It’s the economists, stupid

For quite some time I’ve been arguing that fiscal policy is mostly ineffective because the Fed drives the nominal economy, and the Fed acts as if they are basically content with current levels of AD.  I should add that I find their attitude incomprehensible.  Bernanke says the stance of monetary policy should be judged by NGDP growth and inflation, and by that metric it’s been tighter since mid-2008 than at any time since the 1930s.

Ryan Avent recently linked to a WSJ article suggesting that current Fed policy is roughly what the median FOMC voter wants:

“I am comfortable with the current stance of monetary policy,” Sandra Pianalto, president of the Federal Reserve Bank of Cleveland, said in a speech last week. “Doing more at this time could create too much inflation risk, and doing less could risk weakening an already slow expansion and causing an unwelcome disinflation.” Ms. Pianalto’s comments are notable because she occupies a middle ground in the Fed’s often-polarized decision-making body, the Federal Open Market Committee. Some on the committee worry a great deal about inflation and aren’t inclined to act more, while others worry more about unemployment, and her view gives a sense of where the center of the committee stands.

And my fellow economists seem to share her views.  In the blogosphere you find some economists who think money’s too tight, and some who think it’s too easy.  But out in the real world most economists just seem to yawn, and mumble that Bernanke seems to have gotten it about right.  Anyway (so they suggest) what more could the Fed be expected to do?  “Tightest monetary policy since the Great Depression?”  I’d be viewed as a lunatic if I made that claim at an economics conference, even though I’d be using Bernanke’s own definition of the stance of monetary policy.

When most economists think X% growth in NGDP is about right, and the median voter on the FOMC thinks X% NGDP growth is about right, why would we expect anything other than X% NGDP growth?  Why do we feel a need to search out bizarre conspiracy theories that the Fed is doing the secret bidding of the bankers?  The answer is right in front of our eyes, as plain as day.

And suppose we did some more fiscal stimulus?  I’d guess the Fed would then do less monetary stimulus, and we’d still get X% NGDP growth.

Ryan Avent sums things up nicely:

In other words, I seem to have been wrong about the Fed’s intentions. It has come no closer to effective policymaking at the zero lower bound, and Americans can expect growth between 2% and 3% at best while this regime persists. That is all that the Fed is prepared to engineer or allow.

That’s not to say Ryan endorses my zero fiscal multiplier argument.  It’s possible the Fed is willing to allow faster than X% NGDP growth if it can be engineered with conventional monetary policy.  But it’s a moot point, as there’s no chance of Congress doing significantly more.  And if they did less?  Logic dictates we’d still get X% NGDP growth.  But as my previous post noted, logic seems to play no role at all in the Alice in Wonderland world of Fed policymaking.  So it’s anyone’s guess.

PS.  Paul Krugman seems to agree, at least on the question of who’s to blame:

And I blame economists, who were incoherent in our hour of need. . . .

And this is a terrible thing for those who want to think of economics as useful. This kind of situation is what we’re here for. In normal times, when things are going pretty well, the world can function reasonably well without professional economic advice. It’s in times of crisis, when practical experience suddenly proves useless and events are beyond anyone’s normal experience, that we need professors with their models to light the path forward. And when the moment came, we failed.

And here’s one of my favorite John Cochrane quotations:

Some economists tell me, “Yes, all our models, data, and analysis and experience for the last 40 years say fiscal stimulus doesn’t work, but don’t you really believe it anyway?” This is an astonishing attitude. How can a scientist “believe” something different than what he or she spends a career writing and teaching? At a minimum policy-makers shouldn’t put much weight on such “beliefs,” since they explicitly don’t represent expert scientific inquiry.

We economists know that it’s a bad idea to have monetary policymakers let NGDP grow at the slowest rate since Herbert Hoover was President.  But when it came time for us to ask the Fed to address the problem, most of us just shrugged.


Tags:

 
 
 

57 Responses to “It’s the economists, stupid”

  1. Gravatar of Jason Odegaard Jason Odegaard
    7. March 2012 at 06:40

    Too many people look for secretive, intelligent explanations for occurrences that seem stupid on the surface.

    When I see two possible causes – one with malicious intent, the other stupidity – I usually bet on stupidity as the underlying reason. It’s the safe bet.

  2. Gravatar of Frederic Mari Frederic Mari
    7. March 2012 at 06:47

    Hold on.

    Who said fiscal stimulus doesn’t work? Or, even more outrageous, that most economists don’t believe fiscal stimulus work? I’d like some evidence of that…

    … because, speaking of Krugman, I am pretty sure I distinctly remember him calling for more fiscal stimulus, deficits be damned, quite recently…

  3. Gravatar of Mark A. Sadowski Mark A. Sadowski
    7. March 2012 at 06:54

    The FOMC is obviously satisfied with a new growth track that is 10% lower than its previous track. If you reject that you really need to make your case more strongly.

  4. Gravatar of dwb dwb
    7. March 2012 at 07:01

    keep hammering the point home. I see the analysis bleeding into analysis of Fedspeak among money managers, so veeeery slowly you are starting to get through.

    I seem to live in this bizarre, surreal, alternate universe where monetarism is now considered fringe. Hayek vs Keynes? wha? It’s Hayek vs Friedman and Friedman won hands down {I am not taking up the Friedman/Hawtrey debate ala David Cassel I don’t know enough to have an opinion}. And if i had free time, it would be a rap video too. Hayek is at best a sideshow. C’mon, people should fess up and admit they never heard of Hayek until a few years ago, when the ideas were pushed by someone’s cranky cooky old uncle from Texas.

    Like i said, i see the lexicon bleeding into analysis of monetary policy with terms like “flexible inflation targeting.” It may take a while, but I just do not think history will be very kind to the profession for completely going tabula rosa on monetarism.

  5. Gravatar of Joe Joe
    7. March 2012 at 07:05

    “…most economists just seem to yawn, and mumble that Bernanke seems to have gotten it about right. Anyway (so they suggest) what more could the Fed be expected to do?”

    The two questions, “have they done enough?”, and “what else they can do?” should be independent, but I think that the responses to them are subtly intertwined.

    If the Fed had just taken “ordinary” actions to date, and there were more “ordinary” actions they could take to boost NGDP, more economists would tend to say they should do more. The fact that the Fed has done extraordinary things already and would have to do more extraordinary things, makes economists both skeptical of their ability, and accepting of their result.

    This would argue for a huge fiscal stimulus that would allow the Fed to remove it’s “extraordinary” accommodation. Then the Fed would be in its usual situation, which should lead to more effective policy. Of course, a huge fiscal stimulus would freak out the inflation hawks, and they might be able to put enough pressure on the Fed to undo the whole thing.

  6. Gravatar of Mark A. Sadowski Mark A. Sadowski
    7. March 2012 at 07:10

    I’ll be frank. I’m disapponted with your passivism Scott. I expected more of you. I also expect more of myself.

  7. Gravatar of Joe Joe
    7. March 2012 at 07:19

    Frederic Mari,

    I think it is correct that most economists think that during normal times monetary policy will be used to offset fiscal policy, so fiscal policy is ineffective. Krugman believes that at the zero lower bound there are no monetary options, so fiscal policy can be effective. Cochrane may believe that there is no such thing as the ZLB (I think that is what our host believes). However, having read some of Cochrane has written, I think he’s just confused and over his head.

  8. Gravatar of dwb dwb
    7. March 2012 at 07:30

    … also, Krugman says:
    What kind of action? There was and is a case for large-scale unconventional monetary policy, which in a zero-bound economy has to work largely through inflation expectations.

    only in a bizzarre surreal alternate universe is printing money through QE considered “unconventional.”

    as i said, the real debate has been Keynes vs Friedman: whether printing money is effective at the zero bound. The evidence is overwhelming, at this point. The only conclusion one can come to is that the Fed does not want higher nominal growth. Isn’t it obvious why politicians are running against the Fed??

  9. Gravatar of Lee Kelly Lee Kelly
    7. March 2012 at 07:36

    Heck, it’s even worse for fiscal stimulus proponents than I thought: even if the Fed were out of bullets, so to speak, they wouldn’t want to fire any more if they weren’t. It’s pretty clear that any expansionary effect on spending or prices that fiscal stimulus might have will be sabotaged by tighter Fed policy.

    The whole argument for fiscal stimulus really depends on the Fed wanting higher nominal spending than it can achieve by its lonesome. However, if spending is already where the Fed wants it, then all the crowding out arguments pretty much apply: increased public spending will be matched by lower private spending.

  10. Gravatar of Neal Neal
    7. March 2012 at 07:46

    If the Fed is going to keep NGDP growth at 2-3%/annum for the foreseeable future, how long will it take for expectations to adjust to the new growth rate? As expectations adjust, unemployment will fall back to its natural rate.

  11. Gravatar of Frederic Mari Frederic Mari
    7. March 2012 at 08:05

    Joe,

    I’d still want proof/some references for that belief about ‘most economists’ beliefs’. Last time I checked, the general consensus was that both instrument (spending and monetary) were to be used in contra-cyclical ways. There were a lot of debate about which one had the best cost/benefit bang-for-buck kind of thing but that was about it…

    The third tool, the fiscal pressure, is even more hotly debated but, again, the general consensus, afaict, is that it’s supposed to be contra-cyclical/set at a boosting growth level…

  12. Gravatar of bill woolsey bill woolsey
    7. March 2012 at 08:26

    Why does fiscal policy work?

    Because the Fed can blame Congress.

    Gee, nominal spending rose resulting in higher inflation. It wasn’t our fault, because Congress followed an expansionary fiscal policy.

    If, instead, Congress did nothing, and the Fed expanding base money enough to cause the same incerase in nomiminal expenditure and it caused the “excessively” high inflation, then the Fed would take the blame. it was the Fed’s “excessive” money creation that caused the inflation.

    While I am sure that the Fed is upset that interest rates are so low by historical standards, at least they aren’t flucating.

    Inflation isn’t too high. Or, at least, some measure or other of inflation can be trotted out and show that it isn’t too high.

    The only problem is unemployment. And it is falling, and no one is blaming the Fed. So what problem?

    The Republicans are blaming the Obama and his regulations. The Democrats are blaming the Republicans from allowing them more fiscal stimulus.

    From the Fed’s point of view, everything is peachy.

    Keep short term interest rates stable subject to the constraint that voters not get too pissed off at the Fed due to rising CPI inflation or rising unemployment.

    As for economists, the fundamental choice is whether you want to help the Fed acheive its goal, and have success. Or if you want to try to pressure the Fed to change its goal.

    How is that for a conspiracy theory?

  13. Gravatar of Charlie Charlie
    7. March 2012 at 08:47

    Scott,

    With the 5-year break even rate on TIPS at 2.2% and 3% RGDP in Q4, what do you think about our prospects of crawling out of this? I mean, we are not headed back to the levels we belong at, but but nominal wages are slowly adjusting to this new normal. What do you think about recovery? Will it continue at a slow pace? I know you are worried about structural damage that occurred during the recession, as I am. I wonder what the structuralists will say if we slowly crawl back to unemployment under 6%. Especially if there’s been few if any legal changes. Will they come up another structural Deus Ex Machina?

  14. Gravatar of Ghengis Khak Ghengis Khak
    7. March 2012 at 08:58

    The only conclusion one can come to is that the Fed does not want higher nominal growth. Isn’t it obvious why politicians are running against the Fed??

    But the politicians concerned with the Fed have positioned themselves as opposing nominal growth, have they not?

  15. Gravatar of Joe Joe
    7. March 2012 at 09:23

    Frederic Mari,

    The idea is that fiscal and monetary policy combined determine the growth of NGDP, but the Fed gets to go last. If they choose to accommodate the fiscal changes, by allowing the money supply to grow or contract, then the fiscal changes work. If the Fed thinks that they are already hitting their targets, then they will not accommodate the fiscal changes. They will adjust the money supply to negate them. I think that idea has become fairly uncontroversial among economists.

    That doesn’t mean that we can’t think up good reasons to prefer fiscal policy to monetary policy. It just means that in either case the Fed gets to set the overall path of NGDP.

  16. Gravatar of Joe Joe
    7. March 2012 at 09:29

    bill woolsey,

    I think you’re close to the truth. Your scenario implies that the Fed would accommodate fiscal stimulus and allow it to flow through to NGDP.

  17. Gravatar of Patrick R. Sullivan Patrick R. Sullivan
    7. March 2012 at 09:54

    I love this from Krugman;

    ‘In normal times, when things are going pretty well, the world can function reasonably well without professional economic advice.’

    Yeah, Paul, we hardly even knew you were alive during the quarter century from the end of 1982 through 2007.

  18. Gravatar of Jim Glass Jim Glass
    7. March 2012 at 10:11

    Sort of related….

    Just yesterday, after listening to your podcast at Econtalk I listened to a couple others including one with Eugene Fama, who’s no slouch in his own field. After some time talking about finance they turn to the recession, and I hear…
    ~~~~

    Fama: What more can the Fed do? It can create all the base money it wants, but it can’t make anybody borrow or spend it. Look at the mountain of excess reserves.

    Roberts: But Friedman said they will. When I interviewed him about the Depression…

    Fama: I discussed this with Milton many times. In the Depression there were huge amounts of free reserves. What more could the Fed do? Nobody would use them. Milton could never explain to me, if monetary policy was effective, how could all those excess reserves just sit there? Nobody wanted to use them. At the end Milton would just look at me. With him, even when you won an argument he could make you feel like you lost.

    [The very next question…]

    Roberts: Do you have any thoughts about why the Fed decided to start paying interest on reserves?

    Fama: Absolutely! Ha! That’s easy. With the huge amount of reserves they pushed out, they knew they’d create hyperinflation otherwise.
    ~~~

    So, another case of someone who is no fool believing the Fed is impotent except to create hyperinflation. Of course, if that is true then “do no more” is the best policy.

    I’ve got to read Kahneman’s book on how people organize their beliefs.

  19. Gravatar of dwb dwb
    7. March 2012 at 10:58

    So, another case of someone who is no fool believing the Fed is impotent except to create hyperinflation.

    The Fed’s staff own papers on QE provide evidence for the effectiveness of QE, and some of the mechanisms. I can only assume the feds staff papers are not mere propaganda.

    Lots of otherwise informed smart people confuse reserves and capital. It’s bank capital the governs lending, not reserves. Right now bank capital is actually quite scarce due to: 1)low ngdp expectations; 2)impending BASEL 2.5 market risk rules; 3) Impending Fed stress tests; 4) other regulatory capital potential requirements eg Dodd-Frank.

    As a result, banks are parking a lot of their capital in reserves. printing money (either through direct QE or shadow QE like the LTRO the ECB is pushing) eventually makes capital less scarce and lowers the return on capital to the point it results in more lending. It is not a question of “IF” its a question of how much.

    maybe we need a stealth shadow QE (er, sorry, “liquidity” operation) like the ECB is now doing with LTRO (to the tune of 1 Tn Euros so far) to boost bank “liquidity” …

  20. Gravatar of Charles R. Williams Charles R. Williams
    7. March 2012 at 11:05

    Sound monetary policy may be a necessary condition for a smooth growth path for the price level and NGDP but it may not be a sufficient condition.

    Can the fed hit an NGDP target under all circumstances?

    Would the actions the fed might take to hit an NGDP target have undesirable side-effects?

    Given the persistence of inflation, albeit at low levels, is there less slack in the economy than people think?

  21. Gravatar of W. Peden W. Peden
    7. March 2012 at 11:28

    Jim Glass,

    Fama gets a bad rep these days, but he’s a very good economist regardless of whether or not one tends to agree with him. As a result, he’s the highest-level economist I’ve heard to contradict himself in such a way. Sadly, he’s not the only one.

    The contemporary consensus seems to be that QE has no effect on aggregate demand and also increases inflation. Ugh.

  22. Gravatar of Becky Hargrove Becky Hargrove
    7. March 2012 at 12:11

    If blame is really the word we want to use, there’s plenty of blame to go around besides the economists. Economists do listen to people, after all, and how many people are actually calling for more growth in the present? People are certainly calling for jobs but that’s not the same thing. One recent blog post that called for growth had a commenter say, “My garage is full. What more do I need to add?” And then those who could use a little growth in the present aren’t really a part of the discussion. By the current norms, people are either doing okay, or they most definitely are not.

    And it’s the tight definition of the norm itself, which has caused this problem. In spite of our incredibly disparate incomes, we live as though there are only a few degrees of difference in terms of what we are expected to purchase in the marketplace that is truly important. Economists are turned into pretzels trying to make that incredible reality add up, not to mention the game of ‘hide the tax’ that governments play, just to deal with it. How did people ever come to believe we could live with the same regulation and zoning norms in every city, knowing full well that as a country we believe in wide disparities in income. If we are going to maintain a future with such income disparities without coming apart at the seams, our supply side sector needs to get real. I blame them the most. The set point monetary value of consumer goods they have created are what’s responsible for our fears about inflation.

  23. Gravatar of Patrick R. Sullivan Patrick R. Sullivan
    7. March 2012 at 12:40

    Jim mentioned Econtalk, and the most recent one is with Charles Calomiris,

    http://www.econtalk.org/archives/2012/03/calomiris_on_ca.html

    who had this to say (with a little editing from me), near the end, about the events of 2008;

    ————–quote——————
    I think that the main thing to say here is number 1, there was huge incompetence due to inexperience. The people we had at the top of this effort really didn’t know what they were doing. And I mean that as an historian who has focused a lot of my career and research on financial crises. We had incompetent management.

    The Federal Reserve did not understand securitization. It did not understand financial risks very well. My friend, Ben Bernanke, is a great economist; he knows a lot about the Great Depression; I think he was not really aware of what was going on as of 2006 and even early 2007.

    And I am absolutely sure that Hank Paulson was not aware of what was going on. And more importantly, they didn’t even really know what they didn’t know; and they didn’t know because of the U.S.’s experience. They didn’t really understand crisis management.

    What I mean by crisis management–I wrote a paper in 2005 with two World Bank economists who’d spent a lot of their lives working in different crisis countries on how you deal with financial crises. There’s actually a group of 100 episodes in the last 20-30 years of countries that have financial crises and how you dealt with them. There’s a wide range of things you can know about this topic. We just didn’t have any real institutional memory or understanding of it. I just think that we mismanaged it.

    I look at the variety of experiences, and the fact that we did some balance and didn’t do others as largely reflecting just incompetence, rather than some sort of conspiracy to sometimes help and sometimes not. But I’ll tell you one other thing about Lehman.

    ….I’m talking about–I thought you were asking me about why it was such a kind of random policy: AIG gets bailed out and Lehman doesn’t. …. Here’s the secret I’m going to reveal to you and your listeners, without telling you my source.

    ….In the summer of 2008, it’s probably pretty well known at this point that Met Life looked at buying Lehman.

    Russ [Roberts]: A lot of people did. Barclay’s was in the market; there was a Japanese firm.

    [Calomiris]: Yes. Well, MetLife looked very carefully and they really wanted to get into this area. And as much as they wanted to get into it, they concluded that Lehman was so dead, so under the water, that they couldn’t touch it.

    That was not September of 2008; that was some time around May, June of 2008. And someone called Tim Geithner, who at that point was at the Federal Reserve Bank of New York, and said: Tim, I’m a member of the Board of a certain company and I’ve heard something; and what it comes down to is what I’ve heard is that MetLife has done its due diligence, and as much as they’d like to do this, they can’t do it; and so you have a deeply insolvent financial institution on your hands called Lehman Brothers. And you’ve got to figure something out about it.

    ….And then Geithner apparently pooh-poohed it. And the person on that line said to him: Look, MetLife would like to do this deal, from what I understand; they would like the numbers to work. So what’s their incentive for….For being pessimistic. They have no incentive for being pessimistic. They’d like to make it work. They are walking away.

    And Tim: Wake up call, man! Now, if you want to start talking about incompetence, let’s start there. And then what happens with this incompetent individual? I have to be frank: He then gets promoted.
    —————endquote————–

  24. Gravatar of Gabe Gabe
    7. March 2012 at 13:49

    Well glad you guys are so sure the situation is straightforward. I look forward to being a witness to ya’ll convincing all the real economist that they just need to listen to some logic and then see them change their minds.

    If these smart and open minded economist at the Fed are so filled with the best intentions I bet they will open up a dialogue with clearly knowledgeable people here like Dr Sumner. I bet they would be happy to have a televised discussion where the questions you ask can be directed at them. I’m sure the fed guys don’t want to have the phony flim-flam pres conferences with Foxnews and Reuters journalists. It will be great to see the open debates and exchange of ideas I am sure will be coming soon.

  25. Gravatar of Gabe Gabe
    7. March 2012 at 14:09

    “When I see two possible causes – one with malicious intent, the other stupidity – I usually bet on stupidity as the underlying reason. It’s the safe bet.”

    Jason Odegaard,
    Let me get this straight. you think the Fed is honestly looking out for the best interest of the common man and would give no greater weight to the policy advice or opinions of a powerful old billionaire like David Rockefeller than he would the scholarly argument and policy advice of Scott Sumner? You think Scott Sumner can get on the phone or email and get a response from Ben Bernanke as quickly as Sir de Rothschild?

    I see two possible reasons for your beliefs…you are either naive or stupid…I’ll take your advice and go with the safe bet.

  26. Gravatar of Jason Odegaard Jason Odegaard
    7. March 2012 at 18:07

    Gabe,

    You caught me. Clearly the recession in much of the world is at the direction of the Rothschild family, and while I’m at it 9/11 was an inside job. I was just quite gullible in believing that the recession was caused by poor decision making at central banks, and 9/11 the result of stated intents of a terrorist group and intelligence coordination failure.

    It’s all planned, nothing to chance.

  27. Gravatar of Rien Huizer Rien Huizer
    7. March 2012 at 19:17

    Scott,

    Just what I thought all along. Economic policymaking is too important to be left to economists, despite policy irrelevance*) and economists apparently feel that. . Fortunately, because of policy irrelevance there is also no damage if most economists favour a policy style/direction/strength they probably consider “prudent” (or whatever: neutral, harmless, etc, even if that happens to be (in hindsight) inappropriate.

    Economic policymaking is important because if a politician can attribute success to “his” policies and con the voters to believe that the same will apply in the future, it may increase his market share. As long as he does not internalize policy costs. And that is where economists come in.

    Linking to your recent topic of positive/normative: economics as an abstract, axionmatic branch of applied mathematics is OK (positive). The rest is normative or fiction. But, very useful in the right hands.

  28. Gravatar of Rien Huizer Rien Huizer
    7. March 2012 at 19:20

    Scott,

    No idea how the asterisk got there.

  29. Gravatar of dtoh dtoh
    7. March 2012 at 20:25

    @Jim Glass

    Re: Fama – Fama’s point is exactly the one I’ve been trying to make to Scott. Increasing the base has no effect if the money is not spent. IOER aside (where Fama is just being stupid), Fama is wrong only in degree. Increasing the base will have SOME effect, but it can and often is a blunted effect because you can get a big drop in V which offsets most (or in some cases) all of the increase in M especially if the Fed is increasing the base by buying Tbills, which (as Scott correctly describes) “are close substitutes [for currency] at the zero bound”

    Surely Scott will admit that there will be differing effects on V depending on what type of assets the Fed buys. While the Fed should not be in the business of making loans to businesses or individuals, they certainly could effectively implement monetary policy without the blunting effect of decreased V, by directing banks to create/buy specific assets. This could be easily accomplished by giving the Fed the ability to flexibly set MINIMUM and maximum asset/equity ratios by asset class.

  30. Gravatar of dtoh dtoh
    7. March 2012 at 20:34

    @dwb
    I think you understand the issue, but see my reply above to Jim Glass. The only clarification I would add is that the Fed is limited to action which primarily impacts rates, whereas bank lending (particularly in times of stress) is more constrained by risk, i.e. no matter how low rates go on safe assets, they will not buy anything other than safe assets.

    As in my note to Jim, this problems gets solved if the Fed can force banks to create new assets, which they could easily do if they have the ability to flexibly set bank MINIMUM and maximum asset/equity ratios by asset class.

  31. Gravatar of Jeff Jeff
    7. March 2012 at 21:26

    @dtoh,

    Sure, velocity might drop if you print money. So you just print more. Paper and ink are pretty cheap, and reserves can be created merely by shuffling a few electrons. The idea that we’ll jump from very low NGDP growth to hyperinflation with no possible middle ground sounds pretty nuts to me.

  32. Gravatar of dtoh dtoh
    8. March 2012 at 00:43

    @Jeff
    I don’t think the problem is hyperinflation… it’s actually the exact opposite. Remember the mechanism for printing money is for the Fed to buy Treasury securities, which pushes price up (yields down). If the Fed prints enough money (i.e. buys enough Tbills), then Tbill yields go below zero and base money becomes a more attractive store of value then Tbills (it already is for banks because of IOER), and then the net effect is actually for MV to go down every time the Fed prints more money. (The lower the returns on other assets, the more attractive it becomes to keep cash in a safety deposit box….zero V). In the worst case, printing more money gets you deflation and negative RGDP growth.

    At some point, you have to put money in the hands of people who will spend it and not just in the hands of people who are going to use it as a store of value.

    Normally, you don’t have this problem because the rate differential between base money (i.e. 0%) and other assets is large enough so that base money is not used as a store of value. Additionally, in normal times the spread between the expected NGDP growth rate and nominal interest rates is relatively large and this induces business to invest and banks to lend (i.e. put money in the hands of individuals/companies that will actually use it.) As a result in normal times, increasing the base (printing money) will lead to asset creation (e.g. bank lending), which results in spending (i.e. increased V). In a downturn, this mechanism does not work nearly as well, and conceivably it could break down all together.

    Which is why I keep telling Scott, Fed policy would be more effective if they had the ability to directly force the banks to create/buy assets.

  33. Gravatar of Jim Glass Jim Glass
    8. March 2012 at 01:06

    @Jim Glass

    Re: Fama – Fama’s point is exactly the one I’ve been trying to make to Scott. Increasing the base has no effect if the money is not spent.

    No. Fama said the increase in reserves would have caused hyperinflation if the Fed hadn’t “sterilized” it by paying interest on reserves. Which is, he said — with no lack of emphasis — why the Fed starting paying interest on them.

    If an increase in the base isn’t spent how does it cause hyperinflation?

    If an increase in the base has “no effect” what’s hyperinflation? Where I come from hyperinflation is considered “an effect” — and no small one!

    Increasing the base will have SOME effect…

    Oh, now will it or won’t it?

    Now you have to decide whether you are in the camp that says “central banks can cause inflation”, or the one that says “central banks *can’t* cause inflation” because an increase in base money has “no effect”.

    The latter one is a rather small camp. The requirement that a central bank be *incapable* of increasing M by more than V falls is pretty tough to rationalize. Especially since the first result of an increase in the base having “SOME effect” at increasing inflation is an increase in V.

  34. Gravatar of dtoh dtoh
    8. March 2012 at 02:59

    @Jim
    I’m no expert here, but what Fama said seems obviously contradictory to me. I.e. as you say if no one spends it, you can’t possibly have hyperinflation.

    Where he is right is when he says, that if no one spends the money, it won’t have any effect….no impact on NGDP, no impact on RGDP, and no impact on inflation.

    It does seem to me that OMP will have a different impact on MV depending on the rates environment. At higher interest rates on Tbills no one will be willing hold base money instead of Tbils, and the impact of OMP on MV is large.

    At near zero rates on Tbills, market participants become indifferent to holding base money instead of Tbills. In this environment the impact of OMP on MV is blunted (possibly negligible).

    If the Fed does enough OMP to cause Tbills yields to become significantly negative. Market participants will sell 100% of their Tbill holdings and horde cash at a depository institutions. This would cause a precipitous drop in MV.

    I’m not sure if the latter case is actually feasible since there is probably some way to arbitrage the negative spread, which would bring Tbill yields back to parity with cash.

    Obviously if the Fed does OMP against assets other than Tbills (e.g. MBS, credit card debt, used cars, second hand jewelry, etc.) they can get around this problem. Which is what I’ve been suggesting… only rather than doing it directly, they should just force the banks do it.

  35. Gravatar of Morning Links 3-8-2012 | Modern Monetary Realism Morning Links 3-8-2012 | Modern Monetary Realism
    8. March 2012 at 04:52

    […] TheMoneyIllusion » It’s the economists, stupid […]

  36. Gravatar of dwb dwb
    8. March 2012 at 05:02

    @dtoh
    there are a number of things wrong with Fama’s statement in my opinion. the interest on reserve policy is not keeping the reserves from being hyperinflationary. The interest on reserves is only a small efect compared to the ability to earn a real return, if the bank was able to.

    as you say, i think he is indeed talking out of both sides of his mouth here: reserves have no effect, but if they did IOR is keeping them from having an effect.

    in any case, more fundamentally, he is confusing reserves and capital. bank capital (or lack thereof) is what governs lending (banks have lots of liabilities besides deposits).

    Capital is scarce because a lot of it got destroyed with the crash of the housing market. capital is scarce because of BASEL 2.5, stress tests, regulatory requirements, foreclosure settlement, etc etc. banks are merely expressing a need to hold a lot of capital in the form of nice safe reserves.

    on the other hand, if ngdp was expected to grow faster, banks would be out there raising capital to boost lending instead of losing market share.

    there are banks that are growing by lending even in this economy, so the fundamental thesis is empirically just wrong (that is, QE is neither hyperinflationary nor impotent).

  37. Gravatar of Dtoh Dtoh
    8. March 2012 at 05:42

    @dwb
    A couple of thoughts.

    1) I agree that IOER is not so much the problem as a perceived lack of other safe investments.

    2) Bank capital (equity) is not the problem. It’s the asset to equity ratio for certain types of assets. Way too high pre-Lehman. Way too low now. The Fed needs to regulate this.

    3) The reserves are not capital, they’re an asset….but the wrong type of asset if you’re goal is to boost NGDP growth.

    4) Expectations about NGDP growth are fine but as Scott says, expectations have to be about something. At the zero bound, there needs to be a better tool/mechanism than OMP of TBills.

  38. Gravatar of dwb dwb
    8. March 2012 at 06:20

    @dtoh:

    i have no idea what you mean by 2. bank capital is absolutely positively an issue (for some banks). I work in the banking sector.

  39. Gravatar of ssumner ssumner
    8. March 2012 at 06:38

    Jason, I totally agree.

    Frederic, You asked:

    “Who said fiscal stimulus doesn’t work? Or, even more outrageous, that most economists don’t believe fiscal stimulus work? I’d like some evidence of that…”

    I said fiscal stimulus doesn’t work. As to your second question, I have no idea–who said that?

    Mark, I agree.

    dwb, I agree, and hope to do a post today on how the ideas are getting out there.

    Joe, I agree that most economists think (wrongly in my view) that even more unconventional stimulus like QE2 would be needed. Actually, if we were on target like Australia, then our monetary base would be much smaller. Most economists don’t know that.

    dwb, You said;

    “only in a bizzarre surreal alternate universe is printing money through QE considered “unconventional.””

    Excellent point.

    Lee, I agree.

    Neal, I think Avent was referring to RGDP growth, I’d expect more like 4% NGDP growth next year. Even at that low rate the real economy will gradually recover (as it has been doing), but much slower than we could do.

    Bill, I mostly agree, but I still think the consensus view of economists plays a big role in this mess–the Fed rarely strays far from the consensus.

    Charlie, I agree with your comment, and would point to my response to Neal. I do think inflation is likely to be a bit under 2.2% going forward, in terms of the deflator. Ditto for RGDP growth, a bit under 3%. I hope I’m wrong, there are signs of a pick up in RGDP.

    Patrick, Nice point. He thinks he’s always essential, but I suppose he’d argue the problems today are bigger.

    Jim Glass, I read that and totally missed it. Great find, worth a post.

    Charlie, You said;

    “Would the actions the fed might take to hit an NGDP target have undesirable side-effects?”

    It requires far less action to hit an NGDP target than miss. If you hit like Australia, your monetary base stays low. If you miss like the US and Japan, your base gets bloated.

    I agree that slack is hard to estimate, and of course think those estimates should play no role either way in monetary policy. But my hunch is that the natural rate didn’t suddenly rise to 8.3%. My prediction is that 3 years from now it will be lower.

    Becky, You said:

    “One recent blog post that called for growth had a commenter say, “My garage is full. What more do I need to add?” ”

    Another garage? 🙂

    Patrick, That’s a great story about Lehman.

    Rien, I can’t be that pessimistic about my profession. Little by little we make progress.

    dtoh, You said;

    “Surely Scott will admit that there will be differing effects on V depending on what type of assets the Fed buys.”

    As a purely mechanical matter I do deny significant differences. But as a signaling device I agree that some types of purchases might better convey a future expansionary intent, and hence affect V more.

    By the way, the policy tool is an NGDP target, changes in the base then become endogenous.

  40. Gravatar of Neal Neal
    8. March 2012 at 07:57

    That didn’t quite answer my question, but okay. If you haven’t already, I would like you to do a post sometime on expectation elasticity — how long it takes expectations to adjust to new regimes.

    (Central questions: if the Fed is targeting NGDP growth of 5%, unexpectedly drops NGDP by 50% one year, and then immediately resumes NGDP growth of 5%, how long will it take the economy to recover? If the Fed targets NGDP growth of 5%, then publicly changes the target to 3%, how long will it take for the economy to adapt to the new regime? Why haven’t Japanese expectations adapted? etc.)

  41. Gravatar of dtoh dtoh
    8. March 2012 at 14:48

    Scott,
    “As a purely mechanical matter I do deny significant differences.”

    1. The Fed buys Tbills from a bank who then holds the proceeds from the sale as a deposit with the Fed.

    2. The Fed makes a loan to a business that wants to add production capacity that heretofore has not had access to credit.

    Surely the impact on MV is different.

  42. Gravatar of dtoh dtoh
    8. March 2012 at 15:17

    @dwb
    re: bank capital. It’s only a problem because the regulators are saying your asset/equity ratio can not exceed X. If the regulators (i.e. Fed) turned it around and said your asset/equity ratio must be at LEAST x, (and by the way we’re making the TBTF guarantee explicit), then there would be a surplus of bank capital.

  43. Gravatar of dwb dwb
    8. March 2012 at 15:26

    @dtoh
    so you want regulators to say you have to be at least as levered as x?? really? so assets:equity of 1:1that is not ok but 10000:1 is ok because its at least x? makes 1000000000000:1 ok too, like Enron??

    sure, if the regulators changed the requirement and allowed higher leverage ratios (less capital) than bank capital would be in surplus. duh. but why would i want that? why would i want banks to be as highly levered as lehman, LTCM, the GSEs (including the guarantee fee business), Enron, or MF Global? or even more highly levered?? !!

  44. Gravatar of dtoh dtoh
    8. March 2012 at 17:43

    @dwb
    As I have commented many, many times, you give the Fed the power to flexibly set minimum AND maximum asset/equity ratios by asset class.

    This solves all financial and monetary problems.

  45. Gravatar of dwb dwb
    8. March 2012 at 18:08

    @dtoh:

    they have that power now, and they are willing to use it. BASEL already has prescriptive capital charges by asset classes and ratings (for example) among other things.

    the models say that, thanks to an enormous ngdp decline, which the fed itself allowed to happen, ironically, banks need to hold more risk capital. many of those companies i mentioned should have been holding more capital, not less.

    too much leverage relative to ngdp volatility makes the system (eventually) crash.

    capital is indeed percieved to be scarce, but the answer is not more leverage!!!

  46. Gravatar of iya iya
    8. March 2012 at 19:54

    “too much leverage relative to ngdp volatility makes the system (eventually) crash.”

    Banks don’t invest in NGDP, though. Maybe they should (diversification), but wasn’t it too high leverage relative to e.g. subprime CDO volatility that made the system crash? If Japans bond yields rise, it will be too high leverage relative to their volatility that will be the problem and not NGDP.

  47. Gravatar of dwb dwb
    9. March 2012 at 05:27

    @iya

    Banks don’t invest in ngdp, but they make nominal loans which in aggregate are basically a function of the price level at the time. Deflation requires that nominal debt contracts be reset (witness: many many mortgage debt contracts have yet to reset even after 4 years).

    imagine a universe where banks made loans whose payback was tied to a share of your nominal income (i.e. 37% of your income). These are percetly price-level indexed because the repayment falls with the price level. Bank capital, in aggregate, is now only a function of the output (Q) volatility, not the P. How much a bank can lever up withour failing is a function of the aggregate volatility of its loans.

    nothing to do with yields.

    @dtoh
    incidentally, you are correct that the Fed could control macro policy with capital. I dont mean to suggest otherwise. China actually does (but they dont have much control over interest rates with an exchange rate peg). Sure, the Fed could and does have this power. But why use it? its a brutal, blunt, instrument like cracking an egg with a jack hammer. And probably the reason reserve requirements for banks (and capital requirements) change very infrequently.

  48. Gravatar of ssumner ssumner
    9. March 2012 at 06:24

    Neal, You said;

    “That didn’t quite answer my question, but okay. If you haven’t already, I would like you to do a post sometime on expectation elasticity “” how long it takes expectations to adjust to new regimes.”

    That depends on 100s of factors. In places with hyperinflation, expectations adjust really fast. When the Bank of England was made independent in May 1997, market inflation expectations adjust within days. In general, expectations adjust almost immediately. The reason why it doesn’t seem that way is because there is great regime uncertainty. You might go from thinking it is 20% likely that there is a new regime, to 50% likely, to 80% likely. That’s not expectations being slow to adjust, that true uncertainty about the nature of the regime.

    The Japanese have adjusted to the lower NGDP growth rate, and unemployment is about 4.5% in Japan. But money is not completely super-neutral, at low NGDP growth rates the labor market becomes less efficient. So unemployment might be 3.5% if trend NGDP growth rates were higher.

    dtoh, I suppose that might make a slight difference, but I doubt it would matter very much. In any case, that would be a silly policy.

  49. Gravatar of dtoh dtoh
    9. March 2012 at 06:33

    @dwb
    The problem was not with banks who were subject to capital reserve requirements, it was with institutions whose asset/equity ratios were not regulated and who were therefore over-leveraged.

    Controls on asset/equity don’t have to be a blunt tool at all. By setting both minimum and maximum ratios by asset class, they could easily be used to fine tune MV and would work a lot better than OMP especially when you are near the zero bound.

    Not sure but it seems to me that with IOR, OMP actually causes the banks to de-leverage (i.e. reduces the numerator in the Basel formulas).

  50. Gravatar of dtoh dtoh
    9. March 2012 at 06:53

    Scott
    “I suppose that might make a slight difference, but I doubt it would matter very much. In any case, that would be a silly policy.”

    Slight? If a bank is holding Tbills and sells them to Fed and then holds ER instead, the change to MV is zero. Your whole argument is that the Fed should be targeting NGDP (i.e. MV). If one policy has no impact on MV (your primary policy goal) and another policy has a positive impact, how can the difference be described as “slight?”

  51. Gravatar of dwb dwb
    9. March 2012 at 07:50

    @dtoh
    Controls on asset/equity don’t have to be a blunt tool at all.

    like i said, regulators already have this tool. capital ratios are blunt because most capital is internaly generated. it would be impossible for a CFO to plan their business if they had no idea how much capital they would need in Q4 2012. they are not appropriate for fine-tuning.

  52. Gravatar of dtoh dtoh
    9. March 2012 at 08:07

    @dwb
    Regulators have a tool to set maximum asset/equity ratios but not minimum asset/equity ratios. CFOs (and I assume by that term you are generically referring to bank management) wouldn’t have to worry about their capital; they would just have to worry about how much assets they needed to hold.

  53. Gravatar of dwb dwb
    9. March 2012 at 08:35

    @dtoh:
    yes they do have that tool: when the asset/equity ratio falls below the minimum they shut the bank down. its called bankruptcy (conservatorship, or whatever your favorite term is). All CFOs worry about now is assets. its much harder to worry about assets when there are two moving parts (the second being undefined capital ratios).

    I think you have the asset/equity thing backwards. when my asset/equity ratio drops its because my assets are non-performing (i.e. delinquent or in default). the regulator sets a mimimum … but it does not lower the mimimum to reduce capital requirements. banks by their nature only are near the lower end of the asset/equity ratio because their loans are bad, not because they are risk averse. when they get to the mimimum they do not boost lending, they shut down. reducing the “asset/equity mimimum” only prolongs the existence of zombie banks.

  54. Gravatar of dtoh dtoh
    9. March 2012 at 13:39

    @dwb
    Yes, I do have it backwards. What I’m saying is that in addition to a requirement that banks maintain a minimum levels of capital versus their risk adjusted assets (aka BASEL, i.e. a regulation to prevent over-leveraging), that there should also be separate regulations (which currently does not exist) that in order to more effectively implement monetary policy allows the Fed to require banks to maintain MINIMUM levels of assets by asset class relative to their equity. It’s exactly the opposite of Basel but not necessarily inconsistent with Basel, although in a downturn the Fed might want the banks to increase their leverage to higher levels than normal in order to expand credit, raise asset prices, etc.

    BTW – Basel does not set a minimum asset/equity ratio. It sets a minimum equity/asset ratio. Bad loans reduce the numerator and denominator equally, which causes the ratio to go down.

  55. Gravatar of Neal Neal
    9. March 2012 at 17:40

    Scott,

    “That depends on 100s of factors. In places with hyperinflation, expectations adjust really fast. When the Bank of England was made independent in May 1997, market inflation expectations adjust within days. In general, expectations adjust almost immediately. The reason why it doesn’t seem that way is because there is great regime uncertainty. You might go from thinking it is 20% likely that there is a new regime, to 50% likely, to 80% likely. That’s not expectations being slow to adjust, that true uncertainty about the nature of the regime.”

    So the chief factor is regime uncertainty? So one reason the US recovery has been so slow is that there is some possibility about whether the Fed will boost NGDP back to its former trend in the future? If Bernanke came out tomorrow morning and said, “The Fed is now committed to 5% NGDP growth from here on out,” the real recovery would be more or less instantaneous?

    You also wrote,
    “The Japanese have adjusted to the lower NGDP growth rate, and unemployment is about 4.5% in Japan. But money is not completely super-neutral, at low NGDP growth rates the labor market becomes less efficient. So unemployment might be 3.5% if trend NGDP growth rates were higher.”
    If Japanese expectations have adjusted to the lower NGDP growth rate, then is the slow growth of Japanese living standards due to supply-side issues, not low NGDP growth?

  56. Gravatar of ssumner ssumner
    10. March 2012 at 09:21

    dtoh, I have no idea whether selling bonds to the Fed would have no impact on M*V. Just because the new money is held as ERs, doesn’t mean M*V hasn’t changed. That will depend on expectations of future policy, which is always true of monetary policy.

    Neal, You asked:

    “If Bernanke came out tomorrow morning and said, “The Fed is now committed to 5% NGDP growth from here on out,” the real recovery would be more or less instantaneous?”

    If he said level targeting, and was believed, then there’d be quick upsurge in NGDP. Of course that’s not going to happen, and indeed only happens on rare occasions like 1933. But when it does—watch out!

    Neal, Mostly supply-side, but partly due to low NGDP growth. As I said, expectations aren’t the only factor, non-superneutrality also matters.

  57. Gravatar of Neal Neal
    10. March 2012 at 14:23

    Ah, I think I see. Thank you.

Leave a Reply