A risk-based recession?

Tyler Cowen has a new post entitled:

If we have a U.S. recession this year, it will be a risk-based recession

Not surprisingly, I don’t agree, but I’d rather focus on the question of what exactly this term means.  First let’s quote Tyler again, expressing views closer to mine:

2. In the more recent segment of world history, a lot of cycles have been caused by negative nominal shocks.  I consider the Christina and David Romer “shock identification” paper (pdf, and note the name order) to be one of the very best pieces of research in all of macroeconomics.  Sometimes central banks tighten when they shouldn’t, and this leads to a recession, due mainly to nominal wage stickiness.

3. Workers are laid off because employers are often (not always) afraid to cut their nominal wages, for fear of busting workplace morale, or in Europe often for legal and union-related reasons.

So that provides some context.  Tyler is saying that if there is a recession this year, it won’t be the sort of demand shock recession we’ve often seen in recent history. Next let’s consider some hypotheses:

Perhaps the claim is that we might have a recession this year due to risk, despite 3% plus NGDP growth.  If so, I very strongly disagree.  (This could be viewed as a version of real business cycle theory.)

Perhaps the claim is that if there is a recession, then NGDP growth will slow, but that this will not be the cause.  In other words, even in a counterfactual world where the Fed kept NGDP growing at 3% plus, there would still be a recession for non-monetary reasons.  If so, I very strongly disagree.  (Again, an RBC-type claim.)

Perhaps the claim is that falling NGDP growth is a necessary condition for a recession this year, but it will be caused by growing risk and there is nothing that monetary policymakers can do about it.  If so, I strongly disagree.  (A traditional Keynesian claim)

Perhaps the claim is that falling NGDP growth is a necessary condition for a recession this year, but it will be caused by growing risk that monetary policymakers are too cautious to do anything about.  If so, I mildly disagree.  (A New Keynesian claim.)

Why do I only mildly disagree with the last option?  Because it’s certainly possible, but on balance I believe that growing signs of risk in the asset markets are themselves caused by signs of excessively tight money, which is reducing expected NGDP growth.  In other words, in my view growing risk is the symptom of a recession, should it occur, not the cause.

Just to be clear, I am not predicting a recession this year (nor does Tyler in the post I linked to.)  But I certainly think the risk of one has increased in recent months, and I’d guess he does as well.

To summarize, I view the NGDP shock/sticky wage model as being very powerful, partly because we see this pattern over and over again, under all sorts of monetary regimes, and all sorts of triggers for monetary shocks.  Some intentional (the Fed 1920-21, 1929-30, Volcker 1981) and some unintentional (2008-09).  But always the same result.  NGDP falls much faster than hourly nominal wages, and unemployment soars.  Then wages adjust and unemployment falls.  That’s not to say real recessions are not possible, as Zimbabwe showed in 2008 and perhaps the US in 1974.

Don Geddis sent me a wonderful introduction to market monetarist ideas by Eliezer Yudkowsky, in Facebook.  I probably enjoyed reading this piece more than almost anything else in the past 10 years, partly because it’s very nicely done, but more because I feel gratitude that one of the smartest individuals that I have ever read finds the ideas appealing.  That doesn’t mean we are right, but it’s certainly a good sign.  On a related note, check out my newest post at Econlog, which discusses Yudkowsky, Newcomb’s Paradox, and long and variable leads.



Negative IOR is an OK idea, negative bond yields are a really bad idea

I find that when things go bad with the economy, the level of discourse seems to suffer.  Here are a few items I keep bumping up against:

1.  Why not do a helicopter drop?  Because there are no free lunches in economics, and any fiscal stimulus will have to be paid for with future distortionary taxes.  What if they promise to never remove the money injected in the helicopter drop? Then we either get hyperinflation or perma-deflation, neither of which is appealing.  Won’t it help to achieve the Fed’s inflation target?  The Fed already thinks it’s achieved its target, in the sense that expected future inflation is 2%, in the Fed’s view.  That’s why they raised rates in December.  You and I may not agree, but helicopter drops are a solution for a problem that the Fed doesn’t think exists.  If we can convince the Fed that market forecasts are superior to Philips curve forecasts, then the solution is not helicopter drops, it’s a more expansionary monetary policy.

2.  Are negative interest rates good for the economy?  That’s not even a question.  I don’t even know what that means.  For any given monetary base, lower levels of IOR are expansionary (for NGDP), and lower levels of long term bond yields are contractionary. So there is no point in even talking about whether negative rates are good or bad, unless you are clear as to what sort of interest rate you are discussing.

People often debate whether the problem is that interest rates are too high, or whether the problem is that interest rates are too low.  Neither.  The problem is that we are discussing interest rates, which means we are talking nonsense.  We need to talk about whether NGDP growth expectations are too high or too low.  We need to create a NGDP futures market (which I’m trying to do, but not getting much support) and focus on getting that variable right.

Tyler Cowen’s recent post on negative rates is not helpful, because it fails to distinguish between the fact that negative bond yields are bad and negative IOR is mildly helpful.  The eurozone has negative bond yields because it raised IOR in 2011.  That was a really bad move.

3.  If market monetarism is so smart, how come you guys can’t predict recessions?  The point of economics is not to predict recessions (which is impossible, at least for demand-side recessions) the point is to prevent recessions.

4.  What’s the optimal rate of NGDP growth, or the optimal rate of inflation?  It depends.  If the central bank plans to hit the target you can get by with a lower growth rate than if they plan to miss the target.  If they use level targeting then the optimal growth rate is lower than if they target the growth rate.  If capital income taxes are abolished then the optimal rate of inflation/NGDP growth is higher than otherwise. So I can’t give you a specific number, except to say “it depends.”

5.  What do we make of the fact that the yen depreciated when negative IOR was announced, and later appreciated?  The depreciation that occurred immediately after the announcement was caused by the negative IOR.  The later appreciation was caused by other factors.  The EMH says the market responds immediately to new information.  BTW, talk about a new headline not matching the accompanying article, check out this bizarre story from Bloomberg.

6.  Thomas Piketty recently claimed:

Whatever the case, however, the failures to make such [structural] reforms are not enough to explain the sudden plunge in GDP in the eurozone from 2011 to 2013, even as the US economy was in recovery. There can be no question now that the recovery in Europe was throttled by the attempt to cut deficits too quickly between 2011 and 2013—and particularly by tax hikes that were far too sharp in France. Such application of tight budgetary rules ensured that the eurozone’s GDP still, in 2015, hasn’t recovered to its 2007 levels.

No question?  Anyone making that claim has clearly paid no attention to the recent debate over fiscal and monetary policy. His claim is not just wrong, it’s patently absurd.  I question the claim.  Hence there is a question.  QED.

Seriously, Piketty himself points out that the US kept growing during 2011-13.  And the US did even more austerity than Europe.  And the only significant policy difference was that the US monetary policy was much more expansionary than the eurozone monetary policy.  The logical inference is that the eurozone recession was caused by tighter money in Europe. I’m tempted to say that there is “no question” that tight money in Europe caused the double-dip recession, as eurozone fiscal policy was more expansionary than in the US.  But I won’t, because Piketty clearly questions this claim.

Are there any Keynesians out there who are willing to debate me on this point?  I’d love to see the argument as to how fiscal austerity clearly caused a double dip recession in Europe, even though the US did even more austerity and kept growing. It seems to me as if Keynesians live in some sort of intellectual bubble, where they aren’t even aware of the arguments made by people on the other side.  That’s not helpful if you have to debate the other side.

Another sign of Fed incompetence

Face palm time:

U.S. stock index futures indicated a sharply lower open on Thursday as traders reacted to a sharp fall in European stocks and looked ahead to the second day of Fed Chair Janet Yellen’s testimony in Washington.

Dow futures were indicating a drop of around 250 points in premarket trading, after falling more than 300 points. The pan-European Stoxx 600 index (^STOXX) was down by more than 2.8 percent.

Meanwhile, U.S. Treasurys soared, as the 10-year yield fell to 1.59 percent.

On Wednesday Yellen told the House Financial Services Committee that the Fed was not sure it could legally take rates negative as Europe and Japan have. She also said it was unlikely the Fed would cut rates, having just raised them.

Not sure?!?!?!?  Now they tell us?  This is almost mindbogglingly incompetent.

OK, I admit it.  I was wrong about Yellen.  Obama should have nominated Larry Summers.  I’m sorry Larry.

PS.  Here’s William Dudley back in October:

Federal Reserve officials now seem open to deploying negative interest rates to combat the next serious recession even though they rejected that option during the darkest days of the financial crisis in 2009 and 2010.

“Some of the experiences [in Europe] suggest maybe can we use negative interest rates and the costs aren’t as great as you anticipate,” said William Dudley, the president of the New York Fed, in an interview on CNBC on Friday.

And here’s Janet Yellen in November:

The Federal Reserve would consider pushing interest rates below zero if the U.S. economy took a serious turn for the worse, Fed Chair Janet Yellen said on Wednesday.

“Potentially anything – including negative interest rates – would be on the table. But we would have to study carefully how they would work here in the U.S. context,” Yellen told a House of Representatives committee.

This would happen if the economy were to “deteriorate in a significant way,” she said, adding that she believed negative rates “would have some at least modest favorable effect on banks’ incentives to lend.”

How do we identify sticky wages?

Tyler Cowen has a new post on the subject:

When you disaggregate the data at the state level, wages don’t look so sticky any more:

…states that experienced larger employment declines between 2007 and 2010 had significantly lower nominal wage growth during the same time period…Our estimates suggest that real wages also vary significantly with local measures of unemployment at the state level…there is a strong relationship between local employment growth and local wage growth at business cycle frequencies.

In other words, the supply and demand model doesn’t do so badly after all.

As I explain in this post, this is exactly what you’d expect if nominal wages were sticky.  If this were not true, there’d be something very much wrong with the sticky wage model.

The empirical evidence in favor of sticky wages is simply overwhelming. It’s just about the only thing in macroeconomics that we can be certain is true.

PS.  The supply and demand model cannot explain unemployment (in equilibrium), and hence has nothing to say about the empirical evidence described by Tyler.  In order to even attempt to apply supply and demand to the issue of unemployment, you’d have to assume wages are not in equilibrium, i.e. are “sticky”.  Or am I missing something?

Who predicted what, when and why

Let’s go back to March 3, 2009.  Here’s Paul Krugman:

As Brad DeLong says, sigh. Greg Mankiw challenges the administration’s prediction of relatively fast growth a few years from now on the basis that real GDP may have a unit root — that is, there’s no tendency for bad years to be offset by good years later.

I always thought the unit root thing involved a bit of deliberate obtuseness — it involved pretending that you didn’t know the difference between, say, low GDP growth due to a productivity slowdown like the one that happened from 1973 to 1995, on one side, and low GDP growth due to a severe recession. For one thing is very clear: variables that measure the use of resources, like unemployment or capacity utilization, do NOT have unit roots: when unemployment is high, it tends to fall. And together with Okun’s law, this says that yes, it is right to expect high growth in future if the economy is depressed now.

But to invoke the unit root thing to disparage growth forecasts now involves more than a bit of deliberate obtuseness.

And here is Greg Mankiw’s reply:

Paul Krugman suggests that my skepticism about the administration’s growth forecast over the next few years is somehow “evil.” Well, Paul, if you are so confident in this forecast, would you like to place a wager on it and take advantage of my wickedness?

Team Obama says that real GDP in 2013 will be 15.6 percent above real GDP in 2008. (That number comes from compounding their predicted growth rates for these five years.) So, Paul, are you willing to wager that the economy will meet or exceed this benchmark?

And here’s what I wrote, 5 years later:

Krugman wisely decided to avoid this bet, which suggests he’s smarter than he appears when he is at his most political. In any case, the actual 5 year RGDP growth just came in at slightly under 6.3%. That’s not even close. Mankiw won by a landslide.

In January 2011, Tyler Cowen wrote a book entitled “The Great Stagnation.”  So far Tyler’s hypothesis has proven correct. (Oddly, the media often refer to Larry Summer’s stagnation hypothesis, which (AFAIK) came much later.)

In 2013 Tyler made a bet with Bryan Caplan, that unemployment would not fall quickly back to 5%:

Tyler just bet me at 10:1 that U.S. unemployment will never fall below 5% during the next twenty years.  If the rate falls below 5% before September 1, 2033, he immediately owes me $10.  Otherwise, I owe him $1 on September 1, 2033.

Readers of my blog know that I would have agreed with Bryan.  Tyler Cowen responded by pointing to reasons why these bets are not a good idea:

Bryan Caplan is pleased that he has won his bet with me, about whether unemployment will fall under five percent.  I readily admit a mistake in stressing unemployment figures at the expense of other labor market indicators; in essence I didn’t listen enough to the Krugman of 2012.  This shows there were features of the problem I did not understand and indeed still do not understand.  I am surprised that we have such an unusual mix of recovery in some labor market variables but not others.  The Benthamite side of me will pay Bryan gladly, as I don’t think I’ve ever had a ten dollar expenditure of mine produce such a boost in the utility of another person.

That said, I think this episode is a good example of what is wrong with betting on ideas.  Betting tends to lock people into positions, gets them rooting for one outcome over another, it makes the denouement of the bet about the relative status of the people in question, and it produces a celebratory mindset in the victor.  That lowers the quality of dialogue and also introspection, just as political campaigns lower the quality of various ideas — too much emphasis on the candidates and the competition.  Bryan, in his post, reaffirms his core intuition that labor markets usually return to normal pretty quickly, at least in the United States.  But if you scrutinize the above diagram, as well as the lackluster wage data, that is exactly the premise he should be questioning.

As I’m the only one in this exchange fessing up to what I got wrong, and what I still don’t understand, and what the complexities are, in a funny way…I feel I’m the one who won the bet.

I agree with Tyler’s skepticism regarding the utility of public bets; they oversimplify a very complex set of issues.  They also subtly imply that greatness is a function of not being “wrong” about particular questions.  I’d argue that one doesn’t become a truly great scientist until one’s views have been partially discredited.  That means people are taking your ideas seriously, and pushing them to the point where they are no longer intellectually progressive.  (Think Copernicus, Newton, Einstein, Darwin, etc.)

However, as someone who agreed with Caplan, I don’t entirely accept the implication of Tyler’s final sentence.  I can’t speak for Bryan, but here are the views I’ve expressed:

1. Cycles in unemployment are largely caused by nominal wage stickiness, and unemployment will usually revert back to the natural rate, which tends to be fairly stable in the US (but not completely stable).

2. The US is entering a Great Stagnation, where 3% NGDP growth will be the new norm, measured RGDP growth will also slow sharply, but of course it’s not clear what RGDP actually is, because it’s not clear what economists mean by the term “price level.”

3. The Labor Force participation rate has historically been unstable, unlike the natural rate of unemployment, responding to demographics, welfare reform, disability insurance, prison incarceration, etc., etc., etc.)  Wage stickiness doesn’t explain this.  But Tyler was also skeptical of how far Bryan and I pushed the wage stickiness concept.  Since our view is that wage stickiness explains changes in the unemployment rate, but not the LFPR, Bryan winning his bet is at least as small point in favor of the sticky wage model.

4. Fiscal austerity would not slow growth in 2013, a claim Paul Krugman contested.  I was right and Krugman was wrong.

5. Repealing the extended unemployment benefits in early 2014 should have modestly increased new job creation, by boosting the supply of labor.  This would be true even if NGDP growth (i.e. AD) did not accelerate.  Paul Krugman also contested this claim.  Again, I was right.  Job growth in 2014 was substantially above the 2010-13 rate, despite very modest growth in NGDP. Of course Krugman has been right about many things, especially when he agreed with market monetarists.  Thus he has criticized the mainstream conservative prediction that “easy money” would lead to high inflation.

6. I’ve consistently predicted that unemployment would fall faster than the Fed thought, and that NGDP growth and inflation would be less than the Fed thought.  That’s actually sort of threading the needle, as faster falling unemployment would normally be associated with faster than normal NGDP growth.

Despite the fact that I’ve recently ended up being right more often than wrong, I think the importance of specific predictions is overrated.  If I had been blogging in 2006-09 I would have been wrong about lots of things, because the market was wrong about lots of things.  The economy is very hard to predict, and hence I’ve been lucky.  More important is the reasoning process used.  Here is how I’ve approached this:

1. For low NGDP growth and inflation predictions I’ve relied on market forecasts, which generally seemed more bearish than Fed forecasts.

2. For the Great Stagnation, early on I noticed a “job-filled non-recovery”, which many people oddly called a jobless recovery.  The unemployment rate fell sharply despite anemic RGDP and NGDP growth (for a recovery period).  So I reasoned that if RGDP growth was only 2.0% to 2.5% during a period of fast falling unemployment, then the trend rate of growth must be really slow.  So far I’ve been correct (and I hope my prediction is soon refuted, for the sake of the economy.)

3. For the unemployment compensation issue I relied on basic theory, and on previous studies of the effect of UI on jobless rates.  Back in 2008, Brad DeLong predicted higher unemployment as a result of a very small increase in benefits under President Bush.  It seemed to me that people like Krugman were abandoning mainstream economics for ideological reasons.

4. Standard theory, pre-2008, also implied that the monetary authority drove AD, and that fiscal policy would only impact growth by shifting the AS curve.  I saw no reason to abandon the standard view.

5. As far as wage stickiness and unemployment, my views were shaped by many factors, including my study of the Great Depression, and the fact of wage stickiness documented by many studies.  I also relied upon the strong theoretical implication that if nominal wages are sticky then nominal GDP shocks will lead to volatility in hours worked.  As far as the unemployment rate recovery predicted by Caplan, I relied on both theory (Friedman/Phelps) and evidence—the fact that the US natural rate seems fairly stable at around 5%. That’s the best I could do, and in this case I was right.  But if I’d lived in Western Europe in the late 1970s and early 1980s, I would have been wrong and Tyler would have been right, as the unemployment rate jumped sharply, and never went back down (except in a few countries like Germany, and even then only much, much later.)

Market forecasts are the best we can do.  I suggest that readers pay less attention to who predicted what, and more on the reasoning process behind their predictions.  Occasionally people will get lucky and nail a prediction that the markets missed (think Roubini, John Paulson, Shiller, etc.)  But when you look at their overall track record it’s clear that luck was involved; no one can consistently predict the macroeconomy. Nor should we focus on who has the most impressive mathematical model. Instead we should focus on who has a coherent explanation for what is occurring, an explanation that is consistent with well established theory, and that can be applied to a wide range of cases.  I hope market monetarism is one of those coherent explanations.

PS.  I just returned from the Warwick Economics Summit, and was very impressed by the Warwick students.  I would especially like to thank Ibraheem Kasujee, who helped arrange the visit.  It was good to get out of the Puritan States of America for a few days, and attend a student ball where drinks are served to 18 year olds.  At Bentley even the faculty can’t drink a glass of wine at the Holiday Party.  And Bentley just banned smoking everywhere—basically telling the smokers (who used to huddle outside in the cold) to go away, we don’t want you here.  This university is only for PC puritan paternalists.  (On the plus side, our students do get good jobs.)

I had planned on being home for dinner on Monday, but instead (due to snow at the Boston airport) I was 30 miles north of Reykjavik (at 11 pm Iceland time), in the middle of nowhere, standing in a cold wind with no hat on, looking straight up at a zillion stars in the sky–and a few northern lights as well.  But now I’m back and have a huge amount of catching up to do. (Here’s my earlier unexpected layover in Iceland.)

For readers who didn’t get their fill of Krugman bashing here, I also have a new Econlog post.