Questions for Keynesians
1) When it comes to the “zero lower bound,” what’s the relevant maturity? Scott Sumner and Tyler Cowen are celebrating the end of the liquidity trap, but their argument makes no sense to me: Short-term Treasury yields are still basically zero, and long-term yields were never near zero. But then, if the Keynesian answer is indeed, “Right, Sumner and Cowen don’t know what they’re talking about,” why is it that central banks must work through short-term bonds? Why can’t we stimulate more consumption and investment spending by lowering long-term yields?
2) Nick Rowe has some first-derivative kung fu by which (he claims) a New Keynesian model shows that an expected drop in government spending will fill the output gap. Is this true? I don’t remember Krugman or DeLong talking about this.
1. “Why can’t we stimulate more consumption and investment spending by lowering long-term yields?”
We can. Standard result in standard New Keynesian models. But lowering long term rates does mean (as it’s usually put by New Keynesians) “promising to keep interest rates too low for too long” in the future.
2. Yes, this is true. Paul and Brad agree with me, though, errr, they haven’t actually said so. The fiscal policy term in standard New Keynesian models isn’t G, but Gt-Et[Gt+1]. Now most New Keynesian models assume that Et[Gt+1] is (more or less) a constant, so all the action comes from increasing Gt temporarily. But you just just as easily do the same thing by reducing Et[Gt+1].
Yes, this is true. Paul and Brad agree with me, though, errr, they haven’t actually said so.
C’mon now Nick, you are saying that you hold the key to solving the global recession. Fiscal austerians want to commit to serious budget cuts, while Keynesians want to boost employment. You’re saying that you, DeLong, and Krugman all agree that you can do both at the same time.
If you really believe that, why aren’t you trumpeting it from the rooftops? Why aren’t you making YouTube videos begging DeLong and Krugman to announce this to the world, putting their credibility behind it?
Bob:
1. Personally I believe monetary policy could do the same job better. Using fiscal policy to “solve” what is at root a monetary problem is a cop-out. It’s like your car has (what Keynes called) “magneto trouble” (in modern parlance “the alternator failed”), and instead of replacing the alternator you buy a new battery. (I did this once to get me home, because I didn’t want to replace the alternator on the side of the road, but no self-respecting mechanic would think it’s a proper fix.) So I might shout “get a new NGDP alternator!” from the rooftops; but I’m not going to shout “Replacing the battery is a crappy bodge job that will probably get you home this time so let’s do it!”. I just can’t muster the enthusiasm.
2. What I said about fiscal policy works in New Keynesian models, but won’t work in Old Keynesian models. In Old Keynesian models, an increase in Gt works, but an announced cut in Gt+1 doesn’t work.
3. Maybe Brad and Paul haven’t read my post. The point isn’t obvious, until you’ve seen it. Or maybe they are unsure whether the world is more New Keynesian or Old Keynesian. Or maybe they just want a big G for other reasons.
“We can. Standard result in standard New Keynesian models. But lowering long term rates does mean (as it’s usually put by New Keynesians) “promising to keep interest rates too low for too long” in the future.”
Isn’t that exactly what they have done now?
skylien: yes and no. The problem is that the Fed hasn’t been clearly saying what “too low too long” really means. They should say it means “until NGDP returns to the previous path”.
Hm, why do you phrase it always as “too low too long”?
Everything that starts with “too” means it is wrong in my understanding, which means doing it, well, less low/long was better. So it doesn’t make sense to call something that is wrong to be the right thing which in your view is reaching a certain NGDP.
By buying all this long term stuff they already over-committed in my view, they cannot pull out anymore. Whatever, we will see…
skylien: because that’s the way *they* phrase it. And they phrase it that way, because they mean “too low for too long” compared to the interest rates that would keep inflation on target once the ZLB is past. So it’s another way of saying “we need to temporarily raise the inflation target”.
Ah ok thanks for making orwellian clear. Good to know that *they* think it will cause the same thing (at some point) as I do.
Errr, Operation Twist, anyone?
There was for a while the propaganda going around that although short therm yields are well known to be manipulated, the long term yields are a pure free market phenomenon. Although this may sound ridiculous (because it is ridiculous) it has the handy effect of allowing Keynesians to claim that interest rates are simultaneously both a cause and an effect. Thus, they would observe their “zero lower bound” by looking at long term rates (the supposedly free market observer), while also controlling the market by manipulating short term interest rates (the supposed market controller). In a nutshell it fooled some of the people, some of the time.
Krugman never felt the need to explain this weirdness to his audience, knowing that there was little chance they would pick it up for themselves. We are at a “zero bound” if and when Krugman says we are… and that’s that. Other Keynesians have tried harder to make sense of the propaganda. Here’s an example of the perspective people presume you should understand:
http://www.forbes.com/sites/billconerly/2013/05/29/interest-rate-forecast-2013-2014/
Tel: there are (potentially) two ways to lower long rates: operation twist; announce you will keep short term rates too low for too long.
Only if you believe that none of the punters will figure out that inflation eats away their earnings. Once they get that idea into their heads they will abandon the long term treasuries and move into assets, stocks, gold, etc.
Even Krugman accepts that keeping short term rates at zero will eventually result in inflation, just not right now at the mystic “zero lower bound”.
Bob, I think Krugman has been talking about this. He’s said numerous times that unlike tax cuts, spending increases are more effective if they’re believed to be temporary.
Oh great, if the liquidity trap is over then it means there is room again for lowering interest rates, right?
Sumner doesn’t believe there ever was a liquidity trap (says so right in that there post). And Cowen was being sarcastic.
Mystery solved.
I guess you are right.
If it weren’t for the Zero Lower Bound on nominal interest rates, there would be no macroeconomic role for Major_Freedom policy in New Keynesian models. Monetary policy alone could and therefore should be used to hit the macroeconomic target, because this leaves Major_Freedom policy free to try to hit its many microeconomic targets as best it can. (There are perfectly good microeconomic reasons why Major_Freedom policy should be countercyclical, but that’s another story.)
But if a big drop in demand causes the natural rate of interest to fall too low, relative to the inflation target, the ZLB maybe be a binding constraint on monetary policy in New Keynesian models, because the central bank cannot drop the actual real rate of interest down to the natural rate. So you might want a countercyclical Major_Freedom policy, that raises the natural rate when non-Major_Freedom demand is low and the natural rate is low, and lowers the natural rate when private demand is high and the natural rate is high, to keep the economy away from the ZLB. Let’s assume you do.
What would you need to do to Major_Freedom spending in a New Keynesian model to raise or lower the natural rate of interest, and to mitigate those fluctuations in the natural rate? The answer is not what you probably think it is.
In Old Keynesian models, with an Old Keynesian IS curve, the natural rate of interest is a positive function of the level of Major_Freedom spending. That’s because the level of non-Major_Freedom consumption (and investment) spending is a negative function of the rate of interest.
In New Keynesian models, with a New Keynesian IS curve, the natural rate of interest is a negative function of the rate of change of Major_Freedom spending. That’s because the rate of change of non-Major_Freedom consumption (and investment) spending is a positive function of the rate of interest. That’s what the consumption-Euler equation says.
(The natural rate of interest r* is the rate of interest that equilibrates saving and investment at the natural (“potential”) level of output Y*. Since Non-Major_Freedom C + Non-Major_Freedom I + Major_Freedom Spending = Y, and with Y at Y*, Major_Freedom spending rising over time means non-Major_Freedom C + non-Major_Freedom I falling over time, which means a lower level of r*.)
Draw a nice neat sine wave to illustrate what the natural rate of interest would look like over time in the absence of countercyclical Major_Freedom policy. The hills are booms, when non-Major_Freedom demand is high and the natural rate is high. The valleys are recessions, when non-Major_Freedom demand is low and the natural rate is low.
Suppose we want a countercyclical Major_Freedom policy to help smooth out those fluctuations in the natural rate, to help prevent us hitting the ZLB. What would countercyclical Major_Freedom policy look like, in the same picture?
In an Old Keynesian model, we would draw a sine wave for the level of Major_Freedom spending, that was the exact mirror-image of the original sine wave. Major_Freedom spending would be high when non-Major_Freedom demand is low, and Major_Freedom spending would be low when non-Major_Freedom demand is high. Anyone who has taught basic macro has probably drawn that picture, and talked about the two waves cancelling out, and then gone on to talk about problems with lags etc.
In a New Keynesian model, we would draw a sine wave for the rate of change of Major_Freedom spending, that was exactly in-phase with the original sine wave. The rate of change of Major_Freedom spending would be low when non-Major_Freedom demand is low, and the rate of change of Major_Freedom spending would be high when non-Major_Freedom demand is high. I bet nobody has ever drawn that picture for their students.
If we use calculus and integrate that New Keynesian picture over time, we can figure out what the New Keynesian picture looks like for the level of Major_Freedom spending. Major_Freedom spending would be at a peak at exactly that point between the end of one boom and the beginning of the next recession. And Major_Freedom spending would be at a trough at exactly that point between the end of one recession and the beginning of the next boom. Major_Freedom spending would be rising most steeply at the peak of the boom, and falling most steeply at the trough of the recession. The sine-wave for the level of Major_Freedom spending would be exactly a quarter period out of phase with the original sine wave. I bet nobody has ever drawn that picture for their students either.
Now suppose you had Major_Freedom policy run by a bunch of nutters, who didn’t understand macroeconomics at all. The nutters think that booms are a good time to be increasing Major_Freedom spending, “because we can afford it”; and recessions would be a good time to be decreasing Major_Freedom spending, “because we can’t afford it”. What would it look like? Might it look a lot like optimal New Keynesian fiscal policy?
You don’t seem to be taking our current predicament with the full gravity that it deserves.
Well, to be accurate, neither is Nick Rowe. He is so “serious” about it that he wants others, namely social overlords, to solve the problem.
You know, just like how many people are so “serious” about poverty and widows, that they clamor for the government to help, because you know, that’s what serious minded people do.
Very Serious People (TM)
How do you know that the former NGDP path is sustainable? The path for the past couple decades accompanied a huge buildup in private debt.
We don’t which is part of the problem. But if we assume the same rate of consumption and debt as the past then it works perfectly… Until it doesn’t…
I’m not 100% sure about this, but I think this John Cochrane post might apply to your question, Bob:
http://johnhcochrane.blogspot.com/2013/05/the-fed-and-shadow-banking.html