After year or so of beating his fiscal stimulus drum, Paul Krugman is finally starting to pound on his monetary policy drum. It is about time. There is reason to believe that had influential observers like Krugman been making the case sooner for unconventional monetary policy that aims to shape expectations–versus Ben Bernanke’s narrow focus on “credit easing”–we would not be currently discussing the imminent threat of deflation. As I mentioned in my previous post, the one time unconventionally monetary policy was truly tried it was very effective. Krugman himself admitted last year that the first-best option for a situation like ours today is not fiscal policy but unconventional monetary policy:
The first-best answer — that is, the answer that economic models, like my old Japan’s trap
analysis, suggest would be optimal — would be to credibly commit to higher inflation, so as to reduce real interest rates.
But the key thing to recognize about this answer is that it’s all about expectations — the central bank only has traction over expected inflation to the extent that it can convince people that it will deliver that inflation after the liquidity trap is over. So to make this policy work you have to (i) convince current policymakers that it’s the right answer (ii) Make that argument persuasive enough that it will guide the actions of future policymakers (iii) Convince investors, consumers, and firms that you have in fact achieved (i) and (ii)
So why has Krugman been pushing expansionary fiscal policy so heavily up til now? Here is his answer:
So some readers have asked why I’m not making the same arguments for America now that I was making for Japan a decade ago. The answer is that I don’t think I’ll get anywhere, at least not until or unless the slump goes on for a long time. OK, so what’s next? The second-best answer would be a really big fiscal expansion, sufficient to mostly close the output gap.
In short, Krugman settled for a second-best economic solution because he thought it was a first-best political solution. So much for that strategy. I should not complain too much, though. He seems to be getting on board now and for that I am grateful. Here he is making the case for unconventional monetary policy in his latest column:
But here we are, visibly sliding toward deflation — and the Fed is standing pat.
What should it be doing? Conventional monetary policy, in which the Fed drives down short-term interest rates by buying short-term U.S. government debt, has reached its limit: those short-term rates are already near zero, and can’t go significantly lower. (Investors won’t buy bonds that yield negative interest, since they can always hoard cash instead.) But the message of Mr. Bernanke’s 2002 speech was that there are other things the Fed can do. It can buy longer-term government debt. It can buy private-sector debt. It can try to move expectations by announcing that it will keep short-term rates low for a long time. It can raise its long-run inflation target, to help convince the private sector that borrowing is a good idea and hoarding cash a mistake.
Keep beating that drum Krugman.