I haven’t commented on Paul Krugman for a while:

Hiring plunged; job separations also mostly fell, but that was due to a fall in quits rather than layoffs, which rose during the worst of the crisis, then returned to normal levels.

In all such exercises, you’re looking for the “signature” associated with one or another story; and the signature here is clearly the one you’d expect with a general fall of demand. Keynes roolz.

He’s completely right of course, except for that last sentence.  What could he have been thinking?  All the data shows is that negative demand shocks cause unemployment.  Doesn’t everyone believe that?

1.  Friedman and Schwartz certainly argued that tight money causes unemployment.

2.  Hayek certainly believed that falling NGDP causes unemployment.

3.  Robert Lucas completely accepts Friedman’s and Schwartz’s monetarist interpretation of the Great Contraction, and suggested in a recent talk that falling velocity was a big problem in late 2008.

4.  All the old, new, and post-Keynesians believe demand shocks matter.

5.  RBC-types started out denying the importance of money, but latter added nominal shocks to better fit the data.

I’m not saying that there aren’t a few loonies out there who think if the Fed cut M in half and NGDP fell in half that there be no loss of jobs.  That wages and prices would fall just as fast as M.  But surely not more than a handful.

Here’s what everyone agrees on.  NGDP fell in 2009 at the fastest rate since 1938.   Big falls in NGDP cause lots of unemployment.  The only debate is over whether in addition to the demand-side unemployment, there are also some structural problems.  I think there are, although less than many other right-wing economists seem to believe.  But evidence showing that demand shocks cause unemployment tell us nothing about the relative merits of various business cycle theories.

Part 2.  Krugman and Wells need to consult Mishkin

In another recent post, Krugman makes this admission:

. . . finishing the redraft of the monetary policy chapter in Krugman/Wells 3rd edition (how the heck do we get quantitative easing in without totally muddying everything else?)

It’s easy if you have the right model.  Yesterday I taught Frederic Mishkin’s view of monetary policy at the zero bound, and I had the easiest class of my life.  Everything Mishkin has been saying for years came true in September-October 2010, on rumors of QE2.  I’m referring to his chapter 23, where he looks at unconventional monetary policy transmission mechanisms, which still work at the zero bound.  He lists 10.  Here are a few of the 10 he lists:

1.  Monetary stimulus raises stock prices, and hence the Tobin q, increasing the incentive to invest.  Check.

2.  Monetary policy raises inflation expectations, lowers real i-rates, and increases the incentive to invest.  Check.

3.  Monetary stimulus lowers real rates, depreciates the dollar, and boosts exports.  Check.

4.  Monetary stimulus raises asset prices, raises wealth, and hence increases consumption.  Check.

I would add that monetary stimulus raises commodity prices, and hence raises output in commodity industries.  And because it raises prices, it also reduces real wages.  He’s also got 5 credit view channels that I won’t even bother to discuss.

Of course Krugman’s often argued that QE doesn’t really do much more that change the term structure of government debt.  If that’s all it did, he’d be right to be skeptical.  But we now know it does lots of other things to various asset prices, even though the recent Fed move was far less than we needed.

I’d suggest Krugman and Wells just copy Mishkin’s chapter 23.  If doing so means “muddying everything else” up, then he might want to consider re-evaluating whether “Keynes roolz.””

I frequently assert that no fiat-money central bank ever tried to inflate and failed.  Some people respond by pointing to the long period of mild deflation in Japan.  I won’t repeat all my arguments that the BOJ was intentionally pursuing a highly contractionary monetary policy.  Instead, I’d like to cite the findings of a new study by three Japanese economists, who use a New Keynesian DSGE model to estimate the Taylor rule.  The study by Koiti Yano, Yasuyuki Iida, and Hajime Wago, found that the BOJ seemed to shift from a roughly 2% inflation target in the 1980s and early 1990s, to a roughly negative 1% target after 1995.

Unfortunately, I went to grad school back in the stone age when we mostly taught economic intuition, not math and econometric skills.  So I’m hoping my very smart commenters will help me out with this paper.  I wasn’t quite able to figure out how they got the estimate of minus 1% inflation target.  Does their method seem reasonable?

Part 2:  Three from The Economist

I’ve been so busy that I haven’t had time to link to my last three essays for The Economist.

The ECB has made the European debt crisis much worse

There’s little risk of inflation

QE has helped raise commodity prices

I should have an article in the National Review very soon.  I’ll let you know.

Part 3:  No one should pay any attention to my political forecasts.

I said Obama was unlikely to get more fiscal stimulus, and he got a lot more.   I would have thought if he got a lot more, the Keynesians would have been ecstatic.  Instead they are outraged.  The announcement seemed to raise the expected rate of inflation by about 8 basis points per year over 5 years.  There’s two ways of looking at that.  On the plus side, it shows fiscal stimulus does have a positive multiplier.  On the minus side, it’s not much bang for the buck, as I was under the impression that the FICA tax cut was a surprise.  Real interest rates rose by 13 basis points, and nominal rates rose by 21 basis points.  (So much for Ricardian equivalence.)

But I also believe Obama missed an opportunity.  If you believe as I do that sticky wages explain part of the high unemployment, it would have made much more sense to cut the employer’s share of payroll taxes, not the employee share.  Still, if we need to do fiscal stimulus, I favor tax cuts both for small government reasons, and for stimulus reasons.  I agree with Christina Romer that tax cuts are much more stimulative than spending increases.

Part 4:  The endless, pointless, debate over the EMH

A few reactions to comments on my recent post on the EMH.  Some people get extremely angry when you defend the EMH.  The debate reminds me of arguments I have over free will.  I point out that either events have causes, or they are random.  In either case there is no room for free will.  My opponent responds that he is free to pick up either the salt or pepper shaker in front of him.  The debate never really gets joined, and is thus largely a waste of time.  I’ve decided I shouldn’t waste any more time arguing against free will, or defending the EMH.

I must have done at least 6 posts on the EMH and I always get the following responses, even if they have nothing to do with the specific arguments that I make in the post:

1.  It is noted that some people correctly predicted this or that bubble.  The way I look at it, you have roughly a fifty/fifty chance of being right if you predict prices will fall.  Given there are 7 billion people on planet Earth, I’m not blown away by the finding that some of them predicted this or that bubble would pop.  What does blow me away is that some people who have become world famous predicting bubbles, have done so despite also making important false predictions.

2.  Some commenters point to anomalies.  I point out the EMH predicts there will be millions of anomalies.  Some respond that a few anomalies have even done well in out-of-sample forecasts.  That’s great, but you’d expect that.  I recall reading about studies showing many anomalies failed to do well after they were published.  Was I misinformed?

3.  Some point to experimental economics.  I point out that studies have found experimental results do not always hold up in the real world.  Some commenters found the experimental evidence against the EMH to be irrefutable.  But this is also part of that evidence:

But people do learn. By the third time the same group goes through a 15-round market, the bubble usually disappears.

I’m guessing that real world traders are more savvy than college students playing a game for only the third time.

4.  Don’t get me wrong, I think there is evidence against the EMH (such as the 1987 stock crash), my real argument all along has been that the anti-EMH view is literally useless.  And that which has no practical value has no theoretical value.  In contrast, the EMH has been very useful in my research on the Great Depression.

5.  Several people mentioned market observers who denied bubbles, but no one provided me with a specific example of a bubble denier who became famous because his or her prediction was correct.  During bubbles, I find all the sophisticated people I talk to are pessimists, arguing it’s a bubble and it must burst at some point.  I rarely find people who say it’s going much higher.  So I think a successful bubble denial ought to earn some praise from the intellectual elites.  Given that pessimism is the only fashionable stance if one wants to be viewed as a SERIOUS THINKER, the bubble deniers ought to be viewed as being the ones going against the grain.

So I feel it’s hopeless, I get way more comments than I have time to answer, and only 10% or 20% actually address the specific arguments in my post.  So I’ll just give up, and stop doing bubble posts.  Of course as soon as I find another interesting way of denying the existence of bubbles, I’ll break my vow and post another EMH defense.  After all, it can be logically shown that I don’t have any free will.

PS.  I will be super busy until after New Year’s Day, not doing as much blogging.  (Although I’ll try to do some.)  Apologies to those who used to get Christmas cards from me.  Consider this:  “Merry Christmas,” to be my holiday greeting.

PPS:  I just noticed that Bryan Caplan and Arnold Kling commented on my post.  In response to Bryan Caplan, I think Fama became famous for inventing and defending the EMH, not making a specific correct forecast that a specific bubble would keep inflating.  I don’t know the other guy.  Arnold Kling’s definition of a bubble is one of many out there.  My problem is not that it is wrong, but rather that even if true, it is a useless concept.  I insist that unless a bubble call is an implied prediction, it is useless.

PPPS.  Thanks to Yasuyuki Iida for sending me the paper.  He indicated it was presented at this year’s Econometric Society World Congress (ESWC2010).

More and more I think that the entire bubble/anti-EMH approach to economics is founded on nothing more than superstition.  Superstitions are caused by cognitive illusions; we think we notice more patterns than are actually there.  You dream your son got in a traffic accident, and the next day it happens.  You forget the other 10,000 dreams that didn’t predict the future.

In economics people notice bubbles bursting, but fail to pay much attention to bubbles not bursting.  But I admit I might be wrong, so I’ll give my opponents one more chance.  If it’s not really a cognitive illusion, then bubble deniers who are right ought to be just as famous as bubble predictors who are right.  Indeed as we will see they should be even more famous.

People who actually understand finance know that if the term “bubble” is to mean anything useful, it must contain an implied prediction of the future course of asset prices.  Not a precise prediction (everyone knows that would be impossible) but at least a better than a 50/50 prediction.  If someone said in 2005 that housing prices were a bubble, but still was unable to offer more than a 50/50 odds on whether real housing prices would rise or fall over the next 5 or 10 or 20 years, then what would their assertion actually mean?  Asset prices are very volatile; we know that at some point all markets will go down.  When I read predictions from people like Paul Krugman, I infer that there is an implied prediction that real prices will fall over some reasonable period of time—say 5 years.

And of course Krugman was right in predicting that real US housing prices would fall in the 5 years after 2005, as was Dean Baker, Nouriel Roubini, and some others who became well known and lauded for their predictions.

At the same time we also know that bubble-like patterns don’t always yield reliable predictions of future trends.  The Australian housing market looked just as bubbly as the US market in 2005, but since then has soared much higher.  Some day it will fall, but the 2005 prices no longer look excessive.

If people like Robert Shiller (another person who became famous from bubble predictions) are right about asset prices being too volatile, then it should be true that US-type cases are more common than the Australian case.  I don’t think that’s true— in most developed countries real housing prices have risen since 2005, despite real upswings before 2005.  But let’s say I’m wrong and Shiller’s right.  Then the easy prediction to make is that prices will fall after a big upswing.  The much harder prediction is that prices will keep rising, even from inflated levels.  Those cases would be much rarer, and those who correctly call them when they occur (as in the Australian housing case) should be lauded as great heros of the investment world.

So who are they?

If they don’t exist, I have a theory why.  Most people are convinced bubbles exist, regardless of the data.  Hence if the prediction doesn’t pan out, then the market was in some sense “wrong.”  Traders haven’t yet woken up to the stupidity of their behavior.  When they do, prices will crash and the bubble proponents will be proven right in the long run.  So most people would implicitly think; “Why praise someone for being right for the wrong reason?”  Of course this makes bubble theory into a near tautology, irrefutable in volatile asset markets that will almost always eventually show price decreases.

Perhaps I am wrong and there are lots of famous bubble deniers out there.  But if not, that would in my mind be the last nail in the anti-EMH coffin, pretty much confirming that people are seeing what they expect to see, indeed given the satisfaction we get from seeing the high and mighty brought low, perhaps what they want to see.

One final point; I also have noticed that lots of people are given credit for bubble predictions that were wrong.  John Kenneth Galbraith saying stocks were a bubble in January 1987.  Robert Shiller saying stocks were a bubble in 1996.  Dean Baker saying US housing was a bubble in 2002.  The Economist magazine touting its successful housing bubble predictions of 2003 in an ad, despite the predictions being incorrect for most of the countries listed.  That’s how strongly we want to believe in bubble predictions—we even assume that people who were wrong, were actually right.

PS.  For those interested in global housing prices, The Economist has a great interactive graph.  It helps to show the pattern from say 2000:1 to 2005:1, and then from 2005:1 to the present.  In the earlier period almost all countries showed gains in housing prices, even in real terms.  The two notable exceptions were Germany and Japan, where prices fell sharply.  If I was to use a Shiller-style model that predicts asset prices will self-correct after excessive swings, I would have predicted most housing markets to slump after 2005:1, but Germany and Japan to rise.  Instead almost the opposite happened.  Germany and Japan continued to do very poorly, while almost all other markets rose in nominal terms, and most rose even in real terms.

The two nominal decliners (in addition to Germany and Japan) were the US and Ireland—which is why people assume they had had a bubble.  But why didn’t all the other bubbles collapse?  Perhaps because asset prices are not as easily forecasted as most people naively assume.

BTW, if you can’t get a 2000:1 starting date, then white out all the country boxes and start over.  That worked for me.

As people in the humanities would say, this post’s title is an “homage” to Nick Rowe.  JimP sent me this interesting Bloomberg article:

Montreal undergraduates may help reshape the Bank of Canada’s monetary policy and give Federal Reserve Chairman Ben S. Bernanke and Bank of Japan Governor Masaaki Shirakawa clues about how to ward off deflation.

About 240 students so far have spent two hours in a 25th- floor computer lab near McGill University, earning an average of C$30 ($29.88) by viewing combinations of economic data, including unemployment and gross domestic product, and then predicting what would happen to inflation. Central bank researchers are taking part in the project to see whether people can make such forecasts more easily if policy makers target specific levels in the consumer price index instead of the inflation rate — which might help households and companies make better decisions about spending and investing.

The more accurate the test subjects are, the more they earn. One did so well, “we tried to track this person to see if we could hire her,” said Jean Boivin, 38, a Bank of Canada deputy governor who is helping with the research and has also co-written paperswith Bernanke.

The experiments will help Canada decide if it should switch from inflation targeting to price-level targeting in 2012 and may help the bank better communicate its policies to the public, Boivin said. The test results also might benefit Fed policy makers, who discussed price-level targets on Oct. 15 and voted Nov. 3 to inject another $600 billion of reserves into the banking system to avoid deflation — a widespread drop in prices that has plagued Japan for more than a decade.

Broader Agenda

“Central banks need to know more about how expectations are formed, and so we see that as part of a much broader agenda,” Boivin said in an interview at the Bank of Canada’s Ottawa headquarters in the room where he, Governor Mark Carney and four other policy makers decide on interest rates, including a decision tomorrow that’s scheduled for 9 a.m. New York time.

A few weeks back a Bentley student named David Norrish pointed to a flaw in my NGDP targeting idea.  Why [he asked] should we expect the largest economy in the world to experiment with a risky monetary regime that had never been tried out anywhere else?  I seem to recall that ideas like inflation targeting were pioneered by smaller economies such as New Zealand.  So I’m glad to see that the Canadians are considering serving as guinea pigs for price level targeting, before the policy is deployed in the much more important American economy.

BTW, the critieria for success should not be defined solely in terms of accurate inflation forecasts.  Short term forecasts may be relatively accurate under inflation targeting, even if the price level follows a random walk.  It’s more important to have accurate inflation expectations over the life of nominal contracts (wage and debt contracts.)  That’s where the advantages of level targeting are strongest.

PS.  Canadian readers:  I was just kidding—playing the ugly American for cheap laughs.

Yes, I know about the famous JS Mill quotation.  But when I was younger I thought the right had a lot of intellectual momentum.  The world was moving away from statism and toward neoliberalism, and it seemed like conservatives had most of the good economic ideas.

Of course there has always been a anti-intellectual strain to populist conservatism, as when the right romanticizes the “Golden Age” of the 1950s, before all those evil liberation movements of the 60s gave rights to blacks, women, and gays.  But at least on economics I used to think of conservatives as being relatively hard-headed.  So what is one to make of this appalling column in Forbes magazine:

Amid the very reasonable handwringing about the Fed’s charitably naive attempts to stimulate the economy through “quantitative easing”, there’s an understandable drive among some Fed critics to severely reduce its mandate. Specifically, the Fed can’t create jobs as its defenders inside and outside the central bank presume, so better it would be limit its role to that of inflation watchdog.

All that is fine on its face, but in seeking to redefine the Fed’s doings, naysayers have happened upon the false notion of “price stability.” A recent editorial argued in favor of repealing the Fed’s dual mandate so that it can concentrate “on the single task of stable prices”, and then politicians such as Reps. Paul Ryan and Mike Pence have similarly called for price stability in working to redefine the activities of the world’s foremost central bank.

Sadly, handing the alleged wise men at the Fed control over prices is every bit as mistaken as allowing the central bank to manage unemployment.

Indeed, it is through prices that the market economy is organized. In that certain sense, prices rise and fall with great regularity as consumers tell producers what they want less and more of. Assuming the Fed could do what it cannot; as in fine tune economic activity on the way to stable prices, we would be much worse off if Bernanke et al were to actually succeed.

To see why, it has to be remembered that the cure for high prices is in fact high prices. Or better yet, high prices foretell low prices.

If producers create a consumer product that fulfills unmet needs on the way to high prices, the latter is the signal to other producers to enter the market for the same good on the way to lowering its cost. Gyrating prices are the necessary market signal telling businesses what we need.

Taking this further, if price stability were policy, it would still be the case that a phone call from Houston to Dallas would cost $15 for a half hour of conversation. It would similarly mean that we’d be paying thousands of dollars for flat-screen televisions, not to mention even more for computers that perform very few functions.

I’m not going to insult my readers’ intelligence by describing what’s wrong with the last paragraph.  If you don’t know, go read someone elses blog.  At first I thought this might be an innocent slip up.  Nobody’s perfect.  Editors are very busy people, they can’t spot all mistakes.  But the rest of the piece is equally bewildering:

In that case, rather than price stability, the sole goal of monetary policy should be dollar-price stability. Fed officials would credibly argue that the latter is the preserve of the U.S. Treasury, and they would have a point. Be it Treasury, or Treasury working with the Fed, the mandate should be in favor of stabilizing the dollar’s value.

Um, isn’t the entire point of price stability (which I don’t favor, BTW) stabilizing the value of the dollar?  Indeed isn’t true that, by definition, a stable value of money means a stable purchasing power?  Not to John Tamny.  He seems to define a stable value of money as a stable price of gold.  Why gold?  Why not a stable price of bricks, or toothpicks, or zinc?  He doesn’t say.  Nor does he seem to have the slightest intellectual curiosity about periods in history when the dollar price of gold was stable, like 1929-33, when we had severe deflation (which provided falling prices of electronic goods like radios!), and 25% unemployment, and so discredited capitalism that we elected exactly the sort of politician that Forbes magazine would despise.

Oddly enough, Marx once again had the answer there. Marx, much like the classical economic thinkers of his era, knew that for money values to be stable, they would have to be defined in terms of gold. Marx referred to gold as “money, par excellence.”

Looked at through the prism of today, the dollar lacks a golden anchor, and the result is a money illusion that distorts the real price of everything. Worse, with consumer prices sticky in concert with commodity prices that are most sensitive to dollar-price movements, the beneficiaries of the money illusion tend to be the hard, unproductive assets of yesterday (think housing, art, rare stamps, and oil) that are least vulnerable to currency weakness, and which in fact do best when the unit of account is devalued.

Well if Marx says money must be good as gold, who am I to argue?  Reading this column I can’t help but wonder why all this talk about currency depreciation is occurring when inflation is at the lowest point of my lifetime, indeed lower than during 1896-1914, the so-called Golden Age of the gold standard.

The answer to all of this is very basic. Price stability is a utopian concept on its best day that would hamper innovation on the way to reduced living standards.

The greater, more obvious answer is dollar price stability of the gold kind that would allow investors to rate ideas on their actual merits, as opposed to how they’ll perform amid dollar policy since 2001 that has erred in an economically crippling way in favor of weakness. Fix the dollar, and you fix the U.S. economy. Simple as that.

Isn’t that wonderful!  No need to worry about messy real world issues like macroeconomics.  No need to worry about how nominal shocks can have devastating real effects.  Gold is like a magic wand that will fix the US economy.  But there is one huge flaw with this argument; there are two types of gold standards, and neither produces anything like satisfactory macroeconomic outcomes:

1.  One type is a managed standard, such as we had in the US between 1879-33, and in a weaker form under Bretton Woods.  In that standard the nominal price of gold is fixed (just as Tamny wants) but its real value is highly unstable, as the economy would often suffer from deflation.  The most devastating example was 1929-33.  It’s true that the supply of gold rises at a fairly steady rate, but central bank real demand for gold was highly unstable, and thus the price level was unstable.  Of course you could argue that the central banks should have done a better job of stabilizing gold demand, but by that logic why not just have fiat money and then have them do a better job of stabilizing monetary policy.  Even worse, if we returned to the gold standard almost no other country would be nutty enough to follow.  In that case when people in places like China and India hoarded gold out of fear of inflation, America would suffer deflation.  And from history we know that deflation in America would lead to fears of devaluation, which would cause gold hoarding in America as well, and even more deflation.  Tamny doesn’t even think about those issues, but why should he when he considers deflation to be a good thing?

2.  Some have advocated a laissez-faire gold standard.  In this case the government simply pegs the price of gold, but doesn’t hold large stocks of gold.   This would be even worse than a managed standard, as the relative price of gold would then be determined exactly as the relative price of any other metal is determined, by “industrial demand.”   Rapid economic growth in Asia has been boosting the relative prices of other metals such as silver, copper and iron.  If gold was just an industrial commodity, then its relative price would also be quite volatile.

So either way the gold standard offers no advantages.  At best, a highly managed international gold standard might lead to rough price stability.  But if central banks were really able to manage gold that well, they’d also be able to mange fiat money.

I suppose I am wasting my time with this post.  If the right now believes that deflation doesn’t matter, that 1929-33 is like some bad dream that never really happened, then nothing I say will make any difference.

HT:  Bruce Bartlett