Uneasy Money

I just read John Cochrane’s essay “Inflation and Debt” in the Fall 2011 issue of National Affairs. On his webpage, Cochrane gives this brief summary of what the paper is about.

An essay summarizing the threat of inflation from large debt and deficits. The danger is best described as a “run on the dollar.” Future deficits can lead to inflation today, which the Fed cannot control. I also talk about the conventional Keynesian (Fed) and monetarist views of inflation, and why they are not equipped to deal with the threat of deficits. This essay complements the academic (equations) “Understanding Policy” article (see below) and the Why the 2025 budget matters today WSJ oped (see below).

And here’s the abstract to his “Understanding Policy in the Great Recession” article:

I use the valuation equation of government debt to understand fiscal and monetary policy in and following the great recession of 2008-2009. I also examine fiscal and monetary policy alternatives to avoid deflation, and how fiscal pressures might lead to inflation. I conclude that the central bank might be almost powerless to avoid inflation or deflation; that an eventual fiscal inflation can come well before fiscal deficits or monetization are realized, and that it is likely to come with stagnation rather than a boom.

The crux of Cochrane’s argument is that government currency is a form of debt so that inflation is typically the result of a perception by bondholders and potential purchasers of government debt that the government will not be able to raise enough revenues to cover its expenditures and repay its debt obligations, implying an implicit default through inflation. However, the expectation of future inflation because of an anticipated future fiscal crisis may suddenly — when an expectational tipping point is reached — trigger a “run” on the currency well before the crisis, a run manifesting itself in rapidly rising nominal interest rates and rising inflation even before the onset of a large fiscal deficit.

This is certainly an important, though hardly original, insight, and provides due cause for concern about our long-term fiscal outlook. The puzzle is why Cochrane thinks the possibility of a run on the dollar because of an anticipated future fiscal crisis is at all relevant to an understanding of why we are stuck in a lingering Little Depression. Cochrane is obviously very pleased with his fiscal theory of inflations, believing it to have great explanatory power.  But that explanatory power, as far as I can tell, doesn’t quite extend to explaining the origins of, or the cure for, the crisis in which we now find ourselves.

Cochrane’s recent comments on a panel discussion at the Hoover Institution give the flavor of his not very systematic ideas about the causes of the Little Depression, and the disconnect between those ideas and his fiscal theory of inflation.

Why are we stagnating? I don’t know. I don’t think anyone knows, really. That’s why we’re here at this fascinating conference.

Nothing on the conventional macro policy agenda reflects a clue why we’re stagnating. Score policy by whether its implicit diagnosis of the problem makes any sense.

The “jobs” bill. Even if there were a ghost of a chance of building new roads and schools in less than two years, do we have 9% unemployment because we stopped spending on roads & schools? No. Do we have 9% unemployment because we fired lots of state workers? No.

Taxing the rich is the new hot idea. But do we have 9% unemployment-of anything but tax lawyers and lobbyists–because the capital gains rate is too low? Besides, in this room we know that total marginal rates matter, not just average Federal income taxes of Warren Buffet. Greg Mankiw figured his marginal tax rate at 93% including Federal, state, local, and estate taxes. And even he forgot about sales, excise, and corporate taxes. Is 93% too low, and the cause of unemployment?

The Fed is debating QE3. Or is it 5? And promising zero interest rates all the way to the third year of the Malia Obama administration. All to lower long rates 10 basis points through some segmented-market magic. But do we really have 9% unemployment because 3% mortgages with 3% inflation are strangling the economy from lack of credit? Or because the market is screaming for 3 year bonds, but Treasury issued at 10 years instead? Or because $1.5 trillion of excess reserves aren’t enough to mediate transactons?

I posed this question to a somewhat dovish Federal Reserve bank president recently. He answered succinctly, “Aggregate demand is inadequate. We fill it. ” Really? That’s at least coherent. I read the same model as an undergraduate. But as a diagnosis, it seems an awfully simplistic uni-causal, uni-dimensional view of prosperity. Medieval doctors had three humors, not just one.

Of course in some sense we are still suffering the impact of the 2008 financial crisis. Reinhart and Rogoff are endlessly quoted that recessions following financial crises are longer. But why? That observation could just mean that policy responses to financial crises are particularly wrongheaded.

In sum, the patient is having a heart attack. The doctors debating whether to give him a double espresso vs. a nip of brandy. And most likely, the espresso is decaf and the brandy watered.

So what if this really is not a “macro” problem? What if this is Lee Ohanian’s 1937-not about money, short term interest rates, taxes, inadequately stimulating (!) deficits, but a disease of tax rates, social programs that pay people not to work, and a “war on business.” Perhaps this is the beginning of eurosclerosis. (See Bob Lucas’s brilliant Millman lecture for a chilling exposition of this view).

If so , the problem is heart disease. If so, macro tools cannot help. If so, the answer is “Get out of the way.”

Cochrane seems content to take the most naïve Keynesian model as the only possible macro explanation of the current slump, and, after cavalierly dismissing it, concludes that there is no macroeconomic explanation for the slump, leaving “get out of the way” as the default solution. That’s because he seems convinced that all that you need to know about money is that expected future fiscal deficits can cause inflation now, because the expectation triggers a “run” on the currency. This is an important point to recognize, but it does not exhaust all that we know or should know about monetary theory and monetary policy. It is like trying to account for the price level under the gold standard by only taking into account the real demand for gold (i.e., the private demand for gold for industrial and ornamental purposes) and ignoring the monetary demand for gold (i.e., the demand by banks and central banks to hold gold as reserves or for coinage). If you looked only at the private demand for gold, you couldn’t possibly account for the Great Depression.

PS I also have to register my amazement that Cochrane could bring himself to describe Lucas’s Millman lecture as brilliant. It would be more accurate to describe the lecture as an embarrassment.

HT:  David Levey

A couple of weeks ago (November 18, 2011), responding to the recent groundswell of interest in NGDP targeting, John Taylor wrote a critique of NGDP targeting on his blog (“More on Nominal GDP Targeting”). Taylor made two main points in his critique. First, noting that recent proposals for NGDP targeting (in contrast to earlier proposals advanced in the 1980s) propose targeting the level (or more precisely a trend line) of NGDP rather than the growth rate of NGDP, Taylor conceded that in recoveries from recessions there is a case for allowing NGDP to grow faster than the long-run trend. Strict rate targeting would not accommodate faster than normal NGDP growth in recoveries, level targeting would. However, Taylor argued that level targeting has a corresponding drawback.

[I]f an inflation shock takes the price level and thus NGDP above the target NGDP path, then the Fed will have to take sharp tightening action which would cause real GDP to fall much more than with inflation targetting and most likely result in abandoning the NGDP target.

Taylor’s second point was that NGDP targeting is not an adequate rule, because it allows the monetary authorities too much discretion in choosing how to hit the specified target. Taylor regards this as a dangerous concession of arbitrary authority to the central bank.

NGDP targeting may seem like a policy rule, but it does not give much quantitative operational guidance about what the central bank should do with the instruments. It is highly discretionary. Like the wolf dressed up as a sheep, it is discretion in rules clothing.

In reply Scott Sumner wrote a good defense of NGDP targeting, focusing mainly on the forward-looking orientation of NGDP targeting in contrast to the backward-looking orientation of the rule favored by Taylor. Further, Taylor’s criticism is beside the point, having nothing to do with NGDP targeting; it’s all about level targeting versus growth targeting. Scott also points out that his own version of NGDP targeting precisely specifies what the central bank is supposed to do to implement its objective, avoiding entirely Taylor’s charge of giving too much discretion to the central bank.

All well and good, but no coup de grace.

It took almost two weeks, but the coup de grace was finally administered with admirable clarity and efficiency at 3:58 PM on December 1, 2011 by George Selgin on the Free Banking Blog. Selgin’s main point is that it is illegitimate for Taylor to posit an inflation shock to the price level, because inflation shocks don’t just happen, they must be caused by some other, more fundamental, cause. That cause can either be classified as a (negative) shift in aggregate supply or a (positive) shift in aggregate demand. If the shift affected aggregate supply, meaning that aggregate demand has not changed, there is no particular reason to suppose that any change has occurred in NGDP. So there is no reason for the Fed to tighten monetary policy to counteract the increase in the price level. On the other hand, if the inflation shock was caused by an increase in aggregate demand, then NGDP has certainly increased, and a tightening action would be required, but the cause of the tightening would have been the targeting of NGDP,  but the failure to do so.

Now in fairness to Professor Taylor, one could interpret his point in a different way: Central bankers are not infallible. Try as they might, they will not succeed in hitting their NGDP targets every time. But each miss will require an offsetting change in the opposite direction. The result of random errors in targeting, may be increased instability in NGDP. But if that was what Taylor meant, he should have said so. Selgin identifies the source of Taylor’s confusion as follows:

But lurking below the surface of Professor Taylor’s nonsensical critique is, I sense, a more fundamental problem, consisting of his implicit treatment of stabilization of aggregate demand or spending, not as a desirable end in itself, but as a rough-and-ready (if not seriously flawed) means by which the Fed might attempt to fulfill its so-called dual mandate–a mandate calling for it to concern itself with both the control of inflation and the stability of employment and real output.

What Selgin is arguing for is a policy targeting a (nearly) constant level of NGDP, taking seriously the vague (and essentially non-operational) goal, mentioned by Hayek in his early work, of a constant level of monetary expenditure.

[A]lthough it is true that unsound monetary policy tends to contribute to undesirable and unnecessary fluctuations in prices and output, it does not follow that the soundest conceivable policy is one that eliminates such fluctuations altogether. The goal of monetary policy ought, rather, to be that of avoiding unnatural fluctuations in output–that is, departures of output from its full-information level–while refraining from interfering with fluctuations that are “natural.”

I find Selgin’s formulation really interesting, because a few months ago I was trying to think through the following problem. Suppose there is a supply shock that causes real output to fall. Unless the supply shock is caused by a reduced supply of labor, the real wage must fall. Under a policy of stabilizing nominal income, the nominal wage as well as the real wage would (or at least could) fall if, as a result of the supply shock, labor’s share of factor income also declined. But a falling nominal wage would tend to cause inefficient (involuntary) unemployment, because workers, observing unexpectedly reduced wages, would therefore not accept the relatively low wage offers, becoming unemployed in the mistaken expectation of finding better paying jobs while unemployed. A policy of stabilizing nominal wages would avoid inefficient (involuntary) unemployment, which is an argument for making stable wages (as advocated by Hawtrey and Earl Thompson) rather than stable nominal income the goal of economic policy.  Thus, it seems to me that from the standpoint of optimal employment policy, a policy of stabilizing wages may do better than a policy of stabilizing NGDP.  Of course, if one adopts a policy of targeting a sufficiently high growth rate of NGDP, the likelihood that nominal wage would fall as a result of a supply shock would be correspondingly reduced.

I also want to comment further on Taylor’s criticism of NGDP targeting as unacceptably discretionary, but that will have to wait for another day.