Bullard’s “Death of a Theory”

St. Louis Fed President James Bullard has released a paper entitled, “Death of a Theory”. Overall, I think that the paper is a useful overview of the issues surrounding the use of monetary and fiscal policy in the context of the New Keynesian model and in recent experience.

The basic argument made by Bullard is as follows:

1. The conventional wisdom prior to the crisis was the fiscal policy was largely ineffective as a stabilization tool and therefore stabilization should be left to monetary policy.

2. The New Keynesian model suggests that monetary policy is ineffective at the zero lower bound.

3. The effectiveness of fiscal policy is dependent on the role of monetary policy. Given the ineffectiveness of monetary policy at the zero lower bound, there is a potential role for fiscal stabilization policy.

4. There are three problems with this viewpoint:

i.) The political process in the United States is ill-equipped to make timely and effective decisions on fiscal policy.

ii.) Monetary policy over the last few years has shown that monetary policy is not ineffective at the zero lower bound.

iii.) “The actual fiscal stabilization policy experiment did not involve funding increased government spending with lump-sum taxes, as contemplated in the theory, but instead involved heavy borrowing on international markets. In models, the borrowing would be interpreted as promised future distortionary taxes, but it is exactly the shifting of distortionary taxes into the future beyond the period of the binding zero lower bound and financial market turbulence that can undo most or all of the benefits that might otherwise come from the fiscal stabilization program.”

Some useful quotes can be found after the jump.

Regarding the effectiveness of quantitative easing:

“The literature on monetary stabilization policy when the policy rate is at the zero lower bound is generally supportive of the effectiveness of QE policies. Yet in the baseline New Keynesian DSGE literature, the leading theory in the area, such policies are typically ineffective. This situation reminds me of a paraphrase of something Ronald Reagan used to say — namely that an economist is a person who sees something work in reality and wonders if it works in theory. My judgement is that the discrepancy between the existing theoretical results and the existing empirical evidence says more about the weakness of the assumptions being used to build the theory. In particular, in the theory as it is normally presented, the central bank can buy unlimited amounts of Treasury securities and other assets through base money creation without creating any inflation. This is at odds with the international experience over hundreds of years”

Regarding actual Fed policy:

Accordingly, it is not just sticky prices alone but also monetary policy encountering the zero lower bound that creates the situation where the case in favor of fiscal stabilization policy comes into play in the New Keynesian DSGE framework. At the zero lower bound it may be argued that the monetary authority cannot pursue optimal monetary policy anymore, because, at least inside the model, once the zero bound is encountered there is little the central bank can do to influence the real interest rate. Strictly speaking, this assertion is not true even inside the New Keynesian framework, since the central bank could make credible commitments to keep the policy rate near zero for a period somewhat longer than otherwise expected and could through this mechanism conduct an appropriate monetary policy that would
eliminate the need to turn to fiscal policy for macroeconomic stabilization purposes. In fact, this idea has been a part of the FOMCís actual policy since 2008, first through the “extended period” language and more recently through the “at least through mid-2013” language in the Committee’s statements. So, in addition, one has to assume that this type of promise is not effective either, perhaps because the central bank does not have the ability to make the appropriate type of commitment far into the future.