Bob Solow on Friedman's Presidential address and the natural rate failure

His full paper was published in the Review of Keynesian Economics. He reminds us that it was a talk to undermine 'eclectic Keynesianism' about which he says:

Milton Friedman's famous presidential address of 1968... aims to undermine the eclectic American Keynesianism of the 1950s and 1960s, the habits of thought to which Joan Robinson attached the (unintentionally) complimentary label of ‘bastard’ Keynesianism. I will only say a little about what that was. In fact, the adjective ‘eclectic’ is meant to remind you that it was not a tight axiomatic doctrine but rather the collection of ideas in terms of which people like James Tobin, Arthur Okun, Paul Samuelson and others (including me) discussed macroeconomic events and policies.

More substantively, he argues, correctly my view, that Friedman's misperception model was not accurate, and that the Volcker shock was not caused by any misperception. In fact, Solow suggests that:

So the Fed was in fact able to control (‘peg’) its real policy rate, not for a year or two but for at least six years, certainly long enough for the normal conduct of counter-cyclical monetary policy to be effective.

Note that this is the real, not nominal rate. But perhaps Solow's most important conclusion, drawing from the evidence and Blanchard's more recent contributions is that: "findings imply that there is no well-defined natural rate of unemployment, either statistically or conceptually." In that regard, I think that Solow goes further than Blanchard, and I'm glad he does.

On mainstream Keynesianism

Looking up to Galbraith

The ASSA Meeting was this last weekend in Philadelphia. It was the bomb... cyclone (Nate Cline's joke; I'm sure many others too came up with that one). I don't have much to report actually. I did participate in one section, and will post a link to a preliminary version of my paper soon. I was at the Economists for Peace and Security (EPS) dinner, that honored Jamie Galbraith. This blog was named Naked Keynesianism, as you may know, because years ago Fox News accused him of teaching naked Keynesianism, and I thought that was both funny and a reasonable name for the stuff I did.

Anwar Shaikh was at the dinner, and suggested that Jamie has one foot in each side of the heterodox/orthodox divide, as a result of his paternal influence (Richard Parker noted that as father/son duos come, the Galbraiths do much better than the Friedmans or Steins, and as well as the Gordons), and that for that reason at EPS (presided by Jamie for more than 20 years) we got accustomed to be less segregated from the rest of the profession. That seems about right.

And to prove Anwar right, Joseph Stiglitz was at hand to discuss Jamie's many achievements, and  the many battles, including the one on Greece's debt crisis, and that is far from over, that he fought with Jamie.* Yet, while on policy issues there have been many battles that reasonable, and progressive mainstream Keynesians have fought with heterodox economists (a topic discussed here before), there are important differences between heterodox Keynesians, and their mainstream counterparts. For example, check Stiglitz's new paper on the last issue of the Oxford Review of Economic Policy (OREP).

He acknowledges that: "the economy does not quickly return to full employment," and that "simple models have been constructed investigating how structural transformation can lead to a persistent high level of unemployment, and how, even then, standard Keynesian policies can restore full employment, but by contrast, increasing wage flexibility can increase unemployment." That is essentially correct, and I should add, that perhaps Stiglitz has gone further than most mainstream economists pushing the need for the limits of what he refers to as equilibrium models (mostly of the Monetarist and New Classical/RBC type). But essentially his critiques derive from information problems and limits to rationality, coming from behavioral economics insights.

I often think of Olivier Blanchard when I have to discuss the inability of reasonable mainstream Keynesians incapacity to break with old ways of thinking. Perhaps because of his role until recently at the IMF (now that role was taken over by Maurice Obstfeld). Blanchard tells us in his new paper in the same issue of OREP that: "current DSGE models are flawed, but they contain the right foundations and must be improved rather than discarded."

This is essentially the point of Blanchard's paper on the natural rate too. He essentially suggests that not only the natural rate hypothesis is theoretically reasonable, but that it is relevant for policy makers. Not surprisingly the IMF has not changed its views on macro policy that much (on that see my previous post and the several links to older stuff).

Of course Jamie long ago suggested that the the concept of the natural rate itself should be abandoned. And he did it in the Journal of Economic Perspectives, a journal that was supposed to showcase alternative views in pluralist fashion, but that has failed in being inclusive of heterodox traditions. The inability to ditch the natural rate, even in the face of the last financial crisis (and something that Keynes suggested in the GT) is the main persistent failure of the mainstream.

* Stiglitz acknowledged that Jamie has been studying inequality since before Piketty made it a fashionable topic.

On the possibility of a recession, again

So the yield curve is really flat, not inverted, but really flat, and that has many  (or here) afraid of an impending recession. The fear is basically associated to the inverted yield curve (see below: when the blue line is above the red and green lines, there is an inverted yield curve, with a high short rate and lower longer rates, signaling a recession) which is really flat, and the danger that the Fed will rise the rate in the next meeting in a few weeks.

Yield Curve (click to enlarge)

Blanchard, cited in one of the WSJ pieces above, thinks that the Fed might be forced to hike interest rates, since the economy, presumably is close to the natural rate, that is, to full employment and inflation is a danger. Note that Blanchard is suggesting that the 2% target should be upheld, even though he was against this when he was at the IMF.

I think this is misguided on many levels. On the theoretical front the reliance on the natural rate is problematic, of course. The notion that we are close to full employment is doubtful to say the least, given that participation rate has not recovered much at all since the last recession. Real wages have not grown that much either, and with lower commodity prices the risk of higher inflation (if one is concerned not just with core inflation) is not particularly high. The FOMC should leave the short run rate unchanged. But that is not enough. The Eccles mantra should be repeated more often. Monetary policy is like pushing on a string, in a situation like this one. We need fiscal stimulus.

Blanchard on rethinking macroeconomic policy

Here is Blanchard's summary of the last conference. Nothing much happening in all fairness, and certainly little impact on the policy advice that the IMF provides. On regulation, perhaps higher reserves is Blanchard's solution, and on monetary policy a higher target (which he does not discuss this time) and perhaps a defense of QE. But he only asks whether "the Fed [should] return to intervening only at the short end of the yield curve, or are there good reasons for continuing to intervene along the curve?" No mention that intervening at the long end provides space for expansionary fiscal policy by reducing interest rates (the real reason for QE).

On fiscal policy the same. There is an admission that, contrary to Reinhart and Rogoff, there is no threshold above which debt-to-GDP hurts economic growth. The discussion of the debt-to-GDP ratio has vanished from the last WEO (Apr. 2015). This is good, since in the previous one (Oct., 2014) the IMF still argued that: "many advanced economies have little fiscal space available given still-high debt-to-GDP ratios and the need for further consolidation." Blanchard repeats the language of the last WEO. He says:

"But how to assess what the right goal is for each country? This remains to be done. It has become clear that there is no magic debt-to-GDP number. Depending on the distribution of future growth rates and interest rates, on the extent of implicit and explicit contingent liabilities, one country’s high debt may well be sustainable, while another's low debt may not. Conceptually and analytically, the right tool is a stochastic debt sustainability analysis (something we already use at the IMF when designing programmes). The task of translating this into simple, understandable goals remains to be done."

Interestingly, the policy advice remains the same. For example, on Japan the last WEO says that: "risks to public debt sustainability remain a key concern given high public debt ratios, and a credible medium-term strategy for fiscal adjustment with specific measures is urgently needed to maintain market confidence." And for the US: "the priority remains to agree on a credible medium-term fiscal consolidation plan to prepare for rising aging-related fiscal costs; this plan will need to include higher tax revenue." In Europe, you ask? Well, for the IMF: "in a number of countries, elevated public debt and high fiscal deficits highlight the need for fiscal consolidation." And with lower oil prices: "most oil exporters need to recalibrate their medium-term fiscal consolidation plans." So oil importers might have more fiscal space, wouldn't they? But WEO tells us that: "continued fiscal consolidation, steady implementation of reforms, and external financing are needed to maintain macroeconomic stability" in those countries too. Wait, who doesn't need fiscal consolidation according to Blanchard and his WEO report?

If there is no magic number, they found a loophole and are arguing for a magic range it seems. Whatever the situation fiscal consolidation seems to be a solution. Given that Blanchard's conference is about rethinking policy, not theory, which presumably is doing fine, shouldn't one expect some change in policy advice?

IMF wants austerity and social security reform in the US

Blanchard presenting the WEO Report at the Spring Meetings

The new edition of the bi-annual World Economic Outlook is out (there is one in April and one in October). Olivier Blanchard, from MIT, and the IMF's Economic Counsellor since 2008, is the intellectual force behind the report. In the IMF's view, in the case of the United States:

"The next prominent policy challenge will be a smooth normalization of monetary policy. Building political consensus around a medium term fiscal consolidation plan and supply-side reforms to boost medium-term growth—including simplifying the tax system, investing in infrastructure and human capital, and immigration reform—will continue to be a challenge." [Italics added]

Fiscal consolidation is IMF speak for austerity. Austerity is really about less spending, and higher taxes, but fiscal consolidation should be about the results, meaning lower deficits and debt. Note that austerity is NOT the best way to get fiscal consolidation. Also, normalization of monetary policy can only mean higher interest rates. So for the IMF we are at the natural rate, or so it seems.

In the case of the US labor markets are seen as flexible enough, so immigration is seen as central for keeping real wages low, rather than further deregulation. Yes, supply side reforms are often about lowering real wages. They do not provide much in terms of what austerity would mean. Again from the report:

"Addressing the issue of potential growth will require implementation of an ambitious agenda of supply-side policies in a fractious political environment. Forging agreement on a credible medium-term fiscal consolidation plan is a high priority... [This] will require efforts to lower the growth of health care costs, reform social security, and increase tax revenues." [Italics added]

Reform social security is IMF speak for cutting and delaying benefits, and increasing payroll taxes. Not necessarily privatize it, although some might be in favor of that at the IMF. So supposedly in the US the priority is to promote austerity by reforming social security. The New IMF is great.

On the plus side, the IMF has rediscovered the accelerator (I checked a few older versions and have seen no trace of the accelerator in the last couple of reports) and the report shows:

"estimates of how much investment weakness can be explained by output dynamics based on investment models estimated at the individual-country level. The analysis is based on the conventional accelerator model of investment... A key assumption is that firms adjust their capital stock gradually toward a level that is proportional to output. In addition, firms are assumed to invest to replace capital that depreciates over time... The empirical literature has found strong support for this model, as in Oliner, Rudebusch, and Sichel 1995 and Lee and Rabanal 2010 for the United States, and, more recently, in IMF 2014a and Barkbu and others 2015 for European economies."

Funny, so supply responds to demand, that is, firms adjust their supply capacity to expected demand, but all reforms for growth are based on supply side factors. Yeah, way to use the right theory, but keep the wrong policy advice.

More on the IMF and fiscal policy and Blanchard's rethinking of macroeconomics

I wrote a few days ago on the IMF's persistent views on fiscal policy, and how these views are rooted in an unchanged perception of how the macroeconomy works.  The new Fiscal Monitor tends to support my previous position. The policy recommendations, in the case of advanced economies, suggest that:

"Fiscal efforts in the last five years have stabilized the average debt-to-GDP ratio. Nevertheless, it is still expected to exceed 100 percent of GDP at the end of the decade. It is important to continue to reduce debt to safer levels and rebuild fiscal buffers.

Further fiscal adjustment is needed in most advanced economies to bring down debt ratios to safer levels... reining in age-related Debt (percent of GDP) spending could reduce longer-term fiscal risks."

Why debt ratios have to fall is an incognita, given that we now know that there is no evidence for a 100 percent, or any other for that matter, threshold that leads to lower growth. And it's really annoying that they still want to cut spending on pensions, and perhaps push for privatization (even Chile's famous case now is not an example anymore). For developing economies:

"the time has come to rebuild the fiscal buffers used during the crisis, and to strengthen the institutional fiscal policy framework."

In this case, the notion is that inflation is around the corner, and, hence, that 'emerging' markets are close to full employment. In sum:

"Fiscal consolidation is called for in many economies, advanced and emerging, to reduce high public debt ratios and rebuild fiscal buffers used during the crisis."

More importantly the IMF warns that the higher rates of interest in advanced economies might lead to a crisis in the developing world. They say:

"The historical record indicates that the unwinding of monetary policy support in advanced economies can have a material impact on emerging market public debt costs and on the incidence of fiscal stress episodes."

This suggests that emerging markets have to make an additional effort to promote fiscal adjustment, since the interests costs will go up soon. I'm not only very skeptical about the idea that developing economies are close to their potential output levels, but also about the risk that interest rates will grow substantially in advanced economies. Just check the IMF growth forecasts for the developed world, and you'll see that the probability of higher rates of interest anytime soon are exaggerated.

In addition, Blanchard, the IMF counselor, has published a new paper in line with his previous effort to re-think and evaluate macroeconomics. The interesting thing is that now he suggest more openly that there is a certain consensus between Rational Expectations authors like Lucas and New Keynesians like him and say Krugman. He tells us that:

"the old fresh water/salt water distinction has become largely irrelevant... Fifty years ago, Samuelson (1955) wrote: 

'In recent years, 90 per cent of American economists have stopped being 'Keynesian economists' or 'Anti-Keynesian economists.' Instead, they have worked toward a synthesis of whatever is valuable in older economics and in modern theories of income determination. The result might be called neo-classical economics and is accepted, in its broad outlines, by all but about five per cent of extreme left-wing and right-wing writers.'

I would guess we are not yet at such a corresponding stage today. But we may be getting there."

The consensus is the New Keynesian (NK) model as represented by Clarida et al (1999) and Woodford (2003), neo-Wicksellian really, but that's another story. Funny thing though. According to him: "One striking (and unpleasant) characteristic of the basic NK model is that there is no unemployment!" He explains that this can be circumvented by assuming that:

"unemployment arises from the fact that the labor market is a decentralized market, where, at any time, some workers are looking for jobs, while some jobs are looking for workers... this implies that the wage—and by implication, the cost of labor, employment, and unemployment—depends on the nature of bargaining... It allows one to think about the effects of labor market institutions on the natural rate of unemployment."

Doesn't matter how much lipstick you put on a pig, it's still a pig. The search model proposed basically suggests that unemployment results from frictions, and it would still be true that to solve it, eliminating frictions and reducing wages would lead to the ubiquitous natural rate. Truly Gattopardo Economics, as Tom Palley has called it.

PS: The comic strip above, Mafalda, got it right back in the 1960s. Her mom asks her to pick up her knitted sweater she left on the floor, and she says that she doesn't need to obey, since in her playdate with her friends she was a president. Her mom, astutely as Mafalda perceives, tells her she is the World Bank, the Paris Club and the IMF. Even kids in the periphery know who is really in charge.

How Much has the IMF Changed in Response to the Global Crisis?

Following the 2008 Global Crisis the notion that the International Monetary Fund (IMF) has moved away from orthodox views on a range of issues, but particularly regarding the need for austerity, has been pervasive. For example, Paul Krugman has argued, in his influential blog, that Olivier Blanchard, IMF’s director of research (or economic counselor) is “helping make at least one international institution less austerity-mad than the others.”

So what is this new view, exposed by Blanchard? For example, in the preface to the last World Economic Outlook, Blanchard tells us that:

Potential growth in many advanced economies is very low. This is bad on its own, but it also makes fiscal adjustment more difficult. In this context, measures to increase potential growth are becoming more important—from rethinking the shape of labor market institutions, to increasing competition and productivity in a number of nontradables sectors, to rethinking the size of the government, to examining the role of public investment.

Read rest in Triple Crisis here.

Everything Must Change so that the IMF Can Remain the Same

Recent paper reviewing the role of the IMF after the Global Crisis and the supposed changes in its theoretical views and policy stances, co-authored with the late Kirsten Ford. We concluded that: "The IMF remains fundamentally an instrument of advanced and creditor countries, to force contractionary adjustments on poor, indebted countries."

On the theoretical front, it is worth remembering what Blanchard, the current IMF economic counsellor, said back in 2010:

"It is important to start by stating the obvious, namely, that the baby should not be thrown out with the bathwater. Most of the elements of the pre-crisis consensus, including the major conclusions from macroeconomic theory, still hold. Among them, the ultimate targets remain output and inflation stability. The natural rate hypothesis still holds, at least to a good enough approximation... Stable inflation must remain one of the major goals of monetary policy. Fiscal sustainability is of the essence." [Emphasis added]

So the whole change is a slightly higher inflation target, and a bit more expansionary fiscal policy, when the rate of interest is close to zero. You can read the rest, but if you have doubts about policy check what are the ones promoted by the IMF in the European periphery. As we argue: "If there is any change in the IMF policy advice it is difficult to find in its policies."

Blanchard and the lessons of the crisis, again

Olivier Blanchard has again posted on the lessons from the crisis, and one has reasons to be underwhelmed again (his previous attempt is discussed here). The general tone is the same as before, we don't know enough (#1 on humility is about that, but also #2 that suggests that we don't know enough about how financial markets operate). Caution here is at the service of an Hippocratic oath suggesting that an intervention carries an obvious risk of harm but a less certain chance of benefit.

His rule #4 says that macro-prudential regulations like capital controls "don’t work great. People and institutions find ways around them. In the process of reducing the problem somewhere you tend to create distortions elsewhere." So, first do no harm [no mention of George DeMartino's actual economic oath, by the way], and please don't use capital controls [that's why I remain very skeptical about the IMF's new view on capital controls; for more go here].

The lesson #3 is simply funny; what they didn't know that there are spillover and contagion effects? He is even making the mainstream sound worse than it is [for a more thorough discussion of what the mainstream learned and its limitations go here].

Last but not least there is lesson #5, which suggests that Central Bank Independence (CBI) does not work if the tasks go beyond inflation targeting. Note that he had defended as a change in macro the idea to raise the inflation target from 2% to 4% [seriously!]. Here he tells you that CBI has been "one of the major achievements of the last 20 years." The problem is not with CBI per se, but that with new demands on central banks (why the new demands appeared is an incognita, and he does not think is deregulation, or at least doesn't say so) CBI becomes more difficult.

There is no discussion of why CBI has been orthogonal to the so-called Great Moderation, caused by stagnant real wages and globalization. The problem with CBI is that by definition it imposes a rule of not coordinating with the Treasury on fiscal policy, and in some cases the central bank might be forbidden to do basic things like buying government debt (like the ECB). The justification is the fear of inflationary pressures, while the truth might be closer to Kalecki's view that fiscal and monetary policy are used to maintain a significant level of unemployment to keep workers in line.

So again it seems that Blanchard has learned nothing from this crisis. Mind you, John Taylor, Martin Feldstein and others are out there calling for higher interest rates. So, all in all, you might think that Blanchard, like Krugman and DeLong, is among the most moderate and reasonable in the mainstream. However, he is at the IMF, an institution that is still pushing fiscal austerity, and his inability (or unwillingness) to learn from the crisis has considerably more impact on economic policies around the world.

In Lew of Geithner and more

Yep the chances for a fiscal expansion, already a difficult proposition with a GOP dominated House and a reluctant and fiscal conservative Obama, are now even more unlikely with the eminent nomination of Jack Lew as the new Treasury Secretary in lieu of Geithner, even though some tend to think he is too liberal (see here). Yet ass noted by Mike Norman: "Lew is an avowed deficit hawk and has been very vocal about reducing the government's deficit and supporting the president's push for a "Grand Bargain." This means that Lew will almost certainly be pushing for more austerity."

Meanwhile Olivier Blanchard at the IMF has admitted that the IMF was wrong on austerity. In a recent paper he says:

We find that, in advanced economies, stronger planned fiscal consolidation has been associated with lower growth than expected, with the relation being particularly strong, both statistically and economically, early in the crisis. A natural interpretation is that fiscal multipliers were substantially higher than implicitly assumed by forecasters.

This is a case in which I could say "I've told you so." By the way, by fiscal consolidation, Blanchard means austerity.

The natural rate is 6.5%

At least according to the Fed's new press release. The release says:

"the Committee decided to keep the target range for the federal funds rate at 0 to 1/4 percent and currently anticipates that this exceptionally low range for the federal funds rate will be appropriate at least as long as the unemployment rate remains above 6-1/2 percent, inflation between one and two years ahead is projected to be no more than a half percentage point above the Committee’s 2 percent longer-run goal."

So if unemployment falls below 6.5% expect higher rates of interest, associated to what would be in Bernanke's view the risk of excess demand.

Note that the inflation target continues to be 2%, so even Blanchard's mild-mannered rethinking of macroeconomics (that Krugman and others having been pushing) for a higher inflation target has not been accepted by Bernanke. Obama should get rid of Bernanke next time he has the chance.

PS: In contrasting news the Reserve Bank of India seems to be suggesting, at least according to The Economist, that it would raise its inflation target above 5%. Good for them.

What is new about the IMF's views on capital controls?

I wanted to write about this topic for a while, but didn't have enough time. The IMF has adopted a new institutional view on capital controls, which will inform their policy advice and surveillance of member countries, which they suggest reflects "a very broad consensus" [I'm always a little bit wary of broad consensuses]. Note that the Fund is still in favor of capital account liberalization, as noted in the second key feature of their institutional view, which says that "capital flow liberalization is generally more beneficial and less risky if countries have reached certain levels or 'thresholds' of financial and institutional development."

The question is how to get beyond the threshold, but there is no doubt that liberalization should be ultimately pursued, at least to some degree. They do add a cautionary note that full liberalization might be an impossible goal for many countries. In their words: "countries with extensive and long-standing measures to limit capital flows are likely to benefit from further liberalization in an orderly manner. There is, however, no presumption that full liberalization is an appropriate goal for all countries at all times."

The new institutional view is based on the notion that capital flows will continue to move away from the center, and that developing countries will be faced with a persistent pressure for the appreciation of their currencies. Blanchard says in his post that "looking at the relevant set of investors suggests higher flows to emerging markets are here to stay." He also suggests that the biggest threat from those inflows, the so-called Dutch Disease that New Developmentalist authors like Bresser-Pereira (here, for example) have emphasized, is not that dangerous and the empirical evidence about it is not well established [by the way, I tend to agree with Blanchard on this one, and believe that fears of a Dutch Disease are exaggerated].

My concerns with the new institutional view are twofold. On the one hand, I would rather not accept a general rule in which the IMF has a say on when and why a member country should use capital controls. Right now countries have a right to do it. So this new institutional view actually reduces policy space for developing countries. Note that the IMF, in spite of all the talk about the new macroeconomics is enforcing austerity in the European periphery. So the orderly manner that would lead to benefits from capital account liberalization are basically fiscal asuterity and inflation targets (slightly higher, 4% and not 2%).

Second, the view of the relevance of capital controls is limited to its effects on exchange rates, its volatility, the risk of appreciation, and last the possibilities of depreciations with disruptive outflows (or sudden stops). I tend to see capital controls as an essential tool not just for exchange rate management, but also for industrial policy, since the availability of dollars is often essential for determining which sectors can be promoted by allowing imports of essential goods (e.g. capital and intermediary goods), and which ones would be forced to rely on domestic substitutes. Import substitution and alternative development policies, of course, remain an anathema at the IMF.

Further, exchange rates are connected and do affect income distribution. It is far from clear that the only thing a country wants to do is avoid 'excessive' appreciation and loss of external competitiveness. Higher wages, associated with appreciated exchange rates, might be relevant for demand expansion too. At any rate, the point is that a great deal of discretionary power by domestic authorities should be the norm when it comes to capital controls. The less power the IMF has in this respect, the better.

The inflation expectations fairy

There are confidence fairies and there is the inflation expectations fairy. It's a 4% fairy apparently. I'll explain. So Krugman correctly points out always that the more fundamentalist neoclassical economists (the Talibans that love price flexibility and instantaneous adjustment to full employment, not the moderates that also believe in a natural rate, but think it takes a while to get to it like Krugman himself) believe that the economy would recover if only a proper environment for investment was created. Hence, if confidence returned we would have a recovery.

They obviously invert causality between confidence and recovery. As noted by Marriner Eccles long ago: "confidence itself is not a cause. It is the effect of things already in motion. (...) What passed as a 'lack of confidence' crisis was really nothing more than an investor's recognition of the fact that new plant facilities were not needed at the time." Investment is the result of a growing economy, in which firms tend to adjust their capacity to demand. No demand for your goods no need to invest to create capacity to produce more. Plain and simple.

Now a dispute on what is the appropriate policy for the Fed, and what has been Bernanke's role has developed between Krugman and Bernanke (see here and here) [Ball has a more academic paper saying basically the same as Krugman here]. They argue that Bernanke has been correct in pursuing quantitative easing -- the buying of long term Treasury bonds to keep not just short, but also long term interest low -- and saving banks, but he has been reluctant to increase the inflation target to 4%. Blanchard has said pretty much the same about the need for a higher inflation target (this was hailed as new thinking in macroeconomics; with that criteria when Greenspan disregarded the 6% natural rate of unemployment level, believing it was somewhat lower, he was a radical innovator!). [I’ll leave for another post the question of why are we even talking about an inflation target in the US if the Fed supposedly doesn’t have one].

Krugman notes that Greg Mankiw actually has sent a veiled (or not so veiled threat, as he is the advisor to Romney, which may or may not have something to do with Bernanke’s reappointment in the future), saying that “if Chairman Bernanke ever suggested increasing inflation to, say, 4 percent, he would quickly return to being Professor Bernanke” (originally published here, yep Mankiw also writes regularly for the NYTimes).

So what is the mechanism according to Krugman (and the ‘progressives’ like the IMF chief economist Blanchard) by which a higher inflation target would lead to a recovery? In Krugman’s own words:

"If the Fed were to raise its target for inflation — and if investors believed in the new target — expected inflation over the medium term, say the next 10 years, would be higher. … [and] higher expected inflation would aid an economy up against the zero lower bound, because it would help persuade investors and businesses alike that sitting on cash is a bad idea. "

So if the Fed says it’s willing to accept a higher level of inflation – without doing anything concrete and objective like intervening and forcing banks to refinance the mortgages of people in foreclosure – then if investors are persuaded they may be confident enough to spend more. And that’s not a fairy?! The problem with any theory, including the New Keynesian, that believes [or says it does in order to get published] that there is a tendency to full employment, is that it must end on some sort of confidence for spending story, since under normal conditions the system would actually do it anyways. The confidence fairy is dead; long live the inflation expectations fairy!

Olivier Blanchard didn't learn anything from the crisis

Olivier Blanchard, top economic honcho at the IMF (not the impossible mission force), says things are bleak and here are his four lessons from the crisis (brace yourself):

"First, post the 2008-09 crisis, the world economy is pregnant with multiple equilibria—self-fulfilling outcomes of pessimism or optimism, with major macroeconomic implications. Second, incomplete or partial policy measures can make things worse. Third, financial investors are schizophrenic about fiscal consolidation and growth. Fourth, perception molds reality."

As you can see it all depends on market mood. Apparently markets are not taking their Prozac and that's why we are in this conundrum. Translating into English, bad situations (bad equilibria) may happen if governments take indecisive action, markets are not sure that the fiscal consolidation (which he seems to support, and the IMF is certainly pushing) will work, and this generates perceptions that are self-fulfilling.

No lesson about the problems with fiscal consolidations leading to recessions (no matter what people may think about it). Also, nothing about the need for central banks to buy government debt and maintain interest rates down (irrespective of markets feelings about it, like in the US). No lesson about how a worsening income distribution and a deregulated financial sector push private agents to unsustainable debt positions. And this is the guy rethinking macroeconomics? Here is my New Year resolution: stop reading Blanchard; if this is what he learned, he obviously is clueless.

The IMF still believes in fiscal austerity

In May, Olivier Blanchard, the head of the research department at the IMF, said:

"Earlier fears of a double-dip recession—which we did not share—have not materialized... The inventory cycle is now largely over and fiscal stimulus has turned to fiscal consolidation, but private demand has, for the most part, taken the baton."

The lame excuse for this ludicrous forecast now is that:

"the initial U.S. data understated the size of the slowdown itself. Now that the numbers are in, it is clear that more was going on."

In all fairness I criticized that view in May (here) and in July (here), since it was clear that fiscal austerity (Blanchard says consolidation, but he means reduction of spending and increases in taxes, that is austerity measures, which may not lead to a reduction in deficits, i.e. consolidation; one day I'll publish the IMF-English/English-IMF Dictionary) would not work.

Now that he admits that private demand has not taken the baton you think he would admit that fiscal consolidation (austerity really) is not the solution. You would be wrong, of course. He says in the new World Economic Outlook foreword (WEO, Sept, 2011) that:

"Fiscal consolidation cannot be too fast or it will kill growth. It cannot be too slow or it will kill credibility."

Not very different from what Christine Lagarde, his boss, has been saying. That is, we need fiscal austerity, but not too much (see my critique here). The new claim (in the last WEO) is that China has to import more, since the US private demand will not pick up (and fiscal austerity is needed).

By the way, according to the IMF China will grow 9.5% in 2011, and the yuan has appreciated strongly in real terms (particularly when you deflate by the real wage, that grows astronomically in China). So it's unclear how China could, besides growing sufficiently fast to keep a good chunk of the world economy (in particular exporters of commodities) expanding, also get the US out of its recession.

Perhaps, Blanchard and the IMF should revise their views on fiscal policy for developed countries (the IMF could also change it's adjustment programs based on austerity in Europe too!).