Black Hole Monetary Economics

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Cullen Roche
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Economic nerds are converging on Jackson Hole for their (our?) annual meeting and the big story of the event will be a controversial opinion by Larry Summers, which he laid out on Twitter yesterday. He is presenting a paper in which he argues [gasp] that monetary policy isn’t as effective as the economics profession has been led to believe. This is nothing new to readers of this site and anyone sympathetic to Post-Keynesian economics. I had publicly argued with Paul Krugman about this topic for years and it now looks like they’re coming around. So Summers is on the right track and massively validating an important Post-Keynesian position, but I want to dive a little deeper here because he isn’t going far enough in my opinion. This one’s going to be long, boring and nerdy so you might want to turn back now if you’re not ready. 

A little background first. New Keynesians (basically, the new-ish blend of economists who are sympathetic to Monetary Policy and Fiscal Policy) like Paul Krugman and Larry Summers have argued that we needed more fiscal policy because we were in a period of a “liquidity trap” or “secular stagnation”. The basic view is that the “natural rate of interest” is low and Fed policy can’t target such a deeply negative rate in an effective manner. So standard Fed policy wasn’t going to work. Instead, you needed something unusual, or, as Krugman famously noted, you needed the Central Bank to “credibly promise to be irresponsible”. In other words, you needed QE and other big bazookas from the Central Bank. So, despite emphasizing the need for Fiscal Policy, economists like Krugman and Summers never really swayed from their belief that the Central Bank could gain traction if they just tried hard enough.

Of course, they were right. For the wrong reasons. Yes, the model still led them to recommend Fiscal Policy, but with a hefty dollop of misguided faith in Monetary Policy (MonPol). Regular readers will remember that I made the same case for for Fiscal Policy for years, but my argument has always been different – monetary policy doesn’t work the way many mainstream economists believed and in fact, always works less efficiently than most believe. This wasn’t something temporary. It wasn’t true because of Secular Stagnation or Liquidity Traps. MonPol has always been a poor recession fighting tool because it lacks the operational transmission mechanism to strongly influence the economy. 

To be clear, my view on Monetary Policy is simple – interest rate changes are an extremely imprecise way to manage the economy and the Fed is constrained by specific laws that limit what it can and cannot purchase when it implements QE. So modern Fed policy is essentially limited to discretionary changes in interest rates and swapping high quality assets with high quality assets via QE. These policies have tangential transmission mechanisms, but are imprecise tools. This makes Monetary Policy a very limited stimulus tool. On the other hand, Monetary Policy is a very effective austerity tool as high interest rates and negative interest rates can essentially suffocate a banking system when implemented in the proper environment. So, I guess you could say that I view MonPol as a poor recession fighting tool and a more effective inflation fighting tool. Importantly, this isn’t a temporary thing. It just so happens that the GFC exposed it as the permanent reality.

Why does it matter? I can hear some people saying that none of this really matters. After all, if Krugman, Summers and I all agree that fiscal policy is the right tool moving forward then why can’t we all just agree and move on? Here’s why:

Summers and Krugman use predominantly Wicksellian models (no, not Keynesian models) that are highly sympathetic to using Monetary Policy as the primary tool for enacting change. They call themselves “New Keynesians”, but New Keynesians are, for practical purposes, New Monetarists, with a model that emphasizes the power of MonPol and only uses Fiscal in unusual situations. This is why, when a recession happens, the most influential policy analysts talk about the Fed first. And it is why, even economists like Krugman were saying that Fed policy can still work 7 years after the GFC. Economists have constructed models that portray the Fed as the first line of defense. This is really important because the next time we have a recession we’re going to go through the usual motions because too many influential people still think QE and Fed policy does things that it doesn’t. 

So, when a recession happens again, here is what will happen:

1. We’ll cut rates to 0%.
2. We might even cut rates negative.
3. We will implement more QE.
4. We might even try to some stuff like NGDP Targeting.
5. People will say the Fed isn’t trying hard enough or, as Krugman says, they aren’t being credibly irresponsible enough.
6. Then, when millions of people have lost their jobs we’ll try some fiscal policy.

This is basically what happened during the GFC and it’s how the playbook will work going forward because people still have a hugely misguided faith in MonPol. And people like Krugman and Summers enable this type of thinking by misunderstanding the transmission mechanism and saying that they now “doubt” that MonPol is effective. No, we need to be more emphatic and work from a more operational perspective. Put down the silly models and let’s talk about the actual operational transmission mechanisms here. And the fact is, people like myself, who explained how QE works at an operational level back in 2009, AND also said it wouldn’t do anything, were massively right. And it was consistently clear that the most influential thinkers in economics didn’t understand the transmission mechanism because their model is a Wicksellian or Monetarist version of something that doesn’t reflect reality.

What should be done specifically? Don’t get me wrong. I am not a big fan of discretionary fiscal policy. Much like my financial models, I am a big believer in systematic countercyclical policies. If I had my way and could influence policymakers I would do something like this:

1. Emphasize the fact that MonPol does not work as a recession fighting tool. No, this isn’t temporary and this isn’t some “new normal”. This has always been true. So we need to structure our policies so that they’re less dependent on the Central Bank’s discretionary tinkering with interest rates and QE. The Fed also doesn’t have the tools to be “credibly irresponsible” so Krugman’s entire model is based on a misguided faith in what the Fed can actually do.
2. We should create automatic stabilizers that are even more countercyclical than they currently are. Potential options would be a capital gains and payroll tax that is countercyclical. For instance, you could have a payroll tax that ebbs and flows over time. If economic growth slows to 1% then the payroll tax slows to 1%. If it is 0% then the payroll tax is eliminated. If growth is negative then the payroll tax becomes a payroll subsidy. You get the point.

This sort of policy would be much more effective than relying on the discretionary decisions of the Federal Reserve, or worse, waiting for Congress to realize that things are so bad that they need to do something when it’s already too late. Krugman and Summers are on the right track. But they haven’t gone far enough.