What Does “Easy Money” Even Mean?

Gerald brought up a really good question in my last post on ECB monetary policy stance since the crisis. I’m afraid Buttonwood got a bit trampled there, which in retrospect seems somewhat one-sided, since a big deal of his post is actually very good. Anyways, to the question:

What do you think a really easy monetary policy by the ECB would look like? Is it mostly about increasing the inflation target? Or would your rather have the central bank buy the debt of troubled economies like Greece?

At first I wanted to rush straight into it, but then I noticed that is pointless without clearing up what my definition of “easy money” is in the first place. I’ve spent quite a bit of time in this blog arguing that monetary policy all around the world, but particularly in the eurozone, is much too tight no matter which way you look at it. Let’s see what the ECB announcement brings today. A big issue i have with a lot of the current discussion, particularly in the Media, is that the currently historically low nominal interest rates are assumed to, by themselves, prove that money is “easy”, which is just wrong. So let me try and clarify some of the issues involved from my perspective.

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Let the Failing Continue

It is fascinating how much blogging mileage one can get out of the incompetence of the ECB. Call this act 3 in my ongoing series on the delusions of central bankers and one size fits none monetary policy. Or maybe we all just got stuck in a Groundhog Day like world of monetary policy hell.

Scott Sumners links us to The Economist’s Buttonwood, where we find an article on the continuingly low – much too low – level of inflation in many countries around the world, but particularly in the eurozone. Apparently the inflation rate in October fell to a new 4-year low of just 0.7 percent. Obviously this is also absolutely catastrophic from a rebalancing point of view, as nicely described by Max back in his post on eurozone inflation arithmetic. But let as take a look at the Economist article for a second here.

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Some More on Targets and Inequality

Caution: wandering mind and thoughts in process of clarification.

After reading through Max’s useful feedback in the comment section to my post on the possible effects on inequality of raising the inflation target I was forced to rethink the whole issue somewhat. First of all let me start by saying that, in the bigger scheme of things, the effects of raising the target inflation rate by 2% on inequality are indeed likely to be small, so how much this even matters is a question of debate in and of itself, but I hate to leave loose ends untied. To recap a bit, clearly there is a big difference between expected inflation and unexpected inflation. A central bank increasing its target inflation rate would have the effect of moving the value at which inflation expectations are anchored.

Yet even if fully expected this would have real effects due to what is generally known as the Mundell-Tobin effect – essentially the fact that, due to cash always paying 0% nominal interests, portfolio choices would change. More precisely, people would want to move away from cash and into bonds (or whatever you want to call the financial product used in your model). This move into bonds would raise the prices of bonds while lowering their yields, and it is this switch in portfolio compositions that would also cause the real interest rate in the economy to fall compared to where it was before. It would also change the distribution of income and wealth through various channels. As an example, it might be possible that there are constant entry costs when it comes to entering the bond market. Clearly this would mean that poorer households would be less able to protect themselves from the higher inflation rate as participating in the bond market would involve decreasing average costs, thus increasing inequality. At the same time the literature on the topic generally assumes that poorer households are net-debtors in the economy, and lower real interest rates would mean lower real interest payments, reducing inequality. In short, it seems to be anyone’s guess which effects dominate. Inflation is also generally referred to as a regressive tax on cash holdings, which would again drive up inequality somewhat.

But enough of that: to the main point of the post: from a perspective regarding the most direct effects on inequality, is a higher inflation target or a higher NGDP target preferable? Clearly my first post implied that I consider the answer to be the latter. I am not so sure anymore. As Max correctly pointed out, the change in inflation rate (a one-off effect) affects inequality, but within the moderate levels of inflation we’re talking about, there seems to be no reason to assume that inequality would be meaningfully affected beyond this initial movement. The big difference now between a higher inflation target and an NGDP growth or growing level target would be the degree to which inflation changes over time. Ideally, in the first case it would not change at all, while in the second case inflation would fluctuate as RGDP fluctuates.

Essentially it would seem RGDP, for different reasons including exogenous shocks, would fluctuate under both targets. The main advantage of an NDGP target would be to reduce this fluctuations since, much like the Taylor rule, it includes both output and inflation, while a strict inflation target (like the one of the ECB) does not. Clearly, however, the variance of inflation would, if the central bank does its job, be bigger under an NGDP target. That’s pretty much the feature of it. But, and in line with the thoughts outlined above, this would also mean that constant (essentially central bank-induced changes) in the inflation rate would, even if fully expected, also lead to constant (therefore also essentially central bank-induced) changes in real interest rates. Again, of course this is part of the idea – if RGDP falls, inflation would rise to meet the NGDP target, and real interest rates would fall (not only all other things equal but despite all other things adjusting), which would boost the economy causing RGDP to rise again – the whole point of the exercise.

Now, the general assumption is that variance in RGDP is bad for welfare – we would much rather have a constant real growth rate of, say, 2% per year than growth that is all over the place yet, over a certain period of time, averages 2% as well. Yet what does variance in RGDP do to inequality? I honestly would not know. In general, people with lower qualifications (i.e. on the lower end of the income spectrum) would get fired first in a downturn, but then again they also get hired first in an upturn. Is this process symmetric? That would seem to depend on the costs of hiring and firing people. If they are similar, the process would probably be symmetric, and the impact on inequality unimportant on average. But it would not seem farfetched to argue that, due to e.g. transaction costs and other market imperfections, variance in Inflation hurts the poor more than the rich. Again, if the technology for “inflation protection” (i.e. switching from cash to bonds) has decreasing average costs, as is likely, every switch would be more costly for poorer households than for richer ones. In short, the costs of protecting against inflation, which arise particularly when inflation changes, seem to be higher the poorer you are. So on these isolated grounds, a higher inflation target may be more desirable from a strict inequality standpoint.

Again, probably fairly trivial and not even I’m sure this really matters, but just sayin’.

Eurozone Inflation Arithmetic

It would seem that my initial post on raising the inflation target has sparked a pretty fruitful debate. Here’s a quick follow-up by Max on the topic.

I think the case for raising the inflation target is very strong. But it’s especially strong in the context of the European Monetary Union.

You see, the key problem in the Eurozone crisis is “rebalancing”: The periphery countries (the GIIPS) need to reverse their current accounts. And that requires a real devaluation of the periphery vis-à-vis the core (Germany, mainly). My colleague Christoph Zwick reckons in his new working paper that the periphery-core real exchange rate needs to fall by at least 13-17 percent over the next three years. There is, of course, a lot of uncertainty about this estimate. Nevertheless let’s assume a value of 15 percent, which sounds reasonable. This implies an annual real devaluation of (approximately) 5 percent for the next three years. Within the Eurozone, real devaluation can only come through an inflation differential: inflation in the periphery (p) needs to be 5 percentage points below the inflation rate in the core (p*).

Now the ECB targets the Eurozone inflation rate, i.e. the weighted average of core and periphery inflation rates. The share of the core in total Eurozone GDP is about 2/3. Let the ECB’s inflation target be t. So we have t = (1/3)p + (2/3)p*. If you combine this with the requires inflation differential, p* – p = 5, we get p =  t – (10/3) and p* = t + (5/3). Hence the periphery inflation rate has to be 3.3 percentage points below the Eurozone target and the core inflation rate has to be 1.7 percentage points above.

An inflation target of 2 percent implies 1.3 percent deflation in the Eurozone’s periphery each year for the next three years. This would be incredibly painful. If the ECB would target 4 percent average inflation, it would allow 0.7 percent inflation in the GIIPS. That also hurts, but probably much less than hardcore deflation. Meanwhile, the new target would imply 5.7 percent inflation in the core countries, which is higher than what we had during the last decade but not at all high by historical standards.

Obviously the concrete numbers are debatable, but the general result is not: Under the ECB’s current inflation target, the necessary current account adjustment in the Eurozone seems pretty impossible. Raising that target would make it a whole lot easier.

To Inflate or Not to Inflate

The nomination of Janet Yellen to the chair of the FED seems to be as good an occasion as any to bring this blog back from the dead. No real comment on that other than it’s awesome, so let’s get back into some general monetary economics.

Following the Great Recession there has been a lot of talk about the adequacy of the monetary policy response in its aftermath. Particularly the issue of the zero-lower-bound, well-known to Japan but often treated as something akin to an exotic decease that would never concern countries such as the United States, has been hotly debated. One of the most common calls to try and avoid the issue in the future, or at least make it’s occurrence more unlikely, has been to increase the inflation rate targeted by central banks. In the case of the United States the talk is often about raising it from 2% to 4%, whereas Japan has stopped talking and finally moved to do something about its long-lasting problem by increasing its target from 1% to 2%. And for all it’s worth, it seems to have worked fairly well. The two opposing views on this issue usually range from some weird notions of the “danger of inflation”, of “unanchoring inflation expectations” and everyone dying (or something) on the one hand to an essential no-brainer with little down-side risk on the other hand.

There is not much to say about the first notion other than there seems to be no compelling reason that central banks would have a harder time stabilizing inflation at 4% than at 2%. Even the lowest threshold value found in studies regarding the level at which things start spiraling out of control is around 8% and 4% certainly seems far enough away. Also, fear of inflation in general is essentially the view held by Niall Ferguson, which alone is a pretty safe indication that it is almost certainly wrong. The second view, however, is much more interesting. Indeed, in a perfectly nominal world (i.e. one where everyone and their dog is protected from the effects of inflation), increasing the inflation target by 2 percentage points would seem like the closest thing to a free lunch one might find.

However, and even if it is often downplayed, it would not seem to be that the issue of what a permanently higher level of inflation does to an economy over a longer period of time is as trivial or well-understood as is often portrayed. At least from my review of the somewhat limited literature on the topic it does not seem to be the case that we have all that good of a grasp of what would actually happen. My list of possible channels through which (either directly or indirectly) a higher level of inflation could affect income and wealth distribution, for instance, is solid two pages long and probably more than just incomplete. It also includes a lot of ifs and buts’, necessary assumptions regarding the distribution of creditors and debtors within the society, the nature of government institutions, the nature of different types of contracts and the bargaining power distribution between e.g. workers/unions and companies, just to name a few examples. Changing any of those assumptions flips the entire outcome.

It also does not seem entirely certain to me whether the effects this inflation would have on income distribution and wealth distribution would tend to be pointed in the same direction. And most importantly, the time frame used to make such analysis is vital. In times where the higher level of inflation boosts output back to its potential through monetary stimulus this would seem to almost certainly lower both types of inequality as measured by conventional inequality measures. What happens to the middle class is another entirely different story. It is unlikely to be the case anytime soon that we can declare that the “central problem of depression-prevention has been solved” (as Robert Lucas infamously declared back in 2003), so there will probably be another occasion where we could very much use the higher level of initial inflation. Krugman is also essentially correct in claiming thatone of the dirty little secrets of economic analysis is that even though inflation is universally regarded as a terrible scourge, efforts to measure its costs come up with embarrassingly small numbers”, yet as far as I can tell Friedman’s finding that Inflation is always and everywhere a monetary phenomenon” is about as much as we can say with real certainty.

Overall, systematic changes in inequality are generally a long-run issue, and despite price stickiness and whatnot money remains essentially neutral in the long run for the levels of inflation we’re talking about. Further, inflation most likely impacts inequality mainly through its effect on output to begin with, and from this point of view there is little reason to believe there would be any difference at all between 2% and 4% inflation during normal times. Yet maybe the fact that we would like to increase the inflation rate target says more about the nature of the target itself than about its fairly arbitrary numerical value.

The Incompetent Central Bank Case for Fiscal Stimulus

Keynesianism has made a roaring comeback in the aftermath of the Great Recession. No matter what ideological leaning different world leaders had at the time the crisis struck, they all threw their ideologies out of the window and implemented massive fiscal stimulus measures. A big reason Keynesianism was brushed aside in the past couple of decades is that the contractionary part of it more often than not simply does not happen, mainly for political reasons. And as far as the expansionary side of the coin is concerned, opponents of Keynesianism rightly point out that it is unnecessary and even counterproductive in times where our economies are running at something close to full employment. Even without fully rational expectations, the effects expansionary policy can have on the Philips curve are very real. Yet the whole edifice of Keynesian stimulus actually working at least in bad times is built on shaky ground as well – it is made under the assumption that a country’s central bank simply drops the ball when it is needed the most.

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