Macroeconomic Policy Reform: A Tentative Agenda

It was 24 years ago this week that Larry Summers and I warned that if we were to push the target inflation rate much below roughly 5%/year, then, in the immortal words of Dr Suess’s the Fish in the Pot:

“Do I like this? Oh, no, I do not. This is not a good game”, said our fish as he lit. “No, I do not like it, not one little bit!”

As I see it, if we want good macroeconomic business-cycle stabilization policy over the next generation, we need to do one or more of four things. I think the more of them we do, the better. And I want Summers and Bernanke to chair a commission this fall and winter to establish the order in which we should attempt to do these four things, and to start building the political and technocratic coalition to get them accomplished:

1. Raise the inflation target when the economy has any chance of hitting the zero lower bound on short-term safe nominal interest rates–either by nominal GDP or price-level catchup targeting, or by raising the inflation target to 4%/year or so. The way to sell this is to say that the Fed has a dual mandate, that dual mandate requires tradeoffs, and that those tradeoffs are best accomplished via targeting recovery too and growth along a 6%/year nominal GDP growth path.

2. Give the Federal Reserve the tools that it needs in order to properly manage aggregate demand. That means such things as:

   • Deciding by itself how it is going to use its seigniorage revenue, rather than returning its profits to the Treasury as a matter of course. (Yes, this is helicopter money.)
   • Funding mechanisms to support what ought to be state-level automatic stabilizers in a downturn–states should not be cutting construction and education and public safety spending when the economy as a whole is in recession, and thus when there is plenty of slack in the labor market.
   • More aggressive use of regulatory asset-quality and reserve-requirement tools as countercyclical policy instruments.
3. Act to substantially reduce the risk premium on safe highly-collateralizable assets, both to repair a significant microeconomic financial market failure and to raise the medium-run equilibrium short-term safe real interest rate–the r*–in order to provide the central bank with more sea room on the lee shore it finds itself on. This requires operating both on the side of boosting market risk tolerance and expanding the supply of safe assets. This means moving beyond “government debt and deficits are always bad!” to “under certain conditions, the national debt of those sovereigns with exorbitant privilege that create safe assets when they issue debt can be a global blessing.”

4. Reintegrate macroeconomic policy. Return forecasting from three separate exercises–the White House’s Troika (CEA-Treasury-OMB), Congress’s OMB, and the Federal Reserve–back to the Quadriad (Federal Reserve-CEA-Treasury-OMB) or on to a Pentiad (Federal Reserve-CEA-Treasury-OMB-CBO), with the principals to whom it reports being not just the President and the FOMC, but also the Majority and Minority Leaders of the Senate and the Speaker and Minority Leader of the House.

The argument against (4) is, of course, that the Fed needs to be insulated from the broader policy-political world because (a) the Fed can do the job by itself, and (b) having its elbow joggled by the policy-political world would only bolix things up. Well, the past decade has proven to us that (a) the Fed cannot do the job by itself, and (b) Fed “independence” does not keep the policy-political world from bolixing things up. The moment the Republican Party decided in January 2009 to go all-in in root-and-branch opposition to Obama, it necessarily also decided to go all-in in root-and-branch to policies pursued by Obama–which meant root-and-branch opposition to the Federal Reserve as well.

And certainly if we are not going to do (2), we definitely need to do (4).

Some very recent background reading:

Larry Summers: A Thought Provoking Essay from Fed President Williams:

John Williams has written the most thoughtful piece on monetary policy that has come out of the Fed in a long time…. He stresses the desirability of raising r* by pursuing structural policies to raise growth and affirms the importance of fiscal policy. I yield to no one in my enthusiasm for improved education and educational opportunity, but I do not think it is plausible that it will change the neutral rate appreciably in the next decade given that the vast majority of the 2030 labor force will be unaffected.

If Williams is overenthusiastic on education, he is under enthusiastic on fiscal stimulus.  He fails to emphasize the supply side benefits of infrastructure investment that likely enable debt financed infrastructure investments to pay for themselves as suggested by DeLong and Summers and the IMF.  Nor does he note at current interest rates an increase in pay as you go social security could provide households with higher safe returns than private investments…. Nor does Williams address the possibility of tax measures such as incremental investment credits or expansions in the EITC financed by tax increases on those with a high propensity to save.  The case for fiscal policy changes in the current low r* environment seems to me overwhelming….

Williams’s comments on monetary policy have generated more interest…. If the Fed believed that a 2 percent inflation target was appropriate at the beginning of 2012 when it believed the neutral real rate was above 2 percent, I cannot see any argument for not adjusting the target or altering the framework when the neutral real rate is very plausibly close to zero.  The benefits of a higher target have increased and so far as I can see nothing has happened to change the cost of a higher target. I am disappointed therefore that Williams is so tentative in his recommendations on monetary policy…. Moreover even accepting the current framework, I find the current policy framework hard to comprehend.  If as it asserts, the Fed is serious about the 2 percent inflation target being symmetric there is an anomaly in its forecasts….

Finally there is this:  Everything we know about business cycle history suggests an overwhelming likelihood that there will be downturns in the industrial world sometime in the next several years. Nowhere is there room to cut rates by anything like the normal 400 basis points in response to potential recession.  This is the primary monetary and indeed macroeconomic policy challenge of our generation. I hope it will be very much in focus at Jackson Hole.

Greg Ip: The Case for Raising the Fed’s Inflation Target:

Six years ago, Olivier Blanchard, then chief economist at theInternational Monetary Fund, floated the idea that central banks should target 4% inflation instead of 2%. I remember giving a colleague countless reasons why he was wrong. It was I who was wrong….

Last week John Williams, president of the Federal Reserve Bank of San Francisco, made the case for a higher inflation target in a bank newsletter. The subject will almost certainly be in the air when Fed officials and their foreign counterparts meet next week at the annual Jackson Hole symposium…. The historical case for low inflation rested on the assumption that high inflation created damaging distortions and more frequent recessions. Low inflation or deflation was a trivial risk because central banks could easily drive inflation higher by promising to print more money. But in 2008, central banks around the world cut interest rates to nearly zero and printed copious amounts of money, and only lackluster growth followed….

Here are my original objections and how they have changed.

1. Central banks have invested their credibility in a 2% target. If they raise it, the public will assume they’ll raise it again, and expectations will rapidly become unanchored…. If anything, central banks are too credible: Investors seem to believe 2% is a ceiling, not a midpoint.

2. As inflation rises, individual prices become more volatile, which makes the economy less efficient and more prone to booms and busts. This is still true, but against that we can see the harm from not being able to lower real (inflation-adjusted) rates further is much larger than anticipated. Meanwhile, the microeconomic harm of higher inflation is elusive….

3. Since inflation is below 2% now and there are no new tools to get it higher, it will undermine central banks’ credibility to raise the target. Japan’s success in getting inflation back above zero, albeit not to 2%, suggests adopting a higher inflation target can bring a shift in expectations, and actions, that help make it happen.

4. A higher inflation target makes real interest rates more negative, which would spur reach-for-yield and other speculative excesses. This is true but the alternative may be worse….

5. What happened in 2008 was unique. Why change the target for something that happens maybe twice per century? Interest rates have been near zero now for more than seven years, and there is every reason to think similar episodes are going to happen again…. Williams sees ample evidence that deep-seated structural forces have dragged down the real natural interest rate—which keeps the economy at full employment without stoking inflation—from around 2.5% before the recession to 1% now. It may be lower….

John Williams: Monetary Policy in a Low R-Star World:

The inflation wars of the 1970s and 1980s led to a broad consensus on two fronts among academics and policymakers….

[Larry Summers and I warned]:

First, central banks are responsible and accountable for price stability… often acknowledged through… formal adoption of… inflation targeting…. Second, monetary policy should play the lead role in stabilizing inflation and employment, while fiscal policy plays a supporting role through… automatic stabilizers…. Fiscal policy should focus primarily on longer-run goals such as economic efficiency and equity….

In the post-financial crisis world, however, new realities pose significant challenges…. A variety of economic factors have pushed natural interest rates very low and they appear poised to stay that way…. Interest rates are going to stay lower than we’ve come to expect in the past…. Juxtaposed with pre-recession normal short-term interest rates of, say, 4 to 4½%, it may be jarring to see the underlying r-star guiding us towards a new normal of 3 to 3½%—or even lower…. Conventional monetary policy has less room to stimulate the economy during an economic downturn, owing to a lower bound on how low interest rates can go…. In this new normal, recessions will tend to be longer and deeper, recoveries slower, and the risks of unacceptably low inflation and the ultimate loss of the nominal anchor will be higher…. If the status quo endures, the future is likely to hold more of the same—with the possibility of even more severe challenges to maintaining price and economic stability.

To avoid this fate, central banks and governments should critically reassess the efficacy of their current approaches and carefully consider redesigning economic policy strategies to better cope with a low r-star environment…. Greater long-term investments in education, public and private capital, and research and development…. Countercyclical fiscal policy should be our equivalent of a first responder to recessions, working hand-in-hand with monetary policy…. Stronger, more predictable, systematic adjustments of fiscal policy that support the economy during recessions and recoveries…. Monetary policy frameworks should be critically reevaluated to identify potential improvements in the context of a low r-star…. A low inflation rate… is not as well-suited for a low r-star era…. The most direct attack on low r-star would be for central banks to pursue a somewhat higher inflation target…. Second, inflation targeting could be replaced by a flexible price-level or nominal GDP targeting framework….

We’ve come to the point on the path where central banks must share responsibilities. There are limits to what monetary policy can and, indeed, should do. The burden must also fall on fiscal and other policies to do their part to help create conditions conducive to economic stability…

Simon Wren-Lewis: Helicopter Money: Missing the Point:

I am tired of reading discussions of helicopter money (HM) that have the following structure:

1. HM is like a money financed fiscal stimulus
2. HM would threaten central bank independence
3. So HM is a bad idea….

These discussions never seem to ask… why we have independent central banks (ICB) in the first place. And what they never seem to note, even in establishing (1), is that ICBs deny the possibility of a money financed fiscal stimulus (MFFS)…. Creating an ICB means that a MFFS is no longer possible… [because] it could only happen through ICB/government cooperation, which would negate independence…. Proponents of ICBs say… macro stabilisation can be done entirely by using changes in interest rates, so a MFFS is never going to be needed. Then we hit the Zero Lower Bound….

To then say no problem, governments can do a bond financed fiscal expansion is to completely forget why ICBs were favoured in the first place. Politicians are not good at macroeconomic stabilisation…. Demonstrating (1) does not, I repeat not, imply that ICBs do not need to do HM. Implying that it does is a bit like saying governments could set interest rates, so why do we need ICBs. Most macroeconomists would never dream of doing that, so why are they happy to use this argument with HM?

Which brings us to (2)… never… examined with the same rigour as (1)… just mentioning ‘fiscal dominance’ is enough to frighten the horses…. Imagine the set of all governments that would refuse a request from an ICB for recapitalisation during a boom when inflation was rising–governments of central bank nightmares. Now imagine the set of all governments that, in a boom with inflation rising, would happily take away the independence of the central bank to prevent it raising rates. I would suggest the two sets are identical…. HM does not seem to compromise independence at all. So please, no more elaborate demonstrations that HM is equivalent to a MFFS, as if that is an argument against HM…

Paul Krugman: Slow Learners:

Larry Summers has a very nice essay that takes off from a new paper by John Williams at the San Francisco Fed…. Williams is the highest-placed Fed official yet to suggest that maybe the inflation target should be higher. It’s not a new argument… but seeing it come from a senior official is news. Yet as Larry says, the paper is still weak and tentative even on monetary policy, to an extent that’s hard to understand…. Furthermore, there’s basically no break with orthodoxy on fiscal policy, despite the evident importance of the liquidity trap, evidence that multipliers are fairly large, and basically zero real borrowing costs. Yet Williams is at the cutting edge of policy rethinking at the Fed…. Mainstream thinking about macroeconomic policy has changed remarkably little, remarkably slowly.

You might say that it is always thus. But, you know, it isn’t…. Stagflation emerged as an issue in 1974, after the first oil shock, and pretty much ended with the Volcker double-dip recession of 1979-82–a recession whose end implication was that monetary policy continued to work in a fairly Keynesian way. So it was well under a decade of experience; yet it utterly transformed how everyone talked about macroeconomics.

Then came the 2008 crisis…. The sheer persistence both of depressed economies and of low inflation/interest rates should by now have led to a big rethinking. Depression economics redux has now gone on as long as stagflation did. Yet rethinking has been glacial at best. People who warned about the coming inflation in 2009 are warning about the coming inflation in 2016. Orthodox fears of budget deficits still dominate a lot of discourse. And the Fed still clings to an inflation target originally devised in the belief that the kind of thing that has happened to our economy would never happen.

I’m not entirely sure why learning has been so slow this time. Part of it, I suspect, is that the anti-Keynesian backlash of the 1970s had a lot of political power, and behind the scenes a lot of money, behind it–which influenced even academics, whether they realized it or not. And these days that same power and money is deployed against any rethinking. Whatever the explanation, however, it’s taking a painfully long time for serious policy discussion to arrive at a point that should have been obvious years ago.