A Reply to Mark Calabria on ‘The Conservative Case for QE2’

by David Beckworth

Mark Calabria of the Cato Institute provides a very civil critique of my article in National Review Online. He raises three key objections to my arguments in the article. I will address each one in turn.
Calabria’s first objection:

[Beckworth] argues that spending is far below trend. That is true enough as it goes, but this trend includes a massive housing bubble, where imaginary wealth fueled spending, aided by massive borrowing from abroad. The objective of our economic policies should not be to get back to the top of the previous bubble. It was this desire to replace the lost wealth of the dot-com crash that contributed to the Fed’s juicing of the housing market. All that said, consumption today is higher than at any time during the recent bubble. The primary problem facing our economy is not a lack of demand.

I never argued in the article for a return to a bubble-driven economy, only to a stable total current dollar spending level. Such an objective, which could be achieved via a NGDP level target, does not require a return to debt-fueled consumption and asset bubbles. As I note in the article, all it requires is for creditor households, firms, and banks to simultaneously reduce their demand for money. There is no need for debtors to incur more debt here. Given the excess capacity and sticky prices, the resulting increase in nominal spending by creditors would occur without new asset bubbles emerging. Asset bubbles typically emerge when market interest rates are held below the neutral interest rate level. This happened in the early-to-mid 2000s; it is not happening now. Interest rates are low now, but so is the neutral interest rate given the weakened state of the economy.

Another way of looking at this trend is to remember there are plenty of non-bubble years that follow the trend closely. If it is possible for these periods to exist at trend without bubbles why not now, especially given all the resource slack? Actually, the trend I showed in article understates the extent of the problem. For it is based off of total demand (i.e. total nominal GDP). If one looks to a measure of demand on a per capita basis, then one finds it has not even returned its peak level. For example, below is a figure showing domestic demand per capita: (Click on figure to enlarge.)

I cannot see anything but a demand problem in this figure. Given the Fed has significance influence over nominal spending, the incredibly slow recovery in this figure also indicates monetary policy has been too tight.

Calabria’s second objection:

Beckworth believes we have had no inflation. Again like the Fed, he arrives at this conclusion by subtracting out of the inflation numbers all the things that real people spend their money on, such as food and energy. I would not claim we are facing hyper-inflation, but two facts should be borne in mind. First, over time even low levels of inflation erode away wealth; and second, a large surge of inflation is likely to occur quite suddenly, without giving the Fed months or years of warning.

Yes, core inflation ignores volatile real world items, but it is followed closely for a reason: it is a much better indicator of where inflation is going than the headline number. And after averaging around 2.5 percent, core inflation began a downward slide starting in late 2008 as seen below. This is actually the lowest it has been since the core measure has been recorded…

[Read the rest at Professor Beckworth’s blog here.]