Tuesday, July 22, 2014

Is monetary policy best?

Simon Wren-Lewis is annoyed with market monetarists who are annoyed with Paul Krugman who said that they have no political home in the US. Putting my two cents in, Krugman is right. My family consists of pretty stereotypical conservatives, and about the only thing that would make them say that "printing money" to improve the economy is a good thing is to say Obama is against it or that we'll put Reagan's face on it.

But Wren-Lewis reiterated the idea that today's "Keynesians" and market monetarists agree that monetary policy is the best macro stabilization policy when you're not at the zero lower bound.

Is it?

The more I look into this, the less the monetarist program for macroeconomic stabilization makes sense.
Recessions appear to be discrete shocks that are on top of a long run trend

In the information transfer model, the long run trend runs roughshod right past the shock. In this picture, monetary stabilization consists of temporarily altering the trend to offset a temporary shock and then returning to trend. It's a bit like sailing a ship, getting hit by a gust of wind, and lashing the helm to new course (monetary policy) [1] instead of just turning the wheel temporarily (fiscal policy).

However, in this picture, the economy is already deviating from the trend. What makes any macroeconomist think moving the trend will mean that the deviation will come along with it? Sure, it is not entirely implausible -- in turning the ship to counter a gust of wind, there is no particular reason to believe that the wind will get stronger or weaker in response. But this means you really need a theory of the trends and the shocks [2].

Employment recoveries in recessions seem unaffected by any kind of policy

The employment recovery from a recession has a surprising regularity across many decades (see here for the US and here for Australia). The data almost pose the question themselves: Does any kind of policy actually do anything macroeconomically relevant for unemployment? People do not seem to get hired back faster if monetary policy is "loose" (1960s and 1970s) or it is "tight" (2008). Nor do they seem to get hired back faster if there is significant fiscal stimulus (2008) or not (1991).

So if neither monetary policy nor fiscal policy help speed up the fall in unemployment, then government intervention should not be assessed through macroeconomic relationships with unemployment, but rather assessed via the direct impact of the intervention.

The simplest version of direct impact is something like the Depression-era WPA: the government directly hires people. Additional measures where the government contracts with construction companies to dig holes and fill them up again also fits this bill (preventing layoffs and encouraging hiring).

However, whether you pay for this by borrowing or by printing money does not seem to have a macroeconomic impact on the decline of the unemployment rate. The key point is that the macroeconomic rationales for not using fiscal policy are therefore pretty irrelevant. Another way to put this is that the purported negative consequences of fiscal policy won't make the unemployment rate fall any slower. Crowding out? So what? That won't cause unemployment to fall any slower. Monetary offset? So what? That won't cause unemployment to fall any slower.

Yes, fiscal policy may not make the unemployment rate fall faster, but at least it helps the people that are laid off put food on the table or the people that aren't laid off keep their jobs. And maybe you can fix some of the roads while you're at it. Monetary policy doesn't help people directly -- unless you print money and give it to people.
Note:  I am not saying fiscal or monetary policy don't have an effect on the initial rise in unemployment. My intuition (guess) is that the initial rise in unemployment from the natural rate at the onset of a recession is likely entirely due to human behavior (anxiety/panic), therefore bold assertions from the government couched in the dominant economic paradigm at the time easily calm people down and arrest the rise in unemployment. (This would go part way towards explaining why there are no mini-recessions using something like the "recognition" mechanism Sumner describes.)

Monetary policy sometimes doesn't even work on the things it can affect

In the information transfer model, the impact of monetary policy becomes muted as the size of the economy and monetary base grow. Returning to the ship analogy, the effect of the helm becomes less relevant as the current grows. At that point, directly affecting the current -- e.g. the G in C + I + G + (X-M) -- becomes more relevant.

When it does work, monetary policy works by kind of a dirty trick

Although not the entirety of the argument in favor of monetary macroeconomic stabilization, the mechanism by which it operates is to use inflation to make workers accept a real wage cut while not taking a nominal wage cut (also could be applied to firms or households). Because of money illusion, humans focus on the nominal values so don't notice their real income is falling.

In the information transfer model, there is significant RGDP growth that is caused by expansion of the medium of exchange when the monetary base is small [3], so this is not necessarily true of the information transfer model. However, monetary policy advocates aren't advocating the information transfer model.
If you put these together, you get that monetary policy is a dirty trick that doesn't always work, doesn't seem to help unemployment, asks us to change the trend in response to a temporary event and requires us to swallow a bunch of theory that hasn't been empirically tested. Where do I sign up?

[1] Of course, the real idea behind the market monetarism is that you can just tell everyone on the ship you're still headed for Boston -- you don't necessarily have to turn the wheel -- and you'll eventually get there.

[2] In the market monetarist view, expectations are important. If recessions are temporary shocks then any monetary policy compensating for it will also be perceived as temporary -- and hence not work. The only way this works is if either recessions never happen so monetary policy never has to change in response to it, or if people are tricked into thinking the policy is permanent (see also the last bolded point).

[3] I actually think this is a major issue for monetary economics. How do economies get started? Well, if you create a monetary system you get an economy -- that is RGDP growth. At some point a doubling of the monetary base may just lead to inflation (according to long run neutrality), but when the base is small, a doubling of the base should have some real effect by allowing more transactions to occur.


  1. I think what frustrates me the most about MMs, and you've been explicit about this before, is the apparently unfalsifiable nature of their theories. And it's not even like it's a coherent, well defined theory. All you get is Sumner berating you about "concrete steppes" and vague allusions to "quantum" like behavior (maybe we should call this a fallacy like reductio ad quantum or something). Frankly, while it might be a valuable idea to pay more attention to NGDP, I can't wait for them to all disappear back into the woodwork or something soon enough..

    1. Personally, I'd say any theory that relies on an "expectations" mechanism seems unfalsifiable. The market monetarist view relies more heavily on expectations than most -- down to Nick Rowe's insistence that the central bank doesn't even have to actually do anything to create inflation. It becomes limited only by your imagination.

      But many people are opposed to fiscal policy or government intervention, so it will likely remain an attractive view. Especially when failure just means the central bank just didn't try hard enough.

  2. Jason, you write:

    "...and requires us to swallow a bunch of theory that hasn't been empirically tested."

    This ties into the comment I made on your previous post which I erased (but that I'd still love for you to answer! :D)

    My own position (relating to your post here) is that I *wish* MM were true... (I think it'd be great if the CB could really do what the MMs claim), but a far more important question is "Is it true?" The "Is it true?" question is one I don't see many econ bloggers asking about their own hypotheses much (this blog being an exception).

    Of course you have to be a jack of all trades here: econ theorist, modeler, empiricist, and reviewer... ...at the very least it'd be nice to have a qualified set of independent reviewers take on that last job. E.g. it'd be great if you had Sadowski like people over here every day challenging your findings, methods, etc (what happened to Sadowski anyway? I haven't seen him around). I haven't seen a good reason why your work here doesn't deserve that (a reason other than your amateur status might be annoying to economists :D)

    1. I think one of the issues is that, as Noah Smith puts it, macro data is uninformative. The thing is, that means anyone can technically have a say -- there aren't a lot of unequivocal empirical successes in the literature. It also means there aren't a lot of reasons to give up on priors either.

      In physics, it's not the jargon or the mathematical methods or the models that make it difficult for outsiders to contribute. It's the track record of empirical success built with the jargon, math, etc.

  3. BTW, Nick accuses you of having a "warped mind" in his latest post. Lol...

    Well, perhaps not in the way I've made it sound. :D

    1. Ha! I replied that he was doing some implicit modeling.

  4. I stole your line above about expectations in a question to David Beckworth in his new post here:


    My guess is he'll say something about "level targets" vs other kinds.


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