quickly...before i die...take my magical sword...and set forward guidance for the kingdom...yes, i know interest rates are at zero, but i know you have the power, dammit...quickly, before i am succeeded by republicans

So just around this time last year I wrote the following, which I will quote in its entirety because it’s awesome:

Let’s model a kingdom. In this model, the kingdom is a closed economy, and (very importantly) it is “well-normed” – it has strong norms relating to governance and society that tend to be widely honored and respected.

This kingdom is governed by two individuals: the king, and the wizard. Most formal power, as well as the titles of head of state and head of government, is vested with the king. The king has formally unlimited powers to tax and spend, raise armies, and adjudicate disputes, but in practice is limited by norms, sense of duty (symbolized in a sworn oath to serve in the interest of the whole kingdom and its subjects), and the patience of subjects; therefore, the king tends to maintain inherited intuitions to which their power has been delegated, like courts and military bureaucracy. The crown is hereditary – the first-born child of the king (this is a gender-progressive kingdom) inherits the crown, and in the past, though there have been occasional hiccups, most transfers of power have been peaceful and orderly.

The king must retain a wizard, who is charged in vague terms with independently securing the safety, security, and prosperity of the kingdom. The wizard bears a hat that grants them vast yet mysterious magical powers. Unlike the crown, which is symbolic, the wizard’s hat is in fact where the magical powers are vested, and is not hereditary. When the existing wizard dies, the king selects the next wizard, who receives a lifetime appointment. Extremely strong norms dictate that the king select whomever is widely acclaimed the wisest scholar in the kingdom, regardless of their personal feelings towards that individual or inclination to select an ally as wizard. Often the wizard will survive the king.

As stated above, the wizard has vast powers, but they are mysterious and to some extent ill-defined. There is no user manual for the wizard’s hat, and often throughout history wizards have surprised themselves with the consequences of exercising their powers. Therefore, norms have developed that the wizards exhibit strong restraint in exercising their powers, even in times of emergency. Extremely strong norms have also developed against the king making formal or open requests of the wizard, as well as against the wizard interfering in the quotidian or terrestrial business of the king. In the past, there have been some violations of this norm in both direction, but for the most part it tends to persist. Consequentially, the wizard tends to be reclusive, speak carefully and opaquely, and avoid commitments to use their powers. There is much dispute among the subjects of the kingdom to exactly what the wizard is doing or could be doing, and when the wizard ought to exercise their powers.

Your assignment: model the governance and economy of this kingdom.

Obviously this is kind of an allegory. And I’m going to just blow it wide open by saying the king is the fiscal authority and the wizard is the monetary authority. And while it doesn’t quite match up with how the modern world works, I think it has some implications.

Now there is great sturm und drang in the econoblogobloid about whether Keynesianism or Monetarism is “right” and what “monetary offset” is and I just don’t get it at all because to me it all makes perfect sense together.

My theory is this – monetary policy dominates fiscal policy, but doesn’t always, or even usually, exercise that dominance to determine point outcomes. Instead, it usually determines range outcomes, and within those ranges fiscal policy exerts influence.

So for example if the monetary authority declares “the rule is that inflation will never exceed 2%” that means a whole range of outcomes are possible; just not those where inflation exceeds 2%. So fiscal policy can, by being expansionary or contractionary, have a substantial influence on inflation, unemployment, and GDP, just within the range of outcomes that are possible with below-2% inflation.

If the monetary authority declares “we will print $100 billion and buy bonds with it every month until unemployment hits 3%” that means a whole range of outcomes are possible, but all those outcomes must account for an additional $100 billion of “high-powered money” in the economy every month. So fiscal policy can, by being expansionary or contractionary, have a substantial influence on inflation, unemployment, and GDP, just within the range of outcomes that are possible with regular large monetary infusions.

If the monetary authority declares “we are targeting the path of NGDP and we will never let it deviate ever ever no matter what ever” that means a whole range of outcomes are possible; just not those where NGDP deviates from its price path. So fiscal policy can, by being expansionary or contractionary, have a substantial influence on inflation, unemployment, and real GDP, just within the range of outcomes that are possible with rock-solid 5% NGDP growth.

If the monetary authority declares a whole bunch of stuff, some of which is concrete, some of which is fuzzy, and some of which is muddled, well…many outcomes become possible. But many are not!

So the story of 2013 is not one where monetarism was right because the Fed got exactly what it wanted; it’s one where fiscal contraction couldn’t generate outcomes outside the bounds set by the Fed. But it does mean that outcomes could have been better had fiscal policy been less contractionary. Counterfactuals are hard, but that’s a reasonable one.

Now, I’m a believer in the power of monetary policy, so I think it would be great if the Fed set an NGDP target and committed to not only a growth target but a path target and that they were going to overcompensate to get us back to the pre-recessionary path. I even think an optimal NGDP target is something more like 7%, not Scott Sumner’s girly-man 5%. But what I don’t believe is that absent such direct, confident, dominating policy guidance from the Fed, that Fed policy still generates pinpoint outcomes or even tight ranges of outcomes. The economy improved in 2013. It could, and should, have improved more, and that’s on both the Fed and the Congress.

Now, as much as I really, really don’t like Arnold Kling, there are also some PSST dynamics out there that constrain the power of monetary policy, which is why the auto bailout was a really good idea, but barring massive systems collapse I think monetary policy can do pretty much all the heavy lifting of macroeconomic policy but that conditional on monetary policy fiscal policy can have some room for maneuver.

Note that this is pretty much 100% what both monetarists and Keynesians think when we’re not at the ZLB; all I’m saying is that it is also true at the ZLB, and that monetary policy really doesn’t change that much. We just think it does. Which is part of the problem, because money illusion is a real and serious thing, which goes back to why our NGDP target should be higher. In general countries that are better at avoiding recessions have a somewhat higher tolerance for inflation than we do.

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