Archive for October 2010


Where are the biggest “imbalances?”

There are a couple important principles in international economics:

1.  National boundaries are not necessarily meaningful when evaluating the influence of a particular regional economy.  The GDP of Czechoslovakia did not suddenly change when the country split in two–nor did the impact of its economy on the rest of the world.

2.  When a country’s economy impacts the US, it usually doesn’t matter whether the impact is “natural” or “artificial.”  For instance, suppose we had been gladly importing Ecuadorean bananas for decades, naively thinking that any country named after the equator must be warm.  Then we found out that the weather in Ecuador was actually quite cool (due to high altitude), and that bananas could only be grown there because the government was heavily subsidizing production in greenhouses.  Of course most red-blooded Americans would be outraged by this discovery, as it would indicate that we were a bunch of patsies who had been victimized by the Ecuadorean “dumping” of subsidized goods.  A few economists might argue, however, that if cheap bananas are good for the US, it doesn’t really matter why they are cheap.

With these concepts in mind, I decided to investigate where these so-called international “imbalances” are actually located.  Keep in mind that I don’t think imbalances are of any importance.  But others clearly do—so at least we ought to be aware of the stylized facts being discussed.  I used data from the back page of The Economist, and divided the world up into key regions:

1.  Nordic region:  Population 125 m.  CA surplus = $397.3 b.   (Of which Germany is nearly 2/3 the population, but less than 1/2 the surplus.)

2.  China:  Population 1350 m.  CA surplus =$289.1 b.

3.  Japan:  Population 127 m.  CA surplus = $180.9 b.

4.  Five dragons:  Population 110 m.  CA surplus = $153.3 b.

5.  Russia:  Population 145 m.   CA surplus = $84.2 b.

6.  Club Med:  Population 255 m.   CA deficit = $266.3 b.

7.  Anglo bloc:  Population 420 m.   CA deficit = $556.0 b.  (Of which the US is roughly 3/4s of both categories.)

[The Nordic bloc includes Norway, Sweden, Denmark, Holland, Germany and Switzerland.  Perhaps “Protestant” might be a better term.  Club Med includes France, Spain, Italy, Greece and Turkey.  The five dragons are Korea, Taiwan, Malaysia, Singapore and HK.  The Anglo bloc includes the US, Canada, Britain and Australia.  The Economist did not list small countries like Ireland and New Zealand.  CA is ‘current account.’]

So if CA surpluses are to be viewed as a problem, then there is no one more villainous that the Norwegians and the Swiss.  Both countries have CA surpluses of roughly $10,000 per capita.  That’s about $40,000 for the average family of four in each country.  There are lots of countries where average incomes aren’t even that high.  China has a surplus of about $215/person.  The average Norwegian and Swiss worker is nearly 50 times as destructive of US jobs as the average Chinese worker.   All those xenophobic campaign commercials should be depicting blue-eyed blonds making skis and cuckoo clocks.  That’s where our jobs are going!

I know what you are thinking; “The Nordic countries play by the rules; they don’t have their governments buy lots of foreign financial assets in order to run up massive CA surpluses.”  Ever heard of Norway’s Sovereign Wealth Fund?  Note that the 5 little Nordic countries combine for a $220 billion surplus, with a combined population smaller than South Korea.

Do any of these “imbalances” actually hurt the US?  Of course not, the Fed determines our NGDP.  But I thought it would be interesting to identify the villains, in case you do think it is a problem.  BTW, the other countries on The Economist list tend to have much smaller imbalances.  These are the big ones.

PS.  I used the CA balance.  Some might argue that it is the trade balance that really matters, as it correlates with jobs.  The CA includes income from investments.  If so, China shrinks to a $182.9 b. surplus and Germany rises to $208.2 b. while Russia soars to $151.6 b.  China is just another big country in trade balance terms.

HT:  Bastiat

Surely Krugman can do worse than this?

Paul Krugman continues his habit of assuming the worst about those with whom he disagrees.  In a new post, entitled “The Worst Economist in the World” he discussed the following quotation from the WSJ:

When one country devalues its currency, others tend to follow suit. As a result, nobody achieves trade gains. Instead, the devaluations put upward pressure on the prices of commodities such as oil. Higher commodity prices, in turn, can cut into global economic output. In one ominous sign, the price of oil is up 8.7% since August 27.

OK, it’s not the best thing I’ve ever read.  There are two possible interpretations, neither of which are entirely satisfactory.  First, he might have been referring to the fact that all currencies could simultaneously depreciate against goods and services.  Unfortunately, it seems extremely unlikely that a modern journalist would refer to inflation as “devaluation.”  More likely, he had the following scenario in mind:  The US depreciates first by using QE, then other countries do the same.  This would bring dollar exchange rates back to their original equilibrium, but leave all prices higher.

Does Krugman have any idea, any clue, as to how difficult it would be to win the title of most economically illiterate journalist?  With all due respect to Mr. Krugman, I don’t think the WSJ quotation even comes close.  By analogy, I was always the last person picked for basketball in high school, despite being 6′ 4”.  But was I the worst player in the world?  After all, there are people who are blind, or 105 years old, or in comas.  I expect better, er I mean worse, from Mr. Krugman next time.

I prefer Matt Yglesias’s take on the same quotation.  He senses what the WSJ was trying to get at, but points out that right now higher oil prices might be a positive sign:

If you try to reason in this direction, you end up tying yourself into knots. Is a higher price of oil “ominous.” Well it depends why it’s going up. If a bunch of equipment in the North Sea breaks, then the price of oil is increasing because the quantity of oil available to the world economy has declined. That’s bad because oil is useful. But conversely, if the US economy were to start growing rapidly that would increase the demand for oil and lead to a price increase. That, however, would be a good thing. If the world’s central banks engage in coordinated monetary stimulus, that will result in some inflation (and hence higher nominal oil prices) but some inflation would be helpful at the moment. But if Israel and Iran go to war, that will also increase the price of oil and it’ll be terrible.

In general, higher supply of useful commodities is good (and leads to lower prices) and higher demand for useful commodities is a side-effect of good things (and leads to higher prices) so you can’t just look at commodity prices and draw any conclusions about what’s happening.

That’s right.  Never reason from a price change.  That’s the real problem with the WSJ quotation.

Why doesn’t the government publish monthly GDP data?

A recent David Beckworth post linked to Macroeconomic Adviser’s monthly nominal GDP series.  Please click on the Macro Adviser’s GDP link and take a look at the graph showing estimated monthly NGDP data.  You will see that almost the entire drop in NGDP during this recession occurred during a brief 6 month period between June and December 2008.  This fact is obscured by quarterly data, which show a very large drop in the average level of NGDP between 2008:4 and 2009:1.  But again, by December 2008 it was almost all over, even though the official recession trough wouldn’t occur until June 2009, at a tad below December NGDP levels.

[Update, 10/25/10:  I erred in telling you to look at the graph, which shows RGDP.  The tab at the bottom opens another page which shows the nominal monthly data.   This is even better—all of the decline in NGDP now occurs between June and December 2008, and almost all between July and December.  This almost precisely aligns with the period of ultra-tight money.]

I wish the Federal government would publish monthly NGDP data.  It can’t be that hard to get estimates; after all, GDP is mostly constructed out of other monthly time series.  And even the quarterly GDP reports are estimates, often sharply revised years after the fact.

The period of June to December 2008 also saw one of the tightest monetary policies in American history.  Between July and late November the real interest rate on 5 year  TIPS soared from about 0.5% to 4.2%.  The dollar soared against the euro.  Stock, commodity, and commercial real estate prices plunged.

And all of this occurred before the Fed ran out of conventional monetary policy ammo.  That’s right, it wasn’t until mid-December 2008 when the Fed reduced rates close to the zero bound (0.25%.)  During the crash rates were always at least 1%, and mostly 2%.  And that’s ignoring the contractionary impact of interest on reserves.

Frequent commenter “123” has studied this period more intensively than I have, and he recently sent me a post that sheds new light on the debate over whether the key problem was solvency or liquidity:

Brad DeLong ponders the issue of the root cause of the crisis. Is it that the full-employment planned demand for safe assets is greater than the supply, or is it that the full-employment planned demand for medium of exchange is greater than the supply? In other words, is it the flight to safety, or is it the flight to liquidity? Brad DeLong argues that we have the flight to safety:

“Thus we would expect a downturn caused by a shortage of liquid cash money to be accompanied by very high interest rates on, say, government bonds–which share the safety characteristics of money and serve also as savings vehicles to carry purchasing power forward into the future, but which are not liquid cash media of exchange.”

The problem is that government bonds serve both as savings vehicles and as medium of exchange. As Gary Gorton said, “it seems that U.S. Treasuries are extensively rehypothecated and should be viewed as money”. You purchase groceries with cash, and you purchase other financial assets with U.S. Treasuries, but in both cases we are dealing with media of exchange.

It is very hard to disentangle these two facets of U.S Treasuries, but we have a great natural experiment. After the collapse of Lehman, TIPS were a perfectly safe savings vehicle, but they were much less liquid than cash or other Treasuries. Lehman has mainly used TIPS as repo collateral, and after liquidation the pattern has shifted, the marginal holder of TIPS was more likely to use it as savings vehicle rather than for transactional purposes. The result was what FT Alphaville has called “The largest arbitrage ever documented”, as the price of TIPS fell by as much as 20 cents on the dollar as compared to much more liquid Treasuries. This gives us a clear indication that post-Lehman panic was a flight to liquidity, and not a flight to safety. This means the best policy response was the expansion of the quantity of liquid, rather than safe assets. After March 2009 QE announcement, the Fed has greatly enhanced liquidity properties of TIPS.

This does somewhat undercut my argument that the TIPS spreads showed inflation expectations falling sharply.  They did fall, but not as sharply as the spreads suggest.  But I’ve always acknowledged that the TIPS spreads might have been distorted by a rush for liquidity, and I’ve also argued that the rush for liquidity shows the Fed was behind the curve just as surely as would lower inflation expectations.  Either way, money was much too tight.

It also seems to undercut my cherished belief in the EMH.  Perhaps someone in the mutual fund industry can tell me why bond funds didn’t just construct a portfolio of TIPS plus inflation futures that was guaranteed to outperform Treasury note funds of equal maturity.  123 linked to an arbitrage paper that seemed to suggest there were lots of $100 bills lying on the ground.

PS.  I’ve been so busy that I haven’t linked to this David Beckworth and William Ruger article on Milton Friedman in Investor’s Business Daily.  Good stuff.

PPS.  I also wanted to link to this good James Hamilton post on QE:

A related complication is the fact that the market has already anticipated substantial additional LSAP [i.e. QE]. My guess is that an additional trillion dollars in purchases is already priced into current bond yields and exchange rates.

For all these reasons, the key message of the November FOMC statement may not be the size of purchases that the Fed announces, but instead the framework it offers as guidance for exactly what such purchases are intended to accomplish.

Exactly.  It’s all about the framework.  In retrospect, the biggest problem in the second half of 2008 was the lack of a policy framework.  The was no indication that the Fed would do anything to stop, or later reverse, the sickening plunge in NGDP.

Why are macroeconomists so obsessed with interest rates?

If I wrote a macro textbook, I would try to avoid any mention of interest rates or inflation.  The Fisher equation would use expected NGDP growth.  The AS/AD model would use hours worked as the real variable and NGDP as the nominal variable.  The transmission mechanism would not involve changes in interest rates, but rather the excess cash balance mechanism.  More cash would raise expected future NGDP.  This would raise the current price of stocks, commodities and real estate.  (As in Islamic economics, there’d be no interest rates.)  The higher asset prices would tend to raise current AD.  More nominal spending, when combined with sticky wages and prices, would boost output.

[Update 10/22/10:  This is why I shouldn’t do 4 posts in one day.  Commenters pointed out two flaws.  The Fisher equation uses interest rates.  And interest rates are important for inter-temporal decisions.  How about this:  A macroeconomics free of the concept of inflation, and a business cycle theory that did not use either inflation or interest rates.  Is that slightly less crazy?]

But obviously I’m the exception.  When rates hit zero and the Fed couldn’t move them anymore, I expected economists to shift over to some other mechanism; the money supply, CPI futures, exchange rates, etc.  Instead they started talking about how the Fed could promote a recovery by lowering long term rates.  (But if the policy is expected to work, wouldn’t it boost long term rates?)  Or they talked about how the Fed could reduce real interest rates by boosting inflation.  Some even argued that the Fed would have to boost inflation expectations to 6% in order to get a robust recovery, forgetting that this view directly conflicts with another key assumption of Keynesian macroeconomics—that the SRAS is very flat when unemployment is high.

Some of my commenters argued you couldn’t raise NGDP without first creating inflation expectations, which would lower the real rate of interest.  But that’s not necessary at all.  If you create higher NGDP growth expectations, then even if expected inflation doesn’t rise at all, the Wicksellian equilibrium real rate will rise and monetary policy will become more stimulative.  So the Fed doesn’t need to lower real interest rates in order to stimulate the economy.  Conversely, a policy such as interest on reserves might have had a devastating impact on aggregate demand, even if it had no impact on interest rates.

I’m genuinely confused.  When we explain why a big crop of apples makes NGDP in apple terms rise sharply, we don’t resort to convoluted explanations involving an interest rate transmission mechanism.  Why then, when there’s a big increase in the supply of money, do we think it will only affect nominal GDP in dollar terms via some sort of interest rate transmission mechanism?

Why is the Fed so embarrassed about wanting more AD?

For decades the Fed has steered the economy along a path of two to three percent inflation.  The policy has not been controversial.  Sometimes they ease, and sometimes they tighten.

Recently inflation has run closer to 1%, and Bernanke has suggested pushing the rate back up to 2%.  Others at the Fed are more radical, calling for level targeting.  This would allow a bit above 2% inflation to offset periods of below 2% inflation.  Even those radical proposals are more conservative than the actual 2% to 3% average rate of recent years.  So how is the public reacting to monetary policy proposals that are more conservative that what actual occurred in recent decades?  According to Time magazine, they’re so angry it might lead to a civil war:

What is the most likely cause today of civil unrest? Immigration. Gay Marriage. Abortion. The Results of Election Day. The Mosque at Ground Zero. Nope.

Try the Federal Reserve. November 3rdis when the Federal Reserve’s next policy committee meeting ends, and if you thought this was just another boring money meeting you would be wrong. It could be the most important meeting in Fed history, maybe. The US central bank is expected to announce its next move to boost the faltering economic recovery. To say there has been considerable debate and anxiety among Fed watchers about what the central bank should do would be an understatement. Chairman Ben Bernanke has indicated in recent speeches that the central bank plans to try to drive down already low-interest rates by buying up long-term bonds. A number of people both inside the Fed and out believe this is the wrong move. But one website seems to believe that Ben’s plan might actually lead to armed conflict. Last week, the blog, Zerohedge wrote, paraphrasing a top economic forecaster David Rosenberg, that it believed the Fed’s plan is not only moronic, but “positions US society one step closer to civil war if not worse.” (See photos inside the world of Ben Bernanke)I’m not sure what “if not worse,” is supposed to mean. But, with the Tea Party gaining followers, the idea of civil war over economic issues doesn’t seem that far-fetched these days. And Ron Paul definitely thinks the Fed should be ended. In TIME’s recently cover story on the militia movement many said these groups are powder kegs looking for a catalyst. So why not a Fed policy committee meeting. Still, I’m not convinced we are headed for Fedamageddon. That being said, the Fed’s early November meeting is an important one. Here’s why:

Usually, there is generally a consensus about what the Federal Reserve should do. When the economy is weak, the Fed cuts short-term interest rates to spur borrowing and economic activity. When the economy is strong and inflation is rising, it does the opposite. But nearly two years after the Fed cut short-term interest rates to basically zero, more and more economists are questioning whether the US central bank is making the right moves. The economy is still very weak and unemployment seems stubbornly stuck near 10%.

In the past I’ve argued their mistake was to argue for more inflation, which sounds undesirable.  Contrast Fed policy with fiscal stimulus.  In early 2009 there was lots of criticism about the fiscal stimulus plan, but I don’t recall a single critic arguing that fiscal stimulus was a mistake, because it “might work.”  Instead, they argued it was a waste of money and would probably “fail,” which meant it wouldn’t boost AD.  It was taken as a given that more AD was desirable.  Now monetary policy has become so controversial that people are talking about civil war.  Why?  Because some of the more radical members of the Fed are proposing average inflation rates almost as high as what we have experienced over the last two decades.

What are some possible explanations:

1.  Higher inflation sounds bad–the Fed should have said it was trying to boost AD, or NGDP, or the average income of Americans.

2.  The monetary base has already exploded in size, so people are already worried that only “long and variable lags” separate us from Zimbabwe-style inflation—despite 2% bond yields and despite the fact that similar policies had no effect on long run inflation in Japan.

Today I’d like to suggest a different explanation.  Perhaps this crisis is a sort Waterloo for Keynesian interest rate targeting, analogous to the effects of 1982 on monetarism.  You may recall that in the early 1980s monetarist ideas were popular.  Slower money supply growth helped slow inflation.  But velocity seemed to decline sharply in 1982, so the Fed let the money supply rise above target, and went back to interest rate targeting.  (Indeed some claim they never really abandoned interest rate targets, but let’s put that aside.)

This crisis has put the economy into a position where the Fed’s normal interest rate mechanism doesn’t work.  It can’t steer the economy in the only way it feels comfortable steering the economy.  Maybe we need a new steering wheel.  And the search for a new steering wheel is what is so controversial.

If we had been doing NGDP futures target all along, nothing interesting would have happened in late 2008.   Expected NGDP growth would have stayed at 5%, nominal rates would have stayed above zero, and the monetary base might not have exploded (that is less clear.)  The severe financial crisis would have been far milder, if it occurred at all.  The Fed would have continued steering the economy in the same way it always had.  (BTW, the decline in house prices in bubble areas was already largely complete by late 2008—the second leg down was caused by falling NGDP.)

Instead, when rates hit zero the Fed stopped trying to steer the economy at all; it followed Stiglitz’s advice and stopped using monetary policy.  Of course they were still doing policy (and highly contractionary policy at that) but didn’t realize it, as their normal policy tool had jammed just as the wheels of the car were pointed toward a ditch called “recession.”  In the next post I’ll explain why it’s almost impossible to pry the Fed’s hands off the old steering wheel, even though it is now broken and not connected to the wheels.