Fiscal Austerity Requires Monetary Liberality

Over at Cafe Hayek, Russ Roberts takes on Paul Krugman's claim that most studies show fiscal policy tightening will stall a recovery rather than help it:

Unfortunately, Krugman doesn’t provide a link to those “many studies” of the historical record. Maybe he was busy or simply didn’t have room to provide them. But I will just mention that in 1946, federal spending fell about 55% when the war ended. The Keynesians predicted a horrible depression. Yet despite the release of 10 million people into the labor market with demobilization private sector employment boomed and the economy thrived. That’s a great natural experiment. I am eager to read any of the alleged many studies of the historical record.

Like Roberts, I am skeptical about the ability of discretionary fiscal policy to stabilize the business cycle.  His critique, however, is too quick to embrace the popular view that fiscal policy consolidation actually improves the economy.  On this point, Krugman is correct that most of the empirical evidence (e.g. here, here, and here) does not support this view.  What the evidence does show is that in most cases where fiscal consolidation was accompanied by a robust recovery it happened because monetary policy was accommodative.  In other words, a loosening of monetary policy made it appear that fiscal policy tightening was the cause of the economic recovery when in fact it was not.  For example, the much celebrated case of Canada's fiscal retrenchment in the later half of the 1990s coincided with the Bank of Canada dropping interest rates about 5% which supported domestic demand and increased exports via currency depreciation.  For fiscal austerity to work then, monetary policy needs to be accommodating. 

Along these lines, a more general point is that the impact of any fiscal policy action--where expansionary or contractionary--depends on the stance of monetary policy.  Thus, from 2008-2009 when monetary policy was effectively tight the easing of fiscal policy didn't quite pack much of a punch.  Conversely, in late 2010, early 2011 when there was not much fiscal stimulus, but some monetary policy easing under QE2 there was some improvement in the pace of recovery.  Another way of saying this is that an independent monetary policy will always dominate fiscal policy.

So if Russ Roberts is like me and wants fiscal policy consolidation that works he should really be clamoring for more monetary stimulus.  Otherwise he may get more than he bargained for.

Update: Awhile back I did a related post criticizing hard money advocates to which Paul Krugman replied.  Here was my response to Krugman.

Brad DeLong and Brink Lindsey Agree the Fed Could Be Doing More

Here is an video excerpt from the Brad DeLong-Brink Lindsey bloggingheads discussion that lends itself nicely to my claim in the previous post of the Fed passively allowing monetary policy to tighten.

The Three-Year Tightening Cycle of U.S. Monetary Policy

Back in August, 2010 Fed Chairman Ben Bernanke claimed that monetary policy can be passively tightened by the Fed doing nothing in the midst of a weakening economy.  A failure to act by the Fed when aggregate demand was faltering, he argued, was effectively the same as the Fed tightening monetary policy.   He made this point in 2010 to explain why the FOMC's decided to stabilize the size of the Fed's balance sheet.  Here is Bernanke:

At their most recent meeting, FOMC participants observed that allowing the Federal Reserve's balance sheet to shrink in this way at a time when the outlook had weakened somewhat was inconsistent with the Committee's intention to provide the monetary accommodation necessary to support the recovery. Moreover, a bad dynamic could come into at play: Any further weakening of the economy that resulted in lower longer-term interest rates and a still-faster pace of mortgage refinancing would likely lead in turn to an even more-rapid runoff of MBS from the Fed's balance sheet. Thus, a weakening of the economy might act indirectly to increase the pace of passive policy tightening--a perverse outcome. In response to these concerns, the FOMC agreed to stabilize the quantity of securities held by the Federal Reserve by re-investing payments...By agreeing to keep constant the size of the Federal Reserve's securities portfolio, the Committee avoided an undesirable passive tightening of policy that might otherwise have occurred. The decision also underscored the Committee's intent to maintain accommodative financial conditions as needed to support the recovery.

In short, the FOMC was concerned that a failure by the Fed to reinvest its payments, which amounts to a reduction in the monetary base, would be contractionary in an economy that was struggling at this time.  The FOMC wanted to avoid this passive tightening of monetary policy.

I agree with this line of reasoning about the passive tightening of monetary policy.  I, however, see a passive tightening of monetary policy as being more than just the shrinking of the Fed's balance sheet.  It occurs whenever the Fed passively allows total current dollar or nominal spending to fall, either through a fall in the money supply or through an unchecked decrease in velocity.  In other words, even if the Fed maintained the size of its balance sheet, a sudden rise in money demand not matched by the Fed would also amount to a passive tightening of monetary policy.  With this understanding, monetary policy has been on a passive tightening cycle for the past three years.  For nominal spending began to fall in June 2008 and has yet to return to any reasonable trend level growth path (i.e. one that accounts for the housing boom). It is even worse if we look at domestic nominal spending per capita.  Not only has it not returned to a reasonable trend level growth path, it has yet to return to even its peak value in late 2007, as seen in the figure below.

A key problem behind this passive tightening of monetary policy is that money demand has been and remains elevated and the Fed has yet to successfully address it.  What is frustrating is that the Fed could meaningfully undo this three-year passive tightening cycle by adopting something like a nominal GDP level target.  For many reasons--its political capital is spent, internal Fed divisions, the popularity of hard-money views, etc--it won't and so the U.S. economy remains mired in an anemic recovery.

Update on the Eurozone Crisis

Back on the Eurozone crisis front we find find some great lines from Michael Darda and Marshal Auerback on the latest developments.  Here is Darda from his latest newsletter:

Although there seems to be some optimism in European equity markets that Thursday’s finance ministers’ powwow will bring a “shock and awe”  announcement, we would not wait to exhale. As we’ve argued before, eurozone nominal GDP is about 10% below trend. This has caused tax revenues to collapse and debt burdens to mushroom. Since the ECB has tightened liquidity and raised rates instead of lowering  them and adding liquidity,  we simply  see  no path to  a  recovery in nominal GDP (and solvency) for the European periphery, whose costs and prices are out of whack with the rest  of the eurozone. Rearranging the deckchairs with  alphabet soup bailout schemes and fiscal austerity measures has failed for 14 months and will continue to fail unless accompanied by  a much more  supportive monetary policy by the ECB, in our view...Sterilized interventions -- when a central bank buys an asset but sells another asset so that the money supply remains unchanged -- is like attempting procreation with contraception. It’s set up to fail.

 And here is Auerback in his latest article:

In the past, I have called the euro zone a “roach motel”. But as usual, I’ve been outdone in the metaphor design department by the Italians: Guilio Tremonti, the Italian Finance Minister, last week compared Germany and its small-minded Chancellor Angela Merkel to a first-class passenger on the Titanic. The underlying message is the same: You can be sailing in coach or you can be in the 1st class compartment. But when the ship hits the iceberg, everybody goes down together — Germans, Italians, Greeks, Irish and French alike. All euro zone members have an institutional wide problem of not being able to fund deficits, given that the countries of the euro zone have all acceded to impose gold standard conditions on themselves by forfeiting their fiscal freedom.

To repeat: this is not a problem confined to the periphery. The sovereign risk problem applies to the central core countries, such as Germany and France, as it does to the Mediterranean “profligates”. Once a run on the currency starts and moves into the banking sector, then none of the governments will be able to do anything other than to oversee financial and economic collapse while the fiddlers in Brussels and Frankfurt try to spin some line about “special circumstances” or something without admitting the whole system they imposed on the area is the cause of this crisis. 

I concur with Auerback that the ECB has been fiddling while the Eurozone slowly burns. I just hope it does not turn into an other Lehman-type event.  Should it come to that, here is how I would have the Federal Reserve prepare for such an outcome.

The Inadequacy of the Balance Seet Recession View

Thanks to this David Leonhardt article, the balance sheet recession view is once again getting much discussion.  This view holds that households acquired excessive amount of debt during the housing boom, the value of their assets plummeted during the crash, and now their balance sheet are in need of great repair.  Consequently, the U.S. economy is undergoing a great deleveraging cycle that is slowly restoring household balance sheets.  Some take this view to also mean that only time can heal the wounds of a balance sheet recession. 

I don't like this view for two reasons.  First, it is at best an incomplete story.  For every household debtor deleveraging there is a creditor getting more payments.  Yes, household debtors have cut back on spending, but so have creditors.  The creditors could in principle provide an increase in spending to offset the decrease in  debtors' spending.  They aren't and thus the economic recovery is stalled. In other words, the problem is as much or more about the build up of liquid assets by creditors as it is the deleveraging of debtors.  The balance sheet recession view, however, sees the debtors deleveraging as the main problem.  It completely ignores the creditors buildup of liquid assets and its implications for spending.   

When one begins to focus on the creditors' role, it becomes apparent that the underlying problem is excess money demand.  For if the creditors are not spending their newly acquired dollars there must be an unsatiated demand for money.  Even in the case where banks are the creditor, the excess  money demand problem is present.  For example, if a bank loan is paid down both loans and deposits fall. If those deposits were checkable, saving, small time, or money market accounts–assets used as money–the money supply falls too. For a given demand for money, this drop in the money supply now means there is--if not already--an excess money demand problem. The key issue, then, is to satiate creditors' demand for money and get them to start spending some of their money assets.  This insight is ignored by the balance sheet view of recessions.

The second problem I have with the balance sheet view of recessions is that it leads people to think there is nothing monetary policy can do.  Part of the issue here is the failure to see the underlying excess money demand problem.  If it were widely understood that the fundamental problem was excess money demand, then there would be more faith in using monetary policy.  

Another part of this problem, though, is a failure to look back to history for other examples of balance sheet recessions.  As Frederick Mishkin has shown, households were also significantly deleveraging during the Great Depression.  This experience would fit the standard definition of a balance sheet recession.  Below is a table from his paper that shows household balance sheets in real terms.  Note that between the 1933 and 1936 U.S. household underwent a cumulative deleveraging  in real terms of 20%. This is far more in percentage terms that has happened over the past few years. And yet between 1933 and 1936 the U.S. economy had a robust recovery.  Real GDP averaged almost 8% growth during these years. 

 

The balance sheet recession view cannot easily reconcile the large deleveraging by households and the rapid real economic growth that occurred between 1933 and 1936.  What can explain it is a more nuanced view that acknowledges creditors with excess money demand were confronted by FDR's original quantitative easing program.  This QE program was far better than recent ones in that FDR clearly signaled a price level target and backed it up by devaluing the gold content of the dollar and allowing unsterilized gold inflows. In otherwords, FDR signaled that he was going to allow a significant and permanent increase in the monetary base and followed through on it.  This change nominal expectations and caused creditors to start spending their money balances.  The same could be done today with something like a nominal GDP level target.

Unfortunately, I fear Edward Harrison is correct in saying Fed has burned up most of its political capital. So it is unlikely to try anything radical like nominal GDP level targeting.  That means the economy will be stuck in stall speed for the time being.

Update I: A quick follow-up point to some of the comments.  Whether consumers default or pay down debt is irrelevant to whether there is an excess money demand problem. If consumers default and hold on to their money balances there is an excess money demand problem.  If consumers pay down their debts and the banks (the creditor) mark down their assets and liabilities accordingly, there is still an excess money demand problem since there is now less money supply for a given level of money demand.(By the way, this New York Fed report shows that many consumers have been paying down their debts, not defaulting.)

Update II: Just to be clear, there are more creditors than just banks so it is a little misleading to focus solely on banks.

Is Weak Aggregate Demand Really the Main Problem?

Or is it the regime uncertainty that many observers attribute to the Obama administration? The answer from several recent surveys say it is weak aggregate demand.  First, a Wall Street Journal survey shows most economists see the lackluster recovery as a the result of weak aggregate demand rather than uncertainty over government policy:  

The main reason U.S. companies are reluctant to step up hiring is scant demand, rather than uncertainty over government policies, according to a majority of economists in a new Wall Street Journal survey...In the survey, conducted July 8-13 and released Monday, 53 economists—not all of whom answer every question—were asked the main reason employers aren't hiring more readily. Of the 51 who responded to the question, 31 cited lack of demand (65%) and 14 (27%) cited uncertainty about government policy. The others said hiring overseas was more appealing.

This conclusion is supported by the findings in the most recent NFIB's survey of small businesses.  This survey has consistently shown, and shows for June, that the number one problem facing small business is not regulation or taxes--though they do matter according to the survey--but weak sales.  Here is a table, for example, from the June, 2011 survey that underscores that it is weak sales more than anything else that is creating stress for small firms. Note that regulatory costs and taxes are captured under the increased costs category (see underlined footnote). 

I suspect regulatory costs become more apparent and seem more important when aggregate demand is persistently weak. Conversely, if firms were flush with growing revenues and expected higher sales the regulatory costs would probably seem less burdensome. This is not trivialize the importance of such regulatory costs, but to point out that some commentators should probably spend more time thinking about the problem of weak aggregate demand and what can be done to fix it.

Update:  Nick Rowe makes a good point in the comments section:

[L]ook at the table on page 20 of the report. Once again, only a very small percentage of firms list "quality of labour" as their most important problem. 5% today, compared to 4% one year ago, 3% as the survey low, and 24% as the survey high.  The fact that labour is so easy to hire is more confirmation that there's generalised excess supply, and the problem is AD.

The Other Four Important Insights From Bernanke's Testimony

Chairman Bernanke's testimony before Congress this week generated much attention because he mentioned the Fed remained open to further monetary easing.  Many observers interpreted this statement as Bernanke opening the door for QE3.  Though this was the big news from Bernanke's visit to Congress, there were four other important insights in his testimony worth mentioning too. 

First, Bernanke affirmed his new-found love for the portfolio channel of monetary policy.  The idea behind this channel is that through its purchases of longer-term securities the Fed can cause investor's to rebalance their portfolios toward riskier but higher yielding assets like stocks and capital.  Eventually, these asset prices would increase and their yields drop providing a boost to consumption and investment spending. Here is Bernanke:

The Federal Reserve's acquisition of longer-term Treasury securities boosted the prices of such securities and caused longer-term Treasury yields to be lower than they would have been otherwise. In addition, by removing substantial quantities of longer-term Treasury securities from the market, the Fed's purchases induced private investors to acquire other assets that serve as substitutes for Treasury securities in the financial marketplace, such as corporate bonds and mortgage-backed securities. By this means, the Fed's asset purchase program--like more conventional monetary policy--has served to reduce the yields and increase the prices of those other assets as well. The net result of these actions is lower borrowing costs and easier financial conditions throughout the economy.

Another way of saying this that is that Fed's asset purchasing program is simply moving down the list of assets--i.e.it is going from buying treasury bills to buying treasury notes and bonds--whose yields also affect money demand.  When the zero bound on short-term interest rates is hit and money demand still remains elevated it is time to start lowering yields on other longer-term securities until money demand drops and nominal spending is fully restored. (See Edward Nelson for a more on this channel and see here for evidence that money demand still remains highly elevated.)  

I am glad to see Bernanke get behind the portfolio channel, though the lack of a robust recovery means this channel's potential hasn't been fully utilized.  An important part of this channel is shaping the expected path of nominal spending and interest rates so that investors start rebalancing their portfolios on their own.  The Fed shouldn't have to do the heavy lifting if it sets expectations correctly. But since the Fed has yet to commit to a level target this has not happened.  

Second, Bernanke implicitly acknowledges that interest rates would be low even in the absence of the Fed.  This is an important point that many commentators miss.  Interest rates are low now mainly because the economy is weak, not because of Fed policy.  The weak economy has pushed the equilibrium or neutral interest rate down and the Fed at best has only marginally lowered it. Again, here is Bernanke:

Estimates based on a number of recent studies as well as Federal Reserve analyses suggest that, all else being equal, the second round of asset purchases probably lowered longer-term interest rates approximately 10 to 30 basis points. 

To put this in perspective, the 10-year treasury yield reached a low of about 2.5% in October 2010.  Add the upper-end estimate of 30 basis point to this and the 10-year yield is still only 2.8%, a low number relative to its value over the past decade. Interest rates will rise once the economy begins to really recover, not before.  What is frustrating for me is to see many otherwise thoughtful folks, including some Fed officials, failing to understand this point and calling for higher interest rates. This has the causality completely backwards.  At least the folks at the Swedish central bank get it right.

Third, Bernanke acknowledges the Fed still has plenty of ammunition in its monetary arsenal.  Bernanke, therefore, disagrees with the David Brooks of the world who say there is no magic lever or the Richard Koos of the world who say a central bank can do nothing in a balance sheet recession. Here is Bernanke on what else the Fed can do:

Even with the federal funds rate close to zero, we have a number of ways in which we could act to ease financial conditions further. One option would be to provide more explicit guidance about the period over which the federal funds rate and the balance sheet would remain at their current levels. Another approach would be to initiate more securities purchases or to increase the average maturity of our holdings. The Federal Reserve could also reduce the 25 basis point rate of interest it pays to banks on their reserves, thereby putting downward pressure on short-term rates more generally. Of course, our experience with these policies remains relatively limited, and employing them would entail potential risks and costs. However, prudent planning requires that we evaluate the efficacy of these and other potential alternatives for deploying additional stimulus if conditions warrant.

So the Fed can better shape expectations (which would happen if the Fed would just set a level target!), buy up more longer-term securities, and lower the interest payment on excess reserves. Of these options, I see the first as being the most effective.  In fact, the first option is more or less what Bernanke told Japan to do in the 1990s.  If it is good for Japan, why not the United States?

Fourth, Bernanke reiterated the Fed's desire to slouch on the job and ignore the aggregate demand shortfall.  Okay, he did not exactly say that, but it was implied by the fact the Fed is doing nothing despite the ongoing elevated demand for money and money-like assets.  Bernanke, himself, has recently said that monetary policy can be passively tightened by doing nothing. (He was referring to the Fed's balance sheet passively shrinking by not reinvesting its mortgage earnings.)  As Ryan Avent notes, it is amazing to see Bernanke list all the things  the Fed could still do to help the economy, but chose not to act.