I think we are witnessing the biggest silent shift in macroeconomic thought since the Second World War. For 70 years we have taught, and believed, that we would never again need to suffer a persistent shortage of demand. We promised ourselves the 1930's were behind us. We knew how to increase demand, and would do it if we needed to.
The orthodox have lost faith in that promise; only the heterodox still believe it. And the heterodox have nothing in common, except for keeping the faith.
The orthodox haven't lost hope. They hope that monetary and fiscal policy will be enough to get us out of this recession, and that the limits on monetary and fiscal policy will not be binding this time around. And they are probably right. But they have lost faith that monetary and/or fiscal policy will always be enough – that there are no limits.
And if the Eurozone too turns Japanese, they may start to lose even that hope.
There are two types of macroeconomist.
The first says "What do you mean you can't increase aggregate demand? You run out of paper? Ink? You scared of inflation?"
The second says "But monetary policy won't work at the zero lower bound. And there are limits on fiscal policy, because we daren't let the national debt get too big."
Scott Sumner and Modern Monetary Theorists are examples of the first type of macroeconomist. They have nothing in common, except that one thing. But that one thing is more important than all their differences. And they are heterodox.
Traditional Keynesians and monetarists, the competing schools of the old orthodoxy, belonged to the first type of macroeconomist. They differed only on tactics. They kept the faith. But they have now gone, and only monetary cranks sing the old religion.
The second type of macroeconomist represents the new orthodoxy. Few orthodox macroeconomists today will admit point-blank to having lost the faith, any more than a bishop, no matter how liberal, will admit to being an atheist. But if you believe that monetary policy is ineffective at the zero bound, and that there are limits to how long you can have a big fiscal deficit, it comes to the same thing. You have lost faith that you can always and everywhere increase demand by whatever it takes for as long as is needed.
Losing faith in monetary and fiscal policy, the orthodox turn to financial policy. "If we had better regulation and/or supervision of financial markets and institutions, we wouldn't have gotten into this mess in the first place". That's probably true, but it's also a distraction from the loss of faith. Financial markets and institutions are inherently unstable. They borrow short and lend long; they borrow safe and lend risky; they borrow liquid and lend illiquid; they borrow simple and they lend complex. Finance is magic; you know it can't really be done. Regulation and supervision can never eliminate financial instability. If your faith is contingent on being able to prevent financial crises, you have lost the faith.
Good financial regulation and supervision are important in their own right. A good financial system will better serve the interests of borrowers and lenders. It will create benefits on the supply side. And financial crises will almost certainly cause demand to fall. But just because something causes demand to fall doesn't mean monetary and fiscal policy can't work. The whole point of Keynesian policy was that when (not if) something did cause demand to fall, monetary or fiscal policy could and should be used to increase it back again.
Even suppose the financial system totally collapsed. Why should that prevent monetary and fiscal policy working to increase demand? The biggest flaw of orthodox macroeconomic models is that they have no financial sector. So, if the financial system disappeared, that ought to mean those models would work even better.
This is what I sensed to be the overarching but unspoken theme of a conference at Carleton on the economic and financial crisis. I may do subsequent posts on more specific topics.
Worthwhile Canadian Initiative 
But orthodox macroeconomic models do have a financial sector; they just assume that it is (mostly) working. Otherwise (for example) there would be no connection between the national interest-rate lever and aggregate demand. There won’t be a national interest rate at all, even, with no financial money market.
David: yes, my tongue was partly in cheek when I wrote that. They don’t have an explicit financial sector. You could say they have an implicit financial sector, that is working so perfectly you can’t see it. They also don’t have money, at least not explicitly as a medium of exchange (though it is implicit in the assumptions of the model). Again, one could say that money is functioning so perfectly as a medium of exchange that you can’t see it.
Isnt it simply that all monetary and fiscal policies bear costs and not all of them bring solutions. It really seems to me that many times the “solution” is take on debt until the economy recovers. But the question that never gets asked is what to do when the magical recovery doesnt materialize? At that point you are simply back to where you started but are worse off because you now have to bear the costs of your debt policies.
At some point we are going to have to stop reaching for the easy solutions. Growth is difficult business and the centrally planned economy is usually the worst solution. It seems to me like the centrally planned democracies are going to be facing their ultimate test over the next decade and it will be interesting to see which ones survive and which ones face complete failure.
Every Economic textbook will be re-written in the next 5 years. 1) Keynesians failed because we accumulated massive debt in the good times which tied our hands in the bad times (or will). 2) Monitarists fail because the government won’t bypass the banks (i.e. black holes of debt) to lend directly creating the multiplyer effect. 3) Austrians fail because politicians who embrace it don’t get elected. 4) Efficient market theory is like believing in Santa Clause at this point.
Behavioral Economists will play a huge new role. People are beginning to realize Economics is much more like Sociology than previously thought …and much less like Physics than they imagined.
The first says “What do you mean you can’t increase aggregate demand? You run out of paper? Ink? You scared of inflation?”
No, it goes like this:
The first says “What do you mean you can’t increase aggregate demand? You run out of energy? Oil? You scared of high gasoline prices?”
And the answer, apparent from $140/barrel oil, is yes, energy shortages scare us. Take a look, once again at a constrained economy, in this case constrained by energy shortages. Oil is money. If government wants to get funny with printing money, then they have to do it by printing oil.
Can our 535 members of Congress print oil? Actually yes, there is about 3 million barrels/day of oil easily printed. It exists exactly where we want it, just below the surface of the ground in our most transportation sense areas. Easily printed, but printed with a thing called increase oil efficiency.
In a post-bubble economy monetary stimulus and banking bailouts have the effect of maintaining unrealisticly high valuations on real assets. No-one wants to buy or invest in those assets, because no-one is fooled, they know they are overvalued. The effect is that real investment is choked off, all wealth goes into paper, and the economy stagnates, just as Japan’s has for the past 20 years. Maintaining inflated real wasset values has the same effect as rationing real investment.
Alex Plante, that is perhaps the worst misunderstanding of basic economics yet seen on this blog.
Well, ok, not the worst but pretty bad…
Ian: “Isnt it simply that all monetary and fiscal policies bear costs and not all of them bring solutions. It really seems to me that many times the “solution” is take on debt until the economy recovers. But the question that never gets asked is what to do when the magical recovery doesnt materialize?”
For monetary policy, the only cost was supposed to be the paper and ink. And inflation, only if you overdid it.
And if the recovery doesn’t materialise, it means you are not doing it enough.
Matrixhead: ” 2) Monitarists fail because the government won’t bypass the banks (i.e. black holes of debt) to lend directly creating the multiplyer effect.”
That reminds me: I must write a post on Australian Helicopter cheques. Did Australia miss the Great recession because it mailed cheques directly to households?
Anon: oil is on the supply side. And there’s no fixed ratio between oil and GDP. The energy ratio to GDP has been falling for decades.
Alex: if nobody wants to buy those assets, why is their price so high?
“We” didn’t. William White didn’t. Roger Garrison didn’t. Gerald O’Driscoll, Jr. didn’t. Steven Horwitz didn’t.
You did.
The “mainstream” did.
You are not looking hard enough to identify the underlying pathology.
Greg: I tend to associate Austrians only with the view that monetary policy was too loose, rather than adding the view that it is currently too tight, and can and should be loosened. But I am happy to add you to the honourable band of “monetary cranks” (don’t take that the wrong way) if you think that’s an accurate reflection of Austrian views.
So what’s up with the new orthodox economists who think that printing money wouldn’t work? Are they so orthodox they can’t think of how to create money beyond the zero bound? Or because it has never been done in a serious country (kidding!) it is neither proven nor disproven to work, and can’t be relied on? Or it’s just political realism, because no serious government would try it? I mean it seems so simple and obvious, you don’t even need a helicopter, just finance your fiscal programs with new money. Maybe it’s TOO obvious for an economist? As a mere armchair economist I’d like to know how there can even be any debate about this.
jj: that’s the right question to ask, but I am the wrong person to answer it. Here goes anyway: because monetary policy is interest rate policy, and you can’t lower interest rates below 0%. And fiscal policy means borrowing money. And if you try to talk about money-financed fiscal policy, you end up in a boggy morass of institutional detail.
Sometimes, you need to change the question: “How could we ensure that fiscal policy would in fact be money-financed?”
Nick, You say there is no cost to printing money other than the cost of ink. But what about the difficult to measure discoordination effects of asset booms? What about the costs of individuals taking on too much debt?
I’m not entirely sure if you are playing devils advocate or actually believe these things, but I am interested to know if you think there are other costs.
Nick, When DeLong asked Bernanke why he didn’t shoot for 3% inflation, Bernanke said higher inflation would be a bad idea. Are you claiming that his real belief, despite everything he published about the Japanese, is that there is nothing the Fed can do to create 3% inflation? If so, on what basis?
Alternatively, what new data suggests the previous macro consensus (on the zero bound) is wrong? Surely not economic sluggishness coexisting with near-zero nominal rates and fast base growth, we already knew that about Japan.
This is how White, Horwitz and Sumner understand Hayek — stabilizing MV in the post bost phase requires money expansion by the Fed to counter the secondary post bust deflationary downward spiral.
(Good economics requires that we abandon the simple-minded / brain-dead, overly-aggregated notion of “aggregated demand” — but the brain-dead notion will have to do for the current conversation.)
Hayek supported both monetary and fiscal policies to counteract the deflationary post bust “secondary depression” — have kind words of Keynes’ ideas on this as early as 1931 and as late as the 1980s …
Nick writes:
“Greg: I tend to associate Austrians only with the view that monetary policy was too loose, rather than adding the view that it is currently too tight, and can and should be loosened. But I am happy to add you to the honourable band of “monetary cranks” (don’t take that the wrong way) if you think that’s an accurate reflection of Austrian views.”
If you read his work, Hayek has always been in the “no faith” camp. Hayek called banking, money, and leverage the “loose joint” in the economy — an instability that cannot be eliminated, only made worse by bad policy and bad regulations.
Most people who write on Hayek — completely botching his ideas — have never read his work. And include Keynes in that group. There is no evidence that Keynes knew the work of Hayek, Bohm-Bawerk, Wicksell, Mises, etc. in any competent way. And a great deal of evidence that he was incompetent when it came to these rival theorists. That — of course — was Hayek’s opinion. Keynes was incompetent and unlearned when it came to the economics of these others.
Nick writes:
“You have lost faith that you can always and everywhere increase demand by whatever it takes for as long as is needed.
Losing faith in monetary and fiscal policy, the orthodox turn to financial policy. “If we had better regulation and/or supervision of financial markets and institutions, we wouldn’t have gotten into this mess in the first place”. That’s probably true, but it’s also a distraction from the loss of faith. Financial markets and institutions are inherently unstable. They borrow short and lend long; they borrow safe and lend risky; they borrow liquid and lend illiquid; they borrow simple and they lend complex. Finance is magic; you know it can’t really be done. Regulation and supervision can never eliminate financial instability. If your faith is contingent on being able to prevent financial crises, you have lost the faith.”
Or is there a belief, beyond monetary models, of a dearth of investment opportunities or the courage to accept risks that go with them, of the absence of desire or need of government investment, of impotence of effect, that inflation is all that can be created and prices would increase without any increase in the real economy, or that any attempt to do so would move the market to more than counter anything attempted?
Being an outsider, I wonder if there is really a loss of faith, rather than circling the wagons. Many people have built careers on a set of assumptions and techniques that generate papers, grants, students, and perhaps most importantly, a sense of understanding. How open is the profession to someone wobbling the foundations? How willing are they to wobble the foundations themselves? But the title of the post is encouraging.
Nick, how did the second type (the current economic orthodoxy as you call it) come about? What do you think made this group’s aversion towards increasing national debt to fight off deflation so much stronger now? (assuming they weren’t this way before) Is it because of current fears about the aging demographics, and worries of funding mass retirements? Or has this mindset always been there all along, and is only now becoming more vocal because of the rising debts due to the recent guarantees and bailouts?
I’m with jj, and in the first camp.
My view is that problem a) is that creditors have all the money and debtors are tapped out. Creditors are creditors because they have more money than they want to spend, so if creditors have all the money, its logical that demand will be too low.
The solution is simply to print money which will tip the balance back towards debtors. To be most efficient (biggest bang for the printed buck), the printed money would go exclusively to debtors, but it’s probably more politically feasible, and fair, to simply give the same amount to everyone.
But problem b) is that our policies are dictated by creditors. So even when, backed against a wall, the government prints a little money, they try to arrange matters to give as much as possible to creditors and none to debtors.
If the U.S. government were to print $5,000 for each American and distribute it to them all, I am confident that sales of cars, houses, everything would increase and unemployment would decrease. But this won’t happen, because creditors will worry about the lost purchasing power of the money owed to them.
Ian: “Nick, You say there is no cost to printing money other than the cost of ink. But what about the difficult to measure discoordination effects of asset booms? What about the costs of individuals taking on too much debt?”
Paper and ink, as long as you don’t overdo it and cause inflation. Money pays down debt.
Scott: welcome back! Did you persuade Kevin Dowd to start making his presence felt in the blogosphere? (I know him from UWO, way back).
It is hard to accuse the Archbishop of Canterbury of atheism. My guess is that when he entered the Fed, the staff slowly wore him down. If everyone around you can only speak of monetary policy as interest rates, it must be hard to think of it differently, after a while. And fiscal policy is done by someone else, and must be bond-financed, so the framing of the question dictates the answer. “We used to think the Japanese just weren’t trying hard enough; then it happened to us”.
Lord: No, if increasing demand caused only inflation, rather than increased real output, that would signify a supply-side problem. Supply-side problems have always been with us. No magic bullet there.
RSJ: No, this is not a circling of the wagons. Not everything is insiders vs outsiders. This is insiders changing their beliefs.
Rogue: the change in beliefs about the burden of the debt – that debt was a burden, and there was a limit to the amount of debt that was supportable, happened maybe 20 years ago. That was another silent change. Buchanan was I think influential. But it didn’t matter as long as you believed you could still use monetary policy. Then the recent Neo-Wicksellian/horizontalist approach to thinking about monetary policy as interest rates put limits on monetary policy too.
Declan: Australia did it, so it must be feasible, politically.
From my padded armchair, here’s how to current Orthodoxy came about:
1) WWII and the post-war seemed to prove that Keynesian economics can work, but it has a blind spot to inflation.
2) We got Stagflation in the 1970’s.
Inflation is a problem in a society where we hold a significant amount of nominal assets and depend on those nominal assets for our well-being. Not only pensioners but a good deal of the working population, particularly those low-wage jobs with no unionization, and thus reduced leverage to extract real wage gains.
Furthermore higher inflation historically led to higher interest rates, which played merry hell with home ownership. Ask any middle-class person of a certain age what they thought of 15%+ interest rates. Thus the great bell-curve of nominal rates we see since 1945.
Furthermore, changing to a 3% target would destroy at a stroke the confidence in the certainty of central-bank policy that lies at the core of the inflation-targeting project. Thus that project, the great macro achievement since 1980 would sink. It seems the economists don’t want to abandon the sinking ship just yet. Even Captain Bernanke.
Inflation is good in a disinflationary or deflationary environment? OK, ramp up the debt machine. But that 150% national debt will now require higher taxes to pay it down. Keynes acknowledged this, but applying this in reality has proven to be a hard sell. The current orthodoxy would say that at some point higher taxes will reduce economic growth and the expected higher revenue as it chokes private demand for investment and business formation.
When was the last time we were forced to use debt to fight off deflation? Japan? The 1930’s? Not exactly good track records, either one.
So, the current orthodoxy says Debt = Higher Taxes, Inflation = reduced real wealth.
As Sir Humphrey Appleby would say, for every choice there is a price. Which one do you want to pay?
Well, in that case I’m excited to hear what the new set of beliefs will be. The current mania about the eurozone needing to cut deficit spending in order to promote growth is worrisome, though. Maybe the failure of the EMU will be needed to show a better path forward.
“Australia did it, so it must be feasible, politically.”
Do you have a link to what Australia did? I hadn’t heard about that, although I knew the U.S. did it a bit under Bush. But the key is really to do it without issuing bonds, since issuing bonds to finance the printing just creates another debtor-creditor interest stream which is just more of the existing problem, given that the government is already on the debtor side of the ledger (albeit, maybe not in Australia). Plus, if you decide to pay interest to creditors on the money you print, and that you can only print money to the extent that creditors are willing to ‘lend’ it to you, that puts an upper limit on how much you can print, a limit which may be too low to cause the necessary inflation.
The other alternative to restore debtor-creditor balance is simply widespread debt default/forgiveness, but that seems even less likely, although the high default/foreclosure rates in the U.S. are probably slowly helping to solve problems there, albeit at a massive human cost. It doesn’t help that every time a large entity tries to default, it seems the government steps in to ensure that all the creditors are made whole.
Note, I’m not skeptical about your comment on Australia, just curious.
Well, if your only method of creating money is giving more to those who have nothing to do with it, no desire to spend or invest, but to bank it or buy assets and commodities in anticipation of inflation without entering circulation it won’t have much effect. Only bankruptcies, foreclosures, debt forgiveness, will have the capacity to provide much relief. The Fed should issue debit cards and fund them to remove any idea that it will need to be paid back and use that to target ngdp.
We have pretty well exactly as much in the way of available natural resources as we did in 2005. We have as many people with about as much talent, ability, and knowledge as we had then. We need pretty much the same things as we did five years ago, there are at least as many mouths to feed and minds to keep entertained as there were then.
So we have everything we need to produce and consume just as much as we were in 2005. But we are not doing it! And it makes people idle who don’t want to be and wastes the most valuable resource we have, namely people. Why? Not because of any physical factor in the real world. We are in this mess because we can’t figure out how to properly distribute use money!
So this is not a real physical crisis. It is a mental crisis, not a real one. What is really wrong is that our ideas about how to create and use money were illusions.
I don’t have any magical solutions, though I rather suspect that the so called “modern money theory” economists are on or close to the right track.
But the first solution to a problem caused by bad thinking is to stop and re-think things. But people tend to cling to illusions for a long time and it often takes a really big crisis to get them to drop them and start thinking afresh.
At least you seem to be one of the few who are aware that something must be wrong with our way of economic thinking. That puts you ahead of what seems to be the majority who insist that since their thinking is “obviously” right, it must be that it is reality that has it wrong, and not them.
There appears to be a broad-based recognition that inflation is not purely a nominal issue. In particular, the new soft-spoken consensus is that when the short-term price of credit is pegged, short-term real-interest rates can be set by monetary policy. Any coherent commitment to this policy can peg real-rates perpetually, across the yield-curve.
A problem arises in whether this policy can be maintained in absence of an (positively) accelerating interest-rate.
Lets posit for a moment that the answer is ‘no’. Then the eventual consequence of maintaining this policy is either hyperinflation, OR that the monetary authority will waver in their commitment to a given real-rate target.
Once the monetary authority wavers, real-income will fall simply from the shift in real-rates–even if nominal variables hold to trend because the required nominal growth path is again accelerating not merely on trend.
If real-income falls the choice is either relative poverty for all or a few (unemployment).
Now lets consider what would happen if the real-rate can be held without accelerating inflation. This would imply that the surfeit of demand is satiated by the net liquidation of the capital stock such that again, real-income eventually declines.
You can see this plainly in the most accessible measure of the capital stock: industrial capacity. Whenever, real-rates are negative the capital stock is flat or declining. Every year with positive real-rates shows the capital stock increasing.
Naive reader here: Why is it so hard to deliver a credible commitment to raising inflation? Even now Bernanke is deliberately fighting inflation rather than fostering it. As I understand it, a little inflation is just what you need when you hit the zero lower bound. So far all the objections/explanations seem political, rather than economic. Is there some technical reason why type 1’s fourth question is not germane?
You’re not fooling me, I know MMT/PK aren’t truly heterodox economists 🙂
http://worthwhile.typepad.com/worthwhile_canadian_initi/2009/12/why-do-bad-banks-really-matter.html
Determinant: No. The new orthodoxy has lost faith in their ability to create inflation.
RSJ: “Well, in that case I’m excited to hear what the new set of beliefs will be.”
I think you misunderstand me. There is nothing exciting about the new set of beliefs. It’s either “Let’s cross our fingers, and hope the economy can recover by itself, and with what limited help we can give it” or “We’re screwed”.
Declan: In one of the comments on my “Canada Australia New Zealand” post there’s some information on the Australian helicopter money, IIRC. It’s an open question as to whether it was money- or bond-financed. You can’t really tell just by looking.
Lord: Yes. Theoretically, the key part of “money-financed” expenditure is that it be permanently money-financed (and expected to be permanent). And you can’t just flip a switch to make it permanent. And one problem with MMTers is that they never seem to grasp this temporary/permanent distinction, as far as I can see.
Ed: what you just wrote is exactly what someone would have written 80 years ago. We have come full circle.
Jon: you lost me there.
JD: that’s the question. I’m not going to try to answer it here.
TGGP: Yep. In their horizontalism, the MMT/PK group are very orthodox. But they suddenly become verticalist when they switch to talking about fiscal policy, which they insist is inherently money-financed. The new orthodoxy is equally inconsistent, but in the opposite direction, because they are horizontalist on monetary policy, but maintain the implicit assumption that fiscal policy is bond-financed. If you view monetary policy in horizontalist terms, then whether fiscal policy is money- or bond-financed is an empirical question. It’s not something that can be determined by flipping a switch, or looking at double-entry bookkeeping.
I did a post on this about 18 months ago. I should probably re-visit the question. But I fear I would be forced to fight my way through an impenetrable wall of thickets of accounting and institutional detail, to make what is essentially a simple point.
MMT/PK uses the terms “horizontal” and “vertical” differently than you do
It seems that what the current orthodoxy is good at doing then is getting themselves in power. They’re still influential now even when the economy is begging for more fiscal intervention.
a: “vertical” = the central bank sets M, and i (and P) adjust accordingly.
“horizontal” = the central bank sets i, and M adjusts accordingly.
Rogue: “It seems that what the current orthodoxy is good at doing then is getting themselves in power.” almost by definition! 😉 Those in power must be good at getting themselves in power.
But there is a real question: can monetary and/or fiscal policy always be used without limit to increase demand without limit?
“…even when the economy is begging for more fiscal intervention.” And they could respond that you are begging the question 😉 Would more fiscal intervention potentially make things worse?
“… if you believe that monetary policy is ineffective at the zero bound …”
Is the zero lower bound really the problem or a symptom? Seems to me (I’m certainly no expert so if I’m wrong please correct me) that the machinery for implementing monetary policy is critically dependent on banking and finance. So when banking and finance blow-up – which I suppose means it stops responding to the dials, knobs and levers used by the CB to direct their actions – it’s not really surprising that it get’s hard to implement monetary policy.
If this is the case, then the argument for ‘regulation’ is really about identifying the banking and finance machinery necessary for the CB to implement monetary policy, and making sure it’s very unlikely that it will blow-up – perhaps even at the expense of optimal growth or efficiency.
Is anyone aware of an instance of a modern economy suffering a lack of AD in the absence of a financial system meltdown?
Nick, Kevin has just finished a new book on the financial crisis–so he’s using the old-fashioned method of communicating. And yes, he did mention that he was at UWO. I seem to recall he studied under Laidler.
I still don’t get this, although I don’t doubt that you are at least partly right. But here’s my complaint.
1. Bernanke writes papers arguing the zero bound doesn’t prevent additional monetary stimulus in Japan from being effective.
2. Bernanke says Japan is doing X, but they should really be doing Y.
3. When the US crisis occurs Bernanke refuses to do Y, and people say “Now we see why the Japanese had so much trouble.”
How does any of that make any sense? If you claim policy X was the reason for the failures in Japan, and then adopt policy X in the US, why should you expect anything other than failure?
(I hope it’s obvious that policy X is interest rate targeting in a regime with no price level target.)
But its even worse. Bernake said the Japanese misdiagnosed the problem, assuming it was merely banking whereas the deeper problem was falling prices and falling NGDP. He said the Japanese assumed money was easy, when in fact nominal interest rates are an unrelaible indicator. All this seems to have been forgotten.
I notice the complete absence of the new classicals who claim there is never a shortage of aggregate demand. They thought they were the new orthodoxy. They are well worth ignoring.
So that makes me orthodox !?!?! OK here goes. First you have to decide if you are talking closed or open economy. So let’s start with a closed economy. Can the government spend no matter what ? Sure it can. Just have the central bank make money and give it to the Treasury (this can be Treasury sells bonds to the public and then the Fed does open market operations people will buy if they know they can sell to the Fed).
Now this won’t work if people lose faith in the currency. That would lead to high inflation. That would relax the zero lower bound on nominal interest rates. I mean if a real interest rate of -99.99999999 % is not low enough then you might have some trouble, but really how likely is that ?
The Treasury can buy with cash. If people lose faith in the cash then monetary policy can be used to make real interest rates very large and negative.
The limit on total liabilities of the public sector (bonds and high powered money) is limited demand for money. If the liquidity trap can trap infinite amounts of liquidity, there is no limit on public spending — ever. If it can’t then we can get out of it and use monetary policy.
Uh so why can’t Greece do anything ? Does go without saying doesn’t it. They can’t just print and spend money, because they don’t control the BCE.
Now normally an open economy can’t print unlimited amounts of money as people will use foreign currency for transactions. But the open economy can devalue (and will automatically if they monetize deficits).
What if all the open economies do that ? Then the whole world will be like the closed economy above.
Of course, I can make a model where the government can’t do anything about a recession basically by assuming there is no functioning governemtn(it’s not like the government of Somalia could do much about a recession or anything else for that matter).
But there isn’t a newly discovered problem related to say the USA unless Bernanke goes Trichet on us. The impossibility of doing anything argument is based on the assumption that the Central bank sets nominal interest rates, and doesn’t issue enough high powered money and give it to the Treasury to create demand directly (an odd assumption to make in a continent where the stock of high powered money increased by over US$ 2 trillion).
It looks like the “mainstream” is back to where uber Keynesian John Hicks was 1969-1973, i.e. “the mainstream” in collapse ….
Robert Lucas and the macroecononists then went back to Hayek (yes, Hayek, read the record) — and botched it, getting the “microfoundations” all wrong.
This time?
“Ed: what you just wrote is exactly what someone would have written 80 years ago. We have come full circle.”
True, and I have been watching the “orthodox” economists trying to ignore it for around forty of them, expecting cynically that they would indeed, eventually come back full circle. I’m a tiny bit surprised that it seems to have happened within my lifetime, actually.
Economists as a general class do not seem to be very good at checking their theories with reality. Instead they seem to spend their time vigorously denying the obvious in order to please their employers.
The path of wisdom is first to understand your ignorance. That’s not enough, of course, but it is a decent start. It would be a hopeful sign if more economists realized their ignorance.
One thing economists seem not to have considered is the possibility that making money a commodity destabilizes economies. I do not know if an economy without interest on interest is possible or even a good idea, but it would be nice if someone with real understanding analyzed the possibility. Maybe I have missed that someone has already done it that I don’t know about.
Interest on interest seems suspiciously like a positive feedback to me, and undamped positive feedback is certainly a dangerous thing in electronics as it leads to “squeal”. Of course that’s reasoning by analogy, always a dodgy method.
“The path of wisdom is first to understand your ignorance. That’s not enough, of course, but it is a decent start. It would be a hopeful sign if more economists realized their ignorance.”
Same could be said of commenters on economics blogs Ed.
Nick:”But there is a real question: can monetary and/or fiscal policy always be used without limit to increase demand without limit?
“…even when the economy is begging for more fiscal intervention.” And they could respond that you are begging the question 😉 Would more fiscal intervention potentially make things worse?”
Well, there would always be a limit to intervention. And I could see reasons for the ambivalence to use it right now – so much of any intervention can either just leak out to mercantilist nations, or be hoarded if it trickles towards capitalists, or just be used to pay down debt if given towards debtors. we could easily be testing the upper limits before any intervention actually makes the intended effect. what a mess!
Patrick: You are not obviously wrong about that. But I would say it’s an area that’s not well understood. But even if a banking crisis reduces demand, and also reduces the effectiveness of monetary and fiscal policy in increasing demand, it shouldn’t reduce it to zero. And if there are no limits…..then just give it more gas.
Scott: I don’t get it either. My best guess is (if you’ll excuse the old British imperial expression), is that he’s “gone native”.
Of course, I can’t in any way prove my conjecture that the orthodox have lost faith. I can’t point to persons X,Y, and Z and quote them on this. Especially because the monetary orthodoxy and the fiscal orthodoxy people may not be the same people. But my conjecture helps me make sense of the world. It’s an “as if” hypothesis, if you like.
I did rather hope that some commenter might come right out and say: “Yes of course we’ve lost faith; there clearly are limits on how much fiscal and monetary policy can increase demand, and we would be foolish not to recognise that fact, sad though it may be, so don’t shoot the messenger!” But only the faithful have responded, and they can’t understand why the apostates should have lost their faith.
A case in point:
Robert: Welcome!
Yep, I ignored the classical/real business cycle approach. It’s partly an orthodoxy in academia, but not in the policy world. I was thinking of mentioning it, but doing so would have detoured my argument.
Yep, I’m talking about Canada (US, UK, etc.) and not Greece, which can’t print money, and so is clearly limited in what it can do. And a closed economy for simplicity, and because ultimately it’s about the world economy.
Now, let me say that I basically agree with your analysis. But it’s not quite so simple. Let me throw a couple of spanners into your reasoning:
1. Suppose the Bank of Canada does an OMO and sells bonds today. What that means is that it retroactively changes past deficits from money-financed deficits into bond-financed deficits.
2. It follows from 1. that we cannot say today whether today’s deficit is bond-financed or money-financed. It will depend on what the Bank of Canada does in the future. And since expectations matter, it depends on what people expect the Bank of Canada to do tomorrow in response to today’s deficit.
3. Now switch from a “verticalist” perspective, where the Bank of Canada chooses the stock of M, and the Department of Finance chooses how many Bonds to issue, into a world where M (the monetary base) is endogenous, because the bank of Canada targets i in the very short run, and something else, like inflation, in the long run. That defines a Bank of Canada reaction function. So whether a deficit is money-financed or bond-financed is not something that is chosen as such; rather, it is an empirical question that depends on what it is the Bank of Canada is targeting, and how the variables in the Bank of Canada’s reaction function respond to the deficit. It’s an empirical question.
It’s this last point (3) that is missed by both the “new orthodoxy”, and by those who try to argue one way or the other based on accounting and institutional details.
Ed: ” I do not know if an economy without interest on interest is possible or even a good idea, but it would be nice if someone with real understanding analyzed the possibility.”
It’s a very bad idea. If interest on interest were banned, lenders would only offer 1 day loans to get around the prohibition.
Question:
Under a gold standard, how do monetary authorities constrain excessive money creation due to regular commercial bank lending? How do they prevent commercial banks from creating new deposits with new loans?
“Ed: ” …an economy without interest on interest
a: “imperfectly” would be the short answer, I think. (I’m not an economic historian.)
1. Simplest case. There is no central bank. Each commercial bank issues its own notes and deposits, redeemable in gold. Each bank has to keep a close eye on its gold reserves, and stops advancing loans, and calls in loans, or raises the interest rate on loans, if it fears it lacks sufficient reserves to handle a reduced demand for its notes and deposits.
2. Commercial banks redeem their deposits for central bank notes, and the central bank redeems its notes for gold.
2a. The central bank keeps 100% gold reserves against its notes, so the central bank never fears running out of reserves.
2b. The central bank keeps less than 100% gold reserves. It has to raise the interest rate it charges commercial banks on loans of notes if it fears it has insufficient gold reserves for its outstanding notes, or if it fears the commercial banks have insufficient notes in reserve against their deposits (though the commercial banks themselves should be responsible for this).
“Imperfectly”, because the gold standard suffered financial panics, bank runs, the central bank called in as lender of last resort, and temporary suspensions of convertibility.
Somebody else could (I hope) answer this better than me. Why do you ask?
Ed: my slight knowledge of Islamic banking suggests it makes a great example of the ongoing escalating war between financial institutions and their regulators.
You lend me money for one day. Tomorrow, you make me a new loan that I use to pay back your first loan plus interest. The day after tomorrow we repeat. Etc. The result is we have daily compound interest, even though by law you can only charge me simple interest.
“Why do you ask?”
Just an outstanding question that I’ve never seen explained very clearly.
Also wondering whether/how central banks use interest rate targeting as part of a gold standard. If they use interest rates, how does that figure in with horizontal/vertical, etc.?
thanks
central banks can use raise interest rates when they are short of gold reserves, and lower interest rates when they have too much reserves.
In the very short run (for a given interest rate) this is a horizontal policy.
In the longer run, with the stock of gold fixed, this is a vertical policy.
In the very long run, since new gold can be mined if the cost of mining falls, it’s horizontal again (only with the price level rather than the rate of interest on the vertical axis).
Actually, this is much the same for inflation targeting.
http://worthwhile.typepad.com/worthwhile_canadian_initi/2010/03/why-the-lm-is-usually-vertical-and-the-ad-curve-usually-horizontal.html