26 Aug 2010

You Win Some, You Lose Some: Krugman Lives to Fight Again

Financial Economics 10 Comments

I was suspicious when I read this Krugman blog post defending the current near-zero fed funds rate. Krugman used a “Mankiw Rule” (similar to the Taylor Rule) to argue that we weren’t in a bond bubble, because the economy actually “wants” negative nominal rates right now.

Now the Taylor Rule (and related Mankiw Rule) give a quick and dirty guide to how the Fed should set its target interest rate. It’s a tradeoff between price inflation and unemployment. If unemployment is high, the Fed should set a low interest rate, but if price inflation is high, the Fed should set a high interest rate.

I thought I was going to be able to nail Krugman, because during the housing boom years consumer price inflation wasn’t particularly bad. In fact, people were screaming about “deflation” in the early 2000s. So I thought that if I used Krugman’s own numbers, I could “prove” that Alan Greenspan’s Fed wasn’t setting interest rates too low during the housing boom years (because price inflation was tame).

Alas, the numbers didn’t work out for me. Since I obviously am not going to write up a big article saying, “Krugman’s method is a non sequitur, although even it would have known Greenspan was nuts…” I at least thought I should show the results here:

10 Responses to “You Win Some, You Lose Some: Krugman Lives to Fight Again”

  1. Daniel Hewitt says:
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    First, if the Fed’s actual rate followed the Mankiw Rule that closely, this should serve as a warning how messed up “modern macro” is. Your post illustrates that clearly!

    Second, both unemployment and inflation are creations of the governemnt. What a joke that we trust the government with finding the optimum balance between the two.

    • bobmurphy says:
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      Well, over a longer period, the two are going to match perfectly. The “Mankiw Rule” isn’t based on some a priori prescription; it’s rather an ex post description of what the Fed actually did.

  2. Fogwa says:
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    So is Krugman actually advocating driving interest rates down to -7%?

    • bobmurphy says:
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      Yes. Nominal rates can’t go below 0%, so Krugman thinks the Fed should credibly promise to generate high price inflation to get real rates down to that level.

      However, there are various practical problems with doing this (I can’t remember his exact reasoning), and so Krugman thinks the Congress should just be adults and run up the deficit another trillion or so.

  3. Ben says:
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    The whole target rate thing is meaningless. When you set policy based on CPI numbers, that policy directly fails to target anything that the CPI excludes….cough…cough….housing prices. So yes, interest rates were too low because the methodology used to determine that completely ignored housing prices to begin with. Had anyone cared to notice that housing prices were growing out of control, raising interest rates, instead of setting them at 1%, would have been a no brainer.

  4. von Pepe says:
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    “…because during the housing boom years consumer price inflation wasn’t particularly bad. In fact, people were screaming about “deflation” in the early 2000s. So I thought that if I used Krugman’s own numbers, I could “prove” that Alan Greenspan’s Fed wasn’t setting interest rates too low during the housing boom years (because price inflation was tame).”

    OK, consumer prices were tame…and housing prices skyrocketed. So, was there inflation?

  5. bobmurphy says:
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    Just to be clear, everybody, I am NOT endorsing Taylor or Mankiw’s Rules. I am just saying, I thought I might be able to beat Krugman at his own game, but it didn’t turn out that way. So if we want to criticize the Mankiw Rule, we can’t say, “It would have said Greenspan did the right thing with rates during the housing bubble years.”

  6. Lucas M. Engelhardt says:
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    Well, that may “prove” that the 2.6% interest rate isn’t far off right now. But, I don’t think it proves that bond prices won’t come crashing down in the next 6 years. If the 10-yr Treasury rate goes from 2.6% to 4.5%, bond prices have to fall by 30ish % (making certain assumptions about the coupon rate, getting closer to maturity, blah blah blah). Is what we have today a “bubble”… maybe not, technically. But, there will certainly be losses in the bond market if Krugman’s projections are right.

    That’s a point that I read in the Wall Street Journal not too long ago. A lot of these bonds are so high priced that, even if you hold them to maturity, you lose money. Bubble or not, that should strike people as odd.