Tag: Liquidity Trap

Must-read: Jed Graham: “The Fed’s Historic Rate-Hike Goof–in One Chart”

Posted on by Brad DeLong

Must-Read: The very-sharp Jed Graham has… strong views… about the Federal Reserve’s rather counterintuitive decision to raise interest rates in a quarter at which nominal GDP grew at a rate of 1.5%/year, at the end of a year in which nominal GDP grew at 2.9%. The Fed is placing an awful lot of weight on the unemployment rate, and not on either non-labor market indicators or the employment-to-population ratio, in its decision to raise. I don’t think we even have to reach for the (very true and powerful) arguments about asymmetric risks to find the interest-rate increase technocratically incomprehensible, and the failure to roll it back last month technocratically incomprehensible as well:

The Fed s Historic Rate Hike Goof In One Chart Stock News Stock Market Analysis IBD

Jed Graham: The Fed’s Historic Rate-Hike Goof–in One Chart: “Janet Yellen’s Federal Reserve has done something that no other Fed has done since Paul Volcker…

…aimed to quash runaway inflation in the early 1980s, even if it meant a recession–and it did…. Nominal GDP grew at a 1.5% annualized rate in the fourth quarter…. (Inflation-adjusted GDP rose just 0.7% in Q4.) With the exception of Volcker’s interest-rate hike in early 1982 amid a recession, no other Fed has raised rates during a quarter in which nominal GDP grew less than 3%, dating back to the early 1970s. In fact, a rate hike when nominal GDP is growing less than 4%… from 1983 to 2014, it only happened twice, and one of those times (the second quarter of 1986), the Fed cut rates by a half-point before retracting 1/8th of a point of the reduction…. The first quarter of 1995, when nominal GDP grew 3.7%, [is] the only time since Volcker that the Fed had, on net, raised rates in a quarter when nominal growth was running below 4%. After that early 1995 hike, it should be noted, the Fed proceeded to cut rates three times before the next rate hike…. If one looks at the pace of GDP growth from the year-earlier quarter, the Yellen Fed stands alone as the only Fed to hike rates when nominal growth was below 3%.

Must-read: Tim Duy: “FOMC Recap”

Posted on by Brad DeLong

Must-Read: Once again: if the economy comes in weak, then the FOMC will wish that it had not raised interest rates in December and will find it impossible to induce an offsetting deviation from the ex post interest rate path it will wish it had followed in order to balance things out. If the economy comes in strong, then the FOMC will wish that it had raised interest rates even earlier than December, but it will then find it easy to induce an offsetting deviation from the ex post interest rate path it will wish it had followed in order to balance things out. This ain’t rocket science. This is the simple logic of optionality near the zero lower bound and the liquidity trap.

So why does this logic evade the FOMC? What are they thinking?

Tim Duy: FOMC Recap: “Now they have slow GDP growth and fast employment growth…

…That will make brains explode on Constitution Ave. They don’t know what to do with that when unemployment is at 5%…. If the recessionistas are correct, then they already made a mistake in December. If the optimitistas are correct, they will fall behind the curve if they hold in March. And that is without the uncertainty of the financial markets. Did the Fed release a little steam by shifting into a tightening cycle, the avalanche control of Mark Dow?  Or did they set in motion the next financial crisis? And recognize that this is within the context of a no-win political situation….

So, considering all this, you can’t really blame the Fed for taking a pass on quantifying the balance of risks…. Bottom Line: The Fed got lucky this month. They weren’t expected to do anything, which takes the pressure off. But in March they might have a real decision to make. We have only six weeks of data to digest. Even assuming that labor markets hold solid, will that be enough? Doubtful. They will need more.

Must-read: Ryan Avent: “No Take-Backs: The Fed Makes the Best of the Bad Situation It Created”

Posted on by Brad DeLong

Must-Read: Back at the end of last October, when the Federal Reserve decided it was going to hike interest rates in December, there were three reasonably-likely outcomes for the US economy over what was then the next six months: the economy could roar ahead, and a 2015:IV rate hike followed by a 2016:I one would look prescient while a 2015:IV pause and a 2016:I double-hike would look a little behind the curve; the economy could plod along, in which one hike in either 2015:IV or 2016:I would look arguable; or the economy could dive, in which case a 2015:IV hike would look like a significant unforced error.

Now roaring ahead is off the table. The prospects now for October-April are for either a plod or a dive…

Ryan Avent: No Take-Backs: The Fed Makes the Best of the Bad Situation It Created: “SUPPOSE for a moment that you are sitting on the Federal Open Market Committee…

…You think that it was sensible to raise the fed funds target in December… [think] the second half of 2015… [shows] employers adding workers at a sustained, rapid clip… oil can’t fall that much farther… payroll growth at this pace and unemployment rate has to eventually lead to much faster wage growth and higher inflation. There’s a risk that high inflation would be hard to bring down, and we don’t want to create a new recession by hiking rates a lot in a short period of time. So best to get started with the hikes now…. So you raise rates. And… all hell breaks loose…. Market-based measures of future inflation trip on a stone and faceplant….

So then you all meet again in January…. What do you do, then? Well, you release a statement… which makes the best of December’s unforced error. And… think very hard about how to change gears in March if things continue on…. The Fed… could not simply point to the real-economy data, which don’t look that different now than they did in December, and say that its outlook hadn’t really changed…. A statement… that it remained… hawkish… would force… to a nasty market panic. And enough panic can become self-fulfilling.

The statement therefore needed to… demonstrate that: the Fed’s view is basically unchanged, but the Fed is also aware of potential trouble brewing and stands ready to act accordingly, but the brewing trouble isn’t the sort of thing that should cause anyone to worry…. The problem is that now the Fed doesn’t meet again until March…. If it chooses to wait while markets do their thing, a March policy reversal could come too late to prevent a sharp deceleration in American economic activity….

It is possible that America’s recovery will roar ahead, and the Fed will be able to hike four times in 2016. But the Fed is now in a very uncomfortable position, which could easily become much more uncomfortable still. That was always the risk in hiking before economic conditions really demanded it. When both interest rates and inflation are very low, there is unlimited room to increase rates in response to an unexpected (and improbable) surge in inflation to a rate well above the target. On the other hand, under those circumstances it is very hard to react in time and with adequate force to an unexpectedly weak economic performance…

Must-read: Martin Sandbu: “Ask the big question on central banking”

Posted on by Brad DeLong

Must-Read: Martin Sandbu: Ask the big question on central banking: “Mervyn King and Goodfriend… the controversial decision by the Riksbank to raise interest rates…

…We will not adjudicate whether the decision was ‘not unreasonable’, as King and Goodfriend claim, beyond noting that every rich-country central bank that raised rates early in the recovery (that includes not just Sweden, but Israel, Norway, Denmark, and the eurozone) had to lower it significantly later. For more on this point, read Andrew Haldane’s speech from last year on the challenges of being stuck at low interest rates…

Must-read: David Glasner: “The Sky Is Not Falling… Yet”

Posted on by Brad DeLong

Must-Read: If you think that there is one chance in ten that the sky is falling with respect to the development of deflationary expectations, then you conclude that Federal Reserve policy is not appropriate–that they ought to be straining nerves to make policy looser to diminish that chance.

If you also think that there is one chance in two that in two years an inflationary spiral will have clearly begun… then you also conclude that Federal Reserve policy is not appropriate–that they ought to be straining nerves to make policy looser to diminish the chance of deflation, for there is plenty of policy time and policy space, plenty of sea room, to curb aggregate demand in the future should it attempt to blow us out to sea.

But there is next to no sea room and next to no policy space to boost aggregate demand if needed, for we are on a lea shore right now.

I am kinda thinking these days that only yachtsmen and yachtswomen should be allowed to hold central-banking policy jobs…

David Glasner: The Sky Is Not Falling… Yet: “The 2008 crisis. was caused by an FOMC that was so focused on the threat of inflation…

…that they ignored ample and obvious signs of a rapidly deteriorating economy and falling inflation expectations, foolishly interpreting the plunge in TIPS spreads and the appreciation of the dollar relative to other currencies as an expression by the markets of confidence in Fed policy rather than as a cry for help. In 2008 the Fed at least had the excuse of rising energy prices and headline inflation….

This time, despite failing for over three years to meet its now official 2% inflation target, Dr. Yellen and her FOMC colleagues show no sign of thinking about anything other than when they can show their mettle as central bankers by raising interest rates again…. [But] Dr. Yellen’s problem is now to show that her top–indeed her only–priority is to ensure that the Fed’s 2% inflation target will be met, or, if need be, exceeded, in 2016 and that the growth in nominal income in 2016 will be at least as large as it was in 2015. Those are goals that are eminently achievable, and if the FOMC has any credibility left after its recent failures, providing such assurance will prevent another unnecessary and destructive financial crisis…

Must-read: Stan Fischer: “Monetary Policy, Financial Stability, and the Zero Lower Bound I”

Posted on by Brad DeLong

Must-Read: Very disappointing to me that both nominal GDP targeting and price path level targeting appear to be completely off of Stan Fischer’s radar:

Stan Fischer: Monetary Policy, Financial Stability, and the Zero Lower Bound I: “Are We Moving Toward a World With a Permanently Lower Long-Run Equilibrium Real Interest Rate?…

…Research that was motivated in part by attempts that began some time ago to specify the constant term in standard versions of the Taylor rule has shown a declining trend in estimates of r*. That finding has become more firmly established since the start of the Great Recession and the global financial crisis…. A lower level of the long-run equilibrium real rate suggests that the frequency and duration of future episodes in which monetary policy is constrained by the ZLB will be higher than in the past. Prior to the crisis, some research suggested that such episodes were likely to be relatively infrequent and generally short lived. The past several years certainly require us to reconsider that basic assumption….Conducting monetary policy effectively at the ZLB is challenging, to say the least….

The answer to the question ‘Will r* remain at today’s low levels permanently?’ is that we do not know….

Raising the Inflation Target…. The welfare costs of high and variable inflation could be substantial. For example, more variable inflation would make long-run planning more difficult for households and businesses….

Negative Interest Rates: Another possible step would be to reduce short-term interest rates below zero if needed to provide additional accommodation. Our colleagues in Europe are busy rewriting economics textbooks on this topic as we speak…. It is unclear how low policy rates can go before cash holdings rise or other problems intensify, but the European experience has certainly shown that zero is not the effective lower bound in those countries….

Raising the Equilibrium Real Rate: An even more ambitious approach to ease the constraints posed by the zero lower bound would be to take steps aimed at raising the equilibrium real rate. For example, expansionary fiscal policy would boost the equilibrium real rate…. The Federal Reserve’s asset purchases… have reduced the level of the term premium….

Eliminating the ZLB Associated with Physical Currency….

None of these options for dealing with the difficulties of the ZLB suggest that it will be easy either to raise the equilibrium real rate or to mitigate the constraints associated with the ZLB…

A semi-platonic dialogue about secular stagnation, asymmetric risks, Federal Reserve policy, and the role of model-building in guiding economic policy

Posted on by Brad DeLong
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Sokrates: You remember how I used to say that only active dialogue–questions-and-answers, objections-and-replies–could convey true knowledge? That a flat wax tablet covered by written words could only convey an inadequate and pale simulacrum of education?

Aristoteles: Yes. And you remember how I showed you that you were wrong? That conversation is ephemeral, and very quickly becomes too confused to be a proper educational tool? That only something like an organized and coherent lecture can teach? And only something like the textbooks compiled by my lecture notes can make that teaching durable?

Aristokles: But, my Aristoteles, you never mastered my “dialogue” form. My “dialogue” form has all the advantages of permanence and organization of your textbooks, and all the advantages of real dialectic of Sokrates’s conversation.

Sokrates: How very true, wise Aristokles!

Aristokles How am I to take that?

Xanthippe: You now very well: as snark, pure snark. That’s his specialty.

Hypatia: This is all complicated by the fact that in the age of the internet real, written, permanent dialogues can spring up at a moment’s notice:

Sokrates: And with that, let’s roll the tape:

Other things linked to that are highly relevant and worth reading:

Things I did not find and place outbound links to, but should have:

  • Polya
  • Dennis Robertson
  • Donald Patinkin

Looking at the whole thing, I wince at how lazy people–especially me–have been with their weblog post titles. I should find time to go back and retitle everything, perhaps adding an explanatory sentence to each link…

(Early) Monday DeLong Smackdown: Larry Summers on how we know more than we write down in our lowbrow (or highbrow) economic models

Posted on by Brad DeLong

Larry Summers: Thoughts on Delong and Krugman Blogs: “I think the issue is more on the supply side than the demand side…

…If I believed strongly in the vertical long run Phillips curve with a NAIRU around five percent and in inflation expectations responsiveness to a heated up labor market, I would see a reasonable case for the monetary tightening that has taken place. I am sure Paul and Brad are right that a desire to be ‘sound’ also influences policy.  I am not nearly as hostile to this as Paul. I think maintaining confidence is an important part of the art of policy.

A good example of where market thought is, I think, right and simple model based thought is I think dangerously wrong is Paul’s own Mundell-Fleming lecture on confidence crises in countries that have their own currencies.  Paul asserts that a damaging confidence crisis in a liquidity trap country without large foreign debts is impossible, because if one developed the currency would depreciate, generating an export surge.

Paul is certainly correct in his model, but I doubt that he is in fact. Once account is taken of the impact of a currency collapse on consumers’ real incomes, on their expectations, and especially on the risk premium associated with domestic asset values, it is easy to understand how monetary and fiscal policymakers who lose confidence and trust see their real economies deteriorate, as Olivier Blanchard and his colleagues have recently demonstrated.  Paul may be right that we have few examples of crises of this kind, but if so this is, perhaps, because central banks do not in general follow his precepts.

I do not think this is a pressing issue for the US right now. But the idea that policymakers should in general follow the model and not worry about considerations of market confidence seems to me as misguided as the view that they should be governed by market confidence to the exclusion of models.

Larry is taking the side that our economists’ models are primarily filing systems rather than truth-generating mechanisms. As I have already written twice in the past week, the question is: 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.

The particular fight Larry wants to pick this weekend is over Paul Krugman’s Mundell-Fleming lecture, and Paul’s claim that a floating-rate sovereign that borrows in its own currency and is in a liquidity trap should not worry about maintaining “confidence”. Paul’s argument is that, in the model, pursuing aggressive expansionary policies will eat first to currency depreciation, then to an export boom, then to full employment, and only then will any downsides emerge. Thus the process can be stopped before it begins to generate risks. And it is only after full employment is attained that policy concern should shift to avoiding such risks.

Larry, however, says: We know things that are not in the model. Those things make Paul’s claim wrong.

My problem with Larry is that I am not sure what those things are. Paul notes that in normal times–away from the interest-rate zero lower bound–a loss of “confidence” in a country that floats its and borrows in its own currency an be contractionary:

Now,,, we can examine the effect of a loss of investor confidence… which we can view as a sudden stop… reduction in capital inflows at any given interest and exchange rate…. What would happen to a country with its own currency and a floating rate confronted with a foreign loss of confidence?… The depreciation of the currency at any given interest rate would increase net exports, and hence shift the IS curve out. This might be the end of the story. As I noted… however, the central bank might be concerned about the possible inflationary consequences of depreciation, and would therefore lean against it; in that case the MP schedule would shift up. So interest rates would rise due to rising demand for domestic goods and, possibly, tight money driven by inflation concerns. It is possible, if the latter motive is strong enough, that output could actually fall…

But, Paul says, at the zero lower bound things are different because the central bank has a cushion between what it wants the real interest rate to be and what the zero lower bound forces the real interest rate to be:

Right now the United States, the United Kingdom, and Japan are all stuck in the liquidity trap…. [with] policy… constrained by the zero lower bound…. This in turn means that any shift in the MP schedule, unless very large, won’t lead to a rise in interest rates…. All that matters is the rightward shift in the IS curve…. In short, under current conditions the much-feared loss of confidence by foreign investors would be unambiguously expansionary, raising output and employment in nations like the United States, the United Kingdom, and Japan…

It’s not clear what we know that is not in the model that would reverse this conclusion of Paul’s in the case of a floating exchange rate in a country that borrows in its own currency and happens to be in a liquidity trap. Paul notes that his conclusion goes against market wisdom:

Many people will, I know, object to this conclusion…. [It] seems very counterintuitive… and is very much at odds with what almost every policymaker and influential figure has been saying…. when I have tried laying out this argument to other economists, I have found that in general they recognize the point but argue that real-world complications mean that a sudden stop will nonetheless be contractionary even in countries with independent currencies and floating rates. Why? They offer a variety of reasons….

And Paul goes on:

The short-term/long-term interest rate distinction does not appear to offer any channel through which a nation with an independent currency can suffer a decline in output due to reduced foreign willingness to hold its debt….

Several commentators—for example, Rogoff (2013)—have suggested that a sudden stop of capital inflows provoked by concerns over sovereign debt would inevitably lead to a banking crisis…. [But] why, exactly… should [we] believe that a sudden stop leads to a banking crisis…. [It is] is only a problem for the banks if they have large liabilities denominated in foreign currency…. Inflation—and fear of inflation—is a potential channel through which sudden stops can end up being contractionary even for countries with independent currencies and domestic-currency debt…. Large foreign-currency debt can effectively undermine monetary independence, as can fears of depreciation-led inflation. However, the major nations with large debts but independent currencies don’t have large foreign-currency debt, and are currently quite remote from inflation pressure. So the crisis story remains very hard to tell.

I would say that the major nations with large debts don’t have large foreign-currency debt that we know of…

More musings on the current episteme of the Federal Reserve…

Posted on by Brad DeLong

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.

Musings on the current episteme of the Federal Reserve

Posted on by Brad DeLong

Larry Summers attributes the Federal Reserve’s decision to tighten policy, in what appears to him and to me to be a weakly-growing and high-slack economy, to four mistakes, which are themselves driven by a fifth, overarching mistake. The four mistakes are:

  1. The Fed has much too much confidence in its models that tell it that the unemployment rate takes the temperature of the labor market and the Phillips Curve now still has the slope it had in the 1970s.
  2. The Fed operates as though FOMC members are tased whenever inflation rises above 2%/year, with no countervailing painful consequences of low inflation, low employment, or low output.
  3. The Fed believes–without empirical support anywhere that I can see–that quick sharp moves up or down in interest rates have larger effects in total than the same interest-rate change made gradually and over a longer term.
  4. The Fed thinks–without theoretical support that I can see–that zero interest rates are not a reflection of an economy in a pathological state, but rather a cause of economic pathology that is dangerous now that the economy is once again “normal”.

And Summers sees the fifth, overarching mistake the Fed is making right now as:

(5) The Fed is excessively committed to “existing models and modes of thought… in the thrall of orthodoxy”:

Larry Summers: My Views and the Fed’s Views on Secular Stagnation: “First, the Fed assigns a much greater chance that we will reach 2 percent core inflation…

…than is suggested by most available data…. Second, the Fed seems to mistakenly regard 2 percent inflation as a ceiling not a target…. Third, the Fed seems to be in the thrall of notions that… do not… have analytic support premised on the idea that the rate of change of interest rates, as distinct from their level, influences aggregate demand…. I know of no model in which demand will be stronger in say 2018 if rates rise and then fall than if they are kept constant at zero. Nor… do I know of a reason why recession is more likely if the changes are backloaded…. The argument… is in the category with the argument that I should starve myself in order to have the pleasure of relieving my hunger pangs. Fourth, the Fed is… overestimating the neutral rate…. The desire to raise rates reflects… a sense that zero rates are a sign of pathology and an economy creating 200,000 jobs a month is not diseased….

Why is the Fed making these mistakes if indeed they are mistakes? It is not because its leaders are not thoughtful or open minded or concerned with growth and employment.  Rather I suspect it is because of an excessive commitment to existing models and modes of thought…

I do think–confidently–that Summers is absolutely 100% correct in his identification of the four component intellectual errors that the Federal Reserve is currently making. And it is certainly true that these are the result of an excessive commitment to some current modes of thought–there are, after all, a lot of people who join the Fed in thinking that zero interest rates are a cause rather than the proper treatment of pathology right now, that the Fed needs to raise rates now to give it the space to lower them if need be later, that it is dangerous for inflation to rise above 2%/year ever, that the Phillips Curve somehow has a steeper slope than the recent evidence of the past generation can justify belief in, and that the unemployment rate rather than the detrended employment-to-population ratio gives the temperature of the labor market.

But do these beliefs on the part of the Fed really reflect an excessive commitment to existing models? There I have my doubts. Or, rather, it depends on what you think the proper function of economic modeling is. 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.

But it is clear to me that if you give even minor weight to the first–see well-founded models as a way of generating new insights rather than just organizing old beliefs–that the line of work into the economics of the liquidity trap that I see as well-represented by Krugman’s (1999) “Thinking About the Liquidity Trap” tells us, very strongly, that the Federal Reserve is on the wrong track intellectually right now. It tells us that what is out of whack has not been and is not the real money stock, but is instead the expected inflation rate. Or, rather, that because the expected inflation rate is too low, there is no value of the real money stock consistent with full employment equilibrium. If expected inflation were higher, the existing money stock would be ample, or even require shrinking.

This is the conclusion of Krugman (1999): that the economy needs higher expected and actual inflation, and that the free-market economy with full price flexibility would deliver that inflation. But the Fed does not appear to acknowledge either that the economy needs higher inflation, that the flexible-price benchmark would deliver this inflation, or that the job of the Fed is to mimic that full employment-generating price structure as closely as possible.

Moreover, the Fed does not engage in reflective equilibrium. It rejects the conclusions of what I regard as the standard Patinkin-style existing model of Krugman (1999). But it does not propose an alternative model. There seems to me to be no theoretical ground, no model even considered as a filing system, underpinning the “orthodox” modes of thought that the Fed believes. And it does not seem to feel this absence aaa a problem. I find that somewhat disturbing.