Tyler Cowen on John Cochrane on liquidity traps

Here’s Tyler discussing John Cochrane’s views on liquidity traps:

But on the liquidity trap, John Cochrane is essentially correct.  He has worked through some of the key details, and it’s time to lay that one to rest.

This statement is technically correct, but seems highly misleading to me.  I think 99% of readers would assume that Cochrane doesn’t believe in liquidity traps.  But in fact he does, and indeed much more so than people like Paul Krugman. Krugman thinks QE might have a modestly expansionary effect, although he doesn’t think it’s very powerful.  Cochrane claims it will have no effect at all.  You are just swapping one zero interest rate asset for another.

So what was Tyler Cowen so impressed by?  Probably this passage in the Cochrane post he links to:

New-Keynesian models produce some stunning predictions of what happens in a “liquidity trap” when interest rates are stuck at zero. They predict a deep recession. They predict that promises work: “forward guidance,” and commitments to keep interest rates low for long periods, with no current action, stimulate the current level of consumption.  Fully-expected future inflation is a good thing. Growth is bad. Deliberate destruction of output, capital, and productivity raise GDP. Throw away the bulldozers, let them use shovels. Or, better, spoons. Hurricanes are good. Government spending, even if financed by current taxation, and even if completely wasted, of the digging ditches and filling them up type, can have huge output multipliers.

Even more puzzling, new-Keynesian models predict that all of this gets worse as prices become more flexible.  Thus, although price stickiness is the central friction keeping the economy from achieving its optimal output, policies that reduce price stickiness would make matters worse.

In short, every law of economics seems to change sign at the zero bound. If gravity itself changed sign and we all started floating away, it would be no less surprising.

And of course, if you read the New York Times, people like me who have any doubts about all this are morons, evil, corrupt, and paid off by some vast right-wing conspiracy to transfer wealth from the poor to the secret conspiracy of hedge fund billionaires.

Cochrane’s contempt for “liquidity trap economics” is all 100% justified, but not for the reasons he supposes.  The real problem is that these models assume the Fed is powerless to impact NGDP and that NGDP shocks matter a lot.  Hence you need backdoor solutions. That’s wrong, but you don’t fix the problem by assuming demand shortfalls don’t exist, and thus it doesn’t matter that the Fed can’t control NGDP.  You fix the problem by noticing that nominal shortfalls are a huge problem in the real world, but also that the Fed drives NGDP, even when rates are zero. This means that any attempt at fiscal stimulus will simply be offset by less monetary stimulus.  That’s the real reason fiscal multipliers are zero.

PS.  I agree with almost all of the complaints in the Cochrane quotation. However, if instead of “keep interest rates low for long periods,” Cochrane had said “keep interest rates low until NGDP returns to the pre-2008 trend line,” then I would have strongly disagreed.  The Japanese have showed that long periods of low rates don’t necessary work, but forward guidance in the form of something like a higher inflation or NGDP target certainly does work.


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30 Responses to “Tyler Cowen on John Cochrane on liquidity traps”

  1. Gravatar of benjamin cole benjamin cole
    21. September 2013 at 06:25

    John Cochrane is a famous economist and I am just a fruit tree farmer, but…if you read Cochran’s post about lthis he appears to say say the solution to 2008 was a bout of deflation…
    Okay in a theory or model but what real estate deflation do to banks? Destroys, crushes and
    wrecks them—leading to accelerating gloom in real estate. When banks stop lending, property values fall, meaning banks stop lending…
    But…economists ask this: Sure crushing the banks will wreck an economy in real life…but what about in my model?

  2. Gravatar of Morgan Warstler Morgan Warstler
    21. September 2013 at 07:51

    Benji,

    deflation |= deflationary forces.

    I read Cochrane as saying that taking a bat to price and age stickiness, a different equilibrium, removes the liquidity trap.

    Scott?

  3. Gravatar of Tom Brown Tom Brown
    21. September 2013 at 08:03

    Scott you write:

    “This means that any attempt at fiscal stimulus will simply be offset by less monetary stimulus. That’s the real reason fiscal multipliers are zero.”

    I’m positive you’ve covered this before, so excuse me for bringing it up again, but this sounds like you’re essentially saying fiscal stimulus will fail due to a lack of coordination between the Fed and the government. After all, less monetary stimulus is a choice the Fed makes, that it doesn’t have to make, right?

  4. Gravatar of dtoh dtoh
    21. September 2013 at 08:09

    I think Cochrane’s position is that OMP at the ZLB will just result in the exchange of one financial asset for another (e.g. Treasuries for ER.) And he is right to a certain extent… if OMP does not result in an exchange of financial assets for real goods and services by the non-banking sector, it will have no impact on AD (NGDP). The Fed has ably proven this is possible.

    But this result is only one which ensues from CB incompetence.

    An increase in the real price of financial assets will infallibly cause a marginal increase in the exchange by the non-banking sector of financial assets for real goods/services, and a competent CB can easily insure such an an increase in the price of financial assets in either of two ways: a) limiting the increase in ER (either through pricing or an outright cap), or b) making a credible commitment to inflation as the BOJ has done.

  5. Gravatar of dtoh dtoh
    21. September 2013 at 08:13

    Morgie,
    If you get rid of wage/price stickiness, there is no need for a central bank.

  6. Gravatar of Tom Brown Tom Brown
    21. September 2013 at 08:56

    dtoh, you write:

    “The Fed has ably proven this is possible.”

    What was their secret for “success” here in your view? IOR? Lack of explicit targeting? Both?

  7. Gravatar of Morgan Warstler Morgan Warstler
    21. September 2013 at 08:57

    dtoh,

    That’s like saying in perfect competition there are no profits.

    It’s true, but impossible to achieve. BC reality. Capitalism is about taking advantage of imperfect competition wherever you find it in a free market.

    That’s why it’s so damn important the state WORK TOWARDS perfect competition.

    Wherever ever possible attack:

    Licensing
    Wage supports
    Price supports – including making bankruptcy easier

    The MORAL AUTHORITY of the Central Bank / State stems from its promise to do the above.

    It is IMMORAL to both demand policies of wage stickiness and then say well we need to print money / have a more important CB bc of it.

    We can say similarly, a Central Bank is morally obligated to seek, wherever possible, a Monetary Policy WHERE IT IS NEEDED LEAST.

    The removal of the agency problem.

    Running the Fed with a PC.

    NGDP Futures.

    MM are pragmatic goldbugs.

  8. Gravatar of Edward Edward
    21. September 2013 at 11:28

    Morgan,
    It’s true that government and progressives agitate for policies that increase wage stickiness, like minimum wages. But wage stickiness has a psychological element to it, like money illusion, that is separate from the idea that government causes everything, as some feeble minded Austrians like to assert. And market monetarism is pragmatic libertarianism, rather than pragmatic goldbuggism, whic is the same thing as saying pragmatic religious fundamentalism.

  9. Gravatar of W. Peden W. Peden
    21. September 2013 at 12:32

    Edward,

    There are also some nominal rigidities that are by-products of good aspects of a market economy e.g. menu-costs and long-term contracts.

    Many Keynesians support policies that increase wage stickiness and also advocate smoothing the growth of aggregate demand.

    Many non-Keynesians oppose policies that increase wage stickiness and also oppose smoothing the growth of aggregate demand.

    Market Monetarists say that we should oppose policies that increase wage stickiness and also advocate smoothing the growth of aggregate demand.

    It’s a very coherent worldview: lower/keep low the natural rate of unemployment and don’t led fluctuations in AD cause deviations from that rate.

  10. Gravatar of ssumner ssumner
    21. September 2013 at 12:54

    Ben, No, I don’t think he favors deflation.

    Morgan, I didn’t see that at all.

    Tom, The Fed offsets fiscal policy if it is doing it’s job correctly. I’ve always admitted that fiscal policy might be effective if the Fed is incompetent. But it depends precisely how they are incompetent.

    dtoh, No, Cochrane’s belief in the liquidity trap is about more than just the problem of bonds and money being close substitutes. He doesn’t think other mechanisms work either. For instance, he’s dismissive of forward guidance.

  11. Gravatar of TESC TESC
    21. September 2013 at 13:13

    @ Tom
    “fiscal stimulus will fail due to a lack of coordination between the Fed and the government.”

    I hope my take is helpful. The FED and Congress are coordinating appropriately to keep a decent target of around 2% inflation, but not perfectly. When Congress does less stimulus, the FED does more. When Congress does more stimulus, the FED does less so we are close to the 2% target.

    It is just that Sumner was able to see what was in front of us, all this time. That is, that since the FED and Congress are both pushing AD, Congress through debt and the FED through promises of expanding the MS, why go into debt if the FED can increase MS as much as necessary to meet the goal of 2% inflation and decent unemployment? Besides, monetary policy is more powerful than fiscal in any situation anyway.

    So, I think that is the essence of the “Monetary Off-set” view, which now seems so obviously correct that I was laughing when I read Sumner on it. How could no-one else saw it before? There is the genius of Sumner and the whole MM movement. They have seen the unseen, (Bastiat).

    Thanks Sumner, people in Texas are getting excited about your ideas. We are still working on the gold-bugs.

  12. Gravatar of dtoh dtoh
    21. September 2013 at 13:39

    Scott, you said,
    “No, Cochrane’s belief in the liquidity trap is about more than just the problem of bonds and money being close substitutes. He doesn’t think other mechanisms work either. For instance, he’s dismissive of forward guidance.”

    Yes, I know that know. My comment was based on earlier stuff of his that I had read. After posting my comment, I had a look at his most recent paper.

  13. Gravatar of TallDave TallDave
    21. September 2013 at 16:44

    It’s so odd to assume the Fed can’t impact something it’s not even targeting just because something it does target has gotten into a range where it has little effect.

    As a programmer I’ve learned to be skeptical of simplistic models. They can tell you some useful things but beware assumptions.

  14. Gravatar of Benjamin Cole Benjamin Cole
    21. September 2013 at 17:12

    Scott and Morgan:

    “Thus if we are to return to a low-inflation steady state, we must experience sharp deflation today”–Cochrane.

    That is from Cochrane’s latest post. I will grant that the post, overall, in nearly impenetrable, but that sentence does stand out.

    It seems what Cochrane wants is deflation to do the work that an increase in the money supply and inflation would also accomplish.

    The problem is, deflation is debilitating to a modern economy….

  15. Gravatar of Negation of Ideology Negation of Ideology
    21. September 2013 at 17:39

    TESC – “That is, that since the FED and Congress are both pushing AD, Congress through debt and the FED through promises of expanding the MS, why go into debt if the FED can increase MS as much as necessary to meet the goal of 2% inflation and decent unemployment? Besides, monetary policy is more powerful than fiscal in any situation anyway. ”

    “Why go into debt” – indeed. Once you understand the monetary offset, it’s hard to see any reason why a sovereign government should issue any debt at all. Reasons given for debt are recessions and depressions (drops in NGDP) or wars. Well if fiscal stimulus is off the table the first excuse is gone. And even war is not an excuse is my mind, you can’t spend more than some share of GDP on war anyway so you can pay for it out of higher war taxes. The only legitimate excuse for a national debt is something like the Louisiana Purchase. We should implement market monetarism, then run budget surpluses of 3% of GDP until the debt is completely paid off.

    Great comment.

  16. Gravatar of lxdr1f7 lxdr1f7
    21. September 2013 at 19:03

    The fed needs to affect money measures which are relevant. Narrow money is only a minority of the money supply. The fed needs to directly target or adjust broader money. This can be done by allowing the broader economy to hold reserve accounts at the fed.

  17. Gravatar of Benjamin Cole Benjamin Cole
    21. September 2013 at 19:20

    Back to Cochrane.

    There just seems to be a powerful social norm and premise that QE is no good, and then clever but ultimately contorted or exceedingly esoteric arguments are constructed to try to justify that premise. Cochrane seems like a nice intelligent guy, but he seems driven by this underlying agenda.

    QE is doing nothing, so Cochrane says.

    Then certainly the Fed should buy more federal debt, and take the load off of taxpayers. Why not? If the consequences are nothing, then it is a crime not to buy more debt.

    I do raise one point, and I am disgruntled that no one in the MM community wants to tackle it head on: I say the Fed should monetize debt (as it does in QE) but that the monetization should be permanent.

    Right now, when the the Fed sells the bonds in its QE hoard, or they mature, the Fed must extinguish the proceeds. Thus the debt, monetized under QE, becomes de-monetized. I would prefer the Fed transfer proceeds to the Treasury. I think a smaller amount of QE would then have a larger impact.

    If a nation is suffering from chronic low growth and very low inflation and near-ZLB conditions, I see nothing wrong with a measure of debt monetization.

    Responses?

  18. Gravatar of Saturos Saturos
    21. September 2013 at 19:33

    Ashok Rao on the paradoxes of perfect policy (since he won’t self-promote): http://ashokarao.com/2013/09/18/the-paradoxes-of-perfect-policy/

  19. Gravatar of TESC TESC
    21. September 2013 at 20:57

    @ Benjamin
    I just bought your ebook, I eager to read it.

    “I see nothing wrong with a measure of debt monetization.”

    I am interested on Sumner’s comments on this. At first glance the problem is that in theory, the dollar is backed-up by gov bonds. Monetizing the debt, in the sense of literally paying for the bonds and let them disappear will make the value of the dollar fall, big time. Off-course this is theoretical, if consumers and investors just keep using the dollar as the most valuable non-interest bearing asset in the world, then there is no problem in the real world. But I guess it could also lead to some moral hazzard because Congress would know that it does not ever have to pay certain part of its debts.

    The term “Monetizing the Debt” I read it in a Grad level Macro textbook. They meant that if fiscal stimulus was used, in order to prevent Inv from falling at higher interest rates, the FED will monetize the new bonds so as to prevent crowding out. But now I know that textbooks and the real economy many times are functions of a different reality. So I am not sure how accurate the textbook writer was.

    My question is, does the FED ever allowed gov bonds to just expire, mature or whatever the term is, so that Congress does not have to ever pay them again?

    @ Negation of Ideology

    Thanks, I think I read one of your comments before so I had some of your ideas in my mind.

  20. Gravatar of apt apt
    21. September 2013 at 21:25

    Is it just me or is it weird to see an advocate of free market say something in the sorts of “Deliberate destruction of output, capital, and productivity raise GDP”? Obviously he does not think that it raises GDP directly, but although I have never read anything from him in that concern, probably in the long term? Also, I think that is a deliberate misconception.

    Another part of the passage that caught my attention was the following: “new-Keynesian models predict that all of this gets worse as prices become more flexible.”. Do they?

    Thank you!

  21. Gravatar of benjamin cole benjamin cole
    22. September 2013 at 01:17

    TESC: Marcus Nunes is the brains behind the book and thanks!
    I did pose some interesting questions regarding good governance and the Fed…
    On the Fed monetizing debt…they can but only temporarily now. I agree there is moral hazard…on the other hand doing the Japan thing is no fun either…how about the moral hazard from pompous pettifoggers who genuflect to tight money?

  22. Gravatar of ssumner ssumner
    22. September 2013 at 05:44

    Thanks TESC.

    Ben, I’ll have to take a look at that.

    lxdr, Why not skip the intermediate target, and go right for NGDP?

    TESC, The term “debt monetization” is a bit vague. Yes, the Fed needs to do some of that, but I suspect much less than Ben would like.

    apt, He’s criticizing that view.

    Some NK models say increased wage/price flexibility is destabilizing.

  23. Gravatar of ssumner ssumner
    22. September 2013 at 05:50

    Saturos, Yes, I’ve made the same argument. Easier policy means a smaller balance sheet.

  24. Gravatar of benjamin cole benjamin cole
    22. September 2013 at 06:15

    How much debt monetization would I like? Only enough to get things hopping…a 1970s-style recovery…we can do it…

  25. Gravatar of Charlie Charlie
    22. September 2013 at 16:45

    I don’t understand John’s views and find many of his statements to be in conflict. Did you ever see this unpublished Op-Ed he wrote? I think it was around the time you debated him. I think it sounds a lot like NGDP futures targeting.

    http://faculty.chicagobooth.edu/john.cochrane/research/papers/big_stick.html

    “Instead, the Fed can target the thing it cares about – expected CPI inflation – rather than the price of gold. To do it, the Fed can target the spread between TIPS (Treasury Inflation Protected Securities) and regular Treasurys, or target CPI futures prices. Here’s a simple example. Investors buy a CPI-linked security from the Fed for $10. If inflation comes out to the Fed’s target, they get their money back with interest, $10.10 at 1% interest. If inflation is 2 percent below target, the Fed pays $2 extra — $12.10. This pumps new money into the economy, with no offsetting decline in government debt, just like the helicopter drop. If inflation is 2 percent above target, investors only get back $8.10 – the Fed sucks $2 out of the economy at the end of the year. If investors think inflation will be below the Fed’s target, they buy a lot of these securities, and the Fed will print up a lot of money, and vice versa.

    One might object that these markets are small and undeveloped. I answer that is exactly why the Fed needs to start doing it now, so the markets are large and developed when the Fed really needs them. One might object that this is a pretty wild new proposal. I answer that we need new proposals if all conventional policies eventually run out of steam.”

  26. Gravatar of ssumner ssumner
    22. September 2013 at 17:17

    Charlie, Actually he got that idea from me. I corresponded with him by email on the subject.

  27. Gravatar of errorr errorr
    23. September 2013 at 15:02

    If the government created no debt that means the FED would have to effect the economy through interveneing solely in private debt markets. That seems like a terrible idea from a political optics level. I guess you could create money through having the FED buy commodities but that seems unweildy. I rather the government get any benefit from FED purchases than any private actor.

    I still say a helicopter drop by massive payroll tax cut with guidance from the FED that says it will not offset would still be the most effective stimulus. All of a sudden as the cash poor balance sheets are repaired lending will pick up and the excess reserves will allow massive money expansion which will boost NGDP.

  28. Gravatar of TESC TESC
    23. September 2013 at 16:20

    “I still say a helicopter drop by massive payroll tax cut with guidance from the FED that says it will not offset”

    I think you are right, we just have to work out the details and undesirable consequences.

  29. Gravatar of ssumner ssumner
    26. September 2013 at 10:47

    errorr, A helicopter drop is like 100 times more distortionary than the Fed buying AAA corporate bonds. It hugely increases future tax liabilities.

  30. Gravatar of Geoff Geoff
    26. September 2013 at 15:54

    “A helicopter drop is like 100 times more distortionary than the Fed buying AAA corporate bonds”

    In terms of the credit circulation business cycle phenomena, which has hampered our lives for generations, helicopter drops would actually be LESS distortionary, because the effect on relative prices would be less.

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