Here’s Paul Krugman:
I would submit, by the way, that the quasi-monetarists — QMs? — have actually backed up quite a bit on their claims. They used to say that the Fed can easily and simply achieve whatever nominal GDP it wants. Now they’re more or less conceding that the Fed has relatively little direct traction on the economy, but can nonetheless achieve great things by changing expectations. That’s pretty close to my original view on Japan. But changing expectations in the way needed is hard, especially when the Fed (a) faces massive sniping from the right and (b) has a number of hard-money obsessives among its own officials.
Of course we’ve always focused on expectations; that’s why we’re called market monetarists. When I wrote an open letter to Paul Krugman in 2009, I discussed the need for QE, lower IOR, and a NGDP target, level targeting. That’s still my view. If Krugman thinks we’ve moved in his direction, it’s because he never really understood our views until now. Come to think of it, there’s a lot of evidence that he didn’t understand what we were saying.
In fairness, market monetarists have been supportive of QE2, as that seemed much more politically feasible than NGDP targeting, level targeting. Indeed even more feasible than price level targeting. So it may have appeared we thought that was the optimal policy, at least at first glance. But Krugman also supported QE2.
My areas of disagreement with Krugman have always been over fairly subtle questions. He sees Japan as an example of an expectations “trap,” I see the problem as simply a central bank that has the wrong policy objective–an excessively low inflation target. Not a central bank “trapped” by forces beyond its control. He sees expected inflation as being needed; I see higher expected NGDP growth as being needed (but not necessarily anything close to 4% inflation.) He sees monetary stimulus working through the real interest rate transmission mechanism, I see the interest rate as a sort of epiphenomenon, and instead see the mechanism as excess cash balances driving NGDP higher in the long run (hot potato effect), and expectations of future increases in NGDP driving current asset prices and current AD in the short run. Other market monetarists obviously have diverse views on this question.
Our areas of agreement have always been much more important:
1. We both see a need for much more demand stimulus.
2. We both see temporary currency injections as useless and monetary aggregates as unreliable policy indicators.
3. We both believe that the key is to raise expectations of future monetary stimulus.
4. We both agree (I think) that if QE2 worked at all, it probably worked partly by sending a signal regarding the Fed’s future policy intentions.
5. We both like Gauti Eggertsson’s work on the Depression (AER 2008.) If Krugman thinks I’m a Johnny-come-lately to his expectations hypothesis, he might take a look at the 3 papers I wrote that Gauti cited in 2008, which argued (among other things) that the Fed’s 1932 open market purchases failed (contrary to the claims of Friedman and Schwartz), and that the reason they failed is that the purchases were viewed as temporary because of the constraints of the gold standard.
One final point. There is a difference between Krugman and the market monetarists in terms of how we approach the thought experiment of an increase in the money supply at the zero bound. He assumes the increase is expected to be temporary, and we often assume it’s permanent. Thus the debate is often people talking right past each other, as even Krugman agrees that a permanent monetary injection would be expansionary. In favor of our assumption, standard quantity theory models generally assume a permanent, one time money supply increase, when thinking about the effect on the price level. To see why, consider how Irving Fisher or Milton Friedman would have reacted if told the Fed planned to double the money supply, and then remove the new money 12 months later. Would Fisher and Friedman have predicted that the price of homes would double, but then fall back to the original level 12 months later? Obviously not. On the other hand neither Fisher nor Friedman seems to have fully understood the importance of the distinction between temporary and permanent monetary injections. So Krugman’s 1998 paper did a great service by showing just how important this distinction really was.
But here’s something I never see Krugman discuss. Expectations aren’t just important at the zero bound, they are always important. If interest rates are 5%, and the Fed suddenly announces that they will immediately double the money supply, but then remove the new money a year later, there is little impact on prices. So the expectations approach doesn’t merely challenge the naive QTM models at the zero bound, it does so at positive interest rates as well. Expectations always matter a lot. So why does the problem seem more severe at the zero bound? Nick Rowe has pointed out that the Fed becomes mute at the zero bound. As long as rates are positive, they can send signals about their future monetary policy intentions by adjusting short term rates. Once rates hit zero, they don’t know how to communicate their policy intentions to the public, and the price level becomes unmoored, drifting around aimlessly. At least until they find other tools (like QE) to communicate their future policy intentions.