Monday, September 26, 2011

File under: futility of it all

Long time - no post… But let’s talk about something that’s becoming the last best hope for the developed economies due to bad politics: monetary policy.  Let’s just say that I am rather less optimistic about the ability of monetary policy than Paul Krugman and especially Matt Yglesias to resolve our present economic difficulties, and basically agree with Macro Resilience here but have a few extra quibbles of my own.
Krugman, Karl Smith and others have, while acknowledging the severe limitations of monetary policy at zero lower bound, have nonetheless pushed for more aggressive policy – primarily, I think, through the communication channel. Karl Smith calls it “classic central banking” where the policy is the message and has also called for an explicitly higher inflation target to give us more headroom in the future. Paul Krugman, I think, generally agrees although, in fairness, Krugman’s preferred policy lever is always fiscal. Greg Mankiw and Ken Rogoff are in the same boat here. (See also this Mike Konczal chart which basically summarizes the scope of possible monetarist solutions). Yglesias, in the meantime, has posted this as his monetary policy ideal: in the nutshell, Fed announces a higher inflation target, and further states that it is committed to achieving it via purchases of unlimited amount of stuff, doesn’t really matter what.
So here I have no problems with higher inflation targets generally and think they would be great. Here is a query, however: what’s the mechanism by which policy of the kind described above now would help us achieve full employment. I think there is a bit of magical thinking involved on the part of monetary policy optimists here, not unlike the magical thinking of trickle down economics. I other words, there is a link that I am missing, and I think comes across as readily apparent in Yglesias’ policy proposal. It’s almost like the underpants gnomes story. Step 1: announce higher inflation target. Step 2: buy stuff to achieve inflation target. Step 3: ???? Step 4: full employment.
Let’s suppose for a minute that the communication channel worked it’s magic, and just by virtue of stating it’s commitment to higher interest inflation, the Fed was able to achieve it. Aren’t we even a little bit concerned that the inflation would pop up in places we don’t like? What we want, in other words, are primarily higher wages and possibly higher rents (the latter because eventually higher rents would lead to higher construction employment). But what if what we get are just higher commodity and food costs? It seems to me that we’d get in practice very much depends on which market is tight at the moment. And, of course, we have the least slack in commodities markets: food stuffs and oil (don’t underestimate how much the price of the former is driven by the price of the latter). We have the most slack in the labor market. Rental market is reasonably tight and we might see inflation here regardless of what the Fed does or does not do. Something tells me then, that if we see inflation bumping up, the components of CPI that go up first are likely to be commodities. Then rents. Wages will come last, and we may never get to them: because it’s entirely possible that the price bumps in commodities will just continue to sap demand from the overall economy, as they are of no help at all to the deleveraging consumer.
On the interest rate channel (aka, “the Fed buying stuff”) I can see, for example, how Yglesias’ monetary policy would work if the stuff that the fed would buy were units of labor. That would indeed quite directly result in lower unemployment. But the Fed can’t do that. Instead, it buys debt – mostly government debt, but it could probably buy corporate debt too. So how does that help a deleveraging consumer??? At best, what you get on the consumer side is declining mortgage rates. But does anyone seriously think that this is stimulus enough? Mortgage market, including refinancing market, is not very fluid, there are high costs to refinancing, and cash flow problems, adverse appraisals and tighter credit problems – all of which are already preventing consumers from taking advantage of low rates – are not issues that will disappear when rates are another 50 bps lower.  (I suppose another thing you might get is lower corporate credit rates. But again, corporate balance sheets are not holding back the hiring). In wonkish terms, what you have is a situation where the Fed’s newly created reserves simply become the bank’s excess reserves, as the velocity of money is low. This makes it difficult for the Fed to achieve it’s goal of higher inflation (even if it had such a goal).
What we need are indeed helicopter drops. We need direct transfers of money to the consumer. That’s primarily a fiscal mechanism, but I suppose one could imagine it as a monetary solution. In fact, I’ll propose one: the Fed (or the Treasury – take your pick) should get into consumer banking and propose that each of its new customers gets $10,000 in the account just by signing up. If $10,000 proves insufficient, the Fed/Treasury could do another promotion: use your debit card 10 times in a month and receive another $10,000.

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