What makes commitment difficult?

(No, I’m not talking about relationships.)

Back in the early to mid 2000s, many leading monetary economists proposed policy responses to a liquidity trap, all of which involved commitment of some kind. Lars Svensson argued for the “foolproof way”: a currency devaluation and temporary exchange-rate target, along with a price-level target path. Alan Auerbach and Maurice Obstfeld suggested large, sustained open-market purchases. Clouse et al. offered a massive list of possibilities, including writing options on future interest rates that would pay out if the Fed raised rates beyond a certain level. Gauti Eggertsson modeled “committing to be irresponsible”, suggesting that the government increase its total nominal debt to create inflation incentives. And, of course, Eggertsson and Woodford’s classic 2003 paper argued that the benefits from an optimal interest-rate policy could be approximated through an appropriate price-level target.

There are really two issues here.

First, there’s the question of how the Fed can make its promises credible. As I’ve discussed before, effective policy in a liquidity trap involves making expansionary commitments that will be uncomfortable when the time comes to implement them. Both Clouse et al. and Eggertsson focused on creating fiscal incentives for the Fed to follow through on its commitment: making prolonged low interest rates profitable for either the Fed or the government as a whole.

There are many ways to do this. If the government has lots of longer-maturity nominal debt, it will be (relatively) happy to see inflation. If it has shorter-maturity debt, it will benefit from rolling over the debt at low nominal interest rates. Either way, there’s a benefit from loose monetary policy. The problem, of course, is that goosing the Treasury’s balance sheet isn’t part of the Fed’s mandate: it cares about ensuring macroeconomic stability, not implicit default through inflation. There isn’t a monolithic “government” making these decisions; there’s a central bank, which for good reasons has been given a great deal of independence from the rest of the public sector.

Even if the Fed doesn’t care about the balance sheet at the Treasury, might it care about its own balance sheet? In normal times, the two objectives are identical: the Fed remits virtually all its profits to the Treasury. It’s possible to imagine, however, that a massive expansion of the Fed’s balance sheet could separate the two, by raising the specter of losses so dramatic that they wipe out the Fed’s profits and leave it undercapitalized. This isn’t likely with QE or QE2, but it could happen with a sufficiently large intervention. If the Fed soaked up virtually the entire supply of Treasury and Agency debt—a little over $15 trillion—and funded its acquisitions with interest-paying reserves, it would suffer a hit of $150 billion annually for every 1% it raised interest rates. This is well above its usual profit level from seignorage, and it’s easy to see how the Fed might be swayed at this point by its balance sheet. Large capital losses are embarrassing: can you imagine how a bailout from Congress would affect the Fed’s independence?

So indeed, if the Fed cares about its balance sheet and is willing to make sufficiently dramatic purchases, it can bind itself to a more expansionary course of action in the future. Other proposals, like Clouse et al.’s option-writing, might also do the job—and perhaps more efficiently.

Recent events, however, suggest that elaborate commitment devices aren’t really necessary. The key constraint for the Fed isn’t sticking to its promises. The Fed cares a great deal about its credibility, and has a decent record of keeping promises whenever it has the nerve to make them. Instead, the problem is what kind of commitment to make: how can the Fed make tangible promises about future policy that don’t run the risk of creating larger problems down the road? This is the second issue in the literature, and it’s not trivial.

Svensson’s “foolproof way”, for instance, is best viewed as a simple, explicit type of commitment. It’s commonly misinterpreted: since exchange rate devaluation is a central part of the proposal, people assume that it stimulates by increasing net exports. This is true to an extent, but it’s no more important in Svensson’s proposal than any other. The United States has incredibly open capital markets, and in this environment an exchange rate peg necessitates a specific path for monetary policy. If the peg is intentionally low, expected monetary policy must be loose—and that’s where the stimulative effect arises. The plan uses exchange rates not because they have any wonderful direct influence, but because they are a tangible and easily observable method of commitment.

When Auerbach and Obstfeld suggest long-term open market purchases, they’re also talking about a type of commitment: using money to buy bonds, and (more importantly) not reversing the transaction in the future. This is implicitly a commitment to keep nominal interest rates at zero for a long time, even after the economy has recovered and the policy becomes inflationary. And that’s where the proposal is problematic: thanks to the unpredictability of money demand, the commitment to a keeping a certain amount of money in circulation may correspond to many very different trajectories of monetary policy. Maybe rates will be low until 2013; maybe they’ll be low until 2020. Maybe improved technology for electronic transactions will push money demand so low that the policy will be wildly inflationary. Who knows? Nothing too crazy can happen with Svensson’s proposal; virtually anything is possible in Auerbach and Obstfeld’s. That makes legitimate commitment difficult: can a central bank really promise it won’t reverse open market purchases, even when 20% inflation is in view?

Eggertsson and Woodford have a model in which they can calculate the exact optimal interest rate policy. This is a valuable exercise. But the mathematically optimal policy cannot readily be described in an FOMC statement—it’s too complicated, and too model-contingent. Eggertsson and Woodford recognize this, and show that a price-level target achieves most of the benefits of the “optimal” policy. Like Svensson, they’re looking for a rule that escapes the liquidity trap and is practical for the Fed to follow.

This is the central question in monetary policy today. Until now, the Fed has relied upon meaningless phraseology (“extended period”) or exceedingly indirect signaling mechanisms (QE). Now, it has kinda-sorta promised to keep rates near zero through mid-2013. This is good, but it’s not enough. Yet it’s difficult to see how the Fed can do too much more while making this kind of promise: making a pledge to keep rates at zero for a certain period of time is simply too crude, and extending it much further would be irresponsible. (After all, who knows what the world will look like in 2015?)

It needs some way to make a stronger but more specific promise. Svensson and Eggertsson and Woodford provide one possibility: price level targeting, perhaps with a commitment to devaluation. Scott Sumner and David Beckworth, who stress the benefits of nominal GDP targeting, provide another. Mankiw and Rogoff seem to be arguing for a higher inflation target over the next few years. I’m honestly not sure which of these proposals is best, but I do know that a more aggressive expansionary commitment is necessary to ensure that America doesn’t experience its own lost decade.

If only someone who assailed Japan’s “self-induced paralysis” was in some kind of position of power…



Filed under macro

7 responses to “What makes commitment difficult?

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  3. Benjamin Cole

    Either inflation targeting or nominal GDP targeting makes more sense than a “do nothing” policy. They tried that in Japan.

    BTW, John Taylor wrote a gushing paper in 2006 about the then-success of Japan’s fleeting QE efforts. See his website under papers 2006. Evidently QE worked, but then the Bank of Japan went back to fighting inflation.

  4. Benjamin Cole

    As to what makes commitment so difficult, I can only answer that DC is a fishbowl world (I worked there for the CBO and in media in the 1980s). People become afraid of other people’s perceptions and pressure.

    Surely, Bernanke-san knows what to do. An outsider would say, “What’s the big deal? Even if Bernanke gets canned at the end of his term, a cushy life awaits him in academia or Wall Street.”

    It is maddening. Yet when you are in the middle of the fishbowl, it seems alive and meaningful.

  5. Pingback: Why the zero lower bound matters | Matt Rognlie

  6. I think the problem is worst when people focus on the inputs to monetary policy such as base money and interest rates and not the outputs such as spending levels, unemployment and exchange rates. Once you focus on the outputs, there is no time consistency problem – just hit the target every period.

  7. Pingback: What’s needed in a macro model? | Matt Rognlie

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