Last month I had the privilege of finally meeting one of my very favorite economists—Robert Hetzel, who works at the Richmond Fed.  When I read his work on monetary economics I see a kindred spirit, almost a doppelgänger.  We both studied at the University of Chicago, we were both deeply influenced by Milton Friedman, and in 1989 we both published papers discussing how asset prices could help guide monetary policy (he used TIPS spreads, I used NGDP futures).  Of course he’s had a more distinguished career.  And the other major difference is that he seems like a much better person that I am.  A real gentleman.

Over the next few months I plan to do a number of posts on his work.  Today I’ll look at a key paper from early 2009, which correctly diagnosed the mistakes the Fed had made in 2008.  As far as I know he was the only economist within the Fed who understood (in 2008) the mistakes that we now know were being made.  But I’d like to start earlier, with his basic approach to monetary economics.

Very broadly, I place explanations of cyclical fluctuations in economic activity into two categories. The first category comprises explanations in which real forces overwhelm the working of the price system. According to the credit cycle, or “psychological factors,” explanation of the business cycle, waves of optimism arise and then inevitably give way to waves of pessimism. These swings in the psychology of investors overwhelm the stabilizing behavior of the price system. “High” interest rates fail to restrain speculative excess while R. L. Hetzel: Monetary Policy 203 “low” interest rates fail to offset the depressing effects of the liquidation of bad debt. In the real-bills variant, central banks initiate the phase driven by investor optimism through “cheap” credit (Hetzel 2008a, 12–3 and 34).  Speculation in the boom phase drives both asset prices and leveraging through debt to unsustainable levels. The inevitable correction requires a period of deflation and recession to eliminate the prior speculative excesses. At present, this view appears in the belief that Wall Street bankers driven by greed took excessive risks and, in reaction, became excessively risk-averse (Hetzel 2009b).

Within this tradition, Keynesianism emerged in response to the pessimistic implication of real bills about the necessity of recession and deflation as foreordained because of the required liquidation of the excessive debts incurred in the boom period. As with psychological-factors explanations of the business cycle, investor “animal spirits” drove the cycle. The failure of the price system to allocate resources efficiently, either across markets or over time, produced an underemployment equilibrium in which, in response to shocks, real output adjusted, not prices. In a way given by the multiplier, real output would adjust to the variations in investment driven by animal spirits. The Keynesian model rationalized the policy prescription that, in recession, government deficit spending (amplified by the multiplier) should make up for the difference between the full employment and actual spending of the public. Monetary policy became impotent because banks and the public would simply hold on to the money balances created from central bank open market purchases (a liquidity trap).

Another variant of the view that periodically powerful real forces overwhelm the stabilizing properties of the price system is that imbalances create overproduction in particular sectors because of entrepreneurial miscalculation.

I think that most people hold one of these views, even if they differ on the desirability of the Fed “rescuing” the economy when it gets into trouble.  But not monetarists:

In the second class of explanations of cyclical fluctuations, the price system generally works well to maintain output at its full employment level. In the real-business-cycle tradition, the price system works well without exception. In the quantity-theory tradition, it does so apart from episodes of monetary disorder that prevent the price system from offsetting cyclical fluctuations.  Milton Friedman (1960, 9) exposited the latter tradition:

The Great Depression did much to instill and reinforce the now widely held view that inherent instability of a private market economy has been responsible for the major periods of economic distress experienced by the United States. . . .As I read the historical record, I draw almost the opposite conclusion. In almost every instance, major instability in the United States has been produced or, at the very least, greatly intensified by monetary instability.

Friedman, Hetzel, and I all share the view that the private economy is basically stable, unless disturbed by monetary shocks.  Paul Krugman has criticized this view, and indeed accused Friedman of intellectual dishonesty, for claiming that the Fed caused the Great Depression.  In Krugman’s view, the account in Friedman and Schwartz’s Monetary History suggests that the Depression was caused by an unstable private economy, which the Fed failed to rescue because of insufficiently interventionist monetary policies.  He thinks Friedman was subtly distorting the message to make his broader libertarian ideology seem more appealing.

I’d like to first ask a basic question: Is this a distinction without a meaningful difference? There are actually two issues here.  First, does the Fed always have the ability to stabilize the economy, or does the zero bound sometimes render their policies impotent?  In that case the two views clearly do differ.  But the more interesting philosophical question occurs when not at the zero bound, which has been the case for all but one postwar recession.  In that case, does it make more sense to say the Fed caused a recession, or failed to prevent it?

Here’s an analogy.  Someone might claim that LeBron James is a very weak and frail life form, whose legs will cramp up during basketball games without frequent consumption of fluids.  Another might suggest that James is a healthy and powerful athlete, who needs to drink plenty of fluids to perform at his best during basketball games. In a sense, both are describing the same underlying reality, albeit with very different framing techniques.

Nonetheless, I think the second description is better.  It is a more informative description of LeBron James’s physical condition, relative to average people.  By analogy, I believe the private economy in the US is far more likely to be stable with decent monetary policy than is the economy of Venezuela (which can fall into depression even with sufficiently expansionary monetary policy, or indeed overly expansionary policies.)

Just to be clear, I do understand Krugman’s point, and it is a defensible argument.  But in the end I side with Friedman and Hetzel, for two pragmatic reasons:

1.  I think that most non-monetarists underestimate the extent to which seemingly “real” or “psychological” shocks are actually caused by monetary shocks that were misidentified.  I hope I don’t need to remind readers about how often easy and tight money are confused, due to excessive focus on interest rates as an indicator of the stance of monetary policy. Thus I believe that the Great Recession was triggered by tight money in late 2007 and early 2008, and that the onset of the recession made the economy seem unstable, and in need of what Krugman would regard as a “rescue” from the Fed, and then later from fiscal stimulus, once the Fed (supposedly) ran out of ammo.  If you insist on a “concrete steppe”, then use the sudden stop in the growth of the monetary base, but I’d prefer not to focus on concrete steps at all, as they are unreliable indicators. Note that Krugman specifically points to the growth in the monetary base during the early 1930s, to refute Friedman’s claim that the Fed caused the Great Depression.  But does anyone recall Krugman complaining (in the spring of 2008) about the sudden stop in base growth during August 2007 – May 2008?

2.  Second, I worry that Krugman’s way of thinking will make the public insufficiently demanding of sound monetary policy.  We will expect too little of the Fed, as we clearly did in 2008, when rates were still above zero.  I’m not surprised that the public, the Congress, the President, and the media failed to blame the Fed for excessively tight money in 2008-09, monetary economics is deeply counterintuitive.  But even our best and brightest macroeconomists failed us.  Go back to late 2008 and look for op eds blaming the recession on insufficiently expansionary monetary policy.  You wont find them.

If LeBron James had leg cramps in a game where his trainer had forgotten to bring the Gatorade, we would quite rightly blame the trainer, not the fact that James’s body is “naturally unstable”, unable to do well unless “rescued” by an injection of fluids.  We need to have equally high expectations of the Fed.  Any major shortfall (or overshoot) of NGDP is the Fed’s fault, and all eyes should be focused on the Fed when those problems develop.  In the 1930s, people looked elsewhere. Even Bernanke now admits that the Depression was the Fed’s fault.  In the 1970s, people looked elsewhere.  Even Ben Bernanke now admits that the high inflation was the Fed’s fault.  In September 2008, people looked elsewhere.  Even Ben Bernanke now admits the Fed should have cut rates.

The more we demand from central banks, the better the policy that we will get.  When expectations are especially low (as in the 1930s, or during 2008-13 in the eurozone), the performance will be especially poor.

When NGDP is unstable, it’s ALWAYS the Fed’s fault. Even if my underlying philosophical interpretation of causality is wrong, or not to your taste, it’s a useful fiction to believe in.

PS.  For non-basketball fans, James does occasionally have a problem with leg cramps.  Perhaps because he is among the most athletic “big men” in the history of sports, and puts huge demands on his body.

PPS.  George Selgin has a very good post on interest on reserves.  He knows more about banking than I do, and gets deeper into that issue than I’ve done in my critiques of IOR.  He also has a podcast explaining his views.

I’m assuming the Fed will raise rates tomorrow, probably by a quarter point.  No point even arguing that issue any further; the “zero rate bound” is gone (and in truth has been gone for about a year.)

And yet market forecasts suggest the Fed will continue to undershoot their 2% inflation target, so monetary stimulus is needed. Here’s how they can do both (and don’t worry, nothing NeoFisherian here.)

The Fed should include the following in its statement:

“Further increases in the fed funds target will be entirely data driven. There is no predetermined schedule for the next increase.  Our models suggest that the tightening labor market should cause inflation to rise, but we also recognize that there is uncertainty associated with these predictions.  Thus further increases in the fed funds target will not occur unless and until there is concrete evidence in the data that inflation is clearly on track to approach 2% in a reasonable period. That data might include some combination of higher core inflation, higher TIPS spreads, higher hourly wage gains, and other (non employment) indicators.  Also note that 2% inflation is not a ceiling, the target is symmetrical.”

I believe the market would regard that communication as expansionary, and that it would help the Fed to achieve its 2% goal more quickly.  Ironically, while the resulting path of interest rates might be lower at first, it could actually be higher in the out years.

[I slightly misread the table initially, and wrongly suggested 91%]

One constantly sees articles about America’s shrinking middle class.  Don’t believe them.  The term “middle class” is obviously subjective, and in my view the only interesting fact is the share of Americans who consider themselves middle class, which is 90%.  So how do other news articles come up with much smaller numbers?  They divide up the middle class into three groups, lower middle class, middle middle class and upper middle class.  And then for some strange reason they only consider the middle middle class to be “middle class”.  Weird.  Obviously if you keep slicing the pie into narrower and narrower categories, you’ll get smaller shares in each slice.

When I was young, the common definition of middle class was people who had a decent house or apartment. (I.e. not a shack with an outhouse.)  You needed the basic home appliances (stove, fridge, washing machine, telephone, TV, etc.) and a car.  Maybe in Manhattan you didn’t need a car.  But that was the basic middle class lifestyle, and it still seems a reasonable metric.  Obviously if you used India’s definition of “middle class” then almost everyone in America except the homeless would be considered (at least) middle class, indeed even many of the “homeless” (who actually often do have homes, BTW.) And if you used “the middle third” as your definition, then 33.33333% of Americans would be middle class.

Being middle class is a state of mind.  From age 18 to 25 I had a really low income, low enough to qualified for food stamps if I had applied.  And yet I would have answered “middle class” if a pollster had asked me, and that’s because I think in terms of life cycle. The NYT reports that roughly 73% of Americans spend at least part of their lives in the top 20% of the income distribution.  That’s why even though America’s official poverty rate is 15%; only 7% of Americans are a hard core that views themselves as lower class.  Many are like the younger version of me.

The upper class is only 2%.  And that’s because lots of families have incomes that seem very high in percentile terms, but in a social sense are considered middle class.  Think of a Boston cop married to a nurse, with a family income of $230,000. That’s a pretty high in percentile terms, but culturally they are obviously “middle class.”  I’d guess that most doctors self-identify as upper middle class.

So don’t worry about the naysayers, America is a 90% middle class country and it’s going to stay that way.

PS.  Tyler Cowen has a more pessimistic post on the middle class.

PPS.  I have a new post at Econlog, discussing scurvy and the Phillips Curve.

Stephen Kirchner sent me an excellent AEI piece by Vincent Reinhart:

That Yellen may go down in central banking history as “The Great Tightener” appears to pose more than a little irony, perhaps to the coming surprise and irritation of Senate Democrats who signed a letter to the president endorsing her Fed-chair candidacy in 2013. Yet, the shift in policy does not reflect a transformation of her beliefs, but rather their pursuit by different means. Tightening now follows logically from Yellen’s understanding of the economic outlook and the dynamics of the Fed’s policymaking group, the Federal Open Market Committee (FOMC). Hiking the funds rate, even as economic growth disappoints and inflation remains subdued, buys Yellen the credibility with her colleagues and market participants to subsequently tighten slowly. That is, Yellen positions herself now as a conservative central banker to ensure that she can be a compassionate one later by allowing Fed policy to remain considerably accommodative for a considerable time.

Central bankers sometimes argue that a rate increase will give them more “ammunition” to cut rates in the future.  That’s actually a moronic argument, as it does exactly the opposite. Fed funds target rate increases tend to reduce the Wicksellian equilibrium interest rate, and hence give them less ammunition for the future.  The ECB in 2011 is now the classic example, but you can cite Sweden, or Japan (2000 and 2006) or the US (1937) as well.

In contrast, Reinhart has provided what seems to me to be the most plausible explanation for Yellen’s oddly hawkish views. She’s storing up reputational ammunition, which can be used in the future.

The entire article is worth reading.

Unfortunately, the post itself will disappoint—just a test to see if I could bait people in with that headline.  Here is Wired magazine:

In the popular imagination, the eternal trope is that the porn industry drives the adoption of new technology; that it accounts for some astronomically large portion of all Internet traffic; and, yes, that it generates equally enormous sums of money for all the faceless people who run its operations. We picture these people as sleazy Southern Californians wearing pinkie rings and polyester.  .  .  .

But it isn’t like that at all.

Some of it may have been true in years past. But no longer.  .  .  . With the rise of mobile devices and platforms from the likes of Apple and Google, not to mention the proliferation of free videos on YouTube-like porn sites, the adult industry is in a bind. Money is hard to come by, and as the industry struggles to find new revenue streams, it’s facing extra competition from mainstream social media. Its very identity is being stolen as the world evolves both technologically and culturally.

.  .  .

O’Connell, Adams, and McEwen pull in yearly salaries somewhere in the low six figures, after paying “competitive” wages to a handful of coders in Seattle and Eastern Europe. “None of us own a yacht,” O’Connell says. Or as McEwen puts it: “You can’t understand the obstacles that are in our way.”

‘The Perfect Storm’

She doesn’t mean obstacles of morality or law. Yes, many people frown on porn, calling it exploitative and debasing. But many others just see it as a part of life—a big part of life. There’s an enormous audience for porn, and whatever it signifies, whatever emotions it stirs in critics, this audience isn’t going away. McEwen means economic obstacles, business obstacles, technical obstacles.

It wasn’t always this way. In the early aughts, online porn was ridiculously lucrative. Colin Rowntree, a porn producer, director, distributor, and member of the Adult Video News Hall of Fame, was a just mid-level player, and in those days, he and his wife, Angie, earned millions each year. But at the end of the decade, just about everything changed. Apple introduced the iPhone, which moved so much of our digital lives onto mobile devices while officially banning pornography in its App Store. Google pushed porn to the fringes of its search engine. And as The Economist and Buzzfeed have described, an army of “Tube sites”—essentially Youtube knockoffs with names like Youporn and Pornhub—began offering a smorgasbord of online porn for free, much of it pirated, making it far more difficult for pornographers and distributors to make money. All this happened as the worldwide economy tanked.

.  .  .

The porn biz can issue DMCA takedown notices and threaten legal action like anyone else, but it doesn’t have the clout to enforce the notices on a wide scale—or make anyone care that it’s being ripped off.

“The adult industry isn’t able to enforce its intellectual property protection,” says Kate Darling, a researcher at the MIT Media Lab who explored the economics of the adult industry in the 2013 study What Drives IP without IP? A Study of the Online Adult Entertainment Industry. “It’s not that much different from others industries—except that policy makers don’t really look at the adult industry and aren’t interested in helping the adult industry.” [Emphasis added]

So when the government stops offering copyright protection (and other barriers to entry), it becomes far more difficult to amass large profits.  Incomes fall close to the free market competitive rate of return.

Paul Krugman talks about how the growing inequality of incomes reflects the increasing power of the elites.  This example suggests to me that it’s not so much market power that is key, but rather political power.  Some industries have it, and the porn industry does not.  Too bad America can’t make all its industries look more like the porn industry (in terms of political power, obviously.)

PS.  Wired also explodes some other misconceptions about the industry:

Meanwhile, with the rise of Netflix and YouTube and so many other mainstream video services—including Facebook and Twitter—porn is no longer the dominant form of online video. It’s hard to tell how much porn streams across the ‘net—no reliable operation tracks this, including Sandvine, the primary source for internet traffic research—but it doesn’t account for 37 percent of all traffic. It’s not even close. Mikandi declines to discuss its traffic. But a better barometer is the Pornhub Network, which now spans several of the major Tube sites. Pornhub says its network receives about 100 million visits a day, and at least on part of the network, the average visit lasts about nine minutes.

(Thank God it’s not “more than 4 hours”!)

If you extrapolate, that’s somewhere in the range of 450 million hours of viewing a month. Meanwhile, Netflix serves 60 million subscribers, and these subscribers watch over 3.3 billion hours of programming a month (10 billion a quarter). Youtube claims hundreds of millions of hours of viewing daily.

So we are a bunch of disgusting hypocrites, but not quite as disgusting as we had previously assumed.

PPS.  The term ‘porn’ has become an overused metaphor, as in food porn or architectural porn. But if we are going down that road, why aren’t we calling a certain type of GOP campaign “political porn”?  I can’t precisely define it, but I know it when I see it.  The version aimed at downscale voters can be called “political porn”, and then when other candidates espouse a more sophisticated version of the same hot button views it can be called “political erotica.”