Paul Krugman takes issue with a paper by Mankiw that argues “that fiscal expansion shouldn´t be the tool of choice even at the ZLB; that MP can still work if you can credibly make commitments about future MP”.

Krugman notes (a bit sarcastically):

Early in the present crisis, Greg publicly made exactly the argument his analysis implies: that the Fed needed to promise higher inflation, so as to get negative real interest rates.

As I understand it, he received furious pushback from readers. And in response to this pushback, he stuck to his guns, arguing repeatedly that inflation really was the right policy more or less dropped the subject.

And concludes extolling some of the “virtues” of fiscal expansions:

Now, the thing about fiscal expansion is that people don’t have to believe in it: if the government goes out and builds a lot of bridges, that puts people to work whether they trust the government’s commitment to continue the process or not. In fact, to the extent that there’s some Ricardian effect out there, fiscal policy works better, not worse, if people don’t believe it will continue.

The problem with Krugman´s argument is that you never know how much fiscal stimulus is enough. And that´s how he usually argues: “It didn´t work because it was too small”! And the public debt path has now become a problem…

On the other hand, Mankiw´s conclusion:

A sufficiently flexible and credible monetary policy is always sufficient to stabilize output following an adverse demand shock, even if the zero lower bound on the short-term interest rate binds.

Does not justify pages and pages of “Greek letters”. The problem is that monetary policy was at the root of the “adverse demand shock”. If so, that means that monetary policy was not sufficiently flexible (although it was credible).

The problem lies with inflation being the “target” (formal or informal) that guides monetary policy. And inflation easily becomes an “obsession”. Monetary policy then becomes difficult to implement, not because of the ZLB but because of the OB (“obsession bound”).

Mankiw says that a sufficiently flexible (and credible) monetary policy is always sufficient…But it has become clear that IT does not provide “flexibility”. Blanchard, among others, has proposed a higher IT so as to avoid the ZLB. The smack down on the proposals was “loud”.

Figure 1 indicates that MP was really not flexible. Otherwise, according to Mankiw AD would have been stabilized. In fact, it was MP, set according to an undisclosed target for an undisclosed index, which is behind the big “damage” to AD.

In figure 2 it is shown that the inflation “obsession” flares up as soon as inflation points up even if from a rock bottom level! In that case, AD will never be brought up back to some reasonable level…and unemployment will remain higher for longer. Never mind, that´s “structural” and MP is impotent to do anything about it!


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