Broken Windows and Depreciation

Barry Ritholtz shows a graph that America's durable goods are getting old. That means that they will need to be replaced and when people start replacing durable goods, 'savings' decreases.  One of the many ways that people 'save' during a recession is by putting off purchases of durable goods but eventually their goods break and they finally shell out to replace them.  This is a 'natural' way for the economy to recover.  But it is just like what would happen if someone went around breaking them.  Moneybox: 

waiting for a "natural" economic recovery rather than relying on "artificial" stimulus in the form of fiscal or monetary policy is really just a slow motion version of creating economic growth via the broken windows fallacy. If five percent of America's cars, fridges, toasters, washing machines, and blenders vanished suddenly tomorrow that would be "good for the economy" in the sense that boosting orders for consumer durable goods would lead to a higher GDP growth rate. But the purpose of having an economy is to make people better off, and you clearly don't make people better off by destroying their appliances.

By the same token, even a steep recession will generally come to an end sooner or later. Cars and trucks and buildings and appliances will get old and need to be replaced, in effect raising the "natural rate of interest" and bringing intended savings and desired investment into equilibrium. But this happens by impoverishing the country, just as much as running around smashing windows would.
 

 

 

Models of Inflation

Inflation was too high in the 1970s and early 1980s because mainstream economists had a poor understanding of when inflation is beneficial and when it is harmful and of how to control it.  Today inflation is too low because mainstream economists have a poor understanding of the costs and benefits of inflation and how to control it.  In some ways, we are in the mirror image of the problems of the 1970s. 
Lowering inflation is simple.  Just restrict the money supply and communicate expectations clearly.  Raising inflation is also simple.  Just expand the money supply and communicate expectations clearly.  The important think in both cases is for the central bank to clearly communicate that it will keep doing whatever it takes to bring inflation to the approximate level that it wants.  Today it seems amazing that economists did not understand this in the 1970s and someday it will seem amazing that many prominent economists do not understand this today. 

Supply Shocks

Moneybox explains why Casey Mulligan is wrong about the current recession being due to a supply shock:

Casey Mulligan thinks the recession wasn't caused by a demand shock but is instead a "redistribution recession" caused by the fact that shifts in labor market incentives have made it less worthwhile to work. John Quiggin says we can no this is wrong by looking at the international data, since there's a curious coincidence in timing of the fall in employment in the United States, Iceland, Estonia, United Kingdom, Japan, etc. that seems hard to explain by Barack Obama's Medicaid policies.

But I think there's an easier way to tell that it's wrong, and that's by looking at the inflation data above.

Imagine we passed a law putting the top federal income tax rate up to 75 percent and lowering the threshold for the top bracket to $100,000 for a single person and $200,000 for a married couple and used the revenue to finance a progam that pays you a cash grant of $10,000 a year if you don't have a job but gives you nothing if you're employed. It's pretty obvious that a policy along these lines really would cause some affluent people to downshift their careers and would cause some low wage workers to just quit and live off a combination of the 10 grand and under the table earnings. But in response you'd also see inflation. With some affluent professionals working shorter hours or quitting their jobs to launch the cupcake factories of their dreams, the price of hiring the services of the remaining affluent professionals would be bid up. Similarly, many minimum wage employers would have to raise nominal wages to compete with the increased appeal of not working.

In other words you'd see exactly what you'd see from any other kind of supply shock—a reduction in real output (fewer willing workers) combined with an acceleration in the price level (scarcity) rather than what we actually saw (see above) which is a collapse in the price level at the exact same time as the collapse in output.

Something to recall is that although "supply-side economics" came to just be code for "let's cut taxes" there's an actual reason that phrase came into currency in the late-1970s namely that we were precisely facing a combination of high unemployment and high inflation. That high inflation was an excellent indicator that boosting demand would not be effective in boosting output. So even if you think the specific proposed supply-side remedy was cranky, it was smart to seize the "supply side" label.

But that's not the situation we've been facing.

 

Krugman expounds on this theme:

Mulligan’s ...claim that increased use of the social safety net is a cause rather than a result of the depressed economy [is wrong]. As one of his commenters points out, this amounts to the claim that soup kitchens caused the Great Depression. Quiggin [link] does an admirable job of refuting this claim. I would, however, add one more point. If you really believe that the problem is that excessive generosity to the downtrodden is reducing the incentive to work, so that what we really have is a supply problem rather than a demand problem, you should expect to see upward pressure on wages.
What we actually see:

 The textbook AS-AD model and labor supply models support the analysis that we are not in a supply shock.  In real terms, wages are declining. 


Note that the austerians and their fellow travellers (like Cochrine) have completely forgotten their ideology when it comes to analysis of the “fiscal cliff”.  This is a only problem under a purely Keynesian analysis.  The cliff is the idea that the government will suddenly almost balance its budget!  Everyone is scared that this dramatic Keynesian shock will plunge the nation into recession, but if austerians were consistent, they would be proclaiming it is exactly what is needed to restore confidence. 

Hurricanes and Broken Windows

Note that the US is not technically in a recession.  But this is more of a problem with the official definition of a recession than with the following analysis.  
Moneybox:

On the question of hurricanes and short-term macroeconomic indicators, here's how I would put it. Right now the American economy is [operating below capacity]. Recessions shouldn't happen. The planned saving behavior of firms and households ought to be balanced by the planned investment behavior of firms and households, creating a situation in which roughly all available resources are employed.

When that fails to happen—a recession—it's an indication that the interest rate is too high. A lower interest rate would, at the margin, decrease desire to save and increase desire to invest and bring the system closer to equilibrium. Cut the interest rate low enough and you've restored balance, creating a situation in which roughly all available resources are employed.

But suppose that interest rates are zero. What happens then?

Well, then you've got a recession. The recession could be cured by unorthodox monetary policy or by fiscal policy measures, but it hasn't been. So you're left hoping that the marginal product of capital will increase, thus bringing savings and investment back into equilibrium. An exciting new technological discovery could make that happen. And so could a hurricane. If there are already a bunch of perfectly good cranes in town, then nobody wants to invest in new cranes, and the crane factory sits idle. But if a hurricane wrecks a bunch of cranes, then the marginal value of a new hurricane goes up, and people want to invest in new cranes.

Now before everyone starts screaming "broken windows fallacy," take note: This is a terrible solution to unemployment. By reducing society's stock of capital goods and consumer durables, the hurricane spurs new production into being. But it's also making us poorer.

The point I want to make about this isn't that hurricanes are "good for the economy." The important point is that suffering through a downturn without adequate fiscal and monetary stimulus amounts to rebalancing the economy through a slow-motion hurricane. We will, eventually, return to full employment. But we're getting there by allowing the per capita stock of capital goods (as it happens, mostly houses) and durables to deteriorate year after year. Eventually this will lead us to a rebalancing, but it's a form of rebalancing via impoverishment. Stimulus is much better.

Fiscal Multipliers

Moneybox summarizes an IMF report:

Kate Mackenzie at FT Alphaville gives us the latest from International Monetary Fund chief economist Olivier Blanchard who wrote a little box in the latest IMF World Economic Outlook report arguing that fiscal austerity has been more damaging than the pre-crisis consensus in the economics profession would have suggested. Here's Blanchard:

The main finding, based on data for 28 economies, is that the multipliers used in generating growth forecasts have been systematically too low since the start of the Great Recession, by 0.4 to 1.2, depending on the forecast source and the specifics of the estimation approach. Informal evidence suggests that the multipliers implicitly used to generate these forecasts are about 0.5. So actual multipliers may be higher, in the range of 0.9 to 1.7.

This is part of an ongoing transformation at the IMF over the past decade to becoming a major international opponent of the kind of harsh austerity regimes that the IMF was known for in the mid-to-late 1990s.
The research issue here is that, methodologically speaking, it's difficult to know what "the" fiscal policy multiplier is supposed to be. A lot of good research has been done on the macroeconomic impact of deficit financed military spending. But such spending isn't meant to stimulate a depressed economy and in fact is often paired with monetary policy or other measures specifically designed to strangle domestic consumption (wage and price controls, rationing) and prevent total economy-wide spending from expanding. A country with a depressed economy and a central bank that wants to see total economy-wide spending go up but isn't willing to forcefully deploy tools beyond interest rates to make that happen can see a much bigger fiscal impact. Conversely, a country whose fiscal authorities are trying to paddle upstream in the face of a central bank that wants less demand and less inflation isn't going to get anywhere.
Back to Mackenzie, the bottom line is that we need less budget cutting from countries that have cheap borrowing costs:

And the IMF is urging that countries who have ‘room to maneuvre’ such as the UK, France and the Netherlands, should “smooth their planned adjustment over 2013 and beyond” if growth falls significantly below the IMF’s increasingly gloomy forecasts.

Now what it makes the most sense to do depends on circumstances. In Germany where unemployment is very low already and public services are quite good, it seems like a VAT cut to let Germans enjoy higher living standards (and perhaps buy more goods from southern Europe) would be ideal. In the US we should be avoiding a disastrous payroll tax hike and probably creating slush funds for our budget-strapped state and local governments.

If The Fed Could Not Raise Inflation

Moneybox:

John Cochrane has become well known in recent years for his conservative political views, but the opinion he expresses in today's NYT forum about inflation is strangely widespread across ideological lines. He says that not only would it be unwise for the Federal Reserve to try to create inflation, it would be impossible as well:

The fact is, the Fed is basically powerless to create more inflation right now -- or to do anything about growth. Interest rates can't go below zero, and buying one kind of bond while selling another has minuscule effects.

I've heard this from economists like Jamie Galbraith on the left and Lawrence Summers in the middle as well, and I don't buy it at all. The problem is that there's a huge logical gap between the sentences. It is true that those particular things don't create much inflation. But what if the Fed did other things? For example, consider the "minuscule effects" of quantitative easing. Those aren't zero effects. In fact, inflation expectations have risen when the Fed has announced rounds of easing.

Have they risen a lot? No. Presumably because the Fed doesn't want them to rise a lot. But suppose the Fed announced a big new round of Quantitative Easing and said "the purpose of this bond buying is to raise inflation expectations above 3 percent"? Suppose they said "the purpose of this bond buying is to raise inflation expectations above 3 percent and we'll keep on buying bonds until it happens?"

I think that small tweak in strategy gets you from "miniscule effects" to bigger effects. The issue is that the Fed gets what it wants. If it wants to raise inflation expectations a little, it gets a small effect. If it wants a bigger effect it needs to communicate that fact, and it'll get the effect.

The other way to look at it is not in terms of a policy recommendation, but it terms of what might be possible if the Cochrane viewpoint were correct. The Fed could, on that view, simply buy all the outstanding debt in the country and then tear it all up. Wouldn't that be a bonanza? Yes it would be "unfair" since the highly indebted would benefit more than the prudent. But virtually everyone has at least some debt or owns shares in companies that have debt, and absolutely everyone is implicitly responsible for different forms of public sector debt. And we're not talking about a Universal Jubilee at the expense of creditors here. Every creditor would be paid in full by the Federal Reserve, and every debtor would receive complete relief from debts. Wouldn't that be lovely? But of course it's a fantasy. If you did that there would be tons be inflation.

So I'm not saying we should do that. What I'm saying instead is that Cochrane is wrong. But what I'm saying more broadly is that if you do think the Fed can't create inflation, that's a view with some wild implications for the world beyond boring monetary policy conversations.

Sticky Wages - Unemployment & Recessions

Sticky wages = downward nominal wage rigidity. This creates the market failure of unemployment. Classical economists (and RBC-theorists) thought that if wages fell during a recession, then there would not be any unemployment because this is what a simple labor supply and demand graph shows.  It would cure unemployment, but it would do nothing to cure the recession; it would just spread the wealth around.  A better solution would cure the recession AND reduce unemployment.  Lowering wages would cure unemployment, but it would make the recession worse by lowering the incomes of most people which would create even more bankruptcies and money hoarding.  It is extremely hard to lower nominal wages, but you can solve the unemployment problem by lowering real wages which is much easier. If you want to lower real wages, the best way to accomplish that is through monetary policy.  There are two good options:
1.  Currency devaluation effectively lowers wages compared with the rest of the world.  This is a targeted inflation which raises the prices of all foreign goods (lowers the prices of domestic goods for export) and thereby increases demand for exports. 
2. General inflation also works to lower real wages (IF there is a recession) and it also lowers real interest rates which solves the problem of hoarding money, underinvestment, and excessive debt. 
Krugman comments:

I keep running into comments along the lines of “Well, if you think sticky wages are the problem, why aren’t you calling for wage cuts?”
This is a category error. It confuses the question “What do we need to make sense of what we see?” with the question “What is the problem?” So let me talk about that.
When Keynes argued against the “classical economists”, he was to a large degree arguing against the view that there is no such thing as involuntary unemployment — a view often defended, then and now, by an appeal to the usual logic of supply and demand. If we’re looking at the market for, say, wheat, and there’s an excess supply — sellers want to sell more than buyers want to buy — we expect to see the price fall rapidly to clear the market. So if there were really a large excess supply of labor, shouldn’t we be seeing wages plummeting?
And the answer is no — wages (and many prices) don’t behave like that. It’s an interesting question why, one that has to be answered in terms of psychology and sociology, but it’s simply a fact that actual cuts in nominal wages happen only rarely and under great pressure. So wage stickiness is an essential part of a demand-side story about what’s going on with the economy; it’s how you answer the question of why wages aren’t falling.
But that’s not at all the same thing as saying that excessive wages are the problem. ...[W]e are in a liquidity trap, and balance sheet effects [bankruptcy and household debt] are very important. So there is no reason to believe that cutting wages would be helpful; on the contrary, falling wages would worsen the balance-sheet problem, a point some of us have been making for quite a while.
So when I emphasize nominal wage rigidity, I am defending an analysis of how the economy works, which is not at all the same thing as saying that this rigidity is the problem. On the contrary, for the US (though not for countries like Spain), wage stickiness is if anything good for us right now, helping stave off destructive deflation.

a sovereign debt crisis?

In Greece, Italy, and Spain there is a problem, but the market is charging less and less to loan other rich governments money:

IMF: Balance-Sheet Recessions

The IMF has been famous for imposing austerity upon economies in economic crises in the past two decades.  RortyBomb says, "One has good reason to dread hearing the policies the IMF recommends for a country in a crisis. Maximal labor "flexiblity"? Cat food for old people? Picking government functions out of a hat to privatize?"  IMF privatization, deregulation, and austerity policies didn't work out too well in the Asian and  Latin American financial crises so the IMF has completely reversed their thinking for dealing with the present recession. 
RortyBomb summarizes their latest report:
"1. A run-up in household debt and leverage explains the economic collapse across countries."
 This means a balance-sheet recession.  That is where consumers increase their debt to savers (the elites and elderly) and then they try to pay it down which reduces consumption because the savers don't spend more just because the borrowers are spending less.  
"2. Financial crises are not a driver of prolongued recessions. If anything they are a symptom."
The recession caused the financial crises: 
recession+debt -> financial crisis
not  
financial crisis -> recession & debt 
"4. Foreclosures are a problem."  
It is amazing that most economists have ignored this part of the problem of this financial crisis.  The slow foreclosure process destroys housing value and suppresses home values which makes indebted homeowners feel poor and spend less.   
"5. Demand demand-side stimulus. Across the board. Now."

Temporary macroeconomic policy stimulus...simulations of policy models developed at six policy institutions suggest that, in the current environment, a temporary (two-year) transfer of 1 percent of GDP to financially constrained households would raise GDP by 1.3 percent and 1.1 percent in the United States and the European Union, respectively...Monetary stimulus can also provide relief to indebted households by easing the debt service burden...A social safety net can automatically provide targeted transfers to households with distressed balance sheets and a high marginal propensity to consume, without the need for additional policy deliberation...

Support for household debt restructuring: Finally, the government may choose to tackle the problem of household debt directly by setting up frameworks for voluntary out-of-court household debt restructuring—including write-downs—or by initiating government-sponsored debt restructuring programs. Such programs can help restore the ability of borrowers to service their debt, thus preventing the contractionary effects of unnecessary foreclosures and excessive asset price declines.

Two Articles On Inequality and One Defending RBC

First, Galbraith makes the old Keynsian argument that inequality makes the economy unstable.  Note that this is not a particularly mainstream Keynesian view and, for example, Krugman does not buy it. Interestingly, although Raghuram Rajan comes from the other end of the political spectrum from Galbraith, he seems to agree for somewhat different reasons. 
Another article is about Edward Conard who just wrote a book claiming that inequality is the best thing ever and that we need more inequality in the US.  He is a really rich Wall Street guy who seems like a character out of Margin Call, but he got a bunch of book endorsements from smart people, and he has some interesting things to say. 
The last article is a rare defense of RBC in the popular media. I almost never see a defender of RBC attempt to explain it to lay people because it does not make any sense, so this is a gem.  The author argues that fluctuations in technology (including the weather as a kind of technology) cause recessions by making the economy less productive during recessions when the technology (weather) turns bad. Thus the 2008 recession happened because we suddenly became less productive.  RBC does a great job of describing recessions in primitive agricultural economies where the weather really does mostly determine output because bad weather really does make agruculture less productive, but weather is a poor analogy for technology.  How could there be a great forgetting of productive technology that works  like a massive drought and makes us less productive than we were a year before?    RBC is vague on the specific cause of any recessions and does nothing to explain the housing bubble. RBC theorists never specify what specific technology decline (or adverse weather) caused the 2008 recession.  Instead, they often resort to vague mentions of 'confidence' which is an area that Keynesians have actually studied extensively as Cassidy discusses in his book, How Markets Fail.
Even though I disagree with each of the three articles, each author is smart in his own way and there are grains of truth in each argument:

1. Gailbraith: Inequality of borrowing is part of the core Keynesian story.  During a recession, some people have too much money and are not spending it and others have too little and cannot spend it and so there is a shortage of spending.  Inequality can contribute to economic instability via political channels if nothing else.  Highly inequal societies usually have poor economic growth. 
2. Conard: Too little material inequality can also be a problem as in the case of Cuba and North Korea. On the other hand, you can argue that these countries are not very equal in a more important dimension than market goods.  They have extremely high political inequality because the political elites have absolute power whereas everyone else has less political power than an impoverished voter in a democracy. 
3. RBC Guy:  It works well for explaining recessions in ancient Greece, Robinson Caruso, and to a lesser extent during the 1970s oil shocks. 

SR vs. LR Unemployment and Economic Growth

Moneybox:

Short business cycle downturns like the ones the United States had in the 1950s and 1960s shouldn't have any real long-term consequences even if they're severe. But prolonged spells of mass unemployment provoke things like the current trend of European employers reducing investment in skills training since if there's going to be a surplus of potential workers and a deficit of potential customers, high-investment firms are going to lose out unless they hit incredible home runs.

The same logic should apply to "hard" capital investments as well. When I was in Paris last fall, I was interested to see that Parisian McDonaldses have computer kiosks where customers can place orders without taking up the time of a human cashier. Rival fast food chains like KFC and Quick didn't yet seem to be using this technology and McDonalds was only employing it to a limited extent. If France was facing a high-demand tight labor market scenario for the future presumably McDonalds would double-down on this bet and rivals would either match their productivity-enhancing capital investments or else be displaced by McDonaldses high productivity model. But instead France has had, and looks scheduled to continue to have, a long period of depressed demand and elevated unemployment. Firms have little reason to spend money insuring themselves against workers quitting in search of higher wages and little reason to believe that increased output will actually be purchased.

NGDP targeting is better than inflation targeting.

Most central banks currently have inflation targets (which perversely seem to keep ratcheting downward).  NGDP targeting is better than inflation targeting. Why? Moneybox:

Immunity to the "zero lower bound" problem is one reason, but the more important reason is that an NGDP targeting central bank would respond better to supply shocks than would an inflation targeting central bank. Consider, for example, the possibility that a terrorist attack in Kuwait disrupts world oil supplies. This is going to contract aggregate demand in the United States because as oil gets suddenly more expensive, the dollar value of our imports from non-disrupted countries will soar but those countries aren't going to immediately start importing more foreign goods in response. But the more expensive oil is also going to push the price level way up. Inflation targeting tempts the central bank to respond to this surge in inflation with tighter money even as the economy is being rocked by a fall in demand. An NGDP targeting central bank, by contrast, is able to say "steady as she goes." For the duration of the negative supply shock the country will experience an unusually large amount of inlation and an unusually small amount of real growth, which will suck, but the suckiness won't be compounded by tight money regime. Conversely, an NGDP targeting central bank will simply take a positive supply shock as welcome news. Real growth rises and inflation falls leading to a nice pleasant span of unusually rapid real wage growth. Everyone applauds. An inflation targeting central bank, by contrast, is going to greet the good news with a weird kind of panic as if improved technology or a natural resource boom is some kind of deflationary crisis.

Oil Prices and Recessions

Kevin Drum:

Jim Hamilton, an economist at UC San Diego who has done extensive work on the economics of oil spikes, has just published a summary of the current state of oil macroeconomics called "Oil Prices, Exhaustible Resources, and Economic Growth." His conclusion: "The historical record surely dictates that we take seriously the possibility that the world could soon reach a point from which a continuous decline in the annual flow rate of production could not be avoided."
Translation: peak oil might not be far away, and we should take it pretty seriously. And Hamilton's research suggests strongly that when peak oil does arrive, it's not going to be pretty:

Coping with a final peak in world oil production could look pretty similar to what we observed as the economy adapted to the production plateau encountered over 2005-2009. That experience appeared to have much in common with previous historical episodes that resulted from temporary geopolitical conflict, being associated with significant declines in employment and output. If the future decades look like the last 5 years, we are in for a rough time.
Most economists view the economic growth of the last century and a half as being fueled by ongoing technological progress. Without question, that progress has been most impressive. But there may also have been an important component of luck in terms of finding and exploiting a resource that was extremely valuable and useful but ultimately finite and exhaustible. It is not clear how easy it will be to adapt to the end of that era of good fortune.

"Pretty similar" to 2005-09 means a big spike in oil prices that causes a big recession. The chart on the right shows what he means. The green line shows expected economic growth. The dashed line shows the Great Recession. And the red line? That's his estimate of the effect of the huge spike in oil prices in 2007-08. If Hamilton is right, then the oil spike is responsible for about two-thirds of the Great Recession all by itself. The housing and credit bubbles are only responsible for a fairly small piece of it.
But even if Hamilton is wrong about the precise trajectory of the 2008 meltdown, the evidence is now clear that oil spikes have a very significant effect on the economy. And as the production of oil starts to plateau, oil prices are going to spike a lot. In fact, they're likely to spike every time the global economy starts to grow.

New Monetarism vs. Friedman vs. Hayek vs. Keynes

Here is some intellectual history by a conservative economist who greatly admires Hayek and even thinks that Hayek's macroeconomic theories have some merit even if they are weaker than many others.  I predict/hope that this is a sign of where a new macroeconomic consensus may be heading.  Conservative economists are promoting NGDP targeting and liberals have no problem with it even though many would also like more government spending during a liquidity-trap recession.  The thing that surprised me the most during the 2008 recession is how little conservative economists promoted tax cuts as a fiscal stimulus like they did in the 2001 and 1990 recessions.   David Glasner:

First, it was the Keynes v. Hayek rap video, and then came the even more vulgar and tasteless Keynes v. Hayek sequel video reducing the two hyperintellectuals to prize fighters.

See the rest at Medianism.org

IS-LM

Brad Delong has an excellent summary of Keynesian Macro:

The Changing Multiplier Since 1925...

The largest shifts in economists’s views of what the value of the multiplier is over the last eighty or so years have been the result not of changing views about the structure of demand, but rather of changing views about the conduct of monetary policy.
The IS-LM framework remains the best way to summarize the issues. (See David Romer (2012), Short Run Fluctuations.) With the long-term risky real interest rates on the vertical axis and the level of real GDP on the horizontal axis, the IS curve summarizes the flow-of-funds through financial markets equilibrium condition--or, if you prefer, the representative agent's Euler equation (for they are the same thing, or rather the second is a very special representative-agent version of the general theory that is the first). But that by itself does not pin down the economy's path. Another condition is needed, a monetary policy condition.
Decompose the long-term real risky interest rate that you need for the flow-of-funds equilibrium condition into four pieces: a risk premium; a term premium; an inflation component; and the short term safe nominal interest rate that comes out of the money market, and equilibrates money supply to money demand.
In the years since Hicks laid out this framework in 1937, the economy has transitted through five different monetary policy regimes.
In not historical but rather logical logical sequence:
First in logical order is monetary dominance: the monetary authority has a view of what level of real spending right now is consistent with its long-run inflation target, and it pushes the money stock wherever it needs to in order to hit that target. Real GDP will be set by the monetary authority as a function of inflation and perhaps other variables according to its monetary policy rule.
On the IS-LM diagram under this monetary policy régime, the counterpart curve to the IS curve is not an LM curve but rather an MP curve, a monetary policy curve. And this monetary policy curve is vertical. Under such a monetary policy regime, the multiplier μ is zero. Whatever effect expansionary fiscal policy has on the IS curve will show up 100% as a change in interest rates and 0% as a change in output levels. This was the monetary policy regime that the Clinton administration believed it was operating under when it proposed a substantial deficit-reduction package in the late winter of 1993, even though the unemployment rate was less than a year past its recession peak.
Figure 3A.1: Monetary Dominance: μ=0

Second in logical order is the Friedman rule: the monetary authority has a smoothly growing target for the money stock, and it takes steps to hit that target. If the Friedman rule is credible, expectations of inflation will not vary: shifts in the inflation premium will not tilt what is now an LM curve up or down on the IS-LM diagram as real GDP increases or decreases. However, under the Friedman rule the LM curve is not vertical: it has a positive slope. Higher nominal interest rates raise the velocity of money. A more prosperous economy makes bankruptcy less likely and reduces the risk premium. In this monetary policy regime, the government purchases multiplier exists: μ is not zero. However, μ is likely to be small because of the likelihood of substantial interest-rate, and perhaps price-level crowding out. How much crowding-out there would be was the subject of debate between Tobin and Friedman, with Tobin stating that it was an empirical issue, and Friedman claiming the multiplier was too small to matter unless the interest elasticity of money demand was near infinity.
Figure 3A.2: Friedman Rule: μ Small
 Third in logical sequence comes the gold standard: the monetary base is fixed but the money supply is elastic because banks respond to higher demand for loans and deposits by taking more risks. A Friedman rule central-bank is not passive: it is strongly leaning against the wind, cutting the monetary base in the boom and increasing the monetary base in the slump. A gold standard central bank is almost an oxymoron: if it is actively managing the monetary base, it is not really a gold standard anymore. Under a true gold standard the LM curve is no longer quite an LM curve—although it is also not right to call it an MP curve either. Whatever it is, the fact of an elastic money supply makes it even flatter than the Friedman-rule LM curve.
Figure 3A.3: Gold Standard: μ Moderate

Fourth in logical sequence is a central bank that targets the real rate of interest: call this the “constant monetary conditions” multiplier. This is the multiplier that would be estimated by cross-state fiscal-policy regressions in the United States, or cross-country fiscal-policy regressions in a monetary union, were there neither demand spillovers nor cross-jurisdiction factor mobility to bias the estimated coefficient one way or another.
Figure 3A.4: Real Interest Rate Targeting: μ Larger Still
 Note that a monetary authority that targets the real rate of interest is likely to be pursuing a policy in which nominal interest rates are rather strongly procyclical. Inflation will surely rise with higher levels of real GDP. Risk spreads are likely to fall as well. Both of these must be compensated for by rising nominal interest rates if the monetary authority is truly going to pursue a policy that keeps the real interest rate constant. The multiplier μ under such a monetary policy rule is likely to be rather large: there is neither investment-based nor export-based interest-rate crowding out, since the purpose of the policy is to ensure that the interest rate does not move.
Fifth and last in logical sequence is when the monetary authority finds itself in a liquidity trap, at the zero-nominal interest rate lower bound. In this case the MP monetary policy curve slopes not upward but downward. As output increases and as expectations of inflation rise, the short-term safe real interest rate declines. An economy with higher output is one with fewer bankruptcies and lower risk premia: spreads fall as well, and the short-term real risky interest rate declines even more along this MP curve.
Figure 3A.5: Zero Lower Bound: μ Large 
Under all the other monetary policy régimes the monetary authority could, if it thought wise, shift the MP or LM curve to provide further monetary expansion. Under monetary dominance it would simply change its near-future real GDP target. Under the Friedman rule it would boost the money stock growth rate. Under a gold standard it could sell some of its own gold holdings or change the gold parity. Under a constant real interest rate régime it could change the target real interest rate.
But at the zero nominal lower bound the monetary authority’s available tools are much weaker, and active monetary policy seems likely to be of limited effectiveness. The monetary authority can promise higher inflation in the future—but how is it to make that promise effective and credible, especially in a political and technocratic environment averse to even moderate inflation? Quantitative easing to boost the money stock can always be reversed if the assets purchased by the monetary authority as it issues more cash are traded in thick markets. And if the monetary authority issues cash and wishes to demonstrate that the transaction will not be unwound by using the cash to purchase assets that cannot easily be sold off —bridges, highway interchanges, and the human capital of twelve-year-olds, for example—that looks a lot more like fiscal than monetary policy, albeit a fiscal policy conducted by the monetary authority.
The monetary authority can attempt to reduce risk and duration premia directly by taking default and duration risk onto its own balance sheet, but portfolio balance considerations suggest that the power of such non-standard monetary policy tools is likely to be small.
The flip side of the likely limited power of change in the monetary authority’s policy rule at the zero nominal lower bound is that the fiscal policy multiplier μ appears likely to be at its largest. The fact that the monetary policy régime produces an MP curve that slopes “the wrong way” means that equilibrium levels are fragile in the sense that small shocks can cause the economy to jump a long way—in either direction.

Macroeconomics and Political Ideology

The left -- right (progressive -- conservative) political spectrum still shows some divisions among  macroeconomic theorists. 

On the Right, the macroeconomists involved in government policy and business forecasting are almost all Keynesians, but they tend favor tax-cuts over government spending and their spending priorities are different from those of the Left:
Keynesian: Conservative Keynesians have dominated economic policy for almost every Republican president and Republican candidate (post primary).  They have tended to focus on cutting taxes as an economic stimulus rather than on raising spending.  For example, both McCain's chief economic adviser, (Doug Holtz-Eakin) and Romney's (Glenn Hubbard) are Keynesians.  Everyone I recognize on the list of past presidential economic advisors are Keynesians too going back to at least the Ford administration.  Conservative Keynesians tend to favor government spending for different priorities than progressives.  For example, they are a bit more likely to promote military spending as a stimulus, but military Keynesianism is also fairly popular on the Left.  The American Conservative Magazine wrote that, "An astonishing number of the Republicans’ most cherished economic thinkers can be called Keynesians." 

What is a conservative Keynesian? While there may not be a formal definition—mainstream Keynesianism has many nuanced variations—it is fair to say that a conservative Keynesian 1.) looks at the world in terms of macroeconomic aggregates, that is, total output, total employment, and most especially aggregate demand; 2.) sees government fiscal policy as a way to improve those aggregates; and 3.) embraces or at least tolerates deficit spending and inflation in the short run. That much is pretty close to standard Keynesianism. What makes one a Keynesian of the Right is a preference for tax cuts over government spending, although the intention is the same: to put money into the hands of consumers as a way to increase aggregate demand during recessions.

Monetarism:  This school was based on Milton Friedman's ideas in the 1970s.  It substantially ceased to exist as a separate school by the 1990s because Friedman won and his ideas merged with Keynesianism.  The main effect has been to put greater priority upon monetary policy than fiscal policy both for fighting recessions and especially for reducing inflation.  Ironically, Friedman drew upon some of Keynes' monetary ideas that Keynes' intellectual followers had been ignoring.  Some libertarians on the right like to portray Keynesian economics as 'central planning' in which fiscal policy is 'socialism'.  They see monetarism as a free-market alternative.  Milton Friedman had this leaning although I don't think he ever said it so bluntly.  But monetarism is also a form of central planning in which the government planners at the central bank adjust the most fundamental price in the economy, the price of money, to fine tune the economy.  They fine-tune interest rates and inflation in order to stabilize unemployment and economic growth.  Fiscal policy seems to be more politically contentious, but monetary policy is also a kind of central planning. 
Real Business Cycle (RBC):  Also known as the "new classical school", freshwater economics, liquidationists, etc.  RBC scholars tend to be libertarians who believe that recessions are natural and inevitable and that government policy changes can only make them worse. 
Austrian Business Cycle:  This theory is "now rarely discussed by mainstream economists, but was more actively debated" before the end of the Great Depression.  Even Hayek gave up on working on it by the end of the Depression.  At the PhD level, the last university in the world that still focused on the Austrian theories was Auburn University, but it was disbanded in 1999 and they never had anyone who taught macroeconomics! The Austrians rejected the RBC mathematical methods, but they agreed with the conclusions of the RBC theorists.  They think that recessions are naturally the best of all possible worlds and nothing can or should be done to try to lessen them. 
Austerians: A term of derision for Austrian and RBC economists who think that the government should fight the recession through the opposite of Keynesian (and monetarist) policies.  Austerity is reducing deficits and the money supply.  Austerians think that the recession is being prolonged because people have lost confidence in the government (worries about government inability to pay back debt) and in our money (worries about inflation). Only a small percentage of economists are Austerians, but this ideology has wide populist appeal outside of the economics profession.  Some of the leaders of elite institutions like the European Central Bank, the Bank of International Settlement, and the OECD are Austerians. 

Left:
Keynesian:   The main schools are the new-Keynsians and the old-Keynesians (or neoclassical Keynesians), but both are more favorably predisposed to government spending than conservative Keynesians who are more likely to favor tax cuts as an economic stimulus.  There are a lot of sub-categories of Keynesians on the left, but their policies are all broadly similar:

Neo-Keynesian, Old-Keynesian, or Neoclassical Keynesian:  This was mainstream macroeconomics from 1936-1980.  It is based on Hicks' IS-LM model and the Phillips curve. 
New-Keynesian: Use the same mathematical modelling techniques as RBC, but add 'frictions' like sticky prices to get very similar results as the old Keynesians. They just use different methods to come to very similar conclusions. 
Post-Keynesians: They claim to be very close to the Keynes' original ideas which they say were warped by the neoclassical Keynesians.  
Monetarist:  Friedman won the intellectual debates over the role of monetary policy and almost all economists on the left embrace monetarist solutions as the primary tool for macroeconomic management and they also support fiscal (Keynesian) measures as well.  In Keynes himself supported monetary stimulus.

Agnostic-Apathetic School:  There are a few economists on the left who simply have little opinion about macroeconomic debates because they did not study recessions in graduate school.   They either focused on  microeconomics or they believed that recessions are not important in comparison with  studying economic growth, international trade, or finance.  I would put Jeffrey Sachs in this camp.  He is a brilliant development economist who keeps saying stupid things about the recession because he clearly has not put much thought into it.  His priorities simply lie elsewhere.  Unfortunately,  Obama has economic advisers who are in this camp.  They went along with calls for austerity because they thought it was politically popular and they did not prioritize fighting unemployment.  The big divide on the left is between Keynesian-monetarist economists and the apathetic economists. 

Today the three main macroeconomic schools of thought to know are:

1. Keyensians
2. Monetarists
3. Real Business Cycle (New Classical)

The monetarists and Keynesians have very similar ideas and make similar predictions about the world.  The big ideological divide in macroeconomics is between them and the RBC economists who make radically different predictions and think that the government cannot do anything to reduce recessions.  The monetarist-Keynesian ideological divide is mostly one of priority.  Economists who call themselves Keynesians put more priority on fiscal stimulus and think that works better.  Economists who call themselves monetarists put more priority on monetary stimulus and think that works better.  A few Keynesians think that monetary policy does not work at all in some situations and a few Monetarists think that fiscal policy does not work at all in some situations but most mainstream Keynesians endorse monetarism and vice versa.

Although RBC is important in some prominent graduate schools, almost all the undergraduate Macro textbooks ignore it in favor of the Keynesian-monetarist synthesis.  Personally, I am both a monetarist and Keynesian.  I think they are two great tastes that go great together.  Massive unemployment and idle capital is a waste and a tragedy and we should use all available tools to reduce the tragic waste of unemployed labor and capital.

NGDP

Real Time Economics:

This helps explain why nominal gross domestic product — that is, total GDP without inflation stripped out – has wound up at the center of a debate over how, and whether, the Federal Reserve can do more to stimulate the U.S. economy and lower the nation’s current 9.1% unemployment rate.
The problem boils down to the Fed’s current dual – or in fact, triple – mandate from Congress. Here is the entire wording of the Fed’s mandate, which falls under Section 2A of the Federal Reserve Act.

The Board of Governors of the Federal Reserve System and the Federal Open Market Committee shall maintain long run growth of the monetary and credit aggregates commensurate with the economy’s long run potential to increase production, so as to promote effectively the goals of maximum employment, stable prices, and moderate long-term interest rates.

It is this last part which is at the heart of today’s policy debate. In theory, and in the long run, it should be consistent for the Fed to conduct monetary policy in a way that promotes a healthy economy marked by maximum employment, stable prices, and moderate long-term interest rates. But that is little help at a time like now, when the Fed is roughly meeting the latter two objectives but falling well short on the first; that is, on reaching anything close to “maximum” or full employment, typically defined as something like an unemployment rate of 5% (though many think today, for various reasons including demographic ones, this rate is now closer to 7%). ...
The beauty of the NGDP target, as proponents see it, is that it doesn’t differentiate between inflation and real GDP. So it doesn’t matter whether the gap is closed by three parts inflation and one part real GDP or one part inflation and three parts real GDP. The point is that the gap gets closed, because the Fed is able to be as aggressive as it needs to be, and the economy avoids a prolonged slump and chronically high unemployment a la the Great Depression. And by targeting NGDP, or a stated goal for the total size of the economy, instead of a 3% or 5% inflation rate, the Fed is better able to avoid the backlash that might otherwise undermine its ability to achieve said objective.
But would this really work? Now that NGDP is getting serious attention, this question becomes all the more important. Below, a (very abbreviated) round-up of the debate. Best to get up to speed as much as possible now, as it is only likely to gain momentum from here.
Further reading on NGDP targeting:
–Scott Sumner’s work.
–The Goldman note.
–Karl Smith, “NGDP Targeting in Real Life”
–Interfluidity: “The Moral Case for NGDP Targeting” (with links to many others, including Paul Krugman and Brad DeLong, on this issue)
–Bill Woolsey, emphasizing the monetarist position that underlies an NGDP target.
–Heard on the Street: Inflated Expectations for Economic Fix (and Sumner’s response here.)
–Free Exchange: Understanding NGDP Targeting

The moral case for NGDP targeting

The last few weeks have seen high-profile endorsements of having the Federal Reserve target a nominal GDP path. (See Paul Krugman, Brad DeLong, Jan Hatzius and colleagues at Goldman Sachs.) This is a huge victory for the “market monetarists”, a group that includes Scott Sumner, Nick Rowe, David Beckworth, Josh Hendrickson, Bill Woolsey, Marcus Nunes, Niklas Blanchard, David Glasner, Kantoos, and Lars Christensen....
Here I want to join the market monetarists’ happy dance, and point out several moral benefits of NGDP targeting.

• The most plain moral benefit of NGDP targeting is that it is activist. Relative to the status quo, it demands a serious effort to combat the miseries of depression. This is a big improvement over our current strategy, which is to shrug off and rationalize mass deprivation and idleness.
• A second moral benefit is that under (successful) NGDP targeting, any depressions that occur will be inflationary depressions. Ideally, we’ll find that once we stabilize the path of NGDP, the business cycle is conquered and there will be no more depressions ever again. But that probably won’t happen. If depressions occur even while the NGDP path is stabilized, then they will reflect some failure of supply or technology. Our aggregate investment choices will have proved misguided, or we will have encountered insuperable obstacles to carrying wealth forward in time. It is creditors, not debtors, whom we must hold accountable for patterns of aggregate investment. There always have been and always will be foolish or predatory borrowers willing to accept loans that they will not repay. We rely upon discriminating creditors to ensure that funds and resources will be placed in hands that will use them well. Creditors allocate capital by selecting the worthy from innumerable unworthy petitioners. An economic downturn reflects a failure of selection by creditors as a group. It is essential, if we want the high-quality real investment in good times, that creditors bear losses when they allocate funds poorly. When creditors in aggregate have misjudged, we must have some means of imposing losses without the logistical hell of endless bankruptcies. Our least disruptive means of doing so is via inflation....
  In fact, NGDP targeting, despite the stench of sugar-high money games that Austrians perceive in it, might actually increase our ability to impose losses on foolish creditors via default and bankruptcy. This would pay a huge moral dividend, in terms of our ability to avoid the unfairness of arbitrary bail-outs. Both Nick Rowe and Scott Sumner have suggested to me that if we had sufficiently aggressive monetary stabilization, we could avoid acquiescing to “emergency” rescues that flamboyantly reward bad actors, because allowing bad actors to collapse would no longer threaten the rest of us. Rajiv Sethi has made a similar point:
  

  The main justification for these extraordinary measures in support of the financial sector was that perfectly solvent firms in the non-financial sector would have been crippled by the freezing of the commercial paper market. But as Dean Baker has consistently argued, had the Fed’s intervention in the commercial paper market been more timely and vigorous, it might been unnecessary to provide unconditional transfers to insolvent financial intermediaries....

   In constrast to an inflation-targeting central bank, an NGDP-targeting central bank need not distort the division of income between capital and labor. Under current practice, the Fed tends to encourage asset price inflation but worries frenetically over any growth in unit labor costs, or, equivalently, labor’s share of income. Labor share of income has been collapsing since about 1970.

How Recessions End

Recessions eventually end without government intervention, but it is likely to take a lot longer to happen.  Before Keynes, most classical economists thought that recessions were natural, inevitable, and even a good thing.  After a decade of the Great Depression in his cushy Harvard job, Austrian-educated economist Joseph Schumpeter said in 1939:

Commonly, prosperity is associated with social well-being, and recession with a falling standard of life. In our picture they are not, and there is even an implication to the contrary.  

In other words, Schumpeter thought that recessions may be associated with social well-being and economic expansions with a falling standard of living!  He explained that this is because:

…Times of innovation…are times of effort and sacrifice, of work for the future, while the harvest comes after.…The harvest is gathered under recessive symptoms and with more anxiety than rejoicing.…[During] recession…much dead wood disappears.  BC, 142-143.

So recessions are good because they are like a harvest festival when productive people can enjoy thanksgiving for their leisure as they enjoy their past “effort and sacrifice” and unproductive (people? capital? businesses?) are “dead wood” that must be pruned at during recession!  That is a really bad metaphor.  Similarly, Hayek thought that a fiscal or monetary stimulus could only make a recession worse and that they must end of their own accord without any effort to ameliorate them.   

How Recessions End:

1. Government monetary or fiscal stimulus makes markets clear.
2. Increase in ROI of new capital increases investment. 
1. Depreciation of old capital stock increases ROI of new capital:
• Keynes explained that capital decays and becomes obsolete over time until it becomes scarce enough to make replacement highly profitable. 
• Consumer durables also depreciate.  The US automobile fleet is older than ever and the number of housing units per capita has not been this low in many years. 
2. Technological advances increase ROI of new capital.  
3. Bankruptcy, savings, and refinancing repair balance sheets.  Liquidity constrained consumers and businesses feel free to borrow and spend again. 
4. Prices eventually get flexible in the long run and markets clear.  E.g.: real wages and housing prices drop reducing unemployment and increasing housing sales.  Nominal housing prices rise again and construction begins. 

As Krugman says, without positive government monetary or fiscal stimulus (#1 above), the adjustment, can go on for a long, long, long, long time.  

So let’s look at the NBER business cycle data. What we see is that some of those prewar slumps were really, really long: the Panic of 1873 was followed by a recession that lasted 5 1/2 years.

The NBER data shows that recessions have been getting shorter and less frequent, so something has been helping and better monetary policy (and automatic fiscal stabilizers) are probably part of the reason. 

BUSINESS CYCLE DATES		DURATION IN MONTHS
		Contraction	Expansion
		Peak to Trough	Previous trough to this peak
1854-1919 (16 cycles ‘Free’ Market) 1919-1945 (6 cycles Fed Era) 1945-2009 (11 cycles Keynesian Era)		22 18 11	27 35 59

The Crisis We Should Have Had and Still Might

An interesting question is why didn't we have the economic crisis that most economists thought we would have when the housing bubble popped.  One reason is that savings does not equal investment.  The crisis was supposed to be a credit crunch when developing countries decided to stop saving their money and loaning it to us.  However, that never happened and foreigners kept trying to loan money to the US.  Secondly, the real estate and financial bubble was only partly related to the foreign inflows and its popping is completely unrelated.  Moneybox:  

...Some people sat around looking at the US economy from 2002-2006 and thought all was well. But many people looked at it and could see clearly that all was not well. That we were on an unsustainable path and that we were primed for a crash. The main feature of the unsustainable path was huge inflows of foreign capital into AAA-rated American financial instruments, including US gvoernment debt, mortgage-backed securities, etc. These unsustainable flows were distorting employment patterns and sustaining unsustainable living standards. Americans were maintaining broad-based consumption growth only through excessive household indebtedness and underpayment of taxes relative to the quantity of services being received. Someday soon, the capital flows would come to an end and we'd have a version of a classic developing economy sudden stop of "hot money," except it would be happening to a rich industrialized nation. The value of the dollar would crash, restraining inflation would require high interest rates, and the US economy would feature a period of painful restructuring.

There was no particular reason to believe that this crisis would lead to a prolonged period of mass unemployment since the dollar crash would facilitate exports (including tourism) and import-competing industries, but it would very possibly create a stubbord residual of long-term unemployed people. What's more, it would be a prolonged crisis in American living standards.
...But this is not the crisis we're having. Interest rates are low. Headlines tell us that "U.S. Factories Could Suffer From Dollar’s Appeal". I'm inclined to think that we will, at some future point, face the crisis we should have had and it will need to be addressed in complicated ways. But the crisis we're having is, for all its horror and scale, a pretty banal monetary crunch—the natural rate of interest is below zero, nomimal rates can't go below zero, and the Fed won't act to push real rates lower. Fixing that wouldn't fix "all our problems" any more than ending the Great Depression solved all the problems of the America of its time (Jim Crow, anyone?) but it would solve the problem and it doesn't require us to fix the other stuff first.