Gauti B. Eggertsson watch

I like this guy. This paper suggests deficit spending is productive at the zero lower bound because by increasing the deficit it increases expectations of inflation. Its important, however, for the central bank to coordinate its policy with the fiscal authorities to make this result happen. He very nicely shows that rules-constrained central banks, while not having the inflation bias of discretionary central banks, have deflation bias at the zero lower bound.

Here’s his Palgrave definition of liquidity trap. He argues if the Fed follows a Taylor rule, the liquidity trap really is a trap. Also,

if a central bank is discretionary, that is, unable to commit to future policy, and minimizes a standard loss function that depends on inflation and the output gap, it will also be unable to increase inflationary expectations at the zero bound, because it will always have an incentive to renege on an inflation promise or extended ‘quantitative easing’ in order to achieve low ex post inflation. This deflation bias has the same implication as the previous two irrelevance propositions, namely, that the public will expect any increase in the monetary base to be reversed as soon as deflationary pressures subside.

This should make Sumner happy:

There is a large literature on the different policy rules that minimize the distortions associated with deflationary shocks… Eggertsson and Woodford (2003) and Wolman (2005)… show that, if the government follows a form of price level targeting, the optimal commitment solution can be closely or even completely replicated, depending on the sophistication of the targeting regime. Under the proposed policy rule the central bank commits to keep the interest rate at zero until a particular price level is hit, which happens well after the deflationary shocks have subsided.

This should make Sumner unhappy:

Perhaps the most straightforward way to make a reflation credible is for the government to issue debt, for example by deficit spending. It is well known in the literature that government debt creates an inflationary incentive (see, for example, Calvo, 1978). Suppose the government promises future inflation and in addition prints one dollar of debt. If the government later reneges on its promised inflation, the real value of this one dollar of debt will increase by the same amount. Then the government will need to raise taxes to compensate for the increase in the real debt. To the extent that taxation is costly, it will no longer be in the interest of the government to renege on its promises to inflate the price level, even after deflationary pressures have subsided in the example above.

In other words, the best way to fight deflation, to increase expectations of inflation, is deficit spending.

The ARRA was a fight over distribution. As an economist, I have no dog in that fight. As a libertarian, well…

14 thoughts on “Gauti B. Eggertsson watch”

  1. Since you seem to be on top of this literature, will you take some stupid questions? [I’m not ready to work at this level yet.]

    What shocks drive the economy against the zero bound? And what’s the implied frequency of such events?

    Policy aside (set them passively following some rules), what makes the response of the private sector inefficient? What about short- vs. long-run?

    What would be an estimate of the welfare cost of such an event, in % trend growth in private consumption?

  2. xi is the shock to utility that brings the natural rate below zero. I don’t know if this is the right way to narrate this particular episode because the paper doesn’t explore other moment predicted by the data. I suspect the increase in labor productivity that we’ve seen is counter-factual to a demand shock, but like I said, I’d need to see the impulse responses of other variables.

    In any case, the whole discussion is predicated on it being a demand shock that gets us to the zero lower bound.

    A bigger question is whether or not it makes sense in modern macro to “narrate” particular down turns.

  3. “I don’t know if this is the right way to narrate this particular episode because the paper doesn’t explore other moment predicted by the data.” Is perhaps the worst sentence I’ve ever written and there’s heavy competition. You know what I mean, though. I wanna see other IRFs.

  4. I might be wrong but it seems to me that outside of particular cases, there is no one-to-one relation between paths of endogenous variables and realizations of shocks, i.e. the same outcome can be generated with different shock histories.

    But my request was for you to narrate from the other end, i.e. I’m not asking about what shocks rationalize a particular outcome, but rather what shocks do authors in this literature use to get us there.

  5. So… since that shock is stationary but persistent, the economy should return to the steady state asymptotically, regardless of public policy?

    Since this is a preference show, how should we approach the welfare consequences?

  6. These guys (Eggertsson and the recent paper by Christiano, et al) model the shock in a funny way. The natural rate is negative and then it has some positive probability to go positive every period. This is another reason to suspect this analysis doesn’t really apply currently.

    Your questions about welfare are very good. The Fed can’t set interest rates to their natural rates (the optimal policy in this model) so that’s were badness comes from.

  7. But the only reason we care about their damn interest rate fiddling is because prices are not flexible, right? So, can I infer that, as prices reset, output goes to the right path regardless of the nominal interest rate (stuck at 0)?

    Let’s just say there’s a HUGE opportunity for someone to write a blog post explaining the mechanisms at work in these models? The winner of that awesome prestige could be you!!!

  8. I’ve always wondered why economists think a central bank that wanted to inflate would not be believed by the markets. Is there any real world example of such a crediblity problem? If I thought there was, I might favor Eggertsson’s proposal to run up fiscal deficits. But right now we have set in motion a massive fiscal stimulus that will raise the national debt from 45% of GDP to 85% of GDP. And how has this boosted inflation expectations? The 5 year expected inflation rate in the TIPS market is still less than 1.5%. Meanwhile the Fed hasn’t taken the most obvious step, actually saying they’d like to have a higher price level, and promising to do what it takes to get there. It’s no wonder they are not believed, they haven’t given the markets any statements to believe in.

    BTW, I also like Eggertsson’s work—a few years ago we had a long email correspondence on the Great Depression, an area where we have similar views.

  9. Prof. Sumner, the issue is that the Fed has done a good job over the last 20 years convincing people that it has a low inflation policy or, at least in “normal” times, it will try to get such a reputation. The Fed could sacrifice its long term cred as an inflation fighter for short term gain. This is what is non-credible. Its past success in controlling expectations creates the problem.

    If before this mess started the Fed had a reputation for targeting NGDP or price levels, there wouldn’t be a deflationary bias to policy at the zero lower bound. I don’t think it can credibly change policy regimes in the middle of a crisis and not look discretionary.

    I know you’ll hate this, but looking beyond market indicators of expectations, the headlines these days seem to be more about fiscal sustainability than deflation. Also, it would be interesting to see what TIPS did upon announcements/enactments/etc of the ARRA. Did it bump up when it became obvious deficit spending was on its way?

  10. Gabriel, I think someone should write a dissertation “IS/LM”-izing these models (or NK models in general). Meaning, a simple model that took the key insights from these models and made them accessible to mere mortals and maybe politicians too. This would be a huge contribution. Too bad I’m almost done with my dissertation… If only I knew a upstart macro student… :-)

  11. pushmedia1, OK, lets go with inflation targeting, forget about NGDP and the price level. The two year inflation forecast is around 0.4%. How about the Fed announcing that they will ease policy until inflation expectations are up closer to 2%. In a sense the Fed’s job actually becomes easier with 9.4% unemployment. It is even easier to get 5% NGDP growth without inflation exceeding 2%.

    I can’t answer your second question, but I’d be shocked if TIPS spreads responded much to fiscal news. And I pay no attention to the headlines–they say many things that aren’t true. I look at the markets, which are clearly much more worried about deflation than they are by high inflation.

  12. I agree, Eggertsson’s da man. But I think his argument relies upon more coordination between fiscal policy and monetary policy than we see in real life, especially in Europe. If monetary authorities become inflation hawks as soon as this episode is over and fiscal policy is Ricardian in the long run, then we’re right back in an indeterminacy world…I think…haven’t worked out the math totally. The scary thing about this world is that these vacations into the liquidity trap and inflation expectations within the liquidity trap become self-fulfilling; I think that Cochrane (September 2007 I think….here…. http://faculty.chicagobooth.edu/john.cochrane/research/Papers/determination_taylor_rules.pdf ) and Schmitt-Grohe (can’t remember when, see Cochrane) have written about these things in great detail. Cochrane takes an even stronger stand on the ineffectiveness of interest rate rules; so far as I can tell he seems to be right. But that’s neither here nor there.

    So…um…what policy tools does the Fed have that guarantees 5% NGDP growth if money demand is slack and fiscal policy is Ricardian? Increasing the money supply has an indeterminate effect, since once the liquidity trap ends the Fed will presumably try to stabilize prices wherever they are. The odd thing about a liquidity trap is that there is no mechanism by which monetary authorities alone can commit to a high future price level. The fact that inflation expectations have stabilized seems to be a good thing, but it’s indicative that people expect the federal government to actually pay back the debt. What does the Fed ‘easing’ mean in this context?

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