The Federal Reserve Bored

Paul Krugman points out possibly the biggest challenge to sensible, rational policy making and debating these days:

The Times has an interesting headline here: Richard Fisher, Often Wrong but Seldom Boring, Leaves the Fed. Because entertainment value is what we want from central bankers, right? I mean, Janet Yellen is such a drag — she just keeps being right about the economy, and that gets old really fast, you know?

It really is too bad that it's these 'entertainers' -- they range from the likes of Rick Santelli and Larry Kudlow to the establishment types like Fisher -- get such media attention. I mean, it's not like decent analysis doesn't exist, especially since the appearance of websites like Vox and the increased popularity of economics blogs.

Anyway, in other news, I've had very little time to blog these last few months but I intend to get back into it in earnest fairly shortly so stay tuned.

To follow me on Twitter, just look me up @circuit_FRB.

It's baaack: Paul's Japan paper (monetary policy and expectations in an era of low inflation) (trying not to be wonkish)

One of the ongoing debates in economic policy these days is the question of whether a central bank on its own can be effective at getting an economy out of the doldrums.

The most famous exposition of the idea that a central bank, by itself, has the ability to boost economic activity is Paul Krugman's paper entitled "It's baaack: Japan's Slump and the Return of the Liquidity Trap" (1998).

In the paper, Prof. Krugman explains that, in a (hypothetical) world of Ricardian equivalence in which fiscal policy has no effect on the real economy, the central bank can get households and firms to borrow and spend by announcing it will bring about higher inflation in the future.

Prof. Krugman knows that the assumption of Ricardian equivalence is far fetched and unrealistic; he only includes this simplifying and unrealistic assumption in his paper to make the point that the central bank can on its own stimulate the economy when fiscal policy is unavailable as a policy option (due to policymakers ideological aversion to public spending, the presence of high public debt, etc.).

Now before I go any further I want to say that I'm a huge fan of Paul Krugman. I think he's one of the most sensible economic commentators out there and I agree with almost all his views on policy. On the effectiveness of central banks alone to boost economic activity during a deep recession or depression, however, I'm quite skeptical.

The logic in Prof. Krugman's paper can be summarized as follows:

• households and firms will borrow and spend if they expect higher inflation in the future;
• borrowing and spending is influenced by the real interest rate (i.e., the nominal rate of interest less the expected rate of inflation); and 
• a rise in expected inflation is for all intents and purposes equivalent to (i.e., has the same effect as) a fall in the real interest rate.

In other words, Prof. Krugman is saying that an increase in expected inflation of, say, three percent will have the same expansionary effect as a three percent cut in interest rates.

All this makes for a plausible story. However, things aren't as simple in the real world.

The problem is that Prof. Krugman's 1998 paper makes inflation a function of expected future inflation, as in the New Keynesian Philips curve (which, in passing, since it assumes no trade-off between inflation and output gap stabilization, is "neither Keynesian or a Philips curve", as Robert Solow once quipped).

In the real world -- and the evidence and the current state of economic activity seem to support this -- inflation is a function of backward-looking expectations: inflation displays significant inertia. Peoples' beliefs about expected inflation are based on past and present inflation. The notion that past inflation is irrelevant, as embodied in the New Keynesian Philips curve, seems to me implausible.

Prof. Krugman is aware of this criticism. Economists Robert Gordon, Alan Blinder and Martin Neil Baily all raised this point during the discussion that took place following the presentation of his paper. Here are the minutes that were recorded from that discussion:

Robert Gordon...criticized the assumption in Krugman's models that the monetary authorities can easily change inflationary expectations for the future -- that the announcement of a policy will change expectations despite present slack in the economy. He believed that agents' expectations depend largely on actual experience, and that they will experience increased inflation only when there is pressure in the markets for goods, services, and labor. Alan Blinder agreed. He thought that Krugman's inflationary policy would work if it could be implemented; but that would require the Bank of Japan to create expected inflation, which, in turn, would require persuading people that the future was going to be fundamentally different from the past. Japan had zero inflation in the past six years, and the average in the previous decade was 1.8 percent per year. Thus to create expected inflation of 4 percent, with actual inflation lagging behind, would be difficult.[Martin] Baily concurred, observing that it would be easy for Russia to be credible in announcing inflationary policy but hard for Japan. (Krugman, 1998:201)

True believers in the power of central banks will respond to this line of criticism by reverting to this old saw: a credible central bank would not have let inflation get too low in the first place, thus people's expectations would never had been unhinged as a consequence. To this, I say: wishful thinking!

When it comes to the role of expectations in explaining macroeconomic outcomes, Robert Solow warned that it should be used with caution (though Solow said this in a different context):

...[T]o rest the whole argument on expectations -- that all-purpose unobservable -- just stops rational discussion in its tracks. I agree that the expectations, beliefs, theories, and prejudices of market participants are all important determinants of what happens. The trouble is that there is no outcome or behavior pattern that cannot be explained by one or another drama starring expectations. Since none of us can measure expectations (whose?) we have a lot of freedom to write the scenario we happen to like today. Should I respond...by writing a different play, starring somewhat different expectations? No thanks, I'd rather look at the data. (Solow and Taylor, 1998:93)

The problem with economics and economic policymaking these days is that too much of it relies on monetary policy and the role of the central bank. There are limits to what central banks can do because people do not believe central banks are omnipotent and have the ability to control inflation expectations on demand. For this reason, Old Keynesians had it right: fiscal policy must be resorted to bring about normal economic activity.

To summarize: Inflation displays inertia and peoples' expectations about the future cannot be dictated by the central bank alone. Basically, inflation is the result of the interplay of supply of demand for goods and services. When you have more demand than supply, prices and inflation accelerate; when you have more supply than demand, prices and inflation decelerate. It's that simple. That's the secret to understanding what creates inflation, barring the effect of any bottleneck issues.

The central bank can have an impact on future inflation, but mainly as a result of its influence in affecting aggregate demand and real economic activity in the present and future, not as a result of its ability to affect expected inflation and overall expectations in general.

The ongoing low inflation affecting economies at present despite considerable monetary stimulus and the use of unconventional monetary policies such as forward guidance in countries such as the U.S., the U.K, and Japan is evidence that expected inflation relies on past and actual inflation and that central banks' ability to stimulate economies at present via the so-called expectations channel or by attempting to increase expected inflation is currently severely limited.*

To follow me on Twitter, just look me up @circuit_FRB.

References

Solow, Robert, and John Tayor, Inflation, Unemployment and Monetary Policy, (MIT Press: Cambridge MA), 1998

Krugman, Paul. It's Baaack: "Japan's Slump and the Return of the Liquidity Trap", Brookings Papers on Economic Activity, 2:1998

* This post is dedicated to my heroes in macroeconomics: Robert Solow, Alan Blinder, Robert Gordon, Martin Neil Baily and Paul Krugman, to whom I owe so much for their insights

Secular stagnation, secular exhilaration and fiscal policy

Paul Krugman is right: secular stagnation has historically always referred to a situation of persistent low demand, which, according to my old 1971 Samuelson and Scott textbook, renders it inappropriate for governments to attempt to balance the budget over the business cycle (as per the principle of countercyclical compensation).

While in a secular stagnation (Is the shorthand 'SecStag' catching on?), Samuelson and Scott suggest that constant or near-constant government budget deficits are needed to sustain an adequate level of demand to achieve full employment, as shown here:

Samuelson and Scott (1971:437)

The policy stance required during secular stagnation contrasts with the stance needed during periods of so-called "secular exhilaration" (with high demand), during which the right policy is running budget surpluses as a way to avoid overheating the economy and reduce inflationary pressures.

It's true that sustained deficits will increase public debt; however, the low cost of borrowing that usually comes with secular stagnation should help to ensure public debt levels won't get out of hand.

But hasn't the experience of Japan in the 1990s taught us that big deficits don't work to stimulate a stagnant economy, you might ask?

The answer is no. Kenneth Kuttner and Adam Posen demonstrated in "Passive Savers and Policy Effectiveness in Japan" that low tax revenues caused by a weak economy were to blame for the rising debt levels, not expansionary fiscal policy.

Of course, it's important that the spending be directed toward productive use.

I can think of two ways to achieve this goal. First, governments should invest in early childhood learning, an investment that's well known to pay-off in the long-run. Second, investing in infrastructure is also a good bet, as demonstrated several years ago by David Aschauer and Alicia Munnell, and as recently recommended by the IMF.

References

Aschauer, D., 1989, "Is Public Expenditure Productive", Journal of Monetary Economics, Vol. 23, pp. 177-200.

IMF, "Is it time for an infrastructure push? The macroeconomic effects of public investments", Chapter 3, October 2014.

Kuttner, K. and A. Posen, "Passive Savers and Policy Effectiveness in Japan", Institute for International Economics, 2001.

Munnell, A., 1990, "Why has productivity declined? Productivity and Public Investment" New England Economic Review, Federal Reserve Bank of Boston, January/February issue, pp. 3-22.

Samuelson and Scott, Economics, 3rd Canadian Edition, McGraw-Hill, 1971.

Paul Krugman on currency independence, circa 1999

If there's one macroeconomic observation that has gone from obscure to remarkably mainstream in recent years, it's that a nation that has given up its currency independence is at a big disadvantage relative to nations with independent, sovereign currencies, especially when it comes to options for addressing economic downturns and overcoming the aftermath of financial crises.

Paul Krugman has been a main proponent of this view. And he's been at it for a while.

Here's an excerpt from a classic piece by Krugman from 1999 on the ills faced by Argentina after it experimented with dollarization in the 90s:

The problem, you see, is that the same rules that prevent Argentina from printing money for bad reasons--to pay for populist schemes or foolish wars--also prevent it from printing money for good reasons such as fighting recessions or rescuing the financial system. [...] 

Now, these problems with a rigidly fixed exchange rate are not news. But for a while, currency-board enthusiasts managed to convince themselves that they weren't significant. They argued that as long as governments themselves followed stable policies--and as long as the economy was sufficiently 'flexible' (the all-purpose answer to economic difficulties)--there would be few serious recessions. 

But it turns out that history does not stop just because the currency is stable. And faced with a politically inconvenient recession, the Peronists find that there is nothing they can do. They cannot print money. They cannot even borrow money for some employment-generating public spending, because fiscal indiscipline would undermine the peso's hard-won credibility.

Read the entire column here.

Reference 

Krugman, P., Don't laugh at me Argentina, Slate, July 20, 1999

A kind word for Paul

Paul Krugman's recent posts on the abuse use by politicians of economic studies as a way to support ideologically-driven fiscal austerity have been right on. Here's from his latest:

...the important story isn’t about the sins of the economists; it’s about our warped economic discourse, in which important people seize on academic work that fits their preconceptions. Even if you don’t think Reinhart-Rogoff made much difference to actual policy, the meteoric rise and catastrophic fall of their reputation speaks volumes about why this slump goes on and on.

I made a similar point in an earlier column when I wrote that austerity was a

...prepackaged "solution to a problem" that fits with today's dominant policy-making ideology, which holds that governments have little or no purpose other than catering to financial interests and leaving the path clear for free-market actors to find solutions to every problem facing society.

...[F]iscal austerity is simply another example of a "solution looking for a problem", an empty and empirically ineffectual idea with no clear rationale other than giving the appearance that "something is being done".

This is why I continue to think that the ones who are really responsible for austerity are the politicians who support this view. Economic studies were used to provide cover for these leaders' preferred set of policy choices.

Anyway, there's no matching Prof. Krugman's performance these last few months. Not only have his forecasts been right on, but his retrospective look at why things unfolded the way they did has been downright flawless.

Public investment and productivity growth: How to provide properly for the future

Just as I was thinking about the moral aspects of economic policy, here comes Paul Krugman with a fantastic commentary on how governments today are shortchanging future generations by not taking advantage of record low interest rates and not spending on productivity-enhancing public investments:

Fiscal policy is, indeed, a moral issue, and we should be ashamed of what we’re doing to the next generation’s economic prospects. But our sin involves investing too little, not borrowing too much — and the deficit scolds, for all their claims to have our children’s interests at heart, are actually the bad guys in this story. 

So true. This reminds me of something the late economist Robert Eisner wrote:

...balancing the budget at the expense of our public investment in the future is one way that we really borrow from our children - and never pay them back. (1996)

The reason for this is that the "deficit equals bad" crowd is completely oblivious to the fact that public investment adds to the stock of productive assets that help to enhance private sector productivity in the long run. And public spending on infrastructure, education, basic research and the development of new technology is essential to achieve the level of productivity necessary to improve our standard of living in the future.

And at a time when we are facing an aging population, increasing our future productivity growth should be a (if not the number one) priority.

A good explanation for this is provided by Francis Cavanaugh, former senior US Treasury Department economist and former CEO of the Federal Retirement Thrift Investment Board, who argues that

Significant productivity increases will be necessary as a diminished labor force is called on to support an expanded group of retirees. Without such increased production per worker, a shortage of goods will lead to price increases, and it is likely that the baby boomers will suffer a significant decline in the purchasing power of their retirement dollars. Inflation could soon decimate their retirement savings. That's the economic reality; if you're not working, you're dependent on the productivity of those who are. (1996)

In other words, the best protection against the potential losses that come with an aging population is to take measures today aimed at increasing the productivity growth of tomorrow. This should be the long term goal of policymakers right now.

So Prof. Krugman is right: contrary to what most politicians and commentators believe about how to improve our long-run prospect, slashing government spending is exactly the wrong thing to do at this time. 

References

Cavanaugh, F., The truth about the national debt, Boston: HBSP, 1996

Eisner, R., "The balanced budget crusade", The Public Interest, Winter 1996

Old Keynesian themes in Modern Monetary Theory

Readers of this blog know I'm generally supportive of the views espoused by proponents of Modern Monetary Theory (MMT). The reasons are fairly simple. First, MMT considers unemployment to be an important problem that must be quickly and effectively addressed by the government authorities.  I agree with that.  Also, MMT makes a good case on the important role of fiscal policy in ensuring stable and equitable economic growth.  Again, I agree with that.

But there is another reason I'm generally in agreement with MMT on many issues.  This has to do with the fact that MMT builds on some pretty solid economic thinking, much of which was well understood and accepted by earlier generations of Keynesian economists.  As someone who has a lot of respect for and who finds much insight from this earlier Keynesian tradition, I'm quite pleased to see MMT, a more recent school of thought, disseminate these views.

I was reminded of some of these - let's call them - "Old Keynesian" tenets in a recent blog post by Paul Krugman, in which he discusses a trifecta of issues relating to (1) the benefits of monetary sovereignty (i.e., where a nation issues and uses its own currency), (2) the debate on the supposedly inflationary nature of deficit spending financed via money creation or bond issuance and (3) the recent controversy regarding the potentially expansionary consequences of a "loss of confidence" in US government bonds by international investors .

The first of these views concerns monetary sovereignty, a central MMT theme.  This was also a well understood concept by earlier Keynesian economists.  For instance, monetary sovereignty was a key aspect highlighted in the work of economist Robert Eisner, who brilliantly described in his book The Misunderstood Economy (1994:74) why the US greatly benefits from being a currency issuing nation:

[One] point that is widely misunderstood or unrecognized is that this debt, relatively small as it is, is all owed in its own currency, US dollars.  We pay interest and principal in US dollars.  And our Treasury and Federal Reserve can always create all the dollars we need.  One may object that such money creation or the monetization of the interest-bearing debt may have undesirable consequences, particularly greater inflationary pressure.  But it may also have the desirable effect of stimulating the US economy if that is in order. In any event, the fact that US debt held by foreigners is virtually all denominated in US dollars rules out the possibility of unvoluntary default on US government obligations.

We are not in the position of many third world or other debtor nations that sadly had obligations in foreign currencies, frequently the US dollars.  The only way they could service their debt was to obtain foreign currencies. [...]

The "world's greatest debtor nation" gave the American public visions of the US going bankrupt.  Since the debt was essentially in our currency, however, this made no sense.  We could "print" out own money to pay it off or, in more sophisticated fashion, have the Federal Reserve create the money. (1994:74)

Several other Keynesian economists also held similar views, including economist Lorie Tarshis who emphasized this point in Elements of Economics (1947), the first Keynesian textbook to be published in the US.

Secondly, concerning the ever-lasting debate on the supposedly inflationary nature of deficit spending financed via money creation or bond issuance, MMT considers that the latter should be viewed as more inflationary than the former since the interest payments paid by government on its debt results in a greater expansion in the money supply (in the long run) than if the deficit is financed by money creation.

On this point, it may be instructive to recall that economists Alan Blinder and Robert Solow demonstrated long ago that the "potency" of deficit spending via money creation or bond issuance is not strictly related to the manner of financing.  In fact, Blinder and Solow demonstrate in "Analytical Foundations of Public Finance" (1974) that deficit spending financed via issuance of bonds has under normal, steady-state equilibrium conditions a greater fiscal multiplier than deficit spending via monetary financing in the long run:

When we correct an oversight committed by almost all previous users of the government budget constraint, a still more odd result emerges.  The error has been to ignore the fact that interest payments on outstanding government bonds are another expenditure item in the budgetary accounts. [...]

Under a policy of strict monetary financing, [in a stable system, the long-run government expenditure multiplier is simply the reciprocal of the marginal propensity to tax].  But the issuance of new bonds means a greater multiplier in the long run. (1974:50). (original emphasis)

Finally, as for Krugman's contention that a loss of confidence in US government bonds by investors may have potentially expansionary consequences for the US economy, economist Bill Vickrey presented a similar argument in his article entitled "Fifteen Fatal Fallacies of Financial Fundamentalism" (1996).  On whether a sell-off of US government bonds by foreign investors would have a detrimental effect on the US economy, Vickrey suggested the following:

It is not intended that the domestic government debt should be held in any large quantity by foreigners.  But should foreigners wish to liquidate holdings of this debt or any other domestic assets, they can only do so as a whole by generating an export surplus, easing the domestic unemployment problem, releasing assets to supply the domestic demand, and making it possible to get along with smaller deficits and a less rapidly growing government debt.  The same thing happens if domestic investors turn to investing in foreign assets, thereby reducing their drain on the domestic asset supply.

All that to say that, in my opinion, both Paul Krugman and proponents of MMT stand on solid ground regarding these issues.

References

Blinder, Alan and Robert Solow, "Analytical Foundations of Fiscal Policy," in A. S. Blinder, et. al., The Economics of Public Finance, The Brookings Institution, 1974, pp. 3-115.

Eisner, Robert, The Misunderstood Economy: What counts and how to count it, Boston: HBSP, 1994.

Tarshis, Lorie, The Elements of Economics, New York: Houghton Mifflin, 1947.

Vickrey, William. "Fifteen fallacies of financial fundamentalism: A disquisition on demand-side economies", Proceedings of the National Academy of Sciences of the United States of America, Vol. 95, No. 3, February 1998, pp. 1340-1347.