Tuesday, October 4, 2011

Elementary Questions About Keynesianism

. Tuesday, October 4, 2011

I think I asked this question back in '09 or early '10, but I didn't get a satisfactory answer so I'll ask it again. I am certain that there is a simple answer to it, but I haven't yet seen it. I know some Keynesian economists occasionally read this blog, so I'm hoping they'll set me straight.

As far as I can tell, the whole Keynesian framework depends on the existence of a liquidity trap. Without it, as Krugman keeps repeating, normal rules of macroeconomics apply: trade is good, monetary policy is effective, etc. But in Depression Economics all that is turned upside down. The rules of the game change because of the constraint imposed by the liquidity trap. Normal macroeconomics doesn't work.

In the Keynesian framework monetary policy is ineffective at the zero lower bound because people (banks, businesses, households) hoard cash. Thus there is a decrease in aggregate demand, economic activity slows, unemployment increases, etc. I get all of that. Here's the leap that I can't make: why isn't that true of fiscal policy as well? If I use monetary policy to give people money and they hoard it, why would they not hoard money if I use fiscal policy to give them cash?* The whole idea of Depression Economics depends on a psychological model of mass peoples -- what Keynes called "Animal Spirits"** --  that would seemingly apply universally to all public policy intended to stimulate demand. I see no reason why businesses or households would respond to cheap/free money from the monetary authorities by not hiring, but respond to cheap/free money from the fiscal authorities by hiring.

In other words, if the monetary multiplier is small because of the hoarding impulse derived from animal spirits, then the fiscal multipler should be no greater and probably smaller, for a few reasons. Cash transfers on the fiscal side only moves the money once, and then it should be hoarded in the same way as cash from monetary policy (which is also moved once). But fiscal policy also incurs new debt, which must be serviced. That imposes real future costs in the form of interest -- which is admittedly quite small or even negative in the present environment -- and fiscal drag from future taxation, both of which can be anticipated. Tack on some waste/corruption/deadweight loss and it's hard to see how fiscal policy would be more effective than monetary policy at the zero lower bound or anywhere else. Even at a high discount rate monetary policy can always be cheaper than fiscal policy, so it should seemingly have a higher multiplier.

I freely admit my ignorance and stupidity in this matter. I understand that economics often makes no sense until someone explains it to you, and my economics education effectively ended with my undergrad major. So I'm asking someone to explain it to me: why do animal spirits negate monetary policy at the zero lower bound but not fiscal policy? I'm guessing it has something to do with financial intermediaries, but then doesn't that require an additional, separate assumption about psychology?

*The closing scene in the HBO adaptation of Sorkin's Too Big to Fail has Poulson muttering to one of his deputies something like "We gave the banks the cash; now they better spend it and get the economy moving". I'm sure that's apocryphal, but the whole point is that they didn't. They hoarded it, as a Keynesian would expect from monetary policy, but not from fiscal policy. Poulson, of course, was most concerned with the fiscal intervention.

**While I'm here, there's something else I don't understand: Why is it that Keynesians smirk at assertions that businesses aren't hiring between of "uncertainty" when their entire underlying model depends on precisely that claim? Partisans on the right surely miss part of the story when they attribute this uncertainty only to Obama's policies -- I agree with Summers when he said that the biggest uncertainty is over the entries on the order books, i.e. aggregate demand --  but the uncertainty that matters is over expected profits. One part of that equation is revenue, the other part is costs including regulatory and tax costs. Decreasing uncertainty over the former (in a positive direction) increases confidence and thus investment, but so does decreasing uncertainty over the latter (in a positive direction). Both sides seem to be right and wrong. Or, rather, incomplete without the other.

16 comments:

Russ Grote said...

I think the last paragraph is a bit disjointed in that profit levels vs point where profits are maximized are combined into 'expected profits' when they are in fact different. An increase in demand would push businesses to increase output by hiring people, investing in capital to shift to new point where profits are maximized. If you are a coffee shop and your customer base doubles, you have to increase staff and material inputs to meet demand and increase profits.

A reduction in regulatory and tax costs will increase profit levels at a given point but not induce more hiring. Again, a coffee shop owner now pays less taxes on workers and now has a higher profit margin but no reason to increase output. If regulatory and tax costs rise, this does not reduce the need for workers, only levels of profit. Of course, businesses want more profit but they will still maximize profit and that point (X) is the same if X is X/2.

Access to capital might be an issue generally but not right now.

Matt Rognlie said...

In the Keynesian framework monetary policy is ineffective at the zero lower bound because people (banks, businesses, households) hoard cash. Thus there is a decrease in aggregate demand, economic activity slows, unemployment increases, etc. I get all of that. Here's the leap that I can't make: why isn't that true of fiscal policy as well? If I use monetary policy to give people money and they hoard it, why would they not hoard money if I use fiscal policy to give them cash?

First, I think you're using "cash" in two different ways here. Monetary policy gives people "cash" in the sense that it trades base money (reserves) for other assets. This doesn't directly increase their net wealth; it just changes the composition of their holdings.

Normally, reserves are special because the government requires banks to hold them; thus banks are willing to pay a premium to hold reserves rather than other riskless, liquid assets that don't satisfy the legal mandate. This premium is the nominal interest rate, which has a vast influence on the rest of the economy; through this channel, the Fed can change the price of credit for everyone by making seemingly trivial changes in the size of the monetary base. But at the zero lower bound, base money no longer has any special properties that distinguish it from other short-term riskless assets---so of course trading reserves for T-bills does nothing. This doesn't depend on any kind of strange hoarding behavior or Ricardian equivalence; it just means that there's no difference between holding the two assets.

Fiscal transfers provide "cash" in an entirely different sense. They don't trade one asset for another with a single counterparty. Instead, there is (at least in the short term) a redistributive component: the Treasury is borrowing money from some people (possibly outside the US) and lending it out to others. Granted, if we're in a completely Ricardian world, where households are identical, do not suffer from credit constraints, and act as infinite-horizon optimizing dynasties, then there is no redistribution, because households anticipate future tax increases and buy Treasuries with the money they've been given. But there are many cases where this doesn't happen. Maybe households are credit-constrained. Maybe they think the burden of repayment will fall on future generations (in which case there is also long-term redistribution) and don't care.

I honestly don't know how close an approximation Ricardian equivalence is to reality. Even if you suppose that the concept doesn't hold in its extreme form (e.g. households are myopic to some extent), it's possible that the increased spending from transfers will be spread out over the next several years, and provide minimal short-term kick to demand. But these questions are rather different from the simple observation that swaps of reserves for T-bills do nothing at the zero lower bound (or musings about whether other kinds of asset swaps would be more effective). To say that people are being given "cash" in both instances is to use the word in two inconsistent ways.

Matt Rognlie said...

(continued...)


But regardless, assuming that transfers are effective is not absolutely necessary to have a "Keynesian" view of the world. Transfers are very different from spending. Paul Krugman has harped on this in the past, and it pops out of a simple model by Woodford where there is complete Ricardian equivalence and transfers are ineffective. Basically, the logic for >1 multipliers is the following: government spending can only result in lower consumer spending if it changes the real interest rate. (You might think that the expectation of future taxes causes consumers to spend less---but consumers' wealth is also increasing by the full amount of the stimulus because they are being paid to do the work, so this cancels out.) Holding expected inflation constant, this means that the nominal interest rate has to move. But the nominal interest rate can't move: it's at zero, and the Fed wishes it could be lower. So there's no effect on private spending, and we have a multiplier of exactly 1. But expected inflation is not constant, since spending exerts some upward pressure on prices relative to their existing path. This brings down the real interest rate, and gives us a multiplier of >1. (If Ricardian equivalence fails, we get even more of a kick, just like we do for transfers.)

In sum: monetary policy, transfers, and spending all work for fairly different reasons. Even though it merely swaps one riskfree liquid asset for another, traditional monetary policy works because there is special demand for the asset it provides---and since that asset happens to be the numeraire according to which everything is priced, its supply determines the cost of credit in the economy. Transfer-oriented fiscal policy works (potentially) by overcoming credit constraints, redistributing wealth, exploiting myopia, etc. to increase current demand. And finally, spending-oriented fiscal policy works because (1) with the real interest rate immobile, there is no channel for it to crowd out private spending and (2) expected inflation actually pushes the real interest rate down a little.

I think that the language in which these policies are often discussed is confusing you---commentators will often vaguely discuss them all as ways of "pumping money into the economy", even though that is an incredibly imprecise (not to mention inconsistent) way of describing such different policies.

Sorry that this was a bit of a ramble---just felt that I should cover a lot of territory to emphasize how the mechanisms here are different.

Matt Rognlie said...

One final point: it occurs to me that you might be thinking of "monetary policy" in this instance as a helicopter drop---printing money and giving it to people. This is basically a combined monetary/fiscal operation, and conditional on the irrelevance of conventional monetary policy at the zero lower bound, it will indeed work if and only if traditional transfer policy works---the "monetary" side is irrelevant.

Now, the monetary implications do depend a little on exactly how the helicopter drop is operationalized, and how the Fed acts as an institution. If the Treasury borrows $500 billion in T-bills and sends out a check to every American, it doesn't matter if the Fed immediately buys up those T-bills with newly created money (completing the "helicopter crop") unless it is somehow a signal of future Fed policy. After all, the two assets are equivalent, and no debt has really been expunged from the government's balance sheet. Maybe such an action by the Fed would somehow communicate that it was concerned about the Treasury's level of nominal debt and would pursue inflationary policy in the future to whittle it away, but it's not completely clear why that would be true.

If the Treasury is completely cut out of the loop and the Fed just sends out $500 billion in checks to every American, then the Fed will be undercapitalized---its liabilities (money) will be greater than its assets, something which is not supposed to happen under normal central banking practice. If we view the Treasury/Fed as a clean, integrated unit with a single effective budget constraint, this doesn't really matter---the Treasury will just recapitalize the Fed, or maybe it will receive zero rebated profits from the Fed over a decade or two as the Fed recapitalizes itself. If, on the other hand, this is politically tenuous and the Fed is desperate to avoid undercapitalization, then you can imagine it being biased toward inflation and low interest rates moving forward in an attempt to fix its own balance sheet. In this case, a "helicopter drop" really does change expectations of monetary policy, and it is effective in ways that go beyond an ordinary fiscal transfer. But when you think about it, this case is really bizarre---if the Fed was a person, this would be like committing to walk to work by crashing its car into a ditch. If the Fed is that radical, it can probably just pursue inflationary policy directly.

Matt Rognlie said...

Oh, and I forgot this:

While I'm here, there's something else I don't understand: Why is it that Keynesians smirk at assertions that businesses aren't hiring between of "uncertainty" when their entire underlying model depends on precisely that claim?

I don't think that the model necessarily depends on that claim, but it's definitely a possible basis. I agree that it is silly to dismiss uncertainty as an influence over demand. The reason I smirk (or, more accurately, think about throwing myself off a cliff) when I see claims like this is that they ignore the Fed's role in bringing the supply of savings in line with the demand: if the real interest rate was completely free to adjust (unconstrained by the zero lower bound), then there is no particular reason why worries about uncertainty would depress the economy. More likely, they would just shift investment around, from circumstances where uncertainty was more of an issue to those where it was less. The near-axiomatic assumption that uncertainty will cause a downturn depends on the fact that the Fed is either unwilling or unable to make the necessary adjustments.

So I'd reverse your statement: the liquidity trap is necessary for the "uncertainty" story to make any sense, whereas weak demand due to uncertainty is sufficient but not necessary for the liquidity trap to present itself.

If you replace the word "deleveraging" with "uncertainty" in my most recent post, you basically have my views on the matter.

Kindred Winecoff said...

Thanks for the replies.

Russ, that makes sense, although I'm not quite willing to discount the demand-side effects of taxation nor the supply-side effects of tax/regulatory policy. Changes on the supply-side can definitely affect investment decision even if demand is static.

Matt, I am using "cash" in two different ways, for the reason you describe: in a liquidity trap at the lower bound, one zero-interest asset is indistinguishable from another. Maybe what I don't understand is why that negates the role of monetary policy without negating the role of fiscal policy. If banks are indifferent b/t T-bills and hard currency, then why shouldn't both mechanisms have similar effects?

I don't believe in anything like full Ricardian equivalence, although i do think some of that happens. (My impression of the empirical literature is that an significant portion of cash-transfer stimulus is saved rather than spent.)

Your point about the effect of fiscal stimulus on real interest rates hadn't been internalized; I was basically thinking that inflation expectations don't change, so the fiscal multiplier should be = 1, less some deadweight loss. In any case, if the multiplier depends only and entirely on expected inflation, it seems like monetary policy would be better equipped to adjust inflation expectations than fiscal policy.

Of course monetary policy needs a transmission mechanism, and so I did actually have a helicopter drop in mind as one type of monetary policy. I understand that there is a fiscal move following the monetary move. It seems like that would be preferred to borrow-and-spend fiscal stimulus, since it involves no deadweight loss, no politicized budget process, etc. If we're going to borrow from anyone, it seems like intra-government lending, really just an accounting gimmick, has the fewest downsides.

As long as the demand for cash is strong and the risk of runaway inflation is small, increasing the supply of money seems like a free lunch. That's monetary policy. The precise transmission mechanism from Fed/Treasury to the public seems to be not that relevant, because those authorities can just transfer assets between them as needed to balance the books.

I see your point on "uncertainty", and I don't subscribe to the supply-side view of uncertainty you often hear on CNBC or wherever. But this strikes me as as much of a problem for Keynesians as for supply-siders.

Matt Rognlie said...

Matt, I am using "cash" in two different ways, for the reason you describe: in a liquidity trap at the lower bound, one zero-interest asset is indistinguishable from another. Maybe what I don't understand is why that negates the role of monetary policy without negating the role of fiscal policy. If banks are indifferent b/t T-bills and hard currency, then why shouldn't both mechanisms have similar effects?

I think we agree but are using different terminology. I generally reserve the term "monetary policy" exclusively for when the central bank trades one asset for another. (And, though this is marginal outside a liquidity trap, when the Treasury makes changes to the maturity structure of debt--after all, it wouldn't make sense to classify QE or Twist as "monetary policy" but the equivalent Treasury decision as "fiscal policy".)

"Transfer policy" (which is what I assume you mean by "fiscal policy" in the above paragraph) consists of changes to the tax-and-transfer regime. "Spending policy" is, well, spending. This isn't a flawless taxonomy, but I think it clarifies the distinct mechanisms fairly well.

If by "monetary policy" you mean that the Fed prints money and gives it to someone, then your statement that monetary policy and fiscal policy have the same effects is equivalent to my statement that monetary policy is ineffective---because I think of your helicopter drop as a combined monetary/transfer operation, of which only the transfer part is effective in a liquidity trap, making it equivalent to the standalone fiscal operation.

I understand that there is a fiscal move following the monetary move. It seems like that would be preferred to borrow-and-spend fiscal stimulus, since it involves no deadweight loss, no politicized budget process, etc.

There is still deadweight loss here. Holding the future trajectory of monetary policy constant, the government eventually needs to tax back the amount it spent on transfers. That will incur deadweight loss. If we change the future trajectory of monetary policy to inflate away more of the nominal debt (which consists of bonds and money), then the deadweight loss from future taxes will be lower, but there will be some other welfare cost from the increased inflation. (And if there's not a welfare cost to higher inflation, we should have been doing it anyway---there's no need for it to be accompanied by still-costly fiscal transfers today unless they somehow provide a commitment mechanism that makes optimal policy time-consistent. I am skeptical that this is the case, as I mentioned in my third comment above.)

If we're going to borrow from anyone, it seems like intra-government lending, really just an accounting gimmick, has the fewest downsides.

I agree that it's an accounting gimmick, but I'm not sure what the benefits of this accounting gimmick are, except perhaps shaping expectations in some useful way. (And even if so, it's not clear to me why an accounting gimmick is necessary to shape expectations.) Debt held by the Fed is still included in the gross debt totals used to compute the debt ceiling, for instance---sadly, there's no escape on that front.

Matt Rognlie said...

As long as the demand for cash is strong and the risk of runaway inflation is small, increasing the supply of money seems like a free lunch. That's monetary policy. The precise transmission mechanism from Fed/Treasury to the public seems to be not that relevant, because those authorities can just transfer assets between them as needed to balance the books.

Where is the "free lunch"? The debt incurred by a transfer operation is still on the government's books, whether it's classified as "bonds" or "money". The core tradeoff is still there: will the transfer lead to enough increased spending during the liquidity trap sufficient to offset the deadweight loss of paying for it through taxes down the road? (Not to mention a slightly higher chance of fiscal crisis in the meantime.)


If we take Woodford's observations seriously, borrow-and-spend stimulus during a liquidity trap basically dominates borrow-and-transfer stimulus. Keep in mind that in Woodford's model, borrow-and-transfer stimulus is completely useless (multiplier = 0), while borrow-and-spend has multiplier > 1. Departures from Ricardian equivalence will make borrow-and-transfer stimulus more effective, but they will also make borrow-and-spend stimulus more effective in exactly the same way. For borrow-and-transfer to be optimal, you'd need either (1) an extraordinarily disproportionate impact of the departure from Ricardian equivalence, or (2) stimulus spending that has zero or even negative value.

Steve Waldman said...

Kindred — Matt's response is unsurprisingly thorough and wonderful. I'd disagree with a bit of it, and I'd disagree with some premises of your post: That outside of a liquidity trap monetary policy is always sufficient and trade is unproblematically good is more a New Keynesian perspective than a Keynesian perspective. Recall that Keynes the man carefully architected the Bretton Woods system in order to prevent the sort of the unbalanced trade that the New Keynesian/Neoclassical detente enthusiastically accepted during the 1990s and 2000s.

Re your core question, I want to highlight Matt's point that fiscal policy improves the financial position of the private sector in a way that conventional monetary policy does not.

One conventional form of monetary policy (less popular now, but it used to be the main way the US Fed did policy) is for the Fed to issue money and buy debt from banks, or in English, the Fed would print money and lend it to banks. This made banks more liquid, but not more solvent. Banks get money, but in exchange they promise to deliver a stream of future cash flows to the Fed. Unless the Fed charges unduly low interest, no one gets richer than they were. Institutionally, the Fed's existence amounted to a giant credit card for banks. When you get a credit card in the mail, it creates some useful options for you, but it doesn't amount to new wealth.

Nowadays, the Fed mostly purchases Treasuries for money rather than lending money to banks. But the net effect is similar to when it lent to banks. Some private sector entity would have earned interest on those Treasuries. After the Fed buys them, the private sector gets immediate money, but is deprived of that interest stream. Effectively, the private sector as a whole gets a loan, which it repays slowly with foregone interest. Unless the Fed misprices its purchases, the private sector is made neither poorer nor richer by the operation, just a bit more liquid.

So with monetary policy, the consolidated government/central bank lends money, helping accommodate the private sector's demand for liquidity, but not improving its overall financial position.

With fiscal policy, the government spends money or issues debt but receives no claim to a predictable stream of money in exchange. The private sector receives an asset without a corresponding liability. It is "richer".

Now, you may argue that this is false, by Ricardian equivalence. After all, if the government is bound by a standard solvency constraint, the money or debt that is issued must be backed a stream of expected tax revenue of equal value. So fiscal policy is also an asset swap.

As Matt points out, there are lots of reasons, both theoretical and empirical, why Ricardian equivalence might not apply as a behavioral matter. If, as a behavioral matter, the obligation someday-somehow to pay taxes has a different effect on private sector entities that a stream of certain, negative cash flows, then fiscal policy can induce behavioral changes that monetary policy cannot.

(cont'd)

Steve Waldman said...

If Ricardian equivalence is not true in fact, if the stream of taxation that follows the issue of new debt is less valuable than the debt itself, then fiscal policy amounts to a change in the real wealth position of the private sector. Note that it is easy to see how this might be true in a depression. The government issues debt in exchange for a stream of real goods and services that otherwise would not have been produced, whose inputs would otherwise have gone unutilized. Those goods and services are effectively a repayment of tax in kind: they are real resources commandeered by the state in exchange for the debt issued, and they represent an opportunity cost to no one. The state could sell those goods, and use the proceeds fund a tax payment holiday on the debt it has incurred. The government remains solvent under conventional definitions, but the stream of taxes it collects is less costly than the value of the debt it has issued. The fiscal operation has directly increased the wealth of the private sector (and total net wealth) both in real and financial terms. Monetary policy can never do that. When monetary policy is successful at ensuring that there are no unutilized inputs, fiscal policy can't be used to increase net wealth this way. The use of resources compelled by government spending represents an opportunity cost to private actors, and the net effect is a loss if you think the private sector uses resources more efficiently than government. But conditional on the existence of unutilized inputs (and therefore a failure of monetary policy), fiscal policy offers a free lunch that monetary policy cannot.

Even if Ricardian equivalence holds exactly and there are no unutilized resources in the economy, I'd argue that fiscal policy creates options that cannot be replicated by monetary policy. I'm going to frame the argument in terms of capital structure. The obligation of the private sector to finance the public debt represents an equity claim by the state on the private sector. That is, in order to avoid a currency collapse, the private sector is bound, over an infinite horizon, to service the public debt with taxation. But the arrangement of those tax payouts, their timing and amounts, is at the discretion of the issuer, of the taxpaying citizenry, rather than being fixed and scheduled in advance. Citizens can (at least in theory) service reduce the indebtedness of the state when the private sector's finances are solid, and slow payments to the state when the private sector needs to rebuild its real wealth position. Equivalently, as Keynes argued, the state can reduce its deficit in good times and expand its deficit in bad times.

A citizenry that wishes to avoid devaluation of the state's currency must maintain the expectation that someday, eventually, payments will be made to the state in sufficient value justify the exchange rate between state money and real goods and services. But when the citizentry has financed itself via fiscal policy, when it has "borrowed taxation" from the government, it has incredible flexibility in how it arranges those payments. If the citizenry has financed itself via monetary policy, it has borrowed money from the state in a very regimented way. Holding the public deficit constant, after a money infusion from the Fed, some agent in the economy is put on the hook to repay the Fed on a fixed, perhaps uncomfortable schedule.

(cont'd)

Kindred Winecoff said...

Matt,

My own shorthand is that monetary policy consists of actions taken by the monetary authority. So even though QE, twists, helicopter drops, etc. function similarly to actions taken by the fiscal authority, they are usually classified differently at least in the popular imagination, so I maintain the distinction. Guess it's mostly semantic.

I think this is where I'm getting lost:

There is still deadweight loss here. Holding the future trajectory of monetary policy constant, the government eventually needs to tax back the amount it spent on transfers. That will incur deadweight loss. If we change the future trajectory of monetary policy to inflate away more of the nominal debt (which consists of bonds and money), then the deadweight loss from future taxes will be lower, but there will be some other welfare cost from the increased inflation.

For one thing, in the present environment more stimulus today is actually necessary to bring us back to historical inflation trends. This is the "free lunch" I was talking about: the inflation risk is on the downside right now, not the upside. So you don't need future taxes, nor do you (necessarily) need to accept high future inflation.

So why not have the Fed helicopter drop, have the Treasury recapitalize the Fed with a $1tn coin, and be done with it?

I'll need to read Woodford's paper closely.

I appreciate your patience. Just saw SRW's comments. I'll read them and reply in a bit.

Steve Waldman said...

(p.s. I wrote all that before Matt's second round of responses, also unsurprisingly wonderful, and quite consistent with my views although framed very differently.)

Kindred Winecoff said...

Steve,

Thanks for the comments. I'm learning a lot.

My reference to trade linked to Krugman. I know the story is more complicated than that. As for Bretton Woods, the main difference was in exchange rate policy, not limits on trade. (Which is why Krugman is so gung-ho about going after China, but that's OT.)

So here's where I get confused. In Bagehot's classic formulation, central banks should "lend freely against good collateral" in times of trouble. But the Fed gets to decide what constitutes "good collateral". If the Fed decides my $85,00 house is *really* worth the $120,000 mortgage I have on it, and then pays that much to me for my house, it can make me actually richer. Yes, the Fed takes a "loss" on the transaction, but it's a loss that can be offset by the Treasury more or less at will. (And most likely won't even have to be, if the Fed can hold the house on its balance sheet until the value recovers.)

It's possible that I'm getting confused because I just don't have my accounting straight. Anyway, I really like your equity/debt example, which makes a lot of sense.

Maybe my original question would have been better phrased: Can someone explain to me why MMT (which I think of as existing in a quasi-Keynesian tradition) is wrong: that the monetary authorities truly are stuck in a liquidity trap. If they can do QE, and Twist, and helicopter drops then it doesn't seem like they are. And if they aren't, then Keynesian fiscal spending seems like a third-best option, given the politics dynamics and other issues.

I recall that both of you have written on this before on your blogs, so I'll go back and read those posts rather than expecting additional comments. Maybe that'll clear things up.

Anonymous said...

in light of earlier comments, this might seem simplistic, but why are you making the assumption that cash transfers on the fiscal side will only move once, and then be hoarded?

If the government borrows idle money, and gives a construction company a contract to go build stuff, the construction company is not going to hoard that cash-It's going to hire idle workers and equipment, and set off the multiplier process. It can't just take the government's money and not provide the service its contracted for. On the other hand, the problem with an open market operation at the lower bound is that it has no effect on demand. There would be, if there was an opportunity cost to holding cash (since people would go spend that extra money); but when there's no opportunity cost to holding cash (i.e. when nominal interest rates are zero), there's no incentive to economize on your cash balances, and monetary policy breaks down (hypothetically, I don't think this is actually true). Another way of thinking about it is with the equation of exchange, MV=PY. Monetary policy works through M; fiscal policy works through V. They are different channels.

Monetary policy works indirectly, based on people's incentive to get rid of money when hoarding is costly (i.e. interest rates are positive). Fiscal policy doesn't depend on that same set of incentives; a dollar spent is a dollar spent, and by contributing to an increase in the velocity of circulation, pushes up nominal GDP.

Your main confusion, I think, is the notion that "animal spirits" are why monetary policy breaks down in a liquidity trap, and that those "animal spirits" should vitiate fiscal policy too; that's not true. Monetary policy breaks down in the liquidity trap because of the incentives people face in a zero interest environment, and their rational response to those incentives; that set of incentives does not constrain the effectiveness of fiscal policy. In fact, it will be incredibly effective, precisely because there's no crowding out, as long as you are in the liquidity trap. And after you're out of it...well, that's the whole point.

(brad delong has some very useful explanations of the rationale for fiscal policy in a Keynesian framework from a while back)

JKH said...

Quantitative easing (as Bernanke defines it) and Twist are monetary operations. They are exercises in changing the liability duration of the consolidated Treasury/Fed balance sheet. They are variations on the Fed’s usual asset duration management in normal times.

Qualitative easing (as Bernanke defines it) is also a monetary operation. There is a lot of nonsense around about how the Fed taking intentional losses in its qualitative easing policies. But the collateral it takes in all cases is subject to haircut, with expected losses of zero. This is not a fiscal operation. That is not to say there is not fiscal risk - but the fact is that there is fiscal risk in every Fed transaction – to the degree that every transaction affects its “bottom line”, which is normally remitted to Treasury.

The Fed has not done and will not do any “helicopter drop”. HD by construction is a Fed disbursement of money without receiving an asset in exchange, which therefore must result in a reduction in Fed capital by intention. HD is fiscal. See Scott Fullwiler’s post for detail.

All that said, the Fed’s continuous connection to fiscal is through its earnings and capital position. This is what connects the Fed to Treasury and monetary to fiscal in accounting terms. It includes normal annual Fed profit remittances, and the implied backstop of Treasury capital transactions, should that ever become necessary.

The most prominent MMT proposal for using a central bank balance sheet to conduct fiscal transactions currently is Mosler’s proposal for a trillion Euro helicopter drop from the ECB into EZ treasury accounts at the ECB. In the US case, MMT typically goes straight to conventional fiscal via Treasury, although there is a long standing structural proposal to eliminate bond issuance, effectively combining Fed and Treasury operations.

Matt Rognlie said...

So why not have the Fed helicopter drop, have the Treasury recapitalize the Fed with a $1tn coin, and be done with it?

This wouldn't really recapitalize anything. A $1 trillion coin isn't a claim on any asset; instead, it's just another form of base money, which is also a liability of the Fed. The Treasury could recapitalize the Fed by handing it a $1 trillion T-note, but then the Treasury's debt would be $1 trillion larger.

The key point, I think, is the following: if the government hands out $1 trillion to households somehow without receiving an asset in return, the government's debt is $1 trillion bigger. Period. Now, the government may decide to hold this debt in the form of bonds or money. Either way, however, it's going to have to service the debt and ultimately pay it back, which will be costly.

I know the idea of money being a "debt" that the government has to service sounds weird, but it's right. In normal times, the stock of base money is small enough that the liquidity benefits from holding it are enough to satisfy investors, even when the nominal interest rate on it is zero.

When the Fed massively expands the stock of base money (like it has done recently, and certainly like it would do if it added another $1 trillion), however, at the margin investors are not willing to pay for these liquidity benefits. Therefore the Fed needs to pay a market rate of interest on money. This sounds funny because, after all, the Fed decides what the "market rate of interest" is: it sets the federal funds rate. But the Fed can no longer set the federal funds rate at any rate above zero when its balance sheet is huge, unless it is willing to pay the same rate of interest on reserves. And the Fed ultimately needs to set a fed funds rate that is in line with natural equilibrium real interest rates, or else we'll see runaway inflation.

So there are servicing costs when debt is held in the form of money, exactly as there are costs when debt is held in the form of bonds. The Fed can't escape them. It can try to hold out for a little longer with ZIRP to bring down its financing costs, and that's one of the possible "commitment" benefits of a helicopter drop. But you have to ask why the Fed cares so much about bringing down interest rates on an extra $1 trillion of debt when the government as a whole already has many trillions more---why did that additional $1 trillion change the Fed's mind? The only plausible reason would be that the Fed's own balance sheet is threatened, and it cares about that over and above its concern for the general government balance sheet. (That's why I emphasized undercapitalization.)

All in all, a helicopter drop is (1) a fiscal transfer stimulus plus (2) possibly some kind of weird commitment device for the Fed to keep interest rates low in the future, by putting itself in such a bad financial position that it prizes its own balance sheet ahead of optimal macroeconomic policy in the future.

Elementary Questions About Keynesianism
 
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