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A poll of central bankers

Ignacio Morales of the Costa Rica Central Bank sent me the following, which is from a poll of central bankers readers of Central Banking.com:

Screen Shot 2015-04-21 at 10.07.16 AMI will be traveling over the next few days, so blogging will be intermittent.

Recent activity

I’ll try to keep blogging, but things may slow down a bit as tax season approaches. Meanwhile I have a new post at Econlog comparing Asia, Europe and immigrant societies.  I’ve also had some recent luck getting into major news outlets. A few weeks ago it was the WSJ, today I have a piece in the New York Times (on the strong dollar.)  AFAIK, that’s my first, and hopefully not my last.  Which reminds me, after the sad experience of Razib Khan (recently hired and fired by the NYT on the same day), don’t anyone dare send the Times any of my earlier posts criticizing their fine newspaper.  I take everything back.

:)

Krugman on European growth and the euro

In a recent post I responded to this claim by Paul Krugman:

I’ve already argued that the fall in the euro is much bigger than you can explain with monetary policy; it seems to reflect the perception that Europe is going to be depressed for the long term. And if that’s what drives the weak euro/strong dollar, it will hurt US growth.

I said (without reading the linked to post):

I agree with the reasoning process in the last sentence.  But I don’t think it applies to the current case, as it seems very unlikely that lower growth expectations are what is depressing the euro.  Here’s what we do know:

1.  Eurozone growth expectations have been in the toilet for years.

2.  The euro was valued at about $1.35 for years, and then gradually fell to about $1.05 over the past few months.

3.  During the past few months the growth forecasts of the eurozone have been revised upward, as the euro has been falling.

You don’t need to be an EMH fanatic like me to see a problem with Krugman’s argument. Kudos to him for not reasoning from a price change, for not lazily assuming that a weaker euro meant more growth.  But I think’s he’s gone too far in the other direction, in assuming that the cause of the weaker euro was lower growth expectations.

Vaidas Urba suggested I do look at the linked post.  And I was quite shocked to find it began as follows:

Watch that plunging euro! Actually, it’s good news for Europe. European growth numbers have been better lately, and the weak euro — which makes EZ manufacturing and other tradables more competitive — is surely a large part of the explanation. Not so good for Japan or the US. But how should we think about this?

Wait, that’s my argument—the weaker euro is associated with stronger eurozone growth.  Therefore it’s monetary stimulus at work.  But if you read the entire post you’ll see Krugman does actually have a good argument, albeit one that raises as many questions as it answers.  And I might add that it’s one I’m pretty sure that 99% of his readers would not have understood.

Let’s first discuss Rudi Dornbusch’s (1975) overshooting model, which is sort of lurking in the background.  Dornbusch thought about the impact of monetary stimulus in a world of interest parity, PPP and sticky prices.  The result is quite odd. Suppose the ECB does a once and for all permanent 10% increase in the money supply.  The quantity theory says this will raise prices by 10% on the long run.  And PPP says that will depreciate the euro by 10% in the long run.  So far, so classical. But sticky prices imply a liquidity effect, thus the monetary injections lower nominal interest rates for a few years.  And because of the interest parity condition, lower interest rates imply a higher expected rate of appreciation in the euro. But didn’t I just say the euro would depreciate?  Yes I did, and there is no contradiction.  If you are not seeing the answer, you need to think outside the box. First do some brain exercises.  Connect these 9 dots with 4 lines, without taking your felt tip pen off the paper:

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For simplicity, suppose we started with US and eurozone interest rates being equal. After the monetary injection the eurozone rates are lower.  So the euro is expected to appreciate.  But in the long run it’s expected to be 10% lower.  That means the immediate effect of a monetary stimulus shock must be a more that 10% decline in the euro.  Dornbusch called this exchange rate overshooting.  The model is composed of 4 theories (QTM, PPP, IPT, liquidity effect.)  Most of us are not as adept at juggling 4 theoretical balls in the air at the same time as Krugman, so we struggle with the concept.  As for empirical evidence, these things are hard to test. I’d argue that each component is pretty well established, and that’s good enough (and I suspect Krugman would agree.)  In any case, it’s too beautiful a theory not to use once and a while.  Here’s Krugman:

So, can we say anything about how the recent move in the euro fits into this story? One way, I’d suggest, is to ask how much of the move can be explained by changes in the real interest differential with the United States. US real 10-year rates are about the same as they were in the spring of 2014; German real rates at similar maturities (which I use as the comparable safe asset) have fallen from about 0 to minus 0.9. If people expected the euro/dollar rate to return to long-term normal a decade from now, this would imply a 9 percent decline right now.

What we actually see is almost three times that move, suggesting that the main driver here is the perception of permanent, or at any rate very long term European weakness. And that’s a situation in which Europe’s weakness will be largely shared with the rest of the world — Europe will have its fall cushioned by trade surpluses, but the rest of us will be dragged down by the counterpart deficits.

Now, this is not how most analysts approach the problem. They make a forecast for the exchange rate, then run this through some set of trade elasticities to get the effects on trade and hence on GDP. Such estimates currently indicate that the dollar will be a moderate-sized drag on US recovery, but no more. What the economic logic says, however, is that if that’s really true, the dollar will just keep heading higher until the drag gets less moderate.

Krugman’s looking at real rates to abstract from inflation.  While the Dornbusch overshooting model does a nice job of explaining the recent dramatic plunge in the euro, the model also predicts that the real exchange rate is unaffected in the long run. But that’s because interest rates are unaffected in the long run.  Krugman’s readers don’t know this, but unless I’m mistaken he’s arguing that the recent fall in long-term interest rates in Europe is the income effect, not the liquidity effect.  I actually like that argument, but it’s not the way Keynesians usually look at changes in long-term rates occurring in close proximity to QE.  Most Keynesians would say the ECB is driving bond long term bond yields lower.

So Krugman’s arguing that the big fall in the expected 10-year future exchange rate reflects worsening prospects for long term European growth, not just monetary stimulus.  That argument makes sense to me.  But he’s also arguing that this increasing long-term pessimism occurred at almost exactly the same time that expectations of short-term growth became more optimistic.  That might be true, but I kinda doubt it. And yet I can’t think of a better explanation for the fall in the future expected value of the euro.

So I’ll file this under “unresolved problems.”

PS.  He ends up relying on liquidity trap arguments to draw policy conclusions for the US.  But as I argue in today’s Econlog post (later this afternoon), those arguments are rapidly approaching their “sell by date.”

PPS. The eurozone demand side recession is likely to be over in 10 years.  That means Krugman’s hypothesis implies severe structural problems in Europe—bad news for a continent with 7% of the world’s people, 25% of the world’s GDP, and 50% of the world’s social spending.

PPPS.  Oh yeah, the puzzle.  Because Ray claims his IQ is only 120, he probably provided answer #2. But answer #1 is correct.  I’m sure Rudi would have been able to solve the puzzle. My dad did it first in a competition among friends back in 1962.

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What does MV = PY actually mean?

It means V is PY/M.

And that’s all it means.  But the textbook description of MV=PY is sometimes a bit confusing, as it seems to say two conflicting things:

1.  V is the velocity of circulation, the average number of times a dollar is spent per year

2.  MV = PY is an identity.  But this suggests V is defined as PY/M

So which is it?  It turns out that when MV= PY was first created, V was probably something like #1, but today #2 is the accepted definition.

For example, some money is spent on things that are not a part of GDP, such as used goods, or intermediate goods.  So could we fix the definition by calling V the “average number of times a dollar is spent on final goods”?  Unfortunately no, as there are some final goods for which money is not spent.   Suppose that (on average) each dollar was spent 15 times per year on final goods transactions.  And suppose there were a trillion dollars in money in circulation.  Would NGDP be $15 trillion?  No, as NGDP also includes things like implicit rent on owner-occupied housing, for which no money changes hands.

Similarly, saving once had a common sense meaning that was different from investment.  Saving and investment (as defined in earlier eras) were not equal by definition.  But then economists found it useful to define saving as the funds spent on investment.  They became two sides of the same coin, like sales and purchases.

Now it’s not clear if these identities are useful.  I think they are, as (for instance) it’s simpler to model NGDP if it equals M*V, than if it equals M*V*ff, where ff is a fudge factor to account for the fact that there are issues like owner-occupied housing.

Oddly, there is another version of the equation of exchange where the common sense definition is exactly right:

M = k*P*Y

Where k is both:

1.  M/PY

2.  The average share of gross domestic income held as cash balances (globally).

It’s unfortunate that most textbooks rely on the version of the equation of exchange where the common sense definition is not equal to the official definition.

Suppose the government suddenly redefined cars as a capital good (they are currently considered consumer goods.)  Gross investment would immediately soar much higher (although net investment, which really matters, wouldn’t change all that much.)

So would saving still be equal to investment?  Yes, because at the same moment gross saving would also soar in value, as funds spent on cars would now get included into saving.

Many commenters on confused on that point.  They talk about Americans “spending” lots of money on housing during the housing boom, instead of “saving” the money. But according to the official definition, spending on new housing is saving.  Perhaps spending on cars should also be viewed as gross saving.

Even better, why not stop obsessing over the C+I+G+NX = GDP relationship, and just focus on NGDP.  The line between C and I is quite arbitrary, and not all that important for issues like the business cycle.  It’s NGDP that matters.

At one time Keynesians thought saving was really important for the business cycle, but in the New Keynesian era we all realized that it wasn’t, what mattered was monetary policy.  No more paradox of thrift.  Unfortunately some have forgotten that lesson, others have wrongly assumed that everything is different at the zero bound.  It isn’t.

PS.  This is inspired by a recent post by David Glasner.  This paragraph is worth commenting on:

OK, savings are the funds used for investment. Does that mean that savings and investment are identical? Savings are funds accruing (unconsumed income measured in dollars per unit time); investments are real physical assets produced per unit time, so they obviously are not identical physical entities. So it is not self-evident – at least not to me — how the funds for investment can be said to be identical to investment itself.

The “S” and “I” that are used in national income accounting are both measured in dollar terms.  It’s not the number of houses built that matter, but the dollar value of expenditure on those houses.  So there is no “apple and oranges” comparison problem here.  Both saving and investment can be measured in either real or nominal terms. In either case they will always be exactly identical, because they are defined as being identical.  However, just as with MV=PY, I can imagine definitions of saving where S=I is not an identity.

Japan continues to add jobs at an astounding rate, as unemployment falls to the lowest level in decades

That’s right, the Japanese “recession” grinds on.  A few months ago bloggers on the left and right, as well as the mainstream news media, reported that Japan had fallen into a “recession.”  Only TheMoneyIllusion pointed out that this was nonsense, as analysts were confused by Japan’s falling population.  Japan’s trend rate of RGDP growth is currently no higher than zero, and the post-sales tax increase RGDP slump was completely expected.  The Japanese stock market was not fazed, Japanese companies continue to add workers at a rapid rate, and unemployment just fell to 3.4%, the lowest rate since the 1990s.

Japan’s seasonally adjusted unemployment declined to 3.4 percent in December compared to 3.7 percent reported in the same month of 2013 as the number of employed rose 0.6 percent and the number of unemployed decreased 6.7 percent.

The number of employed persons in December 2014 was 63.57 million, an increase of 380 thousand or 0.6% from the previous year.

The number of unemployed persons in December 2014 was 2.1 million, a decrease of 150 thousand or 6.7% from the previous year.

The jobs-to-applicants ratio increased to 1.15 from 1.12 in the previous month, the highest since March of 1992.

The number of new job offers rose 4.7 percent in December from previous month and rose 5.6 percent from the same period a year ago.

To the uninformed, the 0.6% rise in Japanese employment might seem unimpressive.  But the Japanese working age population is falling by 1.5% per year, so this is equivalent to 2.1% employment growth in a stable population country, or 2.4% employment growth in a country with 0.3% growth in the working age population (such as the US.)  Of course our employment only rose by about 2% last year, and yet that was the strongest performance since the late 1990s.  In other words, the Japanese labor market is even hotter than the US labor market in a cyclical sense.  All the claims to the contrary are written by people ignorant of Japanese demographics.

Abenomics has done the two things that it was capable of doing (reducing unemployment and slightly easing the public debt problem) and failed to do the thing many hoped for, but was never realistic given the demographics (create rapid RGDP growth.)

The people that disagreed with me, claiming Japan really was in recession, told me that unemployment is a lagging indicator (it actually is not, at least not significantly.)  OK you guys, go on record and tell me when the delayed rise in Japanese unemployment will occur.  I want a specific date, or at least a specific year.  Will it be 2015?  If not, then when? How about 2016?

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Off topic, there are times that I just want to give up.  From today’s news:

LONDON/SYDNEY (Reuters) – European and Chinese factories slashed prices in January as production flatlined, heightening global deflation risks that point to another wave of central bank stimulus in the coming year.

While the pulse of activity was livelier in other parts of Asia – Japan, India and South Korea – they too shared a common condition of slowing inflation.

Central banks from Switzerland to Turkey via Canada and Singapore have already loosened monetary policy in the past few weeks.

Switzerland!?!?!?