Friday, November 4, 2011

A Win-Win for Conservatives and Liberals

Ramesh Ponnuru and I have a new article in The New Republic where we argue that conservatives should embrace more aggressive monetary policy while liberals should not fear budget tightening.  Our point is that the Fed could be doing far more to restore robust nominal spending and if it did so, it would be possible to do fiscal consolidation without harming the economy. For example, if the Fed were targeting nominal GDP and government spending cuts proved to be contractionary, then the Fed would offset them so as to maintain a stable nominal GDP growth rate.  It is a win-win situation.  Conservatives get fiscal consolidation and liberals get a meaningful boost to aggregate demand.

Joe Weisenthall objects by arguing the following:
The biggest problem facing the economy is that the private sector is in too much debt. Americans are trapped in their homes, where they owe huge mortgages, and are generally paying off the big credit boom from the last few decades...If you can accept that this needs to come down, it seems ludicrous to think that the answer to the debt crisis is: cheaper loans!
Two responses.  First, nowhere have we argued that indebted households should take on additional borrowing.  Rather, monetary easing via a nominal GDP level target would make its biggest impact, in our view, via changes in expectations that would cause households to rebalance their portfolios in a way that would stimulate spending.  Bank lending and borrowing are not key to this story.  And yes, there is ample evidence that expectations do affect spending decisions. 

Second, while the buildup of household debt is a drag for debtors it does not have to be for the economy as a whole.  If the monetary authority is able to maintain stable nominal spending expectations--that is minimize uncertainty about future nominal income growth--then the creditors should provide a boost to spending that offsets the debtors' reduction in spending.  The "balance sheet recession" view ignores this possibility and ignores the historical examples where this actually happened.  Moreover, a closer look at household balance sheets reveals that the real problem constraining aggregate demand is on the asset side, not the liability side. That is, what best explains in a systematic manner spending changes is the household share of liquid assets not its debt to income ratio.  But even so, a rise in nominal income from adopting a nominal GDP target would make it easier for indebted households to service their liabilities.

Finally, Joe Wiesenthall is troubled with our claim that the fiscal policy multiplier is zero.  Let me explain this claim using this analogy I made in the past:
Scott Sumner once compared arm wrestling with his daughter to the relationship between monetary and fiscal policy.  Scott explained that no matter how hard his daughter tried to win the arm-wrestling contest he would always apply just enough pressure to offset her efforts and keep her in check.  Likewise, no matter how hard fiscal policy may attempt to stimulate aggregate spending the Fed has the ability to offset such actions and place aggregate demand where it so chooses.  In other words, the size of the fiscal multiplier ultimately depends on the stance of monetary policy.
Since the Fed could do more by its own admission and yet seems content doing nothing at the moment, it stands to reason that a fiscal policy stimulus that lead to enough rapid nominal spending growth to close the output gap would be quickly arrested by the Fed.  The problem, then, is with the Fed.  A nominal GDP level target would change the Fed's perspective so that it would allow enough nominal spending growth to return  nominal GDP to some pre-crisis trend.  Fiscal policy in such a setting would be more effective, but then it wouldn't be needed because the Fed itself would be pushing nominal GDP to its target growth path.  

For further comments on our article see Rameh Ponnuru's comments here and here


  1. I realize it is heresy to say it out loud, but temporarily higher inflation would deleverage everybody, including taxpayers and consumers.

    Inflation would also float real estate back up above water. This will help banks.

    Small business can only borrow against collateral, and that generally means real estate (your equipment and employees are nearly worthless). Higher real estate value will help small businesses borrow,

    There are legion reasons to go to NGDP targeting. The arguments against are very weak, and usually involve some sort of genuflection towards gold, and worship of only the facade of monetary policy---fighting inflation.

    Real monetary policy is concerned with the whole, growth and prosperity.

    Has prosperity become a dirty word in monetary circles?

  2. Of course inflation lifts all boats; that is the problem. Whereas default and bankruptcy ensures that losses from bad lending are primarily sustained by those responsible, inflation penalises all creditors, but the least sophisticated, most conservative ones suffer the most. Inflation therefore distorts incentives and hence future behaviour.

    You must stop seeing inflation as some kind of moral issue, Benjamin. It is about economic efficiency over the long term and over repeated business cycles rather than just finding an easy way out of present problems.

  3. Rebel-

    I do not see inflation as a moral issue---precisely the opposite. I favor NGDP targeting, and inflation is the leftover.

    I know there should be moral hazard for slack underwriting and borrowing. Unfortunately, there are times when bankruptcies and foreclosures can become a downward snowball. Like now.

    Japan is an example of a nation that went to tight money following an inflationary boom---and they essentially never came out of recession, even after 20 years. Japanese real per capita GDP is falling relative to the USA's. Their national debt has ballooned.

    Since 1990, the Nikkei Dow is down 75 percent, and real estate is down by 80 percent and still falling. Still falling!

    Okay, they faced up to moral hazard in Japan.

    Better they inflated real estate values, so more loans could be repaid (in nominal yen).

    Japan is on the way to becoming a backwater nation, while China (with an expansionary monetary policy) booms.

  4. On the contrary Benjamin, I would say that Japan is a classic example of what happens when (reasonable) liquidation after a crazy asset boom is avoided - like the balance sheet recession idea, except that in many cases, debts are not being paid off. Many zombie enterprises remain, and make it difficult to set up new, solvent enterprises. Yes, in theory Japan might have washed away its bad debt problem with enough money - although one wonders whether the US would have tolerated the large weakening of the yen that would have been involved - but it probably would be more efficient to simply tighten up accounting standards and apply the bankruptcy laws.

    Note that the US is following a similar path to Japan, having eased its own mark-to-market accounting rules in April 2009.

    Of course politicians would prefer to avoid enforcing such such stark solutions, and will instead harangue the central bank to use its short-term ability to boost growth. It is up to the central bank to have the understanding and the independence to refuse.

  5. Rebel-

    I enjoy your commentary, but what politician is crying for Fed stimulus?

    Obama has ignored the Fed, under the tutelage of Summers and Krugman, who say monetary policy doesn't matter.

    And Rick Perry has spoken for the right, in threatening the gallows for Bernanke if he guns the money supply before the election. The right worships tight money (at least when there is a Dem President).

    Sure, truly bad loans need to be written off. However, mark-to-market in a sudden downdraft is a questionable procedure. If banks lends at 80 percent LTV, and real estate is depressed by 30 percent, the resulting cascade of foreclosures and sales drives prices down even more. It is not prudent to rip the bottom out of real estate at precisely the worst time.

    Better to inflate the economy, and let real estate rise to a higher level---and then the truly bad loans need to be written off.

    I suppose we could argue about Japan forever, and I do not know what happened in Japan on a loan by loan basis. However, it is fair to say Japan's real estate collapsed in 1990-1995, and never recovered.
    How that is a positive I cannot see.

  6. Benjamin, speak of the devil (according to today's news, the recently emerged losses at Olympus cameras originate with attempts to cover up losses on security investments at the end of the bubble period):

    By the way, you have probably heard the story about the land under the emperor's palace in Tokyo being (theoretically) worth more than the state of California during the bubble period. Was it negative that Japanese real estate collapsed in 1990 and never recovered? Would you have had the BoJ inflate enough to lift real estate back above water?