Over the last eleven days something unusual has happened – I
have not only failed to post a blog of my own, but I have not even read anyone
else’s posts. Instead I have taken advantage of a sabbatical term to take a
break [1] in Umbria, during a time of year when it is still cool
enough to walk, but not too cold in the Piano
Grande. Before I left I did write a couple of things that I thought I might
quickly post while away, but with the help of the Italians’ penchant for
starting dinner late and eating four (or more) courses that idea somehow got
lost.
So I’m spending part of today catching up, and reminding
myself why Paul Krugman and Martin Wolf are such great writers. (For example, from
the former, a masterful analysis
of the decent into worldwide austerity, and from the latter, a perfect short account
of why when it comes to government debt the Eurozone really is different.) What
I want to pick up on here is this
Krugman post, where he questions the description in a Nick Crafts piece
of higher inflation as a way out of the liquidity trap as being ‘textbook’. (See
also
Ryan Avent.)
So is raising inflation expectations to avoid the liquidity
trap textbook or not? Let’s take the 2000 edition of the best selling undergraduate macro textbook. Here ‘liquidity trap’ does not appear in the index. There is a page
on Japan in the 1990s, and in that there is one paragraph on how expanding the
money supply, even if it was not able to lower interest rates, could by raising
inflation expectations and therefore reducing real interest rates stimulate
demand. One paragraph among 500+ pages is not enough to make something ‘textbook’,
so it seems as if Paul Krugman has a point.
Yet how can this be? It is not one of those cases where
textbooks struggle to catch up with recent events, because the Great Depression
was a clear example of the liquidity trap at work. How can perhaps the major
macroeconomic event of the 20th century, which arguably gave rise to
the discipline itself, have so little influence on how monetary policy is
discussed? Yet it is possible to argue that the discussion is there, in an
oblique form. A standard way of analysing the Great Depression within the
context of IS-LM, which this popular textbook takes, is to contrast the ‘spending
hypothesis’ with the ‘money hypothesis’: was the depression an inevitable result
of a negative shock to the IS curve, or as Freidman argued could better
monetary policy have prevented this shock hitting output?
A standard objection to the money hypothesis is that nominal
interest rates did (after a time) fall to their lower bound. The
counterargument – which the textbook also suggests - is that, if the money
supply had not contracted, long run neutrality would imply that eventually inflation
would have to have been higher, and therefore real interest rates on average would
be lower. So in one way the story about how higher inflation could avoid a
slump is there.
What is missing is the link with inflation targeting.
Because textbooks focus on the fiction of money supply targeting when giving their
basic account of how monetary policy works, and then mention inflation
targeting as a kind of add-on without relating it to the basic model, they fail
to point out how a fixed inflation target cuts off this inflation expectations
route to recovery. Quantitative Easing (QE) does not change this, because
without higher inflation targets any increase in the money supply will not be allowed
to be sustained enough to raise inflation. In this way inflation targeting institutionalises
the failure of monetary policy that Friedman complained about in the 1930s.
Where most of our textbooks fail is in making this clear.
