Friday I wrote a post trying to get a lay of the debate over how “deleveraging” impacts both the economic recovery and monetary policy, in response to two posts by Matt Rognlie.
This lead to a useful email exchange with Arpit Gupta about the matter, who then went on to write a really great blog post on the matter that you might find helpful in clarifying some of these issues. There are, in general, three meta-arguments about the connection between deleveraging, monetary policy and the economic recovery, and he describes each of them. Using our venn diagram of economic arguments:
1 – Balance Sheet Recession. People who think that deleveraging is real, and no amount of monetary stimulus will help.
These are people like Richard Koo. Their argument goes that the presence of excess debt is the key constraint holding back economic growth. No amount of monetary stimulus will fundamentally change the asset position of households, and so there’s no way it will alter consumption or output (or, at least, not to the degree that is necessary). Raghuram Rajan may believe something like this, as best as I can tell. The MMT folks are probably best placed here as well.
As Beckworth and Rognile point out above, this view doesn’t make sense given the conventional understanding of how monetary policy ought to operate. If we desire greater spending from households or creditors; we can always make that happen by flooding the system with money.
2 – Liquidity Trap People who think that deleveraging is real, monetary stimulus could help, but the Fed won’t deliver enough.
These are people like Paul Krugman. As Rognile points out — Krugman is careful to note how deleveraging is only an issue if you’re in a liquidity trap, but that nuance tends to be lost among many other commentators. Elsewhere, he has argued that fiscal stimulus is only worthwhile as long as interest rates are zero — at other times, he often takes for granted that monetary policy ought to handle the brunt of aggregate demand management (or at least he did in the ’90s).
In that sense, Krugman actually agrees with Scott Sumner on more issues of intellectual substance than, say, with Keynes. It’s just that Krugman believes that in this particular instance, we happen to be in some kind of liquidity trap in which monetary policy won’t be sufficient to tackle the headwinds of a deleverage cycle.
3 – Quasi-Monetarists Then; there are people who believe that deleveraging may be a concern; but monetary policy (even with a zero-rate bound) ought to handle everything.
Here are the market monetarists like Scott Sumner and David Beckworth, as well as Matt Rognile. The belief is not only that monetary policy can fix any conceivable deleverage shock; but that the Fed could do so tomorrow given the set of tools they have; involving perhaps the adoption of a price level, getting more QE, imposing interest on reserves, or offering guidance on the future path of interest rates.
These have very different implications for policy:
Many people on sides 1 and 2 agree on issues; but there’s a fundamental conceptual difference there. Suppose, as Mike Konczal likes to imagine, that we wake up tomorrow and find that interest rates are actually 2%, rather than at 0% for the short-term Treasury rate. What should we do? Some people (like perhaps Koo?) would argue that changing that rate wouldn’t do very much. But people like Krugman would argue that, if we were in an environment in which conventional monetary policy could operate, then that’s basically the only policy channel we should use to get output back.
The only difference between sides 2 and 3 is whether or not the liquidity trap proves binding. This seems like a fairly trivial issue; but it determines entirely whether or not you think that we should adopt fiscal stimulus, or simply replace Ben Bernanke with a more aggressive Fed Chair.
Indeed, Scott Sumners calls for additional action by the Federal Reserve well beyond QE and Operation Twist, yet he signed a Cato organized letter of economists against the ARRA stimulus back in 2009. The stimulus does nothing – it can’t by definition – if the Federal Reserve was doing its job.
It explains why other disagreements have happened. If we are in a balance-sheet recession, should the Fed raise rates to 1%? Krugman and the monetarists would say no – the problem is that we can’t get negative interest rates, and raising rates does the opposite of that. They disagree about whether the Fed is constrained. People like Koo would say it doesn’t matter. Indeed, Koo blasted Krugman recently for supporting QE2, because, since monetary policy can’t do anything, he believes it pushes investors into stocks and commodities to search for returns.
Koo is a fan of fiscal policy because he believes it is the only thing that can support private-sector deleveraging. People like Krugman, channeling Michael Woodford, would say that it also helps because it doesn’t have to go through normal expectation channels.
It also goes to the big policy everyone is talking about: housing relief. How would each approach handle the foreclosure waves and debt overhang? The balance-sheet recession people would say it is essential to recovery, because the debt and subsequent uncertainty are driving the problems. The liquidity trap people would say that housing chaos is keeping interest rates negative, below the liquidity trap, and thus making it difficult for the Federal Reserve to guide the economy back to full employment. The monetarists would probably say it has no interesting macroeconomic consequences that a competent Federal Reserve and monetary policy couldn’t handle, and the policy should be considered on normal efficiency terms alone.