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Sunday, 11 January 2015

On the monetary offset argument

A number of us are highly critical of moving to austerity so early in the recovery from the Great Recession. Market Monetarists (MM) argue that this criticism is unfounded, because monetary policy can offset the impact of austerity on demand. Not when interest rates are at the Zero Lower Bound (ZLB), the critics of austerity respond. The ZLB is not a problem, MM reply.

I want to make a couple of observations. First, MM often imagine that they invented this offset argument. However it forms a key part of the austerity critics’ original objection. If the impact of fiscal consolidation on output is always the same, then the reasons for postponing deficit reduction until the recession is over become significantly weaker. [1] The whole point is to postpone deficit reduction until when the ZLB constraint no longer bites. At that point, monetary policy can offset the demand impact of fiscal consolidation, whereas at the ZLB it cannot (according to the austerity critics). Monetary offset is built into the austerity critics’ main case.

Second, if you are a fiscal policy maker, and you want to take the MM argument seriously, you have to believe two things. First, that monetary policy is capable of offsetting the impact of austerity as much now as later. Second, that this is actually what monetary policy makers will do. If you believe the first, but are not sure about the second, then fiscal consolidation now is a mistake. Sure, you can blame monetary policy makers for not offsetting when they could, but if you knew this might happen then you hold some responsibility.

This second point exposes how weak the MM argument is at the ZLB. They have to argue not only that unconventional monetary policy could offset fiscal contraction at the ZLB, but also that it will. We see immediately that the issue of NGDP targeting is beside the point. Central banks at the moment are inflation targeting, and are likely to continue to do so, so enacting fiscal contraction in the hope that they might change is highly irresponsible.

So the MM argument that the ZLB does not matter has to rely on Quantitative Easing (QE). But here there is a basic problem that MM has never to my knowledge answered. Just how much QE do you do to offset any fiscal contraction? We have no real idea, because we have so little experience. Lags between policy actions and reactions are such that we cannot just say whatever it takes, because we might have lost a lot of output (or created a lot of inflation) before policy makers get it right. In reality, policy makers are likely to be cautious, so almost certainly they will not offset enough, even presuming that QE is capable of offsetting completely. So once again, being realistic about what we know and what monetary policy makers will do, fiscal contraction at the ZLB is irresponsible. (I have talked about this in more detail before.)

These are abstract arguments, but they can be applied to two real examples. First the Eurozone. Here we currently have no QE. We should have QE - indeed I have argued we should think about having helicopter money, but to presume that these things would happen just when they are required would be highly unrealistic. It would also be silly to assume that the ZLB was never going to bite when the new fiscal regime was put together following the crisis. So fiscal contraction in the Eurozone is a major problem and highly irresponsible whichever way you look at it. 

In the UK it is often argued that 2010 austerity was not a problem, because given the rapid inflation that happened in 2011, if austerity had not happened, the MPC would have raised interest rates. However that is an argument made with hindsight [2]. It has no bearing on whether austerity was a good policy choice when it was enacted in 2010. In 2010 inflation was not expected to rise to 5%, so the coalition had no reason to believe that the ZLB constraint would cease to bite in 2011 (assuming that it did). Instead to justify 2010 austerity we have to assume that, if the 2010 forecast proved over optimistic (which it did), QE would have been applied to the required degree to get the economy back on track. Given the uncertainties noted above, that would have been a foolish assumption to make. So 2010 austerity was a costly policy choice which reflects badly on those who made it.

So to conclude, the monetary policy offset argument is not a problem for critics of austerity at the ZLB but a key part of their argument. To believe that monetary offset will continue to apply to the same extent at the ZLB, you have to make quite unrealistic assumptions about what policy makers are capable of doing with Quantitative Easing, and also about what they will actually do.

[1] Convexity of the social welfare function would still be an argument to wait until the recession was over, although to set against that is the point that if the long run desired position involves some level of debt, the longer you leave deficit correction the more adjustment you have to make. This post discusses an IMF exercise which plays around with such things, but ignores the key ZLB argument.

[2] Even with hindsight I would argue it has little purchase, as the period during which 3 members of the MPC voted for higher rates lasted only 4 months in 2011. There is also an issue about whether the inflation caused by the VAT increase was really seen through by policy makers.     

73 comments:

  1. Hi Simon,

    I made an effort to go though some of the other assumptions involved in the monetary offset argument here:

    http://informationtransfereconomics.blogspot.com/2014/05/monetary-offset-what-are-assumptions.html

    However I don't think there's any escaping that "monetary offset" is a model-dependent result and that the very idea of being in a liquidity trap is that any monetary offset model isn't currently valid. Another way, arguing monetary offset against the liquidity trap is actually just ignoring the liquidity trap.

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    1. "Another way, arguing monetary offset against the liquidity trap is actually just ignoring the liquidity trap."

      Or disagreeing with the liquidity trap speculation. Or rather, speculations, since there are a number of different versions of the liquidity trap thesis, which is why it should probably be dropped as a term in economics and replaced by more precise concepts e.g. the ZLB on short-term interest rates.

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  2. I don't want to defend austerity as I think it is pretty clear that it at least has a possibility of doing significant damage in a demand starved world and the alternative pretty much can't hurt.

    But another thing the monetary offset argument entails, and not only at the ZLB, is that fiscal stimulus can be inhibited by monetary offset as we get near or above the inflation target, especially stimulus that is in the form of tax cuts. QE also doesn't really work without higher targets since low targets are an implicit promise to pull out QE as soon as it starts working.

    There is no guarantee that we can get to full employment without a higher target (or massive unmultiplied sustained long term government spending that replaces all missing private spending).

    Without the higher targets, we are cutting off the market for investments that have real returns under -2%. The secular stagnation hypothesis, the savings glut hypothesis and the demographic wave of wealthy countries all support the idea that this could be a growing and important segment of the investment market. Not raising targets and letting governments do all the spending instead might help but without a market for these investments, we can only hope that governments will allocate in the right mix of things and the right maturity structure matching the timing of future consumption needs.

    Because of this offsetting from the top, without higher targets, fiscal stimulus can seem semi-futile. The higher targets. in whatever form they take (higher IT, PLT, or NGDPLT) are important to clear the path to sufficient investment and allow fiscal stimulus to have a multiplier effect.

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  3. Market Fiscalist11 January 2015 at 18:47

    Keynesians and market monetarists are united in the view that stimulus is needed at the ZLB.

    But market monetarists think that 1) monetary offset works even at the ZLB and 2) monetary policy is a more efficient way of stimulating the economy than fiscal policy it would be kind of weird if they didn't push this as the optimal policy.

    However I think that most Market Monetarists would believe that if QE was going to be unacceptable for political reasons they would support fiscal stimulus as a second-best option.

    But isn't the reality that it is large fiscal deficits that are more politically unacceptable than QE ? Right now QE is being discussed for Europe as something that may be needed to fight deflation, while in both the UK and Europe reversing fiscal "austerity" is a long shot.

    Isn't this the time that Keynesian should be rallying behind calls for monetary stimulus ? Even New Keynesian models accept that monetary stimulus will work as long as the CB is able to "promise to be irresponsible" and commit to higher future inflation.

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    1. "promise to be irresponsible" is such a stupid term since it means the opposite: Promising to do the responsible thing and remove overvalued fiat as a barrier to investment and employment.

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    2. All those opposing austerity that I read have also been pushing for maximum monetary policy stimulus. So I look forward to MM clearly saying that the move to austerity in 2010 was a big mistake.

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    3. "All those opposing austerity that I read have also been pushing for maximum monetary policy stimulus."

      Can you give some examples? You certainly don't make it a theme of this blog, though I know you agree with it.

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    4. Oh please, now you are just reverting to MM debating mode, like trying to tell me what my own research is. Do your homework!!

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  4. Austerity can just as easily be opposed on supply side grounds, as on demand side grounds. So I would prefer to have the argument framed as being about "fiscal stimulus" rather than austerity. That aside...you need to deal with the fact that stock markets yawn at fiscal policy, but hang on every word of the central bank governors. If the model says it should be the other way around, because of the liquidity trap, then the model is probably wrong.

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    1. "you need to deal with the fact that stock markets yawn at fiscal policy, but hang on every word of the central bank governors"

      That is a good point, if central banks were so powerless they wouldn't need to weight every words they say so carefully. Another piece of evidence that point toward the central banks holding the big end of the stick in these situations. Of course fiscal stimulus should also be part of the toolset.

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    2. I don't think anyone doubts that CBs can effect financial market outcomes (hence why they hang on to every word of central bank goverments) the key question is whether those changes in financial market outcomes have much of an effect on real economic outcomes (inflation, unemployment etc).

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    3. Good point. And that was exactly the point of the great Keynesian test of MM in 2013 (and 2014). MM passed that test, or wasn't falsified. Growth accelerated even as austerity ticked up. Therefore the test of whether FM outcomes have real impacts was passed.

      And on his broader point on QE/NGDP targeting he shows he doesn't know MM too well. The first M in MM is about using the market to calibrate your monetary policy. You know you have done enough easing when NGDP expectations/forecasts are back on trend, of 5% or so. Or, temporarily higher if you have been so lax as to some NGDP on the downside, hence the LT of NGDP (Level Targeting).

      Time and again we ask whether S W-L has expectations in his models. He remains silent. AS a result he ignores the world as it is, and his case is so much the weaker.

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    4. Try searching for expectations in 'search this blog'. Yet even if expectations are rational, they can be very wrong when there is very little information, which is the case for QE. So talking about the market does not answer my point about policy uncertainty. To use your language, I am still waiting for MM to respond to this point. As it critically undermines their argument on austerity, it is kind of important.

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    5. "Markets can be wrong" is not a persuasive critique of those who rely on market reactions to gauge the stance of monetary policy. Every time you pit smart guys/gals against the EMH, EMH wins. If the market says that a move from the fed is expansionary, it is.

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    6. Bad news James, by any consideration or measure, MM failed the test you refer to (via PK), and failed convincingly. QE failed to offset the fiscal contraction, which for the US in 2013 is widely estimated to have reduced GDP by approx 1.5%. Moreover, you cannot, by any stretch of the imagination simply cite positive GDP figures and use them to conclude that QE passed the test, since the actual contribution of QE to GDP figures is not only very difficult to quantify, and those studies that have attempted to do so report only a relatively modest improvement in GDP thanks to QE. Certainly no where near enough to offset the impact on GDP of the fiscal contraction, which is what the test was mainly about. Strangely, you write "Growth accelerated even as austerity ticked up." Can you explain why you wrote this falsehood?
      The GDP data shows annual GDP for 2013 to be 1.9%. This is lower than the year before, and lower than 2010. Looking at 2013 quarterly GDP, this was mediocre overall, and unlike your description, it was quite erratic - rising, then falling, then rising, but all at fairly modest levels, and likewise for the first quarters of 2014. Growth did not accelerate, James.
      As the NYT in 2014 says about 2013 overall : "the economy was still performing well short of the so-called breakout speed economists and policy makers have been hoping for. Instead, it continues to muddle along at a steady but disappointing pace. From 2010 to 2013, output expanded at an annual rate of about 2.3 percent, strong enough to lift corporate profits and stabilize many parts of the economy, but not fast enough to push unemployment low enough to lead to meaningful wage increases for most workers. That, in turn, has held back big gains in consumer spending, which is responsible for a large share of overall economic growth.
      http://www.nytimes.com/2014/03/01/business/economys-growth-was-slower-in-fourth-quarter.html?_r=0
      Test failed James.

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    7. The test when set was whether there would be any growth, not whether it could have been better. You and I agree it could have been better. You say with added fiscal, I say with NGDPLT. Maybe in 2015 we could test that somewhere, somehow.

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    8. And on the great "uncertainty" point, what is wrong with using market expectations of NGDP Growth to gauge the amount of QE needed? No lags to policy then, but immediate feedback loops. This is Sumner's great advance over Friedman. Work with the market to steer policy. Not too hot, much above 5%, or too cold at much below 5%. None of this blindly steering and hoping for the best.

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    9. Stock market fluctuations show that someone is wrong, but it isn't clear that this someone is an anti-austerian. Stock market fluctuations have a low correlation with subsequent GDP growth, or profits or the achieved present discounted stream of dividends.

      I think your argument is based on the efficient markets hypothesis. That is an odd hypothesis to use when discussing how to policy makers should react to the deflation of gigantic bubbles. On the other hand, you might also think that the beliefs revealed by stock market indices are powerful even if they are irrational. That hypothesis is at least more plausible than the EMH, but it doesn't fit the data very well at all.

      Finally, I don't have the impression that stock prices respond especially dramatically to announcements by monetary policy makers. I stress the word "especially". The announcements may be followed by huge shifts on the order of 1%, but such huge shifts occur on the average trading day. I may be wrong about this last point, but I am not aware of an event study which suggests I am wrong. I am aware of discussions relating changes in indices over a period of months to one monetary policy announcement. I don't think this is sound methodology. Again I might be wrong, but I am not aware of any academic who works in finance who would take such analysis seriously.

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    10. "The test when set was whether there would be any growth, not whether it could have been better."
      Please James, this is becoming more embarrassing. You know this is not true. Afterall, on your previous blog comment (on 'Faith based macro') you correctly noted that:
      "For 2013 PK said the austerity in that budget for that year would test the monetary **offset** theory of Market Monetarism, a good scientific test." You then falsely claimed "The result: monetary policy offset the austerity."
      Just to confirm, the 'test', as stated by Mike Konczal, which PK referred to was:
      "Beckworth and Ponnuru...argued that as long as the Fed is working **to offset austerity**, the country “won’t suffer from spending cuts.”
      We rarely get to see a major, nationwide economic experiment at work, but so far 2013 has been one of those experiments -- ***specifically, an experiment to try and do exactly what Beckworth and Ponnuru proposed***. If you look at macroeconomic policy since last fall, there have been two big moves. The Federal Reserve has committed to much bolder action in adopting the Evans Rule and QE3. At the same time, the country has entered a period of fiscal austerity. Was the Fed action enough to offset the contraction?"
      http://www.washingtonpost.com/blogs/wonkblog/wp/2013/04/27/the-great-economic-experiment-of-2013-ben-bernanke-vs-austerity/
      You read this, you even previously repeated this in your comment, so why now say "The test when set was whether there would be any growth", when clearly this wasn't the test at all? And the test as set out by Konczal was, by the end of 2013, duly failed by MM.

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    11. Robert, appreciate your remarks. My main point is, markets haven't stopped paying attention to central banks because of the liquidity trap. CB watchers aren't out of a job. If anything, they are more in demand than usual.

      One way to explain this is to discard the assumption that central banks are inflation targeting. That may be the stated policy, but it may be a poor model of the actual policy.

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    12. Using RGDP as a measure of the impact of austerity on demand is rather begging the question against Market Monetarists. The difference between NGDP growth in the US in 2013 and 2012 was measurement-error stuff: about 3.7% and 4.2%. So if there was a slowdown in RGDP growth in 2013, it was supply-driven rather than demand-driven.

      I think that Market Monetarists themselves have made a mistake by playing into the terms of the (silly) debate set by Keynesians, and even then not the good Keynesians, who know that RGDP can't be used as a measure of demand, and that such reasoning is the economics of the 1970s and before. I also think that talking about 'falsification' is the philosophy of science of the 1960s and before. The bad old days when giant Popperians walked the Earth and talked about interesting scientific laws being refuted by a single observation are thankfully gone. In fact, the whole debate is frustratingly old-fashioned.

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  5. Are you arguing that Congress can do a better job of calibrating stimulus than the Fed can monetary policy? Color me extremely skeptical.
    Even if the Fed doesn't fully offset stimulus, partial offset changes the cost/benefit analysis dramatically.

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    1. This post is about austerity that has blunted, delayed or prevented the recovery from the recession in the US, UK and Eurozone, and the arguments of many/most/all (?) MM that this did not matter.

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    2. Market Fiscalist12 January 2015 at 06:28

      I think it would be fairer to say "this needn't have mattered". I think most MM agree that in the absence of monetary offset fiscal austerity did slow down the recovery compared to the counterfactual where austerity did not occur. I have read many MM blog posts comparing the recovery in US (with some offset) compared with Eurozone (little or no offset).

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    3. "But here there is a basic problem that MM has never to my knowledge answered. Just how much QE do you do to offset any fiscal contraction?"
      It looks to me like I'm addressing your key (basic) point. Also, Sumner has answered this question: very little. If the monetary authority is explicitly doing level targeting, and is using market forecasts to calibrate, it wouldn't have to do much at all.

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    4. Read the post - NGDP targeting irrelevant.

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    5. 1) Are you saying that fiscal stimulus boosts NGDP & RGDP, but has no impact on inflation? If fiscal stimulus lifts NGDP, it should lift both RGDP and inflation (how much of each depending on where we are on the supply curve).
      2) I didn't mention NGDP targeting. The argument is the same if the Fed is inflation targeting or NGDP targeting. You may disagree with the argument, of course, but that's a different thing.

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  6. Some points in response:

    1. Monetary offset or not, there was no justification for fiscal austerity related to anything cyclical. and in most cases there was no strong secular case for austerity. Apart from Greece perhaps, there were not and in all probability will not be fiscal crises in countries such as the US, UK, and Japan.

    2. The market monetarist monetary offset argument has some subtleties. Ben Bernanke, for example, called for fiscal stimulus even while claiming the Fed still had tools at its disposal for dealing with additional nominal shocks. Market monetarists argue, much as Milton Friedman did, to pay attention to peoples' actions, not their words, as they are often confused about their actions and related effects themselves.

    3. Market Monetarists do not accept that lags in judging the effectiveness of monetary policy apply. Instead, they view market reactions immediately following news from the Fed as the ultimate predictors of policy effectiveness. This makes sense not only from a market efficiency standpoint, but also from the very real fact that it's markets that must be convinced of a policy's future effectiveness if a recovery is to begin at all.

    4. Despite claims about the rationality of uncertainty concerning the effectiveness of QE, following QE programs in Japan, the US, and the UK, immediate market indicators predicted improvement in the future economic growth paths versus the those without QE. and some improvement in economic growth did in fact occur in each case.

    5. The effectiveness of QE programs will depend almost solely on the perceived will of the central bank to maintain the program in the face of sufficiently high inflation. Surely, no one argues that a central bank determined and legally allowed to buy any assets it chooses in any amount couldn't raise inflation to any reasonable(or even unreasonable) level it likes. Otherwise, a central bank could buy all the assets in the world, with little or no inflation.

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    1. 1. I'm glad you agree with the critics of austerity that austerity was unnecessary.
      2. Bernanke's position reflects my argument. He could have done more QE to offset austerity, but he would rather have less austerity because the impact of that QE was so uncertain. I do not think he was confused.
      3 and 4. Are you claiming that markets have a clear idea of the impact of any amount of QE, but economists just have not been able to figure out what markets know?
      5. I think this is repeating one of my points. Policy needs to allow for the monetary policy makers we actually have. This means, as you say in 1, that austerity was a big mistake.

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    2. On 3 and 4 I think MMers would argue that markets have suggested that more QE was needed or not enough - market based inflation expectation indicators such as inflation break evens have been below target. The key issue here being that CBs have ignored these indicators and thus been too conservative in their actions.
      On 5, I agree that it's not sufficient to say austerity shouldn't matter since monetary policy will offset - if only CBs were perfect. On the flip side I think it's also a criticism that could be fired at Keynesianists - ultimately policy needs to allow for the fiscal policy makers we actually have.

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    3. 3. and 4. The markets put up real money, economists only test their models ... and mabye in the very long term their careers. But tenure is a powerful, two-edged sword.

      5. "Policy needs to allow for the monetary policy makers we actually have". Or is it, policy needs to allow for the fiscal policy makers we actually have.

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    4. unreasonable and 5. It is not symmetrical. Keynesians, knowing policy makers, also argue for maximum monetary stimulus. It is MM who imply fiscal policy does not matter.

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  7. Given that the rise to c5% CPI at the end of 2011 was driven by "a series of one-time special events —the decline of the pound, the hike in VAT, and commodity prices" (Krugman blog July 17, 2012 'Declining UK Inflation'), the Coalition should have put the higher rate of income tax up above 70% rather than increasing VAT to 20%.

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  8. I agree with Simon: Market Monetarism is a bit of a nonsense. However, there is one nonsensical element of MM he missed, namely the MM claim that fiscal stimulus is pointless because the central bank will negate that stimulus. That’s like saying it’s pointless a nurse prescribing aspirin for a headache because a doctor will subsequently decide some other treatment (or no treatment at all) is better.

    The reality is that nine times out of ten doctors regard aspirin as being helpful for those with headaches. Likewise, given a recession, central banks nearly always regard monetary stimulus as being helpful.

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  9. To paraphrase Bill Mitchell: 1 Monetary policy including QE, can only work if it stimulates aggregate demand – that is, INCREASES SPENDING.

    The only way it can do that is via the lowering of longer-term interest rates (as the central bank buys up bonds and drives their yields down). But that relies on the private sector having a taste for risk (borrowing) and it is clear that, even with significant reductions in the investment maturity rates, there is little thirst out there for borrowing.

    Why should there be? The private sector is being confronted with fiscal austerity and a household sector intent on battening down and paying down debt. Firms will only invest in new productive infrastructure if they expect that households (and other firms) will purchase the consumer or capital goods that they produce.

    At present, it is clear that firms have more than enough productive capacity to meet current expected aggregate demand. Result? No big investment boom is coming and so borrowing is mute. Further, with more governments scorching the earth with fiscal austerity – mindlessly claiming that by cutting spending you get more – a sort of sick alchemy – households are facing increased unemployment risk again. With record levels of debt hanging over the sector and the risk of joblessness rising in an environment where high levels of unemployment and underemployment persist – why would there be a renewed outbreak of frenzied borrowing?

    2. Building bank reserves – which is all the non-standard liquidity measures have done – will not increase loans. Why? Because banks do not lend out reserves. A lack of reserves is not the constraint. Loans create deposits. The constraint is point 1 – no thirst for borrowing.

    MONETARY POLICY IS NOT SPENDING. FISCAL POLICY IS SPENDING.

    3 Monetary policy might influence spending but only indirectly, with a lag (if at all), and the ultimate impact may well be perverse if the distributional consequences of interest rate cuts, lead creditors to spend less, by more than the borrowers, spend more. Further, monetary policy cannot be regionally or demographically targeted.
    Which tells us that if spending is required, then it would be better for the spending arm of policy to be activated – that is, fiscal policy.

    Government spending is direct, can be targeted (individually, spatially, etc), and can be part of an overall package of redistribution (where tax policy might reduce the purchasing power of one income cohort, for example, and public spending might boost the purchasing power of another).

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  10. Is market monetary theory the same thing as modern monetary theory?

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    1. I was wondering the same thing. This though looks like in-house talk.

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    2. Have a read of Soft Currency Economics by Warren Mosler http://www.mosler.org/docs/docs/soft0004.htm

      That will give you a starter into sovereign fiat currency economies. You can move on from there to the "Post Keynesian School" and MMT. Having studied it, as a retired electrical engineer, in great detail for the last five years, I would go straight to MMT. After that, you can ponder why the hell they ever gave Nobel Prizes for economics.

      On this site there is a lot of pseudo-intellectual claptrap; a lot of name dropping of economic non-entities. You can understand why NASA did not include an example of planet earth's economic model on its deep space probes data bank.

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    3. MM and MMT are two entirely separate sets of ideas.

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  11. anonymous, they disagree on wording (fiscal policy in mmt is monetary policy in mm), and on whether the central bank should be independent.

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  12. Interesting post.

    A few comments.

    1) From what I understand, MM believe fiscal policy matters for countries without independent monetary authority. That's pretty much orthodox economic theory.

    2) MM believes that the 2008-2009 recession was caused by inadequate demand. This is pretty much the Keynesian view.

    3) They believe NGDP is a better indicator of the stance of demand than inflation or RGDP. Keynesians commentators often use RGDP data to look at the effects of austerity or monetary policy on aggregate demand instead of NGDP. In my opinion, the MM take on this issue seems much more sound. NGDP is mostly demand-driven. RGDP is supply and demand-driven.

    4) MM argues for a regime change. They argue that inflation level-targetting would be a much better choice than inflation-targetting. They argue than NGDPLT would be even better. To me, this seems very much in line with, say, Krugman 1998.

    5) MM points to Switzerland, where the monetary authority has targeted a clear nominal target (CHF/EUR) and managed to hit it through massive QE, even though they are at the ZLB. In that context, monetary certainly had traction. Job growth and job creation was quite robust. There was some level of austerity. To me, Switzerland looks like the MM poster-boy and is a bit inconvenient to Keynesianism.

    6) I consider myself open-minded on the issue of the effect of fiscal and monetary policy at the ZBL. One of the reasons is that I am not an economist; I feel I should listen to the arguments made by well-trained economists very carefully and avoid, as much as possible, dismissing them. But the fact is, in the US, NGDP growth has stayed flat at 4% since 2009, no matter the level of austerity. This suggests that the Fed has done almost perfect monetary offset. This is pretty much the MM story.

    7) In the UK, NGDP growth was very weak from 2011 to 2013 (going down to 2.5% at the through). This corresponds to the period of austerity. Monetary offset was not perfect. Employment growth was stalled. This looks like the typical Keynesian story.

    8) The Euro zone actually raised rates twice in 2011! They actually acted as if the Euro economy was overheating. Both MM and Keynesian frameworks tell us that this was a bad idea. Of course, within the EZ, the countries that enforced more austerity were worst off, as both MM and Keynesians predict.

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    1. I think (1), (2), (4) (7) and (8) illustrate that MM and Keynesian analysis have a lot in common. I do not agree with (3), essentially because I take a more structural view, where NGDP is a result of various processes separately influencing real activity and prices, but this is really a separate issue from the points addressed in this post. That is partly why I am not convinced by (6) - the Fed are not targeting NGDP. I should know more about Switzerland - perhaps I need an invitation from some economists to visit!

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    2. "http://mainlymacro.blogspot.in/2015/01/on-monetary-offset-argument.html#comment-form"

      You are right, of course. However, the Fed's dual-mandate suggests that their target-function is related to a mix of the inflation rate and job growth. NGDP is probably a good approximation of such a function.

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    3. Oops, I was responding to "the Fed are not targeting NGDP".

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    4. "I do not agree with (3), essentially because I take a more structural view, where NGDP is a result of various processes separately influencing real activity and prices"

      But you still don't think that RGDP is a good measure of aggregate demand, right? In which case, what do you think is the best measure of aggregate demand?

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  13. But, more importantly, what functions or variables would you suggest using to measure the stance of aggregate demand instead of NGDP? It seems to me that RGDP is even worst than NGDP, since many of the processes controlling real activity, as you mention, are related to supply-effects.

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  14. Prof Wren-Lewis,

    Just a couple of notes:

    1. Scott Sumner is fond of saying that the fiscal multiplier is a measure of central bank incompetence. That is to say, a central bank might fail to offset contractionary fiscal policy, but if it does fail, then that's more a problem with the central bank than with the legislature.

    2. In the depths of the 2008 recession, Frederic Mishkin argued that "that the view that monetary policy is ineffective during financial crises is not only wrong, but may promote policy inaction in the face of a severe contractionary shock. To the contrary, monetary policy is more potent during financial crises because aggressive monetary policy easing can make adverse feedback loops less likely." http://www.nber.org/papers/w14678

    Christy and David Romer expressed a similar thought, in an excellent paper titled The Most Dangerous Idea in Federal Reserve History: Monetary Policy Doesn’t Matter http://eml.berkeley.edu/~dromer/papers/Dangerous_Idea.pdf

    I hope this helps you better understand MM's strong aversion to fiscal stimulus. The very act of viewing monetary policy and fiscal policy as substitutes causes the central bank to implement suboptimal monetary policy. The Romer paper, in particular, is about as good a Market Monetarist manifesto as you'll find.

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    1. 1. Which would be true if the CB knows what it is doing. With QE it does not. You just seem to be avoiding this key point.

      2. I cannot see how implementing austerity, which ensures we stay at the ZLB, invites the central bank to behave suboptimally. This is a nonsense argument. Central banks undertook QE at the same time as fiscal stimulus was enacted in the UK and US.

      I think I understand perfectly well the aversion to fiscal policy, and wrote about it here:

      http://mainlymacro.blogspot.co.uk/2014/11/understanding-anti-keynesians.html

      I've heard nothing subsequently that makes me change my mind.

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    2. Oh, and both Romers are highly critical of austerity, and support fiscal stimulus.

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    3. 1. I don't know what you mean when you say the CB doesn't "know what it's doing" with QE. For the past 2 years, the Fed has fine-tuned language on its exit from QE3 in order to stabilize market expectations of its first rate hike. In fact, the Fed came pretty close to explicity acknowledging they were offsetting fiscal austerity when, on Sept 18, 2013, their press release announcing an unexpected delay in the QE3 taper acknowledged that they were "taking into account the extent of federal fiscal retrenchment" in evaluating the health of the economy. http://www.federalreserve.gov/newsevents/press/monetary/20130918a.htm. I think the burden is on the skeptics to show that the Fed doesn't understand unconventional tools that it has been continuously employing for 6 years or so.

      2. The Romers do indeed support fiscal stimulus, but on page 5 of their paper they liken Fed officials' calls for fiscal stimulus to the Fed's notorious statements from the 70's advocating "nonmonetary" solutions to inflation. They also suggest that the Fed has underestimated the effectiveness of monetary policy.

      As you've noted from other comments, MMs share the same general outlook and many policy preferences with Keynsians like yourself, but I think the main difference is that MMs see Keynsians as generally underestimating the effectiveness of the Fed's toolkit by focusing so much on fiscal policy.

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    4. 1. Just talk to any central banker, or ask most academic macroeconomists. Yes of course they were trying to offset the effects of austerity, but they had little idea how successful they were being, and neither did the markets.

      The main difference between Keynesians and some well known MM is that the latter have this intense dislike of the concept of fiscal stimulus. I suspect their belief in the irrelevance of the ZLB (again not the majority academic view, and certainly not the central bankers view) is to justify this dislike.

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    5. Well, if you concede that the Fed was trying to offset austerity, isn't that enough of a reason for MMs to oppose fiscal stimulus? You're conceding that they are conducting monetary policy, and just alleging that QE is imprecise doesn't change the fact that monetary offset of fiscal stimulus is possible.

      I like your blog, and I don't mind sharp comments when warranted, but I think it's unfair of you to suggest that MMs are arguing in bad faith. Especially when there's a logical explanation for why they are so skeptical of fiscal measures.

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    6. I'm not arguing that MM argue in bad faith, but just faith - which means ignoring arguments or evidence that goes against their position. You keep going back to the idea that monetary offset using QE is possible, which I've never disputed. In a way I do not need to, because it is so obvious how unreliable QE is as an instrument. One of the basics about macro management is that you look for reliable instruments to manage the economy, and QE is just not one of them. That is all this post really says, but the argument has still not been addressed by MM.

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    7. 1. I don't understand how you're using the term "reliable" as it relates to convetional interest-rate policy vs. QE. How are changes in interest rates "reliable"? Is there a function which describes the degree to which the change in interest rates subsequently affects inflation/unemployment?

      2. Neither I nor any MM i've read has ever argued that QE is optimal. Obviously reliable instruments are better, but in this case the "unreliability" of QE is really a moot point, because (as Bernanke argued in his Japan paper) it MUST be true that at some level QE will surely work. Otherwise a central bank could buy every asset in the world without generating any inflation, which is an absurd result. So the CB doesn't need to know the magnitude of QE effects. It just needs to know that more QE is expansionary, and then engage in QE when the economy is poor, and taper QE when the economy has improved. MMs argue the Fed has taken precisely this approach since at least QE3, and it has more or less "worked" by stabilizing inflation and maintaining the pace at which the unemployment rate has improved.

      3. You're wrong that MMs haven't addressed your arguments about the reliability of QE. Scott Sumner wrote the following over a year ago:

      "Another debate revolves around the Fed’s willingness to engage in unconventional monetary stimulus. They do seem somewhat uncomfortable with doing large amounts of QE. In my view, this is the best argument against monetary offset. The Fed might be afraid to use these more extreme measures to offset fiscal austerity, even if they’d be willing to use conventional tools (such as cuts in short-term interest rates) if those were still available.

      And yet we continue to hear Fed officials talk of cutting back on QE as the economy strengthens. This implies that they will do more QE under conditions of austerity than they would if fiscal policy were more expansionary. Perhaps without even fully understanding their role in this complex policy game, the Fed has acted very much like a central bank that was determined to keep the recovery proceeding at a steady pace but would back off whenever inflation or growth seemed to be accelerating. That policy stance almost inevitably leads to monetary offset and largely explains why the recovery continues at a modest pace, despite an increase in fiscal austerity during 2013."
      http://mercatus.org/sites/default/files/Sumner_FiscalMultiplier_MOP_090313.pdf

      In that same paper he goes on to advocate supply-side fiscal stimulus like an employer-side payroll tax cut (also advocated by Christy Romer)

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    8. In all fairness to MM, they argue that OMOs should be used to hit very clear level targets, ideally using market-based predictions to guide the OMOs. Such an approach might be reliable enough to forgo fiscal policy at the ZBL.

      Their other argument is that central bankers are too trigger-happy at tightening monetary policy. They notably point at Japan, where they had two decades of of fiscal stimulus, offset by a central bank that tightened at the first sign of above-zero inflation. From 1998-2003, many Keynesians (including Krugman) argued that this was nonsense and that such fiscal policy was useless. In some sense, MM are 1998-2003 Keynesians.

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    9. Sam

      I'm glad you found that Sumner quote, but after he acknowledges the argument, he fails to subsequently address it. Yes the Fed knows in which direction to act with QE, but not by how much, and as Sumner says (and I said in this post) they are always too cautious. The recent set back for the Japanese economy after they raised sales taxes is just another example of how complete offset does not happen. The lesson from everywhere over the last six years is you do not tighten fiscal policy when at the ZLB.

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    10. You are right. The Fed doesn't know EXACTLY how much QE to do, and they are often too cautious as a result. But we know they use rough guides to future NGDP (inflation plus employment) by looking at a range of "now" indicators like the stock market (expectations about future earnings), various current employment measures, wage growth, inflation expectations, etc. There is lots of data. None are perfect, of course. NGDP Forecasts would be better, or best of all real money NGDP Futures markets.

      Crucially, the Fed will be too cautious whatever, though. If they see fiscal expansion on top of their own monetary accomodation then they will pull back on that accomodation, which in their view is always just right.

      Or are you explicitly recommending the fiscal authorities take control of monetary policy too? If so, we can then all discuss that separately.

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    11. Yeah, I agree that Japan's tax hike is a pretty convincing data point against fiscal austerity.

      (but, then why are democrats so upset about the Republican Congress adopting dynamic scoring?! OK ok, sorry i'll stop the political trolling. Couldn't resist).

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    12. You say that the Fed is "always too cautious" - should we not all be encouraging them to be more aggressive (either in terms of "doing more" or advocating for a better target for MP such as a price level target?

      It seems a major argument against monetary policy at the ZLB is that the size of the effect is impossible to quantify - is that not also the case for fiscal policy (and, truly, monetary policy away from the ZLB too).

      Having said that, my reading of things is that combined fiscal and monetary actions would be best in a severe crisis even if we can't quantify the effects of either, and that both sides of this "debate" are being as unforgiving to the other as possible at times. The main thing I would give Sumner credit for is for relentlessly focusing on the need for a better target for MP in the future - sticking with the instrument of interest rates for targeting inflation is likely to lead us right back to the ZLB (if we ever leave it) in the next recession. I think he's definitely raised the profile of such arguments since launching his blog, and I think it's an important issue.

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    13. There is a difference in degree between the uncertainty associated with conventional instruments and that associated with QE - it is almost inevitable given the data we have. That is why the ZLB is important, and why MM who argue otherwise are wrong.

      I agree Sumner deserves credit for helping push for NGDP - I just wish he didn't have this phobia about fiscal policy. It is quite asymmetric: many New Keynesians like myself support NGDP targets.

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    14. Thanks for the response - can you direct me to some reading so I could educate myself on the degree of difficulty in estimating the effects of conventional instruments and non-conventional? If I'm being honest, I think I've been a little been too non-skeptical about this issue as I've basically just accepted a bit of the argument that the response in financial markets to an unexpected event tells us a lot about the magnitude/direction of an event.

      Thanks again.

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  15. Apologies for the overkill here, but here's one more Scott Sumner comment on monetary offset (through you should read the whole post):

    "And finally, my crusade for monetary offset is both positive and normative. Obviously fiscal stimulus is a moot point in the US anyway; Congress isn’t going to do any. But if I can convince other people that monetary offset is the most natural thing in the world, and also that not only is monetary stimulus not risky, but that not doing monetary stimulus can be highly risky, then monetary offset will be much more likely to be true in the future. Even if my theory is false, it should be true, and we need to make it true. We don’t do that with defeatist talk about monetary impotence that you hear from the world’s most famous blogger, rather we get there with a coalition of market monetarists and progressives like Yglesias who keep insisting the Fed can and should do more."

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    1. forgot the link: http://www.themoneyillusion.com/?p=25914

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  16. Forgive me for asking, but if the richer taxpayers pay the most income taxes, won't a fiscal stimulus just add more money into their savings, which won't actually be spent to drive the economy? And if consumption taxes are cut, will this pump enough money into the system?

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  17. Just FYI don't know if you have seen what Osborne tweeted about inflation at 0.5% and possibly falling to 0.2% or lower (http://www.bbc.co.uk/news/business-30794673) on the back of falling energy prices:
    Chancellor George Osborne hailed the fall in the inflation rate as good news. He tweeted: "Inflation is 0.5% - lowest level in modern times. Welcome news with family budgets going further & economic recovery starting to be widely felt."

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    1. The real possibility of deflation is fantastic news right? Its a sign of the strength of the economy, and prices falling for everyone...whats not to like??? Thanks for the good news George!

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  18. At the ZLB there can be no issue "between the uncertainty associated with conventional instruments and that associated with QE". Conventional instruments are dead at that point, obviously.

    The question then is what to do at the ZLB. How can MM be "wrong" to think QE is helpful at that point, even "given the data we have". You even agree. Your criticism makes no sense.

    Or, are you are fiscal policy is conventional monetary policy? But that sounds odd, too.

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    1. Put it this way. Austerity reduces demand, and central banks have a reasonable idea of how to quantify this. Outside the ZLB they have a reasonably good idea how much to change interest rates to offset it. At the ZLB, they have no idea how much QE to do to achieve the same result. Being cautious, they will underestimate, so output will fall. So simple, and not a bad description of what has happened in the US and UK. Why is this so difficult to grasp?

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    2. Prof Wren-Lewis,

      But if a central bank's "caution" is leading them to hike interest rates prematurely (like the ECB did in 2011) to keep inflation below target, then fiscal stimulus won't work, because it will be offset by premature tightening. Why is my just-so story less believable than yours?

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    3. Now you are talking about the ECB in 2011. I'm talking about a situation where the ZLB bites. We know it bites when QE happens. When QE happens the central bank thinks inflation/activity are too low.

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    4. Ok let's try again.

      If a central bank's "caution" is leading it to withdraw QE prematurely to keep inflation below target, then fiscal stimulus won't work, because it will be offset by premature tightening.

      Note that your points about central bank uncertainty and general aversion to unconventional measures is consistent with the notion that central banks would be willing to withdraw QE more aggressively than they would be willing to raise interest rates. And so, if they stop QE as soon as inflation starts to creep up (as the Bank of Japan did in the mid-2000's) then won't that neutralize fiscal stimulus?

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    5. "At the ZLB, they have no idea how much QE to do to achieve the same result."

      Seems an oddly archaic way of putting it. The issue, given the framework of economists like Krugman 1998 and Sumner, is not about HOW much base money is created, but PERSUADING the public that the future level of base money, NGDP and the price level will be in line with the target.

      It's all talk, not hydraulics.

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  19. Simon,

    I don't think you're entirely wrong, and if I don't necessarily think it's the worst idea in the world to increase infrastructure spending, for example, during a downturn in the economic cycle when at the ZLB. However, then there are graphs like this:

    http://blogs.cfr.org/geographics/2015/01/13/krugmanchart/

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