Tuesday, November 19, 2013

The Serendipitous Independence of the Fed

By Mike Dorf

An NPR story yesterday morning more or less confirmed what most Keynesians and neo-Keynesians (including the WSJ reporter who was interviewed for the story) have been saying for some time: The current focus on deficit reduction in the U.S. and austerity in Europe are drags on the economy.  The reporters note that the latest data show that the U.S. economy has grown at a faster rate than Japan's, which, in turn, has lately grown at a faster rate than that of the EU zone economies, which are essentially stagnant.

Those data only roughly confirm Keynesianism because of the somewhat mixed picture of economic policy in the three regions.  Japan has lately been pursuing both monetary and fiscal stimulus; the U.S. has been pursuing monetary stimulus (via the Fed) and fiscal austerity (via Congress and the President); Europe has been pursuing monetary austerity (until an extremely recent announcement of credit relaxation by the ECB) and fiscal austerity (at least in the most troubled countries, such as Greece, Italy and Spain).   A robust confirmation of Keynesianism would have Japan in the lead, followed by the U.S., followed by Europe, rather than the U.S. ahead of Japan, but Austrian/Austerion policy clearly does badly here, since it would predict that Europe would be in the lead, followed by the U.S., then Japan.  In fact, a number of factors explain the better recent performance of the U.S. economy than that of Japan, including long-term economic and demographic trends in the two countries.

In any event, suppose that the NPR and WSJ reporters are correct (as I believe that they are) that, all things considered, loose credit and substantial deficit spending would have been better for the U.S. economy over the last five years than the policy we have had--loose credit combined with an initial burst of too-small deficit spending followed by a premature effort to lower the deficit.  If that supposition is correct, then it is owing almost entirely to a happy accident that the Fed has been able to use monetary policy to push back against some of the harmful effects of the political branches' fiscal policy.  What accident is that?  Why, Fed independence, of course.

To see the accidental nature of our better-than-it-could-have-been fortune over the last half-decade, consider why a polity might decide to make its central bank largely independent of political oversight. The standard reason is the fear that a politically accountable central bank will loosen the money supply in order to provide short-term stimulus so that incumbents can be re-elected, but that the medium-term effect will be inflation.  In this account, sober central bankers are insulated from political pressure so that they can make the painful but necessary decision to tighten credit before inflation gets out of hand.

And yet, since the 2008 financial crisis, the Fed has been very sensibly pushing easy credit to the chagrin of a fair number of misguided lawmakers--especially but not exclusively on the right--who would have preferred monetary tightening to complement their fiscal austerity.

Well so what?  Central bank independence may have been originally conceived as a means of ensuring we got tight monetary policy when needed, but it appears that it is also useful for ensuring loose monetary policy when that is what's needed.  No harm, no foul, right?

Wrong.  As a matter of institutional design, in a constitutional democracy, government institutions ought to be electorally accountable, at least absent some good reason for insulating them from politics.  Thus, we have an unelected (and thus largely unaccountable) judiciary because the judiciary has a special role to play in protecting the rights of minorities and in insisting upon decisions according to the rule of law rather than partisan interest.  Likewise, the traditional argument for an independent central bank relied on a special reason to depart from democratic accountability--namely, the risk, noted above, that politicians would manipulate the money supply for short-term advantage if given the opportunity.

In the current political climate, it's true that the Fed has been making economically sound decisions while the elected branches of the federal government have been foolishly pursuing deficit reduction, but there is no systematic, structural reason why elected officials can't be trusted to spend sufficient sums of public money to promote economic growth.  Put differently, Congress has been pursuing bad economic policy for the last several years, but it's also been pursuing bad policy in other areas as well.  The fact that I (or you) think the Fed has it right and Congress has it wrong is not a justification for a politically unaccountable Fed, any more than the fact that Congress has it wrong about environmental policy or agricultural policy is a justification for a politically unaccountable EPA or Dep't of Agriculture.

We are lucky that we have an independent Fed that's acting rationally, but it is luck that, in a deep sense, we don't deserve.


Eric Charles said...

Seems to be a win for the MM folk. Do you read Sumner's blog?


"Given the predictions of the Keynesian model, anything even close to 2012 results would have been a win for MM. The Keynesian model predicted a sharp slowdown from the higher income/cap gains/dividends taxes, payrolls taxes, sequester, government shutdown, etc, etc. But we are running ahead of 2012, and even if the last two months are weak we will be essentially even.

And yet on the Keynesian side of the aisle I hear a deafening silence. Where is the discussion of this great “experiment?” Could it be that academics and pundits only like to discuss experiments that validate their priors?"


"Unfortunately for Keynesians, the initial slump in the US and eurozone were fairly similar despite the much larger US stimulus. Then in the past three years the US deficit has actually been shrinking slightly faster than in Europe. And yet it’s the eurozone that has had the double-dip recession, not the US. The eurozone unemployment rate has soared to 12.2% while ours fell to 7.3%. (The two rates were identical about 3 years ago.)

This is another epic failure of the Keynesian model. Another failed 'experiment.'”

David Ricardo said...

It is difficult to reply to Wolflarson without hijacking the Forum, but let’s try. His comments largely illustrate those who would oversimplify economics into a simple two variable model, as opposed to the highly complex economy with many factors that we have. It seems his main claim is that (1) fiscal policy turned contractionary in early 2013 and (2) the economy continues to grow, therefore Keynesian fiscal policy is not valid. But a closer look at the experiences in Europe and the U. S. do not justify this conclusion.

1. Fiscal stimulus was applied in early 2009, and although flawed and inadequate robust economic growth resulted. When that stimulus expired growth was reduced.
2. The fiscal stimulus is designed to “prime the pump” of an economy. So much of what has happened since then is the result of successful Keynesian policy, not its failure. Once stimulated an economic expansion feeds upon itself and is self fulfilling. Fortunately it will take more than the current policy to turn the economy back to recession, although conservatives will certainly try.
3. The type of contractionary tax policy that took place in early 2013 was largely an increase of taxes on high income people. (the payroll tax cut and its restoration was ineffective in both instances, a ridiculous policy). The core of Keynesian economics is demand driven consumption. Raising taxes on high income people does relatively little damage to consumption, as they have idle balances with which to replace lost income, so the expectation of a minor impact from that aspect of the policy has been borne out.
4. There are things in economic analysis called lags. Economic growth is slower today than it was during the first four years of the Obama administration. But the sequestration is only now beginning to take effect, and it is relatively small in terms of the overall economy. So Keynesian economics would predict a small reduction in growth, which is exactly what has happened, the 3-4% growth rate in the early years of the Obama administration giving way to 2-3% rate today.
5. Britain is the best comparison to the U. S. in terms of policy impact. In Britain fiscal contraction resulted in economic contraction. In the U. S. fiscal expansion resulted in economic expansion. And do anti-Keynesians really want to raise the results in Greece, Spain, Portugal and Ireland to justify their position? Really do they?

Keynesian economic has passed the test of time. It is settled policy, it is correct and it is valid. It is opposed only by those individuals who do not like the policy implications of more rather than less government intervention in the economy, similar to the way in which religious fundamentalists do not like the theory of evolution, not because it is not scientifically correct but because its conclusions conflict with their beliefs based on faith. Faith based economics is about equal in validity to faith based science.

Eric Charles said...

"It is settled policy, it is correct and valid" is faith based economics.

See the comments in the remarks by Mark Sadowski:

"Thus tax change multipliers used used by private forecasting firms and by government models such as the Federal Reserve’s FRB/US suggest that about 60% of the ultimate level economic effect of the payroll and income tax increase should have been felt by the third quarter. Similarly government purchase multipliers suggest that about 80% of the ultimate level economic effect should have been felt by the third quarter. See Appendix A for example:


In November 2012 the CBO estimated that the maximum level employment effect would be a decrease of about 200,000 jobs, 640,000 jobs (80% 0f combined payroll and UI effect of 800,000 jobs lost) and 800,000 jobs for the high income tax increase, payroll tax increase, and sequester respectively:


In other words, according to these estimates, the sequester should have decreased employment by about 640,000 jobs, and the tax increases should have decreased employment by about 500,000, as of 2013Q3. That’s a total decrease of 1.14 million jobs.

Instead, employment was up by 1.7 million in 2013Q3 relative to 2012Q4. That’s a significant increase from the 1.4 million jobs created in the previous three quarters.

One is stuck with the inescapable conclusion that monetary policy easily offset a major Federal fiscal contraction (with room to spare)..."

David Ricardo said...

What the previous post has illustrated is not that Keynesian economics wrong or that monetary policy in the past year has been effective but that economic modeling and forecasting is utterly and totally unable to accurately predict the results on any economic policy. One has only to go back and look at the forecasts of the CBO for any period in the past 15 years to document this. Really, go back and look at the forecasts, they are all available on line and they are almost universally wrong.

Look at the forecasts of the CBO on the impact of the Bush tax cuts on the deficit just for fun. Or look at the forecasts in the President’s annual budget messages, Democrat or Republican, they are all WRONG. And look at the Barry Ritholtz report several days ago on how utterly, totally and completely wrong 3 years ago the eminent monetarists were who published a letter in the WSJ and said that Fed policy of QE would result in inflation and debasement of the currency and no job creation. (Debasement of the currency, what is this, the 18th century?) There is no problem in finding economic forecasts that are wrong, but great difficulty in finding ones that are consistently correct.

The same can be said for almost all other models. The quantification of a forecast of specific job losses from this policy is not possible. The models are simply not sophisticated enough to do the job they intend to do, and maybe will never be able to do that job until quantum computers are developed. To justify a position that the results did not conform to forecasts of an economic model is simply not justified. And the idea that the sequestration and tax increases should have cost the economy over 1 million jobs simply does not pass the smell test. Or maybe they did, maybe job creation was 1 million less than would have occurred. Who knows? Of course the changes reduced employment over what would otherwise have taken place, that is the very core of Keynesian economics. But other factors in the economy were also in play.

As far as the claim that monetary policy has offset fiscal policy, this conflicts with reality, namely that monetary policy has not changed in a number of years and has had no incremental impact on the economy for at least two to three years. To put things in their simplest form, business does not invest and create jobs because of lowering taxes, business does not invest and create jobs because of lowering interest rates, business invests and creates job because there is an increase in demand for the goods and services. Fiscal policy creates demand, monetary policy does not when the economy is in a liquidity trap and near zero interest rates are already in place.

It is very easy to find a reputable source in economic analysis and forecasting that will justify any position. But historical data cannot be spun and cannot be denied and the historical evidence is as strong that Keynesian economics is valid as is the historical evidence that the Earth is somewhat older than 8,000 years. Believing otherwise, no matter how sincere, no matter how many so-called authorities are quoted, does not make it true in science or economics.

Look, about the best we can do is to adopt policy that has been subjected to peer reviewed research over many decades and has been implemented many times with successful results. That description fits Keynesian economics, exactly.

Eric Charles said...

Your recent comments mirror Hayek’s message in his Nobel speech, The Pretense of Knowledge, which criticizes the economics profession for treating economics as a physical science that can be measured precisely as opposed to a system of mostly unmeasureable complex phenomena. All that can be hoped for is broad pattern predictions instead of precise outcomes from sophisticated models. You say this “description fits Keynesian economics” but I find this unwarranted based on failed and unrealistic Keynesian models that presumably the CBO relies on.

I think it was Friedman who said there is no Keynesian, Chicago, or Austrian economics, there is only good and bad economics. So the question becomes which technique is most useful for predicting accurately. And this may ultimately be a futile and dangerous exercise as Hayek makes clear.

“Of course, compared with the precise predictions we have learned to expect in the physical sciences, this sort of mere pattern predictions is a second best with which one does not like to have to be content. Yet the danger of which I want to warn is precisely the belief that in order to have a claim to be accepted as scientific it is necessary to achieve more. This way lies charlatanism and worse. To act on the belief that we possess the knowledge and the power which enable us to shape the processes of society entirely to our liking, knowledge which in fact we do not possess, is likely to make us do much harm.”

Paul.K said...

totally and completely wrong 3 years ago the eminent monetarists were who published a letter in the WSJ and said that Fed policy of QE would result in inflation and debasement of the currency and no job creation. (Debasement of the currency, what is this, the 18th century?) There is no problem in finding economic forecasts that are wrong, but great difficulty in finding ones that are consistently correct.FUT 14 Coins
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