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.
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.
Labels: loose lips reflate economies, macro is hard, monetary policy