More on macroeconomic policy arguments during the Great Recession

The Great Recession has become a fertile ground for considerable analysis of the prevailing conventional wisdom macroeconomic policies. The relative merits of contractionary and expansionary monetary and fiscal policies are at the heart of all ideological battles.

Conservatives fret at the inflationary effects of expansionary conventional (zero-bound interest rates) and unconventional (quantitative easing) monetary policies and call for tightening monetary policy or atleast oppose any further monetary expansion. They also point to the unsustainable public debt and fiscal deficit and argue any fiscal expansion. Some even argue that all this is crowding out private spending, despite the overwhelming evidence of massive idling resources and capacity in the US economy. Their general belief is that hard money and sound government finances are necessary for a robust recovery to take hold.

Paul Krugman has been the strongest proponent of the view that when faced with a liquidity trap, increases in the monetary base (which includes bank reserves as well as currency) doesn’t cause inflation, or even a rise in broader definitions of the money supply. Faced with a recession and the zero-bound, businesses postpone investments and consumers their spending, thereby forcing banks to hold on to their reserves. This propensity to hold on to reserves is amplified by the fact that under such conditions, cash and T-Bills become near perfect substitutes, and the Fed cannot therefore expand M2.

Krugman points to the evidence from old and recent history to highlight this. At the onset of the Great Depression, though the Fed expanded the monetary base considerably (admittedly this may have been smaller than was required), it did not result in the expected increase in money supply and inflation remained muted.



Much the same happened in Japan. Despite a dramatic expansion in the monetary base by the Bank of Japan, prices kept falling.



Since the beginning of the Great Recession, the US Federal Reserve has been quick in dramatically expanding its balance sheet and increasing the monetary base. The result - M2 money supply and consumer prices have hardly budged.



However, even among those who favor monetary expansion, there is one group who argue that the Federal Reserve could have done more to avert a deep recession in 2008 and 2009 if it had indulged in much more aggressive monetary expansion. Scott Sumner, David Beckworth and others argue that the central bank using monetary policy tools can do more, even when faced with a zero-bound in interest rates, to stimulate aggregate demand and expand the economy.

They advocate setting an explicit nominal GDP target (or nominal GDP growth path) to shape future market expectations about current and future nominal spending and thereby boost economic growth or prevent aggregate demand crashes. This, they argue, can be done by purchasing assets other than Treasury Bills, like longer-term securities, to lower long-term rates and thereby incentivize investment and consumption spending so as to reach the nominal GDP target. David Beckworth writes,

"Set an explicit nominal GDP level target so that expectations are appropriately shaped. If such a rule were adopted expectations of current and future nominal spending would be anchored around the level target... Even if a spending crash did occur the catch-up growth needed to return nominal spending to its level target would most likely imply an expected path of short-term real interest rates consistent with restoring full employment...

if the monetary base and t-bills became perfect substitutes because the 0% bound is reached the Fed should buy longer-term treasuries or foreign exchange... The 0% bond for us really is not a big deal, but simply an artifact of monetary policy using a short-term interest rate as the targeted instrument."

As David Beckworth acknowledges, this understanding is not that different operationally than a New Keynesian invoking a higher inflation target to lower the expected path of real interest rates or the portfolio channel to drive down the term premium on long-term bonds.

Paul Krugman points to evidence from Japan to question the quasi monetarist position on the utility of monetary policy during such liquidity trap crises. In this context, he also draws attention to the views of the late Milton Friedman who had advocated that the central banks push more reserves into the banking system through monetary expansion. In fact, Friedman had famously blamed the Fed's unwillingness to indulge in sufficient monetary expansion as the major contributor towards the Great Depression.

However, unlike the Fed in the 1930s, the Bank of Japan indluged in massive monetary expansion. However, this did not result in the expected rapid growth in the money supply or monetary base.



Paul Krugman concludes that "in the face of a really big shock, which pushes the economy into a liquidity trap, the central bank can’t prevent a depression". In the circumstances, the only option left is fiscal policy. Here Krugman points to the critical role that the government borrowing and spending played in making up for the steep decline in private consumption.



Update 1 (28/10/2011)

FT Aplhaville points to a Goldman report which advocates nominal GDP targeting for the US.

"For the US, we advocated a shift to nominal GDP targeting, backed up with asset purchases, as the best of these options if further easing is needed. We think nominal GDP targeting probably provides the best way of communicating a credible intention to deliver a more aggressive easing without taking risks on long-term inflation. First, the framework is simple and transparent and avoids the complications of choosing a particular price index. Second, it deals directly with the problem of large excess capacity in the economy and focuses on a variable that is more directly linked to the ability to cope with debt contracts that were mostly made on the assumption that nominal income would be much higher than it currently is. Extending the price level trend for the US or UK would not deliver as strong a case for easing (and in the UK may argue for tighter policy). Third, it does not focus directly on generating inflation, which may make it more palatable to the public, or on the exchange rate, which could raise international tension. Fourth, it defines a clear exit strategy for policy and so minimises the risk of runaway inflation. Other policy options meet some of these criteria, but we think overall score less well."

Why Keynesian models score over classical ones in explaining the Great Recession?

Paul Krugman has a nice summary of why he thinks Keynesian economics triumphs over classical economics in explaining the current macroeconomic environment in developed economies like the US.

First, he argues that unlike the classical paradigm which sees employment and output as determined by the supply-side (and thereby the current unemployment rates are due to structural issues or workers preferring not to work for various reasons), Keynesian models give importance to the demand-side deficiencies. Simple supply-side models cannot explain either the current high rates of interest nor their persistence for this long period. If we taken into account the demand-side, there is an urgent need to boost aggregate demand with expansionary policies that both utilizes idle workers and leaves people with more money to spend.

Second, the classical theory of interest rates claims that increases in the monetary base, due to higher fiscal deficits and fiscal expansion, leads to spikes in interest rates and inflation, apart from crowding out private spending. However, this line of reasoning has not been able to explain the extended period of disinflation and declining interest rates and bond yields despite the increasing deficits and expanding monetary base.

In simple terms, they come up short when faced with the zero-bound in nominal interest rates and the resultant liquidity trap. Keynesian models would indicate that in such conditions, where banks were flush with funds and were without takers from the private sector (or desired savings exceeded desired investment), government borrowings would not cause interest rates to rise or crowd-out private spending. Further, in such liquidity traps, deflation and not inflation was the greater risk.

Update 1`(5/10/2010)

Nancy Folbre has this nice summary of the Keynesian stimulus debate. See these critiques of the structural employment debate here and here. Robert Barro's argument against fiscal spending is made out here.

Professor Bernanke Vs Chairman Bernanke

Facing its lost decade in the nineties, Princeton professor Ben Bernanke advocated that the Bank of Japan Governor Masaru Hayami indulge in aggressive monetary loosening, including signaling a higher inflation target. He even went on to describe the Japanese monetary policy timidity as a "Case of Self-Induced Paralysis".

"Krugman and others have suggested that the BOJ quantify its objectives by announcing an inflation target, and further that it be a fairly high target. I agree that this approach would be helpful, in that it would give private decision-makers more information about the objectives of monetary policy. In particular, a target in the 3-4% range for inflation, to be maintained for a number of years, would confirm not only that the BOJ is intent on moving safely away from a deflationary regime, but also that it intends to make up some of the 'price-level gap' created by eight years of zero or negative inflation...

BOJ officials have strongly resisted the suggestion of installing an explicit inflation target. Their often-stated concern is that announcing a target that they are not sure they know how to achieve will endanger the Bank’s credibility; and they have expressed skepticism that simple announcements can have any effects on expectations.

With respect to the issue of inflation targets and BOJ credibility, I do not see how credibility can be harmed by straightforward and honest dialogue of policymakers with the public. In stating an inflation target of, say, 3-4%, the BOJ would be giving the public information about its objectives, and hence the direction in which it will attempt to move the economy. But if BOJ officials feel that, for technical reasons, when and whether they will attain the announced target is uncertain, they could explain those points to the public as well. Better that the public knows that the BOJ is doing all it can to reflate the economy, and that it understands why the Bank is taking the actions it does."

Now, faced with similar macroeconomic environment and prospects of a similar deflation-induced lost-decade in the post-Great Recession US, the Federal Reserve opposition to higher inflation target mirrors the policy "paralysis" that Prof Bernanke accused the BoJ of. Ironically, the same Ben Bernanke, currently Chairman of the Federal Reserve differs with Professor Bernanke, and lays out much the same reasons for opposing a higher inflation target.

"Such a strategy is inappropriate for the United States in current circumstances. Inflation expectations appear reasonably well-anchored, and both inflation expectations and actual inflation remain within a range consistent with price stability. In this context, raising the inflation objective would likely entail much greater costs than benefits. Inflation would be higher and probably more volatile under such a policy, undermining confidence and the ability of firms and households to make longer-term plans, while squandering the Fed's hard-won inflation credibility. Inflation expectations would also likely become significantly less stable, and risk premiums in asset markets--including inflation risk premiums--would rise. The combination of increased uncertainty for households and businesses, higher risk premiums in financial markets, and the potential for destabilizing movements in commodity and currency markets would likely overwhelm any benefits arising from this strategy."

Monetary policy options at zero-bound

The simplest intuitive case for the superiority of fiscal policy over monetary policy in retrieving a recession-hit economy, especially in the major economies, comes from the fundamental reality that the economy is ravaged with over-capacity across most sectors and private consumption demand is extremely weak. The only way out of this is to generate enough aggregate demand to first absorb the slack and in the process instill enough confidence among businesses to then invest in expanding capacity.

Monetary policy, through lower long term real interest rates, seeks to incentivize businesses to invest by lowering their cost of capital. But, as discussed above, the challenge is not to expand capacity as to fully utilize the existing capacity. The demand side stimulus by way of lower rates (on say hire purchase schemes for consumer durables etc) is marginal and takes effect with a lag. In contrast, fiscal policy, especially those that puts disposable income in the hands of people who are likely to spend it, has an immediate impact on boosting aggregate demand.

Monetary policy becomes even more ineffectual when the economy is facing the zero-bound interest rate and deflation has taken hold (or even when inflationary expectations are firmly under control). In the circumstances, the deflationary shock will lower short-term inflation expectations and therefore increase the real interest rate. Further, with nominal rates touching zero, the real interest rates cannot be lowered beyond a level and remains higher than desired. Even with massive purchases of long-term securities through quantitative easing, real interest rates on them will remain high.

Though economists like Brad De Long and Paul Krugman have advocated fixing a high enough inflation target to generate inflationary expectations and thereby put upward pressure on real long-term rates, the Fed Chairman Ben Bernanke fears that it could undermine the Central Bank's credibility. But the danger with such conservatism during such times is that the deflation may set in motion a self-fulfilling spiral of entrenching deflation and falling output, like that what gripped Japan in the nineties. It has also been suggested that Central Banks should communicate specific interest rate targets or bands, though its success is a function of their existing credibility. Further, the results of this has been mixed to give any meaningful lessons.

Charles T. Carlstrom and Andrea Pescatori of the Cleveland Fed advocate price-level targeting to demonstrate an unequivocal commitment to preventing deflation, "With a price-level target, the central bank commits to sticking to a given path for the level of prices over some horizon. If prices start rising faster than a pre-specified rate, policymakers must lower inflation in the future to get the price level back to the target. Similarly, if there is a deflationary shock, the central bank must inflate in the future because it has to bring the price level back up".

And about the different between inflation target and price-level target, they write,

"There is an important difference between an inflation target and a price-level target. An inflation target 'lets bygones be bygones', while a price-level target corrects for past misses. If prices fall on a year-over-year basis, a price-level target requires the central bank to reinflate prices until they are back to the target. An inflation target requires only that the rate of inflation be returned to its target rate from the present onward. A price-level target is essentially a promise that a deflationary shock today will increase inflation in the future and thus expected inflation today. This promise of future inflation will lower real interest rates even when short-term nominal rates are zero. Long-term inflation is still pinned down as it is with an inflation target."

Economists like Paul Krugman (and here, here, and here) have argued that at the zero-bound since banks’ cash reserves and short-term securities are perfect substitutes, banks have no incentive to lend the money out, and therefore any quantitative easing that focuses on purchasing short-term securities will fail. They simply substitute the cash they receive from the central bank for the securities they were holding in reserves, and therefore the supply of money in circulation is not affected. In other words, they attach no value whatsoever on any liquidity or safety advantage that might be had from holding assets in the form of cash.

Carlstrom and Pescatori however argue that even purchases of long term securities are not likely to yield the desired results in getting banks to lend money since the banks are more likely to sit on the cash they receive from the sales of those securities than lend them out. Even if there is some immediate impact by way of decrease on long-term interest rates (as evidenced in the yields of those securities), it is not likely to be large enough and lasting as long-term inflation expectations take hold.

Further, even if banks transact with the cash available, they are likely to use it to purchase short-term treasuries, whose relative risk-adjusted returns increase. Expectations on long term rates are also likely to keep banks invested in short-term instruments. The long-term interest rates are eventually determined by market fundamentals, namely long-term inflation expectations in conjunction with expected long-term economic growth, which are non-monetary factors. In any case, given the aforementioned excess capacity problems and weak consumer demand, the demand for borrowings is likely to be subdued.

Update 1
Andy Harless feels that one way to have adequate fire power in central bank arsenal to respond to severe financial crisis induced deep recession is to "target an inflation rate that is high enough to give it a lot of room to respond to a crisis (or an incipient crisis) by cutting interest rates far below the inflation rate". He argues that such an arrpoach ensures long term financial stability and minimizes the damage without relying on authorities to behave better or more presciently than they normally do behave.

Update 2
Mark Thoma points to a working paper by Chris Sims about difficulties of policy at the zero lower bound - the difficulty of credible commitment to higher future inflation that is necessary in most New Keynesian models, the difficulty in achieving fiscal and monetary policy coordination, and the problems that may arise when the central bank takes quasi-fiscal actions

Update 3 (17/3/2010)
Paul Krugman has a nice explanation of liquidity trap. He defines liquidity trap as one where conventional open-market operations — purchases of short-term government debt by the central bank — have lost traction, because short-term rates are close to zero. Apart from the liquidity expansions, Central banks can also purchase longer-term government securities or other assets (so as to bring down long term rates), and they can try to raise their inflation targets in a credible way.

Update 4 (23/3/2010)
More evidence of the claim that central banks can apply further monetary stimulus by lowering long-term borrowing costs even when short-term interest rates are stuck at zero.

A New York Fed assessment of the Fed's purchases of medium and long-term maturity assets since December 2008 by Joseph Gagnon, Matthew Raskin, Julie Remache, and Brian Sack find evidence that it led to economically meaningful and long-lasting reductions in longer-term interest rates on a range of securities, including securities that were not included in the purchase programs. These reductions in interest rates primarily reflect lower risk premiums, including term premiums, rather than (normally expected) lower expectations of future short-term interest rates. It found that the Federal Reserve lowered long-term interest rates about 50 to 60 basis points last year through its purchases of $1.7 trillion of longer-term bonds. Joe Gagnon writes,

"The reduction in long-term interest rates applies not only to Treasury securities, but also to mortgages and corporate bonds. Households buying and refinancing their homes took out mortgages worth over $2 trillion in 2009 and they will save about $11 billion in interest payments each year because of the lower interest rates. With interest rates remaining low for new borrowers in 2010, these benefits will continue to grow and will help to support consumer spending and economic recovery. Thanks to the low interest rate environment, corporate bond issuance (net of redemptions) reached a record $381 billion in 2009, helping to finance a turnaround in capital spending late last year that exceeded most private forecasts."

Gagnon had earlier advocated (see also this and this) that the "Fed could push down long-term yields another 75 basis points by buying a further $2 trillion of long-term bonds. Current yields on 10-year Treasury notes, at 3.7 percent, are far above the zero rates on short-term Treasury bills. The benefits to the economy would be rapid and similar to those already observed from the first round of Fed purchases. Moreover, lower long-term interest rates and a faster recovery would also reduce our national debt."

See also this post by Mark Thoma.

Update 5 (13/7/2010)
Paul Krugman advocates buying longer-term government debt and private sector debts, moving expectations by announcing intent to keep interest rates low for a long time, raising long-term inflation target. All this would "convince the private sector that borrowing is a good idea and hoarding cash a mistake".

Scott Sumner too feels that central banks have insufficiently boosted expectations for businesses to have enough confidence to start making investments.

Update 6 (22/7/2010)
Ben Bernanke discusses four options to increase monetary accommodation when faced with the zero-bound

1. The Fed could signal to the markets that it intended to keep its benchmark federal funds rate at zero to 0.25% for even longer than the "extended period" the Fed has been projecting.

2. The Fed could lower the interest rate it pays on excess reserves, the deposits that banks keep at the Fed in excess of what they are required to keep, from its current level of 0.25%.

3. The Fed could again expand the size of its balance sheet, which stands at about $2.3 trillion, by buying additional Treasury debts or mortgage-backed securities, or even other classes of assets, like municipal bonds.

4. On a smaller scale, the Fed could also reinvest the cash it received when the underlying principal on mortgage bonds on its books was repaid, a step that would also keep the Fed’s balance sheet from shrinking.

See also Joseph Gagnon's suggestions on the same issue.

Update 7 (28/8/2010)

Bernanke has this speech outlining his monetary policy options if further accommodation is called for - conducting additional purchases of longer-term securities, modifying the Committee’s communication, and reducing the interest paid on excess reserves.

"Paradox of toil"

One of the most interesting policy debates during the current recession has been over the most effective fiscal policy options to combat the situation. Broadly, the divide has been over which of the two types of policy alternatives - tax cuts and direct spending measures - is superior.

Supporters of tax cuts claim that tax cuts increases the disposable incomes in the hands of individuals and firms and thereby incentivizes them to consume and invest, and is therefore the least distortionary of options. They also point to the relative ease of implementing tax cuts against the well knwn lags in direct spending measures.

However, the supporters of tax cuts may have overlooked the fact that while tax cuts may be an effective (even the better) policy during a normal recession, it may not be an appropriate remedy for the present times. The current recession is exacerbated by the zero-bound induced liquidity trap, which sets in motion a set of rational expectations that are likely to end up perversely affecting indirect measures like tax cuts. In view of the fact that recessions which come along with a zero-bound in interest rates are very rare (the only major such recession being the one faced by Japan at the turn of the century), all available literature examine only the regular economic contractions.

Paul Krugman points attention to a paper by Gauti Eggertsson that examines the types of fiscal policies that are effective at zero interest rates and finds that direct spending policies score over tax cuts. Eggertsson's model finds that when the economy is facing the zero-bound (liquidity trap), tax cuts, on both capital and labor incomes, are contractionary and deflationary spiral takes hold.

Standard New Keynesian models have long argued that when an economy is faced with liquidity trap, tax cuts on capital income unleashes rational expectations that encourages people to save the additional income instead of investing it - paradox of thrift. In Eggertsson's model, cutting taxes on labor income expands labor supply, and puts downward pressure on wages. The resultant deflationary expectations increases the real interest rates and lowers both output and employment. A "paradox of toil" is the result!

Fundamentally, at zero-bound, the economy faces insufficient demand and therefore only fiscal policies that directly stimulate aggregate demand can succeed. Such policies include a temporary increase in government spending and tax cuts aimed directly at stimulating aggregate demand rather than aggregate supply (such as an investment tax credit or a cut in sales taxes). Greg Mankiw recently advocated investment tax credits to incetivize businesses to invest.

The contractionary effect of tax cuts is understandable given the fact that they have no direct effect on consumption spending and investment. The labor and capital income tax cuts increases the supply of disposable incomes in the hands of individuals and businesses respectively, incomes which they can either save, use to pay off debts, or spend/invest. In the prevailing conditions - deflationary and recessionary - both consumers and businesses are more likely to either save or pay off debts, than spend or invest.

Eggertsson's verdict on the debate is fairly conclusive,

"Policy makers today should view with some skepticism empirical evidence on the effect of tax cuts or government spending based on post-WWII US data. The number of these studies is high, and they are frequently cited in the current debate. The model presented here, which has by now become a workhorse model in macroeconomics, predicts that the effect of tax cuts and government spending is fundamentally different at zero nominal interest rates than under normal circumstances."

See also Casey Mulligan's take on the "paradox of toil", one that again ignores the specific circumstances.