Archive for the Category Never Reason From a Price Change

 
 

Is the battle against “reasoning from a price change” unwinnable?

Over at Econlog, I have another post that touches on reasoning from a price change.  I must have already done a hundred such posts.  And yet every day I see more examples of this EC101 error in reasoning almost everywhere I look.  Not just among the uneducated, but in elite newspapers like the WSJ, NYT, Economist, etc. Here’s a new example from the FT:

Loose monetary policy led to share buybacks that enriched mainly the wealthy

One of the great ironies of the 10 years following the financial crisis is the way in which low interest rate monetary policy — which was designed to get Main Street USA back up and running and to help people buy homes and start businesses — has bolstered share prices and the markets more than it has helped ordinary Americans.

This is just embarrassing, and yet it happens all the time.  Is there any way to make people see that this is flat out wrong?  We teach students in EC101 not to reason from a price change, but people don’t seem to get the message.  What are we doing wrong?  Is there any way to explain this that I haven’t yet tried?  Lots of you commenters are closer to people with “average opinion” than I am.  Some of you may have recently learned not to reason from a price change.  So what works? What allows people to see that low interest rates are not a loose monetary policy?

PS.  A few reporters such as Caroline Baum warn against the fallacy of reasoning from a price change, but most don’t seem to get it.

The internet’s highest honor

Vaidas Urba pointed me to a very clever post by John Carney of CNBC.  It includes parodies of many well known bloggers, on the theme of Christmas and economics.  Here’s an example–see if you can guess who:

If the Fed would simply announce a nominal target for presents, we’d all receive more presents on Christmas day.  There are many ways to do NCPT, but I prefer that the Fed creates a presents futures market.

A lot of people look at the amount of presents under the tree and attempt to derive the stance of Santa.  But this is wrong.  You need to examine the demand for presents as well as the supply.  In general, a large pile of presents is a sign that Christmas policy has been too tight, while coal in the stocking is a sign that it has been too loose.

At the risk of spoiling the joke, I’m going to try to improve it further

A lot of people look at the amount of presents under the tree and attempt to derive the stance the parents’ generosity.  But this is wrong.   The pile of presents represents the interaction of generosity and deserts.  In general, a larger pile of presents is a sign that the stance of Christmas policy has been relatively generous.  But the level of generosity also depends on how many presents are deserved, which depends both on the behavior of the child and the wealth of the parents.  An increased pile might represent greater generosity, but also greater deserts, due to improved wealth and/or better behavior by the child.

Yeah, I know, I’ve ruined the joke.

PS.  Although I am now a “somebody”, I am under no illusion that I am anywhere but at the bottom of the class of people called “somebody”.  But at least I’m not a nobody.

Is price flexibility stabilizing?

Rajat directed me to a post by Miles Kimball, entitled “Pro Gauti Eggertsson”. Over at Econlog I discussed one paragraph from his post.  Here I’ll discuss another:

Gauti has also taken a lead in applying the same principles he applied to the Great Depression to the Great Recession. A hallmark of his papers is very careful discussion of how they relate to key controversies in the academic literature, and indeed, they go to the heart of some of the biggest issues in the study of business cycles and stabilization policy. Price flexibility and advance anticipation of inflation are often said to be the keys to monetary policy having no real effect on the economy. But along with Saroj Bhattarai and Raphael Schoenle, Gauti argues in “Is Increased Price Flexibility Stabilizing? Redux” that, short of perfect price flexibility, greater price flexibility is likely to be destabilizing. This idea has a long history, but had not been fully addressed within the context of Dynamic New Keynesian models without investment. Along with Marc Giannoni, Gauti argues in “The Inflation Output Trade-Off Revisited” that contrary to the idea that anticipated inflation does not matter, it can matter greatly when raising expected inflation loosens the zero lower bound. The argument is made in a very elegant and clear way.

In my view, higher expected inflation is  not expansionary, holding NGDP expectations constant.  Thus if NGDP is expected to grow at 5%, then higher inflation is associated with lower real GDP growth.  The proponents of the alternative view would claim that I’m missing the point, that higher inflation expectations will cause higher NGDP growth expectations.  I don’t think that’s right. A more expansionary monetary policy may cause both inflation and NGDP growth expectations to rise.  On the other hand, supply shocks can affect inflation expectations without impacting NGDP expectations. Never reason from a price level change—always reason from a NGDP growth change.

In 1929-32, President Hoover discouraged companies from cutting wages.  This made the Great Contraction of 1929-32 even worse than it otherwise would have been.  In contrast, wages were cut sharply during the severe deflation of 1920-21. Some free market purists make too much of this comparison, suggesting that tight money is not a problem if the government allows wages to be flexible.  Not true, the 1921 depression was quite deep.

But also pretty short.  And one reason it was so short is that in 1921 and 1922, wages adjusted quickly to the lower price level.  If Hoover (and FDR) had allowed wages to adjust in the 1930s, the Great Depression would have been much shorter.

Stable NGDP growth and non-intervention in wages and prices, these policies work together like a hand and glove.

PS.  I encourage people to read Giles Wilkes’s new piece on blogging.  Wilkes was nice enough to include me in with a group of much more deserving bloggers.  I was also pleased to see him talk about Steve Waldman, a wonderful blogger and also a good example of how the blogosphere is a meritocracy, where professional credentials do not matter.

PPS.  Trump?  Still  . . . an . . . idiot.

HT:  Tyler Cowen, Tom Brown

Krugman on high stock prices

Paul Krugman has an excellent post discussing why stock prices are relatively high.  Apart from the opening paragraph, where he (implicitly) dismisses the EMH and rational expectations, I almost entirely agree with his interpretation.  (OK, the last bit defending Obama is also a bit questionable.)  I have expressed similar views, although of course Krugman expresses his ideas in a much more elegant fashion.  David Glasner was critical of this observation by Krugman:

But why are long-term interest rates so low? As I argued in my last column, the answer is basically weakness in investment spending, despite low short-term interest rates, which suggests that those rates will have to stay low for a long time.

Here’s how David responded:

Again, this seems inexactly worded. Weakness in investment spending is a symptom not a cause, so we are back to where we started from. At the margin, there are no attractive investment opportunities.

First let’s be clear about what Krugman means by “investment spending” in the quote above.  He clearly does not mean the dollar volume of investment spending, in equilibrium, because equilibrium quantities cannot “cause” anything, including low interest rates.  Instead he means the investment schedule has shifted to the left, and that this decline in the investment schedule (on a savings/investment diagram) has caused the lower interest rates.  And that seems correct.

Unfortunately, Krugman adds the phrase “despite low short-term interest rates”, which only serves to confuse things. Changes in interest rates have no impact on the investment schedule.  There is nothing at all surprising about low investment during a time of low interest rates, that’s normally the relationship we see.  (Recall 1932, 1938, and 2009).

David is certainly right that Krugman’s statement is “inexactly worded”, but I’m also a bit confused by his criticism. Certainly “weakness in investment spending” is not a “symptom” of low interest rates, which is how his comment reads in context.  Rather I think David meant that the shift in the investment schedule is a symptom of a low level of AD, which is a very reasonable argument, and one he develops later in the post.  But that’s just a quibble about wording.  More substantively, I’m persuaded by Krugman’s argument that weak investment is about more than just AD; the modern information economy (with, I would add, a slow growing working age population) just doesn’t generate as much investment spending as before, even at full employment.

I’d also like to respond to David’s criticism of the EMH:

The efficient market hypothesis (EMH) is at best misleading in positing that market prices are determined by solid fundamentals. What does it mean for fundamentals to be solid? It means that the fundamentals remain what they are independent of what people think they are. But if fundamentals themselves depend on opinions, the idea that values are determined by fundamentals is a snare and a delusion.

I don’t think it’s correct to say the EMH is based on “solid fundamentals”.  Rather, AFAIK, the EMH says that asset prices are based on rational expectations of future fundamentals, what David calls “opinions”.  Thus when David tries to replace the EMH view of fundamentals with something more reasonable, he ends up with the actual EMH, as envisioned by people like Eugene Fama.  Or am I missing something?

In fairness, David also rejects rational expectations, so he would not accept even my version of the EMH, but I think he’s too quick to dismiss the EMH as being obviously wrong. Lots of people who are much smarter than me believe in the EMH, and if there was an obvious flaw I think it would have been discovered by now.

David concludes his post as follows:

Thus, an increasing share of total investment has become capital-deepening and a declining share capital-widening. But for the economy as a whole, this self-fulfilling pessimism implies that total investment declines. The question is whether monetary (or fiscal) policy could now do anything to increase expectations of future demand sufficiently to induce an self-fulfilling increase in optimism and in capital-widening investment.

I would add that the answer to the question that David poses is clearly “yes”, as the Zimbabweans have so clearly demonstrated.  I would rather avoid terms like “self-fulfilling pessimism”, as AD depends on monetary policy, or combined monetary/fiscal policy is you are a Keynesian.  Either way it don’t think it’s useful to view AD as depending on the expectations of investors, pessimistic or not.  Those expectations merely respond to what the policymakers are doing, or not doing, with NGDP.

PS.  Yes, I do understand that under certain monetary policy stances, such as a money supply or interest rate peg, exogenous expectations impact AD.  I just don’t think it’s useful to view those pegs as a baseline policy.

PPS.  Let me repeat what I said earlier, we are going to have an interesting test of the impact of uncertainty on (British) GDP, over the next few months.  Not a definitive test (which would require observations with and without NGDP targeting, to tease out AD vs. AS channels), but certainly a suggestive test.  I have an open mind at this point, and am eager to learn.

Bernanke on Brexit

Scott Freelander recently asked me about a Bernanke post, which appears to be guilty of reasoning from a price change:

The U.K. economic slowdown to come will be exacerbated by falling asset values (houses, commercial real estate, stocks) and damaged confidence on the part of households and businesses. Ironically, the sharp decline in the value of the pound may be a bit of a buffer here as, all else equal, it will make British exports more competitive.

Here I’d probably cut Bernanke a bit more slack than Scott, as the phrase “all else equals” seems a nod in the direction of the dangers of reasoning from a price change.  The pound fell sharply when the Brexit vote was announced, because of an anticipated decline in the demand for pounds.  Brexit will reduce the foreign demand for British goods, services and assets.  Since one needs pounds to buy British stuff, this reduces the value of the pound, as well as the quantity of exports. Think of it as a leftward shift in the demand for pounds, on an S&D diagram. Bernanke presumably meant that British exports fall by less than if the BoE had pegged the pound, while demand was shifting left.  That is correct.

One other point.  I recall one recent example where the pound fell a couple of cents on expansionary talk from Mark Carney.  That can be viewed as a positive shift in the supply of pounds, which would indeed boost exports.

Here’s another example that Scott noticed, from the same post:

In the United States, the economic recovery is unlikely to be derailed by the market turmoil, so long as conditions in financial markets don’t get significantly worse: The strengthening of the dollar and the declines in U.S. equities are relatively moderate so far. Moreover, the decline in longer-term U.S. interest rates (including mortgage rates) partially offsets the tightening effects of the dollar and stocks on financial conditions. However, clearly the Fed and other U.S. policymakers will remain cautious until the effects of the British vote are better sorted out.

Long-term rates probably fell due to a decline in expected NGDP growth after Brexit (or maybe a greater preference for safe assets).  Presumably Bernanke meant that the drop in long-term interest rates would be more expansionary than if the Fed had pegged those rates by selling T-bonds, right as expected NGDP growth in the US was declining.  Again I’m cutting Bernanke some slack, as he’s obviously a brilliant economist and in his memoir I recall him saying that rising long-term interest rates during QE could actually be a sign that it was working.  So I think his views are not far apart from mine.

Nonetheless, I’m pretty fanatic on the “never reason from a price change issue”, and I feel that even while Bernanke is aware of all the points I just made, talking about the effect of lower interest rates and lower exchange rates can tend to mislead the public.  In another recent post I said:

I certainly agree with the 38 out of 40 economists who view anti-trade deficit arguments as reflecting ignorance of the most basic ideas in EC101. And yet, according to the Council on Foreign Relations, guess who else is ignorant of EC101?

Since April, Treasury has been applying a quantitative framework to determine if a country is managing its currency inappropriately for competitive advantage–that is, keeping it undervalued. Japan already meets two of the three criteria–a bilateral trade surplus with the U.S. over $20 billion, and a current account surplus greater than 3 percent of GDP–and will meet the third if intervention exceeds ¥10 trillion in a twelve-month period. This is not a high threshold historically–Japan sold ¥14 trillion in 2011 and ¥35 trillion in 2003-4.

So apparently those highly educated bureaucrats at the Treasury, with their 6 figure incomes and their posh DC lifestyles, are actually a part of the ignorant masses that are pushing Trump-style populism. And in fact they are pushing nonsense, the “quantitative framework” has no more support in economic theory than astrology has in high-level physics. So if the public has been reading articles for decades and decades about how our Treasury officials valiantly try to protect us from evil Asian exporters, is it any wonder that the now are susceptible to the arguments of right and left wing populists?

I worry when experts talk about the expansionary impact of a lower exchange rate, or a lower interest rate.  This recent Forbes piece is an example of what may result:

After Friday’s market close, people remarked that both the bond market and the stock market were at all time highs.

It’s not supposed to work that way.  Now, it is a common misconception that bonds always are negatively correlated with stocks.  Actually, over the long term, they have a correlation of zero with stocks.  But they spend most of their time in one of two regimes, either strongly positively correlated or strongly negatively correlated.  Over time it works out to be zero.  Yet here we are, with stocks and bonds on the highs.

David Zervos, market strategist at Jefferies, commented that “Central banks may finally be taking this too far.”  I think central banks started taking things too far in 1913, but yes, with nearly every financial asset in the stratosphere, you could easily come to the conclusion that there has been too much monetary easing.  I am not the first to say that central banks are addicted to higher asset prices.  It’s hard to imagine a scenario where they willingly let the markets deflate.

We’ve been having a lot of bubbles in recent years (a feature of a world populated with central banks), from the dot-com bubble in 2000 to the housing bubble in 2007 to what people are calling the “central bank bubble” or “the everything bubble” now.  Chances are, this could be the biggest bubble of all, and perhaps the most dangerous.

A few years ago, I predicted that in the future there would be almost non-stop complaints about bubbles.  People would see them everywhere.  That’s because low interest rates are the new normal, and thus P/E ratios, price to rent ratios, etc., will be higher than in the past.  It will look like there are bubbles everywhere, but of course bubbles don’t actually exist.

Part of the problem is that the public thinks it’s been told that low rates are easy money, which should boost asset prices.  So they see this as a central bank phenomenon, even though the lowest rates are in places (like Switzerland) where money has been tightest, and the higher rates are in easier money places like Australia.  The public misreads posts like the Bernanke example I just cited, and learns the wrong lesson.  That why I want economists to stop talking about the causal impact of a change in interest rates, inflation or exchange rates, and start talking in terms of the causal impact of changes in NGDP growth, where expected NGDP growth represents the stance of monetary policy.

Let me remind you of some earlier words of wisdom from Bernanke:

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.

The absence of a clear and straightforward measure of monetary ease or tightness is a major problem in practice. How can we know, for example, whether policy is “neutral” or excessively “activist”? I will return to this issue shortly. . . .

Do contemporary monetary policymakers provide the nominal stability recommended by Friedman? The answer to this question is not entirely straightforward. As I discussed earlier, for reasons of financial innovation and institutional change, the rate of money growth does not seem to be an adequate measure of the stance of monetary policy, and hence a stable monetary background for the economy cannot necessarily be identified with stable money growth. Nor are there other instruments of monetary policy whose behavior can be used unambiguously to judge this issue, as I have already noted. In particular, the fact that the Federal Reserve and other central banks actively manipulate their instrument interest rates is not necessarily inconsistent with their providing a stable monetary background, as that manipulation might be necessary to offset shocks that would otherwise endanger nominal stability.

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.  [emphasis added]

That last sentence seemed true in 2003, but obviously not today.  What happened?