Noah Smith was once even smarter

I think it’s fair to say that we’ve all been impressed by Noah Smith’s brilliance as a blogger.  But a new Smith post leads me to believe that he used to be even smarter.  Smith points to 7 areas where other bloggers have changed his views.  At least three or four would probably make my list as well, but I also see three where I think Noah moved in the wrong direction—two where Paul Krugman was the culprit.  Here’s one:

Paul Krugman convinced me that Japan’s 1990s stimulus had some positive effects.  Living in Japan in the mid 2000s, I picked up the conventional expat wisdom that Japan’s “fiscal stimulus” was a total waste, driven by clientelist construction spending and LDP corruption, concreting over the riverbeds and building bridges to nowhere. And while I still believe there was a ton of waste, Krugman blogged some data showing how mild Japan’s two recessions in the 90s were, despite the incredible severity of the country’s financial crisis. That’s a powerful argument. I now believe that though Japan’s 1990s spending spree probably wasn’t worth it on balance, it probably was not quite as unmitigated a waste as I had thought.

Actually that’s a very weak argument.  Krugman’s right that the recessions were not particularly severe, but it had nothing to do with fiscal stimulus.  The performance of Japanese AD over the past few decades is mind-bogglingly bad, even in per capita terms.  To that extent that RGDP growth has been non-disastrous, that’s due to growth in aggregate supply.  If Greece or Spain was hit by the AD shock that hit Japan, they would have 20% unemployment.

And here Noah is convinced by Steve Williamson:

Steve Williamson convinced me that the macro field is structurally biased toward monetarism.  I can’t find the post(s) now, but Williamson has pointed out that central bank macroeconomists have a strong incentive to choose and promote models in which independent, active central banks are the most important stewards of macroeconomic stability. Since a big percent of top macroeconomists work at central banks, this is a non-trivial observation. I was trained to be pretty monetarist (by Miles Kimball and somewhat by Bob Barsky), but Williamson’s point was a good one, and has given me pause. Of course, it’s a bit of a cynical Marxist type point, but a good one nonetheless.

Actually the profession is nowhere near monetarist enough.  Very few macroeconomists blamed the Fed’s tight money policy for the 2008-09 slump.  Even worse, not many thought the Fed could do much about it, despite the fact that our textbooks say monetary policy is highly effective at the zero bound.  The markets have been way ahead of the economists for many years, and it’s finally starting to sink in.  With markets reacting strongly to even tiny hints of further tightening, even people like Paul Krugman are warning that tapering could slow the recovery.

Many economists underestimate the importance of monetary policy because they think in terms of a money –> interest rate –> investment –> AD transmission mechanism.  A very non-monetarist mechanism, I might add.  For instance, here’s Smith in another recent post:

Econ 102 says that banks lend money to long-term risky projects. They choose to lend if the expected real rate of return from a risky project is greater than r + S, where r is the safe real rate of return, and S is some required spread.

With IROR > T-bill rate (as now), the IROR is the safe asset. With IROR < T-bill rate, the T-bill rate is the safe asset.

The IROR is 0.25%. The T-bill rate is just over 0%. This means that the difference in the expected real rate of return between a world with an IROR and a world without an IROR is about 0.25%. In a world without an IROR, banks lend to any risky project with an expected real rate of return of S. In a world with an IROR, banks lend to any risky project with an expected real rate of return of S + 0.25%.

Therefore, what Feldstein is asserting is that there is an absolutely huge number of risky projects whose expected return is between S and S+0.25. He is asserting that if we lowered the safe rate by 0.25%, a huge panoply of projects would then become worth investing in, and a huge torrential flood of reserves would be released into the economy, boosting inflation and lowering unemployment in the process.

Does that seem reasonable? 

This makes me want to pull my hair out.  Yes, an EC 102 student might look at things that way.  But Smith studied graduate macro under Miles Kimbell.

YOU CAN’T TELL ANYTHING ABOUT THE STANCE OF MONETARY POLICY BY LOOKING AT INTEREST RATES.  (or if you can, low rates probably mean tight money.)

Back in 1937 they didn’t think the higher reserve requirements would do much harm, as interest rates only rose 0.25% in response.  But the demand for base money rose, and that’s deflationary.  If IOR increases the future expected demand for reserves, relative to the supply, it could have a huge contractionary effect, despite the fact that interest rates hardly budged.

If you insist on using Woodfordian NK language, the IOR program increases real interest rates in two ways, higher nominal rates and lower expected inflation.  Indeed a cut in IOR might boost NGDP growth expectations so much that it would be expansionary even if market interest rates don’t fall at all.

Now it’s very possible that IOR did not have a major contractionary impact.  In fact I agree with Noah that it probably did not.  As with any other Fed tool, what matters most is the impact on future expected Fed policy.  I can make plausible arguments either way.  Ironically, the sorts of arguments that Keynesians use to defend fiscal policy (i.e. the Fed doesn’t like to do QE, and hence won’t do monetary offset) actually make it more likely that IOR had a major contractionary impact.

The best way to think about monetary policy is through the lens of the expected hot potato effect.  Any Fed action should be judged in terms of its impact on the long term trends in monetary base supply and demand, not interest rates.  Policies that make the expected future base rise relative to expected future base demand are expansionary, and vice versa.  That approach doesn’t tell us that IOR was highly contractionary, but given that the IOR rate is higher than what banks earn on T-bills, it certainly might have sharply increased base demand.

PS.  Here’s my short course on money for any misguided folks who still evaluate monetary policy through the lens of interest rates.

PPS.  I hope Noah Smith doesn’t take this personally; I had just as many problems with Cardiff Garcia’s list, and I’m sure they could find fault with many items on my list.  If I had one.

HT:  TravisV and Tyler Cowen


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24 Responses to “Noah Smith was once even smarter”

  1. Gravatar of no more banksters no more banksters
    23. July 2013 at 15:41

    Why banksters laugh with the recent ECOFIN decision

    http://failedevolution.blogspot.gr/2013/07/why-banksters-laugh-with-recent-ecofins.html

  2. Gravatar of Arthur Arthur
    23. July 2013 at 15:54

    Scott,

    I think you should read Noah’s point about macroeconomists being monetarist again:

    “central bank macroeconomists have a strong incentive to choose and promote models in which independent, active central banks are the most important stewards of macroeconomic stability”

    Thou he called it monetarism he is not talking about monetarism, and I think you might even agree.

  3. Gravatar of W. Peden W. Peden
    23. July 2013 at 15:58

    Arthur,

    Exactly: central banks have historically been sources of instability more often than stability, and the single most famous monetarist book (A Monetary History of the United States) is a great account of such destabilising episodes.

  4. Gravatar of ssumner ssumner
    23. July 2013 at 16:51

    Arthur and W. Peden, Yeah, I noticed that too, but decided to let it slide as I wanted to focus on a different issue.

  5. Gravatar of SG SG
    23. July 2013 at 17:12

    Noah needs to read the Romers’ paper opining that the most dangerous idea in the history of the federal Reserve is that monetary policy doesn’t matter. The fed is only biased to believe that is omnipotent in good times. When it destroys the economy due to its own incompetence, then it has a strong incentive to convince everyone that it is actually powerless.

  6. Gravatar of TravisV TravisV
    23. July 2013 at 17:36

    Yglesias:

    “This Staggering Video of Chinese Subway Crowding Will Make You Doubt the Country Suffers From Overinvestment”

    http://www.slate.com/blogs/moneybox/2013/07/23/video_chinese_subway_crowding_and_the_questionable_case_for_overinvestment.html

  7. Gravatar of Philo Philo
    23. July 2013 at 19:52

    “Williamson has pointed out that central bank macroeconomists have a strong incentive to choose and promote models in which independent, active central banks are the most important stewards of macroeconomic stability.” Not lately! Given the macroeconomic instability of recent years, central bank macroeconomists have an incentive to dodge the blame.

  8. Gravatar of Benjamin Cole Benjamin Cole
    23. July 2013 at 19:58

    “The macroeconomic field is structurally biased toward monetarism.”

    Will somebody please tell the fed? Tell the fed to announce a very aggressive pro-growth monetary policy that they will stick to until certain growth targets are hit?

    Boy, that’a a relief. Finally people get it. Not.

  9. Gravatar of Noah Smith Noah Smith
    23. July 2013 at 21:38

    This makes me want to pull my hair out. Yes, an EC 102 student might look at things that way. But Smith studied graduate macro under Miles Kimbell.

    YOU CAN’T TELL ANYTHING ABOUT THE STANCE OF MONETARY POLICY BY LOOKING AT INTEREST RATES. (or if you can, low rates probably mean tight money.)

    But Scott, that’s not what I’m claiming.

    What I am NOT claiming: “0.25% is a low number, hence a 0.25% IROR indicates easy monetary policy.”

    What I AM claiming: “0.25% is not much different from 0%, so monetary policy is not much tighter than it would be with an IROR of 0% AND a TBill rate of 0%.”

    See?

    I AGREE with you that the level of the interest rate doesn’t say much about the stance of monetary policy.

  10. Gravatar of Noah Smith Noah Smith
    23. July 2013 at 21:55

    Scott – Also, note that I said the macro field is structurally biased toward monetarism. I also think that nearly everyone outside the macro field is structurally biased against monetarism, severely constraining the not-actually-independent Fed. So though we disagree on this point, perhaps we disagree less than you might think.

  11. Gravatar of Kevin Dick Kevin Dick
    24. July 2013 at 00:00

    @Noah. A pedantic point…

    Scott says, “YOU CAN’T TELL ANYTHING ABOUT THE STANCE OF MONETARY POLICY BY LOOKING AT INTEREST RATES.”

    Then you say you’re not doing that and clarify with the statement, “0.25% is not much different from 0%, so monetary policy is not much tighter than it would be with an IROR of 0% AND a TBill rate of 0%.”

    But clearly the only data in you statement are in fact interest rates. You don’t seem to understand that Scott hates _all_ interest rates. Almost as much as inflation. Just about anything with a % sign can unleash his inner Hulk. The only thing powerful enough to counteract the evil % and soothe the savage beast are the magic incantations “NGDP” and “growth”.

    Why do you insist on making him angry. We don’t like him when he’s angry :-)

  12. Gravatar of Vaidas Urba Vaidas Urba
    24. July 2013 at 01:49

    I agree with Noah that the exact level of IOR is not very important. The ECB has cut the deposit rate to zero one year ago, nothing much has happened, the situation only changed after the OMT was hinted. Please also note that the Bank of England is paying 50bps without any adverse consequences.

  13. Gravatar of davidpaff82 davidpaff82
    24. July 2013 at 02:12

    ” even people like Paul Krugman are warning that tapering could slow the recovery.”
    “what matters most is the impact on future expected Fed policy.”

    I think PK has been saying that since the late 90s re japan and future expectations:

    “In a liquidity trap monetary policy does not work because the markets expect the bank to revert as soon as possible to the normal practice of stabilizing prices; to make it effective, the central bank must credibly promise to be irresponsible, to maintain its expansion after the recession is past.” (December 1999)
    http://www.pkarchive.org/theory/thinking.html

  14. Gravatar of Scott Sumner Scott Sumner
    24. July 2013 at 05:21

    Travis, I already have done a post on that, I’ll put it up later today.

    Philo, Good point.

    Noah, That doesn’t address the overall point of my post at all. It’s not just interest rates that are unreliable, changes in interest rates are also unrelaible. In 1933 FDR did a very powerful monetary stimulus, and rates barely budged. They are simply not informative–in levels or rates of change.

    Vaidas, Yes, you agree with Noah’s conclusion. But I know you are much too smart to agree with his reasoning process. It was his reasoning process I objected to. I said in the post I didn’t think a quarter point cut in IOR would make a big difference.

    David, Yes, he’s been saying the second comment since 1998, but not the first. So your comment is very misleading, mixing up two very different points. He’s only been stressing the importance of QE recently. In earlier years he said QE would be ineffective.

  15. Gravatar of marcus nunes marcus nunes
    24. July 2013 at 05:41

    “Many economists underestimate the importance of monetary policy because they think in terms of a money -> interest rate -> investment -> AD transmission mechanism. A very non-monetarist mechanism, I might add.”

    They would certainly gain by reading Yeager´s Money & Credit Confused:
    http://www.jstor.org/discover/10.2307/1059419?uid=2&uid=4&sid=21102177781263

  16. Gravatar of o. nate o. nate
    24. July 2013 at 05:48

    To be fair to Noah, he was responding to Feldstein’s argument that IOER was restraining growth precisely through the credit channel, by giving banks an incentive not to lend. So his comments about interest rates are very relevant to that argument, however you may feel about their relevance to the overall stance of monetary policy.

  17. Gravatar of TheMoneyIllusion » Replies to Selgin and Smith TheMoneyIllusion » Replies to Selgin and Smith
    24. July 2013 at 07:01

    […] Noah Smith responded to my previous post with this […]

  18. Gravatar of mere mortal mere mortal
    24. July 2013 at 10:59

    “Even worse, not many thought the Fed could do much about it, despite the fact that our textbooks say monetary policy is highly effective at the zero bound.”

    Wait, what? Push on strings much?

    “low rates probably mean tight money”

    Wait, what? Personally, I just refinanced well under 4% and for the first time am more anxious about home improvements than paying down the note. Ergo…

    “I can make plausible arguments either way”

    Finally, something that I can recognize as coming from an economist.

  19. Gravatar of Geoff Geoff
    24. July 2013 at 16:33

    “YOU CAN’T TELL ANYTHING ABOUT THE STANCE OF MONETARY POLICY BY LOOKING AT INTEREST RATES.”

    YOU CAN’T TELL ANYTHING ABOUT THE STANCE OF MONETARY POLICY BY LOOKING AT INTEREST RATES, PRICES, NGDP, OR ANY OTHER NOMINAL STATISTIC IN THE INFLATIONARY SYSTEM ITSELF.”

    We cannot observe subjective valuations manifesting in unhampered prices, for both real goods vis a vis money, and for money vis a vis real goods, precisely because such valuations are overruled by the central bank monopoly.

    The only valid datum of sufficiency or insufficiency in goods and money, is by observing individuals making choices without coercion. That is the true system of values and the gauge of all things economic related. If we want to know if potatoes are insufficient, we look at the behaviors of individuals in an unhampered potato industry relative to non-potato goods production. If we want to know if money is sufficient or insufficient, we look at the behaviors of individuals in an unhampered money industry relative to non-money goods production.

    This is rather trivial. Why complicate it with delusions of monopolist ideology?

    It doesn’t matter what the central bank does with money, given they have a monopoly. We cannot know if money is sufficient or insufficient by observing statistics within that system itself. We have to have access to observing individual subjective valuations manifesting themselves in unhampered exchange ratios (prices). It’s the only way to know whether or not money is sufficient or insufficient.

    It is totally and completely arbitrary to assert that 5% NGDPLT is close to what a free market would generate. Nobody can know this without observing actual individual activity in an unhampered system. All claims to tight and loose money in a central banking system are vain and arrogant presumptions.

  20. Gravatar of Geoff Geoff
    24. July 2013 at 16:37

    Measuring anything requires an EXTERNAL standard of measurement.

    Measuring the stance of monetary policy, using the monetary policy system itself, is a tautology.

  21. Gravatar of James James
    25. July 2013 at 06:43

    “If Greece or Spain was hit by the AD shock that hit Japan, they would have 20% unemployment.”

    This is a typo, no?

  22. Gravatar of ssumner ssumner
    25. July 2013 at 06:48

    o. nate, No, that doesn’t help. A quarter point change in the IOR could have a huge impact on bank lending, if it raised NGDP growth expectations.

  23. Gravatar of o. nate o. nate
    25. July 2013 at 08:24

    If that was Feldstein’s argument, he doesn’t make it very clear. In any case, it’s not clear why a 25 basis point interest rate on reserves should have such a large effect on NGDP expectations, as you’ve already acknowledged.

  24. Gravatar of ssumner ssumner
    25. July 2013 at 14:05

    o. nate, It was very clearly a monetarist argument about the money multiplier and the money stock. It has nothing to do with the credit channel.

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