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More thoughts on the TC rule

April 17, 2011

I’ve been hugely busy for the last 2 weeks.  When I wrote out the rule Friday morning for the first time, I didn’t have any time to write out reasoning or even about the choice of targets.

I am still very busy, but I have a little bit of additional background on the choices, plus some very quick notes.

I’ve realized this is more of a functional finance rule than an MMT rule.  MMT has a rule already for this – it is the famous and controversial Employer of Last resort.  Famous in the MMT world, but unfortunately controversial for most people.  Part of the reason I created a rule was to form a practical rule we can use today, without the need to implement the ELR immediately.   Let’s face it, the ELR won’t be voted into law next year.  We need something useable and practical now.  Thanks to Scott and Beowulf for pointing out the rule is more functional finance than MMT.

Since a country with a sovereign currency cannot go bankrupt, the only remaining worries for this government is the inflation rate and the unemployment rate.  I’ve gone into this with some detail here and over at Interfluidity.

It is very possible that Interfluidity is correct and we need to be concerned with a discontinuous jump in inflation.   I don’t think this is the case for reasons I think I laid out in the comments section at Interfluidity, but it is entirely possible (and thinking about Soros-Popper, extremely likely) that I am incorrect.  We need more research into inflation under a sovereign currency regime.

So we have two targets – the Feds famous dual mandate – of unemployment and inflation.   I prefer to target them directly rather than indirectly through GDP. However, Scott Sumner and David Beckworth have made a good case for targeting NGDP.   This targets inflation and real growth in a single easy to understand number.  I consider NGDP targeting to be a superior to than the Taylor rule.

Still, I don’t think an NGDP target is as good as targeting unemployment.  Unemployment is bad for reasons beyond the sheer economic loss associated with able people sitting around.   We do not need to make a choice between everybody working and high economic growth – we can presumably have both.   NGDP could theoretically limit the economy below full employment due to assuming growth causes inflation.   An unemployment target is less likely to run into a self imposed limitation on economic growth.

Warren Mosler has hinted that he thinks that real economic growth could be 10%+ with good policy.   China has grown at this rate for decades, and Japan had growth approaching this level for decades until they changed their policy.   We don’t know what is possible for long term growth with good policy – we have not yet had the good policy part.  An NGDP target is a potential self-imposed throttle on economic growth.

Beowulf pointed me to Pavlina R. Tcherneva’s paper on fiscal policy.  In it, she makes a great case for targeting effective demand over aggregate demand. The ELR is superior to the TC rule in that it targets effective demand, where the TC rule only targets aggregate demand through the mechanism of % government deficit.  It is a must read paper on the topic, and I wish I had read it the day it came out.  The distinction between Aggregate Demand and Effective Demand eviscerates NGDP targeting or targeting inflation alone.  I cannot recommend this paper highly enough.

Beowulf points out that Okun’s law has been unstable.  Yes, it has.  As far as I know, most economic regressions are unstable.  It’s a problem with any rule that uses empirical relationships in with economic data.  Still, I think using the current accepted multiplier of 1.8 would be a good place to start.  [Update: Beowulf points out why not just use Bernanke’s 2.0 as the multiplier?  Hard to argue with that one, right, Mr. Bernanke?]

Okun’s law also assumes there is some maximum potential GDP rate to generate the multiplier.  This results in something like the NAIRU for the target unemployment rate.  Using this in the law is a self imposed limit on growth, and another reason the ELR is superior.

We can use the TC rule with the ELR as a special case where (u-u) = 0   We are then left with a rule that targets inflation and population growth.

What is the proper inflation rate to use?  Good question.

I used population growth as part of this equation because it is the largest single deflationary (or inflationary) pressure facing any economy.  Maybe I am wrong, but I think of it like this:

100 agents, two groups of 50, with $50 total in the economy, no credit allowed, no desire for savings. Each day 50 of them produce 100 units of food, which is then of course priced at $1 per unit.  The other 50 buy and then consume food and lay about.  The groups switch every day in production and idle time.  Then one day, 10 more identical agents show up with no money and equally join groups, so now each group has 55 in it. The price of the food produced must go down.

Deflation isn’t a problem in this toy economy, but in the real world deflation has much worse consequences than inflation.  Anytime you can increase your wealth relative to other humans by sitting on your ass instead of working your ass off, there is a problem.

Anyway, thats all for now!

  1. beowulf
    April 17, 2011 at 3:29 pm

    I’d keep the fiscal rule formula as simple as possible (after all, it’d have to be approved by Congress, not Fed governors). I’ll point out that the Fed already has fiscal tools available that the governors could adjust at any time instead of Congress adjusting (or allowing automatic adjustment of) tax rates.

    But if Congress were to enact a variable tax fomula, link tax rate to unemployment rate. Let’s use 15.3% FICA payroll tax, which raises about $900 billion (or $1.1 trillion if Soc Sec. FICA were uncapped) and make the formula idiot-proof, each point of U3 unemployment results in FICA tax holiday of 10%. A week after the end of every month, the Dept of Labor releases the latest unemployment figures (April update will be released on May 6 at 8:30). If Congress approved it this month, assume DOL announces on May 6 that April U3 rate is 9.0%, 10 minutes later, Dept of the Treasury would announces a 90% holiday from FICA base rate U3 rate is 7.5%, the FICA base is reduced by 75% holiday and so on.

    I’d actually use 3.8% as the full employment target since that was the actual U3 peak reached in spring of 2000 (and conveniently 5 full points from most recent DOL U3 rate of 8.8%). Since the Okun law ratio is uncertain (and isn’t part of our equation anyway), my druthers is to asuume 2.0%, not least of which it would be fun to watch Fed economists struggle to challenge its validity considering who came up with that ratio (Dr. Benjamin Bernanke, late of Princeton University).

    It doesn’t matter since this formula would work, in theory, all the down to 0 unemployment. In reality, if we’re at a 5.0%, 4.0% or 3.0% rate and inflation is quiet, then let it ride, if inflation is flaring up, Tsy or Fed should have standby authority from Congress to establish the anti-inflation warrants market proposed by Abba Lerner and David Colander and advocated by William Vickrey.
    “if we are to control three major macroeconomic dimensions of the economy, namely the inflation rate, the unemployment rate, and the growth rate, a third control is needed that will be reasonably non-collinear in its effects to those of a fiscal policy operating through disposable income generation on the one hand, and monetary policy operating through interest rates on the other.

    “What may be needed is a method of directly controlling inflation that do not interfere with free market adjustments in relative prices or rely on unemployment to keep inflation in check. Without such a control, unanticipated changes in the rate of inflation, either up or down, will continue to plague the economy and make planning for investment difficult. Trying to control an economy in three major macroeconomic dimensions with only two instruments is like trying to fly an airplane with elevator and rudder but no ailerons; in calm weather and with sufficient dihedral one can manage if turns are made very gingerly, but trying to land in a cross-wind is likely to produce a crash.

    “One possible third control measure would be a system of marketable rights to value added, (or “gross markups”) issued to firms enjoying limited liability, proportioned to the prime factors employed, such as labor and capital, with an aggregate face value corresponding to the overall market value of the output at a programmed overall price level. Firms encountering a specially favorable market could realize a higher than normal level of markups only by purchasing rights from firms less favorably situated. The market value of the rights would vary automatically so as to apply the correct downward pressure on markups to produce the desired overall price level. A suitable penalty tax would be levied on any firm found to have had value added in excess of the warrants held.” (fallacy 6)

    • TC
      April 18, 2011 at 8:50 am

      This is such great stuff that I cannot give it enough time right now.

      Every rule demands an associated policy. The whole point of creating a rule is to compel a policy response in some preferred policy. My associated policy was similar to what you proposed, but with the differences of the driver of the tax refunds as the output of the % G deficit. INstead of just targeting unemployment with the tax holiday, this would then target the desired % G deficit spending. Of course, this isn’t well thought out yet.

      And honestly, I don’t understand the proposed third control variable. I’ve read through it a few times and have a hard time getting the idea, so I don’t want to comment yet. As a first idea, tradable products need to be simple products. This one does not cut it in terms of simplicity.

  2. carnahan
    April 17, 2011 at 5:40 pm

    “Anytime you can increase your wealth relative to other humans by sitting on your ass instead of working your ass off, there is a problem.”

    This problem is not limited to deflationary environments, it applies equally to inflationary ones assuming you own ‘real’ assets that get bid up faster than the rate of general inflation.

    • TC
      April 17, 2011 at 9:25 pm

      It isn’t entirely symmetrical. In a deflationary world, every saver – every single one – makes money just sitting on their ass. In an inflationary world, you need to find a good investment, lest your savings get inflated away.

  1. June 21, 2011 at 2:43 pm
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