Can’t? Or won’t?

Everyone seems to be giving the last rites to orthodox macro.  Here’s Nick Rowe:

I think we are witnessing the biggest silent shift in macroeconomic thought since the Second World War. For 70 years we have taught, and believed, that we would never again need to suffer a persistent shortage of demand. We promised ourselves the 1930′s were behind us. We knew how to increase demand, and would do it if we needed to.

The orthodox have lost faith in that promise; only the heterodox still believe it.

I have certainly lost faith in the promise that we “would do it if we needed to.”  But I still believe it can and should have been done.  Arnold Kling makes this observation:

The only thing I will add to Nick’s post is that the exponents of the orthodox view were contemptuous of dissenters when they held their views of three years ago, and they are just as intolerant of dissenters to the new consensus.

A few years ago, pretty much everyone said that monetary policy could correct any aggregate demand shortfall coming from the collapse of a bubble. Now, pretty much no one, other than you know who, says so. The new consensus is that banks matter, and bailing out banks was a key policy move to prevent calamity.

This sounds similar to Nick, but is actually a radically different proposition.  When Bernanke was asked why he didn’t follow the advice he gave Japan—shoot for 3% inflation—he didn’t say the Fed couldn’t create inflation, he said it would be a bad idea to have higher inflation.  Krugman doesn’t think a higher inflation target won’t work, he thinks the Fed is too conservative to do it.  Woodford doesn’t say OMOs won’t work at zero rates, he says OMOs won’t work at zero rates unless the Fed has a price level target.  Which is what he said before the crisis.  Mishkin revised his text in light of the economic crisis, and kept the part about monetary policy being highly effective when nominal rates are zero. 

When Kling says “you know who” he is really saying “that well known monetary crank that needs no introduction.”  How do I feel about that?  It’s nice to be well known.  But I really shouldn’t be well known, because I am still in the mainstream group of economists described above who believe monetary policy can be highly effective at boosting NGDP at the zero bound.  And let’s not forget about all those right-wing economists who think the liquidity trap idea is silly, but oppose higher NGDP because they think it would be inflationary.  So is orthodox economics dead?  From one perspective it does seem dead.  From another it doesn’t.  There are certainly internal contradictions, which I think can only be resolved when we get rid of all the policy lag hocus-pocus and start targeting NGDP futures prices in real time. 

Tyler Cowen made the following comments in response to my analysis of the Greek crisis:

I don’t yet follow Scott’s reasoning.  If anything, in very recent times the ECB has shown it is willing to abandon independence to monetize various national debts.  How much that will boost nominal GDP I am not sure, but I don’t take it as negative news for nominal GDP, relative to previous expectations.

I am usually reluctant to play “market psychologist,” but I see potentially insolvent banks as a major issue, plus their connection to money market funds.  That has an AD link to be sure, but the uncertainty of another major bailout, and its fallout for intermediation, would be paralyzing to financial markets.  Most of all, the fear is that “Europe-as-we-knew-it” was a bubble of sorts, and that other people’s digestion and comprehension of that possibility will create adjustment problems around the world, including China.

I’m not convinced that the “end of the tunnel” for Europe on this one has to be so dire.

A few comments:

1.  I also don’t see why things have to end so badly for Europe.  I’m not even convinced this is the end of the euro (although a few members may drop out.)

2.  Markets soared May 10 on news of the trillion dollar bailout, and then fell back when they realized the ECB’s action was mostly smoke and mirrors.

3.  The stocks of US manufacturing firms are not plunging because German banks are exposed to Greek debt—they are plunging because markets fear falling AD will lead to falling orders for manufactured goods.  Sure, you can always tell a disintermediation story as Bernanke did for the Great Depression, but I just don’t see how it’s plausible in this case.  We don’t have 9.9% unemployment because firms can’t get financing to meet orders, we have 9.9% unemployment because their order books are half empty.  We need more NGDP, banking will then take care of itself.

One final point.  It’s important to separate out two issues:

1.  Was the recession caused by a nominal shock?

2.  Could monetary policy have stabilized NGDP growth in 2008-09?

Kling thinks the recession was due to real factors, whereas Krugman thinks it was a shortfall of nominal spending.  I seem to recall that Tyler thinks it’s 1/3 nominal 2/3 real.  My hunch is that mainstream macroeconomists (center-left economists at salt water universities) are somewhere between Tyler Cowen and Paul Krugman.  So am I; roughly 20% real and 80% nominal.  So I am very mainstream on that issue.  It’s true I have been more optimistic than most about the possibilities of monetary policy.  But that’s nothing unusual.  In the 1930s NGDP fell in half and most economists didn’t blame the Fed.  Years later the profession slapped themselves on the forehead and wondered how we could have been so obsessed with the gold standard that we let NGDP fall in half.  In the years to come we’ll get the same re-evaluation.  Economists will wonder how the Fed could have been so worried about a return to 1970s-style inflation that they didn’t act aggressively to boost NGDP.  It will take a decade or two of low inflation, but we’ll eventually realize that we were merely afraid of ghosts.  You don’t stumble into high inflation by accident; not after you understand the Taylor Principle.

Off topic:  Is the new banking bill really as bad as the press is making it out to be?  Is Congress really passing a bill that fails to address either of the two problems that caused the financial crisis?  I have to assume I am wrong, but I am reading nothing about bans on subprime mortgages, and nothing about reining in F&F.  (I don’t have time to read these long bills.)  Someone say it ain’t so.  Does Congress really believe the crisis was caused by “derivatives,” and not by foolish loans that people couldn’t repay?


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46 Responses to “Can’t? Or won’t?”

  1. Gravatar of Jon Jon
    21. May 2010 at 20:17

    Off topic? The WSJ named the banking bill as the cause of following stock prices and expectations–and they did so on the front-page.

  2. Gravatar of Joe Joe
    21. May 2010 at 20:28

    Professor,

    Do you find your views as to tight money in ’08 growing amongst academics and economists in the government. Or, are the views that you’ve presented in this blog still relatively rare?

    Joe

  3. Gravatar of matt matt
    21. May 2010 at 20:46

    i don’t get it – how would policy be different if the Fed was targetting nominal GDP?

    many macroeconomists argue that the fed erred by not tightening enough, and cutting too quickly in times gone past – how would this policy have been different under a NGDP rule? i think that their actions suggest they were paying close attention to nominal GDP.

    ought the Fed be doing more QE? is that what this argument amounts to? which assets do you think they ought to buy?

    and do you really think this wold solve the problem? it seems to me that the problem is that banks are being ultra careful about credit risk, and as a result they have not used their (massive) excess reserves to increase their assets.

  4. Gravatar of John John
    21. May 2010 at 21:29

    The economist does an okay job explaining the bill… it actually doesn’t look so bad.
    http://www.economist.com/business-finance/displaystory.cfm?story_id=16192080&source=features_box2

    @Joe I think what Scott was saying was that everybody agreed with him in 2007 and changed their minds in 2008. Do I have this right?

  5. Gravatar of 123 – TheMoneyDemand Blog 123 - TheMoneyDemand Blog
    22. May 2010 at 01:37

    “The stocks of US manufacturing firms are not plunging because German banks are exposed to Greek debt—they are plunging because markets fear falling AD will lead to falling orders for manufactured goods.”
    There are two reasons why US manufacturing shares are falling:
    1. lower AD
    2. during last two weeks, volume of manufacturing sector bond issuance has sharply fallen, indicating much tighter credit conditions for manufacturing companies

  6. Gravatar of Alex J. Alex J.
    22. May 2010 at 04:19

    “one must not be right against the party. One can be right only with the Party”

  7. Gravatar of scott sumner scott sumner
    22. May 2010 at 05:59

    Jon, It’s hard to say if it had much effect.

    Joe, Still very rare.

    matt, A NGDP policy would have been far more expansionary over the past few years. That does not necessarily mean more QE, a negative interest rate on excess reserves is the easiest way to make policy more expansionary. The most important concept is level targeting, which means you commit to catch up for any demand shortfall in later years. This is supported by many academics, including Bernanke, but Fed chairman Bernanke has made it crystal clear he has no intention of doing level targeting.

    I don’t think easy money in 2003 caused the housing bubble, indeed I don’t even think money was particularly easy in 2003 (rates are a poor indicator, as they are near-zero in tight money countries like Japan.)

    John, I find that description shocking. We have this giant sub-prime crisis and Congress can’t even muster up enough courage to ban sub-prime mortgages? None of those provisions would prevent another sub-prime bubble. And nothing is being done about F&F, the other big part of the crisis. Instead there are lots of side issues addressed, which have little or nothing to do with the basic problem.

    Suppose there is another sub-prime bubble, and then housing prices again fall sharply. How does this bill prevent banks from again losing trillions of dollars?

    123, Isn’t the tighter credit conditions a symptom of falling AD expectations?

    Alex, Yes, there is a lot of conformity.

  8. Gravatar of thruth thruth
    22. May 2010 at 06:11

    Regarding F/F: legislation dealing with them lies ahead. For now, they remain in conservatorship with at least a few more years of losses to book.

  9. Gravatar of ssumner ssumner
    22. May 2010 at 07:38

    thruth, If Congress can’t even ban subprime loans–which is a no-brainer–how are they going to go against the powerful special interest groups behind F&F (real estate brokers, developers, banks, low income housing proponents, etc.)

    Congress has done nothing meaningful, as far as I can see. I can’t believe the press is treating this as meaningful reform, when even the supporters (like The Economist) concede it would not have prevented the current crisis.

  10. Gravatar of Bill Woolsey Bill Woolsey
    22. May 2010 at 08:18

    The recession was caused by unscrupulous lenders who charged excessively high interest rates on home mortgages. Because of this high interest rates, the borrowers can’t pay the money back, and so, the banks are in trouble. Their excessive greed, of charging higher than a fair interest rate has resulted in them going broke. Being broke, they can’t lend to business. Business cannot create jobs. So, recession.

    If the government had required that banks charge only a fair interest rate, then the borrowers would have been able to pay the money back. Then the banks would have got their money back with a fair profit. They could continue to lend to business. Business could continue to create jobs, and no interest rate.

    Unfortunately, the banks must be bailed out for their excessive greed, so that they will again lend to business and create jobs.

    But, as long as we have the government protecting borrowers from the banks charging them unfairly high interest rates, then there will never be a problem in the future.

    Further, if the banks are required to reduce what they are charging the borrowers, so that the borrowers can repay their loans, then the banks will be OK. Unfortunately, the banks are too selfish to reduce what they charge. They are so greedy, they just prefer to drive borrowers into bankruptcy but that cuts their own throat.

    Isn’t it all so obvious?

  11. Gravatar of jsalvatier jsalvatier
    22. May 2010 at 09:00

    You mention the “Taylor Principle” is that different from the Taylor Rule (It sounds different)? I haven’t heard you talk about it before.

  12. Gravatar of Alex F. Alex F.
    22. May 2010 at 09:11

    Please excuse my bad English. I have a crazy question for you, but we live in crazy times.
    One of your recommendations for the FED is a negative interest rate on reserves. When Greg Mankiw wrote about negative rates in the NYT, he got tons of hate mail. The same reaction was recounted by Willem Buiter, who also promoted negative interest rates.
    Isn’t this a sign that we have a psychological or moral problem? People can’t understand why saving should be punished. Getting paid to borrow money is just crazy for most people. It’s fundamentally at odds with core values. I think Mises even made an axiom out of it. There always has to be a positive interest rate because nobody has a negative time preference.
    I’m not an Austrian, but isn’t it symptomatic that even intelligent economists like Mises tried to make positive interest rates the 11.commandement. Maybe your recommendations won’t be heard, because they are deeply immoral to most people. At least in Germany, where I live, negative interest rates would never be accepted as a right-wing libertarian position. It sounds more like Silvio Gesell, whose nickname was the “Marx of the anarchists”.
    People think of money as their property. Negative interest is like the intentional destruction of their property. You are trying to destroy their store of value. Your policy tries to influence the velocity of money, which makes money into a public good. So, here is my question: could it be that the policy you are advocating is –in a way- anti-capitalist? That you are endangering the private ownership of money? (I hope my question makes sense. My question is not about economics, I agree with your recommendations, it’s about ideology, how your policy would be perceived.)
    PS: I’m talking about real negative interest rates. You could have nominal negative interest rates together with deflation resulting in real positive rates. But as long as we don’t have deflation any nominal negative interest rate is a real negative interest rate.

  13. Gravatar of jsalvatier jsalvatier
    22. May 2010 at 09:12

    Scott, I think you should work to try to raise the status of your view. I can’t claim I am an expert at this, but I would suggest finding (preferably high status) people who agree with your views and visibly associate with them, perhaps have them guest blog or something. I think changing the popular association of your views with just you to an association with a group of people, would raise the status of your views.

  14. Gravatar of David Pearson David Pearson
    22. May 2010 at 09:27

    Scott,

    There is nothing wrong with charging higher rates of interest on loans to low-fico borrowers — what you call “subprime lending”. This should be allowed in a free market economy.

    There is something wrong when the custodians of taxpayer-backstopped FDIC insurance fail to notice dangerous concentrations of no-doc subprime and Alt A risk on the balance sheets of TBTF banks. There is something wrong when TBTF banks are allowed to think that they can lever up with cheap overnight repo’s and then turn to the Fed for rescue in the event of a panic. There is something wrong when the Fed cannot allow bondholders of such risky institutions as Greece or AIG or Fannie Mae to take losses without jeopardizing the health of the system due to financial panic.

    The financial reform bill relies on “resolution authority” — a quasi bankruptcy process that allows bondholders to take a hit — to eliminate TBTF. So imagine its the next crisis, and this time JP Morgan is the problem bank. Financial panic is in the air, and interbank lending spreads are spiking. Would the Fed and Treasury really force JP Morgan into ‘resolution’? Of course not. Bondholders would dump their bonds, and that would lead to a systemic crisis. Instead, regulators would be much more likely to spend the weekend asking the Fed to kindly guarantee JP Morgan’s liabilities, “before the Asian markets open.”

  15. Gravatar of Jon Jon
    22. May 2010 at 09:43

    Scott: I didn’t say it was ‘settled’ or ‘known’, but it is central to the conversation. So you shouldn’t apologize for bringing it up as ‘off-topic’!

  16. Gravatar of Jason Jason
    22. May 2010 at 10:24

    “Does Congress really believe the crisis was caused by ‘derivatives,’ and not by foolish loans that people couldn’t repay?”

    I’m not sure I understand this. Checking Wikipedia the estimated cost of TARP was ~$400 billion, and the current cost is only about ~$100 billion after repayment which is far less than the S&L crisis, yet we’ve lost a more serious chunk of our GDP than happened at the time.

    My understanding was that the problem was these CDO’s of subprime mortgages were then the subject of CDS’s and other derivatives, amplifying the effect.

    To put it another way, if you constantly blow out your speakers, you should check the wattage of your amplifier, not change the CDs you buy from Slayer to Kenny G. (Although that might also help.)

    That said, I don’t want to give the impression that I don’t think derivatives serve a useful function — they do. I think putting them on an open exchange is an excellent idea.

  17. Gravatar of thruth thruth
    22. May 2010 at 11:12

    “thruth, If Congress can’t even ban subprime loans–which is a no-brainer”

    I think you’ve set your expectations too high if you think subprime loans are going anywhere. I’m not even sure why you think they are so bad. Without the leverage taken on at the institutional level, which was a pre-requisite for funding all of the non-prime lending, I doubt we would have seen the same problems. FHA has managed a subprime portfolio for years without contagious blowups. (They’re going to lose a bunch of money on the private label subprime loans they have refi’d, but that seems to be a deliberate policy choice)

    “–how are they going to go against the powerful special interest groups behind F&F (real estate brokers, developers, banks, low income housing proponents, etc.)”

    It’s certainly possible entrenched interests will prevent anything meaningful from happening. I was just pointing out that the admin has announced it doesn’t plan to do anything about them before 2011. (They’re a useful policy vehicle for now)

  18. Gravatar of Claron Claron
    22. May 2010 at 11:48

    I think that the portion of the bill that is supposed to address sub-prime lending is the CFPA. I don’t know how strong it will be but if you want to read a part of the bill then start there. I also have no idea if the CFPA will have any sway over crappy loans in the commercial sector.

  19. Gravatar of Claron Claron
    22. May 2010 at 11:50

    correction: should read,
    “commercial real-estate sector”

  20. Gravatar of Doc Merlin Doc Merlin
    22. May 2010 at 13:32

    @Bill:
    Amusing sarcasm.

    @Scott:
    The entire purpose of the bill is to solidify wall street’s need to kowtow to the ruling party.

  21. Gravatar of Doc Merlin Doc Merlin
    22. May 2010 at 13:33

    @Scott:

    Also, the fed possibly doesn’t want to raise inflation because it fears that congress will limit its power as a result? Sigh… we really need competitive money issuance.

  22. Gravatar of Mark A. Sadowski Mark A. Sadowski
    22. May 2010 at 16:26

    At this point there are very few shoes that have not fallen off as far as a recent decline in AD are concerned. Will industrial production be down when the figures come out in three weeks? When so many indicators point that way? Just wonderin’.

    P.S. Corporate bond issues are way down and corporate junk bond spreads are way up in the past few weeks.

  23. Gravatar of Jon Jon
    22. May 2010 at 18:39

    Scott wrote in his original post:

    When Bernanke was asked why he didn’t follow the advice he gave Japan—shoot for 3% inflation—he didn’t say the Fed couldn’t create inflation, he said it would be a bad idea to have higher inflation.

    Yes. For two reasons, one is that the Fed engages in policies which could easily create hyper-inflation were it not that inflation expectations are well-anchored.

    Second, the natural real-rate is exogenous to the choice of inflation regime. If the Fed were to target a ten percent-rate, a ten-percent variation around that target would be similar in magnitude to the underlying natural real-rate.

    Since expectations ensure that monetary policy is not neutral in the short-run, Fed policy moves real-rates not just nominal-rates. There are pernicious consequences to doing so, and therefore necessarily doubts about selecting higher inflation targets.

    It remains a mystery to me why these ideas are so mysterious to you…

  24. Gravatar of StatsGuy StatsGuy
    22. May 2010 at 19:11

    David:

    “There is something wrong when the Fed cannot allow bondholders of such risky institutions as Greece or AIG or Fannie Mae to take losses without jeopardizing the health of the system due to financial panic.”

    I think ssumner would agree here – but would also note that a real-time NGDP targeting monetary policy would create huge negative feedback to panics, and do so with much greater certainty and consistency than the Fed or the ECB.

    Armed with market stabilizing expectations of monetary policy, political authorities might (just possibly might) be able to stand up to TBTF firms without cringing in terror that a stock market collapse will trigger a massive wave of demand destruction and layoffs.

    ssumner:

    I don’t think we’re experiencing a mere psychological twitch; we’re seeing competing paradigms. Keynesian vs. Monetarist vs. Austrian, and the Austrian is winning largely because it’s not the incumbent. To the degree the establishment makes half hearted efforts, they will only confirm to the masses that their current paradigms are flawed. It’s nearly impossible to argue with an Austrian – according to Austrians, the Great Depression was caused by Keynesianism and Hoover’s attempts to slow down the liquidation process – and in the end, the Depression was a _good_ thing since it reduced debt overhang. If you show them a chart which clearly shows that debt to GDP INCREASED during the early years of depression, and didn’t reverse until Roosevelt’s deliberate restoration of the price level, they seem to cmpletely miss the point.

    The problem internationally is that any country that defies the global capital markets by trying to force-feed money into the economy risks capital flight to “strong currency” governments which seem oh-so-happy to take the low interest loans to finance their debt, even though it means that their exports die and their economy tanks 8 months later (leaving them with more debt). Capital flight is the boogeyman that keeps Trichet up at night.

    Central Bankers have a perverse incentive structure!!

  25. Gravatar of Bob M. Smith Bob M. Smith
    22. May 2010 at 20:00

    Scott, isn’t the realization that much debt won’t be repaid a REAL factor? Whether it’s housing in America or sovereign debt in Greece, there are many defaults that are inevitable, whether NGDP continues to grow or not. Didn’t you agree that suprime loans were bad loans? Well maybe the market is realizing that A LOT more loans are going the way of subprime and won’t be paid back.

  26. Gravatar of David Pearson David Pearson
    22. May 2010 at 21:06

    Stats Guy,

    I disagree on targeting and TBTF. If you tell banks that nominal prices will never fall, that eliminates asset price tail risk (and then some). Banks will take that and run with it: what kind of leverage/VAR will models spit out when deflation is a “ten sigma” event? Its inevitable that the increase in leverage will lead to higher asset prices, which will beget higher leverage, and so on.

    The problem is economists treat the “V” in the m*V equation as a stable residual of some econometric regression. In reality it is nothing but animal spirits, particularly those of TBTF financial institutions employing leverage to speculate.

    Promise no recessions/deflation and you will create a financial system vulnerable to panics. Velocity controls NGDP at those points, and the Fed will have to bail out levered firms if it doesn’t want velocity to crash. “It won’t get to that point if the Fed is credible” is the counter-argument, but I am saying the very promise of no tail risk will lead to leverage, excessive risk taking, and vulnerability to panic.

  27. Gravatar of Doc Merlin Doc Merlin
    22. May 2010 at 21:58

    @StatsGuy:
    ‘Central Bankers have a perverse incentive structure!!’

    Agreed! This is why we need competitive money.

  28. Gravatar of Bonnie Bonnie
    23. May 2010 at 00:34

    Here’s what I know about the elements of the financial crisis. There may be other things to it as well, but I am rather cool to the ‘evil, greedy’ banker theory because it is almost always presented with only half the facts and it doesn’t square well with what the government was doing to pump the bubble. If the proponents of the theory add the ‘evil, greedy’ politicians and bureaucrats to the narrative, then I think it would satisfy me because they’re all in bed with each other until things start hitting the wall.

    1) Fannie/Freddie (GSE) pioneered the idea of mortgage-backed securities with Bear Stearns in the late 1990s along with the clearinghouses where original mortgages were sold. There is hardly a mortgage in this country that the GSE’s didn’t have their fingerprints all over via the clearinghouses. Sure, go ahead and do terrible underwriting or none at all. Who really cares about it when it will be someone else’s problem?

    2) Community Reinvestment Act: No money? No Problem!! If the evil banker turns you down they don’t get to play with everyone else anymore.

    3) The Recourse Rule (the precursor was established in Jan 2001 and was subsequently fully implemented in Basel II): If a bank invests in government bonds rated AA or securities sold by the GSEs the capital requirement for these will be the same as Treasury bonds. There’s nothing like ultra stimulation of demand for government bonds and mortgage investments by lowering the cost to almost nothing. I’m sure that everyone heard that giant sucking sound of productive capital going to nonproductive uses en mass, and it’s really no wonder that loan officer was considered a hot career and there were accusations of predatory lending. The Fed amended this rule in 2008 to allow firms to utilize their own formulas to calculate capital requirements after it became abundantly clear that it’s not such a hot idea to require almost none for MBS’s from the GSE’s.

    4) Sarbanes-Oxley, Mark to Market: MBS market collapse? Fire sale prices? No value. Sorry, sucks to be you. If I remember correctly the banking crisis was caused by the lack of liquidity when the market for asset-backed securities collapsed and there wasn’t any flexibility in how to account for them. I think the SEC is now allowing fair value to smooth out the road over market volatility.

    CDO’s were a secondary problem after these four, and possibly other elements, did their damage. They were the things that took out the bystanders who likely had no direct interest in mortgage securities at all. If a firm was into both, like Bear and Lehman, they had a real huge problem. I heard AIG was doing some pretty nefarious things with them, but it is hearsay. I can see the rationale of regulating them if even half of what I heard is true. It’s sort of shocking to me that they don’t have these AIG guys up on fraud charges as well.

    All in all, I don’t think we needed a serious overhaul of financial legislation. What we had would have been sufficient if it had been enforced and regulatory bodies didn’t play central engineering games with the direction of investment money. In addition, laws and rules are for the little guy, and the big guys are going to do what they’re going to do with the politicians and bureaucrats trotting along behind them until they do something stupid and embarrass them. It’s the Enron effect.

    That is the reason the new legislation isn’t designed for prevention because that would tie the hands of the powers that be to pump the financial system for what they want out of it. It also gives them a considerably larger stick to deal with dissent.

  29. Gravatar of Doc Merlin Doc Merlin
    23. May 2010 at 01:03

    Scott, if you want your macro theories to be accepted again, then you need to campaign for candidates that believe your macro theories. Politics determines the state of macroeconomic dogma, so ultimately what matters is the voting box.

  30. Gravatar of Real policy problems – Economics - Real policy problems - Economics -
    23. May 2010 at 08:52

    [...] SUMNER quotes a Nick Rowe post on the status of orthodox economics:I think we are witnessing the biggest silent [...]

  31. Gravatar of scott sumner scott sumner
    23. May 2010 at 08:54

    Bill, I am glad I checked the name on your reply before I responded. :)

    jsalvatier, The Taylor Principle is that you should raise interest rates by more than inflation increases, so that the real interest rates will rise and nip any inflation in the bud. I should have added that today we also have TIPS spreads, which were not available in the 1970s–so a repeat of the 1970s is very unlikely.

    Alex, I support negative rates on ERs to make monetary policy more expansionary, so that NGDP will rise faster, so that nominal rates will increase and provide a higher return to savers. But this is a side issue, even without negative rates on ERs, the Fed has all the tools it needs. Believe me, I am very pro-saver–I want to eliminate all taxes on saving and investment, and plan to do a post on that in June.

    jsalvatier, I hope to do that at a conference this October, where I will have a chance to influence some people that I respect. I am also doing way more speaking engagements than I have ever done, and hope to present a paper at the prestigious AEA meetings on a panel with some top economists. So I am trying. But why would a famous economist want to become a follower of an obscure economist? I try to make them think it is their own idea–like when I suggested that Hall’s 1983 paper implied rates on reserves should now be negative.

    David Pearson, You said;

    “There is nothing wrong with charging higher rates of interest on loans to low-fico borrowers — what you call “subprime lending”. This should be allowed in a free market economy.”

    I completely agree. I should have been clearer. I have no objection to firms raising money privately and making sub-prime loans. But commercial banks essentially borrow taxpayers money and lend it out. When you deposit $100 in a bank account, you are actually lending the money to the government, who then re-lend it to the bank. If the bank can’t pay it back, the taxpayer takes the hit, not depositors.

    I also agree with your other points about the resolution authority.

    Jon, I agree.

    Jason, Derivatives don’t amplify the losses, they shift them from one party to another. Just to be clear, I think AIG was a huge problem, so I agree that insurance companies like that shouldn’t be able to take huge risks with derivatives. But none of this wouldn’t have happened if there hadn’t been such huge losses in the mortgage loan area. A minimum 20% down-payment would greatly reduce that problem (again exempting non-government-backed lenders, who should be free to do sub-prime loans.)

    thruth, You said;

    “I think you’ve set your expectations too high if you think subprime loans are going anywhere. I’m not even sure why you think they are so bad. Without the leverage taken on at the institutional level, which was a pre-requisite for funding all of the non-prime lending, I doubt we would have seen the same problems.”

    Other countries have successfully regulated in such a way to discourage sub-prime loans (Canada, Denmark, etc.) But we tried and failed to regulate leverage with Basel II because banks are so clever at finding ways around it. And why couldn’t you have a major fiasco w/o high leverage? If the banking system is hit with a trillion in losses in mortgages, lots of banks will fail even if leverage isn’t that high. Having said all that, I wouldn’t oppose higher capital requirements–it’s worth a shot. But banning sub-primes gets closer to the heart of the problem. Of course the real problem is moral hazard, but I’m not so naive that I think we’ll end FDIC and TBTF. With 20% minimum down-payments instituted in 2003, we wouldn’t be in recession right now. It’s that simple.

    Claron, If they are delegating it to the CFPA, then you know nothing serious will be done. The Obama administration is actually having the FHA subsidize sub-prime mortgages, so don’t hold your breath for serious reforms.

    Doc#1, I agree.

    Doc#2, I think Congress is so clueless they don’t know what they want.

    Mark, Call me an optimist, but I think so far they are just warning of a slowdown, this unwinds the optimism that developed last month with the strong employment growth. It would have to get worse for an absolute recession, markets are signally slower recovery than expected in April.

    Thanks for the corporate data, that is worrisome.

    Jon, You said;

    “It remains a mystery to me why these ideas are so mysterious to you…’

    It remains a mystery to me why you didn’t read what you quoted from me. I said Bernanke wasn’t following his own advice. Do you deny this?

    I don’t agree with your view about inflation. If you read my blog you will know that I favor level targeting. I favor the same long run inflation rate as Bernanke–roughly 2% The difference is that I actually believe we should stick to the target path, and that the economy will be more stable if we engage in level targeting. Woodford, Bernanke, Barro and many others have made the same argument, so I doubt you have found some sort of elementary flaw in the argument.

    Statsguy, I agree that Austrians are winning now (recall my post “we’re all Austrians now.”) I argued it is because the Austrian view is the commonsense view of the crisis. We had the sub-prime orgy, and now the hangover. But when inflation doesn’t pick up the Austrians will gradually lose ground.

    Bob, You said;

    “Scott, isn’t the realization that much debt won’t be repaid a REAL factor? Whether it’s housing in America or sovereign debt in Greece, there are many defaults that are inevitable, whether NGDP continues to grow or not. Didn’t you agree that suprime loans were bad loans? Well maybe the market is realizing that A LOT more loans are going the way of subprime and won’t be paid back.”

    Yes, but it’s funny how the amount of bad loans closely correlates with NGDP forecasts. First it was $1 trillion, then when NGDP plunged the estimates rose to $4 trillion, then when NGDP recovered the estimates dropped to $2.3 trillion. The reason is simple, NGDP dramatically affects peoples’ and governments’ ability to repay loans. Yes, I agree there was a modest real problem, but we made it much worse. The real problem in Greece and Spain is nowhere near enough to drive down US stocks and oil so much without a link to NGDP.

    David#2, I think there is a bit of truth to your point about leverage, but I’m more with Statsguy here. There is still plenty of relative price variation in an economy with low and stable inflation. Banks took a big hit in 2007 and early 2008, even before deflation set in. I don’t want extra macro instability just to make banks take fewer risks. There has to be a better way.

    Bonnie, I agree with your points about lots of regulatory mistakes–especially F&F. I also agree with those on the left who say the private sector made a lot of bad decisions. If we simply focused on not making all the public policy mistakes, but eliminating F&F, CRA, etc, that would help a lot. I’d still like to see something done with private banks–either end deposit insurance, or don’t let them make sub-prime mortgages with taxpayer-backed deposits. So I think you and I are close on these issues.

    Doc Merlin, Are there any candidates who agree with my macro theories? I think you first must change the minds of academics. I think the Taylor Rule approach was dreamed up by academics, not politicians. Monetary policy is too complex for politicians to get deeply involved.

  32. Gravatar of marcus nunes marcus nunes
    23. May 2010 at 10:17

    Free Exchange writes a follow-up:
    http://www.economist.com/blogs/freeexchange/2010/05/monetary_policy_0

  33. Gravatar of Jon Jon
    23. May 2010 at 10:22

    It remains a mystery to me why you didn’t read what you quoted from me. I said Bernanke wasn’t following his own advice. Do you deny this?

    He changed his views. My concern that is that you deny there is any ‘debate’ about the theory that would explain such a shift.

    I don’t agree with your view about inflation. … . Woodford, Bernanke, Barro and many others have made the same argument, so I doubt you have found some sort of elementary flaw in the argument.

    I cannot claim to have found anything new–and not so coincidentally, the Board of Governors appears to agree with me. Let me point you in two directions.

    1) First you can read this simplified “FAQ” from that saltiest of Feds, SF describes matters just as I have done when briefing the public as to the limits of monetary policy.

    2) I suggest taking a look at some of the work of Jeffrey Frankel of Harvard. As an example, he presents a similar narrative in the “The Effect of Monetary Policy on Real Commodity Prices” which was a part of the interesting “Asset Prices and Monetary Policy” compendium. Frankel’s argument is followed by a nice response from Svensson where he endorses Frankel’s based model (but then dissents on Frankel’s policy recommendations).

  34. Gravatar of johnleemk johnleemk
    23. May 2010 at 11:34

    Jon, putting this aside for the moment, I still find it worrying — regardless of what Bernanke thinks — that the zeitgeist among those in charge of monetary policy seems to be that the zero bound is real, and that negative interest rates are impossible. Janet Yellen, President of the San Francisco Fed and who will almost certainly be confirmed as a Governor of the Fed, has explicitly said she believes this is the case — and she is considered an inflation dove!

    It’s one thing for the Fed to believe that they can’t control inflation expectations (something I think Scott would describe as laughably ludicrous), and for this reason should not adopt an aggressively dovish view of inflation. It’s another thing altogether for the Fed to believe they are totally powerless to even drive inflation rates up, even if they want to.

  35. Gravatar of Jon Jon
    23. May 2010 at 13:28

    Johnleemk,

    Issues of the zero bound are definitely a separate problem, and yes, it is a problem that certain people with their hands on the levers of power believe in the zero-bound.

    I’m perplexed by this remark: “It’s one thing for the Fed to believe that they can’t control inflation expectations”. Who believes that the Fed cannot control inflation expectations? I’d argue quite the opposite, its very evident that the people on the levers of power know that they have influence over expectations. And if anything, its people like Brad DeLong who believe in the zero-bound. That’s why he asks ridiculous questions, such as won’t a three percent target be better.

    There is one problem: very few people think the Fed influences short-run inflation. That’s the really frustrating point. This has its roots in Keynesian fallacy: namely that when capacity is slack, inflation is impossible. Indeed, this is arguably the ‘same’ idea: the zero-bound must be feared because once the economy slips, real-rates become strongly positive, overcapacity results, inflation is impossible, and policy cannot react because of the zero-bound.

    Here is my question to you: in the 1930s, this matter had an easy answer, move the gold-peg. Moving the gold-peg was extremely powerful because every nominal contract move with respect to real-produce.

    Is it the same in the fiat-regime? The Keynesian’s argue, NO. Their claim is that the base-money supply gets stuck within the banking system once the real-rate is at the zero-bound, first the real-rate has to move to multiply the money-up.

    Let me cast this is different terms: if the Fed monetizes another 1 trillion in debt, that’s only a 1 trillion change to broad money, without the real-rate shift to goose that, it ends there. But broad-broad money was closer to 110 trillion. That’s the problem. http://www.nowandfutures.com/images/m3_credit_debt_deriv_bkx_vel.png

    With this in mind, I’d much rather see a negative interest on reserves policy rather than further expansion of the MB. The two policies are not equivalently strong. MB expansion has sadly become merely a tool financing politically connected interests.

    The answer to the historical question: why has it been so easy for governments to create so much inflation but now seems so difficult, now has an easy answer: they had a gold peg, we do not, and therefore they had an avenue to devalue all nominal arrangements uniformly in a way that we do not.

  36. Gravatar of StatsGuy StatsGuy
    24. May 2010 at 05:21

    @David Pearson:

    ““It won’t get to that point if the Fed is credible” is the counter-argument, but I am saying the very promise of no tail risk will lead to leverage, excessive risk taking, and vulnerability to panic.”

    You are basically arguing the Greenspan Put. Let me make a hypothetical argument in favor of the Put – at the _aggregate_ level, demand stabilization means reduced investment risk, and therefore higher levels of investment. The problem with the Put is that the Fed has executed demand stabilization entirely through the credit system (e.g. private banks), such that monetary injections are now executed via credit spreads, thus the primary way to grow the money supply is through debt expansion. In the libertarian/monetarist view, private debt is _good_ because it endogenously creates non-public money (which is more efficient than public money). The neoclassical assumption is that credit at market rates is always good, because people won’t take out credit unless it benefits them (in a rational long-run enlightened sort of way), and that usually means higher long term investment levels for the economy (higher growth, higher supply, etc.). Neoclassicals argue this internationally as well – giving developing countries access to credit in non-domestic currencies (which is often misused, or creates vulnerability to exchange rate risk which can create huge correlated macro shocks) is good, because countries wouldn’t take out credit if it didn’t make good sense (and lenders wouldn’t lend unless it made good sense).

    There are really two alternatives to demand stabilization for monetary policy:

    Keynesian stabilization (with its own problems, including the inability to cut fiscal expenditures in an upturn and thus increasing debt load)

    No stabilization (the Austrian solution, with the allegation that if we remove government interference the boom/bust cycle should not be quite as severe – although history begs to differ)

    Price level stabilization via supply restriction – essentially, a social compact to limit over supply, largely through unions. The argument against this is long-term supply = long term demand, although the data clearly show this does not necessarily mean more happiness, longer life span, etc. The major problem with this appears to be that it is unsustainable in a globalized context, unless the compact is international or one aggressively controls trade at the border. Globalization effectively killed the social compact, which neoclassicals love.

  37. Gravatar of StatsGuy StatsGuy
    24. May 2010 at 05:22

    … three alternatives

  38. Gravatar of scott sumner scott sumner
    24. May 2010 at 06:11

    Marcus, Thanks, I may do a post on that.

    Jon, You say that the Board of Governors has found a flaw with this argument. Then why did Bernanke call for more expansionary fiscal policy in 2008? Isn’t the purpose of fiscal stimulus to raise AD? And how is this different from more expansionary monetary policy. is there some new weird theory that fiscal stimulus raises Y but not P?

    Commodity prices are most stable when NGDP is stable, and most erratic when NGDP is erratic.

    If the Fed thinks it has come up with some brilliant new ideas, I would simply ask: How’s that new policy working out for you?

    Regardless of whether Svensson responded politely to Frankel’s model, it is clear from his behavior at the Riksbank that he thinks monetary policy is way too contractionary.

    You mentioned some links in your comment, but didn’t attach them.

    johnleemk, Good point.

    Jon#2; You said: “There is one problem: very few people think the Fed influences short-run inflation. That’s the really frustrating point. This has its roots in Keynesian fallacy: namely that when capacity is slack, inflation is impossible. Indeed, this is arguably the ’same’ idea: the zero-bound must be feared because once the economy slips, real-rates become strongly positive, overcapacity results, inflation is impossible, and policy cannot react because of the zero-bound.”

    This is exactly why NGDP targeting helps clarify issues. The Keynesian model says that when there is slack, monetary stimulus will not raise inflation, but will raise NGDP. And that’s what we want, more NGDP. Inflation is just a means to an end.

    A few other comments:

    1. I agree with you that negative interest is more effective than QE
    2. I think a NGDP or price level target, level targeting, does the same thing as changing the gold peg. The gold peg changes didn’t immediately change the money supply, but they did immediately change the expected rate of inflation, and hence reduced real rates. It also immediately boosted asset prices–which is expansionary. BTW, the terms of trade factor wasn’t that important in 1933. The trade balance actually got worse, as the rapid recovery sucked in more imports.

    Statsguy, Yes, i agree. And one other point about the Greenspan put. If you think of the put as referring to AD, and not stock prices, I have no problem. The problem isn’t having a put, it is giving the market the expectation that there is a Fed put out there, and then not executing it in 2008 when it is most needed. The worst Fed policy is not expansionary or contractionary–it is promising one thing and doing another.

  39. Gravatar of Won’t Does Not Imply Can’t « The Everyday Economist Won’t Does Not Imply Can’t « The Everyday Economist
    24. May 2010 at 09:31

    [...] 24, 2010 · Leave a Comment Scott Sumner has written an excellent post on monetary policy and the difference between whether policy can work and whether [...]

  40. Gravatar of thruth thruth
    24. May 2010 at 12:35

    Scott Sumner said “Other countries have successfully regulated in such a way to discourage sub-prime loans (Canada, Denmark, etc.) But we tried and failed to regulate leverage with Basel II because banks are so clever at finding ways around it.”

    I don’t see why arbitrary product bans will be any more effective than capital regulation changes. Likely worse, because it’s making policy via the rear view mirror. As history has shown, the next financial crisis will come from innovations we’ve never heard of.

    “And why couldn’t you have a major fiasco w/o high leverage? If the banking system is hit with a trillion in losses in mortgages, lots of banks will fail even if leverage isn’t that high.”

    Surely it’s the combined leverage that matters (household + institutional). The more leveraged the bank, the closer it is to the insolvency threshold. As insolvency looms, banks hoard cash and stop lending in order to meet margin and other requirements. That behavior is optimal for management/shareholders but socially destructive because capital allocation at the margin is responding to the condition of the bank not the profitability of new lending. Spread wide enough, it’s a possible cause of depressed asset prices and crashing AD, right?

    “But banning sub-primes gets closer to the heart of the problem.”

    I thought the heart of the problem was an AD shortfall. If AD had not crashed, then we would have seen a minor correction in home prices concentrated in the over built areas. In other words, the opening up of access to subprime credit would have resulted in a secular increase in home prices relative to fundamentals such as rents or incomes. (Not arguing that this is efficient)

    “Of course the real problem is moral hazard, but I’m not so naive that I think we’ll end FDIC and TBTF. With 20% minimum down-payments instituted in 2003, we wouldn’t be in recession right now. It’s that simple.”

    I don’t think it is that simple. Our clever banking system would have found another high risk pony to back in the wake of the dot-com bust.

    ps, why is 20% down the right number? when you ban mortgages without 20% downpayments, do you also ban second liens, home equity lines, credit cards etc?

    pps, my take on the role Fan and Fred in the crisis is a little more nuanced than that coming out of right. First, F/Fs holdings of Subprime and Alt-A mortgages and securities was bad not because of the direct risk F/F took in holding them (by any measure the particular mortgages held by F/F are safer than the stuff in the wild), but because they effectively gave the subprime and Alt-A a US government seal of approval (Too Federally Endorsed Too Fail). Second, F/Fs lower cost of capital enabled by their implicit govt backing ensured their dominance of the conforming market. The trillions in idle capital tucked away in the conforming market created huge incentive for banks and insurers to induce households out of conforming mortgages and into riskier products. To beat F/Fs funding advantage, the private institutions had to underprice their products/take too much tail risk/create “innovative” financing schemes.

  41. Gravatar of thruth thruth
    24. May 2010 at 12:36

    typo: Too Federally Endorsed To Fail

  42. Gravatar of Sum can, sum can’t « ricardian ambivalence Sum can, sum can’t « ricardian ambivalence
    25. May 2010 at 02:03

    [...] 25, 2010 · Leave a Comment Scott Sumner at the money illusion blog has been writing some interesting stuff about negative rates and policy. I was going to write this [...]

  43. Gravatar of Manny C Manny C
    25. May 2010 at 03:55

    An objection to NGDP targeting:
    “let me say I have no problem with price level targeting in theory, but I do have a major problem with it in practice – bond markets are smart, and if you credibly announce an intention of inflation of 10% for 5yrs (say to catch up to your 2%y/y target) long bond yield would shoot higher.

    Under such a scenario, in the US, 30yr conforming mortgages rates could easily exceed 10%, and the US housing market would then double dip – taking the economy and the banks down with it. ”

    http://ricardianambivalence.wordpress.com/2010/05/25/sum-can-sum-cant/

  44. Gravatar of ssumner ssumner
    25. May 2010 at 08:23

    Thruth, We should copy the Canadian system, it has worked much better than ours. Don’t try to reinvent the wheel, use what works.

    Regarding F&F, they are costing US taxpayers much more than the big banks, so that tells me that made more serious errors.

    Manny, Low interest rates are associated with depression, higher intereast rates with booms. If US long rates rose it would be because investors expected stronger NGDP grwoth, which would help increase RGDP.

  45. Gravatar of thruth thruth
    25. May 2010 at 11:09

    Scott Sumner said “We should copy the Canadian system, it has worked much better than ours. Don’t try to reinvent the wheel, use what works.”

    My impression of the Canadian system is that it is generally more conservative than the US system. The Canadian system increases regulation in terms of BOTH capital and product types. That doesn’t mean no subprime, just less subprime. Perhaps the important point is that their banks must take federally backed insurance on their subprime loans. That seems like an important feature given the moral hazard induced by deposit insurance. Simply increasing capital requirements in the US would force banks to return to FHA insured products.

    The flipside is what do you lose if you adopt more restrictive system? The US is the de facto home of innovation (finance included). A disproportionate amount of innovation, good and bad, comes out of the US. Other countries, including Canada, free ride on that innovation by adopting the good stuff at a lag. From my casual reading, it seems like Canadian banks were cautiously increasing their subprime and alt-A lending before the crisis. e.g. see http://www.bis.org/publ/wgpapers/cgfs26traclet.pdf

    “Regarding F&F, they are costing US taxpayers much more than the big banks, so that tells me that made more serious errors.”

    That’s not an error, it’s a policy choice (F/F are an off-balance sheet federal financial program). Lets say the costs end up as high as $400bn. Assuming this is a once in 50 year event, the annuitized cost of the policy of chartering F/F is no more than, say, $20bn/year (much less than the mortgage interest deduction), which benefits the industry and homeowners.

    The more troubling issues, I think, are that the cost to taxpayers is opaque until a crisis and their existence is destabilizing to the broader market for the reasons I outlined above.

  46. Gravatar of ssumner ssumner
    26. May 2010 at 08:57

    thruth, Nick Rowe says the Canadian system is more restrictive in some areas and less in others. They didn’t have branching limits (which created far too many banks in the US.) and they didn’t even have deposit insurance until 1967.

    I don’t think they have no recourse mortgages, but am not sure.

    Regarding F&F, I regard $20 billion a year for 50 years as a massive waste of money, given that F&F serve zero social purpose. And BTW, as someone who rented much of his life, I don’t see “home ownership” as a valid social objective.

    I agree with Krugman on innovation, lots of it has had little social purpose. Let groups like hedge funds, which don’t risk taxpayer money, take on the more adventurous side of finance.

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