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Tuesday, 8 April 2008

The Future Actions of The Federal Reserve And US Govt Are Known

An Occasional Letter From The Collection Agency


An interpretation of The Deflation Bias and Committing to Being Irresponsible by G B Eggertsson


This is going to be a long letter. It will attempt to explain the rational behind the current and future US Federal Reserve intentions from the point of view of Central Bank thinking. Firstly, you will need a coffee, a comfortable chair and an open mind.

I am going to take you on a journey which will require many explanations. You will have to concentrate but you will be rewarded by gaining knowledge of what the Fed is doing, why its doing it and how it will affect the future.

I intend to make extensive use of Federal Reserve material and will be quoting extensively. Remember, the views and assumptions you see in this article are not necessarily in agreement with mine. This is an attempt to get inside the thinking of the Fed.


Without doubt the current methods being employed by the Fed are on a par with those seen in the 1930's. There is fear at the Fed felt specifically with Ben Bernanke that, through inaction or policy mistakes, another re-occurrence of a deflationary recession/depression is allowed to happen again. We remember Bernanke apologising for the mistakes in the 1930's and promising (Friedman) that they wouldn't allow it to happen again. It is my intention to show that this fear is the main driving force behind recent Fed actions and will shape the future path of monetary policy in the future.

The Federal Reserve Makes a Choice.

We can assume that Bernanke is fully aware of the risks and is shaping policy to ensure an outcome that will be neither a Japanese '90s or '30s America scenario. He has studied both periods extensively and probably feels he can chart a course through the hard times and ensure an equitable outcome.

To do this he will try to enact Fed mechanisms that allow counterbalancing forces to be released to combat any deflationary threat. We know that this is his course of action because of decisions already made and suggestions put forward.

Is Bernanke following a Keynesian or Friedman (monetarist) approach in the solution of the current problems? (Here we have to assume that Bernanke sees a problem, current use of new Fed Facilities would reinforce this view).

Although this sound a rather academic based question, it is central to understanding Bernanke's approach. From G B Eggertsson "The Deflation Bias and Committing to Being Irresponsible" the fundamental question is:

  • "Can the government lose control over the general price level so that no matter how much money it prints, it's actions have no effect on inflation or output? Economists have debated this question ever since Keynes' General Theory. Keynes answered yes, Friedman and the monetarists said no."

Remember, I do not intend to get into the rights and wrongs of Keynesian/Monetarist approaches here, I am attempting to uncover the path that Bernanke has chosen. If Bernanke was following a Keynesian approach then any attempt to improve liquidity would be doomed to fail:

As GB Eggertsson put it:

  • "Keynes argued that increasing the money supply has no effect at low nominal interest rates. This has been coined as the liquidity trap."

If Bernanke had been following a Keynesian solution then he would have believed that any increase in money supply would have been ineffective. Yet we see constant attempts to increase liquidity flows. It is clear then that the policies evolving to combat the threat of credit and liquidity contraction are monetarist based. This makes Bernanke’s apology the first signpost on his intended path.

Many attribute Bernanke with the nickname "Helicopter Ben" in reference to remarks he made in a speech about how to combat deflation. It is oft used by those who rail against inflation to paint Bernanke as an inflationist. However, this is misplaced. Bernanke was in fact quoting Friedman. What many don't realise is that there is an assumption the Friedman was invoking Keynes in this approach. This isn't true. Keynes did not believe such an approach could work with low nominal interest rates whereas Friedman believed that changes to both fiscal and monetary policy could allow government control of prices.

Therefore we cannot look at the actions of the Federal Reserve alone. Any action by the Fed would, according to monetarists, be futile without support from the Government. It also supposes that deflation is caused by a negative demand shock that the then current policies where unable to combat. Indeed the current circumstances in credit markets are seen as a Minsky Event, an unexpected shock to the financial system.

However, it would appear that the Fed and the Government were already enacting policies prior to the credit market dislocation last summer. What happened after the dislocation was not an attempt to stop the problem occurring but was the second required tranche of policy that could only be enacted when the problem surfaced.

Let me explain why, for the Fed and Government, there was no "Minsky Moment" but rather a progression of an already foreseen problem. To do this we need to look at why the Japanese Government and Bank of Japan failed to break out of a deflationary scenario. Again I quote from G B Eggertsson:

  • "The deflation bias is closely related, and in some sense, a formalization of, a common objection to Krugman's policy proposal for the BOJ. To battle deflation he suggested that the BOJ should announce an inflation target of 5% for 15 years. Responding to this proposal, Kunio Okina, director of the Institute for Monetary Studies at the BOJ, said in DJN (1999): "Because short-term interest rates are already at zero setting an inflation target of say 2% would not carry much credibility." Similar objections were raised by economists such as, e.g., Dominiguez (1998), Woodford (1999), and Svensson (2001)"

At face value the remarks above would seem to support the Keynesian approach, that at low nominal interest rates, Government deficit spending and quantative easing failed to ignite the inflation required to break out of a deflationary spiral.

Within the quote though is the important point of inflation expectations. It is here that the importance of Bernanke's discussion of a targeted inflation rate and subsequent Fed warnings about inflation expectations remaining anchored becomes central to the main thrust of policy direction.

As we have seen, since 2000 the US Government has run a deficit whilst enabling tax cuts and rebates. The Fed allowed looser lending standards and brought down interest rates, in response to a business led recession. Rather than attempt to hide any inflationary tendencies inherent in these policies, the Fed has become more vocal about inflation ranges with the rhetoric pointing to overshoots of the target range. Inflation expectations amongst business and consumers have, somewhat naturally, been kept high.

The Fed is often measured by its inflation fighting credentials. I believe this is misplaced. The Fed should be viewed as a credible deflation fighter. The Fed had to establish an inflation target, either implicit or within a range, to ensure that further inflation was to be expected in the future.

Why? It is all down to inflation expectations. Japan is unable to break out of its deflationary scenario because no one expects inflation to happen and therefore business, credit and the consumer act accordingly, ensuring demand is constantly put off to a later date. (Why buy today if it is cheaper to buy tomorrow).

Again, I quote from G B Eggertsson: (the Markov equilibrium is covered later in this letter)

  • The third key result of the paper is that in a Markov equilibrium the government can eliminate deflation by deficit spending. Deficit spending eliminates deflation for the following reason: If the government cuts taxes and increases nominal debt, and taxation is costly, inflation expectations increase (i.e., the private sector expects higher money supply in the future). Inflation expectations increase because higher nominal debt gives the government an incentive to inflate to reduce the real value of the debt. To eliminate deflation the government simply cuts taxes until the private sector expects inflation instead of deflation. At zero nominal interest rates higher inflation expectations reduce the real rate of return, and thereby raise aggregate demand and the price level. The two main assumptions underlying this result is that there is some cost of taxation which makes this policy credible and that (2) monetary and fiscal policies are coordinated.

Because of raised inflation expectations, deficit spending by the US Government has the same effect as dropping money from helicopters. It is expected that because assets have been introduced into the economy inflation must rise. (It is useful to have a few members of the Fed that are inflation hawks and vocal in warning about increased spending leading to inflationary pressures).

However, if such funding is directed straight into current money supply it will not increase prices. Again I have to quote from G B Eggertsson:

  • "Deficit spending has exactly the same effect as the government following Friedman's famous suggestion to "drop money from helicopters" to increase inflation. At zero nominal interest rates money and bonds are perfect substitutes. They are one and the same: A government issued piece of paper that carries no interest but has nominal value. It does not matter, therefore, if the government drops money from helicopters or issues government bonds. Friedman's proposal thus increases the price level through the same mechanism as deficit spending. Dropping money from helicopters, however, does not increase prices in a Markov equilibrium because it increases the current money supply. It creates inflation by increasing government debt which is defined as the sum of money and bonds. In a Markov equilibrium, it is government debt that determines the price level in a liquidity trap because it determines expectations about future money supply."

Dropping money from helicopters and cutting taxes are not the only options available and the following paragraph from Eggertsson may jog a few memories:

  • "The government, however, can increase its debt in several ways. Cutting taxes and dropping money from helicopters are only two examples. The government can also increase debt by printing money (or issuing nominal bonds) and buying private assets, such as stocks, or foreign exchange. Ina Markov equilibrium, these operations increase prices and output because they change the inflation incentive of the government by increasing government debt (money & bonds). Hence, when the short-term nominal interest rate is zero, open market operations in real assets and/or foreign exchange increase prices through the same mechanism as deficit spending in a Markov equilibrium."

As an aside, you can see why this paper is central to my article. It is clear that a copy of it sits on Bernanke's desk.

It is becoming clear that Fed and US Govt policy have been in lockstep for some time and that the groundwork for fending off a deflationary attack was laid out over 7 years ago. The actions we have seen since August '07 are not the beginning of the attempted fix but the second stage.

Since 2000:

  • The US Government has run an increasing deficit.

    The Fed has allowed the movement of interest rates to compliment a notionally low interest rate environment. The withdrawal of M3 increased inflationary expectations.

    The loosening of regulatory oversight allowed a wider use of debt and increased consumption.

Since mid 2007:

  • The US Government has explicitly talked of increasing govt debt through tax rebates and targeting relief at overburdened indebted homeowners through the expanded use of Govt Sponsored Enterprises.

    The Fed cut interest rates aggressively below rates of inflation and introduced facilities to engender the outright purchase as well as the long and short term loans of cash and US Govt Bonds.

    The US Treasury does not rule out making the new Fed facilities permanent.

I believe at this point I have made a good case that I have identified the policy and framework that the Federal Reserve and the US Govt are pursuing and that such policies are co-ordinated and have been in place for much longer than most suspect. It is the expectation that such actions are inflationary in nature that encourages spending and investment (Buy today because it will be more expensive tomorrow).

The Future

We now turn our attention to the future. At this point we have to examine something previously mentioned in our article, a Markov equilibrium. Again from Eggertsson:

  • I analyze equilibrium under two assumptions about policy formulation. Under the first assumption, which I call the commitment equilibrium, the government can commit to future policy in order to influence the equilibrium outcome by choosing future policy actions (at all different states of the world). Rational expectations require that these commitments are fulfilled in equilibrium. Under the second assumption, the government cannot commit to future policy. In this case the government maximizes social welfare under discretion in every period, disregarding any past policy actions, except insofar as they have affected the endogenous state of the economy at that date (defined more precisely below). Thus the government can only choose its current policy instruments, it cannot directly influence future government actions. This is what I call the Markov equilibrium.

Essentially policy is either forward looking and adaptive or it works only in the "here and now" and cannot innovate.

Clearly my reading of the current situation is that the Fed and US Govt is committed to a future policy in its actions and has displayed the ability to be adaptive. Therefore we shall take that path to find what future developments may await us.

Again we rely on Eggertsson to lay out the groundwork:

  • "deflation can be modelled as a credibility problem if the government is unable to commit to future policy and it's only instrument is open market operations. This....illustrates how the result changes if the government can use fiscal policy as an additional policy instrument. I first explore if deficit spending increases demand. When the government coordinates fiscal and monetary policies it can commit to future inflation and low nominal interest rate by cutting taxes and issuing nominal debt. I then use the result to interpret the effect of open market operations in a large spectrum of private assets, such as foreign exchange or stocks."

It is without doubt the most forward looking statement I have seen. Or is it? Again we must look at this from behind Bernanke's desk to truly appreciate what we are reading. The statement is forward looking because it has been adopted as policy. We are living with these actions right now and we know that they will exist for at least 6 months as has been made clear in statements from the Fed. Expectations of a continuing inflationary bias must be deeply entrenched in the psyche of anyone connected to asset markets.

Eggertsson continues:

  • "Friedman suggests that the government can always control the price level by increasing the money supply, even in a liquidity trap. According to Friedman's famous reductio ad absurdum argument, if the government wants to increase the price level it can simply "drop money from helicopters." Eventually this should increase the price level-liquidity trap or not. Bernanke (2000) revisits this proposal and suggests that Japanese government should make "money-financed transfers to domestic households-the real-life equivalent of that hoary thought experiment, the "helicopter drop" of newly printed money." This analysis supports Friedman and Bernanke's suggestions. The analysis suggests, however, that it is the increase in government liabilities (money & bonds), rather than the increase in the money supply that has this effect."

  • "Since money and bonds are equivalent in a liquidity trap dropping money from helicopters is exactly equivalent to issuing nominal bonds. If the treasury and the central bank coordinate policy the effect of dropping money from helicopters will have exactly the same effect as deficit spending. Thus this paper's model can be interpreted as establishing a "fiscal theory" of dropping money from helicopters. The model can also be extended to consider the effects of the government buying foreign exchange (or any other private assets).

  • It is often suggested that the central bank can depreciate the exchange rate and stimulate spending by buying foreign exchange (and similar arguments are sometimes raised about some other private assets and their corresponding price). Due to the interest rate parity (and similar asset pricing equations for other private assets), however, buying foreign exchange should have no effect on the exchange rate unless it changes expectations about future policy (since the interest rate parity says that the exchange rate should depend on current and expected interest rate differentials).

  • Will such operations have any effect on expectations about future policy? Open market operations in foreign exchange (or any other private asset) would lead to a corresponding increase in public debt defined as money plus government bonds. This gives the government an incentive to create inflation through exactly the same channel as I have explored in this paper and, therefore, leads to a corresponding depreciation in the nominal exchange rate hand-in-hand with the rise in inflation expectations. An advantage of buying private assets, as opposed to cutting taxes, is that it does not worsen the net fiscal position of the government. It only changes the inflation incentive of the government.

If Bernanke and Co keep with the blueprint (it would be difficult to see how they could deviate now without destroying carefully implanted expectations) we can expect to see continuous and expanding intervention in what was previously thought to be off limit areas.

Treasury bond issuance should rise and does not have to have a defining limit. Tax rebates will continue and grow, expanding beyond traditional areas. Use of current GSEs to expand government debt will be encouraged and may well lead to the formation of "Super GSE's" that could take on second lien loans on property, for example.

The Fed will expand its facilities, including more market participants and widening the range of assets that can be used, including stocks. The facilities will become permanent but will be allowed to run down in use as circumstances dictate. It will be imperative to remove any stigma associated with the use of such facilities, possibly by converting the facilities to a type of GSE, or more likely, a Fed Sponsored Enterprise.

Concerted and possibly international intervention in Forex markets should be given a high level of probability. This will allow a slow and orderly re-pricing lower of the dollar and a continued bias toward inflation.

A campaign of "anti-inflationary" bias will continue and be ramped up if necessary. Rates could be raised without affecting the fight against deflationary forces because expectations would require such a move. A constant attempt will be made to anticipate a move higher in growth.

Is the path hyperinflationary?

To be blunt, no. These are anti deflationary measures that will give the Fed credibility in fending off the dreaded scenario. The threat to the policies is an acceptance of deflationary expectations by private money and consumers.

Hyperinflation would be unable to form as an expectation as long as the Fed continues to display a hawkish approach to inflation. As we have seen the delivery of fiscal debt, in the form of "helicopter drops" would bypass the pricing mechanism. Expectations of hyper-inflation would be negated.

Conclusion. Is it working?

It is at this stage that I can happily say that it would be unfair for me to judge whether the policy is working or not. This because the whole scenario, the playing out of the policy, is to do with perception. The only way that it can be measured by individuals when attempting to answer the question is to screen what they see through this article (or G B E's Fiscal Theory). As the writer if I answer the question I might colour an individual's perception.

What I can say is that with the framework exposed and on public view we have the advantage of spotting potential failure of policy. The potential for failure is increased by discussion and the recognition of the long term policy objectives (avoiding deflation) if such discussion raises the expectation of deflation.

I should remind readers that this article is my interpretation of G B Eggertssons' work. I believe it is the blueprint being used by the Fed and US Govt. Therefore I claim no superior knowledge to Eggertsson, just an understanding and the ability to navigate.

What should be remembered is the title of G B Eggertsson's paper:

The Deflation Bias and Committing to Being Irresponsible

(Edit: The above link to the NY Fed stopped working, I have found another on line version at the IMF and linked to it. I have also downloaded a copy, just in case)

In other words the future actions of the Fed and US Govt may appear "wrong" unless we understand what they truly fear.


Colin said...


This is the most brilliant macroeconomics analysis I have ever read.

What are the implications for the US Dollar , considering the US Current Account Deficit? It would seem to me to be profoundly negative . . .

The Collection Agency said...

Whoa, steady Colin, I'm bigheaded enough already :-)


If the plan works then yes, the $ suffers, unless other Central Banks do the same. Note the UK, BofE injected £15Bn yesterday, £ took a kicking.

Anonymous said...

The problem is that this is not Japan 1995 or US 1931. The problem in the US is not an economy that is overly productive.

There is not too much excess capacity (except in housing). The US problem is too much consumption, and not enough productive capacity outside of the "highly innovative" finance sector.

Because Bernanke misunderstands the fundamental nature of the problem, between overproduction and overconsumption, his Rx will be a disaster in the making.

IMO obviously. Anonymously.

Cheers ;-)

Eric said...

Excellent interpretation of Helicopter Ben's focus. If correct, then Ben is employing an untested and unproven macroeconomics theory. In short, it is Ben's little experiment.

Ben Bernanke is attempting to manipulate and regulate human behaviour, emotions and expectations. While you didn't cover it, it appears that Ben's model also includes the manipulation of gold markets (i.e. keeping the price of gold artificially low(er) via IMF & Central Banks' bogus selling of gold). Historically, gold is the gauge of confidence in fiat money, especially if the currency is being de-based.

The weakness of Ben's macroeconomic experiment is his reluctance to weigh in on political issues:
Bernanke, when questioned about taxation policy, said that it was none of his business, his exclusive remit being monetary policy, and said that fiscal policy and wider society related issues were what politicians were for and got elected for.

and by default, his inability to comprehend the current geopolitical environment, especially in the Middle East where USA is faced with many enemies holding trillions of USD derived from sales of oil. Should the Arabs decide to unleash their trillions of USD into the (undervalued, inflation un-adjusted) gold market and propel the price of gold into the stratosphere, it will be interpreted as an hyper-inflationary signal sending markets into uncontrollable frenzy. While it appears that the Feds are attempting to manipulate the price of gold, the flood of liquidity is putting more and more ammunition into the wrong hands. Would you not agree?

Anonymous said...

Why wouldn't this lead to social instability? Wages fall behind inflation, leaving consumers unable to increase spending. What's to prevent malinvestments from building up and distorting the real economy?

I think what you are seeing is the increase in debt/money going into speculation on commodities (because of inflation expectations). That causes a general rise in prices, but is going to cause social instability if the money doesn't make its way into consumers hands. The next step is what bread lines?

I don't see that this is going to stimulate the economy. It will create inflation, but the real economy will continue to deflate unless malinvestment is somehow sorted out.

Anonymous said...

It would seem that all the Fed needs to do to combat deflation is simply back-out all the hedonistic adjustments to the inflation indicators since the Michael Boskin economic advisor era.

The Collection Agency said...

Hi all,

again, in the spirit of the article, I am not going to answer direct questions such as:

"Why wouldn't this lead to social instability? Wages fall behind inflation, leaving consumers unable to increase spending."

Readers need to look at what Eggertsson is proposing and how the delivery of currency (money, nominal bonds) would occur.

Remember the title of Eggertsson's article as you read his proposals.

I can think of no other article when it is neccessary to leave behind previous inflation/deflation bias to see what they intend to do.

Anonymous said...

What an excellent Macroeconomic essay. I just have one qualm:

"It is becoming clear that Fed and US Govt policy have been in lockstep for some time and that the groundwork for fending off a deflationary attack was laid out over 7 years ago."

I finished Greenspan's book last week and distinctly remember him criticizing the Bush administration for overspending and increasing debt. Supposedly, Bush just brushed-off the Fed's critique on the administration's inflated budget and tax cuts. According to the book, Bush had made promises while campaigning that had to be kept regardless of squandering and misusing the budget surplus. This hardly sounds like the Fed and the govt being in "lockstep," at least not during Greenspan's stay.

I'm having a hard time reconciling these inconsistencies between the author and Greenspan's book.

Brilliant paper and theory nonetheless.

The Collection Agency said...

"I finished Greenspan's book last week and distinctly remember him criticizing the Bush administration for overspending and increasing debt. Supposedly, Bush just brushed-off the Fed's critique on the administration's inflated budget and tax cuts. According to the book, Bush had made promises while campaigning that had to be kept regardless of squandering and misusing the budget surplus. This hardly sounds like the Fed and the govt being in "lockstep," at least not during Greenspan's stay."


Indeed, you are right that AliG criticised the size of the deficit. Within the Eggertsson Theory this would be the correct thing to do as it highlights the inflationary expectations of high Govt debt issuance during a period of low nominal interest rates. It would be "credible" for AliG to make such remarks.

Anonymous said...

"Readers need to look at what Eggertsson is proposing and how the delivery of currency (money, nominal bonds) would occur.

Remember the title of Eggertsson's article as you read his proposals.

I can think of no other article when it is neccessary to leave behind previous inflation/deflation bias to see what they intend to do."

Yes, I do see what you're saying - this is the program the Fed is (and has been) following. I just meant to point out the obvious - this policy is a wealth redistribution mechanism. I'm not sure why you're pussy-footing around that though. I mean Eggertsson works for the Fed. You might have pointed that out.

This policy is going to crush the real economy eventually - its probably the main cause of the recent successive bubbles(malinvestments crashing).

It is irresponsible, I get your point. I guess they're doing it to what? boil the frog, put off a social crisis? My questions are/were largely rhetorical, but I'm wondering why all the smoke and mirrors when presenting smoke and mirrors?

The Collection Agency said...

The original link was to Eggertsson at the NY Fed site. For some reason it has become "404 page not found", so the link now goes to the IMF. There was no attempt to hide Eggertsson's credentials. Well, not by me anyway.

The smoke and mirrors by me was deliberate. I had to write the article without allowing my own judgement to show through, it was written from the perspective of Bernanke and Co using a monetarist "bent". I am not in the monetarist / Keynesian camp.

Thats why I couldn't give a definitive yes or no in the conclusion. It would have diverted away from the subject.

Anonymous said...

Thank you for staying with me - I totally mistook your restraint for something else.

The link to the Eggertsson article was out, so I looked for it. I accidentally came across a photo and bio.

You've shone a light on something I'm not sure I was ready to see. I feel like I'm watching the last lifeboat disappearing over the horizon.

Thank you for your article.