For context, read Tyler (and Scott S.) vs. me on inflation.
1. What if the Fed chairperson explained monetary dominance out loud?
That would mean telling Republicans that tax cuts don’t stimulate and telling Democrats that more government spending doesn’t stimulate. So the Fed chairperson would alienate Congress. Retaliation would likely follow.
How could we distinguish empirically the dose-response model from the autocatalytic model of inflation?
A big challenge is to pin somebody down on how to measure the dose. There are many measures of the money supply to choose from, ranging from a narrow definition of Fedcoin plus currency to a broad definition that includes all financial assets. The current fad is to measure the dose as the difference between the interest rate and “r-star,” which is a mythical interest rate at which the economy is in perfect balance. And here, the choice of which interest rate to compare to “r-star” could vary. Finally, Scott Sumner says to heck with all of these indicators–just look at nominal income as the measure of monetary policy. That threatens to be circular. To be fair, Scott wants to use a market measure of expected future nominal GDP, which removes the circularity. But it also makes it hard to do an empirical study, since we do not have direct measures of market forecasts for nominal GDP–it is up to the investigator to try to find a proxy.
We need to agree on a way to measure dose. I want the dose to be something that the Fed controls pretty directly, as opposed to the measure of money that includes all financial assets or even Scott’s preferred measure of market expectations for nominal GDP. But then you run into the problem that the Fed’s operating procedures have changed periodically, especially with paying interest on Fedcoin.
But if you could agree on a dose measurement a priori (meaning you don’t cheat and look at historical data to try to pick a measure that best correlates with response), then in principle you could look at past experience. What you would be looking for is cases of modest but significant changes in dose. If the conventional wisdom is correct, you should see significant response. If the autocatalytic view is correct, you should see no significant response.
Do you really believe that there is nothing the Fed can do to affect the economy?
Of course I don’t go that far. The Fed could sell $400 billion on bonds tomorrow. Or Janet Yellen could walk into the New York Stock Exchange with a bomb strapped to her waist and blow the whole place up.
But if we stick to normal Fed operations, which are small and gradual, I believe that those are easily absorbed by financial markets without affecting anything important. Obviously, this is an outlier view.
Note that the fact that people believe that the Fed affects things gives it the ability to affect things, just as the fact that people believe that Elon Musk’s tweets matter gives Elon Musk the power to affect stock prices with his tweets. But I don’t think that those effects are very long-lasting in either case.
Thank you for taking the time to answer these questions. Re the first one, you respond that “the Fed chairperson would alienate Congress. Retaliation would likely follow.” But then what? (I’m not trying to be obtuse)
Is the Chair brought in to testify and then yelled at? Seems like that already happens.
The Fed doesn’t receive funding from Congress, and members are appointed for 14 years, so those obvious options don’t seem to apply.
I suppose Congress could threaten to revise the Federal Reserve Act. But actually doing so, and in a way that spanks the Fed, seems unlikely to me (witness their bipartisan legislative record over the past several years).
To be sure, I don’t think the Chair wants to or would say such things out loud (ok, maybe they want to). But the practical fallout to me isn’t obvious.
Do you really believe that cuts in capital gains taxes don’t stimulate?
What about cutting corporate tax rates?
Why would they stimulate? On their own any tax cut without a commensurate spending cut simply means the expected tax burden falls somewhere else.
Investors are more likely to invest in countries with low capital gains taxes. Corporations are more likely to set up headquarters in countries with low corporate taxes.
And what is the other side of the ledger? If taxes are 1 trillion and you cut 100 billion in taxes for corporations then you have to make up that 100 billion in either taxes elsewhere or borrowing. Either way you are increasing by the same amount the drag elsewhere that you are relieving on the corporate sector.
Basically, your argument is that at any given time, there’s a fixed amount of resources and those resources will be used by either the private sector or government. If government doesn’t reduce spending, they’ll take up the same amount of resources whether there’s a tax cut or not.
My argument is that, even at a given moment, resources aren’t fixed because the country isn’t a closed system. We can drive the resources left to the private sector overseas by leaving taxes here higher than they are in other countries or we can bring additional resources from overseas into the country by having lower taxes than other countries.
I understand your argument, but what you are doing is holding all other things constant while making assumptions that can’t hold all other things constant. The assumption that lowering tax rates on corporations will increase their profitability is invalid. If you lower the rate on corporations but raise the rate on individuals then the individuals have less discretionary income or you have higher labor costs. Either way this should be expected to offset (roughly, on average) whatever gains a corporation gets from their tax relief. This isn’t a fixed resource argument, its a fixed cost of government argument. If you keep government expenditures at the same level then a tax break for one group is an implied tax increase for all other groups. Cities try this all the time, they offer large tax breaks for companies to bring new projects to their area, if they don’t couple this with spending cuts then they end up squeezing out the existing businesses slow because they have more fixed costs (the new projects require city infrastructure) and have to redistribute those costs to the existing businesses.
By your argument, high-tax nations wouldn’t lose companies and capital to low-tax nations and high-tax states wouldn’t lose them to low-tax states. Empirically, that’s not what we see.
That is not the logical implication of my argument at all.
Then we’re talking past each other. My whole argument is that low corporate and capital gains taxes will attract companies and capital – and will therefore stimulate the economy, while high taxes will drive them away. I read your replies as saying that’s not true.
Your argument is that that low tax rates will draw in capital, but you are attempting to hold the current capital stock constant. Use my example of cities above, you can draw in capital without it ending up as a net positive for your geographic region. If you have a tax region which lowers capital gains taxes but raises taxes on labor you get more ‘capital’ investment and if you only count that capital investment without considering the losses to labor of course you come out ahead.
Or to put it as straightforwardly as I can- if you cut taxes without cutting spending you cannot hold everything else equal- you have implicitly increased taxes elsewhere and have to factor that in. Bringing in capital from the outside isn’t stimulative if the incentives used are burdening the already existing capital structure. Empirically if you look at countries that lower their capital taxes they get more outside capital flowing in but they don’t get more net growth*. There is no net stimulus.
*unless they also cut spending, or loosen regulations otherwise which rarely happens in concert.
Janet Yellen runs Treasury, not the Fed.
The “R-star” approach is not new. It comes from Wicksell. Maybe it was wrong, but Wicksell’s analysis lead both the Keynes and the Austrian’s macro. It was revived by Woodford, and from examination of the foundations of the Taylor Rule.
I think monetary policy is powerful. Let’s do some controlled experiments, but I prefer we did them in other countries.
Sumner thinks the Fed can and should determine a path for nominal GDP. Concede for a minute that he is right. That does NOT imply fiscal policy is impotent. Fiscal policy can still influence the supply curve. Tax cuts or deregulation could boost investment or hours worked. Infrastructure could boost productivity. Subsidies to science could produce higher productivity growth. With the same NGDP growth, we would have more real GDP growth and less GDP price inflation.
Operation Warp Speed and vaccination distribution, both of which were funded by the government, will cause an economic boom. That is fiscal policy which works! By contrast, the Fed’s QE is small change, so to speak.
Using market expectations doesn’t remove the circularity of Scott’s argument. SS has very explicitly supported the idea of inflation expectations driving growth, where the Fed simply has to convince markets that inflation is coming and if they do that then their actual actions need be nothing. This ends up entirely circular where if markets have high inflation expectations and then lower them, so cut back on investments, so leading to lower growth simply follows the same logic, ie that the Fed didn’t maintain high enough expectations which caused the lower future growth.
The best way to think of the Fed is as a middle-man, as a middle man the only actual positive impact that they can have is to reduce frictions between transactions and on the downside they can increase frictions. However these two sides are asymmetrical, if the Fed does extremely well they can increase the value of financial transactions by a few percent at most, however if they do very badly they can prevent transactions from happening at all and eliminating up to 100% of their value. This is the issue that most people have with thinking about CBs, since there are obvious examples of CBs ruining economies with terrible decisions the assumption seems to be that with great decisions they could be as impactful to the upside. This is a very common asymmetry, a complete idiot could ruin your car with an oil change but the absolute best oil change technician in the world can’t make your car 100% better than an average tech with his skills. Monetarists have noted that some problems can be avoided with solid monetary skills and have concluded that many more problems can be avoided with great monetary skills and are like a person with car trouble continually searching for better and better oil changes because at one point getting an oil change improved their cars performance.
The Fed could never target a market because that market would no longer be non-biased. Plenty of actors could (and would) influence the market for their own purposes if Fed action were linked to it.
Take a look. The Fed does target markets and has been for years. It also targets The (stock) Market.
I don’t have confidence in any of the theories of inflation because they all seem to be leaving out readily obvious points. Like, the Fed obviously has a lot more power than Elon Musk because the words of the fed are credibly backed by institutional action. The Fed really can play the expectations game in a way that nobody else can.
That being said, it’s also obvious that the Fed’s power is quite limited for the other reason that Kling outlines which is that there are a lot of alternatives to spending cash. The Econ 101 model is that the Fed sponges up excess money that would be spent too “enthusiastically”, but the reality often seems that asset markets just sponge up excess money from the Fed and it never really circulates much.
This seems like a fairly stable equilibrium. Excess money keeps nearly everyone solvent bias rising asset prices and, now, long term payday loans. Everyone expects more to come because a change would provoke a dangerous change in equilibrium