Belka-gate – the Polish version of the Sumner Critique?

A key Market Monetarist insight (it is New Keynesian insight as well…) is that budget multiplier is zero if the central bank says it is so. Or rather it the central bank targets inflation, the price level or nominal GDP then the central and will offset any shock – positive or negative – to nominal spending (aggregate demand) from changes in fiscal policy.

This means that the central bank – rather than the ministry of finance – has the full control of aggregate demand in the economy. No matter what the government does with fiscal policy the central bank has the instruments to fully offset this. This is the so-called Sumner Critique.

A major scandal involving the Polish central bank governor Marek Belka that has developed over the last couple of days is a powerful illustration of the Sumner Critique.

This is from Reuters:

A Polish magazine said on Saturday it had a recording of a private conversation in which the central bank chief told a minister the bank would be willing to help rescue the government from economic troubles on condition the finance minister was removed.

The weekly Wprost news magazine said it had a recording of a meeting in a Warsaw restaurant last July between central bank governor Marek Belka and Interior Minister Bartlomiej Sienkiewicz. It did not say who recorded their conversation, or how it had obtained the recording.

According to extracts of the audio recording posted on the Internet by the magazine, which have been heard by Reuters reporters, and were also emailed to Reuters by Wprost in transcript form, the minister sets out a possible future scenario in which the government could not meet its financial commitments and faced election defeat.

The man identified in the transcript as Sienkiewicz refers in vague terms to monetary policy action carried out elsewhere in Europe – an apparent reference to central bank stimulus.

“Is that precisely the moment for launching this sort of solution, or not?” Sienkiewicz asks Belka.

Belka replies, according to the transcript: “My condition would be the removal of the finance minister.”

The finance minister at the time, Jacek Rostowski, was removed last November as part of a cabinet reshuffle.

There you go. Central bankers have the power to control nominal spending in the economy. They might even have the power to have finance ministers removed. Never ignore the Sumner Critique.

PS the Polish central bank has said that the recordings are authentic, but that they have been manipulated and that Belka’s comments regarding the removal of the Finance Minister were taken out of context.

PPS It has been – and still is – my view that Polish monetary policy has been far too tight since early 2012. Maybe an explanation to the overly tight stance could be – and I am speculating – dissatisfaction with the Polish government’s fiscal stance.

PPPS for game theoretical based discussion of the Sumner Critique see my earlier posts here and here.

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No ‘General Theory’ should ignore the monetary policy rule

John Maynard Keynes famously titled his magnus opus from 1936 The General Theory of Employment, Interest and Money. However, General Theory, as it is generally known, is nothing of the kind. It is not a General Theory of macroeconomics – rather it is a specific theory of macroeconomics making very specific assumptions about the workings of the economy and I will argue here that Keynes made very specific assumptions particularly about the monetary policy regime or rule under which the economy operates.

Keynes most likely realised that he had made these assumptions, but later generations of Keynesians – particular from the 1950s to the early 1990s “forgot” that General Theory and the general macroeconomic of implications of it was fully dependent on the fundamental assumptions in General Theory about the monetary policy regime/rule.

When I took my first macroeconomic lessons at the University of Copenhagen in the early 1990s the first model we where introduced to was a rudimentary Keynesian model – the so-called 45-degree model or the Keynesian cross. It was basically said that the model was what Keynes was thinking about in General Theory and I would still agree that this simple model basically captures what Keynes was saying in General Theory about aggregate demand.

When I was taught this rudimentary Keynesian economics we were told that Keynes assumed that prices are sticky and this was what really was the difference between Keynes and the so-called Classics (economists before the Keynesian revolution). We today know that Keynes’ claim the “Classics” (Keynes’ term) did in fact not assume that prices and wages are fully flexible, but this is less important for what I want to discuss here. However, the focus on whether prices are sticky or not took away focus from what in my view is a core assumption Keynes makes and, which economists today continue to make and that is that the economy is essentially operating on a monetary standard similar to the gold standard or a fixed exchange rate regime.

When I was taught the Keynesian cross we where told that there was no money in the model – or at least that we ignored it. No big deal was made of it and there was no discussion about whether this was important or not. Now more than two decades later I think that economics students around the world generally are introduced to macroeconomics in the exact same way. We start out with the Keynesian cross, but students are not told that this starting point makes a clear – untold – assumption about the monetary policy regime.

Hence, the case it not that there is no money in the rudimentary Keynesian model, but rather that the supply of money (base money) was determined by a gold standard-like rule. However, this was never discussed when I took my first macroeconomic lessons – and I suspect this still is the norm around the world.

What I here will argue is that if Keynes instead had set out to write a truly General Theory, where he would have discussed the importance of different monetary policy rules then it would indeed have been a General Theory rather than a Theory of a Specific Monetary Regime (the gold standard). Rather what Keynes discusses in General Theory is how the macroeconomic situation looks like in a variation of the gold standard. He was in fact formulating a model for the British economy in 1930 or so. In that regard it is also notable that even though Keynes had called the gold standard a barbaric relic he argued against Britain giving up the gold standard and he seemed to continue to think of the British economy (and any other economy in the world) as operating on a gold standard-like monetary regime long after the gold standard had been given up around the world. He was of course instrumental in setting up the post-War Bretton Wood system, which introduced a global system of fixed – but adjustable – exchange rates. Thereby ensuring that his “model” of the economy still could be said to be “right”.

Yes, he was assuming that prices and wages where sticky, but that was not the crucial assumption. The crucial assumption was his assumption about the monetary policy regime.

A rudimentary Keynesian model with NGDP targeting    

We can illustrate this by accepting Keynes’ assumption that prices are not just sticky, but completely fixed (at least in the short-run). We can illustrate that in an AS/AD framework by claiming that that the AS curve is horizontal. This means that no matter what level of aggregate demand (AD) we have in the economy the price level will remain unchanged.

The graph below illustrates this.

Keynesian ASAD

Lets say some “animal spirits” causes investments to collapse (this was essential Keynes’ explanation for the Great Depression). The AD curve shifts to the left causing real GDP to drop to Y’ from Y. As the AS curve is completely flat nothing happens to prices. This is essentially what we have in the rudimentary Keynesian model.

But what have we assumed about monetary policy? Well, we have assumed that the money supply/base is fixed. No matter what happens to the economy the money base is just kept unchanged. This is of course what you (more or less) have under a gold standard.

But what if we had another monetary policy rule – for example a rule to keep nominal GDP (nominal spending) constant. This would mean that the central bank would change the money base to keep P*Y constant. Again lets illustrate this within an AS/AD framework and note that we maintain the assumption of completely fixed prices (a horizontal AS curve).

Keynesian ASAD NGDP rule

Here again the AD initially drops for example because some animal spirits cause aggregate demand to drop (1). However, this would cause nominal GDP (P*Y) to drop and as the central bank operates an NGDP target rule it would automatically increase the money base until the AD curve has been push back to the starting point (2).

So even if we assume completely fixed prices the world looks as if it is “Classic”. We will always be at the “full employment” level of real and nominal GDP.

This also illustrates that it was not enough for Keynes to assume that prices are sticky (not a very heroic assumption for the short-run and most “Classic” economists in fact agreed with that assumption), but he also had to make an assumption that the money base was fixed and all his results breakdown if another assumption about the monetary policy regime is introduced.

This of course also illustrate that Keynes’ famous fiscal multiplier and his argument that fiscal policy can (and should) boost aggregate demand are crucially dependent on assuming a gold standard style monetary policy regime. Hence, the graph above illustrates that even if prices are fixed the fiscal multiplier will be zero under an NGDP targeting regime. This is what we today know as the Sumner Critique.

Obviously it was completely natural to assume that the economy was operating within a gold standard when Keynes wrote the General Theory. However, his insistence on focusing on fiscal policy and ignoring the monetary policy regime for decades caused macroeconomic discourse to be side-tracked. Had he instead argued that his results were crucially dependent on the monetary policy regime then he would truly have written a General Theory and the debate could have been shifted to a discussion about the monetary regime.

Keynes was of course right that the gold standard was barbaric relic, but he failed to understand that the Great Depression was not caused by animal spirits, but was a direct result of this barbaric relic. Instead Keynes argued against Britain giving up the gold standard and instead argued for major public works programs. This is what he tried to justify in his General Theory.

For decades after the publication of General Theory macroeconomists around the world adopted Keynes’ reasoning without realising that Keynes’ core policy recommendations were based on an assumption that we remained on a gold standard. Unfortunately most of today’s macroeconomists continue to ignore the crucial importance of what monetary policy regime we operate under.

The straw men – vertical AS curve and the vertical LM curve   

Going back to my university days again. Following the induction of the rudimentary Keynesian model and the introduction of the famous definition of aggregate demand as Y=G+I+C+X-M we where taught that there of course where other schools of thought.

However, it was never emphasised that we basically all through remained more or less ignorant about the importance of monetary policy rules. Hence, instead the discussion instead focused on two other topics. First, whether prices and wages indeed were fixed/sticky or not. Second what assumptions we should make about the interest rate elasticity of money demand and investments.

This boiled down to two “extreme” assumptions in first the AS/AD model (in a Keynesian variant) and in the IS/LM model. First we where told that if we assumed prices where fully flexible then the AS curve would be vertical and that would mean that fiscal policy (and monetary policy) would never be able to increase real GDP and any fiscal or monetary “stimulus” would just cause inflation to increase. This was called – and still is in most mainstream macroeconomic textbook – the Classical position. This very obviously is a misnomer, which we should blame Keynes for. Hence, most pre-Keynesian “Classical” economists did indeed not assume fully flexible wages and prices. Furthermore, the extreme Keynesian position was exactly unrealistic as everybody can see that real-world prices change all the time. Something which rarely where noted when I took my macroeconomic lessons at the University of Copenhagen in the early 1990s.

It was easy for our professors to dismiss the assumption about fully flexible price. Just look out the window. There are lot of wage contracts and “menu costs” etc., which cause prices to become sticky. Hence, the world was essentially Keynesian. The fiscal multiplier was of course positive – or that is how the argument when. It was enough to show to prices are not fully flexible to argue that we where in a Keynesian world.

When discussing the IS/LM model we again were introduced to an extreme position. The position was that the level of interest rates did have no impact on the demand for money, which would cause the LM-curve to become vertical. This was termed the “monetarist” position. This assumption was harder for our professors to dismiss than the assumption of fully flexible prices, but they could nonetheless come up with graphs for different countries that showed a fairly clear negative relationship between the interest rate level and real money balances (M/P).

So my professors concluded that of neither the AS curve nor LM curve where vertical in the real world because prices are not fully flexible and of course the demand for money depend on the level of interest rates so even though our assumptions in the rudimentary Keynesian model were a bit heroic the fundamental conclusions would still hold. The world was Keynesian and fiscal multiplier was positive.

However, as with the rudimentary Keynesian model in these more “advanced” models we essentially maintained the assumption that the supply of money was fixed. The monetary policy rule essentially was a fixed exchange rate or a gold standard. This was never really stated clearly and I am sure that most of my professors never realized just how important this assumption was for the results that they presented to their students and I suspect that this remains the case for most economic professors around the world today.

A Sketch for a simple (alternative) General Theory

If Keynes really had wanted to formulated a General Theory he in my view should have started out with an AS/AD framework and then discussed the macroeconomic outcome under different assumptions of prices “stickiness” AND the monetary policy rule.

I will now try to sketch an alternative General Theory, which basically encompasses all of the “normal” models, which students are introduced to in their intermediate macroeconomic lessons.

The first model is the rudimentary Keynesian model. As my graph above illustrates we get Keynesian results if we assume that prices are sticky (or completely) fixed only if we also assumes that the money stock is “sticky” or fixed – i.e. if we are in a gold standard/fixed exchange rate world.

This “model” probably is fairly useful in understanding the short-term economic developments in countries like Denmark, which operates a pegged exchange rate regime (a peg to the euro) or for a country like the Netherland, which is a member of a currency union (the euro area). It should, however, be noted that we in this world has made a similar problematic assumption. We have ignored the public budget constraint. Keynes did that as well, but it would probably be quite wrong when analysing the present day Greek economy to ignore the budget constrain (while we probably easily could ignore it in the case of Denmark or the Netherlands). So yes, in the case of Denmark, Netherland or Greece the fiscal multiplier might indeed be positive, but in the case of Greece the Greek government cannot afford utilizing this fact.

However, the rudimentary Keynesian model will provide us with very little inside for countries with explicit inflation targets such as Sweden, Canada or Australia. Here the central banks set the money base – and as a consequence the AD curve – to ensure that a certain inflation target is hit. In this world the fiscal multiplier is zero. This would mean that the world looks as if it is “Classic” or “monetarist” (in the textbook lingo). This would even be the case if we assume that prices are completely fixed. This is more or less similar to the second graph above (the NGDP targeting case).

Note this is course not because Swedish prices are more flexible than Danish prices, but because of differences in the monetary policy regime. Paradoxically enough both Danish and Swedish economics students still to this day are introduced to macroeconomics starting with the rudimentary Keynesian model. Rarely (I think) is there made in reference to the importance of the monetary policy regime in the two countries.

When I was at university in the early 1990s the new hot thing in macroeconomics was the so-called Real Business Cycle model. The RBC models were a real break with Keynesian thinking as RBC theorists like Nobel Prize winner Edward Prescott argued that the business cycle essentially was driven by supply shocks rather than demand shocks.

I remember thinking at the time that the idea that the primary cause of business cycles was supply shocks was crazy. As did most other students and professors, but it was mathematically an impressive set-up, which caused some interesting among students and professors and I was personally equally attracted the RBC theorists insistence on having a proper microeconomic foundation for macroeconomics.

However, today even though I am rather sceptical about the empirical relevance of RBC models I most say that the RBC model would likely be the best model to descript the economic development under a “perfect” NGDP targeting regime. Again it is about the monetary policy. Something RBC theorist in a similar fashion as Keynesian before completely ignored. Instead early RBC theorist made rather bizarre assumptions about price and wage flexibility that seemed to live up to live up to Keynes’ caricature of the “Classical” economists.

Anyway, if we in an AS/AD framework assume that the central bank has a nominal GDP target then it becomes obvious that all the ups and downs in economic activity will be a result of supply shocks. Hence, all shocks to demand will be “neutralized” or offset by the monetary policy rule to keep aggregate demand fixed (or fixed around a steady growth path). There will be no aggregate demand shocks. We can get shocks to the composition of aggregate demand, but the fiscal multiplier is zero and even if we assume that investments are determined by irrational and crazy animal spirits aggregate demand will grow at a steady fixed rate.

Hence, under “perfect” NGDP targeting the world would look as if the RBC model is right. This is not because demand shock can’t influence the economy, but because monetary policy ensures that that will not be the case.

Conclusion: The crucial assumption is about the monetary regime

I hope to have demonstrated above that the crucial assumption we make in macroeconomic models is not primarily the assumptions about prices flexibility or interest rate elasticities as macroeconomic students still are taught, but the assumption about the monetary policy regime.

Hence, some real world economies look “Keynesian”, while other looks “Classic” and other look like RBC economies – even if we assume the same level of price stickiness.

It is the monetary policy regime stupid!

Related posts:

How I would like to teach Econ 101
The fiscal cliff and the Bernanke-Evans rule in a simple static IS/LM model
Daniel Lin is teaching macro! Lets introduce his students to the IS/LM+ model

The “Weidmann rule” and the asymmetrical budget multiplier (is the euro zone 50% keynesian?)

During Christmas and New Years I have been able to (nearly) not think about monetary policy and economics, but I nonetheless came across some comments from Bundesbank chief Jens Weidmann from last week, which made me think about the connection between monetary policy rules and fiscal austerity in the euro zone. I will try address these issues in this post.  

This is Jens Weidmann:

“The euro zone is recovering only gradually from the harshest economic crisis in the post-war period and there are few price risks. This justifies the low interest rate…Low price pressure however cannot be a licence for arbitrary monetary easing and we must be sure to raise rates at the right time should inflation pressure mount.”

It is the second part of the quote, which is interesting. Here Weidmann basically spells out his preferred reaction function for the ECB and what he is saying is that he bascially wants an asymmetrical monetary policy rule – when inflation drops below the ECB’s 2% inflation target the ECB should not “arbitrary” cut its key policy rate, but when inflation pressures increase he wants the ECB to act imitiately.

It is not given that the ECB actually has such a policy rule, but given the enormous influence of the Bundesbank on ECB policy making it is probably reasonable to assume that that is the case. That in my view would mean that Summer Critique does not apply (fully) to the euro zone and as a result we can think of the euro zone as being at least 50% “keynesian” in the sense that fiscal shocks will not be fully offset by monetary policy. As a result it would be wrong to assume that the budget multiplier is zero in the euro zone – or rather it is not always zero. The budget multiplier is asymmetrical.

Let me try to illustrate this within a simple AS/AD framework.

First we start out with a symmetrical policy rule – an inflation targeting ECB. Our starting point is a situation where inflation is at 2% – the ECB’s official inflation target – and the ECB will move to offset any shock (positive and negative) to aggregate demand to keep inflation (expectations) at 2%. The graph below illustrates this.

ASAD AD shock

If the euro zone economy is hit by a negative demand shock in the form of for example fiscal tightening across the currency union the AD curve inititally shifts to the left (from AD to AD’). This will push inflation below the ECB’s 2% inflation target. As this happens the ECB will automatically move to offset this shock by easing monetary policy. This will shift the AD curve back (from AD’ to AD). With a credible monetary policy rule the markets would probably do most of the lifting.

The Weidmann rule – asymmetry rules

However, the Weidmann rule as formulated above is not symmetrical. In Weidmann’s world a negative shock to aggregate demand – for example fiscal tightening – will not automatically be offset by monetary policy. Hence, in the graph above the negative shock aggregate demand (from AD to AD’) will just lead to a drop in real GDP growth and in inflation to below 2%. Given the ECB’s official 2% would imply the ECB should move to offset the negative AD shock, but that is not the case under the Weidmann rule. Hence, under the Weidmann rule a tightening of fiscal policy will lead to drop in aggregate demand. This means that the fiscal multiplier is positive, but only when the fiscal shock is negative.

This means that the Sumner Critique does not hold under the Weidman rule. Fiscal consolidation will indeed have a negative impact on aggregate demand (nominal spending). In that sense the keynesians are right – fiscal consolidation in the euro zone has likely had an negative impact on euro zone growth if the ECB consistently has followed a Weidmann rule. Whether that is the case or not is ultimately an empirical question, but I must admit that I increasingly think that that is the case. The austerity drive in the euro zone has likely been deflationary. However, it is important to note that this is only so because of the conduct of monetary policy in the euro area. Had the ECB instead had an fed style Evans rule with a symmetrical policy rule then the Sumner Critique would have applied also for the euro area.

The fact that the budget multiplier is positive could be seen as an argument against fiscal austerity in the euro zone. However, interestingly enough it is not an argument for fiscal stimulus.  Hence, according to Jens Weidmann the ECB “must be sure to raise rates at the right time should inflation pressure mount”. Said in another way if the AD curve shifts to the right – increasing inflation and real GDP growth then the ECB should offset this with higher interest rates even when inflation is below the ECB’s 2% inflation target.

This means that there is full monetary offset if fiscal policy is eased. Therefore the Sumner Critique applies under fiscal easing and the budget multiplier is zero.

The Weidmann rule guarantees deflation 

Concluding, with the Weidmann rule fiscal tightening will be deflationary – inflation will drop as will real GDP growth. But fiscal stimulus will not increase aggregate demand. The result of this is that if we assume the shocks to aggregate demand are equally distributed between positive and negative demand shocks the consequence will be that we over time will see the difference between nominal GDP in the US and the euro become larger and larger exactly because the fed has a symmetrical monetary policy rule (the Evans rule), while the ECB has a asymmetrical monetary policy rule (the Weidmann rule).

This is of course exactly what we have seen over the past five years. But don’t blame fiscal austerity – blame the Weidmann rule.

NGDP euro zone USA

PS I should really acknowledge that this is a variation over a theme stressed by Larry Summers and Brad Delong in their paper Fiscal Policy in a Depressed Economy. See my discussion of that paper here.

Kuroda’s masterful forward guidance

This is from cnbc.com:

Talk of further monetary stimulus from the Bank of Japan helped push the yen to a six-month low and lifted the Nikkei to a six-month high on Tuesday, and the move in Japanese assets may have further to run, analysts say.

Comments made by Bank of Japan (BOJ) governor Haruhiko Kuroda on Monday fueled speculation of further easing, after he told participants at a conference “we are ready to adjust monetary policy without hesitation if risks materialize.”

Is forward guidance important? Yes, it is tremendously important – particularly is you have little credibility about your monetary policy target. The Bank of Japan for 15 years failed to meet any monetary policy target, but since Haruhiko Kuroda became BoJ governor things have changed. His masterful forward guidance has significantly increased monetary policy credibility in Japan.

Few in the market place today can doubt that governor Kuroda is committed to meeting his 2% inflation target and that he will do whatever it takes to hit that target. Furthermore, when Kuroda says that he is “ready to adjust monetary policy without hesitation if risks materialize” he is effectively making the the Sumner Critique official policy.

Said in another way – governor Kuroda will adjust his asset purchases – if necessary – to offset any other shocks to aggregate demand (or rather money-velocity) for example in response to the planned increase in Japanese sales taxes.

As a consequence of Kuroda’s forward guidance market participants know that the BoJ will offset any effect on aggregate demand of the higher sales tax and as a consequence the expected (net) impact of the sales tax increase is zero. This of course is the Sumner Critique – an inflation targeting (or NGDP targeting) central bank will offset fiscal shocks to ensure that the fiscal multiplier is zero.

So what is happening is that market participants expect monetary easing in reaction to fiscal tightening – this is now lifting Japanese equity prices and weakening the yen. This will boost private consumption, investment and exports and thereby offset the impact on aggregate demand from the increase in sales taxes.

The Bank of Japan likely have to step up its monthly asset purchases to offset the impact of the higher sales taxes as the BoJ’s inflation target is still not fully credible. However, given Mr. Kuroda’s skillful forward guidance the BoJ will have to do a lot less in terms of an actually increase in asset purchases than otherwise would have been the case. That in my view demonstrates the importance of forward guidance.

My expectation certainly is that the plan sales tax increase in Japan will once again demonstrate that the fiscal multiplier is zero under credible inflation targeting (also that the Zero Lower Bound!) and there is in my view good reason to think that the Japanese economy will continue to recover in 2014 – to a large extent thanks to governor Kuroda’s skillful forward guidance and his commitment to hitting the BoJ’s inflation target.

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Related post: There is no ’fiscal cliff’ in Japan – a simple AS-AD analysis

Ignore the shutdown

Market Monetarists have a tendency not to get all worked up about fiscal issues. I guess the same goes for the discussion about a possible US government shutdown.

But what is history telling us? Well, it would not be the first time we would have a US government shutdown. Last time it happened was in 1995.

I stole this from Wikipedia:

The United States federal government shutdown of 1995 and 1996 was the result of conflicts between Democratic President Bill Clinton and the Republican Congress over funding for Medicare, education, the environment, and public health in the 1996 federal budget.

The government shut down after Clinton vetoed the spending bill the Republican Party-controlled Congress sent him. The federal government of the United States put non-essential government workers on furlough and suspended non-essential services from November 14 through November 19, 1995 and from December 16, 1995 to January 6, 1996, for a total of 28 days. The major players were President Clinton and Speaker of the U.S. House of Representatives Newt Gingrich.

…A 2010 Congressional Research Service report summarized other details of the 1995-1996 government shutdowns, indicating the shutdown impacted all sectors of the economy. Health and welfare services for military veterans were curtailed; the Centers for Disease Control and Prevention stopped disease surveillance; new clinical research patients were not accepted at the National Institutes of Health; and toxic waste clean-up work at 609 sites was halted. Other impacts included: the closure of 368 National Park sites resulted in the loss of some seven million visitors; 200,000 applications for passports and 20,000 to 30,000 applications for visas by foreigners went unprocessed each day; U.S. tourism and airline industries incurred millions of dollars in losses; more than 20% of federal contracts, representing $3.7 billion in spending, were affected adversely.

It sounds pretty horrible doesn’t it? But now look at how the US stock market performed ahead of, during and after the 1995 government shutdown.

govt shutdown

Are you scared? I am not. If the stock market is up it is normally a pretty good indication that no permanent damage has been done to the economy.

PS If you do not get why I am not scared about this you should take a look at what I said about the “fiscal cliff” a year ago – See for example here. It is all about a rule based monetary policy and the Sumner Critique.

It is time to stop worrying about austerity – also in the UK

I have a piece in City AM today on the impact of fiscal austerity in the UK:

FIVE years ago, nearly every macroeconomist agreed that central banks determined aggregate demand (total spending in the economy), and that fiscal stimulus was therefore unnecessary to lift depressed economies. Conversely, fiscal austerity was seen as irrelevant at best for overall growth; any impact of austerity on demand can be offset by the right monetary policy – though tax cuts could, of course, boost aggregate supply.

But the age-old discussion about the relation of fiscal policy to growth has resurfaced. Keynesian economists – including Òscar Jordà and Alan M Taylor in a paper just released by the National Bureau of Economic Research – claim that government austerity is to blame for lacklustre UK growth since 2010.

There are technical issues with the paper that make Taylor and Jordà’s precise numbers hard to evaluate. And as the economist David B Smith has noted, the important question of fiscal sustainability is not even addressed. But the more fundamental issue in the whole debate is the idea of “monetary offset”.

Read the rest here.

There is no ’fiscal cliff’ in Japan – a simple AS-AD analysis

It is now very clear that what Milton Friedman advocated the Bank of Japan should do back in the mid-1990s – to expand the money base to get Japan out of deflation – is in fact working. Nominal spending growth is accelerating and with it deflation has come to an end and real GDP growth is fairly robust.

However, some have been arguing the success of Abenomics will be short-lived and that the planned increases in the Japanese sales tax might send Japan back into recession. In other words Japan is facing a fiscal cliff.

In this post I will argue that like in the case of the 2013-US fiscal cliff the fears of the negative impact of fiscal consolidation is overblown and that the risk of recession in Japan is very small if the Bank of Japan keeps doing its job and try to get inflation expectations back to 2%. It is yet another illustration of the Sumner Critique.

All we need is the AS-AD framework

I think it is pretty easy to illustrate the impact of a sales tax increase in a world with a central bank with a credible inflation target within a simple AS-AD framework.

We start out with a Cowen-Tabarrok style AS-AD framework. We use growth rates rather levels and aggregate demand curve is given by the equation of exchange (mv=py).

The graph below is our starting point.

AS AD

We have assumed that inflation in the starting point already is at 2%. This obviously is not correct, but it does not fundamentally change the analysis of the “fiscal shock”.

Japan’s sales tax will be raised to 8 percent from 5 percent in April and to 10 percent in October 2015, but here we just assume it is one fiscal shock. Again that is not important for the conclusions.

A negative fiscal shock in a Cowen-Tabarrok style AS-AD framework is basically a negative shock to money velocity (v), which will push the AD curve to the left as nominal spending drops.

However, as it is clear from the graph this will initially push inflation below the Bank of Japan’s 2% inflation target. We are here ignoring headline inflation will increase, but we are here focusing on core inflation as is the BoJ. Core inflation will drop as illustrated in the graph below.

inflation target BoJ ASAD

If the Bank of Japan is serious about its inflation target it will respond to any demand-driven drop in inflation by counteracting that with an one-to-one increase in the money base to bring back inflation to 2%.

The consequence of BoJ’s 2% inflation is hence that there will be full monetary offset of the negative fiscal shock and as a consequence inflation should broadly speaking remain unchanged at 2% and real GDP growth will be unaffected. Hence, under a credible inflation target the fiscal multiplier is zero. As in the case of the US there will be no fiscal cliff. There will be fiscal consolidation but not a negative impact on growth.

This of course does not mean that the fiscal shock will not have any impact on the Japanese economy or markets. It very likely will. It is for example clear that if the markets expect the BoJ to step up asset purchases (increase money base growth) in response to fiscal tightening then that would likely weaken the yen further. Something Japanese exporters likely will be happy about. As a consequence the sales tax hikes will likely change the composition of growth in Japan.

Finally, it should be noted that everybody in Japan is fully aware of the miserable state of public finances and as a result it is hardly a surprise to Japanese households that the government sooner or later would have to do something to improve public finances. In fact the sales tax hike was announced long ago. Therefore, we should expect some Ricardian equivalence effects to come into play here – an increase net government saving is likely to reduce net private savings. So even with no monetary offset there is likely to be some Ricardian offset. That in my view, however, is significantly less important than the monetary policy offset.

How aggressive will the BoJ have to be to offset the fiscal shock?

A crucial question of course will be how much additional monetary easing is needed to offset the fiscal shock. Here the credibility of the BoJ’s inflation comes into play.

If the BoJ’s inflation target was 100% credible we could actually argue that the BoJ would not have to increase the money base at all. The Chuck Norris effect would take care of everything.

Hence, if everybody knows that the BoJ always will ensure that inflation (and inflation expectations) is at 2% then when a fiscal shock is announced the markets will realize that that means that the BoJ will ease monetary policy. Easier monetary policy will push up stock prices and weaken the yen. That will in itself stimulate aggregate demand. In fact stock prices will continue to rise and the yen will continue to weaken until the markets are “satisfied” that inflation expectations remain at 2%.

In fact this might exactly be what is happening. The yen has generally continued to weaken and the Japanese stock markets have been holding up quite well even through the latest round of turmoil – Fed tapering fears, Syria, Emerging Markets worries etc.

But obviously, the BoJ’s inflation target is not entirely credible and inflation expectations are still well-below 2% so my guess would be that the BoJ might have to step up quantitative easing, but it is certainly not given. In fact the Japanese recovery is showing no signs of slowing down and inflation – both headline and core – continues to inch up.

A golden opportunity for the BoJ to increase credibility

Hence, I am not really worried about the planned sales tax hikes. I don’t like taxes, but I don’t think a sales tax hike will kill the Japanese recovery. In fact I believe that the sales tax hikes are a golden opportunity for the Bank of Japan to once and for all to demonstrate that it is serious about its 2% inflation.

The easiest way to do that is basically to copy a quite interesting note from the Reserve Bank of New Zealand on “Fiscal and Monetary Coordination”. This is from the note:

“…the Reserve Bank, therefore, is required to respond to developments in the economy – including changes in fiscal policy – that have material implications for the achievement of the price stability target;”

And further it says:

“These… features mean that monetary and fiscal policy co-ordination occurs through the Reserve Bank taking fiscal policy into account as an element of the environment in which monetary policy operates. This approach is to be contrasted with approaches to co-ordination that involve joint determination of monetary policy by the monetary and fiscal policy agencies.”

And finally:

“While demand – and thus inflation – pressures may originate from a range of different sources, the task of monetary policy is to respond so as to maintain an overall level of demand consistent with keeping inflation in one to two years’ time within the target range. For example, if the government increases its net spending, all other things being equal, monetary policy needs to be tighter for a time, so as to slow growth of private demand and “make room” for the additional government spending.”

If the BoJ copied this note/statement then it basically would be an open-ended commitment to offset any fiscal shock to aggregate demand – and hence to inflation – whether positive or negative.

By telling the market this the Bank of Japan would do a lot to reduce the worries among some market participants that the BoJ might not be serious about ensuring that its 2% inflation target will be fulfilled even if fiscal policy is tightened.

So far BoJ governor Kuroda has done a good job in managing expectations and so far all indications are that his policies are working – deflation seems to have been defeated and growth is picking up.

If Kuroda keeps his commitment to the 2% inflation target and stick to his rule-based monetary policy and strengthens his communication policies further by stressing the relationship between monetary policy and fiscal policy – RBNZ style – then there is a good chance that the planed sales tax hikes will not be a fiscal cliff.

US capital spending and a lesson in the monetary transmission mechanism

This is from Bloomberg.com:

Companies in the U.S. are beginning to empty their deep pockets and boost capital spending as they look past the specter of sequestration and global growth risks.

Orders for capital goods excluding aircraft and military equipment — an indicator of future business investment — increased 1.5 percent in May, a third consecutive advance and the longest streak since October 2011. Chief executive officers are more optimistic about the economy, based on the Business Roundtable’s quarterly outlook index, which rose to 84.3 in the second quarter, the highest in a year.

Spending on information technology is up 4 percent this year compared with 2 percent last year, according to the median in asurvey of 203 businesses by Computer Economics, a research company in Irvine, California.

…Such increases are set to bolster the U.S. expansion between now and year-end as companies unleash cash from their record-high balance sheets amid a brighter economic outlook. Job gains that beat expectations in June have helped firm market projections of a September start for the Federal Reserve to begin reducing its unprecedented $85 billion in monthly asset purchases, indicating confidence that growth is sustainable without record levels of monetary stimulus.

This is exactly what Market Monetarists said would happen if the Federal Reserve eased monetary policy within a rule based framework. This in my view is a pretty clear demonstration of how the monetary transmission mechanism works.

This is how I in 2011 explained it would work:

Lets assume that the economy is in “bad equilibrium”. For some reason money velocity has collapsed, which continues to put downward pressures on inflation and growth and therefore on NGDP. Then enters a new credible central bank governor and he announces the following:

“I will ensure that a “good equilibrium” is re-established. That means that I will ‘print’ whatever amount of money is needed so to make up for the drop in velocity we have seen. I will not stop the expansion of the money base before market participants again forecasts nominal GDP to have returned to it’s old trend path. Thereafter I will conduct monetary policy in such a fashion so NGDP is maintained on a 5% growth path.”

Lets assume that this new central bank governor is credible and market participants believe him. Lets call him Ben Volcker.

By issuing this statement the credible Ben Volcker will likely set in motion the following process:

1) Consumers who have been hoarding cash because they where expecting no and very slow growth in the nominal income will immediately reduce there holding of cash and increase private consumption.
2) Companies that have been hoarding cash will start investing – there is no reason to hoard cash when the economy will be growing again.
3) Banks will realise that there is no reason to continue aggressive deleveraging and they will expect much better returns on lending out money to companies and households. It certainly no longer will be paying off to put money into reserves with the central bank. Lending growth will accelerate as the “money multiplier” increases sharply.
4) Investors in the stock market knows that in the long run stock prices track nominal GDP so a promise of a sharp increase in NGDP will make stocks much more attractive. Furthermore, with a 5% path growth rule for NGDP investors will expect a much less volatile earnings and dividend flow from companies. That will reduce the “risk premium” on equities, which further will push up stock prices. With higher stock prices companies will invest more and consumers will consume more.

I think that is exactly what is now happening in the US economy. The fed’s de facto announcement back in September last year of the Bernanke-Evans rule is moving the US economy from a “bad equilibrium” to a “good equilibrium”.

Hence, it is not only in the increase in the money base, which is lifting the US economy out of the crisis, but also a marked shift in expectations among US investors and consumers. It is the Chuck Norris effect. At least that is what the survey mentioned above indicates.

Furthermore, this is a clear demonstration of the Sumner Critique – the fiscal multiplier will be zero if the fed follows a clear nominal target. Hence, any fiscal tightening will be offset by monetary easing and/or expected monetary easing. So while fiscal policy contracts investments and private consumption is expanding.

I am still puzzled that it took the fed four years to figure this out and I should say that the Chuck Norris effect could have been much more powerful had the Federal Reserve been a lot more clear about its objectives. Now investors and consumers are still to a large extent guessing what the fed is targeting. Had the fed announced an NGDP level target then I am sure we would have seen an even stronger recovery in US capital spending.

The Turkish demonstrations – and the usefulness of the AS/AD framework

Peter Dorman has a blog post that have gotten quite a bit of attention in the blogosphere on the AS-AD model and why he thinks it is not a useful framework. This is Peter:

“Introductory textbooks are supposed to give you simplified versions of the models that professionals use in their own work.  The blogosphere is a realm where people from a range of backgrounds discuss current issues often using simplified concepts so everyone can be on the same page.

But while the dominant framework used in introductory macro textbooks is aggregate supply—aggregate demand (AS-AD), it is almost never mentioned in the econ blogs.  My guess is that anyone who tried to make an argument about current macropolicy using an AS-AD diagram would just invite snickers.  This is not true on the micro side, where it’s perfectly normal to make an argument with a standard issue, partial equilibrium supply and demand diagram.  What’s going on here?”

I am somewhat surprised by Peter’s statement that the AS-AD framework is never mentioned on the econ blogs. That could indicate that Peter has never read my blog (no offense taken – I never read Peter’s blog before either). My regular readers would of course know that I am quite fund of using the AS-AD framework to illustrate my arguments. Other Market Monetarists – particularly Nick Rowe and Scott Sumner are doing the same thing quite regularly. See Nick’s discussion of Peter’s post here.

The purpose of this post, however, is not really to discuss Peter’s critique of the AS-AD framework, but rather to show the usefulness of the framework with a example from today’s financial news flow. Furthermore, I will do a Market Monetarist ‘spin’ on the AS-AD framework. Hence, I will stress the importance of monetary policy rules and what financial markets tell us about AD and AS shocks.

The Istanbul demonstrations as an AS shock 

Over the weekend we have seen large street protests in Istanbul in Turkey. The demonstrations are the largest demonstrations ever against the ruling AKP party and Prime Minister Erdogan. Mr. Erdogan has been in power for a decade.

The demonstrations today triggered a 10% drop in the Istanbul stock exchange so there is no doubt that investors think that these demonstrations and the political ramifications of the demonstrations will have a profound negative economic impact.

I believe a core insight of Market Monetarist thinking is that financial markets are very useful indicators about monetary policy shocks. Hence, we for example argue that if the US dollar is depreciating, market inflation expectations are rising and the US stock market is rallying then it is a very clear indication that US monetary conditions are getting easier.

While the focus of Market Monetarists have not been as much on supply shocks as on monetary policy shocks (AD shocks) it is equal possible to ‘deduct’ AS shocks from financial markets. I believe that today’s market action in the Turkish markets are a pretty good indication of exactly that – the combination of lower stock prices, higher bond yields (higher risk premium and/or higher inflation expectations) and a weaker lira tells the story that investors see the demonstrations as a negative supply shock. It is less clear whether the shock is a long-term or a short-term shock.

A short-run AS shock – mostly about disruption of production

My preferred textbook version of the AS-AD model is a model similar to the one Tyler Cowen and Alex Tabarrok use in their great textbook Modern Principles of Economics where the model is expressed in growth rates (real GDP growth and inflation) rather than in levels.

It is obvious that the demonstrations and unrest in Istanbul are likely to lead to disruptions in production – roads are closed down, damages to infrastructure, some workers are not coming to work and even some lines of communication might be negatively impacted by the unrest. Compared to the entire Turkish economy the impact these effects is likely quite small, but it is nonetheless a negative supply shock. These shocks are, however, also likely to be temporary – short-term – rather than permanent. Hence, this is a short-run AS shock. I have illustrated that in the graph below.

AS AD SRAS shock

This is the well-known illustration of a negative short-run supply shock – inflation increases (from P to P’) and real GDP growth declines (from Y to Y’).

This might very well be what we will see in Turkey in the very short run – even though I believe these effects are likely to be quite small in size.

However, note that we here assume a “constant” AD curve.

Peter Dorman is rightly critical about this assumption in his blog post:

“…try the AD assumption that, even as the price level and real output in the economy go up or down, the money supply remains fixed.”

Peter is of course right that the implicit assumption is that the money supply (or money base) is constant. The standard IS/LM model suffers from the same problem. A fact that have led me to suggest an alternative ISLM model – the so-called IS/LM+ model in which the central bank’s monetary policy rule is taken into account.

Obviously no analysis of macroeconomic shocks should ignore the monetary policy reaction to different shocks. This is obviously something Market Monetarists have stressed again and again when it for example comes to fiscal shocks like the ‘fiscal cliff’ in the US. In the case of Turkey we should therefore take into account that the Turkish central bank (TCMB) officially is targeting 5% inflation.

Therefore if the TCMB was targeting headline inflation in a very rigid way (ECB style) it would have to react to the increase in inflation by tightening monetary policy (reducing the money base/supply) until inflation was back at the target. In the graph above that would mean that the AD curve would shift to the left until inflation would have been brought down back to 5%. The result obviously would be a further drop in real GDP growth.

In reality I believe that the TCMB would be very unlikely to react to such a short run supply. In fact the TCMB has recently cut interest rates despite the fact that inflation continue to run slightly above the inflation target of 5%. Numbers released today show Turkish headline inflation was at 6.6% in May.

In fact I believe that one with some justification can think of Turkish monetary policy as a “flexible NGDP growth targeting” (with horrible communication) where the TCMB effectively is targeting around 10% yearly NGDP growth. Interestingly enough in the Cowen-Tabarrok version of the AS-AD model that would mean that the TCMB would effectively keep the AD curve “unchanged” as the AD curve in reality is based in the equation of exchange (MV=PY).

The demonstrations could reduce long-term growth – its all about ‘regime uncertainty’

While the Istanbul demonstrations clearly can be seen as a short-run supply shock that is probably not what the markets are really reacting to. Instead it is much more likely the the markets are reacting to fears that the ultimate outcome of the demonstrations could lead to lower long-run real GDP growth.

Cowen and Tabarrok basically think of long-run growth within a Solow growth model. Hence, there are overall three drivers of growth in the long run – labour forces growth, an increase in the capital stock and higher total factor productivity (TFP – think of that as “knowledge”/technology).

I believe that the most relevant channel for affecting long-run growth in the case of the demonstrations is the impact on investments in Turkey which likely will influence both the size of the capital stock and TFP negatively.

Broadly speaking I think Robert Higgs concept of “Regime Uncertainty” comes in handy here.  This is Higgs:

“The hypothesis is a variant of an old idea: the willingness of businesspeople to invest requires a sufficiently healthy state of “business confidence,”  … To narrow the concept of business confidence, I adopt the interpretation that businesspeople may be more or less “uncertain about the regime,” by which I mean, distressed that investors’ private property rights in their capital and the income it yields will be attenuated further by government action. Such attenuations can arise from many sources, ranging from simple tax-rate increases to the imposition of new kinds of taxes to outright confiscation of private property. Many intermediate threats can arise from various sorts of regulation, for instance, of securities markets, labor markets, and product markets. In any event, the security of private property rights rests not so much on the letter of the law as on the character of the government that enforces, or threatens, presumptive rights.”

I think this is pretty telling about the fears that investors might have about the situation in Turkey. It might be that the Turkish government is not loved by investors, but investors are clearly uncertain about what would follow if the demonstrations led to “regime change” in Turkey and a new government. Furthermore, the main opposition party – the CHP – is hardly seen as reformist.

And even if the AKP does remain in power the increased public disconnect could lead to ‘disruptions of production’ (broadly speaking) again and again in the future.  Furthermore, the government hard-handed reaction to the demonstrations might also “complicate” Turkey’s relationship to both the EU and the US – something which likely also will weigh on foreign direct investments into Turkey.

Hence, regime uncertainty therefore is likely to reduce the long-run growth in the Turkish economy. Obviously it is hard to estimate the scale such effects, but at least judging from the sharp drop in the Turkish stock market today the negative long-run supply shock is sizable.

I have illustrated such a negative long-run supply shock in the graph below.

LRAS shock

The result is the same as in the short-run model – a negative supply shock reduces real GDP growth and increases inflation.

However, I would stress that the TCMB would likely not in the long run accept a permanent higher rate of inflation and as a result the TCMB therefore sooner or later would have to tighten monetary policy to push down inflation (by shifting the AD curve to the left). This also illustrates that the demonstrations is likely to become a headache for the TCMB management.

Is the ‘tourism multiplier’ zero? 

Above I have primarily described the Istanbul demonstrations as a negative supply shock. However, some might argue that this is also going to lead to a negative demand shock.

Hence, Turkey very year has millions of tourists coming to the country and some them will likely stay away this year as a consequence of the unrest. In the Cowen- Tabarrok formulation of the AD curve a negative shock to tourism would effectively be a negative shock to money velocity. This obviously would shift the AD curve to the left – as illustrated in the graph below.

AD shock

Hence, we initially get a drop in both inflation and real GDP growth as the AD curve shifts left.

However, we should never forget to think about the central bank’s reaction to a negative AD shock. Hence, whether the TCMB is targeting inflation or some kind of NGDP growth target it would “automatically” react to the drop in aggregate demand by easing monetary policy.

In the case the TCMB is targeting inflation it would ease monetary policy until the AD curve has shifted back and the inflation rate is back at the inflation target.

This effectively means that a negative shock to Turkish tourism should not be expected to have an negative impact on aggregate demand in Turkey for long. This effectively is a variation of the Sumner Critique – this time, however, it is not the budget multiplier, which is zero, but rather the ‘tourism multiplier’.

Hence, from a macroeconomic perspective the demonstrations are unlikely to have any major negative impact on aggregate demand as we would expect the TCMB to offset any such negative shock by easing monetary policy.

That, however, does not mean that a negative shock to tourism will not impact the Turkish financial markets. Hence, there will be a change in the composition of aggregate demand – less tourism “exports” and more domestic demand. This likely is bad news for the Turkish lira.

Mission accomplished – we can use the AS-AD framework to analysis the ‘real world’

I hope that my discussion above have demonstrated that the AS-AD framework can be a very useful tool when analyzing real world problems – such as the present public unrest in Turkey. Obviously Peter Dorman is right – we should know the limitations of the AS-AD model and we should particularly be aware what kind of monetary policy reaction there will be to different shocks. But if we take that into account I believe the textbook (the Cowen-Tabarrok textbook) version of the AS-AD model is a quite useful tool. In fact it is a tool that I use every single day both when I produce research in my day-job or talk to clients about such ‘events’ as the Turkish demonstrations.

Furthermore, I would add that I could have done the same kind of analysis in a DSGE framework, but I doubt that my readers would have enjoyed looking at a lot of equations and a DSGE model would likely have reveal little more about the real world than the version of the AS-AD model I have presented above.

PS Please also take a look at this paper in which I discuss the politics and economics of the present Turkish crisis.

PPS Paul Krugman, Nick Rowe and Mark Thoma also comment on the usefulness of the AS-AD framework.

The OECD understands the Sumner Critique – Europe’s problem is monetary

This is from OECD’s Economic Outlook report published earlier today:

In the euro area, the area-wide fiscal consolidation (measured as an improvement in the underlying primary budget balance) of just over 4% of GDP between 2009 and 2013 was similar to that in the United States over the same period. This casts doubts about the role of fiscal tightening in explaining the comparatively weak performance of the euro area.

The OECD is of course completely right. The fiscal tightening in the US and the in euro zone have been more or less of the same magnitude over the last four years. So don’t blame ‘austerity’ for the euro zone’s lackluster performance.

The real difference between the euro zone and the US is of course monetary. The central bank can always offset the impact of fiscal tightening on aggregate demand. The fed has shown that, while the ECB has failed to do so. Rather the ECB continues to keep monetary conditions insanely tight. Aggregate demand is weak in the euro zone because the ECB wants it to be weak.

The ECB has failed. It is as simple as that and the OECD understands that.

HT Jens Pedersen

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