Conservatives are not abandoning market monetarism

Ryan Cooper has a piece in The Week on market monetarism:

During the dog days of the Great Recession, several economists developed a persuasive case that the Federal Reserve was badly bungling monetary policy. Led by Scott Sumner, these “market monetarists” argued that the Fed should be far more prepared to unleash monetary stimulus. To do this, the central bank would have to abandon its dual mandate of keeping unemployment and inflation low, and adopt a much simpler metric: a nominal gross domestic product (NGDP) growth target.

So far, so good.  But then things start to go awry:

The high-water mark of the market monetarists’ intellectual and political influence was in 2011 and 2012, when market monetarism was a key economic plank for reform conservatives, those who have been trying, with little success thus far, to push the Republican Party in a new, less dogmatic direction. Since then, however, the NGDP chorus has quieted somewhat, and the movement’s key political allies have abandoned it.

Ramesh Ponnuru, previously a strong advocate of monetary stimulus, claims that he has not abandoned the NGDP target, just that the times have changed:

I was never going to be a dove for very long. Being a hawk on monetary policy in all circumstances, or being a dove in all circumstances, makes as little sense as being either of those things on foreign policy in all circumstances… My preference would be for a steady rate of increase in nominal spending, say at 4.5 percent a year. If the Fed had pursued that policy over the last half-century, it would have been much tighter during the 1960s and 1970s, a bit tighter during 2003-06, and much looser in 2008-11. [National Review] .  .  .

There are two problems here. First is the choice of target: 4.5 percent is lower than Sumner’s typical 5 percent, and could mean enforcing unnecessarily low growth. Adopting a 4.5 percent target in the 1960s, as he suggests in his first piece, would have choked off a tremendous economic boom in which real GDP increased by 53 percent (as compared to 15 percent during the 2000s).

To quote Cooper, there are two problems here.  First, the difference between 4.5% and 5.0% is unimportant (and I’ve frequently indicated that I’d be fine with either number, or even 4.0%, level targeting.) More importantly, he’s completely wrong about the 1960s. Monetary policy has no long run effect on RGDP growth. Money is roughly superneutral, except at very low rates—far below the rates of the 1960s. The 1960s would have been booming even with a 4.5% NGDP target, and we would have avoided a painful squeeze on the economy in the early 1980s if we’d never let high inflation out of the bag.

The other problem is much more important, and it entails a truly enormous downside risk. Ponnuru argues that a return to the previous economic trend is rapidly becoming impossible. But what if he’s wrong?

If he’s wrong then the economy will find that old RGDP trend line, even with 4.5% NGDP growth.  That’s because 4.5% NGDP growth, when combined with 2% wage growth, leads to a rapidly falling unemployment rate.  It may not feel that way, but we are recovering—indeed we are doing so with less than 4.5% NGDP growth.

A permanent 1.45 percentage point decline in America’s nominal growth path would be indescribably disastrous. As Brad DeLong calculates, by 2014 the cumulative lost output of the Great Recession through that year amounted to roughly $60,000 per person. If nothing restores the trend, the amount lost could reach into the hundreds of thousands, per person.

Again, the growth rate doesn’t matter, unless you fall to very low levels.  Japan has even adjusted to a lower NGDP growth rate.  What matters is volatility.

I think some people were confused by the market monetarist message in 2009, assuming that once a dove, always a dove.  Now it’s quite possible that I’ll end up being dovish for most of the rest of my life, just as I was hawkish during the entire 1970s and early 1980s.  But that’s only if the Fed keeps missing on the low side. The model is symmetrical, and there is no reason at all for all market monetarists to agree on what the Fed should do right now, when the Fed is not even targeting NGDP.  We are in the world of second best, where opinions will differ.

No, conservatives that have adopted market monetarism are not abandoning the ship. Indeed we are still growing.

HT:  Ramesh Ponnuru

Hawks try to rewrite history

LK Beland pointed me to a new Lars Svensson post, which demolishes the Riksbank’s defense of its tight money policy:

In an interview in Bloomberg, Riksbank Deputy Governor Per Jansson again tries to defend the indefensible, the Riksbank’s sharp tightening of monetary policy in the summer of 2010. From the summer of 2010 to the summer of 2011, the Riksbank majority increased the policy rate from 0.25 percent to 2 percent.

The increases “from 0.25 percent in the summer of 2010 up to 2 percent in the middle of 2011 was really mostly about normal things that central banks look at,” given that growth at the time was about 6 percent, inflation was around 2 percent and household credit growth was about 9 percent, [Jansson] said. “There were really, in real time, no comments suggesting that it would be a stupid idea to increase the interest rate.”

But in real time, the Riksbank’s inflation forecast was below the inflation target and unemployment and the unemployment forecast were far above the Riksbank’s estimate of a long-run sustainable rate. In such a situation, easing, not tightening, is the right policy, since it shifts the inflation forecast up and closer to the target and the unemployment forecast down and closer the long-run sustainable rate. It thereby leads to better target achievement. Since tightening instead leads to worse target achievement, it is indefensible. My colleague in the Execeutive Board, Karolina Ekholm, and I indeed dissented from this tightening policy with very clear and logical arguments, namely that easier policy would in this situation lead to better target achievement.

Jansson’s claim of no opposition is extremely misleading, to put it mildly. It’s public knowledge that there was strong opposition to excessively tight money in Sweden by 2011.  The hawks were explicitly ignoring the Riksbank’s legal mandate, and several Riksbank members were pointing that out.  Here’s what was actually happening in 2011:

Ingves hire help to explain the rise in interest rates

Riksbank Governor Stefan Ingves interest rate increases has been questioned by everyone from finance minister to bank forecasters.

Express can today reveal that he hired a star consultant to defend the interest rate increases.

Cost: 140 000.

Riksbank Governor Stefan Ingves has been under fire recently.  Internally, the Bank, he has met with resistance by the so-called doves – Lars EO Svensson and Karolina Ekholm – who time and again expressed its reservations about interest rate hikes and sharp interest rate forecasts.

So the criticism of the hawks was so strong that by 2011 they were hiring a consultant to defend themselves against the dissents of several members of the Riksbank, including Lars Svensson.

For years the hawks have been telling me that monetary stimulus would lead to high inflation.  Now that they’ve been proved wrong, the new strategy is to say, “who could have known that we weren’t doing enough monetary stimulus?” Pathetic.

PS. Who could have known?  The market.

Don’t mix up tactics and strategy (The Straight Story)

Here’s commenter Philo, quoting me and then responding:

“It’s hard to evaluate current policy without knowing where the Fed wants to go, and they refuse to tell us where they want to be in 10 years, either in terms of the price level or NGDP. If they would tell us, I’d recommend they go there in the straightest path possible.” But why accept the Fed’s objective, whatever it may be, as valid? If they wanted to take us to hell, would you recommend that they do so as efficiently as possible? I think the Fed needs your advice about *what objective to aim for*, as well as about how to achieve that objective.

I do give the Fed both kinds of advice, but it’s very important not to mix them up. Suppose while living in Madison I get into an argument with friends about whether to vacation in Florida or California.  I lose the argument and we decide on Florida.  I’m in charge of directions.  Do I have the car head SW on highway 151, or southeast on I-90? If I suggest southwest, because I want to go to California, then when the vegetation starts getting sparse they’ll realize we are going the wrong way, and lots of needless extra driving will occur—the travel equivalent of a business cycle.

Now suppose I favor 5% NGDP growth and the Fed favors something closer to 3% in the long run.  In that case I may suggest they change their target to 5%, but it’s silly for me to give them tactical advice consistent with a 5% target.  After a few years of that we’d plunge to 1%, to create the 3% long run average.  Again we’d get a needless business cycle.  Whichever way they want to go, I’d like them to go STRAIGHT.

Tyler Cowen has a post that links to a FT story warning of a possible repeat of 1937. They should have warned of a possible repeat of 1937 and 2000 and 2006 and 2011, when various central banks tightened prematurely at the zero bound.  Did they ever tighten too late?  Yes, in 1951, in circumstances totally unlike today.  So yes, I’m worried about a repeat of 1937.  I currently think the odds are at least 4 to 1 against a double dip recession next year, but I’d like to see the Fed make those odds smaller still.

Tyler also links to a Martin Wolf piece that starts out very sensibly; pointing out that low rates do not mean money has been easy.  But then Wolf slips up:

The explosions in private credit seen before the crisis were how central banks sustained demand in a demand-deficient world. Without them, we would have seen something similar to today’s malaise sooner.

I see his point, and it’s true in a certain way.  But it’s also a bit misleading.  It would be much more accurate to say that central banks sustained demand by printing enough money to keep NGDP growing at 5%, and could have continued doing so if they had wished to.  It so happens that bad regulatory policies pushed much of that extra demand into credit financed housing purchases, instead of restaurant meals, vacations, cars, etc.  But that has nothing to do with monetary policy, which is supposed to determine AD.

Tyler comments on the debate:

I see a few possibilities:

1. Stock and bond markets are at all-time highs, and we Americans are not so far away from full employment, so if we don’t tighten now, when?  Monetary policy is most of all national monetary policy.

I’d say we tighten when doing so is necessary to hit the Fed’s dual mandate.  And how are stock and bond prices related to that mandate?  And what does Tyler mean by “tighten?”  Does he mean higher interest rates?  Or slower NGDP growth (as I prefer to define tighten)?

I do agree that the Fed should focus on national factors, but otherwise I think Tyler needs to be more specific.  Is he giving advice about tactics or strategy?  Does he believe this advice would help the Fed meet its 2% PCE inflation target?  If so, then why?  Notice that the inflation rate is not mentioned in his discussion of what the Fed should do, even though the Fed has recently adopted a 2% inflation target (2.35% if using the CPI), and is widely expected to undershoot that target for years to come.

2. It’s all about sliding along the Phillips Curve.  Where are we?  Who knows?  But risks are asymmetric, so we shouldn’t tighten prematurely.  In any case we can address this problem by focusing only on the dimension of labor markets and that which fits inside the traditional AD-AS model.

I agree with this, although I think the first and last parts of it are poorly worded.  I think he’s saying that we don’t know where we are relative to the natural rate of unemployment, which is true.  But the term ‘Phillips Curve’ is way too vague, unless you are already thinking along the lines I suggested.  Yes, the risk of premature tightening is important.  Even worse, the risks facing the Fed are somewhat asymmetric, due to their reluctance to target the forecast at the zero interest rate bound.  So excessively tight money will cost much more than excessively easy money, in the short run.  But what about the long run?  Again, that depends on the Fed’s long run policy goals, and they simply won’t tell us.  For instance, if the policy was something like level targeting, then the risks would again become symmetric–overshoots are just as destabilizing as undershoots under level targeting.  That’s one more reason to switch to level targeting.

I also find the last part to be rather vague (although maybe that just reflects my peculiar way of looking at things.)  I certainly think the labor market and AS/AD are the key to monetary policy analysis, but those terms can mean different things to different people. I think Tyler sometimes overestimates the ability of his readers (including me) to follow his train of thought.  “Labor market” might mean nominal wage path or U-3 unemployment.  Those are actually radically different concepts, as the first is a nominal variable and the other a real variables.

Tyler continues:

3. The Fed’s monetary policies have created systemic imbalances, most of all internationally by creating or encouraging screwy forms of the carry trade, often implicit forms.  A portfolio manager gains a lot from risky upside profit, but does not face comparable downside risk from trades which explode in his or her face.  The market response to the “taper talk” of May 2013 (egads, was it so long ago?) was just an inkling of what is yet to come.

Which “policies?”  Is he referring to excessively easy or excessively tight money?  No way for me to tell.  I think policy has created imbalances by being too tight.  I think an easy policy would have led to fewer imbalances.  But most people believe exactly the opposite.  Given that Tyler wants to be understood, it’s probably better to assume he’s addressing “most people.”

How has the Fed’s monetary policy contributed to the carry trade?  At this point I know that some people will want to jump in and insist that it’s all about interest rates.  But interest rates are very different from monetary policy.  And even if you think low rates are the issue, you’d have to decide whether the low rates were caused by easy money or tight money.  As I just mentioned, even sensible non-MMs like Martin Wolf are now skeptical of the idea that they reflect easy money.  So if low rates are the problem, should money have been even easier?  Easy enough to produce positive nominal interest rates such as what we see in Australia?  But wait, Australia’s having the mother of all housing “bubbles,” “despite” the fact that their interest rates are higher than in other countries.  (Sorry for two consecutive scare quotes; I’m getting so contrarian that I’ve almost moved beyond the capabilities of the English language.  Maybe that’s a sign I should stop here.)

No, I’m not done yet.  Why does 2013 suggest that Fed policy has a big effect on emerging markets?  As I recall, the unexpected delay in tapering in late 2013 had a very minor impact, suggesting the earlier EM turmoil mostly reflected other issues, not taper fears.

4. The Fed’s monetary policies have created systemic imbalances, most of all internationally by creating or encouraging screwy forms of the carry trade, often implicit forms.  Fortunately, we have the option of continuing this for another year or more, at which point most relevant parties will be readier for a withdrawal of the stimulus.  That is what patience is for, after all.  To get people ready.

OK, now I see.  I misread what Tyler was doing—these are “possibilities” not his actual views.  Yes, the Fed should be patient here, but certainly not in order to bail out speculators.

5. We should continue current Fed policies more or less forever.  Why not?  The notion of systemic imbalances is Austrian metaphysics, so why pull the pillars out from under the temple?  Let’s charge straight ahead, because at least we know the world has not blown up today.

Forever?  If “Fed policies” means the relatively steady 4% to 4.5% NGDP growth over the past 6 years then yes, by all means let’s continue them forever.  If it means zero interest rates, then no.

Of course now that I know that these are not necessarily Tyler’s views, I can see some sarcasm in the last sentence.  Once again, it all comes down to how we define monetary policy, how we define “straight ahead.”

At least physicists know the difference between up and down. It’s a pity that economists continue to debate the proper stance of monetary policy without having a clue as to what the phrase “stance of monetary policy” means.  As we saw in 2008, that confusion is unlikely to end well.

Alternatively, once we all agree to go straight ahead, we need to find some way to agree on what “straight” means.

PS.  The old man in The Straight Story (who reminded me of my dad) went the opposite way from what I proposed–northeast towards Wisconsin.

Krugman on European growth and the euro

In a recent post I responded to this claim by Paul Krugman:

I’ve already argued that the fall in the euro is much bigger than you can explain with monetary policy; it seems to reflect the perception that Europe is going to be depressed for the long term. And if that’s what drives the weak euro/strong dollar, it will hurt US growth.

I said (without reading the linked to post):

I agree with the reasoning process in the last sentence.  But I don’t think it applies to the current case, as it seems very unlikely that lower growth expectations are what is depressing the euro.  Here’s what we do know:

1.  Eurozone growth expectations have been in the toilet for years.

2.  The euro was valued at about $1.35 for years, and then gradually fell to about $1.05 over the past few months.

3.  During the past few months the growth forecasts of the eurozone have been revised upward, as the euro has been falling.

You don’t need to be an EMH fanatic like me to see a problem with Krugman’s argument. Kudos to him for not reasoning from a price change, for not lazily assuming that a weaker euro meant more growth.  But I think’s he’s gone too far in the other direction, in assuming that the cause of the weaker euro was lower growth expectations.

Vaidas Urba suggested I do look at the linked post.  And I was quite shocked to find it began as follows:

Watch that plunging euro! Actually, it’s good news for Europe. European growth numbers have been better lately, and the weak euro — which makes EZ manufacturing and other tradables more competitive — is surely a large part of the explanation. Not so good for Japan or the US. But how should we think about this?

Wait, that’s my argument—the weaker euro is associated with stronger eurozone growth.  Therefore it’s monetary stimulus at work.  But if you read the entire post you’ll see Krugman does actually have a good argument, albeit one that raises as many questions as it answers.  And I might add that it’s one I’m pretty sure that 99% of his readers would not have understood.

Let’s first discuss Rudi Dornbusch’s (1975) overshooting model, which is sort of lurking in the background.  Dornbusch thought about the impact of monetary stimulus in a world of interest parity, PPP and sticky prices.  The result is quite odd. Suppose the ECB does a once and for all permanent 10% increase in the money supply.  The quantity theory says this will raise prices by 10% on the long run.  And PPP says that will depreciate the euro by 10% in the long run.  So far, so classical. But sticky prices imply a liquidity effect, thus the monetary injections lower nominal interest rates for a few years.  And because of the interest parity condition, lower interest rates imply a higher expected rate of appreciation in the euro. But didn’t I just say the euro would depreciate?  Yes I did, and there is no contradiction.  If you are not seeing the answer, you need to think outside the box. First do some brain exercises.  Connect these 9 dots with 4 lines, without taking your felt tip pen off the paper:

Screen Shot 2015-03-16 at 12.25.14 PM

For simplicity, suppose we started with US and eurozone interest rates being equal. After the monetary injection the eurozone rates are lower.  So the euro is expected to appreciate.  But in the long run it’s expected to be 10% lower.  That means the immediate effect of a monetary stimulus shock must be a more that 10% decline in the euro.  Dornbusch called this exchange rate overshooting.  The model is composed of 4 theories (QTM, PPP, IPT, liquidity effect.)  Most of us are not as adept at juggling 4 theoretical balls in the air at the same time as Krugman, so we struggle with the concept.  As for empirical evidence, these things are hard to test. I’d argue that each component is pretty well established, and that’s good enough (and I suspect Krugman would agree.)  In any case, it’s too beautiful a theory not to use once and a while.  Here’s Krugman:

So, can we say anything about how the recent move in the euro fits into this story? One way, I’d suggest, is to ask how much of the move can be explained by changes in the real interest differential with the United States. US real 10-year rates are about the same as they were in the spring of 2014; German real rates at similar maturities (which I use as the comparable safe asset) have fallen from about 0 to minus 0.9. If people expected the euro/dollar rate to return to long-term normal a decade from now, this would imply a 9 percent decline right now.

What we actually see is almost three times that move, suggesting that the main driver here is the perception of permanent, or at any rate very long term European weakness. And that’s a situation in which Europe’s weakness will be largely shared with the rest of the world — Europe will have its fall cushioned by trade surpluses, but the rest of us will be dragged down by the counterpart deficits.

Now, this is not how most analysts approach the problem. They make a forecast for the exchange rate, then run this through some set of trade elasticities to get the effects on trade and hence on GDP. Such estimates currently indicate that the dollar will be a moderate-sized drag on US recovery, but no more. What the economic logic says, however, is that if that’s really true, the dollar will just keep heading higher until the drag gets less moderate.

Krugman’s looking at real rates to abstract from inflation.  While the Dornbusch overshooting model does a nice job of explaining the recent dramatic plunge in the euro, the model also predicts that the real exchange rate is unaffected in the long run. But that’s because interest rates are unaffected in the long run.  Krugman’s readers don’t know this, but unless I’m mistaken he’s arguing that the recent fall in long-term interest rates in Europe is the income effect, not the liquidity effect.  I actually like that argument, but it’s not the way Keynesians usually look at changes in long-term rates occurring in close proximity to QE.  Most Keynesians would say the ECB is driving bond long term bond yields lower.

So Krugman’s arguing that the big fall in the expected 10-year future exchange rate reflects worsening prospects for long term European growth, not just monetary stimulus.  That argument makes sense to me.  But he’s also arguing that this increasing long-term pessimism occurred at almost exactly the same time that expectations of short-term growth became more optimistic.  That might be true, but I kinda doubt it. And yet I can’t think of a better explanation for the fall in the future expected value of the euro.

So I’ll file this under “unresolved problems.”

PS.  He ends up relying on liquidity trap arguments to draw policy conclusions for the US.  But as I argue in today’s Econlog post (later this afternoon), those arguments are rapidly approaching their “sell by date.”

PPS. The eurozone demand side recession is likely to be over in 10 years.  That means Krugman’s hypothesis implies severe structural problems in Europe—bad news for a continent with 7% of the world’s people, 25% of the world’s GDP, and 50% of the world’s social spending.

PPPS.  Oh yeah, the puzzle.  Because Ray claims his IQ is only 120, he probably provided answer #2. But answer #1 is correct.  I’m sure Rudi would have been able to solve the puzzle. My dad did it first in a competition among friends back in 1962.

Screen Shot 2015-03-16 at 1.23.08 PM

Brilliant Krugman, dumb leftists

In all of the discussion about how wrong the right has been about monetary issues over the past 7 years, it’s also worth pointing out some flaws on the other side.  But first let’s start with the good news.  To put the following Paul Krugman quote into context, he’s responding to a Ambrose Evans-Pritchard story (exposé?) that the Fed sees falling long term rates as a sign of monetary ease, calling for a bit tighter policy stance.  Here’s Krugman making the observation that a contractionary demand shock can actually lead to lower long term interest rates over time:

A first-pass way to think about this is surely to suppose that the Fed sets U.S. interest rates, so that an increased willingness of foreigners to hold our bonds shows up initially as a rise in the dollar rather than a fall in rates. This may then induce a fall in rates because the stronger dollar weakens both growth and inflation, affecting Fed policy – but this means that the rate effect occurs because the capital inflow is contractionary, and is by no means a reason to tighten policy.

It’s only one step from there to Milton’s Friedman observation that low interest rates mean that money has been tight.

Some of my liberal commenters make a big deal of the fact that Krugman, and other liberals bloggers (DeLong, Thoma, Duy, Yglesias, Wren-Lewis, etc.) have favored monetary stimulus, and that lots of silly right wing Congressmen have opposed these policies.

On the other hand the left has not exactly covered itself in glory.  President Obama has done essentially nothing over the past 6 years to promote monetary stimulus.  Ditto for European social democrats.  Elizabeth Warren suggested that ultra-hawk Paul Volcker would be a dream candidate for  Fed chairman (no, I’m not joking.)  And now we have the Finance Minister of Greece, a country fanatically opposed to any sort of meaningful supply-side reform, denigrating Greece’s only hope for a demand-side economic recovery:

The European Central Bank’s bond purchases will create an unsustainable stock market rally and are unlikely to boost euro zone investments, Greek Finance Minister Yanis Varoufakis warned on Saturday.

The ECB began a program of buying sovereign bonds, or quantitative easing, on Monday with a view to supporting growth and lifting euro zone inflation from below zero up towards its target of just under 2 percent.

Bond yields in the currency bloc have collapsed, but record low interest rates so far have not spurred investments that would support growth in recession-hit countries like Italy or Spain.

“QE is all around us and optimism is in the air,” Varoufakis told a business audience in Italy. “At the risk to sound the party pooper … I find it hard to understand how the broadening of the monetary base in our fragmented and fragmenting monetary union will transform itself into a substantial increase in productive investments.

“The result of this is going to be an equity run boost that will prove unsustainable,” he said.

I don’t know whether to laugh or cry.  As Tyler Cowen keeps saying, these are not serious people.

PS.  In the right column of this blog I’ve had a pathetically inadequate and useless set of “categories.”  I’m in the process of vastly expanding that list, although I’m still struggling with how to categorize monetary policy posts—there are too many.  This post will go into the new category “praising Krugman,” among others.  This revision process will take a long time, I’ve only recategorized about the first 100 posts, out of over 2800. So for quite a while these new categories will only include a tiny fraction of the relevant posts.  It’s actually part of a project to turn my blog into a book.

HT:  Luis Pedro Coelho