Mar 11, 2019

Hyperinflation, Fiscal Capacity, and Credible Government Policy

A Macro Musings Transcript
David Beckworth Senior Research Fellow , Ryan Avent

David Beckworth: Our guest today is Ryan Avent. Ryan is an economics columnist with The Economist magazine, and is a previous guest of the show. Ryan joins us today to discuss some of his recent columns including work on hyperinflation, the Green New Deal and Fed policy. Ryan, welcome back to the show. 

Ryan Avent: Thank you for having me again David. 

David Beckworth: Well it's great to have you on. You've been running on some very topical issues. I want to begin with hyperinflation. I think everyone is aware that the place where this topic leads us to is Venezuela. I want to read an excerpt from a column you recently had. The column's title was, “Hyperinflations Can End Quickly Given the Right Sort of Regime Change.” I'm going to start, “Bank notes used as toiled paper. Wheelbarrows of cash exchanged for a loaf of bread. Prices in supermarkets revised upward each hour. These vignettes of hyperinflation would be funny if they did not cause such hardship. This is now Venezuela's situation in what might be the final days of the ill starred regime of Nicolas Maduro. An estimate by Steve Hanke of John Hopkins University puts the country's inflation rate last year to 100,000 percent, with prices doubling roughly once a month. The IMF reckons that in 2019, it may reach 10,000,000 percent.” 

David Beckworth: Wow, so that's a great way to start off a piece on hyperinflation. Again, everyone's probably aware of what's going on down there. It's kind of been a sad story to follow, but an interesting story if you're an economist. Let's begin this discussion by defining what is hyperinflation? How is it different than just high inflation? 

Ryan Avent: It's a good question. There's a number of different ways that people define it. I think the sort of traditional view is that a monthly rate of 50,000 percent kind of counts as the threshold. It's sort of a you know it when you see it kind of thing. Venezuela certainly is in that category particularly as they sort of move into the kind of million percentage inflation area, yeah. 

David Beckworth: Okay so 50,000 percent or more per month? 

Ryan Avent: Per month, yeah. 

David Beckworth: Okay and it has to be sustained? Does it matter if it's one month, two months? Is it just persistent? 

Ryan Avent: I mean I think you'll find analyses which will say if it gets up a period of a few months, that counts. I think usually they don't define it that way unless it's sustained for over the course of a year or more. 

David Beckworth: Okay, and you referenced Steve Hanke. I looked him up, and we've had him on the show before a long time ago, but he has this table where he's collected yet a number of countries now up to 58 including Venezuela. It's interesting to look at some of the top countries, Hungary, Zimbabwe, that's another case that I would think of a recent case, Zimbabwe because I still have my note collection from Zimbabwe, my hundred trillion dollar note. I used to use it when I would teach, great example. I was thinking about Zimbabwe. That occurred in 2008 at the very time when we were having the contraction, and advanced economies, so we were struggling with deflationary pressures, they were struggling with hyper inflationary pressures, kind of ironic. In the case of Venezuela, really high inflation. Hanke, again, said they ended on 100,000 percent. I think his most recent estimates are at around 140,000 percent. 

Ryan Avent: I mean week by week it's ticking upward, yeah. 

David Beckworth: Ridiculously high, it has real effects. Walk us through why is hyperinflation so devastating to an economy? 

Ryan Avent: Well I mean it's devastating in all sorts of ways. I mean it destroys the existing stock of saving in a lot of cases, which is corrosive kind of of the broader civic institutions in a country, but it also makes it really hard to run an economy if you can't count on saving and mobilize those savings to investment. I think in a lot of ways it's a symptom of a broader problem, a broader kind of breakdown in the functioning of government, and that's certainly what we see in Venezuela. I mean you wouldn't consider engaging in any sort of long term capital project, or even a short term capital project in Venezuela at this point, just because you don't know when they'll be able to reestablish kind of the basic function of government, collecting taxes, paying civil servants salaries, all these sorts of things. I think the actual hyperinflation itself is really damaging, but it's also a symptom of a broader collapse in the institutions that make economies work. 

David Beckworth: It's not the case where the central banker accidentally hit the print button, went on vacation for a few weeks, came back said, “Oh my goodness”, that's not hyperinflation. Hyperinflation is a deeper collapse of the state is what you're saying? 

Ryan Avent: Yeah that's absolutely right. 

David Beckworth: Okay. 

Ryan Avent: I think every now and again when inflation ticks up, if you start to get into double digits, things like that, people start to worry, “Oh we're headed toward hyperinflation.” What normally happens in those sorts of cases is that eventually states respond. Really rapid inflation is not particularly popular. If governments have the capacity to step in and do whatever it's going to take to get inflation back down into comfortable levels, they usually do that when the pain gets serious enough. Hyperinflation it's a fundamentally different situation in which governments just lack that capacity. The state is so weak that it can't take those steps. 

David Beckworth: Yeah so I remember the election they had last year which was a bit of a farce, but they had this election, there actually was some opposition candidates. One of the topics they brought up was introducing a new monetary regime. One suggested we go with dollarization, Venezuela go with dollarization. I think Maduro suggested a new cryptocurrency tied to oil. I was talking to someone else about this, and they said, “That's just like putting a bandaid on this”, so there's a deeper problem, that's the collapse of the state, the problem's internally. You can't just fix it by changing the unit of account, it's a deeper fiscal problem I want to get to. I just want to get back to the fact that why it's such a big deal to people. I want to draw on another example, and this is Germany. I've had several guests on the show where I've wrestled with this issue, “Why did the Germans remember the hyperinflation of the early 1920s more than the deflation of the Great Depression in the late 20s, and early 30s?” 

David Beckworth: You could argue that the deflation was more consequential than the hyperinflation, right? Kind of the standard and you're an economic historian yourself, so correct me if I'm wrong here, but kind of the story I've heard is that the Great Depression, the deflation opened the door for Hitler, the rise of Nazis. I know it's a much more complicated story from deflation to Nazis, a lot of things were going on then, but that's kind of the story that's told, and that had huge consequences for Germany, for the world. You think the Germans would look back and say, “Hey we've got to avoid low, low inflation, going down towards deflation”, but instead, what we see is Germans saying, “Hey, hey, hey, we've got to worry about inflation.” They were scarred more by the hyperinflation. I talked to one individual, and his reasoning to explain this was that hyperinflation affects everyone the same. 

David Beckworth: Everyone takes a loss in their savings, destroys commerce interaction, where the deflation may hit different groups differently. Some may get by, the better hedge against it. I wonder if you have any thoughts on that. Why would we remember hyperinflation more than say a deflationary case? 

Ryan Avent: It's a really good question. I think probably the way to look at it is that the hyperinflation fundamentally weakened the sort of civic infrastructure in Germany in a way that made them more vulnerable later when we got into the Depression. I guess if you sort of think about the sources of long-run political stability, you think maybe about the middle class, about people who are there saving, hoping to build up a simple nest egg, maybe small business people, kind of that broad middle class who has invested enough in the future of the country that they really are going to care a lot about what the politicians are doing, making sure that they're on the right track. Then when you have a hyperinflation, that just wipes out their savings, it destroys their ability to kind of plan over the long run and completely undermines I think their faith in the state to be able to promise and deliver on long run goals. 

Ryan Avent: I think that hyperinflation was kind of the nail on the coffin for the stabilizing elements of German society that were still there after this First World War. Then, those elements were probably more likely to be swayed later on when hard times hit again, and when the Nazi party was there claiming to people that they had the solutions to fix what was wrong with German society. We're sort of psychologizing here. It's hard to go back and know exactly. 

David Beckworth: It's fine, that's what the show's for. 

Ryan Avent: Yeah but I think that probably is it, that it fundamentally weakened kind of the faith of people. 

David Beckworth: All right so they're related then. The hyperinflation kind of planted the seeds that made the ground fertile and supported the growth of Nazis, in addition to what the deflationary forces did later in the decade? 

Ryan Avent: Yeah. 

David Beckworth: Okay, fair enough. Now in your piece you mentioned hyperinflation is not exclusively a modern problem. You mentioned Rome under Emperor Diocletian. 

Ryan Avent: Yeah, we all remember that case, yeah. 

David Beckworth: The Romans had their own little taste of it. Those are interesting stories. Back then, they would debase the coins, take them out and melt and put some bad metals in, a little more subtle today they just print, seigniorage is pulled off that way. But, hyperinflation in terms of like numbers is more modern right, in terms of the frequency. Why is that? Why more today versus the past? 

Ryan Avent: I think the big part of it is to move away from commodity backed currencies, and the fact that you've got the printing press there. Governments try to anchor the value of their fiat currencies in different ways. They can peg it to a commodity, they can peg it to some other exchange rate, or something like that. So long as it's just the kind of faith and credibility of the government in adhering to that peg that is keeping the currency stable, you always face the possibility that you'll get into a difficult spot where the path of least resistance for the government is to start printing more, and there's no sort of need to go find more gold that's constraining them. I think that really is the reason it's more of an issue from the 20th century on, is because before that, you didn't really have a lot of fiat currency regimes in place. 

David Beckworth: It opened the door for this opportunity for hyperinflation temptation to be… 

Ryan Avent: I think that's right yeah. 

David Beckworth: -And there's a lot of interesting work done on this. I know Phillip Cagan had a piece back in the 1950s that brought up the seigniorage which is this tax you get from printing more money, inflation there. You can actually, there's an optimal amount of inflation there in tax- 

Ryan Avent: There is. 

David Beckworth: ... so the infamous laffer curve, which says, I think everyone agrees in the idea of a laffer curve, which says if taxes are too high, you won't get any tax revenue. If they're too low, you're not getting enough tax revenue, but that can be applied to inflation, right? There's some optimal inflation right in terms of collecting revenue to the government through inflation. The question is, when you have hyperinflations, are you on the right side of the laffer curve, or the wrong side of the laffer curve? There's a long conversation on that too. 

Ryan Avent: I mean there's all sorts of interesting sort of angles that you don't really think about, and when you start digging into the literature, they pop up. If there's so one thing to think about, if there's a delay between when you gather tax revenues and when you spend them, then hyperinflation can actually be really damaging to government's finances in that extent, between the time between they collect the money, and the time they use it to pay civil servants’ salaries, the value of the money has collapsed. Hyperinflation is actually worsening a government's budget position, rather than improving it as you might suspect. Once you start getting into this bizarro world,- 

David Beckworth: It is a bizarro world. It reminds me of Zimbabwe where the printing presses couldn't keep up with the rate of inflation. I think it was the Germans that initially shut down, “We can't physically keep up with changing the denominations” and stuff. I think it was in 2008 you see the notes go from normal denominations to 100 trillion pretty quickly. It was a race against the growing inflationary expectations. Another kind of interesting, bizarre thing about hyperinflation is if you look back in the case of the US historically, so historically, you mentioned we were tied to the gold standard. The price level up until like World War Two was relatively flat, it was looking like a straight line, you see these occasional upward spikes that would come back down, they were tied to war. 

David Beckworth: I don't know if you would ever classify this as hyperinflation, but really high inflation. Now, I know some people say the revolutionary war was loosely hyperinflationary, and I read one historian say that the US rode the wave of hyperinflation into existence. I had this vision in my head of Uncle Sam on a surfboard and a wave with the label hyperinflation behind it, and Uncle Sam is surfing into existence, the idea that they had to print all these continentals, because they didn't have the capacity to tax. In fact, tariffs were the way they were collecting tax revenues, and they British controlled the seas. In the absence of bond financing or taxes, they had to rely on printing money. It's interesting even in the case of the US. Civil War even- 

Ryan Avent: The Civil War, exactly yeah. 

David Beckworth: ... you see there is more bond financing, but there is a big increase in inflation during that time. Then there's reverting back to the old price level path until we get to post World War Two, and there's a positive inflation path. It's even interesting in the case of the US look back and see. I know there's a debate. I'm sure the economic historians are going to chime in and send emails that it's more complicated than hyperinflation, ergo US existence, but nonetheless, fascinating thought experiments that we could go through. 

Ryan Avent: Well I think that you're absolutely right that these things often occur around wars. Certainly if you look back in the 20th century, most hyperinflations occurred right after the First World War, the Second World War. Obviously, it didn't happen in every situation. Britain had massive inflation during the First World War, but then at the end of the war was committed to getting back onto gold at the pre-war parity, which ended up causing them quite a lot of economic pain. It's interesting to think about the different experience in Britain and in Germany. There's an argument about why Germans experienced hyperinflation. Some people think that it was done almost intentionally to kind of demonstrate to the allies that they couldn't afford the reparations. This is disputed, other people say that this is not in fact the case, it was more that they just couldn't, they were too institutionally weak to raise the money they needed to fund everything. 

Ryan Avent: It's interesting to think about that dynamic as well. 

David Beckworth: Yeah so speaking of war after World War Two, coming out of World War Two, Hungary had a really high rate of hyperinflation. According to Steve Hanke, had the highest, Zimbabwe was the second. What were the numbers in Hungary? 

Ryan Avent: I think the peak inflation rate for Hungary after the Second World War was 42 quadrillion percent, which that's up there. That's above the two percent target. 

David Beckworth: This is for context, I'm pulling in front of me here Steve Hanke's table. It's called the Hanke-Krus World Hyperinflation Tables. He has this large number that Ryan just said, I won't try to repeat, but what it implies is the time required for prices to double is 15 hours. 15 hours, everything doubles. In the case of Zimbabwe, it was 25 hours. Then down in Yugoslavia in ‘94, it was 1.41 days. This goes back to what your piece said earlier that you're literally going to a restaurant and you don't know the price of the meal until when you leave. Prices are constantly being updated. If you're an individual, it's in your interest, you get paid multiple times a day to run and exchange it for some physical commodity or hard currency, which is a waste of time. You're fighting an inflation game, so it's just in many ways, it leads to a breakdown. 

David Beckworth: That leads us to what do we do about it? How do we get out of a situation? What can Venezuela do to get past this ordeal? 

Ryan Avent: Well I think the typical recipe for getting out of a hyperinflation includes a few different things. The most important bit is to kind of credibly fix the fiscal situation. The way you get into this mess is by completely losing your ability as a state to pay for things by raising the taxes you need, so you have to reestablish that. Usually, you have some sort of program that involves a massive fiscal consolidation, and one that the public believes is going 2 stick, not one that the government will stick to for six months and then going back to running the printing presses, so that's one thing. Normally, you need to reestablish the credibility of the currency in some way, and dollarization or establishing some new nominal anchor is usually the way you do that as well. It often helps if there's kind of a broader regime change, so you have someone come in and say, “Look, there's a definitive break with the past. We're not going to be funding the government through the printing presses anymore.” 

Ryan Avent: A lot of it really is about convincing the public that there is a new regime and one that's going to be durable. 

David Beckworth: The key is credibility. You mentioned in your column Thomas Sargent had a famous paper about the ending of four big hyperinflations where he makes that point, right? 

Ryan Avent: Yeah well it's interesting to think about the context for the Sargent piece, which was that there is an ongoing debate about the role of expectations in monetary policy. At the time, in the 70s and 80s, a lot of economies were dealing with double digit inflation, and there was a debate about how to get rid of it. The sort of Keynesian argument was that the only way to get rid of the inflation was to induce really, really high levels of unemployment to change people's expectations. Of course there were other economists, Sargent was among them, who thought that if there's a credible shift and people believe that the policies are going to change, then there's no reason why you should have to go through that pain, that they can just, I don't know if your listeners can hear me snapping, just like that expectations can flip if people believe there's a credible policy shift. 

Ryan Avent: He used the example of these 1920s era hyperinflations to show that when you got in new people making new policies and the policies were credible, that it was really a matter of weeks even that you went from these quadrillion percentage inflation rates down to something in single digits. 

David Beckworth: The flip side of that is in order to avoid hyperinflation, you need credibility today then too. I mean if you're in an environment where credibility is slowly eroding, you can do down the path, which reminds me of the case of Argentina currently. Argentina is one of those countries with high inflation but not hyperinflation. I was reading yesterday as I was preparing for the show, that they had inflation last year around 48 percent which is high, and they've had a number of interesting episodes ahead. Monica de Bolle from Peterson Institute, and we were talking about how their central bank had to raise their inflation target to 15 percent. It was previously like in the eight to ten percent range. So there’s a lot of credibility eroding things going on in the government. The president there is trying to make a stand for reform coming out of the previous government, but the question is credibility. 

David Beckworth: Will Argentina earn credibility, or will its credibility be further eroded, put it on a path toward something like Venezuela? They're a long, long ways from Venezuela, but the question is credibility. Then, that leads us to more of a case like the US right? You've got Venezuela, you've to Argentina kind of in the middle, you've got a case like the Eurozone or the US at the other end, and one could argue we've got almost too much inflation credibility right? 

Ryan Avent: Yeah. 

David Beckworth: It's hard to generate inflation whatsoever. 

Ryan Avent: I think that's right. I mean it's interesting to think about. So, in kind of the classical model of a hyperinflation, you can see it coming a little bit right? You see the government running deficits that go from five percent of GDP to ten percent to 15 percent to 20 percent. As they start going up, inflation rates start going up, and then you have this explosive hyperinflation. Then in the classical model, you can end it quickly whenever you get the regime change. What people have noted is that when you have, and Argentina and Brazil are both kind of the exemplars of this, when you have places that sort of are constantly in the sort of the triple digit inflation range, and every once in a while, have a bout of very serious hyperinflation that the public just over time says, “This is what it's going to be like.” In those cases, it becomes much easier to slip into hyperinflation than in other examples. 

Ryan Avent: You do sort of get this long running erosion of the credibility of the state, which makes it harder to fix the hyperinflation problem. As you say, rich countries have if anything over-solved the problem of convincing people that they're credible on these things. 

David Beckworth: Yeah, which leads us to a nice transition to another column you've written, and that's about the Green New Deal, and the growing popularity of MMT. We recently had on Rohan Gray who briefly explained what that is. One of the arguments I think the MMT folks or at least the folks at the Green New Deal are making is “Look, inflation's been really low. We've earned this credibility. We haven't pushed the credibility to its limit yet before it breaks.” There's some point at which you would begin to erode that credibility. This is an interesting question, does credibility break quickly? I mean you mentioned countries that have repeated problems, but it's kind of like if I make good on this path, forgive me listeners, like a marriage right? If I come home late several nights in a row, my wife's not thinking, “What are you doing out?” She thinks I've been working late. 

David Beckworth: Once it becomes known I had say an affair, the credibility is blown forever, right? Is it a gradual process, or is it a sudden just continuous jump? I mean you mentioned earlier the cases where the countries erode credibility, and it explodes, maybe that's where the affair becomes known. Sorry, that's a terrible analogy to draw, but there's this credibility of trust right, that you trust the government, like trusting in your spouse. In the case of it going back to the US, can we push the limits of what the state's capable of doing? Maybe speak to that a little bit to the column you've written, how that ties into this. 

Ryan Avent: Sure yeah. Well I think it's a bit of a preamble. I think credibility matters in sort of the monetary context, and the fiscal context. Eventually, if you're sufficiently not credible in the fiscal side, that's going to bleed over to the monetary side, no matter how kind of determined the central bank is. I think it's kind of worth noting the distinction there. You're right, with the Green New Deal, people are sort of saying that the deficits don't matter, we've learned they don't matter. You can look at Japan, which has a debt to GDP ratio of 240 percent, and still has this very low inflation. What that means is we've got this fiscal capacity we're not using. We essentially have resources that we're not mobilizing, so let's mobilize them. It's interesting to kind of to try to run that forward and see what the lessons are. You can imagine that you get bigger and bigger deficits, and for a while, we don't hit that threshold, and then more and more people become persuaded of the fact that deficits don't matter, and then at some point the psychology flips. 

Ryan Avent: I don't think in the context of an advanced economy, I don't think it flips to hyperinflation. It probably flips to something- 

David Beckworth: Like the 70s- 

Ryan Avent: Yeah and politicians get voted out and then you sort of somewhat painfully claw your way back to a more sober minded regime. It's interesting to have this debate thrust kind of into the political spotlight. We'll see. I think the longer we're in a regime that has really low unstable inflation, really low unstable interest rates, the harder it's going to be for politicians to resist the urge to kind of let this go a little bit and see what we can do. 

David Beckworth: It definitely is enabling this conversation, this talk, this movement. I also think there might be a generational element to this. I know we've talked before and with others I've talked about how in monetary policy I see a generational element, fighting the last war that many of the leaders of the Fed, the ECB cut their macro teeth so to speak during the 1970s. They never want to repeat that. Well if you go back even further, you go back to the Great Depression right, come out of the Great Depression, a lot of people were very risk averse, they would save a lot, a lot, by the time you get to the 60s, there's another generation who saw that, and they're trying to exploit Phillips curves. They try to get them ... they're like the Green New Dealers of the past. They're like, “Look, look, see what happened guys? You overdid it. We had the Great Depression. We saved, we didn't get much done. There's lack of full employment.” 

David Beckworth: They tinker, tinker, maybe it works a little bit, and then boom, it explodes. We're going through a similar sequence. We had the Great Recession, very austere measures, monetary and fiscal policy, maybe the time scale has shrunk from one event to another, but I do see this pattern, young politicians, basically the Great Recession. They see slow growth, they see a slack, they want to test it right? 

Ryan Avent: Yeah I think that's absolutely right. I think it's partly the sort of the contrasting experience and coming of age during the 70s versus coming of age during the Great Recession. I think in Washington at least there's also ... there are a lot of people of an older generation who look at the fiscal adjustment in the 90s, and the move toward a surplus, and kind of pat themselves on the back and say, “That was the most responsible thing we've ever done, and it was great”, whereas a lot of younger people say, “That was just essentially a wasted opportunity.” They don't see why what the reasoning behind it was, or that it did any good. It is interesting to think what the kind of lag is. Are we going to have a period of 10, 20 years where the children of the Great Recession are like, “Let's spend more, let's spend more, let's spend more”, or is it going to flip fashion? I don't really know. 

David Beckworth: I do think one big difference between like telling the story now versus post Great Depression is the fact that there's this global demand for debt, and we've talked about this before, the same asset shortage. We provide the safest assets to the world. We're the main producers of safe assets, so that expands the capacity, the fiscal capacity of the US, but even then at some point, there will be some threshold where things begin to heat up. 

Ryan Avent: Another aspect of that we have a global financial market now. The real interest rate that the Fed has to think about is in some sense determined globally. I think we're seeing this now. We can talk about the Fed later. The Fed can only put up its interest rate so much in a world where the global real interest rate is zero. If you've got a dysfunctional Europe, if you've got China which has a massive overcapacity problem, then maybe the US has more room to kind of be incredibly stimulative because you're dealing with an excess of capital elsewhere. 

David Beckworth: Right. I mean it's a fair point. It's a much more complicated game, much more challenging. Speaking of the Fed Ryan, I'm glad you brought that up, you're a big follower of the Fed. Before you were a columnist, you were a reporter on the Fed for The Economist, and a lot of interesting developments since we talked last. Let's begin first with just the change in Fed policy. It's February we're recoding this, just last month the Fed had a meeting where they seemed to really take a different direction, more dove is direction. What was your take on that change? 

Ryan Avent: Well there's been I think there's an interesting debate going on about how much of a change in direction it actually was. I think some people think that the Fed had signaled for a long time that they were ready to kind of take it a little bit slower. I think probably there was some new information in the January meeting suggesting that they were much more not just that they were pausing to see how the day to day develops, but that they were acknowledging that maybe the cycle is close to an end. I think if that is the case, and we'll see as we get more data and more Fed meetings, but if it is the case that they are close to stopping, that's a pretty big deal. I mean what we've got now is an effective funds rate around 2.4 percent, that's really, really low to be topping out. The top rate in past- 

David Beckworth: It's the new normal, huh? 

Ryan Avent: ... it's the new normal, and it makes it much more likely that we get back to zero the next time around. That in turn means that it's much more likely that the Fed and other central banks are going to be stuck using these unconventional tools, and that maybe they need to rethink their frameworks. I think it's potentially a big moment. I think it was the right call, and I think absolutely they made the correct decision in not just heeding not just kind of markets, feeling a bit anxious, but also just the harder data. The actual inflation figures were not taking off in the way you might think they would in an unemployment rate sub four percent, so certainly in my view the right thing to do. 

David Beckworth: Yeah and I actually like the subtle turn towards looking at asset prices more. You mentioned inflation is an exception, but if they had just stuck to say GDP unemployment numbers, they may have stayed the course towards multiple rates hikes, but looking at not just stock markets, looking at yield curve, looking at long term Treasury yields, the value of a dollar. If you look at a large number of those in addition to break evens, you get the break evens in there, kind of a collective, and you know Scott Sumner is my colleague here, he would one day dream that having a nominal GDP futures is kind of an amalgamation of all that, but just looking at real time asset prices, kind of a composite index, which was indicating some kind of weakening or at least slowing down. They're more responsive I think in real time, which I find that a good thing. I like to see them more responsive. 

Ryan Avent: Yeah I mean and sort of the view of the public I think it seems a bit unseemly because people are thinking, “Oh well once the traders start losing money, the Fed’s going to step in.” If that's all it were, I think it would be wrong. I think you're right, it reflects on the one hard the fact that markets are saying something about their expectations for the path of growth in the future. I think it also reflects the fact that when markets move like that, you do get some tightening in financial conditions. People find it harder to borrow, banks start worrying about asset prices and how that affects collateral. There's an automatic tightening there that you need to be conscious of, so I think it's totally appropriate. 

David Beckworth: Yeah I fully agree with that. I want to ask about the Fed’s decision last November to have this comprehensive review of its policy. This is less of a kind of a real time policy issue, but more like looking forward and thinking, “How do we want to do monetary policy?” You just mentioned they probably will hit the zero lower bound much sooner next time because the new normal is 2.4, two and a half percent, so they don't have much room to cut interest rates, so they'll turn to maybe negative rates, maybe to QE again. We say that QE maybe did something, maybe didn't pack a big punch. The ECB has tried negative rates, but as long as you have physical cash, there's always going to be an effective lower bound constraint on using that tool. Maybe they need to try something different. I want to read the press release surrounding this comprehensive review because it gave someone like me who is very hopeful about regime change to a level target some hope. 

David Beckworth: Here is the paragraph that was announced last November on their website. This is what it says they're going to do this year. It's already February, so we'll have to see what they're going to be doing. It says, “The Federal Reserve next year will review the strategies, tools, and communication practices it uses to pursue its congressionally assigned mandate of maximum plummeting price stability. The review will include outreach to a broad reach of interested stakeholders. As part of the outreach effort, the Federal Reserve System will sponsor a research conference in June at the Federal Reserve Bank of Chicago with speakers and panelists from outside the system. Additionally, reserve banks will host a series of public events around the country to hear from a wide range of stakeholders.” Then they go on to say that beginning in the middle of 2019, they themselves will begin having discussions. 

David Beckworth: This tells us that there's going to be this great cross country tour, there's going to be tents pitched, there's going to be block parties where Jay Powell is going to show up and give a talk. I have to say- 

Ryan Avent: Crowds will mass and give their views on what the yeah. 

David Beckworth: Exactly, I just haven't seen it yet. Now I know the conference in Chicago is still slated. I've heard people have been invited to that. I haven't seen all these big public events at regional banks, so I'm not so hopeful this actually is going to amount to much. What is your take? 

Ryan Avent: I'm a lot less hopeful also than I was a little while ago. I mean, there's a few reasons for that. I mean I think there has been a sense of complacency that's crept in. If you talk to Fed officials, they feel like they keep pointing there, “Look at the payroll numbers. Look at the unemployment rate. We're doing an incredible job. We don't need to switch things up. You guys should be patting ourselves on the back.” I think the more the economy kind of stays in this groove that it's in, the less they feel like something fundamental needs to change. That's very shortsighted right because- 

David Beckworth: Very shortsighted. 

Ryan Avent: ... when the cycle turns and it will eventually, then you're going to be in a much more difficult position. I think also if you kind of look at the way they've approached the inflation target over the last few years, that also to me gives evidence that they're less worried about the framework than they ought to be because if they were concerned, they would be working much harder to make sure we're at two percent on average, that they're not tightening too quickly. They'd be very eager to make sure that we have room to get nominal interest rates up higher, and they really haven't I don't think. They've been content to have inflation maxed out at two percent rather than go above it. I'm not super hopeful about where this is going to go. 

Ryan Avent: I guess my even at my kind of most optimistic, my view has sort of long been that it's not going to be the central banks that end up changing the framework, that the framework will change when they feel a lot of pressure from politicians and others to do something differently, when the message comes down, “Now you guys have to target NGDP” or whatever, that they're just fundamentally too conservative to make that shift on their own. 

David Beckworth: Yeah now maybe that's what credibility would take, but I agree, now is the time to be making a change. The irony of this is if any Fed officials are listening is back in 2011, you did not make a change when this was discussed, that they had to talk about nominal GDP level targeting, talk about price level targeting it's in the minutes and the transcripts, they did not make the change in the end because the argument is we can't change forces mid-stream. Well they were just about to get into inflation targeting, and they didn't want to be in the middle of all this QE. They didn't want to do something too destabilizing in the midst of a weak recovery. Okay I could buy that back then, but now it's like, “Well it works well enough. We don't need to rock the boat now.” It's like there's no perfect time. I mean if you don't prepare for the event ahead of time, when the time comes, you're going to find an excuse again to put things off. 

Ryan Avent: I guess it's great that they want to have a listening tour or whatever, but we've had 10 years of people publishing papers on what alternative frameworks might look like. I mean there have been papers presented at the conference in Jackson Hole. You've had Ben Bernanke after he left the Fed and was at Brookings saying that “Maybe we should have this sort of temporary price level target when we hit the zero lower bound.” It's not that there are a shortage of good ideas out there, and they just don't know what the alternative could be to a two percent inflation rate target. I don't really understand why this is the approach that they're taking, but maybe we're being too pessimistic now, but I certainly don't think so. 

David Beckworth: To the extent they were actually doing this, and actually making a lot of noise, a lot of publicity, a lot of public scenes, this would be a good way to build up the credibility to a regime change. Take a year to build the public case that we're going to go to a price level target, nominal GDP target, because it'd be hard to just announce something to make it credible. I think this is an opportunity for them to build it up, but they haven't, and I guess that's my concern, they haven't been. There hasn't been Jay Powell hasn't gone around, Richard Clarida hasn't gone around and made the case for why this regime might be better than that regime, or listening to what the people have to say, so I think that's important. I agree, I'm a little concerned, and I'm going to give an example of one development, which in my view went below the radar screen in the last meeting, and that's because I had a strong prior on this, but the Fed announced that it was going to stick to the floor system last meeting. 

David Beckworth: It had an announcement, a forum in addition to the minutes, to the press release, and then Jay Powell was very explicit in his press conferences. He read a statement that “We have decided to indefinitely stick with the floor system, as opposed to going to an asymmetric corridor system.” I have strong views, and we can have a debate over that, but I don't want to get into a debate of floor versus corridor. What it tells me is he said previously we're going to have this extensive debate over what operating system and poof it's done. The Fed had some internal debates, and I could read from the minutes I knew where it was going. They've convinced themselves, but I really believe the reason they did this is because it works well enough as opposed to what's optimal. Again, maybe you could argue it is optimal, but I didn't seem to me to get a big hearing, a big public hearing. That one, that's water under the bridge. 

David Beckworth: The next one, the water coming toward us is what regime level targeting, higher inflation target, nominal GDP level target. I hope that's also just quickly wipe our hands and move on. 

Ryan Avent: I mean you raise an interesting point which is that there's sort of an inherent difficulty here for the Fed, because if you think that you need to make a change in the regime, then probably you feel like you need to make the case to the public that the current regime is inadequate, but then that creates risks. If you think that you might have to face a recession here sometime in the next year or two, the last thing you want to be doing is going around and telling everyone, “We're not able to fight this coming recession. Whenever it hits, it's going to be really bad because we're not prepared.” In a way, you can't publicly make the case that you need to make for a change in framework, but then if you're never able to make the case, maybe you feel like it's going to be hard to make a change. I don't know how much they're grappling with that internally. 

David Beckworth: That's a fair point. 

Ryan Avent: Then I also do get the sense that internally they're not having sort of quiet internal discussion either to the effect that the current system has its shortcomings. I don't know, but I'm not hopeful. 

David Beckworth: Inertia is a strong force. Status quo bias affects all of us. You're a big institution, it's hard to move, big tanker it's hard to turn around, completely understand that. 

Ryan Avent: I mean I think when you look back historically at the things that have led to big shifts in how monetary policy is made, I think a lot of times it has come from external political pressures, whether that's elected governments taking countries off the gold standard, or whether that's Margaret Thatcher saying that we're going to pursue disinflation, it usually is not the central bank I think that ends up making these big regime changes. They're being forced to do so by political actors, and maybe that's what has to happen. It's intriguing, maybe we should get these Green New Deal supporters out there talking about why it's important to have a nominal GDP target. 

David Beckworth: We need somebody. I guess the one exception some of our listeners would think to that comment is maybe, “Well what about Paul Volcker? He liked inflation.” I would argue even Paul Volcker operated within the confines of Congress right? He was almost impeached, there was a bill to impeach him, his life was threatened. If you read some of the history, that's when some of the Fed started taking security seriously, the Board of Governors. Even Volcker was under certain constraints. The way I kind of meta interpretation of that period is the public to some extent even if they didn't like the recession elected people who tolerated what Volcker did. Volcker could have easily been kicked out. I mean he could have easily been, and the problem the high inflation, high employment problem could have been going on for another decade. There was enough political support. 

David Beckworth: To me, I think you're right, there's a bigger political public support behind this. Maybe you need a Volcker, it could be a catalyst, but he has to have the support. Maybe you need a bold chair at the Fed to say, “Hey we've got to do this”, but you've got to have the support behind it so. 

Ryan Avent: I think you're right. Volcker had a memoir that came out late last year where he talked a bit about this, and sort of says that he had some concerns that he wasn't going to be allowed to kind of follow through in the way that he wanted to, but got the assurances he needed from Carter and then later from Reagan, and understood that there was the kind of political backing for a change that people were sick of inflation and were ready to have the central bank to have a go at it. Yeah, I just don't people are upset about all sorts of things to do with the economy. There's no consensus I think that this is something that has any roots in the monetary framework and that we need to change in that direction until we get that. 

David Beckworth: Maybe you do need a crisis, we need to get bad enough before you're going to go in and do surgery so okay. Well, we'll have to wait for the next crisis before we can get nominal GDP targeting sounds like. We'll keep fighting the good fight here at Macro Musings podcast, hopefully people are listening. All right, speaking of the Fed, an interesting article came out from the San Francisco Fed, it's a working paper, research paper, and it speaks to something that you and I both have extensively surmised, we've argued, we've made the case, but the Fed’s two percent inflation target is more of a ceiling, and it's not truly symmetric despite everything that's said, everyone arguing at the Fed to the contrary. 

David Beckworth: Two columnists at the San Francisco Fed Adam Hale Shapiro and David Wilson have a new working paper titled, “Taking the Fed at its Word: Direct Estimation of the Central Bank's Objectives using Text Analytics.” They literally go through the transcripts, they're able to go through 2013 the most recent transcripts are available, so it would be nice to see this more recently. We have to wait five years for the present, but they go through, and they do this text analysis, which is a big thing now. People go through like here at Mercatus, we go through regulatory data looking for patterns. Here, they're looking at what is the target these Fed officials want, and here's what they find. They say, “We find that the FOMC had an implicit inflation target of approximately one, and a half percent on average over a baseline 2013 sample period.” Boom, there you have it. 

Ryan Avent: That's it? That's case closed, right. 

David Beckworth: Right I mean- 

Ryan Avent: I mean it's nice to have this interesting textual analysis. I think that's a really interesting contribution to the discussion, debate. As you sort of noted, it kind of if you look at the behavior of inflation, it's hard to avoid the conclusion that there's not some sort of hard barrier at two percent. Yeah I'm not really surprised. Whether that, I guess the question would be you could say is it really about, and I haven't looked at the paper, maybe they get into this, but is the nature of the two percent ceiling that they're sort of actively working to keep inflation below it, or is it that they just are consistently making mistakes in their forecast of how conditions are going to translate into inflation in the future? If you can kind of go back and look at the projections, they're always, always too high, they're always overestimating the extent to which drops in unemployment are going to translate into increases in inflation. 

Ryan Avent: Maybe it's sort of accidental and they're just not very good at their jobs, or maybe it's they're bad at their jobs in a different way, and they're doing this on purpose but I don't know. 

David Beckworth: The thing is, if you take that latter view, that they're just their model's wrong, they're getting it wrong, they've been getting it wrong for a decade. I mean I know the target starts in 2012, but implicitly, they were doing it before then. As you mentioned, revealed preferences as seen in the data says the core PCE deflated inflation is about one and a half percent over the past decade. They are systematic. You're talking about economics have an unbiased air term. They have a very biased air term in their model and they're either not learning, or maybe they actually want this. 

Ryan Avent: It's like if you're turning into a parking garage, and you always make the turn too quickly and scrape the side of your car on the column, how many times you have to do that before you're like, “Maybe I should not cut there, I'm quite surprised.” They've got a lot of scraped cars there at the FOMC. 

David Beckworth: They do. Jay Powell's learning that his car's getting scraped too. 

Ryan Avent: Does he drive himself? He probably has a driver. 

David Beckworth: Right, true, true. Secret service vehicles getting scraped a lot. This maybe goes back to the earlier point we're making earlier that maybe they're in some ways they're bound by the regime we're in, that there's a low inflation regime, there's political support for low inflation, the Richard Fishers of the world, which by the way the same article they go and identify individuals' stated preferences. He has the lowest one at one percent inflation. The point is, there's this kind of broad public support for a low inflation regime, it's very credible. We saw this with Bernanke during the crisis, what kind of grief would they get if they did allow like a temporary overshoot? That's why I come back to some extent it's not an accident they hit one and a half percent. They're really kind of a slave to the regime, and that's how do you get from one regime to another? Maybe you need a crisis, that or slow conversion of the public which is what we're trying to do here. 

Ryan Avent: It is interesting though I mean the way that there's sort of a ratchet effect. If you go back after the Volcker inflation and in the 80s, a lot of people sort of look back at the late 80s and say, “This was a great economy. It was really healthy and everyone was sort of pleased with in”, you had inflation rates there at the sort of three to four percent right? In the 90s if you go back, this was not accepted towards 98 when you had commodity prices plunging in the Haitian crisis it got lower, but for the most part over the course of the decade, inflation was above two percent. It's sort of what we're willing to accept, or what we consider to be unacceptably high. Inflation keeps falling over time, which is an odd thing. Maybe that's related to demographic change or something of that nature, what seems okay to us shifts over time. Someone just looking at the chart says, “The late 80s were fine. I really don't get why we couldn't have a go at that again.” 

David Beckworth: It doesn't seem to be in the cards so. To be clear to listeners who may not be up to speed, what we're really saying here is at least in my view, I think Ryan shares is but I'm speak for sure on my behalf, when I say one and a half is disappointing relative to two, what I'm really saying is there is it implies a level of aggregate demand or spending that's been depressed. That trend in inflation is a symptom or low nominal GDP growth. There's temporary spikes for caused by other things, but if the trend inflation rate is lower than what you want, it must be the case that trend aggregate demand or trend nominal GDP trend spending is low, which translates into lower dollar incomes for people. If you take the argument there's hysteresis effects, you destroy productive capacity over time, that could be even greater consequences to all of this. 

Ryan Avent: Yeah absolutely. I think it's you want to make sure there's adequate demand. I think it's interesting to think about views relative to available slack in this context. If you go back to 2015, probably even 2013, you can find people on the FOMC saying, “We're getting there. We're close to full employment.” Maybe that's a piece of evidence that it's less an intentional thing but kind of excessive optimism on their part. I think a lot of people would have been shocked five years ago if you told them that we'd be here with unemployment where it is where payroll growth is 200 plus thousand per month, and inflation is where it is. I think it is hard to say whether this is a failure to learn from experience or broader political agreement that low inflation is what we want. 

Ryan Avent: Either way, we're causing unnecessary harm to the economy. It's a shame that we can't fix that. 

David Beckworth: That's fair. I was being very strong that they're just bad learners, but it's true. I think it's a fair point. This actually reminds me of the Orphanides’ work in the 1970s where he goes back, and says, “Contrary to popular opinion, if you take a Taylor rule to the 1970s data, and you plug in real time estimates of the output gap, that the Fed wasn't actually doing that bad of a job.” Kind of the conventional story was the Fed was really awful. Arthur Burns and the Fed for whatever reasons they were just being way too easy. His point is that part of the story is they just in real time they purposefully overstated or misstated the output gap, the data was horrible. You take that kind of thinking to the present, what you just said is they persistently underestimated the amount of slack and elasticity in the economy, which demand is not fulfilled the entire real side of the economy. 

David Beckworth: They could be having the same issue, really bad data. That speaks maybe they need to invest more in data collection, spend some of that huge profit the Fed’s earning that's better information systems, I don't know. Again, a decade of mistakes even if they weren't intentional suggest better learning from experience is needed. 

Ryan Avent: Well I think yeah I mean I think that's absolutely right. I also think that at some point you have to start becoming aware of the fact that the information that you're receiving is not as precise as you might want it to be, and so then you have to adjust your aim essentially. I'm always tweeting, “Why not try overshooting for once?” If it's this unclear to them what the extent of the output gap is, that given the balance of risks, why not just, let's just try a little bit harder to hit that upper bound and then maybe learn something that they haven't so. 

David Beckworth: Or you could try a nominal GDP target- 

Ryan Avent: You could try, exactly. 

David Beckworth: ... you don't even have to know what the output gap is. 

Ryan Avent: Then you can be agnostic about it right? Exactly. 

David Beckworth: Exactly. That's one of the huge positives, you don't have to play God with the primers of the economy, you just say, “Look, we don't know, let's just stabilize total spending.” 

Ryan Avent: Makes sense to me. 

David Beckworth: All right well on that happy nominal GDP targeting note, our time is up. Our guest has been Ryan Avent. Thanks so much for coming on the show. 

Ryan Avent: Thank you, David. 

David Beckworth: Macro Musings is produced by the Mercatus Center at George Mason University. If you haven't already, please subscribe via iTunes or your favorite podcast app, and while you're there, please consider rating us and leaving a review. This helps other thoughtful people like you find the podcast. Thanks for listening. 

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