As expected, Ben is with Lars

Here’s Ben Bernanke on the idea of using monetary policy to address financial imbalances:

Let there be no mistake: In light of our recent experience, threats to financial stability must be taken extremely seriously. However, as a means of addressing those threats, monetary policy is far from ideal. First, it is a blunt tool. Because monetary policy has a broad impact on the economy and financial markets, attempts to use it to “pop” an asset price bubble, for example, would likely have many unintended side effects. Second, monetary policy can only do so much. To the extent that it is diverted to the task of reducing risks to financial stability, monetary policy is not available to help the Fed attain its near-term objectives of full employment and price stability.

For these reasons, I have argued that it’s better to rely on targeted measures to promote financial stability, such as financial regulation and supervision, rather than on monetary policy.

One of the “unintended side effects” of the Fed’s 1928-29 attempt to pop the stock market bubble was the Great Contraction of 1929-33.  Another was Hitler taking power in Germany.  And another was WWII.  So if anything, Bernanke is being too polite to those who favor using monetary policy to prevent financial imbalances.

Now of course they’d insist that they also favored macroeconomic stabilization, and merely wish to use monetary policy at the margin.  But even those more reasonable proposals are highly questionable.  Bernanke cites one study (links further down) that does find that monetary policy might play a role, but not a very large one:

Although, in principle, the authors’ framework could justify giving a substantial role to monetary policy in fostering financial stability, they generally find that, when costs and benefits are fully taken into account, there is little case for doing so. In their baseline analysis, they find that incorporating financial stability concerns might justify the Fed holding the short-term interest rate 3 basis points higher than it otherwise would be, a tiny amount (a basis point is one-hundredth of a percentage point). They show that a larger response would not meet the cost-benefit test in their estimated model. The intuition is that, based on historical relationships, higher rates do not much reduce the already low probability of a financial crisis in the future, but they have considerable costs in terms of higher unemployment and dangerously low inflation in the near- to intermediate terms.

And even this is doubtful, as it depends on the very dubious assumption that low interest rates imply easier money:

A new paper by Andrea Ajello, Thomas Laubach, David López-Salido, and Taisuke Nakata, recently presented at a conference at the San Francisco Fed, is among the first to evaluate this policy tradeoff quantitatively. The paper makes use of a model of the economy similar to those regularly employed for policy analysis at the Fed. In this model, monetary policy not only influences near-term job creation and inflation, but it also affects the probability of a future, job-destroying financial crisis. (Specifically, in the model, low interest rates are assumed to stimulate rapid credit growth, which makes a crisis more likely.)

Indeed a tighter monetary policy during the famous housing bubble of 2005-06 would have probably been associated with lower interest rates, not higher.  Thus in a counterfactual where in 2001-03 the Fed had cut rates to 3%, not 1%, the level of interest rates in the 2005-06 bubble would have had to be lower than the actual path of rates, as the economy would have been in depression.

What most caught my attention is that Bernanke comes down strongly in support of his former colleague Lars Svensson, who quit the Riksbank in disgust over its tightening of monetary policy around 2010-11:

Lars Svensson, who discussed the paper at the conference, explained, based on his own experience, why cost-benefit analysis of monetary policy decisions is important. Lars (who was also my colleague for a time at Princeton) served as a deputy governor of the Swedish central bank, the Sveriges Riksbank. In that role, Lars dissented against the Riksbank’s decisions to raise its policy rate in 2010 and 2011, from 25 basis points ultimately to 2 percent, even though inflation was forecast to remain below the Riksbank’s target and unemployment was forecast to remain well above the bank’s estimate of its long-run sustainable rate. Supporters justified the interest-rate increases as a response to financial stability concerns, particularly increased household borrowing and rising house prices. Lars argued at the time that the likely benefits of such actions were far less than the costs. (More recently, using estimates of the effects of monetary policy on the economy published by the Riksbank itself, he showed that the expected benefits of the increases were less than 1 percent of the expected costs). But Lars found little support for his position at the Riksbank and ultimately resigned. In the event, however, the rate increases were followed by declines in inflation and growth in Sweden, as well as continued high unemployment, which forced the Riksbank to bring rates back down. Recently, deflationary pressures have led the Swedish central bank to cut its policy rate to minus 0.25 percent and to begin purchasing small amounts of securities (quantitative easing). Ironically, the policies of the Swedish central bank did not even achieve the goal of reducing real household debt burdens.

When someone leaves an important policy position, where a person is not really free to speak their mind, to blogging, which is all about speaking one’s mind, you quickly learn a great deal about their views on controversial issues. Anyone want to wager with me on what Bernanke and Svensson think of the ECB’s decision to twice raise rates in 2011?

I was only disappointed by one aspect of the post—Bernanke continues to (implicitly) use a conventional measure for the stance of monetary policy.

Despite the substantial improvement in the economy, the Fed’s easy-money policies have been controversial. Initially, detractors focused on the supposed inflation risks of such policies. As time has passed with no sign of inflation, that critique now looks rather threadbare. More recently, opposition to accommodative monetary policy has mostly coalesced around the argument that persistently low nominal interest rates create risks to financial stability, for example, by promoting bubbles in asset prices or stimulating excessive credit creation.  (emphasis added)

In 2003, Bernanke correctly pointed out that conventional measures such as interest rates are highly flawed:

The imperfect reliability of money growth as an indicator of monetary policy is unfortunate, because we don’t really have anything satisfactory to replace it. As emphasized by Friedman (in his eleventh proposition) and by Allan Meltzer, nominal interest rates are not good indicators of the stance of policy, as a high nominal interest rate can indicate either monetary tightness or ease, depending on the state of inflation expectations. Indeed, confusing low nominal interest rates with monetary ease was the source of major problems in the 1930s, and it has perhaps been a problem in Japan in recent years as well. The real short-term interest rate, another candidate measure of policy stance, is also imperfect, because it mixes monetary and real influences, such as the rate of productivity growth. In addition, the value of specific policy indicators can be affected by the nature of the operating regime employed by the central bank, as shown for example in empirical work of mine with Ilian Mihov.

.  .  .

Ultimately, it appears, one can check to see if an economy has a stable monetary background only by looking at macroeconomic indicators such as nominal GDP growth and inflation. On this criterion it appears that modern central bankers have taken Milton Friedman’s advice to heart.

Of course by that criterion (averaging inflation and NGDP growth), money was tighter in 2008-2013 than in any 5 year period since Herbert Hoover was president.

NGDP research bleg

There are basically three general arguments for NGDP targeting:

1.  It will reduce labor market instability.

2.  It will reduce credit market instability.

3.  It will lead to more pro-market public policies.

I am looking for links to previous empirical research in any of these three areas, but especially the last two.  The first is obviously important, perhaps the most important argument, but it’s also been researched fairly extensively.

Here I’ll sketch out what interests me about the second and third topic:

Financial instability:  It seems like financial crises are often associated with declines in NGDP.  Think about the US and Europe in 1931, Argentina in 2001, the US and Europe in the period after mid-2008.  But that’s just casual empiricism.  I’d like to see rigorous academic studies that look at many different financial crises.  How often are they associated with falling NGDP?  Does this correlation only show up in certain countries?  What about a slowdown in NGDP growth where it still remains positive?  (For instance, did the slowdown in NGDP growth during the 1980s and early 1990s contribute to the S&L crisis?)

Statist policies:  It seems like free market policies do fairly well when NGDP growth is fairly stable (1922-29, 1953-64, 1985-2007) and statist policies do better when NGDP growth is unstable (1913-21, 1930-52, 1965-81, 2008-10).  Obviously there are lots of issues here.  In the case of WWI and WWII, you may have reverse causality—government spending causes the NGDP instability.  But there’s also lots of plausible examples going the other way—the Great Depression leading to the NIRA, the Great Inflation leading to wage and price controls, the Great Recession leading to bailouts, etc.)

It would also be interesting to look at this question from an international perspective.  Out of curiosity, I took a look at the Heritage Economic Freedom scores for the US and Australia, before and after the crisis:

Country    Score(rank)2007     2015

Australia           82.7 (3)           81.4 (4)

USA                  82.0 (4)          76.2 (12)

Australia had much less NGDP instability, at least in a “level targeting” sense (this may not be easy to quantify.)  Is that why the economic freedom score for the US slipped much more than for Australia?  Perhaps, but Australia does slide behind New Zealand, which moved up to number 3, and which nonetheless had a worse recession than Australia.  Another problem is that smaller economies (and commodity exporters) “naturally” have a more unstable NGDP, indeed this is probably desirable.  So you’d need to control for a number of factors.

I seem to recall that the average Heritage Economic Freedom score was rising during the Great Moderation, and began falling after somewhere around 2008.  Is that correct?  I also wonder whether it depends on which regime (statist or market-oriented) is viewed as the plausible alternative.  In the US in 1930 the alternative was statism.  Today in Greece the alternative may be market-friendly policies.  That underlies the conservative fear that NGDP targeting might allow Greece to avoid the needed “tough choices.”

In any case, these are obvious three big issues that need looking at.  I’d guess there’s already some research on these topics, but mostly for labor market instability.  Again, I’d greatly appreciate links to any research on how NGDP instability is correlated with problems like unemployment, financial crises, and statist policies.

Update:  E. Harding sent me a graph showing the average Heritage ranking.  It rose to a peak at 60.2 in 2008, then fell to a trough of 59.4 in 2010, then rose again to an even higher peak of 60.4 in 2015.  Thus the US decline is not typical.

George Selgin has a new blog

George Selgin appraises QE and Fed policy more generally over the past decade. I think it’s fair to say that he’s not a big fan. The way he frames the discussion might lead some readers to think he sharply disagrees with my views, but this is more a stylistic difference in emphasis.  On the core issues we agree:

1.  The Fed policy during the Great Recession should not be viewed as a great success.  Yes, we did better than Europe, but the recovery was still quite disappointing in an absolute sense.

2.  A policy of stable NGDP growth would have been far superior to actual Fed policy.

3.  With a better policy (such as NGDP targeting), it’s quite possible that little or no QE would have been needed, and there would have been less Fed intervention into credit markets.

Keep those three points in mind if it seems like he’s less in favor of QE than I am. George also favors a somewhat lower NGDP target than I favor, which leads him to put more weight on policy errors that occurred before 2008.  I like the way he ends the post:

Am I suggesting that the Fed could not possibly have done worse? Of course not. Only someone with a severely defective imagination could suppose so.  Whatever his shortcomings, Ben Bernanke was far from being an incompetent central banker.  In suggesting that we might have done better than Bernanke’s Fed did, I don’t mean that we could have used a better discretion-wielding central banker. I mean that we might have been better off avoiding seat-of-the-pants-style central banking altogether.

I struggle, moreover, to understand why more people don’t take the same view.   For if it takes a stunted imagination to suppose that things couldn’t have been worse, it takes a no-less defective one to suppose that we couldn’t possibly improve upon the presently-constituted Fed. Far [from] supplying grounds for celebration, or warranting complacency, the events of the last decade or so ought to make it more evident than ever that our monetary system is very far from being the best of all possible alternatives.

George links to a paper by Yi Wen with the following abstract:

We use a general equilibrium finance model that features explicit government purchases of private debts to shed light on some of the principal working mechanisms of the Federal Reserve’s large-scale asset purchases (LSAP) and their macroeconomic effects. Our model predicts that unless private asset purchases are highly persistent and extremely large (on the order of more than 50% of annual GDP), money injections through LSAP cannot effectively boost aggregate output and employment even if inflation is fully anchored and the real interest rate significantly reduced. Our framework also sheds light on some longstanding financial puzzles and monetary policy questions facing central banks around the world, such as (i) the flight to liquidity under a credit crunch and debt crisis, (ii) the liquidity trap, and (iii) the low inflation puzzle under quantitative easing.

Someone needs to explain to me the phrase “even if inflation is fully anchored.” Obviously if inflation is fully anchored then it’s almost logically impossible for expansionary monetary policy to boost RGDP.  (Unless the SRAS was 100% flat, which it isn’t.)  So why would an empirical result of this sort be at all interesting?

Obviously I’m missing something.  But what?

Ryan Avent on Secular Stagnation

In the previous post I sort of hinted that Ryan Avent might be a bit more negative about the Summers/Krugman/Bernanke debate than he was letting on, when I suggested that he was being polite.  Marcus Nunes pointed me to a great Avent post from 2013 that makes this criticism much more explicit:

I think it’s important and welcome for someone of Mr Summers’ stature to point out how serious a problem the zero lower bound is and to note that it is not going away any time soon. But this discussion sorely needs a dose of real talk, and soon. Or nominal talk, I should say.

Just why the real natural rate of interest is so low is an interesting question. Maybe it’s down to a global savings glut, spurred by emerging-market reserve accumulation and exchange-rate management. Maybe it is a transitory symptom of widespread deleveraging. Maybe its roots are more structural in nature: a product of demographic or technological trends. I have my own suspicions, but the important thing to point out is that for the purpose of this discussion and this crisis it doesn’t matter.

The zero lower bound is a nominal problem. However low the real interest rate, an economy can keep nominal rates safely in positive territory by running a sufficiently high rate of inflation. Back in August, another eminent economist, Robert Hall of Stanford University, contributed a paper on the zero lower bound to the Kansas City Fed’s Jackon Hole conference, in which he estimated that the market-clearing real rate of interest is -4%. Now again, just why the real, natural rate of interest is currently -4% is an interesting question, but it’s irrelevant to the challenge of closing the output gap. All that matters there is that expected inflation is between 1% and 2% instead of near 4%. That’s the problem; that’s what’s keeping tens of millions of people out of work and hundreds of millions languishing in a perpetually weak economy: a couple of percentage points of inflation.

And central banks are entirely to blame for that.

So basically Ryan is saying that the real problem is nominal.

PS.  Off topic, Robin Hanson has an excellent post discussing a graph on intangible corporate assets, which played a role in my recent post on how regulation may be increasing inequality.

What if we let the inflation genie out of the bottle?

Ryan Avent has a long and characteristically thoughtful post on the recent debate over global stagnation.  He focuses on the views of Paul Krugman, Ben Bernanke and Larry Summers, three intellectual heavyweights.  In the end I think Ryan’s a tad too polite, although maybe that’s my own frustration showing through.  After all, these aren’t just any three economists; they are two of the most influential policymakers in recent years, and the world’s most famous economic pundit.

Here’s my problem.  After nodding in the direction of inadequate monetary policy, Ryan basically accepts the framing of the demand deficiency debate—it’s all about saving/investment imbalances.  But as Ryan himself acknowledges, that’s only a problem because monetary policy is not behaving normally:

Normally a central bank would try to fix the imbalance between saving and investment by reducing interest rates (which should discourage saving and encourage borrowing). But in a weak enough economy with low enough inflation the interest rate needed to balance saving and investment might become negative—maybe even really negative. Given the difficulty of achieving a negative nominal interest rate, the central bank might find it hard to push an economy out of that sort of trap once it fell in.

Ryan understands (but doesn’t mention in this post) that one way to fix this problem is by raising the inflation target. Many economists (including Krugman) have recommended raising the target to 4%.  In my view 3% would be plenty high for the US.

So why don’t we do this?  I can’t imagine that any serious economist believes that the harm done by an extra 1% in fully anticipated inflation is worse than the damage (supposedly) done from decades of secular stagnation.  One answer is that there are better alternatives, like NGDPLT. That’s true, but we are also not adopting those better alternatives.   Another is that “using monetary policy” would create bubbles.  But we always use monetary policy; not using monetary policy is not an option. What Larry Summers actually objects to is having the private sector allocate increased investment spending, at a time he prefers more public investment on infrastructure.

And yet Summers is obviously not typical of the opponents of higher inflation, who are most often on the right.  The argument that I hear most frequently is that 3% inflation would “let the inflation genie out of the bottle.” We saw in the 1960s that once we let inflation rise to 3%, it rose to 4%, then 5%, then eventually 13%.

And yet . . . prior to the 1960s the Fed had no experience in inflation targeting. Now they’ve shown they can keep inflation close to 2% or slightly lower for as long as they wish. They’ve learned the Taylor Principle.  I know, you are thinking; “Still we can’t really know the effect of a higher inflation target until it’s been tried.” Don’t be a stupid American, the type who pays no attention to the rest of the world.

A few years ago the Japanese raised their inflation target from “stable prices” to 1% inflation.  Then at the beginning of 2013 they again raised their inflation target to 2%.  And what did the mean, scary Japanese inflation genie do once it got out of the bottle?  Well the Japanese CPI was about 99 at the beginning of 2013, and now it’s about 103.  I’ll let you do the math.

Screen Shot 2015-04-04 at 4.22.17 PM

More recently the ECB has sharply depreciated the euro.  The Fed is planning on raising interest rates soon, which means they don’t see any demand deficiency—mostly because the Bernanke Fed did more monetary stimulus than the ECB in previous years.  Monetary policy works at the zero bound.

Here’s how central bankers envision the scary Japanese inflation genie:

Screen Shot 2015-04-04 at 3.46.54 PM

And here’s what it actually looks like:

Screen Shot 2015-04-04 at 3.50.03 PMPS.  I do not favor raising the inflation target, I favor NGDPLT.  But if the choice is between decades of “demand deficiency” and/or billions spent on Japanese style bridges to nowhere, and 3% inflation, I’ll take my chances with the scary inflation genie.

PPS.  Perhaps I’m not afraid because as a child I watched the TV show “I Dream of Jeannie.”