David Beckworth has a post discussing when it is appropriate to use fiscal policy:

Here is how I would operationalize this policy. First, the Fed adopts a NGDP level target. Doing so would better anchor nominal spending and income expectations and therefore minimize the chance of ever entering a liquidity-trap. In other words, if the public believes the Fed will do whatever it takes to maintain a stable growth path for NGDP, then they would have no need to panic and hoard liquid assets in the first place when an adverse economic shock hits.

Second, the Fed and Treasury sign an agreement that should a liquidity trap emerge anyhow and knock NGDP off its targeted path, they would then quickly work together to implement a helicopter drop. The Fed would provide the funding and the Treasury Department would provide the logistical support to deliver the funds to households. Once NGDP returned to its targeted path the helicopter drop would end and the Fed would implement policy using normal open market operations. If the public understood this plan, it would further stabilize NGDP expectations and make it unlikely a helicopter drop would ever be needed.

This two-tier approach to NGDP level targeting should create a foolproof way to avoid liquidity traps. It should also reduce asset boom-bust cycles since NGDP targets avoid destablizing responses to supply shocks that often fuel swings in asset prices. This approach is consistent with Milton Friedman’s vision of monetary policy, would impose a monetary policy rule, and provide a solid long-run nominal anchor. Finally, per Cardiff Garcia’s request it would satisfy both fiscalists and monetarists. What is there not to like about it?

A curmudgeon like me always finds a few things not to like.  While I certainly agree with the thrust of David’s proposal, here’s how I’d tweak it:

1.  I think the first sentence of the second paragraph is slightly misleading, conflating two quite different situations. First, there is the zero bound situation. And second, there is the “Fed is out of ammo” situation.  They are quite different.  So I’d be inclined to say:

If rates fall to zero, and if the Fed sets IOR at negative 2%, and if the Fed buys all eligible assets, and NGDP expectations still remain below target, then go for fiscal stimulus.

I would add that eligible assets include T-securities and government-backed mortgage bonds, at a minimum.  I believe that’s around $20 trillion in eligible assets.  Recall that with IOR at negative 2% there are basically no ERs left in the system.  So unless the public’s appetite for $100 bills is much greater than imagined (greater than $130,000 per family), I think we can safely assume the Fed will never run out of ammo.  Nevertheless, if it will make the Keynesians feel better to have a backup plan. . . .

2.   What if we do need fiscal policy?  First of all, we won’t.  “Yes, but what if we do?”  OK, OK.  I’m opposed to the helicopter drop idea, for several reasons.  First, it’s less effective than people think.  No country has been doing more “helicopter dropping” over the past 20 years than Japan.  They’ve massively boosted both their national debt and their monetary base (which is what “helicopter drops” mean to economists.)  And their NGDP is lower than 20 years ago.  Not good.

Second, there are much better options than helicopters drops.  The fiscal authorities can overcome nominal wage stickiness by cutting the employer-side payroll tax.  This may not boost NGDP, but it will boost employment for any given NGDP level.  Then as NGDP recovers in the long run, the payroll tax can be raised again.

Helicopter drops must be reversed in the long run, at the cost of distortionary taxation.  Better to cut distortionary taxes today.

I believe that many people exaggerate the need for using “every available option” because they wrongly believe money has been easy in recent years, and then infer it hasn’t worked.  (Obviously these remarks do not apply to Beckworth.)

Yichuan Wang has an excellent new post showing that money was not easy in late 2008, at a time most people assumed it was:

The zero lower bound didn’t always bind. For three months after Lehman’s collapse on September 15, 2008, the federal funds rate stayed above zero. In this period of time, the Fed managed to provide extensive dollar swaps for foreign central banks, institute a policy of interest on excess reserves, and kick off the first round of Quantitative Easing with $700 billion dollars of agency mortgage backed securities. Finally, on December 15, 2012, the Fed decided to lower the target federal funds rate to zero.

It is important to remember the sequence of these events. It is easy to think that the downward pressure on interest rates was the inevitable consequence of financial troubles. Yet the top graphic clearly contradicts this. Each of the dotted lines represents a FOMC meeting, and each of these meetings was an opportunity for monetary policy to fight back against the collapsing economy. The Fed’s sluggishness to act is even more peculiar given that there were already serious concerns about economic distress in late 2007. As, the decision to wait three months to lower interest rates to zero was a conscious one, and one that helped to precipitate the single largest quarterly drop in nominal GDP in postwar history. The chaos in the markets did not cause monetary policy to lose control. Rather, the Fed’s own monetary policy errors forced it up against the zero lower bound.

Read the whole thing.

HT:  Paul and Marcos

Yesterday I did a post arguing that “no news is bad news” when it comes to the BoJ, as markets know that more action is needed.  Today CNBC has a story that supports that view:

Since stunning the markets with unprecedented monetary easing in April, the Bank of Japan has taken a back seat, failing to offer solace to investors that have been rattled by violent swings in the country’s bond and equity markets.

According to Kathy Lien, managing director, BK Asset Management, the central bank’s “overconfidence” is to blame for the instability plaguing the market.

“They did nothing because they were stubborn and overconfident that their policies were enough to stabilize markets and the markets said no,” Lien told CNBC Asia’s “Squawk Box” on Friday.

(Read More: A Question Mark on Japan: Pimco CEO )

“This is Japan’s own doing, they had the opportunity to provide markets with a small dose of stimulus in the form of increasing asset purchases or even the maturity on fund supply operations and they did nothing,” she added.

Lien was referring to the BOJ’s meeting this week when the central bank failed to announce additional measures like increasing the maturity on its fixed-rate loan facility to two years from one year.

And yesterday I talked about how the Fed needed to refrain from tapering its bond purchase policy.  Here’s a NYT article that discusses the situation:

A TAP ON THE BRAKES The final theory is that Mr. Bernanke has in fact shifted his stance. While certainly not a hawk, he has intellectually moved closer to ending the asset purchases than people might realize. It is important to remember that the latest open-ended program was conceived at the end of last year, when there was great trepidation about the drag that fiscal retrenchment would have on the economy.

“Back in December, the Fed didn’t know if we would fall off the fiscal cliff,” said David Rosenberg, chief economist at Gluskin Sheff & Associates. “So it may have thought, ‘We’ll shoot now and think later.’ “

It turns out that, in spite of Washington’s budget battles, the economy has been quite resilient. For the economic conditions that exist right now, smaller purchases may be more appropriate. Some economists dispute this line of thinking.

For instance, they say the Fed isn’t going to taper when the inflation rate is declining as it is right now. But Mr. Bernanke may think that dip is temporary, particularly since some forward-looking indicators in the markets predict a rise in inflation. And some economists see strong signs that the latest round of bond purchases is having its desired effect and will lead to a stronger economy as early as the second half of this year.

Let’s talk about the third paragraph.  Instead of “It turns out that . . .”, it should read; “As market monetarists predicted . . . ”  And I’m one of those economists disputing the view that smaller purchases are appropriate.  The surprising strength of the economy this year is predicated on expectations of Fed stimulus.  If they don’t do it, then the economy could weaken.  Bernanke needs to remember the circularity problem.  When you promise something to help the economy, you can’t reneg on the promise just as the data shows that the Fed signaling has worked.

To summarize, recent market weakness is very easy to explain.  The markets believe that the BoJ needs to do more, and they had previously assumed that the BoJ had a “whatever it takes” approach.  Now they aren’t so sure.  The US stock market doesn’t believe (as strongly) that the Fed needs to do more, but they are strongly opposed to the Fed doing less.

As always; “It’s about expectations of the future policy path, stupid.”

PS.  Commenter Mikio Kumada has a more nuanced (and optimistic) look at the Japanese case.  I strongly encourage readers interested in Japan to take a look at his excellent comment.

John Cochrane has an excellent article in the Journal of Economic Perspectives, discussing a wide range of finance problems.  Here’s a small sample:

The period after a news announcement often features high price volatility and trading volume, in which markets seem to be fleshing out what the news announcement actually means for the value of the security. For example, Lucca and Moench (2012, Figure 6) show a spike in stock-index trading volume and price volatility in the hours just after the Federal Reserve announcements of its interest rate decisions. The information is perfectly public. But the process of the market digesting its meaning, aggregating the opinions of its traders, and deciding what value the stock index should be with the new information, seems to need actual shares to trade hands. Perhaps the common model of information”” essentially, we all agree on the deck of cards, we just don’t know which one was picked””is wrong.

That is something I’ve noticed as well.  Here’s a proposed solution to high frequency trading:

Suppose that an exchange operated on a discrete clock, as a computer does in order to let signals settle down before processing them. The exchange could run a once-per-second, or even once-per-minute, matching process, with all orders received during the period treated equally. If there are more buy than sell at the crossing price, orders are filled proportionally. Such an exchange would eliminate extremely high-frequency trading, because there would be no gain or loss from acting faster than a minute.

Here Cochrane discusses whether finance is too big:

Demand that shifts out can shift back again. Demand for financial services evaporated with the decline in housing and asset values in the 2008 recession and subsequent period of sclerotic growth. Much of the “shadow banking system” has disappeared. For example, asset-backed commercial paper outstanding rose from $600 billion in 2001 to $1.2 trillion in 2007″”and now stands at $300 billion. Financial credit market debt outstanding in the flow of funds rose from $8.6 trillion in 2000 to $17.1 trillion in 2008″”and now stands at $13.8 trillion. Employment in financial activities rose from 7.7 million in 2000 to 8.4 million in 2007″”and is now back to 7.7 million (according to the Bureau of Labor Statistics). Study of “why is finance so big,” using data that stops in 2007, may soon take its place alongside studies of “why are Internet stocks so high” in 1999 or studies of “why is there a Great Moderation” in 2006. . . .

.  .  . It is possible that there are far too are far too few resources devoted to price discovery and market stabilization. In the financial crisis, we surely needed more pools of cash prepared to pounce on fire sales, and more opportunities for negative long-term views to express themselves.

Surveying the current economic literature on these issues, it is certain that we do not very well understand the price-discovery and trading mechanism, nor the economic forces that allowed high-fee active management to survive so long.

Note that economic theory predicts that society will devote too few resources to ferreting out useful information about corporate values.

PS.  I thought David Henderson made a very good point in this critique of Krugman on waste in finance:

Now to the three possibilities:
1. If the payments made by Thomson-Reuters and others who get the information earlier are needed to give U. of M. the appropriate incentives to gather quality information, then the payments are not wasted.
2. If the payments made by Thomson-Reuters and others who get the information earlier are not needed to give U. of M. the appropriate incentives to gather quality information, then the payments are producer surplus to the U. of M. and there is no social loss from the payments–it’s just a transfer.
3. If in case #2 above, the producer surplus is used for low-value uses at U. of M.–this is both a non-profit university and a government university, after all–then there is a waste.

So only in case 3 above is it “unproductive finance.” I’m pretty sure Krugman isn’t going with case 3.

The recent Japanese stock market rally and “correction” is almost identical to the US experience of 1933.  During that period FDR was engaged in a policy of depreciating the dollar.  One problem with this policy was that asset prices move on new information.  Thus each day the dollar exchange rate had already factored in the expected depreciation for all of 1933.  FDR could only drive the dollar lower by doing more than expected.  Surprisingly, he was able to do so fairly effectively, partly by pushing much harder than almost anyone expected.  By the time the price of gold had risen from $20.67 to about $28, Keynes said enough is enough, and called for a halt to the policy.  But FDR listed to George Warren, and persevered until he reached $35/oz.

In October 1933 FDR was dissatisfied with the pace of inflation, so he adopted a new technique, called the gold-buying program.  The details are unimportant; the key point is that it gave FDR a way of sending the market signals that he wasn’t satisfied with the pace of dollar depreciation.  Both Abe and FDR faced a similar problem—they needed to send signals to the market that they weren’t satisfied, that they intended to do more than the markets expected.

Here’s where the title of the post comes into play.  Markets knew that FDR would either provide more signals of monetary stimulus, or be silent.  He certainly wasn’t going to call for a stronger dollar.  During the gold-buying program of late 1933, the markets knew that on each day FDR would either raise the official price of gold, or leave it unchanged.  It would not fall.  The EMH predicts that on days where the official price of gold was not raised, news would be viewed as more contractionary than expected, and the free market price of gold would actually fall.  And that’s usually what happened.  (All the details are available in my book, due out later this year.  BTW, the 1933 New York Times commentary on daily movements in the dollar exchange rate were consistent with the EMH; markets moved on more positive than expected policy announcements, not positive policy announcements.

Many pundits are surprised that after rising by 80%, the Japanese stock market fell by 20%.  “There wasn’t much news.”  But that’s exactly the problem (as the NYT understood back in 1933) the EMH predicts that no news will be bad news, when the only two plausible outcomes are further stimulus signals, or nothing.

Yes, I’ve oversimplified slightly; there arguably was some bad news out of Japan, as Lars Christensen pointed out recently.  But the lesson here is still very important.  When a market is rocketing upward under a steady drumbeat of good policy news, even a pause in that drumbeat will cause a market setback.  After all, markets expected the drumbeat to continue, or at least placed a positive probability on that outcome.  When it stops, prices fall.  The markets know that the only two plausible outcomes are Abe calling for a weaker yen, or Abe saying he’s happy where things are right now.  Abe won’t call for a stronger yen, and investors know that.

This is why I’ve been less optimistic about Japan than even some Keynesians like Krugman and Stiglitz.  I regard each day’s level of stock and exchange rate data as the optimal prediction of the long run effect.  And I see that market data indicating modest success, but well short of 2% inflation, at least in 2014.

PS.  The Dow rose about 80% in the first three months of of the 1933 dollar depreciation, then fell 19% in 3 days.  Sound familiar?

Tyler Cowen discusses a large study of panel data on wage changes, which suggests nominal wages are less sticky than many have assumed.

There are some issues with the data.  The US sample is self-reported, and some of the wage changes do not reflect hourly rates.  But let’s assume that the broad conclusions are accurate.  Does this follow?

This paper does not show nominal wages to be fully flexible, nor does it show that observed nominal wage changes were “enough” to re-equilibrate labor markets.  Still, this paper should serve as a useful corrective to excess reliance on the sticky nominal wage hypothesis.  Nominal wage stickiness is a matter of degree and perhaps we need to turn the dial back a bit on this one.

I disagree with this claim, mostly because the stickiness that matters is not at the individual level, but at the aggregate level.  Indeed it would be theoretically possible for individual wages to be highly flexible and aggregate wages to remain very sticky.

During a recession like 2008-09, NGDP growth fell 9% below trend, while nominal wage growth was little changed.  W/NGDP soared.  Using my musical chairs model, we’d expect about 9% fewer hours worked.

I can already anticipate your objection:  “Yes, but that doesn’t prove causation.”  True.  For instance, if the Fed had kept NGDP growing at 5%, instead of falling by 4%, perhaps nominal wages would have risen by 13%, instead of 4%.  In that case the ratio of W/NGDP still would have soared 9% higher, unemployment would have skyrocketed, but there would have been no NGDP shock.  So maybe sticky wages are not the problem.

Yes, that sort of counterfactual would disprove my musical chairs model.  And I don’t doubt that something like that has occurred somewhere.  Indeed something like that occurred in the US during July through September 1933, due to FDR’s (NIRA) policy of raising nominal wages by 20%.   But I don’t believe this sort of thing occurs very often, especially in a large diversified market economy such as the US.  I’ll believe it when I see it.  Until then I’ll continue to assume that had the Fed kept NGDP rising at 5%, nominal wage growth would not have soared to 13%, and unemployment would have risen much less sharply.

There are academic models that show even a small amount of nominal wage and price stickiness at the individual level, can lead to surprisingly large aggregate stickiness.  And the study cited by Tyler shows unambiguously that nominal wage stickiness does occur at the individual level.  The spike on the wage gain graph at “0% nominal wage increases” is the smoking gun.  It’s true that that spike is modest in size, but it doesn’t have to be large, as most workers who got non-zero pay increases also tend to earn non-equilibrium wages.

Tyler also makes this claim:

Note also that this paper need not discriminate against neo-Keynesian and monetarist theories, though it will point our attention toward “zero marginal revenue product” versions of the argument, in which case the flexibility of nominal wages simply doesn’t help much.

I completely agree that the flexibility of individual nominal wages doesn’t help all that much, although a comparison of Hong Kong and Spain suggests that it does help some.  Sticky wages are a background assumption, like gravity.  When a bridge collapses, you don’t look for ways to make gravity less important in that locale (by shifting the Earth’s mass to other regions) you build a stronger bridge.  Wage stickiness will always be with us, the solution is more stable NGDP growth.

If you want to show that wage stickiness is the not the main problem, then find those examples where workers are granted 13% pay raises when NGDP growth is running at 5%.  They should be out there.  After all, my critics claim that the huge spike in W/NGDP in 2009 was not caused by falling NGDP.  I.e. that W/NGDP would still have shot up if NGDP growth had been steady.

Until then, I’ll continue to believe that the musical chairs model featuring sticky aggregate wages (not necessarily sticky individual wages) is the best way to explain cycles in unemployment.