UPDATE: Re-upping my post from July 8, 2011
I indicated in my first posting on Tuesday that I was going to comment on some recent comparisons between the current anemic recovery and earlier more robust recoveries since World War II. The comparison that I want to perform involves some simple econometrics, and it is taking longer than anticipated to iron out the little kinks that I keep finding. So I will have to put off that discussion a while longer. As a diversion, I will follow up on a point that Scott Sumner made in discussing Paul Krugman’s reasoning for having favored fiscal policy over monetary policy to lead us out of the recession.
Scott’s focus is on the factual question whether it is really true, as Krugman and Michael Woodford have claimed, that a monetary authority, like, say, the Bank of Japan, may simply be unable to create the inflation expectations necessary to achieve equilibrium, given the zero-interest-rate lower bound, when the equilibrium real interest rate is less than zero. Scott counters that a more plausible explanation for the inability of the Bank of Japan to escape from a liquidity trap is that its aversion to inflation is so well-known that it becomes rational for the public to expect that the Bank of Japan would not permit the inflation necessary for equilibrium.
It seems that a lot of people have trouble understanding the idea that there can be conditions in which inflation — or, to be more precise, expected inflation — is necessary for a recovery from a depression. We have become so used to thinking of inflation as a costly and disruptive aspect of economic life, that the notion that inflation may be an integral element of an economic equilibrium goes very deeply against the grain of our intuition.
The theoretical background of this point actually goes back to A. C. Pigou (another famous Cambridge economist, Alfred Marshall’s successor) who, in his 1936 review of Keynes’s General Theory, referred to what he called Mr. Keynes’s vision of the day of judgment, namely, a situation in which, because of depressed entrepreneurial profit expectations or a high propensity to save, macro-equilibrium (the equality of savings and investment) would correspond to a level of income and output below the level consistent with full employment.
The “classical” or “orthodox” remedy to such a situation was to reduce the rate of interest, or, as the British say “Bank Rate” (as in “Magna Carta” with no definite article) at which the Bank of England lends to its customers (mainly banks). But if entrepreneurs are so pessimistic, or households so determined to save rather than consume, an equilibrium corresponding to a level of income and output consistent with full employment could, in Keynes’s ghastly vision, only come about with a negative interest rate. Now a zero interest rate in economics is a little bit like the speed of light in physics; all kinds of crazy things start to happen if you posit a negative interest rate and it seems inconsistent with the assumptions of rational behavior to assume that people would lend for a negative interest when they could simply hold the money already in their pockets. That’s why Pigou’s metaphor was so powerful. There are layers upon layers of interesting personal and historical dynamics lying beneath the surface of Pigou’s review of Keynes, but I won’t pursue that tangent here, tempting though it would be to go in that direction.
The conclusion that Keynes drew from his model is the one that we all were taught in our first course in macro and that Paul Krugman holds close to his heart, the government can come to the rescue by increasing its spending on whatever, thereby increasing aggregate demand, raising income and output up to the level consistent with full employment. But Pigou, whose own policy recommendations were not much different from those of Keynes, felt that Keynes had left out an important element of the model in his discussion. As a matter of logic, which to Pigou was as, or more important than, policy, an economy confronting Keynes’s day of judgment would not forever be stuck in “underemployment equilibrium” just because the rate of interest could not fall to the (negative) level required for full employment.
Rather, Pigou insisted, at least in theory, though not necessarily in practice, deflation, resulting from unemployed workers bidding down wages to gain employment, would raise the real value of the money supply (fixed in nominal terms in Keynes’s model) thereby generating a windfall to holders of money, inducing them to increase consumption, raising aggregate demand and eventually restoring full employment. Discussion of the theoretical validity and policy relevance of what came to be known as the Pigou effect (or, occasionally, as the Pigou-Haberler Effect, or even the Pigou-Haberler-Scitovsky effect) became a really big deal in macroeconomics in the 1940s and 1950s and was still being taught in the 1960s and 1970s.
What seems remarkable to me now about that whole episode is that the analysis simply left out the possibility that the zero-interest-rate lower bound becomes irrelevant if the expected rate of inflation exceeds the putative negative equilibrium real interest rate that would hypothetically generate a macro-equilibrium at a level of income and output consistent with full employment.
If only Pigou had corrected the logic of Keynes’s model by positing an expected rate of inflation greater than the negative real interest rate rather than positing a process of deflation to increase the real value of the money stock, how different would the course of history and the development of macroeconomics and monetary theory have been.
One economist who did think about the expected rate of inflation as an equilibrating variable in a macroeconomic model was one of my teachers, the late, great Earl Thompson, who introduced the idea of an equilibrium rate of inflation in his remarkable unpublished paper, “A Reformulation of Macreconomic Theory.” If inflation is an equilibrating variable, then it cannot make sense for monetary authorities to commit themselves to a single unvarying target for the rate of inflation. Under certain circumstances, macroeconomic equilibrium may be incompatible with a rate of inflation below some minimum level. Has it occurred to the inflation hawks on the FOMC and their supporters that the minimum rate of inflation consistent with equilibrium is above the 2 percent rate that Fed has now set as its policy goal?
One final point, which I am still trying to work out more coherently, is that it really may not be appropriate to think of the real rate of interest and the expected rate of inflation as being determined independently of each other. They clearly interact. As I point out in my paper “The Fisher Effect Under Deflationary Expectations,” increasing the expected rate of inflation when the real rate of interest is very low or negative tends to increase not just the nominal rate, but the real rate as well, by generating the positive feedback effects on income and employment that result when a depressed economy starts to expand.