Arnold Kling on monetary and fiscal policy

Arnold Kling has a new article on monetary and fiscal policy. Because he slightly mischaracterizes my views, I should probably respond:

Scott’s argument for monetary dominance is that the Fed, which sets monetary policy, is way more agile than Congress, which sets fiscal policy. It’s like a game of rock, paper, scissors in which if Congress shows rock, the Fed shows paper. Or if Congress shows scissors, the Fed shows rock. The Fed can always win.

I do think the Fed is more agile, but the decisive factor is that the Fed is much stronger. If you want a metaphor that is better than rock, paper, scissors, imagine I’m driving my car and my 6-year old daughter pushes the steering wheel to try to change direction. I’d simply push back more strongly.

I believe in fiscal dominance. That is because I do not think that Peter cares all that much whether he hangs on to his T-bill or exchanges it for money. Scott thinks that Peter will spend more in the latter case. I am skeptical.

This isn’t the right thought experiment. I don’t doubt that if you give the average person a briefcase with a million in cash they’ll go on a shopping spree, and that’s equally true if you give then a million dollars in T-bills. That’s not the issue. Money is special not because it is regarded by individuals as wealth, rather because it is the medium of exchange.

If you add more cash to the economy than people want to hold, they can get rid of the excess cash balances only by pushing up the price level. In contrast, if you add more T-bills than people want to hold, they can drive down the price of T-bills, with no change in the price level. You merely need to assume that they aren’t perfect substitutes. (At least when nominal interest rates are positive, and Arnold seems to be arguing for fiscal dominance even during periods where interest rates are positive.)

Scott, like almost all mainstream economists, sees inflation as having a continuous dose-response pattern. Give the economy a higher dose of money and it will respond with higher inflation. Other economists measure the “dose” as the employment rate. 

I think of inflation as an autocatalytic process. Inflation is naturally low and stable. But it can be jarred loose from that regime and become high and variable. Then it takes a lot of force to bring it back to the low and stable regime.

Nominal variables don’t have natural rates. It’s a policy choice. Inflation was not low and stable for most of American history, but became low and stable after 1990, when the Fed decided to target inflation at roughly 2%. These things don’t happen automatically. That’s why most central banks have set inflation targets, to prevent this:

Here’s Arnold:

Once inflation gets going, the only way to stop it is to slam on the economic brakes. Usually, this means drastically cutting government spending. But in the U.S. in the early 1980s, we slowed the economy without cutting government spending. Instead, the foreign exchange market put on the brakes by raising the value of the dollar, stimulating imports and making our exports non-competitive. And the bond market put on the brakes by raising interest rates, so that nobody could afford the monthly payment on an amortizing mortgage. After a few years of high unemployment, inflation receded. 

Most economists attribute these developments to Fed policy under the sainted Paul Volcker. Scott could say that this was exhibit A for monetary dominance. The economic consensus may be right, but I would raise the possibility that the financial markets were the main drivers.

The price of goods (CPI) the price of foreign currency (E) are two ways of measuring the value of money (actually its inverse.) Here Arnold is saying that monetary policy did not make the dollar strong, a stronger dollar (exchange rate) made the dollar stronger (purchasing power). OK, but the two most plausible theories for the strong dollar were tight money and fiscal deficits. Obviously, Arnold is not saying that big fiscal deficits brought inflation down in the 1980s.

Exhibit A? Volcker was perhaps Exhibit J for monetary dominance; there are so many other examples that one hardly knows where to begin. Remember LBJ raising taxes and pushing the budget into surplus in 1968 in order to bring down inflation? How’d that work out? Budget deficits were pretty low in the 1970s, as a share of GDP. What happened to inflation? Then inflation fell as Reagan pushed the deficit much higher. A big reduction in the budget deficit from $1061 billion in calendar 2012 to $561 in calendar 2013 should have slowed the economy according to the fiscal dominance theory. Instead NGDP growth sped up in 2013. Then the deficit ballooned to a trillion dollars in 2019, and yet inflation stayed below 2%.

Overseas you find the same thing. Japan runs some of the biggest fiscal deficits ever seen in peacetime from the mid-1990s to 2013 and both the price level and NGDP actually fell. Then a new government switched to fiscal austerity and monetary stimulus, and NGDP begins rising (albeit still too slowly.)

Sorry, but fiscal dominance is not remotely plausible, at least with positive interest rates and an independent central bank.

Almost every major school of thought—monetarist, Keynesian, and Austrian, etc.—believe that monetary policy has a major impact on nominal variables. The financial markets respond to monetary policy announcements as if they are extremely important, often adding or destroying hundreds of billions of dollars in wealth within seconds. The history of economics is full of examples of monetary dominance over fiscal policy. Basic theory predicts that a $100 bill is not identical to a T-bill yielding 2% interest; otherwise they’d have the same yield. If Arnold Kling and the MMTers want to convince the me, the rest of the profession, and the financial markets that open market operations don’t matter when interest rates are positive, they are going to need something better than dubious thought experiments about the substitutability of cash and T-bills.

No hay esperanza

There’s a country of 130 million people on America’s southern border—one of our largest trading partners. Interestingly, Americans pay almost no attention to what’s going on in Mexico. How many could even name its leader? Indeed, how many Americans with PhDs could name its leader? I’ll bet more people could name Canada’s leader. Even I couldn’t remember Amlo’s formal name when I sat down to write this post. Here are some facts about him:

1. Andrés Manuel López Obrador was defeated in presidential elections in 2006 and 2012, and then claimed the elections were stolen from him.

Sound familiar?

2. In 2018, he campaigned on revising the NAFTA treaty, and did so after being elected.

Sound familiar?

3. He toughened his southern border to prevent illegal migration.

Sound familiar?

4. He tried to push Mexico away from clean energy sources, and back to fossil fuels:

The government has ended auctions to bring on more renewable projects. It tried to halt the final testing needed for new clean energy plants to come online. And President Andres Manuel Lopez Obrador and his allies are pushing through legislation that would effectively kill existing renewable investments by favoring more expensive and dirtier energy sources. Combined with Mexico’s backsliding on its Paris Accord commitments, such measures will make Mexico a pariah among its more environmentally focused peers. And carbon-based taxes on imports in many markets — starting with Europe — could erode if not end Mexico’s manufacturing advantages. 

Sound familiar?

5. He made almost no effort to control Covid, and Mexico ended up being hit especially hard.

Sound familiar?

6. He campaigned against corruption, and then his office tried to prevent any oversight of corruption in his government:

One scandal featured the president’s wife and a $7 million mansion built by a top government contractor. Another involved the misuse of federal AIDS funds to buy Cartier pens and women’s underwear. Then there was the “Master Fraud,” in which $400 million flowed between 11 government agencies, eight universities and dozens of phony companies — with half disappearing.

Each of the cases was exposed thanks to Mexico’s freedom of information system, often ranked among the world’s most effective. Created in 2002, it has allowed journalists and researchers to wrest documents from a government long known for opacity.

The system has been “one of the most important democratic advances in Mexico” since the end of one-party rule in 2000, said Roberto Rock, a journalist who lobbied for its creation.

Now, President Andrés Manuel López Obrador wants to rein in the National Institute for Access to Information, or INAI, the independent body that runs the system. He says it’s expensive and has failed to end corruption.

Sound familiar?

He’s also not exactly a strong proponent of the MeToo movement.

Obrador is a man of “the left” and Trump is on “the right”, two terms that once had actual significance, but no longer have any coherent meaning in the 21st century.

Obrador was the great hope for the Mexican left for several decades. Then he was finally elected. Why isn’t his administration being widely celebrated? Why does no one seem to even care? Has everyone given up all hope for the future?

Remember when Daniel Ortega was viewed by Reagan as a communist threat in Nicaragua? He’s morphed from atheist left-winger to conservative Christian pro-business corrupt Trumpian presidente-for-life.

I never liked the left, but I do miss the time when people still had hope for the future, however misguided. Now everyone, even on the left, knows that it’s all just dirty politics. Now there’s no hope for the future.

Welcome to the 21st century!

Focus on the target, not the instrument

This tweet caught my eye:

While rising three-year yields might represent a lack of commitment on the Fed’s part, rising interest rates are equally consistent with bond market participants now becoming more optimistic about the economy. This might well be good news.

Interest rates are only a means to an end; the only credibility that matters is the Fed’s 2% AIT.

Lael Brainard on monetary policy and employment

Joe Weisenthal directed me to a recent speech by Lael Brainard. Here’s one excerpt:

The new framework calls for monetary policy to seek to eliminate shortfalls of employment from its maximum level, in contrast to the previous approach that called for policy to minimize deviations when employment is too high as well as too low. The new framework also defines the maximum level of employment as a broad-based and inclusive goal assessed through a wide range of indicators.

Some pundits regard this as a significant change, perhaps indicating that the Fed will stop being so mean to workers looking for jobs. While I don’t oppose the change, I don’t see much difference from previous policy.

This is a really complicated issue with lots of moving parts and lots of subtle distinctions. So here are some of the tools I will work with:

  1. The Plucking model. The business cycle is mostly (not entirely) shortfalls from full employment, not symmetrical deviations around a natural rate of unemployment.
  2. The Natural Rate Hypothesis predicts that (for positive inflation rates) employment does not depend on the average rate of inflation. In the long run, workers adjust to changes in the expected rate of inflation, and hence money is roughly super-neutral in the long run.
  3. The Fed erred in raising rates 9 times during 2015-18, as it relied too heavily on highly flawed Phillips Curve models of the economy. As a result, inflation has averaged less than 2% over the past decade.
  4. The Fed recently switched to average inflation targeting (AIT), which will cause inflation to average roughly 2% in the years ahead.
  5. Under AIT, there is no such thing as hawks and doves.

If you combine the first two points, then the implication is that a Fed policy that minimizes shortfalls in employment is basically the same as a Fed policy that minimizes deviations in employment. After all, the only long run equilibrium in the labor market is full employment, according to the natural rate hypothesis.

[Note: A permanent and unchanging 40% unemployment rate caused by a $35/hour minimum wage is “full employment” as defined by macroeconomists]

The existence of a 2% AIT means we’ve moved beyond hawks and doves; all future disputes will be about fluctuations in inflation and employment, not the average rate of inflation.

That doesn’t mean there is nothing new at the Fed:

For nearly four decades, monetary policy was guided by a strong presumption that accommodation should be reduced preemptively when the unemployment rate nears its normal rate in anticipation that high inflation would otherwise soon follow. But changes in economic relationships over the past decade have led trend inflation to run persistently somewhat below target and inflation to be relatively insensitive to resource utilization. With these changes, our new monetary policy framework recognizes that removing accommodation preemptively as headline unemployment reaches low levels in anticipation of inflationary pressures that may not materialize may result in an unwarranted loss of opportunity for many Americans. It may curtail progress for racial and ethnic groups that have faced systemic challenges in the labor force, which is particularly salient in light of recent research indicating that additional labor market tightening is especially beneficial for these groups when it occurs in already tight labor markets, compared with earlier in the labor market cycle.33 Instead, the shortfalls approach means that the labor market will be able to continue to improve absent high inflationary pressures or an unmooring of inflation expectations to the upside.

The phrase “changes in economic relationships” is a polite way of saying the Fed screwed up in 2015-18 and tightened too soon because they relied on flawed Phillips Curve “economic relationships”. They learned a lesson and promise not to do so again. But despite all the woke window dressing about jobs for minorities, this isn’t really about jobs at all, it’s about achieving their target. The mistake made during 2015-18 was a mistake whether you focus on employment shortfalls or employment deviations.

So what does the Fed’s dual mandate mean today? Roughly this:

We promise to deliver 2% PCE inflation on average, and allow modest fluctuations around that average only to the extent that those fluctuations reduce employment shortfalls. As a practical matter, reducing employment shortfalls means keeping employment close to the natural rate, which implies also reducing employment deviations.

AIT really is new—and an improvement. The increased awareness of the unreliability of Phillips Curve models really is new—and an improvement.

The talk about employment is just a bunch of pretty words. Not that there’s anything wrong with pretty words, if they help to provide political cover for AIT and moving on from Phillips Curve models.

Middlebrow science

When I studied economics at Chicago in the 1970s, I was taught that the FDA was a highly flawed institution, which was structured in such a way as to avoid errors of commission at all costs and not worry so much about errors of omission, even if 100 times more consequential. That’s the system, and we’ve known it for 50 years. The current vaccine fiasco was entirely predictable. This isn’t “Monday morning quarterbacking”.

I presume that FDA officials are decent people, but they are embedded in a bureaucracy that operates with a really bad set of incentives. The solution is not to replace one FDA bureaucrat with another, it’s to take government out the the process of deciding what vaccines are acceptable, who gets them first, and at what price.

Alex Tabarrok recently posted some excellent comments on the vaccine fiasco. Here’s Sure:

The likelihood ratios for RCTs and approval mechanisms are powerful. But we are talking thousands of deaths per day. The odds that these tests will remotely alter management decisions is nil. It is malpractice to delay life saving treatment on tests exceedingly unlikely to change management decisions.

And remember the UK is not seeing horrid outcomes for doing this for a while now. A lot of theoretical failure mechanisms are now off the table.

Science is wholly about building a reliable model that accurately predicts future outcomes of current actions. While doing the actual experiment is the gold standard for knowledge acquisition, it is not the only option and in cases like this pandemic is not sufficiently better than past data to merit waiting.

As far as the regulators. I work with some of them directly. They are not overburdened to anywhere near the degree that the frontline clinicians have been hit. When I ask them to explain their cost benefit calculations, they have none. Not I cannot follow them. Not I disagree with them. They have done not an iota of math to justify their course of action.

Sorry, but I believe in evidence based medicine, not eminence based medicine. If you as a regulator cannot explain to me in technical terms the math behind your decision process, even if only back of the envelope, you are not worth putting in charge.

Approve all the vaccines, FDF, fractional dosing trials, and first dose followed by variolation trials should all be done now.

Here’s Tom Meadowcroft:

Scientific researchers search for the truth. Medical clinicians use limited data balance cost and benefits in the face of uncertainty to save the most lives.

When searching for the truth, it is important to have high standards of statistical significance, integrity, and patience, because credibility and a reputation for integrity is everything. Every academic knows that a retracted paper or an accusation of playing fast and loose with statistics can be the death knell for a career. As a result it is prudent to be very certain before publishing. Public health officials, particularly those in charge of approving vaccines, dread the possibility that a vaccine that will be given to millions of healthy people, often children, to prevent diseases where death is rare, which could harbor some flaw that causes a hundred avoidable deaths; they seek the highest standards of proof of safety and efficacy before approving such a vaccine.

But a pandemic is not a search for truth, and a COVID vaccine administered in the midst of a pandemic is very different than a measles vaccine administered to 2-year-olds. The pandemic makes these decisions for FDF or for vaccine approvals into clinical decisions, where health professionals should be balancing the certain benefit of reducing the thousands of daily deaths against the uncertain cost of the possibilities of harmful side-effects and uncertain details of efficacy (when does immunity kick in, how long does it last, how valuable is a booster) that additional months of testing and trials would reveal more clearly.

Public health researchers, academics for the most part, lack the ability (and courage) to make the sort of cost/benefit analysis with necessarily limited data that clinical physicians make every day in examination rooms. Any good clinician, faced with the citizenry of a country as their patient, would have opted for FDF, the AZ vaccine, and quite likely reduced doses by the start of the year. Because we are stuck with academics and administrators as our decision makes, unable to see beyond their usual routine of searching for the truth and protecting their reputations, thousands more will die.

PS. For those of you who think we are doing fine and that Israel is an outlier, you need to add the Navajo Nation to the list of outliers:

The COVID vaccine rollout in the Navajo Nation has been highly successful, already surpassing its original goal to have administered 100,000 shots by the end of February. It’s an impressive number, given that there are an estimated 175,000 people living in the Navajo Nation. . .

As of Feb. 11, the IHS says, a total of 113,345 COVID vaccinations had been administered in the Navajo area.