Does market monetarism exist in reaction to fiscal stimulus?

I kind of went on a rant in response to a comment where I said something that I think crystallizes something:

[Market Monetarism (MM)] seems like a theory made up solely for the purpose of justifying not doing any fiscal stimulus. It has very little use besides that purpose ...

Sounds harsh, right? But let's look at some history.

• The ARRA passed the US House on Jan 28th, 2009 (it passes the Senate in February) [0].
• Scott Sumner started his blog on Feb 2nd, 2009. That's the Monday after the ARRA passes the House. His first post was a declaration that monetary policy was effective.

A pretty startling coincidence, right? Sumner is linked to by Tyler Cowen on Feb 25th (which causes him to blow up) because Cowen is on the lookout for any links that say fiscal stimulus doesn't work. My intuition for why Sumner blows up on the Internet is that Sumner and what becomes MM are a very good post hoc rationalization of people who read MR and are already opposed to fiscal stimulus (or maybe just Obama). Nothing goes viral like stuff that gives you a reason to hold on to your existing beliefs. In an unsurprising turn of events, Sumner later decides to leave Bentley and join Cowen at Mercatus.

As my wife would say: market monetarism exists in reaction to fiscal stimulus [1].

So the timing is right. What about the content?

Well that initial blog post from Sumner consisted of simply a declaration that monetary policy was effective.

Premise 1: The only coherent way of characterizing monetary policy as being either too”easy” or “tight” is relative to the policy stance expected to achieve the central bank’s goals. 

Premise 2: “Monetary policy can be highly effective in reviving a weak economy even if short-term interest rates are already near zero.” 

Premise 3: After mid-2008, and especially in early October, the expected growth in the price level and nominal GDP fell increasingly far below the Fed’s implicit target.

It adds in that it's not just that monetary policy is effective, but caused the recession. You have to logically include that: if the Fed can control NGDP and P, why did we have a recession? Because the Fed let expected NGDP fall ... it let the recession happen. It still controls it, just badly.

MM as a theory only addresses the price level P, nominal output NGDP (and thus real output RGDP = Y = NGDP/P), nominal wages (note that 2.1 NW ≈ NGDP to a very good approximation, so this isn't necessarily an independent measure) and unemployment U. Exchange rates and stock market are seen as indicators for expected NGDP and P, so they're not independent measures.

The musical chairs piece is just a mechanism for NGDP to affect unemployment. Wages have to be sticky, otherwise monetary policy has no effect. Thus wages are sticky is equivalent to saying the Fed controls NGDP and P (i.e. nominal changes have real effects). It is also equivalent to saying NGDP shocks are the cause of unemployment.

Expected NGDP and P are controlled by the Fed, so therefore the Fed controls the LHS of

NGDP = C + I + G + NX

And the RHS is just a "waste of time" (another early post from Feb 23rd, 2009). It's an accounting identity so you can't say G →G + dG means NGDP → NGDP + dG. Something has to fall like I or C.

That is to say MM consists of just the pieces of 1960s monetarism necessary to tell us why fiscal policy is ineffective demand management. There are no other pieces or implications [2]. That's why I said what I said in my rant. If you think MM is "new", it's really only new in its elevation of expectations. Old monetarists thought expectations had an effect, but did believe you had to actually print money sometimes. They were asymptotic "people of the concrete steppes". In fact, the reason why old fashioned monetarism didn't have Green Lantern expectations (i.e. sheer willpower on the part of the central bank can bring about price level, inflation or NGDP targets) was probably because they thought the idea unrealistic.

My rant was itself in reaction to a comment that asked why I go after Sumner so much. It's because the emperor has no clothes. He is the "head" of an economic "school" that would not exist without the liquidity trap argument for fiscal stimulus. And the reaction to the liquidity trap argument is to say: "nuh-uh". Quite literally, MM just repeats back the empirically invalid premise the liquidity trap argues against. MM simply reminds us of why macroeconomics needed the liquidity trap argument to say fiscal stimulus could work in the first place.

Economist 1: The central bank sets inflation through expectations of monetary policy. 

Economist 2: But that is inconsistent with data from Japan.  

Krugman: What if there is a liquidity trap where it becomes difficult to generate inflation with monetary policy?  

Sumner: There is no liquidity trap. The central bank sets inflation through expectations of monetary policy. 

Economist 2: Weren't you listening to the conversation? We already said that but that's inconsistent with Japan and now the US.

Sumner: Nuh-uh. It's just not a true Scotsman, I mean, inflation target. They just didn't want it enough.

Now one might say the liquidity trap argument exists in reaction to monetarism. But the modern form of it actually exists as an attempt to explain Japan's lost decade(s) ... and why monetary policy seems ineffective there. Unlike for MM, the timing is off. Monetarism had existed for decades and was basically incorporated into so-called "New Keynesianism". The liquidity trap argument exists in reaction to data.

How does MM explain Japan's lost decade(s)? By saying the BoJ is did it on purpose. There's no mystery to ineffective monetary policy. This explanation of Japan is mentioned a couple weeks after Sumner starts his blog:

... to call [the situation in Japan] a “trap” one would have to assume that the BOJ sincerely wanted to end the deflation. Unfortunately, there is no evidence (in their behavior) that they did.

This also explains the antipathy between Scott Sumner and Paul Krugman, the primary popular proponent of the modern liquidity trap argument. MM and the liquidity trap are like matter and antimatter; each is the negation of the other. The liquidity trap argument says it is too hard for the central bank to set expectations; MM says it's easy (if you really want to). At least when the natural rate of interest is negative -- Krugman and Sumner are generally in agreement when the natural rate is positive. That's because MM is basically the parts of 1960s monetarism that were not obviously inconsistent with data (like constant velocity) and were picked up by New Keynesianism.

The best response when any market monetarist argument is: Yes, we know. But that turned out to be inconsistent with the data unless you ignore central banks' public statements on the stance of monetary policy.

Which is why Sumner says NGDP determines the stance of policy, not central banks' public statements. The Fed or BoJ can say it's targeting 2% inflation, but apparently it doesn't mean it unless it shows up in NGDP.

So in summary market monetarism:

• Starts in response to the Obama stimulus (ARRA)
• Is spread by the right-leaning/libertarian econoblogosphere 
• Consists of only the tenets of 1960s monetarism needed to say fiscal stimulus is ineffective
• Is exactly what the 1990s liquidity trap argues doesn't work
• Doesn't have any other consequences [2]

It's the immune reaction to an infection of Keynesianism that lets people keep thinking government spending is bad [3].

Although on a much smaller scale, it's analogous to the resurgence of mysticism and mysteries in the Catholic Church in reaction to the reintroduction of Greek logic to Europe. Yes, the stories and the magic tricks seem illogical, but it's a mystery unknowable by mortals! The wine is turned into blood during the Mass, but still tastes like wine because ... mystery! I wrote about this more on my old blog. But the conclusion there was that such theories, whether religious or political, do not fail when faced with logic or data.

This last piece gives me pause. In writing this blog post on my flight home from a work trip, it has dawned on me that this means MM probably wouldn't be assailable by logic because it's not really about theory or understanding the world. It's a reaction to a theory and a defense against understanding of the world.

So this will be my last post on Scott Sumner and Market Monetarism. In the future, I'll just link back here or the many other posts that take it on (in the process of which I learned a lot) in response to questions about it. I encourage its followers to look deeply into themselves and ask: What do I really want out of market monetarism? When you ask yourself this, remember that confirmation bias is a heck of a drug. If you just want comfort about the state of the world, that's fine! For some people religion has that effect. But if you're genuinely trying to figure out how macroeconomics works, you should accept the fact that macroeconomics is not well understood. No one really knows how central banks interact with the macroeconomy. 

PS I'll still argue with Nick Rowe though because that's usually about math or specific traditional macro models.

...

Footnotes:

[0] There is a possibility that Sumner started his blog after Paul Krugman made his famous "dark ages" swipe at Chicago macro (a day before the ARRA passes the House). The subject is still fiscal stimulus, so that wouldn't necessarily change the main thrust of this post. 

[1] My blog exists in reaction to Noah Smith saying macroeconomics doesn't work. I started it a week after this post.

[2] Ok, so there's not zero additional implications of MM. Sticky wages mean that things designed to "artificially" (I.e. not with monetary policy) raise wages won't work. But that's really just a restatement of the thesis that fiscal policy is ineffective. Sumner adds that taxing wages is contractionary because of sticky wages, but that can't really be true because that is fiscal policy. It would stand to reason that sticky wages implies tax cuts would be expansionary (about half the ARRA was tax cuts).

But wage tax increases is contractionary fiscal policy! MM exists in reaction to fiscal stimulus! So therefore, wage taxes are contractionary, but somehow wage tax cuts aren't expansionary (because the Fed controls expected NGDP).

So these extra implications are either redundant or confused. Potentially both.

[3] MM is also the last gasp of Milton Friedman's "compromise": government bureaucrats are inept, but the central bank (run by government bureaucrats) doesn't have to be.