I once compared liquidity traps to obesity traps, but I can’t find the link.  The basic idea is that a person is stuck in an “obesity trap” if they cannot reduce weight without doing one of the following three things:

1.  Diet

2.  Exercise

3.  Surgery

Experts agree that those three steps would lead to weight loss, but they may require too much self control (diet, exercise) or expensive and painful surgery.  The obesity “trap” results from the fact that it’s difficult to lose weight if you rule out taking one of those three steps.

Similarly, there are steps that experts agree would eliminate the liquidity trap problem:

1.   A higher inflation target

2.  Level targeting (P or NGDP)

3.  Chuck Norris approach (promise to buy whatever it takes)

4.  Currency depreciation

Paul Krugman prefers #1, I prefer both #2 and #3.  But for various reasons central banks generally don’t want to do any of those 4 things. Instead they prefer to do two things that, while being mildly effective, may still fall short of what’s required to hit their target.  Those two things are QE and negative IOR.

Over at Econlog, Bryan Caplan added a 5th idea to the list of things that would work, but that the Fed does not want to do.  He suggests that we could convert all public debt into consols.  Then interest rates would never hit the zero lower bound, because it would imply an infinite price of consols.  This might well work, but central banks would not want to do this because it might expose them to a high level of asset price risk.  Indeed concern about asset price risk is what led Switzerland to switch to a much tighter monetary policy back in early 2015.  So add Bryan’s idea to the list of things that would work, but that central banks do not want to do.

PS.  Over at Econlog, I have a piece discussing Hillary’s views on Fed restructuring.

Marcus Nunes directed me to an article by Narayana Kocherlakota, discussing the impact of negative supply shocks:

Let’s consider three ideas that have been popular on the campaign trail.

• Increasing the minimum wage. What if Congress decided to increase the federal minimum wage by 10 percent a year over the next five years? Typically, economists would be concerned about the impact on employment: Higher wages might lead businesses to employ fewer workers. With monetary policy out of the picture, though, the move might actually help. The expectation of higher wages would cause consumers to expect more inflation over the next few years, leading them to buy more goods and services now, before prices went up. To meet this added demand, businesses would have to boost production and hiring.
• Increasing import tariffs. Suppose Congress gradually raised tariffs on imported intermediate goods, such as steel and sugar. Economists would worry that this would reduce the benefits of free trade. But as long as the Fed didn’t respond by raising interest rates, there would also be a positive effect: Households would expect higher prices, which would again   prompt them to demand more goods and services today — creating much-needed demand for businesses.
• Imposing restrictions on immigration. Most economists would oppose such a move, because immigration is seen as an important contributor to overall growth. Yet again, though, the logic changes somewhat if inflation is too low and the Fed is passive. Households might expect the relative scarcity of labor to drive up wages and prices, triggering purchases that would benefit businesses and the economy more broadly.

The Fed’s response is crucial in all these cases. Typically, the central bank reacts to increases in inflation by raising interest rates sharply — a move that would choke off any demand that the policy measures might generate. With inflation running well below target, however, it’s appropriate for the Fed to hold rates low even if it sees a modest increase in inflationary pressures. It’s this subdued reaction function that allows the policy initiatives to have more positive effects.

I find this peculiar, for a number or reasons.  First, I doubt that any demand-side effects of negative supply shocks would overcome the negative supply-side effects of these policies.  Second, I deny that these policies would boost demand, even at the zero bound. Higher minimum wages will lead to expectations of lower profits, and this will reduce investment.  What makes corporations invest more is higher expected NGDP.  What makes firms build more houses, is more immigration.  The crackdown on immigration in 2006 slowed the housing boom.

If you prefer Keynesian language, negative supply shocks reduce the Wicksellian equilibrium interest rate, making the “zero bound” problem worse.  Low immigration is exactly why the zero bound problem is most severe in Japan, and high rates of immigration is one reason why Australia never even hit the zero bound.  Fast NGDP growth leads to higher nominal interest rates, and no zero bound problem.

So even at the zero bound these policies do not work, as we found out when FDR raised wages sharply in July 1933, aborting a robust recovery in industrial production.  But it’s far worse.  We are not at the zero bound, and hence the Fed would simply raise rates to neutralize the effect on inflation.  Kocherlakota writes the final paragraph in a way that almost seems to suggest the Fed agrees with him, and would react the way he wishes.  But clearly they would not, or the Fed would not have raised rates in December.  So it’s a moot point.  Elsewhere, Kocherlakota says:

The Federal Reserve faces a big challenge: It wants to get inflation up to its 2-percent target, but so far its stimulus efforts have failed to reach that goal.

That’s simply inaccurate, for reasons that Kocherlakota has himself explained numerous times.  The Fed raised rates in December over Kocherlakota’s (wise) objections.  That means the Fed does not share Kocherlakota’s inflation objectives, or else they think they’ve already succeeded in the sense that expected future inflation is 2%.  But either interpretation is inconsistent with Kocherlakota’s “tried and failed” suggestion.  Either they are not trying, or they think they’ve succeeded. Take you pick, there are no other plausible options.

In fact, these initiatives would tend to reduce NGDP growth, as monetary policy would tighten to prevent any increase in inflation, thus reducing real GDP growth. Because wages are sticky, lower NGDP growth would boost unemployment.  And in the case of higher minimum wages, the unemployment effect would be especially large.

The fact that even a dove like Janet Yellen is aggressively raising interest rates to keep inflation from exceeding the Fed’s two percent target is a shot across the bow to progressives.  Yellen is essentially saying; “You go ahead and raise wages to $15/hour.  But we aren’t going to allow higher inflation.  Instead, we’ll raise interest rates enough to create lots more unemployment.”  The progressives have been warned, the only question is whether they care.

I’m starting to see a trend in the comment section that I never thought I’d live to see.  Progressives write in complaining that it’s cruel to have an economic system where low productivity people need to work (even with wage subsidies.)  Instead we should have a guaranteed annual income, so they can pursue other activities, such as hobbies, or volunteer work.

Maybe my lack of empathy comes from the fact that I was abused as a child.  My father tried to give away surplus games to charity, from his little store.  Things like Monopoly games with a few pieces missing.  But the charity would not take them, insisting that children receiving these slightly flawed gifts would be mentally scarred.  So instead he gave them to us.  Since then, I’ve never been the same.

Even worse, I ingested megadoses of lead.

Ben Bernanke has done a series of posts on what central banks can do at the zero bound. His first post looked at negative IOR, and the second examined targeting long-term interest rates.  Of course Bernanke has also advocated the use of QE. Now he looks at the helicopter drop option. Bernanke agrees with my view that helicopter money should be used as a last resort.  Where we may differ slightly is how many options need to be tried before reaching that point.

In my view, it’s too soon to jump to helicopter money, just because the techniques mentioned by Bernanke have been exhausted.  I recall Bernanke once arguing that the inflation target might have to be raised if there was a danger of hitting the zero bound, but he doesn’t mention that here. In my view there are many alternatives that we’d need to run through before considering helicopter drops, such as a higher inflation target, or price level targeting, or better yet NGDPLT.  I’d also want to go beyond T-bond purchases, to the purchase of other assets.  Thus creation of a sovereign wealth fund would be far superior to helicopter drops.

For some reason Bernanke doesn’t consider those alternatives, perhaps because he doesn’t think they would be needed:

In this post, I consider the merits of helicopter money as a (presumably last-resort) strategy for policymakers. I make two points. First, in theory at least, helicopter money could prove a valuable tool. In particular, it has the attractive feature that it should work even when more conventional monetary policies are ineffective and the initial level of government debt is high. However, second, as a practical matter, the use of helicopter money would involve some difficult issues of implementation. These include (1) the need to integrate the approach with standard monetary policy frameworks and (2) the challenge of achieving the necessary coordination between fiscal and monetary policymakers, without compromising central bank independence or long-run fiscal discipline. I propose some tentative solutions for these problems.

To be clear, the probability of so-called helicopter money being used in the United States in the foreseeable future seems extremely low.  (emphasis added)

Almost everyone agrees that the US is likely to hit the zero bound in the next recession.  So obviously Bernanke doesn’t think being at the zero bound, in and of itself, calls for helicopter drops.  But then what would be the trigger?  On that issue he’s a bit vague.

Suppose we assume that “extremely low” means “1% chance”.  My response would be that we could lower than number to something closer to one in a million by adopting a different policy target, and giving the Fed the responsibility to “buy whatever it takes” to keep as close to the target as possible.  Then helicopter drops could be used as a fallback to make the “Chuck Norris effect” credible, without ever actually having to use the policy.

To his credit, Bernanke sees the problems with the helicopter drop theory—it doesn’t really solve any fundamental problem.  Even a helicopter drop may not be effective if the money supply increase is not viewed as permanent.  This causes Bernanke to suggest exotic extensions of the traditional helicopter drop:

As I’ve stressed, MFFPs [money financed fiscal policies] differ from ordinary fiscal programs by being money-financed rather than debt-financed. In my illustrative fiscal program, government spending and tax cuts are paid for by the creation of $100 billion in new money. To have its full effect, the increase in the money supply must be perceived as permanent by the public.

In practice, however, most central banks do not make monetary policy by choosing a fixed amount of money in circulation. Instead they set a target for a short-term interest rate (in the U.S., the federal funds rate) and allow the money supply to adjust as necessary to be consistent with that target. The rationale for this approach is that the relationship between interest rates and the economy appears more stable and predictable than that between the money supply and the economy. If central banks target interest rates rather than the money supply itself, than it’s not immediately obvious how the idea of a “permanent increase in the money supply” can be made operational.

One possible solution for that problem is that the central bank, rather than making an explicit promise about the money supply, could temporarily raise its target for inflation—equivalently, it could increase its target for the price level at each future date. Since the price level and the money supply tend to be proportional in the longer run, aiming for a higher price level could approximate the effects of committing to a higher money supply. A shortcoming of this approach is that it obscures the fact that the fiscal package is being financed by money creation rather than by new debt—a distinction that, again, the public must appreciate if the MFFP is to be fully effective.

This is not just a theoretical possibility.  We know that helicopter drops failed in Japan, because the monetary injections were viewed as temporary.  Bernanke correctly notes that shifting to a level target for prices can overcome this problem. But then level targeting also overcomes the main weakness of QE.  Thus if we do what Bernanke suggests, we don’t even need the fiscal component.

The methods that central banks use to meet their interest-rate targets pose further complications. Before the financial crisis, the Fed continuously varied the amount of money in the system (more precisely, the quantity of bank reserves) to keep the funds rate near the desired level. In the years since the crisis, however, several rounds of quantitative easing have resulted in very high levels of bank reserves, to the extent that the traditional method of making marginal changes to the supply of reserves is no longer effective in controlling the federal funds rate. Instead, following practices similar to those of other major central banks, the Fed currently influences the funds rate by varying the interest rate it pays on bank reserves and on other short-term investments at the Fed. [8]

As my former Fed colleague Narayana Kocherlakota has pointed out, the fact that the Fed (and other central banks) routinely pay interest on reserves has implications for the implementation and potential effectiveness of helicopter money. A key presumption of MFFPs is that the financing of fiscal programs through money creation implies lower future tax burdens than financing through debt issuance. In the longer run and in more-normal circumstances, this is certainly true: The cost to the Treasury of spending increases or tax cuts – and thus the future tax burden – will be lower if the Fed provides the financing. In particular, when the Fed’s balance sheet has shrunk and reserves are scarce again, the Fed will be able to manage short-term rates without paying interest on reserves (as it did traditionally), or in any event by paying a lower rate on reserves than the Treasury must pay on government debt. In the near term, however, money creation would not reduce the government’s financing costs appreciably, since the interest rate the Fed pays on bank reserves is close to the rate on Treasury bills.

Both interest-rate targeting and the payment of interest on reserves make it more difficult to achieve and communicate the cost savings associated with money financing. Here is a possible solution. Suppose, continuing our example, that the Fed creates $100 billion in new money to finance the Congress’s fiscal programs. As the Treasury spends the money, it flows into the banking system, resulting in $100 billion in new bank reserves. On current arrangements, the Fed would have to pay interest on those new reserves; the increase in the Fed’s payments would be $100 billion times the interest rate on bank reserves paid by the Fed (IOR). As Kocherlakota pointed out, if IOR is close to the rate on Treasury bills, there would be little or no immediate cost saving associated with money creation, relative to debt issuance.

However, let’s imagine that, when the MFFP is announced, the Fed also levies a new, permanent charge on banks—not based on reserves held, but on something else, like total liabilities—sufficient to reclaim the extra interest payments associated with the extra $100 billion in reserves. In other words, the increase in interest paid by the Fed, $100 billion * IOR, is just offset by the new levy, leaving net payments to banks unchanged. (The aggregate levy would remain at $100 billion * IOR in subsequent periods, adjusting with changes in IOR.) Although the net income of banks would be unchanged, this device would make explicit and immediate the cheaper financing of the fiscal program associated with money creation.

Or we could just raise the inflation target to 3%.

Or even keep it at 2% and do level targeting.  Or NGDPLT.  All these epicycles to make helicopter drops work make me dizzy.  The simple truth is that monetary policy is all we need if used intelligently, and if not used intelligently (as in Japan pre-2013), even helicopter drops won’t get the job done.  So let’s K.I.S.S., and work out fallbacks that don’t require wildly unrealistic assumptions about cooperation between the Fed and a GOP-controlled Congress.  Instead let’s simply shift the target slightly (4% NGDPLT anyone?), and perhaps add to the securities that the Fed is eligible to buy.

I am more sympathetic to Olivier Blanchard’s view of helicopter drops:

One thing he is not worried about is running out of monetary ammunition. “There is an argument that QE actually becomes more effective, the more you use it,” he said.

As a central bank buys more bonds, the more it has to pay to convince the last hold-outs to sell their holdings. “The effect on the price plausibly becomes stronger and stronger,” he said.

Prof Blanchard said the authorities should stick to plain vanilla QE rather than experimenting with “exotic stuff”.

He waved aside talk of ‘helicopter money’ with contempt, calling it nothing more than a fiscal expansion by other means. It makes little difference whether spending is paid for with money or bonds when interest rates are zero.

Blanchard favors a 4% inflation target, so that central banks would not hit the zero bound.  Again, K.I.S.S.

HT:  Benn Steil, James Alexander, et al.

Benn Steil has a new piece in the Weekly Standard entitled:

Why is Paul Krugman Still Calling for Fiscal Stimulus?

Here’s an excerpt:

With the Fed having raised rates in December, the zero bound – for whatever it might have meant – is gone in the United States. This should mean Krugman, if he is truly following economic science as he claims to understand it, abandoning his calls for fiscal stimulus.

Yet he is not only still advocating a big increase in government spending, he is calling for government intervention to boost wages and union bargaining power. He further says that “mercantilism makes a fair bit of sense” in this environment. Yes, mercantilism – import barriers, export subsidies, and the like. Bring on the trade war.

Krugman justifies all this by arguing that we are still in a topsy-turvy liquidity-trap world because rates are “near zero.” Yet whatever debate we might have about the effectiveness of negative rates and QE, there can be no debate over whether we are in a liquidity trap. We are not. When the Fed’s policy rate is above zero, by any amount, it means that it has determined (rightly or wrongly) that – given the current stance of government fiscal and other policies – the appropriate rate for the economy is positive. Not zero or negative. Importantly, this also means that if the government does significantly increase spending, as Krugman wants, the Fed will react to the higher level of demand by raising rates more rapidly than it would otherwise have done. This will counteract the higher government spending; such effect is known as “monetary offset,” a concept which Krugman considers uncontroversial. Thus calling for fiscal stimulus with positive interest rates is the logical equivalent of wanting to eat more because you are a little bit pregnant. It makes no sense: you cannot be a little bit pregnant, nor can you be in a liquidity trap when rates are positive.

Krugman ended the 1990s sounding much more market monetarist than Keynesian.  As late as 1999, a year after his famous 1998 paper on liquidity traps, Krugman was still dismissive of fiscal stimulus, even at the zero bound:

What continues to amaze me is this: Japan’s current strategy of massive, unsustainable deficit spending in the hopes that this will somehow generate a self-sustained recovery is currently regarded as the orthodox, sensible thing to do – even though it can be justified only by exotic stories about multiple equilibria, the sort of thing you would imagine only a professor could believe. Meanwhile further steps on monetary policy – the sort of thing you would advocate if you believed in a more conventional, boring model, one in which the problem is simply a question of the savings-investment balance – are rejected as dangerously radical and unbecoming of a dignified economy.

Will somebody please explain this to me?

By 2012 he had shifted from monetarist to new Keynesian, believing fiscal policy can be useful, but only when rates are at the zero bound:

People in my camp have repeated until we’re blue in the face that the case for fiscal expansion is very specific to circumstance — it’s desirable when you’re in a liquidity trap, and only when you’re in a liquidity trap.

Here’s another example from 2012:

From the very beginning of the Lesser Depression, the central principle for understanding macroeconomic policy has been that everything is different when you’re in a liquidity trap. In particular, the whole case for fiscal stimulus and against austerity rests on the proposition that with interest rates up against the zero lower bound, the central bank can neither achieve full employment on its own nor offset the contractionary effect of spending cuts or tax hikes.

This isn’t hard, folks; it’s just Macro 101. Yet a large number of economists — never mind politicians or policy makers — seems to have a very hard time grasping this basic concept.

Notice that he’s exasperated with dumb people who believe what he still believed in 1999.

And there are dozens of other examples over the past 8 years.  As Benn Steil points out, Krugman has now shifted again, from new Keynesian to old-fashioned Keynesian.  Krugman was right that EC101 says fiscal stimulus doesn’t work when rates are positive.  EC101 also says that attempts to artifically raise wages will reduce employment.  Ec101 also says the protectionism will impoverish a country.  But EC101 doesn’t matter anymore to a growing number of Keynesians.  Keynesian economics circa 2016 is starting to remind me of the most extreme forms of supply-side economics from the 1980s.

One begins to wonder if the theory and evidence produce the policy implications, or if the policy needs are producing an ever changing set of ad hoc theories.

This sort of thing (from The Economist) makes me want to tear my hair out:

Despite central banks’ efforts, recoveries are still weak and inflation is low. Faith in monetary policy is wavering.

Seriously?  After the Fed raised rates in December, despite “low” inflation and a “weak” recovery, people are still claiming that the poor central banks tried hard to inflate, but that it was just too difficult?  This sort of thing is beyond clueless, it almost leaves me speechless.  What world is the Economist living in?  How hard is it to understand that the Fed raised rates to prevent inflation from rising?  This is not rocket science.

And “effort”?!?!?  How much effort does it take to print currency and buy assets? We aren’t talking about storming the beaches of Normandy, or sending a man to the moon, or building the transcontinental railroad. I know that modern governments have almost completely lost the ability to produce substantive physical infrastructure (except for China.)  But are we to believe that even printing money now requires too much “effort”, and that we need to give those poor souls a break from their arduous duties?  My God! No wonder Trump is doing well, the entire technocratic class in the West is a bunch of worthless lazy bums.  Can’t they do anything?  Even debasing a currency is beyond their ability?

I’m reminded of an old Monty Python routine:

But it gets worse.  The line I quoted might just be a slip of the tongue.  But consider this:

The time has come for politicians to join the fight alongside central bankers. The most radical policy ideas fuse fiscal and monetary policy. One such option is to finance public spending (or tax cuts) directly by printing money—known as a “helicopter drop”. Unlike QE, a helicopter drop bypasses banks and financial markets, and puts freshly printed cash straight into people’s pockets. The sheer recklessness of this would, in theory, encourage people to spend the windfall, not save it.

So let’s see.  We print up a zillion dollars, or euros, or whatever.  What are we going to do with all this money?  Well, we could buy assets.  Perhaps create a sovereign wealth fund, like those lucky countries have, you know, Singapore, Norway, UAE, etc.  Or, we could just give it all away, and continue down the road toward being a bankrupt, debt-ridden economy like Greece.  Hmm, decisions, decisions . . .  don’t rush me . . .

I know, let’s do a helicopter drop, because the sheer recklessness of it sounds neat.  Isn’t that what we were taught in grad school back in the 1970s, just print lots of money and give it away?  Sovereign wealth funds are so boring, and we’d have to keep track of the financial markets.  Giving away money is so much more fun.

PS.  I hope it’s clear I’m not advocating printing up money to create a sovereign wealth fund, I’m just trying to figure out why even that moronic idea (and it is certainly stupid) would not be superior to a helicopter drop.

HT: Jason

Update:  As usual, Tyler is much more polite than me:

So if in a monetary policy or macroeconomic analysis you read the phrase “out of options,” you would do well to substitute in “governments do not wish to pursue their remaining options.”