To the Fed and the Treasury: Can we Please Play Cooperatively?

How should government respond to a situation of high unemployment and low growth? If you are a classical RBC kind of person: the answer is simple. Get out of the way. Let the market perform its magic.

If you are a New Keynesian sticky price kind of person: the answer is also simple. Let the Fed do its magic by lowering the interest rate to stimulate aggregate demand. I have a different answer: replace long dated Treasury bonds in the hands of the public with cash or with short dated Treasury bills. 

Many Keynesian economists, journalists and bloggers have argued that, when at the zero lower bound (ZLB) we must repair our infrastructure. Build roads. Build bridges. Build airports. They argue that, when the overnight rate is zero and the thirty year rate is lower than it has been for a century, public infrastructure should be paid for by borrowing at the long end of the yield curve. Float thirty year bonds. Better still: issue Consols that will never be retired.

While I agree that public expenditure in a depression may be helpful: issuing long bonds is not the right way to do it. I agree with Adair Turner that it is better to finance an expansion by printing money or borrowing in the Treasury bill market. Better still: as I argued in How the Economy Works and as Mark Blyth and Eric Lonergan have argued (here) print money and give it to those who know how to spend it: that would be you and me.

Borrowing at the long end of the yield curve is a bad idea because there are still active private participants in that market. There is not one interest rate: there are many. And although it is not possible to crowd out private expenditure at the short end of the yield curve; it is still possible to crowd out private expenditure at the long end.

The maturity structure of debt in the hands of the public matters. As I argue here, it matters because our children and our grandchildren cannot participate in financial markets that open before they are born.

Once one recognizes that the way that public expenditure is financed matters: it is a short step to recognizing that it is all that matters. If the Treasury increases the stock of thirty year bonds in the hands of the public, it will drive up long yields and crowd out private expenditure. If the Treasury reduces the stock of thirty year bonds held by the public, it will lower long yields and crowd in private expenditure. That leads to the argument for Qualitative Easing. A policy that removes long bonds (or other long dated risky securities) from the hands of the public and replaces them with cash or with Treasury bills, will crowd in private expenditure and increase aggregate demand.

Critics of QE have argued that QE3 was less effective than QE2 and QE1. That is true. But Fed intervention in the asset markets was undone by the Treasury that was simultaneously changing the yield composition of its debt to take advantage of low long-term interest rates. My message to the Fed and the Treasury is simple: can we please play cooperatively?  Much more coming soon on this topic in a forthcoming book.

Please: Lets Agree to Speak the Same Language

Olivier Blanchard finds the drop in the value of American stocks hard to explain in a framework where only fundamentals matter. He concludes that ‘herding’ is to blame.

Can we please agree on terminology? Animal spirits, confidence, sunspots, self-fulfilling prophecies and, sentiments have all been used to mean shifts in markets caused by factors that are non-fundamental. Now Olivier adds herding as one more term. (To be fair, that term too has been used before in the finance literature). Why this smorgasbord of synonyms?

Why a Bottle of Beaujolais is not the same as a Collateralized Debt Obligation (Updated May 2016)

I have updated this blogpost with a link to the new version of my paper. The new revised paper has the title of "Pricing Assets in an Economy with Two Types of People". 

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Brad DeLong kindly tweeted a link to a working paper (updated to new version May 21st 2016) I wrote last year. Matt Yglesias asks Brad to explain the paper. Let me take a stab at that.

Every graduate student of economics learns, early in her career, that markets work well. The idea that ‘markets work well’ has a well defined meaning: allocating resources by buying and selling goods in free markets does at least as well as any other way of allocating them. Let me be more precise.

A society, to an economist, is a bunch of people and a bunch of goods. A good is something that people want. For example, a ticket to see the latest Star Wars movie is a good. A bottle of Beaujolais is a good: and so is a banana. I could go on. But the basic idea here is that everyone in society has preferences over different bundles of goods. I personally would prefer a bottle of Beaujolais and a banana to a trip to the movies: but you may rank things differently.

Scott Sumner and Musical Chairs

Since 2009, Scott Sumner has been a big proponent of nominal GDP targeting. He sees nominal wages as slow to adjust and he has sketched a simple model, the musical chairs model, to explain why his policy should be adopted.

I am a new convert to these arguments. That is my loss. I had assumed, incorrectly, that Scott was proposing that central banks should simply adjust the coefficients on their interest rate policies, so called Taylor Rules, to raise the nominal interest rate when nominal GDP growth is above target and to lower it when nominal GDP growth is below target.I will refer to that variant of NGDP targeting, as growth rate targeting. An alternative, NGDP level targeting, would make these interest rate adjustments in response to deviations of nominal GDP from a target growth path. For an elaboration of that view, see, for example, the article by Evan Koenig, Vice President of the Dallas Fed.

Demand Creates its Own Supply

I have been teaching basic Keynesian economics this week to my undergraduate class and I have just completed a new book manuscript with the working title of Prosperity for All, that will be coming soon to a book

store near you. I am thus highly attuned to the debate over the connection between savings and investment. That debate resurfaced with a vengeance this morning on Twitter when Noah Smith and Jo Michell, among others, engaged in a sometimes testy exchange on the role of the State in promoting investment. Since that debate is at the core of Keynesian economics, and since my class is prepping for Monday’s midterm, this seems like a great opportunity to enlighten readers of all varieties on what Jo and Noah were on about.

A Bridge Too Far?

There is much current angst on the difficult problem of how to escape a liquidity trap. Paul Krugman points out that in Japan, the ratio of debt to GDP is growing, leaving little room for a further tame fiscal expansion. He favors something more aggressive.

Tony Yates argues instead for a helicopter drop. Print money and give it to Japanese citizens. The benefit of that approach is that it does not leave the government with an increase in interest bearing debt. Simon Wren Lewis looks more closely at the technical aspects of this idea.

Give me a One Armed Economist

I'm glad to see that Olivier Blanchard and Yanis Varoufakis have come out in favor of my plan for People's QE.

The following passage is from How the Economy Works, (HTEW) page 151.

Economists are famous for hedging their bets. A typical response to the question of how to run fiscal policy might be: “On the one hand we should raise taxes but on the other we should balance the budget”. President Harry Truman who instituted the Council of Economic Advisors famously quipped; “give me a one-armed economist.”

Here's what I said about fiscal stimulus in HTEW. 

A large fiscal stimulus may or may not be an important component of a recovery plan. My own view is that there is a better alternative to fiscal policy that I explain in [How the Economy Works, Chaper 11]. But if a fiscal policy is used it should take the form of a transfer payment to every domestic resident; not an increase in government expenditure.

Well ok, I didn't call it peoples QE. "Peoples QE", was coined by a speech writer for Jeremy Corbyn, the new leader of the Labour Party in the UK and its one of the less crazy parts of the Corbyn platform.  Why do I believe that? Because I also believe something that may seem contradictory. Its time to get interest rates into positive territory. SOON. Quoting again from an impeccable source (HTEW page 152).

Here are my views on monetary policy. Short term interest rates should be increased as soon as feasible, because a positive interest rate is needed if a national central bank is effectively to control inflation. In future, central banks should use the interest rate for this purpose and not to prevent recessions.

Why do I favor a fiscal transfer, rather than currently popular bandwagon of infrastructure expenditure? Two reasons.

• Because the work of Christina and David Romer suggests that tax multipliers (and by implication, transfer multipliers) are big. 

• Because I trust markets to decide how to allocate a fiscal stimulus more than I trust the government.

So: Raising interest rates is necessary to eventually raise inflation. I'm with the "neo-Fisherians" here. But an interest rate hike must be offset by some other expansionary policy to prevent the normalization of rates from creating a new recession. Here's what I said about that in HTEW.

But if a central bank raises the domestic interest rate without independently managing confidence, the result will be a drop in the value of the national stock market and a further deterioration in the real economy. To prevent this from happening, central banks need a second instrument.

So: Janet, Mark, Mario: yes: raise rates. Please. But give us QE too.