Archive for November, 2011



Understanding the Balanced-Budget Multiplier Theorem

Scott Sumner recently linked to David Henderson who cited the following comment by Professor T. Norman Van Cott of Ball State University to an op-ed by Alan Meltzer trashing Keynesian economics.

Particularly egregious is something labeled “the balanced budget multiplier.” To wit, an equal increase in government expenditures and taxes leads to an increase in national output equal to the additional government expenditures and taxes. Mr. Samuelson, et al., gives the notion a scientific aura by packaging it in equations and graphs.
Economic surrealism? You bet. Note that national output and taxes rising by the same amount means producers’ after-tax incomes are unchanged. How or why would producers produce more for no increase in after-tax income? Hint: They won’t. Never mind the smoke screen of graphs and equations.

I posted the following comment on Henderson’s blog, but my comment came three days after the previous comment so no one seemed to notice.  So I thought I would post it here to see what people think.

David, Just saw a link to your question on Scott Sumner’s blog. I think that the simple answer is that the balanced-budget multiplier presumes that there is involuntary unemployment. The additional output is produced by the employment of those previously unemployed; those previously employed experience a reduction in their real wage. I am not necessarily endorsing the analysis, but I think that is logic behind it.

A further elaboration is that under Keynes’s definition of involuntary unemployment, the way in which you re-employ the involuntarily unemployed is by raising the price of output while holding the wage constant.  So, under Keynes’s (economic) logic you need inflation to get the involuntarily unemployed reemployed.  That logic somehow gets lost in “the smoke screen of graphs and equations.”

Scott Sumner Bans Inflation

Scott Sumner, the world’s greatest economics blogger, has had it with inflation. He hates inflation so much he wants to stop people from even talking about it or even mentioning it. He has banned use of the i-word on his blog, and if Scott has his way, the i-word will be banned from polite discourse from here to eternity.

Why is Scott so upset about inflation? It has nothing to do with the economic effects of inflation. It is all about people’s inability to think clearly about it.

Some days I want to just shoot myself, like when I read the one millionth comment that easy money will hurt consumers by raising prices.  Yes, there are some types of inflation that hurt consumers.  And yes, there are some types of inflation created by Fed policy.  But in a Venn diagram those two types of inflation have no overlap.

So Scott thinks that if only we could get people to stop talking about inflation, they would start thinking more clearly. Well, maybe yes, maybe no.

At any rate, if we are no longer allowed to speak about inflation, that is going to make my life a lot more complicated, because I have been trying to explain to people almost since I started this blog started four months ago why the stock market loves inflation and have repeated myself again and again and again and again. In a comment on my last iteration of that refrain, Marcus Nunes anticipated Scott with this comment.

That´s why I think mentioning the I word is bad. Even among “like thinkers” it gives many the “goosebumps”. What the stock market loves is to envision (even if temporarily) the possibility that NGDP will climb towards trend.

And when Scott announced the ban on the i-word on his blog, Marcus posted this comment on Scott’s blog:

Scott: David Glasner won´t be allowed to place comments here. Early this month I did a post on the I word.
http://thefaintofheart.wordpress.com/2011/10/07/two-words-you-should-never-use-inflation-stimulus/

In DG´s latest post Yes, Virginia, the stock market loves inflation I commented:

That´s why I think mentioning the I word is bad. Even among “like thinkers” it gives many the “goosebumps”. What the stock market loves is to envision (even if temporarily) the possibility that NGDP will climb towards trend.

He answered:

Marcus, I think inflation is important because it focuses on the choice between holding assets and holding money.!

Scott replied

We’ll see how David reacts to this post.

Well after that invitation, of course I had to respond. And I did as follows:

Scott, Even before I started blogging, I couldn’t keep up with you and now that I am blogging I have been falling farther and farther behind. So I just saw your kind invitation to weigh in on your “modest proposal.” I actually am not opposed to your proposal, and I greatly sympathize with and share your frustration with the confusion that attributes a fall in real income to an increase in prices as if it were the increase in prices that caused the fall in income rather than the other way around. On the other hand, on my blog I will continue to talk about inflation and every so often, despite annoying you and Marcus, I will continue to point out that since 2008 the stock market has been in love with inflation, even though it normally is indifferent or hostile to inflation.

I also don’t think that you have properly characterized the Fisher equation in terms of the real interest rate and expected NGDP growth. As a rough approximation the real interest rate (r) equals the rate of growth in real GDP; and the nominal interest rate (i) equals the rate of growth in nominal GDP. So stating the Fisher equation in terms of GDP should give you i = r + p (where p is the rate of inflation or the ratio of nominal to real GDP).

Finally, I am wondering whether you also want to ban use of the world “deflation” from polite discourse. I think it would be a shame if you did, because you and I both think that it was an increase in the value of gold (AKA deflation) that caused the decline in NGDP in the Great Depression, not a decline in NGDP that caused the increase in the value of gold.

So what is the upshot of all this? I guess I am just too conservative to give up using a word that I have grown up using since I started studying economics. It would also help if I could make sense of the Fisher equation — think of it as Newton’s law of monetary motion — without the rate of inflation. So I am waiting for Scott to explain that one to me. And I think that we need to have some notion of the purchasing power of money in order to explain the preferences of individuals for holding money versus other assets. If so, the concepts of a price level and a rate of inflation seem to be necessary as well.

Having said all that, I would add that Scott is a very persistent and persuasive guy, so I am definitely keeping all my options open.

Update:  Thanks to the ever-vigilant Scott Sumner for flagging my mistaken version of the Fisher equation.  It’s i = r + p, not r = i + p, as I originally had it.  I just corrected the equation in the body of the post as well and reduced the font to its normal size.

Do What Is Right Though the World Should Perish

An ancient debate among economists is whether the monetary authority should be subject to and constrained by an explicit operating rule or should be allowed discretion to act as it sees fit.  The debate goes back to the Bullion Debates in Britain after the British government, in the early stages of the Napoleonic Wars, suspended the obligation of the Bank of England to convert their banknotes into gold at the legally prescribed value of the pound.  One side in the debate, the Bullionists, argued that the Bank of England, enjoying special legal privileges that made it the center of the British monetary system, should be bound by a fixed rule, the absolute duty to convert Bank of England notes, on demand, into a fixed quantity of gold.  The other side, the Anti-Bullionists, maintained that there was no need for the Bank of England to be bound by the obligation to convert.

Over 20 years of intermittent exchanges between opponents and supporters of the suspension, producing some of the most important contributions to monetary thought of the nineteenth century, the Bullion Debates led to a general (though not unanimous) acceptance of the need for convertibility into gold as a stabilizing anchor for a money and banking system in which private banks produce a large share of all the money in circulation.  Despite the resumption of convertibility in 1821, Great Britain experienced damaging financial disturbances in 1825 and 1836, leading to the passage of Bank Charter Act in 1844, imposing a fixed limit on the total amount of banknotes issued by the Bank of England and by other private banks, requiring 100% gold cover for any banknotes issued beyond that fixed limit.

Hopes that, by mimicking the fluctuation of a purely gold currency in response to gold inflows and outflows, the reformed monetary system would avoid future crises were soon disappointed, Britain suffering financial crises in 1847, 1857, and 1866.  Each time the government was forced to grant immunity to the directors of the Bank of England for violating the Bank Charter Act and issuing banknotes in excess of the legal maximum in order to calm commercial panics triggered by fears that the Bank of England would be prevented by the Bank Charter Act from satisfying the demand for credit.  Once temporary suspension of the Act was announced, the panic subsided, the knowledge that credit could be obtained if needed sufficing to moderate the precautionary demand for credit.

By the last two decades of the nineteenth century, the Bank of England, the key institution managing what had become an international gold standard, seemed to have figured out how to do its job reasonably well, and the period of 1880 to 1913 is still looked upon as a golden age of economic stability, growth and prosperity.  But the gold standard couldn’t withstand the pressures of World War I, effectively being suspended in substance in almost all countries.  The attempt to recreate the gold standard in the 1920s led to the Great Depression, because the way the gold standard worked before World War I was not well enough understood for the system to be recreated, more or less from scratch, under the new postwar conditions.  Attempting to follow a misguided conception of how a gold standard ought to work, countries, especially France, redesigned their monetary institutions in ways that inordinately increased the total world demand for gold, producing a world-wide deflation that began in the summer of 1929.

The two economists who really understood the nature of the pathology overtaking the international economy in 1929 were Ralph Hawtrey and Gustav Cassel, having warned of just the potential for a deflationary increase in the demand for gold as a consequence of a simultaneous restoration of the gold standard by many countries, but their warnings went largely unheeded.  Instead, the focus of most economists, central bankers, governments, and practitioners of la haute finance, was to preserve the gold standard at all costs, because to tamper with the gold standard was to allow the unbridled exercise of discretion, to make monetary policy unpredictable, to sanction runaway inflation and monetary anarchy.  But runaway inflation was not the danger — in Hawtrey’s immortal analogy to warn of inflation was like crying “fire, fire” in Noah’s flood – it was runaway deflation.  But rules are rules, and one must always follow the rules.  That the rules had been broken, or at least suspended, in the nineteenth century didn’t seem to matter, because as the old maxim teaches, we must do what is right though the world should perish.

The Great Depression came to an end mainly because the rules were not only broken, they were tossed out the window.  The gold standard was junked.  First, Britain gave up in September 1931, and a recovery started within a few months.  The US held out till March 1933, but when Franklin Roosevelt became President, understanding that prices had to rise before a recovery could start, he suspended the gold standard, devalued the dollar, thereby igniting the fastest expansion of industrial output in any 4-month period (57%) in American history while the Dow Jones average nearly doubled.

In our own Little Depression, we have become attached – I would say dysfunctionally attached – to an inflation target of 2% or less.  The inflation target is to the Little Depression what the gold standard was to the Great Depression.  The consequences this time are less horrific than they were last time, but they are plenty bad.  And the justification is equally spurious.  I would not go so far as to say that rules are made to be broken.  Some rules should not be broken under almost any circumstances, and almost any rule may have to be broken under some very extreme circumstances.  But not every rule — certainly not a rule that says that inflation may never exceed 2% — is entitled to such deference.

The European union and the common European currency are now on the verge of disaster because the European Central Bank, dominated by a German aversion to inflation, refused to provide enough monetary expansion to allow the weaker members of the Eurozone to generate enough nominal income to service the interest obligations on their debt.  In the Great Depression, it was Germany that was overindebted and unable to service its obligations.  Attempting to play under the dysfunctional rules of the gold standard, Germany imposed draconian austerity measures in the form of tax increases and public expenditure reductions and wage cuts.  But all such measures were doomed from the start.  All that was accomplished was to pave Hitler’s path to power.  And now, in a historic role reversal, it is Germany that is paving the way for consequences which we may not yet even be able to imagine.  But evidently as long as the European Central Bank can achieve its inflation target, it will be worth it, because, as the old maxim teaches, one must do what is right even if the world should perish.

A Reply to John Taylor

John Taylor responded to my post criticizing his op-ed piece in yesterday’s Wall Street Journal.  Here are some comments on Professor Taylor’s response.

Professor Taylor responds to my charge of exaggerating the difference between U.S. policies “in the years after World War II . . . promoting economic growth through reliance on the market and the incentives it provides” and current supposedly interventionist fiscal and monetary policies and increasingly burdensome regulation by admitting that post-war “American economic policy was not perfect.”  Nevertheless, in the aftermath of World War II, when America helped Japan and Europe recover, “the American model was a far cry from what was being set up in large areas of the world which were not free either economically or politically.” 

Well, yes, but it is somewhat chauvinistic on Professor Taylor’s part to assume that the only intellectual and policy resources on which Europe and Japan could draw were to be found in America.  Economic and political liberalism were imported and adopted, perhaps even improved, by America from Europe, not vice versa.  It is an old story, but perhaps worth repeating for Professor Taylor’s benefit, that in 1948, with the German economy in a state of semi-collapse owing to runaway inflation, price controls, and rationing imposed by the occupying powers, Ludwig Erhard, the German economics minister in the British and American occupation zones, unilaterally lifted price controls and ended rationing while imposing a tight monetary policy, despite the objections of the Allied authorities.   Thus began what would become known as the “German economic miracle” of which Erhard was the acknowledged architect.

Professor Taylor was also a bit shaky in describing what happened in the 1980s and 1990s, calling American economic ideas “contagious, not just in Britain under Margaret Thatcher but in the developing world.”  But Mrs. Thatcher came to power in May 1979, over a year and a half before Ronald Reagan.  So, once again, the flow of ideas went from east to west.

Turning to my charge of inconsistency in opposing quantitative easing by the Fed in 2009 and 2010, when he had supported a similar policy for Japan in 2002, Professor Taylor maintains that since there was actual deflation in Japan (measured by both the CPI and the GDP price deflator) while inflation in the U.S., with only brief exceptions, remained positive after the 2008 financial crisis.  But Professor Taylor himself acknowledged in one of the papers cited in his response to my post that even positive inflation is potentially dangerous when it approaches zero (especially at the zero-interest lower bound) . 

In addition, “increasing the monetary base in Japan” was supposed to “get the growth rate of the money supply . . . back up . . . not to drive up temporarily the price of mortgage securities or stock prices, which is frequently used to justify quantitative easing by the Fed today.”  Ahem, the purpose of getting the growth of the money supply back up in Japan was to stop deflation, thereby increasing output and employment.  Increasing the money supply is just a means to accomplish that objective.  The purpose of quantitative easing in the US is to increase the rate of nominal GDP (NGDP) growth, and thereby increase output and employment.  That some people believe doing so would also have the beneficial side-effect of raising the prices of mortgage securities or stocks is just a red herring.

Professor Taylor also refers to the debate over rules versus discretion in the conduct of monetary policy. 

If a central bank follows a money growth rule of the type Milton Friedman argued for – and which is quite appropriate when the interest rate hit zero in Japan – then the central bank should increase the monetary base to prevent money growth from falling or to increase money growth if it has already fallen.  In other words such an easing policy can be justified as being consistent with a policy rule, in this case for the growth of the money supply.  The rule calls for keeping money growth from declining.  But the large-scale asset purchases by the Fed today are highly discretionary, largely unpredictable, short-term interventions, which are not rule-like at all.  It is the deviation from more predictable rule-like policy by the Fed (which began in 2003-2005 and continues today) that most concerns me.

A Friedman-type rule for growth of the money supply has long since been abandoned even by Friedman, the so-called Taylor rule being an attempt to provide an alternative with which to replace the Friedman rule.  But the Fed, since its unsuccessful attempt to adhere to a Friedman-type rule in 1981-82, has never articulated a specific rule, so it is not clear what rule Professor Taylor believes the Fed has been deviating from since 2003-05.  One could as easily infer from the data that the Fed was following a rule targeting a 5-6% growth path for NGDP as any other rule.  If so, one could argue that quantitative easing designed to restore NGDP growth to its 5-6% long-run trend is as good a rule as any.  Indeed, with inflation expectations (as measured by the TIPS spread) now running well under 2%, and with a substantial output gap, most versions of the Taylor rule would imply that monetary policy should be eased.  If the target interest rate is already at the lower bound, then the alternative is to increase the monetary base.  That’s called quantitative easing. 

Finally, Professor Taylor refers to my “long rebuttal” to his criticism of “recent interventionist fiscal and monetary policies in the United States.”  Inasmuch as nearly half of my post consisted of direct quotations from Professor Taylor, I am afraid that he has an equal share in the blame for the length of my rebuttal.

HT:  Scott Sumner, Lars Christensen, Nick Rowe

A Walk Down Memory Lane with John Taylor

John Taylor has had a long and distinguished career both as an academic economist and as a government official and policy-maker.  He is justly admired for his contributions as an economist and well-liked by his colleagues and peers as a human being.  So it gives me no pleasure to aim criticism in his direction.  But it was pretty disturbing to read Professor Taylor’s op-ed piece (“A Slow-Growth America Can’t Lead the World”) in today’s Wall Street Journal, a piece devoid of even the slightest attempt to make a reasoned argument rather than assemble a hodge podge of superficial bromides about the magic of the market and the importance of fiscal discipline and sound monetary policies.  It is almost surprising that Taylor failed to mention motherhood, apple pie, and American flag while he was at.  Even more disturbing, Taylor proceeds, with no hint of embarrassment, to trash the half-hearted attempts by the Federal Reserve to use monetary policy to promote recovery even though the Fed’s policies are similar to, though much less aggressive than, the “quantitative easing” that he applauded the Japanese government and the Bank of Japan for adopting from 2002 to 2004 to extricate Japan from a decade-long period of deflation and slow growth starting in the early 1990s.

Taylor begins by attacking President Obama’s policies, strongly suggesting that those policies are responsible for the weak economic recovery.

At the most recent [G-20] meeting a year ago in Seoul, the G-20 rejected [President Obama’s] pleas for a deficit-increasing Keynesian stimulus and instead urged credible budget-deficit reduction and a return to sound fiscal policy.  And on that trip he had to defend the activist monetary policy of the Federal Reserve against widespread criticism that its easy money was damaging to emerging-market countries, causing volatile capital flows and inflationary pressures.

With a weak recovery – retarded by new health-care legislation and financial regulations, an exploding debt, and threats of higher taxes – the U.S. is in no position to lead as it has in the past.

Taylor then invidiously compares Obama’s failure in Seoul with the good old days after World War II when America called the shots.

By contrast, in the years after World War II, the U.S. led the world in promoting economic growth through reliance on the market and the incentives it provides, the rule of law, limited government, and more predictable fiscal and monetary policy.

This tendentious characterization of post-war economic policy overlooks the many sectors of the US economy then subject to strict regulation of prices and other aspects of their business operations, the powerful position of labor unions, and top marginal income tax rates as high as 92%, falling to 70% only after the Kennedy tax cuts were enacted in 1964.  High marginal tax rates and powerful labor unions were the norm in all developed countries in the 1950s and 1960s, so economic reality was far from the free-market utopia one might have imagined based on the comic-book picture offered by Taylor.  But that comic-book picture inspires Taylor to draw the following grand geopolitical lesson from the history of the last 65 years. 

As the U.S. has moved away from the principles of economic freedom – instead promoting short-term fiscal and monetary interventionism with more federal government regulations – its leadership has declined.  Some, even in the U.S., may cheer the decline, but it is not good for the world or the U.S.

Warming to his area of special expertise, monetary policy, Taylor continues by expounding on the evils of “monetary interventionism”

In the case of monetary policy . . . decisions on interest rates by foreign central banks are influenced by interest-rate decisions at the Federal Reserve because of the large size of the U.S. economy.  If the Fed holds its interest rate too low for too long, then central banks in other countries will have to hold rates low too, creating inflation risks.  If they resist, capital flows into their countries seeking higher seeking higher yields, thereby jacking up the value of their currencies and the prices of their exports.

But Professor Taylor has not always taken such a negative view of “monetary interventionism.”  In 2006, he wrote a background paper for the International Conference of the Economic and Social Research Institute Cabinet Office of the Government of Japan (September 14, 2006) entitled (I swear) “Lessons from the Recovery from the “Lost Decade” in Japan:  The Case of the Great Intervention and Money Injection.”

Describing his involvement in 2001, while Under-Secretary of the Treasury for International Affairs in the Bush Administration, in the formulation and execution of Japanese monetary policy, Taylor writes:

[I]n March 2001, the Bank of Japan announced that it would follow the new type of monetary policy, which it called “quantitative easing” and under which it would pump up the money supply in Japan until deflation ended.  I was ecstatic when I heard this announcement.  Since 1994 I had been an adviser to the Bank of Japan, a position I had to resign from when I joined the Bush Administration and I had recommended many times that the Bank of Japan focus on increasing the money supply as a means to end their deflation, and many other economists had recommended the same thing.

Now it’s true that inflation in the US as measured by the CPI has been running in the 3-4% range over the past year, but average inflation over the past 3 years has averaged only about 1% and expected inflation over a two-year time horizon has been consistently below 2% for the last year.  So the recent rise in inflation seems to be a transitory phenomenon while GDP growth remains very slow and unemployment very high.  With inflation, after a short blip, again falling and expected to remain very low for years, it is not at all clear that our situation is much different from the situation in Japan in 2001.  Yet Taylor wrote in 2006 that he had been ecstatic when he heard that the Bank of Japan “would pump up the money supply in Japan until deflation ended,” while now protesting his unqualified opposition to a not entirely dissimilar, though certainly less aggressive, policy by the Federal Reserve.

Taylor goes on to describe how the Japanese exited from their “monetary intervention.”

During the fall and winter evidence of a sustainable recovery in Japan mounted, and I thought that the sooner the recovery became clear, the soon Japan could exit from its intervention.  On December 5, 2003, I gave a speech in New York asserting that Japan was on the road to recovery.  It was still a little risky to declare victory that early, but fortunately I was right and the economy had indeed turned the corner.  Michael Phillips of the Wall Street Journal  wrote a piece entitled “U.S. Sees Reason to be Optimistic on Japan Growth” on the morning of my talk saying:  “The Bush Administration believes the Japanese economy may finally have turned the corner after more than a decade of little or no growth.  In a speech to be delivered today, the Treasury Department’s top international official, John Taylor, will credit the Koizumi government’s market changes and the Bank of Japan’s accommodating monetary policy for giving impetus to the country’s laggard economy. . . The upbeat comments from the Undersecretary of the Treasury for International Affairs represent a sharp shift in Washington’s long pessimistic view of Japan’s fortunes.”

In today’s Journal, however, the possibility that “monetary intervention” could give “impetus the [U.S]’s lagging economy” seems never even to have crossed Professor Taylor’s mind.

Some countries . . . are complaining that the Fed is exporting inflation with its near-zero interest rate and massive purchases of long-term government debt. . . And when global inflation picks up, as it has started to do in many emerging markets, it feeds back into more inflation in the U.S. through higher prices of globally traded commodities.  With unemployment already high, the result would be stagflation – slow growth, high inflation, steady unemployment – as we saw in the 1970s.

I guess we are just supposed to forget, along with Professor Taylor, about “accommodating monetary policy giving impetus to the country’s laggard economy.”  Oh my what a difference four or five years make.  Things do change, don’t they?

HT:  Benjamin Cole


About Me

David Glasner
Washington, DC

I am an economist in the Washington DC area. My research and writing has been mostly on monetary economics and policy and the history of economics. In my book Free Banking and Monetary Reform, I argued for a non-Monetarist non-Keynesian approach to monetary policy, based on a theory of a competitive supply of money. Over the years, I have become increasingly impressed by the similarities between my approach and that of R. G. Hawtrey and hope to bring Hawtrey's unduly neglected contributions to the attention of a wider audience.

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