Here’s what FDR told the country in October 1933, when the recovery was faltering under the higher business costs imposed by the National Industrial Recovery Act (perhaps the most misnamed act in US history.)

“although the prices of many products of the farm have gone up . . . I am not satisfied . . . If we cannot do this [reflation] one way we will do it another.  Do it, we will. . . . Therefore the United States must firmly take in its own hands the control of the gold value of the dollar . . . I am authorizing the Reconstruction Finance Corporation [RFC] to buy gold newly mined in the United States at prices to be determined from time to time after consultation with the Secretary of the Treasury and the President.”  (NYT, Oct. 23, 1933, p. 3.)

FDR doesn’t blame foreigners; he realized we needed to put our own house in order, make our own monetary policy much more expansionary with an explicit price level target, and reduce the value of our own dollar.

And here is President Obama:

UNITED NATIONS “” President Obama increased pressure on China to immediately revalue its currency on Thursday, devoting most of a two-hour meeting with China’s prime minister to the issue and sending the message, according to one of his top aides, that if “the Chinese don’t take actions, we have other means of protecting U.S. interests.”

No call on the Fed to adopt a higher price level target.  Instead, we are blaming foreigners for our weak aggregate demand.  Of course the “other means” refers to protectionism, which FDR understood was not the answer.  And what does he mean by “protecting US interests?”  Not yours or mine, but rather car parts makers in the rust belt threatened with Chinese competition.  I suspect it’s too late; five weeks from now the rust belt will vote Republican, repudiating a modern technocratic Democratic party that has lost touch with its working class constituents.

Where’s our modern William Jennings Bryan?

My friends, we declare that this nation is able to legislate for its own people on every question, without waiting for the aid or consent of any other nation on earth; and upon that issue we expect to carry every state in the Union. I shall not slander the inhabitants of the fair state of Massachusetts nor the inhabitants of the state of New York by saying that, when they are confronted with the proposition, they will declare that this nation is not able to attend to its own business. It is the issue of 1776 over again. Our ancestors, when but three millions in number, had the courage to declare their political independence of every other nation; shall we, their descendants, when we have grown to seventy millions, declare that we are less independent than our forefathers?

No, my friends, that will never be the verdict of our people. Therefore, we care not upon what lines the battle is fought. If they say bi-metalism is good, but that we cannot have it until other nations help us, we reply that, instead of having a gold standard because England has, we will restore bi-metalism, and then let England have bi-metalism because the United States has it. If they dare to come out in the open field and defend the gold standard as a good thing, we will fight them to the uttermost. Having behind us the producing masses of this nation and the world, supported by the commercial interests, the laboring interests and the toilers everywhere, we will answer their demand for a gold standard by saying to them: “You shall not press down upon the brow of labor this crown of thorns! You shall not crucify mankind upon a cross of gold!”  (italics added)

A recent paper by Gordon and Krenn argues that the fiscal multiplier during 1939-41 was about 1.8.  Paul Krugman argues that this time period was almost ideal for considering the impact of stimulus:

Although they don’t quite say so explicitly, the paper is to an important extent an answer to Robert Barro’s claim that the World War II experience shows that multipliers are low, because private spending actually fell during the war; as I and others have tried to point out, this was because it was, you know, wartime, with rationing of consumer goods and sharp restrictions on private investment.

What Gordon and Krenn point out is that we actually have more information than a simple comparison between the depressed peacetime economy and the war economy after Pearl Harbor: there was a period of more than two years when the United States was gearing up for war but not yet engaged in combat “” the Arsenal of Democracy era. Rationing was not yet in effect, and for at least part of this period the economy still had excess capacity despite a very large rise in government spending.

What they find is that when there was still excess capacity, there was a quite large multiplier on government spending; that is, fiscal policy worked.

So far so good.  And Krugman overlooks another advantage that he has discussed elsewhere, the short term interest rate was close to zero.  This is important because when rates are positive, an inflation targeting central bank will tend to neutralize the impact of fiscal stimulus.  Krugman concludes:

But in the prewar buildup you had a clear-cut expansion of federal spending on the order of 14 percent of GDP. That’s a real experiment with the economy. And the results were clearly Keynesian.

I agree with that, but for completely different reasons.  What’s most important is that monetary policy was very passive during those years.  The Fed was quite content to let the wholesale price index trend downward from 1937 to mid-1940.  The monetary base was determined by gold inflows.  Under this sort of passive monetary policy regime fiscal stimulus can boost NGDP, and it seems to have done so in 1939-41.

But . . . this natural experiment has no implications for the efficacy of the recent fiscal stimulus.  Unlike in 1939, our Fed is not content to let the US economy slide into a Great Depression.  Any doubts on that score were erased by the recent Fed meeting, which strongly implied they would not allow inflation to fall below about 1%, and were seriously considering policies such as aggressive QE, in order to prevent that from happening.  I won’t repeat all the evidence; my previous post discusses this in a bit more detail.

And in a sense we’ve known this all along.  As far back as March 2009 the Fed responded to the sharply falling NGDP growth expectations with a substantial bond purchase program (albeit nowhere near as much as was needed.)  We don’t know exactly where the “Bernanke put” is, but we can be pretty sure that we were close to it in March 2009.

Many pro-Keynesian commenters will defend the fiscal stimulus, despite its apparent failure, with two arguments:

1.  It was too small.

2.  At least it prevented the economy from sliding into a depression.

I agree that from the perspective of the standard Keynesian model it was too small.  Nonetheless, it did far less than its proponents expected.  The other excuse is much more doubtful.  There is no evidence that the Fed would have allowed things to get worse than they did.  Is it possible?  Sure, anything’s possible.  It’s also possible that in the absence of aggressive fiscal stimulus the Fed would have done much more, and the recovery actually would have been faster.

I’m even willing to concede that it’s more likely the stimulus boosted NGDP in 2009, than reduced it.  But I hope everyone understands that with modern inflation targeting central banks, there is no such things as a “natural experiment” for fiscal stimulus, there is no scientific evidence pointing to how much fiscal stimulus boosted output, as compared to the counter-factual where there was no fiscal stimulus.  In grad school I recall they’d say “it’s a game theory problem,” which translates as “who the hell knows.”

This appears in the Gordon and Krenn abstract:

Only the 1.80 multiplier is relevant to situations like 2009-10 when capacity constraints are absent across the economy.

I love economics, but I’m frustrated that many economists have an excessively narrow or linear way of thinking about policy issues.  Their study has no relevance for 2009-2010.

After Bernanke’s Jackson Hole speech a few weeks back I began a long rambling analysis with what I saw as the key revelation:

Pretty disappointing, but with one silver lining.  We pretty much know where the “Bernanke put” is, he drew a line at roughly 1% core inflation.  That means no more “depression economics.”  Let’s get costs down and we can get a faster economic recovery:

1.  Payroll tax cuts (at the margin, employer only.)

2.  Replace unemployment extended benefits with large lump sum payments to the unemployed.

3.  Temporary (two year) minimum wage cuts to $6.50.

Of course this won’t happen, but it would promote faster growth if it did.  They are things Obama could try.

I recall that my claim there was a “Bernanke put” at 1% inflation, and an implied promise to use QE to make it happen, raised a few eyebrows at other blogs.  How things change in a month!  After the most recent Fed statement this view has become something close to the conventional wisdom everywhere from the sophisticated FT:

The Federal Reserve broke a taboo yesterday when it said quite baldly that inflation in the US is now below the level “consistent with its mandate”. In other words, it is too low. This is a very big statement for any central banker to make, since the greatest feather in their collective cap is that they successfully combated inflation after the 1970s debacle.

To the brash Wall Street Nostradamuses:

• What does he see now? The Fed just announced “we want economic growth, and we don’t care if there’s inflation… have they ever said that before?”

• What’s going to do well? EVERYTHING: stocks, bonds, gold etc. Stocks can’t go down that much, because the Fed is issuing a put. “You’ve gotta love a put.” (See more on the “Fed put” here.)

So the punditry seems to have arrived where I believe we’ve been all along—in a classical world where improved AS moves GDP in the “right” direction.  But when I wrote those lines I did not fully anticipate the implications of this Fed policy.  The term “classical world” is a bit misleading, as it implies a near-vertical AS curve.  In fact, the SRAS is now relatively flat.  And a flat SRAS combined with an inflation-targeting Fed leads to some peculiar policy implications that I haven’t seen anyone else discussing.

Imagine the standard AS/AD model.  When AS shifts downward by one percent, you get a small (short run) increase in output and a small decrease in prices.  In Krugman’s depression model, as formalized by people like Eggertsson, a decrease in costs can actually reduce output, by increasing expectations of deflation.

A model with an inflation targeting Fed and significant economic slack could not be more different from the Krugman/Eggertsson worldview.  Now even a slight decrease in business costs can produce a dramatic rise in output.  Call it a “large supply-side multiplier.”

To see why this occurs, think about what it means to target inflation.  For example, consider a central bank with a 1% lower bound on inflation in a country where the inflation rate is already at the lower bound.  If there is a threat of inflation falling further, the central bank will do enough QE to keep inflation expectations no lower than 1%.  Now assume there in an increase in aggregate supply, shifting the SRAS line to the right.  Normally, that would reduce inflation below 1%.  But with inflation targeting the central bank won’t let that happen.  They’ll do whatever it takes to shift the AD to the right by exactly the amount that AS has shifted right.  Inflation will be unchanged, and the positive supply shock will increase output.

Here’s where it gets interesting.  Think of the supply shock not as moving the AS to the right, but rather as shifting it downward (of course both changes occur.)  Why does it shift downward?  Because the cost of production declines.  Let’s assume Obama does some things to reduce business costs.  Say he cuts the minimum wage by 10%, and also cuts the employer share of the payroll tax by 2%.  Assume these changes reduce business costs by 1%, shifting the SRAS 1% lower in the up and down direction (remember, this is still an increase in AS.)

What happens to output?  Here’s the big surprise; the more correct Paul Krugman is about the SRAS currently being pretty flat, the larger the increase in output.  I think he is much more correct about the “slack” problem than his conservative critics, although I also believe the structural problems are a bit larger than he seems to imply.  Let’s take two cases, in one the slope of the SRAS is 1/3 and the other it’s 1/5.  If the slope is 1/3, and the SRAS curve shifts 1% lower, then the Fed must do enough QE to move AD 3% to the right, in order to prevent a fall in inflation.  If the slope is 1/5, the Fed needs to boost AD by 5%.  I think you see where this is going.  If the Fed is serious about preventing inflation from falling below 1%, and I think it is, we are suddenly in Andrew Mellon country.  You get recovery by driving down business costs.  Wages, real estate, auto parts from China, whatever.  Don’t prop up wages, don’t prop up the property sector, don’t try to force China to raise its prices.  And the biggest irony is that the more Krugman is right about the flat SRAS, the deeper into Mellon country we go.

Now of course I’m being a bit provocative here in my usual irresponsible way.  Mellon also favored tight money, which I don’t.  But I am doing it to make a point.  Krugman’s arguing for exactly the opposite approach; get tough with China, help out people with mortgages, do demand side fiscal stimulus, not cuts in the employer share of the payroll tax.  Indeed consider for a moment the implication of cutting the employee side of the payroll tax, which sounds better to those who live in a Keynesian demand-side world.  With sticky wages it won’t have any immediate supply-side effect, but it will increase AD.  Unfortunately, this will simply cause the Fed to delay its anticipated QE.  Why?  Because as people like me and Tyler Cowen and even Ben Bernanke have frequently observed, the Fed is the last mover in the stimulus game:

Well, in our short-term monetary policymaking, we are able to adjust for the conditions of fiscal policy, however they may be. I think fiscal issues are more important in the long-term sense because of the long-term obligations we have, for example, for entitlements. We have not found the fiscal situation to be a major impediment to our short-term management of monetary policy.

That’s right, he’s sort of saying; “You Congressman can play whatever fiscal games you’d like, but leave the determination of NGDP growth to the grown-ups at the Fed.”

Let’s suppose I oversimplified when I said they had a 1% target, a closer reading of the Fed’s minutes might imply something a bit more sophisticated.  Arguably there is an intention to gradually raise the inflation rate to 2% over the next two or three years.  Does that change my analysis at all?  No, any inflation target will do, it doesn’t have to be a fixed target.

There is a faint glimmer of hope for the Keynesians if you assume the Fed has a 1% lower bound on inflation, has no intention to push it back up to 2%, but will gladly allow fiscal stimulus to push it back up to 2%.  That would be a weird policy, and go against their statement that they eventually wanted to get inflation back to 2%, but it’s possible.  But even then, in that best case, it would merely be an argument for fiscal stimulus, not an argument against austerity.  And let’s face it; fiscal stimulus isn’t going to happen.  I don’t think austerity will either, but there are at least some supply-side policies that the Republicans would support.  It’s up to President Obama.

This result is so counter-intuitive that a visual metaphor might help.  Imagine you’re playing a game with your child, where you stand in one room by the door, and she stands on the other side of the door.  If she pushes one way, you push back so that the door doesn’t move.  If you want the other person to push on the door, you must convince them that they shouldn’t let the door open into their room.  That’s what we’ve been trying to get the Fed to do, push back against sub-1% inflation.  Now they’ve finally committed.  So we are free to push prices as low as we want with supply-side policies, knowing they will push back with demand-side policies to prevent prices from falling.  If the door remains immobile, how have we helped the economy?  The door symbolizes inflation, and it stays at 1%.  But in terms of output, both actions tend to push it higher.  More AS from government policy reforms, and a push-back of more AD from the Fed.

A few other random observations:

1.  Has this been tried?  Yes, in late 1921 the Fed stopped a severe deflation and stabilized the price level.  There was then some severe wage cutting and the economy took off like a rocket.  And this occurred in a situation where there was very little demand-side fiscal stimulus.  Today’s labor markets are nowhere near as flexible, so it would be better to have a bit more monetary stimulus.  As we recover, the 99 week UI extension can gradually be scaled back, and this will promote a virtuous circle of more AS and more AD.

2.  When the Congress passed a law in 2006 raising minimum wages in three steps, they probably anticipated that NGDP would continue growing at a little over 5% per year.  If it had, by now it would be about 10% above current levels.  In other words, the minimum wage in 2010 is probably roughly 10% above where Congress would have set in 2006, if they had had perfect foresight about the economy.  I know there won’t be any minimum wage cut, but it would almost certainly reduce youth unemployment if it occurred.

3.   In the end I still favor a more expansionary monetary policy.  The “Bernanke put” will probably keep us out of a permanent Japanese-style zero rate trap, although we can’t even be certain of that.  But faster NGDP growth would still lead to faster RGDP growth.  Still, the recent language is better than nothing, and may have played a modest role in the recent strength in US equity markets.  Later I’ll discuss the risk that the Fed gets lulled into inaction by the “circularity problem.”  I’m sick today, and don’t have the energy to do any more posts, but I will say that in 2009 I called for a worldwide orgy of beggar-thy-neighbor policies, so you pretty much know what I think of the recent moves by the Japanese.

4.  I know there are some very smart grad students who read this blog, and I would appreciate if you could point me to any research papers that discuss supply-side policies when the central bank is inflation targeting and the SRAS is relatively flat.  In the unlikely event there aren’t any, why not write up a paper?

PS:  I have a wacky commenter who is a combination of gonzo journalist Hunter S Thompson and Andrew Mellon.  Even his name (Morgan) is vaguely reminiscent of the gilded age.  This post is dedicated to him.

HT:  Tyler Cowen, JimP, Daniel Carpenter

I recently did a post entitled: “No Soul-Searching on the left?”

Karl Smith responded as follows:

Scott Sumner complains that liberals are suddenly changing their tune on monetary policy. Perhaps, but this is the time to make love not distracting infighting.

I don’t have to remind Scott that he and I live a life that is virtually recession proof. Millions of Americans do not. This isn’t the time to be alienating anyone who might help our cause.

And just for the record, since I didn’t make the initial list

TUESDAY, MARCH 18, 2008

100 Basis Points

I am off to the state legislature this morning so no faux statement. However, I still maintain that there is no tightrope. The Fed has to be focused on preventing the liquidity trap and jump starting credit markets as soon as possible.

Moreover, M1 is flat and credit contracting. This should be leading to an effective decline in the money supply. Ultimately that is deflationary.

The statement should have some nod to commodity prices and risks but the predominate concern is stability in financial markets and the outlook for growth. In short, look out below, we are heading for 1% as fast as is prudent.

POSTED BY KARL SMITH AT 10:23 AM

I’m afraid I wasn’t reading blogs at that time, and regret overlooking Smith.  More importantly, I now think the title of my post was needlessly inflammatory.  From the reader comments I got the impression that people thought I was attacking the left, or comparing them unfavorably to the right.  That’s not quite what I intended; there is now more support for monetary easing on the left than the right.  I didn’t ask the right to do any soul-searching because it’s hard to find people on the right who have changed their minds.  But soul-searching was a bad metaphor, I meant something closer to “re-evaluating one’s model.”

The purpose of my post was to suggest that those on the left might want to re-evaluate their basic approach to monetary economics, which I think is distorted by an excessively Keynesian worldview.  I provided a very long list of people who were aware that the Fed could do much more in late 2008 and/or early 2009.  It was all the people I could recall at the time.  And the list was almost entirely center right to right.  How did that happen?  How did this group end up talking about the potential for monetary policy before those on the left?  Why were there no nominations for those empty Fed seats for over a year, with almost no complaints about that state of affairs from those on the left?  It was meant to be constructive criticism.

I expect my fellow bloggers to be mature, and to not get defensive when faced with constructive criticism.  In other words I expect them to be like Matt Yglesias, who posted this a few days after my post:

Beyond Fed condemning, though, let me observe that I think I’ve been ahead of the curve among progressives in calling attention to the importance of this topic and that despite that fact I was behind the reality curve. The Great Recession has revealed lack of capacity for engaging with monetary issues to be a major institutional weakness of the progressive movement.

That’s exactly the point I was trying to make.  But in the real world there are all kinds of personalities.  Smith’s right that some of my language was needlessly provocative.  The most important thing right now is to look for allies who will help us change Fed policy.

Bryan Caplan seems to be suggesting that double standards are morally indefensible:

We often have ethical arguments about when it’s morally permissible for us to do seemingly terrible things to them.  Examples:

1. When is it morally permissible for us to deliberately drop a nuclear bomb on their civilians?

2. When is it morally permissible for us to launch an attack that we expect will lead to ten civilian deaths for every target killed?

3. When is it morally permissible for us to torture one of them?

The general conclusion of these discussions – unsurprisingly given group-serving bias – is that it’s morally permissible for us to do almost anything to them.  Sure, there are a few random exceptions – it’s OK to nuke their civilian population, but wrong to waterboard suspects.  (Huh?)  But by and large, we give ourselves a big green light.

At the same time, we almost never have ethical arguments about when it’s morally permissible for them to do terrible things to us.  I don’t think I’ve ever heard a debate about:

1. When is it morally permissible for them to deliberately drop a nuclear bomb on our civilians?

2. When is it morally permissible for them to launch an attack that they expect will lead to ten civilian deaths for every target killed?

3. When is it morally permissible for them to torture one of us?

If Caplan is criticizing double standards, then I don’t agree.  Suppose that in 1943 we knew for a fact that dropping a bomb on Germany and Japan, and killing 3,000 civilians, would have caused them to surrender.  Would the act have been morally justified?  I’d say yes, but only because we were fighting the “bad guys.”  On the other hand even if Al Qaeda knew for a fact that killing 3,000 Americans would cause us to surrender, it still wouldn’t be morally justified.  They were fighting the “good guys”  (or for you Chomsky fans, the “less bad guys.”)

Here’s another example.  Suppose I had been drafted into the German Army in 1940, was opposed the war, but was too chicken to refuse to serve.  Would it have been morally justifiable for me to shoot allied soldiers?  Of course not.  The only moral action would have been for me to intentionally shoot over the heads of enemy soldiers.  (Thereby hoping to end the war more quickly.)  On the other hand it would have been completely justifiable for Russian or American soldiers to shoot me.

BTW, here I am considering a separate issue from the validity of “rules of war.”  One can be a “rules utilitarian” and favor rules that apply to good guys and bad guys equally.  But that’s a different question from whether the liberal-minded German draftee is morally justified in shooting at enemy soldiers.