“Paul Krugman has famously argued that the BOJ can’t inflate, because any commitment to inflate wouldn’t be believed” – Scott Sumner (HT Benjamin Cole).

Long ago, Krugman wrote about Japan:

In short, approaching the question from this high level of abstraction already suggests that a liquidity trap involves a kind of credibility problem. A monetary expansion that the market expected to be sustained (that is, matched by equiproportional expansions in all future periods) would always work, regardless of whatever structural problems the economy might have; if monetary expansion does not work, if there is a liquidity trap, it must be because the public does not expect it to be sustained.

More recently (2008) he took a leaf from another long ago piece to say, now in reference to the US:

The whole subject of the liquidity trap has a sort of Alice-through-the-looking-glass quality. Virtues like saving, or a central bank known to be strongly committed to price stability, become vices; to get out of the trap a country must loosen its belt, persuade its citizens to forget about the future, and convince the private sector that the government and central bank aren’t as serious and austere as they seem.

And a little less than two years ago he wrote:

Yes, America has long-run budget problems, but what we do on stimulus over the next couple of years has almost no bearing on our ability to deal with these long-run problems. As Douglas Elmendorf, the director of the Congressional Budget Office, recently put it, “There is no intrinsic contradiction between providing additional fiscal stimulus today, while the unemployment rate is high and many factories and offices are underused, and imposing fiscal restraint several years from now, when output and employment will probably be close to their potential.”

It seems to me there is a huge inconsistency in the argument summarized by the Elmendorf quote above. At the same time Krugman and Keynesians in general are saying that monetary policy cannot get the economy out of a “liquidity trap” situation because of credibility questions, it is saying that fiscal policy, which does not suffer from that constraint, can!

But time-inconsistency questions affect both. Since Keynesians are “hooked” on the short run (“In the long run we´re all dead”), who would consciously believe that “fiscal restraint will be imposed several years from now…”? What if another recession happens? Do you think they´ll keep their promise to be austere, just because the deficit from the previous fiscal stimulus is still high? Most certainly not and in that case America would only increase its long-run budget problems so no recovery would be forthcoming today!

Bernanke made a bad move earlier this year when he made the 2% inflation target official. He tied his hands, but note that he did so voluntarily. Old fox Greenspan never accepted falling into that “trap” (and while a Fed Governor Bernanke promoted internal discussion on the matter). In that case, being “credibly” expansionary, even if you don´t mention things like a “temporarily higher inflation target”, doesn´t fly!

As Nick Rowe just wrote on the importance of expectations:

Recessions are always and everywhere a monetary (medium of exchange) phenomenon. Recessions are an excess demand for money (the medium of exchange). The demand for money is the demand for an asset. Since the demand for money, like the demand for all assets, depends very much on expectations, especially when interest rates are low, recessions depend very much on expectations too, especially when interest rates are low.

It appears the solution, once again, is to change the monetary policy target. In the wings, garnering new adepts by the month, NGDP Level Targeting. It´s much better and credible than Krugman´s oft-suggested Central Bank commitment to be “irresponsible”.