And now, finally, my post on the optimal tax regime.  It will be nice to finally get this off my chest, as you can’t imagine how enraged I get reading progressives talk about the “principle” that all forms of income should be taxed equally (which is like a “principle” that all fruit should sell at the same unit price.)  Or when they discuss Gini coefficients of inequality based on meaningless income data (not to mention ignoring the fact that the economic incidence of a tax is totally different from its legal incidence.)

Bear with me as I start from first principles; this is an important post.  I will try to convince my progressive readers that they should favor complete abolition of all personal and corporate income taxes, as well as all inheritance taxes.

Suppose 2 brothers both make $100,000 a year.  One spends his income on watermelon, and the other spends it on blueberries.  Would it make sense to decry the inequality of this society, merely because the blueberry eater got to consume a larger number of “fruits” (because their unit price was lower?)  Clearly not, and for two very good reasons.

1.  They are each free to buy either type of fruit.

2.  The higher unit price of watermelon indicates they are more highly valued (per individual fruit.)

Now assume it’s possible to invest income at a real rate of interest that allow one to quintuple one’s wealth between age 25 and 65.  (Say a 40 year zero coupon real bond yielding around 4%.)  In this example let both brothers consume nothing but blueberries.  One brother chooses not to save at all, the other saves 40% of his income.  One eats $100,000 worth of blueberries today; the other eats $60,000 today and saves $40,000.  After 40 years the thrifty brother gets to eat $200,000 worth of blueberries.  Both also get some social security at 65.  Here’s my question:  In this society is there any economic inequality?

I don’t see how anyone could say there is.  Both have exactly the same wage income at age 25.   Yes, they do different things with it, but that’s their choice.  At age 65 one has zero income outside social security, and the other has $160,000 in capital gains, which is generally considered “income.”  But nonetheless there is complete equality for two reasons:

1.  Both are free to choose whether to save or not, so we have no evidence that one brother had more utility than the other.

2.  In present value terms their total lifetime consumption of blueberries is identical.

The mistake is assuming that blueberries in 40 year are the same thing as blueberries today.  Future blueberries only cost 1/5th as much, as they are much less valued than current blueberries.  They are different goods just as much as watermelon and blueberries are different goods.  That $160,000 gain is not “income” in the way most people think of the term, i.e. as some sort of goodie available for spending.  Rather it reflects deferred consumption.  The $200,000 received at 65 is exactly equal in present value to the $40,000 saved today.  Indeed it is the very same wealth, simply measured at a different point in time.  It is nonsensical to say the thrifty brother has income of $100,000 today plus another $160,000 at age 65, you’d be counting the same income twice.

Studies of economic inequality should completely ignore all capital income, and measure only labor income, or consumption.  Indeed the present value of labor income should equal the present value of consumption.  And as we will see, a labor tax (like the 2.9% Medicare tax) is identical to a consumption tax (like a VAT.)

Consider how a 50% payroll tax would affect the previous example.  Every figure would be cut in half.  The spendthrift would consume $50,000 today, and the thrifty guy would consume $30,000 today and $100,000 at age 65.   An equal-sized VAT would have an identical effect, cutting consumption for each person in half, at each point in time.

But now consider a 50% income tax.  The spendthrift would be affected in exactly the same way as with the other two taxes.  But the thrifty guy would pay a much higher tax.  He’d save $20,000, and that would produce $100,000 in 40 years.  The government would then take $40,000 of the so-called capital “income” in taxes, leaving him with only $60,000 for consumption.  If he wants to prepay his future tax liability, he must save $8,000 today in order to pay a $40,000 tax bill at 65.  That means $8,000 of his current saving goes to pay future taxes, and only $12,000 goes toward future consumption.  His total tax is then (in current dollars) $50,000 plus $8,000, or $58,000.  His tax rate is 58%, against 50% for his spendthrift brother.  And all because they have different preferences, not because one brother is in any meaningful sense “better off” than the other brother.  It’s no different from putting a higher income tax rate on a brother who eats blueberries, as compared to one who eats watermelon, merely because he has more blueberries in numerical terms.

At this point you might be thinking “Yes, but wouldn’t eliminating all income and consumption taxes be a giveaway to the rich?”  No, it would be restoring fairness by taxing the thrifty and spendthrift at equal rates.  If we think the rich should pay more tax, then let’s put a progressive consumption tax into effect.  This is easy to do, just turn the regressive FICA into a progressive payroll tax, with much higher rates for those with high wages and salaries.  This sort of tax can achieve any desired degree of progressivity.   Unlike most libertarians, I think a progressive payroll tax is desirable for simple utilitarian reasons.  I don’t buy the “I worked hard for it, it’s my money” argument, for two reasons:

1.  Most of your income comes from luck.  If you’d been born in a poor peasant household in Asia or Africa, your income would be low no matter how hard you worked.  You hit the jackpot just being born in a developed country.

2.  Our wealth comes from living in a highly functional society, thus part of your wealth is due to the fact that your neighbors don’t go around raping and pillaging as in the old days, but rather peaceably go to polling stations to vote.  Am I saying; “It Takes a Village?”  Sort of, more precisely “it takes a civic-minded culture.”

At this point my progressive readers might be willing to go for the progressive consumption tax for those who worked hard and saved their money.  But surely not for that deadbeat trust fund kid, who is living off daddy’s wealth?  Surely there should be an inheritance tax so that those with inherited wealth don’t go through their entire life without paying any tax?

If this is what you are thinking, you are still confused.  I will show that, if anything, we should be subsidizing those trust fund deadbeats.

First recall that if we have an optimal payroll tax then the money they inherit is all after-tax money.  And if we had a VAT, then the heirs would have to pay taxes on their consumption.  Now let’s go back and look at the case of the two brothers.  Suppose both have arrived at age 65 with $10,000,000 in wealth.  Also assume that we have a steeply progressive payroll tax, so they are considered morally justified in spending the wealth they have accumulated after paying those taxes.  The only issue being considered is whether we should have an inheritance tax on top of the payroll tax.  So let’s assume a 50% inheritance tax is introduced.  Compare the follow two scenarios:

1.  Brother A spends the entire $10,000,000 on fancy sports cars, yachts, champagne, glamorous parties, etc.  Brother B spends $5,000,000 and gives $5,000,000 to his only child.  Who should pay more tax?  We’ve already agreed that the guy who consumes all his wealth has already paid his dues through the progressive payroll tax. If not, then make it more progressive.  The other guy would have to pay $2,5000,000 in inheritance taxes, leaving his kid with $2,500,000.  It seems to me that on both efficiency and moral grounds the more generous dad should not pay more, but rather should actually pay less taxes than the other guy:

1.  He is less selfish, so virtue ethics favors the one who makes bequests.

2.  Because of diminishing marginal utility, it’s better to share your wealth with one other person.  He wins on utilitarian grounds.

3.  The inheritance tax discourages saving, and thus reduces the capital stock.  This lowers the real wage of workers who work with physical capital.

Brace yourself.  The optimal policy is a negative inheritance tax.  At age 65 both rich guys should be forced to put some amount (let’s say $100,000) into a government fund.  When they die, the $200,000 should go to the kid who also inherited the rich guy’s money.  I know what you are thinking—why not give the $200,000 to the poor?  Because we already assumed the existence of a progressive payroll (or consumption) tax, which is redistributing the optimal amount of money to the poor.  This extra tax is just trying to make things a bit more equal among two old rich guys, and one worthless trust fund baby.

[Yes, I’m sort of joking here—just trying to rigorously apply the logic of egalitarianism.  (For my trust-fund kid readers–I have nothing against you, I am just parroting society’s prejudices.)  But I am serious about favoring a progressive consumption tax.  Indeed I favor it so much that I would prefer it even if it meant I paid more in taxes than I do right now.  You will never find me complaining that I can’t get by on a family income of over $250,000.]

I think people have a huge mental block about these ideas, because they grossly misunderstand the actual incidence of taxes.  For instance, most people think consumption is much more equal than income, and hence that consumption taxes are regressive.  Actually, consumption taxes are proportional to consumption, which is the only meaningful benchmark.  Income is meaningless gobbledygook.  And most people think wealth is much less equal than income.  But how can both of these perceptions be correct, when wealth is nothing more than the present value of all future consumption for you and your heirs!  Actually, inequality of wealth and consumption are exactly equal, when properly measured in present value terms.  OK, to make this true I have to treat gifts from the rich is part of their consumption.  But even in a society where the wealthy made no gifts, most people would be shocked to find out that wealth and consumption inequality are equal.   And the reason is that our minds are being twisted and distorted by a meaningless concept—income.  People find it hard to shake the notion that income is actually measuring something meaningful.   So we use it as a sort of benchmark for everything from tax progressivity to Gini coefficients.

The beauty of the progressive consumption tax is:

1.  No tax forms for 90% of Americans, it’s automatically collected like FICA.

2.  It’s fair to high savers, treating them equally to spendthrifts.

3.  It encourages more saving and less consumption, which America desperately needs.  This raises economic growth.

The ideal tax system would be:

1.  Externality taxes such as a carbon tax.

2.  A land tax

3.  A progressive consumption tax, preferably on wages and salaries (as the VAT is harder to make progressive.)

4.  If we opt for the high-tax Nordic model, you might also need a VAT.

But why go for the high-tax model, when the lowest-taxed developed country entity in the world has the best infrastructure?  And the second lowest-taxed rich country also has enviable infrastructure plus universal health care combined with a Japanese-level life expectancy?

It would only take four things to make me become a card-carrying Democrat:

1.  If they dumped Keynesianism and favored using monetary policy to target NGDP

2.  If they favored replacing our current tax system with a progressive consumption tax

3.  If they favored replacing the public school monopoly with universal vouchers.

4.  HSAs through forced saving plus subsidies for the lower incomes

Progressive blogger Matt Yglesias already agrees with me on the first two, and Sweden adopted the third.  Singapore combines the 4th with universal health care.  So how can any progressive call me a reactionary Chicago-school economist?

I suppose what’s holding back vouchers in America is liberal sensitivity regarding our troubled racial history, and also a fear of religious schools.  But that’s for another post.

So why the inflammatory title of the post?  I hope I showed that “income” is meaningless if it includes capital income.  It is misleading because it leads people to talk about the share of “income” earned by the top 1% as if it is all actual labor income, whereas it is often mostly capital income, aka deferred consumption and not income at all.  And it’s harmful because it leads to the establishment of an extremely annoying, inefficient, and sometimes even repressive system called the income tax.  And it punishes thrift and rewards spendthrifts.

PS.  Of course there are real world problems with estimating wage income.  How should we deal with the self-employed?  One option might be to tax income from proprietorships, allowing the expensing of investments.  I hope commenter Mark can help me out here, as it’s been 30 years since I read any public finance and am relying on my feeble memory.

Update:  A commenter pointed out that Steve Landsburg did a similar post just a few days ago.

Here’s what Paul Krugman had to say about the role the Community Reinvestment Act played in encouraging reckless lending by Countrywide Financial:

As others have pointed out, Fannie and Freddie actually accounted for a sharply reduced share of the home lending market as a whole during the peak years of the bubble. To the extent that they did purchase dubious home loans, they were in pursuit of profit, not social objectives””in effect, they were trying to catch up with private lenders. Meanwhile, few of the institutions engaged in subprime lending””such as Countrywide Financial””were commercial banks subject to the Community Reinvestment Act.

I’m in no position to judge the accuracy of that statement, as mortgage banking is far from my area of expertise.  However a commenter named Patrick Sullivan sent me the following link from 1994, which casts a very different light on the relationship between Countrywide and the CRA.  It is from a ABA Banking Journal article written by Steve Cocheo:

A group of lenders not subject to CRA–and more directly under HUD’s purview–are the nation’s mortgage banks. In mid-September, the Mortgage Bankers Association of America-whose membership includes many bank-owned mortgage companies, signed a three-year master best-practices agreement with HUD. The agreement consisted of two parts: MBA’s agreement to work on fair-lending issues in consultation with HUD and a model best-practices agreement that individual mortgage banks could use to devise their own agreements with HUD. The first such agreement, signed by Countrywide Funding Corp., the nation’s largest mortgage bank, is summarized on this page. Many have seen the MBA agreement as a preemptive strike against congressional murmurings that mortgage banks should be pulled under the umbrella of the CRA.

Read the entire link, it is quite interesting.  I still think the GSEs were a far bigger problem than the CRA.  But as we saw in the previous post, Krugman also seems to have underestimated the role of the GSEs.

If there is one thing almost every macro book agrees on, is that a large, sudden, and unexpected drop in nominal expenditure relative to trend is a really, really bad thing.   Aggregate demand shocks destabilize the economy, and lead to needless unemployment.  I don’t know about you, but I don’t recall reading; “Severe AD shocks are really, really bad, except when the economy is also suffering from some other structural problem.  Then they’re just dandy!”

As an analogy, suppose you had pneumonia, and then someone stabbed you in the gut.  You show up at the hospital, and the doctor says “there’s no need to patch up that knife wound, your real problem is pneumonia.”  I think you’d look for another doctor.  A severe AD shock causes lots of unemployment; that’s true whether you start from full employment, or whether you already have lots of unemployment from structural problems.

So when economists react to the sharpest fall in NGDP since 1938 by announcing that the economy really needs tighter money, I’m inclined to react as if a doctor ordered leeches for someone already bleeding from a knife wound.  I’m going to look for another economist.  In fairness, many proponents of structural causes of the recession do understand this point.  Tyler Cowen favors monetary stimulus, even though he thinks much of the problem is structural.  Even Arnold Kling thinks it’s worth a shot.

I was reminded of all this by a recent debate between Raghu Rajan and Paul Krugman.  Rajan has said elsewhere that we need tighter money.  Krugman strongly disagrees.  Here’s part of Rajan’s response to Krugman:

First, Krugman starts with a diatribe on why so many economists are “asking how we got into this mess rather than telling us how to get out of it.”  Krugman apparently believes that his standard response of more stimulus applies regardless of the reasons why we are in the economic downturn. Yet it is precisely because I think the policy response to the last crisis contributed to getting us into this one that it is worthwhile examining how we got into this mess, and to resist the unreflective policies that Krugman advocates.

I believe both Krugman and Rajan are wrong.  Rajan thinks the real problem is structural, and that more monetary stimulus might just blow up another housing bubble.  You already know what I think of that argument, so I’d like to focus on Krugman’s response.  Krugman rightly argues that we need much more AD and then suggests that it doesn’t matter why AD fell, we have the tools to boost it now.  I agree we need more AD, but I also think it does matter how we got here.

Both Rajan and Krugman believe the severe fall in NGDP in late 2008 was caused by the financial crisis.  Rajan thinks that means our dysfunctional financial system is the real problem, whereas Krugman thinks the current low level of AD is now the real problem.  In contrast, I think the sharp fall in NGDP during 2008-09 was caused by tight money, and that the solution is easier money.

But why does it make a difference that Krugman and I disagree as to how we got here, isn’t the important thing that we both agree that we need more monetary stimulus?  Yes and no.  Yes, in the sense that you need to patch that knife wound regardless of how you got it.  But if Krugman is right that tight money didn’t cause the fall in AD, then it creates doubt as to whether easy money can patch the wound.

Most economists disagree with my view that if the Fed had done 5% NGDP growth targeting, level targeting, from mid-2008 forward, we wouldn’t have had steep fall in NGDP.  The standard view is that the financial crisis was an exogenous shock, and a devastating shock, and the drop-off in lending would have caused aggregate demand to fall in any case.  Suppose my opponents are right, and the Fed couldn’t have prevented a severe decline in NGDP in late 2008.  Doesn’t that raise doubts as to whether the Fed could now fix the problem?  After all, even in 2010 banks continue to maintain a much more restrictive lending regime.  If that’s the “real problem” then arguably it is just as much a problem today as in 2008.

Of course I don’t think this would prevent easy money from triggering a robust recovery, and perhaps Krugman share’s my view.  But even if he does, it isn’t something you can just assume away.  I don’t face that problem because I believe the big fall in AD was caused by tight money—in September 2008 the Fed’s 2% target rate was way above the Wicksellian equilibrium rate.  But Krugman doesn’t believe that tight money caused the recession, he believes the financial crisis caused the big drop in NGDP.  So he faces a much bigger burden in showing that monetary stimulus can fix the problem.  He needs to show that monetary policy could not have prevented NGDP from falling in late 2008, but now the Fed can boost NGDP.  That’s certainly possible, but it’s not a given.

BTW, unless Rajan’s just making up facts, it seems to me that his response to Krugman is pretty persuasive on the issue of the financial crisis.  He has lots of evidence that Krugman is flat out wrong in asserting that government encouragement of low cost housing didn’t play a major role in the housing bubble.  Here’s just one example:

So Krugman shifted his emphasis. In his blog critique of a Financial Times op-ed I wrote in June 2010, Krugman no longer argued that Fannie and Freddie could not buy sub-prime mortgages.[v]  Instead, he emphasized the slightly falling share of Fannie and Freddie’s residential mortgage securitizations in the years 2004 to 2006 as the reason they were not responsible. Here again he presents a misleading picture. Not only did Fannie and Freddie purchase whole sub-prime loans that were not securitized (and are thus not counted in its share of securitizations), they also bought substantial amounts of private-label mortgage backed securities issued by others.[vi]  When these are taken into account, Fannie and Freddie’s share of the sub-prime market financing did increase even in those years.

In 2008 the left gleefully argued that the banking crisis represented a failure of laissez-faire.  As a result they over-reached, even defending the GSEs.  They would have been better off arguing that the GSEs were private (which isn’t really true, but is sort of plausible.)  By defending the GSEs, they implicitly acknowledged their public dimension.  Now more and more evidence is coming in that the problems with our financial system all start with the letter ‘F’.  (Fannie, Freddie, FDIC, FHA, etc.)  And what does ‘F’ stand for?

HT:  Patrick R. Sullivan

Tyler Cowen wrote an excellent column on the dilemmas faced by our monetary policymakers.  Tyler understands that it isn’t even 100% clear who our monetary policymakers actually are, or for that matter, who they should be.  Should Congress set monetary policy, and have the Fed implement their policy?  Should the President?  Or should the Fed set policy?

Given my fanatical views on monetary policy, I’ll find plenty of little things to nit-pick, and one big thing to praise (which many readers might tend to gloss over.)

Tyler’s strength is his ability to translate complex ideas into simple and clear exposition.  While reading the article I occasionally came across statements that I thought oversimplified the issue, or were perhaps slightly misleading.  In each case, however, I couldn’t think of any other way to present the idea, without going way over the heads on the NYT readers.  But you guys are much smarter, so I’ll present a few examples and ask you what you think:

Here’s the problem: The economy needs help, but monetary policy, which is the Fed’s responsibility, has not been very expansionary. This is true even though the Fed has increased the monetary base enormously since the onset of the financial crisis.

How can this be? Supplying more money did not actually result in enough additional spending. The debilitating financial shock of the last few years convinced many consumers and businesses that they needed to save more. So they are holding on to much of the new money.

Given this problem, there is a logical and seemingly simple move available to the Fed: just make people believe that it is seriously committed to increasing the rate of inflation. Traditionally, the Fed has focused on restraining inflation, not stoking it. But these are unusual times.

If the Fed promises to keep increasing the money supply until prices rise by, say, 3 percent a year, people should eventually start spending. Otherwise, if they just held the money, it would be worth 3 percent less each year.

I’d put it slightly differently.  Almost all the new money created by the Fed is now held by banks (as excess reserves.)  So it’s not quite right to say that the problem is that consumers and businesses are sitting on their wallets.  Does this simplification do any harm?  Perhaps not, but I do get a lot of conservative commenters complaining that I am trying to get Americans to save less and spend more.  Not true.  Keynesians are trying to get Americans to save less and spend more.  I am trying to get Americans to consume more and save more.  But most of all, I want them to reduce their demand for base money.  I want them to hoard less cash, not save less income.  That would increase NGDP, allowing both more saving and more consumption.

I’d be thrilled if people and banks started taking all that base money out from under cushions, or out from excess reserves, and started buying assets like bonds, stocks, commercial REITs, etc.  Of course this “spending” isn’t consumption, it’s saving.  But it would boost asset prices and increase investment in the economy.  And that would be great.  So I do have a slight fear that talking about the need for Americans to save less will send out the wrong message, especially to conservatives who have a well-justified instinctive feeling that one of America’s problems is that we don’t save enough.  There’s never a bad time to save more, as long as you don’t increase your real demand for base money.

Tyler’s at his best when considering the issue of credibility:

In a self-fulfilling prophecy, the Fed could stimulate spending and the economy, and at no cost to the Treasury. Of course, if no one believes the Fed’s commitment to price inflation, spending and employment will not go up. The plan will fail, and people will view their skepticism as vindicated.

In other words, one of our economic problems can be solved, but only if we are willing to believe it can.

In a way this is true, but it tends to create an excessive sense of pessimism.  The reader is left wondering how likely it is that American would expect higher inflation, merely because of an announcement by the Fed.  But there’s more to it than that, as proponents of monetary stimulus also favor specific actions, such as negative IOR (Alan Blinder, me), quantitative easing (many of us), qualitative easing (Krugman), etc.  There’s trillions of assets that the Fed could purchase.  It is extremely unlikely that an aggressive move by the Fed would be met by indifference on Wall Street.  And it is Wall Street’s reaction that matters most, not the views of a housewife in Dayton, Ohio.  So the Tinkerbell-like comment “only if we are willing to believe it can” might be misunderstood by the average reader.

Just a few paragraphs later Tyler discusses a much more serious version of the credibility problem:

Part of the credibility problem stems from the political environment, especially in Congress. Imagine the day after the announcement of a plan for 3 percent inflation. Older people, creditors and workers on fixed incomes “” all connected to powerful lobbies “” would start to complain. Republicans would wonder whether they had found a new issue on which to campaign, namely, opposition to inflation. And Democrats would worry about what position to take. Presidents of some regional Fed banks would probably oppose the policy publicly.

Although the unemployed might prefer such a policy, they are not well-mobilized politically. And President Obama is himself politically weak at the moment, so he cannot offer the Fed much cover.

Can the Fed walk down this path without blinking? Perhaps not.

This is a good point, but it also highlights why we absolutely must stop talking about inflation targeting.  Suppose the Fed were to say;

 “For several decades the total income of Americans rose by just over 5% a year, and we had a healthy economy.  In the last two years there has been almost no growth in the total income of Americans.  We are going to adopt a more expansionary monetary policy with the goal of faster growth in aggregate incomes.  If Americans have more income, then they will be better able to service their debts, and the banking system will be in better shape.  Because the economy current has a lot of slack, we believe that we can achieve 7% annual income growth over two years, and 5% thereafter, without pushing inflation above the 2% to 3% norm of recent decades.”

I ask you, which target would be easier to sell to the American people?  Higher inflation, or higher incomes?

Here’s my favorite part of Tyler’s column:

Sadly, although Mr. Bernanke clearly understands the problem, the Fed hasn’t been acting with much conviction. This is understandable, because if the Fed announces a commitment to a higher inflation target but fails to establish its credibility, it will have shown impotence. It would be a long time before the Fed was trusted again, and the Fed might even lose its (partial) political independence. All of a sudden, the Fed would end up “owning” the recession.

I love that last sentence.  I think the Fed is afraid of “owning” the business cycle, and always has been.  But I’m not sure that it is merely because they have a fear of failure.  Indeed before I thought about this issue, I might have expected exactly the opposite of what Tyler wrote.  In an earlier post I pointed out that the Fed faced a very similar decision in late 1937.  At the time there was criticism that the doubling of reserve requirements had reduced the money multiplier and triggered a recession, now there is criticism (by me and David Beckworth) that interest on reserves has reduced the money multiplier and triggered a recession.  In the minutes of the November 1937 Fed meeting, one member all but admitted that the Fed was reluctant to reverse the increase reserve requirements, because that would be tantamount to admitting the Fed was guilty of triggering the recession.  So they put their own reputation ahead of the public interest.  (Yes, I know that powerful people often have trouble distinguishing between the two.)

I already believe the Fed “owns” this recession, but most people don’t.  Suppose the Fed did everything I wanted, and it worked exactly as I thought it would work.  Wouldn’t that cause more people to go back and re-examine what the Fed did in 2008?  Perhaps a few people might start muttering “perhaps Hetzel, Congdon, Sumner, Beckworth, Thompson, etc, were correct about 2008.”

So that was my initial reaction to Tyler’s comment.  But on further reflection I think it may even be worse, Tyler’s interpretation might also be correct.  Indeed I can see two arguments in his favor:

1.  The mere fact that the Fed announced an intention to boost inflation, would suggest that the Fed thought they always had the power to do so, but were reluctant to pull out the “nuclear option” because they didn’t think the recession was that bad.  Maybe (people would mutter) the Federal Reserve elite don’t personally know anyone who is unemployed.

2.  And suppose the policy fails to boost inflation, would that let the Fed off the hook?  I doubt it.  Does anyone believe a determined central bank couldn’t produce Zimbabwe-style inflation, if it bought up the entire world stock of wealth?  In all probability the Fed would fail without playing all their cards.  They wouldn’t have done level targeting, or negative IOR, or unconventional QE (qualitative easing), or something.  They’d be mocked “What, are you guys so incompetent that you don’t even know how to debase your own currency.   Even the Zimbabweans can to that!  No, failure would not be an option.

As much as I hate to admit it, I fear Tyler is right.  The more aggressive the Fed’s move, the more “ownership” they’ll take for the recession.  And that’s true whether they succeed or not.  Indeed the only way it wouldn’t be true is if they did succeed in creating 3% inflation, but unemployment remained high.  I think that’s very unlikely, and I’m pretty sure they do as well.  So they are in a tight spot—just like in the 1930s.  I hope they show more courage than the 1937 Fed.

And finally, Tyler’s column raises a very difficult political problem:

The Federal Open Market Committee, which votes on monetary policy, has three open seats “” a situation that may be hindering the taking of decisive action. The Senate has not been willing to hold a confirmation vote on Mr. Obama’s nominations. But filling the seats is not enough; somehow, Fed officials have to believe that Congress is firmly on their side.

In failing to push harder for monetary expansion, is Mr. Bernanke a wise and prudent guardian of the limited discretionary powers of the Fed? Or is he acting like a too-hesitant bureaucrat, afraid to fail and take the blame when he should be gunning for success?

We still don’t know which narrative is more accurate, but the Fed is not receiving enough signals of support from Congress.

The very fact that Congress and the President are ignoring this issue, pretty much tells me that they are clueless on monetary policy.  On the other hand, both groups do favor more AD, so their “heart” is in the right place.  And of course I’m a big believer in democracy.  So who do I favor making the decisions; the clueless or the heartless?  I’m tempted to say “Whoever agrees with me; first tell me the target Congress would set.”  But of course that’s cheating.  The honest answer is that I don’t know.  But it is becoming increasingly clear that we won’t get good policy until this dilemma is resolved.

HT:  JimP

Soon after China began its economic reforms a curious pattern developed.  Many of those who quickly rose to prominence in the business world had spent the 1960s and 1970s as members of the Red Guards, torturing and killing people to advance the glorious cause of socialism.  I suppose we shouldn’t be surprised; the highly ambitious and talented are not necessarily particularly ethical, and often rise to the top of any social hierarchy.  Much the same pattern can be found in other former communist or fascist countries.  A sort of convenient amnesia sets in and all crimes are forgotten.

There’s probably no reason to decry this state of affairs, no matter how unfair it may be.  The gains to China from moving past Maoist policies are so great that it would be silly to slow the progress with a lot of score-settling.  Still, it isn’t exactly pleasant to watch.

I was reminded of this phenomenon when I read a recent Washington Post story on the empty seats at the Fed:

Then there’s monetary policy, the Fed’s core function. There is now a strange situation in that the institution in charge of guiding the U.S. economy has only one PhD economist among its top officials, Chairman Ben S. Bernanke. The other three currently serving governors are not monetary policy specialists (they are Tarullo, a former law professor, Duke, a former banker, and Kevin Warsh, a financial markets expert). Two of Obama’s nominees are economists, San Francisco Fed president Janet Yellen and MIT professor Peter Diamond. This is, as it happens, a pretty terrible time for the Fed not to have as many smart economists in its upper ranks as possible; the central bank faces a massively consequential decision over the coming months of whether to undertake new steps to try to boost the economy.

Massively consequential decision?  Yeah, I guess I’d say so.  But I think we can all agree that at this late stage, nearly three years after the start of the recession, it is nowhere near as “massively consequential” as the decisions of September and October 2008, when expectations of inflation and NGDP growth were rapidly falling below the Fed’s implicit target, and just about everyone agreed the economy needed lots more aggregate demand.

I hope I’m not being impolite by bringing up a few inconvenient truths.  As far as I can recall there were virtually no articles in the leading elite newspapers (WaPo, NYT, LA Times, NYR of B, etc) talking about the urgent need for more monetary stimulus.  Yes, there might have been an occasional off-hand mention of monetary policy, acknowledging that perhaps, in theory, the Fed could do something.  But then the idea was quickly brushed off as a long shot, which shouldn’t distract us from the need for fiscal stimulus.  And all those empty Fed seats in early 2009?  Once again, I don’t recall any sense of urgency on the issue.

Of course the media must get its information from somewhere, and I assume most reporters aren’t experts on the fine points of unconventional monetary policy.  I’d guess they talk to their fellow liberal bloggers and academics.  And what were they saying in September and October 2008 about the urgent need for more monetary stimulus?  How about the first half of 2009, when we desperately needed the stimulus?  Weren’t most of the liberal bloggers saying there was nothing the Fed could do when rates were near-zero?  So here’s my question; if there’s nothing to be done when rates are near zero, then why is the Fed now facing a “massively consequential decision”?  Indeed rates were in the 1.5% to 2% range throughout September and October 2008, so not only was the need much greater at that time, but the Fed’s ability to deliver monetary stimulus was also presumably much greater.  (By ‘presumably’ I mean according to the standard model.)

Here’s Brad DeLong on Obama’s biggest mistake:

In fact, it was recess appointment time at the Fed in August 2009–if not earlier. But it is definitely recess appointment time at the Fed. This is, I think, Obama’s largest and most damaging unforced errors.

If not earlier?  How about January 21, 2009?  Obama didn’t even offer up any names until a few months ago.

Perhaps Obama’s one of those arrogant liberals who believes all right-wingers are morons.  Perhaps he never read any Milton Friedman, and never learned that monetary policy is still highly effective at the zero bound.  Maybe he just read Keynes.  Maybe he just relies on reporters who didn’t know about the “massive” importance of monetary policy in early 2009.  Maybe he relies on liberal economic advisers who didn’t understand the massive importance of monetary policy in early 2009.  So he let Fed seats sit empty, instead of immediately filling them with pro-stimulus academics when his high popularity would have allowed them to sail through the Senate.

I suppose my liberal readers are asking why I am picking on progressives.  I have several answers:

1.  I’ve already done lots of columns picking on the WSJ and conservative inflation hawks.

2.  The hawks still haven’t changed their minds, so there’s no reason for them to do soul-searching.

3.  Consider a partial list of those who understood that monetary stimulus was highly effective in late 2008 and early 2009:  David Beckworth, Bill Woolsey, Josh Hendrickson, David Glasner, Jim Hamilton, Nick Rowe, Mike Belongia, Robert Hall, Niklas Blanchard, Tim Congdon, Tyler Cowen, Bryan Caplan, Robert Hetzel, Earl Thompson, and many others whose names don’t immediately come to mind.  Do you notice there aren’t a lot of left-wingers on that list?  I’ll admit that in between his many columns denigrating the possibilities of unconventional monetary stimulus, Paul Krugman did occasionally call on the Fed to do more.  But it was obvious that he held out little hope for success.

Don’t get me wrong, I’m thrilled to see all the sudden liberal support for unconventional monetary stimulus, and I’m angry about Republican senators using delaying tactics.  But I’m also frustrated by the lack of soul-searching on this issue.  It’s clear to me that if all these liberal bloggers and liberal newspapers (and yes, to us right-wingers even the WaPo is liberal) have suddenly woken up to the fact that monetary policy can be highly effective at the zero bound, then the macro model they had in their heads in late 2008 and early 2009 was in some sense flawed.  You’d expect some sort of re-examination of how we got here.

Yes, I know there are only so many hours in the day.  It’s very time-consuming writing posts pointing out that right-wingers don’t know how to read, or are completely nuts.  But perhaps liberal bloggers could set aside just a few minutes to consider whether, like a broken clock that’s right twice a day, right-wingers might once and a while stumble over an important insight.

Why start off with the Cultural Revolution anecdote?  My hope is that monetary stimulus happens, and that it works.  But I have a nagging feeling that when and if that happens, all the liberal Keynesians will say “See, it shows the right-wingers were wrong and the left was right.  It shows the economy really did need more stimulus.”

At this point all I want is monetary stimulus, and I don’t much care who gets the credit.  But I hope future historians will keep in mind that while Obama may have made some “unforced errors,” there were plenty of assists from his fellow liberals.  And those policy errors will have caused untold hardship to the unemployed.  It’s great to have your heart in the right place, but you also need to know how the world actually works.

PS.  I had not yet discovered some of the best liberal blogs in late 2008 (Yglesias, Duy, Harless, etc.), so apologies if I’ve overlooked bloggers who were on top of this issue from the beginning.