The real “beggar-thy-neighbor” policy

Proponents of fiscal stimulus often call on Germany to adopt a more expansionary fiscal policy, in the hope that this will help rebalance and reflate the entire eurozone.  It’s possible it might work, but it’s also possible it might end up being a “beggar-thy-neighbor” policy.

Suppose the ECB is targeting inflation. Fiscal stimulus in Germany will be partly offset (in Germany) by tighter monetary policy. The ECB will want to keep overall eurozone inflation on target.  Hence it will offset any impact on NGDP.  But some of the effect of tighter eurozone monetary policy will be felt in the other countries. So if total eurozone NGDP and inflation are unaffected by the two policy changes, and German NGDP rises, then it is necessarily true that non-German NGDP falls.

Possible objections:

1.  The ECB would never be that cruel.  It’s not about the ECB being cruel; it’s about the ECB doing its job.  A better counterargument is that the ECB is incompetent and won’t do its job.

2.  The argument doesn’t apply at the zero bound.  I would remind you that during over 90% of the past 6 years the ECB has been doing normal monetary policy, raising and lowering its interest rate target with the goal of stabilizing inflation.  Only very recently has it hit the zero bound.  And yet people have been calling for German fiscal expansion for years.  And it’s also worth noting that fiscal proponents who claim that the zero bound “changes everything” were spectacularly wrong in their 2013 prediction that austerity would slow growth in the US. That doesn’t mean that monetary offset applies in each and every case—the ECB is unusually incompetent, but it’s certainly the baseline assumption.

3.  This is one of those ivory tower theories that don’t match the real world.  And yet the idea of fiscal stimulus being a beggar-thy-neighbor policy is actually the standard textbook explanation for the European exchange rate crisis of September 1992.  Germany did a massive fiscal stimulus in the early 1990s, to help rebuild East Germany.  This pushed up real interest rates in the ECU area. The higher real interest rates (combined with a Bundesbank monetary policy tight enough to prevent inflation) led to recession (or aggravated an existing recession) in countries like Britain and Sweden.  Eventually they were forced to devalue, and to this day remain outside of the euro.

So fiscal expansion in one country within a currency zone is a beggar-thy-neighbor policy in both theory and practice.  Over at Econlog, I have a new post explaining why low interest rates do not call for more public investment.

Josh Hendrickson on the problem with “moneyless” NK models

Josh Hendrickson is sort of like my mirror image; he doesn’t post very often, but almost invariably has something interesting to say.  In a new post he discusses a flaw in one common New Keynesian (NK) model, which looks at monetary policy through the lens of interest rates.  But first, a quick review of interest rates and monetary policy.  The easiest way to see the relationship is with the equation of exchange:

M*V = P*Y

When the Fed raises interest rates, pundits tend to call the policy “contractionary.” That’s misleading for all sorts of reasons, but does contain a grain of truth.  The true part comes from the fact that in the very short run, the Fed engineers interest rate increases by reducing the monetary base. Note that by itself the rate increase is expansionary, as it tends to boost the velocity of circulation, by raising the opportunity cost of holding base money.  But that expansionary effect is more than offset by the direct contractionary impact of the lower monetary base.  Here’s Josh, looking at the opposite case, an increase in the money supply:

Now consider the effects of a change in the money supply. As illustrated in the figure above, the increase in the money supply causes the interest rate to decline. This means that when the money supply increases, velocity declines. However, the interest elasticity of velocity is often estimated to be rather small. The initial effect of the increase in the money supply is that the nominal interest rate to fall and nominal spending to rise. The decline in the nominal interest rate is an effect of the change in the money supply, but note that it is not the cause of the change in nominal spending.

So far so good.  But here’s where NKs get into trouble.  Josh says that their models imply that a higher interest rate is contractionary, even if there is no change in the money supply:

The New Keynesians, however, countered that they didn’t need to use open market operations to target the interest rate. For example, Michael Woodford spends a considerable part of the introduction to his textbook on monetary economics to explaining the channel system for interest rates. If the central bank sets a discount rate for borrowing and promises to have a perfectly elastic supply at that rate and if they promise to pay a rate of interest on deposits, then by choosing a narrow enough channel, they can set their policy rate in this channel. In addition, all they need to do to adjust their policy rate is to adjust the discount rate and the interest rate paid on reserves. The policy rate will then rise or fall in conjunction with the changes in these rates. Thus, the New Keynesians argued that they didn’t need to worry about money in theory or in practice because they could set their policy rate without money and their model showed that they could get a determinate equilibrium by applying the Taylor principle.

Nonetheless, what I would like to argue is that their ignorance of money has led them astray. By ignoring money, the New Keynesians have confused cause and effect. This confusion has led them to believe that they know something about how interest rate policy should work, but they have never stopped to think about how interest rate policy works when the central bank adjusts the nominal interest rates in a channel system versus how interest rate policy works when the central bank adjust the nominal interest rate using open market operations.

Unfortunately the post is hard to excerpt; you really need to read the whole thing.

This does not mean that NK interest rate policies will not “work.”  Rather I would argue that they work for reasons that NKs don’t understand, and when they fail they will fail for reasons NKs don’t understand.  Other economists such as Peter Ireland (who is cited by Josh) have pointed out that even with interest on reserves (IOR) you can never really ignore the quantity of money, and that certain quantity theoretic claims continue to hold true.

For me, the easiest way to understand this issue is to think about (non-interest-bearing) currency. Back in 2007 the base was about $850 billion, with about $800 billion of that being currency.  Now suppose Ben Bernanke had been instructed to use interest rates to double the price level over the next 30 years.  He was not allowed to use the monetary base.  For simplicity, assume he never ran into the zero bound problem.  Even in that case, where positive interest rates allowed him to continually use a Taylor Rule-type approach, it’s easy to see that the policy objective would be impossible to achieve.  There would not be enough base money to match the demand for currency at a price level double its current value.  I think this simple truth sometimes gets overlooked in models that focus on bank reserves and IOR, and/or periods of history where there are plenty of excess reserves.

I said that NK policy might work despite its theoretical weaknesses.  That’s because asset markets would probably (correctly) interpret a rise in the IOR rate as part of a broader Fed strategy to reduce future growth in aggregate demand.  Thus markets would assume that the base would also be adjusted over time in whatever direction was necessary for hitting the central bank’s target. (Surely there must already be a Nick Rowe analogy involving steering wheels and social conventions.) As always, monetary policy is 98% expectations, and 2% concrete steps.  What are those expectations about?  They are about future concrete steps, i.e. future changes in the supply of base money, relative to changes in the demand for base money.

PS.  I have a post criticizing Charles Plosser, and 99% of other economists, over at Econlog.  And also a libertarian rant.

Wrong question, wrong answer

John Cochrane has a new piece in the WSJ, criticizing the widespread concern over deflation risks, especially in Europe. I have mixed feelings about this whole enterprise.  I’ve repeatedly argued that inflation doesn’t matter, and that economists should just stop talking about inflation (and deflation.)  But they obviously won’t stop, and hence I guess I can’t blame Cochrane for responding to the often incoherent discussion. He lists 4 reasons to be skeptical about deflation fears:

1) Sticky wages. A common story is that employers are loath to cut wages, so deflation can make labor artificially expensive. With product prices falling and wages too high, employers will cut back or close down.

Sticky wages would be a problem for a sharp 20% deflation. But not for steady 2% deflation. A typical worker’s earnings rise around 2% a year as he or she gains experience, and another 1%—hopefully more—from aggregate productivity growth. So there could be 3% deflation before a typical worker would have to take a wage cut. And the typical worker also changes jobs, and wages, every 4½ years. Moreover, “typical” is the middle of a highly volatile distribution of wage changes among a churning job market. Ultimately very few additional workers would have to take nominal wage cuts to accommodate 2% deflation.

Curiously, if sticky wages are the central problem, why do we not hear any loud cries to unstick wages: lower minimum wages, less unionization, less judicial meddling in wages such as comparable worth and disparate-impact discrimination suits, fewer occupational licenses and so forth?

2) Monetary policy headroom. The Federal Reserve wants a 2% inflation rate. That’s because with “normal” 4% interest rates, the Fed will have some room to lower interest rates when it wants to stimulate the economy. This is like the argument that you should wear shoes two sizes too small, because it feels so good to take them off at night.

The weight you put on this argument depends on how much good rather than mischief you think the Fed has achieved by raising and lowering interest rates, and to what extent other measures like quantitative easing can substitute when rates are stuck at zero. In any case, establishing some headroom for stimulation in the next recession is not a big problem today.

3) Debt payments. The story here is that deflation will push debtors, and indebted governments especially, to default, causing financial crises. When prices fall unexpectedly, profits and tax revenues fall. Costs also fall, but required debt payments do not fall.

Again, a sudden, unexpected 20% deflation is one thing, but a slow slide to 2% deflation is quite another. A 100% debt-to-GDP ratio is, after a year of unexpected 2% deflation, a 102% debt-to-GDP ratio. You’d have to go decades like this before deflation causes a debt crisis.

Strangely, in the next breath deflation worriers tell governments to deliberately borrow lots of money and spend it on stimulus. This was the centerpiece of the IMF’s October World Economic Outlook antideflation advice. The IMF at least seemed to realize this apparent inconsistency, claiming that spending would be so immensely stimulative that it would pay for itself.

4) Deflation spiral. Keynesians have been warning of a “deflation spiral” since Japanese interest rates hit zero two decades ago. Here’s the story: Deflation with zero interest is the same thing as a high interest rate with moderate inflation: holding either money or zero-interest rate bonds, you can buy more next year. This incentive stymies “demand,” as people postpone consumption. Falling demand causes output to fall, more deflation, and the economy spirals downward.

It never happened. Nowhere, ever, has an economy such as ours or Europe’s, with fiat money, an interest-rate target, massive excess bank reserves and outstanding government debt, experienced the dreaded deflation spiral. Not even Japan, though it has had near-zero inflation for two decades, experienced the predicted spiral.

He’s right about point 4, there’s very little risk of a deflationary spiral.  And of course he’s right about the insanity of borrowing money to try to overcome deflation. Point 2 is a lousy metaphor, which doesn’t capture the logic of higher inflation as a way of avoiding a liquidity trap.  If Cochrane insists on shoe metaphors, here’s the right one:

Suppose you occasionally have to go out and shovel snow when it’s 40 below.  You should have one set of shoes that is 2 sizes too large, so that you can wear 4 pairs of socks with it.

Points one and three are examples how conservatives (except for the great Milton Friedman) have an unfortunately tendency to minimize the impact of demand shocks.  It’s true that inflation itself doesn’t matter, and that almost all Phillips Curve models perform really poorly.  But that’s a side issue.  When economists worry about deflation they are actually worried about falling NGDP, they just don’t realize it.  Obvious lower prices, ceteris paribus, are perfectly fine.  But when NGDP growth comes in 10% or 20% lower than workers or borrowers expected when they signed labor and debt contracts, then you have big problems.  Conservatives tend to have a blind spot for that problem (except for Milton Friedman, obviously.)

PS.  I hereby issue “loud cries to unstick wages.

PPS.  Notice to my international readers.  Keep in mind that 40 below zero fahrenheit is equivalent to 40 below zero centigrade.  

HT:  Ramesh Ponnuru

iPredict donations

We finally have a way of donating money to iPredict.  I will soon contact each person who offered a donation, and provide the contact person at the Victoria University of Wellington.  I will ask each person to donate at least 75% of the amount originally promised, if possible.  You may donate the full amount promised if you wish–it would help to sustain the market, but isn’t needed to get it off the ground.  The only exception is one large donor, who will be donating to Hypermind instead.

Thanks again for your support, and patience.

Update:  I should probably mention that the proposal evolved as time went by.  The initial plan called for funding of $31,500, but we later evolved to a different strategy, where the total cost is more contingent on how long the market runs.  Also, Hypermind later contacted us with a different plan, which we are already arranging funding for from a big donor.  The promised donations were considerably more than the amount the iPredict plan originally called for, but some of the donations were rather vague (“if needed”), or no specific amount promised. Some of the funds will be directed to Hypermind.   I believe that 75% of the amount promised should be enough to get a decent NGDP market off the ground with iPredict, even if one or two donors fail to come through.

Update#2:  I told that the US Friends of Victoria University is a US registered 501 c 3.

I’m no expert on taxes, but I believe that is good news.

Please respond to our arguments

Saturos sent me a IEA paper on monetary policy , by Pascal Salin.  There’s a section discussing market monetarism:

Let us assume that, because of excessive taxation and regulation, there is a real rate of growth of -2 per cent in a country. If, because of monetary growth of 3 per cent, there is a 5 per cent inflation rate, the growth rate of nominal GDP will be 3 per cent. If the target for nominal GDP is equal to 5 per cent, monetary authorities will increase the rate of growth of the quantity of money in order to reach the target. This will lead to inflation of 7 per cent. Once again, we cannot solve a problem without knowing its causes. If the low rate of real growth is due to non-monetary factors, one cannot change it just by manipulating monetary instruments.

It is impossible to reach two targets of economic policy with only one instrument (monetary policy) and the NGDP measure combines together two variables which tend to be affected by different types of policy (monetary policy and policies that affect the real economy).

These things make me want to pull my hair out.  We are told that bad policies that reduce trend RGDP growth to minus 2% will result in 7% inflation under NGDP targeting?  With absolutely no boost to RGDP? That’s the claim?  My response is “hell yes” that’s exactly why we need NGDP targeting!  If you target inflation in that scenario then RGDP growth would be well below minus 2%, and you’ll have mass unemployment.  Indeed the (supposedly awful) outcome he describes is exactly why we need MM.

It doesn’t bother me when someone disagrees with market monetarist ideas.  But tell us why! When it’s clear they’ve never read any of our proposals, and are not responding to any of our claims, then there can be no meaningful debate.  I looked at the references at the end of the paper to try to figure out which market monetarist papers he had read.  The references contained a total of three items.  A 1968 paper by Milton Friedman, and 2 papers by the author himself.  That’s it. No wonder he seemed completely unaware of the logic behind market monetarism.

The second paragraph is even worse.  No, NGDP is not two variables, it’s a single variable.  It’s not even debatable.  His logic would imply that inflation is also two variables, as it can be partitioned into goods price inflation and services price inflation.  In any case, even if for some strange reason you were able to convince me that NGDP were two variables, the standard argument that one monetary policy tool can’t hit two variables would have no relevance.  A single monetary policy tool can obviously hit any nominal composite of two variables that represents a weighted average boiled down to a single number.

BTW, here are some odd points about the article:

1.  He seems Austrian, but ignores the fact that Hayek favored NGDP targeting.

2.  He has nice things to say about money supply targeting, and rejects the claim that velocity is quite unstable.  Yes it seems that way (he argues), but just wait until we stabilize the money supply–then velocity will be much more stable.  OK, so he likes money supply targeting and thinks it would lead to stable V.  And if it was as successful as he anticipates then we would end up with . . .

. . . we’d end up with that awful NGDP targeting!