Ambrosini on the fiscal expectations trap

Someone has finally addressed my fiscal expectations trap idea.  Here is Ambrosini:

Sumner argues that if Krugman’s claim is true that the Fed is too conservative, that they will do whatever to curb inflation, then fiscal policy won’t work either. Fiscal policy moves the AD curve right, but the Fed will just move it back left.

Sumners argument only works if policy is not limited by the zero lower bound. Suppose the Fed’s conservative policy requires it to set interest rates at -2%. It can only set them to 0%. When fiscal policy moves the AD curve right, the Fed resets the target rate to -1%, say. Actual rates stay at 0%, the Fed can’t move the AD curve left and so fiscal policy is effective. Sumner says either “the Fed isn’t constrained to just set interest rates (e.g. currency interventions)” or “the Fed shouldn’t be constrained to just set interest rates”.

I see his point, but this proves too much.  If the Fed was unable to neutralize current fiscal policy for this reason, it would be equally unable to neutralize current monetary policy.  My argument wasn’t that a fiscal expectations trap is likely, but that it is more likely than a monetary policy expectations trap.

For the monetary trap to work, you have to assume that at some future date we will exit the liquidity trap, and the Fed will take advantage of that situation by raising rates and controlling inflation too quickly–before we reach the promised price level target.  So either way, you have to assume the future monetary authority has some power, or you can’t get either a monetary or a fiscal expectations trap.

Here is the bottom line.  Suppose the right-wing controls the Fed, and wants the price level to be only 10% higher in 10 years, not 20% higher as Bernanke may want.  The Fed can make that happen, regardless of what fiscal policymakers do.  And if people begin to believe the Fed intends to keep core inflation at 1% per year for the next 10 years, there really isn’t much fiscal policy can do.  Remember that fiscal stimulus works by shifting AD to the right.  If it is to work at all it must raise inflation at least somewhat (assuming the AS curve isn’t totally flat.)  But that means it can’t work if the Fed isn’t expected to play ball in the out years.  How can you significantly raise short term inflation in a world where the total increase in the core price level over the next 10 years is only 10%?  The numbers don’t add up.


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17 Responses to “Ambrosini on the fiscal expectations trap”

  1. Gravatar of StatsGuy StatsGuy
    4. June 2010 at 19:56

    “Here is the bottom line. Suppose the right-wing controls the Fed, and wants the price level to be only 10% higher in 10 years, not 20% higher as Bernanke may want. The Fed can make that happen, regardless of what fiscal policymakers do. And if people begin to believe the Fed intends to keep core inflation at 1% per year for the next 10 years, there really isn’t much fiscal policy can do.”

    True, short of stacking the Fed or legislation. However, this seems to understate the complexity of the Fed’s incentive structure. I have no doubt that Bernanke _wants_ 2% inflation, and may even _want_ to restore the prior price level trajectory. He simply doesn’t want to be seen as _causing_ that level of inflation, nor take the risk that hi action could be blamed for causing even higher inflation. Worst would be the risk that markets stop funding the US treasury needs as massive short term debt (incurred Under Dubya) rolls over (hopefully into longer term notes).

    So if it just so happened that the economy heated up (if, for instance, fiscal stimulus actually worked – and I’m not saying it does or doesn’t) and the Fed could tighten slightly to keep inflation at a steady 2%, Bernanke would be overjoyed.

    Indeed, Bernanke keeps _hoping_ that happens, but doesn’t want to actually be seen as _making_ it happen. Theoretically, you are correct here – but politically, there is a difference between action and inaction (inertia), and between outcomes and blame.

    That isn’t to say that the Tinkerbell Principle doesn’t apply to fiscal policy. Krugman is right about the limits of Ricardian Equivalence – for temporary fiscal spending, taxes to cover spending are spread out, so fiscal spending would pull future demand into the present even if full equivalence were accepted.

    But he misses a key point:

    He keeps talking about the zero bound looking glass, but then casually dismisses the fiscal equivalent – sovereign debt crisis. For instance, here

    http://krugman.blogs.nytimes.com/2010/06/03/rashomon-in-the-oecd/

    There is a point at which fiscal action that is NOT ACCOMMODATED by monetary easing (e.g. European “automatic stabilizers”) will begin to place a country in a sovereign debt crisis. At this point, the markets will begin to doubt government pledges to sustain fiscal stimulus due to fears the capital markets will not finance it (and those fears may be self-fulfilling). The fiscal authority thus may want people to believe that it will sustain demand, so that private demand kicks in, but they desperately hope they can remove fiscal stimulus the moment private demand even looks like it _might_ recover. The markets know this, and thus private deleveraging continues. In essence, all fiscal stimulus does is replace private debt with public debt (as noted in an earlier comment):

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

  2. Gravatar of Doc Merlin Doc Merlin
    4. June 2010 at 22:12

    “How can you significantly raise short term inflation in a world where the total increase in the core price level over the next 10 years is only 10%?”

    Core price level is baloney, as it doesn’t take food or energy into account, because they are too ‘volatile’. It ignores the part of the household budget that has the least demand elasticity. Core price level is dominated by things like housing (which don’t normally change for an individual, unless they have an ARM or are on month to month rent) and electronics (which has massive deflation) so it tends to massively under-predict short term problems.

  3. Gravatar of Will Ambrosini Will Ambrosini
    4. June 2010 at 22:45

    I think I understand. In the expectations trap, the Fed’s actions today are neutralized by their conservative (non-liquidity trapped) actions in the future. These same conservative non-liquidity trapped actions would neutralize fiscal action today.

  4. Gravatar of Jason Jason
    4. June 2010 at 23:13

    I am thoroughly enjoying this argument (in this and previous posts).

    One question I have is essentially Krugman’s argument that fiscal policy used to actually put people to work, that physically employing people has an effect that is robust to monetary policy. If people are employed by government fiscal stimulus, they will remain employed by fiscal stimulus even in the face of contractionary monetary policy designed to counteract it.

    Almost in a sense the government is like a huge business dominating the economy working contrary to rational expectations. If it is large enough (not saying the current amount is) it could push the economy from being “rational”.

  5. Gravatar of Indy Indy
    5. June 2010 at 05:40

    @Jason:

    I’m not so sure that line of argument works if the whole “expectations trap” idea is based on the notion that the over-conservative Monetary authorities will counteract the Fiscal ones.

    So, you would have to ask, over the next 10 years, say, what level of total hours worked would have occurred without Fiscal intervention, vs. with Fiscal intervention but also with Monetary counter-action?

    The government can hire a lot more people to dig ditches, but if employers think that this is – 1. Temporary and 2. As soon as it is over and the Central Bank has the ability, the Monetary authorities will pursue contractionary policies – then they won’t expect future AD growth and they’ll hire fewer workers.

    And maybe Ricardian equivalence isn’t 100% true, but it’s probably more than 0% true – and so the employers would also expect higher taxes to pay off the debts of fiscal interventions – which are also contractionary. Is “Ricardian Equivalence” the fiscal-to-fiscal trap, vs. Krugman’s monetary-to-monetary trap?

    At any rate – if the trap idea is sound, then every additional (temporary) government job displaces some amount of private-hiring. It’s not clear to me which effect dominates, or has the higher net benefit in the long-term.

  6. Gravatar of Indy Indy
    5. June 2010 at 06:18

    Maybe understanding this argument would be easier with the help of a little 2×2 matrix with the fiscal and monetary future vs. present interactions and traps.

    1. Future Monetary-to-Present Monetary: The tendencies and philosophies of the central bankers are too conservative. Their inflation over-hawkishness will emerge as soon as we’re out of our zero-bound trap and they have any capability and excuse to tighter. They will have that capability, and act on it, before it is appropriate. If everyone believes this, then the [Central Bank’s] ability to “goose” AD today disappears because people will expect the Fed to contract AD tomorrow. Krugman’s Keynesian argument seems to say that, because of this phenomenon, (and because the Fed is unable to act ‘big’ enough and needs help in the present) large amounts of stimulating fiscal intervention is warranted.

    2. Future Monetary-to-Present Fiscal: Exactly the same as above, except, replace the bracketed [Central Bank’s] with [The Treasury’s]. But this is inherently more plausible that #1 because the Monetary institution has more continuity and consistency and political independence and would be much less likely to undermine itself than to undermine the uncoordinated initiatives of political authority. This is the essence of the Sumner Critique.

    3. Future Fiscal-to-Present Fiscal: Fiscal Intervention and additional deficit spending and hiring today is both temporary and requires additional debt. That hiring will have to end for ‘recovery’ (restoration of the status ex-ante), and the debt will have to be repaid through additional taxes. This is also contractionary and should reduce AD expectations – if not with 100% Ricardian Equivalence, then at least somewhat.

    4. Future Fiscal-to-Present Monetary: Nothing comes to my mind at the moment. This is probably a null-set, because the Fed gets to acts as the last-mover in these situations. Or maybe someone can think of something smart – I’ll leave it blank for now.

  7. Gravatar of scott sumner scott sumner
    5. June 2010 at 07:10

    Statsguy, You said;

    “There is a point at which fiscal action that is NOT ACCOMMODATED by monetary easing (e.g. European “automatic stabilizers”) will begin to place a country in a sovereign debt crisis. At this point, the markets will begin to doubt government pledges to sustain fiscal stimulus due to fears the capital markets will not finance it (and those fears may be self-fulfilling). The fiscal authority thus may want people to believe that it will sustain demand, so that private demand kicks in, but they desperately hope they can remove fiscal stimulus the moment private demand even looks like it _might_ recover. The markets know this, and thus private deleveraging continues. In essence, all fiscal stimulus does is replace private debt with public debt (as noted in an earlier comment):”

    Keynes made a similar comment in 1930. I need to dig it up because Keynes also worried about fiscal expectations traps. That will be a fun post to write; “Keynes vs Krugman on fiscal expectations traps.”

    The first part of your comment makes some good points. It isn’t so much that I think fiscal traps likely, as that I think it very, very unlikely that a future Bernanke would want to publicly humiliate the current Bernanke. That’s not how I read human nature.

    Doc Merlin, Core inflation measures the underlying trend from demand shocks. But use headline inflation instead, my point still holds.

    Thanks Will.

    Jason, He’s right that government employment would rise. Is that enough? Look how the stock market reacted yesterday to all those census jobs. Tighter future expected monetary policy will reduce CURRENT private sector employment.

    Indy, Those are good points. I would add that Krugman actually relies on Ricardian equivalence in his 1998 paper on monetary policy expectations traps.

  8. Gravatar of Lord Lord
    5. June 2010 at 09:02

    I would say fiscal policymakers can make it not happen whatever monetary policymakers want, but only if they have the courage to do so. Monetary policymakers work at the discretion of fiscal policymakers. It was largely FDR’s abandonment of the gold standard that turned the depression around; they did not try to oppose this. If congress was willing to adapt its own monetary policy, say suspending Treasury’s debt issuance and crediting it with any and all amounts needed, markets wouldn’t doubt which would take presidence.

  9. Gravatar of OGT OGT
    5. June 2010 at 09:34

    Statsguy- That’s a good point about the sovereign debt crisis moment. On the other hand is it plausible that a money printing central bank would allow that to happen? I don’t think so. I’d go so far as to suggest a buyer’s strike can’t happen in the US bond market unless the Fed causes it by overtly signaling that they want one.

    But the CB is final mover only so long as congress allows it, so they aren’t very likely to do this. They are a creation of congress and can eliminated or circumvented with no more legal effort than creating National Folk Dance Appreciation Week. All of the other sovereign defaults I am aware involve borrowing in a foreign currency, or one you can not print.

    None of this is to suggest these are particularly good options, but I think Nick Rowe’s post the other day on the (Mis) Coordination of Fiscal and Monetary Policy lays out the problematic social constructs hampering the whole debate.

    http://worthwhile.typepad.com/worthwhile_canadian_initi/2010/05/the-miscoordination-of-monetary-and-fiscal-policy.html#more

  10. Gravatar of scott sumner scott sumner
    5. June 2010 at 11:12

    Lord, The Fed opposed FDR’s move but couldn’t stop it. You are right, the government could force the Fed to act if they wanted to. But they probably won’t.

    OGT, You said;

    “But the CB is final mover only so long as congress allows it, so they aren’t very likely to do this.”

    That argument applies equally to a monetary or a fiscal expectations trap. I’m not sure sure Congress won’t allow it. Isn’t the Fed neutralizing the fiscal stimulus right now with all the recent talk of exit strategies? Where is the Congressional outrage about this talk? I’ve heard zero outrage from either party.

    It’s not about politics, it’s about the fact that 98% of people disagree with Krugman and my view that money is too tight. We need to change people’s minds, not worry about enforcement mechanisms.

  11. Gravatar of TheMoneyIllusion » Keynes on fiscal expectations traps TheMoneyIllusion » Keynes on fiscal expectations traps
    5. June 2010 at 12:07

    […] I don’t recall his exact reasoning, it may have been partly a crowding out story, but I vaguely recall it was also partly an international confidence story.  Big deficits could lead to a loss of confidence in a country’s ability to repay its debts (perhaps due to fear of devaluation.)  This seems pretty close to the issue raised by Statsguy in the comment section of one of my recent fiscal expectations trap posts. […]

  12. Gravatar of Doc Merlin Doc Merlin
    5. June 2010 at 20:03

    Scott, if 98% of people disagreed with your view that money was too tight, then wouldn’t by your own ideas, it not be too tight?
    There is another possibility. The money is too tight now, because of people in the past preparing for it to be too loose? Excessive past expected looseness causing people to over-leverage?

  13. Gravatar of scott sumner scott sumner
    6. June 2010 at 06:03

    Doc Merlin, No, we don’t disagree about the state of the indicators that I look at, we just disagree about which indicator is the most meaningful.

    People in the markets agree with me. Asset prices are way down from 2008, inflation and inflation expectations are down. Look at the TIPS market, investors agree with me. It’s just a question of what I call an “apple” they call a “banana”. But we see the world in the same way. I agree that rates are low, it’s just that I don’t call that “monetary policy.” But believe me, investors agree with me that all this “monetary ease” doesn’t imply inflation.

  14. Gravatar of OGT OGT
    6. June 2010 at 08:25

    Sumner- I don’t know that 98% percent disagree with you, but your comment and Nick Rowe’s about the perception of what truly is ‘monetary policy’ seem to raise some quasi-existential questions about the area. How can they control expectations when the Fed thinks they’re winning at Hearts while they’re really losing at Spades?

    In any case, I was just trying to game out the scenario where there was a fundamental disagreement between the CB and Congress and what that might mean for investor expectations. Ultimately, I lean toward a reform of the Fed’s mandate from Congress to something along the lines of NGDP targeting that would be a better guide to investors, policy makers and bring more accountability to the Fed.

  15. Gravatar of Doc Merlin Doc Merlin
    6. June 2010 at 08:43

    @Scott:
    Then why is gold so high? I know you believe that prices reflect information. So what information is it conveying?
    Hrm, one possibility: gold has nothing to do with fear of CPI inflation, but rather is priced as a result of fear of government fiscal debt burdens.

  16. Gravatar of Nick Rowe Nick Rowe
    7. June 2010 at 05:11

    OGT: “How can they control expectations when the Fed thinks they’re winning at Hearts while they’re really losing at Spades?”

    Oh God! That is a lovely metaphor. I wish I had thought of that when I did my “interest rate targeting as a social construction” post. You observe the same objective physical facts (the same cards being placed on the table) but the two interpretations of those same facts have vastly different implications.

  17. Gravatar of scott sumner scott sumner
    7. June 2010 at 07:13

    OGT, I agree that there are some deep philosophical questions to think about in this area. I do like your final point about a clear mandate from Congress, hopefully NGDP targeting.

    Doc Merlin, Asian demand and a dearth of new discoveries recently.

    Nick, Yes. And by the way, that was a great post.

    Of course communication isn’t everything. Regardless of their words, 2%/year base growth over the next 100 years will have different implications from 20%/year base growth for 100 years. The key is to communicate as effectively as you can the sort of policy goals that you have. If inflation falls short will you ease, and if so how? If NGDP overshoots will you tighten, and if so how? These are the questions they should be communicating answers to.

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