Archive for September 2011


Statsguy on the environmental impact of Fed/ECB policy

Here’s Statsguy from the comment section of an earlier post:

I would add only this: The Fed (and ECB) are doing tremendous STRUCTURAL damage by over-targeting (rear-looking) headline inflation. That doesn’t mean I don’t think headline inflation is important (it’s quite real, particularly if you’re in the lower income strata), but it’s counterproductive.

Why? Essentially, we’re knee-capping the economy to drop AD to bring down the price of oil (in dollars), which in a sense is SUSTAINING THE OIL INTENSITY OF THE ECONOMY to a great[er] degree than is optimal. What do I mean by that? Simply this: if the price of oil went up (relative to labor and debt), then economic actors would accelerate substitution away from oil – that is, they would substitute more people and more technology for expensive oil. INSTEAD, we’re dropping oil use not by encouraging substitution to alternatives (including increasing labor intensity, which would help with unemployment) but by preserving the current oil intensity and reducing overall consumption (including reduction of consumption of non-oil-intense products, like digital “goods”). It’s dumb.

In a sense, that Fed policy is also encouraging developing economies to move toward a more oil-intense infrastructure than would otherwise exist if oil were priced higher. It is encouraging LESS drilling, LESS technological innovation in the drilling sector, LESS demand for fuel efficient vehicles, LESS investment in alternative transportation, and WORSE city planning.

I don’t have strong views on this issue, but it’s an interesting perspective.

2.  Off topic, but I was originally planning on doing a post criticizing Felix Salmon.  Fortunately, David Beckworth saved me the trouble.  I highly recommend the post.

3.  I get frustrated with a developing argument that it’s tough to address this AD problem because inflation is unpopular.  There are all sorts of flaws with this, which I have discussed elsewhere.  (Opinion polls on inflation are meaningless, and in the past the public has seemed far more satisfied with a bit higher inflation and a lot more jobs.)  But here’s what really frustrates me.  We are letting the Fed off the hook.  The Fed used the biggest debt crisis in world history as an opportunity to drive inflation (and inflation expectations) to the lowest levels in 50 years, to levels lower than their mandate, to 1% over the past three years.  And all along the way Bernanke kept insisting that they had more ammo, but just didn’t think more stimulus would be appropriate.  None of the recent posts claiming the Fed has a political problem because the public hates inflation have addressed this issue.  I guarantee that if interest rates were 8.5%, many unions, Congressmen and business people would be demanding rate cuts right now, inflation or no inflation.  The Fed is EXTREMELY lucky that 99.999% of people don’t have a clue as to how monetary policy works (beyond interest rates.)

4.  Totally off topic, but Matt Yglesias’s predictions are quite similar to my own.  I’m agnostic on his health cost argument, and would clarify his point that although China can grow fast for many years, the actual growth rate will likely slow somewhat.  But those are my forecasts.  However if they are wrong I’ll blame Yglesias, as he’s much smarter than me and should have known better.

PS.  Yesterday I finally answered lots of old comments from a week back.  The backlog was overwhelming.  I do eventually read all the comments, and answer most.  But after three years I am reaching the end of the road for these two:

A.  Liberals asking how monetary policy can work when rates are zero.

B.  Conservatives conceding QE2 raised inflation, but asking how more inflation can boost output.

I think I’ll just start directing people to FAQs.  The blog isn’t really set up for people who don’t understand the AS/AD model.  If they disagree with it fine, tell me why.  But faking ignorance by claiming not to understand how nominal shocks can have real effects is very annoying.

Glasner demolishes Cole and Ohanian

Cole and Ohanian are right that the NIRA and other similar policies greatly retarded the recovery from the Depression.  So why do they have to push things too far, and try to suggest that demand stimulus didn’t play an important role?  David Glasner demolishes their argument in this post.  I’m really surprised they are still making these misleading claims.  I sent Ohanian papers with all the information in Glasner’s post, so I can’t see how they would be unaware that their data is extremely misleading.  At monthly frequencies wholesale prices and output were highly correlated throughout the Great Depression.  Period.  End of story.

I also keep pointing out that Paul Krugman continually misrepresents Lucas’s views of macro.  But he keeps doing it.   Lucas has indicated that the big drop in nominal spending in late 2008 and early 2009 depressed real output.  He does accept Friedman and Schwartz’s explanation of the Great Contraction.  But Krugman keeps implying Lucas believes demand shocks don’t matter.  Maybe Lucas doesn’t use Keynesian terminology, but he certainly buys the standard view that nominal shocks can matter in the short run, but not the long run.   BTW, I don’t agree with everything Lucas says about the Great Recession, but his views ought to be characterized accurately.

PS.  My email box keeps getting busier and busier.  Don’t be surprised if I’m not able to answer requests, or just give a one sentence explanation.  I encourage people to rely more on my previous posts, now that I am somewhat better organized.  The link at right called “Links to key blog posts and papers” is the place to go.  You need to scroll down on the right side of the blog to find that link, I’ll try to rearrange it later.  Eric Morey also recommended I put a link for RSS feeds for all comments, and I’ve done so in the same section.  I expect further improvements soon, and will let you know.

I’d also like to better organize posts by topic.  I spent 2 hours yesterday creating a new category; “China.”  There must be a better way.  I will gradually try to add more.

How we know that faster NGDP growth would lead to faster RGDP growth

A few months back David Glasner produced a fascinating paper showing how the correlation between stock prices and TIPS spreads increased sharply in the Great Recession.  (And Paul Krugman commented favorably.)  The implication was that when NGDP is excessively low, stock investors think higher inflation (and NGDP growth) will lead to faster RGDP growth.  Recall that high inflation hurt stocks in the 1970s, by increasing the real tax rate on capital.  Today, stock investors expect more NGDP to produce more RGDP.

A blog called Inframarginal Divergence has gone a bit farther:

If you want to see how bad things have gotten, you can use the beta of equities vs TIPS spreads. Loosely speaking, this beta is the amount the SPX is expected to increase for a 1% increase in TIPS spreads. If beta equals 10, then the Fed can increase equities prices by 10% by driving up the TIPS spread by 1%. Technically, I am computing the moving ratio of 6 month covariance(TIPS spread, SPX) to 6 month variance(TIPS spread) on a 1 week sampling frequency.

Now, a well-functioning monetary policy shouldn’t have a beta below 0 or above 5 against 5yr TIPS spreads (depending on your discounting any of the numbers in that range are “ideal”, meaning that real variables will be independent of inflation expectations). Well, let’s see what’s actually happening:

Good God! The data’s a bit noisy, but according to my read of this, the Fed is massively constraining real activity through its insane tight money policy. A 1% increase in inflation for 5 years (total increase in expected price level of 5%) is expected to lead to ~20% higher nominal output (integrated over time). That means that we get at least 3% real growth for 1% inflation. I want Obama to lose come Nov 2012 as much as anybody working on Wall Street because I think he’s mucked around on the AS side of the equation enough to do real damage, but I’m not willing to cut off my nose to spite my face with more unnecessary AD-induced doldrums.

So in the last few weeks the correlation has hit a new high.  The stock market has never been so desperate for higher inflation expectations, higher NGDP growth.  (Note, you would not expect a perfectly stable correlation, because inflation due to supply-side factors like Libya does not help the stock market.)

How can I be certain that more NGDP would help?  I can’t be certain, but market forecasts are the best information we have.  When policymakers ignore them, bad things usually happen.

Of course the freshwater economists would roll their eyes at this “Keynesianism”—the idea that printing money can solve real problems.  They’d insist that we have 9% unemployment for year after year because investors are worried that at some future date we might have to raise the top MTR by 5 or 10 points to pay for health care.  And we all know what happened when President Clinton did that.  The freshwater economists are also supposed to believe in efficient markets.  The strong stock index correlations with TIPS spreads just drove a dagger into their real business cycle theory.

PS.  Paul Krugman has a great post showing how the eurozone’s problems are even worse.

PPS.  I do think the Clinton tax increase slowed RGDP growth.  But I’d also like to think I have some common sense about the size of supply-side effects.

The myth of Volcker’s 1979 assault on inflation

Commenter Russ Anderson pointed me toward a Fed publication that discusses the Volcker disinflation:

Twenty-five years ago, on October 6, 1979, the Federal Reserve adopted new policy procedures that led to skyrocketing interest rates and two back-to-back recessions but that also broke the back of inflation and ushered in the environment of low inflation and general economic stability the United States has enjoyed for nearly two decades.

This may be technically accurate, but it’s highly misleading.  It creates the impression that Fed policy became contractionary in 1979 and that this gradually broke the back of inflation.  But this simply isn’t so; monetary policy during 1979-81 was highly expansionary, as evidenced by rapid inflation and NGDP growth.  The Fed only because serious about inflation in mid-1981, when it raised real interest rates sharply.  This immediately broke the back of inflation.  So much for long and variable lags.

The picture is complicated by two factors that seem to support the official narrative:

1.  Monetary policy was briefly tightened in late 1979 and early 1980.

2.  There was a brief recession in early 1980.

Both of those facts are true, but highly misleading.  The tight money of late 1979 was not really all that tight, and it lasted very briefly.  By late-1980 monetary policy was highly expansionary, indeed perhaps the most expansionary in my lifetime.  Only in mid-1981 did the Fed seriously commit to tight money.

The recession of early 1980 was the shortest and mildest recession of the post-war era.  And it occurred against a backdrop of deindustrialization in the rust belt, and punishingly high taxes (MTRs) on capital.  The unemployment rate rose to a peak of 7.8%, but it was nearly 6% during the 1979 boom, evidence that President Carter’s bad supply-side policies were hurting the economy.  In addition to high tax rates, we had energy price controls.

Although the recession officially began in January 1980, RGDP actually rose in the first quarter.  As late as March 1980 few expected a recession, the economy seemed to be in an inflationary boom.  Yes, the Fed raised the discount rate from 12% to 13% in mid-February, but about the same time the January CPI numbers came in at an 18% annual rate.  Gold peaked at $850 in January.  Thus in mid-March Carter put credit controls into effect to try to slow the economy and this pushed RGDP down at a 8.4% rate in the second quarter.  Soon it became clear we were in recession, and the controls were quickly phased out.  The recession was over by July, and housing and auto production recovered quickly.  Nevertheless, during the ensuing recovery unemployment leveled off in the 7% to 7.5% range, despite ultra-easy money.

I’m probably the only person who’s ever called monetary policy during 1980-81 “ultra-easy.”  This is right smack dab in the middle of the infamous Monetarist Experiment of 1979-82, the one that “broke the back of inflation.”  But facts are stubborn things.

In mid-1980 the Fed panicked at rising unemployment, and cut interest rates back into the single digits, despite 13% CPI inflation during 1980.  The result was predictable.  NGDP started recovering briskly in the third quarter.  But it was the next two quarters that were truly astounding; during 1980:4 and 1981:1, NGDP grew at an annual rate of:






That, my folks, is easy money.  I can’t even recall a faster rate over six months, although I don’t doubt there were some.  Think about how NGDP was “recovering” at just over 4% during 2010, and how the Fed huffed and puffed and pushed NGDP growth up to . . . 3.4% so far this year.

Yet this hyper-charged growth in AD did not significantly reduce unemployment.  Believe it or not, 7% was probably the natural unemployment rate by 1981.  It is not true that tight money cost Jimmy Carter the election.  His poor supply-side policies combined with his neglect of inflation produced a high misery index on election day.  That would have happened with or without Volcker.

In 1981 Reagan took over and supported Volcker’s fight against inflation.  By mid-1981 the Fed got serious, and real interest rates began rising sharply.  NGDP growth plunged into the low single digits.  During the recovery Volcker did allow relatively rapid NGDP growth, but not enough to re-ignite inflation.  Once RGDP growth leveled off, NGDP growth also slowed.  The recovery was also helped by Reagan’s good supply-side policies, such as much lower MTRs, energy price decontrol, and a tough stance toward public sector unions.  For the first time in my entire life the US began growing faster than most other industrialized countries.

So the 1979 assault on inflation is mostly myth.  It was just a blip in the ongoing Great Inflation, which didn’t peak until early 1981, when NGDP growth peaked.  Only in mid-1981 did the Fed get serious about inflation, and the results were almost instantaneous.  CPI inflation during Sept 1980- Sept. 1981 was 11%, over the following 12 months it plunged to less than 5%.  NGDP growth from 1981:3 to 1982:4 was at only a 3.4% annual rate.  Why did almost everyone get it wrong?  Because almost everyone believes in long and variable lags.  And many people focus on nominal interest rates.  And because it makes a good story.

PS.  You might ask if monetary stimulus today might lead to disappointing results, just like in 1980-81.  The answer is no, for reasons I’ll explain in the next post.

A critique of the “credit economy” hypothesis

Tyler Cowen recently linked to a post by Ashwin claiming that the US might now be a credit economy, and that this weakens the old quantity theory of money.  This hypothesis is based on two misconceptions.  Here Ashwin quotes Alex Leijonhufvud:

The situation that Wicksell saw himself as confronting, therefore, was the following. The Quantity Theory was the only monetary theory with any claim to scientific status. But it left out the influence on the price level of credit-financed demand. This omission had become a steadily more serious deficiency with time as the evolution of both “simple” (trade) and “organized” (bank-intermediated) credit practices reduced the role of metallic money in the economy. The issue of small denomination notes had displaced gold coin from circulation and almost all business transactions were settled by check or by giro; the resulting transfers on the books of banks did not involve “money” at all.

If we were moving to a credit economy then the demand for currency and base money would be declining.  But it isn’t, indeed it is higher than in the 1920s.  Admittedly this is partly due to the Fed’s decision to pay interest on reserves.  But even the currency component of the base is larger than in the 1920s, even as a share of GDP!  It is not true that the various forms of electronic money and bank credit are significantly reducing the demand for central bank produced money.

Here Ashwin quotes Claudio Borio and Piti Disyatat:

The amount of cash holdings by the public, one form of outside money, is purely demand-determined; as such, it provides no external anchor. And banks’ reserves with the central bank – the other component of outside money – cannot provide an anchor either: Contrary to what is often believed, they do not constrain the amount of inside credit creation. Indeed, in a number of banking systems under normal conditions they are effectively zero, regardless of the level of the interest rate. Critically, the existence of a demand for banks’ reserves, arising from the need to settle transactions, is essential for the central bank to be able to set interest rates, by exploiting its monopoly over their supply. But that is where their role ends. The ultimate constraint on credit creation is the short-term rate set by the central bank and the reaction function that describes how this institution decides to set policy rates in response to economic developments.

This is a common misconception, especially among Keynesians and MMTers.  It is true that central banks often set a short term interest rate target, and that once this target is set short run changes in the base are endogenous.  But if that’s all they did then the price level would become indeterminate.  Instead, they use their monopoly control over the base to move interest rates around in such a way as to target the price level.  Because money is neutral in the long run, a given change in the monetary base will produce a proportional long run change in the price level and NGDP.  Borio and Disyatat did acknowledge that rates are adjusted to target macro goal variables, but they failed to see the implication of that observation.

This can best be explained with an analogy.  In 1973-74 the OPEC oil cartel decided to increase the price of oil from $3 to $10 a barrel.  At the new price, quantity supplied was completely demand determined, OPEC responded passively to consumer demand at that new price point.  OPEC had no short run control over the supply of oil.  But that’s not at all what economists think is “really going on.”  OPEC was able to raise prices by virtue of its ability to sharply reduce would oil supply.  When we teach this in class, we show a leftward shift in the world oil supply curve.  Or we might show a monopoly diagram with OPEC picking the output point where MR=MC.  In either case, they are only able to control prices by controlling quantity.  Indeed they could have even decided not to set an official price, and instead merely set a sharply reduced output level—the effect would have been the same.

When the Fed eases monetary policy we generally notice them cutting their fed funds target.  But the exact same effect would occur if they simply increased the base, and let the fed funds rate fall in the free market.  Indeed they basically tell their trading desk to adjust the base as need to keep market rates at a desired level.  But it doesn’t have to be that way—they could just as well tell the New York trading desk to adjust the base as needed to keep CPI futures contract prices at a 2% premium over the spot level.  In that case no one would say; “the Fed controls the CPI by controlling the CPI.”  They’d say; “the Fed controls the CPI by adjusting the amount of base money in circulation.”  Today people say; “The Fed controls the CPI by controlling the fed funds rate.”  In fact, they control the CPI by controlling the size of the monetary base in such as way as to produce a monetary base and interest rates that are expected to lead to 2% inflation.

There will probably always be money; a pure credit economy is unthinkable.  Without money there is no price level, because the price level is defined as the average price of goods in terms of money.

PS.  Some might object that a higher proportion of currency is now held overseas.  But nothing in the QTM requires currency to be held in the country where it is produced.  Double the currency stock and the price level will double, ceteris paribus, regardless of where currency is held.