Don’t say I didn’t warn you

So here’s what I read when I woke up this morning:

The dollar has been hit by expectations the Fed will announce new stimulus measures next month, diluting the dollar’s value.

But it gained strength Wednesday after a report in the Wall Street Journal suggested the Fed could take a more gradual approach to the stimulus and after an upbeat report on U.S. consumer confidence.

And this:

NEW YORK (AP) — Stocks slid Wednesday as concerns grew over whether the Federal Reserve’s plans to buy Treasury bonds might be smaller and slower than anticipated.

And here’s what I wrote a  month ago:

Here is a recent story from Yahoo.com:

“NEW YORK (Reuters) – Stocks rose on Tuesday after opening lower on weak economic data, with investors saying the data bolsters expectations the Fed will pump more money into the economy, which would support equities.”

And what sort of economic data was weak?

“September data showed U.S. consumer confidence fell to its lowest level since February, underscoring lingering worries about the strength of the economic recovery, while home prices dipped in July.”

Let’s suppose consumers react with a lag to economic data, or suppose the survey was done early in the month.  In that case the survey might have reflected the very weak economic data coming out in August (revised GDP at 1.6%, etc) and also a weak stock market, which was partly a response to the weak data. 

So let me get this straight:

1.  The markets were weak in August, causing a low consumer confidence number in September

2.  This leads investors to expect more easing by the Fed

3.  This leads to a stronger stock market

4.  This will lead to a better consumer confidence number in October

5.  Which will lead investors to fear the Fed won’t ease

6. Which will cause stock prices to fall in October

7.  Which will lead to a weaker consumer confidence number in November.

8.  And so on

Are you getting dizzy yet?  This is the so-called “circularity problem,” which occurs when the Fed tries to target market expectations.  It was discussed in 1997 in a pair of JMCB papers by Garrison and White, and also Bernanke and Woodford.

The Fed needs to be careful here.  It’s easy to say the Fed doesn’t respond to the stock market; but let’s face it, they do.  They cut rates after the 1987 crash, even though there was no sign of recession or deflation, and they announced a bond purchase program in March 2009, right after a sickening plunge in equity prices.  Make all the jokes about the stock market you want, people do see it as an important indicator of which way the economy is headed.  Even if only subconsciously.

So if the Fed were to meet in November and decide not to do QE because the market was looking up, and if the market was looking up because they expected QE in response to weak economic data, then the Fed could end up with a nasty surprise.  Something like what occurred in December 2007 and January 2008, or again in September 2008 and October 2008.  Using Wall Street lingo, they could “fall behind the curve.”

I guess markets aren’t efficient after all.  My blog is “public information” and any investors who bought S&P puts right before the Fed response to the consumer confidence number could have made a killing.  I think I’ll take TheMoneyIllusion.com private, and start charging a fee.

Seriously, this has all happened before.  Here’s how I described the events of late 1933:

The distinction between flexible (commodity) prices and a sticky overall price level is crucial to any understanding of Roosevelt’s policy.  For instance, when Roosevelt decided to formally devalue the dollar in January 1934 [and stop the gradual depreciation], many prominent economists such as E.W. Kemmerer predicted runaway inflation.  Prices did rise modestly, but remained well below pre-depression levels throughout the 1930s.  Pearson, Myers, and Gans quote Warren’s notes to the effect that when the summer of 1934 arrived without substantial increases in commodity prices: 

          “The President (a) wanted more inflation and (b) assumed or had been led to believe that there was a long lag in the effect of depreciation.  He did not understand–as many others did not then and do not now–the principle that commodity prices respond immediately to changes in the price of gold”.  (1957, p. 5664.) 

Warren understood that commodity prices in late January 1934 had already incorporated the anticipated impact of the devaluation, and that commodity price indices were signaling that a gold price of $35/oz. was not nearly sufficient to produce the desired reflation.

One of the most important monetary economics papers of the 20th century was published in 1957 in Farm Economics.  I wonder how many famous economists have even heard of it.

PS.  Please, no angry comments; I was just kidding about predicting the market and going private.  Does anyone really think I’d ever abandon the EMH?

PPS.  I’m going to a conference in Dallas tomorrow (on Karl Brunner.)  Depending on whether the hotel has a computer, the blog may slow down for a few days.  But I’ll be blogging furiously on November 3rd–you can count on that.


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60 Responses to “Don’t say I didn’t warn you”

  1. Gravatar of 123 – TheMoneyDemand Blog 123 - TheMoneyDemand Blog
    27. October 2010 at 08:29

    You should abandon the EMH and start making serious money. You deserve a share of all the stock market wealth this blog has created, but at this time only fund managers (like Hugh Hendry) who are reading your blog are benefiting. :)
    You should keep your blog free as it will maximize the market price impact your ideas are generating. :)

  2. Gravatar of ssumner ssumner
    27. October 2010 at 08:38

    123, Yes, like most people my gut instinct is that the EMH is wrong, and that I can beat the market. But the logical part of my brain says no.

    If I trade on things I’m about to post, would the SEC call that insider trading? It sounds like a joke, but the SEC just went after some railroad workers in Floria who noticed men in suits inspecting the railyard, and intuited that a merger might be coming. Is my hypothesis about the SEC any more far-fetched?

  3. Gravatar of W. Peden W. Peden
    27. October 2010 at 10:16

    The mention of insider trading gives me an excuse to ask a question which I have wanted to ask economists for some time: what are the primary arguments for and against insider trading laws?

    I’ve seen “Wall Street”, I have heard the many stories about ridiculous examples of these laws being implemented and I have read the page on wikipedia, but that’s where my knowledge about the subject ends.

  4. Gravatar of Doc Merlin Doc Merlin
    27. October 2010 at 11:49

    @ W. Peden
    “The mention of insider trading gives me an excuse to ask a question which I have wanted to ask economists for some time: what are the primary arguments for and against insider trading laws?”

    Against:
    1. Its unfair.
    2. It leads to executives thinking more about short term stock price than long term viability

    For:
    1. It lowers the monetary cost of executive pay, because the exec is being now paid partially in valuable information.
    2. It creates incentives for market participants to release inside info into the market by the price mechanism which increases market efficiency.

  5. Gravatar of Simon K Simon K
    27. October 2010 at 13:14

    Doc – Executive pay in Germany is disproportionately low compared with the US and UK, as I’m sure you know. Interestingly, insider trading is not illegal there. I wonder how big a factor that is?

  6. Gravatar of Morgan Warstler Morgan Warstler
    27. October 2010 at 14:26

    +1 Simon.

  7. Gravatar of Morgan Warstler Morgan Warstler
    27. October 2010 at 14:30

    For your futures market….

    My buddy and I bet on sales tax receipts for the state of Texas each month.

    For what its worth there was a noticeable up tick in September over annual trends.

  8. Gravatar of Rebecca Burlingame Rebecca Burlingame
    27. October 2010 at 14:30

    Perhaps the circularity problem is a reason for the “way cool new Fed tool” of IOR that I wasn’t so crazy about.

    …railroad workers in Florida, when it’s perfectly legal for government to engage in insider trading. How wrong is that?

  9. Gravatar of DanC DanC
    27. October 2010 at 17:15

    The market can think that growth going forward will be slow but Fed actions will increase inflation and you switch to stocks as a better hedge against inflation.

    You don’t bet on growth, in real terms, just hedge against inflation.

    Trying to predict what the Fed will do, with increasing uncertainty about the path, should, overtime, create a risk premium in the market due to the uncertainty.

    A cautionary view of an activist Fed.

    BTW A recent post by Fama on EMH
    http://www.dimensional.com/famafrench/2010/10/qa-when-does-active-management-shine.html#more

  10. Gravatar of W. Peden W. Peden
    27. October 2010 at 17:19

    Doc Merlin,

    Thanks for the concise summary. That clarifies the issue somewhat for me. As a non-economist, the kind of basic analysis that is common amongst economists does not come naturally to me.

    Simon K,

    Another possible example might be Japan prior to 1988, which had no insider trading laws but low executive pay in relative terms. This, at least, suggests that other factors are much more important in determining executive pay e.g. Japanese executives apparently tend to be raised “in-house” from lower management and therefore there is less of the hyper-competitive bargaining for executive talent that one finds in the United States.

  11. Gravatar of scott sumner scott sumner
    27. October 2010 at 17:40

    W. Peden, I don’t think the laws make any sense. I guess government officials agree with me, as they exempted themselves from the laws.

    Doc Merlin and Simon, Those are good points.

    Morgan, Interesting. How about satellite photos of how full Walmart parking lots are?

    Rebecca, I completely agree about that Florida case–beyond ridiculous.

    DanC, Stocks do poorly when stagflation occurs–recall the 1970s.

  12. Gravatar of scott sumner scott sumner
    27. October 2010 at 17:45

    DanC, I like that Fama piece. It’s what most opponents of the EMH don’t understand. They cherry-pick those who are (ex post) successful.

  13. Gravatar of JTapp JTapp
    27. October 2010 at 18:50

    David Wessel of WSJ on “What would Friedman do?”

  14. Gravatar of JCE JCE
    27. October 2010 at 19:16

    What’s the name of the paper that is “One of the most important monetary economics papers of the 20th century” and “was published in 1957 in Farm Economics.” ?!?!?!?

  15. Gravatar of Morgan Warstler Morgan Warstler
    27. October 2010 at 20:05

    Scott, I think there’s a negative correlation… the better WalMart does the worse the receipts.

    But that is my one issue with CPI futures – WalMart could totally game the system, and the bigger the futures market gets, the more reason they have to do it.

  16. Gravatar of Simon K Simon K
    27. October 2010 at 21:21

    I second JCE’s question – I’m sure you pros all know what paper you’re talking about, but speaking as an amateur I want to know.

    I love that Fama article – funniest thing I’ve read for ages, in a very sad way. And all the funnier for being so dry.

  17. Gravatar of 123 – TheMoneyDemand Blog 123 - TheMoneyDemand Blog
    28. October 2010 at 01:22

    Scott, you said:
    “Yes, like most people my gut instinct is that the EMH is wrong, and that I can beat the market. But the logical part of my brain says no.”
    My gut instinct is always telling me that other people are very smart and that I should not trade. And when I need to decide whether to buy SWY or KR, my brain tells me that Fama is right and then I just flip a coin.
    But sometimes I just know that people are wrong to ignore the 1957 edition of Farm Economics…

    “If I trade on things I’m about to post, would the SEC call that insider trading? It sounds like a joke, but the SEC just went after some railroad workers in Floria who noticed men in suits inspecting the railyard, and intuited that a merger might be coming. Is my hypothesis about the SEC any more far-fetched?”
    I’m not a lawyer, but I’m afraid that you will breach your fiduciary duty to Bernanke and Fama if you trade on things you are about to post. As they say, “If you have to ask if it’s right or wrong, it’s probably wrong.”

  18. Gravatar of Mattias Mattias
    28. October 2010 at 01:29

    @TheMoneyDemand Blog

    Why do you say Hugh Hendry reads this blog? He’s a believer in ABCT although he’s reached other conclusions than many other Austrians. I find it hard to believe he would be an advocate of NGDP targeting for instance.

    For those of you don’t know who Hugh Hendry is, there are ample clips on CNBC, YouTube etc. One example is

    http://www.youtube.com/watch?v=3oZtPK6hqLU

    when he is debating with Jeffrey Sachs and Gillian Tett on BBC. I’ve never been a big fan of Sachs, but here I think is the one voice of reason.

  19. Gravatar of 123 – TheMoneyDemand Blog 123 - TheMoneyDemand Blog
    28. October 2010 at 02:33

    Mattias, Hugh Hendry extensively quoted Scott’s Vermeer masterpiece in his Eclectica Nov 09 report:
    “But first, I am indebted to Scott Sumner, professor of economics at the University of Bentley, and his essay on the economic lessons that can be drawn from timelessness in art (see http://blogsandwikis.bentley.edu/themoneyillusion/?p=2542). It is a theme that I will constantly revisit in my arguments below”

    Hendry is inconsistent, he seems to support NGDP targeting for Latvia, but not for China.

  20. Gravatar of 123 – TheMoneyDemand Blog 123 - TheMoneyDemand Blog
    28. October 2010 at 02:35

    Mattias, Hendrys report is here:
    http://www.scribd.com/doc/22606253/Hugh-Hendry-Eclectica-Nov09

  21. Gravatar of 123 – TheMoneyDemand Blog 123 - TheMoneyDemand Blog
    28. October 2010 at 02:46

    Mattias, Hendry believes that such anti-Austrian concepts as AD are relevant. Obviously he thinks that EMH is wrong.

  22. Gravatar of Mattias Mattias
    28. October 2010 at 02:56

    I like Hendry but I don’t follow his advice after he said that Potash Saskatchewan could go from 200$ to 1000$ and then it went to ca 50$ :)

    I’ll read what you linked to, though.

  23. Gravatar of 123 – TheMoneyDemand Blog 123 - TheMoneyDemand Blog
    28. October 2010 at 03:27

    Mattias, Hendry is always right. He has got two funds, one is a leveraged bet on agricultural inflation, another is a deflationary macro fund. You have picked the wrong fund to copy :) Keep in mind, that sometimes the first fund is right, sometimes the second.

  24. Gravatar of DanC DanC
    28. October 2010 at 05:29

    I don’t disagree with Scott, I’m just less certain that QE will fully overcome bad fiscal policy.

    How much you can boost the economy in the short run depends, in part, on the long run view of the impact of fiscal policy.

    For example, do you expand when you see increased regulations and taxes occurring just over the hill? Or do you adjust prices and restrain expansion?

    Also I don’t expect big stock market returns, like the 70′s, just a shift out of fixed instruments into commodities and stocks.

    I also think having the Fed dance around the question of QE just adds to uncertainty, increases volatility, and if it continues just creates a risk premium – a Fed tax if you will – to the markets.

    I am not against more QE, I just think absent reform in taxes and regulations the more muted the effect.

    And the more the Fed vacillates on policy, the more they undermine real growth.

    What would Friedman do? Aside from warning us of the dangers of some paths, I’m not sure.

  25. Gravatar of W. Peden W. Peden
    28. October 2010 at 05:44

    JCE and Simon K,

    I assume that Sumner is referring to “Warren as a Presidential Advisor”, in the December 1957 edition of Farm Economics. Sumner refers to this in an article published in 2001 (“Roosevelt, Warren, and the gold-buying program of 1933″).

  26. Gravatar of JimP JimP
    28. October 2010 at 09:07

    Smart market guys who haven’t a clue:

    http://www.bloomberg.com/news/2010-10-28/schwarzman-says-more-fed-easing-won-t-make-much-difference.html

  27. Gravatar of JimP JimP
    28. October 2010 at 11:22

    The Economist on level targeting.

    http://www.economist.com/node/17359344

  28. Gravatar of Simon K Simon K
    28. October 2010 at 12:34

    JimP – There’s a lot of cluelessness out there. Everyone wants to think about what QE will do in terms of interest rates. The problem is what happens to interest rates depends on whether it works or not – my bet is the net impact on rates will be nil. At least Schwarzman is thinking about how businesses will respond to lower rates, which is at least a step beyond just thinking about how bond holders will react.

    As I understand it the point isn’t to get people to borrow more money – they won’t do that until either consumer spending or employment starts to rise. The point is to put more actual medium of exchange into people’s hands, initially the hands of bondholders, who will they go out and buy whatever with it, probably more bonds, but not necessarily. Since rates are already so low, the chances of this impacting rates is not large. What it will impact instead is other prices, we hope! If bond prices rise and bank reserves rise when QE restarts thats a really bad sign – it basically means the bond market is broken as a channel for getting money into the real economy. If that’s true then we’re in a true Keynesian liquidity trap and the Fed needs to start buying something else – bridges, pork bellies, cows, whatever.

  29. Gravatar of TravisA TravisA
    28. October 2010 at 12:36

    Lies, damn lies, and Krugman on Japan.

    http://krugman.blogs.nytimes.com/2010/10/28/friedman-on-japan/

    I guess he just doesn’t realize that Japan raised interest rates. Granted that it wasn’t much, but I think it’s more likely that a small rise in interest rates can be deadly for a depressed economy. The US had a similar experience in ~1937 when the Fed raised the discount rate by a small amount and the US subsequently went into a recession. I think another lesson is that IOR is contractionary right now.

    http://www.tradingeconomics.com/Economics/Interest-Rate.aspx?Symbol=JPY

    You can change the dates and click ‘update dates’

  30. Gravatar of Richard W Richard W
    28. October 2010 at 13:12

    123 – TheMoneyDemand Blog
    28. October 2010 at 03:27

    ‘Mattias, Hendry is always right. He has got two funds, one is a leveraged bet on agricultural inflation, another is a deflationary macro fund. You have picked the wrong fund to copy :) Keep in mind, that sometimes the first fund is right, sometimes the second. ‘

    Hugh Hendry is a fascinating character. I shared quite a few classes with him when we were at university together. I agree I would be surprised if he was an ABCT guy. Although I don’t listen to him often enough to know. I remember him saying around the time of the 2008 banking crisis that he had bought on his personal account a bunch of UK war loan bonds. Of course that was a deflation bet.

  31. Gravatar of 123 – TheMoneyDemand Blog 123 - TheMoneyDemand Blog
    28. October 2010 at 14:37

    Richard W, Hendry is very eclectic, and his job is to identify malinvestments, so there is a significant ABCT element in his thought process, however he is no dogmatic Austrian, and nominal AD analysis is very important to him. His fund is very well prepared for deflationary risks. I guess I could compare him to Tyler Cowen, who has a periodic Austro-Chinese business cycle blog post, but also says that Sumnerian AD stimulus is the best free lunch he has seen in years.

    Hendry is extremely entertaining (imagine Stewart/Colbert with Tyler Cowen’s knowledge), and I am trying to catch every Youtube clip with him.

  32. Gravatar of JimP JimP
    28. October 2010 at 14:39

    Simon

    I think of it as a confidence game. If people become more confident – that their sales (companies) or incomes (people) won’t fall and will rather continue to rise, then they will hire and invest (companies) and spend (people).

    I have said this before – but I never really did realize what a depression was. People are depressed and sad – so they hunker down and hide out and save. And Bernanke himself is depressed and sad – so he is no big help. And the pro-cyclical ranting of the perma-bears is also depressing and sad.

    I remember real well in history class when the teachers talked about how important it was to have that Rooseveltian confidence – all we have to fear is fear itself. Those teaches had themselves heard that speech when they were young and it had this magnetic effect on them – finally a President who is not just glum and grim and sad the way Hoover was.

    I never really understood how important that was – and where is it now? We need that Roosevelt back.

    Of course the confidence must be based on reality – correct policies in our majestic and wonderful country. We need both. Policies and confidence.

  33. Gravatar of Simon K Simon K
    28. October 2010 at 16:18

    JimP – Policy and confidence is absolutely right. You’ve got to execute the policy, but you’ve also got to set the expectation that the policy will continue until it meets its objectives. Its the expectation that determines what people do when they unexpectedly get extra money in place of their treasuries. If they expect the policy to work, they’ll buy something else instead of more treasuries, like equities, or commercial debt, or a refrigerator, because the last thing they want is to by a new treasury with a negative real yield with the expectation that inflation and competition from commercial and mortgage debt will erode the capital too. But if they expect the policy to fail, they’ll just buy a new treasury – in deflation after all, a zero nominal yield might not be too bad, and its not like you’re going to get better anywhere else.

  34. Gravatar of JimP JimP
    28. October 2010 at 17:02

    Simon

    I worry that Bernanke lacks confidence. I think he will go small ball – the putter – buying as little as he thinks he must and no more. Rather than confidently stating that he is aiming at a certain nominal spending (income) target – and that he won’t stop till he gets there – no matter what Plosser, the WSJ, and Larry Kudlow say. Let them scream – the deflationists (the people who currently own the currency and are busy sitting on it. They will always squeal when their purchasing power falls.

    But there is a paradox here. Even if Bernanke does lack confidence, so long as keeps on buying the policy will work, whether he believes it will or not.

  35. Gravatar of Simon K Simon K
    28. October 2010 at 19:06

    Jim – I worry too. I worry he’s going to do little bits and that the communication isn’t clear enough. The trouble with the pussy footing around the deflationists is it creates uncertainty about the Fed’s level of commitment to keep easing and not exit until the job is done. Clear communication from the Fed makes it easier for investors to coordinate their actions and move their money into the real economy. A lack of clear communication means people will stay in liquid assets for longer until they see what’s happening, and then all get out at once. Ironically pandering to the deflationists increases the risk of a spike in inflation as the money flows will be less predictable if people don’t know what’s happening.

  36. Gravatar of W. Peden W. Peden
    28. October 2010 at 19:26

    Re: the David Wessel article.

    I will never understand why people equate the “monetary base” with the “money supply”. The monetary base is a component of the money supply, just like CDOs, but no-one would seriously call CDOs the “money supply”.

    Even looking at $M2* (which is inferior to $M3, but better than the monetary base) the article shows the recent precipitous drop. The monetary problem still exists in the US, which is why QE2 is so important.

    Still, in spite of this error, David Wessell at least arives at a good conclusion.

    * Given that M0, M1, M2, M3, M4 etc. mean different things in different economies, I think there’s a case for going back to currency prefixes, so we know that $M2 refers to the broadest definition of money that is published by the Fed, while £M2 refers to a definition of Sterling that is no longer published at all. $M3 is no longer published by the Fed, though it is available if you know where to look; £M3 was what used to be called “broad money” in the UK before M4.

    That’s exciting, isn’t it? And to think that monetarist debates about measurements of the money supply have been called scholastic!

  37. Gravatar of James in London James in London
    29. October 2010 at 01:16

    Keynesian liquidity traps. You guys are still in a make believe world where the US cannot have structural and fiscal challenges so bad they can hobble the economy, almost by definition. The US is the leader of the free world, after all. It must be something else, a shortage of money, and the Fed magic wand of printing more of it is the solution. From the perspective of the rest of the world, restoring confidence via fiscal prudence and structural reforms is the way ahead, as most of the G20 pointed out to the US last weekend.

    Yet you guys here still persist in thinking of magic wand first and then maybe fiscal prudence and structural reforms later. Your views here remind me of the US approach to dieting, ie don’t do it, but instead look for that magic wand that will make things better (a pill, a special running machine, coke zero, stomach straps), anything but the obvious response of eating less – as self-discipline is tough.

  38. Gravatar of Doc Merlin Doc Merlin
    29. October 2010 at 02:17

    @James:

    You obviously haven’t read much of this blog. Many here (including Scott) have advocated cutting the federal budget.

    @M. Penden:
    Actually things are strange now, because federal debt (T-bonds, T-bills, etc) is used as money as well. Its really hard to say exactly what M is, which makes it nearly impossible to say what V is. In fact the MV=PY aggregation makes very little sense right now as different types of money have very different velocities it makes avg(M)avg(V)≠avg(MV).

    @Simon K.
    “If that’s true then we’re in a true Keynesian liquidity trap and the Fed needs to start buying something else – bridges, pork bellies, cows, whatever.”

    The fed has been buying up real estate lately. It isn’t doing much good.
    Two possibilities:
    1. The fiscal multiplier is 0 and the crowding out effect is preventing any good to come from the monetary effect.
    2. There really is such a thing as a liquidity trap, but the fiscal multiplier is zero so there is no Keynesian way to get out of this mess.

  39. Gravatar of Doc Merlin Doc Merlin
    29. October 2010 at 02:20

    I should add, here is evidence that the fiscal multiplier is zero for the US.

    (ugated version)
    http://econweb.umd.edu/~vegh/papers/multipliers.pdf

    (gated version)
    http://www.nber.org/papers/w16479.pdf

  40. Gravatar of Doc Merlin Doc Merlin
    29. October 2010 at 02:25

    Hrm the comment is awaiting moderation, since scott is out till the third, let me try again.

    Here is evidence that the US fiscal multiplier is 0. This means that any increase in fiscal spending by the government necessitates a decrease in consumer spending.

    (ugated version)
    econweb.umd.edu/~vegh/papers/multipliers.pdf

    (gated version)
    http://www.nber.org/papers/w16479.pdf

  41. Gravatar of Doc Merlin Doc Merlin
    29. October 2010 at 02:33

    Let me correct myself, it should be “statically indistinguishable from zero” not “is zero.” As the mean value is above zero but the confidence interval includes zero.

  42. Gravatar of James in London James in London
    29. October 2010 at 05:53

    Doc, I have in the past been a regular reader, but had not looked for a while. I felt I was being sucked into your “magic wand” solution and had to take a break. In the real world deficit-spending crowds out real activity and also leads to a loss of confidence in the future. People don’t want to invest in an economy run by deficit-spending drug fiends (sorry, well-intentioned socialists like Obama). It’s just too risky. And if there are quack doctors prescribing magic potions then the risk is even higher.

    I rarely saw (and still don’t see) any discussion on this blog about deficit reduction and structural reform. Just like the diet specialists who say eating less is, of course, one solution, but the magic pill, coke zero, gluten-free diet, stomach strapping, new running machine, etc, will work much quicker and be virtually pain free. It’s easy, just sign-up to the $2tn entrance fee and then $100bn a month after that, until it works.

    The US is stuggling because it has been resting on its laurels for too long. Some of the laurels were self-created (rule of law, freedom of trade, massive economies of scale from having a highly uniform culture for a few hundred million people), others were natural bounties (almost limitless land and natural resources). Limited freedom of trade in Russia and China and India allied to decent fiscal discipline is now paying large dividends. The US is struggling to cope with this structural change in its relative competitive position. Throwing money at the problem via huge increases in private and now public sector indebtedness cannot be right.

    I have not seen one blog on debt and leverage on this site (although I haven’t read them all), but every other one seems (effectively) to urge inflation (sorry, the NGDP-targetting magic wand) as a cure for all that debt and leverage. Fiscal conservatism and structural change is what you need, not magic wands.

  43. Gravatar of W. Peden W. Peden
    29. October 2010 at 07:07

    James,

    I suppose many (including myself) think that the case for fiscal conservativism in the US is so obvious as to be barely worth mentioning, while the case for monetary stimulus as an assistance to that tightening is controversial.

    The US debt and deficit is a long-term problem, but it is not the cause of the current parlous state of the US economy. The strangling of the money supply (which is how I approach the monetary problem) IS the cause and very few people are talking about it, outside of this blog.

    A sensible three-barrelled approach to sorting out the US economy would be this-

    (1) A long-term deficit reduction programme. There is very little political will in the US for this right now*, but it would be best to start sooner rather than later.

    (2) Supply-side reform. A simple example: surely, it is time that the US Postal Service monopoly went the same way as the ICC and the airline regulations?

    (3) Monetary stimulus to sort out the nominal problems in the US economy, to work alongside the supply-side reform in ensuring that there is a private-sector led recovery to help ease the fiscal consolidation.

    All 3 are interconnected and need to work together if they are to work well. In Britain, we have a government that understands (1) and (3), but has thus far been disappointing on (2) e.g. the recent pensions reform farce.

    * The Tea Party are fiscal conservatives in the same way that I want the Scottish football team to be better; I would like the outcome, but I have no ideas about accomplishing it. All I have heard from the Tea Party is what they WOULDN’T cut (defence, Medicare etc.).

  44. Gravatar of Doc Merlin Doc Merlin
    29. October 2010 at 08:20

    @ W. Penden:

    There have been actual proposals for cuts made. Paul Ryan (Republican Ranking member on the Budget Committee) published his “Roadmap” which lists very clear cuts including raising the retirement age slowly over time. Its a very long term program though, it doesn’t deal with short term deficits.
    http://www.roadmap.republicans.budget.house.gov

    Ron Paul has suggested finishing our withdrawal from iraq.

    A few tea party candidates have called for ending unemployment benefits.

    Eric Cantor (Republican Minority Whip) has started YouCut which solicits suggestions for things to cut.
    republicanwhip.house.gov/YouCut/

  45. Gravatar of JimP JimP
    29. October 2010 at 09:46

    Confidence – as the man says.

    http://ftalphaville.ft.com/blog/2010/10/29/386951/cash-hoarding-corps/

    begin quote
    The balance sheets of U.S. non-financial companies are in good shape, in contrast to government and household balance sheets. Some $943 billion of cash and short-term investments sat in their coffers at mid-year 2010, compared with $775 billion at the end of 2008 (Figure 1). Corporate America could use these cash holdings to cover a year’s worth of capital spending and dividends and still have $121 billion left over.

    Economists, politicians and everyday Americans contemplate how that cash, if invested in inventory and plants, could strengthen the U.S. economy and get more people back to work. But we believe companies are looking for greater certainty about the economy and signs of a permanent increase in sales before they let go of their cash hoards, which they suffered so much to build. Given low demand and capacity utilization within certain industries, companies are wary of investing their cash in new capacity and adding workers, thereby doing little to abbreviate the jobless recovery.
    end quote

    “signs of a permanent increase in sales” – somehow that sounds like an NGDP target.

    What do you say Mr Bernanke? Do your damn job or we will take your job away from you and give it to someone who knows what he is doing.

  46. Gravatar of Simon K Simon K
    29. October 2010 at 14:57

    Doc – I’m not up on the multiplier debate, and I think its participants see exactly what they want to see. When a conservative economist finds a multiplier of more than 0, or a Keynesian finds it to be less than 1, wake me up. That said, I find it hard to imagine why the Fed printing money and buying bridges would work any less well than the Fed printing money and buying bonds. But its the printing money thats the key step – what happens if the Treasury borrows existing money and buys bridges seems to be the main topic of debate, and I can’t even see how there’s a useful answer to that question.

    W. Peden – I’d vote for your program. Especially if you add getting Scotland to the world cup final …

    JimP – The problem is Bernanke is probably the best there is, judged from his academic work. If he can’t make the Fed do what needs to be done, I don’t know who can.

    James – I hear a lot about the dire fiscal and structural situation, but what I don’t hear is how the specific fiscal and structural problems being pointed to are creating the dire macroeconomic situation. If investors were worried about the fiscal future of the US government they’d be selling its bonds – instead they’re buying them like they were going out of fashion and have been since well before anyone outside of Scott and his like-minded friends started talking about more QE. If investors were worried about inflation they’d be selling bonds across the board – instead they drive yields lower still every time someone claims they’ve hit bottom. If investors were genuinely scared of regulation we’d see them saying that – instead business surveys consistently say the biggest problem is lack of demand (this is a sure sign of recession – during upturns they complain about regulation, go figure). If unemployment were mostly structural, we’d see it disproportionately confined to certain sectors, instead we see it more or less uniform across all sectors.

    In spite of looking, I don’t find strong counter-arguments coming from the deflationist side. Instead I get the impression that we’re meant to believe that debt is a Bad Thing and that overindulgence must have Dire Consequences and that everything else follows.

  47. Gravatar of JimP JimP
    29. October 2010 at 15:55

    Scott

    I agree – its either Bernanke or nothing. But still…….what might have been if only…….

    It is so weird – people say reflation cant work when it already has worked.

    Listening to the deflations rant – it is just so depressing.

    And I think Krugman is as much of an ideologue as John Taylor – and they both say the same thing – the Fed is powerless and we are doomed. It is really disgusting.

  48. Gravatar of W. Peden W. Peden
    29. October 2010 at 18:26

    Doc Merlin,

    Is Ron Paul classed as a Tea Partier? If so, he is the exception, given that he’s marked out most of the Federal government to be scrapped.

    I think I missed the details on that website. There was plenty about taxes to be cut out and things to be protected, but I could not find any detail about cuts. There were sensible ideas for tax reform, supply-side and a clear recognition of the problem, but the politics of fiscal consolidation involves saying who is going to feel pain.

    If done seriously, the politics of fiscal consolidation is an unpleasant, unpopular and unrewarding type of politics. So, while I’m not necessarily saying he was making any wrong points, it was (as you note) lacking in short-term detail, and politics is always reducible to short-term details.

    Of course, there are people out there (say at the Cato Institute) who will provide a lot of detail. But we’re kidding ourselves if we think they are a significant part of the Tea Party movement.

  49. Gravatar of W. Peden W. Peden
    29. October 2010 at 18:40

    Simon K,

    If philosophy has taught me anything, it’s to be sceptical about my capacity for performing miracles. I can turn the UK into Hong Kong circa 1980, at a push, but I don’t promise anything with the national team.

    I think you touch on the problem with the deflationist argument. There’s a certain moral appeal, with the talk about rewarding virtue and punishing vice, but an economy is not a system of meritocracy, it’s a system of rewarding the provision of what individuals want.

    A savers’ moral merit compared to that of the profligate is irrelevant, because the function of the government in a free market monetary policy is simply to facilitate the straightforward creation of contracts. That involves a stable money supply and financial system. If we are to ignore the use of the monetary system to provide a “fair” system of wealth distribution or to reward “socially valuable” professions, then how can we use it to pick winners with regard to saving or consuming?

    My only sympathy for savers (a group of which I am a member) is with regard to fiscal policy, where I favour a progressive consumption tax instead of an income tax, which would at least not punish saving. But I do not think that savers should get bailed out by the state with deflationary policy, anymore than borrowers should get bailed out by the state with inflationary policy. The rate of inflation should be no more and no less than is optimal for the facilitation of private contracts between individuals. That’s equality of process, which is the only kind of equality that is relevant to a classical liberal.

    So, leaving aside the moral case for deflation as no more worthy than the socialist case for income equality, there is the economic argument. I haven’t yet heard a persuasive case for a deflationary monetary policy, outside of the picking winners argument. There is a separate case for states getting their finances under control, but why hamper the private sector recovery by combining that with a tight monetary policy?

  50. Gravatar of W. Peden W. Peden
    29. October 2010 at 18:42

    Doc Merlin,

    Perhaps it is time for someone to start computing $M4. We can go to $M100,000 if need be, when people start using suitcases as currency.

  51. Gravatar of Doc Merlin Doc Merlin
    30. October 2010 at 05:41

    @W. Penden:

    “Is Ron Paul classed as a Tea Partier? If so, he is the exception, given that he’s marked out most of the Federal government to be scrapped.”

    His folks actually held the first tea party. The second was mommy bloggers iirc.

    @James in London:

    I agree that debt is a serious long term problem. It really constrains and causes difficulties for future legislatures. The US needs some serious, cost cutting, but I don’t know if the legislature has the balls or spine for it. The only groups I see that seem very serious about making massive cuts are specific governors of the states (unfortunately mine isn’t one of them).

  52. Gravatar of Doc Merlin Doc Merlin
    30. October 2010 at 05:43

    @W. Penden:
    I’m not sure how useful that would be. I’m thinking of making a measure based on spread in commodities that will make it easier to measure the growth of money substitutes.

  53. Gravatar of JTapp JTapp
    31. October 2010 at 03:41

    Scott (and commenters), Economics21 has a post up critiquing QE and both price level and NGDP targeting.
    “Unmooring inflation expectations is a dangerous game and using the “price level” as a target seems especially dangerous now given that most market participants think in terms of changes to prices – inflation and returns on assets. The targeting of nominal GDP could be even more dangerous since it would deemphasize real changes in output in favor of “catch-up” based purely on increases in the price level.”

    There are several points made in it that it would be useful to hear rebuttal on. (The article doesn’t list an author but there are several well-known economists that contribute, like Ed Lazear.)

  54. Gravatar of Simon K Simon K
    31. October 2010 at 21:11

    JTapp – Whether targeting the prices level unanchors inflation expectations depends in part of whether people are more likely to listen to the Fed, or more like to adapt to what happened last year, when they form expectations. If the Fed makes it clear that the policy actually is – to target the price level or NGDP rather than a higher inflation rate – I don’t see why people would take an adaptive approach. We know from past experience that there are at least times when expectations are not adaptive.

    The point they make about consumer spending being ahead of other components of NGDP is interesting, but looking at their graphs its clear the growth rate of consumer spending is way below what it was before. Although I don’t know for sure, I can imagine that the massive drop in investment is due to the lower-than-trend consumer spending – prior to the recession producers will have “baked in” plans for a given trend in consumer spending. Now that spending is not there, they find themselves with excess capital and inventory.

    There is also a greater flaw to the thesis in the article, though – the idea that the goal of price level targetting is to increase consumer spending. Thats part of it, but its also about making sitting on cash start to look so unattractive banks and big firms either spend the money or re-invest it in riskier investments were it might do some good. To make those cash piles look unattractive requires an expectation of some inflation.

  55. Gravatar of Doc Merlin Doc Merlin
    31. October 2010 at 23:49

    ‘Although I don’t know for sure, I can imagine that the massive drop in investment is due to the lower-than-trend consumer spending – prior to the recession producers will have “baked in” plans for a given trend in consumer spending. Now that spending is not there, they find themselves with excess capital and inventory’

    Austrian Business Cycle Theory suggests this happens. The more data we get from this cycle, the more it looks like an ABC to me.

  56. Gravatar of Simon K Simon K
    1. November 2010 at 11:01

    Doc – Strictly speaking, doesn’t the ABCT say that producers are fooled into over-investing by lower interest rates when the money supply increases, and then pushed into bankruptcy when the money supply stabilizes or drops?

    The interesting thing about this recession that doesn’t quite fit the Austrian theory is that a lot of the debt was held not by businesses investing in production process but by households for consumption. That’s consistent with the picture of the growth rate of consumer expenditures dropping suddenly when the credit crunch hit. Although its rather similar to an Austrian business cycle, its different because the credit shock is conveyed through demand, not investment.

    My biggest disagreement with the Austrian explanation is more on the side of remedies – I don’t think there is such a thing as an undistorted rate of interest that just measures time preference, so I’m not at all confident I can distinguish “fake” unsustainable growth from “real” growth.

  57. Gravatar of Doc Merlin Doc Merlin
    1. November 2010 at 13:25

    @Simon K:

    Not so much “fooled” as in rationally responding to an unsustainable behavior. Think of it like a subsidized natural resource being over-consumed. When borrowing from the future is subsidized (this is what it means when the fed holds interests rates low too low) then there is excessive borrowing from the future.

    “The interesting thing about this recession that doesn’t quite fit the Austrian theory is that a lot of the debt was held not by businesses investing in production process but by households for consumption. ”

    That fits the Austrian story. The main gist is that excessively subsidized interest rates will lead to a credit crunch, because debt will be over used. They tell the story mainly from the production side, but the story is exactly the same when seen from the investment side (which is how housing was treated.)

    “Although its rather similar to an Austrian business cycle, its different because the credit shock is conveyed through demand, not investment.”

    Thats just it, this shock was conveyed through investment.

    ‘My biggest disagreement with the Austrian explanation is more on the side of remedies – I don’t think there is such a thing as an undistorted rate of interest that just measures time preference, so I’m not at all confident I can distinguish “fake” unsustainable growth from “real” growth.’

    I suspect this is because we have centrally planned money, so its impossible to calculate the rates needed (socialist calculation debate now applied to interest rates).

  58. Gravatar of scott sumner scott sumner
    2. November 2010 at 05:54

    JTapp, Wessel interviewed me for an almost hour, but didn’t include any comments of mine.

    JCE and Simon, It’s called “Warren as Presidential Adviser.”

    Morgan, How could they “game” the system?

    123, I know you are joking, but did Fama believe in the strong form of the EMH that includes insider trading, or just the weak form?

    DanC, I agree that QE by itself may not be particularly potent (unless done in very large amounts.) It would work better with an explicit target.

    You said;

    “For example, do you expand when you see increased regulations and taxes occurring just over the hill? Or do you adjust prices and restrain expansion?”

    That’s a dilemma for inflation targeting, which is precisely why I support NGDP targeting.

    W. Peden, Thanks, that was the article.

    JimP, I addressed the Economist article in my next post’s comments.

    Travis, Thanks, I addressed that Krugman argument in some older posts, and also in my newest post.

    James in London. I addressed that in the comment section to my newest post.

    Thanks Doc Merlin. Doesn’t that say the multiplier is roughly 1 for developed economies?

    JimP, Yes, signs of an increase in sales is signs of more NGDP. People don’t link the two because to most people NGDP seems like an abstract concept. In fact, it is roughly what businessmen mean by “the economy.”

    Regarding Bernanke, we’ll find out tomorrow how much leadership he is capable of showing.

    JTapp, Thanks, the whole point of level targeting is to do it before the recession–that’s when it was most needed. That article is awful–I guess I’ll have to do a rebuttal.

    Doc Merlin, All business cycle theories make the same prediction for investment as the ABCT.

  59. Gravatar of 123 – TheMoneyDemand Blog 123 - TheMoneyDemand Blog
    6. November 2010 at 06:25

    Scott, you said:

    “123, I know you are joking, but did Fama believe in the strong form of the EMH that includes insider trading, or just the weak form?”

    I was joking about fiduciary duties to Bernanke, but not about flipping a coin when investing in SWY or KR.

    Fama’s research efforts are concentrated in semi-strong form of EMH, where investors cannot acquire information in the public domain (from the housing bubble covers of the Economist or from 1957 editions of Farm Economics) and then trade to earn super-normal returns with that information. He has also formulated a strong version of EMH, but he supports prohibition of insider trading:

    “Some economists argue that prohibiting insider trading does more harm than good by reducing the flow of useful information. Do you agree?

    EFF/KRF: No. It is difficult to run a company to generate value for shareholders, but it is easy for senior managers to reduce their company’s value so they can profit personally from a short sale. Thus, there is a big moral hazard problem if insiders are allowed to short sell. What about purchases on positive inside information? A firm’s managers are supposed to act in the interests of shareholders. A manager who buys stock based on positive inside information is disadvantaging the seller — an existing shareholder. Moreover, the presumption that allowing insider trading increases the flow of information to the market is tenuous since managers then have an incentive to delay disclosure of information. In short, allowing insider trading creates big moral hazard problems, with lots of negative consequences. This is the logic behind disclosure laws (or at least idealized versions of them), which seek to make all value-relevant information available to all market participants on the same terms.”

  60. Gravatar of ssumner ssumner
    7. November 2010 at 05:24

    123, Does Fama define insider trading as people with a fiduciary interest in the firm taking advantage of that position, or as the SEC does (anyone who knows something that someone else doesn’t know?)

    It seems to me that it is the insider trading laws themselves that allow insiders to loot firms. For instance, they make it much harder to take over a firm, because the person planning on doing a takeover must report stock purchases once they reach the 5% threshold. But that forces them to pay a much higher price, sharing the efficiency gains they will produce with other shareholders. So the top mamagers benefit, as they are protected from hostile takeover.

    I believe that insider should have contracts forbidding them from undertaking actions that would hurt the other shareholders, and also believe that in a free market you would tend to get those types of contracts.

    I seem to recall that in Europe insider trading laws are a recent development. How was the issue handled before those laws.

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