Thursday, June 21, 2012

On the meaning of "two goals"

Persistent attempts to expand the economy beyond its long-run growth path will press capacity constraints and lead to higher and higher inflation, without producing lower unemployment or higher output in the long run. In other words, not only are there no long-term gains from persistently pursuing expansionary policies, but there's also a price—higher inflation.

What strikes me immediately is the absolute assurance of that statement. It is by no means offered as an economic theory, but as certain beyond doubt.

What strikes me next is that I don't like the statement. I still want to get the economy growing. I want to get around the obstacle that FRBSF puts in my way.

But, you know, it has to be true: Persistent attempts to expand the economy beyond its long-run growth path will press capacity constraints... Even if we don't know what "the long-run growth path" is. Actually, I'm thinking they meant "the long-run potential growth path". Yeah, that's what I was thinking.

I'm going with it. If I'm putting words in FRBSF's mouth, so be it.

Persistent attempts to expand the economy beyond its potential will press capacity constraints and lead to higher inflation.

Tautology, isn't it? Repeating the same thought in different words, no?

The quote sets up potential output as a standard by which perfection is measured, sorta like the model Hollie Witchey or the phrase "Don't mess with Mother Nature".

You can't do anything about inflation, the quote tells us. You can't do anything about unemployment. And you can't do anything about capacity constraints -- except, of course, you can make demand-side sacrifices to a supply-side god.

But you know, we've been pressing capacity limits and getting inflation at lower and lower levels for two generations now. So FRBSF's analysis is iffy.

And, you know, we don't really know the true path of potential output. Yes, without doubt, there is one. And that fact adds strength to FRBSF's claim. But don't let them fool you. Just because there *is* a true path of potential output, doesn't mean we're on that path.

And it doesn't mean, if we're not on it, that we know *why* we're not on it.

From the same article:

Monetary policy has two basic goals: to promote "maximum" sustainable output and employment and to promote "stable" prices...

Are the two goals ever in conflict?

Yes, sometimes they are. One kind of conflict involves deciding which goal should take precedence at any point in time... Another kind of conflict involves the potential for pressure from the political arena.

Wrong answer.

Hey, I know they dumb this stuff down so that people like me can "get" it. But the second kind of conflict they describe has nothing to do with economic analysis. And the first one is just a bad answer.

If you have two goals, you're supposed to have two goals. You're not supposed to have one goal for a while, and then switch off and have the other goal for a while. If that is your strategy, you failed from the start.

Despite what everyone says, though, the Federal Reserve is not a complete and utter failure. There was a time there, after the second World War, when inflation and unemployment were both pretty low for a spell.

Two goals: To control inflation by limiting demand, and to control unemployment by unleashing demand. Are the two goals ever in conflict?

The two goals are always in conflict.

It is a beautiful day. There is a magnificent, wide boulevard with fields of flowers left and right. We put the top down. We drive.

When there is inflation, there is too much spending, the road is too wide on the right. Policy makes a correction, and the pavement narrows a bit.

When there is unemployment, we need more spending, the road is too wide on the left. Policy makes a correction, and the road narrows a bit.

We drive. The road occasionally narrows a bit. We drive.

The road narrows. We find ourselves coursing a mountain, with solid rock on the one side and sheer drop on the other. We drive. The road narrows.

There is inflation, and the rock face comes closer to us. There is unemployment, and the sheer drop comes closer to us. We drive. Suddenly we realize there is no guarantee that the road will always be as wide as our vehicle. Then it starts to snow.

The economy of the 1950s provided a wide boulevard for policy actions. But the road narrowed substantially by the 1970s. And it has continued to narrow while both the terrain and the weather became less accommodating. Our own policy choices narrow the options left open to us and put us on a path we cannot navigate, going to a place we do not want to be.

The problem is not the Federal Reserve. The problem is that we do not know how to deal with the fact that our goals are always in conflict.

We want to be moving full speed ahead, but policy has created a narrow, washed-out, dangerous dirt road that leads up a mountain to nowhere.

We know there is a true path of potential output, just as there is a median family income, and just as there is a "best case" in any set of options. There is some dispute over what that true path is. So policymakers work backwards, believing that if there is too much inflation we are pressing the limits of capacity, and the road must be narrowed further.

But it is our make-the-road-narrow policy that undermines and reduces the long-run potential growth of output.

When their concern is inflation, policymakers raise interest rates and take money out of circulation. When their concern is unemployment, they reduce interest rates and encourage the use of credit.

But our concern, really, is always inflation and unemployment. Two goals. To honor these goals, policymakers raise and lower interest rates. And they take away money but encourage the use of credit.

They take away money but encourage the use of credit: They make using money more costly, and they leave us with nothing but debt.

Making money more costly is an unintended consequence of policy. It arises from the effort to meet goals that are always in conflict.

And debt? Debt is not the consequence of government spending or prodigal consumers or bad business practice. Not the massive debt we have. Our debt is an unintended consequence of policies that remove money from circulation and encourage the use of credit.

It is all just one big mistake.


Woj said...

Interesting comments and I enjoyed the story.

IMO, the FRBSF statement suggests a continued belief in the neutrality of money. What always strikes me about this proposition is, if true, why promote monetary "stimulus"? If the long-run real GDP path cannot be altered, then short-term adjustments upwards simply lower future growth. The argument therefore appears to be less about economics and more about psychology.

If we accept that money is non-neutral than monetary policy becomes more influential. As you note correctly, the two mandates are always in conflict. Since the Fed is far more capable of impacting inflation, I continue to hope for the removal of the employment mandate.

Clonal said...


You might also like to read Ellen Brown's - Why the Senate Won’t Touch Jamie Dimon: JPM Derivatives Prop Up U.S. Debt

Jazzbumpa said...

Good post, Art.

The Fed might not be THE problem, but it certainly is A problem.

Woj - The employment mandate has, de facto, been eliminated.

It's all about inflation, and nothing else.


The Arthurian said...

Despite the dual mandate, how it looks to me is this: The Fed fights inflation (or relents); meanwhile, Congress does all it can to boost employment and growth.

How it looks to me is this: The dual mandate allows Congress to point the finger at the Federal Reserve. But in fact it is the conflict between our goals -- and the conflict between the policies of Congress and those of the Fed -- that now undermines the effectiveness of all we try to do.

The problem is that for 60 years we have relied on the Fed to fight inflation while Congress encourages growth.

The solution is that for a time we must rely on Congress to fight inflation while the Federal Reserve encourages growth.

Woj said...

Good point JzB.

Art - Not sure I completely follow your last sentence. Are you suggesting the solution is how things are or should be? If should be, how will the Federal Reserve encourage growth aside from open-mouth operations?

The Arthurian said...

Hi Woj. Thanks for the Q. This is at the heart of my thinking.

We have two tools:
1. Monetary policy and
2. Fiscal policy.

We have two goals:
A. Price stability and
B. Economic growth.

We always pair up tool 1 with goal A, and we always pair up tool 2 with goal B.

For example, we always rely on the Fed to fight inflation (goal A) by raising interest rates and restricting the quantity of money (tool 1).

I want to pair up tool 2 with goal A, and tool 1 with goal B.

I want to fight inflation by accelerating the repayment of debt. I want to do this by tax policy: tax breaks for making extra payments. Tool 2, goal A.

I would have the Fed encourage growth by making sure the quantity of money increases relative to total debt. Tool 1, goal B.

I think that 60 years of monetary restriction has left us with very little non-credit money, and 60 years of Congress doing things to boost spending has got us using credit, and 60 years of conflicting policies have left us with excessive debt.

We have no policy to encourage the repayment of debt. People are left to their own devices while policy encourages us to take on more debt, always.

Woj said...


Thanks for the reply and answers. I think your focus on credit leads to some good solutions. One step that may be missing from your proposal is the need for fiscal policy to correct all current incentives to use credit instead of cash. In my view this includes altering the incentives of banks either by reducing deposit/credit guarantees or regulating the extension of credit. Without these policies I think monetary policy will have a very difficult time influencing economic growth.

The Arthurian said...

Yes, Woj, everything has been designed to promote credit use. This is the result of the fundamental notion that credit is good always for growth, regardless of the level of accumulated debt. Simplistic!

We must reduce the extension of credit and balance this reduction by increasing the circulation of non-credit money. Keep enough money in the economy to keep the economy going, while thinning out the financial sector to reduce financial costs and improve the position of the productive sector.

As far as how to do it... I am not a practical person :)