But how many of those countries saw their currencies appreciate?

A few months ago an astute commenter mentioned a study (was it an IMF study by Rogoff?) that examined nearly 100 previous financial crises.  He said they found that real GDP fell sharply in every case.   He then used this evidence to refute my argument that easier money could have prevented a severe collapse in output during the late 2008 financial crisis.   My response was “yeah, but how many of those countries saw their currencies sharply appreciate during the midst of the financial crisis.”  I’d like to return to this issue, but first I will discuss recent market news.

I was pleasantly surprised to see that the stock market rose strongly this morning, and noticed some interesting comments in the press.  One story (which I can’t find) mentioned that sentiment was helped by a sharp rebound in China.  For months I have been arguing that the strong rebound in East Asia is the most likely cause of the “green shots” now visible in the markets (although not yet the broader economy.)  A more interesting story discussed an increased appetite for risk which was depressing the dollar:

NEW YORK, July 30 – The U.S. dollar fell against a basket of currencies on Thursday as a firmer tone in world equity and commodity markets eroded demand for the greenback as a safe haven.

U.S. stock futures pointed to a higher open, while European shares rallied and crude oil prices advanced above $64 a barrel.

That boosted investors’ appetite for risk and helped the euro and perceived higher-risk currencies to recoup some of the previous day’s sharp losses.

” futures are looking good,” said Ronald Simpson, managing director of global currency analysis at Action Economics in Tampa, Florida. “It’s generally the risk appetite scenario once again.”

.   .   .

Perceived higher risk and commodity-linked currencies such as the Australian and Canadian dollars rallied, with sentiment buoyed by gains in Chinese shares and a recovery in oil prices.

China’s benchmark Shanghai Composite Index ended 1.7 percent higher following a 5 percent loss in the previous session after a senior central banker said loose monetary policies would not be reversed.

In my research on the Great Depression I often found that when a certain factor (such as gold hoarding) caused a sharply stock market decline, the reversal of that factor was associated with an equally sharp rebound.  One of the odd things about the financial crisis in late 2008 was that the dollar rallied strongly.  I know this sounds far-fetched, but is it possible that the US financial crisis did so much damage to the rest of the world that investors seeking a safe haven perversely piled into the currency of the country that triggered the crisis?  Previously I had mostly argued that the rise of the dollar last fall was a symptom of tight money.  I still believe that.  But the scale of the appreciation against the euro was astounding, especially given that monetary policy in Europe was also very tight.  (I seem to recall that the euro fell from around 1.60 to 1.25 between July and November.)

Now let’s consider this news story.  It says that growth in the developing world is increasing investor appetite for risk.  Note that Chinese and HK stocks have outperformed even the US indices.  And what happens to the dollar on the news?  It falls.  And US stocks soar.  This certainly doesn’t prove anything, but if we are seeing a reversal of what happened last fall then maybe the rise in the dollar back then was caused by both tight money and a flight to safety.  Note that the financial crisis was itself partly caused by the tight money, so it is difficult to disentangle all of these effects.  But this did get me thinking about that question posed by my commenter—how did the recent US financial crisis compare to others?

I’m no expert of financial crises, but my impression is that the typical Thai/Mexican/Russian financial crisis was associated with currency depreciation.  If so, then those crises are not models for the US.  I know of one other crisis that definitely saw a currency appreciation, and one that might have.  I’ll start with the maybe.

Argentina had its currency linked to the dollar from about the early 1990s to 2001.  If I am not mistaken, the dollar was very strong around 1999-2001, dragging the Argentine peso up with it.  And I also recall they had a financial crisis and depression at his time.  Argentina had deflation when much of the world was booming.  Could the depression have been prevented by a floating exchange rate combined with inflation targeting?  I think so; the policy seems to work pretty well in Chile.

The other case, which I know much more about, was the US from December 1930 to March 1933.  During those 27 months the dollar was tied to gold.  Nevertheless, the dollar did appreciate strongly because many countries sharply devalued their currencies, and no country revalued their currency.  During this period the US experienced several banking crises, which became increasingly more severe.  And of course there was a deep depression.

So those are the two financial crises that I can think of that are similar to our recent crisis.  Was monetary policy to blame?  I don’t know a lot about Argentina, but in the early 1930s very few Americans thought that tight money was causing the Depression.  After all, rates had been cut to very low levels, and the Fed sharply increased the monetary base.  And of course people are saying the same thing today.  Only a few academic eggheads like Irving Fisher argued that money was too tight.

One other thing, today Irving Fisher’s eccentric view is pretty close to conventional wisdom.

There are two ways to visualize this recent upswing, for those of you confused by my ”tight money” argument.  One is the point that Bill Woolsey keeps emphasizing, that an increased demand for money has the same effect as tight money.  With greater appetite for risk, there is perhaps less demand for dollars, and this is expansionary.  Or we could use the Wicksellian interest rate approach.  The increased appetite for risk translates into a higher Wicksellian equilibrium rate.  Because the policy rate is stuck at zero, this slightly eases monetary policy.  Is it enough?  No, but things are definitely a bit more hopeful than in March.

PS.  A note to my Chinese readers.  If any of you live in Beijing, and can write in English, I hope you can add a comment to this post (I can’t read the Chinese one.)  I have two questions:

1.  To what extent does the recent upswing in China reflect productive investments, as opposed to wasteful projects that may someday create bad loans for Chinese banks.  (Actually, any Chinese reader can answer this one.)

2.  I will be in Beijing during the last few weeks of August and first few weeks of September.  Any ideas on what to do?  I have seen most of the big historical sites on earlier visits to Beijing, and am interested more in new things that may have sprung up since my last visit in 2006.   (Restaurants, art districts, interesting new architecture, music and entertainment, etc.)  I also will spend a day in Tianjin.  Thank you.


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18 Responses to “But how many of those countries saw their currencies appreciate?”

  1. Gravatar of Jon Jon
    30. July 2009 at 11:31

    but is it possible that the US financial crisis did so much damage to the rest of the world that investors seeking a safe haven perversely piled into the currency of the country that triggered the crisis?

    There is plenty of evidence that the financial crisis was not “US” but rather focused in Europe and in European institutional dependency on dollar financing.

    It is this that caused the rapid appreciation of the dollar.

    Although there is some confusion on this point, if you look back to last summer. European banks had leverage ratios similar to US investment banks. Their deposits covered only about 90% of loans. They were heavily dependent on financing from the CP market. They held substantial pools of subprime loans from the US (indeed appear to have been the big players in this market). They held similar pools from emerging markets. Almost singularly they were the counterparty to AIG.

    After the big US bank mergers their balance sheets became encumbered at European levels. People confusingly point to this to suggest that the problem wasn’t European but that pulls the cart before the horse.

  2. Gravatar of Thorfinn Thorfinn
    30. July 2009 at 11:33

    I’m not Chinese, but there’s an article by Vitaliy Katsenelson arguing that virtually the entire upswing has been dominated by government-banked loans, many of which will fail:

    http://www.foreignpolicy.com/articles/2009/07/23/the_china_bubbles_coming_but_not_the_one_you_think

    As with Japan (and the US), rising asset prices and improving economic conditions can tide things over for some time, but it’s anyone’s guess what China’s banking system will look like in the future.

    No doubt, the Chinese Sumner will blame the resulting crash on insufficient monetary targeting of future NGDP…

  3. Gravatar of StatsGuy StatsGuy
    30. July 2009 at 12:45

    The conventional wisdom, btw, is that dollar appreciation was caused by the unwinding of highly leveraged financial instruments, like CDS and/or the dollar/yen carry trade as investors decreased exposure to risk. The dollar was the default settlement currency.

    The long term impact of this might not have been beneficial, btw – US credit to other countries was called in rapidly, thus decreasing future repayments. We actually observed net capital outflows from Latin America (meaning that US investors may benefit less from growth in that region in the future).

    I would add a couple more arguments to the “deleveraging” one:

    1) The commodities boom was an implied dollar-flight. Oil became a hedge against dollar depreciation. Speculative/investor demand thus drove up prices, forcing the Fed to hold up interest rates to stabilize a falling dollar. (I think this was actually what motivated the tight money policy in summer 08). However, by August 08 we started to observe that high prices were actually tamping down petro demand in the US (“demand destruction”), something that most speculators thought unlikely. (Long term energy demand was not as inelastic as they thought.) The commodities bubble popped, reversing dollar flight as everyone sought to dump assets that were falling in value.

    2) Part of the reason the rest of the world markets lagged the US going into this recession was the theory of “decoupling”, which is to say that Asia’s economies were becoming less dependent on the US. This proved somewhat premature.

    The problem has to do with specific assets (physical and capital expenditures). A lot of China’s “wealth” was represented as a future earning stream from exports to the US. The production systems that deliver this wealth are not easily reconfigured to deliver other goods/services to other locations. Against this wealth we need to mark debt liabilities. In a capital (physical or human or organizational) intensive production system, small changes in demand (“shifts” in the curve) can lead to big changes in prices, and modest changes in revenue (sales X price) can lead to big changes in net profit.

    In other words, capital intensive production systems are highly leveraged against future income streams and assets are specific to target markets.

    The problem is even worse for Japanese (and, to a lesser degree, Korean companies). Toyota and Sony, for example, have a lot of wealth invested in specific assets that deliver product to the US. Technological improvements mean those assets depreciate rapidly over time. A “temporary” downward demand shift can therefore be permanently damaging.

    The Chinese (and others) were partly saved by the fact that they had not borrowed money abroad (due to capital controls) to finance; thus China did not owe debt payments denominated in a rapidly appreciating foreign currency (which can cause a spiral of hyperinflation and depreciation – which partly caused the Latin American debt crisis). China can now deploy financial and monetary policy to create domestic demand to absorb productive capacity. The primary need for dollars, now, is not to get technology from US companies, but rather to get raw materials – and that’s what they’re now acquiring (before a true dollar run guts their foreign currency reserves and tbills).

    So, perceived decoupling may have been premature, but real decoupling has been accelerated by this crisis.

  4. Gravatar of rb rb
    30. July 2009 at 13:29

    To your question from MR, others.

    http://www.aei.org/outlook/100061

  5. Gravatar of Rob Rob
    30. July 2009 at 15:00

    Scott,

    I can’t help but wonder if the exact point of your disagreement with, well, nearly everyone, isn’t misplaced. The conventional wisdom is that the crisis happened because the financial world was too leveraged, thus too fragile, and when it hit a bump in the road such as the sub-prime crisis, the system couldn’t handle it. Therefore, at least in retrospect, to most people it is only a matter of why not when.

    It seems key to me that you make not one, but two bold assertions:

    1. The financial system was NOT fundamentally too fragile

    2. If money had been looser back in Sept 08, we would have avoided the crisis

    The majority of your posts are focused on point 2, but I think where most people really disagree is on point 1.

    Because unless point 1 is correct, point 2 is trivial.

    Which makes me realize why the EMH is so fundamental to your hypothesis. Most analysis of the crisis takes a fatalistic view: too many assets were overvalued, too much gearing in the system. This highly combustible mixture only required a spark. Those who shorted the market at the beginning of the year were merely waiting for that spark. It didn’t really matter what created it or when exactly it occurred.

    But there seems to be great strength in your view, because the conventional wisdom necessarily implies that we all should have seen this coming but didn’t. Seems an odd position to take on an issue so complex.

    Yet somehow I still have trouble believing the conventional wisdom isn’t correct.

  6. Gravatar of Rob Rob
    30. July 2009 at 15:07

    On China, what is your opinion of the significance of whether China is growing through wasteful or productive projects? Is it possible it can afford wasteful projects for a long time to come?

  7. Gravatar of Bill Woolsey Bill Woolsey
    31. July 2009 at 03:51

    Rob:

    Why does any spark cause a fragile financial system to cause nominal income to move away from its trend growth path?

    Can’t open market operations (of perhaps heroic scale) keep nominal income on that growth path?

    Regadless of what else may be causing financial problems, won’t nominal income falling below its previous growth path exacerbate those problems?

    How much stagflation can financial problems plausibly generate?

    To me, these questions are key to Sumner’s approach.

    Sumner’s answers are somethine like, high asset prices and “excessive” leverage may well be “fragile” so that any spark is likely to cause lower asset prics and deleveraging, but lower asset prices and deleveraging can occur with nominal income continuing to grow on its long term growth path as long as the central bank is willing to make sufficient open market operations. If nominal income continues to grow on its previous growth path, real production and real income may grow more slowly or even shrink a bit because reallocations of resources take time. It is even possible that firms that have ready buyers will not be able to finance production because of an inability to find finance. If nominal income continues on its previous growth path, the slower growth (or shrinkage) of real output and income will involve higher inflation because of shortages of goods and services. Lack of financing means that things cannot be produced that people want to buy. Similarly, those particular goods that people want to buy cannot be produced because resources cannot be shifted quickly enough.

    Sumner believes that we can be in that world and that it would be much better than the one we are in now.

    Why is it impossible? Well, maybe no matter how many open market operations the Fed makes, nominal income cannot be kept on its previous growth path. Falling asset prices (from these assumed excessive levels) and deleveraging require lower nominal income, no matter what the Fed does. That is the liquidity trap, or maybe the long and variable lags (which is really a sort of short run liquidity trap.)

    Maybe nominal income could be maintained, but the falling nominal income is irrelevant. Production is low because of the the shift in the allocation of resources. If nominal income had continued to grow on target, employment and output would be the same, lower because of the impat of lower asset prices and deleveraging, and the price level would just be that much higher.

    Frankly, I worry that some people are more concerned about the falling asset prices and the deleveraging than the impact of those things on real output and employment. From their perspective, the redistribution effects (say, away from Wall Street investment bankers and traders) to somewhere else _is_ the problem.

    What else am I supposed to think when people keep on talking about deleveraging and falling asset prices? What, Rob?

    Rather than explaining how these make a liquidity trap inevitable (at least in the short run, with the long and variable lags business,) or rather than making a new classical argument that prices and wages are perfectly flexible so low nominal income can never contrain production, it must be some reallocation effect or restriction on productive capacity…

    We just get what looks to me to be parochial concerns.

  8. Gravatar of ssumner ssumner
    31. July 2009 at 05:55

    Jon, You are right that Europe also had banking problems. But it isn’t quite correct to say the crisis was “not US”, as the US had a severe banking crisis.

    Is there data showing the crisis was worse in Europe? I’m not even sure what sort of data would be appropriate, would it be declines in bank stock indices?

    Thorfinn, I’ve seen a lot of those Chinese “bubble” theories written by Westerners (including the one you attached) but I don’t find them very convincing. It isn’t so much that I disagree with the specifics, but rather I don’t have confidence in the way they put it all together into a big picture.

    In the 1990s the Chinese banking system was basically broke, after having made enormous amounts of bad loans. Ten years later the banks were in much better shape. What was the impact of the orgy of bad lending in the 1990s? I’ve never seen a persuasive explanation, and hence I don’t trust any of these articles. But again, I assume a lot of foolish loans are being made once again, I just don’t know what it means.

    (Also, see response to statsguy.)

    Statsguy, You said:

    “The conventional wisdom, btw, is that dollar appreciation was caused by the unwinding of highly leveraged financial instruments, like CDS and/or the dollar/yen carry trade as investors decreased exposure to risk. The dollar was the default settlement currency.”

    Well I guess my theory isn’t so far-fetched, if it is the “conventional wisdom.”

    You said:

    “The long term impact of this might not have been beneficial, btw”

    My concern is the short run impact, which was disastrous.

    Regarding your comparison of China and Japan, I can’t resist responding to Thorfinn sarcasm with this observation.

    1. The Chinese authorities stopped the appreciation of the yua, and their NGDP kept rising.

    2. The BOJ allowed the yen to soar in value in 2008, and their NGDP fell very sharply.

    A tale of two monetary policies.

    rb, Thanks. See my comment to Thorfinn.

    Rob, You said:

    “It seems key to me that you make not one, but two bold assertions:

    1. The financial system was NOT fundamentally too fragile

    2. If money had been looser back in Sept 08, we would have avoided the crisis

    The majority of your posts are focused on point 2, but I think where most people really disagree is on point 1.

    Because unless point 1 is correct, point 2 is trivial.

    Which makes me realize why the EMH is so fundamental to your hypothesis. Most analysis of the crisis takes a fatalistic view: too many assets were overvalued, too much gearing in the system.”

    You may have come late to my blog, but this isn’t at all my view. I have always emphasized that the 2007 subprime crisis was not caused by monetary policy, but rather by weaknesses in the financial system. It is precisely because the financial system was so weak that the deflationary monetary policies of late 2008 were so devastating. A looser monetary policy is never more necessary than in a financial crisis, as it reduces the deflation of asset prices, which is the root cause of the crisis. In 2007 the overall economy was doing OK, so it was appropriate to allow housing to contract after the subprime crisis, but the last thing you want to do when banks are already weak is to impose a huge deflationary monetary shock. That will simply make their balance sheets look much worsein terms of all sorts of assets, which is exactly what happened in late 2008.

    My view of the crisis does not require the EMH to be true. But I do think the EMH modestly supports my argument.

    Rob, Both. But enough of them are productive that the growth is real. Indeed I believe China’s actual RGDP is higher than it’s measured RGDP. I plan a lot of posts on China in the near future.

    Bill, I agree. And I would add that from mid-2006 to mid-2008 the real estate sector shrunk quite a bit due to subprime issues. And yet because the rest of the economy was strong the unemployment rate only rose from the high 4s to the mid 5s. Wouldn’t we like to have 5.5% unemployment today!

  9. Gravatar of Bill Woolsey Bill Woolsey
    31. July 2009 at 06:52

    My preferred measure of “nominal income,” final sales of domestic product, actually rose by $500 million since last quarter. Of course, at $14,305.8 billion, it is remains below its level in the fourth quarter of 2007, 14,328 billion. And it is about 6% below its long run growth path. It should be more like $15.2 billion.

    In further news, the headline CPI is actually above its long term trend.

  10. Gravatar of StatsGuy StatsGuy
    31. July 2009 at 07:28

    “conventional explanation”:

    Risk aversion and deleveraging have been the conventional explanation for the dollar rebound since Nov 08.

    http://seekingalpha.com/article/108305-deleveraging-pushes-the-dollar-up

    Likewise, the asset rebound from March 09 onward was initially belittled as a move “back into beta”, or in other words a move to gain exposure to risk (since risky assets were perceived as undervalued due to the panic-driven selling of risky assets).

    Try doing a google search on ‘dollar risk stock rally 2009′. I’ve been trying to say for a while that (although I think you are basically correct on most things) the Fed is a little more focused on the international currency concerns than this blog, and the currency valuation issues (particularly in the context of debt obligations and commodity/oil pricing) are hugely important. The refusal of the ECB to coordinate monetary policy, for example, has created huge problems – and significant suffering in the US (although the EU is going to suffer more).

  11. Gravatar of D. Watson D. Watson
    31. July 2009 at 07:29

    I have a request for a future blog post. Imagine Bernanke came out tomorrow and announced he was following your every proposal for fixing NGDP growth expectations. Could you walk me/us through how you believe events would unfold and solve the problems we are currently facing?

    I understand that when the diagnosis is “there’s too little iron in your blood,” you eat more iron and you’re done. What we’ve just discussed is that there are several factors going on, of which lack of money is “only” one exacerbating factor:

    “It is precisely because the financial system was so weak that the deflationary monetary policies of late 2008 were so devastating. A looser monetary policy is never more necessary than in a financial crisis, as it reduces the deflation of asset prices, which is the root cause of the crisis. In 2007 the overall economy was doing OK, so it was appropriate to allow housing to contract after the subprime crisis, but the last thing you want to do when banks are already weak is to impose a huge deflationary monetary shock.”

    How does a sudden, EXPECTED, 6% inflation [-1+6=5] convince firms to start hiring, banks to lend, consumers to spend, stock markets to soar, housing prices and builds to stabilize and grow, etc.? The Keynesian framework I recall said that it was only unexpected changes in inflation that produced growth.

    Thank you.

  12. Gravatar of Bill Woolsey Bill Woolsey
    31. July 2009 at 13:03

    D. Watson:

    Where did you get the 6% inflation? What is the -1% and the 5%?

    Is it that real GDP fell 1% and Sumner proposes than nominal GDP rise 5% and you are subrtracting to get 6% and calling that inflation? The numbers don’t add up that way.

    The goal is to get nominal GDP up to its long term growth path. Index futures convertibility aims to get it their one year from today. Right now, spending is about 6% below trend and that growth path continues to rise and so it will be about 11% higher in a year.

    Scott is pretty insistent that it is desirable for that to be at least 2% higher prices. I guess that leaves about 9% more production.

    Anyway, the Keynesian theory of how expected inflation raises aggregate demand is that it lowers real interest rates and that stimulates spending.

    Sumner’s theory is that higher expencted nominal income raises spending. Partly it is higher inflation lowering real interest rates, but it is also higher credit demand by firms due to higher expected sales nad profits. And households because of less fear of unemployment, and so on.

    There is a “monetarist” theory that only unexpected inflation raises real output. It is something like, spending raises prices, and if the increase in prices is unexpected, production will rise too.

    The new Keynesian theory is that prices are sticky so that if spending has decrease (like it has) then output falls. If spending rises back, output rises back. Taht is a bit exaggerated, because not all prices are sticky, so some prices do change. And that, I think, is Sumner’s view.

    So, an ideal Fed policy would raise expectations of total spending in the economy. This would causes prices to rise slightly faster. And production to recover rapidly.

    One more time. It is more spending that raises both prices and output. It isn’t price increases (expected or otherwise) that raise output.

  13. Gravatar of Joe Calhoun Joe Calhoun
    31. July 2009 at 14:13

    Scott,

    I don’t have much to add to what Statsguy says above, but one of Bill Woolsey’s comments made me think of something else. Is your idea of targeting NGDP (and Bill’s idea of maintaining nominal income) just intended to bypass the problem of sticky prices and wages? In other words, if prices and wages were perfectly flexible, would that relieve the need to inflate and maintain NGDP?

  14. Gravatar of Lawton Lawton
    1. August 2009 at 04:55

    Bill wrote: “From their perspective, the redistribution effects (say, away from Wall Street …) to somewhere else _is_ the problem.”

    Excellent point! Last fall, lots of finance types were genuinely worried that “the sky is falling”. And it was — in their niche. But despite that finance is important, I think the larger economy can do ok without them. The 1987 crash’s lack of impact on Main Street seems like a reasonable argument in favor. Of course I’m not saying that massive problems on Wall Street would have NO effect. Subprime issues were probably hurting the economy in early/mid 2008. I’d be happy with those numbers now — even the high oil prices.

  15. Gravatar of ssumner ssumner
    1. August 2009 at 05:30

    Bill, That’s a good point about NGDP relative to trend, and it shows just how conservative my proposal for a 5% starting in February actually is. I was starting after a steep drop, with no catch up implied. Am I right that NGDP was about flat in Q2? If so, then we need 6.25% over the next 12 months to catch up to the trend line from February. But if we are going to err, it should be on the high side, as the extremely depressed nature of the economy in February makes inflation risks very low.

    The CPI data is surprising, given the 1.4% drop in the last 12 months (i.e. 3.4% below trend.) I can only assume that the Fed was never serious about the 2% target, they clearly were implicitly targeting a slightly higher figure, as why else would they have allowed the CPI to go so far above target?

    Statsguy, Those are very good observations. Perhaps I have too much of a closed economy focus, but I really think the US can go it alone in terms of AD if it wants to. Remember that the second biggest economy in the world is fixed to the dollar right now, and many others are at least loosely linked. I think if you move this dollar block you can move so much of the world that you don’t create huge trade distortions.

    One other important point, an effective recovery might bring commodity prices right back up again. Lots of people think commodity prices in 2008 were a bubble, but there were sound reasons for those prices–namely that countries like China and India were boosting demand for oil faster than it could be expanded. And the fact that prices for many other commodities soared showed that it wasn’t just the peculiarities of the oil market.

    On the other hand (as economists always say) in the real world your point has a lot of merit. The Fed is scared of inflation expectations getting so high that their QE looks reckless. And the quickest way to get high inflation expectations (in the press, not necessarily the markets) is to get high commodity prices. I think they blew it by paying attention to commodity prices in mid-2008, but if they think they did the right thing, then you’re right that they might not want to risk repeating that scenario.

    D Watson, Just to clarify I want 6% NGDP growth, not 6% inflation. Inflation would be around 2%, or less. You have a good question about expectations. In the long run actual and expected inflation are equal, and money has no real effects. That’s also true in the short run if the change in inflation is expected. But the key is when these expectations develop. Think in terms of wage stickiness. Right now many workers are working under contracts that were based on faster expected NGDP growth. Maybe not 5%, but certainly not negative 3 or 4%, which we’ve seen since September. So I am trying to undo this damage by getting wages closer to their equilibrium. Even if workers expect 6% nominal wage growth, they won’t suddenly demand high wages, because those still having jobs know that they are earning more than the equilibrium.

    So it is only because near term expected NGDP can move faster than wages that it can have a real effect in the very short run.

    I don’t know how clear this answer is, maybe someone can come up with something better.

    Here is another thought that I think the new Keynesian model suggests:

    1. Even expected money has an effect in the very short run.

    2. Only unexpected money matters over the medium run (a few years.

    3. Neither expected nor unexpected money matters over the long run (a few decades.)

    The models you refer to are distinguishing between 2 and 3.

    See also Bill’s answer, which I just read.

    Joe, I can’t speak for Bill, but I do think wage and price stickiness are the key. If they weren’t a problem then I suppose you would just worry about the nominal debt issue. And if even debts (and taxes) were indexed (which I suppose is the implication of your question) then don’t worry about money at all. There would still be menu costs of price changes, but if we assume no price stickiness we are sort of assuming no menu costs. Maybe a futuristic economy where everything is electronic would eliminate the need to obsess over monetary policy. Bill can explain systems like Greenfield and Yeager better than I can, as he has worked on indirect convertibility.

    I think monetary policy would cease being an important issue. I believe it is these various forms of nominal stickiness that cause problems

  16. Gravatar of Joe Calhoun Joe Calhoun
    1. August 2009 at 09:25

    Scott, after reading your blog for many months, with your last answer about wage and price stickiness, you just gained a convert. I’m a fan of Earl Thompson’s free banking labor standard which I find fascinating but impractical. Your method of targeting NGDP is much simpler and has the advantage of being a workable and understandable system. I didn’t really get it until this post, but between you and Bill, it finally clicked.

  17. Gravatar of ssumner ssumner
    2. August 2009 at 11:26

    Thanks Joe, It’s comments like that that make it all worthwhile. Also note that my own thinking has advanced a lot since I started this blog, and a lot of it is due to how commenters push me.

  18. Gravatar of D. Watson D. Watson
    3. August 2009 at 09:52

    Bill Woolsey,

    Yes, I was getting 6% from -1% real growth recently and his 5% target. While you’ve improved my numbers by one degree, I wonder about your next set. Scott says that _on average_ NGDP growth would be ~2% inflation and ~3% real, but to get 11% NGDP in the next year, we’d need 12% inflation right now (assuming foolishly that the current trajectory holds – I’m less concerned right now with the actual number we need as that Bernanke has announced he’s going to be having coffee and donuts with Scott on a regular basis), and the question still stands.

    On the last part of your comment, if we’re arguing that price changes will cause expectation changes will cause spending changes will cause growth, we’re arguing that price changes cause growth. I admit fully that the price level is cosmetic and without the path through expectations and spending it would do nothing. I’m trying to understand how the path works, though.

    You said, “Partly it is higher inflation lowering real interest rates, but it is also higher credit demand by firms due to higher expected sales nad profits. And households because of less fear of unemployment, and so on.”

    In this description, inflation is an expectations coordinating mechanism [and Scott picked up that I'm really asking for an expectations and sticky price/wages story]. But from what you just described, it sounds fairly instantaneous. The Fed announces that we’re going to spend our way back to the NGDP growth line by August 2010, and that tells firms and households (hhds) to be optimistic: hhds will spend because their jobs are safe and their jobs are safe because hhds will spend. It’s almost a sunspot story and any other plausible enough story would work as well [leaving aside the merits of Scott's proposal as a long-term rule of thumb]. But if even FDR and Obama’s golden tongues can’t induce people to spend because of cosmetic changes, I’m not sure why Bernanke can.

    What I’m really looking for is a couple cases and a description of which prices/wages unstick first: A firm (X) that expects the inflation, a firm (Y) that doesn’t, hhds that get it (A) and hhds that don’t (B). What do each of them do in the immediate aftermath of the announcement? What is their trigger for changing prices, production, hours hired, hours worked, spending behavior?

    opt 1) X moves first: X raises Px (price of its own good) in anticipation of the inflation so it can make some temporary profits while its input costs are sticky. But this causes all hhds to switch to firm Y that will sell them the same thing for cheaper. That sounds like a bad strategy for firm X.

    opt 2) Or is it angry Libertarian hhd A that is disgusted the government is going to tax away its hard-earned savings through inflation going out to spend now while the spending is good that kicks it off? A gets the good deals, X and Y increase production, B’s savings are reduced 10%, and we’re back to the average?

    Scott’s started answering this in his comment. Do A hhds think they are currently “overpaid” or that they are simply lucky to have a job? I think when good times come, most people will simply say ‘okay, it’s time for my annual pay raises to come back,’ and those who realize the size of the coming inflation will demand a larger increase than those who don’t. They know good times are back because their firm is hiring. The firm hires because inflation is making labor cheap, but that gets back to which prices move first.

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