Evidence for monetary offset

As Tony Yates among others has observed, antagonism towards using fiscal policy for macroeconomic stabilisation seems to be an essential part of market monetarism. However their argument is not that fiscal policy will have no impact on demand and therefore output, but rather that monetary policy can always offset this impact. This can be called the ‘monetary offset’ argument.

As I have noted before, the idea of monetary offset is actually a key part of Keynesian objections to austerity in a liquidity trap [1]. In a liquidity trap monetary policy’s ability to offset fiscal austerity is severely compromised, but at other times it can be done. It therefore makes much more sense to postpone austerity until a time when monetary offset is clearly possible. So the idea that monetary offset can happen is common ground. What is in dispute is the extent to which a liquidity trap (or almost equivalently the fact that nominal interest rates cannot become too negative) prevents complete monetary offset.

If empirical evidence could be found that complete monetary offset has operated during a liquidity trap that would be powerful support for the market monetarist case. Scott Sumner recently presented (HT Nick Rowe) some analysis by Mark Sadowski which he said did just that. Taking the cyclically adjusted primary balance as a measure of fiscal policy, it showed that there was no correlation between this and growth in nominal GDP in the single period from 2009 to 2014 for those countries with an independent monetary policy.

There are tons of problems with simple correlations of this kind, some of which I discuss here, which is why quite elaborate econometric techniques are nowadays used to assess the impact of fiscal policy. But there is a rather simpler problem with this correlation. As far as I know, no one had expressed a concern about fiscal austerity because of the impact this will have on nominal GDP. The issue is always the impact on real activity, for reasons that are obvious enough.

So what happens if we relate fiscal policy to real GDP growth, using Sadowski’s data set? Here is the answer.

There are two obvious outliers here: at the top Singapore, and to the right Iceland. Exclude those and we get this.

There is a clear negative correlation between the extent of fiscal tightening and the amount of real GDP growth. Strange that Sumner gave no hint of this :)

Do I think this is definitive evidence? No, for two reasons. First, the obvious problems with simple correlations of this kind noted earlier. Second, this sample includes quite a few countries where interest rates over this period have averaged over 2% (Australia, Norway, New Zealand, and Korea) and so are unlikely to be subject to a liquidity trap. Others may only have been in a liquidity trap for a part of this period. What we can say is that these correlations are perfectly consistent with the view that austerity reduces growth in countries with an independent monetary policy. [2]

If you were to conclude that we just do not have enough data to know to what extent monetary offset can operate in a liquidity trap, I think you would be right. If you then went on to say that therefore the data cannot discriminate between the two sides in terms of policy, you would be wrong. What market monetarists want you to believe is that there is no need to worry about fiscal austerity in a liquidity trap, because an independent monetary policy can and will always offset its impact. This is wrong, precisely because the empirical evidence is so limited. We know, both from theory and the great majority of econometric studies, that fiscal contraction has a fairly predictable impact in reducing GDP. We have virtually no idea how much unconventional monetary policy is required to offset this impact. Given lags, that means trying to achieve monetary offset in a liquidity trap is always going to be hit and miss. The moment you think about uncertainty, the market monetarist argument for not worrying about austerity in a liquidity trap falls apart. 

[1] It is not the only reason why fiscal austerity in a severe recession might be a bad idea. There is a lot of empirical evidence that the impact of austerity is greater in recessions than when the economy is stronger, and there are other theoretical reasons besides monetary offset why that may be the case. This is of some importance for individual economies in a monetary union.

[2] If the coefficient on fiscal policy was lower for this sample than for Eurozone countries (I’ve not tried), would that at least be evidence for some monetary policy offset? The trouble here is that some of the countries driving the EZ results were also suffering from an overvalued real exchange rate as a result of earlier excess demand, and so this might bias upwards the coefficient on fiscal policy in those regressions.

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.     

Monetary Impotence in context

Mainly for macroeconomists

There are a significant group of people who think that monetary policy must be the right answer even in a liquidity trap because of the centrality of money in macroeconomics, and because of ‘basic’ ideas like money neutrality. Call them market monetarists if you like. They dislike fiscal stimulus because - in their view - it just has to be second best, or a fudge, compared to monetary policy. Their view is not ideological, but essentially based on macro theory. Now it may not be very relevant to the real world, but for many holding the theoretical high ground is important, because it colours their view of the real world.

That is the group that Paul Krugman has been arguing with recently, and why the point he made in his post yesterday is so critical. It is set in an idealised two period world where Ricardian Equivalence holds, but that is entirely appropriate for the task in hand. If people believe something because of (in their view) basic theory, and you think they are wrong in terms of basic theory, then that is the level on which to argue.

The argument is that in a liquidity trap, when prices are sticky, temporarily expanding the money supply - even if it involves helicopter money (i.e. money financed tax cuts) - will not do anything to get you out of the trap. Another, and more modern, way of saying the money supply increase is temporary is saying that the inflation target is unchanged, so the long run price level is unchanged. (Long run money neutrality does hold in this world.) I will not go through Paul’s argument in detail - I have gone through the same logic before. The basic point is that the temporary increase in money is saved, not spent, because agents know it is temporary. Short run money neutrality does not hold, and not because prices are sticky, but because of Ricardian Equivalence.

It is exactly the same reason why the Pigou effect is no longer discussed. Ricardian Equivalence killed the Pigou effect as a fundamental theoretical idea. If the inflation target is unchanged, when prices fall today the future price level must fall pari passu, reducing the future nominal stock of money. There is no wealth effect. As I noted here, even allowing money to be special in not being redeemable does not get the Pigou effect back, because with irredeemable money any wealth effect comes from the long run stock of money.

Money is not a hot potato in this world. The potato has gone cold because of the liquidity trap, and the money is happily saved to pay the future tax increases that will be required to keep the long run money stock (and price level) constant. 

While in this largely frictionless world money is impotent, additional government spending is a foolproof way of expanding demand. So is raising the long run price level, which means at some point raising the inflation target.

All I really wanted to do in this post was make an observation. The theoretical point that Paul makes depends crucially on thinking in an intertemporal manner, which gives you Ricardian Equivalence. Just as price rigidity kills short run monetary neutrality, so does Ricardian Equivalence in an inflation targeting liquidity trap world. So here is modern microfounded macroeconomic theory providing support to increasing government spending rather than monetary policy in a liquidity trap. Modern theory is not inherently anti-Keynesian. .  

Synthesis!? David Beckworth's Insurance Policy

Could it be that New Keynesians and Market Monetarists can converge on a common policy proposal? I really like David Beckworth’s Insurance proposal against ‘incompetent’ monetary policy. Here it is.

1) Target the level of nominal GDP (NGDP)

2) “the Fed and Treasury sign an agreement that should a liquidity trap emerge anyhow [say due to central bank incompetence] and knock NGDP off its targeted path, they would then quickly work together to implement a helicopter drop. The Fed would provide the funding and the Treasury Department would provide the logistical support to deliver the funds to households. Once NGDP returned to its targeted path the helicopter drop would end and the Fed would implement policy using normal open market operations. If the public understood this plan, it would further stabilize NGDP expectations and make it unlikely a helicopter drop would ever be needed.”

In fact I like it so much that Jonathan Portes and I proposed something very like it in our recent paper. There we acknowledge that outside the Zero Lower Bound (ZLB), monetary policy does the stabilisation. But we also suggest that if the central bank thinks there is more than a 50% probability that they will hit the ZLB, they get together with the national fiscal council (in the US case, the CBO) to propose to the government a fiscal package that is designed to allow interest rates to rise above the ZLB.

There we did not specify what monetary policy should be, but speaking just for myself I have endorsed using the level of NGDP as an intermediate target for monetary policy, so there is no real disagreement there. A helicopter drop is a fiscal stimulus involving tax cuts plus Quantitative Easing (QE). Again we did not specify that the central bank had to undertake QE as part of its proposed package, but I think we both assumed that it would (outside the Eurozone, where for the moment we can just say it should). I think a central bank could suggest that an income tax cut might not be the most effective form of fiscal stimulus (compared to public investment, for example), but let’s not spoil the party by arguing over that.

Now this does not mean that Market Monetarists and New Keynesians suddenly agree about everything. A key difference is that for David this is an insurance against incompetence by the central bank, whereas Keynesians are as likely to view hitting the ZLB as unavoidable if the shock is big enough. However this difference is not critical, as New Keynesians are more than happy to try and improve how monetary policy works. The reason I wrote this post was not because of these differences in how we understand the world. It was because I thought New Keynesians and Market Monetarists could be much closer on policy than at least some let on. I now think this even more. 

What annoys me about market monetarists

I missed this little contretemps between Nick Rowe and Paul Krugman. Actually this appears to be a fuss over nothing. The main point Paul was trying to make, it seemed to me, was about how far the Republican base were on monetary policy from anything reasonable, and so what he called the neomonetarist movement did not have much chance with this group. By implication, neomonetarism was something more reasonable, although he had well known problems with its ideas. So a sort of backhanded compliment, if anything.

Nick responded by pointing out that what he called neofiscalists (those, like me, who argue for fiscal stimulus at the Zero Lower Bound (ZLB)) hadn’t done too well at finding a political home recently either. Which, alas, is all too true, but I think we kind of knew that.

What interests me is how annoyed each side gets with each other. Following my earlier posts, I will use the label market monetarist (MM) rather than neomonetarist. It seems to me that I understand a little why those in the MM camp get so annoyed with those like me who go on about fiscal policy. Let me quote Nick:

“We don't like fiscal patches that cover up that underlying problem. Because fiscal policy has other objectives and you can't always kill two birds with the same fiscal stone. Because we can't always rely on fiscal policymakers being able and willing to do the right thing. And because if your car has alternator trouble you fix the alternator; you don't just keep on doing bodge-jobs like replacing the battery every 100kms.”

I’ll come back to the car analogy, but let me focus on the patches idea for now. In their view, the proper way to do stabilisation policy outside a fixed exchange rate regime is, without qualification, to use monetary policy. So the first best policy is to try every monetary means possible, which may in fact turn out to be quite easy if only policymakers adopt the right rule. Fiscal policy is a second best bodge. MM just hates bodgers.

As I explained in this post, the situation is not symmetric. I do not get annoyed with MM because I think monetary policy is a bodge. I have spent much time discussing what monetary policy can do at the ZLB, and I have written favourably about nominal GDP targets. But, speaking for just myself, I do get annoyed by at least some advocates of MM.

Before I say why, let me dismiss two possible reasons. First, some find MM difficult because there does not seem to be a clear theoretical model behind their advocacy (see this post from Tony Yates for example). I can live with that, because I suspect I can see the principles behind their reasoning, and principles can be more general than models (although they can also be wrong). Second, I personally would have every right to be annoyed with some MMs (but certainly not Nick) because of their debating style and lack of homework, but I see that as a symptom rather than fundamental.

To understand why I do get annoyed with MM, let me use another car analogy. We are going downhill, and the brakes do not seem to be working properly. I’m sitting in the backseat with a representative of MM. I suggest to the driver that they should keep trying the brake pedal, but they should also put the handbrake on. The person sitting next to me says “That is a terrible idea. The brake pedal should work. Maybe try pressing it in a different way. But do not put on the handbrake. The smell of burning rubber will be terrible. The brake pedal should work, that is what it is designed for, and to do anything else just lets the car manufacturer off the hook. Have you tried pressing on the accelerator after trying the brake?”

OK, that last one is unfair, but you get my point. When you have a macroeconomic disaster, with policymakers who are confused, conflicted and unreliable, you do not obsess over the optimal way of getting out of the disaster. There will be a time and place for that later. Instead you try and convince all the actors involved to do things that will avoid disaster. If both monetary and fiscal policymakers are doing the wrong thing given each other’s actions, and your influence on either will be minimal, you encourage both to change their ways.

MM agrees that fiscal stimulus will work unless it is actively counteracted by monetary policy. Nick says we can't always rely on fiscal policymakers being able and willing to do the right thing. But since at least 2011 we have not been able to rely on monetary policymakers in the Eurozone to do either the right thing, or consistently the wrong thing. So why is anyone with any sense saying that austerity is not a major factor behind the second Eurozone recession? That is just encouraging fiscal policymakers to carry on doing exactly the wrong thing, in the real world where monetary policy is set by the ECB rather than some MM devotee.

Good and Bad Blog Debates

One of the things I really like about blogs is that they can generate considered and informed debates about ideas. But not all blog debates are like that. Debates can get too personal - they begin to become about the people involved in the debate, rather than the ideas. They become a debating contest. Sometimes this can be a contest between two people, or it can be a contest between two groups. This may be a fun sport for those committed fans of either side, but I do not think it is a very good means of informing those who are not committed but who want to know more about the issues involved.

Take the debate involving Mark Sadowski (MS) that started with this post. MS disagreed with a number of things I said, and we had a short back and forth in the comment thread to that post. MS also combined his points as a separate post. All well and good. This debate led me to write two subsequent posts. One was about how the US recovery had continued despite fiscal contraction. The other, actually written following a subsequent post by Giles Wilkes, was an attempt to try and explain in very general terms where the two sides agreed and disagreed on fiscal policy. I wrote neither as sequels in a debate between MS and myself, because they were not intended to be that. I wanted to talk about facts in the first case and ideas in the second, rather than have a debating contest.

I think MS saw it differently. Here he responds to my post on the US recovery, imagining it to be a ‘response’ to his earlier post. Here he responds to my second post. Both are written in a quite personal style, as the titles suggest. Not a style I like, but so what?

Well, if you are going to do this kind of thing, you need to be especially careful that you get your facts right, because it has become personal. In the second half of the second post, he writes:

“At what point will fiscalists stop wringing their hands over the “liquidity trap” and start to worry about what is the consensus assignment of fiscal policy, which is debt stabilization? What I sense is they aren’t really interested in the consensus assignment of fiscal policy.

 And who can blame them? Debt stabilization is dull. It is *really* dull. Why worry about something so dull when you can worry about something which is so much more exciting, which is obviously aggregate demand stabilization.

 And this I think is the crux of the real asymmetry. Monetarists are genuinely interested in the consensus assignment of monetary policy, which is aggregate demand stabilization. Fiscalists show no interest at all in the consensus assignment of fiscal policy, which is debt stabilization.”

Now here he talks about ‘fiscalists’ rather than mentioning me by name, but anyone reading this post would assume that I was among the people he is talking about. Another fiscalist named in this debate is Jonathan Portes. Now it just so happens that Jonathan and I have just written a substantial paper, which is all about debt stabilisation! Whoops.

An unlucky error? No, it’s much worse. A quick look on my homepage will show you that much of my academic research since 2000 has been about debt stabilisation. Unlike MS, I do not think the subject is really dull. Issues like what the long run target for debt should be, how quickly we should get there, what happens to monetary policy when debt is not controlled by the fiscal authority, seem to me rather interesting.

Hopefully that corrects the impression created that these particular 'fiscalists' are not interested in debt stabilisation. But has this post been very informative for someone interested in the issues, rather than the personalities? I learnt very soon after I started this blog, thanks to another market monetarist, that it is generally better to focus on the ideas rather than the individuals putting these ideas forward. This can be difficult, and I do not always get it right, but that at least was what I was trying to do in my last post.

Monetarist vs Fiscalist

Giles Wilkes (ex special advisor to Vince Cable, Business Secretary in the current UK government and LibDem) has a post that compares those he calls ‘fiscalists’ like myself and Jonathan Portes to market monetarists (MM). His post follows some comments and a post by Mark Sadowski responding to an earlier post of mine where Mark took exception to my saying “the major factor behind the second Eurozone recession is not [controversial] : contractionary fiscal policy”. You find much the same debate in this post by Scott Sumner, attacking (mainly) Paul Krugman.

I think Giles Wilkes gets a lot of things right, but I thought it might be useful to set out as clearly as I can how I see the nature of the disagreement. The first, and probably the most important, thing to say is that the disagreement is not about whether fiscal contraction is contractionary, if the monetary authority does nothing. (See, for example, Lars Christensen here.)That is actually what I meant with my statement about the Eurozone recession, which linked to a study that calculated the impact of austerity holding monetary policy ‘constant’. This is so important because, in their enthusiasm to denounce countercyclical fiscal policy, MM often give the impression of thinking otherwise.

The disagreement is over what monetary policy is capable of doing. The second thing to say is that this is all about the particular circumstances of the Zero Lower Bound (ZLB). I do not like the label fiscalist for this reason - it implies a belief that fiscal policy is always better than monetary policy as a means of stabilising the economy. (Giles Wilkes is not the first to use this term - see for example Cardiff Garcia, who includes more protagonists.) Now there may be some economists who think this, but I certainly do not, and nor I believe does Paul Krugman or Jonathan Portes. I described in this article what I called the consensus assignment: that monetary policy should look after stabilising aggregate demand and fiscal policy should be all about debt stabilisation, and there I described recent research (e.g.) which I think strongly supports this assignment. However there has always been a key caveat to that assignment - it does not apply at the ZLB.

Before talking about that, let me illustrate why language can confuse matters. Suppose we had fiscal austerity well away from the ZLB. Suppose further that for some reason the monetary authority did not take measures to offset the impact this had on aggregate demand, and there was a recession as a result. I suspect a MM would tend to say that this recession was caused by monetary policy, even though monetary policy had not ‘done anything’. (In this they follow in the tradition of that great monetarist, Milton Friedman, who liked to say that monetary policy caused the Great Depression.) The reason they would say that is not because fiscal policy has no effect, but because it is the duty of monetary policy to offset shocks like fiscal austerity. That is why fiscal policy multipliers should always be zero, because monetary policy should make them so. So Mark Sadowski got upset with my statement because in his view ECB policy failed to counteract the impact of Eurozone austerity, and could have done so, which meant the  recession in 2012/3 was down to monetary policy, not fiscal policy.

So we come to the heart of the disagreement - the ability of monetary policy to offset fiscal actions at the ZLB. This is all about the effectiveness of unconventional monetary policy (UMP), which is both Quantitative Easing and what I call forward commitment (promising positive output gaps in the future: see David Beckworth here). I do not want to go over these arguments again, partly because I have already written about them elsewhere (e.g. here, here and here). Instead I just want to make an observation about asymmetry.

Economists like Paul Krugman, Jonathan Portes and myself (and there are many others) do not argue against using UMP. Indeed PK pioneered the idea of forward commitment for Japan, and I have been as critical as anyone about ECB policy. We do not argue that fiscal policy will be so effective as to make unconventional monetary policy unnecessary, and so write countless posts criticising those promoting UCM. To take a specific example, I happen to think that the recent ECB moves will have less impact on the Eurozone than continuing fiscal austerity, but I do not say the ECB is wasting its time as a result. They should do more.   

I’m interested in this asymmetry, and where it comes from. Why do MM hate fiscal expansion at the ZLB so much? It could be ideological (see Noah Smith here), but I suspect something else matters. I think it has something to do with monetarism, by which I mean a belief that money is at the heart of issues to do with stabilisation and inflation. MM is not about controlling the money supply as monetarism originally was, but I think many other aspects of monetarism survive. My own view is more Wicksellian (or perhaps Woodfordian), whence the failure to be able to lower interest rates below zero naturally appears central. To those not trained as macroeconomists (and perhaps some that are) these sentences will appear mysterious, so if this idea survives comments I may come back to it later.   

Why Bernanke was right to speak out on fiscal policy

This is a comment on Cardiff Garcia’s post on fiscalists and market monetarists, and also some related criticism of Bernanke’s recent remarks on fiscal policy, criticism which I think is totally wrong. I want to argue that a ‘monetarist’ position which is indifferent to what fiscal policy is doing in current circumstances is untenable. As a result, central bankers have to speak out on the dangers of austerity. [1]

There are two lines that monetarists might take. The first is that unconventional monetary policy, Quantitative Easing (QE), is a perfect substitute for conventional monetary policy. The second is that an appropriate monetary policy regime can, through expectations, undo the restriction imposed by the zero lower bound (ZLB). Let me take each in turn.

The first argument is wrong mainly because of uncertainty. Macroeconomists know little enough, but we do know something about how conventional monetary and fiscal policy works, and we have a lot of data that can help us. We know so much less about unconventional monetary policy. What kind of model we should use is unclear, and we have very little data.

The second argument would be right if we could fix inflation expectations in exactly the same way as we could, absent the ZLB, fix nominal interest rates. Would a nominal GDP target do that? Of course not. I think it would help, particularly compared to an inflation target regime, because the latter actually inhibits inflation expectations rising above that target. That is why I have recently argued that a path for nominal GDP should be adopted by central banks as an intermediate target. Would adopting such a target raise inflation expectations and speed a recovery? - I think it would. Would it raise inflation expectations by enough to negate the need for any fiscal stimulus (or, more realistically, to counteract the impact of fiscal tightening)? There is no logical reason why it should. But let us just suppose it did. Does that mean we can ignore fiscal policy?

Absolutely not. What we are getting in this case is a recovery achieved by raising expected inflation above (in the UK, US and Eurozone) 2%. That is costly, because it means actual inflation must be allowed to go above 2%. The more we deflate demand through fiscal austerity, the higher inflation has to go (or the longer it has to be above 2%). So monetarists who believe in the expectations channel cannot be indifferent to fiscal policy, unless they also believe it has no effect, or that inflation above 2% is costless. (I make a similar point a little more carefully here.) If, as Paul Krugman says, fiscal policy makers are doing the wrong thing, that is a cost worth paying, but it is a cost nonetheless.

This is why it is really important that central banks, like the Fed, make it publicly clear the difficulties that fiscal tightening is causing them in meeting their mandate. Either this is because they are, quite rightly, uncertain about the impact of QE, or they are aware that the more fiscal tightening there is, the more inflation will have to go above 2% to counteract its impact.

The idea that to speak this truth is wrong because it might frighten the horses is silly. I have used the following analogy before. No one wants to hear a pilot tell passengers that they are no longer in control of the plane. However a better analogy in this case would be the pilot not telling the co-pilot, which would be highly dangerous. The horses that matter here are those in charge of fiscal policy, and they need frightening.

[1] Sorry Nick. I have a lot of sympathy for the point that we should not routinely exaggerate with language. The (I think just British) phrase I hate is ‘black hole’ when used to describe a worsening in the government’s accounts. The use of austerity to describe what is happening in parts of Europe and the UK right now is less obviously loaded or misleading, but I’m open to persuasion.