Archive for June 2010


A few thoughts on nominal wage stickiness

Tyler Cowen recently responded to some wage stickiness comments by Bryan Caplan and myself:

But if people who work on commission and tips are out of work in large numbers, or if truly flex-wage workers are being laid off, why see wage stickiness as the #1 culprit?  (Scott isn’t following through the logical implications of his cyclicality point.)  In economies with truly flexible wages, people are forced to retreat into household production in down times and that is perhaps a better parable for America today.  No one will hire them, flexibility or not.  Plus if workers are irrational by focusing on the nominal rather than the real values, it’s easy enough to trick them by cutting real benefits and working conditions, thereby saving the employer money.  Real wage flexibility should be enough to keep them at work, yet it isn’t.

I have 5 comments on this passage.

1.  I don’t follow the logic of the last sentence.  First of all, nominal wage rigidity may be due to contracts, not money illusion.  But even if it is money illusion, Tyler’s argument doesn’t follow.  Just because a factory worker with limited skill at math doesn’t understand the distinction between a cut in nominal wages and a cut in real wages, does not mean that he wouldn’t realize if the assembly line sped up from 60 to 80 cars an hour.  And if he truly wouldn’t realize this, why hadn’t the car company already sped up the line?

2.  Just because aggregate nominal wage stickiness causes aggregate unemployment to rise, doesn’t mean wage flexibility in a single profession can prevent unemployment in that profession from rising during recessions.  There is a coordination problem here.  Suppose the money supply falls 10%, and all economic agents get in a room and immediately decide to cut all wages and prices by 10%.  Will it prevent recession?  We can’t be sure, but later I’ll argue that it will.  But if they don’t do that, then we will have a recession.  In that case most nurses will not lose their jobs even if they refuse to take pay cuts, and many factory workers will lose their jobs even if they take 10% pay cuts.  Nominal shocks cause recessions that have very different effects on cyclical and non-cyclical industries.  I believe that is a prediction of every important business cycle model.

3.  I agree that nominal wage flexibility plays no role in explaining the chronically high unemployment in certain economies.  The argument is that nominal rigidity explains why unemployment rises in the face of nominal shocks, and that’s all it explains.  I have no idea why Haitian businesses don’t cut wages when there are Haitians who are willing and able to do the same work for less.  Perhaps there is some sort of efficiency wage explanation.  In any case, the chronically high unemployment that one observes in certain developing countries, or even in some eurozone members, has nothing to do with nominal wage rigidity.

4.  I don’t see “wage stickiness as the #1 culprit”.  Here is an analogy.  Suppose we observe engine failure once a month on jetliners.  Each time the plane crashes.  What’s the fundamental problem here, bad engines, or gravity?  Most people would say bad engines.  Now assume that every few years the Fed creates a negative nominal shock.  Because nominal wages are sticky, it creates a temporary recession (until wages adjust.)  What’s the fundamental problem here, sticky wages or monetary policy?  I’d say monetary policy.  To me, nominal stickiness is just a part of nature, like gravity.  It is not something you’d think about altering with government policies.  (BTW, it certainly isn’t the fault of “workers” most of whom don’t even set their nominal wage.)  Just as gravity is something airplane engineers must take into account, nominal stickiness is something that the Fed must take into account.  Of course there are government policies that increase real wage stickiness (minimum wages, extended IU benefits, etc) and those can make the problem worse.  At the risk of making my airliner analogy even more ludicrous, these rigidities are analogous to installing giant magnets on the ground, which try to suck airplanes out of the sky.  (Yes, I know that airplanes are aluminum.)

5.  Here’s why I can’t shake the idea that nominal wage (and perhaps price) stickiness is the key problem when AD falls.  Consider the 1920-21 deflation, which was quite rapid.  It was caused by a big drop in the monetary base (I believe around a 17% decline.)  Unemployment rose sharply, until wages had adjusted.  Now it seems to me that if these two facts are not related, if the rapid deflation (more than 20% depending on the index) did not cause the high unemployment in 1921, then I should just quit economics.  It would mean that everything I think I know is wrong–that I have nothing useful to say.  (Some people might wish I’d quit.)  But let’s assume I and the other 95% of economists who believe deflationary monetary policies increase unemployment are correct.  What then?  Well then explain this:  A few years back Mexico experienced 99.9% deflation almost overnight.  Prices plunged far more sharply than they did in the US between 1920-21.  And yet there was no sudden spike in the unemployment rate.  How could this be?  My theory is that Mexico avoided high unemployment during this severe deflation because the government ordered all nominal wage rates to be immediately cut by 99.9%.  Prices fell by a roughly similar amount (I don’t know if the government ordered them to fall.)  The point is that even severe deflation doesn’t cause additional unemployment if there is no nominal wage stickiness in the system.

Until someone can find a plausible alternative explanation for why America experienced high unemployment in 1921, but Mexico did not during a much more severe deflation during 1993, then I’m sticking with the sticky wage (and price) explanation of why nominal shocks have real effects.

One final point.  Once a major deflationary shock creates a severe recession, all sorts of real supply-side factors enter the equation.   I’ve already mentioned the cyclical effects of nominal shocks.  There is also the decision to raise IU from 26 weeks to 99 weeks—something that never would have happened without the initial nominal shock that created the recession.  But once those real factors kick in, the outcome can look very much like a real shock to a casual observer.  Don’t underrate the importance of unemployment benefits and other labor market rigidities.  The eurozone experienced long periods of near 10% unemployment (for reasons unrelated to nominal wage rigidities), there is no reason that it could not happen here—if we follow similar policies.

If the Fed boosts NGDP sharply, unemployment will fall sharply, Congress will let the extended IU benefits expire, and SRAS will shift right as AD is shifting right.  A win-win scenario.  Oh, and the budget deficit will automatically get much smaller.

Why won’t those &$*%#@ bloggers go away?

In a recent essay Kartik Athreya suggests that almost all economics bloggers are basically quacks, hardly worth paying attention to.  OK, take a deep breath and don’t get defensive Sumner; constructive criticism is always welcome:

In summary,  what  I’d like to convince the public that  economics is far, far, more complicated than most commentators seem to recognize.  Because if they did, they could not honestly write the way they  now do.  Everything “depends”,  and this  is just  the  way it is.  And learning  what  “it” depends on, exactly,  takes enormous effort.  Moreover, just below the surface of all the chatter that appears  in blogs and op-ed pages, there is a vibrant, highly competitive, and transparent scientific enterprise  hard  at work.  At this point, the public remains  largely unaware  of this work.  In part,  it is because  few of the economists  engaged in serious science spend any  of their  time connecting to the outer  world (Greg Mankiw and Steve Williamson  are two counterexamples that essentially prove the rule), leaving that to a group almost defined by its willingness to make exaggerated claims about  economics and overrepresent its ability  to determine  clear answers.

That’s right; no need to pay attention to Gary Becker, John Taylor, Paul Krugman, and all the other quacks who lack Athreya’s sophisticated understanding of the “science” of economics.  BTW, any time someone wields the term ‘science’ as a weapon, you pretty much know they are an intellectual philistine.  Am I being defensive yet?

To get serious for a moment, in this essay Athreya is confusing a bunch of unrelated issues:

1.  The style of bloggers; are they polite or not?

2.  The ideology of bloggers

3.  The views of bloggers on methodological issues

4.  Are bloggers competent to opine on important public policy issues?

I don’t recall ever reading a Greg Mankiw post that I didn’t feel knowledgeable enough to write.  On the other hand I’ve read lots of Mankiw posts that I didn’t feel clever enough to write.  That’s an important distinction.  Mankiw is a great economist in the “scientific” tradition, and he’s a great blogger—but for completely different reasons.  He’s a great blogger for the same reason he is a great textbook writer.  There are other bloggers who are also very clever; Krugman, Tyler Cowen, Robin Hanson, Steve Landsburg, Nick Rowe, etc, etc.  Several on that list also wrote textbooks.

I don’t know if Krugman has done a lot of recent research on macro, but he knows enough about the literature to offer an informed opinion.  I often disagree with the views of Krugman, DeLong, Thoma, et al, on fiscal policy, but they can cite highly “scientific” papers by people like Woodford and Eggertsson for all of their fiscal policy views.  There must be dozens of economics bloggers who either teach at elite schools, or have a PhD from elite schools, and who are qualified to comment on current policy issues.

Athreya also takes on those who (he claims) lack formal qualifications in economics.  Here’s how he opens his essay:

The  following is a  letter   to open-minded   consumers  of the  economics  blogosphere.      In  the wake of the  recent financial  crisis, bloggers seem unable  to resist  commentating  routinely  about  economic  events.  It may  always have been thus,  but in recent  times,  the manifold  dimensions  of the  financial  crisis  and  associated  recession  have given fillip to something  bigger  than a cottage  industry. Examples  include Matt  Yglesias, John Stossel, Robert Samuelson,  and Robert  Reich.  In what follows I will argue that it is exceedingly unlikely that these authors  have anything  interesting to say about  economic policy. This sounds mean-spirited, but it’s not meant to be, and I’ll explain why.

Before I continue,  here’s who I am:  The  relevant fact  is that  I work as a rank-and-file  PhD economist operating  within a central banking  system.  I have contributed no earth-shaking ideas to Economics and work fundamentally as a worker bee chipping  away  with known tools  at portions  of larger problems.

Where do I begin?  Yes, bloggers who address important public policy issues sometimes “seem unable to resist” commenting on the biggest economic crisis since the 1930s.  Unlike Athreya, I don’t judge people by their credentials, but rather by the quality of their arguments.  Yglesias is the only person listed above that I read routinely.  Although he is much more liberal than I, and we differ on many public policy issues, I find his reasoning ability on economic issues to be superior to the majority of professional economists that I have met or read.

I guess no one will accuse me of being one of those “worker bees” who churn out ever more macro studies that follow accepted scientific methods.  I notice that those economists had little or no useful advice to offer the Fed when the current crisis hit in 2008.  I may be incorrect in my policy views, but at least I am trying to offer pragmatic policy suggestions.

But maybe it’s not the fault of economists.  Maybe there is nothing that could have been done to prevent this crisis:

I find the  comparison  between  the response  of writers  to  the  financial  crisis and  the  silence that followed two cataclysmic  events in another sphere of human  life telling.  These are, of course, the Tsunami  in East  Asia, and the recent earthquake in Haiti.  These two events collectively took the lives of  approximately half a million people, and disrupted many  more.  Each  of these events alone,  and  certainly  when combined,  had  larger consequences  for human  well-being than  a crisis whose most  palpable  effect  has  been to lower employment to a rate  that, at  worst,  still employs fully  85% of the  total workforce  of most  developed  nations.    However,  neither  of these  events was met  by (i) a widespread  condemnation of seismology, the  organized  scientific  endeavor  most closely “responsible”  for our understanding of these events or (ii) a flurry of auto-didacts rushing to  offer their  own diagnosis  for what  had  happened,  and  advice  for how to avoid  the  next  big one.  Everyone understands that seismology is probably  hard  enough that  one probably  has little useful to say without  first  getting a PhD  in it.  The  key is that  macroeconomics, which involves aggregating the actions  of millions to generate outcomes,  where the constituents pieces are human beings, is probably  every bit as hard.  This is a message that  would-be commentators just have to learn  to accept.  For my part,  seventeen years after  my first PhD coursework,  I still feel ill at ease with my grasp of many issues, and I am fairly confident that  this is not just a question  of limited intellect.

This confuses two unrelated issues, the ability to predict a crisis and the ability to prevent a crisis.  In 1932 no one could have predicted the rapid inflation that occurred during 1933.  But we know exactly what policy choices caused that inflation, the sharp depreciation of the dollar that began in April 1933.  We could have easily prevented the inflation.   (Thank God we didn’t.)  We knew how to prevent the sharp fall in NGDP after mid-2008; we simply chose not to do so.  In contrast, we do not know how to prevent earthquakes and tsunamis.

Athreya ignores the role of the medium of account, and the importance of nominal shocks.  Yes, the economy is incredibly complex, but nominal aggregates are relatively simple.  The Fed has a monopoly on the supply of the medium of account.  It’s their job to target some sort variable linked to aggregate demand (prices, NGDP, etc.)  The tsunami of falling AD all around the world that occurred in late 2008 was not some sort of mysterious event, but rather reflected the loss of monetary policy credibility.  The Fed has the tools to prevent something like that from occurring.  Bernanke explained to the Japanese how to use those tools in 2003.  The fact that he refused to use them in 2008, and never explained why, is certainly grounds for criticism.

A lot of the more scientific economists have a very limited understanding of economic history.  Many do not realize that in the Great Depression some of the most promising ideas came from those on the fringes, like George Warren and Irving Fisher, and that most “respected” economists were peddling snake oil.  Today it is bloggers who are offering ideas on how to boost AD, the sort of ideas that almost everyone now agrees should have been tried in the 1930s, and it is respected economists who are often recommending that no further effort be made to boost AD.  One example in the latter category is Athreya’s boss, the president of the Richmond Fed.  According to press reports he is pressing for tighter money (as if money isn’t already tight.)  Perhaps he’s not convinced that models linking nominal GDP growth with unemployment are sufficiently “scientific.”

In the 1930s many “respected” economists warned that inflation was just around the corner, even as prices kept falling.  Today, many of the more conservative respected economists are issuing the same warning, despite the fact that the markets are signaling lower that target inflation and despite the fact that conservative economists (claim to) believe that markets are efficient.  It seems to me that it is mostly bloggers (on both the left and the right) who insist that the real problem is disinflation.  So who’s right Mr. Scientific Economist, the bloggers with their market signals, or the scientists with their abstract models that were completely unable to predict the current crisis, are unable to explain 16 years of deflation in Japan, but are somehow able to tell us that inflation is the real long term threat?

I don’t think the real problem is that bloggers oversimplify.  If you disagree with someone their views will always seems simplistic.  No, the real problem here is that Athreya likes some simplistic models more than others:

The punchline  to all this is that  when a professional  research  economist  thinks or talks about social insurance,  unemployment, taxes, budget  deficits, or sovereign debt, among other things, they almost  always have a very precisely articulated model that has been vetted  repeatedly  for internal coherence.  Critically,  it is one whose constituent assumptions and parts  are visible to all present, and can be fought over.  And what I certainly  know is that  to even begin to talk about  the effects of unemployment, debt,  deficits,  or taxes,  one  has to think  very hard  about  many,  many  things. Examples  of this  approach  done right  in the  context  of  some of the  topics  mentioned  above  are recent papers by Robert Lucas of the University of Chicago, Jonathan Heathcote  of the Minneapolis Fed,  or Dirk Kreuger  and his co-authors.

When you combine this passage with his previous praise for Steve Williamson’s blog, it becomes pretty clear what sort of research Athreya considers scientific.  What would be an example of non-scientific research?  How about Milton Friedman’s partial equilibrium approach to monetary economics and business cycle theory?  I am a big fan of Lucas’ work on rational expectations, especially the Lucas Critique.  Those were genuine improvements over Friedman’s macro theory.  But that is all.  Lucas’s insistence that good macro can only be done by carefully embedding all the assumptions in general equilibrium models with micro foundations turned out to be an intellectual dead end.  There is not a single idea in monetary economics of use to policymakers that can’t be explained in partial equilibrium terms on the back of an envelope.

If blogs had been around in the 1960s and 1970s, Friedman would have been the world’s best economics blogger.  Here’s what Friedman said about the Japanese crisis in 1998:

The governor of the Bank of Japan, in a speech on June 27, 1997, referred to the “drastic monetary measures” that the bank took in 1995 as evidence of “the easy stance of monetary policy.” He too did not mention the quantity of money. Judged by the discount rate, which was reduced from 1.75 percent to 0.5 percent, the measures were drastic. Judged by monetary growth, they were too little too late, raising monetary growth from 1.5 percent a year in the prior three and a half years to only 3.25 percent in the next two and a half.

After the U.S. experience during the Great Depression, and after inflation and rising interest rates in the 1970s and disinflation and falling interest rates in the 1980s, I thought the fallacy of identifying tight money with high interest rates and easy money with low interest rates was dead. Apparently, old fallacies never die.

The same point is made in Mishkin’s textbook.  And Mishkin is a respected “scientific economist” by anyone’s standards.  So why is it that 90% of the respected scientific macroeconomists don’t understand this?  Why do most keep insisting that the Fed has conducted an “accommodative” or “easy” money policy since 2008?  Maybe they think that doubling the base is easy money, and are unaware that the Fed started paying interest on base money in October 2008.  As Cochrane pointed out, this means that reserves are now effectively bonds, not money.

My claim is that despite all these fancy mathematical models, most scientific economists lack Milton Friedman’s intuitive grasp on what is really important, what is really going on below the swirling mass of data with which we are constantly bombarded.  And I don’t pick Friedman merely because I happen to agree with his politics, Krugman is also very good at looking below the surface (when he doesn’t let ideology get in the way.)

I’m afraid that we won’t get the answers we need from “worker bees.”  Matt Yglesias may not have an economics PhD, but he has a sure grasp of the importance of preventing a sharp break in NGDP growth, something that some much more distinguished economists seemed to overlook in the turmoil of the recent financial crisis.

If Athreya really thinks we are so shallow, then I encourage him to enter the fray, start his own blog.  I’d love to debate monetary policy with him.  He might find out that bloggers know a bit more than he imagined.

HT:  David Beckworth

A few interesting comments and posts

Today I’ll link to a post by Bryan Caplan, and then a couple comments from my previous post.  Here is Tyler Cowen discussing wage flexibility:

Keep in mind that unemployment rates today are disproportionately concentrated in low-income and low-education workers.  Haven’t we been told, for years, that these same individuals are seeing some mix of stagnant and eroding wages?  That they are experiencing downward mobility?  That the real value of health care benefits has been falling and that more and more jobs don’t offer health care benefits at all? 

Doesn’t that mean…um…their wages aren’t so sticky downwards?  And thus Keynesian economics is not the final story?

And here is Bryan’s response:

The obvious responses:

1. The erosion we’ve been told about for years is supposed to have taken years to happen.  Three or four decades, actually.  Even staunch Keynesians probably think that the labor market could right itself over such a long timespan.

2. This erosion took place alongside positive inflation, year after year.  It’s perfectly consistent with complete nominal rigidity.  Consider: Between January 1978 and January 2008, the CPI (set to equal 100 for 1982-4) rose from 62.5 to 211.1 – enough to reduce constant nominal wages by over 75% in real terms.  Tyler mentions the real-nominal stickiness distinction later in the post, but it doesn’t enter into his analysis.

Overall, I think Tyler’s completely wrong here.  Ticker-tape flexibility in the labor market wouldn’t solve all our economic problems overnight, but would quickly solve the unemployment problem.

This  is pretty close to what I would have said.  I’m not sure complete wage flexibility would eliminate cyclical unemployment, but I think it would greatly reduce it. 

BTW, the sticky-wage theory of business cycles does not predict that industries with flexible wages will have lower unemployment during recessions.  Rather industries that produce acyclical goods will tend to have lower unemployment.  Surprisingly, if the wages of factory workers are quite flexible, and the wages of health care workers are quite sticky, it is still likely that factory workers will suffer higher unemployment during a recession.  To see why just consider a thought experiment where money and NGDP fall by 10%, and the economy is 50% health care and 50% manufacturing.  If health care wages are sticky, and output is stable, then nominal spending on factory goods will fall by about 20%.  Unless factory workers accept a 20% nominal pay cut (i.e. 10% lower real wages) they will suffer higher unemployment.  A more plausible outcome is that both prices and output fall in the manufacturing sector.

In my previous post I suggested that Obama erred in allowing two Federal Reserve Board seats to lie empty for a year and a half.  A commenter named Ted finds a plausible explanation for this mistake:

I’m wondering if Larry Summers is telling Obama nothing can be done on the monetary front. I remember in a paper he wrote at least two decades ago where he argued against a long-run zero inflation target partially on the grounds that we needed to avoid a “zero interest rate trap.”

He appears to be pushing that view recently as well too:

May 2010:

“In settings where an economy’s level of output is constrained by demand where the Federal Reserve is unable to relax that constraint, fiscal policy will through the multiplier process have significant impacts on output and employment. … Moments like the present – when the economy faces a liquidity trap and when the Federal Reserve is constrained by a zero bound on interest rates, and when the financial system is functioning imperfectly because of credit problems in financial intermediaries and because of overleveraged borrowers – are moments when these conditions, for fiscal policy to have an expansionary impact, are especially likely to obtain.”

Or here July 2009:

“Economists in recent years have become skeptical about discretionary fiscal policy and have regarded monetary policy as a better tool for short-term stabilization. Our judgment, however, was that in a liquidity trap-type scenario of zero interest rates, a dysfunctional financial system, and expectations of protracted contraction, the results of monetary policy were highly uncertain whereas fiscal policy was likely to be potent.”

Assuming he’s as influential and overbearing as the press reports him as (as if I can trust that?), then he might have already convinced Obama there is nothing that the Fed can do and any argument to the contrary is silly because the effects of monetary policy may be, in Summers words, “uncertain” where as fiscal policy is “potent.”

I don’t think I even need to comment here.  Even Krugman, DeLong and Yglesias have called on the Fed to raise its inflation target. 

I once heard a (possibly apocryphal) story, which goes as follows:  Sometime around 1978 Jimmy Carter asked his economic advisors if there was any downside from the dollar’s recent depreciation in the foreign exchange market.  No one spoke up.  Can anyone confirm that story?

This is a comment made by Luis Arroyo:

Is not J Taylor a cheat?
See he use Zolti/$ data To prove that it has not depreciated in 2009. But REER and Zolti/euro data say clearly that it does depreciate.
see the true data in my blog.

No, John Taylor is not a cheat; I don’t doubt he is sincere in the views he expressed.  But unless I am mistaken, Luis is correct.  I wasn’t able to find the graph in Luis’s blog, but just looking at the graph in Taylor’s post, it seems obvious to me that the zloty must have depreciated substantially against the euro, which I presume is Poland’s most important trading partner.  I must say that I find Luis’ explanation to be far more plausible that Taylor’s.  Yes, it’s good that Poland had its house in order when the crisis hit.  But surely there were other Europeans countries that also had sound macro policies in 2008.   

PS.  If Luis or someone else can find the graph he refers to, I’ll provide a link.

Update:  Indy sent me this link.   The zloty clearly depreciated against the euro during the key period of late 2008 and early 2009.  (And this occurred despite the fact that the euro depreciated against the dollar in late 2008.)

Obama’s most costly error

It’s rather disgraceful that one must read the British press to find out about the most important thing going on right now in America.  Commenter JimP sent me this story from The Telegraph:

Ben Bernanke needs fresh monetary blitz as US recovery falters

Federal Reserve chairman Ben Bernanke is waging an epochal battle behind the scenes for control of US monetary policy, struggling to overcome resistance from regional Fed hawks for further possible stimulus to prevent a deflationary spiral.

Fed watchers say Mr Bernanke and his close allies at the Board in Washington are worried by signs that the US recovery is running out of steam. The ECRI leading indicator published by the Economic Cycle Research Institute has collapsed to a 45-week low of -5.7 in the most precipitous slide for half a century. Such a reading typically portends contraction within three months or so.

Key members of the five-man Board are quietly mulling a fresh burst of asset purchases, if necessary by pushing the Fed’s balance sheet from $2.4 trillion (£1.6 trillion) to uncharted levels of $5 trillion. But they are certain to face intense scepticism from regional hardliners. The dispute has echoes of the early 1930s when the Chicago Fed stymied rescue efforts.

“We’re heading towards a double-dip recession,” said Chris Whalen, a former Fed official and now head of Institutional Risk Analystics. “The party is over from fiscal support. These hard-money men are fighting the last war: they don’t recognise that money velocity has slowed and we are going into deflation. The only default option left is to crank up the printing presses again.”

Mr Bernanke is so worried about the chemistry of the Fed’s voting body – the Federal Open Market Committee (FOMC) – that he has persuaded vice-chairman Don Kohn to delay retirement until Janet Yellen has been confirmed by the Senate to take over his post. Mr Kohn has been a key architect of the Fed’s emergency policies. He was due to step down this week after 40 years at the institution, depriving Mr Bernanke of a formidable ally in policy circles.

Wow!  If this article is correct the implications are mind-boggling:

1.  As I have been speculating, the Fed suffers from the same sort of paralysis as it did in the Great Depression.

2.  This answers Tyler Cowen’s query about why the Fed isn’t doing what people like me suggest.  Tyler noted that Bernanke is a pretty smart guy.  Yes, he’s a much more knowledgeable economist than I am, so it’s good to know he is on my side.

3.  Commenter JimP has been hammering Obama on monetary policy almost since the beginning of this blog.  I suppose at times people might have thought JimP was a bit of a crackpot.  But guess what, Jim gets the last laugh.  Perhaps you didn’t notice a very telling fact presented in the article.  Look at the phrase “Key members of the five-man Board.”  That refers to the Board of Governors.  If you remember your money and banking classes you might think “doesn’t the Board have seven members?”  Usually it does, and it usually dominates the 12 man FOMC (which includes 5 regional bank presidents.)  But two seats were empty when Obama took office.  Did Obama rush to fill the seats so that monetary stimulus could provide support for fiscal stimulus?  No, he waited for over a year to even nominate anyone to the Board.  From this article, I infer that the recent nominees have not yet been confirmed by the Senate.  Ironically, the financial regulation bill agreed upon last night is far less important than getting those two nominees on the Board of Governors.  The buck stops at the President, but I also assume he has not been getting good advice from advisors like Summers and Romer.  Why else would he have waited so long if his economic advisers had been telling him how important it was to fill those seats?

4.  I’ve said this before, but I’ll reiterate.  Yes, the Greek crisis is the deep cause of the current slowdown (perhaps along with Chinese moves to slow investment.)  But the direct effects are tiny compared to the indirect effects.  The indirect effect was to increase the demand for dollars, thus putting deflationary pressure on the US.  The US could have offset that shock if only Bernanke had supplied more dollars.  Now we know why he didn’t.

5.  I’ve been very schizophrenic with my blog.  Half of the time I’ve blamed Bernanke for seeming to forget what he told the Japanese to do.  The other half I’ve speculated that he wants to do more, but he can’t drag the neanderthals on the FOMC along with him.  This article has the ring of truth (although I don’t doubt the info was fed to the Telegraph by doves wanting to look good.)  Unless someone can convincing refute this story, I’m going to assume it’s accurate and I will stop bashing Bernanke.   I’ll go back to my earlier position, expressed in posts such as “Let Bernanke be Bernanke.”    However, even if the article is correct, he is not entirely blameless in this crisis:

Mr Bernanke has fought off calls from FOMC hawks for moves to drain stimulus by selling some of the Fed’s $1.75 trillion of Treasuries, mortgage securities and agency bonds bought during the crisis. But there is little chance that he can secure their backing for further purchases at this point. “He just has to wait until everybody can see the economy is nearing the abyss,” said one Fed watcher.

Gabriel Stein, from Lombard Street Research, said the US is still stuck in a quagmire because Mr Bernanke has mismanaged the quantitative easing policy, purchasing the bonds from banks rather than from the non-bank private sector.

“This does nothing to expand the broad money supply. The trouble is that the Fed does not understand broad money and ascribes no importance to it,” he said. The result is a collapse of M3, which has contracted at an annual rate of 7.6pc over the last three months.

Mr Bernanke focuses instead on loan growth but this has failed to gain full traction in a cultural climate of debt repayment. The Fed is pushing on the proverbial string. The jury is out on whether or not his untested doctrine of “creditism” will work.

“We are now walking on deflationary quicksand,” said Albert Edwards from Societe Generale.

The article also tells us who the villains are:

Kansas Fed chief Thomas Hoenig dissented from Fed calls for ultra-low rates to stay for an “extended period”, arguing that loose money risks asset bubbles and fresh imbalances. He recently called for interest rates to be raised to 1pc by the autumn.

While he has been the loudest critic, he is not alone. Philadelphia chief Charles Plosser says the Fed has blurred the lines of monetary and fiscal policy by purchasing bonds, acting as a Treasury without a legal mandate. Together with Richmond chief Jeffrey Lacker they represent a powerful block of opinion in the media and Congress.

Just like in the Great Depression, the regional bank presidents are the biggest problem.  And just like in the Great Depression, the British press had a better understanding of the deflationary impact of US monetary policy than did the American press.  Funny how things never seem to change.

Read the entire article.

Part 2:  The Finreg bill

And speaking about how nothing ever seems to change, has there ever been a major crisis that led Congress to enact regulation that actually addressed the root problems that caused the crisis?  Obviously I haven’t read the bill, but the press summaries are certainly not promising. There was no mention of outlawing low down-payment mortgages made with federally-insured deposits, nor an mention of abolishing Fannie and Freddie.  Is there something in the bill that addresses these problems?

Part 3:  Fiscal policy in the Depression

A few commenters asked me about a recent paper, which claimed fiscal policy actually was effective during the 1930s, but wasn’t applied in anywhere near the needed amounts.  This is from a Brad DeLong post, which quotes from the paper: [F]iscal policy made little difference during the 1930s because it was not deployed on the requisite scale, not because it was ineffective…. [T]he first set of VAR exercises suggested that [multipliers] were 2.5 on impact and 1.2 after one year. Where significant fiscal stimulus was provided, output and employment responded accordingly.

Individual country experience with large fiscal stimulus was rare in this period, but where it occurred the evidence points in the same direction. One of the biggest fiscal stimuli in this sample occurred in Mussolini’s Italy during 1936-7, as a result of the war in Ethiopia. Italy ran a deficit in excess of 10 per cent of GDP in 1936 and 1937. Italian GDP grew by 6.8 per cent in 1937, by a marginal amount in 1938, and by 7.3% in 1939. According to Toniolo (1976), the Italian economy moved to full employment during this period. In France, the budget deficit increased substantially beginning in 1935, and GDP grew by 5.8 per cent in 1936. The deficit exploded in 1939, during which year the economy grew by no less than 7.2 per cent.

My views on fiscal policy are complicated.  First, I think it is less powerful than monetary policy.  Second, I think it is wasteful, as it incurs future tax obligations that hurt the supply-side of the economy.  But most importantly, I think the effect cannot be quantified because it depends on whether the central bank tries to accommodate or sterilize the fiscal stimulus.

In the two examples cited in DeLong post, France and Italy, monetary policy was extremely accommodative.  Both countries were on the gold standard until 1936, when they sharply devalued their currencies.  That’s not to say that fiscal policy has no effect, it might have forced the central banks to devalue.  My point is that fiscal stimulus must always be examined in the context of monetary policy.  If you have conservative central banks that are rigidly targeting the price level, then fiscal stimulus may be ineffective.  But in fairness to the other side, I’m sure you could build a plausible argument that under the sort of dysfunctional Fed described above, it might have a stimulative effect.  Perhaps Bernanke is not strong enough to take any unconventional policy initiatives, but is strong enough to prevent the conservatives from inhibiting fiscal stimulus through a premature exit strategy.  But as I said, I don’t think fiscal policy is very powerful even if there is no push-back from the Fed.

The more important point is that if Obama and the Congressional Democrats knew all this, there would have been a much greater sense of urgency about monetary policy, and especially the need to fill those seats.  They might also pressure the Fed (in Congressional hearings) to actually fulfill their dual mandate.

BTW, I don’t like dual mandates; I prefer NGDP targeting.  But right now a dual mandate approach (inflation and unemployment targets) would be better than the status quo.

Advice on NGDP futures

One of my commenters (John Salvatier) is thinking about using his own money to set up some NGDP contracts on Intrade.  He sent me an email with this information, and asked for suggestions:

Each contract would be based on the BEA final estimate of NGDP for the specified quarter and the quarter two quarters before (i.e. 6 months before). The formula for the contract payout would be
payout = ln(NGDPend/NGDPstart) * periodsInYear * 1000
if payout > 100: payout = 100
if payout < 0: payout = 0.

This specification has the nice property that payout/10 = continuously compounded annual growth rate of NGDP during that period (in %). However, the drawback of this specification is that 2008q4, 2009q1 and 2009q2 would all have had negative payouts so they would have paid out 0 instead, which means  you would have had trouble gauging expected the severity of the downturn.

An alternative specification is

payout = ln(NGDPend/NGDPstart) * periodsInYear * 500 + 50
if payout > 100: payout = 100
if payout < 0: payout = 0

This specification would have had positive payouts even during the most severe phase of the downturn, but it makes the contract prices more difficult to interpret and reduces the variation in contract payouts.

I would have contracts for the 6 month intervals between now and 2.5 years from now. When one contract expired, another one would be started for 2.5 years from now. I would consider using quarterly contracts instead of semi-annual contracts if people thought that was important.

I will be making markets in these contracts, ensuring a small spread. This will effectively subsidize informed traders by giving them the option to trade a little cost. I may do this manually at first, but I hope to be able to build an automated market maker to do this for me.

A few comments:

1.  I strongly favor NGDP futures markets, and thus am obviously happy to see one being set up.  But I fear that without government subsidies, there will be very low volume.  That’s why I favor having the Fed subsidize trading in an NGDP futures market (by paying higher than market rates on the margin accounts.)  Nevertheless, I greatly appreciate John’s willingness to put his money on the line.

2.  I am not an expert on futures markets, so John and I would appreciate any advice on how best to set up the contracts.  We’d like to make them customer friendly, but also able to provide point estimates of expected NGDP growth.  And I believe John’s proposal does that.   I believe there are currently some RGDP contracts that merely involve binary outcomes, such as whether growth will be higher or lower than 3%.

3.  If this is set up I am going to ask all my readers to please consider trading a few contracts.  The price of the contracts are pretty low (I believe $10), and since NGDP is somewhat predictable it’s unlikely you’d lose more than a few dollars on each contract.  Is that too high a price to pay to show solidarity with the entire Money Illusion project?   I will certainly buy some contracts.   If no one trades the contracts I might just go on strike and not post for a while.    🙂

I’ll keep you posted.