2017 resolution: less agitation for more demand

Former Minneapolis Fed President, Narayana Kocherlakota should definitely join me in this New Year’s resolution, as I explain in some detail below.

Kocherlakota recently put up a post on his home site asserting that macroeconomic policy has been too tight in recent years and that this largely explains the dangerous repudiation of establishment politics throughout the developed world, including here in the US. He sees a further darkening in 2017, because policy makers and various opinion leaders have apparently not learned the lesson that tight policy leads to “social fracturing and disengagement.”

I found this passage the most striking:

Will policymakers begin to engage in the kind of fiscal/monetary easing that is needed to heal our economies and our societies?  Possibly – there is talk from the incoming American administration of increases in government spending and tax cuts. But many elected officials (and professional economists) have also expressed strong opposition to these policy choices. 

Those opponents should bear in mind that there are grave risks associated with overly tight macroeconomic policy and the accompanying shortfall of aggregate demand.

I am definitely among those who oppose fiscal stimulus at this point in the cycle, so I guess Kocherlakota is implicitly warning me.  But I don’t find his warning very convincing.

What Trump is proposing is not even necessarily fiscal stimulus, but rather a set of policy initiatives that would mostly just raise the deficit and transfer income from the lower end to the upper end.  But leaving that aside, many of us who oppose fiscal stimulus per se are not particularly hawkish on monetary policy. So I think it is a source of confusion to conflate monetary and fiscal policy preferences, as Kocherlakota does.

For example, Paul Krugman argues that the Fed should raise interest rates by much less than it seemingly intends to, but also believes that fiscal stimulus at this point in the cycle is largely pointless.  My own view — developed independently! — rhymes very closely with that, although I would put more emphasis on the monetary objective, allowing a modest overshoot of 2% inflation, than on the means to that objective.

Leaving aside my own preference for how monetary policy should be run, there is the more compelling issue of how monetary policy will be run.  The Fed has escaped liquidity trap, at least for now, which is what matters in this context. And it (probably appropriately) believes that the US economy is now within measurement error of full employment.

Accordingly, any exogenous shock – including from fiscal policy – that tends to increase aggregate demand relative to the baseline will lead systematically to an offset from the Fed.  I am always struck by how advocates of fiscal stimulus seem never to bother to address this issue. It is not so much that they argue the idea is wrong as that they just (conveniently?) ignore it.

Maybe one could endorse Trump’s overall macro strategy if it came bundled as a commitment to easing both fiscal and monetary policy, as Kocherlakota’s argument would seem to require.  In other words, we might accept imperfectly timed fiscal stimulus if that was the price to get easier money. But that is certainly not what Trump is offering. Rather, to the extent he is offering anything coherent, it is the Reagan-Volcker policy mix, at precisely the wrong time in the cycle and with the wrong structural backdrop to boot.

To see this, first assume the actual application of at least the logic of a Taylor Rule. The Congressional GOP claims to want this, and the noise from the incoming Administration is that they are certainly down with the basic spirit there. Second, assume a fiscal stimulus that “works” at lifting aggregate demand relative to baseline.

We end up with a larger deficit and probably-very-temporarily higher interest rates, heading into what it probably the late cycle.  This would predictably be followed by recession, fiscal tightening and return to liquidity trap. I don’t see how that reverses “social fracturing and disengagement.”

Even if we could have easier money, by which I mean a higher intermediate inflation objective, with Taylor ideally in Siberia, it it is not clear at all how much we would want to lean on that on possibility.

That path to higher inflation would presumably involve a further decline in the unemployment rate to well below estimates of its natural rate, leaving aside for now the debate about whether the natural rate is a valid concept. (Practically, I think it is helpful, but am humble on the point.) But declines of the unemployment rate to far below the estimated natural rate have apparently proven to be destabilizing, that is, followed by recession.

Monetary doves sometimes insist that the reason for that is only because the Fed has in the past over-reacted. According to this view, the trick would be not to over-react once inflation started moving higher.  Maybe they could pull that off with the appropriate amount of focus and discipline. But even as a (moderate) dove, I think I have to concede that such a program would involve risks. So I don’t think the Fed is crazy to be tapping the breaks here, to prevent a deep undershoot of the natural rate of unemployment, whatever it might be.

Perhaps the most general point to make here is that it seems awfully late in the cycle to be dreaming up ways to lift “aggregate demand.”  This debate would have been fascinating – and I would have enthusiastically joined the doves – if it were held in 2010 or 2011. As it stands, the timing and macro amnesia (not affecting Kocherlakota but others) is really striking.

Finally, there is the issue of Kocherlakota’s amateur political speculation. Is it really self-evident that social fracturing and disengagement can be traced to excessively tight fiscal and monetary policies and the resulting deficiency of aggregate demand? I would be willing to accept that might be the case in Europe, both because European macro policy has been uniquely stupid and because I just find it easier to accept arguments when I don’t have the information base to oppose them.  And I don’t know much about European politics.

But here in the US, the issues look a lot more structural than the devastation wrought by a 4.6% unemployment rate and core PCE inflation at only 1.7%, half a percentage point lower than it was in the prior cycle.  I don’t see the value of endorsing a “fiscal” policy that may not provide much stimulus, would be poorly timed even if it did, and will almost certainly radically exacerbate the income inequality issues that seem much more obviously to be behind the political disintegration.

One final point. I remain a huge fan of Narayana Kocherlakota, who has distinguished himelf for being honest and flexible in recent years. Guy entered Princeton at 16 — in MATH!  Friends don’t let friends mistake the business cycle.