If you asked me to name the five greatest works of macroeconomics during the 20th century, I might produce something like the following list (in chronological order):

1.  Fisher’s Purchasing Power of Money

2.  Friedman and Schwartz’s Monetary History

3.  Friedman’s 1968 AEA Presidential address

4.  The “Lucas Critique” paper

5.  Earl Thompson’s 1982 labor standard of value paper

(BTW, Krugman’s 1998 expectations trap paper might well make the top 10.)

Most economists would replace Thompson’s paper with something like the General Theory by Keynes.  In this post I explained why this 2 page never published paper that looks like something out of the Middle Ages is so important. (Please look at the link; the paper’s formatting is hilarious.)  Thompson’s student David Glasner did some excellent work on this idea in the late 1980s.

Josh Hendrickson has a new Mercatus paper which explains the logic behind the Thompson proposal.  Although Josh’s paper is very clear and well written, I can’t resist adding a few comments, as I fear that the extremely unconventional nature of Thompson’s idea might make it hard for some people to grasp the significance.

Josh starts off with an analogy to a gold standard regime, and then discusses the well-known drawbacks of that approach.  With a gold standard regime, any necessary changes in the real or relative price of gold can only occur through changes in the overall price level (or more importantly NGDP), which can be disruptive to the economy.

Here I’d like to emphasize the importance of the issue of sticky prices.  Adjustments in the overall price level can be costly because many nominal wages and prices tend to be sticky, or slow to change over time.  In contrast, gold prices are very flexible, changing second by second to assure that the gold market stays in equilibrium.  Under a gold standard, the nominal price of gold is fixed, and thus the ability of gold prices to quickly adjust is in a sense “wasted”.  Instead, we ask stickier prices to adjust when the real price of gold needs to change.

When reading Josh’s paper, try to keep sticky wages in the back of your mind.  Whenever the aggregate nominal wage level needs to adjust unexpectedly, some wages will be slow to change, and will be out of equilibrium for a certain period of time.  If there is downward wage inflexibility, especially a reluctance to cut nominal wages, then labor market disequilibrium can persist for years.

Normally, when we think of a government program aimed at fixing a price (gasoline, rents, etc.) we think of a market that is pushed out of equilibrium.  Nominal wage targeting is different.  Under Thompson’s proposed regime, individual nominal wages are still free to change, but monetary policy is adjusted until labor market participants do not want to change the aggregate average nominal wage rate.  In that case, the aggregate average nominal wage should stay at the equilibrium level (although of course individual wages might still occasionally move a bit above or below equilibrium.)

Under our current system, a sudden fall in nominal wage growth actually leaves the aggregate nominal wage too high, as some wages have not yet adjusted downwards.  We’d like to prevent that, by providing enough money so that the aggregate average nominal wage does not need to adjust.

My second comment has to do with the mechanism that Josh discusses:

Suppose that the central bank promised to buy and sell gold on demand at its current market price, but guaranteed that an ounce of gold would buy a fixed quantity of labor, on average. This is a promise to keep an index of nominal wages constant.

This approach is called indirect convertibility, a subject that Bill Woolsey discussed in a series of papers published in the 1990s.  I have a couple brief comments.  First, this sort of scheme need not involve gold at all.  Second it’s essentially a form of “futures targeting”, which is something I’ve done a lot of work on myself.  Indeed, this idea was independently discovered by numerous economists during the 1980s, but Thompson was the first.

If you are having trouble understanding the logic behind the indirect convertibility mechanism for a labor standard, think about the fact that aggregate wage data comes out with a lag, and hence you need to target a future announcement of the wage index.  To assure that monetary policy is set at a position where expected future wages are stable, you need a futures market mechanism where investors could profit any time aggregate wages are expected to move.  Their attempts to profit from wage changes nudge monetary policy back to the stance likely to keep average wages stable.

In addition, the specific proposal discussed by Josh involves a stable wage level, but given political realities it’s more likely the actual target would creep upward at 2% to 3%/year.

Also note that Josh argues that a labor standard is a vastly superior approach for achieving the goals of recent “job guarantee” proposals, put forth by progressives.  I agree.

PS.  I have a new Mercatus Bridge post discussing a WSJ article that called for monetary reform aimed at stable money.

PPS.  My recent post at Econlog on the usefulness of the yield spread got zero comments, which surprised me given all the recent focus on that variable.

Paul Krugman has an excellent piece on the potential effects of an all out trade war.  Likely Krugman, I think it unlikely that we actually go that far.  My view is that before that happened, Trump would become frightened by a sharp fall in stocks and negotiate some sort of face saving deal where he could claim “victory”.  (But when thinking about the stock market as a warning device, beware of the “circularity problem”.  The stock market won’t warn Trump if it thinks he would heed their warning.)

Here I’d like to add one additional downside to a trade war, the way trade policy can (and has) interacted with monetary policy.  A trade war might be even worse than Krugman estimates, if it leads to tighter monetary policy and falling NGDP.

You might think that Krugman has already factored falling NGDP into his estimate that a trade war could reduce RGDP by 2 to 3 percent.  But unless I’m mistaken, he’s using a general equilibrium approach that abstracts from demand shocks.  In other words, Krugman is showing that even in a world where the central bank stabilizes AD, a trade war could reduce RGDP by 2 to 3 percent by making the economy less efficient.  But what if the central bank does not stabilize AD? In that case you might get an ordinary recession, piled on top of the adverse supply shock produced by a trade war.  A recession slows the process of worker re-allocation into non-tradable sectors.

I can see two possible channels by which a trade war could reduce aggregate demand:

1.  Imagine the central bank is targeting interest rates.  If a trade war occurs, it’s likely that investment demand would fall, reducing the global equilibrium (i.e. “natural”) rate of interest.  If the central bank does not reduce the policy rate as quickly as the natural rate is falling, that would lead to (effectively) tighter money and falling NGDP.  (Think of this as a channel that operates if I’m wrong about monetary offset, and the Keynesians are right.)

2.  Imagine the central bank is targeting inflation.  If inflation is kept at 2% while RGDP growth is falling, then NGDP growth will also slow.  (Here the problem can occur even if monetary offset is operative, as long as they target inflation, not NGDP.)

Keep in mind that slower NGDP growth is always a problem, even if there are other problems at the same time.  Careful readers might recall that this is exactly what went wrong in 2008.  The Fed adopted IOR to prevent its liquidity injections aimed at rescuing banking from spilling out into more aggregate demand, out of fear of inflation.  They thought the banking crisis was “the real problem” when in fact there were two real problems, banking distress and falling NGDP.  The falling NGDP led directly to higher unemployment, and also as a side effect made the other “real problem”, i.e. banking distress, even worse.

In my research on the Great Depression I found that the biggest problem caused by Smoot-Hawley was not that it reduced the efficiency of the US economy (the direct effects were modest), or even the retaliation from abroad.  Rather the biggest problem was that Smoot-Hawley led to lower aggregate demand.  This occurred either because of a fall in the Wicksellian equilibrium rate (very bad news under a gold standard), or because it reduced the likelihood of international monetary cooperation, or both.

BTW, this is no surprise:

Fears of a looming trade war between the U.S. and China are paradoxically helping to increase the value of the U.S. dollar in global currency markets, analysts say, potentially undercutting a Trump administration policy goal.

This is what happens when you have a president who hires crackpot economists who don’t even know that the current account deficit is a saving/investment issue, not an import/export issue.

HT:  Tyler Cowen

Love him or hate him, there’s no denying that Krugman is a brilliant economist. David Beckworth’s interview with Krugman is probably my favorite so far in the series, even though on the policy issues I tend to agree more with earlier interviewees such as Bullard.  (Interestingly, these two agreed on a number of issues, despite being far apart on the political spectrum.)

There’s no transcript, so I’ll rely on memory, and then leave a few observations after each point:

1.  When discussing his famous 1998 paper, Krugman said the hard part was determining the implication of an “expectations trap” for policymakers.

This is a very good point, and most people underestimate this problem.  Krugman himself has changed his views as to the paper’s implication, in the years since it was published.

2.  He indicated that when trying to exit a liquidity trap, you don’t need to just convince the central bankers, you also need to convince the public.

I have a “build it and they will come” attitude here.  If the central bank adopts an effective policy response, I think the public will believe it.  The real problem has been the failure of central banks to be willing to adopt “do whatever it takes” policies.

3.  He suggested that price level targeting might not be enough—you might need a higher inflation target if the equilibrium real interest rate fell to very low levels, and stayed there.

Here my view is different.  A liquidity trap should not be viewed as zero nominal interest rates, but rather the zero bound on eligible assets that the central bank has not yet purchased.  Imagine a policy of targeting the price level with CPI futures. That policy will work regardless of how low the equilibrium interest rate falls, as low as the central bank has the ability to adjust its balance sheet to base money demand.  Ditto for exchange rate targeting (i.e. Singapore). Liquidity traps are not times when fiscal policy is needed, they are times when bigger central bank balance sheets are needed.

Krugman cites Japan’s falling population.  On the one hand that might reduce Japan’s equilibrium real interest rate.  But it also reduces aggregate supply, which is inflationary.

4.  Krugman noted that elite policymakers don’t think that an inflation target of higher than 2% is responsible.

My immediate reaction was “Hmmm, where did they get that idea.”  To his credit, Krugman later joked “I may have set back policy by decades with that credibly promise to be irresponsible remark.”

5.  The first QE in the US and Europe helped to restore confidence to economies that had been destabilized by private sector financial turmoil.

My reaction is that that financial turmoil was at least partly caused by bad monetary policy, which was causing NGDP growth expectations to plummet.

6.  Krugman points out that Congress would have objected to a higher inflation target.

I think that’s right, but other options like PL targeting and NGDP targeting we at least possibilities.  More importantly, the Fed could have kept the inflation target at 2% and done far more in the realm of “concrete steppes”.

7.  Krugman’s ideal policy back in 2009 would have been enough fiscal stimulus to get inflation up to 4%, followed by standard monetary policy to stabilize the economy after that (presumably something like policy during the Great Moderation, except with a high enough inflation target to prevent hitting the zero bound.)

That might work, but if you raised the inflation target to 4%, then I doubt you’d even need fiscal stimulus.

8.  On whether 2% was a target or a ceiling, Krugman actually seemed less cynical than David (which might surprise people given their personalities).

I tend to agree with Krugman on this point, but I also believe that David has the better argument, and this is one place where Krugman struggled a bit to refute it. He talked about central bankers wanting to go back to the old days of Volcker, when they fought a heroic battle against inflation, and he also talked about the Fed as an institution having a bias toward fighting inflation.  Of course you could view those observations as supporting David’s claim about 2% being a ceiling, and I sensed that Krugman saw that as well.

9.  Krugman suggested that he had mixed feelings about NGDP targeting, worrying that it might allow too much inflation volatility.

Here again, he struggled a bit in his reply.  At one point he tried to suggest a scary counterfactual of 1% RGDP growth and 4% inflation, and then immediately seemed to realize that a few minutes earlier he had advocated 4% inflation.  In my view Krugman missed the point here.  A period of 1% RGDP trend growth is precisely when you are likely to see the sort of low equilibrium real interest rate that Krugman himself thinks calls for 4% inflation target.  Admittedly I am relying a bit on a sort of “divine coincidence” of RGDP trend growth and equilibrium real interest rates moving together, but I also think there are strong labor market reasons to prefer NGDP targeting. Krugman said something about menu costs of inflation, but surely he cares more about unemployment than menu costs, and labor market stability is almost certainly more closely correlated with NGDP than inflation. Indeed an awareness of that fact (in my view) largely explains why central banks have “flexible” inflation targets.

Like most other mainstream economists, Krugman doesn’t seem aware of all the arguments for NGDP targeting made by market monetarists, and even earlier by George Selgin.  We still have work to do.

Overall a great interview.  Krugman said, “I don’t really know” more often than one might expect from reading his NYT columns, which is to his credit.

I used to think his bashing of the GOP was exaggerated, but now it seems on target.  I say he’s finally got it right, whereas Krugman would presumably say that Trump proves that he was right all along.

Commenter Jim Glass provided another Paul Krugman op ed, this one from 2001 2011:

Nonetheless, Mr. Koizumi is right about one thing: Japan cannot go on like this. Swelling public debt will eventually threaten the government’s solvency; the festering financial problems of the banks will soon require a government bailout that will swell that debt even further. Something must be done. But the actions Mr. Koizumi has proposed could tip Japan into full-blown depression.

There is an answer to this dilemma, one that has become almost orthodoxy among economists who have tried to think seriously about Japan’s plight. This answer involves unconventional monetary expansion, with the Bank of Japan buying dollars, euros and long-term government bonds; it also involves accepting and indeed promoting mild inflation and a weak yen. I could explain why this would probably work, but what’s the point? It’s not about to happen.

For the real tragedy right now is that however innovative and open-minded Mr. Koizumi may be, he will fail unless other important players — mainly the Bank of Japan, but also the U.S. Treasury Department — are prepared to learn from Andrew Mellon’s mistake. And all the evidence is that they are not. The head of the Bank of Japan insists that the country’s continuing slump is the result of inadequate reform — that is, insufficient purging of the rottenness. And although the details are in dispute, the U.S. Treasury secretary, Paul O’Neill, appears to have warned Japan not to let the yen weaken too much.

Poor Japan. It is the victim of those who refuse to learn from the past, and thereby condemn others to repeat it.

So even three years after the famous 1998 liquidity trap paper, Krugman was still favoring monetary stimulus over fiscal stimulus for countries at the zero bound. But I’d like to focus on the comment regarding our Treasury officials.  Krugman’s right that they have consistently warned the Japanese not to engage in “currency manipulation”.  What our Treasury doesn’t understand is that all central banks manipulate currencies—-that’s their job!  The only question is how.  And don’t say “It’s OK to manipulate the purchasing power of a currency but not the foreign exchange value.”  If the manipulation is done via central bank policy, then the two types of manipulation are identical. For decades, the US Treasury has been (unknowingly) warning the Japanese not to manipulate their economy out of deflation.

Ironically, a healthier Japanese economy would also be good for the US, boosting our exports and creating good jobs.  Pity that we are so dense.

PS.  Over at Econlog you’ll find a Trump post that is perhaps a bit less “unhinged” than usual.  At least I hope so.

Paul Krugman frequently suggests that his famous 1998 article (“It’s Baaack, Japan’s Slump and the Return of the Liquidity Trap”) led him to rethink the role of monetary and fiscal policy.  He says that the “expectations trap” model in that paper convinced him that monetary policy might be ineffective at the zero bound, and that fiscal policy might then become necessary.

Previously I’ve pointed to a 1999 Krugman essay that advocated monetary stimulus for Japan, and was quite dismissive of the idea of fiscal stimulus.  While cleaning out my office, I came across a Krugman editorial from the year 2000, which made similar arguments:

Japan has the dubious distinction of being the first major nation since the 1930’s to experience a “liquidity trap,” in which even cutting the interest rate all the way to zero doesn’t induce enough business investment to restore full employment. The result is an economy that has been depressed since the early 90’s, and that in 1998 seemed to be on the verge of a catastrophic deflationary spiral.

The government’s answer has been to prop up demand with deficit spending; over the past few years Japan has been frantically building bridges to nowhere and roads it doesn’t need.

In the short run this policy works: in the first half of 1999, powered by a burst of public works spending, the Japanese economy grew fairly rapidly. But deficit spending on such a scale cannot go on much longer. Japan’s government is already deeply in debt (about twice as deep, relative to national income, as the U.S. was before our own budget turned around). For the policy to do more than buy a little time, the recovery must become “self-sustaining”: consumers and businesses have to start spending enough to allow the government to return to fiscal responsibility without provoking a new recession.

Carping critics (like me) warned that there was no good reason to think this would happen. Sure enough, it hasn’t; as the big public works projects of early 1999 have wound down, so has the economy. . . .

Although the Bank of Japan has already reduced the short-term interest rate to zero, Western economists have pointed out that there are other things it can and should do: buy longer-term bonds, announce a positive target for inflation to encourage businesses to borrow. Indeed, textbook economics tells us that to adhere to conventional monetary rules in the face of a liquidity trap is not prudent; it is irresponsible. (Full disclosure: I personally have been the most visible and vociferous advocate of inflation targeting).

But the current government has actually slowed the pace of reform, and the Bank of Japan — which only recently acquired Federal Reserve-style autonomy — has adamantly refused to do anything unconventional. (When I was in Japan in December, I witnessed an argument between former B.O.J. officials and current officials of the Ministry of Finance. The former declared that it would be wrong to do anything risky; the latter reminded them, to no avail, that the current policy of running up huge debts to finance public works is already very risky.)

Of course Krugman turned out to be absolutely correct.  The fiscal stimulus never got Japan out of the liquidity trap, and it was only in 2013 that Japan finally adopted a 2% inflation target—and then prices started rising.  Krugman was very worried about Japanese debt levels when their national debt was less than 150% of GDP—now it’s 250%.  All those “bridges to nowhere” were a monumental waste of money, when a 2% inflation target back in 2000 would have been far more effective.

Later in 2000, Krugman wrote more articles on Japan, which criticized the BOJ decision to raise rates.  Again, Krugman turned out to be completely correct—Japan fell back into recession and had to cut rates again.

So when did Krugman become “Krugman”?   It seems like the turning point was around 2002, when he started advocating fiscal stimulus for the US:

Not many people realize that in some ways Japanese economic policy responded quite effectively to a sustained slump. It’s easy to make fun of the country’s enormous spending on public works — all those bridges to nowhere in particular, highways with no traffic, and so on. Without question enormous sums have been wasted. But it’s also clear that all that spending pumped money into the economy, preventing what might otherwise have been a full-fledged depression.

So what will be the U.S. equivalent? Right now we are in effect following the reverse policy: slashing domestic spending in the face of an economic slump. Some of this is taking place at the federal level; the Bush administration is nickel-and-diming public spending wherever it can, shaving a billion here, a billion there off everything from veterans’ benefits and homeland security to Medicare payments. More important, the federal government is doing nothing to help as state and local governments, their revenues savaged by recession, make deep cuts in spending on everything that isn’t urgently necessary, and many things that are.

This is a radically different Paul Krugman from the 1999-2000 version:

1.  Now Krugman is making things up—for instance suggesting that Bush had adopted a contractionary fiscal policy, when Bush’s policy was actually quite expansionary (huge tax cuts, massive increases on federal spending on education, homeland security, Medicare drug benefit, military build-up.)  This is a more ideological Krugman than the neoliberal of 2000.

2.  Krugman says it’s easy to make fun of the Japanese public works, but doesn’t tell his readers that back in 1999 he was one of those people ruthlessly mocking the Japanese public works spending:

What continues to amaze me is this: Japan’s current strategy of massive, unsustainable deficit spending in the hopes that this will somehow generate a self-sustained recovery is currently regarded as the orthodox, sensible thing to do – even though it can be justified only by exotic stories about multiple equilibria, the sort of thing you would imagine only a professor could believe. Meanwhile further steps on monetary policy – the sort of thing you would advocate if you believed in a more conventional, boring model, one in which the problem is simply a question of the savings-investment balance – are rejected as dangerously radical and unbecoming of a dignified economy.

Will somebody please explain this to me?

One possibility is that Krugman turned left due to “Bush derangement syndrome.” In fairness, however, you could see a similar pattern in Ben Bernanke, who was a Republican during this period.  In 1999, Bernanke was also contemptuous of the view that the BOJ was out of ammunition, but by late 2008 Bernanke was also advocating fiscal stimulus.  Indeed right about the turn of the century there was a gradually shift to the left in many places.  Regulations started ramping up in the US (i.e. Sarbanes-Oxley).  The British Labour Party abandoned their fiscal austerity, as did the Dems in the US.  So perhaps Krugman was merely a part of this gradual change in the zeitgeist.  I haven’t changed, so I’m not well placed to understand what caused so many other people to become more sympathetic to fiscal stimulus and regulation.