The Fed Faces the End Game — And Blinks?
If you’ve ever been involved in a legal contention, like a business or personal dispute or a contested divorce, you know that the whole game pivots, ultimately, on the potential end game: what would happen if the thing went to court — even if (even because) everyone involved knows that it never will. The fact that it could, and the expected results if push did come to shove, determine the terrain of the playing field and the positions of the players, and all the ploys and counterploys played out on that field.
Ryan Avent brings that principle to bear in one of the nicest pieces I’ve seen laying out the game theory of monetary policy over the next couple of years. For my purposes, starting with the end game (my bold):
At one extreme, we can imagine a situation in which America’s government has entirely lost market confidence and is unable to sell its debt. In that case, the central bank, as lender of last resort, would be unable to avoid stepping in to buy that debt, in the process transferring control over inflation to the fiscal authorities.
Voilá: MMT World, where Treasury is simply spending newly-created money into existence, at the behest of the legislative and executive branches, by depositing it in recipients’ bank accounts. Bond/debt issuance is immaterial, because the Fed has no choice but to buy all the new bonds for “cash.” (Yes, the Fed is actually “printing” the money, but effectively the Treasury is doing so.) There is no Fed “independence.”
This is the scenario that would result if the Republicans were foolish and feckless enough to take their chicken game to the limit and let the head-on collision actually occur, with a default on U.S. debt. It’s the expected (inevitable) result if they “take it to court” — at least if they leave it that way for any period. (Has anybody mentioned the irony of the Republicans’ claim to be creating “confidence”? And, do you think they’d like the MMT World that they’re unwittingly trying to create? They really should, given how much they dislike the “unelected” Fed making decisions…)
Now moving one step back from that end game, Ryan looks at three “fiscal cliff” scenarios as projected (PDF) by the Congressional Budget Office (using a graphic from Brian Beutler at Talking Points Memo):
Just to multiply this out for you, one-year growth under the three scenarios (Q4/12–Q4/13) would be circa 0%, 2%, and 4%.
These scenarios all assume that the Fed does “nothing” in response — which I’ll define as keeping their balance sheet the same size, with no big (net) bond/asset purchases or sales, and making no announcements that that will change.
Which means we need to take another step away from the end game. Here looking at the righthand scenario:
Except, of course, that the economy will almost certainly not grow at a 5.3% rate no matter what Congress does. Arguments to the contrary are subject to what econ bloggers have come to call the Sumner Critique… Growth that rapid would … [prompt] steps to tighten monetary policy.
In Sumner’s words, the Fed — as the last player in every round of the game — would “sabotage” any growth that rapid (especially, I would add, if it saw any traces of that terrifying bogeyman, “wage inflation”).
All the players know that the Fed can do this by simply selling bonds (something they have no shortage of). Bond prices drop, yields and market rates rise, people borrow and spend less, confidence drops, stocks decline, people feel less wealthy, unemployment rises, inflation (and growth) are held in check. As they are at pains to remind us, the Fed has spent decades building this inflation- (and, collaterally, wage- and employment-)quashing credibility.
Nor does anyone doubt that they will do it. They always do, have done since Volcker.
But what about the other push-comes-to-shove scenario — the “fiscal cliff” on the left?
The Fed could therefore proclaim to the world that will maintain aggregate demand growth (in the form of, say, nominal income growth) at all costs, and that it would by no means allow the fiscal cliff to knock the economy off its preferred path. It could explain in great detail what specific steps it would be willing to take to achieve this goal, so as to boost its credibility. And if demand expectations as reflected in equity or bond prices showed signs of weakening ahead of the cliff, the Fed could preemptively swing into the action to establish the credibility of its purpose.
The Fed will almost certainly not do this.
And everybody knows this. After three decades of taking away the (wage- and employment-)growth punchbowl when the party starts getting (“too”) hot, and after four years of subordinating their employment mandate to their cherished inflation-control credibility, the Fed has a serious shortage of “growth credibility.”
Which means that the Fed has created a game that is asymmetrical. It has great power to quash growth through open-mouth operations; we know they’ll sell bonds if they promise and need to, and that doing so will dampen inflation (and growth).
But on the expansionist side, we can’t believe their promises. They would need to make actual bond purchases to spur growth. And even if they do both promise and live up to the promise, we (with the exception of [market] monetarists, few of whom are running large businesses or managing large amounts of money) don’t have great or certain expectations for the results.
“Show me QE3, and show me the results; I’ll believe it when I see it.”
But: Why won’t the Fed adopt policy that delivers strong GDP growth?
There’s the runaway inflation/loss-of-credibility explanation, of course. But the Fed isn’t run by adolescent freshman Republicans who think that 3 or 4 percent inflation is the slippery slope to ZimbabWeimar. They know that if they promise to let inflation rise then fall over a few years, then do exactly that, it would greatly stengthen their inflation-control reputation and credibility.
And there’s my theory: it would transfer hundreds of billions of dollars in real buying power per year from creditors to debtors, and the Fed is run by creditors. (Depression is a choice.)
Ryan has a different theory:
…moral hazard… if [the Fed] promises to protect the economy against reckless fiscal policy Congress will have no incentive to avoid reckless fiscal policy. … lay out a plan for medium-term fiscal consolidation but keep short-term cuts small and manageable.
Now you gotta ask whether manipulating the legislative and executive branches into being “responsible” by setting their expectations is any part of the Fed’s mandate. Talk about a nanny state.
But that aside: this is exactly what the Fed is doing, and has done for thirty years with its inflation-fighting moxie — (promising to) “protect the economy against [so-called] reckless fiscal policy” by reining in inflation (and wage and employment growth). It’s called The Great Moderation. (So by Ryan’s reasoning, the Fed has spent three decades encouraging “reckless fiscal policy.”)
Ryan thinks that the Fed’s afraid that it:
…will need to roll out dramatic, unconventional actions—the fear being, of course, that such actions would leave it hopelessly politicised and powerless to fight inflation. … [They’re] fighting to maintain their vulnerable independence.
Translation: They’re fighting to avoid the MMT-World end game, where the Fed becomes an irrelevant mechanical actor.
And one price of that fight may be the need to occasionally allow fiscal policy to matter—as unfortunate Americans may soon learn.
Why “unfortunate”? Where did that come from?
Is the prospect unfortunate because runaway inflation will result? You can count our problematic inflation periods from the past century on two fingers. Now count the recessions.
Or is it because higher government debt will be a drag on growth? Vague and poorly reasoned concerns based on a few here-and-there sample points nothwithstanding, we’d be well advised to look to our last bout of serious public debt increase: the one that ended in 1947, and was followed by the fastest decades of economic growth in living memory.
Cross-posted at Asymptosis.
MMT is the end game of economics. Costless borrowing and worthless money becomes font of wealth. It’s all down the rabbit hole.
systemic debt / wages
or our current leverage.
what don’t people understand about this graph???
I’m no austerian, but I think we need to start behaving as adults and not just keep trying to borrow our way to prosperity.
It’s time that we start paying our damn taxes. Swedes and Danes don’t like paying their 50%-to-GDP tax levels.
We’re going to have 80 million baby boomers retired by next decade, up 30 million from now. Each boomer will be collecting around $30,000 in benefits.
This math don’t work without massive tax rises.
Be nice if we could find some spending cuts, too.
This nation is so, so screwed going forward.
“I’m no austerian, but I think we need to start behaving as adults and not just keep trying to borrow our way to prosperity.”
It is interesting to see that the problem times were the Reagan and Bush II years, extending into the Obama and Bush I years.
I think that people are borrowing so much because they want their fair share of prosperity. Taxing the rich can help, I suppose.
the problem with your analysis is that Social Security has nothing to do with the debt.
Now if you are talking about other pensions, or the part of Medicare not paid for by the payroll tax, we can fix the Medicare part of that by increasing the tax. Of course it would be nice to reduce the medical care costs at the same time. But the needed tax increase would not be unaffordable. It’s a question of whether you want to put your money into living longer or into trips to Las Vegas.
As for other pensions, to the extent they are not pay as you go, they are supposed to be paid for out of all that investment and growth the private economy keeps promising… so that has nothing to do with taxes at all.
“Borrowing our way to prosperity” is almost a definition of capitalism. It works the same for government… that is, it works when it is done prudently, not when it is done recklessly, as with various Wall Street gambling schemes or “tax cuts forever” government policies.
Frankly I get real tired of “the math don’t work” said by people who don’t do the math.
the math for SS is that those Boomers retirement is already paid for. and the 30,000 dollar pensions look like “current dollars” (inflation) to me. You won’t get 30,000 dollar SS pensions unless average real wages over the preceding forty years have been about 100k.
The math for SS retirement being already paid for requires the general fund to cough up $2.6T + more accumulated interest, on top of the $1.5T free ride it has been enjoying since Congress went along with the Greenspan Commission FICA over-contribution plan.
That taxes are going to have to go up to pay for all of this should be rather obvious at this point.
My larger point was that taxes are going to have to go up to pay the $30,000/yr/beneficiary goodie box due the baby boom, since that population of beneficiaries is going to increase 30 million over the next decade.
My $30,000 was including health benefits, both medicare and public sector retirement benefits.
I get real tired of “the math don’t work” said by people who don’t do the math.
I’ve been doing the math, better than you have I think (TBH).
We’re screwed and I have no clue how the system is going to try to save itself.
I’m not a social security alarmist — we after all do have that $2.6T moral buffer that is all those treasury bonds in that file cabinet, but my general impression of the American people is we are collectively a nation of ‘tards and it’s going to be pretty easy for the 1-5% to manipulate the masses to give up their rights to that money.
“Borrowing our way to prosperity” is almost a definition of capitalism.
Profiting from Capital is the definition of capitalism. Unfortunately, redistribution is not in that dynamic, and that’s capitalism’s fatal flaw. We’ve been using debt take-on to paper over things since 1980 or whenever, but that race is largely run as my above chart showed:
I added the TNX to give an idea of the how much airspace is under us still.
okay, the “math” for this guess is off the top of my head:
currently benefits are calculated by first adjusting your earnings for each year you paid payroll taxes by a factor that reflects the change in average income for workers from the year that income was earned to the year of retirement (small “error” here for simplification purposes, does not affect result).
so that if you earned 3000 dollars in 1960, say and the average income that year was 5000 dollars, and the average income in 2005 when you retire is 40,000, your “adjusted income” for the year 1960 would be recorded as 3000 times (40,000 divided by 5000), or “24,000”. and so on for each year.
now add up your adjusted income for 40 years and divided by 40. this is your “average” adjusted (almost the same as “real”) lifetime income. your benefit rate is calculated by a formula that would be approximately 40% of your average adjusted (monthly) income. so say after 40 years your average income turned out to be 40k/yr. the same as the “average” income the year you retired. your pension would be about 40% of 40k, or about 16000/yr.
In order to get that 30k/yr pension the same arithmetic would have to produce 30 k as the result of the same arithmetic. this would imply an average “real” wage over forty years of about 75 k.
i rounded up because all the “errors” i left in for simplicity seem to me to be in the direction of requiring the higher average income to reach the 30k result.
real wages may average 75k by 2050 or so, but they will not have averaged 75k over all that time.
anyway, this is “math” off the top of my head. if you have better math, go for it.