The New York Times (and former President Bush) need to read Krugman

In my comment section, I keep getting Keynesian commenters claiming that fiscal stimulus is the only way to boost AD in a recession.  Here is a similar example from the New York Times:

WHAT CAN BE DONE NOW? Here is an unpopular but undeniable fact of life: When private sector demand is weak, the federal government must serve as the spender of last resort. Otherwise, collapsing demand sets in motion a negative, self-reinforcing spiral in which lack of demand “” for goods, services and new employees “” leads to ever deepening economic weakness.

That is why when the banks and the economy began to crumble in 2008, President Bush responded with a $700 billion bank bailout and a $168 billion stimulus package.

Now I suppose you could argue that they meant it is necessary when interest rates are at zero.  But of course rates were at 2% when Bush implemented this stimulus.  So that argument won’t work.  As we will see, it doesn’t even work when interest rates are at zero.  But first I want to quote from Paul Krugman, as my Keynesian readers won’t trust anything I have to say:

I notice that commenters keep citing this paper by Alesina and Ardagna as if it were a definitive rejection of Keynesian economics. So I guess I should explain why I’m not convinced.

First, the whole stimulus debate is supposed to be about what happens when interest rates are up against the zero bound. Everything is different if the central bank is busy adjusting rates in response to conditions, and may well raise rates to offset the effects of any fiscal expansion. Yet the Alesina-Ardagna analysis doesn’t make that distinction; Japan in the 90s, which was up against the zero bound, is treated the same as a batch of countries in the 70s and 80s, when interest rates were quite high.

Krugman and I believe that if the central bank is targeting some sort of nominal aggregate like the price level or NGDP, level targeting, it is pretty hard for fiscal stimulus to have much effect.  Any anticipated effect would be mostly offset by monetary policy, indeed completely offset if monetary policy is efficient.  Where we diverge is what happens when rates hit zero.  I assume that at zero rates the central bank can still engage in inflation targeting.  Krugman assumes that . . . well it isn’t always easy to figure out what Krugman assumnes.  Here are some options:

1.  Monetary stimulus is ineffective at the zero bound

2.  Monetary policy is potentially effective if central banks are credible, but they often are not.

3.  Monetary policy is effective but central banks simply refuse to do what is necessary, such as unconventional QE and/or inflation targeting.

Lately he has emphasized the 3rd option, which is the most defensible.  No one can seriously claim that the BOJ has been powerless in recent years.  They could always depreciate the yen.  A few decades ago people used to argue that yen depreciation wasn’t an option because the US would object.  But that view is totally indefensible today, for three reasons.

a.  The focus is mostly on China, not Japan.

b.  The yen recently rose from 120 to the dollar to 90.  So even holding it steady would have been far more expansionary, and obviously there weren’t many complaints from the US when the yen was at 120.  Even if you don’t believe that, surely they could have limited the appreciation to a level closer to 110 than 90.

c. Most importantly, the Japanese government is actually pushing for more expansion, and the BOJ stubbornly resists.  Recall that any US pressure is directed at the Japanese government, not the BOJ directly.

There can no longer be any doubt that the BOJ prefers stable prices or mild deflation over the alternative of mild inflation.  This explains why the Japanese fiscal stimulus failed.  Even if, as Krugman implies, the 1995 stimulus worked, all it did was postpone the problem for a year.  As soon as the stimulus stopped the economy slipped back.  You can’t run big deficits forever, so if stimulus is to work the central bank must be accommodative.  The BOJ was not accommodative, hence the stimulus didn’t work.  If the BOJ had been accommodative I suppose you could claim it would have worked.  But of course if the BOJ had been accommodative then fiscal stimulus would not have been needed in the first place.  It is a fifth wheel.

Part 2.  People also got moody when they saw the Titanic was sinking

I recently argued:

I’m not convinced mood swings are as obvious as they might seem.  I’ve argued that the stock market crash of 1929 was a rational response to the sudden awareness that we were rushing headlong into Depression.  I wonder if that stock market crash was one of those examples where Bryan thinks it’s “obvious” there was a mood swing.  Even if Bryan doesn’t believe that, I’d estimate about 99.9% of historians do look at the crash that way.

Bryan Caplan responded:

I’m not going to argue the Depression with an expert like Scott.  But I saw the 2008 crash and subsequent downturn with my own eyes, and I’m convinced that mood played a key role.  The world freaked out, big time.  It was the economic analog of a riot.

But hasn’t Sumner shown that the fundamental problem was falling nominal GDP?   I’m sympathetic, but he never really explains why money velocity suddenly plunged.  (Yes, the Fed started paying interest on reserves, but that’s far from the whole story).  After the 2008 crash, people clearly became much more reluctant to spend, holding their income constant.

I argued that people were responding to expectations of a fall in NGDP.  The following year NGDP did fall at the fastest rate since 1938.  Bryan is arguing that the public panicked and saw a ghost.  Or more specifically that got very worried about the economy.  Then the economy got much worse precisely because people had become worried.  Self-fulfilling expectations.  BTW, it is rational to be reluctant to spend if your current income is stable, but you expect it to fall very soon.

There are two things wrong with the argument.  First it relies too much on common sense.  When people respond correctly to fundamentals that are hard to discern, it can look like panic.  And the fundamentals are often hard to discern, because if they were easy to spot then people would have seen the problems coming even earlier.  Imagine the point where the smartest person in the world sees a problem.  The market will see it even earlier.  Stocks crashed in early October, not September 2008.  So even in September it clearly was not yet obvious that the economy was about to fall through the floor.  (BTW, don’t say person X saw it before the market.  That’s cheating.  You have to pick the smartest person before the event, not after.  Buffett lost billions in the crash.)

The more significant problem is that Bryan unintentionally ignores the fact that fundamentals drive NGDP in the long run.  And the important fundamental in this case is monetary policy.  The great flaw in Keynes’ General Theory is that it takes the current level of NGDP as a historical datum.  It has no explanation for why current US NGDP is $14 trillion rather than $14 billion or $14 quadrillion.  Instead, the model merely tries to explain changes, starting from a level that is assumed given.  But of course the factor that explains why NGDP is currently $14 billion also will determine what NGDP is three years from now.  And only monetary policy can do that.

So any panic about future levels of NGDP going several years out cannot be a purely self-fulfilling prophecy.   Even if monetary policy operates with a lag (and I think lags are exaggerated) the Fed can always try to steer NGDP back on course at a later date.  But if people expect them to do that, then current NGDP would change much less.  It was pretty obvious that if we had had a NGDP futures market in late 2008, you would have seen NGDP contracts for 1, 2, 3, 4, and 5 years out plunging sharply.  The public wasn’t just losing confidence in current monetary policy, they were also saying, “we don’t expect the Fed to correct its mistake.”  And they would have been completely right.

Bryan also makes an error when he focuses on velocity.  The Fed doesn’t target the base, nor should it.  Under interest rate targeting the base is endogenous, and under the NGDP futures targeting that I favor the base is also endogenous.  The question is not what caused velocity to fall, we know that was an endogenous response to two factors; interest on reserves and expectations for falling NGDP (I won’t argue the relative importance here.)  The question is what caused NGDP expectations to fall.  And that was a failure of monetary policy, as it is their job to keep NGDP expectations on course.  Falling velocity, falling commodity prices, falling stocks, a falling dollar price of euros, falling prices of houses in non-subprime areas, falling commercial real estate prices, were just some of the many symptoms of sharply falling 2010 NGDP expectations in late 2008.

How did the market read the Fed’s intentions back in October 2008?  Why ask me?  The market figured this out way before I did, because they are much smarter than me.  Don’t confuse me with my many commenters who are smarter than the market.  You should ask them how the market correctly saw the Fed would let NGDP stay depressed, and wouldn’t try to bring it back up with the sort of rapid NGDP growth we had in the 1983-84 recovery.  I stand in awe of the market’s wisdom.  If I was that smart (here comes the cliche) . . . I’d be rich.

PS.  I am going to try to stay away from current events for a while, unless I need to respond directly to someone commenting on my posts.



13 Responses to “The New York Times (and former President Bush) need to read Krugman”

  1. Gravatar of Doc Merlin Doc Merlin
    8. February 2010 at 23:52

    I agree about the whole animal spirits bit. Sure markets have emotional responses… but they usually have them for good reasons. Keynes was wrong in treating markets as completely irrational. The bull and the bear may be market emotional sentiments but emotions are formed for reasons and the market effect of them is real, predictive, and rational.

  2. Gravatar of Bill Woolsey Bill Woolsey
    9. February 2010 at 04:17

    I think the claim that velocity fell because of interest on reserves and expectations of falling nominal expenditures is not obvious. Expectations of default on financial assets secured by homes whose prices had fallen could result in a decease in velocity through a vareity of channels, even if there was no expecation that nominal ependiture of final goods and services should fall. In fact, I continue to believe that this step is essential in explaining what happened. Increase in money demand, failure of the Fed to respond effectively, expectations of falling nominal expenditure, much bigger increase in money demnad, and even bigger drop in nominal expenditure.

  3. Gravatar of OGT OGT
    9. February 2010 at 05:26

    I agree with Woolsey that fear of default is key to understanding the sudden rise in the demand for money and revulsion from assets. It’s important to realize that many loans were being made on assets that could not be services even at the trend NGDP growth rate. This includes not only sub-prime loans in the desert, but many other loans including commercial real estate loans on offices and retail malls. Add on top of that the complex high leverage schemes for MBS and CDO’s and it was indeed rational to crave cash, especially if you thought everyone else was doing the same.

    Naturally that doesn’t let the Fed off the hook for not responding adequately.

  4. Gravatar of vimothy vimothy
    9. February 2010 at 05:38

    Thanks for this as well, Scott. Some intersting thoughts to dig into here…

  5. Gravatar of Scott Sumner Scott Sumner
    9. February 2010 at 06:05

    Thanks Doc.

    Bill and OGT, Suppose the financial crisis occurred in the 1970s, when inflation was running 10%. Would banks wishing to be liquid have held lots of zero interest reserves, or would they have chosen to hold T-bills yielding much higher than 0%?

    Vimothy, You are welcome.

  6. Gravatar of Sumner in a Nutshell « feed on my links Sumner in a Nutshell « feed on my links
    9. February 2010 at 07:03

    […] Sumner in a Nutshell By DW I read him every day. […]

  7. Gravatar of Tom Hickey Tom Hickey
    9. February 2010 at 09:27

    Bill Woolsey: Expectations of default on financial assets secured by homes whose prices had fallen could result in a decease in velocity through a vareity of channels, even if there was no expecation that nominal ependiture of final goods and services should fall. In fact, I continue to believe that this step is essential in explaining what happened.

    Agree. Maybe less “animal spirits” than rationality. Lots of folks were and still are way over-leveraged and they knew it. It was OK as long as asset prices were rising, but when that stopped and the “wealth effect” evaporated, then the marginal propensity to save began to increase drastically, as any rational person would expect. With the country still running a persistent CAD, and businesses not investing not only because they didn’t see may opportunities but also the GFC dried up lending, the fall in C, I, and NX, leaves G. Duh. Someone has to increase NAD to close the output gap and since C, I, and NX are out of the picture, only the government can do this, either through deficit spending, reducing taxes, or both. Monetary has had its chance and failed, and Bernanke is not going to be replaced.

    We are in the the third stage of a financial cycle that Hyman Minsky characterizes in his financial instability hypothesis as Ponzi finance. Until that is cleared, the way forward is peppered with land mines. The US needs to resolve its banking problem by imposing some discipline instead of continuing with excessive forbearance and a failed monetary reflation scheme that is not addressing the real problem at the root.

  8. Gravatar of Doc Merlin Doc Merlin
    9. February 2010 at 17:10

    Hrm, another way of stating this.
    … market sentiment is endogenous not exogenous.

  9. Gravatar of The myth of the spending splurge « Freethinking Economist The myth of the spending splurge « Freethinking Economist
    10. February 2010 at 02:43

    […] People’s current expectations of what their future incomes will be – the sum total being the economy’s expectations of forward Nominal GDP – play a dominating role in determining CURRENT spending. About a million hat-tips: Scott Sumner. […]

  10. Gravatar of Scott Sumner Scott Sumner
    10. February 2010 at 07:49

    Tom, You said;

    “Monetary has had its chance and failed, and Bernanke is not going to be replaced.”

    Monetary policy didn’t try and fail, it never tried. The Fed has run tight money since 2008.

    Doc, Exactly

  11. Gravatar of Tom Hickey Tom Hickey
    10. February 2010 at 10:17

    SS: “Monetary policy didn’t try and fail, it never tried. The Fed has run tight money since 2008.”

    That may be, Scott, but we’ll never know now. My point is that it was Bernanke’s policy, and he’s been reappointed. So at this point, we probably can’t expect much different from Fed policy. The Fed also missed the build up of Ponzi finance and now Bernanke wants to be the chief regulator, too. This looks to me like a recipe for continued disaster.

    That leaves fiscal policy to take up the slack if the output gap is to be closed and unemployment addressed, as the US administration and Congress have to do. If we can’t reasonably expect an increase in NGDP monetarily from Bernanke’s Fed, then the only recourse is through increasing NAD fiscally through Congress, which would admittedly be tough politically. So I guess we in the US are mired in deleveraging, stagnant growth, and persistent unemployment for some time.

    BTW, I tried to post the same comment twice on the Payback Time thread, but its seems to have gotten lost somewhere in cyberspace. Basically, I asked whether you had considered Fisher’s debt-deflation theory of depressions and Minsky’s financial instability hypothesis in relation to the GD.

  12. Gravatar of Scott Sumner Scott Sumner
    11. February 2010 at 10:53

    Tom, I just think the Fed will neutralize anything the Congress does. It’s money down the drain. My next post may discuss that.

    Sorry about the technical problems. I’ve never read Minsky, but he sounds kind of post-Keynesian, which means I am not interested. I do like Fisher quite a bit. I see debt deflation as more a symptom of the problem than a cause.

  13. Gravatar of Tom Hickey Tom Hickey
    11. February 2010 at 14:46

    I appreciate your position, Scott. Here’s a link to Minky’s paper if you should ever change your mind.

    The Financial Instability Hypothesis

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