I think it’s fair to say that we’ve all been impressed by Noah Smith’s brilliance as a blogger. But a new Smith post leads me to believe that he used to be even smarter. Smith points to 7 areas where other bloggers have changed his views. At least three or four would probably make my list as well, but I also see three where I think Noah moved in the wrong direction—two where Paul Krugman was the culprit. Here’s one:
Paul Krugman convinced me that Japan’s 1990s stimulus had some positive effects. Living in Japan in the mid 2000s, I picked up the conventional expat wisdom that Japan’s “fiscal stimulus” was a total waste, driven by clientelist construction spending and LDP corruption, concreting over the riverbeds and building bridges to nowhere. And while I still believe there was a ton of waste, Krugman blogged some data showing how mild Japan’s two recessions in the 90s were, despite the incredible severity of the country’s financial crisis. That’s a powerful argument. I now believe that though Japan’s 1990s spending spree probably wasn’t worth it on balance, it probably was not quite as unmitigated a waste as I had thought.
Actually that’s a very weak argument. Krugman’s right that the recessions were not particularly severe, but it had nothing to do with fiscal stimulus. The performance of Japanese AD over the past few decades is mind-bogglingly bad, even in per capita terms. To that extent that RGDP growth has been non-disastrous, that’s due to growth in aggregate supply. If Greece or Spain was hit by the AD shock that hit Japan, they would have 20% unemployment.
And here Noah is convinced by Steve Williamson:
Steve Williamson convinced me that the macro field is structurally biased toward monetarism. I can’t find the post(s) now, but Williamson has pointed out that central bank macroeconomists have a strong incentive to choose and promote models in which independent, active central banks are the most important stewards of macroeconomic stability. Since a big percent of top macroeconomists work at central banks, this is a non-trivial observation. I was trained to be pretty monetarist (by Miles Kimball and somewhat by Bob Barsky), but Williamson’s point was a good one, and has given me pause. Of course, it’s a bit of a cynical Marxist type point, but a good one nonetheless.
Actually the profession is nowhere near monetarist enough. Very few macroeconomists blamed the Fed’s tight money policy for the 2008-09 slump. Even worse, not many thought the Fed could do much about it, despite the fact that our textbooks say monetary policy is highly effective at the zero bound. The markets have been way ahead of the economists for many years, and it’s finally starting to sink in. With markets reacting strongly to even tiny hints of further tightening, even people like Paul Krugman are warning that tapering could slow the recovery.
Many economists underestimate the importance of monetary policy because they think in terms of a money –> interest rate –> investment –> AD transmission mechanism. A very non-monetarist mechanism, I might add. For instance, here’s Smith in another recent post:
Econ 102 says that banks lend money to long-term risky projects. They choose to lend if the expected real rate of return from a risky project is greater than r + S, where r is the safe real rate of return, and S is some required spread.
With IROR > T-bill rate (as now), the IROR is the safe asset. With IROR < T-bill rate, the T-bill rate is the safe asset.
The IROR is 0.25%. The T-bill rate is just over 0%. This means that the difference in the expected real rate of return between a world with an IROR and a world without an IROR is about 0.25%. In a world without an IROR, banks lend to any risky project with an expected real rate of return of S. In a world with an IROR, banks lend to any risky project with an expected real rate of return of S + 0.25%.
Therefore, what Feldstein is asserting is that there is an absolutely huge number of risky projects whose expected return is between S and S+0.25. He is asserting that if we lowered the safe rate by 0.25%, a huge panoply of projects would then become worth investing in, and a huge torrential flood of reserves would be released into the economy, boosting inflation and lowering unemployment in the process.
Does that seem reasonable?
This makes me want to pull my hair out. Yes, an EC 102 student might look at things that way. But Smith studied graduate macro under Miles Kimbell.
YOU CAN’T TELL ANYTHING ABOUT THE STANCE OF MONETARY POLICY BY LOOKING AT INTEREST RATES. (or if you can, low rates probably mean tight money.)
Back in 1937 they didn’t think the higher reserve requirements would do much harm, as interest rates only rose 0.25% in response. But the demand for base money rose, and that’s deflationary. If IOR increases the future expected demand for reserves, relative to the supply, it could have a huge contractionary effect, despite the fact that interest rates hardly budged.
If you insist on using Woodfordian NK language, the IOR program increases real interest rates in two ways, higher nominal rates and lower expected inflation. Indeed a cut in IOR might boost NGDP growth expectations so much that it would be expansionary even if market interest rates don’t fall at all.
Now it’s very possible that IOR did not have a major contractionary impact. In fact I agree with Noah that it probably did not. As with any other Fed tool, what matters most is the impact on future expected Fed policy. I can make plausible arguments either way. Ironically, the sorts of arguments that Keynesians use to defend fiscal policy (i.e. the Fed doesn’t like to do QE, and hence won’t do monetary offset) actually make it more likely that IOR had a major contractionary impact.
The best way to think about monetary policy is through the lens of the expected hot potato effect. Any Fed action should be judged in terms of its impact on the long term trends in monetary base supply and demand, not interest rates. Policies that make the expected future base rise relative to expected future base demand are expansionary, and vice versa. That approach doesn’t tell us that IOR was highly contractionary, but given that the IOR rate is higher than what banks earn on T-bills, it certainly might have sharply increased base demand.
PS. Here’s my short course on money for any misguided folks who still evaluate monetary policy through the lens of interest rates.
PPS. I hope Noah Smith doesn’t take this personally; I had just as many problems with Cardiff Garcia’s list, and I’m sure they could find fault with many items on my list. If I had one.
HT: TravisV and Tyler Cowen