Instead, the yield curve has become more steeply sloped, as longerterm Treasury yields have risen while short-term rates have declined.

TO BE NOTED:

• May 20, 2009, 1:53 PM ET

St. Louis Fed Paper Rebuts Bernanke’s Treasury-Purchase Views

Is Ben Bernanke wrong about the potential effects of the Federal Reserve’s purchases of longer-term Treasurys on yields?

A paper released this week by the St. Louis Fed suggests he might be. Bernanke “seems to suggest that the purchase of a large quantity of longer-term government securities might reduce longer-term rates,” St. Louis Fed economist Daniel Thornton wrote in a research note posted on the St. Louis Fed’s Web site.

And with short-term rates near zero, the yield curve would presumably flatten under that hypothesis, Thornton observed.

That, however, is “inconsistent” with the “commonly held view” that long-term rates are influenced by what’s known as the expectations hypothesis, Thornton wrote.

“Under the expectations hypothesis, long-term rates are equal to the market’s expectation of the short-term rate over the term of the long-term asset plus a risk premium,” Thornton wrote. Therefore, the Fed “cannot permanently affect the shape of the yield curve by purchasing securities in one end of the market,” he wrote.

In March, the Fed announced that it would buy up to $300 billion in longer-term Treasury securities in addition to more than $1 trillion in agency and agency-backed mortgage backed securities.

The announcement, on March 18, led to a stunning rally in Treasurys and flattening of the yield curve that appeared to support Bernanke’s statement in December 2008 that buying longer-term Treasurys or agencies in large quantities “might influence the yields on these securities, thus helping to spur aggregate demand.”

But the yield-curve flattening, Thornton noted, “has vanished” since March. So while the Fed has boosted longer-term Treasury purchases and expanded its balance sheet, “these actions appear to have had no permanent effect on the yield curve,” he wrote."

Economic SYNOPSES
short essays and reports on the economic issues of the day
2009 􀀀 Number 25
After its March 18 meeting, the Federal Open Market
Committee (FOMC) stated that it had decided to
purchase “up to $300 billion of longer-term Treasury
securities over the next six months.” This decision follows
a speech by Chairman Bernanke on December 1, 2008, indicating
that “the Fed could purchase longer-term Treasury
or agency securities on the open market in substantial quantities.
This approach might influence the yields on these
securities, thus helping to spur aggregate demand.”1
It is commonly believed that the FOMC affects longerterm
rates by setting a target for the overnight federal funds
rate. It is also commonly believed that longer-term rates are
determined by the market’s expectation for short-term rates,
in accordance with the expectations hypothesis of the term
structure of interest rates. Under the expectations hypothesis,
long-term rates are equal to the market’s expectation of the
short-term rate over the term of the long-term asset plus a
risk premium. Hence, if the FOMC reduces its target for
the funds rate and the market expects the FOMC to keep
the target low, long-term rates should decline accordingly.
With the funds rate target near zero, it is essentially impossible
for the FOMC to reduce long-term rates by reducing
its funds rate target further.
Chairman Bernanke seems to suggest that the purchase
of a large quantity of longer-term government securities
might reduce longer-term rates. With short-term rates
already near zero, this would cause the yield curve to flatten,
as long-term rates decline relative to short-term rates. How -
ever, the idea that the Fed can influence long-term interest
rates by intervening directly in the longer end of the market
is inconsistent with the commonly held view—that is, the
expectations hypothesis. This hypothesis assumes that there
is a very high degree of substitutability (essentially perfect)
among Treasuries of various maturities. Under perfect
substitutability, the reduction in long-term rates (with
unchanged risk premiums) would cause investors to sell
the lower-yielding short-term assets and purchase the now
higher-yielding long-term assets.( NB DON ) This arbitrage activity
could cause longer-term rates to rise and short-term rates
to fall. This process would continue until the yield curve
returned to its previous structure. The only possible effect
of the increased purchase of long-term securities would be
on the position of the yield curve: It could shift down if the
purchase of long-term Treasuries sufficiently increased the
supply of credit relative to demand. Under the expectations
hypothesis, the slope of the yield curve is determined by
risk premiums that should not be affected by simply purchasing
assets at one end of the term structure relative to
the other.
Either the Fed affects long-term rates because of the
expectations hypothesis, which means that it cannot permanently
affect the shape of the yield curve by purchasing
securities in one end of the market, or the short and long
ends of the market are sufficiently segmented so that the
Fed can permanently affect the slope of the yield curve by
intervening in one end of the term structure relative to the
other. However, in the latter case, the Fed’s ability to influence
long-term rates by controlling the short-term rate is
attenuated by the zero lower bound.
The observed effect of the FOMC’s decision to purchase
longer-term government securities on the term structure
is consistent with the belief that there is a high degree of
substitutability of assets across the term structure. An
announcement effect occurred when the FOMC made
known its intention to purchase up to $300 billion in longerterm
government securities: Longer-term Treasury yields
immediately declined by about 50 basis points. In contrast,
shorter-term rates were unaffected by the announcement.
The announcement effect resulted in a significant flattening
The Effect of the Fed’s Purchase of
Long-Term Treasuries on the Yield Curve
Daniel L. Thornton, Vice President and Economic Adviser
Chairman Bernanke seems to suggest
that the purchase of a large quantity of
longer-term government securities
might reduce longer-term rates.
of the yield curve. Figure 1 shows the
coupon yield curve the day before and
the day of the announcement: There was
very little effect on rates for Treasuries
with maturities of less than a year, but
the announcement effect gets progressively
larger as the term to maturity
lengthens—until about 5 years. (For
maturities of 5 years or longer the
effect is about 50 basis points.) A similar
announcement effect is reflected in the
wide range of longer-term corporate
bond yields.
The FOMC made good on its
announcement and the Fed increased
its holdings of longer-term Treasury
securities by about $59 billion between
March 19 and April 29, 2009. During
this period Treasury yields responded
to Fed actions as well as other changes
in the economic and financial environment.
Figure 2 compares the yield curves
on March 17 and April 29. The marked
flattening of the yield curve associated
with the FOMC’s announcement has
vanished. Instead, the yield curve has
become more steeply sloped, as longerterm
Treasury yields have risen while
short-term rates have declined.
There have been many events that
markets have responded to since
March 18. Hence, it is difficult if not
impossible to attribute the steepening
of the yield curve to a particular factor.
The Fed has increased its purchases of
longer-term Treasuries and expanded its balance sheet by
about $150 billion since March 18. Whatever their immediate
effect, these actions appear to have had no permanent
effect on the yield curve. 􀀀
1 Bernanke, Ben S. “Federal Reserve Policies in the Financial Crisis.” Speech at
the Greater Austin Chamber of Commerce, Austin, Texas, December 1, 2008.
Economic SYNOPSES Federal Reserve Bank of St. Louis 2
research.stlouisfed.org
Posted on May 18, 2009
Views expressed do not necessarily reflect official positions of the Federal Reserve System.

When you buy a Burberry bikini, what you are buying is not a tartan bikini but a promise of exclusivity

From Worthwhile Canadian Inititiative:

"Good News! Interest rates rise.

This Bloomberg story reports the Fed saying that rising bond yields are a good sign. They don't precisely say that monetary easing is what caused the rise in interest rates; they are perhaps too modest to claim credit? But I will say it for them: by buying bonds, and easing monetary policy, the Fed has caused the price of bonds to fall, and interest rates to rise. Yep, an increase in demand for bonds causes the price to fall.

How does an increase in demand for something cause the price to fall? This could only happen if the increase in demand by one buyer caused other buyers to reduce their demand.

I can think of examples where this might happen. I remember a recent case where an "Essex girl" appeared on a British reality TV show wearing a Burberry bikini, and thereby ruined the Burberry brand image. This reduced demand for Burberry from everyone else.

Why are central banks buying bonds like an Essex girl buying a Burberry bikini? Isn't their money as good as anyone else's?

Well, no, it isn't. A central bank's money is actually better than anyone else's. That can't be the problem.

This is the problem. When you buy a Burberry bikini, what you are buying is not a tartan bikini but a promise of exclusivity. When you buy a bond, what you are buying is a promise of money in the future, and the value of that future money depends on its exclusivity. When a central bank buys a bond, and thereby increases the stock of money, it is doing something that other buyers of bonds don't do. The money will be worth less in future, and so the bond is worth less too. When Essex girl buys a Burberry bikini she lowers the fundamental value of Burberry bikinis. When the central bank buys a bond, with new money, it lowers the fundamental value of the bond.

Try telling that story without mentioning the supply of money, you Neo-Wicksellians!

This is the same argument I have been making in the past. It's not so much "I told you this would happen"; it's "I told you this ought to happen". Low nominal interest rates can be seen as a sign of tight money as much as easy money.

Quantitative Easing, like any policy to increase Aggregate Demand, is strongly reinforced if it can create the expectation it will work, both by increasing expected inflation, and by increasing expected output growth. And this makes nominal interest rates a poor choice as a monetary policy control instrument. If the central banks wants to make monetary policy easier, it tries to lower interest rates, by buying bonds. But if it is seen as successful in making monetary policy easier, and increasing AD, it will be raising nominal interest rates. This makes it very hard for the market to interpret changes in interest rates. And this makes it very hard for the central bank to generate that cumulative self-reinforcing confidence that the policy is working. "Look, I'm pushing the lever down, and it must be working, because the lever is moving up!"

That confusion in interpreting the rise in interest rates is reflected in the last part of the Bloomberg story:

The situation poses a “dilemma” for the Fed, because if the rise in yields reflects “erroneous market views” about the economy, it will hold back growth, said former Fed Governor Lyle Gramley.

“The Fed is probably scratching its head at the moment and will wait and not react until the smoke clears,” said Gramley, who is now a senior economic adviser with New York-based Soleil Securities Corp.

There are the Fed's "market views", the bond market's "market views", and firms' and households' "market views" when they make consumption and investment decisions. The danger is if the bond market thinks the policy is working, and expects higher inflation and real output growth, but firms and households don't. The bond market raises nominal interest rates, because it sees the IS curve as having shifted as a function of the nominal interest rate. But if households and firms stay pessimistic, and don't share the bond market's views, consumption and investment will fall.

Posted by Nick Rowe"

Me:

I thought that the plan of QE was to keep short term interest rates low, giving investors an incentive to invest in other higher yielding pursuits now, and have longer term interest rates rise, showing that deflation is being defeated and signaling a recovery in the future when rates will have to go up. In other words, QE attacks the Fear and Aversion to risk with short term incentives and longer term confidence. As far as I can tell, it's working pretty well, if slowly. Posted by: Don the libertarian Democrat

double downward spiral involving the financial sector and balance sheets and asset prices on the one hand and the real economy on the other

TO BE NOTED: From The Growth Blog:

"The Financial and Economic Crisis and the Developing World: Where We Are and Where We Are Going

By Michael Spence

Created 04/14/2009 - 16:46

The financial system in the USA and much of Europe had a heart attack in September 2008. As in the case of a real heart attack, the highest priority has gone to the emergency response and to stabilizing the patient. Once that is done and the crisis is abating and even to some extent as it is going on, it will be important (economically and politically) for some to focus on two related issues: What created the rising risk of an attack? And what combination of actions post-crisis will reduce the risk of a repeat in the future.

There are related issues. Are there lessons in the current crisis (and past ones) or is each one sufficiently idiosyncratic so that reregulating with reference to the past does little to limit the potential future damage. Globally, what is the appropriate tradeoff between risk reduction on the one hand and higher costs of capital and lower growth on the other? Is the financial sector different from most others in that when it malfunctions, the rest of the economy malfunctions along with it, and if so should it be treated differently? Will investors learn from this crisis to a point that much of the “re-regulation” will come from adjusted investor behavior and risk assessment procedures? Or are there inherently large divergences between private and social objectives that need to be aligned through regulatory and oversight structures? Are the answers the same for domestic economies and financial systems and for the global aggregate, or are they fundamentally different?

In climate change there are issues of mitigation (prevention or risk reduction) and adaptation. Good policy is a mix of the two. Corner solutions are unlikely to be the right answer. A similar issue arises in the present case. Whether or not regulation and oversight are adequate depends upon the risks and the consequences of financial instability and distress and the latter depends on the existence and effectiveness of response mechanisms. We will need to talk about both in a coordinated way.

The Crisis of September 2008

Credit locked up, interbank lending stopped, and the payments systems' started to malfunction in the US and much of Europe. The TED spread (The interest rate differential between t-bill rates and LIBOR) and related measures of risk at the heart of the financial, payments and credit system rose from its normal 100 basis points to between 4 and 5 hundred basis points. Asset prices declined rapidly, balance sheets in the financial sector further deteriorated and the household sector experienced a massive wealth loss, triggering a reduction in consumption. The double downward spiral involving the financial sector and balance sheets and asset prices on the one hand and the real economy on the other accelerated and has only recently shown evidence of deceleration.

The financial crisis quickly became an economic problem and then a crisis. Asset price declines (equities globally lost $25-30 trillion or more in a four month period) and very tight credit caused investors and consumers to become extremely cautious, causing consumption to fall and the real economy to turn downward. There was no near-term bottom and few brakes to slow the downward momentum.

A complete credit lock-up (and a depression-like scenario in which businesses that rely on credit simply fail) was averted through rapid action by central banks using a growing variety of programs to increase liquidity or directly supply credit, thereby circumventing the normal channels that were damaged and not functioning. The balance sheet of the Fed more than doubled in size from less than a trillion to more than two trillion and with recent commitments is on its way to 3 trillion dollars.

There were two further issues of central importance. First, the markets in a variety of securitized assets stopped functioning. The shadow banking system through which a substantial portion of credit is provided in the US, froze up. Second, because of a combination of leverage and damaged assets, there was and is a potentially large solvency problem in a significant number of large and systemically important institutions. The solvency and related transparency issues continue to be with us today.

The effects on the developing world were immediately felt, though the awareness of the magnitude increased over time. The two important channels were aggregate demand (globally), and the availability and cost of credit and financing. A third channel, rapid shifts in relative prices apart from credit spreads, were important but on balance beneficial.

The financial channel was dramatic. Credit tightened pretty much instantly in the developing world as capital either rushed back to the advanced countries or stopped flowing out, to deal with damaged balance sheets and capital adequacy problems in the advanced countries. The currencies of all major developing countries except for China depreciated against the dollar. Developing countries with reserves used them to stabilize the net capital flows and to partially restore credit and financing. Trade financing dried up and other capital flows diminished or disappeared. The IMF intervened in several cases while financing and bilateral swap arrangements of a variety of kinds were made by the US and China. Credit remains tight and high priced and there is a continuing need for additional financing on a broad front. The IMF did not have the resources in the fall of 2008. Expanding those resources significantly was part of the G20 agenda. At the G20 summit in early April, an important commitment was made to expand IMF resources by over $1 trillion to restore the availability of trade and other forms of finance on an interim basis to developing countries that need it.

The second channel was aggregate demand and trade. As aggregate demand in the advanced countries dropped for the aforementioned reasons, global aggregate demand fell and with it trade: exports and imports. The trade data show a stunning drop in exports, considerably more than in aggregate demand. In many developing countries that rely on external demand and exports as an engine of growth, the immediate negative effect was lower growth, reduced employment and reduced consumption triggering the usual domestic recessionary dynamics.

Globally, the intent is to counter this loss of aggregate demand with coordinated fiscal stimulus programs in the advanced countries and in developing countries to the extent it can be done without jeopardizing fiscal sustainability. The latter capacity varies considerably across countries. There is dissension in the G20 as to what the right order of magnitude is. There are also issues of free riding and protectionism. It is understandable that citizens in various countries facing fiscal deficits and large future debt service obligations prefer to have the benefits of a stimulus program land domestically.

I have described this incentive structure elsewhere as akin to a prisoner’s dilemma with the non-cooperative dominant strategies being either stimulus with some protectionism or free-riding depending on the size and openness of the economy. One can think of that portion of the G20 effort, the part devoted to openness, as attempting to shift policies away from the non-cooperative Nash equilibrium. Evidently, from data on increases in protectionist measures, this will be only partially successful, but partial success is probably much better than no effort at all. Realistically we may not have the option of choosing the first best, coordinated stimulus with openness, but rather have to be satisfied with an effort at coordinated stimulus with some protectionism, as opposed to openness with feeble stimulus commitments.

More generally there is confusion and disagreement about the role of government in the context of a crisis. I have written at somewhat great length about this issue here [1]. This disagreement complicates the politics of timely and effective intervention and has to be factored into the risk assessments for policy makers and private investors and consumers alike. One thing is clear. Government has become a major player in the financial system and the economy. In the financial system it has morphed from regulator to regulator and participant. Predictability of government action has therefore become a major determinant of risk.

The third channel was relative price changes. The dramatic spike in commodity prices (especially food and energy) was reversed. This ameliorated a twin challenge in most developing countries of dealing with the impact of the commodity price spike on the poor and on inflation. Beyond that, at the country level, those who have gained and lost depends on whether a particular country is a net importer or exporter of commodities.

The commodity price spike and fall brought into focus an important policy issue. Large relative price swings have very important distributional consequences across countries and across subsets of the population within countries. These need to be addressed as part of creating a better managed and more stable global economic system that people will support. [for further reference, see part IV of the Commission on Growth and Development: The Growth Report [2]].

Where Are We Now?

On the real economy side, in the advanced countries and globally, growth has gone negative or slowed dramatically. Global growth is projected to be negative in 2009 for the first time since World War II. Trade has collapsed. While there are some signs that the downward momentum may be slowing, the real economies have not bottomed out and are unlikely to do so in 2009 and perhaps well into 2010.

The advanced countries financial systems have shown some recent signs of improvement, though they are still functioning on life support. There are signs that credit is easing and risk spreads are declining somewhat from very high levels. But that is certainly because the government and central banks have a major and expanding role in the financial system. It is too early to say that the system is starting to return to normal. In the US, the Fed and the Treasury have launched a series of initiatives designed to restart the markets in securitized assets, clarify values, remove the transparency fog surrounding the balance sheets of major financial institutions, and as necessary recapitalize banks and other systemically important institutions, probably by becoming a major (or the sole) owner of some of them. Progress on this front from a policy point of view is relatively recent and it is too early to tell the extent to which they will be sufficient to jump start the sequential healing process and a return to normal functioning.

The US savings rate is rising, a part of the disorderly unwinding of global imbalances. Asset prices remain volatile and it is too early to tell if they have stabilized. It is clear however, that the financial system and the real economy will not return to their previous configurations. Even absent major and likely changes in regulation and oversight, there will be a “new normal”. Global growth in the future will be driven by a different portfolio of saving and investment rates and levels across countries.

The Growth Commission Workshop Meeting And Supplementary Report On The Financial And Economic Crisis

The Commission on Growth and Development is meeting one more time in late April in conjunction with a two day workshop, to consider issues related to the financial and economic crisis and its aftermath. The intent is to produce a special report, additional to the Commission report [3] which came out in May 2008. This special report will likely deal with three broad sets of issues.

One set has to do with post-crisis, the challenge of creating more effective regulatory and oversight structures (domestically and internationally) that reduce the risk of instability and the likelihood that the instability spreads quickly to the entire global system. A second set of issues has to do with crisis response. Are there ways when instability and malfunction occur, to limit the damage and disrupt the transmission channels? Further, can some of this capability be created in advance so that it can be deployed quickly? There is obviously a third issue: are the conditions needed to bring the patient back to health and prosperity being met? And if not, what else do we need to do?

The Commission anticipates that there will be a process overseen by the G20 designed to develop proposals for a different global financial architecture, regulatory and oversight structure. Our intention is to have the augmented Commission report contribute to that process with particular attention to the needs and interests of developing countries, some of whom are represented in the G20 itself and most of whom are not.

As we approach the workshop and the Commission meeting and discussion of these issues, we invite broader comment, input and discussion on the BLOG.

Like many members of the Commission and participants in the workshop, I have been thinking and writing about the financial and economic crisis under the headings of causes, crisis dynamics and policy responses, and post crisis reform. A link to my articles will be published on this blog, and I look forward to your comments."

fix a system that broke when our animal spirits got out of bounds.

TO BE NOTED: From Bloomberg:

"Depression Lurks Unless There’s More Stimulus: Robert Shiller

Share | Email | Print | A A A

Commentary by Robert Shiller

April 15 (Bloomberg) -- In the Great Depression of the 1930s the U.S. government had a great deal of trouble maintaining its commitment to economic stimulus. “Pump- priming” was talked about and tried, but not consistently. The Depression could have been mostly prevented, but wasn’t. Ultimately, the reason for this policy failure was inadequate understanding of the relevant economic theory.

In the face of a similar Depression-era psychology today, we are in need of massive pump-priming again. We appear to be in a much better situation due to the stronger efforts to date. Still, there is a danger that, because of a combination of faulty economic theory and inadequate appreciation of human psychology, as well as deep public anger, we will not continue with such stimulus on a high enough level.

We desperately need to be persistent, keeping our government response adequate for the problem at hand on a sufficient scale and for sufficient time.

George Akerlof and I lay out how economic theory needs to be changed in “Animal Spirits: How Human Psychology Drives the Economy, and Why It Matters for Global Capitalism” (2009). It shows that the most basic questions can only be answered if we take into account how psychology affects fundamentals such as our sense of fairness or corruption in our economic transactions, which helps determine how trusting or wary we are at any given time.

Following John Maynard Keynes, we call such motivations animal spirits.

Confidence is Key

Our theory of animal spirits is centered on confidence, and the vicious downward cycle of loss of confidence leading to decline in economic activity and then to more loss of confidence. This cycle is fed by the proliferation of stories of failure that spread like a virus by word of mouth over months and years. Moreover, our theory emphasizes that the sense that our society is basically fair can become wounded, and if that happens will not heal for many years.

In our analysis of the current economic crisis, we conclude that the government should have two targets. One would be a joint fiscal-monetary policy target. The same kind of expansionary policies embodied in the government expenditure stimulus and tax cuts that are already being tried have to be done on a big enough scale and for a long enough time in the future.

Gauging Success

Following this target, aggregate demand should be sufficiently high that firms producing good products at a price the public would want to pay will be able to sell them. And if this target is met, skilled labor willing to work at a wage that makes it profitable to sell such products will be able to get a job.

The government should also have a credit target. Once again, we are calling for more of the same kinds of existing policies, but there should be an explicit measure of their success, and until that is reached, the scale and time frame of such policies need to be extended.

The Federal Reserve has to be the lender of last resort and to provide credit in circumstances like we have today. Businesses and consumers, who in normal times would be good credit risks with legitimate needs, should find credit available at reasonable terms. Achieving this requires new approaches, like those announced by the Bernanke Fed and the Obama administration, but on a continuing and even larger scale.

Outrage Creates Dangers

But we have lived for years in a system that tolerated the high-flying inequalities of the current financial system to play itself out, without protest. Where was the outcry then? Why should it not be much more generally targeted? We had two large tax cuts at the federal level that gave highly disproportionate tax advantages to those at the very top. It even gave special provision for extremely low tax rates, much lower than you or I pay on our regular wage income, to managers of hedge funds.

In this crisis, acceptance of these measures is being replaced with outrage. It is increasing the blood pressure of the public, and that can’t continue without damage to our system. Compensation practices in the U.S. need to be made fairer. Vast earnings shouldn’t go virtually untaxed, while the middle class is paying a sizable fraction of each extra dollar in taxes. Only then will the government have the mandate to restore our banking and securities institutions to their proper strong role in our economy.

Shutting Hoovervilles

It is now time to stimulate demand. It is also time to repair the credit system. Those are the two targets that must be hit to get us out of the current economic slump, and to restore confidence. It will be costly to meet both of these targets, and it will require new legislation to give enhanced regulatory powers to deal with a greatly changed financial system, now in a systemic slump.

It is time to face up to what needs to be done. The sticker shock involved will be large, but the costs in terms of lost output of not meeting either the credit target or the aggregate demand target will be yet larger.

It would be a shame if we are so overwhelmed by anger at the unfairness of it all that we do not take the positive measures needed to restore us to full employment. That would not just be unfair to the U.S. taxpayer. That would be unfair to those who are living in Hoovervilles in Sacramento and Fresno, California, and elsewhere; it would be unfair to those who are being evicted from their homes, and can’t find new ones because they can’t find jobs. That would be unfair to those who have to drop out of school because they, or their parents, can’t find jobs.

It is now time to keep our eye on the ball and set clear targets to fix a system that broke when our animal spirits got out of bounds.

(Robert Shiller is the Arthur M. Okun Professor of Economics and Professor of Finance at Yale University, and Chief Economist at MacroMarkets LLC. The opinions expressed are his own.)

To contact the writer of this column: Robert.shiller@yale.edu"

We just aren't that good (as if that needed saying).

From Worthwhile Canadian Initiative:

"Might fiscal policy fail to increase aggregate demand?

Yes, it might fail.

Economists ought not be confident enough in our knowledge of how the economy works to say they are certain that a temporary increase in government spending will definitely increase aggregate demand. We just aren't that good (as if that needed saying).

Here is one reason why it might fail. I think it is the least implausible reason why fiscal policy might fail.

A temporary increase in government spending, financed by borrowing, will increase the future level of the government debt, and increase expected future taxes.

Taxes are typically not lump-sum. Most taxes depend on income; the more income you earn, the more tax you pay. Much of our income comes from investment, in physical and human capital. Higher expected future tax rates will reduce the expected future return to current investment, and will reduce current demand for investment.

(This effect on investment is in addition to any effect that future taxes might have on permanent disposable income and current consumption, which by itself should not fully offset the increased government spending.)

The magnitude of this effect is an empirical question. It depends on the elasticity of investment with respect to future returns, and on the exact nature of the future tax increases that people expect. If investment demand were elastic enough, and the expected future taxes distorting enough, it would be possible for a temporary increase in government spending to cause investment to fall by more than government spending increased, so that aggregate demand would fall. An increase in government spending would cause the IS curve to shift left.

I do not know the answer to that empirical question. Nor does anyone else know the answer to that question with certainty. We can only rely on past experience, hope that we have interpreted past experience correctly, and hope that the lessons of the past apply to the present.

This might or might not be what William Poole was talking about. It is more likely that he was talking about something like this than talking about a vertical LM curve. He did mention higher future taxes and tax incentives for investment; he did not mention interest rates.

I draw three lessons:

1. We need to be careful how we interpret people; especially those with whom we disagree. We might learn more if we apply the Principle of Charity.

2. Our preferred policies might fail for reasons we might not have thought of. Critics might think of something we haven't thought of. "Who could have known?" has been heard too often recently.

3. It would be prudent to try to design fiscal policies to minimise the chances that they might fail for all reasons, just in case the critics are partly right. For example, government spending on investments that increase future income would be especially desirable in the light of this critique, because they would be less likely to require future increases in tax rates.

Posted by Nick Rowe on March 02, 2009 "

Me:

Nick,

Doesn't Buiter's proposal work without borrowing?

Leigh and Nick,

Is Ricardian Equivalence a tautology, akin to "Robbing Peter to pay Paul"? If you take, it must be from someone, etc. After all, it sounds as if no one has empirical evidence for this view one way or the other. I can see that it would have some theoretical use, since it focuses on the correlation of a few terms, but it seems dubious empirically. In fact, I'm not sure that it can be shown empirically at all, since it assumes a certain view of human behavior in order to be valid. If that view of human behavior is invalid, then, at best, this is a tautology, or simply, a model construct, useful heuristically, if not empirically. I go on like this when anyone mentions Moore and Wittgenstein. Please excuse me.

Posted by: Don the libertarian Democrat |

And:

"OK. Let's see if I can answer all this at once.

In very simple Keynesian models, a $100 increase in Government spending will cause aggregate demand to rise by more than $100. For example, if an extra $1 of income causes private demand to rise by %0.50 (a marginal propensity to spend of 0.5), then a $100 increase in G will cause AD to rise by $200. Hence the name "multiplier", because the ultimate effects are a "multiple" of the original increase. In this example the multiplier is 2.

But language changed over time, and we began to use the word "multiplier" as a sorthand for "the derivative of AD with respect to G". So we could talk about a multiplier of 2, as in the above example, but we could also talk about a multiplier of 1 (if a $100 increase in G caused AD to rise by the same $100), or even (oxymoronically, but that never stopped economists) a multiplier of 0.5 (if a $100 increase in G caused private spending to fall, so the ultimate effect on AD was a rise of only $50).

And sometimes we define multiplier as the effect not on AD, but on real income, Y. (Whether an increase in AD causes an equal increase in Y depends on the slope of the Aggregate Supply curve).

Strict Ricardian Equivalence says that an increase in G financed by bonds is equivalent to an increase in G financed by current taxes. A logical corollary is that a cut in taxes financed by bonds will have zero effect.

Ricardian Equivalence thus says that the tax cut multipler is zero. And that the (bond-financed) government expenditure multiplier is equal to the "balanced budget" (tax-financed) government expenditure multipliers. In very simple Keynesian models, the balanced budget multiplier is 1. So if we add Ricardian Equivalence to a very simple Keynesian model we get a bond-financed government expenditure multiplier of 1 as well. In more complicated keynesian models (add imports, or an effect of income on interest rates) and the multiplier gets smaller still, but still positive for an increase in government expenditure, even under Ricardian Equivalence.

Ricardian Equivalence is not a tautology. It is almost certainly false (or at least, not exactly true). We can think of good theoretical reasons why it will not be exactly true. It is very hard to test Ricardian Equivalence in isolation. We can only test it in combination with other hypotheses.

I am not up to date with empirical tests of Ricardian Equivalence. I can remember one test by Greg Mankiw, many years ago, where he tested the combined hypothesis of permanent income theory+rational expectations against the current income theory. (Ricardian Equivalence assumes permanent income+rational expectations, while the simplest Kenyesian model assumes the current income theory of consumption.) He found that the facts seemed to be roughly halfway between the two theories. That seemed plausible to me, and even though it was not a direct test of Ricardian Equivalence, I tend to think of Ricardian Equivalence as being about half true, unless someone convinces me otherwise.

I think of it this way: "Ricardian effect" will tend to reduce the size of multipliers, but only full Ricardian Equivalence can reduce a multiplier to zero, and then only the tax-cut multiplier, not the government spending multiplier.

The theory I sketched above, of a negative multiplier, is very different from Ricardian Equivalence (though Ricardian Equivalence would make it easier for my effects to get a negative multiplier). Ricardian Equivalence is about the effect of future levels of taxation on permanent disposable income and hence on current consumption. I am talking about the effect of future marginal tax rates (not the same as tax revenue) on current investment. Ricardian Equivalence is about wealth effects on consumption. I am talking about incentive effects on investment.

Leigh: if you take a standard simple Keynesian model, you will never get the result that increases in G are self-financing. Or rather, you would only get it with a mpc>1, which makes the equilibrium unstable, if it exists.

But it is possible to take a fairly standard ISLM, plus liquidity trap, plus Phillips Curve, plus adaptive expectations, plus a Taylor-rule type monetary policy, and get a temporary increase in G to be self-financing. I sketched it in a post a month or two back. (Damn, but I can't remember the post title). The trick is that the above model has two equilibria, each locally stable. And you can use a temporary increase in G to jump you from the low equilibrium to the high equilibrium. But nobody paid any attention to my radically exciting post, boo hoo!

May respond to other points later.

Posted by: Nick Rowe | March 02, 2009 at 12:39 PM"

And:

"Don:
"Doesn't Buiter's proposal work without borrowing?"

You mean helicopter money? Yes, it works without borrowing. Just print money and give it to people as a transfer, or tax cut.

OK, the government "borrows" the money from the central bank, and gives it bonds in return. But since the government owns the central bank, it's a wash.

The tricky thing is: what if you print a lot of money now, to get the ball rolling, but once it does start rolling you need to reduce the quantity of money, because you realise you've overdone it, and it's starting to cause hyperinflation? The the Central bank needs to buy it back, by selling the bonds it got from the government. And now the government's debt really does go up.

That's what Buiter of the blog, as opposed to Buiter of that paper, was so concerned about.

Posted by: Nick Rowe | March 02, 2009 at 01:30 PM"

Me:

I know I'm alone in this, but I think that's a more solvable problem than Debt-Deflation, which is a kind of economic vertigo. But if Buiter doesn't even recommend it, I guess it won't be going anywhere.

Since I'm for:
1) Buiter's QE
2) The Swedish Plan
3) Narrow Banking
4) A sales tax cut as stimulus
I'm not doing very well in this crisis.

Posted by: Don the libertarian Democrat | March 02, 2009 at 05:06 PM

"but the critics never mention the reason for the low rates nor their benefits."

Bob McTeer takes the blame for turning the water on in the Spigot Theory, which I don't credit:

"When recession becomes an issue, as it now is, the remedy involves increasing total spending, or aggregate demand, to match the capacity of the economy to produce goods and services at full employment( TRUE ).

One way to view aggregate demand is by its spending components such as consumption, investment, and government spending. This "Keynesian approach facilitates a focus on fiscal policy( TRUE ).

An equally valid approach that highlights monetary policy is to treat aggregate demand as the money supply (M) times its velocity (V). MV gives you the same spending totals as above( YES ).

A third approach, rarely used, is productivity (output per hour worked) times the number of hours worked. That too gives the same result. It's like describing the same thing in different languages.( OK )

Productivity growth came into prominence in the late 1990s because its acceleration had very positive results. It enabled employers to give pay increases without increasing their unit labor costs. That permitted an easier monetary policy with less worry about inflation. We had faster growth with falling inflation( YES ).

Remarkably, faster productivity growth continued as we climbed out of the recession in 2002. That was a mixed blessing since business expanded with little or no expansion in employment. Rising output coinciding with rising unemployment led to the term "jobless recovery."( YES. THAT'S SOMETIMES AN ODDITY OF AN INCREASE IN PRODUCTIVITY )

While rising productivity was increasing our standard of living, it also depressed employment growth, which is probably not a desirable tradeoff when the economy is weak( I AGREE ). Rising employment spreads the benefits of growth more widely( YES ).

As 2002 progressed, the recovery sputtered and a double dip recession threatened. Falling inflation threatened to morph into actual deflation. Fear of deflation, was the main reason the Greenspan Fed allowed the Federal funds rate to go so low, eventually reaching one percent. Alan Greenspan is routinely blamed for those low interest rates fueling the housing boom, but the critics never mention the reason for the low rates nor their benefits( TRUE. SAME PLAN AS THIS TIME ).

Whether the policy was justified or not, I left my fingerprints at the scene. At the September 2002 FOMC meeting, I dissented, along with Governor Ned Gramlich, in favor of reducing rates. We didn't prevail at that meeting, but the vote to ease was unanimous at the next meeting, on November 6.

I wrote the following rational for the minutes, which are now public:

Messrs. Gramlich and McTeer dissented because they preferred to ease monetary policy at this meeting. The economic expansion, which resumed almost a year ago, had recently lost momentum, and job growth had been minimal over the past year. With inflation already low and likely to decline further in the face of economic slack and rapid productivity growth, the potential cost of additional stimulus seemed low compared with the risk of further weakness.

So, you see, it wasn't Chairman Greenspan's fault. It was mine."

I would have voted with McTeer. But, as I say, I don't hold Low Interest Rates as the cause of our crisis. My main complaint against Greenspan is not recognizing problems and voicing concerns about them. He was too much of a cheerleader for some dubious views about current Political Economy.

"Deflation: Making Sure "It" Doesn't Happen Here ": So I Don't Have To Think About It

Ben Bernake gave a speech in 2002 about Deflation that I'd like to scan:

"Since World War II, inflation--the apparently inexorable rise in the prices of goods and services--has been the bane of central bankers. Economists of various stripes have argued that inflation is the inevitable result of (pick your favorite) the abandonment of metallic monetary standards, a lack of fiscal discipline, shocks to the price of oil and other commodities, struggles over the distribution of income, excessive money creation, self-confirming inflation expectations, an "inflation bias" in the policies of central banks, and still others. Despite widespread "inflation pessimism," however, during the 1980s and 1990s most industrial-country central banks were able to cage, if not entirely tame, the inflation dragon. Although a number of factors converged to make this happy outcome possible, an essential element was the heightened understanding by central bankers and, equally as important, by political leaders and the public at large of the very high costs of allowing the economy to stray too far from price stability. "

I agree with this. A small amount of inflation bias might well be beneficial, for reasons to do with Human Agency and the perception of prices and goods.

"With inflation rates now quite low in the United States, however, some have expressed concern that we may soon face a new problem--the danger of deflation, or falling prices. That this concern is not purely hypothetical is brought home to us whenever we read newspaper reports about Japan, where what seems to be a relatively moderate deflation--a decline in consumer prices of about 1 percent per year--has been associated with years of painfully slow growth, rising joblessness, and apparently intractable financial problems in the banking and corporate sectors. While it is difficult to sort out cause from effect, the consensus view is that deflation has been an important negative factor in the Japanese slump. "

In Japan, Deflation, a drop in Consumer Prices of about 1% per year, caused, or is associated with:
1) Slow Growth
2) A rise in unemployment
3) Insoluble problems in the financial world

"So, is deflation a threat to the economic health of the United States? Not to leave you in suspense, I believe that the chance of significant deflation in the United States in the foreseeable future is extremely small, for two principal reasons."

They are:
1) "The first is the resilience and structural stability of the U.S. economy itself."

See, this one's a little dodgy.

"Over the years, the U.S. economy has shown a remarkable ability to absorb shocks of all kinds, to recover, and to continue to grow."

Let's hope this ability continues to be operative.

"Flexible and efficient markets for labor and capital, an entrepreneurial tradition, and a general willingness to tolerate and even embrace technological and economic change all contribute to this resiliency."

How about a strong stomach?

"A particularly important protective factor in the current environment is the strength of our financial system: Despite the adverse shocks of the past year, our banking system remains healthy and well-regulated, and firm and household balance sheets are for the most part in good shape."

Here's a good reason not to have a blog. Every idiotic thing I say is recorded.

"Also helpful is that inflation has recently been not only low but quite stable, with one result being that inflation expectations seem well anchored. For example, according to the University of Michigan survey that underlies the index of consumer sentiment, the median expected rate of inflation during the next five to ten years among those interviewed was 2.9 percent in October 2002, as compared with 2.7 percent a year earlier and 3.0 percent two years earlier--a stable record indeed. "

A lot of people blame our current situation on such low rates and the somnolent effect of the formerly great moderation.

2) "The second bulwark against deflation in the United States, and the one that will be the focus of my remarks today, is the Federal Reserve System itself."

Bulwark? The Fed's more like a turret disgorging its ammunition as it rotates around like a spinning top.

"The Congress has given the Fed the responsibility of preserving price stability (among other objectives), which most definitely implies avoiding deflation as well as inflation. I am confident that the Fed would take whatever means necessary to prevent significant deflation in the United States and, moreover, that the U.S. central bank, in cooperation with other parts of the government as needed, has sufficient policy instruments to ensure that any deflation that might occur would be both mild and brief."

Would the Congress would take it back? I was also confident in 2002 that the Red Sox would never win the World Series again.

"Of course, we must take care lest confidence become over-confidence."

We can definitely rest easy here.

"Deflationary episodes are rare, and generalization about them is difficult."

That didn't stop us from predicting a housing bubble wouldn't burst.

"Indeed, a recent Federal Reserve study of the Japanese experience concluded that the deflation there was almost entirely unexpected, by both foreign and Japanese observers alike (Ahearne et al., 2002). So, having said that deflation in the United States is highly unlikely, I would be imprudent to rule out the possibility altogether."

Right now, I can't rule out that Don will be running the Fed soon.

"Accordingly, I want to turn to a further exploration of the causes of deflation, its economic effects, and the policy instruments that can be deployed against it. Before going further I should say that my comments today reflect my own views only and are not necessarily those of my colleagues on the Board of Governors or the Federal Open Market Committee. "

I think that they would have rather you said that earlier.

"Deflation: Its Causes and Effects
Deflation is defined as a general decline in prices, with emphasis on the word "general."

Lot's of prices of things need to decline.

"At any given time, especially in a low-inflation economy like that of our recent experience, prices of some goods and services will be falling. Price declines in a specific sector may occur because productivity is rising and costs are falling more quickly in that sector than elsewhere or because the demand for the output of that sector is weak relative to the demand for other goods and services. Sector-specific price declines, uncomfortable as they may be for producers in that sector, are generally not a problem for the economy as a whole and do not constitute deflation. Deflation per se occurs only when price declines are so widespread that broad-based indexes of prices, such as the consumer price index, register ongoing declines."

Same thing.

"The sources of deflation are not a mystery."

Otherwise, I'd have damned little to say about it.

"Deflation is in almost all cases a side effect of a collapse of aggregate demand--a drop in spending so severe that producers must cut prices on an ongoing basis in order to find buyers."

People stop buying things, so businesses try and cut prices to induce them to buy.

"Likewise, the economic effects of a deflationary episode, for the most part, are similar to those of any other sharp decline in aggregate spending--namely, recession, rising unemployment, and financial stress. "

Deflation causes or is associated with:
1) Recession
2) Rising Unemployment
3) Financial stress

This list is remarkably similar to the earlier one.

"However, a deflationary recession may differ in one respect from "normal" recessions in which the inflation rate is at least modestly positive: Deflation of sufficient magnitude may result in the nominal interest rate declining to zero or very close to zero.² Once the nominal interest rate is at zero, no further downward adjustment in the rate can occur, since lenders generally will not accept a negative nominal interest rate when it is possible instead to hold cash. At this point, the nominal interest rate is said to have hit the "zero bound."

Let me try and understand this. It's pretty profound. If I get a negative interest rate, I'll get less money back than I put in or I'll pay a fee. Given that, I'd rather hold on to my cash, because, at least, it's not going down.

"Deflation great enough to bring the nominal interest rate close to zero poses special problems for the economy and for policy."

It's seems like it will be hard to get people to buy your wonderful negative interest bonds.

"First, when the nominal interest rate has been reduced to zero, the real interest rate paid by borrowers equals the expected rate of deflation, however large that may be.³ To take what might seem like an extreme example (though in fact it occurred in the United States in the early 1930s), suppose that deflation is proceeding at a clip of 10 percent per year. Then someone who borrows for a year at a nominal interest rate of zero actually faces a 10 percent real cost of funds, as the loan must be repaid in dollars whose purchasing power is 10 percent greater than that of the dollars borrowed originally. In a period of sufficiently severe deflation, the real cost of borrowing becomes prohibitive. Capital investment, purchases of new homes, and other types of spending decline accordingly, worsening the economic downturn."

I think that this is the same thing I said earlier. This time it says that you'll pay back your loan in dollars that are worth less, so you'll have to pay back, essentially, more money than you loaned.

"Although deflation and the zero bound on nominal interest rates create a significant problem for those seeking to borrow, they impose an even greater burden on households and firms that had accumulated substantial debt before the onset of the deflation. This burden arises because, even if debtors are able to refinance their existing obligations at low nominal interest rates, with prices falling they must still repay the principal in dollars of increasing (perhaps rapidly increasing) real value."

Actually, this is simply the same point as above , only worse, since deflation essentially starting doing its little dance on you earlier.

"When William Jennings Bryan made his famous "cross of gold" speech in his 1896 presidential campaign, he was speaking on behalf of heavily mortgaged farmers whose debt burdens were growing ever larger in real terms, the result of a sustained deflation that followed America's post-Civil-War return to the gold standard.⁴ The financial distress of debtors can, in turn, increase the fragility of the nation's financial system--for example, by leading to a rapid increase in the share of bank loans that are delinquent or in default. Japan in recent years has certainly faced the problem of "debt-deflation"--the deflation-induced, ever-increasing real value of debts. Closer to home, massive financial problems, including defaults, bankruptcies, and bank failures, were endemic in America's worst encounter with deflation, in the years 1930-33--a period in which (as I mentioned) the U.S. price level fell about 10 percent per year. "

A little history lesson, which is always welcome.

"Beyond its adverse effects in financial markets and on borrowers, the zero bound on the nominal interest rate raises another concern--the limitation that it places on conventional monetary policy."

Quite frankly, it's hard to see how you can have one.

"Under normal conditions, the Fed and most other central banks implement policy by setting a target for a short-term interest rate--the overnight federal funds rate in the United States--and enforcing that target by buying and selling securities in open capital markets. When the short-term interest rate hits zero, the central bank can no longer ease policy by lowering its usual interest-rate target.⁵"

We already know why.

"Because central banks conventionally conduct monetary policy by manipulating the short-term nominal interest rate, some observers have concluded that when that key rate stands at or near zero, the central bank has "run out of ammunition"--that is, it no longer has the power to expand aggregate demand and hence economic activity."

I bet that you find my turret analogy more appropriate now, don't you. This is just a clever phrase for the third time we've gone over this problem.

"It is true that once the policy rate has been driven down to zero, a central bank can no longer use its traditional means of stimulating aggregate demand and thus will be operating in less familiar territory. The central bank's inability to use its traditional methods may complicate the policymaking process and introduce uncertainty in the size and timing of the economy's response to policy actions. Hence I agree that the situation is one to be avoided if possible. "

Let's try it for a fourth time. We can't use the "traditional" methods.

"However, a principal message of my talk today is that a central bank whose accustomed policy rate has been forced down to zero has most definitely not run out of ammunition."

Don't worry. I won't be coming down from this turret in the near future.

"As I will discuss, a central bank, either alone or in cooperation with other parts of the government, retains considerable power to expand aggregate demand and economic activity even when its accustomed policy rate is at zero."

We have ways to get people to spend. It involves free liquor.

"In the remainder of my talk, I will first discuss measures for preventing deflation--the preferable option if feasible. I will then turn to policy measures that the Fed and other government authorities can take if prevention efforts fail and deflation appears to be gaining a foothold in the economy. "

I don't like this approach. Get the rough stuff out of the way first.

"Preventing Deflation
As I have already emphasized, deflation is generally the result of low and falling aggregate demand. The basic prescription for preventing deflation is therefore straightforward, at least in principle: Use monetary and fiscal policy as needed to support aggregate spending, in a manner as nearly consistent as possible with full utilization of economic resources and low and stable inflation. In other words, the best way to get out of trouble is not to get into it in the first place. Beyond this commonsense injunction, however, there are several measures that the Fed (or any central bank) can take to reduce the risk of falling into deflation. "

Wait a second. I need to ponder this one a spell. Don't get into a mess, and you won't have to get out. That's it. We can all go home now.

"First, the Fed should try to preserve a buffer zone for the inflation rate, that is, during normal times it should not try to push inflation down all the way to zero.⁶"

Buffer zone? That's just a fancy way of saying don't get into the mess.

"Most central banks seem to understand the need for a buffer zone. For example, central banks with explicit inflation targets almost invariably set their target for inflation above zero, generally between 1 and 3 percent per year. Maintaining an inflation buffer zone reduces the risk that a large, unanticipated drop in aggregate demand will drive the economy far enough into deflationary territory to lower the nominal interest rate to zero. Of course, this benefit of having a buffer zone for inflation must be weighed against the costs associated with allowing a higher inflation rate in normal times. "

You see, a drop from 3 to 1 is a larger drop than from 1 to 0. Do you see?

"Second, the Fed should take most seriously--as of course it does--its responsibility to ensure financial stability in the economy. Irving Fisher (1933) was perhaps the first economist to emphasize the potential connections between violent financial crises, which lead to "fire sales" of assets and falling asset prices, with general declines in aggregate demand and the price level. A healthy, well capitalized banking system and smoothly functioning capital markets are an important line of defense against deflationary shocks. The Fed should and does use its regulatory and supervisory powers to ensure that the financial system will remain resilient if financial conditions change rapidly. And at times of extreme threat to financial stability, the Federal Reserve stands ready to use the discount window and other tools to protect the financial system, as it did during the 1987 stock market crash and the September 11, 2001, terrorist attacks. "

You know, I tried to scan a Fisher paper and I couldn't. Maybe someone can help me. Oh, and don't get into the mess.

"Third, as suggested by a number of studies, when inflation is already low and the fundamentals of the economy suddenly deteriorate, the central bank should act more preemptively and more aggressively than usual in cutting rates (Orphanides and Wieland, 2000; Reifschneider and Williams, 2000; Ahearne et al., 2002). By moving decisively and early, the Fed may be able to prevent the economy from slipping into deflation, with the special problems that entails. "

What happened to the buffer zone? When you go down from 3, always go directly to 1. It's more like a chasm than a buffer zone.

"As I have indicated, I believe that the combination of strong economic fundamentals and policymakers that are attentive to downside as well as upside risks to inflation make significant deflation in the United States in the foreseeable future quite unlikely."

Just because I brought this topic up, don't go home and hoard cash.

"But suppose that, despite all precautions, deflation were to take hold in the U.S. economy and, moreover, that the Fed's policy instrument--the federal funds rate--were to fall to zero. What then?"

I'm afraid you'll be needing a new chairman. My nickname is "Fair Weather Ben". Just kidding.

"In the remainder of my talk I will discuss some possible options for stopping a deflation once it has gotten under way. I should emphasize that my comments on this topic are necessarily speculative, as the modern Federal Reserve has never faced this situation nor has it pre-committed itself formally to any specific course of action should deflation arise. Furthermore, the specific responses the Fed would undertake would presumably depend on a number of factors, including its assessment of the whole range of risks to the economy and any complementary policies being undertaken by other parts of the U.S. government.⁷"

If this occurs, prepare to be dazzled by the gyrations of my policies. I call it "The Kitchen Sink Approach". It's speculative because I've no real idea of what a kitchen sink has to do with trying everything that you can think of.

"Curing Deflation"

Shouldn't we be listening to the NIH or something?

"Let me start with some general observations about monetary policy at the zero bound, sweeping under the rug for the moment some technical and operational issues. "

This is one of those useless models that we were just talking about.

"As I have mentioned, some observers have concluded that when the central bank's policy rate falls to zero--its practical minimum--monetary policy loses its ability to further stimulate aggregate demand and the economy. At a broad conceptual level, and in my view in practice as well, this conclusion is clearly mistaken. Indeed, under a fiat (that is, paper) money system, a government (in practice, the central bank in cooperation with other agencies) should always be able to generate increased nominal spending and inflation, even when the short-term nominal interest rate is at zero. "

I'm glad you're confident.

"The conclusion that deflation is always reversible under a fiat money system follows from basic economic reasoning. A little parable may prove useful:"

What is this? A mashal? Midrash? Once Rabbi Don Of Tacoma noticed that the prices in Tacoma were going down. "This was really the problem in Sedom and 'Amorah ( ' = ayin )", he said.

"Today an ounce of gold sells for $300, more or less. Now suppose that a modern alchemist solves his subject's oldest problem by finding a way to produce unlimited amounts of new gold at essentially no cost. Moreover, his invention is widely publicized and scientifically verified, and he announces his intention to begin massive production of gold within days. What would happen to the price of gold? Presumably, the potentially unlimited supply of cheap gold would cause the market price of gold to plummet. Indeed, if the market for gold is to any degree efficient, the price of gold would collapse immediately after the announcement of the invention, before the alchemist had produced and marketed a single ounce of yellow metal."

I thought Newton believed in alchemy.

"What has this got to do with monetary policy?"

Who knows? Mashals always lead to other mashals.

"Like gold, U.S. dollars have value only to the extent that they are strictly limited in supply. But the U.S. government has a technology, called a printing press (or, today, its electronic equivalent), that allows it to produce as many U.S. dollars as it wishes at essentially no cost. By increasing the number of U.S. dollars in circulation, or even by credibly threatening to do so, the U.S. government can also reduce the value of a dollar in terms of goods and services, which is equivalent to raising the prices in dollars of those goods and services. We conclude that, under a paper-money system, a determined government can always generate higher spending and hence positive inflation. "

We'll print more money and prices will go up. Isn't this alchemy?

"Of course, the U.S. government is not going to print money and distribute it willy-nilly (although as we will see later, there are practical policies that approximate this behavior)"

We spin a wheel, but it has only a few possibilites on it.

"Normally, money is injected into the economy through asset purchases by the Federal Reserve. To stimulate aggregate spending when short-term interest rates have reached zero, the Fed must expand the scale of its asset purchases or, possibly, expand the menu of assets that it buys. Alternatively, the Fed could find other ways of injecting money into the system--for example, by making low-interest-rate loans to banks or cooperating with the fiscal authorities. Each method of adding money to the economy has advantages and drawbacks, both technical and economic. One important concern in practice is that calibrating the economic effects of nonstandard means of injecting money may be difficult, given our relative lack of experience with such policies. Thus, as I have stressed already, prevention of deflation remains preferable to having to cure it. If we do fall into deflation, however, we can take comfort that the logic of the printing press example must assert itself, and sufficient injections of money will ultimately always reverse a deflation. "

The Fed can spend. Isn't this a stimulus? Or we loan at no interest. Or print money. The point is, we have options.

"So what then might the Fed do if its target interest rate, the overnight federal funds rate, fell to zero? One relatively straightforward extension of current procedures would be to try to stimulate spending by lowering rates further out along the Treasury term structure--that is, rates on government bonds of longer maturities.⁹"

Lower interest rates on longer bonds, to induce spending.

"There are at least two ways of bringing down longer-term rates, which are complementary and could be employed separately or in combination. One approach, similar to an action taken in the past couple of years by the Bank of Japan, would be for the Fed to commit to holding the overnight rate at zero for some specified period. Because long-term interest rates represent averages of current and expected future short-term rates, plus a term premium, a commitment to keep short-term rates at zero for some time--if it were credible--would induce a decline in longer-term rates. A more direct method, which I personally prefer, would be for the Fed to begin announcing explicit ceilings for yields on longer-maturity Treasury debt (say, bonds maturing within the next two years). The Fed could enforce these interest-rate ceilings by committing to make unlimited purchases of securities up to two years from maturity at prices consistent with the targeted yields. If this program were successful, not only would yields on medium-term Treasury securities fall, but (because of links operating through expectations of future interest rates) yields on longer-term public and private debt (such as mortgages) would likely fall as well.

As I said, no interest on certain loans. Say that you won't raise interest rates above a certain point.

"Here is Ed Yardeni's very interesting take:

I know what Ben Bernanke will do next, and it should be very bullish for stocks, bonds, commodities, and real estate. He soon will target the 10-year Treasury yield at 2.50%. It was at 3.40% yesterday. That would immediately bring the mortgage rate down to 4%-5%. The inventory of unsold existing and new homes will plunge as homebuyers swarm back into the real estate market. Home prices would stop falling, and might start rising again. The stock market would jump 25% within a few days. By the spring of 2009, housing starts and auto sales will rebound. The worst of the recession will be behind us after the first quarter of next year. "

You know, the only thing that I can see that this does is encourage spending instead of saving, and maybe help businesses and people buying homes with lower rates.

"Lower rates over the maturity spectrum of public and private securities should strengthen aggregate demand in the usual ways and thus help to end deflation. Of course, if operating in relatively short-dated Treasury debt proved insufficient, the Fed could also attempt to cap yields of Treasury securities at still longer maturities, say three to six years. Yet another option would be for the Fed to use its existing authority to operate in the markets for agency debt (for example, mortgage-backed securities issued by Ginnie Mae, the Government National Mortgage Association).'

Same thing. Get people to spend by lowering longer term rates and capping them. I included the Yardeni quote because he seems to see it as a real boost in demand.

"Historical experience tends to support the proposition that a sufficiently determined Fed can peg or cap Treasury bond prices and yields at other than the shortest maturities. The most striking episode of bond-price pegging occurred during the years before the Federal Reserve-Treasury Accord of 1951.¹⁰ Prior to that agreement, which freed the Fed from its responsibility to fix yields on government debt, the Fed maintained a ceiling of 2-1/2 percent on long-term Treasury bonds for nearly a decade. Moreover, it simultaneously established a ceiling on the twelve-month Treasury certificate of between 7/8 percent to 1-1/4 percent and, during the first half of that period, a rate of 3/8 percent on the 90-day Treasury bill. The Fed was able to achieve these low interest rates despite a level of outstanding government debt (relative to GDP) significantly greater than we have today, as well as inflation rates substantially more variable. At times, in order to enforce these low rates, the Fed had actually to purchase the bulk of outstanding 90-day bills. Interestingly, though, the Fed enforced the 2-1/2 percent ceiling on long-term bond yields for nearly a decade without ever holding a substantial share of long-maturity bonds outstanding.¹¹ For example, the Fed held 7.0 percent of outstanding Treasury securities in 1945 and 9.2 percent in 1951 (the year of the Accord), almost entirely in the form of 90-day bills. For comparison, in 2001 the Fed held 9.7 percent of the stock of outstanding Treasury debt. "

He's saying that history shows that lenghtening the bonds that you're lowering and capping works to increase demand. Beats me. I guess it works.

"To repeat, I suspect that operating on rates on longer-term Treasuries would provide sufficient leverage for the Fed to achieve its goals in most plausible scenarios. If lowering yields on longer-dated Treasury securities proved insufficient to restart spending, however, the Fed might next consider attempting to influence directly the yields on privately issued securities."

Okay. Say doing this to government bonds doesn't work. In that case, we'll fiddle with bonds from outside the government.

"Unlike some central banks, and barring changes to current law, the Fed is relatively restricted in its ability to buy private securities directly.¹² However, the Fed does have broad powers to lend to the private sector indirectly via banks, through the discount window.¹³ Therefore a second policy option, complementary to operating in the markets for Treasury and agency debt, would be for the Fed to offer fixed-term loans to banks at low or zero interest, with a wide range of private assets (including, among others, corporate bonds, commercial paper, bank loans, and mortgages) deemed eligible as collateral.¹⁴ For example, the Fed might make 90-day or 180-day zero-interest loans to banks, taking corporate commercial paper of the same maturity as collateral. Pursued aggressively, such a program could significantly reduce liquidity and term premiums on the assets used as collateral. Reductions in these premiums would lower the cost of capital both to banks and the nonbank private sector, over and above the beneficial effect already conferred by lower interest rates on government securities.¹⁵"

Lend money at low interest rates or no interest rate, and get something in return from the banks as collateral. They could then loan money cheaply, lower rates, discourage saving, attract business loans, etc.

"The Fed can inject money into the economy in still other ways. For example, the Fed has the authority to buy foreign government debt, as well as domestic government debt. Potentially, this class of assets offers huge scope for Fed operations, as the quantity of foreign assets eligible for purchase by the Fed is several times the stock of U.S. government debt.¹⁶"

This is like printing money or a stimulus. I'm wondering why the Fed should do this?

"I need to tread carefully here. Because the economy is a complex and interconnected system, Fed purchases of the liabilities of foreign governments have the potential to affect a number of financial markets, including the market for foreign exchange. In the United States, the Department of the Treasury, not the Federal Reserve, is the lead agency for making international economic policy, including policy toward the dollar; and the Secretary of the Treasury has expressed the view that the determination of the value of the U.S. dollar should be left to free market forces. Moreover, since the United States is a large, relatively closed economy, manipulating the exchange value of the dollar would not be a particularly desirable way to fight domestic deflation, particularly given the range of other options available. Thus, I want to be absolutely clear that I am today neither forecasting nor recommending any attempt by U.S. policymakers to target the international value of the dollar. '

Buying the foreign debt might effect the exchange rate, by fiddling with the price of the dollar. Holy cow, I'm dizzy. Calling Willem Buiter or Brad Setser.

"Although a policy of intervening to affect the exchange value of the dollar is nowhere on the horizon today, it's worth noting that there have been times when exchange rate policy has been an effective weapon against deflation. A striking example from U.S. history is Franklin Roosevelt's 40 percent devaluation of the dollar against gold in 1933-34, enforced by a program of gold purchases and domestic money creation. The devaluation and the rapid increase in money supply it permitted ended the U.S. deflation remarkably quickly. Indeed, consumer price inflation in the United States, year on year, went from -10.3 percent in 1932 to -5.1 percent in 1933 to 3.4 percent in 1934.¹⁷ The economy grew strongly, and by the way, 1934 was one of the best years of the century for the stock market. If nothing else, the episode illustrates that monetary actions can have powerful effects on the economy, even when the nominal interest rate is at or near zero, as was the case at the time of Roosevelt's devaluation."

He printed money and devalued the dollar? Anyway, here's my problem. After printing money, all these proposals look like a stimulus plan to increase spending in the economy. Why have the Fed do it? I guess it has to anyway if the stimulus involves deficit spending, but why have unilateral action by the Fed do these things? Why not vote on them?

"Fiscal Policy
Each of the policy options I have discussed so far involves the Fed's acting on its own. In practice, the effectiveness of anti-deflation policy could be significantly enhanced by cooperation between the monetary and fiscal authorities."

Well, I got my answer. He doesn't like it either.

"A broad-based tax cut, for example, accommodated by a program of open-market purchases to alleviate any tendency for interest rates to increase, would almost certainly be an effective stimulant to consumption and hence to prices. Even if households decided not to increase consumption but instead re-balanced their portfolios by using their extra cash to acquire real and financial assets, the resulting increase in asset values would lower the cost of capital and improve the balance sheet positions of potential borrowers. A money-financed tax cut is essentially equivalent to Milton Friedman's famous "helicopter drop" of money.¹⁸"

Again, a stimulus to encourage spending and demand, propping up prices. I have to say, that, if you have to prop up prices into some slight inflationary effect, it does seem to argue that slight inflation is a good thing.

"Of course, in lieu of tax cuts or increases in transfers the government could increase spending on current goods and services or even acquire existing real or financial assets. If the Treasury issued debt to purchase private assets and the Fed then purchased an equal amount of Treasury debt with newly created money, the whole operation would be the economic equivalent of direct open-market operations in private assets. "

With tax cuts you leave the money in people's hands, with spending you give it to them. That's our current debate. I've talked so much about that let's leave it.

How come it didn't work in Japan?

"First, as you know, Japan's economy faces some significant barriers to growth besides deflation, including massive financial problems in the banking and corporate sectors and a large overhang of government debt. Plausibly, private-sector financial problems have muted the effects of the monetary policies that have been tried in Japan, even as the heavy overhang of government debt has made Japanese policymakers more reluctant to use aggressive fiscal policies (for evidence see, for example, Posen, 1998). Fortunately, the U.S. economy does not share these problems, at least not to anything like the same degree, suggesting that anti-deflationary monetary and fiscal policies would be more potent here than they have been in Japan. "

Japan had:
1) Financial problems
2) High Government Debt
Don't we have these now?

"Second, and more important, I believe that, when all is said and done, the failure to end deflation in Japan does not necessarily reflect any technical infeasibility of achieving that goal. Rather, it is a byproduct of a longstanding political debate about how best to address Japan's overall economic problems. As the Japanese certainly realize, both restoring banks and corporations to solvency and implementing significant structural change are necessary for Japan's long-run economic health. But in the short run, comprehensive economic reform will likely impose large costs on many, for example, in the form of unemployment or bankruptcy. As a natural result, politicians, economists, businesspeople, and the general public in Japan have sharply disagreed about competing proposals for reform. In the resulting political deadlock, strong policy actions are discouraged, and cooperation among policymakers is difficult to achieve."

They couldn't implement useful policies because they would adversely hit some people, and politically that was not found acceptable. Same here now? We'll see.

"In short, Japan's deflation problem is real and serious; but, in my view, political constraints, rather than a lack of policy instruments, explain why its deflation has persisted for as long as it has. Thus, I do not view the Japanese experience as evidence against the general conclusion that U.S. policymakers have the tools they need to prevent, and, if necessary, to cure a deflationary recession in the United States. "

It was politics. They knew what to do, but couldn't stomach doing it. Will we?

"Conclusion

Sustained deflation can be highly destructive to a modern economy and should be strongly resisted. Fortunately, for the foreseeable future, the chances of a serious deflation in the United States appear remote indeed, in large part because of our economy's underlying strengths but also because of the determination of the Federal Reserve and other U.S. policymakers to act preemptively against deflationary pressures. Moreover, as I have discussed today, a variety of policy responses are available should deflation appear to be taking hold. Because some of these alternative policy tools are relatively less familiar, they may raise practical problems of implementation and of calibration of their likely economic effects. For this reason, as I have emphasized, prevention of deflation is preferable to cure. Nevertheless, I hope to have persuaded you that the Federal Reserve and other economic policymakers would be far from helpless in the face of deflation, even should the federal funds rate hit its zero bound.^19"

I usually enjoy Bernanke's talks, but this one wore me out. Here's my bottom line: I think I understand the point of printing money. So do that. Print it willy nilly, I don't care. The other proposals have sent me to the Vicodin. Please God, no deflation. It's hideously awful to reason through.