Warning:  The following post will contain broad generalizations that annoy many readers.  I hope it yields insights into the internet debate over monetary policy.

Over the past three years I’ve responded to numerous comments from people in either the post-Keynesian/MMT tradition or the Austrian tradition.  Many commenters seem self-taught—which is fine with me as I’m also mostly self-taught.  Many have gained insights from major interwar economists (especially Keynes, von Mises and Hayek.)  That’s also fine, as I’ve learned a lot from interwar economists like Fisher, Hawtrey, Cassel, Einzig, and Warren.

But there’s one problem with relying on interwar analysis—it’s very much a product of its time.  Prior to WWII, pure fiat money regimes were treated as pathological cases, associated with hyperinflation.  Most currencies were either fixed to gold, or expected to be fixed in the near future.  Studies have shown that the expected rate of inflation is roughly zero under a commodity money exchange, which is just another way of saying the expected change in the relative price of gold was roughly zero.  This had many important consequences for monetary policy:

1.  There was almost no Fisher effect in interest rates.  This meant that changes in nominal interest rates were probably a better indicator of the stance of monetary policy than today.  (Although still far from ideal.)

2.   Liquidity traps were more likely for two reasons; expected inflation was quite low, and the monetary authority could not credibly commit to a higher inflation target.  That made fiscal stimulus relatively attractive.

3.  The Phillips curve was more stable.

4.  The nominal/real distinction was less important.  The concept of the super-neutrality of money was not well understood.

One of my favorite Milton Friedman sayings was something to the effect that “In the past 200 years macroeconomics has merely gone one derivative beyond Hume.”

When I object to comments by MMTers or Austrians, it’s most often based on the issues listed above.  They seem a prisoner of the interwar period, failing to see how everything changes with a pure fiat money regime.

For instance, both types of commenters put too much weight in interest rates as an indicator of easy or tight money.  In the case of MMTers, there seems an inability to imagine “expansionary monetary policy” as being something like a shift from 10% trend inflation to 20% trend inflation, engineered via faster trend growth in the base.  You certainly won’t find anything like that in Keynes, as far as I know he never once discussed the idea of using central bank policy to permanently  raise the trend rate of inflation.  Of course if this were to occur, you’d get higher interest rates.  MMTers seem to assume the easy money would drive rates to zero, at which point the extra money would be hoarded.

MMTers also seem to make no distinction between real and nominal changes in bank balance sheets.  Consider a monetary policy that has no impact on real bank assets or liabilities. If it created higher inflation, then nominal deposits, nominal loans, and nominal reserves would all rise proportionately.  In that scenario it makes no sense to talk about loans causing deposits or deposits causing loans.  In real terms nothing has caused anything.  Thus the sort of considerations you’d use for analyzing a real change in the banking system is completely different from the sort of analysis you’d apply to a purely nominal change in the banking system.  Microeconomic factors determine the real size of the system (in the long run), whereas monetary policy explains any additional long run nominal changes.

The Austrians often complain that my 5% NGDP target proposal would lead to an unsustainable boom, and then a bust.  Let me be very clear that during the interwar period this criticism would be exactly correct.  A 5% NGDP growth track would have been completely unsustainable, and would have ended in tragedy. But that has no relevance for today, as money is approximately super-neutral in the long run.  You can do 5% NGDP growth from now until the end of time without any unsustainable imbalances developing.  (I don’t think the actual growth track of the 1920s, which was considerably slower, was unsustainable, but reasonable people can disagree on that point.)

Update:  The preceding paragraph assumed a commodity-backed currency, which limits long-term NGDP growth to about 3%/year.

In defense of interwar Austrianism, there was some merit in worrying more about booms than slumps.  After all, the natural rate hypothesis says that you can stabilize the growth track of RGDP by either cutting off the peaks or filling in the valleys—it shouldn’t matter.  But the tools available to policymakers were not symmetrical.  It was easier to restrain a boom via tight money, than to pump up a weak economy through easy money.   That’s because there’s a zero lower bound on gold reserves, but no upper bound.  It’s an asymmetry familiar to students of fixed exchange rate regimes.

But that asymmetry no longer exists in the modern world.  Indeed under a pure fiat regime an Australian NGDP trend growth rate (7%) might be best, as you’d never have to worry about hitting the zero lower bound.  So when Austrian commenters worry that 5% NGDP growth might be unsustainable, they are worried about a constraint that disappeared many decades ago.

I strongly recommend that both MMTers and Austrians take a look at Milton Friedman’s work on money super-neutrality, which is where I first learned the basics of monetary theory.  (Sorry, I don’t recall which articles.)

PS. I think both schools of thought have gained a bit of traction in recent years for roughly the same reason—the current 2% inflation target is a little bit like a gold standard.  So you get some stylized facts that seem to fit each model.  But never lose sight of the fact that central banks can change that target—and when that happens everything changes.

PPS.  I regard New Keynesian economics as the philosophy Keynes would have endorsed once he learned about the super-neutrality of money.

I’ve often argued that the fiscal multiplier would be zero if the central bank was doing it’s job.  Of course the central bank doesn’t always do its job, and hence I wouldn’t argue the multiplier is always precisely zero.  Spending on WWII probably raised both NGDP and RGDP (although it’s doubtful it raised consumption, which is arguably what matters.)  And it’s possible that a big tax increase (such as the highly anticipated taxaggeddon) could slow the economy; certainly via supply-side effects, and perhaps because the Fed would fail to offset the tax increases.

Here’s what I do strongly believe:

1.  If the modest spending increases that have been touted over the past few years were enacted they would have been unlikely to have had much effect, as long as the Fed was targeting inflation at 2% or slightly below.

2.  The Fed could offset even a big fiscal shock, such as taxaggeddon—which is the expiration of a host of previous tax cuts, due to occur in January 2013.

3.  The Fed should offset a big fiscal shock like taxaggeddon.

4.  Most importantly, the economics profession needs to change the way it talks about the role of monetary policy.  No more soft bigotry of low expectations.  We should insist that Fed try to produce an appropriate level of AD.  We should talk as if the fiscal multiplier is zero.  And I’d even go farther than I’ve gone in the past.  If we are so far down in a liquidity trap that there is any question as to whether monetary policy could offset needed fiscal retrenchment, then ipso facto money is already far too tight.

Let me be more specific.  Bernanke has recently argued that current monetary policy is appropriate, and that no further stimulus is needed.  But he’s also argued that the Fed wouldn’t be able to offset taxaggeddon.  Those two answers are simply not acceptable.  It’s the Fed’s job to steer the nominal economy. Period, end of story.  If they feel that they may not be able to do so because of near zero rates, then they need either a different policy instrument, or a higher inflation target.

I believe the economics profession has been far too kind to the world’s major central banks.  Most economists (not all) think the world has an AD problem.  And most economists are not demanding the Fed do more.  That’s what I’m trying to change.

Matt Yglesias did a recent post that made some similar points.  Interestingly, I think we ended up in the same place coming from different directions.  Although I believe the fiscal multiplier is normally zero, I also understand that my hypothesis is “just a theory.”  Commenters like Andy Harless have pointed out that the multiplier might be slightly positive if the Fed is more reluctant to do unconventional stimulus than if all they have to do is cut the fed funds target.  It seems to me that this argument is more likely to apply to very large fiscal shocks, as compared to smaller changes.  So I’m a tiny bit worried about taxaggeddon despite my zero multiplier argument.  And I’m also a small government guy, who’d prefer spending cuts to tax increases.  But even with my theoretical doubts, and my small government bias, I was so outraged by the soft bigotry of low expectations that I did a scathing post a few days back, arguing that it was absurd for Bernanke to claim the Fed couldn’t offset the demand-side effects of tax increases.

Yglesias is more comfortable with bigger government.  But on the other hand he also tends to favor fiscal stimulus.  So he probably feels an ambivalence to tax increases for very different reasons.  He thinks we need fiscal stimulus, but also knows that in the long run Obama’s social spending agenda will require more revenues, and it would be nice if the Fed could provide enough stimulus so that Obama could begin moving in that direction in his second term.

But despite these differences, what strikes me about the Yglesias post is that Matt and I seem to share the same outrage about how little we expect from our central banks.  I suppose it’s dangerous to do mind reading, so read it for yourself and see what you think:

Conventional wisdom in DC is that not only would the full expiration of the Bush tax cuts make people grumpy as they find themselves needing to pay more taxes, it would also provide the macroeconomy a job-killing dose of fiscal drag. .  .  .  I don’t buy it.

The problem is that this chart ignores what I think we’re now going to call the Sumner Critique. In other words, it assumes that the Federal Reserve is somehow going to fail to react to any of this. You can probably construct a scenario in which the Fed is indeed caught unawares, or is paralyzed by conflicting signals, or is confused by errors in the data, or any number of other things. But Ben Bernanke knows all about the scheduled expiration of these tax cuts.  .  .  . Maybe he and his colleagues won’t do anything to offset this drag on demand, but if they don’t as best I can tell that’s on them. This is the very essence of a predictable demand shock, and the policymakers ultimately responsible for stabilizing demand are the ones who work at the Fed.

If I was a progressive I think I’d feel exactly the way he does.  Whether you are on the left or right, it’s very aggravating to see our monetary policy producing massive dead-weight losses, and also pushing fiscal policy away from what it does best.

PS.  Business reporters could learn from sports reporters.  The press tends to mock Lebron James (perhaps unfairly), for failing to take the big shots.  Why don’t reporters do the same with Bernanke?  He’s got a long track record as an academic making fun of the argument that central banks can run out of ammo.  Ask him “Why are you so afraid of taxaggeddon?  Don’t think the big bad Fed has what it takes to get NGDP up to appropriate levels?  You guys have your own printing press, for God’s sake!”

Of course I’m being silly.  But you have to wonder about a press corps that asks tougher questions of 26 year old basketball players, then of the men and women who are most responsible for the health of the global economy.  Maybe it’s the reporters who are afraid to ask the big questions.

Lots of people believe the structural view of the current global recession; some of them are smarter than me.  But everywhere I look I see more and more evidence it’s a nominal shortfall, an AD problem.  Or at least 70% is demand-side.

I’ve already discussed:

1.  The LBJ argument.  He was much more a big government guy than Obama, and the economy boomed for the 5 1/2 years he ruled.  There were problems later, but that’s exactly my point.  Supply-side problems look very different from sudden recessions.

2.  The timing problem.  The big drop in housing construction occurred between January 2006 and April 2008, and yet unemployment was almost unchanged, as the laid off construction workers found jobs in other growing sectors.

3.  The no mini-recession argument.  If recessions were caused by real shocks, then mini-recessions should be much more common than actual recessions.  But we’ve had virtually none–unless you count the 1959 steel strike.  And that ended almost immediately.

4.  The David Glasner argument.  The stock market hated inflation in the 1970s.  Since 2008 stocks have been strongly correlated with TIPS spreads.  In other words the stock market started rooting for more AD about when market monetarists started arguing we needed more AD.

5.  And now we have Greece.  This tiny country is 2% of the EU.  If (God forbid) it was destroyed by an asteroid tomorrow, stock markets would soar upward all over the world.  The Greek crisis would be over.  Yes, banks would hold some worthless Greek debt; but with no further moral hazard concerns, the rest of the eurozone would gladly bail out their banks, and add that Greek debt to their own public debts.  Remember, Greece is 2% of the EU.

Why would stocks soar on the destruction of Greece?  Because it would end the uncertainty, the fear that a Greek departure from the euro would have a contagion effect.  People who talk about structural problems talk about things like malinvestment in too many houses or BestBuy stores, or Obama’s big government policies, etc.  But the markets don’t care very much about those things; they care about things like Greece.  And not because Greece is big enough to have a real effect on the global economy, obviously it isn’t.  Rather Greece matters because it could trigger a financial panic that would reduce AD all over the world.  That’s why global equity markets lose TRILLIONS of dollars when the Greek crisis intensifies.  The real problem is nominal.

Everywhere I look I see more and more evidence that the developed world has a massive AD problem.  Yes, individual countries (southern Europe, to a lesser extent the UK, and to a still lesser extent the US) also have some structural problems.  But the NGDP problem is both easy to fix and a big part of what’s hurting the world economy.  It’s frustrating to see us ignoring it.

It’s now far too big a problem to be addressed by any token fiscal stimulus that could come out of this recent Camp David push for “growth.”  Monetary policy is our only hope.

You won’t see the quotation in the title of this post in any business articles.  Instead you’ll see “stronger dollar cuts commodity prices.”

Never reason from a price change.  If the strong dollar was driving down oil prices, then the weaker euro should be driving them up.  After all, every exchange rate is two-sided, if one currency rises then the other currency falls.  But oil is falling sharply in both dollar and euro terms, which means there’s a third factor involved.  The same third factor that is depressing stock prices everywhere in the world, whether denominated in the rising dollar, the yen, or the euro.  The same factor that would be driving NGDP futures much lower, if our criminally negligent central banks would actually spend a few bucks setting up a NGDP futures market.

It’s the same old gang of four (Fed, ECB, BOJ, BOE) that’s been decimating the world economy and financial system for 4 years.

PS.  Yes, I suppose I’m naive in assuming that powerful institutions would want to set up markets that would expose their ineptitude.  But the Hansonian view of the world is just too depressing to contemplate.

Britmouse recently linked to some comments by David Cameron:

Getting our debt under control is necessary for growth. But it’s not sufficient. Our responsible fiscal policy is being matched by active monetary policy. That’s the best way to support demand and help rebalance our economy away from debt-fuelled consumption and towards exports and investment. And the independent Bank of England is able to do more to support the economy if necessary or if inflation falls below their target.

Fiscal responsibility and monetary activism is the right macroeconomic mix for our over-indebted economy. But the additional ingredient that government will deliver and needs to do even more of is a radical programme of microeconomic reform to make our economy more competitive – including competitive tax rates, planning reform and deregulation.

Unfortunately he’s not getting much help from the BOE, as NGDP growth in anemic.  They also need Swedish-style micro reforms, but it’s unlikely that the British public would stomach those sorts of laissez-faire policies.  I think Cameron needs to bite the bullet and can call for 5% NGDP targeting for three years, and 4.5% thereafter, even though he’d get criticism from within his party.

And here’s something right off the wire:

Obama stressed that events in Europe held “extraordinary” importance for the United States, which unlike the eurozone is growing, albeit slowly.

He said that the G8 summit, which he will convene at his Camp David retreat later Friday, would discuss “a responsible approach to fiscal consolidation that is coupled with a strong growth agenda.”

Meanwhile, Hollande said growth must be the priority, maintaining his stance that austerity measures alone would be insufficient to reverse the crisis in Europe.

In an attempt to smooth over the split within the G8, other European leaders stressed that austerity and stimulus are not mutually exclusive.

“We need to take action for growth while staying the course in terms of putting our public finances in order. Stability and growth go together, they are two sides of the same coin,” European Commission President Jose Manuel Barroso said ahead of the summit.

So let’s see, how do we get austerity and stimulus at the same time?  How about easy money and deficit spending?  No, that won’t work.  Tight money and budget surpluses?  No.  Tight money and big deficits?  Hell no, that’s what we’ve been doing.  That’s how we got into this mess.  How about easy money and budget surpluses?  Bingo.  That’s a growing NGDP and budget surpluses—the Swedish way.

Glad to see Cameron/Obama/”European leaders”/Hollande/Barroso  have finally seen the light.  Now do it.

PS.  And what tiny band of obscure bloggers has been pushing this policy for 3 1/2 years?