Richard Williamson offers a report from the UK. Combining bits via Tyler Cowen and Williamson’s own excellent blog:

I think there has been a lot missing from the discussion of the UK in the blogosphere. We are a bit of a puzzle on a purely AD-based explanation of the recession.

1. We didn’t have deflation (on annual basis at least), and even stripping out the effect of the VAT rise in 2011 should still show persistent inflation over 3% since 2010 http://www.tradingeconomics.com/united-kingdom/inflation-cpi

2. UK inflation expectations seem to be significantly higher here (if falling away a little recently) http://www.bondvigilantes.com/2012/03/19/markets-start-to-think-about-inflation-again/ http://uk.finance.yahoo.com/news/uk-inflation-expectations-drop-1-093038319.html
   …

I’m not really sure what is going on… If we were to just look at inflation (at expectations thereof), the country that ought to be having an AD-driven double-dip recession would appear to be the US…

I am becoming steadily less convinced that [an aggregate demand deficiency] is the whole story, at least for the UK. Back in November, Karl Smith made the clearest statement I have ever read of the New Keynesian explanation of a recession:

I can’t hammer this home enough. A recession is not when something bad happens. A recession is not when people are poor.

A recession is when markets fail to clear. We have workers without factories and factories without workers. We have cars without drivers and drivers without cars. We have homes without families and families without their own home.

Prices clear markets. If there is a recession, something is wrong with prices.

Right now, unemployment remains at over 8% in the UK while real wages are lower than they were 7 years ago and are continuing to fall. Yes, you read that correctly. Which immediately leads one to ask: on this explanation of a recession as expounded by Karl, how much further do real wages have to fall to eliminate disequilibrium unemployment?

There are two broad stories having to do with “sticky prices”. One, the mainstream New Keynesian story, emphasizes rigidity in the price of goods and services, most especially “sticky wages”. The other, emphasized by post-Keynesians and sometimes by monetarists, has to do with the sticky price of satisfying debts.

In the standard New Keynesian story, a depression is caused by the relative prices of goods and services falling out of whack. This is the basis for much of the mainstream policy consensus. The source of macroeconomic problems is sluggish adjustment of some goods and service prices, and stabilizing the price level should diminish the need for such adjustments. Macro policy can’t prevent relative prices in the real economy from needing to change sometimes. But it can prevent difficult-to-adjust prices from requiring frequent updates due to fluctuations in the overall price level. Because some important prices — the price of labor especially — are thought to be “sticky downward” (meaning they can “ratchet” upwards but can’t adjust down), targeting a positive inflation rate is recommended. The gradual, predictable movement of prices allows slow updates, preventing misalignments due to sluggish adjustment. The upward-slope permits “sticky downward” prices to fall in real terms relative to other goods and services by simply not rising with other prices. A recession, in the New Keynesian telling, occurs when this stabilization policy is not sufficient. If changes in supply and demand are so great that “sticky downward” prices must fall faster than the targeted rise in the price level, markets won’t clear. If the “sticky downward” price is workers’ wages, then it is employment markets that won’t clear, and we will experience mass joblessness. If this occurs, a cure would be to increase the targeted rate of inflation until real wages fall relative to other goods and services. When real wages fall enough, employment markets will clear again and the recession will end.

In the post-Keynesian story, a depression is driven by an decrease in agents’ willingness or ability to carry debt. Agents “pay for” decreased indebtedness by devoting their income to the purchase of safe assets (including especially their own outstanding debt) rather than spending on real goods and services. Unfortunately, money spent on financial asset purchases does not create income (they are asset swaps), and may not be cycled back into income for producers of real goods and services. So, in aggregate the attempt to reduce indebtedness can lead to a reduction of income that sabotages the attempt to pay down debt. This is the famous “paradox of thrift”. We simultaneously experience unemployment (reduced spending and income to real goods and service providers plus sticky wages means that people get canned) and financial distress (reduced income and fixed debt makes prior debt ever more burdensome). In this story, reducing real wages is not a solution. Real wage reductions might mitigate unemployment temporarily, but they also engender financial distress. Financial distress then causes agents to redouble their efforts to satisfy debts, reducing aggregate income and requiring further reductions in real wages ad infinitum. The only way out of a post-Keynesian depression is to increase real wages relative to the real burden of debt. In the post-Keynesian story, inflation is helpful only if real incomes hold steady, or, at very least, fall more slowly than the real value of prior debt.

One data point is not dispositive. But Williamson’s account of the UK experience is not consistent with the New Keynesian story, while it is perfectly consistent with the post-Keynesian account. There has been inflation in the UK. The real price of labor has not been sticky. The real burden of debt has fallen, sure, but real wages and incomes have fallen even farther, leaving people less able than ever to satisfy debts they’ve contracted and so purchase financial security.

There is a lesson here. If we mean to pursue reflationary policy, the goal should not be to reduce real wages, but to reduce the real value of debt relative to incomes. One way to do this, which the post-Keynesians’ closest frenemies suggest, is to stabilize the nominal income path at its prior trend while tolerating whatever inflation that engenders. This implies a large increase in nominal income from current levels. Going forward, if we hold nominal income to a gently rising path, the burden of aggregate debt relative to income will never unexpectedly rise. (Unfortunately, predictable distress may not prevent debtors in aggregate from taking on more debt than they can service, due to the competitive dynamic of a boom. I think NGDP targeting would be a big improvement, but not sufficient: We must always be mindful of leverage and debt.)

Pace the very brilliant Chris Dillow, the UK has not stabilized the path of NGDP:

Even if, as Dillow suggests, policymakers could not have held NGDP on path in 2009 due to forecast error, after the collapse they certainly could have restored total income to its prior trend with some combination of monetary and fiscal policy. They have not, and so the burden of debt relative to incomes in the UK has increased.

The UK has just entered a “double-dip” recession, and remains, in my view, in a depression, despite occasional thaws and recoveries. That this has happened, despite the plummeting real wages that Williamson reports, tells a tale. It is not “sticky wages” that should concern us, but the sticky burden of precontracted nominal debt.

Afterward: David Andolfatto wonders whether debt dynamics could play so large a role more than three years after a collapse in nominal income. Yes it can, I argue in his comments.

Karl Smith responds to Williamson here.

• Scott Sumner and Marcus Nunes suggest that our policy failures are in some sense just an “oops!”, that they result from a mix of mistaken theory, institutional frictions, personal quirks, and political forces rather than being, as I argue, a choice. I’d be more sympathetic if these “mistakes” were unique to the United States. Broadly similar choices have been made in Europe, and Japan.

  You can tell idiosyncratic stories of political and institutional failure for each of these countries individually. But ex ante, you’d not have expected similar policy responses. From an international balance perspective, for example, it’s not surprising that Japan did not inflate, but you might expect the United States to jump at a policy response that would reduce the burden of its considerable debt to foreigners. Yet the US and Japan seem to be on broadly parallel tracks.

  There is supposed to be a constituency for stimulative policy. The conventional story is that, during a downturn, election-seeking politicians will be recklessly pro-expansion, in conflict with and checked by an independent central bank. But, at least in the United States and Europe, there is surprisingly little appetite among politicians from “mainstream” parties to emphasize either fiscal or monetary expansion. On the contrary, the political conversation revolves around restraining deficits and “being responsible”, which is code for ensuring that the demands of creditors (public and private) are fully satisfied. This may change. In Greece, Portugal, Ireland, and Spain, parties now viewed as “fringe” may gain influence. But despite a years-long downturn of Great Depression severity, so far elected politicians in all these countries have emphasized a narrative of necessary adjustment and responsibility, and have almost never agitated for monetary policy better tailored to Southern Europe or threatened disorderly default. The behavior of politicians, in Europe as in the United States, suggests that the people to which they are accountable are not primarily the fraction of their labor force that is out of work. This is different from the 1970s, when elected officials did seem to behave as though they were accountable to unemployed people, and put central bankers under intense pressure to be accommodative. Something has changed. In status quo democracies, politicians tend to respond to groups that are numerous, rich, or organized. Since the 1970s, in all the depression democracies, retirees and near-retirees have grown both more numerous (as a fraction of voters) and more rich, while workers have grown less organized. Emerging markets like China have responded to the downturn quite differently. I think this pattern is too systematic to chalk up to idiosyncratic mistakes. [1]

• Kevin Drum writes:

  [The problem is] Steve’s claim that the median influencer — whoever it is — “is panicked by the prospect of becoming poorer,” which explains our financial system’s rabid opposition to inflation higher than 2%. This claim might have made sense 50 years ago, when many of the affluent elderly were coupon clippers. But today it doesn’t make sense even for them, and it certainly doesn’t make sense for anyone else. Hardly anybody literally lives on a fixed income these days. The elderly middle class lives on Social Security, which is indexed to inflation. The broad middle class has its retirement savings invested in 401(k) funds, which do better when the economy does better. The wealthy have their money invested in a variety of sophisticated vehicles, all of which are hedged against inflation in one way or another. We simply don’t live in a world of fixed returns anymore. Unless you’re a hedge fund quant making some specific kind of inflation play, there are very few people today who have any reason to fear higher inflation, especially of the moderate, temporary sort that the Paul Krugmans and Scott Sumners of the world advocate.

  Drum is right that there are no more coupon clippers. There is very little coupon to clip, because interest rates have been in secular decline for the last 30 years. But he is wrong to jump from that to imagine that upper-middle-class retirees and near retirees are immune to inflation. Affluent retirees depend heavily on asset wealth; Social Security cannot cover the lifestyles to which they’ve grown accustomed, and the expenses and commitments they’ve accumulated.

  Affluent older Americans hold a large proportion of their wealth in bonds and cash-like instruments (bank CDs, money market accounts). They also maintain significant positions in stock funds that might “do better when the economy does better”. But, unsurprisingly, retirees keep the wealth they most depend upon in safer, fixed income vehicles. The proportion they keep in stock funds tends to increase with wealth. [2] Since they can’t clip coupons, retirees rely upon asset sales and redemptions for income. They try to manage the pace of sales so they don’t outlive their capacity to maintain their lifestyles.

  Retirees living on asset wealth are very exposed to inflation. It’s an error, a fallacy of composition, to assume that the existence of hedges and “sophisticated vehicles” means that somehow everybody can be protected. Every debt contract imposes inflation risk that some party must bear. Stock markets get the press, but most financial claims on capital are structured as debt, all of which must be held, directly or indirectly, by some human (usually an old or rich human). [3] Any individual retiree can shed inflation risk by switching from, say, municipal bonds or bank CDs into TIPS. But retirees and near-retirees in aggregate can’t do this: there aren’t enough TIPS to go ’round, and somebody has to be persuaded to hold the unprotected bonds. TIPS already pay negative yields. If creditors grow nervous and try to herd into protected assets, TIPS yields would be driven even more sharply negative and prices of ordinary bonds would collapse. Somebody, some creditor, will bear the loss of value imposed on bondholders by inflation. It’s a game of musical chairs. No matter how sophisticated your vehicle, evading inflation risk is and must be costly if markets are remotely efficient. (If markets are not efficient and it is cheap to slough off inflation risk, then someone — quite possibly a gullible retiree — has been made a patsy and persuaded to offer underpriced insurance. “Sophisticated vehicles” tend to benefit those who structure them more reliably than those who purchase them.) [4]

  Affluent retirees do hold some of their wealth in corporate stock, and it is obviously true that the US political system and the Federal Reserve are extremely loss-averse when it comes to the stock market. Note that some equity claims (think banks) are indirect claims on debt, and so are themselves conduits for inflation risk. And there is no necessary relationship between asset inflation and goods inflation. The interests of affluent retirees are best served when financial assets in general (both stocks and bonds) are inflating but goods prices are not. And for the most part, that is what the US political system works to deliver. [5] If you could promise that stimulating the economy would lead to a stock boom, much of the opposition to expansionary macro policy would dissolve. But you can’t promise that. Even if the policy “works” from an employment perspective, stocks may fall. Corporate profits are near all-time highs as a fraction of GDP, and stock markets are priced with optimistic growth assumptions already. Sharing more of the wealth with wage earners may cost more than the benefit to shareholders of incremental sales. Today’s affluent retirees lived through the most stock-market-focused era in human history. They remember the 1970s stagflation, during which the influx of women into the labor force was successfully absorbed but stocks languished. They know that stock wealth is fickle.

  So people who intend to live off their nest eggs rely first and foremost on the “safety” of bonds. Expansionary policy is a hazard for them.

  Consider NGDP targeting. Under this policy rule, Treasury securities would become risk assets, whose real return would be geared to the health of the economy. (NGDP path targeting implies that shortfalls in real growth must be matched by increases in inflation.) Treasuries become low-beta index funds, diversified claims on the real production. Nominal yields would be more stable, but the real value of a future payment becomes as uncertain and volatile as the business cycle.

  More conventionally, an increase of the de facto inflation target from 2% to 4% would be a “tax” on whoever holds fixed income securities at the moment the change is announced. Holders of long-term bonds would lose no matter what. If the inflation target is raised in order to enable steeper negative real yields (and that is the point), then people holding short-term bills and deposits would also face a new 2% per year cost, for as long as the low rates persist. And that’s not the worst of it. Ben Bernanke is speaking in the voice of older affluent Americans when he argues that adjusting the inflation target is bad because it might disturb “anchored” expectations. What people who rely upon asset wealth really fear is a sharp, unexpected increase in inflation. And much as that may not be what dovish economists have in mind, there is no guarantee that higher inflation and lower real rates will succeed at reviving growth and employment. If the new target fails, will the Fed double down and try 6% inflation? Even if the Fed says it won’t, will nervous markets require the bank to prove its credibility at 4%? Will the Fed be willing to hike interest rates into a still depressed economy, to prove it will hold its new 4% inflation target? Should it? All bets are off.

  Affluent retirees and near-retirees have very good reason to fear inflation.

Notes

[1] In Japan, Germany, and France, more than 50% of the total population is over 40 years old. (56.5%, 57.2%, and 50.2% respectively.) They do have children in these countries, so there are many more retirees and working-age people over 40 than there are younger workers. In the US, “only” 45.5% of the population is over 40, but I think as a polity, the United States behaves as though it is substantially older, because its unusual fecundity (for a developed economy) comes from relatively poor and disenfranchised immigrants. By comparison, China’s over-40 share is 40.3%, Brazil’s is 32.8%, and India’s is 27.1%. In the 1970s, when the US policy was, um, plainly inflationary, the over-40 share of the population was 36.1%.

Using 40-years-old as a cut-off age is arbitrary. “Retirees and near-retirees” is a vague formulation, and 40+ is admittedly a stretch. But people do not turn suddenly into zombie-like asset hoarders. As cohorts of workers age, they accumulate financial assets and become less likely to face unemployment. When they retire, their fear of unemployment disappears entirely, and their dependence upon saved assets increases. There is a continuum between the young and poor, who should prefer the risk of stimulus, and the old and rich who should not. It’d probably be best to modify my story to declare “affluent retirees and older workers” the “median influencer”.

By the way, I am guilty of data mining the cutoff age to support my case. (I examined the population pyramids.) Add whatever grain of salt you like, but I think the point stands. The data are via Wolfram Alpha, e.g. “age distribution US 1975“, then “Show Details”.

[2] As of 2001, people over 65 with assets of $1M or less held substantially more in cash and bonds than stock. Richer people held a greater share in stock. See Curcuru et al, Table 6.

[3] Remember Karl Smith’s point that capital is mostly stuff like buildings and cars. In the US, the bond market is roughly twice as large as the public equity market, and that excludes debt held indirectly via ordinary bank deposits.

[4] Throughout this piece, I’m using “inflation risk” to encompass both the risk that inflation will diminish the real value of precontracted payments from long-term, fixed coupon securities and the risk that inflation will enable sharply negative real yields, affecting the real value of floating rate debt and short-term claims.

[5] This lends credence to Matt Yglesias’ view that central banks would use negative nominal rates where they do not use inflation to generate negative real yields. Negative nominal yields would deliver windfall gains to people holding stock and longer-term bonds, while negative yields engineered via inflation would have uncertain effects on stock and reduce the real value of longer term bonds (with or without capital losses, depending on whether yields follow inflation). If the American political system is geared to paying off asset holders, it’s no wonder that reducing nominal yields became “conventional” monetary stimulus.

I enjoyed Matt Yglesias’ suggestion that depressions are merely a technical problem that will go away once the obsolescence of cash eliminates the zero lower bound on interest rates, and Ryan Avent’s rejoinder. Although I’ve toyed with Yglesias’ view myself, I think that Avent has the better of the argument when he characterizes our current policy impotence as reflecting behavioral rather than technical constraints. We don’t lack for technical means to counter people’s self-defeating impulse to hoard cash and safe financial assets. On the contrary, we have a whole cornucopia of options! The squabbling that has preoccupied me lately, between market monetarists and post-Keynesians and mainstream saltwater economists, is an argument over which of many not-necessarily-mutually-exclusive options would most perfectly address address this not-really-challenging problem.

We are in a depression, but not because we don’t know how to remedy the problem. We are in a depression because it is our revealed preference, as a polity, not to remedy the problem. We are choosing continued depression because we prefer it to the alternatives.

Usually, economists are admirably catholic about the preferences of the objects they study. They infer desire by observing behavior, listening to what people do more than to what they say. But with respect to national polities, macroeconomists presume the existence of an overwhelming preference for GDP growth and full employment that simply does not exist. They act as though any other set of preferences would be unreasonable, unthinkable.

But the preferences of developed, aging polities — first Japan, now the United States and Europe — are obvious to a dispassionate observer. Their overwhelming priority is to protect the purchasing power of incumbent creditors. That’s it. That’s everything. All other considerations are secondary. These preferences are reflected in what the polities do, how they behave. They swoop in with incredible speed and force to bail out the financial sectors in which creditors are invested, trampling over prior norms and laws as necessary. The same preferences are reflected in what the polities omit to do. They do not pursue monetary policy with sufficient force to ensure expenditure growth even at risk of inflation. They do not purse fiscal policy with sufficient force to ensure employment even at risk of inflation. They remain forever vigilant that neither monetary ease nor fiscal profligacy engender inflation. The tepid policy experiments that are occasionally embarked upon they sabotage at the very first hint of inflation. The purchasing power of holders of nominal debt must not be put at risk. That is the overriding preference, in context of which observed behavior is rational.

I am often told that this is absurd because, after all, wouldn’t creditors be better off in a booming economy than in a depressed one? In a depression, creditors may not face unexpected inflation, sure. But they also earn next to nothing on their money, sometimes even a bit less than nothing in real terms. “Financial repression! Savers are being squeezed!” In a boom, they would enjoy positive interest rates.

That’s true. But the revealed preference of the polity is not balanced. It is not some cartoonish capitalist-class conspiracy story, where the goal is to maximize the wealth of exploiters. The revealed preference of the polity is to resist losses for incumbent creditors much more than it is to seek gains. In a world of perfect certainty, given a choice between recession and boom, the polity would choose boom. But in the real world, the polity faces great uncertainty. The policies that might engender a boom are not guaranteed to succeed. They carry with them a short-to-medium-term risk of inflation, perhaps even a significant inflation if things don’t go as planned. The polity prefers inaction to bearing this risk.

This preference is not at all difficult to understand. The ailing developed economies are plutocratic democracies. “The people” do have power, but influence is weighted in a manner correlated with wealth. The median influencer in these economies is not a billionaire, but an older citizen of some affluence who has mostly endowed her own future consumption. She would like to be richer, of course. But she is content with her present wealth, and is panicked by the prospect of becoming poorer. For such a person, the depression status quo is unfortunate but tolerable. The risks associated with expansionary policy, on the other hand, are absolutely terrifying.

The revealed preference of my polity is not my personal preference. Perhaps that is because I’m an idealist, and I actually care about the misery provoked by precarity and unemployment. Perhaps it’s simply because I’ve not yet endowed my own future consumption, and I’m scared. Regardless, I object. Although I understand where it comes from, I detest the preference for depression revealed by my polity. Perhaps you do too.

But if we want to change the behavior of the polity, it’s not enough to argue over clever policies that, if implemented, might do the trick. We’ve got to change its preferences, which means either buying off the median influencer, or changing her identity via political struggle. Alternatively, we can wait until what are now problems of aggregate demand morph into supply problems (after people become unemployable and capital decays), or into threats of political and social unrest. The median influencer may change her views if tight supply makes goods costly despite fiscomonetary conservatism. Or if her neighborhood is on fire. But I’d prefer we avoid all that, and take a more proactive route.

In the meantime, we have to recognize that what we are experiencing is not a technical failure. It is not “magneto trouble”. We, collectively, are making a choice. The task before us is to change our mind.

My previous post advocating a collaborative detente between post-Keynesians, market monetarists, and mainstream saltwater economists, has drawn smart and often skeptical comments. Some critics suggest I understate the dissimilarities between the three schools, and argue that any sort of fusion would amount to a muddled middle, centrism only for its own sake. (I like this: “The centrist position on building a bridge would end up with a bridge halfway across the river.”)

If I were advocating some kind of Grand Unified Theory, I might concede the point. But I’m not advocating a theoretical fusion at all. I’m advocating a policy compromise. Quarreling schools may not find very much common ground in arguments over theory. Theory and its inseparable twin, ideology, are too pervasive to admit much compromise. They are indistinguishable from reality. Our eyes form the world before the world forms our vision. When truth itself is at stake, we will not easily give ground.

But it is not the truth that we are after here. We should strive for something far less grand: to do actual good in the world. It just so happens that the theoretical disputes which divide the disciples and apostates of Keynes do not prevent overlap in the solution space. We can work together even when the stories that we tell ourselves are worlds apart.

And since it is at least possible that my side might be wrong, the existence of others who are almost certainly mistaken is actually helpful. We can build insurance policies out of their errors and make resilient analogues of Pascal’s wager. The point is not to take the best a priori position. The point is to avoid going to hell.

I am not neutral between the economic schools I’ve identified for a love-fest. Although I dislike binding myself with labels, I lean post-Keynesian. I agree with many critics that monetary policy alone is unlikely to be effective, and my gut inclination is not at all favorable to monetary policy as an instrument. I think overreliance on monetary policy, especially during the so-called Great Moderation, played a key role in the development of socially destructive inequality and economically catastrophic patterns of aggregate investment.

But, as the finance types like to say, that’s a sunk cost. We are in a global depression. Despite periods of respite, I think we are likely to remain in a depression until we sort out the immense social conflict embedded in the financial and political claims we’ve accumulated against against one another. This is a bad situation. Last time, it took a catastrophic global war before we put our squabbles into perspective and found ways to engineer a reset. That kind of thing is still not off the table.

The incremental cost of trying a bit more monetary policy seems small to me by comparison. I don’t think it’s likely to work, but I am heartened at least that the variant proposed by the market monetarists is much less toxic than the mainstream dogma that, de jure or de facto, prizes price stability above all things. I’m still skeptical, but NGDP path targeting represents a huge improvement over inflation targeting as a monetary policy rule. I’d be willing to give it a try. In exchange, I’d like to try to persuade monetarists of good will to agree to limits on what constitutes legitimate monetary policy, and to assent to a coherent and non-corrupt fiscal lever as a backstop.

This sets up a wager that both sides should smugly accept. The market monetarists should be glad to accept the fiscal backstop, despite theoretical objections, because they should be sure that it will not need to be used. I can put up with one last big monetary push. I expect it won’t work, but it will automatically open the door to policy that I’m pretty sure will work. In either case, whichever side is wrong will be glad to have taken the bet. There are devils in the details, obviously. There are some forms of monetary policy that I’d consider too destructive to try, that might “work” in terms of restoring growth in macro aggregates but that would threaten social values I hold dear. The “fiscal lever” is unlikely to be a decentralized job guarantee engineered by Pavlina Tcherneva and Randy Wray, which in a more perfect world I’d like to see given a try. But the world is as it is, and time is of the essence.

One of the worst unintended consequences of the Obama administration is that it has discredited compromise. We can argue about whether Obama was hapless and naive, or whether he was cynical and canny, using compromise as a fig leaf to promote the center-right outcomes that he actually favors. But to the progressive left, “compromise” has come to mean sacrificing core ideals and values as the starting position in negotiations that only gets worse.

But compromise is not always a bad idea. Sometimes there are people with whom one can find common ground despite important, even fundamental, differences. That doesn’t mean we smudge away the disagreements, that we cease to argue the merits and demerits of conflicting models and worldviews. But we shouldn’t let our debates in the seminar room prevent or delay finding a practical consensus. If we are not, all of us, just a constellation of egos engaged in a masturbatory pissing match to establish our place in academic or journalistic hierarchies, then we need to find ways to leaven our disputes with provisional compromises and coordinated efforts to improve the real world. In real time.

People I admire were calling each other nasty names last week, so I cowered in the corner, put my hands to my ears, and hummed very loudly. I’m talking about the debate over money and banking that involved Steve Keen (1, 2, 3, 4, 5), Paul Krugman (1, 2, 3, 4, 5, 6, 7), Nick Rowe (1, 2, 3), Scott Fullwiler, and Randy Wray among others. Here are some summaries by Edward Harrison, John Carney, and Unlearning Economics. Anyway, although there were some good moments, this debate just made me unhappy. The mechanics of banking are straightforward and uncontroversial, although they are widely misunderstood. [1] Yes, some misunderstandings were expressed and then glossed over rather than acknowledged when corrected. But that is to be expected in a very public conversation in which people are not behaving cordially, but are instead playing “gotcha” with one another. When a conversation is framed with one group calling the other mystics and the other shouting “Ptolemy!”, that is not a good sign.

I don’t mean this as criticism of anybody. Humans have egos, and I’ve certainly behaved worse. But it is terribly frustrating to me. The protagonists in this debate have much more in common than they have apart, and I think some progress could be made intellectually, and perhaps in the governance of the real world, if they’d communicate with an eye toward finding where they agree. Though I get in trouble for saying so, I think that the heterodox post-Keynesians, mainstream saltwater economists, and uncategorizable market monetarists actually agree on a lot. I think they unnecessarily pick fights with one another for reasons that are more sociological than intellectual. I don’t mean to pretend that they don’t have important theoretical differences. They do. They will probably never agree on what sort of policy would be “optimal”. But if we move the goal posts from perfection to better-than-the-status-quo, they’d find a lot of room to join forces. I do my best to understand all of their models, and as imperfectly as I may have done so, I think I’ve learned from them all.

I’m going to switch gears a bit from the banking debate and talk about the fault lines over “fiscal” vs “monetary” policy, however you wish to define those words. We have identifiable groups of thinkers who agree on the most fundamental question — should the state act to stabilize “aggregate demand”? — but who have strong preferences over whether macro policy should be implemented via fiscal or monetary channels. If we frame this as a binary choice, all we have is a fight. But if we realize that we live in a “mixed economy” and are likely to do so for the foreseeable future, there is lots of room for conversation.

• Market monetarists make excellent points about how cumbersome and unsuitable a legislature is to the task of managing high-frequency macro policy. They point out that fiscal interventions may have limited or even paradoxical effect if they are offset with countermoves or diminished activism by the central bank. They emphasize the nimbleness of monetary operations, their inexhaustibility and fast reversibility, and how those characteristics combine to make central banks extremely credible expectation-setters. They suggest that we rely upon consistent rule-oriented monetary policy, and argue that this can be implemented more by anchoring expectations (which become self-fulfilling) than by direct market intervention.

• Mainstream saltwater economists are accustomed to operationalizing monetary policy as interest-rate policy, and pay great attention to the zero lower bound on nominal interest rates. They point out that regardless of your theories of central bank “ammunition”, as a matter of practice or politics, expansionary monetary policy seems to become difficult once the zero lower bound of conventional interest rate management has been hit. They suggest we rely upon monetary policy in “ordinary” times, but that we supplement it with fiscal policy at the zero bound. Conventional “neoclassical synthesis” models did not do a great job of foreseeing or predicting the crisis, but they have done a good job of explaining and predicting macro behavior during the crisis, in the context of “depression economics” or a “liquidity trap”.

• Post-Keynesians did predict a crisis, on broadly the terms that we actually experienced. They argue that there are adverse side effects to using monetary policy to manage aggregate demand. Although in theory this might be avoidable, post-Keynesians point out that in practice monetary stabilization, even above the zero bound, seems to engender increasing indebtedness and financial fragility, and to distort activity towards overspecialization in finance and real estate. They pay much more attention to the details of financing arrangements than the other schools, and emphasize that vertiginous collapses of aggregate demand are nearly always accompanied by malfunctions in these arrangements. Aggregate demand, post-Keynesians argue, cannot be managed without concrete attention to the operation of financial institutions and the conditions that lead to their fragility. Post-Keynesians make the deep and underappreciated point that fiscal policy, even if it is conventionally tax-financed, can deleverage the private sector and reduce financial fragility in a way that monetary operations cannot. Monetary operations, if you follow the cash flows, amount to debt finance of the private sector by the public sector. The central bank advances funds today, in exchange for diverting precommitted streams of future cash from private sector entities to the central bank. Fiscal expansion is more like equity finance of the private sector by the public sector. Public funds are advanced, and captured by parties with weak balance sheets as well as strong. But taxes are not withdrawn on a fixed schedule. They are recouped “countercyclically”, in good times, when private sector agents are most capable of paying them without financial distress. Further, the private sector’s tax liability is distributed according to ex post cash flows realized by individuals and firms, while debt obligations are distributed according to ex ante hopes, expectations, and errors. So tax-financed fiscal policy acts as a kind of balance-sheet insurance. Both by virtue of timing and distribution, taxation is less likely than monetary-policy induced debt service to provoke disruptive insolvency in the private sector. Plus, during a depression, fiscal expansions may never need to be offset by increased taxation. [2] Never-to-be-taxed-back fiscal expenditures, if they are not inflationary, shore up weak private-sector balance sheets without putting even a dent into the financial position of the strong. They represent a free lunch both in real and financial terms.

When I think about these three groups, I don’t think, HIghlander-style, “There can be only one!”. I think “Cool! Let’s put these ideas together.”

The market monetarists are right. Having different agencies conduct fiscal and monetary policy without coordinating or setting expectations is a bad idea, it invites inconsistent and ineffective policy. If we can, as the market monetarists suggest, overcome the status quo inadequacy of monetary stabilization with more aggressive policy or by inventing better tools — new techniques for expectation setting, targeting NGDP futures, negative IOR, etc. — we should do those things! [3] But, the mainstream saltwater types may be right too. Monetary policy at the zero bound seems difficult to do in practice, even if it need not be in theory. So, to avoid having the central bank and fiscal policymakers work at cross-purposes, we can give the central bank fiscal levers it can use as part of its overall policy regime. Some post-Keynesians and market monetarists seem to like the idea of using payroll taxes as a fiscal lever (albeit with different rationales). The monetarist Scott Sumner has endorsed a proposal to use sales-tax surcharges and rebates as a supplement to monetary policy. We might find common ground even on more ambitious fiscal policy ideas, provided they are implemented in an expectations-consistent, rule-oriented way and integrated with monetary policy, rather than reliant upon ad hoc moves by a legislature in real-time. (We may have a harder time finding common ground on the MMT job guarantee, but once we get talking to one another on friendlier terms, who knows?)

There are lots of issues and controversies, but they strike me as far from insurmountable. A lot of people (like me!) distrust status quo central banks. I think central banks tilt the economic scales in favor of rentiers in general and financial industry cronies in particular. But central-bank cronyism is a governance issue. No one is particularly attached to the current governance structure of, say, the US Federal Reserve, which keeps the public and elected officials at a remove but gives the financial industry great influence (via formal ownership and enfranchisement but also via operational interdependence and “dependency corruption“, ht Matt Yglesias). It’s not just the leftish post-Keynesians who are upset about how central banks behave. Market monetarists like Scott Sumner and saltwater Keynesians like Paul Krugman constantly lament the bureaucratic caution of the real-world Fed, when the economic theory advanced by the guy who runs the place demands flamboyant commitment in order to anchor expectations. If there is a correct policy, if the managers of the central bank are competent and understand the correct policy, but it is politically or institutionally impossible to implement the correct policy, then we do not have an “independent central bank”. We have a governance problem that we should remedy. [4]

One nice thing about a monetarist / saltwater / post-Keynesian synthesis, the thing that has me most excited, is that it would be perfectly possible to give our nouveau central bank a mandate that explicitly includes restraint of private-sector leverage in addition to an NGDP target. I think that the post-Keynesians are right to identify financial fragility as a first-order macro concern. On its own, NGDP path targeting would help “mop up” after financial fragility and collapse, because it weds depressions to inflations, engineering wealth transfers from creditors to debtors when things go wrong. But we’d rather avoid the whole cycle of fragility, insolvency, and inflation, if we can. Monetarist David Beckworth has pointed out that stimulative monetary policy need not expand bank-mediated imbalances between creditors and debtors. Proper expectations could encourage creditors to spend (and, implicitly, debtors to save), reducing overall indebtedness. That could happen! But it has not been our experience with expansionary monetary policy in the recent past. Over the Great Moderation, wealth inequality and the indebtedness continually expanded while interest rates were pushed towards zero in order to sustain the pace of debt-funded expenditure. Under an NGDP-targeting regime, however, Beckworth’s view might be vindicated. NGDP-targeting would dramatically increase the vulnerability of creditors to inflation compared to the status quo price-stability commitment. Creditors might become less willing to accumulate large stocks of fixed-income assets, especially as indebtedness and perceived financial instability grows, for fear that a “Minsky moment” will require a path-targeting central bank to engineer a burst of inflation. In my view, nothing has distorted financial market behavior more egregiously than taking inflation risk off the table, which has guaranteed real rents to default-free debt holders, financed if necessary by the taxation of workers and the nonconsumption of the unemployed. Restoring inflation risk to its proper place (a bad economy means crappy real returns even to fixed-coupon debt) may be enough to shift private sector incentives and prevent unwanted accumulations of financial leverage. The market monetarists could be right, full stop.

But the post-Keynesians might be right that treating financial fragility as an afterthought is never sufficient, that the dynamics of endogenous instability identified by Minsky will not be thwarted by vague fears of inflation among creditors. If macro policy were to include a leverage cap as well as an NGDP path target, and if the central bank were empowered with a broadly targeted fiscal instrument, an unwelcome expansion in private sector leverage could be opposed with a shift towards tighter money but looser fiscal. This would reduce the pace of new borrowing, and accelerate repayment of existing private-sector debt, shifting creditors’ claims from fragile private-sector balance sheets to an expanded public sector debt stock. The NGDP path (with the occasional inflations it imposes) and the leverage cap (with the occasional deficits it engenders) would combine to shape the budget constraint faced by the political branches of government. Loose bank regulation would be paid for with automatic fiscal outflows to constrain leverage rather than via occasional crises and bailouts. The cost of borrowing would be related to the level of aggregate leverage and the government’s consolidated fiscal stance, and would be set reactively rather than actively by the central bank to maintain the NGDP path subject to an aggregate leverage constraint.

Maybe this is a terrible idea. I’m intrigued, but I’m kind of an idiot. The rest of you are very nice and smart and reasonable. You should talk with one another and stop picking fights over how many straw men can dance on the head of a DSGE model. Please.

[1] As Henry Ford famously noted, “It is well enough that people of the nation do not understand our banking and monetary system, for if they did, I believe there would be a revolution before tomorrow morning.”

[2] Many post-Keynesians would object to the phrase “tax-financed” as an incoherent descriptor for any government expenditure. But the claim that government expenditures sometimes need never be offset with tax increases is perfectly orthodox, when the cost of interest service is below the long-term growth rate of the economy, or when the present value of incremental growth in tax receipts engendered by the spending (under existing law) exceeds the cost of servicing the debt. Depressions are a time when government paper is sought after by the private sector, driving real debt service costs towards or below zero. If there are unutilized resources in the economy that would have generated no tax revenues absent government expenditure, or that would have elicited real transfers — negative tax revenues — via unemployment or other transfer payments, the incremental growth in real tax revenues engendered by government investment of fallow resources may be large, even if the investment is inefficient. In ordinary times, government expenditures do not “pay for themselves”, but in a depression, they very well might. Note there is no substantive symmetry here with “dynamic scoring” of tax cuts. In a depression, the private sector is leaving resources unutilized, foregoing potential consumption and investment in order to acquire government paper. Cutting taxes only generates incremental tax revenue if the distribution of tax cuts is to people who will invest by putting unutilized resources to work rather than bid-up the price of resources already in use or expand their holdings government paper. That’s a hard kind of tax cut to engineer. In good times, tax cuts may generate some incremental revenues by substituting efficient private-sector resource use for less efficient public-sector use and by sharpening incentives for private-sector production. But incremental revenue will be modest, as we’ve merely replaced a less efficient use with a more efficient use rather than bringing an entirely unutilized resource into service. And the cost of financing the tax cuts that generate this incremental revenue will be burdensome, as real interest rates are high and positive when the economy is booming. It is unlikely that tax cuts ever “pay for themselves”, but expenditures can when the economy is in depression. None of this conflicts with the market monetarists’ view that fiscal policy is unhelpful because depressions can be avoided with sensible monetary policy. If they are right that monetary policy is enough, then there never need to be unpleasant depressions where fiscal policy pays for itself because of inefficient nonutilization of resources by the private sector.

[3] There is some unconventional monetary policy to which we absolutely should object, “credit easing” targeted towards particular institutions or sectors, which is a form of directed subsidy. Fortunately, the market monetarists agree that this is a bad idea.

[4] Perhaps there is less of a tension between technocratic competence and democratic accountability than we once imagined.