Look! The economy’s sinking! Someone should do something!

Ben Bernanke doesn’t think the economy needs any more monetary stimulus, even though many types of monetary stimulus are essentially costless.  Oddly, however, Bernanke does seem to think we need fiscal stimulus, even though fiscal stimulus is extremely costly, imposing huge dead-weight costs on the economy from future tax increases:

Federal Reserve chief Ben Bernanke told Congress on Thursday that the economy needs continued government stimulus spending to strengthen the recovery and reduce unemployment. But more stimulus spending would be a tough sell with congressional Republicans, who say the first round hasn’t helped enough.

This has never made any sense to me.  In the comment section of a recent post, Andy Harless provided the most plausible explanation that I have seen thus far:

Under today’s circumstances, fiscal policy is more precise than monetary policy. (It’s easy to get a vaguely reasonable estimate of the effect of a fiscal policy move, e.g. extending unemployment benefits, on AD. Much harder to estimate the effect of, say, a $200 billion purchase of 5-year T-notes by the Fed.) I think this is somehow related to the conception that most people seem to have that fiscal policy affects real output and monetary policy affects the price level. I’m not sure exactly how.

The term ‘today’s circumstances’ refers to the current monetary base setting and near-zero interest rates.  Harless is arguing that this fulfills the “other things equal” assumption required to get relatively accurate fiscal stimulus multiplier estimates.  Elsewhere I have criticized that view, noting that Fed signals about future policy intentions (exit strategies, etc) are its most powerful tool.  But as this is a minority view, I’d like to focus on some other issues.

1.  The first thing I’d say is that if the Fed believes it doesn’t have any precise tools to use, then it has no one but itself to blame.  In 1988 or 1989 I presented a paper at the New York Fed advocating the targeting of NGDP futures.  The audience assured me that the Fed already had all the tools it needed to target NGDP, and didn’t need any help from futures markets.  So how’s their interest rate targeting working out now?  Even worse, if you run out of interest rate “ammunition,” you’d presumably want to turn to QE.  Unfortunately the Fed began paying interest on reserves in October 2008, which essentially sterilized the effects of QE.  The Fed is like someone who puts on boxing gloves, and then complains that they are having trouble sewing on a button.  Take off your gloves!

2.  The Fed definitely needs to move toward level targeting, and give up on the inflation targeting approach, which has obviously failed.  Under level targeting the economy is much less likely to overshoot toward high inflation, because commodity speculators will know that if inflation rises above target, tight money will later bring it back down to the target.  Even better, since markets are forward-looking, the mere expectation of future corrective action will make overshooting much less likely (as with a credible currency peg.)

3.  But even if the Fed sticks with inflation targeting, they ought to be able to prevent overshooting.  I think many economists are still over-reacting to a very painful episode in American monetary history, 1965-1981.  As you may recall (if you are an old guy like me), the economics profession was continually surprised by unexpected increases in inflation during that period, as the trend rate rose from about 1% to over 10%.  But there are two very good reasons why that won’t happen today.  Unlike during 1965-81, we have TIPS markets which allow us to measure inflation expectations in real time.  And second, the Fed has a much greater understanding of the risks associated with letting inflation expectations drift to higher levels.

You may ask why I focus on inflation expectations, and not inflation.  After all, market expectations can be wrong.  It turns out that it isn’t just me; the Fed also focuses on inflation expectations.  The reason is that transitory movements in actual inflation, which don’t get embedded into expectations, are not very harmful to the economy.  For instance, inflation might rise temporarily because of an oil shock.  But if inflation expectations don’t rise then the temporary rise in actual inflation won’t become embedded in core inflation and wages (which respond to inflation expectations.)

If inflation starts to creep up to unacceptable levels the Fed can raise rates.  There is nothing equivalent to the zero rate bound on the high side.  And the mere fact that markets know the Fed can do this will tend to keep inflation expectations well anchored.  Of course all of this would be much easier if the Fed came up with an explicit price level, or better yet, an NGDP target.

Since I’ve responded to Harless’s comment, I’ll give him the last word.  In a different post’s comment section he expressed skepticism about whether TIPS spreads can be counted on to accurately measure inflation expectations:

Also, it risks getting whipsawed by changes in risk/liquidity premia associated with TIPS vs. nominal bonds. (I’m guessing this might be an even bigger problem with long-horizon NGDP futures, since my impression is that futures with distant settlement dates usually have low liquidity, and I can’t see a way to do NGDP futures with a settlement date before the actual horizon date.)



19 Responses to “Look! The economy’s sinking! Someone should do something!”

  1. Gravatar of John Salvatier John Salvatier
    24. July 2010 at 10:43

    We should not that TIPS have low liquidity relative to other US government debt, but they’re still ultra liquid relative to most types of securities.

  2. Gravatar of Indy Indy
    24. July 2010 at 11:07

    Possibile to introduce a Divisia-style liquidity premia correction?

  3. Gravatar of Mike Sandifer Mike Sandifer
    24. July 2010 at 11:25


    In response to your statements about inflation expectations, sine expectations determine investment, of course only changes in expectations matter.

  4. Gravatar of Richard A. Richard A.
    24. July 2010 at 11:28

    What congress should do is intervene immediately to suspend the Fed’s ability to pay interest on excess reserves.

    From —
    [Bernanke] was asked during Congressional testimony about why the Fed continues to pay a 0.25 percent interest on excess bank reserves despite weak lending conditions in the economy.

    “The rationale for not going all the way to zero has been that we want the short-term money markets like the federal funds market to continue to function in a reasonable way,” he said.

    “If rates go to zero there will be no incentive for buying and selling federal funds, overnight money in the banking system and if that market shuts down … it’ll be more difficult to manage short-term interest rates.”

  5. Gravatar of Benjamin Cole Benjamin Cole
    24. July 2010 at 12:19

    I sense, in the glacial way that characterizes Washington policy-making, that the Fed and related policy groups are in fact migrating to Scott Sumner’s camp.

    There first has to be the necessary harrumphing, posturing, important (and possibly planted) columns, trial balloons, studies and search for high-minded principle to serve as platforms on which to stand.

    And, to be fair, democracy is about building consensus. You ever try to build a consensus?

    But, look at it–pundits are now talking about zero bound, deflation, and even QE. If we take deficit-spending off the table, and we get deflation and zero interest rates, there really isn’t a lot of choice but to follow Sumner.

    My guess is we get minor deflation for the rest of the year. That will set up a backdrop to allow Bernanke to move to QE. Yes, a couple years too late, you could say. On the other hand, getting any government agency to do anything novel ever is tough.

    BTW, I think we are setting up for a very interesting epoch–the era of cheap capital. It may be that if, as an investor, you want the nearly complete security of a US Treasury bill, you will have to settle for slightly negative real returns for the next 20 years or so.

    I am hopeful that cheap capital will mean a boon for business development, equities and property. There is a problem of capital searching for yield by embracing too much risk, leading to busts. See RMBS 2006-7.

  6. Gravatar of Adam Adam
    24. July 2010 at 13:41

    Scott I’m interested in your thoughts on Krugman’s recent article saying about the success of Keynesian fiscal policy in Asia

  7. Gravatar of Doc Merlin Doc Merlin
    24. July 2010 at 14:14

    ‘The term ‘today’s circumstances’ refers to the current monetary base setting and near-zero interest rates. Harless is arguing that this fulfills the “other things equal” assumption required to get relatively accurate fiscal stimulus multiplier estimates.’

    During the nineties didn’t the federal government do a negative fiscal stimulus, raising taxes and cutting spending? Rates were also very low at the time.

    Also, because of taxes on TIPS apply to both the interest and the inflation adjustment, it should always under-predict inflation. (Not that it isn’t still a useful tool!)

  8. Gravatar of scott sumner scott sumner
    24. July 2010 at 17:44

    John, Good point. And I like to constantly emphasize that even when the TIPS market was supposedly distorted in late 2008, it was still sending the right signal in retrospect; more monetary ease was needed.

    Indy, The Cleveland Fed has worked on that issue, and David Beckworth discusses their research. I don’t know much about divisia indices.

    Mike, I think I made a similar point, at least in one of my recent posts. I want to emphasize that I do believe in rational expectations, but that doesn’t mean they are always right.

    Richard, I sympathize. But in the real world if Congress starts messing around in monetary policy, the Fed can do other things to sabotage them. It could create a mess. I’d rather Congress set an explicit NGDP target, or at least a price level target, but of course that won’t happen either.

    Benjamin, Your second and third paragraphs are a very shrewd description of the political process. I wish I had written that. I’ve always thought of my blog as something that might influence others, who then might influence still others. I’ve never believed I could directly influence policy. But I’d be thrilled if I had some influence on the general policy discussion.

    Adam, Hey, I already did three posts today!. Seriously I was thinking about a post on that. I don’t think the data supports his sweeping conclusions. Korea had a massive devaluation in 2008, and elsewhere he says you can’t look at fiscal stimulus without considering the exchange rate. China’s stimulus isn’t enough bigger than Japan’s (or even the US) to make such a difference.

    Doc Merlin, I suppose the 1990s were complicated enough that different interpretations are possible. But I agree that the fiscal restraint didn’t seem to slow the economy.

    I disagree on the tax thing. Both types of bonds are taxed the same way–you must pay taxes on both the real rate and the inflation part of the interest rate. So they are comparable.

  9. Gravatar of Benjamin Cole Benjamin Cole
    24. July 2010 at 19:26

    This guy strikes me as a lulu, but he mentions the topic of QE, and says the Fed will have to do it. The word is getting out, maybe not always in the best way, but it is getting out.

    Faber Sees Fed Introducing `Massive’ Quantitative Easing: Video
    July 16 (Bloomberg) — Marc Faber, publisher of the Gloom, Boom & Doom report, says he’s “convinced” the Federal Reserve will soon implement “massive” quantitative easing policies. Bloomberg’s Sara Eisen reports. (Source: Bloomberg) (Bloomber

  10. Gravatar of Benjamin Cole Benjamin Cole
    25. July 2010 at 10:51

    And this is from The Street.com. I encourage all fans of Sumner to write positive posts on commentators discussing QE. You can also write directly to the Fed, as I have twice.

    Futile? Maybe–but a buzz can develop around a topic. This is what PR shops are hired to do, and many are effective at it.

    “Bernanke and Co. Prepare for QE2: Dave’s Daily
    By Dave Fry 07/21/10 – 06:33 PM EDT1 CommentAdd Comment

    With his senate testimony over and with another shot at it at the House Thursday, Bernanke no doubt is preparing markets for QE2 (Quantitative Easing Part 2). Trial balloons or rumors were launched yesterday noting the Fed might eliminate interest paid to banks on reserves. The idea with this is to stimulate lending. If that doesn’t do the trick in stopping a double-dip then the next sound you hear will be a massive fleet of helicopters with built-in Kinko’s.”

  11. Gravatar of Morgan Warstler Morgan Warstler
    25. July 2010 at 11:07

    My god, why are we acting like we have to sit on 0%? We just need to drive up demand for responsible borrowing. And driving up demand is EASY – if you have a ton of really cheap shit to sell.

    What? We DO have a bunch of really cheap shit to sell?

    If prices go down like Crazy Eddie, capital will get out it’s wallet and borrow aggressively. There are COUNTLESS assets the Government could be selling off dirt cheap and signaling the government will no longer be mucking around in the market. Announce that all the Social Security call centers will be privatized, and 1000 local office buildings will be sold. Privatize Federal lands, privatize roads, parking, make any Federal aid to states contingent on privatizing / outsourcing. The simple process of achieving productivity gains in the public sector, will:

    1. Improve Fiscal outlook.
    2. Improve Private technology economy – it’ll be a tech boom that makes 1999 look soft.

    And as I keep saying… liquidate the foreclosed homes underlying the toxic MBS, and the construction industry will be working overnight.

    The idea that we’ll raise rates when there’s finally an economy looking up, is just so backwards. There are two things that’s making the economy look down:

    1. A desperate attempt to keep the government working as is.
    2. Keeping housing prices up, so the banks aren’t insolvent, so they don’t suffer for their errors.

  12. Gravatar of ssumner ssumner
    25. July 2010 at 18:42

    Thanks Benjamin. Was that a quotation from street.com, or your words?

  13. Gravatar of Morgan Warstler Morgan Warstler
    25. July 2010 at 21:15

    If this doesn’t scream deflate home values and screw the bankers, what does?


    Scott, when you get right down to it, YOUR WHOLE IDEA is not letting the debt to asset value simply return to trend.

    All we need to ask is, what is the quickest way to return to 2005-2006?

    Mine is the fastest way.

  14. Gravatar of ssumner ssumner
    26. July 2010 at 09:53

    Morgan, OK, I did a housing post for you to consider.

  15. Gravatar of ssumner ssumner
    26. July 2010 at 10:46

    Morgan, BTW, the top graph must be wrong, as it makes the debt equity ratio look like 100% up until 2006. But the bottom graph says it was 40%.

  16. Gravatar of Morgan Warstler Morgan Warstler
    26. July 2010 at 12:34

    Scott, you are right and wrong, you have to click through to see the proper description top graph shows:

    1. mortgage debt
    2. 40% of value of asset (from 90 till 2005 it has always been 40%)

    “For many years, total mortgage debt consistently and reliably equalled 0.4 times the value of the US housing stock. Intuitively, this average of 0.4 makes perfect sense as every property usually has a mortgage ranging from 0 to 0.9 times its value. So in 1990, $6 trillion of housing collateral could support $2.5 trillion of mortgages, and by 2006, $23 trillion of housing collateral could support $10 trillion of mortgages. But since then, the US housing stock’s value has slumped to $16 trillion which means the amount of mortgage lending supportable by the collateral has plunged to $6 trillion. However, actual mortgage debt has remained at $10 trillion – $4 trillion too high.”

    So let me say it again:

    Let’s massively foreclose, and sell cheap homes to the guys with dry powder… we’ll even require 40% down… so every new mortgage lands right in at the .4 number.

    So each new house they buy cheap will slightly drop the overall price of homes, but the debt ratio will drop far more.

    What’s more, this really gets expectations working the right way. Fannie and Freddie eat the losses, so no more of that crap. People don’t expect to see their house value increase, and rents keep dropping, so they stop servicing phantom equity, and have MORE money to spend.

    It gives everyone brand new faith in the finance system… the more brutal it is, the more real it is… Cash carries the day. Most big banks are really insolvent.

  17. Gravatar of Scott Sumner Scott Sumner
    27. July 2010 at 06:01

    Morgan, I shouldn’t have to click through, you should tell me if it is mislabeled.

  18. Gravatar of Nathan Nathan
    27. July 2010 at 10:04


    The problem you mention regarding NGDP and the low volatility issue with distant settlement dates, is not a deal-breaker. It seems you can get around that issue by having the settlement date before the realized quarter, and then subtracting the difference and squaring it, and trading that value with more liquidity. As the settlement date looms closer, the remaining difference will be traded with increased liquidity and volatility.

    For instance: Q2-12 contract for 3.0% growth initial price $5000 in Jan ’11, in March 12′ it settles at $5500 reflecting 3.3%, a month before Q2-12 GDP is announced this contract is settled. Now for the remaining month that $500 difference is squared and the resulting contract for the remaining month is $2500 and traded until expiration prior to the announcement.

  19. Gravatar of ssumner ssumner
    28. July 2010 at 08:18

    Nathan, That sounds plausible, but I’m not a finance guy so I’ll let others work out the specifics.

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