Archive for January 2012


Nick Rowe reframes the question

One criticism of using monetary stimulus at the zero bound is that the effects depend on a commitment to do something in the future, which might not be credible.  I happen to think that’s always true of monetary policy, so I don’t find the argument persuasive.  But most people disagree with me.  Nick Rowe has an excellent post showing that fiscal policymakers face exactly the same credibility problem:

OK, so what about a temporary increase in G? Won’t that shift the New Keynesian IS curve upwards, and cause the natural rate of interest to increase temporarily? Yes and no. If you increase G from 200 to 300 today, and promise to reduce it from 300 to 200 tomorrow, that will increase AD today. But if you leave G at 200 today, and promise to reduce it from 200 to 100 tomorrow, that will have exactly the same effect on AD today. Today’s increase in G is not what causes AD to increase. It’s tomorrow’s decrease in G that causes today’s AD to increase.

Here’s the intuition. A temporary increase in G from 200 to 300 and back to 200 is identical to a permanent increase of G from 200 to 300 plus a promise to cut G by 100 tomorrow. We have already established that a permanent increase in G does nothing. Therefore the effect of a temporary increase in G is identical to the effect of a promise to cut G in future.

A decrease in future G (once the economy has escaped the ZLB) causes an equivalent increase in future C. By consumption-smoothing, that increase in future C causes an equivalent increase in current C, for a given real interest rate between today and the future.

OK. Now let’s compare monetary policy to fiscal policy at the ZLB. We can either promise to loosen future monetary policy. Or we can promise to cut future government spending. Which promise is more credible?

Hmmmmm. The answer’s not so obvious, is it?

Notice something weird? I have made absolutely no change in the standard New Keynesian model. The only thing I have done is to re-frame the question. Instead of talking about the effects of a temporary increase in government spending I am talking about the effects of a promise to cut future government spending.

I have changed the definition of doing nothing. Under the original definition, we do something now, when we increase government spending, and we do nothing in the future, when government spending just falls again, all by its little self. Under my re-definition of “doing nothing“, we do nothing now, and we promise to do something in the future, when we will actively cut government spending.

Acts of commission and ommission. Trolley problems. Stuff like that. That’s what we are talking about.

By changing the definition of “doing nothing” I have suddenly made both fical and monetary policy at the ZLB rely on the credibility of promises of future actions. The two policies are now on a par.

Now I’m going to go further, and change the definition of “doing nothing” with monetary policy.

Take the standard New Keynesian macro model, and bolt on a bog-standard money demand function. You can even make that money demand function perfectly interest-elastic at the ZLB, if you like.

It is well-understood by New Keynesian macroeconomists that if you add a money demand function it does nothing whatsoever to the model. The two models are observationally equivalent. For every interest rate reaction function there exists a money supply reaction function, and vice versa. But it lets me change the definition of “doing nothing“.

Again, a credible promise to keep future interest rates too low for too long will increase the expected future price level. That means the future nominal demand for money will be higher too. In equilibrium, money supply equals money demand, so the expected future money supply will be higher too.

A permanent increase in the money supply today is equivalent to a promise to keep future interest rates too low for too long.

Let’s see how the question looks now. The New Keynesians are asking us to believe that a promise to cut future government spending would be more credible than an actual increase in the money supply today. Really?

See how I have turned the tables, just by redefining what “doing nothing” means? All of a sudden it is fiscal policy that requires credibility of a promise of future action. Monetary policy simply requires a belief that central bank will “do nothing” in future. It won’t decrease the money supply back down again.

Roosevelt was at the ZLB. He didn’t promise to keep interest rates too low for too long. Roosevelt simply raised the price of gold. And it worked. Because people naturally assumed he would “do nothing” in future. By “doing nothing” they understood “not lowering the price of gold back down again”. It worked because people thought of “monetary policy” as “setting the price of gold”.

New Keynesian macroeconomists will be tempted to insist that monetary policy really is, is, IS, IS setting interest rates. Any monetarist could insist right back that monetary policy really is, is, IS, IS setting the money supply. And a gold bug could in turn insist that monetary policy really is, is, IS, IS setting the price of gold. That argument will get us nowhere. Nor will arguing over whether fiscal policy really is setting the level of government spending or setting the change in government spending.

It’s all in the framing. There is no reality in these matters. These are all social constructions of reality. We theorists shouldn’t be suckered into believing that our conceptual schemes are out there in the real world. Except, the conceptual schemes of real people out there in the real world are part of the reality of that world, for a social scientist. And the Neo-Wicksellian social construction of reality, in which “monetary policy” is defined as “setting interest rates”, is a damned bad reality to construct. Especially when we hit the ZLB.

A few comments:

1.  I like to see Nick Rowe get post-modern.

2.  I agree about the social construction of reality.  Nevertheless I’d like to convince people that monetary policy really is, is, IS, IS the control of NGDP expectations.  Not because it really is, but rather because no matter what monetary policymakers claim they care about, NGDP really is, is, IS, IS what they care about.  So it’s the logical way of thinking about policy.

3.  We are an NGDP futures market away from blowing interest rate-oriented monetary theory right out of the water.  Once you start targeting NGDP futures, the fed funds rate becomes about as interesting as the price of a bushel of pistachio nuts.

And then reporters can ask Bernanke; “How will your forecast of NGDP two years out change if Congress fails to renew the payroll tax cut, and WHY WILL IT CHANGE?”

PS.  My personal favorite among my posts was about framing affects, although it was quite different from Nick’s post.

We’re not even a contender

Here’s a recent post by Raghuram Rajan:

With the world’s industrial democracies in crisis, two competing narratives of its sources – and appropriate remedies – are emerging.

The first, better-known diagnosis is that demand has collapsed because of high debt accumulated prior to the crisis. Households (and countries) that were most prone to spend cannot borrow any more. To revive growth, others must be encouraged to spend – governments that can still borrow should run larger deficits and rock-bottom interest rates should discourage thrifty households from saving.

Under these circumstances, budgetary recklessness is a virtue, at least in the short term. In the medium term, once growth revives, debt can be paid down and the financial sector curbed so that it does not inflict another crisis on the world.

This narrative – the standard Keynesian line, modified for a debt crisis – is the one to which most government officials, central bankers and Wall Street economists have subscribed, and needs little elaboration. Its virtue is that it gives policymakers something clear to do, with promised returns that match the political cycle.

Unfortunately, despite past stimulus, growth is still tepid, and it is increasingly difficult to find sensible new spending that can pay off in the short run.


Attention is therefore shifting to the second narrative, which suggests that the advanced economies’ fundamental capacity to grow by making useful things has been declining for decades, a trend that was masked by debt-fuelled spending. More such spending will not return these countries to a sustainable growth path. Instead, they must improve the environment for growth.

That’s pretty depressing reading if you are a market monetarist.  The first “competing narrative” is simply inexplicable to me.  The recession was not caused by too much debt, and if it was the solution would not be more “budgetary recklessness.”

The second is slightly closer to the truth.  Growth has slowed slightly in recent decades, and my hunch is that it will slow further in future decades.  But this growth slowdown was certainly not “masked by debt-fueled-spending.”  Either we have the capacity to produce houses, or we don’t.  Whether those houses are purchased for cash or with mortgages tells us NOTHING about an economy’s PPF.  It’s impossible for an economy to produce more than it’s owners and workers can afford.  (But it certainly can consume more than its citizen’s can afford.)

There is a different argument that Rajan could have made, which would be slightly more plausible (although wrong.)  He could have argued that the slowdown in growth was masked by policies that boosted AD, pushing the economy’s output beyond the LRAS curve (i.e. above the ‘natural rate’ of output.)  But there are very good reasons why he didn’t make that argument.  It would imply that inflation should have been accelerating in recent decades, and it has actually been decelerating in recent decades.

It’s discouraging that the most plausible narrative, the one consistent with elite macro theory over the past 25 years, isn’t even a contender.  I’m referring of course to a monetary policy that let NGDP fall 9% below trend between mid-2008 and mid-2009, and which since then has grown at an agonizingly slow pace.  That’s the obvious explanation, and according to Rajan it’s not even one of the competing narratives. 

We’ve got lots more work to do.

HT:  Tyler Cowen

Are there any good arguments against the EMH?

Over the years I’ve swatted away lots of arguments against the Efficient Markets Hypothesis.  The question is not whether the EMH is “true,” how could it be?  Almost no economic model is precisely true.  The question is whether it is useful.  I find the EMH useful, and anti-EMH models to be almost completely worthless.  I’m still looking for the model that will tell me how to beat the stock market.  Just when I was starting to warm up to Shiller’s model, he missed the huge bull market of 2009-11.

Lots of academics in finance departments think you test the EMH by looking for market anomalies.  Yet even if the EMH were completely true, there should be millions of anomalies out there—roughly one million for each 20 million data correlations that one examines.  So that can’t be right.

A better idea is to see if there is evidence that others have found anomalies that are “real,” i.e. not just coincidence.  The way to test that is to see if other people have discovered actual market inefficiencies, i.e. if excess returns are serially correlated.  Yet studies show that if there are persistent excess returns to better than average mutual funds, the gains are so small, and so hard to spot, that this fact is virtually useless to the average investor.

The last stand of the anti-EMH crowd (in my comment sections) was to point to hedge funds.  They argued that only dopes invest in mutual funds, and that all the smart money goes into hedge funds, which are in turn managed by the smart stock pickers.  And they argued that hedge funds consistently earned above average rates of return, at least in aggregate, and over an extended period of time.  Now it looks like even that isn’t true:

There is no doubt that hedge-fund managers have been good at making money for themselves. Many of America’s recently minted billionaires grew rich from hedge clippings. But as a new book* by Simon Lack, who spent many years studying hedge funds at JPMorgan, points out, it is hard to think of any clients that have become rich by investing in hedge funds (whereas Warren Buffett has made millionaires of many of his original investors). Indeed, since 1998, the effective return to hedge-fund clients has only been 2.1% a year, half the return they could have achieved by investing in boring old Treasury bills.

I’ve done much better than that investing on my own.  And then there’s this:

How can that be, when traditional performance measures for the industry show average returns of 7% or so? The problem is a familiar one in fund management and is the equivalent of the “winner’s curse” that occurs with auctions (the successful bidder is doomed to overpay). Take a whole bunch of fund managers and give them an equal amount of money to invest. The managers that perform best initially will tend to attract more investors, and so will gradually become bigger than the moderate or poor performers (who will eventually go out of business).

But the manager will not perform well indefinitely. By the time a bad year occurs, the manager will be running a much larger fund. In cash terms, the loss on the expanded fund may easily outweigh the gains made when the fund was smaller. The return of the average investor will be lower than the average return of the fund.

And this:

What is true for individual funds also turns out to be true for the industry as a whole. Between 1998 and 2003 the average hedge fund earned positive returns every year, ranging from 5% in 2002 to 27% in 1999. Back then, however, the industry was quite small: overall assets only passed $200 billion in 2000.

That strong performance attracted the attention of pension funds, charities and university endowments at a time when their portfolios had been clobbered by the bursting of the dotcom bubble. They duly piled into “alternative assets” like hedge funds and private equity. By early 2008 the hedge-fund industry had around $2 trillion under management.

But that year turned out to be the annus horribilis for the hedge-fund sector. The average performance was a loss of 23%. In cash terms the loss for that single year was more than double the industry’s total assets under management in 2000, when it was still doing well. Mr Lack reckons that the industry may have lost enough money in 2008 to cancel out all the profits it made in the previous ten years.

One of my least favorite maxims is; “the market can stay irrational longer than you can stay solvent.”  I consider that to be a cop out for losers.  If the market is actually irrational, you set up a long term investment strategy to take advantage of that inefficiency.  You don’t gamble everything on one role of the dice.  There should be “anti-EMH” mutual funds that invest on the assumption of market inefficiency, and these should tend to earn above normal rates of return on long term investments.

The past five years should have been an absolute gold mine for the anti-EMH types that supposedly dominates the hedge fund industry.  Just think about it.  Shiller says stocks are way too volatile, and the US stock market has been incredibly volatile since 2007.  No need to worry about the market staying irrational for too long, the long run adjustments occurred quite rapidly.  Then we had the mother of all housing bubbles in 2006, another great opportunity for people to rake in profits from market inefficiency.  The year 2008 should have seen extraordinary profits to the hedge fund industry, with all that “irrationality” being corrected.  Instead they lost more than they’d made over the previous decade.

One guy did beat the market by betting the housing bubble would collapse, but I recently read that he’s been doing poorly ever since.  And we all know about the unfortunate stock market call by Mr. Roubini  in 2009.

The anti-EMH crowd needs to face facts.  Even the smart money can’t beat the market, except by luck.

What is there not to like about the EMH?  It’s an aesthetically beautiful theory.  It’s survived every test thrown at it.  And yet almost everyone thinks it’s wrong.  All the really cool, smart, contrarian bloggers ought to love the EMH.  I don’t get it.  Maybe intellectuals are put off by a theory that implies that the rabble are (collectively) smarter than they are.  But that’s not the right way to look at things.  The rabble all oppose the EMH.  Go to a bar and start talking to the first drunk you meet.  I guarantee he will have an opinion on where markets are going.  I guarantee he won’t say “predictions are impossible because all publicly available information is already incorporated into asset prices.”  Who are you with; him or me?

PS.  Many pundits claim the housing bubble shows the EMH is false.  This post shows why they are wrong.

PPS.  Many people claim that wild speculative bubble always lead to crashes.  This academic study shows that’s not true:

Abstract. The collapse of an investment mania usually reminds people that the phrase “This time is different” is dangerous. Recollections of this mantra then typically either state outright or at least imply that “It is never different.” However, there is at least one counterexample to this cautious view, a giant and wildly speculative investment episode that was profitable for investors. The British railway mania of the 1830s involved real capital investment comparable, as a fraction of GDP, to about $2 trillion for the U.S. today. It faced withering skepticism and criticism, much of it very reasonable, as its supposedly rosy prospects were based on extrapolation from the brief experience of just a couple of successful early railways. Yet by the mid-1840s, it was seen as a great investment success.

The example of the railway mania of the 1830s serves as a useful antidote to claims that bubbles are easy to detect or that all large and quick jumps in asset valuations are irrational.

Of course there were many countries that had housing “bubbles” in 2000-06, where prices never collapsed.

What’s wrong with Britain?

First a small point.  Why is it so hard to find NGDP data for Britain?  There’s been lots of press coverage of the 0.8% (annual rate) decline in RGDP during the 4th quarter, but I can’t find the NGDP data.  Without NGDP data, RGDP is hard to interpret.  “Never reason from a quantity change.”  Of course that doesn’t stop people from doing just that, and in fairness the most likely explanation for the low RGDP is inadequate demand.

Some are now forecasting that Britain will slip into a recession next year.  If America was expected to slide into recession next year due to insufficient demand, you’d see articles bashing Bernanke and the Fed all over the blogosphere.  I’m not seeing articles bashing the Bank of England.  Why not?

[Yes, there weren’t any articles bashing the Fed for tight money as we slid into our 2008 recession, but that was before the rise of market monetarism.  They’d never again get away Scott-free.   :)]

Perhaps it’s the stoic attitude of the British.  (“Mustn’t grumble.”)  But I am seeing article after article claiming that the coming recession is due to fiscal tightening.  I was curious to see just how tight British fiscal policy actually is, so I checked the “Economic and Financial indicators” section at the back of a recent issue of The Economist. They list indicators for 44 countries, including virtually all of the important economies in the world.  Here are the three biggest budget deficits of 2011:

1.  Egypt  10% of GDP

2.  Greece:  9.5% of GDP

3.  Britain:   8.8% of GDP

Egypt was thrown into turmoil by a revolution in early 2011.  Greece is, well, we all know about Greece.  And then there’s Great Britain, third biggest deficit in the world.

I suppose some Keynesians work backward, if there is a demand problem it must, ipso facto, be due to lack of fiscal stimulus.  If the deficit is third largest in the world, it should have been second largest, or first largest.

A slightly more respectable argument is that the current deficit is slightly smaller than in 2010 (when it was 10.1% of GDP.)  But that shouldn’t cause a recession.  Think about the Keynesian model you studied in school.   If you are three years into a recession, and you slightly reduce the deficit to still astronomical levels, is that supposed to cause another recession?  That’s not the model I studied.  Deficits were supposed to provide a temporary boost to get you out of a recession.  At worst, you’d expect a slowdown in growth.

To get a sense of just how expansionary UK fiscal policy really is, compare it to France (5.8% of GDP), Germany (1.0% of GDP), or Italy (4.0% of GDP).  Lots of people blame ECB policies for the recession, but Britain is not in the eurozone.  Outside the eurozone you have Denmark (3.9% of GDP), Sweden (zero), Switzerland (1% surplus).

Obviously there must be some problem in Britain that isn’t affecting some of its more prosperous northern European neighbors.  I suppose if you are a Keynesian you’d say that the housing/banking problems in Britain were worse, and hence you need more fiscal stimulus than Germany or Sweden.  Fair enough, but if deficits are already near the largest in the world, trailing only Egypt and Greece, you’re taking a pretty big gamble to commit to an indefinite number of years of even more massive deficits in the hope it won’t be negated by slow NGDP growth produced by the BOE.  After all, debts do need to be repaid (or at least serviced.)  And the taxes required to service the enlarged national debt will eventually impose significant deadweight costs on the economy.

In contrast, monetary stimulus is costless, and indeed improves public finances by reducing the debt/GDP ratio.  So why aren’t people demanding more monetary stimulus?  In America, my conservative commenters tell me the liberal Keynesians have a hidden agenda to boost the size of the state.  But the British government is already nearly 50% of GDP, with national health care for all.  So that can’t be the reason.  Some claim that when rates are near zero it’s impossible for the central bank to devalue its currency.  But didn’t the Swiss National Bank recently puncture that theory?

My hunch is that the BOE has gotten a pass because of fear of inflation, which was quite high during 2011.  But that would suggest Britain’s problems are supply-side, not demand-side.  Of course fiscal policies like the recent increase in the VAT also affect the supply-side of the economy, but as this Financial Times graph shows, that doesn’t seem to be the main problem:

Following the latest national accounts revisions, one worry is that the  year-on-year growth in nominal GDP in the second quarter was only 3 per cent. Low nominal growth implies semi-fixed cash variables such as public spending, borrowing and debt become a larger share of GDP when the denominator is growing slower than was expected. But that is not all, as the following chart shows.

Until the crisis, Bank of England monetary policy appears to be remarkably successful in keeping nominal GDP growth close to 5 per cent. It almost appears to be the target the Bank was following.

Then in the crisis nominal GDP plunged, but note that the fall in nominal GDP at market prices is greater than that at basic prices due to the temporary cut in value added tax to 15 per cent. Since the basic price adjustment abstracts from taxes and subsidies, the standard nominal GDP variable now stands higher than the basic price version, since it includes the rise in VAT to 20 per cent.

Strip out the VAT rise and underlying nominal GDP (at basic prices) grew by 1.9 per cent – split into 1.4 per cent inflation and 0.5 per cent growth. Worrying about inflation in this climate is crackers…

Unfortunately this data is out of date, but my hunch is that the 3rd and 4th quarter NGDP data isn’t much different.  This graph shows a big fall in NGDP producing a big recession in 2008-09, and presumably the smaller recent drop in NGDP growth will lead to a much smaller recession in 2011-12.  The FT then hints the BOE is allowing this because of a fear of inflation.

Here’s where fiscal policy really may play a role.  The VAT increase seems to have opened up a 1.1% NGDP gap between the expenditure of the public for final goods, and the net revenue received by firms.  But even gross revenue growth is falling sharply.  If the BOE was still targeting 5% NGDP growth, the VAT increase would not trigger a recession—3.9% more net revenue would probably be enough to avoid that outcome.  Instead you have the BOE sharply slowing headline NGDP growth, and then the fiscal contraction reducing net revenue by another 1.1%.  It seems the combination will be enough for a mild recession.

Keynesians are focusing on the fiscal part of the problem, but with Britain already having the third biggest budget deficit in the world, I think people need to start paying more attention to errors of omission by the BOE.  That’s the elephant in the room that almost everyone is ignoring.

And someone tell the British to start making NGDP data easier to find.  You can’t calculate RGDP without knowing NGDP, so there’s no excuse for not publishing the data.

PS.  The October 2011 FT article was entitled “A Nominal GDP Nightmare.”  Bingo.

Live by phony data, die by phony data

I frequently argue that income data is nearly meaningless.  Especially if one is interested in looking at the issue of economic inequality.  That’s why I rarely  get involved in blogger debates over inequality—my views are so out of the mainstream that I’d hardly know where to start.

But let’s say I’m wrong, and that income is an excellent indicator or economic well-being.  In that case I’d still argue that median family income is a nearly worthless indicator of how average families are doing.  I’ve spent a considerable time in all 5 income quintiles.  For instance in college, grad school, and then as an adjunct professor I had a pitifully low income.  At the time I was a fully independent adult, not carried on my parents’ tax return.  Yet it would make little sense to say I was “poor” in a socioeconomic sense, despite my very low consumption bundle.  At the other end of the age spectrum I know old people who pick up some extra money with part-time employment, and yet who aren’t really low income in a socioeconomic sense.  Poverty is one of those “I know it when I see it” conditions.

For years progressives have been pointing to the rather low median income data to suggest how poorly the American middle class is doing, as if the typical median income earner were a middle-aged family with two kids.  They’re not, as the income data mixes together all sorts of different types of households.

The problem with claiming Americans are doing poorly, is that you end up weakening the case for extensive welfare benefits.  For instance, what if the social benefits given to the “poor” exceeded the median income of the entire country?  Wouldn’t that create a massive disincentive to work?  I don’t know how often that happens in America, but it’s recently become a political issue in Britain:

A few days later, in the House of Lords, a coalition of Labour peers and Church of England bishops cited Charles Dickens and Victorian notions of the deserving and undeserving poor as they attacked government plans to restrict the welfare payments received by any one household to the median income of a working family. The rebels won, with the Lords voting to ease the benefits cap for families with many children. Their rebellion will be overturned: some three-quarters of voters support the cap.

There is a good argument against the cap, but it probably won’t work because it would require progressives to admit that the median income data they always cite is deeply misleading.  This is one of the many internal contradictions of progressivism.  By the way, even the Labour Party admits that Britain has a problem with welfare dependency:

Debates about capitalism dominate British politics. The Conservative prime minister, David Cameron, his Liberal Democrat deputy Nick Clegg, and the leader of the opposition Labour Party, Ed Miliband, have repeatedly spoken about building a fairer economy. Responding to voter anger, they talk of reining in bankers’ bonuses and pay packages for company bosses. All three agree that there is a need to curb welfare for the work-shy.

[Full disclosure:  I once lived in Britain.  I shared a flat with a guy in his late 20s who hadn’t worked in years, and didn’t seem to want to.]

PS.  Speaking of the internal contradictions of progressivism, Matt Yglesias points out that many progressives would like to see a significantly larger share of the workforce engaged in services, construction, agriculture and manufacturing.  That’s why Yglesias has become the most persuasive blogger on the left.  He understands that sectoral employment shares need to add up to 100%.

PPS.  Yes, the conservatives have their own internal contradictions, as when they cite data showing that many people are able to move from the bottom 20% to the top 20%.  I was one of those Horatio Algers stories.  But in my own mind I’ve been middle class my entire life.