Paul Krugman is gaining a better understanding of market monetarism

Here’s Paul Krugman:

I would submit, by the way, that the quasi-monetarists “” QMs? “” have actually backed up quite a bit on their claims. They used to say that the Fed can easily and simply achieve whatever nominal GDP it wants. Now they’re more or less conceding that the Fed has relatively little direct traction on the economy, but can nonetheless achieve great things by changing expectations. That’s pretty close to my original view on Japan. But changing expectations in the way needed is hard, especially when the Fed (a) faces massive sniping from the right and (b) has a number of hard-money obsessives among its own officials.

Of course we’ve always focused on expectations; that’s why we’re called market monetarists.  When I wrote an open letter to Paul Krugman in 2009, I discussed the need for QE, lower IOR, and a NGDP target, level targeting.  That’s still my view.  If Krugman thinks we’ve moved in his direction, it’s because he never really understood our views until now.  Come to think of it, there’s a lot of evidence that he didn’t understand what we were saying.

In fairness, market monetarists have been supportive of QE2, as that seemed much more politically feasible than NGDP targeting, level targeting.  Indeed even more feasible than price level targeting.  So it may have appeared we thought that was the optimal policy, at least at first glance.  But Krugman also supported QE2.

My areas of disagreement with Krugman have always been over fairly subtle questions.  He sees Japan as an example of an expectations “trap,” I see the problem as simply a central bank that has the wrong policy objective–an excessively low inflation target.  Not a central bank “trapped” by forces beyond its control.  He sees expected inflation as being needed; I see higher expected NGDP growth as being needed (but not necessarily anything close to 4% inflation.)  He sees monetary stimulus working through the real interest rate transmission mechanism, I see the interest rate as a sort of epiphenomenon, and instead see the mechanism as excess cash balances driving NGDP higher in the long run (hot potato effect), and expectations of future increases in NGDP driving current asset prices and current AD in the short run.  Other market monetarists obviously have diverse views on this question.

Our areas of agreement have always been much more important:

1.  We both see a need for much more demand stimulus.

2.  We both see temporary currency injections as useless and monetary aggregates as unreliable policy indicators.

3.  We both believe that the key is to raise expectations of future monetary stimulus.

4.  We both agree (I think) that if QE2 worked at all, it probably worked partly by sending a signal regarding the Fed’s future policy intentions.

5.  We both like Gauti Eggertsson’s work on the Depression (AER 2008.)  If Krugman thinks I’m a Johnny-come-lately to his expectations hypothesis, he might take a look at the 3 papers I wrote that Gauti cited in 2008, which argued (among other things) that the Fed’s 1932 open market purchases failed (contrary to the claims of Friedman and Schwartz), and that the reason they failed is that the purchases were viewed as temporary because of the constraints of the gold standard.

One final point.  There is a difference between Krugman and the market monetarists in terms of how we approach the thought experiment of an increase in the money supply at the zero bound.  He assumes the increase is expected to be temporary, and we often assume it’s permanent.  Thus the debate is often people talking right past each other, as even Krugman agrees that a permanent monetary injection would be expansionary.  In favor of our assumption, standard quantity theory models generally assume a permanent, one time money supply increase, when thinking about the effect on the price level.  To see why, consider how Irving Fisher or Milton Friedman would have reacted if told the Fed planned to double the money supply, and then remove the new money 12 months later.  Would Fisher and Friedman have predicted that the price of homes would double, but then fall back to the original level 12 months later?  Obviously not.  On the other hand neither Fisher nor Friedman seems to have fully understood the importance of the distinction between temporary and permanent monetary injections.  So Krugman’s 1998 paper did a great service by showing just how important this distinction really was.

But here’s something I never see Krugman discuss.  Expectations aren’t just important at the zero bound, they are always important.  If interest rates are 5%, and the Fed suddenly announces that they will immediately double the money supply, but then remove the new money a year later, there is little impact on prices.  So the expectations approach doesn’t merely challenge the naive QTM models at the zero bound, it does so at positive interest rates as well.  Expectations always matter a lot.  So why does the problem seem more severe at the zero bound?  Nick Rowe has pointed out that the Fed becomes mute at the zero bound.  As long as rates are positive, they can send signals about their future monetary policy intentions by adjusting short term rates.  Once rates hit zero, they don’t know how to communicate their policy intentions to the public, and the price level becomes unmoored, drifting around aimlessly.  At least until they find other tools (like QE) to communicate their future policy intentions.

PS.  I’m having lots of computer problems, so blogging may slow down for a while.



30 Responses to “Paul Krugman is gaining a better understanding of market monetarism”

  1. Gravatar of Benjamin Cole Benjamin Cole
    13. October 2011 at 07:49

    I noticed that blog entry by Krugman as well, and thought much the same thing (in my layman’s terms).

    On expectations: I also say real money in the pocket counts for a lot too.

    Aggressive forceful sustained QE, with lower IOR, will firehose money into the economy, and when people spend it, you get the recovery going. The Fed just has to stick with monthly buying until it gets the results it wants–the nominal GDP target Sumner has advocated.

    BTW, I think inflation will be well-contained due to enormous slack in the system, and open borders. Good, services, labor and capital flow freely. If there is a rise in the price of a good in the USA, more of it will be imported, and services can be offshored. Capital is abundant for valid expansion, and I bet the Mexicans can still outsmart the Border Patrol.

    Go Market Monetarism!

  2. Gravatar of Patrick R. Sullivan Patrick R. Sullivan
    13. October 2011 at 08:54

    Krugman clearly believes in the old Oater policy of, ‘shoot first, ask questions later’. This is typical backing and filling for him.

    Remember when, in 2008, he claimed that Fannie and Freddie had nothing to do with the mortgage crisis because they were prohibited by law from engaging in sub-prime loans? That George W. Bush had received a sweetheart deal from the other investors in the Texas Rangers? That Army Sec’y Thomas White was a felon manipulating Enron’s price?

    He had to back down from those claims too, along the lines of ‘That’s pretty close to my original view on Japan.’ Welcome to the club of Krugman Koncessionaires, Scott.

  3. Gravatar of Nick Rowe Nick Rowe
    13. October 2011 at 09:31

    Good post Scott. Nothing useful to add.

  4. Gravatar of Dan Kervick Dan Kervick
    13. October 2011 at 09:35

    We both believe that the key is to raise expectations of future monetary stimulus.

    Here’s a question, Scott: What exactly is it that I am expecting when I expect a future monetary stimulus?

    You depict QE as just a sort of second-best approach. But you say the key is quantitative cash balances rather than interest rates. So what other quantitative operations is it that you want the Fed to get rational agents to expect?

  5. Gravatar of Morgan Warstler Morgan Warstler
    13. October 2011 at 09:41


    Assume a level target of 3% NGDP, even if you want to back date it a bit, that’s fine, but assume we are now running at 3% RGDP with a level target of 3% NGDP.

    If inflation goes over ZERO, we are going to raise rates to pull back on RGDP.

    This is what DeKrugman think of as reducing the money supply int he future and why he thinks it is temporary, right?

    How would we call it permanent? Just because the price level is on target?

  6. Gravatar of Morgan Warstler Morgan Warstler
    13. October 2011 at 09:42

    Dan, the Fed wants people to know they will raise rates when RGDP is 3% and inflation goes over zero.

  7. Gravatar of james eliot james eliot
    13. October 2011 at 09:53

    with some on the right and some on the left calling for the end of Fed stimulus (and some calling outright with Ron Paul to “end the Fed”), perhaps all the Fed has done is now for naught: having engendered a political backlash (perhaps for having been too opaque at the beginning of the crisis and too transparent since), the expectations in the market place are – as in 1932 – that the stimulus will be short lived.

  8. Gravatar of Brito Brito
    13. October 2011 at 10:31

    Hey, I was wondering if you could elaborate on the hot potato effect?


  9. Gravatar of Dan Kervick Dan Kervick
    13. October 2011 at 10:43

    Thanks, Morgan. But Scott says that interest rates are an epiphenomenon, and that excess cash balances are the key. So I think my question still stands.

  10. Gravatar of Philo Philo
    13. October 2011 at 11:34

    “Once rates hit zero, they don’t know how to communicate their policy intentions to the public . . . .” Let me offer a recommendation: use the English language!

  11. Gravatar of John John
    13. October 2011 at 11:34


    How do macro people like yourself and Krugman think you can boost demand without inflation? It would be bad if inflation got higher than it is now because knocking it back down would require another recession. Could you imagine how painful it would be fighting inflation and with high unemployment? Welcome back to the late-70s.

  12. Gravatar of Benjamin Cole Benjamin Cole
    13. October 2011 at 12:19


    The CPI-U was at 226.5 in August vs. 219.1 in August 2008. That is up 3.4 percent in three years—and many say the CPI overstates inflation. The Cleveland Fed and TIPS markets are also showing Sandy Koufax ERA’s going ahead. (That means well under 2 percent…..sorry).

    The CPI is up so little despite a 30 percent rise in energy prices (that many should be accommodated, rather than fought).

    With 9 percent unemployment, GDP 15 percent below trend, real estate at half-off, and crouching Billy Barty-sized inflation rates—-if we don’t move to stimulate now, when would we move? Are you waiting for a celestial signal?

    This is the classic, textbook, perfect, ideal time for Market Monetarism.

  13. Gravatar of John John
    13. October 2011 at 12:42


    I’m not looking at the last 3 years. I’ve been talking about the past year where headline CPI is up 3.8%. Inflation numbers are coming out in a few days and experts are expecting them to be around 4% again. My point in all this is that unemployment and below trend GDP over the past year is not due to a lack of inflation. The inflation has been there but real GDP growth has been weak. My question to Scott was what are you hoping for right now, inflation really shouldn’t go that much higher, so how are you expecting monetary policy to stimulate real GDP? The money illusion hasn’t really been working over the past 365 days.

    Also, how would market monetarism represent a change right now. Over the past year, we are around 5% NGDP growth. Are you and Scott suggesting a temporary 10% target until we get back to trend? Clamping down on the inflation after that is gonna be tough.

  14. Gravatar of StatsGuy StatsGuy
    13. October 2011 at 13:15

    Good post, have always argued you and Krugman were not that far apart.

    It seems a lot of the misunderstanding going back and forth has to do with expectations of permanence. Among other things, even if the Fed signals an intention to support higher NGDP in the future even if it brings some inflation, we don’t know if it will change its mind. A lot of investors call the Fed’s bluff, believing it will change its mind (partly due to political pressures).

    The KEY – as our recent Nobel recipients showed – is institutional rigidity as a commitment tool. They argued for institutional rigidity to support commitment in the OTHER direction (and they largely got it), and it worked.

    Arguably, cheap talk might be commitment enough. We don’t even know, because the main problem is that the Fed really doesn’t want to commit. How do we know this? Because the Fed hasn’t been specific. The lack of specificity means it hasn’t really committed to anything, they’re keeping their options open, and by keeping their options open their signalling a refusal to commit. They’ve only just barely started to consider more specificity (the recent commitment to 0.25% rates through 2013). Did it work? A little.

    An interesting piece of research would be to measure just how much of market volatility is due to uncertainty about the goals of the monetary authority (and fiscal authority) rather than uncertainty about the real economy. Hard problem.

  15. Gravatar of StatsGuy StatsGuy
    13. October 2011 at 13:20


    Level target. We are still 8% below trend. Imagine you added 8% nominal value to all non-credit assets in existence. What would that do to house prices? Bankruptcy rates? Bank solvency? Expectations? Tax revenue, and hence deficit reduction? Then consider the multiplier effect of all of that…

  16. Gravatar of Benjamin Cole Benjamin Cole
    13. October 2011 at 15:13


    I would take out the money firehoses, and blast away. I wonder if we could even cause inflation—when production goes up, unit costs tend to go down. Maybe there is no real-world Phillips Curve, like some righties say.

    I will concede that commodities markets have become speculative, and that is leading to commodities inflation, medium-term, in upcycles.

    But we can’t choke ourselves to keep commodities down. Besides, you need the commodities booms, to bring on new supply, and suppress demand. Then you get gluts.

  17. Gravatar of StatsGuy StatsGuy
    13. October 2011 at 15:56

    “Besides, you need the commodities booms, to bring on new supply, and suppress demand. Then you get gluts.”

    Bingo, give yourself a cigar.

    Continually suppressing aggregate demand to hold down commodity costs (to subsidize developing country consumption??) only encourages underinvestment in future production and technology to reduce consumption. It is, in fact, anti-market behavior.

  18. Gravatar of ssumner ssumner
    13. October 2011 at 17:36

    Thanks Ben, Patrick, Nick.

    Dan, QE is first best once rates are positive. If interest rates are never positive, than replace all debt with cash. That’s unrealistic, so I think in terms of what monetary policy is like when the economy exits the zero bound. In my view we’re then back in the world where excess cash balances drive the price level and NGDP. Expectations of where the Fed will put prices in 2016, hugely influence the current values of houses and other assets.

    Morgan, I totally don’t understand your question. Woolsey favors 3%, and says we need much easier money now.

    James, We don’t know until we try.

    Brito, In the right column I link to many other post. Open the post entitled links to key blog posts and look for the “Short course on monetary economics” post.

    Philo, Yes, that’s also what I would recommend. But they are too sophisticated for that.

    John, You said;

    “How do macro people like yourself and Krugman think you can boost demand without inflation? It would be bad if inflation got higher than it is now because knocking it back down would require another recession. Could you imagine how painful it would be fighting inflation and with high unemployment? Welcome back to the late-70s.”

    Actually, it’s not at all hard to stop high inflation, it’s hard to stop high NGDP growth, high wage growth. High inflation is incredibly easy to stop if wages aren’t rising fast. I do not favor rapid nominal wage growth. The past year is as unlike the late 1970s as any year in the past 40. Interest rates then were 15%, now they are 0%. That’s the least of our problems, we face exactly the opposite problem.

    But I’m glad you agree about the Phillips Curve. I get lots of conservatives coming on here and denying nominal shocks have real effects.

    BTW, I don’t think inflation means anything, it’s just a number invented by Washington bureaucrats. They say housing costs have risen 7.7% in 5 years, I say they have fallen 32%. Do you trust the government? Or me?

    Statsguy, I have trouble seeing where the 2 year zero rate commitment helped. What are you looking at that tells you it helped?

  19. Gravatar of Morgan Warstler Morgan Warstler
    13. October 2011 at 17:54

    Scott, Woolsey (and I and Tea Party and the Fed) will favor 3% level targeting of NGDP when the switch to Sumner’s Itch is made.

    Simply because we’ll look historically at 3% RDGP, say OK any time we’re hitting this… inflation will be ZERO!

    That is a serious Fed / Tea Party boner. It mean hard money at historically at readily achievable growth – it means we piss on booms pretty damn fast.

    I assume Woolsey like it because he thinks 3% isn’t very likely, but that’s just the opposite side of the same coin.


    Here is my question/point about what DeKrugman says…

    “There is a difference between Krugman and the market monetarists in terms of how we approach the thought experiment of an increase in the money supply at the zero bound. He assumes the increase is expected to be temporary, and we often assume it’s permanent. ”

    Scott, my big knock on you, is that you don’t talk alot about the top side of a 3% level target, when rates are being raised much more frequently than they have been in the past.

    And that’s what I think DeKrugman views as the Fed taking money out of the system int he future.

    He thinks it is temporary BECAUSE he sense that when we go over the target, the Fed is PROMISING to raise rates.

  20. Gravatar of Matt Waters Matt Waters
    13. October 2011 at 17:57

    I don’t have much to add, and so I just have a question about expectations. My approach to economics has almost been exclusively microstructure based. I mean that not in New Classical terms, but in real-world terms which have, say, sticky wages.

    All that to say I have a very hard time wrapping my mind around expectations. If the Fed announces, say, price-level targeting, how exactly does the market respond by, say, increasing inflation expectations and lowering real interest rates? I honestly have a tough time seeing how, if QE by itself won’t increase price/NGDP levels, why would market expectations increase?

    It seems to me that if markets are perfectly rational and QE does nothing to NGDP expectations, then they won’t care about QE. But then if QE2 “worked” because market actors like Bill Gross did not really understand macro policy and they increased inflation expectations, then QE3 would not work because markets are more rational.

    I’m for whatever the Fed can do. I’m just honestly having a tough time wrapping my head around microstructure of NGDP and how real, human market actors would actually put in buy and sell orders to increase NGDP expectations.

  21. Gravatar of Dan Kervick Dan Kervick
    13. October 2011 at 20:08

    Scott, I don’t think I really understood your answer. I personally don’t have many expectations one way of another about what the Fed will do. But suppose I am a hypothetical participant in the markets who believes that the Fed has the power to set the price level and the NGDP level, and who has rational expectations of some kind about where the Fed will set those levels. What precisely, or at least roughly, is it I am expecting the Fed to do to accomplish those things?

    For example, if I told you that I had a rational expectation that my company’s CEO was going to act within the next few weeks to set our company’s total energy use at some specific lower value, I think you would conclude that if my belief was indeed rational, I must have at least a few other beliefs about the specific actions he is going to take – maybe buying a new fleet of fuel-efficient vehicles; maybe turning the thermostats down, etc.

  22. Gravatar of John John
    13. October 2011 at 20:34


    I’m not quite as dumb as you think I am. I understand the idea behind the Phillips Curve and the money illusion. I just don’t think that tricking people out of their purchasing power is good policy. Eventually they get wise. Damn minions and wards of the state ruining our wise overlord’s plans with their self-interest!!!

    Ben Cole,

    If you ever become head of the Fed, I’m unloading all my dollars and buying gold, foreign currencies, real goods, and taking on copious amounts of debt.

    I think sometimes you forget the booms, quick rises in a price that start to take on a life of their own, always have a bust that comes afterwards.

  23. Gravatar of John John
    13. October 2011 at 20:46


    The case I’m trying to make, sound money and the gold standard, is the case for liberty. You’re trying to get the government to keep secretly robbing people through inflation. That’s what taking advantage of the money illusion is really all about.

    Here’s a couple great quotes from Mises on the subject from “The Theory of Money and Credit”

    “It is impossible to grasp the meaning of the idea of sound money if one does not realize that it was devised as an instrument for the prevention of despotic inroads on the part of governments. Ideologically it belongs in the same class with political constitutions and bills of rights.”

    “Thus inflation becomes the most important psychological resource of any economic policy whose consequences have to be concealed; and so in this sense it can be called an instrument of unpopular, i.e., of antidemocratic policy, since it makes possible the continued existence of a system of government that would have no hope of the consent of the people if the circumstances were clearly laid before them.”

  24. Gravatar of John John
    13. October 2011 at 20:52


    Sorry for the third post, but I agree that the government numbers are stupid. There is no scientifically accurate way to measure inflation. A good housewife that keeps track of her family budget knows inflation numbers as well as anyone else in the nation. I’d say that over the past few years home prices are down and rents are up.

    Quick question: How do you get high NGDP growth, which you concede is hard to stop, without high inflation? Or how do you get high inflation without high NGDP growth? In the high inflation, low NGDP growth scenario, the economy would have negative real GDP growth and hence be in the crapper already.

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  27. Gravatar of Scott Sumner Scott Sumner
    15. October 2011 at 08:38

    Morgan, The Fed should leave just enough in there permanently to hit whatever their target is.

    Matt. The Fed first has to decide what it wants to do. If it sincerely decides it wants to set a certain target (and intends to do whatever it takes to hit it) the markets will believe it. The Fed is very transparent, everyone knows what’s being debated there–we all know where each Fed official stands. The Fed is full of leaks.

    The problem has never been a lack of credibility in terms of reflation, it’s always been the Fed and BOJ saying they oppose reflation. So of course no one expected reflation! Why should they? The Fed needs to say it’s ready to buy up all the assets on planet Earth, and then start buying them. If they do that, they’ll probably need to stop within weeks and start selling assets, as the monetary base is already too big for a scenario of fast-growing NGDP expectations.

    Dan, There are two aspects to your question:

    What does the Fed have to do now? Set an NGDP target and start buying assets.

    What do they need to do in the future? Print enough money to hit the target via the hot potato effect.

    Their NGDP growth target is an implicit promise to increase the future money supply over current expectations.

    The easiest way to do all this is to peg the price of NGDP futures contracts at a 5% premium over the current NGDP level.

    John, I said you did understand the Phillips Curve.

    The case for the gold standard is very weak, It did not produce stable prices, prices plunged in the early 1930s. Then defenders say that’s because the government messed it up. But if we need a competent government to make it work, why not rely on fiat money?

    Also, the value of gold has been incredibly volatile recently, why would we want to tie the dollar to gold?

    Fiat money doesn’t steal wealth from savers. Inflation takes a bit of wealth from currency holders, but most currency is held by criminals anyone, so I don’t see that as a big loss. In any case, I don’t favor high inflation.

    John, In the 1983-84 recovery we had 11% NGDP growth and 3.3% inflation, so it is possible to have high NGDP growth and low inflation during a recovery (not during normal times.) And of course I’m calling for much lower NGDP growth, maybe 6% for two years during the recovery, and 5% thereafter.

  28. Gravatar of W. Peden W. Peden
    15. October 2011 at 08:48

    Scott Sumner,

    Can’t the severe fall in prices in the early 1930s be attributed to the existence of the Federal Reserve COMBINED with a Gold Standard, rather than the Gold Standard by itself?

  29. Gravatar of John John
    15. October 2011 at 17:50

    W. Peden,

    The Great Depression was the first time the Central Bank didn’t follow the rules of the Gold Standard. The Gold Standard required policy makers to protect their currency’s tie to gold first and foremost. From 1929-31 was the first time interest rates were severely driven down in order to encourage recovery at the expense of the currency. Previously interest rates weren’t used as stimulative tools. The 1921 recession saw some of the highest interest rates in the first 50 years of the Fed’s operation.

  30. Gravatar of ssumner ssumner
    16. October 2011 at 06:32

    W.Peden, Yes it could, but it could have just as easily happened if they had been no Fed. Don’t forget that under the gold standard prices are determined at the global level, and prices fell in all gold standard countries.

    John, Your history is wrong, as I point out in another comment thread. Neither the US nor other countries followed the rules of the game very closely, before or after the Depression.

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