Archive for August 2011


Not enough

I’ll be travelling in Italy and unable to approve new commenters, or old commenters with multiple links.

The post title refers to my reaction if the Fed does something while I’m gone.

Update 8-26-11: Important story in The Economist.

When legend becomes fact, print the legend

I view the 1920s as a sort of golden age of macroeconomics, before Keynes ushered in the long dark night.  The standard model was similar to the AS/AD model we teach in intro textbooks.  Nominal shocks have real effects in the short run, but merely lead to higher prices in the long run.  Irving Fisher argued the business cycle was “a dance of the dollar.”  He discovered the Phillips curve.  Most economists pointed to wage and price rigidity as the cause of short run non-neutrality, the same explanation that we see in modern textbooks.  People like Fisher, Pigou, Wicksell, Cassel, Hawtrey, etc, did great work in the 1910s and 1920s.  And last but not least, there was the Keynes of the Tract on Monetary Reform (1924) and the Treatise on Money (1930.) 

Hicks (1937) argued that the only thing in the General Theory that was really new was the zero rate trap.  Otherwise it was all known to the economists of the 1920s.  But Keynes had a big ego, and wanted to claim he had revolutionized macroeconomics, rather than just dress up well known ideas in a different language.  So he grossly distorted the actual macro of the 1920s, by creating a fictional “classical” economics where the economy is always at the long run run equilibrium.  His contemporaries were outraged, but since Keynesian economics won out in the long run, modern textbook writers accepted his version of events.  Now we teach all our students a bunch of falsehoods, such as the myth that the pre-Keynesian economists had no explanation for high unemployment.  Or that MV=PY is the quantity theory of money.

Brad DeLong is quite knowledgeable about economic history, so I was surprised to see him buy into the myth of interwar “classical” economics.  He quotes this passage from the GT with approval:

The General Theory of Employment, Interest and Money: The idea that we can safely neglect the aggregate demand function is fundamental to the Ricardian economics, which underlie what we have been taught for more than a century. Malthus, indeed, had vehemently opposed Ricardo’s doctrine that it was impossible for effective demand to be deficient; but vainly. For, since Malthus was unable to explain clearly (apart from an appeal to the facts of common observation) how and why effective demand could be deficient or excessive, he failed to furnish an alternative construction; and Ricardo conquered England as completely as the Holy Inquisition conquered Spain. Not only was his theory accepted by the city, by statesmen and by the academic world. But controversy ceased; the other point of view completely disappeared; it ceased to be discussed. The great puzzle of Effective Demand with which Malthus had wrestled vanished from economic literature. You will not find it mentioned even once in the whole works of Marshall, Edgeworth and Professor Pigou, from whose hands the classical theory has received its most mature embodiment. It could only live on furtively, below the surface, in the underworlds of Karl Marx, Silvio Gesell or Major Douglas. . . .

The celebrated optimism of traditional economic theory, which has led to economists being looked upon as Candides, who, having left this world for the cultivation of their gardens, teach that all is for the best in the best of all possible worlds provided we will let well alone, is also to be traced, I think, to their having neglected to take account of the drag on prosperity which can be exercised by an insufficiency of effective demand. For there would obviously be a natural tendency towards the optimum employment of resources in a Society which was functioning after the manner of the classical postulates. It may well be that the classical theory represents the way in which we should like our Economy to behave. But to assume that it actually does so is to assume our difficulties away. 

Ah, the old “let well enough alone” myth.  A poll in the late 1920s of 282 economists showed that 251 favored a monetary policy aimed at price level stabilization.  Isn’t that sort of like New Keynesian inflation targeting?  And of course the University of Chicago economists of the 1930s favored a combination of fiscal and monetary stimulus. 

What Keynes did was move the profession away from the idea of monetary cures for business cycles–which actually can be effective, toward the idea of fiscal cures, which (short of WWII) are almost never effective.   It would take many decades for money to be rediscovered.  Indeed the influence of Keynes was so powerful that even in 2009 there were many Keynesian economists who should have known better who suddenly announced that monetary policy couldn’t work at the zero bound, and that fiscal stimulus was needed.  Fortunately those Keynesians rediscovered money much more quickly this time, indeed within 2 years.

The End of History: Why the Fed will fail

In 1989 Francis Fukuyama made a bold prediction.  The world would become increasing democratic and market-oriented.  Other political models would gradually wither away.  He called this “The End of History.”  Here are a couple facts about his prediction:

1.  It would be difficult to find any other prediction in the humanities or social sciences that has proved more accurate.  There are many more democratic countries than in 1989, and policy has become much more market-oriented in most countries.

2.  When intellectuals discuss his prediction today, 99% assume it failed to come true.  Indeed most utter the phrase “the end of history” with undisguised contempt.

The juxtaposition of these two realities has made a deep impression on me.  How can we explain why so many brilliant people have failed to acknowledge Fukuyama’s prescience?  In some cases people were too lazy to even inquire as to exactly what the term ‘end of history’ meant.  In other cases they were too mesmerized by what they saw on the evening news. After all, doesn’t it look like “history is being made tonight in Libya”?  In fact, history is probably (knock on wood) ending in Libya.  For the rest of my life it is unlikely that I’ll ever know the name of another Libyan leader.  At least I hope not.

My theory is that it looks very much like history is not ending, if you rely on impressions, not facts.  After all, the cable networks are increasing able to bring political strife into our living rooms, which would have been invisible in past years.  I’m old enough to remember major strife in various parts of the world receiving zero coverage on TV.  Massacres in Africa.  The Cultural Revolution in China.  Pol Pot.  The 1982 massacres in Hama.  The list could go on and on.  The world seems increasing violent, even as it becomes increasing peaceful and democratic and market-oriented.   

How does this relate to the Fed?  Here are two facts about monetary policy.

1.  Economic theory strongly suggests that NGDP falling 11% below trend in the last three years has severely depressed real output (regardless of what other factors might have also depressed output.)

2.  Economic theory strongly suggests that the Fed could have prevented this sharp slowdown in NGDP growth.  Interestingly, the Fed agrees.

The implication is that Fed errors of omission caused much of the Great Recession.  Yet very few economists believe that.  No matter how powerfully theory and empirical evidence point in one direction (the end of history, the Fed’s at fault) if it doesn’t SEEM THAT WAY, even very bright intellectuals will go with the gut, and then invent whatever theoretical rationales they need to make their prejudices plausible.  Policy impotence.  A Fed capable of unlimited money creation is somehow incapable of debasing the dollar.  Structural problems.  Even though unemployment didn’t rise significantly during the big housing crash of January 2006 to April 2008, gosh darn it that housing crash must be to blame for 9% unemployment, because it seems like it’s to blame. 

Imagine the FOMC were composed of 12 Spock-like characters, brutal logicians devoid of any biases.  Ruthless in their reasoning.  Then they might have been able to devise an effective response.  But FOMC members are not Vulcans; they are flesh and blood humans, subject to all the usual biases.

I’m not asking the Fed to do any more than it’s technically capable of doing.  But alas, I am asking it to do more than it’s humanly capable of doing. 

That’s why the Fed will fail.  Oh, they might do something useful, make things somewhat better.  But there is no chance that they will do what Spock would do. 

Part 2.  What is the minimum acceptable action?

I don’t want to end this post on such a downbeat note.  Here’s Jim Hamilton:

I would suggest that the more important and achievable goal for the Fed should be to keep the long-run inflation rate from falling below 2%. The reason I say this is an important goal is that I believe the lesson from the U.S. in the 1930s and Japan in the 1990s is that exceptionally low or negative inflation rates can make economic problems like the ones we’re currently experiencing significantly worse. By announcing QE3, the Fed would be sending a clear signal that it’s not going to tolerate deflation, and I expect that would be the primary mechanism by which it could have an effect. Perhaps we’d see the effort framed as part of a broader strategy of price level targeting.  .  .  .

And while I’m offering predictions, I might as well make it a triple. If events do take this turn and Bernanke does act again, he’ll be the subject of personal political attacks even more vicious than we’ve seen so far. But I expect the Fed chair to go ahead with the policy in those circumstances anyway, because he knows it’s the right thing to do. I could even imagine the Texas Governor delivering a rousing speech, praising in his appealing drawl those who have the courage to make a personal sacrifice for the larger good.

But I don’t expect the Governor to include in such a speech recognition of one person who deserves such praise.

So both Hamilton and Greg Mankiw have suggested a price level target with a 2% trend growth rate.  These are both highly respected moderates who don’t shoot from the hip like I do.  They both praise Bernanke.  I see this as a real test for Bernanke and the FOMC.  If the Fed won’t even do this little amount . . .   Something that would not require tearing up the (implicit) 2% inflation target and replacing with another number.  Something that would anchor the price level and remove any lingering fears of high inflation.  A policy that could be defended even if the Fed didn’t give a damn about unemployment at all, if the Fed lacked a dual mandate.  If they won’t even do that much, then the Fed will have abdicated all responsibility.  

Even the Hamilton/Mankiw proposal would represent failure, relative to what the Fed would be expected to do if rates weren’t stuck at zero.  But at least it would be something (unlike Operation Twist, which seems like nothing to me.) 

PS.  I think Hamilton got a little ahead of himself in the final sentence.  I’d replace “deserves” with “would deserve.”

Update 8/23/11:  I just saw that Matt Yglesias has a similar observation.  Maybe my 99% comment was hyperbole.

Northern Italy bleg

I’m planning a 12 day expedition to try to boost Italy’s NGDP, and hence cut their debt/GDP ratio. I’d appreciate any restaurant suggestions for Vicenza, Padua and Milan. 

Blogging will probably not be possible, as I won’t bring a computer.  Let’s hope the news isn’t as bad as during my trip to Wisconsin a couple weeks ago.  BTW, I forget to mention my Wisconsin top 10 list after my trip.

1.  House on the Rock  — Shag carpet on the ceiling!

2.  Taliesin – Sublime.

3.  Capital building — one of America’s finest.

4.  Wisconsin Dells — like Vegas/Orlando, but much more kitschy

5.  Johnson Wax///Wingspread  — Frank Lloyd Wright in Racine

6.  Devil’s Lake  — Wisconsin lacks great scenery, but the southwest is attractive in a low key way.

7.  Unitarian Church in Shorewood Hills  — called one of the 5 best churches in America.  Most people living a mile away have never heard of it.

8.   Farmers and Merchants Bank in Columbus – Louis Sullivan’s last “jewel box” bank.

9.   Union Terrace, UW student Union in Madison – Back when I was in school a 16 year old could buy a pitcher of beer and sit by the lake drinking all evening.

10.  Milwaukee Art Museum  – designed by Calatrava–I need something in Wisconsin’s only big city.

Most of these are close to Madison, which is the state’s best city.

Lindsey and DeLong discuss me

Well that’s certainly something I’d never expected to see, some prominent pundits talking about my ideas on

Brink Lindsey is sympathetic to my argument.  Brad DeLong suggests that my plan would require the Fed to do twice as much bond buying as under QE2, and keep doing it month after month.  (I.e. about $200 billion/month in bond purchases.)  I’m not sure where he got those figures, but I won’t criticize him.   After all, right after QE2 I said it was roughly half of what the Fed needed to do.  He may have been referring to that comment, or perhaps that’s just his own take on what would be needed.  Brad made the quite reasonable point that it’s politically difficult for the Fed to do enough to end the recession.   I agree; if it weren’t difficult they probably would have already done it.  

And yet, I’m not willing to give up so easily.  Here’s a few other possibilities. 

1.  There are things the Fed could try that don’t involve printing money, and hence might be less controversial.  The most obvious is a lower IOR.  Interest on reserves is seen as a subsidy to fat cat bankers, and it’s opposed by many on both the left and the right.  Of course if you believe the banks control the Fed, you will tell me this can never happen.  But if the banks control the Fed, why would they let NGDP expectations fall so sharply in 2008, and again recently, badly hurting bank balance sheets.

2.  The Fed could try Greg Mankiw’s suggestion of level targeting.  That’s not a cure-all.  But I’m convinced core inflation is likely to remain below 2% for some time.  And 2 and 1/2 year TIPS spreads are only 1.3%.  This would give the Fed room to ease.  It would provide even more room if that started the level targeting from the point at which rates hit zero—which is the theoretically appropriate point in time, according to Woodford, et al.  We are now well below that trend, according to either the core or headline rate. 

3.  The Fed could try for 5% NGDP targeting.  This might be acceptable to the right, as it would take “hyperinflation” off the table.  In addition, throughout history I’d guess that at least 75% of the economists who advocated NGDP targeting were right of center (Hayek, McCallum, quasi-monetarists, etc.)  They could tell Barney Frank that unlike a strict inflation target it addresses the Fed’s dual mandate.  I’d actually prefer slightly higher than 5% during the catch-up period.  But things are so bad now that even 5% would be an improvement.

DeLong might argue that those alternative policies would also require the Fed to buy up lots of bonds.  But that isn’t necessarily the case.  Indeed if the policy were credible, it’s very possible that we could get by with a reduction in the currently bloated base, which includes trillions of excess reserves that are doing nothing.

So even though Brad DeLong’s skepticism about the politics of monetary stimulus is quite persuasive, I’m not willing to throw in the towel.  There are things the Fed can do that are less controversial than QE2 on steroids, and surprisingly, might be even more effective.

HT:  Dennis and Brito