Archive for November 2011


Monetary regimes in your review mirror may be closer than they appear.

Here’s a new idea discussed in the Financial Times:

Nominal consumption, not nominal GDP?

Nathan Sheets, head of the Fed’s international division until August, clearly plans to enjoy his freedom as head of international economics at Citi. In a new note he proposes a fairly dramatic communications option for the Fed – setting a target for the level of nominal consumption – which is definitely not the kind of thing you’re allowed to say in public when you work at the Federal Reserve Board.

As Mr Sheets notes, the Fed has ruled out any dramatic changes to its framework for the time being, but “our view is that in the event of a sizable financial shock from Europe””or evidence that the economy was slipping into recession””the Fed would be looking for a ‘bazooka,’ and such a regime would again be considered”.

Lots of commenters were skeptical last week when I said this:

It’s now quite possible that the Fed may have to move toward NGDP targeting before they would have liked.  The Fed cannot allow another collapse of NGDP like we saw in 2009.  The cost in terms of banking distress, worsening public finances, international discord and mass unemployment is simply too great to contemplate.  I have no doubt that Ben Bernanke of all people understands this.

Perhaps the Europeans will come together and do something dramatic in the next few days.  But if not, the Fed must be prepared to hold an emergency meeting and do whatever it takes.

Commenters argued that the Fed had just decided against doing NGDP targeting.  I had no basis for claiming that it might be on the agenda.  Now a Fed insider is saying the same thing—a euro  crisis could force immediate action.

Yes, nominal consumption is slightly different from NGDP.  But once it gets to the point were we are debating which type of NDP targeting, then the game is almost over.

HT:  Christopher Mahoney, David Levey.

Good news! The world’s central banks boosted (market) interest rates

It’s much too little, but not at all too late.  (No such thing as long and variable lags.)

This morning there was a sudden jump in (Treasury) interest rates all across the yield curve (except the short end where they are pegged at near zero, and were unchanged.)

What caused this good news?  That’s simple, we had an almost perfect example of an event study.  The world’s major central banks did a coordinated easing of monetary policy this morning.

The Federal Reserve and five other central banks agreed to reduce the interest rate on dollar liquidity swap lines by 50 basis points and extend their authorization through Feb. 1, 2013.

The new interest rate has been reduced to the dollar overnight index swap rate plus 50 basis points, or half a percentage point, from 100 basis points, the Fed said in a statement in Washington. The Bank of Canada, Bank of England, Bank of Japan (8301), European Central Bank and Swiss National Bank (SNBN) are involved in the coordinated action, the Fed said.

German stock prices soared 4% on the news, and Wall Street also rose sharply.  With easier money we had a small rise in real interest rates, which mostly reflect expected real economic growth.  Inflation expectations also rose.  Of course this is all completely inconsistent with the Fed’s operating model; they think we need to lower long term rates.  And it’s also completely inconsistent with the standard IS-LM model, as interpreted by Keynesians.  But it’s completely consistent with the market monetarist version of IS-LM, as developed by Nick Rowe:

Brad DeLong’s post on John Cochrane’s upward-sloping IS curve triggered this post. But this is not about John Cochrane. It’s about why tight monetary policy may cause real interest rates to fall, if monetary policy is expected to stay tight for long enough.

The story of an upward-sloping IS curve I’m putting forward here isn’t really new. I read something roughly similar a few months back, but I have forgotten who wrote it. (It was a paper linked by a commenter on a previous post, had “Monetarist” in the title, and was written about 10 years back.)

Authors need to re-write the IS-LM model to show upward-sloping IS curves.

Market monetarism:  Describing the world as it is, not as textbooks say it is.

Update: Today’s stock market reactions understate the actual impact of monetary easing on stock prices, as some sort of move was already anticipated, and priced into stocks.

A note on eurozone money supply growth

I’m not the sort of monetarist who focuses on money supply growth rates, even though I believe changes in the money supply drive nominal aggregates.  The reason is that modern central banks tend to adjust the money supply to offset monetary demand shocks.  On the other hand I don’t regard the money supply as endogenous, because they don’t fully offset money demand shocks.  Nominal aggregates do change.

When I was about 17 I read something by Milton Friedman that had a profound effect on my subsequent development as a macroeconomist.  He was discussing the super-neutrality of money, and pointed to one exception; changes in the money supply growth rate will end up changing the rate of inflation, and hence the real demand for money.  He showed with some ingenious graphs what would happen if a central bank suddenly slowed the rate of inflation, say from 5% to 0%.  This was pre-rational expectations, so he assumed they simply slowed the money supply growth rate.  That would lower inflation and raise the real demand for money.  Now the central bank could temporarily raise the money supply growth rate to accommodate the public’s higher real demand for money, without triggering higher inflation.  But once they had satisfied the demand for higher real cash balances, they’d have to go back to the slower money growth rate, and maintain the lower rate indefinitely.  The transition period would probably involve a recession.  So it’s slower money growth, followed by a spurt of faster growth, followed by slower growth.  That’s what it looks like when the central bank shifts to a lower expected rate of inflation (or NGDP growth, as I’d prefer.)  Keep that in mind as you examine this graph, from a study by Michael Darda:

Notice how money growth slows sharply in 2007-08, then a severe recession drives interest rates close to zero, then monetary growth temporarily soars at the end of 2008, and then in recent years it settles to a new and much slower growth rate.  The “new normal” in the eurozone.

So the last 5 years show exactly the M1 growth pattern that Milton Friedman suggested (way back around 1970) that you would see if a central bank shifted to a lower trend rate of inflation.

BTW, I feel that my awareness of the super-neutrality of money inoculated me against Keynesian macro, which is what I was taught as an undergrad at Wisconsin.  I kept asking (to myself): “If there’s an AD problem, an NGDP problem, why not just increase the money supply growth rate?”  A few years later old Keynesianism was dead, as the new Keynesians basically adopted Friedman’s insight.  And if a central bank was bound and determined to resurrect old Keynesianism, there is no better way than to drive interest rates to zero and simultaneously institute labor market distortions that raise the natural rate of unemployment.

Sorry for that boring trip down memory lane, Michael Darda’s comments are much more interesting:

As the chart to the right shows, the run on Spanish and Italian debt markets began soon after the ECB began to hike rates. Now, with debt markets under immense strain and inflation expectations collapsing, the Wicksellian natural interest rate has likely collapsed to levels well below where it was this spring, meaning the ECB will have to be much more forceful in easing policy than it was in tightening it if it hopes to get in front of the curve. Taking rates down in 25-basis-point “baby steps” is highly unlikely to suffice at this point.

As we noted yesterday, market-based indicators of inflation risk in the eurozone have collapsed. This is a problem because of the real exchange rate misalignment in the eurozone (i.e., peripheral costs are high relative to core costs): The lower the rate of inflation in the core, the higher the rate of deflation in the periphery. We can see this starkly now in the behavior of German and Italian breakeven inflation spreads: As the German five-year breakeven spread has collapsed to below 1%, Italian breakeven spreads have plunged into negative territory. The ECB’s monetary errors are now creating the real risk of a deflationary collapse in the periphery, meaning that no amount of austerity would be able to balance budgets or reduce deficits.

The surge in corporate bond spreads in the eurozone now suggests that nominal GDP could plunge by 3%-6%, which would be a disaster for both peripheral and core budgets.In short, credit markets have tightened massively in the eurozone; if the ECB does not act in a resolute enough manner to offset this tightening (and, so far, it has not), then it will have to shoulder the blame for presiding over perhaps the largest monetary catastrophe since the 1930s.

And yet most pundits keep focusing on side issues, such as rising government default risk, fiscal austerity, bailouts, fiscal union, eurobonds, etc.

Macroeconomics is normally quite difficult.  When NGDP is growing at a steady 5% rate, then macro is like a plate of spaghetti; a dizzyingly complex set of interactions at various financial, economic and political levels.  But when monetary policy goes seriously off course, then macro becomes incredibly simple.  It’s the falling NGDP, stupid.

Fix that, and only the complicated problems remain!

The myth at the heart of internet Austrianism

This post is not about Austrian economics, a field I know relatively little about.  Rather it is a response to dozens of comments I have received by people who claim to represent the Austrian viewpoint.  More specifically, it is a response to the claim that the 1929 crash was caused by a preceding inflationary bubble.  I will show that the 1920s were not inflationary, and hence that there was no bubble that could have caused an economic slump which began in late 1929.

1.  Inflation as price change:  Let’s start with the obvious, the 1920s was a decade of deflation; prices fell.  Indeed the 1927-29 expansion was the only deflationary expansion of the entire 20th century.  That’s right, believe it or not the price level actually declined during the boom at the end of the 1920s.

2.  Inflation as money creation:  At this point commenters start claiming that inflation doesn’t mean rising prices, it means a rising money supply.  I think that is absurd, as that would mean we lack a term for rising prices.  But let’s assume it’s true.  The next question is; which money?  If inflation means more money, then don’t you have to say “base inflation,” or “M2 inflation?”  After all, these quantities often go in dramatically different directions.  Since the internet Austrians seem to blame the Fed, let’s assume they are talking about the sort of money created by the Fed, the monetary base.  In January 1920 the base was $6.909 billion, and in December 1929 it was $6.978 billion.  Thus it was basically flat, and this was during a period where the US population and GDP rose dramatically.  The broader monetary aggregates rose significantly, but the government didn’t even keep data on M1 and M2 until fairly recently.  No one in the 1920s thought the Fed should be targeting aggregates that didn’t even exist.

3.  Housing inflation:  There was no housing bubble in 1929, so there was nothing to burst and cause a depression.

4.  Asset inflation:  There was a stock price boom and crash, but we saw a crash of almost identical magnitude in 1987, and it had zero impact on the economy.  In any case, it would be odd to call rising stock prices “inflation,” because none of these internet Austrian commenters call falling stock prices “deflation.”  Stocks did very poorly during the 1966-82 period, yet I don’t see internet Austrians calling America’s Great Inflation a period of “deflation.”

5.  The price of gold:  Lots of modern internet Austrians focus on soaring gold prices as an indicator of inflation.  If we are going to use gold prices as a proxy, then here are the inflation rates for each year of the 1920s:  0%, 0%, 0%, 0%, 0%, 0%, 0%, 0%, 0%, and 0%.

6.  NGDP:  Ah, now we are talking.  I wish the term ‘inflation’ was used for rising NGDP, not rising prices.  And of course Hayek favored a stable NGDP.  If that’s what they mean by ‘inflation,’ then they can claim a meager victory for the 1920s, but very meager.  NGDP was (according to estimates of Gordon and Balke) $95.98 billion in the first quarter of 1920, and $100.92 billion in the 4th quarter of 1929.  That’s an increase of roughly 5% over 10 years, or about 0.5% a year.  This means NGDP per capita was falling sharply, as the US population rose by more than 15% during the 1920s.  I.e. NGDP per capita did much worse in the 1920s than it has in Japan during an 18 year period where total NGDP actually fell.  In fairness, there were sub-periods of faster NGDP growth, such as the 3% annual growth between the 1926:3 and 1929:3 cyclical peaks.  But that’s still far below average for the US, and thus I have trouble imagining how it could trigger the severe economic slump in late 1929.

And by the way, interest rates were not particularly low during the 1920s, particularly when you consider that it was a period of deflation.  So no one can seriously claim the Fed was following a low interest rate policy.

In my view monetary policy during the 1920s comes closer to the Austrian ideal than any other recent decade.  Then in the early 1930s we had deflation by almost any indicator (prices, NGDP, M1, M2, stock prices, etc) and the economy did poorly.  Too bad the Fed didn’t try to keep NGDP at $100 billion (as Hayek’s policy rule would have called for), instead of letting it fall to less than $50 billion in early 1933.

Austrian monetary economics has some great ideas–most notably NGDP targeting.  I wish internet Austrians would pay more attention to Hayek, and less attention to whomever is telling them that the Depression was triggered by the collapse of an inflationary bubble during the 1920s.  There was no inflationary bubble, by any reasonable definition of the word “inflation.”

PS.  I hope to do much less blogging in December, as I will be quite busy with various other tasks.  Of course if Europe collapses . . .

The Eurozone must not “move forward”

Suppose you are headed home and your GPS leads you down a blind alley.  A dead end.  A cul de sac.  What do you do next?  One solution would be to back out and take another route.  But the alley is narrow and hence backing out would be difficult.  So you decide to “move forward.”  Get the pick axe and shovel out of the trunk, and start demolishing the buildings that are blocking your path.

The policy elite of Europe thought it would be a great idea to have a single monetary unit for 17 different countries, which have very different policy needs.  This was to be done through the wise leadership of unelected technocrats, who would put aside all messy political calculations and focus single-mindedly on low inflation.  Unfortunately things didn’t work out, just as all previous attempts to put multiple economies into a fixed exchange rate straight-jacket eventually failed.

So do they propose abandoning the experiment?  No.  Many of the same people who brought us the euro now want to double-down on some sort of fiscal union, which might involve eurobonds.  Fiscal union would be like the euro on steriods.  All the current problems would be multiplied 10-fold.  German taxpayers would be asked pay for wasteful government programs in Greece and Sicily, even as German voters would have no say in how the money is spent. That’s a recipe for non-stop discord, for a revival of nationalism.  Recall that the taming of nationalism was the central political goal of the EU, which was created to prevent a repeat of the horrors that Europe experienced in the first half of the 20th century.

The beauty of the EU is that it’s currently a highly decentralized system, with EU spending being somewhere around 2% of GDP.  It’s sort of like the US federal government in the 1920s.  Now you might complain that the 1920s was followed by the Great Depression.  That’s right, and that’s why faster NGDP growth is a necessary condition for any sort of resolution of the debt crisis.  (I say necessary, not sufficient.)

Many people seem to be under the illusion that Germany is a rich country.  It isn’t.  It’s a thrifty country.  German per capita income (PPP) is more than 20% below US levels, below the level of Alabama and Arkansas.  If you consider those states to be “rich,” then by all means go on calling Germany a rich country.  The Germans know they aren’t rich, and they certainly aren’t going to be willing to throw away their hard earned money on another failed EU experiment.  That’s not to say the current debt crisis won’t end up costing the German taxpayers.  That’s now almost unavoidable, given the inevitable Greek default.  But they should not and will not commit to an open-ended fiscal union, i.e. to “taxation without representation.”

In addition to not being rich, Germany is fairly heavily taxed, like all other Western European countries.  If taxes were at US/Japanese/Australian levels, it might be possible to extract more revenue without killing the goose that lays the golden egg.  Even at current German tax levels it may be possible to extract a bit more revenue.  But there is certainly much less room for maneuver.

The EU must not move forward, it must move backwards.  That’s because the EU in the 1990s was a much sounder institution.  If it ain’t broke, don’t fix it.  The European Monetary System circa 1998 wasn’t broke, and should not have been fixed.

PS.  Karl Smith scolded me yesterday for my post on Keynes and stocks during 1937.  He argued that this is a very serious topic that affects the lives of millions.  I completely agree.  When I use humor it is to make a point.  I was trying to show that Keynes would have agreed with my claim that there was nothing in the so-called “fiscal contraction” of 1937 that would have led a reasonable Keynesian in early 1937 to expect a recession in late 1937.  Why is this important?  Because there were two great cognitive errors that caused our current recession.  One was made by those (mostly on the right) who didn’t see an AD problem.  The other was made by those (mostly on the left) who saw the AD problem but assumed fiscal stimulus was the best way to address the problem.  Obama was obviously in the second camp.  Fiscal stimulus is extremely weak for all sorts of reasons.  If Obama had focused on stocking the Federal Reserve Board with reliable stimulus proponents back in 2009, we might be far better off today.  Instead he completely ignored monetary policy and instead relied on ineffective policies such as deficit spending.  That’s a very serious mistake, and that mistake was the ultimate target of my post.  I left some additional comments over at Karl’s post.

I’m actually glad that Karl feels so passionately about this issue.  I wish more people felt that way.