Nick Rowe reframes the question

One criticism of using monetary stimulus at the zero bound is that the effects depend on a commitment to do something in the future, which might not be credible.  I happen to think that’s always true of monetary policy, so I don’t find the argument persuasive.  But most people disagree with me.  Nick Rowe has an excellent post showing that fiscal policymakers face exactly the same credibility problem:

OK, so what about a temporary increase in G? Won’t that shift the New Keynesian IS curve upwards, and cause the natural rate of interest to increase temporarily? Yes and no. If you increase G from 200 to 300 today, and promise to reduce it from 300 to 200 tomorrow, that will increase AD today. But if you leave G at 200 today, and promise to reduce it from 200 to 100 tomorrow, that will have exactly the same effect on AD today. Today’s increase in G is not what causes AD to increase. It’s tomorrow’s decrease in G that causes today’s AD to increase.

Here’s the intuition. A temporary increase in G from 200 to 300 and back to 200 is identical to a permanent increase of G from 200 to 300 plus a promise to cut G by 100 tomorrow. We have already established that a permanent increase in G does nothing. Therefore the effect of a temporary increase in G is identical to the effect of a promise to cut G in future.

A decrease in future G (once the economy has escaped the ZLB) causes an equivalent increase in future C. By consumption-smoothing, that increase in future C causes an equivalent increase in current C, for a given real interest rate between today and the future.

OK. Now let’s compare monetary policy to fiscal policy at the ZLB. We can either promise to loosen future monetary policy. Or we can promise to cut future government spending. Which promise is more credible?

Hmmmmm. The answer’s not so obvious, is it?

Notice something weird? I have made absolutely no change in the standard New Keynesian model. The only thing I have done is to re-frame the question. Instead of talking about the effects of a temporary increase in government spending I am talking about the effects of a promise to cut future government spending.

I have changed the definition of doing nothing. Under the original definition, we do something now, when we increase government spending, and we do nothing in the future, when government spending just falls again, all by its little self. Under my re-definition of “doing nothing“, we do nothing now, and we promise to do something in the future, when we will actively cut government spending.

Acts of commission and ommission. Trolley problems. Stuff like that. That’s what we are talking about.

By changing the definition of “doing nothing” I have suddenly made both fical and monetary policy at the ZLB rely on the credibility of promises of future actions. The two policies are now on a par.

Now I’m going to go further, and change the definition of “doing nothing” with monetary policy.

Take the standard New Keynesian macro model, and bolt on a bog-standard money demand function. You can even make that money demand function perfectly interest-elastic at the ZLB, if you like.

It is well-understood by New Keynesian macroeconomists that if you add a money demand function it does nothing whatsoever to the model. The two models are observationally equivalent. For every interest rate reaction function there exists a money supply reaction function, and vice versa. But it lets me change the definition of “doing nothing“.

Again, a credible promise to keep future interest rates too low for too long will increase the expected future price level. That means the future nominal demand for money will be higher too. In equilibrium, money supply equals money demand, so the expected future money supply will be higher too.

A permanent increase in the money supply today is equivalent to a promise to keep future interest rates too low for too long.

Let’s see how the question looks now. The New Keynesians are asking us to believe that a promise to cut future government spending would be more credible than an actual increase in the money supply today. Really?

See how I have turned the tables, just by redefining what “doing nothing” means? All of a sudden it is fiscal policy that requires credibility of a promise of future action. Monetary policy simply requires a belief that central bank will “do nothing” in future. It won’t decrease the money supply back down again.

Roosevelt was at the ZLB. He didn’t promise to keep interest rates too low for too long. Roosevelt simply raised the price of gold. And it worked. Because people naturally assumed he would “do nothing” in future. By “doing nothing” they understood “not lowering the price of gold back down again”. It worked because people thought of “monetary policy” as “setting the price of gold”.

New Keynesian macroeconomists will be tempted to insist that monetary policy really is, is, IS, IS setting interest rates. Any monetarist could insist right back that monetary policy really is, is, IS, IS setting the money supply. And a gold bug could in turn insist that monetary policy really is, is, IS, IS setting the price of gold. That argument will get us nowhere. Nor will arguing over whether fiscal policy really is setting the level of government spending or setting the change in government spending.

It’s all in the framing. There is no reality in these matters. These are all social constructions of reality. We theorists shouldn’t be suckered into believing that our conceptual schemes are out there in the real world. Except, the conceptual schemes of real people out there in the real world are part of the reality of that world, for a social scientist. And the Neo-Wicksellian social construction of reality, in which “monetary policy” is defined as “setting interest rates”, is a damned bad reality to construct. Especially when we hit the ZLB.

A few comments:

1.  I like to see Nick Rowe get post-modern.

2.  I agree about the social construction of reality.  Nevertheless I’d like to convince people that monetary policy really is, is, IS, IS the control of NGDP expectations.  Not because it really is, but rather because no matter what monetary policymakers claim they care about, NGDP really is, is, IS, IS what they care about.  So it’s the logical way of thinking about policy.

3.  We are an NGDP futures market away from blowing interest rate-oriented monetary theory right out of the water.  Once you start targeting NGDP futures, the fed funds rate becomes about as interesting as the price of a bushel of pistachio nuts.

And then reporters can ask Bernanke; “How will your forecast of NGDP two years out change if Congress fails to renew the payroll tax cut, and WHY WILL IT CHANGE?”

PS.  My personal favorite among my posts was about framing affects, although it was quite different from Nick’s post.


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26 Responses to “Nick Rowe reframes the question”

  1. Gravatar of Morgan Warstler Morgan Warstler
    31. January 2012 at 20:38

    “We are an NGDP futures market away from blowing interest rate-oriented monetary theory right out of the water.”

    Is there anyway this could be turned into a game?

    If not, how much cash has to be set up as the bank to get enough cash being bet? Can the margin be as high as Forex?

  2. Gravatar of Major_Freedom Major_Freedom
    31. January 2012 at 21:54

    “OK, so what about a temporary increase in G? Won’t that shift the New Keynesian IS curve upwards, and cause the natural rate of interest to increase temporarily? Yes and no. If you increase G from 200 to 300 today, and promise to reduce it from 300 to 200 tomorrow, that will increase AD today. But if you leave G at 200 today, and promise to reduce it from 200 to 100 tomorrow, that will have exactly the same effect on AD today. Today’s increase in G is not what causes AD to increase. It’s tomorrow’s decrease in G that causes today’s AD to increase.”

    This doesn’t make any sense to me. How can tomorrow’s decrease in G cause today’s INCREASE in AD?

  3. Gravatar of Sandmann Sandmann
    1. February 2012 at 02:08

    This seems like Ricardian Equivalence and I have never been persuaded by textbook “Neo-Keynesianism” that there was a free lunch on offer. I tend to see Keynesian Policies as Deep Crisis Economics. He was looking at the Trade Cycle in the days before automatic stabilisers when poverty was absolute and not relative and the ability of whole regions locked into one production sector ie. mining, shipbuilding, steel ever to emerge from downturns caused by overcapacity especially after war or credit-driven boom.

    The notion post-1945 that Nirvana was available to Mortal Man in a white coat pursuing therapeutic policies owes more to the Cold War focus on guns to keep the Soviets out and butter to keep the voters content than any real Economic principles.

    We only ran into the sand when we lost access to cheap oil and had to grease our economies with cheap credit.

    I think Neo-Keynesianism is basically Joan Robinson and Alvin Hansen and John Hicks trying to hi-jack Keynes as a Capitalist version of Karl Marx with a Unifying Theory of Life, and I do not read that in Keynes. He was a Mathematician-Philosopher running an Insurance Company who thought Markets tended towards Collusion and Imperfection.

    I do not see any policy implications beyond busting cartels and regional policy; yet we have allowed huge global cartellisation and Profits to reach very high share of GDP driving consumers into credit bingeing to keep their consumption up.

    The issue is far less abstract and more practical. Break up Retail Conglomerates which have caused food processor conglomerates and dismantle banks and insurers to create a more dynamic marketplace rather than preserving dinosaurs

  4. Gravatar of D R D R
    1. February 2012 at 05:16

    Looks like Rowe assumes (in comments) that Y does not change. I daresay it is very hard to get a positive multiplier when going down that road.

    http://worthwhile.typepad.com/worthwhile_canadian_initi/2012/01/fiscal-policy-and-the-macroeconomics-of-doing-nothing.html?cid=6a00d83451688169e20167616ffc80970b#comment-6a00d83451688169e20167616ffc80970b

  5. Gravatar of Nick Rowe Nick Rowe
    1. February 2012 at 05:17

    Thanks Scott!

    Yep, it also makes sense to ask: what would be the best way to have the population frame reality? (What sort of beliefs about what “doing nothing” means would lead to the best outcomes?)

    M_F: Suppose tomorrow the economy will be at full employment income. If we cut tomorrow’s G, we let tomorrow’s C increase by the same amount. By consumption-smoothing, that means today’s C increases by the same amount (for a given real interest rate). (Alternatively, note that a decrease in future G means lower future T, and higher permanent disposable income today, so higher C today.)

  6. Gravatar of John John
    1. February 2012 at 05:23

    “Roosevelt was at the ZLB. He didn’t promise to keep interest rates too low for too long. Roosevelt simply raised the price of gold. And it worked.” I’m sick of this historic myth. Roosevelt has the worst economic record and history and people look at him like some kind of genius. In 1934 when the New Deal was in full force, unemployment was 21.7. In 1936 it was 16.9. In 1938 it had risen again to 19% and in 1940, a full seven years into his office, the unemployment rate was still 14.6. Zero lower bounded or not, the record sucks and it is not something we should look to for any kind of model.

  7. Gravatar of StatsGuy StatsGuy
    1. February 2012 at 07:26

    Cute – one observation –

    This argument relies heavily on certain assumptions. Rationality, perfect forecasting, smoothing. It does not do a good job of addressing “credit constraint” issues.

    Nick’s exercise does an excellent job identifying the basis of a theory. IF we believe NewK AND we’re arguing for temporary lift in G followed by a reduction, THEN we could just as easily argue for a planned reduction.

    Conversely, IF we believe that a planned reduction does not yield the same effect as a lift-then-reduce policy, THEN we don’t really believe NewK – we REALLY believe something else is going on (like credit constraints on consumption). And honestly, I think this is what people like Krugman REALLY think, since he constantly argues that if you move money to the poor it WILL get spent.

    But if this is the case, all of these arguments about Ricardian Equivalence/smooth/etc. are plain stupid, because that’s not what people are really arguing about.

  8. Gravatar of Nick Rowe Nick Rowe
    1. February 2012 at 07:38

    D.R. Read my post again carefully (that’s not intended to be a rude response to you, because this is a tricky point to grasp, and it took me some time to see it myself). You will see that I do not *assume* that Y is constant in the face of a permanent increase in G. I *conjecture* that Y is constant, then check my conjecture. It’s an implication of NK theory (depending on the labour supply function), not an assumption on my part.

  9. Gravatar of Major_Freedom Major_Freedom
    1. February 2012 at 08:38

    Nick Rowe:

    “M_F: Suppose tomorrow the economy will be at full employment income. If we cut tomorrow’s G, we let tomorrow’s C increase by the same amount. By consumption-smoothing, that means today’s C increases by the same amount (for a given real interest rate). (Alternatively, note that a decrease in future G means lower future T, and higher permanent disposable income today, so higher C today.)”

    How can consumption spending increase today if government spending didn’t decrease today and remains at 200?

    It looks like your model doesn’t take into account the quantity theory of money, and presumes unlimited cash balances to always be there to provide whatever level of spending your model requires.

  10. Gravatar of D R D R
    1. February 2012 at 09:59

    “I *conjecture* that Y is constant, then check my conjecture.”

    So what? Unless you prove that no other conjectures are valid, then you are still assuming.

  11. Gravatar of Steve Steve
    1. February 2012 at 10:51

    By this pretzel logic, a temporary increase in G today is a permanent increase in G today offset by a ***PERMANENT*** decrease in G later. If you omit the “permanent” on the second part of the union your logic fails. But if permanent changes in G have no effect on Y and a temporary change in G is the union of two permanent changes in G, THEN EVEN A TEMPORARY CHANGE IN G HAS NO EFFECT ON Y, BY ASSUMPTION.

  12. Gravatar of ssumner ssumner
    1. February 2012 at 11:04

    Morgan, We really need the Feds to do this, set up the market.

    Major Freedom, Less future G means less future T, which means more consumption today because what matters is permanent disposable income.

    Sandmann, That’s the first time I’ve seen Joan Robinson and new Keynesianism in the same sentence.

    DR, See Nick’s reply.

    John, FDR did a good job boosting AD, but aborted the recovery with policies that sharply reduced AS. Nick isn’t claiming that everything was rosy, just that it’s possible to boost AD at the zero bound.

    Statsguy, I can’t speak for Krugman, but that sounds plausible. However if this is his view, then he shouldn’t be telling Chicago school economists to go read some NK literature.

    Steve, The key is what’s anticipated, not what actually occurs.

  13. Gravatar of KC KC
    1. February 2012 at 11:10

    @ Steve:

    “if permanent changes in G have no effect on Y”

    No that is not what Rowe is suggesting.
    What Rowe is actually saying that permanent changes in CURRENT G have no effect on Y (because it does not change intertemporal decision). In his example, FUTURE G affects CURRENT Y because of consumption smoothing.

    He got a bit tortuous writing that post and omits a lot of “current” and “future” in there, which is really not ideal for a post on how to frame an argument, but that’s what he’s getting after.

  14. Gravatar of marcus nunes marcus nunes
    1. February 2012 at 12:58

    Scott
    Rogoff´s “elephant in the room” is very different from yours. Also, he manages to “reframe” the whole “need for public intervention (stimulus)” debate!
    http://www.project-syndicate.org/commentary/rogoff89/English

  15. Gravatar of D R D R
    1. February 2012 at 13:09

    I had already seen Nick’s reply, thanks.

    I’m trying to understand many things is…

    Shorter Rowe:
    “If Y is constant, then L is constant, but C falls, so L rises.”

    Perhaps Rowe meant that “People will [want to] trade off to enjoy less leisure and more consumption, now that the marginal utility of consumption is higher because consumption is lower [but do not and are therefore poorer]”

    Shorter Rowe (2):
    “If G rises and people do not produce more, then Y will not rise.”

    Great, but then what does G have to do with it?

  16. Gravatar of marcus nunes marcus nunes
    1. February 2012 at 13:11

    Scott
    See where all the “consumption smoothing” discussion was applied!
    Here’s the thing, though: Bullard’s disclosure form is completely blank. Which means that, except for his house and his Federal Reserve retirement benefits, he has no investments at all worth more than $1,000 — not even a savings account. Or, to put it another way, the president of the St Louis Fed, earning well over a quarter of a million dollars a year, is living paycheck-to-paycheck. Every two weeks, he gets paid $10,819, less taxes and deductions, and yet by the end of the year he still doesn’t have even $1,000 in a checking account.

    Now there might be a good reason why Bullard was completely cleaned out for some reason and left with absolutely nothing but the roof over his head. Maybe there was a lawsuit, or medical bills, or something like that. But still, Bullard’s balance sheet is quite astonishingly bare, for someone in his exalted position.

    Which makes a cynical old journalist like me start wondering about the revolving door. It actually makes perfect sense to live beyond your means when you’re in the public sector, if you know that you’re going to make a lot of money in the private sector later on. It’s called consumption smoothing, and it’s entirely rational. You might not be able to lavish money on your family from a cashflow perspective, but that’s fine, because you’re still a wealthy man if you take into account the present value of massive future earnings.

    http://blogs.reuters.com/felix-salmon/2012/02/01/broke-bureaucrat-of-the-day-st-louis-fed-edition/

  17. Gravatar of Major_Freedom Major_Freedom
    1. February 2012 at 13:12

    ssumner:

    “Major Freedom, Less future G means less future T, which means more consumption today because what matters is permanent disposable income.”

    Only if people have more cash today to spend on C, which ultimately depends on the quantity of money.

    I’m just saying the model ignores the quantity theory.

  18. Gravatar of Patrick R. Sullivan Patrick R. Sullivan
    1. February 2012 at 13:30

    Talk about ‘framing’:

    http://www.chimerareit.com/site/aboutus.aspx

    ‘Chimera Investment Corporation invests in residential mortgage-backed securities….’

  19. Gravatar of Patrick R. Sullivan Patrick R. Sullivan
    1. February 2012 at 13:36

    Then again, maybe re-framing is the next big thing:

    http://www.ft.com/intl/cms/s/0/3642c1ca-4cf3-11e1-8741-00144feabdc0.html#axzz1lAUopWnH

    ‘In an interview with CNN on Wednesday morning, Mr Romney – a former Bain Capital executive – said his campaign was more interested in bolstering the fortunes of the middle class than poor Americans, who were supported by federal government programmes.’

  20. Gravatar of Becky Hargrove Becky Hargrove
    1. February 2012 at 16:33

    Patrick,
    You beat me to it, all I could think about was this post when I saw Romney’s blunder. He will be thinking about the lower classes a lot in the days ahead.

  21. Gravatar of ssumner ssumner
    1. February 2012 at 17:49

    Marcus, Does Rogoff really think that Americans aren’t aware that junk food is bad for you? I talk to many people eating junk food, and that’s not the impression I get. They usually say “I shouldn’t be eating this.”

    Not sure about the Bullard piece, check his update.

    DR, I think he used a conjecture, and then found it represented the equilibrium. Don’t know if that works when there might be multiple equilibria–it’s not my area of expertise. Try adding a comment on his blog.

    Major Freedom, Yes, one weakness of the Keynesian model is that it ignores the quantity of money.

    Patrick, Where do I sign? :)

    Patrick and Becky–it’s going to be a loooong year.

  22. Gravatar of Steve Steve
    1. February 2012 at 19:37

    Marcus,

    The Fed disclosure forms are fascinating.

    Bernanke invests like a Princeton professor: low fee index funds, and a little international exposure.

    Fisher invests like he is channeling Ron Paul: a ranch, undeveloped real estate, over $1MM in gold, and large trades in the double SHORT S&P index ETF.

  23. Gravatar of Steve Steve
    1. February 2012 at 19:58

    Continuing my previous post, based on their asset disclosures:

    Bernanke likes index funds.

    The East Coasters like to buy blue chip stocks (Lockhart, Plosser, Dudley, Rosengren, Pianalto)

    Kocherlakota, Evans, George, and Williams go for mutual funds.

    Lacker and Bullard have substantially no reported assets.

    Fisher likes betting on apocalypse.

  24. Gravatar of StatsGuy StatsGuy
    1. February 2012 at 20:22

    Consider writing a post arguing that:

    NGDP targeting == converting fixed government debt into shares of national GDP.

    That is to say, an NGDP target RULE completely alters the political incentive structure of debt holders. Debt holders now have every incentive to enact policies that improve real growth, because this decreases inflation.

    The bond market, instead of an anti-growth (anti-inflation) force, becomes the ultimate pro-real-growth faction.

    You have an uncanny way of framing issues in counterintuitive but insightful ways, but if you have one weakness, it’s a blindness toward the importance of political incentives.

  25. Gravatar of Steve Steve
    1. February 2012 at 20:32

    Statsguy seems to be of like mind to myself 90% of the time…

    I’ve wondered why you haven’t advocated an NGDP-indexed treasury bond as an analog to TIPS. “Growth Participation Securities” rather than “Inflation Protection Securities.” And the Treasury could implement it rather than the Fed futures market.

  26. Gravatar of ssumner ssumner
    2. February 2012 at 12:20

    Statsguy and Steve, Shiller’s been arguing for NGDP linked bonds, but of course NGDP targeting would serve a similar purpose. I’ll give that some thought.

    Statsguy, You said;

    “You have an uncanny way of framing issues in counterintuitive but insightful ways, but if you have one weakness, it’s a blindness toward the importance of political incentives.”

    Maybe, but where does that leave the rest of the profession? I’m the guy who pointed out that with inflation targeting the Fed would have to try to boost the cost of living of Americans when they were already suffering.

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