Ramblings picking up on: In Lieu of a Focus Post: March 2, 2015:
The kha-khan Cosma Shalizi smacks me down for seeing the Federal Reserve as afflicted by intellectual errors, rather than as a prisoner of Gramscian top 0.1% hegemony and the revolving door.
He has a point, a definite point.
In a good world the Janet Yellens and the Charles Evanses would be the vital center of the Federal Reserve, not its left wing. And they would be acting as its left wing, pointing out the manifold benefits of labor-force upgrading in a high-pressure economy, the extraordinary quiescence of core inflation, and the continued overoptimism of the Fed model.
In a closely-related piece, Paul Krugman tries to untangle why so many center-right and right-wing economists are so resistant to the elementary logic of Hicks (1937) and the IS-LM model—even those who, like Marty Feldstein, teach the IS-LM model to their students, and teach it very well (after all: he taught it to me).
Back in 2009 the sharp and thoughtful Mark Thoma wrote a good piece giving what seemed to me to be the correct answer to the inflationistas: He wrote that there was some reason to fear an outburst of inflation when and if the long run came in which the government budget constraint bound and yet congress was continuing to refuse to either:
- curb the growth of public health care costs, or
- raise taxes to pay for them.
But, he went on, the IS-LM logic meant that that was not a risk in the short run. And the cost of the stimulus program and how much debt was “monetized” by QE had at best a second decimal-place effect on the vulnerability of the U.S. to long-run inflation driven by the fiscal theory of the price level. The big enchilada was health-care costs:
…Once we begin to recover, there are three ways to reduce… inflationary pressures…. We could simply reduce the money supply… by selling bonds to the public. Feldstein’s worry is that the Fed… won’t have enough government bonds to reduce the money supply… and nobody will want to purchase the private sector bonds…. The second choice is to raise taxes…. My inclination is to say good luck with that…. Third, we could reduce government spending…. Health care reform… is where the focus needs to be. The budget worries twenty years from now have little to do with the temporary stimulus measures we are taking today, going forward health care costs are the most important issue by far in terms of the budget, and everything else revolves around solving that problem. So am I worried about inflation? Somewhat…. If deficits persist, it could come down to a choice by the Fed to monetize the deficit–and risk inflation–or allow government debt to pile up and risk high interest rates…
That seemed and seems to me to be right, and that is driven by a coherent theoretical view: (i) an unemployment short-run until production returns to potential output, (ii) a medium run in which confidence and interest rates and full-employment growth rates depend on market assessments of how the long-run fiscal gap will be closed, and (iii) a long run in which, perhaps suddenly and unexpectedly, the fiscal theory of the price level binds.
The only thing wrong with Mark’s analysis back in 2009 that I saw then and that I see now–other than the short run being a very long time indeed, the bending of the health care costs curve occurring much more sharply than I had imagined possible, and a configuration of interest rates which raises the strong possibility that the long-run in which the fiscal theory of the price level binds has been put off to infinity–was that it missed the easiest way of shrinking the velocity of money in a recovery: raising reserve requirements. So I always had a very hard time figuring out what Feldstein and company were fearing at all…
Indeed, it seemed to me not to be coherent:
Martin Feldstein: “The unprecedented explosion of the US fiscal deficit raises the spectre of high future inflation….
There is ample historic evidence of the link between fiscal profligacy and subsequent inflation. But historic evidence and economic analysis also show that the inflationary effects can be avoided if the fiscal deficits are not accompanied by a sustained increase in the money supply and, more generally, by an easing of monetary conditions…. The potential inflationary danger is that the large US fiscal deficit will lead to an increase in the supply of money….
The link between fiscal deficits and money growth is about to be exacerbated by ‘quantitative easing’, in which the Fed will buy long-dated government bonds…. When the economy begins to recover, the Fed will have to reduce the excessive stock of money…. This will not be an easy task since the commercial banks may not want to exchange their reserves for the mountain of private debt that the Fed is holding and the Fed lacks enough Treasury bonds with which to conduct ordinary open market operations. It is surprising that the long-term interest rates do not yet reflect the resulting risk of future inflation…
Feldstein–and Greenspan, and Taylor, and Asness, and all the rest–clearly thought in 2009 and 2010 that U.S. Treasuries were trading way high, in an enormous bubble, and there was an enormous market opportunity to profit with relatively little risk by shorting long-term Treasuries and buying secondarily equities and primarily gold as inflation hedges. I often wonder to how many people they gave this advice, how many of the people they gave it to took it, and what has happened to their portfolios since. But I digress…
As I looked back on the situation in 2009 and 2010–with a dead housing credit channel, and the increasing likelihood of a recovery characterized not as a V or as a U but as an L–I find myself thinking that Marty Feldstein and the others had turned all their smarts to trying to find reasons not to believe the IS-LM models that they (or at least Feldstein and Taylor) had taught, and not to believe that the marginal investor in financial markets was not-stupid. That fiscal and monetary ease would bring back the 1970s in short order was their conclusion. The task was to think of not-implausible reasons and mechanisms that would make this so.
The corollary, of course, is that for them the only good policies are hard-money austerity policies; and the only good portfolios are those that assume a departure from hard-money austerity will produce inflation.
So perhaps there is a deeper problem somewhere…
It made sense for those of my great-great grandfathers who were rich back before World War I to be hard-money guys. The investment vehicles open to them were land that pretty much had to be rented out at fixed nominal rents, bonds that paid fixed nominal yields, and equities where–unless you ran the business–you were quite probably a fool soon to be parted from his money by financial engineering. But it made no sense for my rich grandfather after World War II to be a hard-money guy. He had a much bigger portfolio of assets to invest in: equities backed by more-or-less honest accounts, land that the coming of automobiles and superhighways and the move to the sunbelt meant could be developed as suburbs, as well as leveraged resource speculations. He profited immensely from investments in all of these. Yet, in his heart of hearts, he remained a hard-money guy.
And it really makes no sense for my contemporaries to be hard-money believers. Yet an astonishing share of the rich among them are.
A great and enduring puzzle…
So: To the re-education camp! I have a lot of rethinking to do–but not about IS-LM, hysteresis, or the fiscal theory of the price level; rather, about the connecting-belts between asset values, wealth levels, and people’s ideal interests of what proper monetary and fiscal policy should be.
Wish me luck!
- http://krugman.blogs.nytimes.com/2015/03/01/the-strange-urge-to-raise-rates : The Strange Urge to Raise Rates
- http://www.project-syndicate.org/commentary/inflation-rates-central-bank-by-martin-feldstein-2015-02 : The Deflation Bogeyman
- http://economistsview.typepad.com/economistsview/2009/04/feldstein-inflation-is-looming.html (March 2009): Feldstein: Inflation is Looming
- http://blog-imfdirect.imf.org/2014/03/04/euro-area-deflation-versus-lowflation (2014): “Deflation” Versus “Lowflation”
- http://www.nber.org/papers/w14259.pdf (2008): The State of Macro
- http://www.bradford-delong.com/2015/03/monday-delong-smackdown-cosma-shalizi-says-apropos-of-the-fed-the-cossacks-work-for-the-czar.html : Apropos of the Fed: “The Cossacks Work for the Czar!”