This is from a paper by Gauti Eggertsson, a very distinguished New Keynesian economist:

Tax cuts can deepen a recession if the short-term nominal interest rate is zero, according to a standard New Keynesian business cycle model. An example of a contractionary tax cut is a reduction in taxes on wages. This tax cut deepens a recession because it increases deflationary pressures. Another example is a cut in capital taxes. This tax cut deepens a recession because it encourages people to save instead of spend at a time when more spending is needed.

Elsewhere he showed that in a deep depression, the NK model suggested that artificial attempts to raise wages, such as FDR’s NIRA, could be expansionary.

Several economists have recently suggested that the NK model has NeoFisherian implications. If the Fed were to raise its fed funds target, the policy shift would be inflationary.

Nick Rowe shows that the NK model implies that a slowdown in the rate of government spending growth is expansionary.

To summarize:

1.  The NK model implies that higher taxes on wages can be expansionary.

2.  The NK model implies that higher capital gains taxes can be expansionary

3.  The NK model implies that raising the aggregate wage level by government fiat can be expansionary.

4.  The NK model implies that an increase in the fed funds target can be expansionary.

5.  The NK model implies that fiscal austerity can be expansionary, if done by slowing the growth in government spending.

These are claims made by NK supporters, NK opponents, and people in the middle. And what they all have in common is that they suggest that the NK model has preposterous implications.  These claims about the world aren’t just wrong, they are borderline absurd.  I’ve studied macroeconomics all my life, both the Great Depression and the post-1970 period.  I’ve seen hundreds of natural (policy) experiments, and watched how both markets and the broader economy reacted to those natural experiments.  And if these claims are true then I might as well stop being an economist, because it would mean I understand nothing about the world, absolutely nothing.

Perhaps merely to keep my sanity, I prefer to find another model, which doesn’t yield one preposterous result after another.  Here’s the best I can do:

The Musical Chairs model:

1.  In the short run, employment fluctuations are driven by variations in the NGDP/Wage ratio.

2.  Monetary policy drives NGDP, by influencing the supply and demand for base money.

3.  Nominal wages are sticky in the short run, and hence NGDP shocks cause variations in employment in the same direction.

4.  In the long run, wages are flexible and adjust to changes in NGDP. Unemployment returns to the natural rate (currently about 5% in the US.)

This models seems to fit the stylized facts quite well:

In my model, artificial attempts to raise wages are contractionary, because they reduce NGDP/W.

In my model, higher wage taxes are contractionary, because they reduce NGDP/W (“W” is actually hourly labor costs for firms, including employer-side taxes and benefits.)

In my model, capital gains taxes have little impact on employment.

In my model, increases in the fed funds target are achieved via decreases in the base. This reduces NGDP, and thus NGDP/W, and therefore is contractionary.

In my model, a decrease in the growth rate of government spending doesn’t effect employment.

So in all five cases where the NK model has loony implications, my model has implications that are more consistent with what we know about how the world actually works.

Oh, and one other thing, the NK model has enormous academic prestige, whereas my model is ignored, or dismissed as non-rigorous.

I am quite certain that my model will not win out in the long run; it’s too crude. (Even I could do better.)  But I’m equally certain that the NK model can’t survive in its current form.  It’s time to blow it up, and start over with a completely different framework. Preferably a model that doesn’t focus on inflation, interest rates and output, but rather NGDP, nominal wages, and employment.

PS.  I have a new post at Econlog; metaphors run wild.

The Neo-Fisherian debate continues, and continues to miss the point.  The debate is framed in terms of whether a higher interest rate causes higher inflation.  But that’s not even a question.  Or at least it’s meaningless unless you explain whether the higher interest rate is produced by an expansionary monetary policy or a contractionary monetary policy. Central banks have the tools to do it either way.  On the other hand I am increasingly getting the impression that the New Keynesian model is incapable of handling that distinction.  Here’s John Cochrane responding to a recent Woodford talk on the issue:

This is a particularly important voice, as it seemed to me that standard New-Keynesian models produce the new-Fisherian result. i = r + Epi is a steady state in all models. In old-Keynesian models, it was an unstable steady state, so an interest rate peg leads to explosive inflation or deflation. But in new-Keynesian models, an interest rate peg is the stable/indeterminate case. There are too many equilibria, but if you raise interest rates, inflation always ends up rising to meet the higher interest rate.

What I can glean from the slides is that Garcia Schmidt and Woodford agree: Yes, this is what happens in rational expectations or perfect foresight versions of the new-Keynesian model. But if you add learning mechanisms, it goes away.

My first reaction is relief — if Woodford says it is a prediction of the standard perfect foresight / rational expectations version, that means I didn’t screw up somewhere. And if one has to resort to learning and non-rational expectations to get rid of a result, the battle is half won.

But that’s only preliminary relief. Schmidt and Woodford promise a paper soon, which will undoubtedly be well crafted and challenging.

If that’s true, then the NK model is obviously very, very flawed.  Noah Smith seems to agree that rational expectations is the key assumption:

The question of whether interest rates affect inflation in a Woodfordian way or a Neo-Fisherian way depends on whether people’s expectations are infinitely rational. Woodford’s new idea – which will certainly be a working paper soon – is that people don’t adjust their expectations to infinite order. He essentially puts bounded rationality into macro. He posits a rule by which expectations converge to rational expectations.

I have one small quibble here.  When Smith writes:

The question of whether interest rates affect inflation in a Woodfordian way or a Neo-Fisherian way depends on whether people’s expectations are infinitely rational.

He seems to imply that he is discussing the real world.  Like it would actually matter whether people had ratex. My hunch is that you can easily get either result with or without ratex, if you don’t restrict yourself to the NK model.  The liquidity effect from easy money should be able to be derived with simple sticky prices, even with ratex.  I’d rather Smith had said:

The question of whether interest rates affect inflation in a Woodfordian way or a Neo-Fisherian way in the NK model depends on whether people’s expectations are infinitely rational.

BTW, in this post I showed how you could get a Neo-Fisherian result.  That doesn’t mean I think they are “right”, just the opposite.  But I am increasingly confident that they have stumbled on something important, a serious flaw in the NK model. I’d rather people continue to assume rational expectations, and fix the model in some other way—like defining monetary policy in terms of something other than interest rates.  Stop assuming that “the central bank raises interest rates” is a meaningful statement.  It isn’t.

PS.  I wrote this a couple days ago but wasn’t sure if I was missing something, so I didn’t post until today.  Nick Rowe’s new post convinced me that I’m not missing something obvious.

HT:  Tyler Cowen

Jason Smith has a post that points to a very interesting fact about 2013—federal revenue from asset sales soared, primarily due to dividend payments by Fannie Mae and Freddie Mac.  By my calculations the revenue from asset sales increased by about $111 billion, from $53.6 billion in 2012 to $164.7 billion in 2013.  This is certainly a non-trivial portion of the $500 billion in deficit reduction that occurred during 2013, and in my view offers a far better argument than pointing to things like state and local government (which is just as endogenous to the Federal government as private investment.)

I don’t claim to understand the Keynesian model, so I won’t even pretend to comment on the importance of these payments.  Until recently I thought Keynesians viewed deficit reduction done via reduced transfers and higher taxes as being “contractionary.”  You know, the sort of austerity that you see in Greece.  Now I’m not so sure what they think. FWIW, at the time Matt Yglesias thought these GSE dividends were a contractionary “disaster.”

In normal times, government coffers filled with dividends would be good because they could be put to some use. The government could spend that money on building Hyperloops or repairing schools or vaccinating children. Alternatively, the government could do the exact same things it was doing before, but reduce taxes and put more money in working peoples’ hands. But that would require a functioning political system. Today’s gridlocked Congress isn’t doing anything with the money.

Still, under ordinary circumstances the reduced government borrowing that results from a dividend windfall could be useful. A smaller deficit often allows the Federal Reserve to run lower interest rates without sparking inflation. That makes it easier for people to buy houses or for firms to invest in new production. Today, though, the Fed’s preferred measure of inflation is running at its second-lowest level on record, even though short-term interest rates have been at zero for years now.

So the Treasury is earning tons of Fannie/Freddie money. But the profits aren’t letting us spend more, they aren’t letting us tax less, and they aren’t freeing up private investment capital either. They’re doing nothing. It’s as if the money were sitting around as cash in a storage locker somewhere.

Recently I see some positive signs of consensus.  Back in 2012 there seemed to be a huge split between the “deficit scolds” who insisted that we shrink the budget deficit, and Keynesians who suggested that it was a nutty idea.  At the time, I was under the misapprehension that many Keynesians thought a massive and sudden reduction in the federal budget deficit would constitute “austerity” and hence would slow growth.  Now that the dust has settled, we can calmly look at the data:

Calendar 2012:  Budget deficit = $1061 billion

Calendar 2013:  Budget deficit = $561 billion

A reduction of $500 billion in one year.  I used to be under the impression that Keynesians thought this would be a disastrous policy that sharply slowed growth. I’m now happy to report that I was wrong. (Who says I never admit I was wrong?) The new, new, new Keynesian consensus seems to be that the deficit reduction shown above does not constitute the sort of austerity that would be expected to slow growth.

I was under the impression that massive tax increases and cuts in transfer spending were contractionary.  Now I’m happy to report than only cuts in government consumption seem to count.  (Has Christina Romer been informed yet?)

So we have a new consensus, which spans the ideological spectrum.  Yes, Federal government officials, go ahead and slash the budget deficit by $500 billion in a single year by raising taxes and cutting spending.  Just don’t touch government consumption.  It’s OK, it won’t slow growth.  Who says economists can never agree on anything?

PS.  This post could be interpreted straightforwardly or sarcastically.  You might be surprised to know that even though I wrote the post, I don’t know which interpretation is correct.  Really.  I honestly don’t know what Keynesians think of the $500 billion in deficit reduction, mostly accomplished through taxes and transfers.  I welcome Keynesian commenters who will educate me on this point.  (I.e., if they really don’t think 2013 was austerity that would slow growth, then we really are achieving a consensus, no sarcasm intended.  It makes deficit reduction much easier.)

I recently ran across a very revealing article from April 24, 2012:

NEW YORK, April 24 (Reuters) – Federal Reserve policymakers are sounding the alarm over a “fiscal cliff” at the end of this year, when scheduled U.S. tax hikes and spending cuts could pose a big threat to the fragile economic recovery.

Along with its official mandate of watching unemployment and inflation, the U.S. central bank is keeping a close eye on a potentially debilitating political fight over how to fix the budget deficit.

If lawmakers in Washington do not get rid of the tax hikes and spending cuts due to take effect in early 2013, the country could easily careen into another recession. Any moves by Congress, however, aren’t expected until after the Nov. 6 presidential election.

The Fed is worried that individuals and companies could hunker down and curb spending, making markets antsy as the country awaits the outcome of an election that could pave the way for new tax and spending policies.

Though few expect Washington to do nothing while fiscal policies push the economy into another downturn, partisan politics could undermine the Fed’s unprecedented actions to revive the economy.

“I have been disappointed that the president and Congress are not taking action until after the election,” St. Louis Fed President James Bullard told reporters in Utah last week.

“I’m also worried that markets will react badly to the fiscal cliff at the end of this year. Markets might start to speculate about what might or might not happen … after the election,” he said.

Asked what the Fed can do, however, Bullard seemed to dismiss the possibility of resorting to new bond buying to counter the effects of political gridlock over the budget deficit and economic policy.

“It’s up to the Congress,” he said.

By the end of 2012, it was pretty clear that fiscal policy would sharply tighten in 2013. The Fed responded with QE3 and some additional forward guidance.  Bullard was so confident that these steps would offset the fiscal guidance that he forecast an acceleration of RGDP growth in 2013, to around 3% to 3.5%.  Actual RGDP growth (Q4 to Q4) turned out to be about 3.1%. So we have a nice example of monetary offset, with a happy ending.

But notice something strange at the end of the long quote; Bullard seems to be warning Congress not to expect the Fed to bail them out if the send the economy into a recession with reckless fiscal austerity.

When I was young I got a nice job offer from the New York Fed, at a salary 75% higher than my Bentley salary.  My department chair took the offer to the Dean, who responded, “Tell him I hope he likes New York.”  In the end I stayed at Bentley. (Feel free to insert dog retreating, tail between legs metaphor here.)  I learned a lesson, and indeed not once have I ever told my daughter “If I catch you smoking pot you can forget about me paying for your college education.”  My threats aren’t credible, due to the time inconsistency problem.

Matt Yglesias once wrote a post pointing out that the Fed denies that it engages in monetary offset:

A curious issue that in my opinion he and other proponents of the full monetary offset thesis haven’t fully grappled with is that Federal Reserve officials keep saying it’s not true. I heard John Williams of the San Francisco Fed say it’s not true at the Brookings event this morning. I heard Ben Bernanke say it’s not true at the American Economics Association meeting in Philadelphia earlier this month. I separately heard William Dudley of the New York Fed say it’s not true in Philadelphia. Janet Yellen has repeatedly said it’s not true. And since full monetary offset isn’t just an abstract economic thesis, it’s specifically a thesis about the actual behavior of the Federal Reserve, the fact that nobody in a position of authority at the Fed believes in it seems like a big problem worthy of a more substantive response.

You find lots of counterarguments in this post, written in response to Matt’s post. That post is my best counterargument. But I’d add this post as a footnote, as it shows how statements by Fed officials regarding their intentions may not accurately describe the Fed’s actual future policy response, but rather may reflect a desire to get Congress to do more of the heavy lifting.

That’s not to say that Matt’s completely wrong, indeed his views are actually about halfway between my view and the views of more traditional Keynesians.  Here’s the very next paragraph of the Yglesias post:

What I think clearly is true is that partial monetary offset is very real. The people who thought the tight fiscal policy of 2013 would crush the economy were wrong, and they were proven wrong precisely because of monetary offset.

That’s a reasonable argument, and if my version of monetary offset were proved wrong at some later date, Yglesias’s view would be the alternative that I’d find most plausible.  But thus far the data seem to support something close to full offset—both the 2013 case of austerity in the US, and the cross sectional study by Mark Sadowski.  Of course “further research is needed.”

PS.  Here’s a perceptive observation from the April 2012 article:

“We’re naive if we think that [fiscal cliff] doesn’t play into the Fed’s thinking about monetary policy,” said Tom Porcelli, chief U.S. economist at RBC Capital Markets in New York.

“But the way that the Fed would want to present it is a minor consideration at best, because they don’t want to be supplementing fiscal policy,” Porcelli said.

Porcelli clearly gets it, although the term ‘supplementing’ doesn’t really capture the idea he’s trying to express.  He should have said, “offsetting.”

PPS.  I have a new post on the euro over at Econlog.