Now that the multiple universe hypothesis is gaining increasing scientific acceptance, it’s time to soar beyond our own tiny universe and consider monetary policy in alternative worlds.  Consider a universe very similar to our own, but where central banks target zinc prices, not interest rates.

1.  They started with a “zinc standard,” maintained through open market operations.  It provided a sort of nominal anchor.

2.  Then an economist named Irwin Fisher noticed that the relative price of zinc is unstable, and hence the price level fluctuates even when nominal zinc price are constant.  Even worse, price level fluctuations seem to trigger fluctuations in output and employment.  He suggested lowering the price of zinc by 1% each time the price level rose by 1%, and vice versa.

3.  A few decades later a more sophisticated macroeconomist named Johan Tailor devised a more complex monetary rule, which tried to stabilize NGDP growth by adjusting zinc prices in response to both inflation and output deviations, according to an optimal rule estimated using state-of-the-art econometric techniques.  The zinc price that will stabilize NGDP was called the “Wicksellian equilibrium zinc price.”  The central bank was instructed to do OMOs until the actual free market price of zinc was equal to its Wicksellian equilibrium value.  It no longer even needed to hold stocks of zinc.  It bought and sold Treasury securities until the free market price of zinc moved to the right level.

4.   Then they decided to set up a NGDP futures market.  Now the central bank was instructed to adjust the monetary base until the price of zinc moved to a value that generated a NGDP futures price equal to the NGDP target.

5.  Eventually zinc price targeting started to wither away.  Zinc was increasingly viewed as a barbarous relic.  It played no important role in the monetary transmission mechanism, and the central bank began to directly target NGDP futures, without even bothering to use the intermediate step of zinc price targeting.  This brought about “the end of macroeconomics” as a separate field of study.  All “macro” analysis now had micro foundations.

In other universes other elements were used; cobalt, lead, chromium, etc.  Some used valuable compounds like H20, or NaCl.  In one universe zirconium was quite rare, and was the medium of account.  Diamonds were common, and used for small coins.   Oddly, the “zero lower bound issue” never arose in any of these universes.  Zinc prices can go as high as infinity (and also as low as you want in log terms, which is what matters.)  But in one poor benighted universe central banks adopted interest rates as an intermediate target.  Whenever the Wicksellian equilibrium nominal interest rate fell below zero, the central bankers didn’t know what to do—they ran around like chickens with their heads cut off.  Fortunately they too passed through that stage, and eventually moved to a system where OMOs were used to directly target NGDP futures prices (in the year 2037.)  But during the intermediate targeting period things sure were messy!

It’s good to see Matt Rognlie blogging again.  I’d like to take issue with the following claim:

*You may have heard from Scott Sumner, among others, that interest rates are a terrible indicator of monetary policy. This is actually true if we’re talking about current interest rates: it’s possible for monetary policy to be effectively tight because the Fed’s policy rule is contractionary, even if the current rate is very low. (Maybe it plans to raise interest rates dramatically in a few years, or whenever the economy shows signs of an expansion.) The key is to remember that monetary policy works through the entire expected path of future interest rates, not just the current rate. But interest rates are ultimately the key mechanism through which monetary policy affects the economy.

I’m told many models imply that interest rates are the key mechanism by which monetary policy affects the economy.  But I’ve never been convinced.  Start with a flexible wage/price model.  In that case a one time increase in the money supply will tend to lead to a one time increase in all nominal prices and aggregates, leaving interest rates unchanged.  Ten percent more money leads to 10% more NGDP.  A currency reform is a good example.  Obviously interest rates play no role in that process.

Now it might be argued that wages and prices are sticky, so my model isn’t at all interesting.  Not so fast.  Even Keynesians agree that wages and prices are flexible in the long run.  So it’s not obvious that interest rates play any role in explaining the long run affect of M on NGDP.  They might, but theory says we’d get to the same long run equilibrium, with or without interest rates playing a role in the transmission mechanism.  The “hot potato effect” is enough.

The more interesting question  is whether, in a sticky wage/price model, interest rates play an important role in the short run non-neutrality of money.  They might, but once again that’s not at all obvious.  For instance, suppose prices were much more flexible that wages, with commodity prices adjusting immediately to monetary shocks.  In that case you can get non-neutrality via sticky wages.  I’d guess you could also do so with monopolistic competition and sticky prices, but it’s not my area of expertise.

So theory doesn’t resolve the question, we need to look at which approach is the most useful.  And here’s where I am very underwhelmed by the Keynesian interest rate approach.  Maybe this isn’t fair, but I can’t help pointing out that I repeatedly see Keynesians make spectacularly incorrect calls by using interest rates as an indicator of monetary policy, rather than NGDP growth expectations. 

I see Keynesians argue that tight money didn’t cause the first year of the Great Depression, because rates fell sharply.  It had to be an “IS shock.”  I see Keynesians argue that tight money didn’t cause the Great Recession, because interest rates were very low, and falling, in 2008.  And I’m not just talking about a few crackpots.  These sorts of claims are made by many (perhaps most) of the most respected Keynesian macroeconomists in America.  (And don’t ask me to document this, if you disagree please produce a long list of famous Keynesians who publicly stated money was tight in 2008–and put the list in the comment section.  I think everyone honest with themselves knows I’m right.)

Now of course it’s possible that I’m wrong and the Keynesians are right.  Maybe the low interest rates really do mean that money was easy in 2008.  Then we can argue that issue.

Matt points out that the more sophisticated Keynesian models talk about the entire future path of interest rates, not just the current setting.  But I don’t believe many Keynesians understand just how knife edge those paths can be.  Take the December 2007 Fed announcement, which cut rates less than expected.  Rates obviously rose for short term maturities at 2:15 pm, but only out to a few weeks maturity.  After that rates fell, for maturities from 3 months to 30 years.  Thus a tight money policy reduced almost all interest rates at the point it was adopted.  Why?  Because it led to slower expected NGDP growth at a particularly fragile time for the economy.  Now tell me whether you think higher interest rates on maturities out to a few weeks is enough to drive important real effects in the economy, if longer term rates are going the opposite way.  Yes, using real rates makes this flaw in the Keynesian model smaller.  But most macroeconomists paid no attention to the fact that real interest rates soared in the second half of 2008.  Even worse, tight money can reduce even real interest rates in a forward-looking ratex model.  

Part 2:  While I’m commenting on Matt’s recent posts, I’d also like to discuss an excellent summary he provided of the “commitment problem.”  There are good theoretical models explaining why it might be hard for a central bank to credibly promise to inflate.  My only problem with this literature is that it’s a set of solutions in search of a problem.  No fiat money central bank has ever, ever, had the slightest difficulty in inflating.  No fiat money central bank has ever tried and failed to inflate.  And I think there is a good reason for that.  Central banks are very concerned about their reputation.  It would be humiliating to promise, say, a 5% NGDP target, level targeting, and then 4 years later when out of the recession, go “nah, nah, I was just kidding.”  Again, this isn’t to belittle the excellent models that have been developed to address the “problem,” but I’m afraid the problem doesn’t exist. 

Matt seems to have the same view as I do:

Recent events, however, suggest that elaborate commitment devices aren’t really necessary. The key constraint for the Fed isn’t sticking to its promises. The Fed cares a great deal about its credibility, and has a decent record of keeping promises whenever it has the nerve to make them. Instead, the problem is what kind of commitment to make: how can the Fed make tangible promises about future policy that don’t run the risk of creating larger problems down the road? This is the second issue in the literature, and it’s not trivial.

Paul Krugman on the other hand still doesn’t get this point:

By the way, it’s worth reading Ken Rogoff’s discussion at the end, in part for his confident assertion that raising the rate of growth of the monetary base would be enough to increase inflation. Actually, Japan tried that a few years later, without success; nor has the surge in the US monetary base since 2008 been either inflationary or indeed effective. All of which is exactly as the model predicted.

Actually, the BOJ did not want inflation, which is why they raised rates in 2000, and why they raised rates in 2006, and also reduced the monetary base by 20%.  They have the price level right where they want it.  Policy didn’t “fail.”  The problem is that they don’t want higher prices, not that they can’t get them.

And of course Bernanke repeatedly says the Fed has lots of extra tools, and is far from being out of ammunition.  They just don’t think extra stimulus is needed right now.  They paid 1% interest on reserves in 2008 to prevent that base expansion from causing inflation.  It’s clear from the market response to even trivial Fed rumors that the stock, bond, commodity and forex markets agree with Ben, Matt, and I, and disagree with Paul Krugman.  Monetary policy is highly effective at the zero bound.  It’s time to use it.

PS.  One area I do agree with Krugman is that QE unaccompanied by explicit communication is not the most effective tool, but market reactions to rumors suggest that even that’s better than nothing.

PPS.  Another reason I don’t like models with interest rate transmission mechanism is that some of them imply the Fed can’t create 3% inflation.  It’s 2% or 4%, with nothing in between.  I suspect that’s because you need at least 4% inflation to get real interest rates low enough to generate enough AD expansion to raise actual prices by 4% (or even 3%), given a fairly flat SRAS and when in a liquidity trap.  I’d appreciate if someone would tell me whether my intuition is wrong.  I can’t read math very well.

Two years ago Allan Meltzer warned that the Fed’s policies would lead to high inflation.  Paul Krugman and I told him he was wrong.  In a new article in the WSJ he repeats this warning.  But today I’d like to focus on something more disturbing, the end of monetarism as a powerful intellectual movement that addresses our problems.  Here’s how Allan Meltzer begins:

Day traders and their acolytes tried to pressure the Federal Reserve to open the money spigots wider this week. They called for QE3, a third round of unprecedented quantitative easing. Fortunately, the Fed said no to QE3, at least for now. But it did vote to continue its super-easy, zero-interest-rate policy until mid-2013, well after the next presidential election.

Alarm bells are already ringing.  This isn’t monetarism at all.  Milton Friedman reminded us that ultra-low rates meant money had been tight.  And it wasn’t just Friedman.  In this (undated) paper, Allan Meltzer argued that Japan needed easier money at a time when interest rates were near zero and banks had plenty of reserves.  The argument that money is easy due to low rates is a Keynesian and Austrian argument.  Meltzer continues:

How can the Fed know now that a zero-rate policy will be required two years from now? It can’t. Yes, economic growth has slowed, and forecasts of future growth decline daily. But the United States does not have the kind of problems that printing more money will cure.

So what kind of problem do we have?

Banks currently hold more than $1.6 trillion of idle reserves at the Fed. Banks can use those idle reserves to create enormous amounts of money. Interest rates on federal funds remain near zero. Longer-term interest rates on Treasurys are at record lows. What reason can there be for adding more excess reserves?

This is odd for two reasons.  It doesn’t tell us what sort of problem we have (demand or supply-side.)  Given that NGDP has grown 4% over three years, whereas the trend rate would be about 15%, I would think a monetarist would see the problem as demand side.  Friedman often pointed to the slowdown in NGDP growth in Japan during the 1990s.  I’m also confused by the point of this paragraph.  It seems to imply that the US is in a liquidity trap.  But monetarists like Friedman and Meltzer denied Japan was in a liquidity trap, despite large levels of bank reserves.  This sounds more like Keynesianism.  Meltzer continues:

The main effect would be a further devaluation of the dollar against competing currencies and gold, followed by a rise in the price of oil and other imports. Inflation is now at the edge of the Fed’s comfort range, which is below 2%. Money growth (M2) reached 10% for the past six months, presaging more inflation ahead.

Now I’m totally confused.  If the US were in a liquidity trap, then adding more reserves would not devalue the dollar.  In the monetarist model there is no mechanism where monetary stimulus depreciates the dollar but fails to boost NGDP.  None.  This is the sort of argument made by Joe Stiglitz.  I’m very surprised to see Allan Meltzer make this argument.

I’m even more shocked by the prediction of more inflation ahead.  Oil prices have fallen sharply.  Tips spreads are low.  Stocks are falling.  We have 9.1% unemployment.  Where exactly is this high inflation going to come from?  Gasoline prices?  Rapid growth in wages?  I just don’t see it.  M2 growth was even higher in late 2008, leading to the previous false prediction by Meltzer (of high inflation ahead.)  But at least I can’t deny that using M2 is an application of old-style monetarism.  It’s also why us quasi-monetarists now focus on other indicators.  Skipping ahead a bit:

A large part of our current unemployment problem reflects the unsold stock of housing left from mistaken past housing policies. We cannot quickly convert most carpenters and bricklayers into computer operators. Short-term policy actions will not solve that problem. But population growth, falling housing prices and rising rents will eventually help by stimulating enough new construction to put many in the housing industry back to work.

This is the sort of quasi-Austrian argument that Friedman and Schwartz severely criticized in their Monetary History.  It’s also completely false, for many reasons.  First, the job losses in housing construction were far too small to significantly impact unemployment.  Roughly 70% of the decline occurred between January 2006 and April 2008, and yet unemployment merely edged up from 4.7% to 4.9%.  The big job losses occurred in late 2008 and 2009, as the sharpest fall in NGDP since 1938 (something monetarists should be very worried about) led to a decline in commercial construction, manufacturing and services.  Eventually even state and local government jobs were hit.  Housing construction over the past 10 years is far below previous decades, the empty homes are due to poverty and unemployment caused by falling NGDP, not excess construction.  Many young adults are jobless and still living at home.  Meltzer continues:

The U.S. also has to make a major transition from a consumption economy to one that exports more and grows consumer spending more slowly. That transition has started, but it will not occur quickly. Those who look to consumption spending to recover its old path are hoping for a past that should not return.

That might be true, but wouldn’t monetarists argue that any transitions would be easier if NGDP hadn’t fallen at the sharpest rate since 1938?  Meltzer told us that monetary stimulus would merely depreciate the dollar.  That’s not a monetarist argument, but let’s say it’s true.  Why would that be bad if we need to transition from consumption to exports?  And why did Meltzer argue that Japan should engage in additional monetary stimulus to depreciate its currency at a time when rates were near zero and banks had lots of reserves?  Why was currency depreciation a useful tool for Japan, but not the US?

Meltzer goes on to make lots of sensible arguments for structural reforms to boost productivity growth.  I certainly agree we have structural problems—indeed I’m increasingly sympathetic to Tyler Cowen’s Great Stagnation hypothesis.  But we also have a demand problem, which seems obvious to me when you look at data such as NGDP growth since mid-2008.  In an earlier post Kevin Donoghue made a very astute comment:

You might ask yourself why two people who differ as much in their politics as Krugman and Sumner end up sounding so similar. Could it be that empirical evidence played a part?

I think that’s right.  We both look at lots of empirical data, including forward-looking market forecasts.  These indicators have been consistently warning of too little AD since mid-2008.

It pains me to write this because monetarism has greatly informed my worldview.  Meltzer is probably one of the three most distinguished post-war monetarists (along with Brunner and Friedman.)  But it seems to me that this type of monetarism has reached a dead end.  It needs to be reformulated to incorporate the insights of the rational expectations and EMH revolutions.  It needs to focus on targeting the forecast, using market forecasts, not searching for an aggregate with a stable velocity.  And it must be symmetrical, with just as much concern for excessively low NGDP growth as excessive high NGDP growth.  It needs to offer answers for high unemployment, and advocate them just as passionately as Friedman and Schwartz argued that monetary stimulus could have greatly reduced suffering in the Great Depression.  Just as passionately as Friedman and Meltzer argued for monetary stimulus in Japan once rates hit zero.  Unemployment is the great tragedy of our time.  History will judge the current schools of thought on how seriously they addressed this issue.

HT:  Big thanks to Lars Christensen, who supplied both articles, and some ideas.

Update:  I slightly regret the post title.  Just to be clear, I meant that it’s sad that this once proud school of thought seems to be reaching the end of the road.  Not as a sort of insult to Mr. Meltzer.  I disagree, but there is nothing “sad” about his editorial.  I just think he’s wrong.

Justin Wolfers just sent me the following tweet from Alex Tabarrok:

Hypothesis: In past 48 hours there is some time frame such that combination of short and long i rates and stock prices fits any theory.

I sympathize with this argument, but I think it’s too pessimistic.  Those of us who closely follow the market responses to Fed announcements see some very clear patterns:

1.  In the vast majority of cases it’s easy to see if the announcement was more or less expansionary that expected.  That’s because we know the expected fed funds setting from the futures market, even 5 minutes before the announcement.  And the Fed usually relies on changes in the fed funds target.  Hence a lower than expected fed funds target setting almost always leads to a sharp stock market rally at 2:15, and vice versa.  Interestingly, the response of bond yields is less consistent.  This sort of response in equities is especially likely when the market is worried about a near term recession, or low output during a recession.  Check out the September and December 2007 market responses, for instance.  My assertion here isn’t controversial; I think all Fed watchers on Wall Street would agree.  When the Fed cuts rates more than expected, Wall Street rallies, they don’t say; “Hmm, the Fed must be really worried, maybe we should sell stocks.”  In fact, stocks fall if the Fed disappoints, and the market thinks “Hmm, maybe the Fed doesn’t see what we see.”  I’m not claiming this is always true, but in my experience it is almost always true.

2.  Because the Fed is no longer using current changes in the fed funds rate as a policy instrument, it’s now harder to ascertain whether a particular Fed announcement is an expansionary or contractionary surprise.

3.  In recent weeks both short and long term rates have been highly correlated, and both have been highly correlated with stock prices.  That’s especially true using intraday data.

4.  If you combine items 1, 2, and 3, then it seems very likely that if Fed announcements are moving stock prices, they are doing so through some mechanism other than changes in short and long term rates on T-securities.  If that was the mechanism, then both stock prices and bond yields should move in opposite directions at high frequencies–but they clearly aren’t doing so.

Of course none of this proves my hypothesis (outlined in previous posts) is correct.  But I do think our vast database of market reactions to Fed surprises means there are many fewer degrees of freedom in developing hypotheses than some people might assume–especially if they were merely focusing on the admittedly confusing response last Tuesday.

Now of course if one wants to throw away lots of data, and argue that Tuesday supports the view that Fed rates cuts boosted the market because stocks and bond yields moved in opposite directions, then yes, Alex is right.  But why would we want to throw away the intraday data that strongly supports the alternative hypothesis?  As an analogy, suppose a researcher found variable X and Y were negative correlated for the total change between the two data points 1960 and 2010, but were strongly positively correlated using 600 monthly changes between those two dates.  Which observation would be more meaningful?

David Cay Johnston appears to think the answer is yes:

In China, tax revenues since 2003 have grown a fifth faster than the booming economy.

In America, tax revenues are growing a quarter slower than the sputtering economy.

The result is that tax revenues are up 22 percent as a share of the Chinese economy, but down 7 percent as a share of the American economy.

In China, jobs are everywhere. In America, joblessness is everywhere.

There is a lesson here and it goes to the heart of why America, stuck for a decade in the economic doldrums, risks foundering on the shoals of economic ruin not because it taxes too much, but because it has adopted unsound and profoundly anti-market economic rules while Communist-led China sails into the future ever more prosperous even though its tax burdens are rising.

While China sees growth and taxes as circulatory economics each needing the other, America imagines taxes as bleeding the economy.

ECONOMIC POLICY THAT WORKS

What the Chinese grasp is that it matters where tax money is spent. So they spend it on education, infrastructure and pensions to get older workers out and younger ones in.

In urban China — where half the people live — wide, smooth roads mark the land, the stretch marks of a growing economy. Storm sewers are being built to deal with chronic flooding along the low-lying coast and electric generating plants are coming on line as fast as the now ubiquitous air conditioners that make life in this humid region pleasant.

A few observations:

1.  I’ve had many opportunities to experience the “pleasant” Chinese living standards.

2.  The Chinese people seem to spend their money much more wisely than the Chinese government.

3.  China is poorer than Mexico.

4.  China is growing fast, as you’d expect of a country filled with 1.3 billion people whose culture reveres education, hard work, and entrepreneurship, and who has been moving away from the madness and starvation of Maoism.

5.  I have no doubt that if the US moved some of its vast spending on social programs to highway construction we too could have big new smooth roads.

6.  Taxes normally grow as a share of GDP as countries get more developed, and easier to tax.

7.  The East Asian countries that actually are pretty rich (Singapore, Hong Kong, Taiwan, South Korea and Japan) tend to have tax rates that are well below the average of western countries.

8.  Despite taxes that are much lower than in the US, Singapore has lots of nice roads and new infrastructure.

If we want to find an East Asian model to emulate, I’d suggest looking to low tax, rich, efficient Singapore, not poor and inefficient China.

I do agree with Mr. Johnston that we need to move away from our “anti-market” policies.

HT:  Adam Ozimek