Replies to Baker, Boudreaux, and Hetzel

First of all, I must thank the Cato Institute for hosting this blog discussion on the liquidity trap and its role (if any) in current policy-making, issues which are considered at more length in my new book Money in a Free Society. Secondly, I am also very grateful for the interesting and thought-provoking comments from Dean Baker, Donald Boudreaux and Robert Hetzel, and will cover them each in turn.

But, before that, may I note one point of apparent agreement? We all seem to believe that, when the short-term money market rate (set by the central bank) is zero and monetary policy in that sense is exhausted, the state can still conduct a range of expansionary operations that will boost economic activity. My interpretation is that we also believe that such expansionary operations do not require a widening of the cyclically adjusted budget deficit.

I think Dean and, to a lesser extent, Donald would nevertheless like to involve “fiscal policy” as well. Well, I wouldn’t. In fact, I would like the phrase “fiscal policy” banished from the lexicon of macroeconomics. We do, however, share the view that unemployment is a tragedy, both for the individuals concerned and for society at large, but I would like to avoid rhetoric.

1. Dean Baker

Dean has tripped me up about the meaning of the Obama $800 billion fiscal package. I was wrong to say that the package by itself added $800 billion at an annual rate, and I apologize. Was I talking through my hat? I had in fact taken the trouble to check the data, to be precise, to check the International Monetary Fund’s website with its estimates of the change in the “structural” (i.e., cyclically adjusted) budget position, normally taken to a good summary measure of “fiscal policy.” (On the website the estimates are said to be part of the September 2010 World Economic Outlook database.) The numbers for the period in question are as follows:

General Government Structural Balance
2007 2008 2009 2010 2011 2012
National Currency, $b -304.4 -657.4 -1000.4 -1075.2 -1013.7 -813.0
Percent of Potential GDP -2.2 -4.5 -6.7 -7.0 -6.4 -5.0

We can see that between 2007 and 2010 the U.S. structural budget deficit increased by over $770 billion, with the bulk of the increase occurring in 2008 (before Obama) and 2009 (in Obama’s first year). If Obama and his advisers had made it a priority to bring U.S. public finances under control, they would have avoided any further enlargement of the structural budget deficit in 2009. But in fact they went ahead with a so-called “expansionary” package. In that sense they did endorse a fiscal boost that amounted to almost $800 billion, at an annual rate, relative to the last recession-free year of 2007.

Dean claims that the package did create jobs, citing work on multipliers by Feyrer and Sacerdote. Like Milton Friedman, I reject this sort of analysis. As Friedman said in a 1996 interview (as I quote on p. 192 of Money in a Free Society), “I believe it to be true…that the Keynesian view that a government deficit is stimulating is simply wrong. A deficit is not stimulating because it has to be financed, and the negative effects of financing it counterbalance the positive effects, if there are any, on spending.”

This may be a little sweeping. I wouldn’t deny that an increase in the budget deficit financed by new money creation increases equilibrium national income. (And in fact I am pretty sure Friedman would not have denied this either, when he was being careful.) But that means the value of the fiscal multiplier must depend on the pattern of financing. The multiplier may be positive if the deficit financing is entirely monetary, but a smaller multiplier (perhaps even a multiplier under one) is to be expected when the extra deficit is financed at the long end of the bond market (i.e., exclusively from non-banks). The emphasis should not be on the balance between Federal and state expenditure, but on the balance between monetary and non-monetary financing.

Dean says that the Obama administration’s mistake lay not in their fiscal policy, but in their underestimation of the severity of the recession. That then raises the question of why the recession was so deep. In my opening contribution I concentrated on the money numbers. In particular, I highlighted the contrast between the rapid money growth in the three years to October 2008 and the stagnation of money in the following three years. I submit that the source of the Obama administration’s miscalculation lay in its advisers’ lack of interest in monetary data, their prejudice against monetary activism, and their contempt for monetary economics and monetary economists. Having been on the receiving end of this contempt for most of my career, I say this with some feeling.

Incidentally, I am dismayed that Dean seems to think that the underestimation of the recession’s severity justified a stimulus package calibrated to the creation of 10 – 12 million jobs instead of the 3 million jobs that Obama’s planners had in mind. No, this is what the debate is all about. I deny without reservation the effectiveness of fiscal policy. As I say in the four essays in part three of Money in a Free Society, unless budget deficits are monetized, fiscal policy just doesn’t work.

The Great Recession—like the Great Depression—was the result of adverse monetary trends. The Great Depression was caused by a crash of one third in the quantity of money; the Great Recession was caused by a sudden halt in money growth in late 2008. That sudden halt was due to central banks’ and regulators’ misplaced zeal as they hurried to make the bankers much safer (i.e., with fewer risk assets, leading to a fall in bank deposits) and better-capitalized (i.e., so that banks’ deposit liabilities were replaced with non-money liabilities in the form of bonds and equities).

Dean says I have got Krugman wrong. I would welcome Professor Krugman’s intervention in this exchange, so that he can try to refute me and to sort out the matter more definitely. But let me be blunt. Krugman’s invocation of a change in the inflation rate, as a policy shift of some sort, is a red herring. The inflation rate is not a policy instrument. If it were a policy instrument, such that central banks could determine it by proclamation or even mere assertion, we could chuck out hundreds of textbooks and monographs and go home. Moreover, most economic agents in real-world business and financial markets know that the central bank is not staffed by magicians. Since they know that, a pronouncement from on high that “inflation over the next six months will be x” or “the change in the price level in 2014 will be y” does not change inflation expectations by itself.

My position on monetary control is much the same as that of Keynes and Friedman, and—if I may say so—all of the classic authors in this field. Dean says that M3 (i.e., the quantity of money) is not “directly a policy variable under the control of the Fed.” Check The General Theory, Dean. (And perhaps Krugman should do the same.) Keynes said—consistently and repeatedly—that “the authorities” could control the quantity of money in order, as he saw it, to influence “the rate of interest.” On February 21, 1936, just as The General Theory was being prepared for printing, someone wrote a letter to the Times of London observing, “…no question is more important than the principles on which the Bank of England and the Treasury should fix the quantity of bank money. It has not been discussed lately as much as it deserves to be.” Who was the author of that letter? None other than John Maynard Keynes. At any rate, the quantity of money comes much closer to being a variable susceptible to policy actions (and hence “a policy instrument”) than the rate of inflation or deflation.

Having said that, I agree that understanding The General Theory is not easy. In essay 4 in Money in a Free Society I try to remove some of the “slurring” of definitions that Keynes admitted he had done in his book. That led me to distinguish between different kinds of liquidity trap and different formulae for open market operations. I appreciate Dean’s remarks on my essay, but he seems to have missed the significance of those distinctions altogether.

2. Donald Boudreaux

I don’t have much to say about Donald’s comments on money and the liquidity trap, as we are singing from the same hymn sheet. But Donald really does take the discussion forward with his reference to Higgs and the relationship between regime uncertainty and property rights. This is hugely important, particularly for banking systems. Banks have been unpopular in the United States ever since the early republic, with Jefferson the first and most distinguished in a long line of bank-bashers. The current regulatory assault on the banks has hit their profitability, so that on the stock market they are now typically trading at under book value. But the Federal government and the Federal Reserve want banks to be more highly capitalized, which has meant that some banks have been under pressure to raise extra capital in the market. Unfortunately, shareholders don’t like buying more stock in a business if they will immediately suffer a loss on the investment. (And they will suffer such a loss in bank stocks today. That is the implication of market capitalizations being less than book value.)

There is a great deal to say here. If regulatory officialdom wants banks in the United States (or indeed in any country) to be both strongly capitalized and privately owned, it must be careful not to overload the banks with regulations and to wipe out banks’ profits. Investors buy shares either for income or because over time the market capitalization comes to exceed the sum invested. If regulators overcook the regulation, so that market capitalizations are routinely less than the sums invested in banks, banks will not be able to raise new capital.

3. Robert Hetzel

Again, in some senses Robert and I are singing from the same hymn sheet, and I don’t have much to add. We agree 100% that the zero bound problem and the liquidity trap are separate phenomena. But there is one point worth highlighting. Robert talks of the central bank’s ability to create both money and monetary base (“…the central bank can conduct monetary policy as a strategy” etc.), and emphasizes the central bank’s responsibility for monetary policy and macroeconomic outcomes. I agree, but with a reservation. The point is that the government also can create money by borrowing from banks and using the loan proceeds to buy any asset from private sector non-banks. In fact, in the original version of the paper that has become essay 4 in Money in a Free Society I said that very expansionary open market operations (which involve the state buying assets from non-banks and what I call “debt market operations”) could only be carried out by the government.

That original version was sent by a friend to Milton Friedman for comment. Friedman came back with the devastating criticism that the central bank, too, could buy assets from non-banks and create money, and so my distinction between different types of open market operation was overstated. Robert—who I believe was taught by Friedman—is in much the same intellectual position, perhaps not surprisingly!

They both are right. The central bank can buy assets from non-banks and create money directly. Indeed, the operations that have become known as “quantitative easing” in the current cycle have been conducted by central banks, not governments. Nevertheless, I believe that government creation of money has the advantage that it would avoid the controversial ballooning of central bank balance sheets that we have seen in the last three years. (The subject is discussed on pages 76–81 of Money in a Free Society.) Again, this is a huge topic, of great contemporary importance to public policy in the United States and other leading economies.

Once again, may I thank everyone for their comments and criticisms?

Also from This Issue

Lead Essay

  • Dangerous Waffle about “the” Liquidity Trap by Tim Congdon

    Tim Congdon argues that John Maynard Keynes’ latter-day followers have badly misinterpreted the theorist they profess to follow. Led by Paul Krugman, Keynesians have claimed that a near-zero Federal Funds rate is indicative of a liquidity trap. This diagnosis has several problems. First, it is not what Keynes meant by the term; second, even a rate of zero percent does not exhaust monetary policy; and third, a genuine Keynesian liquidity trap has not happened and cannot plausibly happen, in part but not solely because Keynes assumed constant prices throughout the economy, a condition that is unlikely in the face of a rising money supply. Congdon commends to readers Milton Friedman’s monetary prescription: a gradually and predictably rising supply of money, not the wild swings we have seen in recent years.

Response Essays

  • Keynes and the Current Crisis by Dean Baker

    Dean Baker argues that Keynesians have not given up on monetary policy. Although the federal funds rate can’t go negative, the Federal Reserve can still set a higher inflation target, a solution both he and Paul Krugman endorse. Alongside monetary policy, Baker recommends fiscal policy: The recent economic stimulus legislation worked as intended, he argues, although the recession was more severe than the administration anticipated, and thus the stimulus proved to be too small. Policymakers have a duty to try to return the country to full employment, as the unemployed, who are suffering the most in the current crisis, are not to blame for their troubles.

  • Keynes, Friedman, and Higgs by Donald J. Boudreaux

    Don Boudreaux agrees with Congdon that a monetarist policy approach would be preferable, but he draws our attention to a third relevant consideration: regime uncertainty, as described by the economist Robert Higgs. When businesses are uncertain about the major economic decisions of governments and central banks, they will defer new investments and retain cash rather than hiring new workers. Neither monetarism nor Keynesianism does anything to address the problem, which Keynes himself conceded was real.

  • Tim Congdon on Liquidity Traps vs. Portfolio Rebalancing by Robert Hetzel

    Robert Hetzel reiterates that a zero lower bound for interest rates is a different phenomenon from a liquidity trap. The latter is an “irrelevant academic construct” as long as the central bank can create new money. Still, we learn little from this distinction unless we can determine the nature of the initial shock that caused pessimism among market participants; different types of shocks, monetary and real, call for different remedies. Central banks rarely use the analytical tools that would be necessary for them to evaluate their own roles in economically rigorous ways; instead, they tend to blame difficult times on the private sector, while taking credit for good ones.

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