The Pigou Effect

The Pigou Effect (Double-super-special-wonkish) by Krugman

Via Brad DeLong, Robert Waldmann weighs in on the contributions or lack thereof of Milton Friedman, arguing that much of what he said was already there in Samuelson and Solow 1960. Actually, I’d give him more credit than that; the S-S paper — very unusually for both men, and for Bob Solow in particular — is one of those pieces sometimes described as “rich”, with many points alluded to but not many takeaway lines; to the extent that people did take something away, it was the crude notion of a usable downward-sloping Phillips curve, which turned out to be wrong.

Friedman — like Solow, in most of his work — was in the habit of writing crisp papers with very clear morals. So while you can,on a careful read, see from S-S why you should not in fact trust the Phillips curve to be stable, people didn’t actually get that until Friedman and Phelps laid out the point with stark clarity. Credit where credit is due.

Oh, and yes, I modeled my own intellectual style after Bob Solow’s (and Rudi Dornbusch, who was in the same tradition).

What caught me in the Waldmann piece, however, was the brief discussion of the Pigou effect, which supposedly refuted the notion of a liquidity trap. The what effect? Well, 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.

And that’s where I came in (pdf). Looking at Japan in 1998, my gut reaction was similar to those of today’s market monetarists: 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.

But what I did was a little different from what the MMs have done this time around: 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. [If you have no idea what I'm talking about, you have only yourself to blame -- I warned you in the headline]. 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.

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. Of course, you can invoke various kinds of imperfection to soften this result, but in that case it depends very much who gets the windfall and who pays the taxes, and we’re basically talking about fiscal rather than monetary policy. And it remains true that monetary expansion carried out through open-market operations does nothing at all.

In the simple model, the only channel through which money can operate when you’re against the zero lower bound is by changing expectations of future inflation. And that’s hard to do.

The main point, however, is that we are a very long way from classic monetarism, of the form that says that the central bank can control broad monetary aggregates like M2 at will, and in turn that these broad monetary aggregates determine the course of the economy. That’s not at all true when you’re up against the zero lower bound — which is why Friedman’s analysis of the Great Depression was wrong, and one reason (the other is the madness of the GOP) why modern Friedmanites are a very small group with no real constituency.

So what Bernanke recommended to the Bank of Japan was fiscal policy not monetary policy. So strictly speaking the central bank can do more, it's just that open-market operations do nothing.