More on The Fall of the New Monetary Consensus

By Edward Harrison

Randall Wray wrote a paper on "The Fall of the New Monetary Consensus" which we posted at Credit Writedowns last week. Randy took on the theoretical underpinnings that guided policy makers through the most recent crisis.  He argues that the old IS/LM framework all of us economics students learned, but which has now come to be seen as flawed, has made a spurious comeback in a New Keynesian form which drove that policy.

The basic idea of IS/LM is that there is some sort of trade-off between inflation and long-term real output, that when inflation is low, long-term real output is higher, and when inflation is higher, real output is lower. Implicitly, this concept is what drives monetary policy today.

Randy writes:

The idea is that inflation slows growth so it must be diligently fought. The Fed will keep inflation expectations low, inflation will be low, and growth will be robust.

Every link in that sentence is a delicious illusion.

The Fed supposedly manages expectations by convincing markets that it controls inflation, and so long as it controls expectations it can control inflation.

But if it cannot control expectations it cannot manage inflation and all bets are off. What a flimsy reed upon which to hang public policy!

And in any case, why should low inflation generate robust growth? Because—well, because the Fed says it will, contrary to all evidence.

Out in the real world, expectations alone cannot govern any economic phenomena: inflation expectations will determine actual inflation only if those with ability to influence prices act on those expectations. And inflation below the high double digits has never proven to be a barrier to economic growth.

I think that’s right. There is no strict trade off between inflation and real output growth at low inflation rates. Randy argues the top (and perhaps only) priority should, therefore, be full employment.  But what about the quality of output? When I addressed the deflation issue, asking why is deflation bad, I wrote that:

all prices in any given economy do not move in concert. Some will rise or fall faster than others at any given point. Some could even be rising while others are falling. Gas prices are going down while milk prices are rising for example. How do you use monetary policy without exacerbating those differences, without creating winners and losers? You can’t; monetary policy is a blunt instrument.

The question for policy makers then goes to bias. Do they have a deflationary or an inflationary bias? Typically, a deflationary bias is seen as biased toward lower short-term growth and employment. An inflationary bias favours higher growth and employment in the short-term. But the flation bias also affects buyers and sellers of assets by making those assets worth more or less in nominal terms while still holding the debt used to purchase them constant. The guy who buys a house on credit doesn’t like deflation. The guy who has a lot of accumulated debt hates a deflationary bias. So central bankers fear deflation more than inflation because of how it changes consumer psychology. Central banks therefore look to keep inflation rates positive but low and stable.

My interpretation has less to do with expectations and more to do with minimising the ability of policy makers to pick winners and losers. My hope had been that government would allow losers to lose while still supporting aggregate demand so that the recalculation the US economy needs gets progress. However, there is the issue of government and regulatory capture. As we have seen during the crisis, the nexus of Big Government and Big Bank has meant big bailouts and big subsidies. How can we expect this to change in an environment of fiscal deficits geared to underpinning aggregate demand? 

Yes, I still believe the large amount of accumulated debt, especially in the financial and household sectors should make one fear deflation, especially asset price and debt deflation. That should make US policy geared toward increasing consumer savings, decreasing private sector debt, and increasing short- and long-term term employment as well as long-term capital investment. If one looks at this from a sectoral balances perspective, that means government deficits – useful only if they accomplish the foregoing: more household savings, employment, capital investment and less debt. But what about "the acquisition of unwarranted influence, whether sought or unsought", by Big Bank, Big Oil, and the military industrial complex? Is it even possible to have effective policy geared to sustaining demand when government capture by corporate interests is the order of the day? After this crisis, I am much less positive here. That’s my take.

When I asked Randy and Marshall Auerback about budget deficits in the US and the Japanese example, Randy responded:

On Japan, the deficit came in the ‘bad way’, due to the destruction of private demand and, thus, tax revenues. They tried a few stimulus packages, but then always got caught in deficit hysteria and raised taxes, killing recovery. Japanese manufacturers moved as much employment as possible out of Japan to rest of Asia to keep wage costs down. That also limited employment growth in Japan, and also increased insecurity, which raised savings desires. Yes, household saving rates were (and are) high, and yes that is in part due to a lack of an adequate safety net (especially with corporate downsizing). Of course, they do have small houses. Where would they put the crap if they bought more?

On the US: yes, we do need approximately $2 trillion to repair and replace infrastructure; maybe another $1 trillion to compete with China (which will very rapidly leave us behind). But we also need public consumption–social services for an aging society and also a society in which half of all kids live in poverty and are not receiving decent education, health care, recreation, child care, and so on.

Marshall wrote:

I agree with everything that Randy says here.  It demonstrates the inherent weakness of an export-led strategy, which, of course, is precisely the policy course being pursued by the Obama Administration, which wants to turn the US into an "export superpower".

On the demographics argument specifically, I have always thought this was a bit of a red herring.  Prior to the end of the bubble era, Japan ‘chose’ a low employment path–essentially holding the employment ratio constant–with high aggregate demand, which generated rapid growth of productivity. Demand was maintained at a high level through a combination of very large government deficits, high investment demand, and generally a high flow of net exports after 1980. However, toward the end of the 1980s, the government deficit rapidly fell and the budget moved to balance in 1990.

When the U.S. "double-dipped" in the early 1990s recession and as other Asian countries began to effectively compete with Japan for world markets, foreign demand for Japanese products was hurt. Then came the Asian financial crisis, followed shortly afterward by the bursting of the high tech bubble in the US. Together, these negative influences lowered aggregate demand and contributed to a deep and prolonged recession, as did the country’s “stop-start” fiscal policy undertaken from the mid-1990s until around 2003, where there were repeated misguided attempts to elevate budget reduction above employment and growth as officialdom’s main policy objective.

If one is to judge from the recent statements of the current policy makers, this fiscal stance remains firmly entrenched in Tokyo; during last year’s recent Upper House elections, the PM publicly mooted doubling the country’s consumption tax from 5% to 10% in order to “fund” the public deficits.

As a consequence of this shift in fiscal policy, Japanese demand growth has proven insufficient to generate much growth of per capita GDP; this has led to low growth of labour productivity and the corresponding concerns about adverse demographics. In fact, I would go further and suggest that people aren’t having babies because there’s no growth!  Of course, immigration would help, but that doesn’t seem to be an option that the Japanese are willing to embrace.  But to suggest that demographics are the cause of the demand problem is to confuse cause and effect.

In any event, the US is in a cyclical upswing, predicated on fiscal and monetary stimulus. I think this upturn demonstrates that stimulus works. But, to what effect?  Are we experiencing a sugar high that will lead to more malinvestment and a worse hangover when the high wears off? I would suggest that this is a strong possibility – and I assume Randy and Marshall agree. I am not at all convinced policy is geared to those things that will make this upturn sustainable: increased employment and personal income, increased household savings, reduced financial sector leverage, and capital formation. Is the US just trying to get through the next election cycle by any means necessary? Or despite historic partisanship, is there a discernible and coherent economic policy guiding the US?