In Which Stanford Economist John Taylor Adopts the False, Exploded "Treasury View" of More than Eighty Years Ago...
You know, it is very odd: When nominal interest rates on short-term Treasury securities are at their normal levels--4% or 3% or even 2% per year--I am among the very first to declare that discretionary fiscal policy has no proper role to play, and that the task of managing the business cycle should be left to the fiscal automatic stabilizers and to the Federal Reserve.
But things are--as we economists have known for nearly a century--different when short-term safe nominal interest rates are at their floor to make safe short-term bonds nearly perfect substitutes for cash, for then the standard mechanisms of monetary policy--flooding the system with cash and relying on the fact that holding wealth in cash is expensive (for it means that you forego interest) to trigger a rise in spending--is not guaranteed to work. And then fiscal policy has a place. To deny that fiscal policy has a place is then, it seems, to me, to fail the most basic test of thinking like an economist. As John Hicks put it back in 1937, we know that the speed at which people spend their cash--the velocity of money--is a function of the short-term safe nominal interest rate. And we know that the velocity of money becomes very elastic as the short-term safe nominal interest rate becomes very low:
On grounds of pure value theory, it is evident that the direct sacrifice made by a person who holds a stock of money is a sacrifice of interest; and it is hard to believe that the marginal principle does not operate at all in this field. As Lavington puts it:
The quntity of resources which (an individual) holds in the form of money will be suh that the unit of money which is just and only just worthwhile holding in this form yields him a return of convenience nad security equal to the... net rate of interest.
The demand for money depends upon the rate of interest!...
It is not only possible to show that a given supply of money determines a certain relation between [national] income and interest... it is also possible to say something about the shape of the cure. It will probably tend to be nearly horizontal on the left.... If is lies to the right, then we can indeed increase employment by increasing the quantity of money; but if IS lies to the left [and short-term safe interest rates are at their minimum], we cannot do so; merely monetary means will not force down the interest rate any further...
and we have to resort to fiscal policy and banking policy--things that affect not the quantity of money but the flow-of-funds through financial markets.
Now, however, we have to add John Taylor to the votaries of the 1920s-era "Treasury View": the claim that fiscal policy must be ineffective. He is thus one of those who, as Olivier Blanchard puts it, does not know things that Irving Fisher and Knut Wicksell (or at least John Hicks) knew.
Why John Taylor believes in the "Treasury View" is not at all clear. Paul Krugman writes:
The virus is spreading: I just taped Fareed Zakaria with John Taylor, who is a fine economist. But if I understood John’s position, it was that fiscal expansion is actually contractionary, because deficits drive up interest rates, unless the fiscal expansion takes the form of permanent tax cuts...
I'm not so sure about Taylor. The last paper of his I cracked... wasn't impressive. It was supposed to show that fiscal policy could not be powerful. And it didn't deliver.
Here's what I had to say about it at a conference at Stanford early in May:
Tuesday afternoon I sat down to... Cogan, Cwik, Taylor, and Wieland (2009).... I dug--and found that Cogan et al.’s claim [that they and the Obama administration had analzyed] “exactly the same policy change” was simply wrong. Romer-Bernstein model an increase in government spending with the Federal Reserve expanding and keeping on expanding the money supply in order to keep the short-term Treasury Bill interest rate the same. Taylor (1993) models an increase in government spending with the Federal Reserve contracting the real money supply to push the short-term Treasury Bill interest rate up over time as unemployment falls and inflation creeps up. There is no “robustness” problem with Romer-Bernstein at all: the results are different because the policy changes are different.
“Geez,” my first thought was, “this is embarrassing--none of four coauthors of Cogan actually read Romer-Bernstein at all carefully. Sloppy.” Then I got to page 5 of Cogan: “Romer and Bernstein assume that the Federal Reserve pegs the interest rate....” Cogan et al. know perfectly well that the policy changes are not “exactly the same.” They just say they are.
I am sorry. In Europe that gets you four red cards. In America that gets you sent to the showers. The first intellectual responsibility of critique is to accurately present what you are critiquing. When Cogan et al. learn that they can come back into the game. But not until then.
What is their explanation for not telling us up front that they are assuming a different monetary policy? They give none. What is their explanation for assuming a different fiscal policy? It is this:
Romer and Bernstein assume that the Federal Reserve pegs the interest rate—the federal funds rate—at the current level of zero.... [S]uch a pure interest rate peg is prohibited in new Keynesian models with forward-looking households and firms because it... lead[s] to instability and non-uniqueness.... Inflation expectations of households and firms become unanchored and unhinged and the price level may explode in an upward spiral….
In short, the monetary policy rule that Romer and Bernstein believe that the Federal Reserve is following makes fiscal policy incredibly powerful: so powerful that the level of nominal spending explodes. So we are going to make a different assumption about monetary policy that makes fiscal policy weak because we assume the Federal Reserve neutralizes the effects of government spending.
Do they provide any reason to justify their monetary policy assumption--any reason to believe that the Federal Reserve is currently engaged in raising short-term interest rates to neutralize the effects of fiscal expansion? No, they do not.