Anniversary Party

As I write this, around $200 billion of the “stimulus” has been “awarded”(?). It is worth a refreshing looking at definition of the word stimulus, because the recovery has been fairly anemic. However, this momentous occasion is the first anniversary of the American Recovery and Reinvestment Act!

The relative weakness of the recovery is not something that is shrouded in mystery. On the contrary, the reasons for the poor performance of the economy have firm foundations in macroeconomic theory. It is simply that when rates are at or near zero, everyone seems to forget everything they’ve learned about macro, and the run back to the loving arms of…you guessed it, John Maynard Keynes; whose book, “The General Theory of Employment, Interest, and Money“, is about as clear as mud. But that is beside the point. It is helpful to review what got us to this point:

The Federal Reserve, the central bank of the United States, is a monetary body whose defined mission is to be in two places at the same time. They are tasked with not only keeping prices (inflation) stable, but also keeping the economy at “full employment“. The Fed uses a tool called the Taylor rule to set the interbank interest rate; the Federal Funds Rate, at a level which facilitates the movement of the real interest rate in order to keep the money supply (notably M2) on a stable growth path. The natural interest rate is the price of money which coordinates savings and investment.

Beginning in 2006, headlines featuring odd acronyms like “CDS” and “CDO” became more and more common. The story that was unfolding was a grim tale of a housing boom that was coming to a violent end. Markets in California, Arizona, and Florida became inundated with high levels of foreclosures, write-downs, and unsold housing inventories. This seemed to be a regional phenomenon, as the economy continued to growth throughout 2006. 2007 marked the official NBER start of the recession. It also marked the start of an energy price rally — as crude oil began to soar in price. GDP continued to grow weakly throughout 2007 and 2008, along with the continuing rise in oil prices…but starting in 2008:Q3, real cracks began to appear.

In late June/early July, the energy price bubble collapsed, sending commodities downward in a vicious spiral. This is where the Fed enters the story once more (not that they were ever gone, check out the Financial Crisis Timeline to see an exhaustive list of Fed actions).

Recall that the Fed uses a Taylor rule to forecast the setting of the Fed Funds Rate. Well, an integral identity of the Taylor rule is a measure of the previous period’s inflation rate. For its intents, I believe that the Fed uses CPI (but I could be wrong, however, it is no matter — they use a backward-looking indicator). This is a problem, as rises in energy prices cause core inflation to rise. However, due to the energy price bubble, this was highly misleading. During August and September, as the market (as estimated by the TIPS spread — the difference in interest rates between nominal Treasury bonds and indexed bonds [or TIPS] — began forecasting falling real inflation rates (the Fed has an implicit rate of 2%), the Fed held nominal interest rates. This caused money to become inadvertently tight.

During this time many things seem to happen all at once, and what was originally a mild and manageable recession quickly started deteriorating. By late September, you could rarely turn on the television without hearing some horrible and frightening piece of news coming from a quaint little street in New York. Fears of a financial panic were in the air — and on Monday, October 6th, our fears were confirmed. This misled everyone from the real culprit: tight money.

On October 8th, as markets were in turmoil, the Federal Reserve began strangling the market with a weak 50 basis point (bp) cut in the Fed Funds Rate. Allowing inflation expectations to plummet, the Fed would not ease until December. Another curious thing happened on October 6th, however. The Fed began paying interest on excess reserves (the level of reserves held above the legally mandated amount). This was termed a “confession of contractionary intent” by monetary experts Robert Hall and Susan Woodford. A tiny sum you say…but remember, it is widely regarded by economic historians that a causal factor in the cause of the recession of 1937 was the increase in the reserve requirement by 50bp (?). During this time, the monetary base skyrocketed, and for good reason. At near-zero real rates of return on cash and Treasuries, the risk free return from holding excess reserves was very attractive. This, of course, caused a drop in the money multiplier.

Fractional Reserve Banking: DEAD!

Thus, the financial panic began to look more real, and culminated in NGDP falling by 8% (to -6):

Throughout the rest of 2008, and 2009, the Fed refused to relent in its tight money strategy…it did not set an explicit target, and promise to hit it no matter what, nor did it even notionally signal intents to set a target above its normal one. What did the Fed promise? To keep interest rates low for an extended period. This brings us to the “stimulus”.

Prior to the current recession, there had been little talk of fiscal stimulus in economics — and what little talk there was, was very skeptical. The “conventional wisdom” was that fiscal stimulus was unnecessary in the presence of well-behaved monetary policy. This “good behavior” fell apart in 2008. Thus, many macroeconomists reverted back to the simple IS/LM/Phillips Curve model in which 0% interest rate targets mean monetary policy is out of ammunition. This was the received wisdom of the left (the right seemed to recoil back into the Treasury View, or RBC models). More sophisticated Keynesians quietly stated that a credible inflation target would, in fact, be the first-best policy, but quickly dismissed this notion as political unfeasible:

But the key thing to recognize about this answer is that it’s all about expectations — the central bank only has traction over expected inflation to the extent that it can convince people that it will deliver that inflation after the liquidity trap is over. So to make this policy work you have to (i) convince current policymakers that it’s the right answer (ii) Make that argument persuasive enough that it will guide the actions of future policymakers (iii) Convince investors, consumers, and firms that you have in fact achieved (i) and (ii).

In reality, we haven’t even gotten anywhere near (i): the conventional wisdom is still that any rise in expected inflation above 2 percent is a bad thing, when it’s actually good.

So some readers have asked why I’m not making the same arguments for America now that I was making for Japan a decade ago. The answer is that I don’t think I’ll get anywhere, at least not until or unless the slump goes on for a long time.

So once again, the US was mired in a “liquidity trap“, something not seen since…ever. And, according to the logic coming from a short book published 74 years ago, the only way out of a “liquidity trap” is for the government to spend money to close the output gap. However, more recent macro (you could even call it modern macro!) suggests that the foolproof way out of a liquidity trap is currency devaluation. Something so easily escapable, and yet they still call it a “trap” (I guess cheap Chinese finger traps are called, well, traps…but, of course, you can easily break it and regain your freedom)…in fact, no central bank in the history of the universe has ever failed to hit a nominal target, ever.

Now comes the question: Was the ARRA successful? Well, it depends on how you define success. If you define the term as the timely stimulating of aggregate demand, then no, it was an abysmal failure. But it did succeed in saving some jobs (mostly in the government sector), and preventing some pay cuts.

That may sound great, but it is not. The stimulus never had a chance, and it was not due to its size (unless you happened to have been advocating a $3 trillion bill (which is not reasonable). All of the effect of the “stimulus” bill was known within a week of its passing — it didn’t do anything in the aggregate. How can I say something so egregious? Because the effect was quickly priced into markets, and they were unimpressed. I believe an economist by the name of Paul Krugman outlined a model of “expectations traps”…what the “stimulus” needed to do was create the expectation of future inflation if it was to have any impact, which would require the government to credibly commit to spending billions of extra dollars each year into eternity (which it can not do).

There is only one institution that can credibly commit to inflating in this way, and throughout the recession that one institution failed to rise to the task, thus allowing monetary policy to become unintentionally tight. Had the Fed credibly committed to even a 5% inflation target (indeed, the monetary base more than doubled(!) but was sterilized by interest rates on excess reserves, when it should have devalued the dollar by half!), there would have been no need for the debts incurred by fiscal policy…as inflation makes nominal debts easier to pay. Had the Fed instituted a forward-looking monetary policy (target TIPS spreads to begin?) we would have been dealing with a very manageable slight recession.

I don’t doubt that the ARRA eased the suffering of many individuals by preserving their jobs and present (circa their contract origination date) rate of pay. Unfortunately, what is good for the individual, in this case, is not good for the whole. But, as a macroeconomic policy, the ARRA didn’t ever have a leg to stand on.

So, happy anniversary!
Big hat tip to Scott Sumner and Bill Woolsey for their input an analysis, which greatly helped me!


5 thoughts on “Anniversary Party

  1. Nothing to add really, but this might be your best post yet. Keep up the good work. The only slight quibble I have is with the “inflation makes nominal debts easier to pay” bit. I’m not sure I follow the logic here.

    Suppose I have a fixed net of tax wage of 2000 a month and a budget something like this

    Monthly Rent 500
    Debt Payments 500
    Everything else.

    While it is true that the monthly rent and debts now cost more in the terms of real dollars under deflation, the everything else category has now become cheaper. As such, I can reduce my nominal expenditures on everything else (since my money is worth more) and use the excess to reduce debt holdings. It seems for this assertion about inflation making nominal debt easier to pay only holds at certain debt payment to income ratios. Perhaps you meant to say it makes debts more costly to pay, which I agree with entirely.

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