The Financial Times is a very respected newspaper, so I guess there must be some logic to this column.  But I confess I have no idea what this Belgian professor is talking about.  First prize to someone that can explain this to me.

The dilemma for the US authorities now pops up in the following way. The US monetary authorities pursue a policy aimed at keeping inflation low. It’s not an explicit inflation target as in the case of the UK or the eurozone, but it is certainly an implicit one. This implicit inflation target is close to two per cent which implies that when the Federal Reserve issues dollars it gives an implicit promise that these dollars will buy a basket of US goods and services which is approximately constant (ie declines by only two per cent per year). Given that the US economy grows on average at a rate of close to three per cent per year, this implies that the yearly increase in the supply of dollars should be close to five per cent (two per cent inflation plus three per cent economic growth).

This price stability commitment however conflicts with the international role of the dollar. The worldwide demand for dollars increases at yearly rates that by far exceed the five per cent money supply growth rate that will keep prices in the US approximately stable.

Thus the US monetary authorities have to choose between a policy that accommodates for the high demand for dollars in the world, but then the supply of dollars will increase much faster than the one that will keep approximate price stability in the US. Alternatively, the US sticks to the inflation target, but this requires limiting the supply of dollars to a much lower level, frustrating the high demand for dollars worldwide.

If foreign demand for dollars is rising faster than US demand, doesn’t that mean that the Fed can increase the world supply of dollars at faster that 5% rate and still hit its target.  So what is the “dilemma?”

Even worse, if the Fed didn’t respond by increasing the supply of dollars by more than 5% a year, I still don’t see a problem.  Foreigners would still be free to accumulate all the dollars they wished, it would just mean that the dollar would tend to appreciate in nominal terms (but not real terms) over time.  So what’s the dilemma?

HT:  Marcus

Here is a long passage from pp. 33-36 of a November 2009 paper by Woodford and Curdia, which describes a 2003 paper by Woodford and Eggertsson (you’ll need to open the PDF):

Eggertsson and Woodford show that it can be a serious mistake for a central bank to be expected to return immediately to the pursuit of its normal policy target as soon as the zero bound no longer prevents it from hitting that target. For example, Figure 11 (reproduced from their paper) compares the dynamic paths of the policy rate, the inflation rate, and aggregate output under two alternative monetary policies, in the case of a real disturbance
(here interpreted as an exogenous increase in the probability that loans are bad, requiring intermediaries to increase the credit spread by several percentage points) that begins in period zero and lasts for 15 quarters, before real fundamentals permanently return to their original (“normal”) state.

Note:  I wasn’t able to copy the figure 11.  It is on page 61, and is worth looking at.  The dotted line shows a deep and prolonged recession with a policy of inflation rate targeting.  The solid line shows the economy avoiding a recession (and avoiding deflation) with a policy of targeting the price level.  Note that they are proposing an elastic price target, so it is actually quite close to NGDP targeting.  Of course the other difference is that they do not contemplate targeting the forecast, which I think would make it even more likely that a recession could have been avoided.
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Update:  Here’s my EconTalk with Russ Roberts, where I describe my views on macro.

A few weeks back someone suggested that I describe how my views differ from the mainstream.  A few days ago I did a post describing what I thought was wrong with the standard models of monetary economics.  I ended up with a call for a new paradigm and left the impression that I’m about to provide it.  One commenter said my last paragraph was “remarkably ambitious,” which is a polite way I suggesting it’s crazy for a Bentley professor to be talking about new paradigms.  And he’s right.  So I’ll just list some of the areas where my views differ from others, provide lots of links, and then let others decide whether there is anything coherent in my approach.
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This is a follow up to my somewhat misunderstood previous post.  In the comment section Bill Woolsey made the following point:

Krugman is explicitly saying that real interest rates must be very negative to motivate an increase in real and nominal expenditure.

If the Fed promised 3% inflation, people would still not spend much, and any increase in the quantity of money (aimed at generating that inflation) would be hoarded.

The Fed’s promise of 3% inflation would have little effect, and inflation wouldn’t be 3%.

I agree with Bill that this is what Krugman has in mind.  It’s hard to be sure, but he has said that “high” inflation expectations were needed, and at the same time linked to Fed studies showing the Taylor Rule implied a negative 6% interest rate was needed for a robust recovery.  This of course implies that expected inflation needs to be at least 6%, as nominal rates on loans can’t be negative.  But Krugman also says the SRAS curve is fairly flat right now.  He frequently uses the Keynesian “slack” model of inflation, which suggests that when unemployment rates are very high a large increase in AD would initially lead to much higher output, with at best a small rise in inflation.  I have some problems with the slack model of inflation, but in this case I think Krugman’s about right.  If we had a 10% rise in AD or NGDP over the next 12 months, then we’d probably get around 7% or 8% RGDP growth, and around 2% or 3% inflation. 
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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  . . .
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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.
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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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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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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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Keynesians often live in a sort of alternative universe from me.  One that reminds me of my daughter’s “Opposite Day” at school.  For them, low interest rates mean easy money, for me it indicates money has been tight.  Michael Woodford likes to envision a monetary system without money, where monetary policy is all about interest rates.   I like to envision a monetary system without interest rates, to show how changes in the money supply are the essence of monetary policy.  And now Brad DeLong argues that a policy of targeting future inflation isn’t really monetary policy:

You can call Federal Reserve policies aimed at the sending of signals that alter the expected rate of future inflation “monetary policy” if you want, but then you lose analytical clarity–because the way such policies work (if they work) is not the “normal” way that “normal” monetary policy works. Normal monetary policy works by shifting the private sector’s asset holdings toward assets that people spend more readily and rapidly, thus boosting spending. Quantitative easing at the zero bound does not do that: it simply exchanges one zero-yield government asset for another. What is does do is to change bond prices, rather by raising the safe short-term nominal interest rate and thus giving people an incentive to spend the money they already have more quickly.

In contrast, I regard policies that change the expected track of the money supply and inflation to be the only reasonable definition of monetary policy.
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Every so often I make a list of economists who recognized that money was actually rather tight last year; or at least that a more expansionary policy could have greatly reduced the severity of the recession.  Of course it is hard to draw sharp lines, as there are almost as many different views as there are economists.  For instance Tyler Cowen recently suggested that about 1/3 of the downturn was due to the drop in nominal spending.
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Part 1:  Why is Svensson silent?

In previous posts I have struggled with trying to understand why other economists don’t speak out for easier money.  If you look at Krugman’s writings on liquidity traps it would seem that he should support a more expansionary monetary policy.  More specifically, he should support an explicit inflation target.  And perhaps he does; but he almost never chooses to talk about it.  Another example is Frederic Mishkin, his four key principles of monetary theory underlie my entire argument.  But in a May 2009 AER article he had nice things to say about recent Fed policy.  Yesterday Marcus sent me a paper by Lars Svensson which provided by far the starkest example of this phenomenon.
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Ever since I went to China I seem to have been in a perpetual struggle to keep up.  One of the things I feel most guilty about is that I haven’t had much time to follow Bill Woolsey’s new blog, entitled Monetary Freedom.  By now many of you may have already read it, but those who haven’t should take a look.  From the very beginning Bill has been my most supportive commenter.  And he has similar (though not identical) views on monetary policy errors by the Fed.
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I just got back from a very satisfying trip to GMU, where I met a lot of my favorite economists.  I’ll say more about the trip when I have time, but upon returning I found I was being bombarded on all sides.  I feel like I am in a boat that has more holes in the hull than I have fingers to plug them.  Interested readers might want to check out my ongoing debate on Cato Unbound, where I fend off several reviewers.  You’ll see all the replies in the right margin.
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Next week I go to George Mason University  (which is suddenly my favorite economics department) to present two papers.  On Tuesday I will talk about the relationship between cultural values and neoliberal reforms.  I have already discussed part of that paper on this blog, and will try to do the Switzerland chapter in a few days.  On Wednesday I present a paper on the current crisis.  I had grand ambitions to write this paper in China, but it was a struggle to even keep the blog afloat.  So now I am under pressure to get something done quickly.

I think the best solution is to present a slightly modified version of my recent Cato paper.  This paper is to be discussed by three distinguished economists over the next week; first James Hamilton (of econbrowser.com), then George Selgin, and finally Jeffrey Hummel.  Then we will have a discussion.  It should be a lot of fun, and if I am not able to fully discuss their comments at Cato Unbound (I don’t know if there are space limits) I might add a few comments here.

But then it occurred to me that I really needed to do more than talk about my view of the crisis, I also needed to discuss why almost all other economists are wrong.  (I know that sounds ridiculously arrogant.  Obviously by “wrong” I simply mean “disagree with me.” )

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When I decided to read Tyler Cowen’s new book on the airplane to China, I pretty much knew I was going to arrive in Beijing convinced that I was autistic.  Here are some reasons:

1.  Any time I read some psychology I think they’re talking about me.

2.  I recently heard an autistic guy on NPR who was a wizard with numbers.  His description of the autistic personality reminded me a bit of myself.

3.  I had heard Tyler talk about his book, and knew that he had a favorable view of what he called “the autistic cognitive profile.” 

4.  Autistic people like to make lists of things.

I’m not going to try to explain Tyler’s view of autism, as I would get it all mangled up.  But for those not familiar with his perspective I should at least mention that he is not talking about autism as a mental illness, but rather a certain way of thinking, which may be partly genetic.

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I’ve always found it interesting that the quantity equation (M*V=P*Y) is linked to the quantity theory of money.  Obviously there is no logical relationship between the two, as one is almost always defined as an identity, while the other is a theory.  But there certainly is a perception that the two are somehow linked.

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I wasn’t invited to participate, but since I have a blog I’ll put in my 2 cents worth anyway.  In my view both sides of the debate are wrong.  I disagree with pundits like DeLong, Krugman and Skidelsky, who have used this crisis to argue that mainstream macroeconomics is fundamentally flawed.  Of course there are a few things I’d like to tweak, NGDP targeting rather than inflation targeting, for instance, but the basic building blocks of modern macro are sound.  These include the need for explicit nominal targets for monetary policy, an assumption of efficient markets, and skepticism about using fiscal stimulus as a countercyclical tool.  But what this crisis did clearly demonstrate is that most mainstream economists, indeed nearly all of them, do not know how to apply these tools to a real world crisis.

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Whenever I have a slightly embarrassing post, like my preceding foray into philosophy, I want to get something new up as quickly as possible, in the hope that perhaps people won’t notice the previous one.  So here are few interesting Milton Friedman quotations from 1998 that a commenter named “123″ sent me.  Friedman was discussing Japan:

Low interest rates are generally a sign that money has been tight, as in Japan; high interest rates, that money has been easy.

.   .   .

After the U.S. experience during the Great Depression, and after inflation and rising interest rates in the 1970s and disinflation and falling interest rates in the 1980s, I thought the fallacy of identifying tight money with high interest rates and easy money with low interest rates was dead. Apparently, old fallacies never die.

I thought so too Dr. Friedman.  I don’t think he’d view current Fed policy as expansionary.

PS.  I was going to juxtapose this with the recent comments by Anna Schwartz about low interest rates and monetary ease.  But what’s the point of picking on her, thousands of other economists keep saying similar things.  Still, I feel better knowing that at least Milton Friedman agrees with me.