Global Paul McCulley Central Bank Focus July 2009

What If?

The whole world, it seems, is wrapped many of my Keynesian brethren seem to around the axle about exit strategies be struggling with what to do, arguing from putatively unsustainable policies: against any further near-term fiscal (1) the Fed’s bloated balance sheet, with stimulus, or at least unless enacted simul- some $800 billion of excess reserves taneously with long-term fiscal restraint. sloshing ‘round the banking system, in Indeed, I recently publicly uttered the context of an effective zero Fed funds something along these lines, though rate; and (2) the Treasury’s huge budget I hedged myself by saying long-term deficit, unprecedented in peace time and fiscal responsibility rather than restraint set to stay huge, implying a Treasury debt/ (responsibility is in the eye of the beholder, GDP ratio approaching 100% within a while restraint is more categorical). decade’s time. In any event, there does not seem to be any For some, usually with Monetarist serious consensus as to how the policy mix roots, this combination of policies is a should be adjusted, if at all, despite clear classic brew for a major bout of inflation and present evidence of massive unem- (eventually, it is always stressed). For ployment and underemployment, which others, usually with Austrian tendencies, is putting downward pressure on nominal this policy brew is a deflationary force, personal income (the product of fewer as it will provoke foreign investors to flee jobs, fewer hours and decelerating wages, both the dollar and Treasuries, driving up almost to the zero line). This is not the stuff real interest rates, pole axing any revival of a self-sustaining revival in aggregate in risk asset prices, themselves backed by demand. Thus, my tentative conclusion the fruits of bubble-driven mal-investment. is that maybe the consensus professional And, I’m quite sure, there are some with a economist view is that America should foot in both camps. simply accept that it’s going to have its

So it’s not easy to actually define con- version of Japan’s lost decade, the Calvinist ventional, or consensus, wisdom. In fact, aftermath of the preceding sin of booming Global Central Bank Focus

growth on the back of ever-increasing policy action. It is. But it is not sufficient, leverage and mal-investment. Krugman pounded the table, because if the public believes that the central bank But if that sobering view is indeed the new will, in the future, un-print the money – in consensus, shame on my profession! There today’s jargon, implement an exit strategy is another way. And, irony of ironies, it is from money printing – then the printed not a new way, but rather an old way, one money will simply be hoarded, rather than defined by no less than spent, because deflationary expectations in 1998 and in 2003, when will remain entrenched. lecturing Japan about what to do. I have enormous respect for the intellectual To get the public to spend the money, horsepower of both men, and what they Krugman argued, the central bank should preached back then deserves a re-preach- make clear that the printed money will ing, even if I’m the humble preacher that remain printed, shifting deflationary must take the pulpit. expectations to inflationary expectations. In his famous conclusion, actually advice Krugman in May 1998 to the Bank of Japan, Krugman declared In a delightfully wonkish paper,1 using (his italics, not mine): the enormous horsepower of the IS-LM (investment savings-liquidity preference “The way to make monetary policy money supply equilibrium) framework, effective is for the central bank to he made a powerful case for what Japan credibly promise to be irresponsible – should do to bootstrap itself out of the to make a persuasive case that it will deflationary swamp. I’ll spare you the permit inflation to occur, thereby wonkish part and cut to his commonsen- producing the negative real interest sical conclusion. rates the economy needs.”

In the midst of deflation in the context of In a follow-up (similarly wonkish) paper2 a liquidity trap, with the central bank’s in 1999, Professor Krugman refined his policy rate pinned at zero, it is not enough argument, stressing that the core of his for the central bank to print money, accom- thesis could be implemented through modating massive fiscal policy stimulus, a credible inflation target that was he argued. Not that this is not a necessary appreciably higher than the prevailing

July 2009 Page 2 negative inflation rate in Japan. Thus, he But to its credit, the Bank of Japan tiptoed was not so much arguing that the Bank of the reflationary walk, sticking with QE Japan should act irresponsibly, but rather for five years, exiting in March 2006, after act irresponsibly relative to orthodox, the year-over-year core CPI had turned conventional thinking, which itself was positive in November 2005. A small beer is irresponsible, in that it emphasized the better than no beer. need for an eventual exit strategy from liquidity trap-motivated money printing. Bernanke in May 2003 Professor Bernanke became Fed Governor To get out of the trap, he emphasized, the Bernanke the prior year, making his central bank needed to radically change most famous speech in November 2002, expectations to the notion that there was “Making Sure ‘It’ Doesn’t Happen Here,”3 no exit strategy, at least until inflation detailing the Fed’s anti-deflationary was appreciably higher – not just inflation toolbox. That’s the speech that the markets expectations, but inflation itself. Only then are using as a roadmap for Chairman would the commitment to higher inflation Bernanke’s present anti-deflation policy be credible, with the central bank not just path (it’s actually been quite a good talking the reflationary talk, but walking roadmap!). But a speech in May 2003, the reflationary walk, turning deflationary “Some Thoughts on Monetary Policy swamp water into reflationary wine. in Japan,”4 is equally important, I think,

Naturally, the Bank of Japan didn’t listen because it provides a roadmap for what to Krugman at the time; orthodoxy is as the Fed might do if present anti-deflation orthodoxy does. In March 2001, however, policies prove to be inadequate to the task. the Bank of Japan did serve up a small beer from the Krugman still, adopting The speech is not quite as wonkish as Quantitative Easing (QE), re-enforcing Krugman’s May 1998 missive, but is still its zero interest rate policy (ZIRP) with robustly analytical. Perhaps that’s why my an explicit target for massive creation of profession and the media do not give it the excess reserves, committing to retaining attention it deserves. But Mr. Bernanke’s that policy until the year-over-year core speech does have strong Occam’s Razor CPI moved above zero on a “stable” basis. conclusions, and they are eerily the same A very small beer indeed. as Krugman’s, perhaps even stronger.

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No, Mr. Bernanke did not advocate to consumer price index excluding fresh the Bank of Japan that it credibly commit food) to the value it would have reached to acting irresponsibly, Krugman’s if, instead of the deflation of the past clever turn of phrase. In fact, as noted five years, a moderate inflation of, say, above, Krugman didn’t really, either; he 1 percent per year had occurred. simply wanted the Bank of Japan to act (I choose 1 percent to allow for the responsibly, which would be deemed measurement bias issue noted above, irresponsible in the context of orthodox and because a slightly positive average thinking. Both men know how to think rate of inflation reduces the risk of future outside the proverbial box! episodes of sustained deflation.) Note that the proposed price-level target is a At the time, Mr. Bernanke was a table- moving target, equal in the year 2003 to thumping advocate for the Fed to adopt a value approximately 5 percent above an explicit inflation target. But in Japan, he the actual price level in 1998 and rising upped that analytical ante by advocating 1 percent per year thereafter. Because that the Bank of Japan adopt a price level deflation implies falling prices while target, not an inflation target. the target price-level rises, the failure to end deflation in a given year has the And there is a huge difference. An inflation effect of increasing what I have called target “forgives” past deflation (or below the price-level gap. The price-level gap is inflation target) sins. In contrast, a price the difference between the actual price level target does not forgive those sins, but level and the price level that would have rather demands that the central bank atone obtained if deflation had been avoided for them by explicitly pursuing sufficient and the price stability objective achieved inflation to restore the price level to a in the first place. plateau that would have been achieved if those sins had not been committed. More A successful effort to eliminate the specifically, he advocated that the Bank of price-level gap would proceed, roughly, Japan should (his italics, not mine): in two stages. During the first stage, the inflation rate would exceed the “… announce its intention to restore long-term desired inflation rate, as the the price level (as measured by some price-level gap was eliminated and the standard index of prices, such as the effects of previous deflation undone.

July 2009 Page 4 Call this the reflationary phase of policy. view, this was a risk worth taking, in part Second, once the price-level target was because he felt that a central banker with reached, or nearly so, the objective for strong communications skills could draw a policy would become a conventional distinction between (1) a one-time reflation inflation target or a price-level target to correct a deflated price level back up to that increases over time at the average a level that would have been achieved in desired rate of inflation.” the absence of deflationary sins and (2) the central bank’s long-term inflation objective. This is very powerful stuff! Mr. Bernanke But he acknowledged it would be tricky. knew he was breaking some new ground, at least from the mouth of a sitting But his case didn’t rest simply on skilled policymaker. In actuality, he was drawing central bank communications. While he on some powerful academic work of felt that generating a positive shock to Eggertsson and Woodford,5 which laid short-to-intermediate inflation expecta- out the case that a price level target tions would have the effect of reducing would likely have a more powerful effect real interest rates (remember, the real on inflation expectations than simply an rate is the nominal rate minus inflation inflation target above the prevailing level expectations), he did not think that effect of inflation (or in Japan’s case, deflation). was assured and even if it was, he did not How so? A price level target pegged at the believe it would be sufficient to stimulate starting point of a period of deflation – private sector aggregate demand robust or below target inflation – implies that enough to reduce Japan’s output gap. Thus, the central bank is explicitly committed to reflation, meaning that in the short-to- he advocated explicit cooperation between intermediate term, the central bank the fiscal authority and the monetary will explicitly aim for an inflation rate authority, with the latter subordinating that is higher than its long-term itself to the former. And you thought “desired” rate. Krugman was radical!

Mr. Bernanke recognized that such a While the passage on this topic6 in policy could unmoor long-term inflation Bernanke’s speech is a bit long, it is so expectations, creating a deleterious rise powerful that I think it deserves a full in long-term interest rates. But in his hearing. Here it is:

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“My thesis here is that cooperation Essentially, monetary and fiscal between the monetary and fiscal policies together have increased the authorities in Japan could help solve nominal wealth of the household the problems that each policymaker sector, which will increase nominal faces on its own. Consider for spending and hence prices. The example a tax cut for households and health of the banking sector is businesses that is explicitly coupled irrelevant to this means of trans- with incremental BOJ purchases of mitting the expansionary effect government debt – so that the tax cut of monetary policy, addressing is in effect financed by money creation. the concern of BOJ officials about Moreover, assume that the Bank of ‘broken’ channels of monetary trans- Japan has made a commitment, by mission. This approach also responds announcing a price-level target, to to the reservation of BOJ officials that reflate the economy, so that much or all the Bank “lacks the tools” to reach a of the increase in the money stock is price-level or inflation target. viewed as permanent. Isn’t it irresponsible to recommend a tax cut, given the poor state of Under this plan, the BOJ’s balance Japanese public finances? To the sheet is protected by the bond contrary, from a fiscal perspective, conversion program,7 and the govern- the policy would almost certainly be ment’s concerns about its outstanding stabilizing, in the sense of reducing stock of debt are mitigated because the debt-to-GDP ratio. The BOJ’s increases in its debt are purchased by purchases would leave the nominal the BOJ rather than sold to the private quantity of debt in the hands of the sector. Moreover, consumers and public unchanged, while nominal businesses should be willing to spend GDP would rise owing to increased rather than save the bulk of their tax nominal spending. Indeed, nothing cut: They have extra cash on hand, would help reduce Japan’s fiscal woes but – because the BOJ purchased more than healthy growth in nominal government debt in the amount of GDP and hence in tax revenues. the tax cut – no current or future debt service burden has been created to Potential roles for monetary-fiscal imply increased future taxes. cooperation are not limited to BOJ

July 2009 Page 6 support of tax cuts. BOJ purchases of And Now to the USA at Present government debt could also support The is not presently suffering spending programs, to facilitate deflation in goods and services prices, industrial restructuring, for example. although the core CPI has dipped slightly The BOJ’s purchases would mitigate below the Fed’s putative 2% “target.” So the effect of the new spending on the the extreme measures that Krugman burden of debt and future interest and Bernanke advocated for Japan do payments perceived by households, not translate fully to the United States. which should reduce the offset But they do translate a lot more than the from decreased consumption. More consensus is even willing to discuss in generally, by replacing interest-bear- politically correct circles. ing debt with money, BOJ purchases of government debt lower current America is in a liquidity trap, driven by deficits and interest burdens and private sector deleveraging borne of asset thus the public’s expectations of price deflation, meaning that private sector future tax obligations. demand for credit is axiomatically flat to negative, despite a Fed funds rate pinned Of course, one can never get against zero. The only source of credit something for nothing; from a demand growth in the United States is the public finance perspective, increased Treasury itself. monetization of government debt simply amounts to replacing other And until the deleveraging process runs forms of taxes with an inflation tax. its course, consensus agrees that there is But, in the context of deflation-ridden nothing wrong with such bloated Treasury Japan, generating a little bit of demand for credit: In a recessionary positive inflation (and the associated foxhole, Keynesian religion dominates increase in nominal spending) would all other economic religions. But not all help achieve the goals of promoting believers are equally devout, as noted at economic recovery and putting idle the outset, with many against any further resources back to work, which in turn ramping up of Keynesian stimulus, at would boost tax revenue and improve least without a contemporaneous move the government’s fiscal position.” to ensure long-term fiscal responsibility, so as to prevent a deleterious increase in Powerful, powerful stuff! long-term Treasury interest rates.

Page 7 Facebook… So what should Washington do, if and 1 “Japan’s Trap,” http://web.mit.edu/krugman/www/japtrap.html Stay up to date on when – and I stress “if and when”; I’m not 2 “Thinking About the Liquidity Trap,” http://web.mit.edu/krug- PIMCO with Facebook. man/www/trioshrt.html Search “PIMCO.” making a forecast here! – private sector 3 http://www.federalreserve.gov/boarddocs/speeches/2002/ 20021121/default.htm twitter… aggregate (nominal) demand growth looks 4 http://www.federalreserve.gov/boarddocs/speeches/2003/ 20030531/default.htm Stay in touch with like it’s going to languish in Japan style for PIMCO. Search 5 Gauti Eggertsson, and Michael Woodford (2003). “The Zero the indefinite future? The answer: Take one Bound on Interest Rates and Optimal Monetary Policy,” http:// “PIMCO.” www.columbia.edu/~mw2230/BPEA.pdf cup of Krugman’s advice for Japan and 6 In this case, Bernanke was drawing on his own work, a no- punches-pulled academic essay from December 1999, “Japanese two cups of Bernanke’s advice for Japan – Monetary Policy: A Case of Self-Induced Paralysis,” http://www. princeton.edu/svensson/und/522/Readings/Bernanke.pdf. responsibly act irresponsibly relative For the wonks amongst you that haven’t read it, I strongly urge that you do so! to orthodoxy. 7 Elsewhere in the speech, Bernanke lays out a framework, via an interest rate swap arrangement, for the fiscal authority to assume any losses for the central bank from interest rate risks on its bond purchases, so as to bury that political red herring. As an Yes, as Bernanke intoned, there are no free economic matter, such losses are of no importance when looking at the consolidated balance sheet of the monetary authority and the lunches. But no lunch doesn’t work for me. fiscal authority: If government bond prices go down, the central bank loses money from a mark-to-market accounting perspective, Or the American people. While it is true, as but the fiscal authority makes exactly the same amount from a mark-to-market accounting perspective. Keynes intoned, that we are all dead in the long run, I see no reason to die young from orthodoxy-imposed anorexia.

Paul McCulley Managing Director July 9, 2009 mcculley@.com

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