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Friday, April 25, 2003

More on the Irresponsibility of Being Responsible

Maynard has again come to the rescue by giving me some (as is usual with him) intelligent feedback on my preposterous suggestion that maybe a superficial reading of the US deficit situation was missing something. Firstly Maynard's response:

When I first saw your comment in Brad's weblog I was confused, and
thinking about it since then has not cleared things up.

Here's my problem. Assuming you are correct, and that this is all an act, I still don't see you expect this to play out. The federal debt increases, sure, and long term interest rates increase (supply and demand and all that); and then what? Long term interest rates in and of themselves will not cause inflation. So what's next? The fed floods money into the system via OMC actions, reducing the fed discount rate, maybe even changes the reserve requirements. Why do these require an irresponsibly large federal debt to work effectively?

I think I understand the large scale idea. A future deeply indebted federal government clearly benefits from unexpected inflation that reduces its debt load. What I don't understand is (a) how the federal government gets from wanting this inflation to actually making it happen and (b) won't this be a fiscal disaster for the federal government after some brief cheering? Won't investors, screwed out of their funds once, demand an interest rate for future fed offerings that not just covers the inflation rate but also compensates them for their past losses and for future uncertainty? That seems pretty much what happened when we went through this last time in the early 80's. And won't the federal government be forced pretty close to a desperate situation by such an increased interest rate burden.

Now certain things need to be said at the outset. In the first place I am thinking very much about this situation in the light of the Japanese experience, and in particular in the light of what many influential American economists have had to say about how to address the problem of deflation were it ever to reach the shores of the US. The key texts to keep in mind in this regard are probably Ben Bernanke's speech Making Sure 'it' Doesn't Happen Here and a highly influential paper by Lars Svennson A Foolproof Way of Escaping From a Liquidity Trap . Various articles by Paul Krugman on the liquidity trap issue (links to which can be found on my Deflation Page are also relevant). The problem that may be thought to be facing the US is not being stuck in a liquidity trap, but to avoid entering one. Three strategies are recommended: monetary easing, purchasing securities by the Federal Reserve, and purchasing of non dollar denominated assets to devalue the currency. All of this is being proposed with the objective of creating inflation, or to be more exact of creating the expectations of inflation. Various ideas have been floated as to how to manage this process without provoking on the one hand excessive inflation, and on the other without market participants internalising the idea that the central bank is only engaging in a limited operation which will not be sustained. In other words how do you avoid market participants 'front running' the central bank?

Now the major criticism of this line of argument from inside Japan turns precisely on this question: how do you convince everyone that a solid institution is suddenly becoming irresponsible, and is going to remain irresponsible for long enough. If the Japanese don't adopt inflation targeting, it isn't because they don't understand (or haven't thought about) the argument. It's because they're understandably scared that all they might do is create another asset bubble and another crash. How do you know when to stop?

Well non of this seems to pre-occupy unduly our inflation targeters. And what they can't succeed in getting the Japanese to try out, they may well be willing to experiment with in the US. Paul Krugman and Brad Delong are undoubtedy right to point out the problem of above trend productivity growth coupled with below trend growth in demand: the logic is continual price disinflation, followed eventually by price deflation. According to reasonable estimates this could be only a year or so away (Krugman's back of the envelope guess). Also bear in mind that the negative upward oil price shock could be followed at some stage by a downward one in a slack global economy with Iraq needing (for whatever reason!!!) to sell oil quickly. This would be the push that tips everybody over, and then you can have it: zero interest rate bound, and liquidity trap. This is not inevitable but it is one distinct possibility.

I am convinced that Stephen Roach is right, the Fed is taking this possibility very seriously. Now despite central bank independence the US Treasury do talk to each other. Greenspan's opinion is valued (and via Greenspan Bernanke's) and Greg Mankiw is not stupid. In fact I think the first clue that something might have been on the cards was Mankiw's appointment (and the ignominious sacking of yes-man Glenn Hubbard, which must in my book count as one sign of intelligent life in the White House). The second clue has been dollar policy since O'Neill's departure. There is now no real attempt to suggest that the US is maintaining a strong dollar policy. A significant devaluation has already taken place, and it is entirely possible that another is in the pipeline. But the US economy is not sufficiently open for this to have a critical impact (although on another occassion I would want to say something about the fact that it's level of openness is highly significant in other contexts). The pass through rate on prices is small, and in addition many of the Asian economies (which in some ways are the ones that matter) are tied to the dollar and so relative prices are unaffected. Indeed if SARS becomes important in China, this will mean even more internal deflation there, and in other Asian economies. So in the end the dollar 'correction' may have more to do with that other US deficit: the current account one.

So we come back to domestic policy. How do you convince market participants that the US is serious about inflation. One solution, which is proposed in the paper I cited, would be to weaken the level of perceived independence of the central bank, and have it constrained to print money for a serious fiscal deficit. Now what better Mick and Montmerency double act here than Alan Greenspan and George W Bush. After all everyone's completely convinced that the White House is determined to cynically manipulate everyone in sight. (Look, although I hate to do this, I think it has to be said: in some ways Paul Krugman could have fallen into the trap (I'm sure a non-liquidity one) of perpetuating the image of Bush that would make this a feasible strategy. Bush, the crazy president who is going through unashamed self-interest to ruin his country by running huge inflation-provoking deficits. Or maybe Paul Krugman is actually a true patriot, who is putting country before private reputation, and given credence to the Bush 'madman' view to help legitimate the trap-proof fool).

Now for the questions. Why the fiscal deficit, not massive quantitive easing. Because looking at Japan, even though no one is ready yet to admit this publicly, I think we can see that this alone doesn't work. It doesn't work for a variety of reasons, and if you want to know what I think about them all you'll have to follow developments on my Japan Page as I try work through all the issues involved. The principal problem however is that monetary policy is inherently more limited than it has been fashionable to imagine of late. In particular, you can carry out all the quantitative easing you want, but if the bank managers aren't willing to lend, because they don't believe the expansion is coming, you can find yourself stuck. Let's just call this for the time being the "credibility trap".

Now 'won't this be a fiscal disaster for the Fed after some brief cheering'? Obviously this is the risk. But remember the plan 'B' probably is: after steering nicely clear of the deflation iceberg (and this is, of course, the part of the theory I can't really swallow) they get to say, whoops, sorry folks, we made a (deliberate) mistake, looks like the critics were right all the time. The part I'm not spelling out is that all this would, naturally, involve abandoning those cherished 'tax cuts' that only lock in as the decade advances, but this may be considered the lesser evil (or maybe they believe all the late 90's Greenspan optimism that above trend sustained growth is possible, in which case all the numbers change). Look, I never said I agreed with this (although it has a lot more possibility of working in the US than it ever would in Japan or Europe), what I'm trying to do is explain some puzzling behaviour in a way which is different from the 'simplistic' theories. I like simple theories (a la Occam and Einstein), not simplistic ones (which doesn't mean the simplistic theories are never right, but we should always probe reality a little more, just in case they aren't). I don't know that this is actually what is going through peoples heads, just that it is quite consistent with a close inspection of the pertinent theories, and some of the known facts. Is it surprising that they are not explaining this: well obviously no. For this game-play to work it is important that the other players aren't aware of it. What I do think is that before arriving at strong conclusions we should at least consider all the arguments: I am simply presenting one story, a story which might account for what would otherwise appear to be some highly irrational behaviour. Are they up to it? I haven't a clue.

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