Posts Tagged 'Paul Krugman'

Why Fed Inflation-Phobia Mattered

Last week I posted an item summarizing Matthew O’Brien’s article about the just-released transcripts of FOMC meetings in June, August and September of 2008. I spiced up my summary by quoting from and commenting on some of the more outrageous quotes that O’Brien culled from the transcripts, quotes showing that most of the FOMC, including Ben Bernanke, were obsessing about inflation while unemployment was rising rapidly and the economy contracting sharply. I especially singled out what I called the Gang of Four — Charles Plosser, Jeffrey Lacker, Richard Fisher, and Thomas Hoenig, the most militant inflation hawks on the FOMC — noting that despite their comprehensive misjudgments of the 2008 economic situation and spectacularly wrongheaded policy recommendations, which they have yet to acknowledge, much less apologize for, three of them (Plosser, Lacker, and Fisher) continue to serve in their Fed positions, displaying the same irrational inflation-phobia by which they were possessed in 2008. Paul Krugman also noticed O’Brien’s piece and remarked on the disturbing fact that three of the Gang of Four remain in their policy-making positions at the Fed, doing their best to keep the Fed from taking any steps that could increase output and employment.

However, Krugman went on to question the idea — suggested by, among others, me — that it was the Fed’s inflation phobia that produced the crash of 2008. Krugman has two arguments for why the Fed’s inflation phobia in 2008, however silly, did not the cause of the crash.

First, preventing the financial crisis would have taken a lot more than cutting the Fed funds rate to zero in September 2008 rather than December. We were in the midst of an epic housing bust, which was in turn causing a collapse in the value of mortgage-backed securities, which in turn was causing a collapse of confidence in financial firms. Cutting rates from very low to extremely low a few months earlier wouldn’t have stopped that collapse.

What was needed to end the run on Wall Street was a bailout — both the actual funds disbursed and the reassurance that the authorities would step in if necessary. And that wasn’t in the cards until, as Rick Mishkin observed in the transcripts, “something hit the fan.”

Second, even avoiding the financial panic almost surely wouldn’t have meant avoiding a prolonged economic slump. How do we know this? Well, what we actually know is that the panic was in fact fairly short-lived, ending in the spring of 2009. It doesn’t really matter which measure of financial stress you use, they all look like this:

Yet the economy didn’t come roaring back, and in fact still hasn’t. Why? Because the housing bust and the overhang of household debt are huge drags on demand, even if there isn’t a panic in the financial market.

Sorry, but, WADR, I have to disagree with Professor Krugman.

The first argument is not in my view very compelling, because the Fed’s inflation-phobia did not suddenly appear at the September 2008 FOMC meeting, or even at the June meeting, though, to be sure, its pathological nature at those meetings does have a certain breathtaking quality; it had already been operating for a long time before that. If you look at the St. Louis Fed’s statistics on the monetary base, you will find that the previous recession in 2001 had been preceded in 2000 by a drop of 3.6% in the monetary base. To promote recovery, the Fed increased the monetary base in 2001 (partly accommodating the increased demand for money characteristic of recessions) by 8.5%. The monetary base subsequently grew by 7% in 2002, 5.2% in 2003, 4.4% in 2004, 3.2% in 2005, 2.6% in 2006, and a mere 1.2% in 2007.

The housing bubble burst in 2006, but the Fed was evidently determined to squeeze inflation out of the system, as if trying to atone for its sins in allowing the housing bubble in the first place. From January to September 10, 2008, the monetary base increased by 3.3%. Again, because the demand for money typically increases in recessions, one cannot infer from the slight increase in the rate of growth of the monetary base in 2008 over 2006 and 2007 that the Fed was easing its policy stance. (On this issue, see my concluding paragraph.) The point is that for at least three years before the crash, the Fed, in its anti-inflationary zelotry, had been gradually tightening the monetary-policy screws. So it is simply incorrect to suggest that there was no link between the policy stance of the Fed and the state of the economy. If the Fed had moderated its stance in 2008 in response to ample evidence that the economy was slowing, there is good reason to think that the economy would not have contracted as rapidly as it did, starting, even before the Lehman collapse, in the third quarter of 2008, when, we now know, the economy had already begun one of the sharpest contractions of the entire post World War II era.

As for Krugman’s second argument, I believe it is a mistake to confuse a financial panic with a recession. A financial panic is an acute breakdown of the financial system, always associated with a period of monetary stringency when demands for liquidity cannot be satisfied owing to a contagious loss of confidence in the solvency of borrowers and lenders. The crisis is typically precipitated by a too aggressive tightening of monetary conditions by the monetary authority seeking to rein in inflationary pressures. The loss of confidence is thus not a feature of every business-cycle downturn, and its restoration no guarantee of a recovery. (See my post on Hawtrey and financial crises.) A recovery requires an increase aggregate demand, which is the responsibility of those in charge of monetary policy and fiscal policy. I confess to a measure of surprise that the author of End This Depression Now would require a reminder about that from me.

A final point. Although the macroeconomic conditions for an asset crash and financial panic had been gradually and systematically created by the Fed ever since 2006, the egregious Fed policy in the summer of 2008 was undoubtedly a major contributing cause in its own right. The magnitude of the policy error is evident in this graph from the St. Louis Fed, showing the dollar/euro exchange rate.

dollar_euro_exchange_rateFrom April to July, the exchange rate was fluctuating between $1.50 and $1.60 per euro. In mid-July, the dollar began appreciating rapidly against the euro, rising in value to about $1.40/euro just before the Lehman collapse, an appreciation of about 12.5% in less than two months. The only comparable period of appreciation in the dollar/euro exchange rate was in the 1999-2000 period during the monetary tightening prior to the 2001 recession. But the 2008 appreciation was clearly greater and steeper than the appreciation in 1999-2000. Under the circumstances, such a sharp appreciation in the dollar should have alerted the FOMC that there was a liquidity shortage (also evidenced in a sharp increase in borrowings from the Fed) that required extraordinary countermeasures by the Fed. But the transcript of the September 2008 meeting shows that the appreciation of the dollar was interpreted by members of the FOMC as evidence that the current policy was working as intended! Now how scary is that?

HT: Matt O’Brien

Fear Is Contagious

Ever the optimist, I was hoping that yesterday’s immediate, sharply negative, reaction to the FOMC statement and Ben Bernanke’s press conference was only a mild correction, not the sign of a major revision in expectations. Today’s accelerating slide in stock prices, coupled with continuing rises declines in bond prices, across the entire yield curve, shows that the FOMC, whose obsession with inflation in 2008 drove the world economy into a Little Depression, may now be on the verge of precipitating yet another downturn even before any real recovery has taken place.

If 2008-09 was a replay of 1929-30, then we might be headed back to a reprise of 1937, when a combination of fiscal austerity and monetary tightening, fed by exaggerated, if not irrational fears of inflation, notwithstanding the absence of a full recovery from the 1929-33 downturn, caused a second downturn, nearly as sharp as that of 1929-30.

Nothing is inevitable. History does not have to repeat itself. But if we want to avoid a repeat of 1937, we must avoid repeating the same stupid mistakes made in 1937. Don’t withdraw – or talk about withdrawing — a stimulus that isn’t even generating the measly 2% inflation that the FOMC says its targeting, even while the unemployment rate is still 7.6%. And as Paul Krugman pointed out in his blog today, the labor force participation rate has barely increased since the downturn bottomed out in 2009. I reproduce his chart below.


Bernanke claims to be maintaining an accommodative monetary policy and is simply talking about withdrawing (tapering off), as conditions warrant, the additional stimulus associated with  the Fed’s asset purchases. That reminds me of the stance of the FOMC in 2008 when the Fed, having reduced interest rates to 2% in March, kept threatening to raise interest rates during the spring and summer to counter rising commodity prices, even as the economy was undergoing, even before the onset of the financial crisis, one of the fastest contractions since World War II. Yesterday’s announcement, making no commitment to ensure that the Fed’s own inflation target would be met, has obviously been understood by the markets to signal the willingness of the FOMC to tolerate even lower rates of inflation than we have now.

In my post yesterday, I observed that the steep rise in nominal and real interest rates (at least as approximated by the yield on TIPS) was accompanied by only a very modest decline in inflation expectations (as approximated by the TIPS spread). Well, today, nominal and real interest rates (as reflected in TIPS) rose again, but with the breakeven 10-year TIPS spread falling by 9 basis points, to 1.95%. Meanwhile, the dollar continued to appreciate against the euro, supporting the notion that the markets are reacting to a perceived policy change, a change in exactly the wrong direction. Oh, and by the way, the price of gold continued to plummet, reaching $1280 an ounce, the lowest in almost three years, nearly a third less than its 2011 peak.

But for a contrary view, have a look at theeditorial (“Monetary Withdrawal Symptom”) in Friday’s Wall Street Journal, as well as an op-ed piece by an asset fund manager, Romain Hatchuel, (“Central Banks and the Borrowing Addiction”). Both characterize central banks as drug pushers who have induced hundreds of millions, if not billions, of people around the world to become debt addicts. Hatchuel sees some deep significance in the fact that total indebtedness has, since 1980, increased as fast as GDP, while from 1950 to 1980 total indebtedness increased at a much slower rate.

Um, if more people are borrowing, more people are lending, so the mere fact that total indebtedness has increased faster in the last 30 years than it did in the previous 30 years says nothing about debt addiction. It simply says that more people have been gaining access to credit markets in recent years than had access to credit markets in the 1950s, 1960s and 1970s. If we are so addicted to debt, how come real interest rates are so low? If a growing epidemic of debt addiction started in 1980, shouldn’t real interest rates have been rising steadily since then? Guess what? Real interest rates have been falling steadily since 1982. The Wall Street Journal strikes (out) again.

They Come not to Praise Market Monetarism, but to Bury It

For some reason – maybe he is still annoyed with Scott Sumner – Paul Krugman decided to channel a post by Mike Konczal purporting to show that Market Monetarism has been refuted by the preliminary first quarter GDP numbers showing NGDP increasing at a 3.7% rate and real GDP increasing at a 2.5% rate in Q1. To Konczal and Krugman (hereinafter K&K) this shows that fiscal policy, not monetary policy, is what matters most for macroeconomic performance. Why is that? Because the Fed, since embarking on its latest splurge of bond purchasing last September, has failed to stimulate economic activity in the face of the increasingly contractionary stance of fiscal policy since them (the fiscal 2013 budget deficit recently being projected to be $775 billion, a mere 4.8% of GDP).

So can we get this straight? GDP is now rising at about the same rate it has been rising since the start of the “recovery” from the 2007-09 downturn. Since September monetary policy has become easier and fiscal policy tighter. And that proves what? Sorry, I still don’t get it. But then again, I was always a little slow on the uptake.

Marcus Nunes, the Economist, Scott Sumner, and David Beckworth all weigh in on the not very devastating K&K onslaught. (Also see this post by Evan Soltas written before the fact.) But let me try to cool things down a bit.

If we posit that we are still in something akin to a zero-lower-bound situation, there are perfectly respectable theoretical grounds on which to recommend both fiscal and monetary stimulus. It is true that monetary policy, in principle, could stimulate a recovery even without fiscal stimulus — and even in the face of fiscal contraction — but for monetary policy to be able to be that effective, it would have to operate through the expectations channel, raising price-level expectations sufficiently to induce private spending. However, for good or ill, monetary policy is not aiming at more than a marginal change in inflation expectations. In that kind of policy environment, the potential effect of monetary policy is sharply constrained. Hence, the monetary theoretical case for fiscal stimulus. This is classic Hawtreyan credit deadlock (see here and here).

If monetary policy can’t do all the work by itself, then the question is whether fiscal policy can help. In principle it could if the Fed is willing to monetize the added debt generated by the fiscal stimulus. But there’s the rub. If the Fed has to monetize the added debt created by the fiscal stimulus — which, for argument’s sake, let us assume is more stimulative than equivalent monetary expansion without the fiscal stimulus — what are we supposed to assume will happen to inflation and inflation expectations?

Here is the internal contradiction – the Sumner critique, if you will – implicit in the Keynesian fiscal-policy prescription. Can fiscal policy work without increasing the rate of inflation or inflation expectations? If monetary policy alone cannot work, because it cannot break through the inflation targeting regime that traps us at the 2 percent inflation ceiling, how is fiscal policy supposed to work its way around the 2% inflation ceiling, except by absolving monetary policy of the obligation to keep inflation at or below the ceiling? But if we can allow the ceiling to be pierced by fiscal policy, why can’t we allow it to be pierced by monetary policy?

Perhaps K&K can explain that one to us.

On Multipliers, Ricardian Equivalence and Functioning Well

In my post yesterday, I explained why if one believes, as do Robert Lucas and Robert Barro, that monetary policy can stimulate an economy in an economic downturn, it is easy to construct an argument that fiscal policy would do so as well. I hope that my post won’t cause anyone to conclude that real-business-cycle theory must be right that monetary policy is no more effective than fiscal policy. I suppose that there is that risk, but I can’t worry about every weird idea floating around in the blogosphere. Instead, I want to think out loud a bit about fiscal multipliers and Ricardian equivalence.

I am inspired to do so by something that John Cochrane wrote on his blog defending Robert Lucas from Paul Krugman’s charge that Lucas didn’t understand Ricardian equivalence. Here’s what Cochrane, explaining what Ricardian equivalence means, had to say:

So, according to Paul [Krugman], “Ricardian Equivalence,” which is the theorem that stimulus does not work in a well-functioning economy, fails, because it predicts that a family who takes out a mortgage to buy a $100,000 house would reduce consumption by $100,000 in that very year.

Cochrane was a little careless in defining Ricardian equivalance as a theorem about stimulus, when it’s really a theorem about the equivalence of the effects of present and future taxes on spending. But that’s just a minor slip. What I found striking about Cochrane’s statement was something else: that little qualifying phrase “in a well-functioning economy,” which Cochrane seems to have inserted as a kind of throat-clearing remark, the sort of aside that people are just supposed to hear but not really pay much attention to, that sometimes can be quite revealing, usually unintentionally, in its own way.

What is so striking about those five little words “in a well-functioning economy?” Well, just this. Why, in a well-functioning economy, would anyone care whether a stimulus works or not? A well-functioning economy doesn’t need any stimulus, so why would you even care whether it works or not, much less prove a theorem to show that it doesn’t? (I apologize for the implicit Philistinism of that rhetorical question, I’m just engaging in a little rhetorical excess to make my point a little bit more colorfully.)

So if a well-functioning economy doesn’t require any stimulus, and if a stimulus wouldn’t work in a well-functioning economy, what does that tell us about whether a stimulus works (or would work) in an economy that is not functioning well? Not a whole lot. Thus, the bread and butter models that economists use, models of how an economy functions when there are no frictions, expectations are rational, and markets clear, are guaranteed to imply that there are no multipliers and that Ricardian equivalence holds. This is the world of a single, unique, and stable equilibrium. If you exogenously change any variable in the system, the system will snap back to a new equilibrium in which all variables have optimally adjusted to whatever exogenous change you have subjected the system to. All conventional economic analysis, comparative statics or dynamic adjustment, are built on the assumption of a unique and stable equilibrium to which all economic variables inevitably return when subjected to any exogenous shock. This is the indispensable core of economic theory, but it is not the whole of economic theory.

Keynes had a vision of what could go wrong with an economy: entrepreneurial pessimism — a dampening of animal spirits — would cause investment to flag; the rate of interest would not (or could not) fall enough to revive investment; people would try to shift out of assets into cash, causing a cumulative contraction of income, expenditure and output. In such circumstances, spending by government could replace the investment spending no longer being undertaken by discouraged entrepreneurs, at least until entrepreneurial expectations recovered. This is a vision not of a well-functioning economy, but of a dysfunctional one, but Keynes was able to describe it in terms of a simplified model, essentially what has come down to us as the Keynesian cross. In this little model, you can easily calculate a multiplier as the reciprocal of the marginal propensity to save out of disposable income.

But packaging Keynes’s larger vision into the four corners of the Keynesian cross diagram, or even the slightly more realistic IS-LM diagram, misses the essence of Keynes’s vision — the volatility of entrepreneurial expectations and their susceptibility to unpredictable mood swings that overwhelm any conceivable equilibrating movements in interest rates. A numerical calculation of the multiplier in the simplified Keynesian models is not particularly relevant, because the real goal is not to reach an equilibrium within a system of depressed entrepreneurial expectations, but to create conditions in which entrepreneurial expectations bounce back from their depressed state. As I like to say, expectations are fundamental.

Unlike a well-functioning economy with a unique equilibrium, a not-so-well functioning economy may have multiple equilibria corresponding to different sets of expectations. The point of increased government spending is then not to increase the size of government, but to restore entrepreneurial confidence by providing assurance that if they increase production, they will have customers willing and able to buy the output at prices sufficient to cover their costs.

Ricardian equivalence assumes that expectations of future income are independent of tax and spending decisions in the present, because, in a well-functioning economy, there is but one equilibrium path for future output and income. But if, because the economy not functioning well, expectations of future income, and therefore actual future income, may depend on current decisions about spending and taxation. No matter what Ricardian equivalence says, a stimulus may work by shifting the economy to a different higher path of future output and income than the one it now happens to be on, in which case present taxes may not be equivalent to future taxes, after all.

About Me

David Glasner
Washington, DC

I am an economist in the Washington DC area. My research and writing has been mostly on monetary economics and policy and the history of economics. 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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