Did Krugman UNDERSTATE the fiscal multiplier?

That’s no typo, today I’ll argue that the fiscal multiplier might be bigger than Paul Krugman suggests.  Since I’m no Keynesian, this post is actually a sort of question for my Keynesian readers.  Here’s Krugman discussing Robert Hall’s work:

The Hall approach is to compare changes in real defense spending as a percentage of the previous year’s GDP with the actual percentage growth in real GDP. Over the period 1930-1962 — no point going further, since there hasn’t been a good case since the Korean War — it looks like this:

Clearly, expansionary policy is expansionary, and contractionary policy is contractionary. The apparent multiplier is only about 0.5, but anyone who knows a bit about the history realizes that this is likely to be an underestimate for current conditions: during World War II private spending was constrained by rationing, and postwar effects of the military contraction were partially offset by the pent-up consumer demand; the Korean War was paid for with tax increases amounting to around 4 percent of GDP.

I’ve never liked studies that use RGDP when looking for multiplier effects; it seems to me that the issue should be separated into two distinction questions:

1.  Does more G boost AD, and hence NGDP?

2.  Does more NGDP boost RGDP?

Those are actually unrelated questions.  The Keynesian model predicts that more G will boost NGDP, but also that the effect on RGDP depends on the slope of the SRAS curve.  Keynes assumed a sort of backward L-shape, where it becomes almost vertical at “full employment.”  Beyond that point more demand just leads to higher inflation, with no boost to output.  That’s now realized as being a bit too simple; the economy can temporarily go beyond full employment, as for example when housewives were put in munitions factories during WWII.

As you know, my skepticism about the fiscal multiplier has to do with point one (at least under certain monetary regimes like inflation targeting), not point two.

Now let’s look at the graph provided by Krugman.  I am no econometrician, but I recall being told that in this sort of graph the slope is mostly determined by the 4 points that are way off the Y-axis.  I’d guess the three boom years were WWII, and the big drop was 1946.  If I’m right, then Hall’s study might better be characterized as 1941-46, not 1930-62.  But perhaps there are now more sophisticated econometric techniques, which give more weight to small changes.

In any case, it seems to me that during WWII we were at full employment, so I’d expect the effect of more NGDP on RGDP to be much less than usual.  That’s a very different argument from Krugman’s “rationing” claim.  In other words, if I were Krugman I’d make two separate claims:

1.  The change in NGDP over the change in G is the fiscal multiplier.

2.  The multiplier model will usefully predict changes in RGDP when output is well below capacity (like right now.)

In that case Krugman could argue that the effect of more G on RGDP today might actually be greater than in 1943 and 1944, when we were already at full employment.

There are actually two ways of justifying the Keynesian multiplier, a real mechanism and a nominal mechanism.  The traditional Keynesian approach is basically nominal.  More G gives you more NGDP, and because wages and prices are sticky in the short run, you get more RGDP as well.  But there are also real models that don’t require any change in NGDP, especially those where the government output is quite different from private output.  Thus if the government spent lots of money on the military, it would increase RGDP unless private spending fell by an equal amount.  But a crowding out of private spending would make people “poorer” in terms of consumption, so they’d work harder to maintain their lifestyles.  This harder work would prevent complete crowding out.  (These real multiplier arguments don’t apply to lump sum tax cuts.)

I read Krugman as mostly relying on the traditional Keynesian nominal approach to the multiplier, augmented by an assumption that NGDP affects RGDP.

Since the evidence Krugman supplies is probably mostly based on WWII, here’s my take, FWIW:

1.  After mid-1940 the escalating war in Europe led to sharply higher US military output, and also probably raised expectations for future growth.  The monetary regime at the time was still linked to gold (as Christina Romer showed) and so it was very passive.  The stimulus seems to have boosted NGDP for very Keynesian reasons, as will happen if monetary policy is passive.

2.  Even if monetary policy had prevented any impact on NGDP (as under inflation targeting), I expect there still would have been some effect on RGDP for the “real multiplier” reasons I discussed above.  However in that case it’s unlikely (not impossible however) that Americans would have been better off in terms of living standards.

3.  Just to be clear, I do think Americans were made better off by the very fast 18 months of growth before Pearl Harbor, but that’s because NGDP did rise.  So to some extent we were overcoming suboptimal output due to sticky wages and prices.

To summarize, I think there are two arguments for a fiscal multiplier, both of which are somewhat problematic:

1.  The traditional Keynesian NGDP argument, which relies on incompetent central banks which fail to hit their nominal target (inflation or NGDP.)

2.  Real arguments that work to some extent under any monetary regime, but are more likely to raise RGDP than living standards.

Take the current situation in the UK.  If I’m not mistaken, the British political system is different from that in America.  British governments are basically elected dictatorships, with no checks and balances.  Even though the Bank of England is independent, the government can give it whatever mandate it likes.  If I’m right then both fiscal and monetary policy are technically under the control of the Cameron government.

So I read the UK austerity critics as saying:

Because you guys are too stupid to raise your inflation target to 3%, or to switch over to NGDP targeting, fiscal austerity will fail.  We believe the solution is not to be less stupid about monetary policy, but rather to run up every larger public debts.

Is that right?  Is that what critics are doing?

Some will argue that my views are naive, that Cameron would be savagely attacked for a desperate attempt to print money as a way of overcoming the failures of his coalition government.  Yes, but by whom?  Would this criticism come from Ed Balls?  Perhaps, but in that case he would essentially be saying:

“It’s outrageous that the Cameron government is trying to use monetary stimulus to raise inflation from 2% to 3%, whereas they should be using fiscal stimulus to raise inflation from 2% to 3%.”

I’m sorry to have to repeat this over and over again, but what 99% of pundits on both sides of the Atlantic are treating as a debate about “stimulus” and “austerity” is actually a debate about stupidity.  I’m not saying the pundits are stupid (Krugman certainly understands what I’m saying) but rather they are addressing their audience as if the audience was stupid.

Don’t talk down to Cameron and Osborne!  Don’t say “austerity will fail.”  Say “austerity will work, but only if the BOE becomes much more aggressive, otherwise it will fail.”  That sort of advice would be USEFUL.  Instead we are getting a bunch of pundits getting ego boosts because they can say “I told you so.”

Why are we few market monetarists the only ones to point out that the emperor has no clothes?

Update: The excellent commenter Britmouse says my UK argument was actually much stronger than I thought:

I did a post which touched on that. UK fiscal budget changes are subject to parliamentary approval, so there are “checks and balances”, especially given that we have a coalition government with a thin majority.

The legal mandate for the Bank of England only requires them to maintain “price stability”, where HM Treasury is required to define “price stability”, and can change it at will.

http://uneconomical.wordpress.com/2012/02/20/forecast-to-fail/

So to do a fiscal spending boost, Cameron/Osborne would have to go through parliament. To get a 3% inflation target, they would need only to send a single letter to Threadneedle Street, and the Bank of England would jump to it.

Also… http://uneconomical.wordpress.com/2012/02/21/discretion-and-accountability/

The argument against British austerity just vanished into thin air.  The Cameron government needs to ask for a higher nominal target over at the BOE.  Period.  End of story.


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74 Responses to “Did Krugman UNDERSTATE the fiscal multiplier?”

  1. Gravatar of marcus nunes marcus nunes
    21. February 2012 at 07:23

    Scott
    In the case of the UK, as you pointed out in regards to the NGDP-RGDP graphs I showed in my post, it “suffers from significant supply side problems”:
    http://thefaintofheart.wordpress.com/2012/02/17/another-nail-in-the-more-fiscal-stimulus-is-needed-view/

  2. Gravatar of Lee Kelly Lee Kelly
    21. February 2012 at 07:31

    It’s worth nothing that fiscal stimulus works, if at all, by inducing people to lower their desired cash balances. In other words, more or less, fiscal stimulus works by increasing the velocity of money. Specifically, fiscal stimulus increases the supply of close substitutes for cash balances, i.e. government bonds, and so tends to reduce the demand for money itself.

    There are two interesting observations that follow from this fact:

    1. If government finances are in poor shape, e.g. Greece, then government bonds will not be such close substitutes for money relative to other assets. In such a case, issuing additional government bonds will have little impact of average desired cash balances.

    2. Fiscal stimulus does not depend on rising government spending. In fact, fiscal austerity and fiscal stimulus can be pursued simultaneously, because total spending can fall even while total spending financed by debt rises. Fiscal stimulus depends on creating close substitutes for cash balances, and not on rising government spendingper se

  3. Gravatar of John Thacker John Thacker
    21. February 2012 at 07:59

    What I find really confusing are pundits and writers that claim to think that QE works, and are relieved by Bernanke’s insistence that the Fed can and will do more if necessary, but simultaneously think that we need more fiscal stimulus, that we haven’t had enough fiscal stimulus, and that fiscal austerity is a huge danger.

    I mean, I understand the people who say that monetary stimulus doesn’t work at the zero interest rate bound (though I think that they’re wrong), but that mushy “consensus” view above seems way too common and self-contradictory.

  4. Gravatar of Britmouse Britmouse
    21. February 2012 at 08:10

    I did a post which touched on that. UK fiscal budget changes are subject to parliamentary approval, so there are “checks and balances”, especially given that we have a coalition government with a thin majority.

    The legal mandate for the Bank of England only requires them to maintain “price stability”, where HM Treasury is required to define “price stability”, and can change it at will.

    http://uneconomical.wordpress.com/2012/02/20/forecast-to-fail/

    So to do a fiscal spending boost, Cameron/Osborne would have to go through parliament. To get a 3% inflation target, they would need only to send a single letter to Threadneedle Street, and the Bank of England would jump to it.

    Also… http://uneconomical.wordpress.com/2012/02/21/discretion-and-accountability/

  5. Gravatar of Max Max
    21. February 2012 at 08:11

    Lee, good points. A corollary to (1) is that ECB purchases of government debt are inflationary. QE is not mere placebo in the Euro zone.

  6. Gravatar of K K
    21. February 2012 at 08:18

    “We believe the solution is not to be less stupid about monetary policy, but rather to run up every larger public debts.”

    Why do you only fight paper tigers? That is *not* the principal argument against austerity. New-Keynesians and non-monetarists in general believe that monetary policy, generally defined as stuff the central bank can do via repos or purchases of government bonds and talking about what they might do with those tools in the future and otherwise saying whatever they think might be useful, is unable to maintain the economy at the optimal equilibrium when faced with the ZLB. So no, that’s not what the critics are doing. The critics believe that even a flawlessly executed monetary policy would be imperfect, and perhaps not much better than what we’ve already got. You don’t agree, and we know that. But to persistently fail to acknowledge that *that* is the argument of your detractors in favor of fiscal policy, will gain you zero traction with them.

  7. Gravatar of Britmouse Britmouse
    21. February 2012 at 08:39

    “Is that what critics are doing”

    On this question, I can’t think of anybody making such a coherent argument about UK macro policy. This is typical of the response to QE (from the left) – it might work but we don’t really know:

    http://touchstoneblog.org.uk/2011/10/qe-welcome-with-reservations/

    A lot of this is a BoE comms failure. They say QE boosts NGDP but they don’t say where to, so how can we judge success? If they came out with clear-cut Svensson like language, we could judge that. “We will keep printing £50bn per quarter until the 2yr CPI forecast hits 2%.” They are not quite that clear.

  8. Gravatar of Jeff Jeff
    21. February 2012 at 08:51

    No decent econometrician could look at that plot and conclude anything more than that there is no apparent relationship between the two variable being plotted. As you say, it sure looks like outliers drive the result, and no one with any experience in fitting models to data trusts results driven by outliers.

  9. Gravatar of Jason Rave Jason Rave
    21. February 2012 at 08:56

    Scott,

    I’m a big fan of your NGDP targeting work along with David Glasner and David Beckworth, so I’m familiar with much of what you’re saying. Which is what confusing me to a certain extent. Here you say;

    “Even if monetary policy had prevented any impact on NGDP (as under inflation targeting), I expect there still would have been some effect on RGDP for the “real multiplier” reasons I discussed above.”

    Why would inflation targeting prevent impacts on NGDP? If inflation targeting is stabilizes prices and as you say RGDP is effected, wouldn’t the effect on RGDP be fully transmitted into NGDP?

  10. Gravatar of Charlie Charlie
    21. February 2012 at 09:04

    Arnold Kling called you out by name. I think it’s the same old “wages are changing why do you think they are sticky argument” and he throws in a little reasoning from a price change for the kids.

    http://econlog.econlib.org/archives/2012/02/maladjustment.html

  11. Gravatar of ssumner ssumner
    21. February 2012 at 09:08

    Marcus, I agree.

    Lee, Those are good observations. But in the case of Greece its attachment to the euro makes things more complicated–I’m not sure how it all plays out. The Greek money supply is endogenous.

    John, Yes, exactly my frustration as well.

    Britmouse, Great, I’ll add a link.

    K, False, I did not fail to correctly characterize the Keynesian view. Keynesians think OMOs don’t work at zero rates but higher inflation targets would work. Read Krugman or DeLong. That’s what I mentioned, unconventional polices like higher inflation targets.

    Jeff, That was my reaction too. It’s been so long I forget the terminology–is heteroscedasticity the problem?

  12. Gravatar of dtoh dtoh
    21. February 2012 at 09:09

    New-Keynesians and non-monetarists in general believe that monetary policy…..is unable to maintain the economy at the optimal equilibrium when faced with the ZLB.

    I think this is exactly the problem. I have spoken to a number of well known economists who take it as an article of faith that monetary policy does not work at the ZLB. If they are not monetary economists, they just don’t know.

    Scott, I agree with K. You need to start writing some article and doing some posts titled “Monetary Policy Does Work at ZLB.”

  13. Gravatar of dtoh dtoh
    21. February 2012 at 09:12

    DeLong and Krugman might think higher inflation targets will work, but most main stream macro-economists just think monetary policy does not work at zero or near-zero rates.

  14. Gravatar of dtoh dtoh
    21. February 2012 at 09:15

    Scoot, and one other thing. The fact that DeLong Krugmnan think OMO won’t work is another reason that the Fed should have a policy tool which allows them to set MINIMUM (as well as maximum) asset to equity ration. That would definitely work.

  15. Gravatar of ssumner ssumner
    21. February 2012 at 09:23

    charlie, Thanks, I left this reply:

    “I don’t need 500 words. In my view the problem is nominal wages being sticky relative to NGDP. After 2008 the ratio of W/NGDP rose sharply, creating lots of unemployment. I’ve never based my argument on a labor demand curve with either W or W/P on the vertical axis.”

  16. Gravatar of ssumner ssumner
    21. February 2012 at 09:27

    dtoh, But Krugman and DeLong and Yglesias are a big part of the criticism of British austerity. And they all DO UNDERSTAND.

    I agree that most (non-macro) economists are clueless about liquidity traps. When I meet them I can change their minds in 5 minutes. They’ve never really thought about what fiat money really means.

    And I’m still not buying the capital controls are monetary policy argument.

    I have about 100 posts arguing monetary policy works at the zero bound.

  17. Gravatar of ssumner ssumner
    21. February 2012 at 09:33

    Jason, Perhaps I worded that poorly. I meant that in the Keynesian model monetary stimulus only boosts RGDP via higher NGDP and inflation. So if you target inflation you prevent any increase in NGDP and RGDP.

    If you target inflation and there is a real, non-Keynesian channel for fiscal stimulus, then yes, both NGDP and RGDP rise.

  18. Gravatar of Lee Kelly Lee Kelly
    21. February 2012 at 10:20

    Scott,

    I suppose I’m sceptical that U.K. fiscal policy, whether stimulative or not, has much influence on the demand for money. How near of a near money are U.K. government bonds at the moment? It seems that U.S. fiscal stimulus may be more likely to increase spending in the U.K. than U.K.’s own efforts. These are global financial markets; over 50 percent of U.S. government debt is held by foreigners. To holders of British pounds, U.S. debt is probably a closer substitute than U.K. debt.

    My example of Greece was just to illustrate a point. Greece cannot stimulate spending in the Eurozone by issuing more debt, because Greek bonds are no longer considered a close substitute for money. In other words, people will not finance the purchase of Greek bonds by reducing their cash balances, but rather by reducing spending on other risky and illiquid assets, and the net effect on nominal expenditure will be zero.

  19. Gravatar of K K
    21. February 2012 at 10:28

    Scott,

    First, I didn’t say better policy couldn’t be helpful. There is plenty of space in between “useless” and “optimal,” i.e. varying degrees of fail.  You characterize demand management as optimally managed via monetary policy. Read the NK literature on the liquidity trap, and you’ll find plenty of discussion of best possible monetary policy with or without commitment. But it’s never *optimal*. For optimal control you need a combination of monetary *and* fiscal.

    Second, the moment when you find yourself at the ZLB is a very bad time to decide that you’d like higher inflation because achieving that requires implementing a commitment to sub-optimal future policy (of the inflationary kind) rather than just cutting rates now. Maybe it will be politically feasible to make a reliable commitment (NGDP targeting strikes me as the most likely way) but maybe it wont. To pretend that saying you will do something in the future is as powerful as actually doing it is not credible. If the policy regime can change now, it can change again in the future. So people are right to be skeptical about commitment.

    So fiscal austerity *will* fail because monetary policy alone is sub-optimal at the ZLB and austerity makes it even less optimal. The likely failures of central banks to actually try is just the cherry on top.

  20. Gravatar of Ashwin Ashwin
    21. February 2012 at 11:08

    Scott – to make a credible commitment, you need to have the tools to make good on the commitment. The Bank of England already owns ~30% of the outstanding stock of govt bonds thanks to QE – a much higher proportion than elsewhere. It has repeated many times that it will not buy private sector assets.

    In my opinion, the BoE could buy up the entire outstanding stock of govt bonds and commit never to sell it back and inflation in the UK will not go up one iota.

    If you were in Mervyn King, what exactly would you do to make good on the commitment?

  21. Gravatar of D R D R
    21. February 2012 at 11:40

    “After 2008 the ratio of W/NGDP rose sharply, creating lots of unemployment.”

    Hm. Third-quarter wage shares 2007-11:
    2007: 45.8
    2008: 45.6
    2009: 45.3
    2010: 44.2
    2011: 44.0

    Surely you mean compensation, not wages?
    2007: 56.1
    2008: 56.2
    2009: 56.4
    2010: 55.0
    2011: 54.6

    Nope, still don’t see your point, there.

  22. Gravatar of K K
    21. February 2012 at 12:26

    Ashwin: “In my opinion, the BoE could buy up the entire outstanding stock of govt bonds and commit never to sell it back and inflation in the UK will not go up one iota.”

    Totally agree. In fact, I believe it makes things worse by depriving portfolios of an extremely negative beta hedge in a demand deficient environment. This causes investors to shed risk assets. This is why twist was such a fail. To the extent that any of QE has worked it’s because they were buying mortgage paper.

    If you want QE to work, you have to buy real assets. But that’s industrial policy, not monetary policy.

  23. Gravatar of The guys back in the 1960s understood it better: There´s no Fiscal “Stimulus” without Monetary “Stimulus” | Historinhas The guys back in the 1960s understood it better: There´s no Fiscal “Stimulus” without Monetary “Stimulus” | Historinhas
    21. February 2012 at 12:35

    [...] Scott Sumner has an illuminating discussion on Krugman and austerity: So I read the UK austerity critics as saying: [...]

  24. Gravatar of Chris Chris
    21. February 2012 at 13:05

    So, there are a bunch of points around zero and 4 points outside of zero. Can someone explain why anyone would draw a slope across the four outliers?

  25. Gravatar of J Mann J Mann
    21. February 2012 at 13:13

    Ashwin, you write:

    “In my opinion, the BoE could buy up the entire outstanding stock of govt bonds and commit never to sell it back and inflation in the UK will not go up one iota.”

    If the *worst* case scenario involves Great Britain retiring its entire debt with no side effects, why not do it? At worst, then you’ve freed up the ledger for more fiscal stimulus by retiring the debt . . .

  26. Gravatar of D R D R
    21. February 2012 at 13:41

    Chris,

    If you are going to define outliers as unusually large changes in real defense spending then you are pretty much answering your own question, no?

    Otherwise, the regression models the relation between not-especially-large-changes-in-defense-spending and changes in RGDP.

    I’d be much more concerned about reverse causality in that case– faster GDP growth leading to faster defense spending. On the other hand, I very much doubt that a huge boom in non-defense GDP would cause a huge boom in defense.

    Which is another way of saying I’m leaning toward agreement with Scott when he writes “Hall’s study might better be characterized as 1941-46″

  27. Gravatar of Lee Kelly Lee Kelly
    21. February 2012 at 13:50

    In my opinion, the BoE could buy up the entire outstanding stock of govt bonds and commit never to sell it back and inflation in the UK will not go up one iota.

    Really? The entire increase in the money supply would be exactly offset by an equivalent fall in money velocity? That is, every person who is currently holding U.K. bonds would just hold onto the extra money instead? Nobody would choose to spend any proportion of their additional cash balances on other goods and services? That seem highly unlikely.

  28. Gravatar of Negation of Ideology Negation of Ideology
    21. February 2012 at 14:13

    J Mann makes an excellent point.

    Ashwin – If it’s true that the central bank could buy up the entire national debt without increasing inflation, that would be a good thing. To be clear, I don’t believe it is true.

    If the BOE owns only 30% of the government bonds, and England is still running a large deficit(thus increasing the amount of bonds), we are a long way from worrying about the BOE running out of bonds to buy.

  29. Gravatar of Major_Freedom Major_Freedom
    21. February 2012 at 15:20

    What I don’t see people arguing yet is that the Keynesian multiplier doctrine is utterly fallacious.

    The only incomes that can possibly rise by virtue of the multiplier process that originates with inflation financed government spending, is profit income. The claim is that the higher the marginal propensity to consume, the better off the economy, specifically workers, will be.

    Yet the process doesn’t add a nickel to employment. Expenditures in the form of wages can only come about if people save, but Keynesians treat savings as a “leakage.”

    They can’t claim what they really mean is that higher profits will stimulate more employment and investment, because they say that only to the extent that money is NOT saved, will the multiplier process do its magic to stimulate the economy.

  30. Gravatar of ssumner ssumner
    21. February 2012 at 17:31

    Lee, You may be right.

    K, I can’t imagine what sort of model requires fiscal stimulus to supplement monetary stimulus. The central bank can create Zimbabwe style hyperinflation if it wishes. What more could fiscal stimulus add?

    But seriously, the problem at the BOE isn’t that they are trying to create more inflation and failing, it’s that they don’t want any more inflation. Inflation has averaged about 3% in recent years, that is not a liquidity trap situation.

    Ashwin, You said;

    “If you were in Mervyn King, what exactly would you do to make good on the commitment?”

    If I were him I’d probably buy UK bonds until they TIPS spread rose to the target (which is 2%). Indeed they’ve probably already done that. As far as I can tell the BOE regards their policy either as a huge success, or perhaps as a failure because it’s been too expansionary. They certainly don’t think they’ve failed to provide enough inflation, nor do they think they’d be unable to provide more. If you run out of UK bonds to buy, then buy Treasury debt.

    I find it interesting that commenters keep saying central banks are trying and failing to create inflation, at the same time the central banks themselves are denying any such intention. In the rare cases where they do claim to want more inflation (Bernanke in September 2010), they quickly succeed.

    DR, You have the wrong data, see my new post.

    Chris, I’m also dubious about the statistical significance, although I accept his conclusion that WWII did boost RGDP.

    J Mann, Yes, it would be great if we could buy back the entire stock of debt without creating inflation. But that’s not likely.

    Lee Kelly and Negation of Ideology, And let’s not forget that the BOE is paying interest on ERs, which makes then a sort of debt. Imagine if they paid off the entire debt with non-interest bearing currency!! Does anyone seriously believe that wouldn’t be inflationary?

  31. Gravatar of dwb dwb
    21. February 2012 at 17:45

    Unlike some, I am not operating under the illusion that the “austerity” has anything to do with growth in the UK, at least in the short term. This is about reducing the size of the state pure and simple (I’ve seen Cameron in debates leading up to elections way back and he was itching to roll back the statem cut NHS, and so on, well before the crisis). Britian should be thankful for a Bank far less allergic to “inflation” and QE than the ECB.

    The graph is unpersuasive. I see a bunch of ~zero changes is G where GDP change could be anything, plus a few (maybe 4) outliers. Also, my recollection of wartime economic controls is a little fuzzy, but weren’t there price controls (in addition to rationing) and wasn’t the Fed asked to hold down rates to keep the govt from paying exorbintant rates on war bonds? So what does that prove, we should build a lot of bombs, hold rates down way below inflation, and institute price / wage controls and rationing? oh wait…

  32. Gravatar of dwb dwb
    21. February 2012 at 17:52

    Excellent quote:

    http://ftalphaville.ft.com/blog/2012/02/21/890751/further-further-reading-306/

  33. Gravatar of Max Max
    21. February 2012 at 18:57

    “Imagine if they paid off the entire debt with non-interest bearing currency!! Does anyone seriously believe that wouldn’t be inflationary?”

    QE is a debt maturity change. It’s not replacing a risky asset with a safe asset, because there’s no default risk priced into government bonds (except in the Euro zone).

    The issue is whether short term debt is more inflationary than long term debt. Whether the short term debt is in the form of bonds or base money is not important.

  34. Gravatar of K K
    21. February 2012 at 21:02

    What Max says.

    Scott: “I can’t imagine what sort of model requires fiscal stimulus to supplement monetary stimulus.”

    Market power (Dixit-Stiglitz), sticky prices (Calvo), ratex.

    “The central bank can create Zimbabwe style hyperinflation if it wishes.”

    You really ought to zero in on this in future posts. NKs actually don’t agree with this, Scott, so you really ought to hammer it home. How does the CB do this? What is the formula for doing it with repos and treasury purchases, and without buying real assets or doing helicopter drops (Zimbabwe)? I don’t get it, but it’s clearly at the core of the disagreement so we need to get to the bottom of it. How does it work?

  35. Gravatar of Econoclast Econoclast
    22. February 2012 at 00:41

    Three points on the UK from someone who was deeply sceptical about the government’s embrace of austerity.

    1. Theoretically, you are right to say a UK government is an ‘elected dictatorship’, though the current coailition has some peculiar dynamics given the leftward bias of most Liberal Democrats.

    2. Critics of Osborne and Cameron seem to ‘talk down’ to them presumably because Osborne and Cameron have ‘talked down’ to their critics. They won’t listen to criticism, even it is valid. The template for their austerity is the ‘Thatcher’ consolidation in 1980-81, which was a different economic and political context.

    3. I wholeheartedly agree that the government should raise the Bank’s inflation target. The problem is that Osborne and Cameron are true Conservatives. They talk a lot about ‘credibility’ and ‘confidence’. Faced with a once in a lifetime economic crisis, they can’t decide whicih would be worse for their ‘credibility’ – loosening the fiscal purse strings or raising the Bank’s inflation target. So they are paralysed and the economy remains depressed.

  36. Gravatar of Ashwin Ashwin
    22. February 2012 at 00:47

    K: “I believe it makes things worse by depriving portfolios of an extremely negative beta hedge in a demand deficient environment. This causes investors to shed risk assets.”
    Agreed.

    J Mann: “If the *worst* case scenario involves Great Britain retiring its entire debt with no side effects, why not do it? At worst, then you’ve freed up the ledger for more fiscal stimulus by retiring the debt . . .”
    K’s argument above, also the role played by govt debt in providing a nominally risk-free asset to match duration demand by pension funds and life insurers. The demand for a dollar 30 years out is in many ways similar to a demand for a dollar today (different in many ways as well of course). Also illustrates the folly of looking at monetary and fiscal policy as independent functions.

    Scott – the first round of QE and rate cuts worked because it dragged real rates in the UK down which led to the currency falling by ~20%. The latest round had barely any impact at all either on currency or inflation.
    On related note, the BoE clearly thinks the current malaise in the economy is real, not nominal. Quoting Mervyn King: “While the Monetary Policy Committee can use Bank Rate or asset purchases to help ease the transition, there is a limit to what monetary policy can achieve when real adjustments are required.”
    http://www.telegraph.co.uk/finance/financialcrisis/9082839/QE-scheme-not-enough-to-revive-economy-warns-Bank-Governor.html

  37. Gravatar of Britmouse Britmouse
    22. February 2012 at 01:58

    “The latest round had barely any impact at all either on currency or inflation”

    Inflation expectations have shifted up pretty strongly between the November and February meetings of the MPC. So I’d say QE worked, but they didn’t do enough.

    http://uneconomical.wordpress.com/2012/02/22/mpc-turns-dovish/

    Staying within the bounds of the inflation target I think they’d do better if they committed to unlimited QE as necessary to keep the CPI forecasts at 2%, rather than this fiddly approach of fine-tuning, so as to anchor expectations better.

  38. Gravatar of Tim Worstall Tim Worstall
    22. February 2012 at 03:06

    Britmouse is quite right that Osborne could write that letter and raise the BoE’s inflation target. It would be politically problematic but so what?

    The thing is that the general feeling (hmm, general feeling’s a bit too strong. Perhaps the feeling among those who obssess about these things? Or the feeling in parts of The City?) is that Osborne has already done this.

    Not directly, no, but indirectly. The BoE has to write a letter each time inflation comes in above that 2% to say what they’re doing about it. It’s then rather up to the Chancellor of the time to harrumph or not about what the BoE says they’re going to do about it.

    Inflation has been well above that 2% for several (a couple?) of years now and the letters from the BoE have been greeted with, well, not very much actually. At worst a sort of “Yes old chap, terribly difficult times, do what you think best”.

    The general supposition is that Osborne has lifted the 2% target to something higher, but that he’s just not actually said so.

  39. Gravatar of Britmouse Britmouse
    22. February 2012 at 03:45

    “The general supposition is that Osborne has lifted the 2% target to something higher, but that he’s just not actually said so.”

    The markets don’t really reflect that, 5y breakevens have RPI at 2.2%, which means CPI well below 2%. It is important to differentiate between “allowing short-term CPI deviation” and “changing the long-term inflation target”. The language from the BoE (and Osborne) is ALL about the former, not the latter.

  40. Gravatar of ssumner ssumner
    22. February 2012 at 07:10

    dwb, I agree about rolling back the state for supply-side reasons.

    Always good to get a FT cite.

    Max, Can I take that as a yes? Then why not do it? Bingo, Britain net debt ratio falls to zero! Also reduces the deficit via much lower interest expenditures.

    Can we be serious?

    K, I don’t know what NKs don’t think the central banks can raise inflation at the zero bound. Bernanke, Mankiw, Woodford, Krugman, and Svensson are all NKs, aren’t they? They’ve all proposed ways of raising inflation at the zero bound. No central bank has ever failed (under fiat money.)

    Ratex models are certainly consistent with my approach, because I always use the ratex assumption in all my arguments.

    Econoclast, That’s fine, and you may be right. Here’s my response:

    If they do a U turn on stimulus, as you and I want, the monetary stimulus is more attractive politically and economically than fiscal stimulus. It keeps them on track toward lowering the deficit, unlike a fiscal turnaround, which would be completely humiliating. (And also much worse on the merits.) My job as a blogger is partly to convince conservatives that monetary stimulus right now is in their interest, as it’s a substitute for socialism. So I’m trying to change the political realities, not just accept them. I certainly don’t expect to influence British policy, but I’ve already had a slight influence raising the profile of the monetary stimulus option in America.

    Ashwin, I have no big problem with the claim that QE2 in Britain wasn’t that effective (although later Britmouse says it did raise inflation expectations.) I’ve never focused on QE as being a powerful tool.

    I agree with King that Britain has lots of supply-side problems. I think King has the following perspective, which is probably true:

    1. More monetary stimulus would boost growth modestly.

    2. More monetary stimulus would boost inflation above the 2% target.

    3. Growth would remain disappointing for supply-side reasons.

    4. The policy would be perceived to be a failure on two levels–stagflation, and exceeding the BOEs inflation target.

    Instead of failing in two ways, they’d rather achieve at least one objective (their mandated inflation objective) and suffer an ever bigger output loss. I think that’s what it comes down two.

    There is little doubt in my mind that if the BOE followed my dream policy of 5% NGDP growth, it would be perceived to fail. I think the failure would be less bad then the current failure, but nonetheless my policy would be perceived to have failed, because the P/Y split would be unattractive. Maybe 3%/2%, instead of the current 2%/1%. Today I read that the new 50p tax rate isn’t bringing in much revenue–more supply-side problems.

    Britmouse. Thanks for the data. Keep me posted on the future evidence for the 50p tax rate–the initial returns are disappointing.

    I still may do a new post on your earlier comment.

    Tim, That’s a useful perspective. I’ll point to my earlier response to Ashwin as my take on the situation. I’d love to hear your thoughts.

  41. Gravatar of Mark Mark
    22. February 2012 at 07:43

    Scott, I no longer live in the UK but when I was there over Christmas there were lots of complaints about how inflation (then around 3 or 4 % I think) was eroding living standards for pensioners and people on relatively fixed incomes. These complaints were on the BBC news but they were most common in the Daily Mail and other right-wing press outlets and I’ve heard plenty of Conservative members of parliament complain about inflation.

    Furthermore, my reading of the political system is that Osborne and the BoE are actually much more constrained that you think. The BoE have been very willing to allow inflation > target but the political support for this has been evaporating. Many core conservative supporters seem to prefer low inflation and stagnation to higher inflation and recovery. Cameron may or may not understand monetary policy but he already playing a very difficult juggling act in trying to keep both the Liberal Democrats and the more right wing Tories onside and given how much political support he is already risking by trying to reform education and the NHS (fiercely resisted by Labor, the Guardian, BBC and the liberal elites) there is no way he is going to attract additional flak for explicitly targeting inflation.

  42. Gravatar of Max Max
    22. February 2012 at 08:32

    “Can I take that as a yes? Then why not do it? Bingo, Britain net debt ratio falls to zero! Also reduces the deficit via much lower interest expenditures.”

    If the central bank succeeds, then short term rates will go higher than current long term rates. So it only reduces the deficit if the central bank fails. By buying long term bonds at ultra low yields the central bank is betting against itself. Maybe not the best signal of intentions?

  43. Gravatar of Jeff Jeff
    22. February 2012 at 08:36

    Scott:
    If you have a model

    y(t) = BX(t) + e(t)

    where e(t), heteroscedasticity refers to the situation where the variance of the e(t) is not constant. I wouldn’t call the Krugman plot an illustration of it, because I don’t see a linear relationship between the x and y variable he plots. You can have heteroscedasticity and still estimate a model with estimators that take the nonconstant variance into account, but nothing can “fix” the fact that there doesn’t appear to be any relationship at all between the variables.

  44. Gravatar of J Mann J Mann
    22. February 2012 at 08:39

    J Mann: “If the *worst* case scenario involves Great Britain retiring its entire debt with no side effects, why not do it? At worst, then you’ve freed up the ledger for more fiscal stimulus by retiring the debt . . .”

    Ashwin: “K’s argument above, also the role played by govt debt in providing a nominally risk-free asset to match duration demand by pension funds and life insurers. The demand for a dollar 30 years out is in many ways similar to a demand for a dollar today (different in many ways as well of course). Also illustrates the folly of looking at monetary and fiscal policy as independent functions.”

    Ashwin, I’m sorry, but I don’t understand completely. Are you saying that they BOE could retire the public debt or that it couldn’t? And if it could, are you saying that it should, or that it shouldn’t? And if it shouldn’t, why not? (I appreciate your patience — I’m sure the fault in comprehension is mine).

    I’ll grant that there may be a public good in having a debt market. (This came up when the Clinton/Gingrich surplus potentially held up the idea of making some us treasury periods unavailable.) In that case, I guess we could replace “retire the debt” with “reduce the debt to the socially optimal level.”

  45. Gravatar of 123 123
    22. February 2012 at 10:40

    Scott,
    Please take a two quick looks at BOE’s latest inflation report:
    http://www.bankofengland.co.uk/publications/inflationreport/ir12feb.pdf

    p.17 – there is an interesting NGDP chart with a commentary. Too bad none of the reporters asked questions about NGDP during the inflation report press conference.

    p.21 – there is a chart where “uncertainty about demand” is listed as a key answer to a questions about the factors likely to hold back investment

  46. Gravatar of K K
    22. February 2012 at 12:15

    Scott: “I don’t know what NKs don’t think the central banks can raise inflation at the zero bound.”

    You make this *really* hard by persisting in mischaracterizing the actual arguments that are being made by your detractors. In particular you continue to conflate “they aren’t able to do enough” with “they can’t do anything.” Neither I, nor any of the illustrious economists in your list, would claim that the CB “can’t do anything.” What they say, and what I said above, is that they aren’t able to do *enough* to keep demand an optimal level using monetary policy alone at the zero bound. “Not enough,” not “nothing.”

    In particular I *never* said they couldn’t raise inflation. They can do so to the extent that they are able to credibly commit to future short rate policy and to the extent that such policy can import demand into the present from the future. But they can’t hit any target they want and their impact will be weak to the extent that the forward yield curve is already at zero. If, for example, the curve is at zero for 10 years forward, their only impact on current inflation is via their ability to influence expectations about the contingent rate path *10 years forward*! Then you have to answer the question of what purchases of goods (consumption or capital) could people be persuaded to advance by *10 years* in order to import demand from the future into the present? And even that is contingent on the ability of the CB to credibly commit to policy 10 years forward. We aren’t at ten years, but even three is a lot.

    The New Keynesian model, is about as simple and general a framework as you can make of a perpetual economy with sub-optimal AD with ratex, a ZLB and a plausible model of sticky prices/monopolistic competition. It says monetary policy is *not* omnipotent to hit the LRAS and so would most of the economists you mention above. You don’t like that model though I’m not sure which assumptions in particular you disagree with. I only know that you dislike the conclusions. If you want to be heard by more mainstream economists, you ought to challenge the assumptions of their models and their actual claims head on.

  47. Gravatar of K K
    22. February 2012 at 12:29

    And the “no CB has ever failed to produce inflation” argument is really weak. The failure of which we speak, only occurs at the ZLB. We’ve only had a handful of liquidity traps in modern times and only one severe one. Among those there is precious little evidence for anything, but the evidence we do have is certainly not supportive of CB omnipotence. With a single helicopter drop the BOJ could be back to a 5% equilibrium short rate by tomorrow morning. There is *nothing* monetary policy could do to achieve the same result. Not even close. And Svensson’s bomb proof method, btw, involves the purchase of real assets, i.e. other people’s currency, as a method of escape.

  48. Gravatar of Podunk Podunk
    22. February 2012 at 12:53

    Scott,

    I posted something related to this on MR, but since you’ve answered questions about UK inflation/austerity more directly, I thought I’d ask here. One of the UK ‘austerity’ measures was to bump up the VAT from 17.5% to 20%. Since the price of everything subject to the VAT went up over 2%, inflation jumped alarmingly. It’s now over a year on from that, and we’re getting reports of y/y inflation dropping fast. The BOE thinks it may even drop below the 2% target.

    So my question is, what would the BOE have had to have done to keep measured CPI inflation down to the 2% target when the government mandates that all prices must increase by 2+%? Is it just expected that prices will fall so that the price + VAT will remain the same, so increasing the VAT doesn’t really increase inflation? Or would the BOE have had to contract money to induce non-VAT price deflation? Does the measured CPI inflation tell you anything in this kind of environment? If it does, then can’t the UK just increase NGDP all they want by jacking up the VAT? Total win-win, reducing the fiscal deficit while increasing demand, right?

  49. Gravatar of Floccina Floccina
    22. February 2012 at 13:10

    Assuming the best of them, are advocates of fiscal policy arguing that if monetary policy is used, if you put out enough money to jump start the economy:

    1. It will be too much to bring back in when inflation starts up resulting in high inflation.

    2. Monetary policy does not put enough of the money in poor people’s hands so use fiscal policy.

    I think that we should try NGDP targeting myself. Even if you use the numbers of Obama administration the coast per job of fiscal policy is way too high.

  50. Gravatar of K K
    22. February 2012 at 13:48

    Floccina:

    “It will be too much to bring back in when inflation starts up resulting in high inflation.”

    Haven’t heard that from that crowd. And it’s pretty dumb. 1) If they don’t pay interest on reserves, all the reserved will come back to the Fed the instant they raise rates and 2) if they keep IOR then they are just swapping long term debt for short term debt. If anybody thinks that’s inflationary they’re confused.

    “Monetary policy does not put enough of the money in poor people’s hands so use fiscal policy.”

    The fact that they might be poor is irrelevant. What matters is whether they can borrow at a sustainable rate. This is Fisher debt-deflation or more recently Eggertsson and Krugman 2010. Credit constrained agents can’t respond to distant incentives (long term monetary policy) which produces a powerful liquidity trap. Debt is the ultimate “nominal rigidity” which, IMO, is the best known argument for fiscal policy at the ZLB. NGDP targeting is a good idea in order to avoid getting there in the first place.

  51. Gravatar of Morgan Warstler Morgan Warstler
    22. February 2012 at 14:49

    http://www.telegraph.co.uk/finance/personalfinance/consumertips/tax/9097219/50p-tax-rate-failing-to-boost-revenues.html

  52. Gravatar of Britmouse Britmouse
    22. February 2012 at 16:09

    The 50p rate is the mother of all political gambits. Every time a right-winger attacks the 50p rate, Gordon Brown wins.

    I think it’d be better to keep the 50p rate as political cover for doing proper tax reform; cut NI rates, get rid of the corporation tax, get rid of the 70%+ marginal rates all across the income distribution, etc. Don’t even think about canning the 50p rate before that. It’s easy enough to avoid anyway.

  53. Gravatar of Mike Sax Mike Sax
    23. February 2012 at 02:49

    Now you’re just playing mind games-LOL. When you talk about an incompetent central bank that basically by your definition of incompetent amounts to the pre-Volcker Fed.

    The competent Fed is esseintally what we’ve seen post-Volcker.

    For a gloss on this

    http://diaryofarepublicanhater.blogspot.com/2012/02/now-scott-sumner-is-just-playing-mind.html

  54. Gravatar of ssumner ssumner
    24. February 2012 at 06:25

    Mark, Those comments seem quite plausible, but I don’t see them as conflicting with my argument. The problem in the UK is that people seem to want the impossible, faster growth and lower inflation both produced by demand side policies. I’m just pointing out that if you really want faster growth from demand side policies then don’t complain about inflation, and if you don’t want more inflation then don’t complain if “austerity” puts the UK back in recession.

    Max, I’m interested in what you believe would happen, not whether the BOE will lose money (in a EMH world the expected gain or loss is always roughly zero.)

    Jeff, But if you do a regression it shows “statistical significance.” So I’m asking what the term is for the flaw in that measure of significance.

    123, Note that when the BOE says “demand” they don’t mean “demand.” I should do a post.

    K, I don’t agree with how you characterize the NKs. I can find all sorts of quotations from them to back up my argument.

    And monetary policy can do exactly the same as a helicopter drop. Indeed in the NK model a helicopter drop still doesn’t solve the problem, if it is expected to be reversed in the near future, AD hardly budges. The helicopter drop must be permanent. Sound familiar? That’s the exact same criterion for success of ordinary OMPs under NK models.

    What’s wrong with buying foreign currency? I consider that monetary policy, not fiscal policy, but you can call it whatever you like.

    Regarding your response to my claim of liquidity traps never being a problem in the real world, don’t you think we should actually wait for this sort of problem to exist before spending so much efforts discussing how we would address it if it came up. Let’s see a central bank try to inflate and fail, before discussing possible “solutions.”

    Podunk, They really should target NGDP net of VAT, as that would produce a more stable real output path. In practice, the distinction doesn’t matter all that much, if they pursued a 5% NGDP target, level targeting.

    Yes, they do have to deflate net of VAT prices if they are serious about the 2% inflation target (but they aren’t.)

    Floccina, Those are bad arguments, but you might be right that that is what people are thinking.

    Britmouse, Fine, but isn’t getting rid of the corporate tax just as unlikely? And politically difficult (domestically and in terms of EU relations.)

    Mike Sax, You said;

    “The competent Fed is esseintally what we’ve seen post-Volcker.”

    I assume you are joking.

  55. Gravatar of Jeff Jeff
    24. February 2012 at 10:40

    @Scott,

    The technical term you’re looking for is “bullshit”. You could fudge and say “nonlinearity” because it’s pretty clear from the plot that there isn’t a linear relationship between the variables, or you could get a bit closer to the truth with “poor fit”, but both of those are just obscuring the fact that there doesn’t appear to be any relationship at all.

    Sometimes ocular econometrics beats statistics. No reasonable model you can think of is going to give you data that looks like that plot.

    We do econometrics to fit models to data, to test those models, and to make predictions. It’s obvious from the plot that a linear model will not fit that data very well, any reasonable test of it will fail, and predictions from it will be useless.

  56. Gravatar of Max Max
    24. February 2012 at 11:21

    “I’m interested in what you believe would happen, not whether the BOE will lose money (in a EMH world the expected gain or loss is always roughly zero.)”

    A competent central bank makes money, right? So the purchase of ultra low yield bonds can be interpreted as a commitment to low inflation. Otherwise the central bank has egg on its face.

    So it is perverse from a signaling point of view.

  57. Gravatar of D R D R
    24. February 2012 at 12:55

    “It’s obvious from the plot that a linear model will not fit that data very well, any reasonable test of it will fail, and predictions from it will be useless.”

    You must not understand linear regression. It is not at all clear that the fit is poor– it’s just that the extreme changes in G (*may*) drive the results.

    You may try it with synthetic data. Go ahead. Make a variable X which has a relatively narrow distribution (say, standard normal) and manually throw in a few outliers– say you multiply the most extreme values of X by a factor of 10. Let Y=X, plus a normal error with a standard deviation around 20. Obviously, you’ll find a positive relationship between Y and X. If you take out the extreme values, you’ll still see the positive relation, but the error term is so large you may need a lot of observations in order to pick it out.

    In this case it is true that the extreme values of X drive the significance of the result, but that’s not because the relationship is not there. The relationship is there by construction, but the extreme values can make up for a lack of sufficient observations.

    Now let Z=-X plus a normal error with a standard deviation around 20. Obviously, you’ll find a negative relationship between Z and X. This is exactly the same, as with Y, but with a different sign.

    Now let Q=Z except those extreme values of X, for which Q=Y. That gives us a “multiplier” of -1 for just the small values of X and a “multiplier” of +1 for just large values of X.

    Unless you are “unlucky” you’ll still find a positive relationship between Q and X. It’s true that in this case the extreme values of X drive the result, but it’s not true that the fit is, statistically speaking, poor.

    That’s why I lean toward Scott’s argument that what we see is (likely) a reasonable description of the circa-WWII economy and not obviously much else.

  58. Gravatar of Jeff Jeff
    24. February 2012 at 13:57

    @D R,

    Ed Leamer published a classic paper many years ago about taking the con out of econometrics. In it he coined the term “fragile inference” to describe what you get when you fit models to data like this.

    Look, I’m not going to argue this endlessly. If you want to draw big conclusions based on three or four observations, be my guest. Just don’t expect me to believe them.

  59. Gravatar of D R D R
    24. February 2012 at 14:53

    Jeff,

    If you read what I wrote, you’ll find that I do anything BUT draw big conclusions based on three or four observations.

    I believe there are very good reasons for those few extreme-independent-variable observations to show a different relationship than the others.

    These are extreme observations. Yes, if we tried expanding defense spending by 30 percent of today’s GDP, we would see nothing like a 20 percent increase in GDP because we haven’t got 20 percentage points of slack in the economy. It would be mind-bogglingly successful to eke out a multiplier of 0.2. We literally cannot cut defense by 30 percent of GDP today, because that would put us in negative territory.

    So no, I don’t believe that these extreme observations can necessarily tell us what would happen if we changed defense spending today.

    And no, I don’t believe it is clear from the other observations, either, because we don’t know from eyeballing it whether there is or is not any relation among those data points which is distinguishable from random noise.

    However, if conditions were such that it was *possible* to effect the kind of changes reflected in those extreme observations, then yes, it is much more likely than not that we could see those kinds of multipliers. But at present our policy space is nowhere near as broad as then, and that’s before accounting for political constraints.

    I was just pointing out that there may very well be a statistically significant relation in the data. What you make of it is another matter.

  60. Gravatar of Jeff Jeff
    24. February 2012 at 19:10

    D R,

    I believe there are very good reasons for those few extreme-independent-variable observations to show a different relationship than the others.

    Maybe. But I’ve never seen any empirical evidence that fiscal policy has any effect on aggregate demand. And absent that, why should I believe it does?

    There are nice elegant theories that say fiscal policy matters for demand. But there are equally nice and elegant models that say it doesn’t. And as I’ve noted in other comments on other posts, neither type of model gives us forecasts that are better than simple statistical models like the atheoretic BVARs of Litterman and Sims. That says to me that macro-economic theories are pretty worthless. We have to look to historical experience if we want to figure out what works.

    When we do that, it appears that aggregate demand in the US is driven solely by monetary policy. Fiscal policy “works” when it is accompanied by monetary policy that is pushing in the same direction. Otherwise it doesn’t. In the mid-60′s, both fiscal and monetary policy were expansionary and a boom resulted. But when money is tight and fiscal policy isn’t, like now, demand falls.

    I do think fiscal policy matters, but it matters because of how it affects supply in the long run. It changes incentives and moves decisions from the private to the public sector. (On rare occasions decisions get moved the other way.) Considering how North Korea has fared as compared to South Korea, or how East and West Germany compared shows how important those effects can be.

    But I don’t think that’s what Krugman was trying to say with his plot.

  61. Gravatar of K K
    24. February 2012 at 21:34

    Scott,

    There are lots of papers, e.g. those of Woodford or Eggertsson with a variety of coauthors, which discuss optimal policy with ZLB. If you believe that the NK model in general permits optimal control without fiscal policy, you haven’t read the papers. It simply isn’t the case.

    “What’s wrong with buying foreign currency?”

    For one, it only works by importing demand via devaluation. So we can’t all do it and in the current environment, lots of countries could be tempted to try. Also, it won’t work well in a large, relatively closed economy.

    As far as helicopter drops go, if the Fed sent every American $100,000 there would be massive and immediate inflation, expectations of future policy be damned. There are simply vastly too many currently credit constrained citizens for that not to be the case. There is no comparable act of monetary policy (unless you include heli drops as monetary policy, and why not, if you want to include real asset purchases).

    “Let’s see a central bank try to inflate and fail, before discussing possible “solutions.””

    That would be great. The problem is that they suspect that they are in fact fairly impotent. Since trying and failing poses significant risks to the future of their institutions, they prefer not to try. So we don’t get to run your experiment. It’s all pretty tragic.

  62. Gravatar of 123 123
    25. February 2012 at 01:27

    Scott: “Note that when the BOE says “demand” they don’t mean “demand.” I should do a post.”

    Please do a post, I’d be very interested.

    For me this inflation report looks like being written by a committee, with members having different perspectives.
    Take a look at the inflation written one year ago (p.18):
    http://www.bankofengland.co.uk/publications/inflationreport/ir11feb.pdf
    The first table in the demand chapter reflects the C+G+I+NX perspective.

    These days the committee members who have the “RGDP = NGDP – deflator” perspective have gained the upper hand.

  63. Gravatar of ssumner ssumner
    25. February 2012 at 11:10

    Jeff, Can’t you think up a more impressive sounding term like “bullshitiscedacity?” :)

    Max, No, a competent bank stabilizes NGDP growth and doesn’t worry about profit and loss. Although if you do have stable NGDP growth then central bank profit is also likely to be more stable.

    K, Show me a paper that says pegging the price of NGDP futures contracts won’t work at the zero bound.

    The only skepticism I recall with NK models is either growth rate targeting (which I oppose) or the view that promises to inflate would not be credible (which has never occurred in all of history.) It’s an invented problem.

    You said;

    “The problem is that they suspect that they are in fact fairly impotent.”

    Who are “they?” Would they be Ben Bernanke? Or the BOJ officials that warn monetary stimulus would lead to hyperinflation? Or BOE officials who don’t want to devalue the pound?

    123, I have a new post.

  64. Gravatar of K K
    25. February 2012 at 13:04

    Scott: “Show me a paper that says pegging the price of NGDP futures contracts won’t work at the zero bound.”

    You mean actually manipulating them? Thats totally different From targeting, and every bit as powerful as buying real assets but a *much* better idea. It wouldn’t be considered monetary policy in the NK framework. Monetary policy is just a rule for setting the short rate such as NGDP *targeting*. NGDP targeting (rather than actual futures manipulation) would be such a rule but under the NK framework *nothing* you do with the short rate (or equivalently the money supply) can be optimal under all circumstances. But if you want to include direct manipulation of futures by the Fed I would fully agree and 100% support such a policy as I consider it far less regressive (neutral in fact) compared to buying stocks for example.

  65. Gravatar of ssumner ssumner
    26. February 2012 at 07:46

    K, You said;

    “You mean actually manipulating them? Thats totally different From targeting, and every bit as powerful as buying real assets but a *much* better idea. It wouldn’t be considered monetary policy in the NK framework. Monetary policy is just a rule for setting the short rate”

    Seriously, this is insane. Increasing the money supply is the quintessential monetary policy thought experiment. To say only changing interest rates is monetary policy is borderline insane.

    My NGDP targeting plan contemplates buying T-securities, BTW.

  66. Gravatar of K K
    26. February 2012 at 22:13

    “Seriously, this is insane.”

    :-)

    Away from the ZLB there’s a one-to-one map between the path of the short rate and the path of the money supply. And at the ZLB the money supply is irrelevant. So Occam’s razor suggests we just focus on the short rate. Everything else (buying stocks, the non-balance sheet expanding bits of QE/twist, whatever) could just as well be done by the treasury, so ought to be considered to be fiscal/industrial policy. They all have different possible impacts but shouldn’t be considered monetary policy just because some CBs might have the institutional ability to carry them out. Monetary policy is the exchange of reserves for t-bills.

    Buying T-whatevers is counterproductive in a liquidity trap. The reason is that these assets are negative beta in a severely demand deficient environment, and therefore are equivalent to *negative* quantities of real assets in a portfolio. Removing them make investors less able to hold real assets. But that’s just my opinion. Don’t take that part as the orthodox NK view (it’s true though :-).

  67. Gravatar of W. Peden W. Peden
    27. February 2012 at 04:33

    K,

    “Monetary policy is the exchange of reserves for t-bills.”

    Very American and very modern, I’m afraid. Also, a stipulative definition and therefore rather misleading when engaging in long-standing theoretical debates.

  68. Gravatar of K K
    27. February 2012 at 06:11

    W. Peden: “Very American and very modern, I’m afraid.”

    There are two basic standard operations of the Fed: open market repos of treasuries (or equivalently buying t-bills) to determine the money supply (or more relevantly, the short rate), and discount window operations which are at the option of the borrower but which do the same thing against crappy collateral. In the latter case, in the tradition of Bagehot, there is a higher rate and a large haircut. If the haircut is big enough given the lending term, these two kinds of collateralized lending operations are equivalent and risk free. And there is nothing new about lending freely against sufficient collateral at a penalty rate.

    *Any* of the other things that are sometimes defined as monetary policy, can be considered as a combination of 1) the exchange of money for t-bills and 2) exchange of t-bills for something else. This latter part could be simple (operation twist) or exotic how about exchange of t-bills for future taxation? If you want to extend the idea of “monetary policy” to stuff that has nothing to do with the money supply, then you lose any possible distinction between monetary and fiscal. Of course we’ll never agree on what are the limits of the powers of monetary policy if we refuse to define it or we all make our own hidden assumptions based on our biases or on the institutional idiosyncrasies of our favorite central bank.

    Once you permit the purchase of risky real assets by the CB the whole debate becomes totally meaningless and *of course* “monetary policy” is perfectly omnipotent. How about some houses in my neighborhood? I’d like some money for a new car. I’m good for it. Or how about buying a share of my future human capital? Very valuable, going cheap!! Ridiculous.

  69. Gravatar of ssumner ssumner
    28. February 2012 at 05:51

    K, You said;

    “Away from the ZLB there’s a one-to-one map between the path of the short rate and the path of the money supply. And at the ZLB the money supply is irrelevant. So Occam’s razor suggests we just focus on the short rate.”

    Are you being serious or just making a joke? There’s a one to one map between the money supply and the price of toasters. And at the zero bound the price of toasters can rise or fall. So is the price of toasters monetary policy? The idea that there is always an interest rate implied for any given money supply is utterly meaningless. The point is that with the money supply we know roughly what to expect in the long run, with interest rates we don’t have a clue Indeed I’d be better able to predict future NGDP if I knew the future path of toaster prices than if I knew the future path of interest rates. Suppose you had a crystal ball and knew the future path of interest rates, what would that tell you? The Fed does not wave a magic wand and change interest rates. They have to Do SOMETHING, and the thing they do is adjust the money supply (or demand). That’s monetary policy. Interest rates are an effect of policy, just as changing exchange rates and changing stock prices are an effect.

    And no one claims the money supply is irrelevant at the zero bound. Everyone agrees that the Fed can tighten policy by raising interest rates or reducing the money supply. Indeed the standard Keynesian view is that the Fed raises rates precisely by reducing the money supply, even at the zero bound. So your comment makes no sense.

    Regarding T-bills, they didn’t even exist until fairly late in the game. The Fed used to buy gold. I suppose that wasn’t monetary policy either?

    If you want to call my monetarist views “fiscal policy,” you are entitled to your own private language, but no one else will understand what you are talking about.

  70. Gravatar of Major_Freedom Major_Freedom
    28. February 2012 at 11:53

    ssumner:

    My NGDP targeting plan contemplates buying T-securities, BTW.

    Which grows the size and scope of government activity, BTW. Any entity that can borrow at lower rates and thus increase their borrowing, and have more control over society’s resources, has an incentive to grow. You can’t be for small government and be for central banks monetizing the government’s debt at the same time.

  71. Gravatar of ssumner ssumner
    1. March 2012 at 11:56

    Major, I don’t see any better alternatives, assuming the Fed exists.

  72. Gravatar of Major_Freedom Major_Freedom
    1. March 2012 at 22:24

    ssumner:

    Major, I don’t see any better alternatives, assuming the Fed exists.

    I don’t see any better alternative than to advise and assist rapists and murderers and thieves, assuming rapists and murderers and thieves exist.

  73. Gravatar of Bernanke’s Nightmare, part 2: Preempting market monertarists | A Fools Game Bernanke’s Nightmare, part 2: Preempting market monertarists | A Fools Game
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    [...] Sumner likes to say that no central bank has ever failed to create inflation when it has tried. But I wonder if the perfect track record is due to the fact they rarely deviate from what the consensus view of economists prescribes. The cases where central banks get ahead of the consensus sometimes end badly, but these are retroactively labeled “dysfunctional” countries, where the proper institutional norms to set the correct target don’t exist. Once again, this is tautological. What makes these central banks “dysfunctional,” in the first place, is the lack of consensus-following institutions that create regime stability.  [...]

  74. Gravatar of ‘Free Market’ Double Standards 5.0 « Unlearning Economics ‘Free Market’ Double Standards 5.0 « Unlearning Economics
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    [...] indicators to look at monetary policy, only NGDP. Even though fiscal stimulus is functionally similar, we shouldn’t apply the same logic to [...]

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