Targeting inflation and offsetting fiscal austerity are the exact same thing
Stephen Williamson has a very good post on the Canadian austerity of the 1990s. But in the comment section I think he misunderstands the concept of “fiscal offset.” First an anonymous commenter says:
Canada has offset the contractionary effects of austerity via monetary policy…
And Williamson responds:
That’s part of the point. It doesn’t look like they did. As you say, Canada has an independent monetary policy, but, post-1991 they appear to be behaving as by-the-book inflation targeters. Basically, they make an agreement with the fiscal authority about their policy rule, and then they stick to it, independent of what the fiscal authority is up to.
Sticking to your target regardless of what the fiscal authority does is exactly what fiscal offset means. The idea is simple. A fiscal contraction would normally depress AD, causing inflation to slow. The central bank must do enough stimulus to offset that potential decline in AD, in order to prevent inflation from falling. If you observe the inflation rate always being on target, then the central bank is successfully offsetting any fiscal action that would have otherwise moved AD and inflation. As an analogy, if the temperature in your house is always 22 degrees (centigrade), then the thermostat/furnace is doing an excellent job of offsetting the warm and cold fronts that move through your town.
So why do I call the post “excellent”? Start with the fact that Williamson recognizes that fiscal austerity in Canada was not contractionary. Even better he recognizes something that all too few bloggers understand:
But it might be more appropriate to think about monetary policy in terms of the ultimate goals of the central bank.
Bingo.
PS. Yes, fiscal policy has other channels besides AD, so real GDP could still change. But the AD channel is what Keynesians obsess over.
HT: Tom Brown
Tags:
16. July 2015 at 18:39
” The idea is simple. A fiscal contraction would normally depress AD, causing inflation to slow.”
That isn’t true. A fiscal contraction consists of less money spent by government, and more money spent by those who are taxed less and who lend less to government.
The notion that a fiscal contraction “causes” a fall in spending is based on the false belief that if the government taxes and borrows less, that the money that would have been taxed and/or would have been borrowed by government, is instead hoarded.
But the government cannot tax unless others spend, and the government cannot borrow unless others lend, which means the government is acting within the constraints of existing spending.
Any correlation between reduced government “fiscal” activity, be it reduced overall spending or reduced net deficit on the one hand, and reduced “private” spending on the other, does not prove and was never evidence that reduced “fiscal” activity somehow “causes” reduced overall “spending.”
Sumner wants to call the non-reduction in spending that occurs alongside fiscal austerity to be “evidence” of “monetary offset”.
As if my spending more when I am taxed less is not my activity, but Yellen’s activity.
Price inflation targeting is not fiscal offset. Fiscal offset is a theory that cannot be observed.
16. July 2015 at 21:26
Excellent blogging.
1. First, like I always say, print more money and then let’s figure out what’s going on.
2. I like furnace analogy. The Federal Reserve thinks it has the furnace on “high.” But it doesn’t matter how high you think you have the furnace. Still 51 degrees inside the house, you have to start a fire in the fireplace too!
16. July 2015 at 21:31
Major Freedom you are just wrong. “The government cannot tax unless others spend”- wrong. I pay property tax regardless of my spending.
16. July 2015 at 21:44
Major Freedom you are wrong on the spending side also. The government can and does “borrow” from itself through the Fed whenever we really need it to.
17. July 2015 at 04:06
Great stuff, Scott. Pithy.
17. July 2015 at 04:25
The idea is simple. A fiscal contraction would normally depress AD, causing inflation to slow. The central bank must do enough stimulus to offset that potential decline in AD, in order to prevent inflation from falling.
Although I think you’re ultimately right, I think this post completely sidesteps the point where you and Williamson actually disagree. He understands what a thermostat is, he just doesn’t believe that independent CB policy can be a thermostat all by its lonesome. That is, he doesn’t believe that a CB whose primary activity is to swap reserves for Treasuries can sit around offsetting a fiscal authority’s activities and maintain a given inflation target.
If you then asked him how the CB magically manages to maintain its inflation target, he would say something akin to — who says it’s the CB that is maintaining the inflation target? The EPA could decide that inflation was a big part of its mandate t0o, but that doesn’t mean it is actually the proximate cause of the price level. He would argue that like the EPA, the CB has severe limits in the amount of offset it can do by its asset swapping, so you shouldn’t look to it as the thermostat. If the government’s inflation goal is working really well, you need some broader explanation that includes the fiscal reaction function and/or an equilibrium story that doesn’t pay much attention to any particular institution.
Since pretty much everyone would agree that the hydraulics of any particular, current OMO are a tiny part of the picture, the argument all comes down to whether the Fed can successfully be a thermostat using primarily its much larger power of shaping expectations for all contingent, future OMO (plus whatever emergency stuff it might pull out of a hat in a pinch). This is not really any different from the recent Woodford-strikes-back neofisherite discussion. Can a credibility-imperfect Fed set expectations about its own future behavior successfully enough that it becomes the most useful cause of the path of the price level? I agree with you that the answer in most non-hyperinflation cases is going to be yes, but it’s here and not the basic idea of CB offset where you and Williamson are at odds.
17. July 2015 at 04:35
David Beckworth and Bob Murphy had exactly the same discussion … and I think Prof. Sumner (and Prof. Beckworth) is right, successful monetary offset in the face of a large fiscal shock means stable NGDP (or inflation) moving forward.
http://macromarketmusings.blogspot.com.br/2015/07/did-monetary-policy-really-offset.html
17. July 2015 at 05:24
dlr, If you are correct then the passage I quoted makes no sense. He is using inflation as an indicator of monetary policy. And he is using the fact that inflation is roughly constant at 2% as evidence that monetary policy is stable.
Your comments might or might not be correct, but if they are then the passage I quoted literally makes no sense. I usually give people the benefit of the doubt and assume that they mean what they say. Williamson is a very smart guy.
I’d add that he calls himself a monetarist, so it would be odd if he didn’t think a central bank could control inflation.
Thanks Jose.
17. July 2015 at 05:58
Disagree. Canada had fiscal austerity in the 1990s but the impact of that was limited.
– In the 2nd half of the 1990s the CAD fell against the USD, helping to boost canadian exports to the US. At the same time the US economy kept growing. And some 70 to 75% of canadian exports go to the US. So, the fiscal austerity was offset by strong canadian exports to the US.
– At the same time the rising USD/CAD was also something helped to “impose austerity”.
17. July 2015 at 06:07
Your comments might or might not be correct, but if they are then the passage I quoted literally makes no sense. I usually give people the benefit of the doubt and assume that they mean what they say. Williamson is a very smart guy.
What he says in the comments (and other stuff he has written) is pretty straightforward:
The fiscal authority determines the amount of spending on goods and services, what to spend on, total transfers, who to make the transfers to, tax rates, what to tax, and how to finance the difference between its outlays and its income. The central bank does asset swaps. Why would you expect that the central bank can somehow “neutralize” the actions of the fiscal authority?
I think there are probably other ways to favorably interpret his position still acknowledge where the real disagreement lies. He could see monetary policy as being a relatively anemic contributor to the path of the price that nonetheless might make some difference in some contexts. Imagine he thinks of monetary policy like windows in a room with no thermostat. You could argue that a room temperature within 65-75 degrees is some (highly incomplete) evidence that window policy was “stable” without believing that windows have the power to offset a missing roof. And you should know by now if you’ve read his papers that his definition of “monetarist” is not the same as yours.
17. July 2015 at 06:18
I statement such as, “fiscal austerity in Canada was not contractionary,” is very nearly worthless. It presupposes that we can isolate *fiscal austerity (or profligacy)* from all the other factors that might be relevant to the contraction/expansion of the economy, so that the former might be varied while the latter were held constant. Even if there is some ideal way to do this, I do not think anyone knows what it is. The different ways of describing these other factors lead to different ways of construing what it means to *hold them constant*, and so different answers to the question “Was the remaining factor contractionary?”. Ideally there would be general agreement about which way of sorting things out was *best* (for the purposes of economic science), but we live in a non-ideal world.
17. July 2015 at 06:51
Thanks for the compliment. But…
“A fiscal contraction would normally depress AD, causing inflation to slow.”
You’re taking a giant leap here, in taking the Phillips curve seriously.
17. July 2015 at 06:53
Indeed. Excellent article. He looks further than monetary policies alone.
17. July 2015 at 07:24
Bubble, Did you even read Williamson’s post?
dlr. That’s doesn’t answer my objection. Not at all.
Most likely he means something very different by “neutralize” than “offset AD movements.”
And isn’t the view that monetary policy drives inflation the sine qua non of being a monetarist, at least when interest rates are positive?
Steve, You said:
“You’re taking a giant leap here, in taking the Phillips curve seriously.”
Not at all. The Phillips Curve (a model I don’t like) is about the connection between nominal shocks and real output. My claim is about the government’s impact on nominal aggregates. Nothing to do with the Phillips Curve. I’m saying that fiscal austerity might (and I emphasize might) reduce P and NGDP, at least in some models. And that if the central bank is targeting inflation they will offset the effect on P, and largely offset the effect on NGDP (depending on whether fiscal policy shocks also impact aggregate supply.)
I think the confusion here is that I’m trying to look at this from the perspective of a Keynesian (a model that both you and I don’t like.) They’d argue that fiscal policy impacts real output via the channel of lower AD and lower inflation. So I’m saying that if we accept the Keynesian view that the AD channel is what is important for fiscal policy, then complete monetary offset occurs whenever you have successful 2% inflation targeting. Either the Keynesian are wrong that fiscal policy works by impacting AD and inflation, or they are wrong about monetary offset of fiscal policy. (They are probably wrong about both.)
Just to be clear, I see the textbook Phillips curve as having two components:
1. Nominal shocks have real effects.
2. Higher inflation is caused by rapid growth in RGDP.
I accept the first, but not the second. In other words, I accept Friedman’s interpretation of the PC.
17. July 2015 at 07:30
The biggest problem with historical analogies is there are a lot realities effecting the outcomes. So it is fair to say the Canadian government and central bank did the right thing that led to good growth.
But all this happened when there largest trading partner had the greatest economic growth in the last 80 years. (I remember Chrysler moved 10 models to be built in Canada from a US location in the late 1990s.) So the US was growing so fast with the new economy (who had government austerity as well) that it had huge benefits to Canada.
17. July 2015 at 07:53
Collin, How does your comment relate to this post?
17. July 2015 at 08:17
dlr— when the Fed conducts QE, it buys bonds from the 22 primary dealers. The Fed places reserves into the commercial bank accounts of those 22 primary dealers equal to the amount of bonds purchased. But that is the second step. The first step involves the primary dealers buying bonds in the marketplace. The ultimate sellers of bonds now have 4 trillion dollars in cash. They must read redeploy that cash somewhere. That is how QE works.
QE is not a mere asset swap. $4 trillion cash is created.
17. July 2015 at 08:23
IT is sort of a Newtonian approximation of a relativistic NGFPLT — it works pretty good except in certain circumstances where NGDPLT is a more precise solution.
17. July 2015 at 08:23
@sumner -show your work. Not ‘thought experiments’ like the Austrians do, but actual data. Where’s the proof that the government has impact on nominal aggregates? I offered two proofs that there’s NO statistical correlation between Fed and nominal aggregates, (1) one anecdotal and (2) one statistical. Your move master. You’re blundering badly. – RL
*1) themoneyillusion.com/?p=29008 see Ray Lopez 16. March 2015 at 05:23 reply to Brian Donohue on Fed raising rates and inflation rising, and lowering rates and inflation falling, the opposite of theory.
*2) Lawrence Christiano, Martin Eichenbaum, Charles Evan, “The Effects of Monetary Policy Shocks: Evidence from the Flow of Funds”, Review of Economics and Statistics, February 1996, 78-1, cited in Olivier Blanchard “Macroeconomics”, 2nd edition., p. 96, 5-6, ‘Does the IS-LM Model Actually Capture What Happens in the Economy?’ Shows for data 1960 to 1990, that a 1% increase in Fed funds rate shows over 4-8 quarters a decrease in sales, decrease in output, decrease in employment, increase in unemployment rate up to 6 quarters (then a decrease after 8 to original level). However, the “confidence band” is only 60% probability! (not the usual 95% confidence interval). I might add that if the confidence band was 10% less it would be 50%, i.e., a coin toss (completely random).
17. July 2015 at 08:32
@benjamin cole – on new money created. You are correct, but you’ve not thought through the process of new money creation enough (I made the same mistake at first): the new money is created when the Fed does the steps you outline many, many times, not just in one cycle as you state. That’s because the new money created is the interest rate wedge between what the 22 primary dealers provide and what the Fed gives them. Remember, the primary dealers pay for bonds with ‘old’ cash, likewise when the bonds are bought back by the Fed the dealers are repaid with their ‘old’ cash, but the discount in face value (interest rate) on the paper is the ‘new’ cash that goes into the money supply.
17. July 2015 at 08:39
LPR for US vs Canada since 1976.
http://www.tradingeconomics.com/canada/labor-force-participation-rate
Hard to say how much other factors impact this, but some grounds for NGDPLT optimism: better monetary conditions might have led to a lot more employment and production in the US.
17. July 2015 at 08:46
nice post
17. July 2015 at 10:40
Yet another slam dunk for Scott Sumner doesn’t understand productivity!
“It may also be harder for companies to charge higher prices for innovated product lines, Preston McAfee, Microsoft Corp.’s chief economist says. For instance, when UPS started using new GPS technology to speed package deliveries, it couldn’t charge more for the improvement in service because FedEx and other carriers could easily match them.
“Maybe our mysterious productivity gain is in the form of less inflation than we deserve,” Mr. McAfee says.”
http://www.wsj.com/articles/silicon-valley-doesnt-believe-u-s-productivity-is-down-1437100700
I swear Scott, you want to get ALL of Silicon Valley to demand NGDPLT?
Takes 2 steps:
1. Say, you are right Morgan. If you want you can read Gabe’s other favorite Economist and give him the credit…
2. Focus your thinking on setting the NGDPLT rate based on what optimizes for faster Digital Deflation. Explain why this is best to achieve it.
17. July 2015 at 12:27
Here I thought you’d say he was reasoning from a (basket) price change. Because he is.
17. July 2015 at 13:28
Yes, I read Williamson’s article. And it’s a truly excellent one. I commented over there as well.
17. July 2015 at 16:29
I’m wondering what you make of these comments by Bernanke:
“The risks for the European project posed by these economic developments are real, no matter what the reasons for them may be. In fact, the reasons are not so difficult to identify. The slow recovery from the crisis of the euro zone as a whole is the result, among other factors, of (1) political resistance that delayed by many years the implementation of sufficiently aggressive monetary policies by the European Central Bank; (2) excessively tight fiscal policies, especially in countries like Germany that have some amount of “fiscal space” and thus no immediate need to tighten their belts; and (3) delays in taking the necessary steps, analogous to the banking “stress tests” in the United States in the spring of 2009, to restore confidence in the banking system. I would not, by the way, put “structural rigidities” very high on this list. Structural reforms are important for long-run growth, but cost-saving measures are less relevant when many workers are already idle; moreover, structural problems have existed in Europe for a long time and so can’t explain recent declines in performance.”
“What about the strength of the German economy (and a few others) relative to the rest of the euro zone, as illustrated by Figure 2? As I discussed in an earlier post, Germany has benefited from having a currency, the euro, with an international value that is significantly weaker than a hypothetical German-only currency would be. Germany’s membership in the euro area has thus proved a major boost to German exports, relative to what they would be with an independent currency.”
http://www.brookings.edu/blogs/ben-bernanke/posts/2015/07/17-greece-and-europe
18. July 2015 at 06:20
Andrew, No, he’s reasoning from a spread between actual and target price level, and using that to judge the stance of monetary policy.
Mike, I agree that ECB policy has been too tight, not the rest of it. Don’t know enough about European stress tests to comment. My recent Econlog post demolishes his argument about the weak euro helping Germany.
20. July 2015 at 14:20
“As an analogy, if the temperature in your house is always 22 degrees (centigrade), then the thermostat/furnace is doing an excellent job of offsetting the warm and cold fronts that move through your town.”
True, but if the temperature you wanted was 25, you would not think the thermostat was doing such a great job. (How long has unemployment been above 4%?) And you might also think that even if it was working well, it would still be a good idea not to open the windows when it’s cold out. (Are there any public investments with discounted NPV greater than zero?)