Michael Woodford on the Interdependence of Monetary and Fiscal Policy

(I started writing this post a couple weeks ago and gave up after it got unreasonably long. I don’t feel like finishing it, but rather than let it go to waste I’m putting it up as is. So be warned, it goes on for a long while and then just stops.)

I sat down and read the Michael Woodford article on monetary and fiscal policy I mentioned in the earlier post. It’s very interesting, both directly for what it says substantively, and indirectly for what it says about the modern consensus in economics.

(For those who don’t know, Michael Woodford is a central figure in mainstream New Keynsian macro. His book Interest and Prices is probably the most widely used New Keynesian macro text in top graduate programs.)

The argument of this article is that the question of what monetary policy rule is the best route to price stabilization, cannot be separated from what fiscal rule is followed by the budget authorities. Similarly, any target for the public debt cannot be reduced to a budget rule, but depends on the policy followed by the monetary authorities — though Woodford is not so interested in this side of the question.

This is not a new idea for readers of this blog. But it’s interesting to hear Woodford’s description of the orthodox view.

It is now widely accepted that the choice of monetary policy to achieve a target path of inflation can …, and ought, to be separated from .. the chice of fiscal policy.

Woodford rejects this view — he insists that fiscal policy matters for price stability, and monetary policy matters for the debt-GDP ratio. Most economists think that monetary policy is irrelevant for the debt-GDP ratio, he says,

because seignorage revenues are such a small fraction of total government revenues. … [This] neglects a more important channel … the effects of monetary policy upon the real value of outstanding government debt, through its effects on the price level and upon the real debt service required, … insofar as monetary policy can affect real as well as nominal rates.

There are two deeper issues in the background here, that help explain why orthodox economics ignores the importance of monetary policy for the debt ratio and fiscal policy for price stability. First is the idea, which we can trace from Wicksell through Hayek to Milton Friedman and on to today’s New Keynesians, that the “natural” interest rate in the sense of the interest rate consistent with price stability, must be the same as the “natural” interest rate in the sense of the Walrasian intertemporal rate that would exist in a frictionless, perfect-information economy that somehow corresponded to the economy that actually exists. Few economists are bold enough or naive enough to state this assumption explicitly, but it is fundamental to the project of reconciling orthodox monetary policy with a vision in which money is neutral in the long run. If you want the same interest rate to be “natural” in both senses, it’s a problem if the price-stability natural rate depends on something like fiscal policy, which is not reducible to tastes, technologies and endowments.

Second is the notion of the “long run” itself. For economists, this refers to a situation in which the endogenous variables have fully adjusted to the exogenous variables. This requires a clean (or anyway order-of-magnitude) separation between “fast” endogenous and “slow” exogenous variables; it also requires a sufficiently long time between disturbances.

Woodford, in the passage above, refers to the effects of changes in inflation and interest rates on the burden of the outstanding government debt. This is an important departure from orthodoxy, since in a true “long run” situation, debt would have fully adjusted to the prevailing interest and inflation rates. Woodford, in tune with the practical concerns of central bankers, rejects the ubiquitous methodological condition of modern macroeconomics, that we should only consider fully adjusted long run positions. His whole discussion of public debt, in this paper and elsewhere, rejects the usual working assumption that the existing levels of inflation and interest rates have prevailed since time immemorial. He explicitly analyzes changes in interest and inflation in the context of a historically given debt stock.

Woodford’s attitude toward the “natural” rate is more complicated. He certainly doesn’t take it for granted that the price-stability and Walrasian “natural” rates are the same. But a big part of his project — in Interest and Prices in particular — is precisely to develop a model in which they do turn out to coincide.

Let’s continue with the paper. Most economists believe that:

“Fiscal policy is thought to be unimportant for inflation… [because] inflation is a purely monetary phenomenon,” or else because “insofar as consumers have rational expectations, fiscal policy should have no effect on aggregate demand.”

Woodford rejects both of these claims. Even if people are individually rational, the system as a whole can be “non-Ricardian.” By this he means that changes in government spending will not be offset one for one by changes in private spending. “This happens essentially through the effects of fiscal disturbances upon private sector budget constraints and hence on aggregate demand.” For this reason, “A central bank charged with maintaining price stability cannot be indifferent as to how fiscal policy is set.”

Traditionally, the orthodox view of inflation is that it is the result of the money supply growing at a different rate than real economic activity, the latter being independent of the money supply. This does allow for fiscal effects on the price level, but only insofar as public borrowing is monetized. In the familiar “fiscal dominance” scenario, the primary surplus or deficit is fixed by the budget authorities and if the implied issue of public debt is different from the desired holdings of the private sector, the central bank must finance the difference with seignorage. The resulting change in the money supply produces corresponding inflation.

As Woodford says, this is not a useful way of thinking about these issues in real economies, at least in developed countries like the United States. In reality, even when the central bank is subordinate to the budget authorities, as in wartime, this does not take the form of direct monetization of deficits. Rather, “fiscal dominance manifests itself through pressure on the central bank to use monetary policy to maintain the market value of government debt. A classic example is … U.S. monetary policy between 1942 and 1951. … Supporting the price of long-term [government] bonds seems to have been the central element of Fed policy through the late 1940s.” This policy did not affect the price level directly through the money supply, but rather because the target interest rate was too low during the war (although the resulting inflation did not show up until after 1945, due to price controls during the war itself), and too high during in 1948-1950, when the federal government was running large surpluses. In either case, Woodford emphasizes, the causality runs from interest rates, to the price level, to the money supply; the quantity of money plays no independent role.

The basic story Woodford wants to tell is the fiscal theory of the price level. If the stock of outstanding government bonds is greater than the public wants to hold at the prevailing interest rate, then the price of bonds should fall. Normally, this would mean an increase in rates. But if interest rates are pegged — or in other words, if the price of bonds relative to money is fixed — then the price of the whole complex of government liabilities falls. Which is another way of saying the price level rises. Another way of looking at this is that, if output is initially at potential and the volume of government debt rises  with no fall in its nominal price, this must

make households feel wealthier … and thus leads them to demand goods and services in excess of those the economy can supply. … Equilibrium is restored when prices rise to the point that the real value of nominal assets no longer exceeds the present value of expected future primary surpluses.

Of course, this begs the question of why government debt is voluntarily held at a positive price even when there is no reason to expect future primary surpluses. More broadly, it doesn’t explain why anyone wants to hold non-interest bearing government liabilities at all. Woodford could take a chartalist line, talk about tax obligations, but he doesn’t. But even then he’d haven’t of he wouldn’t have explained why people hold large stocks of government debt, which by definition is in excess of tax burden.  The natural answer is that government liabilities are a source of liquidity for the private sector. But if he says that, the rest of his argument is in trouble. First, if demand for government debt is about liquidity, then private actors should consider the terms on which other private actors will accept government liabilities. Second, if liquidity is valuable, then real outcomes will be different in a liquidity-abundant world than in a liquidity-scarce one. This is the fundamental problem with the idea that money is neutral. If money were truly neutral, in the sense that the exact same transactions happen in a world with money that would happen in a hypothetical moneyless world, then there would be no reason for money to be used at all.

Despite these serious logical problems, Woodford uses the orthodox apparatus to make some interesting points. For example, he argues that the reason the mid-century policy of fixing a nominal interest rate did not lead to price instability, was because of adjustments in the federal budget position. It is, he says, a puzzle how

a regime that … fixed nominal interest rates was consistent with relatively stable prices for so long. … According to the familiar Wicksellian view summarized by Friedman, an attempt to peg nominal interest rates should lead to either an inflationary or a deflationary spiral. … It is striking that people were willing to hold long-term Treasury securities at 2.5% during the temporary high inflation (25% annual rate) of 1946-1947; evidently there was little fear … [of] an explosive Wicksellian ‘cumulative process.’

Woodford is right that the consistency of fixed nominal interest rates with price stability even after the removal of wartime price controls is a problem for the simple Wicksell-monetarist view. Whether his preferred solution — an expectation of continued federal budget surpluses — is right, is a different question.

Turning to the other side, the dependence of the budget position on prevailing interest rates, Woodford gives an excellent critique of the prevailing notion of a government intertemporal budget constraint (ITBC), in which government spending must be adjusted so that the present value of future surpluses just equals today’s debt. It is widely believed, he says, that government must satisfy such a constraint, “just as in the case of households and firms. It would then follow that fiscal policy must necessarily be Ricardian,” that is, have no effect on the spending choices of rational, non-liquidity-constrained private actors. “It is true,” he continues, “that general equilibrium models always assume that households and firms optimize subject to a set of budget constraints that imply an intertemporal budget constraint, though they may be even more stringent (as it may not even be possible to borrow against all … future income.”

Note the careful phrasing: I’ve noticed this in Woodford’s other writing too, that he adopts rational expectations as a method without ever endorsing it as a positive claim about the world. Of course we shouldn’t talk about intertemporal budget constraints at all, it’s a meaningless concept for private as well as public borrowers, for reasons Woodford himself makes clear.

This is a nice part of the paper, Woodford’s treatment of the “transversality condition.” This, or the equivalent “no-Ponzi” condition, says that the debt of a government — or any other economic unit — must go to zero as time goes to infinity. The reason mainstream models require this condition is that they assume that in any given period, it is possible for anyone to borrow without limit at the prevailing interest rate. This invites the question: why not then consume an infinite amount forever with borrowed funds? The transversality condition says: You just can’t. It is still the case that at any moment, there is no limit on borrowing; but somehow or other, over infinite time net borrowing must come out to zero. This amounts to deal with the fact that one’s assumptions imply absurd conclusions by introducing another assumption, that absurd outcomes can’t happen. Woodford sees clearly that this does not offer a meaningful limit on fiscal policy:

What kind of constraint upon fiscal policy does this [theory] require? A mere commitment to “satisfy the transversality condition” is plainly unsuitable; this would place no constraints upon observable behavior over any finite time period, so that it is hard to see how the public should be convinced of the truth of such a commitment, in the absence of a commitment to some more specific constraint that happens to imply satisfaction of the transversality condition.

What Woodford doesn’t see, or at least doesn’t acknowledge, is that the transversality condition is equally meaningless as applied to private actors. Which means that you need some positive theory about what range of balance sheet positions are available in any given period — in other words a theory of liquidity. And, that the intertemporal budget constraint is meaningless, has no place in any positive economics.

But in any case, even if we accept the intertemporal budget constraint for private units, it is not applicable to sovereign governments since, (1) they are large relative to the economy and (2) they are not maximizing consumption. All that is needed is that someone ends up voluntarily holding the government’s debt. Even if the government is optimizing something, it is not doing so with respect to fixed prices — or fixed output, though Woodford never considers the possibility of unemployed real resources, a rather major limitation of all his work I’ve read.

Woodford notes, reasonably enough, that if the government issues more liabilities than the public wants to hold at the prevailing prices, then the price of government liabilities will fall; “but this is a condition for market equilibrium given the government’s policy, and not a precondition for the government to issue” new liabilities. In this respect, he suggests that the government is in the same position as a company that issues stock, or, more precisely, a company that repurchases shares rather than issuing dividends. (The formal argument that dividends and repurchases are interchangeable, for which Woodford cites Cochrane, is relevant for my “disgorge the cash” work.)

The advantage of this analogy [between the government a share-repurchasing corporation] is that it is clear in the stock case that the equation is an equilibrium condition that determines the share price, … and not a constraint on corporate policies. There is no requirement, enforced in financial markets, that the company generate earnings that validate whatever market valuation of its stock may happen to exist.

The government is different from the company only because prices happen to be “quoted in units of its liabilities.”

As a positive argument this is not useful, for two related reasons. First, it is still essentially a monetarist account of inflation, except with total government liabilities replacing “money.” And second, he deliberately leaves out any discussion of real effects of inflation. This means that he doesn’t give any explanation for price stability is important. More broadly, he doesn’t have any account of the inflation process that links up to real-world discussions. The article purports to be about a central bank following a Taylor rule, but the word “unemployment” does not occur in it. Nor does the word “liquidity”, inviting the question of why anyone holds money in the first place. As I mentioned earlier, this is a larger problem with the whole idea that money is neutral. In this case, Woodford suggests that one can fully explain inflation in a framework in which inflation is costless, and then introduce costs (to motivate policy) without the positive analysis being affected. Interest and Prices does not have this problem — it is carefully constructed precisely to ensure that conventional monetary policy is both welfare-optimizing, and produces an outcome identical to a Walrasian world without monetary frictions. But this isn’t general — the book’s central model is custom-designed to produce just that result.

The question raised by the article is: If both price stability and debt sustainability are functions of both the government budget and monetary policy, why do we have such a strong consensus in favor of stabilizing output solely via the interest rate, and adjusting the government budget position solely in view of the government debt? Woodford admits that in principle, price stability can be achieved in a “bond price-support regime” in which the government budget responds to shifts in private expenditure and the central bank is responsible only for interest payments on government debt. Formally, Woodford acknowledges, this type of regime should work just as well as the conventional “independent” central bank setup. The problem is that in practice

the nature of the legislative process in a democracy makes it unlikely that government budgets can subjected to the same degree of discipline as monetary policy actions. A nontrivial degree of random variation in the equilibrium price level would be inevitable under the price-support regime, both as a result of random disturbances to fiscal policy that could not be prevented, and as a result of inability to adjust fiscal policy with sufficient precision to offset the consequences of other real disturbances. 

There it is. The only argument for central bank independence is an argument against democracy. Woodford continues:

Controlling inflation through an interest-rate rule such as the Taylor rule represents a more practical alternative, both because it is more politically realistic to imagine monetary policy being subordinated wholly to this task, and because it is technically more feasible to “fine-tune” monetary policy actions as necessary to maintain consistency with stable prices.

The claim that interest rates can be adjusted more quickly than budgets is worth taking seriously. Though of course, one way of taking it seriously would be to contemplate arrangements under which taxes and spending could be adjusted more quickly. But look at the other point: The selling point of orthodoxy, says the pope of modern macroeconomics, is that policy can “subordinated wholly” to “controlling inflation.” Look at Europe today, and tell me they aren’t reaping what they sowed.

What is the Liquidity Trap?

In the common usage, popularized by Krugman, a liquidity trap is just a situation where the interest rate set by the central bank has reached zero. Since it can’t go below that (the Zero Lower Bound), if more expansionary policy is needed it will have to take the form of fiscal policy or unconventional monetary policy — quantitative easing and so on. But if there were some technical fix (a tax on excess reserves, say, or abolishing cash) that allowed central banks to make the policy rate negative, there would be no limit to the capacity of monetary policy to overcome any shortfall in demand. The idea — expressed by modern monetarists in the form of the negative natural rate — is that there are so few investment opportunities with positive expected returns that if investment rose enough to equal desired saving at full employment, the expected return on the marginal new unit of capital would be negative. So you’d need a negative cost of capital to get businesses to undertake it.

That makes sense, I guess. But it’s not what Keynes meant by liquidity trap. And Keynes’ version, I think, is more relevant to our current predicament.

Keynes himself doesn’t use the term, and his explanation of the phenomenon, in chapters 13 and 15 of the General Theory, is rather confusing. (Lance Taylor has a much clearer statement of it in Reconstructing Macroeconomics, which I may add a summary or excerpt of to this post when I get home tonight and have the book.) So rather than quote chapter and verse, I’m just going to lay out what I understand the argument to be.

Interest, says Keynes, is not, as the classical economists said, the price of consuming in the future relative to the consuming in the present. It is the price of holding an illiquid rather than a liquid asset today. (This is one of the main points of the book.) The cost of holding an illiquid asset (a bond, let’s say) is the inconvenience that it can’t be used for transaction purposes, but also the opportunity cost of not being able to buy a bond later, if interest rates rise. Another way of saying the same thing: The risk of holding a bond is not just that you won’t have access to means of payment when you need it; it is also the capital loss you will suffer if interest rates rise while you are holding the bond. (Remember, the price of an existing bond always moves inversely with the interest rate.)

This last factor isn’t so important in normal times, when opinions about the future rates of bonds vary; if the supply of liquidity rises, there will be somebody who finds themselves more liquid than they need to be and who doesn’t expect a rise in interest rates in the near future, who will purchase bonds, driving up their price and driving the interest rate down. The problem arises when there is a consensus about the future level of interest rates. At that point, anyone who holds a bond yielding below that level will be anxious to sell it, to avoid the capital loss when interest rates inevitably rise. (Or equivalently, to be able to purchase a higher yield bond when they do.) This effect is strongest at low interest rates, since bondholders not only are more likely to expect a capital loss in the future, but are getting very little interest in the present to compensate them for it. Or as Keynes says,

Nevertheless, circumstances can develop in which even a large increase in the quantity of money may exert a comparatively small influence on the rate of interest. For … opinion about the future of the rate of interest may be so unanimous that a small [decrease] in present rates may cause a mass movement into cash. It is interesting that the stability of the system and its sensitiveness to changes in the quantity of money should be so dependent on the existence of a variety of opinion about what is uncertain. Best of all that we should know the future. But if not, then, if we are to control the activity of the economic system by changing the quantity of money, it is important that opinions should differ.

In other words, the essence of the liquidity trap is a convention about the normal level of interest rates. It’s important to note that this convention is self-stabilizing — if everyone believes that interest rates on a particular class of bond cannot be below 3 percent, say, for any extended period of time, then anyone who finds themselves holding a bond yield less than 3 percent will be anxious to sell it. And their efforts to do so will push the price of the bonds down, which itself will increase their yield back to 3 percent, so that the people who did not share the convention are the ones who end up suffering the loss.

This probably seems confusing and tedious to most readers (and tediously familiar to most of the rest.) Maybe it will be clearer and more interesting with some pictures:

10-Year Treasury Rate and the Federal Funds Rate
BAA Bond Rates and the Federal Funds Rate

The horizontal axis of this scatterplot is the Federal Funds rate. The vertical axis shows a market interest rate — the 10-year Treasury bond rate in the first one, and the BAA corporate bond rate in the second. The heavy black diagonal corresponds to a market rate equal to the Fed Funds rate. In both cases, there’s a clear positive relationship over normal ranges of policy rates — 3 percent to 8 percent or so. But outside of this range, particularly at the bottom end, the relationship breaks down. The floor on Treasuries is a hard 3 percent or so, while the floor on BAA bonds varies from time to time but also doesn’t go below 3 percent. [1] This is Keynes’ liquidity trap. [2] And when you look at it, it becomes much less clear that the inability to extend the black line past the origin — Krugman’s liquidity trap — is the problem here. What good would it do, if market rates stop following the policy rate well before that?

UPDATE: A smart, skeptical comment by Bruce Wilder leads me to reformulate the argument in a hopefully clearer way.

The necessary and sufficient condition for a liquidity trap is a consensus among market participants that nominal interest rates are more likely to rise than to fall over the relevant time horizon. Obviously, one basis for such a consensus might be that it is literally impossible for short rates to fall any further. [3] In this sense the ZLB liquidity trap is a special case of the Keynesian liquidity trap. But the Keynesian concept is broader, because conventions about the floor of interest rates can be strongly self-stabilizing, especially where they are backed up by the political power of rentiers.

[1] “The most stable, and the least easily shifted, element in our contemporary economy has been hitherto, and may prove to be in future, the minimum rate of interest acceptable to the generality of wealth-owners. If a tolerable level of employment requires a rate of interest much below the average rates which ruled in the nineteenth century, it is most doubtful whether it can be achieved merely by manipulating the quantity of money. … Cf. the nineteenth-century saying, quoted by Bagehot, that ‘John Bull can stand many things, but he cannot stand 2 per cent.'”

[2] It also, not coincidentally, looks like the textbook LM curve. The replacement of LM with an central bank-determined interest rate curve in newer textbooks, is not progress.

[3] Note that it is not in fact the case that nominal interests cannot be negative, because in the real world cash has substantial carrying costs.