Bernanke on monetary offset and monetary policy impotence
By Scott Sumner
Commenter Bill directed me to an interesting Ben Bernanke post:
As a general matter, Fed policymakers view economic or policy developments through the prism of their economic forecast. Developments that push the forecasted path of the economy away from the Fed’s employment and inflation objectives require a compensating policy response; other changes do not. Consequently, to assess the appropriate monetary response to a new fiscal program, Fed policymakers first have to evaluate the likely effects of that program on the economy over the next couple of years.
Bernanke then correctly distinguished between the AD and AS impacts of fiscal policy:
Fiscal policy influences the economy through many channels. The econometric models used at the Fed for constructing forecasts tend to summarize fiscal effects in terms of changes in aggregate demand or aggregate supply. For example, a rise in spending on public infrastructure, or a tax cut that prompts consumers to spend more, increases demand. Fiscal policies also affect aggregate supply, for example, through the incentives provided by the tax code.
But he goes a bit off course in talking about monetary policy impotence:
The effects of a fiscal program also depend on the state of the economy when the program is put in place. When I was Fed chair, I argued on a number of occasions against fiscal austerity (tax increases, spending cuts). The economy at the time was suffering from high unemployment, and with monetary policy operating close to its limits, I pushed (unsuccessfully) for fiscal policies to increase aggregate demand and job creation. Today, with the economy approaching full employment, the need for demand-side stimulus, while perhaps not entirely gone, is surely much less than it was three or four years ago. There is still a case for fiscal policy action today, but to increase output without unduly increasing inflation the focus should be on improving productivity and aggregate supply–for example, through improved public infrastructure that makes our economy more efficient or tax reforms that promote private capital investment.
He’s right that the fiscal authorities should focus on supply-side policies. But he’s wrong about monetary policy being close to its limits when he was Fed chair, and I don’t think he even believes that. Rather, what I think Bernanke meant to say is that monetary policy was near the limits that were acceptable to a majority of the FOMC, a very different proposition. And I don’t think even that weaker claim was true. The Fed did monetary stimulus in late 2012 in order to offset expected fiscal austerity, which reduced the budget deficit from roughly $1,050 billion in calendar 2012 to about $550 billion in calendar 2013. The Fed was pessimistic about the impact of the fiscal austerity, and doubted that monetary policy would fully offset the effects. But it did offset, and then some–growth actually sped up between the 4th quarter of 2012 and the 4th quarter of 2013.
You might think it’s kind of arrogant of me to suggest that I know that Bernanke misspoke, that he didn’t actually believe that monetary policy was near its limits, and instead meant something else. I suppose I did so because monetary policy was clearly not near its limits, and Bernanke is a smart guy, so presumably he knows this. But how do I know it wasn’t near its limits? Here’s a simple explanation:
Contrary to the claims of at least some Japanese central bankers, monetary policy is far from impotent today in Japan. In this section I will discuss some options that the monetary authorities have to stimulate the economy. Overall, my claim has two parts: First, that— despite the apparent liquidity trap—monetary policymakers retain the power to increase nominal aggregate demand and the price level. Second, that increased nominal spending and rising prices will lead to increases in real economic activity. The second of these propositions is empirical but seems to me overwhelmingly plausible; I have already provided some support for it in the discussion of the previous section. The first part of my claim will be, I believe, the more contentious one, and it is on that part that the rest of the paper will focus. However, in my view one can make what amounts to an arbitrage argument —the most convincing type of argument in an economic context—that it must be true.
The general argument that the monetary authorities can increase aggregate demand and prices, even if the nominal interest rate is zero, is as follows: Money, unlike other forms of government debt, pays zero interest and has infinite maturity. The monetary authorities can issue as much money as they like. Hence, if the price level were truly independent of money issuance, then the monetary authorities could use the money they create to acquire indefinite quantities of goods and assets. This is manifestly impossible in equilibrium. Therefore money issuance must ultimately raise the price level, even if nominal interest rates are bounded at zero. This is an elementary argument, but, as we will see, it is quite corrosive of claims of monetary impotence.
OK, that argument shows that monetary policy has no meaningful limits. But what makes me think that Bernanke is aware of this argument? Because he wrote it.
Another argument is that while the Fed could theoretically create more AD by buying up all the assets in the world, there are institutional barriers to it doing so. I have a counterargument to that as well:
Most of my arguments will not be new to the policy board and staff of the BOJ, which of course has discussed these questions extensively. However, their responses, when not confused or inconsistent, have generally relied on various technical or legal objections—objections which, I will argue, could be overcome if the will to do so existed.
Or how about this:
Japan is not in a Great Depression by any means, but its economy has operated below potential for nearly a decade. Nor is it by any means clear that recovery is imminent. Policy options exist that could greatly reduce these losses. Why isn’t more happening? To this outsider, at least, Japanese monetary policy seems paralyzed, with a paralysis that is largely self-induced. Most striking is the apparent unwillingness of the monetary authorities to experiment, to try anything that isn’t absolutely guaranteed to work. Perhaps it’s time for some Rooseveltian resolve in Japan.
PS. Instead of saying, “acquire indefinite quantities of goods and assets”, I wish Bernanke had written, “acquire indefinite quantities of assets”. That latter phrasing would obviously be an equally compelling reductio ad absurdum argument, and it would avoid confusion with fiscal policy.