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A number of Post-Keynesians (Randall Wray being the most prominent) also argue that the federal government itself (rather than just the central bank) can be engaged in reflation by running deficits not financed by issuing bonds, ie they just cut cheques to people who spend them; there is no vault that runs out. In normal times printing money like this would run the risk of increase inflationary expectations but in a deflationary situation that might just be what the doctor ordered. Is that view consistent with your last resort, Stephen?

We also need to be cognizant of what we mean by inflation. In recent years the Bank has paid attention to consumer prices while asset prices have undergone a massive inflation. Now it is asset prices falling that is the core underlying problem as it generates negative wealth effects. In that sense, we are already experiencing deflation.

This dynamic is also somewhat at play in high-tech consumer durables like computers, software and iPods, and as you have pointed out, is at the core of the debate about whether investment to GDP has been falling (based on nominal calculations) or increasing (based on real) in recent years.

Back to housing, this is less about output gaps and more about self-fulfilling expectations about the future direction of prices. Greed has been replaced by fear, and the real effect of that is a slowdown in new investment after a huge increase in recent years (like 2 percentage points of GDP above normal historical levels).

Marc: (I think you meant me, not Stephen)

Yes, I think we are talking about the same policy. If the government increases transfer payments (same as cutting taxes) and the debt in public hands (i.e. excluding that held by the Bank of Canada) stays the same, then it is money-financed. And that is conceptually the same as Milton Friedman's thought-experiment of the central bank loading helicopters with newly-printed money and dropping it for people to pick up. Friedman thinks of it as monetary policy; post-Keynesians (perhaps) think of it as fiscal policy; I think of it as fiscal+monetary policy; but it's the same policy. I would perhaps prefer money-financed government investment rather than transfers, but that's not central.

In the current context, I'm not sure if it matters exactly how we define inflation/deflation. Sure, different definitions will give you different numbers, and different numbers for the real interest rate as well, but the only thing that matters here is whether the nominal interest rate would need to be negative to prevent a downward spiral in deflation (however defined). As to whether the Bank's inflation target should include asset prices, my views keep changing on that. (15 years ago, in one of my wilder moments, I argued the Bank should peg the growth rate of the TSX, i.e. only asset prices.)

Not sure about the wealth effects of falling asset prices either. Falling house prices for example don't have first-order wealth effects. Prospective sellers are worse off, but prospective buyers are better off.

Thanks, Nick. Sorry to confuse you with Stephen - there is no author tag on the post. As the "new guy" this may come up again.

On the house prices, the dynamic I'm most concerned with is falling housing prices that put more families in negative equity positions, leaving them more vulnerable to the downturn and less likely to engage in other consumption. But you are right, people who have been priced out of the market to date are happier to see prices fall.

Two things I've been wondering:

1) This may explain why Mark Carney was so aggressive in the early stages of this round of interest rate cuts.

2) What role does the exchange rate play in all this? It wouldn't be hard for the Bank to depreciate the exchange rate, and to the extent that this passes through to prices, then this would feed back on inflation. This isn't something that US and Japanese monetary authorities have to consider (much), but it is for us.

If nationalization is a permanent policy fixture, you get an increasing pie share of public sectors at the expense of private. Eventually you might risk bubbles in public sectors like infrastructure construction. In Wpg recent highways and crown buildings budgets have gone far overbudget. Especially Cgy offers an example of construction inflation. On the other hand transit and health can absorb lots of FDR spending. A problem is the social rate of return of many public sectors isn't measured. Flaherty stated he might subsidize sustainable (Japanese knockoffs)models in an auto bailout. Policymakers have to be able to value sectors that are potential nationalization targets. I'd like high-speed transit lines at present materials prices but by the time a construction blueprint is ready to hedge in just a few months the prices may be much higher or lower. As Stephen Harper's mom's portfolio can acknowledge, maybe public actors aren't the best traders.

Marc: Ooops! I hadn't noticed the missing "author tag". Will gather up courage sometime to try to figure out TyePad better.

1. Yes, since the Bank of Canada of course understands this point. Whether it has been aggressive enough, only hindsight will tell. FWIW, I expect a very aggressive (>=50 basis point) cut at the next move, unless credit markets suddenly improve a lot.
2. In normal times it's easy for the Bank to depreciate the exchange rate, if needed, by lowering the overnight rate. But if it hits a lower bound, it's not obvious whether and how this would work. If Canadian deflation were (say) 5%, and expected to stay at 5%, then foreigners, as well as Canadians, might be willing to hold more or less unlimited quantities of Canadian dollars, so the Bank's buying forex and flooding the world market with Canadian dollars might not cause any depreciation. The world demand to hold Canadian dollars might be very elastic.

Phillip: I see money-financed fiscal policy as a temporary measure, that would stop as soon as expected inflation had returned to the 2% target. And since it would be done during a recession, the construction workers for infrastructure investment would be readily available. Of course, whether it would in fact be temporary, given public choice forces, might be another story.

Marc: I have changed my mind on how I would answer your first comment. I now think it does matter how we define deflation (see my latest post).

You say that the BoC should move quickly to reduce interest rates. Are you calling for a more rapid decline than 50 bpt. per meeting? I realise that it would be fairly unusual and thus might make the market more nervous, but I can't imagine that a drastic rate cut could make things much worse.

I tend to agree that infrastructure spending will be called for--too bad the GST cut will likely be saved rather than spent.

Andrew: IF there's any danger of hitting the lower bound, then interest rates should be cut more, and more quickly, than we would cut them if we were certain of our forecasts. Haven't firmed my opinions on it as yet, but I would tend to lean towards a 100 bp cut sometime soon. Just waiting for Stephen Gordon's next post to help make my mind up.

An announced temporary GST cut (like in the UK) would probably encourage more spending than the cut in taxes (MPC>1 if you like).

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