The third-best case for fiscal policy, and moral hazard for central banks

1. If the central bank is doing it right, and targeting the right level of Aggregate Demand, there is no case for fiscal policy to try to influence AD. It's not needed. And it won't affect AD anyway, because the central bank will offset any changes to fiscal policy to keep AD on target.

Fiscal policy should stick to its microeconomic knitting. It should build more schools when there's a baby boom and more kids need more schools, and not when there's an AD bust and the economy needs more AD. It should build fewer schools when there's a baby bust and fewer kids need fewer schools, and not when there's an AD boom and the economy needs less AD. Getting the number of schools right is the fiscal authority's job. Getting AD right is the central bank's job. It would be silly to have the fiscal authority try to do two incompatible jobs at once, while the central bank just sits there unemployed watching it fail. Ditto for tax/transfer policy too. Tax/transfer policy matters for microeconomic cross-sectional and intergenerational efficiency and equity. It can and does transfer command over resources between current and future generations; time-travel is possible.

2a. If the central bank is doing it right on average, but making random mistakes in hitting its AD target, there is still no case for fiscal policy. It is not obvious why the fiscal authority should be smarter than the central bank at foecasting AD. And if it is smarter, it could just give the central bank its superior forecasts. Nor is it obvious that the fiscal authority could react to forecasts more quickly than the central bank (though there might be a case for automatic fiscal stabilisers, that can react before anyone even knows that AD is too high or too low).

2b. If the central bank is targeting AD, but targeting the wrong level of AD, there is still no case for fiscal policy. If the central bank is targeting too low a level of AD, the central bank will offset any changes in fiscal policy, to keep AD too low, but just right for the central bank's too low target.

3. So, what is the third-best case for using fiscal policy to control AD?

You can't just say: 'The central bank is failing to hit its AD target, therefore we need fiscal policy to help it hit its target' (not an exact quote, but I think that's what Paul Krugman is saying to David Beckworth) and leave it at that.

If the central bank is consistently failing to hit its announced AD target, then either its true target is different from its announced target, or else that announced AD target is not feasible.

If you were principal, and your agent were consistently failing to hit his announced target, what would you do? Would you immediately pitch in to help out? Wouldn't you worry about the moral hazard problem that might create? If he knows you will help him out when he comes in below target, he has an incentive to slack off even more.

I wouldn't do that. I would hold an agent responsible to hitting his announced target. And if he says it is impossible for him to hit his announced target, and if I believed him, I would tell him to change the announced target to one he can hit.

If a central bank runs out of things to buy (or needs to start buying things I don't want it to buy), and AD is still below the announced target, then I would believe that the announced AD target is not feasible (or not desirable). Then I would tell the central bank to change the announced target to one that is feasible. Paradoxically, this would mean that the announced target AD growth rate should be raised to make it feasible. Because a higher inflation target (or higher NGDP growth rate target) means a smaller central bank (as a ratio to NGDP).

I do not know of a single case where a central bank has run out of things to buy.

Economists worry (rightly) about the moral hazard problem of bailing out commercial banks when they fail to meet their announced targets (which is to maintain convertiblity of their money into central bank money at par).

Economists should also worry about the moral hazard problem of using fiscal policy to bail out central banks when they fail to meet their announced AD targets. One of the reasons we want central banks to announce their targets is so we can hold them accountable for hitting their announced targets.

Back to marking exams.

Comments

[Kevin Donoghue]

Nick, I don't think you're right about what Paul Krugman is saying to David Beckworth.

Actual Krugman quote: "Monetary policy at the ZLB requires a perceived regime change to be effective, fiscal policy doesn’t — in fact, fiscal policy works better if people believe that it’s temporary, and will end when the economy recovers."

You're talking about telling the central bank to change regimes, Krugman is talking about a central bank that won't do so, and/or can't convince us it has done so.

[Nick Rowe]

Kevin: this is the quote I was thinking of:

"OK, let’s think about this. What Beckworth seems to be saying is that the Fed and the ECB are at their inflation target, and would therefore tighten policy if the economy were to expand and inflation to rise. But they aren’t at their inflation targets! The Fed has been below target for a number of quarters; the ECB is way below target. And don’t say that the failure to raise inflation rates shows that they must be happy with where they are. The whole point of our previous discussion has been that monetary policy is ineffective under zero-interest conditions unless you are willing to change regimes, that is, accept higher inflation over a fairly long period. If you aren’t willing to do that, the central bank loses traction today and is unable to correct low inflation."

I have heard something very similar from commenters here: that the US Fed is not at its target, and therefore fiscal policy will work because it won't be offset.

If I were arguing against the bit you quoted, I would question whether it is more likely that people believe increased G is temporary than believe that increased M is permanent.

[Nick Rowe]

And "increased G is temporary" means "G falls **immediately** the economy escapes the ZLB", which is not very likely. If G does not fall until *after* the economy escapes the ZLB, it won't work, and can even make things worse, because expected future C will be lower, which reduces current C. Which is a whole other can of worms for fiscal policy in an NK model.

Which deserves a post. Maybe tomorrow.

[Jacques René Giguère]

To paraphrase noted philosopher Sly Stallonne:"Gov'ment goota do what a gov'ment gotta do." But this is not fiscal policy. Moreover, a good many things gov'ment orders require specialized knowledge and equipment and is long lasting. Smoothing might be a good thing.
One problem with relying onlt on monetary policy is that you remove policy instruments and degree of freedom.
No doctor would refuse to use a drug on principle. No engineer would rule out using concrete just because. A soldier who would refuse to use a machine gun just because will likely end dead. Why would economists tie their own hands?

[Nick Rowe]

Jacques Rene: "Why would economists tie their own hands?"

When confronted with Samaritan's Dilemma (pdf)

[Min]

"It is not obvious why the fiscal authority should be smarter than the central bank at foecasting AD."

Crowd-sourcing? ;) ;) ;)

[Nick Rowe]

Min: you are echoing Scott Sumner, who wants to use the Wisdom of Crowds (the market) to target NGDP.

[Min]

"I would hold an agent responsible to hitting his announced target. And if he says it is impossible for him to hit his announced target, and if I believed him, I would tell him to change the announced target to one he can hit."

You might also reconsider your belief in how the target is hit. For instance, if your agent has a brake but not an accelerator, only appearing in normal circumstances to have an accelerator when he has merely taken off the brake, then perhaps you would tell your agent to keep his foot off the brake while you try other means to cause acceleration. It is not like you have to hang onto your theory for dear life.

[Min]

Jacques René Giguère: "No doctor would refuse to use a drug on principle."

Mark Van Doren's father was a physician on the American frontier. One night he went to see a patient who he did not expect to survive the night. The patient had a very high temperature, and in those days a temperature was regarded as a defense against disease. Reducing a temperature was regarded as counterproductive. The patient begged Van Doren to do something to reduce his temperature, but Van Doren replied that doing so would be bad medicine. The patient said, "Doc, put me in the rain barrel. If I'm going to die tonight, let me at least be more comfortable." So Van Doren put him in the rain barrel, and the patient survived not only the night, but recovered from his illness. :)

[Min]

Nick Rowe: "Min: you are echoing Scott Sumner, who wants to use the Wisdom of Crowds (the market) to target NGDP."

I hope you noticed the grins. Tongue in cheek. ;)

I actually thought that I as echoing the Austrians. Price discovery, etc.

[Odie]

How do you make unused labor travel through time? And how is that inefficient if you take away something from people that they don't want anyway?

[Nick Rowe]

Odie: read my linked post above, and replace "milk" with "labour". And monetary policy ensures they always do want it. And if it doesn't, read my post above.

[Nick Rowe]

Min: unless I see his pedal on the metal, or a central bank that has run out of things to buy, I won't believe he can't accelerate.

[Too Much Fed]

By AD, do you mean real AD or nominal AD?

[Too Much Fed]

By AD, do you mean real AD or nominal AD?

[Odie]

I read the link. As I see it the fiscal authority borrows milk from the east coast that the people there don't want to consume. It gives it then to the people on the west coast who will consume it. The east coasters get a promise that they can have the milk back at some later point when they want to consume it. The alternative is the fiscal authority not borrowing the milk, it spoils, and the people on the west coast going thirsty. At the end we have two outcomes:
With fiscal policy: West coast gets milk, east coast gets promise for milk when wanted. (As with any promise it may be kept or not.)
W/o fiscal policy: West coast no milk, east coast gets noting.
Does not sound like anyone would be better off in the second case.

How does now the monetary authority ensure the east coast people want to consume the milk; should they drink more or produce less? Or would it just buy it to get AD up and let it spoil themselves? And why should the monetary authority buy it instead of the fiscal authority?

[Nick Rowe]

TMF: "AD" means the AD *curve*. But it doesn't matter for this post.

Odie: "As I see it the fiscal authority borrows milk from the east coast that the people there don't want to consume."

You see it wrong. At the right price/interest rate, they will sell/lend it.

"How does now the monetary authority ensure the east coast people want to consume the milk"

It increases the money supply.

No more comments on this post.

[Min]

Nick Rowe: "unless I see his pedal on the metal, or a central bank that has run out of things to buy, I won't believe he can't accelerate."

Well, the agent in question, the Fed, has consistently fallen below its target for quite some time. That raises reasonable doubt about its ability to meet it, i.e., to accelerate enough. There seems to be a growing consensus that QE has bolstered asset prices, but has not produced much else.

[Nick Rowe]

Min: I think there is a growing consensus that your growing consensus is wrong.

[Too Much Fed]

Min said: "There seems to be a growing consensus that QE has bolstered asset prices, but has not produced much else."

Where would the U.S. economy be without "subprime" college loans, car loans, and fracking loans?

[Determinant]

Fiscal policy should stick to its microeconomic knitting. It should build more schools when there's a baby boom and more kids need more schools, and not when there's an AD bust and the economy needs more AD. It should build fewer schools when there's a baby bust and fewer kids need fewer schools, and not when there's an AD boom and the economy needs less AD. Getting the number of schools right is the fiscal authority's job. Getting AD right is the central bank's job. It would be silly to have the fiscal authority try to do two incompatible jobs at once, while the central bank just sits there unemployed watching it fail. Ditto for tax/transfer policy too. Tax/transfer policy matters for microeconomic cross-sectional and intergenerational efficiency and equity. It can and does transfer command over resources between current and future generations; time-travel is possible.

There's a difference? Seriously, the entire theory of Aggregate Demand Management originated in the observation that with a glut of funds and unemployed resources, you could improve AD through long-lasting government civic projects. And then raise taxes to cool off demand.

We tried military expenditures (WWII), which actually worked, but peaceful projects were seen as more beneficial in the long-term without the bloodshed. Seriously, there was a consensus after the war that if government could spend its way to prosperity in wartime, it could do so in peacetime; the only problem was a lack of will.

[Nick Rowe]

Determinant: "Seriously, the entire theory of Aggregate Demand Management originated in the observation that with a glut of funds and unemployed resources, you could improve AD through long-lasting government civic projects."

It originated in the observation you could improve AD management with monetary policy. Keynes' GT was about monetary policy, and his was not the first.

[Determinant]

No, Nick. I've read the book, and he didn't say that. Quite the contrary, actually. His one graph in the book was to show that AD deficits would persist at any interest rate selected. Keynes included quite a bit about expenditure. This monetary policy thing is a Friedmanite idea. Credit where credit is due.

[Jacques René Giguère]

Min: Van Doren didn't act on principle but on what he thought (heretically at the time but rightly) was sound knowledge.

Nick: humble IO guy know about game theory. But if I was Clint Eastwood at the mexican cemetery
http://www.imdb.com/title/tt0060196/, I still wouldn't mind having a buddy with a machine gun besides me.
I perfectly agree that sound monetary policy by a first-rate CB should be our first line of defence in case of real recessions (shocks that disturb the PSST may be something else). But sometimes, salus populi suprema lex esto.
Great post as usual.
Retiring for some decaf with the dear olds.

[Nick Rowe]

Jacques Rene: Yep. Nothing wrong with wearing both belt and braces, if you want to make really sure your pants don't fall down, and you don't know for sure which theory is right. Especially if braces are on sale. Stephen Harper made a prudent decision. And we might as well sacrifice a couple of goats too, if they are cheap.

But I still want to change monetary policy, so the question doesn't even arise.

[Too Much Fed]

"Economists worry (rightly) about the moral hazard problem of bailing out commercial banks when they fail to meet their announced targets (which is to maintain convertiblity of their money into central bank money at par)."

I'd say the "target" of a commercial bank is to stay solvent. Is that different?

[Nick Rowe]

TMF: Solvency is necessary, but not sufficient. A bank could be solvent but illiquid. Or solvent and liquid, but just refuse to honour its obligations.

But this post is not about commercial banks.

[Too Much Fed]

But I believe demand deposits of the commercial banks are both medium of account and medium of exchange. If that is true, then the central bank has to take into account what the commercial banks are doing because they can affect most targets like price inflation or NGDP.

I think that is what Cullen Roche would say too.

[Andy Harless]

There are risks involved in having a central bank buy all kinds of weird stuff, and central banks are uncomfortable doing this (and of course there are legal limitations on which weird stuff they can buy). There are also risks associated with changing a central bank's objective, and central banks are extremely uncomfortable doing that. I don't see what's wrong with having the fiscal authority try to make life easier for the central bank by trying to assure that the natural interest rate is sufficiently high. Indeed, leaving aside the zero bound issue, there are risks associated with having a very low natural interest rate (risks often wrongly cited in arguments for premature monetary tightening), and a case could be made for the fiscal authority to set a floor on it in any case. (I wouldn't do it by building schools, though; I'd do it with a sovereign wealth fund.)

I would kind of like to see central banks that are really willing to do whatever it takes to hit their target, but those aren't the ones we have in the real world, and I don't think we would get such central banks if we simply refrained from using fiscal policy. (If central banks have reasonable utility functions, we would get more severe depressions despite more monetary stimulus.)

[Andy Harless]

I should add, one of the reasons I'd like to see central banks that are really willing to do whatever it takes to hit their target is that it would force the fiscal authority to act. If the central bank started doing totally crazy stuff, the fiscal authorities would panic and use fiscal policy to render the crazy stuff unnecessary.

[Nick Rowe]

Andy: how would building a sovereign wealth fund increase the natural rate? By issuing more government bonds to buy commercial stocks and bonds, to reduce the yield spread between the two classes of assets (while holding the budget surplus constant)? So the natural rate on government bonds rises (and the natural rate on commercial bonds and stocks falls)? Is that what you had in mind?

"I would kind of like to see central banks that are really willing to do whatever it takes to hit their target, but those aren't the ones we have in the real world, and I don't think we would get such central banks if we simply refrained from using fiscal policy."

I think we would get further away from it if fiscal policy started doing part of the central bank's job. It's hard to hold central banks accountable for hitting their target if they can point the finger at the fiscal authority, to deflect blame.

[Ralph Musgrave]

In contrast to Nick’s claims in his above article, I can think of NUMEROUS reasons for ABANDONING monetary policy as a means to influence AD, and relying instead just on fiscal. (To be more accurate, I favour abandoning the distinction between monetary and fiscal policy, i.e. just have the state create new money and spend it (and/or cut taxes) in a recession).

1. Adjusting interest rates is a form of monetary policy, BUT interest rate adjustments are DISTORTIONARY. An interest rate change works only via households or firms which are significantly reliant on variable rate loans: i.e. those reliant on FIXED rate loans or not reliant on loans at all are not affected by an interest rate change. Thus this policy makes no more sense than boosting an economy only via people with black hair, with blondes, red-heads, etc waiting for a trickle-down effect.

2. QE, another form of monetary policy, has the same defect: it works only via a limited proportion of the population, that is, the rich.

3. There is no link between central bank interest rates and rates for credit cards.

4. As regards LAGS, the evidence is that monetary and fiscal work at about same speed.

5. As to the fact that it can take too much time to implement fiscal stimulus, that’s probably true in the US, where a bunch of economic illiterates known as “Congress” spend their time arguing about deficits and debts. In contrast, some European governments are marginally less moronic: e.g. in the UK, the sales tax, VAT, was adjusted twice at the flick of a switch during the recent crisis.

6. As Jamie Galbraith put it, “Firms borrow when they can make money, not when interest rates are low”. That point was supported by a recent study by the Fed which found only a feeble relationship between interest rates and investment.

7. GDP is maximised when everything is at free market prices (absent market failure). Ergo interest rates should be at free market prices. Put another way, we could boost demand by subsidising say vegetables and laptop computers, but that would distort the market for vegetables and computers, wouldn’t it?

[dan]

ahhhh
This may be one of your best posts.

I think what you are saying is that IF fiscal policy is correct - ie it is in fact 'building the right number of schools' - THEN when the private sector is not fully utilizing all the resources available to it, the right tool to get the private sector going is monetary policy.

Oh boy...

This is both a useful distinction and I think likely pretty useful and also naturally problematic as the there are no sharp distinctions between what is government and what is private sector.

BUT more to the point. If this is the distinction you want to make you need to have an answer to the set of questions around Government's role in the economy. When and how is it determined what schools are needed? What is the right level of government that maximizes the economic output of the economy? As far as I can see, economists have analyzed the problems of risk in the private sector but don't have parsimonious definitions for Governments role in the economy and how to optimize the production of public goods and the coordination functions that are government.

Or more simply, why should we have any reason to think that Fiscal policy is building the right number of schools right now? The recovery is exceptional in that the private sector has grown and government has shrunk. Why should we exclude the possibility that the output gap today exists because the government is building the wrong number of schools?

One of the finer things about your blog and your approach is you seek clarity in the conversation and topic at hand, these conversations have such a circular element to them where the issues are not clearly stated and most of these disagreements are misunderstandings or miss-communication rather than fundamental disagreement of insight.

I do think that a careful integration of governments role in the economy is a well traveled but poorly settled frontier in economics.

[Nick Rowe]

dan: Thanks!

"I think what you are saying is that IF fiscal policy is correct - ie it is in fact 'building the right number of schools' - THEN when the private sector is not fully utilizing all the resources available to it, the right tool to get the private sector going is monetary policy."

Yes. Exactly.

"When and how is it determined what schools are needed?"

Good question. There is a whole area of microeconomics that tries to answer questions like that. Cost-benefit analysis, which is part of public finance economics. In principle the answer is easy ("if the Net Present Value is positive/negative, then build it/don't build it"), but in practice it's very hard to get accurate estimates for all the many numbers you need. (And it would be even harder if you were trying to do a trade-off between the micro objectives and the macro AD objectives).

"Why should we exclude the possibility that the output gap today exists because the government is building the wrong number of schools?"

The government almost certainly is building the "wrong" number of schools. But I don't know if the right number of schools is lower or higher. But the central bank can and should adjust for that fact, and get AD at the right level, even if the government is building too few or too many schools.

Ralph: "BUT interest rate adjustments are DISTORTIONARY. An interest rate change works only via households or firms which are significantly reliant on variable rate loans: i.e. those reliant on FIXED rate loans or not reliant on loans at all are not affected by an interest rate change."

Nope. Past loans, at a fixed interest rate, are a sunk cost (or benefit). It is marginal decisions that matter. And marginal investment and consumption decisions depend on the cost (or opportunity cost) of new funding.

And the equilibrium rate of interest is not fixed in stone; it changes over time, and monetary policy should allow the actual rate of interest to fluctuate following those equilibrium fluctuations.

[dan]

"But the central bank can and should adjust for that fact, and get AD at the right level, even if the government is building too few or too many schools."

This is a big leap that I am not willing to make. Why not have zero (public) schools (which here is a placeholder for 'government' which still is in need of a definition) - and just use monetary policy?

I am willing to at least pencil in the notion that monetary policy can push private sector risk taking towards exploiting available resources (which would mean fiscal policy would not be needed). However, many of those resources which the private sector exploits are public goods such as an educated work force or various infrastructures (including perhaps a level playing field?), I don't think it is enough to leave the analysis at using monetary policy to push the private sector to potential. Why not ask the question what can the government (ie. what can we do collectively to coordinate the production of public goods where risk takers are not able to capture the value created by their investment) do to raise potential?

I also don't agree that the problem with determining the right number of schools is just running a DCF. the question at hand is how many schools and who pays for it, (and how is the benefit apportioned). If it were just a matter of running a dcf why every rational person would just pay for their own education and the matter would have nothing at all to do with government. Why doesn't that happen?

[dan]

I think perhaps the way to say this is that monetary policy is the appropriate tool to match the level of risk taking with available resources.
But the problem remains that not all economic activity is able to be incentivized through the risk reward mechanism of investment/return calculation - managed by interest rate policy.
If interest rates can be used to match risk taking and resources, what can be used to match the creation of public goods with available resources? (and I agree with Daniel Little that creative ways of privatizing public gains will only address at best a narrow subset of the public goods needed to maximize the economy).
I think Daniel Little asks the right question, how do you solve society's inability to make rational investment in its own wellbeing. (http://understandingsociety.blogspot.com/2014/12/underinvesting-in-public-good.html)
I link to Daniel's post here (via Mark Thoma) not to promote his blog, but because Daniel Little is not an economist. This leads me to suspect that the discipline of economics has not properly focused and analyzed this question. (or I and other non-economists wouldn't have to keep asking...)

[bakho]

Monetary Policy that fails to achieve full employment carries huge external negative social costs. Much social dysfunction in the USA is tied to joblessness. Maybe Canada has better safety net and off the job training and does not have the huge negative social costs of the US, Eh?

In the US, post secondary education imposes large, potential unaffordable costs on individuals.
Many individuals in the US get OnTheJob Training or NoTraining.
Long term unemployed = lack of training = deteriorated job skills = unemployable = large negative social costs.
Since the negative social costs are not captured by the models, those are external, costs, & are real. Millions are made to suffer because ideologues are tied to Monetary Policy as the only economic management tool.
-jonny bakho

[Roger Sparks]

Central Banks mediate the creation of financial property.

Nick, I hear you saying that when the fiscal authority builds a school, the Central Bank may adjust AD to keep AD level.

While that ability of the CB may exist, it would usually make no sense to exercise that control. The building of ONE new school requires uncommon skills and materials implying that an extraordinary effort is required. There would be no need to disrupt the ordinary day-to-day economic flow more than the isolated school effort would itself would contribute.

On the other hand, if the fiscal authority undertook the building of THOUSANDS of schools, the disruption to the economy could be massive. There would likely be a need for MORE MONEY or alternative MONEY FLOWS to encourage the anticipated labor and material disruptions. Central Banks could have a role here but it would be a role acting in conjunction with the fiscal authority.

Aggregate Demand is similar. Increased AD implies an increased demand for EVERYTHING. EXACTLY how might the CB create that demand BY ITSELF?

If the CB was going to increase aggregate demand by making more money available, there is a need for a path from printing press to potential buyer. The paths available to the CB without the fiscal authority are few and stratified.

[Majromax]

@Dan

You're conflating the role of government in providing for the common good and the alleged role of government in managing Aggregate Demand.

Let's separate the roles:

*) On one hand, the government builds bridges. Bridges always have a positive social value, and they are not supplied by the market.

*) On the other hand, the government pays people to dig holes in the ground. These holes have zero social value, and they are not supplied by the market.

I submit that the government should always build as many bridges as have positive net present value, regardless of economic circumstances. Furthermore, in an ideal world the government should never merely pay people to dig holes in the ground.

The first point is supply-side economics: the common good is improved by supplying bridges that the market can't itself supply. Each bridge provides a common benefit, some of which will flow back to the government in the form of taxes. That makes building a bridge an investment decision, where the government will take a loan of a long duration to be paid back with the increase in tax revenues resulting from the real economic growth.

In this case, the government acts as if it faced a strict long-run budget constraint. Most importantly, this approach remains the same regardless of monetary policy regime: it works as well in Zimbabwe as in the Eurozone or in Goldlandia. Monetary policy can, however, affect which bridges are worth building, through the same way that it affects aggregate demand in the rest of the economy: by changing the time-cost of money in the present. In this case, the bridge-building function of the government is an AD follower of the central bank, building more bridges when the CB tries to increase demand and fewer bridges when the CB tries to reduce demand.

For the latter point, there is no economic case for a private actor to pay people to dig holes. Likewise, there's no economic case for the government to do so either: each currency unit paid to a worker comes from either a unit taxed or a unit borrowed.

*) If the workers' wages come from taxation, this is an argument about equality. However, if economic efficiency is improved by redistribution, then there is no reason to redistribute only in bad times: there should be as many (advertised positions for) hole-diggers in good times as in bad. [This is also, as I understand it, a basic idea behind certain MMT-proponents of a job guarantee]

*) If the workers' wages come from debt, then absent aforementioned equality concerns this will only affect Aggregate Demand through the Central Bank. Namely, if the CB does not accommodate the debt issue by purchasing the bonds, then the amount of base money in circulation will remain constant; this may even drag on the economy if the government acts as if it has a loose long-term budget constraint and people expect higher future taxes to repay the bonds (Ricardian equivalence).

However, if the CB is willing to purchase newly-issued bonds, then why has it not already done so with the entire stock of old bonds? The same money-creation would seem to be possible without requiring actual people to dig useless holes in the ground and without causing Ricardian concerns over future taxes (Fiscal Theory of the Price Level notwithstanding). If anything, a mishmash of new-debt and CB accommodation acts as a signal that the expansion of the monetary base is temporary, in that people would expect the CB to hold the larger-than-typical level of bonds for far less time than necessary for inflation to eat away at the principal value.

This could potentially be an issue if the CB has legal limits in what it can buy whilst it holds 100% of such assets. The United States, however, is nowhere near this point.

(* Bonus round: Purchases of newly-financed debt are actually more temporary at the ZLB than in ordinary times. If inflation is near-zero, this means that $100 of newly-issued bonds purchased by the CB will still demand $100 of principal repayment in the future, both in present-day and future $; if inflation is moderate, then the real value of the outstanding bond goes down with time whilst interest payments are promptly refunded as seigniorage revenue. In a sense, this is working backwards from the FTPL, where the inflation rate affects the government's fiscal constraint rather than the other way around.)

[Derivs]

"4. As regards LAGS, the evidence is that monetary and fiscal work at about same speed."

I would like to see that. After much banging of my head against a wall, I came to a conclusion that lag is created by the divergence between expectation of monetary policy and actual monetary policy. Therefore, for me, monetary policy 1 vs monetary policy 2 can cause a very inconsistent lag rate.

As for #1. Like Nick said... it's all about opportunity cost. Once you move out far enough in time, whereby convenience yield and seasonality become less meaningful, forward price becomes all about interest rates. At 8% interest rate, contracting at $1 today, or $1.08 in a year, become the same thing. For both parties.

[louis]

Nick - great entry in this ongoing debate.
Your argument, interestingly enough, is more compelling for those who accept the whole "secular stagnation" hypothesis.
In normal times, monetary policy has won the debate as the best way to keep the economy at full employment (given fiscal stabilizers). The debate has only reappeared because the US and Europe are going through a once in a generation (or more) financial crash and downturn, and several major central banks have below-target inflation.
You argue that a change in the monetary "rules" is sufficient to close the output gap. The CBs are slow to do this, and meanwhile people are suffering and productive capacity is wasted. Krugman et al. say "we know fiscal policy can work here, just use it" while you say "if we don't teach the central bankers a lesson now, when will they ever learn?"
It seems silly to emphasize moral hazard if the 2008 crisis is of a rare type and we will seldom need to call on fiscal policy again. It only really makes sense to force a change in monetary policy regime if one thinks we will be back here (at the zero bound) again soon, absent a change.
PS The "right number of schools" argument is a little weak; schools, roads, etc are durable and there is a wide window of time in which they can be replaced. Accelerating a burst of spending to boost AD (when it wont be offset by the CB) is not crazy. Debt-funded tax cuts and transfer payments don't face this issue at all.

[Andy Harless]

Nick,

"how would building a sovereign wealth fund increase the natural rate? By issuing more government bonds to buy commercial stocks and bonds, to reduce the yield spread between the two classes of assets (while holding the budget surplus constant)? So the natural rate on government bonds rises (and the natural rate on commercial bonds and stocks falls)? Is that what you had in mind?"

Yes. Now that I think of it, as regards the ideal arrangement, we don't really disagree on substance. I would be happy to have an institution whose job is to print money and buy whatever it thinks will further its macroeconomic objectives. And I don't personally have a problem with calling that institution a central bank. But I think that name is contrary to current usage, wherein the job of a central bank is only to lend the money it prints (i.e. to buy high-quality finite-maturity fixed-income assets) and sometimes to buy and sell international reserve assets (but this function, at least in the case of the Fed, is not supposed to be at the bank's own discretion). So, to conform to current usage, I call our ideal monetary institution a central bank plus a sovereign wealth fund. It probably needs a better name if it's going to be a single institution, but I'm not sure most people would call it a central bank.

"I think we would get further away from it if fiscal policy started doing part of the central bank's job. It's hard to hold central banks accountable for hitting their target if they can point the finger at the fiscal authority, to deflect blame."

Institutionally, yes, we would get further away from having a fully responsible central bank. But we would also get closer to our macroeconomic objective, because moral hazard is not strong enough to fully offset the effect of fiscal policy (unless the central bank has a really perverse utility function). Sometimes the best way to deal with moral hazard is just to acknowledge it and do the best you can under the circumstances. I can see the advantage of resting responsibility for macroeconomic management in a single institution (and particularly an institution somewhat isolated from day-to-day politics), but I'm not sure I'm ready to take the Leninist "the worse, the better" view that palliative reform (in this case, fiscal policy) is bad because it makes revolution (in this case, the establishment of a fully responsible central bank) less likely.

[Min]

"Min: I think there is a growing consensus that your growing consensus is wrong."

It's not my consensus. I'm just an observer. I would be glad to hear what you perceive to be a consensus, if there is one, about the effects of QE. :)

[Ralph Musgrave]

Nick,

I don’t see why your “marginal decisions that matter” point disproves my claim that artificial interest rate adjustments are distortionary.

Obviously if interest rates are cut in a recession, then more borrowing and/or investment takes place, and that borrowing / investment is by definition marginal in that it’s additional to the borrowing / investment that was already taking place. But that doesn’t stop that additional B / I being distortionary.

The only exception to the latter point would come where a recession was caused solely by some sort of market failure which artificially depressed B / I. But frankly I don’t think there’s much chance of the authorities being able to identify such failure where it exists.

My hunch is that the main cause of most booms and busts is gyrations in confidence or gyrations in Greenspan’s “irrational exuberance”, and that affects both borrowing based forms of activity and non-borrowing based forms of activity. And it affects investment and non-investment spending.

Thus I don’t see the case for countering the economic cycle just via interest rate adjustments.

Re your point that “monetary policy should allow the actual rate of interest to fluctuate following those equilibrium fluctuations”, I have no quarrel with that. All you’re saying is that in a free market, the price for borrowed money, like the price of everything else will fluctuate. But that’s not what we’re arguing about: we’re arguing about whether the state should ARTIFICIALLY adjust interest rates.

[Nick Rowe]

Ralph: what makes them "artificial"? (I sometimes hear Austrians make the same claim.) In NK models, a central bank doing it right sets the actual interest rate equal to the "natural" interest rate. It moves the former *because* the latter moves.

[Nick Rowe]

Min: I don't know what the consensus is. It's *relatively* easy to test whether QE moves asset prices, because asset prices move quickly in response to news, so we can look at event studies. But if real output moves slowly, it is very hard to tell what caused it to move, because we don't know where it would have gone without QE. What's the counterfactual? But it would be hard to argue that QE affects asset prices, and exchange rates, but does not affect real output or inflation. Because everything is connected to everything else. Especially if you argue that the financial crisis and fall in asset prices is what caused the recession.

I think what we can say is that it has probably not had a very big effect on real output, relative to the increase in base money. But even that is problematic. Who knows what would have happened to real output otherwise? It might have gone to 0!

The "consensus" during the Great Depression was a load of cobblers, in hindsight.

[Min]

Nick Rowe: "And the equilibrium rate of interest is not fixed in stone;"

No, it's floating in the clouds in the Great Bye-and-Bye. (Just a little teasing. ;))

[Min]

Nick Rowe: "I don't know what the consensus is. It's *relatively* easy to test whether QE moves asset prices, because asset prices move quickly in response to news, so we can look at event studies."

As I recall, MMT theorists predicted that QE would have no effect, as it was merely trading one highly liquid financial entity for another. Against that, it was claimed that QE, even if it was unconventional policy, would move the whole economy. Events have gone against both predictions.

Nick Rowe: "But if real output moves slowly, it is very hard to tell what caused it to move, because we don't know where it would have gone without QE. What's the counterfactual?"

Indeed. I will touch on that below. :)

Nick Rowe: "But it would be hard to argue that QE affects asset prices, and exchange rates, but does not affect real output or inflation. Because everything is connected to everything else."

As a student of human systems, I agree. Eventually the change in asset prices will have a discernible effect.

Nick Rowe: "I think what we can say is that it has probably not had a very big effect on real output, relative to the increase in base money."

That is part of what I called the growing consensus. :)

Nick Rowe: "But even that is problematic. Who knows what would have happened to real output otherwise? It might have gone to 0!"

The question of counterfactuals is why we study history. :) Does the Long Depression of the late 19th century have no lessons for us today? Especially since the US had no central bank at that time. My guess is that it does, but who is talking about it?

As for discerning causality without counterfactuals, here is something I just found out about. https://medium.com/the-physics-arxiv-blog/cause-and-effect-the-revolutionary-new-statistical-test-that-can-tease-them-apart-ed84a988e . Here is the paper. http://arxiv.org/pdf/1412.3773v1.pdf .

IIUC, the basic idea is that if A causes B, the noise of A will increase the noise of B. OC, if A is just one cause out of many, the increase in the noise of B may be quite small. As against that, QE has been humungous. Perhaps the new test can apply to it.

[Nick Rowe]

Min: possibly interesting linked post, but:

"Another dataset relates to the cost of rooms and apartments for students and consists of the size of the apartment and the monthly rent. Again it is obvious that the size causes the rent and not vice versa."

Rubbish. It's simultaneous causation, demand and supply.

[Min]

Causation paper: "Another dataset relates to the cost of rooms and apartments for students and consists of the size of the apartment and the monthly rent. Again it is obvious that the size causes the rent and not vice versa."

Nick Rowe: "Rubbish. It's simultaneous causation, demand and supply."

Well, there is a causative feedback loop, but it is not simultaneous. It takes longer to build apartments than it does to negotiate rent on an existing apartment.

The difference in time scales might be enough to affect the noisiness. That is, we would expect rents to be more volatile than apartment sizes.

[John Whitesell]

Monetary policy is always faster then fiscal policy? Got any real world proof to go with the very, very, very crucial assumption? I mean we are talking an unhedged judgement about the most important policy question in economics. Sure seems like something worth checking if it actually works in the real world like we have, many times, with Keynesian stimulus.

Also, what evidence is there that "moral hazard" exists among central bankers? I mean over in Europe policy makers refused to "bail out" the ECB but the ECB was a disgrace to the profession so it seems like incompetent fiscal and monetary policy go hand in hand. Or is it supposed to be a long term thing? Do we accept three or four repeats of the Great Depression with panache, knowing that our central bankers will be so amazing when we wring the moral hazard out of the system?

[Nick Rowe]

John: take 9/11 as an example. IIRC, central banks reacted the next day, if not within hours. How long would it take to decide on and implement a new budget? Even in normal times, the Bank of Canada has a fixed announcement Date 8 times a year, using the latest data from a couple of days before. Budgets don't get changed that quickly.

In the mid 90's, there was a massive tightening of Canadian fiscal policy. From big deficits to big surpluses. Did we see a recession or fall in inflation? No. The Bank of Canada kept inflation on target. Because it was held accountable for doing that. So much for observing Keynesian (negative) stimulus working.

" I mean over in Europe policy makers refused to "bail out" the ECB..."

??? They won't let the ECB do QE, which is what it needs to do. The ECB is bad, but the fiscal policymakers won't even let it do the little it wants to do. Let alone holding it accountable for doing what it is supposed to be doing.

[Jacques René Giguère]

Nick: reaction speed is an institutionnal set-up, based mostly when government had to rely on thugs stealing bits of metal from peasants and finding it easier if they somehow agree to get back part of it. It's not basic economic science except in the sense that, being in the real world, we have to take it into account.

[Ralph Musgrave]

Nick,

I fully accept that in a totally free market and given a recession, interest rates would fall. But what’s to stop them falling of their own accord? No much, far as I can see. So why have government amplify the process?

But falling interest rates is NOT ALL that would happen in a perfect market. Another phenomenon is the Pigou effect: that is, the fact that supply for almost everything exceeds demand would mean that prices generally would fall, which means the value of the monetary base (and government debt) rises in real terms. That rise in the value of private sector net financial assets would induce the private sector to increase spending not just on borrowing / investment items, but also on non-borrowing based / non-investment items.

But in the real world, the Pigou effect is stymied by the wages being “sticky downwards” phenomenon. Thus in contrast to interest rates, there IS A CASE for having government amplify the process, and government can do that by increasing its own spending and by increasing household spending (e.g. via tax cuts).

[Ralph Musgrave]

Jacques René Giguère,

I agree with your comment just above. Also, 9/11 was a highly unusual event calling for ultra-fast reaction, and in that case an interest rate cut was doubtless a good idea. In contrast, recessions (and recoveries from recessions) take place much more slowly, which gives time for fiscal adjustments.

Also, the UK adjusted its sales tax (VAT) twice, and at the flick of a switch, during the recent crisis. Thus quick fiscal changes are perfectly feasible given the right institutional set up.

[Majromax]

@Ralph:

> But in the real world, the Pigou effect is stymied by the wages being “sticky downwards” phenomenon.

Or, more importantly, that cash carries 0% interest.

The problem with deflation is that nobody would be willing to lend at a negative interest rate, so the loan market may not clear at what should be its equibrium rate.

> Thus in contrast to interest rates, there IS A CASE for having government amplify the process, and government can do that by increasing its own spending and by increasing household spending (e.g. via tax cuts).

This is at least as distorting as anything you've alleged that Central Banks do.

Remember to make the distinction between kinds of government spending, on bridges and useless holes in the ground. The government should already be building as many bridges as have positive net-present-value, regardless of whether the economy is in a general glut. That would probably represent bridge-building at a faster-than-normal rate, since the government's borrowing cost would be lower than typical.

However, bridge-building alone is unlikely to patch an AD shortfall (since we don't have a bridge-economy). So government "stimulus" spending is, to first order, intrinsically useless as economic activity: it's a transfer payment or dig-and-fill-a-hole spending.

If the government is doing this with newly-printed money, however, it has at least as much effect on interest rates as a Central Bank action (in that its borrowing as a share of economic activity falls). In addition, distributing that money via contract or transfer carries with it distortion, since some people will receive a cheque and some will not. (You can't get away with saying that this is managed just through a deficit, as that acts as a transfer to all the people not taxed in the future -- i.e. it acts just like borrowing and then purchasing those bonds with new money)

So if we're creating money for the express purpose of giving it away, why have the fiscal authority rather than the central bank do it? Furthermore, why not deliver it in the form of an OMO, where it's sold to the people most willing to forego a safe investment (and thus either make a riskier investment or consume)?

[dan]

The logic of this is delightfully obvious; the rough definition of the private sector we have is; people foregoing a safe investment and making a riskier one or consuming.
If the problem at hand is that people are making too few riskier investments and consuming to little (both however measured); there is a sort of ineluctable clarity in suggesting taking the action that most directly increases precisely that action which is missing. Hard to argue against that. And it does seem you are making the less demanding point that your prescription is merely superior.

I like it, I'll use it. However, by all accounts the government is building bridges at a lower than normal rate. Persuasive analysis has been offered that MANY npv positive 'bridges' are not being built. I think its fair to add to your post some comment on that, given that it is a huge direct assumption of your point - and the one that is hanging people up in adopting it. Even if the problem is primarily mixing two different problems together.

It could even be that monetary policy alone can achieve the right level of investing and consumption EVEN when bridge building is not happening or even when, as is the case now apparently, bridges which are npv positive are not built. So fine, you still have the oddity of why aren't those npv projects being done? It must by definition be a problem or else they wouldn't be npv positive. What ineluctable action can or should be taken to push those npv projects to happen?

This post ages well.

[Nick Rowe]

dan: "However, by all accounts the government is building bridges at a lower than normal rate."

The Canadian or US government? This is purely anecdotal, but when I drove to Winnipeg this last summer it seemed to me (I probably exaggerate) that every second bridge on the trans-Canada was being repaired/replaced. Presumably by our Conservative federal government. Which pleased me, given the low real interest rates at which it can borrow, though I haven't seen any NPV calculations, even though I had to do a 600km detour when one new bridge slipped and blocked the road.

[Frank Restly]

Nick,

"I do not know of a single case where a central bank has run out of things to buy."

Strange since central banking (at least in the U. S.) preceded open market operations by about 10 years. I understand the validity of your point, but the existence of a central bank does not automatically mean it has the authority to buy anything. Also, here is the comprehensive list of central banks:

http://www.centralbanksguide.com/central+banks+list/

There are currently 5 countries without any government debt:
http://www.therichest.com/rich-list/rich-countries/the-only-5-countries-in-the-world-living-debt-free/4/

Macao
British Virgin Islands
Lichtenstein
Brunei
Palau

Of these countries, Macao has its own central bank - http://www.amcm.gov.mo/cIndex.htm

What does the Macao central bank buy?

[Derivs]

"The government should already be building as many bridges as have positive net-present-value"

Would that be an NPV calculation based on the additive economic benefits of said bridge (time saved, gas saved,etc), or based strictly on cash flow analysis, the later seems problematic as it does not consider the toll as a tax, and is not offset by a loss of consumption elsewhere.

"government can do that by increasing its own spending and by increasing household spending (e.g. via tax cuts)"

I walk into a wall on that every time because I look at it (holding to the simplified example in the concurrent thread Y=C+G) and feel bound by substituting G = (Y * Tax rate), therefore making C = (Y * (1 - T rate)) and, never avoiding a good circular reference, ... Y= C + (Y * T rate)

“It's *relatively* easy to test whether QE moves asset prices, because asset prices move quickly in response to news, so we can look at event studies “

I would say the exact opposite. Any well done event study should leave one scratching their heads at the results. Formally, it would be very difficult to do, as you would have to filter it by deviation from expectations, obtain all those expectations, probably resulting in the person doing the study to then ignore all data that did not exceed those expectations, or for which they were unable to obtain expectations, which would therefore leave you no longer modeling all news vs. response but instead extreme deviations in 'some' news vs response (which should be more obvious, anyway). Then time becomes an issue, move over/within what time frame? Then, probably most important, is that isolating news at t0 is extremely difficult, as too many other events are occurring simultaneously at t0. There is wisdom in the adage. “Buy the rumor, sell the news”, which is, if you try and chase the news tape, start looking for other work.

[dan]

I was thinking of the US government at the moment, but also more generally.
it strikes me that it would be useful to know if the NPV projects are being built or not - over time and across countries.

even if Canada is at some optimal point today - has it always been?

how can this not be as interesting as examining employment relative to nairu or output relative to potential with an eye towards monitoring activity in the private sector?

Why shouldn't the government's role in building npv projects be measured and aimed for etc just as employment and inflation are?

[Frank Restly]

Dan,

http://en.wikipedia.org/wiki/Net_present_value

"The NPV of an investment is determined by calculating the present value (PV) of the total benefits and costs which is achieved by discounting the future value of each cash flow (see Formula). NPV is a useful tool to determine whether a project or investment will result in a net profit or a loss because of its simplicity. A positive NPV results in profit, while a negative NPV results in a loss."

Does government operate with a profit / loss statement? Does a lack of profits doom a government to bankruptcy, insolvency, etc.?

[Too Much Fed]

Min said: "The question of counterfactuals is why we study history. :) Does the Long Depression of the late 19th century have no lessons for us today? Especially since the US had no central bank at that time. My guess is that it does, but who is talking about it?"

What years are you talking about here?

Gold standard?

[dan]

Does government operate with a profit / loss statement? Does a lack of profits doom a government to bankruptcy, insolvency, etc.?

Yes, no, no - at least that's my view assuming you have your own currency.

But the question really is not about the government but the economy. Does an economy have a profit/loss statement? It's a good question because Germany might say yes, but a closed economy, or the entire global economy is a different story.
I think maybe the way to measure it is does the economy have growth which we can pencil in as Total Factor Productivity growth as the best measure, perhaps.

[dan]

This is essentially the question that is interesting. You have a huge amount of analysis around the economy built up around balancing risk taking and resources, and you have a relatively important economic agent who isn't bound by a risk profile in any sense meaningful to that analysis and I can't find any one focusing on what drives this agent's economic decisions. Where has anyone advanced an analysis for what size the government should be to optimize economic output?

It strikes me as the most interesting in economics to examine at the moment. Far more interesting than the endless discussions about the best way to use policy to influence risk taking and consumption which has been rather exhaustively argued at least enough to be pushed up against the boundaries of what can be demonstrated through data meaningfully enough to advance the collective understanding.