Monetary economics superstar M. Woodford has made a big splash with his 97 page opus belittling the Fed's QE moves and calling for (more or less) NGDP targeting.
Here's Krugman on the paper.
There are three big problems with Woodford's approach. (1)The macro model he uses to produce his results, (2) his assumption that the Fed can commit to anything not in their period by period best interest, and (3) the way he completely ignores real political constraints faced by the Fed.
Let's talk about each of these.
The Model:
It is laid out in Eggertsson & Woodford (2003).
First off, here are a few quotes from the paper:
For simplicity we shall assume complete financial markets and no limits on borrowing against future income.
Our model abstracts from endogenous variations in the capital stock, and assumes perfectly flexible wages (or some other mechanism for efficient labor contracting), but assumes monopolistic competition in goods markets, and sticky prices that are adjusted at random intervals in the way assumed by Calvo (1983), so that deflation has real effects. We assume a model in which the representative household seeks to maximize a utility function
Real balances are included in the utility function, following Sidrauski (1967) and Brock (1974, 1975), as a proxy for the services that money balances provide in facilitating transactions.
The paper presents no evidence that the model is consistent with the data, no evidence that it is capable of producing the kind of economic situation in which we currently labor, no evidence that it has any kind of forecasting power.
All conclusions about policy drawn by Woodford are contingent on the maintained assumption that the underlying model of the economy is correct. And we know that it decidedly is not!
Can the Fed commit?
I am a broken record on this subject, but in its current configuration, there is no way the Fed can credibly commit to an optimal but time-inconsistent policy. The forward guidance / NGDP targeting solutions require the public to believe that the Fed will continue to tolerate inflation higher than they would like AFTER THE ECONOMY RECOVERS. Krugman put it best when he said the Fed must credibly commit to behave irresponsibly! They can't because there is no mechanism that forces them to deliver the policy after the economy actually recovers.
All we can ever hope for from the Fed in its current configuration are time-consistent polices. Woodford's is not.
Here's Krugman again, giving a not technically correct but yet informative explanation of the problem:
What Mike demonstrates is the point that liquidity-trap worriers have been making for a long time – actually, ever since my 1998 piece. Current monetary policy is indeed ineffective in a liquidity trap; but there is still scope for central bank action in the form of credible commitments to keep monetary policy easy in the future, when the economy is no longer at the zero lower bound.
The trouble is how to make those credible commitments.
Actually, it’s a two-stage problem. First you have to convince the central bank itself that it’s a good idea to signal that you won’t return to normal policy (say a standard Taylor rule) as soon as the economy lifts off from the liquidity trap; then you have to convince the private sector that the central bank will not, in fact, just revert to type once the crisis is past.
There's even a third problem. There's no way to convince the private sector that the Fed won't simply revert to type because when the time comes, the Fed will have no incentive not to revert to type!
What about Politics?
Suppose by some amazing coincidence that Woodford's policy conclusions would also follow from the true model of the economy. Suppose also that we can just dismiss all the literature on time inconsistency by commanding the Fed to "just do its job". We still have the problem that the Fed is not independent of politics.
Romney has already said he wouldn't re-appoint Bernanke. There's at least a .4 chance he'll be President. What hope would a Fed have of running a loose policy after the economy recovers in an all Republican government?
The Republicans control the House now. The Republican party seems to be flirting with a return to the Gold Standard! And the Fed is gonna announce, oh, we're gonna keep rates at zero even after the economy recovers?
The Fed has bosses. A sizable fraction of those bosses will never sign off on the kind of polices Woodford advocates. They would be doing so for the wrong reasons, but those ignorant gold-bug bosses would actually be extremely likely to be right.
9 comments:
"The forward guidance / NGDP targeting solutions require the public to believe that the Fed will continue to tolerate inflation higher than they would like AFTER THE ECONOMY RECOVERS."
But isn't this what the Fed did from 2002-04? The Fed wanted to convey it was willing to keep its foot on the gas pedal to fight disinflation/deflation, even after the economy was showing signs of recovering. It was this commitment (and investors' perception of its credibility) that fueled the frenzied carry trade that marked the start of the ill-fated boom.
Alex -
If everything you say is true (and I have no reason to think it isn't) then that makes Angus' point even stronger. Unless you think the Fed is willing to make the same mistake twice, that is.
Either way, the point is that mechanistic models of credibility cannot work if there is no mechanism for enforcing commitments. In 2002-2004 the pressure may have been for loose policy. In this case, the pressures (particularly political pressures) are coming from the opposite direction: tighter policy, not looser.
Of course the Fed is willing to make the same mistake twice. They caused the Great Depression, the 1937 recession-with-a-depression, and now the recent Great Recession.
Of course, if we just replaced the Fed with a computer (as Friedman once recommended), the commitment problem is gone. Computers don't have to worry about sticking to a diet either.
I just remembered that Evan Soltas has evidence that the Bank of Israel is covertly targetting NGDP, even though that means tolerating higher inflation at times.
TGGP, and yet it's impossible to argue that the Fed today has behaved the same way it did in the 1930s.
If we replaced the Fed with a computer we'd still have to hire programmers. Either we give the programmers autonomy -- in which case they have a commitment problem -- or we don't -- in which case someone else has a commitment problem to not hire new programmers to change the formula in the future.
You can't get rid of politics.
I see why the Fed can't commit to deviating from its own utility function in any given period. What I don't see is why we would assume the Fed's utility function doesn't include a desire to "maintain credibility." When I look at statements that come out of the Fed, this seems a much clearer, stronger, and more consistent objective than keeping the inflation rate in a particular range. What empirical research has been done on whether credibility directly enters the Fed's preferences?
Time consistency proves too much, if you assume the Fed has an underlying objective that they will always revert to. You could have said to Volker, you can't lower inflation from 15% because of time consistency, you'll just raise it to 30% a few years later. If the Fed raised inflation now to 4 or 5%, why would time consistency force them to cause deflation 3 years from now? Wouldn't that be politically unpopular? The whole point of the Austrian business cycle is that politicians like credit booms.
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