America's Historical Experience with Low Inflation: Hoisted from 1999

Apropos of Helicopter Money: Barclays Debate with Robert Barro, Moderated by David Wessel: Hoisted from the Archives from Fall 2011

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2011-09-24: DRAFT OPENING: Barclays Debate with Robert Barro, Moderated by David Wessel:

Question: If President Obama invited you into the Oval Office, told you that he recognized that the economic policies he has pursued to date haven't had the desired outcome, and gave you five minutes to tell him what in your opinion he should do now (setting aside whether Congress would go along)?

DELONG: I would say: Mr. President: When you took office, you quickly became convinced for some reason that we were going to see a rapid, "V"-shaped recovery. Hence you took your task to be (a) stopping the panic, (b) recapitalizing the banking system, and (c) filling in a good chunk of the demand gap with the Recovery Act. Then, you thought, the task of macroeconomic stabilization would be finished. And so you turned your attention to (i) health care reform, (ii) financial regulation, (iii) long-run budget balance, and other issues.

This was wrong. We do not have a "V" but rather an "L". Our expectations that the market was strong enough to return the economy to its long-run full-employment configuration within a couple of years--perhaps with assistance from the Federal Reserve--was wrong. The short run of slack aggregate demand, high unemployment, and low capacity utilization looks as though it will last not two to three years after the downturn begin but five to ten years--or more.

What to do? If Milton Friedman were here to advise you, he would give the same advice he gave Japan in the 1990s: Have the Federal Reserve buy bonds for cash. Have it keep buying bonds for cash until total nominal spending in the economy is on a satisfactory trajectory. Announce that it is going to keep buying bonds for cash until total nominal spending is on a satisfactory trajectory.

Milton Friedman's teacher, the ur-monetarist Jacob Viner, had a somewhat different take. Viner worried that when--as now--interest rates are very low, people have no incentive to spend their cash. And when you take bonds out of circulation you reduce the supply and further lower interest rates further. Viner sought a way to boost the money stock without pushing interest rates down further. He recommended coordinated monetary and fiscal expansion: the Federal Reserve buys bonds for cash, and the Treasury than issues bonds and spends, in order to (a) expond the money supply, (b) directly put people to work and © keep falling interest rates from further depressing monetary velocity and so crowding out the beneficial effects of monetary expansion.

Both Friedman and Viner would, right now, say that the problem is that their policy recommendations have not been tried on a large enough scale commensurate with the seriousness of the problem.

I concur.

And when will it be time to think about long-term budget balance? As I believe my colleague Christina Romer used to tell you every single week: the bond market and the inflation rate will tell you when it is time to turn to dealing with long-term budget balance. They are certainly not telling you to do so now.


And from the Notes of the Debate: A Cleaned-Up Version of What I Said:

Brad DeLong: If we are talking long-run, I would say that there is considerable agreement about what the long-run configuration of government policy should be. Cutting back on the tax-free status of fringe benefits--that is definitely there in what Obama has done with the tax on high-cost "Cadillac" health plan in the Affordable Care Act. People who keep their ear to the ground hear a lot of people in and out of the administration liking the Bowles-Simpson commission’s recommendations, and hear a lot of people liking the idea of a progressive consumption tax as a way to balance revenues an the long-run funding costs of social insurance.

But if I were to talk to Obama, I would say: "Mr. President, now is not the time to focus on the long-run here. There is an important short-run long-run distinction, and the short-run problems are the urgent ones.

"When you took office, you were convinced that there was going to be a rapid V-shaped recovery. Hence you took your tasks to be (i) the recapitalization of the banking system, (ii) filling a good chunk of the demand gap with the Recovery Act, and then (iii) your attention to Robert Barro issues--healthcare reform, long run budget balance, financial regulation, et cetera. In retrospect this was wrong. We don’t have a V. We have an L. The expectation that the market was strong enough to return the economy to more or less full employment within a couple of years was wrong.

The short run, during which the economy is depressed and unemployment is high now looks to be not two or three years but rather five to ten years, and we hope it isn't longer. What you should do about this long-lasting short-run business-cycle problem? If Milton Friedman were here, he would give the same advice to the U.S. today that he gave to Japan in the 1990s: Have the Federal Reserve buy bonds for cash. Have the Federal Reserve keep buying bonds for cash until total nominal spending in the economy is on a satisfactory trajectory. And tell everybody that the Federal Reserve will keep buying bonds for cash until total nominal spending is where it wants it to be in order to get everyone involved in stabilizing speculation betting that the Fed will carry out this policy.

Now that is just one recommendation. Back during the Great Depression Milton Friedman's teacher Jacob Viner worried that when interest rates are very very low people have little incentive to spend their cash. When the Federal Reerve buys bonds for cash, it increases the supply of cash but it takes bonds out of circulation. This reduction in the supply of bonds further lowers interest rates--and further depresses the incentive to spend cash. Thus normal expansionary monetary policy may fail. Viner worried that falling interest rates would crowd out the usual effects of monetary expansion.

Viner thus recommended both expansionary monetary policy and expansionary fiscal policy. The Federal Reserve buys bonds for cash. The Treasury then issues bonds and spends the money hiring people to work on government projects. Since the supply of bonds does not fall, interest rates do not fall. So monetary expansion would have its normal expansionary effects.

The right answer to the question--monetary or fiscal stimulus?--is: both.

Then Obama would ask me: "When will it be the time to worry about long -un budget deficits and all of Robert Barro's other issues, like the financing of the social insurance state and marginal taxes and so forth?" I would give the answer that I think Christie Romer gave Obama very single week of the first year and a half of his administration: "The bond market and the inflation rate will tell you when it is time to deal with long-run issues. And they are certainly not telling you to deal with them now."...

Brad: I have a slide that I want to put up now. It explains, I think, why Robert Barro is living in a much happier world than I am.

Robert Barro thinks that there is great uncertainty about the government budget and about government regulatory policy. And he believes that is the reason that the economy is still depressed. But if uncertainty about the government budget were the cause of our current depression, it would have started back in 2003.

In the early 1990s, the Clinton administration dealt with the Reagan deficits--over the unanimous objections of every single Republican member of congress. By the end of the 1990s the Clinton administration had balanced the budget. But by 2003 it became very clear that the Bush administration was intent on undoing as much as it could of the work of the Clinton administration. It became clear that Bush had no plans at all for cutting back federal spending to finance his tax cuts. It became clear that Bush had no plans at all to find any resources to pay for his expansion of Medicare, Medicare Part D.

Thus in 2003 we went from a world in which the long-run federal budget was on a sustainable track--a world that those of us who worked in the Clinton administration had sweated blood to create--to our current world, in which the U.S. debt to GDP ratio is on an explosive long-run trajectory and in which everything about the long-run federal budget is up for grabs. Right now we do not know whether in 25 years federal spending is going to be 20 or 30% GDP, we do not know what taxes are going to be levied to pay for that spending, and we do not even know whether we might default on the debt or inflate it away in a generation.

We have enormous long-run budgetary uncertainty.

This long-run budgetary uncertainty was created suddenly and discontinuously in 2003.

But our current deep economic downturn did not start in 2003, 2004, 2005, 2006, or 2007.

Our current deep economic downturn started with the collapse of housing followed by the Wall Street financial crisis of 2008. And our current deep recession does not continue because businesses are terrified of the future and so have cut back massively on equipment investment spending. Businesses are being reasonably aggressive at investing for the future. What is way down at the bottom is investment in residential construction. That is not a pattern that you would see if the big increase in budgetary uncertainty were the thing that drove the economy down and is keeping it down.

Now don’t get me wrong: If I had been running the Obama administration, I would on January 21, 2009 have promised to veto every bill that did not reduce the projected national debt in 2020. I would have required that every single initiative must be fully paid for within ten years in order for the administration to even consider it. I would have made it a governing principle that the Obama administration was not interested in increasing the long-run budgetary uncertainty created by George W Bush and his tame and craven supporters.

And I would have announced that as soon as the short-term crisis of our current Lesser Depression was over--as soon as the unemployment rate was back down to 6%--as soon as housing was back to normal and people had stopped doubling-up and living in their sisters' basements because they were scared they could not get or would lose their jobs--we would turn to balancing long-run spending and taxes.

But dealing with long-run budget uncertainty that is not the cause of our current Lesser Depression will not cure it....

Brad: I did not say that uncertainty in general rose to its current level in 2003. I said uncertainty about the long-run government budget took a big upward jump in 2003.

Late 2009 sees an enormous increase in regulatory uncertainty as the Republican Party goes into opposition and declares that the healthcare reform ideas created by the Heritage Foundation and underlying RomneyCare are, in fact, Kenyan and socialistic and have to be opposed root-and-branch. That was an enormous increase in regulatory uncertainty. That came in late 2009. That was not the cause of our current Lesser Depression.

The uncertainty that is a major contributing cause to our current Lesser Depression came in 2008. One piece of it is uncertainty about whether the major money center bank you loaned your money to tonight will fail--that they will not open tomorrow. Another piece of it is uncertainty about what the level of aggregate demand is likely to be one, two, three years down the road. A third is uncertainty about whether the German government will bail out the government of Greece and the banks of Spain so they can pay back the banks of Germany so they can pay back their German depositors--or whether the German government will short-circuit the process and simply bail out the banks of Germany so they can pay back their depositors, leaving southern Europe to twist slowly in the wind.

These are the important kinds of uncertainty that are helping to cause our current Lesser Depression.

These are not kinds of uncertainty that are diminished by enacting Robert Barro’s progressive consumption tax, or by further reforming the U.S. healthcare financing system.

When I said that Barro was more optimistic than me, it was because I hear him saying that if only we could get back to the world of 2000--with projected spending levels and tax rates that Bill Clinton left us with, in which the long-run financial future of the U.S. government was secure and we had not made big Medicare Part D promises we have no idea how to fulfill--then the current Lesser Depression would rapidly end.

I would love to see us return to late Clinton policies. I do not believe that if we did so tomorrow it would rapidly cure our current depression. And I hear Robert Barro saying that it would....

Brad DeLong: Let me say that right now we have now have a rare point of agreement between Robert Barro and Paul Krugman. Paul is also highly highly skeptical of quantitative easing. Paul also fears that is is simply swapping one zero-yield government asset for another. Paul also cannot see why this should make a difference. After all, at the margin all you are doing is taking a very small amount of the risk out there onto the government’s balance sheet. It is hard to argue that that would have major effects....

Brad DeLong: Right now there is tremendous demand for long-term nominal U.S. government Treasury bonds, even though there is enormous uncertainty over how the government is going to tax in order to finance the social insurance state. Yet everyone is confident that in the long run the government is going to tax to pay its bills, and that inflation is going to remain low. Maybe the United States is the world’s tallest midget. But it’s a damn tall midget....

Brad DeLong: We really do not know what the effects of quantitative easing and other non-standard monetary policies will be. We haven’t been here before--except in the 1930s and in Japan in the 1990s. All we know is that whatever policies were tried back in the 1930s and in Japan in the 1990s did not work very well. We do not know if alternate policies will.

I think that the right way I think about it is maybe to go all the way back to the cutting edge of the maroeconomics of 1829. Start with John Stuart Mill, the very first economist to say: "Whenever we see high unemployment, it is not the case that we are producing too much. The problem is we don’t have enough financial assets for people to hold to make them happy with their portfolios. Thus everyone is cutting back on spending to try to build up their financial asset balances. And once they have done so they will once again start spending an amount equal to their incomes, and then by the circular flow principle we will quickly get back to full employment."

It has turned out that there are three ways in which people, historically, have been unhappy with their portfolios:

  1. The standard monetarist problem we saw in 1982 was a liquidity squeeze that left everyone desperate for cash. That produced very high nominal interest rates all along the duration and risk yield curve as everyone short of cash dumped their other financial assets as well as spent less than they were earning to try to build up their cash balances.

  2. The standard Keynesian problem we saw in 2001 was that $4 trillion of dot-com wealth had vanished so everybody wanted to hold more saving vehicles--and so people started using the money they ordinarily use for transactions as a savings vehicle instead. That produced very low nominal interest rates all along the duration and risk yield curve.

  3. Today we see that the prices of all risky assets are very low--especially the bonds of the Greek government. But safe assets are, as Robert says, selling at extremely high prices. Households and businesses are cutting back their spending because they don’t think they have enough safe assets in their portfolios.

When you have a depression because the market is short of safe assets, the natural thing to do to cure it is to create the safe assets the market wants to hold. Who can do that? That the public certainly doesn’t trust banks like Barclays to create safe assets right now. The investment banks tried that with mortgage-backed securities. That did not turn out so well....

Brad DeLong: The fear is that if we raise the inflation target from one percent to four percent right now, then the next administration will probably raise it from four to seven, and then from seven to ten, and then 1979 is back again....

Brad DeLong: This crisis had its origins in late 2007, when it became clear that U..S had built two million extra houses, largely in the desert between Los Angeles and Albuquerque. It became clear that there was $500 billion of mortgage debt that was not going to be repaid. And that shouldn’t have been a problem: in a world economy of $80 trillion dollars of GDP each year, in a world where that 500 billion of tax or mortgage debt have been explicitly financed by originate-and-distribute securitization to chop up and lay off this risk to the global investor community rather than keep it in money-center banks, the 500 billion shouldn’t cause day problems.

But then we learn than an awful lot of Ireland and Irish and money center banks were still holding on to a huge amount of risk. And we learn that the capital of nearly every single major financial institution was significantly impaired if not totally gone. And then it went from there to Bear Sterns, in which the Federal Reserve wipes out the equity and option holders of the bank and subsidizes Jamie Dimon and JP Morgan to the tune of up to $30 billion to bail themselves in. After which there is then five months of beating up on Henry Paulson and Ben Bernanke for enabling more risk--for rescuing things that shouldn’t have been rescued, for creating a "we bet, and if we win we win, and if we lose we lose the government pays" state of mind. And Paulson and Bernanke respond to this six months of verbal abuse in the fall of 2008 by saying: "Okay. Well, now, as Lehman Brothers hits the wall we are going to let it default--we are not going to guarantee the creditors of Lehman brothers. See how much you like the market reaction too that!" And then--they thought--their critics would be chastened, and they would regain their freedom of maneuver to conduct proper lender-of-last-resort policy. The problem was that they misjudged how bad the market reaction would be. That decision to let Lehman fails was a complete and total disaster.

We should learn from that.

We should learn that, as Charlie Kindleberger said: In order to have a well-functioning system, everybody must always doubt that the lender of last resort exists before the financial crisis, but everybody must always be extremely confident that the lender of last resort is there in the financial crisis. This is a very neat trick to pull off--very hard to do. But the Federal Reserve via Bear Stearns and Lehman Brothers came close to pulling off the opposite.

There are always need to be people like Robert Barro saying: the right strategy is to let Greece default, and Spain, Portugal, Ireland--and maybe Italy too. Let the consequences of bad actions and overleverage rest upon the bad actors, lest you encourage more overleverage and more moral hazard in the future. But, as Charlie said and as I think Lehman Brothers strongly reinforces this lesson, when the financial crisis does come, if it’s bad and systemic enough, the lender of last resort has to show up. If you ask Charlie how you can reconcile these two he would shrug his shoulders....

Brad DeLong: What should the Europeans do tomorrow? Inflate. Move their long run price level target for the Eurozone as a whole up from its current zero to 1% up to say three to four percent. Explicitly say that we have a continent in which different regions are at very different levels of economic development, and that as a result we aren’t going to be able to maintain anything like Eurozone-wide price stability, and that we are going to aim for a long run inflation rate of 2% in the north west European core, which means 4% in the Eurozone as a whole and up to 6% in the periphery which ought to be undergoing a real appreciation over the long run as it develops.

Do that, and hope that Robert is wrong when Robert says that this will permanently de-anchor inflation expectations, and that you won’t then be able to hold the line at two percent inflation in the Northwest European industrialized core. The purpose of that is to get a slow real partial default so that the bankers don’t have to recognize it on their accounting immediately and can pretend that it isn’t happen until it is. This is how Carmen Reinhart says we solved the end of WWII debt-overhang problem, and Carmen Reinhardt is smart

Brad DeLong: Is the UK on a good governance or bad governance trajectory? Well, will they let the pound go down? Fiscal austerity in response to a recession and to great uncertainty about the long run financing of a government can be an appropriate policy response, but if and only if you are willing to let the value of your currency go where it needs to go so that you can shift activities out of government and into exports and so stay relatively close to full employment--and that means let the value of the currency go way down.

Usually you only want to do this when the bond market is telling you that it is really worried about the long run solvency of the government--when raising today's government spending raises long-term interest rates by so much that you have massive crowding out and fiscal expansion has no traction. Then the depreciation-and-exports channel is the only way to try to stabilize aggregate demand near full employment.

The bond market hasn’t been telling us in the case of Britain.

But if Cameron really wants too, even though the bond market isn’t telling him he must do so, well he won the election--or, rather, Nick Clegg and the Liberal Democrats hate Labour more than they hate him, and so have sent him to the Queen to kiss hands. In this case, however, Cameron very much needs to have the appropriate monetary and exchange rate policies: a weak pound, a very weak pound--that is what is in Britain’s interest, if the entire policy configuration is to make any kind of sense....

Brad DeLong: The first part of your question concerns Robert Barro's point--what Paul Krugman has been saying for 15 years--that when nominal interest rates hit zero conventional monetary policy is simply swapping one zero yield short term government asset for another and you wouldn’t expect anything from it. You should, rather, expect changes in the velocity of money to offset changes in the money supply more or less one for one. Here I would indeed go back to John Hicks and Jacob Viner: For monetary policy to have traction, you have to stuff people's portfolios with enough bonds so that even when you expand the money supply short term nominal interest stay well above zero so people then have an incentive to spend their cash. That is why Jacob Viner back in 1993 ws asking not for monetary policy but for fiscal policy as well. You expand money supply, but also you expand the amount of bonds that the government can issue that people had to hold on their portfolios....


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