LAST week, I set out a view of macroeconomic policymaking which might be summed up in the phrase, "demand is always and everywhere a monetary phenomenon". This is the view of the "market monetarist" school, of which Scott Sumner is the best known representative, and it strikes me as an attractive view which has unfortunately not been elevated to the status of policy paradigm. Within many central banks price stability, rather than demand stabilisation, remains the goal; inadequate demand is therefore judged to be acceptable so long as price-stability goals are being (more or less) met.

It's worth pointing out, however, that there are other challenges to the narrative I presented. Paul Krugman, in a very good post that helps explain the difficulty of internal adjustment within the euro zone, writes:

On demand, I’ll make two assumptions I don’t believe. The first is that the ECB can determine nominal GDP for the euro area. Under liquidity-trap conditions, this is a very problematic assumption, and I don’t mean to drop my skepticism for other purposes. For right now, however, it’s useful, I think, to use nominal GDP as a proxy for the whole range of possible expansionary policies the ECB might follow.

Emphasis mine. So, there is a class of market monetarist critics who accept that more demand would be a good thing, but who argue that there are situations in which demand ceases to be a monetary phenomenon. One sees several different stories about the precise nature of the breakdown:

1) The most prominent may be the liquidity trap story Mr Krugman references above. Definitions of the liquidity trap differ; some use the phrase to refer to the dynamic at the zero-lower bound, at which nominal interest rates can no longer be reduced. Others make a more careful argument: that the liquidity trap is a problem when monetary policy is unable to raise the price level. Any expansion in the money supply is simply hoarded.

2) A related breakdown, which one might consider a special case of the above, is the balance-sheet recession. In this story, a huge fall in asset prices leaves the private sector with a substantial debt overhang. Private firms and households are forced into oversaving to deleverage, a behaviour that is immune to changes in interest rates, making monetary policy impotent.

3) Then there is the "broken financial markets" story, in which problems in markets block key monetary policy transmission channels. If banks are worried about funding conditions, then easier monetary policy may not induce more lending, for instance.

4) And finally, there is the panic story, in which a crisis may make it difficult for the central bank to keep markets focused on its promise to stabilise the economy. When the sky seems to be falling, as was the case in September and October of 2008, pronouncements that nominal output will not be allowed to sink below trend may simply fall into the vortex.

To the extent that proponents of these stories offer solutions, they are mostly fiscal in nature. Given dynamics like those in scenarios 1 and 2, the government can provide a direct boost to demand through deficit spending. Broken financial markets can be addressed through cooperation with fiscal authorities to provide direct lending. And fiscal authorities have more room to take attention-getting action, as through bailing out banks or propping up carmakers.

I remain sceptical that any of these stories capture technical obstacles to the conduct of adequate monetary policy. As Ben Bernanke argued in 1999, the idea that a central bank could create money and buy every last eligible security without denting inflation expectations seems absurd. And if you can raise inflation expectations, you can raise demand.

I can accept that cooperation with fiscal authorities can raise the efficiency of monetary policy. Central bankers may find it easier to shape expectations through a "helicopter drop" (a money-financed tax cut) or a lending programme than through other unconventional operations. I'm not positive that this need necessarily be true. It could be that a central bank that adopts the market monetarist framework and communicates its goals clearly needs nothing more than token action to show commitment and generate a response. But it might be an issue. People are silly beasts who may see the economy as a big, heavy object that requires proportional force to move. In that case, proportional force must be applied, unless the efficiency of the action can be increased through the use of fiscal levers.

But one still has to ask why efficiency would matter. There are no constraints on money creation, so why seek out fiscal entanglements if the same effect can be achieved through a bit more printing?

There could be other logistical constraints. The Fed, for instance, can only buy securities that are backed by the government—like Treasuries or GSE-backed mortgage paper and unlike equities—so the supply of eligible securities is large but not mind-bogglingly large. There could be a concern about the risks associated with proportional force, like a worry that depriving markets of the safe-asset of choice could be financially destabilising. Though in both cases, one has to wonder again whether the proportional force question isn't simply a matter of poor communication.

But ultimately, all of these provisos may collapse to a single caveat: that a qualitatively different central-bank response could destabilise the political relationship between the central bank and elected representatives. We can put this differently. There is no case (or no realistic case) in which a central bank loses the technical ability to adjust demand, but there are situations in which the central bank can only raise demand in ways that reduce the welfare of a critical constituency. In such cases, demand can only be raised through programmes which adjust the distribution of the returns to more demand across political interest groups, which requires fiscal action.

Now, you start musing on that and you start finding yourself enmeshed in very sticky discussions about clashes between generations or classes. You also get pronouncements from central bankers that they absolutely do not take political dynamics into consideration when making policy. Maybe so. But there's a reason, isn't there, that Ben Bernanke is head of the Fed rather than Paul Krugman or Scott Sumner—someone with a strong commitment to prioritising demand stability over price stability?

We're trying to identify the nature of the slump. Economists received a huge gift in the 1930s when governments opted to go off gold and reflate at different times, providing a strong signal about the causes of and cures for Depression. What we really need now (for lots of reasons) are examples of countries that found themselves in Japanese-style slumps and then escaped.