Tag Archives: paul krugman

Casual Monetarism

In an Op-Ed for The New York Times, Japan’s Economy, Crippled by Caution, Paul Krugman is seen using a highly Monetarist language:

As I said, you might think that ending deflation is easy. Can’t you just print money? But the question is what do you do with the newly printed money (or, more usually, the bank reserves you’ve just conjured into existence, but let’s call that money-printing for convenience). And that’s where respectability becomes such a problem.

When central banks like the Federal Reserve or the Bank of Japan print money, they generally use it to buy government debt. In normal times this starts a chain reaction in the financial system: The sellers of that government debt don’t want to sit on idle cash, so they lend it out, stimulating spending and boosting the real economy. And as the economy heats up, wages and prices should eventually start to rise, solving the problem of deflation.

… When you print money, don’t use it to buy assets; use it to buy stuff. That is, run budget deficits paid for with the printing press.

Now, there are several things wrong about this. The most important one is the implicit assumption in the “model” that fiscal expansion via increased government expenditure is about neutral and that domestic demand is boosted only because of the way in which the government debt is financed – i.e., central bank purchases of government debt. In other words, Krugman is saying that if there is deflation and if there is an expansion of fiscal policy via a rise in say government expenditures, it will have little effect when the central bank doesn’t purchase government debt. Put it in another way, it is saying that the government expenditure multiplier effect acts mainly because of central bank purchase of government debt and not because of the increase in government expenditure per se.

This is silly intuition and the cause of this is the notion that fiscal policy is more or less neutral except in special circumstances.

In reality, it is the other way round. If the government expenditure rises, and if the central bank purchases government debt, the rise in output is mainly attributable to the former. This can of course be seen in a stock-flow consistent model but can also be seen by simple accounting and flow of funds. A rise in government expenditure on goods and services raises output directly and also via the multiplier effect. The central bank has a huge control over interest rates and the additional debt is simply absorbed by the bond markets easily. There’s no competition with other borrowers as the wealth of the private sector rises. In addition, if the central bank purchases government debt, it is hardly clear if households know if inflation is going to rise and increase their consumption because of “inflation expectations”. Even if they think that if inflation is set to rise, they might reduce consumption as inflation might reduce their real wealth.

Which is not to say that asset purchase programs of the central bank or “quantitative easing” has no effect on demand and output. It works via capital gains in wealth leading to higher consumption and the feedback effects of this. It also works if economic units shift their portfolios to buying non-financial assets. The effect of all this is unclear. In addition, as mentioned earlier, casual Monetarism like the language used by Paul Krugman mixes up correct attributions of government expenditure and central bank government debt purchases on output, misleading everyone.

Simply say “raise government expenditures”. Why all this casual Monetarism with “printing presses”?

Economists Can Be So Wrong

Oh boy! Krugman could not have been more wrong about Macroeconomics than what he said recently in his blog The Conscience Of A Liberal for The New York Times. In a blog post, Competitiveness And Class Warfare, he concludes:

International competition is a mostly bogus notion; …

In a sense it is not surprising. Paul Krugman has done enough to push free trade. With that position, one is forced to take a position that competitiveness doesn’t matter (or that free trade will lead to a convergence between successful and unsuccessful nations).

The notion that balance of payments does not matter is as old as Monetarism. If it is understood that competitiveness does matter and that for a nation it hurts domestic producers and hence one needs some sort of protectionist measures goes against the notion of free trade. For neoclassical economists other than Paul Krugman, competitiveness does matter but in a different sense. They would argue that it there is divergence in performance of nations because of “loose fiscal policy” or “fiscal profligacy” and so on and that once the government balances its budget and behaves the way as per a standard textbook model, there’ll be convergence in performance because market mechanisms will do the trick. But Krugman is different. During the crisis, he has understood that fiscal policy is important and that it is not impotent as claimed by his colleagues.

There are of course other factors at play in the examples Krugman provides. Japanese producers are highly competitive but at the same time, the government of Japan didn’t expand domestic demand by fiscal expansion and so the performance of the economy of Japan has suffered. But that doesn’t mean that the competitiveness of Japanese producers doesn’t matter. Had they been less competitive, Japanese exports would have been lower than otherwise and Japan would have imported more because foreign producers would beat them at their home. Moreover, a weaker current account balance of payments would have led to a bigger government deficit and the Japanese government would have (incorrectly) tightened fiscal policy in response, with the result that both balance of payments and fiscal policy would have reduced domestic demand and hence output.

So while there are other factors affecting economic performance, none of it ever means that competitiveness doesn’t matter.

Cambridge economists were clear on this. Here’s Wynne Godley in a 1993 article Time, Increasing Returns And Institutions In Macroeconomics, in S. Biasco, A. Roncaglia and M. Salvati (eds.), Market and Institutions in Economic Development: Essays in Honour of Paolo Sylos Labini, (New York: St. Martins Press), page 79:

… In the long period it will be the success or failure of  corporations, with or without active help from governments, to compete in world markets which will govern the rise and fall of nations.

In trying to defend the importance of fiscal policy, some economists such as Paul Krugman become forceful in their views about the way the world works and underplay the importance of matters such as international competitiveness. They seem to falsely believe that this strategy would work for them because accepting the importance of competitiveness would give enough chance for their opponents to argue against worldwide fiscal expansion.  It is a sad and counterproductive strategy.

Krugman And Causality

In a recent post titled Money, Inflation And Models for his NYT blog, Paul Krugman clearly states that “normal equilibrium macro models” say that the direction of causality is from money to prices. Krugman says:

Consider the relationship between the monetary base — bank reserves plus currency in circulation — and the price level. Normal equilibrium macro models say that there should be a proportional relationship — increase the monetary base by 400 percent, and the price level should also rise by 400 percent. And the historical record seems to confirm this idea.

His post is about how this fails when the economy is in a “liquidity trap”. The post hence is the clearest proof of Paul Krugman’s struggle in getting the causality right. Keynes quote from the GT is appropriate here:

The difficulty lies, not in the new ideas, but in escaping from the old ones, which ramify, for those brought up as most of us have been, into every corner of our minds.

Krugman presents a chart which shows the relationship between money and prices but it does not occur to him that the causality is reverse to what he is assuming, whether or not there is a liquidity trap. The simple causal story that a rise in the level of expenditure leads to a rise in the stock of money seems alien to Krugman.

It is of course also true that a rise in the stock of money such as via an asset purchase program by the central bank (“QE”) may have an effect on prices. This happens via a wealth effect: demand has an effect on prices of goods and services. This effect is likely small. The main mechanism — the reverse causality — seems to never occur in Krugman’s mental model of the way the world works.

Krugman has of course written about the “dark age of Macroeconomics”, but has shifted his position since then. Although it is not clear what exactly Krugman’s model is, one can still make an inference: normal equilibrium models work outside of liquidity traps, but in liquidity traps a lot changes. This model is chosen by Krugman so that he can confidently claim that there is hardly anything wrong in Macroeconomics.

Interest Rate, Growth And Debt Sustainability

Frequently, discussions about debt sustainability have discussions about the importance of the interest rate and growth in debt sustainability analysis. See for example, today’s Paul Krugman’s post on his blog. It is concluded that as long as the rate of interest is below the rate of growth, the ratio public debt/gdp doesn’t explode. Unfortunately, this result is erroneous.

John Maynard Keynes’ biggest disservice to the profession is to not start with the open economy. In my view, debt sustainability is tightly connected to balance of payments.

Imagine a nation whose exports is constant. If output rises, it will have adverse effects on the current account balance of payments because of income induced increase in imports. This will have an adverse effect on the international investment position of the nation: the net international investment position will keep deteriorating unless output is slowed down or some measure is taken to improve exports. In the case of rising exports, there is a similar constraint, except it is weaker but dependent on the rate of growth of exports.

If the ratio net international investment position/gdp keeps deteriorating, either the public debt to non-residents or private indebtedness to non-residents or both have to keep rising, all unsustainable.

There are some complications. A nation’s balance of payments also depends on how assets held abroad and liabilities to foreigners affect the primary income account of balance of payments. Also, the exchange rate can depreciate (or be devalued in fixed-exchange rate regimes) improving exports and reducing imports. However assuming that exchange rate movements do the trick is believing in the invisible hand. Foreign trade doesn’t just depend on price competitiveness but also on non-price competitiveness. These complications are highly interesting but do not affect the fundamental fact that a nation’s success is dependent on the success of corporations to compete in international markets for goods in services.

Even the conclusion that the government should contract fiscal policy and aim for a primary surplus in its budget balance or else the ratio public debt/gdp keeps rising if the rate of interest is greater than the rate of growth is erroneous. Consider a closed economy. An expansion in fiscal policy will automatically raise output and gdp and hence tax collections to prevent the ratio public debt/gdp from exploding. The public sector balance may hit primary surpluses but not due to contraction of fiscal policy or targeting a primary surplus in its budget balance.

In short, although the rate of interest and the rate of growth are important in debt sustainability analysis, it is not as easy as is usually presenting in macroeconomics textbooks and in the blogosphere. For a more detailed analysis see the reference below.


  1. Godley, W. and B. Rowthorn (1994) ‘Appendix: The Dynamics of Public Sector Deficits and Debt.’ In J. Michie and J. Grieve Smith (eds.), Unemployment in Europe (London: Academic Press), pp. 199–206

Updated 8 Apr 2015, 6:52 am UTC.

Thomas Palley — New Keynesianism As A Club

Thomas Palley has a new blog post detailing how much recent new Keynesian theory is a rediscovery of ideas developed by old Keynesians and Post Keynesians over the past thirty years and that new Keynesians persistently fail to acknowledge that precedence.

New Keynesianism as a Club

Club, noun. 1. An association or organization dedicated to a particular interest or activity. 2.  A heavy stick with a thick end, especially one used as a weapon.

Paul Krugman’s economic analysis is always stimulating and insightful, but there is one issue on which I think he persistently falls short. That issue is his account of New Keynesianism’s theoretical originality and intellectual impact.

Read more here.

Paul Krugman, Gattopardo Economist, Part 2

As mentioned in my previous blog, Paul Krugman tries his best to put down heterodoxy. His claims that nobody predicted the crisis is deeply unintellectual when someone such as Wynne Godley and other heterodox economists had warned about it. Moreover, Jan Hatzius who uses Wynne Godley’s approach also had made a case for a severe deflation around 2007. There’s a reason I bring in Hatzius because sometime ago, Paul Krugman mentioned Jan Hatzius:

Now, it’s interesting to note that the really smart Wall Street money doesn’t buy into this canon. Jan Hatzius and the rest of the economics group at Goldman have an underlying macroeconomic framework pretty much indistinguishable from mine, and have consistently talked down the risks from easy money and deficits.

[emphasis: mine]

There are two things dishonest about this. First, Jan Hatzius pays tribute to Wynne Godley when he writes for Goldman Sachs about the sectoral balances approach and obviously doesn’t mention Krugman. Second Wynne Godley was a heterodox economist and strongly against orthodoxy. Jan Hatzius uses Wynne Godley’s approach and Krugman claims it is indistinguishable from his and sidelines heterodoxy.

What’s going on here?

Paul Krugman, Gattopardo Economist

In response to Thomas Palley’s op-ed, Paul Krugman has written a couple of pieces on his New York Times blog (here and here)

I have seen many heteredox economists defending Krugman but these pieces should now make it crystal clear that Paul Krugman himself is the head of Gattopardo Economics. Consciously or subconsciously, Krugman’s strategy has been to sideline heteredox, in the hope that pages of history sing praises of him. Unfortunately for him, whenever he gets into a technical argument with heteredox economists on money, he makes the silliest mistakes.

Rather than giving many examples of why Krugman is the part of the problem, let me illustrate one example where he pushed very hard on the issue of free trade. It is a lecture paper for Manchester conference on free trade, March 1996 titled Ricardo’s Difficult Idea.

The following quote is clearly a strategy for propaganda:

5. What can be done?

I cannot offer any grand strategy for dealing with the aversion of intellectuals to Ricardo’s difficult idea. No matter what economists do, we can be sure that ten years from now the talk shows and the op-ed pages will still be full of men and women who regard themselves as experts on the global economy, but do not know or want to know about comparative advantage. Still, the diagnosis I have offered here provides some tactical hints:

(i) Take ignorance seriously: I am convinced that many economists, when they try to argue in favor of free trade, make the mistake of overestimating both their opponents and their audience. They cannot believe that famous intellectuals who write and speak often about world trade could be entirely ignorant of the most basic ideas. But they are — and so are their readers. This makes the task of explaining the benefits of trade harder — but it also means that it is remarkably easy to make fools of your opponents, catching them in elementary errors of logic and fact. This is playing dirty, and I advocate it strongly.

(ii) Adopt the stance of rebel: There is nothing that plays worse in our culture than seeming to be the stodgy defender of old ideas, no matter how true those ideas may be. Luckily, at this point the orthodoxy of the academic economists is very much a minority position among intellectuals in general; one can seem to be a courageous maverick, boldly challenging the powers that be, by reciting the contents of a standard textbook. It has worked for me!

(iii) Don’t take simple things for granted: It is crucial, when trying to communicate Ricardo’s idea to a broader audience, to stop and try to put yourself in the position of someone who does not know economics. Arguments must be built from the ground up — don’t assume that people understand why it is reasonable to assume constant employment, or a self-correcting trade balance, or even that similar workers tend to be paid similar wages in different industries.

(iv) Justify modeling: Do not presume, as I did, that people accept and understand the idea that models facilitate understanding. Most intellectuals don’t accept that idea, and must be persuaded or at least put on notice that it is an issue. It is particularly useful to have some clear examples of how “common sense” can be misleading, and a simple model can clarify matters immensely. (My recent favorite involves the “dollarization” of Russia. It is not easy to convince a non-economist that when gangsters hoard $100 bills in Vladivostock, this is a capital outflow from Russia’s point of view — and that it has the same effects on the US economy as if that money was put in a New York bank. But if you can get the point across, you have also taught an object lesson in why economists who think in terms of models have an advantage over people who do economics by catch-phrase). None of this is going to be easy. Ricardo’s idea is truly, madly, deeply difficult. But it is also utterly true, immensely sophisticated — and extremely relevant to the modern world.

[Highlighting: mine]

Evan Soltas Is The Future Greg Mankiw

A recent post of Paul Krugman points out to a “worrisome campaign against full employment”:

Paul Krugman Recent Posts

The leader of this movement is an economics student named Evan Soltas, although Krugman doesn’t name him, maybe because Soltas is just a student.

If you go over to Soltas’ blog, you will find the vaguest interpretations of data claiming the labour market has become “tight” and that “it’s about time” the Federal Reserve raises interest rates. One of his replies to Dean Baker also brings in some vague statement about the Federal funds futures markets!

I won’t go into an analysis of how completely vague Soltas’ campaign is because Krugman has already done a nice analysis. But in case you weren’t following, let me also point out his Bloomberg article where he tells a story of how labour unions have died in the United States, making it look like such a thing was natural. This is poor rewriting of history because via policy, power has been slowly sucked out of unions.

Soltas also features in Mankiw’s latest book, where Mankiw quotes his argument that there is something wrong about universities having a differential fee structure.

Back to labour market versus policy. Such strong claims disadvantage the opponents who are trying to convince policy makers to expand fiscal policy. It makes a good strategy: shift the debate into something else – monetary policy in this case – and divert attention from fiscal policy even more.

Evan Soltas will be the future Greg Mankiw.

Tobinesque Models

Paul Krugman writes today on his blog on James Tobin’s work:

Let me offer an example of how this ended up impoverishing macroeconomic analysis: the strange disappearance of James Tobin. In the 1960s Tobin developed and elaborated a sophisticated view(pdf) of financial markets that offered insights into things like the role of intermediaries, the effects of endogenous inside money, and more. I’ve found myself using Tobinesque analysis a lot since the financial crisis hit, because it offers a sophisticated way to think about the role of finance in economic fluctuations.

But Tobin, as far as I can tell, disappeared from graduate macro over the course of the 80s, because his models, while loosely grounded in some notion of rational behavior, weren’t explicitly and rigorously derived from microfoundations. And for good reason, by the way: it’s pretty hard to derive portfolio preferences rigorously in that sense. But even so, Tobin-type models conveyed important insights — which were effectively lost.

Compare that to his article in response to another article on Wynne Godley which appeared in the New York Times – completely dismissing Godley’s work.

Three things: first Krugman claimed earlier that we needn’t look at old ideas:

But it is kind of funny to see a revival of old-fashioned macro hailed, at least by some, as the key to a reconstruction of the field

directly contradicting what he says today.

Second – obviously not having read Wynne Godley, he missed the point that Wynne’s analysis has significant improvement of James Tobin’s work.

Third, of course, Krugman’s understanding of monetary economics in general is poor, as can be seen when he gets into debates with heteredox economists and makes the most elementary errors. So it is strange he is lecturing others on this and fails once again to acknowledge heteredox economists.

Here’s Marc Lavoie describing in his article From Macroeconomics to Monetary Economics: Some Persistent Themes in the Theory Work of Wynne Godley in the book Contributions to Stock-Flow Modeling: Essays in Honor of Wynne Godley:

As Godley points out on a number of occasions, he himself owed his formalization of portfolio choice and of the fully consistent transactions-flow matrices to James Tobin. Godley was most particularly influenced and stimulated by his reading of the paper by Backus et al. (1980), as he writes in Godley (1996, p. 5) and as he told me verbally several times. The discovery of the Backus et al. paper, with its large flow-of-funds matrix, was a revelation to Godley and allowed him to move forward. But as pointed out in Godley and Lavoie (2007, p. 493), despite their important similarities, there is a crucial difference in the works of Tobin and Godley devoted to the integration of the real and monetary sides. In Tobin, the focus is on one-period models, or on the adjustments from the initial towards the desired portfolio composition, for a given income level. As Randall Wray (1992, p. 84) points out, in Tobin’s approach ‘flow variables are exogenously determined, so that the models focus solely on portfolio decisions’. By contrast, in Godley and Cripps and in further works, Godley is preoccupied in describing a fully explicit traverse that has all the main stock and flow variables as endogenous variables. As he himself says, ‘the present paper claims to have made … a rigorous synthesis of the theory of credit and money creation with that of income determination in the (Cambridge) Keynesian tradition’ (Godley, 1997, p. 48). Tobin never quite succeeds in doing so, thus not truly introducing (historical) time in his analysis, in contrast to the objective of the Godley and Cripps book, as already mentioned earlier. Indeed, when he heard that Tobin had produced a new book (Tobin and Golub, 1998), Godley was quite anxious for a while as he feared that Tobin would have improved upon his approach, but these fears were alleviated when he read the book and realized that there was no traverse analysis there either.

Draft link here.

Balance Of Payments Adjustments

Paul Krugman seems to have been thinking on issues related to open economy monetary macroeconomics these days! He has recently warned his readers to not confuse accounting identities with causation but in a recent blog post he seems to be doing it himself.

So Krugman says:

So, here we go. Start from the observation that the balance of payments always balances:

Capital account + Current account = 0

where the capital account is our sales of assets to foreigners minus our purchases of assets from foreigners, and the current account is our sales of goods and services (including the services of factors of production) minus our purchases of goods and services. So in the hypothetical case in which foreigners lose confidence and stop buying our assets, they’re pushing our capital account down; as a matter of accounting, then, our current account balance must rise.

But what’s the mechanism? (Remember the fallacy of immaculate causation.) The answer is, it depends on the currency regime.

Strange. The last statement in the quote warns of potential mistake which is present in the previous statement! ie Krugman wants to have it both ways.

So “… as a matter of accounting …” ?

Let us consider a case (fixed exchange rate or floating) where there is an autonomous capital flow – such as a foreigner liquidating a bond and repatriating funds. This by itself doesn’t affect the current account. In fact it can be compensated by some accommodative flow in the capital account of the balance of payments.

There is a nice 1991 article by the BIS Capital flows in the 1980s: a survey of major trends. The author quotes James Meade who makes this distinction between autonomous flows and accommodative flows:

[accommodative capital flows] take place only because the other items in the balance of payments are such as to leave a gap of this size to be filled … [while] autonomous payments … take place regardless of other items in the balance of payments.

Of course because of flexible exchange rates, the distinction can become blurred but the same is also true in fixed exchange rates. So we have an item called Other Investment in the capital account of balance of payments – like the example in the IMF’s BPM6 (note: “financial account” in the BPM6 terminology, capital account means a different thing):

Balance Of Payments Capital Account

In addition Reserve Assets is also one. Again this is somewhat of a simplification and it is possible for other items to accommodate.

“Other Investment” is typically banking sector flows but refer to BPM6 for the full definition. “Reserve Assets” is things such as sale or purchases of foreign currency by the central bank or any other official institution. Sometimes a category Exceptional Financing is used – such as government borrowing in foreign currency in exceptional circumstances or official financing transactions from the IMF.

So changes in some items in the capital account can be balanced by changes in some other account in the capital account and not the current account. Of course this doesn’t mean that there is no causality from the capital account to the current account and I will come to it in a moment but what Krugman says is silly.

Let’s take a few examples starting with the simplest – and you guessed it right – the Euro Area ;-)

Suppose there is a capital flow where a German financial firm liquidates Spanish government bonds and transfers funds back home.

As I have explained in posts long back, this will lead to a TARGET2 imbalance in which the Spanish NCB will have a rise in indebtedness to the ECB (which is considered to be a Spanish non-resident). Either it ends here or the Spanish banking system will try to attract funds from abroad. In either case there is an accommodative flow in the balance of payments – balancing the initial outflow and without affecting the current account.

Now take the example of a nation with its currency pegged to another anchor currency. Suppose a nonresident economic unit sells sells securities and transfers funds outside the country. Since banks acts as dealers in the foreign exchange markets, this leaves the banking system with a short position in foreign currency. It may try to close it by borrowing in foreign currency or try to attract funds from outside. In the latter case that is all there is to it (in the short term) and this flow is accommodating and will appear in Other Investment. In the former case, the banking system is left with an open position in foreign currency. As long as the bank’s own risk management or the central bank (with the confident knowledge that it has sufficient foreign exchange in case it has) thinks this it is alright, this is what there is for the short term. Else banks may need to attract funds from abroad. However if there is a depreciation outside the tolerable band (fixed doesn’t mean god has fixed it) in response to a huge amount of capital outflow, the central bank may sell foreign currency. It may also try to hike interest rates to get attract foreigners.

Again no change in the current account. One item in the capital account cancels another to preserve the accounting identity Krugman quotes.

In floating exchange regimes this is more complicated but the story is not too different from the BoP viewpoint. An outflow of funds will be accommodated by banks’ open position (or inventories). Banks will typically try to offload the inventories depending on market conditions and opportunities and it is sometimes said in the fx microstructure theory that the inventory half-life is around 15 minutes. The currency will depreciate to the point where expectations of the market participants reverse in the direction of appreciation bringing in flows in the opposite direction to the initial capital outflow. How this works precisely is a very challenging open question. Of course looked at from a medium term perspective, in general, it is not immediately obvious why the current account balance and capital account sum to zero since the magnitude of “Portfolio Investment” and “Direct Investment” may be quite different from the current account balance. But the sum of balances is zero as a matter of accounting. In such cases, banks may try to attract funds from abroad themselves by marketing bonds offshore – i.e., they may try to find offshore funding. More complications arise from derivative contracts with nonresidents which is not easy to go into in this post.

Of course this not guaranteed to work – pure float is the luxury of a few nations –  and sometimes the central bank may need to intervene in the foreign exchange markets and in the extremis, undertake exceptional financing transactions such as borrowing from the IMF.

In recent times, the Reserve Bank of India had an interesting swap scheme with the banking system who would attract funds from abroad.

Of course, none of this means there is no causality from the capital account to the current account. A nation may face troubles financing its balance of payments and it may try to deflate domestic demand by fiscal and monetary policy to keep its current account imbalance from getting out of hand. It is important to note here this is not a straightforward result of the identity but there is a more complicated story and that output suffers because of this. Krugman makes it sound as if nothing happens to output.