If you haven’t already read Fisher’s 1933 article “The Debt-Deflation Theory of Great Depressions,” read it today. It contains his theory of booms and busts that later inspired Hyman Minsky to develop the Financial Instability Hypothesis (HM duly acknowledged his debt to Fisher in his 1986 book).  Fisher’s article is unfortunately becoming more relevant by the day.

Fisher notes that the two dominant factors in all great booms and depressions are over-indebtedness and deflation. Over-investment and over-speculation with borrowed money are at the heart of the crisis. Once in a crisis, it is very hard to get out again, especially when prices start to fall (deflation). The typical reaction is to liquidate positions and repay debt. But when this becomes a generalized response to the crisis “the very effort of individuals to lessen their burden of debts increases it, because of the mass effect of the stampede to liquidate in swelling each dollar owed. Then we have the great paradox which, I submit, is the chief secret of most, if not all, great depressions: The more the debtors pay, the more they owe.” (p. 344)

But, according to Fisher, it need not be this way: “it is always economically possible to stop or prevent a depression simply by reflating the price level up to the average level at which outstanding debts were contracted … and then maintaining that level unchanged.” (p. 346). He notes that since the crisis is man-made, we should not leave the solution of the crisis to nature (i.e. through bankruptcies). However, “if our rulers should still insist on leaving recovery to nature and should still refuse to inflate in any way, or vainly try to balance the budget or discharge more government employees, they would soon cease to be our rulers. For we would have insolvency of our national government itself, and probably some form of political revolution without waiting for the next legal elections.” (p. 347)

Fisher was so concerned about the economic situation at the time that he even wrote a letter to President Roosevelt stating his views on what should be done to get out of the crisis: continue reading…

Brookings issued a report yesterday, called Rethinking Central Banking, by a group of high-profile economists including Eichengreen, Rajan, Reinhart, Rogoff and Shin. The group – called the Committee on International Economic Policy and Reforms – argues that the conventional approach to central banking needs to be rethought. The neat separation between price stability and other objectives is no longer feasible. The group wants central banks to adopt an explicit financial stability objective, expand their macro-prudential toolkit, and use monetary policy if needed to support financial stability: “If, in the interest of financial stability the central bank sets policies that could result in deviations from its inflation target, then so be it.” (p. 30) They also support the use of capital controls to stem short-term speculative capital flows, and call for more cooperation and coordination between systemically significant central banks.

These policy prescriptions are not radical or new. Much of the ongoing debate in Basel and Washington is focusing on just how to develop these new macro-prudential policies. What is noteworthy with the report, though, is their acknowledgment of weaknesses in the prevailing paradigm. They note that:

• Central banks have allowed credit growth to run free (p. 6)
• International capital markets are destabilizing (p. 21)
• Interest rates affect financial stability and hence real activity (p. 12)

This is significant, since it undermines some of the cornerstones of the current paradigm for (flexible) inflation targeting. As the report notes, “the traditional separation, in which monetary policy targets price stability and regulatory policies target financial stability and the two sets of policies operate independently of each other, is no longer tenable.” This will hopefully lead to more pragmatic and less dogmatic policy making in the future. How the new framework will affect the current preoccupation with DSGE modeling in central banks is, however, not discussed in the report.

Breaking out of the current paradigm will take time, though. continue reading…

Here is an excerpt from the most important article you will read this year, by George Lakoff:

Here’s how public intimidation by framing works.

The mechanism of intimidation is framing, not just the use of words or slogans, but rather the changing of what voters take as right as a matter of principle. Framing is much more than mere language or messaging. A frame is a conceptual structure used to think with. Frames come in hierarchies. At the top of the hierarchies are moral frames. All politics is moral. Politicians support policies because they are right, not wrong. The problem is that there is more than one conception of what is moral. Moreover, voters tend to vote their morality, since it is what defines their identity. Poor conservatives vote against their material interests, but for their moral identity.

All language activates frames in the brain. Conservative language activates conservative frames, which activate conservative moral worldviews in the brains of those who hear the language. The more those frames are activated, the stronger the conservative moral views get in people’s brains.

Please go to this link, read the article, and then we will discuss it.  (Continued at EconoMonitor…)

The early phases of the 2012 presidential election season have already brought us a great deal of debate on fundamental economic policy issues. Greg Ip, in the Washington Post‘s PostOpinions, writes about the views of a number of Republican candidates (pointer via Economist’s View). Are they believers in the “voodoo economics” that many recall from past elections–tax cuts for the wealthy that supposedly spur growth and reduce deficits and at the same time?

Not according to Ip. He describes a risky, and somewhat novel, approach to economic policy emerging in this year’s political rhetoric. This approach rejects policies that have reduced the severity of the business cycle since the Great Depression.  Ip skewers the politicians’ critique of these Keynesian policies, which blames the country’s economic problems on excessive government action:

Many Republicans consider the tepid economic recovery an indictment of Keynesianism, and use the word as an epithet, as in “Keynesian Utopia” (Sarah Palin) or “Keynesian bubble” (Ron Paul). They argue that aggressive fiscal and monetary stimulus have made things worse by generating uncertainty among firms and investors, and that austerity would put things right.

Rick Perry’s recent reflections/threats regarding quantitative easing have occasioned some speculation about whether his raising the political profile of the issue might actually affect Fed behavior; making the Fed less willing to engage in a third round of easing.  The question of political bias at the Fed has been raised before, here in this Levy Institute working paper (free of any implicit promises of lynching) authored by Galbraith, Giovannoni, and Russo.  The authors reveal that there is in fact an argument to be made for the existence of partisan bias, at least for the period 1984- 2003:

…we find that in the year before presidential elections, the term structure [of interest rates] deviates sharply from otherwise-normal values. When a Republican administration is in office, the term structure in the preelection year tends to be steeper, by values estimated at up to 150 basis points, and monetary policy is accordingly more permissive. When a Democratic administration is in office, the term structure tends to be flatter, by values also estimated at up to 150 basis points, and monetary policy is more restrictive. These findings are robust across model specifications and across time, though the anti-Democrat effect is smaller after 1983. Taken together, they suggest the presence of a serious partisan bias, at the heart of the Federal Reserve’s policymaking process.

Now, perhaps this trend has reversed itself, for some reason, under the leadership of Republican-appointed Ben Bernanke.  But determining whether or not the current Fed has been “playing politics” lately, as Perry alleges, is not as obvious as he might suggest.  continue reading…

You might wonder if this question is a misguided satire of Keynesian proposals like the ones in this Institute one-pager for boosting employment in a time of weak economic growth. The question is not meant as a satire, though. In a time of increasing recession fears, policies specifically aimed at reducing the value of the dollar have gained some supporters. Many scholars see a deliberate weakening of the U.S. dollar and/or a moderate increase in the U.S. inflation rate as something to be sought after in itself, not just as an unfortunate side effect of monetary or fiscal stimulus.

Kenneth Rogoff, for example, recently reprised the classic argument that the burden of debt falls when prices rise across all industries. (Rogoff’s Financial Times article is here. The New York Times discusses his views here.)  To wit, moderately higher prices obviously allow firms that have debt in dollars to more easily meet their debt-service obligations. Furthermore, increases in prices often bring higher wages, albeit with a time lag, making it easier for consumers to pay off their debts on time. In the United States, this is a very salient point, in light of high debt levels in nonfinancial business and the household sector, which we documented in this recent post.

Meanwhile, on the other hand, John Plender skeptically reminds Financial Times readers (and perhaps proponents of modern monetary theory [MMT]) of the possible dangers associated with policies that intentionally or unintentionally invite a spurt of inflation. continue reading…

Throughout the weekend, television news coverage dwelled on Friday’s downgrade of U.S. debt securities by Standard and Poor’s, one of the three main ratings agencies that assess the creditworthiness of the federal government. The meaning of S & P’s action remains somewhat uncertain, and we doubt that, as important as the story was, the downgrade will have strong economic repercussions, provided that it is well understood.

In Sunday’s early print edition of the New York Times, Nelson Schwartz and Eric Dash reported that “…many analysts say the impact [on interest rates] could be modest, in part because the other ratings agencies, Moody’s and Fitch, have not downgraded the government at this time.”

Indeed, yields on U.S. government debt instruments remained very low following the downgrade, after decreasing over the past few months. Investors seem unconvinced that the government could somehow fail to come up with the dollars it needed to meet its repayment and interest-payment commitments. Nonetheless, financial markets were jittery, if only because of the downgrade announcement itself.

Also, we remain convinced that there is no basis for a belief that the federal government will ever have to default on its debt. This statement applies to the United States or any other country with a sovereign currency and a floating exchange rate.

The real problem was probably a fear on the part of S & P that the government might not repay its debt, not that it could not. The debt level has been very high for a long time, but the S & P move did not occur before the near-stalemate over the debt limit. This was a real crisis. A failure to raise the ceiling might conceivably have led to a default. However, a U.S. government failure to pay interest or repay principal cannot occur, as long as national political leaders make it clear that they will permit routine debt issuance and money creation to continue.

What’s more, taxpayer advocates should be aware, as Ronald Reagan was, that the ability to run deficits conferred by a sovereign currency enhances the government’s powers to lower taxes as Congress and the President see fit. (As an aside, it follows that if all of the national governments in Europe had independent, unbacked currencies like the U.S. greenback, they could avoid the ineluctable defaults and ensuing austerity measures that come with a currency union, gold standard, or similar international system, though they would sacrifice the many advantages of a shared currency.)

It goes without saying that in any country, balance is required in decision-making about taxes and spending, bond issuance and money creation, and workers and corporations to go along with competing policy goals, such as low inflation, low unemployment, economic growth, income security, stability of the exchange rate, equity and the like. The U.S. government lost the mostly symbolic weight of its top S & P bond rating mostly because brinksmanship over the debt limit jeopardized its power to weigh these objectives and act upon them.

A deal was reached over the weekend by congressional leaders and the President to resolve the debt-ceiling impasse. By that point, it was clear that the possible way out described by John Carney in a blog post to which we linked on Thursday would not be feasible. Nonetheless, the Fed’s ability to supply cash as needed if the deadline were missed had been made clear in official statements reported by the New York Times in Sunday’s early print edition. To wit, in response to concerns expressed by top banking executives,

“Mr. Geithner made it clear that the Treasury and the Federal Reserve had taken precautions so that payments for food stamps, military wages, and other federal obligations would not bounce, according to people involved in the call.”

An article posted to the Times website Saturday had phrased this point somewhat differently:

“Mr. Geithner assured [JPMorgan Chase CEO Jamie Dimon] that the Treasury and Federal Reserve had taken steps to keep the payment system functioning smoothly, according to individuals briefed on the call.”

The phrase “keep the payment system functioning smoothly” is a euphemism known by Fed observers to entail in practice the types of functions described  in the above quote of the print edition.

Obviously however, this use of overdrafts could not be continued very long, owing to the will of the negotiators and probably the relevant laws. These laws are intended to keep the Federal Reserve largely independent from the federal government.   Hence, while the Fed honors checks written by the Treasury Department and presented to it by banks, the use of this privilege is extremely limited in the U.S. system, compared to “overdraft systems” of the type I described in this earlier post.

On the other hand, if the somewhat artificial distinction between the central bank and the central government were to be eliminated in the United States, the federal government would gain access to the printing press, enabling it hypothetically to back a virtually unlimited amount of outlays. Of course, this process would not create new “debt,” but rather new currency and bank reserves. Of course, the Fed itself can currently use its “printing press,” mostly to stabilize the banking system, a role that led to a massive expansion of bank reserves during the financial crisis of 2007–08.

In current mainstream macroeconomic thought, which is carrying the day in most of the developed world now, a system in which the government has control of the printing press is thought to court intolerable levels of inflation. However, in an economy growing as slowly as this one, it is extremely doubtful that excessive inflation would necessarily follow if the impasse were to be resolved by creating new currency and bank reserves, rather than by selling bonds, increasing taxes, or cutting spending. Yet given the legal independence of the Fed, the latter two options were the only ones open to the negotiators last weekend. Moreover, new taxes were unacceptable to many, if not most, in Congress.  Hence, it now appears that the government may be about to make potentially devastating new cuts to key federal programs.

Many influential mainstream Keynesian economists continue to support high deficits until the nation’s yawning jobs gap is closed. As Laura D’Andrea Tyson observes in a thorough and helpful blog entry posted this morning, this is not a fine-tuning problem requiring a careful weighing of priorities, given the current state of the job market:

Like many economists, I believe that the immediate crisis facing the United States economy is the jobs deficit, not the budget deficit. The magnitude of the jobs crisis is clearly illustrated by the jobs gap–currently around 12.3 million jobs.

That is how many jobs the economy must add to return to its peak employment level before the 2008–9 recession and to absorb the 125,000 people who enter the labor force each month. At the current pace of recovery, the gap will be not closed until 2020 or later.

In other words, we are not even close to full employment; moreover, as many have observed, inflation appears to be extremely low, with few signs that the stimulus measures taken up to now are bringing about an inflationary takeoff. Hence, it is straightforward to see the urgency of increasing job growth relative to worrying about rising prices, at least for the time being.

Parenthetically, while macroeconomists rightly devote a great deal of attention to these cyclical issues, there are numerous pressing matters other than inflation and unemployment that figure in the recent budget debates in Washington. Many of these issues are at stake in the individual spending cuts and tax-code changes now being debated. Some of the changes being contemplated involve very large amounts of money and programs that are crucial to many people. There is a great danger that these concerns will be lost in the rush to meet an artificial deadline that could after all be eliminated immediately by a single act of legislation, with or without “action” on the deficit.

With a near-consensus in the moderate camp on the need for temporary monetary and fiscal stimulus, I think it might be useful in a policy-oriented forum like this one to point out some of the potential contributions of more encompassing Keynesian approaches and of various post-Keynesian alternatives toward a better set of policies. One of the main issues dividing the mainstream Keynesian approach from these more-radical departures is the importance of the distinction between the short and long runs in deciding the role of macro policy in ending a recession or depression.

Throughout the debate, the moderate Keynesians, who have managed to carry the day many times, have argued that Keynesian stimulus should come before serious belt-tightening designed to reduce the federal debt over the long haul.  The rationale has been that “this too shall pass” in the longer run. But with weakening or mediocre economic data prevailing again recently, the long run appears to once again be the long run. The economy’s power to correct its own course is very much in doubt, but so also are the curative powers of modest stimulus bills in the medium and long runs.

A more helpful role for government might be open, once there was an admission that more-permanent action is needed to solve an unemployment problem that no longer seems to be purely cyclical in nature, but nonetheless to clearly implicate a lack of aggregate demand. Such measures could include longer-term employment opportunities, as well as the creation of new mechanisms designed to automatically stimulate the job market whenever the economy begins to falter. In any case, the thought must be of longer-term policy-planning for adequate stimulus to both supply and demand.

In a recent blog piece at the CNBC website, John Carney offers this interpretation of the federal debt ceiling (see also Felix Salmon’s more recent comment):

“The debt ceiling applies to the face amount of obligations issued under Chapter 31 of Title 31 of the U.S. Code—basically, Treasury notes and bills and the other standard kinds of government debt—and the “face amount of obligations whose principal and interest are guaranteed by the United States Government.” But overdrafts on the Federal Reserve wouldn’t be Treasurys and they aren’t explicitly guaranteed by the U.S. government.

“They’re more like unilateral gifts from the Fed.

“And guess what? The Treasury is allowed to accept gifts that “reduce the public debt.” Since these overdraft gifts from the Fed would allow the government to spend without incurring additional debt, it seems very plausible to argue that this kind of extension of U.S. credit would be permitted under the debt ceiling.”

In normal times, when the federal government has not reached a Congressionally imposed ceiling on its debt issuance, the Fed would indeed honor all checks issued by the U.S. Treasury Department, whether or not Treasury securities had previously been issued in sufficient amounts to “cover” the checks.  Carney may indeed be right that the debt limit law might permit this to continue after the debt limit has been reached on August 2. As pointed out by Carney, the legal issue would seem to turn on the question of whether the “overdrafts” to which he refers would be equivalent to federal debt under the relevant legislation.

In my opinion, this would be good news, as federal debt limits are not helpful to the public interest. I have one additional thought to mention. In Carney’s scenario, it would be likely that banks would begin to accumulate excess reserves at the Fed, where they now earn one-quarter percent interest. Hence, a large portion of the reserves created by the Fed to cover expenditures that would otherwise breach the debt limit would become earning assets for banks, with the Fed paying interest on these liabilities. Legally, of course, reserve deposits at the Fed are liabilities of the Fed and not the federal government.

Also, as Carney points out, banks and recipients of new government checks would seek to purchase existing fixed-income securities with some of the newly created money, probably putting downward pressure on yields. The Fed could then try to keep interest rates from falling by selling securities from its open-market portfolio.

Hence, in Carney’s scenario, the Fed would most likely increase its liabilities and/or decrease its asset holdings by large amounts, a process that would in a sense compensate for the lack of new Treasury-security issuance.  The question is whether this would be legal if the debt limit law was at issue.  If the overdraft strategy turns out to be legal and acceptable to the main players, we could have a far better situation than one in which the federal government could not pay for its normal operations.

Clarification, July 28: It should be duly noted that while August 2 is regarded as the hard-and-fast deadline for raising the debt ceiling, the federal government actually reached its debt limit in May. New debt issuance ceased at that point. The federal government has continued to pay its bills using “extraordinary measures” that were recently outlined by Treasury Secretary Geithner in materials posted here. These measures involve temporarily tapping certain government funds set aside for various purposes. The government has estimated that these alternative ways of funding government expenditures will be exhausted on August 2; hence, this is the date by which the resolution of the current impasse must occur according to the administration. This somewhat technical point was misstated in the post above, which implied that the legal debt limit would not be reached until August 2. We apologize for any confusion this may have caused. -G.H.