Targeting Nominal Wealth Leads to a Bubble Economy, Not Stabilizing the Business Cycle

Over the past few years it has become increasingly clear that the Federal Reserve and federal government are targeting rising asset prices, rather than incomes, as a way of generating economic growth. A recent post outlined some of the dangers of persistent negative real interest rates:

Households and businesses “with access to cheap borrowing” have been pouring money into stock, bond, housing and commodity markets rather than investing in tangible capital. The remarkable rise in asset prices has unfortunately not funneled down to households in the bottom four quintiles of income and wealth, only furthering the inequality gap.

Cullen Roche addressed a similar issue yesterday in a post on The Fed’s Disequilibrium Effect via Nominal Wealth Targets:

Fed policy and the monetarist perspective on much of this can be highly destabilizing by creating this sort of ponzi effect where asset prices don’t always reflect the fundamentals of the underlying corporations.  It’s not a coincidence that we’ve have 30 years of this sort of policy and also experienced the two largest nominal wealth bubbles in American history during this period.

The title of this blog is also not a coincidence, since my formative years encompassed both the dot-com and housing bubbles. My relatively limited experience with financial markets and macroeconomics (based on age) has been punctuated by financial instability. These memories are the driving factor behind my desire to study financial instability and inform policy decisions that can stabilize the business cycle.

In a recent post on The Spinning Top Economy, Matthew Berg helps further my goal with insight on measuring financial instability (my emphasis):

Now we have Government IOUs on the bottom, serving as the base of the economy. Bank and Non-Bank IOUs are leveraged on top of those IOUs – somewhat precariously.

In fact, you can think of the economy as a spinning top rather than a pyramid. Like a spinning top, the more top-heavy the economy becomes, the greater its tendency to instability, and the more readily it will topple over and collapse in a financial crisis.

Now, what happens if, as was the case during the dot-com bubble and the housing bubble, private sector net financial assets go negative but net worth continues to grow?

In fact, the difference between the measures of net financial assets and net worth provides us with a good rule of thumb for how to spot a bubble economy. If private sector net worth is growing at a greater rate than private sector net financial assets are growing, then that means that the economy – symbolized by our spinning top – is growing more top-heavy.

So, what happens if we make the spinning top more top-heavy? You can go ask your nearest Kindergartener – it becomes more likely to topple over.

Since Matthew provides the guidelines for spotting “a bubble economy,” let’s take a look at the empirical data to see how well it aligns with the story. The first chart displays the growth rates of private sector net financial assets (NFAs) and private net worth over the past 20 years*:
The negative growth rate in private NFAs corresponds with the Clinton surpluses, while the two positive surges are due to the Bush tax cuts and Bush/Obama stimulus measures. Turning to the growth in private net worth, the brief decline stems from the bursting dot-com bubble and the massive drop from cratering house prices. Combining the two measures will show when/if the economy was becoming “top-heavy” (first chart displays the past 50 years; second chart is the same data but only the past 20 years, for clarity):

Past 50 Years

Past 20 Years

Growth of private net worth began outpacing the growth of private NFAs in 1995 for the first time since 1979. The difference in growth rates then remained positive for 10 of the next 11 years. This streak is truly remarkable given that prior to 1995, the difference had only been positive in five other years dating back to 1961.** At the end of 2006, the U.S. economy was clearly more “top-heavy” than any previous time in the post-war era.

Over the past three decades, growth in private debt exceeding income and declining nominal interest rates have generated enormous returns for asset holders. Throughout the 1980’s and early 1990’s, federal deficits provided more than enough NFAs to keep pace with rising private net worth. Then, in 1995, deficits began decreasing just as the growth of net worth (and private debt-to-GDP) began accelerating higher. The unsurprising result has been more than a decade of meager asset returns, subpar economic growth and high unemployment.

The government policy of targeting nominal wealth, driven by an expansion of private debt, has failed not only at increasing net worth but also, and more importantly, at creating sustainable growth in output and employment. Going forward the focus of policy must return to promoting the growth of income and assets, which in turn will fuel higher output, employment and ultimately wealth.   


*Data for private net worth comes from the Federal Reserve’s Flow of Funds Accounts of the United States (Z.1). Data for private net financial assets (NFAs) comes from the National Income and Product Accounts (NIPA) at the BEA.

**Aside from 1979, growth of private net worth exceeded the growth of private NFAs in 1961, 1965, 1969 and 1978 (0.05%).

Related posts:
The Rise of Debt, Interest, and Inequality
Fear of Bubbles, Not Inflation, Returns to the Fed
Why the Federal Reserve Mandate Means That Bernanke Doesn't Have to Worry About Bubbles

The Dangers of Misunderstanding "Helicopter Money" and Higher Inflation Targets

Ashwin Parameswaran has a fantastic post today explaining why Helicopter Money Is Not Dangerous, All Macroeconomic Policy Is Dangerous “in the sense that irresponsible implementation can lead to macroeconomic chaos.” Before jumping into the main attraction of the post, I want to briefly clarify a general discrepancy regarding what helicopter money actually entails.

More than forty years ago, Milton Friedman famously quipped that price deflation can be fought by "dropping money out of a helicopter."[37] Friedman was referring to central bank policy and, to this day, a “helicopter drop” is typically associated with monetary policies, such as quantitative easing (QE). This is an unfortunate interpretation of monetary policy since most central banks, including the Federal Reserve, are as equally unable to actually implement a “helicopter drop” today as they were back in 1969. Willem Buiter clarifies how the policy could realistically be implemented in a paper on “Helicopter Money” (equations omitted):

Technically, if the Central Bank could make transfer payments to the private sector, the entire (real-time) Friedmanian helicopter money drop could be implemented by the Central Bank without Treasury assistance.

…

The legality of such an implementation of the helicopter drop of money by the Central Bank on its own would be doubtful in most countries with clearly drawn boundaries between the Central Bank and the Treasury.  The Central Bank would be undertaking an overtly fiscal act, something which is normally the exclusive province of the Treasury.47

An economically equivalent (albeit less entertaining) implementation of the helicopter drop of money would be a tax cut (or a transfer payment) implemented by the Treasury, financed through the sale of Treasury debt to the Central Bank, which would then monetise the transaction. If the direct sale of Treasury debt to the Central Bank (or direct Central Bank lending to the Treasury) is prohibited (as it is for the countries that belong to the Euro area), the monetisation of the tax cut could be accomplished by the Treasury financing the tax through the sale of Treasury debt to the domestic private sector (or overseas), with the Central Bank purchasing that same amount of non-monetary interest bearing debt in the secondary market, thus expanding the base money supply. (2004: p. 59-60)

One might inquire whether changing to a “permanent floor” monetary policy regime alters the necessity of monetisation. Apparently prepared for such a future outcome, Buiter says:

This difference between the effects of monetising a government deficit and financing it by issuing non-monetary debt persists even if the interest rates on base money and on non-monetary debt are the same (say zero), now and in the future.  When both money and bonds bear a zero nominal interest rate, there remains a key difference between them: the principal of the bonds is redeemable, the principal of base money is not. (2004: p. 10)

Although monetisation may be necessary to achieve the full effect of “helicopter money,” this practice does not alter the dangers associated with the Treasury’s actions. As Ashwin points out:

Whether they are monetised or not, excessive fiscal deficits are inflationary.

On the topic of inflation, I have recently been engaging in a debate with Mike Sax (see here and here) about the potential benefits of targeting a higher inflation rate. This policy has garnered support from both sides of the political and economic aisle (New Keynesians and Monetarists), yet I think its potential benefits are being extremely oversold. My two basic arguments against such a policy are the following:
1) Higher inflation does not necessarily entail higher nominal wages (which many people clearly assume). 

Aside from the top quintile of households, real income has been declining for nearly 15 years. The only way higher inflation helps reduce real debt burdens is if nominal wages increase faster than nominal interest rates on debt. If instead higher inflation stems primarily from higher costs-of living (nominal food and energy prices), than most Americans may find themselves in the precarious position of requiring even more debt to maintain current living standards.

2) Higher inflation alters saving, investment and consumption decisions which can lead to a misallocation of capital. On this second point is where Ashwin’s post really hits home:

During most significant hyperinflations throughout history, the catastrophic phase where money loses all value has been triggered by the central bank’s enforcement of highly negative real interest rates which encourages the rich and the well-connected to borrow at negative real rates and invest in real assets. The most famous example was the Weimar hyperinflation in Germany in the 1920s during which the central bank allowed banks and industrialists to borrow from it at as low an interest rate of 5% when inflation was well above 100%. The same phenomenon repeated itself during the hyperinflation in Zimbabwe during the last decade (For details on both, see my post ‘Hyperinflation, Deficits and Real Interest Rates’).

This also highlights the danger in simply enforcing a higher inflation target without taking the level of real interest rates into account. For example, if the Bank of England decided to target an inflation rate of 6% with the bank rates remaining at 0.50%, the risk of an inflationary spiral will increase dramatically as more and more private actors are tempted to borrow at a negative real rate and invest in real assets. Large negative real rates rarely incentivise those with access to cheap borrowing to invest in businesses. After all, why bother with building a business when borrowing and buying a house can make you rich? Moreover, just as was the case during the Weimar hyperinflation, it is only the rich and the well-connected crony capitalists and banks who benefit during such an episode. If the “danger” from macroeconomic policy is defined as the possibility of a rapid and spiralling loss of value in money, then negative real rates are far more dangerous than helicopter money.

These pernicious traits of higher inflation and especially negative real interest rates are entirely compatible with recent experience. Households and businesses “with access to cheap borrowing” have been pouring money into stock, bond, housing and commodity markets rather than investing in tangible capital. The remarkable rise in asset prices has unfortunately not funneled down to households in the bottom four quintiles of income and wealth, only furthering the inequality gap. Recognition of these effects is precisely why a Federal Reserve fearing bubbles, not inflation, would be a significant step in the right direction.

To be clear, similar to Ashwin, I am in favor of “helicopter money” and believe higher wages for the bottom 80 percent are key to ending the balance sheet recession as well as ensuring more sustainable growth and unemployment going forward. Targeting higher inflation and larger negative real interest rates is the wrong approach to achieve these goals and may actually work in the opposite direction. Yes, all macroeconomic policy is dangerous. But even more dangerous is misunderstood and misrepresented macroeconomic policy.
 

Bibliography
Buiter, Willem H., Helicopter Money: Irredeemable Fiat Money and the Liquidity Trap (December 2003). NBER Working Paper No. w10163. Available at SSRN: http://ssrn.com/abstract=478673

Bubbling Up...1/24/13

1) Hit the “Defer” Button, Thanks… by David Merkel @ The Aleph Blog

This is why I believe that the biggest issue in restoring prosperity globally, is finding ways to have creditors and stressed debtors settle for less than par on debts owed.  Move back to more of an equity culture from what has become a debt culture.  A key aspect of that would be making interest paid non-tax-deductible for corporations, housing, etc., while making dividend payments similar to REITs, while not requiring payouts equal to 90% of taxable income.  Maybe a floor of 50% would work, with the simplifying idea that companies get taxed on their GAAP income — no separate tax income base.  Would certainly reduce the games that get played.

Anyway, those are my opinions.  The world yearns for debt relief, but governments and central banks argue with that, and in the short-run try to paper over gaps with additional short-term debt that they think they can roll over forever. They just keep trying to hit the “defer” button, avoiding any significant reforms, in an effort to preserve the “status quo.”

Woj’s Thoughts - After reviewing the results of my 2012 predictions, I mentioned:

My main takeaway is that politicians are far more determined to maintain the status quo than I had expected. The underlying economic (and social) problems have once again been kicked down the road for future governments to handle.

Although David’s policy recommendations are becoming increasingly pervasive, they unfortunately remain nowhere near the level necessary for governments to test uncharted waters. 

2) Can Germans become Greeks? by Dirk @ econoblog101

The ECB as well as other policy makers and politicians do not understand economics. They think that a simple recipe like “decrease government spending, export more” is enough to solve the euro zone crisis. The increase in government debt is a symptom of the crisis, not a cause. The cause of rising government debt was negative economic growth and bank bail-outs. These are the two problems which must be tackled. They are intertwined, so solutions should address both. Households cannot pay their mortgages in Spain and Ireland at the existing unemployment levels, and that is due to a lack of demand as households consume less and save more. This downward spiral must be stopped and turned around, since at negative growth rates even a government debt of €1 is too high.

It seems that instead of Greeks becoming Germans now the German are becoming Greeks. That means that without government spending Germany will not have positive growth rates. While this will come as a surprise to many, it shouldn’t be.

Woj’s Thoughts - Germany managed to run a slight fiscal surplus during 2012 that ultimately came at the expense of growth. In the fourth quarter, German GDP shrank by 0.5 percent. Meanwhile, attempts at structural reform (i.e. fiscal consolidation) in the European periphery appear to be speeding up the rise in unemployment and decline in growth. This dynamic is neither economically or socially sustainable, therefore the governments and ECB must either substantially change the current course or wait for countries to eventually exit the Eurozone.

3) Did We Have a Crisis Because Deficits Were Too Small? by JW Mason @ The Slack Wire

The logic is very clear and, to me at least, compelling: For a variety of reasons (including but not limited to reserve accumulation by developing-country central banks) there was an increase in demand for safe, liquid assets, the private supply of which is generally inelastic. The excess demand pushed up the price of the existing stock of safe assets (especially Treasuries), and increased pressure to develop substitutes. (This went beyond the usual pressure to develop new methods of producing any good with a rising price, since a number of financial actors have some minimum yield -- i.e. maximum price -- of safe assets as a condition of their continued existence.) Mortgage-backed securities were thought to be such substitutes. Once the technology of securitization was developed, you also had a rise in mortgage lending and the supply of MBSs continued growing under its own momentum; but in this story, the original impetus came unequivocally from the demand for substitutes for scarce government debt. It's very hard to avoid the conclusion that if the US government had only issued more debt in the decade before the crisis, the housing bubble and subsequent crash would have been much milder.

Woj’s Thoughts - The scenario laid out by JW sounds equally plausible and compelling to me. Changes in tax policies during the 1980’s and 1990’s set the stage for massive increases in real estate loans and the corresponding housing price boom. Then the unmet demand for safe-liquid assets prompted both the rise of shadow banking and the dispersion of U.S. housing assets to the rest of the world. So as the last sentence attempts to make clear, the “crash would have been much milder” but a similar crisis would likely have occurred.

Myth Busting Japan's Lost Decade

Lord Keynes, at Social Democracy for the 21st Century, provides data on Japanese Real GDP Growth from 1925–2001 and notes the following:

In the 1980s, Japan engaged in ill-conceived financial deregulation (Fukao 2003: 134–135), which was one major cause of the asset bubble in these years (although poorly designed tax policies and monetary policy were clearly involved too). The collapse of the asset bubble and the balance sheet recession (a form of debt deflationary crisis) caused the “lost decade.”

From the data above, we can see that the “lost decade” was really an era of low growth, not continuous negative growth. Japan was not in recession from 1993–1997, but had serious deleveraging problems, a banking crisis, and debt deflation.

Many myths have arisen about the lost decade, and one of them is that Keynesianism somehow “failed” to work in this era. That is nonsense. If anything, Keynesianism saved Japan from a terrible depression. In fact, when fiscal stimulus was abandoned for austerity in 1997, the economy plunged into a recession in 1998.

Of the myths regarding Japan’s lost decade (now decades), I’ll admit to having been unaware that 1998 marked the first year of negative real GDP growth since 1974 (and only second since 1945!). Since then, Japan has unsuccessfully tried to get on a fiscally sustainable path (whatever that means) as more frequent recessions have led to larger budget deficits (and growing debt/GDP) that merely prevent larger economic declines. Despite the persistence of misguided fiscal (and monetary) policy, Japan’s per capita economic growth has remained on par with the Western world.  
With nonfinancial private sector balance sheets largely repaired, Japan appears poised to continue leading the Western world if government policies improve. Unfortunately last night’s Joint Statement of the Government and the Bank of Japan on Overcoming Deflation and Achieving Sustainable Economic Growth shows the lessons of a previous age remain forgotten.

Shinzo Abe: Monetarist or Keynesian Hero?

A couple weeks back, Tim Duy argued that many economists were missing the big story in Japan:

Ultimately, it is the story of the end game of the permanent zero interest rate policy.

In a follow up post, Duy noted that:

a thread is making the rounds claiming that Japanese Prime Minister Shinzo Abe is all bark, no bite. Joshua Wojnilower argues that Abe is a closet austerian, thus ultimately the actual stimulus enacted will be of the short-term, low-power variety. Noah Smith is less diplomatic, pointing out that Abe's first time at the helm was something of a disaster because Abe fundamentally has a narrow focus:

"I of course don't mean to imply that Abe's cultural conservatism makes him unlikely to experiment with monetary policy (unlike in America, in Japan "hard money" is less of a conservative sacred cow). Instead, what I mean is that Abe really just does not care very much at all about the economy. I mean, of course he wants Japan to be strong, and of course he doesn't want his party kicked out of power. But his overwhelming priority is erasing the legacy of World War 2, with the economy a distant, distant second."

I highlighted the following chart in my previous post:

Abe’s previous leadership entailed the smallest budget deficit during the past 12 years, by a wide margin (Source: IMF): 

Although Abe may be willing to accept short-term fiscal expansion this time around, his medium and long term views still seem focused on reducing public debt.

Now Abe’s government is following through with a $116bn stimulus package that sent the Nikkei shooting higher and pushed the Yen even lower. Supposedly:

the stimulus will boost Japan’s economy by 2% and create 600,000 jobs.

Has the Monetarist hero suddenly become a New Keynesian icon? For the time being, maybe so, but I maintain my reservations about the mid-to-long term stimulative plans of this government. Fortunately, for me, Noah Smith also remains pessimistic given Abe’s and the LDP party’s history of waste and favoritism accompanying stimulus measures:

Anyway, the tweaked electoral system, lower "clientelist" pork spending, and the disastrous unpopularity of Abe's first tenure as prime minister helped ushed the DPJ into power, breaking the LDP's 55-year run. But now the LDP is back, and they need to re-establish their base of support. This means re-establishing the back-scratching relationship with those construction firms (and, by extension, rural Japan, right-wing Tea Party type groups, and the mafia). The LDP needs to say "Hey, guys, things are back to the way they were." This, I suspect, is the main reason for the "emergency stimulus".

…

To sum up: Once again, I think that Abe's appearance as a bold Keynesian experimenter is a cover for a program of traditional mercantilism and corporatism. I guess we'll see how well that program works.

The Real Story Behind Japan's Re-election of Abe: Fiscal Restraint Continues

The recent Japanese election of Prime Minister Abe has created quite a stir among Market Monetarists. From Scott Sumner’s blog:

Lars Christensen points us toward an article by Ambrose Evans-Pritchard:

Mr Abe plans to empower an economic council to “spearhead” a shift in fiscal and monetary strategy, eviscerating the central bank’s independence.

The council is to set a 3pc growth target for nominal GDP, embracing a theory pushed by a small band of “market monetarists” around the world. “This is a big deal. There has been no nominal GDP growth in Japan for 15 years,” said Mr Christensen.

Since my extreme skepticism towards NGDP targeting has been previously outlined on numerous occasions (here, here, and here for example), I won’t rehash those arguments now. With Monetarists focusing attention on the possible NGDP target, I want to consider a different view from Tim Duy (h/t Economist’s View):

The loss of the Bank of Japan's independence to force the direct monetization of deficit spending is the real story.

…

Bottom Line: Inflation targeting is not the whole story in Japanese monetary policy. It is a facet of a much greater story. A story of a modern central bank stripped of its independence. Of a modern central bank forced to explicitly monetize deficit spending. Ultimately, it is the story of the end game of the permanent zero interest rate policy.

Over the past couple decades, the Bank of Japan (BOJ) has been implicitly monetizing deficit spending through its own QE programs (graph courtesy of billy blog) :
The question then becomes, is making these actions explicit really a game changer? The BOJ has been unsuccessful in trying to stimulate private credit markets (and thereby growth and inflation) for the better part of two decades. Zero-interest rates, a rapidly expanding balance sheet, and unconventional asset purchases have all failed to do the trick. If removing the central bank’s independence simply results in more of the same, with larger quantities and new targets, then I fail to see why the outcome will be any different.

From my perspective, the loss of independence only really matters to the degree it permits a looser fiscal stance. As modern money proponents have frequently shown, currency issuers such as Japan need not worry about bond vigilantes and the BOJ can set interest rates indefinitely at whatever level it chooses. If Abe wishes to increase inflation and nominal GDP, there is little doubt he could do so by expanding the government’s budget deficit. The economic significance of Prime Minister Abe’s appointment therefore lies more with his stance on fiscal policy, not monetary policy.

Since Abe previously held the Prime Minister position from September 2006 through September 2007, we have the good fortune of reviewing his fiscal policies during that time. According to Bloomberg, following that election:

“The government [was] aiming to find as much as 90 percent of the money it needs to achieve a primary balance from spending cuts, with the rest coming from other measures such as higher taxes.”

As the following chart shows, Abe’s previous leadership entailed the smallest budget deficit during the past 12 years, by a wide margin (Source: IMF):
Although Abe may be willing to accept short-term fiscal expansion this time around, his medium and long term views still seem focused on reducing public debt.

After 20-plus years of shifting debt from the private to public sector, the private sector is once again in position to drive growth and inflation higher. The ongoing struggle for policy makers is how to revive private demand for credit that has been lacking for so long (chart courtesy of The Economist):

Considering this background, the most likely outcome from Abe’s election is brief fiscal stimulus that is reversed once the economy begins to recover. As demographics continue to work against the Japanese economy, encouraging private credit demand will become even tougher. Whether or not the BOJ officially loses its independence, explicitly monetizes the budget deficit or targets NGDP, it will be of little consequence for medium-run inflation and economic growth if fiscal policy remains effectively the same.

Economic History Matters

Recently I've been debating which elective courses to take in the coming years and which fields to specialize in. One of the two fields will almost certainly be monetary economics. For the other, I’m currently leaning towards economic history. With that subject in mind, I was pleasantly surprised to stumble across a new paper by Kenneth Carlaw and Richard Lipsey, “Does history matter? Empirical analysis of evolutionary versus stationary equilibrium views of the economy.” (h/t David Glasner) Although I’ve yet to read the full paper, here is the abstract to whet your appetite (emphasis mine):

The evolutionary vision in which history matters is of an evolving economy driven by bursts of technological change initiated by agents facing uncertainty and producing long term, path-dependent growth and shorter-term, non-random investment cycles. The alternative vision in which history does not matter is of a stationary, ergodic process driven by rational agents facing risk and producing stable trend growth and shorter term cycles caused by random disturbances. We use Carlaw and Lipsey’s simulation model of non-stationary, sustained growth driven by endogenous, path-dependent technological change under uncertainty to generate artificial macro data. We match these data to the New Classical stylized growth facts. The raw simulation data pass standard tests for trend and difference stationarity, exhibiting unit roots and cointegrating processes of order one. Thus, contrary to current belief, these tests do not establish that the real data are generated by a stationary process. Real data are then used to estimate time-varying NAIRU’s for six OECD countries. The estimates are shown to be highly sensitive to the time period over which they are made. They also fail to show any relation between the unemployment gap, actual unemployment minus estimated NAIRU and the acceleration of inflation. Thus there is no tendency for inflation to behave as required by the New Keynesian and earlier New Classical theory. We conclude by rejecting the existence of a well-defined a short-run, negatively sloped Philips curve, a NAIRU, a unique general equilibrium, short and long-run, a vertical long-run Phillips curve, and the long-run neutrality of money.

This final statement sets forth very lofty goals that appeal to my biases and probably those of many readers.

Related to economic history, but from a different angle, Lord Keynes presents a historical look at the Austrian perspective on the Government’s Ability to Increase Employment and Output:

Robert Murphy tells us that it is not at all clear that we “should credit QE1 and/or [sc. the] Obama stimulus” with the US recovery in 2009. That reflects a most extreme view that some Austrians can now be found peddling: the idea that expansionary government fiscal policy does nothing or little to increase private investment and consumption, and that government stimulus programs do not work.

How strange it is, then, to see that other Austrians have never denied that government fiscal and monetary policies can increase employment and output.

Take this statement by Huerta de Soto (who is himself an advocate of a most extreme Rothbardian program):

What should be done if, under certain circumstances, it appears politically ‘impossible’ to take the measures necessary to make labor markets flexible, abandon protectionism and promote the readjustment which is the prerequisite of any recovery? This is an extremely intriguing question of economic policy, and its answer must depend on a correct evaluation of the severity of each particular set of circumstances. Although theory suggests that any policy which consists of an artificial increase in consumption, in public spending and in credit expansion is counterproductive, no one denies that, in the short run, it is possible to absorb any volume of unemployment by simply raising public spending or credit expansion, albeit at the cost of interrupting the readjustment process and aggravating the eventual recession.

The whole excerpt from Huerta de Soto includes similar views from Hayek and Lachmann. Due to the current lack of economic history classes in today’s universities, I fear many Austrians will be surprised to learn that government intervention was previously accepted as a short run remedy, albeit with longer run consequences. From the other side, I worry that Post-Keynesians downplay historical lessons about the difficulty and long run costs of ameliorating short run pain.

Regardless of one’s side on the matter, the above posts highlight the benefits of learning and studying economic history (or history of economic thought). The current push to eliminate these courses at most colleges and universities is a huge disservice to the future of economics as a social science (which it inherently is). Hopefully the trend can be reversed, in part, so that I may one day have the opportunity to teach courses in this field.

Are Fiscal and Monetary Policy Both Ineffective?

Tyler Cowen asks us to ponder the following sentences:

This first figure shows that aggregate demand growth has not been affected by a tightening of fiscal policy since 2010.  Specifically, it shows that nominal GDP (NGDP) growth has been remarkably stable since about mid-2010 despite a contraction in federal government expenditures.

Those sentences are from prominent Market Monetarist and NGDP Targeting proponent David Beckworth. His conclusion based on the above graph and a similar one depicting the declining budget deficit is that:

Both figures seriously undermine the argument for coutercyclical fiscal policy and suggest a very a low fiscal multiplier.  They also indicate that the Fed has been doing a remarkable job keeping NGDP growth stable around 4.5%. Monetary policy, in other words, appears to be dominating fiscal policy in terms of stabilizing aggregate demand growth.

Trying to find support for Beckworth’s claim, I thought a brief look at how changes in the money supply over the past couple years compare with NGDP might do the trick. Here’s what I found:
The above chart shows that NGDP has been largely unaffected by both severe tightening and expansion of monetary policy since 2010. Looking at M2 versus NGDP growth displays a similar story:
Both charts suggest that changes in the money supply have little impact on NGDP growth. Given that percent changes in either money supply measure are far greater than those of recent fiscal policy, one might conclude that monetary policy has a smaller multiplier than fiscal policy.

Based on the above charts, which conclusion should we accept? Or are both fiscal and monetary policy ineffective? The reality is that all of these charts tell us very little about the causation between either fiscal or monetary policy and NGDP. Noah Smith says it best:

Beckworth's conclusion is not necessarily valid, and illustrates the danger in drawing conclusions about structural variables from looking at correlations between macroeconomic aggregates. Here's why the conclusion might not be valid:

Suppose that Keynesian demand management policy works perfectly: in other words, fiscal stimulus perfectly smooths fluctuations in aggregate demand. In that case, you will observe substantial swings in fiscal policy, but no swings whatsoever in aggregate demand. When external shocks push AD up, fiscal tightening will push it back down; when external shocks push AD down, fiscal policy will push it back up.

…

To conclude: The graphs Beckworth shows are perfectly consistent with a large fiscal multiplier. In fact, they are perfectly consistent with the hypothesis that monetary policy is essentially ineffective, that the Fed is basically powerless, and that fiscal policy is capable of doing a perfect job of smoothing NGDP growth all on its own.

Smith’s conclusion similarly applies to the charts depicting Monetarist demand management policy. The point is that these graphs can be subjectively interpreted to support fiscal policy, monetary policy, or neither. These charts may appease proponents of the respective camps, but far more and better empirical data will be necessary to actually change any minds.  


Update: A reader asks for a chart depicting M1 versus NGDP during this period. Always trying to oblige my readers' requests:
If monetary policy affects NGDP, this chart doesn’t reflect it.

Are Theories of Modern Money and Heterogeneous Capital Compatible?

The other night, a counterpart in my PhD program claimed that Post-Keynesian economists generally deny any truth behind the Austrian views on heterogeneous capital. While others are free to correct to this statement, I suggested that while modern money approaches often don’t discuss capital as a central theme, the two theories need not be contradictory. Ryan Murphy’s argument that It does matter how new money is injected, but that’s probably bad terminology, offers a chance to briefly discuss my thinking on the subject (my emphasis):

The idea that it matters how new money is injected relates to the way in which money “hits” the markets. For the “traditional” story to apply, the price of time -the interest rate- needs to move before other prices move. If it “hits” consumption goods (or some other vector of goods) first, the traditional ABCT story doesn’t apply, though something similar in substance might.

The simplest way to think about this is with Hayekian triangles. It’s a fairly simple question: can monetary policy disrupt the shape of the triangle in the way Garrison described via interest rates? I don’t see why this would be controversial. Some industries (and economic decisions generally) are more sensitive to interest rate changes than others. If you were at monetary equilibrium and you print money in such a way that causes interest rates to fall, then more resources get drawn into those industries than elsewhere. That is almost true by definition. If you assume heterogeneous interest rate sensitivity and that monetary policy can affect interest rates, then you get heterogeneous real effects.

Ryan’s post is a reaction to one by Scott Sumner arguing that it makes very little difference how new money is injected into the economy. The second paragraph above presents an Austrian explanation that seems readily apparent through recent experience. A decade ago, expectations that short-term interest rates would remain relatively low for quite some time helped bring down long-term interest rates. The housing sector, particularly sensitive to long-term rates, saw increasing growth and speculation. More resources were drawn to the sector than elsewhere, fueling a spectacular bubble. When the bubble burst, the economy experienced a real shock to growth.

These effects from monetary policy are only one part of the story. Looking back at Ryan’s first paragraph above, a modern money perspective (is this better than saying Post-Keynesian?) may provide the “something similar in substance”. This view argues that fiscal policy is partially responsible for injecting money into the economy (“inside” money from private banks being the main source). Depending on the distribution, prices in certain industries may adjust before changes in interest rates. These industries will likely attract more resources temporarily due to changes in expected future demand. When the government reduces or stops supporting those industries, revealing the temporary nature of the demand, prices will tend to fall. In this light, fiscal policy that alters the money supply also creates real effects due to the misallocation of capital.

Starting from either approach, it seems clear that money is non-neutral. Given this agreement, I see no reason why modern money and heterogeneous capital perspectives need be incompatible. Hopefully others can shed some further light on this debate.

(Note: Two bloggers that often combine an Austrian and modern money approach (from whom I’ve learned a great deal) are Edward Harrison of Credit Writedowns and John Carney at CNBC’s NetNet.)

Related posts:
The Fallacy of Monetary Neutrality
Fighting for Endogenous Money on Two Fronts
Hayekian Limits of Knowledge in a Post-Keynesian World

Bubbling Up...11/10/12

1) Global Credit Cycle Lurches Down by BCA Research @ The Big Picture

The credit impulses in all three major economies – the euro area, the U.S. and China – are now negative, albeit very slightly in the case of China. This is the first time in three years that all three components have been simultaneously negative. And after hovering at a point of inflection the combined credit cycle indicator has lurched down again.

Woj’s Thoughts - As I have argued repeatedly on this blog, credit (especially private) is now the main driver of economic cycles. If broad measures of credit contract in all three major economies, it becomes increasingly unlikely that current fiscal deficits will be large enough to maintain current levels of growth (or decline in Europe’s case).

2) The US election and the fiscal cliff by Edward Harrison @ Credit Writedowns

What these three things tell me is that recession is what results from trying to reduce government deficits when the root cause of the deficits lie in private sector debt distress. When the government raises taxes or cuts spending in that situation, the result is less income in the private sector. And to the degree debt distress still exists, the result of less income is less spending and private defaults, also known as recession and credit writedowns. The larger the recession and the credit writedowns, the greater the possibility of bank failure, financial panic and debt deflation.

Woj’s Thoughts - Many pundits are currently arguing that the “fiscal cliff” is over-hyped, or simply non-existent. I think they’re wrong and, similar to Harrison, believe any compromise will still result in marginal tax increases. As noted above, the credit impulse is now negative in the US, suggesting private sector debt distress persists. The fiscal situation should be watched very closely going forward.

3) Nicholas Kaldor On European Political Union by Ramanan @ The Case for Concerted Action
From Kaldor’s essay (pp. 202-207):

THE CONSEQUENCES OF A FULL ECONOMIC

AND MONETARY UNION

This is only another way of saying that the objective of a full monetary and economic union is unattainable without a political union; and the latter pre-supposes fiscal integration, and not just fiscal harmonisation. It requires the creation of a Community Government and Parliament which takes over the responsibility for at least the major part of the expenditure now provided by national governments and finances it by taxes raised at uniform rates throughout the Community. With an integrated system of this kind, the prosperous areas automatically subside the poorer areas; and the areas whose exports are declining obtain automatic relief by paying in less, and receiving more, from the central Exchequer. The cumulative tendencies to progress and decline are thus held in check by a “built-in” fiscal stabiliser which makes the “surplus” areas provide automatic fiscal aid to the “deficit” areas.

...

Some day the nations of Europe may be ready to merge their national identities and create a new European Union – the United States of Europe. If and when they do, a European Government will take over all the functions which the Federal government now provides in the U.S., or in Canada or Australia. This will involve the creation of a “full economic and monetary union”. But it is a dangerous error to believe that monetary and economic union can precede a political union or that it will act (in the words of the Werner report) “as a leaven for the evolvement of a political union which in the long run it will in any case be unable to do without”. For if the creation of a monetary union and Community control over national budgets generates pressures which lead to a breakdown of the whole system it will prevent the development of a political union, not promote it.

Woj’s Thoughts - Although Kaldor espoused these opinions more than 40 years ago, there are still countless people today holding out hope that Europe creates a full fiscal union on the road to political union and ultimately becoming the United States of Europe. In my opinion, U.S. of Europe optimists continually overestimate the ease with which fiscal integration, not only harmonisation, is achievable. Convincing various populations to accept a common social welfare scheme, uniform tax rates and indefinite transfers is likely not achievable within the next decade, if at all. Democracies in Europe are already falling due to the strain of economic depression and widespread unemployment. Relative stability may persist for a few more years, but the political crisis will come to a head well before fiscal and/or political integration is possible.