Words of wisdom from Matt Yglesias

The following comment left by Matt Yglesias is a gold mine, which will generate a number of posts:

The state of the art thinking in DC, as I understand it, is that with interest rates and capacity utilization low monetary policy may not be able to boost NGDP by arbitrary amounts. Under the circumstances, to push it up non-trivially might require “crazy” steps that cause inflation expectations to become dangerously unanchored. So you need fiscal policy + monetary accommodation (i.e., bigger short-term deficit + Fed holds interest rates low) to produce the kind of moderate AD stimulus that’s wanted.

Unclear to me where this model comes from, or what evidence people think they have for it. But it’s a popular view among professional staff at Treasury & Fed and is bouncing around in the heads of some important principals and “name” economists. See Peter Diamond’s remarks to Ryan Avent and what Donald Kohn and Joel Prakken told Dylan Matthews.

To me this seems like what happens when a bunch of really bright people fuck up. Rather than admit that they fucked up, they’re devising clever theories to explain why they haven’t fucked up.

Matt’s very well connected, so I don’t doubt his facts.  And his interpretation is also spot on.  But I think it’s worth discussing all the reasons why the conventional wisdom is all wrong, just as the identical conventional wisdom from the 1930s is now known to be 100% false.

There are all sorts of problems with the conventional view, but they boil down 2 fundamental problems:

1.  Grossly overestimating what the Fed has already done in terms of stimulus.

2.  Grossly overestimating how hard it is to prevent excessive inflation when exiting a liquidity trap.

Those who wrongly think the Fed has already been very accommodative, who think ultra-low rates and large injections of interest-bearing reserves represent “easy money,” are naturally inclined to throw up their hands and think; “If even this did nothing, then imagine how much stimulus would be required to boost AD.  And then think of the risk of hyperinflation.”  The commodity price rise following QE2 probably exacerbated that fear.

But money isn’t easy, it’s very tight.  Policies like Operation Twist were widely viewed as being almost a complete flop after it was tried in the 1960s; there was never any theoretical or empirical evidence that should have led the Fed to expect success by resurrecting that discredited tactic.  QE2 does seem to have had some effect; certainly on markets, and maybe on the monthly jobs numbers in early 2011.  But it was ended.  And things have gotten even worse since the signals were sent out that the Fed was stopping the program.

Most importantly, the Fed has never done any of the things that would really be effective.  The things Bernanke recommended the BOJ do, like level targeting.  I’m sure the Very Serious People in DC don’t care at all what I think, but it should give them pause to consider that no less than Michael Woodford thinks level targeting is essential when rates hit zero.  Better yet, level targeting is explicitly designed to prevent an outbreak of high inflation when a country is attempting to exit a liquidity trap.  Peter Diamond may have a Nobel Prize, but he isn’t 1/10th the monetary economist that Woodford is.  It makes no sense to say the Fed has already been aggressive, when they haven’t even tried state of the art ideas like level targeting, and they have done contractionary policies like IOR (which greatly reduces the effectiveness of QE.)

Fear of excessive inflation is even more unfounded.  Let’s start with a list of all the countries in world history that exited a liquidity trap and ended up with excessive inflation:

1.

OK, now let’s discuss why it’s never happened.  The most aggressive monetary policy during a liquidity trap was FDR’s dollar depreciation policy of 1933-34.  It did produce rapid inflation during 1933-34, but not thereafter (except a brief burst in 1936-37, that was immediately reversed.)   But it failed to achieve the policy goal; reflation to pre-Depression price levels.  Not even close.  And yet at the time all the Very Serious People said it was an inflationary time bomb, which would explode in a couple years.  In fact, during 1934-40 the WPI rose by 5%, less than 1% per year.  One of the Very Serious People was Keynes, who criticized the policy as being too inflationary in late 1933 (when gold prices rose above $28.)  When FDR went back onto the gold standard in January 1934 (at $35/oz), Keynes congratulated FDR for rejecting the views of the “extreme inflationists.”  That’s right; if Krugman wrote for the NYT back in 1934 he would even be criticizing Keynes.

I don’t even need to talk about Japan, which has made no serious attempt to escape the zero rate trap; indeed which tightened monetary policy in 2000 and 2006 when inflation was roughly 0%.  And then went right back into deflation.  Believe me, there is no way the Fed’s going to overreact, whatever they do will be too little, and will almost certainly be judged too little by future economic historians.

In addition, wages don’t move until inflation expectations rise.  And the Fed can prevent that by monitoring TIPS spreads closely and not allowing 5 year spreads to exceed 3%.  I’m not saying they’ll hit their inflation target perfectly, but any overshoot will be trivial compared to the devastation of US and European labor and debt markets by the relentless decline in NGDP growth.  A few years ago 3% inflation didn’t even attract any attention.

Headline inflation is another story.  A robust recovery will cause a sharp, one-time rise in world oil prices.  Are we willing to pay that price, or do we prefer to keep 15 million unemployed so those with jobs can pay less for gas?  If we were at full employment and had $5 gas, should we purposely create 9.1% unemployment in order to bring gas prices down?  What do you think?

A recurring theme in this blog is that policymakers around the world are reacting to how things seem to be, not what history, theory, and logic tells us is actually going on.  Woodford has the theory and logic, and I have the history.  But most people don’t know the history, and few people have the deep understanding of monetary economics that Woodford has.  So we are going with our hunches.  But monetary economics is a very counter-intuitive field.  Really tight money can look just like really easy money.  And since policymakers rely on common sense, we are screwed.

Unfortunately, it increasingly seems likely that sound monetary policy won’t return until we can go back to targeting nominal rates.  Our only hope is to create a robust enough recovery where we can have positive interest rates without those higher rates representing tight money.  And every day that scenario recedes further and further into the future, partly due to the actions of the Fed itself.

Unless they change course dramatically, there is no light at the end of the tunnel—there is no 2% T-bill yield for as far as the eye can see.  And that means no prosperity.


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64 Responses to “Words of wisdom from Matt Yglesias”

  1. Gravatar of Dan Carroll Dan Carroll
    5. October 2011 at 08:46

    Which window should I jump out of?

  2. Gravatar of OneEyedMan OneEyedMan
    5. October 2011 at 08:56

    I wish the Treasury would start lengthening the average maturity of the debt much more. I understand we are at 5 years but it seems with today’s rates and tomorrow’s obligations we should be much closer to 30 years. That might be a way for Treasury to prod an inactive fed. Raising the average maturity would change government incentives by making inflation good for the government’s balance sheet (not just national AD). That would make it harder for the Fed to commit to ultra-low inflation given the political forces that buffet the Fed.

  3. Gravatar of Morgan Warstler Morgan Warstler
    5. October 2011 at 09:08

    Perfect example of being too big for your britches:

    “If we were at full employment and had $5 gas, should we purposely create 9.1% unemployment in order to bring gas prices down? What do you think?”

    False choice. Focus on here and now.

    When you raise gas prices, people stop going out to eat, seeing movies, etc. etc.

    A REAL solution to demand is thus:

    1. DRILL BABY DRILL. Obama and greenies just STFU.
    2. level target NGDP.

    The point is we have to ADMIT the structural fiscal stuff is real and act on it BEFORE we go easy money.

    We can actually KEEP GAS PRICES at $3.50 while we print money IF the left bends.

    They are the ones suffering – let them change their priorities.

  4. Gravatar of Dilip Dilip
    5. October 2011 at 09:10

    Scott
    The link to Matt’s comment is not pointing to the right place. The corrected link is here:
    http://www.themoneyillusion.com/?p=11244#comment-88848

  5. Gravatar of Ryan Sanchez Ryan Sanchez
    5. October 2011 at 09:28

    I see a lot truth in what Morgan is saying, every time I read the transcripts from Bernanke the more I feel like he is ignoring the dual mandate of employment in order to hold the economy hostage until deeper fiscal and regulatory reforms are made. Then once the changes are made, boom, easy money from Bernanke.

  6. Gravatar of Gabe Gabe
    5. October 2011 at 09:46

    Morgan,
    Are you unfamiliar with the many times that Bush and Cheney publicly stated that gas prices being too low in 1995-2000 was a big problem?

    Are you familiar with the many times that Sadam Hussein was critized by the US supported Saudi regime for producing too much oil? and how Iraq production has yet to exceed the production from before the takeover?

    It is silly to argue the leaders of the GOP and Dems are substanitally different on what the ideal price of oil is.

    Could more energy oil and gas be produced…yes much more. Is there any real reason to believe a rick perry led GOP would help eliminate the barriers to production? no, Gardasil Rick works for the same interests as Obama.

  7. Gravatar of fmb fmb
    5. October 2011 at 09:47

    Doesn’t long-run money neutrality imply that there should be a light at the end of the tunnel regardless of Fed policy? Sure, they can make it a long, dark tunnel, but how long is still consistent with long-run neutrality?

    Or perhaps competition (at money creation) is so difficult that tight money can stifle real growth indefinitely?

  8. Gravatar of Morgan Warstler Morgan Warstler
    5. October 2011 at 10:06

    Gabe, I WANT a $1-$1.50 gas / diesel tax, but only if all the revenue goes to cutting SMB taxes… treating SMB profits as capital gains.

    It has to be revenue neutral and the benefits have to flow to Tea Party, not the bankers.

    It is a tall order, BUT an immediate method to cutting oil consumption if the greenies REALLY care about the environment: Pay off the Tea Party, get a gas tax.

    The greenies could let the regs on Natural Gas engine conversion be far less stringent, and overnight you’d have consumers making use of it.

    The point Gabe is ANY change is possible, if the left doesn’t actually gain $ or power from the change.

    So yes there is a substantial difference even though they can both utter the same ideas.

  9. Gravatar of Benjamin Cole Benjamin Cole
    5. October 2011 at 10:35

    There is an incredible post at Stephen Williamson’s blog (extolling Plosser), and in the comments he says he does not want to stimulate the economy, not because we have bad inflation (although he fleetingly contended that inflation was bad right now but baked off) and not because the markets expect inflation (see TIPS). Williamson did not want to stimulate the economy as it might–might–lead to inflation in the future. The uncertain, possibly distant future (and we need some inflation anyway). He is channeling General McClellan?).

    Then, at this uncertain date in the future, the Fed, facing, say 6 percent inflation, would have to crank down. And we would get stagflation.

    And Williamson is a literate fellow, with lots of academic cred (though obvious he never ran a business for even five minutes). Along the way Williamson said John Taylor’s 2006 paper on Japan (that gushed about Japan’s then-successful QE program) was not “scientific.” He also asked who is George Gilder.

    Maybe Williamson is just carrying water for the GOP.

  10. Gravatar of Dan Kervick Dan Kervick
    5. October 2011 at 10:42

    Bernanke is a fairly liberal Republican. He has written favorably of the New Deal and fiscal activism in response to recessions. He is probably more comfortable with Obama than he is with 80% or 90% of Republicans in the field. It’s crazy to think he is recommending some sort of austerity measures.

    Remember, this is “Helicopter Ben”. The whole idea behind a helicopter drop is that the fiscal authorities and monetary authorities have to work together to finance effective additional government spending or tax cuts via money creation, because the central bank lacks the legal authority to do this spending on their own. If Congress authorizes a helicopter drop, the Fed can play its role. Until Congress acts, though, there can be no helicopter drop.

    I’m guessing that is precisely what Bernanke wants Congress to do. He can’t call for a helicopter drop outright, because the Fed is supposed to be “independent” and has a precarious political role. All he can do is send discreet signals about the need for more fiscal action. The Congressional testimony contains a rather obvious and unusually frank signal.

  11. Gravatar of Donald Pretari Donald Pretari
    5. October 2011 at 10:43

    I’m wondering what’s going on here. Some people seem to think that the Fed announcing a plan for higher inflation is a matter of waiting around and seeing what happens. It’s all about the prediction for them. If the prediction is wrong, the Fed will lose credibility. Would that the Credibility of people who have constantly been wrong recently about inflation lost credibility.

    The point is that Investors, remember them, will have to decide on that now. If they are wrong, they will lose money. The point is to change investment decisions now. If investors believe that the Fed will deliver upon their promise, they will invest in Riskier Investments, being the kind of investments that produce gains and growth, like Stocks and Corporate Bonds. If the Economy does grow, the Inflation will likely creep up. Voila! You have Inflation driven by a Growing Economy. I believe that’s what William Gross has been saying.

    Of course, none of us really know the future, so part of this credibility talk is BS, where the Fed is supposed to have God-like Power to guarantee a future outcome whatever actually occurs. I don’t know who is holding the Fed to such a standard, but it sounds foolish to me.

    I also believe that Fears of Inflation trumping Unemployment is a distasteful view, given that, again, none of us actually know what the future holds, while we do know the current misery being suffered by a large number of our fellow citizens.

  12. Gravatar of Bob Murphy Bob Murphy
    5. October 2011 at 12:04

    You know Scott, you are turning into one slippery fish. When you wrote, “Let’s start with a list of all the countries in world history that exited a liquidity trap and ended up with excessive inflation…”, my first reaction was, “Of course not, Scott, since you don’t even believe in liquidity traps.”

    Going back and re-reading your earlier post–in which you argued that liquidity traps don’t exist–I can see how it is consistent with what you are saying here. But c’mon, it’s tough for some of us to follow your zigs and zags. It’s like when you beat us over the head for months about interest rates being irrelevant to monetary tightness or looseness, then go nuts on the ECB for raising interest rates and today predicting that the Fed will raise interest rates too soon.

  13. Gravatar of K K
    5. October 2011 at 12:06

    This is really in large part the fault of the monetarists. People see the quantity of reserves and panic. And the monetarists have been busy promoting the view that there is no liquidity trap and that quantity always matters even at ZLB. But this is the real legacy of QE: OMG!! Look at all that money! It’s gonna blow!

    If anybody had listened to Woodford, Krugman, Eggertsson, etc (but, unfortunately not Bernanke), from the start they would have understood that monetary policy at the ZLB is about the *contingent* path of the policy rate, and that M is irrelevant when the demand for money is perfectly elastic when the price is zero (marginal velocity is zero). The only effect of QE is what the CB does or does not have on its balance sheet. Rather than wealth, it is a risk redistribution, which is really a kind of fiscal/industrial policy.

    Scott, I find that your blog has become immensely wiser over the last couple of years, and your contribution towards the general awareness and understanding of NGDP targeting is a huge public service. But there is *nothing* in this idea that is in any way inconsistent with the NK macro perspective. They are in fact superb complements. But you also used to strongly promote the idea of the importance of the quantity of money at the ZLB. And still, posts such as today’s claim that monetary policy is omnipotent in creating demand are not consistent with the state of the art, which undermines that research and appears to leave open the possibility of some kind of magical power of quantity.

    QE is a scourge on the economy, that has promoted false hopes for the power of money, and now even worse, false fears of hyperinflation. It’s time for market monetarist to either 1) come up with a coherent mathematical model of the transmission of quantity through the banking system and on to AD (independently of the path of the short rate), or 2) become fully constructive in the public discourse by ceasing to assist in the spreading of false hopes and fears. The present post is really good, but an explicit declaration of the irrelevance of reserves at the ZLB would be awesome.

  14. Gravatar of bill woolsey bill woolsey
    5. October 2011 at 12:33

    Scott:

    The Fed needs to target a higher level of spending on output.

    Yglesis and the article he linked to by Klein are all about inflation.

    Klein mentions you, and says that because your target is nominal not real, it is consistent with higher inflation. (If we targeted real GDP, we would really create an opening for inflation.)

    The notion that we need to get people to expect higher inflation so real short rates are lower (or from a more commons sense appoach, people spend now before their money loses value,) leads to these fears of hyperinflation.

    The only relationship with inflation should be that it is no longer a direct concern. We get the inflation rate implied by our series of nominal GDP level targets. We will put up with it if it is high, and applaud if it is low.

    And it won’t get out of control because that is inconsistent with the nominal GDP levels in the future.

  15. Gravatar of bill woolsey bill woolsey
    5. October 2011 at 12:33

    P.S.

    Try to stay on message!

  16. Gravatar of Donald Pretari Donald Pretari
    5. October 2011 at 13:04

    “The notion that we need to get people to expect higher inflation so real short rates are lower (or from a more commons sense appoach, people spend now before their money loses value,) leads to these fears of hyperinflation.”

    Absolutely! I think the policy will work precisely because of your fears. BTW, that’s when a good investor makes money, ie, when other people are afraid.

    Also, enough about Zimbabwe. That was a policy decision adopted by a dictator to remain in power, and not an accident. Sad to say, it worked.

    I’m willing to try Scott’s ideas given the current mess, but there is sense in the view you are belittling.

  17. Gravatar of anon/portly anon/portly
    5. October 2011 at 13:16

    In response to Bob Murphy’s point above, I just took “liquidity trap” to mean “economic conditions that are commonly described or diagnosed as a ‘liquidity trap’.” I didn’t assume any reversal of previously stated liquidity trap skepticism.

  18. Gravatar of Adam Adam
    5. October 2011 at 13:19

    Apologies if this is an annoyingly basic question, but I’m an amateur at this stuff and sometimes can’t keep it all straight. For some reason I thought you rejected Krugman’s notion of “liquidity trap.” When you use it here, do you mean something different? Or am I wrong that you reject it?

  19. Gravatar of Charlie Charlie
    5. October 2011 at 13:20

    “Unless they change course dramatically, there is no light at the end of the tunnel””there is no 2% T-bill yield for as far as the eye can see. And that means no prosperity.”

    I’m really interested in this post. This blog spends a lot of time focusing on what the Fed should do, but I’d love to hear more about what happens if the Fed continues on the path it’s on.

    Don’t we eventually get out though? In the (very?) long run, we still get neutral money, right? Prices adjust and we get into a new equilibrium and the classical model wins out. Even if it takes a lost decade or more. Granted, we can do a lot of structural damage during the bad times, but the monetary policy will go back to being pretty good.

    Are you disagreeing with that characterization I just did?

  20. Gravatar of Krzys Krzys
    5. October 2011 at 13:30

    Scott,

    I have one question about the destructive policies of BOJ and Japanese deflation trap. If money is neutral in the long-term, why is Japan still trapped after 20 years? Or rather, even if it’s trapped, why does it matter anymore? What’s the model/ cause behind it?

  21. Gravatar of grcridlan grcridlan
    5. October 2011 at 13:53

    Bob Murphy, Adam:

    My view, and I believe Scott’s view, is that while theoretically a liquidity trap could exist, the United States is not in a liquidity trap. However, the United States is in a “LiquidityTrap[tm]!” by which I mean interest rates are near-zero and cannot be effectively used as a further easing mechanism. Quantitative measures still work, e.g. QE2.

    we could easily create a liquidity trap. Increase the IOR rate. Presto.

    Charlie:

    The classical model only wins out in the end if the nonclassical features of the economy (monetary policy being the major issue) do not continue to move in the wrong direction. If the Fed continues to endorse 1-2% nominal growth, it effectively forces the economy to continue to diverge from trend. It’s a new negative demand shock every day.

  22. Gravatar of Morgan Warstler Morgan Warstler
    5. October 2011 at 14:02

    bill,

    You and Scott could both spend FAR MORE TIME talking about how targeting at NGDP at say 3%, leads to us quickly havinh to raise rates.

    Or you could talk about how targeting NGDP in 2002-2008 would have kept the bubble from happening.

    This would go a long way to convincing people you are really conservatives.

    Friedman would not make sure a mistake.

  23. Gravatar of grcridlan grcridlan
    5. October 2011 at 14:05

    K:

    I may characterize your position incorrectly, but I don’t mean to construct a strawman here. Your view seems to be that we are in an actual liquidity trap, where quantitative measures are ineffective.

    If that were true however, QE2 would not stoke fears of “hyperinflation” (which appears to mean, in the mouths of yourself and the Washington (er) intelligentsia, inflation above 4% a year). Your model predicts that QE2 would have no effect.

    That isn’t impossible; the existence of IOR, in particular, contributes to the possibility of a liquidity trap. But the market and (possibly) price effects of QE2 seem to put the lie to the model – or at least the suggestion that the model actually describes our situation – because QE2 appears to have had effects. If quantity is irrelevant at the zero lower bound, it can’t create inflation anymore than it can create AD.

    So which is it? You cannot creditably argue that quantity doesn’t matter at the ZLB, AND that we are at the ZLB.

    Query: In your model, does IOR raise the effective ZLB?

  24. Gravatar of stan stan
    5. October 2011 at 15:13

    Has anyone here actually spoken with any of the multitude of real, live employers all over the country who are afraid to hire or expand their businesses despite large cash balances? It’s not because of the Fed.

    Someone who actually has some interest in how things work out here in the real world ought to try it. Talk to people who own businesses. Small ones, mid-size ones, partnerships — all those faceless, hard-working types out in flyover country who actually make the investments and hire the workers that lead an economic expansion. Just talk to them. Talk to a lot of them. Ask them why they are scared to death of hiring or investing new capital. Just ask. They will be happy to tell you.

    Step 2 — after you come to some understanding of the reasons why so many are too frightened to try to grow, you might want to develop an economic theory which actually addresses their concerns. It won’t be more stimulus. It won’t be QE3. BECAUSE NEITHER ADDRESSES THE CAUSE OF THE PROBLEMS!

    My question — what is the market clearing price of a clue around here? Bunch of hammers looking at everything like it’s a nail in a world where the current problem is too many wet blankets.

  25. Gravatar of Scott Sumner Scott Sumner
    5. October 2011 at 15:29

    Dan, Make it a high one, health care is too expensive.

    OneEyedMan, That’s a very good idea that the Obama people could do. Nothing but 30 year bonds from now on.

    Morgan, I like drilling too, but it won’t help for a couple years.

    Dilip, Thanks, I corrected it.

    Ryan, I just don’t think that’s Bernanke’s personality. He seems like a very sincere guy.

    fmb, Here’s the worst case. We react to the recession by making labor market policies worse, and that raises the natural rate to 8%. Also, money may not be neutral at very low rates of wage increase. BTW, the example I just provided provided is precisely what happneed in many European countries during the 1970s and 80s. That’s why I keep emphasizing that supply and demand shocks are “entangled” something you don’t see in any textbooks.

    Ben, I should probably take a look at that.

    Dan and Donald, But none of that explains his apparent contradictions.

    Bob, You aren’t paying close enough attention. I’ve consistently said “liquidity traps” are no barrier to stimulus. I am referring to what others call liquidity traps. I’ve consistently said raising rates doesn’t mean tight money. I’m saying others view it as tight money. So my piece was saying “OK, you people that think raising rates is tight money, why aren’t you calling the ECB policy monetary tightening?” I say it’s tight because NGDP expectations are falling in Europe. Most people don’t agree with that benchmark–they think rates are what matters. OK, now we all agree the ECB is tightening, and making the euro recession worse, don’t we?

    K, You said;

    “If anybody had listened to Woodford, Krugman, Eggertsson, etc (but, unfortunately not Bernanke), from the start they would have understood that monetary policy at the ZLB is about the *contingent* path of the policy rate, and that M is irrelevant when the demand for money is perfectly elastic when the price is zero (marginal velocity is zero). The only effect of QE is what the CB does or does not have on its balance sheet. Rather than wealth, it is a risk redistribution, which is really a kind of fiscal/industrial policy.”

    This is wrong. If the current level of money doesn’t matter, it’s equally true that the current level of interest rates doesn’t matter–because they are stuck at zero. You say the expected future path of rates matters, and I say the expected future path of money matters. That’s what separates NK and market monetarists.

    I’d hope I’ve become wiser, but if you think I’ve moved in the NK direction you haven’t been paying attention. I’ve talked about the importance of nominal targets from day one. I argued (in 1993) that a temporary currency injection has little or no effect 5 years before Krugman did. Eggertsson’s paper on the Depression (AER 2008) cites three of my papers. So I didn’t learn these ideas from the NKs.

    I’ve always said permanent monetary injections matter at the zero bound, and temporary ones don’t. That happens to be true, and also what Krugman says. If you think I ever claimed anything else, I’d love to see you provide a post.

    Only the QTM can explain why the price level is not 1000 times higher or 1000 times lower. Let me know when another model is able to do so, and I’ll start to take it seriously.

    I’ve said QE2 was worth trying (mostly as an indirect way of changing expectations), but so did Krugman.

    You said;

    “It’s time for market monetarist to either 1) come up with a coherent mathematical model of the transmission of quantity through the banking system and on to AD”

    This drives me nuts. Monetary policy has been around for centuries before banks even existed. (Banks are a recent invention.) I want you to explain to me how expansionary monetary policies produced inflation before banks existed. What is the mechanism? Then tell me why this mechanism becomes inoperative after banks are invented. Monetarism is just supply and demand. We assume cash is used for different things (like small transactions) than other assets like stocks and bonds are used for. Price theory says if you have more of X, the value of X falls. This theory applies to cash, which is not a perfect substitute for other financial assets. Since the nominal price of cash is fixed, its value can only fall via inflation. Yes, at the zero bound things get trickier, then it is expectations of M once you have exited the zero bound that matter.

    So that’s my model, S&D. Do I have to express it mathematically?

    Bill reminds me of another thing I don’t like about NK. It’s all about interest rates and inflation, whereas we need a model about money, asset prices and NGDP. Expected inflation doesn’t matter, expected NGDP growth does. There’s a reason China never entered a liquidity trap in the 1990s, despite deflation.

    anon/Portly, That’s what I meant.

    Adam, See above, reply to Bob.

    Charlie, See the reply to fmb above.

    Krzys, Complicated question, with many angles. Yes, Japan is probably growing at trend. But:

    1. Non-zero rates allow the BOJ to respond more effectively to recessions.

    2. Labor markets may be less efficient when wage increases are near zero (hence lower GDP, but not lower growth.) I’d guess with 2% inflation Japan would have 2% or 3% more GDP, but the same low trend rate of growth, which has supply side causes.

  26. Gravatar of Scott Sumner Scott Sumner
    5. October 2011 at 15:34

    stan, That might be the single worst idea I’ve ever heard. We aren’t in a recession because firms aren’t hiring. Tens of millions of jobs are created and destroyed every year. Macro is a very counterintuitive field, there is no worse way to study macro than asking firms why they aren’t hiring, because they are hiring. We need to figure out why nominal GDP is far below trend, and that has nothing to do with the decision of firms to hire, or not hire.

  27. Gravatar of Lorenzo from Oz Lorenzo from Oz
    5. October 2011 at 15:44

    Stan: if they thought their products or services would sell, I bet that they would produce more of them. (I speak as someone who is in business.)

    Scott: I found this Irwin and Eichengreen paper (pdf) (which somehow I suspect you have read) useful in explaining how much the inflationary episodes of the early 1920s (which included the notorious German hyperinflation) affected perspectives in the 1929 onwards period. Fairly clearly, stagflation is performing the same role nowadays: either as something that genuinely worries people (e.g. Volcker) or as a rationalisation/useful bogey for more partisan positions.

  28. Gravatar of Morgan Warstler Morgan Warstler
    5. October 2011 at 15:51

    Scott, next time you want to talk like this:

    “That might be the single worst idea I’ve ever heard. We aren’t in a recession because firms aren’t hiring. Tens of millions of jobs are created and destroyed every year. Macro is a very counterintuitive field, there is no worse way to study macro than asking firms why they aren’t hiring, because they are hiring. We need to figure out why nominal GDP is far below trend, and that has nothing to do with the decision of firms to hire, or not hire.”

    Psst!

    When we want to bring you out and have you justify the shit we’re going to do anyway, we’ll let you know!

    Fisher said he goes out and talks to the business guys PRECISELY to reach the conclusion you don’t like.

    We’re going to erase Obamatime from the economic history books, and AFTER that happens, everything you think will make perfect sense TO THE GUYS FISHER TALKS TOO.

    You have to convince us.

    Dude, if the eggheads really got to be in charge, there would not be a Fed.

    Think on that.

    For the same reason you hate the Fed, they are actually just figureheads.

    The day they get the free hand you want them to have, is the day they close down.

  29. Gravatar of Floccina Floccina
    5. October 2011 at 17:40

    Food and energy industries are the bright spots in the economy. I think that shows what rising prices can do in the current situation. The percent of petroleum that we import has been falling and the economy of North Dakota is booming. Higher food and petroleum prices need not be a net drag on employment.

  30. Gravatar of Dan Kervick Dan Kervick
    5. October 2011 at 17:56

    I want you to explain to me how expansionary monetary policies produced inflation before banks existed. What is the mechanism?

    Governments minted new more money and then spent it into circulation; and they did so in ways that did not increase the production of goods and services at a level commensurate with the increase in the money in circulation, but in ways that resulted in lots more money pursuing the same amount of goods, or only a slightly greater amount of goods. Voila: increased prices.

    The king could both order additional money to be minted or pulled out of vaults, and order it spent on all sorts of goodies for himself or his people. If the king only had the power to mint new money, but not spend it, and could only stick it in his counting house after it was minted, the money-minting would have no inflationary effect.

    Ben Bernanke is not a king who can order money to be created and then spent on goods and services of his choosing. He has some ability to spend, but those abilities are severely limited. He can buy treasury bonds; and he can buy crappy toxic financial assets, and maybe a few similar financial instruments and trinkets. But he can’t buy lots of highways and bridges and solar power plants and wind turbines and schools and grain and beef and books and computers, and he can’t hire teachers and engineers and construction workers and truck drivers. And its the latter that is needed to boost production and wealth creation.

    Bernanke is pretty clear about this in his paper on Japanese Monetary Policy, where he says, “Of course, the BOJ has no unilateral authority to rain money on the population. The policy being proposed – a money-financed tax cut – is a combination of fiscal and monetary measures.”

    So what I don’t understand is why monetarists of the activist, inflationist stamp like yourself are not using their blogs day after to bang on the US Congress and demand that they authorize a round of money-financed spending, instead of banging on Ben Bernanke every day for not producing effects he is institutionally incapable of producing, or is at least profoundly hamstrung in producing. You want inflation from monetary expansion, like in days of yore? Then you need to get the whole government involved, including the spending authorities. If the Congress authorizes money-financed spending, the Fed can create the money. But the central banker of the United States cannot do the things the potentates of the monetary history chronicles legends could do.

    Then tell me why this mechanism becomes inoperative after banks are invented.

    It doesn’t. But the old-timey mechanisms for accomplishing monetary expansion do become largely inoperative when (i) the monetary and fiscal authorities in a country are fragmented and divided among different political institutions, each governed under its own set of laws, and with different responsibilities, and (ii) private banks and other lending institutions are gradually cut free from the reserve requirements and other regulations that once gave the central bank a more direct line of control over them.

    I already discussed (i). On the second point, bank lending decisions are driven primarily by endogenous economic factors, and are then usually just passively accommodated by the central bank, which facilitates the new activity with additional money reserves when needed. The banks make loans and create deposits from thin air in the process. They then acquire the reserves they need to meet their reserve requirements. They have weeks in which to meet these requirements, and the reserves are usually very easy to acquire. And there are exceptions and exemptions.

    There is no empirical basis for thinking that banks are currently chafing at the bit to make new loans, but are being held back by the cost or difficulty of acquiring additional reserves. Nor is there any reason for thinking that if the Fed simply puts more reserves in bank accounts at the Fed, by buying some crap assets from banks that they don’t want or some bonds, that these banks are going to rush out to make new loans. The banks already have all the reserves they need, and they can acquire additional reserves for a song. They don’t lend their reserves. If they had opportunities to profit from more loaning they would be loaning already.

    The creation of new money is primarily a response to increases in economic activity, not a cause. Money in the current institutional system is “pulled” into existence, out of the financial system, by the demand for increased economic activity in the non-financial sector, and the consequent demand for the medium of exchange to lubricate that activity. The Fed is a follower and regulator in this process, not a primary agent. The Fed has some brakes in can apply gingerly to this processes of wealth creation, but no accelerator.

    And we haven’t even talked about the fact that a huge part of the financial system these days isn’t even part of the federal Reserve System any longer! The Fed just doesn’t have the kind of control over economic activity that a lot of monetarists seem to think it does.

    I can already hear you saying, “You’re confusing credit with money.” But I think you and a lot of the other monetarists, including Matt Y., are confusing money itself with the exchanges fueled by money and by promises of money. Money in our current system is created primarily as a response to increases in production and exchange of the means and fruits of productions for promises of money. The circulation of new money, and new promises of money, can enable and stimulate more production. But the mere creation of money doesn’t do anything; the money has to be put into circulation in some effective way.

    Even if the king can crap out solid gold pieces at will, that doesn’t mean you get new production and increases in the price level if the king simply makes a trip to the outhouse. If you want to stimulate activity via money creation alone, you need to start paying a lot more attention to the governments only effective and legally permitted spending mechanisms.

  31. Gravatar of Dan Kervick Dan Kervick
    5. October 2011 at 18:01

    stan, That might be the single worst idea I’ve ever heard. We aren’t in a recession because firms aren’t hiring. Tens of millions of jobs are created and destroyed every year. Macro is a very counterintuitive field, there is no worse way to study macro than asking firms why they aren’t hiring, because they are hiring. We need to figure out why nominal GDP is far below trend, and that has nothing to do with the decision of firms to hire, or not hire.

    This strikes me as mind-bogglingly obtuse. It’s the kind of upside-down statement that makes business-people like me think that academic economists don’t have the slightest understanding of the system they purport to be studying. Not only that, but they have adopted a sort of theology that makes them turn up their noses at the thought of acquiring empirical information about that system.

  32. Gravatar of Bob Murphy Bob Murphy
    5. October 2011 at 19:31

    Scott wrote:

    stan, That might be the single worst idea I’ve ever heard. We aren’t in a recession because firms aren’t hiring. Tens of millions of jobs are created and destroyed every year. Macro is a very counterintuitive field, there is no worse way to study macro than asking firms why they aren’t hiring, because they are hiring. We need to figure out why nominal GDP is far below trend, and that has nothing to do with the decision of firms to hire, or not hire.

    Scott, hold on a second here. (I’m being serious, not trying to entertain the passersby.) Obviously the reason we’re in a recession is that the hiring of firms isn’t outpacing the layoffs.

    Look, I could dismiss your views the way you did to Stan by saying:

    “The problem isn’t nominal spending. People spend millions of dollars every day. So clearly the problem isn’t with NGDP.”

    That would be pretty cheeky, right?

    You are saying that the problem is the increase in NGDP is too slow, and Stan is saying he thinks the problem is that firms aren’t creating enough new jobs on net.

    OK beyond that quibble, here’s my real question: Are you saying that if (somehow) firms in the private sector sustainably created a bunch of new jobs, such that unemployment fell down to 3%, but NGDP continued to grow sluggishly, that the economy would still be in trouble? Do you think that RGDP would grow much faster, if all of a sudden millions of unemployed people now had sustainable jobs in the private sector?

    I personally think that if unemployment fell to 3%, then RGDP would jump way up. If those two things happened, and NGDP happened to continue crawling along at a snail’s pace, then I would say it just showed your focus on NGDP was wrong.

    Do you disagree? I think what you should be saying to Stan is something like, “Stan, right, we ultimately want to get firms to hire more. But I’m saying the way to provide the environment for that to happen is to get NGDP to grow at a steady rate, and the way to get that is to have the Fed target the level.”

    How do you feel about my reformulation of your position? It really sounds like you have been arguing lately that you don’t care what unemployment does, all you care about is the rising level of NGDP. I’m not saying you should *target* unemployment, but are you really saying ultimately unemployment is irrelevant in your worldview?

  33. Gravatar of John John
    5. October 2011 at 19:53

    Dan Kervick,

    I’ve had that basic conversation before. Obviously money needs to get spent into existence and without a demand for loans and credit worthy borrowers, I think that there isn’t anyway for the Fed to get the money circulating instead of parked in reserves. He assured me this wasn’t true because of the “excess cash balance mechanism.” I learned about the thing and it basically just says that when people, like banks, have a ton of cash, they’ll find someway of using it rather than just sitting on it. It sounds like BS to me, Scott has this line of attack on his ideas pretty closed off. It may be worthwhile to press the point farther if you know about what that “excess cash balance mechanism” is supposed to do.

  34. Gravatar of John John
    5. October 2011 at 20:02

    Bob,

    A couple posts ago Scott said NGDP was a panacea. I really think he’s assuming that all problems will go away once NGDP either goes back to trend or gets pegged at 5% going forward. You provided the quote on the blog where he said even if his policy just produced more inflation he would still favor it. I’m pretty sure he believes that the only way to guarantee a healthy economy that lasts is to target NGDP, supply side reforms us Austrians favor wouldn’t be enough even if they got rid of high unemployment.

  35. Gravatar of marcus nunes marcus nunes
    5. October 2011 at 20:07

    Bob Murphy
    You wrote:Obviously the reason we’re in a recession is that the hiring of firms isn’t outpacing the layoffs.
    It´s not the reason but a consequence of being in a recession.
    You also wrote that you could “tease” Scott saying: “The problem isn’t nominal spending. People spend millions of dollars every day. So clearly the problem isn’t with NGDP.”
    The problem is that many billions less than should be spent are not. That´s the reason for the recession/depression.
    The NGDP target view indicates that spending AND employment are down, i.e., the country is in deep sh–exactly because the Fed let the “ball that it did not know it had” (NGDP evolving along a level path) drop!
    http://thefaintofheart.wordpress.com/2011/10/04/seppuku-aka-harakiri/

  36. Gravatar of Bob Murphy Bob Murphy
    5. October 2011 at 20:24

    Marcus, I’ve been reading Scott fairly regularly for two years now. I understand that he thinks we are in a recession because the Fed let NGDP growth fall below trend. I get that.

    What I’m saying is that the way he “blew up” poor Stan was completely unfair. Stan had said the way to get out of the recession was to figure out why firms weren’t hiring. So Scott said (paraphrasing), “That’s dumb. Firms *are* hiring right now; they create millions of jobs every year.”

    So I am saying that Scott’s critique is silly. What Stan (of course) means is that firms aren’t creating enough new jobs, net of the ones they destroy.

    If I wanted to deploy Scott’s trick to his own view, I could say, “There clearly isn’t a problem with inadequate spending, because people spend millions of dollars every day.”

    You are now coming back, and telling me how Scott would respond to my criticism. Right, just like Stan would come back and say, “Oh my gosh Mr. Chicago Economist, I’m saying firms aren’t creating *enough* new jobs. Are you kidding me?!”

  37. Gravatar of marcus nunes marcus nunes
    5. October 2011 at 20:31

    Bob Murphy
    I´m not trying to “defend” SS, but look again at what Stan wrote:
    Step 2 “” after you come to some understanding of the reasons why so many are too frightened to try to grow, you might want to develop an economic theory which actually addresses their concerns. It won’t be more stimulus. It won’t be QE3. BECAUSE NEITHER ADDRESSES THE CAUSE OF THE PROBLEMS!
    He probably means; “Look, this theory of yours is so much BS, go find something that addresses the “real problem”.

  38. Gravatar of Dan Kervick Dan Kervick
    5. October 2011 at 20:51

    It´s not the reason but a consequence of being in a recession.

    It’s both. A recession is something that endures over time, and its harmful effects feed back as causes that both prolong and intensify the recession. Clearly the number of workers firms are employing has something to do with the low level of those firms’ output relative to capacity. And since workers are also consumers of goods, which they purchase with the income they receive for their work, a reduction in aggregate employment in an environment of stagnant wages means a reduction in the aggregate demand for goods. And that means more reductions in production.

    One reason companies are slow to hire up the workers that were released from the workforce during the peak of the initial stages of the crisis, and are slow to give raises to retain their remaining workers, is that they do not anticipate expanding production, and they recognize they are in a buyers’ market for labor. And they do not anticipate expanding production because they do not anticipate demand for their goods going up. And they do not anticipate demand for their goods going up because they correctly perceive that their customers, who do not have as much disposable income as they had previously, are not acquiring substantially more income any time soon. And the reason those customers are not acquiring more income soon is that a lot more of them are unemployed than was the case before the recession. Etc. It’s a vicious cycle of self-reinforcing decisions, with locally rational responses to sub-optimal aggregate conditions combining to prolong those very same conditions.

    Government fiscal action could help break us out of this particular prisoner’s dilemma: money-financed government hiring, or hiring financed by taxes on savings surpluses, would provide more income to newly hired workers/consumers, and release pent-up demand, which would immediately lead to an uptick in market indicators and secondary, tertiary rounds of hiring, increased income and production, increased consumption spending, etc. The government hiring would also pay benefits in terms of whatever goods and services the hired people were hired to produce. But government fiscal action doesn’t appear to be on Congress’s agenda.

    It’s hard for me even to conceive of what kind of world view could produce a statement like “We need to figure out why nominal GDP is far below trend, and that has nothing to do with the decision of firms to hire, or not hire.”

  39. Gravatar of K K
    5. October 2011 at 21:10

    Scott: I’m sorry. I misread your post, and assumed that you had suddenly embraced both the liquidity trap and the “neo-Wicksellian” (as Nick calls it) pure credit economy (yeah, I know, at the cocktail party in my dreams). But even if that had been so, my comment would have been an extremely rude “I told you so”. I believe we are all on the same side here, and I hope you accept my apology. Now on to your points:

    “If the current level of money doesn’t matter, it’s equally true that the current level of interest rates doesn’t matter-because they are stuck at zero.”

    Stuck at zero just means it’s not changing. Not that it doesn’t matter. The supply of money, on the other hand, changes and has no impact. That is the definition of “doesn’t matter”.

    “You say the expected future path of rates matters, and I say the expected future path of money matters.”

    Except the path of money doesn’t matter while rates are at zero. Sure, permanent changes in the money supply make a difference. I’m sure we’ve at least doubled base money by now. If that was a commitment never to reduce it we wouldn’t be able to raise rates (contingent on velocity and reserve requirements being unchanged) until NGDP doubles compared to when we first hit the ZLB. But that’s silly since 1) reserve requirements are silly (see my comment to Dan below) , 2) who knows where velocity will be if and when we ever raise rates again and 3) you want *double* the current NGDP before you ever raise rates again???

    On the day when the Fed decides to hike rates again, they will already have unwound all of QE and only mandatory reserves will be left. Whatever the path of reserves between now and then *is utterly irrelevant*. So they might as well just leave the reserves alone (and let the Treasury screw around with the term structure of government liabilities if they want to play industrial policy). All that actually matters is the condition under which they will raise rates again (not what they do between now and then). And that condition should be based on the level of NGDP, i.e. MV. Not M alone. Nobody needs to care about M or V independently – those will do all kinds of crazy stuff at the ZLB (which is why the exchange equation doesn’t feature in the NK framework). So forget QE. Just give tell us the future path of the short rate as a function of NGDP, prices or whatever. That’s all that matters.

    “Only the QTM can explain why the price level is not 1000 times higher or 1000 times lower.”

    Yes. But MV *is* in the NK model. It’s the thing that grows at the rate of inflation plus growth. So NK doesn’t contradict the QTM. But it doesn’t provide a way to pin down the exact velocity of money because it doesn’t disaggregate MV. But then QTM has no good theory of velocity either which is why it varies so much between different currencies. So we all understand the exchange equation to represent some kind of truth about the value of money, but given that velocity is so unstable and money is so hard to define it’s really fortunate that we don’t have to care. The beauty of the NK approach is that if finds a way to model the critical and observable variables P and Y *without the need* to disaggregate MV.

    “I want you to explain to me how expansionary monetary policies produced inflation before banks existed. What is the mechanism?”

    As I’ve said before, and as Dan so eloquently laid out above, those were helicopter drops. Helicopter drops always work. Our current system, on the other hand, is carefully designed to be impervious to what we call monetary stimulus under conditions of sufficiently fast deflation.

    “So that’s my model, S&D. Do I have to express it mathematically?”

    I think so. The sheer quantity of words that have been exchanged here, and perhaps even more so on Nick’s blog on the meaning of money, banking, credit, supply and demand, etc, etc, etc, is truly vast. If we still do not agree, it is because the terms of the debate are never laid out in unequivocal detail. Every debate is a war of words in which each contestants projects the arguments of the others onto his own internal model. Sure progress is sometimes made, but much of it is circular as is, I suspect, some of the logic of the participants. Without the proper formalisms, I worry that our understanding of the deepest issues will never converge. At least I don’t see any signs of it happening.

    Dan: “The banks make loans and create deposits from thin air in the process. They then acquire the reserves they need to meet their reserve requirements.”

    Right. And in countries like Canada, where mandatory reserves have been abolished, they don’t even do that. Canadian banks typically keep about $25 million (yup, million with an em!) of total overnight balances at the BOC. That’s all of them *together*. So the Canadian banking system operates almost literally without outside money. Will they ever increase reserves in response to a growing economy? No. Those reserves are only there to avoid funding desks having to do pointless trades to get exactly flat at the end of the day. Each bank has literally *zero* reserve requirement.

    The Fed also wants to eliminate mandatory reserves. In their own words: “The Federal Reserve believes it is possible that, ultimately, its operating framework will allow the elimination of minimum reserve requirements, which impose costs and distortions on the banking system.” That is, reserves serve no function in controlling bank balance sheets which are regulated by capital requirements. Reserves are nothing but *costs and distortions on the banking system*.

  40. Gravatar of marcus nunes marcus nunes
    5. October 2011 at 21:14

    Dan Kervick
    In many dynamic processes, including economic ones, feed-back can be pervasive once you start the “ball rolling”. But you concentrate on feed backs in the labor market, which gets you into a “never ending” negative feed-back loop.
    The trigger to a “depressive” labor market was the plunge in NGDP (AD). I think SS means that we have to figure out WHY NGDP is “stuck in the hole”. When that problem is “solved” the hiring decisions of firms will naturally change. And if the trigger of the process was the fall in NGDP, that,as mentioned, has consequences for all markets, not just the labor market. One caveat: The longer you take to “solve” the problem, the negative feed-back loop you mention will tend to make the problems in the labor market more and more “structural”.

  41. Gravatar of K K
    5. October 2011 at 21:49

    grcridlan: “If that were true however, QE2 would not stoke fears of “hyperinflation””

    It didn’t in the market. But the VSP’s who can impact policy will believe all kinds of crap. And if they think it could cause inflation, then we risk policy tightening.

    “In your model, does IOR raise the effective ZLB?”

    Sure. By 20 bps or whatever the IOR is set at. The interbank rate will fall to whatever they set IOR at if they cut it. So we could get an extra 20 bps of stimulus, which obviously isn’t much. But it would be the end of money market funds so the industry would get all freaked out…

  42. Gravatar of Lorenzo from Oz Lorenzo from Oz
    6. October 2011 at 01:16

    Stan: survey data suggests the biggest problem businesses themselves identify is poor sales.

  43. Gravatar of Bob Murphy Bob Murphy
    6. October 2011 at 03:40

    Dan Kervick wrote:

    It’s hard for me even to conceive of what kind of world view could produce a statement like “We need to figure out why nominal GDP is far below trend, and that has nothing to do with the decision of firms to hire, or not hire.”

    I’m guessing the same worldview that says the Fed is more powerful than God, and that “even if I’m wrong and my policies produce only inflation, I’m still right.” :)

  44. Gravatar of Dan Kervick Dan Kervick
    6. October 2011 at 04:15

    The trigger to a “depressive” labor market was the plunge in NGDP (AD). I think SS means that we have to figure out WHY NGDP is “stuck in the hole”. When that problem is “solved” the hiring decisions of firms will naturally change.

    Well, here’s the way it looked to me from my modest middle manager spot, Lorenzo. (Note that a large part of my job consists in running generating and analyzing reports on sales):

    There was a general collapse in the financial markets caused by the bursting of the housing bubble and a collapse in attached the Ponzi-market for mortgage-backed derivatives. Market indices raced downward; major, world-famous financial institutions went belly-up or teetered on the brink up collapse; the US government had to rush in with hundreds of emergency billions to prevent utter ruin and a repeat of 1929. Credit froze up. Everybody was terrified.

    Consumer spending dropped precipitously. In addition to the general atmosphere of terror, which causes people to start saving a higher proportion of their income in anticipation of rough seas and uncertainty ahead, many millions of people soon discovered that half of their retirement savings had gone up in a cloud of smoke. They were poorer. Naturally that also made them spend less.

    Sales began to drop dramatically. And as a result, companies started laying off millions of people. Obviously people who are suddenly unemployed spend less than they spent before, and so the firings themselves contributed to driving sales even further downward. Also, when the axe is coming down all around some employee, that employee’s disposition to shop and spend money changes significantly. In my company, people all around me were being cut loose every day, for months in a row. And in the companies I work with every day, our vendors mainly, I also saw dozens of my old friends and acquaintances ejected from their jobs. I went into work each day fearing that day might be my last on the job. The prospect of unemployment is particularly frightening when you read in the news every day about the growing armies of long-term unemployed, who can’t find work. This state of affairs made me very reluctant to spend money. And I imagine anyone else in a similar corporate environment knows exactly what I am talking about.

    The deluge of layoffs also results in a buyers’ market for labor and the loss of bargaining power. Even the idea of asking one’s company for a raise becomes laughable, when your company is like a ship sailing through waters filled with millions of talented but newly unemployed people who can be fished out of the sea on a moments’ notice, and hired to replace you if you decide to walk. So there is strong downward pressure on salaries and wages; real income from employment stagnates and even falls. Raises and cost-of-living adjustments are postponed; nominal wages stay flat; commissions are cut. During all this time, gas prices have steadily climbed.

    Unemployment leveled off at a high level, and has barely budged now for month after month. Those unemployed people aren’t buying much.

    So, the slashing of work forces might have been, initially, an <effect of market phenomena that are not labor related – a collapse in financial asset values – but those firings are a big part of the reason why the we have stayed in a recession. High unemployment and depressed disposable income are a major component of the market conditions which are prolonging our recession – our persistently diminished level of economic activity and output.

    Our economic system is a mess, and the stupid economists who are trapped in ideologically blinkered, dogmatic, equation-driven, causation-blind, faith-based, hidebound approaches to understanding it and guiding it are part of the problem.

  45. Gravatar of Floccina Floccina
    6. October 2011 at 04:49

    To me this whole episode show why even in a democracy you should not delegate much to the state. This is especially true with something as complex as the monetary system. The median voter does not understand the monetary system and so is easily frightened by the bugaboo of inflation. Free competitive banking is needed but how can you get the median voter to understand that?

  46. Gravatar of Floccina Floccina
    6. October 2011 at 05:45

    Dan Kervick wrote:
    There was a general collapse in the financial markets caused by the bursting of the housing bubble and a collapse in attached the Ponzi-market for mortgage-backed derivatives. Market indices raced downward; major, world-famous financial institutions went belly-up or teetered on the brink up collapse; the US government had to rush in with hundreds of emergency billions to prevent utter ruin and a repeat of 1929. Credit froze up. Everybody was terrified.

    So in a situation like that with cash and loans being somewhat similar and with cash appreciating shouldn’t banks in this case the federal reserve start to buy up the most undervalued assets with newly created cash. But since the federal reserve is part of the government and a monopoly supplier of cash, we do not trust it to do this and the banks who in this case need reserves and do not have the ability to create cash are scared to do it. If they all got together and agreed to lend their reserves they could be confident that the value of their assets would rise and they would be in OK shape but they cannot. IMO the solution would be private issue of cash backed in nothing but bank assets with something like gold used only to allow the different currencies to trade on par. So we are left with just encouraging the federal reserve to buy more t-bills which are the most overvalued assets and should the economy pick up can result in a capital loss.

    The Gov take of currency is the perfect example of Hayek’s quote:
    “The curious task of economics is to demonstrate to men how little they really know about what they imagine they can design.”

  47. Gravatar of Morgan Warstler Morgan Warstler
    6. October 2011 at 06:24

    Oz, nunes, Scott etc.

    There reality is that, and Scott gets that, and doesn’t want to admit that, as and Hanson and Matty says that…

    This is ABOUT who is the god damn boss.

    And whoever is the god damn boss ALSO bosses around the Fed.

    —-

    Everyday I win this argument with you people, and none of you really want to have your little game turned into a little game, so you skip over what I’m saying.

    The Fed is “independent” and only exists because it was how the hegemony kept the Dems in government from gaining real power.

    And even now years later, we see even the Fed bows down to the powers that be.

    Monetary policy is NOT run at the whim of Democracy, it isn’t run according to Scott’s utilitarian calculus.

    This country is run by business interests, and there can be a real debate about which business interests are the most important, but going from 5% don’t have a job to 10% don’t have a job – kinda sucks, but it certainly doesn’t mean we’re gong to let Scott’s eggheaded policy EMBED the recent gains made by the left into our social fabric going forward.

    Asking the question: shall we allow Obamacare to stand is a FAR BIGGER, FAR MORE IMPORTANT issue than whether or not 5%+ more people don’t have jobs.

    And to most of the people that matter, WHETHER YOU LIKE TO ADMIT IT OR NOT, what we’re gong through now is FINE and DANDY if it ends Obamacare.

    Now, you can dislike that the world is this way, you can say it is wrong if the world is this way…

    But that is not economics.

    Economics is about figuring out the big picture, and if you have biases that keep you from working with the facts as they are on the ground, you will forever be seeing irrationality where there is pure logic.

  48. Gravatar of Dan Kervick Dan Kervick
    6. October 2011 at 06:51

    The Austrians are a big part of the prolongation of this mess Floccina. As the effects of both fiscal and monetary policy activism were beginning to kick in, the Austrians, free-bankers, gold bugs and their various Tea Party acolytes and cranks started kicking up hysterical storms about hyperinflation, federal government insolvency and various other bugaboos that turned out to be pure phantoms of their outdated imaginations. The fear and ignorance behind this goofy movement paralyzed government and pushed us back down into two unnecessary years of Hooverite retrenchment and stagnation.

  49. Gravatar of “Lord, show them the light”! | Historinhas “Lord, show them the light”! | Historinhas
    6. October 2011 at 07:55

    […] Scott Sumner went “head over heels” on this Matt Yglesias comment: The state of the art thinking in DC, as I understand it, is that with interest rates and capacity utilization low monetary policy may not be able to boost NGDP by arbitrary amounts. Under the circumstances, to push it up non-trivially might require “crazy” steps that cause inflation expectations to become dangerously unanchored. So you need fiscal policy + monetary accommodation (i.e., bigger short-term deficit + Fed holds interest rates low) to produce the kind of moderate AD stimulus that’s wanted. […]

  50. Gravatar of grcridlan grcridlan
    6. October 2011 at 07:57

    K:

    I read a similar, if much more convoluted, argument for why IOR was necessary for the survival of certain financial transactions. I wasn’t entirely clear, but it appeared to be arguing that since large financial institutions don’t actually execute trades when they’re supposed to, instead basketing them, ending IOR would make trading less efficient because basketed trades would not be satisfied more often.

    I’m not clear, however, on why IOR is actually desirable as a result. Certainly monetary policy doesn’t exist to protect money market fund managers (or maybe I’m being naive).

  51. Gravatar of david stinson david stinson
    6. October 2011 at 09:00

    K:

    ” “I want you to explain to me how expansionary monetary policies produced inflation before banks existed. What is the mechanism?”

    As I’ve said before, and as Dan so eloquently laid out above, those were helicopter drops. Helicopter drops always work. Our current system, on the other hand, is carefully designed to be impervious to what we call monetary stimulus under conditions of sufficiently fast deflation.”

    I thought the quantity of money under a gold standard was effectively endogenous, i.e., not a helicopter drop.

  52. Gravatar of Scott Sumner Scott Sumner
    6. October 2011 at 13:17

    Lorenzo, Very good observation.

    Floccina, The problem is that the Fed tightens monetary policy in response to high oil prices.

    Dan, You seem to be making a distinction that I just don’t see. The normal way the Fed injects money today (liquidity trap or not) is buy buying back government bonds. Those bonds were issued to pay for things like bridges. So how does that differ from king in the old days just paying workers directly to build a bridge, with watered down coins? I don’t get it. It’s seignorage either way.

    Regarding my point to Stan, if 30 million jobs are destroyed every year, and unemployment goes up by 1 million, then the reasons why those 30 million jobs were destroyed will tell you very little about the underlying reasons for the net decrease. Assume for a moment that the cause was a slight drop in the monetary base. Tell be how the guy who owns the Pizza shop and lays off one worker will know that this is the cause. What will he see that will give him that insight?

    Bob, You said;

    “The problem isn’t nominal spending. People spend millions of dollars every day. So clearly the problem isn’t with NGDP.”

    That’s a bad analogy. I didn’t say that the net loss of jobs isn’t a problem, but the individual firm has no access to the net loss of jobs in the US economy. Even in recession the flow of hiring and firing totally dwarfs the net change in jobs. So much so that only a tiny fraction of the gross job losses are directly related to the recession. Other bloggers have documented this with all sorts of graphs.

    Let me ask you this. Are home builders going to say: “We stopped building houses due to fears about Obama regs, or because no one is buying new houses?”

    I don’t doubt that in lots of industries that aren’t particularly cyclical, people are pissed off about regs, but that doesn’t have much bearing on the recession. And I don’t doubt that the gross job losses in those industries will dwarf those of housing. But what if the net job losses don’t exceed housing? Then the interview data will be meaningless. You can’t mix up macro and micro perspectives.

    I agree that if unemployment fell to 3%, RGDP would rise. But I don’t agree that this requires firms to do lots more hiring. In competitive industries growth occurs through new firms entering, not existing firms growing. Regs might knock existing firms below 50 (the cutoff for many regs) That doesn’t mean less jobs, it means smaller restaurants, and more of them (assuming the demand is there.)

    I do care about employment, and hope and expect 5% NGDP growth, level targeting, will create jobs. But I favor NGDP targeting even if it doesn’t create one job, as the US benefits from stable income growth for many other reasons (such as reducing the frequency and severity of debt crises.)

    John, You said;

    “I’ve had that basic conversation before. Obviously money needs to get spent into existence and without a demand for loans and credit worthy borrowers, I think that there isn’t anyway for the Fed to get the money circulating instead of parked in reserves. He assured me this wasn’t true because of the “excess cash balance mechanism.””

    This is odd for several reasons. First, I was discussing a world with no banks, and thinking about the transmission mechanism. It’s hard to imagine high levels of ERs if there are no banks to hold ERs. The second problem is that you seem to assume that loans are the way banks get rid of cash they don’t want. Not true, they buy assets.

    The “excess cash balance mechanism” is the core of monetary theory. I’m amused by the way you put it in quotes, like it’s some strange exotic concept. It’s not my idea, it goes back for centuries. Try reading David Hume–he didn’t need banks to explain the idea.

    John, You said;

    “A couple posts ago Scott said NGDP was a panacea.”

    I don’t recall ever saying anything remotely like that. Nor do I believe it.

    Bob, Regarding being unfair to Stan, I think you misunderstood me. Suppose we lose 30 million jobs, and gain 29 million (a typical year). Suppose only 1 million of the 30 million job losses were due to recession. Then the typical firm won’t cite “recession” as the reason for laying off workers. But the net total of unemployment may rise by 1 million.

    Dan, I’m not a fan of “vicious cycle” explanations, you need an exogenous causal factor for NGDP. And monetary policy clearly drives NGDP. Question; did inflation fall from 10% to 2% in America because Congress decided 2% was right, or because the Fed did? I can’t even take seriously the idea that Congress drives NGDP growth. It’s the Fed that steers the economy.

    K, No need to apologize, you are ultra-polite compared to many commenters. You said;

    “Stuck at zero just means it’s not changing. Not that it doesn’t matter. The supply of money, on the other hand, changes and has no impact. That is the definition of “doesn’t matter”.”

    OK, I worded that poorly. I meant that both money supply increases and interest rate cuts aren’t able to do anything right now. (for different reasons). I meant that in both cases all you can do is promise a different future path of your instrument. So Woodford says promise low rates way out into the future (and I say be careful people don’t interpret that as Japan–you need level targeting to avoid that.) And market monetarists say you must promise a higher money supply in the future when we are no longer in a liquidity trap. That seems rather symmetrical to me.

    You said;

    “2) who knows where velocity will be if and when we ever raise rates again and 3) you want *double* the current NGDP before you ever raise rates again???”

    Here again you misinterpret me. This would be a good argument to use against an old style monetarist, but I’m not one of those, I don’t favor money supply targeting. I was just making the technical point that permanent monetary injections matter at the zero bound. I don’t know why Keynesians think this is an exotic assumption, every econ 101 explanation of the QTM assumes permanent injections. Temporary injections don’t have much effect, even if not at the zero bound. There’s nothing all that special about the zero bound. Does anyone think that if back in 2005 the Fed suddenly doubled the money supply, and announced it would be removed a week later, that prices would have doubled?

    The Fed should be saying “we’ll leave enough of the money in there permanently to allow NGDP to grow 5% per year, long term.”

    Regarding QE, I’ve always argued that it works, if at all, as a signal of easier money. Yes, there should be a better way, but we can see the Fed doesn’t believe in giving explicit signals. It’s a very poor second best. But the market’s liked it for some reason. It’s an open question as to whether buying longer term bonds can work, but obviously buying zero rate T-bills has little direct impact.

    So you are saying the NK model does use the quantity of money to explain the price level? Nick Rowe told me it doesn’t. Maybe I misunderstood. Yes V varies, but not by factors of 1000 (especially in normal times.) So you need the QTM to at least get you in the ball park as to the price level.

    More to come. . .

  53. Gravatar of Scott Sumner Scott Sumner
    6. October 2011 at 14:48

    K, You replied:

    “So that’s my model, S&D. Do I have to express it mathematically?”

    “Yes”

    OK, here’s off the top of my head:

    1. employment = natural rate + alpha times unexpected NGDP growth. (My Philips Curve.)

    So all that’s left is to model NGDP, right?

    NGDP = M*V

    V = f(i, asset prices, expected NGDP growth.)

    i = f(expected NGDP growth, level of employment relative to the natural rate, money shocks)

    expected future NGDP = f(expected path of M from now until infinity plus expected money demand shocks, or the central bank NGDP target, whichever you prefer)

    If the previous equation leads to indeterminacy, make an ad hoc assumption that the public believes the central bank would make the currency convertible into some real assets (gold, foreign exchange, etc) at a future date, if necessary to pin down the price level and NGDP. With that assumption they probably would never have to actually do that.

    Banks play no role in model, other than demanders of base money, just like K-Mart and drug dealers.

    What else do I need to make the model complete?

    If I have to justify the Philips curve, I use three year nominal wage contracts, and let hours worked be negatively related to W/NGDP per capita.

    BTW. I don’t claim this model completely explains the current recession, but at least it explains a severe recession beginning in 2008.

    K, You said;

    “Sure. By 20 bps or whatever the IOR is set at. The interbank rate will fall to whatever they set IOR at if they cut it. So we could get an extra 20 bps of stimulus, which obviously isn’t much.”

    I think you have to distinguish between what the model tells you and what might actually happen, because models are incomplete. Let’s move the IOR to negative 3%. Banks immediately try to dump $2 trillion in cash onto the money market. What happens? The honest answer is no one knows. Nothing like that has ever been done. T-security yields could well go negative, as storing that much cash is quite costly. Then there is the effect on expectations. If the public actually sees that many pictures of dead presidents flooding into the economy, does it change expectations? Krugman says it would all go into safes, but I’m not so sure, that’s a lot of money. What kind of signal would the Fed be sending by doing something so bizarre? The more you think about it, the more you realize our models capture only a tiny chunk of reality.

    Bob, You quoted me as:

    “I’m guessing the same worldview that says the Fed is more powerful than God, and that “even if I’m wrong and my policies produce only inflation, I’m still right.” ”

    Foul!! Out of context. I favor 5% NGDP targeting regardless of what happens to inflation, but I’ve admitted that if NGDP rises sharply, and only prices rise, I was wrong about the cause of the recession. (And the stock market is wrong too.) Read the entire post.

    Dan, You are confusing cause and effect. The factors you describe are the effects of the fall in NGDP, not the cause. Things were far worse in Zimbabwe, yet their NGDP grew much faster than in any other country, even China. I wonder why, given so many Zimbabwean workers were driven into poverty?

    Floccina, Are you saying counterfeiting should be legal? I assume not. So what makes you think free banking would produce a stable economy?

  54. Gravatar of Scott Sumner Scott Sumner
    6. October 2011 at 15:47

    K, You said;

    “As I’ve said before, and as Dan so eloquently laid out above, those were helicopter drops. Helicopter drops always work. Our current system, on the other hand, is carefully designed to be impervious to what we call monetary stimulus under conditions of sufficiently fast deflation.”

    You are wrong, they worked through debasing coins, a very different mechanism. Price theory can explain that inflation, no monetary models are required. And it’s not true that helicopter drops always work, as the Japanese have shown. If the injections are temporary, they don’t work–helicopter or not.

    When you double the money supply the price level will double. This has nothing to do with a helicopter drop. The price level will double regardless of whether the money is dropped out of planes, or used to buy bonds. Of course all this assumes positive interest rates. My response to Dan was not addressing the liquidity trap issue.

    Regarding our system and deflation, the Japanese have shown that if you do everything necessary to get deflation, and loudly say that you oppose inflation, you might well get deflation. Is that a surprise to anyone?

  55. Gravatar of Dan Kervick Dan Kervick
    6. October 2011 at 16:26

    So how does that differ from king in the old days just paying workers directly to build a bridge, with watered down coins?

    Because once the bond is issued and the bridge has been purchased, I don’t think it matters a great deal whether or not the bond is then subsequently swapped for money. The main effect on the prices of goods and services has already occurred.

    When the king mints some money and then sends his agent into the market to buy some horses, that new money is out competing in the market for horses with other money, and bidding up the money price of horses. But if the king mints the money and then simply puts it in his vault, it has no effect on prices.

    It seems to me that open market purchases function more like the latter than the former. Most of the bonds purchased are held by financial institutions, and the repos are just swaps of one kind of financial asset for another. The dollars may be contributing to bidding up the prices of financial instruments, but they are moving around at some remove from the real economy, especially in a stagnating economy where a lot of monetary and financial savings are relatively inert.

    I can’t even take seriously the idea that Congress drives NGDP growth. It’s the Fed that steers the economy.

    I don’t get that. NGDP growth is not necessarily growth in “the economy”. NGDP could rise solely as a result of an increase in the price level, with RGDP remaining flat. The economy is the production and exchange of the real goods and services which financial instruments like money only, as Hume said, “lubricate.” And in our contemporary system, the Fed acts mainly in a passive and responsive way, by adjusting rates and supplying reserves in response to endogenously driven lending activity. It’s not really steering anything.

    The congress and executive branch, on the other hand, constitute a massive enterprise that spends over $3.5 trillion dollars annually. When they increase or decrease spending even by small percentages, they have a very large impact. And of course they write and execute all the laws which determine the permitted shape of economic transactions.

    I picture the central bank as more like the guys shoveling coal into the engines of a battleship in the engine room. A lot might hang on how well they do their job. But they certainly aren’t steering or the ship or conducting the battle. Private sector businesses and the fiscal and legislative authorities are doing that.

    In fact, the CB isn’t even as important as the coal shovelers. The shovelers are the banks. The CB just makes sure the coal hopper is filled up to the right level, so that if there is a sudden need for more shoveling as surface activity picks up, the shovelers don’t encounter an unexpected shortage of coal to shovel.

  56. Gravatar of stan stan
    6. October 2011 at 19:18

    Scott,

    I’ll try to ignore the general stupidity of the notion that an economic theorist should ignore economic reality and simply respond to your specific error.

    Business investment is still more than 10% below pre-recession levels. Personal consumption, disposable income, real GDP have all returned. Private payrolls have not and business investment is even lower. We have a situation which has some similarity to 1936 where FDR’s fierce attacks on business and investors produced the only two years of negative investment during the depression.

    Businesses aren’t investing because Washington has scared the crap out of them. The decision to hire is closely related to the decision process for capital investment. Both are down for the same reason — government-induced uncertainty. By increasing costs and greatly increasing uncertainty about future costs, DC has made investment far more difficult. Just as DC has made hiring more difficult.

    Look at the data. Ask someone why NET business investment is down (and please don’t give me that ridiculous crap again about business are still investing, just not enough).

    Every now and then, theorists need to understand when ceteris paribus doesn’t apply. It’s an assumption that is fundamental to your models and when it fails, your models produce crap (even more than normal). Govt has shifted your demand curve. If you can’t put an accurate number on the extent of the shift, you can’t model the new reality. Of course, that assumes you have an interest in reality and I obviously shouldn’t assume that.

  57. Gravatar of K K
    6. October 2011 at 20:56

    Scott: lots of things I want to respond to and might try tomorrow. Bit then I’m canoeing for a few days, and wont be ably to comment until Wednesday. I hope the thread won’t be totally dead by then or have left me way behind.

  58. Gravatar of grcridlan grcridlan
    7. October 2011 at 14:23

    I said: “If that were true however, QE2 would not stoke fears of “hyperinflation””

    K Said: “It didn’t in the market. But the VSP’s who can impact policy will believe all kinds of crap. And if they think it could cause inflation, then we risk policy tightening.”

    I said: “In your model, does IOR raise the effective ZLB?”

    K said: “Sure. By 20 bps or whatever the IOR is set at. The interbank rate will fall to whatever they set IOR at if they cut it. So we could get an extra 20 bps of stimulus, which obviously isn’t much.”

    Scott said: “I think you have to distinguish between what the model tells you and what might actually happen, because models are incomplete. Let’s move the IOR to negative 3%. Banks immediately try to dump $2 trillion in cash onto the money market.”

    This is what I’m trying to get at. If there is $2 Trillion in M1 parked in reserves due to IOR, doesn’t it make more sense to eliminate IOR than to conduct open market operations in order to increase M1?

    After all, reserves are essentially insurance against failure to pay deposits. It would make better sense to have banks pay an insurance premium based on their deposits than keep reserves anyway… and this is precisely what negative IOR would create.

    If IOR represents the effective ZLB, then we are not at the ZLB if there are excess reserves.

  59. Gravatar of grcridlan grcridlan
    7. October 2011 at 14:43

    Scott: In your models, how do you define a temporary vs. a permanent injection of money? The Fed’s actions are contingent, and as has been belabored, the Fed’s ability to withdraw or supply money is effectively unlimited. How can there be a permanent injection of money?

    I don’t think the ECB or the Fed has sufficient credibility as an inflationary authority to convincingly do that. They have the same problem Volcker faced: They would have to take very drastic action to shed the reputation of the institution.

    To what extent is inflation targeting falling prey to a Friedman-like critique of the Phillips curve, where it works well until people rely on you doing it? It seems to me that inflation targeting was -accidentally- good policy when growth was at or around trend.

  60. Gravatar of Scott Sumner Scott Sumner
    8. October 2011 at 16:53

    dan, I don’t think you understand my argument. No one disputes that if government bonds pay zero interest, they are effectively money. In that case a swap of money for money does nothing significant (unless it changes expectations of future monetary policy–which it might.)

    You said;

    “It’s not really steering anything.”

    It isn’t? So did the 2% inflation of recent decades just happen in all these countries by magic? Did all the various Congresses produce this low and stable inflation? I can’t see how it was fiscal policy, as deficits exploded upward in 1981 just as inflation was plummeting lower.

    Stan, So far as I know every single business cycle model that has ever been invented predicts that investment will fall much more sharply than consumption during recessions. I assume you know that. So why are you bringing up this investment data; what is it supposed to tell me?

    K, I like your comments, so I’ll respond no matter how late.

    grcridlan, The Fed definitely is not a pure inflation targeter–they are probably closer to a Taylor Rule institution. They obviously do care about growth, as they cut rates sharply in 2007-08 when inflation was well above 2%. So they should have no trouble convincing the market that they want 5% NGDP growth, as that’s roughly hat they did for 2 decades.

    As a practical matter the meaning of permanent monetary injections is related to the policy target. If they have a 5% NGDP target, they are implicitly promising to leave enough money in circulation permanently to produce 5% long run NGDP growth. That’s not a radical idea, it’s what they’ve been doing in a very rough sort of way for decades.

    The Fed’s current problem is not that’s it’s trying to raise inflation expectations, and failing, but rather that it’s trying to reduce inflation expectations with promises of an exit strategy the moment we get a tiny bit of inflation.

  61. Gravatar of grcridlan grcridlan
    12. October 2011 at 08:53

    Scott: If the Taylor Rule currently implies a seriously negative interest rate, and we assume that simply printing money will not result in NGDP changes due to a liquidity trap, doesn’t imposing negative IOR create a new “floor” below 0% for the liquidity trap model posited here: (http://web.mit.edu/krugman/www/japtrap.html)

    It seems to me it would; private individuals would have no incentive to hold cash, because they would be facing rising inflationary expectation (we hope), and it would remove the incentive of banks to hold cash.

    Is this a way to correct the divergence from the Taylor Rule visible here: (http://bit.ly/q72ozS)?

    I understand that there is a simpler solution, that is, creating expectations of inflation which will raise nominal rates above zero. But imagine for a moment that you control policy but not the speeches made by the OMC; would negative IOR increase inflation expectations?

  62. Gravatar of Scott Sumner Scott Sumner
    13. October 2011 at 05:51

    grcridlan, The honest answer is we don’t know. Ceteris paribus, a lower IOR is inflationary. But the question is whether ceteris would be paribus. How would it affect future expected monetary policies (QE, fed funds rate, etc.)?

  63. Gravatar of Keynesian Policies: Not Dumb, But Foolish Keynesian Policies: Not Dumb, But Foolish
    13. February 2014 at 10:56

    […] Not surprisingly, people who agree with Yglesias’s monetary views think he is wise. […]

  64. Gravatar of Major_Freedom Major_Freedom
    13. February 2014 at 13:57

    Dollar NGDP is not a reliable indicator of the stance of monetary policy. Money is not tight, it is loose. So loose in fact that SWAT teams are required to force people to keep using dollars as a medium of exchange, through taxing them in dollars.

    If those SWAT teams put down their guns, the value of dollars would quickly plummet to the value of scrap paper, and the massive bubble will be revealed to even the dim witted who believe we have a dollar insufficiency problem.

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