“Lord, show them the light”!

Scott Sumner went “head over heels” on this Matt Yglesias comment:

The state of the art thinking in DC, as I understand it, is that with interest rates and capacity utilization low monetary policy may not be able to boost NGDP by arbitrary amounts. Under the circumstances, to push it up non-trivially might require “crazy” steps that cause inflation expectations to become dangerously unanchored. So you need fiscal policy + monetary accommodation (i.e., bigger short-term deficit + Fed holds interest rates low) to produce the kind of moderate AD stimulus that’s wanted.

Unclear to me where this model comes from, or what evidence people think they have for it. But it’s a popular view among professional staff at Treasury & Fed and is bouncing around in the heads of some important principals and “name” economists. See Peter Diamond’s remarks to Ryan Avent and what Donald Kohn and Joel Prakken told Dylan Matthews.

To me this seems like what happens when a bunch of really bright people fuck up. Rather than admit that they fucked up, they’re devising clever theories to explain why they haven’t fucked up.

Scott Sumner complements:

Matt’s very well connected, so I don’t doubt his facts.  And his interpretation is also spot on.  But I think it’s worth discussing all the reasons why the conventional wisdom is all wrong, just as the identical conventional wisdom from the 1930s is now known to be 100% false.

There are all sorts of problems with the conventional view, but they boil down 2 fundamental problems:

1.  Grossly overestimating what the Fed has already done in terms of stimulus.

2.  Grossly overestimating how hard it is to prevent excessive inflation when exiting a liquidity trap.

This is Tim Duy on exactly the same vein:

Fear of inflation prevents the Federal Reserve from making an unconditional commitment. And therein lies the stumbling block to real policy change. It is virtually impossible to imagine reestablishing the pre-recession nominal GDP trend, and entirely impossible to regain the pre-recession price trend, without accepting a temporary acceleration of inflation along the way.

More succinctly, we will not lift the economy off the zero-bound without accepting higher than 2% inflation. Since the Federal Reserve has made it clear they will not accept inflation greater than 2%, the economy will not clear the zero-bound. And if the economy does not clear the zero-bound, we will be faced with perpetual and unavoidable deficit spending.

Deficit spending is not accommodated by the Federal Reserve via low interest rates; it is made necessary because the Federal Reserve sees no urgency ending the lower bound challenge. Which means it is ridiculous to believe that the Fed can dump off this problem on fiscal policymakers. How can the state of monetary policy have deteriorated so much that now even Bernanke claims “regulation” is holding back the economy? Yet here we are.

This link in Yglesias comment is well worth reading. The title is a contradiction in terms – “Can the Fed increase inflation”? (If not the Fed, who?). Donald Kohn´s take is a good description of the “conventional” mindset:

At this point with the economy operating so far below potential and monetary policy having trouble pushing it higher one might wonder whether either of these would be operative right now,” he said in an e-mail. With demand as low as it is now, convincing the markets that inflation is going up might be impossible, so it could be that the Fed just can’t affect inflation expectations for now.

The pictures below show how “little stimulus” the Fed has actually done – spending remains far below trend and unemployment unacceptably elevated; how a “level target” policy – a price level target announced by FDR, accompanied by the monetary expansion resulting from breaking out from the gold standard – really got “things going” despite the fact that the economy was inside a much deeper hole than at present (contrary to what Kohn argues), and how government intervention encapsulated in the NIRA was a “spoiler”; how a monetary policy geared, even if implicitly, to getting spending back on “track” after deviating from it in the early 2000s did not give rise to “excessive inflation”, and wouldn´t do now given, in Kohn´s estimate, that the economy is operating so “far below trend” (a flat SRAS curve).

The “facts” are very clearly observable, so why is the situation only worsening? Why so much “passivity”? I believe Bernanke is pretty happy with the presence of Plosser, Fischer and Kocherlakota on the board. They have the wrong, but firm, beliefs which make Bernanke, who deep down is also a “rabid” inflation targeter, look like a “saint”. The difference between Bernanke and the “3 Stooges” is that Bernanke, given his academic immersion in the “Great Depression”, is even more fearful of deflation. Being a strong proponent of the “credit channel” of monetary policy, he rushed to “save” the financial system. Feeling that mission was accomplished, all his subsequent actions were undertaken to avoid inflation falling too low, risking deflation. Just look at the inflation picture above for 2008-11; as soon as inflation risked turning into deflation QE2 was implemented. As soon as that risk subsided, the program was terminated!

But there´s no end to inflation or inflation expectations turning “too low”, as long as spending is on a “deep water fishing expedition”. So recently Bernanke has shown renewed deflation worries, and on we go. Tim Duys observation that “if the economy does not clear the zero-bound, we will be faced with perpetual and unavoidable deficit spending” is “tragic” but true, leading the US economy into a “Japanese-like” outcome!