Karl Smith finds this peculiar comment in a Raghu Ragan FT article:

However, the past build-up of debt in now depressed areas may suggest that demand was too high relative to incomes. If so, demand, without the dangerous stimulant of borrowing, will stay weak. Policy should instead help workers move where there are suitable jobs – for instance, by helping them offload their homes and the associated debt without the stigma of default.

Smith can’t figure out what this means either.  Here’s Karl’s interpretation:

So first, when we use demand in the macroeconomic sense, income is simply the equilibrium value of demand at a given price level. It makes no sense to say that demand is too high relative to income.

We might mean that the local area was running a persistent current account deficit. So for example on total the people of Las Vegas were importing more than they were exporting. Las Vegas experienced perhaps the most severe crash of any major US metropolitan area. To undue this balance they need to run a current account surplus. That is they need to export more than they import.

Perhaps, but then his solution (people should work less in the region that has the CA deficit) would make no sense at all.  I really don’t know what Rajan means here, if I had to guess I think he’d claim the people of the problem regions like Vegas and Spain were not producing too much in total, but rather were producing too much of one good (like houses) and too little of other goods.  Then he might argue that in the short run it’s easier for the surplus labor to exit Vegas and Spain and work in a more prosperous area.  That would be a defensible argument, but of course it would have nothing to do with “demand” having been too high relative to income.  And even if output was too high in aggregate (say too many people had moved to Vegas), that would suggest both output and income were too high, not that demand was too high relative to income.

And as Karl points out, Rajan’s also confused about the re-allocation argument.  Here’s Rajan:

This is probably the more pertinent case in several industrial countries, such as the US and Spain.   Increasing employment in a sustainable way today could more than pay for itself if people who would otherwise drop out of the workforce earn incomes.

The key question then is whether more government spending can make a real difference to the most severe employment problems. Here the case for a general stimulus becomes less compelling. In the US, demand is weakest in communities where a boom and bust in house prices has left an overhang of household debt. Lower local demand has hit employment in industries such as retail and restaurants. A general increase in government spending may be too blunt – greater demand in New York is not going to help families eat out in Las Vegas (and hence create more restaurant jobs there). Targeted household debt write-offs in Las Vegas could be a better use of stimulus dollars.

Notice the non-sequitur, from a lack of jobs to the claim that the “key question” is whether we need more government spending.  If there’s not enough jobs (due to a demand shortfall) we need more monetary stimulus.  That oversight is forgivable for Spain, as they lack their own currency.  But the US?  Why would we employ fiscal stimulus, when monetary stimulus doesn’t run up any debts?  And the Vegas/New York comparison makes no sense.  Both regions have high unemployment. But even if they didn’t, regional differences should play no role in aggregate demand policies.  The Fed and the ECB can and should tailor their policy for the entire region.  Obviously both the US and the eurozone have a demand shortfall.  Recently the problem’s been getting slightly better in the US, and slightly worse in the eurozone.  But both could use more monetary stimulus.

Indeed the US needs more monetary stimulus even if AD is currently right on target.  How can that be?  Because we are still doing fiscal stimulus, e.g. the payroll tax cut.  So at a minimum you’d want to do more monetary stimulus until we reached a demand level where Congress felt it could remove fiscal stimulus.  People used to sort of blanch when I talked about the Fed “sabotaging” fiscal stimulus, but Bernanke all but admitted that this is exactly what the Fed is currently doing:

1.  Bernanke says the Fed can do more.

2.  Bernanke says the Fed chooses not to do more, as they think the expected future path of AD is adequate.

3.  Congress continues to hold down payroll taxes because they think the expected future path of AD (without fiscal stimulus) is not adequate.

That’s sabotage folks; there is no other word for it.

I apologize for the snarky post title.  But think about how hard we work to get our undergrads to distinguish between shifts in demand and changes in quantity demanded.  So it’s quite dismaying when a famous economist talks about too much “demand” in a context where he pretty clearly meant something entirely different.  It’s hard to have an intelligent debate if each participant comes to the discussion with their own private language.

PS.  It’s also possible Rajan meant “consumption” when he said “demand.”  That would be a strange use of the term ‘demand,’ and of course the main problem in Vegas and Spain was too much investment, not too much consumption.

PPS.  If anyone (including Rajan) can provide a sensible definition of what he meant by ‘demand’ then I’ll provide an abject apology.

Commenter Bonnie sent me the following 2005 article from BW/Bloomberg:

Why does Bernanke favor inflation targeting?
He thinks that a more “transparent” Federal Reserve policy would promote stable, noninflationary economic growth by giving businesses and consumers more certainty about the future course of interest rates and inflation.

Why is Greenspan against it?
He thinks the Fed can control inflation without announcing a target rate. Plus, he worries that an announced rate would make it harder to respond flexibly and intuitively to a financial crisis or changing economic conditions. Greenspan recognized from a variety of subtle indicators in 1997 that rapid productivity growth was likely to curb inflation — even though most conventional forecasts predicted accelerating inflation. He persuaded fellow Fed policymakers to not raise interest rates, allowing the economy to flourish.

Does Bernanke admit that inflation targeting would decrease the Fed’s flexibility?
No. He says that in a crisis the Fed would do whatever it takes to stabilize the economy. Frederic Mishkin, a Columbia University economist and longtime Bernanke collaborator, says that establishing credibility with the financial markets as an inflation hawk gives an inflation-targeting central bank more, not less, flexibility to tackle recessions.

Bernanke has recently announced that it would not be appropriate to do further stimulus to “tackle” the recession.  And why not?  He says it might lead to higher inflation.  Thus Bernanke and Mishkin were wrong in 2005, inflation targeting does inhibit the Fed’s ability to tackle recessions, as compared to NGDPLT.

Nobody knows exactly what the Fed is up to, and that includes the Fed itself.  Of course inanimate institutions don’t know anything.  What I really mean is that Ben Bernanke doesn’t know precisely what the Fed will do in the future.  But there’s one thing that no one can deny—the Fed has set an explicit 2% inflation goal, and in recent years has frequently moved aggressively when inflation expectations seemed to be diverging sharply from that goal.  Indeed it seems to me that the 2% inflation target is gradually becoming more credible, and hence I would not expect the 5 year TIPS spreads to diverge too far from 2%.

What does all this mean?  Ryan Avent has a good post that discusses one implication:

The bottom line is quite simple, says CBO. If all of the fiscal blow is deflected, the economy should grow at an annual pace of 5.3% in the first half of the 2013 fiscal year. If Congress is unable to find a way to defer some of the impact, the economy will instead shrink by 1.3%.

.   .   .

Except, of course, that the economy will almost certainly not grow at a 5.3% rate no matter what Congress does. Arguments to the contrary are subject to what econ bloggers have come to call the Sumner Critique, after economist and blogger Scott Sumner. It is reasonable to assume, by this critique, that the Federal Reserve has a general path for unemployment and inflation in mind and it will react to correct any meaningful deviation from that path. A 5.3% growth rate is well outside the range of current Fed projections. Growth that rapid would almost certainly bring down unemployment quite quickly, triggering Fed nervousness over future inflation and prompting steps to tighten monetary policy. Growth might run slightly above Fed forecasts for a bit, but the overall fiscal effect will be dampened considerably.

I think this is right.  But Ryan is less confident that the Fed would cushion the blow if we had a fiscal tightening in early 2013:

There can be quite a large lag between the onset of falling real output and a drop in inflation, especially (thanks to downward nominal rigidities) at low levels of inflation. If the Fed becomes less responsive than normal, the fiscal multiplier rises. Imagine a world in which the Fed waits to see how Congress behaves and then waits until the economic impact of Congress’ behaviour translates into falling inflation before stepping into action. Inflation may not depart from trend by all that much, but real output would likely dip substantially as a result of the fiscal cliff.

Ryan points out that it doesn’t have to be that way:

The Fed could therefore proclaim to the world that will maintain aggregate demand growth (in the form of, say, nominal income growth) at all costs, and that it would by no means allow the fiscal cliff to knock the economy off its preferred path. It could explain in great detail what specific steps it would be willing to take to achieve this goal, so as to boost its credibility. And if demand expectations as reflected in equity or bond prices showed signs of weakening ahead of the cliff, the Fed could preemptively swing into the action to establish the credibility of its purpose.

I think these are plausible arguments.  But then he makes a very peculiar claim:

The Fed will almost certainly not do this.

Why? Because the Fed is thinking about moral hazard, specifically, that if it promises to protect the economy against reckless fiscal policy Congress will have no incentive to avoid reckless fiscal policy. The Fed would very much prefer that Congress behave””lay out a plan for medium-term fiscal consolidation but keep short-term cuts small and manageable. It is therefore in the Fed’s interest to imply that the fiscal cliff is a real economic danger, even if it could potentially prevent it from being one.

This is a very peculiar definition of “reckless” fiscal policy.  The standard theory says the Fed should take a tough line on fiscal irresponsibility, and not help Congress out when they run up massive deficits.  They should tell Congress they have no intention of monetizing the debt.  The standard model says the most effective policy is to run small deficits, or even surpluses, and have the Fed do the demand stimulus required to keep aggregate demand on track.  Ryan’s making precisely the opposite claim.  He’s saying that if Congress does the right thing, and gets its fiscal house in order, then it’s in the Fed’s interest to punish Congress with tight money, so they don’t ever again do something so “reckless.”

Now I’m pretty sure that Ryan would claim I’ve mischaracterized his views.  It seems his point isn’t that smaller deficits are a bad thing, but rather that Congress shouldn’t move so precipitously.  And why not?  Presumably because the Fed cannot or will not cushion the blow.  I think they can, and my hunch is that Ryan agrees.  So then it becomes “will not.”  But here’s where things get really strange.  In that case the Fed would be punishing Congress for not realizing just how irresponsible Fed policy really is.  “If you do the policy that would be optimal conditional on us doing the right thing, we’ll punish you for having the audacity to assume we’ll do the right thing, by doing the wrong thing.”  Or something like that.  This is not to say that Ryan is wrong; just that it’s a strange argument, the more you think about it.

Update:  Ryan Avent has a new post clarifying his argument.

Game theory isn’t my forte, so let’s talk about the supply-side, where things are a bit easier to pin down.  In my view the fiscal cliff would slightly reduce aggregate supply.  It might also reduce AD, but I think the Fed would mostly offset that effect.  But aggregate supply is a different story.  Even though the reduction in AS is likely to be small, under inflation targeting it would lead the Fed to reduce AD as well.  So I think growth would slow modestly if there is a fiscal cliff.  Say 1% to 2% RGDP growth in 2013, instead of 2% to 3% with no fiscal cliff.  Inflation would be roughly 2% either way.  That’s just a guess on my part, but then who’s got a model that’s included all the game theory I’ve been discussing?  Have any of our elite macroeconomists figured out how to model the monetary/fiscal interaction?   .    .   .  Bueller?

PS.  Some might argue that the British case undercuts my argument.  But they have a less robust supply-side than the US, with inflation running consistently above target, even in the recession.  It seems unlikely that the US could have both a demand-side recession and inflation running persistently above 2%.  Note that I said “demand side recession,” I’m not disputing that a big oil shock could do the trick.

PPS.  In a previous post I tried to cause trouble between Krugman and Yglesias.  In a new post Matt gracefully avoids being snared in my trap:

When I wrote about this previously, I think I was too clever by half and just acted as if the Fed would in fact offset this all. Very possibly they won’t.

My point is that if they don’t offset it, they’ve failed to do their jobs.

Even though he’s more pro-fiscal stimulus than I am, I love the way Ygleisas writes about this problem.  So many people make excuses for the Fed (on both the left and the right.)  They say it’s not easy for them to do their jobs.  There is public criticism.  True, but then again it’s not really all that hard, when you consider other jobs like fighting in Afghanistan.  I expect our monetary policymakers to step up to the plate and do something dramatic for the millions of unemployed.  Deep down in their guts they know we need more demand.  We should insist on nothing less than the best from them.

PPPS.  During football games when the other team has the ball 4th and 1 on our 40, I’ve always been quietly pleased when the other coach sent in the punter.  This is odd, as the opposing coach should make a decision that makes me upset.  Later I learned from the football equivalent of Bill James that most coaches blow this call, and you actually should go for it.  (Or they used to blow it, perhaps it’s changing now.)  I think the same is true of Bernanke.  I’m pretty sure that over the past three years he’s quietly rooted for the NGDP numbers to come in above the Fed’s forecast.  And that’s just not right.

HT:  Bruce Bartlett

Why did the US government develop all sorts of policies, regulations, tax breaks, etc, which tended to subsidize the real estate industry?  Most smart people respond “special interest politics.”  OK, so why does Washington keep pressing China to raise its exchange rate, and why did they press Japan in earlier decades?  After all, even Paul Krugman admits that a weak yuan doesn’t hurt the US unless we are at the zero bound.  And yet this sort of mercantilism has been official US policy for decades.  Smart people will tell you that it’s special interest politics—the political influence of the US manufacturing lobby.

But there’s a conflict here.  The same US policies that boosted the housing industry, also tended to enlarge our current account deficit—hurting manufacturers.  So which is it?  Does the US government want a big CA deficit, or not?  My theory is that this question doesn’t have an answer, because governments don’t have brains.  They don’t have preferences or opinions.  They are stupid.  Yes, there is someone nominally in charge, but does anyone think Bush or Obama keeps track of all these indirect effects?  Just thinking about it makes one realize the preposterous nature of many “special interest” explanations for policy failure.

Some commenters tell me that it’s obvious why the BOJ has a tight money policy.  It pushes nominal interest rates to zero, which keeps borrowers like the Japanese government afloat.  Others tell me that it’s obvious that the Japanese policy of deflation favors the lenders, the old people who have saved a lot.  So which is it?  And why aren’t we talking about real interest rates?

Some people tell me that the Fed policy of 2009-10 had the effect of steepening the yield curve, allowing the banks to make money by borrowing short and lending long.  Others tell me that Operation Twist, which flattened the yield curve, tends to boost the value of T-securities held by banks.  Some people tell me that the Fed’s tight money policy is all a plot to help the “rentiers” who live by clipping coupons.   But when the government does QE I’m told that it’s a right-wing plot to help fat cats by boosting the price of securities.

All this seems silly to me.  It’s not a zero-sum game, as rich people hold both stocks and bonds.  I’m almost certain that the Fed’s (post-2008) tight money policy has hurt low income people, middle income people, and rich people.  It’s hurt wealthy people who hold of stocks, and it’s reduced the real interest rate on T-securities.  It’s forcing states to reduce benefits to public employees, and it’s depressing the value of 401k retirement accounts for people like me.  It’s hurt the job prospects of many low-skilled workers.  It’s depressed the value of people’s homes, and their businesses.  It’s depressed the stock prices of the big banks.

Given that academic economists clearly don’t have a clue as to what went wrong, why is it such a stretch that government policymakers might be similarly confused.  Are they really that much smarter than academic economists?

Also note that these nefarious special interest groups only seem to come out of the woodwork when rates hit the zero bound.  Thus they didn’t take control of Australian monetary policy in 2008.  And I’d add that monetary policy didn’t seem to change when Obama took office, so these mysterious special interest groups presumably control both our political parties.

Or maybe it’s all just a terrible mistake.

1.  The National Review continues to edge in the direction of market monetarism.  Veronique de Rugy quotes me and then comments:

The whole thing is here. In my view, monetary policy in Europe, or in the U.S. for that matter, would increase the effectiveness of spending cuts and structural reforms (kind of like the water you drink to help the medicine go down). There may even be a good case that it would be useful independently of other reforms. But it is mistake to oversell it and it certainly won’t achieve our long term goals without serious reductions is government spending.

I completely agree.  NGDP targeting won’t even come close to addressing all the structural problems that hold Europe back.  BTW, lower spending is desirable, but the Nordic countries show that neoliberal reforms are even more important.

2.  Jon Hilsenrath of the WSJ discussed how the current recession discredited two views of inflation:

After the financial crisis erupted in 2008, two narratives about inflation dominated economic airwaves and financial-market worry lists.

One was that consumer prices would tumble in a replay of Depression-era deflation because the recession was so deep and unemployment so high. The other was that inflation would soar because the Federal Reserve responded so aggressively to the crisis by pumping trillions of dollars into the financial system.

It turns out that both sets of predictions were wrong.

Those are roughly the views of old-style Keynesianism and old-style monetarism.  He concludes as follows:

Minutes of the last two Fed meetings show Fed staff have been revising up their inflation forecasts because slack hasn’t been as great as they thought.

So inflation since mid-2008 has been the lowest since the mid-1950s, and the Fed staff was expecting even lower?  I.e. they set their policy levers in a position expected to produce even lower inflation than we’ve had, which ipso facto means lower NGDP growth (since monetary policy affects inflation from the demand-side.)

3.  A few weeks back James Hamilton replied to my criticism.  I agree with much of what he has to say, but would quibble slightly with one comment:

I suggested that the current policy, which I read as not allowing inflation to fall below 2%, works well for both objectives.

It seems to me that policy is closer to a ceiling of 2% inflation, even if you assume the Fed puts zero weight on jobs.  Inflation has averaged well under 2% since mid-2008, and at the most recent Fed meeting they declined to offer any additional stimulus, despite a forecast that inflation would average below 2% over the next few years.  That’s too tight even if they had a single mandate to control inflation, as the ultra-conservatives in Congress have proposed.

4.  Paul Krugman did a recent piece where he argued that the PIIGS need deep currency depreciation.  I think he’s right, but differ slightly in my reasoning.  One of Krugman’s arguments is:

Second, Munchau’s argument that Germany was badly overvalued in 1999. But it had a roughly balanced current account; I think it’s hard to make the case that it was a really big overvaluation.

I’m kind of shocked by this.  Krugman is a first rate international economist; he knows that the correct exchange rate is not the one that balances the current account.  Japan’s currency has been overvalued for 20 years, and yet they’ve run consistent CA surpluses.  Some might argue that the standard model doesn’t apply in liquidity traps.  I don’t agree, but the liquidity trap model has no applicability to Germany circa 1999.  The CA surplus reflects relative saving and investment propensities.  You decide whether a currency is under or overvalued by looking at whether aggregate demand is at an appropriate level.

5.  On a lighter note, here’s Krugman again, in a post entitled “None So Blind“:

Eddie Lazear has an op-ed in the WSJ on the fiscal cliff that, among other things, pooh-poohs any concerns that sudden cuts in spending might hurt the economy. He weasels a bit, but basically conveys the impression that there’s no evidence for Keynesian effects.

What this signifies to me is the politicization and corruption overtaking the economics profession. I’ll give Eddie the benefit of the doubt; he is probably just going by what his friends say.

And here’s Matt Yglesias:

Conventional wisdom in DC is that not only would the full expiration of the Bush tax cuts make people grumpy as they find themselves needing to pay more taxes, it would also provide the macroeconomy a job-killing dose of fiscal drag. The chart above from Goldman Sachs illustrates the idea clearly.

I don’t buy it.

The problem is that this chart ignores what I think we’re now going to call the Sumner Critique.

I hope Krugman also gives Matt the benefit of the doubt . . .

HT:  Tyler Cowen, dwb.