Archive for January 2011


Powerful evidence that the big problem is demand, not structural

It’s easy to find a correlation between two macro variables, as the same sort of factors (inflation, output growth, interest rates) tend to affect all sorts of financial and macro variables.  For that reason, one of the most useful statistical tools is time-varying correlations.

For example, when I studied the Great Depression I recall reading a year end summary of the 1931 stock market in the New York Times.  They summarized the US stock market month by month, and mentioned German problems in all the summaries of the last 7 months, but none of the first 5 months.  And sure enough, during the last half of 1931 the price of German war bonds was highly correlated with US stock prices.

But how can one prove cause and effect?  Lots of things might have affected both German war bond prices, and US stock prices.  For example, signs of a strong economic recovery worldwide might boost the value of both assets.  On the other hand, if German problems were depressing US equity markets, then you’d expect a strong correlation between German war bond prices and US equity prices during periods when there were lots of problems in Germany (late 1931), but essentially no correlation during periods when German problems were not particularly significant (early 1931.)  And that’s exactly what I found.  Or to take another example, Steve Silver and I found that US industrial production became negatively correlated with nominal wages after 1933, precisely when New Deal programs began to artificially raise nominal wages.

Almost a year ago David Glasner mentioned that he was working on a similar study, this time estimating the time-varying correlation between US inflation expectations and US equity prices.  He has frequently sent me very significant results, but I held back from mentioning them in order to let him get the project completed before publicizing the results.  He has now placed the paper at the SSRN web site, where others can read it.  In the meantime I notice that others have observed this pattern, indeed the commenter Gregor Bush recently mentioned some similar results.

It is well known that there is normally little correlation between US inflation expectations and US stock prices.  Higher inflation might boost stock prices if associated with growing aggregate demand, but higher inflation can also lead to expectations of tight money, or higher taxes on capital, since capital income is not indexed.  Indeed the high inflation of the 1970s seems to have depressed real stock and bond prices.  In general, the stock market seems content with the low and stable inflation of recent decades, at least judging by reactions to changes in inflation expectations.

David looked at 8 years of data, from January 2003 until December 2010, and divided the sample up into 10 sub-periods.  He found almost no significant correlation between inflation expectations (TIPS spreads) and stock prices (S&P 500) until March 2008.  (Actually, there was a modest positive correlation during the first half of 2003, another period when people worried about excessively low inflation.)  After March 2008, the correlation was highly significant, and positive.  Right about the time where the US began suffering from a severe AD shortfall, the stock market began rooting strongly for higher inflation.  And it still is, even in the most recent period.  Money is still too tight.

There is no way to overstate the importance of these these findings.  The obvious explanation (and indeed the only explanation I can think of) is that low inflation was not a major problem before mid-2008, but has since become a big problem.  Bernanke’s right and the hawks at the Fed are wrong.

Arnold Kling noted that the AS/AD approach can sometimes verge on the tautological.  When inflation and output both fall, demand-side economists are likely to infer that AD is lower.  And they are also likely to claim that the fall in AD caused both the drop in inflation and the drop in output.  Of course that’s not the only evidence demand-side economists have, but in many cases it’s hard to find definitive evidence of causation.

In my view the time-varying correlations between inflation expectations and stock prices are one of the most important pieces of evidence we have that AD became a problem after mid-2008.  It will be interesting to see if those economists who are skeptical of demand-side explanations can come up with a plausible alternative explanation for this pattern.

PS.  If anyone knows how to estimate a continuous time-varying correlation, it would be interesting to find out precisely when in 2008 US equity markets started rooting for higher inflation.

PPS.  I’ve been asked to comment on the very weak performance of NGDP and the very strong performance in final sales during 2010:4.  If I had any confidence in the government numbers I would comment.  Let’s wait a few more quarters, look at lots of different data, and see where we are.  Again, my test of a policy is its effect on expected NGDP, not the actual movements in NGDP (which reflect all sorts of factors.)

Krugman’s right; China should stop whining

Paul Krugman recently discussed the charge that QE2 is stoking inflation in the developing world:

Oh, and what about Ben Bernanke? Well, to the extent that emerging markets are insisting on a fixed exchange rate against the dollar in the face of obvious overvaluation, that contributes to the boom and hence to demand. But I don’t think it’s reasonable to demand that the Fed stop fighting US unemployment in order to keep Chinese currency manipulation from leading to cotton hoarding by Chinese farmers.

He’s right, all the Chinese would have to do is raise the value of the yuan.  You might argue that this would slow their economy.  But if inflation is shooting upward they need to slow the (nominal) economy.

For China to blame the US for its inflation, when they refused to cut back on the number of Treasury bonds they bought as a way of tightening monetary policy and boosting the yuan, would be like the US blaming China for high unemployment, when we refused to buy more Treasury bonds to weaken the dollar and boost the prices of commodities, stocks, TIPS and foreign currencies.  Bernanke and company showed in November that they are quite capable of taking affirmative steps to solve our own problems (although I’d like to see even bigger steps.)  Now China needs to show the same can-do spirit, and stop blaming foreigners for its problems.

BTW, it’s good to see Krugman talking about how the Fed is “fighting unemployment.”  A clear message to all those old Keynesians who whine that there is nothing monetary policy can do once rates hit zero.  Their hero FDR didn’t whine that there was nothing he could do about deflation because rates were at zero.  He engaged in level targeting—set a goal of getting prices back up to 1926 levels.  And he got prices rising fast.

Can we all please stop pretending . . .

.  .  .  that the Fed wants 2% inflation?

I was about to make fun of this quotation from Ryan Avent:

Meanwhile, the Fed got little to worry it on the inflation front. Its favoured inflation measure””the core price index for personal consumption expenditures””came in at a 0.4% annual growth rate. That measure has declined steadily from the fourth quarter of last year.

And then I thought to myself; don’t be a smart-ass.  I’ll bet most macroeconomists would read that without batting an eye.  Sure the Fed claims to want 2% inflation.  But if that were true then economists and reporters would say “increasingly bad news on the inflation front,” not good news.  The fact that they don’t means that at some level everyone understands the Fed wants more NGDP, and would prefer any increase in NGDP to be as much real growth and as little inflation as possible.  So why can’t we drop the pretence that they want 2% inflation, and start talking about NGDP?  Why can’t we say what we mean?

PS.  I’ll start being a smart-ass again in my next post—on Paul Krugman.

Macro: showing how nominal shocks have real effects

Macro is basically about sticky wages and prices, and why nominal shocks have real effects.  Macroeconomists also talk about other issues, but it’s the nominal shock/sticky price problem that requires a separate field.  Otherwise macro is just applied price theory, i.e. classical economics.

Arnold Kling recently discussed the AS/AD model and suggested:

This aggregate supply mechanism assumes that wages stay fixed while prices move. This sticky wage hypothesis is at the center of the whole mechanism.

. . .

I want to particularly exempt Scott Sumner from this. He understands aggregate demand and supply exactly as I understand it.

I pretty much agree with the first part, although I’d add that sticky prices can also be an issue.  As for the second two sentences, I hope for Arnold’s sake it’s not true, as I don’t understand AS/AD very well at all.  And each time I read Nick Rowe I feel like I understand it a bit less well.  (That’s a dig at myself, not Nick.)  BTW, Arnold is clearly talking about long run equilibrium.

Here’s a Nick Rowe post entitled “What equilibrates AD and AS?”

If a binding minimum wage law sets W/P too high, there will be excess supply of labour. People can’t sell as much labour as they want to. If a binding pro-usury law sets r too high there will be excess demand for bonds. People can’t buy as many bonds as they want to. But if M/P is right, AS will still equal AD. The output market clears, even if the labour market and bond market don’t.

Arnold’s still right in a way. If M/P adjustment can be taken for granted, then if people want less labour and less output, or firms want more output and more labour, then W/P will adjust to coordinate their conflicting desires.

And those Keynesians are still right in a way. If M/P adjustment can be taken for granted, then if people want less consumption today and more consumption tomorrow, or firms want less investment today and more consumption today, then r will adjust to coordinate their conflicting desires.

And in the long run M/P adjustment can be taken for granted. And W/P adjusts if we decide we want to consume more leisure and buy fewer Ipads and BMWs. And r adjusts if we want more consumption tomorrow and less consumption today. But we can’t take M/P adjustment for granted in the short run.

After reading all of this, I’m not even sure what the phrase “equilibrate AD and AS” means.  In the comment section Nick points out that the SRAS curve isn’t really even a supply curve.  (He uses the sticky price Keynesian model, which assumes monopolistic competition.)  I’m actually fine with that model, although for some reason people seem to think I believe in flexible prices, maybe because I talk about wage stickiness as the biggest problem.  But if AS isn’t really a supply curve, but rather a sort of loci of equilibria for various settings of AD, then why even talk about the need to equilibrate AS and AD?

I’ll even go further, since prices are such a distraction, let’s entirely remove the price level from macroeconomics.  While we are at it, let’s dump interest rates as well.  BTW, by “macro” I mean business cycle theory, what I was discussing in the intro.  You need interest rates to explain saving and investment, and you need prices to estimate real economic growth; although as we see from the comments to Tyler Cowen’s new book, nobody has a clue as to what “real economic growth” is supposed to mean.  More stuff?  More enjoyment?  Your guess is as good as mine.

Since macro is about nominal shocks having real effects, we need a nominal variable that actually, you know . . . “shocks.”  Inflation won’t do, as the Keynesians tell us that prices are fixed, and only move in response to an overheating real economy.  So I nominate NGDP.  Even the old Keynesians accept that NGDP can move immediately (or at any rate just as fast as RGDP) in response to factors such as monetary and fiscal policy, as well as financial crises.

So just do AS/AD with NGDP on the vertical axis.  Everything is the same, except the AD curve is flat.  People often assume this requires some sort of assumption about the quantity theory of money being true.  No, 100% of AD shocks might be velocity.  Nor does it assume the Fed targets NGDP.  It would work equally well under a free market gold standard.  It’s true that I often equate monetary policy with expected future NGDP, but that’s not required.  You can use NGDP as AD and define monetary policy any arbitrary way you please.  (To me the only definition that makes sense is easy or tight relative to what would be expected to hit the target.)

It’s tempting to make the model even simpler by replacing SRAS and LRAS with a single AS, which crosses the horizontal axis at the natural rate.  No need for an AD line.  Just put NGDP minus expected NGDP on the vertical axis.   But I’ve given up on that idea; there is too much misunderstanding about what the term “expected NGDP” really means.  (It means different things in different contexts.)

Obviously if there is no price level and inflation, there is no RGDP, so put hours worked on the horizontal axis.

The real wage is now W/NGDP, (per capita NGDP if you wish, but it doesn’t really matter.)  This is actually a sort of “relative wage,” the share of national income going to an hour’s labor.  The late 2008 crash raised that relative wage rate, and caused mass unemployment.

This model can explain why nominal shocks have real effects in the short run, but hours worked return to the natural rate in the long run.  If you wish you can add the price level, the nominal or real interest rate, or the price of a pound of pistachio nuts, but none of them will add anything useful to the model.

So how about it Arnold, do you still want to claim you understand AS/AD the same way I do, or do you wish to remain a highly respected economist?

Review of The Great Stagnation

How great was Tyler Cowen’s marketing coup?  Well he forced a technophobe like me to actually learn how to use Kindle.  I wasn’t too happy about that, which makes me inclined to write a very negative review.  But that’s kind of hard to do credibly when I agree with the central proposition of the book; that technological progress (at least as traditionally measured) has slowed dramatically, and will continue to be disappointing for the foreseeable future.

In an earlier post I argued that my grandma’s generation (1890-1969) saw the biggest increase in living standards; most notably a longer lifespan (due to diet/sanitation/health care), indoor plumbing and electric lights.  Less important inventions included home appliances, cars and airplanes, and TVs.  From the horse and buggy era to the moon landing in one life.  And all I’ve seen is the home computer revolution.  Not much consolation for a technophobe like me.  I’m probably even more pessimistic than Tyler.

The parts of the book I liked best were those that discussed governance.  I had noticed that there was a correlation between cultures that are good at governance, and cultures that are good at running big corporations.    But Tyler added an interesting perspective, arguing that the technologies that facilitated the growth of big corporations also facilitated the growth of big government.  I don’t recall if he made this point, but I couldn’t help thinking that the neoliberal revolution, which led to some shrinkage in government size, was also associated with a move away from the big corporate conglomerates of the 1960s, towards smaller and more nimble businesses.

Tyler has a long list of complaints about the wasteful nature of our government/education/health care sectors, which he hinted is really just one big sector.  While reading this section I kept wondering when he was going to mention Singapore, which has constructed a fiscal regime ideally suited for the Great Stagnation.  When he finally did, on “Page” 830-37, he did so in an unexpected context, as an example of a society that reveres scientists and engineers.  He had just suggested that the most important thing we could do to overcome the stagnation was:

Raise the social status of scientists.

My initial reaction was skepticism.  First, how realistic is it to expect something like this to happen?  I suppose the counterargument is that every new idea seems unrealistic, until it actually occurs.  But even if it did, would it really speed up the rate of scientific progress?  My hunch is that if we doubled the number of people going into science, there would be very little acceleration in scientific progress.  First, because the best scientists (think Einstein) are already in science, driven by a love of the subject.  Second, with a reasonably comprehensive research regime, progress in finding a cure for cancer may require a certain set of interconnected discoveries in biochemistry that simply can’t be rushed by throwing more money and people at the problem.  Similarly, progress in info tech may play out at a pace dictated by Moore’s law.  Given Moore’s law, no amount of research could have produced a Kindle in 1983.  Could more scientists speed up Moore’s law?  Perhaps, I’m not qualified to say.  But that’s certainly not the impression I get from reading others talk about information technology.

Here’s another exhortation that caught my eye:

Be tolerant, and realize there are some pretty deep-seated reasons for all the political strife and all the hard feelings and all the polarization.

I couldn’t help thinking of Paul Krugman and Tyler Cowen, the two brightest stars of the economic blogosphere.  If only one of those two are able to have this sort of dispassionate take on policy strife, how likely are the rest of us mere mortals to be able keep a clear head and remain above the fray?  Still, it’s great advice.

There was only one place where I thought the book went slightly off the rails.  Toward the end of chapter three Tyler Cowen suggests:

Another way of putting this is, you can be an optimist when it comes to our happiness and personal growth yet still be a pessimist when it comes to generating economic revenue or paying back our financial debts.

And now we come to the book’s greatest flaw.  Tyler forget to discuss the all-important concept of . . . you guessed it . . . NGDP!  If we had more NGDP, we could pay back all those nasty debts.  Now before everyone starts madly typing out angry comments, I do understand the difference between nominal and real debts, I do realize that Tyler is looking and long term secular problems, not short term cyclical problems, and I do realize that the Fisher effect holds in the long run; you can’t inflate away debts forever.  But that got me thinking, and I started wondering whether Tyler is making an analogous error.

Tyler Cowen argues that the internet might produce all sorts of neat applications that give us endless pleasure and amusement, but without generating much revenue.  He used the term ‘revenue’ over and over again, but I always felt there was something missing.  Why should it matter if it generates much revenue?  One answer is so that we can repay our debts, but that doesn’t really answer my question.  More NGDP allows us to repay our debts.  Fiscal and regulatory reform can prevent us from becoming over-indebted again.  Sure, we might not do those reforms, but Tyler seems to be getting at something deeper, an unavoidable problem with the modern economy.  He seems to imply that even a well-regulated modern economy may not generate enough revenue.  I think that’s wrong.

Consider the following thought experiment.  All sorts of technological innovations on the internet cause our consumption (in real terms) to double, even though they don’t create any more revenue.  Because revenue is unchanged, NGDP is also unchanged.  But by assumption RGDP has doubled, meaning the price level has fallen in half.  In that case why shouldn’t we double NGDP, allowing people to repay their debts?  And even if we don’t double NGDP, people’s real incomes will have doubled, at a constant level of NGDP.  Progress will benefit society whether it generates revenue or not.  Real GDP is real, whether it generates revenue or not.

Tyler also argued that we faced a great recalculation problem, with lots of jobs opening up that need high tech skills, but way too many poorly educated workers.  Yet the facts he presents seemed to point in the opposite direction.  He mentions that the new high tech firms like Facebook can get the job done with an extremely low number of workers.  This webtopia that Tyler foresees won’t require many workers at all.  In that case, what should all our surplus workers do?  How will they find jobs?  Not in agriculture, 2 million farmers can feed the whole country.  Not in manufacturing, we are falling below 10% in that sector.  And most people don’t want three washing machines and four cars.  Where would they put them all?  Here’s what I think most people still want:

1.  A bigger and nicer house, with granite counter-tops.

2.  More restaurant meals.

3.  More fun vacations.

That means we need more construction workers, and granite miners (quarriers?)  We need more cooks and waiters.  We need more hotel receptionists and maids.  More people to work on Carnival cruise ships.  I think our workforce is skilled enough to fill those jobs.  It’s very lucky that the high tech companies that will provide all sorts of wonderful services do not need many workers.  We aren’t Singapore, and would have trouble supplying them.

I’m kind of surprised that Tyler Cowen got detoured into the “where will the jobs come from” cul de sac, as it’s usually associated with people who have very different views from Tyler.  Indeed I’m so surprised that I assume I must have misread him somewhere along the way.  Here’s how I think about jobs.  First, what do we want?  If those things can be provided with very few workers, don’t despair, ask what we want after we have gotten our first wish granted.  And so on, until all the workers are employed.

I also have a slight quibble with his views on education.  I share his intuition that the education/health care/government sector is highly wasteful, but I don’t agree with those who measure the output of education with test scores.  When I went to school I recall sitting in a class of 30, bored out of my mind as the teacher droned on, mostly staring at the clock.  My daughter is usually in a class of 20, often with 3 or 4 teachers in the room, doing all sorts of neat activities.  I hated school, she likes it.  You might argue that we live in a rich suburb, but the city of Boston spends just as much per pupil.

I’m guessing Robin Hanson must have said something to the effect “schooling isn’t about learning.”

FWIW, here are my policy suggestions for the Great Stagnation:

1.  Most important by far; end the war on drugs.  Big pharma can’t cure cancer, but they can end the pain.  But our government won’t let them.  Here’s a government “torture” problem 10,000 times bigger than waterboarding, which is tragically under-reported. (Although Matt Yglesias has a nice post.)

2.  Adopt Houston zoning laws everywhere.  There’s plenty of land around Boston, no reason for houses to be so expensive.

3.  Singapore-style HSAs, pensions and tax regime (including carbon taxes.)

4.  Education vouchers.  It won’t improve tests scores, but it will save boatloads of money.

My review hasn’t given readers a very good summary of this excellent and timely book.  It only costs $4 and one hour—read it yourself.  The best part is a very interesting and perceptive discussion of how the Great Stagnation is putting great strains on many aspects of governance, from political discourse to our ability to finance entitlements and public debts.  I probably agree with 90% of the book.  Even where he has different views from me (say on the social utility of modern finance) he probably has the stronger argument.  My review focused on the 10% where I don’t agree.