Commenter Fed up asked the following question:

Start at IOR = 0% and fed funds rate = 8%.

Next, move to IOR = 2% and fed funds rate = 6%.

What happens?

If you have an interest rate-oriented view of monetary policy then this must be a bit of a head scratcher.  Higher IOR is “raising interest rates” and a lower fed funds rate is “lowering interest rates.” So which is it?

Monetary policy is not about interest rates; it’s about the supply and demand for base money.  In the first case the opportunity cost of holding reserves is 8%, in the second case it’s 4%.  In both cases banks don’t want to hold significant excess reserves, so the impact of higher IOR on the demand for the medium of account (base money) is trivial.  It’s slightly “tighter money” but without much effect.

The fed funds change is different.  Whereas a change in IOR affected the demand for base money, a change in the few funds rate is an effect of a change in the supply of base money.  That’s tighter easier money in the short run, ceteris paribus.  But whether it is actually tighter easier money depends on how the action impacts the expected future path of monetary policy.  For that you look at the response of the NGDP futures market–just as soon as policymakers figure out that they need to create such a market.

PS.  Lots of people have been sending me articles.  Narayana Kocherlakota endorses level targeting.  San Francisco Fed President John Williams suggests we consider NGDP targeting.  Put them together and you get NGDP level targeting.  Williams also says that the Swedish case shows that the Fed needs to be careful about using monetary policy to address financial instability.

PPS.  Martin Feldstein says inflation has been running well below the Fed’s 2% target over the past 12 months:

The Federal Reserve’s preferred measure of inflation””the price of consumer spending excluding food and energy””rose 1.4% over the past 12 months but increased since February at a 2.1% seasonally adjusted annual rate.

I agree.  Here’s the title provided by the WSJ editors:

Warning: Inflation Is Running Above 2%

PPPS.  Surprisingly, I agree with this:

I like to say to my students “no matter how many good arguments you think you have against real business cycle theory, it explains an overwhelming preponderance of the business cycles in the history of the human race.”

PPPPS.  TallDave sent me an interview where Larry Kudlow asks Alan Greenspan about market monetarism.  The answer is completely unintelligible, but Jim Pethokoukis is kind enough to also provide a much more thoughtful comment by Greenspan on NGDP targeting back when he was . . . younger.

PPPPPS.  Transparency in the Ukraine.

PPPPPPS.  Dogs are Republicans.

Posting will get less frequent over the next few weeks due to some trips I’ll be taking.

Here’s Simon Wren-Lewis:

I’m interested in this asymmetry, and where it comes from. Why do MM hate fiscal expansion at the ZLB so much? It could be ideological (see Noah Smith here), but I suspect something else matters. I think it has something to do with monetarism, by which I mean a belief that money is at the heart of issues to do with stabilisation and inflation. MM is not about controlling the money supply as monetarism originally was, but I think many other aspects of monetarism survive. My own view is more Wicksellian (or perhaps Woodfordian), whence the failure to be able to lower interest rates below zero naturally appears central. To those not trained as macroeconomists (and perhaps some that are) these sentences will appear mysterious, so if this idea survives comments I may come back to it later.

A few quick reactions:

1.  I seem to recall that some market monetarists think fiscal stimulus is worth a shot.

2.  I’ve argued that some types of fiscal stimulus can survive monetary offset.  For instance, if the central bank is targeting inflation then an employer-side payroll tax cut can work, by boosting aggregate supply.  Christina Romer has made the same argument, although I’m not sure uses the aggregate supply shift framework.  A cut in VAT rates can also help, if the central bank is targeting prices inclusive of indirect taxes.

I don’t think my views on these issues can in any way be described as ideological.  I actually think VATs and payroll taxes are our most efficient taxes, and instead tend to oppose high personal income tax rates.  And recall that fiscal stimulus can involve either lower taxes or higher spending, so it doesn’t fit neatly into a left/right debate over the size of government.

I think Wren-Lewis has a better argument when he points to the fact that MMs often oppose fiscal stimulus at zero rates.  I could write a whole dissertation on this issue (and arguably have in this blog) but here are a few points that come to mind:

1.  Monetary offset is highly counterintuitive.  It’s like the face/vase picture, where something can be easily seen from one perspective, and yet look invisible from another.  Here are a few examples:

a.  In this post I discuss a few comments by Tim Duy, a respected centrist Keynesian, which perfectly describe monetary offset.  Yet I am almost certain that Tim Duy doesn’t agree with my views on monetary offset (i.e. I doubt he agrees that fiscal multipliers are still zero at the zero bound.)  He sees what I see, but (presumably) interprets what he sees very differently.

b.  Paul Krugman said 2013 was going to be a “test” of the MM claim of monetary offset.  When we passed that test with flying colors (as growth accelerated), he ridiculed the idea that there had ever been a test.  Perhaps that’s because he’s so sure the idea is wrong that he assumed any test that seemed to show otherwise must be wrong.  Indeed in the case of the UK he complained about austerity, and then when GDP started accelerating unexpectedly, said something to the effect that on second thought there hadn’t been much austerity in 2012.  Then why not tell us that in 2012?  And suppose MM had failed the 2013 Krugman test?  Does anyone think he would have said “in fairness to the MMs, it wasn’t a fair test, because other things might have changed?”

c.  Many Keynesians accept that monetary offset applies at positive interest rates, but insist it doesn’t apply at zero rates.  But these same Keynesians often insist that fiscal austerity in the eurozone caused the recession of 2011-13, even though their own model says that interpretation makes no sense when rates are not at zero, and rates were not at zero when the eurozone went into the double dip recession.  The only response I’ve ever heard is that the liquidity trap model also applies to very low but positive interest rates.  Even if that were true, it would not be relevant for a case where the monetary authority is actually “pulling on the string” by raising its target rates, as in 2011.  That showed clear intent to restrain AD growth.  And yet I’ve never once heard a Keynesian refute this point.  So how can we take seriously the austerity claims that were being made in 2011?  If there is a model where austerity reduces NGDP growth during a period where the central bank is raising rates to restrain inflation, I’d love to see the model.  But as far as I know no Keynesian has even produced a defense of this claim.  Just silence.

2.  I also have an ulterior motive.  I think stabilization policy would be much more effective if everyone agreed with Ben Bernanke that the Fed never runs out of ammunition, that they can always do “more.”  Obviously this perception was not widely held, and hence the public put very little pressure on the Fed to boost AD in 2008-09.  I would go even further, I believe Bernanke would have welcomed more pressure on the Fed to stimulate the economy in 2008-09.  Insiders insist that the Fed was frustrated because 90% of what they heard was criticism from “inflation nutters.”  Krugman defenders will (correctly) point to the fact that Krugman asked the Fed to do more.  But I’ve spoken with highly intelligent economists around 2008-09, who read Krugman’s column frequently and very much like Krugman, who were shocked when I told them Krugman thought the Fed could do more.  They said the impression they got was that Krugman thought we were in a liquidity trap, and could do no more. That we needed fiscal stimulus.  His actual (nuanced) message got lost. Maybe the “pro-stimulus” side of the inflation debate needed more single-minded fanatics like me that sent a clear message–the Fed and BoE are steering the nominal economy, and if you don’t think there is enough AD then blame them for not doing more.  Instead the central banks were mostly blamed for doing too much.

This anonymous comment at the end of the Wren-Lewis post is a perfect example of how many Keynesians fail to grasp the implication of the ECB’s 2011 policy.  He/she confuses a situation where rates are low and even lower rates wouldn’t help (a good argument), and the very different case where rates are actually being raised (a bad argument).  If they are being raised then there is a presumption of 100% monetary offset.  I’m not sure why this idea is so hard to grasp.

W. Peden and Nick Rowe have some good comments after the Wren-Lewis post.

Mark Sadowski also replies to Wren-Lewis.

Vivian Darkbloom sent me the following:

The International Monetary Fund underestimated the strength of the U.K. economy when warning against the government’s austerity program, Managing Director Christine Lagarde said.

“We got it wrong,” Lagarde told the “Andrew Marr Show” on BBC Television yesterday. “We acknowledged it. Clearly the confidence building that has resulted from the economic policies adopted by the government has surprised many of us.”

A year after the IMF’s chief economist, Oliver Blanchard, said U.K. budget cutting risked “playing with fire,” the Washington-based lender said in April the U.K. economy will grow 2.9 percent this year, the fastest pace among the Group of Seven nations.

Pressed by Marr on whether she had apologized to Chancellor of the Exchequer George Osborne, Lagarde stopped short of saying so and said “Do I have to go on my knees?”

Paul Krugman often complains that he can’t find anyone to admit they were wrong about austerity.  Here’s a nice example—I wish there were more.

Here’s an item from the Guardian:

Drawing on IMF figures published last week, the graph compares what will happen to government spending in Britain up to 2017 with the outlook for Germany and the US. And what it shows is that the UK will plunge from public spending on a par with Germany in 2009, to spending less than the US by 2017. Had France, Sweden or Canada been included on this graph, the UK would still come bottom. If George Osborne gets his way, within the next five years, Britain will have a smaller public sector than any other major developed nation.

Fan or critic, nearly everyone now agrees that this government wants to shrink the state, but very few take on board what that means. This graph shows just how radical those ministerial plans are. Particularly striking is the fact that Britain will end up spending less as a proportion of its national income than even the US, the international byword for a decrepit public sector.

Here is the IMF data.

Country   G/GDP (2013, IMF)

Australia    35.33%

Canada    41.66%

New Zealand   32.76%

Switzerland  33.44%

UK   44.43%

US  40.47%

Asia:

Hong Kong   18.69%

Japan   40.56%

Singapore   17.88%

South Korea  20.80%

Taiwan  21.05%

Why stop at 40%.  Why not shoot for 33% to 35%, and end up with the even more “decrepit” public services of Australia and Switzerland?

Seriously, the idea that “decrepit” public services are a simple function of government spending as a share of GDP is beyond absurd. Obviously it may play some role, but there is much more involved.  Here is some data for Britain and Singapore, the country with the lowest government spending:

Country    Life expectancy  PISA scores    Infrastructure quality

Britain      80.42 years              1507                         5.3

US             79.56  years             1476                          5.8

Singapore   84.38 years           1666                          6.6

So the Britain comes in about the same as the US and far below Singapore, which spends 17.88% of GDP.  Do I think these are good ways of comparing public services?  Of course not, I’m not stupid.  Rather I provide them because they are the sorts of metrics that others use. Did I cherry pick?  In life expectancy the top 4 countries (excluding tiny places with less than 1 million) are Japan, Singapore, Hong Kong and Switzerland, all of which spend less than Britain.  Singapore is 3rd in the world in infrastructure, trailing small government Hong Kong and Switzerland.  Hong Kong is number 2 in Pisa scores, and Switzerland also scores well above the UK.  Asian countries might do well in life expectancy due to racial/diet factors (Asians live longer than whites even in America.)  But what about Denmark, where life expectancy is only 79.09.  Are we to assume they have even more “decrepit public services” than the US?

Of course this is comparing apples and oranges to some extent; many of the successful countries are small.  But the UK is much smaller than the US.  Closer in population to Canada or Australia.  Yet both of those countries get by with much lower government spending than the UK, without “decrepit public services.”  The US is a sort of bogeyman used by non-Americans on the left to scare voters into supporting bloated government sectors.

Some criticize conservatives for pointing to Singapore, a (supposedly) dictatorial regime.  (It’s not really, but let’s accept that for the sake of argument.)  The Asian data suggests the small government sector there has little to do with a lack of democracy—both Taiwan and Korea also have small government.  And of course there is no country in the world that is more democratic than Switzerland, which spends far less than even the US.  So I don’t buy the “voters prefer big government” argument made by liberals who don’t understand that poll results do NOT measure “public opinion,” because there is no such thing as public opinion.  I can get anywhere from 20% to 60% in Gov/GDP preferences depending on how I word a poll question.  Whenever you come across a blogger saying “the voters will vote GOP but actually agree with the Dems of the issues,” just change channels, you are wasting your time reading that stuff.

America does need better public services, but as the New York case shows higher taxes are not the answer.  Rather we need to lower taxes, and then spend the money more wisely.  Britain should do the same.  I believe 20% of GDP is enough in principle, but given the constraints of politics the UK might want to shoot for a less ambitious target, say the 33% to 35% you see in places like Switzerland and Australia.  Unfortunately, even that number is probably out of reach.

The main focus on Britain should be spending their funds more wisely.

PS.  How about developing countries?  Brazil has a GDP per person of $10,773 ($12,528 PPP).  Costa Rica has a GDP/person of $10,166 ($12,874 PPP).  Pretty similar.  But Brazil has public spending of 39.1% of GDP whereas Costa Rica only spends 18.2%.  So Costa Rica presumably has lousy public services.  Yet it somehow achieves a Human Development Index rating of .773, well above Brazil’s .730. There are “anomalies” all over the map.  It’s not about money; it’s about competence.

PPS.  I’ve added the excellent Britmouse to my blogroll, as well as Giles Wilkes, who also has some sympathy for market monetarism (although he disagrees with me on the optimal size of the UK government.)  At Marcus Nunes’ blog, Mark Sadowski has a very good guest post on Simon Wren-Lewis’s views on fiscal austerity.  Benjamin Cole also does good stuff over there.  Philip Greenspun has an amusing post on the view that we work so hard because we are poor:

At the same time, it does seem odd that people work so hard. My parents were Harvard graduates and my father had a great job with the Federal Trade Commission. The five of us shared a 1500 square foot house in Bethesda, Maryland with a black and white TV. My dad rode the Metrobus to work. Mom drove a dark green 1970 Chevrolet station wagon with black vinyl seats and no air-conditioning that broke down on the New Jersey turnpike every few trips to see the cousins. Putting a kid wearing shorts into the car on an August afternoon was bona fide child abuse that could result in first degree leg burns. (Note to youngsters reading this blog: the car did not break down due to advanced age; even fairly new cars in the old days were not as reliable as a 12-year-old Honda Accord would be today.) We attended public school and read books from the library. Our cavities were filled by a dentist who didn’t use novocaine for pediatric patients because it was too expensive and time-consuming. Kids in our (prosperous) neighborhood generally took between 0 and 2 commercial airline flights through high school graduation. We all shared a rotary-dial telephone. I don’t remember any family discussions over why my Dad didn’t take a second job or my Mom a full-time job so that we could have fancier stuff, a bigger house, or elaborate vacations like the lobbyists took their families on (even then lobbying the government was a great way to make money for all concerned!).

My dentist didn’t use novocaine either.  That’s what made me a utilitarian.

HT:  Jim Ancona