How do you do it?

Count me among the skeptics who believe the Fed has pretty much already done all it can to pull the economy out of the deep hole that it’s in. Zero short-term interest rates, purchases of longer-term bonds to keep long-term rates at historic lows, backstopping various asset markets, emergency loans to banks, etc. It’s helped avert a Second Great Depression, which is nothing to sneeze at. Some economists who I usually agree with are convinced that aggressive new policies could pull us out of the current Little Depression, too. They’re smarter than I am, but they have yet to convince me that these policies could work.

The tonic du jour is nominal GDP targeting, by which the Fed would try to reach a certain level of nominal GDP — say, $16. 3 trillion (the current level of potential GDP assuming that, as I’ve read, current GDP is 7% below its potential. Do the math and that’s a $1.1 trillion gap between current and potential GDP). Christina Romer, Obama’s first head of the Council of Economic Advisors, recently backed this approach in a New York Times op-ed. Scott Sumner has been pushing it all along, and there’s now a whole new school of macroeconomics, “market monetarism,” which revolves around nominal GDP targeting. (Economists: see here for Ed Dolan’s helpful explanation of how nominal GDP targeting is a form of Milton Friedman-style monetarism.)

Now, once the Fed announces this new target, how does it actually get there? Romer provides the clearest answer I’ve seen yet:

‘Though announcing the new framework would help, it probably wouldn’t be enough to close the nominal G.D.P. gap anytime soon. The Fed would need to take additional steps. These might include further quantitative easing, more forceful promises about short-term interest rates, and perhaps moves to lower the exchange rate. . . .’

‘Nominal G.D.P. targeting would make it more likely that the Fed would take these aggressive actions.’

That’s clear, but so is weak tea. None of these actions sound all that different from what the Fed is already doing. Proponents of nominal GDP targeting seem to be counting on a huge “announcement effect,” i.e., that people will hear about the Fed’s commitment to raising GDP and will assume that Fed will make it happen. Yet the Fed’s goals already include maximum sustainable employment, which is the employment rate you’d have at potential GDP, so why should this change the public’s behavior? (Although there is a difference between monetary policy goals, like low unemployment, and targets, which now include interest rates, it’s a rather subtle one. I don’t see why it would move markets.)

Another popular tonic is a higher inflation target. Right now the Fed’s unofficial but almost universally acknowledged inflation target is 2%, and for the past few years the core inflation rate has been below or near 2%. When inflation is very low, real interest rates (nominal interest rates minus inflation) can still be high even when nominal rates are also low. In the U.S. in the early 1930s, for example, nominal rates plunged toward 0%, but deflation was raging, so real interest rates were actually quite high. Economic historian Nick Crafts, in a Financial Times op-ed, says that Britain’s recovery from the Great Depression was greatly aided by a combination of low nominal interest rates and rising inflation rates — i.e., negative real interest rates — which promoted homebuilding. Crafts says targeting a higher inflation rate — say, 4% — could do the trick today.

Again, I just don’t see how you get there. Would I like to see lower real interest rates? Sure. But for 4% inflation to happen, a lot of other things have to happen first. Banks need to loan out their excess reserves, people and businesses need to buy stuff with those loans, the money needs to be redeposited in banks,  more loans need to be made, etc. That’s how monetary policy works — when it works. Right now, the banks have over a trillion dollars in excess reserves that they’re just sitting on. Banks are not eager to lend, and businesses and households are not eager to borrow. Classic liquidity trap.

Nominal GDP targeting and higher inflation targets sound radical, but are they? Chicago Fed President Charles Evans said in a speech this week that he viewed the 2% inflation target as a medium-run target, not a short-run target, saying that as long as inflation averaged out to 2% over a multi-year period, higher inflation rates would be acceptable in the short term. That statement is consistent with either a nominal GDP target (shoot for low inflation when real GDP is high, tolerate higher inflation when real GDP is low) or an inflation target (let inflation rise when unemployment is high), which suggests that neither of those policies is all that new. Both seem to promise much more than they could ever deliver.

We’re caught in a trap

This just in: The Federal Reserve does not control the universe.

Stated differently: The economy is in a liquidity trap (macroeconomists). Or, monetary policy has shot its wad (Pres. Obama to economic adviser Christina Romer in their first meeting, according to Ron Suskind’s Confidence Men). Krugman has been saying this for three years now, and so have a lot of other economists. But until today, I had yet to hear it from a Fed official. Fed Chairman Ben Bernanke has called for Congress to pursue a more expansionary policy fiscal policy, thus implying but not explicitly saying that the Fed has done just about all it can. But in a speech today, Chicago Fed President and Federal Open Market Committee member Charles Evans had the guts to state the obvious:

“I largely agree with economists such as Paul Krugman, Mike Woodford and others who see the economy as being in a liquidity trap: Short-term nominal interest rates are stuck near zero, even while desired saving still exceeds desired investment. This situation is the natural result of the abundance of caution exercised by many households and businesses that still worry that they have inadequate buffers of assets to cushion against unexpected shocks. Such caution holds back spending below the levels of our productive capacity. For example, I regularly hear from business contacts that they do not want to risk hiring new workers until they actually see an uptick in demand for their products. Most businesses do not appear to be cutting back further at the moment, but they would rather sit on cash than take the risk of further expansion.”

Evans went on to suggest a number of measures the Fed should still take, like buying up more mortgage-backed securities to get the housing market going (I’m still on the fence on that one — yes, this is the economy’s weakest sector, but how do you do this without reinflating the housing bubble?), while keeping mum on the subject of whether this would do anything more than just nudge the economy forward, as opposed to bringing us anywhere near full employment. I suppose the question is moot, as long as nobody else is willing to act. Congress is not only unwilling to consider fiscal stimulus but seems to be on the verge of massive budget cuts, either by following the “super committee’s” blueprint or letting an autopilot crash the plane.

Hat tip to Judith Osofsky for today’s video:

Alan Krueger, impeccable choice

. . . to be the new chair of President Obama’s Council of Economic Advisers. Krueger is a world-class economist who has produced much fascinating, groundbreaking research, and he has ample Washington policy experience. Although Krueger is typically classified as a labor economist, not a macroeconomist, his research is far-ranging and his opinions on macro issues, as expressed in his columns and Economix blog posts for the New York Times, look sensible and well supported.

On the other hand (and there has to be an “other hand” — I’m an economist, after all!), will Obama listen to him? Christina Romer and Austan Goolsbee, Krueger’s predecessors at CEA, gave Obama excellent advice about the need for a strong fiscal stimulus but he ignored it, opting for a stimulus only about half as large as they urged. Neither of them could possibly have agreed with this summer’s bizarre pivot away from jobs toward deficit reduction at a time of 9% unemployment, not to mention the way it opened up the president to Republican debt-default brinkmanship.  No wonder Goolsbee was so delighted to leave the job.

The usually excellent Ezra Klein was on “The Rachel Maddow Show” tonight, and for once I’d say he got it wrong. He said Krueger’s policy work experience with Larry Summers in the Clinton and Obama administrations and his tennis partnering with Tim Geithner make him just another insider, not a real change. I see no evidence that Krueger is as willing as Summers or Geithner to kowtow to Wall Street interests, and at this point even Summers seems to be calling for a fiscal stimulus instead of short-term deficit reduction. It looks to me like Krueger is cut from similar nuanced-Keynesian cloth as Romer and Goolsbee, but better connected. The CEA chair who plays doubles with Geithner has a better shot of making a difference.

Raise the damn debt ceiling already

As if the new agreement between the president and Congressional Republicans — to cut $38 billion in spending while the economy is still in a near-depression — weren’t bad enough, now the word is that the Republicans say they won’t vote to raise the debt ceiling, at least not without extracting several pounds of flesh first. Worse still, the overwhelming majority of the public opposes raising the debt ceiling.

I’ve blogged about this topic before. Not raising the debt ceiling would be like pushing the economy off a cliff. With a deficit of $1.5 trillion (and GDP of about $14 trillion), Congress would have to cut spending or raise taxes (or some combination thereof) by more than 10% of GDP. You don’t get that money back. That would be a depression of titanic proportions.  It would be ruinous under virtually any circumstances, but all the more so now, at a time of high unemployment. Herbert Hoover’s and FDR’s budget-balancing blunders during the Great Depression would be trivial by comparison. And Congress probably couldn’t come up with $1.5 trillion or anything close to that anyway. Normally we pay off our Treasury bonds as they come due by selling more bonds, which we would not be able to do anymore if the ceiling is kept constant. So we would default on all the maturing debt, and our new bonds would lose their AAA status, instantly and permanently, and we’d have to pay higher interest rates on our new bonds. With enough defaults our bonds would quickly be junk bonds, paying sky-high interest rates. This would add to the federal deficit and debt, possibly a lot.  So much for looking out for future generations.

If the Republicans pull the same game of brinkmanship that they did last week in nearly shutting down the government, by convincingly threatening to not to raise the debt ceiling and then raising it at the last minute, the bond market will still go oink (as one of my grad school professors used to say), and interest rates on Treasury bonds will still shoot up, meaning higher interest payments and a higher burden of paying them off. Bond investors hate uncertainty, and if default even looks possible, they will no longer regard Treasuries as riskless.

All of this opposition to raising the debt ceiling is a combination of cynicism, ignorance, and self-sabotage. We do have a long-term debt problem that needs to be addressed, but blowing up the economy is the most idiotic and counterproductive solution imaginable. Threatening to blow up the economy is not much better. As long as the economy is in a slump, the optimal amount of spending cuts is $0 (if continued stimulus is out of the question), not $1.5 trillion. And it would be even more optimal to have no more debt ceiling.