The “Krugman manifesto” downplays the power of monetary policy

The “Manifesto for Economic Sense”, signed by hundreds of economists from different countries starts off saying:

More than four years after the financial crisis began; the world’s major advanced economies remain deeply depressed, in a scene all too reminiscent of the 1930s. And the reason is simple: we are relying on the same ideas that governed policy in the 1930s. These ideas, long since disproved, involve profound errors both about the causes of the crisis, its nature, and the appropriate response.

These errors have taken deep root in public consciousness and provide the public support for the excessive austerity of current fiscal policies in many countries. So the time is ripe for a Manifesto in which mainstream economists offer the public a more evidence-based analysis of our problems.

I strongly disagree with this shrug-off of monetary policy:

In the face of a less severe shock, monetary policy could take up the slack. But with interest rates close to zero, monetary policy – while it should do all it can – cannot do the whole job.

Which commits the common error of associating the stance of monetary policy with the level of interest rates. And to all those hundreds of economists’ monetary policy cannot do much! A sad state of affairs indeed.

Towards the end it provides what passes for justification for more “fiscal stimulus”:

In the 1930s the same structural argument was used against proactive spending policies in the U.S. But as spending rose between 1940 and 1942, output rose by 20%. So the problem in the 1930s, as now, was a shortage of demand not of supply.

Interestingly, almost simultaneously with the release of the “Manifesto”, Steven Horwitz and  Michael McPhillips released a new paper entitled: The Reality of the Wartime Economy – More Historical Evidence on Whether World War II Ended the Great Depression , which builds on previous work by Robert Higgs, concluding:

Those who credit the war with economic recovery in the form of giant government expenditures and rising GNP must also explain the absence of any economic downturn following disarmament. What should have been the “worst cyclical downturn” in U.S. history was barely noticeable. The lack of a second depression in 1946 has drawn further attention to the limits of aggregate economic statistics, especially during war when government action can heavily distort figures (Vedder and Gallaway 1993: 3-5). For the same reasons that the calculated GNP did not depict reality in describing what occurred in 1946 as the government reduced spending, we should be skeptical of the validity of the growth rates as government-sponsored production increased between 1940 and 1944.

As has been copiously shown, the recovery which began in 1933 was the result of expansionary monetary policy following FDR severing the dollar from gold. And as the chart below indicates, the adjustment following the end of WWII was quick and swift. Why? Answer: nominal spending (NGDP) didn´t crash, or even falter, like it did in 2008!

6 thoughts on “The “Krugman manifesto” downplays the power of monetary policy

  1. Which is the problem, which is why Scott Summer’s campaign to change the opinion of the median economist is so important, why it still has so far to go and why Krugman is not helping as much as he should be.

  2. Pingback: The “Krugman manifesto” downplays the power of monetary policy « Economics Info

  3. Current nominal private spending is controlled by two variables – the interest rate, and permanent nominal income. But Keynesians always tend to forget about the latter, and how it is affected by the quantity of money (which is a symptom of their Wicksellianism and their general reluctance to model budget constraints). That’s why you should always think in terms of the excess cash balance mechanism, which determines nominal income more generally.

  4. As for the argument from war spending, that in turn is a symptom of the fact that Keynesians under pressure revert to “real” Keynesianism, dropping the rigor that Lucas and Sargent had drummed into them and repeating old fallacies – “back to Samuelson”, as it were.

    And is there a more potent example of the destructiveness of “two-party arrangements” in political disputes than in the framing of the macroeconomic stabilization debate as being between Keynesians and “Classicals” (AD-deniers)?

  5. “And to all those hundreds of economists’ monetary policy cannot do much!”

    That’s a bit of a stretch. Krugman and Layard request those who “agree with the broad thrust of this Manifesto” to sign and it’s clear from the comments that some signed in that spirit. For example:

    “Monetary policy across the G10 should be working far more aggressively to counteract the deflationary impact of fiscal contraction.” — Ray Farris

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