Scott Sumner  

Markets describe reality; models should explain market reactions

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Good for Michael Vick--or Ince... Obama vs. Wall Street Journal ...

Paul Krugman has a new post that explains why he is pessimistic about monetary stimulus at the zero bound. He briefly describes his 1998 paper on the zero bound problem. This paper shows that if base money and bonds are perfect substitutes at the zero bound, and if monetary stimulus is expected to be temporary (i.e. not to affect future money supplies) then conventional open market purchases are ineffective at the zero bound.

From a technical perspective, there is nothing wrong with Krugman's model. The real problem is the way he uses the model. A model by itself cannot tell us much about the impact of monetary policy on the economy, because we don't know if it describes reality, or leaves out important aspects of the real world.

A better way to proceed is to first observe that QE does impact market prices (such as foreign exchange rates) in a way that is at odds with the predictions of Krugman's model, and then construct a new model to explain why. That's actually pretty easy to do, for instance one simple way is to assume that QE affects the future expected money supply. And that's hardly an ad hoc assumption; indeed it is the standard assumption that's been used in monetarist economics for decades. They don't always say so explicitly, but quantity theoretic claims about the impact of money on prices always assumed that monetary injections were permanent. But those implicit monetarist assumptions were just as ad hoc as Krugman's assumption that monetary stimulus is temporary.

We need to look to real world data to figure out how markets perceive a given policy action. Krugman's mistake is to work from his model to conclusions about real world cause and effect. Instead he should be adjusting his model to figure out why QE announcements in the US, Japan, and the eurozone cause currencies to depreciate.

PS. I do agree with Krugman on one important point. When I read Krugman's critics, it seems like some of them do not understand his argument. They really should read his 1998 paper. There's nothing wrong with the paper itself, and indeed after writing the paper Krugman starting criticizing the Japanese for fiscal stimulus, encouraging them to rely more on monetary stimulus. More specifically, he encouraged the BOJ to make its monetary stimulus permanent. Later he reached different conclusions. The model didn't change, just the way he interpreted the model.

PPS. Ambrose Evans-Pritchard points to another important piece of evidence against Krugman's claims. The US, UK, and eurozone all did roughly equal amounts of austerity in the past 4 years, and yet the US and UK created jobs at a much faster rate, due to much more expansionary monetary policies.

HT: Saturos, James in London, TravisV


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COMMENTS (16 to date)
Ray Lopez writes:

@Sumner - I'm sorry but your piece does not do justice to the Krugman debate at all. As you admit, there's nothing wrong with Krugman's paper. Your attempt to rebut his conclusions by pointing to the Forex market is a red herring (currency markets are notoriously hard to model, since currency changes depend on a myriad of factors including probability of default and unsophisticated herd-like speculators who are noise, by way of example). The fact remains: at zero lower bound, you cannot create inflation if the price increase is temporary. Thought experiment: everybody gets a one-off helicopter drop of $100M. What happens to prices? They are all adjusted, over-night to the new price level, but inflation would be zero if the markets understood the helicopter drop was one-off (one time). You just shift the zeros on the price tag is all.

You cite the journalist AEP favorably, but his piece is more laughable than yours when he asserts "America has carried out the most drastic fiscal squeeze since demobilization after the Korean War without falling into recession" when in fact for the last four years the US Federal deficit has been well over 1T dollars or at least 0.5T (see: http://www.usgovernmentspending.com/federal_deficit_chart.html) What planet are you people on when a huge unprecedented deficit is a "fiscal squeeze"?

Then you wonder why nobody takes your target NGDP proposal seriously. I suggest you start acting more serious, like dare I say, Paul Krugman.

Brian Donohue writes:

The consolidation AEP refers to is (a) the end of the 2% payroll tax holiday, (b) the 2013 fiscal cliff tax increases, and (c) the 2013 sequester, a combination Krugman predicted would sabotage the economic recovery.

Market Monetarists argued that Fed QE and forward guidance could neutralize the contractionary effects of fiscal consolidation (monetary offset).

Krugman said ha! and declared 2013 to be a test of market monetarism.

/sad trombone for PK

CMA writes:

"What happens to prices? They are all adjusted, over-night to the new price level, but inflation would be zero if the markets understood the helicopter drop was one-off (one time)."

A price increase is inflation right?

Scott Sumner writes:

Ray, You've already been making a fool of yourself over at TheMoneyIllusion--you really might want to rethink your level of self-confidence before coming over here. Your discussion of Krugman's 1998 paper is so wide of the mark that I'm not even going to respond. You don't seem to even understand what we are debating.

Of course it's Krugman and the Keynesians who think the federal government was engaged in lots of austerity in 2013, not me. It was Krugman who said 2013 was a test of the market monetarist claim that fiscal austerity is not contractionary. I'm happy with people who want to deny there was any austerity at all in 2013--I'm just taking the Keynesians at their word. But I'm not happy with people who are utterly clueless about what the debate is all about, and then acting like know-it-alls.

So shouldn't you be suggesting that Krugman get more serious, not me? He's the guy who sees "austerity." And shouldn't you tone down your ridiculous overconfidence until you've at least begun to study the macroeconomic issues being debated over here?

CMA, You asked Ray:

"A price increase is inflation right?"

Don't confuse him, he's in way over his head, and cannot yet handle those sorts of complex ideas.

Roger McKinney writes:
The US, UK, and eurozone all did roughly equal amounts of austerity in the past 4 years, and yet the US and UK created jobs at a much faster rate, due to much more expansionary monetary policies.

Maybe, but that conclusion could be the result of a spurious correlation and an example of the post hoc fallacy.

It's also possible that the UK and US economies are more flexible, or suffer less from rigid regulations, and those micro effects did the heavy lifting while money just takes the credit.

Ray Lopez writes:

@Sumner - I was responding to this quote by you: Ambrose Evans-Pritchard points to another important piece of evidence against Krugman's claims. The US, UK, and eurozone all did roughly equal amounts of austerity in the past 4 years, and yet the US and UK created jobs at a much faster rate, due to much more expansionary monetary policies..

It is indeed hard to understand what you are talking about, but that's more due to you than the subject matter. At best, what you are trying to cryptically say is (by endorsing AEP): "The US, UK, EU did not expand their fiscal policy as much as Paul Krugman wanted them too--and thus did 'austerity' as defined by Paul Krugman--yet, because the US, UK (but not EU) expanded their monetary policies (as I, Scott Sumner, approve of doing with my targeting NGDP proposals),the UK, USA created jobs and recovered at a much faster rate than Paul Krugman could have imagined, and more than the EU, which did not follow this expansionary monetary policy".

That is what you are trying to say (as best I can tell). But that's not what you wrote. I'll be surprised if I see this reply posted.

[comment edited, per commenter agreement--Econlib Ed.]

Daniel Kuehn writes:

My impression has always been that his recommendations, interpretation, and conclusions haven't changed since Japan - he has just been concerned that the Fed's QE announcements have never indicated the permanence that would be required and he was pessimistic that they would. It has been a couple years since I read the paper, though.

I haven't read this recent blog post though - I'll give that a look.

Nick writes:

Roger,
That could be. I think its worth extending the comparison all the way back to 2008 if you want to look at the structural side of the argument. The EZ was keeping pace with the US and England in terms of the recovery until 2011. The structural problems with their economy did not suddenly get worse then--the ECB raised interest rates.
Now you could point to austerity in 2011-2012 EZ to explain that instead of the interest rate move--but then why didn't the US austerity of 2013 send us into a similar spiral?
The argument is not a proof, certainly. I think problems with international comparisons of price indices alone generate enough uncertainty that you can ignore the data without even making a structural argument if you want.
But from the data we do have, Prof Sumner's story makes the most sense to me.

Scott Sumner writes:

Roger, That could explain the job creation, but not the faster NGDP growth in the US (as compared to the eurozone.) Nor could it explain why we are closer to our 2% inflation target.

Daniel, Half of the time he says central banks can do it, they just won't; the other half he says they cannot, as they are stuck in an expectations trap. In that respect he resembles Keynes.

Nick, Good point.

Everyone, I should not have been so rude to Ray, as I forget about the higher level of courtesy expected over here. I had been used to the constant stream of insulting comments from Ray over at TheMoneyIllusion.com, where the standards are more lax.

ThomasH writes:

Re: Krugman's (uncited) mistaken"claims" the greater monetary expansion in US and UK may not have been independent of the deficits that the US a and UK governments were willing to run. The amount of QE that a central bank needs to do to maintain its NGDP target depends in part on how interest rate sensitive governments in its monetary area are. I see Krugman's main argument with gold bugs and inflation hawks who have resisted the kind of monetary actions needed to restore NGDP growth to its pre-recession trend.

James in London writes:

[Comment removed for rudeness. Email the webmaster@econlib.org to request restoring your comment privileges.--Econlib Ed.]

genauer writes:

a) your "yet the US and UK created jobs at a much faster rate" claim is simply false, see the IMF data on page 2 of
http://de.slideshare.net/genauer/sampler-2-of-imf-2014-weo-data-plots

b) Ambrose-Evans-Pritchard is a well known anti German hate mongerer, english imperialist, arguing at some point in print, that Euro negotiations should be held "with a knife to the throat of Wolfgang Schäuble", the german finance minister, being a wheel chair cripple because of an alien terrorist knife attack.

When it suits his anti-German agenda he also gives aid and comfort to lefties like de Grauwwe and his phantasy numbers about european household wealth.

c) I say that Krugman has never produced anything but equation gimmicks, and I am still waiting for one person to show me otherwise. Just ONE paper of value.

The Krugman 1998 BPEA paper is garbage and, politely, I do ask you, Scott Sumner, to take up my challenge:

"And I am still waiting for one person in this world , who can name a specific Krugman PAPER, explain in a few sentences, in his own words, what is soo good about it, and is willing to defend his judgement versus questions from me"

Ray Lopez writes:

@Scott Sumner - apology accepted. Actually I thought this blog was more like, as you say, the more free-for-all TheMoneyIllusion.com After this comment I'll probably go back there, it's more fun.

@genauer- who says: "And I am still waiting for one person in this world , who can name a specific Krugman PAPER, explain in a few sentences, in his own words, what is soo good about it, and is willing to defend his judgement versus questions from me"
I'm no fan of Krugman, but his contribution is spelled out in layperson terms here: http://www.forbes.com/2008/10/13/krugman-nobel-economics-oped-cx_ap_1013panagariya.html

In a nutshell: can you explain why the USA imports oil products and, at the same time, exports these same product? No it's not just transportation costs. Why they trade with other countries that have exactly the same factor endowments and/or similarities? Free trade before Krugman could explain why two or more countries would trade if they had a comparative advantage (in differential costs, or in different products produced) but a hard time explaining why similar countries with similar costs and products would trade. Krugman solved that puzzle. I think a reasonable person would objectively say that Krugman did good work on this issue.

As for Germans being hated, well, as you say, that's wrong. Turns out there are many different kinds of Germans, some good, some bad, some ugly, but what I find interesting is that after losing two World Wars now all Germans are pacifists and good guys. Well I guess that's human nature. Everybody, as war historian J. Keegan points out, is capable of wartime atrocities when their enemy has been defeated and is prostrate, so ask not for whom the bell tolls.

genauer writes:

@ Ray Lopez
I have choosen my wording "And I am still waiting for one person in this world , who can name a specific Krugman PAPER, explain in a few sentences, in his own words, what is soo good about it, and is willing to defend his judgement versus questions from me" deliberately and therefore put into quotation marks.
Because, the general, unspecific eulogies like you Forbes link , those I have heard often. And I never get an answer, when I then ask, where is specifically, in what specific paper in what specific paragraph.
As a background: I am not a layperson, I have an h-index > 15 and more than 1000 citations of more than 50 refereed papers

As a European, I simply fail to see any problem with that folks trade similar or identical products across country boundaries. to begin with. Certainly not in close vicinity, as here in Europe. There is no puzzle to be solved, at all.
But even globally, let us take the semiconductor industry. 4 big wafer suppliers for an identical product, 1 German, 1 US, 2 Japanese, And everybody in the world, incl Germany and the US buys from ALL 4, to not become dependent on a subset. More important than shipping costs around the whole world.

Your allegation "Germans being hated, well, as you say", where did I say something like that?
Just google "BBC: Germany is the most popular country in the world"
That doesn't change the fact that a tiny number of notorious anti-German hate mongerers like Paul Krugman, George Soros, de Grauvwe, de Buiter are trying to change that.

Your "now all Germans are pacifists" flies in the face of the facts as well.
Until the fall of the Berlin Wall in 1989 Germany had the largest standing western army in Europe with 495 000 men armed and ready, and weapons and reserve structures to increase this to 2 Millions within 2 weeks, of "extremely high quality" as Paul Kennedy said in "The rise and fall of great powers". I was for many years on call for a bomber squadron, like many other. Does this sound "pacifist" to you?

Scott Sumner writes:

Thomas, I don't think central banks have to do any QE in order to do NGDP targeting.

Genauer, Page 2's graph supports my argument. For someone with an h index greater than 15 you have some trouble reading graphs.

I'll avoid any Evans-Pritchard pieces where he mongers anti-German hate. As you know, I approve of German economic policy, it's ECB policy I object to.

genauer writes:

Scott Sumner,

there is nothing wrong with my ability to read graphs, especially when I created them and have the underlying tables at hand : - )
(That IMF 2014 WEO excel sheet is in general a very useful tool for many data checks, and more reliable / usable than the CIA and the OECD)

Soo, would you like to get specific and quantitative on how my page 2 supports your reiterated argument "yet the US and UK created jobs at a much faster rate" against the "Eurozone"?

Maybe especially with the US numbers in 2013 2.9% DOWN below peak in 2007, UK 1.3% DOWN,

but second largest France only 0.9% down, from 2007 to 2013, and Germany, as the largest Euro country

UP by full 4.2%

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