Post-modern recessions

Classical recessions were often caused by shocks that reduced the natural rate of interest.  As market interest rates fell (there was no Fed), the demand for gold increased.  Because gold was the medium of account, this was a negative demand shock.

Modern recessions occurred because the Fed struggled to control inflation, as we gradually moved to a fiat money system after the Depression.  Inflation would rise too high, and this would cause the Fed to tighten.

I recall that Paul Krugman once did a post suggesting that the most recent recessions were not caused by the Fed, but rather were caused by factors such as bubbles and investment/financial instability.  The recessions of 1991, and especially 2001 and 2008, were not preceded by particularly high inflation expectations, which were well anchored by Taylor Rule-type policies. Thus these recent recessions (in his view) were not triggered by tight money policies aimed at reducing inflation, as had been the case in 1982, 1980, 1974, 1970, etc.

I suspect that the post-modern recessions are indeed a bit different, but not quite in the way that Krugman suggests.  Although I don’t think interest rates are a useful way of thinking about monetary policy, I’ll use them in this post.  (If I just talked about slowdowns in NGDP growth it would not convince any Keynesians.)

In the New Keynesian model, a tight money policy occurs when the Fed’s target rate is set above the natural rate of interest. In 1981, that meant the Fed had to raise its interest rate target sharply, to make sure that nominal interest rates rose well above the already high inflation expectations, high enough to sharply reduce aggregate demand.  In contrast, interest rates were cut in 2007, despite a strong economy and low unemployment.  The natural interest rate started falling in 2007 as the real estate sector contracted.

In a deeper sense, however, the post modern recessions are no different than pre-1990 recessions.  They still involve the Fed setting its fed funds target above the natural rate.  The difference is that in recent recessions this has occurred via a fall in the natural rate of interest, whereas in 1981 it occurred through a sharp rise in the market rate of interest.

You might say that we used to have errors of commission, whereas now we have errors of omission.  But that only makes sense if you accept the notion that interest rates represent monetary policy.  But they don’t. Every major macro school of thought suggests that something other than interest rates represent the stance of monetary policy.  Monetarists cite M2, Mundell might cite exchange rates, New Keynesians cite the spread between market rates and the natural rate.  No competent economist believes that market interest rates represent the stance of monetary policy.

Thus in the end, Krugman’s distinction doesn’t really make any sense.  It’s always the same—recessions are triggered by the Fed setting market interest rates above the natural interest rate.  Since 1982, the natural rate of interest (real and nominal) has been trending downwards.  This was an unexpected event that very few people forecast.  (I certainly did not.) The Fed would occasionally end up behind the curve in terms of noticing the decline in the natural rate.  The FOMC would only realize its error when NGDP growth fell well below their desired rate.  Then they’d try to ease policy, but initially they’d underestimate how much they needed to cut rates in order to get the proper amount of stimulus.  The natural rate was lower than they assumed.  Hence slow recoveries.

My hunch is that we are coming to the end of this long downtrend in the natural rate of interest.  That means that future recessions will be caused by some other type of cognitive error.  That’s also why I expect this to be the longest economic expansion in US history.  But that’s not very impressive when you have such a weak recovery.  Much more impressive would be the longest consecutive streak of boom years.  Now that would Make America Great Again!

Dazed and confused

I took a break from the WEA meetings in San Diego, and decided to walk outside and look for some lunch.  Although California is suffering from a heat wave, it’s only 80 degrees (27 C.) in San Diego (and not humid.)  I walked a few blocks and picked a Cheesecake Factory, with a lovely outdoor eating area.

I care much more about restaurant amenities than food.  And I can usually find at least one good dish at a bad chain restaurant.  I noticed that everything on the menu had calories attached, even the various toppings that could be added.  Most dishes and deserts were quadruple digits, even some of the salads:

The menu said the average adult should have 2000 calories a day.  So all I can eat in 24 hours is a salad with grilled chicken on top? (Plus water.) Not even fried chicken?

So I picked the ahi tuna salad and “Tropical Ice Tea”, which totaled only 500 calories, and the tuna was actually pretty tasty.  If I ate 1930 calories for lunch I’d be too sleepy to get any work done in the afternoon.

Walking back to the Marriott I cut through a typically over air-conditioned Hyatt with lobby decor that would impress Trump.  Then back out into the blinding sunshine.  The Marriott had 4 giant stairways to nowhere, each having 4 railings. They were capable of handling the crowds at Tokyo’s busiest subway, and yet all four were completely empty, despite the Marriott being 100% full:

When I reached the shady side of the Marriott I noticed an odd plaque on the wall:

No wonder the WEA chose the Marriott over the new Hyatt–our venue is the hotel analogue of Love Canal.  They must have gotten a great deal.

And another thing puzzled me—hasn’t California banned smoking in hotels?  Then another 100 feet along the wall I spotted another plaque:

Wait a minute.  If there is no smoking within 25 feet of the hotel, then how did those dangerous tobacco fumes get inside the San Diego Marriott?

Then it occurred to me—the Marriott was much older than the Hyatt.  Perhaps someone smoked in the Marriott a few decades back. It is not inconceivable that a few molecules of tobacco smoke linger in the corner of one of the ballrooms holding panels discussing the latest VAR studies of monetary policy.

As I reached the entrance I hesitated.  Dare I enter this repository of dangerous toxins?

Then my mind wandered back to when I was twelve, and spent long evenings sitting next to my dad at a bar, where he smoked one cigarette after another, occasionally asking me to go to a vending machine and buy him another pack (for 40 cents).  I recall his disbelief when they set up no smoking zones in restaurants and airplanes.  “You mean to tell me you can only smoke in the back rows?”  On my first trips to Europe in the 1980s I asked for smoking seats, even though I was a non-smoker.  By that time those sections were pretty empty and I could lie down across 5 seats.

I realized that I’ve already been exposed to so much second hand smoke (and lead, asbestos, etc., etc.) that I’m already a dead man walking.  At age 61 I have nothing to lose.

I feel like Bill Murray in Lost in Translation. And next month I move to this crazy state, to spend my golden years.

 

Bob Murphy on the deflationary effects of devaluation fears

In a recent post, I quoted from a Josh Hendrickson review of The Midas Paradox, particularly the discussion of the deflationary impact of devaluation fears during the 1930s.  I viewed this as a bit of a puzzle.  It’s no surprise that devaluation expectations would raise the demand for gold, and hence the value of gold.  And since gold was a medium of account, that would be deflationary.  But it would also reduce the demand for currency, which was also a medium of account. So why didn’t it reduce the value of currency?  After all, an actual devaluation would reduce the value of currency.

Bob Murphy has a very interesting explanation in the comment section:

Scott,

Forgive me if I’m just saying the same thing you did, in different vocabulary, but, wouldn’t the following make sense? I don’t see what the mystery here is.

(1) Right now the US government will trade gold for dollars at $20.67 / ounce.

(2) Investors are worried that next year, they will charge people $35 to give them an ounce of gold.

(3) So investors naturally shift out of dollars and into gold. (Just like if you suddenly thought Acme stock would go from $20.67 today to $35 next year, at a time of very low interest rates, you would rebalance your portfolio to buy more Acme stock than you were holding 5 minutes ago.)

(4) Yet since right now the US is still on the gold standard at $20.67, as people try to get rid of dollars and hold more gold, the only way to maintain that rate is for the US Treasury to absorb dollars and release gold from its vaults.

(5) As the total amount of dollars held by the public shrinks, prices in general (quoted in dollars) fall.

Am I missing something?

That may indeed be the solution.  If so, what did I overlook?

1. Perhaps I focused too much on the actual currency stock, which did not tend to fall during these episodes.  But that may be because devaluation fears were associated with banking crises.

2.  So let’s assume that Bob is correct that devaluation fears are deflationary because they reduce the currency stock, ceteris paribus.  In that case, the banking panics that increased currency demand could be viewed as a second deflationary shock, and perhaps the central bank increased the currency stock enough to partially offset this increase in currency demand, but not the initial shock of more demand for gold.

3.  Suppose there had been no banking panics.  And suppose that the central bank responded to fears of devaluation by preventing the money stock from falling. What then?  In that case, the shock might not have been deflationary.  But that’s not because devaluation fears are not deflationary, but rather because the central bank would have taken an expansionary monetary action to offset the private gold hoarding.  Under a gold standard, an outflow of gold into private hoards should normally result in a smaller currency stock, keeping the ratio of gold to currency stable.  So if the central bank refuses to let the currency stock fall, that’s an expansionary monetary policy.  It wouldn’t mean the devaluation fears were not deflationary, ceteris paribus, but rather that the deflationary impact of one shock was being offset by an expansionary policy elsewhere.

4.  Bob mentions that the M1 money supply did fall during the banking panics, which simplifies things, but I prefer to do all the analysis through the currency stock (or monetary base), which in this case made things more complicated for me.

5.  How about from a finance perspective?  At first glance it seems weird that people would hold both gold and currency, even though the expected return on gold was higher during a period of devaluation fears.  But gold and currency may not be perfect substitutes, and as the stock of currency declines the marginal liquidity services it provides increase relative to gold.  Or perhaps those who feared devaluation correctly anticipated that the government would confiscate domestic gold hoards.

I am still a bit confused by the evidence that markets respond differently when devaluation (or revaluation) seems imminent.  The markets were not adversely affected by the gold crisis in early March 1933, anticipating that FDR would soon do something dramatic.  And they were adversely affected by fears of revaluation during the “gold panic” of 1937.  So there are still some unresolved puzzles in my mind.  But Bob’s explanation for the basic pattern of the early 1930s seems better than anything else I’ve seen.

PS.  I am currently in San Diego, at the Western Economic Association conference. Blogging will be sporadic for most of the summer.

NBA GMs and Fed Governors

Here is Nate Silver, discussing the growing accuracy of NBA mock drafts:

Mock drafts — and rumors/reporting about who would go where — were shockingly accurate this year. There aren’t a lot of dumb teams in the NBA anymore, and it’s getting harder to find picks that come out of nowhere.

I suppose one could think of mock drafts as sort of like “the market” and NBA general managers as sort of like the Fed.  Are the mock drafts getting more accurate because mock drafters are getting smarter, or because (As Silver hints) NBA GMs are getting smarter?  Or maybe GMs are realizing the market is smarter than they are.

My hope is that the market will become increasingly accurate in predicting monetary policy, because monetary policymakers will increasing take their lead from the market.

Gabe Newell contributes to Hypermind

I’d like to thank Gabe Newell (President of Valve Software) for very generously agreeing to directly contribute $10,000 to the Hypermind NGDP prediction market. You may recall that Mr. Newell made a similar contribution a few years ago, in our previous effort.  Note that some of the recently donated money is still working its way through the bureaucracy, but rest assured it will get there.  I hope to be able to announce a much larger prize total in the near future.  The goal is to boost trading volume.

In this previous post, I explained how you can also assist the prediction market project by contributing to the Mercatus Center.  I believe that this sort of contribution has tax advantages due to the non-profit status of Mercatus.  However I recently learned that Mercatus has a policy where researchers don’t publicly thank donors, as research and fundraising are kept separate.  Sorry about that misunderstanding.  That does not apply to direct donations to Hypermind, but AFAIK those are not tax deductible.

PS.  As I get older, things just seem to get more complicated.  But I’m working hard to simplify my life.  Last month I owned two rental properties. Now I have one.  Next month I’ll have zero.  Never become a landlord.