More musings on the current episteme of the Federal Reserve…

Paul Krugman’s Respectable Radicalism politely points out (at least) one dimension along which I am a moron.

Let me back up: Here in the United States, the current framework for macroeconomic policy holds that the economy is nearly normalized, that further extraordinary expansionary and fiscal policy moves carry “risks”, and that as a result the right policy is stay-the-course. I was arguing that the Economist Left Opposition demand–for substantially more expansionary monetary and fiscal policies right now until we see the whites of the eyes of rising inflation–was soundly based in orthodox lowbrow Hicks-Patinkin-Tobin macro theory. That is the macro theory that economists like Ben Bernanke, Janet Yellen, and Stan Fischer taught their entire academic careers.

Paul Krugman points out—politely—that I am wrong.

The Economist Left Opposition framework contains at least one claim that is substantially non-orthodox: We claim that worries about the debt accumulation from expansionary fiscal policy right now are profoundly misguided. Under current conditions, the government’s borrowing money or printing money and buying stuff does not raise but lowers the debt-to-annual-GDP ratio. However large you think the influence of an outstanding debt burden on interest rates happens to be, interest rates in the future will be lower, the debt as a multiple of annual GDP will be lower, and thus the debt financing burden and all debt-related risks will be lower in the future with a more expansionary fiscal policy than baseline. This is definitely nonstandard. And it is embarrassing to note that this is my idea–or, rather, Larry Summers and I were the ones who did the arithmetic to show how topsy-turvy the macroeconomic world currently is with respect the fiscal policy. This was a really smart thing for us to do. And it is definitely not part of the standard orthodox policy-theory framework in the way that the rest of the Hicks-Patinkin Economist Left Opposition framework is.

As Paul writes:

Paul Krugman: Respectable Radicalism: “Hysteresis [in the context of very low interest rates]… is indeed a departure from standard models…

…But the [rest, the] case that the risks of hiking too soon and too late are deeply asymmetric comes right out of IS-LM with a zero lower bound… the framework I used….

Being an official… can create a conviction that you and your colleagues know more than is in the textbooks…. But… [at the] zero-lower-bound… world nobody not Japanese [had] experienced for three generations, theory and history are much more important than market savvy. I would have expected current Fed management to understand that; but apparently not.

I wrote about Rawls’s reflective equilibrium idea yesterday, so let me just cut and paste: Are models properly idea-generating machines, in which you start from what you think is the case and use the model-building process to generate new insights? Or are models merely filing systems–ways of organizing your beliefs, and whenever you find that your model is leading you to a surprising conclusion that you find distasteful the proper response is to ignore the model, or to tweak it to make the distasteful conclusion go away?

Both can be effectively critiqued. Models-as-discovery-mechanisms suffer from the Polya-Robertson problem: It involves replacing what he calls “plausible reasoning”, where models are there to assist thinking, with what he calls “demonstrative reasoning”. in which the model itself becomes the object of analysis. The box that is the model is well described but, as Dennis Robertson warned,there is no reason to think that the box contains anything real. Models-as-filing-systems are often used like a drunk uses a lamp post: more for support than illumination.

In the real world, it is, of course, the case that models are both: both filing systems and discovery mechanisms. Coherent and productive thought is, as the late John Rawls used to say, always a process of reflective equilibrium–in which the trinity of assumptions, modes of reasoning, and conclusions are all three revised and adjusted under the requirement of coherence until a maximum level of comfort with all three is reached. The question is always one of balance.

What I think Paul Krugman may be missing here is how difficult it is to, as Keynes wrote:

The composition of this book has been for the author a long struggle of escape… from habitual modes of thought and expression. The ideas which are here expressed so laboriously are extremely simple and should be obvious. The difficulty lies, not in the new ideas, but in escaping from the old ones, which ramify, for those brought up as most of us have been, into every corner of our minds…

In this case, the old ideas with respect to the budget deficit are those of various versions of fiscal crisis and fiscal price level theory developed largely out of analysis of Latin American and southern European experience, and those of various versions of monetarist theory based upon the experience of the 1970s. How difficult this is is illustrated by one fact I find interesting about Paul Krugman (1999): Back then, his analysis of the liquidity trap and fiscal policy back in 1999 was… very close to Ken Rogoff’s analysis of the liquidity trap and fiscal policy today:

Paul Krugman (1999): Thinking About the Liquidity Trap, Journal of the Japanese and International Economies 14:4 (December), pp. 221–237: “The story… [of] self-fulfilling pessimism is… a multiple equilibrium story…

…with the liquidity trap corresponding to the low-level equilibrium…. Over some range spending rises more than one-for-one with income. (Why should the relationship flatten out at high and low levels? At high levels resource constraints begin to bind; at low levels the obvious point is that gross investment hits its own zero constraint. There is a largely forgotten literature on this sort of issue, including Hicks (194?), Goodwin (194?), and Tobin (1947))….
Thinking about the liquidity trap

Multiple equilibria… allow for permanent (or anyway long-lived) effects from temporary policies. There may be excess desired savings even at a zero real interest rate given the pessimism that now prevails… but if some policy could push the economy to a high level of output for long enough to change those expectations, the policy would not have to be maintained…. Balance-sheet problems… may involve an element of self-fulfilling slump: a firm that looks insolvent with an output gap of 10 percent might be reasonably healthy at full employment….

‘Pump-priming’ fiscal policy is the conventional answer to a liquidity trap…. In either the IS-LM model or a more sophisticated intertemporal model fiscal expansion will indeed offer short-run relief…. So why not consider the problem solved? The answer hinges on the government’s own budget constraint….

Ricardian equivalence… is not the crucial issue…. Real purchases… will still create employment…. (In a fully Ricardian setup the multiplier on government consumption will be exactly 1)….

The problem instead is that deficit spending does lead to a large government debt, which will if large enough start to raise questions about solvency. One might ask why government debt matters if the interest rate is zero…. But the liquidity trap, at least in the version I take seriously, is not… permanent…. [When] the natural rate of interest… turn[s] positive… the inherited debt will indeed be a problem….

Fiscal policy [is] a temporary expedient that cannot serve as a solution [unless]….

First, if the liquidity trap is short-lived… fiscal policy can serve as a bridge… after [which]… monetary policy will again be able to shoulder the load… a severe but probably short-lived financial crisis in trading partners… breathing space during which firms get their balance sheets in order….

[Second, if] it will jolt the economy into a higher equilibrium…. If this is the underlying model… one must realize that the criterion for success is quite strong…. Fiscal expansion… must lead to… increases in private demand so large that the economy begins a self-sustaining process of recovery….

None of this should be read as a reason to abandon fiscal stimulus…. But fiscal stimulus… [is only] a way of buying time… [absent] assumptions that are at the very least rather speculative…

Since 1999, Paul has changed his mind. He has become an aggressive advocate of expansionary fiscal policy as the preferred solution. Why? And is he right to have done so? Or should he have stuck to his 1999 position, and should he still be lining up with Ken today?

One part of the reason, I think, is–and I say this with whatever modesty I have ever had still intact–that DeLong and Summers (2012) has provided one of the very very few additions of conceptual value-added to Krugman (1999). We pointed out that with a modest degree of “secular stagnation”–a modest fall in safe real interest rates over the long run–and a slight degree of hysteresis, fiscal expansion in a liquidity trap does not worsen but improves the long-run fiscal balance of an economy in a liquidity trap. This was something that Krugman missed in 1999. It is something that people like Rogoff continue to miss today.

This has consequences: The more scared you are of some long-run collapse of the currency from excessive government debt relative to annual GDP, the stronger you should advocate for more expansionary fiscal policy when the economy is in a liquidity trap. The more you think that real interest rates in the long run are coupled to high values of government debt relative to annual GDP, the stronger you should advocate for more expansionary fiscal policy when the economy is in a liquidity trap. The more you worry about debt crowding-out useful and productive government spending in the long run, the stronger you should advocate for more expansionary fiscal policy when the economy is in a liquidity trap. This whole line of thought, however, was absent from Krugman (1999), and is absent from Rogoff and company today.

A second part of the reason is that even modest “secular stagnation” does more than (with even a slight degree of hysteresis) reverse the sign on the relationship between fiscal expansion today and long-run government-debt burdens. It also undermines the effectiveness of monetary policy as an alternative to fiscal policy. Monetary expansion–in the present or the future–needs a post-liquidity trap interest-rate “normalization” environment to have the purchase to raise the future price level that it needs to be effective in stimulating production now. Secular stagnation removes or delays or attenuates that normalization.

Third comes the credibility problem.

Fourth, there is a sense in which Paul has not shifted that much. Look at his analysis of Japan…

Third comes the credibility problem. Back in the days of Krugman (1999), he at least had little doubt that a central bank that understood the situation would want to generate the expected inflation needed. That was the way to create a configuration of relative prices consistent with full employment. That was what a competent central bank would wish to do. And a central bank that wished to create expectations of higher inflation would have a very easy time doing so.

The mixed success of Abenomics, however, has cast doubt on the second of these—on the ability of central banks to easily generate higher expected inflation. Japan today appears to be having a significantly harder time generating expectations of inflation than I had presumed. And

With respect to the first—the desire to create higher expected inflation—Ben Bernanke, while chairman of the Federal Reserve, repeatedly declared that quantitative easing policies were not intended to produce any breach of the 2% per year inflation target upward. These declarations were not something that I expected, and were not something that I understood. They still leave me profoundly puzzled.

Fourth, there is a sense in which Paul has not shifted that much. Look at his analysis of Japan today. In his view, fiscal expansion today is needed to create the actual inflation today that will (i) raise the needle on future expected inflation, and so (ii) allow for a shift to policies that (iii) will amortize rather than grow the national debt. Inflation someday generated by the fiscal theory of the price level and high future interest rates generated by the risks of debt accumulation still have their places in his thought.

Must-read: Mark Thoma: “On Summers: My Views and the Fed’s Views on Secular Stagnation”

Must-Read: I would say that if monetary policy makers wish to place limits on what can be expected from monetary policy, they need to also be making loud and constructive arguments about what will do the stabilization policy job if monetary policy is not going to push the envelope. I don’t think Plosser ever made loud and constructive arguments directing other policy makers to do a constructive job…

Mark Thoma: On Summers: My Views and the Fed’s Views on Secular Stagnation: “The Fed’s job would have been, and will be a lot easier if fiscal policy makers would help…

…I disagree with Charles Plosser’s view on monetary policy, but I have some sympathy for the view that many people have come to expect too much from monetary policy:

On the monetary policy side central banks have clearly pushed the envelope in an effort to stabilize and then promote real economic growth. The pressure to do so has come from inside and outside the central banks… raised expectations of what the central bank can do…. It is not clear that this is wise or prudent.  Many have come to fear that without substantial support from monetary policy our economies will slump into stagnation. This would seem to fly in the face of nearly two centuries of economic thinking…

If secular stagnation is real, the Fed cannot overcome it by itself. Fiscal policy will have to be part of the solution…. Monetary policy — and fiscal policy too — can have a permanent impact on the natural rate of output by helping the economy to recover faster. The faster the recovery, the less the natural rate is lowered. So I agree with Summers that monetary policy needs to take the possibility of secular stagnation into account, I just wish he’d put more emphasis on the essential role of fiscal policy — something he has certainly done in the past, e.g.:

I believe that it is appropriate that we go back to an earlier tradition that has largely passed out of macroeconomics of thinking about fiscal policy as having a major role in economic stabilization…

Must-Read: Paul Krugman: Demand, Supply, and Macroeconomic Models

Paul Krugman talks to journalists during a news conference. (AP Photo/Francisco Seco)

Must-Read: A key factor Krugman omits in which standard Hicksian-inclined economists’ predictions have fallen down: the length of the short run. The length of the short run was supposed to be a small multiple of typical contract duration in the economy–perhaps six years in an economy characterized by three-year labor contracts, and perhaps three years in an economy in which workers and employers made decisions on an annual cycle. After that time, nominal prices and wages were supposed to have adjusted enough to nominal aggregates that the economy either would be at or would be well on the road to its long-run full-employment configuration. Moreover, the fact that price inertia was of limited duration combined with forward-looking financial markets and investment-profitability decisions to greatly damp short-run shortfalls of employment and production from full employment and sustainable potential.

It sounded good in theory. It has not proved true in reality since 2007:

Paul Krugman: Demand, Supply, and Macroeconomic Models: “If you came into the crisis with a broadly Hicksian view of aggregate demand…

…you did quite well… [arguing] that as long as we were at the zero lower bound massive increases in the monetary base wouldn’t be inflationary [and would have near-zero effects on broader aggregates]… budget deficits would not drive up interest rates… large multipliers from fiscal policy…. What hasn’t worked nearly as well is our understanding of aggregate supply… the absence of deflation… [of] the “clockwise spirals”… in inflation-unemployment space as evidence for… Friedman-Phelps…. The other big problem is the dramatic drop in… potential output… correlated with the depth of cyclical slumps….

[The] policy moral[?]… Central banks focused on stable inflation may think they’re doing a good job… when they are actually failing…. Fiscal contraction in a liquidity trap seems… absolutely terrible for the long-run as well as the short-run, and quite possibly counterproductive even in purely [debt burden] terms…. I don’t think even Hicksian-inclined economists have taken all of this sufficiently into account.

New thinking: Larry Summers puts in his 2 cents on “hysteresis” and “superhysteresis”

Let me point out that, to the extent one recognizes even the possibility of hysteresis or superhystesis, obvious optimal control policy when you approach the zero lower bound is to dial up current monetary expansion to the max and call for more fiscal expansion as well. The long-run damage from not generating a V-shaped recovery in the short-run is then immense, and you always dial policy down to be less expansionary should it look like you were about to overshoot. Yet such arguments had no purchase in the Bernanke Fed or the Geithner Treasury, and little inside the Obama White House.

I must confess that I have never understood why people ever thought it reasonable to believe that the pace of potential output growth was the same in a low pressure as an high-pressure economy. And, indeed, it is not:

Larry Summers: Advanced Economies Are so Sick We Need a New Way to Think About Them: “There appear to be more cases where recessions reduce the subsequent growth of output…

…than where output returns to trend. In other words ‘super hysteresis,’ to use Larry Ball’s term, is more frequent than ‘no hysteresis.’… We look at… recessions with different precursors. We find that even recessions that are associated with disinflationary monetary policies or the drying up of credit have substantial long-run output effects–suggesting the presence of hysteresis effects…. [Moreover,] fiscal policy changes have large continuing effects on levels of output suggesting the importance of hysteresis…

But we knew all this back in 1936, no? John Maynard Keynes:

John Maynard Keynes (1936): The General Theory of Employment, Interest and Money, chapter 24: “The enlargement of the functions of government…

…[is] the only practicable means of avoiding the destruction of existing economic forms in their entirety and as the condition of the successful functioning of individual initiative…. If effective demand is deficient, not only is [there] the public scandal of wasted resources… but the individual enterpriser… is operating with the odds loaded against him… many zeros, so that the players as a whole will lose if they have the energy and hope to deal all the cards. Hitherto the increment of the world’s wealth has fallen short of the aggregate of positive individual savings; and the difference has been made up by the losses of those whose courage and initiative have not been supplemented by exceptional skill or unusual good fortune. But if effective demand is adequate, average skill and average good fortune will be enough…

Only in a high-pressure economy, Keynes says, will the “increment of wealth”–the value of productive capital and organizations created–match “the aggregate of positive individual savings”–the amount of resources devoted to trying to boost productive capacity. In a low-pressure economy, a lot of investments that could pay off from a tastes-and-technologies standpoint won’t because of slack demand, and so perfectly-productive factories and organizations will be scrapped and shut down.

And we have to add on to this the perspective, derived from Granovetter, that a great deal of the societal resource-allocation capital of the labor market is the social network of loose ties generated that nobody gets paid for, and is thus a spillover; the perspective, derived from Saxenian, that a great deal of the societal resource-allocation capital of the value chain is the social network of overlapping communities of engineering practice generated that nobody gets paid for, and is thus a spillover; and the perspective derived from Hayek that a great deal of the societal resource-allocation capital of the price system is the revelation by market prices of societal scarcities and values that nobody could calculate on their own, and that nobody gets paid for generating, and is thus a spillover. Externalities all over the place here!

The question is: why did people ever assume otherwise? Yes, a linear Phillips Curve is simple to work with. Yes, the assumption that the rate of inflation expected next year is simply actual inflation last year seems like a not unreasonable rule-of-thumb. But you have to put very great weight on both–weight that the past decade has conclusively proven they cannot bear–to even conclude the business cycles are fluctuations around rather than falls below sustainable levels of production. And you are still absolutely nowheresville with respect to the invariance of potential growth to cyclical conditions.

Must-Read: Paul Krugman: Austerity’s Grim Legacy

Paul Krugman: Austerity’s Grim Legacy: “The consequences of the wrong turn we took look worse now…

…than the harshest critics of conventional wisdom ever imagined. For those who don’t remember (it’s hard to believe how long this has gone on): In 2010, more or less suddenly, the policy elite on both sides of the Atlantic decided to stop worrying about unemployment and start worrying about budget deficits instead. This shift wasn’t driven by evidence or careful analysis… was very much at odds with basic economics. Yet ominous talk about the dangers of deficits became something everyone said because everyone else was saying it… those parroting the orthodoxy of the moment [were the] Very Serious People. Some of us tried in vain to point out that deficit fetishism was both wrongheaded and destructive…. And we were vindicated by events. More than four and a half years have passed since Alan Simpson and Erskine Bowles warned of a fiscal crisis within two years; U.S. borrowing costs remain at historic lows. Meanwhile, the austerity policies that were put into place in 2010 and after had exactly the depressing effects textbook economics predicted; the confidence fairy never did put in an appearance…. [And] there’s growing evidence that we critics actually underestimated just how destructive the turn to austerity would be. Specifically, it now looks as if austerity policies didn’t just impose short-term losses of jobs and output, but they also crippled long-run growth….

At this point… evidence practically screams “hysteresis”. Even countries that seem to have largely recovered from the crisis, like the United States, are far poorer than precrisis projections suggested they would be at this point. And a new paper by Mr. Summers and Antonio Fatás… shows that the downgrading of nations’ long-run prospects is strongly correlated with the amount of austerity they imposed…. The turn to austerity had truly catastrophic effects…. The long-run damage suggested by the Fatás-Summers estimates is easily big enough to make austerity a self-defeating policy even in purely fiscal terms: Governments that slashed spending in the face of depression hurt their economies, and hence their future tax receipts, so much that even their debt will end up higher than it would have been without the cuts. And the bitter irony of the story is that this catastrophic policy was undertaken in the name of long-run responsibility….

There are a few obvious lessons… groupthink is no substitute for clear analysis… calling for sacrifice (by other people, of course) doesn’t mean you’re tough-minded. But will these lessons sink in? Past economic troubles, like the stagflation of the 1970s, led to widespread reconsideration of economic orthodoxy. But one striking aspect of the past few years has been how few people are willing to admit having been wrong about anything…

Question: What Are Our Biggest Economic Problems Right Now?

I have been someone who takes the long-run secular decline in prime-age male employment as a canary in the coal mine: it has seemed to me via sign that information technology which greatly reduces valuable employment of human brains as cybernetic control elements for machines poses us with significant problems that are not necessarily economic but rather in the sociology of social roles. When Case and Deaton on the decline in life expectancy among the white and middle-aged crossed my desk earlier this week, I thought that case was reinforced.

But now I find myself updating and looking at this graph:

Graph Employment Rate Aged 25 54 Females for the United States© FRED St Louis Fed

It now looks quite different from how it looked a couple of years ago.

I had, a couple of years ago, taken the gender gap in trends here as an indication that those trained not to focus on social intelligence were having increasing difficulties finding valued social roles, and thus as a sign that information technology sociological apocalypse was drawing near. But now… relative to 2000, it is much easier to tell a slack-labor-demand-is-most-of-it story.

Thus I am now swinging toward thinking that if we could only focus on expansionary fiscal policy to restore the high-pressure full-employment economy of the Clinton years that we would find our longer-run structural problems solving themselves, or at any rate becoming smaller and moving further away into the distance. And I am now swinging toward understanding Case and Deaton as more evidence on the extremely high sociological costs of a low-pressure economy.

Must-Read: Larry Summers: Advanced Economies Are so Sick We Need a New Way to Think About Them

Must-Read: Larry Summers: Advanced Economies Are so Sick We Need a New Way to Think About Them: “Standard new Keynesian macroeconomics… [and] to an even greater extent… dynamic stochastic general equilibrium (DSGE) models…

…imply that… the only effect policy can have is on the amplitude of economic fluctuations, not on the [average] level of output. This assumption is problematic…. The assumption is close to absurd. It is surely reasonable to assume that better policy could have avoided the Depression or the huge output losses associated with the financial crisis without having shaved off some previous or subsequent peak…. Contrary to the now common view that macroeconomics is best understood by studying the stochastic properties of stationary time series, the most important macroeconomic events are in some sense one off. Think of the Depression or the Great Recession or the high inflation of the 1970s. The problem has always been that it is difficult to beat something with nothing. This may be changing as topics like hysteresis, secular stagnation, and multiple equilibrium are getting more and more attention…