Archive for March 2012


Bernanke was right!

Ben Bernanke has been widely mocked for statements like this:

7/1/05 – Interview on CNBC
INTERVIEWER: Tell me, what is the worst-case scenario? We have so many economists coming on our air saying ‘Oh, this is a bubble, and it’s going to burst, and this is going to be a real issue for the economy.’ Some say it could even cause a recession at some point. What is the worst-case scenario if in fact we were to see prices come down substantially across the country?

BERNANKE: Well, I guess I don’t buy your premise. It’s a pretty unlikely possibility. We’ve never had a decline in house prices on a nationwide basis. So, what I think what is more likely is that house prices will slow, maybe stabilize, might slow consumption spending a bit. I don’t think it’s gonna drive the economy too far from its full employment path, though.

Obviously he can’t predict housing prices, but then no one can.  But he was right about the business cycle:

Jan. 2006:  starts =  2,303,000,   completions = 2,058,000,  average = 2,180,000, U-rate = 4.7%

April 2008: starts = 1,008,000, completions =1,014,000,   average =  1,011,000, U-rate = 4.9%

October 2009: starts = 527,000, completions =  745,000,    average = 636,000.  U-rate = 10.1%

If the great housing construction crash of January 2006 to April 2008 didn’t “drive the economy too far from its full employment path,” I think we can safely assume that no housing crash will ever cause a recession in the US.

Too bad the Fed let NGDP fall in late 2008.

Banana republic watch

The new DeLong and Summers paper looks impressive enough.  I don’t buy their argument for fiscal stimulus, but I am willing to listen respectfully to the hysteresis argument (which seems central to their self-financing stimulus argument.)  Obviously Brad DeLong would not listen respectfully to a conservative arguing tax cuts are self-financing due to long run output effects.  That would be “voodoo economics.”  So the following points should be viewed in this context; I’m not about to trash their paper, which seems excellent.  I’m about to trash the political culture that leads to this sort of paper.  Here’s D&S:

This paper focuses on policy choices in a deeply depressed demand constrained economy in which present output and spending are well below their potential level. We presume for the moment that monetary policy is constrained by the zero lower bound, and that the central bank is unable or unwilling to provide additional stimulus through quantitative easing or other means””an assumption we discuss further in Section V.

Now stop right there.  I want to throw a brick at the screen when I read “unable or unwilling.”  Here’s how things are in the real world.  No fiat money central bank ever tried to inflate and failed.  It will never happen.  It’s really, really easy to debase a fiat currency.  The Fed can engage in 5% NGDP targeting, level targeting, if it so chooses.   You create an NGDP futures market and buy assets until NGDP futures are right on target.  How many assets would you have to buy?  Under NGDP level targeting the monetary base would be less than 1/2 half its current level.  The Fed doesn’t want to do this, or any of the million other methods that would work.  So their entire paper boils down to what is the fiscal multiplier if the Fed chooses to “do the wrong thing.”

So let’s start over.  The Fed is unwilling to provide enough monetary stimulus.  OK, now what is the point of this paper?  Is this to train our future econ PhD students?  Are we trying to teach them the optimal policy regime?  Obviously not.  The optimal regime relies on monetary policy to steer the nominal economy, and fiscal policy to fix other problems.  So we are going to defend the model how?  A blueprint for failed states?  For banana republics?  Fair enough, but ask yourself the following question:  In a failed state, which is more incompetent branch of government; the central bank or the legislature?

Yes, the Fed is bad.  But Congress is downright ugly.  Deep down most economists are technocrats.  They see the central bank as being the best and the brightest, the guys who are above politics, who will “do the right thing.”  And how do economists view our Congress?  The terms ‘stupid’ and ‘incompetent’ don’t even come close to describing the disdain.  So are we supposed to change our textbooks in such a way that the fiscal multiplier is no longer zero under an inflation targeting regime (as the new Keynesians had taught us for several decades?)  And on what basis?  Because the Fed might be so incompetent that we need Congress to rescue the economy?  In what world does that policy regime actually work?  If you have a culture that has its act together, such as Sweden or Australia, the central bank will do the right thing.  If not, then all hope is lost.

[Check the previous post if you have any doubts about which institution is more incompetent.]

And it’s even worse than that.  DeLong and Summers seem to make the common mistake of assuming that as long as the monetary authority is not doing its job, we can assume the fiscal multiplier will be positive, as fiscal stimulus won’t be offset by monetary tightening.  But that’s not right.  It’s not enough for the monetary authority to be incompetent; they must be incompetent in a very special way.  Consider the follow two examples.

1.  After a financial crisis the central bank is completely passive, allowing severe deflation to set in.

2.  After a financial crisis the central bank is slightly thrown off course, and allows inflation to fall 1% below target, but no lower.

In case 1, the fiscal multiplier might well be every bit as high as the textbooks suggest.  But in case 2 the multiplier might well be zero.  If the Fed does just enough QE to keep inflation in the 1% to 2% range, but no more, then any extra fiscal stimulus will be offset by less QE.  I’m not saying that exactly describes the current situation, but surely it better describes recent Fed policy that case 1.

In fairness, in section V DeLong and Summers try to make a more sophisticated argument against the reliance on monetary stimulus:

Perhaps, though, as Mankiw and Weinzerl (2011) suggest, arguments for temporary fiscal expansion are even better arguments for expansionary monetary policy. Here too we are skeptical. While a much richer model would be necessary to fully address the issue, it seems to us that if fiscal policy is self financing it will be de-sirable to use as an instrument once it is recognized that (i) with uncertainty about multipliers diversification among policy instruments is appropriate as suggested by Brainard (1967), (ii) expansionary monetary policies carry with them costs not represented in standard models (including distortions in the composition of investment, impacts on the health of the financial sector, and impacts on the distribution of income), and (iii) the historically-clear tendency of low interest rate environments to give rise to asset market bubbles.

This is a very widely held attitude, but gets things completely backwards.  D&S implicitly make the very common mistake of assuming current Fed policy is expansionary, but not expansionary enough; and then assuming that the monetary policy needed to generate adequate NGDP growth must be much more of the same, and must produce even bigger distortions than this policy.  (Yes, that’s reading between the lines, but I think most readers would share my reading.)

Exactly the opposite is true.  As Milton Friedman pointed out, ultra-low rates are a sign that money has been very tight (driving NGDP far below trend.)  I’d add that a bloated monetary base reflects the same forces.  The base is 23% of GDP in Japan and 18% of GDP in the US because our NGDP growth has been really low in recent years.  It’s only 4% of GDP in Australia because they have a much higher trend NGDP growth rate (roughly 7%) and hence much higher nominal interest rates, and hence a much higher opportunity cost of holding ERs.  If you want an economy free of the “distortions” caused by low rates and the Fed buying up lots of assets–then set a more expansionary monetary policy target.

As far as asset bubbles are concerned, they don’t hurt at all when NGDP growth is maintained (1987), hurt slightly when NGDP growth falls slightly (2000), but they seem to hurt a lot when it isn’t maintained (1929, 2008.)  Actually, the pain of the latter two cases was caused by the falling NGDP, not the bursting bubble, but to the average person it looks like the bubble did it.

If we are going to teach our students how to “do the right thing,” we need to start by eliminating “depression economics” from the curriculum.  Start with the fact that what Krugman calls “depression economics” should actually be called “expected depression economics.”  That’s because fiscal stimulus acts with a lag that is just as long as monetary stimulus.   (Here and here I argued monetary lags are surprisingly short.)  So it doesn’t matter where the economy is right now, but rather where it will be in 12 months.  Monetary policy should always be set in such a way as to produce on-target expected NGDP growth.  That’s the Lars Svensson principle.  If you do that, there’s no room for fiscal stimulus, even if the economy is currently depressed.  With a central bank that targets expected NGDP growth along a 5% growth path, you are in a classical world.  Spending has opportunity costs.  Unemployment compensation discourages work.  Saving boosts investment.  Protectionism is destructive.  And so on.  That’s the policy we should be teaching our grad students.  The optimal monetary policy.  Not a policy mix that only has a prayer of making sense in countries where the central bank is even more stupid and corrupt than the Congress.  As far as I can tell, those countries don’t exist.

PS.  Just to reiterate, this post is a not a comment on the core of D&S.  I’m not qualified to judge their model, but it looks fine to me.  I just don’t buy the assumption that motivates the entire exercise.

PPS.  Marcus Nunes also has a post on the DeLong & Summer paper.

The Fed understands the Romer/Sumner tax cut argument (too bad Congress is brain dead.)

Christina Romer and I have both advocated employer-side payroll tax cuts.  When nominal wages are sticky, that shifts the SRAS to the right, and boosts output if the Fed is targeting inflation.  On the other hand employee-side cuts boost AD, and may be ineffective if the Fed targets inflation.  What does the Fed itself think?

The central bank “is performing about as well as it can on both mandates” of price stability and full employment, Kocherlakota said. It needs help from non-monetary policies such as hiring subsidies to offset the uncertainty and adverse credit conditions that are keeping companies from adding jobs, he said.

But hiring subsidies will only work to boost jobs if the Fed eases monetary policy further, he told reporters later.

Asked if he will support more policy accommodation if lawmakers pass hiring subsidies, Kocherlakota said that such a response would be “appropriate” if subsidies put downward pressure on inflation, as he predicts they would.

Interestingly, his view that hiring subsidies are a key policy tool for boosting employment squares with a paper released Monday from the San Francisco Fed, whose chief is among the most dovish at the U.S. central bank.

The Fed gets it; both the doves and hawks understand the AS/AD model.  Too bad our Congress doesn’t understand, and keeps passing ineffective employee-side payroll tax cuts.

The Fed doesn’t actually “control” short term interest rates

At least not in the sense that NYC controls the rent on apartments.  This post was triggered by a recent Karl Smith post:

The interest rate on T-Bills is simply whatever the Fed wants it to be. T-Bills and bank excess bank reserves are essentially interchangeable. In normal times the value of excess reserves is the Fed Funds rate. Today it is the Interest on Reserves rate. However, both of those are essentially controlled by the Federal Reserve.

This is the conventional wisdom, but I thinks it’s (approximately) wrong.  Because this is very confusing, let’s start off by discussing why controlling interest rates is not like controlling rents.  Under rent control, the government legally mandates a particular maximum rent, and a shortage often results.  The Fed doesn’t put any legal price controls on fed funds or T-bills.   There is no shortage.  Rather it adjusts the money supply as needed to keep short term rates at the desired level.  One might argue that this is merely a quibble, but in fact there is a much bigger problem with Karl’s argument, which he alludes to in this paragraph:

While its possible that the interest rate on T-Bills averages only 3.3% over the next 30 years this is – hopefully – extremely unlikely. It implies that nominal GDP growth will average 3.3% over the next 30 years, as the Fed must ultimately align interest rates with nominal growth rates or the economy will persistently overheat or stagnate.

To see why this matters, consider the following thought experiment.  Suppose the Fed was run by God, and God was considering the following options for hitting a 2% inflation target:

1.  Adjust the monetary base until God himself (or herself) expects 2% inflation.

2.  Adjust the monetary base until the fed funds rate settles at a level that God expects to produce 2% inflation.

3.  Adjust the monetary base until the euro/$ exchange rate settles at a level that God expects to produce 2% inflation.

4.  Adjust the monetary base until the CPI futures market settles at a level that God expects to produce 2% inflation.  This need not be 2% inflation in the CPI futures market, because God knows the exact risk premium in CPI futures prices.  (And I mean “God knows” literally, not in the sense of “who knows?”)

I hope it’s obvious that all 4 monetary regimes are identical.  The path of base money, fed funds, exchange rates and CPI futures prices is exactly the same in all four cases.  I think it’s also obvious that no one would call options 1, 3 and 4 “controlling interest rates.”  Since option 2 is exactly the same, it is also not “controlling interest rates.”

So what is different about our current monetary regime that leads people to think that the Fed does “control” short term interest rates?  I guess we could start with the fact that Ben Bernanke isn’t God.  But seriously, I see two differences.  I foresaw God adjusting the fed funds target continuously, and the Fed actually adjusts the target every 6 weeks.  And I saw God as being omniscient, and the Fed . . .  well let’s just say it’s not.  So obviously there is a sense in which Karl is right.  The Fed sort of “controls” (but doesn’t legally fix) the fed funds rate for 6 week periods.

But the Smith quotation on top referred to T-bill yields, not the fed funds rate.  In this case Karl’s argument is even weaker.  As the market sees the economy strengthen and/or inflation rise, it will bid up T-bill yields in anticipation of the Fed raising the fed funds target at the next meeting.  If the market sees the central bank as operating on a target-the-forecast basis, then T-bill yields will always be determined by the market, not the Fed.  They will represent the market’s estimate of what sort of short term interest rate path would mostly likely be associated with 2% inflation (or 5% NGDP growth, if that were the Fed’s target.)

Looking at monetary policy in terms of interest rate control is likely to lead one astray:

1.  It leads many people to equate low rates with easy money, and vice versa.  (Never reason from a price change.)  Karl doesn’t do that, but lots of people do.

2.  It leads lots of libertarians to assume the Fed is more interventionist that than it really is.  The Fed does have monopoly on money creation, and that’s obviously very interventionist.  It means the Fed steers the nominal economy (although like all captains, it occasionally goes off course.)  But it doesn’t make sense to argue the Fed targets inflation and is also highly interventionist in the credit markets.  If T-bill yields are X% when the Fed is successfully targeting inflation at 2%, then those are essentially free market short term interest rates.  You can’t target two variables with one tool.  It may be that 2% inflation was a bad target in the middle of the housing boom, and tighter money was desirable.  But it makes no sense to argue the inflation target was wrong and also that the interest rates were too low.  Had the target for inflation been lower, or had a 5% NGDP target was been adopted (as David Beckworth recommended), it’s quite likely that short term rates would have been even lower, as economic growth would have been weaker.  Nominal interest rates are strongly procyclical, they are highly correlated with NGDP relative to trend.

PS.  Although Milton Friedman was a great economist, he made one silly mistake.  He once argued that fixed exchange rates were a bad idea because the market should set exchange rates.  But fixed exchange rates are no more nor less interventionist than a fixed growth rate of the money supply (Friedman’s preferred target.)  In a sense all central bank policy targets are equally interventionist.  If the central bank remains in public hands, the only question is which target produces the least harm to the economy.

Do you believe in reincarnation?

Herbert Hoover began his career as a gold mining engineer:

Hoover went to Australia in 1897 as an employee of Bewick, Moreing & Co., a London-based mining company. Hoover first went to Coolgardie, then the center of the Western Australian goldfields, where he worked under Edward Hooper, a company partner. Conditions were harsh as these goldfields were centered in the Great Victoria Desert and Hoover described the region as a land of “black flies, red dust, and white heat.”[5] He served as a geologist and mining engineer while searching the Western Australian goldfields for investments.

He became wealthy, entered politics, and took office in March 1929.  He supported the Fed’s tight money policy during the early stages of the Great Depression.  This despite the fact that the policy led to a gold inflow to the US which greatly weakened economies on the “periphery” of the gold standard.

In contrast, Jean-Claude Trichet started his career as a coal mining engineer.

Jean-Claude Trichet grew up in a family that was greatly influenced by a love of mathematics and poetry, thanks to the efforts of his university professor father, Jean. His father’s influence led the younger Trichet to study math, economics and mining engineering. He gained relevant experience through a job at a coal mine and familiarized himself with politics by actively working with the Socialist Party.

He went on to head the European Central Bank.  He supported tight money policies that caused the biggest crash in European NGDP since the Great Depression.  Policies that led to a flow of money from the periphery of the eurozone to the core countries.

The Trichet bio also provides one of his quotations:

Poems, like gold coins, are meant to last. They are both aspiring to inalterability, whilst they are destined to circulate from hand to hand and from mind to mind.

PS.  Primo; don’t take this personally.

PPS.  Yes, I know that Hoover died after Trichet was born.

HT:  Mark Sadowski, who provided the tip about Trichet.