Matt Yglesias presented a graph showing that since 2005 the Chinese yuan has appreciated about 30% against the dollar. He added this comment:

That’s the nominal exchange rate. In real terms, the yuan is appreciating faster than that because Chinese have more inflation than the United States. This doesn’t mean there’s no problem here, but it should be acknowledged that the problem is getting less serious with every passing day.

If only it were true. There really isn’t any “problem” at all, but the perception is that the yuan is getting increasingly undervalued. Back in 2005, Chuck Schumer said the yuan was 27.5% undervalued, and he demanded a revaluation. China has more than complied with this request; the yuan has increased by nearly 30% in nominal terms and more than 50% in real terms. So is Chuck Schumer happy now? Not quite. He now insists the yuan is 32.5% undervalued, and demands another massive revaluation. All this despite the fact that the previous revaluation didn’t reduce the deficit by 1 cent; indeed the deficit got bigger.

Remember the high school bully that would pick on the nerdy kid? You know, the one that would promise to stop beating him up if he just did what the bully wanted. Then when the victim complied, the bully would just issue more demands, and keep picking on the poor boy. That’s Chuck Schumer.

I wonder if we’ll ever learn. We kept pressuring countries like Japan, Germany and Switzerland to appreciate their currencies. And then their currencies do appreciate very sharply. But the current account surpluses remain very large, because currency appreciation doesn’t address the root cause of those surpluses. Now we are engaged in the same fruitless quest with China. What a waste of time.

Off topic, But Christopher Mahoney just sent me a report from Goldman Sachs, which endorsed NGDP targeting.  Unfortunately, it’s proprietary information, so I can’t link to the report (which is excellent.)   But perhaps they’ll allow me to quote one passage:

A Different Interpretation of the Dual Mandate

While a shift to a nominal GDP level target would clearly be a big decision for the Fed, it would be quite consistent with the dual mandate to pursue maximum employment and low inflation. After all, nominal GDP is equal to the price level multiplied by real GDP, and real GDP in turn is very closely related to employment via “Okun’s law.” So there is a lot of common ground between a nominal GDP level target and a standard Taylor rule in which the desired stance of monetary policy depends on the deviations of inflation and unemployment from their target rates.

But a nominal GDP level target differs from a standard Taylor rule in two key respects:

1. Targeting the price level, not the rate of change.

In a nominal GDP level target, prices enter as a level, while in the standard Taylor rule they enter as a rate of change. There is a long literature on the relative merits and drawbacks of price level vs. inflation targeting, but many studies find that a level target is preferable. The key advantage of a price level target is that it reduces uncertainty about the future price level because the central bank commits to making up for past inflation under- and overshoots. This implies that households and businesses should rationally expect higher inflation following a period of economic weakness and sub-trend inflation. This should push down real interest rates and boost economic activity during times of weak growth.

2. A bigger weight on output/employment.

A nominal GDP level target increases the relative importance of output or employment. Under the standard Taylor rule, a decline in real GDP by 3% percentage points would call for the same monetary policy adjustment as a decline in inflation by 1 percentage point. But under a nominal GDP level target, a decline in real GDP by 3% would call for the same monetary policy adjustment as a decline in the price level (relative to trend) by as much as 3%. This is likely to mean greater responsiveness to output or employment relative to prices while the nominal GDP level target is in place.

Is such a shift desirable? At least currently, we believe the answer is yes because continued weakness in output and employment would increase the risk that part of the increase in unemployment will eventually turn structural. Fed Chairman Bernanke essentially made this case in his remarks at the 2011 Jackson Hole Symposium: “Normally, monetary or fiscal policies aimed primarily at promoting a faster pace of economic recovery in the near term would not be expected to significantly affect the longer-term performance of the economy. However, current circumstances may be an exception to that standard view.” If growth is faster in the near term, this will not only have a near-term but also a longer-term benefit by reducing the risk that unemployed workers become unemployable. This justifies putting more weight on the output and employment part of the dual mandate than under normal circumstances.

I don’t know if the Goldman Sachs endorsement will gain us any converts among the more populist right-wing internet Austrians, but nothing else has worked.

The report was written by Jan Hatzius and Sven Jari Stehn

The post title is in response to a Matt Yglesias post entitled:

Does Ben Bernanke have a secret plan to stymie stimulus?

Matt begins his post as follows:

Scott Sumner wants an answer from Keynesians about how fiscal stimulus is supposed to help a depressed economy if the central bank is determined to offset any impact on total nominal spending.

The answer is that it can’t. The central bank can act faster and prevent fiscal reflation. But my question for Sumner is what makes him think that the central bank we have is doing this.

I believe Bernanke sincerely favors short term fiscal stimulus, and hopes it succeeds.

Now let’s stop talking about what Ben Bernanke believes, and start talking about how the Fed actually behaves.  Here’s Matt again:

It appears to be the case that the real world Federal Reserve operates primarily by targeting interest rates, and in a world like that fiscal policy makes a big difference. I also hesitate to rely on anonymous sources for my arguments, but I sometimes hear from people on the Fed staff and the complaints always point in the direction of saying I should complain less about Fed inaction and more about fiscal policy.

I’m not quite sure what Matt is claiming here.  If the Fed adjusts the fed funds target in such a way as to implement inflation targeting, NGDP targeting, or the Taylor Rule, then fiscal policy has no impact on demand.  Perhaps Yglesias means that since 2008 they have been pegging short term rates near zero.  But it’s also true that since 2008 the Fed doesn’t operate primarily by targeting interest rates, it operates primarily by using various unconventional monetary tools, including QE1, QE2, promises of low rates for varying periods of time, and Operation Twist.  They seem to alternate between periods of aggressiveness and passivity.  And although it’s hard to tell exactly, they still seem to be engaged in targeting some sort of proxy for demand (such as inflation.)

Now in fairness to Yglesias, their implicit target does seem lower than in normal times.  I agree with those who say that if the Fed could cut nominal rates right now, it would do so.  So the move toward unconventional policies has effectively created a more hawkish Fed.  And I even agree with those who say Bernanke would like a bit more demand, especially if delivered by fiscal stimulus.  So it’s possible that fiscal stimulus would work.

But when I look at what the Fed has actually been doing over the past three years, I have a really hard time writing down a set of implicit policy targets that allow for fiscal stimulus to play much of a role.  I see them engage programs like QE2, when core inflation is too low, then see core inflation rising significantly, and then see the Fed disengage (i.e. tighten) as soon as they begin worrying that inflation is too high.  And then when I see growth falter, I see the Fed promise two years of low rates, Operation Twist, and put out strong hints of more to come.

Unfortunately, the Fed seems to also respond to inflation that has no bearing on optimal monetary policy (such as oil prices increases produced by Libya and China.)  I think Keynesians are failing to embed their vision of fiscal stimulus into the Fed reaction function that we actually observe, for levels of political stimulus that are politically plausible.

I don’t doubt that a WWII-style military build-up would more than offset Fed policy conservatism.  But what about politically plausible stimulus, say another $400 billion?  I see the most likely outcome as a modest boost to the economy, which pushes up oil prices and headline inflation, which frightens the Fed, which leads the Fed to refrain from additional unconventional stimulus that they would otherwise do.

How do I know that the Fed would otherwise do more monetary stimulus?  I don’t, but that’s certainly been their pattern over recent years, whenever the economy faltered.  And there are already rumblings of the possibility of additional stimulus.  And the number of hawks on the FOMC drops from 3 to 1 in January.

None of this means I’m right–as I’m no mind-reader.  But if you look at how the Fed actually behaves, rather than what Bernanke says or “really” believes, then you are forced to conclude that the 2009 stimulus was sabotaged.  That stimulus was not enough to create a robust recovery, even with unconventional Fed moves.  If they hadn’t done that stimulus, it looks like the Fed would have done a more aggressive stimulus, as they seem determined to keep core inflation in the 0.6% to 2.0% range.  And thus if we’d never done the 2009 fiscal stimulus, we’d probably be about where we are now–9.1% unemployment and 2% core inflation.  But with a much smaller national debt.

Why do people have trouble accepting my view?  Because at first glance it doesn’t seem to make sense.  Bernanke seems like a good guy, doing his best.  And he probably is.  He keeps assuring us not to worry, that the Fed has plenty of ammunition.  He keeps assuring us that the Fed will act forcefully to prevent deflation.  This means that he is basically assuring us (whether he knows it or not) that if we have fiscal austerity the Fed will act much more aggressively, and use its unlimited ammunition to prevent deflation.  You might ask; “what’s wrong with that?”  Isn’t it the Fed’s duty to act aggressively if we are in danger of deflation?  Yes, but the problem isn’t so much that he would take these aggressive steps if the fiscal authorities fail us, but rather that he won’t take these aggressive steps if the fiscal authorities don’t fail us.  When you put these two statements together, you are led inexorably to the conclusion that the Fed will have tighter policy without with fiscal stimulus than with without it.  And as a matter of pure logic, that means the Fed is at least partially sabotaging fiscal policy–even though I have little doubt that they don’t think of it that way.

[the previous version confused with and without]

A few final comments:

1.  I’ve never denied that fiscal stimulus might work.  One can always construct “God of the gaps” arguments.

2.  Matt Yglesias also said:

I know that before the crisis, Sumner reached the conclusion that this was how fiscal and monetary policy would interplay.

It would be more accurate to say that a zero fiscal multiplier was the standard view of mainstream new Keynesian economists before this crisis.

3.  Some types of fiscal stimulus can work with an inflation targeting central bank–for instance an employer-side payroll tax cut.  I’ve advocated that sort of fiscal stimulus.

4.  If a Fed official ever said to me what he apparently told Matt in a face to face conversation, I’d . . . well, I probably shouldn’t say what I’d do.  I don’t want to sound like Rick Perry.

During the Great Depression prices fell by about 25%.  You might think that a deflation that bad would convince even the most hard-hearted conservative that monetary stimulus was needed.  Not so, conservatives were horrified by FDR’s attempt to reflate, even though the price level remained far below 1929 levels for the rest of the 1930s.

But the conservatives were pragmatists.  They understood the Depression was a big problem.  So instead of monetary stimulus, they supported all sort of other grotesque policies.  Statist policies.  Protectionism.  Much higher marginal tax rates.  Forced cartelization of product and labor markets under the NIRA.

If we’ve got a demand problem, why not simply have a bit more demand, and leave the free market system in place?  I just don’t get it.  What is it about demand deficiencies that makes people become unglued?  What makes people see every other problem in the world except a demand shortfall.  (BTW, I have no problem with people saying there is a demand shortfall, and other problems too.)

I thought of the Great Depression when I read this essay by Martin Feldstein:

HOMES are the primary form of wealth for most Americans. Since the housing bubble burst in 2006, the wealth of American homeowners has fallen by some $9 trillion, or nearly 40 percent. In the 12 months ending in June, house values fell by more than $1 trillion, or 8 percent. That sharp fall in wealth means less consumer spending, leading to less business production and fewer jobs.

But for political reasons, both the Obama administration and Republican leaders in Congress have resisted the only real solution: permanently reducing the mortgage debt hanging over America. The resistance is understandable. Voters don’t want their tax dollars used to help some homeowners who could afford to pay their mortgages but choose not to because they can default instead, and simply walk away.

Gee, I can’t imagine why someone who lives frugally would be resentful of seeing an affluent neighbor with a good job use his house like an ATM machine, with one re-fi after another to buy boats and fancy vacations, and then dump his mortgage on the taxpayer, even though he could afford to pay it, just because his house was underwater.  Why would anyone have a problem with that?

OK, I’m a utilitarian, and am therefore supposed be above emotions like envy.  I’m not supposed to divide people into the deserving and undeserving.  But I don’t see how this could even be justified on bloodless utilitarian grounds:

To halt the fall in house prices, the government should reduce mortgage principal when it exceeds 110 percent of the home value. About 11 million of the nearly 15 million homes that are “underwater” are in this category. If everyone eligible participated, the one-time cost would be under $350 billion. Here’s how such a policy might work:

If the bank or other mortgage holder agrees, the value of the mortgage would be reduced to 110 percent of the home value, with the government absorbing half of the cost of the reduction and the bank absorbing the other half.

And why would a respected conservative advocate this sort of grotesque interference in the free market—leading to all sorts of future moral hazard, future politicization of the credit markets, etc?

But failure to act means that further declines in home prices will continue, preventing the rise in consumer spending needed for recovery. As costly as it will be to permanently write down mortgages, it will be even costlier to do nothing and run the risk of another recession.

Oh, so we have an AD problem.  In that case, WWMS (what would Milton say?)  Doesn’t an AD problem call for easier money?  But not only is Martin Feldstein not advocating monetary stimulus, he opposes it.  So just as in the Great Depression we have conservatives who would apparently abandon the traditional system of private contracts rather than provide some monetary stimulus.  Even though they concede we have a demand shortfall that threatens to push us back into recession. I just don’t get it.

What does all this have to do with Goya?  Nothing much, except for some reason his proposal reminded me of this etching:

Alternative post title:  Sleeping central bankers produce statist monstrosities.

Here’s Narayana Kocherlakota:

Federal Reserve Bank of Minneapolis President Narayana Kocherlakota said the central bank has put its credibility at risk by easing during a year in which inflation rose and unemployment fell.

.   .   .

“As the economy recovers, the FOMC should respond by reducing the level of monetary accommodation,” Kocherlakota said.

“The FOMC should only increase accommodation if the economy’s performance, relative to the dual mandate, actually worsens over time,” he said, referring to the central bank’s goals of maintaining price stability and ensuring full employment.

Between March and December 1933 the unemployment rate probably fell a bit, say from 25% to 23%.  And inflation rose.  So are we to assume that Kocherlakota would have voted to tighten monetary policy at that time?

We can take some comfort from the fact that the Fed is currently headed by a Great Depression scholar.  Surely he wouldn’t recommend tightening monetary policy just because inflation rose at bit and the unemployment rate dipped a bit.  After all, the economy is still severely depressed and most indicators point to low inflation ahead.  See what you make of this statement by Ben Bernanke:

The Fed’s chairman, Ben S. Bernanke, has said since the decision was announced that the central bank is willing to act again if necessary, but also that there would be a high bar. In particular, he has said that the Fed was most likely to act if the pace of inflation abated to the point where there was a risk that prices and wages might begin to decline. Such a trend, known as deflation, can cause buyers to delay purchases, derailing the economy.

Didn’t the decision to end QE2 effectively tighten policy?

I’m sure many of you are thinking that I just don’t get it.  The Fed knows what it is doing; they simply have a different objective function from us market monetarists.  OK, let’s see if they know what they are doing.  Do they rely on voodoo VAR models, or market forecasts of inflation?

The minutes, which are normally released three weeks after a policy decision, made clear that the Fed had not changed its view that the pace of inflation was likely to remain at roughly 2 percent a year, the rate that the Fed considers most healthy.

Yet the TIPS spreads show less than 2% inflation over the next 5 years, and the Cleveland Fed says the correctly measured expected inflation rate is lower still.

“But what makes you think markets can forecast better than the Fed?”  How about this:

The internal divisions were partly the product of a lack of clarity about the health of the economy. In its predictions since the end of the recession, the Fed has repeatedly overestimated the pace of economic growth, and the minutes report that the board does not understand why it has been wrong.

“It was again noted that the cyclical impetus to economic expansion appeared to be weaker than in past recoveries, but that the reasons for the weakness were unclear,” the minutes said.

The Fed noted that labor market conditions in particular had been disappointing, with companies adding fewer workers than expected. It also noted that both consumers and businesses remained surprisingly pessimistic.

When the markets expect your policy to fail, it might succeed.  But I wouldn’t count on it.

Actually, the Fed has no reason to believe it has provided any “accommodation” at all.  None.  Let’s review what they have done:

1.  Cut rates to near zero, just like the Herbert Hoover Fed and the Bank of Japan did.  A situation Milton Friedman correctly called a sign that money has been too tight.

2.  Injected lots of reserves, but then neutralized their effect by paying IOR at a rate exceeding T-bill yields.  High-powered money is high powered if and only if it earns an interest rate below that of bonds.

3.  Promised to keep interest rates at Herbert Hoover/BOJ levels for years to come.

4.  Operation Twist; a policy that was widely viewed by monetary economists to be a pathetic failure when it was tried in the early 1960s.

Have I missed anything?

When I read Brad DeLong’s blog I am in awe of how much he knows.  But despite all his brilliance, I still think I know more about monetary policy than he does.  Here’s what he said last week, in criticizing my market monetarist views:

Well, I would say that not just “modern Keynesians” but a lot of people believed that monetary policy was expansionary in 2008.

They believed so not just because (safe) nominal (and real) interest rates were falling, but because the money supply was expanding.

Brad had lots of fun calling me the “self-blinded man.”  Let’s see who gets the last laugh.  Here’s Brad today:

Right now record-low interest rates are not a tool for improving the economy. They are a consequence of the fact that the British economy is 100% scr—d and about to become 150% scr—d. The risk that other investments in Britain will go south as the double-dip hits is sufficiently large that investors are terrified and willing to buy British Treasury debt at absurd and outlandish prices.

.  .  .

Higher market interest rates right now would be a very positive sign.

That’s right.  And another positive sign would be if their monetary base fell sharply because people weren’t hoarding money.  I wonder if Brad DeLong would regard those two signs as “tight money.”