Gregory Barr sent me an excellent paper by Greg Mankiw and Matthew Weinzierl :
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: QE 2