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(Early) Monday DeLong Smackdown Watch: Paul Krugman: The Simple Analytics of Monetary Impotence

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Paul Krugman: The Simple Analytics of Monetary Impotence: "Monetary policy at the zero lower bound....

...Many... economists... don’t know about an analytical approach that, it seems to me, lets you cut through most of the confusion.... An infinite-horizon model... all the action takes place in period 1.... P* is the period 2 price level, C* the period 2 consumption level... un-asterisked symbols refer to period 1... no investment, just consumption....

What determines period 1 consumption?... If we have rational expectations and frictionless capital markets--which we don’t, but let’s see what would happen if we did--the... ratio of marginal utilit[ies]... equal[s] the relative price of consumption in the two periods, where the relative price is the real discount rate.... Assume logarithmic utility, so that marginal utility is 1/C. Then... C = C*(P*/P)/(1+r).... [This] Euler equation... lets us read off current consumption from future consumption, current and future price levels, and the interest rate....

In a New Keynesian world... prices are... sticky.... At the zero lower bound... r=0.... There’s only one moving part... the expected future price level. Anything... affects current consumption to the extent, and only to the extent, that it moves the expected future price level.... What you do now matters only to the extent that people take it as an indication of what you will do in the future. Don’t talk to me about monetary neutrality, or how it stands to reason that money must matter, or helicopter money, or even money-financed deficits; we’ve taken all of that into account en passant with the Euler equation....

I’m not claiming that this Euler equation is The Truth. If you want to make arguments about policy that rely on some failure of the assumptions, especially imperfect capital markets, fine. But that’s not what I hear... what I hear instead are... unintentional... word games. Instead of telling a specific story about what people are supposed to be doing and why, economists try to reason in terms of concepts like 'monetary neutrality' that aren’t as well-defined as they think, and end up fooling themselves into believing that they’ve demonstrated things they haven’t.

Now, one good exception is Brad DeLong’s argument: that money does too work in a liquidity trap because such traps are always the result of disrupted financial markets.

What I’d say is that they are sometimes caused by financial disruption. But is this one of those times? As the chart shows, we had a lot of disruption in 2008-9. Is that still a major factor in our economic weakness? Do we think that Japan’s problems have been rooted in the banking system all these years? Anyway, that’s how I see it. If you disagree, please try to put your argument in terms of what the people in your model are doing--not in high concepts...

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Touché...

I am not going to get very far by claiming that a BAA-Treasury bond spread of 250 rather than 170 basis points indicates enormous credit-rationing of borrowing by companies that are BAA--especially since, almost invariably, their earnings right now are very healthy and their cash flow is such that they are investing in rather than borrowing from financial markets--am I?

The smackdown consists of two parts:

  1. My household liquidity-constraints argument is really not monetary policy but fiscal policy: a transfer now to households with high marginal propensities to consume matched by future taxes in an environment in which household Ricardian equivalence is broken. I (or Miles Kimball) can call it a Federal Lines of Credit program--and claim that it is not expansionary fiscal policy but rather monetary policy, as we implement it by having everyone with a Social Security number automatically incorporated in Delaware as a bank holding company, join the Federal Reserve, and use the Discount Window--but it really is, when you get down to it, fiscal policy.

  2. Credit spreads are back to normal, which means that the amount of moral hazard-driven credit rationing in financial markets is back to normal, and we do not usually think of that as a first-order macroeconomic phenomenon.

My first response is that I want to reserve the term "expansionary fiscal policy" to apply only to those situations in which the policy requires that the government, in order to balance its accounts, impose taxes on future taxpayers who are not the direct recipients of funds from or the direct beneficiaries of the program. Fiscal policy requires the use of the taxing power. Monetary policy buys and sells assets at market prices. I think this distinction makes more sense than Paul's, which classifies FLC programs as fiscal policy. But this is angels-on-pinheads territory.

My second response would have to be something like this: BAA-Treasury credit spreads are back to normal. But equity earnings yield-Treasury yield spreads are not. Nor is household access to mortgage finance back to normal either.

Maybe you don't want to call an 8%/year equity return premium vis-a-vis Treasury bills a "disrupted financial market" that is unable to properly mobilize the risk-bearing capacity of society/screen and classify investment project risks.

But what, then, do you want to call it?

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