The other money illusion

“But they have already done so much!”

I hear this all the time.  In fact the Fed has done almost nothing to stimulate the economy.  Behind the widespread misconception lies an interesting story, and perhaps the key to the current crisis.

One of my first blog posts was “What would really, really, really tight money look like?“  In a nutshell, it would produce depression and disinflation, and that would drive nominal interest rates close to zero.  If the banking system was already shaky (as in early 2008), it would produce a full blown financial crisis (as in late 2008.)  The combination of financial crisis and ultra-low interest rates would dramatically boost the real demand for base money.  If the central bank did not come close to fully accommodating that demand, you’d have severe deflation, a la 1929-33.  More likely, even a conservative modern central bank, like the BOJ, would not allow deflation of more than about 1% per year.  So if the real demand for base money rose sharply, the central bank would accommodate that with a much higher supply of cash and reserves.  To summarize, a really, really tight money policy would probably lead to:

1.  Near zero interest rates

2.  A large increase in the monetary base.

Unfortunately, most economists and central bankers regard those two indicators as showing a really, really easy monetary policy.  Which is why we are where we are.

Just yesterday I heard a reporter talk about how the Japanese have tried to escape deflation for 15 years, but find it very difficult.  In an earlier post I pointed out that Japan had gotten almost exactly the price level path that they said they wanted—stable prices.  More importantly, they’ve consistently acted as if they didn’t want any inflation, tightening policy at least three times when inflation was near zero.  But the myth that low rates and a bloated base mean easy money is so powerful that even Nobel Prize-winning economist can get sucked in despite all logic pointing in the other direction:

1.  The BOJ says they want stable prices.

2.  The BOJ acts as if they don’t want any inflation.

3.   Japan has a very stable CPI, almost unchanged from 1994.

But at least Paul Krugman wants easier money, and thinks the Fed can do it.  The myth of easy money causes even greater problems when it leads the Fed hawks to oppose stimulus, because they believe the current Fed stance is already highly stimulative, and hence a potential inflationary time bomb.  To show how powerful this misconception is, consider the ultra-respected Frederic Mishkin, who in his textbook emphasized that low rates don’t mean easy money, but when faced with real world application of his insight, blinks:

Purchasing long-term Treasurys might suggest that the Fed is accommodating the fiscal authorities by monetizing the debt—thereby weakening the government’s incentives to come to grips with our long-term fiscal problems. In addition, major holdings of long-term securities expose the Fed’s balance sheet to potentially large losses if interest rates rise.

Such losses would result in severe criticism of the Fed and a weakening of its independence. Both the weakening of its independence and the perception that the Fed is willing to monetize the debt could lead to increased expectations for inflation sometime in the future. That would make it much harder for the Fed to contain inflation and promote a healthy economy.

Expanding the Fed’s balance sheet through large-scale asset purchases can be necessary in extraordinary circumstances, such as during the depths of the recent financial crisis. But in relatively normal times, the costs of using this tool are sufficiently high that it should not be used lightly.

But I think there is an even more dangerous effect of the widespread view that the Fed is already trying really hard.  It leads the good guys, the stimulus advocates, to become pessimistic—advocating radical and unrealistic proposals to try to jump start the economy.  They seem to believe that if even all this hasn’t worked, then truly extraordinary measures are necessary.  They talk of helicopter drops (i.e. monetization of new fiscal initiatives) or zany schemes to pay negative interest rates on money.  I’m all for negative rates on ERs; but currency?  Consider this recent proposal by Willem Buiter:

The first method does away with currency completely. This has the additional benefit of inconveniencing the main users of currency-operators in the grey, black and outright criminal economies. Adequate substitutes for the legitimate uses of currency, on which positive or negative interest could be paid, are available.

The second approach, proposed by Gesell, is to tax currency by making it subject to an expiration date. Currency would have to be “stamped” periodically by the Fed to keep it current. When done so, interest (positive or negative) is received or paid.

The third method ends the fixed exchange rate (set at one) between dollar deposits with the Fed (reserves) and dollar bills. There could be a currency reform first. All existing dollar bills and coin would be converted by a certain date and at a fixed exchange rate into a new currency called, say, the rallod. Reserves at the Fed would continue to be denominated in dollars. As long as the Federal Funds target rate is positive or zero, the Fed would maintain the fixed exchange rate between the dollar and the rallod.

When the Fed wants to set the Federal Funds target rate at minus five per cent, say, it would set the forward exchange rate between the dollar and the rallod, the number of dollars that have to be paid today to receive one rallod tomorrow, at five per cent below the spot exchange rate-the number of dollars paid today for one rallod delivered today. That way, the rate of return, expressed in a common unit, on dollar reserves is the same as on rallod currency.

Exchange our precious dollar for “rallods” worth 95 cents?  Perhaps Mr. Buiter would like to present that idea at a Tea Party event.  I’m sure they’d love it. 

I shouldn’t be sarcastic, his is one of the few ideas that would definitely work.  But let’s be real here; if the Fed won’t do even modest changes, what chance do we have of convincing them to do something radical?  Even worse (indeed much worse) floating these ideas leads to pessimism, a sense that nothing can be done.  But Ben Bernanke has said that there are lots of things that could be done.  We should take him at his word.  He named 4 options; then said that as of now they didn’t plan to use them, but hinted they would if disinflation got worse.  I outlined a very modest proposal that would provide substantial stimulus.  The most important component of my proposal was a 2% core price level target, level targeting, starting at September 2008.  That would require the Fed to set a 2.7% target for the next two years (to catch up for the current 1.4% shortfall from trend), and then 2% thereafter.  Reporters should be asking him why even that is considered too radical by the Fed, and why they have instead set policy at a position expected to lead to 1% annual core inflation for the next couple years.

So both hawks and doves are missing the boat.  The Fed hasn’t done a lot, which means even modest stimulus can do a lot more.  What looks like ultra easy money is actually a symptom of earlier tight money.  The term “money illusion” usually refers to a confusion between real and nominal variables, which contributes to nominal shocks having real effects.  It’s one of the reasons a drop in AD causes recessions.  But there is an even more pernicious form of money illusion, the belief that really, really tight money is actually easy money.  This is why we continue with monetary policies that are in almost no one’s best interest.  So money illusion of one type causes inadequate AD, and money illusion of the other type explains why inadequate AD reduces real GDP.

Some will argue that it is implausible that a smart man like Bernanke, and a smart institution like the Fed, and a smart group of elite macroeconomists, could all be suffering from monetary policy illusion.  But don’t we now know that the Great Depression was in part caused by the widespread illusion that money couldn’t be the problem, low rates and a big base showed it was easy?  And don’t we now know that the Great Inflation was in part caused by the widespread view that high interest rates showed easy money wasn’t the problem?  And wasn’t the Iraq fiasco caused in part by the widespread view that any dictator that once worked on nukes, and later kicked out weapons inspectors, must have something to hide?  Huge policy errors can and do occur due to misconceptions, illusions.  And it’s happening again.

Heh, someone should name a blog after money illusion.

HT:  Mark Thoma, Clark Johnson


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53 Responses to “The other money illusion”

  1. Gravatar of Benjamin Cole Benjamin Cole
    11. September 2010 at 11:42

    Yet another excellent post by Scott Sumner. When, oh when, did we start to worship 1 percent inflation, or even the mythical “price stability,” more than real economic growth?
    Zero inflation is a dangerous utopian pipe dream, to be achieved only at the cost of a Japan-type economy. Remember, on a per capita income growth basis in the last 20 years, Japan has been bested not only by the USA, but by …statist France. France!
    The dithering Japan wing of the Fed will suffocate our economy while pettifogging about price stability.
    It seems we are going down the Japan path of fiscal deficits but coupled with monetary stifling. That leads to chronic deficits and low growth. Your children will inherit an indebted but weak economy, where asset values have been falling for decades. Wonderful.
    Now, you have people like Fed Dallas President Richard Fisher posturing that more QE “might” cause inflation (you know, because Obama is president), so we can’t do it. Of course, less stimulus “might” cause deflation, no?
    BTW, the Boskin Commission found that modern inflation measurement methods probably overestimate inflation by 0.5 percent or so, for reasons you would suspect, such as consumers and businesses constantly migrating to cheaper products and services, and new improved product introductions.
    So, if we are at 1 percent CPI, we could be “really” at 0.5 percent.

    Unless the Fed starts singing a new tune, look forward to years of doldrums.

  2. Gravatar of Niklas Blanchard Niklas Blanchard
    11. September 2010 at 12:19

    I was scared when you insulted an idea that I hold very dear (demurrage on currency). But at least you admitted that it would work.

  3. Gravatar of Morgan Warstler Morgan Warstler
    11. September 2010 at 12:36

    Scott, yes let’s be real here.

    “Purchasing long-term Treasurys might suggest that the Fed is accommodating the fiscal authorities by monetizing the debt—thereby weakening the government’s incentives to come to grips with our long-term fiscal problems.”

    Mishkin is being REAL. Before he even mentions the balance sheet, he says MAKE THE DEMS BEND.

    This is the exact same stance as Friedman would take (or you are lying to yourself). It is the same position I take…

    Just because we can juice the system doesn’t mean we should… we have favorites, and if we have cards up our sleeve we play them when our team is winning, when we accrue the advantages.

    How can you demand we “be real,” when you are pining away like an idealistic 21 year old?

    —–

    Which leads me to a pure policy question over long term institutional knowledge….

    If you have a strong policy preference, something you really believe needs to be embedded into our future selves… a brand new rule….

    Then you 100% want it to be deployed with enough time/space before it is enacted, that future economists / politicians will not be able to argue that it wasn’t your policy that saved the day.

    In business this is said, “when you are absolutely sure you are right, do it the other guy’s way first.”

    Do it with a smile on your face, and make sure know one can say you dragged your feet, just makes sure the other guy owns it, so when you save the day – a deep lesson is learned by all.

  4. Gravatar of e e
    11. September 2010 at 13:54

    If the BoJ has had essentially flat inflation for the last 15+ years shouldn’t expectations anchored to that level yet? If monetary policy is consistent can you explain a lost two decades with any sticky parameter?

  5. Gravatar of Mark A. Sadowski Mark A. Sadowski
    11. September 2010 at 14:32

    e,
    I suspect you may already know the answer to your question.

    If wages/prices are downwardly sticky then doesn’t it make sense that there is a threshold below which any reduction in the inflation rate would greatly reduce efficiency in the factor markets? The Japanese have surely tested it to their great dissatisfaction. Empirical research suggests that rate is about 2% and we have evidently already exceeded it to our own great dissatisfaction.

  6. Gravatar of 123 – TheMoneyDemand Blog 123 - TheMoneyDemand Blog
    11. September 2010 at 14:48

    Japan is one of those interesting cases where Krugman is wrong. He says about 2006:
    ” You can see that reduction in the monetary base in the chart above; it doesn’t look that dramatic to me, but in any case I understood it in terms of the same kind of debate that’s currently going on at the Fed: some central bankers are just itching to exit from unconventional monetary policy. The BOJ didn’t tighten to head off inflation; it skimmed off some of those excess reserves because it believed, wrongly, that the economy was OK, and wanted to go back to business as usual. ”

    Yet when I read BoJ’s 2006 July decision: http://www.boj.or.jp/en/type/release/zuiji_new/k060714.pdf
    it clearly says they want to reduce the inflationary pressures.

  7. Gravatar of e e
    11. September 2010 at 15:36

    Mark,

    I did not think of that but it is pretty intuitive. I was under the impression though that the 19th century had a lot of growing economies with natural deflation. Obviously with the gold standard the Fed couldnt generate deflationary surprises but wouldn’t sudden increases in demand for safe assets create surprise deflation? how does that square with your explaination?

    Judging by your last response I assume this is pretty well understood macro, but I think I know a lot less macro than you thought so I appreciate you walking through it with me.

  8. Gravatar of Joe Calhoun Joe Calhoun
    11. September 2010 at 15:57

    This might be a stupid question but does the Fed really target CPI? Can they really believe the CPI is a true reflection of monetary policy? The period from the early 80s to the mid 00s was about the most stable period of CPI in history (well since the start of the Fed anyway) and the results aren’t exactly anything we should be celebrating. A couple of real estate crashes, two stock market crashes and the near destruction of the banking industry – twice, at least – is not a good track record. Why do they resist acknowledging the obvious? Scott, I know you advocate targeting NGDP but that market doesn’t exist so can’t the Fed at least target a market variable that does exist? The dollar? Credit spreads? Something, anything for God’s sake that gives a better indication of the state of monetary policy?

    I don’t know about the rest of you but I’m beginning to see the attraction of the gold standard. At least it’s consistent. Does anybody really know what the hell the Fed is watching? They claim to want 2% inflation but accept 1%. Well what the hell is it? 1 or 2%? Or is that just a misdirection and Bernanke is actually targeting something else entirely? If he is, why is it such a secret?

    I am beyond frustrated with this bunch. Smart? I’m beginning to wonder.

  9. Gravatar of Mark A. Sadowski Mark A. Sadowski
    11. September 2010 at 16:18

    e,
    Not a problem.

    The big problem is with the supply of gold.

    If there had been a Fed in the 19th century it would have tried to control the price impacts. There is no such thing as natural price deflation. Planned price deflation at a certain pace is impossible, especially if you pin prices to a commodity (such as gold).

  10. Gravatar of Mark A. Sadowski Mark A. Sadowski
    11. September 2010 at 16:40

    e,
    The big problem with pinning prices on commodities is that they are erratic. Anyone who thinks that is the solution doesn’t follow the markets very well. In short, they are naive.

  11. Gravatar of e e
    11. September 2010 at 17:02

    I am not arguing that… or really any policy, I thought that the 19th century featured sustained deflation and robust growth, which would be surprising given the model you gave me earlier. I didnt put a lot of thought into the word “natural”

  12. Gravatar of Mark A. Sadowski Mark A. Sadowski
    11. September 2010 at 17:27

    e,
    Actually the the late 19th century displayed below average GDP per capita growth and above average unemployment(as much as we know) compared to our own period. This is not surprising. It was the period known as the Gilded Age.

  13. Gravatar of Mark A. Sadowski Mark A. Sadowski
    11. September 2010 at 17:44

    e,
    Think grey, dried out “Kansas” as portrayed in the “Wizard of Oz”. Or think “The Cross of Gold Speech” on Bryan’s trip to the nomination.

    (Get It?)

    Or think the many millions who read “Coin’s Financial School”. People then did. In short life was not good in the late 19th centuary.

  14. Gravatar of Mark A. Sadowski Mark A. Sadowski
    11. September 2010 at 18:02

    e,
    Just to reiterate, I speak for myself not for Scott. I’m sure he disagrees with me on one point or another.

  15. Gravatar of Mark A. Sadowski Mark A. Sadowski
    11. September 2010 at 18:14

    The model I follow is the one which expands AD and thus increases output and price level. If there is another model than that than I am not familiar with it.

  16. Gravatar of Ted Ted
    11. September 2010 at 18:29

    I think Bernanke is actually in a trap here. He probably can’t convince the hawks to do the ideal policies and so he can’t go around arguing in favor of them. My guess is once the FOMC transcripts come out he’ll be vindicated, or at least held less harshly in historical light.

    The problem with the Federal Reserve is a lot of the FOMC members simply don’t know much about this stuff. They probably do think interest rates or the monetary base indicate the stance of monetary policy. You have Elizabeth Duke with no background in economics at all (her degree is actually in drama). Same goes for Dennis Lockhart whose background is “foreign service” (what the hell is that?) and international relations. Daniel Tarullo and Kevin Warsh are lawyers. And I haven’t even got to the people with economic backgrounds and considered how minimal they are, especially in the field of monetary economics. I think Bernanke and Charles Evans are the only people there with serious background in this stuff.

    On economists – I actually don’t know what’s going on with economists, or at least the ones that are published in the press. We have some of the Non-Keynesians (e.g. New Classic / Monetarist guys) either thinking hyperinflation is coming because of some bizarre fiscal inflation theory or because of the large monetary base. And the New Keynesian’s believe either one of two things. They either have confused themselves into thinking interest rate policy signals the ease or looseness of monetary policy (even though the models don’t say that). Or they really do believe central banks have almost no credibility and so they have a deflationary bias / expectation trap problem – a problem which I think pretty much only applies in some third-world central bank, not the United States or any developed economy for that matter. The the most basic New Keynesian model gives a pretty clear explanation of what optimal policy is so I’m confused how these NK guys are all confused. Now I’m sure someone like Michael Woodford knows that policy is too tight and the Federal Reserve could alleviate that, but I haven’t seen him say anything about it. Really the only New Keynesian economist I have read a paper on that confronts the Federal Reserve is a recent one by Ricardo Reis of Columbia University (whose sticky information models I find interesting as they can be made consistent with asset prices immediately moving, while still having the lagged effects on real output – though I’m not sure if it’s the correct model, I just find it interesting). He essentially argues the liquidity trap is fictitious; that the key is to raise inflation expectations; that this should be accomplished by a price-level target (or maybe even nominal income target as I know he has endorsed a nominal income target in a separate paper). He also criticizes the Fed for their vagueness about their intentions as well as their credit policies which he argues were probably ill designed.

  17. Gravatar of Mark A. Sadowski Mark A. Sadowski
    11. September 2010 at 18:50

    Ted wrote:
    “Elizabeth Duke with no background in economics at all (her degree is actually in drama). Same goes for Dennis Lockhart whose background is “foreign service” (what the hell is that?) and international relations. Daniel Tarullo and Kevin Warsh are lawyers.”

    And so on and so forth. It’s rather depressing to those of us who’ve made it our life study. You’re point being that the PEOPLE WHO SAY THEY KNOW WHAT THEY ARE DOING ARE IN CHARGE.

  18. Gravatar of e e
    11. September 2010 at 18:52

    Makes sense. Thanks.

  19. Gravatar of Mark A. Sadowski Mark A. Sadowski
    11. September 2010 at 19:02

    Aaarg! I’m going to bed!

  20. Gravatar of Mark A. Sadowski Mark A. Sadowski
    11. September 2010 at 19:33

    But before I go….

    Inspiration, move me brightly
    light the song with sense and color,
    hold away despair
    More than this I will not ask
    faced with mysteries dark and vast
    statements just seem vain at last
    some rise, some fall, some climb
    to get to Terrapin

    Counting stars by candlelight
    all are dim but one is bright:
    the spiral light of Venus
    rising first and shining best,
    From the northwest corner
    of a brand-new crescent moon
    crickets and cicadas sing
    a rare and different tune

    Terrapin Station
    in the shadow of the moon
    Terrapin Station
    and I know we’ll be there soon

    Terrapin – I can’t figure out
    Terrapin – if it’s an end or the beginning
    Terrapin – but the train’s got its brakes on
    and the whistle is screaming: TERRAPIN

    Good night sweet folks!

  21. Gravatar of W. Peden W. Peden
    12. September 2010 at 05:32

    Joe Calhoun,

    Targeting CPI is ridiculous as a macroeconomic stabilisation policy, but even the Bank of England has taken it up (since about 2002 I think). In fact, the BoE has systematically torn apart the great regime designed by Norman Lamont in 1992, which was Retail Price Inflation targeting + monitoring extreme movements in the exchange rate and narrow money. I would have preferred broad money though.

    I note in the Sunday Times that Obama is apparently thinking about a further $180 billion stimulus. It looks more and more like the US might be looking at a Japanese style Lost Decade and long-term economic malaise, although at least it doesn’t have Japanese demographic problems.

    As this particular blog entry shows, there’s no sign that the lessons of the 1930s or 1990s have been learnt or at least not learnt in such a way as to translate into policy.

  22. Gravatar of scott sumner scott sumner
    12. September 2010 at 05:39

    Benjamin, That’s also what I am worried about.

    Niklas, Yes, but it’s still a terrible idea. They should just use the tools that Bernanke discussed, if they are serious about more inflation.

    Morgan, Who is “our team?”

    e, You said;

    “If the BoJ has had essentially flat inflation for the last 15+ years shouldn’t expectations anchored to that level yet? If monetary policy is consistent can you explain a lost two decades with any sticky parameter?”

    I have three responses:

    1. The Japanese problems are mostly supply-side.
    2. Wages are sticky downward, so its hard to adjust to falling NGDP per capita (as in Japan), even if expected.
    3. Within that time period there have been periods of falling prices, like right now.

    Mark, I basically agree, except I’d use 2% per capita NGDP growth, not 2% inflation.

    123, Thanks, I wish I had had that info when I did my previous post on Japan.

    e, You said;

    “I did not think of that but it is pretty intuitive. I was under the impression though that the 19th century had a lot of growing economies with natural deflation. Obviously with the gold standard the Fed couldnt generate deflationary surprises but wouldn’t sudden increases in demand for safe assets create surprise deflation? how does that square with your explaination?”

    Another good question. Again I have several responses:

    1. Monetary policy was more expansionary in the US than in Japan during the past 16 years. In Japan there has been virtually no NGDP growth. In the US NGDP grew substantially.

    2. The deflation was uneven, and there were sizable depressions in the years when prices fell rapidly (1873-75, 1893-95 I believe.)

    Joe Calhoun, You said;

    “This might be a stupid question but does the Fed really target CPI? Can they really believe the CPI is a true reflection of monetary policy? The period from the early 80s to the mid 00s was about the most stable period of CPI in history (well since the start of the Fed anyway) and the results aren’t exactly anything we should be celebrating. A couple of real estate crashes, two stock market crashes and the near destruction of the banking industry – twice, at least – is not a good track record. Why do they resist acknowledging the obvious? Scott, I know you advocate targeting NGDP but that market doesn’t exist so can’t the Fed at least target a market variable that does exist? The dollar? Credit spreads? Something, anything for God’s sake that gives a better indication of the state of monetary policy?”

    I strongly disagree with the way you characterize monetary policy (although like you, I oppose CPI targeting.)

    I think 1983-2007 was the best 25 years in American macro history, the most stable. Can you find another 25 years that were better?

    The recent problems occurred precisely because they abandoned that policy. The tech crash didn’t cause much damage to the economy, and the 1980s S&L problems were a lagged reaction to the very high inflation and interest rates of the early 1980s, along with perhaps deregulation. Fed policy post-1983 wasn’t to blame.

    Mark, Just to add a few points, Id look at NGDP growth, which was substantial during the late 1800s. Also it is volatility that matters most. And finally, wages were far more flexible then, so a given nominal shock didn’t matter as much. Almost half the people were farmers, with 100% flexible wages and prices.

    Ted, Excellent post, I agree with almost everything you said. I don’t know your background, but I believe that you know more monetary theory than 90% of America’s macroeconomists. I am blessed with many other highly knowledgeable commenters who seem to know things the economic establishment has forgotten.

    Morgan, You’re another example of what I just wrote. Thanks for the poem.

    :)

  23. Gravatar of scott sumner scott sumner
    12. September 2010 at 05:42

    W Peden, Good points.

  24. Gravatar of Joe Calhoun Joe Calhoun
    12. September 2010 at 06:27

    Scott,

    I know you won’t agree with this either but it seems to me that whatever “stability” we got in one set of economic variables over that time frame, we gave up in others. Why did that period also see a near constant rise in the level of debt? Why did the savings rate fall constantly during that time? Wouldn’t we be in a better position right now if we had saved more and consumed less over that time? Did monetary policy have nothing to do with those spending/savings decisions? We may have gained more stability in GDP and CPI but at the expense of increased dollar volatility. Were there no consequences for that? The explosion in the use of derivatives over that time is no coincidence given that dollar volatility is directly correlated to commodity and interest rate volatility. Is the diversion of capital required to hedge the consequences of dollar volatility costless to the economy? What is the cost to the Japanese people of our bullying them to raise the value of the yen in the Plaza Accord to “solve” a trade deficit of our own making? Concentrating on the stability of CPI and GDP had a huge cost that monetary policy was able to defer for two and half decades. Now it appears the bill is due.

  25. Gravatar of Philo Philo
    12. September 2010 at 08:37

    Your post primarily concerns monetary theory, but a philosophical sidelight caught my attention.

    Though we often employ it, the commonsense, intuitive contrast between activity and passivity has virtually no theoretical value (see Jonathan Bennett’s *The Act Itself*; also the fact that the distinction has, in recent times, quite lost the status it had been given in earlier philosophy); indeed, it is inapplicable in many contexts. In the case of the Fed, the important issue is whether it is achieving the goal(s) for which it has been assigned responsibility. However one attempted to measure Fed “activity,” the *amount of its activity* would be irrelevant: if it could have achieved its goal(s) and did not, it deserves blame.

  26. Gravatar of Philo Philo
    12. September 2010 at 09:11

    Mark A. Sadowski writes that, since “wages/prices are downwardly sticky[,] . . . there is a threshold below which any reduction in the inflation rate would greatly reduce efficiency in the factor markets . . . . Empirical research suggests that rate is about 2% . . . .”

    I have the impression that Scott does not agree that 2% (or even something slightly higher?) is the *ideal rate of inflation*. His commitment to 5% per annum expected NGDP growth seems “soft,” based on the recent history of ca. 2% inflation; for the long run he is sympathetic to a lower figure (3½%? 3%?) that is compatible with price (near-)stability. But I do not know why he does not agree, since he does seem to agree that wage/price downward stickiness is the cause of our economic malaise.

  27. Gravatar of W. Peden W. Peden
    12. September 2010 at 09:29

    Philo,

    You seem to be getting at the very important distinction between “activity” and “work”, which is all too easily forgotten! All work involves activity, but not all activity is work.

  28. Gravatar of Lee Kelly Lee Kelly
    12. September 2010 at 10:49

    The market exchange ratio of good money should be constant (or slightly rising over time if prices are less flexible downward). This fact seems elementary: a commodity that appreciates or depreciates unexpectedly does not a good medium of exchange make, especially for long-term transactions. Maintaining a constant (or slightly rising) exchange ratio for money is pretty much the same as targeting nominal expenditure. Am I wrong? If not, how does it seem to escape the attention of so many economists?

    Of course, I think we need competing monies. If the Fed is supplying bad money, then a profit opportunity exists for some entrepreneur to do a better job!

  29. Gravatar of Lee Kelly Lee Kelly
    12. September 2010 at 11:18

    Philo,

    The notion that the distinction between “activity and passivity has virtually no theoretical value” strikes me as silly, at least when interpreted broadly. In the context of economics, it is often useful to define passivity as a type of action, but only because the “intuitive contrast” is normally irrelevant to the problems economists are interested in. (Mises made a big deal of this near the beginning of Human Action). But one should be careful not to mistake such redefinitions as insight into the true “essence” of action — whatever that means.

    There is a kind of paradox to meaning. It is customary to say a term has more meaning when it refers to more, i.e. when it can be used truthfully in more statements. But as a word refers to more and more it eventually ceases to make any distinction at all and becomes meaningless — such as the word “freedom” in the mouth of a politician. The unintuitive result is that a term is more meaningful, i.e. more informative, when it refers to less (but more than nothing).

    The “theoretical value” of a term like “action” tends to disappear in contexts where it does not make a relevant distinctions. But sometimes that distinction is useful to the problem which a hypothesis is intended to solve, and so in everyday life the distinction between action and passivity is informative and useful.

  30. Gravatar of Greg Ransom Greg Ransom
    12. September 2010 at 12:47

    What to you make of William White’s Jackson Hole paper?:

    http://www.kansascityfed.org/publicat/sympos/2010/white-remarks.pdf

  31. Gravatar of David Beckworth David Beckworth
    12. September 2010 at 16:12

    Mark A. Sadowski:

    A couple points on your conversation with e.

    (1)As an advocate of NGDP targeting you do implicitly allow for a “natural price deflation” given a sufficiently large positive shock to aggregate supply (AS). As you know, all that NGDP targeting does is to stabilize the the growth path of aggregate demand (AD). So given a sufficiently large positive AS shock (e.g. permanent increase in productivity growth rate) there can be deflation and it will be associated with robust economic growth. For example, if we take 5% NGDP growth and a productivity surge pushes up real GDP growth to 6%, then there has to be 1% deflation.

    All the problems associated with an AD-induced deflation do not apply with AS-induced deflation, at least those caused by a productivity boom. First, even if there are sticky wages labor does not suffer. The real wage increases through the drop in the price level–workers’ purchasing power rise. Second, any unexpected increases in real debt burdens are offset by unexpected increases in real incomes–no debt deflation problems. Third, financial intermediation does not suffer since the productivity boom increases expected future earnings and thus assets prices (i.e. collateral values) go up. No balance sheet problems. Finally, the productivity surge should push up the real interest rate and provide an offset to the deflation drag on the nominal interest rates. Thus, the zero bound is unlikely to be a problem.

    (2) If one looks at the Postbellum period of deflation (1867-1897) and compares it with the Postbellum period of inflation (1898-1914)there is no clear advantage to the inflationary regime. By most measures the deflation period did just as well and in some cases better. And that is despite having the bad batches of AD-induced deflation (1873-1875, 1893-1896)throw in to the deflation sample. Most of the deflation was of the AS kind. Note also that this was 30-year period of sustained decline in prices and yet the U.S. economy still became the leading industrial power by that time. It was also a period during which financial intermediation in increased overall (there were setbacks during the the 1873-1875 and 1893-1896, but the over trend was upward). (BTW, problems like the agrarian revolt were structural in nature and would have happened regardless of monetary regime.)

    Sorry I had to say all that, but I didn’t want e to think he was to far off base regarding the Postbellum period. I know we agree fully that problem today is the possibility of AD-induced deflation and that the Fed is doing way too little to address it. We can save this debate on the “good deflation” when we actually get some (which would take something of a miracle at this point since I don’t see any thing that would cause a productivity boom in the near future).

  32. Gravatar of scott sumner scott sumner
    12. September 2010 at 16:23

    Joe Calhoun; You asked

    “I know you won’t agree with this either but it seems to me that whatever “stability” we got in one set of economic variables over that time frame, we gave up in others. Why did that period also see a near constant rise in the level of debt? Why did the savings rate fall constantly during that time? Wouldn’t we be in a better position right now if we had saved more and consumed less over that time? Did monetary policy have nothing to do with those spending/savings decisions?”

    The debt and saving numbers were bad, but they reflect bad fiscal policies, not bad monetary policies.

    Yes, we should have saved more.

    Yes, monetary policy has nothing to do with the savings shortfall.

    You asked:

    “We may have gained more stability in GDP and CPI but at the expense of increased dollar volatility. Were there no consequences for that?”

    I can’t think of any downside to dollar volatility. Hedging isn’t that costly, certainly not compared to the huge macro instability associated with pegging a currency.

    You asked:

    “Is the diversion of capital required to hedge the consequences of dollar volatility costless to the economy? What is the cost to the Japanese people of our bullying them to raise the value of the yen in the Plaza Accord to “solve” a trade deficit of our own making?”

    We should not have pressured the Japanese, but their problems are self-inflicted. As you see with China, the US does not punish countries that don’t take our advice on exchange rates. We simply don’t have the stomach for it (thank God.)

    You asked:

    “Concentrating on the stability of CPI and GDP had a huge cost that monetary policy was able to defer for two and half decades. Now it appears the bill is due.”

    No, the problem we have now occurred because we’ve moved away from 5% NGDP growth. If 5% NGDP growth had continued, we would not be in a recession right now, and the banking crisis would have been far milder.

    Philo, That’s a very good point, and here is what shocks me:

    Even though what you say is clearly true, 99% of economists do not seem to understand that point. They talk about the Fed doing something or not doing something by looking at whether the interest rate changed, or whether the money supply changed. Theory tells us those variables do not indicate the stance of monetary policy, but 99% of economists simply go ahead and assume they do, seemingly oblivious to the fact that there is no theoretical support for that assumption.

    Lee Kelly, I agree about nominal income. I don’t think however, that there is some logical theoretical answer to monetary policy. I think it depends on the nature of the economy, which is an empirical issue. In my view NGDP works best because of the nature of wage and price rigidity.

    Greg, I don’t find that paper to be very impressive. He seems to be unaware of the role tight money played in the crisis. He seems to not understand the super-neutrality of money. He seems to think monetary policy is ineffective at the zero bound. I’m guessing he would hate this blog.

  33. Gravatar of scott sumner scott sumner
    12. September 2010 at 16:26

    David, Thanks. I defer to your expertise on that era. What you say sounds plausible to me.

  34. Gravatar of TGGP TGGP
    12. September 2010 at 18:16

    Steve Williamson is critical of the recent WSJ roundup of monetary economists (especially Fisher). He also says that the Fed is not “trapped” a la Japan and unable to create inflation, but that we are currently well below a targeted rate of inflation that would have been predictable (the kind of rate that is desirable because we write contracts in nominal terms).

  35. Gravatar of ssumner ssumner
    12. September 2010 at 18:35

    TGGP, Thanks. I’ve already discussed most of those issues quite often. Obviously I agree that the Fed can create inflation if it wants, and it doens’t much matter if they buy T-bills or T-bonds. I don’t support inflation targeting, favoring NGDP targeting over either inflation or the Taylor Rule. And of course I favor targeting expectations.

  36. Gravatar of e e
    12. September 2010 at 18:58

    David,

    Interesting thanks, so are you in agreement with scott about greater labor market flexibility in the postbellum economy, b/c even good deflation should have left the economy vulnerable to an AD shortfall, right?

    Scott,

    The combined explanation between you and Mark made sense but have there any attempts in japan to adjust institutions to make them less vulnerable to a flat inflation environment? It surprises the UofC student in me for a whole nation to keep taking them on the chin for 20 years without trying to adjust, especially since the inflation regime has been pretty consistent and well advertised.

  37. Gravatar of marcus nunes marcus nunes
    12. September 2010 at 19:15

    Jim Hamilton at Econobrowser has lost his mind (or I mine). The link didn´t post so you can check his blog from Scott´s “Sites I Visit” on the right above). One paragraph seemed shoking to me:
    “It is true that price stability– avoiding excessive inflation or
    deflation– has traditionally and quite appropriately been regarded as
    the responsibility of the Fed rather than the Treasury. But I think
    the most important tools at the moment to prevent deflation would be
    exchange-rate targeting, fiscal stimulus, and direct credit extension,
    along with the possibility I’m discussing here of changing the
    maturity structure of publicly held government debt. And all of these
    would more naturally be directed by the White House rather than the
    Federal Reserve”.!!!

  38. Gravatar of Justin Justin
    12. September 2010 at 19:37

    Mark,

    “Actually the the late 19th century displayed below average GDP per capita growth and above average unemployment(as much as we know) compared to our own period. This is not surprising. It was the period known as the Gilded Age.”

    I didn’t think the late 19th century was actually all that bad from a growth perspective. The 1880s looked pretty miserable in terms of growth (slightly negative for the decade based on the data source I was able to find), but the 1870s saw phenomenal real growth despite the long (deflationary) depression.

    Using the dates 1870-1910 (both census years with population counts and the classical gold standard extended into the 20th century), I calculated 4.2% real GNP growth and 2.2% population growth, for ~2.0% real GNP per capita growth over those 40 years. I’ll admit the data isn’t as reliable, and what I have found online might not be the best estimates. While 2.0% real growth isn’t quite as good as what we saw from 1940-1973, it’s still a respectable rate.

    http://books.google.com/books?id=a0SESIMXPcwC&lpg=PA788&pg=PA781#v=onepage&q&f=false

    http://www.u-s-history.com/pages/h980.html

    This paper argues that total factor productivity growth was decent during the late 19th century, and stronger than the late 20th century.

    http://www.scu.edu/business/economics/research/…/field_macroecon_2009.pdf (truncated link, put in search engine)

    It’s hard to find data on the web of unemployment going far back into the 19th century, but I found a link via wikipedia to this paper which suggested low unemployment averages for each decade except the 1870s:

    Stanley Lebergott (1964). Manpower in Economic Growth: The American Record since 1800. Pages 164-190. New York: McGraw-Hill.

    I’m willing to accept that the low unemployment rates were a result of a large population of farmers and that urban unemployment was much higher. The 1870s had a fairly awful average rate. 1893-1897 was clearly very bad as well.

    So from an unemployment perspective there are clearly good reasons to avoid deflation, although it doesn’t seem that periods of sharp deflation damaged real per capita growth too much during the classical gold standard era. I agree with your comments on gold – after reading the Money Illusion (Fisher’s), I was shocked how volatile prices were from the mid 19th century to the late 1920s.

  39. Gravatar of Richard W Richard W
    12. September 2010 at 20:11

    The much missed Professor Buiter’s blog entry from way back 18/11/07 seems prescient about the way the Bernanke Fed was heading.

    ‘ I discern a movement away from the Fed’s symmetric dual mandate to a greater emphasis on price stability as the primary objective of monetary policy. ‘

    http://blogs.ft.com/maverecon/2007/11/

  40. Gravatar of Bill Woolsey Bill Woolsey
    13. September 2010 at 03:55

    Suppose the Japanese price level depends on the expected price level, which is well anchored by the credible BOJ. There may be an output gap, but no one lowers prices because they know the price level will rise again. If the price level did fall, the BOJ would expand the quantity of money, raising money expenditures, real aggregate demand, real output and at least partially close that output gap, and again raise the price level. But the price level never falls, and so the expansion never happens.

    Of course, we know that the price level actually has fallen in Japan from time to time. Still, let us suppose that the process above slows the actual deflation and the BOJ’s actual response. Further, suppose that the impact of expectations gets the price level back up with little monetary expansion, money expenditure expansion, output expansion, or closure of the output gap.

    Naturally, I am groping for an explanation that would allow a target for money expenditures in Japan to generate a stable price level on average and rapid closure of any output gaps.

    By the way, if Japan really is constrained to keep the yen from falling, and they are hard against that constraint, and at the same time they keep the price level stable, doesn’t that imply shifts in net capital flows that would presumably impact the allocation of resources in Japan? Maybe the government needs to constantly borrow more and more domestically?

    If the Japanese save like crazy, and they cannot export savings because that generates trade surpluses that anger foreigners, then don’t they need to have lower real interest rates? If the real interest rate on safe and short assets needs to be negative, and the inflation rate is zero, then the safe and short nominal interest rate needs to be negative. If we have price level target, that would mean, deflation to a lower price level, and then inflation to return to target, and so a negative real interest rate until the target is reached, then you start again.

    My view has been that if you don’t want negative nominal interest rates, (and Sumner has been lambasting that idea,) then the central bank needs to purchase longer and riskier assets. (Contrary to Sumner’s view that they can purchase T-bills because someday the nominal yields on them will rise and the price level will be increased permanently. Of course, that goes with the Dr. Jeckle version of Sumner where he supports price inflation.)

    How can Japan have open capital markets with very low (or negative) real interest rates? Doesn’t that generate the net capital outflow, and lower yen, and a higher trade surplus, all forbidden?

    Obviously, I am not interested enough in Japan. I haven’t even looked at final sales of domestic product, much less tried to generated a trend and look at deviations.

    But my prejudice is that is what they should do. And they should stop trying to stabilize the price level or the exchange rate. I suppose capital incomes could be taxed more heavily at the level of the households. That should reduce the net rate of return while raising the gross rate in Japan. But I wouldn’t really do that, if I were a Japanese politician. Nor would I have the government borrow and pave Japan. I suppose I would fight the special interests in Japan, open markets to imports, and tell the rest of the world not to worry about Japanese net capital outflows and trade surpluses. While that probably wouldn’t work, let the foreigners progressively raise trade barriers.

    If some Japanese nominal interest rates need to be negative, figure out how to do it. Quit basing the monetary system on zero interest currency.

  41. Gravatar of Charles R. Williams Charles R. Williams
    13. September 2010 at 05:33

    Scott: Tight monetary policy causes X. We have X therefore monetary policy is tight.

    Charles: But if Y causes X rather than monetary policy, will QE reverse X? It might help a little. But it matters greatly how it’s done. If the feds buy 30 year treasuries (close substitutes for money) creating excess reserves that bear an above market interest rate, at best nothing will happen. Worst case is the effective money supply will shrink

  42. Gravatar of Philo Philo
    13. September 2010 at 08:24

    @ Lee Kelly:

    “[I]n everyday life the distinction between action and passivity is informative and useful.” Everyday life, yes; theory, no.

    @ Scott:

    Do you believe that for the long run 2% is the ideal rate of inflation, in that the proper NGDP target for the Fed, compatible with 3% RGDP growth, is 5%? An alternative view: in the long run 0% is the ideal rate of inflation, and the Fed’s NGDP target, aiming for 3% RGDP growth, should be 3%. But against this alternative view: because of downward wage/price stickiness, true price-index stability is undesirable; we need 2% inflation. Where do you stand (and why)?

  43. Gravatar of Luis H Arroyo Luis H Arroyo
    13. September 2010 at 09:37

    Yes, a new concept of Monetary Illusion… very good Scott, but here, in Europe, it is much worse. Perhaps in some time, not very much, worse than in Japan.Why Japan has chosen to increase its debt to 200% of NGDP, rather than to slightly increase their CPI? That is a sign of strong conservatism yes, but why during so many years?
    I think now the problem is into the central banks , particularly ECB, which has no idea of what doing. I has bought some bad debt to the banks this summer, but not very much. The banks assets smell not very well. At the same time, public opinion is worried about inflation risk. I´m sorry, but a double (and profound) dip of Europe would not be very good for US.
    (for references: is not a good idea to name the blog after money illusion?)

  44. Gravatar of Mark A. Sadowski Mark A. Sadowski
    13. September 2010 at 15:31

    David Beckworth wrote:
    “I know we agree fully that problem today is the possibility of AD-induced deflation and that the Fed is doing way too little to address it. We can save this debate on the “good deflation” when we actually get some (which would take something of a miracle at this point since I don’t see any thing that would cause a productivity boom in the near future).”

    It’s still never been proved to my complete satisfaction that a good example of deflation even exists. But as long as we acknowledge that the current problem is AD induced deflation then we’re in absolute agreement.

  45. Gravatar of Mark A. Sadowski Mark A. Sadowski
    13. September 2010 at 15:36

    Justin,
    Your points are entirely reasonable and I accept them.

  46. Gravatar of Mark A. Sadowski Mark A. Sadowski
    13. September 2010 at 15:41

    To all (and e in particular),
    I apologize for my lack of inhibition on Saturday. It occasionally strikes me, and then I angrily ramble off what I truly believe. (Oddly, my dissertaion committee wishes it would strike me much more often.)

  47. Gravatar of scott sumner scott sumner
    13. September 2010 at 18:21

    e, It really surprised me too, until we started making the same mistakes. Now I have a better understanding of what went wrong there. I’m guessing that most people in Japan think money is easy, and that the BOJ has done all they can.

    Some people speculate that there is pressure for low inflation because Japan is a nation of savers, with lots of government bondholders.

    Marcus, Yes, I was also disappointed by that Hamilton quote. Why not the 4 stimulus options outlined by Bernanke?

    Justin, Those are good points. There was clearly some supply-side deflation, and some demand-side deflation. And again, we had substantial NGDP growth–unlike Japan.

    Richard W. Yes, but Buiter sure made the wrong call on the most appropriate Fed policy (opposing the Fed’s decision to cut rates a quarter point in December 2007.) The stock market fell sharply because the cut wasn’t even larger, and the US entered recession that month.

    Bill, I don’t think they can target both the price level and the exchange rate. In practice, they have allowed some fairly large fluctuations in the yen’s value. I think they may feel reluctant to explicitly move the exchange rate lower by selling yen and buying foreign assets. After all, they have been criticizing the Chinese for doing exactly that.

    I’m not sure what to say about the real interest rate question. If the equilibrium real rate were negative, and nominal rates fell to zero, do models predict the price level will fall until it is expected to rise?

    As far as Dr. Jeckyl, I still favor NGDP targeting. But if the Fed insists on targeting inflation, I’ll give them advice on what rate is best (or least bad.) For Japan, I’d recommend your 3% NGDP growth target.

    BTW, Congratulations on being elected mayor!

    Charles, I agree that creating more interest-bearing reserves may not accomplish a lot.

    Philo, I favor the same NGDP growth rate regardless of whether inflation is minus 10% or plus 30%. I favor 5% NGDP growth for the time being, and 3% in the long run if we had an ideal futures targeting regime. If we then eliminated taxes on capital (which I favor, I’d probably bump the NGDP target up to 4%. I really don’t believe “inflation” exists, except in the mind of government statisticians. NGDP growth is what matters.

    According to theory, someone who gets a pay increase equal to inflation is just as well off as before. But that’s not true, you need a pay increase equal to your neighbors to feel the same utility level. That’s why NGDP growth is the key.

    Luis, Yes, there is a lot of money illusion in Europe as well, and I do think it is an excellent name for a blog–I hope others adopt it as well, in their own language.

    Mark, No problem. I like people who feel passionately about these issues.

  48. Gravatar of e e
    13. September 2010 at 18:56

    Scott,

    Oh I can probably relate to the public waiting Japan getting confused over macro policy, at least more than you. I meant labor market institutions that would allow for more flexible wages. At some point you would hope potential employees and businesses would find a way to do better than wait for the BoJ to stop doing what theyre explicitly promising to do.

    Mark,

    I appreciate the responses, I found them interesting and convincing.

  49. Gravatar of Mark A. Sadowski Mark A. Sadowski
    13. September 2010 at 19:08

    Your an extraordinary person e. I enjoyed trying to convince you.

  50. Gravatar of ssumner ssumner
    14. September 2010 at 08:05

    e, That’s a good question. We know something about wage and price stickiness, but there remains a certain amount that seems inexplicable–w/o assuming money illusion. i wish I had the answer.

    As I said before, most of Japan’s problems are structural, but I think monetary policy does make things worse.

  51. Gravatar of Mark Mark
    14. September 2010 at 13:54

    Hi Scott, I have a related question which I think touches on this (and hopefully you’ll have time to respond to . . . ).

    UK quarterly inflation has come in above target again at 3.1%. The mainstream media outlets like the BBC are very upset about this and blaming cost-push factors (whole prices etc.). But obviously how this is good news from a NGDP perspective – the combination of an expansionary monetary policy and tightening fiscal policy would be close to what you have advocated in the past. But am I right in thinking that you would chalk this up to the BoE buying different assets than the Fed when it engaged in QE? The BoE do not have a price-level target and are bound by law to try to hit the 2% target so they seem slightly embarrassed by their repeated failure to do so.

  52. Gravatar of MW MW
    15. September 2010 at 04:22

    US Sen Dodd: Could Be ‘Little Appetite’ For Vote On Fed Nominees Before Election. (Newswire headline)

  53. Gravatar of scott sumner scott sumner
    16. September 2010 at 05:02

    mark, You are right that I’d focus on NGDP, so if that is growing rapidly, they are doing a good job. I’d want to look at current NGDP relative to to the 2008 peak, before forming any judgments.

    But I agree, if NGDP is well-behaved then inflation is not a problem, as wages (which are linked to NGDP growth) should also be under control.

    I plan a post soon on the fiscal monetary mix in the UK. I don’t know whether the type of asset purchased made much difference, as I haven’t followed it closely. Currency depreciation probably helped.

    The UK may have some supply-side problems from Brown’s reckless economic policies.

    MW, That’s depressing. I thought Shelby only objected to one. Why not get the other two through? Obama should have done this in January 2009, when he was popular. He made a huge mistake

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