Six reasons to abolish inflation

[New readers sent here by the NYT, this is a wacky, offbeat post.  If you want a serious look at my policy views please check out my FAQs.  In addition, this link discusses what went wrong last year.  And finally, I want to thank Tyler Cowen for his very kind review of this blog.]

When Bob Murphy sees this title he’ll probably think it is a dream come true.  The evil inflationist finally sees reason.  Well I’m afraid it’s more like his worst nightmare.  I don’t propose to abolish the phenomenon of inflation, but rather the concept of inflation.  And to be more precise, price inflation, which is what almost everyone means by the term.  I want it stripped from our macroeconomic theories, removed from our textbooks, banished into the dustbin of discarded mental constructs.

Even worse, I propose doing so for “postmodern” reasons.  I will start by denying the reality of inflation, and then argue for some substitute concepts that are far more useful.  First a bit of philosophy.  There is a lively debate about whether there is a meaningful distinction between our perception of reality, and actual reality.  I had a long debate with a philosopher about whether Newton’s laws of motion were a part of reality, or merely a human construct.  I took the latter view, arguing that if humans had never existed then Newton’s laws would have never existed.  He argued they are objectively true.  I responded that Einstein showed that were false.  He responded that they were objectively true in the limiting case.  I argued that even that might be changed by future developments in our understanding of reality at the quantum level.  He argued that they’d still be objectively approximately true, etc, etc.

Here’s one thing that bugs me about discussions of inflation.  People talk about whether various price indices are “accurate” as if there is some sort of objective entity that we were trying to measure.  If the only good in the economy were 91 octane gasoline, then it might be reasonable to talk that way.  But what is the true inflation rate for PCs?  The current consensus seems to be that we need to do some sort of “hedonic” estimates, that is figure out how much better the new computers are than the old ones.  But better in what sense?  And where are we going with this project, what is the purpose?  I can only think of one quasi-objective definition of inflation.  The rise in aggregate nominal income required to keep aggregate (per capita) utility constant.  Do you have a better definition?  If so, I’d love to hear it.

Of course that is not what the government does, they estimate how much better some new features of a PC are compared to the old features, and call it is a quality improvement.  But that is not objective at all.  Who’s to say what is “better?”  For me, PCs maxed out around the 386 or 486 chips, and as they get “better” I just get more hopelessly confused about how to use them.  I can’t even figure out how to use our new copier, and it’s driving me crazy because I prefer to do my own copying sometimes.  But I’m sure the machine is regarded as “better” by the BLS.  And how about those “productivity improvements” like computers that answer your phone calls?  I know, the answer is that the hedonic statistical techniques tell us the value of the improvements by estimating how much we are willing to pay for them.  But that ignores all the social aspects of utility.  A lot of what makes a new product more valuable is novelty.  Remember when Ford just made black cars?  What if they suddenly came out with a red one?  It would sell for more.  Now suppose they started making nothing but red ones for 20 years.  At that point a black one would suddenly be an expensive novelty, and it would sell for more.  Sometimes I think about the fuzzy B&W TV we had in 1965.  If I replaced my current 52 inch 1080P Samsung LCD with that set, and had to hold the antenna to stabilize the picture, do you think I would enjoy it as much as I did back in 1965?  Especially knowing the better sets that are available today?

I’ve noticed that many “serious” economists approved of the BLS using more and more hedonic techniques as a backdoor way of shaving a few bucks off some old lady’s Social Security check.  All in the name of being responsible about entitlements.  Suppose a scientific study showed that the CPI actually understated inflation.  Suppose that a study showed that people liked to “keep up with the Jones,” and in order to maintain a stable utility people actually needed their incomes to rise as much as the average income in America.  It’s not that far-fetched, surveys in the US show little change in average happiness levels in recent decades.  (I’m not saying those surveys are right, just that it might be true.)  Do you think those same economists (often small government conservatives) would eagerly adopt the view that the CPI needed to be raised based on the latest scientific evidence?

[Now I’m sounding like Paul Krugman.  Shamelessly pandering to my new NYT readers.]

If I’m not mistaken the Brits tried to index their basic initial pension for new retirees to their CPI, and after a few decades of falling behind wage increases, the old folks eventually rebelled.  They saw through all the hedonics.  (By the way, I know this is confusing, but initial benefit levels in the US are indexed to wages, only subsequent increases are indexed to prices.  So in America old folks as a class don’t fall ever further behind the young, as they were doing in Britain.)

Don’t get me wrong, I agree that “living standards” have improved a lot in the ordinary materialistic sense of the term; I’m not one of those people who says real incomes haven’t changed since the 1960s.  What I’m saying is that there is no obvious way to determine how much better off we are.  More stuff?  Better stuff?  Happier?  It all seems arbitrary to me.  And if inflation isn’t useful for estimating how much better off we are, then what is it measuring?

Sorry for the long intro, but I’m trying to establish that there is no reasonable, objective way of measuring inflation that even comes close to matching the concept we have in our minds, which is roughly “how much more expensive stuff is.”  Or “how much more it costs to live these days.”  Since I’m a pragmatist, I fall back on the Rortian question:

What’s the use of it?

We can define inflation any way we wish, in whatever way we find most useful.  Before offering my definition(s), I’d like to remind people of the “circular flow” of the economy—income/expenditure.  On the top we have the expenditure on final goods and services.  On the bottom we have the inputs, the factors of production.  It’s symmetrical.  Therefore we also have two logical definitions of inflation, the average price of inputs, or the average price of output.  There is no obvious reason why one is to be preferred over the other.  It is all a question of which is more useful, and for what purpose.  I’m going to argue that we should focus on input prices, either the average wage rate, or the average nominal income per person (and I’ll just use NGDP for simplicity.)  Price inflation doesn’t seem necessary.

So here are 6 reasons to get rid of inflation:

Reason 1:  NGDP growth is a better indicator of monetary shocks than the CPI.  The CPI is flawed by mismeasurement of housing.  But even if it were accurate, it would not reflect nominal shocks as clearly as NGDP.  Starting last year, NGDP growth went from its normal 5% to almost negative 5%.  In the long run this sort of reduction will eventually impact only prices.  But because prices are sticky in the short run, at first output falls very sharply.  The initial fall in prices may be very small, and may hide the severity of the monetary shock.

Reason 2:  NGDP is a better target for monetary policy than prices.  If you target prices, and there is a severe supply shock such as an oil embargo, then you will need a monetary policy that is contractionary enough to depress non-oil prices.  This will also require lower real wages.  Since nominal wages are sticky, if you are targeting the price level then unemployment will rise sharply during a supply shock.  As Earl Thompson pointed out, in theory a wage target would do best; but because of practical problems I prefer a NGDP target, which is more accommodative during supply shocks.  Of course both price level and NGDP targets respond identically to velocity shocks.  Another advantage of NGDP targeting is that it leans against the wind during asset bubbles such as 1999-2000 and 2004-2006.  Those bubbles almost always occur when real GDP is strong, or above the target path.  Thus a NGDP target will show the need to tighten policy in a much more timely way than a price level target.

Reason 3:  The AS/AD model can be taught with NGDP (or NGDP minus expected NGDP) on the vertical axis and aggregate hours worked on the horizontal axis.  There is no need for the price level.  If you prefer a Phillips curve model, you’ll find that nominal wage inflation works better than price inflation (especially during supply shocks.)

Reason 4:   Income inflation is a better variable to include in the Fisher equation than price inflation.  If the rate of price and wage inflation were identical, then obviously either would work equally well.  But what if they differ?  Let’s think about this example:  We start with zero wage and price inflation.  Nominal and real interest rates are 2%.  Now suppose price inflation stays at zero, but wage inflation is expected to be 10% a year over the next 30 years.  That would cause nominal (and real) wage rates to rise roughly 20-fold over that period of time.  Presumably this would be due to rapid productivity gains.  How would this affect nominal interest rates?  Well, if you knew that 20 years from now you could earn in three minutes what it now takes an hour to earn, wouldn’t that make you much less likely to save (and defer consumption) at a given interest rate?  Wouldn’t you demand a much higher interest rate to take account of the fact that an hour’s labor in the future would produce far more goods than an hour’s labor today?  And doesn’t this sound pretty much like the logic used to justify the original Fisher effect?  But notice that I reached this conclusion in an example with zero inflation by assumption.  Similarly, the demand for loanable funds would increase if wage growth were that high, because you could take out a mortgage to buy a house at a very high interest rate, knowing that you would get rapid wage increases to pay off that loan.  So in a horse race between input prices (wage inflation) and output prices (CPI inflation), it looks like wage inflation belongs in the Fisher equation, not price inflation.

Reason 5:   Many economists argue that deflation can put us into a liquidity trap.  I initially had the same view.  But Bob Murphy points to examples of deflation that did not result in liquidity traps: America in the late 1800s, or China just this year.  With respect to America I think that one factor was that the gold standard pretty much eliminated inflation expectations, so the expected rate of inflation was probably near zero.  But the key point is that as long as real growth is strong (and it was in the period from 1870-1900) then you should be able to avoid a liquidity trap as long as deflation is mild.  The recent Chinese case is instructive.  They have had some deflation in the past year, but because they have experienced fairly high productivity growth, there is still strong demand for credit.  The key point is that although the price level has fallen over the past 12 months, the Chinese NGDP is still up about 4%.  That’s why I have never thought that China would slip into a Japanese-style liquidity trap.  Each country occasionally experiences deflation, but Chinese NGDP growth is far higher.

I have frequently criticized Krugman’s argument that we can’t expect much from monetary policy now because the Fed is too conservative to commit to the high inflation required to get us out of a liquidity trap.  But inflation isn’t what matters, it’s NGDP growth.  If the Fed committed to 6% NGDP growth over the next 12 months, we’d probably get only around 2% inflation.  What’s wrong with that sort of target?  So once again, when thinking about liquidity traps it turns out that CPI inflation just muddles the issues, whereas NGDP growth shows what’s really going on.

Reason 6:  People often talk about workers’ wages catching up to changes in the price level.  But what price level do they want to catch up to?  Output inflation or income inflation?  Obviously the latter.  Essentially there are two components to any worker’s pay increase.  One is the average pay increase for all workers (i.e., wage inflation.)  And the other component is the change in that worker’s wage relative to the average (which depends on industry-specific issues.)  And what role does price inflation play in this labor model?  No role at all.

What’s the use of inflation?  It’s worthless.  Let’s get rid of it.  Take it out of our models.  Take it out of our policy rules.  If indexing is required then use wage inflation.  If you can’t afford to do that for Social Security, tell old folks they’ll get wage inflation minus 1%.  Remind them that although at age 70 they’ll be playing golf and taking cruises, by 90 they’ll mostly be sitting around watching TV.  And by that time even 60 inch 1080P Pioneer Kuros will be considered so crappy that Walmart will be almost giving them away.

PS.  Of course I’m being deliberately provocative here.  The one example I am aware of where inflation affects behavior is the labor/leisure trade-off.  We need inflation to explain why people work fewer hours as society get richer.  NGDP isn’t enough.  And of course inflation may be useful to growth theorists.  What else have I missed?


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96 Responses to “Six reasons to abolish inflation”

  1. Gravatar of Jon Jon
    1. August 2009 at 13:56

    Great post Scott. You should emphasize again though that you think policy should be conducted using forward looking indexes. A wage inflation index is no more forward looking than CPI as tool to set policy.

    Just today I was doing some house cleaning and found an old monthly newsletter from our faculty club. Now the price of lunch at the club has gradually increased more or less in line with “CPI” but many things have changed. Little flourishes gone to cost-cutting. One of these that I noticed today: staples. The current newsletter is just folded glossy paper. The one from four years ago was folded glossy paper with staples in the fold.

    Now is there really value in the staples… no, but they’re subsequent removal forces a minor fact into view. We’re forced to economize in various subtle ways to maintain our standard-of-living. Hedonics indeed.

    A friend of mine showed me a rather astonishing calculation… people frequently cite the weight of gold as a reason for it to not circulate as currency–its too inconvenient. I figure that was probably once so. But at current prices a $20 gold ‘note’ would be lighter and smaller than the paper equivalent.

    That’s the inflation hidden by hedonics.

  2. Gravatar of Ellery Ellery
    1. August 2009 at 15:57

    LOL at this blog.

    Started in 2009?

    Oh…that’s right…nobody could see it coming.

    Not one post regarding Option-ARMs, Liars Loans and the combination of the two. No posts on the Ponzi loans and Heloc fueled economy.

    Yeah…inflation! That’s the ticket. That’ll solve everything!

    So…how do you solve the problem the garden-variety Option-ARM? Where the payments TRIPLE due to RECAST (not “reset”)

    Blech.

    It’s alright. Every professor in my Econ Department when I got my degree was clueless also.

    Reading Assignment- HousingPanic.com (start at the beginning)

    Other blogs that “got it right”

    GlobalEconomicAnalysis.Blogspot.com

    IrvineHousingBlog.com

    I can’t wait for the $2,700,000 option-ARMs to explode like crazy. Yes, there are plenty of them out here in Los Angeles.

    What kind of debt do you have “professor”?

    Are you worried that the debt-fueled “higher-education” ponzi-scheme/bubble is gonna pop?

  3. Gravatar of ssumner ssumner
    1. August 2009 at 16:34

    Jon, Thanks for the comments. I agree the hedonic stuff is tricky. Again, I don’t dispute that things like TVs are way better, its just that I don’t think there is any objective way to determine how much more “utility” we have. And if you can’t do that, then it is all just arbitrary guesswork.

    The gold comment is interesting. I heard a slightly different point, that gold was too expensive for coins. Thus a $20 gold piece (one oz.) is now about $1000, but is barely bigger than a half dollar. So the coins might be so valuable that people would be afraid of losing them. People who say that gold is surprisingly heavy are right–more than even lead. But as you say, a little bit goes a long way.

    In the old days many average people never had gold coins–they were too poor, only carrying silver and copper.

    Ellery, What makes you think this recession was caused by the financial crisis? I thought recessions were caused by falling nominal GDP, and the Fed determines nominal GDP. The subprime crisis happened in 2007. I have no interest in the subprime crisis and don’t spend time on that issue. The steep worldwide recession that began in late 2008 had nothing to do with the subprime crisis, which was far too small to cause the banking system to freeze up last October.

    If you predicted everything I assume you are rich Good for you. Enjoy your wealth.

    I don’t have any debt, to answer your question. I can’t understand why any professional my age and income would have debt unless they or their family had some sort of unfortunate tragedy (illness etc.) I’m a 53 year old college professor, why in the world would I have debt? As it is, I save about half my income. What am I going to spend it on if I just sit here all day blogging?

  4. Gravatar of Don the libertarian Democrat Don the libertarian Democrat
    1. August 2009 at 17:10

    “I’ve noticed that many “serious” economists approved of the BLS using more and more hedonic techniques as a backdoor way of shaving a few bucks off some old lady’s Social Security check.”

    When the govt uses some measure over another, it usually suites their purposes. Often, it involves assessing budgets and paying benefits. In that sense, these govt measures perfectly fit the view that there is no “objective” measure, but the measure chosen is more useful for the govt’s purposes. If you don’t find their purposes copacetic, you generally dislike their method of measurement.

  5. Gravatar of Current Current
    1. August 2009 at 17:27

    Have you ever read “The Theory of Money and Credit” page 187-194?

    http://www.mises.org/books/tmc.pdf

    I agree with you that there are many problems with measures of price inflation. But, the concept of it is quite reasonable. We can talk about what Menger called “changes in the objective exchange value of money from the money side” (well, he didn’t quite call it that, but that’s the nearest english).

    As you point out at the end of the post the long-term and short-term are different. I’m not convinced that one is particularly easier to deal with than the other though. Both are equally subjective.

    Mises in T.M.C., said that for monetary theory we should deal with “inflation” only when price increases are too large to ignore. That is when no reasonable index could avoid showing price inflation. And, apart from that we should deal with “inflationism” and “deflationism”. That is the tendency for politicians to push things in one direction or another against the demand of the population.

    That said, I’m not sure he was right.

    Note that many of your problems apply to real GDP too. For example, suppose my friend Don and I swap beers in a pub. I decide I like his better and he decides he likes mine better. So, from then on we change the sort of beer we normally drink. Suppose we both drink the same. In that case there has been a welfare improvement but this isn’t shown in any statistics.

    Regarding Ellery’s comments. This was what Tom Paine said about inflationists, they had debts hanging over them. In his time I expect he was right. The interesting thing is though that the superficially scientific status of price inflation make people accustomed to it. If it were shown to them that it is as difficult as you say (which it surely is) then they would become a lot more suspicious of it.

  6. Gravatar of Don the libertarian Democrat Don the libertarian Democrat
    1. August 2009 at 17:27

    “I took the latter view, arguing that if humans had never existed then Newton’s laws would have never existed. He argued they are objectively true. I responded that Einstein showed that were false. He responded that they were objectively true in the limiting case. I argued that even that might be changed by future developments in our understanding of reality at the quantum level. He argued that they’d still be objectively approximately true, etc, etc.”

    It’s been a thousand years since I studied this issue,but my view when I did was that we lived in Einstein’s Universe and not Newton’s. However, the effects involved in some cases are very small in Einstein’s Universe. It’s simply much easier for our purposes to pretend that we are in Newton’s Universe. This shows that some theories or explanations can be false, but useful. I’m not sure what it means to be objectively true in the limiting case. That sounds a lot like what I just said, only taking the pretending too literally.

  7. Gravatar of Jian Jian
    1. August 2009 at 17:50

    Your point about the arbitrariness of CPI is well taken, but if you were really serious about physical laws being social constructions, I’ll quote Alan Sokal: “Anyone who believes that the laws of physics are mere social conventions is invited to try transgressing those conventions from the windows of my apartment. (I live on the twenty-first floor.)”

  8. Gravatar of Greg Ransom Greg Ransom
    1. August 2009 at 19:13

    How’s this:

    A neutral/non-inflationary money is marked by a monetary regime which provides market coordinating money rated of interest which do not create a boom and bust cycle by falsely misdirecting investment through the time structure of production goods.

    So, how does that differ from your own definition?

  9. Gravatar of Greg Ransom Greg Ransom
    1. August 2009 at 19:13

    How’s this:

    A neutral/non-inflationary money is marked by a monetary regime which provides market coordinating money rates of interest which do not create a boom and bust cycle by falsely misdirecting investment through the time structure of production goods.

    So, how does that differ from your own definition?

  10. Gravatar of Greg Ransom Greg Ransom
    1. August 2009 at 19:14

    I’m guessing Bob Murphy shares most of the problems with the “mainstream” notion of “inflation” which you rehearse here. Just guessing ..

  11. Gravatar of Mario Mario
    1. August 2009 at 19:22

    Suddenly, after reading this, using inflation as a way to measure general welfare is looking to me like the labor theory of value. Nevertheless, it seems like we would be better off with inflation targeting in some instances when sudden gains in GDP are monopolized by a small minority, rather than filtering down through the whole economy. If oil were discovered by a private party in an agrarian state, for instance, you could see a sudden surge in GDP with comparatively few corresponding welfare enhancements. In that case I think the central bank would be better off ignoring GDP and taking action only to the extent that the benefits are being felt by the economy as a whole, which would mean using the CPI. As a general rule, it would seem that smaller economies would be far more likely to see isolated GDP surges large enough to provoke central bank action then large states, so small economies might be better off sticking to inflation targeting.

  12. Gravatar of Lorenzo (from downunder) Lorenzo (from downunder)
    1. August 2009 at 20:34

    I think most people’s idea of inflation is how what they can get for a dollar changes: changes in the price of money as measured by goods and services. The CPI is indeed a problematic way of measuring that.

    It becomes quite an urgent issue the more prices of the things people generally buy rise. People on wages and salaries differentiate between pay-rises to keep their normal purchases sustainable (i.e. to not go backwards) and pay rises to improve their situation: the former generally are regarded as having a stronger moral urgency. Hardly surprising, since a wage contract is set on the basis of a certain value of the dollar. So, there is a concept of inflation which matters to people’s direct experience. Your “reason 6” does not really seem to cover this.

  13. Gravatar of Fletch Fletch
    2. August 2009 at 00:44

    Scott

    I’m reluctant to post as I’m not totally sure of your objective, except to be provocative, but I can’t resist. I’m still catching on to your dry sense of humor, but I love it.

    You said, “And if inflation isn’t useful for estimating how much better off we are, then what is it measuring?” Inflation doesn’t measure how much better off we are at all. It measures how much more we pay for something that has the same value, but higher price. Hence the term “price inflation.” The price is inflated beyond than the value. If anything inflation measures how much worse off we are having to pay higher prices without receiving higher quality.

    I agree the CPI isn’t accurate in the sense portrayed especially in the media or maybe in the classroom, though back when I was in a classroom I was taught to be aware of what the CPI doesn’t mean as much as what it does mean.

    Now what did I miss.

    Fletch

  14. Gravatar of Russell Munves Russell Munves
    2. August 2009 at 02:34

    GDP is no less subjective than CPI because the GDP reflects production of goods there was no sustainable economic demand. For example,new homes built in response demand from subprime borrows who could not afford the mortgage payments and the malls built to accommodate the those subprime homeowners would appear to have a very high value when built and substantially contribute to the GDP.

    But in reality, there was no demand for these homes and malls from people who could afford to pay for them. These assets quickly depreciated spreading the loss to those who financed them. Just as disastrously, these false signals caused over investment in businesses to build these homes and malls. Thus, including the value of these homes and malls as part of the GDP provides no useful information.

    Money is not wealth. Money is a mere accounting place marker for value that has been created in the past. Money in the bank is only worth what it can buy at any particular time.

    So the best that a government can do is to nurture a transparent economic system where a potential producer of goods or services can determine whether demand signals he or she is seeing have been transmitted by those who can afford to pay. This approach will minimize wasted effort by producers and therefore make goods and services cheaper.

    It is the best way to assure that value of saved money will be preserved such that there will be a maximum amount of something to buy with it.

  15. Gravatar of steve steve
    2. August 2009 at 05:04

    If you use NGDP instead of actual wages, does it matter that we use average wages? What happens when we have a large disparity in incomes? Does the Fed actually have all the tools it needs to achieve NGDP goals or is having the goal enough? (Read you every day, and have had these questions before, but this post intrigues.)

    Steve

  16. Gravatar of Bill Woolsey Bill Woolsey
    2. August 2009 at 05:22

    Scott:

    I don’t think provocative posts about getting rid of the concept of inflation help push forward the policy goal of targetting the growth path of nominal income.

    I will grant that it would help if _you_ would stop talking about inflation. That is, all of your arguments about how the Fed needs to increase expected inflation would be better stated as raising nominal income. It help _you_ avoid sounding like an inflationist.

    That monetary disequilibrium is better shown by expected nominal income being too low and that the better target for monetary policy is nominal income–agreed. (Though, you need to be careful to explain that it is really the nominal expenditure on final goods and services that you have in mind.)

    However, real income and price level performance is still the goal. What “goal” do you propose instead?
    More nominal income is better? Of course not. Nominal wages never increase? Right. Noninflationary real growth has got to be the goal. And, note, that you admit that the price level plays a role in these fundamental real issues==growth “theory” and the labor/leisure trade off.

    Well, that is key when explaining the benefits of this scheme. A macroceconomic environment that results in the least possible distortion of microeconomic coordination due to monetary disequilibrium.

    The reformulation of AD/AS to make it some kind of supply and demand for labor is just confusing. To me, it sounds like you are saying that you keep AD and AS unchanged, and just change what you put on the axis.

    Maybe you would be better served by never talking again about how rapid inflation during Depression resulted in rapid recovery of output. Maybe you have a bad habit of focusing on the conventional AS curve showing higher prices associated with higher output. Maybe _you_ would be better served if _you_ just talked about shifting the AD curve, (understood as nominal expenditure.)

    I, on the other hand, want a tool that can be applied to real growth issues as well as showing the desirable macroeconomic peformance of nominal income targeting in response to both long term growth and a variety of shocks.

    While you want to explain how higher expectations of nominal income will raise nominal interest rates, the Fisher effect is that the nominal interest rate less the expected inflation rate is the real interest rate, and fundamental saving and investment decisions depend on the real interest rate. What is the nominal interest rate less the growth rate of nominal income equal to? Does it plausibly impact people’s decisions regarding saving and invetsment?

    I think it is just better to say that expectations of more repid growth in real output will raise investment and lower saving and raise equilibrium real interest rates, while higher expected inflation will raise nominal interest rates. And both at the same time raise nominal interest rates for both reasons.

    You haven’t come close to convincing me that there isn’t really two sorts of processes going on here. That people care about the difference between nominal interest rate growth and nominal interest rates.

    Again, it is just _you_ who should stop talking about how the Fed needs to get inflation expectations up so that equilibrium nominal interest rates will rise.

  17. Gravatar of ssumner ssumner
    2. August 2009 at 05:25

    Don the libertarian, I agree.

    Current, I haven’t read Mises, but there is no “objective” measure of the exchange value of money, except in a world with one good of unvarying quality. And then it’s not money, it’s barter..

    You said:

    “Note that many of your problems apply to real GDP too. For example, suppose my friend Don and I swap beers in a pub. I decide I like his better and he decides he likes mine better. So, from then on we change the sort of beer we normally drink. Suppose we both drink the same. In that case there has been a welfare improvement but this isn’t shown in any statistics.”

    I agree, that’s why I put aggregate hours in my AS/AD diagram. If you throw out inflation, you ipso facto throw out RGDP.

    Don#2, I plan a post on this to answer questions. But it would be more accurate to say that we used to live in Newton’s universe, and we now live in Einstein’s universe, and later we will live in someone else’s universe. But you make a good point, and I basically agree.

    Jian. Good questions. Stop back tonight or tomorrow. I will have an entire post devoted to answering your question. (And believe me I have heard that argument many times.)

    Greg, Your definition is close, but I would emphasize that it is not precisely my view. Each person might have a slightly different type of inflation in mind. If you stabilize one type of inflation (say the GDP deflator) then investors who made investments based on expectations for the GDP deflator wouldn’t end up ex post with investments they regret for the reason of monetary instability (they might regret them for other reasons.) But others might use the CPI as their benchmark, and even though the GDP deflator is stable, maybe the CPI changes in an unexpected way, and that latter group of investors is slightly thrown off. Surely the rates are close, so you’d at least avoid major problems, but we are not dealing with precise definitions here, in my view. One final point. I am saying that many investors actually have something like NGDP growth in mind when they make investments. Because they have lots of debts and wage contracts in nominal dollars, investors want to know whether next year Americans will be spending 5% more nominal dollars, or 5% less. So I think it is actually NGDP shocks that causes this malinvestment. You may not agree, but I hope you at least see where I am coming from.

    Greg#2, We’ll see what Bob says.

    Mario, I see it differently. A massive oil discovery would sharply cut oil prices. If you target the CPI, you need to raise non-oil prices. I think this causes a destabilizing boom. I know “boom” sounds good, but consider the reverse oil shock and see how “recession” sounds. The goal is relative stability in GDP growth.

    Lorenzo, In my view you are describing real wage rigidity (or downward inflexibility.) But I am not sure real wages are rigid in the way you suggest. I think workers intuitively understand that if the inflation comes from an adverse supply shock, they will simply have to take a lower real wage. In America wages didn’t soar with oil prices in 2008, despite the fact that headline CPI peaked at over 5%. And it was good wages didn’t reflect that. Maybe in Australia unions are stronger and things are different.

    Fletch, That statement was poorly worded. I should have said something like “inflation is supposed to measure how much worse off a person is with a given nominal income. Sorry for the confusion.

    It’s a mixture of serious and provocative. I really think NGDP does better that inflation in many contexts, so I am trying to get people to look at the problem in a different way.

    Russell, You said:

    “GDP is no less subjective than CPI because the GDP reflects production of goods there was no sustainable economic demand. For example,new homes built in response demand from subprime borrows who could not afford the mortgage payments and the malls built to accommodate the those subprime homeowners would appear to have a very high value when built and substantially contribute to the GDP.”

    I’m glad you mentioned this because I didn’t make myself clear. I agree that NGDP is also not a good measure of welfare. All it does is measure the dollar value of what gets produced. I make no claim to have a better measure of living standards, I simply distrust the CPI.

    I want useful models of things like the Fisher effect and business cycles. Even if worthless houses are being built, aggregate hours worked will go up. So if you trying to explain social phenomenon like unemployment, you would want to include the bubble houses. But I agree this isn’t measuring welfare.

    I agree that the best the government can do is establish a stable macro environment where people can make clear decisions. That’s what I am trying to do.

  18. Gravatar of JKH JKH
    2. August 2009 at 06:18

    Scott,

    I thought this was a good opportunity to attempt some wacky in a response today.

    Expenditure and income may be symmetric, but measures of inflation aren’t. The problem for purposes of your preferred monetary policy is that the domain for various measures of inflation has a highly asymmetric topography.

    E.g. your definition of income inflation scopes inflation more liberally as the measure of growth in nominal income. Nominal income includes real and inflation components in conventional terms. Your definition of income inflation includes not only the conventional embedded CPI component, but the real component as well. This is upscale thinking for inflation measurement, compared to a CPI measure that is entirely severed from the real growth component. In that sense, the proper context for CPI in the sense of your symmetric measure is that of an embedded inflation sub-component at best, rather than the measure of inflation per se.

    BTW, you’ve done a bit of a trick in presenting your two logical definitions of inflation as the average price of inputs and the average price of outputs. The average price of outputs doesn’t have the restricted scope of CPI of course, because it includes the same inflation constituents as your income measure, according to the symmetry you define. But you go on to compare the merits of the average price of inputs versus CPI. This is a comparison between a symmetric measure and an asymmetric measure, which while relevant to your case, is not a reflection of your proposed input/output symmetry.

    Your proposed definitions on the other hand are symmetric. The advantages inherent in using income inflation are available in theory using output inflation, defined symmetrically. Both should aggregate to NGDP. So you’re really arguing for the superiority of an input measure, based not primarily on its characteristic as an input, but for its superior scope. You’re comparing one of the two symmetric measures against the asymmetric alternative of CPI, but not against the alternative symmetric measure (average output prices), which you don’t detail further, but which surely must have the same symmetry advantages as average input price.

    In practice though, the calculation of income inflation is more straightforward and available than a corresponding calculation of output inflation. So you’re excused on that basis.

    Enough of that – this slight inconsistency is not important to your core argument, which is the superiority of the most available symmetric measure (income inflation) over the asymmetric CPI.

    The shortcomings of CPI as you describe them include subjective evaluations of hedonic gains. The more fundamental problem I think is that CPI aggregates very poorly for the type of purpose you need. On the other hand, income inflation as you define it aggregates very nicely. The difference is well illustrated in your “Reason 4″ example, which I think is the most important point you make along these lines.

    Looking at Reason 4 more closely, it exemplifies the inflation measurement asymmetry problem. Income inflation as you define it incorporates both real wage gains (conventionally defined) and an embedded or implicit CPI component (the cost of matching CPI increases within nominal wage gains). Income inflation aggregates relatively easily to NGDP growth because of this. On the other hand, CPI alone excludes the growth effect of productivity, so it can’t possibly aggregate to NGDP growth.

    Maybe the language of economics requires some fundamental reconstruction, based on the logical guidance of Boolean algebra. Income inflation includes the inflation of a real component (real wages or productivity). This is a reasonable and useful idea. But how can we talk and think clearly at once about the inflation of a real component and the inflation of an inflation component (CPI)? We’re not looking at a second derivative here; they’re parallel partial derivatives for the entire effect you’re capturing. This parallels your coherent approach to NGDP targeting. The language should be balanced. The existing language in its totality is an incoherent, muddled oxymoron, an illogical presence that tends naturally to reinforce your case for abandoning CPI as a primary monetary policy indicator or target.

    Maybe I overstate this case. “Real exchange rate” used to drive me toward mad cow interruptus. It always strikes me logically as saying that the sum of the nominal foreign exchange rate (inflation) plus foreign price inflation amounts to a real foreign exchange rate (inflation). I suppose guess in a sense it nets out inflation in a similar way as real interest rates – if you stand on your head. No doubt some actual economist can correct me on my wayward thinking here.

    My view of the replacement language construct goes something like this (excuse the notation, if it seems awkward):

    Starting with your ideas of output inflation and input inflation, define each observed constituent price as inflating in two components: r + r’.

    r corresponds roughly to the conventional idea of real growth, etc. It includes hedonic gains.

    r’ corresponds to its complement within the total observation of nominal price increase.

    Each observed output price and each observed input price can be expressed in (r + r’) terms.

    “Inflation” is a word that can be used to describe any or all of r, r’ and (r + r’), according to context.

    I have no idea what word to use to describe r’.

    “Unreal” doesn’t quite make the cut.

    I just know it shouldn’t be the word ‘inflation’.

    I can see why abandoning the conventional inflation concept fits with your view of monetary policy. In an alternative sense, you’ve elevated the meaning of inflation to a broader idea, such as income inflation, in rejecting the conventional one. As applied to NGDP targeting, inflation becomes a word whose meaning is closer to “increase” or “growth” or “nominal growth” than one that is restricted to prices or even growth in the money supply, as per the Austrian emphasis. The latter has its own problems of narrowness and asymmetry. Money supply is a stock. To capture the full NGDP implication of money inflation, one would also have to consider inflation in money velocity.

    In any event, the useful measurement of inflation should be top-down; not bottom up, which corresponds nicely with an NGDP approach for monetary policy.

    I liked the post. This and others on your blog typically offer more creative analysis than the standard cookie cutter, failure-of-imagination commentaries documenting the role of the banking system in the economic crisis. Your analysis here is very consistent with your NGDP targeting theme. And you certainly can’t be accused of not being original or thought provoking.

    P.S. regarding your first definition of inflation, defining it terms of utility correctly reflects the problem of measuring it, I think, but it doesn’t get rid of the problem of measuring it, because the measurement of aggregate utility is in some sense partly an inverse problem to the measurement of aggregate hedonic adjustment. Isn’t it?

  19. Gravatar of JKH JKH
    2. August 2009 at 06:38

    Very complimentary follow up from Tyler Cowen:

    http://www.marginalrevolution.com/marginalrevolution/2009/08/the-monetary-economics-of-scott-sumner.html#comments

  20. Gravatar of Russell Munves Russell Munves
    2. August 2009 at 07:35

    Scott,

    Thanks for the thoughtful reply and I fully support your efforts in this area, whether or not I agree with any particular suggestion or idea.

    It seems to me that the models you are trying to develop are only useful when a) business uses them to plan investment and production and b) consumers use them to plan their economic life.

    When the government uses the models to try to manage the economy, it is a disaster. Witness the USSR’s serial five year plans that failed, the Nixon wage and price controls and Fed’s mismanagement of interest rates earlier in the decade that fueled the real estate bubble (and one could argue failed financial system oversight but maybe the government would not have to regulate the financial system, beyond requiring transparency, if it were not supporting it with money creation and guaranteeing its losses via the FDIC, Fannie Mae etc. in residential mortgages, and other government backstops that result in careless economic behavior. Think about 100% reserve banking instead. But that is another discussion).

    Of course government management of the economy is deeply entrenched in our system because the electorate thinks it is better off that way. This ironic because we learn in history 101 that the Soviet Union and U.S. wage and price controls failed. No one disputes this.

    So long as the public thinks our government can successfully do what no government has ever done before – plan an economy- the illusory promise of government providing economic security through planning will create political pressures that make it impossible improve the situation.

    With the government promising security through social programs that people have come to expect as of right like medicare and social security. Thus the myth of successful government economic planning is very difficult to dispel as is evidence by the fact that the political establishment has known for years that these programs are unsustainable and yet has been able to end them.

    Education is the only hope of reversing the tide. If we can reverse the tide, the reward will be an economy operating at maximum productivity and flexibility to the benefit of future generations. It is worth the effort.

    Russell

  21. Gravatar of tobsen tobsen
    2. August 2009 at 08:20

    Hello Scott,

    first of all, nice blog! I spent the hole afternoon in reading your posts about the liquidity trap.
    At the moment I´m writing my diploma-thesis about this topic, with a main-focus on Paul Krugman´s interpretation of the trap.
    I´ve read your publication (Cato Jounal) and almost every other article about this issue and there are still a lot of unanswered questions. What was Keynes (original) intention when he mentioned this scenario?
    Or jumping to Krugman: If we assume that the central banks face an expectation problem and that every money expansion has no effect(because it´s only temporary), why are these unconventional measures conducted by the central bank? Or is Ben Bernanke thinking that people don´t have rational expectations and monetary policy is always effective?!
    So…what do think?

    Best regards from Germany!

  22. Gravatar of StatsGuy StatsGuy
    2. August 2009 at 12:34

    This post is too heavy for me to understand on no sleep, so I will limit my quibbles to this factual point:

    “But the key point is that as long as real growth is strong (and it was in the period from 1870-1900) then you should be able to avoid a liquidity trap as long as deflation is mild. The recent Chinese case is instructive.”

    Bob Murphy, the source of this claim, seems to be manufacturing history. I agree these were both exceptional times (which you also note), but they were not really _good_ times in the US (China is a completely different case, with MASSIVE govt intervention and control, including recent intervention in the banking sector on a vast scale). Again, just to quibble, I don’t recall history being so kind to this era in the US:

    http://en.wikipedia.org/wiki/Panic_of_1873
    http://en.wikipedia.org/wiki/Panic_of_1893
    http://en.wikipedia.org/wiki/Panic_of_1907

    Indeed, the economy recovered so little in per capita terms from 1873 to 1896 that this was called the Long Depression

    http://en.wikipedia.org/wiki/Long_Depression

    Much of the “growth” came from immigraton, and this was a time of tremendous wealth concentration, but I don’t recall the median worker’s wage improving. Indeed, this era was so brutal that it gave rise to the anti-child-labor movement and the labor movement and even the closest thing to a US communist party.

    Intriguingly, though we like to discuss how our recent financial innovation has caused so many problems, I question whether they are new. The Panic of 1907 was (allegedly) triggered by an inflationary bubble that popped when an attempt to corner the copper market failed and various banks linked to the scheme went under.

    BTW, this rather flies in the face of those who argue that the current speculative crisis was caused by an implicit government backstop of big banked that created moral hazard. The big banks in 1907 had no backstop, and they still did stupidly speculative things.

    I believe your argument is much stronger if you completely wipe out Reason 5.

  23. Gravatar of Bill Woolsey Bill Woolsey
    2. August 2009 at 13:45

    Scott:

    I finally read Cowan’s column in the NYT.

    Yes, it would have been much better if the NYT readers saw him describing the proposal as getting nominal GDP back up to it’s trend growth path and not has a proposal for 2% to 3% inflation.

    In the blog, he again describes the proposal as 2% to 3% inflation, though he mentions parenthetically… or nominal GDP.

    My figures suggest a target of $15.9 trillion for 3rd quarter 2010. We are in 3rd quarter 2009 now. So, if we had index futures convertibility, the Fed would be trading the 3rd quarter 2010 contract now. There would have to be a target for that contract. If we look at the 5% nominal income growth path that we were on, well.. that would be $15.9 trillion next year.

    Try this… I advocate keeping nominal GDP on a 5% growth path. Our problem is that we are well below that path now. We should be at about 15 trillion, but we are now closer to 14 trillion. ($14,142 billion.) We are currently about 5% (5.5%) below our long run trend growth path for nominal GDP. (You don’t know or care how much the CPI should change between July 2009 and July 2010.)

    The Fed should target one year in advance, and the value of the growth path one year from now is $15.9 trillion. Of course, that is a 12.7% increase from where it was last quarter, and so, that is a proposal to raise nominal GDP at a 10% annual rate over 15 months. That can, of course, be partitioned between some growth rate of the CPI and the growth rate of nominal GDP deflated by the CPI. Focusing on a target for the growth rate of the CPI over the period is an error. (I would add that the lower the CPI growth portion, the better. More production and employment is the goal.)

    P.S. I think a $15.2 trillion target for 3rd quarter 2010 is better. But that is moving us to the 3% growth path. We are about 3.6% below that path now (with it starting in 3rd quarter 2008) and to get back to that path by 3rd quarter 2010, that would be 7.7% increase from the last data point to the target, or nominal growth at a 6.2% annual rate.

  24. Gravatar of Kieth Kieth
    2. August 2009 at 13:54

    It seems (to this non-economist) that you used a careful selection in you choice of digital products to criticize the messy, probably inaccurate methods of “adjusting” inflation to reflect product advances. Aren’t products with a high degree of technical transformation really a small-to-negligible part of a nation’s economy? 5%, 8%? remember that not all tech is technically transformative.

    Meanwhile we have hundreds (thousand ?) of commodities and commodity-like services whose cost is legible in (virtually) real time.
    My point is that even if inflation quantifiers ignored technological transformations it would not greatly impact the accuracy of the CPI.

  25. Gravatar of happyjuggler0 happyjuggler0
    2. August 2009 at 14:25

    Bill Woolsey,

    It is Cowen, not Cowan. Not to be too pedantic hopefully.

    Scott,

    I suggest adding a section on the right hand side of your blog titled “timeless posts”, or some such thing. I suspect it must be tiring for you to repeat yourself 100 times on the same blog.

    Until then, keeping in mind any new readers that Tyler Cowen’s NYT post brings in, I suggest a refresher post on why you like 5% NGDP targeting, and why it is not correct to say that that is synonymous with about 2% inflation combined with 3% RGDP.

    Pointing out why one doesn’t really need to believe in EMH in order to see it as superior to top-down rear view mirror thinking might also be a good idea in such a post.

  26. Gravatar of happyjuggler0 happyjuggler0
    2. August 2009 at 14:28

    Or, let me rephrase that. Gulp, this is partially why I don’t want to speak for you elsewhere.

    why it is not correct to say that that is synonymous with about 2% inflation combined with 3% RGDP

    Should read something like this instead:

    “why it is not correct to say that that is synonymous with about x% inflation added to y% RGDP, with the implication of nasty (and worse than useless) 70’s style stagflation”.

  27. Gravatar of Bob Murphy Bob Murphy
    3. August 2009 at 02:58

    StatsGuy, I think Scott himself supplied the 1870-1900 years. It’s not that I disagree with that, but I don’t ever remember giving such a specific set of dates. In any event, the point is that there were plenty of long periods of mild price deflation when the US was on the gold standard. So the idea that deflation=depression is obviously not quite right.

    More generally, I actually agree Scott with most of your post. Austrians oppose money inflation not merely because it may lead to large-scale price inflation, but because it distorts the structure of production and thus causes the boom-bust cycle. There was very modest CPI inflation during the 1920s, yet the Austrian story is that the Fed cut rates / pumped in funny money, which spurred the stock market bubble.

    Last point: What’s the story with you mainstream economists talking about utility as something objective and real? E.g. you define inflation in terms of per capita utility. Did you know the reason Hicks endorsed Pareto’s indifference curve analysis was that it allowed economists to abandon the faulty idea that there were cardinal units of utility?

  28. Gravatar of StatsGuy StatsGuy
    3. August 2009 at 03:43

    Bob:

    OK, more data… Note that the US PER CAPITA GDP growth from 1870 to 1900 starts above the trend line and ends at/below the trend line.

    http://www.bmacewen.com/blog/images/GDPGrowthUS18702004.jpg

    Moreover, the incredible volatility suggests that this period was anything but “mild” in any way (and this is a graph that every gold-standard fanatic should memorize):

    http://www.organissimo.org/forum/uploads/monthly_09_2007/post-353-1188669960.jpg

    I don’t know that the gold standard was really the driving factor, although the gold standard (and lack of govt regulation over the banking sector) certainly seems linked to massively higher volatility as the economy became more sophisticated and dependent on finance/manufacturing (along with credit/inventory cycles).

    I’m sorry, I don’t see how the general time period in question (late 1800s – e.g. the Long Depression) says anything nice about the Gold Standard and moderate deflation…

  29. Gravatar of StatsGuy StatsGuy
    3. August 2009 at 03:44

    On afterthought, perhaps a latter period (with no gold standard) makes a better case:

    There were periods when the US was not on the gold standard where inflation arguably remained very low – from 1987 to 2006, food prices in the US were extraordinarily low and stable.

    The food CPI technically shows a stable 2% rate of increase:

    http://www.ers.usda.gov/briefing/Baseline/gallery/gallery2009/foodinfl.gif

    But this was entirely driven by fresh fruits/vegetables, even though the caloric mix (and therefore the average basket) of food has shifted away from these.

    http://foodsystemfactoids.blogspot.com/2007/03/changes-in-food-prices-1985-2000.html

    The price of wheat, for example, was flat for over a decade.

    http://www.nfu.ca/graph2.jpg

    Fuel prices were stable, airline prices dropped dramatically, prices for electronics dropped dramatically, etc.

    The cost of _living_, as opposed to _living well_, declined or remained steady. (In fact, if you net out health care, which is a very special case, inflation is incredibly tame.)

  30. Gravatar of ssumner ssumner
    3. August 2009 at 11:28

    I found my car doesn’t work, and now I come back here and have lost all my replies–back to the salt mines. Expect lots of typos.

    Bill, You said:

    “However, real income and price level performance is still the goal. What “goal” do you propose instead?
    More nominal income is better? Of course not. Nominal wages never increase? Right. Noninflationary real growth has got to be the goal. And, note, that you admit that the price level plays a role in these fundamental real issues==growth “theory” and the labor/leisure trade off.”

    I don’t see those as the goals. The problem with business cycles is not that real GDP fluctuates, Lucas showed the cost of real GDP fluctuations is trivial (essentially consumption volatility.) Instead, i think the cost of business cycles is unemployment.

    And there are costs to inflation, but in every case there is some other variable that better measures the cost than price inflation. I’d much rather have stable wages and fluctuating prices, rather than fluctuating wages and stable prices.

    You said:

    “I will grant that it would help if _you_ would stop talking about inflation. That is, all of your arguments about how the Fed needs to increase expected inflation would be better stated as raising nominal income. It help _you_ avoid sounding like an inflationist.”

    I’d love to stop talking about inflation and just focus on NGDP, but it is hard to in a society that almost never pays any attention to NGDP, and yet fixates on inflation. Even the term NGDP is bizarre. It shows you how confused economists are that if you say interest rates or wages, they assume you mean nominal, but if you say GDP, they assume you mean real. Tyler was right that if he had used NGDP in the NYT column readers wouldn’t have known what he was talking about. And we have the TIPS market, but there is no similar market showing NGDP expectations. Nobody is more frustrated than me by this state of affairs.

    In the AS/AD question, if you have NGDP on the vertical axis, and average hours on the horizontal axis, then the AD curve is horizontal. If you put NGDP minus expected NGDP on the vertical axis, the the AS curve always cuts the horizontal axis at the natural rate of aggregate hours.

    JKH, You said,

    “E.g. your definition of income inflation scopes inflation more liberally as the measure of growth in nominal income. Nominal income includes real and inflation components in conventional terms. Your definition of income inflation includes not only the conventional embedded CPI component, but the real component as well.”

    I have only used NGDP, because I didn’t want to go through the tideous exercise of explaining NGDP per capita, which is probably a tad better. But let’s say we did use NGDP per capita as the target. Then total NGDP would have a real component, which is population growth (roughly 1% in the US.) And it would have an inflation component, which is nominal income growth per capita (roughly 4% in the US over time.) So that makes it analogous to the real/inflation split in NGDP on the output side. But then I’m not 100% sure this answers your question.

    Again, all I can say is that it simply comes down to which nominal aggregates are the most useful. We know monetary policy can’t peg a real variable, so we must choose among nominal variables. And I just don’t see inflation as being all that important to central banking.

    I think we agree on most points, I’ll see how you respond to my first point here, so I can get a better fix on your idea. It sounds interesting but I don’t think I quite got the key idea.

    JKH#2, Yes, I’ve been very lucky that Tyler keeps giving this blog good reviews. I am very grateful.

    Thanks Russell, I call myself a “pragmatic libertarian” because I think in the vast majority of cases the free market does best, but I am willing to admit there are a few cases where government can probably help. But right now they are doing far too much, and just as importantly (as in health care) there aren’t even doing it in the most effective way. I.e. private health saving accounts would be a more efficient program, if they need to get involved in that area.

    Statsguy, I have a very different view of the history than you do.

    1. I don’t accept that 1873-96 was a long depression. It was a long deflation. At the time, there was no real GDP data, but we know that industrial production soared during that period.

    2. The low living standards reflected two issues. One, failed states in Europe with very low living standards. Two, open immigration to the US. In that environment the supply of labor from Europe is very elastic, and thus it was hard for wages to rise much above the level in Europe (although they may have been somewhat higher.) But the huge flow of labor from Europe to America showed how much better our system was.

    But I was talking specifically about liquidity traps, not whether the gold standard was good (I don’t think it is a good system) so nothing you say refutes my observations about liquidity traps. Yes, China is not a market economy, but market economies (in East Asia) have grown that fast in the past, and I still say you are less likely to get a liquidity trap with high NGDP growth. (One counterexample was 1940 in America.)

    tobson, Welcome, but there is too much there for a brief reply.

    1. On question of what Keynes was thinking, see if you can get a copy of my paper on Keynes in Economic Inquiry (I think it was 1999.) If you have trouble, email me directly and I’ll try to send you a copy.

    2. I don’t think Rational expectations are a big issue here. Most of us assume ratex in our models, and yet monetary policy still has a short run impact on output due to wage and price stickiness. This is even true if the policy is announced. ((i’m giving you the new Keynesian view, which I accept, as doesn Bernanke and Krugman to some extent.

    3. Keep reading through my older posts and you’ll find several where I reply to Krugman’s argument. If the Fed commits to an explicit target path (level targeting), they can overcome their “temporary money injection problem.” But they must commit to offset any short term mistakes.

    I doubt the lending in 1906-07 was anywhere near as foolish as in 2006-07, but I am no expert there. I can’t image there were subprime mortgages back then. In the 1920s I believe mortgages had to be repaid (or rolled over) in 3 years.

    Bill#2, I answer question of Tyler using the CPI in my previous response. You make very good points about the quandry of which target to have. I was aware of this problem from the beginning, and for several reason I choose 5% NGDP growth from February 2009 as my starting point.

    1. Ease of explanation
    2. Avoids need for high inflation to “catch up”
    3. I am already called an inflationist, suppose I said we had to get to $15.9 trillion within 12 months! So it’s a judgment call, and I took a conservative stance. But I am still one of the few people in American calling for a much more expansionary monetary policy than what we have, despite this conservative stance. That tells me that many people are thinking about this issue the wrong way.
    It seems you are also recognizing the need for a conservative target. Interesting, I also think we need about 6.25% over the next 12 months.

    Kieth, That is only one of the problems. In addition let’s not forget that “average cars” like Camry’s and Accords are arguably better cars than the luxury cars of the 1970s. So it’s not just electronics where hedonics come in.

    But hedonics are only one of my problems with the inflation measure. There is also the issue of shifts in what people buy. How do I compare the sushi meal I just ate with steak and potatoes restaurant dinner from the 1970s?

    I agree that we can get a rough estimate of price inflation, especially when we have double digit inflation. But I don’t agree that it tells us anything useful for the core areas of macro–business cycles, monetary policy, interest rates, etc, that we can’t get (even better) from NGDP growth.

    HappyjugglerO, It probably wasn’t a good idea for me to say inflation is a bogus concept, right after Tyler did a column talking about how focused on inflation I am.

    Those are good ideas, but I won’t have much time in the near future. Hopefully they will go to FAQs, which I recommended, and get there questions answered.

    Bob, I probably just assumed you meant the 1870-1900 period, but anyway I think you agree it is reasonable. I was going to be tougher on Krugman, but then I remembered that in his academic papers he does mention that real growth also affects the likelihood of entering a liquidity trap, it’s more in his news columns that he just focuses on inflation. So I cut him some slack (referring to our earlier conversation here.)

    My understanding of utility and indifference curves is the following (it may be wrong):

    Economists define inflation to be X%, if people would have needed X% higher income in order to buy a bundle of goods with the same utility as before, i.e. to be indifferent between the current bundle and the base year bundle. Can any other economists confirm whether this is right?

    Statsguy #2 #3, Yes, I accept there are problems with the gold standard, I favor fiat money targeting NGDP partly because there can be big nominal shocks under a gold standard. My only point was that the trend rate of real GDP growth was fairly strong 1870-1900.

  31. Gravatar of Current Current
    3. August 2009 at 11:40

    Scott: “I haven’t read Mises”

    You should at least read those few pages and his description of the objective exchange value of money. In your recent posts you are tackling issues that are much closer to those that the marginal revolutionaries tackled around 1900. Their work is oddly very relevant today.

    Scott: “but there is no ‘objective’ measure of the exchange value of money, except in a world with one good of unvarying quality. And then it’s not money, it’s barter..”

    Well, I’m using archaic terminology, but in this case it may be useful.

    The “objective exchange value of money” *does* exist. It can be clearly concieved and in some cases measured.

    The objective exchange value of money is the amount of goods exchanged for it. Suppose in the year of an economy total goods T are exchanged for price P in money. In this case T is the price of P, just as P is the price of T.

    However, we aren’t concerned about that value, we are concerned about variations in it. There are two sorts of variations, those from the money side and those from the goods side. The problem is that those from the goods side are entirely subjective. That is what your post is getting to. As such they cannot be clearly and numerically differentiated by any means from the changes that come from the money side. But, we can concieve of a clear difference. Change that comes from the money side comes from the withholding of money from the market and from the creation of money. Though we can’t see it we can discuss it, apply economic logic to it and talk about what institutions tackle it best.

    Scott: “I agree, that’s why I put aggregate hours in my AS/AD diagram. If you throw out inflation, you ipso facto throw out RGDP.”

    That isn’t necessarily any better. Consider unpleasant work.

  32. Gravatar of JKH JKH
    3. August 2009 at 13:19

    Scott,

    “Then total NGDP would have a real component, which is population growth (roughly 1% in the US.) And it would have an inflation component, which is nominal income growth per capita (roughly 4% in the US over time.) So that makes it analogous to the real/inflation split in NGDP on the output side.”

    I don’t understand this part. I would have thought the real component embedded in income inflation as defined includes population growth plus the effect of productivity growth.

  33. Gravatar of Current Current
    3. August 2009 at 13:31

    Statsguy,

    I generally agree with Scott’s description of the era he mentions below:

    Scott: “I don’t accept that 1873-96 was a long depression. It was a long deflation. At the time, there was no real GDP data, but we know that industrial production soared during that period.”

    However, I don’t think this is really the interesting point. We can argue all day about how high living standards were in this era. The more interesting question is the liquidity trap.

    Many Keynesians tell us that deflation must lead to a liquidity trap. This era though demonstrates that this isn’t the case. Not only did industrial production increase, but interest rates were positive. There was no liquidity trap and little evidence of depression.

    The evidence of the volatility in GDP you mention is circumstantial. Statistics were troublesome in that period, price inflation especially.

  34. Gravatar of Bob Murphy Bob Murphy
    4. August 2009 at 05:41

    Scott,

    Your latest formulation, involving indifference curves, is OK. But in your main post you said per capita utility. It makes sense to ask what it would take to render a given person indifferent between two scenarios. But it doesn’t make sense to ask what total social utility divided by the population is. (At least, that’s not the way standard micro texts do consumer theory anymore.)

  35. Gravatar of ssumner ssumner
    4. August 2009 at 06:04

    Current, You said:

    “The objective exchange value of money is the amount of goods exchanged for it. Suppose in the year of an economy total goods T are exchanged for price P in money. In this case T is the price of P, just as P is the price of T.”

    So this year $100,000 can buy 10 goods; 4 Honda accords and 6 books of matches.

    Next year $100,000 can buy 12 goods; 2 Honda accords and 10 books of matches.

    Has the value of money risen? After all, it can buy more goods? Is that objective?

    JKH, You missed my point. The “real component” is completely a function of what you are measuring. If it is output prices, they you are right. But what if you are measuring input prices? The point of my essay was to get people out of thinking that there is one “right way” to think about inflation. The concept “inflation” can refer the the rise in prices of any entities, output goods, labor, whatever. For each entity, there will be a different rate of inflation, and hence a different real/nominal split.

  36. Gravatar of StatsGuy StatsGuy
    4. August 2009 at 06:52

    Current/ssumner:

    The argument for replacing CPI with NGDP neither needs, nor benefits, from throwing in an extraneous argument that modest deflation is not necessarily bad. It especially does not benefit from citing 1870-1900 as a case study:

    First, GDP per capita growth in the US in 1870-1900 was below trend line. That was the point of the graph I linked. It begins the era above the trend line and ends it at or slightly below the trend line. It wasn’t disastrous, but it was sub-par over a 30 year period. It was also accompanied by a massive concentration in wealth, which means the ranks of the poor swelled. And this was in spite of the fact that a good chunk of the US still relied on subsistence living. ssumner’s argument that “it was even worse elsewhere” holds little weight here: the US had vast untapped natural resources, more land per-capita than any of the old countries, and a non-oppressive government.

    Second, every account I’ve ever read of this era does not speak highly of it! This is particularly true for those regions in the US which could not fall back on subsistence agriculture (aka, the cities). Consider Chicago:

    http://dig.lib.niu.edu/gildedage/narr3.html

    “Just as the Panic of 1873 unfolded, Chicagoans had hosted an Inter-State Industrial Exposition to call attention to their rapid rebound from the great fire. But the depression that lasted for the rest of the decade temporarily slowed the city’s growth. Industrialists and entrepreneurs lost fortunes. ONE IN THREE WORKERS LACKED EMPLOYMENT. Many workers had come to Chicago in order to take part in the city’s reconstruction. Now many of these recently arrived, single male immigrants walked the streets as tramps.”

    (emphasis added)

    Third, there’s a legitimate argument that even the sub-par growth achieved in this period only occurred because the opportunities were so immense. This era benefited from a massive technological transformation, which was largely built atop an infrastructure developed by railroads and finance in the 1850s-1870s, and the pace of innovations was incredibly rapid.

    Consider the list of life-changing innovations (which had massive inherent demand) that are entirely exogenous to whether or not prices were inflating or deflating: electric light, better telegraphs, telephones, sound recording, electric rail cars, huge advances in metallurgy…

    And in spite of this, for a great many people, this era was miserable. Indeed, perhaps the best thing about it was that we waged neither a civil war nor a world war during the era.

  37. Gravatar of Current Current
    4. August 2009 at 07:06

    Scott: “So this year $100,000 can buy 10 goods; 4 Honda accords and 6 books of matches.

    Next year $100,000 can buy 12 goods; 2 Honda accords and 10 books of matches.

    Has the value of money risen? After all, it can buy more goods? Is that objective?”

    I think you almost understand my point.

    In the first year we can say what the objective exchange value of money is, it is objective or external. We could in principle measure it, though maybe not in practice. The same is true of the next year. However, between these two years the exchange ratio between goods have changed. Because what is traded in the next year is different to what is traded this year no number can be given to express the difference between the objective exchange value of money in the two years.

  38. Gravatar of Russell Munves Russell Munves
    4. August 2009 at 16:12

    Scott,

    I think everyone is much too wrapped up in measuring money and things. Money has no intrinsic value. It is bookkeeping tool for keeping track of payment for goods and services produced by someone beyond what he or she immediately consumes.

    The world not static. Production is not static. It fluctuates with the cost of supply and perceived demand. What is relatively expensive today may be inexpensive tomorrow when the market invents better ways to produce it, e.g., computers, food etc. We all enjoy deflation in the price of goods that comes from innovation and improvements in efficiency. Deflation is not per se bad.

    In fact, even deflation caused by a drop in demand in a crashing economy that is restructuring to shed excess investment, such in real estate, would not be half so painful if consumers and business were not riding a wave of leverage (loans) that supported the excess investment. The less leverage in an economy, the smaller bubble and the easier the adjustment.

    Does the government need to juice up the money supply so people borrow money to go on vacation, to eat out at restaurants, to buy furniture or other personal assets that are non-productive. If consumers saved to buy them, they would not have to pay interest and they would be able to afford more in their lifetimes. Yet the government is buying securities backed by credit card debt thus encouraging this type of activity. Does this make sense?

    I am concerned that with all the effort going into measuring substantially subjective criteria, people are losing sight of the forest for the trees. We need to develop a sound economic framework to realistically maximize stable economic growth given what we have to work with – human beings and their “animal spirits”.

    The fact that at this late date the our government could even consider trying to ameliorate the bursting of a massively overinflated credit enabled bubble by re inflation seems to indicate that from a societal standpoint, we haven’t a clue.

    What am I missing?

    Russell

  39. Gravatar of Lorenzo (from downunder) Lorenzo (from downunder)
    4. August 2009 at 22:55

    In my view you are describing real wage rigidity (or downward inflexibility.) But I am not sure real wages are rigid in the way you suggest. I think workers intuitively understand that if the inflation comes from an adverse supply shock, they will simply have to take a lower real wage. In America wages didn’t soar with oil prices in 2008, despite the fact that headline CPI peaked at over 5%. And it was good wages didn’t reflect that. Maybe in Australia unions are stronger and things are different.
    Well, unions in Australia are somewhat stronger than in the US, and were very much so during the high inflation of the 1970s (their power has declined noticeable since then: the economy is also much more flexible and works a lot better–which may be connected, in both directions).

    Yes, I think people do distinguish between one-off supply shocks which change the price level and continuous changes in the price level. That is, they distinguish between changes in relative prices and changes in the value of money in a continuing and across-the-board sort of way. I am sure Zimbabweans particularly do.

  40. Gravatar of ssumner ssumner
    5. August 2009 at 10:12

    Statsguy, I never once said modest deflation is a good thing. I never once said the 1870-1900 era was a good era, so you are attacking something I never said. All I said is that liquidity traps are unlikely to form if NGDP growth is high. If you think 1870-1900 was a liquidity trap, fine. But otherwise you are accusing me of making an argument I never made.

    But if we are going to argue about how good it was, you need to put it in perspective. The entire world was a nightmarish place 100 years ago by modern standards, so your narrative showing things were bad in America by modern standards is meaningless. The only thing that matters was were conditions better here than elsewhere at the time. And they were, that’s why millions kept moving here.

    Current, I agree.

    Russell, You asked :

    What am I missing?

    You are oversimplifying things. You are ignoring decades of research by the best and the brightest economists on the effects of unanticipated disinflation in a world of sticky wages and nominal debt. Unless you address theories like Friedman’s natural rate hypothesis you will not convince anyone. I’m not saying you are wrong, I am saying you are simply ignoring that body of work with your all or nothing on inflation. Do have a problem in suddenly going from some inflation to zero inflation in the midst of a debt crisis? If not, fine. I do, and I have a whole blog full of explanations of why this was a disastrous policy, and why what I propose is not advocating inflation as a way of bailing out debtors. Their debt contracts had an expected rate of inflation of roughly 2% built in. If we return to 2% inflation they will be paying exactly the real interest rate they negotiated with banks. No bailouts. I don’t see you addressing this argument, and many others.

    I hope this doesn’t sound too negative, you might want to read my FAQs if you are new to the blog, and then contest some of the specific points I make.

    Lorenzo, I think we agree.

  41. Gravatar of StatsGuy StatsGuy
    5. August 2009 at 12:06

    I’m not attacking you, sorry if it seems that way. I simply think you have a better argument if you delete point 5 in its entirety.

    You write:

    “Many economists argue that deflation can put us into a liquidity trap. I initially had the same view. But Bob Murphy points to examples of deflation that did not result in liquidity traps: America in the late 1800s, or China just this year. With respect to America I think that one factor was that the gold standard pretty much eliminated inflation expectations, so the expected rate of inflation was probably near zero. But the key point is that as long as real growth is strong (and it was in the period from 1870-1900) then you should be able to avoid a liquidity trap as long as deflation is mild. The recent Chinese case is instructive. They have had some deflation in the past year, but because they have experienced fairly high productivity growth, there is still strong demand for credit.”

    First, one can still have non-zero medium term inflation expectations in a time of credit expansion (easy money), although the long run is limited. Constant money supply and increasing productivity/economy can get you deflation (also non-zero inflation).

    But you need to distinguish between “moderate deflation” CAUSED by productivity increases (rather than merely ACCOMPANIED by productivity increases). That type of deflation is OK, in the sense that it is A) expected B) moderate C) doesn’t result from credit contraction. In other words, it’s supply driven deflation (there’s more stuff, and people compensate by consuming more). The only class of economists that argues moderate expected long term supply-side driven deflation is bad are Marxists.

    But… 1873 kicked off one mother of a credit contraction, with MASSIVE DEMAND DRIVEN GDP DECLINE.

    The entirety of Point 5 does not strengthen your argument, and citing Bob Murphy’s argument that “modest” deflation like that in the late 1800s (aka, Long Depression) wasn’t that bad simply steals credibility from this post.

    If, by liquidity trap, Bob Murphy means a situation where the nominal interest rate is zero, then sure… it was a gold standard and no one loans money for free when they can just sit on it until some exogenous shock (e.g. massive technological innovation) drives up demand for credit. If Bob Murphy means that the interest rates were low for that era and that (in spite of low rates) the employment situation was lousy, then this is plainly wrong. Unless one is manufacturing data to serve some sort of agenda.

    Not that I am implying that an adjunct professor and paid speaker for the Von Mises Institute would have an agenda…

  42. Gravatar of Russell Munves Russell Munves
    5. August 2009 at 17:22

    Scott,

    Thanks for your patient reply. You are right, I am not an economist but I have read quite a bit in the area for a non-economist on all sides of the spectrum from Keynes to Austrian school to Robert Shiller’s Animal Spirits and Nial Ferguson’s Ascent of money. And I have now read your FAQs.

    Turning to your particular and appreciated criticism (my philosophy is if you can’t take criticism, you shouldn’t dish it out) to my question “What am I missing?”, let me respond as follows:

    You said “You are oversimplifying things. You are ignoring decades of research by the best and the brightest economists on the effects of unanticipated disinflation in a world of sticky wages and nominal debt. Unless you address theories like Friedman’s natural rate hypothesis you will not convince anyone. I’m not saying you are wrong, I am saying you are simply ignoring that body of work with your all or nothing on inflation. Do have a problem in suddenly going from some inflation to zero inflation in the midst of a debt crisis? If not, fine. I do, and I have a whole blog full of explanations of why this was a disastrous policy, and why what I propose is not advocating inflation as a way of bailing out debtors. Their debt contracts had an expected rate of inflation of roughly 2% built in. If we return to 2% inflation they will be paying exactly the real interest rate they negotiated with banks. No bailouts. I don’t see you addressing this argument, and many others.”

    Fair criticism. You are essentially saying the 0% inflation is not bad per se, just too painful to go to at this time (and clearly politically impossible) given our current predicament. If is too politically difficult and painful, it is precisely because we are an over leveraged society addicted to unhealthy debt that has skewed the underlying investment apparently in a big way given the size of the snap back from bursting of the real estate bubble. But we have to deal with what is, not what we would like so we need to find the best way out of the pickle. I understand that is your goal and applaud the substantial efforts you are making.

    Your FAQ’s are wrong about the foundation of the real estate bubble. It relied on fraud in the subprime market to jump start the bubble. The Fed supplied the money and the facilitators (mortgage originators like Country Wide and Wall Street dealers), used it, not their own money, to make loans that any responsible banker knew had no hope of being repaid out of the borrower’s income.

    I know Wall Street traders and creators of this junk who told me that everyone in the business knew it was a house of cards waiting to implode. They were playing a game that their bosses did not fully understand and turned a blind eye to because the fixed income groups were making soooo much money for the banks as well as themselves. These fixed income groups continued to play the game hoping it would not implode until they got their year end multi million dollar bonuses. Low interest rates by the Fed and failure of regulatory oversight facilitated this game.

    For more practical suggestions than mine, take a look at Alan Meltzer’s testimony before Congress on Financial Regulation: http://www.house.gov/apps/list/hearing/financialsvcs_dem/meltzer_testimony.pdf. He has suggestions for minimizing a repeat performance of the last bubble and injecting financial responsibility into the system with minimal government regulation. I would be interested in your view of his suggestions.

    I understand it is harder for wages to go down because of human psychological resistance. But the resistance is not a wall and it is healthier for wages to readjust to a lower but sustainable level while prices are falling. If they fall in tandem,people will still be able to live and survive until the structural readjustments are made and healthy sustainable growth returns.

    Given human nature, there will always be bubbles but if there is a tight reign on credit creation, they will be smaller and less painful in their readjustment.

    I can’t see that the solution to our current problems is injecting money to reinflate the bubble if for no other reason that it is not fair to those who have saved for a rainy day and don’t get their fair share of the injection. It dilutes their savings. It encourages irresponsible, morally hazardous behavior. It creates new bubbles that implode when the stimulus disappears.

    Regards,

    Russell

  43. Gravatar of ssumner ssumner
    6. August 2009 at 06:23

    Statsguy, Sorry if my reply sounded harsh.

    You said,

    “But… 1873 kicked off one mother of a credit contraction, with MASSIVE DEMAND DRIVEN GDP DECLINE.”

    Friedman and Schwartz argue that this was a myth. Obviously I’m in no position to offer an opinion. But despite all the hardship that immigrants had, doesn’t the sheer fact that America’s cities and industry and railroads expanded fast in the late 1800s suggest that those decades saw fast RGDP growth?

    You said;

    “The entirety of Point 5 does not strengthen your argument, and citing Bob Murphy’s argument that “modest” deflation like that in the late 1800s (aka, Long Depression) wasn’t that bad simply steals credibility from this post.”

    You probably inferred the “not that bad” from my comment that there was no liquidity trap. But deflation can hurt employment even in the absence of a liquidity trap. There was no liquidity trap in 1921 or 1930, and yet employment fell. So we are closer than you think.

    You said:

    “If, by liquidity trap, Bob Murphy means a situation where the nominal interest rate is zero, then sure… it was a gold standard and no one loans money for free when they can just sit on it until some exogenous shock (e.g. massive technological innovation) drives up demand for credit.”

    People can also sit on cash when rates are zero. There is no reason a liquidity trap could not form under a gold standard; indeed interest rates were near zero in 1932 and 1938-40, both times the price of gold was fixed.

    Russell, You said;

    “I can’t see that the solution to our current problems is injecting money to reinflate the bubble if for no other reason that it is not fair to those who have saved for a rainy day and don’t get their fair share of the injection.”

    I hope you realize that this is not what I am proposing. Bubbles are not caused by easy money. Money was very easy in the 1960s and 1970s and there were no large bubbles. Prices were falling in the late 1920s and a huge stock bubble exploded. Bubbles are actually less likely to form when money is very easy.

    I’m afraid your Wall Street friends misinformed you about the housing bubble. Of course everyone knew there were lots of mortgages being made zero down, no income verification to doubtful borrowers. Even I knew that and I pay almost no attention to the real estate market. Everyone was talking about it. That means that the big international banks that lost billions on mortgage bonds knew that. These were sophisticated investors who held these binds, they certainly read their newspaper and knew exactly what was going on. Do you think Bank of America, Citibank, Lehman, Bear Stearns and all the others that lost a fortune were less knowledgeable about what was going on than I was? Believe me, they knew exactly what they were getting into. They took a gamble and lost. There was no fraud involved.

    Sorry if I sound negative, I appreciate the comments on my blog.

  44. Gravatar of Current Current
    6. August 2009 at 11:21

    Statsguy,

    I don’t think we are really disagreeing much here.

    Statsguy: “But… 1873 kicked off one mother of a credit contraction, with MASSIVE DEMAND DRIVEN GDP DECLINE.”

    To be clear. Austrian economists (and myself) don’t think that deflationary shocks are good. The argument is not that large unexpected deflations are good. It is the modest, expected ones that are due to productivity improvements are. What exactly happened in 1873 is open to question. I’ll admit I don’t know much about it.

    Statsguy: “But you need to distinguish between ‘moderate deflation’ CAUSED by productivity increases (rather than merely ACCOMPANIED by productivity increases). That type of deflation is OK, in the sense that it is A) expected B) moderate C) doesn’t result from credit contraction. In other words, it’s supply driven deflation (there’s more stuff, and people compensate by consuming more). The only class of economists that argues moderate expected long term supply-side driven deflation is bad are Marxists.”

    I don’t think we are really disagreeing here.

    Austrian economists describe two sorts of deflation which they consider to be good. The first is the sort I describe above. The second is the so-called “purging” deflation. Bob Murphy has described this in his online articles. I don’t really agree that this sort of deflation is beneficial or necessary. (Lots of Austrian Economists are on my side on that too).

    Statsguy: “First, GDP per capita growth in the US in 1870-1900 was below trend line. That was the point of the graph I linked. It begins the era above the trend line and ends it at or slightly below the trend line. It wasn’t disastrous, but it was sub-par over a 30 year period.”

    I don’t think you realise just how little we know about GDP in the 19th century. I have read a different study of the period that you mention which purports to show that real GDP was above trend not below it. I don’t believe either of these studies.

    I have another book somewhere from the early 1960s which describes the measurement of economic statistics of the time. That was a century after the period we are discussing began. At that time, in the UK in 1960 econometric statistics were awful. The baskets of goods picked for the retail and producer price indexes were not up to date.

    Modern economic historians aim to reconstruct accurate data. I very much doubt that they succeed. So, I agree with you that the period 1870-1900 shouldn’t be used as evidence for these theories about GDP, but I agree because the data is so poor.

    I still think that modest deflation during period of growth is good. That is mainly due to economic logic, not history. Though other recent period of deflation indicate provide some evidence in it’s favour.

    Regarding unemployment, yes, it was very bad in that period, that we know much more surely than the GDP. I still think though that it’s an open question why it was very bad. I don’t think that this fact should be given more weight than the analysis that shows that the type of productivity driven deflation described above is beneficial.

  45. Gravatar of StatsGuy StatsGuy
    6. August 2009 at 12:25

    BTW, I admit a tendency to unfairly lump Austrians together… Which gets me in trouble. I accept the points ssumner and Current raise above.

    However…

    RUSSEL MUNVES writes:

    “I understand it is harder for wages to go down because of human psychological resistance. But the resistance is not a wall and it is healthier for wages to readjust to a lower but sustainable level while prices are falling. If they fall in tandem,people will still be able to live and survive until the structural readjustments are made and healthy sustainable growth returns.”

    By prices, do you include debt-repayment? The whole point of “debt deflation” is that expenses DO NOT fall in tandem with wages because of DEBT REPAYMENT.

    So if I’m paying 40% of net income to my mortgage (and I expect this to decrease over time as my income increases), and then a shock happens that changes the monetary trajectory and my wage falls, and now I’m paying 45% of my net income to my mortgage due to lower wages (and expect this to increase over time), it has a MONSTROUS effect. Why? Because (if you do the math) on a _relative_ basis my available funds to cover the remainder of my expenses just dropped 19%.

    Here’s the math for you:

    My net income is $100
    40% goes to mortgage – $40
    My net income drops to $89 (an 11% drop)
    I’m still paying $40 in debt, but that’s now 45% of income
    I have $49 left over instead of $60 to spend on other stuff… That’s a 18%-19% drop

    In other words, discretionary budget (the portion not going toward fixed-debt-payment) drops MUCH FASTER than incomes or prices, which sustains the debt-deflation spiral through contracting AD.

    And that doesn’t take into account other fixed payments (e.g. phone bill) which are “sticky”.

    The effect is EVEN WORSE if I’m increasing my savings (rather than dissaving, as intertemporal consumption stabilization models innaccurately predict). Why would I do this? Because I’m compensating for asset value declines – in other words, lost WEALTH rather than INCOME. And if I perceive the world as a riskier place.

    All of this is really very simple, and the effects it would have on debt-as-money-supply are intuitive.

    The UNINTUITIVE part is this – the way out is to make cash a bad investment. Which is unpopular, because it makes people feel less secure (but, in a debt-deflation environment, it creates more security for everyone).

  46. Gravatar of Russell Munves Russell Munves
    7. August 2009 at 05:02

    StatsGuy: good point about mortgage debt getting in the way of readjustment. This underscores my comment that it is there is an unhealthy amount of leverage in the system that must be wrung out, rather than supported by stimulus, that is the impediment to healthy readjustment.

    But mortgages are not an impediment everywhere. Many states have non-recourse home mortgages (like CA) so homeowners can simply walk away and buy an equivalent home for what they can afford or rent. Or if banks are smart, the will reduce the payments to market to keep the homeowners in. For states where there is personal recourse on mortgage notes. Lenders need to take this into account when they make loans. That is the reason to require a healthy downpayment. I understand that during the depression, people put down 50%. Of course even 50% isn’t enough when you have a huge recession but it does reduce the pain to the lenders.

    Here is a thought. What do we really gain by making mortgage loans? The loans simply result in more people having more money to bid up housing prices. If there were no mortgage loans, maybe you would be able to buy a house for the 20% people are required to put down today. It make for a more secure homeowner better able to weather economic downturns because there would be no mortgage payment to make and mortgage payments are typically the biggest expense homeowners have. What harm would we suffer if loans were only made on capital investments that are designed to create more wealth?

    Scott said:

    “I hope you realize that this is not what I am proposing. Bubbles are not caused by easy money. Money was very easy in the 1960s and 1970s and there were no large bubbles. Prices were falling in the late 1920s and a huge stock bubble exploded. Bubbles are actually less likely to form when money is very easy.”

    Scott, I am not saying easy money creates bubble. People create bubbles. Easy money simply provides fuel to make them bigger than they would otherwise get such as the money available for “liar loans” which otherwise could not compete in a more limited credit marketplace.

    Scott said: “I’m afraid your Wall Street friends misinformed you about the housing bubble. Of course everyone knew there were lots of mortgages being made zero down, no income verification to doubtful borrowers. Even I knew that and I pay almost no attention to the real estate market. Everyone was talking about it. That means that the big international banks that lost billions on mortgage bonds knew that. These were sophisticated investors who held these binds, they certainly read their newspaper and knew exactly what was going on. Do you think Bank of America, Citibank, Lehman, Bear Stearns and all the others that lost a fortune were less knowledgeable about what was going on than I was? Believe me, they knew exactly what they were getting into. They took a gamble and lost. There was no fraud involved.”

    Scott, your logic is appealing but based on my personal professional experience, it is wrong. Investors, and I am talking about sophisticated investors including hedge funds and pension funds, knew there was some loosening, but the rating agencies were rating the priority tranches of everything AAA and the dealers were selling them as safe investments. The rating agencies used some statistical analysis that would have been valid for the time sampled but it did not take into account the change in the marketplace where mortgage brokers routinely encouraged borrowers to falsify information and take out liar loans and loans that they could not possible afford after the teaser rates adjusted. There was no quantitative information available for investors to determine the scope of this problem so they relied on the rating agencies (who were paid substantial sums to rate them by the issuers and who had no clue of the true underlying situation). You ask any broker originating subprime mortgages at the time and if they are honest, they will tell you that they knew that these loans made no sense. The money was only available for this because the Fed facilitated too much credit expansion (with the Chinese buying Treasuries to aid and abet it so they could keep exporting).

    So you have massive inflation of the subprime market. The subprime sellers take the profit they would not otherwise have had and move up the housing ladder to bigger houses and the financial institutions take the profits and pay huge bonuses and lend the money back in the housing and commercial real estate and commercial loan market on looser and looser terms and the whole thing inflates till it falls of its own wait. Easy government money encourages this because itmade more money available to lend. Banks are competing for a finite universe of borrows. Banks were forced to loosen their lending criteria in the face of competition. The Fed is culpable.

  47. Gravatar of Paul Paul
    7. August 2009 at 05:12

    Russell, I just wanted to say thank you about bringing this up:
    “but the rating agencies were rating the priority tranches of everything AAA and the dealers were selling them as safe investments.”

    For some reason no one in the media seems to be talking about this. If the rating agencies did their damn job, this problem could have been avoided. I don’t know why people are yelling at the rating agencies. Yes, banks should have probably known that these ratings were unusual, but it is the ratings agencies job to rate these securities.

    All I hear is blame on the banks and on homeowners (which I am not saying they aren’t to blame), but if the idiotic ratings agencies would have rated these securities as junk like they should have, I don’t know the exact number, but I would guess banks would own 80% less of these mortgage-backed securities than they did. (I think I recall banks not being allowed to own junk bonds, or only allowed a certain amount, but I could be confusing this with something else)

  48. Gravatar of ssumner ssumner
    7. August 2009 at 06:38

    I skip over the debate on Austria economics and the late 1800s, as I don’t have much to add to your discussion.

    Russell said:

    “I am not saying easy money creates bubble. People create bubbles. Easy money simply provides fuel to make them bigger than they would otherwise get such as the money available for “liar loans” which otherwise could not compete in a more limited credit marketplace.”

    The problem here is that most people assume that easy money means low interest rates. In fact, as Milton Friedman pointed out, tight money usually results in low interest rates.

    You said;

    “Scott, your logic is appealing but based on my personal professional experience, it is wrong. Investors, and I am talking about sophisticated investors including hedge funds and pension funds, knew there was some loosening, but the rating agencies were rating the priority tranches of everything AAA and the dealers were selling them as safe investments. The rating agencies used some statistical analysis that would have been valid for the time sampled but it did not take into account the change in the marketplace where mortgage brokers routinely encouraged borrowers to falsify information and take out liar loans and loans that they could not possible afford after the teaser rates adjusted. There was no quantitative information available for investors to determine the scope of this problem so they relied on the rating agencies (who were paid substantial sums to rate them by the issuers and who had no clue of the true underlying situation). You ask any broker originating subprime mortgages at the time and if they are honest, they will tell you that they knew that these loans made no sense. The money was only available for this because the Fed facilitated too much credit expansion (with the Chinese buying Treasuries to aid and abet it so they could keep exporting).”

    Now you are contradicting yourself. That would not be fraud at all. We both agree that everyone knew all the crazy zero down mortgages were being made. No fraud there. We all knew the rating agencies gave these bonds AAA, no fraud there. Where is the lying? Where is the information that some people had that others didn’t? If I knew everything that was going on, how were Lehman Brothers taken to the cleaners?

    Paul, You are expecting too much of the rating agencies. They don’t have a crystal ball. They used historical trends, by which standard these bonds were safe. Of course we all know about the black swan problem, but that is just as much the market’s fault as the rating agency. The EMH says rating agencies won’t be able to predict black swan events. And the EMH was right in this case.

    Russell, You said;

    “Easy government money encourages this because it made more money available to lend.”

    This confuses money and credit. Credit was easy because Asians were lending us billions of dollars. Money and credit are two totally different things. The Fed does not determine the supply of credit.

  49. Gravatar of Russell Munves Russell Munves
    8. August 2009 at 01:19

    Paul said: “For some reason no one in the media seems to be talking about this. If the rating agencies did their damn job, this problem could have been avoided. I don’t know why people are yelling at the rating agencies. Yes, banks should have probably known that these ratings were unusual, but it is the ratings agencies job to rate these securities.”

    The rating Agencies were no less careless than the banks or the SEC or anyone else. Congress was encouraging Fannie and Freddie to buy up the subprime garbage so they had a hand in it too. Based on historical default rates (as it turned out using insufficient data), they thought the higher tranches were safe. No one was closely analyzing the underlying loan level documentation or cash flow of the deals in the pools until things fell apart because they were all making too much money with their piece of the pie. Well, not no one. Certain hedge funds did and shorted the entire house of cards just before it collapsed and made billions. Good for them.

    Scott said: “The problem here is that most people assume that easy money means low interest rates. In fact, as Milton Friedman pointed out, tight money usually results in low interest rates.” Well you can have both.” Are you saying that the Fed kept credit tight after the tech bubble burst or that had they raised interest rates sooner, it would have not inhibited subprime lending? That is not my understanding.

    Scott said: “Now you are contradicting yourself. That would not be fraud at all. We both agree that everyone knew all the crazy zero down mortgages were being made. No fraud there. We all knew the rating agencies gave these bonds AAA, no fraud there. Where is the lying? Where is the information that some people had that others didn’t? If I knew everything that was going on, how were Lehman Brothers taken to the cleaners?”

    We don’t both agree that everyone knew the extent of what was going on. There was a lot of falsification of documentation by borrowers that only the originators really knew about. Investors had no way of knowing which borrowers falsified their information or the extent of the falsification. The also did not know the extent of the loosening of the lending criteria by mortgage originators or its overall effect on the market. The data wasn’t there to analyze it. All there was was anecdotal evidence in the newspapers. Country Wide and the other originators denied it was significant. This was fraud in my view. Historically, there was a legitimate and predictable subprime market meeting certain lending criteria that resulted in a predictable and acceptable default rate in light of the interest charge. The originators were selling these loans to the dealers. Apparently, the dealers did not due enough due diligence to verify the quality of the loans nor did the rating agencies. Investors relied on the representations of all of them and the banks as a whole themselves did not fully understand what the implications of this were though certainly some people in the groups packaging and selling these securities for the banks must have understood. Merrill appears not to have had a clue and just went with the flow. If the banks had understood, they would not have kept the CDO’s and CDO squareds in their porfolios and may not have allowed the game to continue because they would have realized that eventually they would be left holding the empty bag while the people who ran these businesses for them pocketed millions. Many people knew it was a house of cards but many people didn’t. If credit had not been easy, there would not have been so much competition to make subprime loans which resulted in a disastrous deterioration of quality.

    Scott said:

    Russell said ‘Easy government money encourages this because it made more money available to lend.’

    “This confuses money and credit. Credit was easy because Asians were lending us billions of dollars. Money and credit are two totally different things. The Fed does not determine the supply of credit.”

    Scott, you are being too literal here. The point was that in aggregate there was too much money available that needed to be lent out and the competition to lend it caused a gross, and inappropriate loosening of lending criteria in the US.

    And I fully agree that the Chinese in particular were substantially responsible for that state of affairs because they were taking our dollars to finance their economic growth fueled by exports to the U.S. Then they flooded the US market with these dollars seeking investments and it went inflated the credit markets that could not accommodate it with prudent investments. As many others have said, there were many causes of the problem.

    If you are saying that the Chinese sopping up of dollars and recycling them through the US credit market made it impossible for the Fed to do anything about the subprime market because the could not effectively influence interest rates, I recall having heard that argument. I am not sure of its validity and would like to see some evidence that had the Fed raised the Fed Funds rate, above 1%, that it would not have affected the amount of credit flowing into the markets. Had the Fed tried and failed stem the flow of credit, then we really couldn’t blame them. But they didn’t. They kept interest rates too low for too long. It seems logical that all other things being equal, higher interest rate mean less lending.

  50. Gravatar of Current Current
    8. August 2009 at 04:13

    Scott, Russell,

    This business of “Money” and “Credit” makes things very confusing. The “Money market” is the market for short term credit. When Russell talks about “easy money” he means “easy credit”.

    Scott: “The problem here is that most people assume that easy money means low interest rates. In fact, as Milton Friedman pointed out, tight money usually results in low interest rates.”

    This is disengenuous.

    If more money is issued than is demanded and the market considers that this will continue then the Fisher effect means that more interest rates will rise. If a government starts printing money, as the Weimar Germany did then the rate of interest will rise.

    However, today money is based on loans. Interest rates are altered by the Fed intervening in the loan market. In normal circumstances banks operate close to the minimum necessary reserves. The Fed cut the rate of interest by creating new funds and supplying them to the savings market. So, when the Fed cut the rate of interest in doing so they increase the size of the monetary base. As we have discussed previously in the current extraordinary circumstances this doesn’t apply and the Fisher effect is most significant. But Russell is discussing the situation of the past few years before the crisis, not now.

    I’m not convinced by every part of Russell’s view of the causes of the crisis. But, I’m not prepared to dismiss it entirely either.

  51. Gravatar of ssumner ssumner
    8. August 2009 at 05:47

    Russell, You asked.

    “Are you saying that the Fed kept credit tight after the tech bubble burst”

    Yes.

    Regarding your other point, first you said the ratings agencies were to blame for rating the bonds so highly, but now you seem to be saying it’s not the rating agencies’ fault because all the zero down, no income verification mortgages were some sort of big secret. Well the big banks have access to exactly the same secrets as the rating agencies. Either they both knew, or neither knew. I am convinced that they both knew. You can’t keep a secret between more then 3 people. When 100,000s of people are getting mortgages they have no business getting, and bragging about it to all their friends, the idea that there was some sort of secret becomes untenable.

    Russel, You said;

    “Scott, you are being too literal here. The point was that in aggregate there was too much money available that needed to be lent out and the competition to lend it caused a gross, and inappropriate loosening of lending criteria in the US.”

    This is still confusing money and credit. If banks have “excess reserves” they can always buy government bonds, they don’t “need” to lend it out to high risk borrowers. In any case, monetary policy does not explain the subprime bubble.

    You said;

    “And I fully agree that the Chinese in particular were substantially responsible for that state of affairs because they were taking our dollars to finance their economic growth fueled by exports to the U.S.”

    Just the opposite was occurring. The Chinese were lending us dollars to finance growth in the US. Had they not run a trade surplus, they could have used those dollars to invest in China, and had a much higher growth rate. Their lending to the US actually held down their growth rate.

    I don’t deny that the Fed can pop a bubble if it doesn’t care about GDP. The Fed was completely successful in popping the 1929 stock bubble. But it took a Great Depression to do so. Is that what we want?

    Current, You said;

    “Scott: “The problem here is that most people assume that easy money means low interest rates. In fact, as Milton Friedman pointed out, tight money usually results in low interest rates.”

    This is disingenuous.”

    This is not disingenuous at all. Milton Friedman is exactly right. Even in normal times interest rates are a poor indicator of monetary policy. Between 2003 and 2006 money clearly got easier, and yet interest rates rose sharply.

  52. Gravatar of Current Current
    8. August 2009 at 10:52

    Scott: “Even in normal times interest rates are a poor indicator of monetary policy. Between 2003 and 2006 money clearly got easier, and yet interest rates rose sharply.”

    In that case are you taking the Keynesian view that the supply and demand for interest bearing assets doesn’t drive the interest rate?

  53. Gravatar of ssumner ssumner
    9. August 2009 at 08:05

    Current, No, I believe the supply and demand does determine interest rates. Interest rose because the supply of interest bearing assets rose sharply, not because the Fed engaged in a tight monetary policy

  54. Gravatar of Carl Lumma Carl Lumma
    9. August 2009 at 15:43

    I agree that hedonic estimates are a fool’s errand, and that the NGDP is a better indicator, at least here in the U.S. But imagine a small European nation, where many goods are produced outside the auspices of the GDP. Or imagine targeting GNP here. Prices could get out of whack with wages. Or do exchange rates efficiently measure price levels (including hedonics)?

  55. Gravatar of ssumner ssumner
    10. August 2009 at 05:57

    Carl, I am confused by your comment. I thought GDP did measure what was produced in any country, small or large.

    In a small country it might be better to try to target aggregate wage rates, in order to minimize employment fluctuations.

  56. Gravatar of Jian Jian
    10. August 2009 at 10:53

    Scott,

    There was an op-ed in the Times yesterday about the shortcomings of GDP that reminded me of this post.

    http://www.nytimes.com/2009/08/10/opinion/10zencey.html

  57. Gravatar of How really bad the global economy is… – Page 2 How really bad the global economy is... - Page 2
    10. August 2009 at 15:54

    […] to use it during workouts. Thanks. Speaking of hedonic adjustments, have you read this? Six reasons to abolish inflation __________________ "Apocalyptic thought is curiously pleasurable." -Theodore […]

  58. Gravatar of Carl Lumma Carl Lumma
    10. August 2009 at 23:23

    Scott: Sorry, I was wrong about the difference between GNP and GDP. Let me try to restate my point.

    If we throw out the CPI as you suggest, can we be sure prices will not rise or fall too much with respect to wages?

    Let’s say country A imports most of its food from country B. In 2010, B’s GDP shoots up 20%, while A’s goes up 5%. Will this result in a painful increase in A’s food prices?

    I suppose that will depend on whether B’s GDP rise was nominal or hedonic. Assuming exchange rates are efficient (i.e. currency markets are efficient), A’s food prices should not rise if B’s GDP increase was nominal. On the other hand, A’s food prices will rise if the increase was hedonic.

    That is, assuming exchange rates are efficient, they would serve as an excellent measure of changes in hedonic value, after being adjusted for changes in the supply of each currency. Unfortunately, we think exchange rates are manipulated by governments (tariffs, etc) and are not efficient. Therefore, perhaps the CPI should not be completely abolished, though I agree NGDP is a better monetary policy target.

  59. Gravatar of Current Current
    11. August 2009 at 05:21

    Scott: “Even in normal times interest rates are a poor indicator of monetary policy. Between 2003 and 2006 money clearly got easier, and yet interest rates rose sharply.”

    Current: “In that case are you taking the Keynesian view that the supply and demand for interest bearing assets doesn’t drive the interest rate?”

    Scott: “No, I believe the supply and demand does determine interest rates. Interest rose because the supply of interest bearing assets rose sharply, not because the Fed engaged in a tight monetary policy”

    When you say “the supply of interest bearing assets rose sharply” what do you mean? Interest bearing assets are investments. If the supply of investments increases then the supply curve shifts outwards. That causes the rate of interest to fall, not rise.

    If the Fisher effect is involved things are different though, as we’ve discussed before.

  60. Gravatar of ssumner ssumner
    11. August 2009 at 06:38

    Jian, Thanks, I think RGDP can provide a very rough estimate of how developed a country is, but it has a lot of flaws. For business cycles we might be better off dropping RGDP, and looking at aggregate hours worked, or aggregate employment. So I agree with much of the article.

    Carl, I agree that the CPI might have some role to play in international comparisons. But what matters for exchange rate purposes is not the overall CPI but rather the price index of traded goods.

    Current, You may be confusing prices and yields. If there is an increase in the supply of bonds (say mortgage bonds) the price of these bonds will tend to fall. But when bond prices fall then interest rates rise.

  61. Gravatar of Russell Munves Russell Munves
    11. August 2009 at 07:10

    Scott said: Regarding your other point, first you said the ratings agencies were to blame for rating the bonds so highly, but now you seem to be saying it’s not the rating agencies’ fault because all the zero down, no income verification mortgages were some sort of big secret. Well the big banks have access to exactly the same secrets as the rating agencies. Either they both knew, or neither knew. I am convinced that they both knew. You can’t keep a secret between more then 3 people. When 100,000s of people are getting mortgages they have no business getting, and bragging about it to all their friends, the idea that there was some sort of secret becomes untenable.

    Scott: You are conflating the knowledge of some actors with the knowledge of all. That is simply not reality. Unless you were in the MBS business at the time, you simply had not idea what an MBS, IO, PO, CMO, CDO, RMBS, CMBS etc was, how they worked and how they were valued. People were in specialized groups that did not have access to all the info and the business was making so much money that people at the top relied on the people running them without fully appreciating the risks. Merrill Lynch is a good example. Read some of the stories about the former CEO who pushed them into the business because everyone else was making money without fully appreciating the risks involved. Moreover, at the outset, false statements were made in loan documentation by both borrowers and brokers.

    Scott said: This is still confusing money and credit. If banks have “excess reserves” they can always buy government bonds, they don’t “need” to lend it out to high risk borrowers. In any case, monetary policy does not explain the subprime bubble.

    Scott: If banks buy government bonds, then it is more competition for government bonds and this drives up interest rates (assuming the government does not increase the pool of bonds in which case it could still go up if buyers are afraid the the government will not be able to pay it back and try to inflate its way out of the debt).

    Scott said: Just the opposite was occurring. The Chinese were lending us dollars to finance growth in the US. Had they not run a trade surplus, they could have used those dollars to invest in China, and had a much higher growth rate. Their lending to the US actually held down their growth rate.

    Scott: You are confusing money with something of value. Money is only worth what you can buy with it. China was a huge net exporter to the U.S. and recycled the money into our credit markets which fueled the credit bubble. They did not even out the trade balance by buying our manufactured goods. If they invested the money in China, unless they get something of value for it in the U.S., they are just inflating their own domestic currency pool. It does nothing for Chinese growth either way.

    Scott said: I don’t deny that the Fed can pop a bubble if it doesn’t care about GDP. The Fed was completely successful in popping the 1929 stock bubble. But it took a Great Depression to do so. Is that what we want?

    Scott: The sooner it is popped, the less pain it will cause in the long run. Of course the real problem is identifying the bubble to pop. At the time, it is not always obvious which leads to political outcry that the Fed is ruining the economy unnecessarily. It is a difficult problem. Did you look at Alan Meltzer’s testimony on Regulatory Reform and the Federal Reserve on July 9, 2009 before Congress.? It really has some good practical analysis and ideas on how to deal with this very problem (and it is not long).

  62. Gravatar of Current Current
    11. August 2009 at 08:42

    Scott: “You may be confusing prices and yields. If there is an increase in the supply of bonds (say mortgage bonds) the price of these bonds will tend to fall. But when bond prices fall then interest rates rise.”

    You’re right I am.

    So, you’re view is that there were more investment opportunities in 2003 to 2006. Are you including in those investments the treasury bonds that the Federal reserve sold?

    I see your point now. If there was an increase in investment opportunities then the interest rate may do what you say. I suppose that may have happened in 2003-2006, I’m not sure that it did though.

    The possibility of that happening though makes estimates of monetary tightness from interest rates generally wrong for good times. And the Fisher effect makes it generally wrong for bad times.

  63. Gravatar of ssumner ssumner
    12. August 2009 at 10:09

    Russell, You said;

    “Scott: You are conflating the knowledge of some actors with the knowledge of all. That is simply not reality. Unless you were in the MBS business at the time, you simply had not idea what an MBS, IO, PO, CMO, CDO, RMBS, CMBS etc was, how they worked and how they were valued. People were in specialized groups that did not have access to all the info and the business was making so much money that people at the top relied on the people running them without fully appreciating the risks. Merrill Lynch is a good example. Read some of the stories about the former CEO who pushed them into the business because everyone else was making money without fully appreciating the risks involved. Moreover, at the outset, false statements were made in loan documentation by both borrowers and brokers.”

    I disagree. I think the big banks did know that if trillions of dollars of mortgage debt was defaulted on, if housing prices fell 35%, then those mortgage bonds would lose a lot of value. I think they made a gamble that there would not be a huge housing crash, and they lost. Obviously these bonds were known to be at least a little bit risky, otherwise no one would have ever bought a T-bond with a lower yield. You also have to remember that even the markets were wrong. So it’s not enough to say they were some out of touch CEOs who delegated responsibility. The markets mis-priced these bonds. And no one can argue that the markets lacked information that the ratings agencies had. That is not plausible. So I still don’t see the villains, or at least enough villains to explain any significant amount of the crash (I don’t deny there was some outright fraud, but much of the subprime lending was perfectly legal, and indeed encouraged by the government.)

    You said:

    “Scott: If banks buy government bonds, then it is more competition for government bonds and this drives up interest rates (assuming the government does not increase the pool of bonds in which case it could still go up if buyers are afraid the the government will not be able to pay it back and try to inflate its way out of the debt).”

    So why would that be a problem? Isn’t the goal to get interest rates higher with an expansionary monetary policy? A low interest rate policy sure hasn’t worked.

    You said:

    “Scott: You are confusing money with something of value. Money is only worth what you can buy with it. China was a huge net exporter to the U.S. and recycled the money into our credit markets which fueled the credit bubble. They did not even out the trade balance by buying our manufactured goods. If they invested the money in China, unless they get something of value for it in the U.S., they are just inflating their own domestic currency pool. It does nothing for Chinese growth either way.”

    If they invested the money in their own country, then they would have gotten something of value from the US, presumably capital goods to help them industrialize. In fact if you invest your surplus in your own country, then obviously the surplus goes away, and you have balanced trade. In that case you must be taking something of value back from the US.
    But even if you were right, I don’t see how the statement you made here supports your assertion that they used their trade surpluses to build up their own economy.

    You said;

    “Scott: The sooner it is popped, the less pain it will cause in the long run. Of course the real problem is identifying the bubble to pop. At the time, it is not always obvious which leads to political outcry that the Fed is ruining the economy unnecessarily. It is a difficult problem. Did you look at Alan Meltzer’s testimony on Regulatory Reform and the Federal Reserve on July 9, 2009 before Congress.? It really has some good practical analysis and ideas on how to deal with this very problem (and it is not long).”

    The fed has no business trying to pop bubbles, their job is to try to stabilize the macroeconomy. Meltzer is a monetarist, and unless he has changed his mind in the last few weeks, he also believes the Fed should focus on macro stability, not looking for bubbles to pop. I have zero confidence that the Fed could even identify a bubble. BTW, I have a post a couple months back that criticizes Meltzer’s view that high inflation is just around the corner. His argument was equally applicable to Japan in 1998, and they are still waiting for that high inflation from rapid growth in their monetary base and big budget deficits.

    Current, You said;

    “I see your point now. If there was an increase in investment opportunities then the interest rate may do what you say. I suppose that may have happened in 2003-2006, I’m not sure that it did though.

    The possibility of that happening though makes estimates of monetary tightness from interest rates generally wrong for good times. And the Fisher effect makes it generally wrong for bad times.”

    Here’s the bottom line, interest rates are absolutely worthless as an indicator of the stance of monetary policy. Obviously interest rates rose in 2006 because there was more demand for credit. We know this because the quantity and price of credit both rose. If it had been due to tight money they interest rates would have risen but quantity of credit would have fallen.

    In 2003 business investment was still very weak because of the lingering effects from the recession. That’s why rates were low, not because the Fed had “easy money.”

  64. Gravatar of Current Current
    12. August 2009 at 11:27

    Scott: “Here’s the bottom line, interest rates are absolutely worthless as an indicator of the stance of monetary policy.”

    I see your point. Until I read this post and the currently top I hadn’t realized how useless. It’s brought it home to me now.

    Scott: “obviously interest rates rose in 2006 because there was more demand for credit. We know this because the quantity and price of credit both rose. If it had been due to tight money they interest rates would have risen but quantity of credit would have fallen.

    In 2003 business investment was still very weak because of the lingering effects from the recession. That’s why rates were low, not because the Fed had ‘easy money.'”

    The problem here is the difference between the market for loanable funds “narrowly conceived” and that “broadly conceived”. Marshall had the interest rate determined by the narrowly conceived market, that only for debt. That is wrong though, like the other cases of supply and demand that Marshall used substitutes matter. Investing yourself is a subsitute for saving for some people, so is buying shares for others. So we have to look at the market broadly (Keynes made this point and so did several others).

    Since that is the case how do you solve the supply and demand identification problem?

  65. Gravatar of (Price) Inflation Is All In Your Mind « The Emergent Fool (Price) Inflation Is All In Your Mind « The Emergent Fool
    13. August 2009 at 00:58

    […] uses this bit of philosophy to justify abolishing inflation, not, “…the phenomenon of inflation, but rather the concept of inflation.”  More […]

  66. Gravatar of Russell Munves Russell Munves
    13. August 2009 at 04:27

    Scott said:

    I disagree. I think the big banks did know that if trillions of dollars of mortgage debt was defaulted on, if housing prices fell 35%, then those mortgage bonds would lose a lot of value. I think they made a gamble that there would not be a huge housing crash, and they lost. Obviously these bonds were known to be at least a little bit risky, otherwise no one would have ever bought a T-bond with a lower yield. You also have to remember that even the markets were wrong. So it’s not enough to say they were some out of touch CEOs who delegated responsibility. The markets mis-priced these bonds. And no one can argue that the markets lacked information that the ratings agencies had. That is not plausible. So I still don’t see the villains, or at least enough villains to explain any significant amount of the crash (I don’t deny there was some outright fraud, but much of the subprime lending was perfectly legal, and indeed encouraged by the government.)

    You can beleive what you like but I have seen no evidence to support your theory that everyone knew the scope of the problem and did it anyway. It defies common sense to think that the heads of banks would have put themselves in such a precarious position had they understood the scope of what was going on. Evidence to the contrary is the convential wisdom prior to the popping of credit bubble was that the subprime problems were small and would not affect the economy. Here is an aggregation of pre bubble prognostication from CNBC so called expert interviews. There was only one analyst out of many that was dead on about the scope and affect of the problems. The rest hadn’t a clue. http://www.youtube.com/watch?v=2I0QN-FYkpw

    I said:

    “Scott: If banks buy government bonds, then it is more competition for government bonds and this drives up interest rates (assuming the government does not increase the pool of bonds in which case it could still go up if buyers are afraid the the government will not be able to pay it back and try to inflate its way out of the debt).”

    Scott replied: So why would that be a problem? Isn’t the goal to get interest rates higher with an expansionary monetary policy? A low interest rate policy sure hasn’t worked.

    Scott: My point was that government expanding the amount of credit raises interest rates and hurts business that seek to borrow for productive purposes and makes a recovery harder, not easier.

    I said:

    “Scott: You are confusing money with something of value. Money is only worth what you can buy with it. China was a huge net exporter to the U.S. and recycled the money into our credit markets which fueled the credit bubble. They did not even out the trade balance by buying our manufactured goods. If they invested the money in China, unless they get something of value for it in the U.S., they are just inflating their own domestic currency pool. It does nothing for Chinese growth either way.”

    Scott replied: If they invested the money in their own country, then they would have gotten something of value from the US, presumably capital goods to help them industrialize. In fact if you invest your surplus in your own country, then obviously the surplus goes away, and you have balanced trade. In that case you must be taking something of value back from the US.
    But even if you were right, I don’t see how the statement you made here supports your assertion that they used their trade surpluses to build up their own economy.

    Scott: But the Chinese are not investing the surplus by buying U.S. manufactured goods use in their own country in sufficient quantities to eliminate the huge trade imbalance. Dollars are accepted by everyone. It is the supercurrency of the world (luckily for us or it would have been tanked long ago the way we have been running our economy). If they use the dollars to buy Chinese made goods, then they are just using worthless paper to give the appearance of demand which dies when they run out of paper because the paper is not backed by anything of equivalent value in the marketplace.

    They kept accumulating dollars to keep the exports flowing to the U.S. which was the driving force in building up their infrastructure. Unfortunately, it was built to service demand that was the result of a bubble that they themselves fueled by recycling the dollars into U.S. financial instruments.

    Scott said:

    The fed has no business trying to pop bubbles, their job is to try to stabilize the macroeconomy. Meltzer is a monetarist, and unless he has changed his mind in the last few weeks, he also believes the Fed should focus on macro stability, not looking for bubbles to pop. I have zero confidence that the Fed could even identify a bubble. BTW, I have a post a couple months back that criticizes Meltzer’s view that high inflation is just around the corner. His argument was equally applicable to Japan in 1998, and they are still waiting for that high inflation from rapid growth in their monetary base and big budget deficits.

    Scott: Labeling Alan Meltzer a “monetarist” is no response to the practical suggestions he made to Congress. I would certainly be interested in reading your critique of his suggestions. The main goal I think is in designing a system of rules that minimizes the size and duration of bubbles. Popping bubbles once they start is probably politically impossible even if you recognize them.

    I personally think that the government cannot be relied upon to properly control the money supply but I recognize that a “gold standars” is politically out of the question. My feeling is that we need to restrict borrowing for consumption so that consumers are not so highly leveraged. That includes for homes. There is nothing wrong with renting. Money should only be leant for productive purposes and even then, with substantial collateral. It would lead to much steadier growth in the long run and smaller bubbles. Of course, our economy is now structured to depend on debt on the consumption side. So this cannot happen politically but it would make for a more stable environment in the long run if it did.

  67. Gravatar of ssumner ssumner
    13. August 2009 at 07:21

    Current, You said;

    “The problem here is the difference between the market for loanable funds “narrowly conceived” and that “broadly conceived”. Marshall had the interest rate determined by the narrowly conceived market, that only for debt. That is wrong though, like the other cases of supply and demand that Marshall used substitutes matter. Investing yourself is a subsitute for saving for some people, so is buying shares for others. So we have to look at the market broadly (Keynes made this point and so did several others).

    Since that is the case how do you solve the supply and demand identification problem?”

    First of all, it is not clear Marshall was wrong. Perhaps you could say his theory was less useful. It certainly is true that the interest rate is the equilibrium point in the bond market. I have no solution for the identification problem, except to look for natural experiments. It’s not my area of expertise.

    Russell, You said;

    “You can beleive what you like but I have seen no evidence to support your theory that everyone knew the scope of the problem and did it anyway. It defies common sense to think that the heads of banks would have put themselves in such a precarious position had they understood the scope of what was going on. Evidence to the contrary is the convential wisdom prior to the popping of credit bubble was that the subprime problems were small and would not affect the economy.”

    You haven’t followed my argument, because your last sentence here exactly supports my point. They knew that things could go really bad, but they thought it very unlikely. They thought the subprime problem would be small, and it was huge. Here is an analogy. A casino sets up a roulette wheel. And the first day someone comes in and has a huge winning streak, breaking the casino. The casino knew this could happen, but they also thought it unlikely. The same applies to subprime mortgages. They thought only some would defualt. Instead a huge number defaulted and a huge number of non-subprime mortgages defaulted and a huge amount of non-mortgage debt defaulted. The crisis got far bigger than the original subprime problem. If it was just the risky subprime loans, we wouldn’t be in this mess.

    You said;

    “There was only one analyst out of many that was dead on about the scope and affect of the problems.”

    Then the ratings agencies weren’t to blame.

    You said:

    “Scott: My point was that government expanding the amount of credit raises interest rates and hurts business that seek to borrow for productive purposes and makes a recovery harder, not easier.”

    I don’t follow this at all. Are you talking about monetary policy? If so, an expansionary monetary policy helps borrowers.

    You said:

    “They kept accumulating dollars to keep the exports flowing to the U.S. which was the driving force in building up their infrastructure. Unfortunately, it was built to service demand that was the result of a bubble that they themselves fueled by recycling the dollars into U.S. financial instruments.”

    You are confusing two issues,

    1. Whether exports help Chine develop
    2. Whether a current account surplus helps China develop.

    Exports may help China’s development, but a trade surplus surely slows their development. South Korea ran persistent currant deficits during its years of fast growth, the Chinese would be better off doing the same.

    You said;

    “I personally think that the government cannot be relied upon to properly control the money supply but I recognize that a “gold standars” is politically out of the question.”

    I agree on both points. I have frequently advocated a fiat money regime where the market determines the money supply and interest rate most likely to produce low and stable NGDP growth.

  68. Gravatar of Current Current
    13. August 2009 at 07:56

    Scott: “First of all, it is not clear Marshall was wrong. Perhaps you could say his theory was less useful.”

    In terms of a general theory he was. Since other investments
    *can* compete with bonds. In some historical circumstances his theory may be a legitimate simplification.

    Scott: “It certainly is true that the interest rate is the equilibrium point in the bond market. I have no solution for the identification problem, except to look for natural experiments. It’s not my area of expertise.”

    What I mean is, how can you say: “obviously interest rates rose in 2006 because there was more demand for credit. We know this because the quantity and price of credit both rose.”

    Do you think that Marshall’s view is a legitimate simplification today?

  69. Gravatar of Russell Munves Russell Munves
    13. August 2009 at 13:09

    Scott said: You haven’t followed my argument, because your last sentence here exactly supports my point. They knew that things could go really bad, but they thought it very unlikely. They thought the subprime problem would be small, and it was huge. Here is an analogy. A casino sets up a roulette wheel. And the first day someone comes in and has a huge winning streak, breaking the casino. The casino knew this could happen, but they also thought it unlikely. The same applies to subprime mortgages. They thought only some would defualt. Instead a huge number defaulted and a huge number of non-subprime mortgages defaulted and a huge amount of non-mortgage debt defaulted. The crisis got far bigger than the original subprime problem. If it was just the risky subprime loans, we wouldn’t be in this mess.

    Scott: It is just the reverse, your roulette wheel analogy makes my point. In roulette, everyone knows the odds when the bet is made and assumes the risk. In the subprime debacle, the people running the banks clearly did not appreciate the level of risk because there was no clear quantatative numbers on breadth of the problem or they would have realized that they would likely be giving back all of their profits plus more to boot by playing this game. And no, this does not absolve the rating agencies because they were pretending to know by issuing the ratings. If you don’t have the data, then don’t make a prediction.

    I said: “Scott: My point was that government expanding the amount of credit raises interest rates and hurts business that seek to borrow for productive purposes and makes a recovery harder, not easier.”

    Scott said: I don’t follow this at all. Are you talking about monetary policy? If so, an expansionary monetary policy helps borrowers.

    Scott: I thought that the clear and common sense point I was making is that if the government is competing with business in the credit market because it is borrowing massive amounts of money to inject into the economy through Tarp or Cash for Clunkers or to lend to or invest in banks or GM, it raises interest rates which is a burden on other new economic activity. And they are doing it to prop up failed businesses. Not exactly consonant with a free market approach. But then the old Soviet Union tried to control their economies with successive failures in the form of five year plans. We are no smarter than the Russians. We just had a better system which is being undermined by all this government intervention.

    Scott said: Exports may help China’s development, but a trade surplus surely slows their development. South Korea ran persistent currant deficits during its years of fast growth, the Chinese would be better off doing the same.

    Scott: If your point is that China would have grown faster if they spent the surplus on U.S. goods and imported them to benefit their economy, interesting point. Maybe they were afraid of creating inflation and raising interest rates in the U.S. which would have inhibited our ability to import more Chinese goods. I am not sure this is right either but this approach lead to huge trade imbalances which created huge problems. Maybe it was just a mistake. What do you think?

    Scott said: I agree on both points. I have frequently advocated a fiat money regime where the market determines the money supply and interest rate most likely to produce low and stable NGDP growth.

    Scott: Nice to have some agreement. Too bad we are in the minority here. You would need really good transparency for that to work well but in the computer age, it might be doable practically though not politically.

    From a useful measurement perspective, it seems to me that the one way to measure how well people are faring in an economy is not to measure money which governments monkey around with but rather to measure how long consumers have to work to meet their basic needs and to buy other stuff too. I am sure this is an old idea.

    Of course, that would not capture stability of an economy because these numbers would not capture government subsidies that are unsustainable or warn of unsustainable government programs like medicare or social security.

    I still think leverage is dangerous. Have you read Richard Bookstaber’s book, Demons of their Own Design? It contains really good insights on the Wall Street games that have blown up.

  70. Gravatar of ssumner ssumner
    14. August 2009 at 07:05

    Current, You said;

    “In terms of a general theory he was. Since other investments
    *can* compete with bonds. In some historical circumstances his theory may be a legitimate simplification.

    Scott: “It certainly is true that the interest rate is the equilibrium point in the bond market. I have no solution for the identification problem, except to look for natural experiments. It’s not my area of expertise.”

    What I mean is, how can you say: “obviously interest rates rose in 2006 because there was more demand for credit. We know this because the quantity and price of credit both rose.”

    Do you think that Marshall’s view is a legitimate simplification today?”

    Let me give you an example. Some could say the supply and demand for base money doesn’t determine the price level, because you have left out near-monies like checking account balances. But it is perfectly all right to leave them out. If they affect the price level, they do so by affecting the demand for base money (because they are substitutes.) Now you can debate about whether the monetary base is the most useful way of think about the supply and demand for money, but you can’t argue it is wrong. The same holds for the bond market. The equilibrium point in a supply and demand for bonds is the interest rate. Other types of capital may impinge on that market, but do so through the supply and demand for bonds.
    Whether the bond market is a useful way of thinking about things is a different issue. I think it is more useful to take a broader look, and I think you do as well. But I think so becasue it is easier to see important causal factors if you look at lots of types of capital, rather than relying on the fact that you can figure out how those other sectors impact the supply and demand for bonds, which might be quite difficult.

    Russell, You said;

    “Scott: It is just the reverse, your roulette wheel analogy makes my point. In roulette, everyone knows the odds when the bet is made and assumes the risk. In the subprime debacle, the people running the banks clearly did not appreciate the level of risk because there was no clear quantatative numbers on breadth of the problem or they would have realized that they would likely be giving back all of their profits plus more to boot by playing this game. And no, this does not absolve the rating agencies because they were pretending to know by issuing the ratings. If you don’t have the data, then don’t make a prediction.”

    You seem to be assuming that they estimated the odds wrong. but maybe they estimated them exactly right, but just got very unucky. mayber they thought a housing crash was a 100 to 1 thing, and the one just happened to turn up in 2007. The same could apply to the rating agancies, based on pastr history these bionds were really safe. Now you can argue that they should have seen how conditions had changed, but that is true of everyone. People ask the rationgs agencies to do the best they can. You can’t expect them to get it right every time.

    You said;

    “Scott: I thought that the clear and common sense point I was making is that if the government is competing with business in the credit market because it is borrowing massive amounts of money to inject into the economy through Tarp or Cash for Clunkers or to lend to or invest in banks or GM, it raises interest rates which is a burden on other new economic activity. And they are doing it to prop up failed businesses. Not exactly consonant with a free market approach. But then the old Soviet Union tried to control their economies with successive failures in the form of five year plans. We are no smarter than the Russians. We just had a better system which is being undermined by all this government intervention.”

    I agree with that, but I never said anything different. I had assumed you were disagreeing with something I said. I am certainly opposed to deficit spending, that’s why I prefer monetary stimulus.

    On the Chinese equestion, I’m not really sure what their motivation was. Perhaps they are building up assets because they have an aging population and not much of a social security system. It’s just a theory.

    I haven’t read the book you mention, but I think the main problem wall Street had was not of their own making, but rather the Fed’s tight money policy which led to deflation.

  71. Gravatar of Current Current
    14. August 2009 at 08:23

    Scott: “Let me give you an example. Some could say the supply and demand for base money doesn’t determine the price level, because you have left out near-monies like checking account balances. But it is perfectly all right to leave them out. If they affect the price level, they do so by affecting the demand for base money (because they are substitutes.) Now you can debate about whether the monetary base is the most useful way of think about the supply and demand for money, but you can’t argue it is wrong. The same holds for the bond market. The equilibrium point in a supply and demand for bonds is the interest rate. Other types of capital may impinge on that market, but do so through the supply and demand for bonds.
    Whether the bond market is a useful way of thinking about things is a different issue. I think it is more useful to take a broader look, and I think you do as well. But I think so becasue it is easier to see important causal factors if you look at lots of types of capital, rather than relying on the fact that you can figure out how those other sectors impact the supply and demand for bonds, which might be quite difficult.”

    I agree.

    Let’s go back to what you said a little earlier….

    Scott: “obviously interest rates rose in 2006 because there was more demand for credit. We know this because the quantity and price of credit both rose. If it had been due to tight money they interest rates would have risen but quantity of credit would have fallen.”

    In this excert when you mean “interest rate” do you mean the interest rate on debt generally? When you say quantity which quantity do you mean?

    Treasury bonds, commercial bonds, and bank savings accounts all yield interest. Mortgages, loans, bonds and so on all have interest that must be paid.

    What is the quantity you are referring to here? Is it the overall quantity lent by banks and government? I had no idea that was collated anywhere.

  72. Gravatar of Russell Munves Russell Munves
    14. August 2009 at 14:34

    Scott said: You seem to be assuming that they estimated the odds wrong. but maybe they estimated them exactly right, but just got very unucky. mayber they thought a housing crash was a 100 to 1 thing, and the one just happened to turn up in 2007. The same could apply to the rating agancies, based on pastr history these bionds were really safe.

    Scott: That is just the point. The criteria for granting loans changed, became much looser, from the loans during the period that the rating agencies used as a baseline and they had no handle on the scope, extent or effect of the change. The statistical analysis was based on irrelevant data.

    Scott said: I agree with that, but I never said anything different. I had assumed you were disagreeing with something I said. I am certainly opposed to deficit spending, that’s why I prefer monetary stimulus.

    Scott: We agree.

    Scott said: On the Chinese equestion, I’m not really sure what their motivation was. Perhaps they are building up assets because they have an aging population and not much of a social security system. It’s just a theory.

    Scott: I tend to agree. No social security and less social stability than the U.S. tends to make for a nation with more bias toward savings I would think.

    Scott said: I haven’t read the book you mention [Demons of Their Own Design by Bookstaber], but I think the main problem wall Street had was not of their own making, but rather the Fed’s tight money policy which led to deflation.

    Scott: Oversimplifying things greatly, he suggests it is complexity and leverage leaving not enough leeway for economic fluctuations. Worth looking at. Amazon has it.

  73. Gravatar of ssumner ssumner
    17. August 2009 at 00:53

    Current, I’m not sure what I meant. But I’ll predict that if you look at almost any credit aggregate that experts come up with, it expanded sharply between 2003 and 2006. But I do not know precisely how it should be constructed.

    Russell, The point you raise has to do with objective and subjective esimates of probability. You are essentially pointing out that gambling has objective odds, and financial crises have subjective odds. I agree. And you point out that in retrospect a lot of stuff that happened in 2006 looks foolish. I agree. And thus that experts should have seen the odds as being much higher than 100 to one given the recent events. I agree. You might want to look at mt Rorty and efficient markets post from around April. I think I pointed out that everyone screwed up:

    1. the press
    2. regulators
    3. banks
    4 ratings agencies.
    5. the stock market valuation of banks
    6. many homebuyers
    7. most academics

    In retrospect the housing boom looks like mass hysteria. But almost everyone missed the problem (with a few exceptions.) So I keep asking how can one group be singled out? Maybe the ratings agencies knew a bit more than the others, but not enough more to really single them out as crucial. The others should have known enough, but obviously didn’t. So the problem can’t have been as obvious as it now seems, but much of the cause (massive subprime lending to questionable borrowers) was widely known. That is the paradox.

  74. Gravatar of Russell Munves Russell Munves
    17. August 2009 at 05:27

    Scott said: Russell, The point you raise has to do with objective and subjective esimates of probability. You are essentially pointing out that gambling has objective odds, and financial crises have subjective odds. I agree. And you point out that in retrospect a lot of stuff that happened in 2006 looks foolish. I agree. And thus that experts should have seen the odds as being much higher than 100 to one given the recent events. I agree. You might want to look at mt Rorty and efficient markets post from around April. I think I pointed out that everyone screwed up:

    1. the press
    2. regulators
    3. banks
    4 ratings agencies.
    5. the stock market valuation of banks
    6. many homebuyers
    7. most academics

    In retrospect the housing boom looks like mass hysteria. But almost everyone missed the problem (with a few exceptions.) So I keep asking how can one group be singled out? Maybe the ratings agencies knew a bit more than the others, but not enough more to really single them out as crucial. The others should have known enough, but obviously didn’t. So the problem can’t have been as obvious as it now seems, but much of the cause (massive subprime lending to questionable borrowers) was widely known. That is the paradox.

    Scott: Agree with all of your points above and the paradox it raises. I think the failure has to do with human nature. The best solution in my view is to construct a system that minimizes the amount of fuel avaiable for bubbles. One way to do it is, if we have to have a central bank, to give them a single overriding responsibility, prevent inflation. This will prevent the government from fueling boom bust cycles and, all other things being equal, lead to more long term stability and grow.

    There is one point you made earlier which I do not follow the logic of. I may be taking this out of context but I thought you indicated that you felt that government stimulus was preferable to no stimulus from an economic standpoint. My feeling is that it gives some immediate pain relieve at the cost of creating more economic imbalance in the long run and more pain. I can see why politically it is attractive, and maybe even necessary to prevent civil unrest, but from a purely economic standpoint, I do not see the utility of stimulus (which I equate to a jolt of governmment spending not balanced by an increase in taxes to pay for it).

  75. Gravatar of Current Current
    17. August 2009 at 07:18

    Scott: “but I’ll predict that if you look at almost any credit aggregate that experts come up with, it expanded sharply between 2003 and 2006. But I do not know precisely how it should be constructed.”

    Just one would do. What figure did you use?

  76. Gravatar of ssumner ssumner
    19. August 2009 at 03:18

    Russell,

    You say you want stable prices. I want 5% NGDP growth. Given my goal (which you disagree with) the need for stimulus is obvious—NGDP has fallen about 4%. But even your goal could suggest a bit of stimulus, after all the CPI is down 1.4% in the last year.

    Current, I may no attention to credit, since I don’t think it is relevant to policy. All I can tell you is that I vaguely recall seeing lots of graphs showing an orgy of borrowing by Americans in the 2003-06 period. I know that’s pretty week, but my instincts tell me I’d be proven right if someone checked. Sorry I don’t have the numbers before me.

  77. Gravatar of Current Current
    19. August 2009 at 03:58

    Scott: “Sorry I don’t have the numbers before me.”

    Fair enough. I’ll have a look around myself.

  78. Gravatar of q q
    19. August 2009 at 18:09

    ok, i just have one stupid question.

    in the past few years we built a lot of houses and we don’t have to build as many now.

    that _should_ make us richer, because we have the houses that we didn’t used to have.

    so why does that seem to make us poorer?

  79. Gravatar of Current Current
    20. August 2009 at 03:27

    Of course the houses have made us richer. The problem is that perhaps the capital could have been better invested elsewhere.

  80. Gravatar of ssumner ssumner
    24. August 2009 at 00:40

    Q is right. We are not poorer because we built too many houses. We knew that in late 2007 when the stock market was at record levels. We are poorer because:

    1. Tight money caused NGDP to fall sharply.
    2. Since prices and wages are sticky when NGDP falls sharply RGDP also falls.
    3. When we produce less real output our real income also falls.

    It has almost nothing to do with building too many houses. And it is dismaying that so many economists think it is due to that mistake.

    (Perhaps q’s question was rhetorical, I can never tell as I get so many different types of comments.)

  81. Gravatar of jean jean
    29. August 2009 at 04:33

    Dear Prof. Sumner,
    I really appreciate the idea of futures targeting, but I have some doubts on NGDP as a target.
    While it would undoubtly avoid recessions as we know them, NGDP is subject to weekly, monthly, yearly fluctuations (the awful saturday recession, followed by the monday boom…). It is not necessarily wishable that these fluctuations to be smoothed.
    Another problem is changes in how NGDP is computed (its definition may vary), the variable size of informal economy, as well as the influence of fiscal policy on NGDP.
    How would you take in account these difficulties?

    Last question: do you have an estimate of the size of CPI/NGDP future market if your scheme was put in practice?

  82. Gravatar of ssumner ssumner
    30. August 2009 at 15:49

    Jean, Good questions. I favor targeting the seasonally adjusted NGDP.

    The informal economy is large, but doesn’t play a major role in business cycles. If you stablize measured NGDP, then actual NGDP will also be much more stable.

    The NGDP contracts would be based on the definition at the time the contracts were traded. If the government changes the definition, then they need to continue computing NGDP based on the old definition for the life of the contracts (perhaps 12 months) I think they already do this, but I am not certain.

    I favor a subsidy large enough so that at least several thousand traders will participate in the market.

  83. Gravatar of Russell Munves Russell Munves
    30. August 2009 at 17:35

    Scott said: You say you want stable prices.

    Scott: I don’t want stable prices. I want 0% inflation with inflation defined as more money chasing the same amount and type of goods and services. If we are going to have a Fed, that should be its sole mandate.

    In that environment, market prices will be based on supply and demand rather than the illusion of demand created when inflationary dollars (or credit equivalent) are injected into a particular place in the economy (like the real estate market). You will still have bubbles because of human nature (“Animal Spirits”) but the will be smaller and shorter.

  84. Gravatar of jean jean
    31. August 2009 at 14:15

    Well, my point was not that informal economy (in a very broad sense, including non-monetary transactions) has caused business cycles but that enforcing a constant NGDP growth could trigger recessions if war on crime or fiscal policy expands the formal economy to the detriment of the informal one.

    This is maybe an unimportant problem in developped countries, but I wonder what would be the effect of a surge in women employment if NGDP targeting was in place.

    Note that similar problems could occur if immigration policy (should the target take into account the population?) changes.

  85. Gravatar of ssumner ssumner
    2. September 2009 at 15:38

    Russell, I’m not sure I understand your definitions of inflation and stable prices. You seem to define inflation as the money supply growing faster than real GDP. But that can occur during deflation.

    Jean, Real problems could create a recession under any monetary policy. I’ll just say here that NGDP targeting insulates the economy against real shocks better than inflation targeting.

  86. Gravatar of Jon Jon
    2. September 2009 at 19:54

    Scott writes:

    Q is right. We are not poorer because we built too many houses. We knew that in late 2007 when the stock market was at record levels. We are poorer because:

    If you mean poorer in a nominal sense, then I agree that happened afterward. But might we have become poorer relative to our potential ‘real’ wealth? Aren’t each month that those houses remain empty charge-offs on society’s investment?

  87. Gravatar of ssumner ssumner
    3. September 2009 at 18:23

    Jon, My point was more nuanced. Yes, bad housing investment had an opportunity cost, but not enough to make us poorer, only enough to slightly slow down the rate we got richer. What has made us much poorer was the dramatic decline in the output of things we should have been producing, due to tight money. Indeed even some of the housing glut is due to tight money, not foolish investments.

  88. Gravatar of Jon Jon
    3. September 2009 at 19:53

    Scott: Clearly we agree then. Perhaps though you can substantiate your more aggressive claim: “only enough to slightly slow down the rate we got richer.” I don’t agree, but I’m open to being convinced.

    I think you underestimate the rate of depreciation–the level of investment spending necessary to maintain the capital base. We can take a guess at what this level is: ~20% of GDP.

    We can agree that unemployment destroys potential wealth too… but you have not–on this blog–laid the ground work to claim that there isn’t a process at work that explains how the recession resulted to begin with.

    i.e., what is the process in the economy to which you expect the Fed to be adapting?

  89. Gravatar of Jon Jon
    5. September 2009 at 21:02

    Good timing from the WSJ letters section:

    Regarding this, Ludwig von Mises writes in “Human Action” that, “The final outcome of the credit expansion is general impoverishment. . . . One must guard against the misinterpretation of this term impoverishment as compared with the state of affairs which would have developed in the absence of credit expansion and the boom. The characteristic mark of economic history under capitalism is unceasing economic progress . . . The pace of this progress is so rapid that, in the course of a boom period, it may well outstrip the synchronous losses caused by malinvestment and over-consumption. Then the economic system as a whole is more prosperous at the end of the boom than it was at the very beginning; it appears impoverished only when compared with the potentialities which existed for a still better state of satisfaction.”

  90. Gravatar of ssumner ssumner
    7. September 2009 at 17:56

    Jon, 20% seems a bit too high, actual gross investment is usally less than 20%–perhaps 10% is closer to the truth.

    I agree with Mises that we are better off than before the boom, where I disagree is that I think the main business cycle “problem” is that sticky wages cause employment fluctuations. This I think the main problem is producing too much or too little aggregate output, not the wrong mix of output (although that also occurs, it is a second order problem in my view.)

  91. Gravatar of Jon Jon
    7. September 2009 at 19:44

    10%, 20% I think that is in my margin of error. AFAIK, gross investment is somewhat higher than 20% not lower. My claim was in case ‘rough’. I based it on gross investment plus an assumption that ROI averages around 20% and real growth is less than 2%. I don’t want to quibble over this.

    Tyler linked to this: http://econlog.econlib.org/archives/2009/09/the_recalculati.html

    Which includes the claim:

    The economy needs to reallocate labor away from housing and related industries and into other industries. This means that the composition of the work force has to change, which takes a lot of time. Meanwhile, unemployment rises, which causes further disruption…

    During a Recalculation, there is too much information to be processed in too little time…

    Don’t try to keep people in houses they cannot afford. Instead, give them subsidies to move their belongings to apartments that they can afford. The attempt to bailout home owners just interferes with and prolongs the recalculation.

    A very familiar Austrian claim, which is something akin to avoiding the broken window fallacy. Value is created by making the goods people want, not just be keeping the factories running. Indeed that output is ‘expense’.

    Something that I’ve been thinking about is that its economically wasteful to employ the same numbers of people at reduced wage when business activity slumps. What you want to do is resource the task efficiently and free the excess into doing something else society wants. IMO, that’s the defect of these state furloughs. Yeah, they spare people unemployment, but since the workers strictly do less the work, clearly fewer resources should be deployed.

    Maybe wages should be sticky. Going back to the article linked, the churn is efficient, but unemployment induced by unemployment is noise (and inefficient)

    If you keep, keep making the goods people don’t want–supported by monetary policy–you are destroying wealth along the way. So your claim really does hinge on which is the larger problem: does unemployment destroy more potential wealth or does the prolonged sectoral shift.

    So how do you distinguish? How do you know? Is the same always? Should policy be different?

  92. Gravatar of ssumner ssumner
    9. September 2009 at 01:22

    Jon, I totally agree with the quotation you cite, but let me emphasize again that the process you describe HAS NOTHING TO DO WITH THE CURRENT RECESSION. It does not explain the 9.7% unemployment rate. By mid-2008 we had been reallocating labor away from housing for almost 2 years, with only a tiny rise in unemployment. Then AD fell sharply, a completely unrelated shock, and unemployment soared in all sorts of industries totally unrelated to housing. Yes, unemployment got even worse in housing, but that extra unemployment was not a needed reallocation of labor, but a needless idling of labor due to sticky wages.

    Sectoral reallocation of labor does not cause recessions.

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