There is no such thing as fiscal policy

It can be rather traumatic for children to see their parents fight. I feel a bit like that when I see two of my heroes Scott Sumner and David Glasner discuss fiscal policy. The whole thing started with Scott picking a fight with a couple of Keynesians. To be frank that discussion really didn’t turn me on and even though I read most of what Scott writes this was not a discussion that I was particularly interested in. And it is certainly not my plan to address what the discussion really is about – let me just say I think Scott makes it unusually complicated – even though I think he is right (I guess…). Instead I will try to explain my view of fiscal policy or rather to explain why I think there really is no such thing as fiscal policy – at least not in the sense that Keynesians talk about it.

In an earlier post – “How I would like to teach Econ 101” – I have explained that there seems to be a disconnect between how economists think about microeconomics and macroeconomics. I think this disconnect basically also creates the misunderstanding among Keynesians about what fiscal policy is and what it can do.

The way we normally think of microeconomics is an Arrow-Debreu world with no money. Hence, we have a barter economy. As there is no money we can not talk about sticky prices and wages. In a barter economy you have to produce to consume. Hence, there is no such thing as recessions in a barter economy and hence no excess capacity and no unemployment. Therefore there is no need for Keynesian style fiscal policy to “boost” demand. Furthermore, it is not possible, as public expenditures in barter economy basically have to be funded by “forced labour”. “Taxes” will be goods that somebody is asked to “pay” to government and government “spend” these “revenues” by giving away these goods to other people. Hence, in a barter economy fiscal policy is a purely redistributional exercise, but it will have no impact on “aggregate demand”.

Therefore for fiscal policy to influence aggregate demand we need to introduce money and sticky prices and wages in our model. This in my view demonstrates the first problem with the Keynesian thinking about fiscal policy. Keynesians do often not realise that money is completely key to how they make fiscal policy have an impact on aggregate demand.

Lets start out with the standard Keynesian stuff:

(1) Y=C+I+G+X-M

Where Y is GDP (nominal GDP!), C is private consumption, I is investment, G is government expenditure, X is imports and M is imports. There is nothing wrong with this equation. It is an identity so that is no up for discussion.

Lets make it a little simpler. We assume that we have a closed economy so X=M=0. Furthermore lets assume that we define “private demand” as D=C+I and lets write nominal GDP as P*Y (Keynesians assume the P=1). Then we get the following equation:

(1)’ P*Y=D+G

In the barter economy P*Y is basically fixed hence it must follow that an increase in G must lead to a similar decrease in D. There is full crowding out.

So lets introduce money with another identity – the equation of exchange:

(2) M*V=P*Y

Combining (1)’ and (2) with the following:

(3) M*V=D+G

This basically explains why Scott keeps on talking about monetary policy rules when he discusses fiscal policy. (By the way this is a very simple IS-LM model).

Hence, the impact of fiscal policy on nominal GDP/aggregate demand crucially dependents on what happens to M and V when we increase G.

Under NGDP level targeting M*V will be fixed or grow at a fixed rate. That means that we is basically back in the Arrow-Debreu world and any increase in G must lead to a similar drop in D as M*V is fixed.

However, lets say that the central bank is just an agent for the government and that any increase in G is fully funded by an increase in the money supply (M). Then an increase in G will lead to a similar increase in nominal income M*V. With this monetary policy reaction function “fiscal policy” is highly efficient. There is, however, just one problem. This is not really fiscal policy as the increase in nominal GDP is caused by the increase in M. The impact on nominal income would have been exactly the same if M had been increased and G had been kept constant – then the entire adjustment on the right hand side of (3) would then just have increased D.

There, however, is one more possibility and it is that a change in G in someway impacts money-velocity (V). This is what happens in the traditional IS-LM model. Here an increase in G increases “the” interest rate. As the interest rate increases the demand for “bonds” increases and the demand for money drops. This is the same as an increase in V. This model in my view is rather ridicules for a whole lot of reason and I really should not waste people’s time on it, but lets just say that the whole argument breaks down if we introduce more than the two assets – money and “bonds” (Google Brunner and Meltzer…). Furthermore, lets say that we are in a small open economy where the interest rate is given from abroad then changes in G will not influence the interest rate (as least not directly) and hence fail to impact V. If the interest rate is determined by inflation expectations (or NGDP expectations) then the model also breaks down.

But anyway lets assume that this is how the world works. But lets also assume that the central bank has a NGDP level target. Then the increase in G will lead to a drop in money demand via a higher interest rate and thereby to an increase in V. However, as the central bank targets a fixed level for NGDP (M*V) an increase in V will have to be counteracted by an “automatic” drop in M. So again the monetary policy reaction function is crucial. In that sense it is also rather tragic that we had a long debate during the 1970s between old style Monetarists and Keynesians about the size of the interest rate elasticity of investments and money demand with out having any discussion about how this was influenced by the monetary policy rules. (This is not entire true, but bare with me).

One can of course play around with these things as much as one wants, but to me the key lesson is that fiscal policy only have an impact on aggregate demand if the central bank plays along. Hence, fiscal policy does not really exist in the sense Keynesians (normally tend to) claim. “Fiscal policy” needs to be monetary policy to be able to impact aggregate demand.

That said, fiscal policy of course can have an impact of the supply side of the economy and that is ultimately much more important – especially as the ill (lack of aggregate demand) the Keynesians would like to cure cease to exist if the central bank targets the NGDP level.


PS don’t expect me to write a lot more about fiscal policy. The idea that fiscal policy can be used to “stimulate” aggregate demand is just too 1970s for me. Even New Keynesians had given up on that idea during the “Great Moderation”, but some of them now seem to think it is a great idea. It is not. And no this is not some “Calvinist” idea I have – I just don’t think it will work.

UPDATE: Scott continues the fiscal debate (lets stop it Scott, we won long ago…)

UPDATE 2: Sorry for the typos…trying to write fast – sitting in Warsaw airport waiting to board on my flight back home to Copenhagen.

UPDATE 3: Back home with my fantastic family in Denmark – while my family is now asleep I see that Scott has yet another fiscal policy comment.

UPDATE 4: Nick Rowe sketch a very similar model to mine. Apparently Danish and Canadian monetarists think alike.

US Monetary History – The QRPI perspective: The Volcker disinflation

I am continuing my mini-series on modern US monetary history through the lens of my decomposition of supply inflation and demand inflation based on what I inspired by David Eagle have termed a Quasi-Real Price Index (QRPI). In this post I will have a look at the early 1980s and what have been termed the Volcker disinflation.

When Paul Volcker became Federal Reserve chairman in August 1979 US inflation was on the way to 10% and the fight against inflation had more or less been given up and there was certainly no consensus even among economists that inflation was a monetary phenomenon. Volcker set out to defeat inflation. Volcker is widely credited with achieving this goal and even though one can question US monetary policy in a number of ways in the period that Volcker was Fed chairman there is no doubt in mind my that Volcker succeed and by doing so laid the foundation for the great stability of the Great Moderation that followed from the mid-80s and lasted until 2008.

Below you see my decomposition of US inflation in the 1980s between demand inflation (which the central bank controls) and supply inflation.

As the graph shows – and as I spelled out in my earlier post on the 1970s inflationary outburst – the main cause of the rise in US inflation in 1970s was excessive loose monetary policy. This was particularly the case in late 1970s and when Volcker became Fed chairman demand inflation was well above 10%.

Volcker early on set out to reduce inflation by implementing (quasi) money supply targeting. It is obviously that the Volcker’s Fed had some operational problems with this strategy and it effectively (unfairly?) undermined the idea of a monetary policy based on Friedman style money supply targeting, but it nonetheless clearly was what brought inflation down.

The first year of Volcker’s tenure undoubtedly was extremely challenging and Volcker hardly can say to have been lucky with the timing. More or less as he became Fed chairman the second oil crisis hit and oil prices spiked dramatically in the wake of the Iranian revolution in 1979. The spike in oil prices boosted supply inflation dramatically and that pushed headline inflation well above 10% – hardly a good start point for Volcker.

Quasi-Real Price Index and the decomposition of the inflation data seem very clearly to illustrate all the key factors in the Volcker disinflation:

1)   Initially Volker dictated disinflation by introducing money supply targeting. The impact on demand inflation seems to have been nearly immediate. As the graph shows demand inflation dropped sharply in1980 and the only reason headline inflation did not decrease was the sharp rise in oil prices that pushed up supply inflation.

2)   The significant monetary tightening sent the US economy into recession in 1980 and this lead Volcker & Co. to abandon the policy of monetary tightening and “re-eased” monetary policy in the summer of 1980. Again the impact seems to have been immediate – demand inflation picked up sharply going into 1981.

3)   Over the summer the Fed moved to hike interest rates dramatically and slow money supply growth sharply. That caused demand inflation to ease off significantly and inflation had finally been beaten.

4)   The Fed allowed demand inflation to pick up once again in 1984-85, but at that time Volcker was more lucky as supply factors helped curb headline inflation.

The zigzagging in monetary policy in the early 1980s is clearly captured by my decomposition of inflation. To me shows how relatively useful these measures are and I think they could be help tools for both analysts and central bankers.

This post in no way is a full account of the Volcker disinflation. Rather it is meant as an illustration of the Quasi-Real Price Index and my suggested decomposition of inflation.

My two main sources on modern US monetary history is Robert Hetzel’s “The Monetary Policy and the Federal Reserve – A History” and Allan Meltzer’s “A History of the Federal Reserve”. However, for a critical account of the first years of the Volcker disinflation I can clearly recommend our friend David Glasner’s “Free Banking and Monetary Reform”. I am significantly less critical about money supply targeting than David, but I think his account of the Volcker disinflation clear give some insight to the problems of money supply targeting.

Friedman should have supported NGDP targeting, but never did

I found yet another gold nugget in David Eagle’s research:

“In 2005 at the WEAI conference in San Francisco, Milton Friedman participated in panel where he strongly endorsed IT. After the panel presentations, an economist from the audience asked Friedman how he thought the Federal Reserve should respond to a broad-based 10% drop in real GDP. After spending some time trying think about what could possibility cause such a drop, Friedman responded by saying that the Federal Reserve should respond with a 10% drop in the money supply. However, immediately thereafter, Friedman inserted, “If you ask a foolish question, you get a foolish answer.””

Eagle continues:
“We disagree with Friedman concerning the foolishness of considering unexpected deviations in real GDP because that is when NIT (NGDP targeting) diverges from PLT (Price Level Targeting). Only by considering such unexpected real deviations can we see the differences in central bank responses under IT (Inflation targeting) or PLT from NIT (which we consider to be the equivalent of Friedman’s k percent rule). According to the new equation of exchange, N=PY, if Y unexpectedly increased while N (Nominal spending) remained as expected, the price level would unexpectedly fall. Under NIT, the central bank would be content to do nothing since N is on target. However, under PLT, the central bank would try to interject funds into the monetary system to try to raise N to match the increase in Y in order to return P to its targeted level. Similarly, if Y unexpectedly decreased while N remained as expected, the price level would unexpectedly increase. Under NIT, the central bank would be content to do nothing since N is on target. However, under PLT, the central bank would try to withdraw funds to try to cause N to fall to match the decline in Y in order that the price level not change.”

Hence, shortly before his dead Friedman indirectly said that he was not in favour of NGDP targeting. In my view that is not overly surprising. At that time official inflation targeting had been a success around the world for more than a decade and Friedman undoubtedly saw it as an vindication of his view that central banks should follow rules. So as always Friedman was the pragmatic revolutionary he simply support the successfully (at that time) version of a monetary rule, but I think that was on purely pragmatic reasons. Furthermore, one have to remember that at that time the primary monetary mistakes in recent history was too loose monetary policy rather than too tight monetary policy so from a pragmatic perspective it made “sense” to support inflation targeting.

As I have earlier argued Milton Friedman also acknowledged that velocity was no longer stable and that probably moved him from the left hand side to the right hand side of equation of exchange. By the way that shows that John Taylor’s use of Friedman to criticizing NGDP targeting by stating that Friedman argued that rules should be instrument rules really does not live up to what Friedman came believe in the final years of his life. Yes, Friedman endorsed inflation targeting, but NOT the Taylor rule (See David Glasner’s excellent critique of John Taylor views here). Furthermore, acknowledging that he did not think that velocity was stable (anymore) really makes it hard to use Friedman as an argument against NGDP targeting. BUT, BUT Friedman nonetheless to the end of his life preferred inflation targeting more than anything else.

Would that have change if he had live to see the Great Recession? I really don’t know and does it really matter? I still consider myself a Friedmanite and to me the best pupil of Friedman around is Scott Sumner!


See also my earlier post on related topics:

Friedman provided a theory for NGDP targeting
Friedman’s thermostat and why he obviously would support a NGDP target

Sumner and Glasner on the euro crisis

Recently the Market Monetarist bloggers have come out with a number of comments on the euro crisis. It’s a joy reading them – despite the tragic background.

Here is a bit of brilliant comments. Lets start with Scott Sumner:

“Many people seem to be under the illusion that Germany is a rich country. It isn’t. It’s a thrifty country. German per capita income (PPP) is more than 20% below US levels, below the level of Alabama and Arkansas. If you consider those states to be “rich,” then by all means go on calling Germany a rich country. The Germans know they aren’t rich, and they certainly aren’t going to be willing to throw away their hard earned money on another failed EU experiment. That’s not to say the current debt crisis won’t end up costing the German taxpayers. That’s now almost unavoidable, given the inevitable Greek default. But they should not and will not commit to an open-ended fiscal union, i.e. to “taxation without representation.”

Scott as usual it is right on the nail…further comments are not needed.

But it is not really about whether Alabama…eh Germany… is rich enough to bail out the rest of Europe. The question is why some (all?) euro zone are in trouble. David Glasner has the answer:

“…the main cause of the debt crisis is that incomes are not growing fast enough to generate enough free cash flow to pay off the fixed nominal obligations incurred by the insolvent, nearly insolvent, or potentially insolvent Eurozone countries. Even worse, stagnating incomes impose added borrowing requirements on governments to cover expanding fiscal deficits. When a private borrower, having borrowed in expectation of increased future income, becomes insolvent, regaining solvency just by reducing expenditures is rarely possible. So if the borrower’s income doesn’t increase, the options are usually default and bankruptcy or a negotiated write down of the borrower’s indebtedness to creditors. A community or a country is even less likely than an individual to regain solvency through austerity, because the reduced spending of one person diminishes the incomes earned by others (the paradox of thrift), meaning that austerity may impair the income-earning, and, hence, the debt-repaying, capacity of the community as a whole.”

See also my comment on Ambrose Evans-Pritchard.

Please listen to Nicholas Craft!

Professor Nicholas Craft as written a report for the British think tank Centre Forum on “Delivering growth while reducing deficits: lessons from the 1930s”. The report is an excellent overview of the British experience during the 1930s, where monetary easing through exchange rate depreciation combined with fiscal tightening delivered results that certainly should be of interest to today’s policy makers.

If you are the lazy type then you can just read the conclusion:

“The 1930s offers important lessons for today’s policymakers. At that time, the UK was attempting fiscal consolidation with interest rates at the lower bound but devised a policy package that took the economy out of a double-dip recession and into a strong recovery. The way this was achieved was through monetary rather than fiscal stimulus.

The key to recovery both in the UK and the United States in the 1930s was the adoption of credible policies to raise the price level and in so doing to reduce real interest rates. This provided monetary stimulus even though, as today, nominal interest rates could not be cut further. In the UK, the ‘cheap money’ policy put in place in 1932 provided an important offset to the deflationary impact of fiscal consolidation that had pushed the economy into a double-dip recession in that year.

If economic recovery falters in 2012, it may be necessary to go beyond further quantitative easing as practised hitherto. It is important to recognize that at that point there would be an alternative to fiscal stimulus which might be preferable given the weak state of public finances. The key requirement would be to reduce real interest rates by raising inflationary expectations.

At that point, inflation targeting as currently practised in the UK would no longer be appropriate. A possible reform would be to adopt a price level target which commits the MPC to increase the price level by a significant amount, say 15 per cent, over four years. In the 1930s, the Treasury succeeded in developing a clear and credible policy to raise prices. It maybe necessary to adopt a similar strategy in the near future.

It would be attractive if this kind of monetary stimulus worked, as in the 1930s, through encouraging housebuilding. This suggests that an important complementary policy reform would be to liberalize the planning restrictions which make it most unlikely that we will ever see the private sector again build 293000 houses in a year as happened in 1934/5.”

If I have any reservations against Craft’s views then it is the focus on real interest rates in the monetary transmission mechanism. I think that is a far to narrow description of the transmission mechanism in which I think interest rates plays a rather minor role. See my previous comment on the transmission mechanism.

That minor issue aside Craft provides some very insightful comments on the 1930s and the present crisis and  I hope some European policy makers would read Craft’s report…

I got this reference from David Glasner who also has written a comment on Craft’s report.

If just David Glasner was ECB chief…

The all-knowing David Glasner has a fantastic post on his blog putting the euro crisis into historical perspective. Glasner – as do I – see very strong parallels between the European crisis of the 1930s and the present crisis and it the same “gold standard mentality” which is at the heart of the crisis. Too tight monetary policy and not overly loose fiscal policy is really the main cause for the European crisis.

Here is Glasner deep insight:

“If the European central bank does not soon – and I mean really soon – grasp that there is no exit from the debt crisis without a reversal of monetary policy sufficient to enable nominal incomes in all the economies in the Eurozone to grow more rapidly than does their indebtedness, the downward spiral will overtake even the stronger European economies. (I pointed out three months ago that the European crisis is a NGDP crisis not a debt crisis.) As the weakest countries choose to ditch the euro and revert back to their own national currencies, the euro is likely to start to appreciate as it comes to resemble ever more closely the old deutschmark. At some point the deflationary pressures of a rising euro will cause even the Germans, like the French in 1935, to relent. But one shudders at the economic damage that will be inflicted until the Germans come to their senses. Only then will we be able to assess the full economic consequences of Mrs. Merkel.”

If just Glasner was ECB chief the world would be so much different…

Sumner, Glasner, Machlup and the definition of inflation

David Glasner has a humorous comment on Scott Sumner’s attempt to “ban” the word “inflation”.

Here is Scott:

“Some days I want to just shoot myself, like when I read the one millionth comment that easy money will hurt consumers by raising prices.  Yes, there are some types of inflation that hurt consumers.  And yes, there are some types of inflation created by Fed policy.  But in a Venn diagram those two types of inflation have no overlap.”

While David partly agrees with Scott he is not really happy giving up the word “inflation”:

“So Scott thinks that if only we could get people to stop talking about inflation, they would start thinking more clearly. Well, maybe yes, maybe no…At any rate, if we are no longer allowed to speak about inflation, that is going to make my life a lot more complicated, because I have been trying to explain to people almost since I started this blog started four months ago why the stock market loves inflation and have repeated myself again and again and again and again.”

The discussion between these two light towers of monetary theory reminded me of something I once read:

“When I began studying economics at the University of Vienna, immediately after the First World War, we were having a rapid increase of prices in Austria and, when asked what the cause was, we said it was inflation: By inflation we meant the increase in that thing which many are now afraid to mention – the quantity of money” (Fritz Machlup 1972)

But hold on for a second Fritz! That’s wrong! Lets have a look at the equation of exchange (in growth rates):


If the rate of growth in the quantity of money (m) equals inflation then inflation must be defined as p+y-v. And then if we assume (rightly a wrongly) that v is zero then it follows that inflation is defined as p+y.

What is p+y? Well that is the growth rate of nominal GDP! Hence, using the Machlup’s definition of inflation as the growth of the quantity of money then inflation is in fact nominal GDP growth.

So maybe David and Scott should not disagree on whether to ban the word “inflation” – maybe they just need to re-state inflation as the velocity adjusted growth of the quantity of money also known as NGDP growth.

PS this definition of inflation would also make David’s insistence that the stock market loves inflation a lot more reasonable.

Hawtrey, Cassel and Glasner

Recently I have been giving quite a bit attention to the writings Gustav Cassel (and I plan more…), but I have failed to give any attention to the great British monetary economist Raplh G. Hawtrey. That is not really fair – Hawtrey and Cassel lived more or less at the same time and both played important roles in the debate and formulation of monetary policy and monetary thinking around the world in 1920s and 1930s.

Long ago David Glasner – one of my big heros and the blogger on – and Ronald W. Batchelder long ago wrote a paper on the monetary economics of both Cassel and Hawtrey – “Pre-Keynesian monetary theories of the Great Depression”. You should all read it.

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