Why both sides of the austerity debate are doing harm

I get a lot of criticism from both liberals and conservatives.  The right complains I’m an inflationist, even though I’m actually an inflation hawk.  The left complains about my seemingly irrational crusade against fiscal stimulus.  ”After all they are our allies, and doesn’t every bit help?  Surely you don’t think Mr. Bernanke would sabotage additional fiscal stimulus, after all, he is asking for it.”

That’s what they say.  And my response is yes I do think the Fed would sabotage additional stimulus, and so does the press:

Concerns that the U.S. Federal Reserve could start unwinding its massive monetary stimulus program later this year sent equity markets into a tailspin last week, with the heightened volatility extending into a new week as Asian markets opened lower on Monday. . . .

So the fact that the outlook for the global economy is better than it was six months, albeit not stellar, means the outlook for equities overall remains positive, analysts said.

In fact, it’s some signs of improvement in the U.S. economy and recent comments from Fed officials that have sparked talk of an early end to quantitative easing.

Despite the current round of austerity, growth this year (partly due to QE3) is so strong that the Fed is considering tightening monetary policy.  Now let me emphasize that I don’t think growth is very strong this year, and I oppose tightening monetary policy.  But it doesn’t matter what I think, and I’m not even sure it matters what Bernanke thinks.  It matters what the Fed thinks.  And if they are strongly considering tightening monetary policy under current conditions, just imagine what they’d be doing if Congress was actually doing fiscal stimulus right now!

As I’ve said on numerous occasions, I support sensible fiscal stimulus that works through supply-side channels, such as Christina Romer’s proposal for an employer-side payroll tax cut, or cuts in taxes on investment income.

The Fed is steering the economy.  All this debate over austerity takes pressure off the Fed, leading the public to believe that one side or the other of the squabbling VSPs in Washington are to blame for our weak economy.  In fact, neither side is to blame; the Fed is.  If my views were widely accepted, any move by the Fed to scale back QE would face a torrent of criticism.  Instead, it will happen (when it does) almost unnoticed.  And it will further slow the recovery.


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23 Responses to “Why both sides of the austerity debate are doing harm”

  1. Gravatar of Geoff Geoff
    27. May 2013 at 12:05

    “I’m an inflationist, even though I’m actually an inflation hawk.”

    You sure about that?

    I don’t think so.

  2. Gravatar of Geoff Geoff
    27. May 2013 at 12:07

    “If my views were widely accepted, any move by the Fed to scale back QE would face a torrent of criticism. Instead, it will happen (when it does) almost unnoticed. And it will further slow the recovery.”

    Recovery cannot take place with non-market currency inflation. It is precisely because of (prior) inflation that you are here now talking about insufficient Fed inflation and lack of recovery.

  3. Gravatar of Lars Christensen Lars Christensen
    27. May 2013 at 12:30

    Scott,

    The Krugman-Rogoff battle pretty well shows how the focus of the debate is completely wrong. The Austerians and the Keynesians agree (while they are too busy noticing it) that monetary policy don’t work. And that is of course where they are wrong.

    The fiscal debate is completely irrelevant to getting us out of the crisis. It is however not irrelevant for a longer-term structural debate, but both side of the discussion seem to ignore this as well.

  4. Gravatar of Philo Philo
    27. May 2013 at 13:06

    “I’m actually an inflation hawk.” Yes, but what you’re opposed to is not *inflation*; it’s *the word ‘inflation’*!

  5. Gravatar of Morgan Warstler Morgan Warstler
    27. May 2013 at 13:40

    The Fed will not sabotage:

    Employer side tax cuts
    Tax reform that generates extra revenue thru growth (revenue neutra)

    Basically anything that is Real Growth.

    The Fed will sabotage:

    Federal Spending, Hiring Public employees, Giving public employees raises, basically anything that not Real Growth.

    We ca go further and say that Fed will HAPPILY try to ensure there is more liquidity IF the Govt shrinks but does so thru productivity gains. such as appifying local govt.

  6. Gravatar of Garrett M Garrett M
    27. May 2013 at 14:00

    Krugman again downplays monetary policy in favor of fiscal policy in his post on Portugal:

    http://krugman.blogs.nytimes.com/2013/05/27/nightmare-in-portugal/ (paragraph five)

    “What could help? A much stronger expansion in the euro area as a whole; higher inflation in the European core. Looser monetary policy could help achieve these things, but bear in mind that the ECB, like the Fed, is basically up against the zero lower bound. It can and should try to push unconventional policies, but it needs as much help as possible from fiscal policy too — not a situation in which austerity in the periphery is reinforced by austerity in the core, too.”

    NGDP of all of Europe, including Germany, is so far below trend that EVERYBODY would be helped immensely by expansionary monetary policy, and Japan shows that the ECB can do it whenever it wants.

  7. Gravatar of Matt Waters Matt Waters
    27. May 2013 at 15:21

    Yes, it is utterly sad that Krugman, who truly has the platform to make many angry at the Fed, keeps saying categorically that monetary policy is useless at the zero-bound. It’s odd, because it seems in many cases to be Krugman vs. Krugman. He’s written some supportive things in the past, including the expectations argument, and therefore why does he consistently play down monetary policy so easily? He’s angry at people for using a stimulus that was too small to work to say fiscal policy doesn’t work, but then when he says QE does work why then does he not advocate instead for far more QE? The only answer that makes sense is that he’s strongly tied to the idea of a much bigger government and going full Market Monetarist lets small-government types have the same solution to unemployment he has. It also has “Market” in its name and therefore there must be some grudging admission that profit-seeking actors will usually bring securities to the correct price. However correct that is, it dilutes a generally unending message for more government and issues with the free market.

    On another subject, I do wonder about Scott’s support for these tax cuts if the fiscal multiplier is zero. I do understand the arguments that these tax cuts will have a higher multiplier, but, hey, if you’re going to argue the fiscal multiplier is zero then to all or nothing. If cutting employer payroll taxes increases velocity a good bit by pushing the AS curve to the left, then the Fed may just tighten by that much more.

    Geoff, interesting thing about your post: it does not have a single bit of evidence of theory to support it. Of course, it’s tough to offer evidence of verification without any possibility of falsification, and hard money types hate talking about falsification because it shows how wrong their theories are.

  8. Gravatar of Mike Sax Mike Sax
    27. May 2013 at 16:26

    “As I’ve said on numerous occasions, I support sensible fiscal stimulus that works through supply-side channels, such as Christina Romer’s proposal for an employer-side payroll tax cut, or cuts in taxes on investment income.”

    Trouble is no one is even discussing fiscal stimulus right now. All Keynesians are saying is the sequester is not a good idea.

    Are you saying that if miracles happened and the GOP were forced to take a deal that ended the sequester-which is actually possible as the effects of the sequester are becoming more widespread-this would be a negative for the recovery as it would lead the Fed to offset the end of the sequester?

    Whether you believe they would offset stimulus or not do you really believe the Fed would offset simply ending a fiscal contraction thanks to the sequester?

  9. Gravatar of J J
    27. May 2013 at 16:57

    Lars Christensen,

    I’m not sure if you meant that R-R think monetary policy is ineffective. If you did, then you are incorrect. Based on the letter to Krugman, it is clear that they believe in monetary offset in the eurozone. They have also advocated for much higher inflation targets. Most economist austerians advocate for looser monetary policy or believe we do not have ‘demand’ problems, neither of which implies a belief that monetary policy doesn’t work.

  10. Gravatar of ssumner ssumner
    27. May 2013 at 17:05

    Lars, That’s right.

    Philo, Touche.

    Garrett, It seems a bit odd for Krugman to talk about the ECB’s need for “help”. The ECB caused the current recession in Europe with their tight money policy of 2011-12. They don’t need help, they need to stop causing harm.

    Matt, I’ve never argued the multiplier is zero on the supply-side, just the demand-side. The distinction is very important. There is no contradiction.

    Mike, That’s certainly what the press is suggesting.

  11. Gravatar of ssumner ssumner
    27. May 2013 at 17:08

    J, Actually your correction of Lars is correct.

  12. Gravatar of OhMy OhMy
    27. May 2013 at 17:51

    The Fed can’t sabotage a fiscal stimulus, technically impossible. Before the output gap is closed there wouldn’t be inflation they would want to fight. But even assuming they would see something to make them try to contract, they can’t overturn a fiscal stimulus: by spending say 15T the Treasury raises the GDP by 15T at the very least, so it could double our GDP even if the Fed set rates higher. The Fed cannot do anything else than raise the rates – it can’t “shrink the monetary base” or other fallacies believed around here – trying to shrink the base beyond what the private sector endogenously demands by extending loans the Fed would shut down the banking system which would result in… everyone at the Fed getting fired. So ain’t happening. And shrinking the base less than that is simply undoing the QE which would have the same effect as doing the QE which is next to none.

  13. Gravatar of Full Employment Hawk Full Employment Hawk
    27. May 2013 at 19:18

    Since the Fed is consistently undershooting its 2% inflation target and is not supplying enough monetary stimulus to achieve it, fiscal stimulus that offsets the FED’s excessive caution in conducting monetary policy and gets the economy up to its inflation targed would not be sabotaged by the Fed. That assumes, of course, that the Fed is actually serious about the 2% inflation target and is actully shooting for a lower target.

    But the real issue at the present time is not increasing fiscal stimulus, but ending the strongly contractionary fiscal policy (especially once the relevant state and local governments are included.) At the present time this contractionaly fiscal policy is fighting the expansionary monetary policy. We face the equivalent of a driver pressing on the gas and the brake at the same time. Just switching to a “first of all, do no harm” fiscal policy, where fiscal policy stops being contractionary and becomes neutral, would cause the economy to grow more rapidly and the unemployment rate to come down faster.

  14. Gravatar of Benjamin Cole Benjamin Cole
    27. May 2013 at 19:24

    Excellent blogging.

    I for one, do direct a torrent of criticism at the Fed. They are economic quislings, feeble, dithering, opaque, and need to increase, not decrease QE.

    The Fed needs to show some resolve, some backbone—not quavering, and yellow streaks—for a growth policy.

    Inflation is at one percent.

    This is an “easy” monetary policy? So where does the one percent come from?

    Volcker was “tough” and an inflation-fighter. Inflation was five percent, maybe four percent, when he left town.

    The good news is that almost all Asian central banks are targeting growth.

    The ECB and the Fed seem stuck, maybe taking us to ZLB-land.

  15. Gravatar of Full Employment Hawk Full Employment Hawk
    27. May 2013 at 19:25

    “The Fed will not sabotage …
    Basically anything that is Real Growth.

    So the FED would not sabotage investments in repairing and upgrading our crumbling infrastructure?

    Increased investments in technology and scientific and medical research?

    Increased investment in human capital by providing the children of ordinary working people with greater assistance in obtaining a higher education?

    All of these things will cause major increases in long-run productivity.

  16. Gravatar of Bill Ellis Bill Ellis
    27. May 2013 at 19:36

    Matt Waters says:

    “… it is utterly sad that Krugman, who truly has the platform to make many angry at the Fed, keeps saying categorically that monetary policy is useless at the zero-bound. ”

    “categorically” ? No. Very wrong. Krugman says that Conventional monetary policy is useless at the zero-bound. And doesn’t everyone agree with that notion ?

    He is an advocate of non-conventional monetary policy… believing it works through the inflation expectations channel…. much the same as the Market Monetarists. (though Keynesians and Monetarists have big conceptual differences on how they get there.) PK has believed this since his work on Japan in the 90′s.

    The real conflict between the M&Ms and Krugman and the Keynesians is that the Keynesians believe that optimal policy is achieved by a Combination of the right Monetary policy AND fiscal policy…while the M&Ms believe that the right Monetary policy is all that is needed.

    In fact I would go further… M&M’s or any hard core Monetarists, believe that EVERYTHING is a monetary phenomenon. And that any other approach always messes things up.

  17. Gravatar of Full Employment Hawk Full Employment Hawk
    27. May 2013 at 19:47

    “Whether you believe they would offset stimulus or not do you really believe the Fed would offset simply ending a fiscal contraction thanks to the sequester?”

    Ending the sequester would be an important example of a movement to a “first of all do no harm” fiscal policy that would move fiscal policy from strongly contractionary to becoming neutral.

    A good part of the debate on this site is due to a difference in beliefs of how the Fed will respond to changes is fiscal policy. Obviously if the Fed always offsets any changes in fiscal policy demand side fiscal policy is ineffective. The people who are arguing that fiscal policy can be effective do not accept this view. Clearly a lot more empirical research on the response of central banks to fiscal policy is required. A thorough understanding of this issue is crucial to underatanding the effectiveness, or lack thereof, of fiscal policy.

  18. Gravatar of Tuesday Morning Links | timiacono.com Tuesday Morning Links | timiacono.com
    28. May 2013 at 03:59

    [...] Zero Hedge Low interest rates are the final straw for many company pensions – Washington Post Why both sides of the austerity debate are doing harm – Money Illusion Reinhart & Rogoff ongoing, meme status inevitable – FT Alphaville [...]

  19. Gravatar of ssumner ssumner
    28. May 2013 at 05:12

    OhMy, You said;

    “The Fed can’t sabotage a fiscal stimulus, technically impossible. Before the output gap is closed there wouldn’t be inflation they would want to fight.”

    No output gap means no excessive inflation? Have you forgotten the 1970s?

    “But even assuming they would see something to make them try to contract, they can’t overturn a fiscal stimulus: by spending say 15T the Treasury raises the GDP by 15T at the very least, so it could double our GDP even if the Fed set rates higher.”

    That makes no sense. Is there a model behind that? Even Keynesians would not make that claim.

    And if money is endogenous, why in the world would markets react so strongly to Fed rumors? And how was the BoJ able to sharply depreciate the yen?

    FEH, You said;

    “Since the Fed is consistently undershooting its 2% inflation target and is not supplying enough monetary stimulus to achieve it, fiscal stimulus that offsets the FED’s excessive caution in conducting monetary policy and gets the economy up to its inflation targed would not be sabotaged by the Fed. ”

    That’s simply wrong. According to the press, the Fed is likely to tighten policy with inflation running below 2%, they’ve done it before.

  20. Gravatar of Matt Waters Matt Waters
    28. May 2013 at 06:38

    Bill,

    If non-conventional policy works, then we could do enough of it that NGDP recovers, correct? And therefore fiscal policy is not necessary. The argument then becomes which tool is better, and I haven’t seen utilitarian arguments from Krugman concerning which type of stimulus leads to better RGDP.

    Scott,

    Point taken. If I understand the view correctly, the AS curve shifts to the left which drives down prices even as volume/NGDP increases. The revenue shortfall still needs to be financed by debt though, which makes me still think monetary stimulus only is preferable.

  21. Gravatar of OhMy OhMy
    28. May 2013 at 19:45

    Scott,
    No I haven’t forgotten the 1970s, maybe you have, remember the oil shocks? Cost-push inflation.

  22. Gravatar of ssumner ssumner
    29. May 2013 at 06:01

    OhMy, Oil shocks don’t raise NGDP, which rose at an 11% rate from 1972 to 1981. Nice try.

    Oil shocks would results in more inflation for any given NGDP path.

  23. Gravatar of Geoff Geoff
    29. May 2013 at 07:29

    “Oil shocks would results in more inflation for any given NGDP path.”

    It wouldn’t. If oil prices increase due to a decline in the supply of oil, and we assume the nominal demand for oil is unchanged, or increases, then the prices of other things cannot increase unless there is a greater nominal demand available to purchase those other goods. Cost push inflation is a myth. The only way that the prices of everything else can increase, is either if the nominal demand increases (which we are assuming as stable in the thought experiment), or the total supply declines.

    It would be the rise in the quantity of money and volume of spending that leads to higher prices in general, not the oil shock.

    In other words, if other goods prices rise due to oil prices rising, then that means either there is more nominal demand for those goods, in which case there is less nominal demand for other goods, which puts downward pressure on those prices, and hence there is no “price inflation” as such, or, there would have to be a drop in the supply of those other goods.

    Imagine everyone paying higher prices for oil and gasoline. That would leave fewer dollars available to purchase other goods, and that would put downward pressure on other goods prices. This is not “inflationary”, because some prices would go up while other prices would go down. The higher some prices become, all the more lower other prices would become.

    “Inflation is always and everywhere a monetary phenomenon.” Someone famous said that. Same guy who said low interest rates generally mean money has been tight.

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