Is there a “correct” monetary policy? Yes!

In what way does Peter Gourevitch think that Paul Krugman’s analysis of the Federal Reserve is wrong?

Here we have, first, Gourevitch saying: “opinions of the shape of the earth always differ”:

Peter Gourevitch: This is why Paul Krugman is wrong about the Federal Reserve: “The second set of criticisms reflects a more fundamental disagreement between economics and political science…

…Economists tend to assume that there is a single right answer (even if they disagree bitterly among each other about what the right answer is)…. Political scientists… assume that there is more than one interpretation of what is correct, and try to come up with theories about which “correct” answer is chosen…

I reject this.

I reject this completely.

I reject this utterly.

For more than a hundred years there has been a broad near-consensus among economists that there is such a thing as a “correct” monetary policy.

To quote Keynes (1924):

Rising prices and falling prices each have their characteristic disadvantages. The Inflation which causes the former means Injustice to individuals and to classes,–particularly to investors; and is therefore unfavorable to saving. The Deflation which causes falling prices means Impoverishment to labour and to enterprise by leading entrepreneurs to restrict production in their endeavour to avoid loss to themselves; and is therefore disastrous to employment, The counterparts are, of course, also true,–namely that Deflation means Injustice to borrowers, and that Inflation leads to the over-stimulation of industrial activity. But these results are not so marked… borrowers are in a better position to protect themselves than lenders… labour is in a better position to protect itself from over-exertion in good times than from under-employment in bad times.

Thus Inflation is unjust and Deflation is inexpedient. Of the two perhaps Deflation is, if we rule out exaggerated inflations such as that of Germany, the worse; because it is worse, in an impoverished world, to provoke unemployment than to disappoint the rentier. But it is not necessary that we should weigh one evil against the other. It is easier to agree that both are evils to be shunned. The Individualistic Capitalism of to-day, precisely because it entrusts saving to the individual investor and production to the individual employer, presumes a stable measuring rod of value, and cannot be efficient–perhaps cannot survive–without one…

Paul Krugman’s point is that the consensus of the 1980 MIT macroeconomics posse is that right now a higher inflation target than 2%/year is appropriate and that raising interest rates is not appropriate. “Opinions of shape of earth differ” or even “There is no correct answer when there are competing rival views that are not easily testable in a complex world where one cannot readily carry out controlled experiments with obvious real world interpretations…” simply does not clear the bar as a criticism.

As I like to put it, back in 1820 Thomas Robert Malthus identified a “general glut” as a problem independent from and much more dire than a simple misallocation of productive resources that produced excess supply in one industry and excess demand in another:

Thomas Robert Malthus: The “General Glut” (1820): “[T]he effect of falling [manufacturing export] prices in reducing profits…

…is but too evident at the present moment. In the largest article of our exports, the wages of labour are now lower than they probably would be in an ordinary state of things if corn were at fifty shillings a quarter. If, according to [Ricardo’s] new theory of profits, the prices of our exports had remained the same, the master manufacturers would have been in a state of the most extraordinary prosperity, and the rapid accumulation of their capitals would soon have employed all the workmen that could have been found. But, instead of this, we hear of glutted markets, falling prices, and cotton goods selling at Kamschatka lower than the costs of production.

It may be said, perhaps, that the cotton trade happens to be glutted; and it is a tenet of the new doctrine on profits and demand, that if one trade be overstocked with capital, it is a certain sign that some other trade is understocked. But where, I would ask, is there any considerable trade that is confessedly under-stocked, and where high profits have been long pleading in vain for additional capital? The [Napoleonic] war has now been at an end above four years; and though the removal of capital generally occasions some partial loss, yet it is seldom long in taking place, if it be tempted to remove by great demand and high profits…

And back in 1829 the young John Stuart Mill identified the key cause as our possession of a monetary economy, and in a monetary economy Say’s Law–that supply creates its own demand–is false in theory: a general excess supply of pretty much all currently-produced goods and services, Malthus’s “general glut”, is the metaphysically-necessary consequence of an excess demand for whatever currently counts as money:

John Stuart Mill (1829): Essays on Some Unsettled Questions: “[In a non-monetary economy] the sellers and the buyers…

…for all commodities taken together, must, by the metaphysical necessity of the case, be an exact equipoise to each other; and if there be more sellers than buyers of one thing, there must be more buyers than sellers for another….

If, however, we suppose that money is used, these propositions cease to be exactly true…. Although he who sells, really sells only to buy, he needs not buy at the same moment when he sells; and he does not therefore necessarily add to the immediate demand for one commodity when he adds to the supply of another….

There may be, at some given time, a very general inclination to sell with as little delay as possible, accompanied with an equally general inclination to defer all purchases as long as possible. This is always actually the case, in those periods which are described as periods of general excess… which is of no uncommon occurrence….

What they called a general superabundance, was… a superabundance of all commodities relatively to money…. Money… was in request, and all other commodities were in comparative disrepute. In extreme cases, money is collected in masses, and hoarded; in the milder cases, people merely defer parting with their money, or coming under any new engagements to part with it. But the result is, that all commodities fall in price, or become unsaleable. When this happens to one single commodity, there is said to be a superabundance of that commodity; and if that be a proper expression, there would seem to be in the nature of the case no particular impropriety in saying that there is a superabundance of all or most commodities, when all or most of them are in this same predicament…

And ever since then, every monetary economist worthy of the name has sought a government and a central bank that will pursue a monetary policy that makes Say’s Law true in practice even though it is false in theory. Everyone has sought for a policy that makes the demand for money in conditions of full employment equal to the supply, so that we have neither an excess demand for money and Keynes’s inexpedient Deflation, nor an excess supply of money and Keynes’s unjust Inflation.

There is a single right answer in monetary policy. It is the policy that hits this sweet spot.

October 4, 2015


Brad DeLong
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