Look past the labels
By Scott Sumner
Commenter CA directed me to a recent post by Roger Farmer:
We are stuck in a low inflation liquidity trap, caused by the fact that money and short term securities are currently perfect substitutes. The way out of the liquidity trap is to raise the interest rate; an argument that has been called neo-Fisherian in recent blog posts by Stephen Williamson and Noah Smith. Raising the interest rate however, and doing nothing else, will generate a recession; possibly a large and persistent recession. To prevent that from happening, the Treasury must engage in a simultaneous fiscal expansion. That fiscal expansion could be achieved through a money financed transfer to households; it could also be more efficiently achieved through a government guarantee to support asset prices.
At first glance this didn’t look very promising. Those who follow my writing on monetary policy know that I am not a fan of either Neo-Fisherism or any sort of Keynesianism. Farmer seems to be trying to combine the two.
It’s always important to look beyond labels, however, and on closer inspection Farmer’s views are quite close to mine—closer than that of almost any other non-market monetarist.
Let’s start with my views on Neo-Fisherism. I’ve noted that they do have a point—inflationary monetary policies are generally associated with higher interest rates, and vice versa. My criticism of Neo-Fisherians focused on their tendency to reason from a price change—to discuss the impact of an increase in interest rates, without first asking whether the change was generated by easier money or tighter money. After all, there are multiple ways to boost interest rates.
Farmer notices that simply raising rates would push the economy into recession. I interpret this as Farmer assuming that raising rates via a tight money policy would trigger a recession. And Farmer is correct on that point. We both think higher rates are needed, but only if generated by an expansionary policy mix.
What about Farmer’s call for fiscal stimulus? After all, I’m pretty outspoken in my opposition to fiscal stimulus. Here’s what he recommends:
Do not build roads and bridges as a temporary stimulus. A better way to prevent the recession that might otherwise occur when the Bank raises the Bank Rate would be an explicit commitment by the Financial Policy Committee of the Bank of England, to support the value of the stock market. This could be achieved by offering to buy or sell shares in an Exchange Traded Fund at a value linked to the performance of the unemployment rate.
Just to be clear, this is not my specific policy recommendation. Nonetheless, he’s thinking about the issue in much the same way as I do. Farmer recognizes that a healthy economy would have higher interest rates, but also that an attempt by the central bank to arbitrarily raise rates via a tight money policy would be contractionary. So he wants to combine higher rates with another policy, which boosts aggregate demand. And he doesn’t want that “fiscal stimulus” to consist of more government spending or tax cuts, instead preferring asset purchases. These would be used to target asset prices.
My view is that we can combine higher interest rates with a more expansionary monetary policy if we adopt a higher NGDP target and commit to do whatever it takes to achieve that target. While Farmer wants to target something like a stock market index, I prefer an alternative asset price, preferably NGDP futures. But if I can’t have NGDP futures, then targeting another asset price (exchange rates, commodity price index, stock price index, etc.) would be vastly superior to targeting interest rates.
There is no reliable relationship between interest rates and aggregate demand. We don’t even know whether higher interest rates would be associated with more demand, or less. In contrast, a policy that pushes up the price of NGDP futures, or the price of foreign exchange, or the S&P500, is very likely to be expansionary. Farmer recognizes that our current interest rate-oriented approach to policy has led us to a cul de sac. Promising low rates for the foreseeable future is seen by conventional Keynesians as an expansionary policy. Farmer and I recognize that it might just as well be interpreted by the markets as a promise to “become Japan.”
I’ve advocated a “whatever it takes” approach to monetary policy, combined with targeting the forecast. Thus the central bank buys as many assets as are required to boost NGDP growth expectations up to the target. You start with T-bonds, then if they are exhausted you switch to other safe assets such as AAA bonds, and if necessary you buy riskier assets such as common stocks. Where Farmer and I differ is that I don’t think it would ever be necessary to buy common stock, unless the NGDP growth target were set at a very low level. Farmer is more pessimistic about liquidity traps, and doesn’t think T-bond purchases alone would be enough to do the job.
To conclude, both Farmer and I agree on:
1. Targeting NGDP
2. Higher interest rates are likely to accompany a successful expansionary policy
3. Conventional fiscal policy is unwise
4. We both would prefer the government purchases assets, rather than build infrastructure, if this were needed to hit the target.
5. We both think of monetary policy in terms of targeting a price such as NGDP futures, commodity prices indices, forex prices, stock indices—not interest rates.
We differ on:
1. He calls central bank purchases of assets “fiscal policy”, while I call it monetary policy. That’s just a semantic difference.
2. He prefers to target stock price indices during a liquidity trap; I prefer NGDP futures prices.
3. He thinks the central bank would have to go beyond T-security purchases to escape a liquidity trap. I don’t think they would have to unless the NGDP target were set too low.
This is an example of two economists who travelled very different paths and ended up in almost the same place. Sometimes you need to look beyond the labels to understand what someone is actually proposing.