Deconstructing inflation talk

Post-modernists claim that you have to treat “texts” like a puzzle, where the author is making one set of assertions, but the real meaning is hidden beneath the surface.  In that spirit, I’d like to deconstruct a recent article on inflation in The Economist:  

The inflation of the 1970s had its origins in the 1960s, with economists who believed that a bit more inflation could buy lasting lower unemployment. The natural-rate-of-unemployment hypothesis of Milton Friedman and Edmund Phelps, the rational-expectations revolution and the dismal experience of the 1970s all put paid to that idea. Politicians, aware that high inflation often brought regime change, accepted the idea that central banks should be left to concentrate on inflation. The latest crisis has demonstrated that price stability is no guarantee of financial and economic stability—indeed, a narrow obsession with prices may have led central bankers to neglect asset bubbles and the condition of the banks. Yet in practice price stability has not been dislodged from the centre of central banks’ attention. If anything, some seem anxious to unwind their quantitative easing and normalise interest rates despite the prevalent deflationary pressure.

It seems to me that there are many ways of reading this paragraph.  Recall my argument that the Fed should try to generate more inflation in order to boost economic recovery.  Is my argument consistent with The Economist’s take on things, or inconsistent?  Am I arguing for “price stability” or am I peddling a discredited theory that inflation can reduce unemployment?   I think I am arguing for price stability, and simply applying the Friedman/Phelps hypothesis, but I’ll bet most readers of The Economist would reach a different conclusion.

Let’s start with what The Economist means by ‘price stability.’  Do they mean stable prices, or do they mean a steady 2% inflation rate?  You might say; “It’s obvious, price stability means price stability, i.e. zero inflation.”  But there are two problems with that interpretation.  First, when The Economist suggests that price stability didn’t insure economic stability, they are almost certainly referring to the Fed and ECB’s policies, which are better described by a 2% inflation target than a 0% percent inflation target.  And second, look at what The Economist has to say about the one developed country that actually did have (CPI) ”price stability” in the 5 years leading up to the 2008 crisis:

If anything, the record of quantitative easing in Japan should heighten worries of deflation. As Adam Posen of the Peterson Institute for International Economics notes in our forum, it “did not have a predictable or even large short-term result…We need more humility about what we are capable of doing with monetary policy once deflation begins.”

Japan is treated as an example of failed monetary policy, a country that failed to produce “price stability.”  And yet in the 5 years preceding the crisis, the Japanese price level was far more stable than then US or Eurozone price levels.  OK, what if I am right that by ‘price stability’ The Economist really means 2% inflation?  That would cast an entirely differently light on the first paragraph I quoted.  If price stability is actually 2% inflation, then it is not true that price stability failed to produce “economic stability.”  Indeed, what happened is that the world economy plunged in late 2008 precisely when central banks diverged from a policy of “price stability.”  How do we know?  We need look no further than another article from the same issue of The Economist:

Judging by the discussion in a new online forum of more than 50 leading economists from around the world, which The Economist launched this week, deflation is the bigger short-term danger in big, rich economies, whereas inflation is an immediate worry in many emerging economies and, potentially, a longer-term danger in rich ones.

That seems a fair assessment. In America, the euro area and Japan, deflation is either uncomfortably close or a painful reality, despite near-zero interest rates and other efforts by central banks. In the year to April core consumer prices rose by a mere 0.9% in America, the slowest pace in four decades. In the euro area they rose by 0.7%. And in Japan, which has battled falling prices for more than a decade, they fell by 1.5%.

So inflation began falling sharply below the 2% “price stability” range precisely when the world economy went into free fall in late 2008.  How might people respond to my argument?  I suppose they might argue that I have reversed causation; that inflation fell sharply because of the recession, rather than the fall in inflation causing the recession.  As you know, I prefer to focus on NGDP.  The sharp fall in NGDP caused both the fall in inflation and the fall in RGDP.  This should be the standard view of almost all macroeconomists (excepting those who favor real theories of the cycle.)  But for some reason it isn’t.  The question is why.

I think The Economist would agree that if monetary policymakers had kept NGDP rising at trend, and inflation no lower than 2%, we would not have had a severe recession.  Except for the unusual case of 1974 (a severe supply shock) recessions are almost always associated with lower NGDP growth.  If we still had 2% inflation, the recession would almost certainly have been very mild. 

So why does The Economist imply that a policy of “price stability” failed to ensure economic stability?  I think there are two reasons.  First, they think the financial crisis (not falling inflation) caused the recession.  And second, they don’t think monetary policy could have done much to prevent the fall in inflation.  I plan to do another post soon using data from the IMF, which I believe shows pretty conclusively that the financial crisis was almost entirely due to falling NGDP, and only a small part was due to foolish lending that would have gone bad even with briskly growing NGDP.  But for now let me focus on the second point, which I think is the sine qua non of The Economist’s assertion.  At the end of the first article I linked to, they made this claim:

With the exception of Japan, there have been few instances of governments pressing central banks for more expansionary policies. To be sure, there’s not much more they could do. But perhaps politicians, like central bankers, are not yet ready to discard orthodoxy.

Not much more they could do?  What in the world would make The Economist think that monetary stimulus could not easily boost inflation right now?  Here’s what.  Go back to the second quotation, when Adam Posen expresses skepticism about the ability of monetary policy to arrest inflation.  And why does he express skepticism?  Because of what The Economist calls “the record of quantitative easing in Japan.”  This is where I start to feel like Paul Krugman, wanting to grab the world by the shoulders and scream “wake-up people.”  For the 100th time, inflation targeting in Japan didn’t fail because IT WAS NEVER TRIED.  The evidence is absolutely overwhelming that the BOJ didn’t want even 2% inflation.  The BOJ behaved exactly like a central bank who wanted to keep CPI inflation at 0% or slightly below, and they have succeeded in that objective better than almost any other central bank in the world.  Here’s the evidence:

1.  They twice tightened monetary policy (in 2000 and 2006) when Japan did not have any inflation.  They did this by raising interest rates.  What does that tell you?

2.  The monetary injections of 2002-03 were temporary, and withdrawn in 2006, despite the fact that there was no inflation.  Temporary currency injections are not stimulative.

3.  They let the yen appreciate sharply from about 115 to 85 to the dollar, despite falling prices in Japan.

4.  They continually refuse to set a positive inflation target, as the Fed and ECB have either implicitly or explicitly done.

5.  They refuse to do level targeting, which is known to be very helpful during deflation.  This would force them to make up for past deflationary mistakes.

When will people stop talking about the BOJ as some sort of helpless victim of deflation who did all they could, and recognize that they are an extremely reactionary central bank, much more so that the Fed or ECB?

Why is this important?  Because if you recognize that a regime of level targeting can prevent deflation, even during a financial crisis, then you also recognize that it can prevent a severe demand-side recession in the wake of a financial crisis.  And you will also see the current fall in inflation to levels far below “price stability” as a failure of monetary policy, not some sort of inevitable side-effect of a recession that was caused by financial distress. 

To summarize, The Economist should have written the following; ”Price stability worked well up until 2008.  When central banks switched to a more deflationary policy we got the severe recession predicted by the Friedman/Phelps Natural Rate model.  Monetary policy can prevent this from occurring with level targeting of prices, or better yet, NGDP.  Oh, and the tight money also made the financial crisis much worse.”

While we are deconstructing The Economist, think about this.  The article focuses almost entirely on monetary policy, with almost no discussion of fiscal policy.  Now I don’t have a big problem with that, as I believe monetary policy drives inflation, and fiscal policy has only a minor effect.  But here is what I object to.  When mainstream publications like The Economist talk about ideas for stimulating the real economy to boost growth and lower unemployment, they almost always spend a lot of time on fiscal policy.  I don’t see any theoretical justification for this dichotomy in any of the mainstream macro models that journalists rely on.  Those models say that both fiscal and monetary stimulus boost both prices and output.  The tendency of journalists to talk about inflation in the context of monetary policy and real growth in the context of fiscal stimulus is very revealing.  They have some non-mainstream model in their minds, but for the life of me I can’t figure out what that model could possibly be. 

To end on a more positive note, I really like the first paragraph of the first article I cited in The Economist:

IN THE short run inflation is an economic phenomenon. In the long run it is a political one. This week The Economist asked a group of leading economists whether they reckoned inflation or deflation was the greater threat; this was our inaugural question in “Economics by invitation”, an online forum of more than 50 eminent economists. The rough consensus was that in the near term, as Western economies struggle to recover, the bigger worry there is deflation. But as the time horizon lengthened, more experts cited inflation, because it seems the most plausible exit strategy for governments trying to deal with crushing debts.

I feel bad being so critical of a magazine that invited me to join 49 other much more esteemed economists.  Think of it this way.  I subscribe to the paper edition of The Economist because it is the best magazine/newspaper in the world.  That’s where I found the article.  Similar perspectives can be found in any other serious publication.  So don’t take it personally Mr. and Ms. Anonymous Journalists at The Economist—I still love your work.


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35 Responses to “Deconstructing inflation talk”

  1. Gravatar of TravisA TravisA
    13. June 2010 at 10:44

    Scott, how accurate do you think the Phelps/Friedman natural rate model is in explaining this recession? Can a change in inflation rates of ~2% to ~1% really cause such an increase in unemployment?

    About the only defense of the model that I can think of is that perhaps wages are really sticky and thus the unemployment is going to last a long time as the low inflation slowly erodes real wages.

    I wonder if changes in NGDP are much more fundamental than changes in inflation, since inflation is perhaps a seriously lagging indicator due to sticky prices. If so, shouldn’t the Phelps model be fundamentally revised to focus on NGDP rather than inflation?

    (My guess is that I am preaching to the choir here…)

  2. Gravatar of ssumner ssumner
    13. June 2010 at 10:56

    TravisA, Elsewhere I have argued that the inflation numbers are flawed, and actual inflation fell by much more than 1%. I agree with you that NGDP is a much better way of measuring nominal shocks, and I’d also like to see natural rate models restructured in terms of NGDP. I only talk about inflation when I am addressing other people who think inflation is really important.

    But even if we use measured inflation, I’d make the same argument. A monetary policy capable of preventing a severe recession would have also prevented the recent drop in the core inflation rate. It works the other direction as well. A monetary policy that prevented a drop in the core inflation rate, would have prevented a severe recession.

  3. Gravatar of Cameron Cameron
    13. June 2010 at 12:15

    Another example of an article that is difficult to read without pulling my hair out.

    Production Probably Rose, Prices Fell as U.S. Recovers Without Inflation
    http://www.bloomberg.com/apps/news?pid=20601087&sid=afVs1JzRgfSE&pos=3

    Two notable sentences:

    “It’s really a sweet spot in terms of continuing growth without inflation,”

    and

    “The lack of inflation validates the Fed’s strategy to maintain the benchmark lending rates on overnight loans between banks near zero to spur growth.”

    Yikes.

  4. Gravatar of Ted Ted
    13. June 2010 at 12:48

    I think most people believe fiscal policy generates growth because most politicians have managed to convince everyone (and possible themselves) that it is indeed the case. Obviously fiscal policy plays some role (particularly if you are talking about large sweeping changes in the tax code), but it’s certainty not the only role – nor the primary one in most cases.

    Also, I too am sick of seeing Japan being brought up as the example to support that nothing can be done. That’s just stupid. Of course something can be done, they just wouldn’t do it. Really, I’m waiting for a thorough study of Japan’s political economy to explain why their government and central bank let this happen. I can’t imagine they just have preferences for deflation and low growth.

    Finally, I have a question for you Scott. My reading of monetary theory calls for a long-run inflation target of basically insignificantly above zero or even slightly negative, depending on precisely what assumptions you make. Now I get the need for flexible inflation targeting to deal with price-stability tradeoffs, but how can this possibly explain why most central banks target annual inflation so much higher (usually around 2%) than I believe monetary theory would call for. I know Schmitt-Grohe and Uribe recently made an argument that when there is significant foreign demand for a currency the inflation target should be above 2%, but I haven’t read the paper really and this argument would seem to only apply for the U.S. and possibly Europe (plus, I’m skeptical of their calibration since they argue a 10% per annual rate of inflation would fall in the optimal range for the United States given the foreign demand for our currency – which seems really, really high to me).

    But anyway, why do you think inflation targets are set so high above their optimal level – or do you just disagree that they are?

    I’ve thought a possible reason is that they are worried about bias in the CPI, but all the estimates of bias in the CPI wouldn’t still seem to call for long-run targets far below 2%. I’ve also seen arguments made that higher inflation targets help avoid the zero lower bound (how’s that working out?), but at least in principle it would seem if you had a committed central bank that the problem of the zero lower bound can obviously be overcome.

  5. Gravatar of Ed Dolan Ed Dolan
    13. June 2010 at 13:13

    “The latest crisis has demonstrated that price stability is no guarantee of financial and economic stability—indeed, a narrow obsession with prices may have led central bankers to neglect asset bubbles and the condition of the banks.” I am not a deconstrutionist, but when I read this sentence, I thought the Economist was referring to the Hayekian argument that during period of high productivity growth, the inflation target should be negative. To try to keep prices of goods and services from falling when productivity is rising requires letting real GDP grow faster than potential, which in turn, engenders asset bubbles. Anyhow, that was just my first impression. Maybe the Economist really did mean to imply that the crisis occurred because central bankers held inflation at too low a target, and was not after all making the Hayekian critique of too high a target.

    Ted asks, “why do you think inflation targets are set so high above their optimal level?” CPI bias is one reason, although that supposedly is only about half a percentage point. Beyond that, I tell my students that central bankers are worried about reluctance of workers to accept nominal wage decreases. In order to allow smooth adjustment of relative wages without absolute nominal decline of wages in lagging sectors, the target has to be high enough to allow positive growth of the average nominal wage. (To return to the Hayekian critique, however, it could be that if productivity growth is fast enough, smooth nominal wage adjustment and rising average nominal wages can be consistent with absolute price stability in the sense of zero inflation of goods and services prices.)

  6. Gravatar of Don the libertarian Democrat Don the libertarian Democrat
    13. June 2010 at 13:23

    “Now I don’t have a big problem with that, as I believe monetary policy drives inflation, and fiscal policy has only a minor effect.”

    The Fiscal Policy, Stimulus/Govt Borrowing, should Reinforce the Monetary Policy. It’s size is less important than it’s targeting. But, to the extent that it can help reinforce the monetary policy by helping create the desired expectations, while also serving some useful purposes ( including not raising taxes during a downturn ), it is an essential component of the response. To the extent that the govt does borrow in this response, it would help to tell people that it reinforces the goals of the monetary policy.

    There is one plan that clearly recognizes this:

    Milton Friedman A Monetary and Fiscal Framework for Economic Stability

    The problem seems to be that some people don’t find it ‘libertarian’ enough, while others can’t abide Milton Friedman for reasons having to do with false impressions about him, in my view. In the end, though, I think this type of plan will be put in place. For one thing, it’s based on the idea that we agree on general goods that we want the govt to help provide, and then fashion the most efficient use of resources for supplying those goods. Going forward, our budget woes will force us to develop such a common agenda. The alternative is awfully ugly.

  7. Gravatar of Jon Jon
    13. June 2010 at 13:23

    I was just reading the economist before this post but I haven’t read the same bits as you. No, I got distracted by their cover run about the republican party and there associated essays hammering the point.

    Okay you’re a big supporter… I subscribe too but I can never get my head around their articles on American politics. Am I an alien?

    What I’d like to see is a comparison between the US and Canada for instance–no, not another slobbering discussion about health care but about how the American left and right have been locked in a draw on neoliberalism for 30 years, in particular about the composition and structure of the tax system.

    The economist can be very witty and insightful, but I don’t think they understand the USA…

  8. Gravatar of scott sumner scott sumner
    13. June 2010 at 14:05

    Cameron, I hear you. It’s really great to have inflation coming in well below the 2% target at a time of near 10% unemployment. (rolls eyes)

    Ted, You said;

    “I think most people believe fiscal policy generates growth because most politicians have managed to convince everyone (and possible themselves) that it is indeed the case.”

    I agree. Here’s how I should have put it. Both fiscal and monetary policy affect growth by boosting AD. So if the conventional wisdom is that fiscal policy can boost growth, and monetary policy can’t, then any article discussing inflation ought to spend 90% of their time discussing fiscal policy. But in fact, they mostly discuss monetary policy when examining inflation. All I am saying is be consistent.

    You said;

    “I’ve also seen arguments made that higher inflation targets help avoid the zero lower bound (how’s that working out?), but at least in principle it would seem if you had a committed central bank that the problem of the zero lower bound can obviously be overcome.”

    There are two ways of answering this question. In a perfect world you are probably right. Although even in that case some argue that 2% inflation makes real wages more flexible, due to the reluctance to cut nominal wages in declining industries. But suppose central banks don’t know how to operate in a zero interest rate environment. Then you’d have more liquidity traps at zero percent inflation. My response to the “how’s that working out” is that the one country with zero inflation (Japan) has lots more liquidity traps that the US and Europe. But again, with proper level targeting you could avoid liquidity traps, and 0% inflation is probably better (or 3% NGDP growth.)

    Ed Dolan, I don’t agree that inflation targeting caused very much of the asset bubble, but let’s say I’m wrong and it did. That still wouldn’t address my complaint. The steep fall in NGDP in 2008-09 was not caused by highly expansionary monetary policy, it was caused by highly contractionary monetary policy–relative to the needs of the economy. So why not target the price level or NGDP to raise expectations and lower real rates?

    BTW, I actually favor NGDP targeting, not inflation targeting. NGDP targeting would have slightly reduced the asset bubble, but not much.

    On your second point I agree on the wage issue. And my advocacy on NGDP targeting is right in line with Hayek’s views (except I favor a gradual increase in NGDP.)

    Don the Libertarian Democrat, Of course even if you are right, there should be no monetary/fiscal dichotomy when discussing inflation vs. real growth. I also think that with NGDP targeting, monetary policy can get the job done by itself, and fiscal policy should be conducted on ordinary cost/benefit considerations. But I’m no ideologue here, if that’s the only way we can do it, I’d much prefer a monetary fiscal hybrid to the current muddle.

    Jon, Sure, I often disagree too. But it’s nice to have a non-partisan outside view. Don’t you love how liberal bloggers always call The Economist “conservative.” Let’s see, they endorse Obama for President and also endorse his health care bill. Yep, that’s pretty conservative. No wonder liberals don’t see any media bias. If The Economist is conservative, then all points of view are covered. There are “conservative” magazines that favor Obama, and liberal magazines that favor Obama. What’s the problem?

    But I agree, I like them for their foreign coverage. If I was Belgian I’d probably see all sorts of flaws in their coverage of Belgium.

    I get tired of their views on guns and the death penalty. Both views are defensible, but they overrate the importance of those issue. Very few people are executed, and banning handguns guns would have only a small impact on our murder rate.

  9. Gravatar of Morgan Warstler Morgan Warstler
    13. June 2010 at 14:18

    Scott, I read each of your blog posts with great interest, because you so adamantly insist you are a free market guy. And I believe you view yourself as such.

    I however continue to think the issue we face is price on assets being too high, and I wish you’d spend some more time explaining why you think we’re actually why we risk a deflationary spiral, and need to fear a revaluation towards the guys with dry powder and away from those sitting on loans hoping nobody figures out it isn’t worth as much any more.

    The whole concept of a deflationary spiral REQUIRES that falling prices signals to people not to buy.

    We’re not there right now, what we have now is prices stuck, and a FIRM belief from the dry powder guys that they have better deals coming around the corner.

    The MORAL position then isn’t to try and set some believable policy that their saving will be inflated away.

    But rather, apply the same belief to a policy of “shoot the banker” – force mark-to-market – let the prices drop fast and furious and let the dry powder have the immense opportunity they have been waiting for.

    Everyone with cash – the smart guys – they will believe that “shoot the banker” is the best deal of a lifetime, they are ever going to get.

    The question before us is: What policies can Scott invent that cause banks to have to sell off all their toxic assets, foreclose and sell at auction ALL the homes that are sitting idle.

    A nation of renters means: do whatever we can to get all the homes SOLD and PERFORMING. And whatever polices and prices are necessary to kill off zombies, – zombie banks and zombie properties, those are good policies.

    http://www.capitalismmagazine.com/index.php?news=1289

  10. Gravatar of ssumner ssumner
    13. June 2010 at 14:35

    Morgan, I don’t want to see the Fed worrying about asset prices at all, leave that to the market. But the market value of asset prices will be affected by monetary policy. If we have Zimbabwe style inflation, then all asset prices are currently way too low (compared to what they will be worth next year.) If we have hyperdeflation then everything is way overpriced. In my view if we had a stable monetary policy that did not distort economic decision-making then we’d need about 5% NGDP growth each year, because it is those expectations on which wage and loan contracts were made. If we are going to change to another monetary regime with zero inflation, that’s fine, but do so gradually and not in the middle of a financial crisis.

    My hunch is that if we had 5% NGDP growth, then most asset prices would be higher. So I don’t think they are too low, I think money is too tight.

  11. Gravatar of William William
    13. June 2010 at 14:43

    Scott,

    I don’t want this to sound like skepticism, because I really am basically clueless about this stuff, but when you say the evidence is overwhelming that the BOJ’s policies induced 0% inflation, do I take that as the expert consensus or should I be thinking that’s just something you are really, really convinced of? It seems like people talk about “liquidity traps” so much, I was surprised to see you so adamant on this point.

  12. Gravatar of Morgan Warstler Morgan Warstler
    13. June 2010 at 14:59

    But they ARE worrying about asset prices. And I think deep down, you are too. Everything the Fed and the government have done on housing has been to keep the prices from falling. They are fighting a nation of renters at every turn.

    Here’s a kind of proof of my point, I’ll cull from Krugman trying to respond to Rajan:

    “1. Raising rates a bit wouldn’t significantly deter investment.

    2. “Unnaturally low” interest rates are distorting asset prices.

    The first thing to say about these two assertions is that they are essentially contradictory.”

    No they are not.

    Asset prices are being distorted by unnaturally low interest rates, because the cheap money is keeping the banks from having to sell off bad assets.

    And investment is not just borrowed money. Until all the cash sitting on the sidelines jumps into the pool, it is dumb to worry about investment from borrowing.

    Scott, please answer me this question:

    If you are a banker sitting on a giant pile of underwater mortgages and you have HOPE that somehow, just somehow, say Fed caused inflation, and you aren’t suffering for revenue – say from really cheap reserve money throwing interest – are you going to dump all those homes on market?

    You don’t seem to really answer this, WHY are you against seeing all the mis-priced assets dumped on the market at auction?

    What do you think happens? Why is it bad? And what is your proof that it happens?

    Imagine for a second, that every single foreclosed property & every single proeprty 120 days late – will be sold at auction within the next 90 days as policy.

    What do you think happens?

  13. Gravatar of Morgan Warstler Morgan Warstler
    13. June 2010 at 15:02

    http://krugman.blogs.nytimes.com/2010/06/12/strange-arguments-for-higher-rates/

  14. Gravatar of StatsGuy StatsGuy
    13. June 2010 at 18:04

    @Morgan

    I think you are very adequately expressing the hopes and fears of those holding cash – the hope that prices crash fast enough for them to make a killing buying up distressed assets, and the fear that the Fed might actually do what Bernanke said he would do many years ago before they get their chance, thus leaving them behind as asset markets get away from them. Back in early this year, the angst among those with dry powder was palpable; now they are triumphant in their greed.

    But the issue is this – any asset price crash fast enough to force liquidation at truly fire sale prices would bankrupt every pension fund, insurance company, and other asset-price-dependent entity – including the Federal Government. The liquidation cycle would not stop after one glorious implosion, leaving those with “powder” to lead us into the brave new world of uber-oligopolistic capitalism. I simply don’t think those holding cash realize this – they are clinging to an unstable equillibrium (not unlike Japan). That equillibrium may last 2 years or maybe 10 years, but it can’t last forever.

    There are only two sustainable equillibria – the true disaster folks (Zero Hedge, buy gold!!!), and the price level trajectory targeting folks (Money Illusion). I read both, but I do hope the price targeting folks win.

  15. Gravatar of David Beckworth David Beckworth
    13. June 2010 at 18:34

    Scott:

    Ed Dolan is correct on this one. When The Economist says “the latest crisis has demonstrated that price stability is no guarantee of financial and economic stability—indeed, a narrow obsession with prices may have led central bankers to neglect asset bubbles and the condition of the banks” it is talking about the lead up to the collapse in the early-to-mid 2000s, not the collapse itself. In fact, they had many thoughtful pieces on this issue back then. The main point of these articles was that one cannot look just at a low and stable inflation rate and assume central banks are doing an adequate job. Focusing just on an inflation target can create complacency. Here is one of their articles I excerpted at my blog a while back on this issue:Unnaturally Low.The Economist also drew on this article by William White of the BIS tiled Is Price Stability Enough?. This piece attracted a lot of attention at the time and has a lot of cites.

  16. Gravatar of Morgan Warstler Morgan Warstler
    13. June 2010 at 20:52

    statsguy,

    For a stats guys that’s an awful lot of conjecture.

    Let me just make sure you hear the words back to you flipped upside down.

    The people who held back, who got out, who refused to suspend disbelief are NOT supposed to be rewarded very publicly in the face of god, and you, and scott who is a market + infation guy, and krugman who is evil incarnate.

    WTF? The desperately needed lesson is, “get overextended and get poor,” and the medicine is never worse than the disease. Because the disease IS DEATH. You can’t have capitalism without bankers either: 1)boring 2)sometimes poor.

    And the quickest way of killing capitalism (risk and profit towards growth) is to remove losses.

    So your side = death of capitalism.

    ——-

    That said, here’s what really happens. We’ve got what $15T in performing property assets?

    Let’s say $1T will go to fire sale over next year. The government announces there will be no zombie properties. Mark to market or sell it off.

    Like any good auction, very quickly true prices are found. Greed works, man – the piggy banks will be opened. And frankly, sure we might all experience another 20% brief loss in our real estate prices, but there is a bottom.

    The banks will not have profits for quite some time.

    Banks will be far more likely to cut deals if the few instances where the it actually works.

    The realtors will be happy.

    Construction will tick up. All those cheap houses need fixed up for rentals.

    Rental prices will go down. And we’ll have a more mobile workforce.

    A bottom will be found. We will no longer be taking crazy action after crazy action trying to prop shit up.

    Derivatives: let the chips fall where they may. There will be some losers, but I suspect that its all a little bit of everybody owning and insuring against everybody.

  17. Gravatar of Morgan Warstler Morgan Warstler
    13. June 2010 at 20:56

    Stats guy let me say it this way:

    This is a war between the guys with cash and the bankers. Everyone else will be fine. One of them is going to get the goodies.

    Fuck the bankers.

  18. Gravatar of Steve Steve
    14. June 2010 at 02:44

    Scott,

    you mentioned the 1974 case as unusual. I know we have talked about this before. It is unlikely, but possible, that such a supply shock may come again. Therefore my question: how would your NGDP level target prevent or counteract such a recession? Or is it not capable of doing that?

    And if you are going to say, such a recession is “necessary” since the economy has to adjust to such a supply shock, that reminds me a little of the claim that recession are necessary to pay for our sins. I am sure there is a way to avoid even such 1974 recession. For instance, correct the NGDP target path for oil price (in the 1974 recession, that could have worked).

    Thanks,

    Steve

  19. Gravatar of StatsGuy StatsGuy
    14. June 2010 at 05:51

    Morgan…

    “The government announces there will be no zombie properties. Mark to market or sell it off.”

    Slightly confused here – how is forcing people to participate in an illiquid market against their wishes conducive to preserving capitalism?

    “For a stats guys that’s an awful lot of conjecture.”

    When I lead a comment with “I think”, I hope it’s pretty clear I’m expressing an opinion.

    “—- the bankers”

    It would be a lot easier to —- the bankers if the Fed committed to compensating for the implosion in credit by stabilizing the general price (or, better, NGDP) trajectory. Otherwise, this reminds me of the Industrial Org models on oligopolistic enforcement. Not only is punishment costly, but the high cost causes the threat of future punishment to lack credibility due to incentives to renegotiate.

    “So your side = death of capitalism.”

    I do wish we could have a single definition of capitalism that didn’t seem to change whenever someone alleged a flaw.

    BTW, commenters on this site – unlike many others – have done a pretty good job avoiding the F bomb.

  20. Gravatar of Ed Dolan Ed Dolan
    14. June 2010 at 05:52

    David Beckworth: Thanks for the cites. The BIS paper is going straight onto the reading list for my monetary policy course this fall.

    Scott: I agree that NGDP targeting has advantages over inflation targeting as a starting point for design of stabilization strategy.

  21. Gravatar of scott sumner scott sumner
    14. June 2010 at 06:04

    William, There are mixed views on the issue. I think the more an economist knows about how the BOJ actually works, the more they are likely to agree with my view. The actions that I described are public knowledge, completely uncontroversial. No central bank that wanted inflation would have taken those actions. Nobody put a gun to their heads forcing them to raise rates in 2000 and 2006. No one forced them to sharply reduce the monetary base. No one forces them to refrain from a public inflation target.

    Morgan, The facts simply don’t back up your assertion. Low interest rates are associated with low asset prices (1930s, 2003, 2009) and higher interest rates are associated with higher asset prices (1929, 2000, 2006) So the facts don’t match your assumption that low rates raise asset prices. In fact low rates aren’t a causal factor at all. They are a reflection of low asset prices. When markets crash due to tight money, rates fall naturally to low levels. That would occur even if the Fed had never been created.

    You said;

    “You don’t seem to really answer this, WHY are you against seeing all the mis-priced assets dumped on the market at auction?”

    I am a free market economist and I favor the owners of assets being free to do whatever they want with them, including auctioning them.

    Thanks Statsguy.

    David, I half agree. I do recall all of those articles by The Economist suggesting that inflation targeting is a bad idea. And as you know I favor NGDP targeting. But The Economist is saying more than just that. They aren’t just saying that this policy led to the real estate bubble, they are claiming that it didn’t prevent the current economic crisis around the world. I think that’s a clear implication of their argument. I say they are wrong. I claim that even (forward-looking) inflation targeting, flawed as it is, would have prevented the current severe recession and most of the financial crisis that has swept the world since 2008. I may be wrong, but I am pretty sure that I and The Economist disagree on that point.

    Morgan#2, You said;

    “The people who held back, who got out, who refused to suspend disbelief are NOT supposed to be rewarded very publicly in the face of god, and you, and scott who is a market + infation guy, and krugman who is evil incarnate.”

    This is what you fail to understand. I am not the one calling for bailing out borrowers. I oppose any change in Fed policy after the financial crisis struck. Before the crisis the Fed allowed 5% NGDP growth and 2% inflation. Loans were based on those assumptions. I simply wanted the Fed to continue on with its policy, not change it suddenly in a way that hurt borrowers. It is the inflation hawks who are clamoring for the government to change policy in such a way as to screw borrowers. I want a stable policy.

    Steve, Demand-side monetary policies cannot and should not prevent supply side recessions. But they do cause supply side recessions to be much milder than if we were targeting inflation. So it makes the best of a bad situation. Some recessions may be unavoidable–say a severe drought hits a poor agricultural nation. The US typical doesn’t have supply-side recessions. In the rare cases when we do, they are often aggravated by bad government policies. So even with supply-side recessions, there are things the government can do, even if monetary policy cannot help. In the early 1970s the government should have avoided wage and price controls, that would have made the 1974 recession milder.

  22. Gravatar of scott sumner scott sumner
    14. June 2010 at 06:06

    Ed, That’s good–we need more people to talk up NGDP targeting.

  23. Gravatar of scott sumner scott sumner
    14. June 2010 at 06:11

    Statsguy and Morgan, I generally don’t censor people, but as you can tell from my recent post “Stuff Happens” I write as if my mom is reading the site. So I agree with Statsguy on the language. And some of my best friends are bankers.

    “Screw the bankers” would be slightly more acceptable here.

  24. Gravatar of Gregor Bush Gregor Bush
    14. June 2010 at 07:10

    Scott,
    Wouldn’t it be great if The Economist was right and monetary policy couldn’t affect the future path inflation when nominal rates were at the zero lower bound? Then the Fed, ECB and BoJ could simply monetize the entire stock of outstanding government debt with no inflationary consequences. No need to raise taxes everyone, monetary policy has no impact. Come to think of it, why do we need taxes at all? Why don’t we just print money to cover all government spending? After all, there’s nothing central banks can do to generate higher inflation when nominal short-term interest rates are at zero. The “liquidity trap” is the greatest free lunch in history!

  25. Gravatar of StatsGuy StatsGuy
    14. June 2010 at 09:02

    @ David Beckworth:

    I have a question about the citation – which was a very nice summary. Here is a quote:

    “At this
    juncture, such concerns might seem to provide clear support for the view that insurance against
    deflation is worth having. However, such a conclusion must be qualified to the degree that (as will be
    argued below) high debt levels may themselves have been encouraged by easy financing conditions
    in the past.”

    Is there any recent academic work that takes a similarly comprehensive look at using direct regulation of financial institutions (bank capital ratio, lending aggregates, reserves) as alternate instruments to limit excess lending rather than relying on a single rate policy instrument? I think this is relevant today – Soros recently raised the fact that in the 50s, the government intervened directly using non-rate mechanisms and suggested that some of these mechanisms be brought back.

    http://www.bloomberg.com/apps/news?pid=20601087&sid=aSewDrZuj1Vg&pos=3

  26. Gravatar of Morgan Warstler Morgan Warstler
    14. June 2010 at 09:04

    statsguy, first np, no further f-bombs. second, my assumption is that mark-to-market + no interest on reserves, will cascade us quickly into banks being ill-liquid, and that will lead to the wind down / sell off.

    You disagree?

    And frankly, there is only one definition of capitalism, and risk can’t be written out the equation, it cannot be reduced, not without harming the engine. A capitalist seeks MORE capitalism (risk / reward / loss) than what we have now, if you seek less, find another term for yourself.

    scott,

    “Low interest rates are associated with low asset prices (1930s, 2003, 2009) and higher interest rates are associated with higher asset prices (1929, 2000, 2006)”

    Wait, I think this this is reversed, there were slow downs / crisis, and Fed responded by keeping interest rates low. Raising interest rates happens when prices are going up.

    My point was in regard to Krugman, that he can’t even hold those two ideas in his head at the same time means something about him.

    Because right now we have unnaturally low rates, which is inflating asset prices, which is keeping dry powder on the sidelines… raising rates and setting policy basically admitting this travesty has gone on, and getting dry powder back into the game – is the key thing.

    Look, if prices go down, dry powder invests AND borrowing can still happen at higher rates (after all prices are really low).

    But if prices don’t go down, the dry powder sits and waits. Worry about the dry powder. You can’t build an economy on loans alone, whether they are cheap or not.

    The job of the Fed is not to chase wealth into buying overpriced assets.

  27. Gravatar of StatsGuy StatsGuy
    14. June 2010 at 11:05

    The MtM debate –

    I’ve alleged elsewhere that MtM is procyclical, particularly when capital asset ratios are rigidly enforced and forced liquidations occur correlatd in time (by virtue of the fact that everyone uses the same money).

    Now it may be that MtM is a superior long term regime (I have no idea), even if it may be procyclical, but there are two empirical challenges:

    1) Banks and all financial institutions made decisions that were based on mark-to-maturity accounting, meaning they made long term investments using short term deposits on the understanding they could weather short term (e.g. 5 years or fewer) declines in asset values. A regime change right now would constitute a huge transfer of wealth by radically increasing the price of short term volatility. It’s one thing to say: “From now on, Mark-to-market will be used for all securities purchased after X date.” It’s another to say “MtM will be applied to all past purchases, regardless of the regime the government promised those purchases would operate under.”

    2) Krugman had a nice post on liquidationism almost exactly a year ago:

    http://krugman.blogs.nytimes.com/2009/06/16/the-return-of-liquidationism/

    Worth reading, even if you hate him. Most of the replies I’ve seen to Krugman’s anti-liquidationism seem to argue that liquidationism would have worked _if only_ Hoover hadn’t tried to stop it from 1929 to 1932. This argument seems to lack credibility – after all, it was a conservative gold-standard-loving anti-deficit President who governed during the first 3.5 years of the Great Depression.

    The problem is this – pro-liquidation arguments seem to contend that it’s possible for liquidation to happen fast and then be done, then for the economy to grow from a new base (with the dry powder folks now owning a lot more of it). In practice, mass liquidation (and de-leveraging) is a very long and drawn out legal process. It may take years as firms are bankrupted, assets are sold off and reallocated or idled or scrapped, lawsuits are filed (and pile up in court), and people try to hold on (to houses, to firms, to assets) until liquidation finishes and recovery manifests. Often, liquidation progresses in cycles (as it did in the Great Depression, with many false recoveries).

    So what you appear to be saying is that liquidation could work, _if only_ government has the willpower to force it to happen _really really_ fast.

    But the fallacies are multiple: a (democratic) government can’t have that willpower (almost by definition), a capitalistic regime requires that rules not be changed post-facto in a way that massively redistributes wealth, and giving government the power to force institutions to sell at prices they do not like would invite huge legal challenges.

    Almost by definition, if the government had the will and administrative capacity to execute a cross-economy forced liquidation of the finance sector that would end in 60 days against massive sectoral and social opposition (including pension funds, etc.), then it would have had the will and administrative capacity to properly regulate the financial sector in the first place.

  28. Gravatar of StatsGuy StatsGuy
    14. June 2010 at 11:06

    …2.5 years of the GD

  29. Gravatar of scott sumner scott sumner
    15. June 2010 at 06:16

    Gregor, Yes, I’ve made that argument in a paper. For those who know IS-LM; the flatter the LM, the stronger the argument for monetary stimulus.

    Statsguy, I’d prefer we get to the root of the problem with regulation that reduces the moral hazard problem.

    Morgan, You said;

    “And frankly, there is only one definition of capitalism, and risk can’t be written out the equation, it cannot be reduced, not without harming the engine. A capitalist seeks MORE capitalism (risk / reward / loss) than what we have now, if you seek less, find another term for yourself.”

    So there is no place for insurance companies in a capitalist economy? You are like the Burt Reynolds character in “Deliverance.”

    You said;

    “Wait, I think this this is reversed, there were slow downs / crisis, and Fed responded by keeping interest rates low. Raising interest rates happens when prices are going up.”

    No, I didn’t reverse causation. Rates fell in recessions even before we had a Fed. Market forces affect rates much more than the Fed. In Sept 2008 T-bill rates fell to near zero even as the Fed kept its target rate at 2%.

    You said;

    “The job of the Fed is not to chase wealth into buying overpriced assets.”

    I agree.

    Statsguy, I agree on the liquidationists. Cutting the price of asset prices doesn’t help because the real problem is unemployment. If we have deflation and wages are stuck then you will have high unemployment–regardless of where assets are priced.

    And you were right the first time, it was 3.5 years.

  30. Gravatar of Still Worrying About Deflation Still Worrying About Deflation
    15. June 2010 at 06:20

    [...] troubles with deflation, and weak economic growth, are self-inflicted. Scott Sumner, for example, laid out the case this way: The evidence is absolutely overwhelming that the BOJ didn’t want even 2% inflation. The BOJ [...]

  31. Gravatar of Still Worrying About Deflation | EmpirestateFX.com Still Worrying About Deflation | EmpirestateFX.com
    15. June 2010 at 06:24

    [...] troubles with deflation, and weak economic growth, are self-inflicted. Scott Sumner, for example, laid out the case this way: The evidence is absolutely overwhelming that the BOJ didn’t want even 2% inflation. The BOJ [...]

  32. Gravatar of Doc Merlin Doc Merlin
    15. June 2010 at 13:17

    @Scott:
    “Statsguy, I agree on the liquidationists. Cutting the price of asset prices doesn’t help because the real problem is unemployment. If we have deflation and wages are stuck then you will have high unemployment–regardless of where assets are priced.”

    “Liquidationism” can help a lot with asset prices. Unemployment however has to be cut by changing regulatory and legal policy. I do not believe monetary policy is effective anymore at lowering unemployment (as the 70′s showed).

  33. Gravatar of ssumner ssumner
    16. June 2010 at 06:22

    Doc Merlin, The natural rate of unemployment can’t be cut with monetary policy, and that was the problem in the 1970s. But it can cut cyclical unemployment. In the 1983-84 period an expansionary monetary policy cut unemployment very rapidly after it hit 10.8% in late 1982. We should do the same today.

  34. Gravatar of Doc Merlin Doc Merlin
    21. June 2010 at 17:21

    Thanks for the response Scott, but…
    I guess I was saying, I don’t think we have cyclical unemployment right now. Its been well over two years since the unemployment problems started and U6 isn’t getting any better, this makes me think its structural.

    Shouldn’t cyclical unemployment improve on its own after 2 years even if the central bank doesn’t institute expansionary policy?

    Am I mistaken in my reasoning?

  35. Gravatar of ssumner ssumner
    22. June 2010 at 06:20

    Doc Merlin, I think the cyclical unemployment is improving, but the structural is getting worse. The overall rate has fallen a little bit.

    There is a difference between saying cyclical unemployment is not the whole story, from saying it is not a part of the story.

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