Wednesday, November 11, 2009

Paul Krugman & Scott Sumner Should Favor Ron Paul Bill

There has recently been a spat between Paul Krugman and Scott Sumner over the effectiveness of monetary policy under current conditions (Krugman never mentions Sumner's name, but it is likely that he in his posts on the subject is referring to him). Both agree on the need for more inflation, but they disagree on how to achieve it. While arguing that Fed policy should be as inflationary as possible, Krugman believes that because of the zero bound for interest rates ("the liquidity trap" in Keynesian) there's really not much more the Fed could do to inflate more, meaning that fiscal measures are needed.

Sumner disagrees. He seems to think that the Fed can and should target inflation, or more accurately nominal GDP (NGDP) growth. I really don't think that is possible, at least not with any precision since first of all monetary actions are forward looking and since we can't know for sure what NGDP growth will be in the absence of action, meaning that monetary policy actions can just as well push NGDP growth further from the target as pushing it closer. And secondly it is not possible to know with any precision exactly how great effect monetary policy actions will have on NGDP growth. A reduction in interest rates or asset purchases could have great effect during optimistic periods, but little effect during pessimistic periods.

Also, I don't think one of Sumner's proposed actions for creating inflation and therefore by extension higher NGDP growth, namely raising inflationary expectations, will really be that effective. Almost all market participants already know that the Fed wants inflation to return (specifically to about 2%), and are doing what they believe will be effective to create it. Announcing that target formally won't make any difference.

However, Sumner is right that the Fed could do more to achieve inflation, most notably stop paying interest on bank reserves and instead charge negative interest rates on reserves to make banks more eager to lend.

And, if we are to believe Professors Anil Kashyap and Frederic Mishkin (the latter of whom is a former Fed governor), Krugman and Sumner should also favor the "audit the Fed" bill initiated by Ron Paul. The reason for that is that according to Kashyap and Mishkin, that bill would raise inflationary expectations after it is revealed to the world whom the Fed deals with and in what way. I don't believe in it, but presumably Krugman & Sumner has a higher faith in the assertions of their fellow professors than I do.