Krugman finally acknowledges that it is all about monetary policy

Paul Krugman has a very interesting blog post on the relative economic performance of the US and the euro zone.

Krugman starts out with this graph.


Krugman then goes on to give a complete (Market) Monetarist explanation for this development:

Things really go off track only in 2011-2012, when the U.S. recovery continues but Europe slides into a second recession…

…What was happening in 2011-2012? Europe was doing a lot of austerity. But so, actually, was the U.S., between the expiration of stimulus and cutbacks at the state and local level. The big difference was monetary: the ECB’s utterly wrong-headed interest rate hikes in 2011, and its refusal to do its job as lender of last resort as the debt crisis turned into a liquidity panic, even as the Fed was pursuing aggressive easing.

This is of course what Market Monetarists have been saying forever – we even have a term for it: The Sumner Critique.

According to the Sumner Critique the budget multiplier will be zero if the central bank has a strict nominal target such as inflation targeting or a nominal NGDP target. This means that any shock to aggregate demand/nominal spending from fiscal policy will be offset by monetary policy – not only because the central bank activity will ease monetary policy, but also because under a credible nominal target markets will do must of the lifting by anticipating the easing of monetary conditions.

It is particularly interesting that Krugman essentially acknowledges that monetary policy remains highly potent also when interest rates are at the Zero Lower Bound (ZLB) – something he normally is not willing to acknowledge. In fact, the Fed fast cut the fed funds rate essentially to zero, while the ECB until very recently has kept interest rates positive.

Keeping this in mind then have a look at the accumulative tightening of fiscal policy in the euro zone and the US respectively since 2010 (since the period of fiscal tightening was initiated).

fiscal tightening US EZ

I have calculated this by adding up the yearly changes to the IMF’s measure of the structural deficits in the US and the euro zone.

The graph is clear – in the years of ‘austerity’ (2010-2013) the US undertook significantly more fiscal tightening than the euro zone did. According to Krugman’s normal argument that should have caused a major depression in the US economy.

However, as Krugman’s graph above shows the US economy continued to expand in 2013 despite of a US structural budget deficit being cut by 3%-point of GDP. The reason of course was – as Krugman now seems to finally realize – that ‘monetary offset’ kept US nominal GDP growth – and therefore also real GDP growth – on track in 2013.

The problem was never fiscal in Europe. It was always about too tight monetary policy in the euro zone.

Now I could of course show the traditional Market Monetarist graph with the level of nominal GDP in the US and euro zone, which shows that there has been no NGDP growth in the the euro zone.

However, that graph I have done so many times before so lets be a bit more old-school monetarist and instead have a look at M2 growth in the US and the euro zone.

M2 Euro zone USA

M2 growth shows the same story as other monetary indicators – US monetary policy became broadly neutral in 2010-11, while euro zone monetary conditions have been very tight until Mario Draghi and the ECB initiated proper quantitative easing in early 2015 (see my post from then here).

Paul Krugman finally embraces the Sumner Critique

Concluding, the ‘natural experiment’ of the economic development in the euro zone and the US particularly from 2010 is a very good test of the relative importance of fiscal policy versus monetary policy and I think it is fair to say that the monetarists have been proven right – monetary policy is highly potent and budget multiplier is zero (given a proper nominal monetary policy target. Even Paul Krugman seems to acknowledge now. This is somewhat of a u-turn given that Krugman less than a month ago claimed that monetarism “failed”.

PS In the beginning of the post I wrote that Krugman’s post was “very interesting”. That is in fact not entirely correct as there is nothing new in what Krugman is saying – he is just repeating what Market Monetarists like Scott Sumner, David Beckworth, Nick Rowe, Marcus Nunes and myself have been saying for years. The “interesting” thing is that Krugman now seems to agree with us.

PPS In the case of the US I think we need more of the same – we need fairly deep budget cuts as the US structural budget deficit likely is around 3% of GDP and at the same time we need a clear rules based monetary policy – with a 4% NGDP level target. At the moment we are clearly undershooting 4% NGDP growth so monetary easing – rather than monetary tightening – is warranted.

PPPS Scott Sumner also comments on Krugman here.


Leave a comment


  1. W. Peden

     /  May 1, 2016

    Great post! I agree fully. I also think that Krugman deserves some credit for following the data on this question.

    The next step in his education is to move away from this mistake-

    “… even as the Fed was pursuing aggressive easing.”

    However, it will be a great day when Market Monetarists convince people to move away from using interest rates and base money as measures of the monetary stance!

  2. Lars,
    I know that MM purists prefer to ignore financial phenomena, but a banking crisis is also a monetary phenomenon. In both the US and Europe, credit growth have not recovered from the Minsky Moment:


     /  May 2, 2016


    Have you ever done the real GDP/working age adult for Japan? The official working age population (15-65) is shrinking rapidly. In fact, the government is thinking about officially extending the working age to 70. What might that do to your graph? Really interesting stuff.


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