I regret my haste yesterday in posting a reply to Tyler Cowen on eurozone sticky wages. I hadn’t fully digested the report, merely skimming it until I found data that confirmed my priors. The reality is more complex. My other regret is that I might have seemed to imply that the peripheral countries wouldn’t be in trouble if they had flexible wages. Not so, flexible wages in Spain would not have prevented a sharp fall in eurozone NGDP and RGDP growth after 2008. At a minimum, the ECB policy made a real estate depression in Spain almost inevitable. Re-allocation was needed, and flexible wages don’t prevent the real costs of re-allocation. Let’s rank the possible outcomes:
1. With overbuilding some decline in Spanish housing was inevitable, even with perfect monetary policy
2. With bad ECB policy, the decline in Spanish housing would be even worse, due to declining sales to non-Spanish residents. This is true even if Spain wasn’t in the euro.
3. With Spain in the euro, bad ECB policy would cause an even bigger decline in the Spanish housing industry.
Even in the best case (case 1) completely flexible wages in Spain might not have prevented an economic slowdown. As we move to steps two and three the problem grow larger, even with completely flexible wages. The analogy for the US is that overbuilding in the sub-prime states meant a pullback was inevitable (case 1) but tight money by the Fed (case 3) made it much worse than necessary.
Yesterday a reporter asked me how much QE3 would impact RGDP growth. My guesstimate was in the 0.2% to 0.4% range over the next few years. I didn’t completely pull that number out of thin air, but pretty close. What I did was notice that TIPS spreads seemed to increase by 0.1% to 0.2% on the news. Then I assumed that given the slack in the economy, a boost to NGDP would probably be roughly 2/3 RGDP growth and 1/3 inflation. Obviously that’s a rough guess, but at least I think it gives us a sort of “order of magnitude ” estimate of the power of the Fed’s announcement. Of course some sort of policy change was expected, so this just reflects the effect of the part of the Fed announcement that was more than markets expected—perhaps the open-ended QE and the promise to keep money accommodative well into the recovery.
Clive Crook has some very thoughtful comments on the Fed announcement, and what it means in terms of Woodford’s model. I’d caution readers to read him very closely, as at one point he says that he agrees with Joe Gagnon that QE has some impact on spending. Woodford disagrees. Then Crook goes on to analyze what we should expect if Woodford’s model is true, and also if we take the Fed statement literally. Recall that the Fed didn’t promise any catch-up inflation (i.e. above 2%), there were merely subtle hints of the Fed moving in that direction. So the pessimistic take wasn’t actually Crook’s view, it was the outcome if Woodford’s model is right, and if the Fed can be taken literally. Obviously I have doubts about both assumptions, and even Crook has doubts about one of them (Woodford’s QE views.)
Crook also points out that level targeting of NGDP might lack credibility in the current environment. I think he’s partly right, but I don’t see it as a problem, because he’s actually considering a hypothetical that is both unlikely to occur, and too expansionary from even my perspective. Recall that in 2009 I favored going back to the old pre-2008 NGDP trend line, but more recently have advocated going just a third of the way back. The problem here is that while NGDPLT is completely automatic when fully implemented, discretion is required when deciding where to set the initial trend line. Last year Christy Romer did a NYT column calling for a return to the old trend line. Because we are roughly 10% below that line, this would entail quite rapid NGDP growth (and inflation) over the next few years. Because a lot of time has gone by, and because many wage contracts now reflect the lower NGDP trend line, I no longer favor going all the way back, but rather looking for a pragmatic compromise. I think Crook’s right that 100% level targeting right now (Romer’s plan) would currently lack credibility, there simply aren’t enough economists inside or outside the Fed that favor that degree of stimulus.
But I would warn readers not to become overly pessimistic about credibility on the basis of this thought experiment. The Fed doesn’t stray far from what the consensus of economists favor, and hence any Fed policy that adheres to that consensus and is publicly announced is likely to have a high level of credibility. Here is an example: In the 1920s people like Warren and Fisher favored an inflation target (actually the price level) but the consensus of economists favored the gold standard, which does not allow for inflation targeting. Except for a brief period of price level targeting in 1933 (which was intensely unpopular with mainstream economists) we stuck with gold. Later inflation targeting became the consensus policy, and central banks all over the world were able to fairly quickly bring inflation down, and get long term bond markets to expect roughly 2% to 3% inflation. That’s a big success. If we can get the consensus of economists to shift to NGDPLT (and so far we market monetarists have had much more success than I expected) then a future Fed may adopt NGDPLT, and it will be highly credible. If economists as a class think level targeting is the right way to go, then a period of “catch-up” will not seem “irresponsible.” Even better, level targeting keeps NGDP from wandering so far from trend in the first place.
PS. The reporter who interviewed me also asked if QE3 might push up oil prices and hence derail the recovery. I had three comments:
1. Rising oil prices don’t derail the recovery if they are caused by QE3. That’s because, at least at the global level, real oil prices only rise due to QE3 if it is expected to boost RGDP growth. And QE3 only slightly depreciated the dollar.
2. Oil prices increased only slightly on QE3 news. That’s both good and bad. It’s good because the effects of QE3 get immediately priced into asset markets (EMH) but it’s bad for the same reason–the markets are telling us to expect only a modest boost to growth.
3. Oil prices rising due to non-QE3 reasons (say a war in Iran) could derail a recovery.
And finally, we already pretty much know the expected effects of QE3 on nominal aggregates. If there is any “test” to be passed, it would relate to the impact (if any) of higher NGDP growth on RGDP. That’s what people should keep their eye on. Let’s hope we do better than Britain.
Totally off-topic: Alex Tabarrok has a new “back of napkin model” that should immediately go into all econ textbooks. Also note that many people wrongly assume that it’s best to be at the top of Laffer Curve-type diagrams. Not so, you want to be to the left of the peak.
PS. I did a piece for Yahoo finance. I was told to write it for an average reader, so it’s a bit lower level than my blog posts.