Inflation targeting is a very bad idea

Mark Sadowski triggered an interesting discussion in a previous thread with the following comment about the UK:

The HICP was up 3.2% yoy in November. The core HICP was up 2.5% yoy in November. The HICP at constant tax rates was up 1.5% yoy in November. There is no “core HICP at constant tax rates”, but simple subtraction suggests that if there were one, it would be up by 0.8% yoy in November. Which means all the hysteria about inflation in the UK is a lot of nonsense.

Now I think we all agree price level targeting is superior to inflation targeting, and that NGDP level targeting is better still. But if you are going to target inflation rates than you should at least be targeting a measure of “inflation inertia”. The headline HICP in the UK is seriously skewed by the volatile energy and food component and the two VAT increases. Using the correct measure of inflation inertia, the real danger in the UK right now is deflation, not inflation.

All indications are that the Bank of England plans to tighten policy this May, with the idea of reducing aggregate demand growth in Britain.  At a time of fiscal retrenchment, it is hard to overstate how misguided that policy is.  And it will be justified by reference to the BOE’s mandate to engage in inflation targeting.  If you think that is bad macro policy, then by implication you need to rethink the utility of inflation targeting.  Here’s another way of stating how confused people are about stimulus.  Suppose it is a good idea for the BOE to be raising rates in May.  In that case, if it were true that fiscal retrenchment reduced the UK’s GDP in Q4, then that would be good news.

Mark’s comment points to one of the most serious problems with inflation targeting—there are all sorts of different inflation rates that people can point to.  Headline inflation, inflation without food and energy, inflation holding interest rates fixed, holding the VAT fixed, etc.  This creates a “gap” or grey area, where it is not clear whether the central bank should ease or tighten.  In contrast, NGDP targeting is crystal clear.  There is only one NGDP.  If the UK were doing NGDP targeting, there would be no discussion of tightening in May, indeed they might ease by cutting rates a quarter point, or doing more QE.

Some liberals argue that this problem can be solved with fiscal stimulus.  Not so.  Fiscal stimulus works if and only if it raises AD, and by implication inflation (the SRAS is never completely flat.)  If the central bank has the wrong inflation target, no amount of fiscal stimulus can boost AD.  But additional fiscal stimulus can very much hurt AS.  Indeed Britain has raised the top rate to 50% because of all the fiscal stimulus under the previous Labour government.  This takes away Britain’s one big supply-side advantage over the continent, lower taxes on high-paid professionals in the City.  Tight money and high taxes are a toxic combination.  Just ask Herbert Hoover. 

Two years ago I pleaded with Obama to talk to Christy Romer.  I speculated that she favored monetary stimulus, and in another post I asked if Larry Summers was blocking access to the President.  It was certainly bizarre to see Obama let 3 Fed seats lie empty for an extended period of time; he clearly didn’t understand the importance of monetary policy.  In a new column in the New York Times, Christy Romer confirms my suspicions.  She was aware of the need for monetary stimulus.  She does understand that it can be effective at the zero bound.  She does understand the importance of level targeting.  If you put her and Larry Summers in a room together, most people would find Summers to be the far more impressive figure.  I’d guess that President Obama did as well.  Big mistake.

The commenter Ram provided the Romer link, and had this to say:

She has called for more monetary expansion before, but this is the clearest she has been about what she has in mind, not to mention how urgently monetary expansion is needed. It makes me wonder whether Prof. Sumner’s old post about Larry Summers being the Dick Cheney of the Obama administration might have some merit. Romer clearly supported and supports fiscal stimulus, but I seem to recall Larry Summers discussing the need for a large, government spending-oriented fiscal stimulus in mid-2008, before the bottom truly fell out of the economy. Maybe Romer was insisting on the importance of standing behind good monetary policy, so Summers deliberately kept her out of the inner circle. Hard to know, but it’s remarkable that she’d make this dramatic of a pivot so soon after leaving the White House.

There’s an easy way to tell unsophisticated old Keynesians from the more sophisticated new Keynesians.  Do they call for fiscal stimulus when interest rates are positive.  Even Krugman admits that there is really no case for fiscal stimulus until rates fall to zero.  In September 2008 rates were at 2%, and the Fed refused to cut them after Lehman failed because they were worried about inflation.  Indeed a month earlier some at the Fed wanted to raise rates (and I believe the ECB did raise rates.)  In that environment fiscal stimulus does nothing.

But I don’t want to be too hard on the old Keynesians.  When central banks around the world are this confused and incompetent, it’s not hard to see why people grasp for fiscal stimulus out of sheer frustration.  Most people don’t have a clue as to how monetary stimulus works, or why it neutralizes fiscal stimulus (especially why it does so at zero rates.)  Fiscal stimulus is really easy to grasp at an intuitive level.  Throughout history, only a tiny number of economists have intuitively grasped the incredible power of monetary stimulus (even at zero rates) and also understood the need for monetary stimulus when NGDP is inadequate.  Irving Fisher was one and Milton Friedman was another.  Lots of people are aware of the power of monetary policy.  Lots of people understand the need for stimulus.  But damn few can see both.  And that’s why we are where we are.

BTW:  A long time ago I promised to post the video of Bentley’s team winning the Fed Challenge.  It is finally available:

http://www.youtube.com/watch?v=pYl9AtIGAoQ&feature=feedu

Congratulations.


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133 Responses to “Inflation targeting is a very bad idea”

  1. Gravatar of JimP JimP
    27. February 2011 at 11:29

    Well……….thats settled. Scott was right all along.

    Now if only Obama read the Times. – and then would make a speech demanding this. He could just quote Bernanke back to himself.

  2. Gravatar of JimP JimP
    27. February 2011 at 11:42

    Why oh why did Romer leave? And Summers didnt. I think its because Obama was just not all that interested.

    And why didnt Romer write this immediately upon leaving. And talk about the debates she must have had with Summers. Because these are obviously debates we must have now.

    The inflation empiricists are, I imagine, Democrats. The theorists are Taylor, Meltzer, Posner, Kudlow – et al. The raving deflationists. This is a debate we should have now. And, as I have said over and over, it is a debate Obama can win. Debating about public sector unions is a loser.

  3. Gravatar of marcus nunes marcus nunes
    27. February 2011 at 12:20

    Scott
    And it´s almost frightening to see the “caliber” of some people “crying out” for MP tightening in the UK!
    But the same attitude is begining to show up in the US. Romer´s article was important in this respect. Hope Obama reads the stuff his previous adviser writes.
    Again, it seems that Summer was a “net loss”!

  4. Gravatar of Britmouse Britmouse
    27. February 2011 at 12:33

    The UK NGDP number for 10Q4 is out now, along with the revised-down RGDP:

    http://www.statistics.gov.uk/pdfdir/oie0211.pdf

    “Nominal GDP increased by 0.4 per cent in 2010 quarter.”

    Well at least it went up. Comments about inflation and inflation measures are spot on. 50% tax rates are only half the story, you should add in NI, and there are some truly 70′s-style MTRs around at £100K+ with recent tax code tweaks. Unless Merv can fight off the hawks, we’re screwed.

  5. Gravatar of Mark A. Sadowski Mark A. Sadowski
    27. February 2011 at 13:19

    Thanks Scott.
    I’ve been in a really foul mood lately and this really helped to cheer me up.

    By the way everyone who is a big fan of NGDP level targeting should go and see Marcus’ post on Poland (she left Sweden in the dust):

    http://thefaintofheart.wordpress.com/2011/02/27/poland-didn%c2%b4t-miss-many-beats/

  6. Gravatar of Mark A. Sadowski Mark A. Sadowski
    27. February 2011 at 13:31

    “Maybe Romer was insisting on the importance of standing behind good monetary policy, so Summers deliberately kept her out of the inner circle. Hard to know, but it’s remarkable that she’d make this dramatic of a pivot so soon after leaving the White House.”

    I always thought there was something deeply weird about Christina’s “enthusiasm” for ARRA. It seemed to contradict to her research on the Great Depression. It’s heartening to see her finally speak her mind. This also lowers my already low opinion of Larry Summers to subterranean levels.

  7. Gravatar of Left Outside Left Outside
    27. February 2011 at 13:34

    At least Posen is still calling for QE on the MPC at the BoE (yeah yeah, YHTMAAAIYP). Perhaps the poor Q4 figures will tempt some of the centrists at the BoE to join him.

    Andrew Sentance is your number one enemy at the Bank by the way Scott. He’s gone from a few months of calling for quarter point rises to calling for a half point rise last meeting. Any chance you could e-mail him and talk some sense into him?

    I think the disgressionary way in which bank officials can choose which inflation target they can aim for was a bad idea, it looks like Posen and Sentance (the Ying and Yang of the MPC) are just looking at different interpretations of the inflation rate. No platonic inflation rate exists, it always has to be constructed, and it appears that the committee are all constructing it in different ways.

  8. Gravatar of marcus nunes marcus nunes
    27. February 2011 at 14:11

    Hope it´s true. I heard Andrew Sentance (who should be “sentenced” to life imprisonment for “pretence of knowledge about monetary theory and policy”) is leaving in the next couple of months!

  9. Gravatar of Left Outside Left Outside
    27. February 2011 at 14:49

    “Hope it´s true. I heard Andrew Sentance (who should be “sentenced” to life imprisonment for “pretence of knowledge about monetary theory and policy”) is leaving in the next couple of months!”

    Terrible punning, you’re not by any chance of English extraction?

    It would be good if he left, but I don’t think he has a particularly unrepresentative view. The consensus view is that inflation is a problem in the UK and that temporary increases in inflation caused by things the bank cannot control should be fought with demand decreasing interest rate rises.

    If Sentance leaves then the chancellor gets to appoint a successor, and if the Chancellor is looking to signal more expansionay policy (and I’m sure I’m stealing this gag from Martin Wolf) he should just go ahead and appoint an Argentine, any Argentine, and watch the expected inflation rate tick up.

  10. Gravatar of Scott Sumner Scott Sumner
    27. February 2011 at 14:53

    JimP, Thanks. I wasn’t convinced by here empiricist/theorist distinction–people should be both. I pay lots of attention to expectations, and believe the Fed can raise inflation expectations without reducing unemployment, but still favor easier money.

    Marcus, I agree about Summers. And nice post on Poland.

    Britmouse, Thanks for the NGDP data. Up about 2.5% in two years, or 1.25% per year. No wonder Britain is in such bad shape.

    Yes, I heard about those hidden MTRs. And they are also planning to reduce immigration, which will tend to weaken the recovery (whatever its long run pros and cons)

    Mark, That post by Marcus is really helpful. A bigger devaluation, a faster rise in NGDP, and a faster rise in RGDP.

    Left Outside, We are basically back to pure discretion, it’s as if there is no inflation target.

  11. Gravatar of Scott Sumner Scott Sumner
    27. February 2011 at 14:56

    Left Outside. Speaking of bad puns, yesterday my daughter asked me “Who’s President of China?” “Yes he is,” I replied.

    I’m 2/3 British.

  12. Gravatar of Ram Ram
    27. February 2011 at 15:23

    I have a bad habit of bringing Woodford into these discussions…but I was reading a paper of his the other day about the limitations of inflation targeting. His three main criticisms: (1) it is desirable to have the target criterion not be purely forward looking, but also history dependent (because of the zero lower bound); (2) it is desirable to include certain real variables in the target, chief among them the output gap; (3) the inflation target is often interpreted to be a medium-term objective, implemented over the business cycle, when in fact it is desirable to manage the rate of inflation through the business cycle. These criticisms proceed from conclusions that follow from a wide range of specifications of standard New Keynesian DSGE models. What he praises about inflation targeting is that it involves commitment to & communication of a monetary policy rule, formulated in terms of a forecast-targeting criterion.

    Altogether, these considerations make the case for a flexible price level forecast target, i.e., a rule that determines the stance of monetary policy in a way that forecasts a growing path of the price level, but allows for fluctuations about this path in response to real disturbances (e.g., a rise in the output gap). He also says that the strictly optimal policy may not be optimal in practice, since it may be too complicated to communicate successfully to the public so as to manage expectations appropriately. In other words, simpler is better. But what’s simpler than a nominal income level forecast target? It behaves just like a flexible price level forecast target, but is much less complicated. I wonder what, from a purely academic perspective, Woodford, Bernanke, or Romer thinks of your proposal. We know Bernanke doesn’t like the nominal income growth target, but I haven’t seen him address the level target proposal. It seems like, in light of everything they say about features of the optimal monetary rule, that a nominal income level target fits the bill perfectly. And yet you never hear much about the idea outside of this blog…

  13. Gravatar of Andy Harless Andy Harless
    27. February 2011 at 15:29

    There’s an easy way to tell unsophisticated old Keynesians from the more sophisticated new Keynesians. Do they call for fiscal stimulus when interest rates are positive.

    By this criterion I’ve backslid over the past decade. I used to think that fiscal stimulus was counterproductive in that it crowded out private investment (supply side bad + demand side neutral). Back in 2003, when we started to approach the zero constraint, I started to see the point of anticipatory fiscal stimulus, which I came to appreciate more and more as I thought about it over the subsequent years: hitting the zero constraint is bad, and I would rather not get anywhere near it if we can avoid it. Particularly since fiscal policy tends to be very sloppy in its application, that is a reason to apply it when monetary policy can fairly easily smooth the rough edges rather than waiting until monetary policymakers are panicking and everyone is looking to the sloppy fiscal policymakers to fix things.

    But I also began to realize something else as housing prices were skyrocketing: low interest rates are dangerous, even apart from the risk of their hitting a constraint. Of course it wasn’t until 2008 that I realized just how dangerous they could be. While I oppose the neo-Austrian view that we should allow resources to remain slack rather than allow interest rates to go too low, I appreciate the value of fiscal policy in avoiding that situation in the first place. Indeed, I would say that the purpose of fiscal policy is not to stimulate the economy but to keep interest rates up (or to keep them down via tight fiscal policy when that is preferable). Moderate interest rates are a desirable objective because they make monetary policy easier. And surely after the past 2 1/2 years, you will have to agree that the quality of monetary policymaking can deteriorate during times of very low interest rates.

  14. Gravatar of Andy Harless Andy Harless
    27. February 2011 at 15:35

    (Looking at my last comment, I realize how prescient Alan Greenspan was in his widely reviled statement a decade ago that fiscal surpluses would make monetary policy more difficult. Without the 2001 tax cut, we would almost certainly have hit the zero constraint back in 2002 or 2003, and we would be having the same problems that we are having now.)

  15. Gravatar of Morgan Warstler Morgan Warstler
    27. February 2011 at 15:41

    A very important article:

    http://www.wired.com/magazine/2011/02/ff_myhrvold/

  16. Gravatar of cassander cassander
    27. February 2011 at 16:03

    Forgive my ignorance, but at the core isn’t NGDP targeting just a more sophisticated way of doing inflation/price targeting?

  17. Gravatar of Morgan Warstler Morgan Warstler
    27. February 2011 at 16:23

    “Even Krugman admits that there is really no case for fiscal stimulus until rates fall to zero.”

    Perhaps it would be good to explain the difference as you see ti between “fiscal stimulus from spending” and “deficit spending”

    Because DeKrugam loves deficits even when interest rates are high.

  18. Gravatar of Morgan Warstler Morgan Warstler
    27. February 2011 at 16:24

    er, let’s close the variable…

    Assuming tax rate increases are an impossibility politically, DeKrugman favors deficit spending.

  19. Gravatar of Mark A. Sadowski Mark A. Sadowski
    27. February 2011 at 17:16

    Andy,
    You wrote:
    “Without the 2001 tax cut, we would almost certainly have hit the zero constraint back in 2002 or 2003, and we would be having the same problems that we are having now.”

    Oh gosh, Andy, with all due respect, hand me the printing press and I’ll find a way of generating inflation expectations. There’s always other stuff you can buy. I’ll even buy Morgan’s stuff if that’ll help.

  20. Gravatar of Richard W Richard W
    27. February 2011 at 17:24

    Andrew Sentance leaves the MPC in May. Governor King has not helped matters by saying in his open letter to the chancellor that his two year inflation forecast was based on interest rates being “in line with market expectations”. Well at the time the market was forecasting three 25 basis point rises this year. Confirmation that the market forecast was broadly correct? The following day Mervyn King strongly played down the prospect of any rises this year. Whether it is deliberate central bank ambiguity their communication is muddled and inconsistent. Here is AS last speech on why he believes they should tighten. The hawks fears are that inflationary expectations lose their anchor and become entrenched.

    http://www.bankofengland.co.uk/publications/speeches/2011/speech476.pdf

  21. Gravatar of Benjamin Cole Benjamin Cole
    27. February 2011 at 17:47

    Another great post by Scott Sumner.

    Yes, what is inflation? And why have we become hysterical about inflation? Jeez, rates are so low you need a microscope to see them…and yet some people are making long faces about inflation. When measured inflation is under 1 percent, the Nipponistas are really scared of phantoms–at one percent, it is hard to make a case there is any inflation, as consumers are constantly migrating to the best and new options, making measurement inaccurate.

    I am ready for NGDP policies. Bring ‘em on. I sense the argument is shifting to our side.

    Again, the key PR strategy is to use Japan as the model of what not to do. Tell people they can lose 75 percent of their real estate and property portfolios, if we follow the Nipponistas. That will get their attention. Tight money now will wipe out your portfolio and your children’s future, by suffocating the economy. A monetary noose around our necks is suicidal.

    NGDP targeting can sidestep foolish mistakes made by weak foreign central banks, who lacked American vision and aggressiveness.

    If what I am saying is true–and I think it is–why are we too timid to make the case as I am? Why do we allow the inflation hawks to seize the high moral ground?

  22. Gravatar of Doc Merlin Doc Merlin
    27. February 2011 at 17:54

    @Scott
    Yep, agreed Scott, as I have been saying for a while, inflation targeting turns adverse supply side shocks into a combo of adverse supply side and adverse nominal shocks.

    @Morgan
    England has been increasing tax rates and launching really massive fiscal stimulus.

  23. Gravatar of Doc Merlin Doc Merlin
    27. February 2011 at 17:59

    @Benjamin Cole:

    At this point both price and monetary inflation (or soft defaults) are inevitable, just not yet.

    It will be the result of the cirisis+bailouts+etc as described by Reinhardt and Rogoff in “This Time Its Different.”

  24. Gravatar of Mark A. Sadowski Mark A. Sadowski
    27. February 2011 at 18:10

    Left Outside,
    Impressed by UK ancestry? My mother was a Bucker. (Buckhavanite of Scotland.)

    As for punning I was the captain of my high school’s punster team.

  25. Gravatar of Benjamin Cole Benjamin Cole
    27. February 2011 at 18:10

    Side note to Scott Sumner on Commodities Boom vs. Federal Spending Results in North Dakota Recovery.

    http://www.taxfoundation.org/research/show/22685.html

    The data is old. But, patterns do not change rapidly. Jeez, in 2005, North Dakota received net federal spending (federal spending minus federal taxes) of $4,377 per resident. Per resident!

    So, when the feds start pouring out the fiscal stimulus, this must surge to $6k or so, per resident, in 2010. Per resident!!! A family of four sits down, and there is $24k of federal lard at the dinner table.

    North Dakota receives back $1.68 for every dollar sent to DC.

    With such huge flows of federal lard into North Dakota, one can well wonder if commodities, or federal lard, led to a North Dakota recovery.

    Remember, North Dakota has two Senators. You want to pass a bill–they have two Senators, and so does South Dakota, and Montana, and Idaho and Iowa etc.

    I think a compelling argument can be made that we have created a rural welfare state, and that huge infusions of federal spending boosted small state economies recently. My understanding is that in 2012 new figs will be compiled by the Census Bureau. Census zip code data I have looked at reveals huge federal flows of money into rural areas.

    The picture is even worse, if you look at “cross-subsidization.” Every year, urban users have $8 billion tacked onto their phone bills, so that rural services can be subsidized. Of course, you see the same thing at the Post Office. The “story” is that lazy urban Post Office workers eat up your 48 cent stamp, while sleeping on the job, or shooting each other in bulk mail centers. That may be true–but also true, is that the Post Office runs unprofitable rural routes. They do not lose money running mail from NYC to LAS, or intra-urban. They lose money delivering mail six days a week to Red Bluff, Montana.

    The Red State Socialist Empire has done a terrific PR job is shifting media attention away from the realities of the federal budget. If you look where your income taxes go, you will want to secede from the union–if you live in California or New York or any other major urbanized state.

  26. Gravatar of Morgan Warstler Morgan Warstler
    27. February 2011 at 18:56

    Benjamin, the Red State Socialist Empire is the one the many horrible side effects of liberals trying to cram a Republic into a Democracy.

    Without that large payoff to sparsely populated states, they’ll become radical states rights libertarians, folks that make the Tea Partiers look centrist.

    And its good to see you on the Reagan team – every heard the phrase, “drunk is the truth, sober is the lie”?

    Its the same way with this sorry thing called Democratic capitalism – until you have maxed out the spending, blown through the credit cards – we can’t get down in the dirt and figure out what matters and what doesn’t.

    16% of GDP does sound perfect, doesn’t it?

  27. Gravatar of Richard W Richard W
    27. February 2011 at 19:13

    Doc Merlin
    27. February 2011 at 17:54

    ” England has been increasing tax rates and launching really massive fiscal stimulus. ”

    The last government raised taxes and the present government have raised them even more. However, there was no ‘ massive fiscal stimulus ‘. In 2009, discretionary stimulus was 1.6 percent of GDP, which was at the bottom end of G20 countries and the same as Germany. In 2010, discretionary
    measures were the lowest in the G20 at zero.

  28. Gravatar of Andy Harless Andy Harless
    27. February 2011 at 19:16

    Mark,

    I’d be glad to hand you the printing press, but unfortunately I would have to hand it to the FOMC, which is quite a different matter. You’re saying that because ideal monetary policymakers would have done a better job, therefore we should pretend we actually have ideal monetary policymakers. Monetary policy becomes more difficult when interest rates are low, and I think recent experience shows the advantage to be had from keeping the Fed’s job easy.

  29. Gravatar of Mark A. Sadowski Mark A. Sadowski
    27. February 2011 at 19:33

    Andy wrote,
    “I think recent experience shows the advantage to be had from keeping the Fed’s job easy.”

    No doubt. But I have free time if anyone is ever interested in an economic recovery in our lifetime.

  30. Gravatar of Benjamin Cole Benjamin Cole
    27. February 2011 at 20:02

    Morgan-

    Yes, you are right. As long as we have geographic representation, each representative will vote for more federal lard to their districts.

    I agree that a cap on federal outlays as fraction of GDP is worthy, say 16 percent. We could go lower.

    I don’t know what you mean by “liberals” however. Much of the spending in the Red State Socialist Empire is by conservatives, although the roots of rural welfare go back to LBJ (then in Congress) and FDR. Rural people were living without electricity, and there wasn’t the density to warrant power lines etc.

    LBJ-FDR powered up rural America–but the programs have remained in place and grown continuously since, along with our coprolitic defense establishment.

    Ever wonder why we have huge federal deficits whenever the R-Party is on power, even when we have a growing economy?

    I do not believe the Dems, or liberals, will do much better, although the record of Clinton was not bad.

    Another idea I like is that each state gets back roughly what they send to DC. Thus a balanced budget, and no interstate subsidies going on for generations.

    Another idea I also like is that without subsidies, our Midwest would depopulate so much it might make sense to change it back to a huge natural buffalo range. Antelopes! Tourist safaris!

    The food is so bad in the Midwest, I think this is reason alone to abandon rural America to its just fate. They have been parasites long enough, I say.

  31. Gravatar of インフレターゲットは有害だ by Scott Sumner – 道草 インフレターゲットは有害だ by Scott Sumner – 道草
    27. February 2011 at 21:13

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  32. Gravatar of FT Alphaville » Further reading FT Alphaville » Further reading
    28. February 2011 at 00:08

    [...] – Inflation targeting is a very bad idea. [...]

  33. Gravatar of Doc Merlin Doc Merlin
    28. February 2011 at 00:21

    @Richard W

    Why are you concentrating on discretionary stimulus? I didn’t say discretionary stimulus. I said stimulus.

    @Benjamin Cole

    “Another idea I like is that each state gets back roughly what they send to DC. Thus a balanced budget, and no interstate subsidies going on for generations.”

    And allow states to opt out of federal programs and thus send less and get less back? I would be all for that

  34. Gravatar of Duncan Van Limbergen Duncan Van Limbergen
    28. February 2011 at 02:58

    Inflation targeting is indeed a very bad idea when strong rules of accountability are put in place when, in fact, inflation just doesn’t matter that much to policy makers. Since the beginning of the crisis, the BoE has very clearly revealed to follow an output-smoothing strategy, while keeping a close eye on exchange rates.

    That is the whole point I am missing in this post – unless, of course, your point was to tackle the whole inflation targeting topic.

    Frankly, I don’t see the BoE role being incredibly foul here. A vast part of the British inflation number is fueled artificially, i.e. the VAT hikes. This kind of environment isn’t incredibly central banker friendly neither.

  35. Gravatar of Scott Sumner Scott Sumner
    28. February 2011 at 05:42

    Ram, Great comment. I think this is a good example of the perfect being the enemy of the better. NGDP isn’t perfect, and you can draw up theoretical models where output gaps are better. But it’s hard to measure the output gap (consider all the debate right now over structural issues) and the simplicity of a single target is a huge plus. Just imagine trying to get Congress to approve inflation plus output gap targeting.

    Andy, I do understand the first part of your comment, about how fiscal stimulus may be desirable if monetary policy is highly incompetent. My focus is on making monetary policy less incompetent. I also have very little faith in real world fiscal policy (from a competence viewpoint.)

    You said;

    “But I also began to realize something else as housing prices were skyrocketing: low interest rates are dangerous, even apart from the risk of their hitting a constraint.”

    I think low rates get a bad rap for the housing bubble, which was caused by bad regulation, especially the GSEs, where most of the bailout funds are going. Indeed housing bubbles are just as likely to occur during periods of high interest rates, and high inflation, as housing is an inflation hedge. In addition, I don’t think the Fed caused the low rates on mortgages during 2002-04, I think it was the weak economy after the tech bubble burst. Marcus Nunes has a nice new post showing that low interest rates don’t explain the housing bubble. In any case, central banks are not very good at figuring out when particular price rises are “bubbles” and Congress is even worse.

    You said;

    “Indeed, I would say that the purpose of fiscal policy is not to stimulate the economy but to keep interest rates up (or to keep them down via tight fiscal policy when that is preferable). Moderate interest rates are a desirable objective because they make monetary policy easier. And surely after the past 2 1/2 years, you will have to agree that the quality of monetary policymaking can deteriorate during times of very low interest rates.”

    I agree that policy is bad when rates hit zero, but as Meltzer pointed out long ago in his book on Keynes, that doesn’t call for fiscal policy, it call for a slightly higher inflation target. Or level targeting. Or NGDP targeting. But at a minimum a slightly higher inflation target.

    The interesting question is what would Krugman think of your hypothesis, which implies Krugman made a big mistake when he criticized Bush’s 2001 tax cuts.

    Morgan, French fries? And no, Krugman doesn’t “love deficits.”

    Cassander, Yes.

    Richard, I hope King wins out, but it shouldn’t even be this close.

    Benjamin, Inflation is easier for people to visualize. Most people hardly know what NGDP is. I went to a BEA website where they had about 100 GDP series, not one was percent change in NGDP. That’s the problem.

    Doc Merlin, Yes, but only if the central bank is interest rate targeting.

    Benjamin. I don’t know if you can assume that Federal money goes straight into their pockets. The nuclear weapon bases in North Dakota must be very expensive, for instance, and North Dakota has very few people. Your point is certainly true for agricultural subsidies.

    Richard, Yes, but I think one also has to consider the fact that government spending has risen sharply as a share of GDP (from the high 30s to the high 40s), and some of the increase predated the recession. It might therefore not be called “stimulus” but it created exactly the same supply-side problems.

    Duncan, My point is that the BOE is being pressured to raise rates because of 4% inflation. That’s not a good idea.

  36. Gravatar of Gregor Bush Gregor Bush
    28. February 2011 at 06:18

    Scott,
    I think you’re being a bit unfair to inflation targeting here. The proper way to do it, as Svensson says, is to target the forecast of inflation. Clearly with underlying inflation in the UK below 1%, output still below potential and the growth outlook mediocre, there is no need for the Bank to hike rates any time soon.

    The UK controversy stems from the fact that the BoE doesn’t have a good measure of underlying inflation (CPI ex volatile items and indirect taxes) as its operational target . And it feels that it can’t switch to such a measure now because it will be viewed as “moving the goal posts”. But if the BoE had over the years conditioned the public, the financial markets/press and the academic community that the starting point for its forecast would be the CPI excluding the effects of food, energy, import prices and taxes it would not be feeling anywhere near the same pressure to raise it policy rate.

    Yes, the level of NGDP might well better target. But as you said to Ram, don’t make the perfect the enemy of the better. If the Fed had been strictly targeting its own forecast of inflation it would have been compelled to act sooner and much more aggressively – particularly if the market forecast of inflation was one of its key inputs. It would not have been permitted to show a forecast of inflation remaining below target for four years.

    Is it not a good thing that at least the Fed had a “floor” of 1% on core inflation? Would it not have been better if the “floor” were 1.5% (and the ceiling were 2.5%)?

  37. Gravatar of Full Employment Hawk Full Employment Hawk
    28. February 2011 at 06:43

    In Romer’s article, she says ” Monetary policy makers are all hawks now.”

    There is no question that monetary policy makers should be hawks. The question is WHAT KIND OF hawks should they be?

    The Fed has two mandates, price stability and maximum employment. At the present time the Fed is much farther away from complying with its mandate for maximum employment than for price stability. Therefore, its mandate calls for the monetary policy makers to be FULL EMPLOYMENT HAWKS.

    Having a good job and not having to be afraid of losing it is much more important to the welfare of ordinary working people than absolute price stability. The current focus on price stability and neglect for full employment by people whose jobs are secure is elitist.

  38. Gravatar of Andy Harless Andy Harless
    28. February 2011 at 06:56

    Low rates aren’t a necessary or sufficient condition for a bubble, but they make one much more likely. It’s a matter of arithmetic: the less you discount future flows, the more prices are sensitive to estimates of those flows, and the more mistakes in those estimates can lead to mistakes in pricing. (Note that it is real rates that matter, not nominal rates.) Unlike the neo-Austrians, I don’t blame the Fed for the low rates, but when the world as a whole is trying to shift its consumption into the future, I see value in government policies that lean against that hyperprovidence. It has always seemed ironic to me that many of the people who were most critical of the Bush tax cuts were the same people who were most concerned about the housing bubble.

    central banks are not very good at figuring out when particular price rises are “bubbles” and Congress is even worse.

    I agree. I don’t think governments or central banks should be expected to identify specific bubbles, but governments can act to avoid conditions that raise the risk of bubbles. I would prefer not to even use the word “bubble” and just talk about asset price volatility. The point is not that investors necessarily make big, unreasonable mistakes but that they make small, reasonable mistakes that have big consequences in terms of asset pricing. The government can’t avoid making similar mistakes, but it can help provide an environment in which those mistakes have smaller consequences.

  39. Gravatar of Full Employment Hawk Full Employment Hawk
    28. February 2011 at 06:57

    “All indications are that the Bank of England plans to tighten policy this May, with the idea of reducing aggregate demand growth in Britain.”

    While it is reasonable to conclude that central banks fully (or at least nearly fully) offset expansionary fiscal policy with contractionary monetary policy when an economy at or above potential output and the central bank is fighting inflation, there are strong reasons to conclude that when an economy is depressed any offset for contrationary fiscal policy will be very partial at best, so that the contractionary fiscal policy will slow NGDP growth. What is happening in Britain once again illustrates this. Therefore when an economy is depressed such contactionary fiscal policy should be resisted by people who believe that achieving full employment is an important policy goal.

    For the same reason the Obama administration and the Democrats should pull out all the stops to keep the budget cuts the Republicans are trying to impose as small as possible. They are contractionary and any expansionary offset by the Fed will be very partial and very incomplete so that these budget cuts will slow the recovery and keep the unemployment rate high.

  40. Gravatar of Peter Peter
    28. February 2011 at 07:13

    If Mr Sumner was not an unsophisticated monetarist (funny how he calls everybody “unsophisticated” when lacking arguments) he could maybe learn about sectoral balances as practiced my Mr Hatzius of Goldman (this explains btw why Hatzius has a million dollar job and not Sumner – Hatzius understands that there is sometimes need for fiscal stimulus even if rates are non zero, and can predict where GDP is going by looking at the govt’s fiscal response). The government is as good provider of AD as any other sector, it is as simple as that. This insistence on highly distorting monetary stimulus is simply ideology.

  41. Gravatar of Gregor Bush Gregor Bush
    28. February 2011 at 09:00

    “This insistence on highly distorting monetary stimulus is simply ideology.”
    Peter,
    Why is monetary stimulus “distorting” while fiscal stimulus is not?

    By the way, part of Hatzius’ argument for fiscal stimulus was that the Fed behaves in a sub-optimal way when rates hit zero. He never argued that monetary policy was ineffective when rates hit zero and he was not against the Fed doing QE2. Sumner had been arguing that the Fed should ignore the zero lower bound and apply monetary stimulus by targeting the forecast of growth and inflation (NGDP). So I don’t see Hatzius and Sumner as being fundamentally opposed.

    The problem with fiscal stimulus is that it necessitates higher tax rates or lower spending in the future. Monetary stimulus does not.

  42. Gravatar of Doc Merlin Doc Merlin
    28. February 2011 at 10:32

    @Full Employment Hawk:

    Why do you cling to the idea that monetary stimulus helps reduce unemployment?

  43. Gravatar of OGT OGT
    28. February 2011 at 10:51

    Andy- I remember being quite surprised in the mid-oughts that the fiscal deficits did not lead to higher real rates. Based on the 1992-1994 experience I would have expected some crowding out and bond market pressure to raise rates.

    My current rough hypothesis coincides with Bernanke’s savings glut theory, that the financial crisis and recession are in large part due to the inability of Western institutions to accomodate the rise of the emerging market countries. Part of that is seen in the ever lower real interest rates, indicating very low investment demand, especially in a country with low, low savings rates.

  44. Gravatar of Doc Merlin Doc Merlin
    28. February 2011 at 11:16

    @OGT:
    “My current rough hypothesis coincides with Bernanke’s savings glut theory, that the financial crisis and recession are in large part due to the inability of Western institutions to accomodate the rise of the emerging market countries. Part of that is seen in the ever lower real interest rates, indicating very low investment demand, especially in a country with low, low savings rates.”

    I think a lot of it is that various regulatory reforms in the early 00′s (including Sarbane-Oxley) severely damaged the ability of companies to get investment and so created a artificial shortage of good investment opportunities.

  45. Gravatar of Adam Adam
    28. February 2011 at 11:26

    What was Summers argument against monetary stimulus? The quote mentions he was for fiscal, but those are obvi. not mutually exclusive.

  46. Gravatar of Jay Z Jay Z
    28. February 2011 at 11:42

    Morgan:

    “Without that large payoff to sparsely populated states, they’ll become radical states rights libertarians, folks that make the Tea Partiers look centrist.”

    Yeah, and if my aunt had balls she’d be my uncle.

    Please let me know when the Dakotas choose to give up the representation of Senators Beauregard and Beauregard Junior to California or Puerto Rico.

    Let ‘em go if they want, let them form Western Mongolia, after we dynamite the interstates and pull down the power lines. Those states have always depended on the Federal government. I don’t object to subsidization when appropriate, but if they want to go they can.

  47. Gravatar of Full Employment Hawk Full Employment Hawk
    28. February 2011 at 11:47

    “@Full Employment Hawk: Why do you cling to the idea that monetary stimulus helps reduce unemployment?”

    Doc: Why don’t you ask Scott Sumner why he clings to the idea that monetary stimulus helps reduce unemployment

  48. Gravatar of Full Employment Hawk Full Employment Hawk
    28. February 2011 at 12:05

    “The problem with fiscal stimulus is that it necessitates higher tax rates or lower spending in the future. Monetary stimulus does not.”

    ONE of the advantages of monetary policy over fiscal policy is that while expansionary fiscal policy INCREASES the deficit, expansionary monetary policy REDUCES it. During ordinary, run-of-the-mill recessions, monetary policy plus the automatic stabilizers are the optimal way of dealing with it and discretionary fiscal policy is not desirable.

    But when the economy is hit by a very serious shock and is badly depressed, the federal funds rate cannot be lowered, the financial system is damaged, and the central bank is very reluctant to make the extensive use of unconventional monetary policy that is needed, fiscal policy is needed to help monetary policy. A term is needed for this kind of situation. I suggest calling it a “pseudo liquidity trap.” Monetary policy has not lost its effectiveness, but it needs help from fiscal policy.

    In any case, expansionary fiscal policy is not going to happen under the current political regimes in either the United States or Great Britain. What needs to be done in the area of fiscal policy under the present situation is to do whatever can be done to keep the spending cuts as small as possible, thereby limiting the damage contractionary fiscal policy does, and therefore making it easier for monetary policy to restore the economy to full employment.

  49. Gravatar of Full Employment Hawk Full Employment Hawk
    28. February 2011 at 12:09

    “@Full Employment Hawk:Why do you cling to the idea that monetary stimulus helps reduce unemployment?”

    Because I am not a laissez-faire ideologue, nor a Real Business Cycle theorist.

    In addition, with the federal funds rate having reached the zero floor, because I am not an orthodox Keynesian who believes that we are in a liquidity trap and therefore monetary policy has lost his effectiveness.

    On monetary policy I largely support the Quasi-Monetarist position.

  50. Gravatar of marcus nunes marcus nunes
    28. February 2011 at 12:12

    Doc, FEH
    You have to “fill the hole” opened by letting NGDP fall way below trend. That can only be done by getting NGDP to grow fast enough to “close the hole”!
    http://thefaintofheart.wordpress.com/2011/02/01/%e2%80%9cfill-the-hole-with-not-by-workers%e2%80%9d-%e2%80%93-spend/

  51. Gravatar of Benjamin Cole Benjamin Cole
    28. February 2011 at 12:20

    Side not to Scott:

    Why do think we maintain hugely expensive defense bases? For actual national defense? Or to pour money into certain districts?

    The latter is more and more the case. We have a Cold War archipelago, to fight guys with armed with cell phones and homemade bombs.

  52. Gravatar of Morgan Warstler Morgan Warstler
    28. February 2011 at 13:02

    Benji & Jay Z,

    My point is that if liberals give up on trying to boss everyone around from DC, states rights will take hold – and there will be a natural defunding of small state welfare.

    Of course, what those states do to make up for the losses will give liberals a coronary.

    That’s the beauty of “Democracy” in America – it screws the liberals into being conservative.

  53. Gravatar of justanothereconomist justanothereconomist
    28. February 2011 at 13:33

    Q4 2010 Real GDP growth revised down to 2.79%. In other news, QE’s effects are gigantic. I guess we’ll hope the Q1 2011 numbers are better?

    http://econintersect.com/wordpress/?p=6342

    In other news, the UK’s austerity economy also shrank faster in Q4 2010 than expected.

    http://www.reuters.com/article/2011/02/25/markets-sterling-idUSWEA660920110225

  54. Gravatar of Richard Allan Richard Allan
    28. February 2011 at 14:32

    I think the Office of National Statistics claimed that the entirety of the drop in Q4 growth was down to the bad weather.

  55. Gravatar of Mike Mike
    28. February 2011 at 15:30

    I have been reading the blog for some time now, and I think the case for NGDP targetting is pretty solid. However, I have a question and wonder if anyone wants to take a shot at it. It has to do with “sticky profits.” I am reading the book “All the Devils are Here” and it seems to tell a story that could be described as sticky profits. That is, when the economy was booming the Fed decided to increase interest rates. That made it harder for certain people in the mortgage industry to maintain their level of profits. It seemed they wold lose out to people in the subprime industry who were using unethical methods. Perhaps people are more likely to be irrational and conduct their business unethically if they are used to high profits and see a likely downturn. If this is true, it could mean that raising interest rates from a low level tends to cause bubbles.

    If you can’t raise interest rates from a low starting position without causing a bubble, then NGDP targeting (and inflation targeting) seem to be problematic. Am I way off base?

  56. Gravatar of justanothereconomist justanothereconomist
    28. February 2011 at 15:36

    To be clear, the ONS says that 0.5% of the fall in GDP was explained by the weather. However, with the revision, the UK economy would have shrunk anyway without the weather.

    http://www.guardian.co.uk/business/2011/feb/25/uk-economy-contracted-by-0-point-6-percent

    This hardly points to austerity being irrelevant at the zero bound, in fact it points to austerity being quite painful.

  57. Gravatar of cassander cassander
    28. February 2011 at 15:59

    Scott> Then I don’t get why you think inflation targeting is such a terrible idea. I mean, sure, it’s less optimal, but certainly it must be better than, say, Phillip’s curve unemployment targeting, or “what would Greenspan do” targeting, or even our current policy of “maybe we have an inflation target and maybe we don’t” targeting.

  58. Gravatar of Full Employment Hawk Full Employment Hawk
    28. February 2011 at 17:01

    “Q4 2010 Real GDP growth revised down to 2.79%.”

    That was largely due to the fact that the cuts in state and local government spending had had a much larger negative impact on the growth in output than had been anticipated.

    The de facto fiscal policy of the state and local governments has been and is very contractionary. This is de facto fiscal policy, since the cuts were not made for stabilization purposes, but rather to meet balanced budget requirements. But the aggregate impact on the economy is the same as a contractionary fiscal policy. Krugman is right in calling the state governments “50 little Hoovers.” The Fed has clearly not used expansionary monetary policy enough to offset this contractionary de facto fiscal policy adequately. More financial assistance to the states from the Federal government, so that they would not have had to make these cuts, would have prevented this.

    In other words a greater fiscal stimulus in the form of assistance to the states would have succeeded where the Fed did not.

  59. Gravatar of Full Employment Hawk Full Employment Hawk
    28. February 2011 at 17:14

    “This hardly points to austerity being irrelevant at the zero bound, in fact it points to austerity being quite painful.”

    Austerity is MOST relevant when short-term interest rates are at the zero bound. If they are above zero, the central bank can offset the contractionary effects of a contractionary fiscal policy with conventional expansionary monetary policy (lowering the short-term rate it pegs) which it is more likely to do than what it has to do at the zero bound, where conventional monetary policy no longer can be used. Under such conditions, where monetary policy becomes more difficult and uncertain, and requires unconventional policies, the central bank is less able and less likely to offset the contractionary fiscal policies, so they will do a lot of harm. But, of course, in Britain, the harm will be done to to commoners, not the upper claaases.

  60. Gravatar of justanothereconomist justanothereconomist
    28. February 2011 at 17:20

    “The de facto fiscal policy of the state and local governments has been and is very contractionary.”

    Yep- this is a huge problem

    “The Fed has clearly not used expansionary monetary policy enough to offset this contractionary de facto fiscal policy adequately.”

    Well they’ve done plenty of QE, but it’s not having much of an impact with short term interest rates at zero.

    “More financial assistance to the states from the Federal government, so that they would not have had to make these cuts, would have prevented this.”

    Yes. I think they should federalize medicaid- to have medical care paid for by state governments that can’t run deficits is a farce. This would be an immediate boost to state budgets.

    “Austerity is MOST relevant when short-term interest rates are at the zero bound. If they are above zero, the central bank can offset the contractionary effects of a contractionary fiscal policy with conventional expansionary monetary policy (lowering the short-term rate it pegs)”

    Yes, I agree with this. But I don’t think Scott does, he seems to think that we just need to believe in QE and all will be well. But all is not well at the zero lower bound.

  61. Gravatar of Full Employment Hawk Full Employment Hawk
    28. February 2011 at 17:23

    “My point is that if liberals give up on trying to boss everyone around from DC, states rights will take hold – and there will be a natural defunding of small state welfare.”

    The U.S. does not have 50 autonomous economies, but,rather one unified economy. For example, firms and individuals are free to move around in this economy. The only level of government that can deal effectively with the problems such an economy faces is the federal government.

    Incidentally only individuals have rights, governments do not. Therefore the concept of states rights is inconsistent with the principles of a free society.

  62. Gravatar of Benjamin Cole Benjamin Cole
    28. February 2011 at 17:26

    Morgan-

    Your leap of faith is wonderful.

    I doubt the Red State Socialist Empire will ever voluntarily give up any of its annual Mississippi of federal lard.

    When you get up to $5 and $6 k in net federal lard per rural resident, you are talking about dependence, big-time. Asking a North Dakota or Kentucky to give up federal lard is asking them to forgo their economic future for several generations. Property values would plummet, populations would shrink. Urban America would get a huge positive jolt, both from net income and population inflows.

    Once you study the geographic flows of federal taxes and outlays, you begin to understand why we have a chronic deficit. The large urban states chrocnically pay more to the federal government than they get back, while small rural states chronically pay less than they get back.

    We have a federal deficit due to the Red State Socialist Empire. Actually, when you consider that the 12 farm states have 24 Senators, this is to be expected.

    I happen to have had fleeting experience with the TX and CA Congressional delegations. My limited exposure was that the TX congressmen were well-organized, and pursued regional interests with vigor. They knew what to do.

    The sad-sack CA delegation, while larger, is split by party, and not given to regionalism. They are weak, poorly organized, and given to issues rather than bringing home the bacon.

    Our two Senators, Feinstein and Boxer, are probably more passionate about gay rights than federal outlays in CA.

  63. Gravatar of Full Employment Hawk Full Employment Hawk
    28. February 2011 at 17:37

    “Well they’ve done plenty of QE, but it’s not having much of an impact with short term interest rates at zero.”

    In light of the hole the economy is in QEII has been totally inadequate.

    And not all short-term interest rates are currently at zero. A very important interest rate that is not at zero is the interest the Fed pays on excess reserves. Even though it is only 25 basis points, that is more than the yield on treasury bills and short-term commercial paper. And it is one interest rate that the Fed has direct control over. Cutting and then eliminating this would give the economy a very strong stimulus because banks would shed their excess reserves. The best outcome would be if it caused banks to lend more, but even if they did not and bought government bonds instead, this would cause expected real long-term interest rates to drop for any given level of expectations. More importantly, this would cause economic decision makers to expect a more expansionary monetary policy and faster NGDP growth, which would be very expansionary.

  64. Gravatar of OGT OGT
    28. February 2011 at 18:11

    Doc- Real rates have been falling in the US and throughout the developed world for twenty years. So, I don’t think one can fit Sarbanes-Oxley into the picture in any coherent way. (A more plausible counter hypothesis could be slowing labor market growth in the developed world).

    Sumner- On the internal administration politics, I really think one probably needs to put more blame on Bernanke. At the start of the administration he was working very closely with the Obama team. I believe they were deferring to him on monetary policy, and if he had signaled he needed help I think he would have gotten it.

  65. Gravatar of Mark A. Sadowski Mark A. Sadowski
    28. February 2011 at 19:10

    Wow, big thread. If I weren’t so busy I’d try and contradict somebody.

  66. Gravatar of Contemplationist Contemplationist
    28. February 2011 at 20:44

    Scott how about a post on NGDPs flaws and coming up with a (theoretical) best model? We know you think (I agree) that NGDP would be the best target in this real world of central bankers and politicians, but tell us what would be theoretically the perfect target as well

  67. Gravatar of ApeMan1976 ApeMan1976
    28. February 2011 at 20:53

    “The problem with fiscal stimulus is that it necessitates higher tax rates or lower spending in the future.”

    This is false. It seems from reading this thread that for many commenters here, it’s the central misunderstanding from which all other misconceptions flow.

  68. Gravatar of Morgan Warstler Morgan Warstler
    28. February 2011 at 21:34

    Benji,

    “Our two Senators, Feinstein and Boxer, are probably more passionate about gay rights than federal outlays in CA.”

    As I said, that’s justice baby, when you try and boss the other folks around, nationalizing everything, you have to foot the bill – until you go broke, and they go back to being whatever they want to be.

    The whole point to real rights is that they will not be denied, that they are irrepressible. BTW, I think gays would have gotten a lot more respect far earlier if they armed themselves to the teeth.

    Learning to let go of the deeply unhappy desire to ruin everyone else good time, is more needed on the technocrat left, than the religious right.

    And besides, it is the nationalization of every damn single issue voters’ single issue – that means every discussion has to be a death match. You want just one little thing desperately, but you only get it if one side wins, so you have to go party line.

    Sates rights leaves at stuff at home, so communities can readily horse trade on their c,d,e,f,g issues.

    —-

    Anyway, don’t convince yourself too much on that Western state largess, who knows what kind of crazy cool places the Dakotas would have become out of economic necessity.

    When you cast a wider net, allow for greater deviation, and create bigger mutants – you learn more, you grow stronger faster.

    This country doesn’t need any more Alan Aldas.

  69. Gravatar of Morgan Warstler Morgan Warstler
    28. February 2011 at 21:36

    “Every state has different demographics, every state has different problems,” Hatch said, according to a Utah Statesman report published Monday. “It’s good to allow them to work out their own problems rather than a one-size-fits-all federal government, dumb-ass program. It really is an awful piece of crap.”

    http://thehill.com/blogs/blog-briefing-room/news/146467-hatch-calls-healthcare-law-a-dumb-a-program

  70. Gravatar of justanothereconomist justanothereconomist
    28. February 2011 at 21:59

    “In light of the hole the economy is in QEII has been totally inadequate.”

    Yeah another trillion of excess reserves will definitely do the trick….

    “And not all short-term interest rates are currently at zero. A very important interest rate that is not at zero is the interest the Fed pays on excess reserves. Even though it is only 25 basis points, that is more than the yield on treasury bills and short-term commercial paper.”

    How big of an impact will this have? Scott and his followers keep whining about 0.25%, but you need to make a model to estimate how big of an impact that will have. The fed funds rate is 0-0.25%, so the interest on reserves is consistent with that.

    What impact will a quarter of one hundredth of a percent of the fed funds interest rate have on output? If you can’t even give a ballpark number, then you don’t really have a theory, do you?

  71. Gravatar of Doc Merlin Doc Merlin
    28. February 2011 at 22:11

    @justanothereconomist:

    “Yeah another trillion of excess reserves will definitely do the trick….”

    Agreed, QE is useless here.

    “And not all short-term interest rates are currently at zero. A very important interest rate that is not at zero is the interest the Fed pays on excess reserves. Even though it is only 25 basis points, that is more than the yield on treasury bills and short-term commercial paper.”

    That has a /huge/ effect, because it keeps the money from flowing into the market, which makes QE only have the effect of increasing bank reserves in the short run.

  72. Gravatar of Full Employment Hawk Full Employment Hawk
    28. February 2011 at 22:19

    “Yeah another trillion of excess reserves will definitely do the trick….”

    With no interest on excess reserves, banks would hold fewer of them. I am not in a position to conduct a model of the effect, but that should definitely be done by someone who is in a position to do it.

    Whether another fiscal stimulus would work is of great academic interest, but is irrelevant for policy purposes because it is not going to happenunder the current political regieme. If one wants to bring unemployment down more rapidly, more expansionary monetary policy is the only game in town.

    Incidentally, for me it has never been monetary VERSUS fiscal policy. With the economy in as big a hole as it is we needed both more expansionary monetary AND more expansionary fiscal policy. The 1.2 Trillion dollars of stimulus Christina Romer had recommended should have been passed. The part that could not have been gotten the 60 votes needed to get past the Republican filibuster should have been passed using reconciliation, which requires only 51 votes. At the same time, Obama should have quickly filled the vacancies on the Board of Governors with people who took the Fed’s mandate to achieve maximum employment seriously, so that the Fed would have been reinforcing the fiscal stimulus with expansionary monetary policy instead of offsetting it with contractionary monetary policy.

  73. Gravatar of Full Employment Hawk Full Employment Hawk
    28. February 2011 at 22:27

    “which makes QE only have the effect of increasing bank reserves in the short run”

    The purchase of longer term government bonds also reduces the supply of such bonds,raising their price and therefore bringing longer term interest rates, for any given set of expectations, down. Unfortunately the treasury is offsetting this effect by lengthening the term structure of its borrowing.

  74. Gravatar of Full Employment Hawk Full Employment Hawk
    28. February 2011 at 22:34

    “Every state has different demographics, every state has different problems,” Hatch said”

    That is a half truth. For some problems conditions vary from state to state, and those should be handled at the state level. But with a single unified economy, which is what the United States has, many problems affect the entire country, or at least most of it. For example, the high unemployment rate, the forclosures, and the inability of many people to obtain health insurnace from the private companies, who only want to insure those people who are not likely to need it. Only the Federal government can effectively deal with them.

  75. Gravatar of Gregor Bush Gregor Bush
    1. March 2011 at 06:10

    FEH,
    “But when the economy is hit by a very serious shock and is badly depressed, the federal funds rate cannot be lowered, the financial system is damaged, and the central bank is very reluctant to make the extensive use of unconventional monetary policy that is needed, fiscal policy is needed to help monetary policy.”

    Yes, I agree with this. But the only reason I agree is because of that last condition that you mention: “the central bank is very reluctant to make the extensive use of unconventional monetary policy that is needed”. This reluctance of the central bank to use the tools that it has to hit its own target is the only thing that gives fiscal policy traction. But fiscal policy is very costly. And the point of Scott’s blog is to get economists and policymakers to realize that unconventional monetary stimulus can be very powerful and it is the best way (and perhaps now the only way) out of our current predicament.

    Prior to the crisis, we lived in a New Keynesian policy world, where the central bank was responsible for the business cycle. We thought there was a consensus that, were rates to hit zero, it wouldn’t be a problem because the central bank still has many powerful tools that it could use. But when the crisis hit, the majority of the profession panicked, called for aggressive fiscal stimulus and declared central banks to be impotent. It turns out that the New-Keynesian consensus wasn’t nearly as solid as some of us thought it was. Much of the profession, and many economic and financial market commentators, still saw the stance of monetary policy as being the level of short-term interest rates. So I see Scott’s objective as moving the consensus back to where it should have been (and where we thought it was) all along.

  76. Gravatar of Scott Sumner Scott Sumner
    1. March 2011 at 06:17

    Gregor, I don’t see your comment as conflicting with mine. I certainly agree that an inflation target could be much more clearly spelled out, and also that one could target the forecast. If that were done, then inflation targeting would not suffer from the problems that I cite above. I am talking about real world inflation targeting, which falls well short of that ideal. And I am suggesting that even real world NGDP targeting would mostly avoid this problem, as there is only one NGDP.

    Full Employment Hawk, I agree about jobs.

    Andy, You said;

    “Low rates aren’t a necessary or sufficient condition for a bubble, but they make one much more likely. It’s a matter of arithmetic: the less you discount future flows, the more prices are sensitive to estimates of those flows, and the more mistakes in those estimates can lead to mistakes in pricing. (Note that it is real rates that matter, not nominal rates.)”

    I agree that real long term rates are what matters for bubbles, but the Fed doesn’t set real long term rates, the market does. Those rates were low in 2003 because of a worldwide saving/investment imbalance after the tech bubble burst and Asian net savings rates rose sharply.

    Oops, I should have read your entire comment before responding, I see that you agree. But then I don’t follow the rest. If you are saying that the government should always be trying to raise real rates from low levels, then I don’t see how that doesn’t violate the government’s budget constraint. And if they just do it temporarily, you’re back to the problem of spotting bubbles. Or did I misunderstand your suggestion?

    Full Employment Hawk; You said;

    “While it is reasonable to conclude that central banks fully (or at least nearly fully) offset expansionary fiscal policy with contractionary monetary policy when an economy at or above potential output and the central bank is fighting inflation, there are strong reasons to conclude that when an economy is depressed any offset for contrationary fiscal policy will be very partial at best,”

    I don’t agree, and think that the argument is symmetrical. I think it’s always a mistake to think of central banks as “fighting inflation” or “not fighting inflation.” They are targeting inflation, and they are doing so whether Britain is in a recession or not. In any case, if they raise rates in May they will clearly be acting as if they believe Britain is above potential and has excessive inflation.

    Peter, You said;

    “The government is as good provider of AD as any other sector, it is as simple as that. This insistence on highly distorting monetary stimulus is simply ideology.”

    Yes, and that’s why unsophisticated monetarists like Paul Krugman say fiscal stimulus is only called for at the zero bound.

    The purpose of NGDP targeting is not to “distort” the economy, but precisely the opposite—to prevent monetary shocks like 2008 from distorting the economy.

    BTW, if the government were efficient the Soviet Union never would have crashed.

    Gregor, You are right, I’m pretty sure Hatzius supports QE2.

    Adam, I’m not saying Summers was against monetary stimulus, I’m saying he entirely ignored the issue. He needed to alert Obama to the importance of monetary stimulus.

    Benjamin, I agree about national defense and pork, but I presume those bases were put in ND for a reason (closeness to Russia, or far away from big cities in case the Russkies strike us.)

    justanothereconomist, You sneered:

    “Q4 2010 Real GDP growth revised down to 2.79%. In other news, QE’s effects are gigantic. I guess we’ll hope the Q1 2011 numbers are better?”

    Let’s disentangle the four mistakes in this sneer:

    1. Assuming RGDP is the right indicator of monetary stimulus, not NGDP
    2. Assuming one number is sufficient, ignoring the fastest growth in final sales in 20 years. Or the fall in unemployment from 9.8% to 9.0%. There are lots of conflicting numbers.
    3. Assuming I claimed the effect of QE2 would be gigantic (I said QE2 was much better than nothing, but much less than we needed.)
    4. Most importantly, assuming I claim to be some sort of Nostrodamus. I have never claimed to be able to predict the future, I judge policies by their effects on expectations, not actual growth. If you want a more balanced appraisal of QE2, check out my recent post “QE2 after 3 months” You will see that most of the economic indicators are looking better, but some, (including 4th quarter GDP) are not.

    Obviously I completely agree about the slow growth in the UK, which was precisely the point of this post, was it not? BTW, where is your data on UK government spending in Q4? Isn’t that the relevant data?

    Mike, You said;

    “If you can’t raise interest rates from a low starting position without causing a bubble, then NGDP targeting (and inflation targeting) seem to be problematic. Am I way off base?”

    All monetary regimes require this, if you can’t do it you end up with hyperinflation. So I think we have to assume that interest rates are endogenous over a reasonable time frame.

    I don’t see profits as being very sticky. They are highly volatile, and the behavior you describe is not rational for profit-maximizing firms.

    Cassander, Yes, there are far worse monetary policies, but it doesn’t seem to be doing the job it is supposed to do–tell central banks when to ease or tighten. So in an absolute sense it’s a bad policy.

    Full employment Hawk;

    “This is de facto fiscal policy, since the cuts were not made for stabilization purposes, but rather to meet balanced budget requirements. But the aggregate impact on the economy is the same as a contractionary fiscal policy.”

    This is completely wrong, and a big flaw in the Keynesian model. It’s clear that S&L spending is endogenous, and hence is not a part of federal stabilization policy. Instead, it’s something the federal government must take account of, much like they take account of cutbacks in private investment spending in a recession. It’s now clear that the Keynesian economists who advise Obama utterly failed to take this into account, indeed I’m pretty sure Krugman didn’t as well, as he didn’t start talking about it until after it happened. It is also the reason why Krugman’s suggested $1.3 trillion in stimulus would have also failed.

    justanothereconomist; You said;

    “Well they’ve done plenty of QE, but it’s not having much of an impact with short term interest rates at zero.”

    It had a substantial impact on inflation expectations, stock prices and the dollar, which was exactly what it was supposed to do.

    Your comment on state and local governments completely undercuts your style of argument

    A. Monetary stimulus expected to work, if it doesn’t actually work due to other factors, that shows it failed.
    B. Fiscal stimulus expected to work, if it doesn’t actually work because of S&L cutbacks, then fiscal policy hasn’t failed, after all, there are things beyond the control of the federal government.

    If monetary stimulus fails to produce the boost that most forecasters now expect in 2011 (growth forecasts are being revised upward across the board) then it will be due to some unforeseen factor like oil shocks and/or major euro crisis. The fiscal situation is even worse. The Keynesian models should have put in the S&L cutbacks, but they didn’t. Those cutbacks were entirely forecastable.

    OGT, You may be right about Bernanke.

    Cassander, The best target in theory is an aggregate variable for nominal hourly wage rates. But it’s hard to calculate and politically explosive.

    Apeman1976, Is that a Laffer Curve argument?

    Justanothereconomist, You said;

    “How big of an impact will this have? Scott and his followers keep whining about 0.25%, but you need to make a model to estimate how big of an impact that will have.”

    My next post was going to address that issue–show why no model can answer that question. In December 2007 there was a 500 to 700 point swing in the Dow based on the difference between a 1/4 and 1/2 point cut. No model will explain that. The issue is expectations. BTW, I’ve never argued that the IOR is a huge problem right now. I’ve argued the IOR could be cut by 2%, to negative 1.75%. See how much excess reserves they want to hold at that rate.

    I agree with you that QE is a weak tool, the Fed as far more powerful tools, as even Bernanke admits, but simply doesn’t want to use them. A higher inflation target or better yet a price level target, or better yet an NGDP target would be far better than QE.

  77. Gravatar of bertusmaximus bertusmaximus
    1. March 2011 at 08:07

    i might not agree with all the policy implications of this blog (and at times folks here way too academic) but its fantastic to have this sort of forum for these topics and impressed with the time and effort that scott puts into replying to everyone. have learned lots.

  78. Gravatar of Full Employment Hawk Full Employment Hawk
    1. March 2011 at 08:22

    “i might not agree with all the policy implications of this blog (and at times folks here way too academic) but its fantastic to have this sort of forum for these topics and impressed with the time and effort that scott puts into replying to everyone. have learned lots.”

    I agree. In particular, I have gained a much better understanding of WHY monetary policy continues to be effective when short term interest rates have reached the zero floor.

  79. Gravatar of Full Employment Hawk Full Employment Hawk
    1. March 2011 at 08:39

    “In any case, if they raise rates in May they will clearly be acting as if they believe Britain is above potential and has excessive inflation.”

    True, but the reality is that Britain is well below potential output and therefore the BOE will not be using expansionary monetary policy to offset the contractionary fiscal policy of the Tory government. The bottom line is that whether it is because the central bank is making a mistake, or because it is unwilling to use nonconvetional monetary policy sufficiently, or because the effects of such methods are uncertain and weaker than was expected, when the economy is depressed and the short-term target rate has reached zero, central banks will only partially and incompletely offset the effects of contractionary fiscal policy AT BEST. Therefore such contractionary fiscal policy will cause increased unemployment.

  80. Gravatar of Benjamin Cole Benjamin Cole
    1. March 2011 at 09:38

    Morgan-

    Yes, it was gays touting AK-47s that finally turned the tide.

  81. Gravatar of justanothereconomist justanothereconomist
    1. March 2011 at 10:12

    “My next post was going to address that issue–show why no model can answer that question. ”

    It may be that there is no way to model or test the effect of QE, but then it is a non-falsifiable theory. And you’re no loner even close to a scientific theory, but purely one based on faith. A pure Tinkerbell theory- just believe.

    “In December 2007 there was a 500 to 700 point swing in the Dow based on the difference between a 1/4 and 1/2 point cut.”

    Yes, but other things were happening in the economy.

    “BTW, I’ve never argued that the IOR is a huge problem right now. I’ve argued the IOR could be cut by 2%, to negative 1.75%. See how much excess reserves they want to hold at that rate.”

    This would help, though banks would find a way around this, by storing reserves in their vault or transferring excess reserves abroad to countries without negative IOR. I would hope that, being a libertarian, you will understand these arguments.

    “A higher inflation target or better yet a price level target, or better yet an NGDP target would be far better than QE.”

    But we’re not even hitting the 2% (implicit) inflation target Bernanke admitted to. I’m fairly sure that you would argue that raising the target will raise expectations of the future, etc. but I just don’t see it. If Bernanke can’t hit even a 2% inflation raget despite massive QE, then monetary stimulus (at the lower bound) is ineffective. It’s easy to argue for policies that will never be implemented like negative IOR, but I just don’t see any effectiveness of monetary policy right now.

    How about this… Massive fiscal stimulus until excess reserves are cut in half- then halt fiscal stimulus. Let higher inflation with a zero interest rate take us back to a 5% NGDP trend. The Fed dunds rate should be above 0.25% by then. Then we don’t speak of fiscal policy again, unless we get back to the zero lower bound, and it’s all about monetary policy and NGDP targeting. Deal?

  82. Gravatar of Richard Allan Richard Allan
    1. March 2011 at 11:17

    I hate to be dense, here, but how is fiscal stimulus in the form of spending increases even supposed to work? If it’s tax cuts then I can see it, I would expect a higher expected rate of profit to allow firms to eat the consequent increase in real wages, and thus increase output. But what about spending increases? What kind of spending are we talking about, helicopter money? Is it an attempt to increase velocity by transferring cash to people who would then have “excess cash balances”?

  83. Gravatar of “Change the tune” « Historinhas “Change the tune” « Historinhas
    1. March 2011 at 12:03

    [...] to Scott Sumner: Throughout history, only a tiny number of economists have intuitively grasped the incredible power [...]

  84. Gravatar of Morgan Warstler Morgan Warstler
    1. March 2011 at 12:03

    Another proof set that the US catches a cold and the Middle East coughs up a lung:

    http://en.rian.ru/world/20110301/162803894.html

    ——

    Ok, I think we’re going to have to come to terms with the political economic reality that ANY TIME the economy improves, the price of oil is going to shoot up.

    As such, I think we have get serious about domestic policy:

    1) we have to kiss Big Oil’s ass
    2) we have to do a tax swap – gas/diesel tax for ending taxes on corporations
    3) we have to end all other prices supports of any kind – from public employees, to Davis-Bacon, to mortgage tax deduction, to healthcare deduction.

  85. Gravatar of Full Employment Hawk Full Employment Hawk
    1. March 2011 at 17:48

    “I hate to be dense, here, but how is fiscal stimulus in the form of spending increases even supposed to work?”

    I will assume that you are asking a serious question here and really do not understand how this works, rather than asking a rhetorical question. The explanation is very simple and can easily be explained at the Macro Principles level.

    Aggregate demand is equal to the following categories of expenditures: Consumption, (Physical) Investment, Government purchases, and Net Exports. Increases in government purchases increase aggregate demand, whether they consist of government purchases from private firms or the direct provision of government services. And this does not NORMALLY involve the government increasing the amount of money people hold, although the expenditures can be financed by printing money (as was done during the civil war by both sides).

    The increase in aggregate demand means that most firms will experience an increase in the demand for their products. If the economy is below potential output so that there are idle resources, i. e. idle (physical) capital and labor, the firms will respond to the increase in demand by producing more and therefore hiring more workers. This increases the income of the workers, so they spend more, which increases another component of aggregate demand, consumption, causing firms to produce still more. Also as firms increase their output and therefore capacity utilization increases, firms will increase their (physical) investment, which increases still another component of aggregate demand.

    This will happen even if the central bank holds the money supply constant. This is because as output and income increase, the demand for money increases. When the demand for money increases with a fixed supply of money this raises the interest rate. Since the velocity of money is directly related to the interest rate, the increased velocity will permit the fixed amount of money to circulate the larger volume of transactions that result from the increased income and output.

    But if the central bank pegs the rate of interest, the increase in the demand for money simply causes the central bank to create enough additional money to keep the interest rate constant.

    There are all kinds of arguments that the increase in government purchases will only crowd out an equal amount of consumption or (physical) investment, so that aggregate demand does not change. But as long as the economy has excess capacity none of them are valid EXCEPT the one that if the central bank is pursuing a target that is inconsistent with the resulting increase in output and income, the central bank will offset the expansionary effect of the fiscal policy with a more contractionary monetary policy.

  86. Gravatar of Doc Merlin Doc Merlin
    1. March 2011 at 17:48

    @Richard Allan:

    I agree about fiscal stimulus not working.
    Monetary stimulus can work if the problem was /caused/ by bad monetary policy. Or if the problem is not related to fixing bad monetary policy, it can cause an Austrian Business cycle to form up, and crash the market years down the road.

  87. Gravatar of Doc Merlin Doc Merlin
    1. March 2011 at 17:51

    @ Full Employment Hawk, Richard Allan:

    Your explanation is the standard Keynesian one, but I will add that most people on this blog don’t believe fiscal stimulus actually works.

    Here is a counterargument for you from data: http://www.antolin-davies.com/conventionalwisdom/spend.pdf

  88. Gravatar of Doc Merlin Doc Merlin
    1. March 2011 at 17:52

    @Benjamin cole:
    Speaking of gays with ak-47′s
    http://www.pinkpistols.org/index2.html

  89. Gravatar of Full Employment Hawk Full Employment Hawk
    1. March 2011 at 18:22

    “If Bernanke can’t hit even a 2% inflation raget despite massive QE, then monetary stimulus (at the lower bound) is ineffective.”

    The Federal Funds rate has reached the lower bound, but interesst rates on the whole have not. Most expenditure decisions that are affected by interest rates depend on longer, and long-term interest rates, and these are significantly above zero and rising. So interest rates in the aggregate are nowhere near the lower bound. Therefore the economy is not in a liquidity trap.

    Pegging the federal funds rate is only one of many ways of conducting monetary policy. For example, during the early 1980s, Paul Volker targeted the rate of growth of monetary aggregates. The Fed can use one or more of the other ways of conducting monetary policy to give the economy an additional stimulus. A larger amount of quantitative easing would give the economy a larger stimulus. If the increase in excess reserves is viewed as a problem inhibiting the Fed, cutting the interest rate on excess reserves to zero is the desired alternative since that will give the economy the desired monetary stimulus while REDUCING excess reserves. Even if it does not cause banks to increase lending (the most desired outcome) they will purchase financial assets. This will lower the interest rates that are above zero, and more importantly, increase expectations about future expansionary monetary policy.

    “This would help, though banks would find a way around this, by storing reserves in their vault or transferring excess reserves abroad to countries without negative IOR.”

    If negative interest rates were imposed on excess reserves, they would have to also have to apply to vault cash, which also serves as bank reserves. The Fed can prevent the part of reserves that consist of deposits with it from being “moved abroad” by the use of various accounting tricks. If banks wanted to move the excess reserves abroad they would have to ship huge amounts of currency abroad, which is not very feasible. Converting the excess reserves to government bonds would be much more efficient.

    “How about this… Massive fiscal stimulus ” Even during the first two years of the Obama administration, where the Democrats had large majorities in Congress, the stimulus, as Paul Krugman kept pointing out, was too small. Under the present political regieme, it’s just not going to happen. The reality is if one wants to bring the unemployment rate down more quickly, expansionary monetary policy is the only game in town.

  90. Gravatar of Full Employment Hawk Full Employment Hawk
    1. March 2011 at 18:29

    Note that I have followed my Keynesian posting of why fiscal policy works (if the central bank does not offset it) with a post supporting the Quasi-Monetarist position of why expansionary monetary policy is effective even when the Federal Funds rate has reached the zero floor.

    Being a Full Employment Hawk, I do not see this as a monetary policy VERSUS fiscal policy issue, but, rather a monetary policy AND fiscal policy issue. When the economy is in a deep hole with the finacial system damaged and the conventional monetary instrument the central bank is used to working with ineffective, monetary and fiscal policies should be treated as complements, not substitutes.

    But under the current political regime, expansionary fiscal policy is just not going to happen, so we have the use what we have available, monetary policy.

  91. Gravatar of Andy Harless Andy Harless
    1. March 2011 at 18:35

    Scott:

    If you are saying that the government should always be trying to raise real rates from low levels, then I don’t see how that doesn’t violate the government’s budget constraint. And if they just do it temporarily, you’re back to the problem of spotting bubbles.

    The government doesn’t have to spot bubbles, just spot interest rates that are low enough to create a serious risk of asset price volatility. It doesn’t need to see when assets are mispriced, only when they are difficult to price, which is a much easier task. Ideally, these fiscal easings to drive up interest rates and prevent asset price instability would be counterbalanced by fiscal tightenings when interest rates are too high, so as to shift resources toward private investment.

  92. Gravatar of Full Employment Hawk Full Employment Hawk
    1. March 2011 at 18:35

    “Your explanation is the standard Keynesian one, but I will add that most people on this blog don’t believe fiscal stimulus actually works.”

    I realize that but I am on this site because I agree with Scott’s views on monetary policy. Therefore the fact that most people on the site do not believe that fiscal policy works does not bother me. I also post on Brad DeLong’s site where I can communicate with people who believe it works.

    I made the assumtion that the person asked a sincere question, rather than a rhetorical one, and responded on that basis.

  93. Gravatar of Doc Merlin Doc Merlin
    1. March 2011 at 19:31

    @Andy:

    “The government doesn’t have to spot bubbles, just spot interest rates that are low enough to create a serious risk of asset price volatility”

    And how do you do this?

  94. Gravatar of Mike Sandifer Mike Sandifer
    1. March 2011 at 22:36

    Speaking of inflation, here are some comments from Robert Reich on US monetary policy you might like.

    http://www.cnbc.com/id/15840232?video=3000008138&play=1

  95. Gravatar of Mike Sandifer Mike Sandifer
    1. March 2011 at 22:38

    Oh, and I should say that Steve Forbes’ comments, who was on with Reich, are almost surprisingly ludicrous.

  96. Gravatar of leftoutside leftoutside
    2. March 2011 at 01:20

    http://m.guardian.co.uk/business/2011/mar/01/mervyn-king-blames-banks-cuts?cat=business&type=article

    Off topic, but mervyn’s been talking to parliament and slagging off the banks.

  97. Gravatar of Richard Allan Richard Allan
    2. March 2011 at 04:00

    Thanks, Full Employment Hawk. It was a sincere question because during my three-year Econ degree at the LSE, I don’t remember “Aggregate Demand” being mentioned very often, if at all. In second-year macro we were taught that, according to the Mundell-Fleming model, fiscal policy was ineffective in a small open economy under floating exchange rates and that was that. In the third year we had a brief course led by Kevin Sheedy (do you know of him, Scott?) about New Keynsianism and sticky prices.

  98. Gravatar of Doc Merlin Doc Merlin
    2. March 2011 at 07:12

    @Richard Allan:

    Except at the zero bound, in the mundel fleming model, fiscal stimulus becomes effective again (assuming interest rate stays zero), or every other country is also launching a fiscal stimulus that will have similar effects on rates in each country.

    Here in the states, to most undergrads they don’t teach Mundel Flemming… at best they get a very watered down version of IS-LM, and they teach old-school hydraulic keyensian models… its really rather strange.

  99. Gravatar of marcus nunes marcus nunes
    2. March 2011 at 09:04

    Bernanke is always missing opportunities! What a waste of “discussion time”.
    http://johnbtaylorsblog.blogspot.com/2011/03/lessons-learned-from-ben-bernankes.html

  100. Gravatar of Full Employment Hawk Full Employment Hawk
    2. March 2011 at 09:09

    “I don’t remember “Aggregate Demand” being mentioned very often, if at all.”

    Except for genuine supply shocks, which are easy to recognize, the PROXIMATE cause of business cycles is fluctuations in aggregate demand (or in a dynamic context fluctuation in the rate of NGDP growth). Monetary shocks, other shocks from the financial system, or changes in the “animal spirits” of business persons, etc. all affect business cycles by affecting aggregate demand. Therefore if one does not understand aggregate deamand, one does not understand the cause of business cycles.

    “according to the Mundell-Fleming model, fiscal policy was ineffective in a small open economy under floating exchange rates”

    The United States is not a small economy. Therefore the small economy Mundell-Fleming model is of limited relevance to it. The same is true of the Eurozone, and I think a good case can be made that Great Britain is not a small economy either. In a large open economy with less than perfect capital mobility expansionary Fiscal policy does increase output, assuming that the central bank does not offset it with a contractionary monetary policy, of course.

    This can be easily shown at the Intermediate Macro (at U.S. colleges) level. See, for example, Makiw MACROECONOMICS, pages 375-376.

  101. Gravatar of Doc Merlin Doc Merlin
    2. March 2011 at 09:30

    @Full Employment Hawk:

    “This can be easily shown at the Intermediate Macro (at U.S. colleges) level.”

    Its not shown, its built in, a-priori into the models.

  102. Gravatar of Full Employment Hawk Full Employment Hawk
    2. March 2011 at 12:12

    “Its not shown, its built in, a-priori into the models.”

    I was using the term “shown” loosely here. What is shown is that if the Mundell-Fleming model is modified to apply to a large, open economy with less than perfect capital mobility, it no longer implies that fiscal policy in not effective. What such a modified model implies is that fiscal policy is effective.

    Clearly it is not a general proof that fiscal policy is effective. I understand that. To prove this, using this model, one would have to also prove that the model’s assumptions are (empirically) correct.

  103. Gravatar of Full Employment Hawk Full Employment Hawk
    2. March 2011 at 12:16

    “What such a modified model implies is that fiscal policy is effective.”

    My main point here is that the Mundell-Fleming model for a small open economy cannot be used to prove that fiscal policy is not effective under a regime of flexible exchange rates for economies like the United States, the Eurozone, and probably Britain.

  104. Gravatar of marcus nunes marcus nunes
    2. March 2011 at 18:10

    Just shows that (IT)^2 (Inflation Targeting by means of Interest Targeting) is not good for the economy´s health when the CB messes things up!:
    http://blogs.wsj.com/economics/2011/03/02/war-of-words-taylor-disputes-bernankes-description-of-interest-rate-rule/?mod=WSJBlog&utm_source=feedburner&utm_medium=feed&utm_campaign=Feed%3A+wsj%2Feconomics%2Ffeed+%28WSJ.com%3A+Real+Time+Economics+Blog%29
    I think JT is “campaigning” for the “top job”!

  105. Gravatar of Morgan Warstler Morgan Warstler
    2. March 2011 at 18:30

    Where’d Scott go?

  106. Gravatar of Mark A. Sadowski Mark A. Sadowski
    2. March 2011 at 18:33

    Doc Merlin wrote:
    “Here in the states, to most undergrads they don’t teach Mundel Flemming… at best they get a very watered down version of IS-LM, and they teach old-school hydraulic keyensian models… its really rather strange.”

    This resonates because I recently had to explain AD to a commenter on Econbrowser (he was fixated on “real AD” and I had to explain that that was a contradiction in terms). In the U.S. a simple AS-AD model is usually taught in principles classes. A watered down IS-LM model is usually taught at the intermediate level. The Mundell-Flemming is usually saved for graduate school (who cares, after all we’re a big country).

    It’s interesting to see that the emphasis on what is broached at various levels varies by country.

  107. Gravatar of Morgan Warstler Morgan Warstler
    2. March 2011 at 19:29

    “If businesses can pass on higher costs it will increase the chance that the surge in oil prices turns into broader inflation. The Beige Book reports are another sign that inflation may have passed its trough.

    However, the Federal Reserve does not rely on anecdotal reports, and will want to see hard data showing that companies are able to raise prices. The core consumer price index rose by only 1 per cent in January.

    In the Philadelphia district, “output price increases are becoming more widespread throughout the manufacturing sectors”. In Richmond, “while most sellers were not passing through cost increases yet, many expected to begin raising prices later this year”.

    http://www.ft.com/cms/s/0/b2de27c4-4501-11e0-80e7-00144feab49a.html#axzz1FVHSclFc

    This just makes my stomach sick.

  108. Gravatar of Mark A. Sadowski Mark A. Sadowski
    2. March 2011 at 19:40

    Morgan.
    Why take it so seriously? I came to a similar conclusion recently (that core price disinflation has stabilized in the last few months). I think we just hit bottom and just maybe QE2 prevented a further decline. As long as we don’t let Plosser run the game the future is looking a little brighter.

  109. Gravatar of ssumner ssumner
    2. March 2011 at 20:07

    bertusmaximus, Thanks.

    Full Employment Hawk You said;

    “Therefore such contractionary fiscal policy will cause increased unemployment.”

    This conclusion doesn’t follow from the observation that the BOE might tighten. Suppose the BOE’s policy is to tighten when inflation hits 4%. In that case inflation will max out at 4%. Now suppose the fiscal cuts are rescinded, as the left wants. Does that boost AD? No, as the BOE won’t allow inflation to rise above 4%. Any extra inflation from rescinded the fiscal cuts will simply be offset with monetary tightening.

    I’m not saying you’re wrong, I’m saying it’s not as obviously true as you seem to assume.

    justanothereconomist; You said;

    “It may be that there is no way to model or test the effect of QE, but then it is a non-falsifiable theory. And you’re no loner even close to a scientific theory, but purely one based on faith. A pure Tinkerbell theory- just believe.”

    My point is that we don’t know what QE2 will do until we try it. The model can’t tell us. If we try it, we can observe the effect in the markets (assuming we have an unanticipated policy shock to work with.) But that finding won’t be robust, as it will depend how QE affects expectations. Next ime might be different. But of course the exact same thing is true of any other type of monetary policy, except targeting the forecast. And it’s true of fiscal policy as well. The multiplier depends almost entirely on the extent of monetary offset, something no abstract model can tell us. It’s very contingent on the circumstances of each policy initiative.

    (BTW, when I referred to my next post I was wrong (the 2 today are different), hopefully I’ll do something on this by the weekend.)

    You responded to me:

    ““In December 2007 there was a 500 to 700 point swing in the Dow based on the difference between a 1/4 and 1/2 point cut.”

    Yes, but other things were happening in the economy.”

    No, I mean within a hour or so after the 2:15 Fed announcement, an event study, which is the gold standard of causality in macro. Indeed most of the change occurred within minutes. It’s one of the tiny number of things we actually know for certain in macro–huge stock and bond movements after Fed annoucements are caused by Fed announcements.

    You said;

    “This would help, though banks would find a way around this, by storing reserves in their vault or transferring excess reserves abroad to countries without negative IOR. I would hope that, being a libertarian, you will understand these arguments.”

    I’ve refuted both objections in earlier post, the IOR would apply to vault cash (which are part of reserves, BTW) and foreign bank holdings. The money would actually go out into cash in circulation–I’m quite sure of that. Tell Citibank and BOA that if they are caught hiding the billions in vault cash, the top brass will go to prison for years. They won’t hide it.

    You said;

    “But we’re not even hitting the 2% (implicit) inflation target Bernanke admitted to. I’m fairly sure that you would argue that raising the target will raise expectations of the future, etc. but I just don’t see it. If Bernanke can’t hit even a 2% inflation raget despite massive QE, then monetary stimulus (at the lower bound) is ineffective.”

    Look, I have complained about the Fed as much as anyone, but they aren’t totally incompetent. I’ve argued that Bernanke drew a line in the sand at about 1% inflation, decided he wouldn’t let it go below. With a higher target, he’d draw the line higher. Since the initial rumors of QE2 in late August, the 5 year TIPS spread has risen from 1.2% to well over 2%. In fairness only about the first 0.5% extra was QE2 effects, the rest followed the payroll tax cut and the oil shock. But it does mean the market is expecting somewhat higher inflation. Yes, it’s too little AD, but if they tried to do even more, then would probably achieve a bit more.

    You said;

    “How about this… Massive fiscal stimulus until excess reserves are cut in half- then halt fiscal stimulus. Let higher inflation with a zero interest rate take us back to a 5% NGDP trend. The Fed dunds rate should be above 0.25% by then. Then we don’t speak of fiscal policy again, unless we get back to the zero lower bound, and it’s all about monetary policy and NGDP targeting. Deal?”

    I’m in no position to negotiate, but here’s the fiscal stimulus I’d do:

    1. A payroll tax cut on the empler share, to reduce wage costs, overcome sticky wages.

    2. Go back to 26 weeks UI, but give every worker on UI a big lump sum bonus check, to make up for the average amount of weeks they’d lose by cutting UI from 99 weeks to 26 weeks.

    Those two boost AD a little, and AS a lot. I think the recent labor market data suggests that while the problem is still mostly AD, we do have some AS issues. I’d like to see fiscal stimulus used creatively to try to address that.

    After we leave this recession the Fed needs to tell us how they will avoid the next zero bound. If they can’t give us a convincing answer, then we need a higher implicit inflation target. The current situation is an outrage, much worse than going from 2% to 3% inlfation.

    Everyone, I’m running behind (two new posts) so I’ll address the other comments tomorrow.

  110. Gravatar of Doc Merlin Doc Merlin
    2. March 2011 at 20:25

    @Mark A. Sadowski
    “Mundell-Flemming is usually saved for graduate school (who cares, after all we’re a big country).”

    That part annoys me, as we have some of the highest capital mobility (across our borders) in the world, so in a lot of ways we should be like a small country.

  111. Gravatar of Mark A. Sadowski Mark A. Sadowski
    2. March 2011 at 20:33

    Doc,
    Haha! Sorry to annoy you, but I believe the convention is very practical from a U.S. perspective. (The caveat being that everyone greatly interested in macro should know everything, of course.)

  112. Gravatar of Scott Sumner Scott Sumner
    3. March 2011 at 05:47

    Richard, I’m not sure, but one argument I’ve seen from Keynesians is that fiscal stimulus raises interest rates, and this raises velocity, and this raises NGDP.

    Morgan, Yes, high oil prices are a sign of prosperity, if demand is raising prices. But if supply is falling. . .

    Full employment hawk; You said;

    “This will happen even if the central bank holds the money supply constant. This is because as output and income increase, the demand for money increases. When the demand for money increases with a fixed supply of money this raises the interest rate. Since the velocity of money is directly related to the interest rate, the increased velocity will permit the fixed amount of money to circulate the larger volume of transactions that result from the increased income and output.”

    One small correction. If money supply is fixed, and money demand rises, then ipso facto the value of money rises. But a higher value of money is deflation. You statement would have been correct if you replaced more demand for money with more demand for credit. This raises rates, and velocity.

    Andy, You said;

    “The government doesn’t have to spot bubbles, just spot interest rates that are low enough to create a serious risk of asset price volatility. It doesn’t need to see when assets are mispriced, only when they are difficult to price, which is a much easier task. Ideally, these fiscal easings to drive up interest rates and prevent asset price instability would be counterbalanced by fiscal tightenings when interest rates are too high, so as to shift resources toward private investment.”

    I’m not sure it is all that easy to determine when rates are low, doesn’t that imply an ability to forecast the future movements of long term TIPS prices? But even so, I don’t think low rates cause bubbles. We’ve had two significant bubbles in my lifetime, and one was associated with low rates while the other wasn’t. Some would call the 1987 stock market a bubble, but rates weren’t low. Ditto for 1929. My view is that bad regulation caused the housing bubble. Some point to foreign bubbles in places like Ireland. But Britain, Canada, Australia, New Zealand, etc. didn’t have bubbles. In those countries prices are still roughly at early 2005 levels, or higher. And Ireland had extremely bad regulation.

    Mike, Reich’s statements are surprisingly good. I thought he had a different view a few months back.

    Leftoutside, Thanks for the link.

    Marcus, Yes, I wish he’d simply said the Taylor Rule is inefficient, and we should target he forecast.

    Here’s an interesting study for someone. Calculate the gap between Taylor rule rate settings and actual fed funds settings. Then correlate this gap with the inflation forecast from the TIPS markets (say 2 years, or 5 years.) I doubt you’d find much correlation. I think often when the TR says rates are too low, the TIPS markets would say they’re too high.

    Morgan, Grading papers. I have to earn money some way, because all you freeloaders aren’t paying me for this blog.

  113. Gravatar of What do you get when you fall in love…? « Historinhas What do you get when you fall in love…? « Historinhas
    3. March 2011 at 07:37

    [...] Bank botches its job and lets nominal spending take a dive, as it did after early to mid 2008. As Scott Sumner argues, “Inflation Targeting is a Very Bad [...]

  114. Gravatar of Full Employment Hawk Full Employment Hawk
    3. March 2011 at 11:52

    “One small correction. If money supply is fixed, and money demand rises, then ipso facto the value of money rises. But a higher value of money is deflation. You statement would have been correct if you replaced more demand for money with more demand for credit. This raises rates, and velocity.

    I was explaining the textbook Keynesian model, not a Monetarist model. In the textbook Keynesian model the excess demand for money is idential to the excess stock supply of bonds. Therefore when there is an excess demand for money people attempt to build up their money balances by selling bonds. This drives down the price of bonds and therefore raises the interest rate. Since the demand for money is inversely related to the interest rate, the increase in the interest rate ends the excess demand for money since, in equilibrium the decrease in the amount of money demanded AT EACH LEVEL OF INCOME just offsets the increase in the amount of money demanded because of the increase in income. The higher interest rate does have a contractionary effect on consumption and (physical) investment expenditures, but as long as the amount of money demanded decreases as the intrest rate rises, the expansionary effect of the increase in government purchases is greater than the contractionaionary effect of the reduced private expenditures, so that you end up with both higher output and a higher interest rate. I know that you do not like the IS-LM model, but what I have said above is most easily illustrated using it. You have the standard IS-LM curves with the LM curve sloping up and to the right. The increased government expenditures shift the IS curve to the right. This results in an increase in both output and the interest rate.

    Clearly the differences between the traditional American Keynesian and monetarist positions not only involves differences in positions about the effects of policies on the economy, but it also involves a different analytical framework. While the Keynesian positions can be put into a monetarist framework, its underlying logic becomes more difficult to understand than in the framework designed for it.

  115. Gravatar of Full Employment Hawk Full Employment Hawk
    3. March 2011 at 11:59

    “but one argument I’ve seen from Keynesians is that fiscal stimulus raises interest rates, and this raises velocity, and this raises NGDP.”

    That is an attempt to communicate with monetarists by putting the Keynesian position into a monetarist analytical framework.

    In the Keynesian framework, Government purchases are one of the components of aggregated demand, along with consumption, (physical) investment, and net exports. Therefore an increase in government purchases increases aggregate demand. Assuming there is excess capacity in the economy, firms respond to this increase in aggregate demand by increasing output. Therefore the effect on output is through aggregate demand not velocity.
    What the increase in velocity does is that it permits a fixed amount of money to circulate the increased output and income.

  116. Gravatar of Full Employment Hawk Full Employment Hawk
    3. March 2011 at 12:04

    “Mundell-Flemming is usually saved for graduate school (who cares, after all we’re a big country).”

    Not so. See, for example, Mankiws intermediate macroeconomics text. MACROECONOMICS, 7th. ed. Chapter 12. It even shows what happens when you have a large country with less than perfect capital mobility, which is the relevant case for the United States, and probably Great Britain.

  117. Gravatar of Full Employment Hawk Full Employment Hawk
    3. March 2011 at 12:09

    “I’m not saying you’re wrong, I’m saying it’s not as obviously true as you seem to assume.”

    While I tend to vigorously defend my positions, I understand that, given the current state of economics, virtually nothing is obviously true. We have to do the best we can with the limited knowledge we have.

  118. Gravatar of Full Employment Hawk Full Employment Hawk
    3. March 2011 at 12:19

    “The current situation is an outrage, much worse than going from 2% to 3% inlfation.”

    RIGHT ON! But most conservatives, libetarians, and Republicans will not agree with that.

  119. Gravatar of Full Employment Hawk Full Employment Hawk
    3. March 2011 at 12:22

    “As long as we don’t let Plosser run the game the future is looking a little brighter.”

    That makes a case for using a cut in the intrest rate on excess reserves as the next monetary stimulus. That decision is made by the BOG, not by the FOMC, so Plosser and Fisher do not have a vote.

  120. Gravatar of Mark A. Sadowski Mark A. Sadowski
    3. March 2011 at 21:13

    @Doc Merlin,

    It occurs to me in my response that I should have added the following movie soundtrack:

    http://www.youtube.com/watch?v=u6vREiRNMFc&feature=player_embedded#at=184

    We don’t need no stinking Mundell-Flemming here! That applies to small open countries. We’re a BIG COUNTRY!

    @Full Employment Hawk,
    With all due respect, how many departments use Mankiw’s intermediate macro text? And even so, how many require that instructors cover the sections on Mundell-Flemming?

  121. Gravatar of Mark A. Sadowski Mark A. Sadowski
    3. March 2011 at 21:26

    Oops. You’ll have to rewind it or click on this:

    http://www.youtube.com/watch?v=u6vREiRNMFc&feature=player_embedded#at=0

  122. Gravatar of Doc Merlin Doc Merlin
    4. March 2011 at 01:10

    @Mark A. Sadowsky, aka Gregory Peck:

    rofl

  123. Gravatar of Scott Sumner Scott Sumner
    5. March 2011 at 11:16

    Full Employment Hawk, I accept your point about the Keynesian model. But I guess that’s why I’ve always found it so confusing. You have an increase in the demand for money causing a decrease in the equilibrium real quantity demand of money. Very odd.

    I like to define “demand” against the value of the good in question, i.e. its price relative to all other goods. That’s how we define demand for apples, and it’s how we should define demand for money. But you are right, the Keynesian model doesn’t define it that way.

  124. Gravatar of Full Employment Hawk Full Employment Hawk
    5. March 2011 at 13:52

    “We don’t need no stinking Mundell-Flemming here! That applies to small open countries. We’re a BIG COUNTRY!”

    The Mundell-Fleming model can easily be modified to apply to a large economy with less than perfect capital mobility, and that is relevant to big countries. It, among other things, implies that fiscal policy is effective under a regime of flexible exchange rates, but less effective than in a closed economy.

  125. Gravatar of Full Employment Hawk Full Employment Hawk
    5. March 2011 at 14:09

    “You have an increase in the demand for money causing a decrease in the equilibrium real quantity demand of money.”

    Not quite. What you have is that IF THE SUPPLY OF MONEY IS HELD CONSTANT and AN INCREASE IN INCOME increases the demand for money (at any given interest rate), the interest rate increases and this decreases the demand for money by an amount THAT EXACTLY OFFSETS the increase in the demand resulting from the increased income, so that the quantity of money demanded REMAINS UNCHANGED, which is what is what is needed for equilibrium since, by assumption, the supply of money is being held constant.

    “I like to define “demand” against the value of the good in question, i.e. its price relative to all other goods. That’s how we define demand for apples, and it’s how we should define demand for money. But you are right, the Keynesian model doesn’t define it that way.”

    The demand for nominal balances includes the price level as one of the arguments. But even in the demand for apples, the price of Apples is not the ONLY variables in the demand function. Since money and “bonds” defined broadly are very close substitutes, the interest rate, representating the opportunity cost of holding money instead of bonds, plays an important role in determining the demand.

    But of course, beyond the most elementary level, the demand for money is approached as a demand for real balances, and obviously the price level, appearing on the supply side, is not a variable in the demand for real balances.

  126. Gravatar of Full Employment Hawk Full Employment Hawk
    5. March 2011 at 14:13

    “And even so, how many require that instructors cover the sections on Mundell-Flemming?”

    Let’s hope that none REQUIRE it. Determining the specific contents of a college course should be the prerogutive of the professor.

  127. Gravatar of More on the ECB’s overreaction | Federal Reservations More on the ECB’s overreaction | Federal Reservations
    6. March 2011 at 07:27

    [...] Eurozone is definitely the laggard here!My interpretation of these statistics – and yes, there are many ways to measure inflation – is that the ECB is overreacting to the inflation pressures coming from commodity prices, energy [...]

  128. Gravatar of Mark A. Sadowski Mark A. Sadowski
    6. March 2011 at 07:52

    Full Employment Hawk,
    You wrote:
    “The Mundell-Fleming model can easily be modified to apply to a large economy with less than perfect capital mobility, and that is relevant to big countries. It, among other things, implies that fiscal policy is effective under a regime of flexible exchange rates, but less effective than in a closed economy.”

    I’m not sure I follow you. I would say under the assumption of perfect capital mobility the model suggests that fiscal policy is highly effective in a fixed exchange rate regime (the CB is constrained by the ER policy) and under a flexible exchange rate regime fiscal policy is completely ineffective (the CB is in the driver’s seat). The assumption of less than perfect capital mobility (the BIG COUNTRY) suggests fiscal policy is somewhat potent in the latter case, at least in the short run.

    However, I agree with Doc Merlin to some extent, capital mobility is actually very high in the US, so despite our pretense, we are not really a BIG COUNTRY. Thus the implication is, given we have a flexible exchange rate, that fiscal policy is ineffective, provided you don’t believe in fairy tales like the “liquidity trap”.

    And you wrote:
    “Let’s hope that none REQUIRE it. Determining the specific contents of a college course should be the prerogutive of the professor.”

    What, trusting the judgement and knowledge of the instructor? What would the academic world come to?

    Actually, it varies considerably by institution. But usually core requirements at both the undergraduate level and graduate level have curriculum guidelines.

    From my own experience I can tell you that the University of Delaware is very specific on what should be taught in core requirements and that usually leaves little time for “optional” material. Elective courses of course are much more flexible in content, and are often the creation of a particular professor.

    At Rowan University, on the other hand, the department may go so far as to chose the textbook for the principles classes, but instructors are totally free to teach whatever they want. This actually can lead to problems, as they have a course catalog, but there is no guarantee that what the instructor teaches even remotely resembles the course description.

  129. Gravatar of Scott Sumner Scott Sumner
    6. March 2011 at 09:15

    Full Employment Hawk, You misread my point. I said the REAL quantity demanded fell. Your response said the nominal quantity demanded was unchanged–which is true. Both are true.

  130. Gravatar of Full Employment Hawk Full Employment Hawk
    6. March 2011 at 17:03

    “Actually, it varies considerably by institution. But usually core requirements at both the undergraduate level and graduate level have curriculum guidelines.”

    I was referring to Mankiw’s INTERMEDIATE text. Intermediate macroeconomics is not usually part of core requirements, although it is a required course for bachelors’ degrees in economics. Intructors, at least ones with doctoral degrees need to insist on the right to determine the content of such courses.

  131. Gravatar of Mark A. Sadowski Mark A. Sadowski
    6. March 2011 at 17:21

    Full Employment Hawk,
    At the UD there are curriculum requirements for core intermediate course requirements, and especially for the BA/BS degrees. I can’t speak for other departments.

    I would love to insist on the right to teach what I feel like teaching. But first I need to sign the contract that they (whoever) put in front of my face (which means I’ll do whatever they tell me to do) provided I want to eat, pay my mortgage, heat my house etc.

    This is just the truth. I don’t have a political axe to grind on this issue. But 40% of econ courses are taught like people very much like me (ABDs). And I personally have a great desire to eat.

  132. Gravatar of Let QE2 set sail | PARTISANS Let QE2 set sail | PARTISANS
    8. March 2011 at 01:31

    [...] Inflation targeting is a very bad idea by Scott Sumner [...]

  133. Gravatar of Angry Bear » Evidence says the ECB is overreacting Angry Bear » Evidence says the ECB is overreacting
    6. January 2013 at 13:11

    [...] interpretation of these statistics – and yes, there are many ways to measure inflation – is that the ECB is overreacting to the inflation pressures coming from commodity prices, [...]

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