Is the Fed able to offset “austerity”?

David Beckworth serves up another very good blog post and directs us to this graph of nominal gdp; it seems aggregate demand has been recovering steadily:


Scott Sumner directs us to Marcus Nunes, but here is a quotation from Scott:

In 1937 real government purchases recoiled 4.2% and the economy tanked. In 2012 real government purchases were 4.8% below the 2010 level and the recovery is slow!

Surely something is going on that´s making comparable ‘fiscal austerity’ so much less damning in 2012 than in 1937.

And that ‘something’ is monetary policy.

Here are further remarks from Scott.


'Surely something is going on that´s making comparable ‘fiscal austerity’ so much less damning in 2012 than in 1937.'

Compare defense expenditures from 1937 and 2010, and then consider either the insights from the founding fathers about the cost of a standing military, or if such reolutionary idealists are not quite adequate, then there are also the words of a former Republican president, not to mention SHAEF.

That the U.S. went from being founded, in part, to avoid the wealth draining reality of a standing military to one of the best current examples of just how that works in practice is simply something that some would consider historical irony.

Others, of an even more cynical bent, would consider it inevitable.

"Others, of an even more cynical bent,...."

There are others?!?

Well, all the graduates from different military academies I grew up among and with, tended to remain convinced that the U.S. would return to normalcy when the Cold War ended.

Of course, these officers were under civilian control - civilians who tended to be avid chickenhawks of the non-serving variety, wanting to tout their toughness through spending the lives and treasure of the nation. Chickenhawks who never met a war they couldn't have others than themselves or their families die in.

What's the connection between the sentence you quote and your comment? Were all the spending cuts to defense programs, and therefore good?

This reminds me of 2-star reviews for a product called "Liquid Ass"

How is one lukewarm on liquid ass?

I don't think cutting back on America's vast defense apparatus has anything to do directly with monetary policy, and to quote the former SHAEF -

'Every gun that is made, every warship launched, every rocket fired signifies, in the final sense, a theft from those who hunger and are not fed, those who are cold and not clothed. This world in arms is not spending money alone. It is spending the sweat of its laborers, the genius of its scientists, the hopes of its children. This is not a way of life at all in any true sense.'

However, the difference in defense spending between those two times is interesting - 4.8% of GDP in 2010 according to , and 2.2% according to

Military spending, as pointed out by a military man after being elected as president, is simply spending which decreases a nation's productive capacity.

There is plenty of room in the military budget to reduce this immense drag, a drag already noted at the time of America's founding. By those who revolted to create a new nation, in part due to the taxes levied by a government which had to pay for a standing military. A 'defense' the then British colonists in America did not agree with.

For example, we could reduce the current budget for military expenditures to twice what it was in 1937, representing a savings of .4% of GDP - which, as has been pointed out here, is mismeasured as a decrease in GDP.

But as the general that led the U.S. to victory in Europe over a totalitarian system (the country it was born in is currently remembering the mass book burnings performed in 1933, and again reminding itself how quickly a society turns to barbarism) noted, that amount of GDP also represents genius, and not only sweat.

Theft? Well, that's just wrong. Poor and hungry and unclothed people should not have their guns and rockets and warships taken from them. Outrageous.

If government spending on defense were cut and all the government/military personnel as well as the private sector employees of all the suppliers, you believe that private sector production would increase?

To what end? Be bought by all those workers now on unemployment?

With 10-20 million workers who need work or would work if a job were offered, increased production is not limited by military consumption starving the economy of production capacity.

Rather, the limit on production is too low labor income that caps consumption.

The "rich" are not investing in new production capacity, which would create jobs to build the productive capacity a factory doesn't materialize when money is poured into Wall Street. Instead, the money is simply driving up the market price of old factories which are producing less than they did a decade ago because demand is lower, but the factory has been stripped of every possible labor cost that can be cut to increase the profit margin.

The last time there was a real guns vs butter tradeoff was in the late 60s, but wages of workers had increased so they could consume a lot more, the banks were functional so mortgages and credit were safe and available to fund buying capital assets like houses and cars, and in that context, the draft taking workers out of the factories and putting them overseas at lower wages (maximum 9 month in Vietnam with another year or two someplace else).

In the 20s, 30s and the 50s, government spending created lots of private sector jobs building roads, bridges, schools, libraries, courthouses, water systems, sewer systems, parks, repairing environmental harm. (The 20s, most spending was local, but by the 30s local government was at the limit of their credit lines.) Where I am in NH I hear the debate over repair/replace for critical bridges built back then, as well as widening roads built then.

I have decided I would prefer the roads be privatized and all turned into toll roads, with regulators setting profits like in the 50s/60s based on ROIC so the toll concessions would be getting approval for wider roads and new safer bridges and so on in order to increase invested capital to increase profits. That would create lots of jobs. More employed workers, more consumption, more workers....

I agree that the comparison to 1937 is interesting, but it seems to me that the real test of ZIRP/QE isn't 2009-2013 NGDP growth but what happens in, say, 2015-2020.

Complete the thought. What is the thing that would happen in 2015-2020 that would mean it succeeded? What is the thing that would mean it failed?

That's pretty well covered these days (you can check out my blog if you like but there's plenty of others who've written more on the topic), and I hadn't intended to distill the discussion into a comment box. But just to give you an idea, bad outcomes could include repeat banking crises (from risk taking fueled by cheap credit), more debt solvency crises (student loans? CRE?), extreme economic volatility (could be either severe recessions or inflation depending on if or how fast the Fed decides to exit - rising rates virtually always lead to recession while zero rates and strong growth aren't compatable with low inflation), more asset price bubbles, govt. debt at alarming levels that would push debt service to a higher and higher portion of the budget if rates rise.

If the Fed pulls off a QE exit without any of these types of things happening, that's success.

With the institution of interest on reserves in October 2008 the FOMC effectively adopted a system of monetary policy which had already been in use by most of the advanced world's central banks (e.g. ECB, BOJ, BOE and the central banks of Canada, Australia, New Zealand, Sweden and Norway). There is no evidence that the FOMC plans to undo this change and moreover one of the newest Fed Governors, Jeremy Stein, has written a paper on the impact of interest on reserves on financial stability.

With an interest on reserves system the policy rate and the level of reserves are effectively independent. Thus, all of this talk of "exit plans" is absolute falderal because there is simply is no need to exit at all.

Also, this is not the first time the U.S. monetary base has been this large. It peaked at over 17% of GDP in the 1946 following the Great Depression. It wasn't until 1950 that it fell below 10% of GDP, and it wasn't until 1972 that it fell to the level (5.75%) of GDP that it had been in 1929. So that "exit" took over a quarter of a century during a time that most people regard as relatively free of economic and financial instability.

If you don't see the Fed winding down their mortgage and Treasury holdings (per their own discussion points such as Dick Fisher on CNBC just yesterday), then call it an "excessive stimulus exit." I agree it's hard to say how large the balance sheet should or could be, but the Fed certainly hasn't suggested that there's "no need to exit" from stimulus (they couldn't possibly argue that current policies are permanent), and based on Stein comments this year he's been especially concerned about the timing of when this happens.

When asked about the exit strategy during his biannual testimony before Congress in February, Bernanke said the Fed may decide to hold the bonds on its balance sheet to maturity. In March, Janet Yellen, who is Vice Chair and the leading candidate to replace Bernanke, reiterated that the Fed would raise the interest on reserves first and sell assets later. To my knowledge the only time that Stein ever addressed the issue of the exit strategy was when speaking before the Senate over a year ago during his nomination process, which was of course before he he was actually confirmed as a Fed Governor.

There has been considerable evolution in the Board of Governors' thinking since last year as to what will actually happen when the time comes. In my opinion it looks increasingly like the Fed will sell few if any assets. I don't see by itself how maintaining a large level of reserves can be considered "excessive stimulus", since the Fed's main policy instrument is of course the interest it pays on reserves, not the size of the reserves themselves.

And I wouldn't worry too much about the opinions of permahawk, and nervous Nellie, Dallas FRB President Dick Fisher. He will not be a voting FOMC member until next year, and then not again until 2017 at the earliest. he's very much out of the loop, and in his own private world.

You misunderstood me, MS, I was trying to cut through the semantics and find common ground when I said "excessive stimulus exit." I meant stimulus generally and inadvertently added my view that it's currently excessive (my bad - I'd meant to only suggest that past NGDP isn't the best judgement criterion, not to editorialize on the right policy). I agree that the exit will likely involve rates moving first, that waiting to maturity is one option that's been discussed for the exit, and that thinking has changed within the Fed. I won't comment on your Dick Fisher view.

Excellent discussion- thanks.

Great points Mark, I had never heard that history about the base before.

I'll just add, I think by sticking to the 2% inflation target the Fed is not properly utilizing the Chuck Norris principle here. If they had a flexible target or explicit NGDP targeting they could probably have avoided a lot of intervention.

For a longer reply than I managed 3 weeks ago, I've posted twice on this topic since May 10:

I'll also clarify what I mean by "exit," which led to some confusion in this thread although partly my fault:
- An eventual increase in interest rates would be part of an exit (this could include the Fed Funds rate, the discount window rate and/or the rate paid on excess reserves)
- Rolling off bonds at maturity is part of an exit (requiring the Treasury to issue new bonds to the public to pay for redemptions has the same effect as the Fed selling bonds to the public, apart from slightly different signaling because dealers don't see an offer from the NY Fed's in the first case)
- Tapering of purchases is part of an exit (this may have been a controversial statement 2 or 3 years ago, but it's more acceptable now that more people have acknowledged that the rate of purchases (the "flow") appears to be important, not just the cumulative amount (the "stock").

That's not to say that the balance sheet couldn't be left at the same size (maybe this is Tyler's view based on other posts) - I think it's difficult to say exactly how big it should be, especially with interest on excess reserves and the decline in shadow banking.

What would that graph look like in real gdp terms?

like this[1][id]=GDPC1&s[1][range]=5yrs

Marcus Nunes' post caused me to reread E. Cary Brown’s “Fiscal Policy in the “Thirties: A Reappraisal” (American Economic Review, Vol. 46, No. 5, December 1956, pp. 857–879) and Larry Peppers’ “Full Employment Surplus Analysis and Structural Changes” (Explorations in Economic History, Vol. 10, Winter 1973, pp. 197–210), both of which are mentioned in the Douglas A. Irwin’s paper on gold sterilization and the recession of 1937-38 which Marcus discusses in his excellent post.

Peppers’ paper shows how to calculate cyclically adjusted budget balances from Brown’s paper. By my arithmetic, according to Brown’s data the cyclically adjusted general government balance increased by 3.0% of potential GDP in calendar year 1937. Peppers only looks at the federal budget, and he finds that the cyclically adjusted federal government balance increased by 3.5% of potential GDP in calendar year 1937 and another 0.1% in 1938 for a total of 3.6% of potential GDP.

According to the April 2013 IMF World Economic Outlook (WEO) the U.S. general government structural (cyclically adjusted) balance will increase by 3.9% of potential GDP between calendar years 2010 and 2013. And the March 2013 CBO estimates of the cyclically adjusted federal budget balance show it will rise by 4.6% of potential GDP between fiscal years 2009 and 2013.

So apparently we have repeated the fiscal mistakes of 1937 with approximately a 30% bonus and yet the economy has not plunged into a renewed depression.

Still looking in vain for that darned liquidity trap Krugman keeps talking about!

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