No eurozone mystery

Tyler Cowen has a new post discussing the very low inflation rate in the eurozone:

What is the most economical model here?  The ECB invested in building up a lot of credibility in some areas, such as price level stability, but that means less credibility when it comes to pushing higher inflation.  So to get two percent inflation, perhaps the ECB has to genuinely and truly seek four percent inflation, because a big chunk of the market won’t believe they really want four percent.  Four will get them to two.

The ECB in fact may be wishing for two percent price inflation and getting…less than that.  Which in turn conditions market participants to doubt the commitment of the ECB to the rates of price inflation which it claims to be seeking.  The ECB and the citizenry can get stuck in a self-fulfilling prophecies equilibrium, yet without requiring a standard liquidity trap.

I see a simple explanation, the ECB really is as stupid as they seem.  Over the last 5 years everyone from market monetarists to Keynesians have been absolutely incredulous at the statements made by ECB officials, and the actions taken by the ECB.  They often seem incomprehensible.  ”Surely they can’t really be this stupid, there must be a dark conspiracy somewhere.”  Call me naive, but I’m inclined to actually believe that they believe what they say:

1.  When eurozone inflation briefly rose above 2% in 2010-11, due to obviously temporary factors like VAT and oil price increases, they sharply tightened policy, insisting that unemployment didn’t matter.  They needed to focus like a laser on inflation.

2.  When inflation fell far below 2%, and indeed into deflation in several countries, we were told that falling prices are actually good, as they help restore competitiveness in the PIIGS.

I don’t think there is a model, just atavistic urges.  Yes, Paul Krugman and I pull our hair out when we read these comments, but I see no reason to disbelieve them.  Their words are backed up with actions.  For 6 years they have acted exactly like a central bank that wanted to push inflation far below 2%.  Keep in mind that eurozone NGDP is up less than 5% in the last 6 years—does anyone think that will lead to 2% trend inflation?

The ECB does not need to shoot for 4% inflation to get 2% inflation, they need to shoot for 2% inflation to get 2% inflation.  I might add that the ECB has NOT been at the zero bound throughout the vast majority of the past 6 years.  They’ve been doing “normal” monetary policy–raising and lowering their interest rate target.  So one cannot point to the zero bound issue as an excuse for the ECB’s policy failure.  They can’t even do normal monetary policy correctly.   Outsiders have consistently pointed out that the ECB would fail to hit their target, and we’ve been consistently right.  Second guessing the ECB is like taking candy for a baby, not even a fair contest.  Look, everyone from Paul Krugman to Milton Friedman knew this wasn’t going to work.  Here’s a Friedman interview back in 1999 in the Hoover Digest:

EPSTEIN: Do you think the European Monetary Union will be a success?

FRIEDMAN: I hope so, but I am very dubious.

EPSTEIN: Why so?

FRIEDMAN: Because the European Union is not an appropriate area for a single currency. There are some cases where a single currency is desirable and some where it is not. It is most desirable where you have countries that speak the same language, that have movement of people among them, and that have some system of adjusting asymmetric effects on the different parts of the country. The United States is a good area for a common currency, for all those reasons.

But Europe is the opposite in all these respects. Its inhabitants speak different languages, have different customs. And there is limited mobility between countries. The exchange rate between different currencies was a mechanism by which they could adjust to shocks that hit them asymmetrically—that hit one area differently from another. The Europeans have, in effect, entered into a gamble in which they have thrown away that adjustment mechanism. It may work out all right. But on the whole, I think the odds are that it will be a source of great trouble.

EPSTEIN: What kind of trouble?

FRIEDMAN: The trouble will not be for all of them. Some among them will be affected by developments that would have called in the past for a depreciation of their currency. But given that they are locked into a single currency, the alternative will be a recession.

The only mystery is why the Europeans are confused about why the euro has failed.

PS.  Rereading Tyler’s post after writing this I’m not sure I actually disagree with him.  I suppose aiming for 4% to get 2% might be consistent with incompetence.  I’m not quite sure if I’m arguing that they don’t have a coherent policy, or that they wouldn’t know how to achieve it if they did, or both.  All I know is that there is no technical mystery—if the steering wheel is set for ENE, don’t be surprised if the ship moves in a ENE direction.  Even if the announced target is ESE.

PPS.  Just saw the employment report.  Wages flat in July, up just 2% in 12 months.  We still have slack–we are in recovery mode.  Unemployment can and will decline further.

The failed 2013 Keynesian experiment: even worse than you thought

When 2013 ended I couldn’t help pointing out that we passed Krugman’s famous “test” of market monetarism with flying colors.  GDP growth was initially estimated as being slightly higher in 2013 than 2012 (comparing Q4 to Q4.)

Now the annual revisions are in for 2012 and 2013, and the new numbers look even worse for the Keynesians.  Let’s start with the numbers that Keynesians always (wrongly) use as proxies for demand growth—RGDP:

2011:4 to 2012:4:   1.60%

2012:4 to 2013:3:  3.13%

So real GDP growth almost doubled under the weight of higher income taxes, higher payroll taxes and the famous “sequester” which reduced government spending.  I predict this will do nothing to shake the consensus Justin Wolfers discusses here.

The theoretically appropriate indicator is of course NGDP:

2011:4 to 2012:4:   3.47%

2012:4 to 2013:3:  4.57%

I was asked if the strong growth in Q2 caused me to revise my belief in the Great Stagnation.  Not really, as it is based on long term trends.  Or at least not very much.  (Don’t forget Q1 was very weak.)  I still think we are trending at about 3% NGDP and 1.2% RGDP growth over the next few decades.  With immigration reform, both those numbers might rise a few tenths of a percent.

Of course this means low nominal interest rates for the rest of my life.  I doubt I’ll ever again see T-bills yield 5%.  I hope I’m wrong.

Mark Sadowski missed on the GDP numbers this morning (he had RGDP up 1.6%) but given the massive revisions we often see, perhaps we should wait a bit.  He was far and away the best on Q1, but we didn’t know the actual Q1 RGDP figure was negative 2.1% until today.  It was originally up 0.1%.

When I started blogging I didn’t know we were in a Great Stagnation.  I still think I was right about the mostly demand-side nature of the 2008-09 recession, but in the early years of blogging I modestly overestimated the size of the output gap.  I think that gap is now mostly closed, and will be completely closed next year.  But keep in mind aggregate supply and demand can get “entangled,” and also that policies like unemployment insurance and Obamacare can slightly impact trend RGDP.  So these things are very tough to pin down.

PS. In fairness to the Keynesians, I don’t quite believe that 2012/2013 RGDP growth differential.  I think the BEA overestimated the speed-up in growth in 2013.

PPS.  I have another post on fiscal stimulus at Econlog.

HT:  Commenter Nick

Update:  Commenter Kailer Mullet added this:

The year of Austerity, 2013, had the highest Q4/Q4 (if you use absurd decimal precision) in 10 years.

Does monetary policy explain the British jobs recovery?

There’s been a lot of discussion of the disconnect between British output (which has done poorly over the past 6 years), and total employment, which is reaching new records, and is even at near record levels as a percentage of the population.  After discussing the strong UK jobs growth, Matt Yglesias presents data on the weak RGDP performance, and then comments:

This is a very long time for GDP to recover to its pre-crisis point, and GDP per person is at an almost shockingly low level. This is far worse than the US has done.

There are some different possible interpretations of this. North Sea fossil fuel production is down. Banking has taken a hit everywhere, and it’s a huge share of the British economy. Or perhaps the Keynesian story is right — Cameron and Nick Clegg have kept government spending lower and taxes higher than they should have been, depressing output.

What’s most interesting, however, is not the dispute but two things that look indisputable. One is that something (or perhaps several things) have gone badly wrong for the British economy. The other is that the Bank of England has managed to get the country to weather that bad stuff without endless mass unemployment. Monetary policy doesn’t solve all problems. But the very fact that the UK economy has so many problems, underscores the reality that monetary policy is extremely potent in fighting the particular scourge of unemployment. Here in the USA, productivity and total output have gone much better, but monetary policy has been less aggressive and joblessness is a bigger problem despite a better overall economy.

There are some concepts lurking in the background here, such as nominal GDP and sticky nominal wages.  Yglesias sometimes presents quasi-MM arguments, but couched in more theoretically neutral language.  In any case, I like the way he described the importance of monetary policy in the final paragraph.  I like it a lot. Good monetary policy will keep the labor market in equilibrium, even if RGDP is being battered by real problems.

But no matter how much I like his conclusions, I must in good conscience point out that he’s slightly oversold his case here.  I had exactly the same view until I looked at the data.  I’m going to argue that he’s right, but for the UK/eurozone comparison, not the UK/US comparison.  Here are NGDP growth rates (total) between 2008:1 and 2014:1:

Eurozone  +4.68%

France   +6.62%

Britain  +12.43%

USA    +15.97%

I separated out France, as it’s the European economy most similar to Britain.  They have almost identical populations, GDPs and GDPs per capita.  I think the more expansionary monetary policy does explain why Britain has done better than France and the eurozone, or at least it’s part of the story.  But I see no evidence that UK monetary policy has been any more stimulative than in the US, at least in the sense that would be of importance to market monetarists—NGDP growth.  So why has Britain done better on the jobs front?  Very simple, their wage growth has been significantly more restrained.  Why?  I have no idea.  But in an accounting sense, that’s the explanation.  It might be viewed as a bit of an embarrassment to MMs, as we don’t have an explanation.  But the Keynesians don’t either, and even worse, the left wing of Keynesianism says wage restraint is contractionary.  At least we say it’s expansionary.

Britain a weird country with one really, really positive supply side fundamental–flexible labor markets.  And one really, really negative supply-side fundamental–horrible worker productivity. And it nets out to pretty decent job creation and poor output growth.

If you use the MM model to compare countries, you sort of implicitly assume similar labor markets. Then the country with the faster NGDP growth will have more job creation.  But of course labor markets are not all equal, and some of the inter-country differences in employment will be due to wages, and only a portion will be due to NGDP growth differentials.  Interestingly, none of labor mystery is explained by productivity.  But when you turn to real GDP, then you look at productivity and employment.

Britmouse has a related post:

There is an interesting asymmetry in how people read the macro data.

For a given increase in aggregate nominal spending (income) I think it would be generally agreed that “what we want to see” is a higher volume of output and not much inflation.  Does anybody disagree? Anybody out there who would prefer the trade-off shifts towards higher inflation and lower output growth?  No?

OK.  For a given increase in aggregate nominal income (spending) we can consider the same trade-off between employment and wages.  I had taken it as given that we had a depressed labour market and so “what we want to see” is that increases in aggregate income will translate primarily into higher employment.

Then he presents data on flat hourly wages and discusses how virtually all of the nominal income growth is feeding into jobs, jobs, jobs.  But the reaction from the left puzzles him:

Yet this is seen somehow as a bad thing, see, for example the Guardian here, which puzzles me.  Do you have a sticky wage model of the labour market, in which AD shocks can raise/lower employment, or not?   Is higher employment in 2014 a good thing, or not?   These questions have simple answers for this simpleton blogger.

I can never figure liberals out.  They say unemployment is far worse than inflation. It destroys a man’s spirit.  It’s just plain psychologically devastating in all sorts of ways, even with unemployment compensation programs. Then I suggest replacing the minimum wage and welfare with jobs for everyone and big hourly wage subsidies, and liberals respond; “But isn’t it punitive to make people work?  If the workers aren’t very productive, why not just left them enjoy leisure time with a guaranteed annual income?”

So like Britmouse I’m confused; is unemployment horrible, or isn’t it?

PS.  If someone told you about that 6 year eurozone NGDP growth total of 4.68% back in early 2008, they either would have thought you were crazy, or that the eurozone was about to go into a depression. But the eurozone VSPs insist that monetary policy has nothing to do with the actual depression that did occur. I’m speechless.

PPS.  And now Lars Christensen is telling us that the ECB wants employers to raise wages. Yeah, that’ll create lots of jobs in a eurozone that has seen 4.68% NGDP growth in 6 years.  In honor of Lars’ newest post, I’m going to invoke Godwin’s law: even the Nazis had a better monetary policy.

Is the Fed finally beginning to see the problems with IT?

For years I’ve been arguing that the public doesn’t understand inflation targeting, and that the Fed needs a target that the public does understand, such as NGDP targeting.  In 2010 when core inflation was running below 1%, Bernanke said the Fed would seek to raise the rate of inflation closer to 2%. Talk radio told its listeners that the Fed wanted to raise their cost of living when average Americans were already struggling, and of course there was an uproar.

Now Mike Bryan of the Atlanta Fed has a post that discusses many of these problems.  He starts off with a survey done by Robert Shiller that shows the public and economists have a radically different view of what the word ‘inflation’ means. To average people inflation is something that reduces living standards, by raising the cost of living.  Economists would call that scenario a supply shock, or a fall in real GDP.  Economists think of inflation as something that raises both wages and prices, with no first order effect on real income.  And if the economy is depressed (as in 2010) the second order effect on real incomes is positive.

Here’s Bryan:

Seventy-seven percent of the households in Shiller’s poll picked number 2—”Inflation hurts my real buying power”—as their biggest gripe about inflation. This is a cost-of-living description. It isn’t the same concept that most economists are thinking about when they consider inflation. Only 12 percent of the economists Shiller polled indicated that inflation hurt real buying power.

I wonder if, in the minds of most people, the Federal Reserve’s price-stability mandate is heard as a promise to prevent things from becoming more expensive, and especially the staples of life like, well, food and gasoline. This is not what the central bank is promising to do.

What is the Federal Reserve promising to do? To the best of my knowledge, the first “workable” definition of price stability by the Federal Reserve was Paul Volcker’s 1983 description that it was a condition where “decision-making should be able to proceed on the basis that ‘real’ and ‘nominal’ values are substantially the same over the planning horizon—and that planning horizons should be suitably long.”

Thirty years later, the Fed gave price stability a more explicit definition when it laid down a numerical target. The FOMC describes that target thusly:

The inflation rate over the longer run is primarily determined by monetary policy, and hence the Committee has the ability to specify a longer-run goal for inflation. The Committee reaffirms its judgment that inflation at the rate of 2 percent, as measured by the annual change in the price index for personal consumption expenditures, is most consistent over the longer run with the Federal Reserve’s statutory mandate.

Whether one goes back to the qualitative description of Volcker or the quantitative description in the FOMC’s recent statement of principles, the thrust of the price-stability objective is broadly the same. The central bank is intent on managing the persistent, nominal trend in the price level that is determined by monetary policy. It is not intent on managing the short-run, real fluctuations that reflect changes in the cost of living.

Effectively achieving price stability in the sense of the FOMC’s declaration requires that the central bank hears what it needs to from the public, and that the public in turn hears what they need to know from the central bank. And this isn’t likely unless the central bank and the public engage in a dialog in a language that both can understand.

This is what I’ve been saying for years.  And you do that with NGDP targeting. You tell people the Fed is trying to keep the total income of Americans, in aggregate, rising at say 4.5% per year, or whatever the target is.  My only quibble is that the phrase “cost of living” at the end of the second to last paragraph is strange. “Cost of living” means price level, which is a nominal variable. I think he means “standard of living,” i.e. real GDP. Or maybe he means “that are reflected in changes in the cost of living.”

HT:  Ed Dolan

Andolfatto interviews Woodford

David Andolfatto is a very knowledgeable monetary policy blogger, and here he interviews Michael Woodford, perhaps the world’s leading monetary theorist.  I’ll just focus on one issue:


There is a conventional wisdom of how these tools might work. Can you explain to us the findings of your own research, how they might corroborate these findings or these beliefs? Or go against them in some manner? Is there something surprising that emerges from what you’ve discovered?


I think so. I think a lot of the discussion that you see of the point of asset purchases suggests that there should be a lot of similarity between the effects of purchasing long-term assets and the effects of cuts in the federal funds rate, the Fed’s traditional tool. People say the whole point of cutting the federal funds rate is longer-term bond yields would also go down, and if you can just buy longer-term bonds, push up their prices, that’s doing the same thing with a different mechanism. It’s a different way of doing the same thing. And if you can’t cut the federal funds rate further, then there’s an obvious reason to use the other method.

And our analysis suggests that this analogy between the two tools is not nearly as strong as you might have expected.


Why is that exactly?


Well, one reason is that the question of whether it’s clear that Fed purchases of longer-term assets can affect the prices of those assets as directly as traditional interest rate policy would. But I think the more surprising thing is that our analysis suggests that even under circumstances when the central bank finds that its purchases do affect the market price of the longer-term assets, the connection between that and spending in the economy, and then the effects on inflationary pressure, are not necessarily at all similar to those of conventional interest rate policy.


So you’re suggesting that it is possible, at least in theory, that the Fed engages in the large purchase of a certain class of assets? Injects money into the economy by purchasing a particular class of assets? And that this may, in fact, have very exact opposite sort of effects than conventional data might suggest?


Right. We clearly show that that’s at least a theoretical possibility. And obviously then deciding whether you think that’s actually happening is another thing. But I think the analysis points out that you shouldn’t assume that the mere fact that you could raise the price of the bonds answers then the question about what effect you’re having on the economy.


So can you explain the economic intuition for that effect and whether or not it has some bearing as to the conduct of Fed policy today?


I think the point is a fairly simple one, and it has to do with the question of why the central bank purchases should be able to move the market price anyway, which, again, people thought was kind of obvious. They said if you’re buying more of something, surely that will tend to make it more expensive. But when you ask whether that should actually happen with a lot of sophisticated traders out there in the market that are also trading against the central bank, what we argue is that if the other traders in the economy aren’t constrained in the financing they can mobilize to take the positions that make sense for them, they will tend to automatically have an incentive to trade against the central bank and to neutralize then the effects of the central bank’s trades.

Two things struck me.  First, Woodford has a contrarian view of the effects of QE on long-term interest rates.  Second, market monetarists have a similar counterintuitive view, but for very different reasons.

Woodford starts by pointing out that people expected QE to reduce long-term rates, just as traditional fed funds rate cuts reduce long term rates.  But MM doesn’t even accept the premise. Some of the most dramatic Fed moves toward cutting short-term rates have actually boosted long term rates, via the inflation and income effects.  We think QE also has an ambiguous impact on rates, for similar reasons.  In contrast, Woodford focuses on the risk channel (you should read the whole thing to get his explanation.)

Then Woodford suggests that the relationship between long-term rates and the economy is not as clear as with traditional tools.  We agree that it’s not at all clear (never reason from a price change), but we think that’s also true of traditional tools.  One cannot assume that lower interest rates produced by the Fed will lead to strong growth in AD.  It depends on the relative strength of the liquidity, income and Fisher effects.

In the final paragraph I quote, Woodford points out that most people think that Fed purchases “obviously” boost the price of the asset being purchased.  They misuse the S&D model.  Some commenters are outraged that the Fed is helping group X, because group X owns lots of the assets that the Fed is buying.  They see dark conspiracies.  But the purchase of bonds is also the sale of cash.  And more cash boosts inflation, which reduces bond prices.  During the 1964-81 period the Fed radically increased the amount of bonds it was buying, this led to rapid growth in the monetary base, higher inflation, and much lower bond prices.  So much for Cantillon effects. 

Yes, there are cases where large asset purchases are associated with low inflation (such as recently); my point is that there is no consistent relationship between Fed asset purchases and the price of that asset.

HT:  Tom Brown, TravisV.