Not, mind you, that I think David is a better monetary economist than Mike Woodford--I do find I learn more from paying careful attention to Mike than to David. But I can't think of anybody else I reliably learn more from paying careful attention to…
Uneasy Money: In my previous post, I criticized Ben Bernanke’s speech last week at the annual symposium on monetary policy at Jackson Hole, Wyoming. It turns out that the big event at the symposium was not Bernanke’s speech but a 98-page paper by Michael Woodford, of Columbia University. Woodford’s paper was important, because he is widely considered the world’s top monetary theorist, and he endorsed the idea proposed by the intrepid, indefatigable and indispensable Scott Sumner that the Fed stop targeting inflation and instead target a steady growth path of nominal GDP. That endorsement constitutes a rather stunning turn of events in which Sumner’s idea (OK, Scott didn’t invent the idea, but he made a big deal out of it when nobody else was paying any attention) has gone from being a fringe idea to the newly emerging orthodoxy in monetary economics.
John Cochrane, however, is definitely not with the program…. I am going to challenge two assertions that Cochrane makes. These aren’t the only ones that could be challenged, but it’s getting late.
The first…. Cochrane is simply asserting that expected inflation cannot increase output and employment. The theoretical basis for that proposition is an argument, generally attributed to Milton Friedman and Edward Phelps but advanced by others before… a comparative statics result…. That comparative-statics exercise is fine, but it’s irrelevant to the situation we have been in since 2008. We are not starting from equilibrium; we are starting from a disequlibrium in which output and employment are well below their equilibrium levels [and interest rates are at their ZLB]…. The Friedman/Phelps argument tells us exactly nothing about that issue…. [T]here is also the clear historical evidence that in 1933 a sharp increase in the US price level, precipitated by FDR’s devaluation of the dollar, produced a spectacular increase in output and employment between April and July of 1933….
The second assertion made by Cochrane that I want to challenge is the following…. "Mike recognizes, as I do, that the Fed can do nothing more to raise nominal GDP today. Rates are at zero. The Fed has did [sic] what it could. The trend line was not achievable."
Nick Rowe, in his uniquely simple and elegant style, has identified the fallacy at work in Woodford’s and Cochrane’s view of monetary policy which views the short-term interest rate as the exclusive channel by which monetary policy can work. Thus, when you reach the zero lower bound, you (i.e., the central bank) have become impotent. That’s just wrong…. Rather than restate Nick’s argument, let me add some historical context. The discovery that the short-term interest rate set by the central bank is the primary tool of monetary policy was not made by Michael Woodford; it goes back to Henry Thornton… a commonplace of nineteenth-century monetary orthodoxy… the instrument by which the Bank of England could control the level of its gold reserves…. It was Knut Wicksell who, at the end of the nineteenth century, first advocated using the bank rate as a tool for controlling the price level and thus the business cycle…. Ralph Hawtrey… never wavered in his advocacy of the bank rate as a control mechanism, but even he acknowledged that could be circumstances under which reducing the bank rate might not be effective in stimulating the economy. Here’s how R. D. C. Black, in a biographical essay on Hawtrey, described Hawtrey’s position:
It was always a corollary of Hawtrey’s analysis that the economy, although lacking any automatic stabilizer, could nevertheless be effectively stabilized by the proper use of credit policy; it followed that fiscal policy in general and public works in particular constituted an unnecessary and inappropriate control mechanism. Yet Hawtrey was always prepared to admit that there could be circumstances in which no conceivable easing of credit would induce traders to borrow more and that in such a case government expenditure might be the only means of increasing employment.
This possibility of such a “credit deadlock” was admitted in all Hawtrey’s writings from Good and Bad Trade onwards, but treated as a most unlikely exceptional case. ln Capital and Emþloyment, however, he admitted “that unfortunately since 1930 it has come to plague the world, and has confronted us with problems which have threatened the fabric of civilisation with destruction.” So indeed it had… opinion… became increasingly convinced that the solution lay in the methods of stabilization by fiscal policy which followed from Keynes’s theories rather that in those of stabilization by credit policy which followed from Hawtrey’s.
However… Black observes that Hawtrey understood that monetary policy could be effective even in a credit deadlock….
Hawtrey was inclined to be sympathetic when Roosevelt adopted the so-called “Warren plan” and raised the domestic price of gold…. Hawtrey now envisaged exchange depreciation as the only way in which a country like the United States could “break the credit deadlock by making some branches of economic activity remunerative.” Not unnaturally there were those, like Per Jacobsson of the Bank for International Settlements, who found it hard to reconcile this apparent enthusiasm for exchange depreciation with Hawtrey’s previous support for international stabilization schemes. To them his repiy was “the difference between what I now advocate and the programme of monetary stability is the difference between measures for treating a disease and measures for maintaining health when re-established. It is no use trying to stabilise a price ievel which leaves industry under-employed and working at a loss and makes half the debtors bankrupt.”…
Cochrane asserts that the Fed has no power to raise nominal income. Does he believe that the Fed is unable to depreciate the dollar relative to other currencies?… [D]oes he believe that the Fed is less able to control the exchange rate of the dollar in relation to, say, the euro than the Swiss National Bank is able to control the value of the Swiss franc in relation to the euro? Just by coincidence, I wrote about the Swiss National Bank exactly one year ago in a post I called “The Swiss Naitonal Bank Teaches Us a Lesson.” The Swiss National Bank, faced with a huge demand for Swiss francs, was in imminent danger of presiding over a disastrous deflation…. The Swiss National Bank could not fight deflation by cutting its bank rate, so it announced that it would sell unlimited quantities of Swiss francs at an exchange rate of 1.20 francs per euro, thereby preventing the Swiss franc from appreciating against the euro, and preventing domestic deflation in Switzerland. The action confounded those who claimed that the Swiss National Bank was powerless to prevent the franc from appreciating against the euro.
If the Fed wants domestic prices to rise, it can debauch the dollar by selling unlimited quantities of dollars in exchange for other currencies at exchange rates below their current levels. This worked for the US under FDR in 1933, and it worked for the Swiss National Bank in 2011. It has worked countless times for other central banks. Why at I would like to know is why Cochrane thinks that today’s Fed is less capable of debauching the currency today than FDR was in 1933 or the Swiss National Bank was in 2011?