More on Secular Stagnation

Mauro Boianovsky and Roger Backhouse have written a brief post on the topic, based on a longer paper. As I understand the modern version, due essentially to Larry Summers, it basically suggests that there are insufficient investment opportunities, or a savings glut to use Bernanke's hypothesis, discussed here before. I explained why it doesn't seem particularly compelling story in that previous post. If public spending picked up in the US, so would private investment, and the savings glut would vanish. Yes global imbalances would increase. That would be good. Global imbalances would solve the 'secular stagnation' problem.

Note that the Summers' view is different than the Robert Gordon's view, but not incompatible with it, according to which the innovations of the third industrial revolution are less transformative than those of previous waves of technological change. As noted before also, since I believe the evidence for demand driven technological innovation is strong (something called Kaldor-Verdoorn's Law) I don't think there is much to this argument either. The Gordon hypothesis assumes that innovations are supply side determined, like most neoclassical economists, including Schumpeter.

Boianovsky and Backhouse point out something that I didn't know, since I didn't read Hansen's original paper on this, I might add, that the Turner's hypothesis about the closing of the Western frontier played a role in Hansen's stagnationist hypothesis. Not sure what's the mechanism, so I'll check and report back on that. Also they seem to suggest that Domar's debt sustainability condition depends on the Harrod-Domar model. That result, as far as I understand it, is completely independent of the growth model.

I should also note that the only forgotten author in this revival of the stagnationist thesis, is the most interesting of them all, namely: Josef Steindl, author of the 1952 classic Maturity and Stagnation in American Capitalism. Stagnation resulted from the oligopolistic structure of mature capitalism, in his view. Steindl was famously wrong, in the sense that the 1950s and 1960s were not a period of stagnation.* But at least his explanation pointed out in the direction of social conflicts imposed by the productive structure of advanced economies. As I said on my previous post on the topic, there is no secular stagnation problem, associated to lack of investment opportunities, in my view. There is a political problem that precludes more fiscal expansion, or in Steindl's terms, it's stagnation policy.

* An issue he discusses in his 1979 Cambridge Journal of Economics paper (subscription required).

Bernanke and Summers on global savings glut and secular stagnation

So Ben Bernanke is blogging now. He has basically defended his old idea that interest rates are low as a result of a global savings glut. Yes, it is basically the loanable funds theory of interest—with no consideration of the limitations associated with the capital debates—and the notion that the supply of funds, mostly associated to surplus countries like China, Japan, Germany and oil exporters, has pushed interest rates down.

This is essentially the same argument on negative interest rates that Krugman has made awhile ago, and not surprisingly Krugman has been favorable to Bernanke's post.*

In Bernanke's view the solution for the savings glut is: "to try to reverse the various policies that generate the savings glut—for example, working to free up international capital flows and to reduce interventions in foreign exchange markets for the purpose of gaining trade advantage." This would, presumably, move the investment schedule and lead to a recovery.

Bernanke uses the global savings glut idea to criticize Larry Summers' secular stagnation story. For him:

[...] "unless the whole world is in the grip of secular stagnation, at some point attractive investment opportunities abroad will reappear. If that’s so, then any tendency to secular stagnation in the US alone should be mitigated or eliminated by foreign investment and trade. Profitable foreign investments generate capital income (and thus spending) at home; and the associated capital outflows should weaken the dollar, promoting exports. At least in principle, foreign investment and strong export performance can compensate for weak demand at home."

I have criticized the global imbalances story before. As I noted then the actual problem is that the global imbalances are small. The empirical evidence for a external recovery on the basis of a more depreciated dollar is not convincing, but that is not the main problem with this argument. Both the secular stagnation as discussed by Summers, and the savings glut, as presented by Bernanke rest on the idea of an excess supply of savings, and a negative natural rate of interest. Summers says that the: "essence of secular stagnation is a chronic excess of saving over investment" and that "secular stagnation and excess foreign saving are best seen alternative ways of describing the same phenomenon."**

The main disagreement between Bernanke and Summers is on the solution. Summers is skeptical about exchange rate depreciation as a solution to the US stagnation. In his words:

"Successful policy approaches to a global tendency towards excess saving and stagnation will involve not only stimulating public and private investment but will also involve encouraging countries  with excess saving to reduce their saving or increase their investment.  Policies that seek to stimulate demand through exchange rate changes are a zero-sum game, as demand gained in one place will be lost in another."

And no the problem is not competitive depreciations, as Summers suggest. And not even a question of whether depreciation, the relative price substitution effect, would be enough to boost exports or reduce imports, which might be questionable (the last evidence I saw suggested that income elasticities tend to be larger than price elasticities, meaning that foreign trade responds more to changes in the level of activity), by the way. The problem is this notion that the solution is based on surplus countries spending more, as if the US does not have a privileged position and its external (and by the way domestic) deficits do not matter.

What Summers is saying is that depreciation does not work, but we need China and Saudi Arabia to boost the world economy. Seriously?! The US should be doing expansionary fiscal policy, and with that current account deficit would be even larger. The notion that there is a current account sustainability issue or that the dollar international reserve position might in danger is not particularly strong. But, at least on the policy issue, Summers is correct. Fiscal expansion is needed. Note, however, that there is no secular stagnation problem, associated to lack of investment opportunities. There is a political problem (remember Kalecki) that precludes more fiscal expansion.

* Krugman arguments were normally about the domestic economy, and the problem of the zero bound interest rate, or what he calls the liquidity trap.

** And there are too many problems with the excess savings story to discuss here. The investment schedule and the very existence of a natural rate of interest, negative or otherwise, is plagued by logical problems and by the complete lack of empirical evidence, since investment really reacts to changes in the level of activity (accelerator). Also, the notion that intertemporal decisions govern consumption behavior is not without its problems. That's why Keynes tried to abandon the loanable funds theory and developed effective demand, in which income adjusted for differences between investment and savings.

Mundell-Fleming, Independent Central Banks, Inflation and Openness

Bucknell's Academic West (Bertrand Library in the background)

Teaching international finance this semester, after a long while. At Utah I taught mostly intermediate macro and Latin American Development for undergrads (and macro and history of thought for graduate students), and the eventual elective. But here the course was up for grabs, so to speak. Decided to use Peter Montiel's International Macroeconomics, since his books always provide competent presentations of the mainstream views, plus having worked at the IMF and World Bank, he always tries to cover real problems with plenty of developing country examples.

The limitation of the book is, as it should be expected, that the mainstream analytical view is, as Montiel's (p. x) says: "a generalized and modernized [sic] version of the original Mundell-Fleming model." The book does present in the last chapter the 'modern' intertemporal approach to the current account. In a later post I'll discuss the limitations of the Mundell-Fleming model, but for those interested check this paper by Serrano and Summa. In other words, Montiel's book can present the mainstream views, but lacks any critical perspective, which is not uncommon, but certainly problematic given the poor state of the mainstream understanding of how the economy works.

It is illustrative of the lack of alternatives in the book, the presentation of the relation between openness and inflation. Montiel's follows the evidence on an inverse relation between openness (that can be measured in many ways: import share, imports plus exports over GDP, etc.) and inflation presented in David Romer's well-known paper (see here). Montiel argues that in closed economies governments might tend to run fiscal deficits, that if monetized, would lead to inflation. In a more open economy, the higher deficits and inflation would lead to higher rates of interest, since international creditors faced with a risky government would demand a higher premium. In this context, "the higher interest rates that the government has to pay would tend to discourage excessively expansionary fiscal policies, thus reducing pressures on central banks to expand the money supply." If the central bank is more autonomous or independent from the Treasury then you should expect also less inflation (that would be Bernanke's explanation for the Great Moderation; here).

Many problems, as you can see. Yes, for Montiel inflation is caused by excess demand (fiscal deficits) and by increasing money supply, which seems to be what the central bank controls (let alone that all central banks control really the rate of interest). Worse, in a sense, is the notion that fiscal deficits in domestic currency (presumably, since nothing is said), may cause foreign investors to punish the government. Note that what should have investors concerned would be the current account surplus (which provides foreign reserves) and the amount of foreign reserves held by the central bank. The evidence on interest rates and fiscal deficits, by the way, is less than forthcoming for Montiel's story (see here).

A simple alternative suggests that inflation more often than not is caused by cost pressures, rather than excess demand, and that two of the main sources of cost pressures are the prices of imported goods and wage pressures. In a more open economy, in which firms are faced with competition from foreign firms, and workers might be afraid of losing their jobs, then wage resistance might be subdued. Note that over the last few decades unionization rates have declined and that also constrains the ability of workers to demand higher wages (see here). In this case, lower inflation in the globalized economy has been predicated on a weaker labor force that faces more international competition, and is more willing to accept stagnant wages. Inequality and stagnant wages, rather then well-behaved governments and independent central banks are behind the Great Moderation in this story.

Two ex-graduate students of mine, Perry and Cline (yes, someone was paying attention after all), teamed up and provided some empirical evidence in favor of the alternative story (go here). If you want to see alternative views on inflation, implicit in this discussion, go to the linked posts and papers here.

Dean Baker on The Checkered Past of Ben Bernanke

By Dean Baker

The retrospectives of Ben Bernanke on his leaving the Fed seem to be coming in overly positive. While there is much that is positive about his tenure as Fed chair, many of these accounts have a rather selective view of history.
The part that is clearly wrong is treating Bernanke as a bookish academic who got plucked down in the middle of a financial crisis that was not his making. While Bernanke had a distinguished academic career, he had been in the middle of the action in Washington since 2002. That was when he was selected to be a governor of the Fed. He served as a governor at Greenspan’s side until he went to serve as head of President Bush’s Council of Economic Advisers in June of 2005. After a brief stint as the chief economist in the Bush administration he returned to take over as chair of the Fed in January of 2006.
It was during the period that Bernanke was at the Fed and his tenure in the Bush administration that the housing bubble grew to such dangerous levels. While Bernanke does not deserve as much blame for this as Greenspan, there were few people better positioned to try to deflate the housing bubble before it posed such a large risk to the economy. During this time Bernanke was dismissive of suggestions that the unprecedented run-up in house prices posed any problem. There is no evidence that he dissented in any important way from Greenspan’s view that the Fed need not be concerned about the housing bubble or the innovations in the financial industry that was supporting it.

Read rest here

Larry Summers should not be appointed to the Fed

There are increasing rumors that Larry Summers rather than Janet Yellen might be chosen to substitute Ben Bernanke as the head of the Fed. Dean Baker has summarized all the correct reasons for not doing so. As he says:

"Summers was a key actor in the Clinton economic team that pushed for bigger and less regulated banks. He was there for the repeal of Glass-Steagall. He was also among those hectoring Brooksley Born, when the then head of the Commodity Futures Trading Commission argued that it would be a good idea to regulate derivatives. And he famously ridiculed as Luddites those warning of the risks of financial deregulation at the Fed's Greenspanfest in 2005."

I'm less keen than Dean on the issue of US trade deficits, since in my view global imbalances are actually too small (the US would need to stimulate global demand and actually run higher deficits, which given the role of the dollar would have no significant impact on the American economy).

Also, the Money Illusion blog notes the Summers rumors, while also including a particular quote from Summers that is instructive. Summers said:

"In the model I understand, inflation is mostly driven by demand, and when you increase demand, you increase inflation. And if you don’t increase demand, you don’t increase inflation. But if you’ve solved demand, you’ve solved your problem."

This is basically a result of the believe in the natural rate. Inflation results only from a level of activity that is beyond the natural rate. The Money Illusion is correct in pointing out that this confuses changes in quantities with changes in prices. However, this is in fact probably a problem with all the candidates to the position of Fed chairperson, since they are all from the mainstream.

That's why even Krugman [which the Money Illusion thinks doesn't have the right personality to chair the Fed, why because Summers does?] wants to increase inflationary expectations to raise demand. The confidence fairy is very pervasive.

PS: The Money Illusion has a list of the candidates that would be even better than Yellen (preferred to Summers), namely: "Lars Svensson, Mark Carney, Michael Woodford, Christina Romer, Robert Hetzel, Nick Rowe, anyone from the Reserve Bank of Australia, even the janitor ... Greg Mankiw ... [and] I could even add Krugman." I don't know the janitor, but it seems reasonable. If I had to choose one it would be Jamie Galbraith. Hope springs eternal!

PS: Pablo Bortz (h/t) pointed out this post by Yves Smith that somehow I missed.

Bernanke on fiscal policy: Keynesian ma non troppo

I noted before that Christina Romer, who was the chairwoman of the CEA and responsible for the fiscal package in 2009, held views on the recovery from the Great Depression that were ironical given her position. She argued in her classic paper that fiscal policy was irrelevant. Another New Keynesian that held similar views was Ben Bernanke. He says, in a famous paper published in his Essays on the Great Depression trying to explain industrial output, that:

"In an attempt to control for fiscal policy, we also included measures of central government expenditure in our first estimated equations. Since the estimated coefficients were always negative (the wrong sign), small, and statistically insignificant, the government expenditure variable is excluded from the results reported here."

So in his view (and his co-author, Harold James) fiscal policy was not relevant for industrial recovery. This view was challenged here (a significantly modified paper was accepted for publication). It is worth remembering that the current state of the profession, in which Keynesian ideas are in the defensive and austerity is king, is at least in part the fault of New Keynesians.

A Basic Mistake in Krugman's post

Gustavo Lucas (Guest Blogger)

In a recent post Paul Krugman says the following about the AS-AD model with a Taylor Rule:

"a rising price level doesn’t reduce demand through its effect on the real money supply, it reduces demand through its effect on the mind of Ben Bernanke."

Does it make sense? An increase in the price level, positive inflation, implies a decrease in the real interest rate and hence an increase in the AD through consumption and/or investment:

i – p = r

I´(r) < 0

C´(r) < 0

Y = C₀ – ar

Where r is the real interest rate, i the nominal one (the one used by the Central Bank), I'(r) means that the investment is negatively related to the interest rate, C'(r) is the same for consumption and Co represent the autonomous expenditures and a is the sensitivity of the output to the interest rate (that is, the IS equation).

I am supposing that the inflation is increasing. If inflation does not increase, we do not have any effect on the economy. So, in any case, when Krugman says that the increase in the price level ‘reduces demand through its effect on the mind of Ben Bernanke’ actually means ‘the increase in price level reduces demand through the IS-LM model’ – that does not have monetary policy rule. However, he is explicitly talking about the AD-AS model with monetary policy rule... So, in the end it should be re-stated as ‘the increase in price level reduces demand through the mind of Paul Krugman, since it actually increases demand.’

Currie and the 1937-38 recession

Lauchlin Currie, the first economist to work in the White House (in 1939, that is, before the creation of the Council of Economic Advisers, CEA, in 1946) and main advisor to Marriner Eccles at the Fed, said this in a memo to Eccles in October 1937:

“When the Government disburses more to the community than it collects in taxes, it adds to national buying power and the demand for the products of industry. The excess of spending over tax receipts in the years 1935-36 was the primary factor in increasing national income, in increasing Federal revenues, in increasing national demand for goods and, hence, in finally making it profitable to make additions to plant capacity in 1936.
…
At a time when the national income is shrinking the Government is seeking to raise revenues and cut expenditures this merely intensifies the deflationary trend. We are in danger of starting again the hopeless attempt to increase Federal revenues when the national revenue is shrinking. The attempt failed in 1929-32. It will fall again. The only condition under which the Federal budget can be technically balanced in 1939 is a reversal of the present deflationary trend.”

I hope a memo like this has been sent to Bernanke. Hope springs eternal.

Already in sequestration mode

If you check out the current fiscal stance it is hard not to conclude that we have been under a sort of sequestration mode for a while. Graph below shows the quarterly percent change in total government spending with respect to the previous year.

Note that the numbers have been negative in the last few quarters. This is the result of what Krugman correctly points out in his NYTimes column today, the existence of a growing consensus, since the crisis broke in late 2007, "that fiscal austerity was the appropriate response to an economic crisis caused by runaway bankers." A very short lived Keynesian recovery was allowed, but what really precluded a new Great Depression where automatic stabilizers.

I think that it's very unlikely that the fact that Bernanke, and Stiglitz, as Krugman points out, are for more fiscal stimulus will have any significant impact. I would also add that in part those reasonable New Keynesians (like the ones Krugman cites and himself) that complain about the fact that unreasonable people have taken over not just economic policy, but also the profession, are also partly to blame. You cannot argue that "Joseph Stiglitz, a Nobel laureate and legendary economic theorist whose vocal criticism of our deficit obsession has nonetheless been ignored," without noticing that Bob Lucas, an equally well regarded and Nobel (Sveriges Riksbank Prize) laureate is against deficits.

The natural rate is 6.5%

At least according to the Fed's new press release. The release says:

"the Committee decided to keep the target range for the federal funds rate at 0 to 1/4 percent and currently anticipates that this exceptionally low range for the federal funds rate will be appropriate at least as long as the unemployment rate remains above 6-1/2 percent, inflation between one and two years ahead is projected to be no more than a half percentage point above the Committee’s 2 percent longer-run goal."

So if unemployment falls below 6.5% expect higher rates of interest, associated to what would be in Bernanke's view the risk of excess demand.

Note that the inflation target continues to be 2%, so even Blanchard's mild-mannered rethinking of macroeconomics (that Krugman and others having been pushing) for a higher inflation target has not been accepted by Bernanke. Obama should get rid of Bernanke next time he has the chance.

PS: In contrasting news the Reserve Bank of India seems to be suggesting, at least according to The Economist, that it would raise its inflation target above 5%. Good for them.

Let’s not get ‘carried away’ by Bernanke’s latest twist

By Kevin P. Gallagher

Ben Bernanke, chairman of the US Federal Reserve, should be applauded for boldly putting employment over price stability in his latest move to keep interest rates low and to purchase mortgage-backed securities. Bernanke’s critics (and Bernanke himself) have rightly said that monetary policy is not enough, however. To truly generate employment-led growth in the US, those critics say more fiscal policy is needed.

There is also a need for stronger financial regulation in order to ensure that financial institutions do not steer newfound liquidity into currency and commodity speculation in emerging markets and developing countries—speculation that can wreak havoc on developing countries’ financial systems and growth prospects. Such was the case during previous rounds of interest rate declines and quantitative easing in the US, and could occur again.

Investors may choose not to go down Bernanke’s path but rather to use the carry trade to speculate on foreign currencies. The carry trade is a strategy where investors borrow in low interest rate countries and invest in higher interest rate countries with the “carry” being the difference between the two rates. Profits can increase by orders of magnitude if investors are significantly leveraged and bet against the funding country and on the target country currency.

Earlier this year, the IMF reported that lower interest rates in the US and higher economic growth in emerging markets were associated with a higher probability of a capital inflow “surge”. Surges in capital inflows can cause currency appreciation and asset bubbles that can make exports more expensive and destabilise domestic financial systems. According to that IMF report, one third of the time such surges were accompanied by a sudden reversal of capital flows.

The IMF’s 2011 World Economic Outlook report documents how a “sudden stop” in capital flows can unwind emerging markets and developing economies as well. They show that a 5 basis point increase in US rates could cause capital flight worth 0.5-1.25 per cent of GDP out of the developing world. This is not a short-term problem given that Bernanke has committed to keeping rates low into the future. However, global risk aversion, such as continued euro jitters, can also cause sudden reversals of capital flows.

In 2010 and 2011, many emerging markets and developing countries deployed counter-cyclical capital account regulations such as taxes on inflows or reserve requirements on derivatives transactions to curb the negative effects of cross-border capital volatility. Like earlier studies by the National Bureau of Economic Research and others confirming that regulating capital flows can change the composition of inflows, make for more independent monetary policy and ease exchange rate tensions, new studies by the IMF and others show how countries such as Brazil, Taiwan and South Korea have been at least moderately successful during this recent go-around.

Echoing but formalising work that dates back to Keynes, a new IMF report finds that industrialised countries may need to regulate the outflow of capital as well. The new IMF paper, “Multilateral Aspects of Managing the Capital Account”, argues that when regulating capital inflows is costly or relatively ineffective for borrowing countries, or if the proper regulation would cost too much “collateral damage”, then nations such as the US may need to regulate the outflow of capital.

It may come as a big surprise to learn that the US regulated outflows of speculative capital for close to 10 years, 1963 to 1973. During that period the US administered the Interest Equalisation Tax (IET). The IET was a 15 per cent tax on the purchase of foreign equities. For bond trades the tax variety depending on the maturity structure of the bond, ranging from 2.75 per cent on a three-year bond and up to 15 per cent on a 28.5 year bond. Borrowers looking to float bonds would thus pay approximately 1 per cent more than interest rates in the US, thereby flattening the interest rate differential between the US and Europe.

The proposed Volker Rule would make it harder for US banks to speculate on foreign countries via the carry trade with US deposits. However, an increasing amount of carry trade transactions occur outside the commercial banking system. Moreover, financial interests have led to measures in US trade treaties that make it illegal for trading partners to regulate cross-border finance as well.

Later this autumn, the IMF is set to release a new set of guidelines that will reiterate the need to regulate global financial flows. The fund would do well to incorporate its latest work that shows how industrialised nations may need to regulate capital flows as well. Doing so will help nations across the global economy, regardless of their level of development, achieve their stated economic goals without getting “carried away” by footloose finance.

Published originally here.

Fed up with the full empoyment target?

The debate on Bernanke's views on inflation targeting -- whether it should be 2 or 4% -- as I noted in a previous post is peculiar, to say the least. After all the Fed has a dual mandate, and inflation preoccupations have to be tempered by the pressing question of unemployment. The preoccupation in some quarters is that the Fed has already accepted as a matter of fact that it has single mandate (see here and here). It seems to me that critics (e.g. Krugman, DeLong and others) are correct for the wrong reasons.

The graph below shows the effective Fed Funds rate in the last three recessions (represented by the shaded areas). The rate of interest falls in all three during or just before the recession.

Further, after the trough of the recession the Greenspan Fed took 46 and 35 months to start raising the rate in the previous two recessions. So far, 35 months after the last trough, the Bernanke Fed has not increased the rate. This time around it has done Quantitative Easing allowing for lower long term rates too, which was not done during the Greenspan era. If anything the Fed has done more now than under Greenspan, and unless you believe in the inflation expectations fairy, the old Eccles maxim is still true, monetary policy now is like pushing on a string.

So how is that critics of the Fed are correct and I believe that the dual mandate (full employment and inflation) is gone. Well look at the graph below. It shows the Fed Funds, again, with the 10 year Treasury bonds rate.

Notice that the Fed eventually raises the Fed Funds sufficiently to surpass the bond rate, and invert the yield curve. The point is to slowdown the economy, and avoid full employment. Even in the 1990s, when Greenspan allowed the bubble to continue and unemployment to fall below the then official limit of 6%, he eventually took action, when wages started to increase. Full employment has not been a target, but keeping workers demands for higher wages checked has been very much part of the reaction function. Jamie Galbraith has written about it (go here for a technical paper). So the Fed has a single target mandate, but is not an inflation target, it is a "fear of full employment target."

The Fed can do practical things like helping distressed borrowers (with defaulted or underwater mortgages), but it cannot directly increase spending, and in the absence of private spenders (domestic or foreign), or local governments, it must be the federal government. Bernanke is not the problem right now. Geithner is (and so is Congress).

PS: The New Keynesian view that if you increase expected inflation spending goes up is now defended by Brad DeLong. He says: "an extra $100 billion of quantitative easing boosts the expected price level ten years hence by 1%--and boosts expected inflation after the next decade by an average of 0.1%/year. That is enough to spur higher spending and a more rapid and satisfactory recovery." I'm not against QE per se, the idea of maintaining long term rates low. But the notion that it would lead to inflation (printing money generates inflation) and that expected inflation generates a boost in productive spending is clearly another confidence fairy story.

The inflation expectations fairy

There are confidence fairies and there is the inflation expectations fairy. It's a 4% fairy apparently. I'll explain. So Krugman correctly points out always that the more fundamentalist neoclassical economists (the Talibans that love price flexibility and instantaneous adjustment to full employment, not the moderates that also believe in a natural rate, but think it takes a while to get to it like Krugman himself) believe that the economy would recover if only a proper environment for investment was created. Hence, if confidence returned we would have a recovery.

They obviously invert causality between confidence and recovery. As noted by Marriner Eccles long ago: "confidence itself is not a cause. It is the effect of things already in motion. (...) What passed as a 'lack of confidence' crisis was really nothing more than an investor's recognition of the fact that new plant facilities were not needed at the time." Investment is the result of a growing economy, in which firms tend to adjust their capacity to demand. No demand for your goods no need to invest to create capacity to produce more. Plain and simple.

Now a dispute on what is the appropriate policy for the Fed, and what has been Bernanke's role has developed between Krugman and Bernanke (see here and here) [Ball has a more academic paper saying basically the same as Krugman here]. They argue that Bernanke has been correct in pursuing quantitative easing -- the buying of long term Treasury bonds to keep not just short, but also long term interest low -- and saving banks, but he has been reluctant to increase the inflation target to 4%. Blanchard has said pretty much the same about the need for a higher inflation target (this was hailed as new thinking in macroeconomics; with that criteria when Greenspan disregarded the 6% natural rate of unemployment level, believing it was somewhat lower, he was a radical innovator!). [I’ll leave for another post the question of why are we even talking about an inflation target in the US if the Fed supposedly doesn’t have one].

Krugman notes that Greg Mankiw actually has sent a veiled (or not so veiled threat, as he is the advisor to Romney, which may or may not have something to do with Bernanke’s reappointment in the future), saying that “if Chairman Bernanke ever suggested increasing inflation to, say, 4 percent, he would quickly return to being Professor Bernanke” (originally published here, yep Mankiw also writes regularly for the NYTimes).

So what is the mechanism according to Krugman (and the ‘progressives’ like the IMF chief economist Blanchard) by which a higher inflation target would lead to a recovery? In Krugman’s own words:

"If the Fed were to raise its target for inflation — and if investors believed in the new target — expected inflation over the medium term, say the next 10 years, would be higher. … [and] higher expected inflation would aid an economy up against the zero lower bound, because it would help persuade investors and businesses alike that sitting on cash is a bad idea. "

So if the Fed says it’s willing to accept a higher level of inflation – without doing anything concrete and objective like intervening and forcing banks to refinance the mortgages of people in foreclosure – then if investors are persuaded they may be confident enough to spend more. And that’s not a fairy?! The problem with any theory, including the New Keynesian, that believes [or says it does in order to get published] that there is a tendency to full employment, is that it must end on some sort of confidence for spending story, since under normal conditions the system would actually do it anyways. The confidence fairy is dead; long live the inflation expectations fairy!

It's the ECB stupid!

So the Fed announced yesterday that they will inject money into European banks if needed. Mark Thoma and Paul Krugman posted about it (here and here). This is not new, since the Fed did lend to European banks after the Lehman collapse. The reason is simple, US banks would be also affected by a collapse of the European banking sector. The point is that this not sufficient to end the euro crisis, for that the ECB must act buying European bonds. No substitute for that. So Bernanke is still asking: what are these guys doing over there?

Nominal output targeting

Christina Romer wrote this Sunday about the necessity for the Fed to target nominal output. The implication seems to be that so far the Fed had been targeting inflation, which is obviously incorrect. That would be the ECB. Krugman (here) for some reason liked it. By the way the idea is not new, Samuel Brittan had argued for that not long ago (here), and as noted by David Beckworth so have two other prominent FT columnists (Clive Crook and Martin Wolf).

First of all, Romer calls this a Volcker moment, which is from a historical point of view (and she is a macroeconomic historian) preposterous. Volcker is the guy that tried to use nominal monetary targets, as in Milton Friedman's monetary growth rule (now he is much better and is against de-regulation and too big too fail among other things).

Further, it's not clear how a nominal GDP target would be different from what the Fed is already doing, namely acting as a lender of last resort, and keeping interest rates (short and long, the latter through QE) low. Worse, her argument smells to the confidence fairy stuff you hear from the crazies serious people, and that correctly Krugman deplores. She says:

"By pledging to do whatever it takes to return nominal G.D.P. to its pre-crisis trajectory, the Fed could improve confidence and expectations of future growth."

Sure as objective targets come, nominal GDP is better than inflation,  but since the Fed does not target inflation what is she fighting? Ben Bernanke is fine, Super Mario (Mario Draghi), the new president of the ECB needs whatever is the reverse of a Volcker moment. The US (and Europe) need more fiscal expansion.

Bernanke at Jackson Hole

Finally got around reading Bernanke's speech.  A bit underwhelmed to tell you the truth. Krugman seems to be happy with the fact that Bernanke acknowledged that the recovery is weak, at best. In terms of policy what he said is the following:

"In light of its current outlook, the Committee recently decided to provide more specific forward guidance about its expectations for the future path of the federal funds rate. In particular, in the statement following our meeting earlier this month, we indicated that economic conditions--including low rates of resource utilization and a subdued outlook for inflation over the medium run--are likely to warrant exceptionally low levels for the federal funds rate at least through mid-2013."

In other words, short-term rates will remain low.  On long-term rates (i.e. quantitative easing) he said nothing.  Worse, his comments on fiscal policy were terrible.  He said:

"To achieve economic and financial stability, U.S. fiscal policy must be placed on a sustainable path that ensures that debt relative to national income is at least stable or, preferably, declining over time. As I have emphasized on previous occasions, without significant policy changes, the finances of the federal government will inevitably spiral out of control, risking severe economic and financial damage."

Can you imagine if in 1937-38 (the Roosevelt recession) the concern would have been with not allowing the debt-to-GDP ratio to grow.  Why? Does Bernanke know anything about a magical number above which the debt-to-GDP ratio has a negative impact on the economy?  Has he accepted the Rogoff-Reinhart view that beyond 90% we are doomed? The size of debt in domestic currency with respect to GDP is irrelevant, and shouldn't be a concern.

At any rate, it seems that between congressional Republicans and Obama fiscal stimulus is off the table (in fact, expect fiscal contraction), and monetary policy is wait and see with no radical measures.  So the economy will continue to stagnate.  As Christina Romer said we're "pretty darned f_cked!"

PS: I'll say more on Rogoff-Reinhart in another post.

What would Galbraith ask Bernanke?

Jamie Galbraith endorses the demand for transparency in the management of the Fed, which is central to Senator Bernie Sanders's audit bill.  Here is a critical view of the Fed, that does not ask for its elimination, like representative Ron Paul, but public control and accountability of the Fed actions.  He would also try to democratize the Federal Open Market Committee (FOMC) meetings.