Extended Response to Nick Rowe

Nick Rowe on Twitter earlier today:

If [a] central bank targeted the price of peanuts, would we blame recessions on bad peanut harvests? Or blame [the] central bank for not raising [the] target price?

It depends. It depends on how quickly the central bank finds out about the bad peanut harvest, how quickly the new policy can be enacted, and how effectively the central bank can control the price of peanuts.

Suppose no one know about the size of the peanut harvest until the following period. In this case, the central bank, which we will assume can completely control the price of peanuts for the time being, is not culpable for the recession that occurs because the price of peanuts is too low. The central bank could not have known that the price level (of peanuts) at which output remained at potential was higher than they otherwise thought, so they cannot be blamed for the recession that ensues.

If, on a slightly different note, the central bank faces a delay in policy implementation, it may not be able to act quickly enough to prevent a recession; they can raise the target price with a delay, but there will still be a recession in the meantime and the central bank is not culpable.

Alternatively, assume that the central bank knows about the bad harvest in real time and doesn't face a policy lag, but, for some reason, is unable to set the price of peanuts any higher. In this case, the central bank can't be blamed either -- there is nothing it can do to prevent it from happening, so the correct culprit for the recession is the bad peanut harvest.

Generally, assuming there are no significant lags in information or implementation, the central bank would be to blame for not preventing the recession. The only time that the blame really shouldn't fall on a central bank is when it can't control the price (of peanuts) -- in this case, central bank impotence is to blame for the recession, not actions taken by the central bank.

With that aside, now we can go about determining when central banks are impotent.

Objectives vs. Tools of Monetary Policy

In the comments of one of Nick Rowe's recent posts, Scott Sumner has accused me of confusing objectives and tools of monetary policy:

You are looking at the causal effects of QE, whereas it makes more sense to view QE as the effect of a tight monetary policy that drives rates to zero. If you do a more expansionary monetary policy, such as currency depreciation, then you do not need as much QE. QE is a defensive mechanism, monetary policy needs to be viewed in terms of the policy goals of the central bank, and in terms of whether it will do whatever it takes to reach those goals.

Basically, Scott is suggesting that quantitative easing isn't actually a monetary policy, and is instead the natural conclusion to what he does view as monetary policy -- currency depreciation. Here, Sumner provides an interesting set of definition for what constitutes monetary policy and, more generally, what can reasonably be considered exogenous to a central bank.

In his mind, exchange rates are basically exogenous to the extent that central banks try to influence them. This is evident from his implicit assertion that, if central banks are "doing whatever it takes to reach [their] goals," they will invariably reach those goals. Of course, this isn't necessarily news, everyone has know Sumner's opinion that central banks are nearly omnipotent for quite some time, but this time he has laid it out more directly.

According to Sumner, the evolution of any nominal variable over time can be completely controlled by a central bank and, as such, can be used as a point of criticism for that central bank: "monetary policy needs to be viewed in terms of the policy goals of the central bank." As such, the actual polices that central banks follow are completely irrelevant; it doesn't matter what the path of interest rates is, the correct judge of current Federal Reserve policy (for example) is whether or not inflation is on target.

Of course, I, along with I hope the majority of people, don't see monetary policy in this light. Sumner seems to have made a point of confusing monetary policy -- e.g., QE, interest rate setting, open market operations -- with whatever nominal variable he happens to care about at the moment -- in this case exchange rates. This separation is important; it allows us to understand more directly a central bank's goals and how it intends to achieve those goals.

Evidently, Scott could care less about the how and only wants us to focus on the goals. He basically has reduced his thinking about monetary policy to the point that he views NGDP as an instrument of the central bank -- effectively an exogenous variable -- rather than a variable that a central bank may act to control. This level of abstraction from the operation of monetary policy, in my opinion even more grievous than the New Keynesian obsession with the nominal interest rate, is what allows Market Monetarists to callously ignore every model that doesn't allow exogenous NGDP that says the zero lower bound actually represents a constraint on monetary policy.

If central banks could make NGDP exogenous, would they be able to make NGDP exogenous? Naturally, but no one should care about the answer to such a redundant question, yet this is effectively the answer that you get from Sumner; he'll simply assert that "the BOC can always depreciate the Canadian dollar. The zero bound is not an issue in Canada" (from an earlier comment on the same post). Naturally, we should all trust Sumner's clairvoyance on this issue, clearly no argument about monetary policy effectiveness is necessary (see my first comment on Nick Rowe's post, if you want one anyway) and we can rest assured that fiscal policy is never necessary.

Ideally, considering the ability of monetary policy to effectively deal with challenges should be at least of some consideration and, since monetary policy has proved theoretically capable of offsetting the demand-side effects of fiscal stimulus among other shocks, the only point at which this can be of much concern is the zero lower bound. Both Sumner's and Rowe's refusal to give theoretical arguments against me in this area is rather troubling, evidently just assuming monetary policy is effective in every circumstance is completely acceptable.

Timing and Composition

Family members are often confused by my simultaneous support for looser fiscal policy in the United States and disdain for Republican tax proposals during this election cycle on the ground that they would result in too much deficit spending. On the surface, my policy preferences seem contradictory; I neither support efforts to rein in the deficit nor the large tax cut proposals of the majority of Republicans. There are two primary reasons for this seemingly strange predilection: timing and composition.

The length of time each policy lasts is crucial to my support. As per the 'New Keynesian consensus,' loose fiscal policy should only be used until monetary policy can be reasonably declared unconstrained by the zero lower bound. This is why deliberate deficit cutting policies should not have been undertaken, and arguably should not be pursued further, until two criteria have been met: the federal funds rate must be above the zero lower bound and there must be little to no risk that the zero lower bound will be made to bind by either a tightening of fiscal policy or some other shock to the economy. At the time of writing this post, only the first criterion is fulfilled -- the Federal Reserve has decided to raise the target fed funds rate, but, since it stands somewhere between 0.25% and 0.5% (the Fed has adopted a target range instead of a strict target), it would be reasonable to suggest that a large negative fiscal shock could be more than the Fed can handle without being thrown back into a liquidity trap (in this sense, the US could still be considered to be in a liquidity trap, even though the zero lower bound no longer binds).

GOP tax cut proposals would undoubtedly achieve the temporary goal of looser fiscal policy, but they would be on a completely wrong timescale. Conventional analysis only suggests loose fiscal policy for the duration of the liquidity trap, and, since the tax cuts are permanent to the extent that they are not repealed by future administrations, they fail miserably in this regard. In other words, fiscal policy would be too loose for too long under large tax cuts -- especially if they are not accompanied by corresponding reductions in government spending. Additionally, spending cuts are arguably more damaging than tax cuts are stimulative in liquidity traps, so a fiscal adjustment fully in line with, e.g., Rand Paul's or Ted Cruz' preferences could completely fail to comply with the recommendations of mainstream economics, which scares me enough in its own right to warrant a revocation of support.

My second criticism of the GOP tax plans is more personal; I think that government spending and taxes in the United States should be higher, not lower. There are certainly arguments to be made that government spending in the United States does nothing to raise aggregate utility and should thus be cut, but I believe, and I think most other economists agree with me, that this is definitely not the case. This is especially true in infrastructure, or more generally government investment -- currently at its lowest level as a percentage of GDP since 1948 -- which sorely needs to be increased. Further, spending on Social Security and Medicare should increase over the next decade or two because of the changing demographics of the country. If we adopt the tax proposals of many if not all of the GOP candidates, spending cuts will have to come from somewhere and, given the Republican obsession with massive military spending, they will probably not be defense cuts. This pretty much leaves entitlements and investment -- both of which would cause significant pain going forward if they were cut significantly.

Ideally, fiscal policy makers would focus in the short term on simply not cutting spending too ferociously and in the long run on figuring out how to raise the revenue required for higher levels of government investment and entitlement spending. The GOP seems prepared to do neither of these and, as such, I am not prepared to endorse them for their fiscal policy.

Choosing the Best Model For Each Context

In spite of perhaps attracting the wrath of Jason Smith, I think it is safe to say that economics is too complicated for there to be one generally applicable model of everything. Because of this, there is a veritable plethora of economic models available to the economic theorist. This simply leaves the question of which one to use in which circumstance.

Simon Wren-Lewis seems to think that economists should select between models in an ex-post manner -- that is, we should seen which model better represents the data and use that model from then on:

How do we know if most economic cycles are described by Real Business Cycles (RBC) or Keynesian dynamics. One big clue is layoffs: if employment is fall because workers are choosing not to work, we could have an RBC mechanism, but if workers are being laid off (and are deeply unhappy about is) this is more characteristic of a Keynesian downturn.

 The issue here is that we can only diagnose events after the fact, we cannot reasonably make predictions because of the impossibility of ex ante empirical validation: it is impossible to determine whether or not a recession is New Keynesian or if it is a Real Business Cycle before data are released.

This is why context-based validation of theory is superior to empirical validation in the case of economics. The context -- i.e. the sub-field of economics that is being studied -- should inform model choice almost entirely. If the field is business cycles, then the relevant model is a New Keynesian DSGE model and if the field is growth theory, then New Keynesian models are superfluous and should be tabled in favor of neoclassical models -- whose only difference from their New Keynesian counterparts is nominal rigidity, which is irrelevant over a time scale longer than a decade.

Predictions about the economy can now be made based on currently available information: it is possible to determine whether or not, e.g. financial frictions should be present in our business cycle model based on the current state of the economy: we knew by Q3 2008 that financial frictions were relevant, so we should have put them in a model if we were trying to predict the next few years.

Alternatively, the model I should choose to use depends on the kind of thought experiment I choose to embark on. Am I trying to compare PAYGO pensions with Social Security? If so, the obvious model to use is a simple OLG model without a labor-leisure trade-off or sticky prices. Choice of models is equivalent to choice of assumptions, at least when it comes to the DGE approach currently dominant in economics, and assumption choice depends entirely on the question being asked. Nominal rigidity is obviously relevant for business cycle theory, but completely useless when it comes to determining the level effect of a tax increase.

Hopefully this selection mechanism is specific enough to not be "basically feelings," as Jason Smith would suggest is the case for most of economics.

People Should Be More Honest With Charts

Recently, Scott Sumner wrote a blog post with this chart in it:

 I thought it would be interesting to see how well this relationship held over the period that Sumner didn't include in his chart. Here it is:

It's interesting to note that the relationship doesn't look so good when you look at the entire sample in which all of the data is available. This is aside from that fact that the idea that the NGDP/Wage ratio would track unemployment is part of basic neoclassical theory and has nothing to do with wage stickiness.

Start with a simple Cobb-Douglas production function with employment and capital:

$$(1)\: Y_t = F(K_{t-1},L_t) = K_{t-1}^\alpha L_t^{1-\alpha} $$

Assume that the firm maximizes profits, $Y_t - w_t L_t - r_{t-1} K_{t-1}$ and you get the following first order condition for labor:

$$(2)\: w_t = (1-\alpha)\left(\frac{Y_t}{L_t}\right) $$

Dividing by $Y_t$ will give the nominal wage to NGDP ratio (since the nominal wage to NGDP ratio is the same as the real wage to RGDP ratio), which is

$$(3)\: \frac{w_t}{Y_t} = \frac{1-\alpha}{L_t} $$

It's clear from this that, in a simple neoclassical model, the nominal wage to NGDP ratio is expected to be negatively correlated with employment and, therefore, positively correlated with unemployment -- which is coincidentally the exact thing that Scott's chart shows. Variations in the nominal wage to NGDP ratio are not, in fact, vindications of the musical chairs model.