America’s industrial juggernaut

If you are as old as me, you might remember the 1950s and 1960s, when America was an industrial juggernaut.  Here are a couple pictures from Ford’s giant River Rouge complex, from (I’d guess) the early 1960s:

Screen Shot 2015-05-20 at 10.34.20 AMScreen Shot 2015-05-20 at 10.34.47 AM

Now America has de-industrialized.  And yet, we somehow managed to increase industrial production from 83.7 in June 2009 to 106.2 at the end of 2014.  That’s an increase of 22.5.  But 22.5 is just the change in an index number, what does it actually mean?  Well in March 1961, soon after JFK took office, America’s industrial production stood at 22.2.  That’s right, Obama presided over a boom in industrial production larger than the entire industrial production of the US in March 1961!  (And recall that IP is a real index, adjusted for price level changes.)

Misleading?  Off course, but still kind of interesting.  Note that America’s population has grown since 1961, but it hasn’t even come close to doubling.  Meanwhile IP is up nearly 5-fold.

PS.  IP peaked at just under 46 in November 1973, generally regarded as the date when the post-WWII industrial boom ended.

Do I believe these numbers?  Not really, as I don’t believe the government’s price level numbers.  Lots of this “growth” occurred in the 1990s and is just Moore’s Law in computers, not the US actually producing more “stuff.”  I don’t consider my current office PC to be 100 times better than my 1990 office PC.


Seeing Lu Mountain

Brad DeLong has a post discussing a debate between Paul Krugman and Roger Farmer:

I find myself genuinely split here. When I look at the size of the housing bubble that triggered the Lesser Depression from which we are still suffering, it looks at least an order of magnitude too small to be a key cause. Spending on housing construction rose by 1%-age point of GDP for about three years–that is $500 billion. In 2008-9 real GDP fell relative to trend by 8%–that is $1.2 trillion–and has stayed down by what will by the end of this year be seven years–that is $8.5 trillion. And that is in the U.S. alone. There was a mispricing in financial markets. It lead to the excess expenditure of $500 billion of real physical assets–houses–that were not worth their societal resource cost. And each $1 of investment spending misallocated during the bubble has–so far–caused the creation of $17 of lost Okun gap.

(You can say that bad loans were far in excess of $500 billion. But most of the bad loans were not bad ex ante but only became bad ex post when the financial crisis, the crash, and the Lesser Depression came. You can say that low interest rates and easy credit led a great many who owned already-existing houses to take out loans that were ex ante bad. But that is offset by the fact that the excess houses built had value, just not $500 billion of value. I think those two factors more or less wash each other out. You can say that it was not the financial crisis but the destruction of $8 trillion of wealth revealed to be fictitious as house prices normalized that caused the Lesser Depression. But the creation of that $8 trillion of fictitious wealth had not caused a previous boom of like magnitude.)

To put it bluntly: Paul is wrong because the magnitude of the financial accelerator in this episode cries out for a model of multiple–or a continuous set of–equilibria. And so Roger seems to me to be more-or-less on the right track.

DeLong is certainly right that the housing bust is far too small, but it’s even worse than that.  The vast majority of the housing bust occurred between January 2006 and April 2008, and RGDP actually rose during that period, while the unemployment rate stayed close to 5%.  So it obviously wasn’t the housing bust.  On the other hand you don’t need exotic theories like multiple equilibria—the Great Recession was caused by tight money.  It’s that simple.

Or is it?  Most economists think that explanation is crazy.  They say interest rates were low and the Fed did QE.  They dismiss the Bernanke/Sumner claim that interest rates and the money supply don’t show the stance of monetary policy. Almost no one believes the Bernanke/Sumner claim that NGDP growth and/or inflation are the right way to evaluate the stance of policy.  Heck, even Bernanke no longer believes it.

And even if I convinced them that money was tight they’d ask what caused the tight money, or make philosophically unsupportable distinctions between “errors of omission” and “errors of commission.”

In previous blog posts I’ve pointed out that it’s always been this way.  If in 1932 you had said that tight money caused the Great Depression, most people would have thought you were crazy.  Today that’s the conventional wisdom.  If in the 1970s you’d claimed that easy money caused the Great Inflation, almost everyone except a few monetarists would have said you were crazy.  Now that’s the conventional wisdom.  Even the Fed now thinks that it caused the Great Depression and the Great Inflation.  (Bernanke said, “We did it.”)

The problem is that central banks tend to follow the conventional wisdom of economists.  So when central banks screw up, the conventional wisdom of economists will never blame the central bank (at the time); that would be like blaming themselves. They’ll invent some ad hoc theory about mysterious “shocks.”

The other night at dinner my wife told me that the Chinese sometimes say, “If you cannot see the true shape of Lu Mountain, it’s because you are standing on Lu Mountain.”

In modern conventional macro, most people look at monetary policy from an interest rate perspective.  That means they are part of the problem.  They are looking for causes of the Great Recession, not understanding that they (or more precisely their mode of thinking) are the cause.

Only the small number of economists who observed Mount Lu from other peaks, such as Mount Monetarism or Mount NGDP Expectations, clearly saw the role of central bank policy.  People like Robert Hetzel, David Beckworth, Tim Congdon, etc.

PS.  Before anyone mentions the zero bound, consider two things:

1.  The US was not at the zero bound between December 2007 and December 2008 when the bulk of the NGDP collapse occurred, using monthly NGDP estimates.

2.  Do you personally support having the Fed use a policy instrument that freezes up exactly when you need it most desperately?  Or might the problem be that they’ve chosen the wrong instrument?

PPS.  Yes, not everyone on Mount Monetarism saw the problem, but as far as I know no one on Mount Interest Rate got it right.  Perhaps Mount Interest Rate is Lu Mountain.

PPPS.  To his credit, Brad DeLong thought the Fed should have promised to return NGDP to the old trend line.  If they’d made that promise there would have been no Great Recession, just a little recession and some stagflation.

Recommended reading

1.  For a guy who has been right about everything, Paul Krugman sure is wrong about an awful lot of things.  Bob Murphy has an excellent new post which digs up lots of Krugman claims that turned out to be somewhat less then correct.

Krugman, armed with his Keynesian model, came into the Great Recession thinking that (a) nominal interest rates can’t go below 0 percent, (b) total government spending reductions in the United States amid a weak recovery would lead to a double dip, and (c) persistently high unemployment would go hand in hand with accelerating price deflation. Because of these macroeconomic views, Krugman recommended aggressive federal deficit spending.

As things turned out, Krugman was wrong on each of the above points: we learned (and this surprised me, too) that nominal rates could go persistently negative, that the US budget “austerity” from 2011 onward coincided with a strengthening recovery, and that consumer prices rose modestly even as unemployment remained high. Krugman was wrong on all of these points, and yet his policy recommendations didn’t budge an iota over the years.

Far from changing his policy conclusions in light of his model’s botched predictions, Krugman kept running victory laps, claiming his model had been “right about everything.” He further speculated that the only explanation for his opponents’ unwillingness to concede defeat was that they were evil or stupid.

Read the whole thing.

2.  Caroline Baum has a very nice post on “never reason from a price change.”  She’s one of the relatively small number of journalists that seem to really get this idea.

The Fed is equally confused when it comes to long-term rates. If you were to ask policy makers if interest rates move pro-cyclically, they would all answer yes. But when rising market rates become a reality, the cries go out that higher rates will damage the economic growth. At the same time, a decline in long rates is automatically assumed to provide economic stimulus. Alas, the expectation that the 100-basis-point decline in 10-year Treasury yields last year would boost investment was mugged by reality.

Getting back to oil prices, economists are still waiting (hoping?) for the oil-price-tax-cut to materialize. Bad weather is getting old as an excuse.

Read the whole thing.  Moving from the sublime to the ridiculous:

3.  John Tamny has a post entitled:

Baltimore’s Plight Reveals the Comical Absurdity of ‘Market Monetarism’

In case you are wondering who John Tamny is, in an earlier post he explained that Bernanke’s inflation targeting idea was unwise, as it would imply that each and every price was stable, not just the overall price level.  Flat panel TV prices could no longer decline.

I’m too busy to do a post mocking all of Tamny’s more recent claims, but he was polite enough to write it in such a way that all I really need to do is quote him.  It’s self-mocking:

‘Market monetarists’ believe that economic growth can be managed by the Federal Reserve.  .  .  .

Market monetarists’ believe the Fed can achieve the alleged nirvana that is planned GDP growth and national income through money supply targets set for the central bank by members of the right who’ve caught the central planning bug.  .  .  .

In fairness to the neo-monetarists, they would all agree that Baltimore has problems that extend well beyond money supply. Still, if money supply planning is the alleged fix for the broad U.S. economy, presumably it would have a positive impact locally.  .  .  .

Specifically, ‘market monetarists’ seek consistent money supply growth, and then when the economy is weak, a bigger increase in the supply of money to boost GDP. . . .

It’s kind of simple. Money supply once again can’t be forced. . . .

It can’t be repeated enough that production is money demand, and is thus the driver of money supply. Money supply shrank in the 1930s not because the Fed decreased it (if it had, alternative sources of money would have quickly revealed themselves), but because the federal government erected massive tax, regulatory, and trade barriers to production. All that, plus FDR’s devaluation of the dollar from 1/20th of an ounce of gold to 1/35th of an ounce in 1933 further put a damper on the very investment that powers new production. It’s forgotten by economists today, but when investors invest they’re tautologically buying future dollar income streams.

If you are looking for a few laughs, the Tamny piece is highly recommended. Indeed I’d call it “tautologically funny.”

PS.  Over at Econlog I have a new post that indirectly addresses some of the confusion in the Tamny post.

HT:  David Beckworth

Update:  Well I may not have gotten the ECB to adopt NGDPLT, but consider this comment from yesterday’s post:

Must be nice to be the sort of rich hedge fund manager that gets this “critical” information before the rest of us.

And from today’s WSJ:

The ECB will post speeches of its board members on its website when they are scheduled to begin, without making them available to journalists ahead of time under embargo as the ECB had done for many years.

The decision, which takes effect immediately, came one day after the public release of comments by executive board member Benoit Coeuré caused a stir in financial markets. Mr. Coeuré  said the ECB would front load bond purchases under its €1.1 trillion ($1.2 trillion) quantitative easing program in May and June to account for a summer lull in bond markets.

HT:  lysseas

What happened to the QE skeptics?

I don’t hear much anymore from people denying that printing money boosts NGDP. Perhaps this story from yesterday morning explains why:

The comments from Benoit Coeure, initially made in private on Monday at a conference attended by one of Britain’s richest hedge fund managers Alan Howard, some of his peers and academics, sent markets into a flurry when they were published on Tuesday.

Anticipating a flood of yet more euros onto the market, the single currency tumbled when the ECB released its Executive Board member’s remarks, sending European shares rising to near multi-year highs.

Coeure said the speed of the recent spike in bond yields, was worrisome and that the ECB could “moderately” increase its buying in May and June so that it did not fall below its monthly buying target. He said, however, that the two were not linked.

Other central bankers chimed in with support for the ECB’s fledgling scheme to buy 60 billion euros a month of chiefly government bonds, a programme known as quantitative easing.

“The Eurosystem is ready to go further if necessary …,” Christian Noyer, who as governor of the Bank of France also sits on the ECB’s decision-making Governing Council, said in Paris.

The excitable market reaction, pulling the euro down below $1.12 and paring back the returns or yields on government bonds, illustrates how critical money printing is to confidence.  (emphasis added)

Two comments:

1.  Yes, the markets are right that money printing is critical.

2.  Must be nice to be the sort of rich hedge fund manager that gets this “critical” information before the rest of us.

Then there are those who are agnostic on the real economy, but insist that QE is blowing up bubbles:

Academics will no doubt be discussing the effectiveness of QE in lifting the real economy for a couple of generations at least, and probably not reaching any definitive conclusions. Perhaps it pulls countries out of a recession, or perhaps they would have eventually started to grow again anyway? One thing we can say for sure, however, is that it boosts asset prices.

In fact, it is already happening. A series of Mario Draghi bubbles are already inflating across the eurozone. Where exactly? Well, Spanish construction is booming, Dublin house prices are soaring, German wages are accelerating, Malta is riding a wave of hot money, and Portuguese equities are among the best performers in the world. For a lucky few investors, QE is already working its magic.

In the 21st century, pundits will be unable to see anything other than recessions and “bubbles.”  There will no longer be periods of stable growth without “bubbles,” like the 1960s.  Of course bubbles don’t actually exist, but low interest rates as far as the eye can see means that asset prices will look bubble-like unless artificially depressed by a tight monetary policy that drives the economy into recession.

By the way, the rest of the article has data that supposedly supports the claims in the quote above, but they aren’t even close to being adequate.  Spanish construction is booming”?  How would we know?  They support that claim by pointing to a recent 12% rise in construction.  They don’t tell you whether that’s from a highly depressed level. Didn’t Spanish construction fall something like 60% or 80% during the Great Eurozone Depression? German wages accelerating?  We are told one German union got a 3.4% wage increase. That’s it. Malta’s property prices are up 10%.  Portuguese stocks are up 25%.  Snippets of information that provide essentially no support for the bubble claims being made.  But when you are sure that QE is blowing up “bubbles”, I guess that’s all you need.  After all, there could not possibly be any rational explanation for Malta’s property prices rising 10%, could there?

Neo-Fisherism, missing markets, and the identification problem

I’ve done recent posts on Neo-Fisherism, and the problem of identifying the stance of monetary policy.  I’ve also pointed out that if we can’t identify the stance of monetary policy, we can’t identify monetary shocks.

This is going to be a highly ambitious post that tries to bring together several of my ideas, in a Grand Theory of Monetary Policy.  Yes, that’s means I’m almost certainly wrong.  But I hope that the ideas in this post might trigger useful insights from people who are much smarter than me and/or better able to handle macro modeling.

NeoFisherians argue that if the Fed switches to a policy of low interest rates for the foreseeable future, this will lead to lower inflation rates.  Their critics claim this is not just wrong, but preposterous—and undergraduate level error.  I think both sides are right, and both sides are wrong.

All of mainstream macro (including the IS-LM model) is built around the assumption of a “liquidity effect”.  That is, because wages and prices are sticky in the short run, a sudden and unexpected increase in the money supply will lower short-term nominal interest rates. Interest rates must fall in the short run so that the public will be willing to hold the larger real cash balances (until the price level adjusts and the real quantity of money returns to its original equilibrium.)

One thing that makes this theory especially persuasive is that it’s not just believed by eggheads in academia.  Pragmatic real world central bankers often see nominal interest rates fall when they inject new money into the economy.  It’s pretty hard NOT to believe in the liquidity effect if you see it in action after you make a policy move.

So the NeoFisherians have both the eggheads and the real world practitioners against them.  And yet not all is lost.  Over any extended period of time the nominal interest rate does tend to track changes in trend inflation (or better yet trend NGDP.)  If I had a perfect crystal ball and saw the fed funds rate rise to three percent and then level off for twenty years, I’d expect a higher inflation rate than if my crystal ball showed rates staying close to zero for the next 20 years.  NeoFisherians are smart people, and they wouldn’t concoct a new theory without some good reason.

In previous posts I’ve found it useful to illustrate where NeoFisherism works with a thought experiment.  I’ll repeat that, and then I’ll take that thought experiment and use it to develop a general model of monetary policy.  Here’s the thought experiment:

Suppose Japan wants to raise their inflation rate to roughly 8%/year.  How do they do this?  This requires two steps.  They need a monetary regime that produces 8% steady state trend inflation, and they need to make sure that the price level doesn’t undergo a one-time jump upwards or downwards at the point the new regime is adopted.

To get 8% trend inflation, they’d need to shift the trend nominal interest rates to a much higher level.  To make things as simple as possible, suppose the US Federal Reserve targets inflation at 2%, and the BOJ has confidence that the Fed will continue to do so.  In that case the BOJ can peg the yen to the dollar, and promise to depreciate it at 6%/year, or 1/2%/month.  The interest parity theory (IPT) assures us that Japanese interest rates will immediately rise to a level 6% higher than US interest rates.  (Note, I’m using the near perfect ex ante version of the IPT, not the much less reliable ex post version.)

We’ve already gotten a very NeoFisherian result.  Currency depreciation is an expansionary monetary policy, and the IPT assures us that this particular expansionary monetary policy will also produce higher interest rates.  And not just in the long run, but right away. Although Purchasing Power Parity is widely known to not hold very well in the short run, expected inflation differentials do tend to reflect the expectation than PPP will hold.  So under this regime not only will Japanese nominal interest rates rise almost exactly 6% above US levels, Japanese expected inflation rates will also rise to roughly 6% above US levels.

Of course actual PPP does not hold all that well (although it does far better under fixed exchange rate regimes, or even crawling pegs like this system, than floating rates.)  But that doesn’t really matter in this case; just getting 6% higher expected inflation is enough to pretty much confirm the NeoFisherian result.

Unfortunately, the immediate rise in interest rates might reduce the equilibrium price level in Japan.  But even that can be prevented with a suitable one-time currency depreciation at the point the regime is adopted.  How large a currency depreciation? Let the CPI futures market tell you the answer.  Make your change in the initial exchange rate conditional on achieving a 1 year forward CPI that is 8% higher than the current spot CPI.  Thus the CPI futures market might tell you that the yen should immediately fall to say 154.5 yen/dollar, and then depreciate 1/2% a month from that level going forward.  Whatever amount of immediate currency depreciation offsets the immediate impact of higher interest rates.

Notice that monetary policy has two components, a level shift and a growth rate shift. This idea will underpin my grand theory of monetary policy.  In this case the level shift was depreciating the yen from 120 yen/dollar to 154.5 yen/dollar.  The growth rate shift was going to a regime where the yen is expected to gradually appreciate against the dollar, to one where it is credibly expected to depreciate at 1/2%/month.

Now think about the expected money supply path that is associated with that new policy regime for the yen.  My claim is that if the BOJ simply adopted that expected money supply path, all the other variables (exchange rates, interest rates, inflation, etc.) would behave just as they did under my crawling peg proposal.

So far I’ve been supportive of the NeoFisherians, but of course I don’t really agree with them.  Their fatal flaw is similar to the fatal flaw of Keynesian and Austrian macro, using the interest rate to identify the stance of monetary policy.  But in some ways it’s even worse than the Keynesian/Austrian view.  Those two groups correctly understand that a Fed rate cut is a signal for easier money ahead.  The NeoFisherians implicitly assume the opposite.

People say that the longest journey begins with a single step.  But what the NeoFisherians don’t seem to realize is that central banks generally signal an intention to go 1000 miles to the west by taking their very first step to the EAST.  (Nick Rowe has much better analogies.)  Thus when Paul Volcker decided that he wanted the 1980s to be a decade of much lower inflation and much lower nominal interest rates, the very first thing he did was to raise the short term interest rate by reducing the growth rate of the money supply.

As soon as you realize that central banks usually use changes in short term nominal interest rates achieved via the liquidity effect as a signaling device, then the NeoFisherian result no longer makes any sense.

But now I’m being too hard on the NeoFisherians.  Look at my crawling peg for the yen thought experiment.  And what about the fact that low rates for an extended period do seem associated with really low inflation, in places like Japan.  That suggests there’s at least some truth to the NeoFisherian claim, and at least some problem with the Keynesian/Austrian view.

In my view the two views can only be reconciled if we stop viewing easy and tight money as points along a line, but rather as multidimensional variables:

Monetary policy stance = S(level, rate)

A change in monetary policy reflects a change in one or both of these components of the S function.  You can have a rise in the price level, but no change in the trend rate of inflation.  You can have a rise in the trend rate of inflation, with no change in the current (flexible price) equilibrium price level.  The beauty of the thought experiment with the yen is that it makes it much easier to see this distinction.  You can imagine once and for all change in the exchange rate, as when the dollar went from $20.67 an ounce to $35.00 an ounce in 1933, and then stayed there for decades.  Or you can imagine a change in the trend rate of the exchange rate, as in my crawling peg example.  Or you can imagine both occurring at once.

When NeoFisherians are talking about higher interest rates leading to higher inflation, they are (implicitly) changing the “rate” component of my monetary policy stance function.  Keynesian and Austrians tend to (implicitly) think in terms of changes in levels, once and for all increases in the money supply that depress short-term interest rates and have relatively little effect on long-term interest rates or long run inflation.

In previous posts I’ve expressed puzzlement as to why easy money surprises lower longer-term interest rates on some occasions, and at other times they raise long-term interest rates.  The “perverse” latter result occurred in January 2001, September 2007, and (in the opposite direction) December 2007.

Indeed the December 2007 FOMC meeting produced the most NeoFisherian (i.e. “rate”) shock that I have ever seen in my entire life.  A smaller than expected rate cut (contractionary shock) led to a huge stock market sell-off (no surprise) but also lower bond yields for 3 months to 30 years T-securities (a big surprise.)  This policy announcement had an unusually large “rate shift” component, whereas most US policy announcements are primarily “level shifts”.  The markets (correctly) saw the Fed’s passivity in December 2007 as indicating that inflation and NGDP growth might be lower than normal going forward.  And not just in 2008, but indefinitely.

Unfortunately, while exchange rates nicely capture the rate/level distinction, they are not ideal for developing a general monetary policy theory, as the real exchange rate is too volatile.  And that brings me to the missing market, NGDP futures.  If this market existed we would have all the tools required to describe the stance of monetary policy in the multidimensional way necessary to sort through this messy NeoFisherian/conventional macro debate.  Suddenly we could clearly see the distinction between level shifts and rate shifts.

Unlike exchange rates, NGDP responds to monetary policy with a lag.  But we could use one-year forward NGDP as a proxy for levels.  Thus if one year forward NGDP rose and longer-term expected NGDP growth rates were unchanged then you’d have a level shift.  If the opposite occurred, you’d have a rate shift.  Or you might have both.  The response of interest rates to the monetary policy shock would largely depend on the response of NGDP futures to the monetary policy shock.

In a richer model there would be more than two dimensions, indeed the expected future NGDP at each future date would tell us something distinct about the stance of monetary policy, and thus more fully characterize any monetary shocks that occurred. But I see great benefits of using the simpler two variable description, levels and growth rates.  This simpler version is enough to address many of the perplexing features of monetary policy, such as why economists can’t seem to come up with a coherent metric for the stance of monetary policy, and why the NeoFisherians reach radically different conclusions than the Keynesians.

Ideally we’d create highly liquid NGDP and RGDP futures market, and then we could easily identify the stance of monetary policy, in both dimensions.  This would also allow us to ascertain the impact of policy shocks on both NGDP and RGDP. NeoFisherians could say, “A monetary policy that raises expected inflation rates and/or expected NGDP growth rates will usually raise nominal interest rates.”  That’s a much more sensible way of making their claim than “Raising interest rates will raise expected inflation and/or expected NGDP growth.

PS.  I’ve benefited greatly from discussions with Daniel Reeves (a Bentley student), and Thomas Powers (a Harvard student).  They understand NK models better than I do, and bouncing ideas off them has helped me to clarify my thinking.  Needless to say they should not be blamed for any mistakes in this post.