Reply to Reihan Salam at the National Review

Reihan Salam has requested my thoughts on a recent Economics 21 editorial:

Keep in mind that this editorial is part of an ongoing conversation. It is very possible that the Italy analogy is flawed. I’m hoping that Scott Sumner, Karl Smith, and others who favor a more aggressive use of monetary accommodation will weigh in on the editorial.

I’ve seen Salam on, and he always struck me as a very thoughtful and innovative conservative.  [Any jokes using the term ‘oxymoron’ will be stricken from the comment section.]   So I decided to respond to the Economics 21 piece:

Rather than focus obsessively on the inapt comparison to Japan, the Fed should be more concerned about the growing similarities between the U.S. and 1970s Italy. Italy experienced financial crises in 1974 and 1976 spurred by large current account deficits, excessive public spending, and a central bank that acquired Italian government debt by printing money. These crises required external financial assistance, led to abrupt and disorderly swings in public finances, and bred political instability. The country moved from economic stimulus, to severe fiscal and monetary contractions, back to expansionary policy. Balance of payments difficulties were persistently addressed through currency depreciation to gain competitive advantage. From June 1972 to August 1977, the Italian lira fell from 579.71 versus the dollar to 884.76 – a depreciation of more than 34%.

The chart below compares recent U.S. public financial data to that of Italy in the 1970s. Relative to 1970s Italy, the U.S. has run larger current account deficits and generated slower economic growth. The U.S. investment rate has barely exceeded Italy’s anemic 13.5% average, and the dollar’s depreciation against gold has been only somewhat less steep than the lira’s fall in the 1970s. The U.S. budget deficit is much larger, although this comparison is difficult to make because official Italian budget deficits tended to understate the government’s true financing needs, which exceeded 12% of GDP in 1977.

[click on Economics 21 link above to check out table of data here]

Between 1974 and 1976, the Italian central bank printed lira in mass quantities to buy Italian government debt. This “large scale asset purchase” program led to a more than 100% increase in the monetary base. This was actually a much smaller increase in the monetary base than that engineered by the Fed’s money printing operations. From February 2008 to February 2010, the U.S. monetary base increased by more than 150% – from $822.54 billion to $2.11 trillion. The Italian central bank accelerated its money printing in conjunction with a “large fiscal reflation” package adopted in August 1975, much as the Fed’s quantitative easing began roughly the same time as the fiscal stimulus.

Although the stimulus and money printing succeeded in generating positive growth in 1976, it also precipitated a crisis in the lira. Mario Monti, later competition commissioner of the European Union, predicted the crisis in late 1975 based purely on observed growth in base money. Foreign creditors – responsible for financing 7.2% of GDP in domestic Italian borrowing during 1973-76 – fled Italian securities causing the value of the lira to fall by 35% in less than five months. Less than two years after the last crisis, the Italian financial system was again embroiled in a panic as printing money to accommodate spending in excess of income at both the government and national levels widened current account deficits and triggered a foreign investor revolt.

There are certainly some similarities to Italy, but are they the important ones?   Relying on memory, I think Italy’s problems were roughly as follows:

1.  In the 1970s growth slowed dramatically from the 8% of the go-go 50s and 60s (remember La Dolce Vita?) to a sub-par rate ever since.

2.  If one combines this sharp economic slowdown with a rather dysfunctional political system, you get a fiscal crisis.  When there is political gridlock, the easiest way out is printing money.

3.  The base rose rapidly and this contributed to high inflation and currency depreciation.

How does this compare to the US?  There are some obvious similarities.  We had a real shock in our real estate industry (perhaps comparable to the 1973 oil shock.)  We seem to be adopting bad tax and regulatory policies that will slightly slow our trend rate of growth (but nowhere near as much as in Italy.)  We have political gridlock, which leads to big budget deficits.  And we have current account deficits.  But I think the differences are much more important.

1.  The monetary base in the US has risen for exactly the opposite reason as in Italy, but the same reason as in Japan.  In Italy the base was monetizing the debt, and this produced high inflation.  In the US the base growth is a response to the demand for liquidity during the banking crisis, the payment of interest on reserves, and the very low nominal interest rates and inflation rates.  I doubt we’d have suddenly started paying interest on reserves if the goal was monetizing the debt.

2.  In the 1970s Italy did not suffer from a shortfall in AD.  I am pretty sure that NGDP grew at a robust rate–their problems were supply side.  They did have occasional crises when high inflation led the government to tighten policy, leading to a boom/bust cycle.  In contrast, in 2009 the US saw the sharpest fall in NGDP since 1938.  Even if there had been no banking problems, a fall in NGDP that sharp (relative to trend growth) would have created a severe recession.  And the slow recovery of NGDP (as compared to 1983-84) makes a slow recovery in RGDP and employment almost inevitable.

3.  Despite all the QE in the US, the market indicators of inflation expectations remain quite low over the next 5 years.  In contrast, if TIPS and CPI futures had existed in Italy, I am certain they would have showed a loss of confidence in the domestic purchasing power of the lira.

4.  They did not cite the Rogoff data on banking crises, but I always like to remind people that the US banking crisis of late 2008 was a relatively rare version of what is otherwise a quite common phenomenon.  In the vast majority of banking crises the currency falls in the foreign exchange market.  Three counterexamples were the US in the early 1930s, Argentina around 1998-2002, and the US in late 2008.  In all three cases the currency rose strongly in trade-weighted terms, even in the midst the crisis.  That suggests that tight money (lack of AD) is either the root cause of the crisis (the US in the 1930s and Argentina in the late 1990s) or greatly aggravated a pre-existing banking crisis (the US in the second half of 2008.)

5.  I believe the fundamental problem in Italy was that some real economic problems were poorly handled by the government, and this led to irresponsible fiscal and monetary policies.  The US situation was much different.  Some real problems in the banking and real estate sectors led to a mild slowdown in late 2007 and early 2008.  But this wasn’t enough to lead to highly irresponsible fiscal and monetary policies.  Instead, a severe drop in NGDP relative to trend after mid-2008 (due to Fed errors of omission) led to a severe recession.  The recession was misdiagnosed as banking-oriented, and we first tried to fix banking.  Then we correctly noted AD (i.e. NGDP) was falling fast, but erroneously assumed the Fed could do no more, and went for fiscal stimulus.  Only recently have we realized that the Fed is the key, and we are doing what we should have done 2 years ago.  But even this seemingly large QE has only modestly raised inflation expectations over 5 years (from about 1.2% to 1.7%.)  Conservatives who draw comparisons with Italy are missing the AD problem, the elephant in the room.

Having said all that, I do agree that the recent trend toward higher taxes and regulations are causing “real” problems for the US economy.  I support many conservative ideas such as deregulation, abolishing the GSEs, vouchers, health saving accounts and tax and entitlement reforms that encourage savings.  But even if in the long run those issues are more important than AD shortfalls, we need to keep in mind that these reforms will be harder to achieve if an NGDP growth shortfall worsens the budget deficit and leads to inefficient programs like 99 week unemployment benefits.  In that respect Japan is an important cautionary tale.  They reacted to a monetary problem with inefficient fiscal actions.

Over the past two years I’ve warned conservatives that Paul Krugman would be able to gloat that he was right and they were wrong about our policies leading to high inflation and high interest rates.  Not many conservatives took my advice, and now Krugman has started gloating.  (Which will be the subject of my next post.)



17 Responses to “Reply to Reihan Salam at the National Review”

  1. Gravatar of marcus nunes marcus nunes
    9. November 2010 at 12:53

    Eichengreen highlights a long term danger…:
    “…Herein lies the most convincing explanation for British decline. The country failed to develop a coherent policy response to the financial crisis of the 1930’s. Its political parties, rather than working together to address pressing economic problems, remained at each other’s throats. The country turned inward. Its politics grew fractious, its policies erratic, and its finances increasingly unstable”.

    In short, Britain’s was a political, not an economic, failure. And that history, unfortunately, is all too pertinent to America’s fate.

  2. Gravatar of 123 – TheMoneyDemand Blog 123 - TheMoneyDemand Blog
    9. November 2010 at 13:04

    One very important item is missing in the list (much more important than IOR):

    “In the US the base growth is a response to the demand for liquidity during the banking crisis, the payment of interest on reserves, and the very low nominal interest rates and inflation rates.”

    There is also fear that reserves will be withdrawn too soon. This was especially important before the Fed decided to reinvest the proceeds from mortgage securities, and it was also very important in early 2009 (before the QE), as credit easing was explicitly designed to be a temporary program.

  3. Gravatar of Steve Steve
    9. November 2010 at 14:40

    Trend toward higher taxes? In the U.S.? Huh?

  4. Gravatar of Mike Sandifer Mike Sandifer
    9. November 2010 at 14:45


    I hope you’ll do a post on the World Bank’s Zoelick’s suggestion that

    “The system should also consider employing gold as an international reference point of market expectations about inflation, deflation and future currency values. Although textbooks may view gold as the old money, markets are using gold as an alternative monetary asset today.”

  5. Gravatar of JTapp JTapp
    9. November 2010 at 17:35

    You can use Google Translate to read the website you linked to. Above the graph: “What has the ECB done? Completely fails:”

  6. Gravatar of Simon K Simon K
    9. November 2010 at 18:13

    I’m with Steve – what higher taxes? Aren’t we in the process of re-enacting a completely unsustainable tax “cut”? And isn’t the main argument over whether to symbolically screw over the top 5% of tax payers? I swear these things only get media traction because most listeners don’t understand that income tax rates are marginal.

  7. Gravatar of scott sumner scott sumner
    9. November 2010 at 19:00

    Marcus, Good point, but I think their problems were deeper. They bought into the socialist ideology much more than we did. Even in the 1920s American economists complained that “the dole” was creating high unemployment in Britain.

    123, Maybe, but I’m only confident listing items I have studied, and I simply don’t know as much about that issue as you do.

    Steve, The health care bill raised taxes, Obama proposes more tax increases, and all the experts say our budget nightmare will require still more tax increases. I was looking forward.

    Mike, Sorry–no time. Krugman already demolished that idea. It’ll never happen. Why adopt a contractionary policy when we are trying to raise inflation?

    Thanks JTapp.

    Simon, See my answer to Steve. We have the highest corporate tax rates in the developed world (along with Japan.)

  8. Gravatar of Liberal Roman Liberal Roman
    9. November 2010 at 23:14


    Is it right for people to say that QE is equivalent to monetizing debt?? I mean the Fed always buys treasuries in their open market operations even in normal times. Now, it’s just buying long-term Treasuries.

    But in my opinion, this is not monetizing the debt because the government will still make interest payments to the Fed on those those securities. Monetizing the debt would be printing money, buying Treasury securities and just destroying them and not expecting payments on them.

    Am I right?

  9. Gravatar of 123 123
    10. November 2010 at 04:30

    Scott, you said:
    “Maybe, but I’m only confident listing items I have studied, and I simply don’t know as much about that issue as you do.”

    No. You know about the permanent vs. temporary increases of monetary base more than me.

    And here are FOMC minutes (Jan 2010):

    “Staff described several feasible strategies for using these six tools to support a gradual return toward a more normal stance of monetary policy: (1) using one or more of the tools to progressively reduce the supply of reserve balances–which rose to an exceptionally high level as a consequence of the expansion of the Federal Reserve’s liquidity and lending facilities and subsequent large-scale asset purchases during the financial crisis–before raising the IOER rate and the target for the federal funds rate; (2) increasing the IOER rate in line with an increase in the federal funds rate target and concurrently using one or more tools to reduce the supply of reserve balances; and (3) raising the IOER rate and the target for the federal funds rate and using reserve draining tools only if the federal funds rate did not increase in line with the Committee’s target.

    Participants expressed a range of views about the tools and strategies for removing policy accommodation when that step becomes appropriate. All agreed that raising the IOER rate and the target for the federal funds rate would be a key element of a move to less accommodative monetary policy. Most thought that it likely would be appropriate to reduce the supply of reserve balances, to some extent, before the eventual increase in the IOER rate and in the target for the federal funds rate, in part because doing so would tighten the link between short-term market rates and the IOER rate; however, several noted that draining operations might be seen as a precursor to tightening and should only be undertaken when the Committee judged that an increase in its target for the federal funds rate would soon be appropriate. For the same reason, a few judged that it would be better to drain reserves concurrently with the eventual increase in the IOER and target rates.”

    So the majority of FOMC thought in January 2010 that reserves will be partially withdrawn first before increasing interest rates :”Most thought that it likely would be appropriate to reduce the supply of reserve balances, to some extent, before the eventual increase in the IOER rate and in the target for the federal funds rate”

  10. Gravatar of Doc Merlin Doc Merlin
    10. November 2010 at 05:21

    @Liberal Roman:
    ‘But in my opinion, this is not monetizing the debt because the government will still make interest payments to the Fed on those those securities. Monetizing the debt would be printing money, buying Treasury securities and just destroying them and not expecting payments on them.

    Am I right?’

    You are incorrect, QE is in our case monetizing debt. While its true that the Fed will have to pay interest on it, they will not have to pay the principal back, the Fed will just keep rolling it over. That is the entire point of QE.

  11. Gravatar of C C
    10. November 2010 at 05:48

    To the lay man, it seems like the US is printing money to reduce the value of its debt obligations (broadly speaking, including the banking woes) and ‘get out of jail’ that way.

    Is that what Quantitative Easing is about? Printing money – Higher expected inflation – more paper money to pay off the problems – faster end to problems – higher real growth. ?

  12. Gravatar of Bill Woolsey Bill Woolsey
    10. November 2010 at 12:33


    Money expenditures are 13% below the growth path of the Great Moderation. To get back to that growth path in one year, they would need to grow 21%. After they return, the “should” return to growing 5% a year, and we are back where we started. This would result in roughtly 2 percent inflation in the future.

    In price level is about 2 percent below its growth path of the Great Moderation. If the growth of money expenditures returned the price level to its long run growth path in one year, then that would be 4 percent inflation for that one year, before returning to 2% inflation.

    However, it is possible that the productive capacity of the economy has been depressed for a variety of reasons. If the potential income estimates from the CBO are to be trusted, then more than 4% inflation would be associated with the return of money expenditures to target, and if the productive capacity of the economy continues to grow more slowly, then higher inflation–about 3% would be expected into the future.

    Now, if money expenditures were to grow 21% per year permanently, returning the the past growth path, surpassing it, and creating a new, growth path at a 21% growth rate, then this would be highly inflationary.

    The argument that higher expected inflation is necessary (or at least desirable) involves the claim that real short term, low risk interest rates need to fall further to get money (and real) expenditures higher. Some have argued that the 2 percent inflation target has proven to be too low, and that short term, low risk interest rates need to sometimes be reduced lower than -2 percent. However, these proposals are usually for 4% rather than 2% inflation. I don’t agree with that approach.

  13. Gravatar of Liberal Roman Liberal Roman
    10. November 2010 at 17:25

    OK, let me put it to you another way. When the Fed did $1 Trillion in QE in 2009, if it was really monetizing the debt, $1 Trillion of debt should have come off of the national debt. And now, when the Fed finishes its $600 billion in QE, the $600 billion should come off the national debt. But it won’t. The reason is the debt has not gone away. The Treasury will pay the Federal Reserve that $600 billion back. Now it might do it by issuing new debt. That’s debt rollover. That’s not debt monetizing. Again, debt monetizing in my mind is printing money, buying deb securities with it and then essentialy consider that debt as paid off or forgiven. That’s not what happens when the Fed buy short term Treasuries in normal times and that’s not what’s going to happen.

  14. Gravatar of scott sumner scott sumner
    11. November 2010 at 06:18

    Liberal Roman. Yes, That’s how I look at it too. I realize that technically it’s hard to distinguish between ordinary OMOs and monetizing the debt. But I think in the real world the term monetizing the debt implies the new base money will be left out there permanently, and lead to high inflation. I don’t thank that’s the Fed’s intention, so I think it’s unfair to call it monetizing the debt.

    123, You are right, for some reason I misinterpreted your previous comment. There are two issues that are close, that I may have mixed up:

    1. Currency injections that are known to be temporary, and for a given duration, and that don’t have any effect.

    2. Currency injections of uncertain but temporary duration, that lead to liquidity worries in banks, and hence are deflationary.

    Am I correct that these are two different issues? It seemed to me that you had emphasized the second, and I had emphasized the first. But maybe I am still misreading your argument.

    DocMerlin, The “rolling over the debt” argument is misleading. In that case you must pay the present value of the debt in the stream of future interest payments (on ERs) out to infinity. That is not monetizing the debt.

    C, I agree with Bill, It’s about getting inflation and or NGDP back to a more normal level, not causing abnormal inflation.

  15. Gravatar of 123 – TheMoneyDemand Blog 123 - TheMoneyDemand Blog
    11. November 2010 at 07:24

    #1 is a very useful theoretical model. What I had in mind was a practical application of this model under conditions of uncertainty. This model is certainly applicable to FOMC Jan 2010 minutes. What I am saying is that #1 is (and always was) more important than IOR.

    I would put #2 differently in order to fully separate it from #1. I would say that temporary LOLR operations have weaker effect than permanent LOLR operations. I think that #2 has little relevance now, perhaps “LOLR put” is stronger now than it was in early 2009.

  16. Gravatar of Doc Merlin Doc Merlin
    11. November 2010 at 22:00

    ‘DocMerlin, The “rolling over the debt” argument is misleading. In that case you must pay the present value of the debt in the stream of future interest payments (on ERs) out to infinity. That is not monetizing the debt.’

    It is, because the purchases increases the demand for US debt, thus lowering its rate. The lowered rate is effectively a subsidy on US Gov. borrowing by the central bank, and therefore a (partial) minimization. This is only important if the fed either keeps the assets indefinitently, or there is uncertainty to weather it will or not.

  17. Gravatar of ssumner ssumner
    13. November 2010 at 10:13

    123, I’m continuing this discussion in the more recent posts, where the issues are clearer.

    Doc Merlin, Only in the sense that replacing 30 year T-bonds with lower yielding 3 month T-bills, would be considered monetizing the debt.

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