DeLong on the mother of all black swans

Brad DeLong has a post that is mildly critical of Shiller’s stock market model in almost precisely the same way that I am critical of Shiller’s stock market model.  The only difference is that DeLong knows more finance than I do, and makes the case far more effectively than I can.  I was intrigued by his conclusion:

That is a perspective very different from mine, which regards the failure of the CAPE to spend most of its time north of 25 as a mystery.

But given that it does not, it would be very rash for anybody who is not certain that they can wait out the market to invest more than they can afford to lose. And past performance is not only not a guarantee it may not be an indicator of future results. We have had one real Black Swan–World War I–in the past 130 years.

The first part refers to what DeLong and I think is the real mystery—not so much why stocks were so high in 1929, 2000, and now, but rather why they were so low 90% of the time.

I think WWI is a great black swan example, but without really disagreeing with DeLong I’d like to throw out another possible black swan—1968.  And no, I’m not thinking of all the assassinations and political turmoil in the US (as well as many other countries.)  It’s not clear that the political events of 1968 had much permanent effect; 1979 was the real turning point (see the PPS of this post.)  Instead I’m going to argue the shift from gold to fiat money was a black swan.

First let me digress with a bit of history.  It became illegal for Americans to redeem dollars for gold in 1933.  I seem to recall that in 1968 the gold window was closed to foreign individuals, and in 1971 the window was closed to foreign central banks.  (Someone correct me if I am wrong.)  So the gold standard sort of faded away over a 40-year period.  Then why pick 1968?

Even though Americans could not redeem dollars for gold in the 1960s, they could buy foreign currencies, and/or goods in foreign countries.  And there was a free market in gold in some foreign countries.  So up until 1968 gold continued to provide at least a weak anchor to the monetary system, at an international price of $35/oz.

My second point is that switching to a permanent fiat system was much more inconceivable to people in the old days than you might imagine.  Yes there were brief experiments like the greenbacks of the Civil War and the German paper money of 1920-23.  But even Keynes opposed a pure fiat regime, and viewed these historical examples as sort of pathological cases.  If you had told someone in 1968 that by 1980 the price of gold would be over $800/oz. they would have thought you were a lunatic.  It was $20.67/oz. in 1879.  It was still $20.67 an ounce in 1932.  It was $35/oz. in 1934.  It was still $35/oz. in early 1968. I recall that when gold was around $150/oz. in the 1970s, one of my economic professors at Wisconsin predicted the price would soon fall back into the $40s, as it was far overvalued.

DeLong identifies three periods when stock investors did poorly over the following 10 years—right before WWI, the late 1960s and early 1970s, and the late 1990s.  Even today I’m not sure exactly how much of the poor stock market performance of 1968-81 was due to the Great Inflation. Inflation did punish savers given that the IRS taxes nominal capital income.  But does that explain the entire underperformance?  Was there money illusion (confusing real and nominal interest rates) when discounting future profits?  I’m not sure.  I am confident, however, that moving to a fiat money regime was a black swan for the US 30-year Treasury bond market, and pretty much every other bond market as well.

PS.  And take a look at this excellent post over at MarginalRevolution.

Don’t talk about wages and incomes

Here’s a particularly maddening paragraph in a post by Edward Hugh:

And there are plenty of people in Japan who have been pointing this out all along. Seki Obata, a Keio University business school professor for example, who in 2013 published a book “Reflation is Dangerous,” argues exactly this, that “Abenomics” is exposing Japan to considerable risk without any clear sense of what it can accomplish. Obata also makes the extremely valid point that there is simply no way incomes can rise across the entire economy because the baby boomers are now retiring to be replaced by fewer young workers with post labour reform entry-level wages. Japan’s overall consumer spending power will therefore fall, rather than rise as Abe hopes. “Individual companies may offer wage increases, but because of demographics it is simply impossible to increase the total amount that is paid out in wages,” says Obata. “On the contrary, that amount will shrink.” Simple logic you would have thought, but logic in the face of irrational exuberance scarcely stops people in their tracks.

Not only is Obata’s point not “extremely valid” it’s pretty much meaningless.  I really don’t have any idea what Hugh is talking about in this paragraph, because he uses terms like “wages” and “incomes,” which don’t have any clear meaning.  It might as well be written in Korean.  Now the term “nominal wages” has a very clear meaning.  And “real wages” has a very clear meaning, which is totally, completely, entirely different from the meaning of nominal wages.  Nominal wages are as different from real wages as cucumbers are from nuclear power plants.

Now before you say “come on Sumner, the meaning is clear from the context,” read the paragraph again.  The paragraph makes no sense under either interpretation.  Obviously he can’t mean “nominal wages,” because then Obata’s comment would be “extremely invalid.”  But he can’t mean real wages either, because he is talking about demand-side factors.

What makes this Hugh post so frustrating is that just a few days a go I read an excellent post by the same blogger, discussing how a lack of NGDP growth in Italy was worsening the debt situation. Unfortunately this very long post is riddled with confusion from beginning to end.  After each paragraph you scratch your head wondering whether he is talking about real or nominal problems, and when he does make it clear, you wonder whether he has confused the two problems.

Japan has a public debt problem comparable to Italy’s and an even worse NGDP performance over the last 20 years (essentially no growth in NGDP.)  And yet he cites with apparent sympathy a Japanese commentator who fears Japanese monetary policy is too expansionary.  Elsewhere the opposite concern is expressed; Abenomics is failing to generate inflation:

The Bank has had more success with inflation since core inflation was up 3.3% over a year earlier in June. But that number soon shrinks in proportion when you strip out the estimated impact of the recent tax hike. According to the Bank of Japan the ex-tax number for June was 1.3%, down from 1.4% a month earlier. And even this inflation isn’t demand driven: it is largely a carry over from the earlier yen devaluation. As such it is quite likely to disappear with time.

Then later inflation is so high that it is depressing real wages:

Nominal wages have been rising again in Japan.

Average total wages, consisting of base pay, overtime and bonuses covering both regular and part-time workers, grew 0.4% on year in June, following increases of 0.6% for May and 0.7% for April and March. Four straight months of year-on-year rise is the longest stretch since total wages grew for six straight months between June and November 2010. But real wages – which take into account inflation and matter much more to consumers than nominal wages, declined 3.8% on year in June, the fourteenth consecutive month of decline, and the biggest drop since December 2009.

Reading this post you have no sense of what Abenomics is trying to do, or what would constitute success.  And yet it’s clear to me that the “three arrows” are aimed at boosting both AS (economic reforms) and AD (monetary stimulus.)  Here’s another maddening comment:

Part of the reason they might not see it in the same light as the central bank dependent investment community is that there is a solid body of opinion in Japan that recognizes that a large part of the country’s issue is demographic and that simply “jump starting” a bit of inflation won’t make the problem go away..

The question I would ask is this: given all the doubt which exists about the real roots of Japan’s problem, and the fact that it may well be a permanent structural problem and not a temporary liquidity trap one, is it really justified to run such a high risk, all-or-nothing experiment?

What does that even mean?  Clearly Japan has both AS and AD problems.  There is no single “real problem;” there are multiple “real problems.”  One arrow of Abenomics is aimed at the nominal problem, and one is aimed at the real problem (not ‘real’ as in “actual” but real as in not nominal.) And somehow the specific policy that is aimed at the nominal problem is misguided because it doesn’t address the real (i.e. supply-side problem.)  So what?

Monetary policy has its limits. As Martin Wolf so aptly put it, “you can’t print babies”.

I guess in the blogosphere that’s what passes for a profound comment.  Who would have ever guessed that monetary stimulus cannot solve all problems?  (BTW, tight money in the US clearly did reduce the birth rate after 2008.)

Japan needs more NGDP growth to reduce the debt burden and create jobs. It’s that simple.  Japan just instituted a tax increase that if tried in the US would cause a violent revolution—3% more on the national sales tax. The largest sales tax increase the US adopted in my entire life (that I can recall) was a 4 cent gas tax increase under Clinton, and that was highly controversial.  The Japanese tax increase was probably 50 times worse.  So the Japanese people are frustrated with taking a sudden 3% hit to their standard of living from an adverse supply shock?  No kidding.  And this tells us what about monetary stimulus?

BTW, I reluctantly supported the excise tax increase because . . . well because Japan is going broke if they don’t change their ways.

Is the eurozone’s problem excessively small government?

Commenter Patrick pointed me to new book on the secular stagnation problem.  Lots of contributions by well known Keynesians. A chapter by Guntram Wolff discusses the causes and cures for the eurozone stagnation.  Here’s the abstract:

The persistence of low Eurozone inflation undermines private and public debt sustainability – especially in the periphery where the overhang is greatest. However, since bubbles and unsustainable borrowing supported demand before the Global Crisis, this chapter argues that higher inflation cannot be a permanent cure for secular stagnation. Instead, a targeted quantitative easing programme and increased public investment would help rebalance Eurozone demand. At the global level, population growth in Asia and Africa will provide ample investment opportunities if they can be fully integrated into the world economy.

In the chapter he repeats the often heard claim that relying solely on monetary policy will prop up aggregate demand at the cost of creating serial bubbles.  That tells me that belief in bubbles cannot be viewed as a harmless quirk, like belief in Santa Claus, but rather is something that can seriously damage policymaking.  I don’t believe that bubbles exist.  But even if I am wrong, there is absolutely no evidence that monetary policy is responsible for asset price bubbles, which are actually less common during periods where monetary policy is very easy (like the 1960s through the early 1980s.)  Most people confuse low interest rates with easy money.

I also found it odd that someone would claim that more government spending (or more specifically an increase in public investment) is the answer to the eurozone’s stagnation.  Here are some of the developed countries with the lowest levels of government spending:

Singapore (17.1% of GDP)

Hong Kong (18.5%)

Taiwan  (22.6%)

Switzerland (33.8%)

Australia  (35.3%)

I don’t know the eurozone ratio, but Germany seems well below average at 45.4%, most countries are close to 50%, and France is on the high end at 56.1%.

In fairness, the abstract mentions population growth at the end, which is high in Australia and Singapore.  But France has a relatively high birth rate for a developed country (much higher than Germany) and immigration also adds to its population growth.  And yet France is clearly stagnating.

I do buy into Wolff’s claim that the eurozone is in the midst of a major stagnation—indeed even worse than the US.  However I very much doubt whether this has anything to do with a lack of government spending or even government investment.  AFAIK, there is no “Great Stagnation” in any of the low government spending developed countries (which also tend to run budget surpluses, or small deficits).  My hunch is that while demand has recently depressed eurozone output, there is a longer term supply-side problem in the eurozone that is more likely related to high government spending, combined (in some cases) with an inefficient public sector.

A few notes on the inevitable counterexamples:

1.  Yes, many poor countries have low levels of government spending (but not Brazil!)  Their economies are not developed enough to easily extract large amounts of taxes from poor peasants. There are large informal sectors, where people work off the books.  Nonetheless, significant wealth creators often do face high implicit MTRs in these countries.  My point is that at the top end, just looking at developed countries, the small government countries have done better.

2.  There are some big government economies that are doing alright, such as Germany and the Nordics.  That shows that size of government is not the only thing that matters.  But Germany would do even better with a Swiss-style economy.  Also keep in mind that very few countries have the low levels of corruption seen in the Nordic countries.  In southern Europe, eastern Europe, and most of the rest of the world, any attempt to push government spending to very high levels will get immersed in corruption, and the resulting waste will be a drag on growth.

Why is Krugman so forgiving of the ECB?

Yesterday I posted that the ECB just doesn’t “get it,” secure in the knowledge that Paul Krugman totally agrees with me on at least that one point.  And then look at what commenter Vaidas Urba sends me:

Paul Krugman from a week ago:

The good news is that the ECB does, I think, understand the problem. The bad news is that it has limited options. Europe needs something like Abenomics as badly as Japan does; but the political and institutional setting is not favorable.

And then more recently:

The thing is, I don’t believe that current management at the ECB is that different in its understanding of what policy should be doing from leadership at the Fed. But it has to struggle against an economy that is weaker in its underlying fundamentals, bad history, and a much more powerful contingent of monetary hawks.

It really is quite scary.

Over the years Krugman and I have both bashed the ECB for their almost unbelievable incompetence.  The ECB that has repeatedly raised interest rates in the midst of the biggest recession since the 1930s.  The ECB that says inflation should be targeted at 2% and we should forget about unemployment, and then later says don’t worry about the 2% target, deflation is actually healthy because it restores competitiveness.

So why is Krugman suddenly so forgiving?  Yes, the “underlying fundamentals” are weaker, due to “bad history.”  But the bad history is a tight money ECB policy that created 0.8% annual NGDP growth over 6 years.  Those are the “underlying fundamentals” that led to a negative Wicksellian equilibrium rate.  Remember that guy who killed both his parents, and then asked the judge for leniency because he was an orphan?

Krugman’s usually not so forgiving in this situation, so let’s consider some alternative explanations. This is from his recent Vox article:

And now we are talking seriously about secular stagnation in Europe and the US as well, which means that it could be a very long time before ‘normal’ monetary policy resumes. Now, even in this case you can get traction if you can credibly promise higher inflation, which reduces real interest rates. But what does it take to credibly promise inflation? It has to involve a strong element of self-fulfilling prophecy: people have to believe in higher inflation, which produces an economic boom, which yields the promised inflation. A necessary (though not sufficient) condition for this to work is that the promised inflation be high enough that it will indeed produce an economic boom if people believe the promise will be kept. If it is not high enough, then the actual rate of inflation will fall short of the promise even if people do believe in the promise, which means that they will stop believing after a while, and the whole effort will fail.

If you are confused don’t feel bad.  He’s saying that under certain liquidity trap assumptions there is no rational expectations equilibrium at 2% inflation rate.  Now that’s clearly wrong, you could peg CPI futures contracts at 2% inflation.  So what’s he really saying?  He’s saying that you can’t get 2% inflation in his particular Keynesian model.  If you got it in the real world it would be for some other reason, perhaps they ran out of government securities to buy while pegging CPI futures, and then had to buy other assets.  Viola, redefine that as “fiscal policy.”  QED.  I’ve never found those arguments at all persuasive for reasons I’ve discussed ad nauseum.  In any case, it has no bearing on what’s going on the real world, where the ECB has been doing “normal” monetary policy for most of the past 6 years, raising and lowering interest rates, and has refrained from QE.  The ECB doesn’t have to buy stocks and corporate bonds.  They need a more expansionary monetary policy.

And I’m completely confused by his comparison of US and eurozone fiscal policies in the August 13 post.  Whenever people point to the fact that Britain has run huge deficits, Keynesians like Krugman say they’ve got it all wrong; it’s the change in the deficit that matters.  And the Cameron government reduced the deficit somewhat.  But the data he presents shows the US deficit shrinking faster than the eurozone deficit since 2010.  And yet it was the eurozone that had the horrible growth performance after 2010, not the US.  (Both regions did about the same in the initial downturn.)  How does Krugman react?  Now he’s back to comparing levels–the eurozone has a smaller deficit than the US.  Either deficits matter, or changes in deficits matter; I wish Keynesians would make up their minds.

Of course market monetarists aren’t at all confused by the fact that the US has done much better than the eurozone since 2010.

PS.  Perhaps he’s soft on the ECB because they are sophisticated city people, like him.  He’s only just arrived in NYC and is already ridiculing the foolish life choices of small town Americans who don’t share his love of strolling though Manhattan:

People should get enough exercise — they will, in general, be happier if they do — but they tend not to get exercise if they live in an environment where it’s easy to drive everywhere and not as easy to walk. People should limit their caloric intake — again, they’ll be happier if they do — but have a hard time resisting those giant tubs of popcorn.

I can personally attest to the importance of these environmental effects. These days, I walk around with a pedometer on my wrist — hey, I’m 61, and it’s now or never — and it’s obvious just how much more natural it is to get exercise when I’m in New York than when I’m in Princeton; just a few choices to walk rather than take the subway fairly easily gets me to 15,000 steps in the city, while even with a morning run it can be hard to break 10,000 in the suburbs. Also, the Bloomberg nanny-state legacy, with calories displayed on practically everything, does help curb my vices (greasy breakfast sandwiches!).

The interesting and difficult question is how, and whether, these kinds of behavioral issues should be reflected in policy. There are some conventional externality arguments for promoting walkable development — less pollution, etc.. But can we, should we, also favor walkability and density because it promotes good habits? How far should regulation of fast food go? Etc., etc.

Also, isn’t it kind of interesting that these days big-city residents on average lead more “natural” lives, being outside and getting around on their own two feet, than “real Americans” who live in small cities and towns?

Yup, small town Americans sure are stupid.  They’d be much happier if only they’d listen to Paul Krugman’s advice.

There are two types of central bankers . . .

Those who “get it” and those who don’t.  Commenter James of London sent me some interesting information on how Mark Carney is doing:

http://www.telegraph.co.uk/finance/bank-of-england/11032479/Weak-wage-growth-suggests-interest-rates-on-hold-until-next-year.html

He’s certainly flexible. Before arriving in the job, but after the appointment was announced he made the speech mentioning NGDP targeting being interesting. In itself it caused a monetary easing in the UK, but I detected a lot of very ruffled feathers in the UK amongst the important people, and those on the MPC who were very keen to emphasise their independence.  The important people got a study commissioned by the Treasury into monetary policy targets that proceeded to inelegantly kill the idea of NGDP targeting and reinforced the status quo view of Inflation Targeting.

On arrival in the job he found his MPC stuffed full of internal and external (independent) dyed-in-the-wool Inflation Target’ers (“Ceiling’ers”). So, he pinned them down to a new idea of forward guidance, but couldn’t chose the right target and had to compromise on unemployment as a main trigger.  When unemployment fell more quickly than expected he broadened the range of triggers, including wage growth.

Now things are looking better as both unemployment and employment do better than expected he has focused on average wage growth. Average wage growth is important as it captures the huge mix changes taking place in the UK labour force, that in turn explains the paradox of rapidly rising employment and no average wage growth. The market recognises it very clearly as shown by the reaction to average wage growth numbers and the latest Inflation Report.

http://www.bankofengland.co.uk/publications/Documents/inflationreport/2014/ir14aug.pdf

Section 4.3 on page 33 and the box on page 34 is a specially commissioned investigation into the complexities of measuring wage growth. Although some surveys like that from the Recruitment and Employment Confederation provide headlines for very robust pay growth, this is not the same as average wage or income growth. And the “robustness” is only relative, the growth they refer to is merely back up towards the more long run normal pay growth of 3%-4% rather than the job destroying 0% seen during the worst years of the recession.

At the same time, he has managed to change the MPC too. A number of internal members have retired or been forcefully moved (eg the former Chief Economist Spencer Dale, who is now leaving the Bank of England altogether), and a few external members have reached the end of their terms too, allowing Carney to appoint more open minded people, many with more international experience.

All very exciting, and great news for the young and unemployed, and the employed. The number of young jobless fell by the biggest number “since records began in 1992”. It’s also great news for immigrants, who are clearly not taking British jobs, but making them. No reputable economist would have predicted the big increase in immigrant workers and a rising participation rate. That is the wonder of a good, right, monetary policy.

http://www.bbc.co.uk/news/business-28768552

Britain is starting to catch up to Germany in the jobs/growth stakes.   Some people who are sympathetic to my ideas wonder why I wasn’t tougher on Ben Bernanke.  Perhaps because I see his role as being similar to Carney’s—pushing the Fed to move as far as he could, given the institutional inertia.  At the other extreme you have the ECB, and also the new head of the Indian central bank:

David Glasner has a field day talking about these comments by Raghuram Rajan:

Reserve Bank of India Governor Raghuram Rajan warned Wednesday that the global economy bears an increasing resemblance to its condition in the 1930s, with advanced economies trying to pull out of the Great Recession at each other’s expense.

The difference: competitive monetary policy easing has now taken the place of competitive currency devaluations as the favored tool for playing a zero-sum game that is bound to end in disaster. Now, as then, “demand shifting” has taken the place of “demand creation,” the Indian policymaker said.

Let me just add that I doubt you’d find any serious scholars of the Great Depression who would agree with Rajan, Keynesian or monetarist.  In particular, Ben Bernanke would be horrified by these views, and indeed I recall he had a debate with Rajan a few months back on a related point. Ditto for Christina Romer, Barry Eichengreen, and even Milton Friedman, if he were still alive. Rajan (who was a brilliant finance professor at Chicago) has too much of a finance view and not enough of a macro view.  India should have put him in change of regulating India’s banking system (a job he’d be great at), not running monetary policy.  (Perhaps his current job is both–but that’s asking a lot of one person.)

I no longer have time to post on all the great stuff that is sent to me.  Marcus Nunes has a wonderful post criticizing Frederic Mishkin for adopting what you might call the “interest rates reflect the stance of monetary policy” view, just a few years after the very prescient warning he gave the Fed at his last FOMC meeting, in 2008:

What I’d like to spend some time on—because I feel this is sort of my swan song, but maybe because I’m a classy guy, I’ll call this my “valedictory remarks”—are three concerns that I have for this Committee going forward. I’m not going to be able to participate, but I have a chance now to lay them out.

The first is the real danger of focusing too much on the federal funds rate as reflecting the stance of monetary policyThis is very dangerous. I want to talk about that.

HT:  David Levey

Kevin Erdmann is becoming a must read blogger, and has some very interesting observations about a recent study of home ownership and unemployment:

It is strange to me how difficult it is for us to imagine that, on the margin, some workers might have discretion about the duration of their unemployment.  Here is an article on the effect of homeownership on unemployment duration. (HT: EV)  They find that homeowners with mortgages have unemployment behavior more similar to non-homeowners.  The extended duration and the tendency to exit the labor force come from homeowners with high equity ownership.  Yet, oddly, they seem to stick with the explanation that homeowners are less mobile and are tied to limited labor markets.

To me, this finding obviously comes from the fact that high equity home owners have more savings, more discretion, and more flexibility about how to re-enter employment or about making work-leisure trade offs.  I don’t see any mention of this obvious factor in the paper.  We all know people who have discretion in their labor force decisions.  Why do they disappear when we start thinking about the big picture?