The conservative Fed

Most people agree that the Fed is a conservative institution. But conservative in what sense? Temperamentally, or ideologically? A temperamentally conservative Fed is reluctant to go out on a limb and try new techniques. An ideologically conservative Fed abhors greater than 2% inflation in much the same way that a vampire abhors sunlight. It turns out that it matters a lot whether the Fed is temperamentally conservative, ideologically conservative, or both.

In recent posts, Ryan Avent and Matt Yglesias have criticized the widespread view among Keynesians that the Fed is out of ammunition. People like Larry Summers are skeptical about whether the Fed could stimulate the economy, because doing so would require them to boost inflation. These Keynesians have tended to recommend fiscal stimulus as the only way to boost aggregate demand.

In my view there are two flaws with this argument. First, some Keynesians seem to believe that fiscal stimulus can work without raising inflation expectations, whereas monetary stimulus is only effective at the zero bound if the Fed succeeds in convincing the public that higher inflation is on the way.  But both fiscal and monetary policy work through higher AD.  And unless the SRAS curve is completely flat, higher AD means higher inflation. The markets know this; hence fiscal stimulus will be expected to work if and only if it boosts inflation expectations.  Yes, the early Keynesians believed the SRAS was flat when the economy had lots of slack, but after watching how sensitive oil prices are to growth expectations, I can’t imagine that anyone still believes in a flat SRAS curve.

So if fiscal stimulus is to work, it must boost inflation expectations. This is why we need to know the Fed’s motives. Will the Fed attempt to squash the higher inflation resulting from fiscal stimulus, or will they allow inflation expectations to rise?  Most Keynesians seem to have assumed the Fed was temperamentally conservative. That they were reluctant to make the sort of bold moves required to boost AD at the zero bound, but wouldn’t stand in the way of fiscal stimulus. And in fairness, there are statements by Bernanke that seems to support that assumption. But the actions of the Fed strongly suggest otherwise. Consider Fed policy since 2008:

1. The Fed started paying IOR for the first time in its history.

2. The Fed got involved in bailing out the banking system to an unprecedented extent.

3. The Fed got heavily involved in buying MBSs (QE1)

4. The Fed did QE2, with longer term bonds

5. The Fed did Operation Twist

That doesn’t seem like a timid or cautious Fed to me, that seems quite aggressive. Not at all temperamentally conservative. Now let’s consider evidence for ideological conservatism. Here’s Ryan Avent:

According to the Cleveland Fed’s estimates, 10-year inflation expectations haven’t risen above 2.1% since the end of 2008. At least three times during that span, the Fed has halted or reversed its easing, first by ending its initial asset purchases, then by allowing its balance sheet to contract naturally as securities matured, and then by ending the asset purchases known as QE2. Expectations have remained in check because the Fed has opted not to continue policies that would raise them. The myth of Fed helplessness is just that.

I think that’s exactly right. Ryan is describing a temperamentally ambitious Fed willing to try all sorts of unconventional policies, but which pulls back whenever inflation threatens to exceed 2%. My question to the Keynesians is:

How does fiscal stimulus overcome an ideologically conservative Fed?

I think they have in mind a scenario where the Fed won’t take affirmative moves to kill a recovery, such as raising interest rates. And that may be right. (We’ll see when we actually get a recovery—the FDR-era Fed, the BOJ, and the ECB all raised rates prematurely.) But that’s not the right question. The problem is that the Fed needs to do extraordinary things just to keep inflation from falling well below 2%. And it seems like when inflation rises to 2%, they stop doing those things. That’s ideological conservatism. It may be unintentional on the Fed’s part (I believe it is unintentional on Bernanke’s part) but it means the Fed is not just failing to do its part, it’s actually sabotaging fiscal stimulus.

PS. I’d also note that with an ideologically conservative Fed the most effective fiscal policies (for reducing unemployment) are not at all what progressives would like.  You’d need to lower employer-side payroll taxes, lower minimum wages, cut back on the maximum duration of UI benefits, in order to shift aggregate supply to the right. It’s interesting that a Fed dominated by Republicans does policies that make conservative fiscal policy the only effective option. Morgan Warstler’s fantasy.


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77 Responses to “The conservative Fed”

  1. Gravatar of david david
    11. October 2011 at 16:47

    Maybe borrow until nominal interest rates rise above 0% and sanity takes over? “Oh hey we have ammunition again, let’s validate all that borrowing and print more?”

  2. Gravatar of MikeDC MikeDC
    11. October 2011 at 16:53

    I have a question or two about AS/AD. In every class I ever studied or textbook I’ve ever looked in, money is neutral in the long-run in the AS/AD model. For instance, I just pulled off a Bernanke intermediate macro book off the shelf in my office, and despite a fairly sophisticated discussion of the non-neutrality of money (citing Romer and Friedman no less), the AS/AD model he uses still presents an increase in the money supply as
    1) AD shifts out, increasing output and price level.
    2) SRAS shifts in, decreasing output back to the sustainable LRAS output level.

    So how does non-neutrality work itself into the model?

    My intuition has always been that to actually generate long-term growth, money has to operate on the LRAS. It’s the only thing in the AS/AD model that ever permanently affects anything (especially if AD is a rectangular hyperbola that becomes nearly asymptotic at some price level).

    So to me the big question is why the LRAS is where it is now; far to the left, if we draw it, than where we’d draw the notional potential real GDP numbers the Fed publishes. And how do we get it back to where it should be (near or equal to the potential real GDP estimate).

    Because unless money shifts the LRAS outward, the eventual shift of SRAS in response to an increase in the money supply will simply push us back to the starting point, right?

    So properly speaking, shouldn’t we say that we expect monetary loosening to affect LRAS if it is to affect permanent growth?

    I can imagine reasons monetary expansion would shift LRAS when it’s well below its potential level, but I never see anyone discuss it in these terms. So maybe I’m just out to lunch.

  3. Gravatar of david david
    11. October 2011 at 16:54

    At that, for an ideologically conservative Fed, the liberal response would probably not be to attempting moving AS via policy but instead attack the independence and legitimacy of the Fed, even if it means a return to the political business cycle. Better to lose some of the time than all of the time.

  4. Gravatar of Cassander Cassander
    11. October 2011 at 17:17

    The fed is a bureaucratic institution behaving bureaucratically, not ideologically. Among other things, that means acting incrementally rather than revolutionarily, avoiding accountability at all costs, and a focus on their own understanding of their mission that borders on the pathological. Absolutely nothing the fed has done is remarkable if you look at it from an institutional, rather than economic, perspective.

  5. Gravatar of Scott Sumner Scott Sumner
    11. October 2011 at 17:31

    David, That’s a pretty big risk to take.

    MikeDC, It’s complicated, and I’ve addressed it in many posts. The short answer is that the LRAS has moved a bit to the left because of bad supply side policies, and we are to the left of the LRAS, on the SRAS. If the Fed adopts a neutral policy (5%NGDP growth) unemployment will gradually fall over time.

    Cassander, There’s a lot of truth in what you say, but I still see the 2% inflation obsession as an ideology.

  6. Gravatar of Nick Rowe Nick Rowe
    11. October 2011 at 17:34

    Scott: assume that the IS curve slopes down, as most Keynesians believe. Then monetary policy can only work by reducing the real interest rate, which means raising the expected inflation rate to push the actual real rate down towards the natural rate. But fiscal policy can shift the IS curve right, raising the natural rate up towards the current actual rate. That’s where they are coming from.

    But if the IS curve slopes up, then monetary policy doesn’t need to push the actual real rate down to the natural real rate. In which case an increase in actual inflation may be a side-effect of a successful monetary policy, but is not a necessary requirement for monetary policy to work. If the IS sloped down, an increase in (expected) inflation would be a necessary requirement for monetary policy to work.

  7. Gravatar of Morgan Warstler Morgan Warstler
    11. October 2011 at 17:43

    david, they are too pretzeled to attack the legitimacy of the Fed. Just look at the protests.

    End the Fed plays right to the Tea Party. Period.

    look, liberals WANT to bail out stuff, so they can lay claim to being in control of the things they bail out.

    but lordy, just look at the MMTards – they will never get control of the money supply and print money to paper over their socialist failings.

    On the politics of the Fed, all roads lead to Rome: We’re going to get a far more market based approach to monetary policy that ASSUMES inflation at under 2%.

    As I keep saying a level target of 3% NDGP is HARD MONEY.

    Scott’s one mistake is that he assumed the 2% CPI is some kind of fact.

    Instead start with inflation should be ZERO any time RGDP is 3%. Promise we’ll raise rates to get 1% deflation if we ever go to 4% on real growth. Piss on booms, and public employees will never get raises past inflation.

    Scott should sell 2% inflation as the consolation prize, when RGDP is 1%.

    “Dear Tea Party, the only time I support ANY inflation is when real growth falls below 3%.”

    -

    Scott,

    I have said this over and over, to Ben and Fed:

    bankers > gop > dems

    They use this calculus in everything they do, it isn’t nefarious, that’s just how their brains work.

    Until bankers are desperate, your ideology logic works fine.

    But, when banks are in danger, they start to play Chinese Checkers, not chess.

    Frankly,it’s ONLY the hyperbolic language from the Tea Party, that can force the Fed back into thinking past the banks.

  8. Gravatar of Mike Sandifer Mike Sandifer
    11. October 2011 at 17:45

    Scott,

    Add an income subsidy for the working poor to replace the minimum wage and replace UI with an option to work for the government for the same pay as UI provides and then maybe progressives can come aboard.

  9. Gravatar of Scott Sumner Scott Sumner
    11. October 2011 at 17:47

    Nick, I understand your point about the Keynesian view of IS, but even if it slopes down they are wrong, because the SRAS slopes upward. Thet’s what invalidates the view that you can boost AD without inflation. The oil market alone would generate inflation, even if every single other price in America was fixed.

    I’d put it this way, higher inflation is not a necessary condition for fiscal stimulus to work in the way it is for liquidity trap monetary policy (in the Keynesian view) But that doesn’t matter, because if it works it will shift AD, which will raise inflation. If the Fed stops inflation from rising, they will, ipso facto, stop AD from shifting.

  10. Gravatar of Scott Sumner Scott Sumner
    11. October 2011 at 17:49

    Morgan, I thought this one would be right up your alley.

    Mike, Those are good ideas.

  11. Gravatar of Claudia Claudia
    11. October 2011 at 18:02

    Cassander, the actions of the Fed in the financial crisis (as noted in the post) were bold and not bureaucratic “business as usual.” True the Fed is a large institution addressing a complex mandate…order and stability are likely positives. But does it really matter what adjectives to attach to the Fed? Actions speak louder than words.

  12. Gravatar of Morgan Warstler Morgan Warstler
    11. October 2011 at 18:16

    Mike, those are HORRIBLE ideas, precisely because you get SO CLOSE to the right one – and I’m proud to be moving you there!

    http://biggovernment.com/mwarstler/2011/01/04/guaranteed-income-the-christian-solution-to-our-economy/

    We can totally do a Guaranteed Income, but the labor pool has to be auction to for profit SMBs.

    Look, you need to learn to accept that cheaper daycare, and cheaper lawn care, and cheaper remodeling, and cheaper haircuts, etc. IN THE GHETTO where all the unemployed are…

    these are the ONLY real benefits you can deliver to the poor.

    Why are you fighting this???

  13. Gravatar of Cassander Cassander
    11. October 2011 at 18:32

    Claudia> I’m pretty convinced that the Fed spent 2008 and most of 2009 convinced that their number one priority was to shovel as much money as possible in the direction of the financial sector. Not from conspiratorial or corrupt reasons, just because of panic and ideological capture. To do that, they started a number of policies, like IOR, that were somewhat novel but well within the traditional realm of things controlled by the Fed. Since then, the attitude at the Fed has calmed considerably, but these policies continue because of institutional inertia. Ending them would mean taking some action, and doing nothing is always easier than doing something. The various QEs are even more traditional, and incremental because they have taken place in an atmosphere of considerably less panic than the earlier decisions.

  14. Gravatar of c8to c8to
    11. October 2011 at 19:30

    morgan is getting close to the australian LDP’s 30/30 tax system.

    it is mathematically identical to a guaranteed income of $9000 FOR EVERYONE and thereafter a 30% flat tax on whateveryone earns.

    the reason you don’t sell it like this is because some people are offended by the idea of sending warren buffet a check for $9000 (even though they pay it off)

    so you sell it as a complicated negative tax rate under $30,000 and a positive tax rate thereafter. (congruent to the above)

    i wouldn’t bother taxing income at all, since all income is consumption (net of savings) i would just tax consumption at 30% maybe progressively, that is no tax on cheap goods rising to 30% (or more) on luxury goods.

  15. Gravatar of c8to c8to
    11. October 2011 at 19:31

    link for above: http://www.ldp.org.au/federal/policies/tax.html

  16. Gravatar of John John
    11. October 2011 at 19:38

    Scott,

    It occurs to me that there are problems with fiscal stimulus boosting AD that macro guys would miss. Specifically, if the government undertakes spending projects, what are they spending on exactly? It would be impossible to solve the problems of unemployment and low production because government spending has to be on specific things while the pool of unused resources and labor is extremely heterogeneous. Are the majority of currently unemployed American workers capable and/or willing to work on infrastructure projects, which are basically construction jobs. How many people are sufficiently qualified to work on “green energy” projects?

    I hope you see my point there there is no demand for labor in general that the government can raise across the board. There are specific unemployed workers with specific skills and specific projects that the government would undertake. The only way to sort out the labor and capital goods markets would be through market price adjustments.

    It is also important to point out that many industries suffer a severe shortage of qualified labor right now. In that case, government hiring to create jobs in those sectors would only result in currently employed people becoming more expensive while squandering the capital that could be used to hire in other sectors.

  17. Gravatar of Benjamin Cole Benjamin Cole
    11. October 2011 at 20:07

    Another excellent and insightful post.

    Is a fetish for inflation sub-2 percent an ideology? I was thinking it has become a sort of religion, a presumed moral and ethical good.

    There is some clever language around also, such as “All inflation is theft” (drug dealers agree with that) and “Inflation debases the currency–and if a nation debases its currency, what will it debase next?”

    I won’t even mention the gold nuts, and their peevish, unhealthy and ultimately banal fixation with the value of paper currency.

    I would say worship for the unchanging value of paper currency has become a perverted religion, but not an ideology. (Set aside that even measuring inflation becomes tricky in a world of rapidly evolving goods and services.

    Today I took and scrapped about 100 pictures of furniture, and posted a few online. What is that worth? 20 years ago, it was Polaroids and film, and lots of money–and buying an ad in a newspaper was not cheap.

  18. Gravatar of John John
    11. October 2011 at 21:01

    Ben,

    Us “gold nuts” don’t try to fix a currency’s value. The value of a currency, even a commodity money, is always fluctuating with supply and demand. Further, like you point out in the newspaper vs digital ad example, with the goods people spend money on constantly changing, there is no way to even measure the value of money. The argue we DO make is that increases to the supply of money don’t benefit society as a whole. Here’s what inflating the money supply does do

    1. Enriches some (those closest to the source of newly created money) at the expense of others

    2. Encourages capital assumption by punishing savings

    3. Misleads economic calculation b/c accounting techniques rely on a stable currency.

    A further note, inflation is not rising prices. Inflation is monetary expansion, just like inflating a balloon or how the universe inflated after the Big Bang.

  19. Gravatar of John John
    11. October 2011 at 21:02

    The argument we DO make*

  20. Gravatar of Morgan Warstler Morgan Warstler
    11. October 2011 at 21:17

    c8to,

    I’m far more concerned with the $40 per week ($1 per hour) stating bid auctions on the 20-25M who will sign up for the GI.

    It gives me quite a woody to imagine all the new low cost services that will flourish in poor neighborhoods.

    The signaling to every single worker is awesome, even the handicapped, those on disability, if ANYONE thinks they can put you to work doing something, for $40 er week they can TRY.

    suddenly everybody HAS to have a boss bossing them around, and since they have to work anyway, and they keep 50% of any new higher bids on them, they are pouring our the job market seeing the differences: x job pays y more than z job.

    At the low end, they don’t get this right now, I think this info is magical for them.

  21. Gravatar of Mikko Mikko
    11. October 2011 at 21:35

    Scott: perhaps Fed is conservative in the sense that it is slow to change its actual goals. For the past 30 years, the Fed’s actual goal may have been to push inflation lower (with a number of caveats) – not trying to steer the inflation to a 2% target. There’s always a difference between what you’re officially supposed to do and what the environment actually fosters.

    The fact that Fed has only acted when things have brought actual deflation fears is telling. Only when you are dealing with outright deflation do the deflation hawks have serious enough stuff to say enabling them to convince others that there is some other problem to look apart from the inflation watch.

  22. Gravatar of FT Alphaville » Further reading FT Alphaville » Further reading
    11. October 2011 at 23:09

    [...] And why the Fed is critical to discussing fiscal [...]

  23. Gravatar of Kevin Donoghue Kevin Donoghue
    12. October 2011 at 00:56

    “But both fiscal and monetary policy work through higher AD. And unless the SRAS curve is completely flat, higher AD means higher inflation.”

    One thing (among many) to bear in mind: it’s important to distinguish between a one-off increase in the price level and an increase in expected inflation. A typical SRAS curve just relates levels (P,Y). But maybe you have another type of SRAS curve in mind?

  24. Gravatar of Anders Anders
    12. October 2011 at 01:40

    Scott – you seem to switch from “inflation is an inevitable by-product of raising AD, given an upward-sloping SRAS curve” to “inflation is a necessary condition to raising AD, so if inflation is forestalled by the Fed, AD cannot be effectively raised”. Is this what you are saying?

    A sector financial balances (SFB) approach suggests this is wrong: even in a scenario of loose fiscal policy and tight monetary policy (the opposite of the UK at present), the fiscal stimulus would be effectively speeding the process of private sector balance sheet repair, which would leave the private sector in a better place to drive economic growth than it is at today.

    What is the monetarist objection to this analysis?

  25. Gravatar of W. Peden W. Peden
    12. October 2011 at 05:07

    Anders,

    Monetarists are not committed to the proposition that fiscal policy is ineffective under such circumstances; the claim, as I understand it, is that the tight monetary policy offsets the stimulative effects of the fiscal stimulus.

    As a point of fact, I struggle to see how UK fiscal policy can be described as tight. The UK has the third largest deficit in Europe. How is a 10% of GDP + deficit “tight fiscal policy”? Is it tight because of expectations of future tightening?

  26. Gravatar of david david
    12. October 2011 at 05:29

    Breaking news: Krugman took a swing at you in his blog:

    I would submit, by the way, that the quasi-monetarists — QMs? — have actually backed up quite a bit on their claims. They used to say that the Fed can easily and simply achieve whatever nominal GDP it wants. Now they’re more or less conceding that the Fed has relatively little direct traction on the economy, but can nonetheless achieve great things by changing expectations. That’s pretty close to my original view on Japan. But changing expectations in the way needed is hard, especially when the Fed (a) faces massive sniping from the right and (b) has a number of hard-money obsessives among its own officials.

  27. Gravatar of david david
    12. October 2011 at 05:31

    The difference between Warstler’s and the LDP proposal would be in whether the employed receive the guaranteed income, I suppose.

  28. Gravatar of david david
    12. October 2011 at 05:33

    @Scott

    I’d put it this way, higher inflation is not a necessary condition for fiscal stimulus to work in the way it is for liquidity trap monetary policy (in the Keynesian view) But that doesn’t matter, because if it works it will shift AD, which will raise inflation. If the Fed stops inflation from rising, they will, ipso facto, stop AD from shifting.

    How is the Fed proposed to stop inflation from rising here, though? Raise interest rates? That would be obviously against its mandate and no amount of wailing about ammunition would fix that. Pledge to raise rates in the future? But the whole argument is driven by the Fed’s inability to credibly commit in the long-term.

  29. Gravatar of c8to c8to
    12. October 2011 at 05:33

    yes morgan… it would be great to get a massage for one dollar an hour..

    it might not be quite this utopian but would be better than a minimum wage…

    plus i could become an artist =)

  30. Gravatar of flow5 flow5
    12. October 2011 at 05:44

    I’ve been “FED WATCHING” since the late 60′s. The FED is dominated by con artists. They are arrogant & ignorant. They cover up all their mistakes. They move with the same speed as all of the other government’s bloated bureaucracies.

    I do have great respect for some of their technical staff, but as a whole the organization is driven by the bankers it serves. The Lobbyists virtually control the House Committee on Financial Services & the U.S. Senate Committee on Banking, Housing, and Urban Affairs.

    These interested parties (including the American Bankers Association) routinely spend more money influencing legislation, than all other industry and labor groupings.

  31. Gravatar of Anders Anders
    12. October 2011 at 05:48

    @W Peden – don’t you think it’s actually quite beneficial in the long term to restore private sector balance sheets to financial health? It seems that reducing household indebtedness by 20% via fiscal stimulus has long-term benefits which mean that after this hypothetical monetary tightening is over, the economy is better positioned for growth?

    Monetarism seems congenitally under-interested in the extent of the private sector’s net financial assets, and instead obsessed over the composition of the financial assets between very liquid and slightly less liquid forms.

  32. Gravatar of Anders Anders
    12. October 2011 at 06:07

    @W Peden – yes I would concede that actual fiscal tightening to date is modest (latest broker fcst 8.3% for 2011); it is the vision of reaching balance by 2015 which I was referring to.

  33. Gravatar of Morgan Warstler Morgan Warstler
    12. October 2011 at 06:46

    c8to,

    the moment you give a great massage, some other greedy hedon swoops in and bids $80 on your next week, forcing your satisfied customer to go $100. A $60 bid hike!

    So instead of you getting paid $6.00 per hour, you make $6.75, and the government saves $30 per week on your GI.

    —-

    The reality is that employing 20-25M people this way is a piece of cake, the “excess capacity” will clear immediately and the bid price will quickly increase.

    There are very few people in the top 20% of America who can’t instantly think of a way they could use a $120 per week Boy / Girl Friday.

    If you want to focus the ipside, just geo-fence the labor. Don’t require any recipient to travel further than say 5 miles, or 1 mile even.

    The real sustainable stuff is local entrepreneurs looking at cheap labor as found money.

    In the age of Ebay sticky wages is a complete fabrication. It exists ONLY because we haven’t intentionally attacked it and an evil.

  34. Gravatar of Morgan Warstler Morgan Warstler
    12. October 2011 at 06:50

    This was my proposed schedule:

    http://biggovernment.com/mwarstler/2011/01/31/guaranteed-income-part-ii-a-real-end-to-illegal-immigration/

    Notice it pays out soem GI even when worker is earning $10 per hour.

    You could even funnel the GVT. savings back into the program to raise the GI minimum.

    In this way the “DOLE” is a global budget that will be spent on those that want a job, and positive feedback rewards the system.

    The key this is that employers / bidders don’t own SS, they don’t file forms, they deposit their money, they search for a deal, they make their bid, they get their labor, they leave their feedback.

    Computers are amazing!

  35. Gravatar of JPIrving JPIrving
    12. October 2011 at 07:33

    Completely off topic but you need to know Prof Sumner: There a pro Ron Paul adverts on this blog.

  36. Gravatar of Benjamin Cole Benjamin Cole
    12. October 2011 at 07:48

    John–

    Due to money illusion, inflating the money supply boost economic output when there is slack.

    For example, suppose I print up $200 in perfect counterfeits. I hire someone to repair my roof. Someone I would not have hired had not I got the “free” money.

    Now the roofer gets the money, and spends it on a call girl. He gets an economic good. She takes the money and goes to a hair salon. She gets an economic good, and the hairdresser gets the money etc etc etc.

    Sure, the real wealth of a nation is the roads, factories, farms, infrastructure, technology, clean government, educated work force etc. We all know that.

    But in a modern economy—not in utopia—demand goes sideways or down sometimes, and monetary policy is the best corrective.

    In a perfect world, maybe the gold standard would be a good idea. OR, in a perfect world, maybe we would all honor paper currency understanding it reflects a claim on output.

    No, you cannot print your way to nirvana if you live in the Stone Age.

    But when you have a powerhouse that is starved for demand—the USA today—printing more money makes a lot of sense.

    The costs of inflation is negligible, compared to the gains of economic growth, especially now.

    I share your sentiment about people who are closer to money benefit the most from it. But first, let’s get the economy roaring again. Structural impediments, institutional imperfections can be fixed later. If we wait until we fix every problem before we boost demand, we will never get this party started.

  37. Gravatar of Kevin Donoghue Kevin Donoghue
    12. October 2011 at 07:51

    “I’d also note that with an ideologically conservative Fed the most effective fiscal policies (for reducing unemployment) are not at all what progressives would like. You’d need to lower employer-side payroll taxes, lower minimum wages, cut back on the maximum duration of UI benefits, in order to shift aggregate supply to the right.”

    Basically that’s what the ECB prescribes for the Eurozone. You can see it working (at least I hope it’s working) in Ireland, after a fashion at least. Of course it isn’t actually reducing unemployment yet, but we can see that it might, with luck, eventually. You can see it not working at all in Greece, Italy, Spain….

  38. Gravatar of James in London James in London
    12. October 2011 at 08:20

    So, why are 10yr Treasury yields well above the level before Operation Twist was announced? Why have inflation expectations as measured by TIPS risen so strongly recently? I haven’t seen the Fed do anything over the last few weeks. Does that mean monetary policy is actually set right, and all the handwringing on this website wrong?

  39. Gravatar of W. Peden W. Peden
    12. October 2011 at 08:37

    Anders,

    “don’t you think it’s actually quite beneficial in the long term to restore private sector balance sheets to financial health?”

    Defined as?

    “It seems that reducing household indebtedness by 20% via fiscal stimulus has long-term benefits which mean that after this hypothetical monetary tightening is over, the economy is better positioned for growth?”

    Because the public are now indebted as citizens rather than as households? Also, if the monetary tightening increases the cost of the public’s debts, why should we assume that their household debt would improve IF we assume that the monetary tightening is having an equal effect on demand to the fiscal tightening?

    (Historically, of course, the effect has not been equal: I struggle to think of an example of a tight or loose monetary policy that was overpowered with fiscal policy. However, this seems to me to be a contingent rather than logical point, since we can imagine fiscal policy on a scale that would offset monetary policy; it’s just that, in practice, politically possible monetary moves have been more powerful that politically possible fiscal moves.)

    “Monetarism seems congenitally under-interested in the extent of the private sector’s net financial assets, and instead obsessed over the composition of the financial assets between very liquid and slightly less liquid forms.”

    I fear that you’ve now got a rhetorical advantage, since you’re talking about unnamed monetarists.

    “yes I would concede that actual fiscal tightening to date is modest (latest broker fcst 8.3% for 2011); it is the vision of reaching balance by 2015 which I was referring to.”

    I still don’t quite understand you. Do you mean that UK fiscal policy is currentely tight because of the current expectations of future public-sector deleveraging or do you mean that UK fiscal policy is currentely loose because of the large public sector deficit?

  40. Gravatar of Bonnie Bonnie
    12. October 2011 at 09:53

    Maybe I’m missing something, but I have never seen any rationale for the apparent ~2% inflation target. Given that, assuming 2% is the target seems speculative. How do we know the preferred target isn’t 1% or zero and the Fed keeps overshooting? If that were the case, then some of the statements about “accommodation” might even be justified, as in ‘our target is actually zero, but were letting you have 1.5% – aren’t we generous!’ Given that the Fed remains mum on the topic, its behavior seems either arbitrary or incompetent because there has been nothing contained in any of the recent public statements by FOMC officials that makes much sense.

    Your recent post criticizing statements made about having more tools to use if things get worse is case in point. Those statements aren’t any different than the stock answers coming out the Fed since the beginning – reference back to those sept 2006 issues of The Economist, going all the way through to the full blown crisis in the fall of 2008, where it discusses a Fed on the sidelines promising to intervene if things get worse as our financial system was being sucked into the vortex of the giant crapper from hell.

    These people do not know what they are doing and are likely of the ideology that doing nothing is better than doing something and making a mistake. But when doing something is required, and nothing is done, then this is the kind of result we get.

  41. Gravatar of John John
    12. October 2011 at 10:07

    Ben Cole,

    Continue tracing the path of money a little farther. Yeah counterfeiting benefits the counterfeiter, the people who sell to him, the people who sell to them, and so on, but at some point as the money travels through the system, the higher prices certain people (the ones farthest removed from the counterfeiter) have to pay outweigh the benefits of the increased spending. There is no net positive, only redistribution.

    When the next inflation numbers come out they are estimated to be around 4% year over year. Do you really want to go higher? That’s higher inflation than we’ve had in most recoveries actually. A lack of inflation is NOT the problem.

    I just want to repeat, and I hope it sinks in, that over the last year we’ve had 3.6-4% inflation with no dent in unemployment. That should disprove the theory that more inflation will have a significant effect on unemployment.

  42. Gravatar of Anders Anders
    12. October 2011 at 10:44

    @ W. Peden

    “Because the public are now indebted as citizens rather than as households?”

    You can’t really believe that national public+private debt is more relevant to private sector confidence and behaviour than the level of private debt alone?

    “we can imagine” etc

    OK so for any given quantum of fiscal stimulus there may be a conceivable level of monetary tightening which could entirely offset it by increasing the interest burden. However, given you have income effects from increasing the base rate too, it seems (without modelling it) fairly straightforward for the fiscal authority to keep ahead, so as to speak, of the monetary authority.

    “rhetorical advantage”

    Broad monetarists (ie those focusing on broad aggregates rather than HPM – eg Tim Congdon) whom I have read all seem to accept the ‘real balance effect’ (or as I prefer, the ‘hot potato theory’): the non-bank sector is unable to shed excess deposit balances but in an attempt to do so, it bids up financial asset prices, which boosts consumer spending. I have not come across any of these guys even mentioning the concept of the private sector’s net financial assets – they don’t seem to find it a relevant variable.

    “UK fiscal policy”

    I would concede that it is a stretch to characterise the current fiscal stance as tight given relatively few cuts have taken place, although I wouldn’t necessarily call it loose either, given the level of unemployment and general macro outlook. But I would describe the Coalition’s plans for fiscal consolidation as amongst the more aggressive. I’d also add that the tightness of the fiscal stance should probably be articulated in terms of the sensitivity of the budget deficit to GDP growth, rather than the % deficit itself.

  43. Gravatar of DrJim DrJim
    12. October 2011 at 11:33

    david “for an ideologically conservative Fed, the liberal response would probably not be to attempting moving AS via policy but instead attack the independence and legitimacy of the Fed, even if it means a return to the political business cycle.”

    The only people I see doing that are wing-nuts like Ron Paul, not liberals. Or is this just Poe’s Law? If so, next time include the smiley face …

  44. Gravatar of W. Peden W. Peden
    12. October 2011 at 11:46

    Anders,

    “You can’t really believe that national public+private debt is more relevant to private sector confidence and behaviour than the level of private debt alone?”

    I wouldn’t think about either in isolation from expected income.

    “OK so for any given quantum of fiscal stimulus there may be a conceivable level of monetary tightening which could entirely offset it by increasing the interest burden. However, given you have income effects from increasing the base rate too, it seems (without modelling it) fairly straightforward for the fiscal authority to keep ahead, so as to speak, of the monetary authority.”

    It depends on the institutional arrangements. More than two budgets in a year is extremely rare. Interest rates can change dramatically in a few hours under some conditions. We’re also assuming that the fiscal authorities and the monetary authorities are separate, which has not been the institutional arrangement in the UK for most of the history of UK macroeconomic policy.

    Under the current arrangements of an independent central bank pursuing an inflation target and a government that has to go through parliament to pass a budget, the monetary authorities can move much, MUCH quicker.

    “Broad monetarists (ie those focusing on broad aggregates rather than HPM – eg Tim Congdon) whom I have read all seem to accept the ‘real balance effect’ (or as I prefer, the ‘hot potato theory’): the non-bank sector is unable to shed excess deposit balances but in an attempt to do so, it bids up financial asset prices, which boosts consumer spending. I have not come across any of these guys even mentioning the concept of the private sector’s net financial assets – they don’t seem to find it a relevant variable.”

    I think it’s a question of scale and terminology. They don’t say “net financial assets”, but large fiscal deficits are part of the classic monetarist account of the Barber Boom. There’s also a lot of very, very technical stuff by Gordon Pepper on overfunding and plenty of British monetarist literature on the PSBR in general. A balanced interpretation would be to say that monetarists of the Congdon/Pepper sort are interested in the PRICE of financial assets (and some kinds of financial assets in particular) with quantity becoming important insofar as it affects the price of financial assets.

    Of course, this doesn’t cover every monetarist e.g. “narrow money” monetarists tend to ignore things like the PSBR in favour of the monetary base or transaction money.

    “I would concede that it is a stretch to characterise the current fiscal stance as tight given relatively few cuts have taken place, although I wouldn’t necessarily call it loose either, given the level of unemployment and general macro outlook. But I would describe the Coalition’s plans for fiscal consolidation as amongst the more aggressive. I’d also add that the tightness of the fiscal stance should probably be articulated in terms of the sensitivity of the budget deficit to GDP growth, rather than the % deficit itself.”

    Perhaps here we have a problem of how to define ‘tight fiscal policy’ and ‘loose fiscal policy’. A lot depends on whether one looks at the means, the ends, or the results. I think that fiscal policy begins to have effects as soon as it is announced, so I’m primarily interested in the ends of a programme of fiscal policy. Under that definition, the Coalition’s fiscal policy is very tight and the UK is only avoiding a very serious recession because of offsetting monetary policy.

    Results are the most awkward approach, I think, because (for example) unemployment is affected by lots of things other than aggregate demand and real GDP growth is a function of both demand-side factors & supply-side factors. It is quite possible for demand to be very high and real GDP to be contracting e.g. 1974-1975 in the UK.

  45. Gravatar of Morgan Warstler Morgan Warstler
    12. October 2011 at 11:48

    Ya know if Matt Taibbi was just a weensy tad smarter he’d finally figure out the only real play for the OWS crowd.

    http://www.rollingstone.com/politics/news/my-advice-to-the-occupy-wall-street-protesters-20111012

    The dirty hippies need to FOLLOW the Tea Party.

    So as long as Matt imagines that this protesting stuff is going to loosen up coins that fall from Wall Street to the indebted, he is as doomed as he suspects.

    Strategically, the smartest thing they could do is argue for tax breaks from SMBs at the expense of the Fortune 1000.

    That’s the fastest immediate way for an underdog to get a policy change: stop trying to benefit yourself directly.

    If progressives started screaming that SMB income is really the BEST KIND of capital gains, and it should be taxed at 10% and everything else at 20%, the Tea Party would go wild.

    The combined force of the A power (TP) and the C power (hippies), would crush Wall Street.

    Oligarchs have no votes, and so as long as the progressive cast their vote against the Tea Party, Wall Street wins.

    Progressives should accept is it better to flow benefits to the Tea Party than to Wall Street.

  46. Gravatar of Benjamin Cole Benjamin Cole
    12. October 2011 at 11:55

    John-

    There are various ways to measure inflation, and many (even right-wingers, until recently) stated that the CPI overstates inflation, by perhaps 1 percent. If you check the CPI now compared to three years ago, you won’t see much action.

    Also, as George Gilder pointed out, if we check every commodities inflation by choking our money supply, we both choose a recession and discourage new commodities production (ensuring further rounds of commodities inflation).

    I actually agree with you in some regards; I do not think growth needs to incur inflation. Indeed, I think you can get a virtuous cycle going, in which unit costs actually go down as production goes up—especially true when there is so much unused capacity. Only when you get towards full capacity do we see demand-pull inflation.

    I am not in favor of inflation for inflation’s sake–though right now inflation would help delevering, and would be valuable for that alone.

    I am in favor of printing enough money to spur growth towards 7 percent annually NGDP, for three or four years in a row. Due to competition and slack resources, and open borders (remember, goods, services, capital and labor pour across our border) we are somewhat insulated against inflation, so much of that 7 percent will be real growth. Check out unit labor costs for last three years. They are down.

    If, in the worst case scenario, we get only inflation and no growth, we can stop, although even in that case we will have cut the national debt down by about one-quarter, relieving our children of onerous debts.

    The benefits are huge, and risks tolerable.

    Now is the time for Market Monetarism!!!!!

  47. Gravatar of Fake Herzog Fake Herzog
    12. October 2011 at 12:05

    Totally off topic, but on the subject of Market Monetarism, I’d love to read Scott’s thoughts on Mencius Moldbug, who goes to town on Krugman and fractional reserve banking in this post:

    http://unqualified-reservations.blogspot.com/2011/10/professor-krugman-on-maturity.html

  48. Gravatar of Ken Hirsh Ken Hirsh
    12. October 2011 at 12:33

    I think the Fed has been aggressive proportional to the perceived danger of the situation. Scott lists:

    1. The Fed started paying IOR for the first time in its history.

    2. The Fed got involved in bailing out the banking system to an unprecedented extent.

    3. The Fed got heavily involved in buying MBSs (QE1)

    4. The Fed did QE2, with longer term bonds

    5. The Fed did Operation Twist

    The first three WERE aggressive, but those were conducted at the depths of the crisis. The last two are much less aggressive (particularly #5). For better or for worse, this Fed will only do very aggressive things when they feel that they have no other choice.

  49. Gravatar of John Thacker John Thacker
    12. October 2011 at 13:21

    Interestingly, the Fed minutes just released have two officials arguing that more QE was needed, but went along because the Fed didn’t rule out taking more action later.

  50. Gravatar of John John
    12. October 2011 at 13:56

    Ben Cole,

    I think you’ll get what you want and the growth won’t do much to boost real GDP or employment. When the Fed clamps down on inflation we’ll get another recession; you can take that one to the bank. Every time a country has to slow inflation they get a fall in real GDP and a rise in unemployment. That was Friedman’s claim.

    But I’m wondering if you’ll ask yourself, what would the evidence have to look like to convince me that inflation and employment were unconnected? Here’s a list of the highest inflation countries, see any economic dynamos here?

    Venezuela, Vietnam, Kenya, Angola, Tanzania, Pakistan, Ukraine, Bangladesh, Bolivia, and Mozambique

    Inflation is simply bad economic policy. The countries that resort to it are desperate or have little economic understanding i.e. run by leftists. It’s a sign of bad economic policy all around. We shouldn’t make their same mistakes.

    Market Monetarism makes the same basic mistake as Keynes by equating economic viability (unemployment and output) with the level of total spending. Economics based on that approach are bound to give sub-par results.

    One final note, you know what would have really helped with deleveraging? Letting people go out of business and clearing the mess in bankruptcy court. Much of the failure to recover has come from banks that should’ve gone under sitting on low interest government bonds waiting for their balance sheets to repair.

  51. Gravatar of John John
    12. October 2011 at 14:06

    I think the Fed has shown a relatively realistic view of the limits of monetary policy. Keep in mind that at the end of QE2, unemployment hadn’t budged. The program had been a mixed bag. One the one hand, core inflation got up to around their implicit goal of 2% and the stock market had done well. On the other hand, employment and real GDP hadn’t seen that much improvement. I think it was wise for them to back off at that point.

    I’m not really sure why they bothered with Operation Twist though. It was a de facto tightening as banks want a steep yield curve to borrow short and lend long.

  52. Gravatar of JimP JimP
    12. October 2011 at 14:41

    http://www.breakingviews.com/occupy-wall-street-may-share-fate-of-coxeys-army/1610689.article

    “Coxey, a successful businessman with Populist Party connections, began his march on the capital on March 25, 1894, with 100 participants from his home town of Massillon, Ohio. The marchers demanded federal deficit spending on roads and other public works, with laborers paid in paper money, thus expanding the currency in circulation.”

    Now there is a novel idea – print some money Ben !!!!!!!!!!

  53. Gravatar of Morgan Warstler Morgan Warstler
    12. October 2011 at 14:53

    Massillon, Ohio my home town. Go Tigers.

  54. Gravatar of David Pearson David Pearson
    12. October 2011 at 17:10

    Scott,

    This might seem a stretch, but the Fed minutes today contained a suggestion that the Fed is moving towards formal price level targeting (“the long-run level of inflation”) as a means of communicating policy. I think this was missed by market participants:

    “Participants generally agreed that a clear statement of the Committee’s longer-run policy objectives could be helpful; some noted that it would also be useful to clarify the linkage between these longer-run objectives and the Committee’s approach to setting the stance of monetary policy in the short and medium run. That said, a number of participants expressed concerns about the conceptual issues associated with establishing and communicating explicit longer-run objectives for the unemployment rate or other measures of labor market conditions…In contrast, participants noted that the long-run level of inflation is determined primarily by monetary policy. Accordingly, many felt that if the Committee were to reach a consensus on more explicit statements of its longer-run objectives, it would need to provide an in-depth explanation to the public of how those objectives were determined and how they fit into the policymaking framework. Participants generally saw the Committee’s post-meeting statements as not well suited to communicate fully the Committee’s thinking about its objectives and its policy framework, and agreed that the Committee would need to use other means to communicate that information or to supplement information in the statement.”

  55. Gravatar of Alex Alex
    12. October 2011 at 18:12

    I’m in a favor of ending the Fed, and I’m also a Ron Paul support, but you probably guessed that :P

    Alex, How To Do Hypnotism

  56. Gravatar of JimP JimP
    12. October 2011 at 19:06

    http://newamerica.net/publications/policy/the_way_forward

    Do all the stuff in this paper – or target NGDP.

  57. Gravatar of Jason Odegaard Jason Odegaard
    13. October 2011 at 03:20

    John – which inflation numbers do you use? And why is increases in the monetary base inflationary if the money does not enter the general economy? Seems IOR at the Fed keeps quite a lot of it stuck as cash balances.

  58. Gravatar of ssumner ssumner
    13. October 2011 at 05:09

    John I agree there are skill shortfalls in specific areas, although I doubt that’s stopping infrastructure projects, as there’s lots of unemployed construction workers.

    Mikko, But the Fed cut interest rates in 2007, when we weren’t in recession and inflation was much higher than 2%.

    Kevin, No, I meant the standard AS/AD. Shifting AD to the right increases inflation above what it would be if we didn’t shift AD to the right.

    Anders, You said;

    “Scott – you seem to switch from “inflation is an inevitable by-product of raising AD, given an upward-sloping SRAS curve” to “inflation is a necessary condition to raising AD, so if inflation is forestalled by the Fed, AD cannot be effectively raised”. Is this what you are saying?”

    No, I’m sticking with the by-product assumption.

    Thanks David, I’ll do a reply post to Krugman.

    David, They stop inflation from rising by doing less QE than they would otherwise do.

    Anders; You said;

    “@W Peden – don’t you think it’s actually quite beneficial in the long term to restore private sector balance sheets to financial health? It seems that reducing household indebtedness by 20% via fiscal stimulus has long-term benefits which mean that after this hypothetical monetary tightening is over, the economy is better positioned for growth?

    Just the opposite. Monetary stimulus reduces household indebtedness, fiscal stimulus increases it.

    JPIrving, I’m fine with that.

    Kevin; You said;

    “Basically that’s what the ECB prescribes for the Eurozone.”

    That’s why I favor monetary stimulu. Without NGDP growth, austerity (i.e. internal devaluation) is the only way out, but it’s a brutal process.

    If the ECB won’t play ball, Greece is probably better off going back to the drachma. But what Greece cannot do is avoid austerity, while remaining on the euro–that policy will not work, because they don’t have enough money to implement it.

    James, You are looking at changes, whereas you need to look at levels. The level of expected growth is higher than a few weeks ago (which is good) but still way too low (which is bad.)

    Bonnie, 2% is assumed to be their target, because it’s their long run forecast with “appropriate policy.”

    Ben, Yes, you don’t hear much any more about the CPI overstating inflation.

    Fake, What’s his view on the Canadian banking system, which has never had a crisis? (at least in the past 100 years)

    Ken, I meant that they were willing to try new things.

    John Thacker, Thanks for the tip–that’s hopeful.

    John, You said;

    Keep in mind that at the end of QE2, unemployment hadn’t budged.”

    Actually, it had fallen from 9.8% to about 9.0%.

    JimP, Yes 1894, back when progressives understood monetary policy.

    David Pearson, It sounds more like inflation targeting than price level targeting, but it’s so vague I can’t be sure.

  59. Gravatar of David Pearson David Pearson
    13. October 2011 at 05:44

    Scott,

    A couple of points in that paragraph stood out for me:

    -The Fed is implying they don’t control short-run inflation well. Presumably, this is because of “long and variable lags”.

    -They already have an implicit l.t. inflation rate target of 2%. It doesn’t sound to me like the debate was over whether to make the 2% “formal”. They seem to be considering a bigger change than that.

  60. Gravatar of David Pearson David Pearson
    13. October 2011 at 06:11

    Scott,
    It strikes me that the Fed is saying it can’t hit a short-run inflation target. You argue they can target expectations, and there is a tight link between expectations and realized inflation (sorry, NGDP). My question is, is there empirical evidence for this supposition? What kind of a track record does, say, two-year TIPS have for forecasting realized inflation?

  61. Gravatar of David Pearson David Pearson
    13. October 2011 at 06:19

    BTW, here’s a fact from today’s WSJ that might contribute to the debate over whether a “demand shock” caused commodity prices to rise in 2011. Remember, Brent Crude is still up 40% from Jackson Hole, 2010:

    “The International Energy Agency forecasts Chinese demand for oil to grow by 5.2% in 2012. With oil imports in the first three quarters of 2011 up just 4%, GDP growth expected to slow in 2012, and the 12th five year plan calling for a reduction in energy intensity per unit of GDP, that looks optimistic.”

  62. Gravatar of Steve Roth Steve Roth
    13. October 2011 at 08:33

    Makes sense. There are assorted institutional incentives encouraging temperamental conservatism, but there’s a huge financial incentive encouraging ideological conservatism: inflation is bad for creditors, and the Fed is run by creditors.

    An extra 1% inflation, ceteris paribus, reduces they real buying power of U.S. creditors’ bond holdings by hundreds of billions of dollars a year.

    Given that level of financial incentive, it’s not hard to figure the cause of that ideological conservatism.

  63. Gravatar of Occupy Wall Street, Monetary Policy and the Federal Reserve | Rortybomb Occupy Wall Street, Monetary Policy and the Federal Reserve | Rortybomb
    13. October 2011 at 09:00

    [...] not the Federal Reserve will kill any recovery – especially if driven by new fiscal stimulus - if inflation goes above 2%.  How much do they emphasize their obligation to maximum employment versus inflation?  These are [...]

  64. Gravatar of John John
    13. October 2011 at 11:24

    Jason Odegard,

    I use the official numbers at at the BLS at bls.gov.cpi

  65. Gravatar of mpowell mpowell
    13. October 2011 at 18:12

    I want to ask a question here: why should we consider an increase in the price of gas as inflation? If gas is getting more expensive (and directly driving the price of a few other commodities) that does not tell me that the dollar has gotten less valuable. It tells me gas has gotten more expensive. I’m not even talking about core CPI being a better predictor of future CPI movement than CPI itself. I mean, what if getting to 5% unemployment means $200/barrel oil because there is a limited supply and when 4% more people need to drive to work there won’t be enough supply unless the price spikes to make people think really hard about how much they need to drive around.

    I think it’s crazy to count oil in with everything else. It just isn’t the same kind of thing as what we are talking about when we are talking about the wage-price spiral in an expanding business cycle (and thus what the fed needs to worry about). In the current environment it means that in order to hit a particular inflation target while unemployment drops, the price of wages (and most everything else) needs to be deflating. I see this as a serious problem in getting back to full employment if the fed is going to insist on treating long term increases in the price of gas as inflation (that needs to be killed with fed policy).

  66. Gravatar of Anders Anders
    14. October 2011 at 01:05

    @Scott:

    “Monetary stimulus reduces household indebtedness, fiscal stimulus increases it.”

    If a fiscal stimulus represents (increased) net borrowing by the govt, doesn’t this entail (increased) net lending by the private sector, entailing lower net indebtedness? Or in concrete terms, lower sales tax would increase disposable income, allowing households to pay down their credit card balances.

    Monetary stimulus (lower rates) can reduce net indebtedness for those households which are net debtors, but will presumably worsen the net financial asset position of net creditors via the interest income channel.

    Monetary stimulus in the form of under-funding / QE does increase deposit balances but how can swapping govt bonds for deposits change anyone’s net indebtedness per se?

  67. Gravatar of Anders Anders
    14. October 2011 at 04:58

    @mpowell – what a great point! If all prices were otherwise stable but an oil price rise resulted in the CPI going up, I have no doubt that every Austrian would respond “look, yet more devaluation of the dollar”. Why should an oil price boom warrant deflation being foisted on other parts of the economy?

    But – why stop with oil? It feels a bit arbitrary not to include other commodities too.

    An alternative approach is that, rather than using unemployed people and capital as a buffer stock to keep prices stable, the authorities could start stockpiling commodities (as they did up to the late 60s or early 70s) in order to prevent speculative price spikes in the first place.

  68. Gravatar of BullseyeMicrocaps.com » Ben Bernanke Does Not Have A Secret Plan To Stymie Stimulus BullseyeMicrocaps.com » Ben Bernanke Does Not Have A Secret Plan To Stymie Stimulus
    14. October 2011 at 10:25

    [...] Sumner wants an answer from Keynesians about how fiscal stimulus is supposed to help a depressed economy if the central bank is determined [...]

  69. Gravatar of Bernanke Does Not Have A Secret Plan to Stymie Stimulus — Clearing and Settlement Bernanke Does Not Have A Secret Plan to Stymie Stimulus — Clearing and Settlement
    14. October 2011 at 17:17

    [...] begins his post as follows: Scott Sumner wants an answer from Keynesians about how fiscal stimulus is supposed to help a depressed economy if the central bank is determined [...]

  70. Gravatar of mpowell mpowell
    15. October 2011 at 07:15

    Anders- I would argue that oil has the particular properties of being 1) a significant part of the economy (compared to say: random rare earth elemental) 2) having a relatively hard limit on supply. Thus there is no outlet option if demand spikes. I think this subject really need to be talked about more (though I noticed Scott mentioned it in a recent post). If the fed is responding to oil price movement even in the medium term, I believe we may be screwed.

  71. Gravatar of Scott Sumner Scott Sumner
    15. October 2011 at 09:31

    David, You may be right about the Fed’s comment on inflation targeting, it’s too vague for me to have a strong opinion.

    I don’t know how well TIPS forecast actual inflation, but that’s not relevant for how they’d do under an inflation targeting regime. Presumably if it was a short run target, it would be core inflation. With a 2% core inflation target, wages would be relatively stable, and that would stabilize core inflation. If they don’t target inflation (as in the 1970s) then inflation is really, really hard to forecast, and hence TIPS spreads would have done a poor job. The current regime is somewhere in between these two extremes.

    I’ve never seen a plausible mechanism for how QE2 could have sharply raised oil prices:

    1. It didn’t produce robust growth
    2. it didn’t sharply devalue the dollar on a trade weighted basis.
    3. It didn’t lead to high inflation expectations.

    So there is no mechanism.

    If QE2 had been highly effective, then I would have expected a sharp rise in oil prices, so I don’t deny the possibility.

    Steve, I am a huge saver and I would greatly benefit from easier money. So would the big banks, who have seen their stocks crushed by tight money.

    mpowell, Yes, but I go much farther and stop talking about inflation entirely, as almost everyone confuses supply and demand side inflation, and treats it like a single phenomenon.

    Anders, In a closed economy net debt is always zero. Our economy is open, and some of those bonds are bought by foreigners, so net debt increases.

    Monetary stimulus reduces the real debt we owe to other countries.

  72. Gravatar of Anders Anders
    17. October 2011 at 11:18

    @Scott: so you’re saying that because (A) some net lending to the govt is done by foreigners, (B) fiscal stimulus (which = govt borrowing) per se increases households indebtedness.

    I accept that in the context of a (probably structural) current account deficit, a higher level of govt net borrowing may lead to an increase in the surplus made by the rest of the world (RoW). But a higher level of govt borrowing of say 3% of GDP would only be worse for private sector net indebtedness if somehow it led to the current account worsening by more than 3% points. Any outcome – surely more plausible – where the current account worsened by less than 3% would lead to an improvement in the private sector surplus per se, and therefore probably an improvement in household indebtedness.

  73. Gravatar of Scott Sumner Scott Sumner
    18. October 2011 at 18:11

    Anders, I guess I don’t know what you mean by “net indebtedness” I assumed you meant net foreign debt. If not, I don’t follow your argument. Money one American owes to another is not net debt, is it?

  74. Gravatar of Anders Anders
    21. October 2011 at 03:16

    Scott – I’m following the ‘sector financial balances’ approach, ie dividing the economy into govt, rest of world (RoW) and the domestic private sector; all three need to net to zero in terms of flow (financial surplus/deficit) and stock (net financial assets/liabilities).

    On this basis, fiscal policy (disregarding changes to NGDP and any multiplier effects), has a first-order effect of increasing govt debt and decreasing the aggregate net debt of other sectors (private sector and RoW). With a flat NGDP, a budget deficit of 10% of GDP should lead to govt debt/GDP rising by 10% points; data suggest that most of the offsetting decrease in sectoral debt/GDP is being seen in the private sector as opposed to the RoW.

    Now, unfortunately it appears that firms are getting more benefit than households from the overall private sector deleveraging, but nonetheless the fact that households are able to run a small financial surplus at the moment indicates that large fiscal deficits are facilitating household deleveraging.

    The only constraint on the size of fiscal deficits for the US and UK seems to be inflation – which looks pretty unthreatening at present.

  75. Gravatar of Scott Sumner Scott Sumner
    29. October 2011 at 05:53

    Anders, I don’t see the point of this. Why would we want to do fiscal stimulus rather than monetary stimulus? Fiscal stimulus increases future tax burdens on the economy.

  76. Gravatar of Anders Anders
    31. October 2011 at 04:06

    Scott:

    “Fiscal stimulus increases future tax burdens on the economy”

    Yes, but (1) the tax increases would happen later once the econony is growing again, and (2) the tax increases later might even be lower than the stimulus today and still be consistent with the same govt debt/GDP metric (if that’s the concern), depending on the trajectory taken by NGDP. So you should only be concerned by future tax burdens if you were a Ricardian – I didn’t think you were?

    “Why would we want to do fiscal stimulus rather than monetary stimulus”

    A further monetary stimulus, given where we are now, transforms some asset managers’ liquid, low interest bearing govt bonds into some even more liquid, lower interest bearing bank deposits. This may indirectly boost net financial assets, but would mainly do so via a ‘hot potato’ / real balance mechanism – which may be overstated especially at the present time, when (a) commercial banks have been trying to raise equity and shrink their balance sheets, both of which drain the non-bank sector’s deposits, and (b) the non-bank private sector in general is showing itself increasingly able to shed deposits eg by moving allocations into bond funds which replace bank lending.

    A fiscal stimulus, on the other hand, by increasing govt debt, by definition increases non-govt wealth. It improves households’ and firms’ balance sheets, lowering net debt and increasing net assets, and ought to make short/medium term.

    Ultimately, it comes down to why you think that both households and firms are unwilling to spend (with troubled household outlook being a likely cause for firms not to invest). If you believe it’s a lack of liquidity, then QE seems sensible. But if, as seems plausible to me, it’s a problem of household balance sheets being underwater, then the best approach is for the govt to increase its debt and private sector wealth at the same time, by direct fiscal transfers.

    Best wishes

  77. Gravatar of Scott Sumner Scott Sumner
    31. October 2011 at 16:22

    Anders, I’m worried about the deadweight loss (or excess burdern) of taxes, not Ricardian effects. In my view monetary policy determines NGDP, so I see no reason to use fiscal stimulus, when the Fed would probably just sabotage it.

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