One of the tenets of market monetarism is that acivist fiscal policy is a waste of time, since monetary policy can do all the stabilisation that’s needed. On Twitter last night Joe Wiesenthal at Bloomberg wondered what MaMos would think of a strict balanced budget rule. Would that leave monetary policy able to achieve nirvana?
I thought: surely MaMos would accept that monetary policy works with long and variable lags, the phenomenon, emphasised by Milton Friedman, that this blog is named after? And that therefore we’d get macroeconomic volatility from imperfect control?
Believing in Friedman’s dictum would not undermine MaMoism, since if both fiscal and monetary policy worked with the same long and variable lags, and in the same way, ie if they were perfect substitutes as an instrument, then there would be no need for both.
However, Noah Smith pointed me to this post by Scott Sumner, the leading MaMoist, which contains the phrase ‘long and variable lags is a myth’. The argument in this post seems to me to be full of holes. So, while I wait for an anti-MaMo Matlab program to finish, I will explain why.
First off, it seems to make the argument that mainstream macroeconomists wrongly identify the interest rate (or the money supply) as the sole monetary policy instrument. And therefore – I think – it follows that all the VAR evidence showing how shocks to monetary instruments take time to have their full effect on variables central banks might care about is misguided.
Well, no. Certainly, if one maintains the argument that expected future monetary policy is potent [which, provided you believe in forward-looking expectations is reasonable], and one is prepared to contemplate that there are shocks to expected future policy, VAR based studies that identify only shocks to the contemporaneous instrument are not enumerating all the volatility in the data injected by monetary policy. [And in fact work by Gurkaynak et al, and others, seeks to identify shocks to both current and expected future interest rates in just this way]. However, it does not follow from this that the VAR incorrectly measures the effects of shocks to the instrument. Moreover, as the work that does identify expectations shocks shows, those also take time to have their full effects. In other words, they work with long lags too!
Second, as a purely analytical matter, noting that you can manipulate expected future rates to affect the economy doesn’t preclude that those manipulations, or changes in today’s instruments, take time to have their full effects. In fact, so far as the empirics tell us, both changes in today’s interest rate and changes in expected rates take time to have their full effect [on variables like inflation, GDP, etc].
I’ll attempt an analogy.
If I am playing chicken timidly, I might be able to influence the trajectory of the other car by calling the driver’s mobile, and explaining that I will turn out of the way, perhaps persuading the driver to turn her car back towards mine. However, the other driver might take time to process what I say, and it will still take time for my turn of the steering-wheel to have its full effect on the path of my car.
I’m not sure how well that analogy went. But at any rate, the phenomenon is true of macroeconomic models of policy and the associated empirics.
And the corollary is that because the economy will be buffeted by shocks, and it takes time to respond and counter them, no policymaker would be able to generate stable outcomes for goal variables.
Backing up, I don’t accept, of course, the premise of this line of thinking at all, that monetary and fiscal policy are perfect substitutes, and therefore that the former can be dispensed with. But it’s worth bearing in mind that the logic gone through here works for fiscal policy too, both in the models, and in those attempts to identify shocks to fiscal policy today and in the future.
Sumner cites Woodford and Krugman as commenting on the potency of expectations, and uses this in support of his thesis that changing expectations changing things refutes the long and variable lags thesis. But I am quite sure neither of them believe any such thing. Estimated versions of Woodford’s model (for example, the original Rotemberg-Woodford model) behave just like my account above. And Krugman is a firm believer in sticky prices, talking interchangeably between IS/LM and New Keynesian models. Which behave just as I’ve explained above.
The only model I know where monetary policy has its entire effect instantaneously is the flexible price rational expectations monetary model. And in this case there is no point in monetary stabilisation policy at all. Money has no short-run effects on output. Optimal policy in this model is to set rates at zero permanently, obeying the Friedman Rule. If there are real frictions in this model, like financial frictions, there will still be a role for fiscal stabilisation, however.
I’m sure these mix-ups would get ironed out if MaMos stopped blogging and chucking words about, and got down to building and simulating quantitative models. Talking of which….
[Update: Scott Sumner replies on The Money Illusion here, including some priceless phrases about how his research found that there were in fact, no lags at all between monetary policy changes and their effects, and some other collectibles about there not being a NGDP futures market.]