Serious Economists Are Everywhere! But I Say Cut FICA Taxes, Financed by QE

A guest post by Benjamin Cole

In a recent post, I made a joke about “the oxymoron, ‘a serious economist.’”

Maybe it was no joke.

Come now Foreign Affairs magazine—a “serious” publication, with a proposal from Mark Blyth, a political economist at Brown University (a “serious” school) with a proposal that the U.S. Federal Reserve should have printed up $56,000 in cash for every household in the United States, and forked it over, after the Great Recession. London hedgie Eric Lonergan co-authored.

That $56k Giveaway Plan would have revived the economy a lot better than the Fed’s tweetybirding around with quantitative easing and interest rates, said the pair.

Maybe so.

Crazy….But Not That Crazy

I think there is a problem with the Blyth-Lonergan $56k-Giveaway Plan, and that is moral hazard. People may come to expect occasional fat checks from Uncle Sam in recessions. Why work or save money?

But Market Monetarist, blogger and Western Kentucky University prof David Beckworth has proposed taxpayers be given a break in recessions, and that the Fed simply print up the money and give it to the Treasury, to make up the difference in lost tax revenues.

I like the Beckworth Plan, and I am sorry it was never implemented.

The right way might be a complete holiday during recessions from Social Security and Medicare (FICA) taxes, for both employers and employees, paid for by the Fed. The Fed would print the money not collected, and give it to the federal government. This would expand the money supply, and also encourage hiring and spending.

It may be such Fed cash-financing of Social Security and Medicare becomes a permanent fixture, a subsidy to the tune of a few hundred billions a year—see Martin Wolf, I explain later in this post.

The wipeout of FICA taxes favors the very people serious economists claim they like: Productive people acting productively. Why do we tax people when they work, or run businesses that employ people? That is nuts, no?

New Ideas Everywhere

Well, if you think these ideas are wacky, then consider arch-conservative University of Chicago economist John Cochrane, who has called for eliminating the entire federal debt through QE, which he thinks will result in large commercial bank reserves. Reserves are not inflationary, as long as the Fed-paid interest on reserves is high enough, says Cochrane. The Fed can just print up the interest to be paid, assures Cochrane. Well, la-de-dah, easy as pie, ain’t it?

And we hand a debt-free nation to our children. That has appeal, it is undeniable.

But then listen to Martin Wolf, star Financial Times econo-pundit, who has proposed national governments run permanent deficits financed by QE. Actually, this fits in with my FICA tax holiday plan, so I think Wolf is getting warm. I prefer the QE go into tax cuts, not government spending.

Conclusion

I think there is a strong germ in all of these ideas, and that is that central banks should start printing more money. We can use the cash to run parts of government, or cut taxes on productive people (my idea!).

Ironically, the powerful bulwark against any progress in monetary policy in the United States remains the Fed, and especially the Federal Open Market Committee, and the inflation-hysterics who populate that least democratic of macroeconomic policy-making institutions.

Not only do CPI-fixated FOMC monomaniacs resist any unconventional policies, they think conventional policies are best when the economy is blue in the face from monetary asphyxiation. FOMC’er Charles Plosser has rhapsodized about deflation—but then even the “dove,” Chief Janet Yellen, has enthused about a 1 percent inflation target. Given recent results, that may be her current target, in fact.

So, on the FOMC there are also “serious economists.”

But maybe that expression is an oxymoron.

PS The Blyth-Lonergan $56k Giveaway Plan is way, way, way more complicated than I wanted to address in this limited space, or even contemplate ever. It involves central banks buying a global basket of equities for 15 years, and then (I surmise) selling the booty hoard, and handing the cash to poor people, but only those poor people deemed worthy by their virtuous behavior, such as by spending the money on education etc. Egads.

Mama Mia!

From the WSJ (who else!):

Wednesday’s statement retained the Fed’s language that interest rates will remain low “for a considerable time,” which pleased the doves. For the first time, however, the Fed also explained in some detail how it might exit from its post-crisis monetary exertions, which suggests it really is preparing to raise rates—eventually. But then in her press conference, Ms. Yellen stressed that the exit plan “is in no way intended to signal a change in the stance of monetary policy.” The Open Market Committee vote also included two hawkish dissents, from regional bank presidents Richard Fisher and Charles Plosser. Those men have often been right but never decisive in Fed councils.

Maybe because they´re so often right they´ve got “nicknames”. RF is known as Richard (“Inspector Clouseau”) Fisher while CP answers to Charles (“sooner rather than later”) Plosser.

Aren´t we lucky they´re not decisive?

Four years and things haven´t changed much

That´s what one would think by reading this Gavyn Davies piece from four years ago:

The minutes of the September meeting of the FOMC suggest that the Fed is considering how to communicate its policy message more clearly to the markets.

If you substitute the word “minutes” for “statement” you would think the piece was about now!

But that´s not all. In his piece Gavyn discusses proposed changes to the policy target, specifically he discusses William Dudley´s suggestion of adopting a price level target (PLT) and concludes:

Third, what happens if the Fed is simply unable to hit its PLT, so that the shortfall of the price level relative to target just keeps getting bigger, year after year? I can see that proponents of the PLT might like this, because it would shift the balance of the argument on the FOMC towards more and more QE as the price shortfall kept getting larger through time. But the Fed’s wider credibility would not be enhanced if it were demonstrated repeatedly that it could not actually hit its own chosen price target. In fact, this could backfire, by highlighting the impotency of monetary policy at a time when the economy is stuck in a liquidity trap.

In face of uniquely difficult circumstances, the Fed is being forced to use some very unfamiliar new weapons. A price level target would be one too many.

Fast forward 4 years. In commenting on a post by Lars Christensen, Greg Mankiw qualifies his “Taylor-type” rule as a guide to monetary policy given present circumstances and adds:

There is another (related) argument for not raising rates now to offset shortfalls in the past. It is not about the interest rate. It is about the price level, the ultimate goal of monetary policy and measure of its performance.

If you plot the PCE deflator, there is a clear shortfall relative to a 2% price-level target. A 2% price level target fits very well during Greenspan’s time. By the end of 2008, we were exactly on the 1992-target. But when I look at that plot starting in 2009 until the most recent data I see a gap.

A price-level target rule is optimal in normal times (Ball, Mankiw, and Reis) but is also an optimal policy in response to the dangers of the zero lower bound (Woodford). We have to catch up for the shortfall in the price level right now. And if you look at inflation expectations from surveys or markets, there seems to be no catch up expected, indicating that policy is still too tight.

But exactly nine years earlier, in 1994, Mankiw argued:

Although nominal income targeting is not a panacea, it is a reasonably good rule for the conduct of monetary policy. Simulations of a simple macro model suggest that, compared to historical policy, the primary benefit of nominal income targeting is reduced volatility in the price level and the inflation rate.

Under conservative assumptions, real economic activity would be about as volatile as it has been over the past forty years. If the elimination of spontaneous shifts in monetary policy improves forecasts markedly, real activity could be much less volatile [and it had already become 50% less volatile].

Question: why should we fiddle with start dates for the trend? Mankiw argues that by the end of 2008 we were exactly on the 1992 target, but if the plot starts in 2009 we see a gap. Presumably this would justify higher catch-up inflation (i.e. keep rates low for longer).

In his answer to Mankiw´s comment, Lars puts the start date for the price level trend in 2001, and finds it is now below trend.

There is a good reason for starting the trend in 1992. The year marked the beginning of the second leg of the Great Moderation following Greenspan´s so called “opportunistic disinflation” during the 1990-91 recession, with inflation being brought down to the desired 2% rate.

The chart shows the price trend starting in 1992. After deviating significantly from the 2% trend during the oil shock of 2007-08, the price level is back on trend. No “price gap” exists!

PLT vs NGDPLT_1

In fact, it was exactly because of the FOMC´s “inflation paranoia” in 2008 (see here) that things went astray. It´s as if the Fed were pursuing a price level target and didn´t stand for any deviation (a bad move when the economy is subjected to supply shocks).

The consequence can be observed in the next chart. It would have been much, much better if, instead of “defending to the death” a price level target, the Fed had defended a NGDP level target.

PLT vs NGDPLT_2

In “normal times” they appear to be observationally equivalent. But when significant supply shocks hit PLT shows its intrinsic weakness!

Update: From Michael Woodford´s interview with The Region (Sept 16):

…Now, the specific form of the statement they made was not quite what I had suggested in my lecture, and not really what I would have preferred. But, of course, they had to announce a policy that they thought they could follow.

Region: At Jackson Hole, I believe, you said that nominal GDP target policies were more consistent with what you had in mind.

Woodford: Yes. I had specifically suggested that announcing a target path for nominal GDP would be a desirable way to make an advance statement about the criteria that you would be looking at later.

Now, I wasn’t saying that to suggest that that’s the onlyformula that would be valuable, but I thought it was useful to give a concrete example showing how the thing that I was talking about could be undertaken in practice. It was a simple proposal that nonetheless incorporated the key elements of what I thought was a desirable form of commitment. I also thought it could be understood by a fairly broad public. It incorporated what I thought were key considerations that people on the FOMC were likely to be concerned about, although it turned out that evidently it didn’t address their concerns as much as I was trying to, because it didn’t get much traction with them. (HT: James Pethokoukis)

Previously from Woodford:

Q: What was the thought process that led you to support nominal GDP targeting?

A: Actually, it’s an approach I’ve been advocating for at least a decade, though in my earlier writing about this I referred to a more technical variant of the proposal (what I called an “output-gap-adjusted price-level target“) rather than to nominal GDP targeting. The idea is to have a target criterion with two qualities: It must focus on the level of a nominal variable rather than its growth rate, and it should involve some combination of prices and economic activity. I settled on nominal GDP — the dollar value of all the goods and services produced in the economy — because it’s a measure that a central banker can talk about and be understood by the general public, and it avoids contentious issues such as the correct definition in practice of the “output gap.”

Economy remains under the “considerable time” umbrella

Only die-hards could have expected that the FOMC would drop the “CT” language at today´s meeting! It would have been inconsistent with the inflation report, which showed the headline CPI dropping and the Core rate unchanged over July.

The chart indicates that both measures of inflation have remained below target for the past two years. Although the likes of Plosser were “excited” about inflation moving towards target in recent months, the latest data show they are moving “south” once again!

CT language_1

The next chart shows that while a measure of inflation expectations moved up after QE3, for the past year they have remained pat and well below target.

CT language_2

On a related matter, this post by Matt Iglezias goes to the “heart of the matter” – “Obama’s biggest economic policy mistake”:

But as the country waits to hear the latest announcement from the Fed about how rapidly it will end its Quantitative Easing programs, we are witnessing the biggest mistake of Obama’s presidency: the systematic neglect of the Federal Reserve and of his ability to influence its course of action.

The viewpoint that there is nothing the Federal Reserve can do to boost the economy when short-term interest rates are already at zero, leaving deficit spending as the only effective stimulus option, is not believed by most experts. This particular combination of views is most closely associated with a somewhat marginal group of left-wing thinkers who describe themselves as modern monetary theorists. Except it’s also something that key Obama advisor Larry Summers believes, and the fact that Obama tried to install Summers as Fed Chair indicates that Obama believes it too.

This belief in monetary impotence likely explains why Obama is so lackadaisical about filling vacancies. He believes the Fed’s role in fighting a potential crisis is crucial, but the current team helmed by Yellen and Deputy Chair Stanley Fisher is up to that job. Bolstering the left flank on the FOMC so that Yellen’s consensus-building efforts would land in a more stimulative spot isn’t on the agenda. (HT David Levey)

Also, in “Follow or Break the Rule?” Greg Mankiw shows his MM stripes in critiquing the inventor of the MM moniker:

Taken at face value, the rule suggests that it is time for the Fed to start raising the federal funds rate.  If you believe this rule was reasonably good during the period of the Great Moderation, does this mean the Fed should start tightening now, as the economy gets back to normal?

Maybe, but not necessarily.

Update: Ricardo Reis writes to me the following useful observation:

There is another (related) argument for not raising rates now to offset shortfalls in the past. It is not about the interest rate. It is about the price level, the ultimate goal of monetary policy and measure of its performance.

A price-level target rule is optimal in normal times (Ball, Mankiw, and Reis) but is also an optimal policy in response to the dangers of the zero lower bound (Woodford). We have to catch up for the shortfall in the price level right now. And if you look at inflation expectations from surveys or markets, there seems to be no catch up expected, indicating that policy is still too tight.

Just substitute PLT for NGDP-LT!

A Long-Ago and Forgotten Episode of QE? The Fed “Money Financed” Uncle Sam IOUs in late 1960s

A guest post by Benjamin Cole

Who knew? The U.S. Federal Reserve from 1964 to 1969 bought more Treasury securities than the U.S. Government sold.

Today, that Fed action would be called “quantitative easing” or QE.

But back then, there was no catchphrase for QE, and Kansas City Fed economist V. Vance Roley called the process “money financed debt,” in a paper he wrote in 1981 for the Kansas City Fed Economic Review entitled, The Financing of Federal Deficits: An Analysis of Crowding Out.

It is an astonishing paper!

Roley notes, “Federal Reserve purchases of Treasury securities in the 1964-1969 period were larger than the total debt accumulated by the federal government. Thus, during this five-year period, not only was the accumulated debt money financed, but the net debt outstanding actually declined by $1.1 billion.”

Egads! I never read that before. The late 1960s economic surge coincided with an unnoticed QE program?

The Good Ol’ Days

The late 1960s were boom-times in the U.S. Unemployment shrank to 3.5 percent. In just six years from 1964 through 1969, the number of people employed in the U.S. grew by 14.1 percent, to 77.9 million, annual averages. From 1964 through 1969, the U.S. economy expanded in real terms by 32.8 percent.

Think about that: output per capita in the U.S. rose by nearly a third in just six years, in the late 1960s. It never got any better than that, btw.

Inflation and “The Story”

Of course, today the 1960s is recalled as a period of powerful inflation, provoked by “Guns and Butter,” in remembrance of President Lyndon Johnson’s war in Vietnam, yet new social programs.

And the Fed was “too loose.”

That is “The Story” as recycled by modern U.S. economists.

There is some truth in “The Story,” but only some. Prices rose in the six-year period by 15.8 percent.

In the last and worst year, 1969, the PCE deflator rose—hold onto your hats—by 4.5 percent. By a government index that some contend overstates inflation.

Okay, so maybe inflation was moderate and not runaway, but how about 1960s Guns and Butter, federal deficits—you know, “The Story”?

Federal Spending Just Blah

Well, federal spending 1964-1969 ran around 18 percent of GDP for most of the period, lower than today (and lower than for most of the non-inflationary 1990s). LBJ liked Guns and Butter, but total federal spending was within the usual bounds.

Deficits were hardly worth mentioning: At less than 1 percent of GDP throughout the 1960s, except for 1967 at 1.1 percent of GDP, and then 2.9 percent in 1968. But by 1969 the federal government was back in surplus!

Yes, Guns and Butter and big federal deficits, i.e., “The Story” is…well, revisionism.

Moreover, the federal debt outstanding as percent of GDP, shrank all through the 1960s, from 56 percent to 38.6 percent! Americans became less indebted by federal government in the 1960s, an example usually connected to prudence, not spend thriftiness.

The Slut-Easy Fed?

Okay, maybe the federal government was not so sloppy in the late 1960s. But “The Story”—the Fed was looser than a drunk sailor, no?

Well…as for the Fed, it raised the discount rate from 3.5 percent in 1964 to 6 percent by 1969. Maybe the Fed “should” have hiked rates more, but usually raising rates is not considered “loose.”

For fans of M2, it rose at about a 7 percent rate through the latter 1960s, a strong but not egregious clip, and certainly not too strong considering the real growth going on.

The Rest of The Story

What is interesting about the 1960s is not only the mischaracterizations, but the omissions.

Who knew that the Fed had conducted QE in the late 1960s, buying back even more federal debt than was issued? And why does not that QE program ever get some credit for the late 1960s boom-times (and yes, blame for the moderate inflation)?

But “The Story”—that deficit spending and an undisciplined Federal Reserve led to runaway inflation in the 1960s—seems badly in need of a re-do.

As I have said before, today macroeconomics is not about economics; it is politics in drag, and macroeconomic history mere revisionism.

It is funny what is found in the footnotes of history—that QE might have played a role in the historic 1960s boom.

Who knew?

PS

So…if the Fed raised rates, and the federal government deficits weren’t much, what did cause the moderate inflation of the 1960s?

I think it was strong economic growth and powerful structural impediments or institutional imperfections. It was an era of powerful private-sector labor unions, and strong national manufacturers, such as the Big 3 automakers, or Big Steel. Oil prices were controlled by the Texas Railroad Commission. It was an era before international trade, and the consequent Wal-Mart revolution, and then dollar stores. The Internet (Craigslist) came even later. In the 1960s, whole industries were regulated on price (which is to say self-regulated), such as transportation, telecommunications and banking.

In short, in the 1960s we had an economy prone to inflation, as was found out in the 1970s.

The sad thing is, today U.S. central bankers express hysterical fear of inflation—yet the structural impediments and institutional imperfections that caused inflation in the 1970s have largely disappeared in the last 40 years.

But stories, like “The Story,” die hard.

Elevator QE

A guest post by Benjamin Cole

If you ever farted loudly on a crowded elevator, then you know the reaction of most economists to the idea that national debts should be monetized through central bank quantitative easing (QE), aka “printing money.”

Until recently, monetizing national debts was the most foul of topics, usually dismissed with words like “debauchery,” “debasement,” or “depravity.” Red-light district street winos had more moral fiber than to print money to pay national debts.

But now conservative University of Chicago economist John Cochrane has flatulence in the lift too. In his blog, The Grumpy Economist, has Cochrane’s suggested that the United States government pay off its entire debt through QE.

The elevator doors have also just admitted Martin Wolf, Financial Times econo-pundit extraordinaire, with his new book The Shifts and The Shocks. In this tome, Wolf says national governments should run permanent fiscal deficits, financed by permanent money printing, or QE.

It’s getting crowded in here!

Surely, this is one of the most remarkable developments in the history of modern economic thought. Who ever thought “serious economists” (pardon the oxymoron) would breezily toss off the idea of regularly monetizing national debts?

And whoever thought that serious economists—and me!—might be right?

The Japan Story

Japan applied a modest QE program 2002-2006, one that won gushy praise from John Taylor, the Stanford scholar, arch-conservative and inventor and defender of the “The Taylor Rule.” In 2006 Taylor wrote, “The key to the [Japanese] recovery has been…the quantitative easing of monetary policy,” in a paper entitled Lessons from the Recovery from the ‘Lost Decade’ in Japan: The Case of the Great Intervention and Money Injection.

Of course, Japan’s QE was just what Milton Friedman told the Bank of Japan to do, in his seminal 1998 essay for the Hoover Institution, Reviving Japan.

The modest 2002-2006 Japan QE program was associated with a relief from that nation’s post-1992 deflation-perma-gloom. Nor did the 2002-2006 BoJ QE result in much inflation.

Given what happened after 2006, it seems a case could be made that Japan should have never stopped QE—that the Cochrane-Wolf idea of permanent QE is worthy. Now, of course, the BoJ is trying QE again, and at least Japanese stock and property markets like it.

The U.S. Story

As readers of this space probably know, in the U. S. blogosphere there is an ongoing war (usually of attrition, rather than elucidation) over whether QE rescued the U.S. economy, or whether QE did nothing, or whether the U.S. economic recovery has been retarded by insufficient federal deficits.

My take is that the Market Monetarists have won this blog-war, and that the U.S. economy has grown because of QE and a normal tendency to recover. Bigger QE would have been better, with a clear statement from the Fed that the boost in the money supply would be permanent. In short, the Fed dithered and lacked resolve—much like the BoJ’s timid 2002-2006 QE program.

The even-worse, headache-inducing European econo-scene is due to the European Central Bank’s incredibly ill-timed concerns about inflation, and lack of expansionist resolve, and lack of aggressive QE.

Looking Forward

So, what if Wolf and Cochrane (and me!) are right?

What if QE is a useful tool to pay off national debts, and stimulate the economy? Then what are we to make of the Federal Reserve, as led by the FOMC and Chief Janet Yellen, moving now to quash QE?

My best guess is that the Fed, FOMC and Yellen are making a huge mistake, with terrible consequences for the economy and the national budget and taxpayers. The risks, my friends, are not in extending QE but in ending QE.

The risk of halting QE is Japanitis, and the island nation has yet to demonstrate it can escape perma-gloom. We can hope the BoJ’s current QE program works—but they now have to overcome decades of recession psychology. Who wants to invest in a perma-recession and deflation?

Blinded By A Phantom?

Yet FOMC members remain resolute in their fixation on inflation.

If FOMC members can’t find inflation with a microscope, then they use a telescope and scan the horizons for the slightest clue. And if inflation-scaremongering is not convincing—you know the Cleveland Fed Index of 10-Year Inflation Expectations is now below 2 percent—then there is always the rear view mirror, and the ever-handy horror stories of Weimar Republic.

But the question Yellen should raise to the FOMC at their next (secret, closed-door) meeting is this: “Are we so sure we will not just have to reverse course, like the BoJ, and go back to QE within a few years? While, in the meantime, millions of citizens pay the price in less employment and profits?”

Who is going to get on the elevator next?

Many still believe the Great Recession was the result of a “modeling error”

In “To exit the Great Recession, central banks must adapt their policies and models”, Marcus Miller and Lei Zhang summarize it thus::

During the Great Moderation, inflation targeting with some form of Taylor rule became the norm at central banks. This column argues that the Global Crisis called for a new approach, and that the divergence in macroeconomic performance since then between the US and the UK on the one hand, and the Eurozone on the other, is partly attributable to monetary policy differences. The ECB’s model of the economy worked well during the Great Moderation, but is ill suited to understanding the Great Recession.

And write:

As Wolfgang Münchau has pointed out,

“The ECB is failing to deliver on its inflation target not because it has run out of instruments but because it has based its policy on a poorly performing economic model. The ECB never expects inflation to deviate from the target of just under 2 per cent. Yet each month inflation undershoots, and the ECB is apparently taken by surprise.” (Münchau 2014).

It so happens that the model referred to, based on Smets and Wouters (2003), was built on the basis of Woodford’s analysis and fitted to pre-crisis European data. It worked well during the Great Moderation; but, as it had no financial sector, it failed completely to predict or rationalise the ensuing crisis.

In such models, the economy is inherently stable and, if left alone, will head for high output and target inflation. Could it be that the ECB, charged with managing the newly created euro, believed that it had found the philosopher’s stone – a technically sophisticated model built in line with the latest academic principles that would serve it in good times and in bad?

If so, it could be making a mistake about the nature of economics. As Gilboa et al. (2014) warn in their recent paper, economic models are not in general designed to incorporate universal laws of behaviour. They are often more like elaborate ‘case studies’ fitted to particular circumstances – to be employed with care elsewhere. Thus, as in Table 1 below, the choice of model and policy should be adjusted as best suits the regime. During the Great Moderation, for example, the ECB-style model with a Taylor rule could be appropriate, as shown in the top left; but this should be suspended during the Great Recession, in favour of QE, followed by forward guidance to exit, as shown in the bottom right.

Maybe there´s a “universal law” and that´s: “spending makes the world go around”. It was not because there was no financial sector in the model that made it “fail completely to predict or rationalize the ensuing crisis”. It was the colossal failure of monetary policy that brought the crisis about, just as it is the monetary timidity that is making the recovery so insipid and stretched.

For the recovery being insipid and stretched one reason may be the specter of inflation. David Glasner has a good discussion of this point, concluding:

Before anti-inflationism became a moral crusade, it was possible for people like Richard Nixon and Ronald Reagan, who were disposed to favor low inflation, to accommodate themselves fairly easily to an annual rate of inflation of 4 percent. Indeed, it was largely because of pressure from Democrats to fight inflation by wage and price controls that Nixon did the unthinkable and imposed wage and price controls on August 15, 1971. Reagan, who had no interest in repeating that colossal blunder, instead fought against Paul Volcker’s desire to bring inflation down below 4 percent for most of his two terms. Of course, one doesn’t know to what extent the current moral and ideological crusade against inflation would survive an accession to power by a Republican administration. It is always easier to proclaim one’s ideological principles when one doesn’t have any responsibility to implement them. But given the ideological current ideological commitment to anti-inflationism, there was never any chance for a pragmatic accommodation that might have used increased inflation as a means of alleviating economic distress.

Let´s see how “spending” has shaped the “world” (in this case the US economy over different “Great” epochs).

I´ll start with the epoch that came to be called “Great Inflation”. What caused it? The chart clearly illustrates that the growing trend in spending (NGDP) was followed by a upward trending inflation (sometimes obscured by price controls, sometimes enhanced by oil (supply) shocks).

Model error_1

The next charts illustrate the “Great Moderation” epoch and the “Great Recession”. Back in the day, I think it was Orphanides who coined the expression “opportunistic disinflation” to describe the fall in spending growth that brought inflation to the desired 2% trend. For the whole period, spending growth is quite stable and on the occasions it falters, real output and inflation “react”. The  “Great Recession” is the direct result of a monetary policy blunder that allowed spending to contract! Everyone suffers. Firms don´t sell so they don´t produce and don´t hire (and dismiss “excess labor”). Debtors’ don´t pay and banks (financial system) go “broke”. The Fed comes in throwing liquidity around to rescue the financial system because (as Bernanke knew from his academic work) they have an enormous capacity to propagate the monetary shock. QE1 marks the spending turnaround but it lacks “conviction”, maybe being constrained by the “moral crusade” discussed by Glasner. So the economy “limps” along. But we know that “limping” has side-effects on the “economic body”!

Model error_2

Now, look at the monetary “punch” applied by FDR during the “Great Depression; and how he intervenes again when monetary policy (spending) goes “off-track” in 1937.

Model error_3

It seems that in “sickness and in health” it is the behavior of spending (determined by monetary policy) that “calls the shots”.  The economy is really inherently stable, not by being left alone but by being guided by the appropriate monetary policy, in particular a policy that keeps spending growing adequately.

Deflation can be “good” or “bad”, it depends on the circumstances. Once again, don´t reason from a price change

David Andolfatto has a recent post where he questions the “evils of deflation”:

Everyone knows that deflation is bad. Bad, bad, bad. Why is it bad? Well, we learned it in school. We learned it from the pundits on the news. The Great Depression. Japan. What, are you crazy? It’s bad. Here, let Ed Castranova explain it to you (Wildcat Currency, pp.160-61):

Deflation means that all prices are falling and the currency is gaining in value. Why is this a disaster? … If you hold paper money and see that it is actually gaining in value, it may occur to you that you can increase your purchasing power–make a profit–by not spending it…But if many people hold on to their money, this can dramatically reduce real economic activity and growth…

In this post, I want to report some data that may lead people to question this common narrative. Note, I am not saying that there is no element of truth in the interpretation (maybe there is, maybe there isn’t). And I do not want to question the likely bad effects that come about owing to a large unexpected deflation (or inflation).  What I want to question is whether a period of prolonged moderate (and presumably expected) deflation is necessarily associated with periods of depressed economic activity. Most people certainly seem to think so. But why?

The first example I want to show you is for the antebellum United States (and shows a version of this chart):

Deflation Evil_1

Following the end of the U.S. civil war, the price-level (GDP deflator) fell steadily for 35 years. In 1900, it was close to 50% of its 1865 value. In the meantime, real per capita GDP grew by 85%. That’s an average annual growth rate of about 1.8% in real per capita income. The average annual rate of deflation was about 2%. I wonder how many people are aware of this “disaster?”

People should know that there are “good” and “bad” deflations. In the picture above we see that the real output-price outcome was the result of a shifting AS curve (positive productivity shock).

The next picture gives an example of “bad” deflation, the result of a contraction in AD. In 1933 the opposite occurs when FDR delinked from gold and monetary policy was expansionary, allowing real output to grow strongly with minor impact on prices (given all the “slack” generated by the GD).

Deflation Evil_2

The Great Inflation is the prototype example of inflation “running wild” due to excessively expansionary monetary policy.

Deflation Evil_3

So, in some cases deflation is really a “disaster”.

And in this day and age of inflation targeting, allowing inflation to fall below target (and letting the price level remain permanently below the “inflation target associated price level”) is tantamount to monetary tightening. More expansionary monetary policy would result in the “counterfactual per capita income”. In this case we don´t have deflation but “inadequate inflation” (in reality, inadequate nominal spending), which can also be (very) bad.

Deflation Evil_4

Freshwater meets Saltwater

The other day John Cochrane showed his “freshwater colors” answering to Krugman:

My worries about inflation do not come from monetary policy. I’ve been as outspoken on the view that monetary policy is ineffective at the zero bound as the most solid Keynesian.  In the WSJ,  “Reserves that pay market interest are not inflationary. Period.” If you bothered to read anything before venting, you’d know that.

Milton Friedman “turned in his grave”!

Now they only have to agree on the FTPL.

Plossers, Fishers and Georges are less prevalent among the “public”

The Federal Reserve Bank of San Francisco has a new study out: “Assessing Expectations of Monetary Policy”:

An ongoing concern has been that the public might misconstrue the Fed’s forward guidance about future monetary policy and underappreciate the extent to which short-term interest rates may vary with future news about the economy. Evidence based on surveys, market expectations, and model estimates show that the public seems to expect a more accommodative policy than Federal Open Market Committee participants. The public also may be less uncertain about these forecasts than policymakers.

My bet is on the “public”!