I had always assumed that the point of both monetary and fiscal stimulus was to boost AD.

TO BE NOTED: From The Money Illusion:

"What’s the point of fiscal stimulus and QE?

If you were to rely on the press, you’d think that the purpose of fiscal stimulus was to boost real output, to “get us out of the recession,” and the purpose of quantitative easing (QE) is to boost inflation, to “get us out of the liquidity trap.” I’m sure someone will tell me where I am wrong, but this seems like utter nonsense to me. I had always assumed that the point of both monetary and fiscal stimulus was to boost AD. And that in the short run both policies raise both prices and output. And that the way nominal GDP growth is partitioned depends on the slope of the SRAS curve, not on what caused AD to increase. Did I misunderstand my macroeconomics courses?

I suppose you could argue that fiscal policy also has supply-side effects, but in the current case those are almost certainly negative. There are no supply-side tax cuts in the recent bill (indeed implicit MTRs rise), and even if more spending on health care, energy research and education boost long run productivity, they do nothing to shift the SRAS to the right. It would make more sense to ask whether the fiscal stimulus will succeed in boosting inflation, and whether the QE will succeed in boosting real output.

What set me off was a recent piece in the Washington Post by Johnson and Kwak. Despite my exasperated tone, I am not trying to pick on these two fine economists. Their views are widely held, and I am certainly in the minority—a minority of one on some issues. All I can do is provide my subjective reaction to the following quotations:

After the double-digit inflation of the 1970s and early 1980s, why would anyone want to create inflation? Households and companies alike are trying to “deleverage,” or pay down their debts. But deflation makes it harder to pay down debts, because debts are fixed in dollars and those dollars are becoming worth more and more. Moderate inflation in the neighborhood of 4 percent, by contrast, makes it easier for borrowers to manage their debt loads, and stimulates the economy.

First let’s be very clear about one thing, the Fed can create inflation only by boosting AD, not reducing AS. So Johnson and Kwak are essentially asking “why would anyone want to boost AD?” My response is; why would anyone even ask a question like this? When restated in terms of AD, the answer is simple, because NGDP is now falling at a 7% annual rate and is expected to be far below the Fed’s implicit target for many, many years. Just imagine a discussion of fiscal policy along similar lines: “Hmmm, I wonder why the fiscal authorities see a need to stimulate the economy? Aren’t they worried that NGDP growth is likely to be excessively rapid going forward? Don’t we need to slow down AD growth?” I’m going to go out on a limb and assume that no one has been asking that sort of question recently. But they are asking analogous questions about monetary policy. (BTW, their answer to the question is perfectly fine.) They then ask:

But is the United States really a normal advanced economy anymore? We seem to have taken on some features of so-called emerging markets, including a bloated (and contracting) financial sector, overly indebted consumers, and firms that are trying hard to save cash by investing less. In emerging markets there is no meaningful idea of “slack;” there can be high inflation even when the economy is contracting or when growth is considerably lower than in the recent past.

First of all this is a perfect illustration of why it makes more sense to talk in terms of NGDP growth, not inflation. Monetary and fiscal expansion will raise NGDP growth in all sorts of countries, under all sorts of conditions. That is the Fed’s policy goal. In addition, the Fed has made it clear that they want low inflation, not high inflation, a point acknowledged elsewhere by Johnson and Kwak. We’ve had positive inflation in every recession of my lifetime (except the last 6 months), so why would we expect anything different from a monetary expansion today? In the next paragraph they assert:

If the United States is indeed behaving more like an emerging market, inflation is far easier to manufacture. People quickly become dubious of the value of money and shift into goods and foreign currencies more readily. Large budget deficits also directly raise inflation expectations. This would help Bernanke avoid deflation, but there is a great danger that unstable inflation expectations will become self-fulfilling. We do not want to become more like Argentina in 2001-2002 or Russia in 1998, when currencies collapsed and inflation soared.

What great danger? Why are inflation expectations at record lows in the long term bond market, if there is a great danger of inflation? And if those expectations started to rise, couldn’t the Fed just pull the money back out of circulation to keep inflation expectations in check? (By the way, I’d much rather be like Argentina after inflation “soared,” than Argentina before inflation soared–although I would prefer to avoid both options.)

At the other extreme is Tim Duy, who worries that we won’t be able to get any inflation at all. I’ll use Mark Thoma’s post, as it nicely explains all the competing views. (Be aware of the Russian doll problem, lots of quotations within quotations within quotations.)

The key paragraph in Johnson and Kwak that I [Tim Duy] take issue with is:

“Then in March, the Fed said that it will begin buying long-term Treasury bonds on the open market, hoping to push down long-term interest rates (by increasing the amount of money available for long-term lending) and thereby stimulate borrowing. The implication is that the Fed will finance these purchases by creating money. Not only that, but Bernanke wants us to know exactly what the Fed is doing; he hopes to push up our expectations of future inflation, so that wages and prices will nudge upwards, not downwards.”

The implicit assumption is that the Fed is expanding the money supply via a policy of quantitative easing with the explicit goal of raising inflation expectations. First off, as Bernanke said once again today, he does not describe policy as quantitative easing:

“In pursuing our strategy, which I have called “credit easing,” we have also taken care to design our programs so that they can be unwound as markets and the economy revive. In particular, these activities must not constrain the exercise of monetary policy as needed to meet our congressional mandate to foster maximum sustainable employment and stable prices.”

Pay close attention to Bernanke’s insistence that the Fed’s liquidity programs are intended to be unwound. If policymakers truly intend a policy of quantitative easing to boost inflation expectations, these are exactly the wrong words to say. Any successful policy of quantitative easing would depend upon a credible commitment to a permanent increase in the money supply. Bernanke is making the opposite commitment - a commitment to contract the money supply in the future. Is this any way to boost inflation expectations?

So Tim Duy draws the opposite conclusions from Johnson and Kwak, the danger is no inflation at all. Obviously in terms of likely outcomes, I agree with Duy. But I also think that in this particular exchange Johnson and Kwak’s interpretation of Fed intentions is just as plausible, perhaps more so.

The Fed clearly doesn’t intend the reader to interpret “stable prices” literally, rather they are referring to the Fed’s inflation target, which is more like 2% inflation. So you have one side warning of high inflation if the monetary base remains at the current high levels, and others saying we won’t get any inflation at all if the money is pulled out of circulation later. In a sense both sides are right. So why doesn’t the Fed clearly say that it plans to leave just enough money in circulation to keep long run price levels 2% or 3% (per year) higher than current price levels? Isn’t that what the Fed wants?

By the way, here is another case where NGDP growth makes far more sense than inflation. Most liquidity trap models talk about reducing real interest rates through expected inflation. But if you look at the logic of these models, it is clearly NGDP growth that matters, not inflation. Don’t believe me? Then consider a scenario where the Fed generates 5% NGDP growth expectations, but negative 1% inflation expectations. Do we stay in a liquidity trap? Obviously not, with 6% real growth expectations the Wicksellian natural rate (in real terms) will rise well above 1%, so you don’t have to worry about that problem. And even if you stayed stuck in a liquidity trap, would that be so bad with 6% real growth?

Why doesn’t the Fed simply communicate its inflation target so people aren’t playing this zero inflation/hyperinflation guessing game? They don’t have to tell us exactly how much money they will later pull out of circulation; just tell us that it will be enough to produce X percent inflation. Perhaps the problem is that Congressmen like Barney Frank get upset when the Fed hints that it might ignore its “dual mandate” and focus solely on an inflation target. I have a suggestion for the Fed, it’s a nominal target that gives equal weight to inflation and real growth. Anyone want to guess what I’m thinking?

While I am in a grouchy mood let me get one more thing off my chest. Consider the following quotation from Johnson and Kwak:

If he succeeds in restarting growth while avoiding high inflation, Bernanke may well become the most revered economist in modern history. But for the moment, he is operating in uncharted territory.

First let me reiterate that I don’t blame just Bernanke for the crisis, I blame the Fed and all the macroeconomists who refused to strongly criticize the stance of Fed policy in October 2008, when growth forecasts fell far below any reasonable policy objective—in other words, just about everyone. But Bernanke was chairman of the Fed at that time, and they did refuse to cut rates to zero. Admittedly they did inject a lot of reserves, but then they paid interest on those reserves at rates higher than alternative assets, insuring that almost all the extra reserves would be hoarded. And this was done when financial markets and private forecasters were (correctly) forecasting falling NGDP. So when I see people talking about the potential heroism of Bernanke, I can’t help thinking of the fireman who started fires so that he’d have a chance to become a hero putting them out. Yes, this is almost certainly a bad analogy, Bernanke is both well-intentioned, and a much better than average fireman. But if it is a bad analogy, then it’s a pretty sad comment on the state of our profession.

Update 4/6/09, Despite my disclaimer before the first J&K quotation, a commenter mentioned that my tone was not very polite. That was certainly not my intention, but I can see how people might read it that way. So let me be a bit clearer about this point. Since early October I have been extremely frustrated with about 99% of macroeconomists; who I blame for the worldwide recession/depression. I think they have almost everything backwards. I believe they are looking at totally meaningless “indicators” of monetary policy like interest rates and the money supply, and ignoring the only variable that matters, the expected growth in the central bank’s target variable. So in the unlikely event that J&K come across this post, just assume you are surrounded by 99% of other macroeconomists, including all the greatest minds in the field, and consider me an eccentric economist at a small school taking potshots from the sidelines. I was just venting my frustration with the entire tone of the ongoing debate over macro policy, and picked your piece at random.

I’d like to thank the invaluable Dilip for the links used here. I should probably be paying him for his assistance. But I won’t, unless someone will pay me for doing this blog. With a bunch of new links, I will probably not post for a few days, returning later in the week with a piece on international monetary issues."

Me:

1. Don the libertarian Democrat
   5. April 2009 at 21:01

   Here’s a quote from a paper that I like:

   http://www.princeton.edu/svensson/papers/jep2.pdf

   “The problem is, again, why an expansion of the monetary base today should be viewed as a
   commitment to increased money supply in the future. While the liquidity trap lasts and the interest
   rate is zero, the demand for monetary base is perfectly elastic and excess liquidity is easily
   absorbed by the private sector. However, once the liquidity trap is over and the nominal interest
   rate is positive, demand for money will shrink drastically, in most cases requiring a drastic
   reduction of the monetary base. It is difficult to assess how much the monetary base would have to
   be expanded before inflation expectations and inflation take off. Beyond some unknown threshold,
   deflation may be quickly replaced by hyperinflation.”

   Now, I’m not an economist, but, although Sevensson doesn’t like the idea, he does seem to be talking about QE and inflation together. Am I wrong?

And:

Don, Yes, Svensson thinks QE can raise inflation but he prefers currency depreciation as it is easier to estimate the impact. He may be right in Japan’s case, although as he says it doesn’t apply to the world economy. Svensson favors using internal Fed forecasts, not market forecasts as I prefer, so he worries more about overshooting than I do.