Arnold Kling  

Kipper- Und Wipperzeit Update, August 9

Hayek in "Unbroken", Part Two... Come One, Come All: The Myster...

Livio Di Matteo writes

In essence, resolving the crisis in confidence needs the current ad hoc approach to be replaced with the structure of a more formal mechanism that will generate the confidence in the world financial system needed to restore stability in world markets.

Let me offer some multiple choice questions.
1. What should be the stance of U.S. monetary policy?

a) The Fed is out of ammunition (.0001)
b) The Fed needs to worry about hyperinflation, so it should not attempt any further expansion. (.0499)
c) The Fed should be trying to expand the money supply, and if anything, a little more inflation would be a blessing (.95)

The numbers in parentheses are my estimate of the probability that the answer is correct.

Scott Sumner and Ken Rogoff, two economists with different perspectives but who have been right more often than wrong about the current situation, both favor (c). So do I.

Answer (b) sounds like something out of the Tea-Party fringe. But it is indistinguishable from current Fed policy, which is to note that the economy is weaker than anybody would like, and therefore no policy change is required (If this were chess, I would be putting ??? next to the Fed's choices these days.)

Answer (a) strikes me as nuttier than anything that has come out the Tea Party fringe. The Fed cannot be out of ammunition as long as it can buy stuff by printing money. Conceivably that could happen if the cost of printing money were higher than the value of the stuff that you can buy with it. But we are nowhere near that point. And it's hard to get to that point in an era where printing money can be accomplished by moving bits on a computer network.

2. What should be the stance of fiscal policy in the U.S. and other countries that still enjoy the confidence of the world's investors?

a) Tighten up fiscal policy to keep investor confidence. You are going to need it. (.60)

b) Loosen up fiscal policy to stimulate growth. (.10)

c) Stay the course. (.30)

Everyone who has an opinion on this is well dug in. Nobody is changing any minds. My weights show that I am worried about the long-term fiscal outlook. I am skeptical of the Keynesian idea that more deficit spending would be stimulative, but I am not so sure of myself as to consign the idea to the same trash heap where I would throw "The Fed is out of ammunition."

3. Should some European sovereign debt be rescheduled?

a) Heck no. They hired the money, didn't they? (.05)

b) Yes. Soon, while somebody is still solvent enough to issue something comparable to Brady Bonds. What you want is to replace Greek bonds with a face value of $100 with bonds issued by a reliable entity with a face value of, say, $60. (.60)

c) Maybe some day, but not now, fer Chrissakes. The European banks need to strengthen their balance sheets first, or they'll be wiped out! (.35)

The eurocrats are attempting (c). I believe that this will fail, and the transfers from taxpayers to bank creditors are not a good thing. Unfortunately, most respectable people think that Bernanke and Paulson and TARP and such SAVED THE WORLD, and so that is now the model going forward for handling any situation involving shaky large banks.

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COMMENTS (9 to date)
effem writes:

I dont understand how you separate monetary and fiscal policy so easily? What if the Fed expanded the money supply by engaging in fiscal stimulus? Then you could have your cake and eat it too, no?

It would strike me that the need to tighten fiscal policy is driven by fears of a weak USD, hyperinflation, or high borrowing rates. You rule out hyperinflation, there is no sign of an issue with borrowing rates (quite the opposite), and a weak USD would help us get some inflation - which you claim would be good. So why are you against fiscal stimulus?

I am quite confused.

CharlieH writes:

Problem with question 1 is that we've tried to inflate assets for 30 or so years, and the monetary system is wired to do that with any new money that gets printed.

I'd generally agree that there is a problem of misalignment of asset values , particuarly problematic being the mismatch between housing values and incomes, and a bit of income inflation would go a long way towards righting that balance. But printing money, as we saw last year, tends to push up commodity prices - food and energy - without increasing incomes. That pushes down real incomes - and to the extent it does, that is counterproductive for the purpose of fixing the housing cost / income imbalance.

Question three - even substituting euro bond interest rates for those prevaling in Greece , Italy etc , at face value, would be beneficial - maybe not sufficient but the premiums being paid and the vise of the Euro limiting the options for Greece, Italy, etc to respond with independent monetary policy, will pick of nations one by one eventually sinking the ship if something isn't done. Getting the 60, or 30, cents on the dollar exchange, would probably make a more sustainable fix possible in the perimeter. But don't the euro-banks hold most of the debt anyhow? And isn't that a crux of the problem?

Question 2: I'd go with Krugman , except for a few things. One, the US govt' isn't capable of fiscal policy, though I thought the education block grants were reasonably effective at delaying cuts at the state and local level by a couple years. Shovel ready was a joke, and the US idea of infrastructure is 50 years behind the curve. And three, if 10% of GDP stimulus isn't enough for three successive years, time to redefine the stimulus so it addresses the issues at hand - high unemployment, and an imbalance between asset prices (particularly housing) and incomes.

If it is a solvency problem in a global economy, I'm not sure what kind of stimulus might fix it. Perhaps shifting to a VAT tax that includes imports and excludes exports could help fix some of the US's imbalances with the rest of the world, though 'consumption tax' and 'stimulus' probably do not belong in the same sentence.

To the extent that the US needs to encourage consumption, one way to achieve that is to restore confidence amoung seniors that Social Security and Medicare are reliable, so they won't need to make contingency plans to compensate for their perceived instability.

Various writes:

The implications for #3 are significant. If your assessment is accurate, this could mean that the Euro, Europe in general, and possibly the U.S. could be in for a rough ride.

John Dougan writes:

We've had a massive expansion of the USD monetary base without extreme inflation (at least so far), why do you think this is so? What makes you think that this could continue?

Lewis writes:

"But printing money, as we saw last year, tends to push up commodity prices - food and energy - without increasing incomes."

The only thing that could push up commodity prices without increasing incomes would be the destruction of commodities. The commodity producers receive higher incomes when prices of commodities increase. And when commodities price increases trickle through to core prices more quickly than they do to nominal wages, then real wages effectively decline. This increases profits for business owners and also provides wage income to the marginal workers who are hired due to the real wage declines.

The Fed's actions basically act on nominal spending--through psychology, MV=PQ, interest rates...take your pick. The Fed doesn't just have a big thermostat of prices that it cranks up. Therefore, it doesn't make much sense to say "nominal spending rose so much that prices increased and real spending consequently declined," unless you think businesses are bad at setting prices.

James Hanley writes:

I find myself in agreement both with Kling's PSST argument and with the need for more monetary policy. But are these really compatible approaches? If the PSST argument is correct, won't increasing the money supply just support the current mis-alignment of resources?

Gary Rogers writes:

The Fed’s loose monetary policy consisting of zero interest rates, quantitative easing and expansionary money supply is an absolute disaster for anyone in or near retirement. It discourages savings, encourages risky investments and thwarts strategies for preserving assets. But, from a narrow view based only on Fed policy, I agree that this is what needs to be done. The question is why? Could it be that the Fed policy is compensating for bad fiscal policy? When the government runs a $1.5 trillion deficit it issues bonds, which could be termed quantitative tightening. Quantitative easing entails buying bonds to put money into the economy while quantitative tightening involves selling bonds with the opposite effect. Yes, the government spends the money which returns it to the economy but the money is returned in a different place. Deficit spending results in pulling money from the more productive sectors of the economy, those that can afford to buy bonds, and moves it to less productive places. In the mean time, the Fed reacts to a seeming need for liquidity by pushing money out into the financial sector of the economy causing it to grow more than it otherwise would. I suspect that if we correct our bad fiscal policies, the Fed can return to a more healthy policy.

Nothing shows the need for good fiscal policy, though, than what is going on in Europe. The problem of the PIIGS cannot be resolved by more loans because as long as these countries are spending more than they take in from taxes the problem will continue to grow. A possible solution might be to look at Ireland which we no longer hear about. A year ago, Greece and Ireland were in comparable positions. Today, Ireland is not out of the woods but is at least making progress. Greece on the other hand is not. Greece will be stable when it reduces spending or grows productive activity to the point that it can run a balanced budget and its debt or the interest on the debt has been reduced to a level that can be supported by its economy. Basically a sovereign bankruptcy is in order. The thing that should not happen, though, is to bail out the debt holders.

ChrisA writes:

Generally I agree with your assessment but a couple of points/questions.

Yes the probability of hyperinflation may be low (point 1b), but is the risk (probability multiplied by consequences) low? It seems to me that we have really only one or two examples of deflation in recent (last 100 years), Japan now and the US in 1930's. In both cases the result were not great, but neither were they disastrous in terms of long term effects. Arguably, with today's social transfers much of the worst of the 1930's impact could be avoided. When I go to Japan, it's not obviously much worse than other developed countries (actually in many ways better), but maybe there is some hidden deprivation I am not seeing.

OTOH, we have many more examples of hyperinflation, and the results have been generally much worse, there is a good case to be made that the destruction of societal capital that occurs during hyperinflation was a proximate cause of the 2nd world war. Trust in money and monetary institutions is a huge source of value and cannot easily be regained once lost.

So maybe the Fed is a like a doctor looking at a patient with a debilitating but not fatal illness. He has has medicine which has a high chance of curing, but a small (5%) chance of killing if slightly overdosed. Trouble is, he doesn't know what the overdose is.

My second question is can the Fed can really inflate without coordination between the European Central Bank and China? If the Fed inflates (prints money) on its own, then will this not mostly go to inflate Europe since this is where the biggest output gap exists? And China will try to hold down it's currency by buying US treasuries, effectively sterilizing some of the inflation. Yes eventually the Fed could overwhelm these forces, but by then the monetary expansion could be huge. I would worry about the inflation spike at that point as China finally abandons the peg and/or European demand catches up with output. In the real world, currencies don't smoothly adjust to reflect the increased risk of inflation in one currency versus another.

Given these risks, maybe the best transmission of stimulation by Fed is to target growth in service jobs, since these are least subject to international competition. Perhaps the Fed should be helicoptering restaurant and hair dressing vouchers. But of course this risks a bubble in those industries....

effem writes:


"The commodity producers receive higher incomes when prices of commodities increase. And when commodities price increases trickle through to core prices more quickly than they do to nominal wages, then real wages effectively decline. This increases profits for business owners and also provides wage income to the marginal workers who are hired due to the real wage declines."

So now that profits are near record highs (both domestically and ex-US) we should see hiring, right?

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