Keynesians face a dilemma. If they go to Congress and say the following:
The best way out of the recession is to boost AD. The Fed can do that best, even at the zero bound. They simply need a higher target for whatever nominal aggregate they are targeting, or they can do level targeting. But the Fed won’t do those things because they don’t think we need more AD. They interpret their mandate differently than you guys do. So instead you guys need to create more AD and inflation the hard way, through spending hundreds of billions of dollars and imposing large future tax burdens on our economy.
I think it’s fair to say the message wouldn’t go over very well. So instead they say to Congress that we need fiscal stimulus because monetary policy is out of ammunition. But if they are debating with economists, or at least the dwindling number of economists who understand how monetary policy operates at the zero bound, they won’t be taken seriously propounding that sort of crude 1938 Keynesianism. 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 far-fetched, so the normal argument is; “Yes, the stubborn conservatives at the Fed, ECB and BOJ could do a lot more, but they refuse to set higher inflation targets and thus we need fiscal stimulus.”
I think this two-faced approach has really hurt their credibility. It helps explain why they aren’t being taken seriously in policy-making circles. But I don’t have any good alternatives. The economics profession is split in so many ways that almost any suggestion (including my own argument for monetary stimulus) is not going to get support from enough economists to convince the skeptics.
BTW, I also think this explains why smaller countries seem even less receptive to the fiscal stimulus argument than larger countries. The zero bound isn’t much of a problem for small countries that want to inflate—they can always depreciate their currencies. So why would they even consider fiscal stimulus? Of course small countries that don’t want to inflate (Switzerland) don’t have this option, but if they don’t want more inflation then their problem is not a lack of AD.
I got thinking about all this while reading some posts by DeLong, Cowen and Kling. Here is Tyler Cowen expressing skepticism about fiscal stimulus:
1. The monetary authority moves last anyway.
Brad DeLong responds:
Yes, the central bank can neutralize any additional fiscal stimulus by raising interest rates. (It is not clear that it can undo any fiscal contraction by some combination of lowering interest rates and quantitative easing: it may be able to.) What is clear is that the U.S. Federal Reserve and the Bank of England are right now definitely not in a place where they would neutralize any additional fiscal stimulus by raising interest rates. And my bet is that the ECB is also not in such a place–although it is much harder to figure out what they think and what they will do. That the central bank moves last is important and relevant, but not determinative when you are in the neighborhood of the zero lower bound on interest rates.
I can’t make heads or tails of this, but perhaps you commenters can set me straight as to what I am missing. As I read DeLong, he seems to concede that the Fed “may” be able to offset fiscal restraint, presumably with some unconventional policy like QE or higher inflation targets. I don’t want to put words into DeLong’s mouth, but as the Fed obviously can’t take the conventional step of cutting rates once they have fallen to zero, I don’t see any other interpretation. So let’s assume DeLong is alluding to unconventional monetary stimulus. Note that there is no zero bound for unconventional monetary stimulus. Perhaps it wouldn’t work, but it would fail for reasons other than the zero bound.
But in that case I have no idea what DeLong means by the “What is clear . . .” sentence. The argument that fiscal policy can be offset with monetary policy is not based on moving interest rates, as indeed (I believe) DeLong implicitly admitted in the previous sentence. Just as nobody thinks the Fed would respond to fiscal contraction by cutting rates to minus 1%, nobody thinks they’d raise rates to 1% the day after Congress passed a fiscal stimulus. But they don’t have to. The way monetary policy works at the zero bound is by changing inflation expectations. If the expected amount of inflation over the next 5 years doesn’t change after fiscal stimulus is announced, then the fiscal stimulus is expected to fail.
Why might it be expected to fail if the Fed didn’t raise rates right after the stimulus was passed? Simple; the Fed’s exit strategy would be adjusted. If you think this possibility is far-fetched then you haven’t been paying attention. A couple months ago all the chatter out of the Fed was about how the economy was recovering strongly, and that before too long we needed to be contemplating an exit from stimulus. (Yes, they believe they are actually being stimulative, as they haven’t read their Milton Friedman recently.) Now just two months later all the chatter is about how the exit will be delayed in 2012. What’s happened in between? The Greek and Spanish crises, the strong dollar, higher than expected unemployment claims, lower than expected private job creation, low core CPI inflation, etc, etc. In other words, the Fed most definitely does respond to signals about AD.
I know that Congress doesn’t think of stimulus in terms of inflation, but let’s suppose that the amount of stimulus Congress wants would lead to 12% (total) expected inflation over 5 years and the Fed wants to do a policy that will lead to 7% inflation over 5 years. If the Congress uses fiscal stimulus to bump up the expected inflation rate, the Fed can offset that without raising current interest rates. All they need to do is continue hinting that if AD rises to X level, they will exit their zero interest rate policy.
Now I am not saying this will definitely happen. I can think of several alternative scenarios. The Fed might be intimidated by Congress’s action, and move toward a more accommodative policy stance. Or the fiscal deficits might raise expected inflation by increasing fears that the debt will eventually be monetized. But what I don’t understand is how DeLong’s argument addresses Cowen’s observation that the central bank moves last.
The left likes to claim the fiscal stimulus “worked.” The right likes to point out that growth was less than predicted by Obama. The left responds that “other bad things” happened in late 2008 and early 2009, which explain the disappointing growth. My view is that the “other bad things” were mostly an excessively tight monetary policy in late 2008 and early 2009, which was due to Fed passivity in the face of expectations that fiscal stimulus would carry the load.
Arnold Kling also has an interesting take on this issue:
So the argument for using fiscal expansion instead of monetary expansion needs to be pretty compelling. Consider two arguments:
1. We should be happy about a larger public sector and a smaller private sector.
2. At low interest rates fiscal policy is very effective (no crowding out) and monetary policy may be ineffective (liquidity trap).
When Tyler says that (2) is a “red herring,” he is implying that it is a stalking horse for (1).
That probably plays into conservatives favoring tax cuts during recessions and liberals favoring spending increases.