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Wednesday, March 11, 2020

Targeted Versus Non-Targeted Stimulus

I've run across yet more lazy critiques of Modern Monetary Theory (MMT), arguing that "MMT says governments should just print money to stop the virus!", or similar nonsense. I may only be speaking for myself, my reading of MMT would lead to cautiousness with respect to the limits of fiscal policy at present. Given that we face considerable constraints on output capacity, we can see theoretical inflationary risks if fiscal policy was too active. (My base case view is in line with the collapsing inflation-linked market: inflation is likely to head lower, given the swoon in energy prices.)

If we step back to the 1960s-1970s. we saw a divide between the mainstream (Old) Keynesians and Hyman Minsky. To offer a simplified version of events, Minsky argued that the Old Keynesian emphasis on aggregate demand management posed inflationary risks since they ignored the institutional effects that led to higher wages and prices. The Old Keynesian religion failed in the inflationary 1970s, but the congregation listened to Monetarist critiques, not Minsky's. Within a few decades, the New Keynesian faith was solidified, almost entirely premised on aggregate demand management via monetary policy.  However, the pendulum is swinging back. The upset of the Financial Crisis and the Zero Lower Bound revived Old Keynesian attitudes towards fiscal policy among at least some of the left-leaning New Keynesians.

Nevertheless, the mainstream emphasis is on aggregate demand management. The pandemic is going to blow a hole in aggregate demand, so fiscal packages are being demanded.

My base case view is that we are unlikely to see a wage-price spiral, which is the form of "inflationary pressures" that policymakers need to worry about. The argument is straightforward: labour has a weak bargaining position across the developed countries, and the primary worries about workers' incomes being disrupted due to "social distancing." People who are worried about survival are unlikely to hold out for higher wages.

That does not imply that the CPI must remain stable; we do not know how badly supply chains have been disrupted. However, rising consumer prices represents a fall in living standards that policymakers can do very little about. (There is no way to rebuild off-shored supply chains in a matter of months.) Without wages rising to meet rising consumer prices, volumes will fall, and matters will be corrected. Meanwhile, the collapse in oil prices means that headline CPI is likely to remain weak, even in the face of supply disruptions. (Much of the CPI weight consists of services, and those prices are likely to remain weak in the face of disrupted domestic activity.)

However, one could imagine scenarios where the supply side is disrupted for an extended period, and policymakers are panicking and pushing hefty non-targeted fiscal stimulus. That would presumably impose inflationary risks. The key to the MMT world-view is what matters is the real side -- what resources will be under inflationary pressure? The key is that we cannot try to extract some level of "potential GDP" using some econometric mumbo-jumbo, we have to pin down the areas where resource constraints would be hit. Since we do not even know what the policy response will be, it is far too early to guess what those constraints are -- never mind how far we are from hitting them.

The key point is that the preference is to target fiscal policy, to best deal with the crisis without blowing through real constraints. Dropping money from helicopters to everyone is not exactly the optimal way to achieve that.

(c) Brian Romanchuk 2020

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