Britain needs more AD, no wait . . . less AD

In a number of posts I’ve suggested that there is a basic confusion over stabilization policy.  Instead of viewing fiscal and monetary stimulus as two ways of influencing AD, most people talk as if fiscal policy affects real GDP, and monetary policy affects prices.  Today I’d like to argue that this logical error is deeply embedded in our profession, and indeed is a major cause of the crash of 2008.  Here’s The Economist:

The surprising weakness was caused in part by unusually cold weather but it is not fully explained by it. A frail economy ought at least to be free of price pressures but Britons have had no such luck. Inflation rose to 3.7% in December.  . . .

Such a run of bad news looks like an argument for a policy rethink. If the economy stays weak, it may not be robust enough to withstand further deficit-cutting measures, including a planned rise in national-insurance contributions this April. The persistence of high inflation (it has been well above the 2% target for most of the last three years) calls into question the idea that the Bank of England could counter the effects of fiscal tightening by easing monetary policy. Its benchmark interest rate is already as low as it can feasibly go, and a further round of “quantitative easing” would stretch too far the gap between the bank’s objective of low inflation and its actions. A concern that businesses and wage earners might think policymakers were going soft on inflation led two of the bank’s nine-strong monetary-policy committee to vote for an increase in interest rates this month (see article).

I don’t have a major problem with any individual sentence in this article.  And they end up arguing against a change in the policy mix, which I think is a defensible view.  But I do have a problem with the way the issues are discussed.  There’s very clear implication that it’s the duty of monetary policy to deal with (high) inflation, and the responsibility of fiscal policy to address growth.  If you don’t believe me, if you think in both cases The Economist was focused on AD, and randomly chose to mention the inflationary effect of AD when talking about monetary policy, and the growth impact of AD when discussing fiscal policy, then I have a challenge for you.  Please send me an article from the British press that suggests that Britain needs to address the 3.7% inflation with further fiscal austerity, and needs to address the slow recovery with more monetary stimulus.  That’s the policy I favor, but I doubt you will be able to produce a single article that favors that policy mix, and justifies both changes in the way I describe.

In talking to many ordinary people, in reading the financial press, and in talking to many economists, I have gradually become convinced that almost everyone compartmentalizes these issues in a way that isn’t justified by current macro theory.  I will argue that this has been very harmful.  Not just recently, but also back in the Great Depression.  Here’s what Keynes said in his famous letter to the NYT on December 31, 1933:

The other set of fallacies, of which I fear the influence, arises out of a crude economic doctrine commonly known as the quantity theory of money.  Rising output and rising incomes will suffer a setback sooner or later if the quantity of money is rigidly fixed.  Some people seem to infer from this that output and income can be raised by increasing the quantity of money.  But this is like trying to get fat by buying a larger belt.  In the United States today your belt is plenty big enough for your belly.

People often claim that Keynes didn’t believe in liquidity traps.  If a liquidity trap is a situation where increases in the quantity of money have no impact on AD, then Keynes certainly did believe in liquidity traps.  In the preceding paragraph he is clearly making the “pushing on a string” argument.  But notice that he makes it for output, not prices.  In the very next paragraph Keynes switches gears:

It is an even more foolish application of the same ideas to believe that there is a mathematical relation between the price of gold and the price of other things.  It is true that the value of the dollar in terms of foreign currencies will affect the prices of those goods which enter into international trade.  In so far as an overvaluation of the dollar was impeding the freedom of domestic price-raising policies or disturbing the balance of payments with foreign countries, it was advisable to depreciate it.  But exchange depreciation should follow the success of your domestic price raising policy as its natural consequence, and should not be allowed to disturb the whole world by preceding its justification at an entirely arbitrary pace.

First a little context.  The first sentence of this paragraph is a jab at George Warren, an FDR advisor who claimed a mathematical relationship between the price of gold and the price of goods.  Irving Fisher had similar views, although was perhaps a bit less dogmatic than Warren.  Note that Keynes calls this a “foolish application of the same idea.”  In other words, saying 20% more money means 20% higher incomes and the idea that 20% higher gold prices means 20% higher goods prices are basically two sides of the same fallacy.  Except that they aren’t at all.  Indeed Keynes knows this, he knows that Warren’s dollar depreciation program did raise the US price level, and raised it dramatically.  The WPI rose strongly throughout 1933, and the weekly increases were highly correlated with changes in the dollar price of gold.

More importantly, everyone knew this.   If Keynes had attempted to apply the liquidity trap concept to prices, his reputation would have been torn to shreds.  He almost always applied the monetary policy ineffectiveness concept to real output, almost never to prices.  Especially if the monetary shock was large, and would obviously be inflationary.  Keynes was no fool.  He was careful to suggest there was no “mathematical relation” with prices, a very different argument for no effect at all.  But there is a problem here.  The Keynesian model says inflation and real growth go hand in hand.  When the economy is at less than full employment (as it certainly was in 1933); one cannot have rising prices without rising output.

Here’s an important difference between Keynes and Paul Krugman.  Krugman does understand the implication of Keynesian theory.  He does understand that if monetary policy is ineffective in raising output, then ipso facto it is ineffective in raising prices.  In 2010 the Fed was accused of putting the cart ahead of the horse—artificially pushing prices higher with monetary policy (QE2, which depreciated the dollar) rather than letting prices rise “naturally” as a consequence of economic recovery driven by more domestic spending.  Keynes would have opposed QE2; he would have called it “unnatural” and “arbitrary.”  Krugman, who understands Keynesian theory far better than Keynes ever did, supported the policy.  (BTW, Keynes got his way;  FDR gave up on monetary stimulus two weeks later and never tried it again.)

Allan Meltzer once wrote that it was odd that Keynes never suggested that central banks target inflation at something like 4%, so that they could avoid the zero rate bound, and thus the need for fiscal stabilization policy.  I think Keynes would have been horrified by that idea.  For Keynes, the “natural” price level is a stable one, unless you need a bit of reflation to make up for a previous plunge in prices.  The “natural” way to boost AD is with more government spending, or more investment.  Money should not be a “belt” that prevents economic recovery, but it also shouldn’t be used to “artificially” push the economy higher, by boosting prices.

You’re probably thinking that we have advanced far beyond the primitive analysis of the 1933 Keynes (the low point of his career, BTW.)  Unfortunately not.  Consider the 100 most prominent macroeconomists.  When AD started plunging sharply in the second half of 2008, how many vigorously and loudly insisted on the need for a much more aggressive monetary policy stance?  Here’s the list:

1. . . .

Well that didn’t take long.  But if I had to list the number who forcefully advocated fiscal stimulus, it certainly would be a quite long list.  The general view was; “Well, rates are already pretty low, and the base has been rising.  So monetary policy can’t be holding back the recovery.  The belt is not too tight.  Time to engage in fiscal stimulus—which is more certain to boost spending.  After all, G is part of C+I+G, but I don’t see “M” in that formula.”

This was a tragic error.  The easy fiscal policy and tight money of 2009 have put us where we are today.  By 2010 the Keynesians realized the fiscal stimulus wouldn’t do the job (and to their credit, a few Keynesians like Krugman argued this from the beginning.)  So by 2010 you had famous Keynesians like Alan Blinder desperately seeking monetary policy options.  Since they can’t easily break away from the “interest rates are all that matters” view of monetary policy, Blinder ended up gravitating to the idea of negative rates on bank reserves, a wacky scheme first mentioned in a couple publications by yours truly in early 2009.  Others said printing money was worth a shot, after all, what do we have to lose?

I still think our language is holding us back.  We should never discuss AD issues by talking about prices and output; we should always refer to NGDP.  If we did so, we’d be much less likely to discuss policy in the confused way The Economist does in the excerpt above.  It would sound bizarre to say “The UK government should refrain from fiscal austerity, lest NGDP falls, and they should refrain from monetary stimulus, or else NGDP might rise.

That doesn’t mean the P/Y split is completely inconsequential.  In terms of human welfare we’d prefer to have more real growth and less inflation.  But that’s a supply-side issue, which can’t be addressed through demand-side stimulus.  Some commenters have made clever attempts to argue that fiscal stimulus would be better for aggregate supply, but I guess I’m just too libertarian to buy that argument.  I’d rather have monetary policy target NGDP along a stable 5% growth trajectory, and have all fiscal decisions subject to rigorous cost/benefit considerations.  Because a “targeting the forecast” approach means expected future NGDP would always be on target (even though current NGDP may be below target) there would be no “depression economics.”  Fiscal policy makers should operate in a classical world with real opportunity costs.

How will we know if the quasi-monetarists have won?  When everyone else starts using their language.  The more I see bloggers like Matt Yglesias and Brad DeLong talk about NGDP, the happier I am.  It doesn’t matter if they stay Keynesian—NGDP talk will slowly and insidiously lead to quasi-monetarist thinking.  That’s why Krugman slapped down David Beckworth last year; Krugman argued that talk about NGDP would lead to dangerous monetarist ideas.  At the time I argued that he was being illogical.  Now I see that the field of macro can’t be understood in strictly logical terms.