Scott Sumner on the Princeton School of Macroeconomics and Overcoming Inflationary Fears

Episode Summary

Executive Summary: Scott Sumner and David Beckworth trace the Princeton School of Macroeconomics—Krugman, Bernanke, Woodford, Eggertsson, and Svensson—and its lasting influence on modern zero-lower-bound policy. The discussion centers on liquidity traps, credibility, level targeting, and why central banks often fail to generate expected inflation despite large balance-sheet expansions.

Main Topics: The Princeton School of Macroeconomics (Priority: 5/5): Sumner argues that a group at Princeton in the early 2000s helped define the modern consensus on monetary policy at the zero lower bound, shaping average inflation targeting, price-level/NGDP level targeting, and credible forward guidance. Krugman’s 1998 liquidity trap paper (Priority: 5/5): The conversation treats Krugman’s 'It’s Baaack!' as foundational: it reframed the liquidity trap as an expectations problem and showed that sustained monetary expansion can work if the public believes it will be permanent. Credibility and the permanence problem (Priority: 5/5): A central theme is that monetary stimulus must be seen as permanent and policy-makers must credibly commit to future higher inflation or a higher target path; temporary QE alone is insufficient. Bernanke, Woodford, and Eggertsson extensions (Priority: 4/5): Later Princeton work extended Krugman’s logic into New Keynesian models and historical applications like the Great Depression, emphasizing level targeting, devaluation, and regime change as solutions to low-rate traps. Svensson and the 'foolproof' escape from a liquidity trap (Priority: 4/5): Svensson’s work on exchange-rate targeting in Japan illustrates that a successful expansionary regime can require higher nominal rates immediately, underscoring that interest rates alone are a misleading policy indicator. Average inflation targeting and the Fed in 2021 (Priority: 4/5): The discussion connects the Princeton ideas to the Fed’s new average inflation target, with Sumner cautiously optimistic that it could produce more systematic makeup policy if the Fed follows through. Political economy of central bank caution (Priority: 4/5): Both speakers emphasize that advanced-economy central banks have persistently undershot inflation because of institutional conservatism, past lessons from the 1970s, and reluctance to 'be irresponsible' enough to raise expectations.

Key Arguments: Krugman’s 1998 paper did not just describe a liquidity trap; it redefined it as an expectations trap, where the core issue is whether the public believes future monetary expansion will be sustained. A monetary expansion at the zero lower bound only works if it is perceived as permanent; temporary increases in the base may be neutralized by expectations of reversal. Krugman’s paper can be read in two ways: a more monetarist/market-oriented reading in which credible monetary policy alone solves the trap, and a more Keynesian reading in which fiscal policy is needed because credibility is lacking. Central banks’ persistent undershooting of inflation in the U.S., Japan, Europe, and Switzerland suggests that the main constraint is not technical incapacity but reluctance to commit to higher inflation. Average inflation targeting is a modest version of makeup policy and could improve outcomes if the Fed actually follows through, but price-level targeting or NGDP level targeting would be stronger. Bernanke’s and Woodford’s work extended the Princeton framework by translating it into a more formal New Keynesian setting and by emphasizing regime change, asset purchases, and expectations management. Svensson’s exchange-rate-based escape from the liquidity trap shows that a successful expansionary regime can involve higher nominal interest rates, challenging simplistic 'low rates = easy money' thinking. The balance-sheet expansion of central banks since 2008 does not contradict Krugman’s logic because the demand for base money rose sharply under zero rates and with interest on reserves; what matters is whether balance-sheet expansion exceeds demand and is tied to a credible target path.

Data Points: Princeton contributors: 5 key figures - Sumner identifies Paul Krugman, Ben Bernanke, Michael Woodford, Gauti Eggertsson, and Lars Svensson as the core Princeton School contributors. Krugman paper year: 1998 - 'It's Baaack! Japan's Slump and the Return of the Liquidity Trap' is presented as the foundational paper. Fed adoption of average inflation targeting: 2020 - Beckworth and Sumner discuss the Federal Reserve’s new regime as a response to persistent undershooting. Fed rate hikes: 9 times - Sumner cites the Fed’s 2015-2018 tightening as evidence it was not actually powerless to raise inflation. Japanese QE reversal: 2006 - Krugman’s point about Japan pulling back injected money is used as an example of why temporary QE can fail. Japan inflation target: 2% - Repeatedly discussed as the benchmark Japan failed to hit persistently. Krugman’s illustrative inflation goal: 4% for 15 years - Sumner says Krugman suggested this as a possible policy path for Japan. Implied price-level increase: about 80% - Compounding 4% inflation over 15 years yields a roughly 80% higher price level. FDR gold-price devaluation: 69% - Eggertsson’s Great Depression application highlights the 1933-34 increase in the dollar price of gold. Great Depression price-level drop: about 30% - Used to illustrate how far the U.S. had fallen below its pre-crisis trend. Swedish central bank experience: 2010s - Svensson reportedly faced resistance to targeting the forecast while serving on the Riksbank board. Fed tightening before COVID: 3 rate cuts in 2019 - Sumner says the Fed’s 2019 easing likely prevented a recession prior to the pandemic shock.

Pivotal Quotes: "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." — Paul Krugman (quoted by David Beckworth): Core statement from Krugman’s 1998 liquidity trap paper emphasizing permanence and expectations. "I have to warn you, I do not believe in the liquidity trap." — Ben Bernanke (quoted by Gauti Eggertsson): A Princeton department conversation highlighting Bernanke’s skepticism and the debate over the liquidity trap. "A monetary expansion that the market expects to be sustained... will always work." — Paul Krugman (quoted in discussion): Used to underscore the paper’s claim that credibility and permanence are the essence of effective policy at the zero bound.

Implications: The episode argues that modern central banking should focus less on short-run rate changes and more on credible level targets and makeup policy. If the Fed follows through on average inflation targeting, it may validate Princeton’s framework; if not, liquidity-trap stagnation remains likely.