Sunday, January 5, 2014

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.


  1. OK. I'll bite.

    Krugman was wrong, but not about market monetarism. He was wrong about 2013 being a natural experiment. As a fiscalist, I cringed when he and Konzcal laid out that test; I knew that if the Keynesian deficits run from 2009 - 2012 actually worked, all the credit would go to the monetarists. From the Keynesian perspective, the economic downturn drastically impaired private sector balance sheets. Increased deficits were used to stabilize aggregate demand, maintain profits, and improve balance sheets in the face of decreased private spending. Once the private sector had its house in order, then private sector activity would pick up and drive economic growth. And this is exactly what has occurred, no? (I admit that my account doesn't provide specific growth estimates or time-frames, but that's because we never have all the relevant data to be that precise).

    I guess I am disagreeing with Krugman's reliance on policy change instead of policy level. And I do think intellectual integrity demands that Krugman address this issue more so than he has as of yet. But the 2013 data is perfectly consistent with a Keynesian world. Unfortunately (for science), the 2013 data is also consistent with a market monetarist world. Thus, it wasn't a good natural experiment, a problem all too pervasive in social science.

  2. Right, I cannot conclusively say it was monetary policy. The strongest evidence I would point to is that the varying degrees of monetary policy tried in Japan, USA, and Eurozone lined up with the relative economic performances of those economies.

  3. The test "results" depend on which counterfactual one uses.

    Market Monetarists are using 2012 as the counterfactual, and saying that the results are "obvious." That really has no logical legs. Ceteris, paribus, all that rot.

    Krugman seems to be (unfortunately, mainly implicitly) using previous recoveries as the counterfactual. By that comparator, it's not crazy to say that 2013 has been darned disappointing by many economic measures -- especially (un)employment measures.

    This weak-employment recovery is just the latest in an accelerating series starting with the 81/83 recession(s).

    Secular stagnation starting with the rise of Reaganomics and driven by vastly increasing concentrations of wealth and income? That's not a crazy interpretation.

    Sure, the Fed acts last, but they do so within a long-term economic reality shaped by policies and institutions that are far beyond their purview.

    1. Disagree completely. 2013 has shown a acceleration of growth and unemployment is a lagging indicator. That lag is starting to close as we end the year.

  4. One previous recovery is the one from the Great Depression. In 1937 it featured fiscal austerity at a level similar to what we faced in '13, but no monetary expansion. In that case, the economy fell out of bed and the Depression got a second wind. In '13, that did not happen. Growth appears to have increased and unemployment decreased. That proves nothing in itself, but it certainly doesn't support the ZLB fairy explanation.

  5. I really wonder: Do Market Monetarists think that MP is equally powerful at the ZLB as it is in other conditions? I realize it's hard to define "the same action" by the Fed in different situations, but to the extent that's possible, does a Fed action at the ZLB have as powerful a real-economy effect as it would if inflation and interest rates were somewhat higher? This question especially regarding forward guidance -- an area where it seems especially hard to define "the same action."

    IOW, at the ZLB does the Fed have to make much more muscular efforts? Sorry to resort to "muscular" vagueness, but...?

  6. As with other great debates of our time, it's hard to test empirically.

    I would like to see published models with 5/10/20-year windows and clearly defined parameters suggesting that for input X,Y,Z we will have results A,B,C. Then we can establish exchanges and everyone who wants to can bet on who's right.

    Let empiricism triumph over ideology.

  7. Steve -- The Fed can always inflate if they choose, they are still worrying about "long-term inflation expecations becoming unmoored."

    If they wanted to, they could just change the long-term inflation target, or better yet target NGDP instead.

  8. Steve Roth,

    A lot depends on what you mean by "muscular efforts". Let's say you mean increases in base money. If the Fed committed to an NGDP target like 6% over the next few years, then this would increase the opportunity cost of holding base money and ceteris paribus REDUCE the demand to hold base money. Consequently, the monetary base would be smaller over the next few years than it would be otherwise. Put another way: if the natural rate of interest rises, then the demand for base money will be lower than otherwise, and so less base money is needed. Hence low-inflation countries have relatively large central bank balance sheets and contrariwise for high inflation countries.

    So insofar as base money demand increases in ZLB conditions, a monetary stimulus that takes you out of a ZLB environment should surely require LESS "muscular efforts" than, say, when short-term interest rates are at 5%.

  9. Paul Krugman:
    “…Incidentally, these other factors are why I don’t take seriously the claims of market monetarists that the failure of growth to collapse in 2013 somehow showed that fiscal policy doesn’t matter. US austerity, although a really bad thing, wasn’t nearly as intense as what happened in southern Europe; it was small enough that it could be, and I’d argue was, more or less offset by other stuff over the course of a single year…”

    This is a testable claim. I will assume by "southern Europe" he means the GIPS. By "intense" I will assume he means the amount of fiscal austerity in any given year.

    Using one of Krugman’s favorite measures of fiscal austerity, the change in the cyclically adjusted primary balance (CAPB) from the IMF Fiscal Monitor, the CAPB increased by the following amounts in the US, the Euro Area, the GIPS as a whole (weighted by potential GDP using IMF estimates of potential GDP), Greece, Italy, Portugal and Spain in 2010 through 2013:


    Note that Greece, Italy and Spain started fiscal austerity in calendar year 2010 and the US, the Euro Area as a whole and Portugal started a year later. Note also that US fiscal policy was only less austere than the Euro Area as a whole in 2011. And finally note that 2013 was the first year that US fiscal policy was more austere than the GIPS, but that the intensity of its austerity in 2013 was as great as the fiscal austerity in the GIPS in 2012 which was the peak year for fiscal austerity for those nations as a group.

    Looking at the individual GIPS nations we see that the level of fiscal austerity in the US in 2013 was less than that in Greece in three out of four years, was greater than the worst year of fiscal austerity in Italy which was 2012, was greatly exceeded by Portugal only once in its one truly horrendous year of fiscal austerity which was 2010, and was slightly exceeded by Spain's worst year of fiscal austerity which was 2012.

    I am gratified that Krugman seemingly acknowledges that the US fiscal austerity of 2013 was greater than anything that the Euro Area has ever experienced as a whole. However, I think by objective measures, measures Krugman himself uses, the intensity of fiscal austerity that the US experienced in 2013 is also as intense as the worst year of fiscal austerity experienced in southern Europe as a whole.

  10. 2013 was test of fiscal austerity (2% decline in spending) vs. Fed QE, result = QE helped. Not a resounding victory or demonstration.