Re: Re: Re: Brad DeLong's column

[Jim Devine <jdevine@xxxxxxxxxxxxxxx>]

Mat writes:
> > Both of the quotes-- deficits crowd out private investment and deficits
> > cause high interest rates (more specifically there that lowering deficits
> > cause lower interest rates) are pure Summers, but you are right that
> > "pre-Keynesian" is the correct general label.

Brad ripostes:
> Nah. In the context of the 1980s and 1990s, the Federal Reserve has its
> target for real GDP and unemployment that it will try to hit--so a bigger
> deficit means higher interest rates. It's not the pre-Keynesian childish
> babbling of a Say, but a certain (I think correct) view of how the Federal
> Reserve behaves...

Because the Fed fine-tunes the economy to attain a target real GDP,  Say's
Law is a first-guess guide to the workings of the macroeconomy, so that an
increased government deficits drive up interest rates?  But I thought that
macroeconomists had abandoned the idea of fine-tuning!

(BTW, before I start my diatribe, notice that higher interest rates (Brad's
topic) are not the same thing as "crowding out" of private investment
(Mat's topic). This is especially true because government deficits
encourage private spending via the accelerator effect.)

In the early 1980s, the Fed wasn't targeting real GDP. Rather, it was
trying to break the back of inflation (and indirectly, that of the working
class). In the process, the second problem with Brad's riposte was
revealed, i.e., the assumption that the Fed has the _power_ to target real
GDP. There are several problems with this assumption: the health of the
banks and the financial system can be threatened by policy, so that there's
a conflict among Fed goals; the Fed doesn't control the relevant real
long-term interest and thus the economy well at all; and they don't know
what potential output is.

In 1982, the anti-inflation war started hurting banks (and encouraged the
international debt crisis) and so Volcker retreated from his
anti-inflationary war. Luckily for him, oil prices fell sharply, so that
the war against inflation could be won despite rising real GDP. So the Fed
accommodated the expansionary effects of fiscal policy (the famous Reagan
deficits).

In the late 1980s, because the Fed believed the NAIRU to be 6 percent,
Greenspan (PV's successor) perceived that the economy started over-heating.
So the Fed tried to engineer a "soft landing" in 1989 (sound familiar?)
That is, it tried "to reduce aggregate demand without actually bringing on
a recession" with "a mildly contractionary policy." Despite last-minute
efforts to slow the recession, "the soft landing turned into a stall," the
recession of 1990. The Fed found itself "pushing on a string," having
little effect on the economy. Official unemployment rose from 5.3% in 1989
to 6.8% in 1991 and 7.5% in 1992. If the Fed had been able to target
output, it would have gotten unemployment to stop rising once it got beyond
the perceived NAIRU (6% at the time). [The NAIRU is the rate of
unemployment below which the economy is supposed to produce an inflationary
explosion. It corresponds to potential output.]

Martin N. Baily & Philip Friedman (whose MACROECONOMICS textbook I'm
quoting above, p. 249) point to several problems with this effort in 1989.
(1) a mild decline or slowing of real GDP can be translated into a steep
one by the accelerator effect [a factor that many macroeconomists have
forgotten]; (2) they don't have control over fiscal policy, which was
mildly contractionary in the 1989; (3) there had been over-investment in
offices and shopping centers, combined with excessive borrowing, which
discouraged further investment spending; (4) the balance sheets of many
banks were affected, as excessive borrowing encouraged the borrowers to go
bankrupt, undermining bank assets; (5) there was a steep rise in oil prices
(due to the war between Kuwait and Iraq), which encouraged a cut-back in
consumer spending. Finally, (6) the yield curve became very steep, as the
Fed pushed short-term interest rates down but long-term rates stayed high.
Under conditions like this, the Fed _can't_ target real GDP. [Baily &
Friedman's sources, by the way, are quite respectable: Olivier Blanchard,
Robert Hall, and Alan Sinai. Baily himself heads the President's Council of
Economic Advisors at this point.]

After a long process of recovery (the length of which encouraged the ouster
of President Bush), the Fed started a long period of groping in the dark. I
don't know how the Fed can target real GDP if it can't forecast the future.
They didn't know where the NAIRU was, so they didn't know where potential
output was (or what the "speed limit" for GDP growth was). Greenspan hiked
rates in 1996, assuming that the economy had fallen below NAIRU. In
retrospect, we know that his estimates of the NAIRU were way off, much too
high. (Brad had pointed to the problems with the NAIRU theory in a previous
NY TIMES column. Others have pointed out that the margin of error in
calculating the NAIRU is so large that its estimates are worthless from a
policy-making perspective.) Greenspan is still grasping at straws, not
knowing where the NAIRU is and not knowing what real GDP to target.  In any
event, he switched to inflation-targeting at some point in the late 1990s,
so that Brad's assertion _can't_ apply.

The Fed's recent efforts to slow the economy (to keep inflation from
rising) have so far led to a speed-up of real GDP growth, which also goes
against the idea that they can target GDP. That might lead to a repetition
of 1989-90, this time based on consumer indebtedness, the unpredictability
of foreign exchange markets, and the like, but today my crystal ball is
cloudy.

In summary, if the Fed can't or won't target real GDP, then we can't assume
that Say's Law is a first-guess approximation for the behavior of the
macroeconomy. BTW, in his ACCIDENTAL THEORIST (1998) in an article
published earlier, Krugman put forth the perspective that the Fed could
fine-tune the economy, so that (in effect) Say's Law worked, just as Brad
seems to be saying above. He abandoned that view in 1999, with his "Return
of Depression Economics" in FOREIGN AFFAIRS.

Jim Devine jdevine@xxxxxxx &  http://liberalarts.lmu.edu/~jdevine