Open Letter to Conservatives on Monetary Policy

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By monetary economist Scott Sumner:

1. The Fed isn’t really trying to create inflation.

The Fed doesn’t directly control inflation; they influence total nominal spending, which is roughly what Keynesians call aggregate demand. Whether higher nominal spending results in higher inflation depends on a number of factors, such as whether the economy has a lot of underutilized resources. But it’s certainly true that for any given increase in NGDP, the Fed would prefer more RGDP growth and less inflation. Even after QE2, the Fed still expects less than 2% inflation for years to come. If the Fed had any marketing sense, they’d be telling the public they are trying to boost recovery by increasing national income, not increasing the cost of living. It would also have the virtue of being true.

2. “But doesn’t economic theory teach us that printing lots of money creates high inflation?”

In general that is true. But there are three important exceptions:

1. If the monetary injections are expected to be temporary, the inflationary effect is far smaller. The Japanese central bank did lots of QE in 2003, but pulled much of the money out in 2006 when deflation ended. It worked in preventing high inflation, indeed it may have worked too well.

2. If interest rates are near zero, the public demands more liquidity. The Fed can supply that liquidity with little impact on the price level.

3. If the Fed pays interest on reserves, then the quantity theory of money (more money means more inflation) doesn’t necessarily hold. They recently started paying interest on reserves, and that’s one reason why the big injections from 2008 didn’t have an inflationary impact. The Fed can adjust the rate as necessary, and indeed in my view a lower IOR would be more effective that QE2.

3. “But isn’t the gold market signaling high inflation?”

Possibly, but the indexed bond market is superior to gold prices for two reasons. First, gold is trading in a global market, and we are interested in US inflation. More importantly, gold prices reflect all sorts of factors (industrial demand in Asia, central bank demand, a recent drop-off in new discoveries, a hedge against all sorts of financial risks, including eurozone turmoil.) Furthermore the indexed bond market (TIPS spreads) has recently been more accurate than gold—correctly predicting low inflation in the US since late 2008.

4. “Doesn’t printing money just paper over real (structural) problems in the economy?”

There are structural problems, but there is also a shortfall of nominal GDP. The structural problems showed up when growth slowed in late 2007 and early 2008 as a result of sharply lower housing construction. This is necessary re-allocation of resources and should not be resisted. But even Friedrich Hayek suggested that we needed to avoid a “secondary deflation”, which would show up as falling NGDP, and would depress output in even those healthy industries that had not over-expanded. In late 2008 output fell across the board as NGDP declined. Monetary policy can only address the insufficiency of total nominal spending, not the structural problems. Furthermore, more nominal spending would boost employment, which would speed up the time when Congress eliminates the 99 week extended UI benefits–which is one of the structural problems.

5. “Isn’t this just hubris—the idea that money can be centrally planned?”

Most right wing economists are not comfortable with the idea of giving discretion to the central bank. I am no exception. I happen to favor making the dollar convertible into NGDP futures contracts as a way of stabilizing NGDP growth expectations at a low and stable rate. Milton Friedman favored a stable money supply growth rate, but late in his career (after velocity bounced around) endorsed a policy of stabilizing market expectations of inflation in the indexed bond market. These systems would allow the market, not the Fed, to determine the appropriate level of money for the economy’s needs. But we aren’t there yet, and given the Fed does use discretion, Friedman was not at all hesitant about recommending policies that he thought would do the least damage. I believe that is stable NGDP growth expectations.

6. The conservative critique of stimulus is incoherent

When I started my blog in early 2009, fiscal stimulus was the hot issue. Many conservatives were opposed to fiscal stimulus, arguing (correctly in my view) that it would fail. And they made it quite clear that “failure” meant deficit spending would fail to boost nominal spending. The implicit assumption was (almost everyone agreed) that more nominal output would be desirable, and the argument was that fiscal stimulus could not deliver it. With monetary stimulus, the right is making exactly the opposite argument—they are opposed to QE because it might succeed in boosting NGDP. Both fiscal and monetary stimulus boost NGDP (if they work at all) by shifting AD to the right. Whether that extra spending shows up as inflation or real growth is of course an important issue. But it makes no sense to argue fiscal stimulus would fail because it would not boost NGDP, and simultaneously argue that monetary stimulus would fail because it would increase NGDP. I’m sure the right doesn’t think of its views in those terms, but that is essentially the message they are sending out, and it is an extremely incoherent message.

7. “Won’t monetary stimulus just paper over the failures of the Obama administration, allowing him to get re-elected?”

That’s an argument unworthy of principled conservatives. After 30 years of major neoliberal reforms all over the world (even in Sweden!) it’s time for conservatives to become less defeatist about the possibility of making positive improvements in governance. We need to do the right thing, and let the political chips fall where they may. If monetary stimulus is tried, and succeeds in boosting NGDP (which even conservatives implicitly acknowledge can happen when they worry about inflation) then it would drive a stake through the heart of the Krugmanite fiscal stimulus argument (for future recessions.)

I don’t think conservatives realized it at the time, but I (and a few other quasi-monetarists) had the strongest argument against fiscal stimulus in late 2008 and early 2009. We said; “Yes, stimulus is needed, but monetary stimulus is much more effective and less costly than deficit spending.” At the time, most on the left argued that monetary stimulus wouldn’t work if rates were near zero. Well rates are still near zero, and many of those same liberals are now insisting that the Fed is responsible for fixing the AD shortfall. They’ve come over to our side. Just as in earlier decades they gradually accepted the Friedman/Schwartz argument that monetary policy errors caused the Great Contraction of 1929-33, not the failures of capitalism. If conservatives keep predicting inflation that the financial markets don’t see, Krugamn will continue to rub their faces in failed predictions. If we adopt the view that monetary policy is the appropriate way to keep NGDP growing at an adequate rate, then we win and Krugman loses. So which will it be?

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  1. I’m not learned enough to comment on QE2 but this is the first I’ve heard of setting monetary policy through NGDP futures contracts and I think it’s a brilliant idea. Don’t know if it would be wise but very interesting nonetheless.

  2. The FRBoG doesn’t need to ask permission from me or any other yahoo, conservative unwashed idiot critic. They do whatever Prof Bernanke and his (egg head) Board of Governors think is appropriate.

    I’m with RR. I don’t remember other than monetary policy has to do with interest rates and money supply (with velocity changes somehow). Money supply is usually monkeyed with by reserve requirements and etc.

    Printing money has ever been inflationary. But, former BoG Vice Chairman Blinder and the current VC assure us that even though the FRBoG has never done one thing correct in 97 years, we can be assured that there will be no inflation after printing $600 billion in money: because there was no inflation after buying $1.25 trillion in MBS paper???

    Funny thing there neither was any improvement in employment and minimal upside in national output.

    I will copy the Prof’s comments into a WORD doc and can review after time passes.

    I have little faith in college profs when they play at monteary divination, or when they harrrass college kids.

  3. Dave,

    The full letter and a list of signers can be found here. There are 23 signers, some of whom do not have any particular expertise when it comes to monetary policy (e.g. William Kristol).

    For comparison purposes, over 200 economists signed an open letter opposing Obama’s original stimulus package and a similarly large number signed an open letter opposing TARP. My view would be that the low number of signers is, if anything, an indication that the views expressed in the letter do not have widespread support even among conservative and libertarian leaning economists.

  4. even though the FRBoG has never done one thing correct in 97 years,

    That’s absurd. Stop it.

    There are 23 signers, some of whom do not have any particular expertise when it comes to monetary policy

    Only a few are economists. To be fair, one can wager it was not extensively circulated beforehand. It has some heavy hitters: Michael Boskin, Charles Calomiris, and Douglas Holtz-Eakin.

  5. OK, Art Deco: Name three “things” the FRBoG got right since 1913. Clearing checks and balancing the books don’t count.

  6. T. Shaw, the Board of Governors and the Open Market Committee of the Federal Reserve System have dozens of meetings each year to make consequential decisions on the interest rates they charge, on the quantum of the monetary base, and on regulatory matters within their book. You are telling me you have analyzed every single decision over a period of 97 years and they were in error every single time. Such a statement is nonsensical.

    The successful stabilization of prices in 1951 and 1981-82 should count as successful initiatives, as would be containing panic at the time of the 1987 market crash.

  7. Art Deco – That’s an important point. Thanks.

    I do have some questions though… Where did (or does) the money for whatever stimulus come from? Didn’t they have to print the money to do it/them? They didn’t raise our taxes or sell enough additional bonds to give them out. Fiscal policy is connected to Monetary policy.

  8. Art,

    Shortly, we will see how this scheme works. The $1.25 trillion MBS buys did not raise output, AD, or employment. There are other ‘things’ holding down the economy. To run the inflation machine to solve a problem that is not monetary . . .

    What time frame will we use?

    The “cures” you cite were worse than the diseases, which could have been avoided in the first place.

    I don’t know about 1951. I was a year old. I remember 1987, what a hoot. The Fed has a lot to do with equity markets?

    I lived and worked through the 1980 -1981 Fed moves (Prime Rate 19%, 30 year mortgage rate 20%). That was like economic cancer treatment: radical radiation and chemo-therapy simultaneously administered. If you think that was a good, there is no reasoning with you.

    If you think keeping the fed funds rate at 1% in the 2000’s was a success . . . Ask the shareholders of IndyMac Bank, and $80 billion in FDIC insurance losses . . .

  9. Dave,

    The fiscal stimulus was, I believe, financed by borrowing, not by printing the money for it.

    There are arguments in favor of abolishing the Federal Reserve and/or returning to a gold standard. For the time being, however, we do have a Fed and a fiat currency, so the question is not whether the Fed should print money but how much it should print. Market indicators are that it is not printing enough to keep up with demand. Hence the need for more monetary stimulus.

  10. T. Shaw,

    The 1980-81 recession was harsh. Yet given that the Fed’s alternative was to continue with high inflation, it seems that the Fed made the right call there. Do you really disagree with that?

  11. BA: No.

    But, why was the USA given such an alternative?

    Seems the FRB could not protect USA . . .

    Who’d’a thunk! 12% inflation and 10% unemployment! The Misery Index (calculated by adding inflation and unemployment) rose to 21.9% in 1980 (today it is 10.2%).

    What economic model covers that?

    Here are other 20th century Fed and big government achievements:

    A Perfect Storm of D.C. policy caused the Great Depression:
    In the 1930s, the Smoot-Hawley Tariff Act caused a collapse in global trade.
    The Fed allowed the money supply to shrink by one-third.
    Herbert Hoover raised taxes.

    In the 1960’s – 80’s Washington tried again.
    Great Society welfare and health-care programs.
    Wage and price controls.
    Inflationary Fed policy
    70% marginal tax rates, 50% capital-gains tax rates.
    Highly regulated energy, airline, banking and trucking industries created severe problems.

    Seems to me the Fed has the anti-Midas touch. The powers that be keep placing blind faith therein.

  12. Bovine Scatology. Open letter to ‘conservatives’ from liberals pretending to be conservative. Come on! Who is buying this Bovine Scatology?

    Trying to determine how much and in which way the Fed should do anything is akin to trying to influence Hitler as to how many Jews and Catholics should be killed and in what manner. The Federal Reserve Bank of New York makes all the decisions, Bernanke is just the ‘politically appointed’ face and the BOG is only for show. Congress, the President and the people have no say in this whatsoever.

    The Fed is nothing more than usury. It is immoral, it is unethical, it has NEVER accomplished any of its stated goals and has been relatively effective at accomplishing its intended goals: Control the government through the purse by addicting the politcos to debt borrowing (spending) and then offering a solution to inflate the money supply in order to ‘reduce’ the debt. It is a wealth transfer from all the people to the trans-national financiers and owners of the monster from Jekyll Island and a transfer of sovereign power from the people to the federal (national) government and eventually to a global scheme of corporatist-totalitarianism (or some variation of the Hegelian (evil) synthesis of Capitalism/Communism)

    This is unAmerican, it must be stopped, money weight must be set by Congress. This is anti-Catholic, it must be stopped, usury is a grave evil and along with murder (especially abortion, infanticide, euthanasia) and Sodomy (acceptance of pederasty, homosexualist behavior, porn, masturbation, etc.) are the principle reasons this country is in trouble. Those evils are related and the instigators and perpetrators of these evils are all of a piece.

    You cannot consider yourself an orthodox Catholic and be in support of the Federal Reserve scheme. Ignorance is not an excuse. It is time to end this thing – not abruptly, but a definite transition is necessary and the power of the purse belongs to the Congress in the people’s House and what should be the States’ Senate (repeal the 17th).

    Expect a double Paul pincer attack against this beast in January, watch the authentic conservatives support them and watch the Regressives (‘progressives’, liberals, Democrats and so-called Republicans with absolutist stripes) flail. The Fed is on its heels, it cannot even control what it started, the house of cards is crumbling and the beast is frightened by the people who have learned what it really is. It will NOT live to see its 100 birthday.

  13. David, your referent is to an article which prints a piece of correspondence. The letter-writer is under the false impression that the consumer price index excludes food and fuel prices. It does no such thing. The Bureau of Labor Statistics does produce an additional price index referred to as ‘core inflation’ which excludes food and fuel prices because these are volatile. The Consumer Price Index itself includes food and fuel prices (and why we should regard the Bureau of Labor Statistics as producing unreliable measures and this man eyeballing the price of Raisin Bran at his supermarket as a reliable measure I cannot fathom).

  14. What economic model covers that?

    Milton Friedman’s conception of a family of Phillips Curves, one for each level of expected inflation.

    Here are other 20th century Fed and big government achievements:

    A Perfect Storm of D.C. policy caused the Great Depression:
    In the 1930s, the Smoot-Hawley Tariff Act caused a collapse in global trade.

    The United States in 1929 exported only about 5% of its domestic product (and generally imported less than that). It was not well-integrated into international markets. Only those economies notably dependent on the American market would have been injured by first-order effects of that tariff: that of Canada and perhaps some of the territories of the Caribbean Basin and a scatter of others.

    It should also be noted that the aftershocks of the financial crisis in the Fall of 2008 included an implosion in world trade as severe as that which occurred in 1929-30, without tariff legislation.

    Excises on imports are hardly an example of ‘big government’, unless you consider the era extending from 1789 to 1916, when little use was made of direct taxes or common excises, to be an era of ‘big government’.

    The Fed allowed the money supply to shrink by one-third.

    That is not an example of an excessively busy central government but of an excessively passive one. The Federal Reserve had concerns about the effects of open market operations in the context of the currency peg, so did not attempt them until 1932. The currency peg was there by statute. It was commonly expected that the United States would follow Britain off the gold standard in Sept. 1931. It failed to do so and undertook actions to stem an outflow of gold, so while Britain began an economic recovering, the United States experienced the most harrowing 10 month period in the nation’s economic history. You all need to get your story straight. The Federal Reserve’s maligned program has as its object an expansion in the monetary base to meet the demand for liquidity. This is precisely what the (constrained) Federal Reserve failed to do in the period running from the Fall of 1929 to the Spring of 1932.

    Herbert Hoover raised taxes.

    Congress raised taxes at the President’s request, because the fall in revenue co-incident with the Depression had generated a (contextually) large defecit. The practice of balanced budgets was the orthodoxy of the time, and we can now see the salutary aspects of that orthodoxy, even if it was adhered to in circumstances where it was injurious.

    In the 1960’s – 80’s Washington tried again.
    Great Society welfare and health-care programs.
    Wage and price controls.
    Inflationary Fed policy
    70% marginal tax rates, 50% capital-gains tax rates.

    Highly regulated energy, airline, banking and trucking industries created severe problems.

    This stew of complaints has some validity, but it is perfectly irrelevant to a discussion of monetary policy in 1931 or today. BTW, high marginal tax rates were not a Great Society initiative, nor was the mercantile regulation of the transportation sector or banking. The former was leftover from the 2d World War and the latter from the Depression. I actually rather miss Glass-Steagall, all things considered.

    Seems to me the Fed has the anti-Midas touch. The powers that be keep placing blind faith therein.

  15. BI – BOB RUBIN: “US In Terribly Dangerous Territory,” Bond Market May Be Headed For “Implosion”

    Warning of the risk of an “implosion” in the bond market, former Treasury Secretary Robert Rubin says the soaring federal budget deficit and the Fed’s quantitative easing are putting the U.S. in “terribly dangerous territory.”

    Speaking at an event at The Pierre Hotel in New York City honoring Sen. Kent Conrad (D-N.D.), Rubin joined the growing number of current and former officials (foreign and domestic) to criticize QE2. The Fed’s plan to buy $600 billion of Treasuries “has a lot of risk,” he said, calling the international reaction “horrendous”…

    Bloomberg – Dollar to Become World’s `Weakest Currency,’ JPMorgan Says

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