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

The Old Keynesian prescription to get out of a deep recession

In my previous post, I highlighted an article that shows the most promising unconventional monetary policies for boosting ailing economies right now are overt monetary financing and the policy measures advocated by neo-chartalists.

It's worth mentioning that, from a practical standpoint, this is essentially what the traditional, Keynesian IS-LM model would prescribe in a context of high public debt combined with nominal interest rates at the zero lower bound.

A good example of the application of IS-LM toward this end is Robert Gordon's analysis of the difficulties facing Japanese policymakers in the 1990s:

If monetary policy is impotent because it cannot reduce the interest rate any further, a fiscal stimulus is required to end the slump and bring back the output ratio back to its desired level [...]

The low level of the Japanese interest rate created a policy dilemma in Japan. Monetary policy could not push interest rates appreciably lower, yet fiscal policymakers felt constrained in achieving a large fiscal stimulus by the high existing level of the fiscal deficit in Japan and by the fact that the public debt in Japan had reached 100 percent of real GDP. 

However, the IS-LM model suggests a way out of the Japanese policy dilemma... [:] a combined monetary and fiscal policy stimulus that shifts the LM and IS curves rightward by the same amount can boost real GDP without any need for a decline in interest rates [...]

Also, with such a combined policy there is no need for a further increase in the national debt held by the public, since to achieve its monetary expansion, the central bank can buy the government bonds issued as a result of the increased fiscal deficit [...]

Why did the Bank of Japan resist what seemed to be the obvious solution, which was that the Bank buy up the government bonds issued as a result of the fiscal stimulus? This solution, sometimes called "monetizing the debt", would be the real-world equivalent of shifting the LM curve rightward along with the IS curve, in contrast to the increased interest rates that would result if the IS curve were pushed rightward without a corresponding rightward LM movement. Bank of Japan policymakers retreated into the traditional fear of central bankers that monetizing the debt would undermine the Bank's independence and credibility, two goals that are embedded in the structure of beliefs of central bankers. In fact, as a result of rapid inflation after World War II, the Bank is legally banned from buying bonds directly from government, although it is still able to purchase government bonds indirectly through financial markets. 

The traditional reason for the historic reluctance of central bankers to monetize the debt and conduct a simultaneous monetary and fiscal expansion has been fear of inflation. Yet Japan's problem in the late 1990s was deflation, not inflation [...]

While the prescription of the IS-LM model in favor of a combined monetary-fiscal expansion seemed clear, implementing this policy recommendation was blocked by the reluctance of the Bank of Japan's to give up its historic commitment to price stability. (137-138) (emphasis added)

One final word. This type of policy solution goes back a long way. A variant of this mechanism -- minus the IS-LM language -- is even found in (Keynesian) Lorie Tarshis's textbook published in 1947.

Reference

Gordon, R., Macroeconomics, Eighth Edition, 2000.

Robert Gordon on the death of innovation and end of growth

This TED talk by Robert Gordon (Northwestern) is a must-see (do it, it's only 12 minutes long). You may recall that a paper by Gordon created quite a stir in the news a few months ago because of the bleak outlook it gives regarding future economic growth in the US.

In the talk, Gordon counters the commonly-held idea that economic growth is a continuous process. He makes the case that the rapid growth experienced during the last two and half centuries may have been an anomaly rather than the start of a new, everlasting historical trend.

According to Gordon, economic growth in the coming decades will slow as a result of six headwinds that will reduce future productivity and income growth. In the end, the impact of these six headwinds will leave long-term growth at half or less of the (near) 2 percent annual rate experienced between the mid-1800s and today.

The six negative headwinds that make up Gordon's "exercise in subtraction" are demography, education, inequality, globalization, energy and debt (for more, see Gordon, 2013).

My take on this issue is that I'm generally optimistic about the prospect of continued future growth but becoming somewhat pessimistic about the ability of governments to take the appropriate steps to encourage the type of innovation and technological advancements that promote robust long-term economic growth.*

As I've mentioned before, the current preoccupation of politicians and policymakers with slashing spending and reducing public debt levels is likely going to be detrimental to long-term growth. I doubt there are many growth theorists out there who would argue that trillions of dollars in lost output (as witnessed by the huge amount of idle resources, including unemployed workers) and cuts to public investment are beneficial to a nation's long-term growth prospects.

A few years ago, (the great) economist Albert Wojnilower summed up the problem that's emerged in the US with respect to government support for innovation in a 2011 interview as follows:

Gail Foster: What about the long term? There are many, maybe even a majority, who believe that we are possibly in a temporary innovation funk — maybe not so temporary. In other words, while it may be possible to be encouraged about the short term, we are just getting back to where we were before the recession, and there is not much that is economically exciting to look forward to. Would you agree?

Albert Wojnilower: I wouldn’t sell the future short. There is no lack of new business opportunities (cell phones, Facebook, electric cars, energy innovation, services that cater to aging societies). The question is, where will they be invented, used and exploited? And to whom will the benefits be distributed? The United States has traditionally been a leader in this important growth process; now it is a laggard. The shift in the U.S.’s relative position is a matter of ideology, not economics.

GF: What do you mean by ideology?

AW: The United States has adopted a free-market, small-government ideology, ostensibly copying what we did in the distant past. The difference today is that there is no frontier. Most opportunities tread on someone else’s toes (as in property rights). There is less space for greenfield experimentation. The small-government mentality means that there is no effective arbitrator of the trade-offs to break the log jam. Many of our newest “innovations” have occurred outside the traditional economic sectors — for example, creating a new sector that today we refer to as technology. Major inventions have been made by civil servants, at little personal benefit. The United States has usually been pragmatic on these matters, but now it appears to be headed in a much more dogmatic direction...

GF: Would it be fair to say that you are an optimist with respect to human ingenuity but not human nature?

AW: Yes, indeed.

* For a more optimistic view, see Baily et al, the TED talk by Eric Brynjolffson and this debate between Robert Gordon and Eric Brynjolffson
 
References

Gordon, Robert, US Productivity Growth: The slowdown has returned after a temporary revival, International Productivity Monitor, Spring 2013.

Baily, Martin.N. James Manyika and Shalabh Gupta, US Productivity Growth: An optimistic perspective, International Productivity Monitor,  Spring 2013.

Fosler, Gail and Albert Wojnilower, Interview: Are we out of the woods yet, Gail Foster Group LLC. February 9, 2011.