Sunday, December 2, 2012

Bob Murphy and Scott Sumner both have a fair chance of being wrong about Krugman on any given day

But when they agree about Krugman, the probability that they are wrong goes up considerably.

And if Bob Wenzel agrees, it's a near certainty.

Bob Murphy first quotes Krugman's Japan paper (motivated by what he read of Scott's - brought to his attention by Wenzel) and then writes his own thoughts:

"The point here is that the end of the Depression – which is the usual, indeed perhaps the sole, motivating example for the view that a one-time fiscal stimulus can produce sustained recovery, does not actually appear to fit the story line too well; much though by no means all of the recovery from that particular liquidity trap seems to have depended on inflation expectations that made real interest rates substantially negative.

If temporary fiscal stimulus does not jolt the economy out of its doldrums on a sustained basis, however, then a recovery strategy based on fiscal expansion would have to continue the stimulus over an extended period of time. The question then becomes how much stimulus is needed, for how long – and whether the consequences of that stimulus for government debt are acceptable. …

The political point is that Japan – like, we might note, the United States during the New Deal – appears to have great difficulty working up its political nerve for a fiscal package anywhere close to what would be required to close the output gap. Exactly why is an interesting question, beyond this paper’s scope.

Does this mean that fiscal policy should be ignored as part of the policy mix? Surely not. On the general Brainard principle – when uncertain about the right model, throw a bit of everything at the problem – one would want to apply fiscal stimulus. (Even I wouldn’t trust myself enough to go for a purely “Krugman” solution). However, it seems unlikely that a mainly fiscal solution will be enough. [Bold added.]

Does everyone see the absolute stunning beauty here? Christmas is early this year. Back in 1998, Krugman referred to a “Krugman solution” as being: You get your economy out of a liquidity trap by relying exclusively on monetary policy, not at all on fiscal policy."

[Slightly amended - I lifted a lot of this from a comment on Bob's blog. Bob is more savvy about the Japan paper than the guy I was responding to, so I'm changing this a little. For my original response click the link and find the comment. What Bob misses is that he seems to think Krugman in 1998 was substantially different than Krugman today] Some people think the Japan paper was about how Japan ought to do a lot of fiscal policy because monetary policy wouldn't work. The Japan paper actually said that the solution to the liquidity trap is monetary policy that credibly commits to irresponsibility. The point was only that traditional monetary policy, working through Taylor-rule type interest rate channels - would not work at the zero lower bound. You needed to act on expectations.

That was the headline message. That was what the paper was so famous for saying. The last time anyone talked about a liquidity trap there were no New Keynesians around. Old Keynesians cared about expectations of course, but they never really did a very good job modeling it formally. Nobody did a good job modeling it formally until the rational expectations revolution followed up on the inroads made by Phelps and Friedman w.r.t. expectations and the Phillips Curve. So the Old Keynesians always used to highlight how monetary policy would not work in a liquidity trap.

Krugman, a New Keynesian, sees a liquidity trap in Japan and is able to think about the role of expectations in more formal terms, and says “look we always thought monetary policy was useless in these cases but it’s really not”.

His solution was the credible commitment to irresponsibility.

Liquidity traps are bad news. Fiscal policy can help monetary policy out. You can get this result in a lot of models. Krugman said that too.

As far as I know this was Krugman’s view in 1998 and this is Krugman’s view today. This is only "devastating" if you think Krugman in 1998 was not advocating fiscal policy (he was, because traditional monetary policy was off the table and unconventional monetary policy relied on a commitment to doing things the central bank had a reputation for not doing) or if you really live under a rock and think that the Japan paper was about how monetary policy doesn't work in a liquidity trap.

To be blunt, if you thought the Japan paper was principally about how fiscal policy is the way you fight liquidity traps, you don't understand the Japan paper.


  1. "Krugman, a New Keynesian, sees a liquidity trap in Japan and is able to think about the role of expectations in more formal terms, and says “look we always thought monetary policy was useless in these cases but it’s really not”."

    I agree. It seems to me that there are a lot of quarrels between guys like Sumner and Krugman because the differences between them are subtle.

    Any economist following Neil Wallace's 1981 paper (pdf) believes that naked open market operations are irrelevant as long as reserves are not scarce. This includes New Keynesians and guys like Stephen Williamson, a New Monetarist. The Wallace paper just generalizes the EMH to a central banking setting.

    Market monetarists, guys like Bernanke, and others don't think that naked open market operations are irrelevant at the zero-lower bound.

    Scott Sumner shouldn't be quarreling with Krugman but with Neil Wallace and the EMH, but this would be ironic since Sumner likes the EMH.

  2. Why do Krugman (and others) believe that unconventional monetary policy like QE can work only via the expectations channel and not directly by increasing aggregate demand ? What is the theory behind that view ?

    1. I'm sure there are other things to consider, but I'd expect that a lot of it has to do with liquidity preferences right now and the interest in shoring up balance sheets rather than going out and investing.

      Now if firms knew that stimulus presaged more stimulus down the road (when seas are calmer and balance sheets look better), that would be an incentive to invest in anticipation of that sort of demand.

    2. What's the theory behind the view that the impact of monetary policy on current aggregate is a big issue?

    3. The Market Monetarists believe that if you buy up enough assets you can drive AD (which is more or less the same thing as NGDP) to any level you choose. Setting expectations about your target just means you can achieve it it with less asset buyinh

      This seems to be a logical thing to believe so I just wondered if those that dispute the effectiveness of QE were challenging its ability to increase AD (perhaps they think that in a liquidity trap people will just hold on to the money they get in exchange for assets they sell and not spend it), or if they agree that AD can be increased in this way but that no new investment would be generated from it because all the extra money created would just lead to higher inflation.

      I was

    4. I've never understood why people think this is a logical thing to believe.

      Or let me put it this way: if you think that NGDP is an increasing function of asset purchases (which it obviously is), it seems fine to say "there is a level of asset purchases consistent with any NGDP target you could think of".

      Maybe. Assuming there isn't unfortunate asymptotic behavior associated with all this.

      But even if you think that there seem like a lot of other problems to think about, like the split between prices and quantity and these liquidity preference and balance sheet concerns.

      NGDP is an increasing function of fiscal stimulus too, right? It's an increasing function of a lot of things.

      I've never quite felt that that was adequate. There's too much other stuff going on.

  3. "Why do Krugman (and others) believe that unconventional monetary policy like QE can work only via the expectations channel and not directly by increasing aggregate demand ? What is the theory behind that view ?"

    It's Miller Modigliani. A financial asset's price is determined by its fundamentals, or its future payoffs. The Fed has to be able to increase some financial asset's price above its fundamental price in order to get a "grip" on the price level. It can do this during normal times because reserves are required by law, the supply of reserves is monopolized, and reserves are kept scarce. In unconventional times like ours, reserves are not scarce, so the Fed can't bid financial asset prices above their fundamental value. Therefore, naked QE doesn't do anything.

    1. Thanks JP.

      Having spent the last hour researching (my head hurts) I can see how it works for firms - I'm still trying to see how it relates to monetary policy.

      To cut to the chase: Do Market monetarists reject this theory ? If not , how do they square NGDPT within a framework where MM holds ?

    2. Market monetarists implicitly reject the theory (or at least, they should). Nick Rowe's Chuck Norris is an implicit rejection, since Chuck can always beat all the hedge funds up and push prices higher.

  4. Daniel two things:

    (1) When I read your title, I was sure you had this post in mind. Isn't that freaky?

    (2) Make sure you read my Update to the post that's got you bothered here. The Update won't make you agree with me, but I think you will at least understand a little better why I said it was devastating.


All anonymous comments will be deleted. Consistent pseudonyms are fine.