Maybe someone can help me understand the following:

“Speculators are becoming increasingly confident about pushing the [dollar/yen] currency pair around,” said Michael Woolfolk, senior currency strategist in New York at Bank of New York Mellon Corp., the world’s largest custodial bank, with more than $20 trillion in assets under administration. “Everyone is curious to find out why they chose not to defend the 80 level. Wow. That’s all I have to say, just wow.”

The yen gained to 77.48 per dollar at 5:42 p.m. in New York after passing its post-World War II high of 79.75 reached in April 1995, from 80.72 yesterday.

“We’ve breached 79.75 and there was enormous support there initially and that’s given way with stop losses on a New York close in extremely thin conditions with absolutely no signs of the Bank of Japan and the selling has just snow-balled,” said Kurt Magnus, executive director of currency sales at Nomura Holdings Inc. in Sydney.

For those who don’t follow the yen closely, 77 is an insanely high level.  Japan’s currency is showing amazing strength, and the BOJ is nowhere to be seen.  Tight money in an economy that shows no signs of overheating—unless you count nuclear power plants.    I don’t get it, but then I’ve never understood anything the BOJ did or did not do.

It pains me to write this post, as I am a big fan of Japanese culture.  Although I have never been there, I love the country.  But the truth is that Japan is not particularly good at handling disasters (as we found out after Kobe), and of course has a very spotty record on nuclear safety.  On the other hand there may be a tendency for people to get overly emotional about nuclear issues, so I really don’t know whether markets are over- or under-reacting.  (Yes, I’m a typical two-handed economist.  Pay no attention to my forecasts.)

I almost threw a shoe at the TV when I heard a newsman say the nuclear power plants were built to withstand earthquakes, but that “no one could have predicted anything this severe.”  Really?  I think Chileans, Russians, Indonesians and Alaskans would have had no trouble predicting 9.0 or higher earthquakes–which are not particularly rare, at least not for a power plant built to last for many decades and located in one of the hottest parts of the “ring of fire.”  These “black swans” (which might as well be named the official bird of the 21st century) are coming more and more frequently.  The reaction of authorities makes me more likely to believe those people who warn about the possible effect of solar flares knocking out our electrical grid, or genetically-engineered flu viruses causing pandemics.

[BTW, I think my post “Stuff Happens” holds up pretty well.]

In some ways recent events remind me of the Great Depression:

1.  The central banks didn’t provide enough stimulus.  Some actions were taken, but they would only be effective if things went smoothly–no bumps in the road to recovery.

2.  There were lots of bumps.  More importantly, there were lots of shocks that wouldn’t have caused much of a problem had we not been in a depression.  Smoot-Hawley.  The November 1930 bank run. Credit Anstalt.  France delaying Hoover’s attempt to rescue Germany.  Britain leaving gold.  The election of 1932.  War scares in the late 1930s.  Often these shocks had effects that seemed quite different from what one might expect, for instance Smoot-Hawley was very deflationary in May/June 1930, despite the fact that economic theory says tariffs are inflationary.  (And remember how the Libyan uprising seemed to reduce nominal interest rates?)

I’ve indicated many times that adverse supply shocks can reduce NGDP, if they become entangled with monetary policy.  And that’s especially likely to happen in a depression, when traditional monetary tools are ineffective.  Of course just as with fiscal stimulus, the Fed can neutralize the effect on NGDP.  So why doesn’t that appear to be happening?  Partly it’s because the Fed is targeting inflation, not NGDP.  Fiscal austerity reduces inflation, something the Fed might well offset.  An adverse oil shock (or disruption of the production chain in Asia?) raises prices, and hence is less likely to be offset with monetary stimulus.  We saw the Fed fail to react to a drop in AD during late 2008, partly due to an unhealthy focus on headline inflation (which had soared with oil prices.)  Could the same thing be happening again?

I suppose some people will roll their eyes and say “Sumner thinks even nuclear meltdowns can be fixed with monetary stimulus.”  Actually, I don’t think we should react to nuclear meltdowns or any other situation by changing our monetary policy target.  I favor stable NGDP growth.  The problem isn’t that money is not becoming more expansionary, the problem is that monetary policy (in the US and Japan) is becoming more contractionary.  I’d be happy if they simply stayed put.

The article quoted above did find a few countries that still “do monetary policy”  Countries that actually have targets, that aren’t passive in the face of shocks:

The Australian dollar fell to as low as 97.35 U.S. cents, the least since Dec. 2, before trading at 97.89 cents as of 8:32 a.m. in Sydney. The kiwi dollar slid to 71.30 U.S. cents, the lowest since Sept. 2.

The Aussie tumbled 3.5 percent to 75.56 yen, while the New Zealand currency dropped 4.5 percent to 55.39 yen.

Krona Drop

Sweden’s krona dropped against most major currencies, falling 1.3 percent to 6.4826 per dollar and 2.7 percent to 12.28 yen.

Rather than say Sweden and Australia’s currencies are falling, it might be more accurate to say the yen and the dollar are rising.

Some people have argued that this event might actually help the Japanese economy.  I doubt it.  Of course there’s the broken windows fallacy, but the more sophisticated arguments are that Japan will react with major fiscal stimulus, and that this will somehow force Japan out of its liquidity trap.  I find that implausible, and I’m pretty sure that Japanese stock investors agree with me.  Still, it is certainly possible, especially given the size of Japan’s national debt.  I hope I’m wrong.

PS.  Will Wilkinson has a good post on the economic effects of disasters.  But keep in mind my cautionary note on the Great Depression.  The effect of shocks is very much context-specific.

PPS.  I know that the 77 level was something of a blip–the real question is why the yen isn’t going much lower.

. . .  in countries with flexible exchange rates (i.e. autonomous monetary authorities.)

In How Big (Small?) Are Fiscal Multipliers? (NBER Working Paper No. 16479), co-authors Ethan Ilzetzki, Enrique Mendoza, and Carlos Vegh show that the impact of government fiscal stimulus depends on key country characteristics, including the level of development, the exchange rate regime, openness to trade, and public indebtedness. . . .

Exchange rate flexibility is critical: economies operating under predetermined exchange rate regimes have long-run multipliers greater than one in some specifications, while economies with flexible exchange rate regimes have multipliers that are essentially zero. The differences in the responses to increases in government consumption in countries with fixed and flexible exchange rate regimes are largely attributable to differences in the degree of monetary accommodation to fiscal shocks in these nations. The results imply that the central banks’ response to fiscal shocks is crucial in assessing the size of fiscal multipliers.   (Italics added.)

I wonder how many multiplier studies modelled the central banks’ response in their estimates of the size of “the” multiplier.

PS.  I haven’t had time to do any blogging, and am somewhat overwhelmed with work.  If you email me don’t expect an immediate response.  I’ll try to do something on the current world situation when I have time.  This post is just a stop-gap to show I am still around.

Or so he claims:

Some have asked if there aren’t conservative sites I read regularly. Well, no. I will read anything I’ve been informed about that’s either interesting or revealing; but I don’t know of any economics or politics sites on that side that regularly provide analysis or information I need to take seriously. I know we’re supposed to pretend that both sides always have a point; but the truth is that most of the time they don’t. The parties are not equally irresponsible; Rachel Maddow isn’t Glenn Beck; and a conservative blog, almost by definition, is a blog written by someone who chooses not to notice that asymmetry. And life is short …

That’s right, and George Will isn’t Michael Moore; and a liberal blog, almost by definition, is a blog written by someone who chooses not to notice that asymmetry.  No need to read Marginal Revolution, Becker/Posner, Econlog, John Taylor, Greg Mankiw, Robin Hanson, Steven Landsburg, etc, etc.  Nothing of interest, just move right along folks.  I’m always amazed when someone so brilliant can be so clueless about life.  How someone can reach middle age and still live in a kindergartener’s world of good guys and bad guys.

Perhaps if Krugman would get out a bit more he might make fewer embarrassing errors,  like this one, where he forgot the fallacy of composition, something taught in EC101.  I guess none of his liberal friends have the nerve to point out these sorts of silly errors.  So it’s still there, uncorrected after two weeks.  A monument to his pride at being ignorant of the views of those with whom he disagrees.

You might ask whether I’m being a bit harsh calling him “ignorant.”  Actually, he’s the one who proudly flaunts his ignorance of conservative thought.

I find that reading good liberal blogs like Krugman, DeLong, Thoma, Yglesias, etc, sharpens my arguments.  It forces me to reconsider things I took for granted.  I’d guess that when Krugman tells people at cocktail parties that the post-1980 trend of lower tax rates, deregulation, and privatization was a plot devised by racist Republicans, they all nod their heads in agreement.  If he occasionally read a conservative blog he might learn that all those trends occurred in almost every country throughout the world after 1980, usually much more so than in the US.

I wonder if his blanket condemnation of reading conservative outlets would include books that attack silly liberal arguments for protectionism.  Or articles that show the folly of liberal opposition to sweatshops.  Are those conservative ideas also no longer worth reading?

Some conservatives have given up on reading Krugman because of his insulting tone.  That’s a big mistake—indeed it’s playing right into his hands.  Krugman is right in many of his criticisms of conservative ideas (such as tighter money.)  Conservatives need to hear his views.  Better to read things that annoy you, and respond when you are outraged, than to be oblivious to the best arguments against your worldview.  The best liberal bloggers are those who don’t stay in their echo chamber, but rather are willing to also read blogs that annoy them.

PS.  I will be away for a few days, and hence won’t do much blogging.

Update:  Many commenters failed to click on the link in Krugman’s post, so they didn’t realize that he cited Tyler Cowen as the sort of conservative who is so partisan that he “doesn’t notice that asymmetry” and therefore is not worth reading.  I don’t even consider Cowen to be a conservative (much less partisan), but Krugman obviously does.

Bruce Bartlett sent me a new paper by Peter Ireland.

This paper uses a New Keynesian model with banks and deposits, calibrated to match the US economy, to study the macroeconomic effects of policies that pay interest on reserves. While their effects on output and inflation are small, these policies require important adjustments in the way that the monetary authority manages the supply of reserves, as liquidity effects vanish and households’ portfolio shifts increase banks’ demand for reserves when short-term interest rates rise. Money and monetary policy remain linked in the long run, however, since policy actions that change the price level must change the supply of reserves proportionately.

I found the long run neutrality of monetary policy to be quite interesting, as I’d assumed that relationship broke down with interest on reserves.  The fact that IOR has little effect on inflation and growth is also interesting, but I would caution that this sort of finding needs to be interpreted with caution.

In December 2007 the Fed was trying to decide between cutting rates by 1/4 and 1/2 point.  They actually cut them by 1/4 point, and the Dow promptly fell by 300 points.  Because fed funds futures showed a 58% chance of a 1/4 point cut and a 42% chance of a 1/2 point cut, we can infer that the Dow would have risen about 400 points with a 1/2 point cut.  (One of the few things even anti-EMH types accept is that the expected return on the Dow over any 2 hour period is roughly zero.)

Are there any models that predict that a 1/4 swing in the fed funds target would mean 700 points on the Dow?  I doubt it, because most models look at these things rather mechanically.  But in the real world the effect of a change in almost any monetary policy variable (fed funds rate, the base, IOR, M2, etc) depends almost entirely on how the change impacts the expected future path of policy.

I agree with Peter Ireland that a decision to pay IOR will have very little macroeconomic impact, ceteris paribus.  On the other hand, ceteris is rarely paribus.  It’s possible that an IOR decision might lead to changes in the expected path of monetary policy.  For instance, it might lead to fears that future QE would be less effective, as banks would have an incentive to hoard any extra cash.  Or markets might have already been expecting QE (to provide liquidity during a banking crisis) and the additional step of IOR might lead them to think the QE will not immediately drive short term rates to zero.

Since the impact of a policy depends on its impact on the expected future path of policy, it is almost impossible to model these effects.  They are highly contingent on the economic situation in which they occur.  For instance, the December 2007 quarter point cut would normally have had little market impact, but coming on the edge of the Great Recession, its impact was greatly magnified.  It made investors far more pessimistic about future Fed policy (correctly pessimistic, I might add.)

Does this mean there is no hope of ever being able to estimate the impact of policy decisions?  Far from it.  Louis Woodhill looked at the only three IOR decisions in the Fed’s 98 year history.  In each case stocks fell very sharply around the time of the decision:

At the time of the Fed’s IOR announcement, the S&P 500 was down by a total of 12.18% from its pre-Lehman close, 15 trading days earlier. However, the day that the Fed announced IOR, the S&P 500 fell by 3.85%, and it was down by a total of 17.22% three days later.

On October 22, 2008, the Fed announced that it would increase the interest rate that it paid on reserves. The S&P 500 fell by 6.10% that day, and it was down by a total of 11.11% three days later. On November 5, 2008, the Fed announced another increase in the IOR interest rate. The S&P 500 fell by 5.27% that day, and it was down by a total of 8.60% three days later.

To play it safe it’s probably better to go with the single day returns, as the EMH suggests the effect on asset prices should be immediate.  On the other hand, the concept of IOR was fairly unfamiliar to Wall Street, so arguably there might have been some delay as the program was discussed and explained.  But even using the more conservative one day window, what are the odds of three drops like that occurring on the only three days in history when the IOR was raised?  I’d guess no more than 1 in 10,000.  Economists get published with results no more unlikely than 1 in 20, and yet I am so skeptical of statistical significance that even 1 in 10,000 seems merely suggestive to me.  I think IOR might have had a significant contractionary impact, but I am not certain.

Whenever the model says one thing and the markets say another, I always go with the markets.  The markets seemed to think the IOR program was a big mistake, and the QE2 program was an important step in the right direction.  That’s all we know right now, and probably all we’ll ever know.

PS.  After the third and final increase in IOR, the S&P500 actually fell 10% in just two days.  Thus the market declined over 38% in 10 trading days–October 6, 7, 8, 9, October 22, 23, 24, 27, and November 5, 6.  Think about what it means for US equities to lose 38% of their total value in 10 trading days.  Coincidence?  Maybe, but a pretty unlikely one.  Using 2 day windows the total drop was about 24%.  Even the three single day drops add up to more than a 15% decline.

And then there is Sweden, with its negative IOR and record RGDP growth.  Hmmm . . .

Memo to Bernanke:  Cut the IOR to 0.15%.  It will give banks a bit less incentive to just sit on all the QE you’re sending their way.  But it will still be high enough to prevent the MMMFs from going belly up.  And you guys at the BOG can do it on your own–no pesky regional bank presidents to deal with.  Even Ron Paul will approve—less subsidy to fat cat bankers.  Git er done.

Here’s a comment from Andy Harless:

The question of whether monetary policy was tight in late 2008 is largely a matter of definition. How does one define “tight” monetary policy? If you define it by comparing the nominal policy interest rate to the latest reported 12-month inflation rate, then it wasn’t tight. If you define it by comparing forecast NGDP to the historical trend, then it was very tight.

I have to admit, when I first heard (second or third hand and incomplete, some time in early 2009 IIRC) about what you were saying, I dismissed it as some crackpot idea. But when (a year or so later) I actually started to read your blog, I became convinced that your definition of monetary tightness is as reasonable as any other. In monetarist terms, NGDP is just a velocity-adjusted monetary aggregate, so it’s a variation on a traditional way of measuring the ease of monetary policy. In New Keynesian terms, it’s a special case of a forward-looking Taylor rule, and it’s the most obvious special case “” a lot more obvious than Taylor’s original rule “” so it deserves some presumption. In October 2008, if the Fed had been following a forward-looking, equal-coefficient Taylor rule, the governors would have been tearing out their hair trying to find ways to simulate negative interest rates rather than dragging their feet about cutting rates while obsessing about providing liquidity.

I had similar thoughts swirling around in my mind, but he expresses the idea very clearly and elegantly.  He nails my approach to defining monetary policy, and my critique of policy in late 2008, all in one concise paragraph.  People need to pressure Andy to get back to blogging.

Here’s Mark Sadowski (from the same thread):

There’s a lack of interest in most economics departments in economic history primarily because most students are concerned about the job market and economic history only prepares you for academia and there aren’t many openings in economic history because students aren’t interested in studying it (and around and around we go). Other graduate students openly sneered at me whenever I mentioned I was taking a course in economic history. It’s a vicious downward spiral and unfortunately I think a major reason why economists were blindsided by the Financial Crisis and the Great Recession is the lack of knowledge of economic history by some otherwise very bright people.

Exactly.  Most economists have in the back of their mind the idea that Keynes showed monetary policy was ineffective at the zero bound during the Great Depression.  How many of these economists know that by the end of 1933 (with near 25% unemployment) Keynes was complaining that FDR’s monetary policy was too inflationary.  Or that when Roosevelt returned to the gold standard in January 1934, Keynes congratulated FDR for rejecting the advice of the “extreme inflationists.”  Or how many know that most banks didn’t take reckless risks in the late 1920s, but were actually very conservatively managed.  Or that the banking crisis happened because the nominal incomes of Americans fell in half.  Queue up that old George Santayana quotation.

I haven’t commented on the ECB’s latest blunder, but Paul Krugman, Matt Yglesias, David Beckworth, Kantoos, etc, have already said what needs to be said.

A commenter sent me a link to a video that I made for the Warwick Economic Summit in England.  (I wasn’t able to attend.)  I can’t bear to watch myself on TV, so I have no idea how it turned out.  I felt awkward standing in front of a black screen with no audience.  There are supposed to be PowerPoint slides interspersed.  I was limited to about 15 minutes, so the talk is sort of cut off at an awkward time.

Why do people hate watching themselves?  A reminder that others don’t see our beautiful minds, but rather our not-so-beautiful bodies?