There are two kinds of people . . .
By Scott Sumner
Ideology is perhaps the most common way of dividing economists into groups. You have Allan Meltzer on the right, and Paul Krugman and Joe Stiglitz on the left. Today I’d like to argue that in one very important way it is Krugman and Meltzer who should be grouped together, and Stiglitz placed in a separate category.
Back in 1988 Meltzer wrote a book on Keynes. In a footnote (the most important part of the book, BTW) Meltzer wondered why Keynes didn’t recommend an inflation target high enough to prevent a liquidity trap. After all, if the trend rate of inflation were high enough, then nominal interest rates would never fall to zero. In that case, the central bank could stabilize the economy, and fiscal policy wouldn’t be needed. The entire General Theory would be superfluous.
At about this time, the Keynesian community began to assume that inflation was high enough that we didn’t need to worry about monetary policy ineffectiveness, and “new Keynesianism” was born. A few years later Japan hit the zero bound, and Paul Krugman began worrying that it could happen here as well. When it did happen here, Krugman made essentially the same point as Meltzer, why not raise the inflation target high enough so you don’t face the zero bound problem? So did Brad DeLong. In that case the central bank could stabilize the economy, and there’d be no more “Great Recessions.”
I believe Meltzer and Krugman and DeLong are right that a high enough inflation target would prevent the zero bound problem. But I also believe that all four of us are very much in the minority. Most economists don’t think in nominal terms, they think in real terms. Stiglitz is much more representative of the profession as a whole. They think in terms of bank loans, demographics, inequality, deregulation, investment, and a million other factors that might impact the credit market, but have no impact on demand if the central bank is inflation targeting. In the majority view, monetary policy is not the all important policy tool that steers the nominal economy, but rather just one of many factors to put into the equation, to explain changes in “aggregate demand.” They might see declining Japanese population as something that reduces aggregate demand, whereas to me, it obviously reduces aggregate supply.
Why do so many people overlook these strange affinities and differences? I think one reason is that when monetary policy does fail, and we end up at the zero bound, people like Paul Krugman and Brad DeLong start saying things that sound a lot like what Joe Stiglitz says. Paradox of thrift, fiscal stimulus, etc., etc. In contrast, Meltzer continues to assume that monetary policy steers the nominal economy. So we put them in separate boxes.
When I read other economists I immediately put them into one of two groups—people who think in terms of nominal shocks when discussing AD, and people who think in terms of real factors. Like most economists, I arrogantly assume that I am right, and hence I believe that the nominal people like Meltzer, Krugman, DeLong and me are a sort of “inner sanctum” who have access to the “secrets of the temple.” The rest are just like average people, who think in real terms. Too many houses were built in 2006, or not enough Japanese babies were born in recent decades—that sort of thing.
Real AD? That term makes my hair hurt. When the AS curve shifts to the right (positive supply shock) what happens to the real quantity of goods and services that are demanded? Look at the graph. What should we make of that change in quantity demanded? What does it tell us about “demand”?
Think about it.