Saturday, November 17, 2012
The difference between Sumner and Krugman on liquidity traps
Daniel Kuehn and Robert Murphy wonder why Scott Sumner takes Paul Krugman to task on liquidity traps when they each seem to be saying the same thing - monetary expansion will get you out of a trap.
The phrase "monetary expansion" can mean many things. I think Krugman and Sumner have categorically different opinions concerning one specific sense of the phrase – quantitative easing's ability to have independent effects in a liquidity trap, .
When it comes to thinking about monetary policy, Krugman, Delong, Eggertson, Woodford, and other New Keynesians begin with a frictionless model populated by rational agents. No individual has the power to set prices and everyone can attain any quantity of assets at a given price. There is no limit on borrowing. With these assumptions and interest rates at zero, quantitative easing is powerless. That's because all asset prices are uniquely determined by the present value of their future cash flows. A central bank that threatens to buy bonds/stocks/gold so as to push their prices above their fundamental value will be unable to do so. All central bank purchases will be met with a wave of hedge funds sales (and short sales), thereby ensuring that the prices of these assets stay at their fundamental value. QE can't get any traction, so it's irrelevant.
On the other hand, Sumner, Nick Rowe, Miles Kimball, and others attribute an independent effect to quantitative easing. This is because they either explicitly or implicitly do not accept the assumptions of the frictionless model used by Krugman et al.
The market monetarist's departure from the assumptions of a frictionless model begins with the colourful idea of Chuck Norris walking into a room and telling everyone to get out. If they don't, he'll beat them up. Because his threat is credible, people file out of the room without Chuck Norris having to lay a finger on them. Now take a central bank that threatens to move up prices through large scale asset purchases. Hedge funds refusing to accept the threat will be pummeled by the central bank. Rather than resist, hedge funds cry uncle. Asset prices rise above their fundamental value because Chuck Norris says so. That's how QE gets traction.
So the difference between New Keynesians and market monetarists seems to rest on a few assumptions. In a frictionless model, hedge funds will undo the effects of central bank purchases. In a market monetarist model, hedge funds can't beat Chuck Norris and QE has bite. It'll be a long time before Krugman and Sumner agree on the specifics.
Nick Rowe, Miles Kimball (here, here and here) , Michael Woodford (pdf), Paul Krugman (and here). See my old posts Don't fight the Fed and QE Zero.