Taking Krugman's Side
By Arnold Kling
Goodness knows, I don’t want to. I still think he owes me a correction–and in fact an apology–in his column for putting in quotation marks an inaccurate, misleading, and distorted version of something I said.
But here is Tyler Cowen continuing to endorse Scott Sumner’s monetarism.
I should add that I don’t think anyone (I’m not talking about Krugman here) has responded to the claim that quantitative easing, and other monetary reforms, could substitute for a very expensive fiscal stimulus.
I will attempt to provide the sort of response that Tyler is looking for, because I think it can bring out some interesting points about macro theory.Start with a Tobin model, in which there are three assets–money, bonds, and stocks, and stock prices drive investment. Tobin puts together a substitution matrix in which it is plausible that an increase in the public’s holding of money and a decrease in its holding of bonds will serve to raise the demand for stocks, causing stock prices to go up and investment to increase.
Krugman is saying that monetary policy will not work in the current environment. He is saying that when the Fed buys bonds now, it is exchanging what in the public’s mind are very close substitutes, so that the effect on other asset prices is minimal. I think that is true.
In fact, I think that it is almost always true that monetary policy is ineffective, because it is almost always true that money and other assets are close substitutes. In Can Greenspan Steer?, I pointed out that long-term interest rates were falling (this was August of 2002) even though Fed policy was to hold rates steady.
Think of an expanded Tobin model, with hundreds of assets and a gigantic substitution matrix. The Fed ordinarily makes short-term repurchase loans to bond dealers. The repo loans use near-term Treasuries as collateral. Out of all the interest rates in the system, the Fed is basically working on the short-term repo rate for holders of riskless collateral. There are plenty of reasons why open market operations might leave other rates unaffected, and those other rates are more important determinants of spending by businesses and consumers.
The only time when I think that monetary policy matters is when there is runaway inflation. When we have runaway inflation, then money is not a good substitute for other assets. Money is depreciating, while hard goods are appreciating and financial assets have nominal interest rates that incorporate an inflation premium. In that environment, with highly imperfect substitutability between money and other assets, a slowdown in money growth will help to end the inflation.
However, in normal times without runaway inflation, money and short-term assets are close substitutes. That makes monetary policy pretty ineffective.
It is true that the Fed could use its balance sheet to purchase assets that are not close substitutes for money. It could buy securities backed by mortgages or commercial loans. That would have real effects. But that would be equivalent to an expenditure that subsidizes mortgage lending or commercial lending. Whether you call it fiscal or monetary policy may come down to a matter of semantics. To see the similarity, consider that the Fed might buy state and local bonds to lower the cost of financing shovel-ready road projects.
Sumner and Cowen talk about the possibility of announcing an inflation target of, say four percent. If announcements of policy targets can change behavior, then that certainly is a cheap way to fight a recession. However, I don’t see how the strip-mall business in Peoria is supposed to hire a worker or take out a loan based on the inflation target announced in Washington.