Reinhart and Rogoff on monetary offset

Commenter J directed me to a passage by R&R from their now famous letter to Paul Krugman:

We don’t see your attraction to fiscal largesse as a substitute. Periphery Europe cannot afford it and for Germany, which can afford it, fiscal expansion would be procyclical.  Any overheating in Germany would exert pressure on the ECB to maintain a tighter monetary policy, backtracking some of the progress made by Mario Draghi. A better use of Germany’s balance sheet strength would be to agree on faster and bigger haircuts for the periphery, and to support significantly more expansionary monetary policy by the ECB.

If Germany stimulates their economy then German inflation will tend to rise, and at least to some extent this will raise overall eurozone inflation.  Now consider the fact that the ECB is supposed to be targeting eurozone inflation.  German fiscal stimulus would then force a tighter ECB policy, which would reduce inflation in the non-German part of the eurozone.  Because no fiscal stimulus would be occurring outside Germany (by assumption, and because they are broke) the lower non-German inflation induced by tighter ECB monetary policy would mean lower non-German NGDP and RGDP.  As an analogy, think of how the US tech boom of 1998-2001 reduced Argentina’s NGDP and devastated the Argentine economy.

This is a really good example of how people thinking in terms of “trade balances” are often led astray.  It seems like a booming German economy would help the rest of the eurozone.  And it could, but only if generated by a more expansionary monetary policy, or by supply-side reforms.

A few years back I did a number of posts criticizing the view that the Chinese trade surplus costs jobs in the US.  I pointed out that the alleged transmission mechanism (lower US AD) would not operate if the Fed was targeting inflation.  And even if it did operate, it would be entirely the fault of US policymakers, not China.

Of course Ken Rogoff advocated a highly aggressive monetary stimulus a few years back, and if the major central banks had followed his advice the AD situation in both the US and Europe would be far better, and we would not even be having this debate over fiscal austerity.



20 Responses to “Reinhart and Rogoff on monetary offset”

  1. Gravatar of rob rob
    27. May 2013 at 18:19

    With the Fed doing its job and targeting inflation(or NGDP), the economy once again becomes essentially classical and one needn’t worry about effects on AD of policies or events, unless of course you work at the Fed. I wish macro was taught with that near the beginning.

  2. Gravatar of Sal Sal
    27. May 2013 at 19:05

    I think You’re missing the point here. Fiscal hawks in Germany and monetary hawks at the ECB are … well, actually the very same people.

    And because of them the ECB is failing to follow even its own fake inflation target.

    So basically You can’t take this “all other things being equal”: a fiscal stimulus passing in Germany would most probably indicate a large change of the entire fiscal/monetary management of the EZ.

  3. Gravatar of ssumner ssumner
    28. May 2013 at 05:04

    Sal, Don’t confuse correlation with causation.

  4. Gravatar of Fearghal Fearghal
    28. May 2013 at 06:23

    Doesn’t the periphery have to reduce its price level relative to Germany anyway? If so, then if there’s no overheating in Germany, won’t prices have to fall even more in the non-German Eurozone. Or can the Eurozone economies rebalance without changes in relative prices?

  5. Gravatar of Michael Michael
    28. May 2013 at 06:31

    I’ve had trouble reconciling “monetary offset” with Bernake’s repeated calls for short term fiscal stimulus (or at least removal of short-term fiscal drag, which is the same thing).

    What I’m left with is this:

    Bernanke is a believer in monetary offset, but he is also enough of a believer in the risks of unconventional monetary policy that he is not willing to push it as far as it could go. (Or he is not a believer in the risks but the FOMC consensus is concerned about the risks).

    If true, he would like to see short-term fiscal stimulus for one of two reasons:

    1. To allow faster economic growth under the current level of monetary accomodation.

    2. To allow a faster exit from unconventional monetary policy.

    If #1 is true, we would see more growth if there was new fiscal stimulus. If #2 is true (and I tend to lean in this direction as far as what to expect), the fiscal stimulus would just buy a faster wind down of QE.

  6. Gravatar of SG SG
    28. May 2013 at 06:40

    @ Michael

    I’ve also wondered what could possibly be in Bernanke’s mind to make him think that anyone outside the Fed would be responsible for AD policy. Your 2nd hypothesis sounds plausible enough, but if true, it demonstrates that Bernanke’s real conceptual problem is that he doesn’t understand that monetary “policy” is not about tools or instruments, conventional or unconventional.

    This blog has done a masterful job of explaining that “doing” monetary policy means HAVING A PLAN. There has to be some sort of goal or destination of where the Fed wants its relevant nominal variables. The Fed has announced that their intended “destination” is 2% inflation, which the markets have understood to mean between 1.5% and 2.0% inflation. If that’s the plan, and it looks like it is indeed the plan (for now at least), then your first hypothesis is impossible, because the Fed won’t tolerate >2% inflation.

  7. Gravatar of Tommy Dorsett Tommy Dorsett
    28. May 2013 at 07:02

    The demand side fiscalists — Delong, Krugman et al — continue to advocate a near free lunch scenario that doesn’t square with the Fed’s current targets and prerogatives. Funny, since these were some of the same and most cacophonous voices railing agains the notion of supply side feedback effects from reducing high MTRs during the late 1970s and early 1980s. Biased, wrong and personally nasty. Nice combo.

  8. Gravatar of Patrick R. Sullivan Patrick R. Sullivan
    28. May 2013 at 07:12

    ‘Biased, wrong and personally nasty. Nice combo.’

    Exactly, but I think you forgot ‘deliberately obtuse’ and ‘self-congratulatory’.

  9. Gravatar of Michael Michael
    28. May 2013 at 09:05

    SG wrote:

    “I’ve also wondered what could possibly be in Bernanke’s mind to make him think that anyone outside the Fed would be responsible for AD policy. Your 2nd hypothesis sounds plausible enough, but if true, it demonstrates that Bernanke’s real conceptual problem is that he doesn’t understand that monetary “policy” is not about tools or instruments, conventional or unconventional.”

    Or there may be limits to what he can sell the FOMC on.

  10. Gravatar of J J
    28. May 2013 at 09:19


    There are costs and benefits. Yes, that would speed up relative wage movements between Germany and the periphery. But, money would be tighter in the periphery. The net effect on NGDP is the issue.

  11. Gravatar of J J
    28. May 2013 at 09:25

    It seems like Krugman has truly forgotten how to read:

    He quotes the part about fiscal policy in Germany being procyclical and leaves out the part about monetary offset. Then, he acts “baffled” because he doesn’t understand why R-R wouldn’t want inflation in Germany from fiscal policy but would want expansionary monetary policy. Finally, he says: “I have no idea what their point is.” Clearly, their point is that monetary offset exists. And, it’s not about disliking inflation in Germany, but rather preferring inflation spread everywhere by monetary stimulus.

    Also, this post by Krugman should dispel any notion that he truly supports monetary as well as fiscal stimulus. He completely brushes off the plausibility of monetary stimulus and yet writes post after post calling for fiscal stimulus.

  12. Gravatar of Lucas Lucas
    28. May 2013 at 09:52

    Yeah, Krugman looks really bad in his assessment of R-R’s position on fiscal vs monetary policy.
    I can’t understand why he thinks fiscal stimulus in the eurozone is more politically palatable than monetary action.

  13. Gravatar of Fearghal Fearghal
    28. May 2013 at 10:02


    I’m a little baffled too. I read R&R, above, as saying:

    Fiscal expansion in Germany would be counter-productive (for the periphery) because that would lead the ECB to tighten monetary policy. A better solution would be for the ECB to loosen monetary policy.

    Weeelllll, yes. But you can’t say “Your suggestion of Plan A wouldn’t work because that would cause B to happen. Our, much better, solution is – Not-B.” Not-B would then mean Plan A would work, wouldn’t it? Or at least, it removes that objection to it.

    And as you agreed with in your first post, inflation in Germany is preferable to inflation spread everywhere (in the Eurozone), because the Eurozone economies have to rebalance.

  14. Gravatar of TheMoneyIllusion » Krugman misses R&R’s point TheMoneyIllusion » Krugman misses R&R’s point
    28. May 2013 at 10:09

    […] Paul Krugman has a new post criticizing Reinhart and Rogoff’s view that fiscal stimulus in Germany might be counterproductive.  Here is R&R: […]

  15. Gravatar of J J
    28. May 2013 at 10:56


    You are missing the idea of monetary offset. Inflation in the eurozone is controlled by the ECB. It is low now because they want it to be low. R-R aren’t invoking some logic fairy for their argument. It is simply true that if inflation increases, then the ECB will pull back because the ECB is not interested in higher inflation.

    Given that inflation in the eurozone is set at a level by the ECB, the optimal thing is for that inflation to be spread to the periphery. More inflation in Germany, keeping eurozone inflation fixed, will mean less inflation in the periphery. The rebalancing comes at the expense of less periphery inflation.

    Finally, not-B does not mean that plan A would work. R-R, and Sumner, are not advocating for the elimination of monetary offset. They are advocating for a higher inflation target and/or a NGDP target. If the ECB adopts a higher inflation target of, say, 3%, then the same monetary offset situation will hold (except at 3% inflation) and fiscal stimulus in Germany will still lead to more inflation in Germany and less inflation in the periphery.

  16. Gravatar of J J
    28. May 2013 at 10:58


    By the way, Krugman doesn’t even dispute the monetary offset point. He simply ignores it and says he has no idea why R-R oppose fiscal stimulus. If he disagrees, he at least has to acknowledge what their point is first.

  17. Gravatar of Fearghal Fearghal
    28. May 2013 at 11:22


    Ah, maybe that’s the point. Many people would say that inflation in the periphery ran too high before the crisis hit and that it needs disinflation relative to the core. If we all had our own currencies, we’d devalue and be done (assuming we’d borrowed in our own currencies). But we don’t, so pretty much the stated policy of the European powers that be is that the periphery needs to carry out an internal devaluation. Given that inflation in the Eurozone is set at a level by the ECB, and the fact that the periphery needs to rebalance wrt to the core, how on earth can it be optimal for inflation to spread to the periphery?

    I mean, if the periphery economies could thrive with a relative price level even higher than what pertains now, then great! But I can’t think of anyone who thinks this is true. Failing this, they need to rebalance, and if there isn’t higher inflation in the core, then it means a long slow grind of very low inflation, or a large dose of deflation. And either way that’s pretty bad for the debt burdens. (Debt restructuring would help with that last bit, but not with the need to regain competitiveness)

  18. Gravatar of Charlie Charlie
    28. May 2013 at 13:15

    “Of course Ken Rogoff advocated a highly aggressive monetary stimulus a few years back”

    His comments were still pretty cringe worthy. He wanted to raise the inflation target to erode the value of debt, and called raising the inflation target “the lesser of two evils.”
    As if, central banks doing there job and stabilizing NGDP is evil or if all debt was written indexed to inflation there’d be no reason to have expansionary policy. So while your statement is true, I’m not sure he actually helped the cause. Friends like these… [kind of like credibly promise to be irresponsible…].

  19. Gravatar of ssumner ssumner
    29. May 2013 at 05:59

    Fearghal, You don’t want the lower inflation to come from tight money, you want lower wages for a given NGDP.

    Michael, I think Bernanke wants the Congress to accept more of the burden, the Fed doesn’t like doing unconventional policies.

    J and Lucas, I agree about his reading skills, and did a post.

    Charlie, Yes, his proposal was far from optimal.

  20. Gravatar of Krugman Doesn't Worry Over Krugman Bashers | Last Men and OverMen Krugman Doesn't Worry Over Krugman Bashers | Last Men and OverMen
    20. February 2017 at 14:18

    […] by a more expansionary monetary policy, or by supply-side reforms.”     Krugman did answer R-R on this one. Of course, Sumner had an answer for that […]

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