Mankiw and Weinzierl on stabilization policy

Gregory Barr sent me an excellent paper by Greg Mankiw and Matthew Weinzierl :

Conclusion

The goal of this paper has been to explore optimal monetary and fiscal policy for an economy experiencing a shortfall in aggregate demand. The model we have used is in many ways conventional. It includes short-run sticky prices, long-run flexible prices, and intertemporal optimization and forward-looking behavior on the part of firms and households. It is simple enough to be tractable yet rich enough to offer some useful guidelines for policymakers.

One clear implication of the analysis is that how any policy is used depends on which other policy instruments are available. To summarize the results, it is fair to say that there is a hierarchy of instruments for policymakers to take off the shelf when the economy has insufficient aggregate demand to maintain full employment of its productive resources.

The first level of the hierarchy applies when the zero lower bound on the short-term interest rate is not binding. In this case, conventional monetary policy is sufficient to restore the economy to full employment.  That is, all that is needed is for the central bank to cut the short-term interest rate. Fiscal policy should be set based on classical principles of cost-benefit analysis, rather than Keynesian principles of demand management. Government consumption should be set to equate its marginal utility with the marginal utility of private consumption. Government investment should be set to equate its marginal product with the marginal product of private investment.

The second level of the hierarchy applies when the short-term interest rate hits against the zero lower bound. In this case, unconventional monetary policy becomes the next policy instrument to be used to restore full employment. A reduction in long-term interest rates may be sufficient when a cut in the short- term interest rate is not. And an increase the long-term nominal anchor is, in this model, always sufficient to put the economy back on track. This policy might be interpreted, for example, as the central bank targeting a higher level of nominal GDP growth. With this monetary policy in place, fiscal policy remains classically determined.

The third level of the hierarchy is reached when monetary policy is severely constrained. In particular, the short-term interest rate has hit the zero bound, and the central bank is unable to commit to future monetary policy actions. In this case, fiscal policy may play a role. The model, however, does not point toward conventional fiscal policy, such as cuts in taxes and increases in government spending, to prop up aggregate demand. Rather, fiscal policy should aim at incentivizing interest-sensitive components of spending, such as investment. In essence, optimal fiscal policy tries to do what monetary policy would if it could.

The fourth and final level of the hierarchy is reached when monetary policy is severely constrained and fiscal policymakers rely on only a limited set of fiscal tools. If targeted tax policy is for some reason unavailable, then policymakers may want expand aggregate demand by increasing government spending, as well as cutting the overall level of taxation to encourage consumption. In a sense, conventional fiscal policy is the demand management tool of last resort.  (Italics added.)

I agree, and would just add a few observations:

1.  Between the Big Bang and 2011, there has never been a central bank that promised to create inflation, and was not believed.  At least not in the Milky Way.  So there is really no need to go beyond step two.

2.  If we add sticky wages to the model, then I think that the investment tax credit could be augmented with a payroll tax cut–employer share only– as a way of moving the labor market closer to its flexible wage–Walrasian equilibrium level of employment.

As you know, I’d like to eliminate the inflation and the price level from business cycle theory, and use NGDP as my nominal aggregate (where the price level is currently used, such as the Fisher equation and the AS/AD diagram.)  Real wages would be nominal wages over nominal GDP per capita.  A negative nominal shock like 2008-09 would cause (sticky) nominal hourly wage rates to rise as a share of NGDP, causing fewer hours worked. (Hours worked replace RGDP in the AS/AD model.)  Since prices can be affected by both supply and demand shocks, they are an unreliable indicator of nominal shocks.

I just noticed that Paul Krugman commented on this paper:

Now bear in mind that in order to make a commitment to inflation work, central bankers not only have to stand up to the pressure of inflation hawks — which is much harder when you’re having to testify to Congress than it is if you’re a Harvard professor — but, even harder, they need to convince investors that they’ll stand up to that pressure, not just for a year or two, but for an extended period.

Now, the thing about fiscal expansion is that people don’t have to believe in it: if the government goes out and builds a lot of bridges, that puts people to work whether they trust the government’s commitment to continue the process or not. In fact, to the extent that there’s some Ricardian effect out there, fiscal policy works better, not worse, if people don’t believe it will continue.

On a personal note: I supported fiscal expansion in 2008-2009 precisely because I didn’t believe that the kind of commitment-based unorthodox monetary policy that works in the models could, in fact, be implemented in practice. Nothing I’ve seen since has changed my views on that subject.

Where does one start?  With the fact that the Dems controlled Congress during the Great Recession and would have welcomed more monetary stimulus?  With the fact that meaningful fiscal stimulus was also not politically feasible (according to Krugman it never happened.)  With the fact that unemployment was 7.8% when Obama took office and 9.8% in November 2010, when QE2 was announced?  With the fact that rumors of QE2 in September and October 2010 affected all sorts of asset prices (including TIPS spreads) in exactly the way us quasi-monetarists predicted?  How can Krugman say nothing he’s seen has changed his views on the relative political feasibility of fiscal and monetary stimulus?  The reason the Fed didn’t do more wasn’t Ron Paul, it was pushback from regional Bank presidents within the Fed.  Oh, and Obama “forget” and left two or three seats empty for over a year.

Krugman seems to misunderstand the role of pundits.  It’s our job to explain what needs to be done, in order to make it more politically feasible.  In early 2009 politicians would have been elated if someone told them there was a way to boost AD without running up big deficits.  But they didn’t know because just about the only people making that point forcefully and loudly were us quasi-monetarists.

In contrast to Krugman, this very wise pundit does understand the role of bloggers is to push the Fed to be more aggressive:

So why am I even slightly encouraged? Because the critics did, at least, succeed in moving the focal point. Not long ago gradual Fed tightening was the default strategy; but as I said, at this point the Fed realized that continuing on that path would have unleashed both a firestorm of criticism and a severe negative reaction in the markets.

What we need to do now is keep up the pressure, so that at the next FOMC meeting the members are once again confronted by the reality that not changing course would be seen as dereliction of duty. And so on, from meeting to meeting, until the Fed actually does what it should.

I know: it’s a heck of a way to make policy. In a better world, the Fed would look at the state of the economy and do what was right, not the minimum necessary. But wishing for that kind of world is like wishing that Ben Bernanke were running the place.

The statement was made in August 2010, just days before the first Bernanke speech hinting that more needed to be done.  Who was this prescient blogger?  Click here and find out. 

(And you thought it was going to be me.)

PS.  Neither the Boston Fed nor any local universities have ever asked me to present a paper on how NGDP targeting–level targeting–targeting the forecast, could have greatly reduced the severity of the asset price collapse of late 2008, the associated banking crisis, and the recession itself.  I’ve put together a persuasive group of PowerPoint slides, have honed my presentation at the AEA meetings and elsewhere, and am ready to go if anyone wants an interesting and controversial take on the Great Recession.  I’ve debated countless economists, including some pretty distinguished ones, and found no holes in my logic.  Don’t expect me to be a pushover just because I come from a small school.


Tags:

 
 
 

21 Responses to “Mankiw and Weinzierl on stabilization policy”

  1. Gravatar of John Hall John Hall
    18. March 2011 at 10:53

    I tried to get a job with the HoR’s Monetary Policy Committee and part of my cover letter was to get guys like you (+ Larry White/Selgin, rather than only the gold standard brigade) to testify. I didn’t get an interview…

    Anyway, I’d be interesting to post the powerpoint or a video taken of the presentation if that ever happens. I’d listen, even if I couldn’t convince my bosses to bring you out.

  2. Gravatar of ssumner ssumner
    18. March 2011 at 11:03

    Thanks John, There was a short version posted on youtube a few weeks ago, but someone said it was taken down. It was presented at the Warwick Economic Summit in february–they may still have a copy. But it’s only 15 minutes, and I really need about 45.

  3. Gravatar of Ralph Musgrave Ralph Musgrave
    18. March 2011 at 11:24

    Mankiw and Weinzierl claim that in a mild recession, “conventional monetary policy is sufficient to restore the economy to full employment”. Doubtless they are right, but I don’t agree with their next inference, namely that in mild recessions fiscal policy is not desirable.

    Cutting interest rates to boost demand is distortionary in that it works only via entities that are significantly reliant on borrowing. In contrast, fiscal policy can and should be more or less distortion free.

    I therefor prefer this 2001 paper which advocates an automatic fiscal element in ALL recessions.

    http://www.blackwellpublishing.com/specialarticles/INFI097.pdf

    Coincidentally the latter idea is similar to the idea behind the comment I left in response to Scott Sumner’s NBER / fiscal multiplier post just below.

  4. Gravatar of Alex Arnon Alex Arnon
    18. March 2011 at 13:01

    What would a Fisher equation with NGDP replacing prices look like?

    Also, from the General Theory:

    “…the well-known, but unavoidable, element of vagueness which admittedly attends the concept of the general price-level makes this term very unsatisfactory for the purposes of a causal analysis…In dealing with the theory of employment I propose, therefore, to make use of only two fundamental units of quantity, namely, quantities of money-value and quantities of employment.”

    Great minds…

  5. Gravatar of marcus nunes marcus nunes
    18. March 2011 at 13:06

    I reproduce my comment on your The Great Depression of 1963-73 post:
    A “war” is being played out: The ZLB guys led by PK and the OB (“obsession bound”) guys led by the likes of Plosser and Fisher. Mankiw steps in but doesn´t help resolve the issue. It seems the perfect time to advocate NGDP level targeting:

    http://thefaintofheart.wordpress.com/2011/03/18/zlb-vs-ob/

  6. Gravatar of Alexander Hudson Alexander Hudson
    18. March 2011 at 15:54

    Your point about the relative feasibilities of fiscal and monetary policy is a great one, but I think it misses Krugman’s point in this particular case. As I see it, his point is that with fiscal policy, what’s done is done. Whereas with monetary policy, that’s not true. What you’ve “done” is said what you WILL do later, and that, of course, may or may not happen. If the Fed had made explicit promises about future inflation back in early-to-late 2009, wouldn’t those promises have been about their actions right now, with Republicans in control Congress?

  7. Gravatar of W. Peden W. Peden
    18. March 2011 at 16:13

    With the fiscal and monetary policy difference, isn’t fiscalism a problem here? For many people, “fiscal stimulus” means more jobs, more government activity and doing a lot of things, i.e. things these people very much want. More importantly, they can visualise most of the transmission mechanism.

    Contrariwise, “monetary stimulus” is not easily visualised (for most of us, at least) and brings to mind inflation, bankers and printing money like in Weimar Germany. In short, the core idea of fiscalism- the proposition that monetary policy determines the nominal and that fiscal policy determines the real- makes monetary policy a hard sell, particularly when interest rates hit zero.

    On the other hand, there are boundaries other than this conceptual problem like the international money markets and debt generally which have made greater monetary policy at least NO MORE difficult than greater fiscal policy, as 2009 proved. In fact, I think that it is the 2009 fiscal stimulus that seemed to be a case of akrasia in the face of constraints, while the 2009 monetary non-stimulus was a product of the creditism (the view that credit and lending matter, not monetary supply and demand) that has corrupted modern monetary macroeconomics and destroyed much of its relevance to situations like that of the present.

  8. Gravatar of Bryan Willman Bryan Willman
    18. March 2011 at 17:42

    Devil’s advocate question:

    Why are we sure that any politically feasible and technically implementable monetary or fiscal policy will actually change the course of a recession very much, once the recession has started?

    Put another way “When one gets a common cold, there are all sorts of meds that might make one more comfortable, but which provably don’t affect the duration of the cold much at all. Prove that a recession is somehow more amenable to treatment than a common cold”

    I think *all* “treatments” suffer from people and orgs reacting to them. So Krugman’s claim that building a bunch of bridges works as stimulus even if people don’t trust it, is wrong – because people will see all that and go “oh no, we’ll be burried in debt and have horrible taxes, we need to save more than govt is spending”

    To be fair, a part of the arguments presented here (and by Mankiw and Weinzierl) are of the “be really credible about changing an important economic variable, over a decent time, so people will trust you”

    Also, most people are “pinned” by various contraints – so they have no choice but take a bridge building job, and no choice but to spend the earnings on basic consumption. So some part of the population of persons and orgs will be swept along by any monetary or fiscal policy because they have no choice.

  9. Gravatar of W. Peden W. Peden
    18. March 2011 at 18:11

    Bryan Willman,

    I think the answer to your lead question depends on two things: one is how broad one interprets “policy”; I think that the right monetary regime could contain most recession with little difficulty, but that’s a matter of changing the framework of government rather than just using existing tools.

    The second thing is that whether or not one thinks that recessions can be mitigated AT ALL depends on how one interprets the causes of recessions. If one believes that the Great Recession and other such events are the result of market failures, surely one can logically hold that these events are almost uncontainable, unless one has a reason (or a faith) to believe that they can be mitigated; Marxists would be an example of people who don’t have this belief.

    On the other hand, if one believes- as monetarists and Austrian Schoolboys do- that the Great Depression et al are the result of failures of government, then one can certainly and axiomatically say with no difficulty that the government can not only mitigate existing recessions, but also prevent recessions in future.

    I think that speculation about political feasibility is fun but rather unimportant. Lots of things that were feasible in 1961 are no longer feasible and lots of things that weren’t feasible in 1961 are feasible today. What matters is making the unfeasible ideal policies into the feasible realistic policies and that takes the difficult combination of time & patience.

  10. Gravatar of Mark A. Sadowski Mark A. Sadowski
    18. March 2011 at 18:12

    Scott,
    You wrote:
    “Neither the Boston Fed nor any local universities have ever asked me to present a paper on how NGDP targeting–level targeting–targeting the forecast, could have greatly reduced the severity of the asset price collapse of late 2008, the associated banking crisis, and the recession itself.”

    I’d love to have you take part in our research seminar at the University of Delaware, but I’m just a lowly doctoral candidate and to give you an idea of what I’m up against let me share the following.

    Our last research seminar was presented by Pierre-Daniel Sarte of the Federal Reserve Bank of Richmond. His paper was “Sectoral vs. Aggregate Shocks: A Structural Factor Analysis of Industrial Production.” Sarte was a classmate of Jorge Soares, who teaches our Advanced Macro course and consequently writes that portion of the UD PhD comp. The two of them studied under Charles Plosser at the University of Rochester so it was nice little RBC reunion (I had to control my gag reflex).

    Needless to say the paper makes the argument that business cycles can largely be explained by structural factors. I personally had to muster every ounce of strength to surpress myself from breaking out in hysterical fits of laughter. Nevertheless, it was well recieved by those in attendance.

    Sometimes I feel like my department is totally living on another planet. (Tralfamadore perhaps?)

  11. Gravatar of Mark A. Sadowski Mark A. Sadowski
    18. March 2011 at 19:24

    In Kurt Vonnegut’s “Slaughterhouse-Five” the protagonist Billy Pilgrim describes the Tralfamadorians in the following manner:

    “They were two feet high, and green, and shaped like plumber’s friends. Their suction cups were on the ground, and their shafts, which were extremely flexible, usually pointed to the sky. At the top of each shaft was a little hand with a green eye in its palm. The creatures were friendly, and they could see in four dimensions. They pitied Earthlings for being able to see only three.”

    This explains alot. I thought I was seeing things.

    P.S. Vonnegut, like me, was a University of Chicago dropout.

  12. Gravatar of Joe Joe
    18. March 2011 at 22:03

    Dear Professor,

    You have argued that NGDP targeting is as far as you need to go. But Mankiw has a few steps beyond. I believe it would be interesting if you commented, argued, or whateve,r either here in these comments or on a post, why Mankiw’s paper need not go past that mark. I suppose, in a way, to disagree with the paper.

    Best wishes,

    Joe

  13. Gravatar of Lorenzo from Oz Lorenzo from Oz
    19. March 2011 at 02:09

    Enjoyed the paper. One of the pleasures of this blog, being directed to useful and informative economics papers.

  14. Gravatar of Some Commentary – Economics - Some Commentary - Economics -
    19. March 2011 at 02:47

    [...] comments on my new paper with Matthew Weinzierl on optimal stabilization policy.   Scott Sumner likes it.  Paul Krugman is predictably [...]

  15. Gravatar of browsing catharsis – 03.19.11 « Increasing Marginal Utility browsing catharsis – 03.19.11 « Increasing Marginal Utility
    19. March 2011 at 04:08

    [...] Sumner comments on a nice new paper by Mankiw and Weinzierl. [...]

  16. Gravatar of Scott Sumner Scott Sumner
    19. March 2011 at 06:05

    Ralph, You said;

    “Cutting interest rates to boost demand is distortionary in that it works only via entities that are significantly reliant on borrowing. In contrast, fiscal policy can and should be more or less distortion free.”

    There are lots of mistakes here. First of all, expansionary monetary policy usually raises rates. Second, interest rates should reflect the condition of the economy. If investment is too low you want interest rates to be low. Third, fiscal policy is far more distortionary—monetary stimulus leads to the free market deciding where the extra output should go, not the government. If the Fed always keeps expected future NGDP on target, then monetary policy will not produce any distortions at all. Indeed the optimal monetary policy is precisely the policy that minimizes economic distortions.

    Alex, What are “the quantities of money-value?”

    The Fisher equation would be real rates equal nominal rates minus expected NGDP growth.

    Marcus, Thanks for that link. I agree. But at least Mankiw mentioned NGDP growth targeting–that’s progress.

    Alexander, You said;

    “Your point about the relative feasibilities of fiscal and monetary policy is a great one, but I think it misses Krugman’s point in this particular case. As I see it, his point is that with fiscal policy, what’s done is done. Whereas with monetary policy, that’s not true. What you’ve “done” is said what you WILL do later, and that, of course, may or may not happen. If the Fed had made explicit promises about future inflation back in early-to-late 2009, wouldn’t those promises have been about their actions right now, with Republicans in control Congress?”

    Krugman is wrong. Both policies will work if and only if they raise expected inflation rates. And that will occur if and only if future expected monetary policy is expected to allow for a higher price level. Fiscal stimulus requires cooperation from future monetary policymakers just as much as monetary stimulus. This is one reason fiscal stimulus doesn’t work very well.

    In any case QE2 showed Krugman was wrong about the impact of monetary stimulus on inflation expectations, so it’s all a moot point.

    W. Peden, That’s exactly right, common sense suggests fiscal stimulus will work much better than it actually works, and common sense suggests monetary stimulus will not work as well as it actually works. People don’t understand the transmission mechanisms.

    Bryan, We know it works because it has clearly worked in the past–the evidence is extremely strong–especially from the 1930s.

    Mark, Don’t worry, I’m trying to avoid travel in any case.

    Joe, Because if you use monetary policy to set expected future NGDP equal to target NGDP, there is no role for fiscal policy. Suppose government policymakers want NGDP to rise 7% in 2012. If the Fed sets policy at a position expected to produce 7% NGDP growth, then what role is there for fiscal stimulus?

    Thanks Lorenzo.

  17. Gravatar of flow5 flow5
    19. March 2011 at 06:44

    The lag in the proxy for core inflation is exactly 2 years (never shorter, nor longer). It has always been the same for the last 97 years. There is no such thing as long & variable monetary lags. MVt bottomed in JAN.

    Aggregate monetary purchasing power (nominal gDp), is our means-of-payment money X’s its transactions rate-of-turnover. Money flows are easy to measure, and as a target, are easy to achieve.

    The lag in the proxy for real-output is also always of a fixed length (no variation, but much shorter). So really what you subscribe to is a monetary policy for targeting real-output (which assumes that there will always be an output gap).

  18. Gravatar of Old Whig Old Whig
    19. March 2011 at 08:43

    From Swedish Econ blogger Niclas Berggren, http://nonicoclolasos.wordpress.com/2011/03/18/stimulerar-utgiftshojningar-ekonomin/
    presents new research whether stimulus works or not in countries with floating currency exchange rates, not!

    My translation: New study, ”How Big (Small?) Are Fiscal Multipliers?”, Ethan Ilzetzki, Enrique G. Mendoza, Carlos A. Végh http://www.nber.org/papers/w16479
    shows that Keynesian multipliers varies between the 44 countries surveyed but in countries that has floating currencies such as Sweden [my quote: and the US] the multiplier is zero.”

    Text from study:

    “Based on a novel quarterly dataset of government expenditure in 44 countries, we find that (i) the output effect of an increase in government consumption is larger in industrial than in developing countries, (ii) the fiscal multiplier is relatively large in economies operating under predetermined exchange rate but zero in economies operating under flexible exchange rates; (iii) fiscal multipliers in open economies are lower than in closed economies and (iv) fiscal multipliers in high-debt countries are also zero.

    The differences in the responses to increases in government consumption in countries with fixed and flexible exchange rate regimes are largely attributable to differences in the degree of monetary accommodation to fiscal shocks in these nations. The results imply that the central banks’ response to fiscal shocks is crucial in assessing the size of fiscal multipliers.”

  19. Gravatar of Luis H Arroyo Luis H Arroyo
    19. March 2011 at 10:51

    I find Mankiw´s & al paper a little eclectic.
    I like a lot your definition of real wage = NW/NGDP.
    However, I can´t be convinced completely that the “financial problem” can be absorbed in a monetary problem. I think that the financial hearthquake affected decisively expectations, and that “only” a NGDP objective was no sufficient. I don´t mean that is was not necessary, of course. But I can´t see MP to fix the problem of deleveraging whitout originate an hiperinflation.
    Financial turbulances mattered a lot. We didn´t know what level of systemic risk was hidden underground, except for the higher leveraging in the history – which few would have seen.
    I agree in the rection of monetary policy to a fall in NGDP, but the Central bank need additional arms for financial mess.

  20. Gravatar of ssumner ssumner
    19. March 2011 at 15:44

    flow5, I don’t agree that monetary lags are long. In 1933 prices and output responded immediately to a monetary shock. NGDP targeting is not RGDP targeting, which leaves the price level indeterminate.

    Old Whig, Thanks for the link.

    Luis, Much of the financial mess was caused by falling NGDP.

  21. Gravatar of Some Commentary | AcheFor.com Some Commentary | AcheFor.com
    25. March 2011 at 02:25

    [...] comments on my new paper with Matthew Weinzierl on optimal stabilization policy.   Scott Sumner likes it.  Paul Krugman is predictably [...]

Leave a Reply