Kocherlakota’s argument for fiscal expansion in the US

Is there a macroeconomic case for tax cuts in the United States right now? Paul Krugman and I say no, using the following logic. The Fed thinks we are close to full employment, if we use the term to denote the level of employment that keeps inflation constant. Generalised tax cuts (rather than just tax cuts to the very rich) will tend to raise aggregate demand, which will lead inflation to increase. The Fed will therefore raise interest raise rates further to offset this increase in demand before it happens. As a result, the tax cuts will have no impact on demand, but simply make funding investment more expense.

There are clear grounds for saying that the Fed is wrong about the economy being close to full employment, and therefore any increase in aggregate demand from any source would not raise inflation. But a central bank that acts in the textbook manner will not wait for the higher inflation to materialise, but will anticipate it because it takes time for interest rates to influence demand and inflation. As a result, tax cuts will lead to higher interest rates and there will be no net impact on demand.

Narayana Kocherlakota, who used to be on the committee that sets US interest rates, presents another possible reason why an increase in demand will not raise inflation. He argues that aggregate supply has been suppressed by low demand, and that rising demand might itself stimulate supply. For example, a lot of technical innovations might have been shelved while demand was depressed, but would be brought into production if demand looked like expanding rapidly. As these technical innovations would expand the capacity of firms to produce more, they would not raise prices as a result of any increase in demand. As these innovations would produce more from the existing labour force, there would be no inflation pressure coming from wages either.

If this sounds like wishful thinking, remember than the US economy, like most, is still way below the level of output that pre-recession trends would have suggested were likely. Did research into new and better production techniques really slow down substantially during the recession years, or did the research still take place to be implemented at some later date?

Even if this argument is plausible, and I think it is, it would still be irrelevant if the Fed didn’t make any allowance for it. They would still believe that tax cuts would raise demand and inflation, and so they would raise interest rates and crowd out any increase in demand. Indeed, if the Fed believed this ‘endogenous supply’ argument, they surely wouldn’t have raised rates in 2016.

What Kocherlakota wants the Fed to do is follow an approach put forward by Federal Reserve Bank of Chicago President Charles Evans. He puts the case in this speech. Essentially the Fed should depart from the usual policy approach of targeting expected inflation, and wait for inflation to actually rise above target before it raises rates. This would mean that it ignored any fiscal stimulus (whether it be tax cuts or additional public investment), and focused simply on the actual inflation rate. If we were in fact below full employment, or if demand created its own supply, the fiscal expansion would raise output and welfare.

An important point that Kocherlakota makes, and I have made in the past, is that you do not need to believe with certainty that we are below full employment or that demand will create its own supply. All you have to do is give it some significant probability of being true. You then look at the costs and benefits of pursuing an Evans type monetary policy weighted by this probability. A key point here is that the costs of a short term overshoot of the 2% target are likely to be a lot smaller than the cost of missing out on a percent or two of national output for potentially some time.

Does this change my views on a prospective Trump stimulus package? Not really. There is a very strong case for more public sector investment on numerous grounds. But that investment should go to where it is most needed and where it will be of most social benefit, and I think it is very unlikely (along with I suspect most economists) that a Trump Presidency and a Republican House can deliver that. That extra public investment will give the economy the stimulus that could work with an Evans type monetary policy. From a macroeconomic viewpoint there seems no point in doubling up on stimulus through tax cuts, and in terms of how the Fed reacts it may even be counterproductive.

Reactionary Keynesianism revisited

I wrote my original post on this to counter the idea that the size of any increase in the deficit was at least as important as its composition, with particular reference to any fiscal expansion likely to come from Donald Trump. To put it very simply, I argued that any fiscal expansion that focused on tax cuts for the very rich and extremely dubious mechanisms designed to increase infrastructure investment should not be welcomed by those who think (as I do) there is still spare capacity in the US economy. Some subsequent helpful feedback suggests that in making this argument I should have said some things a little better.

I started my discussion with an example of how a tax cut for the rich could, in theory at least, be deflationary. The idea was that the rich would immediately consume very little of any tax cut, but if the non-rich thought that in the future their taxes might rise because of the higher deficit they might decrease current consumption. [1]

Talking about the rich and non-rich was very imprecise of me. I actually had in mind people who were income rich. The distinction between income and asset rich could matter, following an Econometrica paper by Kaplan and Violante that Narayana Kocherlakota pointed me to. This paper argues that there is an important group that they call the ‘hand-to-mouth wealthy’. These are asset rich individuals that hold their wealth in non-liquid form (e.g a pension), and because of the non-liquid nature of the wealth they might have a high marginal propensity to consume out of current income. It is an interesting idea with some empirical backing, but which I think only emphasises the importance of thinking about the composition of any tax cut when calculating the degree of stimulus.

In retrospect it might have been simpler to give a better known example of the potential disconnect between the aggregate deficit and a stimulus, which is the balanced budget multiplier. To the extent that fiscal policy under Trump may involve cuts in government consumption, that example could be very relevant, as Paul Krugman notes.

In the case of public investment, I again argued that the nature of this investment mattered. If the mechanism used to increase public investment (see this piece by Stiglitz for example) meant that a good proportion of this investment involved projects with a low social return (white elephants), then once again people on average would not be better off. This point depends on something which I took for granted but which I should have been spelt out: monetary offset.

Because the US economy is no longer at the zero lower bound, then an increase in GDP caused by building lots of white elephants would almost certainly lead to an increase in interest rates. [2] As a result, GDP might not actually increase, and useful private investment would be crowded out by useless public investment.

Once interest rates start rising from their zero lower bound, then those who argue that demand should be increased in the US (see here or here) are really complaining about monetary policy, not fiscal policy. An expansionary fiscal policy that is crowded out by the Fed might have some indirect advantages, in raising the natural interest rate for example, but the famous ‘digging holes’ argument used by Keynes no longer applies.

Once we leave the zero lower bound, tax cuts for the rich amount to a regressive redistribution of income. People should not be fooled into thinking that the tax cuts will somehow pay for themselves, through Keynesian or any other means. There is an extremely strong case for a large expansion in public investment financed by additional public borrowing, but this investment needs to go where it is needed, rather than to schemes that will generate a quick return to private sector financiers. There is a strong case for using additional demand to expand the US economy, but it will not happen as long as the Fed believes otherwise.

[1] I confusingly talked about the wealthy as acting as if Ricardian Equivalence held, when I should have simply said that because they were wealthy they would focus on lifetime rather than current income, and so would have a low MPC from a temporary tax cut. Assuming a tax cut for the rich is permanent is equivalent to assuming the Republicans never lose power.

[2] Assuming, of course, that the Fed remains independent, but Krugman argues that even if it did not we might still see higher interest rates.

The Eurozone recovery

Which posted the strongest growth at the beginning of 2016: the US, UK or the Eurozone? The answer is the Eurozone. Growth at 0.6% for the quarter (about 2.5% at an annual rate) is nothing to write home about, but it is not the stuff of doom and gloom either. Reasonable growth like that should come as no surprise. The economy is receiving as much monetary stimulus as the ECB can currently muster, and fiscal contraction has come to a halt.

Inflation is still well below target, but the reason for that is straightforward enough (as Martin Sandbu points out): there is still a lot of spare capacity. Inflation will only stabilise at around the 2% target when that spare capacity has disappeared. Policy should be doing everything (more public investment!) to ensure that happens through strong growth rather than, as seems to have happened in the UK, a gradual contraction in supply. On inflation the ECB should make their target 2%, rather than the current ‘below but close to’ 2%, to avoid the Japan problem that Narayana Kocherlakota discusses here.

I went further when I wrote two weeks ago (the GDP figures came out a week ago) that “I also think we may see rapid Eurozone growth before [2020]”. By rapid growth I mean something in excess of 2.5%. I said that because I was adding one other factor into the mix of fiscal neutrality and monetary expansion, which is that the Euro has been pretty competitive for well over a year. As Martin points out, that has so far not contributed anything to recent Eurozone growth.

I have read in a few places recently people saying that the impact of international competitiveness is not what it was. I agree with Paul Krugman that this pessimism is unlikely to be warranted. I have spent a significant part of my working life estimating and applying trade elasticities (the impact of international competitiveness on trade and hence demand), and this experience has taught me that this effect is a bit like Milton Friedman’s description of how monetary policy works: there can be long and variable lags. So I expect that the Eurozone’s competitiveness gain over the last year and a half will begin to impact on Eurozone GDP at some point in the next year or two, and that might just provide more rapid growth than we saw at the beginning of 2016.

Helicopters are easy to fly

The debate over helicopter money seems to have got past the ‘shock, horror, people’s faith in the monetary system would collapse’ phase, and past the ‘it wouldn’t work because people wouldn’t spend the money’ phase, to the ‘what happens next’ phase. And to be fair to the critics, many proponents of helicopter money have not been clear on this issue.

The point was put very clearly yesterday in an FT Alphaville piece by Gerard MacDonell. Once the recession is over, there is likely to be too much money in the economy from the central bank’s point of view (which means, money has to be withdrawn to maintain the inflation target). We cannot say how much, but equally it would be wrong to ignore the problem. So what happens next?

I think I have been clear (at least recently) on this point. First, helicopter money as I see it is not a way to get inflation overshooting by the back door. The idea that the increase in money is ‘permanent’ is meaningless, as Eric Lonergan says. Overshooting may be a good idea, but there is no need to be devious about it. Second, the obvious way to ensure the central bank still achieves its inflation and other objectives is to recapitalise the bank if necessary. The central bank could enforce very high reserve ratios on commercial banks, but is that a desirable thing to do?

In my view helicopter money would be accompanied by a commitment by the government to recapitalise the central bank if that was needed. Yes, commitments can be broken, but only by the kind of government that would happily revoke central bank independence anyway.

The answer to what happens next is therefore easy. When it becomes clear after the recession that there is now too much money in the economy, the central bank takes it out. In other words, monetary policy acts as normal. If the central bank runs out of assets to do this, it gets recapitalised. Recapitalisation means more government debt. So we can end up in a position which is exactly equivalent to one where the distribution of money had been financed by an increase in debt in the first place: a conventional fiscal expansion.

In this world, helicopter money is (a particular type of) fiscal expansion by the back door. As Narayana Kocherlakota points out, this back door method has no purely macroeconomic advantages over the real thing. But the reason why we need a back door is obvious right now. Economists need to get real about these political constraints. Obsession with debt is not just based on ignorance, but it serves an ideological purpose which is not going to go away.

Yet even if governments were not obsessed with current levels of debt (and that is all they are obsessed by), go back to the textbooks on why monetary policy is prefered to fiscal policy as a stabilisation tool. One of the reasons you will find is that monetary policy is quick to invoke, with no institutional (aka democratic) hurdles to pass. Those who argue that helicopter money is just like fiscal policy seem to ignore this. There is also the (obvious) point that helicopter money allows what I call the consensus assignment to work (by expanding the meaning of monetary policy a little beyond interest rate changes), rather than leaving it with the rather large Achilles Heel of the zero lower bound.

Helicopter money is just another way of doing textbook demand management. What it does is move around current institutional boundaries a bit, to reflect real institutional and political constraints. There is nothing magical about the current institutional boundaries. Perhaps if you think (as Brad DeLong does) about the profits the central bank makes as a social credit that gets automatically distributed to people rather than given to an intermediary (the government), you might feel easier about it.       

When to be optimistic on growth

I’m afraid I did not respond to requests to talk directly about the debate over Gerald Friedman’s numbers. I think I can only cope with that kind of thing one country at a time, and there were better people on the case. But I suspect a key to seeing your way through the wider debate is to know when to be optimistic about economic growth, and when not to be.

Martin Sandbu, channeling Narayana Kocherlakota, is quite right that we should not discount the possibility that economic growth could be unusually strong over the next decade or two. There is a significant chance that some of the slowdown that has appeared to have occurred to trend growth since the Great Recession might be reversible, partly because many hysteresis effects are also reversible. Inflation may not respond positively to strong growth as it has done in the past.

That possibility is high enough that it should have a big influence on monetary policy, for reasons I and others have outlined many times. The cost of needlessly throwing away potential resources is much higher than the cost of small overshoots of an inflation target. For that and other reasons the Fed’s decision to raise rates - and the MPC's decision not to cut them - was a mistake, as is continuing austerity.

Does that mean we should hard wire this optimistic view into budget projections? Essentially no, because budget projections should be based on your central guess of what is going to happen rather than any best case scenario. Almost every politician thinks they have the magic ingredient that will lead to strong growth. There is nothing wrong in that, but they should hope for the best and plan for the ordinary.

Doing this imposes a discipline on the electoral process that is essential to stop some politicians pulling the wool over voters eyes. If a politician or party wants to go with optimistic numbers, then the debate should be about how reasonable those numbers are, so voters can see what is going on. A world where these things are not debated is a world where everyone promises the moon and no one is any the wiser.

Where the discussion can get confused is if we put these two things together, and note also that fiscal stimulus involving additional investment would be good for the world right now. But that should and is argued for without pretending that it can all be paid for with the taxes that will come rolling in as it happens. There is a rock solid case for paying for extra investment - investment in its widest sense including human capital - by borrowing, because future generations benefit from that investment. When real interest rates are as low as they currently are, you have to be ignorant, duplicitous or slightly mad to say otherwise.

A comment on Kocherlakota's suggestions for clarifying monetary policy objectives

In a recent speech (HT MT), Narayana Kocherlakota (who helps set US interest rates) makes two suggestions to clarify what US monetary policy is trying to do. The first I completely agree with. The Fed should make clear that the 2% inflation target is symmetrical. Inflation at 1% is just as much of a problem as inflation at 3%. We only need to look at the Eurozone to see the dangers of asymmetry (which in their case is explicit).

His second suggestion is that the Fed should articulate a “benchmark two-year time horizon for returning inflation to the 2 percent goal.” You can see why Kocherlakota is suggesting this change, particularly in the current context. A target which is only going to be achieved in the indefinite long term may cease to have value. However applying the two year benchmark to just the inflation target may create inappropriate pressures in different circumstances.

The UK’s Monetary Policy Committee operated until quite recently what appeared to be exactly this two year benchmark. As evidence for this, here is a chart of the Bank’s own forecast for inflation two years ahead. (The dates refer to when the forecast was made.) The inflation target was 2.5% until 2003, and 2% thereafter.

Until the Great Recession, the forecast was generally pretty close to the target. Since then, the dates on which inflation two years ahead was expected to be below target roughly correspond to dates on which the Quantitative Easing (QE) programme was expanded. (More details in this post.)

The problem with this strategy emerged in 2011. As a result of the delayed impact of the 2008 depreciation in Sterling, increases in sales taxes (VAT) and higher commodity prices, actual inflation briefly exceeded 5% in 2011. As a result, in 2011 the MPC came pretty close to following the Eurozone in increasing interest rates. (For a number of months, 3 MPC members voted to raise rates, and the remaining 6 voted for no change.) A major concern of those who voted for higher rates was that inflation would not fall back to 2% within 2 years, and that as a result the credibility of the inflation target would be damaged.

So the 2 year time horizon came close to having a very damaging impact in the UK. (Arguably it did cause some damage, because it inhibited additional QE.) Now it is of course true that the combination of cost-push shocks experienced by the UK during that period was unusual, but even if rules allow for opt-outs in exceptional circumstances, they can nevertheless exert inappropriate pressure in those circumstances. Arguably the 2013 paper issued by the UK Treasury on monetary policy was at heart a message to the Bank to no longer apply the two year ahead rule.

Luckily there is a simple way of avoiding this danger, by making a small addition to Kocherlakota's suggestion. This is to apply the two year time horizon to both the inflation target and the output gap. I can see no convincing argument why the two year horizon should not be applied to both elements of the dual mandate. The problem in the UK arose partly because the UK does not have a dual mandate. If it had had this dual mandate, and the two year horizon had applied to both elements of the mandate, then the pressure to raise interest rates in 2011 would have been much less. (Few expected the UK output gap to close by 2013, even without interest rate increases.)

There is a more general argument that is completely independent of what happened in the UK. Whatever the intention, if the two year horizon is applied to only one element of the dual mandate, there is a danger that it appears to give priority to that element over the other. So my own opinion, for what it is worth, is that Kocherlakota's suggestions are a good idea, as long as the two year time horizon benchmark is applied to both parts of the dual mandate.