Posts Tagged 'Krugman'

How not to Win Friends and Influence People

Last week David Beckworth and Ramesh Ponnuru wrote a very astute op-ed article in the New York Times explaining how the Fed was tightening its monetary policy in 2008 even as the economy was rapidly falling into recession. Although there are a couple of substantive points on which I might take issue with Beckworth and Ponnuru (more about that below), I think that on the whole they do a very good job of covering the important points about the 2008 financial crisis given that their article had less than 1000 words.

That said, Beckworth and Ponnuru made a really horrible – to me incomprehensible — blunder. For some reason, in the second paragraph of their piece, after having recounted the conventional narrative of the 2008 financial crisis as an inevitable result of housing bubble and the associated misconduct of the financial industry in their first paragraph, Beckworth and Ponnuru cite Ted Cruz as the spokesman for the alternative view that they are about to present. They compound that blunder in a disclaimer identifying one of them – presumably Ponnuru — as a friend of Ted Cruz – for some recent pro-Cruz pronouncements from Ponnuru see here, here, and here – thereby transforming what might have been a piece of neutral policy analysis into a pro-Cruz campaign document. Aside from the unseemliness of turning Cruz into the poster-boy for Market Monetarism and NGDP Level Targeting, when, as recently as last October 28, Mr. Cruz was advocating resurrection of the gold standard while bashing the Fed for debasing the currency, a shout-out to Ted Cruz is obviously not a gesture calculated to engage readers (of the New York Times for heaven sakes) and predispose them to be receptive to the message they want to convey.

I suppose that this would be the appropriate spot for me to add a disclaimer of my own. I do not know, and am no friend of, Ted Cruz, but I was a FTC employee during Cruz’s brief tenure at the agency from July 2002 to December 2003. I can also affirm that I have absolutely no recollection of having ever seen or interacted with him while he was at the agency or since, and have spoken to only one current FTC employee who does remember him.

Predictably, Beckworth and Ponnuru provoked a barrage of negative responses to their argument that the Fed was responsible for the 2008 financial crisis by not easing monetary policy for most of 2008 when, even before the financial crisis, the economy was sliding into a deep recession. Much of the criticism focuses on the ambiguous nature of the concepts of causation and responsibility when hardly any political or economic event is the direct result of just one cause. So to say that the Fed caused or was responsible for the 2008 financial crisis cannot possibly mean that the Fed single-handedly brought it about, and that, but for the Fed’s actions, no crisis would have occurred. That clearly was not the case; the Fed was operating in an environment in which not only its past actions but the actions of private parties and public and political institutions increased the vulnerability of the financial system. To say that the Fed’s actions of commission or omission “caused” the financial crisis in no way absolves all the other actors from responsibility for creating the conditions in which the Fed found itself and in which the Fed’s actions became crucial for the path that the economy actually followed.

Consider the Great Depression. I think it is totally reasonable to say that the Great Depression was the result of the combination of a succession of interest rate increases by the Fed in 1928 and 1929 and by the insane policy adopted by the Bank of France in 1928 and continued for several years thereafter to convert its holdings of foreign-exchange reserves into gold. But does saying that the Fed and the Bank of France caused the Great Depression mean that World War I and the abandonment of the gold standard and the doubling of the price level in terms of gold during the war were irrelevant to the Great Depression? Of course not. Does it mean that accumulation of World War I debt and reparations obligations imposed on Germany by the Treaty of Versailles and the accumulation of debt issued by German state and local governments — debt and obligations that found their way onto the balance sheets of banks all over the world, were irrelevant to the Great Depression? Not at all.

Nevertheless, it does make sense to speak of the role of monetary policy as a specific cause of the Great Depression because the decisions made by the central bankers made a difference at critical moments when it would have been possible to avoid the calamity had they adopted policies that would have avoided a rapid accumulation of gold reserves by the Fed and the Bank of France, thereby moderating or counteracting, instead of intensifying, the deflationary pressures threatening the world economy. Interestingly, many of those objecting to the notion that Fed policy caused the 2008 financial crisis are not at all bothered by the idea that humans are causing global warming even though the world has evidently undergone previous cycles of rising and falling temperatures about which no one would suggest that humans played any causal role. Just as the existence of non-human factors that affect climate does not preclude one from arguing that humans are now playing a key role in the current upswing of temperatures, the existence of non-monetary factors contributing to the 2008 financial crisis need not preclude one from attributing a causal role in the crisis to the Fed.

So let’s have a look at some of the specific criticisms directed at Beckworth and Ponnuru. Here’s Paul Krugman’s take in which he refers back to an earlier exchange last December between Mr. Cruz and Janet Yellen when she testified before Congress:

Back when Ted Cruz first floated his claim that the Fed caused the Great Recession — and some neo-monetarists spoke up in support — I noted that this was a repeat of the old Milton Friedman two-step.

First, you declare that the Fed could have prevented a disaster — the Great Depression in Friedman’s case, the Great Recession this time around. This is an arguable position, although Friedman’s claims about the 30s look a lot less convincing now that we have tried again to deal with a liquidity trap. But then this morphs into the claim that the Fed caused the disaster. See, government is the problem, not the solution! And the motivation for this bait-and-switch is, indeed, political.

Now come Beckworth and Ponnuru to make the argument at greater length, and it’s quite direct: because the Fed “caused” the crisis, things like financial deregulation and runaway bankers had nothing to do with it.

As regular readers of this blog – if there are any – already know, I am not a big fan of Milton Friedman’s work on the Great Depression, and I agree with Krugman’s criticism that Friedman allowed his ideological preferences or commitments to exert an undue influence not only on his policy advocacy but on his substantive analysis. Thus, trying to make a case for his dumb k-percent rule as an alternative monetary regime to the classical gold standard regime generally favored by his libertarian, classical liberal and conservative ideological brethren, he went to great and unreasonable lengths to deny the obvious fact that the demand for money is anything but stable, because such an admission would have made the k-percent rule untenable on its face as it proved to be when Paul Volcker misguidedly tried to follow Friedman’s advice and conduct monetary policy by targeting monetary aggregates. Even worse, because he was so wedded to the naïve quantity-theory monetary framework he thought he was reviving – when in fact he was using a modified version of the Cambride/Keynesian demand for money, even making the patently absurd claim that the quantity theory of money was a theory of the demand for money – Friedman insisted on conducting monetary analysis under the assumption – also made by Keynes — that quantity of money is directly under the control of the monetary authority when in fact, under a gold standard – which means during the Great Depression – the quantity of money for any country is endogenously determined. As a result, there was a total mismatch between Friedman’s monetary model and the institutional setting in place at the time of the monetary phenomenon he was purporting to explain.

So although there were big problems with Friedman’s account of the Great Depression and his characterization of the Fed’s mishandling of the Great Depression, fixing those problems doesn’t reduce the Fed’s culpability. What is certainly true is that the Great Depression, the result of a complex set of circumstances going back at least 15 years to the start of World War I, might well have been avoided largely or entirely, but for the egregious conduct of the Fed and Bank of France. But it is also true that, at the onset of the Great Depression, there was no consensus about how to conduct monetary policy, even though Hawtrey and Cassel and a handful of others well understood how terribly monetary policy had gone off track. But theirs was a minority view, and Hawtrey and Cassel are still largely ignored or forgotten.

Ted Cruz may view the Fed’s mistakes in 2008 as a club with which to beat up on Janet Yellen, but for most of the rest of us who think that Fed mistakes were a critical element of the 2008 financial crisis, the point is not to make an ideological statement, it is to understand what went wrong and to try to keep it from happening again.

Krugman sends us to Mike Konczal for further commentary on Beckworth and Ponnuru.

Is Ted Cruz right about the Great Recession and the Federal Reserve? From a November debate, Cruz argued that “in the third quarter of 2008, the Fed tightened the money and crashed those asset prices, which caused a cascading collapse.”

Fleshing that argument out in the New York Times is David Beckworth and Ramesh Ponnuru, backing and expanding Cruz’s theory that “the Federal Reserve caused the crisis by tightening monetary policy in 2008.”

But wait, didn’t the Federal Reserve lower rates during that time?

Um, no. The Fed cut its interest rate target to 2.25% on March 18, 2008, and to 2% on April 20, which by my calculations would have been in the second quarter of 2008. There it remained until it was reduced to 1.5% on October 8, which by my calculations would have been in the fourth quarter of 2008. So on the face of it, Mr. Cruz was right that the Fed kept its interest rate target constant for over five months while the economy was contracting in real terms in the third quarter at a rate of 1.9% (and growing in nominal terms at a mere 0.8% rate)

Konczal goes on to accuse Cruz of inconsistency for blaming the Fed for tightening policy in 2008 before the crash while bashing the Fed for quantitative easing after the crash. That certainly is a just criticism, and I really hope someone asks Cruz to explain himself, though my expectations that that will happen are not very high. But that’s Cruz’s problem, not Beckworth’s or Ponnuru’s.

Konczal also focuses on the ambiguity in saying that the Fed caused the financial crisis by not cutting interest rates earlier:

I think a lot of people’s frustrations with the article – see Barry Ritholtz at Bloomberg here – is the authors slipping between many possible interpretations. Here’s the three that I could read them making, though these aren’t actual quotes from the piece:

(a) “The Federal Reserve could have stopped the panic in the financial markets with more easing.”

There’s nothing in the Valukas bankruptcy report on Lehman, or any of the numerous other reports that have since come out, that leads me to believe Lehman wouldn’t have failed if the short-term interest rate was lowered. One way to see the crisis was in the interbank lending spreads, often called the TED spread, which is a measure of banking panic. Looking at an image of the spread and its components, you can see a falling short-term t-bill rate didn’t ease that spread throughout 2008.

And, as Matt O’Brien noted, Bear Stearns failed before the passive tightening started.

The problem with this criticism is that it assumes that the only way that the Fed can be effective is by altering the interest rate that it effectively sets on overnight loans. It ignores the relationship between the interest rate that the Fed sets and total spending. That relationship is not entirely obvious, but almost all monetary economists have assumed that there is such a relationship, even if they can’t exactly agree on the mechanism by which the relationship is brought into existence. So it is not enough to look at the effect of the Fed’s interest rate on Lehman or Bear Stearns, you also have to look at the relationship between the interest rate and total spending and how a higher rate of total spending would have affected Lehman and Bear Stearns. If the economy had been performing better in the second and third quarters, the assets that Lehman and Bear Stearns were holding would not have lost as much of their value. And even if Lehman and Bear Stearns had not survived, arranging for their takeover by other firms might have been less difficult.

But beyond that, Beckworth and Ponnuru themselves overlook the fact that tightening by the Fed did not begin in the third quarter – or even the second quarter – of 2008. The tightening may have already begun in as early as the middle of 2006. The chart below shows the rate of expansion of the adjusted monetary base from January 2004 through September 2008. From 2004 through the middle of 2006, the biweekly rate of expansion of the monetary base was consistently at an annual rate exceeding 4% with the exception of a six-month interval at the end of 2005 when the rate fell to the 3-4% range. But from the middle of 2006 through September 2008, the bi-weekly rate of expansion was consistently below 3%, and was well below 2% for most of 2008. Now, I am generally wary of reading too much into changes in the monetary aggregates, because those changes can reflect either changes in supply conditions or demand conditions. However, when the economy is contracting, with the rate of growth in total spending falling substantially below trend, and the rate of growth in the monetary aggregates is decreasing sharply, it isn’t unreasonable to infer that monetary policy was being tightened. So, the monetary policy may well have been tightened as early as 2006, and, insofar as the rate of growth of the monetary base is indicative of the stance of monetary policy, that tightening was hardly passive.

adjusted_monetary_base

(b) “The Federal Reserve could have helped the recovery by acting earlier in 2008. Unemployment would have peaked at, say, 9.5 percent, instead of 10 percent.”

That would have been good! I would have been a fan of that outcome, and I’m willing to believe it. That’s 700,000 people with a job that they wouldn’t have had otherwise. The stimulus should have been bigger too, with a second round once it was clear how deep the hole was and how Treasuries were crashing too.

Again, there are two points. First, tightening may well have begun at least a year or two before the third quarter of 2008. Second, the economy started collapsing in the third quarter of 2008, and the run-up in the value of the dollar starting in July 2008, foolishly interpreted by the Fed as a vote of confidence in its anti-inflation policy, was really a cry for help as the economy was being starved of liquidity just as the demand for liquidity was becoming really intense. That denial of liquidity led to a perverse situation in which the return to holding cash began to exceed the return on real assets, setting the stage for a collapse in asset prices and a financial panic. The Fed could have prevented the panic, by providing more liquidity. Had it done so, the financial crisis would have been avoided, and the collapse in the real economy and the rise in unemployment would have been substantially mitigate.

c – “The Federal Reserve could have stopped the Great Recession from ever happening. Unemployment in 2009 wouldn’t have gone above 5.5 percent.”

This I don’t believe. Do they? There’s a lot of “might have kept that decline from happening or at least moderated it” back-and-forth language in the piece.

Is the argument that we’d somehow avoid the zero-lower bound? Ben Bernanke recently showed that interest rates would have had to go to about -4 percent to offset the Great Recession at the time. Hitting the zero-lower bound earlier than later is good policy, but it’s still there.

I think there’s an argument about “expectations,” and “expectations” wouldn’t have been set for a Great Recession. A lot of the “expectations” stuff has a magic and tautological quality to it once it leaves the models and enters the policy discussion, but the idea that a random speech about inflation worries could have shifted the Taylor Rule 4 percent seems really off base. Why doesn’t it go haywire all the time, since people are always giving speeches?

Well, I have shown in this paper that, starting in 2008, there was a strong empirical relationship between stock prices and inflation expectations, so it’s not just tautological. And we’re not talking about random speeches; we are talking about the decisions of the FOMC and the reasons that were given for those decisions. The markets pay a lot of attention to those reason.

And couldn’t it be just as likely that since the Fed was so confident about inflation in mid-2008 it boosted nominal income, by giving people a higher level of inflation expectations than they’d have otherwise? Given the failure of the Evans Rule and QE3 to stabilize inflation (or even prevent it from collapsing) in 2013, I imagine transporting them back to 2008 would haven’t fundamentally changed the game.

The inflation in 2008 was not induced by monetary policy, but by adverse supply shocks, expectations of higher inflation, given the Fed’s inflation targeting were thus tantamount to predictions of further monetary tightening.

If your mental model is that the Federal Reserve delaying something three months is capable of throwing 8.7 million people out of work, you should probably want to have much more shovel-ready construction and automatic stabilizers, the second of which kicked in right away without delay, as part of your agenda. It seems odd to put all the eggs in this basket if you also believe that even the most minor of mistakes are capable of devastating the economy so greatly.

Once again, it’s not a matter of just three months, but even if it were, in the summer of 2008 the economy was at a kind of inflection point, and the failure to ease monetary policy at that critical moment led directly to a financial crisis with cascading effects on the real economy. If the financial crisis could have been avoided by preventing total spending from dropping far below trend in the third quarter, the crisis might have been avoided, and the subsequent loss of output and employment could have been greatly mitigated.

And just to be clear, I have pointed out previously that the free market economy is fragile, because its smooth functioning depends on the coherence and consistency of expectations. That makes monetary policy very important, but I don’t dismiss shovel-ready construction and automatic stabilizers as means of anchoring expectations in a useful way, in contrast to the perverse way that inflation targeting stabilizes expectations.

Is John Cochrane Really an (Irving) Fisherian?

I’m pretty late getting to this Wall Street Journal op-ed by John Cochrane (here’s an ungated version), and Noah Smith has already given it an admirable working over, but, even after Noah Smith, there’s an assertion or two by Cochrane that could use a bit of elucidation. Like this one:

Keynesians told us that once interest rates got stuck at or near zero, economies would fall into a deflationary spiral. Deflation would lower demand, causing more deflation, and so on.

Noah seems to think this is a good point, but I guess that I am less easily impressed than Noah. Feeling no need to provide citations for the views he attributes to Keynesians, Cochrane does not bother either to tell us which Keynesian has asserted that the zero lower bound creates the danger of a deflationary spiral, though in a previous blog post, Cochrane does provide a number of statements by Paul Krugman (who I guess qualifies as the default representative of all Keynesians) about the danger of a deflationary spiral. Interestingly all but one of these quotations were from 2009 when, in the wake of the fall 2008 financial crisis, a nasty little relapse in early 2009 having driven the stock market to a 12-year low, the Fed finally launched its first round of quantitative easing, the threat of a deflationary spiral did not seem at all remote.

Now an internet search shows that Krugman does have a model showing that a downward deflationary spiral is possible at the zero lower bound. I would just note, for the record, that Earl Thompson, in an unpublished 1976 paper, derived a similar result from an aggregate model based on a neo-classical aggregate production function with the Keynesian expenditure functions (through application of Walras’s Law) excluded. So what’s Keynes got to do with it?

But even more remarkable is that the most famous model of a deflationary downward spiral was constructed not by a Keynesian, but by the grandfather of modern Monetarism, Irving Fisher, in his famous 1933 paper on debt deflation, “The Debt-Deflation Theory of Great Depressions.” So the suggestion that there is something uniquely Keynesian about a downward deflationary spiral at the zero lower bound is simply not credible.

Cochrane also believes that because inflation has stabilized at very low levels, slow growth cannot be blamed on insufficient aggregate demand.

Zero interest rates and low inflation turn out to be quite a stable state, even in Japan. Yes, Japan is growing more slowly than one might wish, but with 3.5% unemployment and no deflationary spiral, it’s hard to blame slow growth on lack of “demand.”

Except that, since 2009 when the threat of a downward deflationary spiral seemed more visibly on the horizon than it does now, Krugman has consistently argued that, at the zero lower bound, chronic stagnation and underemployment are perfectly capable of coexisting with a positive rate of inflation. So it’s not clear why Cochrane thinks the coincidence of low inflation and sluggish economic growth for five years since the end of the 2008-09 downturn somehow refutes Krugman’s diagnosis of what has been ailing the economy in recent years.

And, again, what’s even more interesting is that the proposition that there can be insufficient aggregate demand, even with positive inflation, follows directly from the Fisher equation, of which Cochrane claims to be a fervent devotee. After all, if the real rate of interest is negative, then the Fisher equation tells us that the equilibrium expected rate of inflation cannot be less than the absolute value of the real rate of interest. So if, at the zero lower bound, the real rate of interest is minus 1%, then the equilibrium expected rate of inflation is 1%, and if the actual rate of inflation equals the equilibrium expected rate, then the economy, even if it is operating at less than full employment and less than its potential output, may be in a state of macroeconomic equilibrium. And it may not be possible to escape from that low-level equilibrium and increase output and employment without a burst of unexpected inflation, providing a self-sustaining stimulus to economic growth, thereby moving the economy to a higher-level equilibrium with a higher real rate of interest than the rate corresponding to lower-level equilibrium. If I am not mistaken, Roger Farmer has been making an argument along these lines.

Given the close correspondence between the Keynesian and Fisherian analyses of what happens in the neighborhood of the zero lower bound, I am really curious to know what part of the Fisherian analysis Cochrane finds difficult to comprehend.

Temporary Equilibrium One More Time

It’s always nice to be noticed, especially by Paul Krugman. So I am not upset, but in his response to my previous post, I don’t think that Krugman quite understood what I was trying to convey. I will try to be clearer this time. It will be easiest if I just quote from his post and insert my comments or explanations.

Glasner is right to say that the Hicksian IS-LM analysis comes most directly not out of Keynes but out of Hicks’s own Value and Capital, which introduced the concept of “temporary equilibrium”.

Actually, that’s not what I was trying to say. I wasn’t making any explicit connection between Hicks’s temporary-equilibrium concept from Value and Capital and the IS-LM model that he introduced two years earlier in his paper on Keynes and the Classics. Of course that doesn’t mean that the temporary equilibrium method isn’t connected to the IS-LM model; one would need to do a more in-depth study than I have done of Hicks’s intellectual development to determine how much IS-LM was influenced by Hicks’s interest in intertemporal equilibrium and in the method of temporary equilibrium as a way of analyzing intertemporal issues.

This involves using quasi-static methods to analyze a dynamic economy, not because you don’t realize that it’s dynamic, but simply as a tool. In particular, V&C discussed at some length a temporary equilibrium in a three-sector economy, with goods, bonds, and money; that’s essentially full-employment IS-LM, which becomes the 1937 version with some price stickiness. I wrote about that a long time ago.

Now I do think that it’s fair to say that the IS-LM model was very much in the spirit of Value and Capital, in which Hicks deployed an explicit general-equilibrium model to analyze an economy at a Keynesian level of aggregation: goods, bonds, and money. But the temporary-equilibrium aspect of Value and Capital went beyond the Keynesian analysis, because the temporary equilibrium analysis was explicitly intertemporal, all agents formulating plans based on explicit future price expectations, and the inconsistency between expected prices and actual prices was explicitly noted, while in the General Theory, and in IS-LM, price expectations were kept in the background, making an appearance only in the discussion of the marginal efficiency of capital.

So is IS-LM really Keynesian? I think yes — there is a lot of temporary equilibrium in The General Theory, even if there’s other stuff too. As I wrote in the last post, one key thing that distinguished TGT from earlier business cycle theorizing was precisely that it stopped trying to tell a dynamic story — no more periods, forced saving, boom and bust, instead a focus on how economies can stay depressed. Anyway, does it matter? The real question is whether the method of temporary equilibrium is useful.

That is precisely where I think Krugman’s grasp on the concept of temporary equilibrium is slipping. Temporary equilibrium is indeed about periods, and it is explicitly dynamic. In my previous post I referred to Hicks’s discussion in Capital and Growth, about 25 years after writing Value and Capital, in which he wrote

The Temporary Equilibrium model of Value and Capital, also, is “quasi-static” [like the Keynes theory] – in just the same sense. The reason why I was contented with such a model was because I had my eyes fixed on Keynes.

As I read this passage now — and it really bothered me when I read it as I was writing my previous post — I realize that what Hicks was saying was that his desire to conform to the Keynesian paradigm led him to compromise the integrity of the temporary equilibrium model, by forcing it to be “quasi-static” when it really was essentially dynamic. The challenge has been to convert a “quasi-static” IS-LM model into something closer to the temporary-equilibrium method that Hicks introduced, but did not fully execute in Value and Capital.

What are the alternatives? One — which took over much of macro — is to do intertemporal equilibrium all the way, with consumers making lifetime consumption plans, prices set with the future rationally expected, and so on. That’s DSGE — and I think Glasner and I agree that this hasn’t worked out too well. In fact, economists who never learned temporary-equiibrium-style modeling have had a strong tendency to reinvent pre-Keynesian fallacies (cough-Say’s Law-cough), because they don’t know how to think out of the forever-equilibrium straitjacket.

Yes, I agree! Rational expectations, full-equilibrium models have turned out to be a regression, not an advance. But the way I would make the point is that the temporary-equilibrium method provides a sort of a middle way to do intertemporal dynamics without presuming that consumption plans and investment plans are always optimal.

What about disequilibrium dynamics all the way? Basically, I have never seen anyone pull this off. Like the forever-equilibrium types, constant-disequilibrium theorists have a remarkable tendency to make elementary conceptual mistakes.

Again, I agree. We can’t work without some sort of equilibrium conditions, but temporary equilibrium provides a way to keep the discipline of equilibrium without assuming (nearly) full optimality.

Still, Glasner says that temporary equilibrium must involve disappointed expectations, and fails to take account of the dynamics that must result as expectations are revised.

Perhaps I was unclear, but I thought I was saying just the opposite. It’s the “quasi-static” IS-LM model, not temporary equilibrium, that fails to take account of the dynamics produced by revised expectations.

I guess I’d say two things. First, I’m not sure that this is always true. Hicks did indeed assume static expectations — the future will be like the present; but in Keynes’s vision of an economy stuck in sustained depression, such static expectations will be more or less right.

Again, I agree. There may be self-fulfilling expectations of a low-income, low-employment equilibrium. But I don’t think that that is the only explanation for such a situation, and certainly not for the downturn that can lead to such an equilibrium.

Second, those of us who use temporary equilibrium often do think in terms of dynamics as expectations adjust. In fact, you could say that the textbook story of how the short-run aggregate supply curve adjusts over time, eventually restoring full employment, is just that kind of thing. It’s not a great story, but it is the kind of dynamics Glasner wants — and it’s Econ 101 stuff.

Again, I agree. It’s not a great story, but, like it or not, the story is not a Keynesian story.

So where does this leave us? I’m not sure, but my impression is that Krugman, in his admiration for the IS-LM model, is trying too hard to identify IS-LM with the temporary-equilibrium approach, which I think represented a major conceptual advance over both the Keynesian model and the IS-LM representation of the Keynesian model. Temporary equilibrium and IS-LM are not necessarily inconsistent, but I mainly wanted to point out that the two aren’t the same, and shouldn’t be conflated.

Krugman on Minsky, IS-LM and Temporary Equilibrium

Catching up on my blog reading, I found this one from Paul Krugman from almost two weeks ago defending the IS-LM model against Hyman Minsky’s criticism (channeled by his student Lars Syll) that IS-LM misrepresented the message of Keynes’s General Theory. That is an old debate, and it’s a debate that will never be resolved because IS-LM is a nice way of incorporating monetary effects into the pure income-expenditure model that was the basis of Keynes’s multiplier analysis and his policy prescriptions. On the other hand, the model leaves out much of what most interesting and insightful in the General Theory — precisely the stuff that could not easily be distilled into a simple analytic model.

Here’s Krugman:

Lars Syll approvingly quotes Hyman Minsky denouncing IS-LM analysis as an “obfuscation” of Keynes; Brad DeLong disagrees. As you might guess, so do I.

There are really two questions here. The less important is whether something like IS-LM — a static, equilibrium analysis of output and employment that takes expectations and financial conditions as given — does violence to the spirit of Keynes. Why isn’t this all that important? Because Keynes was a smart guy, not a prophet. The General Theory is interesting and inspiring, but not holy writ.

It’s also a protean work that contains a lot of different ideas, not necessarily consistent with each other. Still, when I read Minsky putting into Keynes’s mouth the claim that

Only a theory that was explicitly cyclical and overtly financial was capable of being useful

I have to wonder whether he really read the book! As I read the General Theory — and I’ve read it carefully — one of Keynes’s central insights was precisely that you wanted to step back from thinking about the business cycle. Previous thinkers had focused all their energy on trying to explain booms and busts; Keynes argued that the real thing that needed explanation was the way the economy seemed to spend prolonged periods in a state of underemployment:

[I]t is an outstanding characteristic of the economic system in which we live that, whilst it is subject to severe fluctuations in respect of output and employment, it is not violently unstable. Indeed it seems capable of remaining in a chronic condition of subnormal activity for a considerable period without any marked tendency either towards recovery or towards complete collapse.

So Keynes started with a, yes, equilibrium model of a depressed economy. He then went on to offer thoughts about how changes in animal spirits could alter this equilibrium; but he waited until Chapter 22 (!) to sketch out a story about the business cycle, and made it clear that this was not the centerpiece of his theory. Yes, I know that he later wrote an article claiming that it was all about the instability of expectations, but the book is what changed economics, and that’s not what it says.

This all seems pretty sensible to me. Nevertheless, there is so much in the General Theory — both good and bad – that isn’t reflected in IS-LM, that to reduce the General Theory to IS-LM is a kind of misrepresentation. And to be fair, Hicks himself acknowledged that IS-LM was merely a way of representing one critical difference in the assumptions underlying the Keynesian and the “Classical” analyses of macroeconomic equilibrium.

But I would take issue with the following assertion by Krugman.

The point is that Keynes very much made use of the method of temporary equilibrium — interpreting the state of the economy in the short run as if it were a static equilibrium with a lot of stuff taken provisionally as given — as a way to clarify thought. And the larger point is that he was right to do this.

When people like me use something like IS-LM, we’re not imagining that the IS curve is fixed in position for ever after. It’s a ceteris paribus thing, just like supply and demand. Assuming short-run equilibrium in some things — in this case interest rates and output — doesn’t mean that you’ve forgotten that things change, it’s just a way to clarify your thought. And the truth is that people who try to think in terms of everything being dynamic all at once almost always end up either confused or engaging in a lot of implicit theorizing they don’t even realize they’re doing.

When I think of a temporary equilibrium, the most important – indeed the defining — characteristic of that temporary equilibrium is that expectations of at least some agents have been disappointed. The disappointment of expectations is likely to, but does not strictly require, a revision of disappointed expectations and of the plans conditioned on those expectations. The revision of expectations and plans as a result of expectations being disappointed is what gives rise to a dynamic adjustment process. But that is precisely what is excluded from – or at least not explicitly taken into account by – the IS-LM model. There is nothing in the IS-LM model that provides any direct insight into the process by which expectations are revised as a result of being disappointed. That Keynes could so easily think in terms of a depressed economy being in equilibrium suggests to me that he was missing what I regard as the key insight of the temporary-equilibrium method.

Of course, there are those who argue, perhaps most notably Roger Farmer, that economies have multiple equilibria, each with different levels of output and employment corresponding to different expectational parameters. That seems to me a more Keynesian approach, an approach recognizing that expectations can be self-fulfilling, than the temporary-equilibrium approach in which the focus is on mistaken and conflicting expectations, not their self-fulfillment.

Now to be fair, I have to admit that Hicks, himself, who introduced the temporary-equilibrium approach in Value and Capital (1939) later (1965) suggested in Capital and Growth (p. 65) that both the Keynes in the General Theory and the temporary-equilibrium approach of Value and Capital were “quasi-static.” The analysis of the General Theory “is not the analysis of a process; no means has been provided by which we can pass from one Keynesian period to the next. . . . The Temporary Equilibrium model of Value and Capital, also, is quasi-static in just the same sense. The reason why I was contented with such a model was because I had my eyes fixed on Keynes.

Despite Hicks’s identification of the temporary-equilibrium method with Keynes’s method in the General Theory, I think that Hicks was overly modest in assessing his own contribution in Value and Capital, failing to appreciate the full significance of the method he had introduced. Which, I suppose, just goes to show that you can’t assume that the person who invents a concept or an idea is necessarily the one who has the best, or most comprehensive, understanding of what the concept means of what its significance is.

Explaining Post-Traumatic-Inflation Stress Disorder

Paul Krugman and Steve Waldman having been puzzling of late about why inflation is so viscerally opposed by the dreaded one percent (even more so by the ultra-dreaded 0.01 percent). Here’s how Krugman phrased the conundrum.

One thought I’ve had and written about is that the one percent (or actually the 0.01 percent) like hard money because they’re rentiers. But you can argue that this is foolish — that they have much more to gain from asset appreciation than they have to lose from the small chance of runaway inflation. . . .

But maybe the 1% doesn’t make the connection?

Steve Waldman, however, doesn’t take the one percent — and certainly not the 0.01 percent — for the misguided dunces that Krugman suggests they are. Waldman sees them as the cunning, calculating villains that we all (notwithstanding his politically correct disclaimer that the rich aren’t bad people) know they really are.

Soft money types — I’ve heard the sentiment from Scott Sumner, Brad DeLong, Kevin Drum, and now Paul Krugman — really want to see the bias towards hard money and fiscal austerity as some kind of mistake. I wish that were true. It just isn’t. Aggregate wealth is held by risk averse individuals who don’t individually experience aggregate outcomes. Prospective outcomes have to be extremely good and nearly certain to offset the insecurity soft money policy induces among individuals at the top of the distribution, people who have much more to lose than they are likely to gain.

That’s all very interesting. Are the rich opposed to inflation because they are stupid, or because they are clever? Krugman thinks it’s the former, Waldman the latter. And I agree; it is a puzzle.

But what about the poor and the middle class? Has anyone seen any demonstrations lately by the 99 percent demanding that the Fed increase its inflation target? Did even one Democrat in the Senate – not even that self-proclaimed socialist Bernie Sanders — threaten to vote against confirmation of Janet Yellen unless she promised to raise the Fed’s inflation target? Well, maybe that just shows that the Democrats are as beholden to the one percent as the Republicans, but I suspect that the real reason is because the 99 percent hate inflation just as much as the one percent do. I mean, don’t the 99 percent realize that inflation would increase total output and employment, thereby benefitting ordinary workers generally?

Oh, you say, workers must be afraid that inflation would reduce their real wages. That’s a widely believed factoid about inflation — that inflation is biased against workers, because wages adjust more slowly than other prices to changes in demand. Well, that factoid is not necessarily true, either in theory or in practice. That doesn’t mean that inflation might not be associated with reduced real wages, but if it is, it would mean that inflation is facilitating a market adjustment in real wages that would tend to increase total output and total employment, thereby increasing aggregate wages paid to workers. That is just the sort of tradeoff between a prospective upside from growth-inducing inflation and a perceived downside from inflation redistribution. In other words, the attitudes of the one percent and of the 99 percent toward inflation don’t seem all that different.

And aside from the potential direct output-expanding effect of inflation, there is also the redistributional effect from creditors to debtors. A lot of underwater homeowners could have sold their homes if a 10- or 20-percent increase in the overall price level had kept nominal home prices from falling below nominal mortgage indebtedness. Inflation would have been the simplest and easiest way to avoid a foreclosure crisis and getting stuck in a balance-sheet recession. Why weren’t underwater homeowners out their clamoring for some inflationary relief?

I have not done a historical study, but I cannot think of any successful political movement or campaign that has ever been carried out on a platform of increasing inflation. Even FDR, who saved the country from ruin by taking the US off the gold standard in 1933, did not say that he would do so when running for office.

Nor has anyone ever stated the case against inflation more eloquently than John Maynard Keynes, hardly a spokesman for the interests of rentiers.

Lenin is said to have declared that the best way to destroy the capitalist system was to debauch the currency. By a continuing process of inflation, governments can confiscate, secretly and unobserved, an important part of the wealth of their citizens. By this method they not only confiscate, but they confiscate arbitrarily; and, while the process impoverishes many, it actually enriches some. The sight of this arbitrary rearrangement of riches strikes not only at security but [also] at confidence in the equity of the existing distribution of wealth.

Those to whom the system brings windfalls, beyond their deserts and even beyond their expectations or desires, become “profiteers,” who are the object of the hatred of the bourgeoisie, whom the inflationism has impoverished, not less than of the proletariat. As the inflation proceeds and the real value of the currency fluctuates wildly from month to month, all permanent relations between debtors and creditors, which form the ultimate foundation of capitalism, become so utterly disordered as to be almost meaningless; and the process of wealth-getting degenerates into a gamble and a lottery.

Lenin was certainly right. There is no subtler, no surer means of overturning the existing basis of society than to debauch the currency. The process engages all the hidden forces of economic law on the side of destruction, and does it in a manner which not one man in a million is able to diagnose. (Economic Consequences of the Peace)

One might say that when Keynes wrote this he was still very much of an orthodox Marshallian economist, who only later outgrew his orthodox prejudices when he finally saw the light and wrote the General Theory. But Keynes was actually quite explicit in the General Theory that he favored a monetary policy aiming at price-level stabilization. If Keynes favored inflation it was only in the context of counteracting a massive deflation. Similarly, Ralph Hawtrey, who famously likened opposition to monetary stimulus, out of fear of inflation, during the Great Depression to crying “fire, fire” during Noah’s Flood, favored a monetary regime aiming at stable money wages, a regime that over the long term would generate a gradually falling output price level. So I fail to see why anyone should be surprised that a pro-inflationary policy would be a tough sell even when unemployment is high.

But, in thinking about all this, I believe it may help to distinguish between two types of post-traumatic-inflation stress disorder. One is a kind of instinctual aversion to inflation, which I think is widely shared by people from all kinds of backgrounds, beliefs, and economic status. After arguing and pleading for higher inflation for over three years on this blog, I am a little bit embarrassed to make this admission, but I suffer from this type of post-traumatic-inflation stress disorder myself. I know that it’s weird, but every month when the CPI is announced, and the monthly change is less than 2%, I just get a warm fuzzy feeling inside of me. I know (or at least believe) that people will suffer because inflation is not higher than a measly 2%, but I can’t help getting that feeling of comfort and well-being when I hear that inflation is low. That just seems to be the natural order of things. And I don’t think that I am the only one who feels that way, though I probably suffer more guilt than most for not being able to suppress the feeling.

But there is another kind of post-traumatic-inflation stress disorder. This is a purely intellectual disorder brought on by excessive exposure to extreme libertarian dogmas associated with pop-Austrianism and reading too many (i.e., more than zero) novels by Ayn Rand. Unfortunately, one of the two major political parties seems to have been captured this group of ideologues, and anti-inflationary dogma has become an article of faith rather than a mere disposition. It is one thing to have a disposition or a bias in favor of low inflation; it is altogether different to make anti-inflationism a moral or ideological crusade. I think most people, whether they are in the one percent or the 99 percent are biased in favor of low inflation, but most of them don’t oppose inflation as a moral or ideological imperative. Now it’s true that that the attachment of a great many people to the gold standard before World War I was akin to a moral precept, but at least since the collapse of the gold standard in the Great Depression, most people no longer think about inflation in moral and ideological terms.

Before anti-inflationism became a moral crusade, it was possible for people like Richard Nixon and Ronald Reagan, who were disposed to favor low inflation, to accommodate themselves fairly easily to an annual rate of inflation of 4 percent. Indeed, it was largely because of pressure from Democrats to fight inflation by wage and price controls that Nixon did the unthinkable and imposed wage and price controls on August 15, 1971. Reagan, who had no interest in repeating that colossal blunder, instead fought against Paul Volcker’s desire to bring inflation down below 4 percent for most of his two terms. Of course, one doesn’t know to what extent the current moral and ideological crusade against inflation would survive an accession to power by a Republican administration. It is always easier to proclaim one’s ideological principles when one doesn’t have any responsibility to implement them. But given the current ideological commitment to anti-inflationism, there was never any chance for a pragmatic accommodation that might have used increased inflation as a means of alleviating economic distress.

Eureka! Paul Krugman Discovers the Bank of France

Trying hard, but not entirely successfully, to contain his astonishment, Paul Krugman has a very good post (“France 1930, Germany 2013) inspired by Doug Irwin’s “very good” paper (see also this shorter version) “Did France Cause the Great Depression?” Here’s Krugman take away from Irwin’s paper.

[Irwin] points out that France, with its undervalued currency, soaked up a huge proportion of the world’s gold reserves in 1930-31, and suggests that France was responsible for about half the global deflation that took place over that period.

The thing is, France itself didn’t do that badly in the early stages of the Great Depression — again thanks to that undervalued currency. In fact, it was less affected than most other advanced countries (pdf) in 1929-31:

Krugman is on the right track here — certainly a hopeful sign — but he misses the distinction between an undervalued French franc, which, despite temporary adverse effects on other countries, would normally be self-correcting under the gold standard, and the explosive increase in demand for gold by the insane Bank of France after the franc was pegged at an undervalued parity against the dollar. Undervaluation of the franc began in December 1926 when Premier Raymond Poincare stabilized its value at about 25 francs to the dollar, the franc having fallen to 50 francs to the dollar in July when Poincare, a former prime minister, had been returned to office to deal with a worsening currency crisis. Undervaluation of the franc would have done no permanent damage to the world economy if the Bank of France had not used the resulting inflow of foreign exchange to accumulate gold, cashing in sterling- and dollar-denominated financial assets for gold. This was a step beyond classic exchange-rate protection (currency manipulation) whereby a country uses a combination of an undervalued exchange rate and a tight monetary policy to keep accumulating foreign-exchange reserves as a way of favoring its export and import-competing industries. Exchange-rate protection may have been one motivation for the French policy, but that objective did not require gold accumulation; it could have been achieved by accumulating foreign exchange reserves without demanding redemption of those reserves in terms of gold, as the Bank of France began doing aggressively in 1927. A more likely motivation for gold accumulation policy of the Bank of France seems to have been French resentment against a monetary system that, from the French perspective, granted a privileged status to the dollar and to sterling, allowing central banks to treat dollar- and sterling-denominated financial assets as official exchange reserves, thereby enabling issuers of dollar and sterling-denominated assets the ability to obtain funds on more favorable terms than issuers of instruments denominated in other currencies.

The world economy was able to withstand the French gold-accumulation policy in 1927-28, because the Federal Reserve was tolerating an outflow of gold, thereby accommodating to some degree the French demand for gold. But after the Fed raised its discount rate to 5% in 1928 and 6% in February 1929, gold began flowing into the US as well, causing gold to start appreciating (in other words, prices to start falling) in world markets by the summer of 1929. But rather than reverse course, the Bank of France and the Fed, despite reductions in their official lending rates, continued pursuing policies that caused huge amounts of gold to flow into the French and US vaults in 1930 and 1931. Hawtrey and Cassel, of course, had warned against such a scenario as early as 1919, and proposed measures to prevent or reverse the looming catastrophe before it took place and after it started, but with little success. For a more complete account of this sad story, and the failure of the economics profession, with a very few notable exceptions, to figure out what happened, see my paper with Ron Batchelder “Pre-Keynesian Monetary Theories of the Great Depression: Whatever Happened to Hawtrey and Cassel?”

As Krugman observes, the French economy did not do so badly in 1929-31, because it was viewed as the most stable, thrifty, and dynamic economy in Europe. But France looked good only because Britain and Germany were in even worse shape. Because France was better off the Britain and Germany, and because its currency was understood to be undervalued, the French franc was considered to be stable, and, thus, unlikely to be devalued. So, unlike sterling, the reichsmark, and the dollar, the franc was not subjected to speculative attacks, becoming instead a haven for capital seeking safety.

Interestingly, Krugman even shows some sympathetic understanding for the plight of the French:

Notice, by the way, that the French weren’t evil or malicious here — they were just adhering to their hard-money ideology in an environment where that had terrible adverse effects on other countries.

Just wondering, would Krugman ever invoke adherence to a hard-money ideology as a mitigating factor in passing judgment on a Republican?

Krugman concludes by comparing Germany today with France in 1930.

Obviously the details are different, but I would argue that Germany is playing a somewhat similar role today — not as drastic, but with less excuse. For Germany is an economic hegemon in a way France never was; it has responsibilities, which it isn’t meeting.

Indeed, there are similarities, but there is a crucial difference in the mechanism by which damage is being inflicted: the world price level in 1930, under the gold standard, was determined by the value of gold. An increase in the demand for gold by central banks necessarily raised the value of gold, causing deflation for all countries either on the gold standard or maintaining a fixed exchange rate against a gold-standard currency. By accumulating gold, nearly quadrupling its gold reserves between 1926 and 1932, the Bank of France was a mighty deflationary force, inflicting immense damage on the international economy. Today, the Eurozone price level does not depend on the independent policy actions of any national central bank, including that of Germany. The Eurozone price level is rather determined by the policy choices of a nominally independent European Central Bank. But the ECB is clearly unable to any adopt policy not approved by the German government and its leader Mrs. Merkel, and Mrs. Merkel has rejected any policy that would raise prices in the Eurozone to a level consistent with full employment. Though the mechanism by which Mrs. Merkel and her government are now inflicting damage on the Eurozone is different from the mechanism by which the insane Bank of France inflicted damage during the Great Depression, the damage is just as pointless and just as inexcusable. But as the damage caused by Mrs. Merkel, in relative terms at any rate, seems somewhat smaller in magnitude than that caused by the insane Bank of France, I would not judge her more harshly than I would the Bank of France — insanity being, in matters of monetary policy, no defense.

HT: ChargerCarl

Carlaw and Lipsey on Whether History Matters

About six months ago,  I mentioned a forthcoming paper by Kenneth Carlaw and Richard Lipsey, “Does history matter? Empirical analysis  of evolutionary versus stationary equilibrium views of the economy.”  The paper was recently published in the Journal of Evolutionary Economics.  The empirical analysis undertaken by Carlaw and Lipsey undermines many widely accepted propositions of modern macroeconomics, and is thus especially timely after the recent flurry of posts on the current state of macroecoomics by Krugman, Williamson, Smith, Delong, Sumner, et al., a topic about which I may have a word or two to say anon.  Here is the abstract of the Carlaw and Lipsey paper.

The evolutionary vision in which history matters is of an evolving economy driven by bursts of technological change initiated by agents facing uncertainty and producing long term, path-dependent growth and shorter-term, non-random investment cycles. The alternative vision in which history does not matter is of a stationary, ergodic process driven by rational agents facing risk and producing stable trend growth and shorter term cycles caused by random disturbances. We use Carlaw and Lipsey’s simulation model of non-stationary, sustained growth driven by endogenous, path-dependent technological change under uncertainty to generate artificial macro data. We match these data to the New Classical stylized growth facts. The raw simulation data pass standard tests for trend and difference stationarity, exhibiting unit roots and cointegrating processes of order one. Thus, contrary to current belief, these tests do not establish that the real data are generated by a stationary process. Real data are then used to estimate time-varying NAIRU’s for six OECD countries. The estimates are shown to be highly sensitive to the time period over which they are made. They also fail to show any relation between the unemployment gap, actual unemployment minus estimated NAIRU and the acceleration of inflation. Thus there is no tendency for inflation to behave as required by the New Keynesian and earlier New Classical theory. We conclude by rejecting the existence of a well-defined a short-run, negatively sloped Philips curve, a NAIRU, a unique general equilibrium, short and long-run, a vertical long-run Phillips curve, and the long-run neutrality of money.

UPDATE:  In addition to the abstract, I think it would be worthwhile to quote the three introductory paragraphs from Carlaw and Lipsey.

Economists face two conflicting visions of the market economy, visions that reflect two distinct paradigms, the Newtonian and the Darwinian. In the former, the behaviour of the economy is seen as the result of an equilibrium reached by the operation of opposing forces – such as market demanders and suppliers or competing oligopolists – that operate in markets characterised by negative feedback that returns the economy to its static equilibrium or its stationary equilibrium growth path. In the latter, the behaviour of the economy is seen as the result of many different forces – especially technological changes – that evolve endogenously over time, that are subject to many exogenous shocks, and that often operate in markets subject to positive feedback and in which agents operate under conditions of genuine uncertainty.
One major characteristic that distinguishes the two visions is stationarity for the Newtonian and non-stationarity for the Darwinian. In the stationary equilibrium of a static general equilibrium model and the equilibrium growth path of a Solow-type or endogenous growth model, the path by which the equilibrium is reached has no effect on the equilibrium values themselves. In short, history does not matter. In contrast, an important characteristic of the Darwinian vision is path dependency: what happens now has important implications for what will happen in the future. In short, history does matter.
In this paper, we consider, and cast doubts on, the stationarity properties of models in the Newtonian tradition. These doubts, if sustained, have important implications for understanding virtually all aspects of macroeconomics, including of long term economic growth, shorter term business cycles, and stabilisation policy.
UPDATE (12/28/12):  I received an email from Richard Lipsey about this post.  He attached two footnotes (1 and 5) from his article with Carlaw, which he thinks are relevant to some of the issues raised in comments to this post.  Footnote 1 explains their use of “Darwinian” to describe their path-dependent approach to economic modeling; footnote 5 observes that the analysis of many microeconomic problems and short-run macro-policy analysis may be amenable to the static-equilibrium method.

1 The use of the terms Darwinian and Newtonian here is meant to highlight the significant difference in equilibrium concept employed in the two groups of theories that we contrast, the evolutionary and what we call equilibrium with deviations (EWD) theories. Not all evolutionary theories, including the one employed here, are strictly speaking Darwinian in the sense that they embody replication and selection. We use the term, Darwinian to highlight the critical equilibrium concept of a path dependent, non-ergodic, historical process employed in Darwinian and evolutionary theories and to draw the contrast between that and the negative feedback, usually unique, ergodic equilibrium concept employed in Newtonian and EWD theories.

 5 Most evolutionary economists accept that for many issues in micro economics, comparative static equilibrium models are useful. Also, there is nothing incompatible between the evolutionary world view and the use of Keynesian models – of which IS-LM closed by an expectations-augmented Phillips curve is the prototype – to study such short run phenomenon as stagflation and the impact effects of monetary and fiscal policy shocks. Problems arise, however, when such analyses are applied to situations in which technology is changing endogenously over time periods that are relevant to the issues being studied. Depending on the issue at hand, this might be as short as a few months.


About Me

David Glasner
Washington, DC

I am an economist at the Federal Trade Commission. Nothing that you read on this blog necessarily reflects the views of the FTC or the individual commissioners. Although I work at the FTC as an antitrust economist, most of my research and writing has been on monetary economics and policy and the history of monetary theory. In my book Free Banking and Monetary Reform, I argued for a non-Monetarist non-Keynesian approach to monetary policy, based on a theory of a competitive supply of money. Over the years, I have become increasingly impressed by the similarities between my approach and that of R. G. Hawtrey and hope to bring Hawtrey's unduly neglected contributions to the attention of a wider audience.

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