The awkward moment when George Selgin realized he agreed with Paul Krugman

This is my hero George Selgin:

I never thought it would happen–perhaps I’m slipping.  But as I was preparing to bang-out this post, my first in over a month here, I discovered that, a couple hours ago while I was toiling away in class, Paul Krugman stole my thunder.

Despite that bad omen, I’m plunging in with my two-cents, which, like Krugman’s, has been provoked by an article in today’s New York Times.  The article, which is mainly about Minneapolis Fed President Narayana Kocherlakota, who just recently rotated onto the FOMC, includes a quote from Ed Prescott, who is himself (among other things) a member of the Minneapolis Fed’s research staff.  What Prescott said–and what put Krugman in high dudgeon–is: “It is an established scientific fact that monetary policy has had virtually no effect on output and employment in the U.S. since the formation of the Fed.”

That’s right: no effect–none, nada, zero, zilch–on output, or on employment, ever.  Not even in the 30s.  Or in the 70s.  Or recently.  Why, the Fed might as well set its policy targets by throwing darts at a board, for all the difference it would make to real activity.  Money’s just a veil, after all.  We know that–what’s more we know it “scientifically.”

Krugman rightfully pours scorn on Prescott’s assertion, which states a “scientific fact” only in the peculiar sense that distinguishes such facts from ordinary, unqualified, plain-old facts, that is, the sort of facts one might glean from experience.   A “scientific fact,” apparently, is not such a grubby affair.  It is, rather, something much more pure, even virginal; it is a fact implied by a theory.  The theory in this case is of course the “real business cycle” theory for which Prescott (and coauthor Finn Kydland) are famous.  The theory starts with the New Classical premise that prices always adjust instantly to their general equilibrium levels, thereby all but eliminating any scope for real consequences of monetary disturbances.  It then proceeds–hey presto!–to the conclusion that, if real variables bounce around, they must do so in response not to monetary but to real shocks.   It follows, as a matter of logic, that the world economy must have met with a whale of an adverse supply shock in the 1930s.  What shock, you wonder?  What difference do such details make?  There had to be a big bad shock, dontchyasee: the theory proves it.   If the historians and econometricians can’t find it, well, so much the worse for history and econometrics.

 I can understand George. I have had the same awkward feeling of agreeing with Krugman on numerous occasions. I probably feel less uncomfortable about it than George – maybe I have gotten used to it.This is of course a bit of fun, but the point is that monetarists and market monetarists and economists who think like us (including Free Bankers like George) think that money is hugely important for the economy. In our view both inflation and recessions are monetary phenomena. This also mean that we tend to stress the demand side of the economy when think about the business cycle. Keynesians like to talk about aggregate demand, while monetarists like to talk about nominal spending, but it is really the same thing. Furthermore, (Market) Monetarists and Keynesian agree that the present crisis is mostly a result of a contraction in aggregate demand (monetarists would say monetary tightening).

However, in Real Business Cycle models money are assumed to always be neutral – both in the short and the long run. I fundamentally think that is completely crazy and all empirical evidence is telling us that money is certainly not neutral i the short-run. Keynesian and monetarists (and even Austrians) agree on that, but the Real Business Cycle theorists do not agree. They basically think that recessions are a result of people suddenly wanting take have very long vacations (ok, that is not what they are saying, but it is fun…)

PS As I have stressed before all the different models of the business cycle are basically about different assumptions about the monetary policy rule. Hence, we would in fact be in something, which looked like a Real Business Cycle world if the central bank targets nominal GDP. So if the central bank had got it “perfectly right” then Prescott would have been sort of right, but we of course know that central banks tend to get it horribly wrong.