Posts Tagged ‘Functional Finance’

The TC Rule: MMT Inspired Fiscal Policy

June 21, 2011 50 comments

If you were going to make a rule on fiscal policy, what would you do?

A while back I had some thoughts on what a rule might be that could guide fiscal policy.  I came up with:

c(u-u) + (i-i) + f*Population Growth = %G [Update: This is %G Deficit]

Where :

c(u-u) is Okun’s law, relating the change in GDP to change in unemployment.  According to most people, c is about 1.8 and (u-u) is the difference between the “natural” rate of unemployment and current unemployment.

(i-i) is the difference between the current core inflation rate and the target inflation rate

% Population growth is for the entire currency area – we might want to include China in this area given the current policy of China.  f is a multiplier, set to 1 for now.

This is a rule for the size of the deficit the government should run to get the economy back to full employment. It would tell us how much we should be spending to get the economy moving back to full employment.  It can even tell us to cut back on spending.

Then, I wanted something we could plug and play tomorrow. The rule targets the important things we’re concerned about on a large scale.  Employment, population growth, and inflation – these are the concerns, right? That’s what the TC rule targets. I’d suggest any rule for fiscal policy should have these as first order concerns.

I had some conversations with people about the TC rule, and they had great ideas.  Beowulf had one of the best observations. This spending needs a place to be spent.  Where should the spending be targeted?

Probably the best place to spend is on payroll tax cuts. The reason why is simple – it targets effective demand.

When the economy needs to get moving, effective demand is the place to look.

Not aggregate demand, but effective demand.  We don’t need some random spending thrown around the economy, we need money spent where it will make maximum impact.

Why not infrastructure spending?  I am not always 100% confident about government spending being spent wisely.  It might be spent, but frankly, spending $1T in Iraq doesn’t quite have the same attraction for me as spending $1T on infrastructure projects. But they all count to the deficit.

This feeling is wide spread – people don’t like the government just spending.  Tax cuts are a much easier sell.

One good way to target effective demand is through payroll tax holidays.  In fact, its probably the best way to target effective demand that has any hope of being implemented here in the United States.

For this, turn to Pavlina Tcherneva:

“As already noted, for Keynes, the principal goal of fiscal policy was to secure true full employment and the principle measure for adjudicating among different policy responses was their employment-creation effects (Kregel 2008). Unfortunately, what is considered to be Keynesian policy today is largely a misinterpretation of the Keynesian prescriptions, which largely stems from a fundamental misidentification of Keynes’s theory of effective demand with the theory of aggregate demand (Tcherneva 2011). In the General TheoryKeynes carefully articulated that employment determination depended not on the volume of aggregate demand but on the point of effective demand which was very hard to stabilize and fix at full employment.” [Bold Mine]

Wow!  That’s bold stuff.  She makes an excellent case that the optimal way to do this is through targeting employment directly.

But let’s face it. We are not going to see an Employer of Last Resort program next year, or any time in the next 2 score years here in the U.S. It’s a political non-starter.

But tax cuts…everyone loves tax cuts.  They are the sweet, sweet words that every politician likes to say, over and over again.

So the TC rule is going to target payroll tax holiday.   It’s a tax cut.  People love tax cuts.  And a payroll tax cut is probably the best place to target effective demand we’re going to get.

Remember those posts about corporate profits not causing hiring? I am trying to start a meme about hiring:  Businesses hire when they are swamped with demand, not when corporate profits are high.

Well, a good way to swamp companies with demand is to have people spend more money at the store.  Payroll taxes target people who are extremely likely to spend more money.  If we want more people to be hired, one good way to get this moving is through a payroll tax cut.

The formula beowulf suggested was to balance the dollar value of the amount of deficit spending with the size of the payroll tax cut.  This would target effective demand as well as we could, given the political climate.

The more spending required, the higher the payroll tax holiday.  It could be reset monthly, or every 8 weeks like we have the fed do with monetary policy, or every quarter.  My suggestion is to reset the level every month, as new employment and inflation numbers come out.

I don’t have the actual amount of tax holiday for different amounts of needed deficits, but maybe soon…and much thanks to beowulf!


“Chapter 2: In Which the Traders Crucible slays the Intertemporal Government Budget Constraint, and Mr. Rowe demonstrates his Worth

April 29, 2011 41 comments

There has been lots of confusion lately over at Brad Delong’s place by the usually unconfused Brad.  Nick Rowe of the incorrectly named Worthwhile Canadian Initiative jumped in.  (why incorrectly named? Should be named “Essential Canadian Initiative” – the dude is freakin’ smmmmaaaarrt, and you’ll see why later.).

But this is about the budget constraint.  The Intertemporal Government Budget Constraint has a single, seemingly innocuous assumption of no Ponzi for government spending. The no Ponzi assumption is that the net present value of our spending/debt must equal the net present value of future taxation.  The books must balance across generations. If this doesn’t hold, the currency must go to zero.  Sounds prudent right?

There is only one problem with this assumption.  We cannot know if it is being violated or not with much certainty at all.  We cannot see the future.  We do not know with perfect knowledge if this constraint holds. We cannot know if the no Ponzi criteria is being held with certainty, because we cannot see the future.

And it gets worse, much worse.  We cannot tell if the no Ponzi criteria is being violated within a rather large band of certainty.  In fact, anyone who says we conform to the no Ponzi criteria must be lying, given the history of governments.  But then, anyone who says we are not conforming to the no Ponzi assumption is lying too.  They ignore hard empirical data from today, right now, given todays data, and given history of the United States.   So far, the U.S. has held to the no Ponzi quite well.

All the data points to that the U.S. holds to the no Ponzi over time. And yet we are foolish to assume we can hold to it

This to me sounds like a paradox.  There is no reasonably certain correct answer.

Is Observation the Key?

Still, We can only know what we observe today.

All we can know today is what people think about the value of their money.  If the no Ponzi assumption holds or does not hold, we have to look to current inflation rates to tell us the opinion of what people think is the ultimately unknowable answer.  There is no other way to tell other than inflation rates today, because the future is obscured to our observation.

It turns out the assumption is irrelevant for this reason.

The no Ponzi assumption is irrelevant

The no Ponzi assumption kinda sorta ignores the fact that any violation of the assumption has to be observable today.

We know this because the conclusion of the no Ponzi assumption says words like “We would see rates of inflation increase to levels that make g < r if people think the no Ponzi assumption is being violated.”  But then people forget we cannot know the future with much certainty, so there is this eternal hand wringing over current inflation rates.

These people cannot know if there is a Ponzi violation.  It’s a guess, at best. It’s mad-cap speculation at worst.  How can we ever really tell?

Future Ponzi violations or no violations are impossible to know information. They are not falsifiable for any current levels of real growth or real interest rates.  Nobody knows, or can know, what the future levels of primary deficits will be 20 or 100 years or 1000 years from today.  Anyone can always say “Well, future levels of spending might be too high and spur hyperinflation,” and there nothing anyone could ever say that will prove that statement false.  Those levels of future spending might turn hyperinflationary or not, and we cannot know.

Of course they could also say “We are going to be so rich in the future when we  energy that costs 5% of current costs that these current deficits are trivial”.  How can you tell?

Todays evidence shows we are within the bounds of any reasonable no Ponzi assumption given by Scott Fullwiler.  But who in the hell knows? We cannot know the future.

So how does can the no Ponzi assumption help us manage policy real world policy in any practical way?  It doesn’t. It’s a myth, a spook story economists tell their kids at night. “Spend too much, and the Intertemporal Government Budget Constraint will get you.”

The only way we can possibly guess if this assumption is being violated is through current inflation rates, real interest rates, and rates of real growth.   Even then, these observable rates change all the time.  Over the course of decades, these observable rates are all over the place.

Still we have some guidance here with observable market prices of things.  All violations of the no Ponzi assumption must be observable. If we don’t have significant inflation, the no Ponzi cannot be being violated as far as we could ever know.

Inflation is the observable change in the price of money in real world goods, services, and transactions, including all financial assets.  In other words, the overall market for money will show us the violations of the no Ponzi assumption.

Violations of the no Ponzi assumption must be observable otherwise the EMH is false for the largest, most transparent, most liquid market possible 

If the violations of the no Ponzi criteria are not observable for the most liquid and transparent possible market in any economy, then the EMH must be wrong. No EMH in the market for money has devastating consequences.

It’s at this point where I raise the head of the IGBC and proclaim the dragon slain.  Either you believe the inflation rate as the only way to tell if people believe the IGBC is holding, or go back to believing in crystal balls telling the future.  If you insist on a strong belief in magic, then I hand over the head of the EMH.

As an aside, even if the violations are not observable, it would be foolish to act in any way but to accept the EMH as true in the market for money – which as far as i can tell, is the largest, most transparent, most liquid market possible within current human experience.

This might sound astonishing, but I am not over yet.  Living in a no Ponzi world has incredible consequences.  Nick Rowe knows exactly what I am talking about.  We are living in a world where g is greater than r, nearly all the time, except when some normal business cycle pushes g below r.   

Next up, “Chapter 3, in which Mr. Rowe proves his worth.”

More thoughts on the TC rule

April 17, 2011 5 comments

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!

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