Low rates aren’t the answer, they are (a symptom of) the problem

This WaPo story is slightly worrisome:

The Federal Reserve would consider reopening its program to support the mortgage market if interest rates spiked or the economy showed new weakness, Federal Reserve Bank of New York President William C. Dudley said in two new interviews.

Low long term rates are usually the sign of a weak economy, and rates normally rise as the economy recovers.  We saw this during 2009, when rates moved up somewhat after the economy seemed to pick up a bit in the second half.  I would be happier if the Fed was saying that they stood ready to respond with more stimulus if long term rates declined.  

Why do I say that I am only slightly worried?  Because Dudley also mentions that signs of further economic weakness would trigger additional stimulus.  Of course that begs the question:  How weak does the economy have to get before the Fed decides the US would be better off if aggregate demand were a bit higher?

Part 2.  I found the WaPo excerpt in an Arnold Kling post.  Kling makes the following observation:

Rates on 30-year, fixed-rate mortgages are 5 percent. The market wants those rates to be higher. Down the road, the market probably will want those rates to be much, much higher. If so, the ultimate lenders are going to take huge losses, as the interest rates they pay to keep these mortgages in portfolio will exceed 5 percent.

Who will bear these losses? As taxpayers, we will.

I’m no expert on the default risk on these securities, but I’d like to make one observation about interest rate risk, which is the subject of Kling’s remarks.  He is of course correct in noting that if rates rise sharply, the value of the Fed’s MBS portfolio will drop sharply, and ultimately the taxpayers will bear the cost.  I would add, however, that by far the strongest determinant of long term interest rates is the level and growth rate of NGDP.  Rates tend to be low when NGDP is falling, or is rising from a very low level (like right now.)  In my view the sort of macroeconomic environment that would produce much higher interest rates would also produce a robust recovery in the economy.  If we abstract from default risk, and consider Treasury bonds for instance, the worst thing that could happen would be if the Fed made a large profit on the T-bonds it accumulated in the so-called QE program.  That would indicate that long term rates had fallen to Japanese levels, and that for every dollar the Fed gained in higher asset prices, the Treasury was losing $10 in lower tax revenue and higher unemployment and welfare payments.

This is not to excuse the Fed for its purchases of MBSs.  I’d rather they would buy enough ordinary Treasuries to boost NGDP very sharply.  That’s the best way to help housing.  Trying to micro-manage specific sectors almost never works.

Part 3.  Tim Duy; devil’s advocate

Tim Duy has also been a critic of the Fed’s passivity in the face of a severe recession.  In this post he tried to play the devil’s advocate and look at things from the Fed’s perspective.  I think he makes a lot of excellent points, but I want to comment on this assertion:

We need to see sustained growth at more than twice that rate to bring unemployment quickly down to acceptable levels.  But there is simply no faith that such a feat can be achieved.  Most doubt there is sufficient pent up demand in the consumer to do the job, while Calculated Risk has repeatedly stated the case against a quick rebound in housing.  With fiscal stimulus set to slow, that leaves investment and the external sector to big up the slack – neither of which packs the weight of the consumer.  Consequently, the Fed can hold policy steady on the back of the current forecast, which lacks the post-1982 surge.

This is a fairly standard Keynesian approach to evaluating the prospects for a rise in AD.  I read similar things every recession.  But do you recall the phrase “it’s darkest just before the dawn?”  In almost every single recession things look bleak right before a rapid recovery occurs.  If you are deep in recession, and consumers are suffering massive job losses, you’d naturally expect sluggish consumer spending going forward.  The same would be true of business investment, as factories have excess capacity.  I grant you that housing is one area where we are worse off than usual.  In past recessions low rates have sometimes led to an early recovery in that sector.  But I still maintain that this approach to AD is wrong.  It seems to look at AD as a real variable, a collection of sectoral demands that must be added together.

The fastest AD growth in US history probably occurred between March and July 1933, when by all accounts no sector of the economy should have been doing well. We had 25% unemployment.  Where was all that AD going to come from?  Now instead of thinking of AD as a real variable, think of it as a nominal variable; NGDP.  And think of monetary policy (broadly defined as MV, not just M) as the driving force behind AD.  Then the only question is whether or not when NGDP grows rapidly (as it did after March 1933), the growth is prices or output.  It was mostly output in the spring of 1933, and I expect it would be today as well.

In the end I agree with Tim Duy’s conclusion that the recovery will muddle along at a slow rate.  After today’s drop in unemployment I am a bit more optimistic than last night.  But I think the real AD approach (C+I+G+NX) obscures the transmission mechanism of monetary stimulus in a deep recession, leading the casual observer to think more G is the only answer.  If people did draw that conclusion, it would be unfortunate.  At the same time I do understand the appeal of this approach.  Remember I am also a teacher.  I know how easy it is to explain ideas like the expenditure multiplier to students, and how hard it is to get them to grasp the essence of monetary economics–that people’s attempts to get rid of excess cash balances drives AD higher, even if you cannot see the effect in your own behavior.

Part 4.  Brad DeLong solves the age-old problem of estimating crowding out.

Many researchers have tried to estimate the extent to which government expenditures crowd out private expenditures.  We basically know that the crowding out is roughly one for one if at full employment, and also if the central bank has some sort of nominal target, such as inflation.  In other cases it is hard to tell.  As you know I am skeptical of the estimates for all sorts of reasons.  But as David Henderson points out, DeLong basically ignores the ceteris paribus problem in his criticism of a recent post by Steven Horwitz.  Here is Henderson making the sort of comment I had planned to make:

If wages are not falling, then that well could be due to extension of unemployment benefits and some of the additional spending in the stimulus package. DeLong has arbitrarily chosen zero real-wage increase as his baseline. But in a readjustment, what Arnold Kling calls a recalculation, there’s a case to be made for some real wages to fall. At those lower real wages, some of the currently unemployed would be employed. Those jobs that aren’t created, therefore, are a cost of the stimulus package. No one, including Steve Horwitz, claimed that there was a one for one. So the jobs not created by the private sector are indeed a cost of the stimulus package.

I was going to make a similar point about both wages and interest rates.  If DeLong’s evidence was really as definitive as he claims, then the whole crowding out debate should have been resolved long ago.  Just look at wages and interest rates!  They tell us everything we need to know.  No need for messy multiple regressions. 

I’ve never met Mr. Horwitz.  But when I saw him insulted in DeLong’s headline, I knew he must be a fine economist.  One of my proudest days was when DeLong treated me in the same way he treats distinguished economists like Fama and Cochrane.  I still proudly display the post on my office door.  “Scott Sumner simply loses his mind.”

PS.  If you ever forget DeLong’s blog address, just Google ‘Scott Sumner loses his mind.’  It will take you right there.


Tags:

 
 
 

58 Responses to “Low rates aren’t the answer, they are (a symptom of) the problem”

  1. Gravatar of Charlie Charlie
    5. February 2010 at 19:20

    I saw Delong this morning at the Center for American Progress. They did a book forum on his latest book, The End of Influence. He sat there while his co-author, Steve Cohen (Berkeley Regional Planning Prof), railed on and on about the virtues of industrial policy, and how only government could generate true, lasting innovation, because private firms wouldn’t take big enough risks. The entire time, Delong sat there and bit his tongue (and allowed a book to be published under his name that argued the same). It was clear from his expression that he didn’t really believe these things (lots of looking away when the topics were discussed). I think much of his partisan blogging (particularly the vitriolic attacks on those he calls “partisan hacks”) is him projecting the way he feels about himself onto others. There were several standard progressive false claims made by his co-author that he just couldn’t believe as a respectable macroeconomist, and he made no effort to correct these flawed arguments. The discussant, an in-house defense policy analyst, was actually the most engaging and thoughtful person in the room. I do not doubt Delong’s aptitude – he’s smarter than 99.99% of the population – but he has little room to call anyone else a partisan hack.

  2. Gravatar of Lorenzo from Oz Lorenzo from Oz
    5. February 2010 at 20:01

    I’ve never met Mr. Horvitz. But when I saw him insulted in DeLong’s headline, I knew he must be a fine economist.
    Wow, when you do bitchy, you do bitchy good

  3. Gravatar of StatsGuy StatsGuy
    5. February 2010 at 20:30

    A point of view on the notion that, just maybe, this “recovery” really is “different”.

    http://www.zerohedge.com/article/charting-worst-and-soon-be-shortest-economic-recovery-ever

  4. Gravatar of TGGP TGGP
    5. February 2010 at 21:17

    His name is actually Horwitz. I guess in Germany it would be pronounced the same. I’m not entirely sure, despite having taken years of German courses.

  5. Gravatar of malavel malavel
    5. February 2010 at 23:56

    I never liked the fiscal multiplier when I studied economics. It felt more like voodoo magic to me.

  6. Gravatar of Doc Merlin Doc Merlin
    6. February 2010 at 00:24

    Yes, Statsguy, its looking more and more like a double dip, now. :-(

    Agreed, Scott. Thats something people don’t understand. They often treat prices (and interest rates) as only coming from demand or from supply. But the reasons for those demand and supply changes are just as important for understanding what will happen. That was one of the (many) big mistakes of the Keynesians. They completely ignored reasons.

    At the same time, however, both demand and supply shifts in the economy in the short run can happen for positive or negative reasons. If interest rates go up because demand for credit is up, because businesses are about to fail and they are making last ditch attempts to stay afloat… this is a sign of immanent downturn. At the same time if they go up because lots of individuals are wanting to invest in new ventures this is a sign of an immanent upturn.

    Anyway, as a side note: because a central bank is functionally a monopoly, it has a very hard time properly pricing its credit/money creation, and since it often relies on a single price, we have a huge deadweight loss as a result.

  7. Gravatar of Daniel Kuehn Daniel Kuehn
    6. February 2010 at 04:30

    “Just look at wages and interest rates! They tell us everything we need to know. No need for messy multiple regressions.”

    This is unfair, Scott. It’s precisely the messy multiple regressions that get us the multiplier estimates and net employment impact estimates that Horwitz claimed were being ignored, but obviously weren’t. Stever Horwitz and David Henderson are not the first ones to realize that you have to count jobs crowded out in these estimates too. And those jobs are counted – in precisely the “messy multiple regressions” that you criticize DeLong for… for what? For not including in a blog post?

    The point is – the 1.5-2 million jobs figure produced by the administration IS based on those messy multiple regressions. Horwitz is tilting at windmills here.

    Now – as for wages and interest rates. Of course it’s a short cut. Of course there are other things to consider. But when you have a broad-ranging fiscal stimulus and some smart-aleck like Horwitz wants to put a stop to it in the middle of the biggest recession since the Great Depression, it’s reasonable to expect him to have an answer to the question of why wages are stagnant and why interest rates are flat if there is substantial crowding out. Of course you’re right that the discussion doesn’t end there, but anyone making claims as presumptuous as Steve Horwitz should be prepared to provide an answer to that question.

  8. Gravatar of Bill Woolsey Bill Woolsey
    6. February 2010 at 05:45

    Scott:

    Steve Horwitz is a GMU PhD and a very good “macroeconomist” of the free banking/monetary disequilibrium branch of Austrian economists. His approach is very similar to Selgin’s.

    Bill

  9. Gravatar of Steve Horwitz Steve Horwitz
    6. February 2010 at 06:02

    Thanks Scott and thanks Bill and TGGP.

    Scott: I consider it a badge of honor to be attacked by DeLong by name in a post title. In fact, I’m thinking of adding a new line on my CV: “Names I’ve been called by Brad DeLong.” I’m also thinking of doing up my university publicity photo into a movie review type look with DeLong’s insults “stamped” on it. Here too, I think this will enhance my reputation among the rational, civil community of economists.

    And if you’re interested Scott, my book on Austrian macro is now out in paper at a very reasonable $31 at Amazon: http://xrl.in/4g4x And for Scott or any of his interested and interesting commentariat, my cv is here: http://myslu.stlawu.edu/~shorwitz/Vitae/cvlatest.htm and I blog at http://www.coordinationproblem.org with Pete Boettke, Pete Leeson and others.

  10. Gravatar of Mike Sandifer Mike Sandifer
    6. February 2010 at 06:06

    I am confused about something and do not necessarily expect an answer, but I was under the impression that when liquidationist policies are followed, interest rates rise, at least at the beginning of recessions. My thinking is that this would especially be true during and after a financial crisis. Perhaps this is only the case with short-term rates, but my impression is that this would slow down “liquidation.”

  11. Gravatar of scott sumner scott sumner
    6. February 2010 at 06:34

    Charlie, I would have liked to seen the look in his face. :)

    If I had the time I’d read his book. Then I could make fun of those wacky left wing ideas that you say were inserted by his co-author.

    Lorenzo. Thanks, I guess.

    Statsguy, Thanks, I agree. And I don’t think there is any mystery why. People are forecasting 3% NGDP growth. We had nearly 10% in the 1983-84 recovery from 1982. Even if you subtract 2% to account for the higher trend inflation in the 1980s, that’s huge difference.

    TGGF, Thanks. I actually checked, but had only corrected in in one place. Now I corrected the other.

    Malavel, I agree.

    Doc merlin, Agreed. Now if the “single price” was NGDP futures, we be much better off.

    Daniel, You said;

    “This is unfair, Scott. It’s precisely the messy multiple regressions that get us the multiplier estimates and net employment impact estimates that Horwitz claimed were being ignored, but obviously weren’t. Stever Horwitz and David Henderson are not the first ones to realize that you have to count jobs crowded out in these estimates too. And those jobs are counted – in precisely the “messy multiple regressions” that you criticize DeLong for… for what? For not including in a blog post?”

    I don’t get this at all. DeLong says Horwitz is a bad economists for reason X. I show reason X is silly. And you say that’s unfair to DeLong because Horwitz might have made a mistake for some reason DeLong didn’t mention? I must be misunderstanding your argument, as that makes no sense to me.

    Even if there were multiple regressions out there, there are huge problems with identification in macro. So it would be no reason to call Horwitz a bad economist. All he said is the government’s estimates of job creation might have been too high. That’s not a reasonable hypothesis?

    As for stopping the fiscal stimulus, the burden of proof is on those who favor spending $800 billion in our tax money. There is a reason that fiscal policy almost disappeared from upper level macro in recent decades–monetary policy is a much better way to stimulate the economy. Even DeLong now favors a more expansionary monetary policy. And don’t say Obama has no control over it, he just appointed his guy to head the Federal Reserve.

    Bill, Thanks. I knew that. I should have made that clearer. I am overworked.

    Steven, Yes, I knew of you, as most of the Austrians I talk to list you as one of the 4 most distinguished modern Austrian macroeconomists (along with Selgin, White and Garrison.) Unfortunately I haven’t had time to read much of the literature (although that doesn’t stop me from talking about it.) If I ever finish revising my book I’ll try to broaden my range of blogs.

    Mike, It depends. In this recession interest rates fell from the very beginning. The same was true in 2001. But there may be recessions where rates did rise in the early months.

  12. Gravatar of David Pearson David Pearson
    6. February 2010 at 09:07

    Scott,

    Your observation that higher rates would be positive (as they signal strong NGDP growth expectations) is interesting.

    Assume the Fed does what you want and NGDP expectations rise to 6% for the next two years. Where would mortgage rates be? Probably close to 8%.

    So what happens to RGDP expectations when mortgage rates rise to 8%? Will they remain at 3%? Of course not. The consumer is over levered, and housing still faces a “shadow inventory” of foreclosed-upon and “underwater” homes. Moreover, Option ARM, ARM, and subprime-ARM loans made in 2005-2007 have not been a problem because re-sets of those loans to new interest rates have actually LOWERED payments. These resets to HIGHER rates would be periodic and on-going, and they would further harm the housing sector.

    Beyond housing, the consumer is over-levered and its difficult to imagine that consumer credit would grow if interest rates were yet higher. Further, taking away the implicit low-rate yield-spread subsidy to the banks would harm their profitability, which in turn would make them MORE reluctant to lend. Then there’s CRE — the lions share of regional bank portolfios — which is just starting to see rising delinquencies and falling prices.

    Remember, your NGDP growth expecations are manufactured exogenously — by the Fed. But when it comes to the path of real GDP, that is manufactured by leading sectors of the economy. Normally, those leading sectors are housing and durable goods, but I’m making the case that both would literally crash as a result of higher interest rates, even nominal ones.

    Here’s something to consider: the impact of a 3% rise in NGDP expecations (from 3 to6%) is MUCH greater on debt servicing than it is on income. Calculate a mortgage payment on a $300k California house at 5%, and then at 8%, and you’ll see what I mean…The 8% rate is $600/mo more. Assume a 4x debt to income number for the mortgage, and you get roughly $60k in annual income, or $5k a month. A rise from 3% to 6% in income growth produces about $150 a month more in income to service that $600/mo increase in payment.

    Of course, it all works out as income compounds, but try telling that to the family that is trying to meet its mortgage payment.

    Leverage matters. An economy with a debt/GDP ratio of 330% — where much of that debt was incurred at ultra-low rates — is highly vulnerable to interest rate shocks. To be very clear, what you are talking about when you say the Fed should immediately raise NGDP expectations to 5-6% is an interest rate shock of the highest magnitude.

    BTW, as far as a leading sector being exports, its too bad that Japan and Europe don’t seem like they are on board with that. Perhaps China could run a trade deficit. But then, then they would have to sell Treasuries to finance it…

  13. Gravatar of Running | Dude LOL Running | Dude LOL
    6. February 2010 at 09:13

    […] TheMoneyIllusion » Low rates aren't the answer, they are (a … […]

  14. Gravatar of David Pearson David Pearson
    6. February 2010 at 09:29

    BTW, if you argue that higher NGDP growth expectations would help house prices, you would be absolutely right. In Argentina, for instance, dropping dollar convertibility made house prices rise dramatically in Peso terms — but only after they CRASHED as borrowers suffered a huge interest rate shock. The pattern is the same in most countries resorting to a maxi-deval to immediately raise NGDP expectations: inflation expectations become very lopsided initially. They are concentrated in areas of the economy that have little leverage, while the high-leverage sectors have to suffer a massive debt write-down before they can participate.

  15. Gravatar of vimothy vimothy
    6. February 2010 at 09:51

    “people’s attempts to get rid of excess cash balances drives AD higher, even if you cannot see the effect in your own behavior”

    This is what I was talking about in the other thread: in order for an increase in the money supply to have an effect, there has to be a change in behaviour. The increase itself is not enough.

    In addition, the assertion that the Fed controls the money supply is contested.

    I’m not sure that looking at the accounting identities as nominal variables makes that much difference to the analysis. If nominal GDP is total spending is total income, the solution has to come from a restoration of AD, and that has to come from from somewhere. Where that somewhere is is a function of the names or symbols you use to disaggregate the economy. It makes no odds. If monetary policy is to help it must change behaviour and lead to more total spending (NGDP).

  16. Gravatar of vimothy vimothy
    6. February 2010 at 09:58

    BTW, what do you think of Benjamin Friedman’s “crowding in” argument?

  17. Gravatar of thruth thruth
    6. February 2010 at 10:26

    David Pearson:

    Interesting line of thinking (I generally like a lot of the pushback on Scott’s views that your posts provide).

    “inflation expectations become very lopsided initially. They are concentrated in areas of the economy that have little leverage, while the high-leverage sectors have to suffer a massive debt write-down before they can participate.”

    Isn’t that the creative destruction that we want? The debt overhang has to be removed one way or another. We either slow bleed in the status quo or just get on with it. I’d much rather get people into jobs than keep them in houses they can’t afford (and just maybe helping the job situation will help keep people in homes too).

    I generally agree that the distributional consequences of the Fed’s actions may be a constraint policy choices.

  18. Gravatar of OGT OGT
    6. February 2010 at 11:21

    Pearson- That’s quite a good point. There’s no free lunch. I don’t know that I’ve ever seen a blow by blow account of how Sumner would expect the economy to respond if the Fed took his advice.

  19. Gravatar of vimothy vimothy
    6. February 2010 at 11:34

    OGT,

    The much more fundamental problem is: How will the Fed take Scott’s advice?

    Notice that there are two necessary assumptions:

    1, the Fed controls the supply of money to the economy;

    2, the Fed can affect the behaviour of the public such that an increase in the money supply raises inflation and therefore NGDP.

    Is either assumption reasonable?

  20. Gravatar of Arash Arash
    6. February 2010 at 11:49

    Scott,

    I agree with almost everything you say. I just cannot get your point of the distinction between NGDP as a nominal expression of aggregate demand (which is true by definition) and the Keynesian C+I+G+NX-real version of AD. Both are nominal: Mv=NGDP=C+I+G+NX! In old IS-LM, each component of AD can shift without a compensating move of other components only because the initial shift is accompanied by a changing velocity. Real aggregate demand is given by aggregate ouput. In the short run, if prices are rigid, additional Mv will also do the job … but this is so for NGDP as well as C+I+… .

  21. Gravatar of vimothy vimothy
    6. February 2010 at 11:57

    Indeed.

  22. Gravatar of Jon Jon
    6. February 2010 at 12:00

    Something I’ve always struggled with is that G is a classic example of temporary stimulus. Therefore, it can not generate positive ngdp growth expectations. Monetary stimulus works because convertibility is either nonexistent (present situation) or convertibility can be crediblely impaired by devaluation.

  23. Gravatar of vimothy vimothy
    6. February 2010 at 12:03

    All of the variables in the identity are flows.

  24. Gravatar of 123 – TheMoneyDemand 123 - TheMoneyDemand
    6. February 2010 at 13:44

    “This is not to excuse the Fed for its purchases of MBSs. I’d rather they would buy enough ordinary Treasuries to boost NGDP very sharply. That’s the best way to help housing. Trying to micro-manage specific sectors almost never works.”

    The best QE is purchasing a market basket of ordinary private sector investment grade bonds. NGDP boost is even larger, and interest rate risk is softened by credit risk premium earned by central bank.

  25. Gravatar of vimothy vimothy
    6. February 2010 at 13:52

    Agreed. But what are the aggregate effects of credit easing QE? The stimulatory effect of cheaper credit to AD must exceed the loss of capital gains and interest income to savers. And notice too that the private sector is now net creditor to the public sector. The net effect is therefore also (whatever else) a reduction of the overall government deficit with respect to the non-government sector.

  26. Gravatar of Bill Woolsey Bill Woolsey
    6. February 2010 at 13:53

    Vimothy:

    The Fed controls the monetary base. Of course, it cannot adjust base money and stabilize overnight lending rates between banks. The proposal is to quit worrying about that.

    The goal isn’t to change inflation and then change nominal GDP.

    The point is to change nominal GDP (nominal expenditures) and that will, unfortunately, impact inflation as well as real output.

  27. Gravatar of vimothy vimothy
    6. February 2010 at 13:58

    Bill–are you talking about Scott’s position, or your own?

    I agree that the Fed does not control the money supply. I agree that nominal expenditures need to be changed. And I agree that inflation will not be impacted without, at the very least, additional sales (an increase in aggregate spending).

  28. Gravatar of vimothy vimothy
    6. February 2010 at 14:12

    So the problem is, how does the Fed increase total spending? With what policy instrument? Bringing down long rates will not be enough if the economy continues to contract. Only if there is demand for that credit from borrowers the banks want to lend to and an increase AD as a consequence will the economy recover. Total spending must increase.

    Moreover, if that recovery comes from the private sector in the first instance, that has implications for the public sector’s balance sheet. Even if we can goad the public into spending more and saving less, would we necessarily want to do it?

  29. Gravatar of Greg Ransom Greg Ransom
    6. February 2010 at 15:14

    Official construction unemployment is 25% …

  30. Gravatar of ca ca
    6. February 2010 at 22:30

    Scott, I’m curious if you’ve read Amity Shlaes’ book “The Forgotten Man,” and if so, do you find it to have any merit?

  31. Gravatar of scott sumner scott sumner
    7. February 2010 at 07:33

    David Pearson, You said;

    “Your observation that higher rates would be positive (as they signal strong NGDP growth expectations) is interesting.”

    You shouldn’t be surprised at all, there is absolutely nothing controversial in what I said. I can’t imagine any macroeconomist disagreeing, as the data makes this very clear. You shouldn’t be asking “what’s wrong with Sumner’s argument here” because I am certainly correct, rather you should ask “why do I find this fact surprising.”

    I think people find it surprising because most people misunderstand S&D at both the macro and micro level. They think “If demand rises, this will raise prices, but the higher prices will cause demand to drop.” But this is false as it confuses a shift in demand with a movement along a demand curve.

    BTW, the sort of NGDP grow I envision would probably not cause mortgage rates to rise to 8%. Rather, they would rise to a level consistent with on-target expected NGDP growth, whatever that level is. It might be just 100 basis points above where we are now. I don’t know. But it would certainly be higher.

    If as you say, consumers can’t afford 8% rates when NGDP growth is on target, then they won’t rise that high.

    David#2, I do not recommend we follow Argentina, I favor stable NGDP growth, they went from a big fall to wildly inflationary increases. That’s nuts.

    vimothy, You are mixing up real and nominal concepts. If the Fed increases the nominal money supply, and the public’s real demand for cash balances is unchanged (as a fraction of income), then NGDP will rise sharply.

    I am distrustful of all fiscal policy multiplier estimates, as they tend to ignore plausible monetary reactions.

    thruth, I strongly disagree. See my response to David. But if you are right about harm to real estate, then I do agree with you–let’s get NGDP back on track and let the free market decide where to allocate resources. (or I should say what’s left of the free market in a world of Government Motors.)

    OGT, In my earlier posts I have lots of discussion of tranmission mechanisms. I see more cash raising future expected NGDP through the excess cash balance transmission mechanism. That’s not very controversial. The wrinkle I add is that an increase in future expected NGDP tends to immediately raise more flexible asset prices (stocks, real estate, commodities.) That, combined with sticky wages, pushes output higher. New Keynesians tell a similar story, but they use a fall in real interest rates, rather than a rise in asset prices. (And they use expected inflation rather than expected NGDP) I think interest rates focus too much attention on credit markets, as monetary policy will boost NGDP even in an economy w/o credit markets.

    Arash, You said;

    “I agree with almost everything you say. I just cannot get your point of the distinction between NGDP as a nominal expression of aggregate demand (which is true by definition) and the Keynesian C+I+G+NX-real version of AD. Both are nominal: Mv=NGDP=C+I+G+NX! In old IS-LM, each component of AD can shift without a compensating move of other components only because the initial shift is accompanied by a changing velocity. Real aggregate demand is given by aggregate output. In the short run, if prices are rigid, additional Mv will also do the job … but this is so for NGDP as well as C+I+…

    Very good point. Of course both are tautologies. Keynesians assume prices are fixed in the short run, even though they aren’t. Thus they assume that any rise in AD will initially show up as an increase in real purchases of goods and services in various sectors. Then they try to evaluate which sectors are mostly like to grow, as a way of predicting whether total AD can grow.

    I don’t assume fixed prices. I start by looking at a shock that causes more nominal money to be spent. Everything else is endogenous. The extra nominal spending pushes up NGDP. What happens to RGDP and prices depends on the slope of the SRAS, which I assume is not vertical. The allocation between sectors depends on how those sectors respond to expectations of higher future NGDP.

    Actually, some of these assumptions have worked their way into the New Keynesian model, which does account for interest rates.

    I think where your confusion comes in is that both approaches must at some level be telling the same story, simply using different languages. But each approach makes certain views seem more plausible. The C+I view makes monetary policy ineffectiveness seem more plausible than the MV view does. But you are right, logically they should be compatible.

    Jon, That is a great point. Even a very conventional macroeconomist like Mishkin makes the same point. There is a reason why fiscal stimulus was almost completely forgotten in recent upper level macro. It really can’t work without monetary stimulus. So why not just focus on monetary stimulus. In the simple model it raises NGDP in a recession, but in more sophisticated forward-looking Keynesian models, current NGDP is hugely impacted by future expected NGDP. And fiscal policy can’t influence that.

    Let’s take an example with numbers. Assume fiscal policy can boost velocity while in effect, but not while not in effect. So fiscal expansion raises NGDP from 14 trillion to 15 trillion. But the public knows the stimulus won’t last forever, they know velocity and NGDP will fall back to 14 trillion in a couple years. Who would do an investment project in the year when NGDP is 15 trillion, knowing it will fall back to 14 trillion? So you don’t get the multiplier effect. Unless, monetary policy is accommodating and keeps NGDP at the new higher level of 15 trillion. But if monetary policy can do that, can raise future expected NGDP, why use fiscal policy at all? It’s a fifth wheel.

    123, I can’t say you are definitely wrong, part of it depends how it affects expectations. Your proposal might be seen as more aggressive, and hence might boost NGDP expectations by a larger amount.

    vimothy, You misunderstood Bill. He most definitely does believe the Fed can control M, check out his blog. He said they can’t control both M and i at the same time. But it was poorly worded, so I don’t blame you for being confused. Bill and I both agree on this.

    Greg, Even when there has been no misallocation, as in the 1920s, a deep recession will create a lot of unemployment in construction.

    ca, No, but I’ve bought it and will eventually read it.

  32. Gravatar of vimothy vimothy
    7. February 2010 at 09:42

    “You are mixing up real and nominal concepts. If the Fed increases the nominal money supply, and the public’s real demand for cash balances is unchanged (as a fraction of income), then NGDP will rise sharply.”

    I made two points. The second was: every variable in the identity can be nominal but the spending *has* to come from one of them.

    The first was that inflation is not magic. An increased stock of money will only increase NDGP (i.e. PQ) if either of those two components increases. The demand curve must shift–changing behaviour. You assume that an increase in the money supply will increase AD. That is not a given, merely a possible outcome. Depending on the preferences of the public, that increased stock of money might be spent or it might not. If it is not and the non-government sector spending flows do not change (holding the BOP constant), there is no recovery in PQ.

    The private sector will not reach its desired level of spending relative to income if there no offsetting balance from outside maintaining AD and holding total income constant, unless those two flows balance (private sector spending and income sum to zero).

  33. Gravatar of vimothy vimothy
    7. February 2010 at 10:38

    Scott,

    You are letting the ex post identity drive causality in the model. Even if the money supply is exogenous, you have to hold output constant for an increase to raise nominal income. You are assuming this problem away. We need to stabilise private sector spending flows so that its net savings preferences can be satisfied by doing what you assume as an outcome: supporting AD with an offsetting sectoral flow. Otherwise the aggregate demand curve keeps shifting left.

  34. Gravatar of vimothy vimothy
    7. February 2010 at 10:40

    Probably should add:

    “Otherwise the aggregate demand curve keeps shifting left as total income continues to fall.”

  35. Gravatar of David Pearson David Pearson
    7. February 2010 at 11:03

    Scott,

    Its hard for you to imagine that NGDP can rise while RGDP falls, stagnates, or gyrates wildly. For those of us who have lived through just such events, many times over, I would say the “tail risk” of this occurring is much higher than you let on. This is essentially our disagreement. As a Latin American, I see the U.S. going down the same path (chronically low savings, repeated monetary stimulus, no political “stomach” for recessions) that your Southern neighbors have followed. The risk, essentially, is that policy makers here dismiss the tail risk and engage in risky experimentation born of American exceptionalism — “no need for recessions in this country, because we are much to modern and smart for that.”

    You see, recessions, and even Depressions, are tragic but temporary. Eventually, markets clear, asset prices fall to levels that produce attractive returns, companies invest and hire — all things that happens if the government stays out of it. In the end the population is worn out but actually made stronger from the experience.

    By contrast, the debasing of a currency causes permanent damage: it fosters mistrust in public institutions and contracts, a mistrust that insinuates itself into the economy and causes long term decline. More importantly — and again, I have seen this first hand — people are unhappy when they lose this trust, and it is essentially the government’s fault.

    Engineers spend as much of their time thinking of what would take down their structure as they do thinking of how to put it up. Unfortunately, I don’t see economists doing the same thing — not even close. Who is supposed to push back, ask questions, point out the risk of policies like Greenspan’s 1998-2008 asymmetric monetary policy? Practically no one in the profession did. Certainly Greenspan didn’t practice much self doubt. Frankly, would feel infinitely better about your policy innovations if you acted more like an engineer, less like an economist.

  36. Gravatar of marcus nunes marcus nunes
    7. February 2010 at 11:54

    From Jim Hamilton:
    “My bottom line: the scales tipped last week in the direction of near-term deflationary pressures, despite the strong 2009:Q4 U.S. GDP report and falling unemployment rate”.
    http://www.econbrowser.com/archives/2010/02/reactions_to_la.html

  37. Gravatar of thruth thruth
    7. February 2010 at 11:56

    Scott Sumner said “thruth, I strongly disagree. See my response to David. But if you are right about harm to real estate, then I do agree with you-let’s get NGDP back on track and let the free market decide where to allocate resources. (or I should say what’s left of the free market in a world of Government Motors.)”

    To be clear … when I said I like David’s posts its because they’re provocative, not necessarily because I agree (I rarely do). When I said:

    “I generally agree that the distributional consequences of the Fed’s actions may be a constraint [on] policy choices.”

    What I have in mind is that the Fed’s explicit mandate is price stability and employment. Doing more stimulus might help achieve both of those goals, but at the same time it is limited to policy tools that might be percieved as benefiting certain groups disproportionately, which might be seen as overstepping the mandate. Wasn’t it your thesis that the demand slump caused most of the house price declines? If the Fed had arrested the demand slump wouldn’t it also have been seen as bailing out “irresponsible” homeowners banks and mortgage investors?

    Interestingly, Goldman Sachs economists (notably Jan Hatzius) were well ahead of the curve in predicting a deflationary spiral. In late 2007 they were warning of the potential spillover effects of the subprime crisis, all premised on credit drying up as banks conserve capital to cover losses. At work, a colleague and I poked fun at this view because (a) the Fed would never let it happen; and (b) why wouldn’t the banks just raise more capital? Now the joke’s on us. Goldman sure seems to be doing well, though… (and they are still warning that the Fed is erring on the side of deflationary)

    As a final aside, you have often contrasted the “banking” view with the “monetary” view of the crisis. I see them as complementary, though people seem to come to very different policy conclusions depending on which view they have so maybe I’m missing something. But it seems clear to me that you can’t sensibly talk about financial regulation without putting monetary policy on the table too.

  38. Gravatar of John Papola John Papola
    7. February 2010 at 19:26

    Brad DeLong’s only definitive understanding of “crowding out” is the way he crowds out any comments that conflict with his myopic worldview on his blog.

    The man is a disgrace to the very notion of what education is and what educators should be.

  39. Gravatar of Patrick R. Sullivan Patrick R. Sullivan
    7. February 2010 at 21:37

    John Papola, Amen. I’ve mentioned it here before, but I have a personal history with DeLong (and I know many others who can say the same) from years ago that exactly matches what you said.

  40. Gravatar of Greg Ransom Greg Ransom
    8. February 2010 at 07:06

    I notice you don’t explain why:

    “a deep recession will create a lot of unemployment in construction”

    Science explains patterns. This is a pattern. Where’s your explanation?

  41. Gravatar of scott sumner scott sumner
    8. February 2010 at 07:11

    vimothy, Your comment about changing behavior is very misleading. During currency reforms nominal GDP often falls 99% in one day, as 100 old pesos are swapped for 1 new peso. And yet “behavior” hasn’t changed much, at least in the ordinary meaning of “behavior”. That’s what a pure nominal shock looks like, in a world of flexible prices and wages.

    vimothy#2, Why does output need to be constant for prices to rise?

    David Pearson, You said;

    “Its hard for you to imagine that NGDP can rise while RGDP falls, stagnates, or gyrates wildly. For those of us who have lived through just such events, many times over, I would say the “tail risk” of this occurring is much higher than you let on. This is essentially our disagreement.”

    No this isn’t at all hard for me to imagine, I’ve also lived through many examples. My point is that right now if NGDP rises 8%, I would not expect prices to rise more than 8%. But it isn’t because I don’t remember that happening in the 1970s. The difference is that wages were rising very fast in the 1970s, they aren’t now and won’t be for many years.

    You said;

    “all things that happens if the government stays out of it.”

    This is a common misconception. Unless you favor barter, or abolishing the Fed, they won’t stay out of it. If you do realize (like me) that the Fed is inevitable, then the government will be involved. And that means they should do as little damage as possible, the most neutral policy possible. That would be stable NGDP. That’s the most they can do to “stay out of it” Of course since 2008 they have been doing anything but staying out of it, they have become highly involved with a very contractionary policy, which is why we are in this mess.

    One area that I agree wtih you, is that I also oppose Greenspan’s asymmetric polcy. Policy should be symmetric, centered on steady and low rates of NGDP growth, level targeting.

    Thanks Marcus, That makes depressing reading. I still think we’ll avoid outright deflation next year, be we may get pretty close.

    thruth, You said;

    “Wasn’t it your thesis that the demand slump caused most of the house price declines? If the Fed had arrested the demand slump wouldn’t it also have been seen as bailing out “irresponsible” homeowners banks and mortgage investors?”

    You may be right, but it would be a sad comment on how low our profession has fallen. We would not blame the Fed for house prices falling sharply, even though NGDP also fell, but if they rose we would assume the rise was caused by the Fed. Yeah, I can see people thinking that, but it just makes me almost want to give up. What can you do when people are so illogical.

    It seems like economics has merely become a bunch of superstitions.

    I agree about GS, whenever I read something of theirs it seems more perceptive than the other banks.

    John and Patrick, He crowded out one of the comments I left after he called me nuts.

  42. Gravatar of StatsGuy StatsGuy
    8. February 2010 at 10:51

    ssumner:

    “Thanks Marcus, That makes depressing reading. I still think we’ll avoid outright deflation next year, be we may get pretty close.”

    We’ll avoid outright deflation – but we could easily have 1.8% inflation. The Fed will now “target” inflation, even if they are not explicitly doing so, but that target is 2%, and they would rather err on the low side. That means real growth of less than 2% for a while.

    You might think that if you can just explain the issue with level targeting and the superiority of expected NGDP targeting, they would get it and change. You would be wrong.

    The current powers that be – including Obama – fully understand that 2% inflation target means dissappointing real growth. They are spending their time managing down expectations, however, rather than trying to change outcomes.

  43. Gravatar of vimothy vimothy
    8. February 2010 at 11:00

    Statsguy,

    Perhaps you can explain then–it is all very well to say that the Fed should target NGDP (you can target whatever you want) but how and with what actual instrument?

  44. Gravatar of marcus nunes marcus nunes
    8. February 2010 at 11:24

    @vimothy
    McCallum has a few articles from the 1980´s (and chapter 16 in his 1989 Monetary Economics textbook) on how to level target NGDP

  45. Gravatar of marcus nunes marcus nunes
    8. February 2010 at 11:29

    @vimothy
    A link to McCallum article from 1987:
    http://www.richmondfed.org/publications/research/economic_review/1987/pdf/er730502.pdf

  46. Gravatar of vimothy vimothy
    8. February 2010 at 11:31

    The Fed doesn’t have that many tools. Just tell me which one it should use and how it will move NGDP. (I’ve read quite a few papers on it, BTW, but thanks for the tip).

  47. Gravatar of StatsGuy StatsGuy
    8. February 2010 at 14:56

    I’m hardly the expert on NGDP regimes – who do you think runs this website? I personally dislike futures, though, particularly if the market is thin – but a month or so ago the possibility of Treasury floating NGDP indexed bonds (“trills” with finite lifespan, say 5 years) on a rolling basis popped up. The secondary market for such instruments, which would mature on a staggered basis, would provide a strong indication of market expectations, and the sheer size of our debt load would create a very nicely deep/liquid debt market to prevent gaming/manipulation even if the trills covered only a modest % of US funding needs.

    A level target regime would be projected Trill expectation + 5% – recent actual NGDP.

    In terms of actual instruments to affect outcomes, many – the Fed seems to have no trouble thinking of stuff to buy (though one might disagree with their choices due to distributional reasons). Altering the rate paid on reserves is another option, though I have to say, I hate this option – I certainly did not see the Fed charging negative rates on bank reserves when it should (instead, it used a 0.25% rate to transfer taxpayer money to help recapitalize banks, because they probably felt charging banks for reserves would help cause a run on banks), but as the Fed tightens it will likely pay higher rates on reserves. Doesn’t this strike anyone as nefarious and one-sided in the extreme?

  48. Gravatar of vimothy vimothy
    8. February 2010 at 15:19

    Perhaps there is a misunderstanding here.

    The Fed has a very limited number of policy instruments at its disposal. Specifically which tool do you want them to use? (If you propose that they use one that they do not possess, they will not be able to use it). What should they then do with this instrument? And how will it increase NGDP?

    If there are no existing policy instruments and something new will have to be created–that’s fine (or maybe not). I just want to understand where everyone stands.

  49. Gravatar of marcus nunes marcus nunes
    8. February 2010 at 17:21

    @vimothy
    There are too many people for you to get an understanding of “where eveyone stands”. And I´m certain no one has stayed put over time.

  50. Gravatar of marcus nunes marcus nunes
    8. February 2010 at 17:49

    @vimothy
    Since you are a recent arrival to this blog, you´ve probably missed the finding discussed last month that 10 years ago Bernanke thought that the CB could do level targeting. Check this out:
    http://people.su.se/~leosven/und/522/Readings/Bernanke.pdf

  51. Gravatar of scott sumner scott sumner
    8. February 2010 at 19:11

    Greg, As far as I know, every single business cycle theory predicts that capital goods industries will be much more procyclical than consumption. One example is the permanent income theory, which suggests that C is a function of permanet income, and that S and I are very procyclical.

    Statsguy, I basically agree, except that I think inflation will be less than 1.8%. If you told me inflation would be 1.8% in 2011, I’d be pleasantly surprised. I believe the TIPS market expects about 1% inflation over the next two years.

    Vimothy. The Fed creates new tools all the time. In this cycle they started paying interest on reserves. I suggested the rate should be negative, which wouldn’t be a new tool, just a different setting of that tool. Another new tool was buying MBSs. I favor targeting expectations. As far as the policy instrument, I prefer simple OMOs preferably using Treasury securities.

    For the target I prefer NGDP expectations. The best option would be to specially create a NGDP futures market. If we don’t do that, the Fed should try to estimate NGDP growth using market inflation indicators, as well as RGDP estimates derived from private forecasters and market data and perhaps their own forecasters.

  52. Gravatar of vimothy vimothy
    9. February 2010 at 03:44

    Scott,

    Thanks! I will be back with a response when I get a spare moment…

  53. Gravatar of Doc Merlin Doc Merlin
    11. February 2010 at 05:40

    “but as the Fed tightens it will likely pay higher rates on reserves. Doesn’t this strike anyone as nefarious and one-sided in the extreme?”

    Some of the guys at econlog thought that the only logical explanation was that.

  54. Gravatar of Steve Steve
    11. February 2010 at 08:35

    Dear Scott,

    I have a potentially stupid question: why do you think it makes a difference if the Fed bought Treasuries? Treasuries and money were perfect substitutes, so that would not have shifted NGDP or inflation, would it? Wasn’t that the argument for buying other stuff than Treasuries (and also why Cochrane propsed the Fed should by new asset backed securities)?

    Sorry if you have explained that before.

    S

  55. Gravatar of ssumner ssumner
    12. February 2010 at 06:32

    Doc merlin, Do you have an econlog link?

    Steve, That is a good question, and not easy to answer. The purpose of buying Treasuries is not to create an expansioanry monetary policy, but rather to accommodate the increased demand for cash that might occur if you target NGDP, or the price level. Suppose you want NGDP to grow 5%. And suppose that at expectations of 5% NGDP growth there is an extra 8% demand for base money. Then you must raise the base by 8% to hit that NGDP growth target.

    Cash and T-bonds are not perfect substitutes. When you are about to run off to the store, are you indifferent between whether your wallet has cash or T-bonds? Thus altering the supply of cash will alter its value, if the change is viewed as permanent.

  56. Gravatar of Brad DeLong Brad DeLong
    19. February 2010 at 16:46

    Re: Charlie: “only government could generate true, lasting innovation, because private firms wouldn’t take big enough risks…”

    Is there a point to stating that what Charlie says is not true–that it is neither what Steve thinks (he has been a *big* booster of Silicon Valley’s effects on the American economy for a generation) or what he said?

  57. Gravatar of scott sumner scott sumner
    20. February 2010 at 06:25

    Brad, Yes, there is a point to clarifying what Charlie said, and posting that clarification on my blog. At least there is a point in doing so as long as I don’t delete your comment, which as you can see I haven’t done so far.

  58. Gravatar of ‘Credit where it’s due’ is launched today « Freethinking Economist ‘Credit where it’s due’ is launched today « Freethinking Economist
    28. February 2010 at 16:31

    […] discussed. My enthusiasm has partly stemmed from the excellent guide to this topic that I found in The Money Illusion, Scott Sumner’s passionate blog about how monetary policy could (in his view) have prevented […]

Leave a Reply