A nightmare from which we will not awake

Here’s Matt Yglesias:

If you look at the last two bits of big-time macro stabilization failure in the west—the Great Depression and the inflation of the 1970s—you got what I’d call a change of regime as a result. The Depression discredited the gold standard and a whole set of related notions. The Great Inflation discredited ideas about the Phillips Curve (note interestingly that Keynes himself warned about this). So now we’re here again mired in failure and we’re getting … what?

Very good point (although he’s far too kind to Keynes.)  Matt continues:

We had, until recently, the Great Moderation Consensus that automatic fiscal stabilizers are a good thing and then beyond that the Federal Reserve has the ability to stabilize the macroeconomy by fiddling with interest rates. Well now here we are and the Federal Reserve can’t stabilize the macroeconomy by fiddling with interest rates. That calls for the creation of a new regime. But it’s clear that despite a few stabs in the direction of Quantitative Easing and communications management that Ben Bernanke isn’t going to give it to us. It’s not simply that the current recession isn’t being brought to a rapid end, it’s that nothing whatsoever is being done about the underlying weaknesses in the American economic system that it revealed.

It’s too soon to throw in the towel.  In the spring of 1940 the US unemployment rate was quite high—and we’d been in depression for more than 10 years.  Neither government officials nor academics had any good ideas about how to bring the rate down.  (Then Germany invaded Western Europe.)  In the 1970s we were well into the Great Inflation, and still clueless about how to deal with it.  So there is still time.  Yglesias continues:

This is a really big deal. It means that either we need to discover a new paradigm for stabilizing aggregate demand, or else we need a whole new way of thinking about economic policy choices that doesn’t assume the economy will operate at nearly full employment over the long-term. New paradigms for demand management seem to strike a lot of America’s policy elite as uncomfortably radical, but if you think about it the implications of the other option are much more radical.

We’ve been here before.  In the early1930s the conservative establishment would not accept monetary stimulus, so we ended up with much more radical and less effective programs like the tariffs, the WPA and the NIRA.  In the 1970s the liberal establishment would not accept monetary contraction, so we ended up with much more radical and less effective programs like wage/price controls.  Matt’s right that in an environment without demand stabilization it becomes much harder to dismiss radical ideas.

The good news is that we did eventually learn from the 1930s and 1970s.  So there’s still hope.

The bad news is that in some respects I think it’s even worse than Yglesias suggests.  This is the first recession in my entire life where nominal interest rates fell to near zero.  And yet I wouldn’t be at all surprised if this occurred in every single future recession during my lifetime.  In my view, Japan is the future of the global economy.  Not the deflation (I think the Fed will be able to keep inflation close to 2%) but the low real interest rates.  In retrospect the 2001 recession (when rates fell to 1%) was the canary in the coal mine.  Nominal rates will probably be unusually low from this point forward.  Global saving will increase dramatically as Asian countries get richer (remember that most people are Asians) and slowing population growth outside of Africa will dramatically reduce the demand for investment funds.

Need I say something about the S=I identity?   :)

Yglesias says this recession has exposed flaws in the dominant interest rate targeting approach to monetary policy.  That’s true.  The interest rate establishment in economics is hoping that this is just a nightmare that will pass away over time.  They are as attached to interest rates as their grandfathers were to the gold standard. But what if this is the new normal?

It’s likely that rates will rise as we recover.  But if I’m right about future recessions, we’ll be facing the same problem over and over again.  We’re committed to a policy regime that totally freezes up at the moment we need it most.   We market monetarists are standing on the sidelines willing and able to offer advice, just as soon as policymakers realize that the zero rate bound is quite likely to occur in future recessions.

We don’t necessarily have to adopt NGDP level targeting, or NGDP futures contracts, but we certainly do need to move away from a monetary theory and policy apparatus based on the notion that interest rates are the be-all and end-all of monetary policy.

HT:  Marcus Nunes


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51 Responses to “A nightmare from which we will not awake”

  1. Gravatar of marcus nunes marcus nunes
    2. February 2012 at 06:13

    One consequence is that they keep searching for “structural” explanations!
    http://thefaintofheart.wordpress.com/2012/02/02/it%C2%B4s-the-baby-boomers-fault-a-new-stab-at-a-structural-explanation/

  2. Gravatar of Nick Rowe Nick Rowe
    2. February 2012 at 06:15

    Yep. On the demographics and interest rates angle: it’s not just that populations are aging. What I think is unprecedented, globally, is that a lot of people are expecting to retire a long time before they expect to die.

    A simple model used to be a 2-period OLG model. In the first period you were young, and in the second period you worked. That has changed to a 3 period OLG model. We’ve added a third period, where you are retired. And that third period is getting longer. So the desired stock of savings is getting bigger. Which means lower equilibrium real interest rates.

    Aside from monetary policy questions, we need to start thinking about Samuelson 1958, only in a world of uncertainty. NGDP bonds ought to be able to handle the uncertainty, by indexing to NGDP, not CPI.

  3. Gravatar of Greg Greg
    2. February 2012 at 06:40

    “And yet I wouldn’t be at all surprised if this occurred in every single future recession during my lifetime. In my view, Japan is the future of the global economy. Not the deflation (I think the Fed will be able to keep inflation close to 2%) but the low real interest rates. In retrospect the 2001 recession (when rates fell to 1%) was the canary in the coal mine. Nominal rates will probably be unusually low from this point forward. Global saving will increase dramatically as Asian countries get richer (remember that most people are Asians) and slowing population growth outside of Africa will dramatically reduce the demand for investment funds.”

    I think this nails it. The problem of retirees, who are already “undersaved” for retirement, will be a drag on future growth, which will increase the threat of future deflation, and will help drive rates lower. The only thing that may contradict this, however, is that there will also pressure on governments to support retirees through social security-like programs because they are a big voting block and because they will be in a crisis. This will drive up deficits , which could theoretically increase rates, but I don’t think this has ever really been proven for an economy that prints its own currency.

    Governments could also increase taxes, which I believe would decrease rates. So overall, there will be downward pressure on rates. It used to be you thought you could retire on $1MM and live off the short-term interest rates….now instead you would need $5MM to live the same way! To me, this is deflationary. This is the only way I could understand economists like Rajan arguing that the fed should raise rates, because of the drastic punishment it is delivering to savers.

    Also, see Cochrane: http://johnhcochrane.blogspot.com/2012/01/demographics-and-stock-prices.html

  4. Gravatar of ssumner ssumner
    2. February 2012 at 06:48

    Marcus, Good point. It’s bizarre that the NGDP time path suggests that AD is the problem, but because they don’t know how to or are unwilling to fix it, they go into denial and try to insist the problem is structural. NGDP problems aren’t structural.

    Nick. Good point. Have you read Shiller’s paper on NGDP bonds?

    Greg, Good points. And the problem with raising rates is that Japan tried it in 2000 and 2006, and the ECB tried it last April. And all three times the economy slowed and they had to cut them again. They were putting the cart ahead of the horse.

    I forgot about deficits. I suppose that might cut the other way, as you suggest, but I just don’t think they’ll be big enough. Deficits large enough to keep rates high would probably push the debt/GDP ratio to unacceptable levels. I agree with your point that the evidence that deficits raise rates is pretty weak for countries with their own currencies.

  5. Gravatar of ssumner ssumner
    2. February 2012 at 06:54

    Greg, The Cochrane article is a good one.

  6. Gravatar of david david
    2. February 2012 at 07:06

    Why not argue for a higher NGDP target then, so that recessionary interest rates will be above the ZLB?

  7. Gravatar of Morgan Warstler Morgan Warstler
    2. February 2012 at 07:35

    “This is a really big deal. It means that either we need to discover a new paradigm for stabilizing aggregate demand, or else we need a whole new way of thinking about economic policy choices that doesn’t assume the economy will operate at nearly full employment over the long-term.”

    And Matty misses completely through-out everything he writes on the subject…

    My Guaranteed Iincome is far better stimulus because it both ends uneployment and creates downward wage pressure.

    New rule: good stimulus encourages liquidation / market clearing

    —–

    Matty can’t talk about employment without explicitly glaringly exposing his illogical underpanties:

    1. He SAYS we need inflation to bring down wages.
    2. He wants stimulus to get full employment.
    3. BUT, he never hits on a strategy to use the least amount stimulus to drive down wages to clearing level.

    In his mind, we have to use the HIGHEST AMOUNT of stimulus….

  8. Gravatar of Mike Sax Mike Sax
    2. February 2012 at 07:53

    So if nominal interest rates are near zero for the long term guess there’s no reason to argue with the MMTers who always said we should keep them at zero no matter what…

    “We don’t necessarily have to adopt NGDP level targeting, or NGDP futures contracts, but we certainly do need to move away from a monetary theory and policy apparatus based on the notion that interest rates are the be-all and end-all of monetary policy.”

    So if you can’t get NGDP anything or even inflation smoothing would you take if that’s all that’s on offer a temporary raise of the inflation target?

    Seems to me that at least Bernanke could say something that has been suggested-that as full employment is the part of the mandate they are failing on maybe until the unemployment rate goes beneath say 7 percent they will tolerate higher inflation than 2%.

  9. Gravatar of Randy Randy
    2. February 2012 at 08:23

    Of course your proposals for NGDP are the best way to solve problems with monetary policy. However, it seems to me that a big reason we are going to keep bumping against the ZLB is the lower inflation target of 2% that the central bank is looking at and using it as more of cap. Could this issue not be solved (partially) by having a higher inflation target of 4% that Karl Smith and others have advocated?

    The complete policy regime shift is desirable, but I’m not sure it is necessary.

  10. Gravatar of James in London James in London
    2. February 2012 at 08:36

    Apart for ending IOR and talking about targetting NGDP, both of which you often advocate, how should the Fed achieve higher NGDP? Or are those two policy tools enough? What else practical would you urge them to do? I keep missing those posts on hard policy actions.

    Your scepticism on BoE QE and silence on the ECB’s LTROs (which have Europe agog, if not the US), leaves me a bit puzzled.

  11. Gravatar of UnlearningEcon UnlearningEcon
    2. February 2012 at 09:14

    ‘Very good point (although he’s far too kind to Keynes.’

    I think the fact that Robert Lucas taught you Keynes has affected your perceptions heavily, Scott. It must have been all the whispering and giggling.

  12. Gravatar of dwb dwb
    2. February 2012 at 09:15

    personally, I think 2-2.5% on the 10-year treasury should be the new normal. There is no reason one should get a real return on virtually a risk-free bond thats a pretty close money substitute. Now its not really risk free (some inflation volatility and interst rate risk) but on average if one thinks that the Fed will hit a 2% inflation target its hard for me to justify much more than 2.5% on the ten year.

    Any “real” return treasuries have accrued over the last 30 years is merely an artfact of the great disinflation. There is nothing wrong at all with seeing 2% on a 10-year treasury, its a result of substantial credibility the Fed has built up over 30 years.

    For example, I see Tim Duy quoting some other blogger i’ve never heard of lamenting the “toxicity” of low rates. however will the Fed get us out of the next recession.

    The trough real rate on short term rates (e.g. FF-PCE) coming out of recessions has varied, hitting about about 0 in 92 and -2% in 2003 (its hard to draw conclusions before the 90s since for example PCE was still 3+% into 92, above the Feds comfort zone, so disinflation had not not yet been achieved).

    But if one thinks the 2000 recession is in some sense “typical” then 0% Fed funds coming out of a recession would be perfectly consistent with 2% inflation.

    But that is the price of money.

    Keep in mind that the return on investment requires taking some risk, like building a factory. It is perfectly consistent to see low 10-year treasury rates in the 2% range but high ROI on savings (e.g. wide credit spreads) because all the money needs to be put to work building things for those future wealthy people who will suddenly demand more autos and ipads and such.

  13. Gravatar of George George
    2. February 2012 at 09:30

    Contrary to oft repeated myth, the Great Depression was caused by the lack of a proper gold standard, the opposite of what is suggested, i.e., that gold was somehow responsible. A hard money system where liabilities are 100% backed by hard assets (risking bankruptcy or fraud litigation otherwise) would not support the systemic boom-bust cycles that are present with a fiat money system combined with fractional reserve banking. Read “What has Government done to our money?” by Murray Rothbard for more detail.

  14. Gravatar of Cthorm Cthorm
    2. February 2012 at 09:41

    @dwb

    Really? 10-year treasury yields under 2% are outrageous. Today it’s more like 1.818%. That is a negative real return if you’re a buy-and-hold investor. The only source of returns on treasuries now is capital gains, because the US is the cleanest dirty shirt in the drawer. How do you fund an annuity these days? You should be investing in extremely low-risk assets that provide a very modest return, but doing that will drain your principal now!

    I’m really shocked that a reader of this blog says this: “There is nothing wrong at all with seeing 2% on a 10-year treasury, its a result of substantial credibility the Fed has built up over 30 years.”

    Credibility? The same kind of credibility the ECB has as a central bank that refuses to do it’s job of allowing modest inflation to maximize employment.

    >Keep in mind that the return on investment requires taking some risk, like building a factory.

    Yes, riskier investments provide higher returns. But in almost every other situation of the last 100 years one of those risks has not been ‘the overall economy will be significantly SMALLER next year’.

  15. Gravatar of Lars Christensen Lars Christensen
    2. February 2012 at 09:52

    Scott, “This is the first recession in my entire life where nominal interest rates fell to near zero. And yet I wouldn’t be at all surprised if this occurred in every single future recession during my lifetime. In my view, Japan is the future of the global economy.”

    This is too pessimistic Scott. Why would you think that? We have the instruments to pull out of this. It nearly seems like you are saying that we are in a “New Normal”. I am more optimistic. Money supply growth is accelerating in the US (and the markets are pretty clearly indicating monetary easing) and even in the euro zone it seems like LTRO is leading to an increase in the money base. This is stealth QE. Neither the Fed nor the ECB dare say what they are doing, but I am pretty sure that we are moving in the right direction. It is not Japan yet (and of course Japan did eventually do QE).

    Lets keep an optimistic view of the world – otherwise we might as well become Austrians…

  16. Gravatar of dwb dwb
    2. February 2012 at 09:54

    incidentally, deficits might raise rates except i think it depends largely on the extent to which the Fed leans against them to subdue any potential inflationary implications.

  17. Gravatar of Benny Lava Benny Lava
    2. February 2012 at 10:18

    Scott,

    I agree that you well nail it, and that this is the new normal with Japan as a template. I know a lot of people that are into doomsday stuff and I think they are more afraid of the status quo going on for a long time.

  18. Gravatar of dwb dwb
    2. February 2012 at 10:28

    @Cthorm,

    In general, no, I would not expect any real return to goverment bonds from here on out (nor any capital gains). PCE inflation has averaged about 2% since the mid-90s and the 10-year is telling you to expect a little less than that over the next ten (PCE probably overstates real inflation a tad too). Sounds like a strong validation of the efficient markets hypothesis to me… real return requires real risk-taking. Yes, the Fed has built up substantial credibility – that does not mean i agree with the policy, its just a statement of fact that the market generally belives the fed has achieved what it set out to do (~2% inflation) and will continue to do so. As for how one funds an annuity, thats a pretty complicated question. depends on what return one has promised, mortality assumptions, and so on.

    But, yes, if you want positive real returns, you need to invest in something like stocks, corporate bonds, land, and so on. I don’t know why a reader of this blog would expect the government to do a better job investing money than themselves, or someone with (even a half decent) business plan to build widgets.

  19. Gravatar of Benjamin Cole Benjamin Cole
    2. February 2012 at 10:29

    “This is the first recession in my entire life where nominal interest rates fell to near zero. And yet I wouldn’t be at all surprised if this occurred in every single future recession during my lifetime. In my view, Japan is the future of the global economy. Not the deflation (I think the Fed will be able to keep inflation close to 2%) but the low real interest rates. In retrospect the 2001 recession (when rates fell to 1%) was the canary in the coal mine. Nominal rates will probably be unusually low from this point forward. Global saving will increase dramatically as Asian countries get richer (remember that most people are Asians) and slowing population growth outside of Africa will dramatically reduce the demand for investment funds.”

    I suspect this is exactly right.

    A query: Forever, we economists have talked about taxing consumption and not investment income. Time to change? What if there are constant gluts of investable capital? We if we need to encourage consumption?

  20. Gravatar of Major_Freedom Major_Freedom
    2. February 2012 at 10:43

    “We’ve been here before. In the early 1930s the conservative establishment would not accept monetary stimulus, so we ended up with much more radical and less effective programs like the tariffs, the WPA and the NIRA.”

    The conservative establishment would not accept monetary stimulus?

    The Fed very much did engage in monetary stimulus throughout the entire 1930s!

    Oh that’s right, I forgot the escape clause monetarist tautology: They couldn’t have engaged in monetary stimulus because GDP/NGDP/employment didn’t rise enough.

    One can never be wrong with that as a theory.

  21. Gravatar of Cthorm Cthorm
    2. February 2012 at 11:03

    >But, yes, if you want positive real returns, you need to invest in something like stocks, corporate bonds, land, and so on. I don’t know why a reader of this blog would expect the government to do a better job investing money than themselves, or someone with (even a half decent) business plan to build widgets.

    These are all investments with a very different risk profiles, tax considerations, and income/return characteristics. This is exactly how you have to fund an annuity/retirement fund these days. If interest rates were not pushed so low, which wouldn’t be necessary if the Fed had picked any one of several more reliable targets (inflation, NGDP, taylor rule), then one could earn a 2-5% return on 10year treasuries. That is an appropriate return for a risk-free investment when you consider the time-value of money. I’m not saying that the spread between treasuries and riskier assets should be smaller, I’m saying that pushing the risk-free rate below zero is bad for investors, but especially for the risk-averse sort.

  22. Gravatar of ssumner ssumner
    2. February 2012 at 11:07

    David, I don’t think we need to do that. If we have a 5% NGDP target, level targeting, then liquidity traps won’t be a problem.

    Morgan, He has different goals.

    Mike Sax, They won’t always be at zero with a 2% inflation target–perhaps if we had Japan’s deflation target they would be.

    But in any case pegging rates at zero leads to hyperinflation in the long run, unless they are produced via a deflationary monetary policy. I don’t think MMTers want that.

    Mike and Randy, If the Fed wants to stick with the current policy, then yes, a 3% inflation target would be better. I doubt 4% is needed, at least if they are serious about 3%. (They haven’t been serious about 2%.)

    James, I believe the key is to either do NGDP futures targeting, or NGDP level target (preferably both.) If you do those things, I’m not sure much more is needed. You could probably even keep IOR (although I’m not a fan of that policy for excess reserves.) The monetary base should be made endogenous.

    UnlearningEcon, You said;

    “I think the fact that Robert Lucas taught you Keynes has affected your perceptions heavily, Scott. It must have been all the whispering and giggling.”

    Actually Lucas is a fan of Keynes. But he didn’t teach me anything about Keynes.

    I learned my Keynes from reading the Tract, Treatise and General Theory. How about you?

    dwb, I reach the same conclusion from a different perspective.

    1. With taxes on interest, there is nothing “fair” about zero real yields. The after tax yield is negative.

    2. These yields have been well above zero for most of a century, so the explanation must come from changes in saving and investment schedules. I don’t agree that it’s at all a money substitute. Not even close. Try spending a 10 year bond at Walmart.

    George, No, the gold standard was a major factor in the Great Depression. The idea of a “pure” gold standard is as much of a myth as a pure fiat money system, untainted by government.

    Lars, My comment wasn’t meant to be pessimistic, just a prediction. There’s nothing at all wrong with zero rates as long as we keep NGDP growing at 5%. And I certainly do think we will pull out of this. But if we don’t change monetary policy we’ll fall right back in during the next recession. As I pointed out in the post it took us a while to learn the lessons from the Great Depression and Great Inflation–I hope with your support we eventually learn the lessons from this debacle. It’s up to our policymakers and pundits.

    Benny, Thanks. Jut to be clear I’m not predicting Japanese nominal rates, just Japanese real rates. I think nominal rates will cycle between 0% and 4%, unless we change policy.

    Ben, That’s one approach, but I’d rather solve the problem with a better monetary policy.

  23. Gravatar of Cthorm Cthorm
    2. February 2012 at 11:25

    >Actually Lucas is a fan of Keynes. But he didn’t teach me anything about Keynes.

    I learned my Keynes from reading the Tract, Treatise and General Theory. How about you?

    You weren’t talking to me, but I’ll answer anyway. I learned my Keynes from Robert Crouch, Perry Shapiro, Marek Kapicka, and Henning Bohn. They taught me about Tract, Treatise and General Theory. The most informative into Keynes himself was actually from old interviews with Hayek. Hayek knew Keynes very well, in that friendly competitive way, and he had a very high opinion of Keynes as an economist. But Hayek also saw that Keynes was inexpressibly cocky and willing to change his opinions on a moment’s notice. Hayek even remarked that Keynes should have called “General Theory” the “Special Theory”. Of course Keynes died before the economy ever normalized, thus he never got the chance to change his opinion one last time.

  24. Gravatar of Alex Godofsky Alex Godofsky
    2. February 2012 at 11:52

    Scott, I think you are a little to blase about the prospect of low interest rates. During the aughts even when we had normal NGDP growth we still saw low interest rates, and it’s at least possible that with 5% growth the natural nominal rate of interest could fall below 0, at which point the bond market wouldn’t clear. That would at least constitute *some* sort of macro problem even if the central bank keeps NGDP on track.

  25. Gravatar of Max Max
    2. February 2012 at 12:01

    Has the conventional wisdom completely flipped? I thought most economists were predicting high real rates eventually due to strains on Social Security etc. (Although this is contradicted by the one data point we have, Japan).

    I noticed that the batch of Fed ‘predictions’ including a long term Fed Funds of >4%, which implies >2% real. (What’s the historical average? Closer to 1% isn’t it?)

  26. Gravatar of dwb dwb
    2. February 2012 at 12:19

    1. With taxes on interest, there is nothing “fair” about zero real yields. The after tax yield is negative.

    2. These yields have been well above zero for most of a century, so the explanation must come from changes in saving and investment schedules. I don’t agree that it’s at all a money substitute. Not even close. Try spending a 10 year bond at Walmart.

    you are absolutely right about taxes of course but PCE probably also overstates inflation; the government provides a safety net and buys bombs and drones, and does an extremely poor job capturing “welfare gains” from its policies so personally, i think a negative real return on U.S. treasuries sounds about right. I dont think the century-comparision for returns is apt since there has been a lot of monetary policy regime changes and a lot more historical inflation risk – the philly fed survey of professional forecasters forward inflation expectations for example did not achieve a ~2.5% expected long-term inflation rate until about 1997 which is somewhat a line in the sand for me insofar as Fed credibility. prior to that, lots more risk IMO. Anyway, if you really want to hedge your own personal future consumption against price increases first you need to know what they are likely to be (heath care, food, and vacation lodging?) and invest in a basket that captures that. I doubt the PCE captures that well.

    You are right i cannot directly spend a 10-year bond at wal-mart, but I use my debit card at Wal-Mart, which comes from my checking account. A lot of short-term money (instruments e.g. repos) backing deposits and used to transfer reserves between banks are in fact backed by collateral such as 10-year treasuries. If my bank has some capital parked in 10-year treasuries and I make a purchase at Wal-Mart and it needs to transfer money, it can lend (borrow) those, just like actual money, to effect the transfer from my bank to Wal-Mart’s bank. So i would have to say treasuries are a darn close substitute and very integral to what happens to effect the $$ exchange behind the scenes. Also, if i have them i can take them anywhere in the world, deposit them in any bank, and get money (or a checking account that comes with a debit card that i can conveniently use to buy things).

  27. Gravatar of Morgan Warstler Morgan Warstler
    2. February 2012 at 12:34

    Scott,

    Yes we know what Matty’s goals are… and he’s still a kid in flux…

    He still must be cornered intellectually and trapped.

    You are off to a good start, but ultimately he has to accept that the only reason the hegemony is going to adopt the monetary policy he wants, is WHEN he gives up the fiscal policy he wants.

    http://www.slate.com/blogs/moneybox/2012/02/02/ben_bernanke_is_wrong_about_debt_and_interest_rates.html

    Note here: if you clear the housing market, mortgage rates will go up…. and drag everything else up too. But the Fed is more concerned with the price level on housing – they are more concerned with bank balance sheets EVEN TODAY.

    If Ben could get the GVT. to lower entitlement spending and put that money into propping up home prices he’d take that deal in a second.

    Fascinating discussion above on the theory that loaning money to the gvt. should pay no return over inflation.

    There’s something there.

    I think I’d rather legislate it, and keep the gvt. from crowding out risk appetite in the private sector.

    If we’re going to provide Guaranteed Income and “Soup Kitchen Care” to the uninsured, we ought to gain something for that lift…

    The payback should be forcing people with capital to either tread water or go private.

  28. Gravatar of Cthorm Cthorm
    2. February 2012 at 12:37

    @dwb

    You are describing liquidity. Being highly liquid doesn’t make an investment instrument money, it just means there is a large market for it so that it can be exchanged for money without too much difficulty. By your definition Spyder SP500 ETFs would be money too. For both instruments you are not certain what price you will get when you sell the instrument.

  29. Gravatar of Greg Greg
    2. February 2012 at 13:16

    Max,

    Good question. It is hard trying to track the competing theories on interest rates.

    Here is what I would take as the “conventional wisdom” (future rates go up):
    http://faculty.chicagobooth.edu/john.cochrane/research/papers/John_H_Cochrane_Why_the_2025_Budget_Matters_Today_WSJ.pdf

    Hers is what I would take as the liquidity trap wisdom (rates go down):
    http://web.mit.edu/krugman/www/deflator.html

    I am pretty new to market monetarism, so I will let those purveyours respond. My guess is that they would say in the long run they agree with the “conventional view” but in the short run central banks often “take away the punch bowl” way too soon so we never get to the long run. But I could be very wrong on this.

    From my reading I would also say that there is not much consensus on the effect of large deficits on interest rates. I’ve seen Paul Krugman fret about large deficits duringthe Bush tax cut years (in effect, they would push up interest rates). Now he advocates massive deficits.

    Alternatively, I’ve seen Alan Reynolds advocate deficits during the Bush tax cut years as being no problem. Now he is completely against them because they will crowd out private spending.

    So there are also significant political games going on behind the theory.

    This is also a good post on competing theories:
    http://marginalrevolution.com/marginalrevolution/2011/10/has-the-is-lm-model-made-good-predictions-lately.html

    Take your pick!

  30. Gravatar of UnlearningEcon UnlearningEcon
    2. February 2012 at 13:18

    Cthrom,

    I think it was Schumpeter who first said that about the ‘special’ theory, and it is far from true. Keynes thought the classical (neoclassical) was the special case and only applied at full employment. His was a general theory of non full employment (not depressions, just most of the history of capitalism), and the way monetary policy could be used to approximate full employment and make the classical theory ‘true’.

    Scott,

    I just feel like you have this intrinsic bias against Keynes having been taught at the UoC in its anti-Keynes heyday. Some of the stuff you say about him seems to be a bit simplistic and based on a caricature. Your post on Keynes, for example, concludes that the overall thrust of his work was the concept of AD. You don’t even mention uncertainty or liquidity preference.

  31. Gravatar of dwb dwb
    2. February 2012 at 13:24

    @Cthorm,
    I said “darn close substitute” but no i am not (merely) describing liquidity (yes, i know what that is). liquidity is necessary but not sufficient. treasuries cannot buy goods, but are an integral part of the plumbing that makes it possible to buy goods with your debit/credit card. you can’t transfer SPY from one bank to another via Fedwire – but treasuries can be wired directly through the NY Fed and settled same day in many circumstances – which makes it possible to temporarily borrow (lend) reserves and move money between banks and between banks and the Fed. Nor can one typically post margin or collateral with SPY either. to a bank, treasuries are as good as cash, and very little else is as good as treasuries except possibly for GNMA and FNMA/Freddie MBS.

  32. Gravatar of o. nate o. nate
    2. February 2012 at 14:26

    “In my view, Japan is the future of the global economy. Not the deflation (I think the Fed will be able to keep inflation close to 2%) but the low real interest rates.”

    But, real rates in Japan aren’t that low, esp. compared to the US!

  33. Gravatar of Cthorm Cthorm
    2. February 2012 at 14:40

    @dwb

    There are many levels of ‘cash equivalents’ in practice for financial firms. Any highly-rated security with a very low duration qualifies. FNMA/FHLMC/SLMA/FHLB are just some examples. What qualifies as a ‘cash equivalent’ is totally dependent on whether you’re talking about a well-capitalized firm, a small organization, or an individual.

    I have no problem with T-Bills (maturity of 1 year or less) yielding close to zero, although it should be zero in real after-tax terms in my opinion. But treasury notes or bonds, (maturities from 10 to 40 years) are investments and not ‘cash equivalents’ in almost every sense of the word. Even by virtue of the time-value of money there should be a positive real return for such a long duration investment.

    Speaking of which, do you know what 10 year TIPS are yielding today? -0.329%.

  34. Gravatar of Cthorm Cthorm
    2. February 2012 at 14:56

    Japan CPI is at about -0.2% YoY. Japan 10 year bond yields are at 0.945%. Sounds pretty low to me Nate.

  35. Gravatar of Jim Glass Jim Glass
    2. February 2012 at 15:38

    The Fed very much did engage in monetary stimulus throughout the entire 1930s!

    By the chart you link to, you mean only during the last half of the 1930s.

    And any good economic history of the period will tell you that was not due to monetary stimulus by the Fed but was the result of gold inflows from Europe, largely due to Hitler, that were monetized as per the law of the day.

    Far from “engaging in monetary stimulus” the Fed famously disastrously tightened against this by doubling of the reserve requirement. (See the shaded part of your graph, 1937-8).

    Oh that’s right, I forgot the escape clause monetarist tautology: They couldn’t have engaged in monetary stimulus because GDP/NGDP/employment didn’t rise enough.

    That would be as naive as arguing that if the base money increased over a period of time the Fed must have been engaging in monetary stimulus, even as it increased the reserve requirement.

    FDR’s Fed Chairman, Mariner Eccles, was a fiscalist who didn’t believe money policy could stimulate and thought increased government spending was required for that. But he was afraid of inflation rising in the later 1930s due to the gold inflows, hence the doubling of the reserve requirement (and recession of 1937).

  36. Gravatar of dwb dwb
    2. February 2012 at 15:42

    should be a positive real return for such a long duration investment
    there is no “should” – the term premium is not an entitlement program. The government “invests” in social insurance programs, bombs, and guns. Caterpillar invests in machines that are used harvest food to feed hungry people and move earth to mine ores used to build housing. I have no reason to think that there “should” be a real return to treasuries just because there has been. looking at various maturity treasury bonds is merely looking at the expected price of money at various points in the future. it has nothing to do with “real” returns.

  37. Gravatar of Cthorm Cthorm
    2. February 2012 at 16:32

    @dwb

    You are venturing into whole new territory then with your theory of what constitutes money and what return is appropriate for investments in government bonds. You will have plenty to write about in your new portfolio theory, including a morals-adjusted time value of money.

    “I have no reason to think that there “should” be a real return to treasuries just because there has been.”

    And I have no reason to believe the Earth will continue to orbit the sun, just because it has in the past. There is no explanation for gravity either, it’s only justification thus far is that we observe such an attractive force.

  38. Gravatar of dwb dwb
    2. February 2012 at 18:01

    I don’t really think so. and it has nothing to do with “morals”. bond spreads are telling you there is more juice elsewhere in the real economy. the term premium in treasuries is largely a function of inflation risk and the market is telling you that there is not much if any juice left there- the Fed is likely to achieve slightly below 2% inflation over the next ten years. Given that its achieved 2% over the last 15, I happen to agree. Any other “real” return in the past is a function of the holder taking on much more risk and being rewarded by being right via lower than expected inflation. that’s gone forever and going forward is a 50-50 proposition: there’s been a regime shift in Fed policy so the analogy to past data and the sun rising is not meaningful. other than that, do I think an “investment” in a governemtn bond deserves a real return? no. At best its a nearly risk free future-money instrument (9 years and 9 months its a T-Bill and almost certainly “money”)- and merely reflects differential inflation risk across time. At worst, government projects (with some exceptions) produce a negative IRR and deserve a negative real return. Deficits are mostly only financing current consumption on some pretty useless items (useless in terms of the capacity to generate future consumption). I contrast that with caterpillar not because of morals but because I am pretty sure the machines caterpillar builds will be useful in feeding people 20-30 years from now, hence will produce future consumption, and I am pretty sure there will be a big need for food 20-30 years from now.

    I have never been a big fan of the “savings glut” argument. I have heard it many times over the years. bonds spreads are actually somewhat wider than over the 2004-2007 period which means Mr market is saying allocate capital out of treasuries and into the real economy.

    http://research.stlouisfed.org/fred2/graph/?id=BAMLC0A4CBBB,BAMLC0A1CAAA,

  39. Gravatar of Bonnie Bonnie
    2. February 2012 at 18:11

    Do you suppose that if, perhaps, we get our energy policy straightened out the Fed would be more willing to engage in “demand management?” I’m aware that, in theory, individual specifics in the economy really shouldn’t matter, but the Fed is currently concentrating on specifics, like with its housing working group, which I don’t think is helpful. About 6 months ago Bernanke made comments regarding commodity prices going through the roof with QE. Some of that can be expected, especially in recovery from a recession, but the degree to which energy, and subsequently food prices, took off, I think, has far more to do with inefficient public policy than monetary policy itself. There is likely an element of politics here, especially with angry mobs shouting outside the Federal Reserve building, that has yet to be resolved, and that Bernanke, and perhaps the rest of the Fed governors, have problems managing.

    It’s hard for me to say whether or not we are the next Japan because they did try to do the right things with QE, it just didn’t go over very well. Perhaps if we get a new President, he will get a Fed Chairman who has some brass ones, won’t be afraid to be a straight shooter, and will be able to get some of these more pressing issues resolved. Ol’ Ben might be a really great guy, but he isn’t very effective in a political sense.

  40. Gravatar of o. nate o. nate
    2. February 2012 at 19:01

    “Japan CPI is at about -0.2% YoY. Japan 10 year bond yields are at 0.945%. Sounds pretty low to me Nate.”

    Hmm, maybe the difference is using the CPI vs. the GDP deflator, but I see a World Bank real rate of 3.85% for 2010 (not sure what maturity that’s for) which is not too far off from their historical average.:

    http://www.tradingeconomics.com/japan/real-interest-rate-percent-wb-data.html

  41. Gravatar of Mark A. Sadowski Mark A. Sadowski
    3. February 2012 at 00:36

    “And yet I wouldn’t be at all surprised if this occurred in every single future recession during my lifetime.”

    My God that’s a depressing thought!

    I’ve been clinging to a cyclical theory of economic history (e.g. “The Fourth Turning” and Kondratrieff waves and other similarly superstitious nonsense).

    But what happens if there’s not turning point and we continue to persist in a perpetual “Winter” state?

    I really hope you’re wrong. In my opinion we are incredibly ignorant creatures who vastly overcompensate for past mistakes and are doomed to repeat history ad infinitum.

    As depressing as that sounds it actually sounds very much preferable to what you seem to be suggesting.

  42. Gravatar of James in London James in London
    3. February 2012 at 01:04

    Soctt. Is it really just hot air you advocate? Sorry to have to ask again, but what are the tools you recommend? Targetting NGDP through futures or levels don’t seem to me to be tools, just targets, just talk. So, I’ll ask again, what are the practical measures you think the Fed should take to achieve it’s targets? ECB-style LTROs? BoE-style QE?

  43. Gravatar of Nick Rowe Nick Rowe
    3. February 2012 at 06:58

    James in London is one of the people I was addressing in this old post: http://worthwhile.typepad.com/worthwhile_canadian_initi/2011/10/engdp-level-path-targeting-for-the-people-of-the-concrete-steppes-.html

  44. Gravatar of Floccina Floccina
    3. February 2012 at 07:41

    The way that I see it, for the Federal Reserve system to work well the median voter, many of who are still talking about hyper inflation, needs to understand how the monetary system works. The median voter is slow to learn. That is why I am an advocate of free banking, a political impossibly but perhaps some technology could bring it about. The way I see it in a free banking system even the banker do not need to understand the monetary system as a whole.

  45. Gravatar of ssumner ssumner
    3. February 2012 at 08:42

    Cthorm, Good comment.

    Alex, That’s not a problem, it’s an opportunity for Uncle Sam to borrow $15 trillion dollar interest free.

    The Fed should supply whatever base money is demanded. In practice, that won’t be a big issue with 5% NGDP growth, level targeting. Recall that Japan has zero percent NGDP growth.

    Max, I think other economists expect higher rates than me.

    dwb, I suppose the bottom line is whether increasing the base and increasing the supply of 10 year bonds has a similar impact on AD. I doubt it, at least when rates are positive.

    Morgan, I agree that a tighter fiscal policy would lead to a more expansionary M-policy.

    o. nate, Yes, but they’d be lower (in my view) if not for the zero bound. And note they are at the zero bound even during expansions like 2003-07. That tells me that they are way above equilibrium during Japanese recessions.

    unlearnignEcon, I certainly agree that liquidity preference and uncertainty is a big part of Keynes’s worldview, and indeed I think people underestimate the importance of the liquidity trap. My views of Keynes weren’t formed at the UC because he wasn’t discussed much there. It comes from my reading of Keynes, and my reading of many others who interpreted Keynes. I think Hicks and Friedman had the most interesting interpretation.

    I have a paper in Economic Inquiry on Keynes (around 1998 or 1999) if you are interested.

    dwb, You said;

    “bonds spreads are actually somewhat wider than over the 2004-2007 period which means Mr market is saying allocate capital out of treasuries and into the real economy.”

    Just to be picky, it’s impossible for capital to move out of Treasuries into the real economy, because for every seller there is a buyer. You should say that real returns were rising, suggesting less propensity to save or more propensity to invest.

    Bonnie, I don’t think energy policy has a big impact on M-Policy. It’s also a bit of a myth that the BOJ tried QE. The injections were temporary, and temporary currency injections don’t work.

    Mark, I don’t see low rates as a problem if the Fed has a sound monetary policy, so I’m not all that depressed. I think they’ll eventually figure it out.

    James, Your problem is not listening to what I say. No one who pays any attention to market monetarism could come over hear and claim that “QE is a test of market monetarism.” Yes, the central bank might have to do QE to meet it’s objective. But that’s not a policy, it’s a technique that might be used to enact a policy. If you do QE without an explicit target, there’s no expectation that it would work.

    Market monetarists want to target NGDP expectations, and do level targeting. The money supply might need to be adjusted to hit those targets, but I don’t know if it would have to be increased or decreased until we actually set an NGDP target. It depends how high the target is set.

    Floccina, I doubt the median voter will ever have a good understanding of the monetary system. At least as long as the median economist doesn’t understand the system.

  46. Gravatar of Alex Godofsky Alex Godofsky
    3. February 2012 at 09:46

    “Alex, That’s not a problem, it’s an opportunity for Uncle Sam to borrow $15 trillion dollar interest free.”

    Scott, are you saying in that case the government should actually issue more debt so it can spend more? Or that it should just sit pat and enjoy not paying interest? In the former case, under the assumption of full employment that should just divert resources from the private sector, and in the latter case you’ve got the problem that the low natural nominal rates of interest don’t just affect public debt. They also pass through to private debt. If you’ve got markets that aren’t clearing, that has to be a problem in *some* way.

    More importantly, though, is that the zero rate trap may make full employment impossible *even under NGDP level targeting*. Because of the trap bonds are underpriced, so people would like to buy more bonds than actually exist. Normally they buy the bonds with money. Now, however, money itself acts as a pretty good bond – and people can buy money with output. So *money itself* is underpriced in terms of output, and people will want to purchase more money with output than is actually possible. Each person can only get more money by reducing spending (in the sense of buying fewer consumer goods OR investment goods with it) and output falls.

    To restore full employment the money price of output would have to fall, but as we know it is really hard for nominal prices (especially wages) to fall.

    The logic here suggests that if natural nominal interest rates corresponding to your target NGDP path fall enough, that path may just be unattainable. Either you’ll have to undershoot it through a recession or overshoot it enough to make natural nominal interest rates positive.

  47. Gravatar of James in London James in London
    3. February 2012 at 12:42

    Nick Rowe. Thanks, read your piece. Hot air it mostly is, you hope. But you could still argue that the central bankers are pulling levers as best they can.

    What I find puzzling is why you and Scott are so dismissive of BoE QE and their implicit threat of more to come, the new ECB 3 year LTROs and rumours of more to come. It seems to be working.

    Both politics and correctly cautious money printers makes it difficult to raise inflation targets, sorry NGDP targets, to 5% “whatever the balance between inflation and RGDP”.

    So, King at the BoE and the new guys at the ECB have to be a bit roundabout, just like the Fed and all it’s enormous asset purchases. And they’d like to see fiscal authorities acting, or planning to act, responsibly and not just relaxing into the lovely flood of new money as we’ve seen many many times before.

  48. Gravatar of Morgan Warstler Morgan Warstler
    3. February 2012 at 12:55

    “Morgan, I agree that a tighter fiscal policy would lead to a more expansionary M-policy.”

    Perhaps you ought to explain that so others understand you better!

  49. Gravatar of ssumner ssumner
    4. February 2012 at 06:24

    Alex, No I’m not saying they should issue more debt, and no the market will clear. The Fed issues enough cash for the market to clear. The $15 trillion figure (15 times the normal monetary base) is the actual public debt. So buy it all. If the demand for liquidity still hasn’t been satiated then start buying foreign government bonds from Germany and Canada and Japan and Britain and Sweden, etc.

    To target NGDP you must issue enough cash so that the market clears. If the market doesn’t clear, you’d also fail to target NGDP.

    James, You really need to go back and read my old posts. you said;

    “What I find puzzling is why you and Scott are so dismissive of BoE QE and their implicit threat of more to come, the new ECB 3 year LTROs and rumours of more to come. It seems to be working.”

    That’s pretty much what I said at the beginning of QE2. It might have an effect via expectations, but don’t expect any surge in growth. It did raise expectations modestly, but the impact wasn’t that large. So I was right. And I’d say the same thing about the UK. If they’re really serious about a robust recovery, they need to be more explicit, not use QE as a subtle signaling device. Having said that, I’ve always agreed QE is better than nothing, as I believe it does send some sort of signal.

    Morgan, Check out today’s post.

  50. Gravatar of Alex Godofsky Alex Godofsky
    4. February 2012 at 13:22

    Scott, if the natural nominal rate of interest is below zero (and there’s no penalty rate on reserves) the bond market *can’t* clear. It’s not a problem of liquidity; the money price of bonds is necessarily bounded above by par value.

  51. Gravatar of ssumner ssumner
    5. February 2012 at 06:18

    Alex, If the Fed adjusts the monetary base until it hits the NGDP target, then the natural rate on government debt would be zero if T-bill yields were zero. The adjustment in the base prevents the problem you are worried about.

    If it didn’t then you’d obviously miss your NGDP target.

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