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Some things I found interesting recently

First, Karl Smith offers up a beautifully simple explanation of monetary policy in the course of pushing back against Stiglitz’s theory linking inequality and poor economic conditions.   I’m generally a fan of Stiglitz, but I think Karl has the best of this particular argument.   A key graph:

Deflationary pressure causes the economy to contract. And, if inequality is steadily increasing then it makes sense that the economy could be repeatedly contracted over a long period of time. Each contraction only lasts over the “short run”, but because this contractionary pressure keeps repeating, the economy could trend downward or grow very slowly for a long time.

To stop this the Fed needs to apply inflationary pressure. On a day-to-day basis it does this by lowering the path of short term interest rates.

The whole thing is worth reading, especially for people not accustomed to thinking about monetary policy.   As I would translate Karl’s point, it’s that inequality may have contributed to low interest rates prior to the bust, but in terms of the Fed coming to the rescue loose money can’t but help–monetary stimulus is much more about the change in monetary conditions (implied by, but not equivalent to, falling interest rates) than the level of the interest rate.   This means that in practice, money is almost certainly too tight if interest rates are zero, since they can’t continue to fall.

Still, I would quibble here that inequality did imply low interest rates to begin with, and the fact that interest rates were low on the eve of the crisis was a major (if not THE major) contributor to our current depression (since interest rates had very little room to fall before the zero-lower-bound on interest rates was hit).

Next up, Steve Randy Waldman discusses the morality of price stability.   His case is, IMHO, brilliantly reasoned and straightforward.   What I especially enjoyed was how he separated the problem into symmetric and asymmetric price targets.   I’ve touched on his basic arguments before, but his case was so well argued that, if I were to teach Macro again, I might present this as required reading to my students.

One thing I might add is the political dynamic his case implies.   For example, hard money types are:

People who benefit from nonincreasing prices are people who hold nominal-dollar assets. That includes most obviously creditors — people with money in the bank, bondholders, etc. — but also people with stable employment but little bargaining power to pursue raises.  These groups would see their purchasing power fall in an inflation. If the government restrains prices by reducing aggregate demand, it helps these groups by shifting costs to others.

On the other hand, the soft money types are:

If prices are stabilized via monetary policy, debtors pay: both the increase in interest rates and the reduction of aggregate demand increase the burden of repaying debts. If prices are stabilized via increased taxation, then obviously whoever bears the incidence of the new tax pays.

Although not his point, this to me encapsulates the asymmetry of inflation’s political economy.   Who benefits from disinflation?   Creditors and the stably employed.   Who pays?   Debtors and the marginally employed.   Creditors are a stable political block (finance/the rich), debtors are not (the middle class/non-finance business); and workers are split between pro- and anti- infaltion.   A single middle-class household may pay/benefit simultaneously–as homeowners (pro) and stably employed (con).   A household near/at retirement is almost certain to be against (home loan paid off (con), likely stable employment (con)).   Businesses perhaps would be pro-inflation in the abstract, but business managers are likely to be anti-inflation.  This is all to say there is no coherent pro-inflation political coalition.

During the progressive era, the pro-inflation forces centered on commodity producers (i.e. farmers), which formed a large politically powerful block.   There’s nothing like that now, which is perhaps why Bernanke is so terrified of allowing inflation to rise.

There’s much more in the original post, including a discussion of symmetric or asymmetric inflation targets as different forms of insurance.

Finally, this morning was this great article in the FT from Martin Wolf, echoing much of my own thinking.   For example, this is a point well taken;

In retrospect, the only way the Spanish authorities could have prepared themselves for the shock would have been to run fiscal surpluses of 10 per cent of GDP over the five or six years before the crisis, so generating a positive net asset position of at least 20 per cent of GDP. That might have been enough (though even that is uncertain).

Indeed.  As even he suggests, even this is optimistic.   For example, suppose Spain had run these extremely large fiscal surpluses and had accumulated a “rainy day fund” on the order of 20 per cent of GDP.   I have to ask, a fund invested in what?   Mortgage backed securities?   That would have seemed the most logical thing to do circa 2005, but if that had been the strategy, the fund itself would have fallen, drastically, in value anyway.   It also would have done nothing to stop the housing bubble–just as much money would have been flowing to the housing sector.

Or Spain could have purchased German bonds?   That would have been low yield and, frankly, I would expect the Germans to be calling bloody murder and protectionist… but otherwise, I think that would have worked.   In retrospect.   Its also possible that the ECB would have responded by pushing the Euro down against the dollar, making America’s problem worse.

I think this summarizes the point nicely, “In my view, Spain made only one big mistake: joining the euro.”  ‘Nuff said.

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