The Krugman Multiplier is too big

Posted on December 31, 2011 by Henrik Jensen

Paul Krugman is a very active blogger. Almost every time he writes a post on his New York Times blog, there are several comments made around the economic blogosphere. And sometimes Krugman will respond to a few of the comments made, and then it sets off further comments, and so on. It is a Krugman Blog Multiplier. I posit that it needs no formal empirical evidence to establish that it is way above 1. Way above. In this New Year’s post I’ll show a recent example, and argue why this multiplier is too high, and why one should not always “exploit” large multipliers.

Probably one of the issues on which Krugman has been blogging most intensively, is the need for fiscal expansion in the US during the current recession. As his blog is targeted a wider, and non-economically trained, audience, repetition becomes unavoidable (and a presidential election is lurking around the corner). But along with repetition and the urge to politicize, comes a tendency to attack and target those who argue against fiscal spending. Here is the latest example:

In a December 26 post on how “freshwater” economists presumably don’t understand “their own doctrines” (yes, Krugman does continue to group economists into tightly defined categories; a sure sign of politicization), it is his fellow Nobel Prize recipient Robert E. Lucas who is the target. In a luncheon speech at a Council on Foreign Relations Symposium back in March 2009 (!), Lucas said in relation to fiscal stimulus:

“If the government builds a bridge, and then the Fed prints up some money to pay the bridge builders, that’s just a monetary policy. We don’t need the bridge to do that. We can print up the same amount of money and buy anything with it. So, the only part of the stimulus package that’s stimulating is the monetary part.

…

But, if we do build the bridge by taking tax money away from somebody else, and using that to pay the bridge builder — the guys who work on the bridge — then it’s just a wash. It has no first-starter effect. There’s no reason to expect any stimulation. And, in some sense, there’s nothing to apply a multiplier to. (Laughs.) You apply a multiplier to the bridge builders, then you’ve got to apply the same multiplier with a minus sign to the people you taxed to build the bridge. And then taxing them later isn’t going to help, we know that.”

You can even see and hear it for yourself (Lucas starts at around 7:30):

To Krugman, this proves that Lucas does not understand the Ricardian Equivalence theorem, but nevertheless uses the theorem to discard the effectiveness of fiscal stimulus.

This set off a number of blogging responses around the world. Among them, David Andolfatto asks whether Krugman actually understands Ricardian Equivalence? (And he has links to several other bloggers’ responses.) Then Krugman re-posts accusing Andolfatto for not being able to “read straight.” And the blogging continues. The multiplier is huge.

Let me first comment on contents, then on the Blog Multiplier. Everything starts from the Lucas quote. A few statements from a rather informal speech as far as I can see. As I read the first part, Lucas doesn’t think government spending has an effect. He thinks the government spending multiplier is zero, and if there was to be an effect, it comes from the associated monetary policy. The argument is muddy at best. The second part has a gist, but just a gist, of Ricardian Equivalence to it. Now government spending is financed by taxes. And he still thinks that the impact effect of spending is zero. I.e., he believes that the famous balanced-budget multiplier is zero (and not 1). Obviously, in an intertemporal perspective future taxation would not make a difference. Clearly that has a Ricardian Equivalence flavor (timing of taxation is irrelevant), but this is not Lucas’ argument against the zero multiplier. That argument is just not stated. He does not explain why the balanced budget multiplier is zero. So, I think Krugman is barking up the wrong tree.

To make it perfectly clear, I think both Lucas and Krugman knows very well what the Ricardian Equivalence Theorem says and does not say. Andolfatto gives a nice exposition of the Theorem in his post (I tried the same earlier this year when a similar round of posting was in effect): It does not say anything about spending effectiveness. Every trained economist knows that and we don’t have to resort to interviews with Robert Barro to get it sorted out. He wrote a paper about in Journal of Political Economy back in 1974. Go dig it up!

So is there anything wrong with this? Is it really bad that prominent economists spend time on the internet accusing each other for ignorance? I think so. For a number of reasons. What originally starts as a political statement (with personal ingredients as I suspect Krugman is essentially mad at Lucas for bashing Christina Romer’s fiscal multiplier computations), suddenly appears to be revealing a profound scientific disagreement about basic concepts within economics. But this is not the case! It just blurs a valid argument about empirics: How large is the fiscal multiplier? It blurs serious discussions about the right thing to do: Should we have expansive fiscal policy? These are the two central issues. The issues people should be writing about. Bashing each other for not having understood a Theorem is just highly counterproductive.

And I believe it is particularly counterproductive when it is Paul Krugman who ignites these discussions. He is a Nobel Laureate, and that gives his words a huge impact. In a recent post he mentioned that he did not like it when economists are”pulling rank“, and I have never seen him doing that. But other people “pull his rank” and use his, often politicized, writings in academic discussions. I am probably not the only one that has to explain students that Krugman blog posts are not valid references for anything. And they stunningly exclaim: “But he has a Nobel?”. Moreover, Wikipedia also gets filled with nonsense lifted off famous economists’ internet musings. This picture is a screenshot of the Wikipedia article on “Ricardian equivalence” (a picture it should be, the article could say something different tomorrow):

This is why Wikipedia never becomes a bona fide academic reference (all the Footnotes are to various blog posts). How relevant is that information to the subject at hand? It is truly a “wash”! So when one has such a big Blog Multiplier, one should consider whether one should exploit it so often. One’s debt level could become unsustainable.

So, my hope for the New Year is that bloggers everywhere will put more weight on quality and less weight on quantity. Also I hope that those with high ranks take their ranks seriously, and think one more time before starting a wave of blog posts. The example shown here demonstrates how one economist reads something into another economist’s informal talking, and then sets off series of inefficient uses of resources (thiswhich must then include this post, but it is written in my spare time). Talk serious economics instead, since that is your trade. Be formal (which doesn’t necessitates math). To express it differently, here is one of my all-time favorite quotes; incidentally by Paul Krugman:

“. . . just talking plausibly about economics is not the same as having a real understanding; for that you need crisp, tightly argued models.” (Pop Internationalism, Ch. 7, The MIT Press, 1996)

This is a simple, and yet deep, credo, which I think one should adhere to. Quite admirably, Krugman repeats it, in other words, in a blog post of today (which I now multiply). And on this, for me, happy note, I wish you all, wherever you are, a very Happy New Year!

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Structural Divergence in Europe: Death Foretold

Posted on December 28, 2011 by Henrik Jensen

One of my mantras is that doing economics is not about “being right,” but about getting wiser all the times. Note that the two things may not overlap. I, for example, would rather be wrong all of the time but know why I am being wrong instead of being right without having a clue as to why. So, I think it is a good mantra, and I will stick with it. Now, after the beginning of the current financial crisis and recession, more or less prominent economists lined up to tell the world that they were “right” as they had seen the crisis coming. Some actually had something to back up their claims with, whereas most had cried wolf for years and were just bound to get lucky.

Here, during the Holidays, I take the liberty of deviating from the mantra and submit myself to those who claim to “be right” about something. The “something” is the current debt crisis in Europe. A paper I wrote (with Roel Beetsma, University of Amsterdam) a long time ago, actually predicts that when heterogeneous countries form a monetary union they will diverge in terms of structural performance from each other. Interpreting structural performance in a fiscal dimension, it predicted that debt and deficits would diverge after unification. This would be in contrast to a form of unification that can easily be undone (“reversible” unification), say, a fixed exchange rate regime like the EMS. Under such a regime there would be no structural divergence. But in a regime that is hard to undo—in the paper literally impossible (“irreversible” unification)—divergence will be the result, as is currently the sad case in reality.

I humbly note that this captures important facts of European monetary history of the last 30 years. The paper is Roel M.W.J. Beetsma and Henrik Jensen (2003): Structural convergence under reversible and irreversible monetary unification, Journal of International Money and Finance 22, 417–439. The first draft was circulated in August 1998, and I presented it during 1999 (just at the time of the formation of the Euro; without the Euro currency). The polite commentators said it was a nice technical exercise with little relation to the real world. The more critical commentators said it was a silly exercise with no relation to the real world. One of the features that was considered unrealistic, I think, was that we used a Barro and Gordon (1983, Journal of Political Economy) credibility model as a foundation for our framework. That sort of model was out of fashion at the times (as most apparently thought that all policymakers acted as under commitment, or that credibility problems were an issue of the past).

Well, the basic mechanisms of the model are simple. a) Structural problems (unemployment, too high debt, etc.) leads to credibility problems in monetary policy; b) Credibility problems leads to inflation; c) Such inflation is costly and gives incentives to perform structural policy measures (reduce debt, etc.).  If a country have bad structural performance and high inflation, it will gain from joining a monetary union with a low-inflation country in terms of inflation going down. However, this reduces the incentives for structural reform! (This point I made specifically in terms of debt in the 1994 paper Loss of Monetary Discretion in a Simple Dynamic Policy Game, Journal of Economic Dynamics and Control 18, 763-779.) The implications of these simple mechanisms are, as described in the paper:

“We show first that structural distortions in the high-inflation country will be  worse—all things equal—under monetary unification than with independent monetary policymaking. This is because the lower inflation rate under a union reduces the incentive of the government of the distorted economy to conduct structural adjustment. Then, we turn to the interplay between endogenous structural reform and the timing of monetary unification. Under reversibility, the high-inflation country will at some point in time undergo a one-time adjustment so as to meet the requirement for entering the union. This entry requirement, endogenously determined by the existing union members, is formulated in terms of the level of structural distortions of the high-inflation country. After entry, structural distortions remain unchanged for a while, as further adjustment is too costly, while structural divergence triggers exclusion from the union.

Under irreversible unification, entry into the union will also take place after a onetime adjustment. However, in contrast to reversible unification, the adjustment is followed by structural divergence because the threat of being expelled at a later date is absent under irreversibility. The government of the new union member can therefore reap the gains of lower inflation without having to suffer the losses associated with structural adjustment. Because the initial union members suffer from such divergence, they are likely to impose a stricter entrance criterion under irreversible than under reversible unification. This tends to postpone irreversible unification relative to reversible unification.” (pp. 418-419)

We further emphasized the public debt aspect by:

“Of course, the actual EMU entry requirements are formulated in terms of observable variables such as inflation and budgetary performance, rather than the underlying structural distortions. However, given the problems of observability and quantification, in practice, it would be difficult to formally apply the latter as a criterion. Nevertheless, because structural distortions are harmful for output, one would expect them to lead to higher inflation and a worse budgetary performance, for example.” (p. 420)

These explanations are then modeled in a dynamic game, and the subgame-perfect Nash equilibrium under both “reversible” and “irreversible” unification are illustrated in the paper’s Figure 2:

Structural divergence under monetary union

Here, the y-axis is the measure of structural distortions in the country with relatively bad structural performance. If it was always outside a monetary union, its structural distortions would follow the lowest downward-sloping line labelled yI (with two arrows pointing to the line). If it was always inside a monetary union, its structural distortions follow the highest downward-sloping line labelled yU (with two arrows pointing to the line). This shows the result that being in a union lowers the incentive for structural reform policies; yU>yI always. Note also that the model has optimistic long-run predictions in the sense that structural distortions vanish at t=T. This was just for computational ease and follows from an assumption about exogenous reductions in distortions over time. The interesting is the endogenous developments in structural distortions, and they should be unchanged by this assumption.

The figure highlights the endogeneity of structural reform when formation of a union, and the timing of the formation, is endogenous. Under reversible unification, there will be an entry requirement y*, and the country meet that at some date Tru. From then on, see the dotted line, there will be no change in structures for a while: Further reform is too costly (remember that the country would, if it was certain to stay in the union, like to slack up to yU), and less reforms, y>y*, leads to exclusion from the union, which is costly in terms of inflation. Under an irreversible unification, as we imagined an EMU to be, at least relative to a fixed exchange rate regime, things are dramatically different: The entry requirement is stricter, y*Tiu<y*, and as a result, formation happens later (Tiu>Tru). But when the union is formed, the country with structural problems “relaxes,” and let structural problems be structural problems. See the bold line. There will be structural divergence. The country “free-rides” on the lower inflation imported from the being in the union, and its incentives to take the costs of structural policies, say, fiscal consolidation, are weakened.

So what would one have said in 1998 when reading this paper? Something along the lines of “The formation of the EMU will pave the way for structural divergence among member countries. In fiscal terms this means that those countries who have undergone fiscal adjustments to meet (or almost meet) the entry requirements, will stop or maybe even reverse the fiscal process when inside the union.”

To most at that time, it was considered a way too far-reaching theoretical exercise. In light of recent events, I should perhaps follow many of those who claimed to have predicted the financial crises and refer to myself as “among those of us who predicted the European debt crisis”? Nah, I better stick with my mantra. But I still believe that Roel and I made a few valid points there in the late 1990s.

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Sargent and Sims (2011): LIVE!

Posted on December 13, 2011 by Henrik Jensen

This year’s Nobel Prize Lectures in Economic Sciences:

“United States Then, Europe Now” (at the nobelprize.org site)
Thomas J. Sargent, New York University

“Statistical Modeling of Monetary Policy and its Effects” (at the nobelprize.org site)
Christopher A. Sims, Princeton University

YouTube version of live TV broadcast of everything. Lectures start 10 minutes into the broadcast (with an introduction by Per Krusell):

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Draghi cuts and markets flip

Posted on December 12, 2011 by Henrik Jensen

Last week marked the second time where new President of the European Central Bank, Mario Draghi, governed an interest-rate decision for the Euro area. And for the second time it was and interest rate cut, implying an interest rate on main refinancing operations of 1.00% effective from 14 December. This ties the lowest level in Euro history, which was effective from 13 May 2009 to 13 April 2011. So, loosely speaking the interest rate is back at the financial crisis level. The decision makes sense given the economic outlook for the Euro area: A continuation of high unemployment and absence of inflationary pressures. It was, however, not a unanimous decision.

At the ensuing press conference, Draghi expanded on the economic outlook and emphasized that some of the prolonged economic contraction was due to the crisis in sovereign debt markets. Also, severe downside risks pertaining to confidence issues in the financial sector were singled out as an important factor. As a direct measure towards the latter problem, the ECB announced a number of temporary initiatives to enhance liquidity in the Euro area (among them a loosening of collateral requirements and reserve ratios for loans with the ECB). As for the sovereign debt problem, Draghi emphasized that all euro-area government “urgently need to do their utmost to support fiscal sustainability” and that a new “fiscal compact” consisting of fiscal rules and fiscal commitments are a precondition. Also, he stressed the need for structural reforms.

Following the press statement, Draghi (and Vice-president Vitor Constâncio) took questions from the press. Not surprisingly, given the sovereign debt crisis, most attention was directed to the fiscal issues. Discussing the “fiscal compact”, Draghi essentially touched upon the issues being negotiated by EU governments these days, namely how to rethink the Stability and Growth Pact. He was to me quite blunt (and correct) when stating, although indirectly, that lack of credibility of rules have been of essence in the current situation, and that a more automatic system of fiscal constraints would be needed for credibility. And only when such credibility is in place, will any kind of fiscal stabilization mechanisms be of relevance. This is quite consistent with what I wrote more than 10 years ago with Roel Beetsma in the paper (published in Journal of International Economics in 2003): “Contingent deficit sanctions and moral hazard with a stability pact“.

After dodging some questions on the economic situation of particular countries, Draghi was asked about the Securities Markets Programme (under which the ECB now holds more than € 200 bn. worth of government bonds). Will it be expanded, continued or what? He then, much to my liking, reminded the press about the Treaty on European Union:

“. . . we have a Treaty and the Treaty states what our primary mandate is, namely to maintain price stability. Also, the Treaty prohibits monetary financing. I am old enough to remember that, when this Treaty was written in the early 1990s, some of the countries around that table were actually doing what you suggest doing now, namely some of the central banks of these countries were financing the government expenditure of their governments through money creation, and the consequences were there for all of us to see. That is why, in a sense, this Treaty embodies the best tradition of the Deutsche Bundesbank, whereby monetary financing has always been prohibited.”

Right on! I have, however, always been wondering how a central bank can purchase government bonds and still be acting within the spirit of the treaty (the legal issue is that when the bonds are purchased on the secondary markets and not directly from the government, then the treaty is not violated by the letter). But the ECB has invented some story about the SMP being necessary for the functioning of the monetary transmission mechanism and thereby for the attainment of price stability. I have never really bought that story, and I think that Draghi (probably unintentionally) was close to stating that he doesn’t buy it himself. Asked specifically about the SMP, and whether similar initiatives could be considered state financing and thus against ECB law, Draghi replied:

“. . . one can construct many different cases. But, as I said before, the key thing is that we should not try to circumvent the spirit of the Treaty. No matter what the legal trick is, I think what matters for the people and what matters for the confidence and credibility of the institution is the spirit of this provision of the Treaty.”

That is probably the closest thing to a confession one can get: “No matter what the legal trick is”. At least I choose to be optimistic in the sense that the ECB has a President that is honest, and also tries to emphasize that fiscal support should not be the doings of the ECB.

The financial markets read it the same way, but took it very badly. The news that the ECB may start to live up to what is actually written in treaties, was met by price drops on several already low-priced bonds. The interest rate on Italian government bonds thus rose around 30 basis points, and the Euro dropped 2 percent vis-à-vis the dollar. Markets are really unpredictable. Would they have become happy if Draghi had promised to intensify purchases of government bonds thereby probably putting an end to serious structural reform efforts?

It is rather amazing how left-wing the markets appear to be on these matters!

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At the Fed: What did come next?

Posted on November 4, 2011 by Henrik Jensen

September 22 the Federal Reserve initiated “Operation Twist” where they announced that they would start restructuring its debt by buying up long bonds with the proceedings from short bond sales, with the aim of lowering the long-term yields.

As I mentioned in my post on that occasion, the Fed and Ben Bernanke had then exhausted the three main ways of conducting unconventional monetary policy as defined by Bernanke himself in a paper from 2004: I. Shaping Interest-Rate Expectations; II. Altering the Composition of the Central Bank’s Balance Sheet;  III. Expanding the Size of the Central Bank’s Balance Sheet. In case nothing new would happen to the American economy, the obvious question I asked was “what will come next”?

The “answer” came two days ago where the Fed announced an unchanged policy stance. That is, the Fed funds rate is kept around zero for at least until mid 2013 (unless new information arrives) and Operation Twist continues. Many commentators took this as the same as doing nothing. Paul Krugman saw indications of a Bernanke not realizing that “radical action” was needed. Others were disappointed that Bernanke would not contemplate a change in policy mandates (from the current dual mandate of price stability and maximum employment to, say, nominal GDP/GDP growth targeting).

First of all, I think it is unfair to compare a decision of an unchanged policy stance to that of doing nothing. They could have done a lot of “something” that would be quite bad. I don’t think, for example, that one should engage in discussions about policy changing policy mandates in the midst of a crisis situation. This could undermine longer-term credibility. Wait until calmer times. (I have, e.g., written positively about nominal income growth targeting elsewhere, but these are not the times.). Secondly, the question is whether the Fed hasn’t gone as far as it can? It could, of course, do a third round of quantitative easing, but as it is entirely unclear whether the second round did any good, it appears a bit desperate.

And have we really come to a point where policymaking bodies should make a change just for the sake of it? I think one must realize that monetary policy is now doing what it can to help the US recovery. So, maybe it is time to look at the structures on the labor market, if we want to understand why unemployment keeps up at 8-9 % in a country that for many Europeans was seen as an ideal in terms of labor-market flexibility. As Krugman states in the same post mentioned above:

“we don’t want “stabilization” right now – we want an escape from a slump that is crushing our future.”

He is completely right. However, while monetary policy can do stabilization, it is usually not the remedy against what seems to have become a structural issue.

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Draghi says Hello and cuts the ECB interest rate

Posted on November 3, 2011 by Henrik Jensen

Today, new ECB president Mario Draghi led the Governing Council of the ECB in its meeting on monetary policy decisions. It turned out to be an interest cut, as the interest rate on main refinancing operations was decreased from 1.5% to 1.25%.

The move was mainly motivated on falling inflation expectations and an expectation of dampened economic activity (with emphasis on downside risks). As such this is a move that is consistent with inflation targeting, and it appears that the ECB under Drahgi will continue the practice to let interest-rate decisions be guided by short-run developments in real economic activity, while securing that inflation expectations are held in check. Hence, immediate elevated inflation is downplayed in policymaking (HICP inflation is projected to hit 3% in October).

Let us hope that ECB under its new President can maintain the low inflation credibility it appears to enjoy despite its continued peculiar behavior in other dimensions of policy (say, fiscal policy).

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Trichet says Goodbye and SMP peaks at 173 bn. €

Posted on October 31, 2011 by Henrik Jensen

Today marks the last day of Jean-Claude Trichet’s tenure as president of the European Central Bank. Bild am Sonntag interviews him on the occasion.

In terms of being the main person responsible for the ECB’s mandate of price stability, he has been a success. The inflation measure used by the ECB has moved quite closely around the value which after some introductory opaqueness is stated as close to, but not above, 2%. Surely, during the peaks of the financial crises there were upward and downward swings, but on average you would not call Trichet a man that leaves a bank with little anti-inflation credibility.

What he does leave is a central bank that holds a lot of government bonds of unknown origin. One can, however, guess that they come from countries in the Southern parts of Europe. Effectively, through the Securities and Markets Programme, the ECB has bought up bonds from governments in fiscal distress to dampen yields. As mentioned several times on this blog, this was in my view never the intention of the Treaty on Monetary Union, where the union central bank should be independent of government pressure of any kind.

But Trichet emphasizes that there was never any pressure, and that

It was for monetary policy reasons that the Governing Council, in full independence, adopted all the non-standard measures.

I am not sure whether a bad move gets much better when you admit that you did it completely on your own, and uses arguments about “monetary policy reasons” that many still don’t quite understand.

Fact is that the ECB, after the renewed activity in the SMP in August, now holds government bonds worth 173 billion Euros (slightly above 2% of total EMU GDP). It reflects a steady increase from the 96 billion in mid-August. This fact may be seen as an indication of a defeat of the Bundesbank-style hardliner approach to monetary policymaking. Indeed, former member of the ECB executive board Otmar Issing voiced strong critique of the SMP recently. Oh, and Axel Weber and Jürgen Stark both left the ECB after the SMP began . . . .

Well, let me give Trichet the final word for today. When asked about whether he thinks that money rules the world, he sympathetically answers:

“Money is a means, not an end; an instrument, not the ultimate goal; un moyen, pas une fin.”

————————————–

Edit: November 3

Michael asks into the inflation performance of the ECB in more detail. If we look at inflation measured by the ECB’s own goal variable, percentage changes in the HICP relative to same month the year before, the data is:

While this covers the whole lifetime of the Euro, it shows in a sense what is the status at the departure of Trichet. Quite intriguingly (and admittedly rather coincidental), the average of the inflation rate shown in the figure is 2.008. That is quite close to the stated goal of not having inflation above 2 %!

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Don’t Fence Me In: Sargent rejects slogans

Posted on October 31, 2011 by Henrik Jensen

This is just a heads up for a recent interview with the new Nobel Laureate Thomas Sargent. In the New York Times article, “The Slogans Stop Here“, he explains the futility of trying to label economists as belonging to various theoretical or political “camps”. It is a great read, and I can’t help emphasizing the following:

“If you go to seminars with guys who are actually doing the work and are trying to figure things out, it’s not ideological,” he said. “Half the people in the room may be Democrats and half may be Republicans. It just doesn’t matter.”

These are simple, but great words. In my part of the world they are currently quite important, as the government-supporting left-wing party wants to amend the foundation for the Danish Council of Economic Advisors such that its economic experts are recruited according to their political views (allegedly to secure balanced policy recommendations). Such deliberations miss the point about economic sciences altogether. I dare believe Sargent would agree as the article says:

He doesn’t wear his political opinions on his sleeve. “They really don’t matter in my research,” he said.

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