What makes “Operation Twist” different from old-fashioned quantitative easing is that in QE2, they tried to push all bond yields down, whereas in a twist move, you try to alter the shape of the yield curve. What does that mean? It’s perhaps easiest just to illustrate what changed between the 20th and the 21st:

The short-term rates, you see, went up slightly even as long-term rates fell. That’s the twist. It also shows, incidentally, that contrary to some press reports the financial markets weren’t fully expecting action of this scale in advance of the announcement. The whole pre-announcement week saw minor changes in rates going in the other direction. At any rate, as you can see the Fed’s strategy worked and the yield curve is now flatter.

Given that this “worked,” the question is why Ben Bernanke thinks it’ll work. What’s really supposed to happen as a result of this? Non-underwater households will presumably refinance their mortgages at a somewhat greater clip and that’ll put some cash in their pockets. But nothing’s been done here to alter expectations. And why do this rather than QE3? My understanding of the original 1961 Operation Twist is that the idea was to promote capital inflows in order to maintain US gold reserves. The contemporary parallel would involve raising the price of the dollar, which given the size of the trade deficit is totally counterproductive.

Thinking harder on the GOP letter to the Federal Reserve yesterday, I want to say that even though I think the policy they were pushing was entirely wrong, I wish more politicians would offer opinions about this kind of thing.

In my view, the best model for central bank independence would be our independent Supreme Court. The justices’ decisions are not subject to veto by congress, and the justices don’t stand for election. But the justices are part of the political process, and the power to appoint Supreme Court justices is rightly understood as an important aspect of presidential authority. Candidates for the presidency are required to talk about their approach to judicial appointments, and it’s expected that important judicial decisions will be debated by political figures including incumbent members of congress. That’s not “politicizing” the court, it’s a recognition of the fact that the Supreme Court is an important government institution.

By the same token, the Federal Reserve is an important government institution and the elected officials in the government ought to talk about it.

For all the attention played to the president’s recent jobs speech, and even to his deficit plan today, by far the most important economic news of the week is going to come out of the September meeting of the Federal Reserve Open Market Committee. It’s set to be a special two-day affair in order to give members the time necessary to familiarize themselves with the options available to create additional monetary stimulus.

Most people see that as a sign that Chairman Bernanke has basically decided that he favors additional stimulus and needs a long meeting in order to whip votes and get everyone comfortable with his ideas. And certainly over the past couple of months, I’ve heard more frequently from professional staff that I’m underrating the basic lack of agreement around methods of delivering an economic boost rather than the desirability of doing so. Of the ideas under consideration, the one you ought to be rooting for is Chicago Fed President Charles Evans’ call to explicitly state that the Fed will tolerate a bit of extra inflation until unemployment drops several percentage points. My view (which I should add is by no means widespread among economists) is that such a statement would, on its own, increase real output. But even if it doesn’t, it’s a necessary first step to getting a boost.

I don’t think Kenneth Rogoff’s proposed “Great Contraction” framing device is any better than the “Great Recession” terminology he wants to replace it with. The real moral of his story is that we’re experiencing a Great Deleveraging:

But the real problem is that the global economy is badly overleveraged, and there is no quick escape without a scheme to transfer wealth from creditors to debtors, either through defaults, financial repression, or inflation. [...]

For example, governments could facilitate the write-down of mortgages in exchange for a share of any future home-price appreciation. An analogous approach can be done for countries. For example, rich countries’ voters in Europe could perhaps be persuaded to engage in a much larger bailout for Greece (one that is actually big enough to work), in exchange for higher payments in ten to fifteen years if Greek growth outperforms. [...]

In my December 2008 column, I argued that the only practical way to shorten the coming period of painful deleveraging and slow growth would be a sustained burst of moderate inflation, say, 4-6% for several years. Of course, inflation is an unfair and arbitrary transfer of income from savers to debtors. But, at the end of the day, such a transfer is the most direct approach to faster recovery. Eventually, it will take place one way or another, anyway, as Europe is painfully learning.

Of course we haven’t done that and we haven’t had a quick escape. In the narrowest view, you can say that creditors have succeeded politically in resisting pressure to eat losses. But the cost of that has been lower economy-wide output which ultimately doesn’t help the creditors since you can’t be repaid money if the people who owe you money don’t have it. That said, within the broad class of “creditors” there are diverse interests, each one of which is perfectly rational in trying to avoid pressure to eat losses. But if they’re all successful, you get a negative sum outcome.

Via Paul Krugman, Eugene Fama offers a syllogism on macroeconomic stabilization:

Again, here is my argument in three sentences.

1. Bailouts and stimulus plans must be financed.

2. If the financing takes the form of additional government debt, the added debt displaces other uses of the same funds.

3. Thus, stimulus plans only enhance incomes when they move resources from less productive to more productive uses.

Are any of these statements incorrect?

In his attack on me Krugman implicitly assumes that sentence 3 above is true; that is, the stimulus plan will on balance move resources from less productive to more productive uses. This is indeed the focus of the issue.

One way to understand what’s wrong with this is to consider the circumstances under which it might be true. Suppose that we were living in the Kingdom of Coneria and “funds” meant “gold coins.” In that case, anything the government does to stimulate the economy requires the acquisition of additional gold coins. You could borrow the gold coins, you could tax the gold coins, you have options, but somehow you’ve got to get the coins. In this case, due to the objective scarcity of coins the only real issue is whether you’re shifting the coins from a low-efficiency use to a high-efficiency one.

But now suppose you swap everyone’s coins for little pieces of paper with the king’s face on them. Just as before, economic actors need a medium of exchange. And just as before, taxes are due. But instead of paying taxes with gold coins, you pay them with little pieces of paper. This makes the pieces of paper commodities worth having, and thus convenient for use as a medium of exchange. Now the king is riding around one day and he notices that 9.1 percent of the population is unemployed. He also sees that there’s a bridge in disrepair. So he prints up some more little pieces of paper, walks over to some unemployed dudes, and says, “I’ll give you some paper if you fix the bridge.” The dudes are short on little pieces of paper, so they jump at the opportunity. This use of pieces of paper doesn’t need to be more efficient than some alternative use of the paper. You just had the paper printed. All that has to happen is that it has to be more efficient for the dudes to be building a bridge than for the to be sitting on the couch scouring the help wanted ads and feeling depressed.

I was pondering Scott Sumner’s argument yesterday that a true inflation-targeting regime from the Federal Reserve would imply extremely small fiscal multipliers. But it’s difficult to get around the fact that this cuts against the stated views of the Fed’s top official as well as all the staff economists I’ve ever heard from:

Federal Reserve Chairman Ben Bernanke warned Congress on Thursday that overzealous cuts to government spending could derail an already fragile recovery and said a U.S. debt default could wreak financial havoc.

“I only ask … as Congress looks at the timing and composition of its changes to the budget, that it does take into account that in the very near term the recovery is still rather fragile, and that sharp and excessive cuts in the very short term would be potentially damaging to that recovery,” Bernanke told members of the Senate Banking Committee.

There are a lot of ways you can reconcile Bernanke’s view with Sumner’s, including by just saying that the Fed isn’t doing inflation targeting. But it sure would be nice to know what the Fed’s own theory is. The ambiguity around this is one of several reasons that I think it would be desirable for the Fed to have a clearer and less ambiguous mandate.

I have genuinely no idea why William Galston thinks the point that the mortgage-debt overhang is playing a huge role in the recession constitutes a “new” theory of the recession. But I’m not peevish, so I’ll just say he’s correct and we should talk about solutions:

It’s time, then, to reexamine our housing policy from the ground up. If employers won’t hire until consumer demand increases, and if demand won’t increase until household balance sheets recover, then policymakers should focus on accelerating that recovery. Here’s a back-of-the envelope calculation: If we need to return the household debt burden to where it stood before the bubble, we can either wait another four or even five years (which is what it would take at the current rate without additional intervention), or we can speed it up by allocating the losses of principal that lenders need to accept and remove from their books. Moving the household debt to disposable income ratio from 118 percent to the pre-bubble 100 percent implies a total debt reduction of roughly $1.5 trillion.

As I said yesterday, doing that might actually end up requiring more “bailouts” of institutions paired with firings of bank managers. Politically speaking, that’s a hard lift.

This is one of several reasons why I believe that the best resolution would be to set a higher Nominal GDP growth target and clarify that the Fed is willing to accommodate Reagan-era levels of inflation if that’s what’s necessary to achieve it. Most mortgage debt, and a decent share of other debt, is denominated in nominal terms, so inflation accommodation would speed the process of getting people out from under debt overhangs. But unlike targeted mortgage relief, it would also help people (like, say, me) who have mortgages but aren’t underwater. Last, such a commitment from the Federal Reserve would also encourage high net wealth individuals and cash-rich firms to reduce their holdings of safe low-yield assets and increase their purchases of real goods and services or riskier private business investments.

I found an enormous amount to like in Alan Blinder’s column on America’s jobs crisis, but this bit on the Federal Reserve is wrong:

Creating jobs costs money—whether it’s via tax cuts or more spending. (The Federal Reserve normally can create jobs without budgetary costs, but with interest rates already near zero it says it’s out of ammunition.) If Congress and the president are fixated on reducing the federal budget deficit to the exclusion of all else, we are not going to make headway. So yes, let’s enact a major deficit reduction program right away, but start the cutbacks only in the future. For now, we need a jobs bill.

One point on this that I find a lot of progressive economists miss is that even if you think there’s nothing the Fed can do to boost job creation, this isn’t something the Fed has ever said. On the contrary, the Fed’s position is that both QE1 and QE2 boosted job creation, they’ve given no reason to think that they think QE3 wouldn’t work, and much of Ben Bernanke’s scholarship is dedicated to the idea that “zero lower bound” does not in fact bind. The Fed isn’t doing more because it doesn’t want to do more. As Bernanke put it in 2002: “A central bank whose accustomed policy rate has been forced down to zero has most definitely not run out of ammunition.” What’s more, this seems to me to be obviously correct once you think about it. For one thing, it’s right there in the idea of an accustomed policy rate. A central bank can always force other interest rates lower. What’s more, by shaping inflation expectations, a central bank can push real rates lower. Last, per Blinder, “creating jobs costs money,” but the Fed can manufacture money.

In terms of specific ideas and leaving QE3 aside, perhaps the most overlooked lever in the Fed’s arsenal is the interest on excess bank reserves. Traditionally, the Fed has set a regulatory floor on how much money banks need to hold in reserve. And everyone’s understood that raising the reserve level is contractionary and lowering it is expansionary. And traditionally, if banks want to hold larger reserves than that, they’re allowed to, but they would earn no interest on it. In the fall of 2008, the Fed started paying a small amount of interest on excess reserves. Since that time, bank holdings of excess reserves have skyrocketed. This is contractionary for all the same reasons that a higher required reserve level would be contractionary. The Fed could bring this rate back down to zero or it could follow Sweden’s central bank and set it at a negative level. Either this strategy or a “helicopter drop” strategy seem to me to be absolutely guaranteed to increased nominal spending and thus employment.