Why monetary policy matters less every day

by on May 5, 2012 at 4:03 am in Economics | Permalink

1. Resource misallocation and unemployment get “baked in” to some extent, due to hysteresis.  I also would argue that some of the long-term unemployed are revealed as having been “baked in in the first place,” once the boom demand for their labor ended and their marginal products were more closely scrutinized.

2. Many nominal values end up reset, more and more as time passes and as new projects replace the old.

3. As banking and finance heal, debt overhang is less of an AD problem.  The debt repayments get rechanneled into investment, rather than falling into a black hole.

4. The Fed, at least right now, is not able to make a credible commitment toward a significantly more expansionary policy for very long.  Putting aside the more general and quasi-metaphysical issues with precommitment, just look at the key players.  Bernanke leaves the scene in 2014 and is a lame duck at some point before then.  Obama could be gone by the end of this year, and in any case is unlikely to be reelected with a thundering mandate.  Romney’s actual views on monetary policy are a cipher.  Either house of Congress could change hands.  There is less public support for a consensus view of the Fed today than in a long time.

On this issue I feel Scott Sumner is insufficiently Sumnerian.  He correctly stresses the role of expectations and credible commitments, but I still do not understand why he does not accept the implied pessimism in this, at least for May 2012.  2008-2009 was the time to act, in a Ludwig Erhard/Douglas MacArthur/Alexander Haig “I’m in charge now and we’re doing ngdp targeting try to challenge me in the chaos and confusion” sort of way.

5. The Fed already has failed to act, for whatever reasons.  That makes it all the harder to achieve the credible commitment now.  The market expectation has become “the Fed can/will only do so much.”  It’s like a guy hemming and hawing on the marriage proposal for three or four years, and then trying to suddenly set it right and show real commitment to the woman.  That’s hard to do, even aside from the points in #4.

I still believe in a looser monetary policy, I just think that what we can get for that now is much much less (a fifth? a tenth?) of what we could have received in 2008-2009.

Scott Sumner believes that Jim Hamilton somehow has changed his mind (and is puzzled by my approving link to Hamilton), but I don’t see that.  I simply believe Hamilton realizes he is now writing for a world where the credible commitment from the Fed mostly isn’t there.  Angus understands this well.

This will sound counterintuitive, but we should be debating real factors more and nominal factors less, all the more as time passes.

Circa 2012, monetary policy matters less every day.  You might feel outraged by that reality, and by the policy omissions from the past, but still monetary policy matters less every day.  That point follows from basic insights from Milton Friedman and Irving Fisher, or for that matter modern most mainstream neo-Keynesian models.  By the way the labor force participation rate declined in the latest round of data, and will likely remain low for a good while, so I am not convinced by graphs which beg the question about the size of the output gap.

I also stress that I haven’t changed my views at all, not since 2008-2009, and not since my early column on Scott Sumner (someday I’ll do a post on why I wrote that column in terms of prices rather than ndgp).  Same views, but I do see the clock ticking on the wall.

This entire point is hardest to grasp in a mental framework of “accumulated blame,” easiest to grasp within a disciplined, non-moralizing look at marginal products.

You also could write a post “Fiscal policy matters less every day.”  It’s not a message that a lot of people want to hear.

Steve Sailer May 5, 2012 at 4:23 am

As Tyler implied in The Great Stagnation, what really matters in the long run is quantity and quality of population. We are paying the price now for ignoring that for decades.

Ano May 5, 2012 at 8:09 am

Tyler is right about what matters in the long run. We should always be working toward long-run solutions. But the “low hanging fruit” (to use Tyler’s phrase) on long-run policy at this moment is to lower unemployment to the NAIRU level (maybe 6-6.5% today?), because young workers are having their lifetime productivity permanently lowered by the fact that they can’t get into the labor force right now. This is a small part of the long-run problem that can be solved with more aggregate demand now.

Andrew' May 5, 2012 at 8:49 am

See #1. I think you could solve an animal spirits problem but you can’t solve a boom-bust problem with wishful thinking.

I still haven’t seen anything more than “we have a problem, you guys aren’t fixing it.” I have no idea who you are talking to.

Ranjit Suresh May 5, 2012 at 11:09 am

Quality of population, i.e. race in Sailer’s parlance, doesn’t work as an explanation. Racially pure, high IQ Japan and Korea have also faced the same problem of declining GDP growth rates. Likewise, we do not see a sorting of Western nations by level of non-Western immigration. Peter Thiel’s technology explanation – that cognitive elites the world over are having difficulties extending the technological frontier futher works much better because it explains stagnation among *all* so-called industrialized countries.

Morgan Warstler May 5, 2012 at 11:10 am

Steve Sailer is a horrible racist.

The whole of the private economy should be closed off to him by free thinkers owners making free thinking decisions.

He should be starved into submission.

Yancey Ward May 5, 2012 at 12:02 pm

Advocating conformity in the free thinkers is a bit odd.

Morgan Warstler May 5, 2012 at 2:14 pm

I’m not advocating conformity, I’m advocating everyone do what I want… which is to as individuals make Steve’s life more miserable than it already is….

This is EXACTLY how liberty and property works to fix what is broken.

maguro May 5, 2012 at 2:22 pm

“I’m not advocating conformity, I’m advocating everyone do what I want… ”

Are you some kind of parody? This stuff is hilarious.

maguro May 5, 2012 at 12:04 pm

Nice example of what passes for “free thinking” these days.

Steve Sailer May 5, 2012 at 5:06 pm

“He should be starved into submission.”

Oh, come on, don’t hold back. Tell us what you really want: “A boot stomping on Sailer’s face forever.” There, now, doesn’t that feel even better?

jim May 6, 2012 at 1:11 pm

I admire Steve Sailer’s courage in the face of The Totalitarian Left, I mean Progressives.

The Progressives first instinct seems always to purge the unbelievers.

TallDave May 5, 2012 at 8:18 pm

Interesting, Rand Paul got in a lot of trouble for briefly espousing a similar view of the Civil Rights Act. I still think he was right.

DW May 5, 2012 at 6:30 am

tl;dr
Sumnerian monomania’s grip on the commentariat has waned, Cowenesque “solutions are messy because life is messy” is in the ascendent.

Doc Merlin May 5, 2012 at 4:33 pm

‘Cowenesque “solutions are messy because life is messy”’
Is the excuse that politicians use in order to justify their corruption. Remember, one man’s corruption is another man’s messy solution.

Ray Lopez May 5, 2012 at 6:39 am

Balderdash. Point, counterpoint.

Re #1–it’s true marginal players were employed, but why does the employment rate drop to pre-1992 levels? There’s something broke and that something is Aggregate Demand (AD), not the retirement of incompetents who never should have been hired.
Re #2 -” 2. Many nominal values end up reset, more and more as time passes and as new projects replace the old.” – that’s what they said in Japan–20 years ago and still counting. How do you square that circle?
Re #3 – ” As banking and finance heal, debt overhang is less of an AD problem. ” – Id. Japan’s Lost Decades
Re #4 – “The Fed, at least right now, is not able to make a credible commitment toward a significantly more expansionary policy for very long. ” – presupposes that Bernanke’s successor will be a hawk. Why would that be? Just as likely not.
Re #5 – “5. The Fed already has failed to act, for whatever reasons. That makes it all the harder to achieve the credible commitment now.”- Nope. That’s a fallacy as much as the sunk costs fallacy of “we paid a lot of money for this White Elephant so why not pay more to keep it going now?”

Here’s a question for the class: the collapse of the oil industry in the early 1980s was supposedly 5% to 10% of GDP. The rise of oil prices in the mid 00′s was supposedly 8% of GDP. The finance sector was supposedly 15% of GDP in recent times. Housing construction was 9% of GDP at the peak, less than 5% now. So tie these facts together: (1) oil prices collapsed in the early 1980s and so did Houston, TX real estate, but the nation did not follow into severe recession (there was one but we snapped out of it), (2) oil rose by three to four times from a 2003 base but the economy did not tank (or did it?) because of rising oil, (3) finance at 15% (same with medical services) collapsing should be like oil collapsing, namely, should not have a national impact, (4) Id for housing.

Conclusion: we lack AD. it’s nothing more than that. True, long term, the USA will go into the toilet maybe, due to lack of education, lack of savings, demographics, imperial overstretch, etc etc etc, but this sharp drop now is not due to “structural” reasons. And I hate to say it, since I’m anti-Keynesian.

Ed May 5, 2012 at 11:40 am

“(2) oil rose by three to four times from a 2003 base but the economy did not tank (or did it?) because of rising oil,”

It did. There is a strong historical correlation between rising oil prices and recessions and falling oil prices and recoveries/ booms. This turned out to hold true in the most recent case.

Econoblog, a much more statistically oriented but less entertaining blog than this one, has been good on this. This is s recent Econonbrowser post on this very topic, again its dry but its worth looking at:

http://www.econbrowser.com/archives/2012/03/disentangling_t.html

Suppose the world hit a big supply shock due to reaching peak oil production internationally in 2005 (oil prices have eased off a bit since then due to falling demand)? In the meantime, a big amount of leverage and financial products were added based on the presumption that the GDP growth rates that have been the norm in the previous decades would continue.

If this is true, alot of the recent debate on this stuff basically looks like hand waving. And the wealth used in the big bailouts has to come from somewhere.

careless May 5, 2012 at 11:45 am

We’ve been in a bubble or a recession (or this thing we have now} for 15 straight years, I don’t know what you can tell about where we should be given that.

liberalarts May 5, 2012 at 6:56 am

On the equivalence of oil and housing price declines, oil price reductions helped many consumers and business sectors, with the loss focused on labor and capital employed in that sector. Housing is (or was) owned by 2/3 of Americans, so in addition to the employment impact on the construction sector, its decline lowered the wealth and expectations of future wealth of most Americans. That is a big difference.

liberalarts May 5, 2012 at 6:58 am

Also, the oil price decline of the 80s was driven by off-shore supply increases, while the housing price declines were driven by domestic demand reductions. Another big difference.

Ano May 5, 2012 at 8:20 am

Ok, so we would have gotten the biggest bang for our monetary and fiscal policy buck a few years ago, and such policies can do less good now than they would have then. Agreed.

I am trying to cut through to what you are saying we should do at this point, given this fact. Your post is phrased in terms of “should talk about AD less, should talk about real factors more” now.

My questions:
1. You are not saying that it would be a bad idea to do a lot more to goose AD now, but rather that we should talk about something else since the powers that be have already said “no” to more AD, right?
2. Do you agree that the “baking in” of structural unemployment is not fully complete, so more AD is actually one way we could address the “real” economy for the next few decades? (Your points about whether anyone will listen if we continue to talk AD notwithstanding.)
3. Do you agree that switching the monetary paradigm now (NGDP targeting, or maybe even just a 5% inflation target) is still worth doing because it will lower the chance that the NEXT recession ends up in zero-lower-bound land? (Your points about whether anyone will listen if we continue to talk AD notwithstanding.)

Doc Merlin May 5, 2012 at 11:50 am

“Ok, so we would have gotten the biggest bang for our monetary and fiscal policy buck a few years ago, and such policies can do less good now than they would have then. Agreed.”

We had the largest monetary stimulus in the history of the US, it just didn’t do any good. Why do people keep saying we didn’t have any?

Ano May 5, 2012 at 3:24 pm

I meant the additional stimulus many are saying we should have done. I think this additional stimulus is the subject of Tyler’s post. I read him as saying, roughly, “whether or not we should have done more in the past, that ship has partially sailed so we should talk a bit more about real economy factors and a bit less about how we need more AD.”

The Original D May 5, 2012 at 4:19 pm

What evidence do you have that it didn’t do any good?

The largest stimulus in history came in the face of a financial crisis similar to that which precipitated the Great Depression. However, a second Great Depression did not ensue. Was that just luck or did the stimulus play a role?

msgkings May 5, 2012 at 9:29 pm

+100 to Original D

Yancey Ward May 5, 2012 at 10:34 pm

What is your evidence that it did?

The Original D May 6, 2012 at 7:04 pm

We are not in a second Great Depression despite a financial crisis that was an order of magnitude bigger than 1929.

We have a Fed chairman who’s specialty is the Great Depression and who took massive action specifically because he thought the Fed’s failure to respond in 1929 precipitated the Great Depression.

What other evidence do you need?

The Original D May 6, 2012 at 7:07 pm

I might add that the Fed’s policy during this period would, according to standard monetarist theory, lead to massive inflation. The fact that inflation is still quite moderate suggests that stimulus was absolutely necessary to prevent deflation.

TallDave May 5, 2012 at 8:17 pm

Doc — I think Tyler just means the Fed did not do Sumnerian NGDP targeting, which would have been a much larger monetary stimulus.

Becky Hargrove May 5, 2012 at 8:50 am

Here is where monetary policy still matters and will continue to matter whoever is in power: those who have sufficient money to go about their business and lives as usual. At the very least, it needs to be pursued so that these individuals are able to meet their financial commitments.

On the other hand, the window of opportunity could already be closing for those at lower to middle income, unless quick and certain action takes place to redefine the supply side of our economy. Every person alive needs to take part in that happening. While NGDPLT matters for overall context in the lives of the marginalized, it may not always be able to influence them directly, unless they are in some way recipient of enlightened policy. That can in fact still happen, if some buy into a new reality where money provides a base for lower to middle income instead of having to pay the bills for all of their knowledge and human skill operations and activities. Such a base needs to come from for profit activities generated to meet the actual product needs of our more mobile population, rather than government funding. That’s where supply side could be fixed, to create flexible modes of ownership for the hunter gatherers in our midst.

mw May 5, 2012 at 8:59 am

you need to point to specific predictions where the default model has failed, rather than suppositions, that imply that nominal factors are no longer important, or better yet where this “real factor” model has succeeded where the default model has failed.

Bill May 5, 2012 at 10:05 am

In this post, Tyler is giving the strongest argument for early aggressive fiscal stimulus.

Too bad it wasn’t earlier.

You see, the argument that unemployment, after a while gets baked in, and that monetary stimulus over time becomes less effective, is an argument for early and aggressive fiscal stimulus– unemployment doesn’t get baked in, and if monetary stimulus comes earlier with aggressive stimulus, it is more effective.

Tyler Cowen May 5, 2012 at 10:07 am

Many of you are reading this through the lens of mood affiliation, rather than looking at the words I actually wrote.

Doc Merlin May 5, 2012 at 11:54 am

Words like this:?
“The Fed already has failed to act, for whatever reasons. That makes it all the harder to achieve the credible commitment now. The market expectation has become “the Fed can/will only do so much.” It’s like a guy hemming and hawing on the marriage proposal for three or four years, and then trying to suddenly set it right and show real commitment to the woman. That’s hard to do, even aside from the points in #4.”

No, No, No. The Fed acted very, very aggressively. We had the largest monetary stimulus in the history of the US. It just failed to do much good.

Tom May 5, 2012 at 12:07 pm

Sure, one should try to interpret others positions in the most generous possible way, unless given legitimate reason otherwise. But I’ve never understood how the notion of ‘mood affiliation’ can differentiate between something seen as objectively dispassionate and something else seen as obviously emotional and associative. It seems perfectly legitimate for one person to analyze another person’s arguments by saying that its seemingly realist conclusions are actually unduly pessimistic. And yet the ‘fallacy of mood affiliation’ seems to judge such an approach invalid.

msgkings May 5, 2012 at 9:32 pm

Doc, as Original D pointed out, the good it did was prevent Great Depression II

That’s plenty good.

TallDave May 5, 2012 at 7:48 pm

It’s very hard to avoid.

To some extent, you learn to moderate this tendency in professional environments, but it’s especially difficult online. I catch myself doing it all the time, usually only after I’ve hit Submit. One of the reasons I wish we had an edit function here!

chuck martel May 5, 2012 at 10:10 am

The needle gets pegged on the Pretension meter when academics analyze unreliable numbers and then propose actions meant to affect a multi-trillion dollar economy where a like number of individual decisions are made every day. Policy initiatives meant to positively enhance the lives of complete strangers are made by individuals that get parking tickets, forget to renew magazine subscriptions and don’t know their wife’s dress size yet have a plan for saving the world. People just never get tired of making the planet a better place.

Ian lippert May 5, 2012 at 10:17 am

Are we getting caveats from NGDP’ists even before they get to implement their theory?

“if you guys don’t implement this completely untested economic theory in a window that is shorter than it will take to convince you then it’s all your fault the economy wasn’t saved! It’s too bad the time to falsify our NGDP theory has passed, we still consider ourselves correct and therefore will continue to condemn all mainstream economists from high upon our blogosphere!”

Sorry I’m still not convinced that NGDP targetting would not have been an inflationary disaster and the only good thing about Cowens mea culpa is that hopefully NGDP will be relegated to the dustbin of economic history.

Joseph Ward May 5, 2012 at 10:24 am

Could you please link for what you mean by the term “baked in”?

Willitts May 5, 2012 at 11:23 am

The biggest problem with this economic banter is the overreliance on inappropriate metaphors. I saw this too much in law, when judges made decisions on the legal foundations of what were essentially faery tales.

Right or wrong, the quality of Hamilton’s essay I liked the most was the absence of metaphors. He did, in fact, engage in thought experiments which compared and contrasted proposed policies to absurd propositions, but this is permissible in formal logic.

When people use metaphors, they rely crucially on a common understanding of the words and their analogs and presume there are no confounding factors that can invade their storyline.

Hamilton might be wrong, but he made his argument from how the bond markets and banks actually work, not how academics envision they might work. The debate is infected with fairy tales of pump priming, traps, paradoxes, goosing, ditch digging, helicopter drops, debasing, printing presses, et al, ad nauseum.

I’m not confident in any policy which involves government entities getting away with lies, tricks, or fraud in order to be effective.

Zachary May 5, 2012 at 12:34 pm

Indeedy!! I hate when people say that the economy (Not sure what they’re addressing first of all) “over-heats”.

I’m like huh? Can you please talk about the subject and not a mechanical device? It’s an allegory which, I think, reveals a lack of understanding or at least a lack of attention to detail.

Bill May 5, 2012 at 10:35 am

….and, where can I get one of those mood rings that Tyler is talking about.

I thought they went out of style in the late 60′s.

derek May 5, 2012 at 10:58 am

The Fed has done two things. Recapitalized the banks, and prevent a fiscal crisis by keeping intersest rates low, especially on treasury bonds.

So the Wall Street Washington corridor of power is maintained. The banks are larger and more powerful and just as stupid. And politicians can be as stupid as they want to be on borrowed money.

If the Fed wanted to really help, they would stop backstopping foolishness.

Right now 10% of gdp borrowing gives you 1.7% growth. The Fed is as close to the cliff of inflation as they dare. A regulatory environment with a crucifiction complex.

Since growth will only come from private investment, is it any wonder that growth is stagnant?

The only rational course is to get in line for the handouts. Which is exactly what our fearless leaders want.

Jon Rodney May 5, 2012 at 11:02 am

The marginal benefit of further monetary (and fiscal) expansion may be gradually decreasing, but I don’t agree that we should be paying less attention to it. History has a way of repeating itself. If we believe that NGDP targeting (or any other monetary policy target) would be a better cushion against this type of crisis, then one of the most important long-term reforms we can make is to enshrine that in policy now, before the next crisis comes along. Do we really want to have this same policy debate if a recession in 2017 again brings us to the zero lower bound?

Yancey Ward May 5, 2012 at 11:48 am

History has a way of repeating itself. If we believe that NGDP targeting (or any other monetary policy target) would be a better cushion against this type of crisis, then one of the most important long-term reforms we can make is to enshrine that in policy now, before the next crisis comes along.

A better cushion has been identified after every crisis, only to be determined a failure. The safest bet is that NGDP targeting will also be found to be a failure.

Doc Merlin May 5, 2012 at 11:56 am

“A better cushion has been identified after every crisis, only to be determined a failure. The safest bet is that NGDP targeting will also be found to be a failure.”

THIS!

When will people realize that policy itself is a failure, not just some specific type of policy.

Jon Rodney May 7, 2012 at 10:54 am

Sorry, but the fact that we haven’t yet found a perfect monetary policy is not a reason to avoid looking for one. Obviously the current fed regime hasn’t been successful in bringing our current crisis to a quick resolution. It’s still pretty easy to argue that it has been pretty successful at moderating downturns and controlling inflation since the 70′s, and that it was an improvement on what came before. You’re right, NGDP-targeting may fail to moderate future financial crises … but if we think it’s better than the current regime we should try it anyway.

Bill May 5, 2012 at 11:15 am

I am reminded of Platos theory of the forms–some idealized form that we can only see the shadows of– with the posts claim that “some of the long-term unemployed are revealed as having been “baked in in the first place,” once the boom demand for their labor ended and their marginal products were more closely scrutinized.”

What this imagines is that there is some ideal marginal value of labor that exists independently of current exuberant conditions or that there is some equilibriazed perfect economy–just like Platos ideal forms–where this persons contribution would be valued.

But we live in the real, and not the ideal, world. Who is the philosopher king who says what the ideal economy would have been but for the exuberance, or what the true value is in a period of irrational pessimism.

superflat May 5, 2012 at 11:53 am

this is exactly right. the problem with all policy counterfactuals is that they can’t be falsified, so they’re nothing but hot air (that keeps their proponents employed, unless the proponents are dumb enough to take jobs where they actually make decisions based on their theories, and then get falsified by real-world events, leading them to flee back to academia).

Willitts May 5, 2012 at 12:24 pm

We don’t need to observe the counterfactual to know that the housing and financial bubble diverted resources, including human resources, into industries which were quickly and inevitably underminng their own foundations.

No one can say with certainty where those resources should have or would have been best employed, but we know with certainty where they should NOT have been employed. And we know exactly why they were so employed.

This insight might not tell us what policy will correct the problem or at least ameliorate the consequences, but it must instruct us on what not to do in the future.

As someone aptly pointed out, our economy consists of hundreds of millions of people making quadrillions of individual decisions. It’s arrogance to think you can manage that with policy in a way that achieves specified goals without unintended consequences. The folly of always having to “do something” is how we got here, and it’s not going to get us out of here, wherever it is we’d rather be.

Being in the labor force is a choice. Most people are in it almost as a given. Millions of people were drawn into it or decided to remain in it by the proposition of large benefits for doing so. Now that those benefits have evaporated, they are making different choices. We need not imagine some ideal equilibrium to understand this. We only need to accept the weaker assumption that people make decisions at the margin based on the information available, and that information includes incentives and expectations. It also includes moods.

TallDave May 5, 2012 at 7:46 pm

Exactly. Aggregating G with C and I can lead to very mistaken conclusions.

Incentives will continue to matter.

TallDave May 5, 2012 at 7:54 pm

You can also come to some really interesting conclusions about GDP looking at this: if we produced, say, $10T of housing between 1995 and 2005, and it turns out have only been worth $5T, was GDP overstated by $5T from 1995 to 2005? For government, the misallocation is even harder to measure.

And I think we’re going to be asking similar questions re China in the medium term.

The Hat of the Three-Toed Man-Baby May 6, 2012 at 3:23 pm

Clearly you don’t understand how to calculate GDP — the value of the housing stock may well have fallen, but at the time it was worth what it was worth. Today is not 1995, and therefore investment in 1995 is not priced using 2012 prices. Go take Econ 101 again and return.

TallDave May 7, 2012 at 3:14 pm

You’re missing the point, which is precisely that GDP as calculated is not meaningful because in retrospect, what we produced was NOT worth what we thought it was at the time.

This is what Tyler refers to when he says “we were not as wealthy as we thought we were.” By extension, we were also not as productive as we thought we were.

For asset prices, this is something we tend to ignore because we assume market prices are reasonable. Government, otoh…

Doc Merlin May 5, 2012 at 11:48 am

“The Fed already has failed to act, for whatever reasons. ”

We had the largest monetary stimulus in the history of the US. Just because it didn’t have much of an effect, doesn’t mean that the Fed didn’t act.

The Original D May 5, 2012 at 4:23 pm

You keep saying this but offer no evidence it had no effect. Bernanke took massive action specifically based on his theories about the Great Depression. A second Great Depression has not materialized. On that fact alone you have to wonder if maybe the stimulus worked.

Yancey Ward May 5, 2012 at 10:39 pm

Bernanke didn’t undertake as big a stimulus, as many stimulus advocates think was necessary, based on his theories about the Great Depression. A second Great Depression has not materialized. On that fact alone you have to wonder if maybe stimulus didn’t work.

The Original D May 6, 2012 at 7:11 pm

No, but we are most definitely in a Great Recession, the worst since the Great Depression.

Matt Rognlie May 5, 2012 at 12:26 pm

“2. Many nominal values end up reset, more and more as time passes and as new projects replace the old.”

I agree with your other points to some extent, but this one is highly questionable—not because of the assumption that more nominal values end up reset (they do), but because of the inference that this will alleviate a demand-side recession.

I think you have in mind an old-style model where there is a certain amount of “nominal demand”, and price adjustment will eventually bring us to the point where real output equals potential real output. (To be fair, this is Scott Sumner’s implicit mental model too.) In this model, faster price adjustment gets us to the ideal point more quickly.

In “modern New Keynesian models”, on the other hand, recession occurs because for some reason, the natural real interest rate has fallen below the level achievable by a zero nominal rate and the prevailing long-term inflation target. In the absence of some kind of dynamic commitment by the Fed, this leads to an output gap. And faster price adjustment will only make this output gap worse! (It makes inflation lower, possibly even leading to deflation, making it even harder to achieve the ideal real interest rate.) The entire idea that “faster nominal resets will end the recession” is a relic of models where “nominal demand” is used as a reduced-form representation of monetary policy; the exact opposite happens in models that directly incorporate the zero lower bound.

Gauti Eggertsson has been pounding home this theme, most notably in his NBER Macro Annual paper on “Which Fiscal Policy is Effective at Zero Interest Rates?”
http://data.newyorkfed.org/research/economists/eggertsson/EggertssonNBERmacroannual.pdf

The point is that as long as you’re in a demand-constrained recession, any temporary improvements to the supply side (say, a temporary tax cut) are actually harmful—they don’t directly affect demand because that’s pinned down by long-term expectations and the path of interest rates, and by improving supply they lead to lower inflation or even deflation, making the central bank’s job harder to achieve.

Now, I don’t think that this is a particularly important channel to consider, because I don’t think that nominal flexibility is high enough for the effects Gauti is talking about to really do much; I also think that the model is a little too stark and excludes many other realistic effects. But as a benchmark to inform our intuition, it’s tremendously important. The overriding theme is that you don’t want the aggregate price level to adjust downward in response to the recession, because expectation of that adjustment that will make your job even harder.

It’s true that if nominal rigidities play an important role in translating weak demand into bad outcomes (say, unemployment concentrated among a few people, rather than everyone working a little less), then greater flexibility can be beneficial even if it makes the demand side worse, by allocating the demand more efficiently. But although I think that nominal rigidities are important, I don’t think that a simple, textbook model is enough to capture the dynamics that translate low demand into unemployment; there is a whole set of labor market rigidities at work, and making nominal wages reset more quickly doesn’t do very much.

Anon1 May 5, 2012 at 3:15 pm

Matt:

The problem with Gautti’s argument is that it assumes the central bank will allow the supply-side innovations that cause the downward price pressures to actually materialize as disinflation/deflation. That doesn’t seem even remotely possible for the Fed. That is why Krugman is also wrong when he says that wage flexibility would be bad for the recovery. He too assumes the Fed would allow it to lead to a lower price level.

Matt Rognlie May 5, 2012 at 12:37 pm

By the way, I think that the benchmark model of zero-lower bound recessions in Eggertsson and Woodford’s papers is absolutely terrific. They model the “natural interest rate” with a Markov-switching process, where the economy starts at a very low natural interest rate (unachievable by the Fed, leading to a demand-side recession), and at each given instant has a certain probability of returning to a business-as-usual higher natural interest rate.

This gives us a recession with the following properties:
1. The output gap is constant during the recession.
2. Inflation/deflation is constant during the recession. (The intuition that inflation has to be declining during a demand-driven recession comes from an old-school adaptive-expectations Phillips curve, which has some nice features but probably isn’t a very good representation of reality; the rational-expectations New Keynesian Phillips curve does not give us the “accelerating deflation” result at all.)
3. More nominal flexibility during the recession leads to worse outcomes.

There is no improvement over the course of the recession as “nominal resets” work their magic; in fact, anticipation of the existence of such nominal resets makes everything worse (though ex post there is no effect; it all works through expectations and the resulting change in effective real interest rates).

Of course, this model is unrealistic in a billion ways, yada yada yada. But it is tremendously valuable as a benchmark, because it shows how you can write a relatively sensible model of zero-lower-bound, demand-constrained recessions that has none of the properties that someone steeped in intuition from older models would expect. I don’t want to be a uncritical booster of “new” models just for the sake of their newness, but I think that this particular transition—from models that don’t explicitly represent the monetary policy problem at hand, relying instead of a reduced-form specification of nominal demand, to simple models that actually have a zero lower bound and a central bank—is an unmitigated positive.

Todd Ramsey May 5, 2012 at 1:04 pm

Bad microeconomic policies (excessive regulation, Affordable Care Act, Dodd-Frank, demonizing success from the bully pulpit, future tax uncertainty) are making private individuals too unwilling to invest. Consequently we have low monetary velocity, making the large increase in the monetary base ineffective — “pushing on a string”. That’s the source of the Fed’s ineffectiveness in reviving the economy.

The Original D May 5, 2012 at 4:27 pm

Gimme a break. I live in the heart of liberalism (Boulder, CO) and VC investment here is at an all time high.

BTW notice something about those other states? They’re all deep blue. Colorado is more purple.

TallDave May 5, 2012 at 8:14 pm

Be careful of generalizing from local, partial data.

In 2006, gross private domestic investment reached its most recent peak, at $2.33 trillion (in constant 2005 dollars), or 17.4 percent of GDP. After remaining almost at this level in 2007, this measure of investment fell substantially during each of the next two years, reaching $1.59 trillion, or 11.3 percent of GDP, in 2009. This decline is severe enough, but it does not give us all the information we need to gauge the extent of the investment bust.

http://www.campaignforliberty.org/node/12182

It’s recovered a bit since then, but only to mid-90s levels.

http://research.stlouisfed.org/fred2/series/GPDIC96/

Also, incentives do matter. One might observe that the areas of the ocean that are most heavily fished produce the most fish, and conclude that fishing increases the number of fish…

The Original D May 6, 2012 at 7:21 pm

In the IT sector, a VC dollar buys 10x what it could buy in 1995. My company has two partners and no employees. We do things with IT that would have have required at least 10 people plus 10x more hardware.

Obviously, not all sectors have the increasing return dynamic of IT, but it sure is creating a lot of wealth. I’ve never heard anyone complain about excessive regulation and high taxes as a reason not to do something.

TallDave May 7, 2012 at 3:21 pm

And yet, investment declined anyway.

I’ve never heard anyone complain about excessive regulation and high taxes as a reason not to do something.

You must not read the WSJ.

Philo May 5, 2012 at 1:57 pm

“Bernanke leaves the scene in 2014 and is a lame duck at some point before then.” True, but how important is this? Bernanke seems not to be a forceful leader; he has almost reduced himself to just a single vote on the FOMC. And the Fed consists mostly of Obama appointees with longer terms.

But Sumner’s main point is that *the Fed follows the policy preferences of the economics profession as a whole*. So he’s concerned more with affecting the views of economists in general than with specific appointments to the Fed.

Michael G Heller May 5, 2012 at 2:11 pm

It’s very interesting to hear that monetary policy will matter less.

By coincidence I was just reading Schumpeter on Irving Fisher who Tyler mentions. Schumpeter admired Fisher for emphasizing the problem of over-indebtedness caused by easy money, but said Fisher did not adequately locate the deeper mechanism of technological-economic cycles (the loan financing they needed etc.).

By the way (it has a monetary angle) if anyone is interested in reading a short quote of Schumpeter laying into the stupidity of budget deficits (possibly even in a depression) and the interests of the people who profit from and live on budget deficits you can read it here on my blog:

http://www.project-syndicate.org/blog/schumpeter-s-opinion-of-budget-deficits

Ray Lopez May 5, 2012 at 3:46 pm

Thanks for that blog note, but Schumpeter’s credibility is undercut by this from your article: “Note in passing, Barry Eichengreen’s remark that Schumpeter “was a skeptic of all things Keynesian, given his self-conscious competition with Keynes for the mantle of greatest economist of the 20th century”.” – so indeed Schumpeter may be simply adopting an anti-Keynes position just to stake out turf on the opposite spectrum to Keynes, regardless of Keynes’ arguments merits.

Michael G Heller May 5, 2012 at 5:40 pm

You misunderstand. It was Barry Eichengreen staking out his position for Keynes. Eichengreen probably does not know a great deal about Schumpeter, certainly not enough to understand Schumpeter’s subconscious or self-conscious motivations. Generally Schumpeter is very gentlemanly and fair to Keynes, never as far as I remember attacking him by name. Too fair in other words.

Donald Pretari May 5, 2012 at 2:24 pm

I agree with Prof. Cowen that Fisher’s Views lead to the conclusion that, if you don’t immediately Sufficiently Reflate, it will get harder over time to get out of what I call Slow-Motion Debt-Deflation, in which, although you have a bit of Inflation, people are acting as if we had a bit of Deflation. This comes about due to the different Optics of Inflation and Deflation. Once you begin looking through a Deflationary Optic as a habit, it becomes harder to reorient yourself. It’s very possible that the consequences of this state vary from Crisis to Crisis, and that, even if we don’t have a Great Stagnation, it appears that we do.

My real fear is that, over time, people will get so set in their ways that only a Credit/Stock Bubble of some kind, which feels like a great release from Slow Growth, will get the economy really going again. It will feel too good to curb.

Jason May 5, 2012 at 3:57 pm

Shorter Cowen: I have been arguing against activist policy since before all the human capital was destroyed and now activist policy is moot.

Ray Lopez May 5, 2012 at 4:18 pm

Professor Cowen mentions Irving Fischer in his blog, and here (http://fraser.stlouisfed.org/docs/meltzer/fisdeb33.pdf ) is a short and amazingly easy to understand paper of his from 1933 that adopts a Keynesian perspective. Seems like in a way Keynes, Friedman, Fischer were all part and parcel the same rather than opposed to one another. The Austrians are different but except for their “no wars are good” and “gold as a constant money supply is good” and “deflation don’t matter” arguments (all three arguably wrong), they don’t seem to be very logical.

Matt Waters May 5, 2012 at 4:51 pm

No, no, no, no, no!

Maybe it’s true in some terrifyingly narrow since that monetary policy “matters less.” That’s not really the point of this post, though, is it? Here’s what the post is really saying.

“Yes, the evidence points overwhelmingly to how continued high unemployment is not due to ZMP or other structural supply-side issues. Many, many such theories have been proposed over four years and they have all failed bitterly in the face of evidence. But instead of yelling from the rooftops for monetary policy to end millions of man-years of unnecessary idleness and untold real economic suffering, I, Tyler, will keep arguing instead for neoliberal reforms and keep avoiding the potency of monetary policy because the real-world market failures will hurt the purity of an the neoliberal message. Damn the evidence or the reql-world economic suffering, I will not say clearly that the market failure are real and last for a decade or more and monetary policy can wipe most all the suffering away very soon.”

Have a nice day.

Ray Lopez May 6, 2012 at 3:37 am

Don’t know if that’s what the good professor was saying, but he felt strongly enough to post here in the comments that we mere mortals misunderstood him, so maybe we did? Or he is being like the Oracle of Delphi and/or Alan Greenspan and/or any good economist and being obtuse? Since let’s face it economics is a non-linear equation and at any time, like in modern physics, you can for a brief period of time be on the opposite side of a line (tunneling effect as they call it). Literally you, reader, have a very small mathematical chance of a part of you being on the opposite side of the earth as you read this (for a split second). Same with economics. As for monetary policy curing a recession–that would be nice but unlikely–same for fiscal policy (in my mind linked to monetary policy) curing a recession. That was tried in Japan during the 1990s–look at this chart below–all tried and failed.

from: “Reviving Japan’s Economy: Suggestion for a Consumption-Driven Policy Ho-Chul Lee Shahid Yusuf Akifumi Kuchiki ”

Monetary Policy Announced Date Changing in Interest Rate in Japan: 1993 February to September 3.25% –> 2.5% –>1.75; … lots of further reductions in interest rates here… until 1999 February reduction to 0.0%

Fiscal policy: Aug. 1992: 2.3% of GDP stimulus package; April 1993: 2.8% of GDP stimulus; Feb. 1994 3.2% of GDP stimulus; …. smaller ones in 1995 deleted … Sep. 1995: 2.9% of GDP stimulus; Dec. 1997: 3.1% of GDP stimulus; April 1998: 3.4% of GDP stimulus; Nov. 1998: 5.4% of GDP stimulus; Nov. 1999: 3.6% of GDP stimulus – ALL TRIED AND ALL FAILED. Unless you are Paul Krugman who thinks “even more stimulus was needed” I think this is a compelling case that both monetary and fiscal stimulus fail in the long run to do anything to revive an economy in a funk. Perhaps this was Tyler’s point? That we are in the “long run” now, and thus “short term first aid methods” will fail.

TallDave May 5, 2012 at 7:39 pm

“It’s not a message that a lot of people want to hear.”

A guy whose only tool is a hammer does not like to hear the problem is not a nail.

TallDave May 5, 2012 at 8:03 pm

I was leaning toward Sumner’s argument for a while, but over time I’ve become more skeptical that NGDP targeting can really work as hoped (though it would have been very, very interesting to have tried in 2008-9, and perhaps it’s a shame we didn’t if only for empirical reasons). Interesting points though, especially #1 — there should be an expiration date on the some of the arguments against a structural problem.

Jacob AG May 6, 2012 at 12:11 am

“2008-2009 was the time to act, in a Ludwig Erhard/Douglas MacArthur/Alexander Haig “I’m in charge now and we’re doing ngdp targeting try to challenge me in the chaos and confusion” sort of way.”

Also a Hank Paulson “I’m in charge now we’re doing inflation targeting OH WAIT NO WE’RE NOT we’re doing ngdp targeting try to challenge me in the chaos and confusion” sort of way.

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