It’s always a good day when Paul Krugman throws a nice easy pitch over the fat part of the plate.  In this post commenting on Beckworth he combines all of the worst features of his blog, in one nice package with a bow on top.

Here’s my problem. Underlying the focus on nominal demand or GDP is some notion that there’s a quantity equation:

MV = PY

where M is the money supply, V the velocity of money, P the price level, Y real GDP. And of course this always holds true, by definition. But the temptation is to take it as a causal relationship — to say that real GDP fell because nominal GDP fell, and that this in turn was caused by either a fall in M or a fall in V; and furthermore that any such decline is a failure of monetary policy, because the central bank should have either prevented the fall in M or increased M enough to offset the fall in V.

The second sentence has to be one of the weirdest things I have ever read by a famous economist.  I have no idea the point he is trying to make.  It is essentially saying that underlying the statement that A*B is important is the implication that A*B = M*(A*B/M).  Okay  . . .

The problem in this post is that Krugman confuses the view that falling nominal GDP is a problem, with various monetarist dogmas.  He is essentially saying that if you mention that falling NGDP is the problem, you might be led to think of the MV=PY equation, and that if you even think about the (completely true) MV=PY equation, then you might start thinking about some sort of monetarist dogma that he thinks is false, and that he thinks he proved is false in a 1998 paper, even though the 1998 paper actually shows that the monetarists are completely correct in asserting that a once-and-for-all increase in M will cause PY to increase.  Got that? 

In fact, almost everything Krugman has written on the crisis has implicitly assumed that falling NGDP is precisely the cause of our recession, and that stimulus aimed at boosting NGDP is the solution.  How does he suddenly reach the conclusion that falling NGDP is not the problem?  First he points out that in his 1998 model of liquidity traps the price level is fixed in the short run.  Of course in the real world the price level is not even fixed in the short run, and responds to changes in AD.  But let’s put aside that little objection, and see what the fixed price assumption implies.  If the price level is fixed then movements in RGDP and NGDP are identical.  Thus any policy that effectively prevents a fall in NGDP will also prevent a fall in RGDP.  Of course Krugman has been arguing that fiscal stimulus can do this more effectively than monetary stimulus, but that’s a completely unrelated issue.  Even if fiscal stimulus is the only solution, it would not in any way change the fact that falling NGDP is the cause of our crisis.  A turnaround in NGDP is both a necessary and a sufficient condition for economic recovery in Krugman’s model, and falling NGDP is both a necessary and sufficient condition for any demand-side recession in his fixed-price Keynesian model. 

Even worse, when opponents of the NGDP view have attempted to come up with real explanations of the recession, he has ridiculed those views.   These alternative theories include Kling’s “recalculation hypothesis” which suggests that a recovery in RGDP requires time-consuming and costly restructuring, downsizing, retraining, etc.  If Kling is right then the current recession is not just a shortfall in nominal spending  (as Krugman implicitly assumes in his analysis) but rather represents a real problem.  Kling’s argument and some related Austrian and RBC explanations suggest that higher NGDP might lead to higher inflation rather than more real output.  So if Krugman is contemptuous of all those right-wing “real” explanations of why fiscal stimulus won’t work, how in the world can he claim NGDP is not the problem?  Of course it’s the problem. 

Sometimes it seems like waving MV=PY in front of a Keynesian is like waving a red flag in front of a bull.  It so enrages them that they lose sight of economic logic.  Keynes’s entire General Theory is basically a theory of PY, and hence necessarily a theory of MV.  (In fact V doesn’t have any independent meaning; it’s just PY/M.)  Sure Keynes often assumes fixed prices in the GT, but not always.  And what happens when he relaxes the fixed price assumption, which variable does he see AD affecting, RGDP or NGDP?  The answer is obvious.  Keynes relaxes the assumption at full employment, or what he calls “bottlenecks” in the economy.  If the economy has reached capacity then any further increases in AD continue to cause increases in NGDP, but RGDP no longer rises.  So the General Theory is first and foremost a theory of nominal income determination.  The impact of AD on RGDP is entirely contingent on the slope of the SRAS curve.   For the millionth time, the equation MV=PY has zero monetarist implications, and that’s doubly true for the concept of nominal GDP. 

Now let’s look at the more important part of Krugman’s post, his argument that money can’t save us now, and that this result was proved in his 1998 paper, which he increasingly describes as a sort of a road to Damascus moment in his intellectual career.  There is just one little problem with this story, the article he cites makes the opposite argument from what he keeps claiming in these posts that link to it.  It claims monetary policy can be effective in a liquidity trap, and that an appropriate monetary strategy seems a more promising option than fiscal stimulus.  First let’s see what he says in the article, and then figure out what’s really going on.

In his 1998 paper there is only one type of monetary stimulus that is ineffective, a temporary currency injection.  Some Krugman defenders will undoubtedly say “well he did concede in his blog that unconventional monetary strategies might work, but they could be risky, etc.”  But the problem with that argument is that his 1998 paper says that the most conventional, the most garden-variety monetary strategy imaginable will in fact be highly effective in a liquidity trap.  What is the most basic plain vanilla monetary policy?  Think about the simple thought experiment that most monetary theory courses use to motivate the discussion.   They begin with a once-and-for-all 10% increase in the money supply.  You can’t be much more basic than that.  Increase the money supply and then leave it at the new and higher level.  And in Krugman’s 1998 model that sort of one-time policy shock would be highly effective, even in a liquidity trap.  So how does he get the monetary policy ineffectiveness result?  By assuming that a current increase in the money supply has no effect on the future expected money supply:

A good way to think about what happens when money becomes irrelevant here is to bear in mind that we are holding the long-run money supply fixed at M*, and therefore also the long-run price level at P*. So when the central bank increases the current money supply, it is lowering the expected rate of money growth M*/M

In other words he makes an assumption (analogous to Ricardian equivalence in fiscal stimulus) that monetary injections are expected to be temporary.  But that doesn’t mean monetary policy is ineffective in a liquidity trap, it just means that a silly and misguided strategy might be ineffective in a liquidity trap.  Elsewhere I give Krugman credit where credit is due, the Fed has adopted exactly that misguided strategy, promising to pull the recent base injections out of circulation long before NGDP returns to its previous trend line.  But it didn’t have to be that way, they could have followed the monetary strategy that Krugman recommended in his 1998 paper.  He should be using his column to bash Bernanke, not praise him.  Take a look at this passage from 1998, and notice how Krugman first considers the pros and cons of fiscal stimulus, and then ends up suggesting that monetary policy is more promising:

Fiscal policy: The classic Keynesian view of the liquidity trap is, of course, that it demonstrates that under some circumstances monetary policy is impotent, and that in such cases fiscal pump-priming is the only answer. The framework here is rather different in its implications for monetary policy, but it does suggest that fiscal expansion could work. Obviously the model is subject to Ricardian equivalence, so that tax cuts would have no effect. But government purchases of goods and services in the first period, while they would be partly offset by a reduction in private consumption expenditures, could indeed increase demand and output.

While this policy could work, however, is it the right one for Japan? Japan has already engaged in extensive public works spending in an unsuccessful attempt to stimulate its economy. Much of this spending has been notoriously unproductive: bridges more or less to nowhere, airports few people use, etc.. True, since the economy is demand- rather than supply-constrained even wasteful spending is better than none. But there is a government fiscal constraint, even if Japan has probably been too ready to use it as an excuse. And anyway, is it really true that it is impossible to use the economy’s resources to produce things people actually want?

Monetary policy: It may seem strange to return to monetary policy as an option. After all, haven’t we just seen that it is ineffective? But it is important to realize that the monetary thought experiments we have performed have a special characteristic: they all involve only temporary changes in the money supply.

This point needs enlarging upon. Because the traditional IS-LM framework is a static one, it cannot make any distinction between temporary and permanent policy changes. And partly as a result, it seems to indicate that a liquidity trap is something that can last indefinitely. But the framework here, rudimentary as it is, suggests a quite different view. In the flexible-price version of the model, even when money and bonds turn out to be perfect substitutes in period 1, money is still neutral – that is, an equiproportional increase in the money supply in all periods will still raise prices in the same proportion. So what would a permanent increase in the money supply do in the case where prices are predetermined in period 1? Even if the economy is in a liquidity trap in the sense that the nominal interest rate is stuck at zero, the monetary expansion would raise the expected future price level P*, and hence reduce the real interest rate. A permanent as opposed to temporary monetary expansion would, in other words, be effective – because it would cause expectations of inflation.

Let us now bring this discussion back to earth, and to Japan in particular. Of course the Bank of Japan does not announce whether its changes in the monetary base are permanent or temporary. But we may argue that private actors view its actions as temporary, because they believe that the central bank is committed to price stability as a long-run goal. And that is why monetary policy is ineffective! Japan has been unable to get its economy moving precisely because the market regards the central bank as being responsible, and expects it to rein in the money supply if the price level starts to rise.

The way to make monetary policy effective, then, is for the central bank to credibly promise to be irresponsible – to make a persuasive case that it will permit inflation to occur, thereby producing the negative real interest rates the economy needs.

This sounds funny as well as perverse. Bear in mind, however, that the basic premise – that even a zero nominal interest rate is not enough to produce sufficient aggregate demand – is not hypothetical: it is a simple fact about Japan right now. Unless one can make a convincing case that structural reform or fiscal expansion will provide the necessary demand, the only way to expand the economy is to reduce the real interest rate; and the only way to do that is to create expectations of inflation.

By the way, it is odd to describe this policy as “ineffective.”  The BOJ said it wanted a stable CPI and for the most part got one.  The term ‘misguided’ would be much better than ‘ineffective’ as the latter term suggests (wrongly) that Japanese policy failed achieve its objectives.  It succeeded in achieving its objectives; the problem was that it had the wrong objectives.

If we now turn to Krugman’s blog we find him singing a completely different song from the 1998 paper.  Now he has one post after another arguing that fiscal stimulus is the answer.  And he creates the strong impression that monetary policy is ineffective in a liquidity trap:

In that model, prices are assumed sticky in the short run, so P is predetermined. What, then, determines Y? Well, it’s a real thing — as opposed to a nominal thing. In the model it’s actually tied down by an Euler condition, by future consumption and the real interest rate (which is stuck thanks to the zero lower bound). Monetary policy has no traction at all against the right hand side of the equation.

Now, the equation still holds. But all that tells us is that any changes in the money supply are offset one for one by changes in velocity. Focusing on nominal spending makes you think that low nominal spending is the problem, a problem with a monetary solution; but actually it’s the symptom, and monetary policy doesn’t matter (unless it can affect expected future inflation, but that’s another story).

I suppose Krugman defenders will again point to the final parenthetical remarks.  But how many of his readers would even notice that, or understand what it means?  How many people realize that in a rational expectations model that has an upward sloping SRAS curve all monetary stimulus, liquidity trap or no liquidity trap is only effective if it can influence the future expected inflation rate.  As a practical matter if monetary injections have no impact on the expected future inflation rate then they won’t impact current AD.  So all he is really saying is that monetary policy is ineffective, unless it is effective.  I can’t argue with that!

Now let’s review Krugman’s criticism of Levitt and Dubner’s chapter on global warming.  Recall that their chapter opened with a charming and entirely accurate anecdote about how “some” scientists had predicted global cooling in the 1970s.  But then Levitt and Dubner went on to emphasize that the current science on global warming was quite solid, and therefore we needed to consider some pretty extreme policy options for dealing with this very serious problem.  Krugman argued that their opening 1 1/2 pages of this 45 page chapter were misleading, leaving the clear impression that the current consensus for global warming was suspect.  I don’t see how anyone reading the entire chapter could conclude that, but let’s say Krugman was right.  Even Levitt and Dubner’s worst enemies would have to concede that they also presented lots of evidence in favor of the global warming hypothesis. 

Now let’s compare that to Krugman’s post.  He makes the very misleading statement that his 1998 paper shows monetary policy doesn’t work in a liquidity trap, when the paper actually ends up arguing that monetary stimulus is one of the most promising policy options for Japan.  And then he hides the relevant policy option in a parenthesis.  That is far more misleading than anything Levitt and Dubner were accused of doing.  After all, Levitt and Dubner’s chapter contained comments like the following:

There is essentially a consensus among climate scientists that the earth’s temperature has been rising and, increasingly, agreement that human activity has played an important role.

And then they spent 20 pages discussing promising options for dealing with the problem.  Even worse, Krugman did this when discussing one of the most important issues facing the world today.  The unemployment rate hit 10.2% today because of a lack of NGDP.  Monetary stimulus plans discussed in Krugman’s 1998 paper offer a very promising way of addressing that nominal shortfall (although NGDP targeting would be even better than inflation targeting.)  And Krugman gave the average reader little reason to be hopeful about monetary stimulus.  

Here’s how Krugman scolded L&D:

Levitt now says that the chapter wasn’t meant to lend credibility to global warming denial — but when you open your chapter by giving major play to the false claim that scientists used to predict global cooling, you have in effect taken the denier side.  .  .  .  And that’s not acceptable. This is a serious issue. We’re not talking about the ethics of sumo wrestling here; we’re talking, quite possibly, about the fate of civilization. It’s not a place to play snarky, contrarian games.

That’s how I feel about Krugman.  He creates the impression that monetary stimulus can’t work, even though his scientific writings suggest otherwise.  And a recession causing tens of millions of workers around the world to become unemployed, perhaps for many years, is also a very serious issue.

PS.  Check out Beckworth’s excellent post and see how many times he mentions the hated MV=PY equation, the equation that one can’t help thinking about anytime one mentions nominal GDP.

PPS.  I am assuming someone else (like Kling) will handle Krugman’s proposal for a new WPA and CCC.  How would this work in the 21st century?  Someone with a better imagination than me can run with this one.  We need monetary stimulus, and we need it soon.

Everywhere I look I see patterns.  Because of the off year elections I started thinking last night about the odds of Obama being re-elected.  I was familiar with the data showing that when presidents run for re-election, more often than not they succeed.  But then I started noticing another pattern; the more interesting correlation was between success in being re-elected and the number of years a given party has held the presidency. 

I have finally memorized all the Presidents since 1900, and noticed that only in 1980 was a party rejected after 4 years in the presidency (out of 11 chances.)  So I thought “wow, it looks like Obama’s got a 91% chance of being re-elected.” 

Since my readers are curious about the world, and numbers-oriented, I’m sure you have reasoned through issues in much the same way.  And I’m sure you know what’s coming next; I’m going to accuse myself of data mining.  But there is a solution to data mining—do an out-of-sample test. 

Well that didn’t take long to blow my lovely theory out of the water.  In 1888, 1892, and 1896 the presidency was lost by a party that had held it for just 4 years.  So my 91% estimate is falling fast.  But wait a minute, wasn’t there something wrong with the 1888 election?  Yes, Wikipedia shows that Cleveland was robbed in 1888.  Cleveland (who I am shamefully ignorant of, but Dems seem embarrassed by him so I figure he was a good president) actually won the popular vote in three consecutive elections, 1884, 1888, and 1892.  So now let’s refine my theory a bit.  We can pretend Cleveland served three terms by using the popular vote as the criterion, but then of course we have to take away one Bush term.   And what about President Tilden?  So that won’t work. 

Do you see what my mind was trying to do?  I was looking for some pattern that would allow me to predict the future.  If I tweak the “model” enough I could probably get 100% accuracy, after all there haven’t been all that many elections where the incumbent party had held office for just four years.

And all I really had to do was just look at Intrade, and we can see that the Dems have a nearly 2-1 shot of winning again.  The 20th century was a fluke.  The odds of replacing a party after 4 years are long, but they aren’t that long.

PS.  I woke up this morning with a black president in a country that is 14% African-American, with a black governor in a state that is 5% African-American, and with a black mayor in a city that is maybe 2% African-American.  Hmmm, what are the odds of that .  .  .  .

Update 11/5/09:  Patterns, patterns, everywhere.  Here is another misuse of probability theory.

Update 11/6/09:  Russ Roberts sent me this post on Cleveland.  No wonder modern Democrats are embarrassed by Cleveland—he took seriously his oath to uphold the Constitution.

I’ve been giving some thought to how my views of macro are different from those of other economists.  Until this crisis hit, I assumed that I was doing “normal economics,” to use Thomas Kuhn’s terminology.  NGDP targets are different from the Taylor Rule, but they aren’t all that different.  Even Ben Bernanke has talked about targeting the forecast.  You’ve seen me endlessly recite Mishkin’s 4 key concepts from his monetary textbook.  They are a virtual blueprint for my current critique of monetary policy.  So I’ve never thought of my views as being particularly heterodox. 

And yet . . . .  You could count on one hand the number of economists who think money was tight last fall.  And you could count on one hand the number of right-wing economists who think that the economy currently needs much more stimulus.  So although my views are not completely unique, there is apparently something rather unusual about my approach to macro.

Kuhn is famous for arguing that scientific revolutions were preceded by a buildup of “anomalies,” or things that were difficult to explain within the standard model.  I’d like to discuss two possible anomalies, although in this case I don’t think that either are currently recognized as such.  I hope to change that.  The discussion will actually be more of a challenge to my fellow economists.  Can you explain these anomalies in a way that is consistent with the standard model?

Anomaly 1:  Economists talk about “monetary policy” without having a coherent idea of what they mean by the term.

Recall that a standard model should have an agreed upon set of terms, so that communication between scientists is possible.  OK, what do we mean by the “stance of monetary policy?”  What do we mean by “easy money?”  How about “tight money?”  Surely if we claim to be a science it’s not good enough to say “it depends” or “I know it when I see it.”  We must have some metric in mind, something in the real world we can point to, beyond our gut instinct.  So let me throw out this challenge:  I say it is impossible to come up with any sort of coherent meaning for terms like ‘easy money’ and ‘tight money’ in the context of the standard model.  Economists use these terms all the time, and yet are really just spouting nonsense.  To make things simpler I’ll offer 6 options, which conform to all of the ways in which I have heard people try to give meaning to the term:

1.  The Joan Robinson interpretation:

As you may recall, I like to mock Joan Robinson’s statement that the German hyperinflation could not possibly have been caused by easy money; after all, nominal interest rates were not low in Germany during the early 1920s.  I think it is fair to say that Joan’s views are no longer part of the standard model.  It is now widely believed that the German hyperinflation was caused by easy money, and hence nominal interest rates cannot be the right indicator for the stance of monetary policy.  When economists say “easy money” they can’t possibly be referring to low nominal interest rates, otherwise they’d have to accept Joan rather eccentric views.

2.  How about real interest rates?

When I make the preceding argument to economists, the quick retort is usually “of course what I really meant was that easy money means low real interest rates, and tight money means high real interest rates.”  Fair enough.  So let’s look at the record.  Real interest rates on five year TIPS rose from 0.57% in mid-July 2008 to 4.24% in late November 2008.  If real interest rates are the appropriate indicator of the stance of monetary policy, then this 4 month period was one of the most sudden and aggressive examples of monetary policy tightening in all of recorded history. 

So maybe we do have a coherent view of the stance of monetary policy.  It refers to the level of real interest rates.  Except there is just one problem.  When I tell other economists that money became ultra-tight in the second half of 2008, I am met with stares on incomprehension, as if I had just escaped from a lunatic asylum.  So whether or not real interest rates are the “right” indicator (and for what it’s worth I don’t think they are) one thing is perfectly clear—this is not the standard model.  If only a tiny handful of economists think money was tight last fall, most economists obviously are defining “tight” as in terms of much higher real interest rates.

3.  The monetary base:

I used to like this one.  It seems to conform best to what the Fed actually does.  They print money.  And the money they print isn’t M1 or M2, it’s base money.  But again, whether or not this is the best indicator (and I no longer think it is) it’s clear that it hasn’t been the standard view for decades, if ever.  As Friedman and Schwartz showed the base was extremely misleading in the Great Depression, as M1 and M2 fell sharply at the same time as the base was rising rapidly.  Most of the profession now accepts their view that Fed policy was very tight in the early 1930s.  During that period the sharply falling M1 and M2 seemed to be better indicators as we also experienced extreme deflation, not what you’d expect from easy money.  Now of course there are other ways to look at this picture.  Krugman has argued that one could think of money as being easy, but that because we were in a liquidity trap the easy money did no good.  However, the fact that Krugman might make this argument doesn’t mean that he thinks the monetary base is the right indicator of the stance of monetary policy.  I rarely see him (or other Keynesians) pay any attention to the base.  I suppose one could still argue that the base is the right indicator of monetary policy, but that view is certainly not the standard view.  I’ll bet 90% of the economists who claim Greenspan ran an easy money policy in 2003 have never once examined the base data from that year.

4.  How about the broader aggregates?

In some ways M2 is better than the other three.  It certainly gave a more useful indication of monetary policy than either the base or nominal interest rates during the Great Depression.  (And my hunch is that even real rates were misleading, although there is some debate about whether the deflation was anticipated.)  But once again, it is certainly not the standard view that M1 or M2 are the right indicator of the stance of monetary policy.  Indeed, after the early 1980s most economists lost any interest in these variables.  Mike Belongia argues that we can and should come up with much more informative aggregates.  He may be right, but that’s not the issue I am examining here. 

This week’s Economist mentioned how M2 has recently been flat, and then a few sentences later asked “whether all this fiscal and monetary stimulus will work.”  Obviously they are assuming that nobody would view M2 as the right indicator of monetary policy. 

5.  The Taylor Rule

Lots of economists have argued that the Taylor Rule suggests rates should now be much lower.  I know there is some debate about their interpretation, but I’d like to focus on something different.  Even those economists who say rates need to be much lower according to the Taylor Rule, do not draw the implication that money is currently very tight.  So it is very clear that even economists who use the Taylor Rule don’t generally think it is an indicator of the stance of monetary policy.

6.  The “it depends” view:

Once they’re painted in a corner, and there no longer seems any single coherent definition of monetary policy, some economists will strike a more nuanced pose.  They will argue that it depends on a variety of factors.  You can’t just look at one metric.  It depends on the condition of the economy.  But again, this is not the view within the standard model.  If this were the standard view, then communication on monetary policy issues would look much different.  Suppose we had an English professor go through reams of economics discussions, debates, articles, etc, looking for how economists use terms like ‘easy’ and ‘tight’ money.  I am quite certain that he or she would find the terms used in a fashion that indicated their meaning was clear, and that both the speaker and the listener had the same shared understanding of what these terms mean.  In other words, economists uses these terms in the same way scientists use terms like force and mass.  But there is just one problem; scientists can point to agreed upon metrics (such as kilograms) for measuring their concepts.  So here is my big challenge to the economics profession:

Where is the metric for the stance of monetary policy?

I say we don’t have one.  Even worse, I say we think we have one, we talk as if we have one, but we aren’t even close to having one.  Given how monetary policy moved front and center in macro after the new Keynesian consensus of the 1980s, I’d say that’s a pretty big problem.

Anomaly 2:  Economists who claim to believe in markets, ignore the fact that the markets decisively reject their policy views.

Here’s one Krugman and DeLong would like, in the off chance they read this post.  Lots of economists on the right talk with a high degree of confidence about whether money is too easy, or too tight.  Let’s put aside the problem of defining easy and tight, and pretend there was a consensus.  My reading of history is that more often than not the markets don’t agree with right-wingers, and even worse, those right-wingers who claim to believe in efficient markets and rational expectations just brush off the markets’ rejection of their policy views.

Some examples:  I found that in the Great Depression the Fed mistakes identified by Friedman and Schwartz rarely had any discernable effect on asset prices.  But gold market shocks had a huge impact on asset prices.  Or take the “real business cycle” view, the view that nominal stimulus can’t boost real output, as recessions are caused by real shocks.  In the Great Depression the real value of assets like stocks often soared on news of easier money.  In addition, default risk fell sharply (as the Aaa/Baa yield spread fell on news of easier money.)

And we have seen the same in recent months.  For anyone who pays even the slightest attention to equity markets, it is obvious that during a recession stock prices react extremely positively to even a slightly greater than expected easing of monetary policy.  (And one thing Krugman won’t like, that’s even true when rates are at the zero bound.) 

Here’s my favorite example.  I recently saw a graph showing inflation expectations over the next few years.  As I recall the medium forecast was about 2%, which is somewhat above market forecasts.  But here is what was interesting; the distribution of forecasts was much wider than usual.  There were a lot of 1% forecasts, and a lot of 3% forecasts.  The typical distribution is much tighter.  Some of my more astute commenters made this argument to me, after I cited the TIPs markets as evidence that we didn’t need to worry about inflation.  They argued that those buying gold might have a very high inflation forecast, but aren’t participating in the bond market.

So who is right, those in the bond market or those economists forecasting much higher inflation?  The answer is easy, those with money on the line.  Remember how during the Bush years liberals used to make those sarcastic comments about faith-based vs reality-based views?  There is a bit of truth in what they were saying (although of course they have their own biases.)  It seems to me that if you take a “realistic” look at the big picture, inflation is likely to stay low.  But some economists have “faith” in models that say when we have big deficits and double the monetary base then inflation will be just around the corner.  Unfortunately, those models were wrong in Japan and they will be proved wrong here as well. 

So my explanation for the wide dispersion of inflation forecasts is quite simple, ideology is driving the forecasts to a much greater extent than during normal times.  And in this particular case the Keynesian model just happens to yield predictions that are closer to “reality.”  Of course that’s not always true, the view that economic “slack” prevents higher inflation didn’t work very well in the 1970s, and performed absolutely horribly in the year after the dollar was devalued, when prices rose rapidly despite 25% unemployment.  Still, right now the right is wrong.

 BTW, this example also addresses a question I am often asked:  “If even economists can’t agree on the right model, how could average traders possibly have rational expectations, how could they form expectations consistent with the right model.”  Well I don’t know how the wisdom of crowds comes about, be we are currently seeing a beautiful example of rational expectations in action.  Traders are rationally blowing off simplistic quantity theories of money, which some academic economists continue to cling to.  They are trading TIPS as if they understand that the Fed interest payments on excess reserves changes everything.

I’ve gone on way too long.  I think it makes sense to first see if any economist can meet my challenge, can come up with a coherent metric for measuring the stance of monetary policy that is also consistent with the standard model.  Heck, I’d be happy with any metric that is consistent with the views of any substantial fraction of respected economists, on either the right or the left.  I say there isn’t any.

In my next post I’ll discuss where I think  macro needs to go and explain why we might need new concepts, new metaphors, indeed a completely new paradigm (something I never would have imagined before October 2008.)  It will be a macroeconomics without lags and without multipliers.  A macroeconomics where all important concepts are embedded in parallel asset prices measurable in real times.  Where shocks and have no important macro implications.  A macro free of VARs.

Paul Krugman has a very important post showing fast recoveries from previous big recessions.  The 1983-4 recovery was particularly fast.  But lest anyone think Reagan might have done any good he points out that a rapid recovery also occurred in 1976.  So how did they do it? 

BEA

I decided to go back and look at the data on fiscal stimulus, and was quite surprised by what I found.  In both earlier recessions the budget deficit rose by just over 3% of GDP; from a bit under 1% to 4% of GDP between 1973 and 1975, and then from 3% to just over 6% between 1980 and 1982.  I’m no expert on Keynesian economics, but isn’t that mostly the effect of the recession?  I don’t see a lot of room for discretionary stimulus.  And if we look at the especially fast 1983-84 recovery, we find that the discretionary stimulus that did occur was exactly the kind that Krugman says doesn’t do much good—tax cuts for the rich (who have a lower marginal propensity to consume.)
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I’m not sure what more I can say about monetary policy.  The 3rd quarter was another huge disappointment.  NGDP grew at a 4.2% pace.  Not only was it too slow to return us to trend, but we fell even further behind.  So AD continues to fall relative to trend, despite a monetary policy that many continue to wrongly call “expansionary,” not to mention a fiscal stimulus that doesn’t seem to even be able to get NGDP up to its normal rate of growth.  Yes, we got some real growth for a change, but only because wage cuts are shifting SRAS to the right.  You econ teachers out there might want to think about this fact:  You know when you teach the options for recovering from a recession?  One option is for the government to do nothing, just wait for SRAS to shift right.  The self-correcting mechanism.  Well that is what is happening now (and probably in the 4th quarter as well.)  So today let’s take a break from the dreary subject of demand stimulus, or the lack thereof.
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Yesterday’s online version of The Economist, also known as known as Free Exchange, did a nice piece on my recent China post.  They contrasted my views with those of Paul Krugman, and also asked a few questions.  Here I’ll try to respond to those questions, but first I’ll clarify exactly where Krugman and I differ.
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Check out this link that I found in John Taylor’s blog.  The best 3:53 clip in game show history:

http://www.youtube.com/watch?v=p3Uos2fzIJ0

A few reactions (watch the clip first.)  As Taylor says, this is a great example to use when teaching the Prisoner’s Dilemma.
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I have some recent posts bashing Krugman and his pal DeLong.  So maybe it’s time to show that I can be just as “fair and balanced” as Fox News, er, I mean NPR and the BBC.  This won’t be entirely positive, but I think Krugman fans will be very pleased by the ending.  (Bob Murphy may want to skip this one.)  Let’s start with three recent posts by Krugman that show him fighting the good fight against the forces of reaction:
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The best thing that happened to the world economy in 1933 was that FDR sharply devalued the dollar against gold.  Prices and output started rising rapidly, and the US began to suck in a lot more imports from the rest of the world.  Our trade surplus got smaller.  Even better, this policy inspired other countries to devalue as well.  Paul Krugman knows all this, and often cites FDR’s actions with approval. 

The best thing that happened to the world economy this year, indeed just about the only good thing, was the V-shaped recovery in Asia, almost certainly led by China.  This recovery was aided by the Chinese government’s decision to stop appreciating its currency.  The Asian growth spurt was also a major factor behind the recovery in the US, which began in asset markets in March and spread to the real economy a few months ago (although we need a much faster recovery.)  Paul Krugman does not seem to know this, indeed he is now arguing that the Chinese need to reverse the very policies that provided green shoots to the world economy in the dark days last winter.  Here is what Krugman has to say:

Although there has been a lot of doomsaying about the falling dollar, that decline is actually both natural and desirable. America needs a weaker dollar to help reduce its trade deficit, and it’s getting that weaker dollar as nervous investors, who flocked into the presumed safety of U.S. debt at the peak of the crisis, have started putting their money to work elsewhere.

But China has been keeping its currency pegged to the dollar — which means that a country with a huge trade surplus and a rapidly recovering economy, a country whose currency should be rising in value, is in effect engineering a large devaluation instead.

And that’s a particularly bad thing to do at a time when the world economy remains deeply depressed due to inadequate overall demand. By pursuing a weak-currency policy, China is siphoning some of that inadequate demand away from other nations, which is hurting growth almost everywhere. The biggest victims, by the way, are probably workers in other poor countries. In normal times, I’d be among the first to reject claims that China is stealing other peoples’ jobs, but right now it’s the simple truth.
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They say that in Hollywood any publicity is good publicity.  Thus I was delighted to see Brad DeLong paying attention to my random thoughts on the Krugman/Dubner dispute,  Indeed he officially declared that I had lost my mind.  But that is not all bad, because in America there are always second acts.  On the same day Brad DeLong formally announced that the little known blogger Andrew Sullivan would henceforth be welcomed back into polite society.  Someone may want to inform Andrew in case he hasn’t heard the wonderful news.  So I knew that there was still hope that a similar fate awaited me someday; when and if I adopted the “correct views” I too might be welcomed back, like a reformed mental patient in one of Stalin’s hospitals.  Or just as Fox News can expect to start get interviews again once they “shape up.”  Or just as the insurance industry can expect to get a better deal in the health care legislation once it stops saying those awful things.
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In a comment to my previous post, Statsguy raised a number of objections to geoengineering.  In principle, those objections should be included in the pricing scheme.  Thus if the sulfates approach has more nasty side effects that the cloud creation approach, then the (risk adjusted) estimated cost of those nasty side effects should be incorporated into the relative subsidies (or taxes) on various geoengineering-type strategies.  But I understand that not everyone will find this persuasive, so here I will try to answer my critics with some relatively pragmatic arguments.  Statsguy linked to an article with 20 objections to geoengineering.  How many of these are persuasive?  I’d say only the first one, and even that one is debatable.
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A recent post by Matt Yglesias challenged the libertarian community on their seemingly anti-market approach to global warming:

For basically Popperian reasons I don’t think it makes sense for political pundits to spend a lot of time debating the relative difficulty of developing different hypothetical future technologies.  Instead, I would just say that the best way to find out whether human ingenuity is better at keeping atmospheric CO2 concentrations at a sustainable level by developing artificial trees or by developing better windmills is to . . . implement a binding emissions reduction scheme that puts a price on CO2 emissions.

This isn’t, in other words, an either/or choice. If you had a cap-and-trade system in place, that would put a range of modalities—better efficiency, more clean energy production, more trees & algae, and carbon-scrubbing machines—in a competitive framework. One assumes we’d be looking at some kind of mix. But defining the correct mix in advance seems very hard. Hence the appeal of a basically market-esque mechanism that creates incentives to work on these various ideas without unduly prejudging the appropriate level of investment in speculative technology.

What I think is remarkable is the extent to which people on the right, in their zeal to avoid a market mechanism that the business establishment happens to hate, have a tendency to talk up what instead amounts to a kind of Five Year Plan approach. Instead of regulating carbon, let’s just direct scientists of invent miracle trees! Let’s turn the sky red!

I like his argument, so I am going to take the challenge.  But first let’s diagnose the problem and come up with the right pricing policy.  I’m going wager that Matt’s friends in the environmental community won’t like the outcome. 
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This post was inspired by Bill Woolsey’s recent post on a monetary constitution based on index convertibility.  I’d like to follow a similar procedure, but emphasize slightly different issues.  The goal is to show that we can get to the same place from several different directions, but also that Woolsey’s approach offers some conceptual advantages over the approach that I have been emphasizing.
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I’ve previously complained about how Krugman misrepresented my views, John Cochrane’s views and Milton Friedman’s views.  Now we can add Levitt and Dubner to the list.  That’ right, the following statement made by Krugman is pure fabrication:

The chapter opens with the “global cooling” story — the claim that 30 years ago there was a scientific consensus that the planet was cooling, comparable to the current consensus that it’s warming.

Why does Krugman keep doing this?  Why does he continually misrepresent what others say?  My theory is that he assumes those he disagrees with are either fools or knaves.  Instead of doing a sympathetic reading, trying to discern what others are really trying to say, he looks for the “gotcha.”  I just read the chapter, and it bears little resemblance to his description.  And I have read a lot of scientific papers on geoengineering, on both sides of the issue, so I know a bit about the field. 
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It has come to my attention that the standards of intellectual discourse have been slipping.   Fortunately, Paul Krugman has provided us with a set of ethical standards for blogging in a recent series of posts on global warming.  In the first post he takes Levitt and Dubner to task for their counterintuitiveness on an important issue:

At first glance, though, what it looks like is that Levitt and Dubner have fallen into the trap of counterintuitiveness. For a long time, there’s been an accepted way for commentators on politics and to some extent economics to distinguish themselves: by shocking the bourgeoisie, in ways that of course aren’t really dangerous. Ann Coulter is making sense! Bush is good for the environment! You get the idea.

Clever snark like this can get you a long way in career terms — but the trick is knowing when to stop. It’s one thing to do this on relatively inconsequential media or cultural issues. But if you’re going to get into issues that are both important and the subject of serious study, like the fate of the planet, you’d better be very careful not to stray over the line between being counterintuitive and being just plain, unforgivably wrong.

I could not agree more.  It certainly helped the career of the snarky John Maynard Keynes.  He continually shocked the bourgeoisie with counterinituitive assertions that saving was actually harmful and that we’d all be better off if we buried bottles full of money and paid workers to dig them up.
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You have to be careful when reading Tyler Cowen’s posts.  Whereas I can ramble on and on saying very little, he condenses a lot of ideas into very short posts.  When I first glanced at this post two things stuck out; Tyler didn’t understand the “helicopter drop of cash” and he confused me with Milton Friedman.  On closer examination he does understand the helicopter drop, and I have no complaint if people start associating me with ideas that Friedman actually developed.  In fact there is a long tradition of this in economics, recall the “Phillips Curve” was actually first popularized by Irving Fisher.  Here’s what Tyler has to say:

$250 for each senior or $13 billion in total.  It’s bad precedent to go around a COLA calculation, even on a one-time basis, but you can construct a partial defense of the policy (here is Matt’s semi-defense).  Think of it as a helicopter drop of money, a’la Scott Sumner.  If the helicopter drop substitutes for (part of) a second fiscal stimulus, that’s a net gain.  .  .  .   How will the expenditure be financed?  Obama was vague on that, but as usual the Fed moves both first and last in the monetary policy game.  All Obama has to do is make the second stimulus $13 billion less than it otherwise would have been, wink and nod to Ben B., and it is all (or mostly) for the better.

My first thought was that Tyler was confusing fiscal and monetary policy.  The $13 billion would not directly impact the money supply.  But in the final sentence he alludes to his assumption—a larger fiscal stimulus would lead the Fed to adopt a more accommodative monetary stance.  This raises two questions; precisely what would the Fed have to do to turn it into a helicopter drop, and how plausible is this assumption?
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The Economist just published a piece that looks at the performance of quantitative easing (QE) in Japan from 2001 to 2006.  The article suggests that the policy failed, and provides extensive testimony from The Bank of Japan’s Governor, and one of its top economists.

THE Bank of Japan (BoJ) pioneered the process known as quantitative easing (QE) in 2001-06, when it massively boosted the reserves that commercial banks held at the central bank. Its verdict on how well QE worked then ought to interest policymakers today. It will also discomfort them. For all that it propped up Japan’s creaking banking system, QE did not really improve the economy nor end the country’s deflationary mindset (see chart).

Yes, by all means “see chart.”  In fact, take a very close look at the chart.  I don’t know about you, but to me that looks like perhaps the most successful monetary policy in all of world history.  Can you think of a central bank that did better?  So why is The Economist so pessimistic?  And for that matter why does Paul Krugman keep citing Japan as an example of why QE doesn’t work?  There are two reasons:
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Update 10/15/09:  I was just interviewed by the PBS station in Denver (KGNU.)  I’ll post a link when I get one.  If any PBS listeners wander over here and are curious about my letter to Krugman, here is the link.

Update 10/16/09.  Here is the PBS interview.

I plan to take a break to recharge my batteries.  I know I have been overstressed when I tried to link to Yahoo News this morning, and accidentally stumbled onto a story at The Onion about Obama winning a Nobel Prize.  I can’t recall what field, probably chemistry or something similar.  And the next story had Somali pirates “mistakenly” attacking a French military flagship.  Yeah, I also have trouble distinguishing French naval vessels from tankers.   So I need a break.   In any case, I thought I should provide some links for those who stumble onto my blog by mistake.  I’ll start with one from the AEI’s online magazine, which just appeared this morning:

The American

Here’s my essay at Cato.  The links for the subsequent debate with Hamilton, Selgin and Hummel are in the right margin:

Cato Unbound

Here’s my essay at Vox:

Vox

Here’s my debate with Ohanian at CBS Moneywatch:

Ohanian debate

Here is my debate with John Cochrane:

Cochrane debate

Here is my bloggingheads.tv debate with Mark Thoma

Thoma debate

Here is my piece at Reason magazine:

Reason

And finally, a New York Times article on this blog:

New York Times

I have done a number of posts on two closely related themes.  In this recent post I discussed the common perception during each recession that “it’s different this time.”  In particular, each recession is supposed to have special characteristics that make it unlike the normal garden variety recession—you know what I mean, the kind we learn about in our intro to macro textbooks.  Here are some recent “special” recessions:

1.  1970:  Inflation isn’t falling like other recessions; wages are not responsive this time.

2.  1974:  The big oil shock, this one is supply-side.

3.  1980:  This one is caused by Carter’s credit card restrictions.

4.  1982:  No bounce back this time, the rust belt jobs are gone forever.

5.  1991:  The S&L bubble burst, many banks failed, and commercial real estate was overbuilt.

6.  2001:  This time it was the tech bubble bursting, not a drop in AD.  Plus 9/11.

7.  2008:  The housing/financial crisis.

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Sometimes when I post on an unfamiliar topic, I preface my comments by stating that I am pretty sure that I have overlooked something important, as the standard view can’t be as silly as it seems.  And I have never had greater doubts than in this post.   Mainstream economists can’t have overlooked something so basic.  And fiscal multipliers are something I rarely even think about.  So I hope you guys can set me straight.

Update 10/10/09: Alex and Leigh did set me straight.  I thought the long run multiplier of 1.5 meant that if you increase G by $1, then in the long run Y would rise by $1.50.  Instead, it looks like a long run multiplier of 1.5 means that in the long run the effect of G on real GDP is zero.  Indeed, I am pretty sure that if Alex and Leigh are right, and if G had a permanent effect on the LRAS curve, then the long run multiplier would be positive or negative infinity.  Thus you might want to skip the rest of the post.  (This will teach me to stay out of hydralic Keynesianism.)  Others are free to offer insights, but I no longer have confidence in my interpretation of the paper in question.
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