A Time For Nuance

by: Scott Sumner

Macroeconomics is really complicated. I would consider myself a supply and demand-sider, a rational expectations and efficient markets guy, and a market monetarist.

So it's not surprising that I am often misunderstood, just as more famous bloggers like Paul Krugman are often misunderstood. When things are far out of whack, as in 2009, it's much easier to be understood. You simply need to pound the "monetary stimulus" theme with a sledgehammer. No nuance required. As the economy gets closer and closer to the natural rate of unemployment (and we are only about 6 months away), the issues get more and more complicated. Here are some things I find that I need to continually address in comment sections:

1. Real shocks matter, even when demand is a problem. If someone with cancer gets stabbed by a mugger on the way to the hospital, they have multiple problems. Which problem is worse? Well the stab wound is more acute, but the cancer is a bigger problem in the long run. A demand shortfall may be more acute, but like a stab wound is more easily treated than structural problems. When an economy has severe structural flaws, a policy of monetary stimulus will not fix the country's problems. It will just fix one of them, leaving the more severe problems in place.

2. Contrary to the recent claim of the New York Times, the definition of a recession is not 2 consecutive quarters of falling RGDP. The US had a recession in 2001, but we did not have two consecutive quarters of falling RGDP, whereas Japan may have recently seen two consecutive quarters of falling RGDP, but is not in recession. Economists look at many factors before determining whether a recession has occurred. Recessions are periods where output falls well below trend. It matters a lot whether the trend rate of RGDP growth is 7% (China) or zero percent (Japan.)

3. Monetary offset works by adjusting the long run expected rate of growth in nominal aggregates (such as inflation or NGDP) to offset the effect of fiscal actions. It is not capable of smoothing out high frequency fluctuations due to real shocks. A sudden change in government spending, sales tax rates, or a natural disaster, will affect RGDP in the near term, even if monetary policy is offsetting any effects on NGDP 12 or 24 months out in the future.

4. A failure to achieve RGDP growth and a failure to achieve NGDP growth are logically distinct events. Don't confuse them. Many economists use the wrong data when evaluating policy success. If you are making the Keynesian argument that monetary stimulus is incapable of boosting AD, you use NGDP data. If you are making the Real Business Cycle (RBC) argument that monetary stimulus will not boost output you use RGDP data. Many Keynesians seem to be oblivious to the distinction between a change in aggregate demand and a changed in the aggregate quantity demanded (caused by a supply shock.) For instance, the April 1 sales tax increase sharply depressed Japanese RGDP in Q2, leaving NGDP almost unchanged. Keynesians don't seem to realize that when they complain about slow RGDP growth in a country with high inflation (like Britain a few years back) they are making a RBC argument, which tends to discredit the Keynesian model. There are lots of ways that policy can "fail." If you don't know the right data to cite to make your point, no serious economist will pay attention to your arguments.

Furthermore, the EMH says the efficacy of policy is evaluated at the point it is announced (if a surprise) not after the fact. There is no "wait and see to ascertain whether Abenomics worked." It was obvious from the get go that it would "work" in a limited sense, but fail to achieve the announced goals. And it has. If Japan wants to boost trend RGDP growth, then they need to adopt supply-side reforms. Printing money doesn't solve that problem, especially in a country with 3.6% unemployment.

5. Rational expectations theory says that monetary policy cannot be evaluated in isolation, but rather must be considered in the context of a clearly spelled out policy regime. Admittedly, when things are clearly far off course, (as in 2009) you can assume monetary policy is too tight under any plausible policy regime. But not today. For instance, I could easily construct plausible arguments for money being either too easy or too tight:

a. Too tight: Because we are likely to hit the zero bound in the next recession, policy should be more expansionary, to promote a trend rate of NGDP growth high enough to keep us away form the zero bound.

b. Too easy. NGDP growth is likely to average a bit over 3% over the next few decades, given the Fed's inflation target. In recent years it has run a bit over 4% per year. If it keeps that up it will later have to be offset with sub-3% NGDP growth, perhaps leading to recession. Inflation should be low during booms and high during recessions. Yet Janet Yellen seems to be determined to raise inflation up to 2%, probably getting there near the peak of the business cycle.

Which do I believe? Neither. I don't know what's optimal until I'm told what sort of objective the Fed has in the long run. Tell me their long run NGDP target, and I'll tell you whether money is too easy or too tight today.

It's much better to live in a place like Switzerland where the problems are complex and the solutions are unclear, rather than North Korea where the problems are simple and the solutions are straightforward.

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