By Nathan Tankus, a student and research assistant at the University of Ottawa. He is currently a Visiting Researcher at the Fields Institute. You can follow him on Twitter at @NathanTankus
Mainstream economic discussions employ a false dichotomy. At one “extreme” you have Austrian economists who believe the current Federal Reserve policy is (or should be) causing inflation, malinvestment, and all sorts of other maladies. They think the nominal interest rate set by the Fed is too low and should be raised (For this post I will take the “Austrian position” as the one argued by Hayek in the early 1930s. This rendition is favorable to the Austrians because it is the most coherent and reasonable version of this theory I have seen). At the other “extreme” you have Paul Krugman and “New Keynesian” company, who argue that the nominal interest rate set by the Fed is too high and should be lowered in some way. Further Krugman argues that since the nominal interest rate is already near zero (the dreaded “lower zero bound”), one should use fiscal policy and/or inflation expectations to increase output and thus employment. To the causal observer who is unfamiliar with the history of economic thought, these two positions seem diametrically opposed. They, in fact, are not.
Let us begin with what they agree on:
A central bank that sets a short term interest rate
In contrast with monetarists of many stripes, both camps argue that the short term interest rate (the “Fed funds” rate in the United States) is set by the central bank (In the U.S., the Federal Reserve). This is a major point of agreement. Many more economists (Milton Friedman for a time) believed that they can and should have money supply targets. Whether they think this target is a necessity is another issue (I suspect they do not). However, the case remains that this has generally been a minority position in the history of economic thought, although it is correct.
Money is an endogenous, not an exogenous variable
It follows from the argument that central banks set a short term interest rate that they control the price of settlement balances (sometimes called “reserves” ) and not their quantity. On this Hayek is very clear:
Elasticity in the credit supply of an economic system, is not only universally demanded but also — as the result of an organization of the credit system which has adapted itself to this requirement — an undeniable fact, whose necessity or advantages are not discussed here. (page 178 [mises.org/document/680/ ]. see also page 172).
Krugman on the other hand, is often less clear. He defends IS-LM which contains the assumption that an increase in settlement balances will increase the supply of loans and thus economic activity at all points except the “liquidity trap” (more on this later). On the other hand, he has also acknowledged that the views of those who actually control monetary policy contradict this view:
It’s instructive, in particular, to read the minutes of Federal Open Market Committee meetings, which clearly show that monetary policymakers pay little attention to monetary aggregates, and are instead attempting to use discretionary changes in interest rates to stabilize the economy. In the minutes for the 11 December 2007 FOMC meeting, for example (Federal Reserve, 2007), there is extensive discussion of the economic outlook and the possible need for interest rate cuts. There is only one mention of a monetary aggregate — and M2 is treated as an endogenous variable, an indicator of shifts in the ﬁnancial markets, rather than as a target. (Krugman 2008 [http://www.sciencedirect.com/science/article/pii/S030439320800069X])
This again is contrary to monetarist dogma (that article was in fact a response to an attack from Milton Friedman’s lesser known – but still prominent – co-author Anna Schwartz. As an aside, a statement this clear makes his argument with Steve Keen and company last year puzzling.
A belief in a “natural” rate of interest that generates a full employment “equilibrium”
Both Krugman and Hayek have argued quite consistently that there was a “natural rate of interest” which according to Krugman is “the rate of interest that would match desired savings with desired investment at full employment. “ Hayek makes the same argument in his writing. This interest rate is not the interest rate set by the central bank, indeed it is not an interest rate set on any market. It is a hypothetical interest rate which we will finally know if or when full employment returns.
Disagreeing over the number of angels on a pin
The reader must now be asking, what do they actually disagree on? The answer is a little discussed but crucial point – what distinguishes these two groups – here represented by Friedrich von Hayek and Paul Krugman – economic views is not really their analytical framework but different beliefs about variables in their model.
As noted above, they both agree that there is a natural rate of interest. Their disagreement is over its precise value. In short, Hayek believes the natural rate of interest was positive, while Krugman believes it is negative. It must be emphasized that this concept is completely unmeasurable. It is as much a figment of their imaginations as aliens or ghosts are of the supposedly “Crazy”.
Like astrologists, they even have their favorite measurable variables to tell them what is happening to their invention. Hayek for example says:
…this additional demand [for credit] is always a sign that the natural rate of interest has risen that is, that a given amount of money can now find more profitable employment than hitherto.
Krugman meanwhile points in the opposite direction:
Look, the natural rate of interest (like the natural rate of unemployment) needs to be assessed on a PPE basis — that’s “proof of the pudding is in the eating”. If the economy is depressed due to inadequate demand — and it is — then that fact tells you that the natural rate is below, not above, the market rate.
Both of these positions are quite defensible in terms of the theory by making small adjustments or even emphasizing a different portion. As Hyman Minsky said nearly thirty years ago :
These results indicate that the Walrasian general equilibrium framework is useless as a basis for macroeconomic analysis. In the hands of a skilled practitioner auxiliary propositions can be introduced into the general equilibrium framework to yield well nigh any desired result even as the basic framework cannot assimilate money.
Thus the Austrians and the “New” Keynesians should not be treated as bitter enemies but close cousins. Given that the conclusions Krugman comes to regarding “progressive” policies are all based on his beliefs about unmeasurable and hypothetical inventions, it would be wise for the left to avoid relying on Krugman for intellectual defenses of their pet policies. Or at least pray the natural rate of interest in his mind doesn’t rise.