The soft bigotry of low expectations

I’ve often argued that the fiscal multiplier would be zero if the central bank was doing it’s job.  Of course the central bank doesn’t always do its job, and hence I wouldn’t argue the multiplier is always precisely zero.  Spending on WWII probably raised both NGDP and RGDP (although it’s doubtful it raised consumption, which is arguably what matters.)  And it’s possible that a big tax increase (such as the highly anticipated taxaggeddon) could slow the economy; certainly via supply-side effects, and perhaps because the Fed would fail to offset the tax increases.

Here’s what I do strongly believe:

1.  If the modest spending increases that have been touted over the past few years were enacted they would have been unlikely to have had much effect, as long as the Fed was targeting inflation at 2% or slightly below.

2.  The Fed could offset even a big fiscal shock, such as taxaggeddon—which is the expiration of a host of previous tax cuts, due to occur in January 2013.

3.  The Fed should offset a big fiscal shock like taxaggeddon.

4.  Most importantly, the economics profession needs to change the way it talks about the role of monetary policy.  No more soft bigotry of low expectations.  We should insist that Fed try to produce an appropriate level of AD.  We should talk as if the fiscal multiplier is zero.  And I’d even go farther than I’ve gone in the past.  If we are so far down in a liquidity trap that there is any question as to whether monetary policy could offset needed fiscal retrenchment, then ipso facto money is already far too tight.

Let me be more specific.  Bernanke has recently argued that current monetary policy is appropriate, and that no further stimulus is needed.  But he’s also argued that the Fed wouldn’t be able to offset taxaggeddon.  Those two answers are simply not acceptable.  It’s the Fed’s job to steer the nominal economy. Period, end of story.  If they feel that they may not be able to do so because of near zero rates, then they need either a different policy instrument, or a higher inflation target.

I believe the economics profession has been far too kind to the world’s major central banks.  Most economists (not all) think the world has an AD problem.  And most economists are not demanding the Fed do more.  That’s what I’m trying to change.

Matt Yglesias did a recent post that made some similar points.  Interestingly, I think we ended up in the same place coming from different directions.  Although I believe the fiscal multiplier is normally zero, I also understand that my hypothesis is “just a theory.”  Commenters like Andy Harless have pointed out that the multiplier might be slightly positive if the Fed is more reluctant to do unconventional stimulus than if all they have to do is cut the fed funds target.  It seems to me that this argument is more likely to apply to very large fiscal shocks, as compared to smaller changes.  So I’m a tiny bit worried about taxaggeddon despite my zero multiplier argument.  And I’m also a small government guy, who’d prefer spending cuts to tax increases.  But even with my theoretical doubts, and my small government bias, I was so outraged by the soft bigotry of low expectations that I did a scathing post a few days back, arguing that it was absurd for Bernanke to claim the Fed couldn’t offset the demand-side effects of tax increases.

Yglesias is more comfortable with bigger government.  But on the other hand he also tends to favor fiscal stimulus.  So he probably feels an ambivalence to tax increases for very different reasons.  He thinks we need fiscal stimulus, but also knows that in the long run Obama’s social spending agenda will require more revenues, and it would be nice if the Fed could provide enough stimulus so that Obama could begin moving in that direction in his second term.

But despite these differences, what strikes me about the Yglesias post is that Matt and I seem to share the same outrage about how little we expect from our central banks.  I suppose it’s dangerous to do mind reading, so read it for yourself and see what you think:

Conventional wisdom in DC is that not only would the full expiration of the Bush tax cuts make people grumpy as they find themselves needing to pay more taxes, it would also provide the macroeconomy a job-killing dose of fiscal drag. .  .  .  I don’t buy it.

The problem is that this chart ignores what I think we’re now going to call the Sumner Critique. In other words, it assumes that the Federal Reserve is somehow going to fail to react to any of this. You can probably construct a scenario in which the Fed is indeed caught unawares, or is paralyzed by conflicting signals, or is confused by errors in the data, or any number of other things. But Ben Bernanke knows all about the scheduled expiration of these tax cuts.  .  .  . Maybe he and his colleagues won’t do anything to offset this drag on demand, but if they don’t as best I can tell that’s on them. This is the very essence of a predictable demand shock, and the policymakers ultimately responsible for stabilizing demand are the ones who work at the Fed.

If I was a progressive I think I’d feel exactly the way he does.  Whether you are on the left or right, it’s very aggravating to see our monetary policy producing massive dead-weight losses, and also pushing fiscal policy away from what it does best.

PS.  Business reporters could learn from sports reporters.  The press tends to mock Lebron James (perhaps unfairly), for failing to take the big shots.  Why don’t reporters do the same with Bernanke?  He’s got a long track record as an academic making fun of the argument that central banks can run out of ammo.  Ask him “Why are you so afraid of taxaggeddon?  Don’t think the big bad Fed has what it takes to get NGDP up to appropriate levels?  You guys have your own printing press, for God’s sake!”

Of course I’m being silly.  But you have to wonder about a press corps that asks tougher questions of 26 year old basketball players, then of the men and women who are most responsible for the health of the global economy.  Maybe it’s the reporters who are afraid to ask the big questions.


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102 Responses to “The soft bigotry of low expectations”

  1. Gravatar of Ben J Ben J
    20. May 2012 at 10:45

    Scott,

    Loving the blogging lately. I’ve been quizzing all the monetary policy guys at the university (here in Australia) about what they think of NGDP targeting. John Quiggin wrote a piece called ‘The tyranny of the inflation target” a while back, supporting NGDPLT, and he is taken seriously here. Times are slowly a changin…

    I was at a corporate meet and greet over the weekend (for undergrads like me) and I was chatting to a couple of guys from the policy desk at the RBA. I asked them specifically about NGDP targeting, and about if the bank has started making any formal plans for dealing with the shortcomings of IT at the ZLB.

    They smiled and said that “the policy desk closely examines monetary policy issues from around the world.” I think we’ll have to be content with the ‘average over the cycle inflation targeting’ for now.

  2. Gravatar of Saturos Saturos
    20. May 2012 at 11:15

    Ben J,

    You’re an Aussie too? Which University you at?

  3. Gravatar of Jon Jon
    20. May 2012 at 11:32

    Scott writes:

    And it’s possible that a big tax increase (such as the highly anticipated taxaggeddon) could slow the economy; certainly via supply-side effects… But he’s also argued that the Fed wouldn’t be able to offset taxaggeddon.

    Can you find clear evidence that Bernanke views ‘taxaggeddon’ through an AD lens? Or is he, as I suppose, discussing just those supply-side effects you mention. We can agree, I hope, that monetary policy tackles AD not AS.

  4. Gravatar of Alexander Hudson Alexander Hudson
    20. May 2012 at 12:47

    Jon, I suppose Bernanke could be referring to AS, but I doubt it. From my vague recollection of his statements on the issue, he’s essentially making a demand argument. Correct me if I’m wrong, but Bernanke has been careful in the past to warn Congress about the long-term deficit without favoring a particular ratio of spending cuts to tax increases. My guess is that he (rightly) views that as outside his purview.

    Scott, this is a nice example of what Evan Soltas said in a recent blog post about how the left and right have come to the same views on monetary policy while emphasizing different concerns. Your concern is about the supply-side consequences of increasing top marginal tax rates, while Yglesias’ concern is (at least in your reading) that it might be slightly contractionary given the Fed’s reluctance to use its unconventional policy tools.

  5. Gravatar of Ben J Ben J
    20. May 2012 at 12:50

    Saturos,

    I’m at University of Queensland mate!

  6. Gravatar of Bill Ellis Bill Ellis
    20. May 2012 at 13:27

    Professor Sumner, I don’t think you are being silly at all. Working the ref is as important in politics as it is in sports.

  7. Gravatar of Greg Ransom Greg Ransom
    20. May 2012 at 13:58

    “Spending on WWII probably raised both NGDP and RGDP.”

    This is an open and shut argument against mindlessly using NGDP and RGDP as measures of wealth, economic coordination, production, wealth production, or much of anything else.

    If you want to do a reductio on NGDP targeting — forever discrediting the idea — stick to this theme.

  8. Gravatar of Jon Jon
    20. May 2012 at 14:07

    Alexander writes:

    Correct me if I’m wrong, but Bernanke has been careful in the past to warn Congress about the long-term deficit without favoring a particular ratio of spending cuts to tax increases.

    Yes, he has been circumspect regarding the debt-limit; however, “taxaggeddon” isn’t about debt-limit policies–at least not directly.

  9. Gravatar of DonG DonG
    20. May 2012 at 14:47

    I fully expect Congress to work out a retro-active compromise on taxes sometime before Apr 15th. How should the FED “react” to that?

    –DonG

  10. Gravatar of Morgan Warstler Morgan Warstler
    20. May 2012 at 14:48

    Scott, let’s just be clear….

    It is NICE that you want to play fair, butyou don’t count any more than playing fair matters.

    Nov. 2012 if Obama loses, we will KNOW:

    1. The Fed can and will offset fiscal spending or tax cuts.

    2. the Fed can and will not offset tax increases and spending increases.

    This is and has ALWAYS BEEN what is meant by the Fed is independent.

    The Fed is a not a referee that Fed ROOTS for the private sector and it blows raspberries at the pubic sector.
    —-

    Once again, I don’t care about your notion of fairness or justice, I can about you as an economist being able to LEARN from the facts on the ground and formulate policy within the boundaries of allowable behavior.

    Tax cuts are not fiscal policy and the Fed’s job is not make the economy run smooth no matter what the govt. does.

  11. Gravatar of Morgan Warstler Morgan Warstler
    20. May 2012 at 14:49

    This sin’t SOFT bigotry.

    This is HARD NASTY private sector bias.

    No one is acting dumb here, you are just pretending to be naive.

  12. Gravatar of dwb dwb
    20. May 2012 at 15:09

    huh, imagine that:

    http://online.wsj.com/article/SB10001424052702303879604577412570692271812.html?mod=WSJ_hp_LEFTTopStories


    “Expectations are more important than many people had recognized,” says Frederic Mishkin, a Columbia University professor and former Fed governor.

    now, um, can we get those nominal expectations up please???

  13. Gravatar of Major_Freedom Major_Freedom
    20. May 2012 at 15:12

    Tax rate increases cannot put a damper on aggregate demand unless the tax rate increases discourage private sector spending that otherwise would have taken place, but doesn’t, as money is “hoarded.”

  14. Gravatar of dwb dwb
    20. May 2012 at 15:24

    ^^ the more i think about that WSJ piece the more surreal i think it is. “Fed staff decides expectations actually matter.”

    this passes for deep insight? are they inventing macro from the ground up here??

  15. Gravatar of CA CA
    20. May 2012 at 15:46

    In the past I think Scott had mentioned that he teaches out of Mishkin’s textbook.

  16. Gravatar of dwb dwb
    20. May 2012 at 15:51

    Mishkin was a Fed Governor and on the FOMC. yeah, the Mishkin text is good, if only the current FOMC members would read it!

  17. Gravatar of dwb dwb
    20. May 2012 at 16:22

    three FOMC members just found a secret room in the basement:

    Lacker: What is this room?
    Bernanke: I dunno, Greenspan never told me about this.
    Evans: There’s a button over there.

    Lacker: what does the button do?
    Bernanke: Did I mention the part where Greenspan never told me?
    Evans: There’s a big “E” on it.

    Lacker: Dont touch it! It might set off an alarm!

    [Ghost of alan greenspan haunting the room]: you igit. its to set expectations.
    Bernanke: We’ll need to take this back to the commitee and study it.

    [lights flicker]
    Bernanke: did you see that?
    Evans: look, there’s a compartment underneath that just opened up.
    Bernanke: no i mean someone pushed the button.

    Lacker: not me.
    Evans: not me.

    [Ghost of alan greenspan haunting the room]: you igit, you are all pushing the damn button

    Evans: look a note.
    Lacker: whats it say?
    Evans: nothing, just some letters.
    Bernanke: whats are the letters.

    Evans: N-G-D-P-L-T
    Lacker: Bernanke, your supposed to be the chair,
    whats it mean?
    Bernanke: Did i mention the part where Greenspan never told me how this thing worked?? All he said was “just do it!”

  18. Gravatar of Dan S Dan S
    20. May 2012 at 17:18

    Scott,

    I’m curious how you would feel about a policy that is a Taylor Rule (which is functionally very similar to NGDP targeting) at positive Fed Funds Rates, and then if the zero bound is ever reached, 1% of the outstanding national debt is permanently monetized every 2 weeks or so until the NGDP target is hit (which I suspect wouldn’t take long).

    I wonder if that might be more palatable to the economics profession. It still allows the Fed to do “interest rate targeting” most of the time, but when it’s time to get unconventional, it’s done in a way that is the least “weird” and is the most well-understood historically: simple, permanent debt monetization. There is also no way that anybody could argue that it would be “ineffective.” Either it “works” and the economy recovers, or it “fails” and the entire national debt is monetized with no adverse consequences. It would be better if it failed!

  19. Gravatar of ssumner ssumner
    20. May 2012 at 17:40

    Ben J. Thanks for that info.

    Jon, He didn’t say, but the implication was clearly demand side. Otherwise his comments would have been very oddly worded.

    Saturos, I once taught at Bond U.

    Alexander, That sounds reasonable, although I think Yglesias’s views on the monetary offset issue are virtually identical to mine. Normally you’d expect an offset, but there may be circumstances where it doesn’t occur.

    Bill Ellis, Yes, I am basically trying to “work the refs” with this blog. I view the mainstream economic consensus as the refs.

    DonG, The Fed needs to be more expansionary regardless of what Congress does. They simply need to do more—how much more is the only question.

    Greg, Looks like you missed the point. I was criticizing that view.

    dwb, It was blocked for me–anything interesting?

    And you have a future as a screenwriter!

  20. Gravatar of ssumner ssumner
    20. May 2012 at 17:43

    Dan, I have two problems with the Taylor rule. I prefer level targeting to growth rate targeting. And I prefer to target the forecast. Under the Taylor Rule the Fed responds to past data.

  21. Gravatar of dwb dwb
    20. May 2012 at 17:49

    heh, it was probably blocked to keep your head from exploding. “Fed staff decides expectations actually matter.” (my title)

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

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

    It turns out that both sets of predictions were wrong. Consumer prices have neither collapsed nor taken off. When the Labor Department reported last week that the consumer-price index was up 2.3% from a year earlier—very close to the Fed’s 2% target—it was a nonevent in financial markets. That tame consumer-price reading is confirmed by low yields in inflation-sensitive bond markets, surveys of households and the recent retreat of commodities prices.

    Why were many people wrong about inflation? The answers lie in the different views of what drives it.

    The deflation fear rested on the idea of slack. It holds that recessions produce so many idle economic resources—in the form of unemployed workers, empty buildings and unused factory capacity—that workers and businesses would accept lower wages and prices to generate demand for their goods and services.

    The inflation concern rested on the role of money. The fear has been that by pumping up the supply of money in the financial system, the Fed would effectively cheapen its value.

    Both sides have powerful advocates. Top Fed officials—including Chairman Ben Bernanke and Vice Chairwoman Janet Yellen—have placed heavy emphasis on the role of slack in the economy. Critics of the Fed, including some regional Fed bank presidents, have assailed the central bank for stirring inflation by putting more money into the economy through the purchase of Treasurys and mortgage bonds.

    To some extent the two forces could be canceling each other out.

    But economists are coming to see that money and slack provide unsatisfying explanations.

    The Fed has printed lots of money, but banks have been slow to resume lending and have kept much of it parked at the Fed itself, where it earns 0.25% interest. The Fed can keep the money and inflation immobilized simply by raising that interest rate, says Marvin Goodfriend, an economist at Carnegie Mellon University and a member of the Shadow Open Market Committee, which acts as an independent watchdog on Fed policy.

    Fed officials have been wrestling with the limitations of the slack argument recently, too. The Fed keeps forecasting bigger inflation slowdowns than occur. In April 2011, for example, the Fed projected inflation in 2012 would be between 1.2% and 2% and that core inflation—which strips out volatile measures—would be between 1.3% and 1.8%. Both measures in the first quarter were above the projections.

    “It’s a little surprising that core inflation has been as high as it’s been and it hasn’t slipped further,” says Donald Kohn, a Brookings Institution scholar and former Fed vice chairman.

    One reason inflation might not be as responsive to slack as thought is because firms, though willing to freeze wages, are reluctant to actually cut them even when there is an overabundance of workers, he says. That results in resistance to prices falling once inflation has gotten very low.

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

    “The predictive content of slack on inflation is very weak,” says Mr. Goodfriend.

    Instead, a third, more ethereal factor, could be the most important factor of all—the public’s expectations. When households and businesses expect consumer prices to take off—as they did in the 1970s—they push for wage and price increases in anticipation of these events, triggering inflation. But when they expect inflation to be little changed, it turns out, it actually remains little changed.

    Measures of the public’s inflation expectations have remained remarkably stable since the financial crisis, despite worries on both sides of the equation. Households surveyed by the University of Michigan, for instance, have expected inflation between 2% and 4% in 36 out of the past 40 months since 2009. Measures of expected inflation over five years in the Treasury Inflation Protected Securities market have moved narrowly between 2.1% and 3.3%.

    “Expectations are more important than many people had recognized,” says Frederic Mishkin, a Columbia University professor and former Fed governor.

    This is more than just an academic development. It affects the Fed’s plans for interest rates.

    Deflation now looks like much less of a real threat than a couple of years ago. That means there is less reason for the Fed to try to prop up prices. At the same time, if a spurt of inflation isn’t a threat either, that gives the Fed leeway to do more to attack the unemployment problem. This is one of the next intellectual battlegrounds for a divided Fed as it ponders what to do next.

  22. Gravatar of Saturos Saturos
    20. May 2012 at 20:05

    Scott, with these blocked WSJ articles (and I think FT articles as well, though they have free registration) the trick is to Google the URL, and click that link, and then you circumvent the paywall – you can even read the printable version instead (which I’m doing right now). Although I prefer dwb’s title.

    You taught at Bond, huh? Excellent, now I have a mental picture of you surfing on the Gold Coast…

  23. Gravatar of Saturos Saturos
    20. May 2012 at 20:29

    Mark Zuckerberg just got married: http://www.tmz.com/2012/05/19/mark-zuckerberg-married/

    Does anyone else think he looks like Scott?

  24. Gravatar of Saturos Saturos
    20. May 2012 at 20:57

    Seriously, though, it’s been 4 years since demand collapsed. Why haven’t prices and wages adjusted down to the new trend yet?

  25. Gravatar of Saturos Saturos
    20. May 2012 at 21:05

    Also, I have a new question. Doesn’t the optimality of NGDP targeting as a response to supply shocks depend on the model of aggregate supply which is used? According to Bradley and Jansen (http://research.stlouisfed.org/publications/review/89/11/Understanding_Nov_Dec1989.pdf):

    For example, one aggregate demand-supply
    model generates a positively sloped aggregate
    supply curve by assuming that workers have incomplete
    information about the current economic
    environment; specifically, they lack information
    on the current prices of goods that they
    purchase infrequently. Workers accept nominal
    wage offers based on their forecasts of the
    price level rather than the price level itself.
    Nominal wages are assumed to be set by an
    auction market for labor services, in which the
    wage adjusts instantaneously to current economic
    conditions.” In this case, a larger-thanexpected
    rise in the price of all goods means
    that workers’ forecast of the price level are
    below the actual price level, thereby inducing
    workers to accept lower nominal wage offers
    than usual. Until workers discover what has
    happened to the price level (which includes
    observing prices for goods purchased relatively
    infrequently), they will continue to offer their
    labor services at a lower real wage than the one
    they would demand if they were fully informed.
    This lower real wage induces firms to expand
    employment and output. In this alternative
    framework, nominal GNP targeting may be
    preferable to a fixed money rule; but price level
    targeting always works to keep real GNP at the
    natural rate.

    Does the experience of summer 2008 refute this model?

  26. Gravatar of Saturos Saturos
    20. May 2012 at 21:24

    New Developments: http://www.bloomberg.com/news/2012-05-21/tips-give-bernanke-green-light-to-ease-amid-record-yields.html

  27. Gravatar of Ben J Ben J
    20. May 2012 at 22:52

    Scott Sumner on a board at Surfer’s Paradise is cracking me up. “Target the forecast of the crest of the wave, target the forecast!”

    Saturos, where are you?

  28. Gravatar of Saturos Saturos
    20. May 2012 at 23:01

    Actually , this is probably good evidence against that model as well: http://thefaintofheart.wordpress.com/2011/04/14/the-crisis-from-an-ad-perspective/

  29. Gravatar of Saturos Saturos
    20. May 2012 at 23:02

    Ben J, as you can see from my profile page, I’m in Perth.

  30. Gravatar of Saturos Saturos
    20. May 2012 at 23:06

    Btw Scott, what do you think of the money supply as a signalling instrument instead of interest rates?

  31. Gravatar of Saturos Saturos
    20. May 2012 at 23:07

    RBA likes to argue that “the public understands the relevance of the cost of borrowing to their own lives”.

  32. Gravatar of Mike Sax Mike Sax
    20. May 2012 at 23:38

    “Yglesias is more comfortable with bigger government. But on the other hand he also tends to favor fiscal stimulus. So he probably feels an ambivalence to tax increases for very different reasons. He thinks we need fiscal stimulus, but also knows that in the long run Obama’s social spending agenda will require more revenues, and it would be nice if the Fed could provide enough stimulus so that Obama could begin moving in that direction in his second term.”

    Yep that’s basically my position as well. Which is why yes too do want to see the Fed do more. For me I’ll take whatever’s on tap right now-fiscal or monetary policy. If monetary policy can as you think do it all fine. Trouble is that neither is happening.

  33. Gravatar of Lorenzo from Oz Lorenzo from Oz
    21. May 2012 at 00:19

    Agree entirely, which is why all MM supporters need to keep plugging away wherever they can so mainstream media commentators eventually get the message and start holding central bankers publicly responsible. One of the factors which matters is the RBA is subject to much more searching media commentary in Oz than the Fed is in the US media. I grant you that is because of floating interest rate mortgages and a society highly leveraged on bureaucratic approval (i.e. inflated housing in land-rationed markets), but whatever the reason, the effect is to make the RBA more accountable.

  34. Gravatar of J.V. Dubois J.V. Dubois
    21. May 2012 at 01:01

    Completely agree here. It is indeed very strange that journalists let the most influential people in the world right now escape with shabby explanations. While there are some swallows, like NY Times reporter question during last press conference, it is still too little.

    And I am not even saying anything about ECB, that is an utter disaster in the making. And contrary to others I think that you are actually too soft on them. In a Better world Trichet and Draghi would be in Haag explaining to the international court of justice who is responsible for creating and maintaining a monstrous system that perpetuates crimes against the humanity on a global scale. I would love to see how judges would see their excuses that they are just following orders to “keep prices stable” and it was not their job to do something about the human suffering even if they could.

    I wonder if these arrogant egomaniacs in ivory towers realize (borrowing Obama’s quote) – that the sloppy journalism is the only thing standing between them and the pitchforks.

  35. Gravatar of Saturos Saturos
    21. May 2012 at 01:04

    “Searching” commentary? Really? Here’s the latest:
    http://www.smh.com.au/business/rba-hints-at-further-rate-cuts-20120514-1yn0s.html
    http://www.news.com.au/business/rba-flags-concern-over-labour-costs/story-e6frfm1i-1226346840222

    The first one’s bad enough, but the second is positively Keynesian.

    “whatever the reason, the effect is to make the RBA more accountable”

    In economics we distinguish between intentions and results.

  36. Gravatar of Saturos Saturos
    21. May 2012 at 01:32

    Update from the Atlanta Fed: http://www.frbatlanta.org/news/speeches/120521_lockhart.cfm?d=1&s=tw

    Under current circumstances, sustained accomodation is warranted. Communication is a policy tool and the Fed needs to continue to improve on this front. However, we don’t need another round of asset purchases.

  37. Gravatar of Full Employment Hawk Full Employment Hawk
    21. May 2012 at 02:20

    “The Fed could offset even a big fiscal shock, such as taxaggeddon—which is the expiration of a host of previous tax cuts”

    But even if it could, would it? I really do not think so.

    We have had an experiment of the response of a central bank to contractionary fiscal policy in Britain, a contractionay policy weaker than taxageddon.

    The Bank of England is far more competent in the conduct of monetary policy than the Fed, (and, of course enourmously more so than the ECB). Clearly the contractionary fiscal policy of the Cameron governmnet was not offset by the Bank of England and the British economy has contracted. We can argue about whether this is due to lack of will or lack of ablilty, but in any case, the offset did not happen.

    There are good reasons to conclude that the response of monetary policy to contractionary fiscal policy, especially when the economy is depressed, is very different from the response of monetary policy to expansionary fiscal policy. One can debate whether this is due to different effectiveness of monetary policy under the two conditions, or different responses by the central bank, but the results with respect of the effects on output and income the results are similar.

    In any case, the experiment by the Cameron government shows that we cannot expect the Fed to offset taxageddon. From the pure standpoint of increasing our knowledge of macroeconomics, it would be best if taxageddon happened. This would throw the economy into a second dip recession and demonstrate that in practice, with the kinds of central banks we actually have, this kind of contractionary fiscal policy really does contract the economy, as Keynesian theory predicts. But obviously I absolutely do not want the American people to be subjected to this experiment.

    May you live in interesting times is a curse, not a blessing.

  38. Gravatar of Full Employment Hawk Full Employment Hawk
    21. May 2012 at 02:35

    “the Fed can and will not offset tax increases”

    The economy boomed after Clinton raised taxes. If the Fed did not offset the effects of the tax increase, why did this happen?

  39. Gravatar of Full Employment Hawk Full Employment Hawk
    21. May 2012 at 02:44

    “Spending on WWII probably raised both NGDP and RGDP (although it’s doubtful it raised consumption, which is arguably what matters.)”

    In WWII the normal effects of spending on consumption were suppressed.

    1. Consumer goods were rationed. If one had additional income, but no ration stamps, there were many important consumer goods that one could not purchase.

    (I am actually old enough to remember rationing during WWII, but from the German side, where the rationing was much more severe.)

    2. The availability of consumer goods was serverely limited. The production of passenger cars was halted shortly after the beginning of the war as the auto plants were converted to military production. Since expenditures on cars are a major component of consumption, this had a very negative effect on it. Most other durables were only available in very limited quantities.

    The huge increase in military expenditures, rather than consumption, was what mattered most during this time.

  40. Gravatar of Dan Kervick Dan Kervick
    21. May 2012 at 03:36

    There is no such thing as “the nominal economy” that the Fed can “steer”. This is a lunatic post. If the “economics profession” starts talking the way you think they should talk, it will only further confirm that that profession is filled with incompetent model-addled crackpots who don’t live in the real world.

  41. Gravatar of J.V. Dubois J.V. Dubois
    21. May 2012 at 05:41

    Dan: Wow. Actually it is your post that is lunatic. There clearly is such thing as a “nominal economy”. Real economy can be observed measuring “real” physical goods and services produced such as quantities (tons of steel, number of iPads). Then you have “nominal economy” that is what you get if you are measuring money values of goods and services. As long as there is money used for exchange of goods and services, nominal economy *exists*. It does not cease to exist because you do not find it convenient.

    If you want to salvage at least something from your argument, please start again. You can come with claim like “Nominal economy obviously exists (because we can observe it whenever we buy or sell something using money), but it has no influence on real economy. And my arguments are …”

    And they have to be pretty good arguments because as Carl Sagan says “extraordinary claims require extraordinary evidence” And in case you did not notice “economic profession” happens to posess pretty good evidence to the contrary – that nominal variables (prices, money) have huge influence on real variables (tons or pieces of things produced and consumed/invested).

  42. Gravatar of Dan Kervick Dan Kervick
    21. May 2012 at 06:07

    J. V. Dubois, you are not describing anything that deserves to be a called a “nominal economy”. You are talking about the nominal measure of the transactions in the total economy. Those measures themselves are not an economy and there is therefore nothing separate in them, over and above the total economy, that the Fed can “steer” as any meaningful exercise of. That would be like claiming that the Bureau of Weights and Measures can a significant role in policy concerned with the healthy growth of America’s schoolchildren because it steers the production specifications of the rulers and tape measures.

    Now I suspect what you are talking about is not really the “nominal” economy, but the monetary economy, since the nominal terms we use for measuring transactions for actual goods and services are derived from the denominations of the established medium of exchange that is employed in almost every one of those transactions, and in terms of which the prices of goods and services are stated and recorded.

    But the very fact that money in some form is used in virtually every transaction in our economy is all the more reason for recognizing that there is no “monetary” economy which can be separated from, and steered independently of, the rest of the economy. Money is entangled with, wrapped around, embroiled in, and inseparable from the total economy. We can speak maybe of the “soybean economy” as a useful abstraction, because only a relatively small set of transactions in our economy involve soybeans, and so our total economy has a soybean sector. But it should be obvious that there is no usefully separable “monetary sector” of our economy. The monetary sector of our economy is essentially the total economy.

  43. Gravatar of Dan Kervick Dan Kervick
    21. May 2012 at 06:08

    Augment:

    “that the Fed can “steer” as any meaningful exercise of.”

    to

    “that the Fed can “steer” as any meaningful exercise of economic policy.”

  44. Gravatar of Peter N Peter N
    21. May 2012 at 06:25

    Saturos,

    Interesting. It seems to me that the first article misses a few important details.

    1) The explosion of weak loans wasn’t primarily the result of government home ownership policies or interest rates. The most important factor was incentives. Because of the way loans were repackaged by the wall street rocket scientists, the worst loans were the most profitable. Once the magical risk vanishing cream was applied, profit was proportional to loan interest rate. The worst loans were the best loans.

    2) The expanding financial sector needed more risk free collateral than the US government cared to provide by issuing debt (Triffin dilemma). Mortgage based securities could fill the gap. All that was needed was a way to make them risk free, which was a mere detail.

    3) despite the Fed’s pushing up interest rates, the supply of broad money fueling the bubble continued to increase. At the heights of booms, financiers always seem to manage to create enough credit to keep the boom going for a while, even though both the central bank and sanity oppose them.

    4) GDP is over used and over rated. It only purports to measure production, not expenditure, and it doesn’t even really manage to do that. It’s a creature of the system of national accounts, and not a basic economic variable. A large part of it is imputed activity. And much, much more.

    The biggest and most obvious problem is that focus on GDP makes “non-productive” transactions effectively invisible. This fosters the illusion that the inflation of asset prices relative to goods prices doesn’t matter, and that it’s impossible to determine when the economy is in a bubble.

    It may be impossible to determine exactly when the bubble will pop, but that’s, of course, not the same thing. If you drive on the highway at 120 MPH, you’ll crash. That the exact moment of the crash is unpredictable is no argument for doing it.

    Economic models often use a “corrected” form of GDP, although there’s no agreement on what the right corrections are. Targeting NGDP may be better than targeting inflation, but targeting whatever would produce the optimal result (assuming we had an idea what that might be) would be better yet.

    Perhaps it would be total expenditure. It’s relatively recently that the money velocity equation started using GDP as a variable. It used to use expenditure. Keynes used two different velocities – one for production and one for non-production.

    5) It’s a peculiar model of this economy that ignores the role of debt. I thought that we had reluctantly come to the conclusion that we can’t dismiss the subject by saying “we owe it to ourselves”. After all, Hume refuted that argument almost 300 years ago.

    6) Debt is an attempt to create a time machine for goods and services. We aren’t trying to save money, whatever that might mean, we’re trying to stake a claim on a quantity of future goods approximately equal to the quantity the savings would purchase today.

    If the total of these claims vastly exceeds the likely available quantity of future goods, and this discrepancy becomes apparent to the creditors, then the process of resolution starts. Either:

    a) The price of goods increases.

    b) The value of the savings vehicles decreases.

    c) The debt is forgiven or defaulted on.

    It seems obvious that how the resolution is apportioned between the alternatives would have significant economic consequences. This is not a problem that can be left for the market to decide, because it’s a social/legal decision.

    When we do things like change bankruptcy laws or limit the terms of debt, we change how the market will operate with respect to it. The invisible hand may be able to patch up the problem, but we have to decide what kind of patch it will use.

  45. Gravatar of Morgan Warstler Morgan Warstler
    21. May 2012 at 06:41

    “The economy boomed after Clinton raised taxes. If the Fed did not offset the effects of the tax increase, why did this happen?”

    Clinton’s tax increases were approved by Greenspan.

    He met with Greenspan Jan 1993, and came out of meeting and made full life-changing commitment to paying down debt with spending cuts and mild tax increases.

    And once paid down, Greenspan went to the mat to get the Bush tax cuts through.

    The driving issue of the day was debt service as a percentage of tax revenue.

    If it hadn’t been that high, I’m sure Greenspan would have been more circumspect about the taxes.

    Again, the Fed has two completely different mental approaches to tax / spending cuts vs. increases.

    It doesn’t make sense, nor is is intellectually honest for the econ profession to play wish in one hand / shit in the other.

    ——

    You are ideologues, where is your realpolitik???

    The rules to the game of life are generally written by the folks who have won in the past, if you don’t get out of your theory tree and STUDY THE RULES, you won’t be advocating the most effect policy within the boundaries of what is ALLOWABLE.

  46. Gravatar of Negation of Ideology Negation of Ideology
    21. May 2012 at 06:42

    This is a debate where both sides are right. If the Fed is doing its job, then the fiscal multiplier is obviously zero. The Fed would react to any change in AD caused by government spending the same as it would react to any change caused by corporations or individuals. That’s the Fed as a thermostat view.

    Keynesian economists are right to the extent that the Fed doesn’t act that way. In their view, the FOMC is more like a monetary Congress. If Bernanke can only get the votes for a certain dollar amount of QE, then all that’s left is for the real Congress to vote to increase velocity by borrowing more money and spending it.

    Of course, that’s not precisely right either. Congress can issue legal tender US Notes like it used to if it believes the Fed is not issuing enough monetary base. That would be much more effective in raising AD. It doesn’t need to increase government spending at all, just cover part of the deficit that already exists. If the Keynesians are right, then the Fed would not necessarily offset that action. But for some reason there’s this slippery slope argument that if Congress issues currency when inflation is at Eisenhower era levels we’ll become Zimbabwe. If that’s the fear, then Congress can instead change the Fed’s mandate to an NDGP target, which is my first choice anyway – adjust the thermostat.

    But this idea that Congress and the President are powerless over monetary policy is both Constitutionally wrong and a cop out.

  47. Gravatar of J.V. Dubois J.V. Dubois
    21. May 2012 at 07:08

    Dan: Ah, so we now have linguistic discussion, where you as expert say that there is no such thing as “nominal economy”. Well, maybe you can correct some Wiki articles? Maybe you could start on the entry “Planned economy” because it obviously does not have anything with production of plans, not in the same way that “soybean economy” has to do with production of soybeans.

    I mean, you are really beyond being obtuse. You intentionally misunderstood a word from a perfectly clear article, which gave you excuse good enough to start name-calling like “lunatic” and “crackpot”.

    But on the other hand, I see this as a proof that Sumner does a good job if this is all that his opponents have left to say. Since as we know he now has policymakers among his readers maybe he will need to get used to the treatment other publicly known economists (like Krugman) get themselves from those who actually are crackpot lunatics.

  48. Gravatar of Mike Sax Mike Sax
    21. May 2012 at 07:39

    “you won’t be advocating the most effect policy within the boundaries of what is ALLOWABLE”

    Morgan you still don’t get it. This time the Democrats are going to determine this. One of two things will happen at the end of the year. Either the GOP learns to negotiatie rather than dictate or the Bush tax cuts all expire-which is fine with me as I never liked them anyway.

    ONe of thoes two things will happen. What wont happen is the GOP unilaterally making any more decisions not after the blew it last Summer.

  49. Gravatar of dwb dwb
    21. May 2012 at 07:42

    “why” are we putting things in “quotes”

    the “nominal economy” is a “well understood” phrase that distinguishes the “real economy” from the “price level.” Any “mainstream economist” would understand the difference between “nominal gdp” and “real gdp” as it is being used here. is there an “argument” for why the Fed cannot “steer” “nominal gdp” or are we just being intentionally “obtuse”?

  50. Gravatar of Dan Kervick Dan Kervick
    21. May 2012 at 07:53

    A planned economy is a particular type of economy J.V. Dubois. Are you saying a nominal economy is a particular type of economy?

    It’s not lunacy to understand that there are different ways of measuring the value of goods and services produced and exchanged in the economy; nor is it lunacy to understand that one of those ways is in terms of the monetary prices we frequently use to denominate those values. But it is lunacy to think this means there is a nominal economy that can be separated from the total economy as a policy matter and steered by the Fed.

    Since these notions are so dotty, they deserve scare quotes when used.

  51. Gravatar of Full Employment Hawk Full Employment Hawk
    21. May 2012 at 08:14

    “And once paid down, Greenspan went to the mat to get the Bush tax cuts through.”

    Which shows that conservatives are not really concerned about deficits. When deficits provide a rationale for cutting government spending on programs that benefit working people and the poor (the guys I’m rooting for) they make a huge ado about the deficit and how harmful it is. But when tax cuts that increase the deficit are under consideration deficits don’t concern them at all. Deficit, schmeficit. This was certainly the case for Ayn Rand disciple Greenspan.And let us not forget Cheney’s “deficits don’t matter.”

    There is part of my realpolitic.

  52. Gravatar of Negation of Ideology Negation of Ideology
    21. May 2012 at 08:18

    Mike Sax –

    “Either the GOP learns to negotiatie rather than dictate or the Bush tax cuts all expire-which is fine with me as I never liked them anyway. ”

    I’ve said it before, that may be the best case scenario. Congress becomes hopelessly gridlocked. All the tax cuts expire, the sequester takes effect. Then Bernanke and his two new Board members respond with NGDPLT. They call it an emergency switch in response to gridlock so they don’t have to admit they were wrong before.

    The combination of the savings from the “fiscal cliff”, estimated to be as much as $700 Billion a year, and the savings from the NGDP increase, which would be in the hundreds of billions per year, puts us close to a balanced budget in 2013 with a surplus in 2014.

    Now the only hope is to extend gridlock long enough to start chipping away at the national debt.

  53. Gravatar of Full Employment Hawk Full Employment Hawk
    21. May 2012 at 08:31

    “Clinton’s tax increases were approved by Greenspan.”

    Obama has now appointed 6 out of the 7 members of the BOG. If he has appointed the right people for his fiscal policies, the Fed will try to offset tax increases on the rich. Obviously the reappointment of Bernanke was a major blunder on his part, which many people, including Krugman (and I) did not see at the time. It will be interesting to see what the final 2 appointments are like.

    A progressive President, when he has the votes, also needs to limit the election of the president of each of the individual reserve banks to the Class C directors to reduce the influence of the banks in making monetary policy.

  54. Gravatar of J.V. Dubois J.V. Dubois
    21. May 2012 at 08:41

    dwb: Quotes are maybe just bad habit of mine, when I want to emphasize that I use terminology or a meaning of a word that is used by someone else – and that I do not necessary agree upon in other discussions. I admit that I do overuse it sometimes :)

    Dan: So you are now full meta on me. Ok, whatever. So since we now know what other means by words he says – do you have anything valid to add about FED steering nominal ehm, excuse me monetary economy?

  55. Gravatar of Don Geddis Don Geddis
    21. May 2012 at 08:42

    Dan Kervick: “it is lunacy to think this means there is a nominal economy that can be separated from the total economy”.

    Let’s take a specific example: in 1992, the Argentina currency (“austral”) was replaced by a new peso, at a 10,000:1 ratio. This had a four orders of magnitude effect on the numbers printed in restaurant menus, labor contracts, GDP totals, etc. With approximately zero effect on the country’s production and consumption of (“real”) goods and services.

    Most economists use the label “nominal economy” to refer to the first thing, which was affected by four orders of magnitude in 2002. And they use the label “real economy” to refer to the thing which was completely unaffected, at that time.

    Do you disagree about the facts of history? Do you happen to not like the chosen English labels that everybody else is using unambiguously? Do you have any actual point to make?

    Because clearly your statements, using the words as they are generally understood, are simply wrong. The Argentine government in 1992 obviously had no problem at all in making and enforcing a completely arbitrary decision to reduce the numbers used throughout their economy by a factor of 10,000.

  56. Gravatar of Full Employment Hawk Full Employment Hawk
    21. May 2012 at 08:45

    “Then Bernanke and his two new Board members respond with NGDPLT.”

    The experience of Great Britain with the Cameron austerity plan makes this response highly doubtful.

    The Bank of England, which is much more competent with respect to monetary policy than the Fed has been has failed to offset the contractionary fiscal policy of the Cameron administration and the British economy is in a second recession. There is no reason to expect the Fed to do any better.

    What the Obama administration has to do is to take whatever measures it can to postpone the cliff until after the election.

    If Romney wins, he will deservedly get blamed for the second recession. If Obama wins and has the votes, he can still undo this.

  57. Gravatar of Full Employment Hawk Full Employment Hawk
    21. May 2012 at 08:47

    “until after the election.”

    Correction: Until the new adminstration and congress take over.

  58. Gravatar of Morgan Warstler Morgan Warstler
    21. May 2012 at 08:52

    FEH,

    Those are your feelings. It’s got nothing to do with realpolitik. You don’t LIKE that they do it, but you don’t have a workable gambit to beat them.

    You end up tilting at windmills.

    Sax / FEH, look I know you are both really hoping Obama wins, but your entire strategy RELIES on it.

    What if he loses? You just scream and yell?

    For me, if Obama wins, NGDPLT is my real strategy…. and political games are just gravy.

    If Obama loses, NGDPLT is the gravy, the meat and potatoes is spending all the money on non-Dem voters.

    —-

    Let me ask it this way, if it turns out that Obama loses, will you believe:

    - he could have won if he made like Clinton (focused on Balancing the Budget)

    - it isn’t worth it to be President if you have to do this?

    - that the right has a impossible to beat strategy, so whats your next approach?

    What I don’t get is an inability of progressives to really think out side the box. Why does it always take strong central action? Why not move power to places where liberals are in heavy concentration? Why not get different kinds of rich fighting with each other?

  59. Gravatar of ssumner ssumner
    21. May 2012 at 10:53

    Thanks dwb, Notice that the two models that were discredited were basically old Keynesianism and old monetarism.

    Saturos, Thanks for the tip, but when I do that I just come right back to this post, presumably because it contains that URL.

    Yes, I had a beautiful apartment overlooking Surfers Paradise back in 1991. The Aus$ was 65 cents. It was paradise.

    You said;

    “Does anyone else think he looks like Scott?”

    And we both have Chinese wives. And we are both rich (by global standards.)

    You asked:

    “Seriously, though, it’s been 4 years since demand collapsed. Why haven’t prices and wages adjusted down to the new trend yet?”

    Do you know how many times I have had to answer that question?

    Regarding NGDP targeting, any article mentioning “GNP” is out of date. Seriously, we didn’t do either NGDP or price level targeting in 2008 (recall the price level fell in 2008.) It’s possible that price level targeting would have led to a much milder recession, but I still think NGDP is a safer bet.

    And yes, NGDP is not optimal for all types of supply shocks, aggregate nominal wage targeting is more robust.

    The money supply is a better signalling instrument than interest rates, but NGDP futures is far superior.

    Lorenzo, I wish our Fed was that accountable.

    JV, Good point about the ECB.
    FEH, You said;

    “In any case, the experiment by the Cameron government”

    Actually it doesn’t show what you think it does. the Cameron government instructed the BOE to shoot for 2% inflation. They overshot. Under those conditions more fiscal stimulus could not have had any effects, it would simply have led to less monetary stimulus. I think Keynesians tend to underrate the importance of supply-side problems in the UK.

    Cameron should have experimented with a higher NGDP target, but he refrained from doing so. That should have been his first move back in May 2010.

    FEH, I don’t doubt that rationing played a role in WWII, but consumption would have fallen anyway due to crowding out. The unemployment rate was only about 1%.

    Dan, You said;

    “That would be like claiming that the Bureau of Weights and Measures can a significant role in policy concerned with the healthy growth of America’s schoolchildren because it steers the production specifications of the rulers and tape measures.”

    This makes no sense unless you are trying to claim that nominal shocks have no real effects. Is that your claim?

    Negation, You said;

    “Keynesian economists are right to the extent that the Fed doesn’t act that way. In their view, the FOMC is more like a monetary Congress. If Bernanke can only get the votes for a certain dollar amount of QE, then all that’s left is for the real Congress to vote to increase velocity by borrowing more money and spending it.”

    Not really because the amount of stimulus depends on the condition of the economy. There’s no fixed amount of QE. As inflation falls below 2% QE tends to increase, and vice versa.

  60. Gravatar of Dan Kervick Dan Kervick
    21. May 2012 at 11:23

    J.V. Dubois, I have already discussed in numerous places my view that the Fed does not have the degree of influence on monetary phenomena that the market monetarists think it has. The Fed cannot, in my view, steer the monetary dimension of the economy.

  61. Gravatar of Saturos Saturos
    21. May 2012 at 19:30

    “Seriously, though, it’s been 4 years since demand collapsed. Why haven’t prices and wages adjusted down to the new trend yet?”

    Do you know how many times I have had to answer that question?

    Well, it’s not in the FAQs, and I’m sorry if it’s a dumb question, but can someone please tell me?

  62. Gravatar of Full Employment Hawk Full Employment Hawk
    21. May 2012 at 22:56

    “the Cameron government instructed the BOE to shoot for 2% inflation.”

    I was under the impression that the Bank of England is independent of the government so that is is free to ignore any instructions from the government. Is this incorrect? There have been disagreements between the various members of the monetary policy committee about how much, or little, monetary stimulus to apply. In any case, the BOE did not increase its bank rate while measured inflation was WAY over 2% (and rightfully so). This appears to be indicative of an attempt by the BOE to offset the contractionary effects of the fiscal policy.

    “more fiscal stimulus”
    The Cameron government moved the economy to a CONTRACTIONARY fiscal policy. So the alternative here would have been a less contractionary fiscal policy, or even a continuation of an expansionary policy.

    What the data show is that output was recovering until the Cameron government imposed a contractionary fiscal policy on Britain. So up to that point the BOE was not succeeding in offsetting the expansionary fiscal policy of the Labor government with a less expansionary monetary policy. At about the time of the onset of the Cameron austerity, the growth in outut stopped and finally moved into a second dip recession. Therefore the BOE failed to offset the contractionary fiscal policy.

    Incidentally, roughly around the time the Cameron government imposed the contractionary fiscal policy I predicted on this site that this would slow the growth of the British economy and, while the BOE would attempt to offset this, it would not succeed in doing so. I have mixed feelings about this outcome. I would have preferred that the BOE had succeeded in offsetting it, showing that a really determined central bank could do it. Also having the long-suffering British workers saved from more economic hardship would have been highly desirable. But, on the other hand a demonstration that a contractionary fiscal policy will, with the kind of central banks real world economies have, contract the economy is also highly beneficial to increasing our understanding of macroeconomics.

  63. Gravatar of Full Employment Hawk Full Employment Hawk
    21. May 2012 at 23:00

    “Why haven’t prices and wages adjusted down to the new trend yet?”

    Nominal wages become very sticky downward at the 0% level. Workers react differently to a reduction in their real wages resulting from actual reductions in their nominal wages than a reduction in their real wages resulting from nominal wages increasing more slowly than the price level.

  64. Gravatar of Full Employment Hawk Full Employment Hawk
    21. May 2012 at 23:34

    “Let me ask it this way, if it turns out that Obama loses, will you believe: he could have won if he made like Clinton (focused on Balancing the Budget)”

    Absolutely not. Clinton was greatly helped in getting reelected because the economy was growing solidly and the unemployment rate was coming down. Obama’s tilt from stimulus to deficit reduction in 2010 was a fatal error.

    If Obama loses, it is because he did not make getting the economy to grow fast enough so that the unemployment rate was coming down at a solid rate his overriding objective. If the unemployment rate were coming down at a solid rate Obama could have run on a “Its Morning in America Campaign,” just as Reagan did. This would have given Obama a solid majority and given the Democrats control of both houses. With a strongly dropping unemployment rate, the only people concered about the deficit would have been people who would have voted Republican anyway on ideological grounds.

    If I had advised President Obama, I would have told him “Deficit schmeficit, its the jobs, stu-err Mr. President.”

    Such a policy would have involved filling the vacancies on the BOG with full employment hawks, carefully questioning Bernankee about his views on monetary policy and replacing him on the basis of the answers he gave (I am assuming he would have given honest answers), and using reconciliation to get a larger stimulus past the Republican filibuster. It wasn’t monetary versus fiscal policy. It was expansionary monetary AND fiscal policy.

    Since I grew up in a blue collar household I have a first hand knowledge of how important having a good job and not being afraid of losing it, not only for oneself but for one’s relatives and friends, is to ordinary working people. And they are not choosing leisure if they are unemployed during a recession. The New Classicals do not have a clue about this. If the jobs are not happening they blame the President.

  65. Gravatar of Full Employment Hawk Full Employment Hawk
    21. May 2012 at 23:41

    “Those are your feelings. It’s got nothing to do with realpolitik. You don’t LIKE that they do it, but you don’t have a workable gambit to beat them.”

    My gambit is:

    Phase 1: Promptly fill the vacancies on the BOG with people who take the Fed’s mandate to achieve maximum employment seriously.

    Phase 2: Eliminate the influence of bankers on monetary policy by letting only Class C directors vote in electing federal reserve bank presidents.

  66. Gravatar of Full Employment Hawk Full Employment Hawk
    21. May 2012 at 23:48

    “For me, if Obama wins, NGDPLT is my real strategy”

    And mine. If and when the Fed successfully follows this strategy fiscal policy is freed to aim for other objectives, like investment in infrastructure and technological research, investment in human capital, and, most importantly of all, policies to increase equality of opportunity.

  67. Gravatar of Peter N Peter N
    22. May 2012 at 00:16

    “Nominal wages become very sticky downward at the 0% level. Workers react differently to a reduction in their real wages resulting from actual reductions in their nominal wages than a reduction in their real wages resulting from nominal wages increasing more slowly than the price level.”

    Certainly true, but is this reaction based on the workers rational expectations or are they, as a group, irrational?

  68. Gravatar of Saturos Saturos
    22. May 2012 at 00:38

    What – Scott has been to Perth!!!

    (http://www.themoneyillusion.com/?p=2139)

    “I was able to visit all the states except South Australia and Tasmania.”

    Don’t worry, you didn’t miss much.

    The really nice spots are are all down the east coast (and interior NSW), and in the south-west corner.

    “Imagine Florida but with a better climate, less crime, lower prices, prettier scenery, nicer people and casino gambling.”

    That’s a real compliment – I’ve heard the Floridians are really nice.

  69. Gravatar of Saturos Saturos
    22. May 2012 at 01:09

    “Why haven’t prices and wages adjusted down to the new trend yet?””

    Is this related to the problems you have with the “slack” model of inflation?

  70. Gravatar of W. Peden W. Peden
    22. May 2012 at 01:14

    Saturos,

    And there was me thinking that Scott had come to Scotland and inexplicably decided that Perth was the place for him to go.

  71. Gravatar of W. Peden W. Peden
    22. May 2012 at 01:14

    (On the basis of your first sentence in the penultimate comment above mine.)

  72. Gravatar of J.V. Dubois J.V. Dubois
    22. May 2012 at 05:06

    Peter N: there is a perfectly rational explanation to wage stickiness – it is a coordination problem. If we assume that your objective is to maximize real wage (or to be more precise – relative wage to your competitors on labor markets) then if boss comes to you with proposal of wage cut, your real wage will depend on whether other workers in economy also agree on the wage cut of the same magnitude.

    Inflation (or wage inflation that some economists including as main measure of inflation) just provides you with an anchor. If CB would target wage inflation, you now have something where to start your negotiations that you may use as a basis when negotiating your price. Negotiations are less costly and less time-consuming as opposed to an environment with uncertainty.

  73. Gravatar of dwb dwb
    22. May 2012 at 05:39

    “Why haven’t prices and wages adjusted down to the new trend yet?”

    There are really two kinds of rigidities: wages, and nominal debt.

    residential mortgage debt (to a lesser extent other kinds of private debt) is very hard to “renegotiate” downward relative to the new ngdp trend (if you think of the perfectly flexible debt contract as one whose principal is indexed to aggregate nominal gdp).

    “renegotiation” aka “principal reduction” requires 5 federal agencies (no joke) along with the top management of two GSEs (plus, lobbyists from 20 banks who will opine, and Congress persons as well). If I wanted to institute a new “shared equity” type mortgage product, I would need the approval of about 10 federal agencies (maybe more if i need to include the SEC), 50 state agencies, and get the GSEs and some banks on board. I might need legislation to address recourse issues (which would be worse). talk about a coordination failure, the govt has been “discussing” it for 4 years, and it only takes one agengy (right now the FHFA) to veto it.

    There are 50 million mortgage contracts (and each state has its own laws).

    It takes 2 years for a house to work through the foreclosure pipeline.

    right now, the stickiest contracts in the economy are the nominal debt kind, not wages. What is holding back construction is mainly that we have not worked through the process of resetting millions of debt contracts.

  74. Gravatar of Saturos Saturos
    22. May 2012 at 06:14

    dwb, so you’re saying wages have adjusted, it’s just the debts holding us back? Demand for labor is low because of deleveraging?

  75. Gravatar of dwb dwb
    22. May 2012 at 06:55

    “Demand for labor is low because of deleveraging?”

    demand for “housing” is low because of deleveraging (from a 30,000 foot view, when people are locked into above market prices for something, they demand less of it, a debt contract represents a contract for housing at a previous price/income level). Wages are also sticky (weekly construction wages in FL and NV have not changed much in the last three years, they average around ~20/hr). If you cut everyone’s construction wages, it would not do much for new housing demand because people still do not have the disposable income to pay for it until until they are done deleveraging (paying down debt, or cancelling it).

    because the house is used as collateral for a loan, cyclical unemployment creates a vicious circle as well: suppose construction wages get cut to minimum wages, and homebuilders start offering new homes for 1/2 price. Then the collateral for your mortgage loan becomes even more worthless, so you have an even longer deleveraging process. (that’s the idea of the Fisher debt-deflation process).

    In some sense, the debt deflation process happens because wages (income) are less sticky than debt contracts.

    {just to be clear, wages are empirically rigid downwards, but i put much less weight on that with respect to this recession}

  76. Gravatar of Saturos Saturos
    22. May 2012 at 07:07

    As Scott says, unemployment happens when NGDP falls whilst nominal hourly wages stay constant, leading to less hours worked. You’re saying that due to debt-deleveraging, aggregate spending is too low? But that falls victim to all the standard critiques – for every debtor there is a creditor, etc. Or are you saying that due to fixed debts spending on housing is too low? But then, why would that lead to economy-wide unemployment?

    What do the best models say about how long it takes wages to adjust to a decline in aggregate demand? Once the new rate of NGDP growth is anticipated, aren’t wage contracts supposed to adjust?

  77. Gravatar of ssumner ssumner
    22. May 2012 at 08:32

    Saturos, Price stickiness is related to wage stickiness. Wage reductions are relatively uncommon due to money illusion. Workers feel much worse about a 1% wage cut when prices are stable, then a 3% wage increase when prices rise 5%.

    There are of course lots of other factors. Government wage stickiness for government jobs, a huge (40%) minimum wage increase during the recession, 99 week extended unemployment insurance, etc.

    FEH, You said;

    “I was under the impression that the Bank of England is independent of the government so that it is free to ignore any instructions from the government. Is this incorrect?”

    Partly. The government sets the target, and the BOE is independent in terms of instrument settings.

    You are wrong about the interaction of fiscal and monetary policy. The BOE has recently refrained from additional stimulus due to fear of higher inflation. It’s very much an issue, even with doves like Posen.

    I also disagree with your assertion that fiscal policy has been contractionary, but that’s really just an argument over semantics. In any case, the BOE is instructed to target inflation. It’s doing its job, it’s just unfortunate that that job means sabotaging fiscal stimulus. If fiscal policy had been even more expansionary, then monetary policy would have been even tighter.

    And of course Britain has big supply-side problems, As evidenced by its poor inflation/growth splits.

    Saturos, I drove from Darwin to Perth in 1991–4000 miles. I slept in the back of my van at night.

    W, Peden, I’ve been to Scotland, but not Perth.

  78. Gravatar of Saturos Saturos
    22. May 2012 at 09:01

    Saturos, Price stickiness is related to wage stickiness. Wage reductions are relatively uncommon due to money illusion. Workers feel much worse about a 1% wage cut when prices are stable, then a 3% wage increase when prices rise 5%.

    There are of course lots of other factors. Government wage stickiness for government jobs, a huge (40%) minimum wage increase during the recession, 99 week extended unemployment insurance, etc.

    I am familiar with these points, but can they explain 4 years of nominal wage rigidity? Why hasn’t nominal wage-rate growth fallen behind NGDP growth enough to clear the labor market (to any significant extent)? Is UI that bad? If NGDP growth remained constant from now on, how long would it take for wages to fall and clear the market? Is there some sort of NK model which explains this in detail?

    I drove from Darwin to Perth in 1991–4000 miles. I slept in the back of my van at night.

    That would have been beautiful. But the mozzies must have killed you.

  79. Gravatar of dwb dwb
    22. May 2012 at 09:06

    “You’re saying that due to debt-deleveraging, aggregate spending is too low?”

    sort of, let me use a slightly different reference frame. Both sticky prices and sticky wages can cause unemployment until the prices (wages) reset to the flexible price equilibrium.

    It’s better to think of there as being several markets for housing: the rental market, the owner-occupied market, and the vacation-home market. demand for each is a function of income.

    1. Now, suppose we have extremely sticky prices in the owner-occupied market. The sticky prices are called mortgage debt contracts (which makes them downwardly rigid, not upwardly rigid). Now, suppose the relative (supply) price between owner-occupied housing and rentals changes (due to financing costs or lending standards). Demand does not change at a given income nor does income.

    For example, if I am locked into a mortgage I would *love* to cancel it (default!) and move into a rental to get a cheaper mortgage payment. However, this is very costly. At least 70% of underwater homeowners are current: their preference is to “deleverage” or reset their housing contract a small amount at a time by paying down the balance, even when the debt is 50% more than the house.

    *Assuming my income stays the same*, my demand has not changed (I still want that 2nd vacation home!), however, there could be some level of “long term structural ” frictional unemployment unemployment due to the sticky mortgage prices and the relative price shift: construction workers need to move from owner-occupied to rental markets.

    (And this is about the point we were in mid-2008: 18 months into the housing recession, it is simply not the case the total housing demand dropped because there are about 15 million new people aged 18+ in the last 4 years).

    2. Now suppose: the central bank responds to the change in relative prices with bad monetary policy by changing everyones’ demand curve as well, by letting ngdp (incomes) drop. The demand curves in all three housing markets change.

    Then: cyclical unemployment forces people to “deleverage” the hard way (they can no longer pay, and even if they can they have lower demand in all three markets). Before in case #1 we were “deleveraging” the easy way, a little bit at a time.

    The cyclical component of deleveraging (#2) also impacts banks, capital, and has the vicious effect knock-on effects that magnify the effects.

    Compare delinquencies / unemployment in Sept 2008 with 2009 / 2010 against the 1992 previous peak (I put ngdp potential on inverse scale):
    http://research.stlouisfed.org/fred2/graph/?g=7on

    It is difficult to break down how much deleveraging and unemployment is from #1 (frictional rebalancing due to relative price changes) and how much from #2 “cyclical” because ngdp dropped. The Fed sure screwed the pooch with price signals! We have no idea which is which.

    I personally think about 50%-75% is “cyclical” in nature, because mortgage delinquencies are still about 2x normal (but we wont really know for a couple more years).

    “But that falls victim to all the standard critiques – for every debtor there is a creditor”

    not sure what you mean by that critique.

  80. Gravatar of dwb dwb
    22. May 2012 at 09:12

    @Saturos:
    I am familiar with these points, but can they explain 4 years of nominal wage rigidity?

    see my above post: also there are some good graphs on CalculatedRisk.

    It takes 2 years for a house to work its way through foreclosure, so yes, mortgage debt as a “sticky price” can explain many years of “rigidity”

    http://www.crgraphs.com/2011/10/mortgage-delinquency-graphs.html

  81. Gravatar of Saturos Saturos
    22. May 2012 at 09:29

    dwb, that sounds like a supply-side ish story. And it still doesn’t explain why non-housing workers should be unemployed.

    The standard critique – see here:
    http://macromarketmusings.blogspot.com.au/2011/06/monetary-policy-efficacy-during-balance.html
    http://macromarketmusings.blogspot.com.au/2011/08/other-side-of-households-balance-sheets.html
    http://macromarketmusings.blogspot.com.au/2011/07/inadequacy-of-balance-seet-recession.html

    Bryan Caplan has pointed out (somewhat obviously; but then common sense is often lacking in macro) that demand-side unemployment is necessarily an above-market clearing wage problem.

    Scott, do you endorse this stuff that dwb is saying? I’m probably just too stupid to get it, so I need an imprimatur.

  82. Gravatar of dwb dwb
    22. May 2012 at 09:53

    And it still doesn’t explain why non-housing workers should be unemployed.

    i am saying there are both supply and demand side issues that are impossible to disentangle.

  83. Gravatar of dwb dwb
    22. May 2012 at 10:01

    just to be clear: i am saying the fed responded to a supply side issue by essentially reducing demand, a classically bad idea. you cannot tell how much is structural and how much is cyclical (i think about 65% is cyclical but people disagree). Getting ngdp some or most of the way back to trend fixes the “demand side” but you will still have somewhat higher-than-normal “full employment” for a couple years after.

  84. Gravatar of dwb dwb
    22. May 2012 at 10:28

    @Saturos,

    I went back and re-read Beckworth’s posts, i agree with them, but i can see why you might be confused (although I am still not sure). While it sounds like I am agreeing with the “balance sheet recession view” I am only agreeing with 1/2 of it, if that makes sense. I think a better framework for what I am suggesting is the Dallas Fed paper by Koenig a couple months ago.

  85. Gravatar of Full Employment Hawk Full Employment Hawk
    22. May 2012 at 13:56

    “I also disagree with your assertion that fiscal policy has been contractionary, but that’s really just an argument over semantics.”

    No matter how one defines the terms, what the British experience shows is that WITH THE KINDS OF CENTRAL BANKS AND CENTRAL BANK POLICIES ACTUAL MARKET ECONOMIES, when an economy is depressed and struggling to recover, cutting spending and raising taxes from their previous levels is contractionary and will slow the recovery at best, and if strong enough, will kill the recovery and throw the economy into another recession, just as Keyensian theory predicts. The same thing will happen in the United States if similar policies are imposed here.

  86. Gravatar of Saturos Saturos
    22. May 2012 at 19:26

    dwb, I can’t find it, is it this one?
    http://www.dallasfed.org/assets/documents/research/staff/staff1202.pdf

    Which half don’t you agree with?

    “Getting ngdp some or most of the way back to trend fixes the “demand side””

    Suppose you don’t fix the “demand side”. That means more unemployment. How is that not eliminable by falling wages?

    I just wanted to know whether pre-recession models were able to predict that NGDP consistently below trend for 4 years would lead to 4 years of excess unemployment – whether wages would stay that far above NGDP all that time.

  87. Gravatar of dwb dwb
    22. May 2012 at 19:52

    @Saturos:
    not sure i understand your question, sorry maybe i lost it in all the posts – which half don’t i agree with- which half of what?
    As to: “Suppose you don’t fix the “demand side”. That means more unemployment. How is that not eliminable by falling wages?”

    I am not sure if this answers your question: the value of real estate assets backing real estate debt is a function of trend ngdp growth.

    Suppose we were to stay on this growth path (not revert to trend). First, debt contracts (via debt paydown and cancellation) reset such that they are “at market” (that process will take more years); then also, (sticky) wages will have to reset in relation to the new real estate values as wages are a function of the real estate prices. The tricky part is that both have to happen, it takes longer to reset debt than wages.

    I would say in a “normal” recession you are resetting just some sticky prices/wages, but in a fisher-type debt deflation (which we were in), you are also resetting a bunch or nominal debt on top of that which is more costly/lengthy and more difficult to “coordinate”. It also presents the possibility of a self reinforcing cycle: declining wages, declining debt-service capacity, more delinquencies, higher loss severity, further declining real estate prices, etc. until real estate is free as are the wages.

    I guess my point is, there is a “normal” recession and this one.

    “whether pre-recession models were able to predict that NGDP consistently below trend for 4 years would lead to 4 years of excess unemployment – whether wages would stay that far above NGDP all that time.”

    I dont know about most models, but the ones I am familiar with would have *grossly underestimated* the time homes spent in the foreclosure pipeline. They would have also grossly underestimated delinquencies (which were the worst in 70 years). The “worst case scenarios” for a housing crash in 2006 was the 1990 real estate collapse, which was a cake walk compared to this.

    so, i dont know about all models, but if you had suggested a recession of the magnitude we saw the response would have been “you are a lunatic” and laughter, much the way we treat MF. thats why i like him around to remind me that even the impossible is possible.

  88. Gravatar of Full Employment Hawk Full Employment Hawk
    22. May 2012 at 19:53

    “The government sets the target”

    That does change the situation significantly. Since the bank rate was not raised in the face of high measured inflation, I had been under the impression that the BOE had been trying to offset the contractionary EFFECTS of the Cameron spending cuts and tax increases with more expansionary monetary policy.

    That means that the Cameron administration not only imposed a fiscal policy that has a strong contractionary EFFECT on the economy (whether one calls that a contractionary fiscal policy or not), but also instructed the BOE to NOT offset this with a more expansionary monetary policy (by setting this 2% inflation target).

    No wonder the recovery stalled and Britain went into a second dip recession.

  89. Gravatar of dwb dwb
    22. May 2012 at 19:54

    ^^ oh and yes thats the dallas fed paper.

  90. Gravatar of Full Employment Hawk Full Employment Hawk
    22. May 2012 at 19:58

    “but also instructed the BOE to NOT offset this with a more expansionary monetary policy”

    Essentially the Keynesian models of fiscal policy model the effects of fiscal policy on the economy through the demand side IF, AND ONLY IF, the central bank does not respond to changes in the fiscal policy or only responds inadequately.

  91. Gravatar of Saturos Saturos
    22. May 2012 at 23:44

    dwb, my problem is this. You seem to be modelling the rigidity of debt contracts as equivalent to the rigidity of certain asset prices. So when nominal income falls, there is less income to spend on other things after allocating funds to deleveraging, so spending in general falls. But that doesn’t explain a labor market glut – wages must therefore be above market clearing levels. Lower nominal income means less spending on goods anyway – and sticky asset prices mean even less spending elsewhere. But the only reason why there should be unemployment if prices and wages are stuck elsewhere. Unless fixed debt contracts are equivalent to fixed goods prices everywhere, such that more production cannot be sold and extra workers have effective ZMP all across the economy, it’s not clear why there should be excess supply in the labor market.

    But I notice you said that wages are a function of asset prices. How does that work? I thought they were a function of supply and demand in the labor market?

    It’s simple. If all prices adjust, then markets clear. Ergo if markets aren’t clearing, then some prices aren’t adjusting. So if debt rigidity explains gluts, then debt rigidity is equivalent to some price rigidities. Since the gluts are in labor markets everywhere, there must be sticky wages in labor markets everywhere, and/or sticky prices in corresponding goods markets everywhere. So sticky debts are equivalent to sticky wages/prices everywhere. The only mechanism I saw you mention explaining that was when you said real estate prices determine wages, but how does that work? How do fixed debt contracts for real estate keep wages above market clearing levels?

  92. Gravatar of Saturos Saturos
    22. May 2012 at 23:45

    Effective ZMP = ZMRP.

  93. Gravatar of Saturos Saturos
    22. May 2012 at 23:48

    Now perhaps fixed debts are holding back spending on goods across the economy. But that’s just a contribution to the decline in nominal spending – it doesn’t explain how the decline in spending leads to a decline in output. For that you need the output prices to be rigid. So unless the debt contracts are the output prices…

  94. Gravatar of Saturos Saturos
    22. May 2012 at 23:51

    Scott pointed to wage rigidity as the cause of unemployment, and said that was caused by money illusion, UI, minimum wages etc. I’m just wondering whether there’s an NK model which predicts that these factors would lead to a continuing failure of the SRAS curve to shift right onto the intersection of AD and LRAS, even 4 years out from the demand collapse. In other words, how long until the long run?

  95. Gravatar of dwb dwb
    23. May 2012 at 05:16

    @Saturos:
    “Ergo if markets aren’t clearing, then some prices aren’t adjusting. So if debt rigidity explains gluts, then debt rigidity is equivalent to some price rigidities.”

    yes, exactly: nominal debt contracts (to people who bought their house) are de-facto sticky prices for owner occupied housing.

    suppose I bought a house in 2006 at the peak, and got a 30-year mortgage. I pay x dollars a month for 30 years (some people have 10 and 15 yr mortgages, but these are a minority). For owners, the price of “housing” is determined well in advance of when they will consume it, by virtue of debt contracts. {However, it is based on expected demand/supply, i.e. expected future income at the time of agreement}.

    here is Taylor’s handbook (with lots of references) where he goes through stuff extensively.

    http://www.stanford.edu/~johntayl/Papers/handbook.pdf

  96. Gravatar of ssumner ssumner
    23. May 2012 at 05:53

    Saturos, You said;

    “If NGDP growth remained constant from now on, how long would it take for wages to fall and clear the market? Is there some sort of NK model which explains this in detail?”

    No, there is no model that addresses these sorts of questions, as the real world is far too complicated. For instance, you’d need a Congressional reaction function. As U falls, Congress will tend to lower the maximum UI benefit. But how fast?

    Back in 1921 the labor market was much more flexible, and it adjusted to falling NGDP much faster. By the 1930s the labor market was far more rigid than in 1921, and adjusted much more slowly. The sort of abstract models that we teach our students can’t easily accommodate those real world factors. Either one learns this stuff on your own, or (as with many academic economists in their ivory tower) one never learns.

    FEH, Yes, British experience shows that actual British policy will push you back into recession. But which policies? Bad supply side policies? Not enough demand side fiscal stimulus? Not enough demand side monetary stimulus? It’s by no means clear where the culprit is. Britain had one of the world’s largest budget deficits in 2011. It’s not obvious to me that the cause of the recent British slump is that the deficit wasn’t even bigger. Maybe that’s obvious to you. I tend to blame monetary policy and supply-side weaknesses.

    It would be borderline insane for Cameron to do fiscal stimulus, when he could simply instruct the BOE to shoot for a higher NGDP target. What would be the logic of the fiscal stimulus in that case? It would be money down the drain, as the BOE would simply tighten policy to prevent inflation from rising.

    Saturos, You said,

    “I’m just wondering whether there’s an NK model which predicts that these factors would lead to a continuing failure of the SRAS curve to shift right onto the intersection of AD and LRAS, even 4 years out from the demand collapse. In other words, how long until the long run?”

    I’m confident the economy has already fully adjusted to the negative demand shock from 4 years ago. That’s not the problem. And it’s probably responded to part of the demand shortfall from three years ago. But there was also a shortfall in 2011. The real problem here isn’t just the severity of the recession, but also the very low NGDP growth during the recovery. In order to respond as quickly as during 1983-84, the US would have had to have 7.7% RGDP growth and more than 3% deflation. How likely would that be?

    Don’t oversimplify the recession. There are lots of complex factors on both the supply and demand side. I might have expected a slightly faster recovery given 4% NGDP growth, but certainly not dramatically faster. We are pretty close to where NK models say we should be, and any discrepancies can be explained by thing like the housing crash, the extended UI, the higher minimum wage, etc.

  97. Gravatar of Full Employment Hawk Full Employment Hawk
    23. May 2012 at 07:27

    “It’s not obvious to me that the cause of the recent British slump is that the deficit wasn’t even bigger.”

    I understand that the Keynesian theory of fiscal policy correctly predicts the effects of changes in spending and taxes on aggregate demand IF AND ONLY IF the central bank does not fully offset their effects with monetary policy in the opposite direction; either because it cannot, due to a liquidity trap (which is not the case here), it is reluctant to use nonconventional monetary policy, or it has a target imposed on it.

    In light of the inflation target the BOE was given, it was difficult, if not impossible, for it to offest the contractionary effects of the Cameron fiscal policies. Therefore the combination of the Cameron fiscal policies AND THE INFLATION TARGET TOGETHER are, in my opinion, the primary cause of the new British recession.

    GIVEN THE CONSTRAINTS ON MONETARY POLICY due to the inflation target the BOE has imposed on it, the recovery would not have stalled and the recession would not have happened if Cameron had not tried to reduce the deficit. But I fully agree with the following:

    “It would be borderline insane for Cameron to do fiscal stimulus, when he could simply instruct the BOE to shoot for a higher NGDP target. What would be the logic of the fiscal stimulus in that case? It would be money down the drain, as the BOE would simply tighten policy to prevent inflation from rising.”

    Fiscal policy should only be used as a Plan B if the central bank cannot do the job for any of the reasons stated above.
    If the BOE has difficulty hitting a higher inflation target in the face of the contractionary fiscal effects of additional spending cuts and tax increases, these should be postponed until the British economy has recovered.

    JOBS FIRST, DEFICIT REDUCTION SECOND!

  98. Gravatar of J.V. Dubois J.V. Dubois
    23. May 2012 at 09:00

    Scott:

    Very good posts. But I have to vote for very good questions from Saturos to the two important questions that I would personally like to see more answers to:

    1. How is it possible that there is insufficient AD even with positive inflation: so far I have two possible answers

    a) Inflation inertia (I got a very good response on this from Nick Rowe once): it can be either caused by “sticky information”, overlapping price settings plus real rigidity

    b) Inflation has mostly supply side reasons and CB does not allow it to rise – as now infamous 2011 ECB rate hike also known as a moment when markets realized that ECB will sacrifice its own currency on the altar of so called “price stability”

    2. Can we experience prolonged demand-side slumps? Was Japan harbinger of such a new thing in macroeconomic history?

    I think that this is hard to explain. I do not think prolonged demand-induced slump is “possible” unless it is generated by very incompetent and chaotic CB that engineers one monetary tightening after another. Most of the literature focusing on Japan says something like this

    “Sure, Japan has serious supply side issues like demography or inefficient banking system. But they also have a problem with demand because my pet demand indicator (now insert pet demand indicator for the given economists like interest rate or even NGDP) is low.”

    I saw noone tackling this conundrum head on. But now I also play with an idea if having a country with permanent supply side issues that would require drop (or large decrease of the rate of growth) of RGDP could basically behave like in point b) in 1)

    But anyways, I would love to see series of posts (and discussions bellow those posts) that would focus on these issues.

  99. Gravatar of ssumner ssumner
    24. May 2012 at 06:26

    FEH, You said;

    “In light of the inflation target the BOE was given, it was difficult, if not impossible, for it to offset the contractionary effects of the Cameron fiscal policies. Therefore the combination of the Cameron fiscal policies AND THE INFLATION TARGET TOGETHER are, in my opinion, the primary cause of the new British recession.”

    This is exactly backward. Under IT the multiplier is zero. That’s because contractionary fiscal policy tends to reduce inflation. Since the BOE is targeting inflation, they expand AD enough to keep inflation on target.

    Yes, they don’t do that perfectly, but as a first approximation the multiplier is zero under IT.

    JV, You asked:

    “1. How is it possible that there is insufficient AD even with positive inflation: so far I have two possible answers”

    But this is exactly what the standard model predicts. The standard natural rate model says you can have inflation during slumps if the inflation rate is falling. And sure enough, inflation since mid-2008 has been the lowest since the mid-1950s.

    Now I’ll concede that one might have expected inflation to fall even further, and instead it rose somewhat in 2001. I attribute that to adverse supply shocks, which is also consistent with the model. Then there are all the things I mentioned to Saturos (extended UI, minimum wage increase, etc.)

    JV, You asked:

    “2. Can we experience prolonged demand-side slumps? Was Japan harbinger of such a new thing in macroeconomic
    history?”

    This is a very tricky question, as I’ve argued that supply and demand shocks get “entangled.” So boosting AD might cause improved AS (say by leading Congress to gradually reduce maximum UI back to 26 weeks.) Or by eroding the real value of the minimum wage. So I’d say this–in theory if we stay near 2% inflation, we ought to gradually go back to the natural rate of unemployment. Hence the answer is no. But if we adopt a Japanese-style slightly negative inflation rate, then the labor market may never fully recover, as there is money illusion on downward wage adjustments, and hence the natural unemployment rate will be permanently raised. Or if we never went back to 26 week maximum UI, then the natural rate would rise slightly, as we saw happen in Europe when they adopted extensive welfare systems.

    BTW, I did do posts on this in the past. Here’s one.

    http://www.themoneyillusion.com/?p=6737

  100. Gravatar of J.V. Dubois J.V. Dubois
    24. May 2012 at 07:16

    Thanks for comments Scott. As for the first point it is more of a question stemming from simplistic view: inflation comes about if aggregate demand is greater then aggregate supply. Of course this can be caused by both – supply or demand shocks – but introducing inflation inertia makes it more interesting.

    And since Market Monetarism is all abut unshackling inflation from its anchor and I would like to know more about possible issues this may have. Like is inflation inertia short-term thing or does it respond to long-term trend (expectations)? If people resist sudden changes of inflation and CB would need to put it down in order to maintain 5% NGDP growth after recovery from sligthly longer RGDP drop – would not inflation inertia make larger part of adjustment come via less RGDP growth?

    As for Japan, I think you are right. That is the only explanation that makes sense for me.

    BTW: As for the UI effects it does not have to be all bad efficiency-wise at least according to Raj Chetty: http://rortybomb.wordpress.com/2010/07/07/unemployment-insurance-1-raj-chettys-research-presented-at-epi/

  101. Gravatar of Chris Mahoney Chris Mahoney
    24. May 2012 at 11:22

    Academic economists, like Bernanke at Princeton, can preach whatever they want. Fed chairmen are in a different position; they are the Pope. Bernanke will not stray too far away from conventional wisdom, nor will he make policy with a narrow FOMC majority. Over time, as radical monetarism slowly becomes orthodox, the FOMC will drift in that direction. Science make progress one death at a time.

  102. Gravatar of ssumner ssumner
    25. May 2012 at 12:17

    JV, I discussed Chetty’s research in an earlier post.

    I’m not concerned about the prospect of greater inflation instability, because the problems that most macroeconomists think are caused by greater inflation instability, are actually caused by greater NGDP instability. So if you can anchor NGDP expectations, and let inflation drift off, then output should actually be more stable.

    Chris, Exactly.

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