The Current Moment in Macropolicy

A week ago, a Portuguese journalist asked me a few questions about current debates in macroeconomic policy: fiscal stimulus and monetary expansion versus deficit and inflation hawkery. I used the opportunity to organize some of the arguments I've presented in previous posts.

1. With near-zero percent interest rates (negative in real terms) and $2.3 trillion balance sheet, and no clear results translated in growth, employment and credit to the real economy, which feasible options has the Federal Reserve? Is the FED playing a dangerous gamble as Kansas City FED’s chairman just said?

These are really two questions: (a) What arrows does the Fed still have in its quiver? (b) Is the Fed’s current set of policies elevating the risk of future inflation?

a) As many, including Ben Bernanke’s former self, have pointed out, the Fed can engage in almost unlimited balance sheet expansion through purchases of private sector debt. Thus, rather than exchanging MBS and similar items as they mature with long-term government debt–the current “hold steady” policy–the Fed could acquire even more. This option is predicated on the assumption that the economy can absorb much more liquidity, that the true risk is deflation rather than inflation. My own view is that a bit of additional quantitative easing can help at the margin, but that fiscal policy would more effectively offset the effects of private sector deleveraging on effective demand. Moreover, the level of private sector debt acquisition necessary to fully absorb this deleveraging would expose the Fed, and US taxpayers, to significant credit risk.

Another proposal is that the Fed should raise its announced inflation target. This originates with Krugman and is receiving a lot of support. To see why this may not work, note that it rests on two premises: first, that agents will adopt the target as their new basis for calculating real interests rates (making real rates more negative at the zero nominal lower bound), and that this recalculation will induce them to resume borrowing. The first is rather a leap under current conditions; why should agents believe that the announced target will be realized within their planning horizons? The second overlooks the fact that (1) many sectors of the US economy really are overleveraged and need to reduce their debt burdens, and (2) investment is stymied by a lack of anticipated demand, not the real cost of credit. But I don’t think raising the target will cause any harm, so why not? It would then be more consistent with the emerging view of (some) macroeconomists that the optimal inflation band in normal times may have an upper bound of 3-4%.

I should add that the weight now being placed on the Fed’s shoulders is unfair. Everyone is looking to them to forestall a second dip and put the US (and world) economy on a growth track, but that’s because we have given up on Obama’s willingness/ability to push significant policy through Congress. The Fed just can’t do it alone; it needs lots of help. The political paralysis in the US is an extremely important contextual factor. If the global economy does take a second plunge or simply remains mired for a prolonged period, future historians will surely place much more of the blame on Obama and Congress than Bernanke and the Fed. But they will also have harsh words for the failure of global policy coordination, with no leader willing to rise above short-term domestic political motives.

b) In the short run it is obvious that inflation is not a problem. First, it would require monetary expansion of Zimbabwean proportions to induce serious inflation at current levels of unemployment and productive slack. Second, a bit more inflation would be a good thing. The real question is, if the Fed continues to bulk up its balance sheet and private sector credit starts flowing again, can the Fed get out in time so that there isn’t an explosion in the money supply? Most economists, myself included, think that easing of credit conditions will be gradual and visible, so that the Fed can exit as the private sector reabsorbs its debt. From a political point of view, to allow a given stock of debt to shift back from public to private hands is neutral with respect to macropolicy, so there is no reason to expect that the Fed will fail to do this. Having said this, however, I think the risk of a future inflationary surge as a result of current policies is not zero. Deleveraging could be reversed at a speed the Fed can’t keep up with. Or the specific markets that would be impacted by a Fed asset sale might not be sufficiently liquid: the Fed holds asset A and the public wants asset B. Or some other problem, currently unforseen, could interfere with the Fed’s withdrawal from private markets. On balance, though, the near-term risk of deflation exceeds the highly speculative longer-term risk of inflation.

2. Has federal Treasury political support to new Keynesian interventions preventing the risk of a double-dip, or the debt-to-GDP, the fiscal deficit-to-GDP and slightly changes from Chinese Central Bank policy gives no fiscal space for those options?

Rewording, I see the question, do either the trajectory of US fiscal deficits/debt to GDP ratio or the prospects for reduced Chinese demand for this debt limit the ability of the US government to implement a second round of stimulus? Again there are two questions.

a) I think the attempt to impose a mechanical rule for fiscal debt/GDP are misguided and have no basis in the historical evidence. The reason is that fiscal deficits are endogenous: they are jointly determined by private sector debt growth, the external balance, terms of trade, and other factors that influence both the numerator and the denominator. (And politics, of course.) Economics has a lot to say about the exact ways these factors interact, but in any given situation you have to evaluate policy on the basis of the full set of variables. For instance, to make an obvious point, on the one hand the US has for some time had a structural trade deficit of substantial proportions, and the economy has organized itself around chronically high private and public deficits. (We are biased toward the production of goods financed by these deficits: housing, military goods, etc.) On the other, the dollar remains the world’s primary reserve currency, and this fact permits the US to borrow much more than others might–the “exorbitant privilege”, in Eichengreen’s term. (Portugal too could borrow much more if the ECB were willing to underwrite all your debt, which they aren’t. We don’t have this problem with the Fed in the US.) In a nutshell, I don’t think the US faces an immediate constraint on its ability to market its public debt, and the deeper problem is the current account imbalance that necessitates this debt.

b) There are many aspects, some rather complex, in the China-US financial relationship, but the broad outlines are simple. China, along with the other surplus countries, finances US net borrowing, and the reason this net borrowing needs to be financed is that these countries have surpluses vis-a-vis the US. In principle, the solution is rebalancing, which would mean less financing and less debt, simultaneously and equally. In real life, of course, there are potential potholes in this road. The main risk is that there could be a sudden stop if confidence in dollar assets drops unexpectedly. This risk is ever-present and is proportional, more or less, to the scale of dollar recycling. Therefore a gradual Chinese retrenchment, if it means reduced trade surpluses, directly or indirectly, with the US, would be very positive for the world economy.

But it’s not only China. The US runs deficits with the EU, the oil exporters and just about everyone else. We need rebalancing on every front. This would remove much of the need for Keynesian stimulus in the US. It should be obvious: a country with a roughly balanced current account finances episodes of fiscal stimulus domestically. A deficit country is likely to require more stimulus more often and must finance to some extent externally. This second condition is less sustainable. You would think we wouldn’t have to argue about this.

3. America and Europe is living a deficit hysteria regarding the hot topic of “debt-to-growth”, or a deficit threshold is a real problem for future growth?

Hysteria.

4. You refer, in your critic of Rogoff and Reinhart debt-to-GDP threshold that the most important is to identify the processes, the mechanisms governing the expansion and contraction of fiscal space. Can you argue more extensively about that?

I think I did this above, up to a point. Perhaps I should emphasize the particular importance of looking at public debt in the context of private debt. The US ran fiscal surpluses under Clinton, but this was possible (especially in a deficit country) only to the extent that private debt exploded. Private deficits fell in the aftermath of the dot.com bubble, and (again in the context of external deficits) the US faced the choice between much higher fiscal deficits or punishing shortfalls in aggregate demand. We went with the fiscal deficits in the 00's, especially since we didn’t face a borrowing constraint. Spain, by contrast, was a model of fiscal rectitude in the 00's, but their external deficits were monumental and financed by private leverage. The collapse of the housing bubble puts Spain in a position like the US in 2002, except (1) Spain’s current account deficit is even larger, and (2) they face a severe borrowing constraint. The moral of the story is that anyone who looked at the US in the 90's or Spain in the 00's and said, “No problem, the public budget is under control” would be making a big mistake. (And to dig back in history, the US emerged from WWII with a gargantuan public debt, far beyond the R&R threshold, but with little private debt in the wake of Depression-era writedowns, and the prospect of large, continuing structural trade surpluses.)

I used the R-R thesis as an opportunity to make a more general point about economics, what it can do well and what it can’t. Economists try to be like physicists, formulating the “laws of nature”. The Reinhart/Rogoff 90% rule is a rough version of this approach, aspiring to provide something like a gravitational constant. But the subject matter of economics is too complex for this approach; it is more like geology or ecology. A geologist does not have a formula that explains the location and height of every mountain range on earth, or even the “mean mountain”, but detailed knowledge of the forces (plate tectonics, erosion, isostatic uplift, etc.) that constitute the menu of possibilities. Then he or she goes to a particular region, provides a deep description of the local factors at work, and applies the knowledge of geological processes.

It is revealing that R&R have very little to say about processes–exactly how public debt/GDP ratios affect further growth. Their comments in this respect are casual, not the product of careful research. Instead, they search for a single, simple pattern in growth/debt ratio space. It is ineffective physics, rather than the geology we actually need.