Arnold Kling recently made this criticism of my argument:

I think that my least favorite Sumnerian proposition is that the Fed can affect the economy by announcing a long-term target for a nominal variable. I think that in order for this to work, you have to assume that people are forward-looking and focused on future monetary policy. On the other hand, his mechanism by which monetary policy works is the conventional story in which nominal wages are sticky, so that with higher aggregate demand you get lower real wages and more real output. But for nominal wages to be sticky, workers cannot be forward-looking and focused on monetary policy. So, on the one hand, for targets to matter, people have to be forward-looking. On the other hand, for monetary policy to matter, people cannot be forward-looking. I cannot past what I see as a basic contradiction.

Commenters frequently ask me what would be the point of higher inflation expectations.  Doesn’t the rational expectations model imply that only unanticipated inflation has real effects?  Yes and no.  As far back as the late 1970s people like Fisher had already shown that in a new Keynesian ratex model with sticky prices, monetary policy could still influence real variables.  For this to happen, the monetary shock must occur after some wage or price decisions have already been made, but before those wages and prices are scheduled to be re-adjusted.

Kling probably knows this, which is why he focuses on long run inflation targets.  Suppose we target NGDP growth over the next 5 years, surely all wages and prices would have adjusted by then?  Yes, but the point of changing future expected NGDP is to change current AD, and hence current NGDP.  And if we do that, and if wages and prices are sticky, then monetary policy can have real effects in the short run.

Here is an analogy.  Suppose than the US government announced that starting three years from today it would begin buying unlimited quantities of gold at $2000/ounce.  But for now it would not intervene in the gold market, leaving prices at their current $1250.  Obviously the policy, if credible, would cause gold prices to immediately rise to about $1900, and employment in the gold mining industry would rise.  Even a promise to intervene to hit a future target can have powerful current effects on output.

[BTW, this experiment actually occurred in 1933, when the government hinted that once it returned to the gold standard it would buy unlimited gold at the new price point.  That’s why higher gold prices in 1933 mattered, even though the implicit promise wasn’t implemented until 1934.]

Here is Arnold Kling on recalculation:

I do not think of the prosperity we experienced a few years ago as inherently false. It happened to be false because it relied on unsustainable beliefs. If we had not had a housing bubble, I think it is possible that instead firms and households could have created patterns of specialization and trade that resulted in full employment and affluence that were more sustainable. Ultimately, I think that the Recalculation will result in such new patterns of specialization and trade.

As it is, a lot of people’s plans have been disrupted by the collision between prior habits and reality. I do not think that there is much that government can do about it.

I agree that the prosperity of mid-2007 was partly false.  But the so-so economy of mid-2008 (with 6% unemployment) was not false.  By mid-2008 the housing crash had occurred, but the rest of the economy was doing OK.  Then AD fell sharply, and the economy went from so-so to horrible.  Not only can government do something about this, but government caused the problem with its tight money policy that depressed NGDP 8% relative to trend, and caused the financial crisis to worsen dramatically.

Here is Karl Smith:

The simple fact of the matter is that the structure of the American economy hasn’t changed that much in that last 24 months. We were building houses at an unsustainable rate, sure. But, at its peak the US employed about 7.7 million construction workers. It now employees about 5.8 million. That’s a difference of a little less than 2 million workers or about 1.5% of the American workforce.

He doesn’t say this, but the vast majority of those jobs had been lost by mid-2008, when unemployment was still at fairly reasonable levels.  Here is Matt Yglesias commenting on Smith:

In October of 2007, the unemployment rate was at 4.4 percent. By January of 2008, it had risen to 5.4 percent. Then it dipped down a bit, but by July of 2008 it was at 6 percent, about the level you’d expect from 2.2 million construction workers losing their jobs. But then by Election Day it was all the way up to 6.5 percent. Between Election Day and Barack Obama’s inauguration, it increased two more percentage points. Then in the following year, it went up another 1.1 percentage points before very slowly starting to tumble.

This is, as Smith argues, not about the difficulty of shifting those construction workers into other segments of the economy. It’s about system-wide excess demand for money, and a failure of the policy department to respond appropriately.

Now I know that some of my commenters will respond that “it wasn’t just houses, we were making too much of almost everything.”  Too many cars, too many drapes, too many washing machines, etc.  Funny how these generalized “overproduction” problems affecting almost all sectors just happen to show up at precisely the moment when NGDP begins falling.  Funny how the cars and houses produced in the 1920s found buyers, but suddenly in the early 1930s when NGDP fell in half we found out that all along we had been producing too much of almost everything.

PS.  Speaking of Yglesias, he issues the following challenge to right-of-center economists:

That’s because Congress is unwilling to extent UI eligibility beyond 99 weeks. Which means that soon enough we should see . . . something. But what? My guess is not much. My guess is that basically nobody wants to hire the vast majority of the current long-term unemployed. So my guess is that the labor market prospects of people who’ve been unemployed for 98 weeks will look an awful lot like people who’ve been unemployed for “only” 70 weeks. I wonder what people with a more right-of-center approach would predict? Are we going to see a surge in employment among people around the 99 week mark? Will they uncover hidden secret jobs that are stashed away somewhere?

A few comments.  I am surprised that this in an open question.  We had extended benefits in other recessions—surely we must already know the answer?  But if not, then yes, I would expect a big increase in job finding success for those whose benefits have run out.  Not because they are deadbeats, but because unemployed factory workers would get desperate and take jobs at McDonalds.  Obviously I differ from most economists on the right in that I favor more stimulus, whatever the answer to this question.  And I favor Singapore-style self-funded UI, whatever the answer.  But I do accept Yglesias’ implicit argument that if there is no surge of job-finding, then (in the absence of an optimal self-funded UI scheme) it would strengthen the case for extended benefits during recessions.

Someone has finally addressed my fiscal expectations trap idea.  Here is Ambrosini:

Sumner argues that if Krugman’s claim is true that the Fed is too conservative, that they will do whatever to curb inflation, then fiscal policy won’t work either. Fiscal policy moves the AD curve right, but the Fed will just move it back left.

Sumners argument only works if policy is not limited by the zero lower bound. Suppose the Fed’s conservative policy requires it to set interest rates at -2%. It can only set them to 0%. When fiscal policy moves the AD curve right, the Fed resets the target rate to -1%, say. Actual rates stay at 0%, the Fed can’t move the AD curve left and so fiscal policy is effective. Sumner says either “the Fed isn’t constrained to just set interest rates (e.g. currency interventions)” or “the Fed shouldn’t be constrained to just set interest rates”.

I see his point, but this proves too much.  If the Fed was unable to neutralize current fiscal policy for this reason, it would be equally unable to neutralize current monetary policy.  My argument wasn’t that a fiscal expectations trap is likely, but that it is more likely than a monetary policy expectations trap.

For the monetary trap to work, you have to assume that at some future date we will exit the liquidity trap, and the Fed will take advantage of that situation by raising rates and controlling inflation too quickly–before we reach the promised price level target.  So either way, you have to assume the future monetary authority has some power, or you can’t get either a monetary or a fiscal expectations trap.

Here is the bottom line.  Suppose the right-wing controls the Fed, and wants the price level to be only 10% higher in 10 years, not 20% higher as Bernanke may want.  The Fed can make that happen, regardless of what fiscal policymakers do.  And if people begin to believe the Fed intends to keep core inflation at 1% per year for the next 10 years, there really isn’t much fiscal policy can do.  Remember that fiscal stimulus works by shifting AD to the right.  If it is to work at all it must raise inflation at least somewhat (assuming the AS curve isn’t totally flat.)  But that means it can’t work if the Fed isn’t expected to play ball in the out years.  How can you significantly raise short term inflation in a world where the total increase in the core price level over the next 10 years is only 10%?  The numbers don’t add up.

Now that I am starting to tangle with Krugman, I might as well go for broke, and pull out all the stops.  So at the risk of sounding ridiculously over-confident, here is my grand new theorem:

The Sumner Critique (of arrogant right-wing economists and naive left-wing economists)

In any rational expectations model, government policymakers have no basis for confidence in a policy succeeding, unless it is expected to succeed (by the markets.)

Yes, the title is meant to echo the famous Lucas Critique of my former dissertation chair.  And yes, I do understand that it is a bit grandiose to claim that sort of title for a theorem that on close inspection looks suspiciously like a tautology.  And it’s not really original, as Robin Hanson has discussed similar ideas.   But I believe it is worth thinking about, as I don’t think its implications for macroeconomics are fully understood.

For those on the right:  If the market forecast of inflation suggests that monetary policy is too tight, then it is too tight.  Don’t try to arrogantly assert that “right wing economists know best.”  You are the guys who like ratex models.  If you don’t believe the implications of your models, then change your beliefs about policy, or change your model.

For those on the left:  As soon as Obama was elected, his fiscal stimulus should have started working.  If it was expected to work, then spending should have begun rising on the announcement of the intent to offer fiscal stimulus.  That is the lesson of Eggertsson’s 2008 AER paper.  Starting in early November 2008, it was Obama’s economy.  And guess what; markets didn’t expect Obama’s fiscal stimulus to work (very well.)  That is why asset prices fell so sharply until March 2009, when the Fed adopted QE and China’s recovery started raising the world’s (Wicksellian) natural rate of interest.

Part 2:  A critique of Sumner

I’ve been reading a Javier Marias novel called Fever and Spear, and ran across this interesting passage:

The most striking and dangerous thing about this whole business is that you, too, begin to believe yourself capable of seeing and fathoming.  Boldness never rests, it waxes and wanes, it burgeons or shrivels, it slips away or subjugates, and may disappear altogether after some major setback.  But boldness, if it exists, is always on the move, it is never stable and never satisfied, it is the very opposite of stationary.  And its main tendency is towards limitless increase, unless kept in check or brought up brutally short, or else systematically forced to retreat.  In the expansive phase, perceptions become excitable or intoxicated, and arbitrariness, for example, ceases to seem arbitrary to you, believing, as you do, that your judgements and insights, however subjective are based on solid criteria . . .

Ouch!  That hits close to home.  I don’t know about other bloggers, but I go through cycles.  When things are going well, I start to get more confidence.  People say good things about my blog.  Gradually I get more cocky.  I start dispensing with “maybe” and “perhaps.”  I go out on a limb, play hunches.  Soon I’m pontificating on things I know little about (financial regulation.)  I read a few items in the newspaper, and suddenly I expert enough to offer 6 point plans to save the world financial system—right off the top of my head.  The ego keeps swelling, eventually reaching titanic proportions.  Then bigger than the Titanic, into James Cameron territory.

And then it all comes crashing down.  A commenter who knows more than me about some area (say statsguy or 123) will put some real facts and logic into the comment section, and puncture the boldness balloon.  I’m forced to temporarily scurry away like a dog with its tail between its leg.  I get more cautious.  But Marias is right, boldness always waxes and wanes, it’s never stable.  After growing more cautious I regroup, and start building up again.  In no time at all I am acting like I know more than Nobel Prize winners.

I don’t know if every blogger goes through these cycles.  Tyler Cowen never seems over-confident.  Others seem to have egos that are in a permanent state of inflation.  Like they’re taking Cialis for the brain.  I thought of this passage in Marias’ novel because whenever I think I get a clever idea, it puts me on an upswing.  And I thought the application of the expectations trap to fiscal policy was kind of neat.  So today is a good day.  (Plus I saw the new Kore-eda film.)

Now I’m just waiting for this idea to be punctured, it’s just a matter of time before someone actually reads what I wrote carefully, and finds flaws in the argument.  And then it’s back to earth.  Like pulling the plug on Kore-eda’s air doll.

In a recent post I argued that the expectations trap idea applied even more strongly to fiscal policy that monetary policy.  The argument for the expectations trap is that future monetary policymakers might sabotage the attempt of current monetary policymakers by adopting a policy that is too tight to hit the inflation target.  Expectations of that happening would depress current AD.  I argued that it is even more likely that they would try to sabotage current fiscal policymakers, as you’d expect them to have a closer affinity for their own predecessors.  And in my typical long-winded way, I made the argument not one but four times.  (Feel free to skim, if you already read it.)  Here they are:

1.

For some reason people don’t worry about this problem with fiscal policy; and the reason is very odd.  Perhaps without knowing it, people tend to assume that future monetary policymakers would be expected to sabotage current monetary policymakers, but would not be expected to sabotage current fiscal policymakers.  This is a rather odd assumption, as you’d expect that future monetary policymakers have more respect for current monetary policymakers than they do for the bozos in Congress.

2.

After all, given the very long terms served by Greenspan (and now apparently Bernanke) the future and current monetary policymakers are often the very same person.  Is future Mr. Bernanke expected to differ from current Mr. Bernanke, by more than future Mr. Bernanke differs from the current Congress?

3.

Here’s one way to think about this issue.  The future Fed is considered the last mover in this game.  The current Fed can do QE, and the future Fed can undo QE.  Or the future Fed can raise rates sooner than expected, or by more than expected.  But that’s also true of fiscal policy.  The Congress can pass a bill to spend more money, and the Fed can raise rates right afterward if they think inflation is going to exceed their target.  I’m not saying that’s likely, but I also don’t think it’s likely that the future Mr. Bernanke would try to sabotage the current Mr. Bernanke if the current Bernanke publicly announced “We need to get core inflation back up to the trend line of 2% extending out from September 2008, and will do whatever it takes.”  Why would the future Mr. Bernanke try to sabotage the current Mr. Bernanke, if he made that promise publicly and explicitly?   After all, if he did so he would make both Bernankes look like fools in the history books.

4.

So please don’t take this post the wrong way.  When I say that the expectations trap is equally applicable to fiscal policy, I’m not saying that I think the Fed is likely to go out of its way to sabotage fiscal policy.  But it is even less likely to sabotage monetary policy, indeed the latter hypothesis seems much more far-fetched to me.

Now a commenter named Q2 suggests that Krugman (and Thoma) did not read my post carefully:

I believe both Thoma and Krugman did not read your entire post, or at least not carefully, as they seemed to miss the point that the Fed can counteract any attempt to raise AD through fiscal policy. As I read it, they think you’re arguing that in order for fiscal policy to work, the *legislator* needs to be credible, which is why they emphasize that all the legislator needs to do is spend the money; they don’t need to set expectations.

I hope not, as I never mentioned this idea.  I believe Q2 is referring to the following passage in Krugman’s post, which I didn’t read closely enough the first time (there seems to be a lot of that going around.)

And the Tinkerbell principle NEVER applies to fiscal policy. If the government goes out and hires a million people to dig ditches, the direct effect is that a million people have been put to work digging ditches. It doesn’t matter whether people believe it will work. Some of the effect might be partially offset if people believe the government will have to raise taxes later (though not completely offset- we’ve had that discussion). The point, however, is that expectations effects if anything diminish the effectiveness of fiscal policy, which actually works best if expectations don’t change at all.

I’d hate to think that when I finally got a Nobel Prize winner to pay attention to my clever new idea, he actually thought I was simply making a tired old argument and claiming it was my clever idea.  But I always get in trouble when I try to interpret Mr. Krugman, so I’ll let you commenters weigh in.  What do you think?  Did he “misunderestimate” me?

Even better, maybe Brad DeLong would weigh in.  A few weeks ago he did a post entitled “Can Scott Sumner read? The empirical evidence suggests not”  It’s good to have someone scolding bloggers who don’t do their due diligence, as long as they aren’t swayed by ideological bias.  So what do you think Brad DeLong?

PS.  If Brad DeLong does agree with me, I do hope he comes up with an equally clever post title using Paul Krugman’s name.  If not . . . well, nevermind.

PPS.  I couldn’t find a similar quotation from Mark Thoma, so I’ll give him the benefit of the doubt.  But I would like to respond to this quotation in Thoma’s post:

More generally, if people want to go back and use older or different models to make their arguments, that is fine, but it doesn’t have a lot to do with the argument I was making. Perhaps they believe these models are superior to the models that Woodford and Eggertsson are using, that’s certainly their prerogative, but which model provides better answers to the questions we are asking is a completely different argument. For the most part, the issues being raised about credibility have been considered and addressed within the New Keynesian framework.

My model isn’t older than Eggertsson and Woodford’s model, because it was only developed yesterday (At least I think it was; keep in mind that whenever I think I have a new idea, I always find out someone else got their first.)   BTW, several years ago Gauti Eggertsson and I had a fairly extensive email discussion.  I am familiar with his work, and respect it.  But I don’t always agree with him on the policy implications of this way of thinking about macro.

Paul Krugman recently responded to my expectations trap post, and most of his comments were either wrong or misleading.

What Scott is suggesting is that all macro policy, both monetary and fiscal, is subject to what we might call the Tinkerbell Principle: you can fly, but only if you believe you can fly.

This one is correct.  But just so there is no misunderstanding, Thoma was the one making the Tinkerbell argument for monetary policy, and in my expectations trap post I thought it exceedingly unlikely that it would be a problem in practice.  I said:

So please don’t take this post the wrong way.  When I say that the expectations trap is equally applicable to fiscal policy, I’m not saying that I think the Fed is likely to go out of its way to sabotage fiscal policy.  But it is even less likely to sabotage monetary policy, indeed the latter hypothesis seems much more far-fetched to me.

For those who don’t know, the Tinkerbell argument (which I believe Krugman developed for monetary policy in 1998) is based on the fact that current AD is heavily influenced by future expected AD (and hence future expected monetary policy.)  If current policy is expansionary and next year’s monetary policy is expected to be highly contractionary, then current AD won’t rise very much because the effect of future expected monetary policy on current AD is much stronger than the effects of current monetary.  And I would argue that the same applies to current fiscal policy.   (We don’t have to worry as much about future expected fiscal policy, because most new Keynesian models assume that you aren’t going to be in a liquidity trap forever, and hence monetary policymakers drive NGDP growth in the long run.)

Suppose the price level is 100, and you want to raise it to 110 in two years.  In principle, this could be done with either monetary or fiscal stimulus.  Of course fiscal stimulus is assumed to boost AD by raising velocity.  I have doubts about the efficacy of fiscal stimulus, but certainly concede that it might have some stimulative effect.  But not if the public expects the Fed to change course in 12 months, and start trying to drive the price level back to 100 in 2 years.  Unless the public expects prices to be at 110 in two years, current attempts to boost AD will be largely ineffective.

I don’t think it is difficult to raise inflation expectations.  The central bank merely needs to lay out an explicit price level or NGDP target, level targeting, and promise to catch up for shortfalls.  If they do that they will be believed.  Why wouldn’t they be believed?  If they aren’t believed, then they need to consider other plans, like currency depreciation, or NGDP futures targeting.  But let’s cross that bridge when we come to it.  There is no example of central banks that were determined to inflate but failed.  Even Krugman criticizes modern central banks for their refusal to set higher explicit inflation targets.  So I don’t worry about the Tinkerbell Principle, at least for monetary policy.  It’s Thoma (and Krugman?) who seem to take it seriously.

[Update:  I should have said “fiat money central banks” or “governments” who wanted to inflate.  There may have been central banks that lacked the authority to inflate due to gold standard or currency board considerations.  HT:  Alex.]

Here’s Krugman again:

But this isn’t even true about monetary policy, unless you’re at the zero lower bound. Under normal circumstances, an open-market operation will reduce short-term interest rates, regardless of what the market believes. It’s only when you’re up against the lower bound that increasing the current monetary base does nothing, so an open-market operation matters only if people believe it signals higher inflation later.

In a 1993 paper I argued that if the Fed doubled the money supply, and was expected to cut the money supply in half a year later (i.e. return it to its original level) then prices would show little or no short term gain, despite the predictions of the simple Quantity Theory of Money.  I argued that prices could not double in the short run, as that would imply they’d be expected to fall in half over the following year.  But that would imply an implausibly high real yield on cash (100%.)  Instead, people would mostly hoard the extra cash.  And this is even true if T-bill yields were 5% when the Fed made the bizarre monetary injection.  Krugman might reasonably argue that the policy would immediately drive short term rates to zero, and I’d agree.  But I don’t think interest rates are the right way of thinking about monetary policy.  What matters is the impact of policy on asset prices; stocks, commodities and real estate.   These are forward-looking markets.  So while a cut in the current fed funds rate might have a tiny effect, it is always true that monetary policy is much more about future expected changes in policy, than the current setting of the fed funds rate.  Even new Keynesians like Woodford and Eggertsson agree on this point.

Krugman also errs in the preceding quotation in assuming that a lower short term interest rate means monetary policy has eased.  There was a severe negative monetary shock in December 2007, when the Fed eased less than expected.  Stocks plunged on the 2:15 announcement.  Krugman’s model would predict that three month T-bill yields should have risen on the news.  Instead they fell, as investors suddenly expected a much weaker economy.  And investors were right, the economy began weakening almost immediately, and the Fed had to scramble with some aggressive make-up calls in January–125 basis points of cuts in 2 weeks.  As Milton Friedman pointed out, ultra-low interest rates usually mean money is very tight.  Indeed over time tight money can so weaken real economic activity that even short term real rates end up lower (as Robert King showed.)

Krugman continues:

And the Tinkerbell principle NEVER applies to fiscal policy. If the government goes out and hires a million people to dig ditches, the direct effect is that a million people have been put to work digging ditches. It doesn’t matter whether people believe it will work.

This is wrong.  If the public doesn’t believe inflation will be higher, then they don’t believe the AD curve will shift to the right.  Why might they believe the AD won’t shift to the right?  Let’s use Krugman’s own assumption that central bankers are scrooge-like reactionaries who have an inordinate fear of inflation.  As soon as Congress passes that stimulus, the Fed will begin plotting to gradually tighten money, so that inflation doesn’t rise.  But you can only prevent inflation from rising if you prevent AD from rising.  And that means you must tighten monetary policy enough so that any gains to AD from fiscal stimulus, are offset by decreases in private sector activity due to monetary tightening.  Again, I am not claiming this would happen, what I am claiming is that it is more likely that the future Fed would sabotage the current Congress, than that the future Fed would try to sabotage an explicit inflation promise made by the current Fed.  I’m not the Tinkerbell!  (Not that there is anything wrong with a grown man styling himself after Tinkerbell.)

[As an aside, it is odd that Krugman would make this argument without at least addressing the reasoning I used for why the Tinkerbell Principle applies to fiscal policy.  Is or is not the Fed the last mover?]

Krugman continues:

Beyond the theoretical confusion, Scott argues that

“Almost everyone agrees that Japan does not face an expectations trap. They can devalue the yen whenever they wish, as much as they wish.”

Someone should tell my current hosts. The Swiss National Bank has been trying hard to prevent an appreciation of the franc: since the start of the crisis Switzerland has added around $100 billion, or 20% of GDP, to its foreign exchange reserves. An equivalent intervention for the US would be $3.5 trillion. Yet the franc has still strengthened from .6 to .7 euro.

The point here is that currency intervention is actually just a form of quantitative easing “” conceptually no different from buying commercial paper or long-term bonds. And the same problem arises “” namely, that you have to engage in a huge expansion of the central bank’s balance sheet to gain traction. You can say that’s OK, and in fact I would; I’d like to see the Fed add several trillion to its assets. But central banks are leery of doing this, for various reasons, including the fact that they’re taking on risk.

So it’s just wrong to suggest that currency intervention offers an easy way out of the expectations trap; there’s nothing special or magical about that particular form of QE “” or rather, nothing special except that it’s a beggar-thy-neighbor policy.

There are all sorts of problems here.  First one quick observation.  If the Fed was concerned that a bloated monetary base was leading them to take on too much risk, they’d have an interest penalty on excess reserves (or at least a zero rate.)  Instead they actual pay banks a quarter point to encourage them to hold on to a trillion dollars in ERs.  Second, there are trillions in T-bills and T-notes that could be bought with modest risk.  But in any case if they set a higher explicit inflation target it would reduce the demand for base money.  I’m not arguing for using QE as the weapon—inflation or NGDP targeting is the weapon. QE merely accommodates whatever demand the public has for base money at that target.

But let’s focus on the main issue here.  A central bank can always depreciate it’s currency by offering to sell unlimited amounts of currency at whatever nominal rate they wish to peg.  That open-ended offer becomes the market price.  So far I am not disagreeing with Krugman, but some of his readers might have misinterpreted what he was saying here.  His real point is that to do this they might have to expand the monetary base by a large amount.  I have two reactions to this:

1.  If so, (and he is probably right about Switzerland) then the Swiss basically have to choose which problem is worse; mild inflation, or a big monetary base.  If the bloated base is mostly due to bank reserves, then the Swiss can put a negative interest rate on reserves, and that will lower the demand for base money.  They could also set a higher inflation target; in that case fewer people might want to hoard Swiss Francs.  It’s their choice.

2.  It is clear from the behavior of the BOJ (which tightened monetary policy in both 2000 and 2006) that they don’t want inflation.  They are behaving exactly like a central bank would behave if it didn’t wish to boost prices.  So naturally there is a bloated demand for Japanese base money, their GDP deflator has been falling at 1% a year for 16 years.  But that’s their choice; if they wanted a higher trend rate of inflation they wouldn’t have tightened monetary policy in 2000 and 2006.  If you have a low rate of trend inflation, you’ll have a lot of demand for your base money.  It’s their choice.

Here’s where Krugman is misleading.  You do not need to inject a lot of base money to accommodate a credible and significantly positive inflation target, because when inflation expectations are significantly positive, people generally don’t want to hold a lot of base money.  Krugman puts the horse before the cart here.  Bloated monetary bases aren’t evidence of good faith inflationary attempts that failed, they are evidence of central banks that refuse to set robust inflation objectives, level targeting.

Krugman’s right that in one respect currency depreciation and open market purchases are two sides of the same coin.  They are both expansionary monetary policies.  But there is an important difference.  Simple OMPs don’t signal future price level intentions very clearly.  On the other hand if the BOJ starts pegging the yen at 150 to the dollar, it would be a pretty clear signal that they wished to sharply raise their future price level.  The reason is complicated, and has to do with interest parity and purchasing power parity.  People like Lars Svensson and Bennett McCallum have worked out “foolproof” models of reflation involving currency depreciation.  The basic idea is that when rates are near zero, interest parity implies that any fall in the spot exchange rate is associated with a fall in the forward rate.  And a lower forward rate (ceteris paribus) implies a higher expected rate of inflation.

What most discouraged me about Krugman’s comment here is the remark about “beggar-thy-neighbor” polices.  I think (but am not certain) that Krugman’s comments above imply that even ordinary OMPs, if they are to work at all, have effects similar to currency depreciation.  But this means that if the Japanese tried to do a more expansionary monetary policy, even without any intervention in the forex markets, it would be expected to depreciate the yen if investors thought it credible.  If we want the Japanese to do this (and I was under the impression that Krugman did) then the last thing we want to do is raise the issue of beggar-thy-neighbor policies any time they yen falls.  Perhaps Krugman is merely saying that the BOJ should buy domestic assets, not foreign assets.  Fair enough.  But let’s be aware that the yen might fall sharply if anything effective is done on the domestic front.  Let’s not even talk about “beggar-thy-neighbor” polices.

BTW, Gauti Eggertsson’s 2008 AER piece discusses how FDR did exactly what I suggested.  In 1932 the Fed’s OMOs failed to produce significant reflation.  They were not credible because of fears that the gold standard constraint would limit the Fed’s ability to carry through with the stimulus.  Gold outflows surged.  In 1933 FDR tried depreciating the dollar to get prices back up to pre-Depression levels (aka level targeting.)  Just as expected, this did raise inflation sharply.  And with little change in the monetary base.  So much for Krugman’s theory that currency depreciation is not much different from open market purchases.  Indeed the WPI rose by over 20% in 12 months, and RGDP started to recover.  And all this occurred at the zero bound.  FDR understood that “all we have to fear is fear itself.”  If we believe we can fly (inflate), and act on those beliefs with explicit nominal targets, level targeting, then we can fly.

PS.  David Pearson raised this point in the comment section to my earlier post:

I think the “expectations trap” is something we agree on: the Fed can avoid it if it shows enough determination. Where we disagree is that you think the cost of doing so is small.

Here’s where I disagree with just about everyone else in the world.  What others see as huge barriers to a higher inflation target, I see as symptoms of the current disinflationary policy.  Change that policy and those barriers won’t look nearly so formidable.

HT Marcus.