Paul Volcker’s puzzling views on stimulus

I have frequently discussed a bizarre schizophrenia in the way many pundits approach demand stimulus.   Monetary stimulus is “bad” because it leads to higher inflation.  Fiscal stimulus is good because it leads to more growth.  You often see this perspective in the UK.  Of course both boost AD, and the inflation/growth split depends on the slope of the SRAS curve.  If one of them is more inflationary it is fiscal stimulus, which often has unfortunate supply-side consequences.  Here’s Paul Volcker:

At a time when foreign countries own trillions of our dollars, when we are dependent on borrowing still more abroad, and when the whole world counts on the dollar’s maintaining its purchasing power, taking on the risks of deliberately promoting inflation would be simply irresponsible.

It is that conviction that underlies Mr. Bernanke’s six words. Let’s not forget them.

President Obama has now set out new proposals to support economic growth. I hope he will be able to work with a responsible Congress to find the common ground that is urgently needed to deal with the economic challenges before us, restoring a healthy economy “in a context of price stability.”

I can’t make any sense out of that statement.  Isn’t Obama proposing fiscal stimulus?  And doesn’t fiscal stimulus work (if at all) by boosting AD and hence inflation?  Why is he not recommending that Congress reject Obama’s proposals for fiscal stimulus?

HT:  Paul Krugman


Tags:

 
 
 

43 Responses to “Paul Volcker’s puzzling views on stimulus”

  1. Gravatar of marcus nunes marcus nunes
    19. September 2011 at 08:03

    It´s definetely not the same Paul Volker of 30 years ago. Maybe he stopped smoking cigars!

  2. Gravatar of Stephan Stephan
    19. September 2011 at 08:08

    OK. I do understand why you constantly hype monetary stimulus and loathe fiscal stimulus. This is part of your job description: be a Quasi-Monetarist. (And YES I won’t abandon the Quasi. Market Monetarism is way to benign as a label.)

    But to suggest that with fiscal stimulus automatically comes demand-driven inflation is flat out wrong. It didn’t happen the last time and it won’t happen the next time. And I’m curious to learn more about “unfortunate supply-side consequences.”

  3. Gravatar of bill woolsey bill woolsey
    19. September 2011 at 08:13

    Expansionary fiscal policy raises the natural interest rate and this plausible raises the real exchange rate.

    Expansionary monetary policy plausibly causes the market interest rate to fall, and plausibly lowers the real exchange rate. (I know that it doesn’t have to work that way under current conditions.)

    Exactly how much impact these changes in the growth path of the real exchange rate will have in the context of more raid inflation and changes in the nominal exchange rate is questionable.

    Also, I reall think it is better to say that expansionary monetary and fiscal poilcy both expand AD and hopefully raise real output and any unfortunate inflationary impact should be the same for both. (Not that both work through inflation.)

    (And then we have the real exchange rate diffirence above.)

    I always wonder to what degree that central banking practice goes back to an international gold standard. As a pratical matter, the goal was to maintain gold redeemability. A domestic change in money demand creates a liquidtiy effect on interest rates, and by lending at a constant interest rate, the quantity of money is adjusted to match changes in demand to hold money. And then, interest rates have to be changed based upon international gold flows to maintain redeemability.

    Letting interest rates and exchange rates depend on market forces? Heaven forbid!

  4. Gravatar of Benjamin Cole Benjamin Cole
    19. September 2011 at 08:15

    “The whole world counts on the dollar maintaining its purchasing power.”

    As Laurel would say to Hardy, “This is another fine mess you gotten us into.”

    Really? We can’t conduct a monetary policy for our own benefit due to Olympian worldly concerns?

    Phil the Bricklayer is unemployed for years thanks to our obligations as a global currency?

    Abbot and Costello would not have agreed to a mess like this.

  5. Gravatar of Scott Sumner Scott Sumner
    19. September 2011 at 08:16

    Marcus, I agree.

    Stephen. It’s not me who claims fiscal stimulus is inflationary, its the propenents of fiscal stimulus–the new Keynesians. Fiscal stimulus, if it works at all, works by shifting the AD curve to the right. Come to think of it that’s exactly the same way monetary stimulus works. When AD shifts right you get higher inflation.

    The reason the 2009 fiscal stimulus didn’t increase inflation is fairly obvious, it didn’t work. It didn’t shift AD to the right because the Fed sabotaged it.

    Now if you want to argue it made the recession milder than otherwise, fine. I’ll just argue then that it made the disinflation milder than otherwise.

  6. Gravatar of Scott Sumner Scott Sumner
    19. September 2011 at 08:20

    Bill, You said;

    “Also, I really think it is better to say that expansionary monetary and fiscal policy both expand AD and hopefully raise real output and any unfortunate inflationary impact should be the same for both. (Not that both work through inflation.)”

    That’s right, although I’d say fiscal stimulus is a bit more inflationary, because it reduces AS (as the government sector is less efficient than the private sector.)

    Ben, Good point.

  7. Gravatar of Matt Waters Matt Waters
    19. September 2011 at 08:24

    Stephan,

    I assume you’re referring to World War II as the last time fiscal stimulus was done. Well, the price level went up 72% from 1940 to 1948, with much of that inflation coming after World War II when the price and wage controls were lifted. I don’t know about monetary policy during World War II, but I would call that “demand-drive inflation.”

    I always go back to the tautology that Volker has apparently forgotten, MV=PY=NGPD. Fiscal stimulus increases the V and enough fiscal stimulus without offsetting monetary tightening will lead to P going up dramatically. Monetary policy does the same thing, with either M or V. The fact that its M instead of V sometimes makes no difference. Monetary and Fiscal policy set out for the same goal.

    As far as Volker, I have no idea what to make of the editorial. I can only guess he’s become another Very Serious Person, an economist telling everybody else to suffer needlessly while having no economic insecurity himself.

    Reading such things from VSP’s, my mind just screams out “Well, what would you do to fix unemployment then?!” The basic fact that downfall in AD causes cyclical unemployment and central banks can fix AD and thus fix unemployment is just too quick and easy to make good New York editorials. It’s why Volker made this editorial and why Brooks said we “had to pay for our sins.” The only issue with such ritualistic blood-letting is that it’s not true. We should pay for our sins by working and paying off our debt, not being unemployed and sitting at home.

  8. Gravatar of Kevin Donoghue Kevin Donoghue
    19. September 2011 at 08:40

    It’s not me who claims fiscal stimulus is inflationary, its the propenents of fiscal stimulus-the new Keynesians.

    Maybe Volcker is an Old Keynesian. I know you like to think that homo keynesiensis antiquus has been extinct for decades, but I can assure you they are still around, maybe even breeding. And there’s any number of hybrids, like Krugman, whose DNA shows traces of Hicksian ancestry.

    Or did Keynes ever say that spending on public works is inflationary (other than in the vicinity of full employment)? I don’t think he did.

  9. Gravatar of Josh Josh
    19. September 2011 at 10:01

    I don’t think it’s quite accurate to say New Keynesians are demanding fiscal stimulus, that seems mostly to be tyler cowen’s “New Old Keynesians”. NK is about monetary policy the vast vast majority of the time, as you know. I think non-blogging NKs are fairly evenly split on fiscal stimulus at the zero rate bound.

    And really, there are plenty of academic circles out there where modern economics is divided into NK and RBC, with everyone that accepts sticky price/wages being lumped into the NK column (and that would include you!). I’m not saying that’s accurate, I do understand your dislike of focusing on interest rates and all that.

  10. Gravatar of Patrick R. Sullivan Patrick R. Sullivan
    19. September 2011 at 10:16

    ‘I’d say fiscal stimulus is a bit more inflationary, because it reduces AS (as the government sector is less efficient than the private sector.)’

    I’d say you’re exactly right, and that might explain the mini-stagflation we seem to be experiencing right now.

  11. Gravatar of Stephan Stephan
    19. September 2011 at 10:19

    @Matt
    Nope. I was referring to the “stimulus” put in place by the Obama administration dilettantes who seem to rule the waves not only in regard to fiscal policy but also monetary policy. The policy rule of the day seems to be: let’s do a little bit. Which means for the FED to do nothing to cause no harm. And for the Treasury to do something but we will pay for it. Indeed very strange times. I would love to learn whether this aggressive NGDP targeting works. My prediction: it won’t.

    The good news: you Americans are blessed with world-class public servants compared to our European losers. I was shocked to learn that Timothy Geithner was the only rational man present at the meeting of European finance ministers last weekend. The people running our public affairs are completely clueless. We have crazy central bankers like Jens Weidmann. If violating my BuBa rules means the Euro will implode so be it. And finance ministers like Schäuble who write absurd op-eds in the FT about how government spending will bring on a disaster.

  12. Gravatar of Morgan Warstler Morgan Warstler
    19. September 2011 at 10:21

    Volker, like other economists, doesn’t like finding out that we only want and will only use the part of their theory that supports the hegemony.

    Obama is not the hegemony. Inflation fighting is the hegemony, Volker resents it. See Bruce Bartlett.

    Economists! Get in the bottom of the boat and row!

    Pawns on the chess board all want to be kings and queens.

    The faster you adopt this thinking, the faster NGDP targeting will become the gold standard of modern economic thought.

  13. Gravatar of Morgan Warstler Morgan Warstler
    19. September 2011 at 10:23

    “Phil the Bricklayer is unemployed for years thanks to our obligations as a global currency?”

    Not really. We care about dollar purchasing power just because… that doesn’t change when foreigners own dollars, but that fact does let us get credit for promoting winners in the country too.

    If winners don’t win, no one will try.

  14. Gravatar of Scott Sumner Scott Sumner
    19. September 2011 at 10:44

    Matt, Good point.

    Kevin, But you can’t have it both ways. If Volcker thinks the SRAS is flat he should be screaming for more monetary stimulus–but he opposes it.

    Josh, You may be right, but certainly Woodford is calling for fiscal stimulus, and I’d consider him the leader of the NKs.

    Patrick, I agree, especially the 99 week UI extension. (Also the 40% higher minimum wage, although that isn’t fiscal stimulus of course.)

    Morgan, You said;

    “Economists! Get in the bottom of the boat and row!

    Pawns on the chess board all want to be kings and queens.”

    You seem to be plunging into a sort of Alice in Wonderland world. Have you been eating mushrooms?

  15. Gravatar of Kevin Donoghue Kevin Donoghue
    19. September 2011 at 11:24

    I read the reference to “the limitations on orthodox policies” as meaning that Volcker accepts that the US is in a liquidity trap. The Old Keynesian remedy is fiscal policy: orthodox monetary policy is ineffective. Yes, the SRAS curve is flat, but so is the LM curve. Fiscal expansion shifts the AD curve and the IS curve, with no impact on P or r. Only Y increases.

    I’m not saying he’s actually a textbook Old Keynesian. But this piece is quite consistent with OK thinking AFAICT.

  16. Gravatar of marcus nunes marcus nunes
    19. September 2011 at 12:08

    On route to the FOMC meeting, markets indicate MP is “very tight”: Stoks fall, dollar apreciates and 10 year Treasuries rise (price)!
    But Bernanke is only concerned about his “beloved 2% inflation target”!

  17. Gravatar of Martin Martin
    19. September 2011 at 12:15

    Scott,

    “Of course both boost AD, and the inflation/growth split depends on the slope of the SRAS curve. If one of them is more inflationary it is fiscal stimulus, which often has unfortunate supply-side consequences.”

    I think you should view this from a public finance perspective: it’s opportunity costs. There are only negative AS consequences when you’re going to engage in spending you would not have engaged in otherwise.

    If it is true that there is some maintenance to public goods that would have to be done anyhow, there can’t be negative AS-consequences. Arguably the spending actually has positive AS consequences: financing spending at historically low rates means lower future taxes.

    The trade-off is then (possible) higher future inflation vs. pulling forward spending and financing it at a lower rate than would otherwise be possible.

  18. Gravatar of Dan Kervick Dan Kervick
    19. September 2011 at 12:16

    Scott,

    Monetary stimulus can raise AD, but it depends on how its conducted, and also on economic circumstances outside central bank control. But maybe I’m confused about what you are counting as monetary stimulus. What specific actions are you talking about? Do you mean a fiscal expansion that is supported by open market purchases?

    Fiscal expansion need not be inflationary, if the spending goes into directly demanding new goods and services that employ human and material resources that are currently unemployed.

  19. Gravatar of Andy Harless Andy Harless
    19. September 2011 at 12:47

    Monetary policy would cause more inflation than fiscal policy if it were undertaken with inflation expectations as the mechanism of its operation. Fiscal policy would raise the natural interest rate, thus increasing AD without necessarily affecting the actual interest rate, either real or nominal, and thus it would not necessarily produce inflation (though presumably it is likely to produce some inflation as a side effect, since AS is not likely to be horizontal). Monetary policy, if it were undertaken using the expected inflation mechanism suggested by Krugman, Mankiw, and others, would lower the actual real interest rate without necessarily affecting the natural rate. This would necessarily involve a higher inflation rate — even if AS is currently horizontal (though obviously it wouldn’t work unless AS becomes non-horizontal at some point).

    To make this clear, imagine that AS is backward L-shaped. In that case fiscal policy can theoretically get your right to the kink and stimulate the real economy without producing any inflation. But monetary policy, in order to be effective via the short-term real interest rate mechanism, has to go beyond the kink. The region between the current position and the kink is not available, because the inflation rate will be the same and nominal interest rate will still be zero, so the real interest rate will be the same, and there will be no stimulus to get you from here to the kink. (I realize you think there are other mechanisms for monetary policy, but there are people who believe that short-term real interest rates are the only mechanism, and for those people, it makes perfect sense to say that monetary policy has to be inflationary but fiscal policy doesn’t.)

    More generally, there are a range of possibilities as far as (1) to what extent short-term interest rates are the transmission mechanism for monetary policy and (2) how convex the AS curve is. Without believing that short-term interest rates are the only possible mechanism, and without believing that the AS curve is backward L-shaped, one can still be close enough to that position to think that monetary policy requires more inflation in order to be effective, as compared to fiscal policy.

  20. Gravatar of Jim Glass Jim Glass
    19. September 2011 at 12:51

    And I’m curious to learn more about “unfortunate supply-side consequences.”

    The Obama stimulus sent $350 million to New York City’s Metropolitan Transit Authority to fund construction of the infamous Second Avenue Subway.

    This while the Transit Workers Union, a hugely politically powerful government employees monopoly, was negotiating its next contract and threatening an illegal strike, as always. The Democratic politicians kicked the contract dispute to mediation with a pro-union mediation board (headed by the previous head of the union). The board found $350 million of excess funds available in the MTA’s construction account — excess because they weren’t in the MTA’s original construction plans, and money is fungible — and used them to give the union an 11% pay raise.

    This happened while the MTA was so broke that it was not only raising fares but also being bailed out by a new state-leveled employment tax imposed on workers in communities up to 80 miles away from the nearest subway station.

    So at the height of the Great Recession, with unemployment going up to 10%, the union got an 11% pay raise paid for with stimulus money.

    Net result: Zero new construction, zero new jobs, and when the stimulus funds run out the MTA will have no means to finance the permanently higher wage level (except more fare hikes and bigger tax increases) which will be the base from which the next demand for a raise is made … all at the mere cost of $350 million added to the national debt.

    How do the supply-side effects look there?

    NYC is hardly unique. Multiply by countless episodes across the country.

  21. Gravatar of marcus nunes marcus nunes
    19. September 2011 at 12:56

    Josh hendrickson replies to Arash Molavi>
    http://everydayecon.wordpress.com/2011/09/19/does-market-monetarism-forsake-modern-theory/
    Things are “warming up”

  22. Gravatar of Jim Glass Jim Glass
    19. September 2011 at 13:30

    Volcker was the man who led the brutal fight to break inflation in 1981 and on. I still remember farmers parading their tractors in front of the Fed.

    With the scars he took, he’s the *one* central banker I give a pass to, for still being fixated on inflation today.

  23. Gravatar of Jim Glass Jim Glass
    19. September 2011 at 13:35

    “I’d say fiscal stimulus is a bit more inflationary, because it reduces AS (as the government sector is less efficient than the private sector.)”

    I’d say so. Consider the Second Avenue Subway example above. Or Murtha Airport, and the backup runway it needed for its three flights a day, via stimulus funds. Multiply by … a whole lot. I don’t know how small “a bit” that reduces to.

    This is one thing the Krugmans of the world never want to mention. I saw Krugman on Charlie Rose explain stimulus this way:

    “Here in NYC and there are potholes all over the roads. Well, you hire unemployed persons to fill the potholes. Now you have better roads making the community wealthier, and more newly employed persons who are better off and spending money on others in the community. It’s as simple as that”.

    Ha, as if the city’s unions would let unemployed people be hired to do their jobs, any more than the TWU would.

    Then we have the week’s actual NYC pothole-filling story
    ~~~~ quote ~~~~

    A gaping crater in the middle of a busy Brooklyn street — which went unrepaired for weeks while the city dithered over what to call it — was filled yesterday morning, then ripped up just hours later.

    As if that wasn’t weird enough, more city workers came after four of their colleagues dug up the freshly paved hole — and filled it for a second time.

    That makes for two refills in one day — perhaps the height of bureaucratic bungling.

    The street action came after The Post revealed that former Taxi Commissioner Felix Del Valle complained about the hole and another one nearby to 311, but they weren’t fixed because, technically, they weren’t “potholes.”…
    ~~~~~

    That’s even *better* than Keynes’s idea of burying bottles with money in them and paying people to go dig them up.

    It’s like burying the bottles … realizing somebody forgot to put the money in them … paying people to dig them up … then putting the money in them … paying people to bury them again … then paying people again to dig them up again!

    And also paying all the government bureaucrats you hired to manage the entire process.

    Stimulus!!

  24. Gravatar of Patrick R. Sullivan Patrick R. Sullivan
    19. September 2011 at 13:56

    Jim’s example of the NY subway is a good one, especially as the NY subway used to be a private business that operated profitably unti lthe city’s politicians horned their way.

    All across the country ARRA funds displaced productive companies that had been repairing ‘our crumbling infrastructure’ from gas tax revenue for years. But, not being politically connected they’re out in the cold (as are their employees).

  25. Gravatar of John John
    19. September 2011 at 14:09

    Scott,

    Does the SRAS model ever include a case where more AD stimulus would produce lower real growth? It seems like economists really just think more AD= more growth with the only downside being higher inflation. In the real world is seems that demand stimulation often keeps an economy down.

  26. Gravatar of Morgan Warstler Morgan Warstler
    19. September 2011 at 14:18

    Jim Glass,

    What has to happen is the direct implied tit for tat…

    When the Union is starved into a 11% pay cut, we’ll be standing the the way side with a printing press JUST IN CASE the economy slows down.

    That is the only way Scott’s policies will be adopted in reality.

    I’m not sure everyone here is truly committed, like the pig is committed to the plan as stated.

    —-

    Targeting NGDP at 3% level is almost exactly the same as King Dollar.

    It just seems like King Dollar without the annoying boom / busts.

  27. Gravatar of flow5 flow5
    19. September 2011 at 14:30

    Volcker is the guy that killed monetarism. He’s not puzzling:

    Paul Volcker’s version of monetarism (along with credit controls), was limited to Feb, Mar, & Apr of 1980. With the intro of the DIDMCA, total legal reserves increased at a 17% annual rate of change, & M1 exploded at a 20% annual rate (until 1980 year’s-end).

    Why did Volcker fail? This was due to Volcker’s operating procedure. Volcker targeted non-borrowed reserves when at times 10 percent of all reserves were borrowed. That’s before the discount rate was made a penalty rate. And the fed funds “bracket racket” was simply widened, not eliminated. Monetarism actually has never been tried.

    Then came the “time bomb”, the widespread introduction of ATS, NOW, & MMMF accounts — which vastly accelerated the transactions velocity of money (all the demand drafts drawn on these accounts cleared thru demand deposits (DDs) – except those drawn on Mutual Savings Banks (MSBs), interbank, and the U.S. government).This propelled nominal gNp to 19.2% in the 1st qtr 1981, the FFR to 22%, & AAA Corporates to 15.49%. My prediction for AAA corporate yields for 1981 was 15.48%.

    By the first qtr of 1981, the damage had already been done. But Volcker screwed up again (supplied an excessive volume of legal reserves to the banking system), in late 1982-83. I forecast in FEB 84 that stocks & bonds would bottom in June 84. Stocks bottomed June 15 @1086.90 & bonds on July 2 @13.76%

    No, Volcker didn’t deserve to be FED CHAIRMAN.

  28. Gravatar of flow5 flow5
    19. September 2011 at 14:58

    “Policy makers should focus on core inflation to better reflect trends that are “likely to be sustained over the medium term,” the International Monetary Fund said”

    “Columbia University’s Michael Woodford and Harvard University’s Kenneth Rogoff are among proponents of faster price increases”

    http://www.bloomberg.com/news/2011-09-18/bernanke-joins-king-tolerating-more-inflation-as-economies-fail-to-revive.html

  29. Gravatar of Patrick R. Sullivan Patrick R. Sullivan
    19. September 2011 at 15:36

    Anyone old enough to remember the dictum that, ‘The civil servant will never have much, but he’ll have it for sure.’?

    http://seattletimes.nwsource.com/html/localnews/2016241176_citysalaries18m.html

    ———quote————
    The number of Seattle city employees making at least $100,000 has grown tenfold in less than a decade, with one in five workers earning six figures last year.

    But it’s not bureaucrats behind desks driving the surge.

    Of the 2,309 city employees in the six-figure club last year, 79 percent worked in three departments: police, fire and City Light. The vast majority were rank-and-file union employees “” police officers, firefighters and power-line workers “” not management types.

    You can trace significant increases in $100,000 employees to recent contracts for those workers.
    ———–endquote————-

  30. Gravatar of Becky Hargrove Becky Hargrove
    19. September 2011 at 16:44

    I hope this question is not too far out in left field, for I am trying to understand monetary and fiscal stimulus in terms of actual monetary wealth creation: do both add money to the economy in an aggregate sense? The individual activates a monetary scenario when she takes out a loan at a bank. That also means money is placed into the economy that was not already there. Now if I understand correctly, when the government takes fiscal action, no new money is being created but simply moved from another place. How could that be more inflationary?

  31. Gravatar of Morgan Warstler Morgan Warstler
    19. September 2011 at 17:09

    Patrick, you just make sure to vote for Rick Perry.

    We’ll gut public employees like fish.

  32. Gravatar of Scott Sumner Scott Sumner
    19. September 2011 at 18:35

    Kevin, If orthodox Keynesian theory say monetary stimulus is inflationary at the zero bound but fiscal stimulus is not, then perhaps it’s time to junk old Keynesian theory.

    Marcus, And what’s scary is that those markets reflect an expectation of Fed stimulus–what if they don’t do anything effective?

    Martin, I don’t buy that sort of “depression economics,” at least for any significant amount of stimulus. The efficiency cost from higher taxes will exceed any gains from smoother roads. Notice that S&L governments also don’t buy that argument, as they are doing the opposite. So the Feds have to assume that S&L governments are “irrational” and override their decision.

    Dan, If fiscal stimulus works it will shift the AD to the right. Because the SRAS is certainly not completely flat, it will raise inflation.

    Andy, I’ve heard that theory but I just don’t buy it. Consider the thought experiment where the Fed targets the price of a NGDP futures contract. Now tell me how much you think fiscal stimulus will boost NGDP. Now have the Fed target the price of a NGDP futures contract at that level. It seems to me that thought experiment disproves their argument. They assume that what matters is the relationship between the nominal interest rate and inflation, but what actually matters is the relationship between the nominal interest rate and NGDP growth.

    Jim Glass and Patrick, Those are good examples, and also consider that green energy firm that just went bust with a half billion in tax money.

    John, Sure, at near full employment fiscal stimulus can reduce RGDP.

    flow5, I’m skeptical of anyone telling me they can predict turning points in the stock market.

    Becky, Good question, and your instincts are correct. What I meant was that a monetary and fiscal stimulus that each boosted AD by X amount are equally inflationary. But for the reason you indicated, it would take a lot more fiscal stimulus to boost AD by X amount.

  33. Gravatar of Martin Martin
    19. September 2011 at 23:58

    Scott,

    “The efficiency cost from higher taxes will exceed any gains from smoother roads.”

    As Friedman used to say: ‘to spend is to tax’. If you are going to spend the money anyway, and use historically low interest rates to do so, then you will have lower taxes in the future, not higher.

    Hence why I said: “There are only negative AS consequences when you’re going to engage in spending you would not have engaged in otherwise.”

    If you have blob of capital of say $ 1000 and it depreciates at $100 a year and in year 2 there is a depression, then it makes sense to repair that capital and borrow $200 as rates are low. The alternative is that you have to borrow or save (out of the national income) and spend it when rates are higher. Sure you could way when it has depreciated to $500 and repair it then, but I do not see why.

  34. Gravatar of flow5 flow5
    20. September 2011 at 05:15

    flow5, I’m skeptical of anyone telling me they can predict turning points in the stock market.

    Then you obviously don’t understand money & central banking period.

  35. Gravatar of Andy Harless Andy Harless
    20. September 2011 at 06:57

    The thought experiment with NGDP futures doesn’t prove anything unless you know the outcome. The outcome could be what you expect, with the contracts settling close to their market prices and relatively modest monetary policy actions necessary to keep the contracts on target, or it could be extreme volatility, with wild swings in supply and demand in the futures market leading to wild swings in monetary policy. Believers in the “excluded middle” theory would expect the latter. The point is that target NGDP may not be an equilibrium, so you can end up with a market that is constantly flip-flopping between two equilibria on either side.

    My own view is that there is probably enough heterogeneity in the market to make target NGDP an equilibrium for some large enough margin of market participants, so the outcome is likely to be stable, but I’m not 100% confident in this outcome.

  36. Gravatar of Scott Sumner Scott Sumner
    20. September 2011 at 08:04

    Martin, Why don’t you think S&L governments follow your advice?

    flow5, I’m honored that you put me in the same class as Friedman and Taylor.

    Andy, I am having trouble following your argument. The model you presented suggested that monetary policy would fail to boost NGDP. If investors are rational that means it will fail to boost NGDP expectations. But how can that occur if the Fed is pegging an NGDP futures contract? I could simply go short and make tons of money off the government?

  37. Gravatar of flow5 flow5
    20. September 2011 at 09:02

    “flow5, I’m honored that you put me in the same class as Friedman and Taylor.”

    You don’t qualify. No one that has ever studied economics was ever as dumb as Milton Friedman. And Taylor’s formula is straight out of some history lesson – not some future condition.

    “flow5, I’m skeptical of anyone telling me they can predict turning points in the stock market”

    I’ll take your bet anytime.

  38. Gravatar of flow5 flow5
    20. September 2011 at 09:07

    I was in Dr. Pritchard’s (Chicago 1933) money & banking class when the DOW was over 1000 & he told students (that were awake enough to know what was going on) that the DJIA would be 600 when we returned to school. That’s exactly what happened in 74.

    Then again Business Week published 27 price forecasts by individuals & 9 by econometric models (the range 4.9 the high 6.5). Pritchard said 8-9% for 78.

    I fine tuned it in July 1979 (Dr. Pritchard said “the correlation of the time series is remarkable”)

  39. Gravatar of Martin Martin
    20. September 2011 at 10:30

    Scott,

    “Martin, Why don’t you think S&L governments follow your advice?”

    Political constraints most likely. Don’t S&L-governments often have a balanced budget requirement? Another reason and a close second could be a lack of projects. Third and final reason would be too much spill-over: Full costs & only fraction of the benefits.

    Absent these, I don’t see a good reason not too. Note though that Volcker is proposing fiscal stimulus at the federal level and not the S&L level. #3 then virtually disappears and #2 becomes less likely, leaving us with #1.

  40. Gravatar of Ride of the Volckery « Renaissance Roundtable Ride of the Volckery « Renaissance Roundtable
    20. September 2011 at 14:57

    […] Scott Sumner: I have frequently discussed a bizarre schizophrenia in the way many pundits approach demand stimulus.   Monetary stimulus is “bad” because it leads to higher inflation.  Fiscal stimulus is good because it leads to more growth. […]

  41. Gravatar of Andy Harless Andy Harless
    21. September 2011 at 12:23

    Scott:

    The model you presented suggested that monetary policy would fail to boost NGDP.

    Not exactly. What is says is that monetary policy can’t boost NGDP to just the target. There are feasible equilibria below the target, and there are feasible equilibria above the target, but the Fed is (hypothetically) aiming to hit the target exactly. In the end (assuming we end up in equilibrium) there will either be a big overshoot or a big undershoot, but you don’t know which. And the Fed makes it particularly hard to know which, because every time one outcome becomes more likely the Fed aggressively steers away from that outcome. If you’re a market participant, you don’t know which one to bet on, so you buy and sell huge amounts depending on small changes in observable variables that lead you to expect one or the other outcome. Hence instability.

  42. Gravatar of Andy Harless Andy Harless
    21. September 2011 at 13:14

    Just to make this clear. Suppose AS is backward L-shaped with a kink corresponding to 3% RGDP growth; suppose the short-term real interest rate is the only transmission mechanism; and suppose the natural real interest rate is negative 3%. Monetary policy can certainly boost NGDP if the Fed makes a credible commitment to an NGDP growth rate greater than 6%, because you’ll have 3% RGDP growth and (more than) 3% inflation, so the market will operate based on a real interest rate of (less than) negative 3%, which will stimulate the economy enough to push the economy beyond the kink in the AS curve and can thus generate the 3% inflation on which it is premised.

    Or the Fed can credibly promise the hit the other equilibrium. Let’s say for simplicity that the previously anticipated inflation rate is zero and that the RGDP growth rate associated with a zero real interest rate is also zero. Then the Fed can credibly promise zero NGDP growth.

    But let’s say the Fed promises 5% NGDP growth. This promise isn’t credible, because the point on the AS curve corresponding to 5% NGDP growth also corresponds to a 2% inflation rate, which means a negative 2% real interest rate, which is still above the natural real interest rate of negative 3% required to get the economy past the kink in the AS curve.

    So if the Fed promises 5% NGDP growth, perhaps initially the market will anticipate 0% NGDP growth and NGDP futures will collapse. But then the Fed, seeing that the market is collapsing, will go wild and crazy to convince the market it means business. If the Fed tries hard enough (which it must if it is absolutely committed to targeting the futures), then it will go so wild and crazy that it will eventually convince the market that the 6% NGDP growth rate is going to happen (since the market still knows that 5% isn’t feasible). But then the Fed will tighten until the market becomes convinced that the 0% NGDP growth rate is going to happen. But then the Fed will see the futures collapsing and go wild and crazy again until the market is convinced that the 6% NGDP growth rate is going to happen. But then the Fed will see the futures overshooting and tighten again until the market is convinced that the 0% NGDP growth rate is going to happen. And so on.

    Basically, if you take my multiple equilibrium case and add a Fed reaction function that will not accept any of the feasible equilibria, you end up with no equilibrium at all. The system has no solution. You can give the market rational expectations, I guess, but in this case the Fed is behaving irrationally by pursuing an equilibrium that doesn’t exist.

  43. Gravatar of Scott Sumner Scott Sumner
    26. September 2011 at 11:14

    Flow5, No need to bet me, you can bet the market. Anyway, even if you “won” how would we know it wasn’t luck?

    Martin, I’m not expert, but I don’t think the balanced budget rules applies to capital projects.

    Andy, OK, I give up. If you assume lots of things that aren’t so, like and L-shaped SRAS and the real interest rate being the only transmission mechanism, then maybe there is no equilibrium. Sorry this took so long, I got swamped last week.

Leave a Reply