It’s now generally accepted that the fiscal stimulus multiplier is roughly zero in countries where the central bank targets inflation.

[Well, at least in graduate level economics, not undergrad textbooks.  And of course we live in a world ruled mostly by people who never got beyond undergrad economics.]

Some economists continue to insist that fiscal stimulus can work in the special case where interest rates are stuck at zero.  But that argument doesn’t apply if the country is able to do unconventional monetary stimulus such as currency depreciation and/or QE.  We haven’t yet figured that out, but the new British government seems to understand:

The independent Office for Budget Responsibility (OBR), which now oversees Treasury forecasts, delivered an encouraging verdict in June on the probable economic impact of the budget. Though it trimmed GDP growth forecasts made on the basis of Labour’s policies, from 1.3% to 1.2% in 2010 and from 2.6% to 2.3% in 2011, the downward adjustment was surprisingly small given Mr Osborne’s accelerated fiscal consolidation.

And why do they think the fiscal austerity will have such a small impact?

In its quarterly take on the economy on August 11th, the Bank of England lowered its growth forecast, but still expects a respectable recovery. Presenting its Inflation Report, Mervyn King, the bank’s governor, played down the importance of Mr Osborne’s extra austerity in the downward revision to growth. The government thinks its harsh fiscal policies will permit more monetary balm, whether through resuming the policy of quantitative easing or keeping interest rates lower for longer. Judging by this week’s report, the central bank is in no mood to tighten policy and takes the view that the rise in inflation will eventually be doused by spare capacity.

Of course in a perfect world the BOE would more than offset the fiscal stimulus, pushing expected NGDP growth even higher.  We’re not there yet, but we are moving in the “right” direction.

I think we all form mental maps of our profession.  In my field (monetary economics) I saw the new classical/RBC groups as being on the right, and the old Keynesians (or Post Keynesians) as being on the left.  Both believed in “monetary ineffectiveness,” at least to some extent, but the right thought of the ineffectiveness in real terms and the left thought in nominal terms.  In this mental map the new Keynesians were in the middle, and thoroughly dominated the upper echelon of the profession.

I tended to read quite a bit of stuff by Bernanke, Krugman, Svensson, and Woodford, who I believe were all at Princeton sometime around the early 2000s.  To me, these economists seemed to be both at the ideological center of macro, and also at the cutting edge of research.  And when Bernanke was picked to run the Fed, it pretty much confirmed my image of new Keynesianism being the standard model of macroeconomics.

I now believe my mental map of the profession was completely false.  At least three of these guys are way out on the fringes, despite appearing to be in the center.  Perhaps the real split is between theoreticians and pragmatists.  Between those who take a common-sense approach, and those who understand the deeply counter-intuitive nature of monetary economics.  A few brief comments on each:

1.  Michael Woodford wrote what is generally regarded as the bible of new Keynesianism.  So I always sort of assumed that he was a towering figure in the profession.  But how often do you see his ideas discussed in the elite press?  (I.e., the WSJ,  NYT, FT, The Economist, etc.)  He argues that when rates hit zero you shouldn’t be doing inflation targeting, you need price level targeting.  Do you see those ideas being discussed?  I don’t.

2. Lars Svensson is a member of the Swedish Riksbank.  With no disrespect to the other 5 board members, I’d have to assume that his academic reputation towers over the others.  Yet look how little influence he has:

Sept. 17 (Bloomberg) — The Swedish Riksbank’s most outspoken board member on the risks of deflation said central banks shouldn’t raise rates to curb asset-price growth when inflation is low — a path his own bank is pursuing.

“The policy rate is an ineffective instrument for influencing financial stability,” Riksbank Deputy Governor Lars E. O. Svensson said in a speech delivered in Tokyo and published on the bank’s website yesterday. “The use of the policy rate to prevent an unsustainable boom in house prices and credit growth poses major problems for the timely identification of such an unsustainable development.”

Sweden’s central bank on Sept. 2 raised its benchmark repo rate a second time in as many months in part, it said, to cool the housing market. Inflation, which has lagged behind the bank’s 2 percent target since December 2008, slipped 0.2 point to 0.9 percent last month. Policy makers in Sweden, which emerged from an eight-month bout of deflation at the end of last year, may be underestimating the risk that price declines can return, some economists say.

“The Riksbank’s Monetary Policy Committee, except for Svensson, is not taking deflation seriously,” said Par Magnusson, chief Nordic economist at Royal Bank of Scotland Group Plc’s Stockholm office. “But they should. Deflation is a far greater threat than inflation.”

According to New York University Professor Nouriel Roubini, deflation is becoming a broader threat, with the U.S. also at risk of experiencing price declines as it faces the prospect of a sluggish recovery. Magnusson says deflation is tougher to tackle for central banks than inflation, especially when rates are already low.

‘So Much Worse’

“The effects of deflation are so much worse than the effects of slightly too high inflation,” he said. The Riksbank “really should rather be safe than sorry in their policy and not hike until they are dead sure” there’s no deflation threat.

Svensson was the only Deputy Governor of the Riksbank’s six board members to vote against the Sept. 2 quarter-point rate increase. “The market is right and the Riksbank is wrong about the level of the repo-rate path,” Svensson said, according to the minutes of this month’s meeting, published Sept. 15.

The Riksbank has signaled it will raise the main rate by another 0.5 percentage point over its next two meetings in October and December, bringing it to 1.25 percent by the end of the year.

“The market is right and the Riksbank is wrong.”  Replace ‘Riksbank’ with ‘Fed’ and you have described our own policy failures.

3.  Paul Krugman is easily the most influential economic blogger in the world.  The favorite columnist of many Democratic readers.  And recall that well over 50% of the Washington DC and NYC intellectual establishments are Democrats.  Three fourths of academic economists vote Democratic.  So his ideas on the need for more monetary stimulus must be really popular, right?  Then why does he consider himself (with Robin Wells) a voice crying in the wilderness?

In the winter of 2008-2009, the world economy was on the brink. Stock markets plunged, credit markets froze, and banks failed in a mass contagion that spread from the US to Europe and threatened to engulf the rest of the world. During the darkest days of crisis, the United States was losing 700,000 jobs a month, and world trade was shrinking faster than it did during the first year of the Great Depression.

By the summer of 2009, however, as the world economy stabilized, it became clear that there would not be a full replay of the Great Depression. Since around June 2009 many indicators have been pointing up: GDP has been rising in all major economies, world industrial production has been rising, and US corporate profits have recovered to pre-crisis levels.

Yet unemployment has hardly fallen in either the United States or Europe””which means that the plight of the unemployed, especially in America with its minimal safety net, has grown steadily worse as benefits run out and savings are exhausted. And little relief is in sight: unemployment is still rising in the hardest-hit European economies, US economic growth is clearly slowing, and many economic forecasters expect America’s unemployment rate to remain high or even to rise over the course of the next year.

Given this bleak prospect, shouldn’t we expect urgency on the part of policymakers and economists, a scramble to put forward plans for promoting growth and restoring jobs? Apparently not: a casual survey of recent books and articles shows nothing of the kind. Books on the Great Recession are still pouring off the presses””but for the most part they are backward-looking, asking how we got into this mess rather than telling us how to get out. To be fair, many recent books do offer prescriptions about how to avoid the next bubble; but they don’t offer much guidance on the most pressing problem at hand, which is how to deal with the continuing consequences of the last one.

Nor can this odd neglect be entirely explained by the mechanics of the book trade. It’s true that economics books appearing now for the most part went to press before the disappointing nature of our so-called recovery was fully apparent. Even a survey of recent articles, however, shows a notable unwillingness on the part of the dismal science to offer solutions to the problem of persistently high unemployment and a sluggish economy. There has been a furious debate about the effectiveness of the monetary and fiscal measures undertaken at the depths of the crisis; there have also been loud declarations about what we must not do””warnings about the alleged danger of budget deficits or expansionary monetary policy are legion. But proposals for positive action to dig us out of the hole we’re in are few and far between.

4.  If Krugman sometimes seems a figure of almost Shakespearian complexity, then Bernanke seems enmeshed in Hamlet’s predicament. (Someone with more skill than me should rewrite the famous soliloquy as “To ease or not to ease . . .”  I’ll spare you from my lack of literary talent.)

There are two ways to visualize Bernanke’s current position.  Perhaps he still does represent the ideological center of American macroeconomics.  In other words, maybe that center has shifted far to the right since the days when Bernanke was criticizing the Japanese for showing a lack of boldness, a lack of what he called “Rooseveltian resolve.”  Or perhaps he finds himself surrounded by lots of people who fail to understand the need for stimulus, and lots of other people who do realize that we need more AD, but fail to understand the effectiveness of unconventional policy tools.  I suppose we’ll find out when we read his memoirs.  I’m guessing they will provide yet another example of the famous maxim; “It’s lonely at the top.”

In a recent post I argued that Milton Friedman would have been extremely critical of the Fed’s tight money policy since late 2008.  I cited a number of factors, including:

1.  He said in late 1997 that the ultra-low interest rates in Japan were actually a sign that money had been too tight.

2.  Late in his career he moved from money targeting toward other options like inflation targeting.  He even endorsed Hetzel’s proposal to target TIPS spreads.

3.  I forget to mention the interest on reserves policy, which is very similar to the 1936-37 policy of doubling reserve requirements.  Both programs only raised short term rates by about a 1/4 point, but Friedman (and Schwartz) understood that the 1937 policy was highly contractionary despite the tiny interest rate increase, because it sharply reduced the money multiplier.  He would have been a severe critic of the current IOR policy.

But there was one weakness in my argument, which I acknowledged.  Friedman was famous for favoring steady money supply growth, and M2 and MZM grew quite rapidly during 2008-09.  So would Friedman now have opposed stimulus, despite the fact that growth in these aggregates fell close to zero after mid-2009?  John Taylor thinks so.

But I have found an even more recent Friedman article that sharply undercuts the only plausible argument that Friedman would have been with the inflation hawks.  In 2003 he wrote a very interesting article on recent trends on monetary policy, and basically made peace with the new Keynesian inflation targeting approach:

To keep prices stable, the Fed must see to it that the quantity of money changes in such a way as to offset movements in velocity and output. Velocity is ordinarily very stable, fluctuating only mildly and rather randomly around a mild long-term trend from year to year. So long as that is the case, changes in prices (inflation or deflation) are dominated by what happens to the quantity of money per unit of output.

Prior to the 1980s, the Fed got into trouble because it generated wide fluctuations in monetary growth per unit of output. Far from promoting price stability, it was itself a major source of instability, as Chart 1 illustrates. Yet since the mid ’80s, it has managed to control the money supply in such a way as to offset changes not only in output but also in velocity. This sounds easy but it is not — because of the long time lag between changes in money and in prices. It takes something like two years for a change in monetary growth to affect significantly the behavior of prices.

The improvement in performance is all the more remarkable because velocity behaved atypically, rising sharply from 1990 to 1997 and then declining sharply — a veritable bubble in velocity. Chart 2 shows what happened. Velocity peaked in 1997 at nearly 20% above its trend value and then fell sharply, returning to its trend value in the second quarter of 2003.

The relatively low and stable inflation for this period documented in Chart 1 means that the Fed successfully offset both the decline in the demand for money (the rise in V) before 1973 and the subsequent increase in the demand for money. During the rise in velocity from 1988 to 1997, the Fed kept monetary growth down to 3.2% a year; during the subsequent decline in velocity, it boosted monetary growth to 7.5% a year.

Some economists have expressed concern that recent high rates of monetary growth have created a monetary overhang that threatens future inflation. The chart indicates that is not the case. Velocity is precisely back to trend. There is as yet no overhang to be concerned about. (Italics added.)

Note that Milton Friedman is criticizing “some economists” who have “expressed concerns that the high rate of money growth . . . threatens future inflation.”  Today those “some economists” are obviously monetarists, Austrians, and conservative Keynesians (but not all in those camps.)  And Friedman is telling his fellow conservatives (from the grave) that they are wrong, that this “is not the case.”

Friedman would have understood that the financial crisis was a special case that led to a rush for liquidity and safety, and a temporary fall in M2 velocity.  He would have seen the low interest rates and low TIPS spreads as indicators of tight money.  He would have favored temporarily allowing higher M2 growth to offset the low velocity, until the economy was back to normal.  Somehow modern conservatives seem to merely recall the bumper sticker message “stable money growth” but overlook the nuanced and highly sophisticated monetary analysis that made Milton Friedman an intellectual giant.

HT:  Jeffrey Hummel

Between 2005 and 2008 the Chinese yuan appreciated by a bit over 20%.  Then when the recession got bad in late 2008, the yuan was (wisely) re-pegged to the dollar.  Now Fred Bergsten calls for another round of yuan appreciation:

C. Fred Bergsten, director of the Peterson Institute for International Economics, a leading research organization here, told House lawmakers on Wednesday that a similar increase over the next two to three years would create about 500,000 jobs. He said it would reduce China’s current account surplus by $350 billion to $500 billion, and the American current account deficit by $50 billion to $120 billion.

The United States should seek to mobilize the European Union and countries like Brazil, Russia and India to press China to realign the renminbi, and should seek W.T.O. authorization to impose restrictions on Chinese imports if it does not do so, Mr. Bergsten said.

I’m not opposed to modest yuan appreciation, and indeed I think it will gradually occur over the next three years.  But I am opposed to a trade war, which is utter madness in a world struggling to recover from the Great Recession.  Here’s what I don’t understand however.  Between 2004 and 2008 the Chinese CA surplus rose from about $70 billion to about $430 billion.  Why does Bergsten now expect “a similar [yuan] increase over the next two to three years” to reduce the Chinese CA surplus by roughly that amount?

And for those of you expecting a Republican Congress to rescue us from Obama’s foolish statist polices, check out this quotation:

Mr. Grassley added: “The administration should go one step further and bring a case against China’s unfair currency manipulation at the W.T.O.”

In 1985 Paul Krugman (p. 7) argued that the dollar needed to fall sharply in order to prevent chronic CA deficits, which he said would lead to “infeasible” foreign debt levels.  He was right about the dollar, it did fall sharply after 1985.  But we’ve had 25 years of almost nonstop CA deficits, and no sign of a light at the end of the tunnel.  Why?  Because the falling dollar didn’t address the fundamental cause of the CA deficit, a saving/investment imbalance produced by a fiscal regime that is profoundly anti-saving.  You can’t fix that with a band-aid.

Policymakers need to go back and reread Mundell.

PS. Perhaps the term ‘reread’ represented my own triumph of hope over experience.

HT:  Mike Belongia

Because I teach several courses today, I don’t have time to respond to all the comments right now.  But I skimmed those after my Krugman post and I really think almost everyone is looking at these issues in the wrong way.  People are confusing historical claims with theoretical presumptions, and making distinctions between “natural” and “artificial” that are themselves . . . well, totally artificial and arbitrary.

Start with this statement by Paul Krugman:

You may see claims that China’s trade surplus has nothing to do with its currency policy; if so, that would be a first in world economic history.

That could mean several things:

1.  Every time there is a trade surplus, there is an undervalued currency.

2.  Every time there is an undervalued currency, there is a trade surplus.

3.  The more undervalued the currency, ceteris paribus, the bigger the trade surplus

It seems to me that 99% of Krugman’s readers would assume he meant #1 or #2.  But obviously both are wrong, even my critics seem to agree on that.  (As I’m sure Krugman would.)  After all, they define “undervalued” on the basis of government intervention in the foreign exchange market to depress exchange rates below their natural value.  So to defend Krugman you have to assume he meant #3.  And I imagine he did.  But what a misleading way to make a point.  He would then merely be saying that there is a theoretical presumption that undervalued currencies make surpluses bigger.  But then why suggest there are no historical counterexamples?  There is no real world evidence I could cite that would disprove that assertion.  No matter how many countries I found with CA deficits, that were also depressing their currencies by buying foreign exchange, he could say that the action was still, ceteris paribus, making the CA deficit smaller. When you challenge people to find one real world example that would refute your argument, as Krugman does in that sentence, there is an assumption that he is asserting something more than a tautology.  And I’m sure his readers read it that way.  “Look, China has a big surplus, find me one of those that wasn’t caused by an undervalued currency.”  If his defenders’ interpretation is correct, then his call to search the world for a counterexample is essentially meaningless.

An even bigger problem occurs when people try to differentiate between “good” surpluses due to “natural forces” and bad surpluses that are “artificial.”  This is associated with confusion about the role played by China’s exchange rate peg.  Here are some key points:

1.  If China stopped pegging the yuan and let it float, but continued buying $100s of billions in foreign exchange every year, then China would continue to run large CA surpluses.  The root cause is high Chinese saving (relative to investment) and the currency is merely the transmission mechanism.  As an analogy, the root cause of less gasoline consumption in 1974 was OPEC producing less, and the transmission mechanism was the high price.  OPEC didn’t even need to peg the price, just produce less.

2.  If China stopped pegging the yuan, and stopped buying dollars, they would still run a huge CA surplus as long as the Chinese government found some other way to save a lot.  Suppose they set up a Norwegian-style sovereign wealth fund, and bought $100s of billions worth of German, French and British equities each year.  Nothing from the US.  Chinese aggregate saving would still exceed aggregate investment, implying a big CA surplus.  And the Chinese would not be interfering at all in the forex markets, as the term is usually defined.

3.  Ah, but some of you laissez-faire types (who strangely support Krugman) will say that’s not pure enough, not virginal enough.  The Chinese government is still involved in all that saving.  It’s artificial.  You’d say “saving should be done by the free markets, not governments.”  You’d say only in that case is a CA surplus OK.  Otherwise the exchange rate is still at an artificial level.  Evil countries like China and Norway must be punished for all their governmental saving.

4.  OK, the Chinese government stops intervening in the foreign exchange markets, and stops saving of any kind.  But instead they set up a Singapore fiscal regime, and force all workers to set aside 31% of income into various private forced savings accounts.  China would still save more than it invests, and still run a huge CA surplus.  Indeed Singapore’s CA surplus is much bigger in relative terms than China’s.  Is this OK?  After all the Chinese government is not saving or intervening in the forex markets. It is private citizens doing the saving.  I can just see people responding; “No, that high saving is still tainted, still artificial.  To be truly virginal, truly free of sin, the country has to save without any government encouragement.”

5.  I give up.  Sorry for being so ridiculous, but I’m trying to make the point that we are thinking about the entire issue in the wrong way.  Seriously, at what point on the preceding list does the distinction between natural and artificial become at all meaningful?

What I find so bizarre about these “natural” and “artificial” distinctions is that in trade theory they are almost universally viewed as bogus.  If Korea exports cars to US at a low price, when is it evil?  When they directly subsidize production?  When the government builds schools that train automotive engineers?  When they provide cheap land for car factories?  Economists usually roll their eyes at those distinctions.  All that matters is whether the US gains from being able to buy low-priced cars from Korea.  Similarly, if foreign CA surpluses really did hurt us we should oppose them whatever their cause.  To be fair, Krugman has criticized Germany’s free market surplus, arguing the German government needs to save less.  So he clearly understands the point I am making.  Where he and I disagree is that I don’t think foreign CA surpluses hurt us by reducing NGDP, because I believe NGDP is determined by monetary policy.  So I’m not upset with either China or Germany, and I certainly don’t draw any moral distinctions between the two cases.

Nick Rowe asked:

Think back to your earlier analogy, that if all countries intervene in forex markets, and buy each others’ bonds, it is like every country doing QE. Which is good. But if the Bank of China can buy US bonds, but the Fed can’t buy Chinese bonds (because China won’t allow it), then it’s asymmetric.

I’m not quite sure what Nick is getting at here.  If he is saying that if each the 20 biggest countries bought $100 billion in bonds from the next country to its west, or to its east, it would be like a global QE, then I agree.  Of course the exact same effect would occur if they each country bought $100 billion of their own bonds.  If China doesn’t want to sell us bonds, we can weaken the dollar against goods and services (which is all we care about) by buying German bonds, or even US bonds.  It makes no difference.  Of course that’s assuming the transactions affect the money supply.  But there is no necessary effect of Chinese forex purchases on the Chinese money supply, as I presume they sterilize them to prevent inflation.  Only if China’s peg forced it to buy more forex than they felt comfortable holding, would the Chinese purchases be monetized.

Another reason the exchange rate is very misleading is that people focus on the nominal rate, which the Chinese government pegs.  But it is the real rate that matters.  It is true that China can influence the real rate, but only by adjusting the amount of government saving.  Which against shows it is the saving/investment relationship, not the exchange rate, that is the key to understanding CA surpluses.

Andy Harless said:

The argument would be that currencies are undervalued whenever governments collectively engage in reserve transactions that result in a (sufficiently large) net increase in the availability of that currency in foreign exchange markets. (Obviously if the US were to offset China’s dollar purchases by buying yuan, this would not be the case.)

That seems like a pretty good argument to me: if the value of the currency is what the private sector would determine it to be in the absence of official reserve transactions, then it is fairly valued (on the assumption that private markets are efficient enough to give it a fair valuation). If net official reserve transactions are reducing the actual market value of the currency relative to that “fair” market value, then it is undervalued.

First of all they aren’t buying dollars, they are buying bonds.  Yes, they are bonds denominated in dollars, but it would make no difference whether they bought bonds denominated in euros, or Swedish kroner, or stocks denominated in euros.  All that matters is the impact on Chinese national saving.  Again, there are lots of countries that have governments buying forex, which also run CA deficits.  Whether you run a surplus depends on the saving/investment balance.  I am not denying that governments can influence that relationship, and I am not denying the Chinese government has influenced it (as has our government, by massively discouraging saving), what I am denying is that the “official reserve transactions” affect the CA surplus more than some other form of government saving.

In the previous post I said:

“The standard argument is that trade surpluses (actually CA surpluses) are caused by excesses of domestic saving over domestic investment.“

Andy Harless responded:

That doesn’t sound right to me. The level of the CA surplus is simultaneously determined with the levels of saving and investment, but the levels of one do not cause the levels of the other. If the quantity that a country wishes to invest and the quantity it wishes to save are both fixed (inelastic) at certain levels, then those quantities will determine the CA surplus, but they will do so largely by affecting the exchange rate. (For example, the excess saving will bid down domestic interest rates, thus making the domestic currency less attractive and causing it to depreciate, so that domestic goods become more attractive relative to foreign goods, thus inducing a CA surplus.) The exchange rate is still the proximate cause of the CA surplus. There is no “immaculate transfer.”

This is like the oil example.  The OPEC cutback in production was the root cause of Americans’ driving less.  If you want to call higher oil prices the “proximate cause,” that’s fine.  I’d call it the transmission mechanism.  Suppose OPEC had gradually increased prices in the 1970s and 1980s by making “National Parks” out of land they had previously intended to drill new wells in.  That sounds very environmentally conscious, doesn’t it?  But it would have had the same effect on prices as an “artificial” order to the oil companies to produce less.  I’m saying those distinctions are meaningless.  It doesn’t matter why oil production fell, only the fact that it did.  Norway gets praised for its high national saving rate; “They are so wise to put their oil money into a sovereign wealth fund, unlike all those less civilized countries.”   You know the things people say.  But when China does the same thing, they are viewed as being “sinister.”  Yes, the CA surpluses are probably not in China’s interest (unlike Norway), but that’s hardly a reason to punish the Chinese people.

So what am I missing here, as everyone seems to disagree with me?