Krugman vs. Krugman

27 Mar, 2015 at 09:26 | Posted in Economics | 16 Comments

Paul Krugman wonders why no one listens to academic economists …

Listening_TitleOne answer is that economists don’t listen to themselves. More precisely, liberal economists like Krugman who want the state to take a more active role in managing the economy, continue to teach an economic theory that has no place for activist policy.

Let me give a concrete example.

One of Krugman’s bugaboos is the persistence of claims that expansionary monetary policy must lead to higher inflation. Even after 5-plus years of ultra-loose policy with no rising inflation in sight, we keep hearing that since so “much money has been created…, there should already be considerable inflation” … As an empirical matter, of course, Krugman is right. But where could someone have gotten this idea that an increase in the money supply must always lead to higher inflation? Perhaps from an undergraduate economics class? Very possibly — if that class used Krugman’s textbook.

Here’s what Krugman’s International Economics says about money and inflation:

“A permanent increase in the money supply causes a proportional increase in the price level’s long-run value. … we should expect the data to show a clear-cut positive association between money supplies and price levels. If real-world data did not provide strong evidence that money supplies and price levels move together in the long run, the usefulness of the theory of money demand we have developed would be in severe doubt …

A permanent increase in the level of a country’s money supply ultimately results in a proportional rise in its price level but has no effect on the long-run values of the interest rate or real output.”

This last sentence is simply the claim that money is neutral in the long run, which Krugman continues to affirm on his blog …

You might think these claims about money and inflation are unfortunate oversights, or asides from the main argument. They are not. The assumption that prices must eventually change in proportion to the central bank-determined money supply is central to the book’s four chapters on macroeconomic policy in an open economy …

So these are not throwaway lines. The more thoroughly a student understands the discussion in Krugman’s textbook, the stronger should be their belief that sustained expansionary monetary policy must be inflationary. Because if it is not, Krugman gives you no tools whatsoever to think about policy …

Liberal Keynesian economists made a deal with the devil decades ago, when they conceded the theoretical high ground. Paul Krugman the textbook author says authoritatively that money is neutral in the long run and that a permanent increase in the money supply can only lead to inflation. Why shouldn’t people listen to him, and ignore Paul Krugman the blogger?

J. W. Mason/The Slack Wire


  1. The problem here is conceptual, one might almost say, “ontological” as that term is sometimes thrown around in these parts.
    That the size of the unit of account is of no consequence was an insight of Hume in the 18th century. By transforming this trivial insight into the portentous claim “money is neutral in the long-run” is to import all manner of dubious reactionary ideas under cover of night. As Simsalablunder comments above, there’s no causal mechanism in this long-run where money is neutral, but one clear implication is that all our short-run policy machinations in which money is not-neutral are to be undone by the long-run in which it is. And, really, Krugman is fully on board with this ideological commitment, as JW Mason made clear in the linked post. He quotes Krugman:

    . . . this plays a surprisingly big role in my own pedagogical thinking — we do want, somewhere along the way, to get across the notion of the self-correcting economy, the notion that in the long run, we may all be dead, but that we also have a tendency to return to full employment via price flexibility. Or to put it differently, you do want somehow to make clear the notion (which even fairly Keynesian guys like me share) that money is neutral in the long run.

    This claim that money is neutral in the long-run is tied directly to the notion of a self-correcting economy. But, notice that this is a purely ideological claim; there’s no mechanism, and, therefore, no social science; it’s magic, the magic of the market.

  2. You are being a bit sneaky here. Now we are in a liquidity trap, when — as Krugman has argued repeatedly — the normal rules don’t apply. Does Krugman’s textbook really not discuss liquidity traps? This would be an oversight, but I’m doubtful given Krugman’s harping on this issue.

  3. That’s a pretty standard graph found in most textbooks. I think the most comprehensive study is by Maccandless and Weber

    Click to access qr1931.pdf

    But I like the lecture notes by fabrice collard

    Click to access handout_facts.pdf

    • Thank you.

      • Thanks Nic the NZer, I wouldn’t have thought of that. I know that Bill Mitchell says that the central bank will always make reserves available (at a price) to banks as part of ensuring that the payment system operates. Is that what you mean? As in banks make new loans, expanding M2, then central bank makes reserves available to the banks resulting in an expansion of M0?

      • Yes, that’s what I was thinking in terms of M0 expanding in response to M2. It’s pretty much a matter of public record that central banks apply this policy of course. In New Zealand the reserve price is called the ‘Official Cash Rate’ and information about it is publicly visible as is the inter-bank lending rate (called the 90 day rate in New Zealand) resulting from reserve bank policy.

    • The McCandless and Weber paper is interesting. I think they are showing that there is a very high correlation between increases in the money supply and inflation (more so for M2, less correlation for M0, but still very high). And it finds no correlation between inflation and real output growth. But then it also finds that “For these countries [OECD], there is a positive and relatively high correlation between average rates of growth of money and real output…[math stuff]… This indicates that within the group of OECD countries, those with higher rates of growth of the money supply tend to have higher rates of real output growth.”

      The OECD group is only 21 of the 110 countries that they deal with in this time period between 1960 and 1990. But my guess is that they account for at least 50 to 70 percent of the real output that McCandless and Weber are measuring during that time frame . So I don’t know if that really shows if money is always neutral in the long run.

      • Correlation is not causation. They are making an assumption that it is the money supply that drives inflation without bothering looking into other possibilities to what could have been the cause of inflation in a given country, like policy for instance.

      • Yes Simsalablunder, I agree that correlation is not causation. McCandless and Weber were also careful not to state causation even though it might seem implied. But such a oorrelation as shown in the links that Pontus was kind enough to provide are worth investigating. I am still trying to evaluate the claim that money is neutral in the long run. Any help would be appreciated.

      • @Jerry Brown, Lets imagine there are some other (not monetary expansion) causes of price increases. In that case what will the banking system do when prices in the economy increase, and more spending ability is required to meet those increased asking prices. I propose it will in those circumstances expand the money supply to bridge the financing gap endogenously (e.g the amount of bank credit will expand to bridge this gap). So you are going to see a correlation between inflation, and the money supply if causation runs in either direction.

        Also if we measured inflation, and monetary expansion it means that extra spending has happened, at those new prices. So the banking system has by this stage already bridged the financing gap.

        There have also been studies which show M0 increases follow M2 increases, which is observable, and likely shows (they are statistical studies) that causation is running in the opposite direction to the one put by the ‘money is neutral’ camp. This also happens through a similar mechanism where M0 needs to expand to meet the requirements of additional interbank payments in an expanded M2 money supply.

  4. If we were to include treasuries in the money supply, it would become easier to understand why recent “money printing” does not increase inflation. QE amounts to an asset swap between treasuries and bank deposits. So, all that money printing does not increase anyone’s financial assets.

    So we are back to the situation that new money in the economy comes from bank lending or government deficit spending each of which increase bank deposits.

  5. @ pontus
    Impresssive chart, at first glance.
    Do you know the source of this data and which countries are included and excluded? No info on this is given in the link you give.

    Looking more closely at the chart, it seems that most countries had <20% p.a. average inflation and < 20% p.a. average money growth over 30 years. For these countries, the relationship is very unclear. If there is a relationship, it looks rather flat, which contrasts sharply with your comment.

  6. “Suppose you collect data from a large group of countries over 30 years. For each country, you measure the average annual inflation rate and the average annual growth rate of the “money supply,” which includes the physical currency in circulation and the total value of bank deposits. You then have a single data point for each country, showing that country’s inflation-money growth combination. If you plot these data, you’ll get the closest thing to a straight line that economic data ever generate: Countries with high long-run rates of money growth are also countries with high long-run rates of inflation, and vice versa (see chart).”

    • Thanks for the link. That is, at least visually, a very powerful chart. One question that I have about it- Is the “central bank- determined money supply” that J.W. Mason says is essential to the argument in Krugman’s book essentially the same as a money supply which includes the total value of bank deposits that James Moore uses in the graph?

    • Does not address causation issues.

  7. Maybe Krugman’s ‘long run’ will be reached once the crisis is definitely over and the economy starts booming again. Then it will be necessary to tighten the money supply.

    I think this is wrong anyway (endogenous money creation), but it could explain why Krugman the textbook author and Krugman the blogger seem to disagree.

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