Reply to Brad (Part II) – Pigou, Haberler, Friedman v Hicks, Hansen, Krugman

I agree with Brad DeLong that Paul Krugman has correctly diagnosed most of the big global economic calls since the mid-1990s. My beef is with his policy prescription.

The issue at stake is how to get out of a liquidity trap – or, what to do when rates are close to zero.

This (double-super-special-wonkish!) Krugman blog gets to the heart of the matter. It’s about the Pigou effect, or what should be called the “Pigou-Haberler-Friedman” effect.

If you remember the Pigou effect you will probably think it trivial. It’s the idea that deflation raises demand because the value of real balances (money) rises. That’s the straw man version. The Haberler-Friedman version is much more powerful – and obviously true: If there is no inflation and the central bank prints money and transfers it to households, private sector wealth rises (money is a component of wealth), and so does demand.

This is why Friedman argued correctly in his famous 1968 address that monetary policy works at the near-zero bound  or in a “liquidity trap”.

We have to be very clear about what Friedman and Haberler  argue. Open-market operations (or QE) don’t work because: 1) interest rates can’t fall any further, and 2) net private sector wealth is unchanged – the private sector loses a bond and gains money. But expanding the monetary base by making transfers to the household sector is totally different: net household wealth rises. It’s obvious that Friedman and Haberler are right. So why did everyone ignore them, and why does Krugman dismiss the “Pigou-Haberler-Friedman” effect?

Krugman’s initial instincts on this were right. He says:

“Pigou claimed that even if interest rates are up against the zero lower bound, falling prices will be expansionary, because the rising real value of the monetary base will make people wealthier. This is also often taken to mean that expansionary monetary policy also works, because it increases money holdings and thereby increases wealth and hence consumption.

I was sure that the Bank of Japan could reflate the economy if it were only willing to try. IS-LM said no, but I thought this had to be missing something, basically the Pigou effect: surely if the BoJ just printed enough money, it would burn a hole in peoples’ pockets, and reflation would follow.”

So far, so good. Then Krugman takes an odd detour:

“I set out to prove my instincts right with a little model, a minimal thing that included actual intertemporal decisions instead of using the quasi-static IS-LM framework. … And to my considerable surprise, the model told me the opposite of my preconception: there was no Pigou effect. Consumption was tied down in the current period by the Euler equation, so if you couldn’t move the real interest rate, nothing happened.”

Not the consumption Euler equation again! Don’t worry if you don’t know what it is: it captures the very simple idea that when interest rates fall we save less (and consume more). Now there are very good reasons in fact why this effect is neutered at low rates, as I have discussed here. But that is not the key point. Increases in net wealth always raise consumption – there is no model that says otherwise: why would anyone save more if their wealth rises? (If you want chapter and verse on the Euler equation, and why an increase in net wealth increases consumption in all periods, Nick Rowe spells it out.)

Krugman then introduces a second argument:

“One way to say this — which Waldmann sort of says — is that even a helicopter drop of money has no effect in a world of Ricardian equivalence, since you know that the government will eventually have to tax the windfall away.”

What?! Since when did we care about Ricardian equivalence, and even if we did, it’s not relevant to base money-financed spending.

I have argued at length (as have Nick Rowe, Willem Buiter, Paul de Grauwe and Simon Wren-Lewis) that base money is not a debt – so Ricardian equivalence does not apply. Even without Ricardian equivalence, you might argue that the windfall might be reversed at some point in the future. But this is a terrible argument. First of all, there is “Keynesian uncertainty”: no one knows when or if an expansion of the monetary base in a recession will be “reversed”. So no one knows what future taxation will look like. Many people don’t care, because they have more pressing needs. Either way, all the empirical evidence suggests that cash payments to households in a recession or under deflation will boost demand. By how much is contentious – but if you are at all worried about “balance sheet recessions” you don’t mind if cash is used to repay debt, you just do more.

But there is a more fundamental point. The beauty of all aggressive counter-cyclical policies is that they self-fund. We saw that with the Fed’s intervention during the crisis. It would be the same with helicopter drops in a recession: the government’s balance sheet is likely to come out looking stronger. This is the opposite of self-defeating austerity. It is entirely reasonable to expect your own circumstances to be better in the future if your central bank can act effectively and promptly to shorten recessions and strengthen recoveries. That is the real meaning of “confidence”.

Superficially, I can see why Krugman wants to argue that the central bank needs to raise inflation expectations – he wants to raise demand by getting the real interest rate down. But central banks cant just do that by aggressively making no change to the net wealth of the private sector! And the consumption Euler equation may well be broken as we approach zero – lower real rates may prove counter-productive.

But there is a much simpler, more reliable alternative, which raises demand directly: the Pigou-Haberler-Friedman effect. And it works. Brad DeLong has advocated “social credit”, as has Simon Wren-Lewis. We need Paul Krugman too.

About The Author

Eric Lonergan is a macro hedge fund manager, economist, and writer. His most recent book is Supercharge Me, co-authored with Corinne Sawers. He is also author of the international bestseller, Angrynomics, co-written with Mark Blyth, and published by Agenda. It was listed on the Financial Times must reads for Summer 2020. Prior to Angrynomics, he has written Money (2nd ed) published by Routledge. He has written for Foreign AffairsThe Financial Times, and The Economist. He also advises governments and policymakers. He first advocated expanding the tools of central banks to including cash transfers to households in the Financial Times in 2002. In December 2008, he advocated the policy as the most efficient way out of recession post-financial crisis, contributing to a growing debate over the need for ‘helicopter money’.

3 Responses

  1. CMA

    Another respect in which heli drops are superior is that they generate less portfolio rebalancing and credit than rate targeting and QE. As a result the financial sector growth will grow less because it underpins credit and portfolio flows. A smaller financial sector should result in higher real gdp. Lower credit and portfolio flows should also translate into more stability.

  2. Horacio Schreyer

    Krugman has been advocating about the usefulness of the original Hicks article of 1937, as a proper stylized model of Keynes ideas about monetary policy; which due to the fact that it had been taught for several years, is particularly fit for wide public discussion.
    No wealth effect was included by Hicks there. Hence at least since his own 1998 paper that you quote, Krugman adopted a cash-in-advance scheme to introduce money within a very simple inter-temporal approach, and then cross-check its results.
    I think there cannot be objection with that; I mean, considering money just as a way for commodity exchange, not less that alternatively, one might add the ability of money as a store of value, and thus part of non-government aggregate wealth, which incidently would underline that money is government debt, albeit not redeemable.
    If you agreed with this, it would be immediate to conclude that there is no need to allow a central bank to give grants directly to people, instead of doing that from the government treasury, which by the way is already entitled to do so. What it is needed then is only that the central bank buy the bonds issued to finance those grants.
    I understand your concern about the political implications of your proposal about enabling “helicopter money” in terms of avoiding unnecessary musings to boost the economy promptly, but I think that has nothing to do with a model’s elegant assumptions addressed to make a point, which in this case is that even without positive wealth effects coming from deflation, there is a way to return to equilibrium by means of achieving an expected negative real rate of interest under the firm commitment of steady & cumulative money creation for a sufficient number of periods.

    • Eric Lonergan

      Horacio, I think we are in agreement here, in the sense that theoretically I see no difference between creating new base money and giving it to the government to spend, and creating new base money and giving it to households to spend. My preference for the latter is institutional – I want the central bank to have control over base money, and I think it is probably preferable to allow households to make the spending decisions in recessions, because they know what they need. My argument with Krugman however is that he believes in magical inflation expectations controlled by policymakers. And he thinks raising inflation expectations is the best way of dealing with demand deficiency. I don’t. I think CBs can just create demand.


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