15 - Stabilization Policy - Activist vs. Nonactivism
See opening quote by Robt. Gordon, p. 385.
Or another example - you get sick, take medication, but the medication has a three day delay.
Driving your car by looking in the rear view mirror.
See graphs on page 387 and 389. Economic instability and monetary instability. Possible strong link between these two variables.
Widespread agreement about the goals of macro policy: low un, high levels of employment, real output growth, low and stable inflation, etc. The debate in macro is between activist vs. nonactivist (passive) approach to policy. Rules vs. discretion debate.
Passive, Rules Approach: fixed money growth, balanced budget amendment, term limits, flat tax, expiration dates on legislation, etc. Maintain stable, predictable fiscal and monetary policy during all phases of the business cycle. Don't attempt countercyclical fine-tuning, it will be destabilizing.
Historical consensus, traditional view:
Market economy failed in the 30s, self-correcting mechanisms didn't work, government intervention is what finally rescued the economy. Led to the growth in Keynesian economics, dominated the economics profession and strongly influenced policymakers - Congress and presidents. "We're all Keynesians now."
In the 50s and 60s, economists and policymakers became confident in the Keynesian approach - activist, stabilization policy, mostly fiscal policy. During a recession: run a budget deficit and have expansionary monetary policy. During an expansion, run a budget surplus and contractionary monetary policy. More faith in the ability of policymakers to smooth economic flucuations than in the self-correcting mechanisms of the market economy.
What about the problem with lags? Page 393-395. Recognition lag, policy lag and impact lag.
Possible solution to Lags: Forecasting Tools.
1. Index of Leading Economic Indicators. An index of ten economic variables that as a group tend to move AHEAD of economic conditions, predict economic expansions and contractions. There is also the Indexes of a) coincident indicators (move with the business cycle) and b) lagging indicators (move after the business cycle). Based on historical evidence.
See page 390. All eight recessions were predicted by the Index. Also 5 false predictions.
Example: housing permits are a leading indicator, a predictor of future housing activity, housing contstruction might be a coincident indicator, and furniture or appliance sales might be a lagging indicator.
Some labor market variables (avg workweek in hours, un claims), some wholesale variables (new orders, slower deliveries, plant and equipment order, housing permits), some financial variables (M2, int rate spread, stock prices) and expectations (consumers). The index of leading of leading economic indicators receives the most attention - used as a forecasting tool for where the economy is headed. Can give policymakers a head start to avoid the recognition lag.
2. Forecasting Models- Large econometric models of the economy. Mixed evidence on accuracy of forecasting from computer models. Reason: 1) even the best econometric model can't predict unforeseen events and 2) forecasting models use past performance to predict the future, assumes that people will react the same in the future as in the past. Past can be an imperfect indicator of the future. Dynamic and unpredictable economy, not static.
3. Market Signals - using changes in market prices like commodity prices and ex-rates to predict future economic activity. More useful for monetary policy than fiscal. Example: changes in the price of gold or a commodity index of several commodity prices can predict future inflation (deflation). If commodity prices are increasing, it could signal inflation - move to restricte monetary policy.
Current price of gold is $280 vs $310 one year ago.
Also, the value of the dollar in the foreign exchange market indicates investors perception of the supply of dollars. If the dollar is depreciating, it could reflect foreigners' unwillingness to hold an asset they expect to depreciate in the future. Could signal a move toward tighter monetary policy.
Market prices can provide signals about future trends, can be used to supplement other forecasting tools as a guide for policymakers.
To the extent that forecasting aids are accurate, the case for discretionary, activist policy is strengthened.
Lags and the Timing Problem
1. Recognition lag
2. Policy lag
3. Impact lag
Estimate of the combined duration of the lags: 12-18 months for monetary policy, longer for fiscal policy.
1. Duration of lags is unpredictable.
2. Recessions last 12-18 months.
3. Policymakers can't get organized fast enough to stabilize.
4. Policy can't be reversed or undone.
5. Perfect timing is almost impossible.
6. Without perfect timing, discretionary policy will be destablizing.
See page 395, graph. Nonactivists argue that disecretionary policy will usually destabilize, not stabilize. They favor rules, passive policy approach.
Another potential problem with activist policy. Public-choice analysis: Politicians are short-sighted, want to get re-elected. Tempation for politicians to use influence to apply pressure for expansionary policy before an election, to stimulate the economy. Political business cycle theory. Some evidence to support. See page 390. Most recessions occur between the four year presidential election cycle.
International study: 90 elections in 27 different countries. National income increased in 77% of election years vs. 46% of years without election. Evidence of expansionary policy to influence the outcome of the election.
Also, expansionary fiscal policy with tax cuts usually doesn't involve across the board tax cuts. Usually some special tax credit to a special interest group. Leads to wasteful rent-seeking.
1970s - Rational Expectations revolution, Neo-Classical. Renewed faith in the self-correcting features of the economy. People are rational and forward looking. Markets are efficient. Also, people will figure out policy patterns and adjust behavior to changes in policy and therefore make the policy ineffective: policy-ineffectiveness theorem. Stabilization relies on catching people off guard and surprising them with fine-tuning policies. Once people figure out the policy pattern, the policy won't stabilize, it will probably destabilize.
Example - if people fully anticipate inflation, there is no stimulus from monetary expansion. All prices adjust, profits remain the same, output and employment are the same. The only effect is higher inflation and higher interest rates.
If the economy is in a recession, everyone expects expansionary fiscal and monetary policy action - some stimulus from tax cuts and/or monetary stimulus (lower interest rates). Then everyone will wait until the policy is enacted to make a decision on whether to invest or not. Anticipating the policy will then actually create a business cycle - people delay investment projects until the tax cut or lower int rates take effect. Makes the current recession worse, and then causes the economy to overcorrect itself. Once the stimulus takes affect (lower taxes, lower int rates), the pent up demand will casue people to invest even more than is desirable from a stabilization viewpoint. People behaving rationally undermines the effectiveness of fiscal policy.
Or if the economy expands, and people anticipate future tax increases, they will invest/spend now before the tax increase, this will then create a boom, increase the expansion. Anticipation of Restrictive fiscal or monetary policy creates econ boom now.
Conclusion: Rational, forward looking people will undermine discretionary policy once they catch on to the pattern. Activist policy will be ineffective and neutral in the best case, and may be destabilizing and negative in the usual case.
In the 70s, the experience of stagflation led economists to rethink several Keynesian conclusions -
1) money didn't really matter and
2) activist approach could stabilize the economy by fine-tuning.
Expansionary monetary policy was supposed to lead to economic growth in short run, but it led to economic stagnation. See graph page 397. Money growth was declining prior to, and during, most recessions. That is the exact opposite of what should happen - expansionary monetary policy during a recession, not restrictive. Timing of monetary policy has been poor, due to problem of lags.
Monetarist approach gained strength in the 70s - Friedman won Nobel Prize in 1976 - emphasized the role of money, especially the role of monetary instability. Monetarist favored rule-based monetary policy as the best way to stabilize the economy. No fine-tuning.
1990s - Bionomics. Economy as an ecosystem. Delicate balance and rhythm in the economy, just like in an ecosystem, rain forest. Self-correcting mechanisms and feedback loops act in a way to make the economy self- adjusting, in an optimal way. Any interference will distort the balance and lead to a sub-optimal result.
Example - oil supplies run low, prices rise, consumers conserve and use less, producers try to find more oil, increase oil exploration, research into alternative fuels increases. Automatic adjustment process that requires no interference. Intervention in the form of price controls will just distort the economy and lead to sub-optimal result.
Monetarism, Neo-Classical (rational expectations), Public Choice, and Bionomics generally advocate a NON-activist approach to policy.
Keynesians and Neo-Keynesians, Marxists, politicians advocate Activist approach. Economy as a machine.
See summary on page 401.
Policy conclusions of nonactivists: Monetary Policy Rules to Avoid erratic, stop-and-go, unpredictable, or mistimed discretionary policy:
1. Monetary growth rule. Fixed growth rate of MS at 3%, for example, the growth rate of LRAS. Would provide appropriate countercyclical policy. During a rapid expansion, real growth = 5%, monetary policy would be automatically tight/restrictive. Deflationary pressure.
When economy slows to 1% growth or negative, the fixed growth rate of 3% would be expansionary.
Advantage: creates predictable, stable money policy. Eliminates possible political influence problems (political business cycle). Avoids problems with lags. Creates confidence in monetary policy - everybody knows what to expect. No possibility of hyperinflation, or other abuses by central bank.
Disadvantage: Financial deregulation and innovation may have reduced the effectiveness of fixed rule policy in the 1980s and 1990s. Starting in 1980, interest could legally be paid on checking, dramatically changing M1. M1 has grown rapidly, and has been somewhat volatile and upredictable. The rapid growth was not indictative of expansionary monetary policy. For example, M1 grew at 12% during 1992 and 1993, but inflation was very low. M2 grew at only 1.5%. People were shifting money balances from saving accounts to checking accounts. Possible solution to the variability of M1 - target M2 growth instead of M1.
2. Nominal Income Rule - Modified monetary rule. Target nominal income (GDP) to grow at the same rate as real income, about 3%. Since real income/output grows at 3%/year, nominal growth of output at 3% would imply price level stability, inflation = 0%. Instead of increasing money growth at a fixed rate, this rule would increase MS by the amount of real output growth MINUS the change in the velocity of money.
MV = PY
%M + %V = %P + %Y, we want %P = 0.
%M + %V = % Y
If V is constant, then MS grows at %Y.
If V is changing, then the rule is modified. Remember that V is inversely related to MD. During the 1970s, V was increasing as people held less money due to credit cards, faster check clearing. V was also increasing in the 1990s. During the 1980s V was decreasing, MD was increasing, due to interest being paid on checking.
If V is going up by one percent, MS only has to grow by 2% to match output growth of 3%. If V is falling by 2%, MS has to increase by 5% to match real output growth.
3. Price Level Rule -Target the inflation rate from the CPI or GDP Deflator. Example: inflation rate = 3%, or =0%, or some range 1-2%. Since money is neutral in the long run, and only influences the price level (not real output, employment, income, etc.), why not target the one variable that MS growth actually determines?
New Zealand used to have erratic and high inflation. They now have a Price Level Rule, current at 0-2% inflation. If not met, the chairman of the central bank can be fired. Has been very successful there, being considered elsewhere. Forces the central bank to focus on its main goal: Price Level Stability.
Emerging Consensus View-page 400-401.
1. Activists and nonactivists recognize that misguided, mis-timed policy is destabilizng. See Depression analysis, page 402-403.
2. Both agree that policies should be transparent, so that we know exactly what is going on, we can plan, and can judge the effectiveness of policy. Full Information.
Indexed Treasury Bonds - Recent Devleopment. May help guide monetary policy by having a precise measure of expected inflation. Started in 1996, index bonds have a market determined real interest rate, plus they pay a premium to reflect the actual rate of inflation. Example, all bonds have a "face value" of $1000, payable at maturity. Usually fixed at $1000. Indexed bonds adjust the face value every yr based on inflation. If inflation = 3%, the face value is adjusted to $1030, to compensate for the loss of purchasing power of 3%.
We can now compare regular Tbills with nominal interest rates, and the yield on indexed Tbills, which is the real rate. The difference is the expected rate of inflation. Example: current 1 yr Tbills yield 5.5% (nominal), and indexed bonds yield 3.5% (real), so the current expected rate of inflation is about 2% for the next year.
If the differential widens, future inflation is expected to be higher than previously. FRS should move toward restrictive monetary policy to prevent inflation. Also allows us to monitor Fed performance, by watching the stability of expected inflation over time. The more stable the int rate differential, the better the job the Fed is doing.