Where Is Radar O’Reilly When You Need Him?

Calculated Risk:

Usually the Fed minutes are pretty boring, but the minutes for the two day meeting held on June 22nd and 23rd, to be released on Wednesday, might be a little more interesting.

This release will include a revised forecast. Look for the Fed to revise down estimates for GDP and for inflation. And revise up estimates for unemployment.

The Fed April forecast for 2010 (most recent) was:

  • Change in real GDP: 3.2% to 3.7% (probably under 3.0% in first half, and GDP growth will probably slow in the 2nd half)
  • Unemployment rate: 9.1% to 9.5% (Unemployment averaged 9.7% in the first half, and will probably remain elevated)
  • PCE inflation: 1.2% to 1.5% (PCE inflation increased at a 0.7% annualized rate over the first 5 months – and appears to be dropping).Also the Fed might have discussed possible additional easing measures at the June meeting, and if so, it will be interesting to see the options discussed.
  • Jon Hilsenrath at WSJ:

    Fed officials still expect the U.S. economy to keep growing. But an updated forecast to be released Wednesday afternoon with the minutes of the Fed’s late-June policy meeting is likely to show that officials have trimmed their second-half forecasts—as have many private forecasters.

    One topic under debate is the possibility that today’s already-low inflation may turn into a debilitating bout of deflation, a broad drop in prices across the economy.

    Fed officials disagree on the risk of deflation. A few see it as a threat; others call it very unlikely, Fed officials said in recent interviews.

    For now, the Fed—and particularly its most-powerful member, Chairman Ben Bernanke, who has ultimate say—appears to be very much in wait-and-see mode. But differences among his colleagues are growing more evident. One problem: Having already cut interest rates to near zero, most of the Fed’s options for spurring growth aren’t very appealing.


    In public comments, Mr. Bernanke has played down the risk of a double-dip recession. But he has been keeping his options open.

    The Fed is better equipped to solve some economic problems than others. As Mr. Bernanke noted in a now-famous 2002 speech, the Fed has the power to fight deflation—or falling wages and prices—by printing money.

    But the bank’s tools aren’t perfectly suited to reducing unemployment, which is influenced by a range of factors including fiscal policy, regulation and global demand.

    Paul Krugman on Hilsenrath:

    Sorry, but that’s totally wrong. The question is whether, at the zero bound, the Fed has the ability to increase aggregate demand — full stop. If it can increase aggregate demand, it can fight both deflation and unemployment; if not, not.

    In a way, the problem with Bernanke’s speech was that he made increasing demand and fighting deflation sound too easy. The Fed can print money, if you increase the supply of something its price will fall, end of story.

    But as I tried to point out a long time ago, this simple story breaks down when short-term interest rates are near zero.

    Here’s one way to think about it: when the Fed conducts an open-market operation, buying short-term debt with newly printed money, this normally affects the short rate because bonds and money are imperfect substitutes: money yields less, but has the advantage of being something you can use directly to make payments, that is, it’s more liquid.

    But when you have bought so much debt and created so much money that rates are near zero, the public is saturated with liquidity; from that point on, they’re holding money simply as a store of value, which makes it no different from bonds — and hence a perfect substitute for bonds. And at that point further open-market operations do nothing — they just swap one zero-interest asset for another, with no effect on anything.

    So why not forget about open-market operations, and just drop the stuff from helicopters? Well, remember that at this point cash and short-term bonds are equivalent. So a helicopter drop is just like a temporary lump-sum tax cut. And we would expect people to save much or most of such a tax cut — all of it, if you believe in full Ricardian equivalence.

    Brad DeLong:

    But we don’t believe in full Ricardian equivalence. Maybe we would if this year’s helicopter drop was to be followed by next year’s great helicopter vacuuming, but it isn’t. So printing money now–and promising never to buy it back–is a way of having some impact on future inflation, and thus of getting some traction. Moreover, “much or most” is not all.

    The “much or most” is, I think, reason to go for money-financed government spending as a preferable policy to a helicopter drop–which is a money-financed tax cut. And it is reason to go for an explicit raising of the Federal Reserve’s long-term inflation rate target from 2% to 3%.

    But if we are not going to do either of those things–and it looks like we are not–it’s time to rev up the helicopters…

    Tyler Cowen:

    First, cash and short-term bonds may be near-substitutes but they are not literally, strictly equivalent.  The nominal rate on T-bills is not exactly zero and furthermore you can’t use a T-bill for every retail purchase.  The demand curve for real cash need slope down only slightly for a quantity theory result to hold.  After everyone spends the new cash balances, and prices rise, people end up with the quantity of real balances which they initially desired.  These equilibria have “knife-edge” properties, where “identical to T-Bills” and “nearly identical to T-Bills” do not bring the same results.  Tsiang showed this in a very good JMCB article on Friedman’s optimum quantity of money, in the early 1970s and you might regard it as implicit in Bewley’s Econometrica article on Friedman.

    Second, after a helicopter drop no one need expect future taxes to be raised to retire the money (although maybe a sufficiently credible government could create such an expectation).  So there is no Ricardian motive to save the new cash, as Brad DeLong points out.  Indeed, if you think there is some chance that others will spend the money, raising the price level, you will want to spend your new cash soon, so as to preserve its value against forthcoming price inflation.  The resulting game-theoretic equilibrium, applying dominant strategies, again leads to higher prices, higher aggregate demand, and the desired quantity of real cash balances held.

    Those are not the only possible cases (see the work of Fischer Black) but I take them to be the most sensible default cases.  Both indicate that a helicopter drop of cash will work fine in boosting aggregate demand.

    The most likely scenario for no positive AD effect is simply that the helicopter drop is so small that no one expects a price level rise and thus no one expects an inflationary tax on the new cash, people (for bounded rationality reasons) treat the new cash as a transfer purely to themselves, the precautionary motive for saving is strong, and so the new money is simply held.  A larger helicopter drop should overcome that inertia, if need be.

    Maybe these arguments are incorrect but they date from a consensus established in the mid- to late 1960s and early 1970s, much of it springing from Patinkin’s book on money and the subsequent discussions thereof.  Krugman suggests this perspective is wrong, but he hasn’t yet given me — or others — a reason to budge from it.

    Tom Maguire:

    Well, suppose our helicopter flies very carefully and only hovers over the homes of the unemployed; further, suppose the pilot also announces “this is unemployment insurance” before pushing the money out the door.

    Now, at least as I understand current Dem talking points, this is no longer a useless tax cut but a vital stimulus program.  But I am not sure when the substantive change occurred.  As the money fell through the air, maybe?

    Well.  The unemployed may calculate that aggregate taxes are likely to rise in the future, but they may also guess that those taxes will rise for Someone Else (it’s the American Way!).  In which case, they will feel free to spend all of their helicopter windfall.  Of course, The Current Rich may increase their own saving in anticipation of these future taxes, but what about the Future Rich?  Are law school students going to forego pizza in anticipation of higher taxes on their partnership income in fifteen years?  Maybe not.  (As a related puzzle, why is it that temporary tax cuts don’t spur permanent changes in hiring and investment but temporary spending increases do?  File that under Unsolved Mysteries.)

    Could similar logic apply to a lower-income payroll tax cut today made up by (likely) taxes on “the rich” later, resulting in transfers as stimulative as unemployment benefit extensions?  I am not smart enough to be a Dem strategist or psychologist. I just know tax cuts are something they can’t say yes to.

    Matthew Yglesias:

    Meanwhile, I think Paul Krugman, Brad DeLong (and again), and Tyler Cowen are really all saying the same thing about the prospects for re-inflating the economy by printing money and dropping it from helicopters.

    To make monetary stimulus work, you need to raise inflation expectations. But to achieve this, you need token of your inflationeering. If you drop the money and say “don’t worry about inflation, I have an exit strategy” that won’t work. If you just drop the money and don’t say anything, it might or might not work depending on some hard to assess factors. But if you drop the money and say “I’m dropping this money because I want prices to go up faster in order to catch up to the long-run trend” that should work.

    Noah Millman at The American Scene:

    I have a question for people who know more economics than I do.

    Right now, if I understand the state of debate about the Fed, there are two camps.

    One camp holds that the Fed can do a variety of things – such as purchasing debt of somewhat longer maturity than T-bills – that are metaphorized as “dropping money from helicopters” in order to reduce the value of money, which should stimulate demand, and help pull us out from what might otherwise be a double-dip recession.

    The other camp holds that the Fed really shouldn’t do these sorts of things at all except in a Titanic-scale emergency because of the risk to the ultimate credibility of the currency – that you’ll overshoot the desired outcome of “inflation expectations go up” and go directly to “the Fed’s gone mad – let’s put all our money in gold (or Euros, or whatever looks like a better store of value than dollars that are being dropped from helicopters).”

    (Interestingly, Paul Krugman, in his 1998 article on Japan argues that it is only the expectation of precisely this kind of irresponsibility that could possibly make unconventional monetary policy work:

    If this stylized analysis bears any resemblance to the real problem facing Japan, the policy implications are radical. Structural reforms that raise the long-run growth rate (or relax non-price credit constraints) might alleviate the problem; so might deficit-financed government spending. But the simplest way out of the slump is to give the economy the inflationary expectations it needs. This means that the central bank must make a credible commitment to engage in what would in other contexts be regarded as irresponsible monetary policy – that is, convince the private sector that it will not reverse its current monetary expansion when prices begin to rise!

    Put that in your rotor and smoke it, helicopter Ben.)

    In any event, the alternative to action by the Fed is action by the Treasury – increase borrowing and put the money into the economy via either government spending or tax cuts. We all know the political constraints on this kind of action, and I rather think it’s subject to the same kind of criticism – if the Treasury issues a whole bunch of 10-year debt, that should push up the yield on government bonds, which should stimulate more private savings to take advantage of the yields, and that rise in private savings should offset the stimulative effect of the tax cuts, so there isn’t any point. Japan’s public debt has grown positively brobdignagian since the early 1990s, but it’s all financed by domestic savings and has therefore traded off with dwindling private sector demand; hence it’s done precious little to stimulate growth. Again, the only way to make this work is to reduce confidence that the government will pay back the bonds in good coin – in other words, to behave truly irresponsibly.

    So now we come to my question.

    Our goal is to increase the output of the economy, either increasing aggregate demand for goods and services relative to demand for money (the demand side approach), or encouraging the deployment of “dead” money in productive investment (the supply side approach).

    Wouldn’t a meaningful wealth tax do both?

    A tax on wealth (financial assets and real property) is functionally equivalent to a rise in inflation (that’s why inflation is also described as a tax on savings). Money currently earning a nominal zero percent per year in a savings account would now earn negative two percent per year because of the tax. Spending on assets that naturally depreciate (cars, toasters, trips to Florida) would look more attractive than watching one’s money evaporate through taxes. So would taking risk on a productive investment that might yield a big return but might go bust – just as when inflation expectations rise people shift out of safe short-term bonds and into riskier assets, to “stay ahead of inflation.”

    More Krugman:

    Does the Fed have the right to do a helicopter drop, i.e., just hand out cash? My guess is not: it’s empowered to buy assets, which is what it does in an open-market operation, but not just to give stuff away.

    So to do the equivalent of a helicopter drop, the Fed would have to work with the Treasury: it would have to buy government debt, and the Treasury would then hand out the money.

    But the Treasury can’t do this without enabling legislation.

    And enabling legislation can’t pass without Ben Nelson.

    I think we have a problem here. There’s a hole in the bucket.

    However, the Fed can change its inflation target any time it likes.


    I think that with a modicum of creative thinking the Fed could get around that. True, the only thing the Fed can do is buy assets. But who’s to say what constitutes an asset? They could start up a Sock-Backed Lending Facility (SBLF) that offers “loans” of up to $1,000 per person in exchange for a pair of socks as collateral. Citizens who fail to repay the loan default ownership of their pair of socks to the Fed but don’t otherwise face any consequences. That’s not the same as literally dropping money from helicopters, but it’s about the same.

    The important thing, as Krugman was saying earlier, isn’t so much what exactly you do but how you frame it in terms of expectations. You don’t want people to think of this as an early government tax refund that’s going to have to be repaid soon enough. People need to see that you’ve got a wacky bunch of characters running the central bank who are determined to keep printing up cash and trading it for socks until the economy re-inflates back to the trend level. The idea isn’t just that you want people to spend the $1,000 (or go buy new socks), it’s that you want to purge the economy of the excessive demand for money and get people thinking they’d like to trade their money for something else—consumer goods, fixed investment, blah blah.

    Now it seems the Fed isn’t inclined to do this, but it can be encouraged to change its mind. The problem is that you can’t have the President of the United States running around talking about belt-tightening. The country isn’t stricken by a crop plague that’s inducing a famine. We’re not at 9 percent unemployment because we’ve become a society with less skills or capital goods than we had ten years ago. If there’s less stuff to go around, then everyone has to tighten their belts. But our shortage is a shortage of money and demand and the government doesn’t fix that by tightening belts, it fixes it by creating more money and more demand.

    UPDATE: More Krugman

    Bruce Bartlett

    More Yglesias


    1 Comment

    Filed under Economics, The Crisis

    One response to “Where Is Radar O’Reilly When You Need Him?

    1. Pingback: What We’ve Built Today « Around The Sphere

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