Wars make people think and do stupid things. So does deflation caused by tight money. The intellectual low point of 20th century macro occurred in 1938, when a promising recovery in 1936 turned into renewed depression and deflation. Interest rates fell to zero, feeding the view that money was irrelevant. A 1938 EJ article by Joan Robinson provides a good example of the 1938 zeitgeist. Here she criticizes Bresciani-Turroni’s argument that the German hyperinflation was caused by the German government printing too much money:
“An increase in the quantity of money no doubt has a tendency to raise prices, for it leads to a reduction in the rate of interest, which stimulates investment and discourages saving, and so leads to an increase in activity. But there is no evidence whatever that events in Germany followed this sequence.”
So easy money couldn’t possibly have caused the German hyperinflation because German interest rates were not very low. And everyone knows that easy money is associated with low interest rates. I won’t insult the intelligence of my readers by explaining what is wrong with her reasoning.
But perhaps we shouldn’t be too hard on poor Joan Robinson. Unlike some of the more wimpy Keynesians, she at least had the courage of her convictions. If interest rates are the right indicator of monetary policy; then doggone it money must have been really tight in Germany during the early 1920s. Let’s not be distracted by a few wheelbarrows full of cash.
Fortunately, after WWII economics gradually crawled out of this intellectual morass. Friedman and Schwartz explained how money was actually very tight in the 1930s, despite the low interest rates. By the 1980s the new Keynesians had acknowledged that interest rates were not a good indicator of the stance of monetary policy. The best selling money textbook (Mishkin, p. 606) informed students that:
“It is dangerous always to associate the easing or the tightening of monetary policy with a fall or a rise in short-term nominal interest rates.”
For a while it seemed all was well with macroeconomics. It was a golden age of inflation targeting; the Great Moderation of 1982-2007. And then Fed policy lost credibility and we slipped into deflation. Deflation always brings out the worst in economists. We started to hear that opportunity costs didn’t matter—there were free lunches out there waiting to be consumed. And suddenly interest rates again started to be good indicators of monetary policy. A few days ago I even saw an example in Krugman’s blog. He posted a graph showing that the fed funds rate is negatively correlated with unemployment (i.e. is procyclical.) Then he argued that we shouldn’t view the recent rise in unemployment as evidence fiscal stimulus doesn’t work, after all we don’t view the recent rise in unemployment has evidence that monetary stimulus doesn’t work. What was his evidence that monetary stimulus had been tried? Low interest rates!
Of course, we all understand that the correlation runs the way it does because the Fed cuts rates in an effort to fight recessions.
But here’s the thing: a lot of people are asserting that because unemployment has risen along with the budget deficit, fiscal expansion has failed or even made things worse. Why don’t we apply the same standards to monetary policy?
BTW, is it really true that interest rates fall in recessions because the Fed cuts them? Why did rates fall in recessions before there was a Fed?
It seems to me that Krugman is moving further and further away from the sort of new Keynesian research he did back in the 1990s. Consider the following progression from new Keynesianism to the crudest version of 1930s style Keynesianism:
1. In the late 1990s Krugman develops an explanation of the Japanese liquidity trap based on rational expectations theory. He suggests that fiscal stimulus leads to “bridges to nowhere,” and recommends that the BOJ adopt an explicit inflation target.
2. Then Krugman seems to have some doubts about whether monetary stimulus can be effective in Japan. He discusses how an expectations trap can form if a central bank has a conservative reputation and cannot convince the markets that a monetary stimulus will be permanent. Monetary policy is still highly effective, but only if expected to be permanent.
3. Then he starts leaving expectations out of his analysis. Now we are back in the 1930s where swapping cash for zero interest T-bills has no effect. “Period. End of story.”
4. And then a few days ago he started arguing that low interest rates indicate that the stance of monetary policy is expansionary. Now he is back in Joan Robinson’s world. Tight money couldn’t have caused the crash of 2008; after all, interest rates were low! Perhaps in a few weeks we can expect a graph showing the correlation between interest rates and inflation in the German hyperinflation, disproving the theory that easy money was to blame. And let’s not forget the high inflation of the 1970s; the cause couldn’t possibly have been easy money, weren’t interest rates really high in the 1970s?
This progression reminds me of the scene in 2001 where the astronauts are deprogramming the HAL 9000. Krugman’s new Keynesian intellectual components seem to be disappearing one at a time.[Let’s just hope his next post doesn’t start out Daisy, Daisy . . . ]
No sooner did I finish writing this vicious smear of our newest Nobel Prize winner than I realized it was all a horrible mistake. Krugman’s not the one who’s lost his marbles, I am. Or at least I think that is the only plausible explanation. I’ll lay out the evidence, and you decide which view seems more likely.
This morning I noticed that I was linked to by a blogger way over in England. It seems he wanted to find an economist who was crazy enough to think that Fed policy has recently been tight, despite the low interest rates, and I was the only one he could think of. You’ll have to admit that it would be odd to cite an authority as obscure as me, if there were more famous economists making the same point. Here is what Leigh Caldwell said:
Scott Sumner has argued that money did become tighter later in the decade, more so than signified by interest rate movements; if true this could be one reason that asset prices are not recovering despite very low interest rates
Despite very low interest rates? Wait a minute, I though asset prices were usually low when rates were low, and high when rates were high. High rates and high asset prices in 1929, low rates and low asset prices 1932. Ditto for 2000 and 2002, and ditto for 2007 and 2009. Why the term ‘despite,’ I thought my view was conventional wisdom?
Now I’m starting to feel like Kevin McCarthy in the film Invasion of the Body Snatchers. Have I “misremembered” my history of progress in 20th century macro? Has some quantum fluctuation plunged me into a parallel universe where post Keynesian theory accurately describes the laws of macroeconomics?
I try to remain dispassionate and look at things logically. What are the odds that some pod-people from space have not only rewired Paul Krugman’s brain, but that of most other macroeconomists? Isn’t it more likely that I am going crazy? Like a character in a Borges story, I am now afraid to open Mishkin’s textbook, for fear that the passage I remember may not be there. If you see a tall thin guy at the Harvard or MIT economics parking lots, jumping on the windshields of cars, please call the appropriate authorities.