Friday, December 12, 2014

Inflation Targeting's Big Wrinkle

Inflation-targeting central banks are in an awkward position. Their objective is to stabilize the rate of inflation, but they now face a development that could jeopardize it: the surge in oil production that is driving down oil prices. The decline in oil prices is a much-needed boon to the global economy, but it may also mean inflation temporarily drops beneath its targeted value.  What to do? David Wessel calls this development a wrinkle for central bankers:
On balance, falling oil prices are welcomed by the world’s major central banks, but there is a wrinkle. Lower oil prices are good for growth in the U.S., Europe, and Japan. But they’ll also reduce the headline inflation rate at a time when the central banks, particularly the Bank of Japan and the European Central Bank, are struggling toraise the underlying inflation rates in their economies and keep public and investor expectations of inflation from falling. That involves a lot of psychology as well as economics. While central bankers often look beyond volatile food and energy prices to gauge the underlying inflation rate, they know that ordinary consumers don’t. “It’s important that [the drop in oil prices] … doesn’t get embedded in inflation expectations,” the ECB’s Mario Draghi said last week.
This wrinkle has generated a lot discussion on how the Fed should respond. As noted by Cardiff Garcia, both Fed officials and commentators are divided over it. This wrinkle, in short, is adding some uncertainty about the future path of monetary policy.

The interesting thing about this wrinkle is that it is not a new problem. It is just the latest supply shock which always have been problematic for inflation-targeting central banks. Supply shocks push output and inflation in opposite directions and force central banks into these awkward positions. 

Supply shocks were an issue in 2002-2004 when the much-ballyhooed productivity boom (a positive supply shock) of that time made Fed officials worry about deflation. They consequently kept interest rates low even though the housing boom was taking off. Supply shocks were also an issue in the fall of 2008 when Fed officials were concerned about rising commodity prices (a negative supply shock) and, as a result, decided to do nothing at their September FOMC meeting despite the collapsing economy. 

Across the Atltantic, the ECB has struggled even more with supply shocks. The ECB raised interest rates multiple times in 2008 and 2011 in response to the commodity price shocks (negative supply shocks). Below is a figure from a Robert Hetzel paper on this crisis that shows how misguided the rate hikes were. They occurred even though spending was already falling. It is no wonder the Eurozone has struggled so much since 2008.


One can trace this wrinkle back further. Ben Bernanke, Mark Gertler, and Mark Watson argue the reason oil supply shocks have historically been tied to subsequent weak growth is not because of the shocks themselves, but because of how monetary policy responded to those shocks. That is, central banks typically responded to the inflation created by the supply shocks in a destabilizing manner. With the advent of inflation targeting in the early 1990s, this wrinkle has become institutionalized across most central banks.

Now in theory modern inflation targeting should be able to handle these shocks. For the modern practice is to do 'flexible inflation targeting' which aims for price stability over the medium term and therefore allows some wiggle room in responding to supply shocks. The problem, as demonstrated above, is that in practice it rarely works. Responding to supply shocks in real time requires exceptional judgement and usually some luck. In fact, as I note in this policy paper, some scholars think that the successes of inflation targeting prior to the crisis were due largely to luck. There were simply fewer supply shocks during the early years of inflation targeting. Going forward, this seems less likely given the rapid productivity changes of an increasingly digitized world. So this problem is not going away and is likely to get bigger.

What is needed, then,  is an approach to monetary policy that does not get hung up on supply shocks. It would fully offsets demand shocks, ignore supply shocks, while still maintaining a long-run nominal anchor...if only  there were such an approach. Oh wait, there is such an approach and it is called nominal GDP targeting.

Wednesday, December 10, 2014

Institutional Money Asset Growth Remains Weak and It Matters


Lawrence Goodman, head of the Center for Financial Stability, reminds us that institutional (or 'shadow banking' ) money growth remains weak. A large portion of these money assets disappeared during the crisis so this weak growth means there is still a sizable shortfall relative to its pre-crisis trend. Institutional money assets are an important part of the global financial system and there is a limit to how much of the shortfall can be offset by the growth in U.S. treasuries. So this is a big deal. 

One way to see its importance is to note that these assets function as an important input to economic activity--they reduce transaction and search costs via their medium of exchange role--and therefore their ongoing shortfall reflects a reduction in the productive capacity of the economy. In short, potential GDP may be less because of the shortage of institutional money assets.

Here is Goodman:
The tainted image of shadow banking along with the nefarious sounding name is a disservice to the U.S. economy. Shadow banking to a substantial degree is simply “market finance.” In fact, many cite access to “market finance” as essential to provide the U.S. financial system with strength and flexibility. This market or non-bank based finance provides a stark contrast with the more rigid and heavily bank dominated system in Europe. 
Over the last four decades, market finance has largely provided fuel for corporations in the form of commercial paper and money market funds as well as liquidity for financial markets (see Figure 1). Yet,it also played a central role in enabling many financial crises. In fact, the proliferation of market finance reached unforeseen highs prior to the recent crisis and facilitated numerous excesses. However, CFS data reveal that the reduction in the role of market finance in the economy is likely 
excessively steep and detrimental to future growth. The shadow banking system is under severe strain. Of course, market finance grew too large in advance of the recent financial crisis and the reduction in the sector provides a healthier base for the US economy and markets. Yet, the deterioration is unprecedented. Liquidity provided to corporations and financial market participants via market finance is down a stunning 45% in real terms since its peak in March 2008! In fact, the availability of market finance shows no sign of stabilization with a series of successive drops from the beginning of the crisis to the latest CFS monetary data available through October 2014. 
The shriveling nonbank financial sector threatens the health of the U.S. economy through the curtailment of funds available to corporations and liquidity for financial markets. Typically, the shadow banking system contracts coincident with recessions, but by an average of only 9% in contrast with the 45% witnessed through October 2014. Likewise, the decline from peak-to-trough in market finance is typically much faster at a scant 13 months later. 
The cyclical low in October 2014 marks the 79th month of crises in nonbank finance!
Now the U.S. economy does seem to be turning around despite this problem. Just look at last Friday's employment report. The question, then, is would the economy be doing even better if this shortfall of institutional money asset were not a problem?

Monday, December 8, 2014

Monday Morning 'Money Still Matters' Round Up

As part of my effort to start blogging more regularly again, I plan to post every Monday morning a round-up of articles that remind us money and monetary policy still matter. This is is the first installment.

The Jekyll and Hyde Monetary Views of the BIS. Ambrose Evans-Pritchard directs us to a recent BIS report that is concerned about what a Fed tightening cycle will do to the global economy. This is the same BIS that only a few months ago argued that the Fed's monetary policy was too loose and should be tightened. Yes, this is puzzling. Here is Evans-Pritchard summarizing the recent report:
Off-shore lending in US dollars has soared to $9 trillion and poses a growing risk to both emerging markets and the world's financial stability, the Bank for International Settlements has warned. The Swiss-based global watchdog said dollar loans to Chinese banks and companies are rising at annual rate of 47pc. They have jumped to $1.1 trillion from almost nothing five years ago. Cross-border dollar credit has ballooned to $456bn in Brazil, and $381bn in Mexico. External debt has reached $715bn in Russia, mostly in dollars... BIS officials are worried that tightening by the US Federal Reserve will transmit a credit shock through East Asia and the emerging world, both by raising the cost of borrowing and by pushing up the dollar.

"The appreciation of the dollar against the backdrop of divergent monetary policies may, if persistent, have a profound impact on the global economy. A continued depreciation of the domestic currency against the dollar could reduce the creditworthiness of many firms, potentially inducing a tightening of financial conditions," it said... 
So the strengthening dollar and related tightening of Fed policy could trigger problems for the global economy. Maybe, then, we should be less concerned about "currency wars". That leads us to the next piece.

It's the Domestic Demand Stupid! Ramesh Ponnuru reminds us why worrying about "currency wars" is misguided when economies are depressed. It completely misses the point:
Some practical people these days are fretting about "competitive devaluation" or "currency wars." The concern is that countries are engaged in a zero-sum game of devaluing their currencies to boost their net exports. This game can't help the world as a whole because the net exports of all countries have to add up to zero (excluding any trade with space colonies). "For every winner, there's a loser," writes Alen Mattich in the Wall Street Journal, though he allows that this may be true only in the short term...The economist Barry Eichengreen has been challenging this historical understanding for decades. He summarized his case in 2009: "In the 1930s, it is true, with one country after another depreciating its currency, no one ended up gaining competitiveness relative to anyone else. And no country succeeded in exporting its way out of the depression, since there was no one to sell additional exports to. But this was not what mattered. What mattered was that one country after another moved to loosen monetary policy because it no longer had to worry about defending the exchange rate. And this monetary stimulus, felt worldwide, was probably the single most important factor initiating and sustaining economic recovery." Eichengreen was still at it in 2013, calling fear of currency wars "the meme that will not die."

In the depressed conditions of recent years, expansionary monetary policies that cause currencies to devalue seem to have helped both the countries that undertook them and other countries. The International Monetary Fund concluded that the "spillover effects" of the first round of quantitative easing in the U.S. were positive. If the Federal Reserve had followed a monetary policy as tight as the European Central Bank's, our economy would be performing as poorly as the euro area -- and Europe wouldn't be better off for our joining its misery.
So it is not the depreciation that matters, but the boost to domestic demand from easing monetary policy. Unfortunately, not every central bank is interested in stabilizing domestic demand as noted next.

Monetary Policy Differences Explain a Lot. Martin Wolf looks across the global economy and finds a common factor behind the variation in economic growth: the stance of monetary policy.
Monetary policy provides the best key to understanding the variegated global picture. The central banks of the US, UK and Japan all adopted easier policies and were rewarded with an upturn. Given weak wage growth and a lack of fiscal support, such stimulus ought to continue.

Europe is an unhappy exception. Despite German misgivings, low interest rates are no evidence that money is too loose: nominal GDP growth stutters along at less than 3 per cent, a clear sign that the stance is much too tight. In recent years the ECB twice made the mistake of raising rates too soon, and thereby punished Europe with a deeper recession and a worse fiscal crisis. If its president Mario Draghi cannot ease policy further, the consequences will be just as serious.
He is sounding a lot like Scott Sumner here. Speaking of Scott, he had a recent post speaking to the question of why has not nominal GDP targeting swept the economics profession.

The Nominal GDP Targeting Glass is Half Full. This post was in response to a series of questions posed by Brad DeLong:
I'm not sure NGDP targeting has not "swept the economics community," at least in a sort of "glass half full" sense. Let's start with the initial position of market monetarists (MMs). I think I was pretty typical of my fellow MMs in not being very well known...Thus given the initial starting position of MM, I think endorsements of NGDP targeting by the likes of Woodford, Christy Romer, Jeffrey Frankel, and some other top people is pretty good. And of course there's Brad DeLong, who clearly is in the elite group, especially in the intersection of macro/macro history/history of thought. Then there are also lots of prominent economists in the "it's worth a shot" category, including (AFAIK) Paul Krugman. When I speak to various people at conferences and after talks, I find lots of people who tell me privately that they are on board. But they don't necessarily announce it in the New York Times, (as Romer did). So given our humble beginnings, I do see a lot of progress.

I would add that in my view I'm not even at the 50% mark in terms of my effectiveness. The NGDP futures market has been slow to materialize, but it will happen in 2015. Recent discussion with various think tanks has suggested to me that there is still a lot of interest in the NGDP targeting idea, and people are looking for ways to help. Hopefully these discussions will lead to something soon. And note that it's the conservative/libertarian think tanks that invite me---I see that as being really important, given that the names I mentioned above are all at least slightly left of center. Here's a question to think about:

Is there any monetary policy proposal other than NGDP targeting that has substantial support in the Keynesian, monetarist and Austrian communities?
Let's also not forgot that NGDP targeting was fashionable in the 1980s. Many top academics endorsed it back then. It fell by the way side once inflation targeting took off in the 1990s. Market monetarists have been trying to return NGDP targeting to its previous glory. Our work is still cut out for us, but like Scott I am optimistic. The glass is half full.

Free Banking and the Fiscal Theory of the Price Level. Last week I appeared on Boom-Bust with Erin Ade and had a great time discussing free banking, the fiscal theory of the price level, Abenomics, and some other issues. Our conversation starts at about 13 minutes into the video:

Wednesday, December 3, 2014

Are We Mismeasuring Productivity Growth?

I am in Washington, D.C. for the Future of U.S. Economic Growth conference at the CATO Institute. Brink Lindsey, the conference organizer, has put together a great group of speakers who will cover everything from secular stagnation to the singularity to the decline in economy dynamism. What makes this conference really interesting is that it has thoughtful participants on both sides of key issues. For example, there is an panel that  has both Erik Brynjolfsson and Robert Gordon on it. That should be fun to watch! I confess to coming in with strong priors on some of these issues--see my National Review article with Ramesh Ponnuru on secular stagnation--but look forward to being challenged and informed by the presenters.

One issue that is important to this debate and I hope to hear discussed is the issue of mismeasurement. It seems clear to me that economic activity is getting harder to properly measure. If so, then some of these debates may be moot. Below is an excerpt from an older post that makes this point for the measurement of productivity. Note in particular the figure below that shows the 'Great Flattening' in consumption productivity. It indicates there has been practically no productivity growth in consumption goods and services since the mid-1970s. That does not seem right and makes me skeptical that productivity is being properly measured:
[T]echnology growth appears to be rapidly growing but getting harder to measure. This point has been made recently by Joel Mokyr  in the Wall Street Journal and Erik Brynjfolsson and Andrea McAfee in The Second Machine Age: Work, Progress, and Prosperity in a Time of Brilliant Technologies. Their basic point is that the economy is being radically transformed via smart machines and this will spur a period of great productivity growth, high returns to capital, and more investment. For example, imagine all the new infrastructure spending that will have to be done to support the increased use of driverless cars and trucks. Even over the past few decades there have been meaningful gains as illustrated by this hilarious spoof the show 24 being made in 1994. Noah Smith makes the case for big productivity gain even more recently. The secular stagnationists should take these developments more seriously. 

Probably one reason these developments get overlooked is that they are hard to measure. As I noted in my Washington Post piece, a good example can be found in your smartphone. It contains many items you had to formerly purchase separately--books, newspapers, cameras, scanners, bank ATMs, voice recorders, radios, encyclopedias, GPS systems, maps, dictionaries, etc.--and were counted part of GDP. Now most are free and not a part of GDP. My sense is this is not a recent phenomenon, but has been going on for sometime as the economy has become more service orientated. Measuring productivity in the service sector is notoriously hard. And it is only going to get harder.

Here is a great illustration of this measurement problem. Tyler Cowen has made the case that there has been a Great Stagnation in innovation that explains the observed slowdown in productivity data. I looked at the John Fernald TFP data and found this troubling chart. It seemed to confirm the Great Stagnation theory. It showed a sharp break in trend TFP growth starting around 1973:


Tyler Cowen approved of the chart, but Noah Smith raised some good questions about it. He observed that the Fernald TFP data can be decomposed into TFP in investment production and TFP in consumption production. TFP in investment looks better than the overall TFP:



While that is interesting, what is really striking is the TFP in consumption. It has basically flatlined since the early 1970s and is what is driving the Great Stagnation. In the spirit of Tyler Cowen, let's call this segment "The Great Flattening."
 
The Great Flattening does not seem reasonable. Has productivity growth in consumption really been flat since the early 1970s? No meaningful gains at all? This does not pass the smell test, yet this is one of the best TFP measures. This suggest there are big measurement problems in consumption production. And I suspect they can be traced to the service sector. I suspect if these measurement problems were fixed there would be less support for secular stagnation (and maybe for the Great Stagnation view too). 
If we want to have the right debate, we have to have right measures.

What Do John Cochrane, Paul Krugman, and Scott Sumner Have in Common?



What do John Cochrane, Paul Krugman, and Scott Sumner have in common? A lot more than you think. It would be easy to conclude otherwise based on the macroeconomic debates these three individuals have engaged in since the onset of the Great Recession. Each has certainly pushed a distinct policy objective, but underlying their macroeconomic prescriptions is an edifice of understanding that is complementary and points to a  fundamental agreement among them on the key determinants of aggregate demand.

This commonality among them became clear to me over the past few months as I was reading and thinking about what it takes to generate robust aggregate demand growth in a depressed economy. John Cochrane's 2011 European Economic Review article in particular helped me make the connections and was the inspiration for the above figure I sketched over the Thanksgiving holiday. This figure highlights the differences among them, but also points to their commonality via the two equations in the genie bottle. These equations come from the Cochrane paper and go a long way in helping one make sense of how monetary and fiscal policy interact and affect aggregate demand. Consequently, they help clarify some of the questions on Neo-Fisherism that have recently generated.

So what exactly do these two equations tell us? To answer this question let's look closer at these equations:


The first term is a stripped-down intertemporal government budget equation. The left-hand side shows the current monetary base (Mt) and current government bonds (Bt) divided by the price level (Pt). The right-hand side shows the discounted present value of all expected future government surpluses [i.e. it shows the present value of expected future tax revenues (Tt+i) minus expected future government expenditures (Gt+i)]. This equation tells us that in order for the current stock of government debt to maintain its value the public must expect future budget surpluses be large enough to pay it off.

The second term is the equation of exchange. It simply shows that the monetary base (Mt) times how often it is used [or its velocity (Vt)] equals total dollar spending on output (PtYt).

With these two equations one can demonstrate both the fiscal theory of the price level (FTPL) and the more common monetary theory of the price level (MTPL). Now John Cochrane uses this framework to motivate the FTPL view, but Scott Sumner could also use to think about the MTPL. Paul Krugman, who often invokes both views, could use it too. One of the big takeaways is that the FTPL and MTPL should be seen as complementary views of price level. This can be seen by taking a closer look at each theory.

Consider first the FTPL. This is how Cochrane summarizes this view in light of the two equations:
The fiscal equation affects prices in an intuitive way. If people start to think surpluses will not be sufficient to pay off the debt, they try to unload government debt now, buying other assets or goods and services. This is just “aggregate demand.”
In other words, if expected future budget surpluses suddenly decline, people will start unloading government bonds in anticipation of them loosing value. This will cause the velocity of money to increase as portfolios are rebalanced away from public debt and, in turn, cause the price level to raise. Note that the stock of money does not change (though its velocity does). Hence, its FTPL name. In terms of the equations,  The figure below shows the causality through the two equations.


Episodes of hyperinflation provide strong evidence for this view. John Cochrane, however, is concerned that this process might also unfold in the United States given the large run up of public debt over the past five years. He worries that the U.S. fiscal credibility might unravel if the growing public debt is left untouched. 

Paul Krugman shares Cochrane's belief in the FTPL, but notes that it also implies that there could too much fiscal credibility. If so, it would be creating a drag on aggregate demand growth (i.e. higher expected future surpluses imply lower velocity today and, in turn, mean lower aggregate demand growth). While this argument may apply to the United States, Krugman is certain it applies to Japan. Here is Krugman discussing the proposed tax hikes in Japan:
I see no prospect that Japan will put off the tax hike forever. But even if it were true, this is credibility Japan wants to lose.

After all, suppose investors conclude that Japan will never raise taxes enough to service its debt. What would they think would happen instead? Not default — Japan doesn’t have to default, because its debts are in its own currency. No, what they might fear is monetization: Japan will print lots of yen to cover deficits. And this will lead to inflation. So a loss of fiscal credibility would lead to expectations of future inflation, which is a problem for Abe’s efforts to, um, get people to expect inflation rather than deflation, because … what?

Long ago I argued that what Japan needed was a credible promise to be irresponsible. And deficits that must be monetized are one way to make that happen...
Interestingly, John Cochrane the made the same point in his 2011 paper:
The last time these issues came up was Japanese monetary and fiscal policy in the 1990s... Quantitative easing and huge fiscal deficits were all tried, and did not lead to inflation or much‘‘stimulus’’. Why not? The answer must be that people were simply not convinced that the government would fail to pay off its debts. Critics of the Japanese government essentially point out their statements sounded  pretty lukewarm about commitment to the inflationary project, perhaps wisely. In the end their ‘‘quantitative easing’’ was easily and quickly reversed, showing those expectations at least to have been reasonable.
As I said earlier,  Paul Krugman and John Cochrane have a lot more in common than you think. Along these lines, one can see why the modest tax increase this year could had such large effect on the Japanese economy. The tax hike signaled the government's commitment to future surpluses and that, rather than the tax hike itself, may have stalled aggregate demand.

Even though Krugman and Cochrane may agree on the mechanism and its potential to raise aggregate demand, their policy prescriptions are different. Krugman would like to have countries like the United States and Japan ease up a bit on fiscal credibility as a way to shore up aggregate demand growth, whereas as Cochrane sees such discretionary moves as potentially destabilizing. Cochrane is concerned doing so might let the aggregate demand genie out of the bottle in an uncontrollable manner.

That it is where Scott Sumner and his push for level targeting becomes important. A level target, specifically a NGDP level target, would get Krugman the aggregate demand growth he wanted without letting the aggregate demand genie out of the bottle in an uncontrollable manner. A NGDP level target, in a depressed economy, would temporarily allow rapid catch-up growth in aggregate demand until it hit its targeted growth path. And since a NGDP level target would be radical regime change for monetary policy, its adoption would require enough political consensus such that fiscal policy would play a supportive role. 

This takes us to the standard MTPL. It says that independent of what fiscal policy is doing, the path of the price level is also determined by permanent changes to the monetary base. It would causally operate through the two equations as follows (note the equality still holds in the first equation):


Scott Sumner's call for NGDP level targeting is implicitly a call for a permanent expansion of the monetary base if needed. Paul Krugman has also explicitly called for a permanent expansion of the monetary base. These calls are endorsements of the MTPL. Note that the Fed's QE programs have not been permanent expansions of the monetary base and this explain why their effect on aggregate demand has been muted. 

John Cochrane also believes that a permanent increase in the monetary base would raise aggregate demand and the price level. He, however, only believes this is possible if the monetary policy is allowed to permanently monetize the debt. And that decision, he says, is really a fiscal one. Hence, he sees the MTPL as just a special case of FTPL. Here he is explaining this point in the context of helicopter drops:
Suppose a helicopter drop is accompanied by the announcement that taxes will be raised the next day, by exactly the amount of the helicopter drop. In this case,everyone would simply sit on the money, and no inflation would follow. The real-world counterpart is entirely possible. Suppose the government implemented a drop, repeating the Bush stimulus via $500 checks to taxpayers, but with explicit Fed monetization. However,we have all heard the well-explained ‘‘exit strategies’’ from the Fed, so supposing the money will soon be exchanged for debt is not unreasonable. And suppose taxpayers still believe the government is responsible and eventually pays off its debt. Then, this conventional implementation of a helicopter drop,in the context of conventional expectations about government policy, will have no effect at all.

Thus, Milton Friedman’s helicopters have nothing really to do with money.They are instead a brilliant psychological device to dramatically communicate a fiscal commitment, that this cash does not correspond to higher future fiscal surpluses, that there is no ‘‘exit strategy’’, and the cash will be left out in public hands... The larger lesson is that, to be effective, a monetary expansion must be accompanied by a credibly communicated non-Ricardian fiscal expansion as well. People must understand that the new debtor money does not just correspond to higher future surpluses. This is very hard to do—and even harder to do just a little bit.
So here again Cochrane is speaking to Krugman's concerns about there being too much fiscal credibility. In this case it is preventing the Fed from doing what needs to be done to get out of a recession. 

I disagree with Cochrane that the MTPL is just a special case of the FTPL. First, on a practical level the Fed has effectively been doing one long helicopter drop since its inception and never has had to worry about fiscal policy. Over time as the economy has grown the Fed has permanently increased the monetary base and done so through permanent open market operations. That is, it has permanently expanding its balance sheet as seen in the figure below. So it is not clear that should the Fed attempt to permanently increase its monetary base (say as part of a transition to a NGDP level target or a higher inflation target) that fiscal policy would offset it. 


Second, the Fed is not limited to purchasing just treasury securities. It can also buy foreign exchange, among other assets. So even if expected future budget surpluses were increasing the Fed could still increase the monetary base through foreign exchange purchases. This is what the Bank of Israel did during the crisis.

In short, the FTPL and MTPL can be seen as separate but complementary determinants of the price level working through common mechanisms. And this is why John Cochrane, Paul Krugman, and Scott Sumner have much more in common than you might imagine.

Sunday, November 16, 2014

Another Look at Neo-Fisherism

Below the fold is a recent Twitter discussion I had with David Andolfatto and Noah Smith on Neo-Fisherism. The big takeaway from this conversation is that we all view the expected path of the consolidated government balance sheet as being a key determinant for current aggregate demand growth. This understanding has been implicit in Market Monetarist's calls for level targeting and explicit in our calls for a permanent expansion of the monetary base in a depressed economy. The fact that we have not seen rapid aggregate demand growth is strong evidence that the Fed's QE programs are not expected to permanently alter the consolidated government balance sheet.

The key difference between us that I see is that Neo-Fisherites question our assumption that fiscal policy would not offset a central bank attempting to permanently expand the monetary base. My reply is that if in a depressed economy monetary policy did go to some kind of level targeting (or a higher inflation target for folks like Paul Krugman) it would be a big regime change that would require political consensus and have Treasury's backing. Nick Rowe goes further and argues that even in a normal economy fiscal policy typically responds in a supportive role to monetary policy, not the other way around:
I am of the view that the Bank of Canada targets 2% inflation (or NGDP or whatever), and it adjusts the nominal interest rate (or base money or whatever) to hit that target, and its actions affect its profits, and those profits affect the government's spending and taxation decisions. In the long run, the government adjusts its budget to be consistent with the Bank of Canada's actions. Not vice versa. We saw that adjustment in 1995.
The point is that absent a troubled-state environment where fiscal policy does dominate and shape monetary policy actions (e.g. Zimbabwe 2008-2009) it is reasonable to assume the actions of fiscal policy will support and be consistent the objectives of monetary policy.

Along these lines, it is interesting to look back at my NGDP growth path target proposal that would have the U.S.Treasury Department take over and do helicopter drops when the Fed failed to hit some NGDP level target. My original motivation for this proposal was to insure against central bank incompetence in stabilizing aggregate demand. (The threat of the Treasury temporarily taking over monetary policy would also provide a strong incentives for Fed officials to do their job.) In doing so, however, this proposal would also serve to manage the expected path of the consolidated government balance sheet in a manner that would stabilize aggregate nominal expenditures. The proposal, then, is very Neo-Fisherian in spirit. So in some ways we are not all that different.

Monday, September 22, 2014

The Love Affair Conservatives Should Be Having

Paul Krugman and Josh Barro are going after conservatives for their "new love affair with Canada". They claim conservatives are incorrect to view Canada's successful fiscal consolidation in the 1990s as evidence of  "expansionary austerity." Here is Krugman:
Canadian austerity in the 1990s was offset by a huge positive movement in the trade balance, due to a falling Canadian dollar and raw material exports...Since we can’t all devalue and move into trade surplus, this meant that the Canadian story in the 1990s had no relevance at all to the austerity debate of 2010.
Actually, the Canadian story is very relevant to the austerity debate of 2010, but not in the way portrayed by most conservatives. For the Canadian story is largely about expansionary monetary policy offsetting contractionary fiscal policy. The Canadian dollar's fall was not some random event, but the result of concerted efforts by the Bank of Canada to counter the drag of fiscal austerity. This is an important story and it is not the first time it has transpired. About fifteen years earlier the Bank of England also used monetary policy to offset fiscal policy. Ramesh Ponnuru and I wrote about it these experiences back in 2012 in The Atlantic:
The Bank of England vividly demonstrated the power of central banks to offset fiscal policy at the dawn of the Thatcher era. In 1981 her government introduced a budget that would sharply reduce the deficit in the midst of a recession. Most economists opposed it on Keynesian grounds, with 364 of them signing a now-famous letter arguing there was "no basis in economic theory or supporting evidence" for it. Yet the Thatcher government implemented its plan and by late 1981 the economy was recovering. The Bank of England at the same time had begun a cycle of monetary policy easing, and the economists had underestimated its effects.
Something similar happened in Canada in the mid-1990s. After running several decades of budget deficits that had led to a debt-to-GDP ratio of 70 percent in 1995, then-Finance Minister Paul Martin introduced a budget plan that began a half decade of reducing the federal budget, largely through cuts in spending. This fiscal tightening led to budget surpluses by the early 2000s. As in the British case, the Bank of Canada eased monetary policy over the same time, offsetting any fiscal drag. The economy performed nicely.
The U.S. economy over the past two years has exhibited the same pattern. Since mid-2010, total federal expenditures, measured in dollars, have trended down. The budget deficit as a share of the economy has fallen more than 2 percent over this time. This fiscal tightening has taken place in the midst of a barrage of economic shocks including the Eurozone crisis, the 2011 debt ceiling talks, and concerns about an Asian economic slowdown that have kept economic uncertainty elevated. Yet nominal spending has been incredibly stable, growing at about 4.5 percent a year. The recovery has been sluggish, but the Fed appears to have kept fiscal contraction and other economic shocks from ending it.
So yes, the Canadian experience was very relevant in 2010. And it became even more relevant in 2013 when budget sequestering further tightened fiscal policy. In fact, the context of the above article was the "fiscal cliff" crisis of 2012 that led up to the sequester. We were arguing back then the Fed, like the Bank of England and the Bank of Canada, had the ability to offset the looming fiscal austerity of 2013. Paul Krugman, on the other hand, was worried the spending cuts would further depress the economy. Here, for example, was an October, 2012 comment by Krugman:
[T]he only reason to worry about the fiscal cliff is if you’re a Keynesian, who thinks that bringing down the budget deficit when the economy is already depressed makes the depression deeper.
Fortunately, the Fed started QE3 and the Evans Rule about that time. We believed that though these programs were far from perfect--they were not properly designed to restore full employment--they had the potential to at least offset the fiscal austerity of 2013 even with a binding zero lower bound (ZLB). As Mike Konczal noted our views would be put to the test in 2013. The year 2013, therefore, would provide a natural experiment of sorts that would test whether monetary policy could offset contractionary fiscal policy at the ZLB. Even Paul Krugman recognized this point: 
On the right are the market monetarists like Scott Sumner and David Beckworth, who insist that the Fed could solve the slump if it wanted to, and that fiscal policy is irrelevant... [A]s Mike Konczal points out, we are in effect getting a test of the market monetarist view right now, with the Fed having adopted more expansionary policies even as fiscal policy tightens.
And let's be clear: fiscal policy was tightening. The IMF's cyclically-adjusted government budget balance as a percent of potential GDP showed fiscal policy had been tightening since 2010. It just tightened more so in 2013. This natural experiment would put all the Keynesians, Post-Keynesians, and sectoral-balance theories to the test. Many of these folks made dire predictions about the sequester. There are many I could list, but one predicted it would cost 700,000 jobs over 2013-2014.

So how did this natural experiment at the ZLB turn out? The economy did not collapse and 700,000 jobs were not lost. Real GDP maintained stable growth and over 4 million new jobs have been created so far in 2013-2014 period. More importantly, the one variable both fiscal policy and monetary policy directly affect, aggregate nominal spending, did not collapse in 2013-2014.This experiment indicates, then, that monetary policy can offset fiscal policy at the ZLB.

Conservatives should be having a love affair with this outcome. It shows that government spending can be curtailed without adverse consequences for the economy if monetary policy provides an offset. It is the same story that unfolded in Canada in the mid-1990s and the United Kingdom in the early 1980s. Conservatives need to embrace this view and run with it. It implies a reduced role for fiscal policy in stabilizing the economy.1 Some conservatives have embraced it, but most have not and continue to draw the wrong lessons from these experiences. If they want to make a convincing argument against an activist fiscal policy this is it.

P.S. Unfortunately, the many voices who were predicting doom and gloom because of the sequester have gone silent. No mea culpas from them. Their silence speaks volumes. Others, instead, point to the continued absence of full employment, but this is simply a moving of the goal posts. The original argument made by Market Monetarist was only that an offset was possible. We did not claim QE3 and the Evans Rule would restore full employment. We argued that would require something bolder like a NGDP level target.

Update: I was asked for evidence showing the Bank of Canada (BoC) explicitly eased policy in the mid-to-late 1990s. Below is a figure of their target policy interest rate corridor from a BoC report in 1998. It shows a sustained path of lowered policy interest rates--roughly 500 basis points!-- through early 1998. Here is a link to how the BoC manages its target.



1Okay, I have endorsed a NGDP-level target-based helicopter drop which is technically fiscal policy. The proposal is outlined here. The main reasons for my endorsement is to incentivize the Fed to act properly and provide insurance against central bank incompetence. This is a pragmatic proposal.