Word games: Krugman's odd definition of tight money
By Scott Sumner
Some Keynesians define the stance of monetary policy in terms of interest rates. This is of course a really bad idea, as it implies monetary policy is highly contractionary during periods of hyperinflation. Give Paul Krugman credit for avoiding that trap, but I’m not much happier with his criterion:
Ted Cruz somewhat surprised Janet Yellen by accusing the Fed of causing the Great Recession by tightening monetary policy in 2008; David Beckworth sort-of-kind-of supports Cruz by arguing that the Fed did in fact “passively” tighten by failing to do enough to offset falling spending.
Uh-oh: it’s starting to look a bit like the Friedman two-step, only this time done at internet speed.
By the Friedman two-step, I mean the process of argument that began with Friedman and Schwartz on the Great Depression, in which they argued that the Fed could have prevented the Depression by aggressively expanding the monetary base to prevent a sharp fall in broader monetary aggregates. This was a defensible argument, although it looks much weaker in the light of more recent developments; as I warned in 1998, in a liquidity trap the central bank loses control of monetary aggregates as well as the real economy; it’s by no means clear that the Fed really could have prevented the Depression. Still, that remains a live argument.
But what happened over time — and Friedman himself was very culpable — was that the claim “the Fed could have prevented the depression” turned into “the Fed caused the depression.” See? Government is the root of all evil!
I’m really having trouble making sense of this. First of all, Krugman frequently complains that market monetarists have no influence in the conservative policy establishment. So why is he complaining when a prominent conservative takes seriously our claim that money was too tight in 2008? After all, interest rates were not yet at zero. Surely Krugman agrees with this complaint, so why is he not applauding our success?
Second, where did this idea come from that changes in the monetary base represent the Fed “doing something” and non-changes mean monetary policy is doing nothing? Suppose the hoarding of US dollars in Eastern Europe had risen strongly after the collapse of the Soviet Union. And suppose the Fed had not accommodated that increased demand with more base money. And suppose that as a result interest rates in the US spiked upward, and we went into recession. Would Krugman claim the Fed did nothing to cause the recession, because the base didn’t change? Or would he point to the rise in the fed funds target as a big policy mistake. “The Fed did it.” In other words, does Krugman only see inaction by looking at the monetary base in cases where the interest rates also suggest the Fed is not to blame? I suspect the answer is yes, but if you can find counterexamples I’ll amend this claim.
Also, the monetary base in the US fell by 7.2% between October 1929 and October 1930, and then subsequently increased strongly as the Fed partially, but not fully, accommodated the increased demand for base money during the banking panics. So does Krugman believe the Fed triggered the Depression with tight money, but that it got worse due to banking instability? That seems to be the implication of his claim, but I don’t recall him saying that.
In addition, the monetary base rose by 33% between August 2001 and August 2007. That’s a rate of just under 5%/year, which is pretty consistent with trend NGDP growth. But then over the next 9 months it was basically flat, or perhaps 0.1% higher. Why did the Fed suddenly slow the growth rate of the monetary base? In Krugman’s worldview is that sudden slowdown a tight money policy? It would seem so. Does that count as doing something? I don’t know. Does anyone recall Krugman complaining about the sharply slowing growth in the monetary base in late 2007 and early 2008? I don’t recall him complaining. So then why is the monetary base suddenly the criterion for the Fed doing something?
Yes, just as in the 1930s, the initial slowdown in the base led to near zero interest rates, which increased base demand sharply in late 2008. So just as with interest rates, the base is not a reliable indicator of the stance of policy.
If the Fed had adopted a steady growth target for the monetary base, then I suppose I could understand Krugman’s claim. But the Fed claims to be targeting inflation, which began plunging in late 2008. They also target stable employment, and employment also began plunging in late 2008. Shouldn’t we hold them accountable to their actual announced policy goals, and not some monetary base aggregate that no one pays attention to, and even the old school monetarists didn’t want to target?
If a bus driver careens off the road at a sharp turn, is the driver exonerated if he was steering straight ahead, and the road suddenly curved? Krugman seems to think that libertarians believe bus drivers should never turn the steering wheel. That’s a caricature of our views. And he suddenly seems awfully forgiving of the Fed when anti-government conservatives make attacks on it. Suddenly Ben Bernanke is his ally again. The Fed’s not to blame. And this despite the fact that at no time between June and mid-December was the economy even at the zero bound, and yet almost all the damage was done in that 6-month period:
[Monthly estimates from Macroeconomics Advisors]
Ben Bernanke has said that neither the money supply nor interest rates show the stance of monetary policy, you need to look at NGDP growth and inflation. By those criteria money became really tight after mid-2008.
Ben Bernanke now says the Fed erred in not cutting rates in September 2008, after Lehman failed.
Frederic Mishkin says that you need to look past short-term interest rates, at other asset prices. Those other asset prices all plunged sharply in late 2008.
Vasco Curdia says you need to look past interest rates, and focus on the gap between the policy rate and the Wicksellian rate. By that criterion money was tight throughout 2008.
Unlike Cruz, these are all mainstream economists. But even with the killer standing over the body, with the gun in his hand and smoke pouring out of the barrel, some people still can’t seem to find evidence that the Fed killed the economy.
But using the monetary base as an excuse? When does Krugman even look at the monetary base, except when he’s trying to bash conservatives? I wish he had ignored who made the claim, and looked at the merits of the claim that the Fed caused the recession to get much worse with an inappropriately tight monetary policy.
PS. David Beckworth has a very good post on the “passive tightening” of 2008.
PPS. This post is not about Cruz’s views on the gold standard and/or Bretton Woods, which are never coming back and hence totally irrelevant to any critique of Fed policy. Nor is it about Cruz’s suitability to be President. It’s about how Krugman defines the Fed “doing something”.
HT: Marcus Nunes, TravisV, Christian List