Krugman on forecasting, and AS/AD

Paul Krugman produced a couple good posts yesterday.  Here are some of his comments on forecasting:

So as I see it, we should first of all be evaluating models, not individuals; obviously we need people to interpret those entrails models, but we’re looking for the right economic framework, not the dismal Nostradamus. Second, we should be evaluating models and the individuals who claim to have these models based on broad performance, not single events; if your approach (say) predicted the housing crash but then also predicted runaway inflation from Fed expansion — I assume everyone knows who we’re talking about — it’s not a good approach. Finally, I think we’re looking for conditional predictions — what happens given events that are themselves not part of the model — not absolute predictions. It was, for example, very hard in the fall of 2011 to know how the ECB would respond to the escalating financial crisis in Europe; failing to predict that Mario Draghi would find a way to funnel vast sums to debtor nations through discounting would have lost you a lot of money, but wasn’t really a failure of the economic model.

Of course I prefer market forecasts, which are conditional on current expectations of the future path of policy. If policymakers don’t like those forecasts, they need to change the policy.

Here’s Krugman on AS/AD:

So why do AS-AD? First, you do want a quick introduction to the notion that supply shocks and demand shocks are different, that 1979-80 and 2008-2009 are different kinds of slump, and AS-AD gets you to that notion in a quick and dirty, back of the envelope way.

Second — and this plays a surprisingly big role in my own pedagogical thinking — we do want, somewhere along the way, to get across the notion of the self-correcting economy, the notion that in the long run, we may all be dead, but that we also have a tendency to return to full employment via price flexibility. Or to put it differently, you do want somehow to make clear the notion (which even fairly Keynesian guys like me share) that money is neutral in the long run. That’s a relatively easy case to make in AS-AD; it raises all kinds of expositional problems if you replace the AD curve with a Taylor rule, which is, as I said, essentially a model of Bernanke’s mind.

So there is a place for AS-AD, although it’s an awkward one, and the transition to IS curve plus Taylor rule plus Phillips curve, which is the model you really want to use for America right now, is a moment that fills me with dread every time we take it on in a new edition.

I mostly agree, but I’d prefer to stick to AS/AD over any interest rate-oriented model.  Keynesians view interest rates as the indicator of monetary policy, and also the transmission mechanism.  In my view NGDP expectations are the best indicator, and the most important transmission mechanism.  Another 2 Krugman posts from a few days back illustrate my point.  Here’s Krugman on May 29:

And while day by day there are variations, basically what you see over the last month or so is line 3: falling bond prices accompanied by rising stocks and a rising dollar. So this looks like a story about macroeconomic optimism.

In other words, interest rates are rising because things are getting better.  And here’s Krugman on June 1, just three days later:

With stocks down and the dollar up, this looks like a market that has upgraded its estimate of the chances that the Fed will tighten too soon. And yes, I mean too soon, for sure.

Sorry Krugman bashers, I’m not going to accuse him of inconsistency.  I think he was right on May 29th (growth expectations were driving up interest rates) and he was right on June 1st (fears of tighter money were driving down stocks and pushing the dollar higher.)  My only quibble is the previous paragraph from the same post:

Still, a rise in bond rates is not helpful just as there are signs the economy is gaining momentum despite the best efforts of politicians. So what is happening?

These two statements (please read original post for context) create the impression that the Fed has reduced stock prices by driving up long term rates.  But long term rates are positively correlated with stock prices.  The stock market was pretty strong in the period up to May 28, and long term rates were rising.  Long rates have been flat since the 28th, and stocks have fallen.  Krugman’s right that monetary policy expectations are driving the various asset markets (no liquidity trap), but overstates the usefulness of long term interest rates as a monetary indicator.  For long term rates, the inflation and income effects often dominate the expected liquidity effect.  In other words, a higher expected future path of short rates might reflect tighter money, but it might also reflect faster growth generated by a successful Fed policy of managing expectations.

Since he looks to stocks and forex markets to figure out what the various interest rate movements actually mean, why not just cut to the chase and focus on direct indicators of monetary policy?  In other words, why not have the Fed create and subsidize trading in an NGDP futures market?  And if we don’t have that, look at the asset prices most strongly correlated with expected NGDP growth. (TIPS spreads, and, for high frequency changes—stocks.)

Update:  Nick Rowe has an excellent post on AS/AD.  And Lars Christensen.


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24 Responses to “Krugman on forecasting, and AS/AD”

  1. Gravatar of Arthur Arthur
    3. June 2013 at 12:07

    When I read Krugman talking about how interest rates does not tell you about the stance of monetary policy I thought to myself: “Scott Summers won”

  2. Gravatar of Greg Ransom Greg Ransom
    3. June 2013 at 12:17

    ‘Approaches’ don’t dictate prediction outside of impossibly imperfect empirical judgments — who the hell is Kugman talking about? No one who actually exists.

    No approach ‘dictated’ the both ‘predictions’ Krugman identifies — it’s just another case of Krugman bullshit smearing people without having the honor or courage or dignity to name names.

    No one should engage anything Krugman asserts until first pointing out and unspinning all of the cheats and lies and bullshit built into his consistently unhelpful and misleading remarks.

  3. Gravatar of Michael Michael
    3. June 2013 at 12:19

    Nick Rowe also has a blog on AS/AD:

    http://worthwhile.typepad.com/worthwhile_canadian_initi/2013/06/in-defence-of-the-as-ad-framework.html

  4. Gravatar of Steve Steve
    3. June 2013 at 13:00

    You should become a Chicago-style blogger and demand a quid pro quo before making statements like this: “Paul Krugman produced a couple good posts yesterday.”

  5. Gravatar of Robert Robert
    3. June 2013 at 13:45

    @Steve That’s impossible because Scott has liberal tendencies.

  6. Gravatar of Robert Robert
    3. June 2013 at 14:18

    What do you believe in? limited government like Friedman or social democracy?

  7. Gravatar of Cthorm Cthorm
    3. June 2013 at 14:19

    I am starting to doubt that the Fed will really manage to not tighten policy too early. The consensus seems to be that Bernanke will leave when his term is up. I’m nervous that the status quo on the board will be shaken up, and not in a good way. It will come down to who Obama chooses to nominate, and who can get through confirmation.

  8. Gravatar of Patrick R. Sullivan Patrick R. Sullivan
    3. June 2013 at 14:23

    ‘Sorry Krugman bashers…’

    Like this guy;

    http://dilbert.com/strips/comic/2013-06-03/

  9. Gravatar of dirk dirk
    3. June 2013 at 14:57

    That Dilbert cartoon is a lot funnier than I suspect Scott Adams realizes.

  10. Gravatar of ssumner ssumner
    3. June 2013 at 16:12

    Arthur, You said;

    “When I read Krugman talking about how interest rates does not tell you about the stance of monetary policy I thought to myself: “Scott Summers won””

    I haven’t won when my name is confused with the former Treasury secretary.

  11. Gravatar of Steve Steve
    3. June 2013 at 23:12

    http://krugman.blogs.nytimes.com/2013/06/03/our-driven-elite-trivial-and-time-wasting/

    Krugman has another typically nasty piece up where manages to throw a racism accusation at executives who get chauffeured.

    “the Journal isn’t reflecting the attitudes of people who drive around Manhattan; it’s reflecting the attitudes of people who are driven around Manhattan…

    I often reject the offer of car service, because of the magic of New York’s 4-track subway system…

    But if you’re the type who gets antsy jammed up against lots of people of various classes and colors, I suppose that’s not an appealing option.”

  12. Gravatar of Rademaker Rademaker
    3. June 2013 at 23:51

    The main problem I see with looking at AD as an indication of monetary expansiveness is that it fails in situation where inordinate amounts of monetary expansiveness (under other definitions) are required to get AD up to (or near) 100%. Your metric has an “as much as it takes” clause that I’m very uncomfortable with. Always do “whatever it takes” to get AD back up. I think it is already being used as a motivation for wealth redistribution via the central bank’s balance sheet (i.e. permanent debt monetization by keeping the balance sheet expanded forever).

  13. Gravatar of ChargerCarl ChargerCarl
    4. June 2013 at 00:49

    Rademaker, Scott already addressed that point long ago. Monetary policy does not redistribute wealth. Fiscal policy does.

  14. Gravatar of James in London James in London
    4. June 2013 at 01:14

    Five year TIPS dropped from 1.99% to 1.86% on 29 and 30th May. But they had also been falling quite sharply from the high of 2.41% reached on 14th March. The S&P500 has risen pretty sharply thorughout that period of TIPS weakness, some 5% over just two months. Markets are a bit confused, I feel.

    I’d still like to hear your view on the paradox of the financial markets more or less “getting” MM, but 99% of the spokesmen for the financial firms in those markets – the finance types – not getting MM.

  15. Gravatar of Ashok Rao Ashok Rao
    4. June 2013 at 01:38

    “Rademaker, Scott already addressed that point long ago. Monetary policy does not redistribute wealth. Fiscal policy does.”

    I can understand the argument that monetary policy should not be based on distributive effects. However that it does not redistribute wealth at all is very confusing. If that were true, it would indicate one Pareto-dominant solution, which by definition doesn’t happen. (Because monetary policy can have real effects in the short run, which makes us richer, but without redistribution it makes everyone equally richer).

    Take above-trend inflation, which redistributes wealth from savers to borrowers. Take quantitative easing which has disproportionately increased the wealth of home and stockowners which is not a random selection of America as a whole.

    Or take the fact that monetary policies can effect tax revenue and hence redistribution. If the Fed could have prevented our nominal shock and hence the employment crash (as MMs argue) the unemployment insurance system would have been used less.

    Monetary and fiscal policy are codependent insofar as distribution. I can see how in a political sense the onus falls on the latter, though.

  16. Gravatar of marcus nunes marcus nunes
    4. June 2013 at 04:10

    For those interested, I recommend reading this article by Robert Gordon, a ‘co-founder’ with the late Rudi Dornbusch, of what he calls 1978-Era macro:
    http://faculty-web.at.northwestern.edu/economics/gordon/GRU_Combined_090909.pdf

    Summary:
    “As combined in 1978-era theories, empirical work, and pioneering intermediate macro textbooks, this merger of demand and supply resulted in a well-articulated dynamic aggregate demand-supply model that has stood the test of time in explaining both the multiplicity of links between the financial and real economies, as well as why inflation and unemployment can be both negatively and positively correlated. The achievement of 1978-era macro was to retain the best of Keynesian demand-side economics while dropping the negatively sloped inflation-unemployment tradeoff with its neglect of supply shocks. 1978-era macro recognizes that the correlation between inflation and unemployment can be either negative or positive, just as microeconomics has long predicted that the correlation between the price and quantity of wheat can be either negative or positive depending on the size of the shocks to demand and supply.”

  17. Gravatar of Rademaker Rademaker
    4. June 2013 at 05:47

    “Rademaker, Scott already addressed that point long ago. Monetary policy does not redistribute wealth. Fiscal policy does.”

    What about fiscal policy funded by permanent monetization on the part of the Fed? You realize this is the government’s debt that the Fed is nullifying, right? It induces more of the fiscal action that you yourself admit is redistributive.

  18. Gravatar of Michael Michael
    4. June 2013 at 05:50

    Rademaker wrote:

    “The main problem I see with looking at AD as an indication of monetary expansiveness is that it fails in situation where inordinate amounts of monetary expansiveness (under other definitions) are required to get AD up to (or near) 100%. Your metric has an “as much as it takes” clause that I’m very uncomfortable with. Always do “whatever it takes” to get AD back up. I think it is already being used as a motivation for wealth redistribution via the central bank’s balance sheet (i.e. permanent debt monetization by keeping the balance sheet expanded forever).”

    I see the opposite. I think the failure to maintain adequate AD drives inequality. (I’m not denying that there are some redistributional aspects of the Fed’s QE policies – e.g. they are disproportionately better for those who hold treasuries and equiteies than those who do not), but it’s hard to come up with many policies that would be better for those who work for a living than adequate AD, since inadequate AD means lower wages, fewer job opportunities, worse working conditions (since employees have less ability to find a new job and quit).

  19. Gravatar of ssumner ssumner
    4. June 2013 at 06:09

    Rademaker, No, it’s a policy that keeps AD on target by letting the market decide how much base money they want to hold. If we did that, the monetary base over the past 5 years would have been far smaller.

    James, Part of any short term movement in TIPS reflects oil prices. Admittedly oil often moves with the broader US economy, but this time I suspect it’s more a question of weakness overseas driving oil lower, and reducing TIPS spreads.

    I first discovered the split between movements in stock prices and the ideology of finance types when I studied the 1930s. FDR’s dollar depreciation program was often viewed as being ineffective, even as it was enriching stock investors. I assume that people “compartmentalize” their thinking. Alex Tabarrok has a post on this very subject today. When you put money on the line, the difference between the ideology of Dems and Republicans gets much smaller.

    Ashok, I agree that monetary policy can have short run redistributive effects. But be careful of these fallacies:

    1. The choice is never between using monetary policy and not using monetary policy. Monetary policy is always “used.” The only question is which policy.

    2. Monetary policy does not affect long run income distribution (very much.)

    Marcus, Great quotation.

    Rademaker, I assure you the Fed has no intention of monetizing the debt. They are targeting inflation.

  20. Gravatar of Ashok Rao Ashok Rao
    4. June 2013 at 06:55

    “1. The choice is never between using monetary policy and not using monetary policy. Monetary policy is always “used.” The only question is which policy.” That’s a point I’ve made before, my mistake if I accidentally conflated “policies” and “policy”.

    “2. Monetary policy does not affect long run income distribution (very much.)”
    I agree with that, largely because nominal changes have real effects only in the short-run. But I believe in hysteresis and in fact our lack of aggressive monetary policy disproportionately hurts the unemployed which tend to come from more vulnerable people.

    That any policy does not have “distributive” effects is a shocking claim to me because policies are by definition designed to have such effects. Not even “broad growth” policies want to increase everyone’s output by n%.

    That monetary policy’s long-run distributive effect is asymptotic to fiscal policy is something I’m totally on board with, so I suppose we agree.

  21. Gravatar of Rademaker Rademaker
    4. June 2013 at 07:35

    I don’t doubt their intentions, Scott, I think the permanent monetization is what it takes to counter deflation. I listen to people like Dirk Bezemer, Michael Hudson and Steve Keen and what they tell me, in the most basic terms, is that a debt overhang (public and private) confers a deflationary pressure on a nation’s AD. The Fed can only sustainably counter that pressure using QE by neutralizing said debt permanently.

  22. Gravatar of Patrick R. Sullivan Patrick R. Sullivan
    4. June 2013 at 09:38

    Whatever the merits of the Gordon paper–i.e. its focus on rigid wages and prices–there’s a lot absolutely, horrible, wrong with it. First, its claim that Glass-Steagall was repealed in 1999, thus;

    ‘However, this account places much too little emphasis on the role of regulatory failure, which began back in 1999 with the Clinton Administration’s decision to repeal 1930s‐era
    banking legislation known as the Glass‐Steagall Act that had erected a wall between commercial and investment banking.’

    As I’m famous for pointing out, that ‘wall between commercial and investment banking’ was NOT repealed in 1999, and is still the law.

    Then, worse;

    ‘Perhaps the most glaring failure, thus far little discussed in the commentary on the financial meltdown, was the absence of Federal regulation requiring stringent down‐payment
    requirements on residential mortgages.’

    Au contraire, it was the federal regulations demanding the elimination of down payments, on the grounds they were racially discriminatory, that caused that problem, not the ‘absence of Federal regulation’. Not to mention that it’s hardly been little discussed, even before 2008.

  23. Gravatar of ssumner ssumner
    4. June 2013 at 11:48

    Rademaker, That argument makes no sense to me.

    Patrick, And the Feds are still encouraging low downpayment mortgages.

  24. Gravatar of Petar Petar
    6. June 2013 at 01:57

    I may be wrong, but isnt this Krugman quote

    “It was, for example, very hard in the fall of 2011 to know how the ECB would respond to the escalating financial crisis in Europe; failing to predict that Mario Draghi would find a way to funnel vast sums to debtor nations through discounting would have lost you a lot of money, but wasn’t really a failure of the economic model.”

    kind of opposite of what he was writing, in already seminal, “How did economists et it so wrong…”. Couldn’t models miss Fed mistakes in Summer of 2008 (especially if based on interest rates as MP stance)? So basically all those evil Chicago something-water economists were not really wrong, it was just that a government agency made a huge mistake?

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