The fiscal cliff and why fiscal conservatives should endorse NGDP targeting

One of the hottest political topics in the US today is the so-called fiscal cliff. The fiscal cliff is the expected significant fiscal tightening, which will kick in January 2013 when the Tax Relief, Unemployment Insurance Reauthorization, and Job Creation Act of 2010 expires – unless a deal is struck to postpone the tightening. The fiscal cliff is estimated to amount to 4% of GDP – hence a very substantial fiscal tightening.

So how much should we worry about the fiscal cliff? Keynesians claim that we should worry a lot. The Market Monetarist would one the other hand argue that the impact of the fiscal cliff will very much depend on the response of the Federal Reserve to the possible fiscal tightening. If the Fed completely ignores the impact of the fiscal cliff on aggregate demand – if there will be any – then it would be naive to argue that there would be no impact at all on aggregate demand – after all a 4% tightening of fiscal policy in one year is very substantial.

On the other hand if the Federal Reserve had an NGDP target then the impact would likely be minimal as the Fed “automatically” would fill any “hole” in aggregate demand created by the tightening of fiscal policy to keep nominal GDP on track. This of course is the Sumner critique – the fiscal multiplier will be zero under NGDP targeting or inflation targeting for that matter.

Note that I am not making any assumptions about the how the economy works. Even if we assume we are in a Keynesian world, where the “impulse” to aggregate demand from a fiscal tightening would be negative an NGDP targeting regime would ensure that the world would look like a “classical world” (fiscal policy will have no impact on aggregate demand). This by the way would also be the case under inflation targeting – which of course is closer to the actual policy the Fed is conducting.

Said in another we should expect that if fiscal policy indeed would be strongly negative for aggregate demand in the US and push inflation sharply down then the likelihood of more aggressive monetary easing from the Fed would increase and hence sharply reduce any negative effect on aggregate demand (note that nominal GDP is really just another word for aggregate demand – at least according to Market Monetarists like myself). Therefore, we should probably be significantly less worried than some Keynesians seem to be.

Furthermore, it is notable that the US stock market continues rise and inflation expectations have been inching up recently. This is not exactly an indication that the US is facing a sharp drop in aggregate demand in 2013. We can obviously not know why the markets seem so relatively relaxed about the fiscal cliff, but I would think that the reason is that the markets are pricing in a combination of a political compromise that significantly reduces the fiscal tightening in 2013 and also is pricing an increased likelihood of QE3 becoming a reality.

So the conclusion is that Keynesian fears about the scale of the shock to aggregate demand is somewhat overblown as a combination of the Sumner critique and political logrolling will probably reduce the negative shock. We, however, can’t be sure about that so wouldn’t it be great if we didn’t have to worry about this issue? NGDP level targeting could seriously reduce the worries about fiscal shocks.

Fiscal conservatives should endorse NGDP targeting

Both in the US and the euro zone calls for scaling back fiscal consolidation have been growing larger and politicians like the French President Hollande and from Keynesian economists like Paul Krugman and Brad DeLong have even demanded fiscal stimulus. To me it is pretty simple – the state of public finances in most euro zone countries and the US is horrible so I fundamentally don’t think that most countries can afford much fiscal stimulus. That said, I also think that the calls for austerity is somewhat hysterical and I find it rather unlikely that the markets would react very negative if the US budget deficit became 1-2 percentage points of GDP larger next year – just look at US treasury yields it is not so that the markets are telling us that the US economy is on the verge of bankruptcy. The markets are often wrong, but government default rarely happens out of the blue.

However, from a public choice perspective we should probably think that the deeper a country falls into recession the more likely it is that the wider public will vote for politicians like Hollande and policy makers are more and more likely to start listening to economists like Paul Krugman. That unfortunately will do very little to ending the crisis. Fiscal stimulus is not the answer to our problems – monetary easing is.

So fiscal conservatives are likely going to face more and more resistance – whether we like it or not. On the other hand if the central bank was operating a credible NGDP level target then fiscal conservatives could argue that negative impact of fiscal consolidation would be met by an easing of monetary policy to keep NGDP on track. Therefore there would be no reasons to worry about fiscal tightening hitting growth and increasing unemployment.

Even better imagine that the Federal Reserve tomorrow announced that it would do as much monetary easing needed to bring back NGDP to its pre-crisis trend by for example raising  NGDP by 15% from the present level by the end of 2013. Do you then think anybody would worry about a fiscal tightening of 4% of GDP? I think not.

Therefore, the conclusion is clear to me. Fiscal conservatives should endorse NGDP level targeting as it completely would undermine any Keynesian arguments for postponing fiscal consolidation. Furthermore, a commitment to keep NGDP on track would also likely make fiscal consolidation much less unpopular and therefore the likelihood of success would also increase.

Finally I would highlight two historical examples of successful fiscal consolidation. In the mid-1990s both the US and the UK undertook significant successful fiscal reforms that led to a significant improvement in the public finances. Both was undertaken while monetary conditions was eased significantly. As a result there was very little opposition to fiscal consolidation at the time and there was basically no negative impact on US and UK growth. In fact both economies grew robustly through out the fiscal consolidation phase. This of course is the opposite of the German experience from the early 1990s where the Bundesbank completely “neutralized” any stimulus from fiscal expansion in connection with the Germany reunification (See my earlier post on that topic here.)

PS Above I have not given any attention to the supply side effects of the “scheduled” tax hikes that follows as a result of the US fiscal cliff. NGDP level targeting would not deal with that problem and the issue should certainly not be ignored. Tax hikes can never increase the long-term growth potential of any economy, but the issue is not going to have any visible impact on real GDP growth in 2013 or 2014 for that matter. Supply side effects mostly work with long and variable lags. Furthermore, I am not arguing that one should ignore the fiscal cliff just because the Fed has the power to counteract it. After all the Fed’s performance in recent years has not exactly been impressive so a political compromise would probably be helpful for US growth in 2013 – at least it would reduce some risks of the US falling back into recession.

PPS this is my blog post #400 (including guest posts) since I started blogging last year.

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Related posts:
Market Monetarism vs Krugmanism
Guest blog: NGDP Targeting is NOT just for Central Banks! (David Eagle)
The Bundesbank demonstrated the Sumner critique in 1991-92
“Meantime people wrangle about fiscal remedies”
Please keep “politics” out of the monetary reaction function
Is Matthew Yglesias now fully converted to Market Monetarism?
Mr. Hollande the fiscal multiplier is zero if Mario says so
Maybe Jens Weidmann and Francios Hollande should switch jobs
There is no such thing as fiscal policy

The Bundesbank demonstrated the Sumner critique in 1991-92

I have recently written a number of posts (here and here) in which I have been critical about Arthur Laffer’s attempt to argue against fiscal stimulus. As I have stressed in these posts I do not disagree with his skepticism about fiscal stimulus, but with his arguments (and particularly his math). It is therefore only fair that I try to illustrate my view on fiscal stimulus and why fiscal stimulus (on it own) is unlikely to work.

My view of fiscal policy is similar to that view Scott Sumner as articulated in what has been called the “Sumner critique”. According to the Sumner critique if the central bank for example targets inflation or nominal GDP any action by the government to “stimulate” aggregate demand will only work if it does not go counter to the central bank’s nominal target.

Imagine that the central bank is targeting 2% inflation and inflation and expected inflation is at exactly 2%. Now the government in an attempt to spur growth increases the government spending by 10%. In a normal AS-AD model that would shift the AD-curve to the right from AD to AD’ as illustrated in the graph below.

The increase in government spending will initially increase real GDP (output) from Y to Y’, but also push up the price level from P to P’ and hence increase inflation.

However, as the central bank is a strict ECB type inflation targeter it will have to act to the increase in inflation by tightening monetary policy to push back the price level to P (yes, yes I am “confusing” the level of prices and growth in prices, but bare with me – I might just have written the whole thing in growth rates or argued that the central bank targets the price level).

Hence, once the government announces an increase in government spending the central bank would announce that it would reduce the money base (or the growth rate in the money base) to counteract any impact on inflation from the “fiscal stimulus”. The reduction in the money base would push the AD curve back to AD.

This is the Sumner critique – the government can not beat the central bank when it comes to aggregate demand. The central bank will ultimately determine aggregate demand and if the central bank targets for example inflation, the price level or nominal GDP then fiscal policy will have no impact on aggregate demand and note that this is even the case in a situation where unemployment is above the natural rate of unemployment. Hence, we have full crowding out even in a model with sticky prices and wages and underutilization of production factors (involuntary keynesian unemployment).

Furthermore, if the inflation target is credible then investors will realise that any fiscal expansion will be counteracted by a monetary contraction. Therefore, once the fiscal expansion is announce the markets would react by starting to price in a monetary contraction – leading to a strengthening of the country’s currency, falling stock markets and lower inflation expectations – this on its own would counteract the increase in aggregate demand. This is the Chuck Norris effect in fiscal policy.

Obviously in the real world neither monetary policy nor fiscal policy is ever 100% credible and there will always be some uncertainty about the scale and commitment to fiscal expansion and uncertainty about the central bank’s reaction to the fiscal stimulus. However, anybody who have follow developments in the euro zone over the past two years will realise that “promises” of fiscal austerity have been led to a rally in the stock markets (and fixed income markets in the PIIGS countries) as the markets have priced in the impact on aggregate demand of the expected monetary easing from the ECB. This is the reverse Sumner critique – fiscal tightening will not lead to a drop in aggregate demand if the markets expect the central bank to “cover” the short-fall in aggregate demand.

Hence, I think that the Sumner critique is highly relevant for the discussion of fiscal policy today both in Europe and the US. Below I will try to illustrate the Sumner critique with an episode from recent economic history – the German reunification.

The Bundesbank took all the fun out of German reunification 

After the fall of the Berlin wall in 1989 West Germany and East Germany was reunified. Due to the nature of the collapse of communism in East Germany the reunification of Germany happened extremely fast. Hence, most economic-political decisions were highly influenced by political expediency and geo-political and electoral concerns rather than by rational economic considerations.

One such decisions was the imitate political unification of the two Germanys. In fact East Germany was “absorbed” into West Germany. That for example mend that all social benefits and pensions etc., which were available to West German immediately (or more or less so) became available to East Germans and more or less from day one the benefit levels became the same in the entire unified Germany. This obviously led to a rather sharp increase in German government spending. The unification obviously also led to other forms of increases in public spending – for example the Capital was moved from Bonn to Berlin.

It is always hard to estimate how large a fiscal expansion is as the budget situation is not only influenced by discretionary changes in fiscal policy, but also by so-called automatic stabilizers. However, judging from calculation made by the Bundesbank (in the 1990s) the fiscal expansion due to reunification was substantial. In 1989 the cyclical adjusted budget surplus was around 1% of GDP. However, after unification the budget swung into a deficit. In 1990 the cyclical adjusted budget deficit was 2.5% GDP and in 19991 it had increased to 4.2% of GDP. Hence, the fiscal expansion from 1989 to 1991 amounted to more than 5% of GDP. This by any measure is a substantial fiscal easing.

It is very hard to assess what impact this strong fiscal easing had on the German economy – among other things because the Germany of 1989 was not the same country as the Germany of 1990 and 1991. Furthermore, this fiscal easing coincided with significant monetary easing as it controversially was decided to exchange one East Mark for one West Mark. That led to a rather substantial initial increase in the unified Germany’s money supply. However, while it can be hard to assess the direct impact on growth from the fiscal expansion it is much easier to assess the German Bundesbank’s reaction to it.

The Bundesbank was horrified by the scale of fiscal expansion and the potential inflationary consequences and the Bundesbank did not led anybody doubt that it would have to tighten monetary policy to counteract any inflationary consequences of the unification. Secondly, it also pushed strongly for the German government to fast tighten fiscal policy to reduce the budget deficit. Hence, market participants from an early stage would have had to expect that the Bundesbank would tighten monetary policy and that it would “force” the government to tighten fiscal policy. This in many ways is the exact same thing we see in the eurozone today, where the Bundesbank dominated ECB is telling policy makers if you don’t tighten fiscal policy then we will effectively allow monetary conditions to become tighter.

Already in 1991 the Bundesbank moved to counteract perceived inflationary risks and started tightening monetary policy. In a series of aggressive interest rate hikes the Bundesbank increased its key policy rate to nearly 10% in 1992. In that regard it should be noted that the Bundesbank hiked interest rates at a time when global growth was weak due among other things a spike in global oil prices in connection with the first Gulf war. Furthermore, the Bundesbank also put significant pressure on the German government to tighten fiscal policy, which it did in 1992.

There is no doubt that the Bundesbank wanted to demonstrate its independence to the government and probably for exactly that reason chose to be even more aggressive in its monetary tightening that was warranted even according to its own thinking. As a consequence of disagreement between the German government and the Bundesbank the governor of the Bundesbank at the time Karl Otto Pöhl resigned in October 1991 after having initiated monetary tightening.

The monetary tightening in 1991-92 not only sent Germany into a deep and prolonged recession it also was the direct cause of the so-called EMS crisis in 1992-93.

This particular episode in German (and European) monetary history is a powerful illustration of the Sumner critique. It is pretty clear that even substantial fiscal easing (around 5% of GDP) did not have long lasting impact on growth in Germany due to the Bundesbank’s counteractions to curb the perceived (!) inflationary risks.  I do not claim to have proven that the fiscal multiplier is zero, but I hope I have demonstrated that it is that it is unlikely to be positive if the central bank does not play along.

In the case of Germany in the early 1990s the fiscal multiplier was probably even negative as the Bundesbank decided to punish the German government for what it perceived as irresponsible policies. Anybody who is following the political struggle among European governments and European central bankers would have to acknowledge that it is very similar to the situation in Germany after the reunification.

Consequently I think it can be concluded that monetary policy will never be able to lift aggregate demand if the central bank refuse to do so – and that will often be the case if the central bank is worried about its credibility and independence.

I am no Calvinist and I tend to think that some of the calls from certain economists for austerity is rather hysterical given our problems particular in Europe primarily are monetary, however, I do think that the Sumner critique is highly relevant and we under normal circumstances (that is circumstances where the central bank for example pursues an inflation target) should expect the fiscal multiplier to be close to zero.

We all of course also know there are numerous other problems with fiscal easing – for example any temporary increase in public spending seem to become permanent and that is hard good for long-term growth in any economy, but that discussion is more or less irrelevant for the present crisis, which in my view mostly a result of misguided monetary policies rather than failed fiscal policies.

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My discussion above was among other things inspired by Jürg Bibow paper “On the ‘burden’ of German unification” (2003) and a discussion with chief economist in the Danish think tank CEPOS Mads Lundby Hansen

Related posts:

“Meantime people wrangle about fiscal remedies”
Please keep “politics” out of the monetary reaction function
Is Matthew Yglesias now fully converted to Market Monetarism?
Mr. Hollande the fiscal multiplier is zero if Mario says so
Maybe Jens Weidmann and Francios Hollande should switch jobs
There is no such thing as fiscal policy

More on Laffer’s math

I guess that most of my readers have noticed that I have been somewhat upset by Arthur Laffer’s attempt to demonstrate that fiscal stimulus doesn’t work. While I am certainly very skeptical about how fruitful fiscal stimulus will be I was not impressed with Laffer’s “evidence” that fiscal stiumulus does not work. I did, however, not plan to write more on this – as I certainly do not want to promote fiscal easing anywhere and find this fiscal issue somewhat boring and irrelevant for understanding the present crisis – but then I got an interesting email from Jim Allbery.

Jim is not an economist, but a software developer with a degree in math. Jim had been equally upset by the bad math in Laffer’s Wall Street Journal piece as I had been and Jim actually has taken a closer look at Laffer’s math. Jim sent me a note on his considerations about Laffer’s math. I think Jim’s note is rather interesting and Jim has kindly allowed me to publish it. So here is Jim’s comment on Bad Math in the WSJ

Finally, just to get my position clear. I believe there is a rather significant need for fiscal consolidation in both the US and the euro zone. There is therefore no room for fiscal easing in the US or in most euro zone countries. However, the fiscal position is being made worse by overly tight monetary policy, which seriously depresses growth in both the US and the euro zone. I therefore agree with Laffer that fiscal stimulus is not the way forward in the present situation. However, I am no Calvinist and I do not believe that our present problems are due to bad fiscal policies, but rather due to overly tight monetary policy.

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Related posts:

Arthur Laffer you’re embarrassing yourself
More on Laffer and Estonia – just to get the facts right
“Meantime people wrangle about fiscal remedies”
There is no such thing as fiscal policy

David Glasner’s posts on Laffer’s math:
Arthur Laffer, Anti-Enlightenment Economist
A Laffer Postscript

More on Laffer and Estonia – just to get the facts right

Arthur Laffer’s recent piece in the Wall Street Journal on fiscal stimulus has generated quite a stir in the blogosphere – with mostly Keynesians and Market Monetarists coming out and pointing to the blatant mistakes in Laffer’s piece. I on my part I was particularly appalled by the fact that Laffer said Estonia, Finland, Slovakia and Ireland had particularly Keynesian policies in 2008.  In my previous post I went through why I think Laffer’s “analysis” is completely wrong, however, I did not go into details why Laffer got the numbers wrong. I do not plan to go through all Laffer’s mistakes, but instead I will zoom in on Estonian fiscal policy since 2006 to do some justice to the fiscal consolidation implemented by the Estonian government in 2009-10.

In his WSJ article Laffer claims that the Estonian government has pursued fiscal stimulus in response to the crisis. Nothing of course could be further from the truth. One major problem with Laffer’s numbers is that he is using public spending as share of GDP to analyze the magnitude of change in fiscal policy. However, for a given level of public spending in euro (the currency today in Estonia) a drop in nominal GDP will naturally lead to an increase in public spending as share of GDP. This is obviously not fiscal stimulus. Instead it makes more sense to look at the level of public spending adjusted for inflation and this is exactly what I have done in the graph below. I also plot Estonian GDP growth in the graph. The data is yearly data and the source is IMF.

Lets start out by looking at pre-crisis public spending. In the years just ahead of the escalation of the crisis after the collapse of Lehman Brother in the autumn of 2008 public spending grew quite strongly – and hence fiscal policy was strongly expansionary. I at the time I was a vocal critique of the Estonian’s government fiscal policies.

There is certainly reason to be critical of the conduct of fiscal policy in Estonia in the boom-years 2005-8, but it does not in anyway explain what happened in 2008. Laffer looks at changes in fiscal policy from 2007 to 2009. The problem with this obviously that he is not looking at the right period. He is looking at the period while the Estonian economy was still growing strongly. Hence, while the Estonian economy already started slowing in 2007 it was not before the autumn of 2008 that the crisis really hit. Therefore, the first full crisis year was 2009 and it was in 2009 we got the first crisis budget.

So what happened in 2009? Inflation adjusted public spending dropped! This is what makes Estonia unique. The Estonian government did NOT implement Keynesian policies rather it did the opposite. It cut spending. This is clear from the graph (the blue line). It is also clear from the graph that the Estonian government introduced further austerity measures and cut public spending further in 2010. This is of course what Laffer calls “fiscal stimulus”. All other economists in the world would call it fiscal consolidation or fiscal tightening and it is surely not something that Keynesians like Paul Krugman would recommend. On the other hand I think the Estonian government deserves credit for its brave fiscal consolidation. The Estonian government estimates that the size of fiscal consolidation from 2008 to 2010 amounts to around 17% (!) of GDP. I think this estimate is more or less right – hardly Krugmanian policies.

And maybe it is here Laffer should have started his analysis. The Estonian government did the opposite of what Keynesians would have recommend and what happened? Growth picked up! I would not claim that that had much to do with the fiscal consolidation, but at least it is hard to argue based on the data that the fiscal consolidation had a massively negative impact on GDP growth. Laffer would have known that had he actually taken care to have proper look at the data rather than just fitting the data to his story.

Laffer of course could also have told the story about the years 2011 and 2012, where the Estonian government in fact did introduce (moderate) fiscal stimulus. And what was the result? Well, growth slowed! The result Laffer was looking for! Again he missed that story. I would of course not claim that fiscal policy caused GDP growth to slow in 20011-12, but at least it is an indication that fiscal stimulus will not necessary give a boost to growth.

I hope we now got the facts about Estonian fiscal policy right.

PS David Glasner has an excellent follow-up on Laffer’s data as well.

PPS If you really want to know what have driven Estonian growth – then you should have a look at the ECB. Both the boom and the bust was caused by the ECB. It is that simple – fiscal policy did not play the role claimed by Laffer or Krugman. It is all monetary and I might do post at that at a later stage.

PPPS Time also has an article on the “Laffer controversy”

Guest post – Keynes: Evidence for Monetary Policy Ineffectiveness? (Part 2, by Clark Johnson)

Guest post: Part 2 – Keynes: Evidence for Monetary Policy Ineffectiveness (continued)

By Clark Johnson

(See the previous post in this series here)

a)    The 1937-38 Contraction in the US

A few years later, Keynes disregarded evidence of the role of monetary policy in triggering a sharp relapse into near-depression conditions in the US during 1937-1938.  The dollar depreciation of 1933 and the formal increase of the gold price to $35/ ounce in 1934 meant automatic revaluation of central bank gold stocks and gave impetus to increased gold exploration and production – concentrated, as it happened, in the Soviet Union.  (Keynes noted the irony that increased Soviet efficiency in mining of gold was bailing out world capitalism!) He also noted that new gold reserves were bringing increased effective demand to the world economy that might result in “abnormal profits.” [1]  Keynes understood (at least some of the time) the role of growing liquidity in the economic recovery of the mid-1930s.

In what now appears as one of the worst mis-steps in its history, the Federal Reserve, responded to rising wholesale prices in 1936 by deliberately sterilizing new gold inflows.[2]  A money supply measure (M2) that increased by 12 percent annually during 1934 -1936, suddenly turned flat and even slightly negative from about January 1937 to July 1938.[3]  Real GDP fell by 11 percent during this period, and industrial production fell by 30 percent.  Rather than sterilize gold, had the Fed intervened in financial markets to target a modest rate of increase in any of a number of variables – a price index, industrial production, either real or nominal GDP growth, even a money supply indicator – most of the 1937-1938 contraction could have been avoided.  By August 1938, the sterilization policy was jettisoned, and economic recovery resumed.

In February 1938, Keynes offered advice in a private letter to President Roosevelt that mentioned little of this.  He did acknowledge that addressing “credit and insolvency problems” was an essential step toward recovery, as this created a necessary “supply of credit” – while, one infers, demand for that credit would have to come from elsewhere.  This comment reflected Keynes’ ongoing view that expected returns on investment – the schedule of marginal efficiencies of capital — was independent of monetary policy.  He went on the recommend that the US could “maintain prosperity at a reasonable level” only through “large-scale recourse to … public works and other Investments aided by Government funds or guarantees.” [4]

Despite Keynes’ recommendations, the lesson of all four of the illustrations here is that increasing money balances – through open market purchases, or through new gold or foreign exchange reserves – does affect expected returns on investment in plant and equipment, in equities, and in real estate.

ARGUMENTS FOR FISCAL  ACTIVISM

We could stop here, having assembled evidence of Keynes’ dubious conclusions about relative un-importance of monetary factors in specific pivotal events.  Indeed, evidence from these cases points strongly in the opposite direction, toward the crucial role of such factors.  But the prominence of Keynes’ fiscalist legacy requires that we go further.   Evidence aside, what was Keynes’ argument?   In fact, he had a sequence of arguments.

In 1929, Keynes offered a comparative argument in favor of fiscal stimulus, and against monetary stimulus, specific to economic circumstances in Britain at the time.[5]  Keynes anticipated some portion of an argument Robert Mundell was to make decades later regarding the “policy mix,” that is, the appropriate mix of monetary and fiscal policy to meet both domestic output and external exchange rate targets.[6]  Britain in 1929 was on the international gold standard, hence was constrained externally by the need to maintain gold reserves.  The Bank of England could not simply create credit, because, Keynes reasoned, “such credit might find its way to foreign borrowers, with the result of a drain of gold out of the Bank.”  Hence Keynes proposed fiscal stimulus to increase domestic demand and employment, alongside monetary constraint to maintain Britain’s reserve and exchange rate targets.

This well-grounded argument also offers possible insight into the 1890s, where demand for gold reserves among central banks generated monetary contraction.  Keynes, as we saw, did not make that argument – but we can construct it post facto.  While the best solution might have been some international agreement to increase demand by modifying the international gold standard, a purely national approach could have looked to a fiscalist demand boost.  But Keynes soon abandoned this policy-mix argument.

a)    Removing external constraint on Monetary Policy

The US had freedom of action in monetary policy in 1933 and 1934.  By March 1933, the dollar had been floated against gold, hence removing the external policy constraint – and, in any event, the US had by then accumulated vast gold reserves.  In Keynes’ comments in January 1934, he had moved beyond his 1929 analysis.  His newer interest was to argue that fiscal activism was preferable to monetary expansion even if the latter was not constrained.

Keynes in the General Theory (Ch. 15, “Incentives to Liquidity,”) offered the argument that monetary policy was specifically unsuited to boost economic demand when interest rates approached zero percent.  In conditions where interest rates could not be lowered further, he reasoned, a condition of “absolute liquidity preference” held, later dubbed a “liquidity trap.”  He observed, “In this event, the monetary authority would have lost effective control over the rate of interest.”  This argument is cited endlessly by later-day Keynesians in support of a fiscalist agenda.  (For example, see the reference to Summers mentioned at the outset.)

But the argument establishes much less than Keynes needed for his fiscalist agenda.  Near-zero interest rates did not prevail in any of the four situations discussed earlier – yet Keynes wanted fiscal activism in all of them.  So his case against monetary activism went beyond situations of absolute liquidity preference.

As noted earlier, Keynes pointed to a collapse in the marginal efficiency of capital as the trigger for the “slump of 1930.”  The General Theory does much more to advance the concept that investment volume is unstable.   Much of Keynes’ vision for government intervention, including fiscal activism, follows from his discussion of the fickleness of financial markets (Ch. 12, “Long Term Expectations.”)  Noting the instability of private sector investment volume, he advocated a larger role by the government in stabilizing investment demand, often through direct outlays.

Keynes’ argument often shifted from the instability of the investment function to concern that investment was and would remain chronically weak – hence the conclusion that high unemployment was not self-correcting, but could persist for years.  In Ch. 17 on the “Essential Properties of Interest and Money,” Keynes noted situations where the:

…rate of interest declines more slowly, as output increases, than the marginal efficiencies of capital-assets measured in terms [of the same asset].[7]

As formulated in one of several instances in Ch. 22 (“Notes on the Trade Cycle”):

A more typical, and often the predominant, explanation of the crisis is, not primarily a rise in the rate of interest, but a sudden collapse in the marginal efficiency of capital.[8]

This pattern of falling marginal efficiencies of capital made Keynes increasingly skeptical of monetary remedies.[9]

A counter-argument is that adding liquidity – through open market purchases, gold inflows, or variations on these – might directly boost demand, and hence boost the marginal efficiency of capital, by increasing cash balances.  But Keynes usually argued, to the contrary, that monetary policy worked mainly through raising or lowering interest rates –this was certainly a premise of the “liquidity trap” argument in Ch. 15.  Further on, he wrote that “the primary effect of a change in the quantity of money on the quantity of effective demand is through its effect on the rate of interest.”[10]  In the Treatise chapter on “Control of Investment,” where he calls for open market operations a outrance, the goal is to bring “the market rate of interest … down to the limiting point.”  In 1937 articles on “finance,” where Keynes stressed the crucial role of monetary policy, he again emphasized the channel of lowering interest rates.[11]


[1] Keynes, “The Supply of Gold,” Economic Journal, Sept 1936.

[2] That is, coupling purchases of gold with offsetting sales of other central bank assets to drain liquidity

[3] Doug Irwin, Gold Sterilization and the Recession of 1937-1938,  NBER Working Paper No. 17595, Nov 2011.

[4] In Collected Works of JM Keynes, Vol 21, pp. 434-39.

[5] Keynes, “A Program of Expansion (General Election, May 1929),” in Essays on Persuasion (1931), p. 124f.

[6] For ex., Robert Mundell, The Dollar and the Policy Mix (1973)

[7]Keynes, General Theory of Employment, Interest, and Money (1936), p. 236.

[8] General Theory, p. 315.

[9] Axel Leijonhufvud offers a variation on this argument with the comment that in in Ch. 37 of the Treatise “the assumption that entrepreneurs are right was dispensed with” – that is, entrepreneurs became, in Keynes’ judgment, excessively bearish.  In “Keynes and the Effectiveness of Monetary Policy,” Information and Coordination (1981).  Leijonhufvud argues that Keynes’ subsequent arguments therefore relied more on fiscal intervention.

[10] General Theory, p. 298.

[11] For ex.,Keynes, “The ‘Ex Ante’ Theory of the Rate of Interest,” Economic Journal 46 (1937)

Guest post – Keynes: Evidence for Monetary Policy Ineffectiveness? (Part 1, by Clark Johnson)

I am extremely happy to announce that my blog this week will feature four guest posts by Clark Johnson. I have for some time tried to convince Clark to write something for my blog so I was very happy when Clark’s manuscript for his paper Keynes:  Evidence for Monetary Policy Ineffectiveness?” arrived in my in-box recently. Clark and I have decided to split up the paper in four parts which will be published in the coming four days.

Clark Johnson is not only a brilliant economic historian and author of the great book “Gold, France, and the Great Depression, 1919-1932”, but he is also a clever observer of the current monetary policy debate. Clark last year authored an insightful paper on the causes of the Great Recession, which in my view already is a Market Monetarist classic.

Lars Christensen

Guest post 

Keynes:  Evidence for Monetary Policy Ineffectiveness? (Part 1)

by Clark Johnson

Lawrence Summers, who was President Obama’s chief economist during 2009-2010, and who by accounts continues to be an important advisor, recently called on the US and other government to increase borrowing at current very low interest rates.[1]  He observes that, based on inflation-protected bond rates, current Treasury borrowing costs for securities of five and ten year maturities are negative.  He adds that interest rates elsewhere in the world – Germany, Japan, and Britain – are also extremely low.  He then argues that governments should look on such rates as an opportunity to borrow cheaply and thereby improve their long-term fiscal positions.

Summers is presumably correct from a fiscal management perspective about benefits of borrowing when interest rates are low.  But as a macroeconomic strategy for recovery, that is only the beginning.  Whether we turn to John Taylor on the right or Paul Krugman on the left, the essential element for fiscal stimulus to succeed is to stabilize expectations: will the stimulus continue for long enough to drive expectations, so that market participants know the boost will ongoing and not soon withdrawn?    Summers’ then shifts to monetary policy, where his case is weaker.  He says there is no point in “quantitative easing”, the open-market mechanism the Federal Reserve uses to inject reserves, as interest rates are already rock-bottom – and monetary easing works, he explains, through the mechanism of lowering interest rates.  Presumably, this is what he has been telling Obama since 2009.

Summers’ reasoning draws at least in part, on John Maynard Keynes’ discussion about “absolute liquidity preference” that occur when interest rates are very low, and demonstrates a key argument used in policy circles against more aggressive use of monetary policy.   I believe Keynes was, and Summers is, mistaken.  Literature on Keynes is abundant.  To gain a different perspective, I want to look at various evidence Keynes adduced against monetary remedies.  I will then return to arguments he used in the General Theory (1936) and elsewhere, hopefully with fresh perspectives.

KEYNES’  ILLUSTRATIONS FOR MONETARY POLICY INEFFECTIVENESS

A portion of Keynes’ reputation as an economist, and of his place in history, rest on his diagnoses of crisis situations and his proposed remedies.  Well-known examples include his tract on the post-World War One Versailles Conference, The Economic Consequences of the Peace (1921), and subsequent writings on hyperinflations and then on British deflation during the 1920s.   Another, less well-known, was his discussion of French monetary and political crises during 1925 and 1926, which I credited in my own work on the period.[2]  His two-volume Treatise on Money (1930) provided detailed and often shrewd observations on a wide range of economic policy matters.

In contrast, the General Theory, the heart of Keynes’ contribution to economic ideas, is light on historical or even contemporary illustration.  So the reader seeks to fill in the gaps by turning to other writings.  Consider four prominent cases as they reflect on Keynes’ view of roles of monetary and fiscal policy.

a)    British Deflation in the 1890s

An unexpected embrace of fiscal activism comes in the Treatise discussion of the deflation of the early 1890s, where Keynes argued that the Bank of England’s gold reserves were abundant and credit was easy.  But prices in Britain and the world nevertheless went into decline, which undermined profit and investment and reduced employment.  He wrote:

I consider, therefore, that the history of this period [1890-1896] is a perfect example of a prolonged Commodity Deflation – developing and persisting in spite of a great increase in the total volume of Bank-Money.  There has been no other case where one can trace so clearly the effects of a prolonged withdrawal of entrepreneurs from undertaking the production of new fixed capital on a scale commensurate with current savings.

Keynes then concluded (anticipating his arguments a few years later, including in the General Theory,) that monetary expansion does not always work, and that there might therefore be a role for public investment projects to boost demand.[3]

Keynes’ discussion of the 1890s misses the point.  Britain in the late nineteenth century was part of an open world economy, with easy movement of goods, people, and especially capital.  Keynes neglected to mention that system-wide demand for gold rose much more than the supply from the 1870s through the 1890s as nearly two dozen countries adopted or re-adopted the gold standard, and hence needed to accumulate reserves.  Indeed, demand drove the commodity-exchange value of gold to the highest level it was to reach in four centuries of record-keeping[4] — the flip-side of commodity price deflation.  The commodity price decline reduced profits and chilled investment demand; but commodity prices were determined in international markets, not in Britain.

While demand for gold was surging, the world’s monetary gold supply in the mid-1890s was at its lowest point it was ever to reach relative to its 1800-1920 trend line.[5]  As the mines in the South African Rand cranked up production in the 1890s, relative gold supply and commodity prices increased, nearly in tandem after 1896 – thus ending the Commodity Deflation, and initiating a gentle inflation.  A growing money stock affected not just the supply of credit (as reflected in a declining interest rate), but also the demand for it.  A result was nearly two decades of economic growth in all of the industrial powers, which was sadly interrupted by the First World War.

Monetary events were at the heart of both the origins of and recovery from the depression of the early 1890s.  Keynes himself gave this backhand acknowledgement with his comment a few paragraphs later that, “the fall of prices [in the early 1890s] could only have been avoided by a much greater expansion of the volume of bank-money.”  It is revealing that Keynes could discuss price trends during that period without mentioning the geographic expansion of the gold standard – easily the most important monetary development of the era.

b)    The onset of the Great Depression

Moving to then contemporary events, Keynes’ discussion of the “slump of 1930,” also in the Treatise, builds on similar themes.[6]  Gustav Cassel and Ralph Hawtrey had argued a few years earlier that the undervaluation of gold following restoration of gold standards at prewar gold prices would force world-wide monetary contraction, especially as former belligerents Britain, France, Germany, and Italy restored their gold standards.   Keynes, in contrast, told the Royal Commission on Indian Currency in 1926 that central banks would adjust their currency reserve cover ratios if  their gold stocks became inadequate – which allowed him to dismiss the danger.  Keynes underestimated what we might call the mystique of gold money.

Keynes listed factors driving interest rates higher during the 1920s: corporate borrowing for new industries; governments borrowing to pay reparations and war debts; central banks borrowing to add reserves; and speculators borrowing to buy shares of stock.  He identified but was less able to explain the collapse internationally in anticipated returns in investment – what he would later call the marginal efficiency of capital — that occurred in the mid-1920s.  As in considering the early 1890s, he did not connect the fall-off in real yields on new investment with systemic monetary constraint.  Parallel to what happened in the 1890s, the middle and late 1920s saw a commodity deflation as key countries adopted or returned to gold standards.  He thought monetary expansion worked through lowering interest rates, without directly affecting demand for goods and services.  He wrote that the only ways to boost demand were by lowering interest rates, especially long rates, further – or by government fiscal activism.  He did not understand that the world required a higher gold price to restore gold-to-currency reserve ratios, or perhaps needed a departure from gold money altogether.

c)     The Roosevelt Recovery in 1933

Keynes’ comments in January 1934 on the monetary-fiscal mix in the US were baffling.  In one of his initial acts after Roosevelt’s accession to power in March 1933, the dollar was allowed to depreciate against gold.  This was a momentous event in monetary history – the underlying cause of the interwar deflation had been removed, and the gold standard was never restored with the same conviction.  Keynes nevertheless wrote:

One half of [Roosevelt’s] programme has consisted in abandoning the gold standard, which was probably wise, and in taking various measures … to depreciate the gold value of the dollar… [But i]t is not easy to bring about business expansion merely by monetary manipulation.  The other half of his programme, however, is infinitely more important and offers in my opinion much greater hopes.  I mean the effort to cure unemployment by large-scale expenditure on public works and similar purposes.[7]

This summary scarcely acknowledges the results of the real-time experiment in expansionary monetary policy undertaken in the US within the previous year.  Depreciation succeeded at least to the extent any advocate could have hoped.  Industrial production soared by 57 percent during the first four months of the Roosevelt Administration beginning in March 1933 – this was the actual increase, not an annualized rate — making up half of what had been lost since 1929.  It was the fastest four-month rate of expansion in industrial production in the history of the US. Yet Keynes apparently considered this event to be “infinitely” less important than the boost to come from fiscal borrowing for public works programs.

Had the experiment continued for a few months more, pre-crash production levels might have been recovered.  Unfortunately, the NIRA (National Industrial Recovery Act, announced in July 1933, brought micro-policy changes that had the effect of stopping the recovery in its tracks.  The NRA (National Recovery Administration), set up under NIRA, then negotiated specific sets of codes with leaders of the nation’s major industries; the most important provisions were anti-deflationary floors below which no company would lower prices or wages, and agreements on maintaining employment and production. Within a short time, the NRA reached agreements with most major industries. In a phrase, the NIRA wanted to increase prices by restricting output rather than by increasing demand.   Scott Sumner provides several rounds of evidence for the contractionary impact of NIRA policy in his soon-to-arrive book, The Midas Curse: Gold, Wages, and the Great Depression.

Lest this appear suspect as a predictable right-wing narrative of the New Deal, consider that Keynes himself pointed to the “fallacy” of the NRA approach: He noted that “rising prices caused by deliberately increasing prime costs or by restricting output have a vastly inferior value to rising prices which are the natural result of an increase in the nation’s purchasing power.”  He added that it was “hard to detect any material aid to recovery in the National Industrial Recovery Act.”[8]  Within six months after the NRA went into effect, industrial production had dropped twenty-five percent,[9] erasing nearly half of the gains recorded during Roosevelt’s more successful initial months in office.

So here we are.  We saw an historically sharp recovery for four months during 1933, driven almost entirely by a decision to break the straightjacket imposed on monetary policy by the international gold standard.  Keynes had previously been an able critic of the gold standard, for example in the Tract on Monetary Reform (1923) and then in several chapters in the Treatise. The 1933 recovery was then stalled by micro-policies of which he was explicitly critical.  Yet Keynes seemed to dismiss this entire episode in his call a few months later for fiscal stimulus!


[1] Lawrence Summers, “Look beyond interest rates to get out of the gloom,” Financial Times, 3 June 2012

[2] H. Clark Johnson, Gold, France, and the Great Depression, 1919-1932  (Yale, 1997)

[3] John Maynard Keynes, Treatise on Money (1930), Ch. 30 (ii).

[4] Roy Jastram, The Golden Constant (1977)

[5] League of Nations chart, reproduced in Johnson, p. 52.

[6] Treatise, Ch. 37 (iv) “The Slump of 1930.”

[7] Keynes, “Roosevelt’s Economic Experiments,” The Listener, 17 January, 1934.

[8] Keynes, “Mr. Roosevelt’s Experiments,” London Times, 02 Jan 1934.

“Meantime people wrangle about fiscal remedies”

The other day I wrote a piece about the risks of introducing politics (particularly fiscal policy) into the central bank’s reaction function. I used the example of the ECB, but now it seems like I should have given a bit more attention to the Federal Reserve as Fed chief Bernanke yesterday said the follow:

“Monetary policy is not a panacea, it would be much better to have a broad-based policy effort addressing a whole variety of issues…I’d be much more comfortable if, in fact, Congress would take some of this burden from us and address those issues.”

So what is Bernanke saying – well he sounds like a Keynesian who believes that we are in a liquidity trap and that monetary policy is inefficient. It is near-tragic that Bernanke uses the exact same wording as Bundesbank chief Jens Weidmann used recently (See here). While Bernanke is a keynesian Weidmann is a calvinist. Bernanke wants looser fiscal policy – Weidmann wants fiscal tightening. However, what they both have in common is that they are central bankers who apparently don’t think that nominal GDP is determined by monetary policy. Said, in another other way they say that nominal stability is not the responsibility of the central bank. You can then wonder what they then think central banks can do.

What both Weidmann and Bernanke effectively are saying is that they can not do anymore. They are out of ammunition. This is the good old  “pushing on a string” excuse for monetary in-action.  This is of course nonsense. The central bank can determine whatever level for nominal GDP it wants. Just ask Gedeon Gono. It is incredible that we four years into this mess still have central bankers from the biggest central banks in the world who are making the same mistakes as central bankers did during the Great Depression.

Yesterday Scott Sumner quoted Viscount d’Abernon who in 1931 said:

“This depression is the stupidest and most gratuitous in history!…The explanation of our anomalous situation…is that the machinery for handling and distributing the product of labor has proved inadequate. The means of payment provided by currency and credit have fallen so short of the amount required by increased production that a general fall in prices has ensued…This has not only caused a disturbance in the relations between buyer and seller, but has gravely aggravated the situation between debtor and creditor. The gold standard, which was adopted with a view to obtaining stability of price, has failed in its main function. In the meantime people wrangle about fiscal remedies and similar devices of secondary importance, neglecting the essential question of stability in standard of value…The situation could be remedied within a month by joint action of the principal gold-using countries through the taking of necessary steps by the central banks.”

It is tragic that the same day Scott quotes d’Abernon Ben Bernanke “wrangles about fiscal remedies”. Bernanke of course full well knows that the impact on nominal GDP and prices of fiscal policy depends 100% on actions of the Federal Reserve. Fiscal policy does not determine the level of NGDP – monetary policy determines NGDP (Remember MV=PY!).

The Great Depression was caused by monetary policy failure and so was the Great Recession (See here and here). In the 1930s the Lords of Finance Montagu, Norman, Meyer, Moret, Stringher, Hijikata and Schacht were all wrangling about fiscal remedies and defended their failed monetary policies. Today the New Lords of Finance Bernanke, Shirakawa, Draghi and Weidmann are doing the same thng. How little we – or rather central bankers – have learned in 80 years…

UPDATE: Maybe our New Lords of Finance should read this Easy Guide to Monetary Policy.

Guest blog: NGDP Targeting is NOT just for Central Banks! (David Eagle)

Guest blog: NGDP Targeting is NOT just for Central Banks!

By David Eagle

Because of Lars Christensen’s blog on “Market Monetarism vs Krugmanism,” I am interjecting a new topic into my guest blog series.  I agree with the comments from JJA and Scott B. on Scott Sumner’s blog.  While some of the market monetarists do not believe in the effectiveness of fiscal policy, I think there is a great opportunity for those fiscal conservatives among us to openly welcome Keynesians to bring fiscal policy into the realm of NGDP targeting.  I agree with JJA that NGDP targeting should be the aim for BOTH monetary and fiscal policy.  In other words, both monetary and fiscal policy should target NGDP, although under normal times that responsibility should fall on the central bank.  Let me restate this very important statement: The role of fiscal policy in stimulating aggregate demand should also be governed by the NGDP target.  In other words, if NGDP is below target and the central bank says it needs help from fiscal policy to boost NGDP, then those in favor of using fiscal policy should advocate for fiscal stimuli.  However, when NGDP is at or above target, then the fiscal policy should be directed towards fiscal surpluses to make up for the previous deficit spending.  If the central bank and fiscal authorities were to agree on a NGDP target, then we would not have had the huge fiscal deficits that we did have preceding 2008.

However, unfortunately the central bank and fiscal authorities have not been following a mutually agreed upon and transparent NGDP target.  Because of the murky waters concerning what the central bank is doing, fiscal and monetary policy often work in different directions.  In particular, when the central bank targets inflation, it often is not clear what the central bank’s intentions are with regard to NGDP.  (Because I agree with Scott Sumner that we should treat NGDP and aggregate demand as the same concept, even a central bank targeting inflation should be transparent about what its intentions are concerning aggregate demand, i.e., NGDP; but alas central banks today are not that transparent.)  Because of these murky waters, politicians have often been able to pass politically desirable tax cuts and increased government spending under the guise of stimulating the economy (i.e., stimulating aggregate demand, i.e., stimulating NGDP), even though the central bank is content to let bygones be bygones and keep NGDP on its current track, but consistent with its future inflation target.

The Japanese Experience:

Take Japan, for example, where the Bank of Japan was under pressure to be more independent of the Japanese Government and be more like “western central banks” at maintaining price stability.[1]  Then came the 1990s and the Japanese Government followed Keynesian fiscal policy to stimulate the economy.  Meanwhile the Central Bank of Japan was determined to follow in Paul Volker’s footsteps of regaining credibility for maintaining price stability.  As Scott Sumner (2011) reported, the Bank of Japan actually pursued restrictive monetary policy at times when the Japanese government was trying to be expansionary with its fiscal policy.[2]  Because they were pulling the economy in two different directions, the result was (i) the Bank of Japan offsetting much of what the aggregate-demand effects of the fiscal stimuli, and (ii) the national debt in Japan skyrocketed from 51% of GDP at the beginning of the 1980s to over 220% now.  Then came 3/11/11, the day of the triple supply shock in Japan – earthquake, tsunami, and nuclear crisis.  In addition to their enormous national debt, now Japan faces the high costs of rebuilding.

Lack of Coordination between US Fiscal Policy and the Federal Reserve:

The United States I think is another example.  In 2003, the Bush administration passed tax cuts and kept them in place for a long time (they are still in place today).  These tax cuts were to stimulate the economy.  However, at the same time, the Federal Reserve was content to “let bygones be bygones” and let the NGDP base drift caused by the 2001 recession continue (see my guest blog that explains NGDP base drift).  As a result, if the tax cuts did have any stimulative effect, the Federal Reserve would have countered them with monetary policy.  On the other hand, if both the Federal Reserve and the Bush administration had agreed upon a NGDP target, and if that NGDP target was above where NGDP was at the moment, then the Federal Reserve could have tried to boost NGDP by using tools that Ben Bernanke said he had and that Scott Sumner believes he had.[3]  Also, as I will explain in a later guest blog, expectations has an important role to play.  If the public expects the central bank and fiscal policy to succeed in boosting NGDP up to its target, then they will be more inclined to spend more because of higher expected short-term inflation, helping the monetary and fiscal policy reach this goal.  Unfortunately, despite all the rhetoric about the transparency of inflation targeting (IT), IT is not as transparent as NGDP targeting.  I believe the ultimate in transparency for both monetary and fiscal policy is NGDP targeting.

The Two-Headed British Media:

Sumner (2011) reports an example in Britain of how the lack of transparency with regard to aggregate demand, i.e. NGDP, led to the British media simultaneously condemning both fiscal and monetary policy simultaneously:

“Recent events in Britain provide a perfect example of the confusion generated by drawing this sort of false dichotomy between monetary and fiscal policy. The government of Prime Minister David Cameron has been sharply criticized for its policy of fiscal austerity. The recovery from the recent recession has been even weaker in Britain than in the United States, and there are fears that budget cuts will lead to a double-dip recession. At the same time, the press has been highly critical of the Bank of England for allowing inflation to rise far above the 2% target. But these criticisms cannot both be correct: Either Britain needs more aggregate demand or it does not. If it needs more, then the inflation rate in Britain needs to rise even higher, because the Bank of England needs to provide even more monetary stimulus. If inflation is too high and Britain needs less aggregate demand, then [the British] should desire fiscal austerity that would slow the economy. The press seems to believe in some sort of policy magic whereby fiscal stimulus can create growth without inflation and monetary tightening can reduce inflation without affecting growth.” (brackets added after consultation with Scott Sumner)

If the British media is confused, then obviously the British public is confused.  If British fiscal and monetary policy both pursued a NGDP target, I believe the British media and British public would finally understand that it cannot criticize both fiscal and monetary policy under these circumstances.  As I said before, expectations plays an important part to boosting aggregate demand (NGDP), and I know no better way to guide the public expectations concerning aggregate demand than a credible and transparent NGDP target for both monetary and fiscal policy.

Summary: NGDP targeting for both fiscal and monetary policy:

In summary, if the central bank and those in favor of fiscal policy could agree on a NGDP target and then jointly pursue that target, our economies would be so much better today.  In particular, on the fiscal side, we would have no justification for the high federal government debt we have accumulated.  If fiscal policy followed a NGDP target, then over half the time we should have fiscal surpluses rather than fiscal deficits.  Also, a NGDP target is so much more transparent for both fiscal policy and monetary policy than the murky waters of inflation targeting that we face today.  With fiscal policy and monetary policy following a NGDP target, expensive fiscal stimuli could not be justified to stimulate the economy when NGDP is at or above target.

Reference:

Sumner, Scott (2011). “Re-Targeting the Fed,” National Affairs Issue #9.


[1] Ben Bernanke (http://www.federalreserve.gov/newsevents/speech/bernanke20100525a.htm) reported in 2010, “The importance of central bank independence also motivated a 1997 revision to Japanese law that gave the Bank of Japan operational independence.9 This revision significantly diminished the scope for the Ministry of Finance to influence central bank decisions, thus strengthening the Bank of Japan’s autonomy in setting monetary policy.”

[2] Scott Sumner states, “But the Japanese twice tightened monetary policy in an environment of zero inflation (in 2000 and 2006), so it would be hard to claim that they were trying to create inflation.”

[3] Sumner (2011, p. 4) states, ““But the Fed itself never claimed to be ‘out of ammunition,’ even after rates hit zero.  Indeed, Chairman Ben Bernanke has repeatedly stressed that the Fed still has many options for boosting demand, and he has proved the point with two rounds of ‘quantitative easing.’  Indeed, it is hard to see how a fiat-money central bank would ever be left unable to boost nominal spending.  That would logically imply it was unable to raise the rate of inflation – that is, to ‘debase the currency,’ which it can always do.  There is no example in history of any fiat-money central bank that tried to create inflation and failed.”

© Copyright (2012) by David Eagle

Guest blog: The Integral Reviews: Paper 3 – Hall (2009)

Guest blog – The Integral Reviews: Paper 3 – Hall (2009)
by “Integral”

Reviewed: Robert Hall (2009), “By How Much Does GDP Rise If the Government Buys More Output?” NBER WP 15496

Executive summary

The average government purchases multiplier is about 0.5, taking into account empirical and structural evidence. The only way to get “large” multipliers of 1.6 is to assume a large degree of non-optimizing behavior, an inflexible wage rate, at the zero lower bound on nominal interest rates, and assuming monetary policy is completely ineffective at influencing aggregate demand but the fiscal authority retains that influence.

The key ingredients to generating a large output multiplier are sticky wages/prices, a highly countercyclical markup ratio, and “passive” monetary policy which does not counteract the fiscal expansion.

The assumptions that underlie “the effectiveness of monetary policy” (sticky prices and a countercyclical markup) also drive “the effectiveness of fiscal policy.” The two are similar in that respect.

Summary

Hall provides a convenient overview of the state of economic knowledge about the government purchases multiplier. He does this in four steps: simple regression evidence, VAR evidence, structural evidence from RBC models, and structural evidence from various sticky-price/sticky-wage models.

Empirical evidence begins with the simple OLS regression framework. Hall obtains the output multiplier by regressing the change in military expenditures (a proxy for the exogenous portion of government spending) on the change in output. He finds multipliers significantly larger than zero but less than unity, mostly in the neighborhood of one-half. This estimate of the “average multiplier” is confounded by two problems: (1) the implied multiplier be taken as a lower bound rather than an unbiased estimate due to omitted variable bias, and (2) the estimates are driven entirely by observations during WWII and the Korean War.

The VAR approach produces a range of estimates. Hall surveys five prior studies and finds that the government purchases multiplier is non-negative upon impact across all studies and consistently less than unity, but there is much variation in the exact point estimate. The VAR approach typically suffers the same omitted variable bias as OLS.

Hall then turns to a review of the structural evidence. He first shows the standard RBC result that if wages and prices are flexible, the output multiplier is essentially zero or even negative. While a useful benchmark this is not particularly useful for applied work.

Adding wage frictions forces laborers to operate off of the labor supply curve, so output could plausibly expand from an increase in government demand. Hall indeed finds that the multiplier is higher in small-scale NK models and depends on consumer behavior. With consumers pinned down by the permanent-income/life-cycle model, multipliers tend to range around 0.7. If consumers are rule-of-thumb or iiquidity constrained, one finally finds multipliers above unity, in the neighborhood of 1.7, in the presence of the zero lower bound on nominal interest rates.

Review

The empirical evidence is plagued by persistent endogeniety and omitted-variable bias, which Hall frankly acknowledges. Identification is extraordinarily difficult in macroeconomics; as a practical matter it is impossible to untangle all of the interrelated shocks the economy experiences each year.

On the theory side, Scott Sumner would consider this entire exercise a waste of time: the Fed steers the nominal economy and acts to offset nominal shocks; government shocks are a nominal shock, so the Fed will act so as to ensure that the government expenditures multiplier is zero, plus or minus some errors in the timing of fiscal and monetary policy.

Is this a good description of the world? On average over the postwar period, a $1 exogenous change in government spending has led to a $0.50 increase in output; excluding the WWII and Korean War data drive this number down significantly. As a first-order approximation the fiscal multiplier is likely zero on average. But we don’t care about the average, we care about the marginal multiplier, at the zero bound. In that scenario, multipliers are on average higher but still below unity. A crucial open question is to what degree the monetary authority “loses control” of nominal aggregates at the zero lower bound, and to what degree fiscal policy is impacted if the monetary authority is “helpless”. (If we are in a situation where the Fed cannot move nominal aggregates, why wouldn’t Congress be similarly constrained?)

Hall’s paper does not explicitly discuss monetary policy. However, adding a monetary authority to his models would only reduce the already-low multipliers that Hall uncovers. His point, that one cannot plausibly obtain multipliers in excess of unity in a modern macro model, is already well-established even without explicitly accounting for the central bank.

Christensen’s “postmodernist mind fuck”

I have now been blogging since early October last year and I truly enjoy it. Most of my readers seem to be happy about what I write and I believe that most of my readers and commentators are quite Market Monetarist sympathies. However, there is one exception – lefty blogger Mike Sax. Yes, I called him lefty – I don’t think Mike would not disagree with this (if he called me a libertarian that would not make me angry either…). Mike is actually reading the Market Monetarist blogs and I think he pretty much understands what we are talking about. I will readily acknowledge that despite the fact that I probably disagree with 99% of what he has to say about economics and monetary theory.

Today I ran into a comment Mike wrote a couple a days ago about the debate about fiscal policy between on the one side the New Keynesian (Old Keynesians??) and on the other side the Market Monetarists  (and John Cochrane). Even though Mike is extremely critical of  my views I actually had quite a lot of fun reading it.

Here is Mike Sax (and yes, believe it or not the name of his blog is “Diary of a Republican Hater”…):

“If you want to get the endgame of this whole market monetarist phenomenon I say put down Scott Sumner and check out Lars Christensen. His post is called simply Market Monetarist, and indeed the very name of market monetarism is actually his coinage rather than Scott.

During the interminable tangent-a rather amusing three ring circus that Sumner led-Lars wrote a post called “There is no such thing as fiscal policy.” This is a pretty radical attack on fiscal policy. From Cochrane claiming that fiscal policy can’t work-till his bout face today-and Sumner saying it can never be as effective as monetary policy in reviving demand-we have Lars claiming it simply doesn’t exist.

Whoa! I guess if it doesn’t even exist we can’t use it. Ever. It’s another postmodernist mind fuck evidently. What are Cochrane and Christensen going to say to each other now? I will suggest that if you want to make any sense of market monetarism read Lars. You get it much more concisely and to the point if nothing else.

Now here is his point. In a barter economy, he tells us, there can be no fiscal stimulus. Why is this? Because, “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.”

Fiscal policy can redistribute income but not effect demand.

“in a barter economy fiscal policy is a purely redistributional exercise, but it will have no impact on “aggregate demand”

https://marketmonetarist.com/2012/01/18/there-is-no-such-thing-as-fiscal-policy/

Ok but maybe the title of this post is wrong. It shouldn’t say there is no such thing as fiscal policy just fiscal stimulus.

The reason we believe that fiscal policy can impact demand is because of money illusion.

“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.”

What NGDP targeting is meant to do is to take away money illusion by taking away this misleading effect of the velocity of money.

“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.”

The goal of NGDP targeting therefore as Sumner, Lars, David Glasner, et al, conceive it is a return to in effect a barter economy. Money is therefore for them kind of like the root of all evil or at least original sin. Like for old fashioned philosophers appearance was the veil that led us to misapprehend true existence, so for the market monetarists, money is the veil that makes us misapprehend the truth of the economy.

Yet Lars does admit that fiscal stimulus can work or seem to work due the the Circe of money.

“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.”

Yeah let’s say that. Actually I think this accurately describes the actual historical record of the Fed between the time of Marriner Eccles and the 1970 when Milton Friedman started whispering sweet nothings in Nixon’s ear.

To be sure Christensen claims that this effect is still misleading as it’s the printed money-monetary policy-that does the real heavy lifting. It would have been exactly the same had the supply of money been increased and government spending been kept constant.

In a way these claims by Lars actually straddles the line with MMTers who do actually argue that it makes no difference whether the Fed or Treasury prints the money but where they go from here is obviously more or less diametrically opposed to what the MMers do with it. The Market Monetarists vs. The Modern Monetary Theorists… Talk about a battle royale.

Again though Lars should call this “There is no such thing as fiscal stimulus.” It seems to me though that even if you believe that fiscal stimulus is a fiction it may nevertheless have proved to be as the belief in God once was.

For what’s curious is during the time we believed fiscal stimulus we had the Keynesian era. Since we gave it up we have had an anti-Keynesian era. During this anti-K ear we have seen the wages of median Americans stagnate. Is this all coincidence? What do you think?

In any case Sumner’s oft repeated argument that the fiscal multiplier is roughly zero because any fiscal stimulus will be followed by monetary tightening according to Lars depends on the policy of the Fed. It wasn’t true during the Keynesian ear. However in this anti inflation era, post Volcker and of the Taylor Rule-the much lauded Great Moderation-it is true of how the Fed has in fact acted. This doesn’t prove that fiscal stimulus doesn’t work but rather the Fed is off the rails and probably could use the kind of reforms Barney Frank wanted for it. Namely not ending the Fed as Ron Paul says but rather ending its “independence.””

Frankly speaking, Mike of course have no clue about economics, but he is 100% right – I should of course have said that there is no such thing as fiscal stimulus (and not policy), but then he would have had nothing to write about. Mike don’t know this, but I hate everything “postmodernist” so he succeed with his low blow.

Anyway, let me say it again fiscal policy is not important. People like Paul Krugman (and Mike Sax) think that we need massive fiscal stimulus to take us out of the slump in Europe and the US and some think (for example European policy makers) think that the only solution is fiscal austerity. I think both parties are wrong – lets fix monetary policy and then we don’t have to worry (too much) about fiscal policy (other than balancing the government budgets in the medium to long run…). This is why I find it so utterly borrowing to discuss fiscal policy…

PS Mike mentions Battle Royal…he is unaware that that is my favourite Japanese movie.

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