Archive for July 2010


Earl Thompson, R.I.P.

I was saddened to hear that Earl Thompson just passed away, at the age of 71.  Although I never met Professor Thompson, I found him to be one of the most brilliant and original thinkers in the field of macroeconomics.  Unfortunately for him, he was far ahead of his time, and his insights still have not been incorporated into macro theory.  Last year I pointed out that he was one of the few economists who understood that tight money in 2008 was behind the current economic crisis.  Here is an obituary from UCLA, where he taught. 

I was disappointed that the obit didn’t even mention his innovative work on monetary policy.  He was one of the first to call for nominal wage targeting to minimize employment fluctuations, and developed an approach to overcome policy lags that was close to my futures targeting idea.  I believe he may have been the first economist to ever propose this idea, but the paper was never published.  A year later Robert Hall published a different method of using market expectations to implement a price level target.  

He also did excellent work on the role of gold in the Great Depression.  I don’t know much about his work in other fields, but the UCLA obituary has a good summary.

My sympathy to his wife Velma Montoya, and their son.

Why the Fed won’t directly target exchange rates

I saw this comment over at MarginalRevolution:

On the AD front, Scott Sumner has been vindicated more than any other writer.  His best critic is Arnold Kling, especially with regard to whether there are only two kinds of inflation regimes, low or high and variable.  A related question is what a looser monetary policy would have done to financing the long-run debt burden and the use of the interest rate spread to recapitalize banks.  

A few thoughts:

1.  It’s nice to be complimented.  BTW, did people notice that one of our commenters here (statsguy) had a post that Tyler Cowen named best post of the year?  Whatever success I’ve had is mostly due to the good fortune of being promoted by blogs like MR and Econlog.

2.  Regarding the impact of looser monetary policy, I put a lot of weight on the correlation between NGDP growth expectations and the severity of the banking crisis.  The estimated total losses to the US banking system got worse when NGDP growth expectations were declining, and have improved since NGDP growth expectations began improving. 

3.  I am a huge fan of Kling’s posts, but I think his strength is micro/public policy/banking and the real side of macro.  I still don’t see a persuasive model of nominal shocks.  (Persuasive to me anyway.)  Of course I focus on nominal shocks, and mostly leave the real side of macro to others.   Since the time of David Hume, the best minds in the field have struggled with trying to explain why nominal shocks have real effects.  All they have come up with is some lame sticky wage/price models.  I won’t be able to do any better, although I suspect the profession slightly underestimates the relative importance of wage stickiness.  So I focus on explaining AD shifts, and assume the SRAS is upward sloping when in a recession.

4.  Kling also has some astute views on macroeconomic thought.  He was the one who noticed that my view should be the standard view of the recession, but for some strange reason isn’t.  I didn’t leave the profession, the profession abandoned me.  He and I also view the relative popularity of Keynesian and Austrian views as being cyclical.  But on purely monetary policy issues, I think Nick Rowe, Andy Harless, and Paul Krugman have been my toughest critics.

Speaking of Kling, here is a recent comment about my views:

Scott Sumner writes,

“The US can’t really use the exchange rate as a policy tool, it is too controversial.”

And so, we have to turn to less controversial tools, like pouring more wood on what the CBO says is a fiscal fire.

That is not what Sumner says, of course. He says that the Fed can just announce a target for nominal GDP, and the markets will obey.

I find that highly implausible for nominal GDP, but I do find it plausible for the exchange rate. If the Fed announced a policy of “20 percent weaker dollar or bust,” and proceeded to buy euros, yen, and other currencies, by golly, I do not think that private speculators would try to get in the way. And if foreign governments tried to get in the way, that would probably lead to some sort of worldwide monetary expansion that I imagine would make Sumner happy.

One point to make here is that this represents another reason to reject the notion of a liquidity trap. If the Fed runs out of T-bills to buy, it can always buy foreign currencies.

I agree about the liquidity trap; Svensson, McCallum and many others have pointed out that currency depreciation is a foolproof way out of liquidity traps.  And FDR showed it works.  I shouldn’t have said the Fed “can’t” do it; the problem is that they won’t because it will be (wrongly) viewed as a beggar-thy-neighbor policy.  There are two problems with that argument.  First, any expansionary policy, even QE, will depreciate the dollar.  Indeed the dollar fell sharply in March 2009 on the date that QE was announced.  But if the Fed specifically targets the exchange rate, the Europeans and Japanese will whine ”beggar-thy-neighbor.”  The other problem is that under a fiat money regime, other countries can easily prevent any US currency depreciation from reducing their NGDP.  Of course if they offset the US action, their currencies will also depreciate.  All currencies cannot depreciate against each other, but they can all depreciate against goods and services.

I’m not sure why Kling doesn’t think NGDP targeting would work.  Remember, I want to target expectations.   Just eliminate interest on reserves and do enough QE so that NGDP expectations rise to the desired level.  You will also depreciate the dollar as a side effect.  Since he thinks dollar depreciation works, why wouldn’t other actions that have a side effect of depreciating the dollar also work?  BTW, I don’t claim announcing a target is enough; you must also accommodate the public’s demand for base money at that target.  Kling continues:

However, I cannot leave this issue without referring to the two-regime theory of monetary policy, which would say that this sort of policy risks moving the U.S. into a regime where the inflation rate becomes high and variable. Instead of keeping cash in mattresses, people will try to conserve on cash, and this will raise the velocity of money, even as the Fed is expanding the money supply. There is a risk that we will overshoot the inflation target. If higher inflation solves a lot of our unemployment problem, then, fine, Scott Sumner is a hero. If not, then, well, he is something else.

I’m not at all worried about being tarred and feathered, because I favor targeting expectations, and also level targeting.  That combination will prevent an outbreak of inflation.  If you need to drain a trillion in base money out of the system in one day—you do it.  Indeed if an outbreak of inflation were to occur, I could get rich by going long on CPI futures, with no risk.  I seriously doubt there will ever arise an economic scenario where I could become rich at no risk. 

Technically the preceding argument assumes that the price level doesn’t wildly gyrate around the 2% growth trend (if we assume 2% inflation is the Fed’s target.)  I suppose you could have 12% inflation one year and negative 8% the next.  But the volatile part of the CPI is commodities like food and oil, and intertemporal arbitrage prevents that sort of response to monetary shocks.  The bigger (core) part of the CPI is mostly driven by wage growth, and is very inertial.  Believe me, if you keep price level expectations in the TIPS markets growing along a 2% upward sloping trend line, the actual CPI is not going wildly fluctuate above and below that level, unless there are some pretty big supply shocks that have nothing to do with monetary policy.  Ditto for NGDP targeting.

Fear of overshooting toward a high inflation scenario is common among economists, but represents 1970s thinking.  There were no TIPS markets warning us about rising inflation expectations back then.  If it happens again, we will be able to watch the accident in slow motion, hour by hour in the TIPS markets, and will have no one to blame but ourselves.  I’ll refuse to take the rap.

There are dozens and dozens of developed countries.  How many have experienced double digit inflation in the past 20 years?  There’s a reason for that.

Losing face

A commenter named Marcus Nunes just sent me one of the most chilling quotations I have ever read, and it was from the minutes of a Fed meeting.  But first a bit of background.  In October 2008 the Fed made the same mistake as in early 1937; they put into effect regulations that increased the demand for bank reserves, just at the moment we were entering a recession.   The 1937 action was actually more justifiable, because the recession was not yet visible.  In both cases many economists made a logical error.  In 1937 they assumed that higher reserve requirements wouldn’t be a problem because banks had lots of excess reserves—forgetting that they held ERs for a reason.  In 2008 most economists focused on interest rates as the indicator of monetary policy, not expectations of future policy actions.  The interest on reserves (IOR) program did not immediately raise rates, but did prevent them from immediately falling to zero.  Much worse, it made future QE much less effective, as markets understood that any future increases in the monetary base would now be held as excess reserves.  

Now the Fed is considering eliminating IOR as a way of stimulating the economy.  Of course if they do that, it will be an implicit admission that the October 2008 action was contractionary in effect, and it will go down in the history books as an even worse mistake than the 1937 RR increase.  Will the Fed be willing to “lose face” and admit its error? 

My wife tells me that the Chinese don’t like to lose face.  I assure her that we don’t have that problem here, Americans have no difficulty in admitting their mistakes and moving on.  But the quotation that Marcus sent me has caused me to re-evaluate my view of Americans.  Could the Fed really put losing face ahead of the well-being of hundreds of millions of Americans, many without jobs?  It seems unthinkable, almost unimaginably cruel, but the following excerpt suggests that it did happen in 1937.  Read it and then I’ll explain why.  By the way, the opening and closing passage are from a paper by Orphanides

On May 1, 1937, the final leg of the tightening was completed. With that in place, excess reserves fell back to levels as low as had not been seen since several years earlier (Figure 4). May 1937 also marked the peak of the incomplete expansion from the Great Depression of 1929-1932. The economy promptly returned to recession. Though the extent of the sharp decline in activity was not immediately evident, by Fall it became fully clear to the Committee that the economy was thrown back to a severe recession, once again. The following evaluation of the situation by Williams at the November 1937 meeting is informative, both for offering a frank admission that the FOMC apparently wished for a slowdown to occur and also for outlining the case that the recession, nonetheless, had nothing to do with the monetary tightening that preceded it. Particularly enlightening is the reasoning offered by Williams as to why a reversal of the earlier tightening action would be ill advised.

“We all know how it developed. There was a feeling last spring that things were going pretty fast … we had about six months of incipient boom conditions with rapid rise of prices, price and wage spirals and forward buying and you will recall that last spring there were dangers of a run-away situation which would bring the recovery prematurely to a close. We all felt, as a result of that, that some recession was desirable … We have had continued ease of money all through the depression. We have never had a recovery like that. It follows from that that we can’t count upon a policy of monetary ease as a major corrective. …  In response to an inquiry by Mr. Davis as to how the increase in reserve requirements has been in the picture, Mr. Williams stated that it was not the cause but rather the occasion for the change. … It is a coincidence in time. … If action is taken now it will be rationalized that, in the event of recovery, the action was what was needed and the System was the cause of the downturn. It makes a bad record and confused thinking. I am convinced that the thing is primarily non-monetary and I would like to see it through on that ground. There is no good reason now for a major depression and that being the case there is a good chance of a non-monetary program working out and I would rather not muddy the record with action that might be misinterpreted. (FOMC Meeting, November 29, 1937. Transcript of notes taken on the statement by Mr. Williams.)”

The Federal Reserve made every effort to build a convincing case that the cause of the 1937 downturn could be more than accounted for by factors other than the monetary tightening and that policy action by the rest of the government and not by the Federal Reserve were needed to restore prosperity.

I suppose someone will say that Williams is denying that the RR increase caused the 1937 depression.  Yes, he’s denying it, but you’d have to be even more naive than me (and that’s a pretty bad insult by the way) to believe he is sincere:

1.  He admits that the policy was intended to be contractionary, indeed intended to cause a “recession.”

2.  By November 1937 it was clear that the “recession” was becoming a depression.

3.  They are discussing lowering RRs as an expansionary device.

4.  Later on when the depression got worse (in 1938) they did lower RRs.

Let’s put him on the couch:

“We all felt, as a result of that, that some recession was desirable”

I.e., it wasn’t just my fault, we all felt that way.

If action is taken now it will be rationalized that, in the event of recovery, the action was what was needed and the System was the cause of the downturn.

Do I even need to comment?

It makes a bad record and confused thinking.

Yes, we mustn’t let the public become “confused.”

I am convinced that the thing is primarily non-monetary and I would like to see it through on that ground. There is no good reason now for a major depression

A depression can’t be happening now, because that would mean I was wrong. 

I would rather not muddy the record with action that might be misinterpreted

Muddy the record, or muddy my reputation?

A depression did occur, as NGDP fell roughly 5%.  To give you an idea of just how bad it was, the largest yearly decrease since then was only 1.7%.  BTW, that occurred in 2009, just after the Fed started the IOR.

Although I am generally a non-interventionist, for some strange reason I supported the Iraq War.  (Actually 6 or 7 reasons, none of which seem very good today.)  Sometimes in conversation I will mention how the Iraq War was a mistake, and people will say “But I thought you supported the war.”  And I think to myself, “Yes, and your point is . . . “  Sometimes you just have to bite the bullet, admit your mistake, and move on.

I’ve led a sheltered life.  I wasn’t in the room when Nixon conferred with his advisers after Watergate, or Kennedy met with his legal team after Chappaquiddick.  So I am pretty naive about people.  This transcript was a real eye-opener for me.

You probably think that I’m getting ready to accuse the Fed of being evil if they don’t get rid of the IOR.  I’m afraid my naivete is so deeply ingrained that within days I’ll again be assuming they are well-intentioned civil servants doing the best they can.  You guys are free to draw your own conclusions.

Fisher explains why more NGDP growth won’t help

CNBC discusses the views of Dallas Fed President Fisher:

Signs are rife that the U.S. economic recovery is slowing, with retail and housing sales down, manufacturing slowing, and unemployment at a stubbornly high 9.5 percent. Some Fed officials, including Fed Chairman Ben Bernanke, have recently raised the possibility that the Fed may need to ease monetary policy further if the economy worsens.

Fisher said such a move would be ineffective, and could even make matters worse.

Businesses are distressed and dispirited by uncertainty over upcoming rule changes and are unable to conduct long-term planning, he said.

“They are calling time-outs and heading to the sidelines while they wait for the referees to settle on the rules of the game,” Fisher said. “If this is so, no amount of further monetary policy accommodation can offset the retarding effect of heightened uncertainty over the fiscal and regulatory direction of the country.”

I don’t get this at all.  There was lots of governmental activism during the Lyndon Johnson years, and yet rapid NGDP growth led to rapid RGDP growth.  During FDR’s first term there was far more activism and far more uncertainty than right now, but fast NGDP growth led to fast RGDP growth.  I’m no fan of Obama’s policies; I think they have modestly increased the structural rate of unemployment.  But monetary stimulus remains the key to recovery.  It will also eventually lead to fewer policies that reduce aggregate supply, such as extended UI benefits. 

Fisher sought to assure his audience that the Fed will not allow itself to be pushed into printing money to resolve the deficit and signaled he would would oppose any further easing on that basis.

Of course he has things exactly backward.  Many of the spending programs that he doesn’t like were undertaken precisely because monetary policy reduced NGDP nearly 8% below trend between mid-2008 and mid-2009.  And the current recovery is anemic, with NGDP growing at less than 40% of the rate it grew during the 1983-84 recovery.

Calling price stability the Fed’s “ultimate goal,” he said the U.S. central bank will not tolerate either inflation or deflation.

“The Federal Reserve is absolutely committed to its goal of achieving price stability,” he said. “This entails keeping inflation extremely low and stable.”

I’ve already said enough about “opportunistic disinflation.”

If it quacks like an ultra-conservative central bank . . .

Paul Krugman recently contested my argument that Japan is not stuck in any sort of deflationary trap.  Ryan Avent already showed why Krugman doesn’t have much of an argument:  

And…I’m genuinely mystified. The only thing I can think of that would square this circle is if Mr Krugman and I are using different definitions of the word “prefer”. As best I can tell, he has conclusively shown that Mr Sumner is right, and Japan hasn’t been in a deflationary trap. It just needs to fire all of its central bankers.

I’m not surprised that Krugman wants to claim the BOJ is stuck in a deflationary trap; he published the best model we have to explain why that might happen.  But I’m afraid it didn’t happen, and although Avent’s post is pretty definitive, even he didn’t address all of the problems with Krugman’s argument. 

Let’s start with his response to my admission that my view is the minority view:

He guesses right: that’s not at all the view of those who have been following Japanese monetary policy since the 1990s, and have even talked to BOJ people now and then.

So Bank of Japan officials are not publicly admitting to favoring mild deflation.  Is that really surprising?  And regarding “those who have been following Japanese monetary policy since the 1990s” (does that include me?), I was under the impression that many of them were highly critical of Japanese monetary policy for being too contractionary.  That sort of criticism of the BOJ is hardly consistent with the view that the Japanese are “stuck” in some sort of deflationary trap.

As far as I can tell, the Fed has an implicit target of roughly 2%, maybe a bit less.  The ECB is about the same, perhaps a bit lower.  The BOJ has target of stable prices, which means zero inflation.  I don’t know what inflation index they use, but their CPI has been amazingly stable since February 2002 (roughly when the QE started.)  The CPI was 100.1 on February 2002, and is now 99.7.  That’s a grand total of 0.4% deflation over a period of 8 years!  Price stability just doesn’t get any better than that.  Other that a few months in 2008, when oil prices soared, the Japanese CPI never moved more than 1% up or down from the February 2002 figure.  (BTW, the Bullard study that I was commenting on looked at 2002-10 data.)   If you don’t like my February 2002 starting point, the Japanese CPI has fallen by a grand total of 0.5% since June 1993, a period of 17 years.  Not per year—total.  So if the CPI is their target, then the Japanese just might be the most skilled central bank in all of world history.  Who else has produced such absolute price stability!

Now I will admit that the core inflation rate shows a bit more deflation, but it’s still pretty close to price stability.  (Eyeballing the graph in the Bullard paper, it looks like about 0.3%/year deflation since 2002.)  So the BOJ really isn’t very far off target, even if you use the core rate.  But let’s take the worst case, and assume the BOJ prefers stable prices to very slight deflation.  I still think Krugman is wrong.  And the reason is that the BOJ abhors positive inflation like a vampire fears sunlight.  So when there is any sign of inflation, the BOJ immediately does something contractionary.  They always err on the side of mild deflation, even if their first best choice is precisely zero inflation.  

Krugman points to the large increase in the monetary base during the early 2000s, but skims over the big drop in 2006, indeed doesn’t even consider it to be that dramatic.  I’d consider a drop of over 20% from peak to trough to be pretty dramatic, as far as I know it is larger than any monetary base drop experienced by the US in the past 100 years, including the Great Deflation of 1920-21.  But let’s say Krugman’s right and that it’s no big deal; that still doesn’t explain why it occurred.  The explanation seems obvious to me; the BOJ was terrified that after years of very mild core deflation, they might have 1% inflation.  So they tightened monetary policy, just as you’d expect a central bank to do if it wasn’t “trapped.”

Krugman also argues that depreciating one’s currency is not as easy as it looks, and points to the Swiss case.  First of all, I think we both agree that there is no technical barrier to depreciating a currency; the central bank can offer to sell unlimited amounts of its currency at a lower value than the current exchange rate.  The risk Krugman refers to is that they might have to buy up a lot of assets, and then later sell them off to prevent an outbreak of inflation (with a risk of capital losses.)  That’s a fair point, but it probably applies more to a small country whose currency is a popular safe haven, than to Japan.  It’s hard for me to believe that the sort of monetary base increase required to depreciate the yen would expose the BOJ to unacceptable risk of capital loss.  And if it did, it begs another question; if they don’t want a big and volatile monetary base, what the heck are they doing setting a zero inflation target?  A two or three percent inflation target will result in a much lower monetary base to GDP ratio, and probably a more stable one as well.

So here is where we are:

1.  The Japanese are supposedly stuck in a deflationary trap, even though their CPI has been amazingly close to their zero long run inflation target.

2.  Even the core CPI shows only exceedingly mild deflation

3.  Every time the rate of inflation threatened to break above zero, the BOJ tightens monetary policy.

4.  It’s known that temporary currency injections are ineffective, but the BOJ nonetheless sharply reduced the base in 2006 only a few years after doing QE.

5.  The BOJ refuses to set a 2% inflation target, like normal central banks.

How in the world is all that not consistent with a central bank that officially targets zero inflation, but would prefer a bit of deflation to a bit of inflation?  And since absolutely perfect price stability is a practical impossibility, didn’t the BOJ get the mild deflation that they clearly prefer to mild inflation?  So what precisely is the problem?  Where is the policy failure?  I just don’t see it.

Sometimes I think you need to stand back and look at how policymakers act, not what they say.  For example, every time President Carter or President Clinton put out feelers about normalizing relations with Cuba, Castro would commit some outrage, to undercut the initiative.  At some point don’t you have to ask yourself whether Castro really wants 100,000s of rich Cuban-American tourists flaunting their wealth, buying up hotels in Havana.  How long would communism last if Castro couldn’t use the trade embargo as an excuse?   (Which is precisely why an anti-communist like me has always been opposed to the embargo.)

My hunch is that if Krugman was sitting around a poker table with his former colleagues Svensson, Bernanke and Woodford, having a few beers, they wouldn’t be talking about how sorry they felt for the poor BOJ officials, unable to escape their quicksand-like deflationary trap.  The only debate would be over whether they were incompetent buffoons or evil reactionaries.  (I believe they are well-intentioned reactionaries.)

I’ll grant Krugman one very important point.  He was one of the first to point to the conservative nature of modern central bankers, and how their strong desire to maintain a reputation as inflation fighters threatens to drive the world into deflation (or at least disinflation.)  It looks like Krugman might have been right.  But I’m not willing to grant them a sort of “central bankers will be central bankers” excuse.  The world shouldn’t have to spend trillions on fiscal stimulus just because central bankers have made a fetish of stable prices.

Believe me, if you put 12 Paul Krugmans on the BOJ policymaking board, you’d get inflation.