Making It Up
According to Bloomberg, Raghuram Rajan is now getting specific: he wants Bernanke to raise the Fed funds rate by 200 basis points in the face of 9.5 percent unemployment and inflation under 1 percent.
Let me try to explain what bothers me about this sort of thing, aside from the fact that it would be an utter disaster for the economy: it’s the way Rajan — and many other economists — seem to be making up new doctrines on the fly to justify their policy prejudices.
I’m all in favor of innovative thinking. But my view is that what you say about policy at any given time should be based on some kind of model — and furthermore, you should be willing to apply the same model to other situations, not make it a one-off used to justify what you happen to favor right now.
My writing on policy in this crisis has been based on the same model of macroeconomic policy I use in normal times; it’s just that the situation is different. The quick-and-dirty version looks like this:
That is, other things equal, demand is higher, the lower the real interest rate. Do you really want to quarrel with that? But right now, thanks to the aftermath of the financial crisis, even a zero nominal rate, which is a slightly negative real rate, isn’t low enough to produce full employment.
In normal times, when the zero lower bound isn’t binding, this basic framework suggests that conventional monetary policy can play the key role in stabilization. So in normal times I’m all in favor of having the Fed take on the job of managing the business cycle, and basing fiscal policy on long-term concerns.
But now we’re up against the zero lower bound; and that changes everything.
The idea that it would be good if we could raise expected inflation comes straight out of this minimalist framework: the economy “wants” a negative real interest rate, and the only way to get that given the zero lower bound is to have positive expected inflation.
The case for fiscal expansion also comes out of this fairly straightforwardly: if you can’t raise employment by cutting interest rates, deficit spending — which doesn’t crowd out private spending when the interest rate doesn’t change — becomes a way to put unemployed resources to work.
The point is that I’m not making it up as I go along; I have a consistent view here, which yields unorthodox conclusions right now only because we’re in an unusual situation.
So what is Rajan’s model? What’s the justification for raising real rates in the face of high unemployment? How would that model work in normal times?
My sense, obviously, is that a lot of the people who want monetary tightening start from a prejudice — they just dislike the idea of easy money — and then look for some arguments to back up that prejudice. And that’s no way to do economics.
Let me try to explain what bothers me about this sort of thing, aside from the fact that it would be an utter disaster for the economy: it’s the way Rajan — and many other economists — seem to be making up new doctrines on the fly to justify their policy prejudices.
I’m all in favor of innovative thinking. But my view is that what you say about policy at any given time should be based on some kind of model — and furthermore, you should be willing to apply the same model to other situations, not make it a one-off used to justify what you happen to favor right now.
My writing on policy in this crisis has been based on the same model of macroeconomic policy I use in normal times; it’s just that the situation is different. The quick-and-dirty version looks like this:
In normal times, when the zero lower bound isn’t binding, this basic framework suggests that conventional monetary policy can play the key role in stabilization. So in normal times I’m all in favor of having the Fed take on the job of managing the business cycle, and basing fiscal policy on long-term concerns.
But now we’re up against the zero lower bound; and that changes everything.
The idea that it would be good if we could raise expected inflation comes straight out of this minimalist framework: the economy “wants” a negative real interest rate, and the only way to get that given the zero lower bound is to have positive expected inflation.
The case for fiscal expansion also comes out of this fairly straightforwardly: if you can’t raise employment by cutting interest rates, deficit spending — which doesn’t crowd out private spending when the interest rate doesn’t change — becomes a way to put unemployed resources to work.
The point is that I’m not making it up as I go along; I have a consistent view here, which yields unorthodox conclusions right now only because we’re in an unusual situation.
So what is Rajan’s model? What’s the justification for raising real rates in the face of high unemployment? How would that model work in normal times?
My sense, obviously, is that a lot of the people who want monetary tightening start from a prejudice — they just dislike the idea of easy money — and then look for some arguments to back up that prejudice. And that’s no way to do economics.
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