Paul Krugman Plugs Market Monetarism

No, seriously. He has done it before, so it should not be surprising. This time, though, the plug is subtle and requires a little detective work. To see it, first recall how he observed that one of market monetarism's big claims--that monetary policy could offset fiscal policy even at the zero lower bound--was being put to the test in 2013. That year the sequester was tightening fiscal policy and at the same time the Fed was easing monetary policy with QE3. These two developments provided a nice natural experiment. Here is Paul Krugman in early 2013:

On the right are the market monetarists like Scott Sumner and David Beckworth, who insist that the Fed could solve the slump if it wanted to, and that fiscal policy is irrelevant... [A]s Mike Konczal points out, we are in effect getting a test of the market monetarist view right now, with the Fed having adopted more expansionary policies even as fiscal policy tightens.

I agreed at the time that this would provide a natural experiment to test our claims, but cautioned that it only was a test of how effective QE3 would be against the sequester. It was not a test of my ideal of a NGDP level target against fiscal austerity. Still, Paul Krugman was correct that an interesting experiment was under way.

As in most experiments, this one had a tricky measurement question: how best to measure fiscal austerity? Fortunately, Paul Krugman explained how to carefully measure the impact of fiscal austerity upon an economy:

Now, measuring austerity is tricky. You can’t just use budget surpluses or deficits, because these are affected by the state of the economy. You can — and I often have — use “cyclically adjusted” budget balances, which are supposed to take account of this effect. This is better; however, these numbers depend on estimates of potential output, which themselves seem to be affected by business cycle developments. So the best measure, arguably, would look directly at policy changes. And it turns out that the IMF Fiscal Monitor provides us with those estimates

The nice thing about the IMF's measure is that it includes all levels of government--local, state, and federal--when calculating the government balances. It is a thorough measure. Now note that Paul Krugman stresses the use of policy changes rather than the level of policy. That is, one must look at the change in fiscal austerity, not the level to properly ascertain its effect on the economy. 

Given these instructions from Paul Krugman, I put together the following figure using the latest IMF Fiscal Monitor. It shows the 2013 changes in fiscal policy for the three largest advanced economies. A negative number means fiscal policy tightened, while a positive one means it was expansionary:

This figure is striking. It shows that in 2013 the sharpest change in fiscal austerity was in the United States.

Now let us put this all together. The Fed QE3 program was pitted against the sharpest change in fiscal austerity across the largest advanced economies. Many observers predicted this fiscal austerity would lead to a recession. Other predicted it might costs as many as 700,000 jobs. Market monetarists like Scott Sumner and myself were more optimistic. 

So how did this natural experiment turn out in 2013? Not all the number are in, but what we do know is that economy did better than expected and outpaced 2012. Here is Michael Darda, Chief Economist for MKM Capital, on 2013:

Despite a two-year contraction in nominal federal outlays for the first time in more than five decades and a raft of tax hikes starting in early 2013, job gains are running slightly ahead of the 2012 pace. Non-farm payrolls (+203K in November and 200K in October) have averaged 189K during the first 11 months of 2013, ahead of the 179K 11-month average in November 2012 and the 170K average for November 2011. Over the last 12 months, non-farm payrolls have averaged 191K, also above the 12-month averages for the last three years. Indeed, year-to-year gains for overall payrolls and private sector jobs have been very steady despite the most intense fiscal consolidation since the Korean War demobilization. Many observers late last year were of the mindset that the fiscal cliff and/or sequester would either throw the U.S. economy back into recession, or slow it materially. It has done neither because, in our view, the Fed has offset it. Although monetary policy has beenfar from perfect, allowing the financialsystem to crash in 2009 (instead of doing QE1), allowing low inflation to morph into deflation in 2010 (instead of initiating QE2) and allowing the full force of the sequester/tax hikes to hit in 2013 (rather than rolling out QE3) do not seem like particularly desirable outcomes. The Fed has managed much better than the ECB and that is the proper counterfactual. 

In other words, market monetarism passed the test. And since Paul Krugman pointed out and discussed the implications of the natural experiment, he implicitly plugs for market monetarism given the outcome. There is no way to get around this implication, no matter what he now says.

P.S. Here is Scott Sumner's reply to Paul Krugman.