Rogoff-Reinhart on Monetary Stimulus

Ken Rogoff and Carmen Reinhart have an excellent new column in the FT:

The recent debate about the global economy has taken a distressingly simplistic turn.

Actually, it’s been simplistic from the beginning.  The real problem in the developed world is tight money.   Or should I say the nominal problem. Here’s more:

One of us [Rogoff] attracted considerable fire for suggesting moderately elevated  inflation (say, 4-6 per cent for a few years) at the outset of the crisis.  However, a once-in-75-year crisis is precisely the time when central banks  should expend some credibility to take the edge off public and private debts,  and to accelerate the process bringing down the real price of housing and real  estate.

Structural reform always has to be part of the mix. In the US, for example, the bipartisan blueprint of the Simpson-Bowles commission had some very  promising ideas for simplifying the tax codes.

A few comments:

Rogoff is right that higher inflation would have been desirable back in 2008-09.  But today wage growth has fallen so low that even 2% inflation would promote a robust recovery.  We don’t need to clobber savers with high inflation.  And we won’t.

Over the past year NGDP growth has been running around 3.5%; 2% real and 1.5% inflation.  Given the slack in the economy, if the Fed bumped that up to 5.5% NGDP growth for 2 years, we’d get around 2% inflation and 3.5% RGDP growth.  At worst it would be 2.5% inflation and 3% RGDP growth.  In either case the unemployment rate would quickly fall back to the natural rate (whatever it is.)

Unfortunately there is very little chance that the Fed will achieve 5.5% NGDP growth.  Some have argued that fiscal austerity is slowing the recovery.  Indeed the Fed has argued that fiscal austerity is slowing the recovery.  And that’s because fiscal austerity is slowing the recovery.  RGDP growth in Q2 will likely be lower than if the sequester had not taken effect.  So why do I keep prattling on about  ”zero fiscal multiplier?”

This is a hard concept to explain, so let me use the analogy of Lucas’s critique of discretionary monetary stimulus.  Lucas argued that discretionary monetary policy was undesirable.  He argued that monetary stimulus was ineffective if anticipated, as it would already be factored into wages and prices.  Then people would ask Lucas why unanticipated stimulus would not work.  He replied that one had to think in terms of systematic policy rules that one could write down on a piece of paper, otherwise there was little hope of producing a welfare-enhancing monetary regime.  Suppose you wrote down “Every time unemployment rises above 7% we’ll do an unexpected monetary stimulus.”   Then it would no longer be unexpected!  In other words, the monetary authority could only surprise the public by doing “wild and crazy” things which people had no reason to expect.  How likely is that to work?

I think wages and prices are stickier than Lucas believes, so I think even systematic monetary policies will have some real effects.  But the logic of his argument applies pretty well to the monetary offset issue.  The claim today seems to be “fiscal stimulus can work if it catches the Fed off guard, as with the April 2013 sequester.” Yes, but now think about this game from a “timeless perspective,” (not a 2013:2 perspective) where you don’t know the starting point.  Over time, there will be equal number of cases where fiscal stimulus is greater than expected, and less than expected. Thus on average fiscal stimulus will have no effect.  Since 2009 there have certainly been some quarters of greater than expected stimulus and some quarters where it was less than the Fed expected. But it’s absurd to think we can have long run success from fiscal stimulus via a policy of Congress continually fooling the Fed.  It’s hard to imagine a less nimble organization than Congress.

I’ve emphasized that estimates of fiscal multipliers are nothing more than estimates of central bank incompetence.  When the Fed took some aggressive steps late last year, they said that one purpose was to offset fiscal austerity.  They said their actions, combined with the expected results of the fiscal cliff, would lead to 3% to 3.5% RGDP growth.  They will probably fall short, but why?

1. Faulty model; over-estimating expansionary effect of the Evan Rule, or the very low rates, or QE?
2. A worsening global environment?
3. More fiscal austerity than expected?
4. All three?

Who knows? But I’m still not seeing any evidence that RGDP growth will slow by 1.5% as compared to recent years, as the anti-austerians predict.  However I do see evidence of central bank incompetence. So I’ll re-iterate that the zero multiplier is a baseline for starting to think about the problem, or as the average effect over long periods of time, not a precise estimate of the effect of fiscal stimulus in each and every case.

Here’s the question that should be of interest to serious macroeconomists (as opposed to ideologues.) If the fiscal contraction of 2013 had not been expected, what would the Fed have done in late 2012? And what would their forecast for RGDP growth have been?  I’m not certain exactly what the Fed would have done, but I’m pretty sure their forecast for 2013 growth would have been around 3% to 3.5%.  Maybe a tad higher than otherwise, but nothing close to the 1.5% extra RGDP growth predicted by the anti-austerians.