Guest post – Keynes: Evidence for Monetary Policy Ineffectiveness? (Part 1, by Clark Johnson)

I am extremely happy to announce that my blog this week will feature four guest posts by Clark Johnson. I have for some time tried to convince Clark to write something for my blog so I was very happy when Clark’s manuscript for his paper Keynes:  Evidence for Monetary Policy Ineffectiveness?” arrived in my in-box recently. Clark and I have decided to split up the paper in four parts which will be published in the coming four days.

Clark Johnson is not only a brilliant economic historian and author of the great book “Gold, France, and the Great Depression, 1919-1932”, but he is also a clever observer of the current monetary policy debate. Clark last year authored an insightful paper on the causes of the Great Recession, which in my view already is a Market Monetarist classic.

Lars Christensen

Guest post 

Keynes:  Evidence for Monetary Policy Ineffectiveness? (Part 1)

by Clark Johnson

Lawrence Summers, who was President Obama’s chief economist during 2009-2010, and who by accounts continues to be an important advisor, recently called on the US and other government to increase borrowing at current very low interest rates.[1]  He observes that, based on inflation-protected bond rates, current Treasury borrowing costs for securities of five and ten year maturities are negative.  He adds that interest rates elsewhere in the world – Germany, Japan, and Britain – are also extremely low.  He then argues that governments should look on such rates as an opportunity to borrow cheaply and thereby improve their long-term fiscal positions.

Summers is presumably correct from a fiscal management perspective about benefits of borrowing when interest rates are low.  But as a macroeconomic strategy for recovery, that is only the beginning.  Whether we turn to John Taylor on the right or Paul Krugman on the left, the essential element for fiscal stimulus to succeed is to stabilize expectations: will the stimulus continue for long enough to drive expectations, so that market participants know the boost will ongoing and not soon withdrawn?    Summers’ then shifts to monetary policy, where his case is weaker.  He says there is no point in “quantitative easing”, the open-market mechanism the Federal Reserve uses to inject reserves, as interest rates are already rock-bottom – and monetary easing works, he explains, through the mechanism of lowering interest rates.  Presumably, this is what he has been telling Obama since 2009.

Summers’ reasoning draws at least in part, on John Maynard Keynes’ discussion about “absolute liquidity preference” that occur when interest rates are very low, and demonstrates a key argument used in policy circles against more aggressive use of monetary policy.   I believe Keynes was, and Summers is, mistaken.  Literature on Keynes is abundant.  To gain a different perspective, I want to look at various evidence Keynes adduced against monetary remedies.  I will then return to arguments he used in the General Theory (1936) and elsewhere, hopefully with fresh perspectives.


A portion of Keynes’ reputation as an economist, and of his place in history, rest on his diagnoses of crisis situations and his proposed remedies.  Well-known examples include his tract on the post-World War One Versailles Conference, The Economic Consequences of the Peace (1921), and subsequent writings on hyperinflations and then on British deflation during the 1920s.   Another, less well-known, was his discussion of French monetary and political crises during 1925 and 1926, which I credited in my own work on the period.[2]  His two-volume Treatise on Money (1930) provided detailed and often shrewd observations on a wide range of economic policy matters.

In contrast, the General Theory, the heart of Keynes’ contribution to economic ideas, is light on historical or even contemporary illustration.  So the reader seeks to fill in the gaps by turning to other writings.  Consider four prominent cases as they reflect on Keynes’ view of roles of monetary and fiscal policy.

a)    British Deflation in the 1890s

An unexpected embrace of fiscal activism comes in the Treatise discussion of the deflation of the early 1890s, where Keynes argued that the Bank of England’s gold reserves were abundant and credit was easy.  But prices in Britain and the world nevertheless went into decline, which undermined profit and investment and reduced employment.  He wrote:

I consider, therefore, that the history of this period [1890-1896] is a perfect example of a prolonged Commodity Deflation – developing and persisting in spite of a great increase in the total volume of Bank-Money.  There has been no other case where one can trace so clearly the effects of a prolonged withdrawal of entrepreneurs from undertaking the production of new fixed capital on a scale commensurate with current savings.

Keynes then concluded (anticipating his arguments a few years later, including in the General Theory,) that monetary expansion does not always work, and that there might therefore be a role for public investment projects to boost demand.[3]

Keynes’ discussion of the 1890s misses the point.  Britain in the late nineteenth century was part of an open world economy, with easy movement of goods, people, and especially capital.  Keynes neglected to mention that system-wide demand for gold rose much more than the supply from the 1870s through the 1890s as nearly two dozen countries adopted or re-adopted the gold standard, and hence needed to accumulate reserves.  Indeed, demand drove the commodity-exchange value of gold to the highest level it was to reach in four centuries of record-keeping[4] — the flip-side of commodity price deflation.  The commodity price decline reduced profits and chilled investment demand; but commodity prices were determined in international markets, not in Britain.

While demand for gold was surging, the world’s monetary gold supply in the mid-1890s was at its lowest point it was ever to reach relative to its 1800-1920 trend line.[5]  As the mines in the South African Rand cranked up production in the 1890s, relative gold supply and commodity prices increased, nearly in tandem after 1896 – thus ending the Commodity Deflation, and initiating a gentle inflation.  A growing money stock affected not just the supply of credit (as reflected in a declining interest rate), but also the demand for it.  A result was nearly two decades of economic growth in all of the industrial powers, which was sadly interrupted by the First World War.

Monetary events were at the heart of both the origins of and recovery from the depression of the early 1890s.  Keynes himself gave this backhand acknowledgement with his comment a few paragraphs later that, “the fall of prices [in the early 1890s] could only have been avoided by a much greater expansion of the volume of bank-money.”  It is revealing that Keynes could discuss price trends during that period without mentioning the geographic expansion of the gold standard – easily the most important monetary development of the era.

b)    The onset of the Great Depression

Moving to then contemporary events, Keynes’ discussion of the “slump of 1930,” also in the Treatise, builds on similar themes.[6]  Gustav Cassel and Ralph Hawtrey had argued a few years earlier that the undervaluation of gold following restoration of gold standards at prewar gold prices would force world-wide monetary contraction, especially as former belligerents Britain, France, Germany, and Italy restored their gold standards.   Keynes, in contrast, told the Royal Commission on Indian Currency in 1926 that central banks would adjust their currency reserve cover ratios if  their gold stocks became inadequate – which allowed him to dismiss the danger.  Keynes underestimated what we might call the mystique of gold money.

Keynes listed factors driving interest rates higher during the 1920s: corporate borrowing for new industries; governments borrowing to pay reparations and war debts; central banks borrowing to add reserves; and speculators borrowing to buy shares of stock.  He identified but was less able to explain the collapse internationally in anticipated returns in investment – what he would later call the marginal efficiency of capital — that occurred in the mid-1920s.  As in considering the early 1890s, he did not connect the fall-off in real yields on new investment with systemic monetary constraint.  Parallel to what happened in the 1890s, the middle and late 1920s saw a commodity deflation as key countries adopted or returned to gold standards.  He thought monetary expansion worked through lowering interest rates, without directly affecting demand for goods and services.  He wrote that the only ways to boost demand were by lowering interest rates, especially long rates, further – or by government fiscal activism.  He did not understand that the world required a higher gold price to restore gold-to-currency reserve ratios, or perhaps needed a departure from gold money altogether.

c)     The Roosevelt Recovery in 1933

Keynes’ comments in January 1934 on the monetary-fiscal mix in the US were baffling.  In one of his initial acts after Roosevelt’s accession to power in March 1933, the dollar was allowed to depreciate against gold.  This was a momentous event in monetary history – the underlying cause of the interwar deflation had been removed, and the gold standard was never restored with the same conviction.  Keynes nevertheless wrote:

One half of [Roosevelt’s] programme has consisted in abandoning the gold standard, which was probably wise, and in taking various measures … to depreciate the gold value of the dollar… [But i]t is not easy to bring about business expansion merely by monetary manipulation.  The other half of his programme, however, is infinitely more important and offers in my opinion much greater hopes.  I mean the effort to cure unemployment by large-scale expenditure on public works and similar purposes.[7]

This summary scarcely acknowledges the results of the real-time experiment in expansionary monetary policy undertaken in the US within the previous year.  Depreciation succeeded at least to the extent any advocate could have hoped.  Industrial production soared by 57 percent during the first four months of the Roosevelt Administration beginning in March 1933 – this was the actual increase, not an annualized rate — making up half of what had been lost since 1929.  It was the fastest four-month rate of expansion in industrial production in the history of the US. Yet Keynes apparently considered this event to be “infinitely” less important than the boost to come from fiscal borrowing for public works programs.

Had the experiment continued for a few months more, pre-crash production levels might have been recovered.  Unfortunately, the NIRA (National Industrial Recovery Act, announced in July 1933, brought micro-policy changes that had the effect of stopping the recovery in its tracks.  The NRA (National Recovery Administration), set up under NIRA, then negotiated specific sets of codes with leaders of the nation’s major industries; the most important provisions were anti-deflationary floors below which no company would lower prices or wages, and agreements on maintaining employment and production. Within a short time, the NRA reached agreements with most major industries. In a phrase, the NIRA wanted to increase prices by restricting output rather than by increasing demand.   Scott Sumner provides several rounds of evidence for the contractionary impact of NIRA policy in his soon-to-arrive book, The Midas Curse: Gold, Wages, and the Great Depression.

Lest this appear suspect as a predictable right-wing narrative of the New Deal, consider that Keynes himself pointed to the “fallacy” of the NRA approach: He noted that “rising prices caused by deliberately increasing prime costs or by restricting output have a vastly inferior value to rising prices which are the natural result of an increase in the nation’s purchasing power.”  He added that it was “hard to detect any material aid to recovery in the National Industrial Recovery Act.”[8]  Within six months after the NRA went into effect, industrial production had dropped twenty-five percent,[9] erasing nearly half of the gains recorded during Roosevelt’s more successful initial months in office.

So here we are.  We saw an historically sharp recovery for four months during 1933, driven almost entirely by a decision to break the straightjacket imposed on monetary policy by the international gold standard.  Keynes had previously been an able critic of the gold standard, for example in the Tract on Monetary Reform (1923) and then in several chapters in the Treatise. The 1933 recovery was then stalled by micro-policies of which he was explicitly critical.  Yet Keynes seemed to dismiss this entire episode in his call a few months later for fiscal stimulus!

[1] Lawrence Summers, “Look beyond interest rates to get out of the gloom,” Financial Times, 3 June 2012

[2] H. Clark Johnson, Gold, France, and the Great Depression, 1919-1932  (Yale, 1997)

[3] John Maynard Keynes, Treatise on Money (1930), Ch. 30 (ii).

[4] Roy Jastram, The Golden Constant (1977)

[5] League of Nations chart, reproduced in Johnson, p. 52.

[6] Treatise, Ch. 37 (iv) “The Slump of 1930.”

[7] Keynes, “Roosevelt’s Economic Experiments,” The Listener, 17 January, 1934.

[8] Keynes, “Mr. Roosevelt’s Experiments,” London Times, 02 Jan 1934.

“Meantime people wrangle about fiscal remedies”

The other day I wrote a piece about the risks of introducing politics (particularly fiscal policy) into the central bank’s reaction function. I used the example of the ECB, but now it seems like I should have given a bit more attention to the Federal Reserve as Fed chief Bernanke yesterday said the follow:

“Monetary policy is not a panacea, it would be much better to have a broad-based policy effort addressing a whole variety of issues…I’d be much more comfortable if, in fact, Congress would take some of this burden from us and address those issues.”

So what is Bernanke saying – well he sounds like a Keynesian who believes that we are in a liquidity trap and that monetary policy is inefficient. It is near-tragic that Bernanke uses the exact same wording as Bundesbank chief Jens Weidmann used recently (See here). While Bernanke is a keynesian Weidmann is a calvinist. Bernanke wants looser fiscal policy – Weidmann wants fiscal tightening. However, what they both have in common is that they are central bankers who apparently don’t think that nominal GDP is determined by monetary policy. Said, in another other way they say that nominal stability is not the responsibility of the central bank. You can then wonder what they then think central banks can do.

What both Weidmann and Bernanke effectively are saying is that they can not do anymore. They are out of ammunition. This is the good old  “pushing on a string” excuse for monetary in-action.  This is of course nonsense. The central bank can determine whatever level for nominal GDP it wants. Just ask Gedeon Gono. It is incredible that we four years into this mess still have central bankers from the biggest central banks in the world who are making the same mistakes as central bankers did during the Great Depression.

Yesterday Scott Sumner quoted Viscount d’Abernon who in 1931 said:

“This depression is the stupidest and most gratuitous in history!…The explanation of our anomalous situation…is that the machinery for handling and distributing the product of labor has proved inadequate. The means of payment provided by currency and credit have fallen so short of the amount required by increased production that a general fall in prices has ensued…This has not only caused a disturbance in the relations between buyer and seller, but has gravely aggravated the situation between debtor and creditor. The gold standard, which was adopted with a view to obtaining stability of price, has failed in its main function. In the meantime people wrangle about fiscal remedies and similar devices of secondary importance, neglecting the essential question of stability in standard of value…The situation could be remedied within a month by joint action of the principal gold-using countries through the taking of necessary steps by the central banks.”

It is tragic that the same day Scott quotes d’Abernon Ben Bernanke “wrangles about fiscal remedies”. Bernanke of course full well knows that the impact on nominal GDP and prices of fiscal policy depends 100% on actions of the Federal Reserve. Fiscal policy does not determine the level of NGDP – monetary policy determines NGDP (Remember MV=PY!).

The Great Depression was caused by monetary policy failure and so was the Great Recession (See here and here). In the 1930s the Lords of Finance Montagu, Norman, Meyer, Moret, Stringher, Hijikata and Schacht were all wrangling about fiscal remedies and defended their failed monetary policies. Today the New Lords of Finance Bernanke, Shirakawa, Draghi and Weidmann are doing the same thng. How little we – or rather central bankers – have learned in 80 years…

UPDATE: Maybe our New Lords of Finance should read this Easy Guide to Monetary Policy.

Mr. Hollande the fiscal multiplier is zero if Mario says so

 The newly elected French president Hollande’s rallying cry has been “Yes to growth and no to austerity”.

While I am certainly is no Keynesian (I my readers know that very well…) and my gut instincts are (very!) fiscally conservative I have some sympathy with what Hollande is saying. While I strongly believe that Europe needs massive structural reforms to bust productivity growth in the longer run I also believe that the present crisis has very little – if anything – to do with the lack of structural reforms. The crisis in Europe has nothing to do with tax evasion in Greece, rigid Italian and Spanish firing and hiring rules or an overly generous French pension system. These are all massive problems that need to be addressed, but they are not the causes of the crisis. The crisis is primarily a result of the massive drop in nominal GDP, which we have seen in the euro zone since 2008. And that problem can only be solved by the ECB moving towards a much easier monetary policy stance. There is no way around this.

While I have sympathy for Mr. Hollande’s concerns about the direction of economic policy in Europe I nonetheless think that his analysis of the situation is seriously flawed. Mr. Hollande fully well knows that no government, company or household in the long run can spend more money that it earns. This is simple mamanomics – my mom always used to tell not to spend more money than I earn. This is not economic Calvinism, but simple economic law. That said, how much revenue the French government brings in is crucially dependent on the level and growth of nominal GDP.

Mr. Holland understands this, but he is wrong when he seems to believe that you can increase nominal GDP by boosting public spending. Said in another way the fiscal multiplier is zero.

Lets imagine that we get a Hollande style European “growth pact” which dictates that fiscal policy will have to be eased by 5% GDP in all euro zone countries. Imagine then that this miraculously does not have any negative impact on market sentiment and that increases NGDP by lets say 2% across the euro zone. Hollande would be happy, but would the ECB also be happy?

We most assume that the ECB thinks that nominal GDP in the euro zone is exactly where it should be right now – neither too high nor too low – otherwise the ECB would have done more to boost NGDP. Hence, if Mr. Hollande is able to able to increase the euro zone NGDP by 2% then the ECB would be in a situation where it would face an level of NGDP which would be too high for its liking and as a consequence it would have to move towards a tightening of monetary policy. Hence, the ECB will always have the final word on the level of NGDP – no matter what Mr. Hollande thinks. This is why I have earlier argued that there really is no such thing as fiscal policy – at least in way Keynesians traditionally think about fiscal policy. Fiscal policy cannot on its own increase NGDP. Only the central bank can do this.

You might object and say that ECB does not think that the NGDP level is where it should be. Well, if that is the case then the ECB tomorrow can increase NGDP to exactly the level it want. There are numerous ways to increase NGDP and if you think that the central bank cannot do it then you might want to consult Gideon Gono.

So yes, Mr. Hollande is right when he says that we desperately needs growth (in NGDP) in the euro zone, but he is wrong if he think that it can be achieved by increasing the budget deficit in France or anywhere else in Europe. Only Mario Draghi and his colleagues in the ECB can increase euro zone NGDP.

At the core of Mr. Hollande’s failed analysis is that he is doing “national accounting economics”. He starts out with a national accounting identity: Y=C+I+G+NX. As a consequence he think he by increasing government spending (G) can increase GDP (Y). Had he instead started out with the equation of exchange (MV=PY) then he would have realised that recessions are always and everywhere a monetary phenomenon and that the fiscal multiplier is zero.

I am sorry for sounding like a broken record, but it is saddening and frustrating that nearly no European policy makers realise that at the core of our problems is an overly tight monetary policy and the crisis cannot be solved by more austerity nor can it be solved by a more expansionary fiscal policy. Neither the Keynesian nor the Calvinists are right. It’s not about fiscal policy. It is about monetary policy and if Ralph Hawtry, Gustav Cassel or Milton Friedman were alive they would scream it at you!

PS Maybe British Prime Minister David Cameron is the European leader who comes closest to understanding the need for monetary easing to solve the European crisis. See Britmouse’s excellent comment on Cameron’s recent speech on the UK economy.

Maybe Jens Weidmann and Francios Hollande should switch jobs

There seem to be two main positions on how to solve the European crisis. One represented by Bundesbank chief Jens Weidmann and that is that monetary policy should not be eased anymore and fiscal policy needs to be tightened (this is the Calvinist position). The other position is held by the new French president Francios Hollande who wants to spur European growth by easing fiscal policy (this is the keynesian position)

I would claim that both positions are wrong. At the core of the European crisis is rising public debt ratios in Europe. The public debt ration (d) is defined in the following way:

(1) d=D/NGDP

Where D is public debt in euros and NGDP is nominal GDP.

Anybody with rudimentary monetarist insights would inform you that D is determined by the fiscal authorities, while NGDP is determined by monetary policy (remember MV=PY).

If you want to stabilize or reduce d then you have to either decrease D and/or increase NGDP. So what you basically need is fiscal tightening and monetary easing.

Unfortunately Weidmann is basically arguing for reducing NGDP and Hollande is arguing in favour of increasing D. Both positons will lead to an increase in d and hence worsen the crisis. Hence, it would be better if the two gentleman switched jobs  – at least mentally. It would be a lot more productivity if Weidmann argued for monetary easing and Hollande argued for fiscal consolidation. That would do the job and the crisis would come to an end fairly fast.

Between the need for fiscal tightening and the need for increasing NGDP I have no doubt that it is much more important to increase NGDP. The public debt ratios in Europe has not primarily increased because fiscal policy has been eased, but because NGDP has collapsed. In that sense the crisis is not a debt crisis, but a monetary crisis.


Note to the two gentlemen:

To President Hollande (The keynesian): Fiscal policy cannot increase NGDP. Recommend reading: There is no such thing as fiscal policy

To Bundesbank chief Weidmann (The Calvinist): Monetary policy is a panache and it can increase NGDP as much as you like it to be increased. Recommend reading: “Ben Volcker” and the monetary transmission mechanism

Guest blog: NGDP Targeting is NOT just for Central Banks! (David Eagle)

Guest blog: NGDP Targeting is NOT just for Central Banks!

By David Eagle

Because of Lars Christensen’s blog on “Market Monetarism vs Krugmanism,” I am interjecting a new topic into my guest blog series.  I agree with the comments from JJA and Scott B. on Scott Sumner’s blog.  While some of the market monetarists do not believe in the effectiveness of fiscal policy, I think there is a great opportunity for those fiscal conservatives among us to openly welcome Keynesians to bring fiscal policy into the realm of NGDP targeting.  I agree with JJA that NGDP targeting should be the aim for BOTH monetary and fiscal policy.  In other words, both monetary and fiscal policy should target NGDP, although under normal times that responsibility should fall on the central bank.  Let me restate this very important statement: The role of fiscal policy in stimulating aggregate demand should also be governed by the NGDP target.  In other words, if NGDP is below target and the central bank says it needs help from fiscal policy to boost NGDP, then those in favor of using fiscal policy should advocate for fiscal stimuli.  However, when NGDP is at or above target, then the fiscal policy should be directed towards fiscal surpluses to make up for the previous deficit spending.  If the central bank and fiscal authorities were to agree on a NGDP target, then we would not have had the huge fiscal deficits that we did have preceding 2008.

However, unfortunately the central bank and fiscal authorities have not been following a mutually agreed upon and transparent NGDP target.  Because of the murky waters concerning what the central bank is doing, fiscal and monetary policy often work in different directions.  In particular, when the central bank targets inflation, it often is not clear what the central bank’s intentions are with regard to NGDP.  (Because I agree with Scott Sumner that we should treat NGDP and aggregate demand as the same concept, even a central bank targeting inflation should be transparent about what its intentions are concerning aggregate demand, i.e., NGDP; but alas central banks today are not that transparent.)  Because of these murky waters, politicians have often been able to pass politically desirable tax cuts and increased government spending under the guise of stimulating the economy (i.e., stimulating aggregate demand, i.e., stimulating NGDP), even though the central bank is content to let bygones be bygones and keep NGDP on its current track, but consistent with its future inflation target.

The Japanese Experience:

Take Japan, for example, where the Bank of Japan was under pressure to be more independent of the Japanese Government and be more like “western central banks” at maintaining price stability.[1]  Then came the 1990s and the Japanese Government followed Keynesian fiscal policy to stimulate the economy.  Meanwhile the Central Bank of Japan was determined to follow in Paul Volker’s footsteps of regaining credibility for maintaining price stability.  As Scott Sumner (2011) reported, the Bank of Japan actually pursued restrictive monetary policy at times when the Japanese government was trying to be expansionary with its fiscal policy.[2]  Because they were pulling the economy in two different directions, the result was (i) the Bank of Japan offsetting much of what the aggregate-demand effects of the fiscal stimuli, and (ii) the national debt in Japan skyrocketed from 51% of GDP at the beginning of the 1980s to over 220% now.  Then came 3/11/11, the day of the triple supply shock in Japan – earthquake, tsunami, and nuclear crisis.  In addition to their enormous national debt, now Japan faces the high costs of rebuilding.

Lack of Coordination between US Fiscal Policy and the Federal Reserve:

The United States I think is another example.  In 2003, the Bush administration passed tax cuts and kept them in place for a long time (they are still in place today).  These tax cuts were to stimulate the economy.  However, at the same time, the Federal Reserve was content to “let bygones be bygones” and let the NGDP base drift caused by the 2001 recession continue (see my guest blog that explains NGDP base drift).  As a result, if the tax cuts did have any stimulative effect, the Federal Reserve would have countered them with monetary policy.  On the other hand, if both the Federal Reserve and the Bush administration had agreed upon a NGDP target, and if that NGDP target was above where NGDP was at the moment, then the Federal Reserve could have tried to boost NGDP by using tools that Ben Bernanke said he had and that Scott Sumner believes he had.[3]  Also, as I will explain in a later guest blog, expectations has an important role to play.  If the public expects the central bank and fiscal policy to succeed in boosting NGDP up to its target, then they will be more inclined to spend more because of higher expected short-term inflation, helping the monetary and fiscal policy reach this goal.  Unfortunately, despite all the rhetoric about the transparency of inflation targeting (IT), IT is not as transparent as NGDP targeting.  I believe the ultimate in transparency for both monetary and fiscal policy is NGDP targeting.

The Two-Headed British Media:

Sumner (2011) reports an example in Britain of how the lack of transparency with regard to aggregate demand, i.e. NGDP, led to the British media simultaneously condemning both fiscal and monetary policy simultaneously:

“Recent events in Britain provide a perfect example of the confusion generated by drawing this sort of false dichotomy between monetary and fiscal policy. The government of Prime Minister David Cameron has been sharply criticized for its policy of fiscal austerity. The recovery from the recent recession has been even weaker in Britain than in the United States, and there are fears that budget cuts will lead to a double-dip recession. At the same time, the press has been highly critical of the Bank of England for allowing inflation to rise far above the 2% target. But these criticisms cannot both be correct: Either Britain needs more aggregate demand or it does not. If it needs more, then the inflation rate in Britain needs to rise even higher, because the Bank of England needs to provide even more monetary stimulus. If inflation is too high and Britain needs less aggregate demand, then [the British] should desire fiscal austerity that would slow the economy. The press seems to believe in some sort of policy magic whereby fiscal stimulus can create growth without inflation and monetary tightening can reduce inflation without affecting growth.” (brackets added after consultation with Scott Sumner)

If the British media is confused, then obviously the British public is confused.  If British fiscal and monetary policy both pursued a NGDP target, I believe the British media and British public would finally understand that it cannot criticize both fiscal and monetary policy under these circumstances.  As I said before, expectations plays an important part to boosting aggregate demand (NGDP), and I know no better way to guide the public expectations concerning aggregate demand than a credible and transparent NGDP target for both monetary and fiscal policy.

Summary: NGDP targeting for both fiscal and monetary policy:

In summary, if the central bank and those in favor of fiscal policy could agree on a NGDP target and then jointly pursue that target, our economies would be so much better today.  In particular, on the fiscal side, we would have no justification for the high federal government debt we have accumulated.  If fiscal policy followed a NGDP target, then over half the time we should have fiscal surpluses rather than fiscal deficits.  Also, a NGDP target is so much more transparent for both fiscal policy and monetary policy than the murky waters of inflation targeting that we face today.  With fiscal policy and monetary policy following a NGDP target, expensive fiscal stimuli could not be justified to stimulate the economy when NGDP is at or above target.


Sumner, Scott (2011). “Re-Targeting the Fed,” National Affairs Issue #9.

[1] Ben Bernanke ( reported in 2010, “The importance of central bank independence also motivated a 1997 revision to Japanese law that gave the Bank of Japan operational independence.9 This revision significantly diminished the scope for the Ministry of Finance to influence central bank decisions, thus strengthening the Bank of Japan’s autonomy in setting monetary policy.”

[2] Scott Sumner states, “But the Japanese twice tightened monetary policy in an environment of zero inflation (in 2000 and 2006), so it would be hard to claim that they were trying to create inflation.”

[3] Sumner (2011, p. 4) states, ““But the Fed itself never claimed to be ‘out of ammunition,’ even after rates hit zero.  Indeed, Chairman Ben Bernanke has repeatedly stressed that the Fed still has many options for boosting demand, and he has proved the point with two rounds of ‘quantitative easing.’  Indeed, it is hard to see how a fiat-money central bank would ever be left unable to boost nominal spending.  That would logically imply it was unable to raise the rate of inflation – that is, to ‘debase the currency,’ which it can always do.  There is no example in history of any fiat-money central bank that tried to create inflation and failed.”

© Copyright (2012) by David Eagle

Market Monetarism vs Krugmanism

Here is an interesting comment from ‘JJA’ over at Scott Sumner’s blog:

“Scott, I have enjoyed reading your blog. As a practitioner (firm level decisions regarding export related efforts) I find you (and other market monetarists, especially Christensen and Nunes) very understandable and convincing. But… But I find Krugman and DeLong very understandable and convincing also… From my micro-level point of view it seems to be the case that both sides are right, but something is missing in-between.

Well, I am not an economist, but I think that I see NGDP as the ultimate aim in order to manage stable and prosperous economy. At the same time I see the importance of fiscal activity (from the state or whatever public body), and that is at the same time when I think that the monetary policy is the most important part of the situation. But I feel that monetary policy alone is not enough in order to achieve good results in a reasonable time. Therefore fiscal.

From my practical point of view, both market monetarists and old-style keynesians seem to be right at the same time. It may be that I am mad or something vital is missing from our understanding of economics.

But in any case, I just make decisions in practice. By the way, I am from the Eurozone (unfortunately).”

I think JJA raises a number of interesting questions about the similarities between Market Monetarism and “Krugmanism”. Yes, Krugman has endorsed NGDP level targeting as do Market Monetarists. However, just because we share the policy recommendation (and I am not sure we really do…) that does not mean that our theoretical thinking is close.

I do fundamentally think that Keynesians (including Krugman) and Market Monetarists (and old style Monetarists) are quite far away from each other theoretically.

I have three earlier posts that might clarify this:

On our macro/micro foundation: How I would like to teach Econ 101

On why we don’t think fiscal policy is effective. There is no such thing as fiscal policy

On why we favour a RULES based monetary policy: NGDP targeting is not a Keynesian business cycle policy

These three posts should make it clear what the key theoretical differences between Market Monetarists and Keynesians are.

That said, for the US and the euro zone Market Monetarists and New Keynesians (at least Krugman, DeLong and Romer) agree that monetary easing is warranted and that this could be done within the framework of NGDP level targeting. That said, Market Monetarists do not want to “fix” the economy and unlike keynesians we do not think that the problems are real, but rather nominal. The crisis is a result of a monetary policy mistakes rather than a “market failure”.

In regard to fiscal policy I might add that Market Monetarists probably are less concerned about the general fiscal troubles in the US and the euro zone than many “establishment” economists (and particularly European policy makers). David Beckworth have a number of good posts on this issue (See for example here). We agree that the present fiscal path is unsound in both the US and the euro zone, but if we get monetary policy right (target the NGDP level of the pre-crisis trend) then that would reduce the fiscal stress very significantly – not to speaking of reducing banking problems. Get monetary policy right and then the European and US banking problems and the fiscal policy problems will become manageable (on an overall level).

That said, Market Monetarists do in general not think that fiscal policy on its own can increase nominal spending in the economy so even though we think that fiscal policy should not be a major concern if monetary policy is “right” we also don’t think it is useful to spend a lot of time trying to “stimulate” the economy with fiscal measures. The only role we see for fiscal policy is to ensure long-term productivity growth and growth in the labour supply, but that is certainly not what Paul Krugman has in mind.

Guest blog: The Integral Reviews: Paper 3 – Hall (2009)

Guest blog – The Integral Reviews: Paper 3 – Hall (2009)
by “Integral”

Reviewed: Robert Hall (2009), “By How Much Does GDP Rise If the Government Buys More Output?” NBER WP 15496

Executive summary

The average government purchases multiplier is about 0.5, taking into account empirical and structural evidence. The only way to get “large” multipliers of 1.6 is to assume a large degree of non-optimizing behavior, an inflexible wage rate, at the zero lower bound on nominal interest rates, and assuming monetary policy is completely ineffective at influencing aggregate demand but the fiscal authority retains that influence.

The key ingredients to generating a large output multiplier are sticky wages/prices, a highly countercyclical markup ratio, and “passive” monetary policy which does not counteract the fiscal expansion.

The assumptions that underlie “the effectiveness of monetary policy” (sticky prices and a countercyclical markup) also drive “the effectiveness of fiscal policy.” The two are similar in that respect.


Hall provides a convenient overview of the state of economic knowledge about the government purchases multiplier. He does this in four steps: simple regression evidence, VAR evidence, structural evidence from RBC models, and structural evidence from various sticky-price/sticky-wage models.

Empirical evidence begins with the simple OLS regression framework. Hall obtains the output multiplier by regressing the change in military expenditures (a proxy for the exogenous portion of government spending) on the change in output. He finds multipliers significantly larger than zero but less than unity, mostly in the neighborhood of one-half. This estimate of the “average multiplier” is confounded by two problems: (1) the implied multiplier be taken as a lower bound rather than an unbiased estimate due to omitted variable bias, and (2) the estimates are driven entirely by observations during WWII and the Korean War.

The VAR approach produces a range of estimates. Hall surveys five prior studies and finds that the government purchases multiplier is non-negative upon impact across all studies and consistently less than unity, but there is much variation in the exact point estimate. The VAR approach typically suffers the same omitted variable bias as OLS.

Hall then turns to a review of the structural evidence. He first shows the standard RBC result that if wages and prices are flexible, the output multiplier is essentially zero or even negative. While a useful benchmark this is not particularly useful for applied work.

Adding wage frictions forces laborers to operate off of the labor supply curve, so output could plausibly expand from an increase in government demand. Hall indeed finds that the multiplier is higher in small-scale NK models and depends on consumer behavior. With consumers pinned down by the permanent-income/life-cycle model, multipliers tend to range around 0.7. If consumers are rule-of-thumb or iiquidity constrained, one finally finds multipliers above unity, in the neighborhood of 1.7, in the presence of the zero lower bound on nominal interest rates.


The empirical evidence is plagued by persistent endogeniety and omitted-variable bias, which Hall frankly acknowledges. Identification is extraordinarily difficult in macroeconomics; as a practical matter it is impossible to untangle all of the interrelated shocks the economy experiences each year.

On the theory side, Scott Sumner would consider this entire exercise a waste of time: the Fed steers the nominal economy and acts to offset nominal shocks; government shocks are a nominal shock, so the Fed will act so as to ensure that the government expenditures multiplier is zero, plus or minus some errors in the timing of fiscal and monetary policy.

Is this a good description of the world? On average over the postwar period, a $1 exogenous change in government spending has led to a $0.50 increase in output; excluding the WWII and Korean War data drive this number down significantly. As a first-order approximation the fiscal multiplier is likely zero on average. But we don’t care about the average, we care about the marginal multiplier, at the zero bound. In that scenario, multipliers are on average higher but still below unity. A crucial open question is to what degree the monetary authority “loses control” of nominal aggregates at the zero lower bound, and to what degree fiscal policy is impacted if the monetary authority is “helpless”. (If we are in a situation where the Fed cannot move nominal aggregates, why wouldn’t Congress be similarly constrained?)

Hall’s paper does not explicitly discuss monetary policy. However, adding a monetary authority to his models would only reduce the already-low multipliers that Hall uncovers. His point, that one cannot plausibly obtain multipliers in excess of unity in a modern macro model, is already well-established even without explicitly accounting for the central bank.

Christensen’s “postmodernist mind fuck”

I have now been blogging since early October last year and I truly enjoy it. Most of my readers seem to be happy about what I write and I believe that most of my readers and commentators are quite Market Monetarist sympathies. However, there is one exception – lefty blogger Mike Sax. Yes, I called him lefty – I don’t think Mike would not disagree with this (if he called me a libertarian that would not make me angry either…). Mike is actually reading the Market Monetarist blogs and I think he pretty much understands what we are talking about. I will readily acknowledge that despite the fact that I probably disagree with 99% of what he has to say about economics and monetary theory.

Today I ran into a comment Mike wrote a couple a days ago about the debate about fiscal policy between on the one side the New Keynesian (Old Keynesians??) and on the other side the Market Monetarists  (and John Cochrane). Even though Mike is extremely critical of  my views I actually had quite a lot of fun reading it.

Here is Mike Sax (and yes, believe it or not the name of his blog is “Diary of a Republican Hater”…):

“If you want to get the endgame of this whole market monetarist phenomenon I say put down Scott Sumner and check out Lars Christensen. His post is called simply Market Monetarist, and indeed the very name of market monetarism is actually his coinage rather than Scott.

During the interminable tangent-a rather amusing three ring circus that Sumner led-Lars wrote a post called “There is no such thing as fiscal policy.” This is a pretty radical attack on fiscal policy. From Cochrane claiming that fiscal policy can’t work-till his bout face today-and Sumner saying it can never be as effective as monetary policy in reviving demand-we have Lars claiming it simply doesn’t exist.

Whoa! I guess if it doesn’t even exist we can’t use it. Ever. It’s another postmodernist mind fuck evidently. What are Cochrane and Christensen going to say to each other now? I will suggest that if you want to make any sense of market monetarism read Lars. You get it much more concisely and to the point if nothing else.

Now here is his point. In a barter economy, he tells us, there can be no fiscal stimulus. Why is this? Because, “As there is no money we can not talk about sticky prices and wages. In a barter economy you have to produce to consume. Hence, there is no such thing as recessions in a barter economy and hence no excess capacity and no unemployment. Therefore there is no need for Keynesian style fiscal policy to “boost” demand.”

Fiscal policy can redistribute income but not effect demand.

“in a barter economy fiscal policy is a purely redistributional exercise, but it will have no impact on “aggregate demand”

Ok but maybe the title of this post is wrong. It shouldn’t say there is no such thing as fiscal policy just fiscal stimulus.

The reason we believe that fiscal policy can impact demand is because of money illusion.

“for fiscal policy to influence aggregate demand we need to introduce money and sticky prices and wages in our model. This in my view demonstrates the first problem with the Keynesian thinking about fiscal policy. Keynesians do often not realise that money is completely key to how they make fiscal policy have an impact on aggregate demand.”

What NGDP targeting is meant to do is to take away money illusion by taking away this misleading effect of the velocity of money.

“Under NGDP level targeting M*V will be fixed or grow at a fixed rate. That means that we is basically back in the Arrow-Debreu world and any increase in G must lead to a similar drop in D as M*V is fixed.”

The goal of NGDP targeting therefore as Sumner, Lars, David Glasner, et al, conceive it is a return to in effect a barter economy. Money is therefore for them kind of like the root of all evil or at least original sin. Like for old fashioned philosophers appearance was the veil that led us to misapprehend true existence, so for the market monetarists, money is the veil that makes us misapprehend the truth of the economy.

Yet Lars does admit that fiscal stimulus can work or seem to work due the the Circe of money.

“lets say that the central bank is just an agent for the government and that any increase in G is fully funded by an increase in the money supply (M). Then an increase in G will lead to a similar increase in nominal income M*V. With this monetary policy reaction function “fiscal policy” is highly efficient. There is, however, just one problem. This is not really fiscal policy as the increase in nominal GDP is caused by the increase in M. The impact on nominal income would have been exactly the same if M had been increased and G had been kept constant – then the entire adjustment on the right hand side of (3) would then just have increased D.”

Yeah let’s say that. Actually I think this accurately describes the actual historical record of the Fed between the time of Marriner Eccles and the 1970 when Milton Friedman started whispering sweet nothings in Nixon’s ear.

To be sure Christensen claims that this effect is still misleading as it’s the printed money-monetary policy-that does the real heavy lifting. It would have been exactly the same had the supply of money been increased and government spending been kept constant.

In a way these claims by Lars actually straddles the line with MMTers who do actually argue that it makes no difference whether the Fed or Treasury prints the money but where they go from here is obviously more or less diametrically opposed to what the MMers do with it. The Market Monetarists vs. The Modern Monetary Theorists… Talk about a battle royale.

Again though Lars should call this “There is no such thing as fiscal stimulus.” It seems to me though that even if you believe that fiscal stimulus is a fiction it may nevertheless have proved to be as the belief in God once was.

For what’s curious is during the time we believed fiscal stimulus we had the Keynesian era. Since we gave it up we have had an anti-Keynesian era. During this anti-K ear we have seen the wages of median Americans stagnate. Is this all coincidence? What do you think?

In any case Sumner’s oft repeated argument that the fiscal multiplier is roughly zero because any fiscal stimulus will be followed by monetary tightening according to Lars depends on the policy of the Fed. It wasn’t true during the Keynesian ear. However in this anti inflation era, post Volcker and of the Taylor Rule-the much lauded Great Moderation-it is true of how the Fed has in fact acted. This doesn’t prove that fiscal stimulus doesn’t work but rather the Fed is off the rails and probably could use the kind of reforms Barney Frank wanted for it. Namely not ending the Fed as Ron Paul says but rather ending its “independence.””

Frankly speaking, Mike of course have no clue about economics, but he is 100% right – I should of course have said that there is no such thing as fiscal stimulus (and not policy), but then he would have had nothing to write about. Mike don’t know this, but I hate everything “postmodernist” so he succeed with his low blow.

Anyway, let me say it again fiscal policy is not important. People like Paul Krugman (and Mike Sax) think that we need massive fiscal stimulus to take us out of the slump in Europe and the US and some think (for example European policy makers) think that the only solution is fiscal austerity. I think both parties are wrong – lets fix monetary policy and then we don’t have to worry (too much) about fiscal policy (other than balancing the government budgets in the medium to long run…). This is why I find it so utterly borrowing to discuss fiscal policy…

PS Mike mentions Battle Royal…he is unaware that that is my favourite Japanese movie.

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