Christina Romer defends NGDP targeting

I found this excellent Chistina Romer interview at

I’d like to briefly discuss the extent to which we should try to return to the previous trend line, and also the location of that trend line.

In the comment section you will occasionally see people criticize Romer for starting the trend line from 2007, when according to people of the Austrian persuasion (and many others as well) overheated economy was experiencing unsustainable levels of real estate speculation.  In fact, by 2007 the real estate industry was already sharply depressed from 2005-06 levels, but let’s accept that critique for the sake of argument.

I decided to see what would happen if we pushed the trendline back to the 3th quarter of 2001, which was the trough of the previous recession.  I don’t think anyone would claim the economy was overheated at that time.  In the following table I list the current NGDP gap (2011:Q3) assuming 4 possibilities:

Starting date            5% trend      4.5% trend

2001:4                      -10%              -5%

2007:4                      -12.4%           -10.4%

Romer used a 4.5% trend and estimated a roughly 10% NGDP gap.  She probably used calendar 2007 as a starting point, which may explain the slight discrepancy.

There are good arguments for both 4.5% and 5%.  The long term trend for RGDP growth has been about 3%.  So given the Fed’s 2% implicit inflation target, 5% seems about right.  On the other hand many people (including me) think trend growth has now slowed to about 2.5%, or even a bit less.  That makes 4.5% seem more appropriate.

[BTW, I don’t think this is the right way to think about the target, as I believe problems generally attributed to inflation are actually due to changes in either employment or NGDP.  But I will play along since everyone else views low and stable inflation as one of the policy goals.]

I favor level targeting, which means returning to the previous trend line.  But which trend line?  In 2009 I favored returning to the trend line up through mid-2008.  But so much time has now gone by that it’s no longer clear where the relevant trend line is.  It would be different if the Fed had already announced a NGDP target, then we could draw a 5% trend line from that point forward.  But they didn’t.  If you don’t follow my argument, take this reductio ad absurdum example:

Assume that economic historians determined that the Roman Empire’s NGDP grew at a 5% annual rate during the reign of the “five good emperors.”  They also showed that Italian NGDP is currently 23% above a trend line extrapolated from 180AD, the date Marcus Aurelius died.  Should the Bank of Italy exit the euro and deflate Italy’s NGDP by 23%?

Each day that goes by makes the 1990-2007 trend slightly less relevant.  Don’t get me wrong, I strongly support Christina’s Romer’s policy if the alternative is current policy.  But at this late date it’s perhaps too much to expect the Fed to return all the way to the previous trend line.  And I’m not sure it’s still optimal; many labor and debt contracts have been made post-2008, and much lower expected levels of future NGDP.  So a good compromise might be to use the 2001:4 cyclical trough as the starting point, and 4.5% as the trend rate of NGDP growth.  Those are both highly conservative assumptions, and yet allow us 5% worth of NGDP “catch-up,” before returning to the trend line.  That’s 7% NGDP growth for 2 years, far higher than currently expected.  If the Keynesians are right (and I think they are 80% right) the vast majority of that extra growth would be real.  That would bring unemployment down quite rapidly, facilitating pro-supply side adjustments to the UI program.  A virtuous circle would ensue.

PS.  Don’t expect consistency in my blog posts; I’ll probably continue to throw out 5% numbers for simplicity.  I also favor targeting per capita NGDP, not total NGDP, but usually don’t bother mentioning that fact.  Let’s first get the Fed on board for the general concept, then we can work out the details.

PPS.  Speaking of emperors, did Berlusconi remind you more of Caligula (orgies) or Nero (fiddling while Rome burned?)

Random thoughts on Italy

Totally off topic, but my wife and I recently spent 12 days in Italy.  Here are a few thoughts/suggestions for those thinking of visiting.

1.  I am currently teaching a course on “The Good Life.”  I don’t know what that means, but it seems like the US has “the convenient life” whereas Italy has “the beautiful life.”

2.  Italy is arguably the best country in the world.  I said arguably—I agree that arguments can be made for lots of other countries.  But it least it’s not one of those countries that are not arguably the best country in the world, like Moldova.

3.  I hate Italian cars.  I am one of those stupid Americans who never learned how to drive manual cars.  My rental car was actually considered an automatic–but I don’t know what that term means in Italy.  Fiat500, powered by a lawnmower engine.

4.  Venice isn’t just the best city in the world, the circa 1600 AD version was the best city ever.  Man’s greatest achievement.  Don’t miss Scuola San Rocco, which Ruskin called one of the three most valuable buildings in the world.  The other two, the Sistine Chapel and Campo Santo of Pisa, are also in Italy.  (Too bad the USAF didn’t read Ruskin.)  After seeing one of San Rocco’s Tintorettos Henry James commented “Surely no single picture contains more of human life; there is everything in it; including the most exquisite beauty.”

5.  Venice was packed to the gills with tourists–NEVER go there in August.  Fortunately the Accademia was nearly empty.  The arts are underfunded in Italy (or perhaps I should say they simply have too much art to take care of.)  The museum was obviously in need of money, but that made things easier for tourists.  You could walk right up to paintings like Giorgione’s The Tempestwithout even a guard nearby.   There are superb paintings by Bellini.    The room of Carpaccios is stunning.  Oddly, I saw very few Titians in Venice.  The Guggenheim has a nice collection of surrealist works, but that’s not why people go to Venice.

6.  We’d stayed in Vicenza for two days, but I recommend Padua instead.  It has a much livelier city center, with many good restaurants.  You can take the train to Vicenza and see the highlights in a single day (Villa Rotonda, Villa Valmarana, Teatro Olimpico, Piazza dei Signori.)  You can also see Venice with a short train ride from Padua.

7.  In Bellagio we stayed in the Hotel Panorama, which (as the name suggests) has an awesome view.  It’s only 2 stars, perhaps because the showers are too small.  But recall the set point theory of happiness.  All your aggravation in the shower will merely heighten the enjoyment of exploring the area.  We also had more luck conversing with people there than in the 3 star or higher hotels, just as David Brooks predicted.

8.  If democratic capitalism is the end of history, then Venice was the beginning of the end.  They were  a quasi-democracy, where the elected doge was nearly powerless.  About 2000 people from “good families” were given the vote.  It seems to me there is a sort of parallel between Venice and the Nordic countries.  The Nordics thrive despite relative high taxes.  Venice thrived despite the fact that it was a very expensive place to build, the entire city rests on millions of wood pilings driven deep into the mud.  In both cases the advantages of good governance overcame the disadvantage of higher costs (taxes or pilings.)  The first example of Seasteading?

9.  Is a market economy inconsistent with great art?  Answer:  Bellini, Carpaccio, Giorgione, Titian, Tintoretto, Veronese, Tiepolo, Canaletto.

10.   When I first visited Venice at age 30 I thought about how I’d later return to do it right; with more money, time, and freedom.  I didn’t realize that when I returned I’d see the city through the eyes of a 55 year old man, not a 30 year old.  Don’t put off travel until you are old.

Northern Italy bleg

I’m planning a 12 day expedition to try to boost Italy’s NGDP, and hence cut their debt/GDP ratio. I’d appreciate any restaurant suggestions for Vicenza, Padua and Milan.

Blogging will probably not be possible, as I won’t bring a computer.  Let’s hope the news isn’t as bad as during my trip to Wisconsin a couple weeks ago.  BTW, I forget to mention my Wisconsin top 10 list after my trip.

1.  House on the Rock  — Shag carpet on the ceiling!

2.  Taliesin — Sublime.

3.  Capital building — one of America’s finest.

4.  Wisconsin Dells — like Vegas/Orlando, but much more kitschy

5.  Johnson Wax///Wingspread  — Frank Lloyd Wright in Racine

6.  Devil’s Lake  — Wisconsin lacks great scenery, but the southwest is attractive in a low key way.

7.  Unitarian Church in Shorewood Hills  — called one of the 5 best churches in America.  Most people living a mile away have never heard of it.

8.   Farmers and Merchants Bank in Columbus — Louis Sullivan’s last “jewel box” bank.

9.   Union Terrace, UW student Union in Madison — Back when I was in school a 16 year old could buy a pitcher of beer and sit by the lake drinking all evening.

10.  Milwaukee Art Museum  — designed by Calatrava–I need something in Wisconsin’s only big city.

Most of these are close to Madison, which is the state’s best city.

Moscow on the Adriatic

Nothing original here, this was inspired by some recent Matt Yglesias posts:

1.  Russia is a mafia-ridden corporatist state.

Italy invented the term ‘mafia.’

2.  The Russian government controls the media.

Berlusconi owns the media.

3.  The Russian government likes to have reporters killed.

Berlusconi likes to joke about it.

4.  The Russian government is soft on Qaddafi

Italy is too.

5.  Putin jokes about ruling until he’s 120.

Berlusconi does too.

6.  Putin projects a macho image.

So does Berlusconi.

Consider the following quotation from Tyler Cowen (which I strongly support:)

SHAFFER: What’s one economic lesson you wish all politicians would learn?

COWEN: A simple one is to do the right thing. That sounds naïve, but if you think about these people, if they don’t get reelected, the jobs and lives they fall into are remarkably good. And I don’t just mean by the broader historical standards of the human race, compared to the Stone Age, but even compared to other wealthy people in 21st-century America. So most politicians ought to have the stones to vote for what they think is right, even if it may be an idea I disagree with, and say to the voters, “Send me back to my life as whatever. I’m willing to do this to address our fiscal problems, or fight for the right kind of reform, and risk my office.” And I just don’t see much of that. And that’s disheartening.

Forget about whether a country is ruled by the left (Chavez, Kim Jong Il) or by the right (Putin, Berlusconi.)  The success of governance is highly (and negatively) correlated with how much contempt their leaders have for Tyler Cowen’s admonition.  If they don’t agree with Tyler, then their governments are both corrupt and ineffectual.  In the modern world the terms “left” and right” are becoming increasingly meaningless.

A few weeks back I got push-back from commenters who seemed to think I was naive in arguing that politicians shouldn’t favor the special interest groups that got them elected.  Politics is about doing deals (they argued)—I help your special interest, you help mine.  But if it was so easy to do Pareto-improving deals, then why are the economies of corrupt countries so messed up?

I’m afraid that altruism is our only hope.  Without at least somewhat idealistic politicians, there is no hope, no safety net to stop us from falling into into a gangster state.  And we won’t have civic-minded politicians without a civic-minded public.  All over the world (except Denmark) moms are inculcating dictator values into their cute little babies—raising the next generation of Putins and Berlusconis.

Reply to Reihan Salam at the National Review

Reihan Salam has requested my thoughts on a recent Economics 21 editorial:

Keep in mind that this editorial is part of an ongoing conversation. It is very possible that the Italy analogy is flawed. I’m hoping that Scott Sumner, Karl Smith, and others who favor a more aggressive use of monetary accommodation will weigh in on the editorial.

I’ve seen Salam on, and he always struck me as a very thoughtful and innovative conservative.  [Any jokes using the term ‘oxymoron’ will be stricken from the comment section.]   So I decided to respond to the Economics 21 piece:

Rather than focus obsessively on the inapt comparison to Japan, the Fed should be more concerned about the growing similarities between the U.S. and 1970s Italy. Italy experienced financial crises in 1974 and 1976 spurred by large current account deficits, excessive public spending, and a central bank that acquired Italian government debt by printing money. These crises required external financial assistance, led to abrupt and disorderly swings in public finances, and bred political instability. The country moved from economic stimulus, to severe fiscal and monetary contractions, back to expansionary policy. Balance of payments difficulties were persistently addressed through currency depreciation to gain competitive advantage. From June 1972 to August 1977, the Italian lira fell from 579.71 versus the dollar to 884.76 – a depreciation of more than 34%.

The chart below compares recent U.S. public financial data to that of Italy in the 1970s. Relative to 1970s Italy, the U.S. has run larger current account deficits and generated slower economic growth. The U.S. investment rate has barely exceeded Italy’s anemic 13.5% average, and the dollar’s depreciation against gold has been only somewhat less steep than the lira’s fall in the 1970s. The U.S. budget deficit is much larger, although this comparison is difficult to make because official Italian budget deficits tended to understate the government’s true financing needs, which exceeded 12% of GDP in 1977.

[click on Economics 21 link above to check out table of data here]

Between 1974 and 1976, the Italian central bank printed lira in mass quantities to buy Italian government debt. This “large scale asset purchase” program led to a more than 100% increase in the monetary base. This was actually a much smaller increase in the monetary base than that engineered by the Fed’s money printing operations. From February 2008 to February 2010, the U.S. monetary base increased by more than 150% – from $822.54 billion to $2.11 trillion. The Italian central bank accelerated its money printing in conjunction with a “large fiscal reflation” package adopted in August 1975, much as the Fed’s quantitative easing began roughly the same time as the fiscal stimulus.

Although the stimulus and money printing succeeded in generating positive growth in 1976, it also precipitated a crisis in the lira. Mario Monti, later competition commissioner of the European Union, predicted the crisis in late 1975 based purely on observed growth in base money. Foreign creditors – responsible for financing 7.2% of GDP in domestic Italian borrowing during 1973-76 – fled Italian securities causing the value of the lira to fall by 35% in less than five months. Less than two years after the last crisis, the Italian financial system was again embroiled in a panic as printing money to accommodate spending in excess of income at both the government and national levels widened current account deficits and triggered a foreign investor revolt.

There are certainly some similarities to Italy, but are they the important ones?   Relying on memory, I think Italy’s problems were roughly as follows:

1.  In the 1970s growth slowed dramatically from the 8% of the go-go 50s and 60s (remember La Dolce Vita?) to a sub-par rate ever since.

2.  If one combines this sharp economic slowdown with a rather dysfunctional political system, you get a fiscal crisis.  When there is political gridlock, the easiest way out is printing money.

3.  The base rose rapidly and this contributed to high inflation and currency depreciation.

How does this compare to the US?  There are some obvious similarities.  We had a real shock in our real estate industry (perhaps comparable to the 1973 oil shock.)  We seem to be adopting bad tax and regulatory policies that will slightly slow our trend rate of growth (but nowhere near as much as in Italy.)  We have political gridlock, which leads to big budget deficits.  And we have current account deficits.  But I think the differences are much more important.

1.  The monetary base in the US has risen for exactly the opposite reason as in Italy, but the same reason as in Japan.  In Italy the base was monetizing the debt, and this produced high inflation.  In the US the base growth is a response to the demand for liquidity during the banking crisis, the payment of interest on reserves, and the very low nominal interest rates and inflation rates.  I doubt we’d have suddenly started paying interest on reserves if the goal was monetizing the debt.

2.  In the 1970s Italy did not suffer from a shortfall in AD.  I am pretty sure that NGDP grew at a robust rate–their problems were supply side.  They did have occasional crises when high inflation led the government to tighten policy, leading to a boom/bust cycle.  In contrast, in 2009 the US saw the sharpest fall in NGDP since 1938.  Even if there had been no banking problems, a fall in NGDP that sharp (relative to trend growth) would have created a severe recession.  And the slow recovery of NGDP (as compared to 1983-84) makes a slow recovery in RGDP and employment almost inevitable.

3.  Despite all the QE in the US, the market indicators of inflation expectations remain quite low over the next 5 years.  In contrast, if TIPS and CPI futures had existed in Italy, I am certain they would have showed a loss of confidence in the domestic purchasing power of the lira.

4.  They did not cite the Rogoff data on banking crises, but I always like to remind people that the US banking crisis of late 2008 was a relatively rare version of what is otherwise a quite common phenomenon.  In the vast majority of banking crises the currency falls in the foreign exchange market.  Three counterexamples were the US in the early 1930s, Argentina around 1998-2002, and the US in late 2008.  In all three cases the currency rose strongly in trade-weighted terms, even in the midst the crisis.  That suggests that tight money (lack of AD) is either the root cause of the crisis (the US in the 1930s and Argentina in the late 1990s) or greatly aggravated a pre-existing banking crisis (the US in the second half of 2008.)

5.  I believe the fundamental problem in Italy was that some real economic problems were poorly handled by the government, and this led to irresponsible fiscal and monetary policies.  The US situation was much different.  Some real problems in the banking and real estate sectors led to a mild slowdown in late 2007 and early 2008.  But this wasn’t enough to lead to highly irresponsible fiscal and monetary policies.  Instead, a severe drop in NGDP relative to trend after mid-2008 (due to Fed errors of omission) led to a severe recession.  The recession was misdiagnosed as banking-oriented, and we first tried to fix banking.  Then we correctly noted AD (i.e. NGDP) was falling fast, but erroneously assumed the Fed could do no more, and went for fiscal stimulus.  Only recently have we realized that the Fed is the key, and we are doing what we should have done 2 years ago.  But even this seemingly large QE has only modestly raised inflation expectations over 5 years (from about 1.2% to 1.7%.)  Conservatives who draw comparisons with Italy are missing the AD problem, the elephant in the room.

Having said all that, I do agree that the recent trend toward higher taxes and regulations are causing “real” problems for the US economy.  I support many conservative ideas such as deregulation, abolishing the GSEs, vouchers, health saving accounts and tax and entitlement reforms that encourage savings.  But even if in the long run those issues are more important than AD shortfalls, we need to keep in mind that these reforms will be harder to achieve if an NGDP growth shortfall worsens the budget deficit and leads to inefficient programs like 99 week unemployment benefits.  In that respect Japan is an important cautionary tale.  They reacted to a monetary problem with inefficient fiscal actions.

Over the past two years I’ve warned conservatives that Paul Krugman would be able to gloat that he was right and they were wrong about our policies leading to high inflation and high interest rates.  Not many conservatives took my advice, and now Krugman has started gloating.  (Which will be the subject of my next post.)