Expectations traps: They’re even more applicable to fiscal policy
Tyler Cowen links to this post from Mark Thoma:
As for Tyler’s (and others’) call for monetary policy instead of fiscal policy, here’s the problem. It relies upon changing expectations of future inflation (which changes the real interest rate). You have to get people to believe that the Fed will actually be willing to create inflation in the future when it comes time to do so. However, it’s unlikely that it will be optimal for the Fed to cause inflation when the time comes. Because of that, the best policy is to promise that you’ll create inflation, then renege on the promise when it comes time to follow through. Since people know that, and expect the Fed will not actually carry through, it’s hard to get them to change their expectations now. All that credibility the Fed has built up and protected concerning their inflation fighting credentials works against them here.
Paul Krugman developed the idea of an expectations trap as a way of explaining the dilemma faced by the Bank of Japan. Except there is just one problem. Almost everyone agrees that Japan does not face an expectations trap. They can devalue the yen whenever they wish, as much as they wish. Some claim they would not be able to do this because there would be too much resistance from their trading partners. There are two problems with this argument. First, even if true, why would they have recently allowed the yen to rise from 115 to the dollar to 90 to the dollar in the midst of deflation? Surely if they had simply kept it at 115, they would not have attracted much attention. But even if I am wrong, the expectations trap argument is still wrong. If the problem was foreign pressure; that would have also precluded BOJ attempts to spur the economy through open market purchases. After all, if Japan truly can’t depreciate its currency, then logically it could not do any policy action that would cause its currency to depreciate. And of course any credible and effective policy of open market purchases will cause a currency to depreciate. So even in that case, it wouldn’t be an expectations trap, it would be a case where the big bad Westerners are forcing Japan into a policy of deflation. It would be a “bully trap.”
But here’s the bigger flaw with the whole expectations trap argument. People think it applies to monetary policy, but they forget it applies equally to fiscal policy. (Indeed I never realized this until today.) Here’s why. Krugman’s model relies on rational expectations, indeed you can’t get the expectations trap without ratex. But if you have ratex in your model, then no policy can work unless it is expected to work. That’s why ratex should actually be called “consistent expectations.” What you are really assuming is not that that people are “rational” (which is pretty much a meaningless term anyway), but rather that their expectations are consistent with the predictions of the model. So if monetary policy is aimed at boosting nominal spending by 10%; it will only “work” in a ratex model if it is expected to boost nominal spending by 10%. But that’s equally true of a fiscal policy aimed at boosting nominal spending by 10%. It won’t work unless it is expected to work.
So why do people think this applies to monetary policy but not fiscal policy? Because they visualize the transmission mechanisms in vastly different ways. Most Keynesians (wrongly) think monetary policy is all about getting lower real interest rates. In fact, it’s been shown that a highly effective monetary policy might lead to such bullish real growth expectations that real interest rates rise. The real problem is linking current and future aggregate demand. Woodford showed that it’s hard to boost current AD unless expected future AD also rises. Think of this in terms of a price level target. It’s hard to get current prices to rise unless future expected prices also rise. But that will only occur if future expected monetary policy becomes more expansionary.
[If this is confusing think of a micro analogy. If the government decides to pump up copper prices by buying massive quantities of copper, the policy will be almost totally ineffective if the government is expected to give up on the policy and sell off its copper hoards in 6 weeks. Why would buyers stock up on copper today at $5 a pound, if they expected copper to sell for $3 a pound in 6 weeks?]
For some reason people don’t worry about this problem with fiscal policy; and the reason is very odd. Perhaps without knowing it, people tend to assume that future monetary policymakers would be expected to sabotage current monetary policymakers, but would not be expected to sabotage current fiscal policymakers. This is a rather odd assumption, as you’d expect that future monetary policymakers have more respect for current monetary policymakers than they do for the bozos in Congress. After all, given the very long terms served by Greenspan (and now apparently Bernanke) the future and current monetary policymakers are often the very same person. Is future Mr. Bernanke expected to differ from current Mr. Bernanke, by more than future Mr. Bernanke differs from the current Congress?
Here’s one way to think about this issue. The future Fed is considered the last mover in this game. The current Fed can do QE, and the future Fed can undo QE. Or the future Fed can raise rates sooner than expected, or by more than expected. But that’s also true of fiscal policy. The Congress can pass a bill to spend more money, and the Fed can raise rates right afterward if they think inflation is going to exceed their target. I’m not saying that’s likely, but I also don’t think it’s likely that the future Mr. Bernanke would try to sabotage the current Mr. Bernanke if the current Bernanke publicly announced “We need to get core inflation back up to the trend line of 2% extending out from September 2008, and will do whatever it takes.” Why would the future Mr. Bernanke try to sabotage the current Mr. Bernanke, if he made that promise publicly and explicitly? After all, if he did so he would make both Bernankes look like fools in the history books.
So please don’t take this post the wrong way. When I say that the expectations trap is equally applicable to fiscal policy, I’m not saying that I think the Fed is likely to go out of its way to sabotage fiscal policy. But it is even less likely to sabotage monetary policy, indeed the latter hypothesis seems much more far-fetched to me.
Over in the comment section for an intriguing post in Nick Rowe’s blog I asked: When in the entire history of the universe has a central bank explicitly tried to create inflation and failed? Until someone can answer that question, I’ll keep assuming that it’s really easy to get inflation. And also that the reason monetary policy seems to have so much trouble generating inflation at the zero rate is because monetary policymakers don’t want inflation, and go out of their way to say they are opposed to inflation. Indeed they are even opposed to inflation that merely would bring us back to the implicit target trend line for the core CPI (which we have fallen below.)
PS. A couple quick comments on the Tyler Cowen post I linked to. I completely agree that real interest rates are less important than many people believe. I look forward to his future post on this. As far as uncertainty, I think we might be looking at the same concept from a different angle. Suppose Walmart is thinking about building 75 new stores in America next year. And suppose NGDP is currently $20 trillion and expected to be $21 trillion next year. If Walmart is certain it will be $21 trillion, they are more likely to make irreversible investments than if there is a 50% chance it will be $20 trillion and a 50% chance it will be $22 trillion. I understand that businessmen don’t use terms like “NGDP,” but when they are considering “how business will be next year” they are implicitly thinking about some sort of aggregate for total spending. So I agree that uncertainty hurts investment. Where I suspect we disagree is that I think an enormous amount of this aggregate uncertainty comes from not having a clue as to where NGDP is going over time. From 1984 to 2007 we could be pretty confident that aggregate “business” next year would 5% more than business this year, plus or minus a couple percent. Starting in 2008 things got vastly more uncertain. I blame the Fed.