Effective Monetary Policies are All Alike, Every Ineffective Policy is Ineffective in Its Own Way

More than 100 years ago Tolstoy got to the heart of what’s wrong with Keynesianism.  I don’t know why it took me so long to figure it out.

An effective monetary policy will steer NGDP growth at a fairly steady rate, such as the roughly 5% growth we experienced during the Great Moderation.  But suppose we don’t have effective monetary policy, what then?  Then we have Keynesian economics.

Keynesian economics purports to explain how all sorts of stuff will impact AD, which is roughly NGDP.  (NGDP and AD aren’t always defined as being identical, but in most standard Keynesian models than move in the same direction.)

Thus a change in business animal spirits, fiscal policy, consumer optimism, mortgage lending, the trade balance, etc, etc, will impact AD, according to the Keynesian model.  But if we have an effective monetary policy it will not affect AD.  I don’t think that’s very controversial.

Here’s where it gets controversial.  Many people will say; “but we don’t have an effective monetary policy, so the Keynesian model is valid.  The Fed won’t offset those real demand shocks; hence the shocks will end up moving AD.”

There are three problems with this Keynesian view.  First, as we saw during the Great Moderation, one cannot assume the Fed won’t offset the “non-monetary” demand shocks.  Quite often they did so, and very effectively.

But let’s say I’m wrong, and monetary policy is incompetent.  Even that doesn’t save the Keynesian model.  Because their next step is to assume “other things constant.”  They hold monetary policy constant when considering the impact of some expenditure shock in one of the economy’s sectors.  But you can’t hold monetary policy constant, because the entire concept is meaningless.  You can hold interest rates constant, or exchange rates constant, or M2 constant, or the monetary base constant, or TIPS spreads constant, or you can assume we constantly adhere to the Taylor Rule.  But there is no such thing as “monetary policy held constant.”  The term is hopelessly vague, and means different things to different people.

And of course even if you could hold monetary policy constant, any estimates of the impact of expenditure shocks would be worthless, because monetary policy in the real world would not be held constant, according to any criteria.  The Fed doesn’t hold interest rates constant.  It doesn’t hold M2 constant; it doesn’t hold the exchange rate constant.

There is only one effective monetary policy (stable NGDP growth), but there are a billion ineffective policies.  Policy can fail in a dizzying variety of ways.  And for each inept monetary policy, there is a completely different impact from a given expenditure shock.  That means there are a billion Keynesian models:

  1. There is the Keynesian model if Bernanke runs the Fed, and has three hawks on the FOMC.
  2. There is the Keynesian model if Volcker runs the Fed.
  3. There is the Keynesian model is G. William Miller runs the Fed.
  4. There is the Keynesian model if Bernanke runs the Fed, and there is one hawk on the FOMC.

and so on.

So when people talk about the effect of some “shock to AD, from a redistribution of income from low savers to high savers,” my response is “Huh?”  What are you talking about?  That isn’t science, it’s witchcraft.  How should I know how Bernanke would respond to that?  You convinced me he’s not following effective monetary policy.  So I’ve bought into that part of the Keynesian model.  But I have no idea which ineffective policy he is following.  And when I talk to others I realize that they are absurdly overconfident in their particular Keynesian model, mostly because they are blithely unaware of the problems I just laid out in this post.  And I’m calling out pretty much all the top macroeconomists in my field, including a certain unnamed Nobel Prize winner.

There is one Nobel prize winner I will name; Paul Krugman.  He does sort of understand this problem.  And his particular Keynesian model, his particular “ineffective monetary regime,” is nominal rates stuck as zero and no unconventional monetary stimulus.  Too bad that doesn’t describe our current Fed, or else Krugman’s version of the Keynesian model might have something useful to tell us about the impact of various expenditure shocks.

Just wait till we exit the liquidity tap, then you’ll see me really go ballistic in response to all the Keynesian drivel you see in the press.

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About Scott Sumner 492 Articles

Affiliation: Bentley University

Scott Sumner has taught economics at Bentley University for the past 27 years.

He earned a BA in economics at Wisconsin and a PhD at University of Chicago.

Professor Sumner's current research topics include monetary policy targets and the Great Depression. His areas of interest are macroeconomics, monetary theory and policy, and history of economic thought.

Professor Sumner has published articles in the Journal of Political Economy, the Journal of Money, Credit and Banking, and the Bulletin of Economic Research.

Visit: TheMoneyIllusion

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