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June 11, 2009

Economist's View - 3 new articles

"Price Stability and the Monetary Base"

The Atlanta Fed's David Altig takes issue with Arthur Laffer. This is another way of saying that money sitting in banks as excess reserves is not inflationary:

Price stability and the monetary base, by David Altig: Arthur Laffer, as several readers (and friends) have pointed out to me, is taking aim at the Fed:

"… as bad as the fiscal picture is, panic-driven monetary policies portend to have even more dire consequences. We can expect rapidly rising prices and much, much higher interest rates over the next four or five years, and a concomitant deleterious impact on output and employment not unlike the late 1970s.

"About eight months ago, starting in early September 2008, the Bernanke Fed ... radically increased the monetary base—which is comprised of currency in circulation, member bank reserves held at the Fed, and vault cash—by a little less than $1 trillion. The Fed controls the monetary base 100%..."

...The increase in the U.S. monetary base has indeed been something to behold, and the Laffer article gives a good explanation about why you might be worried about that:

"Bank reserves are crucially important because they are the foundation upon which banks are able to expand their liabilities and thereby increase the quantity of money.

"...Banks now have huge amounts of excess reserves, enabling them to make lots of net new loans…

"At present, banks are doing just what we would expect them to do. They are making new loans and increasing overall bank liabilities (i.e., money). The 12-month growth rate of M1 is now in the 15% range, and close to its highest level in the past half century."

OK, but in my opinion it is a bit of a stretch—so far, at least—to correlate monetary base growth with bank loan growth:

Let's call that more than a bit of a stretch.

The Laffer argument is in large part about what the future will bring. But we know that the payment of interest on bank reserves—which we have discussed in this forum many times (here and here, for example)—means a higher demand for reserves in the future than in the past. This change, of course, means that levels of the monetary base that would have seemed scary in the past will become the new normal. How big can the "new normal" be? That's a good question, and one I will continue to contemplate. But the assertion in the Laffer article that "a major contraction in monetary base" is required cannot be supported by either current evidence or simple economic theory.

There is, however, more. Whatever policy choices are required to deliver a noninflationary environment going forward, Mr. Laffer seems convinced that the central bank is not up to making them:

"Alas, I doubt very much that the Fed will do what is necessary to guard against future inflation and higher interest rates. If the Fed were to reduce the monetary base by $1 trillion, it would need to sell a net $1 trillion in bonds. This would put the Fed in direct competition with Treasury's planned issuance of about $2 trillion worth of bonds over the coming 12 months. Failed auctions would become the norm and bond prices would tumble, reflecting a massive oversupply of government bonds."

On this I will just turn to my boss, Atlanta Fed President Dennis Lockhart, who addressed this very issue in a speech given today at the National Association of Securities Professionals Annual Pension and Financial Services Conference in Atlanta:

"The concerns about our economic path are crystallized in doubts expressed in some quarters about the Federal Reserve's ability to fulfill its obligation to deliver low and stable inflation in the face of very large current and prospective federal deficits. In a word, the concerns are about monetization of the resulting federal debt.

"I do not dismiss these concerns out of hand. I also recognize that the task of pursuing the Fed's dual mandate of price stability and sustainable growth will be greatly complicated should deliberate and timely action to address our fiscal imbalances fail to materialize. But I have full confidence in the Federal Reserve's ability and resolve to meet its inflation objectives in whatever environment presents itself. Of the many risks the U.S. and global economies still confront, I firmly believe the Fed losing sight of its inflation objectives is not among them."

'Nuff said, for now.


The Return of the Great Debt Scare

Robert Reich is worried that the "Great Debt Scare" will lead to a repeat of the Clinton administration's abandonment of its investment agenda due to concerns over the deficit:

The Great Debt Scare: Why Has It Returned?, by Robert Reich: It's the kind of thing I expect to hear from deficit hawks and chicken littles -- from the self-described "fiscally responsible" right, from the scolds Ross Perot and Pete Peterson, from my former cabinet colleague Bob Rubin. But yesterday I was shown slides developed by the putatively liberal Center for American Progress intended to make the point. And today's front page story in the New York Times, by the eminent David Leonhardt, entitled "Sea of Red Ink: How It Spread From A Puddle," puts the issue right before our progressive noses, so to speak.

The Great Debt Scare is back.

Odd that it would return right now, when the economy is still mired in the worst depression since the Great one. ...

Odder still that the Debt Scare returns at the precise moment that bills are emerging from Congress on universal health care, which, by almost everyone's reckoning, will not increase the long-term debt one bit because universal health care has to be paid for in the budget. In fact, universal health care will reduce the deficit and cumulative debt -- especially if it includes a public option capable of negotiating lower costs from drug makers, doctors, and insurers, and thereby reducing the future costs of Medicare and Medicaid.

Even odder that the Debt Scare rears its frightening head just as the President's stimulus is moving into high gear with more spending on infrastructure. Every expert who has looked closely at the nation's crumbling infrastructure knows how badly it suffers from decades of deferred maintenance... These public investments are as important to the nation's future as are private investments.

First, some background: Deficit and debt numbers ... take on meaning only in relation to ... the size of the national economy..., in particular, to the debt/GDP ratio. True, that ratio is heading in the wrong direction right now. It may reach 70 percent by the end of 2010. That's high, but it's not high compared to the 120 percent it was in 1946, after the ravages of Depression and war.

Over time, the basic way America has reduced the debt/GDP ratio is by growing the U.S. economy. GDP growth makes even large debts manageable. When the economy is cooking, more people have jobs and better wages. So they pay more taxes. And they require less unemployment assistance and other social insurance. That's why it's so important now, in the depths of depression, that government, as purchaser of last resort, steps in and runs large deficits. Without large deficits this year and next, and perhaps the year after, the economy doesn't have a prayer of getting back on a growth path, and the debt/GDP ratio could really get ugly. ...

In this respect, national budgets are like family budgets. It's dumb for an indebted family to borrow more money to take a world cruise. But it's smart even for an indebted family to borrow money to send their kids to college. So too with the Obama budget. Public investments, just like family investments, build future wealth. They allow faster growth. They make the debt/GDP ratio even lower and more manageable over time.

Don't get me wrong. I'm not saying there's nothing to worry about when it comes to long-term deficit and debt projections. I'm just saying now's not the time to worry, and we ought to temper our worries by understanding the larger context.

Not every expert agrees that a deficit-driven stimulus is the best and fastest way to get the economy back on a growth track, or that public investments can speed growth. Conservative economists, Republicans, and many Wall Streeters are skeptical because they don't think government can do anything well. But look at the record of the last seventy-five years -- look at how the nation got out of the Great Depression, and consider the critical role public investments have played since then in speeding the nation's growth, investments such as the interstate highway system -- and you have ample evidence that the deficit hawks are wrong. They were wrong when they convinced Bill Clinton to chuck a large part of his investment agenda (the nation is now paying the price) and they're wrong now.

So, back to the mystery. Why are the ostensibly liberal Center for American Progress and New York Times participating in the Debt Scare right now? Is it possible that among the President's top economic advisors and top ranking members of the Fed are people who agree ... with conservative Republicans...? Is it conceivable that they are quietly encouraging the Debt Scare even in traditionally liberal precincts, in order to reduce support in the Democratic base for what Obama wants to accomplish? Hmmm.

Not so sure about that, but the larger point is certainly valid. The economy needs short-term demand stimulus, and that stimulus can be from spending on infrastructure, or it could be on something with little long-run benefit such as large firework shows held throughout the nation - big extravagant events that spend millions and millions of dollars in the most depressed economic areas. In the short-run the goal is to kick start the economy, and a firework show is just as good at that task as infrastructure spending if the spending is approximately the same.

Where they differ is in the long-run. The firework show leaves only memories - and sometimes that's enough to justify an expenditure - but let's assume that for the most past the shows were nothing more than an excuse to spend money to get the local economies moving (not that there's anything wrong with that; also, perhaps a series of shows would be better so that the impulse is spread out over time and sustains the economy through the downturn, but the idea is the same). However, as Robert Reich explains above in his example of borrowing to go on a cruise versus borrowing to go to college, infrastructure spending does have long-run benefits and can help the economy grow faster.

So, to the extent that we can, we should do both - deficit spend to get the economy moving in the short-run, and spend the money on infrastructure so the spending has long-run benefits. But the main thing is to get the economy moving again through deficit spending, it doesn't have to be on infrastructure (and there are plenty of things to spend the money on in the short-run that don't necessarily help with long-run growth but are nevertheless justified, there are choices other than firework shows and cruises, but the politics work against this).

So deficit spend in the short-run and target infrastructure as much as possible - until further spending on infrastructure begins to threaten short-run goals because, for example, it can't be done fast enough - then switch to other types of spending to give aggregate demand the kick it needs.

It may seem like I disagree with Robert Reich in that he is insisting that the spending be to rebuild our physical and social infrastructure, where I am saying it doesn't matter, but that's because we need to separate two reasons for deficit spending. What I have just described is deficit spending to offset cyclical swings in the economy, so called countercyclical policy. What Robert Reich describes in his example with the family is spending that is an investment in the future. You borrow money now in the hopes of a higher return in the future (in terms of economic growth), a return that is high enough to justify the costs. Note that this type of spending is entirely justified independently of spending to offset recessionary conditions. However, because of the politics involved, and because it can be efficient in any case, combing the two types of spending - i.e. using infrastructure spending to stimulate the economy - has benefits.

But although right now deficit spending is justified by countercyclical policy and by the need for social and physical infrastructure, we also need a plan for the long-run that credibly manages the resulting debt. Not immediately, but slowly over a long period of time. Importantly, however, that plan should not threaten or compromise our ability to do what's needed to offset the effects of this recession. I wouldn't mind having the conversation about managing the long-run debt now if it didn't do exactly that, i.e. cause policymakers to be wary of deficit spending and do less than is needed to combat the recession. But it does, and as Robert Reich notes, that is likely the point of the conversation.

I want both monetary and fiscal policy to have the best possible chance for success in dealing with our present difficulties, and that requires a large sustained shock to the system both in term of Fed actions and deficit spending. But success also requires managing the long-run appropriately. When things improve we have to pay for the stimulus to the economy (i.e. pay for all of the countercyclical part plus our share of the investment in infrastructure) and take the steps necessary to bring the budget into long-run alignment. If we don't do that, the conclusion will be that we can deficit spend when times are bad without any problem, and sure, that is helpful, but we simply do not have the discipline to pay for what we borrowed when times are better. Our inability to implement countercyclical policy effectively could then mean that future generations would not have countercyclical fiscal policy at their disposal when they need it.

But for now the main thing to realize is that "This thing ain't over yet," and we need to continue to support aggressive policy action. We do have work to do to get the long-run budget fixed, and working on health care is a large step in that direction, but for now short-run policy goals must come first.


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