Nick Rowe’s wall and the Great Recession

OK, I’m ready to throw in the towel.  I just made the mistake of checking Drudge.  His website is frequently shameless, but you have to admit he often picks up the zeitgeist.  All the news about the economy is dreary.  Then I looked at Bloomberg and here are the latest TIPS spreads:

5 year conventional T-bonds 1.33%,  Indexed bonds 0.08%,  TIPS spread 1.25%

10 year conventional T-bonds 2.50%, Indexed bonds 1.03%, TIPS spread 1.47%

Both have been falling like a stone.  This suggests that a sharp slowdown in NGDP growth is very likely.  Until now I’ve tried to remain an optimist, disappointed in the pace of recovery, but assuming that we were at least muddling forward.  But it is now clear that we are no longer recovering.

So let’s put this fiasco into perspective.  What can we compare it to?  As far as I know, there are four great recessions/depressions with near zero rates:

1.  The 1929-33 contraction

2.  The 1937-38 contraction

3.  Japan since 1994.

4.  The US since 2008.

The real economy did grow after 1938, but mild deflation continued.  A serious recovery only began with WWII intensifying in mid-1940.  Japan never really had a satisfactory recovery, although there were some reasonably good years such as 2003-07.  And of course the recovery from 1929-33 only began when the dollar was sharply devalued.  The bottom line is that zero interest rate malaises don’t seem to end like ordinary recessions; short of some sort of dramatic shock like dollar devaluation or World War, they seem to linger.  What can we learn from that?

Before explaining my analogy (actually Nick Rowe’s analogy) considering the following paradox:

1.  Near-zero nominal rates are always associated with economic malaise: a weak economy with deflation or disinflation.  So we don’t want near-zero rates.

2.  Lowering nominal rates below zero is impossible.

3.  Directly raising nominal rates through monetary policy is contractionary, and will make the recession/deflation worse.

So what do we do?  As you know I think there is a simple answer.  Indeed I think there are lots of simple answers (massive QE, negative IOR, explicit NGDP targeting, etc.)  But I think we need to face the fact that for some reason our monetary authorities don’t see it this way.  They view all these ideas as exceedingly risky, as exceedingly reckless, as exceedingly expansionary.

Go back and review the history.  Short of World War, the only escape from zero rate deflation was in 1933, with dollar devaluation.  Your history books never gave you any idea how controversial that was.  Think about this.  FDR basically had the Federal government take over the economy through programs like the NIRA and AAA.  They controlled almost everything.  And yet there was little objection from Wall Street.  People just went along.  But dollar devaluation was different.  It wasn’t just the conservatives who were apoplectic.  The unions were opposed.  FDR saw one top economic advisor after another resign in protest.  And these were his supporters.  The program was highly successful in raising prices (and output until the NIRA raised wages 20%), but nevertheless was the most controversial thing FDR ever did.  Even more than the Court packing.

Milton Friedman once noted that ordinary people were shocked when told that unelected Fed officials were free to simple double the money supply anytime they wished.  I think the same thing is true of changing the value of the dollar, as when FDR arbitrarily decided each dollar would be worth 60 cents (in gold terms.)  People seem OK with interest rate targeting, but anything else seems radical.  But interest rate targeting doesn’t work anymore.  So we are stuck.

Nick Rowe uses the analogy of balancing a long pole in your hand.  If you want the top to go left, you move your hand right.  By analogy, if the Fed wants inflation/growth (and long term rates) to go up, they lower the fed funds rate.  But if you bump up against a tall wall, then you may not be able to move your hand in the direction required to move the pole in the other direction.  You are stuck.  The only solution is to rely on some other method–such as directly grabbing the top of the pole.

The Fed needs to raise NGDP growth by some method other than lowering nominal rates.  It is up against the wall.  That means they need some other policy tool.  It might be the printing press (QE), negative IOR, price level or NGDP targets, dollar devaluation, etc.  But it can’t be done by manipulating the fed funds rate.  And for some reason the Fed seems paralyzed.

I guess because I have spent my whole life studying unconventional policy tools, and because I never favored interest rate targeting in the first place, these alternatives don’t seem at all scary to me.  FDR created inflation when he raised the price of gold.  And the inflation basically stopped when he stopped raising the price of gold.  Excluding WWII, no one has ever overshot toward high inflation coming out of a zero rate trap.  That’s why Krugman and I can have such serene confidence that the inflation scare-mongers will be proved wrong.  I’ve seen this movie already.  Several times.

Because deflation make rates low, and leads to cash and reserve hoarding, it makes money seem really loose when it is actually very tight.  Fed officials currently argue that money is very loose.  They are wrong, but that’s what they think.  Now we need to convince conservative central bankers, who are devoted to price stability, to take what seems like ultra-loose monetary policy, and make it far looser.  The thought makes me despair.  That’s why it is so tragic that Milton Friedman died in late 2006.  He was a voice that central bankers would listen to.  He was a respected conservative.  An inflation hawk.  Regarding the Japanese malaise, he said:

Low interest rates are generally a sign that money has been tight, as in Japan; high interest rates, that money has been easy.

.   .   .

After the U.S. experience during the Great Depression, and after inflation and rising interest rates in the 1970s and disinflation and falling interest rates in the 1980s, I thought the fallacy of identifying tight money with high interest rates and easy money with low interest rates was dead. Apparently, old fallacies never die.

That’s right Dr. Friedman, it’s just too counter-intuitive for people to accept.  And that’s precisely why we are fated to suffer through the Great Recession.  It’s a real pity.

PS.  Nick’s analogy is in the comment section of the link.

PPS.  Andy Harless has a post showing a Fed president stumbling over the interest rate paradox discussed above.



57 Responses to “Nick Rowe’s wall and the Great Recession”

  1. Gravatar of Liberal Roman Liberal Roman
    24. August 2010 at 20:13

    So, when can we realistically expect a recovery assuming no more stimulus is coming. I am thinking no earlier than in the mid-20s. That’s when the demographics might line up to give us the necessary boost in demand.

    I guess to put it another way, what else (besides war and monetary stimulus) can provide a recovery?

  2. Gravatar of scott sumner scott sumner
    24. August 2010 at 20:22

    Liberal Roman, I am still not completely pessimistic. The Fed may see the light at some point, or the stronger fundamentals here (compared with Japan) might raise the Walrasian equilibrium real rate above zero at some point (say after population growth leads to more home building.) I guess that was your point too. Were that to occur, a recovery could develop. My point is that it’s not an automatic thing, as it was during all the previous recessions during my life. We need either easy money, or luck.

  3. Gravatar of JEStevens JEStevens
    24. August 2010 at 20:41

    Could the Fed be shocked into action? Lets say the Republicans do reasonably well in the midterms, winning back the House and closing the gap in the Senate. They demand some level of austerity, and given the current public fear of the large budget deficit a decently sized bipartisan budget cutting bill is passed. Going with Cowen’s “the monetary authority moves last” idea (albeit in the complete opposite situation) do you think the Fed would act through additional QE to counteract the fall in AD that would be associated with the austerity?

    As far as I can tell there are really only three things that can happen:
    1. Bernanke reconnects with his past self and rides into the next FOMC meeting on a white horse, holding a sword high above his head and threatening any dissident Governor or regional bank president with swift decapitation should they oppose heavy additional monetary stimulus. Horse and sword optional.

    2. Bernanke and company realize that they have to do something, and engage in just enough QE/etc. to bring us back to the current sluggish levels.

    3. Bernanke and company take a mental vacation and do nothing, unemployment goes up significantly, GDP contracts sharply and markets take a pretty severe hit.

    The first of course would be the ideal, the second I suppose would be better than nothing- we’re about equally bad off but at least the deficit is somewhat lower, the third would be disastrous.

  4. Gravatar of Jon Jon
    24. August 2010 at 20:48

    Harless is wrong. If the Fed can peg a low-rate with little to no open-market activity, then the public believes that the Fed is communicating that the inflation rate will low for the period over which rates are held low.

    If you rollback the past 22 months, you’ll see that the Fed got the public to accept a 0.25 rate with almost no OMO. Ergo, the Fed communicated and the public accepted a very low interest-rate. The public also accepted the announcement that rates would remain low for an extended period of time. They accepted this with very little OMO activity.

    Now if the Fed genuinely been pumping the MB in an unsterilized fashion, the story would be different.

    Kocherlakota has the story right. The Fed has convinced the public the future holds low inflation.

    What’s wrong is his diagnosis of how this happened. The public isn’t convinced because rates are low, the public is convinced because the Fed sterilized the MB with IOR while calling that policy ‘loose’. Ergo, if that policy is ‘loose’, neutral must be tight, and tight must be a noose.

    I see no evidence that Bernanke gets this either and most of the profession seems to view 0.25 IOR as a minor step from 0.0 and roughly insignificant.

  5. Gravatar of Guy S Guy S
    24. August 2010 at 21:07


    Not sure if you are familiar with the Consumer Metrics Institute Daily Tracking series, but it’s worth a look.

  6. Gravatar of Liberal Roman Liberal Roman
    24. August 2010 at 21:27

    I’ll try to be positive. Bernanke has a speech on Friday. Maybe he can signal something expansionary in it.

  7. Gravatar of Bill Woolsey Bill Woolsey
    25. August 2010 at 03:09


    Stop advocating higher inflation.

    The rhetorical strategy that Woodford talks about inflation so you should do has failed.

    How bad can inflation get with a target for the growth path of money expenditures?

    I know it is your first best solution. But because everyone has heard of the inflation targeting approach, too many people just hear, “higher inflation.”

  8. Gravatar of Leigh Caldwell Leigh Caldwell
    25. August 2010 at 03:27

    In this comment was going to suggest a theory of what the Fed might be thinking. A theory that’s economically worrying – but at least self-consistent. And if we understand the Fed’s thinking and behaviour, perhaps we can help persuade it to change.

    But reading Scott’s post, I realised the truth might be even more scary than I first thought.

    My first idea (mentioned here, and Andy Harless also hinted at this in a comment a few days ago) was this: The Fed is not basing its actions on economic theory at all, but on a learned action-response rule.

    Perhaps the Fed governors distrust economics and economists, but have learned through experience that cutting the Fed funds rate boosts AD and inflation. If so, they may genuinely think they have done all they can. Sure, some monetary cranks are pushing other weird ideas – but that’s just theory. The Fed’s job is to change interest rates and it can’t do that any more.

    On this theory, there is potentially a role for fiscal stimulus – because the Fed will not be the last mover. On this theory, the Fed does recognise there is a problem – it does want higher AD and a higher inflation rate – but believes that it doesn’t have the tools to achieve that. Or, the governors are not willing to take a risk with the Fed’s reputation by trying them. On this theory, the Fed would be quite willing to allow fiscal stimulus to occur without neutralising it.

    But today, I realised that the truth might be much worse. Maybe it’s not just a matter of misunderstanding the tools they have to solve the problem. Maybe they do not think there is a problem.

    After all, the economy’s growing, inflation is low – what’s not to like? We aren’t in a depression – there has been no 25% decline in output – so let’s just carry on, accept a bit of pain and we’ll be fine.

    Of course, another few years of this and we will have output 25% lower than it could have been – but the psychology of loss aversion says, in essence: we won’t miss what we never had. Presumably if we had ten years of 3.3% growth followed by a 25% decline, the Fed would take some action. The public would demand it. But ten years of 1% growth – which is a worse outcome – would probably be accepted. The reason FDR could take radical actions in the 1930s was because the huge collapse in output was incredibly salient, and obvious to everyone.

    Well, there’s one other reason he could do it. It’s also the one bittersweet hope of a way out for us now. Unemployment. The 25% unemployment of the 1930s led to immense social pressure for a solution. 9.5% unemployment isn’t yet creating that pressure. And the Fed is easily able to withstand what pressure there is – after all, their proudest moment in recent history was the 1982-83 recession, when their ability to ignore 11% unemployment established their inflation-fighting credentials for decades.

    Even though Niklas Blanchard thinks unemployment is not a problem, it really is. Yes, in theory we would all prefer not to work – but in practice, unemployment really is involuntary, it wastes resources and lives, it destroys real human capital, it leads to a really bad social distribution of wealth and it makes people unhappy.

    Unfortunately, I don’t see a persistent rate of 9% unemployment as being enough to politically legitimise radical solutions. If it creeps up above 10-11% then it might start to make a difference. But that probably won’t happen for a couple of years at least.

    Everyone reading and commenting on this blog knows that the monetary crank solutions are actually not that radical at all, and probably have very little downside risk. But they look radical, and the administration does not have much political capital right now. Let’s hope that the new Fed governors will help to provide some more.

  9. Gravatar of JTapp JTapp
    25. August 2010 at 03:31

    Rogoff and Reinhart don’t focus specifically on monetary policy, or the zero bound, but according to them our recovery is right on track with the average historical recoveries after other financial crises. Is that because central banks and fiscal policymakers always repeat the same mistakes? Rogoff has repeatedly called for higher inflation, but I’ve never seen him say something specific like “historically, countries whose central banks aim for higher inflation end up recovering more quickly.” That would have been a loud message given the attention they’ve gotten. Maybe someone who has finished reading This Time is Different can give some insight?

  10. Gravatar of scott sumner scott sumner
    25. August 2010 at 05:34

    JEStevens, Yes, I have been using the idea that the Fed moves last to argue that fiscal stimulus doesn’t matter as much as people think, and the same is true of fiscal austerity. Indeed, I’ve argued that since aggressive monetary stimulus is more powerful that most people believe, and fiscal stimulus less so, that replacing fiscal stimulus with monetary stimulus probably would actually boost growth.

    Jon, You are right that 0.25% is not easy money, it’s an indication of tight money. But Kocherlakota is wrong that you solve this problem by raising short term rates. You solve it with expansionary monetary policy—which he opposes. The Fed raised rates 200 basis points in October 1931, and the Depression just got worse, dragging rates even lower in the long run.

    I’d also point out that the base doubled in late 2008, so the cut to 0.25% was accompanied by OMOs. But you are right that the IOR neutralized all that, so I accept your broader point.

    Guy, That’s a very worrisome graph. What sort of metrics go into that index?

    Liberal Roman, I have my fingers crossed.

    Bill, The worst offended is Krugman, who kept talking about the “need to be irresponsible.” That will convince sober central bankers! I’ve emphasized simply returning to trend lines (hopefully NGDP, but even the price level would be much better than nothing at this point.)

    But you are right, calling for inflation really sounds bad. Even in 1933, when prices had fallen 25%, it was highly controversial.

    Leigh, You make some really good points. But I’d point out that the fiscal question is not cut and dried:

    1. The Fed did resort to QE in March 2009, when things seemed to be slipping into depression territory.

    2. Jim Hamilton just pointed out that the hawks have recently made public predictions that the recovery is on track. If it falters (as he and I think it will) there will be pressure on them to allow more stimulus. So I think that window of opportunity for fiscal policy is fuzzy. When the fiscal authorities act, the hawks seem to put out statements that even Krugman now concedes amount to contractionary monetary policy in terms of their effects.

    There is a parallel here with Japan. The BOJ never really solved deflation, but always acted when it threatened to get worse than about 1% a year.

    In 1982 the Fed was helped by public disgust at inflation. But still, there was pressure for stimulus. And they did oblige. They abandoned (so-called) monetarism in late 1982, and engineered annual rates of 11% NGDP growth and 7.7% RGDP growth over the first 6 quarters of recovery. If only . . .

    I now think there is actually a pretty good chance that unemployment will creep back up over 10%. And I believe this might occur even if the economy grows 1% or 2%, which many are now expecting. That’s still less than trend for the US.

    JTapp, In 1933 we grew really fast after the severe 1933 banking crisis. But R&R’s main problem is that they have misdiagnosed this recession. They lump it in with Mexico, Thailand, etc, which were real shocks. Think about this, the dollar soared in value during the teeth of the Lehman banking crisis (July-Nov. 2008) How many times did other countries see their currencies soar in value during financial crises? Argentina in the late 1990s and early 2000s? Well they had a very fast recovery. The US in 1931-33? Well we also had fast growth after 1933. But that’s about it. We had a tight money nominal shock in 2008, and I don’t think R&R or the rest of the profession yet understand that.

  11. Gravatar of JKH JKH
    25. August 2010 at 06:13

    Nick’s analogy is appealing, although the wall being in play doesn’t actually advance the argument for preferring unconventional monetary policy to fiscal policy at this point.

    Time for Nick to add more bricks or poles or something to the analogy.

  12. Gravatar of Gregor Bush Gregor Bush
    25. August 2010 at 06:27

    I’m seeing 1.19% on teh 5-year TIPS spread. The 10-year TIPS spread has now fallen 100bps since late April which means that the expect price level in 2020 in now 10% lower than it was just four months ago. That is an unusually large decline and, needless to say, is highly contractionary.

    If the 10-year TIPS spread had risen 100bps you can be sure that the Fed would have said something about it. But when it plunges at a time when unemployment is close to 10% the, all the Fed does is tell us that inflation expcetations are stable. Markets are forced to conclude that the Fed is trying to grind inflation even lower or, at the very least, thier target is not at all symmetric.

  13. Gravatar of Martin Martin
    25. August 2010 at 06:49

    I think that Caldwell has a point here. There is a difference between what is right from a social welfare perspective and what is right from the perspective of the decision maker.

    This distinction isn’t original, it goes back all the way to Wicksell, but we are still assuming that the incentives faced by the Board are the same set of incentives faced by that of a benevolent despot.

    Bernanke probably will already go down in history as the man saving us from the Great Depression and the reason for not doing more, contrary to what he has said in his published work, can easily be rationalized in a number of ways.

    If however he would do more and it would backfire he would probably go down into history the same way that Hoover did; not a terrible pleasant prospect. The only way the Board can be prompted to do more is if all the metrics show that the double dip is coming. The reputational damage-problem is then removed.

  14. Gravatar of jsalvati jsalvati
    25. August 2010 at 07:11

    Scott Sumner and the Blog of Despair

  15. Gravatar of Nick Rowe Nick Rowe
    25. August 2010 at 07:24

    Thanks for the plug Scott!

    That speech by Narayana Kocherlakota is really disturbing. This guy is a top macroeconomist, and he totally f***s it up. I mean totally. It wasn’t just misspeaking, because he is quite clear the second time he makes the mistake. If the natural rate of interest rises exogenously, and the Fed doesn’t raise the nominal rate in response, the result will be….DEflation! And he’s a Fed President (so presumably this guy has some sort of power over monetary policy?).

    You guys in the US are so scr***d. (And maybe we up here are too, since you are so big, even though we’ve got flexible exchange rates).

    He went straight from a math undergrad into a PhD. I bet that’s the problem. He missed Intro Economics. (And he has the nerve to cr*p on Intro Economics too).

  16. Gravatar of Morgan Warstler Morgan Warstler
    25. August 2010 at 07:57

    Our stars are ALIGNED! Let’s hope you can see it as such…

    You want the Fed to do more QE. I want them to liquidate homes.

    What we both KNOW for sure, is that currently the Fed is TERRIFIED of more jingle mail.

    The answer is clear: BOTH of us should be screaming from the highest pole, that homes values are not going up anytime soon, and we should be encouraging underwater home owners to mail in their keys.

    And we even have a lever in MERS:

    If this were to give cover to homeowners to just walk away, we’d have a winner.


    Said another way, in order to win over the conservative base you need to come up with a QE policy that intentionally kills off zombie banks, and rewards savers.

  17. Gravatar of Benjamin Cole Benjamin Cole
    25. August 2010 at 08:44

    Once again, I find myself in complete agreement with Scott Sumner. I am getting a bad feeling about this economy, that it is losing steam.
    We know we can not look forward to any more massive fiscal stimulus.
    That leaves the Fed.
    There are times when doing the safe thing is not really the safe thing. What seems reckless is really “safer” than standing pat.
    The Fed is facing such a period. Moreover, they have developed a culture steeped in the glory of inflation-fighting.
    That suggests they will be very slow on the uptake.

  18. Gravatar of Nick Rowe Nick Rowe
    25. August 2010 at 08:54

    JKH: you are trying to drive a herd of cattle in a straight line across the middle of a field. There’s a stream along one side of the field. The cattle can cross the stream, but you can’t (you forgot your boots, or something).

    There are two ways to drive cattle:

    1. From behind, carrying a stick. If you want them to move right, get to the left of them; if you want them to move left, get to the right of them. This method works, more or less, as long as you can switch sides more quickly than the cattle can turn. Unless they cross the stream.

    2. Walk ahead of them, carrying a bag of meal. In fact, just tell the cattle that you are heading for a particular spot on the other side of the field.

    Remembering my farmboy days.

  19. Gravatar of David Pearson David Pearson
    25. August 2010 at 09:34

    The Nick Rowe “pole grabbing” and “cattle hearding analogies” are apt. The question is, will a small, temporary increase in inflation move the pole end much beyond vertical? Will the cattle follow along if promised the same feed they have been promised for some time?

    This is about framing the debate. Frame it as, “we can spark growth by reducing real wages with by merely following through on our existing inflation commitment.” Then there should be no debate.

    If you frame it as, “we need to dislodge deflationary expectations by promising higher long term inflation,” then you can start to understand why some would hesitate.

    For the Fed, espousing the first frame carries a specific sort of risk. If it were to, say, promise 3.5% inflation for eighteen months and 2% thereafter, and inflation expectations did not budge, then the Fed would have to work even harder to move them. By “even harder”, I mean, “offer an even higher long term target.” In other words, incrementalism is a risky strategy, even while on its face, it might seem as the lowest-risk one.

    The tail risk of incrementalism rises when you look “under the hood” of inflation expectations. Shelter is 40% of core CPI.

    So for the Fed, the issue isn’t the point-estimate prediction for inflation expectations following a “return to trend” promise. The issue is the tail risk that inflation expectations do not respond, thus costing valuable credibility and raising the long term cost to the economy of dislodging deflation.

    The tail risk of incrementalism rises when one looks under the hood of inflation expectations. Shelter is 40% of core cpi. Do you think that a 2% long term inflation target is sufficient to counteract twelve months of housing inventory as a driver of house price expectations? If not, then what components of CPI should one expect will react to the Fed’s 2% promise, and when?

  20. Gravatar of Liberal Roman Liberal Roman
    25. August 2010 at 09:41

    @David Pearson,

    To be honest, even if inflation expectations got out of hand it would be a much better problem and an easier to deal with problem than the deflationary environment we are in today.

    Since, we are in the mood for analogies, you worrying about inflation getting out of hand is like worrying about water damage when your house is on fire.

    “Take it easy with that water hose Mr. Fireman. I got some nice crown moldings inside that blazing inferno.”

  21. Gravatar of Morgan Warstler Morgan Warstler
    25. August 2010 at 09:56

    There’s PLENTY OF MONEY and there’s PLENTY OF DEMAND. The problem is only price.

    In a truly free market, the price would be much, much lower… and there would be very little excess inventory.

    We have tons of insolvent banks only in business because Fed policy is DESPERATE to keep housing prices from falling too quickly.

    RIP OFF THE BAND-AID. All of you are morally bankrupt people. You KNOW there are countless good “current” home owners who are horribly under water, with totally irrational expectations about ever getting any money out of their mortgage.

    Since SCOTT BELIEVE’S that the Fed isn’t going to do QE anytime soon – Scott has a moral obligation to tell these poor souls HOW DUMB they are for not mailing int he keys.

    Scott, what is your advice to someone who’s 30%+ underwater, making their payments religiously, knowing full well the average person changes homes in 7 years?

    What is your advice to that person?

  22. Gravatar of David Pearson David Pearson
    25. August 2010 at 09:57

    A 5% NGDP target may not solve the problem of having to promise more inflation. The reason has to do with markets’ views of probable scenarios. What probability would markets assign to a 0% RGDP/5% CPI scenario? Very low given consensus on the importance of the output gap. In other words, the Fed would have to be perceived as “reckless” to produce that outcome, and the Fed would not be perceived in that way unless it is seen as being willing to risk higher long term inflation. If one virtually eliminates the 0%/5% scenario, then the distribution of expected inflation skews left, towards lower inflation. The more it skews left, the more tail risk of deflation remains, and the less effective the Fed’s attempt to set expectations. To prevent this skew, maybe the Fed has to be seen as Ronald Reagan was during the U.S./Soviet arms race–not exactly calmly rational.

    BTW, as Scott points out above, FDR’s abandonment of the gold standards was certainly perceived as a reckless action.

  23. Gravatar of Rebecca Burlingame Rebecca Burlingame
    25. August 2010 at 10:22

    I’ve finished reading This Time is Different, but can only give a little info from a non-economist’s perspective. It seemed that part of the problem was a lack of recording internal insolvencies, on the part of many countries. Without such recording how is anything to be determined accurately. The most likely recording to be done over the centuries, or decades, was external insolvencies. However, for a lot of countries, both insolvencies seemed to occur at the same time.

  24. Gravatar of jj jj
    25. August 2010 at 11:28

    If the fed changes nothing, how long will it take for the real economy to regain its original real growth rate by adjusting to the new NGDP growth path, with permanently lower inflation? Anybody care to hazard a guess?

    In the mean time we’ll have lost some % of GDP, but to be the optimist, that might be mitigated in a couple ways:
    1) Similarly to how poor countries catch up to richer ones, the economy might catch-up to some advancements in science. Some ideas just require time to percolate, and some research is just slow and plodding regardless of higher or lower funding.
    2) Hopefully the real GDP we’ve lost was subject to diminishing returns. If the investments not made were those least valuable, then that 25% missing GDP isn’t as bad as it sounds.

    I should emphasize that none of this lets the fed off the hook.

  25. Gravatar of marcus nunes marcus nunes
    25. August 2010 at 11:47

    S. Williamson elaborates further on N.K.:
    I argued here that we should not be worried about deflation. In part, this was a backward-looking argument, based on the behavior of the stock of currency, along with observations about the implied inflation premium on long-term Treasuries. Now, if you have been watching bond yields recently, you will have observed two things: (i) The yields on both nominal Treasuries, and inflation-indexed Treasuries (TIPS) have both fallen; (ii) The difference in those yields (a measure of the inflation premium on long Treasuries) has also fallen. This may reflect the view of the market that, given the last Fed statement, and public statements by Jim Bullard, among others, the Fed knows something the market cannot see directly, which is that inflation is going to be much lower for an extended period, if not negative.

    In this case, I agree with Kocherlakota, that the market has it wrong. As Kocherlakota argued, most of our monetary models tell us that, if the Fed maintains a constant nominal interest rate target forever, that will essentially determine the inflation rate, by way of the Fisher relation. If the Fed keeps the short-term overnight rate at 0.25% forever, and if the long-run real interest rate is 2%, the inflation rate must be -1.75%, which would be supported (roughly) by long-run growth in some monetary quantity of -1.75% plus the long-run growth rate in real GDP.

    This makes deflation seem like a real possibility if the Fed maintains a target nominal interest rate of 0.25% for an “extended period,” as specified in the FOMC statements since all the trouble started. However, consider this. Suppose, as seems to be implied by the last FOMC statement, that the Fed intends to hold the size of the balance sheet constant, in nominal terms, for the immediate future. Suppose that what they mean by this is that the balance sheet will remain constant until the stock of excess reserves “runs off,” at which time we will go back to a “normal” policy regime. By normal policy, I mean an implicit inflation target of 2% supported by a nominal fed funds target, recalibrated at each FOMC meeting.

    Now, what happens between now and the time at which excess reserves go to zero? Suppose over that period that the interest rate on reserves (the relevant policy rate when excess reserves are positive) stays at 0.25%. Suppose that the inflation rate over that period is 2% and that real GDP grows at 3%. Also suppose that the quantity of currency relative to nominal GDP is constant, implying that the stock of currency outstanding is growing at 5% per year. At this rate, excess reserves will run off in about 18 years. By that time, the majority of the MBS on the Fed’s balance sheet will have disappeared, and the Fed will be back to having mainly Treasuries in its portfolio. Could this be an equilibrium path for the economy? Well, given what I specified here, it seems unlikely that banks will wish to hold excess reserves for 18 years given a real return of -1.75%. Somewhere in that 18-year period, the Fed will have to raise the interest rate on reserves, otherwise the stock of currency will be growing in excess of 5% per year, and the inflation rate will rise above 2%. Thus, if anything, the inflation risk appears to be on the up side, given stated policy. I don’t see the deflation risk.

  26. Gravatar of Benjamin Cole Benjamin Cole
    25. August 2010 at 12:22

    Nunes: Turn to page C11 of the WSJ today, re falling prices prompt large commercial property owners to “turn over the keys.”

    Buried in the story is the figure that $1.4 trillion in commercial r/e loans are underwater, and coming due by 2014.

    So, all those loans get turned over to banks, and we have another financial 9/11 on our hands.

    Of course, a round of property inflation would resolve this problem–that is why I am firmly ensconced in the reflationist camp, and I encourage others to join, to get the Fed to start stimulating.

    You saw what $2 trillion in bad home loans did. This is another $1.4 trillion. It starts to add up.
    At some point, we have to pragmatic. Theories are fine, but the reality is $1.4 trillion in sour loans. We use nominal dollarsin real life.

    If we have deflation, these loans are certain to default.

  27. Gravatar of Morgan Warstler Morgan Warstler
    25. August 2010 at 12:34

    Benjamin, if prices go down on property, we do not have deflation. We simply have falling prices on real estate. We should not be counting rents in the CPI.

    And that “turning over the keys” is GREAT. According to the market, the wrong people “own” the property right now, and many of the banks that wrote the loans are insolvent.

    No one needs help owning something they cannot afford. This is ENTIRELY about who gets to own the assets tomorrow.

    When you figure out a way to target NGDP, and still sell those commercial properties super cheap to the guys who have cash on hand right now, let me know!

    Concern yourself with with your opposition’s concerns when you try and motivate them.

  28. Gravatar of JKH JKH
    25. August 2010 at 12:45

    Nick 8:54

    Nicely done.

    Although you do need the right bag of meal for it to work.

    Farmboy targets the forecast?

  29. Gravatar of Benjamin Cole Benjamin Cole
    25. August 2010 at 13:11


    First, I would have to understand you in order to debate you.

  30. Gravatar of Morgan Warstler Morgan Warstler
    25. August 2010 at 14:19

    Benjamin, you called it deflation. We have disinflation. And if you factor rents out of the CPI, we have 2% inflation – which is above our pre-recession numbers.

    Do you understand that?

    Do you understand that $100 in savings with 4% inflation is worth only $81 in 5 years?

    Do you understand that hundreds of banks are insolvent, in any conventional understanding of their underlying assets (mark to market)?

    Do you understand that if guys sitting on side lines could bid say $100K with 40% down, on a home that last sold for $400K in 2007:

    1. They’d do it even if interest are higher.
    2. Any of the remaining banks would finance the rest.

    The point here is you are worried about how much money there is, I’m concerned with who owns the hard assets.


    And then AFTER we have hte right guys starting to own the assets… if you want to target NGDP, figure out how to do it so the right people benefit from the change in policy.

    If you do not concern yourself with the right people benefiting from this policy, your policy will cause a political firestorm.

    Here let me give you another example: Let’s target NGDP, but let’s do it by printing money, actual currency.

    But then, lets hand it out ONLY to those people who have paid off their only house free and clear. Say 50M household each receive a check for $20K ($1T in printed money).

    Suddenly, the people who didn’t participate in the bubble HAVE an extra $20K to go spend… we still get the expansive money supply, but the right kind of people benefit.

    My point is if you are going to piss off the savers with your policy, make sure ALL the new money goes to them.

    Problem solved.

  31. Gravatar of JL JL
    25. August 2010 at 14:23


    Could a looming sovereign debt crisis force the Fed to print money (i.e. monetizing the debt)?

    Because if that is so, perhaps Krugman was right. Perhaps we should have pushed for the biggest stimulus.

    Come to think of it, why did FDR devalue the dollar? Was it because of smarts, or was he forced, because of the debt?

    And finally, perhaps this might be a good reason to favor generous unemployment benefits instead of, or in addition to, forced savings accounts, a sort of self-correcting mechanism:

    If a great recession becomes reality, the government will be forced to borrow in order to pay the unemployment benefits, and eventually the debt will grow so large that the Fed is forced to monetize it.

  32. Gravatar of Benjamin Cole Benjamin Cole
    25. August 2010 at 14:46


    I think the CPI overstates inflation, as consumers and businesses constantly migrate to lower-cost options. The changing mix of outlays cannot be captured by static measuring methods. The CPI is updated, but is always behind the curve.

    As to rents, I am not sure I follow. People pay for housing. Rents have gone down for all forms of real estate, commercial, retail, industrial, residential. So we don’t count that?

    I am familiar with mark-to-market, more so than I would want, having worked in the S&L industry in 1980s, and covered them as a financial reporter after that. I will concede to mixed feelings on mark-to-market. Yes, it makes sense—but then, it feeds an artifical downward spiral if landers are forced mark losses, and thus decrease lendable capital at teh vary time the economy is starved for loans. I prefer a five-year rolling mark-to-market.

    How many insurance companies would be solvent, if we forced quarterly mark-to-market? Interesting question.

    Whether we like it or not, loans have been made in nominal dollars, and commercial banks and the CMBS and RMBS markets all measure loans in nominal dollars. If the loans get paid back, we all are better off.

    There may be theoretical better long-term arrangements to make–I am talking about getting us through the next five years.

    In the long-run, there are all sorts of improvements to make, including altering the tax code to favor equity not debt, and work, not consumption.

    You seem to suggest you know who are the right and wrong people to own property and receive federal money. Your suggestion we hand out a $20k check to people who have paid off their mortgages strikes me as novel, although a great boon to elderly Auny Miltilda.

    If you want to avoid moral hazard, then run a national lottery, but make payouts in cash and far in excess of ticket-purchases. I suggest also we secretly goose payouts at race tracks, because I have a soft spot for old horseplayers.

  33. Gravatar of rob rob
    25. August 2010 at 14:47

    Don’t know if you read twitter, but Garrett Jones just tweeted:

    “If the U.S. Congress were functional, then Scott Sumner would be testifying monthly.”

  34. Gravatar of Morgan Warstler Morgan Warstler
    25. August 2010 at 15:40

    “As to rents, I am not sure I follow. People pay for housing. Rents have gone down for all forms of real estate, commercial, retail, industrial, residential. So we don’t count that?”

    When we make our nice little graphs showing unsustainable GDP growth, and then using them to explain we must print money to target NDGP – those numbers have embedded in them rents – rents that were far ton high, as in unsustainable boom prices.

    It is natural that they go down, the pint is the path of growth does not have to be so steep, but it is not real growth, it is simply printing money.
    But specifically on inflation, until housing prices have fallen back to trend (say inflation from 2001), the fact that rents are going down, is uninteresting commentary on inflation.

    What’s interesting is whats happening to prices apart from rents.

    Moral hazard: See this is what I’m talking about – your unwillingness to lay blame is suspect. We’re Americans we love blame and justice. We want to see the good guys win. A lottery does not avoid moral hazard. What we want is to ensure that anyone who refi’d and took out cash – gets nothing, that anyone who bought and is now underwater, gets nothing. No one in real estate or banking, you get the idea.

    This of course is ludicrous, which why is makes sense to establish an aggressive property and liquidation policy – where by we are rewarding those people who have dry powder, ending zombie banks and RAISING interest rates.

    The problem is that rates are at zero. What would cause people to want to buy so many houses that they do so with higher interest rates? If the houses are super cheap.

    Do we have a bunch of super cheap houses laying around? OMG! We do!

    Solving this is easy, create the situation where ten years from now, the smart guys in every town look back and say to their wives, “My god can you believe we bought all 4 of these houses for $200K?”

  35. Gravatar of Mark A. Sadowski Mark A. Sadowski
    25. August 2010 at 15:42

    I haven’t commented much recently but that’s not because I haven’t been reading as much as it’s because I’m in total agreement and I’m extremely busy. (The WSJ article was truly terrifying.)

    Actually I’m defending my PhD research proposal tomorrow (Tax Structure and Growth – Evidence from the EU-27 during 1995 to 2007). In short, consumption taxes are good for growth, and income taxes are bad. I;m not worried as everything is in the bag (for me) as it were.

    I’m also teaching this fall at Rowan University in NJ. I’ve even been given the opportunity to design my own course. I’m calling it “Issues in Monetary Policy.” I may not cite you specifically but I should let you know that you (and your arch counterpoint Krugman) will be a huge influence.

    I’m not sure if I’ll start class with the Krugmansque “Capital Baby-Sitting Coop” or my own personal favorite “The Wizard of Oz” as a parable on monetary policy. In either case I’ll be thinking of both your self declared mission as well as our brutalized economy.

    P.S. Will someone please oil the Tinman?

  36. Gravatar of Drifting at the Sea of the Economic Depression Drifting at the Sea of the Economic Depression
    25. August 2010 at 15:55

    […] went to now our annual lunch with Professor Scott Sumner who runs influential among economists blog The Money Illusion. Significantly Professor Scott Sumner thrown in the towel today to call this …, well he […]

  37. Gravatar of OGT OGT
    25. August 2010 at 17:13

    This, and Kocherlakota’s comments, are the best arguments that Obama should have done a massive fiscal stimulus package. Krugman once used the term, ‘escape velocity,’ which I took to mean enough spending and tax cutting to gin up ‘V’ to the point that the Fed could and would raise interest rates legitimately. It’s what the Fed knows how to do, anything outside of that may be asking too much of the institution as presently constituted.

    As it is this roughly 2% NGDP growth is settling in as the new normal.

  38. Gravatar of scott sumner scott sumner
    25. August 2010 at 17:47

    JKH, There are lots or reasons to prefer unconventional monetary policy. Starting with the fact that it doesn’t add to the debt, and to future deadweight losses from higher taxes. Indeed it lowers the debt.

    Gregor, I agree. A minor quibble here:

    “I’m seeing 1.19% on teh 5-year TIPS spread. The 10-year TIPS spread has now fallen 100bps since late April which means that the expect price level in 2020 in now 10% lower than it was just four months ago. That is an unusually large decline and, needless to say, is highly contractionary.”

    I’d prefer to say future NGDP is 10% lower than estimated in April. Part of the reason for lower nominal rates is lower real rates, associated with lower expected RGDP growth. Either way, money is too tight, as you say.

    Martin, If I have anything to say about it, then Fed policy will go down in history as the cause of the Great Depression. I’m trying to be the Friedman and Schwartz of the Great Recession.

    jsalvati. Was “The Blog of Despair” one of the Harry Potter books?

    Thanks Nick, I like that comment.

    Morgan, I’ll work for more NGDP, and you push for ending bailouts to banks, as they won’t need them anymore.

    Benjamin, Unfortunately big institutions are not nimble–they don’t do things quickly (unless bankers are in trouble.)

    Nick#2, I am from Wisconsin, and even I don’t know enough about cows to come up with that analogy.

    David Pearson, A few comments:

    1. Don’t do just one thing, do all the things (QE, no IOR, higher NGDP targets.) A comprehensive strategy will impress the markets.

    2. Do it until TIPS markets show it is credible. There is no limit to how many bonds the Fed can buy.

    3. If you target expectations in real time, there is little risk of overshooting.

    4. Houses are assets. Even with a big inventory, much stronger NGDP expectations can boost housing prices right now. Some markets have already turned around, and they also have inventory.

    Morgan, There is plenty of money but not plenty of demand.

    Some homeowners should mail in the keys. That’s what big property developers do in NYC when their investment goes bad.

    David, I favor a 5% NGDP long term trajectory. I have said we need a bit faster growth to catch up (part way) to the trend line.

    jj, You make some good points about the long run. But the short run is very difficult to model. It’s not even clear what it means to say the Fed does nothing. Does that include talk about exit strategies? (Which can affect expectations.)

    Marcus, I don’t follow his argument. I left a question about Japan. Let’s see how he responds.

    Benjamin, I am planning a post on commercial property loans–if I can ever find time.

    JL, Unfortunately (or fortunately) we aren’t poor enough or in debt enough yet for even a bigger stimulus to trigger monetizing the debt. We are at 60% of GDP, other countries are over 100%

    If we are going to help the unemployed, give them a big one-time lump sum, so there is no disincentive to go back to work. But easy money is the best way to help them.

    rob, Thanks. I’m a fan of Garrett Jones. Met him at GMU and found he is really smart. I wish this crisis would end so I’d have time to read his research.

    Mark, It’s great to hear from you, and I am flattered by your willingness to use my ideas in your course.

    I am very interested in your tax research as I am a big fan of consumption taxes, and a big opponent of income taxes. If you have anything interesting that you would allow me to use in my blog, please pass it along. I hope to do more tax posts if this crisis calms down a bit. Keep in touch.

    I forgot, is the tinman Bernanke? I think he has a heart, but is intimidated by the hawks. Cowardly lion? Seriously, the last WSJ article made it clear how difficult his position really is–I now have more sympathy for him.

  39. Gravatar of scott sumner scott sumner
    25. August 2010 at 17:52

    OGT, I don’t even know if 1.3 trillion would have gotten the job done. In that case the Fed would not have done the March 2009 QE, and we still might be in the same place. Japan did a ton of fiscal stimulus, and has 15 years of mild deflation.

    Your argument is defensible, but it isn’t a slam dunk. I’ll keep working for the easiest way out. More money.

  40. Gravatar of Gregor Bush Gregor Bush
    25. August 2010 at 18:43

    Wouldn’t the expected price level be 10% lower (as signaled by the TIPS spreads) and expected NGDP even more than 10% lower as signalled by both the decline in the TIPS spread and the decline in real rates (as you suggest)?

  41. Gravatar of Richard W Richard W
    25. August 2010 at 18:57

    It is clear that all the economic data is suggesting that things are slowing down. However, I don’t think the TIPS market is as efficient as you think it is.

    With TIPS only being 7% of the outstanding marketable treasury securities the TIPS market is illiquid compared to conventional Treasuries.

    The issuance of all categories of securities over the last two years has seen the smallest increase in issuance go to TIPS.

    Foreign buyers who are often noneconomic buyers have been buying up around 25% of the issuance at 10-yr auctions for the last 18 months.

    There have been large inflows into mutual funds buying up scarce TIPS. The Treasury have contributed to the scarcity through poor debt management by not issuing enough securities. Possibly the Treasury think issuing lots of TIPS would send a negative signal on inflationary expectations. All of this contributes to a shortage of securities for day-to-day repo trading. Moreover, negative TIPS real yield can also mean investors expect inflation to be higher than nominal bond yields are suggesting.

    Can an illiquid market be an efficient market?

  42. Gravatar of Doc Merlin Doc Merlin
    26. August 2010 at 00:55

    Again, with this much incompetence shown by our money central planners, why aren’t you calling for free banking?

  43. Gravatar of jj jj
    26. August 2010 at 05:53

    Morgan, I’m starting to follow what you’re saying. People who bought too much house shouldn’t be bailed out, we can agree on that. But I’m curious what if any portion of the blame you lay on the Fed. It’s not so simple to define which groups of owners are right and wrong, when there’s a powerful institution that can change the dynamics of the game at any time.

    Think of it abstractly: say the Fed one day cuts the money supply in half, and house prices correspondingly fall by half. Does it make sense to say that everybody who owned a house was Wrong, and every renter was Right? Renters were right only in the sense that they correctly predicted what the Fed would do. Therefore, the goal of the Fed should be being predictable. Nobody should be screwed over OR bailed out by the Fed, instead we just let people win or lose on the basis of their own decisions.

    I think you will agree with the above, Morgan? If so then I understand your argument that the fed is just inflating assets to bail out poor decisions. Nonetheless I would disagree, because I think the big NGDP drop shows the Fed failed at its mission of predictability. Scott is only asking for NGDP to return to its former predicted path.

  44. Gravatar of OGT OGT
    26. August 2010 at 07:17

    Sumner- I’ll take defensible as a compliment since that’s precisely how I see the ‘escape velocity’ argument. Without a clearer mandate that Fed officials can be held accountable to, I am not sure there are many arguments that are more than defensible if they leave the current mandate in place. You formulate policy with the Central Bank you have…

    The Fed seems to be a borderline dysfunctional institution at the zero bound, I agree with an earlier post of yours that argued that CB independence had failed.

  45. Gravatar of Morgan Warstler Morgan Warstler
    26. August 2010 at 08:50


    I asked Scott this in the next thread: where in the theory of the function of money does it serve to provide Full Employment.

    It doesn’t. Money doesn’t care if there’s full employment. It is a silly after-thought tacked onto the Fed’s true mission – to protect the storehouse value of the currency from inflation.

    The FUNDAMENTAL ASSUMPTION, the thing MOST Americans truly deeply believe, is that inflation should be fought down to the nub. We all know instinctively why this is… because saving, delay of gratification, is a positive moral virtue. Consumption is grand, and it has enough crack-like addiction to it, that it does not need PUMPING.

    It certainly doesn’t need Sumner advocating that your $100 saved, is worth $81 in 5 years – not if there are other ways – to achieve such.

    The Fed cannot have an antagonistic relationship with US citizens. It’s job is not to try and shift bait around the maze to get the rats to move where it wants them to go.

    I keep saying this, but IF WE ARE GOING TO HAVE A FED, then in order to ENSURE there are no booms and busts, we only need one thing:

    A FED that stands against the vulgar lie promoted by liberals of wage and price stickiness. If unions struggle within this paradigm – who cares? They certainly aren’t worth an invisible 4% tax every year.

    UNIONS ARE DONE. They are a vestige from the olden days like racism, and homophobia. Labor price shifts are EASY. More and more of our workers not only bounce jobs, but work on commission, and if we don’t ACTIVELY try and trip up wage stickiness we are functionally retarded.

    Look, in one years time, rents in Austin, TX fell by 20%.

    In mid 2008, we saw grass prices hit $4, and restaurants actually scratched out prices on their menus, and did it again when prices fell back to earth.

    There’s nothing in our day to day lives that doesn’t have the ability to reprice, including labor.


    That said, the EXPECTATION we as citizens have of our Fed, is that it protects our money supply. Why in the hell, would it be “independent” if that wasn’t its job?

    That’s what WE EXPECT.

    The incredibly frustrating thing is that IF WE DO NOT HAVE an accounting right now, where the hard assets flow to the balance sheets of the guys who have dry powder – my kind of people (think Tea Party) will make it happen.

    Scott’s ideas WILL NOT get instituted and turn things around before the government is over-run with people who refuse to accept that the Fed is supposed to worry about unemployment.

    My people watch Glen Beck.

    So, I’m trying to make a very important point here to the eggheads Macroeconomists:

    FIRST, let the losers lose, kill the zombie banks, get the assets into the right hands. If you are worried about those foreclosed on, use this MERS thing to wipe their credit – but stop trying keep the banks afloat, and the home values up.

    THEN, after the come-to-jesus, has happened, Sumner can come riding to the rescue….

    But remember, this will be the first real Austrian liquidation – and I’m betting 20M homes sales in 180 days with interest rates raised 2%, might do wonders for the economy.

    Since Scott is so confident, Austrians deserve their shot first.

  46. Gravatar of Jeff Jeff
    26. August 2010 at 10:21


    You can think of the drop in NGDP expectations as a demand shock. Banks have a term-structure problem: their assets tend to be shorter term than their liabilities. So if the Fed doesn’t counteract the demand shock, it will take them longer to get healthy than if the Fed responded correctly. At some point, the distress in the banking sector is bad enough that you can think of it as an adverse supply shock. Finance is, after all, a factor of production. When it doesn’t work, aggregate supply is lessened.

    The upshot of this is that some of the loss of output may be permanent, i.e., the trend growth of potential output may shift down. Japan is an example of this. Bad monetary policy can be as bad as bad fiscal policy in this respect.

    OTG, there is no credible empirical evidence that fiscal “stimulus” has ever worked. So there’s no reason to think a bigger fiscal stimulus would have worked. Advocates of fiscal stimulus are either misled, or, in the case of economists (like Krugman) who know better, just liberals who want an excuse to grow the government.

  47. Gravatar of jj jj
    26. August 2010 at 12:06

    Morgan, why do you say inflation is a tax? That’s only true if you’re holding cash, otherwise who cares because your assets will grow at the same rate as prices. If inflation is stable and expected, even at 20% it would be irrelevant to the real economy, after we adjusted to the situation. Sure it makes life a bit simpler to have price stability at 0%, which I’m all for in theory, but I don’t understand why you think ANTICIPATED inflation really hurts anybody. (Unanticipated inflation is obviously bad.)

    PS – I’m talking only about stable inflation, not escalating hyperinflation.

  48. Gravatar of jj jj
    26. August 2010 at 12:10

    Jeff, can you explain how the trend growth of output can change permanently? This is one thing I’m not clear on re: Japan. I would have thought that after the market ‘got it’ that the BOJ wasn’t going to re-inflate, everybody should have adjusted to the new normal — painfully — but I’d think 10 years for that is plenty, and they’re going on 15.

  49. Gravatar of ssumner ssumner
    26. August 2010 at 12:34

    Gregor, Of course you are right. I misread read your comment, thinking you meant nominal rates fell 100 basis points. Silly mistake on my part.

    Richard, It depends what you mean by liquidity. What is the bid/asked spread? My guess is that it is pretty narrow. I’ve never suggested TIPS spreads are perfect, but when the spread narrows sharply it is a pretty good sign inflation expectations are falling. That happened in late 2008, and proved accurate (in a qualitative sense.)

    I believe the CPI futures markets tell roughly the same story.

    Doc Merlin, Or NGDP futures targeting.

    jj, Yes, but the real problem isn’t the Fed, it’s the Bush/Obama policy of propping up housing. Unfortunately, given the tight money policy, the adminstration (both of them) finds it hard to walk away from the housing market.

    OGT, It’s a game theory problem, which is a fancy way of saying the answer is unclear. We agree on central bank independence.

    Morgan, You need your own blog–you’d be good at it, as you write with verve.

    Jeff, Good point. One of my problems with fiscal stimulus is that $800 bilion is a lot to spend on something where you are relying on the theories of a 1930s British economists who had no model for NGDP. It may work, but so far it doesn’t look like is has worked this time. For those who say we needed more, the stimulus was twice the share of GDP as in 1982-83, and the recovery is less than half as fast.

    jj, I mostly agree about inflation, but if taxes on capital are not indexed, then inflation can also hurt financial assets, not just cash (i.e stocks and bonds did very poorly in the 1970s.)

    Japan has slowed down mostly for reasons unrelated to money, but tight money has made some of the recessions worse than necessary.

  50. Gravatar of Doc Merlin Doc Merlin
    26. August 2010 at 13:09

    NGDP futures targeting, while better than our current system is still a centralized system where the fed would set rates based on what they think will happen in the NGDP futures market. For the system to truly work without fed malfeasance or incompetence it needs to be self executing and leave no room to centralized discretion.

  51. Gravatar of Morgan Warstler Morgan Warstler
    26. August 2010 at 13:42

    “Morgan, why do you say inflation is a tax? That’s only true if you’re holding cash, otherwise who cares because your assets will grow at the same rate as prices. If inflation is stable and expected, even at 20% it would be irrelevant to the real economy, after we adjusted to the situation. Sure it makes life a bit simpler to have price stability at 0%, which I’m all for in theory, but I don’t understand why you think ANTICIPATED inflation really hurts anybody. (Unanticipated inflation is obviously bad.)”


    ALL legitimate lending of capital comes from savings.

    The less capital has been saved, the less is available to loan – the higher the rates of interest: supply / demand.

    The higher the cost of borrowing, the fewer innovations get brought to market, the less productivity gains there are – the less growth there is.

    Say it with me, “All growth comes from productivity gains.”


    So anything that taxes savings INTENTIONALLY – necessarily decreases savings, will decreases overall investment, and raises the cost of borrowing, reduce new ideas – and you get the idea.

    You don’t need hyper-inflation to see an uptick in Versace shirts sold in third world countries. Without fear of inflation, a culture of savings can take root.


    Again this is not a continuum. Too much loose money in the venture space – see 1999, and there are literally TOO MANY inventions / ideas chasing too small a group of consumers.

    This isn’t all that bad, because very quickly the jig is up, Mark Cuban shorts Yahoo – and the companies die off.

    So it is possible to have too much savings. But thats not what this is…

    Think of savings as a cup we want to keep full all the time – so you can maximize investment / invention, you can maximize productivity gains – growth. See Germany.

    I have no idea how we keep the cup full when Scott is taxing savings 4% a year – but I do know it’ll sell more Versace.

  52. Gravatar of jj jj
    27. August 2010 at 05:05

    Morgan, you didn’t answer my question: HOW does inflation work as a tax on savings? What is the mechanism?

    To Scott’s point, I agree, and I can’t imagine either party fixing the tax system to work properly under inflation (no capital gains tax, indexed brackets, etc)…

  53. Gravatar of scott sumner scott sumner
    27. August 2010 at 16:54

    Doc Merlin, In my system the market sets rates and the money supply, not the Fed.

  54. Gravatar of Doc Merlin Doc Merlin
    28. August 2010 at 18:26

    @ Morgan

    Well argued, but I differ on one point.

    Price Inflation rate doesn’t mean a tax on savings. Price inflation is separate from purely monetary inflation. The number of dollars could be perfectly unchanged and velocity perfectly unchanged and aggregate demand unchanged and we still have high inflation rate from destruction of aggregate supply.

    Purely monetary inflation is a tax on savings. It is inflation caused by expansion of money supply with supply and demand side issues removed.

    Now what Friedman ment when he said that all inflation was monetary? He meant that all inflation could be dealt with by monetary inflation targeting. It is true, however, it will cause NGDP shocks that increase pro-cyclicality.

  55. Gravatar of Doc Merlin Doc Merlin
    28. August 2010 at 18:27


    How does the market turn NGDP futures into interest rates (or money expansion/contraction) in your system?
    I’m really interested in the mechanism you propose.

  56. Gravatar of scott sumner scott sumner
    29. August 2010 at 09:41

    Doc Merlin, That is a very good point. I’ve argued that where people use inflation, they really should be talking NGDP growth. You’ve highlighted one such area. The problem is actually NGDP (MV) growth.

    Doc Merlin, I thought you had seen my argument earlier. Here is a post:

  57. Gravatar of Two worlds (fail to) collide | Quotar Blog Two worlds (fail to) collide | Quotar Blog
    29. September 2010 at 08:30

    […] Wednesday, I read at Scott Sumner’s blog that: …there are lots of simple answers (massive QE…etc.) But…for some reason our […]

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