Nick Rowe on Monetarism

I just discovered a very good blogger that shares some of my ideas (and has actually been blogging much longer than I have.)  The blogger, Nick Rowe, has a couple of very interesting posts on monetarism here and here.  (He also linked to my blog, but I have been so busy that I only now noticed.)  Mr. Rowe indicates that he was a student of David Laidler, and before talking about Nick’s ideas, I’d like to say a few things about Mr. Laidler.

Mr. Laidler believes that macroeconomists have a great deal to learn from studying the history of their field.  I read several of his excellent books on the history of monetary theory, linked here and here.  It seems to me that scholars like David Laidler occupy an increasingly marginal place in modern macroeconomics, mostly on the fringes—such as the history of economic thought.  But I’m coming to believe that the field of macroeconomics made a big mistake in adopting a highly technical and abstract style in recent decades.

If this crisis shows anything, it is the importance of having people who can think along a number of different dimensions at once.  I am not impressed by young hotshot theoreticians who tell me that the liquidity trap “all boils down to X.”  Or “monetary policy is simply this.”  No, it doesn’t all boil down to anything, as you may have gathered from my other posts.  You cannot understand liquidity traps without understanding the history of the Great Depression, and 1994-2008 Japan.  (In my other posts I argue that neither “trap” was what it seemed to be.)  You need to understand exactly how the Fed works, what the policy of paying interest on reserves means, and whether that rate could be negative.  You need to understand the issue of policy credibility, and what sort of signals markets are likely to find credible.  You need to understand the pros and cons of unconventional open market operations involving risky assets.  You need to understand the many different channels by which monetary injections can impact AD.  You need to understand the international political friction caused by currency devaluation.  It even helps to understand how word choice subtly shapes our thinking (i.e., use of the term “expectations trap,” for what is not necessarily a trap at all.) It doesn’t “all boil down to” anything.  It’s complicated, not mathematically complicated, but conceptually complicated.

The world economy right now desperately needs a lot more people with the depth of knowledge and wisdom of David Laidler, and fewer people who are adept at doing DSGE models, but are unable to offer practical advice in a crisis.

I only met him once, and I recall that we chatted about the tech bubble.  Mr. Laidler argued that this event showed that inflation targeting was flawed, and that central banks needed to pay more attention to asset prices.  I replied (no surprise) that I thought if the Fed targeted NGDP it would at least partially address the issues that he was worried about.  I do think that my NGDP proposal is looking even better after the events of the past 5 years, but even I would have to concede that these events favor Mr. Laidler’s point of view even more strongly than mine.

Nick Rowe does a much better job that I could of explaining the current trends in monetary theory, especially Woodford’s “Neo-Wicksellian” model, which completely excludes money.  BTW, I have always thought that money must appear somewhere in Woodford’s model, as you can’t have a price level without a medium of account.  I think that what Woodford means is that you don’t need a medium of exchange (i.e. M1.)  I vaguely recall that Bennett McCallum argued that the model did contain a money-like asset, interbank clearing balances.  (Someone correct me if I am wrong here.)

Nick Rowe also sees the need to take another look at some of the ideas put forward by the monetarists:

So we need to revert to an older, earlier way of thinking. Monetary policy is about changing the stock of money. The objective of monetary policy, in a recession, is to create an excess supply of money. People accept money in exchange for whatever they sell to the central bank, because money by definition is a medium of exchange. But they don’t want to hold all that money. Or rather, the objective of the central bank is to buy so much stuff that people don’t want to hold the money they temporarily accept in exchange. An excess supply of money is a hot potato, passing from hand to hand. It does not disappear when it is spent. It spills over into other markets, creating an excess demand for goods and assets in those other markets, increasing quantities and prices in those other markets. And it goes on increasing quantities and prices until quantities and prices increase enough that people do want to hold the extra stock of money.

That’s classic Monetarism. That’s what I learned from David Laidler. That’s what I hear when I read Scott Sumner too.

When I first read that paragraph I thought “wait a minute, I’m not a monetarist.”  I have a major problem with classic monetarism in two areas, monetary aggregates and policy lags.  I think that poor choices regarding these two issues did much to discredit the broader quantity theory approach.  The specific errors were to assume that the demand for money, however defined, was stable enough to make it a useful indicator (or instrument) of monetary policy.  The second mistake was to reject inflation or NGDP targeting on the grounds that because of policy lags, it would do more harm than good.  And as I will argue in a later post, because monetarists paid insufficient attention to the fact that monetary policy affects financial markets immediately, they misidentified many monetary shocks, and overestimated the length of policy lags.

Nevertheless, when I read Milton Friedman’s monetary economics I feel that he is saying important things than most other economists overlook.  So I am sure than certain core concepts of monetarism are deeply ingrained in my bones.  It wasn’t hard for Nick Rowe to notice that.

My problem with Woodford’s Neo-Wicksellian approach, and indeed any Keynesian interest rate-oriented view of monetary policy, is that it doesn’t seem to  explain many real world phenomena in a way that I find transparent.  During the Great Inflation of the 1960s-80s, some countries averaged 5% inflation, some 10%, some 20%, some 40%, some 80%.  I don’t doubt that Woodford’s model is technically correct, and I’m sure there is some way to explain these differing long run inflation rates with the time path of the policy rate relative to some (unobserved) natural rate of interest, but it is hard for me to visualize the process.  Much easier to just think about different money supply growth rates (always being aware of the fact that velocity does change.)

And I don’t think it is just me.  The two most famous proponents of the interest rate approach to monetary policy are Wicksell and Keynes.  (With Keynes’ main contribution being the ineffectiveness of money at the zero bound.)  It is striking that both of these figures reverted to a sort of crude quantity theory in the early 1920s.  Why did this happen?  Because in the early 1920s the world saw some of the most dramatic movements in price levels ever seen.  Germany and some other European countries experience rapid growth in their  money supply, and hyperinflation.  The U.S. and several other countries with stable exchange rates experienced extraordinary declines in their monetary base (perhaps the largest decline in U.S. history) and extremely rapid deflation.  One constant theme in my research into the history of monetary thought is that developments in theory almost always reflect the issues of the day.  That’s why one cannot really understand monetary economics, even at a theoretical level, without understanding history.  And that’s what people like myself and Nick Rowe learned from David Laidler.

I strongly recommend Nick Rowe’s blog to my readers.

P.S.  The work by Keynes that I referred to was the Tract on Monetary Reform (1923.)  I’ll try to dig up the Wicksell quotation.

Update:  The Wicksell quotation may not be in English.  But Lars Jonung discusses it in the European Economic Review, 32, pp 2-3, 1988.  I should also mention that my earlier comments were not intended to be anti-math.  Abstract models can be useful, and many of the top macroeconomists have both great technical skills and a very suble intuitive understanding of macro issues.  My point is that it is increasingly difficult for people like Laidler to get published in good journals, or hired by top departments (unless there have been recent changes that I am not aware of.)


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34 Responses to “Nick Rowe on Monetarism”

  1. Gravatar of Bill Woolsey Bill Woolsey
    10. March 2009 at 07:32

    I know cashless payments systems, and these “money less” models have money. Rowe’s quotation about Hamlet and the like get to the point. It is that money isn’t part of the model. The existence and creation of monetary disequilibrium is fully accounted for in the disquilibrium impact on short term interest rates. That all of these securities are paid with money and goods and services are traded for money is implicit.

    I think your are correct Scott, that if people take these models so seriously that they don’t even understand how it is that a central bank has any impact on interest rates, then… well, I guess it is difficult to take seriously anything they say.

    As someone who advocates institutional reform to allow for negative nominal interest rates, it always seems to me that the zero negative bound is treated in a very adhoc way. Why is there a zero negative bound? R greater than or equal to zero? It’s in the model?

    To me, if you think about the process, it becomes clear that the lower bound on interest rates is negative and equal to the cost of storing currency. To me, currency drains from the central banks and the banking system would have to play a key role. But these aren’t part of macro models.

  2. Gravatar of Jon Jon
    10. March 2009 at 09:33

    “I only met him once, and I recall that we chatted about the tech bubble. Mr. Laidler argued that this event showed that inflation targeting was flawed, and that central banks needed to pay more attention to asset prices.”

    You aren’t exactly clear here: was Laidler arguing that inflation targeting was wrong per se or that the estimate of inflation was flawed (and fixable).

    The definition of CPI-U and related indexes changed pretty substantially in 1981 and 1993. Reconstructions of the earlier techniques showed pretty startling warning signs over the tech bubble and housing bubble. Also, the earlier methods (applied forward) show much better with correlation broad-money growth-rates.

    After 1993, the correlation between inflation and broad money growth basically switches off. Greenspan famously attributed this to the integration of ex-soviet manufacturing into the global system and the rise of low-cost asian production.

  3. Gravatar of ssumner ssumner
    10. March 2009 at 12:36

    Bill, I agree with you about monetary models lacking money.

    I have a question about your institutional reforms to allow for a negative interest rate. I can see how that works for bank reserves (as has been discussed on this site) but what about cash? Do you envision a system of electronic money, such as debit cards, on which negative interest could be charged? This would avoid the inconvenience of Gesell’s stamped money idea.

    Jon, I am not certain, but I think Laidler might have concerns in both areas. Am I correct in assuming that the problem of changing definitions relates primarily to high tech products? I.e. that some sort of “hedonic” approach was adopted after 1993, allowing PC prices to fall sharply every time chip speed doubled? This could have masked rising inflation from non-high tech products.

    But I am also pretty sure that Laidler’s concerns went beyond definitional issues. Even if the CPI was measured perfectly, in his view a period where inflation is stable could be associated with sharply rising asset prices, leading to macroeconomic instability (especially related to long-lived investment projects.)

  4. Gravatar of Nick Rowe Nick Rowe
    10. March 2009 at 13:33

    Jon: Here is a link to a recent paper by David Laidler and Robin Banerjee on the subject: http://www.cdhowe.org/pdf/commentary_278.pdf . A very short (crude) answer: stick to inflation targeting, but total rather than core, prefer a version of CPI that indirectly includes house prices (homeowners’ replacement cost in the Canadian CPI), and watch asset prices as an indicator.

    Scott: thank you very much for your kind words and recommendation! I very much appreciate it, having been following your posts closely. By the way, I have only been blogging a few months longer than you, since Stephen Gordon kindly invited me to join his long-established blog as guest-blogger. (Fortunately, unlike you, I am on sabbatical this year :-) so have lots more time to blog).

    My last couple of blog posts are my attempts to sketch a model in which monetary policy could work even when nominal interest rates on the second most liquid asset (after money) are at zero. (My response to Paul Krugman’s 1998 paper showing it couldn’t work). I’m getting there, but not satisfied yet.

    Thanks again!

  5. Gravatar of Bill Woolsey Bill Woolsey
    10. March 2009 at 15:21

    I don’t think that tangible, hand-to-hand fiat currency should be the basis of the monetary system. I think that some sort of deposit accounts, generally with positive, but in unusual times with negative, nominal interest rates, should form the basis of the financial system.

    In crisis periods, the deposit-based payments system, financial markets, and the flow of production and income should be able to carry on. Redeemability into zero interest currency should cease when necessary. The difficulties this would cause for currency dependent sectors of the econonmy (like vending machines) must be borne. I recognized that currency dependent segments of the population, like the poor, would suffer.

    Basically, if the interest rates on low risk, short term assets are as negative as currency storage costs so a currency drain is a problem, and the Fed has bought up the national debt and has gone through all the AAA commercial paper, and we are looking at the sort of dodgy assets the Fed is actually buying now, then, a currency suspension should be considered as an alternative.

    The Fed is issuing liabilities so that people can avoid risk while accumulating risky assets–choose which assets it should hold.

    With a currency suspention, then currency would trade at its own price. While I suppose one could say that the currency price level would fall, the actual prices and wages that people use could continue to grow (or remain stable) consistent with the nominal income target.

    In the long run, I favor replacing government issued hand-to-hand currency with currency issued by banks and redeemable through the clearing system along with checks. I think any such currency would need to be callable, and that if it became unprofitable to issue, it would be called. Currency would disappear.

    So, this sort of loss of confidence would show up not in reduced nominal income, production, or employment in general, but with a difficulty in getting hand-to-hand currency. If banks want to issue dated currency at a premium, then they can.

    In such a system, under ordinary conditions, the only difference is that base money is solely made up of bank reserves. But the Fed could target the Federal Funds rate and use open market operations in T-bills to meet the target.

    In my view, I don’t think there is any problem with paying interest on reserves as long as they are paying less than the T-bill rates that the Fed is buying. And less than the Federal Funds rate that the Fed is targeting.

    And as the target drops, the amount banks are paid on reserve balances turns into payments they must make. And when it stops being profitable to issue currency, banks will stop. Perhaps the result will be 100% electronic payments in normal times too.

    I don’t favor outlawing zero interest hand-to-hand currency and forcing everyone to solely use deposits for money. But I don’t think the government should be providing it for people. And even if the govenrment does provide it, it shouldn’t be the basis of the payments system and the financial system. Everything shouldn’t be redeemable into zero interest hand to hand currency.

  6. Gravatar of David Stinson David Stinson
    10. March 2009 at 16:59

    Hi Scott.

    A few thoughts.

    First, I totally agree that studying the history of economic thought is crucial, for several reasons. Old texts can yield new insights or spark new thoughts when people are ready for them. My sense is that a number of the great early theorists were men of the world (not something that most academics could be accused of these days) and had a connection to urgent reality lacking amongst many modern theorists (e.g., monetary economics without money). Living through tumultuous times no doubt sharpened their need to understand what was happening around them and made clear the importance of particular events or facts. The policy and theoretical arguments that have been sparked by the current crisis make clear that the old debates are still very much alive, probably much to everyone’s surprise. Finally, widespread knowledge of the history of economic thought would make it more difficult for dominant schools of thought to ignore inconvenient issues or interesting ideas raised by the old debates or to condemn rival schools to obscurity for what may be ideological reasons (say it ain’t so! economists are scientists aren’t they?).

    Second, I don’t really understand why people think the Wicksellian transmission mechanism has “goes to a blank screen” once the central bank reduces short term nominal interest rates to zero. I get that obviously it can’t reduce those particular rates below zero but the Wicksellian mechanism, as I understand it, involves not the level of interest rates per se but the gap between the policy or target rate and a free market natural rate. A gap presumably still exists when the nominal rate is zero and thus is still exerting an influence. Furthermore, quantitative easing, by putting upward pressure on the prices of other assets, presumably more directly reduces, in effect, other rates. That’s not to say that there may not be other mechanisms operating as well.

    Third, it may be that the demand for money is “unstable” but perhaps that simply means that we don’t understand the factors affecting it so it moves around in ways we can’t predict or understand. I don’t see how one can understand the potential impact of monetary policy without understanding the interplay of demand and supply for money. Presumably, at least in the short run, the transmission mechanism relies on either excess demand for or supply of money. I have been struck by how little of the recent discussion one sees regarding monetary policy (and in particular regarding the Japanese experience or policies necessary to avoid deflation in the US), has involved any serious analysis of money demand. Maybe I just haven’t come across it.

    Fourth, math is undoubtedly useful in economics. It gives us another logical tool or language with which to develop or extract the implications of theory. However, I am not an academic and I have been out of school for a longish while but it appears to me that math ceased simply to be the servant of useful economic insight quite awhile ago. In that regard, mathematical macroeconomics may be approaching its “emperor-without-clothes” moment, if it hasn’t already. Mathematical models can provide clarity and simplicity but only at the expense of necessarily being approximations. They therefore lack the richness of insight that only verbal descriptions or analyses can provide, even with (or especially because of?) their ambiguity. Perhaps this is why much earlier works can be a continuing source of insight.

  7. Gravatar of Bill Woolsey Bill Woolsey
    11. March 2009 at 02:26

    Stinson,

    Great post.

    It seems to me that neo-Wicksellian approaches generally abstract away from the structure of interest rates and risk premia. Monetary policy impacts “the” interest rate.

    When short term rates hit zero, then monetary policy cannot impact “the” interest rate. The entire structure of interest rates can’t move up or down. Instead, it must compress the structure of interest rates. Longer term and higher risk interest rates are brought closer to short term interest rates.

    In the current crisis, I think there was a change in risk premia and a greater dispersion of interest rates. In my opinion, Fed policy, and much of what they call “quantitative easing” is trying to reverse the increase dispersion. Many people have argued, the Fed is targeting spreads.

    My view is that the additional risk premia reduces the natural interest rate. It is more than a bit ambiguous, but if the high risk projects are not going to be undertaken and so will not be a claim on resources, then lower risk investment projects, household investment in durable goods, and the current flow of consumption need to expand to utilize the resources. It looks to me like a lower natural interest rate.

    I also think that when a speculative bubble pops, we discover that the past natural interest rate was partly an illusion and that the relevant one is now lower. The market signal was generated that there was a lot of additional future output to be generated. Of course, in reality, there were naive momentum traders and those investing in the hope of selling to a greater fool. When this ends, we are back to more realistic opportuntites for future production. And that reality is a lower natural interest rate.

    So, if the new spreads are given, then the solution could be negative short term interest rates. Bring down “the” interest rate to reflect the new realities. In reality, some interest rates will be higher and others lower because of the new risk premia. But the general level needs to be lower.

    And, if that is impossible, then we are left with compressing the structure with monetary policy.

    Or, of course, using fiscal policy to raise the natural interest rate. With the government selling low risk debt, that should help “solve” the compression problem by increasing the supply on the low risk side.

    My view is that if we “rule out” monetary disequilibrium analytically, then the market interest rate must always be equal to the natural interest rate. And, if the market interest rate is equal to the natural interest rate, then there can be no montetary disequilibrium–the quantity of money is equal to the demand to hold money.

    We should be able to undestand market phenomenon through either framework.

  8. Gravatar of Nick Rowe Nick Rowe
    11. March 2009 at 02:55

    Bill: good analysis. But is it a *risk* premium, or an *illiquidity* premium, determining the spreads? (Or a bit of both.) I have greater confidence that Central banks could influence the illiquidity premium.

  9. Gravatar of David Stinson David Stinson
    11. March 2009 at 08:07

    Hi Nick & Bill.

    1) Excellent point, Bill, that quantitative easing will compress the risk/term structure of interest rates when the target rate has hit zero.

    2) This may be a question of semantics (and a symptom of my creeping Austrianism) but I think of the “natural” rate has the free market rate obtaining in a pristine world “before the fall” (i.e., without central banking), determined ultimately, I suppose, by time preference (in the case of risk free rates) and the combination of time preference and investment project risk characteristics (in the case of risky rates). Activist monetary policy affects, perhaps to varying degrees depending on term and risk, the interest rates that actually obtain in the market but by definition do not affect the natural rate.

    Nick, with respect to the nature of the market spreads that would be compressed by quantitative easing, would it not be the case that both term and risk spreads would potentially be compressed as a result of a) direct purchase of the associated financial assets by the central bank combined with b) arbitrage amongst the various non-zero elements of interest rate structure?

  10. Gravatar of JimP JimP
    11. March 2009 at 08:17

    Perhaps Bernanke is listening:

    http://online.wsj.com/article/SB123673192900789965.html

    by JON HILSENRATH

    Federal Reserve officials, preparing for a policy meeting next week, are considering whether to pump more money into the economy by expanding their lending and securities-purchase programs.

    Struck by the sharp deterioration in stock markets — despite Tuesday’s rally — and renewed strains in credit markets, Fed officials are likely at next week’s meeting to assess what success they have had with existing efforts and what more they can do to ease financial strains and prop up the economy.

    View Full Image
    Federal Reserve Chairman Ben Bernanke prepares for his speech Tuesday.
    Getty Images

    Federal Reserve Chairman Ben Bernanke prepares for his speech Tuesday.
    Federal Reserve Chairman Ben Bernanke prepares for his speech Tuesday.
    Federal Reserve Chairman Ben Bernanke prepares for his speech Tuesday.

    The Fed has already used its main tool to the limit, having pushed its target interest rate, the federal-funds rate, to near zero. It already has ramped up lending and asset purchases. But it could decide to push harder by, for instance, purchasing long-term Treasury securities or increasing its purchases of debt issued or guaranteed by Fannie Mae and Freddie Mac. It is unclear whether the Fed will decide to take new steps at its meetings on March 17 and 18.

    Treasury purchases could help bring down long-term interest rates by pushing up the price of government bonds and thus pushing down their yields. That, in turn, could bring down other long-term rates because Treasury debt is a benchmark for many loans and securities.

    Fed officials have wavered on taking such a step, but recently have been struck by the initial success the Bank of England appeared to have with such a move last week.

    “The world is suffering through the worst financial crisis since the 1930s, a crisis that has precipitated a sharp downturn in the global economy,” Fed Chairman Ben Bernanke said Tuesday in comments at the Council on Foreign Relations.

    A recovery, he added, would be “out of reach” until officials stabilize the financial system, and even if that happens the recession will persist until “later this year.”

    Adding a dose of humility to his assessment, Mr. Bernanke conceded, “My forecasting record on this recession is about the same as the win-loss record of the Washington Nationals.” The Major League Baseball team had 59 wins and 102 losses last year, the worst in baseball.
    [firepower]

    The Fed is in the process of building up a consumer lending facility called the Term Asset-backed Securities Loan Facility, or TALF, which it hopes to expand substantially. Officials also are likely to review issues such as how to unwind programs once the economy recovers.

    Mr. Bernanke has signaled in recent months his willingness to take aggressive action to combat the crisis. His reference Tuesday to the Great Depression stood in contrast to comments earlier in the week by European Central Bank President Jean Claude Trichet, who held out hope for a turnaround.

    In some respects, the Fed’s existing efforts are having success. For instance, interest rates on high-rated commercial paper have come down since the Fed introduced a program to backstop that market last year. But with broader market strains unrelenting and the recession not showing signs of reversing, the next steps are on the agenda.

    New York Fed President William Dudley underscored the Fed’s concern in comments last week, noting that the deleveraging hitting markets and households was not yet done, and “as the recent employment data have underscored, the economy has considerable momentum to the downside.”

    In the past few months, officials have put aside the idea of buying Treasurys and have instead focused on programs such as TALF that they hoped would more directly spur lending to businesses and consumers. Some Fed officials also have been wary of taking a step that could be seen by markets as an effort to help the government fund large budget deficits, which could be inflationary.

    But officials have seen firsthand evidence in recent days of the potential benefits of a Treasury purchase program. The Bank of England announced last week that it would begin buying U.K. government bonds. After the announcement, yields on those instruments briefly fell below 3% from more than 3.6% beforehand.

    Treasury purchases should “certainly” be on the list of possible next steps, said Charles Plosser, president of the Federal Reserve Bank of Philadelphia. Mr. Plosser isn’t a voting member of the policy-setting Federal Open Market Committee, which is composed of Fed board members in Washington and five regional Fed bank presidents. He has been an occasional critic of Fed policy, calling for more explicit targets by the central bank to help guide its actions.

    The Fed could easily increase its purchases of debt issued or guaranteed by Freddie and Fannie, the government-backed mortgage giants. The central bank has already committed to purchase $600 billion of these securities and since December has taken on more than $90 billion toward that goal.

    Mr. Bernanke has noted in recent speeches that this effort seems to be helping mortgage markets. Rates on conventional mortgages have fallen to 5.15% from more than 6% since the program was announced, according to Freddie Mac.

    The Fed’s total assets grew from about $900 billion to $1.9 trillion as of March 4, an indication of the huge amounts of cash it is pumping into the financial system.

    That amount has shrunk by more than $300 billion in recent weeks as some of its programs are tapped less aggressively. But it is likely to grow substantially in the months ahead. The TALF program, for instance, could grow to as much as $1 trillion.

    “We’ve grown our balance sheet by a factor of about two,” said Mr. Plosser. “It’s going to get bigger before it gets smaller.”

  11. Gravatar of Nick Rowe Nick Rowe
    11. March 2009 at 09:26

    David:
    “Nick, with respect to the nature of the market spreads that would be compressed by quantitative easing, would it not be the case that both term and risk spreads would potentially be compressed as a result of a) direct purchase of the associated financial assets by the central bank combined with b) arbitrage amongst the various non-zero elements of interest rate structure?”

    Yes, and the Keynesian part of my head sees it this way, in terms of what the Fed is buying.
    But the monetarist part of my head says it matters more what the Fed is selling (money). There is nothing special about the Fed’s ability to buy risk. Anyone can do that. But there is something special about the Fed’s ability to create liquidity, and thus bring down liquidity premiums.

    Is this a solvency crisis, or a liquidity crisis? I stress the latter (though questionable solvency is a major cause of the liquidity crisis, by making assets less liquid).

  12. Gravatar of ssumner ssumner
    11. March 2009 at 11:30

    Great comments.

    Nick, I guess I didn’t recall my conversation with David quite accurately. But after reading the paper you sent me you are clearly right–his big complaint is the use of a misleading inflation indicator. A couple comments on the CPI: I do agree that more often than not the overall CPI gives better warnings than the core CPI or PCE. That was certainly true in the mid part of the decade. But a NGDP target would have also signalled policy was too expansionary–as NGDP growth accelerated sharply in 2004-06 and was well about its 5% average during 1995-2008. Now lets go to a more recent divergence, 2008. The overall CPI spiked again in the first half of 2008, but NGDP growth average only 3.3% in 2007.4-2008.2 (perhaps slightly higher using final sales.) So the NGDP numbers were not signalling monetary overexpansion, and risk of rising inflation, and again I think NGDP was right in retrospect. So although I agree with David’s diagnosis of the problem with current inflation targeting, I still think NGDP targeting is the solution. I have an open mind on level vs rates targeting, but lean toward level.

    On page 9 he noted that the 1987 crash was unusual in that it was confined to financial markets. I really liked reading that result, as I had just done a post “Three Octobers” arguing two points:

    1. One should look at market indicators, including stock, bond and commodities markets.

    2. The 1929, 1937 and 2008 stock market warnings were accurate, but not 1987.

    When I wrote that I wasn’t sure what had happened to non-financial markets in 1987. Now it looks like my “look at all markets” idea was 4 for 4, as a forecast tool that could be utilized by central banks. In 1987, the stock warning was not confirmed in markets for real assets.

    Does Stephen Gordon still research Nordic countries? I was about to shift over to that area when the financial crisis hit, but I do have one post on Denmark which i think is kind of interesting (although I’m sure he’d find it very simplistic, as it’s just a blog post.)

    Bill, The bad news is that I don’t see the public accepting a system where cash may not trade at par. The good news is that the sort of reform you are considering takes a while to institute, and for better or worse I think cash will be replaced by electronic money (debit cards) sooner than people realize. When that happens, no more liquidity traps. Even better, using market expectations we will be able to stabilize the economy in real time. For me nirvana would be a system where NGDP expectations never budged from 5%, or maybe 3% if downward wage rigidity is not a problem.

    David, I think you misunderstand the “blank screen” problem. The fear is that the Wicksellian natural rate is now negative (partly due to deflation, partly due to financial crisis and weak economy.) If so, the policy rate must be above the natural rate. But Wicksell said that when AD is falling, you want the policy rate to be below the natural rate. (Someone correct me if I misunderstood his question.)

    The second part of your comment gets into quantitiative easing, and I agree that that can solve the problem, IF DONE RIGHT, by raising the expected infation rate, and hence getting the natural rate above the (assumed zero) policy rate.

    I totally agree that people don’t take money demand seriously enough. It is not infinitely elastic. And I also agree with your comment on the overemphasis on math.

    Regarding the discussion between Bill and Nick on liquidity/risk/compresssion, it is not my area of expertise. But let me throw out one strongly held view. many people thuinking through liquidity trap type scenarios underestimate how dramatically monetary policy can reshape the whole environment. I agree with Nick that monetary policy doesn’t have much direct impact on risk premiums. But I think if the policy is credible, like FDR’s dollar devaluation program, it can have a major impact on risk premiums via its expected impact on AD, growth, inflation, corporate profits, etc. The spread between the Baa and Aaa bonds was highly (negatively) correlated with the dollar price of gold over daily frequencies during the 1933 devaluation.

    JimP, I hope you are right, but perhaps someone can explain this for me; the MB has fallen from 1770b in early January to 1547b in early March. Why? I totally agree with someone who argues the MB is misleading right now (otherwise we’d be in hyperinflation.) But doesn’t that apply to increases in the MB? If someone asked the FOMC; why did you cut the base sharply, what would they say?

    1. They could say the base is irrelevant. But then I have no confidence that they will pursue QE aggressively.

    2. They could say the MB is relevant, and they are worried about inflation as banks reduce their demand for reserves. My response to that would be, huh?

    Can someone help me here, what am I missing?

    Nick, Regarding your final comment, can I assume that you see the MB as normally being a rather special asset, whose control can steer the (nominal) economy, but during financial crises other assets become very close substitutes in terms of liquidity, and thus the Fed needs to control that entire basket? If so, don’t you need something a bit more specific than highly liquid, something like near-zero short term expected rate of return assets, which could include T-securities with substantial long term yields, but near-zero short term yields as their price is expected to fall by almost the coupon payment over the next year or two. Does that make sense? I say this becasue it is theoretical possible to have a fairly liquid asset (Google stock?) that’s not at all a close substitute for base money (because it’s risky.)

    Again, all great comments.

  13. Gravatar of JimP JimP
    11. March 2009 at 12:53

    ss –

    Sadly – I don’t think you are missing anything. They are not committed to inflation – they are committed to screwing around in the credit markets without causing inflation. They are deflationists – which is exactly why they are paying interest on reserves.

    I can imagine only one reason. They are scared of crashing the dollar.

    But we need a lower dollar. We need the dollar to crash – against gold and houses and whatever else. Debase the currency – and get on with it!

  14. Gravatar of Jon Jon
    11. March 2009 at 13:46

    “But there is something special about the Fed’s ability to create liquidity, and thus bring down liquidity premiums.”

    I don’t think you need to resort to such an abstraction to comprehend money policy. In particular, at the first order, the Fed is just like any other individual with savings. By trading money for something, the Fed becomes a market participant and changes AD or if you like changes the MPS–regardless of whether it changes other individuals MPS.

    The Fed’s money is liquid in the sense that it hasn’t already been accounted for in Broad measures, there is a full velocity/reserve-ratio gearing yet to come–whereas ordinary savings have already been counted.

    I don’t think that the liquidity premium enters into it.

  15. Gravatar of David Stinson David Stinson
    11. March 2009 at 14:09

    “David, I think you misunderstand the “blank screen” problem. The fear is that the Wicksellian natural rate is now negative (partly due to deflation, partly due to financial crisis and weak economy.) If so, the policy rate must be above the natural rate. But Wicksell said that when AD is falling, you want the policy rate to be below the natural rate. (Someone correct me if I misunderstood his question.)”

    Thanks Scott, that does address my question. I understand your and Nick’s point now. I had assumed that the natural rate would be above the policy rate even now given that we have a) excess demand for money, and b) excess demand for credit (or so we are told), leading in the absence of monetary policy to interest rate increases.

    This is probably a dumb question but given the concerns regarding the availability of data that accurately reflects price inflation (as expressed by David Laidler and others, particularly in the Austrian camp), how do we know that we are close to a deflationary situation?

  16. Gravatar of Jon Jon
    11. March 2009 at 14:23

    “This is probably a dumb question but given the concerns regarding the availability of data that accurately reflects price inflation (as expressed by David Laidler and others, particularly in the Austrian camp), how do we know that we are close to a deflationary situation?”

    Good question. Following the 1981 methodology inflation is at 8%. Following the 1991 methodology inflation is at 3% …if you believe John Williams.

  17. Gravatar of ssumner ssumner
    12. March 2009 at 04:52

    JimP, I share your frustration, but will just add a couple observations.

    1. I think Bernanke may see the need for expansion a bit more than some others on the FOMC, but that’s just a guess.

    2. I know people must be sick of me talking about 1933, but in June 1933 FDR torpedoed the World Monetary Conference (which was trying to stabilize exchange rates) basically saying “look guys, I’m going to do what’s necessary to reflate the U.S. economy. If you don’t like seeing your currencies appreciate, you should do the same.” You may be right that the Fed is concerned about a falling dollar, but I think aggressive action by the Fed would encourage the ECB to move.

    Jon, I agree that money is special. What’s frustrating to me is that it is really hard to figure out exactly how much of this is T-bills becoming near perfect substitutes, and how much is caused by the Fed paying interest on reserves. Without knowing the answer, I prefer a multipronged approach that would work whoever is right. There is certainly some truth to the view that even without interest on reserves, T-bills and reserves would be close substitutes right now (as rates on both might fall to zero), and increasing the sum total of reserves and T-bills MIGHT be more effective than swapping T-bills for reserves. But I think you me and Nick are mostly on the same page regarding the broad outline of policies that could be effective, we may just differ about the details.

    David, We don’t know whether we are in deflation. Over the past 6 months the CPI has fallen, but it could well be flat over the next six months, or even slightly up. I also think, however, that the relevant “expected inflation rate” for the Fisher effect should probably have more things like the price of houses, and less like “rental equivalent” which may be a stickier price. Investors care about the expected change in (flexible) asset prices.

    Jon, I’m not familiar with John Williams, what sort of methodology does he use?

  18. Gravatar of David Stinson David Stinson
    12. March 2009 at 06:09

    “Jon, I’m not familiar with John Williams, what sort of methodology does he use?”

    I think he was referring to this fellow:

    http://www.shadowstats.com/section/primers

  19. Gravatar of Greg Ransom Greg Ransom
    12. March 2009 at 07:30

    David Laidler’s _Fabricating the Keynesian Revolution_ is a real eye opener.

    I especially recommend the book to Greg Mankiw — who needs to read it and then see if he can still look himself in the mirror after cranking out his laughably erroneous undergraduate Macroeconomics textbook year after year.

  20. Gravatar of crisis: Maybe Economists Show Know Something More Than The Hot Fashion Of the Moment In Mathematics crisis: Maybe Economists Show Know Something More Than The Hot Fashion Of the Moment In Mathematics
    12. March 2009 at 07:36

    […] Quote Of The Day: Mr. Laidler believes that macroeconomists have a great deal to learn from studying the history of their field. I read several of his excellent books on the history of monetary theory, linked here and here. It seems to me that scholars like David Laidler occupy an increasingly marginal place in modern macroeconomics, mostly on the fringes””such as the history of economic thought. But I’m coming to believe that the field of macroeconomics made a big mistake in adopting a highly technical and abstract style in recent decades. […]

  21. Gravatar of David Stinson David Stinson
    12. March 2009 at 08:14

    I took courses in macro from both David Laidler and Michael Parkin when I was Western for my MA. Both great teachers, very courtly, very pleasant, encyclopedic knowledge, old school (in the good sense).

    David Laidler’s “Demand for Money” is a classic and Prof Parkin’s intermediate macro text is also very good.

  22. Gravatar of Greg Ransom Greg Ransom
    12. March 2009 at 09:26

    The AEA Committee on Graduate Education wrote on this problem in the early 1990s. Someone on that committee said the graduate schools were producing a generation of “idiot savants”.

    David Colander has also written a lot on this topic, and produced survey work proving that graduate students in the top economics graduate departments effectively knew nothing about the real world of business and the economy, next to nothing about basic economic institutions, next to nothing of the history of economic theory, etc., etc. About the only bank of knowledge the graduate students at the top grad schools had was the mathematical technique produced and fashionable at the time.

  23. Gravatar of ssumner ssumner
    12. March 2009 at 12:34

    David, As I read the attachment from Williams, he is claiming that inflation was actually 10.8% in 2006. Is that really what he believes? Funny, I don’t feel like my real income fell 7%, I must have missed something. Someone tell me if I am misinterpreting his argument. (By the way, I think the CPI may slightly understate inflation, but not that much!)

    Greg, I actually like Mankiw’s book, but all textbook authors seem totally clueless about macro history. Their “Keynesian” model (AS/AD with a LRAS curve) is actually closer to the model of Hume, Fisher, Pigou ,Hawtrey etc., and what they call the “classical model” is actually a real business cycle model.

    David, Yes, I like both Laidler and Parkin.

    Greg, I hate to make broad-brushed generalizations about a whole discipline, but let’s just say that the response of the macro community to the economic crisis has made me more receptive to Colander’s argument. On the other hand, on this issue I don’t know whether I agree with the non-technical economists any more than I do the technical economists. But clearly we need to spend more time thinking about pragmatic issues. I don’t understand why the Fed didn’t have an effective anti-liquidity trap policy ready to deploy in case of crisis. And if they did, and this is it, then I hardly know what to say. Positive interest payments on reserves!!

  24. Gravatar of David Stinson David Stinson
    12. March 2009 at 14:16

    Re natural vs market vs policy rates, I found this to be useful:

    http://www.auburn.edu/~garriro/natneut.pdf

  25. Gravatar of David Stinson David Stinson
    12. March 2009 at 14:35

    I am not particularly familiar with the ShadowStats guy. I had heard of him via discussions on mises.org. I did take a look awhile back at some of the methodological pieces on his web site regarding the CPI – they centre as I recall on two things: adjustments for quality changes (hedonics) and assumed substitution away from certain goods as they become more expensive to less expensive alternatives. As I recall he may also have a concern with weightings used and the way they change to potentially understate inflation. His concern with hedonics relates mostly (I think) to the opportunities for exercise of perhaps questionable judgment in making the adjustments. There’s always the possibility that the exercise of this judgment may be, ahem, “informed” by incentives facing governments.

    The clearer argument it seems to me is the one relating to substitution. He argues that the inflation rate ought to measure increases in the cost of maintaining the same standard of living, not a change to the cost of, in effect, a new lower standard of living that inflation forced one down to.

    http://www.shadowstats.com/article/consumer_price_index

    http://www.shadowstats.com/article/special-comment

  26. Gravatar of Greg Ransom Greg Ransom
    12. March 2009 at 14:52

    The issue isn’t technical competence vs no technical competence. We want technical competent. The issue is whether very narrow technical competence is all that is to be rewarded in the economics profession.

    This is really a systemic issue for which there is no solution. Let me say it again. I’m not against technical economics nor technical proficiency — but as far as I can tell professional competence is judged by almost nothing besides technical proficiency, leading for example to the elimination of graduate level history of economic course requirements from almost every top graduate department in the country. All sorts of other kinds of competence have been eliminated from the graduate schools — even if the “behavioral” economics stuff, and some other trends, has opened a tiny bit of room off to the side.

    What you have is a relentless Ph.D factory, publish or perish, and self-selection system that filters out a particular product — a product very different than you got out of say the LSE in the 1930s when when a Ronald Coase could still be produced.

    Scott wrote:

    “Greg, I hate to make broad-brushed generalizations about a whole discipline, but let’s just say that the response of the macro community to the economic crisis has made me more receptive to Colander’s argument. On the other hand, on this issue I don’t know whether I agree with the non-technical economists any more than I do the technical economists.”

  27. Gravatar of Greg Ransom Greg Ransom
    12. March 2009 at 14:59

    Here’s the major part of what does the “filtering”.

    What is the easiest thing to teach? Math.

    What is the easiest / fastest thing to publish? Math and/or data “testing”.

    What is that fastest way / most reliable way to produce a dissertation? Math and data “testing”.

    What is the easiest way to judge something is “science” or is “objective”? Math and data “testing”.

    I’m not the first to point these things out. Coase, Colander, Hayek, and many other have written about all this.

    The role of macroeconomics and the macroeconomists in the current crisis should put a big spotlight on the sociology of economics of the sort that Colander has pioneered.

  28. Gravatar of Jon Jon
    12. March 2009 at 17:09

    Scott notes:
    “he is claiming that inflation was actually 10.8% in 2006. Is that really what he believes? Funny, I don’t feel like my real income fell 7%, I must have missed something.”

    I don’t subscribe to John Williamson’s stuff, so I don’t really know his thinking. But lets say this was a debate club and I had to argue the point:

    How fast is tuition growth at Bentley? What about medical costs? Housing? Legal advice? One explanation for the Balassa-Samuelson effect is that inflation does not effect prices uniformly. Rather prices of goods with strong international markets are held down but insular goods and services inflate. This is possible whenever the currency exchange value is distorted e.g., by the unique status of the dollar or other qualitative judgment about the regime.

  29. Gravatar of David Stinson David Stinson
    13. March 2009 at 05:10

    It’s hard to disagree with John Williamson on the question of substitution towards less expensive products. It seems to me that that it is unquestionably going to bias the inflation figure downwards. I gather that that change was introduced in the early 1980s or ealry 1990s (I don’t recall which).

    I suppose it also implies a larger point which is that using representative basket is problematic in and of itself in that it may lead to confusion over whether prices changes are due to excess supply of money (“inflation”) or whether they are due to changes in the relative price of the basket vis-a-vis things not in the basket.

  30. Gravatar of Jon Jon
    13. March 2009 at 08:00

    “It’s hard to disagree with John Williamson on the question of substitution towards less expensive products.”

    Its pretty conservative to believe in the ’91 methodology. The subsequent switch to geometric averaging strains credulity given that it does precisely as John suggests: it de-weights rising prices and emphasizes falling prices.

  31. Gravatar of ssumner ssumner
    13. March 2009 at 17:08

    David, Without getting into a lot of technical debates, let me indicate a few general points. If you don’t take the substitution effect into account you get nonsense. Why isn’t the argument symmetrical? To reproduce my current standard of living in 1982 would cost millions–because just the computer power in front of me would have cost millions. So if I wanted to go back in time w/o subtitution, it would make it look like the cost of living was actually higher in the old days.

    In addition, don’t leftists always say that median incomes have stagnated since the 1960s? But when I was a kid a middle class house was often a 2 or 3 bedroom ranch with one bath, a one car garage and a formica-countered kitchen. People didn’t eat out much or take many vacations by jet etc. The society simply looks much richer to me today than it did back then. (Yes, I know more women work, but still.) Now others might feel differently. But if inflation is actually near 10%, then it is even far worse than the leftists claim, we are rapidly regressing to Mexican real income levels–even accounting for two incomes.) I just don’t believe that makes sense.

    Greg, I think the argument you make is very well put, better than I did. I’ll have more to say about journal bias in a later post.

    Jon, Here’s a few wild guesses off the top of my head, to explain why I don’t believe the 10.8% figure. I’d guess the official Bentley tuition went up by 8%, I’d bet average tuition went up by 6% (because of growing price discrimination.) I’d guess the true CPI went up 4%. And I’d guess the measured CPI went up 3%. Those are all guesses, but it gives you an idea of the sort of numbers I find plausible, and I don’t have an axe to grind in this debate.

  32. Gravatar of ssumner ssumner
    13. March 2009 at 17:09

    David, Without getting into a lot of technical debates, let me indicate a few general points. If you don’t take the substitution effect into account you get nonsense. Why isn’t the argument symmetrical? To reproduce my current standard of living in 1982 would cost millions–because just the computer power in front of me would have cost millions. So if I wanted to go back in time w/o substitution, it would make it look like the cost of living was actually higher in the old days.

    In addition, don’t leftists always say that median incomes have stagnated since the 1960s? But when I was a kid a middle class house was often a 2 or 3 bedroom ranch with one bath, a one car garage and a formica-countered kitchen. People didn’t eat out much or take many vacations by jet etc. The society simply looks much richer to me today than it did back then. (Yes, I know more women work, but still.) Now others might feel differently. But if inflation is actually near 10%, then it is even far worse than the leftists claim, we are rapidly regressing to Mexican real income levels–even accounting for two incomes.) I just don’t believe that makes sense.

    Greg, I think the argument you make is very well put, better than I did. I’ll have more to say about journal bias in a later post.

    Jon, Here’s a few wild guesses off the top of my head, to explain why I don’t believe the 10.8% figure. I’d guess the official Bentley tuition went up by 8%, I’d bet average tuition went up by 6% (because of growing price discrimination.) I’d guess the true CPI went up 4%. And I’d guess the measured CPI went up 3%. Those are all guesses, but it gives you an idea of the sort of numbers I find plausible, and I don’t have an axe to grind in this debate.

  33. Gravatar of TheMoneyIllusion » Seeing the world in a different way (one year later) TheMoneyIllusion » Seeing the world in a different way (one year later)
    2. February 2010 at 12:25

    […] example of this is the post I did on liquidity traps, which argued against reductionist models that “it all boils down […]

  34. Gravatar of Leota Vitanza Leota Vitanza
    10. December 2011 at 15:35

    Technically, its a corollary of Godwins Law that Godwin himself endorsed, and is so widely coupled with the original law that most people assume it to be a part of the original law and act accordingly.

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