Tyler Cowen and Tinkerbell

Tyler Cowen wrote an excellent column on the dilemmas faced by our monetary policymakers.  Tyler understands that it isn’t even 100% clear who our monetary policymakers actually are, or for that matter, who they should be.  Should Congress set monetary policy, and have the Fed implement their policy?  Should the President?  Or should the Fed set policy?

Given my fanatical views on monetary policy, I’ll find plenty of little things to nit-pick, and one big thing to praise (which many readers might tend to gloss over.)

Tyler’s strength is his ability to translate complex ideas into simple and clear exposition.  While reading the article I occasionally came across statements that I thought oversimplified the issue, or were perhaps slightly misleading.  In each case, however, I couldn’t think of any other way to present the idea, without going way over the heads on the NYT readers.  But you guys are much smarter, so I’ll present a few examples and ask you what you think:

Here’s the problem: The economy needs help, but monetary policy, which is the Fed’s responsibility, has not been very expansionary. This is true even though the Fed has increased the monetary base enormously since the onset of the financial crisis.

How can this be? Supplying more money did not actually result in enough additional spending. The debilitating financial shock of the last few years convinced many consumers and businesses that they needed to save more. So they are holding on to much of the new money.

Given this problem, there is a logical and seemingly simple move available to the Fed: just make people believe that it is seriously committed to increasing the rate of inflation. Traditionally, the Fed has focused on restraining inflation, not stoking it. But these are unusual times.

If the Fed promises to keep increasing the money supply until prices rise by, say, 3 percent a year, people should eventually start spending. Otherwise, if they just held the money, it would be worth 3 percent less each year.

I’d put it slightly differently.  Almost all the new money created by the Fed is now held by banks (as excess reserves.)  So it’s not quite right to say that the problem is that consumers and businesses are sitting on their wallets.  Does this simplification do any harm?  Perhaps not, but I do get a lot of conservative commenters complaining that I am trying to get Americans to save less and spend more.  Not true.  Keynesians are trying to get Americans to save less and spend more.  I am trying to get Americans to consume more and save more.  But most of all, I want them to reduce their demand for base money.  I want them to hoard less cash, not save less income.  That would increase NGDP, allowing both more saving and more consumption.

I’d be thrilled if people and banks started taking all that base money out from under cushions, or out from excess reserves, and started buying assets like bonds, stocks, commercial REITs, etc.  Of course this “spending” isn’t consumption, it’s saving.  But it would boost asset prices and increase investment in the economy.  And that would be great.  So I do have a slight fear that talking about the need for Americans to save less will send out the wrong message, especially to conservatives who have a well-justified instinctive feeling that one of America’s problems is that we don’t save enough.  There’s never a bad time to save more, as long as you don’t increase your real demand for base money.

Tyler’s at his best when considering the issue of credibility:

In a self-fulfilling prophecy, the Fed could stimulate spending and the economy, and at no cost to the Treasury. Of course, if no one believes the Fed’s commitment to price inflation, spending and employment will not go up. The plan will fail, and people will view their skepticism as vindicated.

In other words, one of our economic problems can be solved, but only if we are willing to believe it can.

In a way this is true, but it tends to create an excessive sense of pessimism.  The reader is left wondering how likely it is that American would expect higher inflation, merely because of an announcement by the Fed.  But there’s more to it than that, as proponents of monetary stimulus also favor specific actions, such as negative IOR (Alan Blinder, me), quantitative easing (many of us), qualitative easing (Krugman), etc.  There’s trillions of assets that the Fed could purchase.  It is extremely unlikely that an aggressive move by the Fed would be met by indifference on Wall Street.  And it is Wall Street’s reaction that matters most, not the views of a housewife in Dayton, Ohio.  So the Tinkerbell-like comment “only if we are willing to believe it can” might be misunderstood by the average reader.

Just a few paragraphs later Tyler discusses a much more serious version of the credibility problem:

Part of the credibility problem stems from the political environment, especially in Congress. Imagine the day after the announcement of a plan for 3 percent inflation. Older people, creditors and workers on fixed incomes “” all connected to powerful lobbies “” would start to complain. Republicans would wonder whether they had found a new issue on which to campaign, namely, opposition to inflation. And Democrats would worry about what position to take. Presidents of some regional Fed banks would probably oppose the policy publicly.

Although the unemployed might prefer such a policy, they are not well-mobilized politically. And President Obama is himself politically weak at the moment, so he cannot offer the Fed much cover.

Can the Fed walk down this path without blinking? Perhaps not.

This is a good point, but it also highlights why we absolutely must stop talking about inflation targeting.  Suppose the Fed were to say;

 “For several decades the total income of Americans rose by just over 5% a year, and we had a healthy economy.  In the last two years there has been almost no growth in the total income of Americans.  We are going to adopt a more expansionary monetary policy with the goal of faster growth in aggregate incomes.  If Americans have more income, then they will be better able to service their debts, and the banking system will be in better shape.  Because the economy current has a lot of slack, we believe that we can achieve 7% annual income growth over two years, and 5% thereafter, without pushing inflation above the 2% to 3% norm of recent decades.”

I ask you, which target would be easier to sell to the American people?  Higher inflation, or higher incomes?

Here’s my favorite part of Tyler’s column:

Sadly, although Mr. Bernanke clearly understands the problem, the Fed hasn’t been acting with much conviction. This is understandable, because if the Fed announces a commitment to a higher inflation target but fails to establish its credibility, it will have shown impotence. It would be a long time before the Fed was trusted again, and the Fed might even lose its (partial) political independence. All of a sudden, the Fed would end up “owning” the recession.

I love that last sentence.  I think the Fed is afraid of “owning” the business cycle, and always has been.  But I’m not sure that it is merely because they have a fear of failure.  Indeed before I thought about this issue, I might have expected exactly the opposite of what Tyler wrote.  In an earlier post I pointed out that the Fed faced a very similar decision in late 1937.  At the time there was criticism that the doubling of reserve requirements had reduced the money multiplier and triggered a recession, now there is criticism (by me and David Beckworth) that interest on reserves has reduced the money multiplier and triggered a recession.  In the minutes of the November 1937 Fed meeting, one member all but admitted that the Fed was reluctant to reverse the increase reserve requirements, because that would be tantamount to admitting the Fed was guilty of triggering the recession.  So they put their own reputation ahead of the public interest.  (Yes, I know that powerful people often have trouble distinguishing between the two.)

I already believe the Fed “owns” this recession, but most people don’t.  Suppose the Fed did everything I wanted, and it worked exactly as I thought it would work.  Wouldn’t that cause more people to go back and re-examine what the Fed did in 2008?  Perhaps a few people might start muttering “perhaps Hetzel, Congdon, Sumner, Beckworth, Thompson, etc, were correct about 2008.”

So that was my initial reaction to Tyler’s comment.  But on further reflection I think it may even be worse, Tyler’s interpretation might also be correct.  Indeed I can see two arguments in his favor:

1.  The mere fact that the Fed announced an intention to boost inflation, would suggest that the Fed thought they always had the power to do so, but were reluctant to pull out the “nuclear option” because they didn’t think the recession was that bad.  Maybe (people would mutter) the Federal Reserve elite don’t personally know anyone who is unemployed.

2.  And suppose the policy fails to boost inflation, would that let the Fed off the hook?  I doubt it.  Does anyone believe a determined central bank couldn’t produce Zimbabwe-style inflation, if it bought up the entire world stock of wealth?  In all probability the Fed would fail without playing all their cards.  They wouldn’t have done level targeting, or negative IOR, or unconventional QE (qualitative easing), or something.  They’d be mocked “What, are you guys so incompetent that you don’t even know how to debase your own currency.   Even the Zimbabweans can to that!  No, failure would not be an option.

As much as I hate to admit it, I fear Tyler is right.  The more aggressive the Fed’s move, the more “ownership” they’ll take for the recession.  And that’s true whether they succeed or not.  Indeed the only way it wouldn’t be true is if they did succeed in creating 3% inflation, but unemployment remained high.  I think that’s very unlikely, and I’m pretty sure they do as well.  So they are in a tight spot—just like in the 1930s.  I hope they show more courage than the 1937 Fed.

And finally, Tyler’s column raises a very difficult political problem:

The Federal Open Market Committee, which votes on monetary policy, has three open seats “” a situation that may be hindering the taking of decisive action. The Senate has not been willing to hold a confirmation vote on Mr. Obama’s nominations. But filling the seats is not enough; somehow, Fed officials have to believe that Congress is firmly on their side.

In failing to push harder for monetary expansion, is Mr. Bernanke a wise and prudent guardian of the limited discretionary powers of the Fed? Or is he acting like a too-hesitant bureaucrat, afraid to fail and take the blame when he should be gunning for success?

We still don’t know which narrative is more accurate, but the Fed is not receiving enough signals of support from Congress.

The very fact that Congress and the President are ignoring this issue, pretty much tells me that they are clueless on monetary policy.  On the other hand, both groups do favor more AD, so their “heart” is in the right place.  And of course I’m a big believer in democracy.  So who do I favor making the decisions; the clueless or the heartless?  I’m tempted to say “Whoever agrees with me; first tell me the target Congress would set.”  But of course that’s cheating.  The honest answer is that I don’t know.  But it is becoming increasingly clear that we won’t get good policy until this dilemma is resolved.

HT:  JimP


Tags:

 
 
 

41 Responses to “Tyler Cowen and Tinkerbell”

  1. Gravatar of JL JL
    19. September 2010 at 13:22

    Saving more and spending more is not a free lunch, it’s inflation. And any educated person with an ounce of common sense knows that inflation is a form of taxation .

    These things are highly counter-intuitive. You will have to simplify in a way that resonates with common sense.

    Having dollars sit in bank vaults while businesses go bankrupt and lay off workers because they can’t get a loan. In turn bankruptcies and unemployment cause other businesses not in need of new loans to have less revenue and go bankrupt themselves, defaulting on their loans, causing banks losses and incentivizing them to hoard cash, not lend it.

    Now that resonates with common sense.
    A reasonably educated person can grasp that such incentives could cause a depression, vicious circle, a downward spiral, a self-enforcing negative spiral.

    The solution seems obvious: The government must act as lender of last resort to honest businesses. As a temporary measure to end the loop.

    Of course, this solution amounts to “printing money”, but would you tell this exact same story as “We can solve the depression by printing money”, people would naturally be skeptical.

  2. Gravatar of JL JL
    19. September 2010 at 13:23

    The first paragraph should have displayed something like:

    BEGIN-DEVILS-ADVOCATE
    Saving more and spending more is not a free lunch, it’s inflation. And any educated person with an ounce of common sense knows that inflation is a form of taxation .
    END-DEVILS-ADVOCATE

  3. Gravatar of TGGP TGGP
    19. September 2010 at 13:33

    Bang on the word “investment” to get out of that saving vs consumption dichotomy. The right are the most hostile to inflation, but they like businesses investing. Right now they’re saying businesses think the future is too uncertain because of Obama’s bad fiscal/regulatory policies. Tell them people are uncertain about getting the price level/NGDP back on track, and what they should be complaining about is Obama failing to nominate central bankers! Contrast the Japanese waste of money covering everything with concrete to Australia today or the inflationary Reagan recovery.

  4. Gravatar of Ram Ram
    19. September 2010 at 13:55

    I find it difficult to believe that while the Fed was willing to risk its statutory independence by unambiguously backing the bailouts of the shadow banks, it is unwilling to slightly raise its inflation target (or explicitly commit to a higher than normal target) for fear of losing its independence. I do not doubt that the Fed is always under some political pressure, as Congress & the Administration have the constitutional authority to take back control over monetary policy from the Fed whenever they please. It seems to me, however, that the bailouts, being so politically toxic, posed (pose?) a much greater threat than a controlled rise in the inflation rate.

    The best case the Fed could have made for bailing out the banks despite the political risks involved was that failing to do so would result in a catastrophically weak economy. But that is precisely the result we’re experiencing due to the Fed’s failure to raise its inflation target (or commit to a price level path target, or engage in further QE, or…)! Together with the observation that the majorities in Congress & the White House would benefit greatly from a higher NGDP growth rate in the short run, I find myself unable to place the blame for the Fed’s passivity upon the politicians.

    Even if the president had made his appointments to the Fed earlier, and even if they had been approved more quickly (or made as recess appointments), there would still be hawks on the FOMC, and their dissenting comments to the press would undermine the credibility of, and generate more uncertainty surrounding, any commitment the majority of FOMC members make to any kind of target with which the hawks disagree. The chairman is understandably seeking consensus, which is a means to clarity in the Fed’s communication of its objectives. If we’re going to blame anyone for the Fed’s poor performance during this crisis, we ought to blame the hawks, and perhaps by extension the politicians who made the (unintended?) mistake of appointing them to such powerful positions.

  5. Gravatar of Who Shall Arbitrate? «  Modeled Behavior Who Shall Arbitrate? «  Modeled Behavior
    19. September 2010 at 14:03

    […] that much in late 2008. In any case, I would like to provide a concise answer to a question Scott raises on his blog today: The very fact that Congress and the President are ignoring this issue […]

  6. Gravatar of Jeff Jeff
    19. September 2010 at 14:35

    The bailout of Bear Sterns told the world that Bernanke and Geithner lacked the courage to do the right thing. From that standpoint, all of the subsequent Fed and Treasury failures have been predictable. In support of this view, remember what happened after they blinked first and took $29 billion of Bear’s dogdy assets off of JP Morgan’s hands with only a $1 billion haircut. You might have expected that Bear Stern’s failure would be a shot across the bow that would scare the big banks into deleveraging. But at least some of them took Bernanke and Geithner for suckers and levered up even more.

  7. Gravatar of DanC DanC
    19. September 2010 at 18:34

    Or if you think fiscal policy is so bad that QE will just lead to stagflation.

    People like Taylor seem to be arguing that fiscal policy needs to be reformed

    http://online.wsj.com/article/SB10001424052748703466704575489830041633508.html?mod=WSJ_Opinion_LEFTTopOpinion

    Also Taylor makes the following point about Japan
    “Other interesting points in the speech were that the recent Japanese-style deflation has been remarkably mild compared to the Great Depression and that “Empirical studies on Japan mostly show that quantitative easing produced significant effects on stabilizing the financial system, while it had limited effects on stimulating economic activity and prices.”

    on his blog

  8. Gravatar of Benjamin Cole Benjamin Cole
    19. September 2010 at 19:17

    Another terrific blog by Scott Sumner, who is doing his part to advance the debate.

  9. Gravatar of Lorenzo from Oz Lorenzo from Oz
    19. September 2010 at 20:40

    It is a general principle of analysis: when asking what those in charge of an organisation will do, ask what will most benefit them as the people in charge of that organisation? The decisions of the Catholic Church, for example, are clearly driven by the decision principle: what will best maintain/protect/extend the authority of the priesthood? Do we think the Fed is more altruistic than the Catholic Church? And if so, why?

    That is, after all, one of the fundamental problems with discretion: over time, it will tend to be used to benefit those with the discretion.

  10. Gravatar of greg ransom greg ransom
    19. September 2010 at 21:27

    “I’d be thrilled if people and banks started taking all that base money out from under cushions, or out from excess reserves, and started buying assets like bonds, stocks, commercial REITs, etc.  Of course this “spending” isn’t consumption, it’s saving.  But it would boost asset prices and increase investment in the economy.”

    This is what Hayek & Robbins advocated for Britain in their letter attacking Keynes, in the early 1930s.

  11. Gravatar of MW MW
    20. September 2010 at 01:11

    Scott – am I correct in thinking that you believe NGDP targeting would be ‘better’ (in some sense) than what the Fed has been doing/is doing because it get rids of their discretion?

  12. Gravatar of tweeting tweeting
    20. September 2010 at 02:23

    Not scott here, but NGDP or other measures would allow Fed more freedom to try other and combine more options. The anchor of expectation would’ve allow masking of activities (for average people and politicians). In short, if the existing target prohibits optimal response, the solution is to shift to another target.

    ———————–

    I will disagree with promoting saving through the form of REIT, part of the reasons this blow-up was so bad because housing became the anchor/sole(last) source of saving (investment) (stocks are small time ompare to this in value and in psychique impact). Bonds, stocks and other financial investment services are markedly more “perishable”, and certainly understood so for US citizens. Stop promoting housing as an investment will actually make it safer. Secondly, why are we promoting the rising value of financial assets to stimulate indirectly, consider we can inject economic activity directly? The former has been correctly viewed as a bail-out to those engaged in gaming financial assets by the public. The latter isn’t big enough, as far as keysians are concerned, so rather than 1.5 tril QE for banks, it should have been another 1.5 tril fiscal stimulus on economy directly (QE created excess reserve, did zilch for banking’s real capitalisation). Sorry sumner, it just sounds like something you mentioned in the past, plan from 2nd best guy run by the 3rd best assisted by the 4th. However, negative IOR or zimbabwe style currency debasement for raising inflation (outright stealing) is much better, as their impact gets felt as directly and much faster (not that I prefer it, but its merit for inflation stands).

    As for Bernanke? Sorry, but he has no guts, with or without political support. Volcker had to withstood few years of bashing to administer the cure (initially he had backings of public and congress, but those went away fast as induced recession shock hits).

  13. Gravatar of StatsGuy StatsGuy
    20. September 2010 at 04:44

    ssumner:

    “I am trying to get Americans to consume more and save more.”

    “I want them to hoard less cash, not save less income.”

    I am going to argue that this is slightly flawed, and this should not be your goal.

    1) It makes no difference whatsoever if people want to hoard a little bit of cash, so long as they spend more. Cash hoarding is a rational response to volatility in asset prices, and until you can CONVINCE people that asset prices will be stabilized (which is hard to do in an era of flash crashes and massive volatility and ridiculous correlation across asset classes), people SHOULD hoard a bit of cash.

    2) What you should be advocating for is to allow the government to inject enough cash INTO HOUSEHOLDS that people can still hoard the cash AND spend more. Instead, the governments give it to banks, who hoard the cash and use their privileged liquidity positions to extract rents from households.

    3) Structurally, the real problem is neither – the real problem is insufficient and poorly executed investment. The world should be preparing for a period of moderate scarcity as world population peaks for 50 years before declining, the world population ages, marginal resources become more expensive to extract, and the the world needs to fund adjustment costs to deal with the consequences of warming. Unfortunately, rather than building small homes with a 200 year lifespan and low maintenance costs, we built large homes that are costly to maintain. The same is true with commercial buildings and public infrastructure. Structurally, our _real_ discount rate is too high, but for purposes of spurring AD it is too low. So is the problem insufficient consumption, insufficient investment, or insufficient liesure, or poor distribution across the population?

    The deep question you should be asking is, why the mismatch?

    If we are limited to a single policy instrument, then any efforts to stimulate AD by monetary policy and thus increase the real rate has the effect of shortening the time horizon for investments.

    I know you advocate forced savings regimes (e.g. Singapore). You’ve convinced me there. But I am not entirely clear on how forced savings regimes (if ALL countries pursue this policy) can lengthen global investment time horizons if at the same time the central banks ensure that the real discount rate is high. (Let’s presume lengthening horizons is a good thing – one could argue that point.) I suppose if people are forced to save, and cash is a bad asset (due to higher inflation) they will move to other assets, bidding up their prices – but let’s take the example of bonds. If bonds get bid up, then this means real interest rate is falling.

    Personally, I do not think this is inconsistent – but I think you should have written this:

    “I am trying to get Americans to invest more and save more.”

    “I want them to invest more, not save less income.”

    The key here, however, is decreasing perceived asset price risk. Asset price risk is a serious problem. Let’s say that a risk free world economy would make investments with an 80 year time horizon. Even a small bit of risk aversion among individual players can drop this to 10 to 20 years.

  14. Gravatar of scott sumner scott sumner
    20. September 2010 at 04:56

    JL, You said;

    “Saving more and spending more is not a free lunch, it’s inflation. And any educated person with an ounce of common sense knows that inflation is a form of taxation.”

    Actually it isn’t. It’s more AD, which is what we want.

    TGGP, Yes, those are good points.

    Ram, I agree, although I think three more doves might have made a difference. We’ll probably find out in December.

    I agree the Bear Stearns bailout was a mistake, but mostly because it would have been much better to have the crisis in the spring of 2008, rather than the fall.

    DanC, It’s no surprise that QE had little effect in Japan, it was temporary. Temporary QE is well known to be ineffective.

    Thanks Benjamin.

    Lorenzo, You said;

    “Do we think the Fed is more altruistic than the Catholic Church? And if so, why?”

    My fear is that those explanations will be too ad hoc. People will say; “The Fed produced deflation in the 1930s because it was in their interest, stable prices in the 1920s and 1950s because it was in their interest, high inflation in the 1970s because it was in their interest, low inflation in the 1980s because it was in their interest, deflation in 2008-09 because it was in their interest. I’m not saying you are wrong, but I wonder whether some of this might simply be honest mistakes by well-meaning public servants. My hunch is that Bernanke’s motivation is that he wants to go down well in the history books. And that’s the motivation we’d like him to have, isn’t it.

    Greg, Yes, but that’s not a policy, it’s a wish. If the public isn’t doing that, the Fed must supply more dollars.

    MW, Yes, and no. I favor an explicit target to get rid of their discretion, but either a price level or a NGDP target would do that. I think an NGDP target is better than P-level targeting for many reason, one is that it would lead to smaller business cycles and smaller bubbles.

    tweeting, Reread my post, I said commercial RE not residential RE. I was anticipating your criticism.

  15. Gravatar of scott sumner scott sumner
    20. September 2010 at 05:08

    Statsguy, You said;

    “1) It makes no difference whatsoever if people want to hoard a little bit of cash, so long as they spend more.”

    This is confusing. For any given quantity of money, more hoarding of money is deflationary, by definition. That’s because the price level is identical to the nominal stock of money over the real demand. And hoarding is defined as an increase in the real demand for money. So the only way your statement would make sense is if you assumed the supply of money rose faster than the demand.

    You said;

    “2) What you should be advocating for is to allow the government to inject enough cash INTO HOUSEHOLDS that people can still hoard the cash AND spend more.”

    Yes, I should be advocating that, and I am. We need QE and lower IOR.

    You said;

    “If we are limited to a single policy instrument, then any efforts to stimulate AD by monetary policy and thus increase the real rate has the effect of shortening the time horizon for investments.
    I know you advocate forced savings regimes (e.g. Singapore). You’ve convinced me there. But I am not entirely clear on how forced savings regimes (if ALL countries pursue this policy) can lengthen global investment time horizons if at the same time the central banks ensure that the real discount rate is high.”

    I strongly disagree here. You are talking about a long run problem, and monetary policy has no impact on the long run real rate. The high savings rate would lower the long run real interest rate. As long as you target NGDP at a high enough growth rate, even a low real real rate is consistent with effective monetary policy, as the inflation rate will be high enough to keep nominal rates above zero. So I think you are mixing nominal and real issues here.

    I’m not too worried about big houses, in 100 years people will be vastly richer than us. So what if we steal a bit of wealth from them. I do favor a carbon tax, however.

    I do agree with your final point, but I was deliberately trying to provoke the Keynesians.

  16. Gravatar of DanC DanC
    20. September 2010 at 05:16

    Scott, this is a bit off topic but do you know much about the “Long Depression” from 1873-1879 or some say 1873-1896.

    In the United States the government sought to return to the gold standard after the Civil War and dramatically cut the money supply. At the same time you saw decreased prices, due in part to (or along with) increased trade, competition, and increased productivity.

    Plus a bubble (and fraud) in railroad investments to open the American west.

    Some argue that the long depression only ended with the discovery of gold in California, Alaska, and South Africa.

    Europe had a different set of problems (but did fund much of the railroad construction).

    That depression lasted a very long time.

    What lessons can we learn from this period?

  17. Gravatar of Joe Joe
    20. September 2010 at 06:24

    Professor Sumner,

    Two quick comments

    First, this post technically disproved the famous “paradox of thrift.” Both saving and consumption are just money passing from one person to another. Wolsey made the same argument previously, but I was “afraid” to believe it until I had confirmation by another!

    Second, it seems to me that you are a follower of the “monetary disequilibrium” school like that that of Leland Yeager. That is, Say’s law breaks down when you have tight money. When Keynesians see a general glut they see the fiscal side, which is a fall in AD. But on the monetary side its just tight money.

    I’m starting to believe that 200 years of recessions, depressions, and financial crises have been nothing more than one episode of tight money after another.

    Best.

    Joe

  18. Gravatar of Keith Keith
    20. September 2010 at 07:21

    Scott,

    Isn’t the primary issue that economic growth is driven by savings and investment and not consumption per se: investment in productive assets — the things that enable us to produce more in the future.

    Although consumption spending sends a signal as to where investment might be profitable and can for some provide the revenue to invest, consumption in and of itself does not grow an economy; investment does.

    Growing the money supply has the potential to promote economic growth via the fact that increasing the money supply in relation to production forces all prices to change — yet not all prices change with the same speed. Specifically, wages tend to lag other prices. This phenomenon lowers the cost of labor by forcing a near term cut in real wages. Furthermore, this phenomenon increases real returns by shifting more income to asses owners and less to wage earners.

    Cheaper labor and higher returns can promote economic growth by encouraging people to invest (real growth not just nominal). But, this is not guaranteed is it? It is still investment that drives growth. If for other reasons people still don’t invest in productive assets but instead spend all this new money on consumption (or gold or treasuries), stagnation would seem a possible/likely outcome?

    Furthermore, an explicit transfer of wealth is occurring: 1) to those receiving the new money first from those receiving the new money last and 2) from those getting a smaller piece of the pie (wage earners) to those receiving a larger piece (asset owners).

    Money is critical to the function of the economy but I personally do not believe it is the driving engine, perhaps the oil inside.

    Lastly, could we not accomplish the same benefit by simply having Congress pass a law cutting everyone’s wage’s by 10% tomorrow and forbidding raises for a year or two? And if cutting real wages in the near term is the goal should not an honest debate make that clear? After all, in a free society, aren’t wages a contract negotiated between employer and employee and not the Fed?

  19. Gravatar of StatsGuy StatsGuy
    20. September 2010 at 07:22

    “We need QE and lower IOR.”

    True enough – I wonder what 2008 says about the safety of assuming exogenous preference formation. I wonder if the events of 2008 have increased long term preference for liquidity/cash. I wonder if some bright grad student will do some work trying to decouple risk perception from behavioral preference for liquidity, or showing perhaps there is no decoupling.

  20. Gravatar of StatsGuy StatsGuy
    20. September 2010 at 07:31

    @Kieth:

    “Isn’t the primary issue that economic growth is driven by savings and investment”

    Pet peeve – it’s driven by investment (good investment). Savings merely finance investment. They are the vehicle for encouraging delayed consumption in order to free up resources (capacity) to support investment.

    Of course, if the economy has widespread excess slack, there’s no need to free up resources to support future investment. Those resources already exist. Moreover, if the primary reason for lack of investment is lack of anticipated future demand, we have a depression on our hands.

    Theoretically, investment could be supported by alternative financing mechanisms (including credit). There’s a real argument that the problem isn’t really the US investment financing system (credit), or Singapore’s (savings), but the juxtaposition between the two. This creates a net flow of savings that – due to lack of a singular taxation/monetary/fiscal/redistribution authority – is unsustainable.

    Personally, I don’t like the US credit based investment financing system because it seems to have domestic distributional implications. However, I am deeply opposed to the current mechanism for transitioning from credit to savings – a mechanism in which certain players were clearly rescued due to political influence.

  21. Gravatar of Lee Kelly Lee Kelly
    20. September 2010 at 07:46

    It occurs to me that money is too safe.

    If currency were issued in a competitive free banking system, then it would not be such a safe alternative to other assets. If chequing accounts were not insured by the government, then the risk of holding them would could not be socialised. This relative and artificial risklessness of holding money (and base money) can only exacerbate fluxuations in money demand, since the risk of holding it will not track the risk of other assets so closely.

  22. Gravatar of Greg Ransom Greg Ransom
    20. September 2010 at 08:21

    “Greg, Yes, but that’s not a policy, it’s a wish. If the public isn’t doing that, the Fed must supply more dollars.”

    As you are aware, there is more to it that that — Higg’s point about government created uncertainty comes into play, and all sorts of other influences on the decision of entrepreneurs and investors to act (can you say Obama regulations and mandates?)

  23. Gravatar of Keith Keith
    20. September 2010 at 08:44

    @StatsGuy

    “it’s driven by investment (good investment). Savings merely finance investment.” Agreed. An unstated assumption.

    Measured or reported “slack” can be a red-herring. Excess capacity in the housing sector is for practical purposes worthless (beyond salvage value), given the excess supply of housing. Replacing the real income lost with this “slack” capacity will require new investment in other areas — will it not?

  24. Gravatar of Philo Philo
    20. September 2010 at 09:10

    If I have a piggy bank into which I put coins, or if I from time to time stuff a few dollar bills into my mattress, most people would describe my activity as “saving.” But I take it you (and most economists?) would say: No, that is not *saving*–it is *hoarding*.

    I’m not sure how ‘hoarding’ is to be defined (please clarify!); but am I right that you would define it to be utterly disjoint from ‘saving’?

  25. Gravatar of Lee Kelly Lee Kelly
    20. September 2010 at 10:38

    I don’t like the word “hoarding” in this context; it misleads people to opposing saving generally.

    Income minus consumption equals saving. Unless “hoarding” is consumption (as with coin collectors), then “hoarding” is saving. More precisely, “hoarding” is income spent on increasing money balances without an increase in the supply of credit. In other words, the resources saved by hoarding are not redeployed to produce goods for future consumption.

  26. Gravatar of Keith Keith
    20. September 2010 at 10:52

    @Philo

    I am not an economist but I’d like to take a stab at this.

    Stuffing a few dollar bills into your mattress would indeed be “savings”, especially from your perspective. But from the perspective of the economy as a whole, the question is not simply how much you save but what you do with it. Savings represent income which we allocate toward the future.

    In one sense savings represent our efforts to save today’s labors for tomorrow, but we can’t really save today’s labors because after today, they are gone. So, instead we save today’s labors by acquiring things that hold or grow in value over time. Federal Reserve Notes or gold or land may hold value over time and may enable us to exchange today’s labor some time in the future for consumption goods of equal or greater value than today. But, then again these things may not hold value over time. If, on the other hand, I acquire a couple of cows and a bull with my savings, I might be able to grow a herd that not only holds my original value (at least in terms of cows) but grows over time. By acquiring cows, my savings is able to work — not only holding value but increasing by productive capacity.

    To grow our economy, we have to increase our productive capacity. Savings represents the flow of income we set aside each day, week and year that is available to invest in productive assets (like cows or factories or knowledge). But to actually grow our economy, we have to apply our savings to productive investments. When we put our “savings” in the mattress or buy gold or lend to someone who uses it for consumption, we are not using it in a fashion that can grow our productive capacity — even though it may hold value for us.

    Since our savings represent the pool of resources available for growing our productive capacity (economy), the more we put into “non-productive” investments (the mattress), the slower our economy will grow. Put enough savings under the mattress and the economy will shrink as old capital is consumed through use but not replaced. So, it is not that putting coins into a jar is not saving, it is that those coins are not productive and cannot generate any real return.

    The professionals can give your their answer but that is my layman’s perspective.

  27. Gravatar of StatsGuy StatsGuy
    20. September 2010 at 10:59

    @ Greg

    “As you are aware, there is more to it that that “” Higg’s point about government created uncertainty comes into play, and all sorts of other influences on the decision of entrepreneurs and investors to act (can you say Obama regulations and mandates?)”

    As you are aware, this mantra is a political hack job circulated by media outlets.

    http://www.economist.com/blogs/freeexchange/2010/09/small_business_0

    Compare today to the mid-1990s – back then the concerns were govt. regulation and insufficient quality labor. Today, labor is not a concern, regulation is a lower concern, and the major concern is lack of sales. The data do show a spike in concern over regulations that roughly aligns with the health care bill passage, but it’s still trumped by demand. We can only wish to have the problems we had in the 1990s.

  28. Gravatar of StatsGuy StatsGuy
    20. September 2010 at 11:19

    @Keith

    “Excess capacity in the housing sector is for practical purposes worthless (beyond salvage value), given the excess supply of housing.”

    I’m not sure I follow. Productive capacity in housing (employees, construction companies, etc.) is different from inventory. If the inventory represents poor (rather than excessive) investment, then those resources should be actively employed in salvage and reconfiguration of the capital stock.

    If the problem is how to fund investment, it’s important to distinguish between nominal constraints (where do I get the nominal funding) and real constraints (how do I free up excess capacity to support investment activity). Monetarists merely claim that regardless of the preference of savings/credit, any particular set of preferences can be accommodated by the appropriate monetary regime to ensure the economy is operating at close to short term peak capacity subject to holding to a non-accelerating rate of inflation. It’s unclear why savings should be preferred over credit unless one resorts to things outside this model. Nor is credit necessarily evil – it allows people with opportunities and little capital to initiate investments, instead of requiring capitalists to initiate all investments. It’s really the micro issues that move this argument (agency concerns, risk, transaction costs, etc).

  29. Gravatar of Bernard Guerrero Bernard Guerrero
    20. September 2010 at 11:28

    “And any educated person with an ounce of common sense knows that inflation is a form of taxation.”

    I object! Sure, inflation provides seigniorage gains to the government. However, this can be more than offset by the degradation of calls-on-resources that won’t be used (or usable) until the future. Case in point: Social Security. The benefits are defined in nominal terms and then are subject to COLAs. Eliminate COLAs and then let inflation rip. In effect, it becomes a wealth-transfer from the old to the young.

  30. Gravatar of Keith Keith
    20. September 2010 at 14:52

    @StatsGuy

    Here’s what I was trying to get at. Was excess productive capacity in the housing sector created: employees, construction companies, wall board manufacturing lines, door and window manufacturing lines, etc. This would be related to the excess inventory of houses, but really a separate issue. If excess productive capacity exists in housing, it may be that this capacity will never (or for a very long time) be utilized in generating income. Counting this as “slack” could be misleading as it can’t necessarily be utilized in its current configuration. This is not to say that productive capacity cannot be re-directed to other uses, but that may take time and investment.

    My basic line of thought is that if an economy suffers a loss in its productive capacity for whatever reason (war, over-investment, changing consumer preferences, etc.), it requires investment to replace (or re-allocate) that productive capacity in other areas in order to generate prior income levels. If the capacity if physically still there, utilization data could be misleading.

    Does that make sense?

  31. Gravatar of David Tomlin David Tomlin
    20. September 2010 at 16:50

    DanC:

    In the United States the government sought to return to the gold standard after the Civil War . . .

    Not exactly.

    Strictly speaking the U.S. wasn’t on a gold standard before the Civil War. It was on bimetallism, but at a ratio that overvalued gold. That resulted in an informal, ‘Gresham’s law’ gold standard.

    After the Civil War, the policy of the Treasury was to allow the value of the dollar to gradually rise, until convertibility could be restored at pre-war values. (In my opinion it would have been better to restore convertibility immediately after declaring a devaluation of the dollar.)

    In 1879 Congress restored convertibility, but only to gold. That was the first time in history the U.S. was formally on a gold standard.

    Btw, this accounts for some of the self-righteousness of the silver agitators, such as Bryan’s famous ‘cross of gold’ speech. They saw bimetallism as traditional, natural, and American. They saw the gold standard as an unnatural innovation and a foreign import. Britain, in those days still the number one enemy, had been on the gold standard since restoring convertibility after the Napoleonic Wars.

    . . . and dramatically cut the money supply.

    Not according to Friedman and Schwartz. Their story is that the money supply rose gradually while the economy grew rapidly. Also, government policy didn’t have much effect on the money supply until ‘the Treasury entered the market on a large scale after 1877 to accumulate gold’ in preparation for resuming convertibility. (p. 79)

  32. Gravatar of StatsGuy StatsGuy
    20. September 2010 at 17:08

    @Keith

    Yes, makes sense. But a lot depends on how fungible the capital stock (including human capital) is. If it’s entirely specific, and it makes sense to keep it dedicated, then we end up with excess capacity. That’s the “it’s all real” argument. However, one would argue that it’s at least partially fungible (housing resources – labor especially – can be devoted to other activities). Then it becomes a real wage issue.

  33. Gravatar of DanC DanC
    20. September 2010 at 18:28

    Thank you Tomlin, do you know of a good history of this period

  34. Gravatar of DanC DanC
    21. September 2010 at 02:41

    Tomlin
    It does seem fair to say that the United States sought to reduce the money supply (or the growth of the money supply) after the civil war by returning to a metals packed currency.

    While the currency may have increased, it did not keep up with the significant increase in population and other growth factors in the economy (increase in land and labor, investment by foreigners, increased trade, technology)

    So what was the cause of the deflation, why was it negative on the economy, and why was the speculative bubble in railroads so destructive.

    What was the state of fiscal policy at this time, and how did political corruption affect fiscal policy.

  35. Gravatar of David Tomlin David Tomlin
    21. September 2010 at 02:42

    @DanC

    A general history of the U.S. after the Civil War? Sorry, no, I can’t help you there.

    The above information is from two books: Money Mischief: Episodes in Monetary History, by Milton Friedman; A Monetary History of the United States, 1867-1960, by Milton Friedman and Anna Schwartz. The latter is the one I referred to as ‘Friedman and Schwartz’. I thought someone reading this blog would know what I meant. AFAIK this book is still the definitive work on the subject. It’s the place to go if you want to know what was happening to the U.S. money supply at any time within the period it covers.

    Money Mischief has some fascinating chapters on the Free Silver controversy.

    I know of a couple of good books by leftists that have some information on the impact of economic distress in the 1890s. The Triumph of Conservatism, by Gabriel Kolko, argues that the movement to regulate Big Business was co-opted, resulting in legislation that restricted competition for the benefit of big established firms. The Tragedy of American Diplomacy, by William Appleman Williams, covers the whole Twentieth Century up to the time of writing, so only the early part deals with the late Nineteenth Century. Williams argues that one response to the economic slump was to look for ways to expand foreign trade, which had important implications for American foreign policy.

    You might be interested in the novel The Gilded Age, by Mark Twain and Charles Dudley Warner. It’s about the interaction between business and politics after the Civil War. It was written in 1873, so it might be too early for the period you’re interested in.

    Again, sorry I couldn’t be more helpful.

  36. Gravatar of scott sumner scott sumner
    21. September 2010 at 05:39

    DanC, There was no long depression, it was a long deflation.

    Joe, That’s right, and Nick Rowe also has good posts on how the paradox of thrift is really about money hoarding, not saving.

    Keith, You said;

    “If for other reasons people still don’t invest in productive assets but instead spend all this new money on consumption (or gold or treasuries), stagnation would seem a possible/likely outcome?”

    Yes, and those “other reasons” might be things like high taxes on saving.

    You said;

    “Lastly, could we not accomplish the same benefit by simply having Congress pass a law cutting everyone’s wage’s by 10% tomorrow and forbidding raises for a year or two? And if cutting real wages in the near term is the goal should not an honest debate make that clear? After all, in a free society, aren’t wages a contract negotiated between employer and employee and not the Fed?”

    Good point. My goal is to move real wages to where they would be if they hadn’t been artificially distorted by an unexpected slowdown in NGDP.

    You said;

    “Furthermore, an explicit transfer of wealth is occurring: 1) to those receiving the new money first from those receiving the new money last and 2) from those getting a smaller piece of the pie (wage earners) to those receiving a larger piece (asset owners).”

    I hear this all the time from commenters, and I don’t know why. There is absolutely no advantage in receiving the new money first. It’s a complete 100% myth. Nothing to it.

    Statsguy, You might be right about rising risk aversion, but it just means the needed MB/GDP ratio is slightly higher.

    Lee Kelly, Why is money being safe a problem?

    Greg, Obama’s regulations affect RGDP, not NGDP.

    Philo, I have no problem with you calling that saving. But even so, if you turn that into ordinary saving, you are creating some other form of capital, other than real cash balances. To call that saving, you must consider the real monetary base to be part of the US capital stock.

    Keith, I think that’s a pretty good response.

    Keith and Statsguy, The value of unoccupied houses is their current market value.

    Bernard, You are half right. Persistent inflation is a tax on money-holders, but a temporary rise in the price level can help the economy, and make people richer.

    David Tomlin, Thanks, that info sounds right to me.

  37. Gravatar of Lee Kelly Lee Kelly
    21. September 2010 at 06:30

    Scott,

    It seems to me that money is artificially safe in comparison to alternative assets. The monopolistic and tightly regulated nature of money protects it from competition and socialises its risks. In consequence, money demand is more volatile.

    Although money, even when supplied by a free banking system, will tend to be safer than alternative assets, its safety still depends on the liquidity and solvency of the issuing bank. If the assets on the banks’ balance sheet appear more risky, then its chequing accounts and banknotes will also be more risky.

    This transmission mechanism, whereby money tends to track (to some degree) the riskiness of the issuing banks other assets, is broken in our monetary system. In other words, the relative safety of money increases during a crisis and increases money demand more than it would increase otherwise.

    Perhaps this analysis is terribly off in some respect, but it seems valid to me.

  38. Gravatar of DanC DanC
    21. September 2010 at 07:31

    Scott I apologize for the digression.

    Is
    Forty Years of American Finance: A Short Financial History of the Government and People of the United States Since the Civil War, 1865-1907 by Noyes a good book on the “Long Depression”

    And until recent events, I never had a big interest in Macro so I had no desire to tackle A Monetary History…

    I took Macro with Mishkin and Lucas, but to be honest, I don’t have strong memories of either class. My fault.

  39. Gravatar of D. Watson D. Watson
    21. September 2010 at 09:58

    Bravo.

  40. Gravatar of Keith Keith
    22. September 2010 at 09:57

    Scott,

    I stand corrected on the “receiving new money first” comment. I should choose my words more carefully. Would it be safe to say that with an inflation, a transfer of wealth occurs from those whose prices or wages rise last to those whose prices or wages rise first?

    Exchanging a security with the Fed for notes (even newly printed notes) would be no more beneficial to the security seller than making that exchange with anyone else.

  41. Gravatar of scott sumner scott sumner
    22. September 2010 at 16:05

    Lee Kelly, I think I see your point, but you are just considering the advantages and not the disadvantages of private money. Yes, the demand for public money varies, but they can adjust the supply to prevent price level fluctuations. There is no assurance that private issuers of money would adjust the supply to keep the value stable.

    Dan, I haven’t read that book, so I can’t say. I also took macro from Lucas and Mishkin, maybe we were in the same class.

    Keith, Yes, now you have it exactly right.

Leave a Reply