Archive for October 2010


Newly fashionable ideas

In the previous post I criticized this FT piece by Joseph Stiglitz.  But I left out his most intriguing comment:

In certain circles, it has become fashionable to argue that monetary policy is a superior instrument to fiscal policy – more predictable, faster, without the adverse long-term consequences brought on by greater indebtedness. Indeed, some advocates wax so enthusiastic that they support recent drives for austerity in many European countries, arguing that if there are untoward effects they can be undone by monetary policy.

I don’t recall these ideas as being particularly fashionable in early 2009, when I argued that both sides of the fiscal stimulus debate were missing the point.  I’m glad to see they have become so fashionable that the British government is now cutting spending and relying on easier money to offset the negative effects.

I thought it might be interesting to create a list of newly fashionable ideas:

1.  Using monetary stimulus instead of fiscal stimulus (recently adopted in Great Britain)

2.  Cutting the IOR as an expansionary policy tool (an option discussed recently by Bernanke.)

3.  Negative IOR (recently advocated by Alan Blinder and adopted by the Swedish Riksbank.)

4.  QE (likely to be adopted by the Fed.)

5.  Level targeting (being widely discussed at the Fed.)

6.  NGDP level targeting (recently mentioned as an option in the minutes of a Fed meeting.)

7.  Monetary policy might currently be restrictive despite low rates and a large monetary base (recently suggested by Chicago Fed President Charles Evans.)

Of course some of these ideas (such as QE) are hardly novel.  And others (such as level targeting) are well known in academia.  But I think it’s fair to say that we quasi-monetarists were ahead of the curve in most of these areas.

In a complex field like economics all arguments are tentative—subject to further revision.  Objective proofs are almost impossible.  What matters is whether an economist is able to change the conversation, to shift the perspective of others.  I think we quasi-monetarists (including both bloggers and commenters) have had real success in that regard.  We shouldn’t be discouraged by Stiglitz’s criticism; it shows how far we’ve come.

Joseph Stiglitz and the Tea Party

Randall sent me a perplexing Financial Times piece by Joe Stiglitz.  He begins by comparing the proponents of monetary stimulus to the monetarists of the 1980s:

A quarter-century ago proponents of monetary policy argued, with equal fervour, in favour of monetarism: the most reliable intervention in the economy was to maintain a steady rate of growth in the money supply.

In fact, a better comparison would be with the Keynesians of the 1980s, or the Keynesians of today.  It is Keynesians that favor monetary stimulus in recessions, monetarists advocate stable money growth.  Stiglitz knows this, which makes me wonder why he is warning his fellow progressives that monetary stimulus is a dangerous monetarist idea.

This was followed by the discredited pushing on a string idea:

Traditionally, monetary authorities focus policy around setting the short-term government interest rate. But, leaving aside the fact that with interest rates near zero there is little room for manoeuvre, the impact on the real economy of changes in the interest rate remains highly uncertain. The fundamental reason should be obvious: what matters for most companies (or consumers) is not the nominal interest rate but the availability of funds and the terms that borrowers have to pay. Those variables are not determined by the central bank. The US Federal Reserve may make funds available to banks at close to zero interest rates, but if the banks make those funds available to small and medium-sized enterprises at all, it is at a much higher rate.

Then there is this:

It should be obvious that monetary policy has not worked to get the economy out of its current doldrums. The best that can be said is that it prevented matters from getting worse. So monetary authorities have turned to quantitative easing. Even most advocates of monetary policy agree the impact of this is uncertain. What they seldom note, though, are the potential long-term costs. The Fed has bought more than a trillion dollars of mortgages and long-term bonds, the value of which will fall when the economy recovers – precisely the reason why no one in the private sector is interested. The government may pretend that it has not experienced a capital loss because, unlike banks, it does not have to use mark-to-market accounting. But no one should be fooled.

So the Fed might suffer some modest capital losses if QE works, and promotes a faster than expected recovery.  Wouldn’t that be a tragedy!  And he ignores tax revenue gains to the Treasury from a fast recovery.  And what makes Stiglitz think he can predict the future movements of bond prices better than the market?  Is he telling me I’ll get rich if I short T-bonds right after QE2?  Should I believe him?

But all this is nit-picking.  Here’s what really bothers me about Stiglitz’s article.  It’s not that he favors a different monetary policy than I do; it’s that he seems to oppose the Fed having any monetary policy at all.  (Hence the connection with those “abolish the Fed” elements within the Tea Party.)  I defy anyone to read the article and find any monetary policy being advocated.  Indeed I don’t see any evidence that Stiglitz even knows what monetary policy is.

There is no discussion of any nominal target, whether prices, the Taylor Rule, or NGDP.  He seems to think of policy in terms of interest rate changes, but interest rate targets are not Fed policy, they are a tool to implement Fed policy.  If you use interest rates as THE policy, the price level becomes undefined–it shoots off to zero or infinity.  For instance, he indicated interest rates were too low back in 2002-03.  That suggests to me he thinks money was too easy.  Maybe so.  But inflation was below the Fed target at that time.  This suggests that if money had been tighter, inflation might have slowed even more, and a dangerous deflationary spiral could have developed.  That’s why most economists support something like the Taylor Rule, or inflation targeting. Interest rates aren’t enough.

Here ‘s how modern macro works.  Economists assume the Fed has some policy goal or goals.  They choose a nominal target to help implement those goals.  Then they set their various monetary policy tools (such as fed funds rate, IOR, QE, etc) at a level most likely to achieve that nominal target.

But Stiglitz seems oblivious to all this.  He doesn’t advocate a different monetary policy; he suggests we shouldn’t be relying on monetary policy at all.  But the Fed can never be “doing nothing.”  Any policy is an affirmative decision.  The Fed can set policy at a level expected to succeed, or it can set policy at a level expected to fail.

I anticipate some people will argue that Stiglitz does favor more AD, he just wants to “use” fiscal stimulus.  Fair enough.  But once fiscal stimulus is done, what is the Fed supposed to do with monetary policy?  And this is hardly an academic question, in all of American history fiscal policy has never been more “done.”  Even this Congress can’t pass more fiscal stimulus—just imagine the next one.  So it comes down to a basic decision about monetary policy; what is to be done?  And Stiglitz dodges the question, or perhaps implies he’s happy with a monetary policy that is likely to leave unemployment in the 9% to 10% range for several years.  I can’t quite tell.

I have no objection to people criticizing the Fed; I do it all the time.  But then suggest an alternative policy.  What is your nominal target?  How do you think the Fed should try to improve the macro economy?  My problem with Stiglitz is not that I disagree with his answer; it is that I suspect he doesn’t understand there is a question that needs to be answered.

The end of Bretton Woods II?

The following is related to my most recent essay at The Economist.

I suppose it’s presumptuous for me to pontificate on Bretton Woods II, given I found out the meaning of the term only a few weeks ago.  But heh, that’s never stopped me before.  Here’s Wikipedia:

Bretton Woods II was an informal designation for the system of currency relations which developed during the 2000s. As described by political economist Daniel Drezner, “Under this system, the U.S. is running massive current account deficits to be the source of export-led growth for other countries. To fund this deficit, central banks, particularly those on the Pacific Rim, are buying up dollars and dollar-denominated assets.”

Well at least I was aware of the phenomenon.

There’s been a lot of recent discussion of whether Bretton Woods II is about to fall apart, with this post by Tim Duy being perhaps the most authoritative:

The inability of global leaders to address global current account imbalances now truly threatens global financial stability.  Perhaps this was inevitable – the dollar has not depreciated to a degree commensurate with the financial crisis.  Moreover, as the global economy stabilized the old imbalances made a comeback, sucking stimulus from the US economy and leaving US labor markets crippled.  The latter prompts the US Federal Reserve to initiate a policy stance that will undoubtedly resonate throughout the  globe.  As a result we could now be standing witness to the final end of Bretton Woods 2.  And a bloody end it may be.

I don’t know whether Bretton Woods II is about to collapse or not.  But I am skeptical of much of the discussion of global imbalances, which in my view focuses far too much on currency/trade questions, and far too little on savings/investment imbalances.  Before considering Duy’s views, I’d first like to address an argument recently made by Michael Pettis:

For that reason I am always puzzled by people who say that devaluing the dollar will have no impact on the US trade deficit because the problem is low savings relative to investment.  No, that is not the problem.  That is simply one of the definitions of a current account deficit.  But if the dollar devalues, and consumer prices rise, US consumption is likely to decline.  In addition, to the extent that any of the stuff Americans used to import before the devaluation is now produced domestically (not all, but any), then US production must rise.  Since savings is equal to production minus consumption, the US savings rate must automatically rise.

As you may know, I’ve never liked arguments that “reason from a price change”:

1.  Next year the price of oil will be higher, therefore we can expect consumers to . . .

2.  Interest rates will fall therefore we can expect investment to . . .

3.  The dollar will fall therefore we can expect exports to . . .

This is often a misuse of basic supply and demand theory.  There is no necessary correlation between a price change and a quantity change; it entirely depends on why the price changed.  Was it more supply, or more demand?  Now that doesn’t mean Pettis is wrong here, he probably assumed a particular cause of the price change in the back of his mind.  But we need to start with that fundamental cause.

Often when people talk about the need for the US to devalue the dollar, they imagine it occurring through an expansionary monetary policy.  But monetary policy doesn’t have real effects in the long run, so it can’t solve secular problems.  There is no particular reason to expect that having the Fed devalue the dollar would “improve” the US trade balance:

1.  In the long run money is neutral; hence the real exchange rate is unaffected.

2.  In the short run the trade balance might get worse due to the J-curve effect.

3.  If monetary stimulus has a business cycle effect, then the trade balance might get worse if the stimulus creates a boom in the US.

So while Pettis might be right, I don’t have much confidence that the sort of dollar depreciation people are currently discussing would materially affect the US trade balance.  The most “beggar-thy-neighbor” policy in American history was probably the massive devaluation of 1933, and the trade deficit initially got worse.

Of course it may be the case that a country adjusts its currency value by altering the savings/investment equation.  For instance, many people are calling on China to revalue it’s yuan by purchasing fewer foreign bonds.  That doesn’t necessarily reduce Chinese saving (it depends what else the Chinese government does) but there are certainly scenarios where it might.

On the other hand I don’t have much confidence that a laissez-faire attitude in China would materially affect the US trade balance in the long run.  Remember that if China removed all currency controls, it would also be much easier for Chinese citizens to invest overseas.  I think we need to see China in a broader East Asian context.  One reason I could foresee Bretton Woods II being around for a long time is that East Asia is very different from the West, and those differences will become much more important over time, as East Asian wealth skyrockets.  (The term “skyrocket” is not hyperbole, Chinese wealth is set to rise dramatically.)  All of East Asia seems to be moving toward ultra-low birth rates and economies that are structured to produce high saving rates.  I don’t know if Singapore intervenes to weaken their currency, but given the extraordinary high savings rates there you’d expect a big CA surplus even if the government wasn’t accumulating foreign reserves.  The exact same thing occurs if the Singapore public buys the assets, and puts them in retirement accounts.

Over the next few decades China will get much richer.  As it does so, I’d expect its economy to resemble other East Asian countries more than the US.  And that will be true even if their government ends its weak yuan policy.  To take just one trivial example, I’d expect far more Chinese citizens to be speculating in property in LA, Vancouver and Sydney, than Westerners buying vacation homes in Shanghai or Hainan.

The East Asian economy is set to become extremely large in 20 or 30 years.  Given the enormous structural differences from our economy, I think it quite likely that the imbalances will become even larger in absolute terms.  When I lived in Australia in 1991, many Aussies were worried that their huge CA deficits were unsustainable, and also the cause of their recession.  They haven’t had a recession since, and they have continued to run very large deficits.  I see no reason why this “unsustainable” trend cannot continue for many more decades.

This is not to suggest that I disagree with Pettis’ policy recommendations, indeed I think his views on restructuring the Chinese economy make a lot of sense.  He also seems to share my view that while moderate yuan appreciation would be desirable, a sudden and sharp appreciation might be counterproductive:

This is why I worry that we are putting too much pressure on the renminbi.  There are many ways for China to rebalance, and they all involve the same process of transferring income from producers to households.  Raising the value of the renminbi, for example, increases the real value of household income in China by reducing the cost of imports.

It balances this by lowering the profitability of exporters.  The net result is that if it is done carefully, the household income share of China’s GDP rises when the renminbi is revalued, and with it consumption rises too.  Since China must export the difference between what it produces and what it consumes or invests, raising the value of the currency also reduces China’s trade surplus.

But what would happen if China were to raise the currency too quickly?  In that case the profitability of the export sector would decline so quickly that exporters would be forced either into bankruptcy or into moving their facilities abroad to lower-wage countries.  Either way, they would have to fire local workers.

Tim Duy also seems skeptical of those who put all the focus on Chinese surpluses:

But I don’t want to make this piece about China.  It is more than China at this point.  It became more than China the instant US Federal Reserve policymakers woke up one morning and decided they needed to take the dual mandate seriously.  And seriously means quantitative easing.  Brad DeLong suggests that when the Fed actually acts on November 3, it will be too little too late.  But if it is too little, more will be forthcoming.

Put simply, the Federal Reserve is positioned to declare war on Bretton Woods 2.  November 3, 2010.  Mark it on your calendars.

So perhaps Bretton Woods does not end because foreign governments are unwilling to bear ever increasing levels of currency and interest rate risk or due to the collapse of private intermediaries in the US, but because it has delivered the threat of deflation to the US, and that provokes a substantial response from the Federal Reserve.  A side effect of the next round of quantitative easing is an attack on the strong dollar policy.

Even if we could boost US demand by bashing China (and I doubt we could) there is a much better way; boost NGDP with a more expansionary monetary policy.  Where I differ with Duy is that I don’t think it will permanently end Bretton Woods II.  Yes, there may be some short term reduction in imbalances, but once the US recovers I have trouble seeing why we would not revert to running large deficits.  In my view there are only two permanent ways to address the US CA deficit; raise the US saving rate through fiscal reforms, or depress investment by adopting demand and supply-side policies that impoverish the country.  I think you know which approach I prefer.

BTW, David Beckworth posted on this earlier, and he shares my skepticism about the end of BWII.  Bill Woolsey also has a good post on exchange rates.

HT:  Marcus Nunes

Krugman’s double standard

Paul Krugman has gotten a lot of flack from people who noticed that he seems to have a double standard.  He argues that the US should threaten China with trade sanctions, in order to force them to revalue the yuan.  In earlier posts he acknowledged that a strong yuan would not be a problem under normal circumstances, as the US could simply offset the negative impact on AD with an easier money policy.  (Note to commenters; this argument is unrelated to the fact that the yuan is pegged to the dollar.)

Krugman also argues that the US and Europe are stuck in liquidity traps, and hence monetary policy cannot be used to offset the effects of the undervalued yuan.  But when Europeans complained that monetary stimulus in the US was weakening the dollar and hurting their export industries, he made this sarcastic comment:

In other words, how dare you act to protect your economy from deflation and double-digit unemployment? By doing so, you make our inappropriate tight-money policy even more destructive!

I thought his retort was great, and said so.  But I think you can see the problem.  Suddenly the concerns of the country with the strong currency are brushed aside; they should just adopt their own monetary stimulus.  What happened to the idea that monetary stimulus doesn’t have any effect at the zero bound?  And if the Europeans can do that in response to the weak dollar, why can’t we do that in response to the weak yuan?

In a new post Krugman acknowledges the critics, but fails to dig himself out of the hole he’s in.  To his credit, he doesn’t mention the yuan peg, which is a phony issue raised by some of my commenters.  That’s not the problem in Krugman’s view– the problem is that the Fed can’t raise AD because we are at the zero bound.  So how does he defend himself?  He changes the subject, arguing that we have much more reason to complain about the weak yuan than the Europeans have to complain about the weak dollar:

In various comments and other places I keep seeing people compare European complaints about the weak dollar to American complaints about the undervalued renminbi. It’s a false equivalence, which should be obvious if you think about the basics of the situation.

What the United States is doing is an expansionary monetary policy in the face of a depressed economy and threats of deflation; what else do you expect us to do? Now, one effect of that policy, if it isn’t matched abroad, is a weaker dollar “” but that’s not the goal of the policy.

But even if he is right (and I’ve argued he’s wrong for all sorts of reasons), this argument does not rebut the charge that he changes the argument when the US is the country in the hot seat.  We critics do understand that one might be able to make a stronger argument for a weak dollar than for a weak yuan.  What we complain about is that he assumes the ECB can do nothing to boost AD when the issue is China, but when there are complaints against the US depreciating the dollar the liquidity trap seems to vanish into thin air.  That’s the double standard.  Krugman’s smart enough to know he has a weakness there, and so he also makes this argument:

What about the argument that America can offset any effects from China’s policies through looser money? Well, I don’t really get why some commentators can’t grasp the distinction between the proposition “quantitative easing is worth trying, and would probably help” and the proposition “quantitative easing will allow the Fed to do whatever is needed, never mind the zero lower bound.” I subscribe to the first, not the second.

This is a game he’s been playing from the beginning.  When it suits his purpose to claim monetary policy can do nothing (i.e. calling for fiscal stimulus or bashing the Chinese) he does so.  When it suits his purpose to claim that monetary policy still has unused ammunition (as when he’s bashing the Fed, or bashing the ECB) suddenly monetary policy can do much more.  His only way out is to confuse the issue—maybe it’s a 50/50 proposition.  Maybe monetary stimulus will work, maybe it won’t.  But notice how when he attacks China it’s all about the 50% chance it won’t work, and when he attacks the ECB it’s all about the 50% chance it will work.

Of course the truth is it will work.  Indeed the entire discussion of how the Fed is depreciating the dollar makes no sense if we were really in a liquidity trap.  That’s because when you are in a liquidity trap monetary stimulus has no effect on the exchange rate.  So let’s get serious here–we all know that the Fed can offset China’s impact on NGDP if they want to.  Indeed they can raise NGDP at Zimbabwean rates if they really set their minds to it.  Krugman’s right that they are too conservative to do that–but that just means we have  no one but ourselves to blame for our unemployment.  The Chinese have every right to scold our Fed just as Krugman scolded the ECB.  (Ironically, the Chinese are doing the opposite!)

Earlier Krugman and I had a debate about whether the Bank of Japan had tried and failed to inflate, or had never really tried at all.  He takes the former view, which required him to make the deeply implausible argument that even a fiat money central bank might get stuck in a liquidity trap.  I pointed out that the BOJ had repeatedly tightened policy at any sign of even a tiny increase in the price level, hence it was no surprise that Japan fell back into deflation any time the inflation rate poked its head above zero.

I recall that Ryan Avent thought Krugman’s reply actually supported my argument.  Now Matt Yglesias has weighed in the the issue.  As you know, Yglesias’s Keynesian views on fiscal stimulus are much closer to Krugman’s than to mine.  But he is also a very smart and fair-minded progressive.  Here’s how he sees the evidence:

I heard from some readers, for example, that the Bank of Japan spent a lot of time trying to create inflation and failed. That’s not really what happened. Instead, the Bank of Japan spent a fair amount of time trying to fight deflationand had limited but real success. They always indicated, however, that they wanted “price stability” not inflation and certainly not catchup level targeting of anything. This kind of stop/start policymaking does exactly what it’s supposed to do””it prevents collapse without being unduly unorthodox””but it can’t really lift the price level or the economy. But that’s not to say policymakers don’t have the ability to say that unorthodox measures will remain in place until full employment resumes. Thus far, in both Japan and the US, they’ve simply chosen not to do so.

I can’t imagine how any fair-minded observer could look at all the evidence on the BOJ and reach any other conclusion.  This blows away Krugman’s argument about the US being victimized by China.  How can we claim to be a victim when we haven’t even tried to stimulate?  Especially as monetary policy can do the job almost costlessly.  And how do I know we haven’t made a good faith effort?  Because Krugman said so today!

There are multiple things wrong with that paragraph “” but what on earth would give one reason to consider our political system “responsive”? The truth is that we’re responding worse than Japan did.

Krugman’s right.  Our attempts to boost AD have been completely pathetic.  So why the heck are we blaming the Chinese for our failures?

Krugman’s right about one thing, we are in a recession and China isn’t.  So we need the stimulus more than they do.  But the issue is not how much unemployment China has now, but rather how many Chinese would lose their job if China sharply revalued the yuan. I favor a gradual appreciation in the yuan, and the Chinese government has recently resumed the policy of gradual appreciation that was conducted from 2005-08.  But here’s what China expert Michael Pettis says might have if there was a sharp appreciation in the yuan:

And so there is a good chance that the US will overreact, and will use the threat of tariffs to force the renminbi to appreciate much faster than China can absorb.

.   .   .

So after years of dragging its feet, postponing a rebalancing, and forcing rising trade surpluses onto the rest of the world, China may have to adjust its currency policies so quickly that it risks a sharp contraction at home.

Note that unlike me, Pettis agrees with Krugman’s argument that the weak yuan has hurt the US.  But he is still very concerned about the impact of a sharp revaluation.  Think about it.  How could such a policy help the US by sharply curbing our imports from China, without costing the jobs of many Chinese workers in the export sector?  China’s a very big country, I could easily foresee more jobs being lost in China’s export sector, than gained in the US (even if you accept the zero sum approach used by some protectionists.)

So even if you accept Krugman’s argument that yuan appreciation would help the US (and I don’t) he’s still asking a country with 1.3 billion mostly poor people to take a chance on a policy that Michael Pettis says could cause severe problems, all because of our failure to boost AD.  And even Krugman blames our own policymakers for that failure.   How can a progressive make that argument?

Yes, I know, I don’t get the fact that we can’t be 100% sure that monetary stimulus will work.  And can he or anyone else be 100% sure a sharp yuan revaluation wouldn’t cost China millions of jobs?  Especially given that China’s economy slowed sharply and experienced deflation after the yuan became overvalued in 1998?

HT: Master of None

When the weak are strong

Those who are as old as I am, and who have read The Economist for more than three decades, can recall dozens of economic crises in far-flung places all over the world.  Thailand, Mexico, Turkey, Indonesia, Brazil, Korea, Russia, etc, etc.  And in almost every case the collapsing economy and banking distress are associated with sharply falling currencies.

But every so often you find a peculiar case; a feeble economy associated with a strong, muscular currency.  I posted this right after the Japan post, because I wanted readers to ponder just how unusual it is for a currency to be strong in an economy that is so weak.  Another example occurred in the US during 1929-33, when the trade-weighted dollar rose in value, even as the real economy collapsed.  The same thing occurred in Argentina in the late 1990s and early 2000s.  Let’s consider what these odd cases have in common:

1.  Deflation.

2.  Real economies that had been doing well prior to the crisis.  Japan was the envy of the world in the 1980s.  The economy of the US in the 1920s was one of the most efficient the world has ever seen, in terms of economy policy.  The business press was very optimistic in mid-1929, as we had trade and budget surpluses, low taxes, weak unions, stable prices, free markets, etc, etc.  Argentina did some neoliberal reforms around 1990 and grew rapidly in the 7 years before the crisis hit.

3.  All three crises saw banking problems.

How can we explain these perverse cases—weak economies and strong currencies?  Perhaps the usual direction of causation was reversed.  Perhaps the strong currency caused the weak economy, by causing deflation.  Indeed, it’s now almost conventional wisdom that money was too tight in the US during 1929-33.  Some blame the drop in M2; some blame the ideology of pegging the dollar to a metal that was itself appreciating in real terms.  But most experts see the problem as monetary, broadly defined. The same is true of Argentina, which attached its currency rigidly (through a currency board) to the US dollar during a period when the dollar was appreciating from the tech boom.  And of course many economists such as Paul Krugman criticize the Japanese central bank for being too conservative, for pursuing deflationary policies.

So it seems to me that the profession does have an answer to the mystery of strong currencies in weak economies.  When this phenomenon occurs, the strong currency is itself the cause of the problem.  It seems that deflation can severely damage a formerly quite productive economic machine.

But (like TV detective Colombo asking “just one more question”) here’s what bugs me.  Didn’t the US economy go down the toilet between July and November 2008?  And didn’t the dollar not collapse, but rather soar in value against the euro during that 4 month period?  So why do almost no economists consider tight money to have been the problem during that period?  Why isn’t that like the US in the early 1930s, Argentina in the early 200os, and Japan in the 1990s?

I’d love to put on a rumpled raincoat and ask Mr. Bernanke that “one last question.”