Krugman vs. Meltzer

The money supply is soaring.  Renowned monetarist Allan Meltzer says inflation is our greatest threat:

Besides, no country facing enormous budget deficits, rapid growth in the money supply and the prospect of a sustained currency devaluation as we are has ever experienced deflation. These factors are harbingers of inflation.

When will it come? Surely not right away. But sooner or later, we will see the Fed, under pressure from Congress, the administration and business, try to prevent interest rates from increasing. The proponents of lower rates will point to the unemployment numbers and the slow recovery. That’s why the Fed must start to demonstrate the kind of courage and independence it has not recently shown.

In the other corner is Nobel prize-winning Keynesian Paul Krugman, who says wage deflation is coming:

Wages are falling all across America.  . . .

Whatever the specifics, however, falling wages are a symptom of a sick economy. And they’re a symptom that can make the economy even sicker.

So who does not-so-renowned “right wing monetarist” Scott Sumner think is right?  Obviously Krugman is right, or mostly right.  I was with him until the last sentence.  He thinks falling wages can reduce AD, I think it is merely a symptom of falling AD, and that it can boost AS.  Nevertheless I don’t think wage deflation is the solution to our current problems.  Rather I agree with Earl Thompson that under an effective monetary regime there would be no tendency for aggregate nominal wages to move unexpectedly.  They would be stable (with a rising trend in my view.)  I do not agree with Krugman’s diagnosis of the causes of falling AD, or the most effective cures.  But at least he understands the problem we face.

Robin Hanson asked me for examples of where macroeconomists have views at variance with information in the financial markets.  Right now the TIPS market is showing 0.9% expected inflation over the next 5 years.  1.43% over the next 10.  Is that consistent with Meltzer’s policy advice?  If monetarists won’t believe in market efficiency, who will?   BTW, the inflation number has been slowly creeping upward, which is good.

One other point.  There is a country that has run huge budget deficits, massive increases in its monetary base, smaller increases in M2, and has seen its GDP deflator fall something like 13 out of 15 years.  That’s a long time.  True, it hasn’t seen much currency depreciation, but hasn’t the dollar rallied strongly from a year ago (against the euro?)

On most issues I agree with Meltzer, not Krugman.  But the tendency to ignore expectations embedded in asset prices is the Achilles heel of nearly all modern applied macro (excluding a few supply-siders.)



14 Responses to “Krugman vs. Meltzer”

  1. Gravatar of JTapp JTapp
    4. May 2009 at 11:32

    From a strictly eco 101 textbook view, don’t the falling wages simply mean that SRAS is moving to the right, moving us back toward full employment? Given that it’s happening at the same time as the gov’t is stimulating AD, why should we be concerned about it?

  2. Gravatar of Bill Woolsey Bill Woolsey
    4. May 2009 at 11:35


    It is the long and variable lags.

    The current level of base money has supposedly put higher inflation in place for next year. Further increases in base money would not increase aggregate demand now. It will just exacerbate the increases in the future.

    As an aside, the out of control spending and debt does create a logic of future inflation.

    When the economy recovers, the interest rates the government has to pay may well increase a lot. And this might well create a temptation to use the inflation tax more. Worse, the temptation for inflationary default will be there.

    Your view (and mine) is that base money should be higher now (well, taking into account getting rid of interest on reserves and maybe charging for them,) but that it will need to drop in the future (or interest must be paid on reserves then.)

    The problems that will be generated by retiring baby boomers and the continuing desire to treat health care as a right, especially for the elderly, when combined with the massive increase in ordinary debt, really do create a long run threat of inflation. And it could actually jump foward in time.

    The finanical market indicators you describe could change suddenly.

  3. Gravatar of JTapp JTapp
    4. May 2009 at 11:45

    Per Bill’s point, the CBO projects the national debt to be 89% of GDP in 2019.

  4. Gravatar of Josh Josh
    4. May 2009 at 12:16

    “BTW, the inflation number has been slowly creeping upward, which is good.”

    There was a financial news reporter who will remain nameless that wanted to discuss why the yields on long term bonds were rising when the Fed was buying so many of these bonds. I was screaming (okay, not screaming) at the television, “because it’s working!”

  5. Gravatar of Jon Jon
    4. May 2009 at 12:20

    Scott: I think Krugman is being non-responsive. Meltzer is making a point about future actions, Krugman is making a point about present ones.

    The Fed must have “guts” to raise rates before inflation rises or unemployment falls as those are both lagging indicators.

  6. Gravatar of StatsGuy StatsGuy
    4. May 2009 at 17:24

    @Jon – Let’s give Krugman some credit. His counterpoint to Meltzer’s “there’s no example of” argument was the example of Japan’s lost decade. 10 years of massive deficits, huge increases in the base money supply, and currency devaluation.

    And deflation.

    @Josh, thank you for the chuckle.

    @Bill, there is no way out of the federal debt without inflation eating into the long term returns of US bondholders. The vicious opposition to the necessity of some level of inflation contributed to delaying the inevitable – at the cost of dramatically worsening the crisis.

    If, by some freak chance, we don’t get inflation (if, for instance, we increase bank capitalization requirements to put a cap on velocity rebound), the fed can keep printing money to pay off debt. If we do get inflation, then hopefully nominal tax revenue rises faster than interest obligations. If not, we’re in bad shape – we need to print money even faster.

    The really bad part is if everyone sees inflation coming, and builds it into expectations. That’s why if the Fed is going to inflate to payoff debt, they should do it fast – once, and done. But they need to cut debt levels (aka, increase taxes), because after doing it once, they aren’t going to get cheap credit anymore for 30 years.

    TIPS, by the way, are a hellishly bad idea. Treasury should kill that bird before it roosts.

  7. Gravatar of Bill Woolsey Bill Woolsey
    5. May 2009 at 03:59


    Inflation isn’t inevitable. Budget surpluses caused by less govenrment spending. Or increased tax revenue. While I don’t favor higher taxes, it is evident that civilization will not collapse if Americans had to start paying social security taxes like the Europeans, or a value added tax too. Or, the population imbalance can be resolved by allowing more Chinese and Indias to move to the U.S. That will raise real income. (Health care as a right and money is no object will lead to financial collapse, but not necessarily inflation.)

    Finally, there is always explicit default. Change the terms of the govenrment bonds. Rather than money, you get 30 year bonds with a low nominal interest rate. That or nothing.

    However, inflationary default and a higher inflation tax could also be used. But the politicians who choose such an approach should never be excused with the statement that there is no alternative. There are alternatives. I favor all of the above in place of hyperinflation, including sky-high taxes. Naturally, I will advocate cutting them and government spending.

  8. Gravatar of ssumner ssumner
    5. May 2009 at 04:36

    More great comments (as with)

    JTapp. Good question. Think of wage deflation as the canary in the coal mine. It is warning us that money is too tight. Given the bad monetary policy, it does help gradually reduce unemployment by shifting SRAS to the right, as you say. But a much more effective solution is to stop the monetary policy-caused drop in AD in the first place.

    Bill, Yes, there are lags, but no lags between current policy and current inflation expectations, which is the point Meltzer missed. And yes, fiscal policy could be a time bomb, but what Meltzer misses is that the huge fiscal deficits are CAUSED by falling NGDP, and that is caused by . . . well we both know what it is caused by. So Meltzer should not be asking the Fed to tighten monetary policy today, as it will worsen the budget deficit and make future inflation even more likely. So I don’t like it when Meltzer lumps monetary policy and fiscal policy together. They are working at cross purposes.

    JTapp, See previous answer to Bill.

    Josh, Great observation! That just gave me an idea for a future post.

    Jon, Krugman was right for the wrong reason, Meltzer wrong for the right reason. Krugman doesn’t seem to pay much attention to TIPS (or at least doesn’t talk about them much.) Rather his argument seems to be that monetary policy is now ineffective–he uses Japan as another example. Meltzer is right that monetary policy can be effective, but the TIPS market shows it is not currently working.

    Statsguy, Yes, after I thought up the Japan counterexample I saw Krugman got there first. Amazing how on some issues Krugman and I think much alike.

  9. Gravatar of Travis Travis
    5. May 2009 at 09:51

    Krugman did blog earlier about TIPS this year. I think in general Krugman writes for mass consumption, and TIPS are a little hard to understand (if not out right fraudulent). But hey just like all the deratives I just wish someone else would trade them on their own market, Americans just need a break from all this “Financial Innovation”

  10. Gravatar of Winton Bates Winton Bates
    5. May 2009 at 15:06

    Your reference to Japan makes me wonder if there is any evidence of what has happened to inflation expectations in Japan during the last 15 years. Has the central bank in Japan been so worried about the massive increase in its monetary base that it has clamped down on AD whenever inflation expectations have begun to rise?

  11. Gravatar of ssumner ssumner
    6. May 2009 at 05:53

    Thanks Travis.

    Winton, I am pretty sure inflation expectations stayed very low. Their long term bond yields were ridiculously low.

  12. Gravatar of Bill Woolsey Bill Woolsey
    7. May 2009 at 04:18


    I am just telling you where Meltzer is coming from. And just about every other free market economist who understands anything about monetary disequilibrium. It is the long and variable lags. In their view, base money has already risen enough–too much. Further increases now will have no impact on aggregate demand in the next few months. It will just exacerbate the inflation that is already coming next year.

    What is my opinion? Well, comparing the level or growth of base money according to historical standards and ignoring the money multiplier is crazy. As long as the Fed is half-way competent, they will be able to smoothly offset changes in the money multiplier and prevent an “explosion” of money (or credit) as reserve ratios drop.

    Reducing the money supply as money demand falls (or velocity rises, if you prefer) is much more challenging. And so, looking at what we _know_ are bad measures of the money supply, and suggesting that they are very large and grew very fast compared to past periods, and that money demand/velocity could readjust quickly and the Fed will never know until too late–well, that is more plausible to me.

    Weighing against this reality, are your arguments about rational expectations. I agree that when the Fed says that we expect slow nominal income growth for a long time, they are saying that we aren’t going to increase base money enough to keep nominal income on target. Why don’t they target their expectations? (Everyone will let them blame “the market” for the slow growth and if they overshoot and cause excessive growth in spending, it will be the Fed’s fault? It is the bureacratic need to protect the Fed?)

    Anyway, then we have the various market measures that show expectations of slow growth. I just don’t see why Meltzer can’t say that market participants are infected by Keynesian thinking. The notion that “the market” all understands about quantitative easing, that none of them identify monetary policy with targetting the Fed funds rate and that since it is near zero, monetary policy is “out of ammunition” appears to be wishful thinking. They have real money at stake, so they can’t be wrong.

    The second part of my argument had to do with the fiscal problems in the long run, where I have always agreed with Meltzer. The long run prognosis, is major inflatoinary threat.

    While I will grant that a deep recession and low tax revenues, combined with higher government spending aimed at stimulating aggregate demand is exacerbating the problem, the problem preexisted the current crisis.

    I support nominal income targetting (yes, level targetting.) I agree that the only reasonalbe approach is to target it in the future==2, 3, or four quarters ahead.

    Reducing base money now because it will need to be reduced in the future, or worse, reducing it now because of long term fiscal programs that will maybe one day motivate inflatinary default, is insane.

    But I do think the inflationary threat is real. And, by the way, telling people that, (if they beleive it) is expansionary.

    It is the Krugmans of the world that are talking the economy down. (The only answer is even more mega spending projects, if we don’t do that, it is depression forever? If people beleive that, what does it do when only a 2 trillion is spent rather than the “needed” 5 trillion?)

    As you have said, the Fed should say, we are going to raise base money enough to get nominal expenditure back to target.

    And they should follow through.

    I think all the talk of inflation and real interst rates is counterproductive. (WE must raise inflation expectatiosn so that the real interest rate on government bonds and interbank lending is at levels consistent with the operation of the rules we used to follow…. right.)

  13. Gravatar of ssumner ssumner
    7. May 2009 at 18:17

    Bill, I posted the inflation item today before I got around to reading this one. It addresses some of your issues, but not all. This seems like a good issue to continue focusing on. I’ll try to give it more thought.

  14. Gravatar of TheMoneyIllusion » The sad end of monetarism TheMoneyIllusion » The sad end of monetarism
    13. August 2011 at 06:48

    […] Two years ago Allan Meltzer warned that the Fed’s policies would lead to high inflation.  Paul Krugman and I told him he was wrong.  In a new article in the WSJ he repeats this warning.  But today I’d like to focus on something more disturbing, the end of monetarism as a powerful intellectual movement that addresses our problems.  Here’s how Allan Meltzer begins: Day traders and their acolytes tried to pressure the Federal Reserve to open the money spigots wider this week. They called for QE3, a third round of unprecedented quantitative easing. Fortunately, the Fed said no to QE3, at least for now. But it did vote to continue its super-easy, zero-interest-rate policy until mid-2013, well after the next presidential election. […]

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