Archive for February 2011

 
 

Inflation targeting is a very bad idea

Mark Sadowski triggered an interesting discussion in a previous thread with the following comment about the UK:

The HICP was up 3.2% yoy in November. The core HICP was up 2.5% yoy in November. The HICP at constant tax rates was up 1.5% yoy in November. There is no “core HICP at constant tax rates”, but simple subtraction suggests that if there were one, it would be up by 0.8% yoy in November. Which means all the hysteria about inflation in the UK is a lot of nonsense.

Now I think we all agree price level targeting is superior to inflation targeting, and that NGDP level targeting is better still. But if you are going to target inflation rates than you should at least be targeting a measure of “inflation inertia”. The headline HICP in the UK is seriously skewed by the volatile energy and food component and the two VAT increases. Using the correct measure of inflation inertia, the real danger in the UK right now is deflation, not inflation.

All indications are that the Bank of England plans to tighten policy this May, with the idea of reducing aggregate demand growth in Britain.  At a time of fiscal retrenchment, it is hard to overstate how misguided that policy is.  And it will be justified by reference to the BOE’s mandate to engage in inflation targeting.  If you think that is bad macro policy, then by implication you need to rethink the utility of inflation targeting.  Here’s another way of stating how confused people are about stimulus.  Suppose it is a good idea for the BOE to be raising rates in May.  In that case, if it were true that fiscal retrenchment reduced the UK’s GDP in Q4, then that would be good news.

Mark’s comment points to one of the most serious problems with inflation targeting—there are all sorts of different inflation rates that people can point to.  Headline inflation, inflation without food and energy, inflation holding interest rates fixed, holding the VAT fixed, etc.  This creates a “gap” or grey area, where it is not clear whether the central bank should ease or tighten.  In contrast, NGDP targeting is crystal clear.  There is only one NGDP.  If the UK were doing NGDP targeting, there would be no discussion of tightening in May, indeed they might ease by cutting rates a quarter point, or doing more QE.

Some liberals argue that this problem can be solved with fiscal stimulus.  Not so.  Fiscal stimulus works if and only if it raises AD, and by implication inflation (the SRAS is never completely flat.)  If the central bank has the wrong inflation target, no amount of fiscal stimulus can boost AD.  But additional fiscal stimulus can very much hurt AS.  Indeed Britain has raised the top rate to 50% because of all the fiscal stimulus under the previous Labour government.  This takes away Britain’s one big supply-side advantage over the continent, lower taxes on high-paid professionals in the City.  Tight money and high taxes are a toxic combination.  Just ask Herbert Hoover. 

Two years ago I pleaded with Obama to talk to Christy Romer.  I speculated that she favored monetary stimulus, and in another post I asked if Larry Summers was blocking access to the President.  It was certainly bizarre to see Obama let 3 Fed seats lie empty for an extended period of time; he clearly didn’t understand the importance of monetary policy.  In a new column in the New York Times, Christy Romer confirms my suspicions.  She was aware of the need for monetary stimulus.  She does understand that it can be effective at the zero bound.  She does understand the importance of level targeting.  If you put her and Larry Summers in a room together, most people would find Summers to be the far more impressive figure.  I’d guess that President Obama did as well.  Big mistake.

The commenter Ram provided the Romer link, and had this to say:

She has called for more monetary expansion before, but this is the clearest she has been about what she has in mind, not to mention how urgently monetary expansion is needed. It makes me wonder whether Prof. Sumner’s old post about Larry Summers being the Dick Cheney of the Obama administration might have some merit. Romer clearly supported and supports fiscal stimulus, but I seem to recall Larry Summers discussing the need for a large, government spending-oriented fiscal stimulus in mid-2008, before the bottom truly fell out of the economy. Maybe Romer was insisting on the importance of standing behind good monetary policy, so Summers deliberately kept her out of the inner circle. Hard to know, but it’s remarkable that she’d make this dramatic of a pivot so soon after leaving the White House.

There’s an easy way to tell unsophisticated old Keynesians from the more sophisticated new Keynesians.  Do they call for fiscal stimulus when interest rates are positive.  Even Krugman admits that there is really no case for fiscal stimulus until rates fall to zero.  In September 2008 rates were at 2%, and the Fed refused to cut them after Lehman failed because they were worried about inflation.  Indeed a month earlier some at the Fed wanted to raise rates (and I believe the ECB did raise rates.)  In that environment fiscal stimulus does nothing.

But I don’t want to be too hard on the old Keynesians.  When central banks around the world are this confused and incompetent, it’s not hard to see why people grasp for fiscal stimulus out of sheer frustration.  Most people don’t have a clue as to how monetary stimulus works, or why it neutralizes fiscal stimulus (especially why it does so at zero rates.)  Fiscal stimulus is really easy to grasp at an intuitive level.  Throughout history, only a tiny number of economists have intuitively grasped the incredible power of monetary stimulus (even at zero rates) and also understood the need for monetary stimulus when NGDP is inadequate.  Irving Fisher was one and Milton Friedman was another.  Lots of people are aware of the power of monetary policy.  Lots of people understand the need for stimulus.  But damn few can see both.  And that’s why we are where we are.

BTW:  A long time ago I promised to post the video of Bentley’s team winning the Fed Challenge.  It is finally available:

http://www.youtube.com/watch?v=pYl9AtIGAoQ&feature=feedu

Congratulations.

Random links

Part 1: Yesterday I did a post showing how all sorts of prominent people on the left recently engaged in the fallacy of composition.  On the same day, Nick Rowe posted an even better essay on the fallacy of composition in macro.  Highly recommended.

Part 2:  As you know, I’ve been highly skeptical of fiscal policy multipliers, partly for reasons of monetary policy offset.  That’s not to say I’m dogmatically obsessed with a zero multiplier argument.  I’d guess that suddenly slashing public sector jobs reduces real GDP, if only for re-allocation reasons.  But what I can’t accept is the sort of argument illustrated in this graph, which received favorable mention by Menzie Chinn and also a link from Brad DeLong (without comment):

.

.

.

.

.

.

.

.

.

.

Look at the lowest counter-factual line.  How likely is it that Ben Bernanke allows that to happen?  We’d have been on QE7 by the end of 2009.  I find it hard to comprehend how these exercises are taken seriously.  Last summer the Fed basically drew a line in the sand at about 1% inflation—they simply aren’t willing to allow inflation to fall much below that level.  As long as we’re close to 1% inflation, more or less fiscal stimulus has little effect.  Not zero, but much less than these naive models predict.

Part 3:  I haven’t talked about China in a while.  The Economist has four neat interactive graphs here.  A few surprises; (Inner) Mongolia has rapidly climbed up the GDP per capita rankings, undoubtedly due to the mining boom.  Zhejiang seems to have slipped sharply relative to Jiangsu and Guangdong provinces in the last couple years–does anyone know why?  A result of provincial cheating on the figures?  Migrant labor distorting population? 

Also, I notice that the most populous provinces are no longer inland Sichuan and Henan, but coastal Guangdong and Shandong.  That’s a sign China’s population is moving east, albeit gradually.  If you want to see how concentrated their export machine is, take a look at the graph below (in billions of dollars).  As you do so, recall that numbers 2, 3, and 4 on the list are actually one place, the Yangtze River delta.  And most Guangdong exports come out of the relatively small Pearl River delta.  If you circled those two areas on a map of China, they would look tiny.  Rapid growth is happening all over China, but export growth is still highly concentrated.

The things we teach that aren’t true

One could write an entire book discussing all the assertions in economics textbooks that are not true.  I seem to recall that Coase complained that economics textbooks kept using lighthouses as an example of goods that can only be supplied by the government, even after it was shown that private organizations had supplied lighthouses. 

I don’t know whether textbooks claim that supply shocks help explain the high inflation of the 1970s, but at a minimum they leave that impression.  In fact, the high inflation of the 1970s was caused by monetary policy.  As the following data suggests, NGDP rose extremely rapidly during the 1970s and early 1980s.  Because RGDP rose at pretty much the same (3%) rate it rises in any other decade, fast rising NGDP is both a necessary and sufficient condition for the Great Inflation.  The only question is what caused such rapid growth in NGDP, or M*V.

1970 5.5
1971 8.5
1972 9.9
1973 11.7
1974 8.5
1975 9.2
1976 11.4
1977 11.3
1978 13.0
1979 11.7
1980 8.8
1981 12.1
1982 4.0

To the extent that oil shocks have any effect on NGDP, it is probably contractionary.  That’s why NGDP growth slowed in 1974 and 1980.  Thus the energy price shocks contributed almost nothing to the Great Inflation, although they help explain why inflation was higher in some years than others, as oil shocks tend to temporarily depress RGDP growth.

Marcus Nunes sent me a quotation from a 1997 paper by Bernanke, Gertler and Watson:

Macroeconomic shocks such as oil price increases induce a systematic (endogenous) response of monetary policy. We develop a VAR-based technique for decomposing the total economic effects of a given exogenous shock into the portion attributable directly to the shock and the part arising from the policy response to the shock. Although the standard errors are large, in our application, we find that a substantial part of the recessionary impact of an oil price shock results from the endogenous tightening of monetary policy rather than from the increase in oil prices per se.

Bernanke got to put this theory in action in late 2008, when the Fed tightened monetary policy in response to the high oil prices of mid-2008.  In this case monetary policy was much tighter than in 1974 or 1980.  In those earlier cases, NGDP growth slowed a bit, but RGDP slowed much more, producing “stagflation” in both years.  In contrast, in late 2008 monetary policy was so tight that we ended up with a disinflationary recession in 2009.

I was looking at the GDP deflator data and noticed an interesting pattern.  During my entire life (I was born in 1955) the GDP deflator rose by 1% or less only twice.  Any guesses?  Hint, they were the two years when many right wing economists predicted skyrocketing inflation as a result of the Fed’s supposedly ”easy money” policy of late 2008.  The period right after they doubled the monetary base in just a few weeks.  That’s right, only 2009 and 2010 saw a GDP inflation rate of 1% or less.

The implication of the Bernanke, et al, study is that the Fed shouldn’t overreact to supply shocks, or else they might trigger a recession.  Let’s see how they respond to the current surge in oil prices.  The early indications are that nothing has been learned:

One of the Federal Reserve‘s leading hawks warned Wednesday of the risks of maintaining easy monetary policy in the face of rising commodity prices

PS.  Some people think that Jimmy Carter had “bad luck” because of the 1979 revolution in Iran.  Look at NGDP growth in the years before the revolution—a period when oil prices were stable. 

Update, 2/26/11:  Marcus Nunes just sent me this link to his blog.  He had previously made the same point, with much more comprehensive data.

HT:  Marcus Nunes

Small is irrelevant (in macro)

Paul Krugman and I occasionally disagree on the fine points of some macro issue, but almost never do I see him making a basic logical error.  Until today:

Dean Baker points us to Feyrer and Sacerdote, who use cross-state variation in stimulus spending per capita to estimate the employment effects of the stimulus. They find a clear positive effect: states that got more money per person did better on jobs. And as Baker points out, the national effects must have been larger, since some money spent in New Jersey presumably creates jobs in New York and vice versa.

One thing I might point out, by the way, is that this is something of a “Well, duh” result. Of course more federal spending in a given state or county creates more jobs. And the burden of proof should always have been on stimulus critics to explain why this doesn’t mean that stimulus spending creates jobs at the national level too. In normal times you can argue that the positive job effect of higher spending is washed out by higher interest rates — that fiscal expansion will be offset by contraction on the part of the Fed. But with interest rates up against the zero lower bound, that argument doesn’t apply.

The argument about Fed policy in the second paragraph is flat out wrong, as I’ve pointed out 100s of times.  But even if it is right, this study tells us nothing about the macro effects of fiscal stimulus.  It’s a near perfect example of the fallacy of composition.  Every single anti-stimulus model would predict exactly the same finding at the micro level.  If the federal government builds a billion dollar military base in Fargo, North Dakota, I think all economists agree that the number of jobs increases—in Fargo, North Dakota.  Does the number of jobs increase at the national level?  Very possibly yes, but nothing in the Feyrer and Sacerdote study addresses that question.  Krugman, Dean Baker, Brad DeLong, etc, are very smart guys, I don’t know why they keep hyping this study. 

Even worse, Krugman suggests that their instrumental variable analysis (which used state population) tells us that stimulus mattered.  Small states got more aid, and small states did better job-wise.  My preceding argument suggests that study is also irrelevant, but there’s another problem here.  Smaller states may have a different industry mix (say more commodity-oriented) that allowed them to better ride out the recession.  So it’s doubly irrelevant.

By the way, just a few weeks ago I criticized a Brad DeLong post on similar grounds.  If Paul Krugman would have read that post he would have avoided falling into the fallacy of composition.

Micro studies can’t tell us whether fiscal stimulus works.  Micro studies can’t tell us whether monetary stimulus works.  Micro studies can’t tell us whether RBC or sticky price models are better.  Micro studies can’t tell us anything about macro.  That’s why macro is a different field.

Why do the best arguments against the RBC model involve exchange rates?

The “real business cycle” model has led some conservatives to claim that monetary stimulus will merely lead to more inflation, not more real economic growth.  They don’t believe that nominal shocks have real effects.

The two most famous arguments against the RBC model both involve exchange rates.  One argument was discussed in a recent post by Paul Krugman.  He presented a graph showing that real exchange rates became vastly more volatile after the Bretton Woods exchange rate regime was abandoned around 1971.  You might ask: So what?  Is it any surprise that exchange rates became more volatile after the world abandoned fixed exchange rates?  It’s not surprising that nominal rates got more volatile, but real rate volatility is a bit more of a surprise.  Recall that the RBC model predicts that nominal shocks won’t have real effects.  (Indeed even some non-RBC types like Milton Friedman didn’t expect such dramatic volatility.)

A second example was recently discussed by Ryan Avent; the famous study (by Barry Eichengreen) that showed countries tended to begin recovering from the Great Depression precisely when they left the gold standard.  Again, if nominal shocks don’t have real effects (as some RBC proponents claim), then this pattern is hard to explain.

I don’t recall anyone explaining why economists use foreign exchange data to refute the extreme RBC view that nominal shocks don’t matter.  After all, nominal shocks are also supposed to have real effects in closed economies.  Why not use a more conventional indicator of monetary stimulus, such as the money supply, or interest rates, or the inflation rate?  One answer is that it’s very hard to identify monetary shocks using those indicators.  Low rates may reflect easy money, or they may reflect a weak economy expected as a result of tight money.  A big increase in the money supply might reflect easy money, or might be the Fed accommodating more demand for base money in response to past deflationary policies.  The rate of inflation might rise due to supply shocks, or due to demand shocks.

In the interwar period there was a pretty good correlation between money, prices, and output, as there were big monetary shocks that led to procyclical movements in the price level.  That looks good for conventional demand-side models.  But postwar data is less clear.  Now the monetary authority tries to offset changes in velocity, so money and prices are much less clearly correlated with output.

Exchange rates are almost ideal in two respects.  Unlike interest rates and the money supply, a rising value of the dollar is a relatively unambiguous indicator of tighter money, and vice versa.  And unlike changes in inflation, it’s pretty easy to separate out changes in exchange rates that reflect exogenous policy decisions, and those that reflect other factors.  For instance, both the abandonment of the gold standard, and the abandonment of Bretton Woods were pretty clearly exogenous policy decisions.  Indeed they were “monetary policy” broadly defined to include “changes in the international value of one’s money.”

I prefer NGDP, but many of my critics say that indicator assumes away the question.  How do we know central banks can influence NGDP? I think that’s wrong, especially if you use expectations, but nevertheless exchange rates are clearly something that governments can control.

I recently mentioned some very suggestive data for Sweden and Denmark, and a commenter named Justin Irving (a student at Uppsala University) sent me data which repeats the two famous experiments that I cited above, albeit in a slightly less impressive way (only three observations.)  He sent me graphs showing NGDP and RGDP for three major Nordic countries.  (Norway was not included, presumably because its vast oil wealth would make it an unrepresentative country.)

.

.

.

.

.

.

.

.

.

.

.

.

.

.

.

.

.

.

.

.

.

.

.

.

.

.

.

.

.

.

.

.

.

.

.

.

.

.

.

.

.

.

.

.

.

.

.

.

.

.

.

.

.

.

.

.

.

.

.

.

.

.

In 2008 both Denmark and Finland were either in the euro, or fixed to the euro.  Sweden was floating, and as soon as the recession hit it allowed the krona to depreciate sharply.  As you can see from the graphs above, Sweden’s NGDP grew significantly faster than the other two.  This is no surprise; both RBC and conventional macro models would predict this result.  But now look at RGDP growth.  The RBC model suggests that devaluing a currency will simply result in higher inflation, not faster RGDP growth.  Yet it’s clear that Sweden did much better than Denmark and Finland in terms of RGDP.  Why is that?  I believe the faster NGDP growth caused the faster RGDP growth.  A real business cycle proponent would presumably say it was just coincidence, just as it was coincidence that America started recovering in 1933 and France began recovering in 1936, etc.  Lots of interesting coincidences.

All these natural tests of the RBC model lead me to wonder what we can infer from the fact that economists use exchange rates, not conventional monetary indicators, when attempting to refute the RBC.  What does that tell us about contemporary monetary economics?  Here are some answers:

1.  Postwar conventional macro models that identify monetary shocks on the basis of interest rates or money supply changes are not reliable.  Instead when researchers want convincing evidence they reach back to the definition of monetary policy provided by that “monetary crank” of the 1930s, George Warren.  Warren proposed that monetary shocks were changes in the price of gold.

2.  We need a variable that gives a clear and unambiguous indication of changes in the stance of monetary policy (like exchange rates), and which also can be measured in real time, (like exchange rates.)

3.  The best way to get that variable would be for the Fed to create and subsidize a NGDP (and RGDP) futures market. 

No longer would we have to wait for serendipitous experiments like the staggered ending of the gold standard, or the end of Bretton Woods.  We’d have a perfect real time indicator of monetary shocks.  We could observe how Fed actions (and policy speeches) impacted NGDP futures prices.  We could observe how changes in NGDP futures impacted various real variables.  The actual parameters of all sorts of macro models would lay naked and exposed, like the skeleton of a dead animal lying in the midday Libyan sun.  Want to know the slope of the SRAS?  Is Plosser right or is Krugman right?  Just compare the reaction of RGDP and NGDP futures to a sudden Fed announcement that under the pressure of regional Fed presidents, QE2 was being ended prematurely.  Something tells me that Plosser would not be happy with the answer that the markets would give him.

The experiments discussed by Krugman and Avent tell us something important (and unpleasant) about modern RBC models.

The fact that those experiments had to rely on exchange rate shocks tells us something important (and unpleasant) about modern conventional macro.