Sunday, May 5, 2013

The Paul Krugman Two-Step

I have argued before here at EPJ that NYT columnist Paul Krugman seems to be able to think only two steps deep in economics and then fails to take into account any factors that require deeper thought. It is not clear whether Krugman does this all the time because he has trouble thinking more than two steps deep, or if he has an agenda that makes it convenient for him to only argue two steps deep. I suspect it is a little of both.

Krugman's recent column at NYT provides a good example of my point. He writes in a column titled, Not Enough Inflation:
Ever since the financial crisis struck, and the Federal Reserve began “printing money” in an attempt to contain the damage, there have been dire warnings about inflation — and not just from the Ron Paul/Glenn Beck types.

Thus, in 2009, the influential conservative monetary economist Allan Meltzer warned that we would soon become “inflation nation.” In 2010, the Paris-based Organization for Economic Cooperation and Development urged the Fed to raise interest rates to head off inflation risks (even though its own models showed no such risk). In 2011, Representative Paul Ryan, then the newly installed chairman of the House Budget Committee, raked Ben Bernanke, the Fed chairman, over the coals, warning of looming inflation and intoning solemnly that it was a terrible thing to “debase” the dollar.

And now, sure enough, the Fed really is worried about inflation. You see, it’s getting too low. 
It’s not hard to see where inflation fears were coming from. In its efforts to prop up the economy, the Fed has bought more than $2 trillion of stuff — private debts, housing agency debts, government bonds. It has paid for these purchases by crediting funds to the reserves of private banks, which isn’t exactly printing money, but is close enough for government work. Here comes hyperinflation!

Or, actually, not. From the beginning, it was or at least should have been obvious that the financial crisis had plunged us into a “liquidity trap,” a situation in which many people figure that they might just as well sit on cash. America spent most of the 1930s in a liquidity trap; Japan has been in one since the mid-1990s. And we’re in one now.
There are a few problems with this narrative, The first problem is that Krugman, like most Keynesians, believes that because of the so-called "liquidity trap," money must be printed to create price inflation to "get the economy going."

Anyone who holds this position simply can't believe that supply and demand in a free market will cause market clearing prices. But this is absurd. If consumers, or corporations desire to hold larger cash balances, prices would simply adjust to the new lower price level and products would clear. To be sure such a price deflation would cause pain to those holding debt and it may cause some to file for bankruptcy, but the alternative, more money printing, will simply distort things in favor of those who get newly printed money first. Thus, during the downturn of the government central bank caused business cycle, it is not a case that there won't be pain, but who will suffer the pain. By calling for more money printing, Krugman is calling for what will help out the powerful, government connected banksters and other cronies, who benefit from inflation (monetary and price). He doesn't even consider the alternative, which would be for the Fed to stop printing money and letting the markets force the liquidations of the malinvestments and eliminate the business cycle forever.

Krugman also seems to focus on the amount of super money (the monetary base) that the Fed has printed, rather than how much has been getting into the system.

Since the start of the crisis in 2008, we have seen some strong growth in the monetary base, though with something of a roller coaster rhythm to the growth, as can be seen in the chart below.

But, money supply (M2) growth, for the same period, has been a lot slower and even more erratic than the monetary base, as can be seen in this chart:

The difference in the growth of the monetary base versus the growth in the money supply is something   Krugman does not discuss at all. He simply implies that a lot of money has been printed, has entered the system, but has not caused price inflation. He writes: 
In its efforts to prop up the economy, the Fed has bought more than $2 trillion of stuff — private debts, housing agency debts, government bonds. It has paid for these purchases by crediting funds to the reserves of private banks, which isn’t exactly printing money, but is close enough for government work. 
Well it may be good enough for government work and Krugman work, but it isn't for the EPJ Daily Alert.  I regularly point out in the ALERT that there is a big difference between the monetary base (which Krugman alludes to) and the money supply. This is important because since the financial crisis, and since Bernanke has started paying interest on reserves, excess reserves are just being put by banks back on deposit at the Fed. The money is no getting into the system. Here's the chart on excess reserves.

The data above goes back to 1950, it shows that until the recent crisis, banks hardly parked any money at the Fed  as excess reserves. It has certainly changed since!

According to the latest data from the Fed, $1.7 trillion is sitting as excess reserves and, thus not in the system.

Thus, while Krugman talks about the Fed buying "more than $2 trillion of stuff," he again fails to go deeper and point out that of that $2 trillion, $1.7 trillion is back at the Fed and not in the economy bidding up prices. In fact, while the monetary base since the start of 2008 has climbed by 170%, the money supply (M2) has grown by only 41%.

Now, it is one thing for Glen Beck and Ron Paul not to understand all the deep technicalities of money growth, but you have to wonder about a Nobel Prize winning economist, such as Krugman, who puts out a column pointing out that the Fed has printed  nearly $2 trillion, but then fails to note that most of this money is sitting at the Fed, that it is not bidding up prices, but that it is like a pack of mountain snow that could pour into the economy like an avalanche, at any time.

The erratic up and down growth in money supply under Bernanke is what is making the exact timing of price inflation difficult to predict. It is not, as Krugman implies, a simple case of Bernanke printing money and it not having an impact on the economy. If that money comes flying out of excess reserves, price inflation will heat up faster than the time it will take you to come up with the names of Krugman's two cats.

If the Fed at that time attempts to slow the flow of excess reserves, it will have to raise rates dramatically and crash the economy. At present, the Fed continues to aggressively add to the monetary base by making additional purchases of agency mortgage-backed securities at a pace of $40 billion per month and longer-term Treasury securities at a pace of $45 billion per month. BUT most of this is ending up as excess reserves.

Money supply (M2) growth, according to the Fed's own numbers, shows a decline from 6.9% over the last 12 months to 2.0% annualized growth over the last three months.

I calculate the numbers a bit differently in the ALERT. According to my numbers, three month annualized growth peaked around the first of the year at 11.4% and is now down to 3.96%.  If this slowdown in money growth continues, we are likely to have another stock market crash within months.

It is instructive that Krugman does not focus on the possibility of this stock market crash. It is a case of him not thinking deep enough, again. He just doesn't get that the stock market has been fueled by the earlier aggressive money printing, which resulted in annualized quarterly growth of 11.4% in money supply and that the latest slowdown in money growth will cut off the booming stock market. That is, he doesn't understand the business cycle. For him, it is limited thinking about a boom in overall price inflation to get the economy going, without understanding that where the money goes is as important to understanding an economy as the amount of money the Fed prints and the price inflation ramifications.


  1. NYT highlighted this comment:

    Diana Moses - Arlington, MA
    NYT Pick
    I am willing not to call it inflation, but my cost for the same basket of goods and services has gone up, and continues to go up. I don't want to hear "newspaper subscriptions are different," "food doesn't count," "wear a synthetic sweater instead of wool," "insurance increases are regulated," "get a new-customer deal from a new internet service provider," "stop taking the bus and walk instead," "buy a different brand of boots," and so on, as each example is rejected as technically not evidence of inflation. If I try to keep doing the same things, I pay more. If that's not inflation, then can we give it a name of its own and then talk about it? I am not arguing that we have the run-away inflation we are being warned to be alarmed about, but what I am experiencing I would not call very low inflation, either. If the term inflation becomes too much of a term of art, then what are we really talking about? Have we divorced the discussion from the reality?

  2. "If that money comes flying out of excess reserves, price inflation will heat up faster than the time it will take you to come up with the names of Krugman's two cats."

    I do agree that Kruman does not understand the monetray system.