First let me relay Peter Klein’s take on the Fed’s non-taper announcement:
The above is a good summary of the Rothbardian view on our current situation.
Now, there have been some developments in just the last week or so that, in a just world, would cause severe angst in the psyches of those who have been blaming the Great Recession on inadequate demand.
First, there’s David Laidler’s surprising interview with Russ Roberts. Laidler is as old school monetarist as they come; he actually helped Friedman and Schwartz with their famous Monetary History that overturned the then-prevailing Keynesian explanation of the 1930s, and got economists thinking that the Fed committed a sin of omission. The omnipresent (on the Internet) von Pepe sent me the interview and drew my attention to the implications for poor Scott Sumner. Consider these excerpts:
Russ: And I would say especially if it originates in the financial sector. There’s some debate–you allude to it in your writing–about what I would call the ‘real side’ or the microeconomics side. And you point out that the Austrian view, the idea that both the 1929 collapse and the current mess did see a very rapid run-up on asset prices that suddenly collapsed; and that obviously caused some challenges for the financial sector.
Guest [David Laidler]: Yeah. I mean, that’s right. People keep calling these things ‘financial crises’. They are really asset market crises. And they happen on the margin between markets for financial assets and markets for real assets. Like real estate and factories and physical investment. I don’t think the monetarist story of the onset of the Great Depression by the way, or the monetarist story about the onset of this Great Recession, is quite plausible enough. I can’t find anything in the data in the 1920s or the data in the run-up to this event, that shows a degree of sort of conventional tightening of money growth that can account for the speed of the subsequent downturn. That really looks like, in both cases, an economy where something was going badly wrong in real asset markets, and it just needed a little bit of tap from the financial markets to set a downward spiral going. And, you’re right–the Austrians were the pioneers of this kind of analysis, in the 1920s even; and of course there are still Austrians around. And if I may sort of put in a plug for Cambridge, England, where John Maynard Keynes was, Keynes’s colleague, Sir Dennis Robertson was developing a parallel analysis to this in the 1920s. And he wrote a little textbook; and its 1928 edition has got a couple of paragraphs expressing his fears about what was likely to happen in the United States if that asset market boom kept on going. And this was before the Great Depression and before the stock market crash. In contrast, the representative of monetarism in the United States in the 1920s was probably Irving Fisher; and Irving Fisher didn’t see anything coming. He was just concentrating on the behavior of the price level and saying all is well, right down to October 1929. And indeed afterwards. So, I think we’ve got to give the Austrians and Dennis Robertson some credit. And I’d like to see our profession start taking that analysis a little bit more seriously. I mean the mainstream of our profession; because of course the people who have been propounding it are certainly professionals themselves. But they are in a minority.
And the part that excited von Pepe:
Russ: So, you think it’s much more than just a monetary phenomenon.
Guest: Yeah, I do. I never thought I would live to say this, but on this particular instance, I’m inclined to line up with the Austrians. I think they really have a point about this issue, about asset market distortions. After long periods of monetary stability.
Russ: This again puts you in a small group of economists who have learned something from the crisis. Most economists–I find it remarkable how many people have managed to keep their theological views unchanged by this experience.
Guest: Well you must remember that I’m retired, so I don’t have to worry about pleasing journal editors any more.
Russ: Yeah. Well, no comment. What would be your view on, going forward, would be the ideal monetary policy? Should we be doing something like the Taylor rule? Do you think anything positive about Scott Sumner’s approach and that of others who argue for nominal GDP targeting? Milton at one point–he changed sometimes, but he argued for a steady growth rate in the rate of money. Where do you think we are right now?
Guest: Let me back up. Let’s think about a state of affairs in which we are out of the aftermath of the recession. So, two or three years more down the path. I still am pretty happy with the inflation rate as the target of policy. I base this a lot on Canadian experience. We’ve been targeting the inflation rate since 1991; we’ve done it pretty successfully. We didn’t have a big asset market crisis here. We had not had a recession until 2008 since 1991. So inflation targeting worked pretty well for us. And it worked I think because it was a very explicit policy target agreed between the government and the Bank of Canada. It wasn’t an informal thing, as it was in the Fed. It was discussed continually. And as time passed, the targets were hit and it gained in credibility. So I would see no reason to go from that to a nominal GDP target. I don’t like nominal GDP as a target for policy, for the simple reason is: that’s a variable that’s measured with a lag and it’s subject to a lot of revision. And I don’t see how you can run forward-looking monetary policy targeting the behavior of a variable that you don’t get a good reading on for 18 months after it’s happened. With inflation targeting based on a Consumer Price Index, you get timely data and it’s not subject to revision. The indices are not perfect, but they are well understood by policy makers and the general public understands them as well. If I tell my wife the Bank of Canada is targeting nominal GDP, she’ll just look at me and wonder what on earth I’m talking about. If I tell her they are telling her they are targeting the rate at which the cost of living goes up, she understands that. And knowing that there is that target out there affects the behavior of ordinary consumers and producers, not just financial markets.
However, as exciting as it is to see Laidler throw Market Monetarism under the bus, what’s really got my attention is John Cochrane’s paper castigating the liquidity trap. At times like this, I wish I were a tenured college professor, because if Cochrane actually did what he claims to have done, this is absolutely devastating to both Krugman and Sumner. First Cochrane sets up the context:
New-Keynesian models produce some stunning predictions of what happens in a “liquidity trap” when interest rates are stuck at zero. They predict a deep recession. They predict that promises work: “forward guidance,” and commitments to keep interest rates low for long periods, with no current action, stimulate the current level of consumption. Fully-expected future inflation is a good thing. Growth is bad. Deliberate destruction of output, capital, and productivity raise GDP. Throw away the bulldozers, let them use shovels. Or, better, spoons. Hurricanes are good. Government spending, even if financed by current taxation, and even if completely wasted, of the digging ditches and filling them up type, can have huge output multipliers.
Even more puzzling, new-Keynesian models predict that all of this gets worse as prices become more flexible. Thus, although price stickiness is the central friction keeping the economy from achieving its optimal output, policies that reduce price stickiness would make matters worse.
In short, every law of economics seems to change sign at the zero bound. If gravity itself changed sign and we all started floating away, it would be no less surprising.
And of course, if you read the New York Times, people like me who have any doubts about all this are morons, evil, corrupt, and paid off by some vast right-wing conspiracy to transfer wealth from the poor to the secret conspiracy of hedge fund billionaires.
OK, now on to the devastation (if true):
So I spent some time looking at all this.
It’s true, the models do make these predictions. However, there is a crucial step along the way, where they choose one particular equilibrium. There is another equilibirum choice, where all of normal economics works again: no huge recession, no huge deflation, and policies work just as they ought to.
So Cochrane first shows that he knows how to reproduce Krugman’s (and Sumner’s, mind you) favored outcome: Cochrane can use a New Keynesian model to produce an economy in a perverse equilibrium in which big deficits help, and even the Fed just promising to be irresponsible in the future (without doing anything today) can help. Thus, you could use such a model to justify Bernanke’s rounds of QE and Obama’s stimulus package. People like Eugene Fama, John Cochrane, and little old me are shown to be complete fools. What’s even crazier, is that even though “sticky wages and prices” are the reason you get equilibrium unemployment in a New Keynesian model, Cochrane can reproduce Krugman’s claimed result that making prices and wages less sticky (though not perfectly flexible) will just deepen the slump.
However, Cochrane then uses the same models and finds that there are different equilibria, where all the rules of Henry Hazlitt (my term, not his) apply:
The paper shows that all the magical policies are absent in this equilibrium: The multiplier is always negative, announcements about the far off future do no good, and deliberately making prices sticker doesn’t help.
These are not different models. These are not different policies or different expected policies. Interest rates follow exactly the same path in each case, zero from t until T=5, and following the natural rate thereafter. These are different equilibrium choices of the same model. Each choice is completely valid by the rules of new-Keynesian models. I don’t here challenge any of the assumptions, any of the model ingredients, any of the rules of the game for computation. Which outcome you choose is completely arbitrary.
The difference between the calamitous equilibrium and the mild local-to-frictionless equilibirum, in this model, is just expectational multiple equilibria (with an implicit Ricardian regime.) If people expect the inflation glide path, we get the benign equilibrium. If they expect inflation to be zero the minute the trap ends, we get the disaster.
I won’t quote him, but Cochrane goes on to say that if you’re trying to use empirical evidence to decide which equilibrium we’re currently in, then the Krugman story implies very large (price) deflation during the liquidity trap, whereas the “Treasury View” (aka classical economics aka full-employment economics aka “micro 101”) only works if we assume there have been impediments to the supply side since 2008. Hmm, can anybody think of any government policies that would hamper the economy since 2008?
And then, just to make sure we all agree that the interventionist New Keynesian approach “predicts” price deflation for times like ours, here’s Krugman commenting just yesterday nonchalantly on David Romer’s class notes:
I’ve mentioned David Romer’s nice formulation of modern applied macro — the way people actually think, as opposed to the intertemporal maximization with whipped cream that’s respectable. David now informs me that he has a set of publicly available class notes (pdf) that have been regularly updated, covering that ground even better — with an extensive section on the liquidity trap.
Romer’s notes still imply that a protracted liquidity trap should lead to accelerating deflation, which doesn’t seem to happen; I think most of us have turned to downward nominal wage rigidity as an explanation. In any case, this is more or less the state of the practical art, and I’m delighted to learn that he’s put it together.
Everyone catch the part I put in bold? The “state of the practical art”–you know, the approach that has blown the Austrians and austerians out of the water for its superior predictive ability–predicted accelerating deflation, according to Krugman. (NB, I think Cochrane’s NK model instead predicted an initially huge price deflation, which gradually shrinks as the liquidity trap continues. Not sure why there is a discrepancy, or maybe I’m misunderstanding.) But no worries, Krugman et al. just patched that up by turning to “downward nominal wage rigidity as an explanation.”
So, from now on, whenever any Keynesian guffaws at my inflation worries, I’m going to say, “I’m a scientist. In light of the new data, I realized that in 2009 I gave insufficient weight to the inertia in CPI, which I call the ‘ceiling friction coefficient.’ Other than that, my model came through with flying colors.”