Tuesday, 24 February 2015
Monetary offset is a joke.
One of the central ideas, if not THE CENTRAL idea of Market Monetarism is so called “monetary offset”. Scott Sumner is one of the World’s leading proponents of monetary offset, if not THE leading proponent. He explains the idea in an article entitled “Why the Fiscal Multiplier is Roughly Zero”.
Monetary offset according to Sumner is the idea that fiscal stimulus is very ineffective (as the title of his article implies) and THE REASON apparently is that if the fiscal authorities implement too much stimulus, the monetary authorities (i.e. the central bank) will “adopt a more contractionary monetary policy in order to prevent inflation from exceeding their 2 percent target.”
Now anyone with a grasp of economics ought to be able to spot the flaw in that idea. Incidentally I’ve put the relevant passage from Sumner’s article below under the heading “Sumner’s own words” and in italics. And of course readers wanting an even more detailed look at his ideas are free to read his whole article.
Anyway, for the benefit of readers who haven’t spotted the flaw, I’ll spell it out, and in fact the flaw can be illustrated very nicely by reference to a car, as follows.
Suppose one person has control of the accelerator (fiscal policy), and someone else controls the brakes (monetary policy), obviously one of the things the “brake controller” will do is to apply the brakes if the “accelerator controller” has stepped on the gas too much and the car is exceeding the speed limit.
Sumner’s conclusion from the latter is that the accelerator (fiscal policy) is near useless, because if too much of it is applied, the brake controller will slow down the car. Well hopefully most readers will by now have seen the flaw in the argument.
The flaw of course is that an accelerators is a good way of controlling a car’s speed. There’s nothing inherently wrong with accelerators. And the fact that drivers sometimes to too fast and need to apply the brakes is not an argument against accelerators.
Moreover, the idea that if inflation looks like getting excessive, that the central bank will apply the brakes is not exactly an original idea. Everyone including the average taxi driver knows central banks do that. I.e. there is no need whatever or a gradiouse new theory called “monetary offset”.
Monetary offset is nothing more than a verbal sleight of hand. It’s for people who don’t like fiscal policy, but can’t find any serious flaws in fiscal policy.
Sumner’s own words.
“Why has the effect of fiscal stimulus been so meager in recent years? After all, interest rates in the United States have been close to zero since the end of 2008. The most likely explanation is monetary offset, a concept built into modern central bank policy but poorly understood. We can visualize monetary offset with the Keynesian aggregate supply and demand diagram used in introductory economics textbooks. If fiscal stimulus works, it’s by shifting the aggregate demand (AD) curve to the right. This tends to raise both prices and output as the economy moves from point A to point B, although in the very long run, only prices are affected. Now let’s assume that the central bank is targeting inflation at 2 percent. If fiscal stimulus shifts the AD curve to the right, then prices will tend to rise. The central bank then must adopt a more contractionary monetary policy in order to prevent inflation from exceeding their 2 percent target. The contractionary monetary policy shifts AD back to the left, offsetting the effect of the fiscal stimulus. This is called monetary offset.”