Here is Tyler Cowen on the current debate over fiscal stimulus:

5. Macroeconomics really is just a theory.  Politicians are reluctant to spend more money, in tough times, on the basis of a mere theory.  Advocates of fiscal stimulus make it sound as simple as solving an undergraduate homework problem and I think they sometimes genuinely do not realize how much the rest of the world, including politicians, views them as simply being very convinced by their own theory.  There are plenty of historical examples with confounding factors and I’ve linked to some of them lately.  One default hypothesis is that the ranges of fiscal policy being discussed, whether looser or tighter, aren’t going to matter much one way or the other.

That’s my view as well.  Of course I suppose one could say that my monetary ideas are also “just a theory.”  But there is no significant budget cost if I am wrong.  (If I am right then the Fed may see the market value of its assets fall a bit, but the Treasury will gain by even more.)

Unfortunately, many conservatives are opposed to greater monetary ease.  Fortunately, some of them are now paying a price for their irrational fear of inflation, when disinflation is the real problem.  This is from the WSJ (via a recent post by Niklas Blanchard):

Putting his money where his mouth is? Eric Cantor, the Republican Whip in the House of Representatives, bought up to $15,000 in shares of ProShares Trust Ultrashort 20+ Year Treasury ETF last December, according to his 2009 financial disclosure statement. The exchange-traded fund takes a short position in long-dated government bonds. In effect, it is a bet against U.S. government bonds””and perhaps on inflation in the future.

Here’s Matt Yglesias’s take:

Given his investment positions, Cantor should be joining me in calling for more short-term fiscal stimulus and urging the Federal Reserve to act more aggressively to raise the price level. But either Cantor doesn’t understand his economic self-interest properly, or else he’s more committed to his principled opposition to sound macroeconomic stabilization than he is to the performance of his portfolio. One doesn’t normally urge members of congress to be more greedy and venal, but in this case it might do a lot of good.

Please, no more greed, more enlightenment.  Here are three forms of government:

The Good:  Enlightened and civic-minded

The Bad:  Unenlightened and civic-minded

The Ugly:  Greedy

We’ve got enough problems without encouraging Cantor to move from unenlightened to greedy.  (Yes, I know that Yglesias was kidding.)

The reason this Cantor story is such good news is that if conservatives and libertarians keep losing money this way, perhaps they will re-evaluate their views of cause and effect.  Maybe they’ll start taking markets more seriously, instead of believing they are smarter than the markets.  Or maybe not.

Better yet, let’s turn monetary policy over to the (NGDP futures) markets.  Let them determine who’s model is right.

It serves me right for not doing my homework.  I checked some data and it’s not clear that Sweden’s recession was milder than Britain’s.  Sweden saw RGDP fall more sharply, and recovered more strongly.  On balance they probably have done a bit better, but not much.  More importantly, I should never make assumptions based on a few numbers pulled out of the air.  I recall reading that Britain has high CPI inflation, and the pound is sharply lower.  I assumed that meant Britain had followed an easy money policy in the recession.  Nothing could be further from the truth.  Here are some British real and nominal GDP changes during the downturn:

2008:2 to 2009:2   NGDP fell 5.1% and RGDP fell 5.9%.

That’s a much tighter monetary policy than in the US, and only 0.8% inflation.  And the most recent year isn’t anything to write home about either:

2009:1 to 2010:1   NGDP rose 1.46% while RGDP fell 0.34%.

That means inflation bumped up to 1.8%, but NGDP is still far below the 2008 peak.  Again, monetary policy in Britain seems much tighter than the US.

Memo to myself:  Never again trust CPI data.

The next question is; “How can money in Britain be so tight with the pound depreciating so sharply?”  As I indicated in the previous post, there are probably real weaknesses in the British economy.  The post elicited a lot of great comments, some of which supported my view that Britain is more of a service/banking economy, whereas Sweden exports lots of manufactured goods.  Sweden may be recovering faster for the same reason Germany has done pretty well.  But note that even Sweden isn’t doing all that well in absolute terms. The commenter named tatonnement had some excellent data on Britain’s trade problems.

The commenter Marcus found data showing the Canadian government spending 40% of GDP and the UK government spending 52%.  I presume both numbers are inflated by the recession.  Nevertheless, Britain looks like a country where both the public and private sector spend too much and save too little.  That means they first need monetary expansion to get out of the recession, and then fiscal retrenchment to shrink government (as Canada did in the 1990s.)  And more Singapore-style incentives to save.

The commenter Jon linked to a paper which argued that expectations of higher taxes in Britain would lower AD.  In my view the dominant effect would be to lower AS, not AD.  But in either case output falls.

Statsguy points to the need for Britain to devalue, and also mentions that British manufacturing workers have much higher unit labor costs than Swedish workers.  I agree. Econoclast mentioned that the Labour government felt that they needed to spread around the wealth created in the City, so that London didn’t end up looking like Hong Kong.  Is there a ‘golden goose’ analogy that comes in here?  After living in Britain for 5 months in 1986, my impression is that there is a large skill (and attitude) gap between the lower and upper classes (relative to a country like Sweden.)  I don’t see why the British lower classes deserve part of the wealth created by the City, merely because their homes are located closer to the City than those of Swedish workers.  Perhaps I am again drawing mistaken inferences based on a tiny bit of data and some personal observation.  If so, please set me straight.

Both Brad DeLong and Matt Yglesias are critical of this FT piece discussing Swedish and British stabilization policy:

Because Sweden has been living within its means it is one of the member states that has weathered the crisis best. In Britain, on the other hand, the new coalition government has inherited the largest budget deficit of any EU country.

They both point to the fact that Sweden has depreciated the kronor.  Let me say right up front that I don’t have any easy answers to the issues raised here.  But I do think they slightly oversimplify what’s going on.  First let me indicate where I agree:

1.  Both Britain and Sweden should avoid policies that contract aggregate demand.

2.  Part of Sweden’s relative success may be due to the fact that the kronor has depreciated against most currencies.

But here’s what DeLong and Yglesias seem to overlook.  The kronor has not depreciated against the British pound; this link shows the pound has depreciated slightly against the kronor (with some month to month variation.)  In other words, the British pound has depreciated against the dollar and euro even more sharply than the kronor has depreciated against the dollar and euro.  So it doesn’t really solve the mystery of why Sweden has done better than Britain, with far less fiscal stimulus, to simply point to the fact that the kronor has depreciated.

My hunch is that fiscal stimulus probably has less effect than its proponents believe.  But I would also admit that in the case of Britain my preferred solution ( monetary stimulus) also doesn’t seem to have been all that effective.  I haven’t had time to study the British situation, but my hunch is that the sort of real factors that Arnold Kling and Tyler Cowen discuss are relatively more important in Britain, as its economy is heavily dependent on the banks in the City of London.  But that’s just a guess based on the relatively high inflation rate in Britain.  In contrast, Sweden may do some of the same sort of machinery exporting to the developing countries that Germany does.  Or there may be other structural issues in Britain having to do with labor markets, VATs, etc, that I am unaware of.

If anyone has any useful information on the British situation, I’d appreciate hearing about it.  (I know one commenter did mention some data earlier, but I’m afraid I lose track of these things.)  I’d be interested in data on British NGDP, wage rates, inflation, and possible distortions in the inflation data.  I know that the UK government has grown dramatically as a share of GDP over the past 10 years, much more than can be explained by the recession.  It would also be interesting to compare the size of the UK government with the government in a country like Canada.  Why is the UK government so much larger, without apparently producing any better public services?  And thoughts?

PS.  I’m not saying that what DeLong and Yglesias wrote is incorrect, I just don’t think their comments resolve the issues raised by the quotation.  And DeLong’s Keynes quotation is a great one.

In the 1930s the right had to choose between a modest amount of inflation (returning prices to the pre-Depression levels) or more socialism.  They weren’t thrilled with big government, but their strongest opposition was reserved toward policies of inflation.  So we ended up with deflationary policies between 1929 and 1933.  Of course the voters wouldn’t accept 25% unemployment, so we got big government instead of the inflation.

As this video shows, we are essentially facing the same choice today.  We could pump up the economy through monetary policy, or we can have Fannie and Freddie continue to throw $100s of billions down the drain, socialize the auto industry, extend unemployment benefits to 99 weeks, etc.  And if that isn’t enough there are also calls to move away from free trade policies.  And then there’s the higher taxes we’ll pay in the future to cover the costs of debts run up in a futile attempt to stimulate the economy.

Just as in the 1930s, the right seems to have decided that a little bit of socialism is better than a little bit of inflation.  What do I mean by a little bit of inflation?  I mean enough so that the post-September 2008 trend rate of inflation is the same as the pre-September 2008 trend rate of inflation.  Apparently even that little bit of inflation is more distasteful than massive government intervention in the economy.

And the irony is that many of the policies I describe, such are Fannie and Freddie propping up the housing market, unemployment insurance extensions, and trade barriers, are themselves slightly inflationary.  But they don’t just raise the price level, they also cause all sorts of distortions—they move prices away from their free market equilibrium.   (I’m looking at you Morgan.)

The even greater irony is that this isn’t even one of those pick your poison cases.  The inflation I am calling for would be nothing more than a continuation of the inflation that occurred in the previous two decades.  We’d want it even if we hadn’t had a housing crisis and recession.  I don’t recall conservatives complaining loudly that 2% inflation was a disaster when Clinton was president.  So why the sudden and hysterical opposition to 2% inflation?  Is that really a fate worse than socialism?

The still greater irony is that the more the conservatives win today, the more inflation we’ll get in the long run.  The conservatives got their way in the early 1930s, but it so discredited their ideology that it opened the door to much higher inflation over the next 40 years.

Part 2.  A few more “whiffs” of racism directed against Fannie and Freddie.

As you know, some fearless bloggers have exposed the “whiff” of racism in attempts by conservative economists like Raghu Rajan to blame the government for the mortgage fiasco.  Here for example, is Edmund Andrews:

Of all the canards that have been offered about the financial crisis, few are more repellant than the claim that the “real cause” of the mortgage meltdown was blacks and Hispanics.

Oh, excuse me — did I just accuse someone of racism?   Sorry.  Proponents of the above actually blame the crisis on “government policy” to boost home-ownership among low-income families, who just happened to be disproportionately non-white and immigrant.  Specifically, the Community Reinvestment Act “forced” banks to make bad loans to irresponsible borrowers,  while Fannie Mae and Freddie Mac provided the financial torque by purchasing billions worth of subprime paper.

The argument has been discredited time and again, shriveling up almost as soon as it’s exposed to sunlight.  But it keeps coming back, mainly because the anti-government narrative gives Republicans a way to deflect allegations that de-regulation allowed Wall Street to run wild.   It’s the financial version of Sarah Palin’s new line that “extreme environmentalists”  caused the BP oil spill.

Paul Krugman caught a whiff of it in a recent commentary by Raghuram Rajan in the FT, and quickly denounced it.

Now Bloomberg.com seems to be making those sorts of racist accusations:

June 14 (Bloomberg) — The cost of fixing Fannie Mae and Freddie Mac, the mortgage companies that last year bought or guaranteed three-quarters of all U.S. home loans, will be at least $160 billion and could grow to as much as $1 trillion after the biggest bailout in American history.

.   .   .

The companies’ liabilities stem in large part from loans and mortgage-backed securities issued between 2005 and 2007. Directed by Congress to encourage lending to minorities and low- income borrowers at the same time private companies were gaining market share by pushing into subprime loans, Fannie and Freddie lowered their standards to take on high-risk mortgages.

Many of those went to borrowers with poor credit or little equity in their homes, according to company filings. By early 2008, more than $500 billion of loans guaranteed or held by Fannie and Freddie, about 10 percent of the total, were in subprime mortgages, according to Fed reports.

It seems even the Fed is peddling those vicious racist lies.

Even worse, they assert that Fannie and Freddie’s heavy involvement in sub-prime lending continued even during the height of the housing bubble:

The composition of the $5.5 trillion of loans guaranteed by Fannie and Freddie suggests that the surge in delinquencies may continue. About $1.98 trillion of the loans were made in states with the nation’s highest foreclosure rates — California, Florida, Nevada and Arizona — and $1.13 trillion were issued in 2006 and 2007, when real estate values peaked. Mortgages on which borrowers owe more than 90 percent of a property’s value total $402 billion.

That doesn’t seem to mesh with what I’ve been reading in Krugman’s blog:

He [Schwarzenegger] asserted, as a simple matter of fact, that “government created the housing bubble”, because Fannie and Freddie made all these loans to people who couldn’t afford to pay them.

This is utterly false. Fannie/Freddie did some bad things, and did, it turns out, get to some extent into subprime. But thanks to the accounting scandals, they were actually withdrawing from the market during the height of the housing bubble “” the vast majority of the loans now going bad came from the private sector.

Yet it’s now clear that the phony account of the crisis “” that it’s all due to Fannie, Freddie, and nasty liberals forcing poor Angelo Mozilo to make loans to Those People “” is setting in as Republican orthodoxy

If you are wondering what the phrase “it turns out” refers to, perhaps it is this earlier post by Krugman:

But here’s the thing: Fannie and Freddie had nothing to do with the explosion of high-risk lending a few years ago, an explosion that dwarfed the S.& L. fiasco. In fact, Fannie and Freddie, after growing rapidly in the 1990s, largely faded from the scene during the height of the housing bubble.

Partly that’s because regulators, responding to accounting scandals at the companies, placed temporary restraints on both Fannie and Freddie that curtailed their lending just as housing prices were really taking off. Also, they didn’t do any subprime lending, because they can’t: the definition of a subprime loan is precisely a loan that doesn’t meet the requirement, imposed by law, that Fannie and Freddie buy only mortgages issued to borrowers who made substantial down payments and carefully documented their income.

So whatever bad incentives the implicit federal guarantee creates have been offset by the fact that Fannie and Freddie were and are tightly regulated with regard to the risks they can take. You could say that the Fannie-Freddie experience shows that regulation works.

Just to get serious for a moment; when I get upset at “Those People,” I am thinking about the Congressmen who created Fannie, Freddie and the CRA.  And yes, I know that the CRA was only a minor factor in the crisis, but everyday it becomes clearer that Washington’s attempts to enlist Fannie and Freddie into their crusade to make every American a homeowner lies at the center of this crisis.  Indeed the misdeeds of the “too-big-to-fail” banks (and their associated bailout with TARP funds), now comes in a distance third (or fourth if you include the Fed), far less costly to taxpayers than even the misbehavior of smaller banks that exploited the incompetence of the FDIC.

The experts say we can’t eliminate F&F right now, and I suppose they are right.  But only because we don”t have a monetary policy that stabilizes NGDP growth expectations.

Paul Krugman has recently had a lot of good posts on monetary policy, and also on the messages that are being sent from the bond market (if only we’d pay attention.)  Even where I disagree with him (as on fiscal stimulus) I concede that he has much better arguments than his opponents.  In this post he criticizes University of Chicago economist Raghu Rajan for advocating higher interest rates:

Rajan’s argument boils down to two assertions:

1. Raising rates a bit wouldn’t significantly deter investment.

2. “Unnaturally low” interest rates are distorting asset prices.

The first thing to say about these two assertions is that they are essentially contradictory. If the difference between current rates and the rates Rajan wants is trivial “” just a wafer thin mint “” how can that same difference be leading to a major distortion in financial markets? Are we to believe that an interest rate change that matters not at all to firms making real investments somehow has huge effects on speculators? And actually, don’t asset prices themselves matter for real investment?

It might be worth noting, in this context, that just because the interest rate on safe bonds is near zero, that doesn’t mean that people making risky investments can borrow at near-zero rates.

Beyond all that, what does Rajan mean by “unnaturally low” rates? What makes them unnatural?

My take on the current economic situation is quite simple, and I would have thought corresponds to standard economics. Right now, we clearly don’t have enough demand to make full use of the economy’s productive capacity. This means that the real interest rate is too high. And so the “natural” thing is for the real rate to fall. Yes, that would mean a negative real rate. So?

And then here he (and Brad DeLong and Richard Serlin) point out that recent conservative arguments echo arguments that conservatives were making in the 1930s:

The attitude on display from quite a few economists bears a distinct resemblance to Depression-era liquidationism, as described in Brad DeLong’s excellent but somehow never published book on the economic history of the 20th century:

I have been making similar arguments in this blog.  Krugman’s observation reminded me of Milton Friedman and Anna Schwartz’s Monetary History of the US.  Friedman and Schwartz fought a battle on two fronts; against liberals who said monetary policy was ineffective in a depression, and against right-wingers who said it was effective in boosting nominal demand, but that this would be an undesirable outcome.  The conservatives saw the Depression as a sort of hangover—painful but necessary.  Friedman and Schwartz were particularly critical of the Austrian view that the roots of the Depression lay in easy money policies during the 1920s (policies that they correctly noted weren’t particularly easy.)

Unfortunately, Milton Friedman died in 2006 and Anna Schwartz has recently gone over to the dark side (as I showed in this post.)  If Friedman were alive, I am pretty sure that he would disagree with Rajan’s view that low interest rates lead to high asset prices.   Here is Friedman in 1998:

Low interest rates are generally a sign that money has been tight, as in Japan; high interest rates, that money has been easy.

.   .   .

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.

No kidding!   Without Friedman, there doesn’t seem to be anyone left to make the argument that low interest rates are actually a sign of tight money.  

Although Friedman is best known for his advocacy of targeting the money supply, he was even more strongly attached to the idea of market efficiency.  In the 1990s he endorsed Robert Hetzel’s proposal to have the Fed target inflation expectations in the TIPS market.  Now if only we could find an economist who is willing to carry on the tradition of Milton Friedman.  Low interest rates are a sign of tight money, and we need to target inflation forecasts, not interest rates.  Who will resurrect the old Chicago School?

PS.  I hope Brad DeLong gets that book published.  I know how it feels to have a book weighing down on one’s shoulders for 15 years.