I saw this comment over at MarginalRevolution:
On the AD front, Scott Sumner has been vindicated more than any other writer. His best critic is Arnold Kling, especially with regard to whether there are only two kinds of inflation regimes, low or high and variable. A related question is what a looser monetary policy would have done to financing the long-run debt burden and the use of the interest rate spread to recapitalize banks.
A few thoughts:
1. It’s nice to be complimented. BTW, did people notice that one of our commenters here (statsguy) had a post that Tyler Cowen named best post of the year? Whatever success I’ve had is mostly due to the good fortune of being promoted by blogs like MR and Econlog.
2. Regarding the impact of looser monetary policy, I put a lot of weight on the correlation between NGDP growth expectations and the severity of the banking crisis. The estimated total losses to the US banking system got worse when NGDP growth expectations were declining, and have improved since NGDP growth expectations began improving.
3. I am a huge fan of Kling’s posts, but I think his strength is micro/public policy/banking and the real side of macro. I still don’t see a persuasive model of nominal shocks. (Persuasive to me anyway.) Of course I focus on nominal shocks, and mostly leave the real side of macro to others. Since the time of David Hume, the best minds in the field have struggled with trying to explain why nominal shocks have real effects. All they have come up with is some lame sticky wage/price models. I won’t be able to do any better, although I suspect the profession slightly underestimates the relative importance of wage stickiness. So I focus on explaining AD shifts, and assume the SRAS is upward sloping when in a recession.
4. Kling also has some astute views on macroeconomic thought. He was the one who noticed that my view should be the standard view of the recession, but for some strange reason isn’t. I didn’t leave the profession, the profession abandoned me. He and I also view the relative popularity of Keynesian and Austrian views as being cyclical. But on purely monetary policy issues, I think Nick Rowe, Andy Harless, and Paul Krugman have been my toughest critics.
Speaking of Kling, here is a recent comment about my views:
Scott Sumner writes,
“The US can’t really use the exchange rate as a policy tool, it is too controversial.”
And so, we have to turn to less controversial tools, like pouring more wood on what the CBO says is a fiscal fire.
That is not what Sumner says, of course. He says that the Fed can just announce a target for nominal GDP, and the markets will obey.
I find that highly implausible for nominal GDP, but I do find it plausible for the exchange rate. If the Fed announced a policy of “20 percent weaker dollar or bust,” and proceeded to buy euros, yen, and other currencies, by golly, I do not think that private speculators would try to get in the way. And if foreign governments tried to get in the way, that would probably lead to some sort of worldwide monetary expansion that I imagine would make Sumner happy.
One point to make here is that this represents another reason to reject the notion of a liquidity trap. If the Fed runs out of T-bills to buy, it can always buy foreign currencies.
I agree about the liquidity trap; Svensson, McCallum and many others have pointed out that currency depreciation is a foolproof way out of liquidity traps. And FDR showed it works. I shouldn’t have said the Fed “can’t” do it; the problem is that they won’t because it will be (wrongly) viewed as a beggar-thy-neighbor policy. There are two problems with that argument. First, any expansionary policy, even QE, will depreciate the dollar. Indeed the dollar fell sharply in March 2009 on the date that QE was announced. But if the Fed specifically targets the exchange rate, the Europeans and Japanese will whine ”beggar-thy-neighbor.” The other problem is that under a fiat money regime, other countries can easily prevent any US currency depreciation from reducing their NGDP. Of course if they offset the US action, their currencies will also depreciate. All currencies cannot depreciate against each other, but they can all depreciate against goods and services.
I’m not sure why Kling doesn’t think NGDP targeting would work. Remember, I want to target expectations. Just eliminate interest on reserves and do enough QE so that NGDP expectations rise to the desired level. You will also depreciate the dollar as a side effect. Since he thinks dollar depreciation works, why wouldn’t other actions that have a side effect of depreciating the dollar also work? BTW, I don’t claim announcing a target is enough; you must also accommodate the public’s demand for base money at that target. Kling continues:
However, I cannot leave this issue without referring to the two-regime theory of monetary policy, which would say that this sort of policy risks moving the U.S. into a regime where the inflation rate becomes high and variable. Instead of keeping cash in mattresses, people will try to conserve on cash, and this will raise the velocity of money, even as the Fed is expanding the money supply. There is a risk that we will overshoot the inflation target. If higher inflation solves a lot of our unemployment problem, then, fine, Scott Sumner is a hero. If not, then, well, he is something else.
I’m not at all worried about being tarred and feathered, because I favor targeting expectations, and also level targeting. That combination will prevent an outbreak of inflation. If you need to drain a trillion in base money out of the system in one day—you do it. Indeed if an outbreak of inflation were to occur, I could get rich by going long on CPI futures, with no risk. I seriously doubt there will ever arise an economic scenario where I could become rich at no risk.
Technically the preceding argument assumes that the price level doesn’t wildly gyrate around the 2% growth trend (if we assume 2% inflation is the Fed’s target.) I suppose you could have 12% inflation one year and negative 8% the next. But the volatile part of the CPI is commodities like food and oil, and intertemporal arbitrage prevents that sort of response to monetary shocks. The bigger (core) part of the CPI is mostly driven by wage growth, and is very inertial. Believe me, if you keep price level expectations in the TIPS markets growing along a 2% upward sloping trend line, the actual CPI is not going wildly fluctuate above and below that level, unless there are some pretty big supply shocks that have nothing to do with monetary policy. Ditto for NGDP targeting.
Fear of overshooting toward a high inflation scenario is common among economists, but represents 1970s thinking. There were no TIPS markets warning us about rising inflation expectations back then. If it happens again, we will be able to watch the accident in slow motion, hour by hour in the TIPS markets, and will have no one to blame but ourselves. I’ll refuse to take the rap.
There are dozens and dozens of developed countries. How many have experienced double digit inflation in the past 20 years? There’s a reason for that.