Sunday, November 15, 2009

Sumner and Krugman are both wrong

Or at the least way overoptimistic about what monetary policy can accomplish.

Tyler has been cooling lately in his ardor for the monetary views of Scott Sumner (here is an historical compendium), though he cites Krugman's latest piece as an "Answer to Scott".

In that piece, Paul avers that the first best monetary policy would be a Sumnerian "credible commitment to higher inflation". Why? "In order to reduce real interest rates".

People, it is just not clear that is possible, or if possible, it may be so in only a very limited sense. 

Can the Fed set the real interest rate at whatever value it wants? I don't think so. 

Do you think they could simultaneously credibly commit to say 10% inflation and successfully hold the nominal interest rate at zero? Me neither. 

What about the simultaneous achievement of 5% expected inflation and a zero nominal interest rate? Doubtful at best.

The bottom line is that Fed can target the nominal rate or the inflation rate, but they simply cannot have independent targets for each. That is a basic message of the huge "instruments & targets" policymaking literature that appears to be lost in the current debate.


15 comments:

Sammy said...

I don't think Sumner cares about targeting the nominal rate. Where did you get that idea?

Angus said...

To the extent I understand Sumner, his argument about targeting nominal income growth suffers from the exact same problem as Krugman's argument about targeting inflation expectations. They are basically the same argument, that's why Tyler titled his link the way he did.

Anonymous said...

I believe Sumner is advocating targeting expected NGDP. He wants the Fed to set an explicit level target and then print (or buy) money until the market expects them to hit this target. In this scenario, I'm not sure how interest rates or NGDP growth rates are relevant.

Angus said...

AAAARRRGGGGHHHHH!!!

Look, it's the same argument. You can target nominal gdp but you cant also target its split between prices and real GDP. Targeting nominal GDP is not a panacea for raising real GDP out of a recesssion.

I didn't even bother with the impossibility of the Fed "credibly committing" to either policy.

The idea that too tight of monetary policy led to or worsened the crash is just wrong in so many ways.

azmyth said...

Scott's basic argument is that there is some policy Fed could do that would that would result in inflation (and/or NGDP) expectations being 2% (5% respectively). He's stated that he does not care about interest rates as an indicator of monetary policy.

There is a clear case to be made that it may not be possible for the Fed to be expansionary enough to hit an NGDP or inflation target in one quarter, but surely the Fed can do something to be more expansionary (quantitative easing, debt monetization, exchange rate targeting, etc). Scott would not claim that "they could simultaneously credibly commit to say 10% inflation and successfully hold the nominal interest rate at zero" I'm not sure what Krugman would say, but I don't think he'd make that claim either. He'd probably just argue for another trillion or two in fiscal stimulus.

James Hamilton raised similar concerns in the Cato Unbound article: http://www.cato-unbound.org/2009/09/16/james-d-hamilton/its-harder-than-it-looks/

Anonymous said...

yes, my understanding matches azmyth's. it's basically the same as krugman cerca 1998. the fed is supposed to target nominal gdp expectations. this doesn't directly make real gdp growth positive. but it does address the liquidity trap in that it reduces speculative demand for cash and other nominal assets. this means that buying stuff or investing is the rational thing to do rather than hoarding cash. if everyone took their money and spent and invested it, a lot of economic activity would ensue.


(krugman cerca 2009 is a noisy signal and political pundit and it's hard to know what he thinks with his economist hat.)

Anonymous said...

I think Sumner is arguing the following; say a financial crisis hits and changes a) the fundamentals in the economy, and b) the demand for money. If the Fed prints enough money to keep expected NGDP on target, then the crisis will act like a productivity shock - some reallocation will have to occur, and there will be some higher unemployment. If the Fed doesn't keep expected NGDP on target, then people must also deal with unanticipated changes in the aggregate price level on top of everything else, which lead to further unemployment.

He has argued that the effects of the financial crisis weren't too large until late 2008 - when people realized the Fed was going to allow NGDP to fall from its historical path.

Charlie said...

The whole point is that the market clearing real interest rate is below 0. If the fed can create inflation expectations, the real rate can clear the market.

What is the argument here? Are you just saying the real rate is above 0? Krugman and Mankiw both think you're wrong and they don't agree on much, so you might want to expand your point.

Doc Merlin said...

The fed can't actually target NGDP growth effectively, this is why Scott suggests using NGDP futures for the targeting. Also, what is targeted through the futures is expected NGDP growth.

I am still leery of the idea, I'd prefer some sort of free banking, but I think you have slightly misrepresented what he was saying.

Scott Sumner said...

I've never advocated targeting both inflation and interest rates, or both NGDP and interest rates. With one instrument you can only hit one target.

There are many differences between my proposal and Krugman's. I favor using market expectations of NGDP as policy targets. I am not aware of Krugman ever proposing targeting the forecast. Krugman thinks high inflation is necessary. I don't. I favor level targeting, I have no idea what Krugman's views are on level targeting.

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Robert Simmons said...

"You can target nominal gdp but you cant also target its split between prices and real GDP."
That's true, and Scott has said that the split will be determined by the supply curve. With the slack in the economy/low capacity utilization, we are on a relatively flat part of the curve, so increasing NGDP will mostly increase RGDP with only modest inflation.

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