Archive for the Category Cognitive illusions


The problem with “existing store sales”

Quick follow up to my previous post.  Some commenters seem confused about the distinction between existing retailers and new retailers.  New retailers can have a dramatic impact on growth rates, even if a small part of the total.  For simplicity, assume that 94% of the Chinese retail sector is more than year old, and 6% is comprised of new brick and mortar retailers. (Many retailers in China are small family firms, and the country is urbanizing rapidly.)  Also assume that the growth rate of sales at existing brick and mortar retailers (plus those that closed down) is 0%. The growth rate of online is 33% and they comprise 15% of retail.  The new firms might not seem to be a big enough share of the market to dramatically impact the overall growth rate.  In fact, if new firms are 6% of the market, then their contribution to retail sales growth would also be 6%, as (by assumption) they were zero percent of the market one year earlier.

I’d guess that about 5% of China’s 11% retail growth is from online firms, another 6% from new firms, and essentially zero from existing firms.  (That’s based on information in a recent Tyler Cowen post that suggests existing retailer sales are flat.)

I’m sticking with my 6% RGDP forecast for 2016.

Off topic, suppose markets are OK with 1/8% but not 1/4%. How should they respond if this is the Fed’s strategy?

At VTB, global strategist Neil MacKinnon says a 1/8 percentage point increase — which would be the first such move since December 1986 — should be accompanied by a signal from Chair Janet Yellen that the Fed will act again in October if the initial shift has proved acceptable to markets.

And are all Cretans still liars?

Seeing Lu Mountain

Brad DeLong has a post discussing a debate between Paul Krugman and Roger Farmer:

I find myself genuinely split here. When I look at the size of the housing bubble that triggered the Lesser Depression from which we are still suffering, it looks at least an order of magnitude too small to be a key cause. Spending on housing construction rose by 1%-age point of GDP for about three years–that is $500 billion. In 2008-9 real GDP fell relative to trend by 8%–that is $1.2 trillion–and has stayed down by what will by the end of this year be seven years–that is $8.5 trillion. And that is in the U.S. alone. There was a mispricing in financial markets. It lead to the excess expenditure of $500 billion of real physical assets–houses–that were not worth their societal resource cost. And each $1 of investment spending misallocated during the bubble has–so far–caused the creation of $17 of lost Okun gap.

(You can say that bad loans were far in excess of $500 billion. But most of the bad loans were not bad ex ante but only became bad ex post when the financial crisis, the crash, and the Lesser Depression came. You can say that low interest rates and easy credit led a great many who owned already-existing houses to take out loans that were ex ante bad. But that is offset by the fact that the excess houses built had value, just not $500 billion of value. I think those two factors more or less wash each other out. You can say that it was not the financial crisis but the destruction of $8 trillion of wealth revealed to be fictitious as house prices normalized that caused the Lesser Depression. But the creation of that $8 trillion of fictitious wealth had not caused a previous boom of like magnitude.)

To put it bluntly: Paul is wrong because the magnitude of the financial accelerator in this episode cries out for a model of multiple–or a continuous set of–equilibria. And so Roger seems to me to be more-or-less on the right track.

DeLong is certainly right that the housing bust is far too small, but it’s even worse than that.  The vast majority of the housing bust occurred between January 2006 and April 2008, and RGDP actually rose during that period, while the unemployment rate stayed close to 5%.  So it obviously wasn’t the housing bust.  On the other hand you don’t need exotic theories like multiple equilibria—the Great Recession was caused by tight money.  It’s that simple.

Or is it?  Most economists think that explanation is crazy.  They say interest rates were low and the Fed did QE.  They dismiss the Bernanke/Sumner claim that interest rates and the money supply don’t show the stance of monetary policy. Almost no one believes the Bernanke/Sumner claim that NGDP growth and/or inflation are the right way to evaluate the stance of policy.  Heck, even Bernanke no longer believes it.

And even if I convinced them that money was tight they’d ask what caused the tight money, or make philosophically unsupportable distinctions between “errors of omission” and “errors of commission.”

In previous blog posts I’ve pointed out that it’s always been this way.  If in 1932 you had said that tight money caused the Great Depression, most people would have thought you were crazy.  Today that’s the conventional wisdom.  If in the 1970s you’d claimed that easy money caused the Great Inflation, almost everyone except a few monetarists would have said you were crazy.  Now that’s the conventional wisdom.  Even the Fed now thinks that it caused the Great Depression and the Great Inflation.  (Bernanke said, “We did it.”)

The problem is that central banks tend to follow the conventional wisdom of economists.  So when central banks screw up, the conventional wisdom of economists will never blame the central bank (at the time); that would be like blaming themselves. They’ll invent some ad hoc theory about mysterious “shocks.”

The other night at dinner my wife told me that the Chinese sometimes say, “If you cannot see the true shape of Lu Mountain, it’s because you are standing on Lu Mountain.”

In modern conventional macro, most people look at monetary policy from an interest rate perspective.  That means they are part of the problem.  They are looking for causes of the Great Recession, not understanding that they (or more precisely their mode of thinking) are the cause.

Only the small number of economists who observed Mount Lu from other peaks, such as Mount Monetarism or Mount NGDP Expectations, clearly saw the role of central bank policy.  People like Robert Hetzel, David Beckworth, Tim Congdon, etc.

PS.  Before anyone mentions the zero bound, consider two things:

1.  The US was not at the zero bound between December 2007 and December 2008 when the bulk of the NGDP collapse occurred, using monthly NGDP estimates.

2.  Do you personally support having the Fed use a policy instrument that freezes up exactly when you need it most desperately?  Or might the problem be that they’ve chosen the wrong instrument?

PPS.  Yes, not everyone on Mount Monetarism saw the problem, but as far as I know no one on Mount Interest Rate got it right.  Perhaps Mount Interest Rate is Lu Mountain.

PPPS.  To his credit, Brad DeLong thought the Fed should have promised to return NGDP to the old trend line.  If they’d made that promise there would have been no Great Recession, just a little recession and some stagflation.

Xenophobia plus cognitive illusions = mass ignorance

Don’t be offended by the title of this post.  I’d guess 99.9999999% of people don’t understand currency manipulation or quantum mechanics.  So I’m using the term ‘ignorance’ loosely. And of course since I’m in the tiny minority (of seven people, based on the percentage above), there’s always the small chance that I’m the stupid one.  This post is to organize my thoughts, as I’m going to be interviewed on “currency manipulation” tomorrow.

Let’s start with the term ‘currency manipulation.’  That’s what central banks do.  They manipulate the nominal value of currencies.  Period. End of story.  On the other hand:

1.  Monetary policy has no long run effect on real exchange rates.  Once wages and prices adjust, real exchange rates go back to their equilibrium values.

2.  In the short run, central banks can reduce real exchange rates via easy money, however . . .

a.  There is little evidence that this creates a more “favorable” trade balance, for standard income and substitution effect reasons.

b.  The term “favorable” is misleading, as trade surpluses do not steal jobs from other countries, they do not depress AD in other countries, for standard monetary offset reasons.

3.  Real and nominal exchange rates are so different that they should not even be covered in the same course.  And yet 99% of the discussion of exchange rates doesn’t even make clear which concept is being discussed.

4.  Currencies can be manipulated equally well under fixed and floating exchange rates.  That distinction has no importance for any policy issue that I know of.  The fact that a country “pegs” an exchange rate doesn’t mean it manipulates it, except in the sense that all central banks manipulate the value of their currencies.

5.  Many people focus on long run chronic current account (CA) surpluses, and regard those currencies as “undervalued”.  If that’s your concern then you should focus on the real exchange rate, as the nominal exchange rate doesn’t matter in the long run.  (Here I’m thinking about complaints of chronic CA surpluses in Germany, China, Japan, etc.)

6.  There is no theoretical justification for assuming that long term CA surpluses imply undervalued currencies.  None.  At the cyclical frequency there is a Keynesian argument against CA surpluses, which I regard as beyond lame, bordering on preposterous.  But for long run surpluses in China or Germany, there is no argument at all.  The idea that CA surpluses help a country “develop” is laughable.

7.  Monetary policy can’t generate a “undervalued currency” in the long run.  It’s not clear if any government policy could, but the best argument would be that pro-saving policies could lead to lower real exchange rates and CA surplus.

8. This means that in the long run it makes no difference whether a country has its own currency or not. Germany and the Netherlands can “manipulate” their real exchange rate just as easily as Britain, even though they lack their own currency.  They can do so (if at all) by implementing pro-saving policies.

9.  Any pro-saving policy will do, it makes no difference whether the government buys foreign bonds, domestic bonds, or domestic stocks.  If Germany stops taxing capital gains, that will boost domestic saving.  If Singapore and Norway create sovereign wealth funds for future retirees, that’s pro-saving.  And of the PBoC buys lots of Treasuries bonds at a fixed currency peg, that’s pro-saving.  It’s impossible to say that one country “manipulated” its currency more than the other.  But that doesn’t stop 99.9999999% of people, including most economists, from pointing at China.

So basically nobody knows what currency manipulation is, or how to identify it. Almost no one understands the crucial difference between real and nominal exchange rates. No one seems to understand that all central banks manipulate nominal exchange rates, and in the short run, real exchange rates.  No one understands that currency manipulation has nothing to do with fixed vs. floating rates.  No one understands that (in the long run) eurozone countries can manipulate their currencies (real exchange rate) just as easily as countries with their own central bank.  No one understands that currency manipulation may not even affect the CA in the short run, or that changes in the CA don’t affect AD in other countries.

And yet there is room for hope!  Despite this tale of woe, all is not lost. It turns out that complainers are paper tigers.  Countries are often falsely accused of currency manipulation, but no one ever does anything about it.  Is that because they secretly know I’m right?  Don’t make me laugh.  They are cowards, thank God.  The Great Depression and WWII made countries more passive.  I hope they stay that way.

PS.  The real exchange rate is the nominal rate (value of domestic currency) times the domestic price level, divided by the foreign price level.

PPS.  Do I still believe in the wisdom of crowds, despite 99.9999999% being wrong? You bet I do!  I believe that if the Fed “manipulates” the dollar lower at the next FOMC meeting, foreign stock markets will rise, despite our “beggar thy neighbor” policy. People are stupid but markets are very, very wise.

If something can’t go on forever . . . it will

Occasionally I do post inverting Ben Herbert Stein’s famous observation:

If something can’t go on forever, it won’t.

Some of my commenters say things that are clearly not true, such as the claim that NGDP cannot keep growing at 5% forever.  Yet even economists can make those sorts of claims, as when they argue that Australia can’t keep running 4% of GDP current account deficits forever.  (I heard that when I lived there in 1991, and yes it can.)  Here’s an old FT article by Willem Buiter from January 2009, which is worth re-reading to get a sense of how even very smart people can misjudge which trends are unsustainable:

Some of the excess returns on US investment abroad relative to foreign investment in the US may have reflected true alpha, that is, true US alpha – excess risk-adjusted returns on investment in the US, permitting the US to offer lower financial pecuniary risk-adjusted rates of return, because, somehow, the US offered foreign investors unique liquidity, security and safety.  Because of its unique position as the world’s largest economy, the world’s one remaining military and political superpower (since the demise of the Soviet Union in 1991) and the world’s joint-leading financial centre (with the City of London), the US could offer foreign investors lousy US returns on their investments in the US, without causing them to take their money and run.  This is the “dark matter” explanation proposed by Hausmann and Sturzenegger for the “alpha” earned by the US on its (negative) net foreign investment position. If such was the case (a doubtful proposition at best, in my view), that time is definitely gone.  The past eight years of imperial overstretch, hubris and domestic and international abuse of power on the part of the Bush administration has left the US materially weakened financially, economically, politically and morally.  Even the most hard-nosed, Guantanamo-bay-indifferent potential foreign investor in the US must recognise that its financial system has collapsed.  Key wholesale markets are frozen; the internationally active part of its financial system has either been nationalised or underwritten and guaranteed by the Federal government in other ways. Most market-mediated financial intermediation has ground to a halt, and the Fed is desperately trying to replace private markets and financial institutions to intermediate between households and non-financial operations.  The problem is not confined to commercial banks, investment banks and universal banks.  It extends to insurance companies (AIG), Quangos (a British term meaning Quasi-Autonomous Government Organisations) like Fannie Mae and Freddie Mac, amorphous entities like GEC and GMac and many others.

The legal framework for the regulation of financial markets and institutions is a complete shambles.  Even given the dismal state of the legal framework, the actual performance of key regulators like the Fed and the SEC has been appalling, with astonishing examples of incompetence and regulatory capture.

There is no chance that a nation as reputationally scarred and maimed as the US is today could extract any true “alpha” from foreign investors for the next 25 years or so. So the US will have to start to pay a normal market price for the net resources it borrows from abroad. It will therefore have to start to generate primary surpluses, on average, for the indefinite future.  A nation with credibility as regards its commitment to meeting its obligations could afford to delay the onset of the period of pain.  It could borrow more from abroad today, because foreign creditors and investors are confident that, in due course, the country would be willing and able to generate the (correspondingly larger) future primary external surpluses required to service its external obligations.  I don’t believe the US has either the external credibility or the goodwill capital any longer to ask, Oliver Twist-like, for a little more leeway, a little more latitude.  I believe that markets – both the private players and the large public players managing the foreign exchange reserves of the PRC, Hong Kong, Taiwan, Singapore, the Gulf states, Japan and other nations – will make this clear.

There will, before long (my best guess is between two and five years from now) be a global dumping of US dollar assets, including US government assets.

Maybe eventually, but don’t hold your breath.

Hmmm, I wonder if it’s time again for one of my “Apocalypse Later” posts on how another year went by without the expected collapse of the Chinese economy.  I’ll take China’s 7% RGDP growth with all its “imbalances” over Brazil’s 0% growth.

PS.  There are lessons in Buiter’s erroneous forecast.  He lets emotion get in the way of cold hard logic.  I can see how people believed that after all its economic/foreign policy screw-ups the US deserved to get its comeuppance.  But life is not fair.

What if Wittgenstein had been a macroeconomist?

The commenter Jason sent me a great Wittgenstein quotation, and I immediately knew I had to use it somewhere.  It took me 10 seconds to decide where:

“Tell me,” the great twentieth-century philosopher Ludwig Wittgenstein once asked a friend, “why do people always say it was natural for man to assume that the sun went around the Earth rather than that the Earth was rotating?” His friend replied, “Well, obviously because it just looks as though the Sun is going around the Earth.” Wittgenstein responded, “Well, what would it have looked like if it had looked as though the Earth was rotating?”

It’s quotations like this that make life worth living.  So I wondered what Wittgenstein would have thought of the current crisis:

Wittgenstein:  Tell me, why do people always say it’s natural to assume the Great Recession was caused by the financial crisis of 2008?

Friend:  Well, obviously because it looks as though the Great Recession was caused by the financial crisis of 2008.

Wittgenstein:  Well, what would it have looked like if it had been caused by Fed policy errors, which allowed nominal GDP to fall at the sharpest rate since 1938, especially during a time when banks were already stressed by the subprime fiasco, and when the resources for repaying nominal debts come from nominal income?

OK, not nearly as elegant as Wittgenstein’s example.  But you get the point.

Jason also wonders what future generations will think of the Keynesian/monetarist split.  Which model will seem like the Ptolemaic system?  I won’t answer that, but will take a stab at a related question.  The Great Depression was originally thought to be due to the inherent instability of capitalism.  Later Friedman and Schwartz blamed it on a big drop in M2.  Their view is now more popular, because it has more appealing policy implications.  It’s a lot easier to prevent M2 from falling, than to repair the inherent instability of capitalism.  Where there are simple policy implications, a failure to do those policies eventually becomes seen as the “cause” of the problem, even if at a deeper philosophical level “cause” is one of those slippery terms that can never be pinned down.

In 50 years (when we are targeting NGDP futures contracts) the Great Recession will be seen as being caused by the Fed’s failure to prevent NGDP from falling.  Not through futures contracts (which didn’t exist then) but through a failure to engage in the sort of “level targeting” that Bernanke recommended the Japanese try during their similar travails.

PS.  W. Peden thinks the quotation is apocryphal, and notes that it’s used in Tom Stoppard’s play “Jumper.”  For some reason I prefer it be Wittgenstein.