There is at least some economic theory behind the first prescription; indeed, I used to believe it myself, as I set out here.  But this is a purist approach, which simply hasn’t survived contact with reality, as Chris’ own articles show. If monetary policy alone was indeed enough in practice, we wouldn’t be where we are now, with unemployment in the UK a million higher than the official estimate of the natural rate, and no prospect of it coming down in the immediate future. Any demand management policy that delivers that outcome is not one that policymakers should regard as remotely adequate.

I’ll bet most people read this and nod their heads in approval.  But suppose you replaced the phrase “if monetary policy was indeed enough in practice” with “if fiscal policy was indeed enough in practice.”  Would that not be equally true?  I’d say so.  On the other hand I’m pretty sure Portes would disagree.  But why?  Here’s where I’ll try a bit of mind-reading.  I’ll bet Portes would say; “we (in Britain) have tried monetary stimulus, but not fiscal stimulus.  Hence the demand shortfall is best explained by a lack of fiscal stimulus.”  Even if I’ve misread his mind, I don’t doubt that plenty of Keynesians think that way.  But as we’ll see, there’s really no reason for doing so.  First let’s consider what we mean by monetary and fiscal stimulus:

Naive, man-on-the-street view:

Monetary stimulus is low interest rates and/or a rapid increase in the money supply.  Fiscal stimulus is huge budget deficits.

By that definition Britain’s had plenty of monetary and fiscal stimulus; its interest rates are very low and its budget deficits over the past few years have been among the world’s largest.

Now let’s consider the more sophisticated view:

Bernanke says you can’t judge the stance of monetary policy by looking at interest rates or the money supply, only indicators of nominal demand growth are reliable.  Paul Krugman says you can’t judge fiscal stimulus by the budget deficit, you need to look at the full employment deficit, at the tax/expenditure mix, at the change in the deficit.

Money obviously hasn’t been expansionary by the more sophisticated perspective, and Keynesians claim fiscal policy hasn’t been expansionary (I have my doubts, but I’ll take their word for it here.)

[Update 5/26/12: I've corresponded with Portes by email, and he emphasized that he was thinking in terms of the effects of the fiscal tightening of the new government, which took office in mid-2010.  It's probably better to view this post as a critique of broad trends in Keynesian ideas, rather that Portes' specific views.]

No one can claim that Britain has done easy money and tight fiscal policy, regardless of whether they use the naive or the sophisticated policy definition.  Indeed you’d have to use the naive view of monetary policy and combine it with the sophisticated view of fiscal stimulus, to be able to claim Britain has done easy money and tight fiscal policy.

The bottom line is that either fiscal policy has been tried and failed (my view),  or neither fiscal nor monetary stimulus has been tried (the sophisticated Keynesian view.)  Let’s say I’m wrong and the sophisticated Keynesians are right.  Then what?

Then Cameron should choose the optimal policy.  He could either:

1.  Call on the BOE to hit a higher NGDP target.

or

2.  Do a big fiscal stimulus, and continue to insist that the BOE adhere to a 2% inflation target, which forces the BOE to cut back on unconventional monetary stimulus every time the fiscal stimulus boosts NGDP and inflation.  That’s obviously nuts.  The Japanese have gone down that road for 20 years and have a countryside paved over with bridges to nowhere, and zero NGDP growth since 1993.

The current British policy is not working—I agree with Portes on that point.  The question is where do we go from here?  I see lots of good arguments for setting a higher NGDP target.  I see no good arguments for relying of fiscal stimulus.

But suppose I’m wrong.  Suppose it’s politically impossible for Cameron to tell the BOE to switch away from a 2% inflation target.  What then?  Well then you’d instruct the fiscal authorities to target inflation at a higher level, and fight it out with the BOE.  Just imagine Cameron announced:  “The BOE is instructed to keep shooting for 2% inflation, but we fiscal authorities will set a 4% inflation target because that’s what it will take in an economy that had its a supply-side weakened by Gordon Brown’s big government policies.  Thus we plan to fight it out with the BOE, and see who is stronger.”

Cameron would instantly be the laughing stock of the global economy.  But that’s essentially what Keynesians are asking him to do; they simply want him to be quiet about it.  They know that the idea of the fiscal authority targeting a higher rate of inflation is absurd, indeed laughable.  And why is it crazy?  Because it would require the fiscal authorities to be able to control aggregate demand, i.e. total nominal expenditure.  Oh wait . . . Keynesians do believe that.

PS.  Last Friday Karl Smith came up with the phrase “the Sumner Critique.”  Within three days the phrase had spread to Matt Yglesias at Slate, Ryan Avent at The Economist, Josh Hendrickson, and across the ocean to Britmouse.  Someone better find a antidote quickly, before the virus spreads even further.

PPS.  Speaking of Karl Smith, at his new Forbes home he has a wonderful graph showing data relevant to the “re-calculation argument.”  It seems that the share of our economy devoted to information technology is plunging, whereas the share devoted to primary metals production is soaring.  In 2000 IT was 2 1/2 times larger than primary metals.  Now primary metals is far bigger.  We desperately need to retrain Silicon Valley engineers on how to dig up copper in the Arizona desert; otherwise Silicon Valley will soon look like Detroit.

Svensson then makes the eminently logical suggestion that the Riksbank ought to choose the target path that best meets the mandate they’ve been given (which is 2% inflation and high employment–interpreted as the natural rate of unemployment equalling 6.5%)  Svensson points out that the actual decision (keeping rates at 1.5%) produces an inferior outcome to the alternative lower interest rate path.

He prefaced his analysis by pointing to the basic “principle” of monetary policy.  First predict the path of the economy under alternative policy scenarios, and then choose the path that best fulfills your mandate.  It would be an understatement to suggest that other members were annoyed at Svensson pointing out the obvious:

Mr Jansson then commented on Mr Svensson’s contribution to the discussion regarding issues of principle. Mr Jansson said that he did not really understand the point of taking up these issues at the monetary policy meeting. These are questions that can be discussed at length, but there is not enough time available at a meeting of this nature. Mr Jansson said that Mr Svensson makes it sound as though the Executive Board has never discussed these issues before, which he considers to be totally misleading. These questions have often come up for lively discussion in recent years, and several of them have also led to concrete projects in the departments’ business plans. It is important that those outside the Riksbank are not given the impression that the Riksbank never talks about these issues.

Just imagine if the Fed presented not just its forecast for the economy, but also an alternative forecast for inflation and unemployment, conditional on a different amount of QE or a longer promise to hold rates at zero.  “Yes, we could have done that, but chose not to.”  I give the Riksbank a lot of credit for clearly explaining the alternatives to the path actually chosen.

Mr. Jansson also seemed perturbed that Svensson pointed out that the Riksbank had been significantly undershooting their inflation target, ever since the policy was adopted in the 1990s:

Mr Jansson considered that the new calculations presented by Mr Svensson rely on a number of assumptions that are rather difficult to digest. Firstly, it is assumed that the Riksbank for some reason should want to deliberately and systematically aim to attain a different inflation rate than the one it has chosen to introduce as a target. Disregarding the fact that this would appear to lack logic, it is something that Mr Jansson does not recognise at all from his almost 15 years of working at the Riksbank.

My goodness!  What would make people believe that the Riksbank is intentionally undershooting their inflation target?  Perhaps the fact that their own forecasts suggest that, given current policy settings, they are likely to miss their target.  Of course the same is true of the Fed.  Pity we don’t have someone like Svensson at the Fed; someone to shine a bright light on that policy failure.

However, the past build-up of debt in now depressed areas may suggest that demand was too high relative to incomes. If so, demand, without the dangerous stimulant of borrowing, will stay weak. Policy should instead help workers move where there are suitable jobs – for instance, by helping them offload their homes and the associated debt without the stigma of default.

Smith can’t figure out what this means either.  Here’s Karl’s interpretation:

So first, when we use demand in the macroeconomic sense, income is simply the equilibrium value of demand at a given price level. It makes no sense to say that demand is too high relative to income.

We might mean that the local area was running a persistent current account deficit. So for example on total the people of Las Vegas were importing more than they were exporting. Las Vegas experienced perhaps the most severe crash of any major US metropolitan area. To undue this balance they need to run a current account surplus. That is they need to export more than they import.

Perhaps, but then his solution (people should work less in the region that has the CA deficit) would make no sense at all.  I really don’t know what Rajan means here, if I had to guess I think he’d claim the people of the problem regions like Vegas and Spain were not producing too much in total, but rather were producing too much of one good (like houses) and too little of other goods.  Then he might argue that in the short run it’s easier for the surplus labor to exit Vegas and Spain and work in a more prosperous area.  That would be a defensible argument, but of course it would have nothing to do with “demand” having been too high relative to income.  And even if output was too high in aggregate (say too many people had moved to Vegas), that would suggest both output and income were too high, not that demand was too high relative to income.

And as Karl points out, Rajan’s also confused about the re-allocation argument.  Here’s Rajan:

This is probably the more pertinent case in several industrial countries, such as the US and Spain.   Increasing employment in a sustainable way today could more than pay for itself if people who would otherwise drop out of the workforce earn incomes.

The key question then is whether more government spending can make a real difference to the most severe employment problems. Here the case for a general stimulus becomes less compelling. In the US, demand is weakest in communities where a boom and bust in house prices has left an overhang of household debt. Lower local demand has hit employment in industries such as retail and restaurants. A general increase in government spending may be too blunt – greater demand in New York is not going to help families eat out in Las Vegas (and hence create more restaurant jobs there). Targeted household debt write-offs in Las Vegas could be a better use of stimulus dollars.

Notice the non-sequitur, from a lack of jobs to the claim that the “key question” is whether we need more government spending.  If there’s not enough jobs (due to a demand shortfall) we need more monetary stimulus.  That oversight is forgivable for Spain, as they lack their own currency.  But the US?  Why would we employ fiscal stimulus, when monetary stimulus doesn’t run up any debts?  And the Vegas/New York comparison makes no sense.  Both regions have high unemployment. But even if they didn’t, regional differences should play no role in aggregate demand policies.  The Fed and the ECB can and should tailor their policy for the entire region.  Obviously both the US and the eurozone have a demand shortfall.  Recently the problem’s been getting slightly better in the US, and slightly worse in the eurozone.  But both could use more monetary stimulus.

Indeed the US needs more monetary stimulus even if AD is currently right on target.  How can that be?  Because we are still doing fiscal stimulus, e.g. the payroll tax cut.  So at a minimum you’d want to do more monetary stimulus until we reached a demand level where Congress felt it could remove fiscal stimulus.  People used to sort of blanch when I talked about the Fed “sabotaging” fiscal stimulus, but Bernanke all but admitted that this is exactly what the Fed is currently doing:

1.  Bernanke says the Fed can do more.

2.  Bernanke says the Fed chooses not to do more, as they think the expected future path of AD is adequate.

3.  Congress continues to hold down payroll taxes because they think the expected future path of AD (without fiscal stimulus) is not adequate.

That’s sabotage folks; there is no other word for it.

I apologize for the snarky post title.  But think about how hard we work to get our undergrads to distinguish between shifts in demand and changes in quantity demanded.  So it’s quite dismaying when a famous economist talks about too much “demand” in a context where he pretty clearly meant something entirely different.  It’s hard to have an intelligent debate if each participant comes to the discussion with their own private language.

PS.  It’s also possible Rajan meant “consumption” when he said “demand.”  That would be a strange use of the term ‘demand,’ and of course the main problem in Vegas and Spain was too much investment, not too much consumption.

PPS.  If anyone (including Rajan) can provide a sensible definition of what he meant by ‘demand’ then I’ll provide an abject apology.

Why does Bernanke favor inflation targeting?
He thinks that a more “transparent” Federal Reserve policy would promote stable, noninflationary economic growth by giving businesses and consumers more certainty about the future course of interest rates and inflation.

Why is Greenspan against it?
He thinks the Fed can control inflation without announcing a target rate. Plus, he worries that an announced rate would make it harder to respond flexibly and intuitively to a financial crisis or changing economic conditions. Greenspan recognized from a variety of subtle indicators in 1997 that rapid productivity growth was likely to curb inflation — even though most conventional forecasts predicted accelerating inflation. He persuaded fellow Fed policymakers to not raise interest rates, allowing the economy to flourish.

Does Bernanke admit that inflation targeting would decrease the Fed’s flexibility?
No. He says that in a crisis the Fed would do whatever it takes to stabilize the economy. Frederic Mishkin, a Columbia University economist and longtime Bernanke collaborator, says that establishing credibility with the financial markets as an inflation hawk gives an inflation-targeting central bank more, not less, flexibility to tackle recessions.

Bernanke has recently announced that it would not be appropriate to do further stimulus to “tackle” the recession.  And why not?  He says it might lead to higher inflation.  Thus Bernanke and Mishkin were wrong in 2005, inflation targeting does inhibit the Fed’s ability to tackle recessions, as compared to NGDPLT.

What does all this mean?  Ryan Avent has a good post that discusses one implication:

The bottom line is quite simple, says CBO. If all of the fiscal blow is deflected, the economy should grow at an annual pace of 5.3% in the first half of the 2013 fiscal year. If Congress is unable to find a way to defer some of the impact, the economy will instead shrink by 1.3%.

.   .   .

Except, of course, that the economy will almost certainly not grow at a 5.3% rate no matter what Congress does. Arguments to the contrary are subject to what econ bloggers have come to call the Sumner Critique, after economist and blogger Scott Sumner. It is reasonable to assume, by this critique, that the Federal Reserve has a general path for unemployment and inflation in mind and it will react to correct any meaningful deviation from that path. A 5.3% growth rate is well outside the range of current Fed projections. Growth that rapid would almost certainly bring down unemployment quite quickly, triggering Fed nervousness over future inflation and prompting steps to tighten monetary policy. Growth might run slightly above Fed forecasts for a bit, but the overall fiscal effect will be dampened considerably.

I think this is right.  But Ryan is less confident that the Fed would cushion the blow if we had a fiscal tightening in early 2013:

There can be quite a large lag between the onset of falling real output and a drop in inflation, especially (thanks to downward nominal rigidities) at low levels of inflation. If the Fed becomes less responsive than normal, the fiscal multiplier rises. Imagine a world in which the Fed waits to see how Congress behaves and then waits until the economic impact of Congress’ behaviour translates into falling inflation before stepping into action. Inflation may not depart from trend by all that much, but real output would likely dip substantially as a result of the fiscal cliff.

Ryan points out that it doesn’t have to be that way:

The Fed could therefore proclaim to the world that will maintain aggregate demand growth (in the form of, say, nominal income growth) at all costs, and that it would by no means allow the fiscal cliff to knock the economy off its preferred path. It could explain in great detail what specific steps it would be willing to take to achieve this goal, so as to boost its credibility. And if demand expectations as reflected in equity or bond prices showed signs of weakening ahead of the cliff, the Fed could preemptively swing into the action to establish the credibility of its purpose.

I think these are plausible arguments.  But then he makes a very peculiar claim:

The Fed will almost certainly not do this.

Why? Because the Fed is thinking about moral hazard, specifically, that if it promises to protect the economy against reckless fiscal policy Congress will have no incentive to avoid reckless fiscal policy. The Fed would very much prefer that Congress behave—lay out a plan for medium-term fiscal consolidation but keep short-term cuts small and manageable. It is therefore in the Fed’s interest to imply that the fiscal cliff is a real economic danger, even if it could potentially prevent it from being one.

This is a very peculiar definition of “reckless” fiscal policy.  The standard theory says the Fed should take a tough line on fiscal irresponsibility, and not help Congress out when they run up massive deficits.  They should tell Congress they have no intention of monetizing the debt.  The standard model says the most effective policy is to run small deficits, or even surpluses, and have the Fed do the demand stimulus required to keep aggregate demand on track.  Ryan’s making precisely the opposite claim.  He’s saying that if Congress does the right thing, and gets its fiscal house in order, then it’s in the Fed’s interest to punish Congress with tight money, so they don’t ever again do something so “reckless.”

Now I’m pretty sure that Ryan would claim I’ve mischaracterized his views.  It seems his point isn’t that smaller deficits are a bad thing, but rather that Congress shouldn’t move so precipitously.  And why not?  Presumably because the Fed cannot or will not cushion the blow.  I think they can, and my hunch is that Ryan agrees.  So then it becomes “will not.”  But here’s where things get really strange.  In that case the Fed would be punishing Congress for not realizing just how irresponsible Fed policy really is.  “If you do the policy that would be optimal conditional on us doing the right thing, we’ll punish you for having the audacity to assume we’ll do the right thing, by doing the wrong thing.”  Or something like that.  This is not to say that Ryan is wrong; just that it’s a strange argument, the more you think about it.

Update:  Ryan Avent has a new post clarifying his argument.

Game theory isn’t my forte, so let’s talk about the supply-side, where things are a bit easier to pin down.  In my view the fiscal cliff would slightly reduce aggregate supply.  It might also reduce AD, but I think the Fed would mostly offset that effect.  But aggregate supply is a different story.  Even though the reduction in AS is likely to be small, under inflation targeting it would lead the Fed to reduce AD as well.  So I think growth would slow modestly if there is a fiscal cliff.  Say 1% to 2% RGDP growth in 2013, instead of 2% to 3% with no fiscal cliff.  Inflation would be roughly 2% either way.  That’s just a guess on my part, but then who’s got a model that’s included all the game theory I’ve been discussing?  Have any of our elite macroeconomists figured out how to model the monetary/fiscal interaction?   .    .   .  Bueller?

PS.  Some might argue that the British case undercuts my argument.  But they have a less robust supply-side than the US, with inflation running consistently above target, even in the recession.  It seems unlikely that the US could have both a demand-side recession and inflation running persistently above 2%.  Note that I said “demand side recession,” I’m not disputing that a big oil shock could do the trick.

PPS.  In a previous post I tried to cause trouble between Krugman and Yglesias.  In a new post Matt gracefully avoids being snared in my trap:

When I wrote about this previously, I think I was too clever by half and just acted as if the Fed would in fact offset this all. Very possibly they won’t.

My point is that if they don’t offset it, they’ve failed to do their jobs.

Even though he’s more pro-fiscal stimulus than I am, I love the way Ygleisas writes about this problem.  So many people make excuses for the Fed (on both the left and the right.)  They say it’s not easy for them to do their jobs.  There is public criticism.  True, but then again it’s not really all that hard, when you consider other jobs like fighting in Afghanistan.  I expect our monetary policymakers to step up to the plate and do something dramatic for the millions of unemployed.  Deep down in their guts they know we need more demand.  We should insist on nothing less than the best from them.

PPPS.  During football games when the other team has the ball 4th and 1 on our 40, I’ve always been quietly pleased when the other coach sent in the punter.  This is odd, as the opposing coach should make a decision that makes me upset.  Later I learned from the football equivalent of Bill James that most coaches blow this call, and you actually should go for it.  (Or they used to blow it, perhaps it’s changing now.)  I think the same is true of Bernanke.  I’m pretty sure that over the past three years he’s quietly rooted for the NGDP numbers to come in above the Fed’s forecast.  And that’s just not right.

HT:  Bruce Bartlett

But there’s a conflict here.  The same US policies that boosted the housing industry, also tended to enlarge our current account deficit—hurting manufacturers.  So which is it?  Does the US government want a big CA deficit, or not?  My theory is that this question doesn’t have an answer, because governments don’t have brains.  They don’t have preferences or opinions.  They are stupid.  Yes, there is someone nominally in charge, but does anyone think Bush or Obama keeps track of all these indirect effects?  Just thinking about it makes one realize the preposterous nature of many “special interest” explanations for policy failure.

Some commenters tell me that it’s obvious why the BOJ has a tight money policy.  It pushes nominal interest rates to zero, which keeps borrowers like the Japanese government afloat.  Others tell me that it’s obvious that the Japanese policy of deflation favors the lenders, the old people who have saved a lot.  So which is it?  And why aren’t we talking about real interest rates?

Some people tell me that the Fed policy of 2009-10 had the effect of steepening the yield curve, allowing the banks to make money by borrowing short and lending long.  Others tell me that Operation Twist, which flattened the yield curve, tends to boost the value of T-securities held by banks.  Some people tell me that the Fed’s tight money policy is all a plot to help the “rentiers” who live by clipping coupons.   But when the government does QE I’m told that it’s a right-wing plot to help fat cats by boosting the price of securities.

All this seems silly to me.  It’s not a zero-sum game, as rich people hold both stocks and bonds.  I’m almost certain that the Fed’s (post-2008) tight money policy has hurt low income people, middle income people, and rich people.  It’s hurt wealthy people who hold of stocks, and it’s reduced the real interest rate on T-securities.  It’s forcing states to reduce benefits to public employees, and it’s depressing the value of 401k retirement accounts for people like me.  It’s hurt the job prospects of many low-skilled workers.  It’s depressed the value of people’s homes, and their businesses.  It’s depressed the stock prices of the big banks.

Given that academic economists clearly don’t have a clue as to what went wrong, why is it such a stretch that government policymakers might be similarly confused.  Are they really that much smarter than academic economists?

Also note that these nefarious special interest groups only seem to come out of the woodwork when rates hit the zero bound.  Thus they didn’t take control of Australian monetary policy in 2008.  And I’d add that monetary policy didn’t seem to change when Obama took office, so these mysterious special interest groups presumably control both our political parties.

Or maybe it’s all just a terrible mistake.

The whole thing is here. In my view, monetary policy in Europe, or in the U.S. for that matter, would increase the effectiveness of spending cuts and structural reforms (kind of like the water you drink to help the medicine go down). There may even be a good case that it would be useful independently of other reforms. But it is mistake to oversell it and it certainly won’t achieve our long term goals without serious reductions is government spending.

I completely agree.  NGDP targeting won’t even come close to addressing all the structural problems that hold Europe back.  BTW, lower spending is desirable, but the Nordic countries show that neoliberal reforms are even more important.

2.  Jon Hilsenrath of the WSJ discussed how the current recession discredited two views of inflation:

After the financial crisis erupted in 2008, two narratives about inflation dominated economic airwaves and financial-market worry lists.

One was that consumer prices would tumble in a replay of Depression-era deflation because the recession was so deep and unemployment so high. The other was that inflation would soar because the Federal Reserve responded so aggressively to the crisis by pumping trillions of dollars into the financial system.

It turns out that both sets of predictions were wrong.

Those are roughly the views of old-style Keynesianism and old-style monetarism.  He concludes as follows:

Minutes of the last two Fed meetings show Fed staff have been revising up their inflation forecasts because slack hasn’t been as great as they thought.

So inflation since mid-2008 has been the lowest since the mid-1950s, and the Fed staff was expecting even lower?  I.e. they set their policy levers in a position expected to produce even lower inflation than we’ve had, which ipso facto means lower NGDP growth (since monetary policy affects inflation from the demand-side.)

3.  A few weeks back James Hamilton replied to my criticism.  I agree with much of what he has to say, but would quibble slightly with one comment:

I suggested that the current policy, which I read as not allowing inflation to fall below 2%, works well for both objectives.

It seems to me that policy is closer to a ceiling of 2% inflation, even if you assume the Fed puts zero weight on jobs.  Inflation has averaged well under 2% since mid-2008, and at the most recent Fed meeting they declined to offer any additional stimulus, despite a forecast that inflation would average below 2% over the next few years.  That’s too tight even if they had a single mandate to control inflation, as the ultra-conservatives in Congress have proposed.

4.  Paul Krugman did a recent piece where he argued that the PIIGS need deep currency depreciation.  I think he’s right, but differ slightly in my reasoning.  One of Krugman’s arguments is:

Second, Munchau’s argument that Germany was badly overvalued in 1999. But it had a roughly balanced current account; I think it’s hard to make the case that it was a really big overvaluation.

I’m kind of shocked by this.  Krugman is a first rate international economist; he knows that the correct exchange rate is not the one that balances the current account.  Japan’s currency has been overvalued for 20 years, and yet they’ve run consistent CA surpluses.  Some might argue that the standard model doesn’t apply in liquidity traps.  I don’t agree, but the liquidity trap model has no applicability to Germany circa 1999.  The CA surplus reflects relative saving and investment propensities.  You decide whether a currency is under or overvalued by looking at whether aggregate demand is at an appropriate level.

5.  On a lighter note, here’s Krugman again, in a post entitled “None So Blind“:

Eddie Lazear has an op-ed in the WSJ on the fiscal cliff that, among other things, pooh-poohs any concerns that sudden cuts in spending might hurt the economy. He weasels a bit, but basically conveys the impression that there’s no evidence for Keynesian effects.

What this signifies to me is the politicization and corruption overtaking the economics profession. I’ll give Eddie the benefit of the doubt; he is probably just going by what his friends say.

And here’s Matt Yglesias:

Conventional wisdom in DC is that not only would the full expiration of the Bush tax cuts make people grumpy as they find themselves needing to pay more taxes, it would also provide the macroeconomy a job-killing dose of fiscal drag. The chart above from Goldman Sachs illustrates the idea clearly.

I don’t buy it.

The problem is that this chart ignores what I think we’re now going to call the Sumner Critique.

I hope Krugman also gives Matt the benefit of the doubt . . .

HT:  Tyler Cowen, dwb.

Over the past three years I’ve responded to numerous comments from people in either the post-Keynesian/MMT tradition or the Austrian tradition.  Many commenters seem self-taught—which is fine with me as I’m also mostly self-taught.  Many have gained insights from major interwar economists (especially Keynes, von Mises and Hayek.)  That’s also fine, as I’ve learned a lot from interwar economists like Fisher, Hawtrey, Cassel, Einzig, and Warren.

But there’s one problem with relying on interwar analysis—it’s very much a product of its time.  Prior to WWII, pure fiat money regimes were treated as pathological cases, associated with hyperinflation.  Most currencies were either fixed to gold, or expected to be fixed in the near future.  Studies have shown that the expected rate of inflation is roughly zero under a commodity money exchange, which is just another way of saying the expected change in the relative price of gold was roughly zero.  This had many important consequences for monetary policy:

1.  There was almost no Fisher effect in interest rates.  This meant that changes in nominal interest rates were probably a better indicator of the stance of monetary policy than today.  (Although still far from ideal.)

2.   Liquidity traps were more likely for two reasons; expected inflation was quite low, and the monetary authority could not credibly commit to a higher inflation target.  That made fiscal stimulus relatively attractive.

3.  The Phillips curve was more stable.

4.  The nominal/real distinction was less important.  The concept of the super-neutrality of money was not well understood.

One of my favorite Milton Friedman sayings was something to the effect that “In the past 200 years macroeconomics has merely gone one derivative beyond Hume.”

When I object to comments by MMTers or Austrians, it’s most often based on the issues listed above.  They seem a prisoner of the interwar period, failing to see how everything changes with a pure fiat money regime.

For instance, both types of commenters put too much weight in interest rates as an indicator of easy or tight money.  In the case of MMTers, there seems an inability to imagine “expansionary monetary policy” as being something like a shift from 10% trend inflation to 20% trend inflation, engineered via faster trend growth in the base.  You certainly won’t find anything like that in Keynes, as far as I know he never once discussed the idea of using central bank policy to permanently  raise the trend rate of inflation.  Of course if this were to occur, you’d get higher interest rates.  MMTers seem to assume the easy money would drive rates to zero, at which point the extra money would be hoarded.

MMTers also seem to make no distinction between real and nominal changes in bank balance sheets.  Consider a monetary policy that has no impact on real bank assets or liabilities. If it created higher inflation, then nominal deposits, nominal loans, and nominal reserves would all rise proportionately.  In that scenario it makes no sense to talk about loans causing deposits or deposits causing loans.  In real terms nothing has caused anything.  Thus the sort of considerations you’d use for analyzing a real change in the banking system is completely different from the sort of analysis you’d apply to a purely nominal change in the banking system.  Microeconomic factors determine the real size of the system (in the long run), whereas monetary policy explains any additional long run nominal changes.

The Austrians often complain that my 5% NGDP target proposal would lead to an unsustainable boom, and then a bust.  Let me be very clear that during the interwar period this criticism would be exactly correct.  A 5% NGDP growth track would have been completely unsustainable, and would have ended in tragedy. But that has no relevance for today, as money is approximately super-neutral in the long run.  You can do 5% NGDP growth from now until the end of time without any unsustainable imbalances developing.  (I don’t think the actual growth track of the 1920s, which was considerably slower, was unsustainable, but reasonable people can disagree on that point.)

Update:  The preceding paragraph assumed a commodity-backed currency, which limits long-term NGDP growth to about 3%/year.

In defense of interwar Austrianism, there was some merit in worrying more about booms than slumps.  After all, the natural rate hypothesis says that you can stabilize the growth track of RGDP by either cutting off the peaks or filling in the valleys—it shouldn’t matter.  But the tools available to policymakers were not symmetrical.  It was easier to restrain a boom via tight money, than to pump up a weak economy through easy money.   That’s because there’s a zero lower bound on gold reserves, but no upper bound.  It’s an asymmetry familiar to students of fixed exchange rate regimes.

But that asymmetry no longer exists in the modern world.  Indeed under a pure fiat regime an Australian NGDP trend growth rate (7%) might be best, as you’d never have to worry about hitting the zero lower bound.  So when Austrian commenters worry that 5% NGDP growth might be unsustainable, they are worried about a constraint that disappeared many decades ago.

I strongly recommend that both MMTers and Austrians take a look at Milton Friedman’s work on money super-neutrality, which is where I first learned the basics of monetary theory.  (Sorry, I don’t recall which articles.)

PS. I think both schools of thought have gained a bit of traction in recent years for roughly the same reason—the current 2% inflation target is a little bit like a gold standard.  So you get some stylized facts that seem to fit each model.  But never lose sight of the fact that central banks can change that target—and when that happens everything changes.

PPS.  I regard New Keynesian economics as the philosophy Keynes would have endorsed once he learned about the super-neutrality of money.

Here’s what I do strongly believe:

1.  If the modest spending increases that have been touted over the past few years were enacted they would have been unlikely to have had much effect, as long as the Fed was targeting inflation at 2% or slightly below.

2.  The Fed could offset even a big fiscal shock, such as taxaggeddon—which is the expiration of a host of previous tax cuts, due to occur in January 2013.

3.  The Fed should offset a big fiscal shock like taxaggeddon.

4.  Most importantly, the economics profession needs to change the way it talks about the role of monetary policy.  No more soft bigotry of low expectations.  We should insist that Fed try to produce an appropriate level of AD.  We should talk as if the fiscal multiplier is zero.  And I’d even go farther than I’ve gone in the past.  If we are so far down in a liquidity trap that there is any question as to whether monetary policy could offset needed fiscal retrenchment, then ipso facto money is already far too tight.

Let me be more specific.  Bernanke has recently argued that current monetary policy is appropriate, and that no further stimulus is needed.  But he’s also argued that the Fed wouldn’t be able to offset taxaggeddon.  Those two answers are simply not acceptable.  It’s the Fed’s job to steer the nominal economy. Period, end of story.  If they feel that they may not be able to do so because of near zero rates, then they need either a different policy instrument, or a higher inflation target.

I believe the economics profession has been far too kind to the world’s major central banks.  Most economists (not all) think the world has an AD problem.  And most economists are not demanding the Fed do more.  That’s what I’m trying to change.

Matt Yglesias did a recent post that made some similar points.  Interestingly, I think we ended up in the same place coming from different directions.  Although I believe the fiscal multiplier is normally zero, I also understand that my hypothesis is “just a theory.”  Commenters like Andy Harless have pointed out that the multiplier might be slightly positive if the Fed is more reluctant to do unconventional stimulus than if all they have to do is cut the fed funds target.  It seems to me that this argument is more likely to apply to very large fiscal shocks, as compared to smaller changes.  So I’m a tiny bit worried about taxaggeddon despite my zero multiplier argument.  And I’m also a small government guy, who’d prefer spending cuts to tax increases.  But even with my theoretical doubts, and my small government bias, I was so outraged by the soft bigotry of low expectations that I did a scathing post a few days back, arguing that it was absurd for Bernanke to claim the Fed couldn’t offset the demand-side effects of tax increases.

Yglesias is more comfortable with bigger government.  But on the other hand he also tends to favor fiscal stimulus.  So he probably feels an ambivalence to tax increases for very different reasons.  He thinks we need fiscal stimulus, but also knows that in the long run Obama’s social spending agenda will require more revenues, and it would be nice if the Fed could provide enough stimulus so that Obama could begin moving in that direction in his second term.

But despite these differences, what strikes me about the Yglesias post is that Matt and I seem to share the same outrage about how little we expect from our central banks.  I suppose it’s dangerous to do mind reading, so read it for yourself and see what you think:

Conventional wisdom in DC is that not only would the full expiration of the Bush tax cuts make people grumpy as they find themselves needing to pay more taxes, it would also provide the macroeconomy a job-killing dose of fiscal drag. .  .  .  I don’t buy it.

The problem is that this chart ignores what I think we’re now going to call the Sumner Critique. In other words, it assumes that the Federal Reserve is somehow going to fail to react to any of this. You can probably construct a scenario in which the Fed is indeed caught unawares, or is paralyzed by conflicting signals, or is confused by errors in the data, or any number of other things. But Ben Bernanke knows all about the scheduled expiration of these tax cuts.  .  .  . Maybe he and his colleagues won’t do anything to offset this drag on demand, but if they don’t as best I can tell that’s on them. This is the very essence of a predictable demand shock, and the policymakers ultimately responsible for stabilizing demand are the ones who work at the Fed.

If I was a progressive I think I’d feel exactly the way he does.  Whether you are on the left or right, it’s very aggravating to see our monetary policy producing massive dead-weight losses, and also pushing fiscal policy away from what it does best.

PS.  Business reporters could learn from sports reporters.  The press tends to mock Lebron James (perhaps unfairly), for failing to take the big shots.  Why don’t reporters do the same with Bernanke?  He’s got a long track record as an academic making fun of the argument that central banks can run out of ammo.  Ask him “Why are you so afraid of taxaggeddon?  Don’t think the big bad Fed has what it takes to get NGDP up to appropriate levels?  You guys have your own printing press, for God’s sake!”

Of course I’m being silly.  But you have to wonder about a press corps that asks tougher questions of 26 year old basketball players, then of the men and women who are most responsible for the health of the global economy.  Maybe it’s the reporters who are afraid to ask the big questions.

I’ve already discussed:

1.  The LBJ argument.  He was much more a big government guy than Obama, and the economy boomed for the 5 1/2 years he ruled.  There were problems later, but that’s exactly my point.  Supply-side problems look very different from sudden recessions.

2.  The timing problem.  The big drop in housing construction occurred between January 2006 and April 2008, and yet unemployment was almost unchanged, as the laid off construction workers found jobs in other growing sectors.

3.  The no mini-recession argument.  If recessions were caused by real shocks, then mini-recessions should be much more common than actual recessions.  But we’ve had virtually none–unless you count the 1959 steel strike.  And that ended almost immediately.

4.  The David Glasner argument.  The stock market hated inflation in the 1970s.  Since 2008 stocks have been strongly correlated with TIPS spreads.  In other words the stock market started rooting for more AD about when market monetarists started arguing we needed more AD.

5.  And now we have Greece.  This tiny country is 2% of the EU.  If (God forbid) it was destroyed by an asteroid tomorrow, stock markets would soar upward all over the world.  The Greek crisis would be over.  Yes, banks would hold some worthless Greek debt; but with no further moral hazard concerns, the rest of the eurozone would gladly bail out their banks, and add that Greek debt to their own public debts.  Remember, Greece is 2% of the EU.

Why would stocks soar on the destruction of Greece?  Because it would end the uncertainty, the fear that a Greek departure from the euro would have a contagion effect.  People who talk about structural problems talk about things like malinvestment in too many houses or BestBuy stores, or Obama’s big government policies, etc.  But the markets don’t care very much about those things; they care about things like Greece.  And not because Greece is big enough to have a real effect on the global economy, obviously it isn’t.  Rather Greece matters because it could trigger a financial panic that would reduce AD all over the world.  That’s why global equity markets lose TRILLIONS of dollars when the Greek crisis intensifies.  The real problem is nominal.

Everywhere I look I see more and more evidence that the developed world has a massive AD problem.  Yes, individual countries (southern Europe, to a lesser extent the UK, and to a still lesser extent the US) also have some structural problems.  But the NGDP problem is both easy to fix and a big part of what’s hurting the world economy.  It’s frustrating to see us ignoring it.

It’s now far too big a problem to be addressed by any token fiscal stimulus that could come out of this recent Camp David push for “growth.”  Monetary policy is our only hope.