Archive for December 2012


Old anxiety (and a bit of auld lang syne-ity as well)

I notice that other bloggers are discussing the big events of 2012, or predicting the big events of 2013.  I don’t do predictions, other than to echo market predictions.  (Yes I know; how boring!  And yes, that does mean I’m not an alpha male.)

I suppose this means I think Chinese growth will keep plugging along at 8% plus, as that number seems to be embedded in market forecasts.  So if the markets are wrong then I will have also been wrong.  Ditto for any previous errors made by the market consensus.  This puts me at odds with people like Michael Pettis (he predicts a sharp slowdown in Chinese growth.)  I think Chinese growth will slow, but gradually.

This is also a time for New Year’s resolutions, but I’m too unselfish (or too much a realist) to think that I’d ever actually fulfill promises to myself.

As I look back over the past 4 years I see a steady deterioration in this blog.  The posts are increasingly simplistic, repetitive, grouchy and snarky.  Bill James says that baseball players peak at age 27.  I don’t know when “peak blogging” occurs, I’d guess somewhere between Evan Soltas’s 19 and my 57. Probably somewhere in Ezra Klein/Matt Yglesias/Ryan Avent/Bryan Caplan territory.  I’m over the hill.

When I reread my posts from the first year it sometimes seems like they were written by a completely different (and better) person.  Slightly more naive, but also more idealistic and less cyclical.  It would be nice to blame others for my decline—perhaps I’ve gotten worn down by interacting with those commenters who are both insulting and moronic.  On the other hand my many brilliant commenters have probably raised my game a bit.

If 2012 was a bad year for in terms of style and sophistication, it was a good year for the ideas I am promoting.  Market monetarist themes (especially NGDPLT, but also the importance of aggressive monetary stimulus at the zero bound) are increasingly influential.  The zeitgeist is slowly moving in our direction.

Another “excuse” (or is it “explanation” I’ve never been clear on the distinction) is that I was overworked in 2012.  In the fall semester I taught an overload, and had to deal with a lot of travel and other outside obligations.  I suppose many people would be able to handle my workload with no problem, but I’ve lived for decades with a certain lifestyle, and then suddenly added in 40 or 50 extra hours a week of writing posts, answering comments and reading other posts and articles.  And I type everything with two fingers.

I hate the feeling of always being busy.  And since I’m not good at saying no, the work keeps piling up.  The good news is that I don’t have to teach in 2013 and thus will be less overworked.  My Depression book is scheduled to (finally!) be released later in the year, and I plan to use my sabbatical to turn my blog into a book.

PS.  One comment on prediction.  If it’s prestige you seek, then the key is not to be right, but rather to be perceived as being right.  Contrast Fukuyama’s 1989 prediction of a global move toward democracy and market economies, with Shiller’s 1996 prediction that stocks were overvalued.  Fukuyama was right and Shiller was wrong, but almost everyone thinks exactly the opposite.

If you seek success in the stock market, then you need to be correct (Keynes was wrong; it’s not a “beauty contest.”)  But if it’s social success you seek then the key is to feed the prejudices of your audience.  Each year you need to keep predicting the Chinese “bubble” will collapse.  Then when China eventually has a mild recession, everyone will forget your previous misses and hail you as a genius.

And always be a pessimist, as pessimism is the intellectually fashionable pose.  Being an optimist in an intellectual milieu is as jarring as wearing Doris Day pinks to an art show in Chelsea.

PPS.  Grouchy?  Wait until you see me discuss the fiscal cliff deal.

Feed the dragon (but not too much)

Yesterday I developed a monetary post using a dragon parable.  In a bizarre coincidence Frances Woolley has beaten me to it.  Here’s my version:

There’s a enormous dragon living just outside a village of peasants.  If the dragon is not adequately fed it lashes out and destroys part of the village.  If it’s overfed then it produces lots of noxious gases.  This is not as damaging as an underfed dragon, but not optimal either.  There is a bell that rings whenever the dragon needs to be fed, but the bell often malfunctions.

I’d like to use this parable to better explain my post from a few days back, where I argued that the recent US recession was triggered in late 2007 by the Fed’s failure to provide enough $100 bills for tax evaders, drug dealers and foreigners (TDFs).

It just so happens that TDFs have a growing demand for $100 bills.  If the Fed doesn’t meet that demand, we get a recession.  If they feed too many $100 bills into the economy, then we get excessive NGDP growth (aka “demand-side inflation.”)  Not as bad as a recession, but not optimal either.

This post met with lots of objections.  Some pointed out that the Fed can’t control how much of the new base money goes to the TDFs in the form of $100 bills.  That share is “endogenous.”  Yes that’s true, but has no bearing on my post.  The same is true of the M2 money supply.  The Fed controls the base, not the ratio of M2/MB. That ratio (called the “M2 multiplier”) is determined by the public (and the Fed via reserve requirements.) And the ratio of $100bills/MB is also determined by the public. However the Fed can target either M2 or the quantity of $100 bills, if it wishes to do so.

My point was that a recession occurred because the Fed did not meet the rising demand for base money in late 2007 and early 2008.  And secondarily, that that increased demand came mostly from TDFs wishing to hold more $100 bills.  Go back to the dragon analogy, and now assume there are three dragons.  The big one represents the hunger for $100 bills by TDFs.  Another dragon, less than half as large, represents the demand for currency for transactions.  And a third, roughly 1/10th as large, represents the demand for bank reserves in 2007.  The villagers throw food into the dragon den, but can’t control how the dragons divy it up. Damage from underfed dragons is proportional to the size of the dragons, and the extent to which they are underfed.

Another criticism was that the entire monetary base is endogenous.  Nick Rowe has some excellent posts that clarify the “endogenous money” issue.  Whenever the central bank pegs one variable (say exchange rates, gold prices, or M2, or the base, of the fed funds rate, or inflation), then all other variables become endogenous.  But once again, that has no bearing on my argument.  I wasn’t claiming the Fed targeted the base, much less $100 bills.  They don’t, and they shouldn’t.  They tend to target the fed funds rate in the very short run, and then adjust the fed funds rate every so often in order to target inflation or NGDP over longer periods of time.  But that fact has no bearing on whether a shortage of $100 bills caused the recession.

Let’s see how things change if the Fed has a fed funds target.  Some people argued that any extra demand for $100 bills would be smoothly accommodated by the Fed, which would supply enough cash to keep interest rates stable.  Like the bell in the dragon example, the fed funds rate often does send out timely signals.  But on occasion the bell fails to ring when the dragons are hungry, and on occasion the fed funds rate does not send out a warning that the TDFs need more $100 bills.  Late 2007 and early 2008 was one of those failures.  You could say the recession was “caused” by a malfunctioning bell, but I prefer to say it was caused by underfed dragons lashing out at the villagers.

The interest rate signalling mechanism only works well if the Wicksellian equilibrium interest rate is constant.  In late 2007 and early 2008 the Wicksellian equilibrium rate fell sharply.  The Fed did cut the actual fed funds target somewhat, but not enough to keep the TDFs well fed.  As a result the supply of currency, which had been trending upward at roughly 5% per year for many years, suddenly stopped growing.  And this was associated with a sharp slowdown in the rate of growth of M*V, where M is defined as the monetary base.  In an accounting sense, the sharp slowdown in the growth in the base caused the recession.

However this is not my preferred way of thinking about the problem, as it may (wrongly) suggest that if only the Fed had kept the base growing at 5% per year we would have avoided a recession in late 2007.  Maybe, but maybe not.  It’s quite possible that 5% more base money would have led to 5% less velocity.  I prefer to talk in terms of the Fed’s control of M*V, where a monetary policy failure occurs when the Fed allows M*V to grow too fast, or too slowly.  But that’s not good enough for most people, they want the process explained using what Nick calls “concrete steppes.”  They ask “What caused velocity to suddenly plunge in late 2007 and early 2008?”  To those people I say, “Velocity did not plunge, indeed it rose slightly.”  If you want “concrete steppes” using the old M*V=P*Y workhorse, then I’d say the recession was caused by sudden stop in base growth, and a failure of V to rise enough to offset this “monetary tightening.”

There are no policy implications from the fact that during normal times most of the growing demand for base money comes from TDFs squirrelling away lots of $100 bills.  If the Fed runs a sensible monetary policy, they will smoothly accommodate those shifts in base demand.  But that will only occur when and if the Fed replaces the faulty “fed funds target bell” with a much more reliable “NGDPLT futures bell.”

PS.  Astute readers like Nick, Bill and Saturos will notice that I’ve avoided the question of whether the MOE role of money is central to the entire process.  They might argue that only the smaller two dragons can actually damage the village.  At worst, an underfed big dragon takes food away from the smaller two dragons.  So the big dragon can be a problem, but only indirectly.  I think the big dragon can directly damage the village.

Ted Kennedy, Godfather of American Neoliberalism

Ed Lopez recently reminded us of the pivotal role that Ted Kennedy played in the US neoliberal revolution.  (I define neoliberalism as deregulation of market access and pricing, privatization, freer trade, and lower MTRs.)

By the mid-1970s, criticism of airline regulation had moved from academics to economists in think tanks (Brookings, AEI) and in government. At an economic conference on inflation convened by the Ford Administration, the delegates focused unexpectedly on a different idea: existing regulations were producing high prices. Yet as every economist in Washington knows, many reform ideas never become policy. Then came the political entrepreneurs.

First, Senator Ted Kennedy. An ambitious member of the Senate Judiciary Committee and chairman of the subcommittee on administrative procedure, Kennedy saw an opportunity to attack the over-regulated and under-competitive airline industry by critically examining the rules it played by.

Most judiciary subcommittee hearings were mind-numbingly boring, but airlines were sexy, and Kennedy turned the CAB hearings into high theatre, trotting out real but outrageous examples. A flight from Los Angeles to San Francisco (intrastate and thus not CAB-regulated) cost half as much as a flight from Washington to Boston (interstate and CAB-regulated). Even the dimmest reporter could connect the dots. The CAB looked bad. Kennedy looked good, as did the odds for reform.

Then the Carter Administration tapped Kahn to run the CAB.  . . .

Kahn built on Kennedy, who built on the work of intellectuals in Washington’s think tanks and policy circles, who in turn built on good academic research. Importantly, he found allies across the political spectrum, from the American Conservative Union to Common Cause, from business interests to consumer groups. This odd mix prevented easy dis­missal of reform as the pet project of the left, the right, or any special interest.

With passage of the Airline Deregulation Act of 1978, Congress closed the CAB and left behind an unprecedented example of radical reform.

This success was followed by the deregulation of many other industries, including banking and trucking, all with bipartisan support.

Then in 1986 there was a push for tax reform.  The Packwood plan would slash top income tax rates down to 28% (from 70% when Reagan first took office.)  A significant number of GOP senators were opposed, but fortunately the highly influential Ted Kennedy stepped up to the plate, and top income rates were slashed.

In the early 1990s both Bush and Clinton fought for NAFTA.  But the very popular Ross Perot was opposed, and it was a difficult battle in Congress.  Al Gore debated Perot, and swung American public opinion behind the plan.

[Which, BTW, shows the utter meaningless of so-called "public opinion" on issues where the public hasn't actually studied the issue.  It's not just the framing problem with polls, when the public actually focuses on an important issue, they give very different answers.  Were the public to actually study the budget situation, you can be sure that they'd understand the need for something more than taxes on the rich and cuts in foreign aid.]

In the Senate vote Ted Kennedy stood with Clinton, and NAFTA became law.

So next time you progressives bemoan the loss of the glorious 1950s and 60s, with our unionized factory workers protected from foreign competition, and our highly regulated industries, and our 70% to 90% top MTRs, remember the man without who’s support the neoliberal revolution in America might not have been possible.

Noah Smith on innocence

Here’s a wise old man named Noah Smith:

Monetarists are an innocent lot. American bloggers, op-ed writers, and economists seem quite taken in by Japanese Prime Minister Shinzo Abe’s promise of a grand monetary experiment. Abe is threatening to revoke the Bank of Japan’s independence, forcing those recalcitrant hard-money-loving inflation hawks to set a hard target of 2% inflation or higher. To an American monetarist, this is really Christmas. Finally, we get to actually test the hypothesis that a central bank can hit an inflation target if it really puts its mind to it! Finally, we get to see the ultimate two-men-enter, one-man-leaves doomsday showdown between the immovable object of Japan’s implacable deflation and the irresistible force of Print Money And Buy Stuff!

But it is not to be. Shinzo Abe is not the Jesus of monetary policy. American monetarists, I feel for you – I would love to see the idea of monetary policy dominance put to a stark test – but I just don’t think it’s going to happen.

It would be interesting to know which monetarists Noah is talking about.  (The only “innocent” monetarist Noah links to is Matt Yglesias, who is neither innocent nor a monetarist.)  Like Noah, I’ve been skeptical of the intentions of the Abe government, noting that bond yields don’t show much sign of inflation expectations.  On the other hand the yen has weakened, so there’s likely to be at least a modest change in policy.  But I put faith in markets, not politicians.
Noah continues:

You see, unlike most Americans who weren’t watching back in 2006-2007, I remember Shinzo Abe’s first term as PM.

Unlike most Americans, so do I.  And my hunch is that lots of bloggers have been following Japanese politics since before Noah was born.

PS.  We already know that central banks can hit 2% inflation targets, they’ve been (approximately) doing that for decades.

PPS.  And we already know there is no such thing as liquidity “traps,” the yen wouldn’t have depreciated on Abe’s comments if there were.

It’s (almost) all about the Benjamins

In the past I’ve argued that monetary policy mostly consists of Federal Reserve changes in the currency stock. Yes, the monetary base also includes “member bank deposits” at the Fed, but prior to 2008 that was only about 5% of the base.  And even that tiny share was mostly a disguised tax on banks, in the form of required reserves. If we took that requirement away (as we should) then the base would be more than 99% currency (including coins) in normal times.

Several people sent me a link to a recent discussion of the recent big increase in $100 bills in circulation.  Another link shows that the currency stock is currently about 75% composed of $100 bills, and that that share is rising rapidly.  Because these bills are used only rarely in transactions, and because during normal times their rate of return is dominated by equally risk-free FDIC-insured bank accounts, the demand for “Benjamins” is mostly attributed to tax evaders, drug dealers and foreigners.  Let’s call these people “TDFs.”  Also note that this demand has little to do with the famous “equation of exchange,” as most $100 bills are not used in US transactions during a given year, and most transactions do not involve currency.  Instead let’s use the Cambridge equation (M = k*PY) and think in terms of the total demand for Benjamins as a share of US GDP.

Now let’s explain what caused a recession to begin in December 2007.  Between July of 2007 and May of 2008 growth in both the monetary base and the stock of currency in circulation suddenly halted.  In previous years they had been increasing at a fairly steady rate of about 5% per year.  If the Cambridge k had fallen at this time, this would not have been a problem.  But the TDF’s thirst for Benjamins did not suddenly end in late 2007 and early 2008.  So when the Fed refused to meet that demand, and k did not fall sharply, NGDP growth had to slow dramatically.  The actual and prospective slowdown in growth in the currency stock tipped the economy into a recession in December 2007.

As the economy slowed sharply, market interest rates declined.  This reduced the opportunity cost of holding Benjamins, and after mid-2008 the k ratio began rising.  Now the Fed saw its mistake, and began increasing the supply of Benjamins more rapidly.  But not fast enough, and as a result the recession got even worse.  But this time the culprit was a rising k ratio.

What about the claim that monetary policy is about the control of short term interest rates?  I’d prefer to put it this way; most central banks like to target short term interest rates, and do so by (mostly) adjusting the current and expected future supply of Benjamins.  And I would add that the “expected future supply” is especially important, as economists like Woodford like to emphasize.  (Actually he emphasizes expected future interest rates, but in any case it’s future monetary policy that matters.)  So even if the injections of new base money initially go into banks, during normal times 95% of that extra base money spills out into currency within a few days.  It’s all about the Benjamins.

In normal times the demand for Benjamins by TDFs tends to trend upward at around 5% per year, or even more.  If the Fed refuses to meet that demand, you’ll get a recession, regardless of what they do or don’t do to interest rates, reserve requirements, IOR and all their other policy instruments.  It’s all about the Benjamins.

And remember that Benjamins are rarely used in transactions, so this model isn’t much different from Fama’s famous “spaceship” model, where the medium of account was permits to operate a spaceship.  Fed policy in 2007 mostly consisted of adjusting the quantity of a medium of account that wasn’t even primarily a medium of exchange; it was mostly a store of value.  It really doesn’t matter what you make the medium of account, just make sure that its value falls at a steady 5% per year, where “value” is defined as the share of NGDP that can be purchased with each unit.

PS.  It might be objected that the Fed can no longer control the stock of Benjamins, once rates hit zero.  Extra cash simply goes into bank ERs.  Maybe, but the same objection could be made about M2.  And no one thinks it weird when monetarists talk about control of M2 as the essence of Fed policy.  In fact, the Fed can control the stock of currency even at the zero bound.  The question is whether or not they want to.  And if they went back to the pre-1914 system where the base was 100% currency, then monetary policy would be nothing more than currency control.

Instead, we are headed for a cashless society (however despite pleas by Miles Kimball–it’s at least 50 years away) where the Fed will control policy by adjusting IOR–interest on reserves.  Finally the Keynesians will be right.  And when they are, they’ll (wrongly) insist that they were right all along.  The bad news for Keynesians is that once that happens no one will be able to claim a role for fiscal policy.  And that WAS true all along.

HT:  Chuck E, et al.