Expectations traps: They’re even more applicable to fiscal policy

Tyler Cowen links to this post from Mark Thoma:

As for Tyler’s (and others’) call for monetary policy instead of fiscal policy, here’s the problem. It relies upon changing expectations of future inflation (which changes the real interest rate). You have to get people to believe that the Fed will actually be willing to create inflation in the future when it comes time to do so. However, it’s unlikely that it will be optimal for the Fed to cause inflation when the time comes. Because of that, the best policy is to promise that you’ll create inflation, then renege on the promise when it comes time to follow through. Since people know that, and expect the Fed will not actually carry through, it’s hard to get them to change their expectations now. All that credibility the Fed has built up and protected concerning their inflation fighting credentials works against them here.

Paul Krugman developed the idea of an expectations trap as a way of explaining the dilemma faced by the Bank of Japan.  Except there is just one problem.  Almost everyone agrees that Japan does not face an expectations trap.  They can devalue the yen whenever they wish, as much as they wish.  Some claim they would not be able to do this because there would be too much resistance from their trading partners.  There are two problems with this argument.  First, even if true, why would they have recently allowed the yen to rise from 115 to the dollar to 90 to the dollar in the midst of deflation?  Surely if they had simply kept it at 115, they would not have attracted much attention.  But even if I am wrong, the expectations trap argument is still wrong.  If the problem was foreign pressure; that would have also precluded BOJ attempts to spur the economy through open market purchases.  After all, if Japan truly can’t depreciate its currency, then logically it could not do any policy action that would cause its currency to depreciate.  And of course any credible and effective policy of open market purchases will cause a currency to depreciate.  So even in that case, it wouldn’t be an expectations trap, it would be a case where the big bad Westerners are forcing Japan into a policy of deflation.  It would be a “bully trap.”

But here’s the bigger flaw with the whole expectations trap argument.  People think it applies to monetary policy, but they forget it applies equally to fiscal policy.  (Indeed I never realized this until today.)  Here’s why.  Krugman’s model relies on rational expectations, indeed you can’t get the expectations trap without ratex.  But if you have ratex in your model, then no policy can work unless it is expected to work.  That’s why ratex should actually be called “consistent expectations.”  What you are really assuming is not that that people are “rational” (which is pretty much a meaningless term anyway), but rather that their expectations are consistent with the predictions of the model.  So if monetary policy is aimed at boosting nominal spending by 10%; it will only “work” in a ratex model if it is expected to boost nominal spending by 10%.  But that’s equally true of a fiscal policy aimed at boosting nominal spending by 10%.  It won’t work unless it is expected to work.

So why do people think this applies to monetary policy but not fiscal policy?  Because they visualize the transmission mechanisms in vastly different ways.  Most Keynesians (wrongly) think monetary policy is all about getting lower real interest rates.  In fact, it’s been shown that a highly effective monetary policy might lead to such bullish real growth expectations that real interest rates rise.  The real problem is linking current and future aggregate demand.  Woodford showed that it’s hard to boost current AD unless expected future AD also rises.  Think of this in terms of a price level target.  It’s hard to get current prices to rise unless future expected prices also rise.  But that will only occur if future expected monetary policy becomes more expansionary.

[If this is confusing think of a micro analogy.  If the government decides to pump up copper prices by buying massive quantities of copper, the policy will be almost totally ineffective if the government is expected to give up on the policy and sell off its copper hoards in 6 weeks.  Why would buyers stock up on copper today at $5 a pound, if they expected copper to sell for $3 a pound in 6 weeks?]

For some reason people don’t worry about this problem with fiscal policy; and the reason is very odd.  Perhaps without knowing it, people tend to assume that future monetary policymakers would be expected to sabotage current monetary policymakers, but would not be expected to sabotage current fiscal policymakers.  This is a rather odd assumption, as you’d expect that future monetary policymakers have more respect for current monetary policymakers than they do for the bozos in Congress.  After all, given the very long terms served by Greenspan (and now apparently Bernanke) the future and current monetary policymakers are often the very same person.  Is future Mr. Bernanke expected to differ from current Mr. Bernanke, by more than future Mr. Bernanke differs from the current Congress?

Here’s one way to think about this issue.  The future Fed is considered the last mover in this game.  The current Fed can do QE, and the future Fed can undo QE.  Or the future Fed can raise rates sooner than expected, or by more than expected.  But that’s also true of fiscal policy.  The Congress can pass a bill to spend more money, and the Fed can raise rates right afterward if they think inflation is going to exceed their target.  I’m not saying that’s likely, but I also don’t think it’s likely that the future Mr. Bernanke would try to sabotage the current Mr. Bernanke if the current Bernanke publicly announced “We need to get core inflation back up to the trend line of 2% extending out from September 2008, and will do whatever it takes.”  Why would the future Mr. Bernanke try to sabotage the current Mr. Bernanke, if he made that promise publicly and explicitly?   After all, if he did so he would make both Bernankes look like fools in the history books. 

So please don’t take this post the wrong way.  When I say that the expectations trap is equally applicable to fiscal policy, I’m not saying that I think the Fed is likely to go out of its way to sabotage fiscal policy.  But it is even less likely to sabotage monetary policy, indeed the latter hypothesis seems much more far-fetched to me. 

Over in the comment section for an intriguing post in Nick Rowe’s blog I asked: When in the entire history of the universe has a central bank explicitly tried to create inflation and failed?  Until someone can answer that question, I’ll keep assuming that it’s really easy to get inflation.  And also that the reason monetary policy seems to have so much trouble generating inflation at the zero rate is because monetary policymakers don’t want inflation, and go out of their way to say they are opposed to inflation.  Indeed they are even opposed to inflation that merely would bring us back to the implicit target trend line for the core CPI (which we have fallen below.)

PS.  A couple quick comments on the Tyler Cowen post I linked to.  I completely agree that real interest rates are less important than many people believe.  I look forward to his future post on this.  As far as uncertainty, I think we might be looking at the same concept from a different angle.  Suppose Walmart is thinking about building 75 new stores in America next year.  And suppose NGDP is currently $20 trillion and expected to be $21 trillion next year.  If Walmart is certain it will be $21 trillion, they are more likely to make irreversible investments than if there is a 50% chance it will be $20 trillion and a 50% chance it will be $22 trillion.  I understand that businessmen don’t use terms like “NGDP,” but when they are considering “how business will be next year” they are implicitly thinking about some sort of aggregate for total spending.   So I agree that uncertainty hurts investment.  Where I suspect we disagree is that I think an enormous amount of this aggregate uncertainty comes from not having a clue as to where NGDP is going over time.  From 1984 to 2007 we could be pretty confident that aggregate ”business” next year would 5% more than business this year, plus or minus a couple percent.  Starting in 2008 things got vastly more uncertain.  I blame the Fed.


Tags:

 
 
 

24 Responses to “Expectations traps: They’re even more applicable to fiscal policy”

  1. Gravatar of marcus nunes marcus nunes
    3. June 2010 at 20:12

    Scott
    I understand this to mean that in some situations Inflation Targeting can be “bad for the economy´s health”.
    It´s OK when you are cruising along the “normal” growth path but when for some reason (even an honest mistake of confusing the nature of the shocks) you are thrown far off the “normal” path, the “nature” of MP has to change.
    This is exactly what Bernanke advised Japan to do since at least 1998. It is also true that people usually do not practice the good advice they give others!

  2. Gravatar of Capitalism V3.0 Roundtable » Blog Archive » The Credibility of Monetary and Fiscal Policy Capitalism V3.0 Roundtable » Blog Archive » The Credibility of Monetary and Fiscal Policy
    3. June 2010 at 23:25

    [...] Sumner, responding to a post by Tyler Cowen, says: Expectations traps: They’re even more applicable to fiscal policy, by Scott Sumner: Tyler Cowen links to this post from Mark [...]

  3. Gravatar of 123 – TheMoneyDemand Blog 123 - TheMoneyDemand Blog
    4. June 2010 at 02:22

    In the comment section of Nick Rowe’s post and also in my blog here: http://themoneydemand.blogspot.com/2010/06/four-myths-about-european-central-bank.html I have argued that solvency of ECB is the limiting factor in creating inflation outside Germany. If there are fears ECB is insolvent, more AD will flow to Germany, and this will increase fears of Eurozone breakup, such fears are initially deflationary outside Germany.

  4. Gravatar of scott sumner scott sumner
    4. June 2010 at 04:25

    Marcus; You said;

    “It is also true that people usually do not practice the good advice they give others!”

    I’ve noticed that too.

    And yes, you need “level targeting,” which means returning to the price level path when you have deviated from it.

    123, I am not sure exactly how to define the term “solvency” here, but I agree that uncertainty over the euro is a problem. A more expansionary policy from the ECB would reduce that uncertainty, by reducing debt problems in the southern tier of the eurozone.

  5. Gravatar of marcus nunes marcus nunes
    4. June 2010 at 04:34

    Scott
    ‘Krugman hits back”
    http://krugman.blogs.nytimes.com/2010/06/04/policy-and-the-tinkerbell-principle/

  6. Gravatar of marcus nunes marcus nunes
    4. June 2010 at 04:52

    I Think this is a good summary (from q):

    “He (SS) is saying that for both fiscal and monetary policy to work, the *central bank* needs to have a credible policy of sticking with inflation”.

  7. Gravatar of Nick Rowe Nick Rowe
    4. June 2010 at 04:52

    Scott: you are at least partly right on this. Ironically, Mark Thoma’s (very good) “icy hill” metaphor can help explain why you have a point.

    By the way, Tinkerbell is very real. The whole of society (including of course the economy) is a Tinkerbell effect.

    Will do a post on this, probably later today.

  8. Gravatar of David Pearson David Pearson
    4. June 2010 at 05:00

    Scott,

    I think the “expectations trap” is something we agree on: the Fed can avoid it if it shows enough determination. Where we disagree is that you think the cost of doing so is small. In the past you have argued that there is no reason to deviate from an NGDP target that implies 2% inflation. Lately you have said that the Fed should “temporarily” target 9% (if I remember correctly), implying a tolerance for something like 4-6% inflation. Doesn’t the word “temporarily” put the Fed square in the expectations trap problem?

    The Fed can create inflation expectations if it wishes. There is a potential cost, and significant tail risk, of doing so. Nick Rowe put the potential cost as “the ketchup problem”, where the Fed pushes on expectations harder and harder until they are released all at once. As far as tail risk is concerned, it is the risk that hedging behavior results in an adverse positive feedback loop of hedging, velocity, term premiums, higher deficits, and more hedging.

    So yes, the Fed is in command of expectations. The question is the cost of moving them. Bernanke said in Japan recently that the Fed didn’t need to absorb that cost. Perhaps today’s employment number will make clear that the Fed will have to finally make an explicit choice between inflation risk and deflation risk. My sense is the markets will not leave that choice unpenalized either way. If you see stocks reacting meekly to a Fed ease, it will tell you a lot about the expected mix, with in NGDP, between inflation and RGDP.

  9. Gravatar of Indy Indy
    4. June 2010 at 05:37

    Some more on the BOJ. Here are the movements in currencies compared with the US Dollar from their 2008 high until today:

    -40% to -30%: Poland, Iceland, Hungary

    -30% to -20%: Euro, British Pound, Mexico, Russia, Pakistan, Turkey, Estonia, Argentina.

    -20% to -10%: Australia, Israel, South Korea, Switzerland, India, Brazil.

    -10% to +10% (basically 0): United States, Canada, China, Singapore (and all the other pegged countries, of course.)

    +20% (ok, cheating, from 2008 low) – Japan.

    This is the only major currency I can find that has appreciated significantly at all against the dollar compared to where it was before the crisis – and it’s a significant appreciation.

    The idea that the Japanese can’t do anything about that is simply absurd. If they would have tried to hold parity with, say, the Euro or the Pound, they would depreciate almost 50% from where they are today.

    The question is why they’ve chosen the path they have.

    And by the way – The developed countries always complain about China holding their currency too low – but notice what group China is in. Because of its peg to us, China has appreciated quickly significantly compared to almost every other country in the world in the last two years.

    North America and Japan are the only major exceptions. Will everybody else stop complaining now?

  10. Gravatar of Alex Alex
    4. June 2010 at 05:54

    Run Goldilocks! The bears are out to get you.

  11. Gravatar of 123 – TheMoneyDemand Blog 123 - TheMoneyDemand Blog
    4. June 2010 at 06:48

    Scott, you said:

    ” I am not sure exactly how to define the term “solvency” here, but I agree that uncertainty over the euro is a problem. A more expansionary policy from the ECB would reduce that uncertainty, by reducing debt problems in the southern tier of the eurozone.”

    If people think ECB is solvent, ECB is able to focus monetary stimulus on PIGS reducing deflationary pressures in those countries while avoiding overheating in Germany. If people start to think that ECB is insolvent, any additional stimulus will flow to Germany while deflation will strengthen in PIGS. So far markets think that the risk of ECB insolvency is very low, so more monetary stimulus will indeed help PIGS.

  12. Gravatar of Krugman/Sumner Death Match: Let There Be Peace on Earth, and Let It Begin With Me Krugman/Sumner Death Match: Let There Be Peace on Earth, and Let It Begin With Me
    4. June 2010 at 07:13

    [...] when I see Scott Sumner and Paul Krugman (also Mark Thoma) arguing over the best way to destro fix the economy–should [...]

  13. Gravatar of StatsGuy StatsGuy
    4. June 2010 at 07:19

    ssumner – Perhaps a critical point in support of your position (credibility of fiscal policy) is perhaps slightly missing in the previous post, that might be relevant to the argument with Krugman.

    Krugman says Tinkerbell Economics applies to monetary policy whenever the economy approaches the zero bound (aka, through the looking glass).

    Fiscal Policy has a _direct parallel_ to the zero bound – it’s called sovereign debt crisis, and the EU is hitting it right now. Hard.

    That is, households and firms make long term investment and spending decisions based on expectations of future income, and if they’re aware that future income is reliant on government spending, AND they believe that government spending is unsustainable, AND they believe the environment is deflationary, they WILL HOARD. In this situation, government spending does not necessarily stimulate, but merely allows private balance sheets to be rebuilt by transfering debt onto the public balance sheet. Observe:

    http://blogs.reuters.com/rolfe-winkler/files/2010/02/US_DEBT1209.jpg

    or more detail on later years

    http://1.bp.blogspot.com/_ZG0dXWEc4DE/S6O6kqM5qSI/AAAAAAAAACg/o6Q8qa6GRBU/s400/United+States+Public+Debt.jpg

    Firms and households do not perceive this to be a sustainable increase in aggregate demand. This is particularly true when EVERYONE recognizes that our persistent trade deficits and the aging population imply a strong secular downward pressure of future deficit spending. Que all the arguments about US off balance sheet obligations.

    In composing a response to Krugman, please consider the argument above, and consider citing as a prime example the US employment numbers today. We had _massive_ job growth (below expectations, but massive). And everyone took this as indicative of future economic trouble. Why? It’s all census, and everyone knows it’s temporary, because they know the federal government is fiscally and politically constrained. Thus, they hoard.

    My only critique of the ssumner side of the argument is that I think it needs to grapple a little more with international finance markets, bond vigilantes, and the leveraged firepower provided by derivative-backed bets.

  14. Gravatar of Bob Roddis Bob Roddis
    4. June 2010 at 07:38

    Central bank money dilution is based upon the theft of purchasing power from others holding the existing money. The newly created money is then spent, artificially bidding up prices and distorting the price, investment and capital structure. No one knows (or can know) what anything is worth in real goods and services. This artificial boom must lead to a painful bust so that everything may be re-priced to reflect reality. How can one not see this simple reality?

  15. Gravatar of DanC DanC
    4. June 2010 at 07:54

    1)
    Japan is dependent on the importation of raw materials and a devaluation might lower living standard on net, perhaps they fear this possibility.

    2)
    What if it isn’t a liquidity trap but that people have decided that there is a reduction in their permanent income due to the expansion of government along with a lower expected return on investment due to higher taxes and regulation.

    Wouldn’t that cause a significant decrease in AD.

    For example means testing Social Security can lead to having private investment returns turn negative for some people. What would be the unintended consequences?

    You have a Federal government that is determined to follow policies that are really anti-growth and redistributive. Have most people decided how these changes will play out in their lives. If they don’t believe, really believe, that these changes are going to be positive going forward then does Tinker Bell spreading the magic dust of government spending really matter that much?

    Isn’t is rational for people to be uncertain of the impact of “unintended consequences”? If they think the governments path is fraught with dangers (ie the health care numbers were cooked)

    Do people feel poorer then they did four years ago? Do they view it as a permanent decrease in their incomes? Have expectations for future growth declined significantly?

  16. Gravatar of TheMoneyIllusion » Tinkerbell strikes back: Why Krugman is wrong TheMoneyIllusion » Tinkerbell strikes back: Why Krugman is wrong
    4. June 2010 at 08:20

    [...] misunderstanding, Thoma was the one making the Tinkerbell argument for monetary policy, and in my expectations trap post I thought it exceedingly unlikely that it would be a problem in practice.  I said: So please [...]

  17. Gravatar of Greg Ransom Greg Ransom
    4. June 2010 at 09:22

    No. They could care less about aggregate spending.

    They are thinking about spending on _their_ products.

    Home builders don’t give a fig about aggregated total spending for the whole economy, they care about spending in the local place where they build houses.

    Once again, the “macroeconomists” fallacy of “aggregate demand” leading to non-economical thinking, anti-marginalist thinking, non-relative price thinking, no production goods thinking, etc.

    Scott writes:

    “I understand that businessmen don’t use terms like “NGDP,” but when they are considering “how business will be next year” they are implicitly thinking about some sort of aggregate for total spending.”

  18. Gravatar of TheMoneyIllusion » Paging Brad DeLong TheMoneyIllusion » Paging Brad DeLong
    4. June 2010 at 15:46

    [...] a recent post I argued that the expectations trap idea applied even more strongly to fiscal policy that monetary [...]

  19. Gravatar of scott sumner scott sumner
    5. June 2010 at 09:09

    Marcus, Thanks.

    Nick, Yes it’s real, but it’s not a “problem”. People do believe the Fed when it makes explicit promises. The problem is that it rarely makes explicit promises.

    David, With price level targeting there is no ketchup problem. (Inflation is more debatable.) I also responded to you in the footnote of a later post.

    The commitment to return to trend prevents excessive instability of expectations. Hence no ketch-up problem.

    Indy, Thanks for that data.

    Alex. They’re just teddy bears.

    123, That sounds a bit like 1931. I’ll have to think about it a bit more, but you are probably right.

    Statsguy, Good post. As I said in the comment to a later post (I do these backward) Keynes made a similar observation. I also mentioned the census and stock market reaction in the comment section of a later post.

    I will try to do something on the international angle soon.

    Bob, The word “theft” in your first line should be “legitimate taxation.”

    DanC, 1. Maybe, but of course that wouldn’t be an expectations trap.

    2. You asked:

    “What if it isn’t a liquidity trap but that people have decided that there is a reduction in their permanent income due to the expansion of government along with a lower expected return on investment due to higher taxes and regulation.

    Wouldn’t that cause a significant decrease in AD.”

    No, or if it did AS should rise equally. When people feel poorer they don’t choose to work less. The problem is low NGDP, which means monetary policy.

    More generally, these sorts of policies have only a modest effect on the business cycle. LBJ did the same in the 1960s, and the economy boomed. I agree that they are long run problems (see the 1970s) but it shouldn’t dramatically slow growth now.

    Greg, Individual businessmen think of individual market demands, the aggregate of all businessmen are implicitly focused on AD.

  20. Gravatar of TheMoneyIllusion » Fiscal expectations traps: Reply to Woolsey TheMoneyIllusion » Fiscal expectations traps: Reply to Woolsey
    5. June 2010 at 13:07

    [...] Woolsey has a response to my fiscal expectations trap idea.  I agree with most of what he has to say, but want to respond to a few points: Krugman’s [...]

  21. Gravatar of TheMoneyIllusion » In major oversight, Robert apparently not invited to be guest contributor at The Economist TheMoneyIllusion » In major oversight, Robert apparently not invited to be guest contributor at The Economist
    6. June 2010 at 17:51

    [...] to be outdone, Scott Sumner forgets that C, G, and NX contribute to aggregate demand and argues that a fiscal stimulus works only if people believe it will work (Via Paul Krugman and [...]

  22. Gravatar of You Can’t Stimulate Consumption | Collective Conscious You Can’t Stimulate Consumption | Collective Conscious
    7. June 2010 at 06:46

    [...] a fairly vicious back-and-forth (starting here and ending here), I’ve been inspired to think a bit harder about stimulus targeting as it [...]

  23. Gravatar of TheMoneyIllusion » Mixed messages TheMoneyIllusion » Mixed messages
    20. June 2010 at 11:07

    [...] Sometimes they play around with “expectations trap” models, although as I discussed here, those are even more applicable to fiscal policy.  In any case, the expectations trap is a bit [...]

  24. Gravatar of TheMoneyIllusion » Strange new respect from Krugman TheMoneyIllusion » Strange new respect from Krugman
    23. August 2010 at 10:28

    [...] have argued that this problem is even more applicable to fiscal stimulus, as future central bankers would be more likely to sabotage fiscal stimulus than monetary [...]

Leave a Reply