Here we go again?

This past May I pointed out that the euro debt crisis was increasing the demand for dollars and depressing AD in the US.  One sign was the dollar appreciating as investors fled to safety.  As I expected, this slowed the US economy in the second and third quarters, necessitating the Fed’s QE2 program.  QE2 did “work,” at least to a limited extent.  It raised the prices of assets such as stocks and foreign exchange.   Rumors of QE2 may have roughly offset the effects of the euro crisis, putting the dollar and expected NGDP growth back where they were in April.

Unfortunately, the euro crisis seems to be flaring up again.  Look at how the euro has recently slipped from 1.40 to 1.35.  As the dollar rises again, stocks start declining.  Let’s hope this is just a temporary blip; if the euro crisis became severe it could have a deflationary impact on the US economy–requiring still more QE (or better yet something more effective like level targeting or much lower IOR.)  Ironically all this occurs against a backdrop of relentless criticism of the Fed’s “inflationary” policies.

Readers of this blog might recall I often say “never reason from a price change.”  So why am I making such a big deal about changes in exchange rates?  In fact, it is very dangerous to draw conclusions from exchange rates alone.  You need to look at the news events that cause the changes, and look for confirmation in other asset markets such as stocks, commodities, commercial real estate and TIPS spreads. 

The ECB doesn’t seem to realize that its policy is far too tight for most eurozone members; not just the PIIGS, but also major economies like France.  This is making the eurozone debt crisis even worse, although in my view they also face serious long term fiscal imbalances that go beyond the current recession. 

The tight money policy in Europe causes the debt crisis to flare up and the euro itself depreciates as there is a flight to safety.  And guess which major exporter of machinery benefits from the weaker euro?  My Canadian readers might like this analogy: Suppose commodity prices plunge.  This might weaken the Canadian dollar, as Canada is a major commodity exporter.  But it might also help the manufacturing exporters in the Ontario region.

Currencies are not a zero sum game.  The tight money policy of the ECB makes eurozone NGDP growth decline, even if the euro depreciates during a debt crisis.  An exchange rate of 1.35 could represent easy money in both the US and Europe, or tight money in both regions.  With all the focus on exchange rates let’s not lose sight of the underlying monetary policies, which show up in expected NGDP growth rates in each region.  Get those right, and it makes little or no difference what happens to exchange rates.

PS:  A few posts back I linked to an amusing anti-QE video.  A commenter named “wkw ” animated it for me, and Greg Ransom was nice enough to colorize the animation.  (He doesn’t know that I prefer watching classic film is the original B&W version.)  If I knew people were going to be speaking my lines, I wouldn’t have used ungainly phrases like NGDP.


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68 Responses to “Here we go again?”

  1. Gravatar of Stephan Stephan
    16. November 2010 at 13:35

    NOPE. The EUR/USD isn’t a temporary blip. This is an essential part of our tactics for the upcoming currency battlefield. Tactical rules for developed countries with a CA surplus:

    (1) form a club with a lot of other less productive countries (2) to smooth the club’s financial transactions adopt a common currency (3) export like crazy while other club member’s debt cause a falling currency. (4) loudly complain about the other club members idiocy and silently bailout their debt to keep the export train rolling.

  2. Gravatar of Indy Indy
    16. November 2010 at 14:27

    Time to start thinking about QE3.

    Looks like you’re going to get that international currency war you once talked about (hopefully, if I remember correctly).

    Prediction: By the end of 2011, the Fed’s balance sheet will contain two trillion dollars of US Notes – in addition to all the other assets.

    Somewhere, something big and important is unraveling and breaking down.

  3. Gravatar of marcus nunes marcus nunes
    16. November 2010 at 15:17

    Scott: Meanwhile, the SPF released yesterday by the Philly Fed shows that expectations of both NGDP and Core Inflation continue to drop! And the information set for the expectations contained the preliminary release of GDP and the Fed´s QE2 policy.

  4. Gravatar of Bonnie Bonnie
    16. November 2010 at 16:12

    Here’s a snippet from a CNNMoney story about the DOW “plunge” today:

    “Producer prices rose 0.4% in October, matching the growth rate for the previous two months, but falling short of analyst expectations. The measure had been forecast to have risen 0.8% for October, according to a consensus of economists surveyed by Briefing.com.”

  5. Gravatar of rob rob
    16. November 2010 at 16:29

    I’m just an independent stock trader without any textbook theory to back anything, but I think you have the cause and effect backward. I don’t believe it is a coincidence demand for dollars has gone up a few weeks after the QE2 announcement: it is the market’s considered response to the announcement. It is the wrath of the mistress who didn’t get what she wanted. I suspect her tantrum will last a while.

  6. Gravatar of Mark A. Sadowski Mark A. Sadowski
    16. November 2010 at 16:49

    Exchange rates are dependent on so many things it is very hard to generalize. However, if QE2 raises the rate of return on investment in the US wouldn’t that make US investments and the US dollar more attractive? And didn’t the 2001-2006 QE in Japan coincide with an increase in the value of the yen?

    That being said, developments in Europe are somewhat disturbing. It seems everytime we make an effort to boost our AD they rob it from us through their own stupid policy mistakes. There’s something terribly unfair about this situation.

    P.S. Despite being a black and white film addict (TCM is my channel) I actually loved the colorized (Paws) version of the Sumner video. I’ve already posted it in a couple of places that would be most likely to provoke both the left and the right (Krugman and the WSJ).

  7. Gravatar of scott sumner scott sumner
    16. November 2010 at 18:13

    Stephan, Interesting theory.

    Indy, It seems like a currency war, but it really isn’t. China’s revaluing upward, so is Japan, and the dollar/euro bounces around randomly. In a currency war you’d get high inflation.

    marcus, Worrisome, but I pay more attention to market indicators like the TIPS spreads. Still, I agree that expected NGDP growth is way too low.

    Bonnie, And didn’t the core PPI fall 0.4%.

    rob, If you look at the timing it’s clearly linked to the euro crisis. Markets aren’t that stupid–if they were I’d be rich by now.

    Mark, Thanks, I also prefer the colorized version.

    I have doubts about whether QE2 pushed up the dollar. The dollar seemed to fall on rumors of QE2. In my view it would only push up the dollar (later) if it led to faster growth than the markets expected–but that doesn’t seem to be in the cards right now. But I’ll keep an open mind on your argument.

  8. Gravatar of Mark A. Sadowski Mark A. Sadowski
    16. November 2010 at 18:42

    Scott wrote:
    “Mark, Thanks, I also prefer the colorized version.”

    Not a problem. From my point of view we’re all on the same team.

    Krugman actually posted my comment (often they’re not):
    http://community.nytimes.com/comments/krugman.blogs.nytimes.com/2010/11/16/merchants-of-misery/?permid=85#comment85

    Excuse me for any plagiarism. I was in a hurry to make a point.

    As for the effect on exchange rates only time will tell. But wouldn’t that be a thorn in the sides of the dollar hawks?

  9. Gravatar of JimP JimP
    16. November 2010 at 18:57

    M3 history. A gift from Ben. It is sickening.

    http://www.shadowstats.com/alternate_data/money-supply-charts

  10. Gravatar of rob rob
    16. November 2010 at 19:10

    Scott, you said: “If you look at the timing it’s clearly linked to the euro crisis.”

    You give too much importance to timing. If I pitch a poorly made tent and a strong wind blows five hours later which knocks down the tent, you going to blame that wind or the poorly made tent?

    I agree the market isn’t stupid. But neither is it omniscient.

    QE2 wasn’t enough, it has now been tested and it is being blown over. Why do I feel like a crazy person saying that on this blog? Anyway, I’m short gold and long dollars now and more concerned with my money than my mouth.

  11. Gravatar of Morgan Warstler Morgan Warstler
    16. November 2010 at 19:52

    Those damn Europeans just ruined Scott’s plan! Can you believe that the US$ falling might “convince” the Euro Bond guys that Ireland might have a harder time of it?

    If Germany isn’t making enough money they can’t bail out Ireland… damn!

    I imagine Scott ruthlessly hitting refresh on EURUSD pair Google finance page as it heads to $1.25 at which point, Euro states fortunes start looking up – and Scott barks out, “It’ll all work if we just print more money!”

    How many “here we go agains?” until you finally focus on cheering Public Employees being gutted?

    I just want to make 100% SURE we agree that if things turn around when the real cuts to Public Labor Costs happen – you aren’t trying to jump on my coat-tails.

  12. Gravatar of Full Employment Hawk Full Employment Hawk
    16. November 2010 at 20:20

    “If I knew people were going to be speaking my lines, I wouldn’t have used ungainly phrases like NGDP”

    Why not speak of Aggregate Demand growth? People who have taken the typical college macro principles course, and actually paid attention, have learned about the concept.

  13. Gravatar of Full Employment Hawk Full Employment Hawk
    16. November 2010 at 20:27

    YOU SHALL NOT PRESS DOWN UPON THE BROW OF LABOR THIS CROWN OF THORNS!

    YOU SHALL NOT CRUCIFY THE EUROZONE UPON A CROSS OF EUROS!

    With apologies to Willian Jennnigs Brian.

    Britain was very smart in staying out of the Eurozone. As a result its monetary policy is not determined by the new classical dogma in Frankfurt. If Spain were out of the Euro and could conduct its own monetary policy it would not be saddled with 20% unemployment.

  14. Gravatar of Mark A. Sadowski Mark A. Sadowski
    16. November 2010 at 20:35

    Don’t appologize FEH. WJB was the best president who never was.

  15. Gravatar of Mark A. Sadowski Mark A. Sadowski
    16. November 2010 at 20:48

    http://www.youtube.com/watch?v=3IjDQzCg5Rs&feature=player_embedded

  16. Gravatar of Mark A. Sadowski Mark A. Sadowski
    16. November 2010 at 21:13

    as Tom Joad said:

    “I’ll be all around in the dark – I’ll be everywhere. Wherever you can look – wherever there’s a fight, so hungry people can eat, I’ll be there. Wherever there’s a cop beatin’ up a guy, I’ll be there. I’ll be in the way guys yell when they’re mad. I’ll be in the way kids laugh when they’re hungry and they know supper’s ready, and when the people are eatin’ the stuff they raise and livin’ in the houses they build – I’ll be there, too.”

    I pray every night that Tom Joad drives John Galt into the GD earth.

  17. Gravatar of Mark A. Sadowski Mark A. Sadowski
    16. November 2010 at 21:31

    And I say this because to me John Galt is the boogey man. He’s the Michael Myers of our day. We keep on trying to (necessarily) kill him and he keeps on coming back.

  18. Gravatar of Mark A. Sadowski Mark A. Sadowski
    16. November 2010 at 21:48

    “Yields on 10-year Irish treasuries rose to 8.24 percent Tuesday from Monday’s closing yield of 7.94 percent.”

    Let me get this straight.

    The Neoliberal champion of Europe is failing because of negative monetary policy. And yet almost no libertarians have chosen to stand by her side. I guess that means libertarianism is an abismal failure.

  19. Gravatar of Doc Merlin Doc Merlin
    17. November 2010 at 03:28

    @Mark:
    “The Neoliberal champion of Europe is failing because of negative monetary policy. And yet almost no libertarians have chosen to stand by her side. I guess that means libertarianism is an abismal failure.”

    1. Neoliberalism is far, far to the left of libertarianism, please don’t confuse the two.
    2. Ireland’s problem was land use restrictions (created a housing boom and bust) and excessive social welfare spending (created a massive debt). Both of these policies are very un-libertarian.

  20. Gravatar of James in London James in London
    17. November 2010 at 03:59

    Doc
    Ireland does’t really have a big social welfare budget. It does have a fairly small tax base, though. That tax base got overwhelmed when it’s banks failed and it had very foolishly guaranteed ALL the liabilities despite them being several multiples of GDP. Earlier, Irish banks got into trouble as a result of a bubble in their reputation encouraged huge funding inflows, possibly encouraged by some ECB/Euroland “put” or guarantee of being bailed out (the old TBTF problem). I’d see Ireland’s bank industry failure more as just one of “failure in the market”, a common problem but one real libertarians understand and live with, but US liberals and all conservatives fear. Market failure is myth, as we know.

    I think those who fear deflation are conservatives, and that includes pretty much all non-lbertarians (from the left and the right). And yes, “left” wing liberals are conservatives, they hate the anarchy of the market. I do wonder where Scott, and you,really stand on this issue?

  21. Gravatar of Morgan Warstler Morgan Warstler
    17. November 2010 at 07:09

    Mark, have you not seen the signs in Ireland? “High Rents are KILLING our jobs!”

  22. Gravatar of Morgan Warstler Morgan Warstler
    17. November 2010 at 07:16

    Mundell speech starts at 1:13:30

    http://www.heritage.org/Events/2010/04/The-Dollar-The-Euro-and-the-International-Monetary-Order

    Describing what you see:

    “The story starts out pretty well. In August 2007, financial firms all over the world experienced a sudden liquidity crisis (the blue band on the chart). The Fed turned on the monetary faucet, and the gold price shot up to about $950 per ounce (150 on the chart). Good Fed. Consumer prices increased, too. But then, somewhere in early 2008, things went wrong. After the Bear Stearns bailout in March (gray band), the gold price started actually declining, meaning that monetary policy was tightening. Bad Fed. By the September 2008 meltdown of Fannie, Freddie, and Lehman Brothers (pink band), the gold price was in free-fall, meaning that monetary policy was bar-tight. Very bad Fed. It took ’til November 2008 before the Fed got a handle on things and got the monetary spigot open again. No wonder President Bush was moved to warn that “If money isn’t loosened up, this sucker could go down.”

    You have to say, What is the point of appointing these clowns to operate the central bank, the “lender of last resort”? They know nothing and they do nothing. Here’s Federal Reserve Chairman Ben Bernanke, the world’s foremost deflation expert, and what does he do in the crunch? He runs a tight deflationary monetary policy right through the most critical financial crisis in modern history.

    What’s the point of a government if it can’t even do the job of lender of last resort?

    Bob Mundell has a very mild-mannered way of making a speech. But he also has a way of modestly slipping Bob’s Greatest Hits into his remarks, as in the eight-year U.S. expansion from 1982 to 1990, followed by the ten-year expansion from 1991 to 2001. In particular, he’s rather proud of the 31-year expansion in China.”

    http://www.americanthinker.com/2010/04/the_fed_did_it_says_bob_mundel.html

  23. Gravatar of Richard W Richard W
    17. November 2010 at 08:23

    The USD appreciating is obviously a de facto monetary tightening for the US. However, it is unlikely to head back to the May 1.20 level unless the Europeans allow the situation to really escalate out of control. There is the potential because the whole EZ periphery is a monumental mess. They will just keep patching things up but the whole project in its current form is doomed. Despite the problems the ECB are still tightening monetary policy, so that will stop the USD appreciating too much unless there is an escalation.

    The US Treasury yields are interesting. The fact that they have risen suggests to me the government paper market was overbought before the QE announcement. The $600 billion was much less than was expected throughout September into October. The Fed could have announced much more with the proviso that they would adjust it down if things improved. I think some people drawing conclusions from the rise in yields have it all wrong. Remember the yields were falling since Jackson Hole in anticipation of easing. The counterfactual is where would yields be without any QE.

  24. Gravatar of Richard W Richard W
    17. November 2010 at 09:10

    Irish social welfare payments are the highest in Europe. Although that is not really what got them in trouble.

    http://www.timesonline.co.uk/tol/news/world/ireland/article6690571.ece

    What annoys others with the Irish issue is they have indulged in tax arbitrage against other countries. Although they are entitled to set their tax rates at whatever level they wanted. However, it is now the taxpayers of the other countries arbitraged against who themselves are facing cuts in spending and who will now need to bail the Irish out. Moreover, it is the state not just the Irish banking sector who are being bailed out. Not that the state exists as a sovereign entity in any meaningful way now. They are a ward of the ECB.

  25. Gravatar of James in London James in London
    17. November 2010 at 09:36

    Richard
    Good spot, although total spending (ex-bank bailouts) is only c.30% of GDP … just that revenues are only c.20%. Virtually no spending on defence, maybe that will come later ;-)

  26. Gravatar of Ted Ted
    17. November 2010 at 10:07

    The ECB’s target for the HICP is around 1.5-2%. In 2009, the HICP was about 0% – so obviously they induced a large nominal shock. But now inflation is back up to 1.9% as measured and so I think they think everything is fine now. Obviously level-targeting should be done, but my guess is they see 1.9% inflation and they think everything is great – when it really isn’t. This illustrates again the problem of mindlessly looking at inflation and why nominal income level targeting would be superior.

    I also think they are making a different technical error that is impeding policy also – one they have been making for about a decade really. The ECB is conducting their monetary policy like nominal rigidities are equivalent across countries – namely they are targeting the union-wide inflation rate. This is a technical fallacy. Monetary policy is attempting to undo a distortion and you need to consider both the size of the economic regions and the degree of nominal rigidities. It simply is not true that the rigidity of wages is equal across countries in Europe and since monetary policy can’t control relative wages and prices you have a problem when you try to target union-wide inflation. I forgot where I read this, but estimates of nominal wage rigidity in Italy are almost twice as great as nominal wage rigidity in Spain. That makes a huge difference for an inflation-targeting central bank! This means that optimal policy – even at an inflation-targeting central bank– should likely be much looser to accomodate those nations with much more rigid labor markets (price rigidities seem to be relatively constant across most European countries so this isn’t so much of an issue). And, unfortunately, some nations would have to suffer higher inflation. But that’s the price you pay for a joining a badly conceived monetary union. Also, I’m aware my critique of the ECB technically applies to the Fed as well since the U.S. is diverse enough that it really is a currency area – but I think wage rigidities are much more comparable across U.S. states than they are euro countries.

  27. Gravatar of Benjamin Cole Benjamin Cole
    17. November 2010 at 10:17

    Core rate out today CPI at 0.6 percent.
    Given that the CPI probably overstates inflation, we are probably in deflation now.
    Nippon is on the phone.

  28. Gravatar of Doc Merlin Doc Merlin
    17. November 2010 at 11:12

    @Benjamin Cole

    1. The core rate because it ignores food and energy (both of which have been inflating hugely currently) it completely misses the actual price inflation.

    2. You claimed earlier that a “peer reviewed’ study said that CPI understated inflation by 0.8%. care to link it? I know that the old metric we used for inflation understated it, but the new metric (a geometric mean of the Laspyres and Paasche indexes) shouldn’t, especially once hedonic adjustments are done to it.

  29. Gravatar of David Pearson David Pearson
    17. November 2010 at 11:46

    Scott,

    The World Council global gold supply/demand data is out for Q3. A comparison of the 3q10 annualized run rate vs. 2008:

    -Jewelry demand is 1,990 tons down from 2,190 tons
    -Industrial demand is 421 tons down from 439 tons
    -Inferred institutional investment is 122 tons up from -300 tons
    -Central Bank net purchases are 160 tons up from -232 tons

    The total increase in demand coming from Central Bank and institutional gold hoarding was 800 tons. The total increase from jewelry and industrial is -220 tons. The gold price is about 40% higher than in 2008.

    http://www.research.gold.org/supply_demand/

  30. Gravatar of David Pearson David Pearson
    17. November 2010 at 11:51

    BTW, mine supply, both gross and net of hedging, is running higher than 2008.

  31. Gravatar of David Pearson David Pearson
    17. November 2010 at 11:52

    The data in the first post is 3q10 YTD annualized, not 3q10.

  32. Gravatar of Benjamin Cole Benjamin Cole
    17. November 2010 at 12:37

    Doc-

    First some background, and if you wish to google, you should be able to get to orignal document.

    How big is the CPI’s bias? Well, in 1996, the Social Security Administration commissioned a study on the accuracy of the CPI as a measure of the cost of living. This so-called “Boskin Commission Report” said the CPI was overstated by about 1.1 percentage points per year. The commission identified several sources of potential bias, but about half of the 1.1 percentage points resulted from new products and quality changes that were slow or otherwise imperfectly introduced into the price statistic.

    Since that time, the Bureau of Labor Statistics has initiated a number of methodological changes that have reduced the CPI’s mismeasurement. In a 2001 paper, Federal Reserve Board economists David Lebow and Jeremy Rudd put the CPI bias at only about 0.6 percentage points. And again, of this amount, the big share of the bias (about 0.4 percentage points) resulted from the imperfect accounting of new and improved goods.

    Now, in an article (available to all in its working paper version) appearing in the latest issue of the American Economic Review, Christian Broda and David Weinstein say the earlier estimates of the new goods/quality bias may be a bit understated. The authors examine prices from the AC Nielsen Homescan database and conclude that between 1996 and 2003, new and improved goods biased the CPI, on average, by about 0.8 percentage points per year. If this estimate is accurate, consumer price increases since last October would actually be around zero, or even slightly negative, once we account for the mismeasurement of the CPI caused by new and improved goods.

  33. Gravatar of Doc Merlin Doc Merlin
    17. November 2010 at 12:43

    Ok, from what I see, it seems they are saying that CPI overstates a change in cost of living. ” So, if you can’t afford what you could before because of price increases, but can afford cheaper not as good items, then it shouldn’t count as inflation.” Thats a BS argument.

  34. Gravatar of Benjamin Cole Benjamin Cole
    17. November 2010 at 13:46

    I think you don’t understand, Doc Merlin.

    A cell phone today does things no cell phone could do 20 years ago, and costs less. Ditto almost any electronic good. I bought a Kaypro 2X computer in 1985, and it was considered pretty hot.

    Today, such a computer is hopelessly obsolete and underpowered and expensive.

    (BTW, I recently canned three phone lines at $150 a month, and went to a single cell phone for $50 a month. I get better service for less money).

    I bought products in the 1970s, from toasters to cars to microwaves, and I can tell you product quality is much higher now.

    My ad’s 1966 Ford Falcon had one AM radio, roll-up windows and no AC. It had a “three-on-the-tree” manual transmission. Consequently, it often chattered between gears, and that was acceptable. No airbags, cruise control, leather seats etc. It had rubber-mat flooring, vinyl seats, and an enamel paint job that was chipping off. Evidently impressed, my Dad later bought a Ford Maverick.

    These are not hedonic choices (ie, buying chicken if beef gets expensive), but product quality improvements.

  35. Gravatar of JTapp JTapp
    17. November 2010 at 14:14

    Mankiw’s response on QE showing that he apparently only sees the effect of QE through a long-term interest rate channel is disappointing. I guess I wanted him to be a little more monetarist.

  36. Gravatar of Rafael Rafael
    17. November 2010 at 15:28

    Hey Scott,

    Brad DeLong favors your 5% NGDP growth proposal.

    “I favor Ben McCallum’s proposal to target nominal GDP growth at about 5%. Since we were on track with that target before QE II…. If there were evidence of a need for further loosening to raise the growth of nominal GDP… some quantitative easing might be a reasonable proposal….”

    http://delong.typepad.com/sdj/2010/11/throwing-milton-the-red-over-the-side.html

    Ben McCallum’s??????

  37. Gravatar of Bonnie Bonnie
    17. November 2010 at 15:49

    It does look like QE2 is a failure before it even got off the launching pad. I’m not sure what to make of the new round of stress tests being ordered, except that maybe the Fed might back down after being such crappy sales people and is hunkering down for the sequel to the Great Recession. At least I found that I do agree with Chis Dodd on one point: Republicans need to keep their hands off the Fed mandates. A few of the higher ranking ones in the new Congress are threatening to remove the full employment mandate if it won’t back off QE2. This zeitgeist of fear of everything the Fed does is really getting out of hand and I fear for what is to come next should they get their way. What a sorry state of affairs.

  38. Gravatar of Lorenzo from Oz Lorenzo from Oz
    17. November 2010 at 16:16

    Full Employment Hawk. Spain has massive unemployment because it is very hard to sack people, which greatly increases the risk of hiring them. France and Greece have similar problems but, as I understand, the Spanish law is the most restrictive.

    Regulatory protection of incumbents is a curse in both housing and labour markets. And taxi markets. And …

  39. Gravatar of Full Employment Hawk Full Employment Hawk
    17. November 2010 at 18:22

    “Spain has massive unemployment because it is very hard to sack people,”

    With austerity causing NGDP growth to slow, if it was easier to sack people there would be more layoffs and more unemployment. Making it hard to sack people reduces unemployment when output is in decline, but slows the drop in unemployment when output has started to grow again.

  40. Gravatar of Lee Kelly Lee Kelly
    17. November 2010 at 20:33

    Full Employment Hawk,

    How do austerity measures slow NGDP growth? I do not understand why they should have any influence over the supply and demand for money.

    People who would have bought government bonds purchase something else. Instead of government officials spending tax revenues, people take home a little more money and spend it themselves. NGDP should remain about constant, because austerity measures only imply a shift in relative spending, not total spending.

  41. Gravatar of Doc Merlin Doc Merlin
    17. November 2010 at 21:40

    @ Lee kelly:

    Full Employment Hawk is a hydraulic Keynesian. He believes that increased government spending builds GDP.

  42. Gravatar of marcus nunes marcus nunes
    18. November 2010 at 05:54

    Tyler Cowen has this to say about the Fed:
    2. “The Fed made the recent crisis much better than it otherwise would have been. Without a Fed, we would have experienced something akin to a Great Depression, including a frozen payments system”.
    http://www.marginalrevolution.com/marginalrevolution/2010/11/what-is-the-case-for-the-fed.html

  43. Gravatar of Morgan Warstler Morgan Warstler
    18. November 2010 at 05:57

    Benji,

    My god, you just SAVED $1200 through Productivity Gains! And it sits in a bank ready to be LOANED, driving down the cost of borrowing…. increasing the Animal Spirit spritzer we have to seed the economy WITHOUT printing money.

    Holy shit! Morgan was right! Productivity Gains = Growth. Capital Formation through savings is the only legitimate way of creating money to loan.

    And now, let’s see what some Dems are adding to the Audit the Fed meme:

    http://www.youtube.com/watch?v=EjTZOekaQlE

  44. Gravatar of JTapp JTapp
    18. November 2010 at 07:12

    @rafael Brad Delong was quoting someone else the block quotation just got messed up on his blog, go to the FrumForum site.

  45. Gravatar of Full Employment Hawk Full Employment Hawk
    18. November 2010 at 07:37

    “People who would have bought government bonds purchase something else. Instead of government officials spending tax revenues, people take home a little more money and spend it themselves. NGDP should remain about constant, because austerity measures only imply a shift in relative spending, not total spending.”

    This argument is confused. Reducing government spending does not give people more income to spend on something unless taxes are also cut, which is not austerity. The case of government spending being reduced with tax rates remaining constant is different from the case of cuts in government spending matched by tax cuts.

    I will take only the case of government spending being reduced with tax rates unchanged here to keep the note from getting too long. The fallacy in your argument in that case is that you assume that the supply of loanable funds remains unchanged when government spending is reduced. This is the same error that Cochran makes. If government spending is reduced, output and income decrease. Since part of income is saved, this reduces the supply of loanable funds. Therefore the loanable funds that would have gone to the private sector if the government had not been borrowing AND THE SUPPLY OF LOANABLE FUNDS HAD NOT CHANGED is not there to go to the private sector because the supply of loanble funds has decreased. Therefore the reduction in government purchases is not offset by private purchases. As a result NGDP declines.

    The false assumption that the supply of loanable funds remains unchanged when government purchases change is one of the most frequent errors made by people who believe that changes in government purchases do not affect aggregate demand a.k.a.NGDP.

  46. Gravatar of Full Employment Hawk Full Employment Hawk
    18. November 2010 at 07:42

    “And now, let’s see what some Dems are adding to the Audit the Fed meme:”

    Auditing the Fed will not create one single additional job. On the contrary, by making the Fed more reluctant to act, it will help keep the unemployment rate high. The reason the Dems lost badly this election was because the unemployment rate was stalled at about 9 1/2%. Democrats, if they know what is good for them need to concentrate on doing things that get the unemployment rate down.

  47. Gravatar of Full Employment Hawk Full Employment Hawk
    18. November 2010 at 07:46

    “A few of the higher ranking ones in the new Congress are threatening to remove the full employment mandate if it won’t back off QE2.”

    If they try to do this it is a golden opportunity for the Dems to attach the Republicans for not caring about jobs.

  48. Gravatar of Full Employment Hawk Full Employment Hawk
    18. November 2010 at 07:50

    “I do not understand why they should have any influence over the supply and demand for money.”

    This requires an additional reply.

    As income goes down, the demand for money decreases.

  49. Gravatar of Lee Kelly Lee Kelly
    18. November 2010 at 08:42

    Full Employment Hawk,

    I think it is you who are confused. The supply of loanable funds has nothing to do with the matter — its rises and falls should not have any impact on aggregate demand.

    Suppose the government increases spending. The government finances spending with taxes or borrowing, so either it increases taxes or issues more bonds. In the case of increasing taxes, private spending falls but public spending increases in proportion, and only the composition of demands change, not the aggregate. In the case of issuing more bonds, private individuals reduce spending on something to finance the purchase of the bonds and public spending increases in proportion, and only the composition of demands change, not the aggregate. Now, when the government reduces its spending, all these relations are reversed, the composition of demands change and the aggregate remains constant.

    Only when there is an excess demand for money can an increase in government spending increase aggregate demand, because by issuing more bonds the government can soak up some of the excess demand for money. Likewise, only when there is an excess supply of money can a decrease in government spending reduce aggregate demand, because by issuing fewer bonds the there can be a spillover into the demand for money.

    Unless you are claiming there is currently an excess supply of money, then your claim that austerity reduces aggregate demand does not follow. Do you believe there is an excess supply of money?

  50. Gravatar of scott sumner scott sumner
    18. November 2010 at 10:06

    Mark, Thanks for infecting the Krugman blog with the Sumner virus. :)

    JimP, Yes, it’s ironic that so many monetarists worry about inflation, when the broader aggregates that they supposedly think are more accurate are signaling disinflation.

    rob, You said;

    “QE2 wasn’t enough, it has now been tested and it is being blown over. Why do I feel like a crazy person saying that on this blog?”

    I don’t know why you think I disagree with this. But when looking at the effect of policy actions, the immediate market reaction is what matters. If the Fed were targeting the forecast then future adverse gusts of wind wouldn’t matter.

    Morgan, I’ll never jump on your coattails.

    Full employment hawk, Yes, AD or nominal income would have sounded better.

    FEH and Mark, I quoted the whole cross of gold passage a few months back. But Mark, as a Dem do you think WJB was better than Gore? He did have some odd views as well.

    Mark, You said;

    “Let me get this straight.

    The Neoliberal champion of Europe is failing because of negative monetary policy. And yet almost no libertarians have chosen to stand by her side. I guess that means libertarianism is an abismal failure.”

    Good point, but my favorite models (developed before the crisis in 2008) were Denmark, Switzerland and Singapore. Last time I looked all three were doing fairly well. Ireland’s problems are at least 80% banking and no more than 20% tight ECB money. They may have been a low tax rate model, but according to a long article in the NYR of Books last month, their housing/banking/government interrelationship made Russia seem uncorrupt by comparison.

    Morgan, Thanks for the Mundell speech. He’s right about 2008 and he will be proved wrong about 2010.

    Richard W, I hope you are right about the euro, and I agree that rising yields don’t necessarily mean tighter money.

    I see why other countries in Europe don’t like the Irish tax system, but that’s not how they got in trouble. The problem is the massive bank bailout. Take that away and they can pay their bills. They did a poor job regulating banking. The low corporate tax model did work in attracting multinationals, and they should and will try to keep that model. But they should blow up their banking system. Perhaps they should make deposit insurance so high that only foreign banks can operate there.

    Ted, I completely agree with your first paragraph. Your second point is quite interesting, and probably right. But it’s also awful hard to implement in the real world.

    Benjamin and Doc Merlin, I also focus on the core rate. If in a 12 months when food and energy has (according to Doc) “hugely inflated” we still only have 1.2% headline inflation, what does that tell you about the threat of high inflation? That’s what the conservatives are missing.

    David, That data doesn’t conflict with anything I said (you need to distinguish between demand and quantity demanded, and supply and quantity supplied.) I agree people are hoarding more gold. But I forgot to mention the most important reason, real interest rates are very low, indeed negative. Gold prices tend to be correlated with real interest rates. This does not mean people are worried about inflation in the US, we don’t even know how much of the total gold demand is coming from the US. How much of those massive central bank purchases were from the US? I’d guess zero.

    JTapp, Yes, and Mankiw worries far too much about the risk. I had heard the Fed wasn’t buying many 30 year bonds, mostly maturities around 5 years? Is that right? If so, the risk to the Fed is trivial.

    Rafael, Yes, McCallum proposed it way back around 1980.

    Bonnie, QE2 was a modest success, but no where near enough. If things go bad now, they would have been even worse w/o QE2.

    Lorenzo and FEH, Didn’t Spanish unemployment recently rise from about 10% to 20%. I can’t imagine the jump being much worse under an alternative labor market regime, after all, it’s not like they are in a Great Depression.

    Or perhaps my memory is off.

    marcus, Thanks, I have a new post on that.

  51. Gravatar of David Pearson David Pearson
    18. November 2010 at 10:26

    Scott,

    Occam’s razor applies:

    Investors and central banks can store wealth in dollars, other currencies or gold. They choose to hoard gold only only when they expect dollars and other currencies to be worth less in terms of gold.

  52. Gravatar of Morgan Warstler Morgan Warstler
    18. November 2010 at 10:31

    Scott, remember, Mundell has better insight into what China and Europe are going to do too.

  53. Gravatar of Lorenzo from Oz Lorenzo from Oz
    18. November 2010 at 18:53

    I was referring to the fact that Spanish unemployment was already high and had been notoriously high for years. (Spain had 8.4% unemployment in 2007.) Spain now has the highest unemployment rate in the OECD, so I don’t think their regulations helped slow the rise in unemployment given that, even in downturns, there is job “churn” and such rules slow down the rate of churn. So the impact of falling NGDP has been to make a dysfunctional labour market even more dysfunctional.

  54. Gravatar of Mark A. Sadowski Mark A. Sadowski
    18. November 2010 at 19:08

    Scott wrote:
    “But Mark, as a Dem do you think WJB was better than Gore? He did have some odd views as well.”

    History will tell. I believe Gore’s views on climate change may well be proven to be of great practical importance. But I doubt any of his speeches will ever be remembered as much as WJB’s.

    And I sometimes wonder how history might have been different with WJB as president. Might there never have been a GD? No, not even I’m a big enough fool to think that.

  55. Gravatar of Mark A. Sadowski Mark A. Sadowski
    18. November 2010 at 19:21

    Scott,
    You wrote:
    “Ireland’s problems are at least 80% banking and no more than 20% tight ECB money.”

    I call you on that statement Scott. This contradicts some of what you’ve said previously on the direction of causality of financial and monetary crises.

    I know the numbers pretty well when it comes to Europe and it seems to me that there is a very strong relationship between investment and monetary policy. The areas of most rapid development (due to favorable policy and natural factors) are the ones that suffer most when policy is tightened.

    In the US that means that the Southwest was most affected. In Europe that meant Ireland and the Baltic States were the most affected.

    I don’t subscribe to structural factors at all. The biggest problem is that the tide withdraws most from where is was the most flush. Money is a force as powerful as the ocean and ignore it at your peril.

  56. Gravatar of Full Employment Hawk Full Employment Hawk
    18. November 2010 at 19:34

    “They choose to hoard gold only only when they expect dollars and other currencies to be worth less in terms of gold.”

    Not so. They will hoard gold even if they only fear that dollars and other currencied MAY become worth less than gold. Since every time a Eurozone country has difficulties the flight to quality includes purchases of dollars, fear of disruption of the Eurozone or even the collapse of the Euro seems to be the main factor that drives the price of gold up.

  57. Gravatar of Full Employment Hawk Full Employment Hawk
    18. November 2010 at 19:55

    “I think it is you who are confused.”
    “Do you believe there is an excess supply of money?”

    The apparent confusion is due to the fact that we are using different analytical frameworks. As I have mentioned, I am a 2/3 Keynesian who agrees with you about monetary policy. I am looking at this from the standpoint of income and expenditures, not the supply and demand for money. My point is that the borrowing of the governent to finance the goverment purchases will not reduce the loanable funds available to the private sector. The reason is that the increase in government expenditures will increase national income and part of this increased national income is saved. This increases the supply of loanable funds and provides the extra loanable funds required to finance the government borrowing, so that it does not have to come out of loanable funds available to the private sector. Krugman has used an analogous argument, using a textbook income-expenditure model instead.

    This, to keep things simple, ignores the complication that there is a lag between the time the goverment purchases are made and income, and therefore, the supply of loanable funds increases. Demonstrating that the logic still holds under such conditions requires a long paper, rather than a short note, but it can be done.

  58. Gravatar of Full Employment Hawk Full Employment Hawk
    18. November 2010 at 20:03

    CORRECTION

    That should have been “who agrees with Scott Sumner on monetary policy.”

  59. Gravatar of Lee Kelly Lee Kelly
    18. November 2010 at 20:27

    Full Employment Hawk,

    You wrote: “My point is that the borrowing of the governent to finance the goverment purchases will not reduce the loanable funds available to the private sector.”

    I never said it would. Look, it depends on how the buyers finance their purchase of government bonds. For example, all else being equal, if buyers reduce spending on corporate bonds to finance the purchase of government bonds, then the supply of loanable funds available to the private sector will be reduced. However, all else being equal, if buyers reduce spending on consumer goods and services to finance the purchase of government bonds, then the supply of loanable funds available to the private sector will not change.

    You wrote: “The reason is that the increase in government expenditures will increase national income and part of this increased national income is saved.”

    Just no, a thousand times. If the buyer of a government bond instead purchased a corporate bond, then a corporation spends the money on various goods and provides income to producers of those goods. Alternately, if the buyer of a government bond instead purchased consumer goods and services, then the buyer spends the money on consumer goods and services and provides income to producers of those goods and services. The fact that government receives and spends the money does not increase total nominal spending.

    You wrote: “This increases the supply of loanable funds and provides the extra loanable funds required to finance the government borrowing, so that it does not have to come out of loanable funds available to the private sector. Krugman has used an analogous argument, using a textbook income-expenditure model instead.”

    What you are describing can only occur when there is an excess demand for money (i.e. deficient aggregate demand, a shortage of nominal spending, or whatever). I may not agree with Krugman on a lot, but I am sure he also understands this point.

    More to the point, what are you talking about? Previously you contended that reductions in government spending would depress the economy by reducing aggregate demand. Now you are arguing that increases in government spending will stimulate the economy by increasing aggregate demand. These are not the same thing.

    In any case, both are wrong as general statements, because each only holds under particular circumstances. When the economy is in equilibrium, an increase in deficit-financed spending does not increase aggregate demand, because every dollar more the government spends is a dollar less spent by someone else — it’s a wash for the economy as a whole. Likewise, when the economy is in equilibrium, a decrease in deficit-financed government spending does not decrease aggregate demand, because every dollar less the governments spends is a dollar more spent by someone else.

    Only when there is an excess supply or demand for money can government spending have the effects you describe, and only then because government bonds are close substitutes for money. A reduction in the supply of government bonds — or any other close substitute for money — will tend to cause demand to “spillover” into money. This is the way that a reduction in deficit-financed government spending may reduce total nominal spending, but the Fed should be able to offset it with minor asset purchases.

  60. Gravatar of 「またですか?」 by Scott Sumner – 道草 「またですか?」 by Scott Sumner – 道草
    18. November 2010 at 23:59

    [...] by Scott Sumner // Scott Samner のブログから、Here we go again? (November 16th, [...]

  61. Gravatar of Scott Sumner Scott Sumner
    19. November 2010 at 15:11

    David, I put zero weight on what central banks think will happen to gold prices and US inflation. They aren’t “markets”. In any case, I think it is mostly a few like Russia/China/india, which suggests it is political, not fear of inflation.

    Morgan, You can say I told you so when the high inflation comes.

    Lorenzo, I agree.

    Mark, You said;

    I call you on that statement Scott. This contradicts some of what you’ve said previously on the direction of causality of financial and monetary crises.

    Good question, but you need to pay close attention to the nuances of my argument. I have ALWAYS clearly indicated that the housing collapse in the subprime states of mid-2006 to mid-2008 was not monetary, but rather reflected errors by the parties involved. I’ve argued money became much too tight in mid-2008, and that’s when asset prices started falling in non-subprime areas, and non-real estate areas. If Ireland is like Las Vegas, then I’d also say Vegas’s problems are mostly non-monetary.

    Perhaps the 20% figure is wrong, but I’ve always argued the subprime bubble was mostly a real problem and I instead attributed the loss of jobs in manufacturing and services to tight money. I suppose manufacturing and services in Ireland are also down due to the recession, but it is housing that makes Ireland special (compared to other manufacturing countries.)

    BTW, Places like Vegas and Phoenix were not hit hard in previous US recessions. Casino business was down, but the city kept booming. The subprime mess was special, and much of the pain occurred before the tight money.

  62. Gravatar of Full Employment Hawk Full Employment Hawk
    19. November 2010 at 19:08

    “What you are describing can only occur when there is an excess demand for money (i.e. deficient aggregate demand, a shortage of nominal spending, or whatever).”

    Obviously. The question I am addressing is whether increases in government spending can provide a stimulus for an economy THAT IS DEPRESSED. I am I am explaing why that is the case under such conditions. I certainly do not think that an increase in government spending has a stimulative effect when the economy is at potential output, nor do I advocate such a policy.

  63. Gravatar of Mike Sandifer Mike Sandifer
    21. November 2010 at 09:37

    Scott,

    How much of a problem have the Fed’s vastly overoptimistic forecasts had to do with their hypo-stimulation? In particular, I seem to recall the Fed’s original GDP forecast for this quarter at least around double the result.

  64. Gravatar of scott sumner scott sumner
    23. November 2010 at 12:45

    Mike Sandifer. That wasn’t the main problem. Even their forecasts were for very unacceptable levels of nominal growth.

  65. Gravatar of Mike Sandifer Mike Sandifer
    23. November 2010 at 16:35

    Good point. Thanks.

  66. Gravatar of Luis H Arroyo Luis H Arroyo
    24. November 2010 at 11:31

    Scott, I agree completely. But te problem is not that the ECB monetary policy is too tight; it´s that it is tight for ours, for example, and accurated for Germany -perhaps. Impossible to say with complete conviction.
    ECB has bought, for example, in a month, 130 mm € of Irish debt, after Trichet announced that it was time to think in inflation risk…
    ECB, I´m affraid, is KO.

  67. Gravatar of Scott Sumner Scott Sumner
    25. November 2010 at 08:44

    Luis, It’s too tight for the entire eurozone–all have seen big drops in NGDP growth.

  68. Gravatar of Luis H Arroyo Luis H Arroyo
    27. November 2010 at 02:04

    Yes, that ´s true

    http://sdw.ecb.europa.eu/browseChart.do?node=bbn184&FREQ=Q&sfl1=3&DATASET=0&DATASET=1&DATASET=2&SERIES_KEY=119.ESA.Q.I5.S.0000.B1QG00.1000.TTTT.L.U.A&SERIES_KEY=119.ESA.Q.I5.S.0000.B1QG00.1000.TTTT.V.U.A

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