Mark Thoma writes:

As for Tyler's (and others') call for monetary policy instead of fiscal policy, here's the problem. It relies upon changing expectations of future inflation (which changes the real interest rate). You have to get people to believe that the Fed will actually be willing to create inflation in the future when it comes time to do so. However, it's unlikely that it will be optimal for the Fed to cause inflation when the time comes. Because of that, the best policy is to promise that you'll create inflation, then renege on the promise when it comes time to follow through. Since people know that, and expect the Fed will not actually carry through, it's hard to get them to change their expectations now. All that credibility the Fed has built up and protected concerning their inflation fighting credentials works against them here.

This makes perfect sense in terms of a model, but I don't see inflationary expectations as the relevant factors for the real world.  Let's say the government/central bank prints up rebate checks and mails them around.  People either spend those checks or they don't.  If the checks are spent, AD goes up and the policy more or less succeeds.

If people don't spend the checks, they are engaging in "balance sheet repair."  In absolute terms, things are going less well than in the previous scenario, but still they're going as well as possible, given the dour expectations.  Balance sheet repair probably is needed and it is preparation for a later expansion, once the repairs are finished.  The policy still is "as successful as a policy can be."  (The alternative of fiscal policy won't have much of a multiplier and the higher debt may cause some more balance sheet worry.)

Which scenario will come to pass?  I doubt if it has much to do with the expected rate of inflation, or changes in real interest rates, at least not within normal U.S. ranges for those variables.  It probably has more to do with overall sentiment, indebtedness, joblessness, and so on.  A non-credible Fed, when it comes to the rate of future price inflation, need not crush the possibility that the funds will be spent.  I don't trust the Fed, or the ECB for that matter, and last night we went out for dinner.

Keep also in mind that balance sheet repair does not require currency holdings.  (Keynes is clear on currency vs. savings, but I'm not sure the current debates always are.)  Saved funds go to the bank.  The bank may or may not make more loans, and spur more investment and durables purchases, but we're no longer in a position where financial intermediaries are "broken."  The additional lending, while it's hardly guaranteed, could indeed happen and that would occur at the same time as balance sheet repair.  What a nice outcome.  Again, it is not obvious to me that the expected rate of price inflation, or expected real intereest rates, are major factors in determining how well this goes; I would again look to the overall state of expectations, including how much uncertainty there is.  I'll blog a bit more soon on why real interest rates don't always matter so much.

Even if it does come down to credible expectations, perhaps people only need to believe that the Fed will continue expansionary policy if unemployment remains high.  If a recovery is booming, expectations can allow for the Fed to contract a bit, because the first-order influence of all those positive income effects is so high.  Let's say you thought the Fed would contract as we approached macro-near-Nirvana and that was coming in three years' time.  I still think you'd be willing to spend your rebate check today.

I'm all for credible central banks, I just don't think that is currently the missing ingredient.

Japan is, in effect, short its own currency and, to aggravate matters further, so is the international hedge fund community.

Here is more.

Brad DeLong writes (do read his entire post on my post, it is too long to excerpt; also read the comments on his post):

In this environment, an increase in uncertainty–a mean-preserving spreading-out of ex ante investment project return distributions–causes a greater share of investment projects to fail to make the 1/β guaranteed gross-rate-of-return hurdle. So production of investment goods falls…

…and production of consumption goods rises, as labor is redirected.

There is no employment-reducing fall that I can see in aggregate supply in response to an increase in uncertainty. Yes, there is a structural readjustment as investment-goods industries shed labor and consumption-goods industries gain labor. But this is no more a fall in aggregate supply that leaves an extra 5% of the labor force with nothing productive to do than there was a fall in aggregate supply earlier, when perceived uncertainty fell and labor moved into investment-goods production–remember, back when financial engineering guaranteed by S&P and Moody's offered a way to create more of the AAA assets that the representative worker wanted to hold. There is a fall in aggregate supply in the sense that the value added by investment projects falls–but that fall shouldn't have implications for employment.

I think Brad is assuming I've fallen into the "Paul Krugman is right and Austrian Business Cycle theory is wrong" trap, but it's a different story.  I have in mind a model of costly-to-reverse investment where many entrepreneurs decide to wait.  It's also the case that producing consumption goods can be risky, even non-durable consumption goods: look at the decline in the number of luxury food items in a Whole Foods over the last few years.  Brad may not be convinced, but there's no logical problem in the story.

Here is one of the empirical pieces on how uncertainty reduces investment and yes RW this is also a negative supply shock, as it makes extant resources less productive, at least for the time being.  Here are more papers in the area.  Here is one recent relevant model or see the papers of Robert Pindyck.  Again, I don't wish to push "uncertainty" as the only story, it's rather the simplest means of seeing that it's not all just about weak aggregate demand.

Scott Sumner likes to scream from the rooftops about how Bernanke has forgotten his previous work on monetary economics.  I like to note that there is more than one — indeed more than two — Ben Bernankes.  He wrote his MIT dissertation on uncertainty and irreversible investment.  One of the Ben Bernankes I follow is in part a real business cycle theorist.

Brad also writes:

…the cost of borrowing for the government has fallen–the market value troday of future cash tax flow earmarked for debt repayment has gone way, way up–therefore we should dedicate more future cash flow to debt repayment by borrowing more. There is no "but even." Expansionary fiscal policy is a good idea.

I'll blog more on that soon, in a separate post.  For the time being I'll repeat my point that the monetary authority moves last anyway, so it's ultimately a matter of monetary rather than fiscal policy, whether we like that fact or not.

But despite all this, there's one pretty good reason to think that Tyler is basically right: tax cuts. Lefty economists might generally believe that increasing spending is a more efficient way of stimulating consumption than reducing taxes, but they'd almost certainly accept a big tax cut as an almost-as-good substitute. And tax cuts have two big advantages over spending. On the substantive side, they work faster. Spending takes time to work its way through the economy, but a tax cut (for example, a payroll tax holiday) boosts the economy almost immediately. And on the political side it's quite doable. Republicans would be persuadable because they love tax cuts and Democrats would be persuadable because it would help the economy. For Obama, then, it would be the best of all worlds: a fast stimulus that gets bipartisan support, something that boosts the economy while dampening the inevitable criticism he'd get for blowing up the deficit.

But he's not pushing for this. Not even quietly. And this suggests that Tyler is right: Obama's advisors might be in favor of further fiscal stimulus, but not by much. And the best explanation for this is that lefty or not, they're genuinely afraid, as Tyler says, that it would bring only marginal improvements at the cost of significant problems down the road.

The full link is here.

Matt Yglesias writes:

We right now have the capacity to produce more–much more–than has ever been produced before in the history of the planet. There are dozens of supply-side policies that could be improved in every country on earth, but that’s not a new fact about the world. What’s new is the lack of demand, the willingness of the key leaders in Tokyo, Frankfurt, Washington, Berlin, and now it seems London as well to tolerate stagnation and disinflation in the face of some of the most exciting fundamental new opportunities for human economic betterment ever.

You can take that quotation as a stand-in for the more general Keynesian AD views about the current recession.

First, I am fully on board with Scott Sumner-like ideas to boost AD through monetary policy, as is Yglesias and are many other Keynesians.  There is no practical disagreement, but it remains an open question how effective such measures (or a bigger stimulus) would be. 

Consider a simple model, in which uncertainty goes up, first because of the U.S. financial crisis, now because of Greece and the Euro and the open questions about Spain and how well Europe can cooperate.  I'm not saying that's the only or even the prime cause of what's going on, it's simply an illustrative story.

With higher uncertainty, investors pull back, wait, and exercise option value.  Aggregate supply declines, as does employment.  As a result, aggregate demand declines too, and that includes real aggregate demand, not just nominal aggregate demand.  Until the underlying uncertainty is resolved, the economy remains in the doldrums.

Note that there is still a case for fiscal policy, based on the idea of intertemporal substitution.  With some labor unemployed, a sufficiently finely targeted fiscal policy can build a new road at lower social cost than before, by drawing upon unemployed resources.  But even if that fiscal policy is a good idea, it won't drive recovery, at least not for plausible values of the multiplier.

There is also still a case for countercyclical monetary policy.  As real AS and real AD are falling (see above), there is also downward pressure on nominal variables.  Aggressive monetary policy, or for that matter the velocity-accelerating aspect of fiscal policy, can limit the negatives of this process and check the second-order fall in employment.

I'm all for countercylical AD management, noting that for other reasons I prefer monetary to fiscal policy in most cases and even if you don't agree with me there it suffices to note that the monetary authority moves last in any case.

That all said, the countercyclical monetary policy won't drive recovery either, or set the world right again, it just limits the damage.  We still have to wait for the uncertainty to be cleared up. 

Reading the Keynesian bloggers, one gets the feeling that it is only an inexplicable weakness, cowardice, stupidity, whatever, that stops policies to drive a more robust recovery.  The Keynesians have no good theory of why their advice isn't being followed, except perhaps that the Democrats are struck with some kind of "Republican stupidity" virus.  (This is also an awkward point for Sumner, who seems to suggest that Bernanke has forgotten his earlier writings on monetary economics.)  The thing is, that same virus seems to be sweeping the world, including a lot of parties on the Left.

Romer, Geithner, Summers, et.al. know all the same economics that Krugman and DeLong and Thoma do.  If a bigger AD stimulus would set so many things right, they'd gladly lay tons of political capital on the line to see it through and proclaim triumph at the end of the road.

Except they expect it would bring only a marginal improvement.  And for that marginal improvement they have only a marginal desire to:

1. Raise the long-term national debt (if it's fiscal stimulus)

2. Put their reputations behind policies which might backfire or irritate Congress,

3. Put additional pressure on the independence of the Fed (if it's more aggressive monetary policy)

4. Wreck the current term spread of interest rates, which is a) making the short-term debt easy to finance, and b) restoring major banks to profitability rather quickly.

I still think they should try to do it — through more aggressive monetary policy — but it's a judgment call and that's why they are more or less staying put.

In general you should be suspicious of explanations which take the form of "if only the good people would all band together and get tough."