Archive for December 2010

 
 

Matt Yglesias on monetary and fiscal stimulus

I recently was invited by Brink Lindsey to speak to a group of bloggers, reporters, academics, think tankers, and policymakers in Washington DC.  I was surprised at how many well known people showed up to hear my views on monetary policy.  Many of the faces (Bob Samuelson, Bruce Bartlett, Ezra Klein, etc) were instantly recognizable (even though I had never met them.) I met two of my favorite bloggers for the first time; Ryan Avent and Matt Yglesias.  The next day I had lunch with a bunch of George Mason faculty/bloggers, including Tyler Cowen, Alex Tabarrok, Bryan Caplan, Garett Jones and Robin Hanson.  I’m not used to feeling like the dumbest guy at the table.

[Note, I said “feeling like,” I didn’t say “not used to being the dumbest guy at the table.”]

Because I’ve been so busy I haven’t had much chance to respond to some of the comments on my National Review piece.  I plan to return to the issues raised by Cowen and DeLong at a later date, but for now I’d like to respond to Yglesias, and then Kling.

Yglesias liked part of my article, but criticized my shameless attempt to cozy up to conservatives (first me, then Yglesias):

“This sort of policy regime addresses many of the liberal arguments for big government. Right now conservatives don’t have good counterarguments to Paul Krugman’s insistence that all the laws of economics go out the window when we are in a “depression.” Classical economics assumes full employment; how credible are classical arguments against federal job-creation schemes when unemployment is 9.8 percent? Yes, government intervention doesn’t even work very well when there is economic slack. But with NGDP futures targeting, there is no respectable argument for fiscal stimulus, as the money supply would already be set at the level expected to produce the desired level of future nominal spending.”

As a way of surveying the political scene, this seems very shortsighted to me. Yes, it happens to be the case that in January 2009 Barack Obama was President of the United States, Susan Collins was the pivotal member of the US Senate, Paul Krugman had a New York Times column, and David Obey was chair of the House Appropriations Committee. Consequently, we got a stimulus bill oriented around progressive objectives and a lot of Krugman columns about the virtues of stimulus. But if you think back to January 2001 when George W Bush was President, the GOP ran the House, and Dianne Feinstein was the pivotal Senator as I recall our response to the recession was a large debt-financed tax cut. A large debt-financed tax code sold, mind you, with Keynesian arguments about the need to fight the recession.

I’m not quite sure what Yglesias is trying to say here.  If he’s arguing that the Republicans pushed the 2001 tax cut for anti-recession reasons, I don’t entirely agree.  Bush ran on the idea in 2000, when the economy was still booming.  He did take the opportunity to sell it in 2001 using Keynesian arguments, but that’s because Keynesianism is more intuitively appealing, especially to swing voters and Congressmen.  Indeed I imagine even Bush himself finds demand-side arguments to be more plausible than supply-side arguments.  But the motivation of the GOP was supposed to be starve the beast and lower MTRs.

Or perhaps Yglesias was suggesting that I was implying the Dems are the bad guys who favor fiscal stimulus and the Republicans are the good guys who oppose fiscal stimulus.  If so, I guess he’s partly right.  I did imply that, and he’s right I was incorrect in doing so.  But I don’t see the two cases as being at all identical.  My opposition to a massive spending stimulus was that it would require a sharp increase in future distortionary taxes.  Bush’s tax cuts might also require future tax increases, but at the time it seemed (to me) like they would not.  Indeed if spending under Bush had grown at the same rate as under Clinton then the budget deficit would not have been a significant problem, even with the Bush tax cuts.  Naive me, I didn’t realize that when the GOP took all three branches of government (for the first time in my life), they’d increase both military and domestic spending at a rapid rate.  In addition, even if future taxes must be raised, it is still better to have the benefits of lower distortionary taxes now, being offset by higher distortionary taxes in the future, as compared to a spending stimulus, which increases future distortionary taxes without any current reduction.  BTW, some argue that Obama’s stimulus didn’t end up involving much spending.  But any tax cuts that are not cuts in MTRs, are effectively spending increases in terms of their impact on current and future distortionary taxes.

Or perhaps Yglesias was suggesting that I am naive in thinking that politicians will refrain from fiscal stimulus, just because NGDP futures targeting makes it redundant.  Perhaps, but the 2001 case certainly doesn’t show that, as we weren’t doing NGDP futures targeting in 2001.

On some other issues, Yglesias effectively critiques the so-called “Latvian success story.”  (But they did build some pretty neat banks, for a country of only 2 million people.)

Yglesias also plumps for a “target the forecast” policy.  (That’s the first time in my life I’ve written “plumps for.”)

Yglesias also takes on the tricky issue of “what is money.”  I don’t have anything earth-shaking to add, as I am a pragmatist about language.  It’s not a question of what does the term ‘money’ really mean, but rather what is a useful definition of money.  Yglesias seems to take the same approach.  I would add, however, that I find the concept of the ‘medium of account’ to be very useful.  In monetary models the price level is the inverse of the value of money.  To see why this matters, consider walking into a yacht dealer with $100,000 dollars and $100,000 worth of Microsoft stock.  You see a $100,000 sticker price on a new yacht.  Can you buy the yacht with either asset?  Probably; the dealer might slightly prefer cash, but he’d also be willing to take the stock ,which he knows he can quickly sell for roughly $100,000.  After all, there is probably some wiggle room in the listed price anyway.  So I’m not denying that stock could serve as money in the sense of “medium of exchange.”  But now consider the following two thought experiments:

1.  The Fed doubles the (non-interest bearing) monetary base.

2.  Microsoft doubles the amount of stock outstanding.

Both actions would probably reduce the value of each individual paper asset.  (The dilution effect.)  The difference is that if the value of Microsoft stock fell in half, its nominal price would probably fall in half.  If the value of cash fell in half, its nominal price cannot change.  Instead, the nominal price of all other goods must double.  That’s why I find it convenient to define money in a way that focuses on its role as the medium of account.

Reply to DeLong on NGDP futures targeting

I tried to leave a comment at Brad DeLong’s blog, but I just can’t figure out these newfangled comment sections.  So I’ll post it here.  (I did leave a similar comment at Tyler Cowen’s post)

I’m kind of amused to see Brad DeLong suggest I finally “plump” for NGDP futures targeting.  I’ve devoted my entire career to the idea.  Indeed I presented this idea at the AEA meetings in 1987, and have 6 publications on the futures targeting idea.

My 1995 JMCB piece is an inferior version of the plan, which I have pretty much abandoned.  I’m sticking by my 1989 version, as well as my 1997 version.  But my two most recent publications are probably best.  I have an Economic Inquiry article with Aaron Jackson, and a B-E Contributions to Macroeconomics article, both from 2006.  The latter is closest to what I have just described. Many others have published similar ideas (Thompson, Hall, Woolsey, Glasner, Dowd, Hetzel, etc.)  Milton Friedman once endorsed Hetzel’s proposal, which is actually inferior to the others.  Hall’s was in the JME.  Dowd’s was in the Economic Journal.  At least one of my publications was refereed (I’m almost sure) by one of the smartest macroeconomists in the universe.   I also mentioned the idea to John Cochrane last year, and a few months later he seemed to endorse a similar idea.  None of this makes it right, but there has certainly been a long literature on the subject.  Yet DeLong treats it like some wacky idea I dreamed up for the National Review.

Bernanke and Woodford wrote an article criticizing the concept in 1997.  (The critique doesn’t apply to the version discussed below.)  So did Garrison and White.  I’m embarrassed to admit that I forgot that Tyler Cowen had also done so.  I need to reread his article and think about it, but I won’t have time for quite a while, as I am travelling tomorrow.

Of course the National Review paragraph had to grossly simplify, and cut lots of corners.  The 3% interest Brad DeLong mentions is wrong, it doesn’t factor in at all.  But I can’t blame him, as I didn’t provide enough information.  There are three completely different ways of setting this up, but I prefer to think about the following thought experiment:

1.  Set a policy goal, say 2% inflation over the next year.

2.  Have each FOMC member vote on the monetary base setting most likely to achieve that goal.

3.  Set the actual instrument at the median vote.

4.  One year later have the doves (i.e. those voting for a more expansionary setting) pay the hawks a $1000 salary bonus if the CPI is above 2%, and vice versa.  This encourages accurate voting.

5.  Now expand the FOMC from 12 members to all 7 billion humans (excluding North Koreans, who might vote as a bloc).  Make voting voluntary.

6.  Switch from one-man-one-vote to one-dollar-one-vote.

7.  Make the reward/punishment proportional to amount by which the actual CPI misses the target.

8.  Require every voter (speculator) to have a margin account.  Pay interest on the margin accounts at a rate high enough to create a sufficiently liquid market.

9.  Now you have CPI futures targeting.

10.  Switch to a 5% NGDP target and you have NGDP futures targeting.

Here’s my challenge.  I started with something close to real world monetary policy (you could even use the fed funds instrument, unless up against the zero rate bound.)  I moved one step at a time to my preferred policy.  At which step did I make a mistake?

Of course there are lots of issues like the risk of someone moving the entire economy to make money on a side bet elsewhere, which can be dealt with using pragmatic fixes, like having the central bank take a position against a large and highly suspicious bet from a single individual or firm.

BTW,  I mentioned the idea to John Cochrane last year, and a few months later he seemed to endorse a similar idea.

Contrary to DeLong’s claim, there’d be no huge swings in the monetary base, as the real demand for base money is fairly stable when expected NGDP growth is on target.  But if there was a surge in the liquidity needs of the economy, so be it.

Regarding helicopter drops on bankers; banks need play no role in my plan.  The Fed could swap briefcases of $100 bills with private individuals who own bonds.

The point of this policy is not to provide a painless way out of this hole (there might be price risk on the assets bought by the central bank) but rather to prevent us from getting in the hole in the first place.

PS.   Ignore DeLong commenters like Waldmann, he completely misunderstood the proposal.  There are no arbitrage opportunities because the Fed only pegs the price of 12 or 24 month forward NGDP contracts.  Trading begins on a new contract long before the previous one matures.

PPS.  I have a cold, will be travelling, and have lots of grading to do.  Don’t expect comments to be answered anytime soon.

PPPS:  Here’s a blog post that discusses the idea in a bit more depth.

My National Review article

I don’t have much time today, so a few quick comments.

In the National Review I try to show why conservatives should embrace NGDP targeting.

Here’s a recent Yahoo.com article on higher interest rates:

With the U.S. housing sector still mired in a prolonged rut, higher rates are certain to do more damage, curtailing refinancing activity and worsening a logjam in foreclosures linked to faulty documentation.

Against that backdrop, it is somewhat baffling to see forecasters frantically raising projections for economic growth. Berner at Morgan Stanley says the tax agreement could push growth up by as much 1.2 percentage points in 2011, putting it above 4 percent.

I’ll let David Beckworth explain, although I imagine you already see the problem.

Here’s another quotation worth pondering:

The central bank’s $600 billion stimulus plan was supposed to lower interest rates. But President Barack Obama’s tax deal with Republicans, by rekindling fears of budget deficits in the bond market, has pushed them higher.

As the Fed meets this coming week, the surprise shot in the arm from the fiscal authorities might strengthen the case of hawks at the central bank, who think the economy is already growing of its own momentum. They could argue to scale down the $600 billion in bond purchases announced in November.

“The shift to fiscal stimulus implies that officials would be less inclined to extend the current program beyond the second quarter of 2011,” said Richard Berner, an economist at Morgan Stanley.

Suggestion to grad students who want to embarrass their Keynesian professors:  Ask them how the Fed reaction function is modelled in their estimates of the fiscal multiplier.  Ten to one they won’t be able to answer your question.

I replied to Arnold Kling in the comment section of this post.

David Henderson pointed out that I misused the term ‘conspiracy’ in my previous post.   I should add that my slightly mocking style probably led you to think I have a negative view of Mishkin.  I was actually just trying to be funny—I agree with his rebuttal of Inside Job (linked to in the final postscript.)   BTW, David is my favorite critic of the National Security State.

Mishkin’s revealing omissions

I’m not happy about having to criticize Frederic Mishkin’s money textbook.  He was my teacher at Chicago and he seems like a great guy.  I’ve used his text for roughly 20 years and it’s a fine book.  Even worse, he was recently victimized by an unfair and misleading ambush interview.  But I must pursue The Truth wherever it takes me.

One of my favorite things about Mishkin’s text was that it presented aggregate demand curve in two ways.  At the beginning of chapter 22 it developed what is sometimes called the “monetarist” version of AD, which shows the curve as a fixed level of nominal GDP, i.e.  a rectangular hyperbola in P-Y space.  Only then does he present the so-called “Keynesian” version of AD, which is so hard to understand that I won’t even try to explain it.  And if I can’t understand it, I’m pretty sure our undergraduate students can’t either.  BTW, I have no idea why an AD curve shaped like a rectangular hyperbola is called “monetarist.”  It has nothing to do with whether V is constant or not (although Mishkin implies it does.)

Thus I was very disappointed to see Mishkin drop the monetarist AD curve from the new edition.  Textbook changes are usually made under the influence of criticism from professors at obscure community colleges, and perhaps that happened here as well.  I guess most professors prefer to teach a model that no undergraduate is likely to understand, rather than a simple and elegant framework that partitions macro into two parts; models that explain changes in nominal spending, and models that explain how nominal shocks get partitioned into output and inflation.  What could be simpler?

If I was a conspiracy buff, I would note that this change occurred right after the biggest fall in NGDP since 1938.  If one used the monetarist framework, it might lead students to ask uncomfortable questions about why the monetary policymakers allowed M*V to fall so sharply.  But I’m not a conspiracy buff.

Another thing I really liked about the 7th edition was the following question (on p. 368) about IOR:

10.  The Fed has discussed the possibility of paying interest on reserves.  If this occurred, what would happen to the level of e [the excess reserve ratio]?

I loved this question.  And when it actually happened, I couldn’t wait to show my students how Mishkin’s book predicted the dire consequences of the Fed’s October 2008 decision to adopt IOR.

So you can imagine how disappointed I was to find the question mysteriously deleted from the 8th edition.  If I was a conspiracy buff I’d wonder whether Mishkin was trying to hide something.  Surely students who did this question would be inclined to ask why the Fed did a highly contractionary policy in the midst of the biggest fall in AD since 1938 (that is if they still understood that AD=NGDP, which is doubtful.)

You might ask whether I am being too suspicious, after all, authors extensively revise texts with each new edition.  Times change, books need to reflect issues of current importance.  Actually, one of the dirty little secrets of the publishing world is that new editions are almost identical to old editions.  The publishers frequently revise editions so that they can sell new copies to students at $124 each, rather than have students buy old copies from previous students.  And of course far from being an obsolete question, the IOR question could hardly have been timelier.

Fortunately I’m not a conspiracy buff, so I’m willing to give Mishkin a pass.

A year ago I did a long post discussing how Mishkin’s text provided a template for my critique of the conventional wisdom circa October 2008.  I specifically cited 3 of the 4 key principles that Mishkin identified in his summary of the monetary policy transmission mechanism (pp. 610-11):

1.  It is dangerous always to associate the easing or the tightening of monetary policy with a fall or a rise in short-term nominal interest rates.

2.  Other asset prices besides those on short-term debt instruments contain important information about the stance of monetary policy because they are important elements in various monetary policy transmission mechanisms.

3.  Monetary policy can be highly effective in reviving a weak economy even if short term rates are already near zero.

I had thought that all economists accepted these propositions, as they are taught in the number one undergraduate money text.   And not just taught; they are the summation of the most important chapter in the text.   And they also happen to be true.  But I found out in late 2008 that very few economists accept these propositions.

I was anxious to get Mishkin’s new text, where he could take a sort of victory lap.  He could show how the Fed made a huge mistake allowing all sorts of asset prices to crash in late 2008, which signaled ultra-tight money.  But before I got the new edition, I read some articles where Mishkin seemed to be defending Bernanke’s moves.  I guess I shouldn’t have been so naive.  Mishkin and Bernanke are both center-right New Keynesians.  Both served on the Federal Reserve Board.  And of course Bernanke had also held similar views in the early 2000s, when he insisted that BOJ policy was far too tight, despite low rates.  So if Bernanke did a complete flip flop, why should I be surprised if Mishkin did as well?

Still, there was the question of how he would reconcile his views of the 2008 crisis with those three key principles of monetary policy.  I know what you are thinking—he dropped the key principles.  No, those are far too important to eliminate.  Did he refrain from discussing the crisis?  No, how could he do that?  Instead, he stated his view of the crisis just one page before the three principles that completely conflict with his view of the crisis.  That takes chutzpah!

Here’s what he says about the crisis on page 609:

With the advent of the subprime financial crisis in the summer of 2007, the Fed began a very aggressive easing of monetary policy.  The Fed dropped the fed funds rate from 5 1/4% to 0% over a fifteen-month period from September 2007 to December 2008.

Wait a minute; doesn’t he say just one page later than low rates don’t mean easy money—that you have to look at other asset prices?  Yes, but perhaps Mishkin didn’t know about all the other asset markets (TIPS, stocks, commodities, forex, commercial real estate, etc), which all started screaming that money was too tight in late 2008, as rates were gradually cut from 2% to 0%.

After discussing the crisis, Mishkin continues (p 610):

The decline in the stock market and housing prices also weakened the economy, because it lowered household wealth.  The decrease in household wealth led to restrained consumer spending and weaker investment, because of the resulting drop in Tobin’s q.

With all these channels operating, it is no surprise that despite the Fed’s aggressive lowering of the fed funds rate, the economy still took a bit [sic] hit.

So I guess he did know.  But perhaps there is nothing more the Fed could have done once rates hit zero?  Surely I can’t seriously claim that monetary policy can be highly effective once rates hit zero?  Go back and read Mishkin’s third principle.

If I was a conspiracy buff, I’d say that Mishkin followed almost every other famous economist in assuming that Fed policy was easy during late 2008, despite plunging stock and commodity prices, soaring real interest rates on 5-year TIPS, plunging inflation expectations, a soaring dollar, and plunging real estate prices.  And he assumed there was nothing the Fed could do about it because they had already cut rates to zero.

If I was a conspiracy buff, I’d wonder if he knew there was a contradiction, and erased any passages of the book that might alert students to the possibility that the Fed policy was actually tight (such as the IOR question) or that the sharp fall in M*V was the big problem in 2008–i.e. the monetarist view of AD.

If I was a conspiracy buff I’d even wonder if he was so nervous and distracted typing the last line I quoted that he misspelled ‘big’.  That he was nervously looking ahead to the very next section in his textbook; the Lessons for Monetary Policy.

Fortunately I’m not a conspiracy buff.  But now I understand why so many people believe Bush was behind 9/11, or LBJ was behind the Kennedy assassination, or FDR knew about Pearl Harbor before it happened, or the CIA overthrew Allende.  It really is a lot of fun being a conspiracy buff.  What a satisfying view of the world!  Everything has an understandable cause, all loose ends tied up with a nice Christmas bow.

PS.  Cowen and Tabarrok do AD the correct way.

PPS.  In this earlier post I argued that confused professors probably forced Mankiw to remove the one question that actually taught S&D correctly, which showed students that one should not expect consumers to buy less after a rise in the price.

PPPS.  BTW, I really do think Mishkin was treated unfairly in the interview.  Keep in mind that this was done by a director who used Barney Frank to explain what went wrong in the sub-prime crisis.

Andy Harless on monetary policy

I’ve been asked to comment on a recent Andy Harless post that denied the existence of monetary policy:

So there you have it: there is no such thing as monetary policy. There is “central bank directed stabilization policy,” and, for convenience, you can refer to that as monetary policy if you want. If so, recognize that you are using the term loosely, and let’s not get into arguments about whether some particular Fed action is “really” monetary policy. None of it is really monetary policy.

I agree that when one takes a close look at monetary policy, things are never quite what they seem.  And that it’s hard to draw a bright line that separates monetary policy from other policies.  But I still think one can identify two basic types of monetary policy:

1.  Policies that affect the supply (or quantity) of the medium of account. 

In the US, the Fed creates two assets that serve as the medium of account; currency and bank deposits at the Fed.  This aggregate is referred to as the monetary base.  Open market operations are the primary method by which the supply of base money is altered, although discount loans are also used.  Thus the base is increased when the central bank buys an asset, or when the central bank lends base money to others.

2.  Policies that affect the demand for the medium of account.

The central bank can affect the demand for base money in numerous ways:

a.  Reserve requirement changes.

b.  Changes in the interest rate on reserves (and perhaps currency when we fully shift to electronic money.)

c.  Changes in the nominal policy target.  Thus a higher price level target, a higher NGDP target, or a higher foreign exchange rate peg would tend to reduce the real demand for base money, by creating higher inflation expectations.  Indeed any action that increases the future expected supply of base money will tend to reduce the current real demand for base money.

To summarize, an expansionary monetary policy is any action or statement by the Fed that increases the supply of base money, or reduces the real demand for base money.

I see base money as being special because it is a medium of account.  Thus the price level can be modeled in terms of changes in the value of “money.”  T-bills are different.  An increase in the supply of T-bills might increase the price level, or it might reduce the nominal price of T-bills.  Money is special; by convention its nominal price is equal to one.  Fiscal policy has little impact on the price level.  When Reagan generated huge deficits via tax cuts and a military buildup, and Volcker fought back with tight money, we all know who won.  And the Fed also came out ahead when LBJ tried a tight fiscal policy in 1968-69, but monetary policy stayed easy.  That’s why monetary policy is important, and worthy of special attention.