Friday, August 27, 2010

The Impotence of Monetary Policy

Bernanke's Jackson Hole speech was meant to give some insight into what the Fed might do in coming months. I think it reveals how powerless the Fed is in general, and how little it understands the economy it is meant to oversee.
The prospects for household spending depend to a significant extent on how the jobs situation evolves. But the pace of spending will also depend on the progress that households make in repairing their financial positions... But on the other hand, the upward revision to the saving rate also implies greater progress in the repair of household balance sheets. Stronger balance sheets should in turn allow households to increase their spending more rapidly as credit conditions ease and the overall economy improves.
Agreed. But then here are the policy options he puts forth.
A first option for providing additional monetary accommodation, if necessary, is to expand the Federal Reserve's holdings of longer-term securities
How does changing the term structure of Fed assets help households repair their balance sheet?
A second policy option for the FOMC would be to ease financial conditions through its communication, for example, by modifying its post-meeting statement.
How does the Fed saying different words help households repair their balance sheet?
A third option for further monetary policy easing is to lower the rate of interest that the Fed pays banks on the reserves they hold with the Federal Reserve System
How does lower IOER (already just 0.25%) help households repair their balance sheet? Actually, this seems to make things worse, whereas the others have simply been irrelevant.
A rather different type of policy option, which has been proposed by a number of economists, would have the Committee increase its medium-term inflation goals above levels consistent with price stability.
And what mechanisms does the Fed have in place to help it achieve its "medium-term inflation goal" regardless of where that goal is set?

What's happening is that, in a time of over-indebted households and weak aggregate demand, workers are simply losing their jobs and remaining unemployed. While unemployed, they draw Government benefits, and thus maintain some baseline level of consumption, avoiding 1930s style debt deflation. At the same time, this large pool of unemployed workers mean businesses can keep wages down, sell into what Government supported aggregate demand is there, and pocket the rest as profits.

The big lever here is fiscal policy -- announce a payroll tax holiday, and let households actually repair their balance sheets.

UPDATE: In the meantime, low interest rates take income out of the economy. Their net effect is very unclear.



Blogger Devin Finbarr said...

The big lever here is fiscal policy -- announce a payroll tax holiday, and let households actually repair their balance sheets.

Even a payroll tax holiday is slower than ideal. The total net fall in private paper wealth was something like $15 trillion. That's a a lot of balance sheet to restore. A payroll tax holiday would only add $1 trillion a year. It's a lot better than what we got, but still a bit slow.

A quicker route to recovery would be to pass a law that multiplies the face value of every FDIC backed account, every money market fund account, and every treasury bill, by 50%. So that you're not just benefiting the wealthy, maybe also mail a check to every American for $15K.

Money costs nothing to create, so there is no reason not to simply do all the balance sheet restoration at once. The only trick is to distribute the money in a way that is fair and doesn't create distortions (a way that doesn't favor rich over poor, poor over rich, profligate over savers, or asset holders over dollar holders, etc).

12:14 PM  
Blogger winterspeak said...

Hi Devin:

Yes, what you suggest would be faster. But I'm not confident exactly what level of "repair" is needed. A FICA holiday is slow but steady -- easy to modulate to make sure you don't go overboard and get inflation.

12:54 PM  
Blogger Devin Finbarr said...


Yes, going overboard and getting inflation is a possibility. But let's think of the reasons why inflation is actually bad. Inflation is bad because it:

1) creates menu switching costs
2) punishes existing holders of currency and T-Bills
3) as a corollary of 2), current dollar holders might ditch their dollars for a more stable store of value, creating a hyperinflation
4) punishes laborers with long term, fixed wage contracts
5) punishes holders of non-government long term debt

Let's look at these reasons in light of my proposal:

1) menu costs are trivial compare to the costs of 10 million unemployed.

2) since my proposal primarily puts dollars in the hands of existing holders of dollars, it does not punish dollar holders. To make an analogy with stock markets, stock split does not hurt stock holders, while a stock dilution can.

3) since 2) is not a problem, there is no additional hyperinflation risk.

4) most labor contracts aren't that long term, and it's better to have a job in the first place. High unemployment rates put downward pressure on wages too.

5) This is a more pressing concern. But my proposal would significantly reduce default rates, which would benefit bond holders. If needed, one could also multiply the face value of all rated bonds by X% (by simply printing the money and attaching it to the bond, not by making the debtors pay more). The mechanics of this are far harder, though, so I'm not sure it would be a good idea.

The net of it is that I think its much better to overshoot on the side of inflation (as long as that inflation is non-diluting/not distortionary). The problems of unemployment greatly outweigh the problems of inflation above. Even if the overshoot created 10% inflation for three or four years, I don't think that's a big deal, because the inflation is a result of rewarding savers, not a result of diluting/punishing savers.

1:26 PM  
Blogger Ray Sawhill said...

I dunno, Devin. Four years of 10% inflation would reduce this retiree's income by nearly half. That'd be quite a battering for me, and presumably many millions of retirees like me. It'd make life much harder for me and others like me. Given that I'm hardly living it up on my modest retirement resources, and given that I got to this financial stage of my life by working for decades and saving some of the money I made as I went along, it'd also be a very bitter potion to swallow. Any thoughts about why I should root for such a policy?

11:48 AM  
Blogger winterspeak said...


Isn't social security indexed to CPI? Also, if inflation was 10%, wouldn't FFR also be pretty high?

Curious how your income would be cut in half. Your savings might be if they were in cash or cash equivalent.

9:48 PM  
Blogger Ray Sawhill said...

Winterspeak -- I have a pension, whose monthly payment isn't going to change no matter what inflation does or doesn't do. Ten percent inflation for three or four years, and my pension's nearly down to half its worth.

My investments? God only knows if I'll guess right about anything. I've shown zero investing knack so far in my life -- why should that change? And why should governmental financial planning take it for granted that oldies are competent and/or lucky investors? That's crazy. Many oldies struggle to make sense of what's going on in the world, let alone with their Schwab statements.

As for Social Security:

Plus, I assume you know that COLA adjustments are pegged to what the cost of living is for a working person, not a retiree. They don't take into account the way medical costs (which consume more and more of your money the older you get) tend to rise faster than most other costs.

But are you trying to make the point more generally that high inflation doesn't have a hard-to-manage impact on the fixed (OK, mostly-fixed) income crowd? You must not hang out with many older people.

3:53 PM  
Blogger Ohm (Ώ) said...

The ONLY event in which Inflation is good is when it is a side effect of generating more employment, or achieving an income distribution where the consumtion-saving-investment gets optimally geared to produce a well functioning economy @ full employment. Even there, inflation rate of 10% is intolerable - it hits hard the pensioners as Ray is explaining. Looking at Dow movement against inflation thru the years too is misleading, as the composition of the index keeps changing -- a dozen or more of Dow constituents might fold up over 3-4 decades but Dow doesn't bite the same dust as it has moved on - leaving those companies out much earlier. The index fund would yield nothing close to what the nominal Dow chart wld suggest.

And Externally induced inflation is totally 'havocous': The proximate cause of the precipitation of the financial crisis was the oil price spike leading to an inflation that the flat incomes of American labor could not absorb in their household budgets. A critical mass of foreclsures by people on the edge, and the whole home equity financing vaporized with the home 'valuations' melting.

The US Govt will have to get the fiscal deficit right. Very targeted investments that generates employment while producing facilities that adds value to the rest of the populace: Education, roads, parks et al. The home equity credit bubble needs to be replaced by incomes at the base of the pyramid. Trickle Down oriented 'spinding' will have a wreckage effect not much different from what i am calling 'externally induced inflation'.

11:50 PM  
Blogger Ohm (Ώ) said...

Inflation is no economy boosting fuel that many economists seem to assume. It is more like friction...if we need mechanical parts to move against each other, we have to accept it as fait-accomply, but a little bit too much of it, and we see falling efficiencies, so we make external inputs (lubrication) to keep it low. If the inflation does not come from rising wages and employment of the relatively lower income, consuming sections, only thing it'll beget is lower consumption not more. Are we going to buy 2 shirts at Walmart or Kohls instead of one 'cause prices have begun to rise now, as the Krugman types seem to suggest ? The real life is that we will take a hard look at our current shirt and reckon, "Do I really even need one more right now? Maybe tomorrow when some of this inflation translates to a wage increase to me!" Recession will only be back with a bang.

Inflation expectations might have people prepone their home buying though. But i think in the absence of a speculative bubble and reckless financing, inflation of everyday goods and home prices are inversely correlated when the incomes of large percentile are flat. When they are rising, both consumer and asset prices will inflate on internal pressure (Good Ol' Demand Pull)

12:13 AM  
Blogger Devin Finbarr said...


Under my proposal, there would have to be a stipulation that if the stimulus did overshoot and cause 10% inflation each year, the government would adjust pension payments upward in an amount equal to the increased inflation.

BTW, while retirees have to pay more for healthcare, you also get medicare, so you don't pay the full amount. Also, housing prices in general have risen faster than inflation over the last 40 years. Retirees are a net beneficiary of rising housing prices.

6:05 PM  

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