A Slightly Off-Center Perspective on Monetary Problems

By Jul 21, 2011, 7:54 AM Author's Blog  

I’m not sure whether I should be amused or frustrated by watching a Nobel Prize winner (and two people who didn’t win, but deserved to) talk past each other for two years.  Their misunderstanding is blindingly obvious, but I don’t ever see any acknowledgement.  As you know, two years ago Paul Krugman accused Eugene Fama and John Cochrane of not understanding the most basic principles of macroeconomics, the fact that fiscal stimulus can boost AD, and thus boost the level of output when there is economic slack.

And Paul Krugman keeps making this charge over and over again, despite the fact that it is clearly false (at least for Cochrane and Barro, and probably Fama as well.)  It’s true that you can cherry pick quotations that make it seem like the three deny the possible that fiscal stimulus can work, almost as a matter of logic.  If that was their entire argument, then it would be shockingly uninformed.  But both Cochrane and Barro clearly indicate that they are holding nominal aggregates constant, i.e. any shortfall in NGDP would presumably be fixed by printing money, leaving no role for fiscal stimulus.  Of course that’s also my argument, yet I do believe fiscal stimulus might be able to boost NGDP, because I don’t believe (as a matter of logic) that the Fed would necessarily create the right amount of money.  (I’m skeptical of fiscal stimulus for “likely Fed response” reasons, not as a matter of logic.)

It’s actually really simple to prove my point, as Krugman criticized a Fama and Cochrane article, and Eugene Fama links to the same Cochrane article, and also a Barro article for support.  So what do Barro and Cochrane say in their articles that Fama cites with approval?  Here’s Robert Barro:

John Maynard Keynes thought that the problem lay with wages and prices that were stuck at excessive levels. But this problem could be readily fixed by expansionary monetary policy, enough of which will mean that wages and prices do not have to fall. So, something deeper must be involved — but economists have not come up with explanations, such as incomplete information, for multipliers above one.

And here’s John Cochrane:

My first fallacy was “where does the money come from?” Well, suppose the Government could borrow money from people or banks who are pathologically sitting on cash, but are willing to take Treasury debt instead.  Suppose the government could direct that money to people who are willing to keep spending it on consumption or lend it to companies who will spend it on investment goods. Then overall demand for goods and services could increase, as overall demand for money decreases.  This is the argument for fiscal stimulus because “the banks are sitting on reserves and won’t lend them out” or “liquidity trap.”

In this analysis, fiscal stimulus is a roundabout way of avoiding monetary policy. If money demand increases dramatically but money supply does not, we get a recession and deflation. If we want to hold two months of purchases as money rather than one months’s worth, and if the government does not increase the money supply, then the price of goods and services must fall until the money we do have covers two months of expenditure. People try to get more money by spending less on goods and services, so until prices fall, we get a recession. This is a common and sensible analysis of the early stages of the great depression. Demand for money skyrocketed, but the Fed was unwilling or, under the Gold standard, unable, to increase supply.

This is not a convincing analysis of the present situation however. We may have the high money demand, but we do not face any constraints on supply. Yes, money holdings have jumped spectacularly. Bank excess reserves in particular (essentially checking accounts that banks hold at the Federal Reserve) have increased from $2 billion in August to $847 billion in January. However, our Federal Reserve can create as much more money as anyone might desire and more. There is about $10 trillion of Treasury debt still outstanding. The Fed can buy it. There are trillions more of high quality agency, private debt, and foreign debt outstanding. The Fed can buy that too. We do not need to send a blank check to, say, Illinois’ beloved Governor Blagojevich to spend on “shovel-ready” projects, in an attempt to reduce overall money demand. If money demand-induced deflation is the problem, money supply is the answer.

Some people say “you can’t run monetary policy with interest rates near zero.” This is false. The fact of low interest rates does not stop the Fed from simply buying trillions of debt and thereby introducing trillions of cash dollars into the economy. Our Federal Reserve understands this fact with crystal clarity. It calls this step “quantitative easing.” If Fed ignorance of this possibility was the problem in 1932, that problem does not face us now.

So they are both basically saying; “Of course if the problem is nominal, then monetary policy can fix it much more easily.  But I don’t think it’s nominal.  And if we hold nominal spending constant, fiscal policy can’t fix it.”  And that’s true, even within the Keynesian model. Fiscal stimulus can do nothing if the Fed has got NGDP where it wants it.

[BTW, Barro's claim that Keynes assumed prices were sticky is a side issue.  I think Barro is right, but even if wrong it doesn't invalidate his argument at all.  Keynes certainly assumed higher NGDP was a necessary condition for fiscal stimulus to work.]

Needless to say I think Barro and Cochrane are wrong about the need for monetary stimulus, but it’s really rather sad when people like Krugman and Brad DeLong keep insisting that these guys don’t understand basic macro principles.  Krugman and DeLong are both very bright, and they have access to the same information I just presented to you.  Why do they ignore it?

Of course I don’t know for sure that Fama was using the same implicit assumption as Cochrane and Barro.  But earlier in the article Cochrane made the fiscal policy can’t work argument without the stable NGDP qualifier, so I think it quite likely that Fama was also cutting corners.

Lots of brilliant people talking past each other.  Lacking a common language for communication.  Welcome to elite macroeconomics, circa 2011.

The right doesn’t think we need more NGDP and the left doesn’t understand that the Fed is our only realistic hope for more NGDP.  Welcome to elite macroeconomics, circa 2011.

If I was going to assign blame I’d single out Krugman/DeLong for rudeness and Fama/Cochrane for poor communication skills.  But of course I have no business attacking such distinguished economists.

PS.  I’ve avoided talking about the debt ceiling thus far, partly because I don’t know much about it, partly because these things always seem to get resolved at the last minute, but mostly because the whole idea of a debt ceiling seems incredibly stupid.  This morning when I woke up up the first thing I heard was that the Gang of Six had agreed to massive spending cuts, abolition of the hated AMT, and reduction of the top rate to between 23-29%.  Oh, and a slash in the corporate top rate too.  I thought I was dreaming.  Surely this is too good to be true!  And then I heard that Obama endorsed the plan.  Now I knew I was dreaming.  Then I heard that it wouldn’t pass because of GOP opposition in the House.  Ouch, I was brutally shaken out of my reverie.  If only life could be like our dreams.  Unfortunately, there’s always the House GOP to keep it real.

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