Open Letter to Conservatives on Monetary Policy
By monetary economist Scott Sumner:
1. The Fed isn’t really trying to create inflation.
The Fed doesn’t directly control inflation; they influence total nominal spending, which is roughly what Keynesians call aggregate demand. Whether higher nominal spending results in higher inflation depends on a number of factors, such as whether the economy has a lot of underutilized resources. But it’s certainly true that for any given increase in NGDP, the Fed would prefer more RGDP growth and less inflation. Even after QE2, the Fed still expects less than 2% inflation for years to come. If the Fed had any marketing sense, they’d be telling the public they are trying to boost recovery by increasing national income, not increasing the cost of living. It would also have the virtue of being true.
2. “But doesn’t economic theory teach us that printing lots of money creates high inflation?”
In general that is true. But there are three important exceptions:
1. If the monetary injections are expected to be temporary, the inflationary effect is far smaller. The Japanese central bank did lots of QE in 2003, but pulled much of the money out in 2006 when deflation ended. It worked in preventing high inflation, indeed it may have worked too well.
2. If interest rates are near zero, the public demands more liquidity. The Fed can supply that liquidity with little impact on the price level.
3. If the Fed pays interest on reserves, then the quantity theory of money (more money means more inflation) doesn’t necessarily hold. They recently started paying interest on reserves, and that’s one reason why the big injections from 2008 didn’t have an inflationary impact. The Fed can adjust the rate as necessary, and indeed in my view a lower IOR would be more effective that QE2.
3. “But isn’t the gold market signaling high inflation?”
Possibly, but the indexed bond market is superior to gold prices for two reasons. First, gold is trading in a global market, and we are interested in US inflation. More importantly, gold prices reflect all sorts of factors (industrial demand in Asia, central bank demand, a recent drop-off in new discoveries, a hedge against all sorts of financial risks, including eurozone turmoil.) Furthermore the indexed bond market (TIPS spreads) has recently been more accurate than gold—correctly predicting low inflation in the US since late 2008.
4. “Doesn’t printing money just paper over real (structural) problems in the economy?”
There are structural problems, but there is also a shortfall of nominal GDP. The structural problems showed up when growth slowed in late 2007 and early 2008 as a result of sharply lower housing construction. This is necessary re-allocation of resources and should not be resisted. But even Friedrich Hayek suggested that we needed to avoid a “secondary deflation”, which would show up as falling NGDP, and would depress output in even those healthy industries that had not over-expanded. In late 2008 output fell across the board as NGDP declined. Monetary policy can only address the insufficiency of total nominal spending, not the structural problems. Furthermore, more nominal spending would boost employment, which would speed up the time when Congress eliminates the 99 week extended UI benefits–which is one of the structural problems.
5. “Isn’t this just hubris—the idea that money can be centrally planned?”
Most right wing economists are not comfortable with the idea of giving discretion to the central bank. I am no exception. I happen to favor making the dollar convertible into NGDP futures contracts as a way of stabilizing NGDP growth expectations at a low and stable rate. Milton Friedman favored a stable money supply growth rate, but late in his career (after velocity bounced around) endorsed a policy of stabilizing market expectations of inflation in the indexed bond market. These systems would allow the market, not the Fed, to determine the appropriate level of money for the economy’s needs. But we aren’t there yet, and given the Fed does use discretion, Friedman was not at all hesitant about recommending policies that he thought would do the least damage. I believe that is stable NGDP growth expectations.
6. The conservative critique of stimulus is incoherent
When I started my blog in early 2009, fiscal stimulus was the hot issue. Many conservatives were opposed to fiscal stimulus, arguing (correctly in my view) that it would fail. And they made it quite clear that “failure” meant deficit spending would fail to boost nominal spending. The implicit assumption was (almost everyone agreed) that more nominal output would be desirable, and the argument was that fiscal stimulus could not deliver it. With monetary stimulus, the right is making exactly the opposite argument—they are opposed to QE because it might succeed in boosting NGDP. Both fiscal and monetary stimulus boost NGDP (if they work at all) by shifting AD to the right. Whether that extra spending shows up as inflation or real growth is of course an important issue. But it makes no sense to argue fiscal stimulus would fail because it would not boost NGDP, and simultaneously argue that monetary stimulus would fail because it would increase NGDP. I’m sure the right doesn’t think of its views in those terms, but that is essentially the message they are sending out, and it is an extremely incoherent message.
7. “Won’t monetary stimulus just paper over the failures of the Obama administration, allowing him to get re-elected?”
That’s an argument unworthy of principled conservatives. After 30 years of major neoliberal reforms all over the world (even in Sweden!) it’s time for conservatives to become less defeatist about the possibility of making positive improvements in governance. We need to do the right thing, and let the political chips fall where they may. If monetary stimulus is tried, and succeeds in boosting NGDP (which even conservatives implicitly acknowledge can happen when they worry about inflation) then it would drive a stake through the heart of the Krugmanite fiscal stimulus argument (for future recessions.)
I don’t think conservatives realized it at the time, but I (and a few other quasi-monetarists) had the strongest argument against fiscal stimulus in late 2008 and early 2009. We said; “Yes, stimulus is needed, but monetary stimulus is much more effective and less costly than deficit spending.” At the time, most on the left argued that monetary stimulus wouldn’t work if rates were near zero. Well rates are still near zero, and many of those same liberals are now insisting that the Fed is responsible for fixing the AD shortfall. They’ve come over to our side. Just as in earlier decades they gradually accepted the Friedman/Schwartz argument that monetary policy errors caused the Great Contraction of 1929-33, not the failures of capitalism. If conservatives keep predicting inflation that the financial markets don’t see, Krugamn will continue to rub their faces in failed predictions. If we adopt the view that monetary policy is the appropriate way to keep NGDP growing at an adequate rate, then we win and Krugman loses. So which will it be?