Category: Monetary Policy

Income inequality and aggregate demand in the United States

Posted on by Emilie Openchowski
Income inequality has been on the rise for decades in the United States, but a new working paper looks at how that might be affecting macroeconomic activity through the aggregate demand channel.

Income inequality has been rising for decades in the United States. While there are many reasons why this trend may be concerning, one particular worry for economists and policymakers is the effect that it might have on macroeconomic activity through what is sometimes called the aggregate demand channel. The argument is as follows: There is some evidence that the rich save more than the poor. A rise in income inequality implies more income accruing to the rich, a trend that may be depressing overall consumption and in turn lowering aggregate output and employment.

A competing argument, however, focuses on the resulting increase in savings, which could be expected to translate into an increase in investment, raising the capital stock and economic output in the future. In this view, higher income inequality creates some losers, but it leads to an increase in aggregate Gross Domestic Product. Whether the first or the second effect dominates depends on what macroeconomists call general equilibrium considerations, and in particular, on our presumptions about the response of monetary policy to rising income inequality. This column examines those two effects, based on our newly released working paper.

A model of the effect of income inequality on aggregate demand

Before turning to that analysis, let us first briefly establish the basis of our inquiry-rising income inequality. Two common measures of inequality in the United States are the standard deviation of log earnings (a measure of inequality within labor income) and the capital share (a measure of inequality between labor and capital). As has been widely documented, both measures have risen since the 1980s.1 (See Figure 1.)

Figure 1

Up until now, most general equilibrium macroeconomic models that were used to evaluate the effects of rising inequality were built under the assumption that the U.S. Federal Reserve would immediately accommodate increases in income inequality by lowering interest rates. Those models accord with the second view-that inequality leads the Fed to lower the cost of capital, encouraging investment, which can lead to an economic boom. In our paper, we show that if we assume that monetary policy has limited willingness or ability to respond to the rise in inequality, then the outcome for GDP looks more concerning.2 Lower consumption lowers employment and individual incomes, feeding back into even lower consumption. Firms disinvest because they anticipate lower employment in the future, and this lowers incomes even further.

Our new model fits known facts about individuals’ marginal propensities to consume and their saving behavior. We use the model to predict the potential effect of an increase in inequality on economic output, assuming that monetary policy is at the zero lower bound for nominal interest rates, so that it is constrained not to respond to increases in inequality. We show that the key determinant of the effect of inequality on GDP is its effect on asset demand. This is the answer to the question: How much would aggregate wealth increase if we were to artificially hold all other macroeconomic factors such as interest rates and incomes constant? For illustration, we consider two scenarios: one in which inequality rises temporarily-as in the year-to-year fluctuations in the 1990s-and one in which it increases permanently. (See Figure 2.)

Figure 2

In each case, we assume an increase in inequality of four log standard deviation points (the extent to which the light green line in Figure 1 rose since the 2000s). The orange line in Figure 2 shows that if this increase lasts for only a year, then the effect on output is negative but small-less than two-tenths of a percentage point of GDP. The reason is that marginal propensities to consume are negatively correlated with individual incomes, but this correlation is small-a fact that holds not only in our model but also in datasets that have information about individuals’ incomes and marginal propensities to consume. Hence there is a small effect on asset demand, and a small effect on output.

Our more provocative result is the red line in Figure 2-the case of a permanent increase in inequality. There, our model predicts that the level of output could fall permanently by around 2 percentage points as a result. The reason is that inequality causes individuals’ asset demand to rise permanently by a large amount. In our model, this is because inequality leads individuals to face more risk and volatility in their incomes-and that of their offspring-going forward, leading them to increase savings for precautionary and income smoothing purposes.3 In general equilibrium, employment has to fall by a substantial amount to restore equality between the demand and the supply of assets.

Asset demand, asset supply, and equilibrium interest rates

While this is a stark outcome, our new paper suggests ways in which policy can mitigate the effect of income inequality on aggregate demand. The first is fiscal policy, including government spending and budget deficits. In our model, increases in budget deficits help mitigate the fall in economic output because more government debt increases asset supply.

Similarly, monetary policy can respond by lowering interest rates. In fact, the decline in U.S. interest rates that we have observed since the 1980s could have been a response, in part, to rising inequality. Our model predicts what might have been the effect of rising inequality (as in the light green line of Figure 1) on the “equilibrium” or natural interest rate-the interest rate that the Fed needs to set in order to maintain full employment without generating inflation. (See Figure 3.)

Figure 3

Our model suggests a decline of 80 basis points in that equilibrium rate due to rising income inequality, about one-fifth of the 4 percentage point decline documented by Federal Reserve economists Thomas Laubach and John C Williams between 1980 and 2013.4 One implication of our finding is that inequality might have been one of the factors bringing the Fed closer to the zero lower bound of interest rates in the aftermath of the financial crisis beginning in 2008.

Another implication of our demand-supply framework is that of the effect of a rising capital share on equilibrium interest rates and aggregate demand. The dashed red line in Figure 1 shows an increase in that share over the past 30 years. Economists Paul Krugman and Lawrence Summers have argued that this might have contributed to depressing the equilibrium interest rate-or that further increases in market concentration today would be detrimental to aggregate demand.5 In our model, these claims are incorrect. We find that an increase in the capital share always leads to an increase in asset supply because more profits get capitalized into assets that households can trade. This increase in the supply of tradable assets has the exact opposite effect from the increase in asset demand due to higher income inequality: It raises equilibrium interest rates and raises output in liquidity traps.

Policy implications

Our work has a number of important policy implications. First, it suggests that the Federal Reserve and other central banks should keep track of income inequality over time because it influences the decisions that central banks ought to take. Second, our work suggests that not all forms of income inequality have the same effect on equilibrium interest rates: Inequality that raises future risk depresses the natural rate of interest, but technological advances that raise the capital share raise can have the opposite effect. Our model also suggests a more benign view of fiscal deficits than is often assumed in policy discussions because of their beneficial effects on asset supply. A combination of detailed data work narrowing in on the causes of rising income inequality, combined with a model that teases out its aggregate implications, can help the Fed conduct better monetary policy.

Adrien Auclert is an assistant professor of economics at Stanford University and Matthew Rognlie is an assistant professor of economics at Northwestern University. Auclert is a Washington Center for Equitable growth 2015 grantee.

What to do about the Federal Reserve

Posted on by Austin Clemens

AP Images

About the author: Alan Blinder is Gordon S. Rentschler Memorial Professor of Economics and Public Affairs at Princeton University and former vice chairman of the Board of Governors of the Federal Reserve System.

The short answer is: not much. Hippocrates offered good advice when he said “first do no harm.”

This does not mean that the Federal Reserve is perfect. Parts of its governance structure read like they date from 1913 (as they do) and could use a tune-up. But by and large, the Fed continues to perform the functions assigned to it by Congress well—even in this time of dysfunctional government—and to be genuinely non-political (see below). The next president should not upset either of these apple carts.

Federal Reserve independence

Four points are important to understanding the independence of the Fed. All should be preserved.

  1. Federal Reserve independence is limited to monetary policy. The Fed is engaged in other functions, such as financial regulation and supervision, where it generally shares responsibility with other agencies. In those other domains, the Fed has relatively little ability to take unilateral action, that is, little independence. Preserving the Fed’s independence in monetary policy is extremely important to the nation’s economic health and does not require independence in other domains.
  2. Federal Reserve independence is not absolute, even in monetary policy. In fact, it’s based more on tradition than law. Congress can abolish Federal Reserve independence (or the Federal Reserve itself) any day it chooses if the President would sign the bill. That creates a certain fragility and causes angst at the Fed whenever Congress considers ideas that would encroach on its independence. The new President should vigorously support Federal Reserve independence as it exists today. Writing it into law would be even better, if possible. But it probably isn’t, so I wouldn’t advise expending much political capital on this.
  3. The President, with the consent of the Senate, appoints the Board of Governors of the Fed, most notably its Chair. This appointment power is an important—probably the most important—element of political influence on monetary policy. And it’s entirely legitimate, even necessary; the Fed should not be a self-perpetuating oligarchy. The appointment of a new (or the same) Fed chair in early 2018 will be among the most important appointments the new President ever makes. It merits serious consideration early in the administration, and should be resolved by late summer or early fall 2017, lest it become a source of market jitters.
  4. While appointments to the Federal Reserve Board are “political” in the literal sense, the appointees themselves have generally not been very “political” people (with a few notable/notorious exceptions). Janet Yellen, a Democrat appointed by Barack Obama, is a non-political technocrat. Prior to that, President Obama had reappointed Ben Bernanke, another non-political technocrat, even though he was a Republican originally appointed by George W. Bush. That non-partisan tradition goes back a long way ( Ronald Reagan reappointed Paul Volcker, a Democrat.) We do not want to turn top Fed appointments into partisan political donnybrooks like Supreme Court appointments. Sadly, Senate Republicans have started down that path in recent years by blocking or refusing to consider appointments to the Federal Reserve Board. That tendency should be fought.

Troublesome bills
now in Congress

I started with “first do no harm” because Congress is now considering three very bad ideas.

  1. Audit the Fed: H.R. 24 and S. 2232 are two versions of what used to be called “Audit the Fed.” A more accurate name would be “Institutionalize Browbeating of the Fed.” The Federal Reserve’s books are already audited, and have been for years. This bill would give Congress (using/abusing the Government Accountability Office as a vehicle) more ways to second-guess the Fed’s monetary policy decisions. Individual members of Congress can, of course, do that whenever they please—and some do. Why would anyone want to give Fed-bashing institutional stature and legitimacy? The answer is obvious: to intimidate the Fed.
  2. Form Act: Formerly the FRAT Act, H.R. 3189, which includes “Audit the Fed,” would also add a requirement that the Fed enunciate-and explain why it ever deviates from-a mechanical formula for monetary policy. (There are counterpart bills in the Senate.) There is a long academic debate over “rules versus discretion,” but that debate preceded the unprecedented circumstances the Fed has faced since 2008. It is frightening to contemplate what might have happened if the Fed had followed a pre-2007 rule under those never-before-imagined circumstances. Legislating compliance with a rule now seems both dangerous and irresponsible.
  3. Congressman Hensarling’s proposed replacement for Dodd-Frank. Proposed legislation by Rep Jeb Hensarling (R-TX) has many bad features, one of which would subject the Fed’s budget to annual congressional appropriations. Freedom from annual appropriations is perhaps the lynchpin of the Federal Reserve’s independence. No central bank can be independent if a displeased legislature can squeeze its budget as Congress routinely does with other regulatory agencies.

The new President should oppose these three anti-Fed bills, and veto them if Congress passes any of them.

What (that’s sensible)
might be changed?

According to a wise old principle, if it ain’t broke, don’t fix it. The Fed is not “broke.” So preserving the status quo is not a bad policy.

It is true that, were the Federal Reserve Act being written today rather than in 1913, it would look different in several respects. For instance, the boundaries of the 12 Federal Reserve Districts and the locations of the 12 Federal Reserve Banks would certainly be different. Those boundaries, which reflect the economic geography and political logrolling of 1913, look a little comical in 2016. But moving them is almost certainly not worth the political fight it would provoke.

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A better case can be made for revisiting the 1913 Wilsonian compromise between two competing visions of a central bank: one controlled by private parties (mainly bankers), the other controlled by the federal government. The Federal Reserve Act (and its 1935 amendments) split the difference by dividing power between a seven-member, politically appointed Board of Governors in Washington and 12 Federal Reserve Banks, which are joint-stock companies owned by member banks, and whose presidents are not political appointees. (They are, instead, selected by each bank’s board, just as private corporations do.) The Fed’s powerful Open Market Committee consists of the seven Washington-based governors and the 12 bank presidents (only five of whom get to vote at a time). It is odd, to put it mildly, to have men and women with no political legitimacy making national economic policy.

In increasing order of “radicalness,” the Wilsonian balance could be tilted more in the governmental direction by:

  1. Removing all bankers from the boards of the Reserve Banks (doing so, however, would create an odd legal situation since the private banks are the Reserve Banks’ shareholders.)
  2. Making the President of the Federal Reserve Bank of New York, which has a special status within the Federal Reserve System, a presidential appointee confirmed by the Senate, just like the Board of Governors
  3. Making all 12 Federal Reserve Bank presidents political appointees, appointed either by the president or by the Board of Governors
  4. Converting all the Federal Reserve banks into government agencies, with their presidents appointed by either the Board of Governors or the President

Another sensible reform would be to shorten existing term limits. Under current law, a Federal Reserve governor (including the chairman) could, in principle, serve almost 28 years. Although this has never happened, Alan Greenspan did chair the Fed for 18½ years, and William McChesney Martin served a few months longer than that. For such a powerful position, that seems too long. When he retired in 2014, Ben Bernanke did not try to set a “George Washington” precedent that two four-year terms is enough. Perhaps we should write that into law.

What about the next recession?

Should the U.S. economy encounter a recession any time soon—say, within the next two years—the old “leave-it-to-the-Fed” attitude will probably not suffice. For one thing, interest rates will still be very low, leaving the Fed limited scope for cutting rates. For another, the Fed’s balance sheet will still be huge, leaving it limited scope for further “quantitative easing”—not to mention the fact that quantitative easing probably ran into sharply diminishing returns years ago. All this is not to say that the Fed would be powerless to fight, say, a 2017 recession, but only that it will be considerably less powerful than it has been in the past, leaving the nation more vulnerable.

What to do? The obvious answer would be to deploy fiscal policy—that is, government spending and tax cuts—as was done in 2009. But, depending on the composition and attitudes of the next Congress, that might prove challenging (or impossible) politically.

So the first, and easy, policy recommendation is that the new administration should quickly formulate contingency plans for a possible fiscal stimulus and, to the maximum extent possible, seek buy-in from the congressional leadership.

That “maximum extent possible” might prove to be zero, however. So the new administration should also consider legislation that would increase the strength of the automatic stabilizers.

  1. Any increases in marginal tax rates, or in the marginal generosity of transfer payments such as unemployment benefits and food stamps, will have this effect as a by-product. If marginal tax rates were higher, however, tax bills would fall faster when incomes declined.
  2. In addition, the new administration should consider legislation that raises unemployment benefits and food stamps formulaically and automatically when the economy crosses certain (adverse) thresholds—when the unemployment rate rises above 6 percent, 7 percent, and so on. President Obama made such a proposal for unemployment benefits this year.

A Powerful Intellectual Stumbling Block: The Belief that the Market Can Only Be Failed

Posted on by Brad DeLong

Over at Project Syndicate: The Trouble with Interest Rates: Of all the strange and novel economic doctrines propounded since 2007, Stanford’s John Taylor has a good claim to propounding the strangest: In his view, the low interest-rate, quantitative-easing, and forward-guidance policies of North Atlantic and Japanese central banks are like:

imposing an interest-rate ceiling on the longer-term market… much like the effect of a price ceiling in a [housing] rental market…. [This] decline in credit availability, reduces aggregate demand, which tends to increase unemployment, a classic unintended consequence…”

When you think about it, this analogy makes no sense at all.

When a government agency imposes a rent-control ceiling, it:

  • makes it illegal for renters to pay or landlords to collect more than the ceiling rent;
  • thus leaves a number of potential landlords willing but unable to rent apartments and a number of potential renters willing but unable to offer to pay more than the rent-control ceiling.

When a central bank reduces long-term interest rates via current and expected future open-market operations, it:

  • does not keep any potential lenders who wish to lend at higher than the current interest rate from offering to do so;
  • does not keep any potential borrowers who wish from taking up such an offer;
  • it is just that no borrowers wish to do so.

The reason we dislike rent-control ceilings–that it stops transactions both buyers and sellers wish to undertake from taking place–is simply absent.

So why would anyone claim that low interest-rate, quantitative-easing, and forward-guidance policies are like rent control?

I think that the real path of reasoning is this:

  1. John Taylor, and the others claiming that central banks are committing unnatural acts by controlling the interest rate, feel a deep sense of wrongness about the current level of interest rates.
  2. John Taylor and his allies believe that whenever a price like the interest rate is “wrong”, it must be because the government has done it–that the free market cannot fail, but can only be failed.
  3. Thus the task is to solve the intellectual puzzle by figuring out what the government has done to make the current level of the interest rate so wrong.
  4. Therefore any argument that government policy is in fact appropriate can only be a red herring.
  5. And the analogy to rent control is a possible solution to the intellectual puzzle.

If I am correct here, then the rest of us will never convince John Taylor and company.

Arguments that central banks are doing the best they can in a horrible situation require entertaining the possibility that markets are not perfect and can fail. And that they will never do. We have seen this in action: Five years ago John Taylor and company were certain that Ben Bernanke’s interest-rate, quantitative-easing, and forward-guidance policies risked “currency debasement and inflation”. The failure of those predictions has not led John Taylor or any other of the Republican worthy signatories of their “Open Letter to Ben Bernanke” to rethink and consider that perhaps Bernanke knows something about monetary economics. Instead, they seek another theory–the price-control theory–for why the government is doing it wrong.

Thus all we can do is repeat, over and over again, what both logic and evidence tell us:

  • That with the current configuration of fiscal policy, North Atlantic monetary policy is not too loose but if anything too restrictive.
  • That as far as the real interest rate is concerned, the “‘natural rate’… that would be ground out by the Walrasian system of general equilibrium equations”, as Milton Freidman would have put it, is lower than the one current monetary policy gives us.
  • That our economies’ inertial expectations and contracting structures have combined with monetary policy to give us nominal interest and inflation rates that are distorted, yes–but an interest rate that is too high and an inflation rate that is too low relative to what the economy wants and needs, and what a free-market flexible-price economy in a proper equilibrium would deliver.

Why does the North Atlantic economy right now want and need such a low real interest rate for its proper equilibrium? And for how long will it want and need this anomalous and disturbing interest-rate configuration? These are deep and unsettled questions involving, as Olivier Blanchard puts it, “dark corners” where economists’ writings have so far shed much too little light.

Hold on tight to this: There is a wrongness, but the wrongness is not in what central banks have done, but rather in the situation that has been handed to them for them to deal with.

Must-Read: Refet S. Gürkaynak and Troy Davig: Central Bankers as Policymakers of Last Resort

Posted on by Brad DeLong

Must-Read: So should central bankers be given more tools–conduct monetary/fiscal policy via “social credit” assignment of seigniorage to individuals and monopolize financial regulation? Or should central bankers focus on price stability and only price stability? I would say central bankers should be (a) more modest, but also (b) commit not to price stability but to making Say’s Law true in practice…

Refet S. Gürkaynak and Troy Davig: Central Bankers as Policymakers of Last Resort: “Central banks around the world have been shouldering ever-increasing policy burdens beyond their core mandate…

…of stabilising prices… without an accompanying expansion of their policy tools. They have become policymakers of last resort, residual claimants of macroeconomic policy. As central banks take on the duty of addressing policy concerns other than inflation–and consequently take the blame for not completely solving those problems–other policymakers get a free hand in pursuing alternative goals, which may not be aligned with social welfare. The end result is that tools available to the central bank may be used excessively but ineffectively….

As Orphanides (2013) highlights, the increase in central banks’ implicit mandates is widely visible. In the developed economies, this is most clearly manifested in central banks’ attempts to compensate for fiscal tightening after the Great Recession. More recently, attention has turned to using interest rate policy to promote financial stability. In developing and emerging market economies, central banks carry out policies to affect a long list of macroeconomic outcomes, including capital flows, exchange rates, bank loan growth rates, housing prices and the like, as well as keeping an eye on inflation. An implicit expectation that central banks will take on these objectives, along with their willingness to do so, runs the risk of producing inferior outcomes compared to when central banks mind their core business of fostering price stability…

Must-Read: William Poole: Don’t Blame the Fed for Low Rates

Posted on by Brad DeLong

Must-Read: You know, given the demographic headwinds of this decade, the consensus of economic historians is likely to say that job growth under Obama was not weak, but quite possibly the second-strongest relative to baseline since the Oil Shock of 1973–somewhat worse than under Clinton, a hair better than under Carter or Reagan, and massively superior to job growth under either Bush:

Graph All Employees Total Nonfarm Payrolls FRED St Louis Fed

William Poole: Don’t Blame the Fed for Low Rates: “Long-term rates reflect weak job creation and credit demand, both a result of President Obama’s poor economic stewardship…

…The frequent claim that Federal Reserve Chair Janet Yellen and her colleagues are responsible for continuing low rates of interest may be correct in the small, but not in the large…. The real villain behind low interest rates is President Obama. Long-term rates reflect weak job creation and credit demand…. The real rate of interest, currently negative for short-term interest rates and only slightly positive for long rates, is a consequence of non-monetary conditions that have held the economy back….

Disincentives to business investment deserve special notice…. The Obama administration has created one disincentive after another… the failure to pursue tax reform… insistence on higher tax rates… environmental activism… growth-killing overreach in the Affordable Care Act and Dodd-Frank to the Consumer Financial Protection Bureau, the Environmental Protection Agency and the Labor Department….

The Fed is responsible, however, for not defending itself by explaining to Congress and the public what is going on. The Fed is too afraid politically to mention any details of its general position that it cannot do the job on its own. Yes, there are “headwinds,” but they are largely the doing of the administration…. The Obama administration didn’t create Fannie Mae and Freddie Mac, for instance, or the government’s affordable-housing goals—both of which fueled the 2008 financial crisis. But the Obama administration has failed to correct the economic problems it inherited. It has simply piled on more and more disincentives to growth. These disincentives have kept long-term rates low.

It seems to me that very little of William Poole’s argument makes any sense at all.

If the factors he points to were there and were operating, they would operate by lowering the future profits of both new capital and old capital. They should thus produce both (a) a fall in interest rates and (b) a fall in the equity values of established companies. We have the first. We do not have the second. Thus I find it very hard to understand in what sense this is made as a technocratic argument. It seems, instead, to be some strange fact-light checking off of political and ideological boxes: Obama BAD! Federal Reserve GOOD!!

Must-Read: Menzie Chinn: “Inflation Expectations Can Change Quickly…”

Posted on by Brad DeLong

Must-Read: It is not clear to me that inflation expectations would undergo a “rapid and dramatic shift” even if we had a “drastic regime change”. Or rather, as Stan Fischer told me when we were discussing Tom Sargent’s “Stopping Moderate Inflation” and “End of Four Big Inflations” papers, we say after the fact that we had a drastic regime change if and only if inflation expectations underwent a rapid and dramatic shift. It’s not something that one can do–especially living, as we do, not in Plato’s Republic but in Romulus’s Sewer…

Menzie Chinn: “Inflation Expectations Can Change Quickly…”: “One of the arguments for acting sooner rather than later on monetary policy…

…is that if the slack disappears, inflationary expectations will surge… [aA] in this quote from reader Peak Trader’s comment…. I am sure if there is a drastic regime change, one could see a rapid and dramatic shift in measured expectations; the question is whether that scenario is relevant and/or plausible…. I will let readers decide whether expectations turned on a dime. They seem pretty adaptive to me.

Inflation expectations can change quickly Econbrowser

Must-Read: Thomas Laubach and John C. Williams: Measuring the Natural Rate of Interest Redu

Posted on by Brad DeLong

Must-Read: If our estimates of the real natural rate of interest are that it is less than zero, and if inflation is below target, what is the argument for even talking about raising interest rates? Isn’t the argument that ought to be made that one should raise the inflation target? One does want to have a late-expansion nominal federal funds rate of at least 6%/year, does one not?

Thomas Laubach and John C. Williams: Measuring the Natural Rate of Interest Redux: “Persistently low real interest rates have prompted the question…

…whether low interest rates are here to stay. This essay assesses the empirical evidence regarding the natural rate of interest in the United States using the Laubach-Williams model. Since the start of the Great Recession, the estimated natural rate of interest fell sharply and shows no sign of recovering. These results are robust to alternative model specifications. If the natural rate remains low, future episodes of hitting the zero lower bound are likely to be frequent and long-lasting. In addition, uncertainty about the natural rate argues for policy approaches that are more robust to mismeasurement of natural rates.

Www frbsf org economic research files wp2015 16 pdf Www frbsf org economic research files wp2015 16 pdf

Must-Read: John Maynard Keynes (1937): The General Theory of Employment: Today’s Economic History

Posted on by Brad DeLong

Must-Read: Today’s Economic History: John Maynard Keynes (1937): The General Theory of Employment: “There are passages which suggest that Professor Viner is thinking too much…

…in the more familiar terms of the quantity of money actually hoarded, and that he overlooks the emphasis I seek to place on the rate of interest as being the inducement not to hoard. It is precisely because the facilities for hoarding are strictly limited that liquidity preference mainly operates by increasing the rate of interest. I cannot agree that:

in modern monetary theory the propensity to hoard is generally dealt with, with results which in kind are substantially identical with Keynes’, as a factor operating to reduce the ‘velocity’ of money.

On the contrary, I am convinced that the monetary theorists who try to deal with it in this way are altogether on the wrong track.

Again, when Professor Viner points out that most people invest their savings at the best rate of interest they can get and asks for statistics to justify the importance I attach to liquidity-preference, he is over-looking the point that it is the marginal potential hoarder who has to be satisfied by the rate of interest, so as to bring the desire for actual hoards within the narrow limits of the cash available for hoarding. When, as happens in a crisis, liquidity-preferences are sharply raised, this shows itself not so much in increased hoards–for there is little, if any, more cash which is hoardable than there was before–as in a sharp rise in the rate of interest, i.e. securities fall in price until those, who would now like to get liquid if they could do so at the previous price, are persuaded to give up the idea as being no longer practicable on reasonable terms. A rise in the rate of interest is a means alternative to an increase of hoards for satisfying an increased liquidity-preference.

Nor is my argument affected by the admitted fact that different types of assets satisfy the desire for liquidity in different degrees. The mischief is done when the rate of interest corresponding to the degree of liquidity of a given asset leads to a market-capitalization of that asset which is less than its cost of production…

John Maynard Keynes (1937), “The General Theory of Employment”, Quarterly Journal of Economics 51:2 (February), pp. 209-223 http://www.jstor.org/stable/1882087

Mr. Phillips and His Curve: “What Should the Fed Do?” Weblogging

Posted on by Brad DeLong

Nick Bunker says:

Nick Bunker says: A Kink in the Phillips Curve: “Look at the relationship between wage growth and another measure of labor market slack, however, [and] the [Phillips-Curve] relationship might hold up. Take a look at Figure 1:

A kink in the Phillips curve Equitable Growth

This is entirely consistent with inflation-expectations anchored near 2%/year–or inflation so low that shifts in inflation expectations are not a thing–and a Phillips Curve that gradually loses its slope as wage growth approaches the zero-change sticky point:

A kink in the Phillips curve Equitable Growth

This is entirely consistent with inflation-expectations anchored near 2%/year–or inflation so low that shifts in inflation expectations are not a thing–and a Phillips Curve in which the right labor slack variable is some average of prime-age employment-to-population and the (now normalized) unemployment rate:

A kink in the Phillips curve Equitable Growth

It is really not consistent with any naive view that holds that the Phillips Curve has the unemployment rate and the unemployment rate alone on its right-hand side, and that inflation is about to pick up substantially with little increase in the employment-to-population ratio.

Thus not only does the right wing of the Federal Reserve expecting an imminent upswing of inflation because of MONEY PRINTING! have it wrong, it strongly looks as though the center of the Federal Reserve has it wrong too…

Central Banks Are Not Agricultural Marketing Boards: Depression Economics, Inflation Economics and the Unsustainability of Friedmanism

Posted on by Brad DeLong

Central Banks Are Not Agricultural Marketing Boards: Depression Economics, Inflation Economics and the Unsustainability of Friedmanism

Insofar as there is any thought behind the claims of John Taylor and others that the Federal Reserve is engaged in “price controls” via its monetary policy actions.

Strike that.

There is no thought at all behind such claims at all.

Insofar as one did want to think, and so construct an argument that the Federal Reserve’s monetary policy operations are destructive and in some ways analogous to “price controls”, the argument would go something like this:

The Federal Reserve’s Open Market Committee’s operations are like those of an agriculture marketing board–a government agency that sets the price for, say, some agricultural product like butter or milk. Some of what is offered for sale at that price that is not taken up by the private market, and the rest is bought by the government to keep the price at its target. And the next month the government finds it must buy more. And more. And more.

Such policies produce excess supplies that then must be stored or destroyed: they produce butter mountains, and milk lakes.

The resources used to produce the butter mountains and milk lakes is wasted–it could be deployed elsewhere more productively. The taxes that must be raised to pay for the purchase of the butter and milk that makes up the mountains and the lakes discourages enterprise and employment elsewhere in the economy, and makes us poorer. Taxes are raised (at the cost of an excess burden on taxpayers) and then spent to take the products of the skill and energy of workers and… throw them away. Much better, the standard argument goes, to eliminate the marketing board, let the price find its free-market equilibrium value, provide incentives for people to move out of the production of dairy products into sectors where private demand for their work exists, and keep taxes low.

Now you can see that a central bank is exactly like an agricultural marketing board, except for the following little minor details:

  1. An agricultural marketing board must impose taxes to raise the money finance its purchases of butter and milk. A central bank simply prints–at zero cost–the money to finance its purchase of bonds.
  2. The butter mountains and milk lakes that the agricultural marketing board owns cannot be sold without pushing the price down below its free-market equilibrium and thus negating the purpose of the board. A central bank does not want to sell its bond mountains, but merely to collect interest and hold them to maturity, at which point they are simply money mountains.
  3. The butter mountains and milk lakes are useless for the agricultural marketing board: all it can do with them is simply watch them rot away. The bond mountain turns into a money mountain–seigniorage–which the central bank then gives to the government, which lowers taxes as a result.

So a central bank is exactly like an agricultural marketing board–NOT!!! They are identical–except that they are completely different.

But, somewhat smarter John Taylor and others might say, a central bank is like an agricultural marketing board. The extra money it puts into circulation when its bonds mature and it transfers profits to the government devalue and debauch the currency. It raises the real resources needed to finance its bond purchases by levying an “inflation tax” on money holders–by reducing the value of their cash just as an income tax reduces the (after-tax) value of incomes.

And I would agree, if the inflation comes. Under conditions of what I like to call Inflation Economics, money-printing and bond purchases do push the interest rate below the natural rate of interest–push bond prices above their natural price–as defined by Knut Wicksell. Money-printing and bond purchases then do indeed cause economic problems somewhat analogous to those of a marketing board that keeps the prices of butter and milk above their natural price.

But what if the inflation does not come? What if our economy’s phase is one of not Inflation Economics but Depression Economics, in which the central bank is not pushing the interest rate below its Wicksellian natural rate but is instead stuck trying to manage a situation in which the Wicksellian natural rate of interest is less than zero?

Then the analogies break down completely. Money-printing is then not an inflationary tax but instead a utility-increasing provision of utility services. Bond purchases do not create an overhang that cannot be sold without creating an opposite distortion from the optimal price but instead push the temporal slope of the price system toward what a benevolent central planner would want the temporal slope of the price level to be.

Milton Friedman was very clear that economies could either have too much money (Inflation Economics) or too little money (Depression Economics)–and that a central bank was needed to try to hit the sweet spot. He hoped that hitting the sweet spot could be made into a somewhat automatic rule-controlled process, but he was wrong.

So trying to construct a thinking argument that central banks are engaged in something analogous to “price controls” via their monetary policy actions leads even a substantially sub-Turing entity to the conclusion: Sometimes, under conditions of “Inflation Economics”, but not now.

And let me offer all kudos to those like David Beckworth, Scott Sumner, and Jim Pethokoukis who are trying to convince their political allies of these points that I regard as basic and Wicksellian–cutting-edge macro from 125 years ago. But I think that Paul Krugman is right when he believes that they are going to fail. Let me turn the mike over to Paul Krugman to explain why he thinks they are going to fail:

Paul Krugman: More Artificial Unintelligence: “David Beckworth pleads with fellow free-marketeers to stop claiming that…

…low interest rates are “artificial” and comparing them to price controls…. The Fed isn’t imposing a price ceiling… monetary policy… nothing at all like price controls…. What interest rates would be in the absence of distortions and rigidities [is] the Wicksellian natural rate…. The actual interest rate, at zero, is above the natural rate…. But… Beckworth should be asking… why almost nobody on the right is willing to think… not just… ignoramuses like Rand Paul and George Will. The “low interest rates = price controls” meme is bang-your-head-on-the-table stupid–but… John Taylor…. [It’s] a line of argument that people on the right really, really like….

Beckworth is… tak[ing] the… Friedman position… trusting markets… except… [for] the business cycle…. This is… [intellectually] problematic…. You need… market failure to give monetary policy large real effects, and… why… is the only important failure?…

Let me, as an aside, point out that it could indeed be the case that monetary policy joins police, courts, and defense as they only significant areas in which the costs of rent-seeking, regulatory-capture, and other government failures are less than the costs of the market failures that the government could successfully neutralize. It’s unlikely. But it’s possible. Indeed, Milton Friedman thought that that was the case. And he was not at all a dumb man. And laying down general rules sector-by-sector about the relative magnitudes of market and government failures is almost surely a mistake. As John Maynard Keynes wrote in his “The End of Laissez-Faire”:

We cannot therefore settle on abstract grounds, but must handle on its merits in detail what Burke termed: “one of the finest problems in legislation, namely, to determine what the State ought to take upon itself to direct by the public wisdom, and what it ought to leave, with as little interference as possible, to individual exertion…”

But let’s give the mike back to Krugman to make his major point:

More important… this position turns out to be politically unsustainable. “Government is always the problem, not the solution, except when it comes to monetary policy” just doesn’t cut it for modern conservatives. Nor did it cut it for traditional conservatives. Remember, during the 1930s people like Hayek were liquidationists, with Hayek specifically denouncing expansionary monetary policy during a slump as “the creation of artificial demand.” The era of Friedmanism, of free-market views paired with tolerance for monetary stimulus, was a temporary and unsustainable interlude, and no amount of sensible argumentation will bring it back.

But this doesn’t mean that Jim, Scott, David, and company should not try, no? It is not just the Milton Friedman was a galaxy-class expert at playing intellectual Three-Card Monte, no? It is true that at times my breath is still taken away at Friedman’s gall in claiming that a “neutral” and “non-interventionist” monetary policy was one which had the Federal Reserve Bank of New York buying and selling bonds every single day in a frantic attempt to make Say’s Law, false in theory, true in practice. But he wiped the floor with the Hayekians intellectually, culturally, academically, and politically for two generations.

Krugman’s line “claiming that laissez-faire is best for everything save monetary policy (and property rights, and courts, and police, and defense) is intellectually unstable and unsustainable in the long-run” may well be true. But as somebody-or-other once said:

This long run is a misleading guide to current affairs. In the long run we are all dead. Economists set themselves too easy, too useless a task if in tempestuous seasons they can only tell us that when the storm is long past the ocean is flat again…

UPDATE: And I should add a link to Krugman’s original:

Paul Krugman: Artificial Unintelligence: “In the early stages of the Lesser Depression…

…those of us who knew a bit about the… 1930s… felt… despair…. People who imagined themselves sophisticated and possessed of deep understanding were resurrecting 75-year-old fallacies and presenting them as deep insights…. [Today] I feel an even deeper sense of despair–because people are still rolling out those same fallacies, even though in the interim those of us who remembered and understood Keynes/Hicks have been right about most things, and those lecturing us have been wrong about everything. So here’s William Cohan in the Times, declaring that the Fed should ‘show some spine’ and raise rates even though there is no sign of accelerating inflation. His reasoning….

The price of borrowing money–interest rates–should be determined by supply and demand, not by manipulation by a market behemoth….

[However,] the Fed sets interest rates, whether it wants to or not–even a supposed hands-off policy has to involve choosing the level of the monetary base somehow…. How would you know if the Fed is setting rates too low? Here’s where Hicks meets Wicksell: rates are too low if the economy is overheating and inflation is accelerating. Not exactly what we’ve seen in the era of zero rates and QE…. There are arguments that the Fed should be willing to abandon its inflation target so as to discourage bubbles. I think those arguments are wrong-but… they have nothing to do with the notion that current rates are somehow artificial, that we should let rates be determined by ‘supply and demand’. The worrying thing is that… crude misunderstandings… are widespread even among people who imagine themselves well-informed and sophisticated. Eighty years of hard economic thinking, and seven years of overwhelming confirmation of that hard thinking, have made no dent in their worldview. Awesome.