Archive for March 2011


Recessions are predictions . . .

. . . of bad policy.  That’s what Michael Woodford thinks, and I agree.  Not all recessions.  In 2001 economists didn’t even see a recession coming until about September, and the recession was over by November.  I’m talking about severe recessions, those where there is the feeling of going over the crest in a roller coaster, then that “uh-oh moment,” followed by a sickening plunge.  Like 1920-21, 1929-30, 1937-38, 1981-82, 2008-09.  Can policy address the problem once it has occurred?  Yes and no.  Technically it can, but it is very unlikely to work in practice, precisely because it is very unlikely to be tried.

The markets are pretty smart, and when they perceive one of those uh-oh moments, they are usually correct.  I mean all markets, BTW, not just the stock market, which often sees ghosts that aren’t there.  If stocks, bonds, commercial RE and commodities all signal a big drop in NGDP, it’s almost certainly on the way. We’ve all seen the NGDP “downshift” graph that Beckworth, DeLong, Yglesias, Woolsey, Hendrickson, et al, keep showing.  The one with no trend reversion.  That’s what markets gradually realized in late 2008.

In a strange way this relates to Paul Krugman’s liquidity trap argument.  His strongest argument is that conventional monetary stimulus is ineffective at the zero bound.  Since conventional monetary stimulus is cutting nominal short term rates, no one can really contest this part of Krugman’s argument.  His more controversial argument is that while there are some unconventional things that a central bank could do, they are not likely to do those unconventional things.  In a sense that’s right, if they were likely to do those things the asset markets never would have crashed in the first place.  Woodford showed that current AD is strongly influenced by expected future AD.  But of course this is equally true of fiscal stimulus.  The sickening plunge in asset prices and economic activity from August 2008 to March 2009 was an implied prediction that (take your pick) fiscal stimulus doesn’t work very well, or would not be done in large enough amounts (probably some of both.)

I doubt that a quasi-monetarist policy regime (say targeting NGDP expectations) would be effective in future severe recessions.  Why not?  Because if the regime was expected to be quasi-monetarist then the deep slump should never have happened.  Alternatively, if it did happen then markets would presumably be forecasting that there would be no NGDP targeting.  Only in the case where policy was quasi-monetarist, but not understood by markets to be quasi-monetarist, would this policy actually be adopted and work.  By how likely is that?  I keep coming back to 1933 because it’s a rare example of a huge stimulus surprise, although there are some smaller examples like QE2.  In the real world policymakers are rarely able to surprise markets.  Investors understand the policy regime, and draw the relevant conclusions.  When they become pessimistic about policy, their fears are generally confirmed.  We need to stop thinking about deep slumps as a sort of random “problem” that needs to be “fixed.”  They need to be prevented; if they aren’t, they probably won’t be fixed.

I’m not sure whether Krugman really understands this point, despite all his excellent work on “expectations traps.”  Consider the following:

Now bear in mind that in order to make a commitment to inflation work, central bankers not only have to stand up to the pressure of inflation hawks “” which is much harder when you’re having to testify to Congress than it is if you’re a Harvard professor “” but, even harder, they need to convince investors that they’ll stand up to that pressure, not just for a year or two, but for an extended period.

Now, the thing about fiscal expansion is that people don’t have to believe in it: if the government goes out and builds a lot of bridges, that puts people to work whether they trust the government’s commitment to continue the process or not. In fact, to the extent that there’s some Ricardian effect out there, fiscal policy works better, not worse, if people don’t believe it will continue.

I don’t know enough macro theory to say this is completely wrong, but at a minimum it is very misleading.  He’s right that monetary stimulus is only effective if it is expected to be somewhat permanent.  That’s even true (to slightly lesser extent) when we aren’t in a liquidity trap.  It’s always (mostly) about the expected future path of monetary policy.  The public might expect future monetary policymakers to sabotage current stimulus, and the mere expectation of that future sabotage would prevent prices from rising today.  But that’s also true of fiscal stimulus.  Both fiscal and monetary stimulus raise prices by shifting AD to the right.  If the central bank is composed of inflation hawks that don’t want inflation, then fiscal stimulus won’t raise future inflation because the public will expect future central banks to sabotage fiscal stimulus.  Of course one can argue about whether this offset or sabotage would be as complete for fiscal stimulus as for monetary stimulus.  Krugman clearly thinks wouldn’t be; I think it would be even worse, as monetary policymakers worried about long run credibility would be unlikely to sabotage their own announced stimulus policy.  But one certainly cannot pretend that it applies only to one type of stimulus.  And it’s not just my model, in Krugman’s expectations trap model it is extremely important that future monetary policymakers are expected to behave as we’d like them to behave.  Which once again suggests that we desperately need NGDP targeting, level targeting.  That’s how you get the right expectations.  If you do that, fiscal stimulus might work.  But of course if you do that then fiscal stimulus wouldn’t be needed in the first place.

What sort of policy is best during a severe recession?  The sort of policy that would have prevented it in the first place.   In late 2008 we had a severe slump precisely because markets (correctly) predicted that the Fed would not take the steps necessary to prevent NGDP from falling, and staying on a lower trajectory. That’s why pessimists like Krugman are often right.  A Fed that would provide effective stimulus in a deep slump is one that would have prevented the deep slump in the first place.  We don’t have that sort of Fed; now it’s all about minimizing the damage, and educating policymakers so that we are better prepared for the next financial tsunami.

PS.  This Matt Yglesias post makes some related arguments.

The Wizard of the Fed

Everyone remembers that scene at the end of the Wizard of Oz, where the curtain is pulled back and we see the wizard without all the surrounding hocus-pocus.  What a disappointment!  I had that feeling reading Alan Greenspan’s new piece on the recession.  After just two sentences I was about ready to throw my shoe against the screen:

The US recovery from the 2008 financial and economic crisis has been disappointingly tepid. What is most notable in sifting through the variables that might conceivably account for the lacklustre rebound in GDP growth and the persistence of high unemployment is the unusually low level of corporate illiquid long-term fixed asset investment.

No.  The reason for the lackluster rebound in what Greenspan mistakenly calls “GDP growth” (which should correctly be called “real GDP growth,” as nominal should always be the default in economics) is very simple.  As I showed in this post, real GDP growth is very slow because NGDP growth is very slow.  And of course it’s the Fed’s job to control NGDP growth.

Then Greenspan suggests the problem is over-regulation:

As a share of corporate liquid cash flow, it is at its lowest level since 1940.  This contrasts starkly with the robust recovery in the markets for liquid corporate securities. What, then, accounts for this exceptionally elevated level of illiquidity aversion? I break down the broad potential sources, and analyse them with standard regression techniques. I infer that a minimum of half and possibly as much as three-fourths of the effect can be explained by the shock of vastly greater uncertainties embedded in the competitive, regulatory and financial environments faced by businesses since the collapse of Lehman Brothers, deriving from the surge in government activism. This explanation is buttressed by comparison with similar conundrums experienced during the 1930s.

Greenspan’s right about the 1930s, or at least the NIRA, but he’s wrong about the current policy environment.  None of the recent changes can explain the slow NGDP growth, and if that’s not persuasive enough then consider that the economy boomed in 1963-73, when government activism was far more aggressive than today.  Furthermore, a large share of corporate profits are now earned in booming overseas markets, so there is no mystery to be explained.

I found the following to be particularly dismaying, coming from a supposed libertarian:

But human nature being what it is, markets often also reflect these fears and exuberances that are not anchored to reality. A large number, perhaps a majority, of economists and policy makers see the shortfalls of faulty, human-nature-driven markets as requiring significant direction and correction by government.

Oh yes, those irrational market participants need to be herded like sheep by us hyper-rational academics and policymakers.  You know; the academics who almost universally failed to predict the crisis, and the policymakers who were acting as cheerleaders for the housing boom—complaining that banks weren’t doing enough sub-prime lending.  The policymakers who reacted to the gigantic sub-prime fiasco by finally getting around to banning sub-prime mortgages.  Oops, I mean by having the FHA subsidize even more sub-prime mortgages.

Here’s what Greenspan should have said:

Policymakers, particularly monetary policy makers, are subject to all sorts of fears that are not anchored in reality.  These include fear of unconventional monetary policy, once conventional policy is no longer possible.  Thus human-nature-driven policymakers require significant correction and direction by the markets.

HT:  Paul Krugman, who’s dismayed for slightly different reasons.

Matt Yglesias on monetary policy

Matt Yglesias has a very good piece on monetary policy.  It is primarily addressed to progressives, but everyone should read it.  Here are just a few excerpts of a much longer article:

Clearly, the Fed bears enormous responsibility for the health of the economy. But the way the current system works, the Fed’s members are hardly ever held accountable when the Fed fails to live up to that responsibility. The current Great Recession is, like all passing economic disasters, a major failure of macroeconomic stabilization. On the one hand, in its role as bank regulator, the Fed clearly failed to prevent widespread misbehavior. On the other hand, as a monetary policymaker, the Fed let inflation expectations fall well below customary levels even as output and employment were plummeting. Yet so far the key monetary policy-makers have been reappointed, and discussion of the issue has been dominated by cranks warning of nonexistent inflation and pushing for antiquated ideas like a gold standard. And the Fed did, in fact, engage in a flurry of unfamiliar activity to support the economy. So at the very time the collapse in output suggested the need for even more unorthodox monetary expansion, the aggressive expansion itself invited criticism that too much money was being created or that the Fed was simply continuing an unduly cozy relationship with the banking sector.

Much of the blame lies with the Fed’s current statutory mandate. Simply put, it is maddeningly vague. The interpretation of both “maximum employment” and “stable prices,” as well as the correct balance between the two, is up for grabs. Some FOMC members (or some members of Congress) may decide that 2 percent inflation is too high and the concept of “stable prices” should be re-interpreted to mean something closer to 1 percent or 0 percent inflation. Alternatively, many or most FOMC members may believe that the kind of more drastic QE measures that would be necessary to boost growth and inflation to target levels would be too politically damaging to undertake. Most plausible of all is that we’re currently experiencing some combination of the two. Some members probably regard sky-high unemployment as a price worth paying for the goal of a reduced rate of inflation, while others would prefer to do more but worry about the politics. The result is to leave the FOMC semi-paralyzed and unable to offer a fully coherent account of its own conduct. A candid description of internal disagreements and the resulting policy compromise would ameliorate the communication problem, but at the cost of undermining the aura of unanimity that the Fed relies upon to preserve its credibility and independence.

Nobody can say the FOMC is doing a bad job because nobody can say definitely what its job is. Not only the committee itself, but each individual member thereof, is free to define the FOMC’s mission freelance. Policy-making is essentially an accountability-free zone.

But while FOMC members are overempowered to set their own goals, they’re underempowered to push back against outside critics who don’t like the smell of certain unorthodox measures or who simply have partisan political motivations. Without an unambiguous mandate to follow, critics and interested parties can easily politicize unfamiliar moves.

Conversely, failing to define a clear mission for the Fed is a convenient way for Congress to duck responsibility for economic decisions. A clearer mandate for the Fed would make it easier for Congress to hold the central bank accountable for poor performance, but it would also force politicians to focus more clearly on who is responsible for what. Past economic calamities have, appropriately, prompted rethinking of monetary policy””the key lever for providing macroeconomic stability. Amidst the Great Depression, FDR’s Administration took the dollar off the gold standard, creating, in effect, an enormous expansion in the money supply and setting the stage for recovery. And after the tremendous inflation of the 1970s, the Fed was refocused on fighting price increases and was distanced from the president’s short-term political interests. The economic calamity of our generation ought to provoke a similar rethinking””one aimed at empowering the central bank to respond forcefully to a big crash while also demanding that it deliver results. There’s no reason we should listen to the cranks, but we should at least hear them and recognize that they’re gaining credibility for the very good reason that the powers that be have failed and nobody else is talking.

One step in this direction would be to start taking Federal Reserve governance more seriously. Currently the chairman of the system tends to be a quasi-celebrity post, but the other members of the Board of Governors languish in obscurity. It’s like forgetting that the associate justices of the Supreme Court have important jobs. Even worse, the regional bank presidents are, in part, selected by private banks in a way that wreaks havoc on any notion that policy should be accountable to the public interest.

.  .  .

In our stovepiped movement, nobody is watching the basics of economic stability. This is a major lacuna in the progressive institution-building of the past ten years. Unless people are so naive as to think we’re currently living through the last major recession in world history, it’s a gap that needs to be filled. Putting a non-conservative in the Fed chairman’s seat would be a nice start. And more programmatic emphasis is needed in our think tanks and journals to bridge the gap between academic research on monetary policy and the political world. The institution that failed us so badly in the current crisis is bound to fail again, and it’s crucially important that next time, there’s someone out there ready to talk about it other than Ron Paul.

Is economics a science? Should we care?

I’ve always thought that the debate over whether economics is a science is actually a debate about the meaning of the term ‘science.’  If science is when people build models to better understand the world around us, then economics is a science.

Some people distinguish between soft sciences like economics, and hard sciences like physics.  I don’t understand that distinction.  Are physicists very good at predict earthquakes, tornadoes, heat waves, etc?  Obviously not.  Some people claim that those events belong in geology or meteorology, but not physics.  My response is that physicists claim that their models explain those phenomena, so we have just as much right to expect them to predict tsunamis as we have to ask economists to predict recessions.  Indeed even more of a right, as economics has a sort of Heisenberg uncertainty principle, which says that (demand-side) recessions should not occur if they are expected.

Economics can predict some things very well and other things not so well.  The more complex the system, the less well we predict–just like physics.  I predict that bond prices will be unusually volatile between 8:30 and 8:35am on the first Friday of each month over the next few years.  But our most useful predictions are conditional forecasts.

Tyler Cowen has an interesting post on this question, but ends up with a perplexing assertion:

I conclude that economics is not yet a science.  Economics is most like a science when people do not care about the outcome of the argument.

Tyler is much better read than I am, but I was under the impression that scientists often became emotionally attached to their theories, and that it was hard to dislodge them.  Didn’t Max Planck say that science progresses one funeral at a time?

There is also a widespread view that we economists should try to become more scientific.  I’m not sure what that means.  If economics is not a science, I don’t think it should try to be one; just as I don’t think music, law, and accounting should try to become sciences.  We should try to become more useful, not more scientific.  I happen to think we are a science, BTW, as we do build models and use them to try to explain cause and effect in the world around us.  But if I am wrong and we aren’t a science, then I presume there is a good reason for us not being a science.

To summarize:  I see us as being a science.  Those who disagree with me simply define science differently.  It makes no difference whether we are or are not a science; all that matters is whether we are useful.  Law and music are not sciences, but they are very useful.  I hope this blog is useful.

An excellent Ramesh Ponnuru piece on the crash of 2008

Marcus Nunes sent me what might be the first mainstream media article to correctly describe what went wrong in 2008.  It appears in the National Review, one of those conservative magazines that Paul Krugman thinks only publishes articles written by gold bugs and austerians.

Ramesh Ponnuru relies heavily on the views of quasi-monetarists like David Beckworth, Josh Hendrickson and myself.  And he gets it right.  (I hope this doesn’t sound condescending, but the MSM often doesn’t quite understand monetary economics, as the field is full of counter-intuitive arguments and subtle distinctions that are hard to grasp.)

Josh Hendrickson””an economist at the University of Toledo, and like Beckworth a right-leaning blogger””has shown that the Fed did a pretty good job of stabilizing the growth of nominal income at roughly 5 percent per year during the “great moderation” that lasted from the mid-1980s until the current recession. (Although Beckworth notes that growth was slightly above trend during the housing boom, for which he faults the Fed.) Most debts””notably, most mortgage debts””are contracted in nominal terms, with no inflation adjustment. If people are used to 5 percent growth in nominal incomes each year and make their arrangements accordingly, then an unexpected drop will make their debt burdens heavier and also make them reluctant to make plans for a suddenly uncertain future.

That’s what happened during the recent crisis. Scott Sumner””yet another right-of-center econoblogger, this one based at Bentley University””often notes that in late 2008 and early 2009, we saw the sharpest fall in nominal income since 1938.  In his view, much of what we think we know about the recession of 2007-09 is wrong. Not only has money not been loose since the crisis began, but tight money is the fundamental reason the recession was so severe and the recovery has been so halting. He argues that it was more fundamental than the housing bust, since residential-construction employment started falling long before the crisis hit.

The article is entitled “Not Enough Money: Why QE2 Worked.”  Sorry, I can’t find a link.

Karl Smith should be much more famous.  Here he criticizes Paul Krugman’s defense of the liquidity trap.

I wrote an article for the Adam Smith Institute called “The Case for NGDP Targeting.”  I can’t find it online, but they have paper copies.