Tuesday, February 27, 2018

Paul Krugman on Temporary vs Permanent Monetary Injections

Paul Krugman looks back on the past twenty years of macroeconomic policy and finds that his 1998 paper was more prescient than he or anyone could have imagined. Back then many observers assumed that central bankers--particularly those at the Bank of Japan--need only increase the monetary base to increase the price level. It was that simple.

Ken Rogoff, for example, said the following in commenting on Krugman's 1998 article:
No one should seriously believe that the BOJ would face any significant technical problems in inflating if it puts it mind to the matter, liquidity trap or no. For example, one can feel quite confident that if the BOJ were to issue a 25 percent increase in the current supply and use it to buy back 4 percent of government nominal debt, inflationary expectations would rise.
Krugman disagreed in his 1998 paper. He showed, using a New Keynesian model, that it was more complicated than many imagined. It depended on whether the monetary injections were expected to be temporary or permanent. Here is how he summarizes his 1998 article (my emphasis):
[T]he proposition that money issuance must raise the price level was false. Or if you like, it was missing a word: permanent money issuance would raise the price level. But a monetary expansion the private sector expected to be temporary, to be wound down after the crisis had passed, would do nothing at all: the extra monetary base would just sit there. Furthermore, it was reasonable for the private sector to assume that even large increases in the monetary base in a liquidity-trap economy would be temporary, to be wound down after the crisis had passed, would do nothing at all: the extra monetary base would just sit there
He goes to note that the public should, in fact, expect large expansions of the monetary base to be temporary. Otherwise, it would imply an implausibly large jump in the price level that would not be politically tolerated. For example, if the several-hundred percent increase in the U.S. monetary base expansion under the Fed's QE were expected to be permanent then the price level would have proportionally jumped several hundred percent as well. 

Krugman notes that the actual performance of Japan's first QE program of 2001-2006 and the Fed's QE programs bore out his predictions. These large-scale asset purchase programs ultimately proved to be temporary monetary programs. 

This is an important point and one that I stress in my own work. Just to be clear, permanent means an exogenous increase in the monetary base that (1) is beyond that required to accommodate normal money demand growth and (2) is not expected to be reversed. 

To illustrate this point, I want to repeat what I showed in an earlier post. There I used the Fed's median forecast of its assets through 2025 from its 2016 SOMA Annual Report to create projections of the Fed's balance sheet. These projections show the trend growth path of currency and a series I call the 'permanent monetary base' extrapolated to 2025. The latter series is the monetary base minus excess reserves. These two measures, which reflect the liability side of the Fed's balance sheet, are plotted along side the forecasted path of the asset side of the Fed's balance sheet.

Note that the Fed's median forecast of its assets eventually converges with the trend growth of currency which historically has made up most of the monetary base. Consequently, the permanent measure of the monetary base roughly tracks currency's trend path.

The figure implies the Fed's balance sheet forecast confirms the temporary nature of the monetary expansion  under the QE programs. That is, the Fed expects most of the permanent growth in the monetary base in 2025 to have come from the normal currency demand growth. This endogenous money growth would have happened in the absence of QE. There is no sign of an exogenous permanent increase in the monetary base. 

Krugman's bigger point is that to have robustly raised nominal demand over the past decade required a permanent increase in the monetary base. This did not happen at the Fed or the ECB. Krugman thinks it sort of happened in Japan under Abenomics. Maybe so, but I am not completely convinced. In my view, the shackles of inflation targeting made such permanent increases very hard to do at most advanced-economy central banks over the past decade. 

So what would a permanent monetary base expansion look like in practice? In my paper, I argue one could look to the experience of Israel over the past decade. An even better example comes from the U.S. economy coming out of the Great Depression. It is fairly easy to see the permanent jump in the monetary base during the early 1940s:

That is what Krugman would call being credibly irresponsible. It took a war to accomplish this permanent jump in the monetary base. The same can be done more efficiently and in a rule-like manner with a NGDP level target. Credibly going to a NGDPLT, however, would require a major regime change to U.S. monetary policy. And that brings us back to Krugman's article:
Given the way experience has undermined much of the original case for a 2 percent inflation target, and given the severity of the economic crisis, you might therefore have expected some  revision – a rise in the inflation target, or a shift to some other kind of targeting – price level or nominal GDP targeting. But that hasn’t happened... This is quite remarkable. If the worst economic crisis since the 1930s, one that cumulatively cost advanced nations something on the order of 20 percent of GDP in foregone output, wasn’t enough to provoke a monetary regime change, it’s hard to imagine what will.
His pessimism is understandable. However, I am more hopeful as noted in my last post. We are making progress. We have changed the conversation and that is the first step forward. 


  1. Well, excellent post, but....

    Does anyone really expect the Bank of Japan to ever sell its hoard of JGBs, now 45% of total outstanding?

    I find this not a compelling argument, due to the example of the Bank of Japan.

    Really, the private sector is that clued in to the intricacies of monetary policy, that the expectation that the Fed would sell its bonds is what has kept inflation at record-low levels? Not the immediate forces of competition in the marketplace?

    Yes, I am obsessed with monetary policy. Maybe after eight years of reading Scott Sumner's and other blogs and even more I have a clue, and some would say I still don't.

    Something does not add up here.


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  2. The arguments around QE have always seemed obscure to me, and I'm not sure that I'm persuaded that it is the credible permanence of the monetary expansion that really matters.

    Consider two strategies: that actually followed by the FED over the last decade, and "helicopter money", where the monetary expansion is achieved by putting money directly into the hands of the population.

    First, the FED strategy. Clearly, the expansion of the monetary base once the lower bound had been reached had no effect...the extra money just sat in excess reserves, and had no way of influencing actual economic behavior. The effect of QE (the purchase of longer term debt securities) perhaps lowered longer term rates modestly by depressing the term premium, and that probably had a modest effect on the economic activity of credit-worthy borrowers, but the effect seems to have been modest, and certainly did not ignite the raging fires of economic activity that some seemed to believe it capable of doing. "Helpful at the margin" seems like a fair verdict on QE as practiced by the FED.

    By comparison, I find it very hard to believe that "helicopter money"...putting money directly in the hands of the populace, particularly if the hands in question are those of the poorer part of the US population that lives essentially paycheck to paycheck, would not have had direct and immediate consequences for demand, and hence for economic activity. The money would have been spent, and quickly.

    Nor does the credible permanence of a "helicopter money" monetary expansion seem particularly necessary. Perhaps the permanence of the resulting economic expansion would be somewhat relevant to its effectiveness through its influence on desired savings, but there is no particular reason that I can see that the prospect of future FED operations to reduce the monetary base, aimed at controlling future inflation while maintaining full employment, would have inhibited the spending of the helicopter windfall. The only credibility over the long term that matters would seem to be that the FED was going to engineer a full recovery of employment. Indeed, managing such a recovery in a non-inflationary way would seem to require the FED to reverse the monetary expansion at some point, and probably fairly promptly.

    1. Mark, even a helicopter drop will prove futile if it is expected to be reversed. The original Japan QE was accommodated by big deficits. It was effectively a helicopter drop, but the expected and confirmed reversal of the monetary base shows more is needed than just relying on helicopter drops. You need a tolerance that allows for some reflation--and that implies a willingness to let the monetary injections be permanent. A price level or NGDP level target would do just that.

      Here is an earlier post I did on Japan's helicopter drops:

  3. OK, but actually the FOMC and especially Ben Bernanke made the argument that the purpose and the actual effect of QE was to lower long term interest rates and not raise inflation, at least not directly. The arguments that a temporary expansion of the monetary base would be inflationary did not come from the Fed but from outsiders who were obviously wrong.

    Although Krugman is correct his model does not address the claims that QE did or did not lower long term rates; did or did not affect inflation expectations even slightly; did or did not act only as a signal that rates would stay low for longer. My view is that QE mainly acted as a signal that zero interest rates would persistent for at least as long as QE was in effect. There was almost no direct effect on long term interest rates due to the Fed taking long term Treasury securities out of private hands, which is what Bernanke thought would happen.

    The FOMC sees inflation as a consequence of full employment i.e. the Phillips curve which is being discredited as a useful model for forecasting inflation. Yet, economists for the most part are unwilling to discard or even be critical of the very model the FOMC clings to as its main inflation forecasting tool. Notice that the idea that low unemployment causes inflation directly contradicts the model that says a permanent increase in the monetary base should cause the price level to rise almost immediately due to the rise in inflation expectations.

    1. Doug, yes, Ben Bernanke was always fairly clear that QE was about the asset side of the balance sheet not the liability side. He even said to call it "credit easing" instead of quantitation easing. But therein is the rub. But ultimately limiting the expansion of the liability side (the monetary base) the Fed was reduced to rely on a portfolio rebalancing channel that itself was limited in what it could do. The Fed effectively handcuffed itself to theoretically questionable channel that failed to spark a robust recovery in nominal demand growth.

  4. My car has a brake pedal and a gas pedal and both function exactly as expected. If I punch both pedals at the same time though, the car might speed up or slow down. This doesn't mean that the brakes or the gas pedal don't work as expected. The problem is pushing both at the same time.
    The Fed didn't just do QE. It also started paying IOR - and it paid IOR to the banks at rates in excess of market rates. No wonder the economy wasn't stimulated more. Let's face it, if Krugman were precisely right then the Fed wouldn't be raising the rate of IOR now. All it would need to do is send out a Tweet with that Figure 5 showing that the balance sheet was going to return to the prior trend and we'd see no inflation. But I doubt that's true. The concrete steps give us insight into the Fed's intentions and influence our expectations. If the Fed had accompanied QE with no change in IOR, it would have been more effective. If the Fed had gone with negative IOR, then QE would have been even more effective. And if it had added a 5% NGDPLT target, more effective still.
    Oh, and I can push my brake and gas pedals just enough that the speed doesn't change too. :-)

    1. This comment has been removed by the author.

    2. I really like this analysis, Bill. IOR makes very little sense in terms of productively helping the economy.

      Paying banks IOR:
      1) incentivizes banks to just horde cash at the Fed, where it does nothing useful for the economy. Why invest in short term treasuries, when you can get more by keeping it at the Fed?
      2) The "big banks" will now be pushing/lobbying to have IOR keep going higher and higher.. which it does, each time the Fed raises its rates. When the Fed raises rates, it impacts the SHORT end of the curve, but is very indirect in raising the long term rates.

      What are the future implications?
      1) Eventually, the short term rates (which is also the IOR rate), will likely go higher than the long term rates.
      2) Next financial crisis occurs.
      3) Fed then has to buy bonds again, and lower rates back to zero or worse.

      What will the banks do with their excess reserves, when they are making zero on it? Buy short term treasuries most likely, lowering short term rates.

      Is the Fed really planning on unwinding its assets, or just trying to build a very small buffer to give us a little wiggle room before the next collapse?

  5. Wouldn't it make more sense to say that the monetary base expanded after WWII due to the inflation caused by massive deficit spending for the war effort? It seems odd to focus on the ~$20B jump in monetary base instead of the ~$200B jump in Federal debt, when the only difference between the two is a bit of interest.

    In fact, I don't understand where this idea of the monetary base as an independent variable comes from. How can the Fed control interest rates and the monetary base at the same time? Only at the zero lower bound or when paying interest on excess reserves do the two become independent, and in that case, the monetary base is indistinguishable from government bonds (so it's meaningless).

    Obviously, I've been reading MMTers and am not an economist.

  6. In a financial crisis, when unemployment spikes and consumer spending plummets, monetary injections won't work to boost the economy, at least not on the consumer side, as the unemployed don't spend because they don't have a job and the employed don't spend because they lack confidence that the economy will quickly recover (when times are bad, the psychology is times will always be bad). Thus, monetary injections in those times work if but only if it spurs capital (investment) spending. But it didn't, as firms and investors chose safe (i.e., government bonds) investments over capital investments. I would point out that capital investment didn't recover until the past two years, and even then a large share of investment continued to be in real estate, stocks, cryptocurrencies, and other forms of non-productive capital.

  7. David (and all),

    The chart of the adjusted monetary base from 2008 to date seems for all practical purposes indistinguishable from yours during the late 30s to mid 40s. What remains to be seen is whether ours shrinks or eventually moves higher. In other words, the jury is still out.

    I’m inclined to agree with those who wonder about the usefulness of the permanent/temporary distinction. Not because it’s unimportant in the abstract but because of the difficulty of being able to make that distinction in real-time.

    What it does do is point to something that to me seems vitally important, namely confidence. So long as the vast majority of participants believe in the essential integrity of current monetary arrangements, all manner of unconventional policy moves will be accepted with relative equanimity. The day that changes life becomes infinitely more complex for central bankers (and for everybody else).

    I’ve been surprised by the durability of this trust but probably shouldn’t have been. It’s so deeply ingrained in countries like the US which haven’t experienced monetary catastrophes for a very long time (and arguably never) that questioning this cornerstone is for most literally unthinkable. We can only hope it remains so.

    In any event, given that’s the case it doesn’t seem to me all that surprising that QE hasn’t triggered greater inflation. There are countervailing forces and as yet no obvious transmission mechanism into the real economy. First amongst these forces, I think, is the secular deflationary influence of newly emerging mercantilist players such as China and its Asian neighbours. So far, quite apart from their depressing effect on wage levels in the developed world, they’ve provided a tremendous and continuing net addition to the supply-side. Even though one can argue this is a once only effect, it’s of staggering magnitude.

    As many here have mentioned, another critical factor is IOER. In its absence, I’m pretty sure things would be a great deal hotter than they are at present. So far, banks haven’t had to treat excess reserves as hot potatoes; if anything, they’ve been rather attractive. The day that’s no longer true, for whatever reason, will see the endogenous credit creation machinery spinning up very quickly. Given the banking system as a whole can’t get rid of excess reserves (since their level is for all practical purposes entirely within the Fed’s control), one can only imagine the consequences of individual banks desperately fighting to get rid of some of their excess reserves through lending or asset purchases.

    To date, most of the effects of QE have been confined to asset markets. There, there’s been no shortage of inflation. However, in an economy which (at least until recently) has been quite subdued, and in which many participants were struggling to right their balance sheets, there was no natural way for QE to find its way into income and hence expenditure. At least not in any dramatic fashion. Still, we shouldn’t forget the very real possibility that in the absence of these extraordinary official efforts, the crisis 10 years ago would probably (in my view certainly) have quickly mutated into a full on deflationary depression. In other words, the absence of any obvious inflationary effects doesn’t mean they haven’t occurred; it may simply mean (much as per “bill’s” amusing but useful brakes vs accelerator analogy) that something dramatic on the flip side was avoided.

    To my mind, the last 10 years has mostly been about delay and dissembling. Very few of the underlying structural issues have been dealt with and new and interesting ones have been created. The reckoning still awaits, I suspect, but whether it will be inflationary or deflationary, or (as is my view) some unhappy combination of the two, remains to be seen.

    1. Fed should be incentivizing banks to make productive (GDP-raising) investments. Incentive to horde at the Fed is probably the worst of all possible choices?

  8. Not sure why my old website address was shown instead of my name at the top of the recent comment (signed in via WordPress).

    Anyway, for a first time comment it feels off. Trying via Google this time but in case it goes wrong again it should have said Ingolf Eide.

    1. I went to your old website address linked on top of your comment and found much of interest but nothing new since about 2016. Please tell us how to find your new writings. By the way when you comment here under "select profile" choose "name/URL" and it will use your name rather than your world press website.


    I mention David Beckworth in above link...

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