Good monetary policy raises inflation during recessions

Moneybox notes that Ben Bernanke has the worst economic record on inflation since the great depression, but he thinks he is one of the best!

Testifying before Congress recently, Ben Bernanke bragged, "my inflation record is the best of any Federal Reserve chairman in the postwar period, or at least one of the best, about 2 percent average inflation."

Catherine Rampell's numbers show that Bernanke has, in fact, delivered the lowest inflation of any postwar Fed chair, coming in at an average of 2 percent. On the other hand, Floyd Norris notes that unemployment under Bernanke has been second-highest of any postwar Federal Reserve chairman. Now if you ignore the "postwar" qualifier, the picture looks different. Several Depression-era Fed chairs had less inflation and more unemployment than Bernanke. And putting those Depression-era bankers into the mix serves to highlight how absurd Bernanke's boast is. No sensible person would look at America's economic performance in the 1929-1933 period and say "man, they did a great job of fighting inflation."

It is true that inflation was very low—indeed, negative—for most of this period, but that simply goes to show they were doing a terrible job.

Suppose Ben Bernanke resolved to deliver enough aggregate demand to get the inflation rate up to its Greenspan-era average of 2.6 percent. Unless you believe there is literally zero slack or excess capacity in the economy, that would create some extra jobs and real growth. And was inflation so terrible in the Greenspan years? Nope. At the time, Greenspan-level inflation was considered a historic victory in the war on inflation.

Moneybox later points out that there are many prominent media voices calling for higher inflation on both the political right and the left, but almost no voices in positions of political power including at the Fed. 

I regularly give Ben Bernanke a hard time for the excessively tight monetary policy he's run at the Federal Reserve, and his most recent congressional testimony has been the chance for more of that. But in Bernanke's defense I should say that the really striking thing about his appearance is the utter and total lack of influence of dovish monetary policy views on Capitol Hill.

If you read a lot of economics coverage on the Internet, you'll be struck by the amazing success of "dovish" monetary policy views. I've been pushing them here at Slate, Ryan Avent pushes them at the Economist, Matt O'Brien pushes them at The Atlantic, Tim Fernholz and Miles Kimball push them at Quartz, Josh Barro and the Stevenson/Wolfers team push them at Bloomberg, Ramesh Ponnuru pushes them at National Review, Ezra Klein pushes them on Wonkblog, Paul Krugman and Tyler Cowen have both pushed them in the New York Times, etc. It's not like an overwhelming consensus or anything, but normally a political stance with this much representation in the media could find at least one significant politician to stand up for it. But while we have Obama's former Council of Economic Advisors Chair and the chief economist at Goldman Sachs on our side, we seem to have zero members of congress.

This is not an excuse for the Fed's too-tight policies ...but it's probably a reason for it. If nobody in congress objects to crucifying mankind upon a cross of 2 percent [core inflation] targeting then realistically it seems unlikely to stop.

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.