Archive for January 2010

 
 

Exchange rate policy and monetary policy

Michael Pettis has the best blog on the Chinese economy that I have been able to find.  If you are interested, you should check out his recent post on how the policy debate looks from within China (and yes there is vigorous debate inside China.)

But today I want to respond to one comment I don’t entirely agree with, which he made in a post in early January:

For those who remember the 1980s, when many policymakers in Japan insisted that Japan’s trade surplus had nothing to do with the value of the currency, and everything to do with domestic competitive advantages in manufacturing, it is a little weird seeing them now worry so much about the impact of a rising yen on their manufacturing sector and on the process of economic recovery.  Currencies do matter, I guess.

I’m paranoid.  Since I was one who didn’t think the value of the yen explained the 1980s surpluses, and who also strongly believes the strong yen has recently devastated their manufacturing sector, I naturally assumed he was talking about me (despite the fact that I’ve never even made any public statements about 1980s yen policy.)  The thing is, I don’t see any conflict at all. 

Here’s how I think about things.  The real exchange rate is not determined by the government, but rather by the propensities to save, invest, import, export, etc.  Beginning in the 1980s, Japan saved much more than they invested, so it was natural for them to run trade surpluses.  Indeed given their demographics, it would have been foolish to do anything else.  Even with all the surpluses they have run up, I have no idea how they are going to address their demographic time bomb.  All during this period their trading partner Australia was running massive current account deficits.  Whose shoes would you rather be in today?

[However I do agree with Mike Pettis that the Japanese government's explanation, that it was all due to their manufacturing prowess, was silly.  South Korea was running deficits at the same time.]

The nominal exchange rate is a completely different animal from the real rate.  Monetary policy determines the nominal rate.  That doesn’t mean the central bank should target nominal rates, indeed I favor NGDP targeting instead.  But let’s say the central bank isn’t targeting NGDP, indeed it doesn’t have any coherent monetary strategy.  It just drifts along with nominal rates stuck near zero.  What then?

In that case I’d say a sharp rise in the nominal value of the yen might be an indicator of an excessively tight monetary policy, that is, a monetary policy that was driving NGDP expectations sharply lower.  This would be even more true if there were other market indicators showing money was too tight, like falling stock and commodity prices, and (surprisingly) falling long term bond yields. 

The argument against my position is that the central bank can also control real exchange rates over a significant period of time, say at least several years.  I accept that, but I think persistent trade surpluses are an extremely long term issue, lasting over decades, and I don’t think monetary policy has real effects over a time frame of more than a few years.  I still think the classical dichotomy holds in the very long run.  Indeed the unwelcome deflation in Japan during the late 1990s, and again recently, is partly a reflection of the fact that Japanese monetary policy was pushing the real value of the yen up to unsustainable levels.  This forced the real exchange rate to adjust downward through painful price level adjustments.

As for the seeming inconsistency of my position, consider this analogy.  You are a development economist at the IMF.  You tell the Indian government, “Don’t think you can speed up the pace of economic development by merely printing money.  Development requires improvements in human capital, infrastructure, better institutions, etc.”  Then a few years later the IMF economist comes back and says “Egad, you drove India into a recession with your tight money policy!”  Was he being inconsistent, first arguing that printing money doesn’t make a country richer, and then arguing that tight money made it poorer?  Not really, there are theories appropriate for business cycles, and very different theories appropriate for long term economic growth (unless you are a RBC economist, in which case life is blissfully simple.)

PS.  If you want to know why I like his blog so much, consider this quotation from the same January 9th post:

Already some of my students whose parents own their own businesses have been telling me that Chinese speculative money held abroad is flowing back into the country.  One of my students from rich coastal city Wenzhou, the most free-wheeling and business-savvy city in China, and perhaps the world, just rolled his eyes when I asked him if his family and friends were tying to bring money into the country.  “Of course,” he said.  I didn’t get the impression that he thought mine was an especially astute question.

Meanwhile all the big guns in the “monetary alarmist” camp in China have been pounding the table (in the discreet way preferred of policymakers here) about the risks of monetary expansion.  As everyone now knows, the PBoC yesterday sold three-month bills at a higher interest rate for the first time in 19 weeks.  Long Chen, one of the students in my PBoC Shadow Committee seminar, reported to the class via email as soon as it happened: “Hey guys, the primary yield of 3M PBOC bill increased this week. Significant sign.”

Yes, although the increase was tiny, it may indeed be a significant sign that the PBoC no longer wants to wait and is starting to tighten conditions, although I can only add that conditions are so alarmingly loose that it would take an awful lot of tightening to get back just to “loose”, and it would be hard to do this without seriously undermining current growth and employment in the short term. 

First of all, Wenzhou is crying out for a serious sociological study.  (Or has one been done?)  In a nation of fairly entrepreneurial people how can this one middle size city stand out so dramatically?  Their relative success within China is roughly comparable to that of what Thomas Sowell called “middlemen minorities” (Indians in Africa, Chinese in SE Asia, pre-war Jews in Eastern Europe, etc.)  And yet to us Americans the Chinese (or at least the 92% of them who are Han) seem a fairly homogenous group.  You won’t think China is a simple place after reading Pettis.  And he writes very well.

And how about that inside info from his former student!  Take a look at this graph showing how the Hong Kong stock market has done in the three weeks since he provided his money tightening tip on January 9th.  I know, I’m an EMH guy.  Still it never hurts to check your horoscope, and also Mike Pettis’ blog.

My Congressman on the Big Think

Barney Frank starts off by trying to blame the Bush administrations for the financial crisis:

And the Clinton Administration was better than the Bush Administration.  When the Bush Administration came in, they appointed people who didn’t believe in regulation. So it was not that the banks captured them, it’s that they volunteered to become parts of that operation.

I agree, but it is not at all black and white, as this New York Times story from 2003 shows:

WASHINGTON, Sept. 10— The Bush administration today recommended the most significant regulatory overhaul in the housing finance industry since the savings and loan crisis a decade ago.

Under the plan, disclosed at a Congressional hearing today, a new agency would be created within the Treasury Department to assume supervision of Fannie Mae and Freddie Mac, the government-sponsored companies that are the two largest players in the mortgage lending industry.

The new agency would have the authority, which now rests with Congress, to set one of the two capital-reserve requirements for the companies. It would exercise authority over any new lines of business. And it would determine whether the two are adequately managing the risks of their ballooning portfolios.

The plan is an acknowledgment by the administration that oversight of Fannie Mae and Freddie Mac — which together have issued more than $1.5 trillion in outstanding debt — is broken. A report by outside investigators in July concluded that Freddie Mac manipulated its accounting to mislead investors, and critics have said Fannie Mae does not adequately hedge against rising interest rates.

”There is a general recognition that the supervisory system for housing-related government-sponsored enterprises neither has the tools, nor the stature, to deal effectively with the current size, complexity and importance of these enterprises,” Treasury Secretary John W. Snow told the House Financial Services Committee in an appearance with Housing Secretary Mel Martinez, who also backed the plan.

.   .   .

Significant details must still be worked out before Congress can approve a bill. Among the groups denouncing the proposal today were the National Association of Home Builders and Congressional Democrats who fear that tighter regulation of the companies could sharply reduce their commitment to financing low-income and affordable housing.

”These two entities — Fannie Mae and Freddie Mac — are not facing any kind of financial crisis,” said Representative Barney Frank of Massachusetts, the ranking Democrat on the Financial Services Committee. ”The more people exaggerate these problems, the more pressure there is on these companies, the less we will see in terms of affordable housing.”

Barney Frank defended his actions by arguing that he favored low income rental support, but opposed sub-prime lending.  Even so, I can’t help thinking that tighter oversight of the capital reserve ratios would have been helpful.  Frank also argues that the Obama administration is doing a much better job regulating:

One of the things that happened under the Bush Administration was the FHA, was allowed to deteriorate.  We’re building that back up again with safeguards. 

Maybe so, but given that these new ”safeguards” allow people with credit scores of 590 to get FHA mortgages with 3.5% down-payments, I am not reassured.  I am also not convinced by the following, although Cochrane and Taylor will agree:

Bernanke and Paulson, came to us in September of 2008 and said, “If you don’t act, there’ll be a total meltdown.  There’ll be the worst depression ever.”  By the way, even if you didn’t think that was going to be the case, and I think it probably was, when the Secretary of the Treasury and the Federal Reserve say, “If you don’t do this, there’ll be a meltdown,” there’s going to be a meltdown.  It’s a little bit self-fulfilling.

If there is one thing we have learned from this crisis, it is that we need to separate politics and banking.  There was far too much political pressure (from both Democrats and Republicans) for banks to make loans to people who simply could not afford to pay them back.  That wasn’t the only problem, but it was certainly part of the problem.  Thus I was not reassured by this statement from Congressman Frank:

They tell us, “Oh, but if you make us pay this tax, we won’t have any money to lend.”  First of all, they’re doing a lousy job of lending now and we’ll be having a hearing a couple weeks after this interview to force them to do more if we can.

Have we learned nothing from the crisis? 

There are good things in the interview, such as a promise by Frank to end the too big to fail policy.  But how can that sort of promise have credibility as long as Congress keeps following the Augustinian maxim: 

O Lord, help me to be pure, but not yet.

There is only one comment that really annoyed me:

Unfortunately, the economy was deteriorating, I think as a consequence of their refusal to regulate the financial industry, and President Obama inherited one of the worst recessions in history, the worst since the Great Depression, and it is much harder to do things in a very depressed economy with revenues tied up and people hurting than it was in a good economy.  So by the policies that led to this terrible recession that Obama inherited, things became more difficult.

Obama did not inherit the worst recession since the 1930s.  Here are some unemployment rates:  Nov. 1949 – 7.9%, May 1975 – 9.0%, July 1980 – 7.8%, Dec. 1982 – 10.8%, Jan. 2009 – 7.7%.

Yes, Obama inherited a bad economy.  It’s a shame he didn’t ask Cristina Romer how FDR was able to turn things around immediately.  How FDR took office in March 1933, a period of rapidly rising unemployment, and within a little over a month had industrial production rising at the fastest rate in history, despite a banking crisis far worse than the one Obama inherited.

By the way, in December 1983 the unemployment rate was 8.3%.  Yes, that means that a mere 12 months after unemployment peaked at 10.8% in December 1982, it had already fallen by 2.5%.  This time around unemployment peaked at 10.1% in October 2009.  I hope it falls by 2.5% by October 2010, but most forecasts I’ve seen suggest it will still be around 10% at that time.   

Obama should consider himself lucky that the economy was mismanaged so badly under Bush.  This gives him some breathing room, as many people have bought into the false assumption that there is nothing that can be done about the recession in the short run.

By the way, NGDP rose 6.36% in the 4th quarter.  This is the best we have seen in quite a while.  Nevertheless, I keep emphasizing that the focus needs to be on the expected growth rate of NGDP.  We don’t have a futures market, but my reading of various indicators is that NGDP is likely to grow at about 5% going forward, perhaps even less.  And that is not enough to recover quickly, although unemployment may fall gradually as wages adjust.   

I would also note that nominal final sales only grew by about 3%, and this is the indicator that Bill Woolsey looks at.  I think this also explains why most forecasters expect NGDP growth to slow—as the fourth quarter saw a sharp slowdown in the rate of inventory liquidation.  But the final sales aren’t there yet to support robust NGDP growth going forward.

I hope this doesn’t sound too negative.  The 6.36% figure is much better than what we have recently seen.  Further good news comes from the 5.7% rise in RGDP, confirming my supposition that the SRAS is very flat right now, and that any boost to NGDP will mostly show up in the form of higher real output, not higher inflation, until unemployment falls somewhat.  Just to be clear, I oppose real targets like unemployment; consider this a prediction of the likely real implications of the nominal target I do favor.

Guess who discussed negative interest rates on money in 1998?

Part one will have some fun with a golden oldie from 1998.  Part two will be more serious, and might be the first journal article to come out of this blog.  Nothing earthshaking, but a different way of thinking about the zero rate bound.  I’ll let you guys be the referees.

Part 1.    The following quotation was taken from a longer discussion of a 1978 paper (JMCB, by Joan and Richard Sweeney) that used the example of a babysitting co-op to illustrate the monetary model of recessions.  The price of babysitting services was arbitrary fixed by the co-op.  Who said this about their paper in 1998?

Now what happened in the Sweeneys’ co-op was that, for complicated reasons involving the collection and use of dues (paid in scrip), the number of coupons in circulation became quite low. As a result, most couples were anxious to add to their reserves by baby-sitting, reluctant to run them down by going out. But one couple’s decision to go out was another’s chance to baby-sit; so it became difficult to earn coupons. Knowing this, couples became even more reluctant to use their reserves except on special occasions, reducing baby-sitting opportunities still further.

In short, the co-op had fallen into a recession.

Since most of the co-op’s members were lawyers, it was difficult to convince them the problem was monetary. They tried to legislate recovery–passing a rule requiring each couple to go out at least twice a month. But eventually the economists prevailed. More coupons were issued, couples became more willing to go out, opportunities to baby-sit multiplied, and everyone was happy. Eventually, of course, the co-op issued too much scrip, leading to different problems …

If you think this is a silly story, a waste of your time, shame on you. What the Capitol Hill Baby-Sitting Co-op experienced was a real recession. Its story tells you more about what economic slumps are and why they happen than you will get from reading 500 pages of William Greider and a year’s worth of Wall Street Journal editorials. And if you are willing to really wrap your mind around the co-op’s story, to play with it and draw out its implications, it will change the way you think about the world.

For example, suppose that the U.S. stock market was to crash, threatening to undermine consumer confidence. Would this inevitably mean a disastrous recession? Think of it this way: When consumer confidence declines, it is as if, for some reason, the typical member of the co-op had become less willing to go out, more anxious to accumulate coupons for a rainy day. This could indeed lead to a slump–but need not if the management were alert and responded by simply issuing more coupons. That is exactly what our head coupon issuer Alan Greenspan did in 1987–and what I believe he would do again. So as I said at the beginning, the story of the baby-sitting co-op helps me to remain calm in the face of crisis.

Or suppose Greenspan did not respond quickly enough and that the economy did indeed fall into a slump. Don’t panic. Even if the head coupon issuer has fallen temporarily behind the curve, he can still ordinarily turn the situation around by issuing more coupons–that is, with a vigorous monetary expansion like the ones that ended the recessions of 1981-82 and 1990-91. So as I said, the story of the baby-sitting co-op helps me remain hopeful in times of depression.

That’s right; it’s Paul Krugman, back in the days he wrote for Slate.com.  Back in the days when right-wing economists looked forward to reading his delightful posts.  Back before he became a political analyst.  You know; the sort of guy who now thinks Obama’s biggest problem is that he hasn’t moved far enough to the left.  How does such a first rate international economist forget about the concept of comparative advantage? 

[I know.  Who am I to talk?]

My favorite parts are his counter-intuitive assertions that even if a recession seems to be caused by some sort of real factor, it is actually caused by too little money:

Above all, the story of the co-op tells you that economic slumps are not punishments for our sins, pains that we are fated to suffer. The Capitol Hill co-op did not get into trouble because its members were bad, inefficient baby sitters; its troubles did not reveal the fundamental flaws of “Capitol Hill values” or “crony baby-sittingism.” It had a technical problem–too many people chasing too little scrip–which could be, and was, solved with a little clear thinking. And so, as I said, the co-op’s story helps me to resist the pull of fatalism and pessimism.

Yes, there was a time when Krugman found it easy to avoid fatalism and pessimism.  But here I can’t blame him for changing his stripes, in those halcyon days I shared his optimism that the Fed could and would, do what’s necessary to avoid a shortfall in AD.

So banking crises may appear to cause recessions (the crony remark was a reference to recent banking problems in East Asia) but the real problem is monetary.  Where have we heard that idea before?  Not only have I been arguing that monetary policy is the real problem, I’ve also been arguing that with each new recession most economists initially get fooled into thinking real shocks are the problem.

Krugman fans will say; “Scott, he still believes this, but only if we aren’t in a liquidity trap.”  Sorry to tell you this, but he’s got that base covered too:

But what about Japan–where the economy slumps despite interest rates having fallen almost to zero? Has the baby-sitting metaphor finally found a situation it cannot handle?

.   .   .

The basic problem with the winter co-op is that people want to save the credit they earn from baby-sitting in the winter to use in the summer, even at a zero interest rate. But in the aggregate, the co-op’s members can’t save up winter baby-sitting for summer use. So individual efforts to do so end up producing nothing but a winter slump.

The answer is to make it clear that points earned in the winter will be devalued if held until the summer–say, to make five hours of baby-sitting credit earned in the winter melt into only four hours by summer. This will encourage people to use their baby-sitting hours sooner and hence create more baby-sitting opportunities. You might be tempted to think there is something unfair about this–that it means expropriating people’s savings. But the reality is that the co-op as a whole cannot bank winter baby-sitting for summer use, so it is actually distorting members’ incentives to allow them to trade winter hours for summer hours on a one-for-one basis.

But what in the nonbaby-sitting economy corresponds to our coupons that melt in the summer? The answer is that an economy that is in a liquidity trap needs expected inflation–that is, it needs to convince people that the yen they are tempted to hoard will buy less a month or a year from now than they do today.

But it is a bit misleading to call this proposal “expected inflation.”  The price level is fixed in the co-op, one unit of script pays for one hour of baby-sitting.  Rather his proposal is analogous to expected inflation.  What is it actually?  A negative nominal interest rate on money.  Silvio Gesell’s idea, rediscovered last year by a grad student at one of those Ivy League econ PhD programs that don’t think it is worthwhile to study monetary history.  And of course there are technical barriers to actually paying negative interest on currency, but not on bank reserves.  Negative interest on reserves; hmmm . . . where have we heard that idea before?

Part 2.  Reflections on the end of the zero rate bound.

A few days ago I did what I thought was one of my more important posts, pointing out that the Fed’s likely new operating target will eliminate the problem of the zero rate bound.  There are always some misunderstandings in the comment section when I bring up negative rates on reserves.  What about vault cash?  What about the impact on bank profits?  What if firms don’t want to borrow even at very low rates?  The simple answers are vault cash can be dealt with in many ways–it isn’t a problem.  And the system can be set up in a way that bank profits aren’t hurt.  And the purpose of the plan is not to get firms to borrow more, but to reduce bank demand for the medium of account.  This is all discussed in earlier posts like this one.

But I also anticipate some push-back from serious economists on another point.  Negative interest rates on reserves would not drive free market short term rates significantly below zero.  So have we actually solved the problem of the zero rate bound?  The answer is an emphatic yes.  But it doesn’t seem that way, and it is worth considering why.

I am pretty sure that many economists are confused about the nature of the liquidity trap.  In particular, they confuse two very distinct issues:

1.  The inability of the Fed to move the fed funds target lower once it has reached zero.

2.  The inability of monetary policy to boost AD once rates hit zero.

Krugman and I both agree that monetary policy can still be highly effective once rates hit zero.  And we both agree that conventional monetary policy is ineffective once rates hit zero, if ‘conventional monetary policy’ is defined as adjusting the fed funds target, and/or a temporary injection of reserves into the banking system.  But if the Fed doesn’t use either fed funds targeting or temporary base injections as the policy lever, then monetary policy doesn’t become ineffective once short term rates hit zero.  To explain this, it will be helpful to consider some potential operating targets for the Fed:

1.  The fed funds rate

2.  The interest rate on reserves (IOR)

3.  The monetary base

4.  The exchange rate (or price of gold)

5.  CPI or NGDP futures targeting

Although there appear to be zero bounds on the exchange rate and the monetary base, in practice there are no limits to either policy lever.  No matter how low the base or exchange rate fall, they can always be cut another 10%.  Of course if you think of absolute changes there is a lower bound of zero.  But if that were the exchange rate it would mean the Fed handed out free money to anyone that wanted it.  I think we can assume that policy would boost NGDP (to infinity.)  And as you approach a zero monetary base, you would approach hyperdeflation.  So I think we can rule that one out as well, as few governments are frustrated by an inability to create hyperdeflation.  Indeed few want any sort of deflation.  So for all practical purposes there are no zero bounds, except for the fed funds target.

But then you might wonder; “What happens if the Fed increases the monetary base and short term rates stay stuck at zero?”  Doesn’t this mean you are still stuck in a liquidity trap, even if the policy lever can still be moved around?”  If you think this way, you are probably confusing the two issues I discussed above.  You are probably thinking (in the back or your mind) that the fed funds rate is part of the transmission of monetary policy, and that without a lower fed funds rate you cannot get a boost in AD, in NGDP.  But in fact the fed funds rate does not play an important role in the monetary transmission mechanism.  When you are deciding whether to buy a new car, a new house, or construct a new office building, the last thing you care about is the nominal fed funds rate.  Rather, you care about expected RGDP growth, or asset prices, or real wages, or perhaps longer term real interest rates.

So the real question isn’t whether the fed funds rate might stay at zero in response to changes in some alternative policy lever, but rather whether these alternative policy levers can boost AD.  Almost everyone agrees currency depreciation is a foolproof way of boosting NGDP; the only question is whether it is politically feasible.  And even Krugman concedes that increases in the monetary base that are expected to be permanent will be expansionary, even at the zero bound. 

[BTW, I’ve never heard anyone else note that money supply increases that are expected to be temporary will have little or no impact on the price level, even if you aren’t at the zero rate bound.  So the question of temporary currency injections is essentially unrelated to the zero bound problem.]

But the interest on reserve lever is different from all the other policy levers discussed above.  It is a policy lever that works by changing the demand for base money, not the supply.  In addition, it only applies to the portion of the base that is held by banks.  Thus once the IOR goes a couple points below zero, further decreases have essentially no impact on excess reserves.  This is because at even a negative 2% IOR, banks will cut excess reserve holdings to the bare minimum, and further rate cuts will not have any additional impact on ER demand, or market interest rates.  So isn’t that a sort of zero bound?

One answer is that changes in the IOR can have a huge impact between 0% and negative 2%, whereas the fed funds rate is already spinning its wheels at 0%.  Between 0% and negative 2% almost all of the monetary base (except required reserves) moves out into circulation.  But I don’t find that a satisfactory answer. 

The best way to think of the IOR policy lever is that it is analogous to reserve requirements.  In most money and banking textbooks reserve requirements are the only Fed tool that impacts the demand for base money, not the supply.  I have a feeling that textbooks are about to change.  IOR also affects the demand for base money.  And just as reserve requirements cannot lower the demand for required reserves below zero, no change in the IOR can lower the level of excess reserves below zero.  So again, why isn’t that a sort of zero bound to expansionary monetary policy?

The answer is that like reserve requirements, the IOR allows another degree of freedom.  The Fed can still control the supply of base money.  If the Fed wants to boost AD, it can lower the IOR enough to drive ERs to the bare minimum, and then any further open market purchases will go straight to currency held by the public, or to required reserves and hence the broader aggregates.  And of course there is no zero rate bound problem for changes in the monetary base, which can be increased as much as the central bank wishes.

Indeed the Fed has already begun this two-track policy.  They prefer to have a large monetary base for the time being, and plan to tighten by raising the IOR in the future.  But the same macro objectives could be achieved through open market sales, if they so desired.  They now have one extra degree of freedom.  Personally, I don’t think the IOR tool is very valuable, but if it ends the silly superstitions about zero rate bounds, it will all have been worthwhile.

Perhaps the best way to summarize all this is to go back to Nick Rowe’s observation that the fed funds rate (and hence the zero bound) matter if people believe they matter.  Ironically just one day before I noticed the article hinting at the Fed’s imminent policy change, Nick made this cryptic statement:

There are probably two (stable) equilibria: one in which monetary policy *is* interest rates, and we can get stuck in liquidity traps; and a second in which it isn’t, and we don’t get stuck. Social construction of reality, again, which is just an extreme form of a convention, which not only affects how we behave, but how we see the world. It defines the “social facts” of what central banks “do”.

Question: if this (above) view is correct, what exactly is it that Scott Sumner is *doing* (on this blog)? What *is* he? Not a policy advocate, in the standard sense.

And, if this view is correct, forget about trivia like cutting the overnight rate by 0.25%. Banning all public mention of the overnight rate would be a more effective policy!

It didn’t take long for the Fed to see the wisdom of Nick’s suggestion.  So thank you very much Nick Rowe.  Now perhaps Rasputin, I mean Nick, could do the following post:

Mr. Bernanke, look into this glass ball

Repeat after me

There is no such thing as inflation

There is no such thing as inflation

There is only NGDP

HT:  Marcus Nunes

Why didn’t the housing crash cause high unemployment?

A recent FT article by Vernon Smith and Steven Gjerstad discusses two big housing crashes, one occurred between 1928 and 1929, and the other occurred between 2006:1 and 2008:2.  Both were associated with substantial increases in RGDP.  Why didn’t real GDP decline during these two big shocks to a major industry?  Why was unemployment so low?

There are two reasons.  First, jobs in housing construction are not a particularly large share of total employment.  The direct loss of jobs was in the 100,000s, not millions.  In addition, many of the workers who lost jobs in construction gained jobs in other sectors.  Thus RGDP continued to grow.

The article by Smith and Gjerstad contains two of the best graphs I have ever seen for illustrating the amazing resilience of the US economy.  In 1929 (a boom year) housing output fell by roughly 30%.  The recent downturn is even more striking.  Notice the severe decline in housing for 9 straight quarters during a period where RGDP is trending upward. The ability of RGDP to grow while a major sector is contracting is quite amazing.  Yet for some odd reason they drew almost the exact opposite conclusion that I did; they argued that the housing crashes of 1928-29 and 2006-08 caused severe recessions.  Why is that?

In my view their key mistake was to misinterpret the role of monetary policy.  In each case, housing continued to decline further after the period I cited.  And in each case NGDP, which had been growing, suddenly began declining as well.  It was the decline in NGDP, not the additional fall in housing, which caused the severe recession and the job losses all across the economy.  If NGDP had kept growing at 3% to 5% after 1929, and after 2008:2, the housing downturn probably would have ended, and the economy would have avoided a severe recession.

You might ask; “Isn’t it a bit implausible that two severe recessions would be preceded by housing collapses, if those collapses had no causal role in the recessions?”  In fact, the housing collapses and the subsequent recessions probably were related, but in a very indirect fashion.  Here’s what probably happened in both cases.  As housing declined, the equilibrium “natural rate of interest” began to decline as well.  There was less demand for credit.  At some point the natural rate fell far below the Fed’s policy rate, causing monetary policy to tighten accidentally.  Because Fed officials (and many private economists) wrongly think that the level of interest rates are a good indicator of the stance of monetary policy, they failed to notice that monetary policy had tightened sharply.  But the markets noticed, and there were big stock market crashes in October 1929 and October 2008.

But that can’t be the whole problem, because Smith and Gjerstad do discuss the fall in velocity, and correctly attribute it to the decline in nominal interest rates.  And of course this fall in velocity is just another way of thinking about the fall in the natural rate of interest that I discussed earlier.  So they understand that a housing collapse can reduce interest rates, velocity, and hence NGDP.  So again, why do they reach such different conclusions?

I think in the end it has to do with their approach to monetary policy.  They view the fall in velocity as something that the Fed would have had a hard time counteracting.  And they would undoubtedly point to the fact that the Fed did in fact fail to counteract it.  In contrast, I am much more optimistic about the ability of the central bank to maintain stable expected NGDP growth in a period of financial turmoil, and believe that very little of the fall in velocity that Smith and Gjerstad cite was actually caused by the housing slump.  Instead, almost all of it was caused by two monetary policy mistakes.  One was the failure to do NGDP targeting, level targeting, which would have maintained positive longer term NGDP expectations.  And the other error was paying interest on excess bank reserves.

In his Big Think interview, Vernon Smith suggested that banks took excessive risks in the 1920s.  This seems plausible, after all, lots of banks failed in the 1930s.  But in fact banks were much more conservatively managed in the 1920s than today.  If you take a close look at this graph from The Economist, you will see that bank equity was above 10% of assets throughout the 1920s, and was close to 15% on the eve of the Great Depression.  So that wasn’t the problem.

Then what went wrong?  Why did so many banks fail in the 1930s?  The answer is simple, NGDP fell in half.  The funds people and firms use to repay loans comes from income.  If nominal income falls in half, there will be many defaults, regardless of how sound the loans seemed before the Depression began.

What about today?  It is more complicated.  This time Smith is partly right.  There were many foolish loans made during the past decade, and we know this because the sub-prime crisis occurred while the economy was still booming in 2007.  About all you can say in defense of the banks is that the fall in NGDP after mid-2008 made the losses several times worse than otherwise.  But even some of that is the banks fault, as they need to anticipate the possibility of at least a mild recession, although perhaps one can excuse them for not expecting NGDP to fall at the fastest rate since 1938.

In any case, it’s not about blame, it is about figuring out where we go from here.  And despite the fact that I diagnose the problem slightly differently from Smith and Gjerstad, I reach almost identical policy conclusions from those discussed by Smith in his recent Big Think interview:

1.  We should require much more collateral on loans and derivatives

2.  We should raise the price level 6% (although I would substitute NGDP for the price level.)

PS.   I couldn’t copy the FT graphs, but this one from The Economist shows just how much of the housing downturn had occurred before the recession even began.  Starts had fallen from over two million to roughly one million in late 2007.  In the early part of the recession, starts actually leveled off at close to one million, but then fell to 500,000 when NGDP declined sharply.

PPS.  Tyler Cowen links to a graph showing the effect of “recalculation.”  Oddly, a few weeks back I linked to a similar graph arguing that it showed recalculation was a minor factor in the current recession.  BTW, the graph he links to has an error; unemployment rose between July 2009 and November 2009, whereas it shows a decline.  But I shouldn’t throw stones as a commenter named Tom found errors in my graph as well.

I was born in Michigan, grew up in Madison, and went to grad school in Chicago.  These three areas encapsulate how I think about the recession.  Chicago is a cross-section of America, with a highly diversified economy.  Its unemployment rate is 10.3%, close to the national average.  Madison is blessed with unusually acyclical industries, and I don’t recall it ever experiencing high unemployment.  Because its economy is dominated by state government, college education, insurance, biotech, and dairy, it has only 5.5% unemployment.  At the other extreme is Detroit, with 15.4% unemployment.  Detroit has two problems.  First, heavy industry is unusually cyclical, and thus steel, autos, machinery, etc, will suffer more job losses when AD falls, even if there is no recalculation.  Of course the auto industry is the main problem in Detroit.  It is not true that the US auto industry is in a long term state of decline, but the Big 3/UAW auto industry is in a long term state of decline.  So Detroit’s unusually high unemployment rate is due to both cyclical factors and structural (recalculation) factors.

HT:  Mike Belongia

Zero Rate Bound, RIP

The zero rate bound in economics plays much the same role as black holes (or “singularities”) play in physics.  It is the point where all the laws of macroeconomics break down.  Quantitative easing doesn’t work, the central bank can’t ease policy by cutting rates, increased saving no long leads to more investment, wage cuts don’t boost employment, and the AD curve may slope upward. 

I’ve never believed most of this Keynesian nonsense, but as I argued in the previous post, if other people believe it, especially other people who are central bankers, then it matters.  But within months the zero rate bound will be a thing of the past, merely of interest to antiquarians.  What will cause this momentous change?  The Fed is about to drop the use of the fed funds rate as its short run target (sometimes called “instrument”) of policy.  It will be replaced with the interest rate on excess reserves.  Because that is an administered rate, it really will be an instrument of policy.  And it can be either positive or negative.

Jan. 26 (Bloomberg) — Federal Reserve policy makers are considering adopting a new benchmark interest rate to replace the one they’ve used for the last two decades.

The central bank has been unable to control the federal funds rate since the September 2008 bankruptcy of Lehman Brothers Holdings Inc., when it began flooding financial markets with $1 trillion to prevent the economy from collapsing. Officials, who start a two-day meeting today, have said they may replace or supplement the fed funds rate with interest paid on excess bank reserves.

“One option you might want to consider is that our policy rate is the interest rate on excess reserves and we let the fed funds rate trade with some spread to that,” Richmond Fed President Jeffrey Lackertold reporters on Jan. 8 in Linthicum, Maryland.

The central bank needs to have an effective policy rate in place when it starts to raise interest rates from record lows to keep inflation in check, said Marvin Goodfriend, a former Fed economist. Policy makers are concerned that the Fed funds rate, at which banks borrow from each other in the overnight market, may fail to meet the new target, damaging their credibility and their ability to control inflation as the economy recovers.

‘Extended Period’

The choice of a benchmark is the “front line of defense against inflation, and also it’s at the heart of the central bank being able to precisely and flexibly guide interest-rate policy in the recovery,” said Goodfriend, now a professor at Carnegie Mellon University in Pittsburgh.

The Federal Open Market Committee is likely to maintain its pledge to keep interest rates “exceptionally low” for an “extended period” in a statement at about 2:15 p.m. tomorrow, economists said. The Fed probably won’t raise interest rates from record lows until the November meeting, according to the median of 51 forecasts in a Bloomberg survey of economists this month.

Fed Chairman Ben S. Bernanke, in July Congressional testimony, called interest on reserves “perhaps the most important” tool for tightening credit.

OK, it doesn’t say it’s definite.  But let’s face it; these sorts of highly coordinated “trial balloons” aren’t accidental, especially when Bernanke’s name is attached.

This is a huge policy shift.  Since 1913 the Fed had mostly conducted monetary policy by changing the supply of the medium of account.  (The exception was the 1936-37 RR increase.)  In the US the medium of account is called the monetary base, and is composed of bank reserves and currency held by the public.  It looks like (starting later this year) monetary policy will be implemented through changes in the demand for base money.  The Fed will adjust the demand for base money by adjusting the rate that they pay on excess reserves.  This fulfills one part of Robert Hall’s radical policy proposal of 1983.  The other part is to have the interest rate adjust ex post in such a way as to keep the expected future price level stable.

I think the profession as a whole used to think that Hall’s many “optimal monetary regimes” were a bit silly.  “How can there be more than one,” was a joke I once heard.  Maybe it’s time to take another look at his innovative work on monetary economics. 

Up until now “conventional” monetary policy has been defined as adjustments in the fed funds target rate.  This rate cannot go below zero, otherwise banks would simply hold on to the reserves.  And this explains why people like Paul Krugman often emphasized that conventional policy became ineffective at the zero bound:

I keep seeing economics articles and blog posts that insist that we’re NOT in a liquidity trap (and, of course, that yours truly is all wrong) because the situation doesn’t meet the author’s definition of such a trap. E.g., the interest rates at which businesses can borrow aren’t zero; or there are still things the Fed could do, like buying long-term bonds or corporate debt, or something.

Well, my definition of a liquidity trap is, purely and simply, a situation in which conventional monetary policy — open-market purchases of short-term government debt — has lost effectiveness. Period. End of story.

Now, if you prefer a different definition of a liquidity trap, OK; call our current situation a banana, instead. But changing the name does not change the essential fact — namely, conventional monetary policy has lost effectiveness.

Within a few months Krugman’s statement will become “inoperative,” as “conventional monetary policy” will be adjustments in the rate paid on reserves, which obviously can be negative.  Krugman may reply that this doesn’t eliminate the problem of the liquidity trap.  The public can still hoard currency.  He’s fond of pointing to the fact that in the late 1990s large safes were the most popular consumer durable in Japan.  But rates are near zero in America, and the main problem with hoarding is banks holding excess reserves, not the public holding currency.  I won’t get into all the minutia of this issue; I discussed them in another post.  The bottom line is that negative rates on reserves don’t completely eliminate the need for the central bank to manage expectations, but they make it easier to use their policy lever as a means of doing so.  Alternatively, you might say that it doesn’t eliminate the liquidity trap, but it cuts it in half. 

[Technically it cuts it in half from the monetarist perspective; from the Keynesian perspective it may have no impact, as short term rates stay near zero.  But you know what I think of the Keynesian perspective.]

Part 2.  Dr. Stranglelove and the Doomsday Machine

For some reason I often think of this line from Dr. Strangelove:

Dr. Strangelove: Of course, the whole point of a Doomsday Machine is lost, if you *keep* it a *secret*! Why didn’t you tell the world, EH?
Ambassador de Sadesky: It was to be announced at the Party Congress on Monday. As you know, the Premier loves surprises.

I guess the Fed also like surprises.  But perhaps someone can explain this to me.  Why would the Fed adopt a new policy ideally suited for overcoming the zero rate bound, at the very moment that they are about to embark on a policy of gradually raising interest rates?  Isn’t the whole point of the interest on reserve program that it allows you to cut the policy rate below zero, and prevent banks from hoarding ERs?  (Something that can’t be done with a conventional Fed funds target.)

And for you conspiracy buffs, how about this little nugget from the Bloomberg article I linked to at the top:

The new reliance on reserve interest could also increase the policy clout of Fed governors in Washington at the expense of the 12 regional Fed bank presidents, Reinhart said.

Congress gave only the Fed governors the authority to set the deposit rate. The presidents have historically favored higher rates and voiced more concern about inflation.

“The Federal Reserve Act puts a very high weight on comity,” said Reinhart, now a resident scholar at the American Enterprise Institute in Washington. Using interest on reserves for setting policy “can change the tenor of the discussions, and I don’t know how they get around it.”

If you’re wondering what this means, you might want to go an re-listen to the first 20 minutes of Michael Belongia’s interview with Russ Roberts on Econtalk.

HT:  Daniel Carpenter