Ramesh Ponnuru on the Politics of Monetary Policy

Ramesh Ponnuru is a "National Review" senior editor, "Bloomberg View" columnist, and a visiting fellow at the American Enterprise Institute. Ramesh has written widely on many topics, from healthcare reform to tax policy, to national security. He writes regularly on monetary issues for the National Review, Bloomberg View, as well as other outlets like "The New York Times," "The Atlantic," and "The New Republic." Ramesh joins David to discuss the former’s adventure into monetary economics. Ramesh shares his thoughts on some of the current-day misconceptions surrounding Federal Reserve policy and makes the case for a more nuanced, yet rules-based approach toward monetary policy.

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Note: While transcripts are lightly edited, they are not rigorously proofed for accuracy. If you notice an error, please reach out to [email protected].

David Beckworth: Ramesh, welcome to the show.

Ramesh Ponnuru: Thanks for having me.

Beckworth: I want to begin by asking how you became so engaged in monetary issues. That wasn't your natural background, correct?

Ponnuru: That's right. I had some interest in it in the 1990s. I had been an intern at the Institute for Economic Affairs in London one summer. IEA published George Selgin's paper, "Less Than Zero," on the case for productivity norm which is to say for a mild and gentle deflation in conditions of rising productivity. I thought that was interesting and convincing. I sort of filed it away in the back of my mind.

A few years later, there was one of these periodic panics in the late 1990s about the threat of deflation. I commissioned an article from Professor Selgin making his case for National Review.

Then I stopped paying a great deal of attention to monetary issues for the next decade or so. I guess like a lot of other people I was lulled into complacency by the great moderation and the thought that the Fed seemed to be doing a relatively good job. But then of course the economic crisis hit, and I was starting to write a little bit more about the monetary debate which began to heat up again in 2009 and 2010.

I called up Professor Selgin, and he suggested that I look at a blog, Macro and Market Musings, by you. I started reading you, and then through you, Scott Sumner and others. What can I say? You convinced me.

Beckworth: Thanks. It's interesting you mentioned George Selgin, because he was also my major professor. In some ways we're both students of Selgin, which is interesting. I recall an article from 2003 you wrote in the National Review, when you were going over these different views of deflation. You put forth Selgin's argument, there's both benign deflation and malign deflation. I believe that's the first introduction I have of you. Did you write anything before that, or was that the first...

Ponnuru: That may have been the first thing I wrote.

Beckworth: I remember reading that. Interestingly, the productivity norm which you mentioned, which is Selgin's signature approach to monetary policy, is really a nominal GDP rule. It's just a special case of it, a special form. That was my first introduction to it, and I guess it would be yours too. Little did I understand the full implications of that until the crisis came around.

We both trace our roots back to Selgin, but I want to move forward to the crisis. Both of us, I think, learned a lot. I know I learned an immense amount of monetary economics, more than I ever imagined, because of this crisis. We wrote some articles together about this. One of them is "Monetary Regime Change" in 2012. We also wrote "The Right Goal for Central Bankers."

I want to hear your view. What do you see as the big lessons that we've learned from this crisis, and the slow recovery that followed it?

Economic Lessons Learned from the Great Recession

Ponnuru: I don't think "We" have learned many lessons, if we mean "We" in the sense of our society or policymakers, generally. It always strikes me when I write about these things that it took decades for people to absorb what we now tend to think of as the lessons of the Great Depression.

At the time, as people were living through it, they didn't think that what had gone wrong was a catastrophically tight monetary policy. In fact, the Federal Reserve thought it was doing a bang‑up job. I think that the lessons still remain to be learned. In my view, those lessons are several.

One is that, looking backward for what has been happening to inflation, is the wrong way to go. To the extent that you're trying to have inflation be your guide to monetary policy, you should be looking at forward‑looking, market‑based indicators of what the inflation rate is going to be and TIPS spreads are what we tend to look at or models based on TIPS spreads. That's one thing.

One other big one, which we should've already known and this is something that Sumner stresses all the time, is that, we shouldn't think that low interest rates are a sign that monetary policy is accommodative. That is something you see over and over and over again everywhere you look in the financial press.

People are suggesting that we've had this ultra‑easy monetary policy. The fact is that a very low interest rate can in fact be a sign of a very tight monetary policy. It could be a sign of a monetary policy that's so tight that the economy has been choked off and investment opportunities have been squeezed.

Beckworth: Yes. In fact if you look at the 1970s, we had really high interest rates and if you took that line of reasoning you might conclude, monetary policy was really tight, but we know, as a matter of fact it was very loose.

There is this confusion and it comes from I think both economists like myself and you do a better job of educating students but also from policymakers that interest rates are the signal or the sign of monetary policy. You mentioned inflation being something you've grown more skeptical of as a measure or a guide for monetary policy.

What are some of the challenges with it? I know one of the big things that you've written about is that supply shocks really throw off a simple bank that targets inflation. Can you explain that?

Supply Shocks and the Inflation Target

Ponnuru: My mind goes back to Selgin in less than zero. He makes this case that if you have a negative productivity shock, and I think the example he uses the oil embargoes of the 1970s, then that the natural consequence of that is going to be the prices rise.

If your Central Bank tries to prevent that from happening because it has a rigid price stability mandate, let's say a zero inflation mandate, then it's going to make the hit to the real economy worse than it would have to be just from the mere fact of the embargo in the first place. You have, instead of acting as a shock absorber you have made the shock worse.

Similarly, if you have a pleasant surprise in productivity and that has a deflationary effect, then in trying to counter that in the name of price stability you are going to be stimulating an economy that's already doing well. So you have this perversely pro‑cyclical policy.

It follows, although I actually didn't draw this conclusion at the time, that inflation just isn't the right indicator to look at. One of the great things about nominal income or nominal spending is that it automatically adjusts for those supply shocks either positive or negative.

Beckworth: Yeah, I find this remarkable that this far after the crisis there's still such strong belief in flexible inflation targeting. If you look at the Federal Reserves in 2008, it was highly worried about inflation so what did it do with settlements at hands. It waited for the economy to collapse. In Europe, the ECB actually tightens in 2008 because of inflation concerns in 2011. It tightened twice.

Looking back we now see those were supply shocks. Those were driven by these commodity price shocks. They weren't demand shocks. It is pretty evident in 2008 demand wasn't overheating but the way the Fed acted, it was interpreting inflation as though it was. That's the issue with inflation. It's a symptom not the underlying cause we want to address?

Ponnuru: Now, if you look at the mid‑September Federal Reserve meeting when you were already seeing pretty significant signs of economic stress, the Fed cites the danger of inflation. This is at a time when those market‑based indicators of inflation were already plummeting but again they were looking through the rearview mirror.

Beckworth: Right. One thing that flows out of that, if you want to address inflation, stabilize the inflation that arise from demand shocks, but we don't want to respond to ones that arise from supply shocks. So what is a policy, what's the obvious policy choice that falls out of that understanding?

Ponnuru: I think what you should have is a target for nominal income, nominal spending, nominal GDP. All of these things are economically equivalent.

Under such a target inflation would rise and fall in the opposite direction of productivity. Basically what the Federal Reserve would be saying. For example, "We want nominal spending to grow at a 4.5 percent rate each year."

In years when productivity is good that might be 3 percent real economic growth and 1.5 percent inflation. In years when productivity growth is bad maybe that'll be 1 percent real growth and 3.5 percent inflation.

The Central Bank doesn't actually need to know what is happening with productivity in that year. It just needs to stay on its target.

Nominal GDP Targeting

Beckworth: That's one of the nice features. It gets past this knowledge problem. The Fed doesn't have to play god, try to divine when inflation's moving, because it's supply or demand.

To recap, what you're saying is that if I focus on stabilizing spending or demand the composition can change and what was the money spent on. The amount of money growth, spending, is consistent.

Sometimes it's higher inflation. Sometimes it's higher real growth. It depends. Let the market, the real relative prices, sort it all out.

Ponnuru: You're right. To take a step back, the idea is that if you're going to have a central bank, what it should be doing is creating a stable macroeconomic environment in which people can make their own long‑term plans and coordinate with others.

What environment is that? I think if you think it through the answer is an environment in which you can roughly predict how much total is going to be spent, is going to change hands in a given year.

It's not as important to be able to predict the price level 10 years from now as it is to be able to predict how much is going to be spent in the economy 10 years from now. That's for a few reasons.

One very important one is that most labor contracts and debt contracts are written in nominal terms. If somebody's trying to figure out if they're going to be able to afford a 30‑year mortgage, having a sense of what the nominal income trend is going to be across the economy is pretty important.

Beckworth: If you look at the countries during the crisis that effectively did something like a nominal GDP target or kept demand stable during the crisis, Australia, Israel ‑‑ they did much better during this crisis period.

The ones that did the worst were the US, the Eurozone. In fact, the Eurozone continues to do poorly.

These countries weren't necessarily targeting in an explicit fashion nominal income or nominal GDP, but effectively they were doing that. The contrast is stark, how different things turned out for those countries.

Ponnuru: Also, look at the example of the United States during the Great Moderation. Josh Hendrickson has made the case that, whether or not it was explicitly targeting nominal spending, the Federal Reserve did a pretty good job of keeping its growth on a pretty steady trend line.

I think partly we learned from experience here that an unstable and rapidly accelerating growth of nominal GDP in the 1970s wasn't good. Plummeting in GDP in the 1930s or in 2008 to 2009 wasn't good either.

The steady growth of, let's say, 1983 through 2007 was a pretty good economic environment. To the extent it was flawed, it was flawed when we deviated from steadiness.

Beckworth: There's been an increase in awareness of nominal GDP targeting thanks to the efforts of you and others, like Scott Sumner. There was even at some point a discussion at the Federal Reserve of adopting it.

It didn't happen, but at least they discussed it. Some other central banks have talked about it, but it hasn't occurred anywhere. I think part of that is that there's still some misconceptions about nominal GDP targeting, both by central bankers.

You had a piece out in Bloomberg Review, I believe, where you talked about Bernanke's concerns that nominal GDP targeting has a communication issue. Can you speak to some of these misconceptions about nominal GDP targeting?

Ponnuru: In Bernanke's case the worries seem to be that the Central Bank has built up credibility with an inflation targeting regime. That would all be thrown away if you abandoned it for a new nominal GDP targeting regime.

He's mistaken on two points in my view. One is that you could very easily move in an incremental way towards nominal GDP targeting. If you have flexible inflation targeting you can view nominal income targeting as a kind of flexible inflation targeting where the flexibility is constrained by a rule.

You would say, for example, "We are targeting an average inflation rate of two percent, but that rate is going to go up and down around that average depending on productivity."

Once you've done that you've got, effectively, a nominal spending target and you can slowly move in that direction. Eventually you can say, "Guess what, we're on a nominal spending regime and we have been for a few years."

That's number one. Number two, I think that there's a political judgment that's simply mistaken, because if you're going to have an inflation target, at some point you're going to, as a central bank, have to deliberately try to raise the inflation rate.

That is something that's extremely hard to explain to people, how that could possibly be a good idea. Because when most people hear that the Central Bank is trying to raise inflation, they don't think, "Well, OK, the price of my groceries is going to go up two percent more than it otherwise would, but so will my wages."

They just see the first part of that, that it's an increase in their cost of living and therefore a bad thing. They think it's perverse.

One benefit of a nominal income target is you wouldn't ever have to try to communicate the case for rising inflation. You would instead be saying, "We're providing stability in nominal income levels."

It would be a little bit novel for people, but you wouldn't ever have to be in that situation where you're trying to raise inflation rates. Inflation rates might rise as a byproduct of the policy, of course, but it wouldn't be your goal.

Beckworth: I think people can identify with stable income growth. As you mentioned earlier, maintaining the ability to pay for your debt contracts and other obligations they've incurred in dollar terms.

Ponnuru: One other great misconception is because of the context in which the recent discussion of nominal income targeting has occurred. It has made the idea seem like a kind of dovish idea, like the idea is to have higher inflation.

As we were discussing, I actually got interested in this from the other side of it. I was interested in it as a way of achieving a gentle long‑term deflation and having really a tighter average policy than the Federal Reserve had run for decades and decades. This is just a contextual issue.

There's no necessary connection between nominal GDP targeting and dovishness or hawkishness. Instead it is a way of determining when the Fed should be more hawkish and when it should be more dovish on the principle that it's kind of absurd to be dovish or hawkish under all circumstances.

Beckworth: I wonder if many of the advocates and fans of nominal GDP targeting beyond the right ‑‑ people on the left, because there are a number of individuals who also were excited about it on the left ‑‑ would they stick with it once we got past the recovery, we got to a boom, productivity accelerates and the implication leads to low inflation, maybe even mild deflation?

Would you still have that same kind of support from the left?

Ponnuru: I do think that there is suspicion on the right and enthusiasm on the left based on the same misconception that this always pushes you in the direction of more looseness, so it's hard to say. However, I would say that during the great moderation, the voices on the left for a looser policy were pretty contained. It was not a constant challenge beating them back.

Beckworth: I think there is a way to sell this to people on the left as well as to the right. On the left I think one of the big issues is, if you have a nominal GDP target that allows the price level to gently fall but also stabilizes nominal incomes, as you mentioned earlier, that means real wages will be growing.

One of the big concerns you read about a lot these days is the advent of smart machines and robots taking over our jobs ‑‑ rapid productivity growth, capital getting all the income, labor getting none.

One way for labor to share in that rapid growth would be through a gently lower price level. I think you could pitch that to them. Do you think that would be something they would buy or would it, be a tough sell?

Ponnuru: The psychology of American liberalism is sometimes beyond my ken, so I won't try to make any authoritative judgment on that one.

Beckworth: Let's talk about the Fed now. We've talked about how nominal GDP targeting seems like a great idea, but let's move onto the Fed itself. You've written quite a bit about the need for rules‑based monetary policy. You had a recent Bloomberg View column titled, "The Fallible Fed Needs a Few Good Rules."

I believe the motivation for it was the knee‑jerk response from many Fed fans, Fed officials, to calls to audit the Fed, the Fed Oversight and Modernization Act that would have the Fed state a rule that it would follow.

It would be a non‑binding rule, wouldn't actually force the Fed to follow it, but if the Fed did deviate they'd have to give a report to Congress. What is your argument for a rules‑based Fed, and what do you think of the push back we've seen against it?

Arguments for a Rules-Based Fed

Ponnuru: Whenever a proposal for rules‑based approach is made, I think there are two classes of arguments. One is that the particular rule that is being promoted is a bad rule, and if it's not a particular rule that's being promoted, that a bad rule could end up being adopted and this would have all kinds of negative effects.

That's true, but then there's the second class of argument which is central banking is an art, not a science, and the Fed has to be left free to work its magic. I think the second category is completely absurd if you look at the central bank's actual track record. The Federal Reserve's actual track record is not especially good and has sometimes been disastrous.

The 1930s catastrophic depression ‑‑ largely brought about by the Fed. The 1960s and 1970s inflation ‑‑ the Federal Reserve's fault, and I believe over time people will see that the boom‑bust cycle that we have been through most recently is also the fault of the Federal Reserve.

It doesn't seem to me that there is this fantastically well‑performing institution that we have to avoid interfering with. It seems to me we have a pretty badly‑performing institution. That doesn't mean that things couldn't get worse. As a conservative I believe that things can always get worse.

Some of the rules that people have talked about do strike me as bad ideas. I think it's completely unconvincing to argue against it on the basis that the central bankers all know what they're doing. I think they demonstrably don't.

Beckworth: Over the past few years I think one can reasonably say that the Fed has been incredibly ad hoc. You look at QE, QE1, QE2, Operation Twist, QE3, those were all made up on the fly.

No‑one knew for certain when they would start, when they would end, and the forward guidance the Federal Reserve provided was really a moving target. They kept changing the dates when it would end, they changed to an Evans rule, that was finally dropped ‑‑ very ad hoc.

If you look at the actual speeches by Fed governors and Fed officials, often they'll say very different views, send different signals. Sometimes I wonder if even Fed officials know what they're going to do at the next meeting. It seems to be very ad hoc.

If you look at every time Janet Yellen gives a press conference after an FOMC meeting, it's something that everyone watches very closely, every word that comes out. There's this increased reliance, this increased interest in what the Fed's doing as discretion increases, so a more rules‑based approach would eliminate some of that, would at least provide some certainty?

Ponnuru: Again, the intuition is that the point of the central bank is to provide stability. It can do that better if it is adhering to a rule that makes its behavior predictable. An environment in which nobody knows what the Fed is going to do in three months because it's all a great mystery and not governed by any rule is the opposite of that.

You can see the attraction of it, and I should stipulate that I assume that everybody at the Fed is well‑meaning, but I do think there is an institutional aversion in almost any institution to being held accountable and to seeing its discretionary power reduced.

You don't have as free a hand to do what you might want to do if you have to obey a rule. People can say, "You said you were going to do this, you didn't do this ‑‑ you failed." They don't want to be held accountable in that way.

Beckworth: I suspect that's behind some of the push back against the FORM act and other bills started at the Fed. What would be some incremental steps the Fed could take to make it more rules‑based?

We would love to go to a rules‑based nominal GDP target, but in the absence of that, you've mentioned before the Federal Reserve may be releasing its estimates of its own short run natural interest rate. Would that increase the transparency about the Fed, make it more accountable in some sense?

Ponnuru: One value of that would be improving its communication strategy, not necessarily even telling us what it's going to do next but telling us why it is doing what it is doing now. One of the great confusions about Federal Reserve policy in recent years has been, again, this idea that it is keeping interest rates low and that this is a very accommodative policy.

If the Fed were to say in 2010, for example, "We estimate that the natural or equilibrium interest rate right now is negative," then two things become clearer to people.

One is that the Federal Reserve isn't actually being all that accommodative, that in some ways it has actually a tight policy because its target interest rate is higher than its estimate of what the natural interest rate is. The second thing is why it thinks that target interest rate is appropriate, the answer again being that it believes it's appropriate because the natural rate is so low.

Beckworth: Let's say they did that. One of the concerns I have is that people on the right would still have a hard time buying the argument that interest rates can go negative. Whenever I've brought this up and you've brought this up, people have a hard time. They always claim the Fed has artificially lowered interest rates, they can do that.

I believe for example in the early to mid‑2000s, during the housing boom, it contributed to some extent to the excesses. It lowered rates too low for too long. During the crisis, I share the view that rates were negative, the equilibrium rate was negative, and to me it makes sense from a free market capitalism perspective.

Sometimes prices go up, sometimes they go down. In really severe crisis, prices have to go down sometimes to clear the market. The interest rate is simply an inter‑temporal interest rate ‑‑ it's a price for goods across time. Why is it so hard to get that point across to people on the right?

Ponnuru: It's very complicated. I find when I'm writing about it I want to say something about how it's not the Fed's fault that interest rates are low, it's that the natural interest rate is so low, but I stop myself before I write that because it's not quite correct.

The Fed can also lower the natural interest rate if it creates uncertainty about whether it's going to keep nominal spending on track. If it creates the expectation that it might let nominal spending plummet in the future, that is going to have a depressive effect on natural interest rates.

I think that it's probably more important to avoid the situation in the first place where the natural interest rate goes negative. Here I think we should mention another aspect of this, which is that it's not enough to just target nominal income at say four and a half percent. You also need the Fed to commit to making up for past errors.

If it allows nominal spending to rise at only four percent one year, it goes up to five the following year, and vice‑versa ‑‑ if it does five percent, if it overshoots its target, then it undershoots the next year ‑‑ the idea being that it's the long run path that it's trying to stabilize, and that you shouldn't have more and more uncertainty as your time horizon gets longer.

What I think that helps do is create a floor under interest rates when there's a shock, that there is this expectation that the Fed will not, in the long run, allow this shock to knock it off course, and therefore you don't have as sharp a market reaction in the first place.

You can do that, and I think you should do that, with the price level as well. If you're going to have an inflation target, it should really a price level target where higher inflation in one year is made up for by lower inflation the next year. Again, the idea is to set that floor, to make the long run more predictable, and to prevent you from getting into a situation where you've got negative natural interest rates.

Beckworth: How would that help during a crisis? You mentioned earlier, debt contracts. People took out 30 year mortgages with a certain expectation of income over those 30 years. Explain how that level target you just described would have helped in that situation.

Ponnuru: I think it would've helped in a lot of ways. One would be that people with those mortgages would've had the expectation that maybe right now, servicing this debt is hard, but it's going to get easier because the Fed will step in and make sure that that happens.

The other thing is, I think you wouldn't have had the difficulty in the first place, because you wouldn't have had, the crash in expectations about nominal spending, and therefore you wouldn't have had this panic in which people think it's going to happen, and therefore they stop spending, and nominal spending goes further and further down.

That's the whole point of stabilizing expectations, that it allows people to make decisions on the basis of those stable expectations. You wouldn't have had crashing asset values, which were based on crashing expectations of future nominal income streams. Of course, that had cascading effects for the economy as well, during the crisis of 2008.

Beckworth: That idea has a lot of appeal, but I believe the only place it's been tried is in Sweden. In the '30s, they had a price level target. Many academics like it, but I don't think it's ever been tried anywhere. Not purposefully, we can look again at Australia, and Israel. They had something that looked like it, in practice, but it'd be interesting to see how you could sell it.

As you mentioned earlier, one of the challenges is at times, there would be this catch‑up inflation, or maybe even deflation, if spending got off track. You'd have to tell the people, "Look, we're doing this to stabilize your dollar income." In the short run, that might mean some variation in prices that you're not used to, but in the long run you're better off.

Ponnuru: Right. This is another way in which I think that stabilizing your dollar income is actually more attractive than stabilizing the price level. As I mentioned earlier, you do, in some cases, if you're talking about price levels or inflation stabilization, you do have to commit to raising inflation, and raising inflation as your goal, which is just going to be very counterintuitive for people.

Beckworth: This is the presidential election season. We've been hearing some debates, and you've written about the Republican candidates. You have a column where you talk about some of the misunderstandings that the Republican candidates have. Can you speak to that? What do they get wrong, what do they get right?

Ponnuru: You've heard a lot about how the Federal Reserve is running a wildly accommodative policy that's holding interest rates down, and that's therefore punishing savers. I think the fallacy there is one we've been talking about. When you've got a very low, or even negative natural rate, interest rates are going to be low, and a looser policy under those circumstances would be good for the economy, and that would ultimately be good for savers, too.

Because a revived economy would feature higher interest rates. We've just got their cause and effect story all tangled up.

Beckworth: What if there had been, in 1929, a nominal GDP level target? Or in 2008? Would that have changed the political dynamics? Absent the great recession, absent the great depression, would FDR have been able to do the New Deal? Would President Obama have had the political motivation, the justification to do the big fiscal stimulus?

Ponnuru: I certainly think that times of severe economic contraction caused by tight monetary policy, creates opportunities for status economic proposals. I haven't studied Argentina, but Scott Sumner makes this case that they actually had pretty good economic policy in the late 1990s there, unfortunately coupled with an excessively tight monetary policy that then led to this left‑wing reaction for several years, that they're still dealing with the after‑effects of.

That's one issue. Another is that it just tends to discredit free markets and capitalism generally, when you have this kind of economic environment. The idea that markets work on their own, with minimal interference, becomes a harder sell.

Beckworth: We have often talked about the ability of monetary policy to offset fiscal policy, kind of a transition to what you were just saying. In 2013, we had an experiment, the sequester. Sizable reductions in the growth of government spending, and other tax changes.

Tell us about the article that came out in The New Republic, that you co‑authored, "Tight Budgets, Loose Money," and the discussion that generated in terms of an experiment.

“Tight Budgets, Loose Money”

Ponnuru: I collaborated with an economics professor, forget his name. Before the sequestration came into effect, and before the fiscal cliff, where taxes were automatically going to rise, our argument was that the Federal Reserve could prevent that change in the deficit from having macro‑economic effects.

We didn't suggest that it could prevent all economic effects. For example, a tax increase would reduce the incentives to work, save, and invest, and the central Bank couldn't make up for that, but these Keynesian arguments where people were predicting hundreds of thousands of jobs lost because of the fiscal tightening didn't have to happen.

If you had a central bank that was targeting either nominal spending, or inflation, doing so credibly, then this kind of fiscal contraction should be a nonevent. Let's say the Fed is aiming for two percent inflation. If the fiscal policymakers threatened to bring that down to 1.5 percent, then the central bank ought to loosen, stay on that two percent target.

The only thing that ought to change, really, is the composition of GDP. For example, if you have spending cuts, less of it will be government, and more of it will be private sector. Similarly, if you have a nominal income spending target of 4.5 percent, if the fiscal policy makers threaten to bring that down, the central bank ought to bring it back up.

Even more than that, even more controversially, we argue that to the extent that markets thought that the central bank was willing to do whatever it took to stay on that target, and a lot of that adjustment would happen automatically. People would expect nominal spending to stay on target, and they would continue to engage in economic activity at the appropriate level to keep it on that target.

Of course, the sequestration actually ended up happening. The tax increases ended up going into effect, and the people who were projecting hundreds of thousands of jobs being lost, including Paul Krugman, turned out to be wrong. Growth actually accelerated, and job growth accelerated, and the people who had been predicting that responded by moving the goalposts.

Beckworth: I want to read a quote by Mike Konczal in the Washington Post in 2013, during the time of the sequester. He brought up this article that we wrote, and he viewed it as a great opportunity to test these ideas, these market and monitoring ideas. Let me read what he said.

"We rarely get to see a major, nationwide economic experiment at work, but so far 2013 has been one of those experiments. Specifically, an experiment to try to do exactly what Beckworth and Ponnuru proposed. If you look at macro‑economic policy since last fall, there have been two big moves."

"The Federal Reserve has committed to much bolder action in adopting the Evans rule in QE3. At the same time, the country has entered a period of fiscal austerity. Was the Fed action enough to offset the contraction?"

That set the stage for an interesting debate, as you bring up. Of course we responded, Scott Sumner responded. This discussion went on, Paul Krugman, of course he jumped on that. He endorsed Mike's question, Mike's experiment. Where did it end up? What was the conclusion? Any consensus on this great experiment?

Ponnuru: Well, I think the conclusion is that Krugman and Konczal have moved on, and decided not to talk very much about this, because the results were pretty good. It wasn't, as you mentioned, a test that we set up. It wasn't a test under ideal conditions for our point of view.

For example, it's not as though the Fed had committed to a nominal spending target, or to catch up if it missed its target, but even under the fairly weak conditions that we faced. We passed the test. The predictions of doom didn't happen. In fact, you had an acceleration of growth.

The alleged harms from austerity just didn't take place. Now, to be even more controversial, I think that if our basic argument is right, it also follows that the conventional wisdom that the economic stimulus of 2009 was successful, is very flawed.

For the most part, when people are making that argument, they're using a model which says fiscal stimulus must've worked, because we assume that fiscal stimulus works. Those models don't take into account the possible responses of monetary authorities.

I think that, in the absence of fiscal stimulus, the central bank would've done more. Maybe would've tried for devaluation, would've announced a level target, would have done more QE, earlier, in order to keep deflation from setting in, or inflation from running too low. You would've ended up with approximately the economic performance you ended up with, but with a lot less federal debt.

Beckworth: It's both rewarding, but also frustrating, looking back at that experience. On one hand, it does show this ability of the Federal Reserve to offset what happens to fiscal policy. At the same time, it demonstrates how religiously devoted the Fed is to that two percent inflation target.

That two percent inflation target puts a floor under the economy. Any fiscal contraction is offset, but also puts a lid on it. There's a ceiling to how fast nominal income could grow.

Ponnuru: I think you have to question whether the Fed actually does have a two percent inflation target. Maybe what it really has is something like 1.4 to 2 percent inflation range targets, in which it is much more willing to see error on the downside of two percent than error above two percent.

If you look at its recent decision to raise interest rates, I don't think under the circumstances we're in that it's a catastrophic decision, the way, say, the ECB's decision to raise interest rates in 2011 was a catastrophic decision. Inflation, and inflation expectations are running below that two percent, and you raised interest rates anyway.

If two percent is really your target, and you really believe that the average inflation rate over the next decade should be two percent, I think it's very hard to rationalize that decision.

Beckworth: If you look at the actual track record, as you mentioned, they've consistently gone between one and two percent. An average of about 1.4, as you mentioned. It's like if you're doing target shooting, and you're aiming for the bull's eye. Occasionally you should go above, occasionally you should go below, or to the side, but on average, you hit that target.

What the Fed's doing is consistently heading beneath the bull's‑eye. After some point, you realize that's not just an accident, it's not a down‑wind. It's a bias, a systematic part of the Fed. If the Fed's not meeting its own stated inflation target, something is wrong.

I'm going to come back, now, to the Republican candidates in the time we have left. In particular, Ted Cruz ‑‑ he's made a number of statements about monetary policy. One, in particular, that caught my fancy, that is he argued that the Fed in 2008 actually made things worse. We've alluded to this already.

It sheds a new light on the movie, "The Big Short," on the standard view that it was all housing boom, all financial crisis. Can you shed some light on that alternative view?

Ponnuru: Sure. Everybody assumes that the housing bust is what caused the economic crisis of 2008, 2009, and the weak recovery. The story goes, housing crisis causes financial crisis, causes economic crisis.

I think that the timeline fits better with an alternative story, in which the central bank, by running an excessively tight policy at the worst possible time in 2008 causes an economic crash that has effects in financial and housing markets.

The housing market actually peaks, if I remember correctly, at the beginning of 2006. It has a fairly orderly decline for the following two years, where construction employment declined, but overall job growth in the economy makes up for it.

In fact, you have net job growth. What you have is the economy working as it's supposed to work, that resources shift out of a declining sector, and into other sectors. What changes in 2008 is that you have a tightening of policy. You have a Federal Reserve that is overly concerned with inflation, and that is signaling that it's going to tighten policy.

You have that at the same time that market conditions have gotten worse. You've had a recession start. In retrospect, it's been dated to December of 2007. I think you may very well have had a mild recession, but what made it into "The Great Recession," is that the Fed picked that moment to start tightening policy.

Pretty much all through the spring and summer you had Fed policy makers saying, "Danger, inflation ahead. We're going to have to tighten." As I mentioned earlier, even in mid‑September, the Federal Reserve is warning about inflation. Lehman Brothers collapses in September, and the first policy change from the Federal Reserve is to institute interest on excess reserves.

Which is A, a contractionary move, and B, a move that is explicitly made in order to keep control of inflation. It's only after that, the Fed finally decides to lower its policy interest rates. Under those conditions, you get a collapse in nominal spending ‑‑ the steepest decline since the late 1930s, when you had a similar Federal Reserve mistake.

You're not going to have a decline in nominal spending for the first time in decades, without having very severe effects on the economy, including crashing asset prices. Which includes crashing housing prices, crashing prices of mortgage based securities, and so everything gets worse.

The way I would put it is, you could've had a decline in housing without having an economic crisis. The evidence for that is, we had a decline in housing without an economic crisis. What you couldn't have had is a decline in nominal spending without an economic crisis.

Pretty much as soon as nominal spending starts falling, you do get that economic crisis in 2008. What I would say is a disentangling cause and effect here, you've got to look for the "But for" cause. It seems to me, the but for cause of the economic crisis was Federal Reserve tightening.

Beckworth: It'll be interesting to see if this view of history becomes more widely accepted as time goes on. As historians take a look back, and evaluate what actually did happen.

Ramesh, thank you for visiting the show today.

Ponnuru: You're welcome. It's been great.

Beckworth: We'll have to have you come back in the future.

Ponnuru: That'd be great.

David Beckworth
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May 16, 2016
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Stop Worrying About Inflation

Wednesday, February 17, 2021
David Beckworth

Warnings of an impending inflation crisis are greatly exaggerated. Read more at the New York Times

A Monetary Correction

Thursday, February 22, 2018
David Beckworth

ur economy is finishing its ninth year of expansion following the economic crisis of 2008 and 2009. While this expansion has been long-lasting, it has also been weak by post–World War II standards. Theories abound for this weakness. One common explanation, particularly on the right, is that the Federal Reserve’s attempts to stimulate the economy have had the perverse effect of keeping economic growth low.

In 2007 and 2008, the Federal Reserve reduced the federal-funds rate — the interest rate it targets — from 5.25 to 0.25 percent. It held that rate down for seven years. Since 2015, it has increased it in increments to 1.5 percent. The Fed has also made large-scale asset purchases to ease credit. Most of the Fed’s conservative and libertarian critics allow that some of these moves were justified as a response to a sharp recession, but maintain that the Fed has kept monetary policy too loose for too long. Its actions distorted markets so much as to amount to “financial repression.” With interest rates held low, investors moved to risky assets, including stocks, to reach for yield. Inequality worsened but the real economy did not prosper.

Many of these same critics spent the first years of the recovery warning that easy money would lead to a surge in inflation. With no such surge having occurred, the argument has shifted. The current critique is that the expansion has been artificial, and will be revealed as such as the Fed retreats from its extraordinarily accommodative policies. As interest rates rise to normal levels and the Fed’s asset holdings shrink, that is, we will see how dangerously dependent the economy has become on support from the Fed to achieve even modest growth.

There is an alternative perspective that better fits the facts. The truth is that poor Fed policy has contributed to the weakness of the expansion. But the Fed has erred by keeping money too tight, not too loose.

The best indicator of the stance of monetary policy is the rate of growth of spending throughout the economy. Accelerating growth in spending signals an expansionary policy and decelerating growth a contractionary one. In the 1970s, spending growth was high and rising, leading to high rates of inflation. During the Great Moderation that followed that period, spending grew at a relatively steady pace, averaging 5.3 percent a year. This steady pace promoted macroeconomic stability. Economic actors were able to make and coordinate their plans against a backdrop expectation that the volume of spending would keep growing at the accustomed rate.

The crash of 2008 and 2009, however, saw the steepest decline in spending since the Great Depression. In its aftermath the Fed did not pursue a policy of letting spending bounce back to maintain its average growth rate. The red line in Figure 1 shows what a historically normal spending path would have looked like. A loose-money policy would have led to growth significantly above that line. Instead, as the figure shows, spending grew at a level significantly below the pre-crisis rate. It has risen at 3.7 percent per year during the recovery.

Inflation is another indicator of the stance of monetary policy, and it too has signaled tight rather than loose money. Since the end of the crisis, inflation as measured by the Fed’s preferred indicator — the core PCE price index — has averaged 1.5 percent per year. That rate is below the average level of the previous decades, and, as Figure 2 shows, also below the Fed’s target of 2 percent inflation. Both Fed officials and many outside observers call the low inflation rate a “puzzle” given loose monetary policies. But there is no mystery once you drop the assumption that monetary policy has been loose.The crash of 2008 and 2009, however, saw the steepest decline in spending since the Great Depression. In its aftermath the Fed did not pursue a policy of letting spending bounce back to maintain its average growth rate. The red line in Figure 1 shows what a historically normal spending path would have looked like. A loose-money policy would have led to growth significantly above that line. Instead, as the figure shows, spending grew at a level significantly below the pre-crisis rate. It has risen at 3.7 percent per year during the recovery.

Inflation is another indicator of the stance of monetary policy, and it too has signaled tight rather than loose money. Since the end of the crisis, inflation as measured by the Fed’s preferred indicator — the core PCE price index — has averaged 1.5 percent per year. That rate is below the average level of the previous decades, and, as Figure 2 shows, also below the Fed’s target of 2 percent inflation. Both Fed officials and many outside observers call the low inflation rate a “puzzle” given loose monetary policies. But there is no mystery once you drop the assumption that monetary policy has been loose.

Against Higher Inflation

Wednesday, July 5, 2017
David Beckworth

Does the U.S. economy need more inflation? A group of 22 progressive economists has written a letter to the Federal Reserve urging it to appoint a blue-ribbon commission to study whether the central bank should raise its target for inflation above its current 2 percent. Fed chairman Janet Yellen, in her press conference following the latest interest-rate increase, called it “one of the most important questions” facing the organization. 

The economists’ advice shouldn’t be rejected out of hand, but it should be rejected. They make some valid points in their diagnosis of the ills of the current monetary regime. But the Fed can and should address these problems without raising inflation. 

For most people it is probably puzzling that anyone should want inflation to rise. They consider inflation a hit to their standard of living and don’t want more of it. But the extent to which inflation reduces standards of living depends mostly on what drives it. If an oil embargo raises costs throughout the economy, it will indeed tend to raise prices and cut into real incomes. An inflation driven by the central bank’s creation of extra money, on the other hand, should increase prices and wages very close to proportionally. (We’re using the term “inflation” the way most people and economists do, as a rise in the general price level.) This kind of inflation is unpopular mostly because people assume that they have earned their inflated wages but resent paying inflated prices. 

Which is not to say such inflation is costless. If inflation is unpredictable, businesses and households will have difficulty making long-term economic plans — in part because it creates arbitrary wealth transfers. When inflation comes in higher than expected, the bank that provided your fixed-rate mortgage will take a bath; when it comes in lower, you will. Inflation also raises the burden of taxes on capital, since our laws do not adjust for it: It is possible to pay a capital-gains tax on an asset even when it has not appreciated at all in real terms. Then there are the costs of having to adjust prices to keep up with a constantly changing price level: what economists, thinking of the restaurant business as a good example, call “menu costs.” 

When inflation is both low and stable, however, these costs are manageable. Central banks the world over have converged on a 2 percent target rate for inflation during the last few decades partly as a matter of happenstance, but economists have generally considered 2 percent a reasonable number. The costs mentioned above would not rise much higher with year after year of 2 percent inflation than they would with year after year of 0 percent inflation. (And they would be lower still if our capital-gains taxes adjusted for inflation.) 

The slightly higher rate has a few advantages over the lower one. It can make economic transitions smoother. Employees are more hostile to wage cuts of 2 percent with 0 percent inflation than they are to stable wages with 2 percent inflation, even though these outcomes are economically identical. A little inflation therefore makes it easier for employers to lower labor costs by not giving pay raises rather than by laying people off. 

One of the other reasons central banks preferred 2 percent to 0 percent inflation is that it gave them more flexibility. During a recession, central banks usually cut interest rates in order to stimulate the economy. The higher the interest rate is at the start of the recession, the more they can cut it. Since interest rates are composed of both a real return to savings — the real interest rate — and compensation for expected inflation, a 2 percent inflation target will keep interest rates higher than a 0 percent one.

And that brings us to the case for an even higher inflation target. The supporters note that a higher inflation target would give the Fed even more room to maneuver. International comparisons bolster this case: Countries that have tolerated higher inflation over the past decade have fared better than we have. Australia had some of the same vulnerabilities we did before the Great Recession — a real-estate boom and a surge in household debt — and was more exposed than we were to swings in commodity prices. Yet its economy continued to grow during the crisis. It came into the crisis with a core inflation rate of 4 rather than 2 percent, which meant higher interest rates. Australian monetary authorities could thus cut interest rates more than we did. 

Israel did not avoid the recession, but it had a more robust recovery than we did. Higher inflation played a role there too, albeit a different one than in Australia. After Israeli interest rates fell close to 0 percent, monetary authorities allowed the inflation rate to go as high as 5 percent in 2009. Although this inflation eventually caused interest rates to rise, its immediate effect while interest rates were stuck near 0 percent was to push real interest rates deep into negative territory and thus spur more spending. 

The argument, then, is that both Australia and Israel did better than the United States during the crisis by tolerating higher inflation. Why not tolerate a bit more inflation here, the advocates say, through a higher inflation target? 

The proponents also argue that a higher inflation target is needed because real interest rates have been headed downward for decades. Many economists, especially those who want a higher target, say that slowing productivity growth and an aging population are bringing real interest rates down. 

Over the decades before the Great Recession, inflation averaged 2 percent and the real interest rate roughly 3 percent, making for an interest rate a little above 5 percent. These days it is often estimated that the economy can sustain real interest rates near 1 percent. To get interest rates above 4 percent again would therefore require raising the inflation target to the 3 to 4 percent range. 

These arguments for a higher inflation target are reasonably strong if you accept the premise that keeping inflation stable should be the Fed’s principal task in the first place. There is, however, a superior alternative. That alternative would stabilize the growth of nominal spending: the total amount of dollars spent throughout the economy. The growth rate of nominal spending equals the sum of the rates of inflation and of real economic growth. (In 2015, for example, inflation ran at 1.2 percent and the economy grew by 1.6 percent in real terms, so nominal spending grew by 2.8 percent.) Under a level target for nominal spending, the Fed would commit to keeping total spending growing at a steady rate, say 4 percent. It would commit, further, to correcting for any failure to hit the target. If nominal spending grew by 4.5 percent one year, that is, the Fed would shoot for 3.5 percent the following year. 

This policy would capture the benefits of inflation targeting, such as facilitating long-term economic planning by households and businesses. It would arguably serve that purpose a little better than inflation targeting, since most debt and labor contracts are written in nominal terms. It would be compatible with keeping inflation low and fairly stable. If the economy’s real growth rate over the long term averages 2 percent, then hitting a 4 percent nominal-spending target implies achieving a 2 percent average inflation rate too.

A key difference between the two policies is that a nominal-spending target would allow inflation to fluctuate over the short term in response to movements in productivity. A negative supply shock, such as the oil embargo we mentioned earlier, will push prices up and output down. A strict inflation-targeting central bank would try to keep prices from rising by raising interest rates — at the cost of harming an already weak economy. Something like that happened in 2008: Rising commodity prices led the Fed to refrain from cutting rates in the early months of the recession. A nominal-spending target would have had more tolerance for a short-run increase in inflation. 

A positive supply shock, on the other hand, will pull prices down. In that case, an inflation-targeting central bank, whatever inflation rate it has chosen, will be tempted to lower interest rates to keep inflation from falling. If it does it will overstimulate the economy. This appears to have happened in 2002–04, when a productivity boom made the Fed fear deflation and it responded by holding interest rates too low for too long. Under a nominal-spending target, on the other hand, the Fed would have allowed productivity to reduce inflation. 

A key argument for a higher inflation rate, you will recall, is that real interest rates have declined as the economy’s productive potential has. But those interest rates can move rapidly. The San Francisco Fed uses a measure of the “natural” real interest rate — the rate justified by the economic fundamentals — that fell from 2.12 percent at the end of 2007 to 0.34 percent a year later. That was a rapid decline tied to the business cycle. There is no reason in principle that the real interest rate could not rise rapidly as well. If it did, the argument for a higher inflation target would go into reverse: A lower one would be justified. But changing the target with every change in productivity would nullify the advantage of stability.

A nominal-spending target, on the other hand, would not need to alter in response to changes in productivity. Changes in productivity would change the composition of nominal spending — the more productivity grows, the higher the ratio of real economic growth to inflation — but not the total. 

As for Australia and Israel, it’s worth noting that in both countries nominal spending grew at a steady pace. Spikes in inflation may have been helpful, that is, only insofar as they enabled the stabilization of nominal spending. 

We have not yet mentioned one peculiarity of the argument for a higher inflation target. Even though Yellen signaled her openness to that argument, we have actually been below 2 percent inflation for eight years — which is to say, before, during, and after the Fed’s formal adoption of that target. In some quarters the Fed’s failure to hit its target has led to doubt about whether the Fed even has the capacity to raise inflation any more, in which case its capacity to increase nominal spending would also have to be questioned. This doubt is unjustified: The Fed has repeatedly refrained from taking steps that would have increased inflation further, and taken steps that reduced it. 

A nominal-spending target would make for a stabler macroeconomic environment than an inflation target, for the reasons we have described, and would not require enduring higher inflation rates on average. But no target is going to work as well as it could if the Fed is unwilling to take it seriously. And no blue-ribbon commission is going to supply that willingness. 

Yes, the Fed's Errors Made Recession Worse

Monday, February 8, 2016
David Beckworth

Bold theses should receive skeptical reactions, and ours did. We argued in the New York Times that, contrary to what just about everyone believes, the financial crisis and the Great Recession that blew up the American economy in 2008 were not the necessary consequences of a housing bust. They would not have happened if the Federal Reserve had responded appropriately to increasing economic weakness over the course of that year. Barry Ritholtz (a Bloomberg View colleague), Edward Conard, Mike Konczal and Paul Krugman are among those who criticized our argument. Here we respond.

Things We Did Not Say

Since some criticisms were directed at arguments we didn’t actually make, we should clarify a few things.

First, we are not saying that the right Fed policy would have kept any recession from happening. As we noted, the recession began in December 2007, before the Fed mistakes we discussed: failing to cut interest rates between early April and early October 2008, and even spending much of that time suggesting rate increases were on the way. Our argument, rather, is that these mistakes turned what could have been a mild recession into a “great" one.

Second, we aren't saying that better Fed policy could have prevented serious financial turmoil. Again, we explicitly note that financial stress began before the Fed’s worst errors. Our argument is the errors made that stress much worse.

Third, we aren’t ignorant of the fact that the Fed lowered interest rates between October 2007 and April 2008. We stated it in our op-ed. Again, we were discussing mistakes made after this period.

Fourth, our article did not say that uncertainty about the value of mortgage-backed securities caused the decline of housing prices.

How the Fed Mattered 

By missing these points some of our critics misconstrue our views and make invalid arguments against them. They note, as though it contradicts our story, that Bear Stearns collapsed in March 2008. But that’s entirely consistent with our argument: Stress in the financial sector pre-dated the Fed’s errors, but that stress did not have a severely negative effect on the broader economy. Neither inflation expectations nor nominal spending declined at that time; they declined later, when expected future interest rates rose relative to the natural rate.

Konczal says that the Valukas report on the collapse of Lehman Brothers in September 2008 does not indicate that a looser Fed policy would have staved it off. But here’s what the report says in its introduction: “There are many reasons Lehman failed, and the responsibility is shared. Lehman was more the consequence than the cause of a deteriorating economic climate.” We agree with that assessment. Our view is that raising expected future interest rates was a contractionary move, taken at an especially unfortunate time, and contributed greatly to that climate.

Krugman thinks the behavior of long-term real interest rates contradicts our thesis. They rose in the middle of 2008, but not, he says, catastrophically, as they should have if the Fed were really running a much-too-tight policy. Krugman is incorrect about the implications of our account. We would expect the Fed’s contractionary mistakes to have led to an increase in the risk premium. It did. We would also expect it to reduce the prospects of economic growth and thus lead to a decline in long-term real interest rates adjusted for the risk premium. Again, that’s what happened.

Yes, the Fed Was Wrong

The critics offer different reasons for thinking we are too hard on the Fed. Inflation was “showing unsettling signs of picking up” in 2008, writes Ritholtz, and it’s a “fundamental error” on our part to dismiss the concern the Fed had at the time. But we’re not just applying hindsight: Market expectations of inflation, as measured by TIPS spreads, were declining rather than rising. And those expectations turned out to be correct.

Conard says that monetary loosening in 2008 would not have spurred more lending and would have punished savers. But the decline of lending was an important symptom of the economic crisis, not the cause. Higher nominal income and higher expected nominal income would have increased asset values, which would have increased lending. And savers would have been better off with the higher interest rates they would have received once the economy had strengthened.

Konczal suggests that when Fed officials warned during the spring and summer of 2008 that inflation was rising, they may have helped the economy by increasing the expectations that this would happen. But the Fed’s most powerful way of shaping economic expectations is not by speculating about the future but by indicating what its policy will be. The Fed was signaling that monetary policy would tighten in the future: a contractionary move.

And this brings us to another point. Our critics say or imply that our story just can’t be true: that it’s implausible that the combination of a failure to cut interest rates and some rhetoric about future monetary tightening, even if these were ill-advised, had such disastrous effects. We believe they are thinking about monetary policy too mechanically.

Under most circumstances, the difference for the economy between cutting interest rates and not cutting interest rates would be small. In most circumstances, the difference between taking antibiotics and not taking them would also be small: if, for example, you’re not sick. In certain circumstances, however, the difference is profound.

At a moment of great uncertainty, the Fed signaled that it was more likely to take action to throttle inflation -- a threat markets did not believe existed -- than to prevent a panic. It kept signaling it as that panic grew. And more than signaling: Even after Lehman Brothers collapsed, the Fed’s first policy change was a contractionary one. It started paying interest on excess reserves.

Terminiology, Motives, and Other Distractions

Several of our critics suggest that our argument amounts to saying that the Fed should have prevented a severe recession by taking quicker action, and that we are wrong to say it caused the collapse by tightening money. In truth, we pointed to Fed errors of both omission and commission, but the difference between these types of mistakes does not strike us as especially important in this context. If you don’t turn the ship’s wheel when you’re headed for an iceberg, is that “just” a failure to act?

What matters here is the underlying reality, not the words used to describe it. If our critics come to agree with us that a better Fed policy would have led to a better outcome in 2008, we can agree to disagree on terminology.

Krugman questions our motives. He says that like Milton Friedman before us, we are blaming the Fed for an economic calamity to bolster our laissez-faire ideology. The ideological stakes are not as high, though, as he implies. Even if we are right about the Fed’s responsibility for the Great Recession, it does not mean that, for example, everything was fine in the financial industry and that increasing regulation on it was a mistake. It just means that it is less important to get financial regulatory policy right than we would otherwise have thought, and more important to get monetary policy right.

It is true that, like Milton Friedman, we have views about public policy; it is true that these views are related to one another; and it is true that our political views may have affected our understanding. We daresay all these things are also true of Krugman. Whatever the motives, the arguments have to stand or fall on their own merits. Those merits are strong enough to withstand the criticisms that have been lodged against them.