Sunday, August 14, 2011

Why do economists keep advocating impossible policies?

Policy activists on both the fiscal and monetary side are united by one common thread. The policies they propose are impossible to credibly implement.

Start with the fiscal side. Christina Romer in the NY Times again calls for an increase in our debt now for "stimulus" combined with a long term reduction in our debt. Mark Thoma and many others have made similar calls.

Dr. Romer is an excellent economist with a fantastic research record, but her policy proposal is impossible! In our political system, we cannot make any type of future long term commitment to do anything.

We cannot bind future politicians. Long run plans will only come to pass if they are in the interest of the politicians who are in office at each point in time over the course of the plan. In econo-speak, the policy must be time-consistent if it is ever going to be followed.

Amazingly we find the exact same problem on the monetary side. We are told by the Sumnerians that targeting a path for nominal GDP or the price level would help avoid situations like our current one.

But for these policies to work, when shocks hit the economy people have to believe that the Fed will do things in the future that they know the Fed doesn't like to do!

The Fed cannot bind either (A) future Feds, or (B) future politicians, who after all actually created and run the Fed.

The popular economics discussion of policy alternatives seemingly takes place in a world where Finn Kydland never won the Nobel Prize.

I will allow that there are papers that take commitment issues seriously in monetary policy. Many of them are well discussed in this excellent post. But, reading the post will show just how thorny those issues are and just how hard it actually is to implement an "optimal" policy over time.


Norman said...

So I see how the time consistency problem can prevent fully Keynesian policies: if the budget is determined one year at a time, the government can't really make binding commitments more than a year out.

Similarly, time consistency prevents a discretionary monetary policy from making commitments on interest rates several years out, which makes the most recent FOMC statement confusing. How do they know conditions will warrant low rates through 2013? If the economy goes into boom mode throughout 2012, will they renege?

But I'm not sure that's a problem with Sumner's policies. He's advocating switching from a (soft) inflation-targeting regime to a level-targeting regime. It might be that the Fed prefers discretion over rules, but I'm not sure why explicit price level targeting is any less time consistent than explicit inflation targeting, which plenty of central banks do.

John Thacker said...

I also don't see the similarity between Sumner's proposals and the Keynesians who want cyclical fiscal stimulus.

After all, I think one can argue that, contra your statement, the Fed does "like to" fight inflation when it appears.

The Fed has before and currently does fight inflation, even when growth is slow. By contrast, the idea of running big surpluses in good times has never happened.

The political argument that inflation is more insidious and likely than deflation (one which I have in the past subscribed to) is because deflation results in pain right now, and hence there will be intense political pressure to avoid it, whereas inflation tends to result in more delayed pain.

However, according to Sumner's views, the Fed is doing the thing that politics should make it not want to do *right now*. It's as though we were running a surplus with this economy.

So the one proposed policy is impossible, but I don't think that the other is.

Angus said...

Norman & John: Sumner is so wily. He has bewitched you. but consider a price level path policy. We have a negative shock and inflation falls. The price level is below target, the Fed is committed to pushing the price level back up to where it would have been in the absence of the shock. This means that the Fed is going to have to create more inflation in the future, most likely more than they would ideally like to create. This has to happen for the policy to work the way it's supposed to. It's the certainty of the future inflation that stimulates current spending and helps recovery from the shock.

But, this policy, quite simply, is time inconsistent in a world with unpredictable shocks. There is no way the Fed can credibly promise to do it. Announcing they will do it is IN NO WAY the same as actually credibly committing to do it. Think about exchange rate pegs around the world and how long they last despite insistence of the peg setters.

Norman said...

I was going to object to the example (foolish student that I am), but I thought better of it when I reversed the example: If the price level is well above target, the Fed won't want to create *negative* price growth in order to get back to the price path. So even if the Fed wanted to get back on path, there would be a speed limit to how quickly the price level would return to trend. You're pointing out that this holds in the opposite direction.

I'm not sure I would say that makes the policy 'impossible,' but it does mean that there are practical and political limits to how big an impact level targeting would have. In some sense, it's just an orderly way of deciding when to raise/lower the inflation target within a broader range than 1-2%.

And I completely agree that Sumner is wily. He also has a habit of glossing over pragmatic and political considerations. But I still think it's a different scale of problem from getting congress to commit to future budget surpluses.

Angus said...

Without a binding commitment mechanism, things that are time inconsistent are impossible.

Norman said...

I feel like I'm missing a piece of the argument here. Why is having inflation in the range of 1-2% time consistent, but having it in the 0.5-2.5% range isn't? If we think the Fed can effectively target a 1% wide range given the expected volatility in the economy, why does shifting that range up half a percent when the price level is low (or down half a percent when the level is high) trigger time inconsistency?

I guess I'm trying to figure out if the time inconsistency problem kicks in because central bankers would never commit to inflation outside the precise 1-2% range, or if central bankers might allow some more wiggle room, just not as much as the impossible policies of Sumner, Rogoff, Obstfeld, etc. call for.

Hasdrubal said...

Just ran across a piece by Mario Rizzo on Think Markets advocating the opposite: "Many years ago, the distinguished economist, William H. Hutt, wrote a pamphlet called “Politically Impossible?” He argued that economists should not seek political relevance by proposing only those policies that they perceive as politically possible, practical or feasible. They should speak truth to power, so to say, and advocate those policies that they perceive to be in the “public interest.” (Interestingly, it is often considered a key element of the economic rationality of agents to be able to distinguish the desirable from the feasible.)"

It's at