the Fed having any monetary policy at all.  (Hence the connection with those “abolish the Fed” elements within the Tea Party.)  I defy anyone to read the article and find any monetary policy being advocated.  Indeed I don’t see any evidence that Stiglitz even knows what monetary policy is.

There is no discussion of any nominal target, whether prices, the Taylor Rule, or NGDP.  He seems to think of policy in terms of interest rate changes, but interest rate targets are not Fed policy, they are a tool to implement Fed policy.  If you use interest rates as THE policy, the price level becomes undefined–it shoots off to zero or infinity.  For instance, he indicated interest rates were too low back in 2002-03.  That suggests to me he thinks money was too easy.  Maybe so.  But inflation was below the Fed target at that time.  This suggests that if money had been tighter, inflation might have slowed even more, and a dangerous deflationary spiral could have developed.  That’s why most economists support something like the Taylor Rule, or inflation targeting. Interest rates aren’t enough.

Here ‘s how modern macro works.  Economists assume the Fed has some policy goal or goals.  They choose a nominal target to help implement those goals.  Then they set their various monetary policy tools (such as fed funds rate, IOR, QE, etc) at a level most likely to achieve that nominal target.

But Stiglitz seems oblivious to all this.  He doesn’t advocate a different monetary policy; he suggests we shouldn’t be relying on monetary policy at all.  But the Fed can never be “doing nothing.”  Any policy is an affirmative decision.  The Fed can set policy at a level expected to succeed, or it can set policy at a level expected to fail.

I anticipate some people will argue that Stiglitz does favor more AD, he just wants to “use” fiscal stimulus.  Fair enough.  But once fiscal stimulus is done, what is the Fed supposed to do with monetary policy?  And this is hardly an academic question, in all of American history fiscal policy has never been more “done.”  Even this Congress can’t pass more fiscal stimulus—just imagine the next one.  So it comes down to a basic decision about monetary policy; what is to be done?  And Stiglitz dodges the question, or perhaps implies he’s happy with a monetary policy that is likely to leave unemployment in the 9% to 10% range for several years.  I can’t quite tell.

I have no objection to people criticizing the Fed; I do it all the time.  But then suggest an alternative policy.  What is your nominal target?  How do you think the Fed should try to improve the macro economy?  My problem with Stiglitz is not that I disagree with his answer; it is that I suspect he doesn’t understand there is a question that needs to be answered.

Check out this interview with Chicago Fed president Charles Evans(sent to me by JimP):

Here is Paul Krugman, right after I did a really nice post praising him:

Brad DeLong manfully takes on the efforts of various commentators to define away the paradox of thrift and redefine our current problems as somehow wholly monetary. As I see it, this is all a desperate attempt to cut and stretch things into a quasi-monetarist framework, for no good reason.

.   .   .

So what’s wrong with my “one model to rule them all”? Well, it doesn’t easily translate into anything that looks like monetarism “” for a good reason: when short-term interest rates are near zero, the distinction between the monetary base, which the central bank controls, and the much broader class of safe short term assets, which it doesn’t, more or less vanishes. That’s not a bug, it’s a feature; it says that when you’re in a liquidity trap, thinking in terms of the supply and demand for money is just not a helpful way to approach the issues.

Let’s start with some propositions that all us new Keynesians and quasi-monetarists can agree on:

1.  If interest rates are 5% and the Fed announces a doubling of the money supply, and also announces that all the new money will be pulled out of circulation a month later, almost nothing will happen to prices and output.

2.  If interest rates are 0% and the Fed announces a doubling of the money supply, and also announces that all the new money will be pulled out of circulation a month later, almost nothing will happen to prices and output.

3.  If interest rates are 5% and they announce a permanent doubling of the monetary base, prices will rise sharply.

4.  If interest rates are 0% and the Fed announces a permanent doubling of the money supply prices will rise sharply.

Monetary policy is never very effective if the injections are temporary, and (almost) always very effective if permanent.  (Unless the liquidity trap is expected to last forever.)  So the problem during a liquidity trap isn’t really that cash and T-bills are perfect substitutes, it’s more complicated.

So what’s the real issue here?  Unfortunately, just like in the game “wack-a-mole,” a new objection pops up as soon as you answer the previous one.  A little history might be helpful.  For decades the new Keynesians have been driving the economy using a flawed interest rate instrument.  They got away with it until rates hit zero.  Now they are looking for answers.  The quasi-monetarists are suggesting that the Fed increase the supply of base money (QE) and/or reduce the demand for base money (lower IOR and higher inflation targets.)  The more progressive new Keynesians like Krugman support these ideas, but get bent out of shape when quasi-monetarists try to define our AD shortfall problem as essentially monetary, rather than simply an implication of the paradox of thrift.  [BTW, I prefer autistic to Procrustean.]

So what are the issues that separate us?

1.  The quasi-monetarists have higher expectations for monetary policy.  We all agree the Fed could do a lot more.  We all want them to do a lot more, but only the quasi-monetarists actually assume that the Fed is still driving the car, still determining NGDP growth.

2.  Communication.  The new Keynesians drove the economy off the cliff, yanked off the steering wheel, handed it to the quasi-monetarists, and said “OK, you drive smarty-pants.”  But at the zero bound driving the economy requires a whole new form of communication.  We can’t use interest rates and the markets aren’t used to anything else.  Remember, only permanent money supply increases are effective.  But since base demand is so unstable at low rates, we can’t really target the base credibly; it would leave prices too unstable.  [That’s why we’re quasi-monetarists, not monetarists–we don’t assume stable money demand.]  So we have to combine changes in the money supply with changes in the inflation target.  We need to tell the public we’ll inject enough money to push prices X% higher over the next few years.  The new Keynesian will respond “Aha, but that’s not monetarism, that’s new Keynesianism.  The inflation target is doing all the work, not the money supply increase.”  Yes and no.  It is mostly the target, but not completely.  That’s because the Keynesian liquidity trap model is slightly unrealistic in several ways:

a.  The Fed can limit reserve demand by cutting rates on bank reserves to zero, or negative.  In that case it’s all about cash held by the public.  And the reasons people hold cash are different from the reasons they hold securities.  Most cash is held for tax evasion and petty transactions–neither of which can be easily done with T-bills.  So they aren’t quite perfect substitutes.  Still, rates on T-bills could go negative enough to make them near perfect substitutes.

b.  Cash is even less of a perfect substitute for other types of securities, which the Fed could also purchase.

c.   Most importantly, QE is also a form of communication.  If you are trying to convince markets that you are adopting a more expansionary monetary policy, it is easier to do if you both announce a higher inflation target, AND ALSO DO SOMETHING.  Roosevelt understood this, which is why he adopted a gold buying program in late 1933.  The amounts of gold purchased were far too small to have any macro effect, but nonetheless the program did move market prices.  Why? Because it was a signal that FDR was soon going to do something which would be effective—permanently devalue the dollar.  He bought gold at higher and higher prices, which was a signal to the markets about the likely future price of gold.  QE would be Bernanke’s gold-buying program, only slightly effective on its own, but very powerful when combined with a higher inflation target.  Even if the inflation target isn’t explicit, but merely hinted at.

It’s slightly annoying the way people like Krugman and DeLong imply their opponents don’t understand the paradox of thrift.  Yes, if people try to save more, and rates fall, the real demand for base money will rise.  And if the Fed doesn’t offset that then AD will fall.  We do understand that.  But we continue to insist the problem is fundamentally monetary because we see the Fed as being able to offset any shifts in public or private saving.  And how can Krugman disagree with that on theoretical grounds?  Hasn’t he just been hammering the Fed for not doing enough to boost AD?  It’s a bit late to claim the Fed can’t do anything when rates are zero.  Now he’s certainly entitled to claim that he doesn’t think the Fed would completely offset an attempt by the public to save more, or a program of austerity by the government, but that’s an empirical judgment.  It has nothing to do with new Keynesian theoretical models that supposed “prove” there is a paradox of thrift at the zero bound.

The paradox of thrift models are only pulled out at the zero bound, because that’s when monetary policy is (allegedly) ineffective.  So you have the bizarre spectacle of Krugman castigating the Fed every Monday, Wednesday, and Friday for not doing enough, and then on Tuesday and Thursday criticizing economists who don’t believe in the paradox of thrift—a model that only makes sense if the Fed can’t do anything!

As for Mr. DeLong, his reply to Nick Rowe’s comment is fine as far as it goes, but it doesn’t go anywhere near deeply enough into the problem.  No one is asking the Fed to merely do a few desultory OMOs, and then imply they’ll soon be reversed.   And at times he still seems to be struggling to free himself from the influence of 1930s Keynesianism, as when he claims the problem can’t be monetary, because interest rates on government bonds aren’t very high:

Thus we would expect a downturn caused by a shortage of liquid cash money to be accompanied by very high interest rates on, say, government bonds–which share the safety characteristics of money and serve also as savings vehicles to carry purchasing power forward into the future, but which are not liquid cash media of exchange.

I wish we could stop all this skirmishing on side issues, and focus on what really separates us–whether it is most useful to think of monetary policy driving inflation and NGDP growth, even at the zero bound.  Or whether (as Krugman and DeLong seem to believe) it is more useful to think of monetary policy as passive and ineffective at the zero bound, and do macro analysis on that assumption.  They’re entitled to that belief, but then I don’t see why the Fed should listen to their complaints that money’s too tight.

One final comment.  Keynesians argue that only permanent monetary injections matter at the zero bound, and thus that it is pointless to increase the current money supply.  But that’s true equally true of interest rates in normal times.  If you raise rates 1% and announce they’ll be cut again a month later, almost nothing will happen.  Woodford showed it’s all about the expected future path of policy.  So this argument that current changes in the money supply are not important is always approximately true, and equally true of interest rates.  Plan on quitting smoking?  Heh, light up another cigarette!  After all, it’s the long run path of your cigarette consumption that really matters.  My response would be that there is no better time to start QE than right now.  Remember, the longest journey begins with a single step.

OK, let’s all get together now and go after the real enemy—the hawks at the Fed.

BTW, Krugman says his model’s best because he predicted interest rates and inflation weren’t going to rise.  Well I predicted interest rates and inflation weren’t going to rise, AND I was screaming at the Fed to ease money in late 2008.  How does that call for action look now?  Sometimes one needs a relentlessly single-minded focus, and if people consider that Procrustean, so be it.

HT:  David Beckworth, TravisA