Matt Yglesias has a new post challenging my views on monetary offset:
Scott Sumner became famous in the world of popular economics writing with the bold contention that even at the “zero bound” the Federal Reserve both could and should bring the economy back to full employment even in the face of contractionary fiscal policy. But he’s always paired this with a stronger claim, namely that the Fed does in fact bring about exactly the level of Aggregate Demand that it wants to have regardless of the tightening or loosening of fiscal policy.
And he’s become pretty testy about people like Larry Summers who think that looser fiscal policy would be a helpful means of restoring full employment more swiftly.
A curious issue that in my opinion he and other proponents of the full monetary offset thesis haven’t fully grappled with is that Federal Reserve officials keep saying it’s not true.
Those three paragraphs are a bit misleading, but that’s partly my fault. It’s a complex and subtle topic, and I’m sure I’ve occasionally taken shortcuts in some of the things I’ve said, which left those impressions. I’ve probably said the Fed is satisfied with this crappy economy—out of sheer frustration. First a few clarifications, and then what I actually do believe:
1. In 2009 NGDP growth was clearly far below what the Fed wanted, in 2010-13 it was modestly lower than they would have wished. So the first paragraph is not really accurate.
2. The second paragraph is accurate but slightly misleading. I did get testy, and Summers did argue that fiscal stimulus would help boost employment. But what I was testy about was his other claim, that he’d favor fiscal stimulus even if monetary policy (by itself) led to on-target AD. Summers argued that the private sector would waste resources when interest rates were low, and hence the government should be more heavily involved in allocating resources. Matt Yglesias once characterized those views as “socialist”, and I made the mistake of also using that term in the post he links to. I apologized in my next post. What can I say; I pick up terminology from blogs I like. Matt’s encouraging me to talk like Rush Limbaugh.
3. I have done several posts discussing the fact that Fed officials don’t seem to believe in monetary offset. So the third paragraph is also inaccurate. But I suppose most of the discussion has been in comment sections that few people read.
Here are a few thoughts that come to mind:
1. One has to be careful interpreting the statements of Fed officials. First of all, monetary offset can sound unpatriotic if framed one way, and not doing monetary offset can sound unpatriotic if framed another way. Thus Fed officials sometimes say that that they take fiscal policy as a given, and do what’s best for the country given the stance of fiscal policy. That implies offset. They say that QE3 and forward guidance were done partly in order to offset the effects of fiscal austerity in 2013. On the other hand, if you ask Ben Bernanke “If Congress does fiscal stimulus to boost employment, will you sabotage their effort with higher interest rates?” then I’m sure he will answer no. But that’s also the answer to that question that he would give when interest rates are positive, and even Matt Yglesias agrees that monetary offset is the right model in that case. Framing effects. Now of course none of this proves there is complete monetary offset, and I’ve always acknowledged that fact. But much of the analysis of fiscal stimulus in the blogosphere, including at the highest level (i.e. Krugman) simple assumes there is no monetary offset.
2. In the 1970s Fed officials said they could not be expected to offset the inflationary effects of budget deficits. We now know those protestations were incorrect. Were they untrue at the time? Depends on your theory as to what caused the Great Inflation. But we know that when Reagan dramatically boosted the budget deficits the Fed did offset. They also offset the LBJ tax increase of 1968, which therefore failed to reduce inflation. The BOJ offset fiscal stimulus for more than a decade. They presumably denied doing so.
3. Matt also discusses a theory that I first heard from Andy Harless, that the Fed views unconventional monetary stimulus as costly, and hence fiscal stimulus might not lead to 100% offset. This is a very logical theory, and might be true. But it’s not as self-evident as one might assume. For instance, the fact that the Fed has fallen short of its goals for AD might well reflect bad forecasting. I seem to recall Yglesias pointing out that GDP growth has consistently underperformed Fed forecasts. So perhaps they tried to offset and failed. Another possibility is that the Fed would prefer not to do monetary stimulus, and favors fiscal stimulus for that reason. But that doesn’t mean they won’t act if necessary, just that they would prefer someone else deal with the complaints from the Ron Paul’s of the world. There are many occasions when I hoped someone else would do something unpleasant, but when they didn’t I went ahead and did what I thought needed to be done. Like taking out the trash.
I’ve also argued that the Fed tends to overestimate the impact of conventional policy tools (such as interest rate changes), and underestimate the impact of unconventional tools such as forward guidance. Suppose the Congress had done no stimulus in 2009. Would Bernanke have said to himself; “Oops, looks like I’m going to go down in history as the worst Fed chairman since 1930, as another depression is on the way.” Or might he have decided to do some of the things that he had earlier recommended the Japanese do, such as level targeting? I happen to think level targeting is much more powerful that the Fed itself probably believes. If they had done level targeting in 2009 to make up for a lack of fiscal stimulus, in my view the recovery would have been even faster. So more than 100% monetary offset is perfectly possible. As long as we are in the realm of irrational behavior, anything is possible. I’ll wager that if you asked the average Fed official whether the recent decision to taper would turn out to be expansionary, approximately 100% of them would have said no. But it was! That’s because they “offset” the taper with more extended forward guidance, and the forward guidance turned out to boost AD more than the taper reduced it. Stocks rose on the news.
4. At this point we are left with a few basic facts:
a. Monetary offset is the standard assumption at positive interest rates.
b. Monetary offset should be the baseline assumption when rates are zero. Alternative assumptions require explanations. They might be true, but they require Fed stupidity.
c. It’s an empirical question as to how actual, real world central banks will behave, when faced with shifts in fiscal policy.
As I look at the empirical evidence several points seem clear. First, the Fed would have done more monetary stimulus back in 2008 and 2009 if they knew then what they know now. They are perfectly willing to boost the balance sheet by many trillions. They did not do so in 2009 because they thought their earlier actions were enough. They were wrong. But if the Congress had done less the Fed would have done much more QE and much more forward guidance in 2009. Second, several Keynesians including Paul Krugman said that 2013 would be a test of monetary offset. When the results came in exactly as the market monetarist predicted, they changed their minds. There was no test. Yes, it was far from a decisive empirical test, but where are the empirical tests in the other direction? Are we to spend hundreds of billions of dollars on fiscal experiments that (by assumption) doesn’t pass conventional cost-benefit tests because there are theories out there that fiscal policy can work if the Fed officials are incompetent, and although we don’t have any empirical evidence to back that up other than public statements which may be little more than CYA, we’ll go ahead anyway? Remember that Congressmen are the lunatics and Fed officials are the “grownups” in the policymaking realm. My opponents want to base stabilization policy on a regime that ASSUMES the lunatics know better than the grownups how to stabilize the economy. How likely is that to work in the long run?
I’ve argued that estimates of the fiscal multiplier are nothing more than estimates of central bank incompetence. A point in Matt’s favor is that central banks are in fact somewhat incompetent. But to make fiscal stimulus work they have to be incompetent in a very specific and peculiar way. In the end we will never have an answer to the interesting policy counterfactuals. By the time we get there, central bank behavior will have changed, and the reaction function will be different. The Fed of 2014 is not the same as the Fed of 2008. The search for “the multiplier” is futile; it’s a chimera. Monetary offset in the purest form is also probably false, in the sense that all social science theories are false. But it seems to me to be the most useful place to begin the analysis.
And finally, my crusade for monetary offset is both positive and normative. Obviously fiscal stimulus is a moot point in the US anyway; Congress isn’t going to do any. But if I can convince other people that monetary offset is the most natural thing in the world, and also that not only is monetary stimulus not risky, but that not doing monetary stimulus can be highly risky, then monetary offset will be much more likely to be true in the future. Even if my theory is false, it should be true, and we need to make it true. We don’t do that with defeatist talk about monetary impotence that you hear from the world’s most famous blogger, rather we get there with a coalition of market monetarists and progressives like Yglesias who keep insisting the Fed can and should do more.
I suppose one can argue that it’s a mistake to mix up positive and normative analysis. But then I’m not the only one who makes this mistake. Here’s Matt Yglesias sounding very monetary offsetish:
Conventional wisdom in DC is that not only would the full expiration of the Bush tax cuts make people grumpy as they find themselves needing to pay more taxes, it would also provide the macroeconomy a job-killing dose of fiscal drag. . . . I don’t buy it.
The problem is that this chart ignores what I think we’re now going to call the Sumner Critique. In other words, it assumes that the Federal Reserve is somehow going to fail to react to any of this. You can probably construct a scenario in which the Fed is indeed caught unawares, or is paralyzed by conflicting signals, or is confused by errors in the data, or any number of other things. But Ben Bernanke knows all about the scheduled expiration of these tax cuts. . . . Maybe he and his colleagues won’t do anything to offset this drag on demand, but if they don’t as best I can tell that’s on them. This is the very essence of a predictable demand shock, and the policymakers ultimately responsible for stabilizing demand are the ones who work at the Fed.