Here’s a puzzling passage from a recent Paul Krugman post:

One question I’ve been asked a lot is why I spent 2009 campaigning for fiscal expansion rather than monetary expansion. Well, at the Keynes conference this morning Mike Woodford gave an overview of policy options when you’re up against the zero lower bound that in some ways expressed better than I’ve managed to what I was thinking at the time.

First, Mike argued that monetary expansion once you’re at the ZLB mainly works, if it does, through affecting expectations. If people don’t perceive the expansion as representing a change in policy that will persist even after the economy has recovered, even big changes in the monetary base have hardly any effect. Mike had a chart of Japan 2000-2008 that I’ve crudely reproduced:

Note both that Japan reversed much of the initial expansion in the monetary base, confirming the expectations of those who might have regarded that expansion as temporary – and Japan did this even though deflation continued! Note also that nominal GDP never moved at all despite the huge amount of money “printed”.

Krugman and Woodford are both extremely smart guys, so I can’t understand why they continue to misinterpret this graph.  The Bank of Japan clearly wants to avoid inflation.  That’s why they sharply tightened monetary policy in 2006 “even though deflation continued!”  Indeed that’s the only plausible explanation for this tightening.  But Krugman and Woodford continue to insist that this shows the impotence of monetary stimulus, i.e. the difficulty of changing expectations.  They continue to assume that the BOJ was trying to inflate, but failed.

In fact, this shows that expectations in Japan were rational.  The public correctly predicted what the BOJ would do.  The problem isn’t convincing that public that the BOJ wants to inflate; the real problem is convincing the BOJ that they should try to inflate.  Krugman and Woodford are confusing cause and effect.  They see low interest rates as inhibiting monetary stimulus, whereas the low interest rates are actually a consequence of tight money, of central banks aiming too low.  It’s not that the BOJ and Fed don’t know how to raise NGDP growth, it’s that they don’t want to.  Don’t believe me?  Then read any recent Fed statement explaining why they decided against continuing QE2.

In 2009 Krugman was too pessimistic about monetary stimulus, and thus focused on fiscal stimulus:

That’s about what I was thinking in, say, January 2009. With the severe financial crisis still relatively recent, and many people still expecting a V-shaped recovery, it didn’t seem possible to persuade the Fed to commit to a permanent rise in the monetary base or a rise in the medium-run inflation target, nor did it seem possible to convince markets that there had been a long-run change in policy. The chances for persuading Congress to agree to a large temporary fiscal stimulus seemed much better.

Back in 1998 Krugman knew better than to rely on fiscal stimulus.  From It’s Baaack:

If temporary fiscal stimulus does not jolt the economy out of its doldrums on a sustained basis, however, then a recovery strategy based on fiscal expansion would have to continue the stimulus over an extended period of time. The question then becomes how much stimulus is needed, for how long – and whether the consequences of that stimulus for government debt are acceptable.

.  .  .

The political point is that Japan – like, we might note, the United States during the New Deal – appears to have great difficulty working up its political nerve for a fiscal package anywhere close to what would be required to close the output gap. Exactly why is an interesting question, beyond this paper’s scope.

Does this mean that fiscal policy should be ignored as part of the policy mix? Surely not. On the general Brainard principle – when uncertain about the right model, throw a bit of everything at the problem – one would want to apply fiscal stimulus. (Even I wouldn’t trust myself enough to go for a purely “Krugman” solution). However, it seems unlikely that a mainly fiscal solution will be enough.

That was quite prophetic.  Fiscal stimulus in the US was woefully inadequate.  The US political establishment did find the consequences for government debt to be unacceptable.  And I love the quotation about a “purely ‘Krugman’ solution.”  That would be one that relied solely on monetary stimulus.  By August 2010 Paul Krugman had attached a different name to the money-only approach:

And I don’t understand at all [Koo’s] argument that monetary expansion is positively harmful. He seems to be making up arguments on the fly here; he’s so determined to defend the primacy of fiscal policy that he has to insist that anything else is a very bad thing. (In that sense, I guess, he’s the anti-Scott Sumner).

So now it’s the “purely Sumner solution.”

In the 1990s Krugman assumed that monetary policy steered the nominal economy, and criticized protectionists who thought Asian exporters stole jobs from the US.  He had lots of great arguments.  If he’s done with them, I’m happy to use his discarded ideas.

Part 1:  A new study by Martin Feldstein estimated that QE2 created an extra $2.5 trillion in stock market wealth for Americans.  It should be noted that foreign markets also rose sharply in anticipation of QE2, so my $5 trillion estimate from last year for world gains may be on the low side.  (US stock wealth is about $17 trillion; world stock wealth is closer to $50 trillion.)

To be sure, there is no proof that QE2 led to the stock-market rise, or that the stock-market rise caused the increase in consumer spending. But the timing of the stock-market rise, and the lack of any other reason for a sharp rise in consumer spending, makes that chain of events look very plausible.

The magnitude of the relationship between the stock-market rise and the jump in consumer spending also fits the data. Since share ownership (including mutual funds) of American households totals approximately $17 trillion, a 15% rise in share prices increased household wealth by about $2.5 trillion.

I conservatively assumed a 10% gain on $50 trillion, whereas Feldstein assumed 15% on $17 trillion.  Either way, the world gained a lot of wealth.

Part 2:  In August (right before rumors of QE2) Paul Krugman argued that pressure from outside pundits was one of the only ways to move that stubborn mule called the Fed:

So why am I even slightly encouraged? Because the critics did, at least, succeed in moving the focal point. Not long ago gradual Fed tightening was the default strategy; but as I said, at this point the Fed realized that continuing on that path would have unleashed both a firestorm of criticism and a severe negative reaction in the markets.

What we need to do now is keep up the pressure, so that at the next FOMC meeting the members are once again confronted by the reality that not changing course would be seen as dereliction of duty. And so on, from meeting to meeting, until the Fed actually does what it should.

I know: it’s a heck of a way to make policy. In a better world, the Fed would look at the state of the economy and do what was right, not the minimum necessary. But wishing for that kind of world is like wishing that Ben Bernanke were running the place.

And it worked!

Part 3:  Last month Ryan Avent published the following observation over at The Economist.com:

I SEE that Scott Sumner is taking a victory lap of sorts””not unearned””over the fact that views of monetary policy have come full circle since the years before the crisis. Once upon a time, the Fed was viewed as having near-absolute power over the path of the economy. Then crisis struck and many argued that the Fed had run out of ammunition and fiscal policy was required. Eventually people began arguing that the Fed could do more and should do more, thanks largely to the efforts of Mr Sumner himself.

“So what you’re saying is . . .”

I’m not saying anything, just reporting news from the blogosphere.

Part 4:  Off topic, but I am complete burned out, and have been for months.  I’ve blogged an average of eight hours a day, seven days a week, for over two years.  I’ve only kept going in recent months out of a sense of obligation to keep pushing these issues.  But now that lots of other people are saying the exact same thing, it’s time for me to take a break.  So I’ll stop blogging for a few months, unless there is some huge news story like QE3, in which case I’ll add a couple posts.  Or if someone does a hit job on my marshmallow post, I may need to briefly respond.  Otherwise I’m done for now, and will return sometime this summer.

I hoped my school would give me some support for blogging, but that’s not how things work in the real world.  Perhaps I could find a way to make some money and buy out a few courses.  I was thinking about ideas like writing a macro version of Freakonomics, or doing speaking engagements, or perhaps even consulting.

Please don’t tell me that so and so does even more blogging than me while teaching; I’m not so and so.   Here are a few reasons I’m taking a break:

1.  Like corrupt politicians resigning under pressure, I need to “spend more time with my family.”  Indeed I might want to spend a few minutes with my 11 year old before she graduates from high school.  And then there is my long-suffering wife.

2.  More time to actually read a few books for pleasure, or see some films.

3.  I do have a job.

4.  The blog has spun off a lot of activities that you don’t see.  I read lots of papers that people send me, do more speaking than before, conferences, etc.  I hope to get my book out this year.  Maybe I can write some papers.

I thought about cutting back, but blogging is like a drug addiction for me—it won’t work.  Better to go cold turkey for a while.

Of course all the other quasi-monetarists (Rowe, Beckworth, Woolsey, Hendrickson, Kantoos, etc) will continue to cover the same sort of topics that I discuss.  On the progressive side, Yglesias is very good on money.  Don’t overlook Marcus Nunes, who contributed greatly to my blog, and also has his own blog now.  His views on monetary policy are quite close to mine.

I suppose I naively thought that if my blog was successful then support would magically turn up somewhere.  But let’s face facts, most people outside the blogosphere view what we do as a cute hobby, like growing miniature Bonsai trees, or raising chinchillas for fun and profit.  For all you young academics out there, the “Wisconsin Idea” is dead; it’s all about the pubs.  But do it anyway; it’s the right thing to do.

PS.  You’re probably thinking Avent exaggerated this blog’s importance by a factor of 100, because he’s a nice guy.  I agree.  So go redo the math and tell me what I’m worth.

PPS.   I’ll occasionally look at the comment section.   Long-time commenters can always ask me questions about current events, and I’ll try to give a quick reaction.

PPPS.  Christina Romer is now my official spokesperson on all matters relating to monetary policy and payroll taxes.

Michael Darda sent me some interesting information about the Japanese monetary base:

There are several ways of looking at this data.  The growth in the base over the past 20 years has been much slower than during the previous 20 years.  Thus it would be hard to claim QE didn’t work in Japan, as they didn’t even increase the base half as fast as when they weren’t doing QE.

On the other hand during the past 18 years Japan’s NGDP has been relatively flat.  So the growth rate of the base was much higher than NGDP, suggesting a falling rate of base velocity.  That does make QE look ineffective.  Especially when you consider that there were brief periods when base growth soared to nearly 40%.

But an even closer look as the data shows that these spurts in base growth were temporary, and were partially rescinded just a few years later.  Note the QE in the late 1990s when deflation first became a major problem.  Then the small drop in the base just a year or two later.  There was an even bigger bout of QE in the 2002-03 recession, followed by a much bigger drop in the base after the economy picked up a bit.  This doesn’t show that QE doesn’t work; it shows that temporary monetary injections don’t have much impact on NGDP.  But we already knew that, in fact it’s rather obvious if you think about it.

How do I know that the base declines in 2000 and 2006 were not just random?  How do I know the BOJ was intentional tightening policy?  Because on both occasions the BOJ raised interest rates, which is something no central bank does in a liquidity trap.  Ever. 

Some people look at these facts and see a central bank that was powerless to boost NGDP.  That seems crazy to me.  Why would a central bank trying to raise NGDP reduce the monetary base?  Why would they raise rates?  Here’s an alternative view.  Suppose the BOJ was trying to prevent inflation.  Then every time the CPI inflation rate rose up to zero, they would tighten policy.  If my hypothesis is correct, then what type of path would one predict for the Japanese monetary base?  The answer is surprising; almost exactly the path that we actually observed.  Here’s why:

1.  Because the trend rate of inflation fell sharply between 1970-90 and 1991-2010, nominal interest rates fell close to zero (the Fisher effect.)  This would produce a large increase in the real demand for base money, or a large fall in velocity.  And that’s exactly what we observed in Japan after 1990.

2.  When near the zero bound, the demand for base money will not be stable.  When conditions are depressed, the demand for money will pick up somewhat, and the BOJ will have to inject large amounts of base money to prevent severe deflation.  That’s the late 1990s, and 2002-03.  When things pick up a bit the demand for money will fall, and the BOJ will have to remove a significant amount of base money to prevent inflation.  And that’s what happened in 2000 and 2006.

3.  But they won’t remove all the base money injected earlier.  Recall that at near zero interest rates there is that permanent increase in the demand for liquidity.

Bennett McCallum once proposed that the Fed adjust the monetary base to offset changes in velocity during the previous quarter.  That would keep NGDP relatively stable.  I seem to recall McCallum proposed that NGDP be allowed to grow at a modest but steady rate.  The Japanese seem to have basically adopted this policy, but with a zero percent NGDP growth target.   No, I don’t believe they are consciously behaving this way, but it is interesting to consider that this is almost exactly the way the BOJ should behave if it wanted to keep NGDP constant, or the NGDP deflator falling at about 1% per year.

So QE did work in Japan.  They got steady NGDP.  The next question is why they acted as if they had such a peculiar policy target.  Some people tell me that “Japan” likes low inflation because they have lots of old people on fixed incomes.  But “Japan” isn’t a person, it’s a country.  Japan didn’t decide to follow a policy of stable NGDP, the BOJ did.  At the very same time the BOJ was deflating the economy the Japanese fiscal authorities were aggressively trying to boost NGDP through expensive construction projects, which have put Japan deeply in debt.  The BOJ sabotaged those efforts.  No, “Japan” did not adopt a stable NGDP target (or mild deflation target), the BOJ did.  That’s even more peculiar.

PS.  I will try to catch up on comments this weekend.

PPS.  I just added an interesting Romer quotation to the end of the previous post.

Marcus Nunes sent me what might be the first mainstream media article to correctly describe what went wrong in 2008.  It appears in the National Review, one of those conservative magazines that Paul Krugman thinks only publishes articles written by gold bugs and austerians.

Ramesh Ponnuru relies heavily on the views of quasi-monetarists like David Beckworth, Josh Hendrickson and myself.  And he gets it right.  (I hope this doesn’t sound condescending, but the MSM often doesn’t quite understand monetary economics, as the field is full of counter-intuitive arguments and subtle distinctions that are hard to grasp.)

Josh Hendrickson””an economist at the University of Toledo, and like Beckworth a right-leaning blogger””has shown that the Fed did a pretty good job of stabilizing the growth of nominal income at roughly 5 percent per year during the “great moderation” that lasted from the mid-1980s until the current recession. (Although Beckworth notes that growth was slightly above trend during the housing boom, for which he faults the Fed.) Most debts””notably, most mortgage debts””are contracted in nominal terms, with no inflation adjustment. If people are used to 5 percent growth in nominal incomes each year and make their arrangements accordingly, then an unexpected drop will make their debt burdens heavier and also make them reluctant to make plans for a suddenly uncertain future.

That’s what happened during the recent crisis. Scott Sumner””yet another right-of-center econoblogger, this one based at Bentley University””often notes that in late 2008 and early 2009, we saw the sharpest fall in nominal income since 1938.  In his view, much of what we think we know about the recession of 2007-09 is wrong. Not only has money not been loose since the crisis began, but tight money is the fundamental reason the recession was so severe and the recovery has been so halting. He argues that it was more fundamental than the housing bust, since residential-construction employment started falling long before the crisis hit.

The article is entitled “Not Enough Money: Why QE2 Worked.”  Sorry, I can’t find a link.

Karl Smith should be much more famous.  Here he criticizes Paul Krugman’s defense of the liquidity trap.

I wrote an article for the Adam Smith Institute called “The Case for NGDP Targeting.”  I can’t find it online, but they have paper copies.

Gregory Barr sent me an excellent paper by Greg Mankiw and Matthew Weinzierl :

Conclusion

The goal of this paper has been to explore optimal monetary and fiscal policy for an economy experiencing a shortfall in aggregate demand. The model we have used is in many ways conventional. It includes short-run sticky prices, long-run flexible prices, and intertemporal optimization and forward-looking behavior on the part of firms and households. It is simple enough to be tractable yet rich enough to offer some useful guidelines for policymakers.

One clear implication of the analysis is that how any policy is used depends on which other policy instruments are available. To summarize the results, it is fair to say that there is a hierarchy of instruments for policymakers to take off the shelf when the economy has insufficient aggregate demand to maintain full employment of its productive resources.

The first level of the hierarchy applies when the zero lower bound on the short-term interest rate is not binding. In this case, conventional monetary policy is sufficient to restore the economy to full employment.  That is, all that is needed is for the central bank to cut the short-term interest rate. Fiscal policy should be set based on classical principles of cost-benefit analysis, rather than Keynesian principles of demand management. Government consumption should be set to equate its marginal utility with the marginal utility of private consumption. Government investment should be set to equate its marginal product with the marginal product of private investment.

The second level of the hierarchy applies when the short-term interest rate hits against the zero lower bound. In this case, unconventional monetary policy becomes the next policy instrument to be used to restore full employment. A reduction in long-term interest rates may be sufficient when a cut in the short- term interest rate is not. And an increase the long-term nominal anchor is, in this model, always sufficient to put the economy back on track. This policy might be interpreted, for example, as the central bank targeting a higher level of nominal GDP growth. With this monetary policy in place, fiscal policy remains classically determined.

The third level of the hierarchy is reached when monetary policy is severely constrained. In particular, the short-term interest rate has hit the zero bound, and the central bank is unable to commit to future monetary policy actions. In this case, fiscal policy may play a role. The model, however, does not point toward conventional fiscal policy, such as cuts in taxes and increases in government spending, to prop up aggregate demand. Rather, fiscal policy should aim at incentivizing interest-sensitive components of spending, such as investment. In essence, optimal fiscal policy tries to do what monetary policy would if it could.

The fourth and final level of the hierarchy is reached when monetary policy is severely constrained and fiscal policymakers rely on only a limited set of fiscal tools. If targeted tax policy is for some reason unavailable, then policymakers may want expand aggregate demand by increasing government spending, as well as cutting the overall level of taxation to encourage consumption. In a sense, conventional fiscal policy is the demand management tool of last resort.  (Italics added.)

I agree, and would just add a few observations:

1.  Between the Big Bang and 2011, there has never been a central bank that promised to create inflation, and was not believed.  At least not in the Milky Way.  So there is really no need to go beyond step two.

2.  If we add sticky wages to the model, then I think that the investment tax credit could be augmented with a payroll tax cut–employer share only— as a way of moving the labor market closer to its flexible wage–Walrasian equilibrium level of employment.

As you know, I’d like to eliminate the inflation and the price level from business cycle theory, and use NGDP as my nominal aggregate (where the price level is currently used, such as the Fisher equation and the AS/AD diagram.)  Real wages would be nominal wages over nominal GDP per capita.  A negative nominal shock like 2008-09 would cause (sticky) nominal hourly wage rates to rise as a share of NGDP, causing fewer hours worked. (Hours worked replace RGDP in the AS/AD model.)  Since prices can be affected by both supply and demand shocks, they are an unreliable indicator of nominal shocks.

I just noticed that Paul Krugman commented on this paper:

Now bear in mind that in order to make a commitment to inflation work, central bankers not only have to stand up to the pressure of inflation hawks “” which is much harder when you’re having to testify to Congress than it is if you’re a Harvard professor “” but, even harder, they need to convince investors that they’ll stand up to that pressure, not just for a year or two, but for an extended period.

Now, the thing about fiscal expansion is that people don’t have to believe in it: if the government goes out and builds a lot of bridges, that puts people to work whether they trust the government’s commitment to continue the process or not. In fact, to the extent that there’s some Ricardian effect out there, fiscal policy works better, not worse, if people don’t believe it will continue.

On a personal note: I supported fiscal expansion in 2008-2009 precisely because I didn’t believe that the kind of commitment-based unorthodox monetary policy that works in the models could, in fact, be implemented in practice. Nothing I’ve seen since has changed my views on that subject.

Where does one start?  With the fact that the Dems controlled Congress during the Great Recession and would have welcomed more monetary stimulus?  With the fact that meaningful fiscal stimulus was also not politically feasible (according to Krugman it never happened.)  With the fact that unemployment was 7.8% when Obama took office and 9.8% in November 2010, when QE2 was announced?  With the fact that rumors of QE2 in September and October 2010 affected all sorts of asset prices (including TIPS spreads) in exactly the way us quasi-monetarists predicted?  How can Krugman say nothing he’s seen has changed his views on the relative political feasibility of fiscal and monetary stimulus?  The reason the Fed didn’t do more wasn’t Ron Paul, it was pushback from regional Bank presidents within the Fed.  Oh, and Obama “forget” and left two or three seats empty for over a year.

Krugman seems to misunderstand the role of pundits.  It’s our job to explain what needs to be done, in order to make it more politically feasible.  In early 2009 politicians would have been elated if someone told them there was a way to boost AD without running up big deficits.  But they didn’t know because just about the only people making that point forcefully and loudly were us quasi-monetarists.

In contrast to Krugman, this very wise pundit does understand the role of bloggers is to push the Fed to be more aggressive:

So why am I even slightly encouraged? Because the critics did, at least, succeed in moving the focal point. Not long ago gradual Fed tightening was the default strategy; but as I said, at this point the Fed realized that continuing on that path would have unleashed both a firestorm of criticism and a severe negative reaction in the markets.

What we need to do now is keep up the pressure, so that at the next FOMC meeting the members are once again confronted by the reality that not changing course would be seen as dereliction of duty. And so on, from meeting to meeting, until the Fed actually does what it should.

I know: it’s a heck of a way to make policy. In a better world, the Fed would look at the state of the economy and do what was right, not the minimum necessary. But wishing for that kind of world is like wishing that Ben Bernanke were running the place.

The statement was made in August 2010, just days before the first Bernanke speech hinting that more needed to be done.  Who was this prescient blogger?  Click here and find out.

(And you thought it was going to be me.)

PS.  Neither the Boston Fed nor any local universities have ever asked me to present a paper on how NGDP targeting–level targeting–targeting the forecast, could have greatly reduced the severity of the asset price collapse of late 2008, the associated banking crisis, and the recession itself.  I’ve put together a persuasive group of PowerPoint slides, have honed my presentation at the AEA meetings and elsewhere, and am ready to go if anyone wants an interesting and controversial take on the Great Recession.  I’ve debated countless economists, including some pretty distinguished ones, and found no holes in my logic.  Don’t expect me to be a pushover just because I come from a small school.