Tag Archives: Krugman

Finite and Infinite Games

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I recently read Finite and Infinite Games, by James Carse, poolside while on vacation. Excerpt:

Seriousness is always related to roles, or abstractions. We are likely to be more serious with police officers when we find them uniformed and performing their mandated roles than when we find them in the process of changing into their uniforms. Seriousness always has to do with an established script, an ordering of affairs completed somewhere outside the range of our influence. We are playful when we engage others at the level of choice, when there is no telling in advance where our relationship with them will come out—when, in fact, no one has an outcome to be imposed on the relationship, apart from the decision to continue it.

To be playful is not to be trivial or frivolous, or to act as though nothing of consequence will happen. On the contrary, when we are playful with each other we relate as free persons, and the relationship is open to surprise; everything that happens is of consequence. It is, in fact, seriousness that closes itself to consequence, for seriousness is a dread of the unpredictable outcome of open possibility. To be serious is to press for a specified conclusion. To be playful is to allow for possibility whatever the cost to oneself.

The book is obviously not about game theory, and it lives up to its subtitle, “A Vision of Life as Play and Possibility.”

It is a book that I wish were more widely read, not merely because I enjoyed it, but because it would enable for me a new mode of discourse. In the short time since I read the book, I have found myself on numerous occasions wanting to say, “So-and-so is playing a finite game,” and be understood. When Tyler invites Krugman to come out and play, and Paul responds with “This is not a game,” Paul is playing a finite game. When Mike Elk trashes bloggers in general and Matt Yglesias in particular, Elk is playing a finite game.

I read the book as pro-blogging, even though it was written before the invention of blogging, and pro-anarchism (of a certain kind), even though I doubt Carse has read the anarchism literature. More broadly, it promotes bottom-up processes not on Hayekian or consequentialist grounds, but on the grounds of meaning and personal satisfaction.

I recommend the book to people who are highly Open (and to a lesser extent non-Conscientious) on the Big Five personality model.

Forensic Semantics: The Meaning of Liquidity Trap

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I promise not to do too many more posts about a) macro or b) Paul Krugman. I don’t just love macro, these are not my most popular posts, and Krugman is too shrill to read on a regular basis. Nevertheless, I think I can sort through some of the recent disagreement about liquidity traps.

The term “liquidity trap” comes from Keynes. He described it as a theoretical possibility under which monetary policy would be ineffective; it would be unable to stimulate an economy in recession. Consequently, fiscal policy would be needed. To my knowledge, Keynes was not claiming that the economy ever has been in a liquidity trap; it’s simply a possibility that occurs under very specific conditions. Those conditions define “liquidity trap,” but there is disagreement over when they hold.

What is at stake here is the status of fiscal policy. If the economy sometimes experiences liquidity traps, then that is perhaps a good reason to keep fiscal policy in our toolbelt. If the economy never experiences a liquidity trap, then monetary policy strictly dominates fiscal policy: it is faster, less wasteful, and does not increase sovereign debt. It’s sometimes hard to say whether advocates and detractors of fiscal policy take those sides because of their position on liquidity traps or vice versa.

Krugman is among those who think that the world does experience liquidity traps, that we are in one now, and that we need more fiscal policy. Why does he think this? Arnold Kling does some of the forensic work and uncovers an old and a recent statement from Krugman on liquidity traps. Arnold says they are inconsistent, but I think they are perfectly consistent. The old statement:

My view … is that the liquidity trap is real: no matter how much the Fed increases the monetary base, it has no effect, because it just substitutes one zero-interest asset for another.

The new statement:

The economy is in a liquidity trap when even a zero nominal interest rate isn’t enough to restore full employment. That’s it.

What Paul is saying is that the economy is in a liquidity trap when the nominal interest rate on short-term Treasuries is zero. When the Fed tries to expand the money supply by buying up short-term Treasuries, it is swapping cash for Treasuries. Normally, cash and Treasuries have different properties: cash has a nominal interest rate of zero and Treasuries bear some positive nominal interest rate. However, when Treasuries bear an interest rate of zero, they are basically the same as cash. They are backed by the US Government and they don’t carry interest. Why should swapping one asset for an identical asset make any real difference in the world? On this narrow point, Krugman is clearly correct: it wouldn’t make a difference at all.

Krugman is wrong, however, that this constitutes a liquidity trap, either in the sense that Keynes meant it or in the looser sense that monetary policy is ineffective, because swapping cash for short-term Treasuries is not the only (or even necessarily the best) way to conduct monetary policy. First of all, it is important to recognize that there is not just one nominal interest rate. There is an infinity of nominal interest rates. If the interest rate on short-term Treasuries is zero, the Fed can swap cash for longer-term Treasuries. It could in theory buy private bonds, or stock, or mortgage-backed securities, or even non-financial assets. In any of these cases, the Fed is increasing the amount of money in circulation, and it is removing less liquid assets. This is expansionary except in extraordinary circumstances I’ll discuss below.

Incidentally, the Fed can also conduct monetary policy by other means. It can simply print money and distribute it, the infamous “helicopter drop.” It can buy foreign currency. It can lower the interest rate or raise the penalty on excess reserves that banks hold at the Fed. It can promise to inflate more in the future. All of these actions are expansionary, again except perhaps in extraordinary circumstances.

What are the extraordinary circumstances in which all monetary policy is ineffective? Keynes got it right. Monetary policy is ineffective when people want to hoard whatever cash they can get their hands on. In technical terms, the demand for money is infinitely elastic. The point is that increasing liquidity in the system (buying illiquid assets with liquid assets, say) does not translate into more spending because people soak up whatever liquidity there is.

When is demand for money infinitely elastic? Basically never. This is what Tyler is saying in his most recent post on liquidity traps. In Tyler’s terminology, there are multiple margins on which people express preferences for liquidity. There is the money-bonds margin, and in fact, there are multiple money-bonds margins. When the nominal interest rate on short-term Treasuries is zero, that is one margin on which people are expressing a preference for liquidity. But as I argued above, there are other bonds, and people are generally willing to sacrifice liquidity for a non-zero rate of return. There is also the money-goods margin. People are generally willing to sacrifice liquidity for stuff. That is, if you give them money, they spend some of it. But since Keynes is all about aggregate spending, you can see how it would be the case that if people infinitely preferred liquidity to goods (they were unwilling to spend even if you gave them more money), then it would be desirable to have the government to engage in direct spending (fiscal policy) to boost aggregate demand.

So why does Krugman fixate on only one interest rate, on only one particular money-bonds margin? I think that it’s just a lack of imagination about what monetary policy consists of. Traditionally, monetary policy in the US has consisted primarily of open market operations on short-term US Treasuries. But there is nothing special about this particular kind of monetary expansion. If Krugman wants to call it a liquidity trap when the nominal interest rate on short-term Treasuries is zero, he needs to abandon the conclusion that fiscal policy is called for in a liquidity trap. I prefer to retain Keynes’s original meaning and conclusions by defining a liquidity trap as an infinitely elastic demand for money.

Why RBC is Awesome

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Paul Krugman disses RBC theory and those who study it as unscientific. I’m not an RBC theorist, but I’ll stick up for freshwater macro. Here are some reasons why RBC theory deserves more respect than Krugman gives it.

1. Suppose monetary policy is conducted so that all nominal shocks are perfectly offset. Zero percent of net shocks, shocks adjusted for changes in the quantity of money, are nominal; 100% of net shocks are real. Therefore as monetary policy improves it is the policy conclusions of the RBC literature, not the New Keynesian literature, that are relevant.

2. Empirically, I agree with Krugman and others contra pure RBC theory that money appears to be non-neutral. But why is money non-neutral? Saltwater macro offers answers to this question that are frankly absurd. Menu cost arguments rely on a fallacy of composition. Even if all businesses face costs of changing prices, unless they synchronize their price changes, there is no reason to believe that the price level as a whole is sticky; see Caplin and Spulber. If the nominal price level is not sticky, there is no reason to believe that real stickiness—efficiency wages and so on—can be the source of monetary non-neutrality. Freshwater macro has advanced the much more plausible idea that money is non-neutral because of legal restrictions on financial intermediation. Under laissez-faire, money would be neutral, and RBC would be correct.

3. Critics of RBC argue that it is hard to find shocks to real factors such as technology, particularly negative shocks, to account for recessions. However, they overlook shocks to credit, which is—wait for it—a real not a nominal factor.

4. Critics of RBC ridicule the theory by saying that according to freshwater economists, the Great Depression was the Great Vacation. But their own theory is no less ridiculous. According to saltwater economists, unemployment of over 20 percent persisted for almost a decade because people were too stubborn to accept wage cuts. Sorry, not plausible.

5. RBC makes strong assumptions, but it should be appreciated for what it is, which is an attempt to do macro as pure economics without post hoc additions to make the theory fit with measurement (which is, after all, imperfect). In contrast, other approaches exhibit a tendency toward, to coin a phrase, Macro of the Gaps. The models don’t always make this clear, but a lot of the features that do the work in saltwater theory are residuals. I am not aware, for instance, of a serious effort to give a theoretical account of the value of the fiscal multiplier. Instead, the fiscal multiplier is whatever regressions say it is. I am not against empirical work, but how convenient that regressions set the multiplier to whatever level is necessary to make the theory work. In fairness, some RBC papers empirically calibrate models, but there is more honesty about the fact that they are calibrating, not independently estimating results.

6. As Tyler used to say in Macro I, 98 percent or more of business cycles in human history were indisputably real business cycles. There was no central bank and no fiscal authority in caveman days. “My theory explains 98 percent of business cycles” seems like pretty good justification to me.

As I said before, I’m not an RBC theorist, but not everything has to be about petty tribalism. RBC is both scientific and worth studying.

A Picture for Krugman

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“The lights are going out all over America—literally.” So begins Paul Krugman’s latest NY Times column, in which he laments the crumbling of America’s foundations. The proximate cause of this decline, according to Krugman, is insufficient government spending on infrastructure and education. But the root cause is rhetoric:

How did we get to this point? It’s the logical consequence of three decades of antigovernment rhetoric, rhetoric that has convinced many voters that a dollar collected in taxes is always a dollar wasted, that the public sector can’t do anything right.

I could easily write a thousand-word post refuting this claim, but that would just be more antigovernment rhetoric. Instead, I want to show you a picture. The data comes from the BEA’s NIPA Tables (3.1, 1.1.4, and 7.1).

If antigovernment rhetoric over the last three decades were as effective as Krugman claims, what would this picture look like?