. . . when Congress raises the top (combined federal and state) marginal tax rate to Swedish levels. You guys will have brought this on yourselves. In the early 1930s the forces of reaction controlled the Fed, and they did the bidding of the conservative bond holders on Wall Street. Eventually deflation got so bad that the public revolted and the top income tax rate was raised from 25% to 90%. A new and left-wing President tore up the gold clause in debt contracts. The dollar was devalued. Pro-union legislation was passed. And of course the national debt ballooned.
And now they are doing it again. I have always wondered why the Fed wasn’t more aggressive in this crisis. Everything Bernanke published before he became Fed Chairman suggested that he should have agreed with my position. He wrote that monetary policy can still be effective at the zero bound, that it was important to avoid deflation at all costs, etc. A new column at Free Exchange provides the most plausible explanation that I have yet seen for the strange passivity at the Fed:
Based on baseline forecasts alone, more monetary stimulus is easily justified. Based on the tail risks around that forecast, the case is even stronger; such a large output gap could turn low inflation into pernicious deflation. There are risks of inflation and bubbles on the other side, but as Mr Gagnon notes, these are easily dealt with, either by rapidly tightening monetary policy (in the first case) or aggressive regulatory intervention (in the second).
As befits a Fed alumnus, Mr Gagnon’s work is technically elegant. I don’t doubt that many of his former bosses at the Fed, Mr Bernanke included, agree with his premises; they may even find the specific estimates reasonable. But the barriers to further quantitative easing at the Fed aren’t economic, they’re political. The Fed was taken aback by how critics on Wall Street, in foreign central banks, and in Congress screamed that its modest, $300 billion Treasury purchases were monetising the government deficit and paving the path for future inflation. They have added to the atmosphere of hostility now surrounding the Fed. The Fed has essentially decided to pursue a second-best (i.e. insufficiently aggressive) monetary policy because a first best monetary policy could bring political perdition.
I hate to say it, but I suspect Free Exchange is right.
The post at Free Exchange discusses an excellent new paper by Joseph Gagnon, who used to be at the Fed and was a senior advisor to Ben Bernanke. Gagnon makes a strong argument for additional monetary stimulus at the four key central banks (the Fed, ECB, BOJ, and BOE.) He concludes with this observation about the choice between fiscal and monetary policy:
Altogether then, either monetary or fiscal stimulus would help to attain more satisfactory outcomes for economic activity, employment, and inflation than those envisaged by the main economic forecasts. Monetary stimulus has the added advantage of also reducing net public debt, whereas fiscal stimulus increases net debt. In total, central banks in the four main developed economies should buy an additional $6 trillion in longer-term debt securities, which is expected to reduce 10-year bond yields around 75 basis points.
This is what conservatives just don’t get. The public won’t put up with high unemployment for year after year. If the right doesn’t offer any answers, the public will turn to the left. And that means fiscal stimulus, big deficits, and much higher taxes in the future. Sometimes after I show that inflation expectations over the next few years are quite low, my commenters will point to the fear that big deficits will lead to higher inflation in the long run. Yes, but that’s precisely why we need more monetary stimulus today. Monetary ease will slightly raise inflation over the next few years, which is good, and by reducing the debt/GDP ratio it will also greatly reduces the tail risk of monetizing the debt in the out years, which is also good. Sound macro policy is a win-win. Good things happen when NGDP grows at a low but steady rate.
Milton Friedman understood all this, which is why he argued that Fed policy was too tight in the 1930s, despite the massive increase in the monetary base and the ultra-low interest rates. He understood that his and Anna Schwartz’s account of the Depression was essentially a defense of free markets. Monetary policy should prevent MV from falling, and let free markets do the rest. And that’s why Friedman favored additional monetary stimulus in Japan in the late 1990s, despite low rates and a big increase in the base. Alas, this pragmatic understanding of the role of monetary policy has been almost lost at my beloved University of Chicago.
Mr. Friedman was too good an economist to think that there was any mechanical relationship between changes in the monetary base and changes in the price level. He would have understood how the new program of interest on reserves was a game changer. But those who just vaguely recall hearing about the QTM in their econ classes are not able to draw these subtle distinctions. As Keynes once said:
” . . . the ideas of economists and political philosophers, both when they are right and when they are wrong, are more powerful than is commonly understood. Indeed the world is ruled by little else. Practical men, who believe themselves to be quite exempt from any intellectual influences, are usually the slaves of some defunct economist. Madmen in authority, who hear voices in the air, are distilling their frenzy from some academic scribbler of a few years back. I am sure that the power of vested interests is vastly exaggerated compared with the gradual encroachment of ideas. Not, indeed, immediately, but after a certain interval; for in the field of economic and political philosophy there are not many who are influenced by new theories after they are twenty-five or thirty years of age, so that the ideas which civil servants and politicians and even agitators apply to current events are not likely to be the newest. But, soon or late, it is ideas, not vested interests, which are dangerous for good or evil.”
This simplistic fear that more money means high inflation is a perfect example of Keynes’ observation. The “vested interest” of Wall Street is for a much higher nominal GDP. So they are going against their own interests with their constant harping about the Fed monetizing debts.
Sure there is a relationship between the monetary base and the price level. But lots of other factors matter as well. One complicating factor is the opportunity cost of holding cash (and now reserves, which is even lower.) Another is whether the monetary injection is perceived as temporary or permanent. And as Joseph Gagnon points out in his paper, if aggregate demand starts growing faster than anticipated we have plenty of time to watch the asset markets and adjust policy appropriately. Inflation doesn’t get embedded in the economy until it starts influencing wages.
Gagnon favors an aggressive policy of QE. On pure theoretical grounds I would prefer to target NGDP expectations directly. But let’s face it, that’s not going to happen. So Gagnon’s proposal might be the best we can get given the natural reluctance of conservative organizations to avoid radical policy experiments. And actual QE would almost certainly be less than Gagnon asks for. The Fed would probably bend over backward emphasizing the temporary nature of the injections. As people like Krugman and Woodford have pointed out, those statements undermine the expansionary impact. Nevertheless, even with all these caveats, I believe a bold and unexpected announcement of QE would boost NGDP expectations, and provide a boost to real output as well.
Part 2. Two Cheers for Arnold Kling
When I started reading this Arnold Kling post I was taken aback by the following line:
I mention Scott Sumner a lot on this blog. Why? Because I see him as sticking up for mainstream macroeconomics. I myself have been pushing a non-mainstream idea, sort of a muddle between Leijonhufvud and Hayek that I call the Recalculation Story.
I thought; “What a minute, I’m the contrarian here. I’m the one saying that what looks like a recession caused by real financial and housing problems, is actually a garden variety nominal shock, just like in the textbooks. I’m one of a tiny number that blames the recession on tight money.” But then I read the rest of his post, which ended with this perceptive observation:
I am prepared to offer pushback against the Sumner-Hetzel viewpoint. However, it really deserves the status of the “null hypothesis.” In a more reasonable world, everyone would be starting from the presumption that Sumner and Hetzel are correct. Those of us arguing folk-Minskyism and telling the Recalculation Story should be the ones fighting an uphill battle to bring our ideas into the policy debates. That this is not the case, and that SC [the scholarly consensus] is now on the fringe, is one of the most remarkable stories of this whole macroeconomic episode.
This is exactly what I have been trying to say. It’s like I’ve been trying to grab economists by the lapel and (figuratively) shake them out of their stupor. Your own models say that falling NGDP is a failure of monetary policy!
Earlier I used a (SF Fed President) Janet Yellen quotation for a post title; “We should want to do more.” What does that even mean? Of course you should want to do more! And she said this when unemployment was significantly lower than it is today. OK, if you should want to do more, then why don’t you in fact want to do more? What’s holding you back? Why the strange passivity? Her answer was that the Fed couldn’t do more, rates were already at zero. That attitude should be an immediate disqualifier for being on the FOMC. Like a Supreme Court nominee saying they oppose Brown vs. Board of Education at a Congressional hearing. James Hamilton once said something to the effect of “if they don’t know how to create a bit of inflation, then give me try.”
So at the Fed you have inflation doves who would want to do more but haven’t advanced beyond 1938 Keynesianism, hawks who seem more worried about the possibility that inflation will rise from 1% to 2% then they are about 15 million unemployed, and centrists who are intimidated by criticism of Wall Street. And so here we are.
Why two cheers for Kling? This post was one of the funniest that I have read in a long time. (Also check out Ambrosini.) Kling is great on almost everything. Strangely enough he is only weak when he ventures into my money/macro turf–especially when he disagrees with me. He doesn’t seem autistic enough. But then he probably thinks I’m too autistic.
HT: Bill Woolsey.