Archive for March 2012

 
 

Yup, it’s your father’s recession, and your grandpa’s too.

Karl Smith recently posted this graph showing the inverse relationship between real wages and durable goods sector hours worked:

He also inverted the real wage series, to make it easier to see the correlation:

Remember how conservatives used to mock that old NYT headline?

Prison Population Soars Despite Lower Crime Rates

I had a sudden vision of a puzzled reporter remarking:

Workers choose to work fewer hours, despite higher real wages.

Of course real wages aren’t the best indicator, wages/NGDP works better when you have supply shocks.  But it’s good enough for the period Karl Smith examined, and it was good enough when I investigated the 1930s:

Recessions are actually pretty simple.  Nominal wages are sticky.  So when NGDP falls you get fewer hours worked.  Of course this isn’t true of all recessions—on occasion an asteriod impact will reduce hours worked by 10%.  But not very often.

PS.  The recent tsunami had no apparent impact on the Japanese unemployment rate.

PPS.  Nick Rowe has done a number of posts arguing that recessions are almost inevitably due to monetary disequilibrium.  Here’s his latest.

PPPS.  David Beckworth has a very good post showing why the Fed should welcome higher long term interest rates.

The mouse that roared

One of my best commenters is called “Britmouse.”  He frequently helps me to better understand what’s going on with the UK economy.  Now he has a new blog, and came out with both guns blazing in his first post:

The Office for National Statistics’ current data on quarterly UK nominal GDP growth in 2008 is as follows, at Seasonally Adjusted Annual Rates:

  • Quarter 1: 4.3%
  • Quarter 2: -1.7%
  • Quarter 3: -5.2%
  • Quarter 4: -3.4%

That collapse in nominal spending has no precedent in the data, and is certainly worse than anything since the 1930s. . . .

Let’s review the Bank of England’s base rate decisions during the first three quarters of 2008:
  • January: Bank Rate left at 5.5%
  • February: Bank Rate lowered to 5.25%
  • March: Bank Rate left at 5.25%
  • April: Bank Rate lowered to 5%
  • May: Bank Rate left at 5%
  • June: Bank Rate left at 5%
  • July: Bank Rate left at 5%
  • August: Bank Rate left at 5%
  • September: Bank Rate left at 5%

.  .  .  During September 2008, Lehman Brothers failed. In October, already well behind the curve, the Bank of England dramatically cut the base rate to… 4.5%.

That’s far worse than the Fed.  In the US the downturn in NGDP occurred a bit later, and the rates during this period were much lower.  The entire post is worth reading.

In another post he points out that both Labour and the Conservatives could have raised the inflation target (or switched to NGDP targeting) whenever they wished.

(A note to those who call for a higher inflation target: HM Treasury, not the Bank, has the legal power to change the specific interpretation of “price stability” at any time; there would be no need even for Parliamentary approval. It is easier to change the inflation target than to change the fiscal budget!)

Some commenters have argued that Bush and Obama shouldn’t be blamed for the recession, as they don’t control Fed policy.  The British case suggests this isn’t the real problem; rather the passivity of the executive branch represents either ignorance about monetary policy or fear of being labeled “inflationistas.”  If it’s fear of bad publicity, this strongly supports the argument I made in my National Affairs article; the strongest argument against inflation targeting is that the public has no idea what it is, and will resist attempts to intentionally raise the inflation target during adverse supply shocks.

Here he describes the new NGDP data for Britain:

For the year as a whole we have an estimate of 3.1% NGDP growth against a 2.3% deflator:

In my view that means Britain has serious problems on both the supply and demand side.  However the inflation numbers are biased by a VAT increase in early 2011.

Britmouse also criticizes Wren-Lewis’s advocacy of fiscal stimulus.  Because I went a bit overboard bashing a Wren-Lewis post a few months back, here I’ll say some good things about him.  Here is Wren-Lewis:

A rather better argument (see the first comment on this post) is that if fiscal policy had not tightened in 2010, the Monetary Policy Committee (MPC) of the Bank of England would have raised interest rates in 2011. In the Spring of that year, 3 of the 9 members voted for an interest rate rise from the zero bound floor level of 0.5%. If the economy had been stronger because of less austerity, would two or more committee members have switched sides, leading to an increase in UK interest rates?

A think it is far from clear that they would. Inflation was high in part because of the result of those austerity measures. VAT was increased from 17.5% to 20% at the beginning of 2011, which probably added around 1% to inflation in 2011. You could argue that as this was always going to be a temporary influence, it was neither here nor there as far as MPC decisions were concerned. I think this would be a little naive. One of the major concerns of MPC members around that time was the loss of reputation that the MPC might suffer if inflation got too high, and here I think the actual numbers mattered.

I’ve always conceded that fiscal stimulus that shifts SRAS to the right might work under certain conditions.  Those conditions would be a central bank that targets inflation out of either stupidity or public pressure.  In Britain they call these policymakers “inflation nutters.”  Examples of this sort of fiscal stimulus include employer-side payroll tax cuts and VAT cuts.  This is a supply-side policy that works through short run wage and price stickiness, and shouldn’t be confused with supply-side policies that work in the long run by changing incentives.   Here’s another interesting Wren-Lewis post:

Last and not least, the Chancellor should instigate an immediate investigation into the possibility of replacing the inflation target by a nominal GDP target. There is a significant amount of evidence, from the Great Depression and more recently, that expectations of rising prices can provide a strong stimulus to demand. A nominal GDP target, suitably constructed, could help generate those expectations.

With Britmouse, we have another excellent market monetarist blog.  It is gratifying to see all the interest in market monetarism, particularly in the Anglophone and Nordic countries.

Paul Krugman recently had this to say:

On the academic side: look, to a first approximation nobody ever admits being wrong about anything. But my sense is that a lot of younger economists are aware, even if they don’t dare say so, that freshwater macro has been a great embarrassment these past four years, and that liquidity-trap Keynesianism has done very well. This will affect future research; it will, over time, break the stranglehold of decadent Lucasian doctrine on the journals.

I believe that “liquidity-trap Keynesianism” is one of the major causes of the Great Recession—it contributed greatly to the monetary policy passivity.  It’s been an abject failure.  But I agree with Krugman’s deeper point.  This recession will lead younger economists to rethink the conventional wisdom.  I’ve recently been doing a lot of speaking at other colleges, and I’m seeing lots of interest in the ideas of market monetarists among grad students.  I also get many emails from macroeconomics students all over the world.  I’ve recently received two different emails from textbook writers who plan to add market monetarism to their EC101 texts.

In my view the major battle going forward in mainstream macro will be between those who favor monetary policy rules as a demand-side stabilization tool, and those who favor fiscal stimulus.  On the fringes you’ll have the MMTers, the Austrians, the RBC-types, etc.  But they’ll never have much influence, because they don’t offer (stabilization) policy advice that is taken seriously in the halls of government.

Update: I forget to mention Nicolas Goetzmann’s excellent work in France.  Here’s the abstract of a piece he wrote for Atlantico:

Dans son discours du 17 mars, François Hollande annonce son intention de réformer la BCE. Cette dernière devrait selon lui agir selon un double mandat afin de contenir l’inflation tout en soutenant la croissance. Derrière la promesse électorale, quelles implications politiques réelles ?

Google translate:  “In his speech on March 17, Francois Hollande announced its intention to reform the ECB. This he said should act according to a dual mandate to contain inflation while sustaining growth. Behind the campaign promise, real policy implications?”

A note on the financial crisis of 1929

There was no financial crisis in 1929.

Mark Thoma links to a very interesting series of graphs, which show how quickly countries recovered from various financial crises.  A few caveats:

1.  Countries like Korea and Hong Kong were seeing their trend rates of RGDP growth slow at about the time of the 1997 crisis, as they were quickly approaching rich country levels of RGDP per capita.  This makes it look like they failed to recover, when in fact they recovered just fine.  This is probably true in many other cases as well.   I hope Rogoff and Reinhart took that into account.

2.  One of the graphs has two serious mistakes:

The blue line needs to be shifted one year to the left, as the pre-Depression RGDP peak occurred in 1929, not 1930.  More seriously, the financial crisis occurred in 1931, not 1929.  So relative to the blue line, the vertical “start crisis” line needs to be shifted three years to the right.  That makes a big difference.  The US economy had fully recovered from the 1931 financial crisis by 1936, even though it didn’t recover from the Depression itself until 1941.

Oddly, Robert Hall made a similar mistake in the opening sentences of an important JEP paper published in 2010:

The worst financial crisis in the history of the United States and many other countries started in 1929. The Great Depression followed. The second-worst struck in the fall of 2008 and the Great Recession followed.

Three mistakes in three sentences.  How does stuff like that get past the editor?

Markets are market monetarists

Stock and Watson have a new paper that provides support for the market monetarist view of the recession:

First, a combination of visual inspection and formal tests using a DFM estimated through 2007Q3 suggest that the same six factors which explained previous postwar recessions also explain the 2007Q4 recession: no new “financial crisis” factor is needed. Moreover, the response of macro variables to these “old” factors is, for most series, the same as it was in earlier recessions. Within the context of our model, the recession was associated with exceptionally large movements in these “old” factors, to which the economy responded predictably given historical experience.

This is what we’ve been saying all along.  The massive decline in NGDP after mid-2008 was by far the worst demand-side shock since the 1930s.  A severe recession would have occurred after such a shock even if there had been no financial crisis at all.  They don’t attribute all of the decline to monetary policy, but that’s probably because of the way they identify monetary policy: the fed funds rate.  In 2003 Ben Bernanke pointed out that the fed funds rate is not a reliable indicator of monetary policy, and suggested that aggregates such as NGDP and inflation are “the only” reliable indicators.  If you average those two indicators, then 2008-09 was the tightest money since the Great Depression.  Had Stock and Watson used that indicator, they would have blamed the Fed for almost all of the Great Recession.

Stock and Watson correctly noted that the slow recovery in RGDP is partly due to a slowdown in labor force growth.  However that doesn’t explain the sharp rise in unemployment, which is the distinctive feature of the recovery.  In addition, it doesn’t really explain the slow growth in NGDP, another factor in the slow recovery.  But they are right that if the labor force was still growing at the peak rates of the 1960s to 1990s period, then the recovery would have been better in RGDP terms (although not in terms of the unemployment rate.)

Here’s Tyler Cowen:

The paper itself can be found here (pdf). By the way, for market monetarists, equity markets seem to agree.  Stock and Watson, of course, are two of the most technically accomplished macroeconometricians.  This is further evidence “” perhaps the most thorough empirical paper on the topic to date “” that the Great Recession has been about the interaction of cyclical and structural forces.

The second sentence had me a little confused.  Tyler had just quoted some material from Stock and Watson pointing to the structural factors in the slow recovery.  This is certainly consistent with market monetarism, as we do not think monetary stimulus can magically increase the trend rate of labor force growth.  But it has no bearing on the slow recovery in the unemployment rate.  In addition, I don’t see the link in the second sentence as providing any meaningful evidence that equity markets agree with Stock and Watson (although I’d guess they do, as Stock and Watson are probably right about the slower trend growth rate.)

Tyler’s link is to a Sober Look post, which shows that current P/E ratios are currently below the 10 year average.

The equity markets are pricing in a significantly slower growth for most of the world than we’ve experienced in the past decade.

A few observations:

1.   What is actually being forecast is future expected profit growth, which has been only loosely correlated with economic growth during recent years.

2.   FWIW, experts on stock prices such as Robert Shiller argue that stocks are hugely overvalued.  I don’t agree, but I find it odd that the experts can’t agree on whether stocks are hugely undervalued or overvalued on a P/E basis

3.  The US has experienced roughly 3% trend RGDP growth for more than a century, and wildly volatile P/E ratios.  This makes me wonder whether P/E ratios are a useful predictor of changes in trend RGDP growth.  I.e., all the previous wild swings in P/E ratios have failed to predict any sustained and significant shift in trend RGDP growth.

4.  Having said all of that, I do buy Tyler’s conclusion, but don’t see the connection to market monetarism.

Part 2:  Why wasn’t the recession far worse?

I recall that in the past Tyler has argued the recession was about 1/3 nominal shock and 2/3 real shocks (or perhaps monetary/structural, I don’t recall the exact terminology.)  It seems like he sees the Stock and Watson paper as providing at least some support for this view.  I don’t agree.

Let’s suppose Tyler was right, and that the recession was 2/3 real.  In that case the unemployment rate would have risen by about 2/3 as much as it did, even in the absence of any nominal shock at all.  Thus if the Fed had kept NGDP from growing at 5% throughout this period, we still would have had a pretty severe recession.  At this point some real shock proponents will rebel, insisting that NGDP fell partly as a result of the real shock.  That may be true, but it’s beside the point.  We are interested in the independent effect of each shock.

Consider a medical analogy.  Suppose someone with lung cancer gets pneumonia, and then dies of pneumonia.  How could we separate the impact of pneumonia and lung cancer, as cancer often triggers pneumonia?  The best way would be to treat a group of lung cancer patients with an antibiotic that prevents pneumonia. If (as I suspect) they would have eventually died of lung cancer in any case, then it’s reasonable to see the lung cancer as the more important factor in the cause of death.

If I’m right that NGDPLT can prevent serious declines in NGDP, then the key counterfactual for the structuralists is to come up with a plausible estimate of how bad the recession would have been with the real estate bust/banking crisis, but without the fall in NGDP.  In my view we might not have had any recession at all, or at worst a very mild recession.

Here’s the problem with the structural argument.  If 2/3 of the recession was due to real factors, then monetary factors would have caused at worst a very small increase in unemployment, maybe 1.7% points of the roughly 5 percentage point increase.  That would be milder that any post-WWII recession.  But we know for a fact that the nominal shock was by far the worst since the 1930s.  So if we are to take seriously the structural view, we’d have a bizarre situation where a massive negative nominal shock, which by itself should have caused a severe recession, miraculously failed to produce any sort of big increase in unemployment.  How did we get so lucky?

Remember, it doesn’t matter why NGDP crashes; falling AD will always reduce short term growth.  If it crashes because Mexican drug lords hoard lots of Federal Reserve notes, and the Fed doesn’t increase the monetary base to accommodate that demand, then we get a severe recession.  Note that there is no direct real effect of drug lords on our GDP, just the indirect effect of tightening monetary policy.  A financial crisis is both a monetary and a real shock.  It disrupts credit allocation, hurting credit-intensive industries, and it indirectly causes the Fed to lose control of NGDP (due to their foolish interest rate targeting approach.)  Both hurt the economy, but the part of the damage due to lower NGDP is not miraculously less bad just because there are real problems too.

If you are stabbed with a knife soaked in pneumonia bacteria, the direct damage from the knife itself isn’t mitigated by the bacteria on the blade.  Suppose the knife wound was of the sort that would normally kill someone.  Would we need to even consider the effects of the pneumonia germs in the post mortem?  The NGDP shock was a knife wound to the US economy severe enough, all by itself, to cause the current recession.  A priori, I’d expect the banking crisis to have made things even worse, but I see almost no evidence that it did.  If it did reduce RGDP, why wasn’t the recession far worse?  The NGDP decline already explains the severity.

But it’s even worse for the structuralists, far worse.  The banking crisis itself was roughly two thirds caused by the fall in NGDP expectations.  So if there’s no nominal shock, then the real shock is also much smaller.  Thus whatever small part of the recession is real, is itself 2/3rds caused by the fall in NGDP.  That makes the real part of the recession extremely small.

The Sober Look post provided one data point for the US recession (of dubious relevance.)  Fortunately, there many other stock market data points in support of market monetarism.  As David Glasner and others have discovered, the stock market “rooted” for more inflation after 2008, but much less so before 2008.  Another study found they rooted against higher inflation during the Great Inflation.  All these market responses are consistent with the argument that stocks do best with steady 5% NGDP growth.  And recently stocks have responded strongly to even small hints of modest monetary easing, which refutes those who argue monetary policy is ineffective in a liquidity trap.

The stock market hates the RBC model, and it’s equally contemptuous of the post-Keynesians who say the Fed is out of ammo.  It’s not surprising that the markets are market monetarist, as my views of macro were largely developed by watching how markets responded to the massive and hence easily identifiable monetary shocks of the interwar period.  That’s why I never lose any sleep at night worrying about whether market monetarism will ever be discredited; I know the stock market agrees with me.

“This is a policy and not an expedient.”

Here’s Noah Millman discussing NGDP targeting:

A variety of much more knowledgeable commentators than I have been making the case for some time that the primary cause of our lingering economic difficulties is that the Fed has been too tight with money. Scott Sumner is probably the best exponent of this view, and of the view that a change in the Fed’s policy framework is necessary to address this problem effectively for both the short and long term (if the Fed targeted NGDP rather than following some version of the Taylor rule, he argues, the policy responses during both the Great Recession and the Great Inflation of the 1970s would have been more correct), and he’s won support from both the left and the right for his views – which makes sense because, from the left’s perspective, he’s making an argument for higher inflation and for placing a higher priority on reducing unemployment versus protecting the interests of asset-holders, while from the right’s perspective he’s articulating a policy alternative that could actually address our economic problems without increasing spending or the scope of involvement of the Federal Government in the economy (as a Keynesian fiscal policy would be likely to do).

But the implicit assumption behind a call to shift to NGDP targeting is that we know what the long-term growth potential of the economy is. But what if we don’t?

He has this exactly backwards.  Yes, we do not know the potential output level.  But that’s exactly why we should replace the Taylor Rule (which requires such knowledge) with NGDP targeting, which does not.

Millman’s essay is entitled “Is our economy too broken for the Fed to fix it?”  In a recent post I argued that the Fed should not try to “fix problems.”  It should aim for steady 5% NGDP growth, level targeting, regardless of whether inflation is negative 20% or positive 20%.  The Fed shouldn’t even be estimating potential output, it’s job is to control nominal aggregates like NGDP.

Because I’ve often criticized Fed policy in recent years, I think many readers assume I view the Fed as a sort of toolkit that can fix problems.  That was Fed policy during the Great Inflation, and it of course ended up doing more harm than good.  Here’s Franklin Roosevelt in October 1933:

Some people are putting the cart before the horse. They want a permanent revaluation of the dollar first. It is the Government’s policy to restore the price level first. I would not know, and no one else could tell, just what the permanent valuation of the dollar will be. To guess at a permanent gold valuation now would certainly require later changes caused by later facts.

When we have restored the price level, we shall seek to establish and maintain a dollar which will not change its purchasing and debt-paying power during the succeeding generation. I said that in my message to the American delegation in London last July. And I say it now once more.

Because of conditions in this country and because of events beyond our control in other parts of the world, it becomes increasingly important to develop and apply the further measures which may be necessary from time to time to control the gold value of our own dollar at home.

Our dollar is now altogether too greatly influenced by the accidents of international trade, by the internal policies of other Nations and by political disturbance in other continents. Therefore the United States must. take firmly in its own hands the control of the gold value of our dollar. This is necessary in order to prevent dollar disturbances from swinging us away from our ultimate goal, namely, the continued recovery of our commodity prices.

As a further effective means to this end, I am going to establish a Government market for gold in the United States. Therefore, under the clearly defined authority of existing law, I am authorizing the Reconstruction Finance Corporation to buy gold newly mined in the United States at prices to be determined from time to time after consultation with the Secretary of the Treasury and the President. Whenever necessary to the end in view, we shall also buy or sell gold in the world market.

My aim in taking this step is to establish and maintain continuous control. This is a policy and not an expedient.

In the end FDR did not achieve his goal, partly because of bad advice from his staff.  But at least he understood the proper role of monetary policy—level target a nominal aggregate that you believe will promote macroeconomic stability.  (Of course I prefer NGDP to prices.)

Stable money does not magically eliminate real shocks to the economy, there will still be periods of “stagflation.”  Rather it prevents the monetary authority from making those problems even worse.

Arnold Kling suggests that many Keynesians and monetarists don’t understand that monetary policy is not a panacea:

Another monetarist, Scott Sumner, argues that the worst monetary policy deviations came not before the crisis but afterward. In his view, the issue is less the Fed’s earlier looseness and more the Fed’s excessive tightness in 2008 and ever since. .  .  .

Neither stubborn Keynesians nor stubborn monetarists see a need to take into account financial markets or structural unemployment. Instead, they take the view that any desired macroeconomic outcome can be achieved with the right fiscal and monetary policy approach.

He’s right that I don’t want to take structural factors and financial markets into account when setting monetary policy (except to the extent financial markets signal expected NGDP growth.)  I also oppose basing monetary policy on recent asteroid collisions on Jupiter.  There’s no need be defensive about about this seemingly blinkered approach to monetary policy.  The burden of proof is on those who claim that monetary policy should look at variables other than NGDP growth expectations.  The burden of proof is on those who think the Fed was correct in worrying about stock prices in 1929 despite low and stable NGDP growth.  Or who believe the Fed was correct in trying to estimate potential output in the 1970s even as NGDP showed policy wildly off course.

But Arnold is wrong in claiming that we think “any desired macroeconomic outcome can be achieved” via monetary policy (or fiscal policy.)  Real shocks will continue to cause real problems.  If an asteriod destroys 1/2 of the US, the Fed should keep NGDP (per capita) growth right on target for the other half.
I don’t have time to comment on everything I read during my recent trip, so I’ll let Tim Duy respond to Felix Salmon’s claim that debt can impact potential output:

My additional criticisms of Salmon approach is that is seems primarily a demand side story to a supply-side question. Presumably, all of the productive resources (or nearly all of them, allowing for some hysteresis effects) still exist.  The debt is just plumbing in the background that helps support the demand for those resources.  So Salmon’s story just collapses down to an aggregate demand shortfall that really has nothing to do with potential output.

BTW, I don’t deny that one can construct stories where debt indirectly affects the supply-side of the economy (although I’m not persuaded by those stories), but Salmon doesn’t even try to do that.  The reader of his column is apparently supposed to follow his logic without any explanation.  I’d guess that (with the exception of Tyler Cowen) almost all the readers who nod their heads in approval when reading Salmon don’t even know that his argument makes no sense without a supply-side transmission mechanism.

HT: Marcus Nunes