In this week’s Graphs that Subvert Conventional Wisdom we see why monetary policy shouldn’t be run by gold standard cranks that think it’s just obvious that the Fed’s loose monetary policy is debasing the dollar and causing commodity prices to spike. Only a gold standard can prevent that! Ahem.
David Andolfatto of the St. Louis Fed:
Imagine that you are 50 years old in September 1980. Imagine that a trusted friend of yours–oh, let’s say your doctor–convinces you to put all your savings into gold. The reason he offers is that the Fed is pursuing a policy of “relentless money expansion.” He warns you that the money supply is set to grow by 300% over the next 20 years. So you listen to him.
You buy gold at $673 per ounce. And then you wait. You wait until you turn 70. And then you go to withdraw your savings. You discover that the gold price in March 2001 is $263 per ounce. That’s a whopping rate of return of…wait for it… -60% over 20 years. That’s a minus sixty percent.
(graph via MacroMania)
Fascinating interview with Alan Greenspan:
[Sorry, Edit, can't get this video embeded. Watch here.]
Whenever evaluating policies, I find it useful to form a logical model in my mind of how different scenarios should plausibly work out. Doing so requires I walk through various alternatives through their logical steps. I hope some Socratic questioning can be illuminating for us.
Questions for inflationists:
Do you think inflation, currently at historical lows, would be higher, lower, or the same had we not used fiscal stimulus and the first round of quantitative easing?
The Fed has already loosened monetary policy and previously tried the first round of quantitative easing which expanded the money supply in the economy. The Bush and Obama administrations expanded the money supply through fiscal stimulus. Presumably we’d have lower inflation had those policies not happened. At 0.6% annual increase in CPI, wouldn’t deflation have been a likely possibility?
Given all their rhetoric about soaring inflation and the dangers of flooding the economy with cheap money, you’d think they’d answer it’d be lower. But if it was any lower it’d be outright deflation.
Finally for all those worried about the dangers of printing money to fight off potential deflation, what would the inflation picture have to look like for you to argue that the government or the Fed should add more money into the economy?
There is no doubt that there is uncertainty in our markets. Advocates of fiscal and monetary stimulus are under no obligation to deny that uncertainty can negatively affect the economy. In their popular Keynesian book, Animal Spirits, George Akerlof and Robert Shiller approvingly quote Washington Post writer Anna Youngman from the Great Depression:
At present, Mr. Dupont [president of the chemical company] notes, there is uncertainty about the future burden of taxation, the cost of labor, the spending policies of the Government, the legal restrictions applicable to industry-all matters affecting computations of profit and loss. It is this uncertainty rather than any deep-seated antagonism to governmental policies that explains the momentary paralysis of industry…
If it actually exists to the level some conservatives now say it does (I’m still waiting on the evidence: here and here), how far does this etherial “uncertainty” go? And to what extent should it affect our policy decisions?
This is how I come at the question. Currently aggregate demand is very low. Small businesses are reporting in greater numbers that “poor sales” is a major problem. Personal consumption and retail sales remain low.
Earlier last year government consumption was offsetting some of the drop in private consumption, but as fiscal stimulus fades that has also dropped off.
So imagine you own a company that produces shoes. You’re uncertain how different legislation will affect your future costs – you may believe your taxes could go up, so maybe you shouldn’t hire another worker despite receiving lots of applications. You’re making decent money now and your workers are producing more than enough shoes to satisfy their current customers. You have plenty of excess capacity to make more shoes but, since labor costs a lot (healthcare, taxes, salary, training, etc) you may even be keeping your workers’ hours fairly limited and may even cut back. I think that largely encapsulates the uncertainty picture for a business.
Now let’s assume that all of a sudden there is a big spike in demand for your product (which is what stimulus advocates want to create). You’re selling your supply out. There is NO CHANGE in healthcare legislation, tax rates, labor costs, and shoe material costs, although you’re still uncertain about the future of those costs. If you were the shop owner, can you imagine yourself still not hiring new workers if doing so would be the only short-term way you could satisfy the increased demand for your product?
I submit that businesses aren’t going to forgo making more money now to sell customers more of what they want because they are “uncertain” about various potential future problems. This scenario doesn’t suggest that uncertainty doesn’t matter at all; it just suggests that when looking at the policy prescriptions it seems to have little value for our short-term unemployment crisis.
Now consider another scenario. You’re a business owner that has poor sales, but the congress decides to repeal the healthcare bill, permanently continue all the Bush tax cuts currently in place, cut unemployment benefits, cancel any unspent stimulus money, downsize the federal employment roles, and will promise not to add any new regulations on business. Furthermore, the Fed decides not to add any more money into the economy.
I can’t prove that businesses wouldn’t upon hearing this news and rush out and hire lots of new workers, but let’s just say I’m skeptical of how strong that changes the incentive of businesses to hire new workers.
In our economy we have poor sales and, according to many, policy uncertainty created by the Obama administration and the Fed. In scenario 1, there are poor sales and uncertainty. If poor sales change to strong sales while uncertainty continues, it seems businesses will still hire new workers. In scenario 2, there are poor sales and uncertainty. Nothing was done to directly shift demand rightward by increasing consumption, but some supply side and other right-wing wishes were granted. So we supposedly tackled “uncertainty” but not sales. I personally don’t see how that clearly answers the unemployment problems in our economy. Yet this is the position of some on the political right (via Kevin Drum).
What am I missing? What’s Phase 2?
Just in case people think quantitative easing is some left-wing wacky idea, here are some conservative economists that favor it.
When I started my blog in early 2009, fiscal stimulus was the hot issue. Many conservatives were opposed to fiscal stimulus, arguing (correctly in my view) that it would fail. And they made it quite clear that “failure” meant deficit spending would fail to boost nominal spending. The implicit assumption was (almost everyone agreed) that more nominal output would be desirable, and the argument was that fiscal stimulus could not deliver it. With monetary stimulus, the right is making exactly the opposite argument—they are opposed to QE because it might succeed in boosting NGDP. Both fiscal and monetary stimulus boost NGDP (if they work at all) by shifting AD to the right. Whether that extra spending shows up as inflation or real growth is of course an important issue. But it makes no sense to argue fiscal stimulus would fail because it would not boost NGDP, and simultaneously argue that monetary stimulus would fail because it would increase NGDP. I’m sure the right doesn’t think of its views in those terms, but that is essentially the message they are sending out, and it is an extremely incoherent message.
My view is that QE2 is a modestly good idea. I say it is a “good idea” because, like Ben Bernanke, I am more worried at the moment about Japanese-style deflation and stagnation than I am about excessive inflation. By lowering long-term real interest rates below where they otherwise would be, QE2 should help expand aggregate demand. I include the modifier “modestly” because I don’t expect these actions to have a very large effect.
Well, it is impossible to say whether he’d support QEII specifically because he’s dead, but he certainly didn’t have a problem with using monetary policy as a tool to increase the money supply to remedy the economy.
“The Bank of Japan can buy government bonds on the open market…” he wrote in 1998. “Most of the proceeds will end up in commercial banks, adding to their reserves and enabling them to expand…loans and open-market purchases. But whether they do so or not, the money supply will increase…. Higher money supply growth would have the same effect as always. After a year or so, the economy will expand more rapidly; output will grow, and after another delay, inflation will increase moderately.”
Again, where and when did the switch to socialism happen? I can’t seem to find it in the data… Hmmm…. Also, where was the massive increase in spending for stimulus?
Total Government Spending (all levels of government):
The only way you see a massive increase in government is if you only look at short term federal government spending AND ignore the fact that GDP collapsed because of the recession. Yes, taxes coming in are much less because of cuts and because of the recession – that’s what’s really causing the short term deficit.
We’re not going bankrupt because we’re spending too much on infrastructure or any such nonsense. It appears we’re still short about $2 Trillion for infrastructure (well, according to some reports anyway). Entitlements need to be reformed, the tax base increased, and we need to find a way to increase economic growth. Maybe the Fed actually intends to try something new now.
(graph via Krugman)
The legislature is clearly impotent to do much to improve the economy right now. It looks like the best it can hope for is piecemeal bills to keep things from getting much worse. Given that it seems the Fed really needs to step in, stop worrying about its image, and do what it can to help the economy. Here’s a few ideas that seem worth trying to me.
If the Fed promises to keep increasing the money supply until prices rise by, say, 3 percent a year, people should eventually start spending. Otherwise, if they just held the money, it would be worth 3 percent less each year.
In a self-fulfilling prophecy, the Fed could stimulate spending and the economy, and at no cost to the Treasury.
Mark Thoma seconds Cowen’s own questions about that policy:
As for Tyler’s (and others’) call for monetary policy instead of fiscal policy, here’s the problem. It relies upon changing expectations of future inflation (which changes the real interest rate). You have to get people to believe that the Fed will actually be willing to create inflation in the future when it comes time to do so. However, it’s unlikely that it will be optimal for the Fed to cause inflation when the time comes. Because of that, the best policy is to promise that you’ll create inflation, then renege on the promise when it comes time to follow through. Since people know that, and expect the Fed will not actually carry through, it’s hard to get them to change their expectations now. All that credibility the Fed has built up and protected concerning their inflation fighting credentials works against them here.
Thus many economists believe that the Fed has unwittingly encouraged banks to sit on their cash and not lend it by paying interest on reserves. Eliminating interest on reserves would therefore encourage lending. A rumor that the Fed might do so caused the stock market to rise earlier this week, according to press reports. But the policy remains in place.
Discouraging Excess Reserves
Some economists go further and suggest that the Fed impose a penalty rate on excess reserves. This is what Sweden’s central bank does. There, banks currently pay 0.25 percent on reserves — called the deposit rate — rather than receiving 0.25 percent as they do here. This may be a key reason why Sweden has bounced back much more rapidly from the worldwide economic crisis than the United States has.
Scott Sumner enlists Milton Friedman to support monetary stimulus:
I forget to mention the interest on reserves policy, which is very similar to the 1936-37 policy of doubling reserve requirements. Both programs only raised short term rates by about a 1/4 point, but Friedman (and Schwartz) understood that the 1937 policy was highly contractionary despite the tiny interest rate increase, because it sharply reduced the money multiplier. He would have been a severe critic of the current IOR policy.
[update 09/20]: Here’s a David Leonhardt column from about a month ago that should help squelch some readers fears about inflation.
(Bureau of Labor Statistics, via Haver Analytics) (Six-month change in the Consumer Price Index.)
Over the last two years, inflation has been zero. Over the last year, it has been just 1.3 percent. Over the last six months, it has been below zero — negative 0.7 percent.
The Fed — especially the regional Fed banks — is filled with economists and bankers who have strong memories of the 1970s and 1980s inflation. They’re always on guard against it.
There is no question that inflation can be terrible. Right now, though, it sure looks like the last war.
By the way, can we at least fully staff the Federal Reserve!?
He may not be perfect but he’s the best choice for continuing on the path away from economic collapse. In a New York Times op-ed, Alan Blinder advocates support for his friend and former colleague.
[H]is job performance since, say, October 2008 has been superlative. To cite just a few examples, Mr. Bernanke led the Fed to lower its interest rates to virtually zero in December 2008 and then to hold them there. The central bank also invented approaches to lending and purchasing assets that breathed some life into moribund markets like commercial paper and mortgage-backed securities. It led the highly successful “stress tests” of 19 large financial institutions last spring.
The success of these policies is demonstrable. The simplest and most objective measures of financial distress are the differences, or “spreads,” between various (risky) interest rates and the corresponding (risk-free) Treasury rates. During the worst of the crisis, in September to November 2008 and again in February to March 2009, these spreads skyrocketed to dizzying heights. Since then, they have fallen remarkably, providing direct evidence that the Fed’s cure is working.
If the Senate fails to confirm Bernanke, it will further politicize the Fed and disrupt the growing confidence in the financial markets that underpin a healthy economy. People who expect instant gratification and instant recovery from one of the worst potential recessions in modern global history shouldn’t be given the encouragement that is better placed with the leaders our precarious recovery.