Scott Sumner  

You know you're in trouble when even the Italians forget how to inflate

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Do bad times make us less smart? It sometimes seems that way. When times are good, people dispassionately explain how you don't want to overreact to plagues with draconian policies like quarantines, especially if the disease is not highly contagious. During a plague the reptilian brain takes over, and xenophobia becomes highly personal.

During the 1990s the economics profession seemed pretty smart. They had abandoned ideas like bailouts and fiscal stimulus to create jobs, and understood that monetary policy could and should steer the nominal economy. Liquidity traps were only a problem for the stodgy, uncreative Bank of Japan. There didn't seem to be much difference between top-notch economists such as Greg Mankiw (dismissing the idea that across-the-board tax cuts would boost revenue) and Paul Krugman (defending the exploitation of cheap third world labor.) To be fair, I have no reason to assume either individual has altered their specific views on those two issues. But no one can deny things look very different in the 2010s.

[Update: Commenter Vivian pointed out that at least Mankiw has not changed his views.]

I saw a recent example of the effect of growing pessimism in this story discussing Mario Draghi:

President Mario Draghi said expanding the European Central Bank's balance sheet is the last monetary tool left to revive inflation although there is no target for how much it might be increased.

"It's very difficult for me to give you an exact figure at this point in time," Draghi told reporters in Washington today during the annual meeting of the International Monetary Fund. "I gave you a kind of ballpark figure, say about the size the balance sheet had at the start of 2012."


To be fair, this statement might be defensible if you define "tool" very narrowly. All the ECB can really do is reduce the demand for base money (negative interest on bank reserves) or increase the supply of bank reserves (QE.) But I don't think that's how the markets would interpret Draghi; they'd assume he was saying the ECB is almost out of ammunition. This isn't just wrong, it's crazy. The ECB is the monopoly producer of a fiat currency. They can debase it any time they wish. And I'm not just talking about unlimited QE. Switching from inflation targeting to a 1.8% growth rate price level target would be hugely expansionary, far more so than an extra trillion euros of QE. And completely within the ECB's mandate.

Perhaps Draghi knows all that, but is expressing frustration that the powers that be won't allow the ECB to do what is necessary. Either way, this is scary for the markets. To eurozone stock investors it doesn't much matter whether the ECB "can't" or "won't" do what's necessary---either fear drives eurozone equity prices lower. In the world of money, speech is policy. Tighter money in this case. Here's a recent news video:

Pisani: Stocks drop after Draghi's sour speech CNBC's Bob Pisani reports ECB President Mario Draghi's comments on rates drove down trading in Europe.
Notice that while we don't know whether Draghi thought it was a matter of "can't" or "won't," the markets do know. If it was "can't" there would have been no market reaction. Why should stocks fall on public information? Only "won't" is "news."

Because we lack a NGDP futures market, I don't know what any of this means for the US. TIPS spreads in the US have recently fallen, but that might reflect lower commodity prices due to slowing growth overseas. Stocks have fallen, but much less sharply than in Germany. And don't forget that more than 46% of S&P500 earnings come from overseas profits. If I had to guess I'd wager than NGDP expectations have fallen in the US, but only slightly.

So far. . . .


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COMMENTS (22 to date)
Nick writes:

'And don't forget that more than 46% of S&P500 earnings come from overseas profits. If I had to guess I'd wager than NGDP expectations have fallen in the US, but only slightly.'

The S+P makes its money overseas but the Russell does not and it has been getting rocked.
The best performers are giant companies making profits in the US, but plenty of large companies with overseas earnings have outperformed small (and mid) cap US stocks. Could be nothing, the Russell is coming down from an elevated level, but I'd say US ngdp expectations have fallen more than slightly.

Vivian Darkbloom writes:

"There didn't seem to be much difference between top-notch economists such as Greg Mankiw (dismissing the idea that across-the-board tax cuts would boost revenue) and Paul Krugman (defending the exploitation of cheap third world labor.) To be fair, I have no reason to assume either individual has altered their specific views on those two issues."

Mankiw explicitly reaffirmed his view on October 1:

"The IMF endorses the free-lunch view of infrastructure spending. That is, an IMF study suggests that the expansionary effects are sufficiently large that debt-financed infrastructure spending could reduce the debt-GDP ratio over time.

Certainly this outcome is theoretically possible (just like self-financing tax cuts), but you can count me as skeptical about how often it will occur in practice (just like self-financing tax cuts). The human tendency for wishful thinking and the desire to avoid hard tradeoffs are so common that it is dangerous for a prominent institution like the IMF to encourage free-lunch thinking."

http://gregmankiw.blogspot.fr/2014/10/the-imf-on-infrastructure.html

Not so sure about Krugman, though. It's one thing to change your mind and another to change your rhetoric.

Ken from Ohio writes:

Can't or Won't - that is the question. So far, my opinion is "Can't".

The ECB's price stability mandate stipulates an inflation target of "close to" but less than 2%. An so the ECB has room to expand in order to go from the current inflation rate of 0.3% to its target of close to 2%.


".....we are now experiencing a prolonged period of low inflation, which will be followed by a gradual upward movement towards inflation rates below, but close to, 2% later on"---Mario Draghi Feb 2014.


So what are the policy tools available to the ECB to accomplish 2%?

The primary open market operation tools available to the ECB are:

MRO - Main Refinancing Operation -this is a collateralized loan from the ECB to its participating banks. The term of the loan is 1 week. The collateral is both private assets and government bonds. Interestingly government bonds currently comprise only 10-15% of the collateral. The interest rate on the loan is determined by the market and is currently near zero - 0.05%.

LTRO - Long Term Refinancing Operations - this is also a collateralized loan from the ECB - similar to MRO but has a long term. 3-12 months. The market interest rate, like MRO has been pushed to nearly zero - currently 0.15%.

Given that the interest rates on MRO and LTRO are essentially zero, the ECB has exhausted this policy tool and must now turn to its Structural Operations in order to facilitate further monetary expansion.

Structural Operations is essentially a program of asset purchases. But what assets can the ECB legally purchase? This seems to be the problem.


A question from the Feb. 2014 ECB press conference:
Question: Do you have any concerns at all about the legality of quantitative easing via government bonds in the euro area?

Draghi: I have said repeatedly and I continue to say, that in our pursuit of our mandate of maintaining price stability, all the instruments that are allowed by the Treaty are eligible. There is no issue of legality. And at the same time the Treaty forbids monetary financing. So we know what is eligible and what is not eligible.

To me, Draghi's response if vague. Is QE by government bond purchases (monetary financing) legal or not?

And then there is the issue of market distortion that could occur with a bond purchasing QE. Keep in mind that the Eurozone bond market is not a single market but many smaller domestic markets (Germany, France, Belgium, Greece, etc) that together are roughly the size of the U.S. bond market. And that a QE program could potentially significantly distort any of those individual markets.


"This means, among other things, ensuring that any such purchases comply with the Treaty, keeping in mind that Article 18 of the ESCB Statute allows the ECB and national central banks to operate in the financial markets by buying and selling outright claims and marketable instruments. It also means guarding against operations that unduly distort market allocations or worse, that would have intended distributive effects."

Benoit Coeure - ECB Executive Board -April 2014

It seems as though the ECB is going to turn to a QE program through the purchase of private Asset Backed Securities (ASB). This would be an unconventional -and unprecedented - policy move on the part of the ECB.

Again from the Feb 2014 press conference:
Question: "And my second question is on the ABS. ......I just wonder what time frame are you speaking about? How quickly can we create such a market? Is this something that could happen during the course of this year or would it take five years?"

Draghi: On the last question, there was a broad discussion where all instruments of monetary policy were talked about. But most, if not all, of the discussion was focused on examining the additional need for information and the uncertainty. That is the key substance of the discussion the Governing Council had.

So how long would it take to establish an ABS QE program? It's a good question and Draghi did not answer it.

It has never been done before - it may take a few years to really come together.

So is an ABS QE program legal? It seems like it is more legal than a government bond purchase QE.
But it seems like Germany says "nein".

From the March 2014 press conference:

OMT means Overt Market Transactions (Asset Purchases)

Question: My first question is on OMT because, just one day after your last press conference, the German Constitutional Court came out with a “non-ruling”.

Draghi: They would disagree with that definition, but those are your words.

Question: That’s true, but there are opinions in the market that, for now, the OMT programme is on hold because the Bundesbank might not participate. What is your opinion on that? I would also like to know your opinion about the IMF calling on the ECB for more stimulus in recent articles. How do you feel about that?
Draghi: Let me say that the OMT programme is ready, it is there and it is ready to be activated if and when needed. In this sense, we welcome the referral of the OMT case to the European Court of Justice. OMT, in our view, falls within our mandate of pursuing price stability over the medium term.

And so it seems as though Draghi says "si" and Germany says "nein" to an ABS QE program.

To me, the take home message is that, unlike the American Fed, the ECB serves many masters. So it is difficult for the ECB to disentangle itself from political and policy disputes - especially when it comes to unconventional monetary policy.

And so for now, it seems as though the ECB "can't" proceed with monetary expansion.

(sorry for the length)


Scott Sumner writes:

Nick, Good point. I'll keep an open mind. But this is why we need a NGDP futures market.

Vivian, Yes, I should add an update.

Ken, The ECB can inflate any time it wishes. But I agree that the politics make it difficult, as the ECB board is composed of people from many differnet countries. If you put 25 Draghis on the board they'd be much more expansionary.

You didn't even discuss level targeting, which is a far more powerful tool than QE.

BTW, QE is basically nothing more than expanding the monetary base. The ECB has been expanding the monetary base since they were first set up. They can continue doing so if necessary.

Andrew_FL writes:

I get the logic of not wanting to let NGDP shrink suddenly, I'm less clear why raising it's growth rate once growth in "real" output is positive is desirable or expected to improve growth in "real" output. Is it just because people won't believe real income is rising unless its nominal value does? How long would it take to "unlearn" that fallacy? Why does it persist?

ThomasH writes:

"[Economists] had abandoned ideas like bailouts and fiscal stimulus to create jobs, and understood that monetary policy could and should steer the nominal economy."

Had they abandoned the ideas or just never imagined that the Fed would allow them to become relevant again? Didn't they just assume that because the Fed could steer the nominal economy that it would?

Ditto fiscal policy? Who expected that when government borrowing rates fell to near zero governments would not only not crank up investments in all their projects with positive net present values at hose rates, but lay off hundreds of thousands of people?

Don Geddis writes:

@Andrew_FL: The answer to your question is sticky wages, and especially the empirically observed sharp cliff at 0% raises, showing the extreme resistance in the labor market to nominal wage cuts.

Krugman has written about the significance of the huge cliff at 0% a number of times, e.g. about the US in 2012, and about Spain in 2014.

So it's not really about a "fallacy" (although, at root, it is indeed a confusion between nominal wages and real wages). But it's more that (low, stable) inflation allows the labor market to be more efficient.

Ken from Ohio writes:

I am skeptical of the statement that "the ECB can inflate anytime it wishes"

It seems to me that the MRO and LTRO facilities have reached their limit with those rates at .05% and 0.15%.

I suppose the ECB could try to get those rates into the negative. I'm not sure how that would technically be accomplished other than if the loan is 1-2% more than the value of the collateral.

It is my understanding that the member banks are full of reserves and so the ECB could charge a penalty on these excess reserves - thus geting the money into circulation with a multiplier effect.

But i don't know if that policy is available to the ECB.

So I am interested in specifically what policy the ECB could implement (a policy that is clearly within its charter and politically acceptable to the Eurozone members) to immediately inflate towards 2%. (A question for Prof. Sumner)

As far as NGDP level targeting goes, there are many (including me) that appreciate the merit of this. But the ECB does not.

The ECB charter goes to great length to express its advocacy of the neutrality of money. And so the ECB cannot use GDP -either real or nominal- as a policy goal.

The ECB could back into a NGDP target as it pursues its mandate of price stability, But unless the ECB charter is changed (not likely in our lifetime), NGDP targeting will not be part of the plan.

Ken from Ohio writes:

Don-

It is my understanding that another mechanism of rising NGDP is that it stabalizes debt contracts.

In a recession when wages would otherwise go down, a rise in nominal wages allow the debtor to avoid default.

Systemic debt default related to falling wages -it seems- can create a cascade effect - thus worsening a recession.

Andrew_FL writes:

@Ken from Ohio

That would be a reason for not allowing NGDP to fall in the first place, less than it is for making it increase afterwards.

@Don Geddis

That's more or less what I thought the answer was, although if Scott has a different one I'd still like to hear it.

(I'm not sure how people confusing nominal and real wages isn't fallacious-semantics?)

Another thing I was getting at was how much of the resistance to non-rising nominal wages is based on expectations based on past experience? And whether, in a situation where people weren't used to the idea of persistent long term inflation, they'd still want nominal wages to always rise.

I'm inclined to think it's a mistake to place maximizing labor market efficiency as the end-all beat-all goal of an ideal monetary policy (which, I would think, ought to be aimed at minimizing monetary disequilibrium). If low inflation decreases the efficiency of other markets at the expense of maximizing efficiency of the labor market, then there's a trade off involved, one which probably shouldn't be made so definitively in favor of one option.

Ken from Ohio writes:

The idea of inflation and labor markets is ineresting.

To channel Milton Friedman-

Inflation is always and everywhere a monetary phenomenon.

and

Inflation is always and everywhere a policy decision.

So who wins with inflation?

I've always considered that employers benefit from inflation. Particulary employers in rigid labor markets (like Europe)- where emplyees cannot be laid off easily.

Wth inflation - an employer can simply provide yearly COLA (inflation) wage increases. So the nominal wage goes up - while the real wage remains constant. The employer keeps real abor costs under control (without laying anyone off), while the employee feels like he is getting a bit of a raise.

So in this context, various factions lobby for or against an inflationary monetary policy - depending on their "win or lose" position with inflation.

so when a Central Bank serves many interest groups - like the
ECB - it may be that the policy is influenced in this way.

For example, Germany seems to be against an inflationary policy.
This may be because Germany has a less rigid labor market than other Eurozone countries, and also because Germany is a net exporter - and low inflation tends to protect the value of cross boarder trade contracts.

An importer may be more inclined to favor inflation because the nominal price paid is lower than the real price in the contract.

Scott Sumner writes:

Andrew, The key is to have a steady growth rate of NGDP. The exact number is less important than the predictability. You do not want ad hoc policies.

Thomas, I don't think the Fed did allow the ideas to become relevant, but they certainly allowed them to become popular (something I admit I did not foresee.)

Ken, Given that they have already done negative interest on reserves, I presume they can do negative interest on reserves. You haven't addressed a price level target, which is certainly within their mandate.

Andrew_FL writes:

@Scott

As I thought it's more important essentially that there is an implicit or explicit rule about the growth rate than that the rate exceeds the rate of real growth by some significant amount.

Or I should say, I expected you would say that, which differs from Don's and Krugman's view, I guess, in the theoretical reasoning. They would say that even if you could maintain, say, a 0% growth rate at all times, that would be bad for the labor market. Presumably, you would say that as long as people expect a 0% growth rate it wouldn't be a problem. But that as it stands, people expect inflation, plan for inflation, and therefore need there to be inflation, but for it to be fairly steady so that their plans can incorporate it accurately. This is exactly what I was trying to get at. Thanks.

Ken from Ohio writes:

To Andrew's point

I agree - and it seems that stability - at least in the short term is the key.

As long as inflation - and inflationary expectations - remain essentially constant, labor contracts, debt contracts, trade contracts are stable and predictable. All is well in the short term.

But even a little inflation - say constant year over year 2% (which is the explicit policy goal of the ECB and the seemingly implicit goal of the American Fed)there is a long term tax on savings and investment. Even at 2% - purchasing power is reduced by half over a 35 yr period.

So the way I see it - low steady inflation is OK for the short term - but bad in the long term.

Andrew_FL writes:

@Ken from Ohio

I'm less inclined to think it's okay in the short term, either. What I was getting at when saying that monetary policy should mainly be about preventing monetary disequilibrium. Inflation would seem to me a strong indication that the supply of money is strictly greater than the demand to hold it.

Actually I could argue that growing NGDP (ie MV) is itself a sign of monetary disequilibrium, even if "real" growth is occurring at the same rate (which would mean the price level is constant).

Scott Sumner writes:

Andrew, Debt contracts can obviously adjust to any trend growth rate. It's possible that labor contracts may have trouble adjusting to very low NGDP growth rates, due to money illusion. I would suggest a rate higher than zero.

Ken from Ohio writes:

From a price stability point, zero inflation is best - so I agree with Andrew on this.

But so far there has been no monetary policy able to achieve this.

Even with the classic gold standard there was chronic 1% deflation, which of course, presents its own problems (debt contracts ect).

Prof Sumner makes a good point (as I understand it), that 0% inflation can impede economic growth (insufficient money for transactional needs - a reduction of money velocity).

So it seems like the monetary authorities have settled on the least bad option - low steady predictable inflation.


That seems to be a trade-off between slow steady predictable purchasing power erosion and economic growth

ThomasH writes:

@ Scott

By "relevant" I meant that economists never expected that the Fed would get itself into a ZLB/liquidity trap and need to use QE. Maybe that's what you meant by "popular." And fiscal stimulus should never have become necessary, either.

Andrew_FL writes:

@Ken-Actually, I meant stable nominal income not stable P so we disagree somewhat (stable MV would be deflationary in the long run)

During the gold standard, as i see it, the problem was not deflation per se, which as Scott says debt contracts can account for (just like inflation) as long as it is anticipated. The real problem i think was twofold:

1. Banking regulations that severely handicapped the banking system's ability to stabilize nominal income (accomodate changes in V with changes in M)

2. Gold only approximates the behavior you'd want out of an ideal reserve commodity

2 is a minor problem compared to 1.

That being said, the secular deflation itself was not bad-not withstanding episodes of bad deflation, most of it was a consequence of economic growth, not a hinderance to it. There's actually little to no indication that our modern system of secular inflation is an improvement.

All that being said, with a free banking system you could hypothetically have monetary policy achieve whatever growth rate of nominal income you want, if the reserve commodity is federal reserve notes and you follow a strict rule for monetary base growth.

With regard to labor contracts, it seems likely to me that much present behavior of workers in this regard is based on the understanable belief that the monetary authority will always inflate. It'd be interesting to see if this was less common before the Federal reserve was in place.

Ken from Ohio writes:

All very good points.

This entire series of comments goes to show how interesting monetary economics is.

Majromax writes:

@Ken from Ohio:

But even a little inflation - say constant year over year 2% (which is the explicit policy goal of the ECB and the seemingly implicit goal of the American Fed)there is a long term tax on savings and investment. Even at 2% - purchasing power is reduced by half over a 35 yr period.

Be careful -- you equate savings and investment, but that isn't exactly so.

With stable and anticipated inflation, any investment will take that inflation into account with its nominal rate of return. Savings in the form of cash will not, obviously.

That means that anticipated and stable inflation acts as a tax on cash savings but not on investment, which is precisely what we want. Cash savings are effectively monetary tightening, only conducted by private persons rather than by the central bank. A well-regulated system should discourage long-term cash savings in order to maintain control over the economy.

Andrew_FL writes:

@Majromax

If by "cash savings" you mean hoarding (which I think you do, since you refer to it as the same as monetary tightening, which doesn't make sense if saving means supplying loanable funds directly or through banks) Inflation isn't necessary, all that's necessary to keep investment equal to voluntarily deferred consumption is for banks of issue to be able to respond to decreases in bank money velocity by increasing M.

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