The professor vs. the markets

Turkey’s authoritarian leader sacked the central bank head just months after appointing him to the position:

When Turkey raised interest rates more than market expectations last week, Naci Agbal was cheered by investors who viewed the move as more evidence that the central bank governor was willing and able to pursue a conventional monetary policy.

Two days later, he was out of a job — the third governor President Recep Tayyip Erdogan has sacked in less than two years — and the currency was set to tumble as much as 14 per cent.

The shock decision announced in the early hours of Saturday has rattled investors who hoped the appointment of Agbal, a market-friendly economist, four months ago meant Erdogan was ready to cede a degree of autonomy to the bank.

The fact that Turkey’s currency depreciated does not necessarily mean it was a bad decision.  It would be good news if the yen depreciated 14% on news of new leadership at the Bank of Japan, an indication that the new central bank chief was likely to make progress toward Japan’s 2% inflation target.  But Turkey has 15% inflation, and doesn’t need monetary stimulus.

Sahap Kavcioglu, who has replaced Agbal, said in a statement on Sunday that monetary policy instruments would “continue to be used in an effective way towards the fundamental goal of a permanent decline in inflation”. He said the Monetary Policy Committee would meet as scheduled on April 15, suggesting there would no extraordinary MPC meetings.

But Kavcioglu, a little-known professor of banking, shares the president’s unconventional view that high interest rates cause inflation.

High interest rate don’t cause inflation, just as low interest rates do not cause inflation.

It’s one thing to advocate NeoFisherian ideas as a college professor.  But markets are quite efficient, too smart to engage in the fallacy of “reasoning from a price change”.  Mr. Kavcioglu is about to discover that the world doesn’t work the way he thinks it works.


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Will the Fed follow its rhetoric or its rule?

In recent years, the Fed has increasingly adopted the rhetoric of 1960s Keynesianism.  Go for growth.  Don’t worry about a bit more inflation.  Jobs are much more important.  Given that 1960s Keynesianism gave us the Great Inflation, should we be worried about today’s rhetoric?

Oddly, at roughly the same time that they adopted all this expansionary rhetoric, the Fed switched to average inflation targeting, which makes 1960s-style expansionary monetary policy totally impossible to implement.

So what will the Fed do in the 2020s?  Will inflation average 2%, or will it average 4%, 6%, or 8%?  I don’t know, but my hunch is that a portion of this Keynesian rhetoric is just the Fed trying to be PC, trying to keep up with a generally leftward shift in public opinion on stimulus.  Another part might be the Fed’s perceived need to create “credibility” for its 2% inflation target, given that inflation ran below 2% over the previous decade, and given that (until recently) market indicators have been skeptical that we’d reach 2% inflation, on average.

One way or another, we’ll soon find out.

Some people seem concerned by the fact that the markets expect interest rates to rise faster than the Fed itself current predicts.

But this isn’t actually a problem at all, at least if you take the Fed’s 2% average inflation target seriously.  At the moment, markets expect a modest overshoot of inflation over the next 5 years, to make up for the undershoot during 2020.  Then roughly 2% inflation for as far as the eye can see.  But that’s exactly what the Fed says it wants!  If the markets think that this good outcome will require higher interest rates than the Fed currently expects, that’s not a lack of policy credibility, it’s just a difference of opinion on the future path of the natural rate of interest.  A lack of policy credibility would occur if the markets didn’t expect inflation to average 2% during the 2020s.  More likely, rising rates reflect increased confidence that the Fed will achieve its goals.

Don’t confuse the rhetoric with the policy rule.  The rule is the actual Fed policy—the rhetoric is just a bunch of pretty words.

PS.  Of course the other problem with the tweet that Yglesias links to is that Perli is reasoning from a price change, assuming that rising longer-term yields reflect predictions of a tighter monetary policy stance.

PPS.  People often ask me about “yield curve control”.  That would be like a ship captain announcing “steering wheel control”, a commitment to hold the ship’s steering wheel at a fixed position for days on end, regardless of changes in wind and currents.  What do you think?  Does that sound like a good idea?


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Did people eat two dinners in the 1970s?

This Yahoo article made me smile:

And so simply put, the Fed does not believe any pricing pressures in the economy will warrant a change in its interest rate policy for the next three years.

To help explain this thinking, Fed Chair Jay Powell cited dinner norms in his press conference on Wednesday afternoon.

“There very likely will be a step-up in inflation as March and April of last year drop out of the 12-month window, because they were very low inflation numbers,” Powell said. “Those will be a fairly significant pop in inflation, but those will wear off quickly because [of the way] the numbers are calculated.”

“Past that,” Powell added, “as the economy re-opens, people will start spending more. You can only go out to dinner once per night, but a lot of people can go out to dinner. And they’re not doing that now, they’re not going to restaurants, they’re not going to theaters…and travel, and hotels, that part of the economy is really not functioning at full capacity.” (Emphasis ours.)

And while the Twitter commentariat had fun with Powell’s exact phrasing — apparently the kind of person who watches the entirety of a Fed press conference is also a multiple-dinner enthusiast — the point the Fed chair makes is economically sound.

I’m actually not sure what point Powell is making.  Is it a point about aggregate demand (which can rise at trillions of percent per year, as we saw in Zimbabwe), or aggregate supply, which is limited by labor, capital, and technology?

Yahoo continues:

The anticipated increase in growth, inflation, and a recovery in the labor market is all part of a one-time recovery story in the U.S. economy. A demand surge against stressed supply chains or understaffed restaurants and bars that results in higher prices this year will not last.

The dinner is a metaphor.

No one thinks the economy will grow at 6% for years to come. No one thinks the 7 million or 8 million jobs added back to the economy this year will be repeated next year. And Powell does not think any inflation pressures that result from this unlocking of activity will re-set the current inflation regime.

This is the Keynesian fallacy on steroids—the idea that inflation is caused by fast RGDP growth.  In fact, it is precisely because economies can’t grow at 6% forever that inflation is a threat if NGDP grows too fast.  I don’t currently fear high inflation, but not because of the reluctance of people to eat two dinners.  In 2008, Zimbabweans often lacked even one dinner.  Rather, I don’t currently fear high inflation because I expect the Fed to limit growth in aggregate demand to a path consistent with 2% long run PCE inflation.

Inflation is caused by too much money chasing too few goods—NGDP growth minus RGDP growth.


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Alan Blinder’s Tin Ear on Inflation

I’m taking Jeff Hummel’s Masters’ course in Monetary Theory and Policy. Two lectures ago, he discussed the costs of inflation and highlighted Greg Mankiw’s discussion of it in Greg’s Intermediate Macro text. Greg covered many of the bases but the tone of his treatment suggests that he doesn’t think high inflation, even when it exists, is much of a problem. He compares the views of the public and the views of economists on the issue and finds the views of the public deficient.

Jeff disagreed and highlighted three areas that Greg left out. One is that inflation presents a “signal extraction” problem, making it difficult for people to know whether and by how much relative prices have changed. The second is that high inflation virtually always tends to be variable, and for a given mean inflation rate, variable inflation is more destructive than constant inflation. The third is that inflation is a tax. Greg dealt with that issue but focused on the deadweight loss from the tax rather than the DWL plus government revenue from the tax. When you look at how non-economists think about other taxes, you see that they care about the fact that the government is getting revenue from them. That seems like a reasonable concern, whether the revenue generator is a sales tax or an inflation tax.

Greg did note that inflation creates apparent capital gains (I call them “phantom gains”) that are not gains at all. You buy a stock for $100, inflation is 10%, you’re in a 20% capital gains tax bracket, the stock holds its real value at $110 a year from now, you sell the stock for $110, and you pay $2 in capital gains tax. You’re left with $108, which, inflation-adjusted, is worth $98.18, which is less than what you paid for it a year ago.

I assume that Greg focused on the capital gains tax rather than income taxes because Reagan and Congress, in the Economic Recovery Tax Act of 1981, implemented indexing of tax brackets for inflation, effective in 1985. But there are a few things to note. First, other things besides the capital gains tax are not adjusted for inflation. The thresholds after which you pay taxes on your Social Security income have not been adjusted for inflation in 3 decades. Second, the income cutoff beyond which you can’t contribute to a Roth IRA is not adjusted for inflation. Third, many state governments have not adjusted their tax brackets for inflation.

The discussion in class reminded me of two people. The first is Princeton University economist Alan Blinder.

Blinder, even more than Greg Mankiw, missed people’s upset about inflation in his 1987 book, Hard Heads, Soft Hearts. I reviewed it in Fortune, November 9, 1987. Here’s part of what I wrote on the issue.

In discussing employment and inflation, Blinder says we worry too much about inflation. He estimates that for every percentage-point reduction in the inflation rate, we must accept a two point or so increase in the unemployment rate for one year. Blinder says that is too high a price to pay, and launches into an argument about the true cost of inflation, which, he says, noneconomists tend to exaggerate. If inflation is running at an 8% rate while real wages are rising by 2%, people’s money wages will increase by 10%. The noneconomists among them will attribute the whole 10% gain to their own increased productivity [DRH note: I’m not sure he’s right; I never met this mythical non-economist] and will feel that inflation robbed them of the other 8%. They weren’t robbed at all, Blinder argues: 2% is all they were entitled to, and 2% is what they got.

That argument is incomplete, however. Before 1985 people were being robbed because individual income taxes were not indexed: Inflation kept bumping people into higher margin tax brackets, thus enabling the Treasury to steal some of the income they were entitled to. Blinder acknowledges this difficulty and says at one point that a failure to index the tax system can impose “sizable costs.” But then he turns around and says that unless you are an economist or accountant, this cost “will leave you yawning.”

Where was Blinder during the late 1970s? I knew people with only a high school education who noticed instantly that an 8% increase in their hourly rate translated into only a 6% or so increase in their take-home pay, not enough to stay abreast of inflation. They didn’t yawn when that happened–they got mad, which is one reason taxes ended up being indexed.

By the way, in writing this, I had in mind a discussion I had with a high school graduate named Chrissy Morganello, who was a secretary to three other faculty members and me from 1975 to 1979, when I was an assistant professor of economics at the University of Rochester’s Graduate School of Management.

Here, by the way, is Blinder’s first rate article on “Free Trade” in David R. Henderson, ed., The Concise Encyclopedia of Economics.

Next up: Alice Rivlin’s blasé attitude about high inflation in the 1970s.





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The Price Level Shortfall

Had we run a 2% price level target since December 2007 (the beginning of the previous recession). Figure 1: Personal consumption expenditure price level, chain-type (black), 2% target from 2007M12 (red), and CBO projection (teal). CBO monthly data interpolated from quarterly using quadratic match. 2% in log terms. Source: BEA via FRED, CBO (February 2021), […]

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Structural Factors and Central Bank Credibility Limit Inflation Risks

By Gita Gopinath After ending last year with unexpectedly strong vaccine success and hope that the pandemic and economic distress it caused would recede, we woke up to the reality of new virus variants and the unpredictable, winding road that it can lead the world down. Something similar has happened with the discourse on inflation. […]

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Hume, hockey sticks, and The Great Forgetting

In the 21st century, macroeconomics is entering a new Dark Ages. We seem to be forgetting much of what we learned in the last half of the 20th century.

That judgment may be harsh, but if I’m wrong then you should no longer read anything I write (including the book I have coming out this year), because in that case I wouldn’t actually know anything useful about macroeconomics.

Perhaps the most firmly established proposition in late 20th century macroeconomics is that the Great Inflation of 1966-81 was caused by central banks printing too much money. If that proposition is wrong, then I might just as well give up. Everything else I believe about macro hinges on that being true. If the Great Inflation wasn’t caused by too much money, then what can macroeconomics tell us about the world?

1. Hockey sticks, wherever you look

People often talk about “hockey stick” graphs.  Deirdre McCloskey using that metaphor for the explosion in real incomes in recent centuries.  Demographers use it for the Earth’s population.  Environmentalists use it for carbon emissions.  Tech people for gigabits of information.  And there’s also a hockey stick graph for the US price level, as well as the price level of many other developed countries.  The US price level was fairly flat during the first 150 years of US history, and then exploded upward 20-fold after 1933.

Back in 1752, this was all explained by David Hume.  Out-of-sample forecasting is the gold standard of model success, and by that standard Hume might be the greatest macroeconomist of all time.  Of course he didn’t use modern terminology like “nominal GDP”, but if you translate his core argument into modern lingo, it goes something like this (my words):

A large exogenous increase in the money supply will cause a roughly proportional increase in NGDP.  There would not be a precise correlation, as velocity moves around as well.  Because real growth is caused by non-monetary factors, excessive growth in money will simply lead to inflation, as NGDP growth outpaces RGDP growth.

During the first 150 years of US history, the monetary system was commodity based (bimetallic and then a gold standard.)  That kept money growth close to the rate of growth in RGDP, and hence there was almost no long run inflation (although prices moved up and down erratically around a near-zero inflation trend line.)

Then we tried Hume’s experiment.  After many decades of fixing the price of gold at $20.67/ounce, we let it rise sharply.  Today it’s over $1800/oz.  We used that freedom to print lots of money, and as the monetary base began rising much faster than RGDP, inflation also took off.  The numbers were pretty much what Hume would have predicted.  And most of the “anomalies” were explained during the 1950s, 1960s and 1970s by economists doing technical research into what caused shifts in money demand.  The one thing Hume didn’t predict is the advent of interest on bank reserves in 2008, which caused the relationship between the money supply and inflation to weaken.  But that wasn’t a factor during the Great Inflation.

2.  The Great Forgetting

Doug Irwin directed me to a recent paper by Itamar Drechsler, Alexi Savov, and Philipp Schnabl on the Great Inflation.  Here’s the abstract:

We propose and test a new explanation for the rise and fall of the Great Inflation, a defining event in macroeconomics. We argue that its rise was due to the imposition of binding deposit rate ceilings under the law known as Regulation Q, and that its fall was due to the removal of these ceilings once the law was repealed. Deposits were the dominant form of saving at the time, hence Regulation Q suppressed the return to saving. This drove up aggregate demand, which pushed up inflation and further lowered the real return to saving, setting off an inflation spiral. The repeal of Regulation Q broke the spiral by sending deposit rates sharply higher. We document that the rise and fall of the Great Inflation lines up closely with the imposition and repeal of Regulation Q and the enormous changes in deposit rates and quantities it produced. We further test this explanation in the cross section using detailed data on local deposit markets and inflation. By exploiting four different sources of geographic variation, we show that the degree to which Regulation Q was binding has a large impact on local inflation, consistent with the hypothesis that Regulation Q explains the observed variation in aggregate inflation. We conclude that in the presence of financial frictions the Fed may be unable to control inflation regardless of its policy rule.

I’m going to annoy almost everyone here, so let me apologize in advance.  I realize that these authors are now in the mainstream and that I’m a hopeless dinosaur.  It’s a perfectly fine paper by conventional standards. Nonetheless, I can’t get past the very first sentence of the abstract.  Why do economists think it’s a good idea to propose a new explanation for the Great Inflation?  Imagine a physics paper that began by noting that while Isaac Newton had already proposed a theory for why feathers and steel balls fall at the same rate in a vacuum tube, the authors were about to provide a “new explanation”.  Why?

As I got into the paper, my frustration only increased.  I expected them to push back on what I thought was the standard theory, the idea that the Great Inflation was caused by the Fed aggressively increasing the money supply.  Instead, they suggest that the standard explanation is that the Fed failed to act aggressively to stop the Great Inflation, which presumably happened for some other unnamed reason:

The standard narrative of the Great Inflation places much of the blame on the Federal Reserve. By failing to act aggressively enough, the Fed had allowed inflation to get out of hand and squandered its credibility with the public (Clarida, Gali and Gertler, 1999). The loss of credibility raised inflation expectations, which made inflation accelerate further.

Now you might argue that an aggressive rise in interest rates would have reduced money growth, but that just annoys me in two other ways.  First, it confuses cause and effect.  Prior to 2008, the Fed raised interest rates by reducing money growth, not vice versa.  Second, it ignores the income and Fisher effect, and more broadly the NeoFisherian perspective.  The Great Inflation happened partly because the Fed had forgotten Humean economics, the idea that inflation is caused by printing too much money.  Instead, the Fed wrongly thought that the high interest rates of the late 1960s and the 1970s were a tight money policy.  It was not.

And it’s not just these three economists.  A week ago I quoted Paul Krugman:

The truth is that I’ve always been a bit uneasy about the standard story of inflation in the 1970s, even though it seemed to fit the prediction of clockwise spirals. My uneasiness came from the sense that the economy never seemed to run hot enough to explain such a big rise in inflation. I actually remember the 70s! And while there were years of good job markets, they never felt as good as the 60s, the late 90s, or 2019.

Krugman’s “standard story” is not printing money, it’s not an unaggressive Fed, it’s not even Regulation Q.  Rather Krugman suggests that the standard story of the Great Inflation is the Phillips curve model—high inflation is caused by low unemployment (a hot economy).  But while the Phillips curve may have some limited ability to account for negative inflation/unemployment correlations at business cycle frequencies, it tells us precisely nothing about long run inflation dynamics (or, as Lucas (1975) showed, cross sectional differences in inflation.)  And the Great Inflation was a long run phenomenon.  There were four recessions between 1966 and 1982.  The economy certainly ran “hot enough” in NGDP growth terms to fully explain the Great Inflation.

More broadly, the Great Inflation is clearly just an extreme event embedded within a much greater Great Inflation of 1933-2020, when the CPI rose 20-fold.  I cannot emphasize enough that this was a monetary event.  Unemployment wasn’t substantially different during the gold standard era than during modern times, indeed it was lower during 1923-29 (a period of roughly zero inflation) than during the 1970s, a period of high inflation.  The price level is 20 times higher in 2020 than 1933 (after essentially no change in the previous 150 years) because we printed a lot of money, not because of anything to do with Phillips curves or Regulation Q.

3.  Cognitive illusions, everywhere you look

Since the high inflation on the right side of the price level hockey stick was clearly due to monetary policy, why wouldn’t we have expected a sharp acceleration of money growth in the 1960s to lead to a sharp acceleration of inflation?  Why did we forget the monetary theory of inflation and begin seeking other explanations?

I see three explanations, each of which plays a role:

1. Too much focus on Phillips curve models, which should not be used to explain persistent changes in inflation.

2.  Too much focus on interest rates as an indicator of whether money is easy or tight.  This makes it look like monetary policy doesn’t play much of a role, as high interest rates usually occur during periods of high inflation, and vice versa.

3.  Incorrect predictions of inflation by monetarists and others when the Fed adopted quantitative easing, as pointed out by the authors of the Regulation Q study:

Scholars of the Great Inflation, such as Allan Meltzer (2009; 2013) and John Taylor (2009), worried that low interest rates and Quantitative Easing would lead to a repeat of the 1970s.

Lots of monetarists underestimated the impact of the 2008 decision to begin paying interest on bank reserves, which weakened the link between money growth and inflation.  Hume’s amazing “out-of-sample” success that had lasted for 256 years came to an end in 2008.

I can’t really blame younger economists for finding the monetarist view of inflation to be hopelessly outdated.  Even before 2008, the Fed was already targeting interest rates.  Lots of economists don’t even know that (prior to 2008) the monetary base was 98% currency (the stuff in your wallet) and that the Fed moved interest rates by adjusting the quantity of base money, which as a practical matter meant adjusting the supply of currency.

Almost every aspect of our monetary system was designed to hide what’s actually happening.  Even though the base was 98% currency in 2007, and even though almost all new base money quickly went out into circulation as currency, the new money did initially enter the system as electronic bank reserves.  And even though the Fed controlled inflation by controlling the monetary base, they did so by moving the base to a position that moved interest rates to a position that was expected to lead to 2% inflation.  In that regime, it’s easy to ignore money entirely, even though it was the money printing that was actually causing the inflation.

After 2008, it became even easier to ignore money.  With the payment of interest on reserves the Fed no longer even had to adjust the monetary base in the background in order to move interest rates.  Now they could simply adjust IOR to move rates directly.

Like journalists, economists are seduced by power.  Once the powerful central bankers decided to focus on interest rates, macroeconomists decided that interest rates were the appropriate monetary variable for their models.  The more “money-less” your model, the more sophisticated and up to date it seemed.  What sounds more appealing to young economists, Michael Woodford’s futuristic vision of a cashless economy, or my reactionary obsession with the old days when the currency stock was more important?

Again, if you can show me that this post is wrong, and that the Great Inflation was not caused by printing money, then I’ll just give up.  I’ll quit my job, I’ll stop blogging, and I’ll publicly apologize to all my former Bentley students, as it would mean that almost everything I taught them for 30 years was wrong.  My entire view of macroeconomics is predicated on monetary policy driving nominal aggregates.

In my view, the “money printing caused the Great Inflation” hypothesis is not a theory in the sense that the man on the street uses the term theory (unproven hypothesis), it’s a theory in the sense that scientists use the term when discussing well established models like evolution.


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What is this “monetary policy” that you refer to?

Tyler Cowen recently linked to a study by Alina Bartscher, Moritz Kuhn, Moritz Schularick, and Paul Wachtel of the effects of “monetary policy” on racial inequality. The study focuses specifically on the effect of unanticipated monetary shocks on racial inequality:

For the empirical analysis, this paper relies on the most widely used monetary policy shock series – the (extended) Romer-Romer shocks (Coibion et al., 2017) as well as different financial market surprise measures taken from Bernanke and Kuttner (2005) and Gertler and Karadi (2015). The estimations yield a consistent result. Over a five-year horizon, accommodative monetary policy leads to larger employment gains for black households, but also to larger wealth gains for white households. More precisely, the black unemployment rate falls by about 0.2 percentage points more than the white unemployment rate after an unexpected 100bp monetary policy shock. But the same shock pushes up stock prices by as much as 5%, and house prices by 2% over a five-year period, while lowering bond yields on corporate and government debt and pushing up inflation. The sustained effects on employment and stock and house prices appear to be a robust feature in the data, across different shock specifications, estimation methods, and sample periods.

These empirical results seem plausible to me, but what are the policy implications? In my entire life, I’ve never met anyone who favored having the Fed go around and create a bunch of “unexpected 100bp monetary policy shocks”.

You might argue that this doesn’t matter, and that the results would also hold for anticipated changes in monetary policy. But decades of macroeconomic research suggests that one cannot draw this inference; unexpected changes in monetary policy have vastly different effects from expected changes in monetary policy. For instance, an unanticipated easing of monetary policy will often boost asset prices, while an anticipated expansionary policy will often reduce asset prices, as during the 1970s.

Now you might argue that asset prices didn’t do poorly during the 1970s because of easy money, they did poorly because of high inflation.

Ahem . . .

When economists have debates about the appropriate monetary policy, they usual agree that policy should in some sense be predictable and stable. Disagreement may occur over issues such as the optimal rate of inflation. One economist may advocate 2% trend inflation, another may advocate 4%, and a third may advocate 0% inflation. Or they might prefer a different target, such as NGDP growth.

A study of the effect of monetary shocks on asset prices tells us nothing about the effect of changes in the steady state rate of inflation. Thus unexpected monetary stimulus often creates a temporary boom, boosting asset prices, while a permanent increase in inflation raises the effective tax rate on real capital income, thus depressing real capital prices. This is what happened during the 1970s.

This means that a temporary switch to easier money will boost the racial wealth gap by raising asset prices, and a permanent switch to much easier money (say 10% inflation) will reduce the wealth gap—but only by making the rich poorer at a faster rate than it makes the poor even poorer.

While I question the authors’ interpretation of their results, I completely agree with the final sentence of their conclusion:

Clearly, this does not mean that achieving racial equity should not be a first-order objective for economic policy. We strongly think it should. But the tools available to central banks might not be the right ones, and could possibly be counter-productive.

PS.  Here’s some data on the racial wealth gap:


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Olivier Blanchard on monetary offset

This tweet identified the real issue:

People often talk about the risk of economic overheating, but that seems unlikely.  TIPS market participants seem to agree, as that market also forecasts close to 2% inflation going forward.

The actual risk is that a very large fiscal stimulus package will not stimulate the economy (at the margin), as the Fed will offset the effect. (Just as the Fed offset fiscal austerity in 2013).  Instead, we will merely add to the national debt.

Given low interest rates, there’s a respectable economic argument for a slightly higher steady-state budget deficit, and some of the fiscal package may be useful.  But quickly dumping $1.9 trillion into the the economy is almost certainly not a policy that minimizes the long run deadweight cost of taxes.  I’d encourage policy makers to take a deep breath and think about their long run objectives.  What are they actually trying to accomplish, and what’s the most cost effective way of getting there?

And think at the margin.

PS.  I began blogging on monetary offset back in 2009.  Expect to see a lot more discussion of this issue in the years ahead.


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