Wednesday, June 3, 2009


Scott Sumner Identifies (Yet Another) Contradiction in Keynesian (and Monetarist?) Theory

I think Scott Sumner's theory that Bernanke has not been inflationary enough is "nuts," and I have told him as much even in email. ('Twas all in good fun.) But Sumner has forgotten more mainstream macro than I'll ever know, and he is very good at spotting inconsistencies. A little while ago he had a truly brilliant catch, which I forgot to highlight at the time.

The context was all the recent hullabaloo about the US economy needing -5% interest rates, and/or the Fed promising to hold rates down at around 0% for a long long time. As Scott observed, this is totally inconsistent with standard Keynesian theory, even though it is being promulgated as an implication of standard Keynesian theory:
Let’s start with the idea that we need a negative 5% real interest rate. Doesn’t that mean that monetary policy would have to be expansionary enough to create expectations of at least 5% inflation? And if expectations are rational, doesn’t that mean monetary policy would have to be expansionary enough to actually create 5% inflation? And if the SRAS is very flat when the economy is deeply depressed (like right now) doesn’t that mean we’d need an extraordinarily large amount of NGDP growth to get 5% inflation. In other words, are these Fed estimates (reportedly derived from a Taylor Rule model) at all consistent with the Keynesian SRAS [short-run aggregate supply curve]?

Of course, the problem with Scott's blog posts is that you have to wade through 16 paragraphs of caveats before getting to the punchline--but that's why we love him so. Here it is:
Let’s imagine the Fed did succeed in getting 5% expected inflation, and also assume that Keynesians are right about SRAS being relatively flat in a deep slump. Then what sort of real GDP growth would we be looking at? I can’t even imagine a plausible number....

Now you may differ from me as to the current slope of the SRAS, but is there any conceivable way one could get 5% inflation out of any plausible choice of optimal NGDP growth? What would happen to nominal wages? We are at 8.9% unemployment and going much higher, does anyone think nominal wages are about to accelerate? Certainly Krugman doesn’t, he’s worried about wage deflation. But then from where are we to get this rapid rise in the GDP deflator?

Let me be clear about one thing, I’m not denying the Fed could generate 5% inflation if they showed enough recklessness; you’ve seen me point to Zimbabwe numerous times. Rather what I’m arguing is that there is no plausible NGDP growth path that the Fed would have as a policy goal, that would be expected to generate anything like 5% inflation. But that means the Fed believes it could generate all the NGDP growth it thinks prudent at inflation rates far below 5%. And that means the Fed could generate all the NGDP growth it thinks prudent at real interest rates much higher than negative 5%. Somehow the “appropriate real interest rate” coming out of these Taylor Rule-type models is nonsense.

Let me translate the master's profundities for you: Scott is saying that in the standard Keynesian view, pumping up aggregate demand does not cause price increases so long as the economy is at less than full employment. No, in that context, the AD curve shifts to the right along a relatively flat (short-run) AS curve, increasing real output while prices don't rise much at all.

Then, once we hit full employment, the SRAS curve starts rising rapidly, meaning that further increases in AD won't squeeze out much more real output, but instead will simply cause price hikes. (Everyone remember this stuff?)

So: Scott is saying, how can it be true that the Keynesian models say we need 5% price inflation in order for the markets to clear? Suppose the Fed promises enough future inflation (a la Krugman and Mankiw) to stimulate enough spending in the present, in order to close the gap between potential and actual GDP. By the time we hit full employment, price inflation will still only be 3% or whatever. So why would the Fed have needed to promise delivery of an inflation rate 2 percentage points higher than that?

Scott made the point even more simply in a different post (I think). I can't find it right now, but he said something like: When the Fed promises that it will hold rates near 0% for the next two years, it is telling investors that we will be in recession for at least two more years. After all, once we had clearly left the recession, everybody knows the "right" thing to do at that point would be for the Fed to raise rates.

In the grand scheme, what Scott has done here is show how ad hoc Keynesian theory is. These are not intertemporal, general equilibrium models with time-consistent policy functions. Or rather, to the extent they are, then they don't yield the op ed analysis pushed by Keynesians when they talk about how the economy works.

I don't know what the onomatopoeia is for the sound of my brain fizzling after reading this nonsense but that's what I would've typed here if I did.
i think you are looking for:

Well I think everything short of the KABOOM part... it didn't actually explode because there is little combustible material (little material at all, actually) up there.

But yes, it was like a light bulb surging before finally blinking out. Good job!
The post you're talking about is here:
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