Archive for February 2014


Channels to nowhere

When there is a big crop of apples, the value of apples tends to fall.  There is no need to discuss obscure “channels” such as bank lending.  Apples are worth less for “supply and demand” reasons. When there is a big crop of money, the value of money tends to fall.  Again, no need to talk about “channels.”  This post was motivated by a recent comment, which is something I see pretty often:

The CB [central bank] interacts with counterparties that have little or no propensity to spend and the lending channel is blocked.

That’s a fairly common view, and yet it contains no less than three serious fallacies.  This is what the commenter overlooked:

1.  Counterparties don’t matter.  The Fed buys assets from counterparty X, who almost always immediately cashes the check and the new base money disperses through the economy almost precisely as it would if the Fed had bought assets from counterparty Y, or counterparty Z.

2.  The propensity to spend doesn’t matter for the same reason.  Once counterparties get rid of the new base money, the impact on NGDP depends on the public’s propensity to hoard money, and any change in the incentive to hoard.  In the long run money is neutral and NGDP changes in proportion to the change in M, regardless of whether the person receiving the money has a marginal propensity to consume of 90% or 10%.  Either way they’ll almost always “get rid of” the new money, either by spending it or saving it.  Saving is not hoarding, it’s spending on financial assets.

3.  The lending channel doesn’t matter.  In the long run all nominal prices rise in proportion to the change in M.  In the short run sticky wages and prices cause the new money to have non-neutral effects.  Those non-neutral effects reflect wage and price stickiness, not “channels” of spending.

Here’s where the confusion comes from.  As soon as we move from a world of flexible prices and money neutrality (as with a currency reform) to a sticky-price world, real effects become the most noticeable short run effect of monetary shocks.  This causes many observers to reverse causality. They assume that easy money boosts real GDP, and if output rises enough it eventually triggers inflation. Thus they see real shocks triggering nominal changes.  If that’s your view of the world then channels of causation would seem to make lots of sense.  Why does RGDP change?  And which types of output change first?  Does more real lending cause more RGDP?  Do changes in interest rates cause more RGDP?  These are the questions you would ask.

If instead you think in terms of nominal shocks having real effects then the “channels” approach is totally superfluous.  A change in M causes a change in NGDP for supply and demand reasons, and if wages and prices are sticky then the change in NGDP triggers a change in RGDP.  Because NGDP affects RGDP, it will also affect all sorts of other real variables like real lending quantities and real interest rates.  But those are the effects of monetary shocks, they aren’t monetary shocks themselves.

Because money is a durable asset, expectations of the future value of money play an important role in its current value.  I suppose that is a channel of sorts, but it’s merely a channel connecting future expected NGDP to current NGDP.  To go from there to real variables such as output and employment, you simply need sticky wages and prices; channels like lending and interest rates add no explanatory power.

PS.  Ramesh Ponnuru has an excellent new post on monetary offset.

PPS.  Totally off topic, have other bloggers picked up this story:

The latest attempt by academia to wall itself off from the world came when the executive council of the prestigious International Studies Association proposed that its publication editors be barred from having personal blogs. The association might as well scream: We want our scholars to be less influential!

The beatings will continue until morale improves

Mark Sadowski directed me to a very perplexing post by Mickey Levy at Vox.  In fairness, it contains lots of good stuff. There’s a solid analysis of Abenomics, with a plausible forecast that core inflation will run in the 1% to 2% range in 2014.  Then a good analysis of the US:

In the US, the year-over-year core Personal Consumption Expenditures (PCE) index is at 1.2%, and the core CPI is at 1.7% – down from 1.8% and 1.9%, respectively, in the previous year. This disinflation is a lagged consequence of the disappointingly modest growth in aggregate demand that has constrained business pricing power, and high unemployment that has dampened wages, along with lower prices of selected goods and services benefitting from technological innovations.

However, nominal GDP – the broadest measure of aggregate demand – has grown comfortably faster than estimated real potential throughout the soft economic recovery. In the second half of 2013 it grew at an annualised rate of above 5% – a significant acceleration from the previous year’s 3.1%. Such growth in aggregate demand far in excess of productive capacity virtually rules out deflation.

Then a good analysis of the eurozone:

Europe’s recovery from financial crisis and its many necessary adjustments are at a much earlier stage. Weak aggregate demand puts downward pressure on product pricing. Nominal GDP in the Eurozone rose 0.7% in 2012 and an estimated 1% in 2013 – below estimates of potential growth. High unemployment and slack labour markets are expected to persist, and still lower wages are needed in troubled nations to regain competitiveness. To date, the stickiness of wages – which continue to rise in real terms in France and Italy – highlights the slow adjustments to the new economic realities. Despite some positive reforms, an array of regulatory, economic, and fiscal policies continue to constrain productive capacity, and many reforms and austerity measures have been put on hold. Europe’s risks of deflation are nontrivial.

I agree that the problem in the eurozone is that AD has been much weaker than in the US, and of course that implies that money has been far too tight.  But then Levy says the following:

Europe’s road to healthy economic performance will be difficult, and policymakers face tough choices and tradeoffs. Should the ECB move aggressively with a US- or Japanese-style round of quantitative easing in an attempt to avert deflation? No. The challenges facing Europe are real and not monetary, and the ECB’s monetary policy is already accommodative, with a negative real policy rate and ample liquidity in the financial system. Unintended consequences of aggressive QE may be costly. Such an ECB shift may signal to Europe’s fiscal and economic policymakers that they may postpone necessary reforms.

If you are going to argue that a region’s problems are real and not nominal, why would you preface the argument with a long string of paragraphs suggesting the problem is monetary, not real?  That makes no sense to me. He also says that monetary policy has been accommodative, citing the low real interest rate.  Of course real interest rates tell you whether credit is tight, not whether money is tight, but that’s a common mistake.  And if he thinks so, then why not advocate an even more expansionary monetary policy, as in the US and Japan?  Apparently taking the ECB’s foot off the throats of Greece and Spain and Portugal might induce their leaders to slack off on “necessary reforms.” Hence the title of the post.

PS.  Mark Sadowski had the following take on Levy’s post:

I give him points for acknowledging that nominal GDP (NGDP) *is* aggregate demand (AD). But he looks favorable on the US situation despite QE, and unfavorably on the Euro Area situation and advises against QE because of the “unintended policy side effects”. Has he never considered that more NGDP might be attributable to QE and that this is an *intended side effect*?

A passage towards the end on seems to give a clue:

“These innovation-based price reductions improve standards of living and free up disposable income to spend on other goods and services. They boost aggregate demand and enhance economic performance. And they contribute positively to longer-run potential growth.”

What model of the economy is this that nominal effects (AD) are attributable to real variables (technological innovation) and mysterious “unintended policy side effects” are attributed to nominal variables (QE)?

Levy seems to have misidentified a supply shock as a change in AD.  Or am I missing something?

PS.  A note to commenters.  The comment section here is not the place to argue whether the eurozone’s problems are structural or demand.  They are both.  The comment section is the place to discuss why Levy would present lots of evidence that the problems are demand side, and then claim they are structural.

PPS.  I have three new posts over at Econlog, over the past three days.  Take a look.

Transcripts post #1: Reasoning from price changes

The transcripts from 2008 are quite long.  I’ve only had time to read the 108 page transcript for September 2008, but already notice some interesting patterns.  Here’s a fairly typical comment (from Kohn):

Not all news affecting spending has been negative. Capital goods orders have held up. The decline in interest rates and commodity prices that respond to the markdown in global growth will help support domestic demand . . .

Many other participants made similar comments.  Now in fairness there are cases where these factors can help.  It depends why oil prices and long term interest rates are falling.  But I am nonetheless struck by the lack of curiosity on this issue.  The participants didn’t seem willing to even entertain as a hypothesis what we now know was the actual cause of these price changes, NGDP was falling of a cliff in the June to December period.  Falling oil prices and falling long term interest rates were actually exceedingly bad news, reflecting plunging demand for oil in the US and elsewhere, and plunging demand for credit in the US.  Everyone seemed to assume they were good news.

Perhaps the FOMC bought into the view that the EMH was bunk.  Hence asset prices were plunging for irrational reasons, and thus were a boon to consumers.

I was also somewhat puzzled by their reaction to the plunging TIPS spreads, which had fallen to 1.23% over 5 years by the day of the meeting (a number that was pretty accurate, in retrospect.) Here’s the staff economist Dave Stockton:

We continue to see reasonably encouraging signs on inflation expectations. The medium-term and long-term inflation expectations in the preliminary Michigan report last week dropped 0.3 percentage point, to 2.9 percent. TIPS haven’t really done very much, and hourly labor compensation continues to come in below our expectations.

That’s simply inaccurate, which is scary when you consider that the members of the FOMC rely on the staff economists for guidance as to the data.  Later in the meeting Janet Yellen correctly notes that TIPS spreads were falling fast:

Furthermore, we have seen a remarkable decline in inflation compensation for the next five years in the TIPS market.

Elsewhere some people referred to the relatively stable 5 year, 5 year forward TIPS spread, so perhaps that’s what Stockton was referring to.  But that’s the wrong data point to look at during a crisis.  Didn’t Keynes say something about the sea becoming calm after the storm was over?

I’ve never trusted RGDP data as much as either industrial production or real gross domestic income data.  Thus I was interested in this comment by Stockton:

Now, this sharp rise in the unemployment rate is a bit difficult to square with a GDP figure that looks as though it was running above 3 percent in the second quarter and even 2 percent if you want to average the first and second quarters together. There are occasionally large errors in Okun’s law, as I think I’ve noted in the past. It seems as though Okun’s law gets obeyed about as frequently as the 55 mile an hour speed limit on I-95. [Laughter] But still, one of the things that we should probably be considering is that perhaps the economy has not been as strong as suggested by the real GDP figures. Real gross domestic income, which is output measured on the income side of the accounts, has risen about 2 percentage points less than GDP over the past year. And if we look at industrial production and compare that with the components of GDP that are, in essence, goods production, there’s about a 1 percentage point discrepancy there, with industrial production suggesting weaker figures than GDP.

The real GDP numbers for the first half of 2008 have been revised sharply lower, and hence we now know the other data was more accurate.  If the Fed had ignored the RGDP data and focused on the more negative information, they might have behaved differently in the second half of 2008 NGDP.

Here’s Bernanke:

If not, let me just make a few comments. Personally, I see the prospects for economic growth in the foreseeable future as quite weak, notwithstanding the second quarter’s strength. I think what we saw in the recent labor reports removes any real doubt that we are in a period that will be designated as an official NBER recession. Unemployment rose 1.1 percentage points in four months, which is a relatively rapid rate of increase.

In the US, that sort of rise in unemployment means recession 100% of the time.  Bernanke was correct in assuming we were in recession, but did not draw the correct policy implication.

Bernanke also noted that some of the rise in the unemployment rate was presumably due to George Bush’s decision to extend the unemployment benefits beyond a maximum of 26 weeks.  At the time, Brad DeLong (correctly) predicted that Bush’s actions would raise the unemployment rate 0.6% by election day, and thus hurt McCain’s chances.  (Recall that this was 2008, before liberals stopped believing that incentives affect the behavior of workers and employers.)

After each participant read their statement, most of the debate was over whether the statement should indicate that markets were being monitored “closely” or “carefully.”  They opted not to use ‘closely,’ as they feared it would lead people to think the Fed was actually paying close attention to the information conveyed by asset prices.  I don’t care which term they use, but I would like to them to pay closer attention to asset prices.

But that wasn’t the only problem in late 2008.  In the early part of 2008 the Fed had adopted a Svenssonian “target the forecast” approach, and it actually worked fairly well.  Here’s Bernanke:

As President Plosser pointed out, we really shouldn’t argue about the level of the funds rate or the level of the spreads. We should think about the forecast and whether our policy path is consistent with achieving our objectives over the forecast period. I am sympathetic to the general view taken by the staff, which argues that those recession dynamics and financial restraints are important, that we are looking at slow growth going forward, and that inflation is likely to moderate. Based on those assumptions, I think that our policy is looking actually pretty good. To my mind, our quick move early this year, which was obviously very controversial and uncertain, was appropriate.  .  .  . As I said, I think our aggressive approach earlier in the year is looking pretty good, particularly as inflation pressures have seemed to moderate.

For some reason the policy was abandoned in late 2008.  The Fed began forecasting a path for aggregate demand that was clearly below their implicit policy goals.  They weren’t just ignoring market forecasts; they were ignoring their own forecasts.  And they did so even before rates had hit zero. Why?

When I talk to elite economists they tell me that reducing rates to zero a bit earlier would not have helped much.  OK, but even so why not do it?  And why not also do QE and forward guidance?  And why pay interest on reserves?  (The rate was significantly higher than 1/4% during November 2008.)

As of September 2008 I’d been basically fine with Fed policy for 25 years.  I generally had a “whatever” attitude.  Suddenly policy seemed obviously, shockingly, far off course.  And no one has been able to explain to me why I was wrong.  I’m still waiting for a good explanation for the Fed’s decisions—these transcripts certainly don’t provide one.

From the comment section

Here’s a comment that TallDave left over at my recent Econlog post (which discusses the Fed transcripts released yesterday.)

Failure to fire the harpoon of forward guidance will someday be remembered as this generation’s real bills doctrine.

Policy wasn’t as suboptimal as TGD, but that’s damnation with faintest praise — how much should we have learned by now?

It’s interesting that in 2013 the US, Japan and Britain all adopted a form of forward guidance. Unfortunately the guidance was extremely weak; perhaps 10% of potential in the US and Britain, and 20% of potential in Japan.  Interestingly, even that was enough for all three economies to strongly outperform the predictions of standard Keynesian models in 2013.

When I think of what might have been had 100% full strength guidance been adopted in 2008, it almost makes me want to cry.

Karl Smith on the importance of NGDP

As I indicated earlier, I won’t have much time for blogging this semester, although you can check over at Econlog where I do some posting.  Meanwhile, this is an excerpt from an excellent Karl Smith post at FT Alphaville:

The period of mildly slower-than-average Nominal GDP growth from 2001 to 2004 is matched by a similar sized period of faster-than-average “catch up” growth from 2004 to 2006. That suggests Nominal GDP was roughly back on track late 2006. On the other hand, the extreme slowdown in Nominal GDP growth that began in 2008 has never been made up for, and indeed Nominal GDP continues to lag to this day.

This pattern is far more consistent with the experience of the US economy than the one found in stock market data. Thus, while Mr. Smith writes…

It seems obvious to most people that the Great Recession was caused by stuff that happened in the financial sector; the only alternative hypothesis that anyone has put forth is the idea that fear of Obama’s future socialist policies caused the recession, and that’s just plain silly.

…we can think of at least one economist who hypothesised a central role for Nominal GDP long before the Great Recession began.

BTW, what does “Alphaville” mean?  Is it a reference to the Godard film?

HT:  Vaidas