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In a Times article a few days ago is this interesting quote from Laurence Meyer, a former Fed governor:
It was this impending gridlock that might have pushed Mr. Bernanke to move, said Laurence H. Meyer, a former Fed governor. “Bernanke has said that fiscal stimulus, accommodated by the Fed, is the single most powerful action the government can take for lowering the unemployment rate, when short-term rates are already at zero,” Mr. Meyer said. “He has nearly pleaded with Congress for fiscal stimulus, but he can’t count on it.”
I’m taking this as a explicit, and unshrouded nod to the concept of “money financed fiscal policy”. Or, what is lovingly referred to in the press as “monetizing debt”. This is a situation where the government draws up a plan to distribute money, whether through direct transfers or increases in government consumption/investment, has the Treasury issue debt in the amount decided upon Congressionally, which the Fed then purchases with newly-coined money (and for hysterics, this money is created “out of thin air”!).
As Karl has noted, and as concurred upon by commenter Jazzbumpa, a program such as this would inevitably “work”. And by work, I mean it would raise inflation expectations such that businesses would be induced out of cash and into consumption and capital goods. This, of course, is something that the ARRA failed to do. This is true, but it is optimal policy?
I say no. I don’t think that fiscal policy need ever enter the picture. I think that the Federal Reserve should announce an explicit target to get the growth path of nominal expenditure to the previous level from the Great Moderation, and then continue to level target a stable growth path from there. In doing so, the Fed should immediately stop sterilizing its own open market operations by paying interest on excess reserves (indeed, the interest in reserves should be slightly negative, reflecting real rates). The Fed could then move down the yield curve, and buy Treasury debt that currently resides on the balance sheets of banks, businesses, and individuals; moving the price up while moving the yield down to zero. I suspect that there is enough debt out there that it would not run out of things to buy before hitting its nominal target. However, if it does, then it can move on to other assets.
The key thing here is that there are many interest rates in the economy, and not all of them are pegged at zero. My point is that far from needing to bring fiscal policy into the picture, monetary policy could go it alone. If the SRAS curve is relatively flat, which is a prediction of macro models, then the resultant inflation expectations would produce much more real output than inflation (lets ballpark and say 5% real growth, 2% inflation), up until full employment is reached — at which point, the Fed would revert to its normal level target. I do not think that Bernanke is “pleading with Congress” for fiscal policy. Why would he? If he identifies that aggregate demand is low relative to the Fed’s own target, then by all means, he should be taking steps to move aggregate demand to where the Fed is most likely to hit their target goals.
To those who say that it is unrealistic that the Fed would do this, is it any more unrealistic than hoping for money-financed fiscal policy?
Another chart to steal from Real Time Economics, this time provided by Justin Lahart.
The classic hydraulic macro story would imply that someone is hoarding cash. It would be really nice then if we could look around and see some cash being hoarded. Indeed, we do.
A point I want to make is that none of these pieces of evidence is in-and-of itself conclusive: The small business survey, the flow of funds, inflation expectations, etc.
There could be explanations for all of them that involve something other than the traditional liquidity demand story: that is that recessions are caused by excess demand in the market for cash/bonds/safety.
However, the liquidity demand story suggests that certain things should all be happening at the same time: a decline in the demand for labor, a decline in the purchase of durables, a decline in consumer prices and business’s pricing power, a decline in asset prices, a decline in inflation expectations, an increase in cash holdings, an increase in the ease of finding workers, etc.
And, all of those things are happening.
I like to focus on inflation because I think just about all of us have agreed that inflation is primarily controlled by actions at the Fed. Thus close patterns between inflation and other variables should suggest that they are also controlled by the Fed.
Here is fraction of income spent on durables and inflation.
Ed Leamer likes to say that its all durables and housing. I think there is more going on in housing than money creation but lets check the Leamer story versus inflation.
Looking at durables only suggests that inflation might flatten out soon. Looking at durables and new houses suggests that deflation will be upon us for sure. It will be interesting to see what happens.
Note, however, that this is not saying that a reduction in income spent on durables and housing will cause a decline in inflation. Its saying the Fed has already taken certain actions. The immediate result of those actions is a decline the fraction of income spent on durables and new houses. The future impact of those same actions will be a decline in inflation.
In other words the inflation decline is already baked in. What we have to ask ourselves now is whether we want to take actions that would raise inflation expectations for the medium future.
Update: I probably should have put “during the recession” in the title. Unfortunately it’s gone to press.
Chevelle, at Models and Agents, explains why the previous round of “quantitative easing” performed by the Fed did not have a [sufficient] expansionary effect:
By that metric, the Fed’s past LSAPs have probably fallen short. Clearly, measuring the counterfactual is impossible, but there are reasons to believe that the impact on aggregate demand was small. Why? First, because the reduction in mortgage rates boosted refinancings only by people who could refinance—i.e. people with jobs and some positive equity in their home. Not exactly the most cash-strapped ones who would have spent the extra cash.
Second, the portfolio-balance effect of the LSAPs on the prices of assets like corporate bonds or equities is at best weak, if not counterproductive. The reason (which I explained in detail here) has to do with the fact that US Treasuries and MBS are not “similar in nature” to corporate debt and equities. Unlike the latter, Treasuries/MBS have more of a “safe haven” nature—so that removing them from investors’ portfolios create demand for more “safe” assets, rather than boosting the prices of equities, high yield bonds, etc.
Luckily, one Benjamin S. Bernanke explained how to perform private asset purchases that would, in fact, have an expansionary effect:
If the Treasury issued debt to purchase private assets and the Fed then purchased an equal amount of Treasury debt with newly created money, the whole operation would be the economic equivalent of direct open-market operations in private assets.
If you see that guy around, tell him to talk to the Federal Reserve. I remember hearing a podcast with Scott Sumner a while back where he floated the idea of the Fed buying bonds off of the public (i.e. You and I), and paying for them with cash. Lets get to it!
That is the title of today’s Wall Street Journal Symposium [Gated]. And the overwhelming answer from preeminent monetary economists? Nothing.
Not that they didn’t answer the question. Most of the panelists’ answers amount to the Fed remaining passive. Here is John Talyor:
To establish Fed policy going forward, the best place to start is to consider what has worked in the past. During the two decades before the recent financial crisis, the Fed employed a reasonably rule-based strategy for adjusting the money supply and the interest rate. The interest rate rose by predictable amounts when inflation increased, and it fell by predictable amounts during recessions.
Fairly predictable. John Taylor has made this point numerous times, and is a very hard rules-based guy. I’m a rules-based guy as well…but I don’t see the inherent virtue in the Taylor rule, however defined. Essentially Taylor seems to want the Fed to stabilize NGDP growth around a Taylor rule at the current (reduced) output level, which puts us permanently behind the previous trend rate of output. As far as I can tell, he doesn’t care to make up the slack…which of course means elevated unemployment for an extended period of time.
Richard Fisher, who is a predictable hawk, lived up to expectations as well:
One might assume that with more than $1 trillion in excess bank reserves and significant amounts of cash held by businesses, the gas tank of those who have the capacity to hire is reasonably full. One might also conclude that the Fed, having cut the cost of interbank overnight lending to near zero and used quantitative easing to coax the entire yield curve downward, has driven the cost of gas to virtually nil for businesses that are creditworthy. And yet businesses still aren’t hiring.
This is a mind-bogglingly insane statement. When suffering an immediate deficiency of aggregate demand, supply-side factors are second order. Yes, we should streamline regulatory hurdles…but that has nothing to do with why firms aren’t hiring. Fisher must have missed a lot of economics, and apparently doesn’t understand that demand for safe assets (which in developed countries equates to cash) drives most recessions (especially during a time where there is a lack of supply of safe [private] assets), and that the Fed decided to pay banks to hoard cash…and so they did. I’m having a hard time figuring out how Fisher landed his current position.
On to the most depressing, Frederic Mishkin:
Purchasing long-term Treasurys might suggest that the Fed is accommodating the fiscal authorities by monetizing the debt—thereby weakening the government’s incentives to come to grips with our long-term fiscal problems. In addition, major holdings of long-term securities expose the Fed’s balance sheet to potentially large losses if interest rates rise.
Such losses would result in severe criticism of the Fed and a weakening of its independence. Both the weakening of its independence and the perception that the Fed is willing to monetize the debt could lead to increased expectations for inflation sometime in the future. That would make it much harder for the Fed to contain inflation and promote a healthy economy.
Expanding the Fed’s balance sheet through large-scale asset purchases can be necessary in extraordinary circumstances, such as during the depths of the recent financial crisis. But in relatively normal times, the costs of using this tool are sufficiently high that it should not be used lightly.
9.5% unemployment, falling CPI and inflation expectations, and exploding national debt due to the political anxiety to “do something” is now ‘normal times’? This amounts to saying that the Fed has the tools, but shouldn’t use them unless we’re in the Great Depression. The Fed’s job is to keep us out of financial panics like the Great Depression, not make its job significantly harder by passively waiting until the depths of the abyss, and then acting. I don’t agree with that at all.
I don’t really know anything about Robert McKinnon, but he is worried about international currency flows, asset bubbles in China, and thinks that the Fed should mediate interbank lending to stabilize the yield curve at “normal interest rates”. I’m fairly confident that China can sterilize any dollar inflows that happen upon its shores…so I don’t see this as a problem that needs to be addressed by anyone but Chinese policymakers, and I happen to think that the Fed should be much more aggressive than stabilizing yield curves AAAAAND raising interest rates now is, of course, insane punditry. Apparently so does the Vincent Reinhart believes the Fed should be more aggressive as well:
As a consequence, the Fed has to be both aggressive and nimble. The Fed should promise to purchase government and mortgage-related securities between its regularly scheduled meetings as long as activity is forecast to be subpar and inflation is low or headed down. Purchases of, say, $100 billion every six-to-eight weeks would add up to a number worthy of shock and awe for those with a somber economic outlook.
All-in-all a very depressing symposium. They should have interviewed Scott Sumner, Bill Woolsey, David Beckworth, Nick Rowe, and Paul Krugman. Then, perhaps, the world could be saved.
Update: Beckworth seems to have beaten me to the punch, linking to Mark Thoma, who did as well…a
In an update to his popular post, which is causing some interesting commentary on Twitter, my co-blogger Karl Smith has this to say:
My argument is no, this isn’t just another bad experience. Its a failure of our most basic institutions and is leading to pure loss.
Indeed, I think that the wrong way to think about the problem of recessions is that there is a fundamental problem with market economies, or that recessions (no matter how deep) represent a market failure. To me, this recession (both the depth and length) is fairly clearly a monetary failure…and if you catch me on a bad day (or a good day, depending on your disposition I suppose), I’d even go as far as to claim that the type of money system we use makes our economies prone to the types of failures we have recently experienced. In fact, financial crises are not rare. The World Bank has identified 96 banking crises (large enough to cause economy-wie problems) and 176 monetary failures since the dismantling of the Bretton Woods in 1971.[1]
Even before the termination of gold convertibility, massive crashes were remarkably common the world over. From the Holland tulip mania to the Great Crash of 1929, these crashes have happened with frightening regularity. Being as these types of economic issues span countries, time periods, regulatory regimes, and degrees of economic development; I think that it is safe to say we should begin turning a inquiring eye toward the one system that permeates all of these societies throughout time and location.
That, of course, is the type of money we use, the characteristics of which have been replicated by nearly every society since the relinquishment of barter, and the dawn of what we would consider “modern money”. This recession is, of course, no different. An increase in the demand to hold safe assets (of which the medium of exchange is generally the safest, at least in developed economies) causes a disconnect between workers and factories. People and machines sit idle. Productive capacity dwindles, along with hours worked. Price and wage stickiness facilitates a real downward adjustment to market clearing rates to cause grinding deflation (or disinflation, which under a regime of positive trend inflation is similarly problematic).
Is there a bug inherent in the money system that is used the world over that causes these disconnects? I think that analyzing the dynamics of the flow of biomass through natural ecosystems can provide useful insights into how the money we use causes the economy (or sectors of the economy) to become brittle (too brittle to sustain?) and prone to failure.
There has been a lot of chatter around the blogosphere about Narayana Kocherlakota’s speech in Michigan last week, and seeing as I am trying to catch up on news, I think that is a good a place as any to start. First, here is the whole speech, so that you can read it if you would like.
The big focus, especially among left-leaning commentators, has of course been Kocherlakota’s comments on the unemployment situation. The only troubling thing to me about a monetary policymaking body discussing unemployment is the fact that it is happening at all. I don’t believe that there is anything “special” that monetary policy can do to alleviate unemployment — even in a booming economy. The capacity of monetary policy to act is to keep nominal GDP growing at a constant rate, year over year, and to tighten a little when it overshoots and loosen a little when it undershoots — such that the trend path of NGDP is a constant upward slope. I’m not an expert on the welfare-maximizing trend rate of NGDP…but people who are much smarter than me on average advocate 5% NGDP growth.
In any case, in the speech, Kocherlakota breaks down how Fed meetings operate, and then breaks down his “forecast speech” that he gave to the FOMC. Along those lines, he has three points: GDP (real), inflation, and unemployment. On those three points, he has this to say:
Typically, real GDP per person grows between 1.5 and 2 percent per year. If the economy had actually grown at that rate over the past two and a half years, we would have between 7 and 8.2 percent more output per person than we do right now. My forecast is such that we will not make up that 7-8.2 percent lost output anytime soon.
[…]
The Fed’s price stability mandate is generally interpreted as maintaining an inflation rate of 2 percent, and 1 percent inflation is often considered to be too low relative to this stricture. I expect it to remain at about this level during the rest of this year. However, our Minneapolis forecasting model predicts that it will rise back into the more desirable 1.5-2 percent range in 2011.[1]
[…]
Monetary stimulus has provided conditions so that manufacturing plants want to hire new workers. But the Fed does not have a means to transform construction workers into manufacturing workers. […] Given the structural problems in the labor market, I do not expect unemployment to decline rapidly. My own prediction is that unemployment will remain above 8 percent into 2012.
[1]5yr TIPS spread is at 1.43, 10yr @ 1.55.
Now, not making up the lost employment is partially a function of his previous point about per capita GDP remaining under trend for an extended period of time. This is the cyclical component of unemployment. Cyclical unemployment is created due to the relationship of the economy to the cycle of time. As such, the level of cyclical unemployment correlates well with the business cycle, seasonal factors, etc. I believe that most of the unemployment we are currently experiencing is of cyclical nature.
I think the error in Kocherlakota’s thinking stems from this quote:
Monetary stimulus has provided conditions so that manufacturing plants want to hire new workers. But the Fed does not have a means to transform construction workers into manufacturing workers.
This is wildly baffling. Not only does Kocherlakota make the forecast above — i.e. we will not be hitting any of our targets (nominal or otherwise) any time soon — he also states that he believes that money has been easy. That implies that monetary policy has zero effect on the economy, any time. He also identifies that low rates for an extended period of time are a sign of monetary failure, but does so in a future-orientation. While it is true that low rates can (and do) accompany* a deflationary “trap”, the policy prescription that follows is not to raise short-term rates regardless of the composition of employment. The proper policy response in that situation is to set a positive nominal target, level targeting and commit to move heaven and earth to hit that target.
That, rather than his statements about unemployment, is what I view as Kocherlakota’s underlying problem.
*H/T to Andy Harless in the comments. Also, read his post about Kocherlakota’s statements.
Modeled Behavior 