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…