Winner of the New Statesman SPERI Prize in Political Economy 2016

Monday 6 January 2014

Monetary versus Fiscal: an odd debate

A long time ago, the debate between monetarists and Keynesians was the debate in macro. But it was a rather limited debate: both sides generally used the same model (IS-LM), and so it was all about parameter values. It was also, dare I say, a little dull. More recently, but before the recession, that debate had largely gone away, but since then it seems to have come back. This post asks why that is.

Before the recession, what I have called the consensus view was this. Under flexible exchange rates, monetary policy was the instrument of choice for demand stabilisation. Textbooks tend to give you a list of reasons why this is, but as I and colleagues argue here, it follows naturally in a New Keynesian model. It is not because fiscal policy cannot stabilise demand, but because (in fairly simple cases) monetary policy is better at doing so. From a welfare point of view, it dominates.

Does that mean, when monetary policy is unconstrained, it is all you ever need in a New Keynesian framework? In theory no. To take just one example, in a model with wage and price stickiness, real wages will deviate from their natural level following shocks, and in principle changes in income taxes or sales taxes could correct this. Even more obviously, these same taxes can in principle offset cost-push shocks. However you might describe this as a niche role for fiscal policy: the basic and fundamentally necessary task of stabilising demand is best handled by changing interest rates.

The qualification that monetary policy is unconstrained is critical, of course. If you are a member of a monetary union, it is a completely different game, and now fiscal policy’s ability to influence demand makes it useful, although perhaps not essential. I have argued that a failure to understand this was a major factor behind the Eurozone crisis.

The other example of a constrained monetary policy is of course the Zero Lower Bound. At the ZLB we have fiscal policy versus unconventional monetary policy. There are good reasons for thinking that unconventional monetary policy will not dominate fiscal policy as a stabilisation tool. Analysis of one particular unconventional policy, forward commitment (which is not the same as forward guidance), shows fiscal policy is not dominated in this case.

So which is better comes down to parameter values and the details of the model used. Given the uncertainties here, the only reasonable approach to take in advising policymakers is to use a combination of both policies. If you are thinking that concerns about debt might rule out using fiscal policy, you are wrong: temporary balanced budget changes in government spending can still be a useful tool.

This eclectic approach seems to me to be the one taken by, say, Paul Krugman or Brad DeLong. What I do not understand is why there are others who take a different view, and want to argue that monetary policy is still all you need. Where does this certainty about the powers of unconventional monetary policy come from? As I have already noted, it does not come from the theory that I know. So maybe it comes from a belief about parameter values, but given how untried this policy is, how can you be so certain as to not want to hedge your bets with fiscal action?

But perhaps it’s not the effectiveness of unconventional monetary policy that is crucial here, but a profound mistrust concerning the effectiveness of fiscal actions. Yet I cannot see the macroeconomics behind that either. In its purest form, all fiscal stimulus involves is bringing forward public spending, just as monetary easing encourages the private sector to bring forward their spending. That is bound to be effective in combating demand deficiency. Is the fact that the spending takes place this year rather than in five years time that costly, particularly if the spending is investment like in character?

So I remain mystified where this desire to downgrade the usefulness of fiscal policy at the ZLB comes from. I suspect I am missing something, and would like to know what that is.


  1. This is a very good question. Here are possible answers:

    1. An overarching belief that recessions are good/necessary/politically useful.

    2. A belief that the economy is always at full employment.

    3. A belief that monetary policy is always effective.

    4. A belief that we are always close to panic in the government bond market.

    5. A belief that government cannot be trusted with discretion on anything.

    Of course, none of these is a good argument. But they are the arguments I have seen on my columns.

    1. Martin Wolf misrepresents number 4 on his list. What people (like me) say in comments on his columns is that Britain may be close to a difficult-to-retrieve situation NOW. Assuming fiscal policy works (see previous debate), it would be nice to use it countercyclically, but the problem is that in practice, the economy has never been quite strong enough for politicians to espouse contractionary fiscal policy, meaning that the debt increases inexorably. At some point, you - if not the bond market - have to say "that is far enough", and inevitably you are going to crash into that point during a time of economic weakness, so the decision is not going to be easy. But such are the choices that need to be made if Britain is to remain stable and acceptably prosperous. While Martin Wolf and Keynesians reasonably argue that it is unwise to tighten fiscal policy during a downturn, they can offer little but blind faith and questionably relevant history that a sustainable upturn is coming.

      This is often perceived as a right-wing argument, but that is certainly not my position - my choice would be to tighten fiscal policy with taxes on wealth, such as site value taxation and increased inheritance tax. In fact, the Tory welfare cuts are so crass that, given what we know about deprivation leading to delinquency and poor health, they might be better characterised as another form of borrowing.

    2. Voiced concerns are not the real concerns. The real rationale is simple: monetary policy is not redistributive; fiscal policy can be redistributive. The further we are down the road to plutocracy, the more opposition there will be to fiscal policy.

    3. @ Tim Young, I find most of this very puzzling. But then, as you know, I usually do.

      We agree on the last paragraph. So there is no debate there.

      On the first paragraph, why do you say that the debt increases inexorably? In fact, it does no such thing. UK debt has exploded relative to GDP over the last three centuries in only two situations - world wars and a huge financial crisis. There is absolutely no reason to believe it rises "inexorably", because it doesn't.

      In fact, the UK public debt was extraordinarily low, by all historical standards, as the country entered into the Great Recession. I know I have made this point often. But it happens to be true. Yes, that was partly because of inflation in the 1960s-70s. But then the UK had a real mountain of debt to get rid of after WWI and WWII, not, like now, a mere molehill.

      You say that I have only "blind faith" in a sustainable upturn. Now if this were, say, 1850, that would seem a reasonable point. But we have now had two centuries of a "sustained upturn". You surely have to have "blind pessimism" to believe the economy is never going to grow strongly again.

      As to the fear of some terrible bond market crash, well I think you really have to do much much better than such vague fear-mongering. What are the probabilities, in your view, and at what point do they kick in? How much bigger are they at a net debt ratio of 110 per cent, instead of 90 per cent? What difference does it make as well if the country borrows for investment? I would have thought that if the country has been able to more-than-double its debt ratio and end up with far cheaper debt than before, you would feel that you need to produce something better than a completely unspecified bond-market bogeyman.Yes, choices have to be made. But since you haven't produced an empirically-grounded argument, it doesn't seem to me to be very difficult to make that choice. You say we are close to an irretrievable point NOW. Prove it. You can't of course, by definition. It's just scare-mongering. But I can prove that the UK has had more debt than this for much of its history without any of the catastrophic consequences you cite. Now that is a fact.

      By the way, the answer to your question on why fiscal policy works is, in monetarist terms, "velocity of circulation". The most important point about a recession, for a monetarist, is that either M collapses of V collapses (or possibly both). M did not collapse. So V did. But the government can borrow idle money and make it circulate faster.

    4. @ Alphonse, Monetary policy is indeed redistributive, big time. It favours the financial sector, at least to some degree. Above all, it favours debtors in this situation.

  2. My impression from the discussion on the De Long blog (which triggered this blog) is that is that it is belief No.3 in Martin Wolf's list; plus the belief that monetary policy is always so omnipotent (even unconvetional monetary policy at the ZLB) and the Central Bank so omniscient that that the Bank can always achieve the precise level of Aggregate Demand that it wants. Therefore the Bank can and will completely offset what would otherwise be the effects of fiscal policy upon the level of income.

    For reasons mentioned by Professor Wren-Lewis, I find the position unconvincing. For what it's worth, I also find plausible the suggestion in DeLong's blog that the current US disussion is at least partly motivated by the desire to refute Krugman, who has been dismissive of the MMT proponents.

  3. Pretty sure the only thing you are "missing" is that the view that fiscal policy cannot be effective is entirely politically-motivated by a belief that big government is bad, and fiscal policy = big government. I really don't think there is the remotest hint of intellectual rigor behind the opposition to fiscal policy.

    1. Yes, I agree with this explanation. Pure politics, plain and simple.

    2. Completely agreed that no intellectual logic applies, although practical considerations with especially investment in infrastructure (probably the least controversial fiscal stimulus) surrounding the whole planning procedure mess in many Western countries, could play a role to. I am writing this from Singapore, where that obviously does not apply.

  4. As someone with no economics education but a keen interest (thanks in part to this blog) this issue is something I've never quite understood. When the economy is weak everybody agrees that cutting interest rates is the appropriate response. The main impact of this policy is to boost demand. If demand is sufficiently suppressed then interest rates hit the ZLB and only fiscal policy or unconventional monetary policy is left to play with. The government has decided that unconventional monetary policy is preferable/sufficient; you can argue about that, but fine. What is confusing is that to get to this point we have followed the logic that the economy is basically suffering a massive shortfall of demand, hence the ZLB and unconventional monetary policy. How can the government accept this analysis, yet simultaneously propose supply-side reforms and shrinking the state as solutions to the problems in the economy? It's just seems totally incoherent to accept a Keynesian analysis to identify the problem, then adopt a Hayekian solution to that same problem. Why would you agree with cutting interest rates to boost demand yet embark on austerity, which reduces demand? The only conclusion I can see is that the government is using conventional and unconventional monetary policy, not to boost the economy, but rather to offset the effects of dismantling the welfare state.

  5. Once klugman is referenced as in anyway valid you are doomed. This is a man stuck on the UN teat through more than one of his so called think tank/institutes. He is in no way an original nor independant source. The entire financial world can be understood using the Vegas model. The house always wins. The owners of 'the house' set the odds. The rest is a vast complex charade. The Stock Exchange their off track betting. Gilts are now 1's and zeros ensnaring a political cast not fit for purpose think of the Vegas infrastructure and it's as plain as the nose on your face. Yru Bliti. Institute For Human Liberty.

    1. I don't understand several of the terms you use. Please be a little more explanatory for those of us who are not members of your cult.

  6. I get the impression that monetary policy is perceived as more 'fair', while fiscal is more directed to certain parts of the market, and therefor prone to being misused by government to favour their friends and pet projects. However .. neither method is free of this problem.

    It is related to the dogma that central banks must be independent of politics. Which is a good idea, although ultimately central banks are of course utterly dependent on political support for what they do. And there are good reasons for saying that politics should decide the basic goals of a central bank, democratically.

    In Europe there is the additional problem that nobody knows of a fair way to share out the power of the central bank's money-creation. The fear is that a few lazy-bum countries will always drink from the fountain of free money, while the hardworking countries will need to ensure that this fountains keeps running. As long as EU countries don't trust each other, we forbid any form of 'monetisation'. Which then further erodes that same trust.

  7. I guess Martin Wolf's comment captures well the most common reasons. But he leaves out a critical one: sheer ignorance.

    I mean, the claim that Ricardian Equivalnce, in principle, rules out any role for fiscal policy is simply incoherent. Also, as Olivier Blanchard rather bluntly put it once:
    "Say's Law: False".

    The fact that there were prominent academic economists who who were ignorant of the basics is an appalling reflection of the state of macro.

    Greg Clark(2009):
    'Recently a group of economists affiliated with the Cato Institute ran an ad in the New York Times opposing the Obama's stimulus plan. As chair of my department I tried to arrange a public debate between one of the signatories and a proponent of fiscal stimulus -- thinking that would be a timely and lively session. But the signatory, a fully accredited university macroeconomist, declined the opportunity for public defense of his position on the grounds that "all I know on this issue I got from Greg Mankiw's blog -- I really am not equipped to debate this with anyone."'

    1. Well, if it is so obvious to you, but apparently not to various Nobel-winning economists, why Say's Law is false, perhaps you would care to contribute to the related discussion a couple of posts ago:

      As I said there, something that annoys me about Keynesians is their jibes, like yours here, that doubters are just wrong, apparently without feeling the need to offer any kind of supporting argument (I cannot access the Blanchard article). The tale of the Emperor's New Clothes comes to mind.

    2. Try downloading the Blanchard paper here (works for me but YMMV):

    3. The Nobel winner in question, Lucas, retreated very quickly, claiming his views had 'evolved'. John Cochrane also later said that he did not believe in Say's law.

      The claim that Say's Law fails in a monetary economy is not controversial.

      An ungated NBER version of the Blanchard paper is

    4. @Kevin and Herman, Thanks. I will read and try to understand!

    5. Are you seriously asking why Say's Law is wrong? Sigh.

      Most economist (except for Post-Keynesians) actually think that Say's Law is right most of the times except during recessions. In a recession we witness two facts: output (growth) falls and millions of people become INVOLUNTARILY unemployed. Technically this means that we have an excess supply in the output and the labour market.

      By the way, there is nothing "Keynesian" about opening your eyes and seeing that even without supply side shocks like e.g. during the oil crisis an economy can enter a recession and become demand-constrained unless "Keynesian" is supposed to mean "connected to reality".

  8. Professor Wren-Lewis,

    I think the argument is that trying to get behind fiscal stimulus is a waste of time. Market monetarists like Scott Sumner believe economists' resources would be much better utilized in getting a NGDP level targeting regime, which in his eyes would leave fiscal policy useless in affecting aggregate demand.

    Also, doesn't the news of US Q3 NGDP growth seem to support the notion that monetary policy does a good job of offseting fiscal policy? The fact that the US had such severe fiscal contraction and still is growing at a pace similar to 2012 certainly doesn't hurt the position of MM'ers.

    1. The NGDP targeting versus inflation targeting argument is entirely separate from the fiscal versus monetary argument. That is, one could target NGDP using just fiscal policies, though as it happens, the advocates of NGDP targeting tend to favour monetary policies.

      As to the fact that monetary can offset fiscal, MMers talk a load of nonsense there I think. Scott Sumner makes the ridiculous claim that the fiscal multiplier is zero because it’s bound to be offset by monetary. Now that’s plainly not the case: indeed during the recent recession, far from monetary offsetting fiscal, monetary AUGMENTED fiscal. That is there was a certain amount of fiscal boost, and central banks AUGMENTED that with interest rate cuts, QE, etc. I expanded on that point in a recent post on my own blog:

  9. Simon,
    The key question to ask others... Why are we at the ZLB? Is it because the interest rate still needs to go lower to raise demand? Or is it because interest rates are kekpt low to lower the governments' interest payments on debt?
    Remember that tax revenues are extremely low as a % of GDP. Governments feel they have to watch their spending.
    You see interest rates at the ZLB as still too high. Others see interest rates at the ZLB as artificially too low. So then they reason that less government spending must complement low interest rates to lower government deficits. The end result of their reasoning is that they see the ZLB as justification to cut spending even more.
    ZLB and cuts in spending accomplish the same goal.
    Another possibility... We all make certain assumptions that affect our reasoning. And you assume that there is still a large output gap. Your assumption leads you to believe that the ZLB is still not low enough in order to close the large output gap. Yet, the output gap may not be as large as you think. Economic potential may have shifted downward, and maybe you do not see it yet.

  10. Simon,

    The point that “mystifies” you mystifies me as well. But I’d take it further. That is, I don’t even agree that when interest rates are positive, that monetary policy is preferable to fiscal. Reason is that there must be some free market or optimum rate of interest, and given a recession, I see no reason for assuming that it’s an excessively high interest rate (i.e. inadequate investment spending) that’s the cause of the problem rather than inadequate household spending.

    Indeed, the recent crisis was sparked off to a significant extent by those underwater mortgagors cutting their weekly spending, i.e. deleveraging.

    Also, it’s not a good idea to distort an economy in any direction (e.g. in the direction of investment spending). That distortion only has to be unwound later, and that involves people shifting from one job to another.

    Plus, as Galbraith put it, “firms borrow when they can make money and not because interest rates are low”.

    Plus, it was irresponsible borrowing and lending that sparked the crisis, from which one might plausibly conclude that interest rates were TOO LOW, and needed raising.

    So could you explain why you and others think that monetary policy should be the weapon of choice when interest rates are positive? I’d be very grateful.

  11. Scott Sumner also responds to DeLong's post:

  12. I posed the question a few days ago why it is the BBC has been critical of neoconservatism but not neoliberalism.

    The only answer I can come up with is that most BBC editors vote Liberal Democrat. They have rejected Labour after the build-up to the Iraq war and its aftermath, and they have rejected the Tories as many of their MPs want the BBC abolished.

    This has led to the BBC turning a blind eye to the concept of a fiscal stimulus, as shown by their refusal to use the term about Japan after the 2008 economic crisis, but their posts before 2008 on Japan do use the term 'fiscal stimulus' and 'liquidity trap'.

    It is the choice of the Liberals to go into Coalition to save the Euro side of neoliberalism that has given cover to the Tories to save their Thatcher-Reagan side of neoliberalism, whilst the Labour Party flounders about not least because the BBC will not be as robust against neoliberalism as neoconservatism due to the BBC's relationship with members of the New Labour Party.

  13. This comment has been removed by the author.

  14. Two questions:

    1) What is "unconventional monetary policy"? Is monetary policy targeting 2% inflation unconventional? Is practice of central bank to print money unconventional?

    2) What is "interest rates"? Did you mean real interest rates? Is central bank unable to lower or at leat to threaten to lower real interest rates by inducing inflation?

    The most frustrating aspect of comments by people who are much into fiscal stimulus is hopping from one concept to another to prevent direct discussion.

    Or do you mean that "conventional" monetary policy just setting s nominal short term interest rate? Then there was no "conventional" monetary policy in USA for last 5 years or so and in Japan there was no monetary policy in last 20 years. All those meeting of FOMC that caused turmouil in markets were only figments of our collective imagination, no change in "conventional" short-term nominal interest rate means there is nothing to see. How dumb a definition of monetary policy has to be so that countries can go decades without having any change - despite of things actually happening in real world?

    So to end this tirrade sooner - by far your biggest sin is you insisting on a particulary maddening framing of discussion. It goes by using these claims

    1) "Monetary policy is about setting interest rates, and we are at ZLB now!

    Answer: is it not real interest rates that matter? Is it not true that CB can print money to increase inflation so that real interest rates go down?

    2) "No, no. Monetary policy *IS* 2% inflation target. You go above that an it is "unconventional"

    What the heck? How is then fiscal stimulus supposed to work? If fiscal stimulus stimulates economy so that it produces above 2% inflation does it not mean that monetary policy has to tighten? And why should we even start to engage in fiscal stimulus (assuming below 2% inflation) when we can get there by, you know, conventional money printing?

    This is what the whole debate of monetary offset was about. Just look at Japan: 2 decades of brutal fiscal stumulus and the inflation was still right where Bank of Japan wanted it to be - at 0%. Monetary policy trumps fiscal policy if it is set to be so - for instance by targeting inflation.

    If there is any one sentence that characterizes monetary offset theory it is this:


    or this one


  15. Automatic fiscal stabilizers are the first response of choice to an economic downturn; monetary policy is a second choice and slower than automatic stabilizers. Automatic stabilizers are so ingrained they are ignored in conversations about the speed of fiscal versus monetary response. Fiscal stabilizers are inadequate and should be expanded. Few would disagree about the value of automatic stabilizers (which are fiscal policy) so most everyone would agree that some fiscal policy is important.

    What about other fiscal policy (stimulus)? Milton Friedman developed his monetary policy theory in an era when fiscal policy was adequate in most economies. This gave a false notion that fiscal policy is not important. Now we are in a era when too many economies have woefully inadequate fiscal policy. Surprise: No monetary policies are adequate! All are impotent. The best monetary policy cannot fully compensate for bad fiscal policy. We are try to answer the question, "Given woefully inadequate fiscal policy, what is the best monetary policy?" This is a difficult question to answer because no monetary policy will adequately address the economic problems. The better question to ask and pursue is "What combination of fiscal and monetary policies are needed to get economies back on track".

    -jonny bakho

  16. I think you miss the point.

    1. NKs (or Krugman anyway) have denied the efficacy of monetary policy at the ZLB. MMs vigorously dispute this.

    2. MM's assert that if the CB targets an NGDP level and actually sticks to the target that any fiscal policy is superfluous and will in any case be offset by a change in monetary policy in order to maintain adherence to the original target. Or to put it another way, MMs don't dispute the efficacy of fiscal policy .... just its necessity.

    3. MM's would contest the existence of what you call unconventional policy. To MMs monetary policy is very simple.... there is a target: NGDPLT; and there is tool: the exchange of money for financial assets (and it doesn't much matter whether you call the tool OMP, or QE, or asset purchases since these are primarily only differences in nomenclature).

    1. Monetary policy can be marginally effective at the ZLB.
      It has been tried and the results are in.
      Monetary policy at the ZLB is woefully inadequate. Krugman is correct.

      Better to use fiscal policy to push the economy away from the ZLB into conditions where monetary policy can be more effective. Advocates of monetary policy dominance would be wise to choose an inflation rate that is farther above the ZLB than 2 percent to avoid the zone of monetary impotence.

      Monetary policy works primarily as a set of brakes on a sound economy. By applying or easing the brakes, the rate of growth can be controlled.

      In a economy at the ZLB there is inadequate natural growth. Easing the monetary brakes does not return output to capacity. Monetary policy is only useful for braking an economy. Generating demand in a slack economy requires a heavy does of fiscal intervention.

      -jonny bakho

  17. Simon wants to know where the “desire to downgrade the usefulness of fiscal policy… comes from”. Some of it comes from the following inconsistency in one of the basic arguments behind market monetarism (at least MM a la Scott Sumner).

    In Sumner’s introduction to MM, he says (Item No.10) that “Some of us are skeptical of fiscal stimulus, partly because we think monetary stimulus is more efficient for the usual deadweight cost of future taxes reasons, and partly because the central bank might offset the effect by targeting inflation or NGDP.” See:

    As to the “deadweight cost of future tax” I assume he’s referring to the fact that if those in receipt of fiscal stimulus dollars/pounds think their windfall will be confiscated by future tax, that will substantially reduce their desire to spend the windfall. Well fair point.

    But at the same time, and in reference to monetary stimulus, he says “…that monetary stimulus is only effective when it is expected to be permanent, is something I’ve been arguing since 1993, and Krugman picked up on in 1998. It’s a core component of market monetarism. Nick Rowe once said that policy is 99% expectations of the future path of policy and 1% the current stance.” See:

    In short Sumner is saying that fiscal policy is not too effective because windfall recipients think their windfall with be confiscated. But at the same time he admits that for monetary policy to work, the impression must be given that windfalls WON’T BE confiscated!!! Hardly a fair way of comparing fiscal to monetary policy!!

    Second, there is Sumner’s claim that fiscal policy may be ineffective because “the central bank might offset the effect by targeting inflation or NGDP.”

    Well now, to criticise fiscal policy because the central bank might negate it is not a good argument against fiscal policy. That’s like saying that turning your central heating on is a waste of time because someone might turn it off again. Alternatively it’s like saying “I’ve decided to dig a hole with a shovel rather than a spade, therefor spades are useless.” There is a choice as to whether to use monetary or fiscal measures (or some combination) just as there is a choice as to whether to use a spade or shovel.

    1. Actually I think that the deadweight loss point was different. I would say it is about tax smoothing, meaning that having periods of low taxes in recession (assuming stimulus is carried out as lowering taxes) and periods with high taxes after recession is inferior to an arrangement with average taxes.

      So even with ideally constructed fiscal stimulus that is timely and that does not distort how ideal long-term level involvement of government in economy as is decided in political process, it is still inferior from welfare point of view.

  18. Ironically the upswing we now have could be taken by Keynesians as vindicating their stance. Look (they can say) the economy is now returning to trend, the previous years of growth were not after all an illusion. there was no long term risk in running a loser fiscal policy, and all you have done is delayed the inevitable.

    The real problem with fiscal policy is not theoretical, but practical. Political constraints in a democracy prevent fiscal policy being used save at the margins. So, we can bring forward or postpone infrastructure investment, or CGT a bit, but the political cost in (say) introducing a serious LVT or really cutting into the welfare budget is too high. It only ratchets one way, and all any government can do is slow its progress.

    See recent history for proof. Despite all the rhetoric about austerity in the UK (which bizarrely economists seem to have taken at face value) Osborne has hardly been able to cut anything from overall expenditure. When Labour win in 2015, we'll have a 50% top rate again, but no radical reorganisation of tax.

    Real austerity was possible in Ireland and Spain because the governments were left wiht no choice: cut or leave the euro.

    Monetary policy has its limits (see the political limit reached on Black Wednesday) but is a lever that it is politically possible to pull.

    1. Interesting point SpinningHugo. I also wonder, I guess the reason why unconventional MP at the moment is monetarising private sector liabilities rather than government debt (long or short term) is the government is cutting back (to some extent). But can you really say we have contractionary macro-policy at the moment with the BOE purchasing on the scale it has been?

  19. Mr Wren-Lewis,

    I recommend you to write balance sheets of entities(corporation, household, bank, central bank and government) on a sheet of paper, and guess what happened to each balance sheets before the bubble, at the peak of bubble and after the burst of bubble. This process is needed to get the whore picture.

    Banks make loans to the entities to purchase the real estate(or MBS), and the price of real estate surge. One must think how velocity of money will be described on the sheet, and how money creation under peoples’ expectation (that the price of real estate will go up) will be described. Every entities behave to maximize their profit on balance sheet.

    But once the bubble burst, every entity(corporation and household) behave to sell the real estate and minimize(repay)their debt. They don’t want to borrow money any more. Every Bank tries to collect its loan, which leads to ZLB.

    One must remember that, when bubble burst, face value of real estate will disappear from their balance sheets. Not that cash has disappeared.

    To rescue the situation, FRB, ECB and Bank of Japan had to purchase government bond and finance its government for fiscal policy.

    In this situation, for the governments to repay their government bond aftermath, they must bring
    about bubble again, or, the new monetary policy is needed, as below.

  20. Yamada's describes the situation very well. It sounds like it comes from someone who is seeing the situation first hand. It reflects a very Japanese understanding about the situation. This was the Japanese language discussion in Japan the late 90s, 2000s. (Not the English language discussion by Japanese economists, many who did their education at MIT and were probably not even in the country.) At this time, US economists, including the Great Bernanke and Krugman were saying Japan had too much debt! Anyway, both are on the right side now, and at least can admit their mistakes. What I would like a few more to do is to put the models and gimmick away and actually look at what is going on. That involves looking at bank and central bank balance sheets.

    1. By the work above, you see the velocity of money(money creation), on the balance sheets between banks and corporations, or between banks and households under bubble. That is, money is created between banks and corporations, or between banks and households on the balance sheet. You will also see that central bank unable to control money creation. This all happens under people’s expectation that price of real estate should rise. The balance sheets among these three entities(banks, corporations and households) swell. This is what the monetarist suggested before. Because money creation is uncontrollable by central bank under bubble nowadays, certain new model that enables control is needed.

  21. This debate is a bit like the oxbridge boat race. I'll just jump in the river, if I may. Many believe structural policies are the only thing to have a lasting impact.

  22. Great post. Surely the answer you seek was given five times by Martin Wolf? It's all about 'Belief'.

    Belief depends on how the brain's "Happy Chemicals" wired up the neurones of people's brains to avoid the stress hormone, Cortisol, or to seek the reward chemicals Dopamine and Serotonin. How their brains are wired depends on what was happening in their lives when they were pre-schoolers and again when they were teenagers when new neurone pathways were being created.

    Look at the economic and political circumstances that shaped the lives of today's decision makers and you might see why they cling to ideas that can be proven to be at odds with both facts and theory; it's got nothing to do with logic. Decisions are not made logically, they are chosen by what 'feels right' - then logic is later used to justify those decisions.

    Hence you have people such as Osborne (b. 1971) and Cameron (b.1966) who were exposed to their families' stress during the Arab oil crisis in the early 70s, and then to the Thatcherite application of monetarism and privatisation as solutions to this stress in their teenage years. Consequently, their neurone pathways will always make them uneasy about any solution that is different to those they grew up with.

  23. It's the politics, stupid (to coin a phrase...).
    I simply don't understand why economics is no longer called the study of the political economy.
    Beliefs (I am delighted that MW participated on this blog), entrenched interests, biases etc. etc. all are expressed in economic outcomes.

    I recommended a stock that was not bought, it ended up doing well. The PM blamed me - he said I didn't do my job if I couldn't get a good idea into the portfolio.

    That's the way it works - if we have bad econ policy - it's not the policy makers fault it's the economists fault. You aren't doing your job if you can't get good economic policy implemented.

    Economists have once again set themselves too easy a task by simply studying the economy and blaming someone else for the politics.

    To know and not to act is not to know. Economists don't know a thing if they can't make it happen.


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