The WSJ discussed a recent paper by Benjamin Friedman and Kenneth Kuttner, which supports two of the major themes of this blog:

New research on monetary policy is reinforcing the idea that when it comes to the Federal Reserve, watching what officials say is as much or maybe even more important than watching what they do.

A new paper published by the National Bureau of Economic Research, written by economists Benjamin Friedman and Kenneth Kuttner, sought to get to the heart of how monetary policy actually brings about changes in the economy. The economists note the world’s major central banks, most notably the Fed, can bring about changes in interest rates almost entirely by stating that they want a shift in the cost of borrowing.

This is one point I keep emphasizing, monetary policy is most effective when the central bank signals future policy intentions; movements in the fed funds rate only matter to the extent that they signal future policy intentions.  This means that when the central bank appears to be “doing nothing” it actually might be quite active.  The old Keynesian economics of the liquidity trap, which implicitly underlies all arguments for fiscal stimulus, is predicated on the assumption that a sort of singularity is reached when nominal rates hit zero.  They can’t be lowered, and political pressure makes increases unlikely during periods of high unemployment.  So (the argument goes) fiscal policy multipliers can be calculated under the assumption of “other things equal,” i.e. no monetary policy sterilization.  But that’s not how things work in the real world.  As soon as a massive fiscal stimulus is passed, and conservatives start worrying about inflation, then central banks start chattering about exit strategies.  This chatter is monetary tightening, just as surely as a rise in the fed funds rate.  We are always in the classical world, there is no Keynesian world.

“There is little if any observable relationship between the interest rates that most central banks are setting and the quantities of reserves that they are supplying,” the paper said. Studies of central banking action “consistently show no relationship between movements in policy interest rates and the supply of reserves” in the U.S., the euro zone and Japan, it added.

Instead, the change in rates across the yield curve, driven by a central bank shift in a very short-term rate few actually can access, is tied to what the institution has told financial markets.

“The announcement effect has displaced the liquidity effect as the fulcrum of monetary policy implementation,” the economists wrote. When it comes to the U.S. central bank, “on many occasions, moving the federal funds rate appears to have required no, or almost no, central bank transactions at all”-the market did the Fed’s work for it, the paper stated.

Woodford and Eggertsson are best known for the view that what really matters is not the current setting of policy instruments, but rather changes in the expected future stance of policy.  And in my own small way I reached that conclusion independently during my research on the Great Depression.  The Friedman and Kuttner paper provides support for the idea that Fed signals drive monetary policy much more than current changes in policy tools.  Of course eventually those policy levers must adjust, but that adjustment may occur over long periods of time.

The paper doesn’t assert that markets for bank reserves are steady, noting that “since 2000 the amount by which reserves have changed on days of policy-induced movements in the federal funds rate has become noticeably larger on average.”

But the trading is just noise: “In a significant fraction of cases-one-third to one-fourth of all movements in the target federal funds rate-the change in reserves has been in the wrong direction,” calling into question the central bank influence in the process.

The paper gives some hope to policy makers who believe that resolute talk about keeping inflation in check, along with preparation for future action, will keep prices contained in a time of historically high bank reserves.

It should be no surprise that reserves often move in the “wrong” direction.  Changes in overnight fed funds rates are not driving the economy, they are reflecting economic conditions.  Here is a simple example.  Suppose the economy booms and lots more transactions are occurring.  The boom will raise rates, and the level of reserves will also rise to reflect the higher level of transactions (assuming the Fed is inflation targeting.)  The whole process is driven by the Fed’s inflation targets; once those are set then the money supply and interest rates are both endogenous.  But there is a great danger in this kind of thinking:

Fed officials have argued managing market expectations is the key. If the Fed appears to remain a credible guardian of price stability, then inflation should remain in check. While that may seem like a rather ephemeral bulwark against an inflation surge, the paper says it’s this very notion of expectations and communications that drives policy in the best of times too.

Here’s real problem.  The Fed’s inflation targeting signals are far too vague.  Taken literally, sudden price stability would be a disaster.  If the Fed suddenly reduced inflation from the recent 2.5% norm to zero, then unemployment would rise sharply.  (Come to think of it, they just did that!)  Of course people will say; “By price stability the Fed implicitly means 2% inflation.”  Fine, but that requires a symmetric response to changes in inflation in either direction.  The WSJ writer clearly seems to think only excessively high inflation is a potential problem, not excessively low inflation.  And the Fed behaves as if they suffer from the exact same confusion as the WSJ writer.  The Fed is ever-vigilant against above normal inflation, but doesn’t seem vigilant against below normal inflation.  And that doesn’t even address the fact that their “dual mandate” implies they should actually be even extra vigilant against excessively low inflation.

Yes, Fed signals drive AD and NGDP.  But we need clear signals, signals that are consistent with the Fed’s policy goals.  And what are the Fed’s policy goals . . .

HT:  Tyler Cowen

And now for something completely different.  I’m bored with the Fed, so I’d like to discuss a few ideas triggered by something I recently ran across in a novel by Javier Marias:

The present era is so proud that it has produce a phenomenon which I imagine to be unprecedented: the present’s resentment of the past, resentment because the past had the audacity to happen without us being there, without our cautious opinion and hesitant consent, and even worse without our gaining any advantage from it.  Most extraordinary of all is that this resentment has nothing to do, apparently, with feelings of envy for past splendours that vanished without including us, or feelings of distaste for an excellence of which we were aware, but to which we did not contribute, one that we missed and failed to experience, that scorned us and which we did not ourselves witness, because the arrogance of our times has reached such proportions that it cannot admit the idea, not even the shadow or mist or breath of an idea, that things were better before.  No, it’s just pure resentment for anything that presumed to happen beyond our boundaries and owed no debt to us, for anything that is over and has, therefore, escaped us.  It has escaped our control and our manoeuvrings and our decisions, despite all these leaders going around apologising for the outrages committed by their ancestors, even seeking to make amends by offering offensive gifts of money to the descendants of the aggrieved, regardless of how gladly those descendants may pocket those gifts and even demand them, for they, too, are opportunists, an eye on the main chance.  Have you ever seen anything more stupid or farcical: cynicism on the part of those who give, cynicism on the part of those who receive.  It’s just another act of pride: how can a pope, a king or a prime minister assume the right to attribute to his Church, to his Crown or to his country, to those who are alive now, the crimes of their predecessors, crimes which those same predecessors did not see or recognize as such all those centuries ago?  Who do our representatives and our governments think they are, asking forgiveness in the name of those who were free to do what they did and who are now dead?  What right have they to make amends for them, to contradict the dead?  If it was purely symbolic, it would be mere oafish affectation or propaganda.  However, symbolism is out of the question as long as there are offers of “compensation”, grotesquely retrospective monetary ones to boot.  A person is a person and does not continue to exist through his remote descendants, not even his immediate ones, who often prove unfaithful; and these transactions and gestures do nothing for those who suffered, for those who really were persecuted and tortured, enslaved and murdered in their one, real life: they are lost forever in the night of time and in the night of infamy, which is doubtless no less long.  To offer or accept apologies  now, vicariously, to demand them or pro-offer them for the evil done to victims who are now formless and abstract, is an outright mockery of their scorched flesh and their severed heads, of their pierced breasts, of their broken bones and slit throats.  Of the real and unknown names of which they were stripped or which they renounced.  A mockery of the past. No, the past is simply not to be borne; we cannot bear not being able to do anything about it, not being able to influence it, to direct it; to avoid it. And so, if possible, it is twisted or tampered with or altered, or falsified, or else made into a liturgy, a ceremony, an emblem and, finally, a spectacle, and simply shuffled around and changed so that, despite everything, it at least looks as if we were intervening, even though the past is utterly fixed, a fact we choose to ignore.  And if it isn’t, if that proves impossible, then it’s erased, suppressed, exiled or expelled, or else buried.  And it happens, Jacobo, one or the other of these things happens all too often because the past doesn’t defend itself, it can’t.

I love this passage, especially the final sentence.  It also touched off a train of thought, or perhaps I should say resentments, that go back to my childhood.

As a schoolboy I always resented the unspoken assumption that we were right and that every other time and place was wrong.  Even if we romanticized some aspect of the past, or some exotic culture in a faraway country, we were always implicitly flattering some aspect of  ourselves.  At first I was drawn to science fiction, as a way of escaping the here and now.  As I got older I became more interested in history, and in travel literature.  The more exotic the better.

As an adult I have mostly come to terms with our culture, but still am very annoyed by the way we think about other times and places.  History is increasingly seen as nothing more than victims and villains, especially by liberals.  Conservatives see the future as a sort of dystopian nightmare, at least if the residents of future worlds have the temerity to discard our value system.  We have obviously achieved perfection, even though every previous generation before us was morally flawed.  I don’t know whether future citizens will embrace designer babies, or cryonics, but that’s there decision, isn’t it?  Our ancestors would be shocked by gay marriage, or the fact that we routinely wager on the death of our spouse, where a “win” occurs if the spouse dies.

[For those who don’t know, our ancesters understood that life insurance was morally revolting.]

If I ever became well-known then future people would look back at me and be disgusted by some aspect of my life.  “Sumner was a decent economist; pity about the meat-eating.”

And then there are foreign cultures.  We like to pride ourselves with our love of “diversity,” but how many people enjoy living in a world where others don’t share their moral intuitions?  When we read this in the NYT:

We asked to see Jovali’s parents. The dad, Georges Obamza, who weaves straw stools that he sells for $1 each, is unmistakably very poor. He said that the family is eight months behind on its $6-a-month rent and is in danger of being evicted, with nowhere to go.

The Obamzas have no mosquito net, even though they have already lost two of their eight children to malaria. They say they just can’t afford the $6 cost of a net. Nor can they afford the $2.50-a-month tuition for each of their three school-age kids.

“It’s hard to get the money to send the kids to school,” Mr. Obamza explained, a bit embarrassed.

But Mr. Obamza and his wife, Valerie, do have cellphones and say they spend a combined $10 a month on call time.

In addition, Mr. Obamza goes drinking several times a week at a village bar, spending about $1 an evening on moonshine. By his calculation, that adds up to about $12 a month “” almost as much as the family rent and school fees combined.

I asked Mr. Obamza why he prioritizes alcohol over educating his kids. He looked pained.

Don’t we say to ourselves:  “Oh dear, I’d never behave that way.”  As if we know how we’d behave if we were a poor villager in some God-forsaken part of the Congo.

I suppose people will think I am advocating moral relativism.  Actually I am not making any sort of moral argument, my argument is aesthetic.  I am celebrating the existence of times and places that are rich and strange worlds unto themselves, whether it be 17th century Venice, 18th century Tahiti, 19th century London, or 21st century Tokyo.

I hate how our discussions of “the far” always implicitly assume that we are right and they are wrong.  If East Asian culture is more puritanical than us in some respects, we are to believe that they are Objectively Wrong.  And if in other respects the very same society is less puritanical, well they are also Objectively Wrong in those practices.  Thus I find it refreshing to read travel literature like this from Lawrence Osborne:

I got a lift with John Purdoe back to Sukhumvit, and in the car he told me why he, too, was exiled in Bangkok, though he had never expected to be.  A Jewish boy from Brooklyn working closely with a Catholic priest in a Buddhist slum in Southeast Asia.

“I just wish sometimes I could talk to someone about Isaac Bashevis Singer.  I wish I could talk to someone who’s actually heard of Isaac Bashevis Singer.  But who can I do this with?  There’s no literary culture here.  It’s embryonic.  It’s the one thing that bothers me.  One has to do without that.”

At this very moment, a bike shot by with two Thai girls perched behind the driver.  It was lightly raining and they held two banana colored umbrellas above their identical haircuts.  As they glided past his window they shot John a declarative, sultry, all-the-sex-you-want smile.  For the scholarly-looking boy from Brooklyn, it was enough,

“And then that happens.  You get that come-hither look.  Spontaneous, for no reason, just like that.  Woman to man.  No, no come-hither looks in Brooklyn.  That’s what keeps me here, apart from the work with father Joe.  The come-hither look.  It makes your day.  Perhaps you find that foolish.”

‘Not at all.  It’s like being surrounded by open doors.  You aren’t going to walk through them, but they’re open all the same.”

“Exactly.  It makes you feel alive.  Here, you are alive.  This is the most alive place on earth.  Even if it doesn’t have Isaac Bashevis Singer.  And even if our women wouldn’t understand in a million years.”

Wouldn’t they, though?  I have met plenty of farang women who love Bangkok precisely because it’s the only city in which they aren’t constantly harassed.  No one even looks at them.  They can wander the three-a.m. bars with total anonymity, impunity, for once in their lives reduced to the status of sexual ghosts.  As for the Gloria Steinem brigade—well, what was the point of even trying.  There was no pleasing them about anything.  They were not inclined to consider the question of sex as anything but a problem of crime.  And I thought of all those “hard-hitting exposes” you see in the Bangkok Airport about the sex business, consisting of interviews, economic analyses, and political laments, and I wondered why I never found this type of enquiry particularly enlightening.  Perhaps because it contains so few surprises.  Perhaps because we are invited so crudely to disapprove and wring our hands.

There is social science and there is literature.  Two totally different and incommensurable ways of apprehending the world.  I am a social scientist, and a utilitarian to boot.  The ultimate do-gooder.  I suppose some will be outraged by what seems like moral relativism.  “Why shouldn’t all societies follow our utilitarian values?”  Umm, since when are we utilitarians?  Which Western nation has followed Iran’s policy of saving thousands of lives by allowing the sale of organs?

I’m all for making the world a better place; but please, let’s not mix moral and aesthetic judgments.  And I wish we could be a bit less arrogant in our belief that our values are obviously better than those of the past, those of the future, and those of other cultures.

We all live in our own worlds and we all do the best we can; even when we are failing to do the best we can.

PS.  Readers:  Thanks for letting me get that off my chest.  I feel ready to return to economics.  BTW, don’t be fooled by the cover of the Osborne book, it’s G-rated.

PPS.  The Congo article reminded me of this Robin Hanson post.

PPPS.  And I forgot to mention bias against other generations.  Being the father of a little girl, I am frequently asked how I’ll deal with my daughter’s adolescence, as if it is some sort of horrible affliction.  “Aren’t you worried . . . ”   There’s an interesting question here.  I suppose young people may underestimate the risks of certain types of behavior, and nervous middle-aged parents overestimate those risks.  But who is further from the truth?

Am I really claiming that young people might be more mature than we are?  Of course not.   Seven-year olds rarely hold grudges for more than a few hours.  I know adults who react to a real or imagined slight by holding a grudge for decades.  Young people simply don’t have the discipline or maturity to persevere in that way.

As you may know, a number of bloggers have suggested that Krugman’s views on monetary policy have been inconsistent.  Here is his response:

Some readers are clearly confused about my stance on unconventional monetary policy. In some posts I have expressed skepticism about how effective the Fed can be; in others I have called on the Fed to do more.

But these aren’t contradictory positions.

I believe that given the grim economic situation, all players in the game should be trying to do whatever they can. There are other things the Fed can do; they would help; uncertainty about how much they would help shouldn’t be a reason not to try.

You might be surprised to read that I can see Krugman’s point, although I don’t completely agree.  I think I’ve followed his writings on macro as closely as almost anyone else, and I can see how the model he used to analyze Japan in the late 1990s is pretty flexible in its policy implications.  The relative merits and effectiveness of monetary and fiscal policy depend on all sorts of judgments about what is politically feasible, as well as the credibility of various monetary policy options.  I almost never see Krugman make a statement that is flat out 180 degrees inconsistent with what he said earlier.  Instead, I have three other problems with his posts on monetary policy.  I’ll list them in order of importance, starting with the least important.

Sloppiness –I am way busier than I’d like to be, and I can imagine that Krugman is much busier than I am.  So it’s not surprising that he might quickly skim someone’s post, and misinterpret the argument.  Even so, when he does that to me it is annoying.  The first time he responded to my blog he seemed to assume I was simply advocating conventional open market purchases, when I was clearly advocating unconventional open market purchases and inflation or NGDP targeting.  I am pretty sure that even back then he would have agreed with me if he had read the post more carefully, but he responded as if he just skimmed the first few paragraphs.  In revenge response I was able to find quotations that made him seem inconsistent, whereas it was probably more a question of sloppiness.  Of course that’s just my ego at work, and is of trivial importance.

Political miscalculation– In early 2009 Krugman complained that fiscal stimulus was too weak.  Instead of pushing hard for monetary stimulus, he seemed to devote most of his effort into pushing harder for fiscal stimulus.  I happen to think even a larger fiscal stimulus package would have been mostly ineffective, for all sorts of reasons, so I encouraged him to switch his focus to monetary stimulus.  I think everyone would now concede now that the level of fiscal stimulus that would have been needed was politically impossible, even if fiscal stimulus is effective.  Some of the accusations of inconsistency come from readers who notice Krugman now pushing the Fed much harder to inflate, after seeming to disparage the effectiveness of monetary policy in 2008 and 2009.  And that is what Krugman is responding to in the quotation above.

Poorly communicating the message –The preceding complaint feeds into what I think is the most important problem with his writings on monetary policy.  The vast majority of his readers interpreted his 2008-09 posts on monetary policy as supporting the old Keynesian “pushing on a string” view.  And this is not really surprising, as Keynes really did hold that view, and Krugman likes to quote Keynes and also kept saying we needed to relearn the insights of the General Theory.  But Krugman’s own “expectations trap” model was different in some very important ways.  No longer is all monetary policy ineffective at the zero interest rate bound, only currency injections expected to be temporary are ineffective.  Krugman’s biggest fear was that the conservative nature of modern central bankers would make people think that currency injections would in fact be temporary.  When the base doubled and the economy continued to deteriorate, Krugman naturally saw events confirming his views on expectations traps.

Krugman’s readers missed the fact that there is something central bankers could do in this situation.  He believed the actions might not work, but would at least be worth trying.  The most important step would be to set a higher inflation target.  But the Fed, ECB and BOJ weren’t even doing that.  Nor were they willing to do price level targeting.  Nor NGDP targeting.  Nor getting rid of interest on reserves.  Etc, etc.

So here’s the problem I have with Krugman’s money posts from 2008-09.  It’s not that I don’t think he understood what was going on with monetary policy.  Indeed in one respect he was ahead of me–I had assumed that a Bernanke Fed would react more aggressively to the deflation of late 2008.  My complaint is that when I read his posts it was obvious to me that they were written in such a way that 99% of his readers would interpret his message as; “Don’t waste time with monetary policy.  It can’t do much at zero rates.  Put all your effort into fiscal policy.”  I talked to many intelligent people who read Krugman all the time, and every single one thought that was his message.

I can understand why Krugman feels frustrated that people don’t see the nuances in his argument.  I think I do see those nuances.  But Krugman is an important and talented communicator who is read by many of the movers and shakers in Washington.  Think about how those Fed seats lay empty for 18 months.  Why weren’t people screaming about the issue 18 months ago?  Part of Krugman’s worldview is the belief that there’s a lot more the Fed could be doing.  I am more confident than he is about how well these things would work, if implemented by an aggressive central bank.  But even he thinks they are very much worth trying, and thus we aren’t far apart.   So who’s fault is it that his readers failed to get that message for almost 2 years?  And why is the liberal blogosphere only now demanding easier money, when we desperately needed easier money in September/October 2008, when TIPS spreads/stocks/commodities/real estate prices/industrial production were plummeting?

One of the privileges of blogging is that you get to stick your own title back on an essay, after the editors at The Economist change it.  Here is my third essay over at The Economist’s “By Invitation.”

Why “structural unemployment” is a dangerous copout

I suppose that’s bad grammar, but it made sense to me.

Consider this:

The present depression is not an act of God for the purification of men’s souls. It is not a business cycle. It is not due to extravagant living. It is not due to unsound business practices. It is not due to too great efficiency. It is not due to lack of confidence, but is the cause of lack of confidence. It is due to high demand for gold following a period of low demand for gold. It teaches the devastating effects of deflation, but teaches no other lesson that is good for society. (Warren and Paerson, 1933, p. 125)

I think that’s the first time I ever used both italics and bold font in the same passage.  I would have preferred to have used a megaphone—in an FOMC meeting, but my computer doesn’t have that option.  Here is Gustav Cassel:

 “the way in which the Gold Delegation presents the causes of the breakdown of the gold standard seems to me entirely unacceptable. What we have to explain is essentially a monetary phenomenon, and the explanation must therefore essentially be of a monetary character. An enumeration of a series of economic disturbances and maladjustments which existed before 1929 is no explanation of the breakdown of the gold standard. In fact, in spite of existing economic difficulties, the world enjoyed up to 1929 remarkable progress. What has to be cleared up is why the progress was suddenly interrupted.” (1932, League of Nations, Memorandum of Dissent.)

HT:  Douglas Irwin