Must-read: Paul Krugman (2014): “The Limits of Purely Monetary Policies”

Must-Read: The arguments for quantitative-easing-as-stimulus were always twofold: (1) Taking duration risk off of private-sector balance sheets is a thing, even if a small thing. (2) It is unreasonable for markets to believe and for liquidity injections this large to be completely unwound at the end of the day when the long-run comes and the sea is calm and flat again. (1) appears to be small. And (2) appears to be false. But is (2) false because markets expect quantitative easing to be totally unwound? Or is it because markets don’t have “expectations” of anything the way we economists think they do? Moreover, I had an argument (3)–that the liquidity trap only emerged because financial disruption destroyed the risk-bearing capacity of the market, and that quantitative easing would (a) provide some of that risk-bearing capacity directly via the government, and (b) lure private-sector risk-bearing back into the marketplace. Why is it wrong?

Paul Krugman (2014): The Limits of Purely Monetary Policies: “But, asks Evans-Pritchard, what if the central bank simply gives households money?…

…Well, that is, as he notes, really fiscal policy…. [And] central banks aren’t in the business of just giving money away… [but] of asset swap[s]…. Still, isn’t this just theory? Well, no. Huge increases in the monetary base in previous liquidity trap episodes had no visible effect…. I have supported QE in both Britain and the US, on the grounds that (a) central bank purchases of longer-term and riskier assets may help and can’t hurt, and (b) given political paralysis in the US and the dominance of bad macroeconomic thinking in the UK, it’s all we’ve got. But the view I used to hold before 1998–that central banks can always cause inflation if they really want to–just doesn’t hold up, theoretically or empirically.

Paul Krugman (2014): The Simple Analytics of Monetary Impotence: “If we have rational expectations and frictionless capital markets…

…which we don’t, but let’s see what would happen if we did… [plus] logarithmic utility… then…

C = C(P/P)/(1+r)…

an Euler equation that lets us read off current consumption from future consumption, current and future price levels, and the interest rate…. Now suppose that we’re in a New Keynesian world in which prices are temporarily sticky; so P is given. And… we’re at the zero lower bound, so r=0. Then there’s only one moving part here: the expected future price level. Anything you do–monetary or fiscal–affects current consumption to the extent, and only to the extent, that it moves the expected future price level. Full stop, end of story. An immediate implication is that the current money supply doesn’t matter…. Don’t talk to me about monetary neutrality, or how it stands to reason that money must matter, or helicopter money, or even money-financed deficits; we’ve taken all of that into account….

Now, if we let households be liquidity-constrained, giving them transfer payments can affect current spending; but that’s a fiscal point…. Another perhaps less immediate implication is that there is no crowding out from temporary fiscal expansion…. Notice that this is in an approach with full Ricardian equivalence; so every economist who claimed that Ricardian equivalence makes fiscal expansion ineffective has actually shown that he doesn’t understand the concept….

I’m not claiming that this Euler equation is The Truth. If you want to make arguments about policy that rely on… imperfect capital markets, fine. But that’s not what I hear in most of this discussion; what I hear instead are attempts to talk things through that end up being, unintentionally, word games… reason[ing] in terms of concepts like monetary neutrality that aren’t as well-defined as [people] think… fooling themselves into believing that they’ve demonstrated things they haven’t.

Now, one good exception is Brad DeLong’s argument that money does too work in a liquidity trap because such traps are always the result of disrupted financial markets. What I’d say is that they are sometimes caused by financial disruption. But is this one of those times?…. If you disagree, please try to put your argument in terms of what the people in your model are doing–not in terms of catchphrases.

December 21, 2015


Brad DeLong
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