Scott Sumner  

Monetary offset: Reply to my critics

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Not surprisingly, there has been lots of criticism of my claim that the Keynesian test of 2013 failed. Let me respond to some of the points:

1. I was accused of cherry picking dates, as I compared growth in the 4 quarters before and after the onset of austerity on January 1st, 2013 (when all the tax increases kicked in--the sequester came a few months later.) Growth rose from 1.60% in 2012 to 3.13% in 2013 (Q4 to Q4.) But my critics are correct that 2012 was an unusually slow year, so maybe a longer time period would be better. Here are growth rates over:

The previous 2 years: 1.65%
The previous 3 years: 2.04%
The previous 4 years: 1.47%
The previous 5 years: 0.59%
The previous 6 years: 0.81%
The previous 7 years: 1.05%
The previous 8 years: 1.33%
The previous 10 years: 1.91%
The previous 15 years: 2.51%

All lower than in 2013. (I ignored compounding to save computational time; the actual growth rates were slightly less, strengthening my point.)

So cherry-picking data isn't the issue. What if you go forward more than 4 quarters, say 2 years? The winter 2014 quarter was slow because of unusually bad winter; however both the spring and summer of 2014 were red hot. It looks like 2014 will also show decent growth when Q4 data comes in.

Another complaint is that the increase in growth in 2013 was not significant. There are actually two issues here, measurement error, and the problem of ceteris paribus. As far as measurement error, I've always acknowledged that the government probably overestimated the speed up in 2013, as other data like job creation shows a much smaller acceleration. But the point is that even the other data shows faster growth, which refutes the Keynesian prediction that growth would slow.

A better argument is that the speed up was within the normal year-to-year fluctuations reflecting all sorts of factors. To see the problem with this argument, we have to go back and look at the "test," and consider what the Keynesians were trying to show. It might be helpful to first look at a case where the RGDP data went as the Keynesians expected, Britain after the election of the Conservatives in 2010.

The Conservatives were accused of slowing the British recovery with a policy of "austerity." I use the scare quotes because Britain continued to run just about the largest budget deficits in the world during the early years of Cameron. But let's accept the Keynesian method of estimating changes in cyclically-adjusted deficits. One thing I noticed is that Britain had a very odd growth slump:

1. Britain continued to generate more jobs than many other developed countries.
2. Britain experienced relatively high and rising inflation.

Now I'm not arguing that Britain had no AD problem, I think it did have one. But given the jobs growth, surely some of the British slowdown in RGDP growth was due to productivity factors unrelated to low AD. Some have pointed to less North Sea oil output and less earnings from big banks in the City. Perhaps the "big government" policies of the previous Brown government slowed trend productivity growth a little bit. I don't claim to know all the reasons, but Britain would be a textbook case where you might want to question whether it was austerity, or some other factor that explained the RGDP growth slowdown. The ceteris paribus problem.

Nonetheless, the impression I got reading people like Paul Krugman and Simon Wren-Lewis was simply; Austerity ---> RGDP slowdown, case closed.

Suppose that if instead of increasing from 1.60% to 3.13% in 2013, growth in the US had slowed by an equal amount (to near zero). Let's be serious for a moment, and please answer this honestly. Does anyone think the Keynesians would have been saying, "Gee, that pause in the recovery can't be attributed to austerity, because the drop in RGDP growth is not statistically significant?" If any reader answered "yes," I hereby accuse you of intellectual dishonesty.

Now some want to argue that even if Krugman, et al, got this wrong, and also used sloppy techniques for considering UK and eurozone austerity, this doesn't definitively prove market monetarism is correct or Keynesianism is false. Sure, I'd agree with that. Personally, I prefer market tests. I like to look at how market prices respond to new information about monetary policy. And of course this is one reason why the Fed needs to subsidize trading in NGDP (and RGDP) futures markets. And I'd prefer looking at NGDP growth, whereas the Keynesians use RGDP growth.

My point is different; market monetarism passed the test as set up by Keynesians, using the Keynesian ground rules. Their own model failed their own test.

PS. Sometimes Keynesians refer to more systematic studies, but these generally involve lots of observations for regions lacking an independent monetary policy. Numerous researchers have found the correlation goes away if you exclude observations lacking an independent monetary policy. (Mark Sadowski, Kevin Erdmann, Benn Steil & Dinah Walker.)

PPS. I am certainly not dogmatic on this issue:

1. Fiscal stimulus that lowers inflation can be expansionary, even with monetary offset (VAT cuts and employer-side payroll tax cuts are two examples of fiscal stimulus that might work by encouraging monetary stimulus to raise inflation up to target.)

2. Supply-side cuts in capital taxation can boost real GDP growth.

3. Spending on wasteful things like military output can boost RGDP (at the expense of lower living standards) by encouraging people to work harder to try to maintain living standards.

4. If central banks are incompetent in a very specific way then fiscal stimulus might help. But not incompetent in the way the ECB was incompetent when they tightened in 2011 by raising their target rates. More (demand-side) eurozone fiscal stimulus in 2011 would not have helped.


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COMMENTS (12 to date)
Marcus Nunes writes:

Krugman et al should have no doubt about the monetary offset. After all, during Clinton´s deficit reduction program:
"All of these developments were known at the time, but they had not fully cohered when Clinton began to construct his first economic plan. The key decision was not whether to reduce the deficit—given its size, the White House had no other realistic option—but rather what effect this would have upon the economy. Everyone present assumed that raising taxes or cutting spending would, at least in the short run, dampen economic growth. White House economists gave serious consideration to the possibility that their plan would throw the economy into recession. The only way to avoid this dismal fate was if the Federal Reserve or the bond market would lower interest rates to spur economic activity and make up for the depressing effects of deficit reduction." Clinton's colorful response may be found at http://prospect.org/article/clintons-bequest

Interesting that while the monetary offset was being applied, the US experienced a productivity boom, in which case the ongoing fiscal offset became "too much" and NGDP growth went up, later requiring an adjustment, which initially was too strong...The instability of 1998-03 ensued!

[Comment edited with permission of commenter. --Econlib Ed.]

Andrew_FL writes:

On point 3 (second list) I'm reminded that Kuznets did argue originally that military spending was the purchase of an intermediate good.

Of course, that was because GDP was originally intended to for more living standard oriented/welfare purposes. For a measure of the "effective money stream" (Hayek's term from Prices and Production) there is no reason to exclude spending even if it is wasteful. But, the effective money stream is a nominal variable. There is actually very little of Fisher's PT that one would have good reason to exclude from it, actually. Although assuming I understood the response Bill Woolsey gave when I asked about that, there would be good reason to exclude stocks/financial assets.

I still think RGDP is ill grounded in value theory, but, if we did want to create an index like it to measure living standards, the "real value" of wasteful spending should be set to a price near or at zero (possible negative).

tesc writes:

Dr. Sumner, this is frustrating. Keynesians predicted negative growth because of fiscal contrantion. It did not happen because of monetary expansion.

What part of "They lost, we won" they do not understand?

End of rant.

Scott Sumner writes:

Marcus, Good find!

Andrew, The question of how to define MV=PY, or PT depends entirely on the purpose you plan to use it for. Are you interested in explaining GDP, or transactions.

tesc, Good question.

ThomasH writes:

I sense that Scott and the "Keynesians" are talking past each other.

The "Keynesian" prediction that discretionary reductions in expenditures in 2013 would reduce RGDP was made with respect to a counter-factual RGDP without the reductions and ceteris paribus that monetary policy would not adjust to offset the reductions. The way to see how good or bad that prediction was is to put them in a model and see how they work. With/without is not usually the same as before/after.

Maybe the "Keynesians" were wrong. Monetary policy did not adjust and there were no other positive shocks that increased AD.

Maybe the "Keynesinas" were right. Monetary policy did adjust by enough to compensate the expenditure reduction or monetary policy did not adjust but there were other positive shocks.

I have not seen either the MM or the "Keynesian" side do this. Maybe this would be a good first project for Scott's new program at GMU.

It seems to me that the main differences between "Kenesians" and "Market Monetarians" are differences in view of how central banks can and will react to changes in fiscal policy. Both seem to be united in their views, in contrast to those of inflation hawks, of how markets will react to changes in the central bank balance sheets.

Andrew_FL writes:

@Scott Sumner-I agree completely. I was just saying that wasteful military (and other) spending may have no place in a welfare measure (As RGDP was intended to be) but does have a place in a measure of the "effective money stream" (As NGDP is at least roughly a proxy for).

Ironically, Kuznets set out to construct a Keynesian measure to gauge the success or failure of Government policies on general welfare, but what we ended up with is really more a monetary flow measure, useful for Market Monetarists and fellow travelers, but not so much Keynesian purposes per se.

james in london writes:

ThomasH.
One issue with the Keynesians is that their model already assumes that monetary policy cannot offset the fiscal contraction since their model says monetary policy is not possible at the ZLB. So they would be right, in terms of their model. But that won't be very insightful.

Ray Lopez writes:

I don't think this post adds anything that was not covered in the post http://econlog.econlib.org/archives/2015/01/the_keynesian_s.html and in particular the exchange between Sumner and Ram there.

Further, Krugman says a lot of things, as did Keynes (who for instance adopted a gold standard to fix exchange rates, despite calling it a 'barbaric relic'). Therefore, a link to what was the offending quote is in order, with the realization that economists tend to exaggerate to make their case. For instance, the "Open Letter" cited by Sumner is fairly uncontroversial, simply arguing that growth in 2013 would be higher without sequestration cuts (which cannot be disproved since it was not done).

The only controversial (and clearly wrong) statement in the Open Letter is this one, as there was no double-dip recession in 2013: "At the end of the year, we face a congressionally-created "fiscal cliff," with automatic "sequestration" spending cuts everyone agrees should be stopped to prevent a double-dip recession."

But Krugman did not sign this letter. His austerity is bad column found here: http://www.nytimes.com/2012/09/28/opinion/krugman-europes-austerity-madness.html is not about this debate since it discusses the EU austerity plans, not the USA's.

The other link to Krugman austerity, this one by Sumner: "http://krugman.blogs.nytimes.com/2013/04/28/monetarism-falls-short-somewhat-wonkish/" is full of qualifications such as "seems to be" ("austerity seems to be taking its toll"), which is speaking to the future, and Krugman was wrong about this seeming toll taking. But Krugman does discuss in the same paragraph that austerity was bad for the UK ("I would add that the UK experience provides a similar lesson.")--so this is the claim that should be addressed, not what Krugman mistakenly thought 'seems to be' happening in the USA in 2013.

In short, seems Sumner and his critics are both talking past each other. It's much ado about nothing seems to me.

Don Geddis writes:

@ThomasH: "The "Keynesian" prediction that...reductions in expenditures...would reduce RGDP was made...ceteris paribus that monetary policy would not adjust to offset the reductions."

You're being far too generous to the Keynesian predictions. The "ceteris paribus" about monetary policy was essentially never mentioned. You might counter that it was "obviously always assumed", or something like that. But given how critical that factor is, to the final effect on the economy, they should have been far more vocal about this critical assumption. (Assuming, of course, that they actually did think about this, or even believe it.)

Scott Sumner writes:

Thomas, Take a look at my new post over at money illusion (liberalism in 2007) See if that helps. I do see your point.

Andrew. Good point, and my previous reply wasn't meant as criticism.

Ray, Are you saying the MMs and Keynesians didn't have sharply different views on how austerity would affect the economy in 2013? If so, I don't agree.

Mark Bahner writes:
His austerity is bad column found here: http://www.nytimes.com/2012/09/28/opinion/krugman-europes-austerity-madness.html is not about this debate since it discusses the EU austerity plans, not the USA's.

No, he had a column in December 2013 that called U.S. spending "unprecedented austerity."

That was followed a single bad quarter and two pretty darn good quarters. If we have a third quarter in a row of decent growth, it seems hard to make a case that "unprecedented austerity" is something to be feared.

Ray Lopez writes:

@Mark Bahner - Krugman did not predict any recession in his blog post you cite. Krugman could be (in his mind) be considering the case that with no austerity the USA would enjoy even greater growth. Please show me the Krugman post that predicted a recession due to austerity in the USA.

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