06 Nov 2009

Krugman Gains the Upper Hand…And Then Sumner Flips Him

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Whoa this was a good exchange. I read Krugman’s blog post on people abusing MV=PY and totally understood where he was coming from. But then I read Scott Sumner and he destroyed Krugman. The only parts I objected to in Scott’s response were:

(1) Scott says that he doesn’t even understand what Krugman is talking about in the beginning, when I for one certainly “got” Krugman’s take on people using MV=PY inappropriately. Not only did I get it, I was nodding my head in agreement.

(2) Scott maintains that the Freako guys were not trying to cast doubt on climate models by bringing up the global cooling scare in the 1970s, when of course that’s what they were doing. (And I don’t necessarily fault them for it, by the way. I just wish they’d stop pretending that that’s not the impression they were trying to convey.)

Anyway if you are not a trained macroeconomist and are lost in the details of this exchange, let me summarize: Krugman keeps pointing to his 1998 work and his “aha!” moment when studying the case of Japan. He keeps telling us (now) that he realized monetary policy doesn’t work in a liquidity trap, and that’s why you need more fiscal stimulus.

But as Scott points out, Krugman is full of it. If you go and actually read the 1998 paper, it’s not an argument for running budget deficits–it’s an argument for promising future inflation! And I actually heard Krugman give a talk at NYU on this very topic. (I don’t remember the exact year, but I think 1999 or 2000.)

And I can confirm that Krugman’s moral was this: He told the Bank of Japan that it could fix its problems by credibly promising to cause future price inflation. Because nominal interest rates were stuck at the 0% lower bound, the “answer” (Krugman said) was to raise the expected future price level, so that the real interest rate could be pushed more and more negative, where it needed to be in order to restore full employment.

I don’t remember Krugman saying one word about budget deficits. Of course he may have discussed them, but that was clearly not the point of the talk. No, the whole point was that the model showed him something he hadn’t thought of: that the monetary authorities had more options at their disposal once the target hit zero, because they could promise to inflate in the future and thereby affect the current expected real interest rate.

And so to repeat, Krugman keeps pointing to this eureka moment as proof that he’s known since 1998 that monetary policy doesn’t work when interest rates hit zero. (!!!!!)

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