Archive for April 2012


“The credibility of the ECB is one of the few things left.”

No, this is not an old news article from the 1930s, it’s from today’s Financial Times:

A political backlash against fiscal austerity left mainstream French and Dutch politicians struggling on Monday to shore up support as a key economic indicator highlighted the eurozone’s slide into deeper recession.

François Hollande’s first round victory in the French presidential elections – which raised fears of renewed wrangling over the eurozone’s economic strategy – and the collapse of the Dutch government, after a clash over fiscal policy, hit financial markets.

The heightened political uncertainty sent European stock markets tumbling and put pressure on French and Dutch sovereign debt, while Germany’s government bonds benefited from inflows from spooked investors.

Economic fundamentals also appeared to deteriorate as purchasing managers’ indices for the 17-country eurozone showed private sector economic activity had contracted unexpectedly sharply this month, dashing official hopes of an early return to growth.

The composite index covering manufacturing and services fell for a third consecutive month to 47.4 points in April, the lowest reading for five months. A figure below 50 indicates a contraction in activity. That pointed to an intensification of a recession which started in the final three months of last year, when the eurozone debt crisis was at its most intense. Economists had expected a modest improvement.

In the Netherlands, one of the eurozone’s most fiscally disciplinarian governments collapsed as Mark Rutte, prime minister, tendered his government’s resignation at a meeting with Queen Beatrix, clearing the way for elections. That sent the euro down to $1.3105 against the dollar, a session low. In France, the Socialist Mr Hollande’s first-round victory was accompanied by a surge in support for the far-right National Front.

And here’s how the ECB responds to the collapsing Eurozone economy:

Mario Draghi, European Central Bank president, has struck a distinctly gloomy note on eurozone growth prospects, dropping previous references to a gradual recovery this year.

.   .   .

He played down the prospects of the ECB reactivating its government bond-purchasing programme. The central bank had to stick to its “primary mandate” of combating inflation and not breach the European Union ban on “monetary financing” – central bank funding of governments. “The credibility of the ECB is one of the few things left,” he said.

Let’s do a survey.  What’s more scary:

1.  That the head of the ECB said this.

2.  That the head of the ECB doesn’t seem aware of the irony in what he is saying.

While campaigning for re-election in 1932, Herbert Hoover bragged that although the economy was looking a bit weak, voters could take comfort in the knowledge that his adroit leadership had preserved the dollar/gold peg.  Soon after, that old regime was swept away by a political and economic tsunami.

Read Paul Krugman and then read this:

I just read Paul Krugman’s NYT article on the Fed.  It’s a good article and I’ll have lots to say about it when I can free up some time.  If you want to suffer from a severe case of mental whiplash, read Krugman first and then read the following article by Eijffinger and Mujagic from Foreign Affairs:

Regardless of who wins the 2012 U.S. presidential election, President Barack Obama will end his first term having decisively shaped U.S. monetary policy for at least the next two decades. Thanks to a stroke of lucky timing — the Federal Reserve Board happened to have an unusually high number of vacancies during the president’s first term — Obama will have either appointed or reappointed every single one of the seven members of the Federal Reserve’s Board of Governors, including its chairman, Ben Bernanke, by the end of 2012. With the governors each set to serve a 14-year term, they will ensure Obama’s long-term impact on the U.S. economy.

Bernanke was originally appointed board chair by President George W. Bush in 2006. In 2010, Obama reappointed him until 2014. Even if Obama or his successor stripped him of that role, he will continue to sit on the board until 2020. Janet Yellen, the economist and vice chairman of the Fed board, whom Obama appointed in April 2010, is set to serve until 2024. Daniel Tarullo, a professor of law at Georgetown University whom Obama appointed to the Fed board in January 2009, is not scheduled to step down until 2022.

Two of the other governors, Elizabeth Duke and Sarah Bloom Raskin, who are not Obama appointees, will serve until 2012 and 2016, respectively. That means Obama will certainly be able to reappoint or replace Duke and might be able to do the same with Raskin, locking in his picks until 2030. Finally, the two last seats on the board are currently vacant because Obama’s nominations have been held up in the Senate. If those two are appointed this year, they will stay at the Fed until 2026.

BTW, I read this quotation three times, and I still don’t have a clue as to what they are trying to say.  Did Obama appoint Raskin, or didn’t he?

Because of grading I may be very slow to respond to comments.

What Ben Bernanke can learn from Humpty Dumpty

“When I use a word,” Humpty Dumpty said, in rather a scornful tone, “it means just what I choose it to mean””neither more nor less.”
“The question is,” said Alice, “whether you can make words mean so many different things.”
“The question is,” said Humpty Dumpty, “which is to be master — that’s all.”

Paul Krugman recently made the following claim:

The shared starting point here is that we are in a situation in which the Fed would clearly cut rates if it could; based on historical relationships between unemployment, inflation, and policy rates, the Fed funds rate “should” be something like -4 percent. But the Fed can’t do that.

I think that’s probably right, although I doubt the Fed would cut rates by 400 basis points, even if they were able to.  But why not cut the fed funds target?  The conventional answer is that it “wouldn’t do any good, as nominal rates can’t fall below zero” (or even below the IOR rate, if you want to be picky.)  That’s true, but while there’s a lower bound on the actual fed funds rate, there’s no lower bound on the fed funds target.

Before you assume I’ve completely lost my mind, I strongly suggest readers take a look at this provocative Nick Rowe post:

The natural rate of interest is not a number; it’s a time-path. And the central bank doesn’t observe that time-path, so when it sets the actual rate it will almost always miss the natural rate time-path. And when the economy is off that time-path, that will cause the time-path to shift. Because expectations will change. And because reality will change too, as investment changes and capital stocks (understood in the broadest sense to include human capital and the stock of employment relations) change too. So, while useful as a theoretical concept, the natural rate of interest is perhaps not so useful as a practical guide to monetary policy as the Neo-Wicksellian approach requires.

Which is perhaps why all of us, central banks especially, should stop framing monetary policy in terms of interest rates. Setting interest rates is not what central banks really really do. It’s a social construction of what they do. When central banks talk about setting interest rates that is only a communications strategy, and not a very good communications strategy, especially at times like this.

[Update: Tom Hickey asks: “So monetary policy boils down to central bank communications leading to expectations?

My response: That’s 99.9% of it, yes!

So cutting the fed funds target to negative 4% isn’t quite as good as cutting the actual fed funds rate to minus 4%, it’s only 99.9% as good.  In other words, it’s like cutting the actual fed funds rate by 3.996%.  I’ll take that!

By now many of you are looking for the flaw in my argument.  You won’t find it.  At least you won’t find a flaw in the logic.  Instead you’ll plunge down a rabbit hole into the endlessly paradoxical world of monetary policy.  A world where it’s not at all clear what the Fed “really does.”  Does it control the money supply, control interest rates, or control NGDP expectations?  Where it’s now believed that what really matters is the expected future path of policy, and current policy decisions work primarily by changing expectations of future policy.

Almost everyone now agrees that during normal times a temporary $10 billion dollar open market purchase will temporarily reduce short term interest rates.  And almost everyone believes that if the OMP is expected to be reversed in one month, it will have almost no impact on the macroeconomy.  And almost everyone agrees that if the OMP is permanent it will result in roughly 1% higher prices and NGDP in the long run.  The implication of all this is that current monetary policy actions matter, if at all, by changing expectations of future monetary policy.

Assume that during normal times the Fed sees indications that NGDP will grow at slightly less than the desired rate of 4.5% over the next 12 months.  They might respond with a cut in the fed funds target, which the markets take as a signal that the Fed intends to do what it takes to boost expected NGDP growth back up to 4.5%.  Some conceive of that action as lowering the expected future path of rates relative to the natural rate, other see it as raising the expected future money supply.  But the key is expectations—if you don’t change expected future policy, you aren’t going to significantly impact the macroeconomy.

The program called “QE2” consisted of the Fed exchanging an interest-bearing risk-free government liability called excess reserves for another interest-bearing risk-free government liability called Treasury securities.  One can make a pretty good argument that this program “didn’t do anything” in a narrow technical sense.  But nonetheless markets responded in the following fashion:

1.  Equity prices rose on the news.

2.  Inflation expectations rose on the news.

3.  The dollar depreciated on the news.

That’s quite a bit of activity for a program that “didn’t do anything.”  Of course it did do one thing—it communicated something about the Fed’s determination to do whatever it takes (over a long period of time) to prevent the economy from slipping into deflation.

Nick Rowe has argued that once rates hit zero the Fed loses its ability to communicate, at least in its preferred language.  I’ve accepted that argument, and to some extent I still do.  But not completely.  I now think that the Fed should have developed a back-up plan for how to operate at the zero bound, how to communicate policy intentions.  At one time I thought they had (partly based on my reading of Bernanke’s academic work.)  Now I can see that they don’t have any coherent strategy, and are just making it up as they go along.

I strongly believe that interest rates are the wrong policy instrument.  But most people disagree with me.  Even when the Fed does QE, they justify it as an action that will reduce long term rates.  They seem completely unable to communicate to the public in any non-Keynesian language.  OK, then why not keep talking Keynesian?

Here’s my suggestion:  If the Fed is committed to communicating in terms of the fed funds rate, why not continue to have the Fed set a “shadow fed funds target.”  The proposal would work as follows.  The FOMC would continue to meet every six weeks and vote on the fed funds target that would be most effective in communicating their macro policy goals.  For instance, this might be the number that results from the Taylor Rule formula.  No consideration would be given to whether this was a positive or negative number.  Then the Fed would announce the target, and instruct the New York trading desk to get as close as possible (which would be zero, or perhaps the IOR rate.)

In my view this policy would be a disguised form of semi-level targeting.  This will require some explanation, as most people are used to thinking in terms of growth rate targeting.  But first a digression on policy since 2008.

In the opening quotation Paul Krugman overlooks one weakness in his argument.  The fed funds target was above zero during the entire collapse of NGDP from June to December 2008.  This collapse is best seen using monthly NGDP estimates from Macroeconomics Advisers:

This might be viewed as a policy error, perhaps partly due to lags, partly due to backward-looking policy, and partly due to the mistaken belief that the banking crisis was the “real problem” and that saving banking was the key to preserving NGDP growth.  But whatever the cause, the Fed had three choices.  Try to go all the way back up to the pre-2008 trend line (level targeting.)  Try to go part way back (semi-level targeting.)  Or start a new trend line from the 2009 trough (growth rate targeting.)  They actually chose the latter option, although it’s not clear if this was intentional, as the Fed is highly secretive about its NGDP policy goals.)

Once rates hit zero, the most effective Fed actions were steps that would communicate the policy goal.  In practice, they’ve behaved as if they were doing growth rate targeting.  (Let bygones-be-bygones and go for 4.5% NGDP growth from the 2009 low.)   But it’s certainly possible that they would have preferred semi-level targeting, i.e. going at least part way back to the original trend line.  I strongly suspect Bernanke would have preferred faster NGDP growth, but it’s hard to read the overall FOMC because it includes members that seem to use a non-mainstream macroeconomic framework, and hence talking about the “FOMC view” requires rather heroic assumptions.

Under my plan the 2010 meeting that led to QE2 might have gone as follows:  The FOMC meets and sees that NGDP growth is slower than they’d like.  They vote to cut the shadow fed funds target by 1/2%, from negative 2.75% to negative 3.25%.  This sends a signal to the markets that the Fed will engage in future policy actions to raise NGDP slightly faster than the markets previously expected.  Interestingly, that’s exactly how monetary policy works in normal times, or at least that’s 99.9% of how it works.  The other 0.1% is that a small change in the fed funds rate over just the next 6 weeks actually affects a few investment decisions.

For those readers from the “concrete steppes” who have trouble visualizing how a purely symbolic fed funds target can impact the macroeconomy, you might try the standard Keynesian explanation.  The Fed is known to move slowly and methodically, it’s highly inertial.  If the fed funds target falls from minus 2.75% to minus 3.25%, then it pushes the date where rates are expected to rise above zero out further into the future.

(BTW, I don’t see that as being the mechanism, rather I see it “working” by increasing the future expected level of cash in circulation, but I’m in the minority.)

OK commenters, now’s your chance to tell me what an idiot I am.

PS.  I’d pay a lot of money to see Ben Bernanke start quoting Humpty Dumpty next time he testifies in front of Congress.

Update: I see from the comments that people are missing the point–probably because I tried to get too cute.  Here it is:

1.  During normal times the Fed communicates its NGDP intentions (or weighted average of inflation plus output gap, if you prefer) with fed funds target signals.  During January 2001, September 2007, and December 2007, the equity markets immediately swung plus or minus 4% to 8% over Fed decisions about whether to cut rates by 1/4% or by 1/2%.  To put it bluntly, the markets don’t give a s*** what the fed funds rate is over the next 6 weeks, they care about these anouncements because the Fed is signalling its future intentions for NGDP.  Yes, it would be easier if they would explicitly tell us where they want to go, but they won’t.

2.  The Fed wrongly thinks it’s communicating by changing the fed funds rate, but the markets are responding to the fed funds target, and what that tells us about the future path of monetary policy.

3.  Because the Fed wrongly thinks the actual fed funds rate over the next six weeks is what is important, they wrongly believe they have gone “mute” once rates hit zero, they don’t think they are able to communicate with the markets.

4.  But they haven’t gone mute, the actual fed funds rate over the next 6 weeks is an epiphenomenon of monetary policy, it’s the fed funds target that signals the actual (long run) policy.  They can use that target to signal future policy intentions regardless of where the actual fed funds rate is, as long as future interest rates are expected to rise above zero.  (If they aren’t expected to then the government should just monetize the national debt.)

5.  If they thought about things correctly, in a Nick Rovian way, they’d realize they had never really lost their voice, they just thought they had.

6.  If they insist on talking interest rate talk, then don’t stop talking once rates hit zero!

The WSJ channels Rothbard

Mark Spitznagel published the following in the Wall Street Journal:

In the 20th century, the economists of the Austrian school built upon this fact as their central monetary tenet. Ludwig von Mises and his students demonstrated how an increase in money supply is beneficial to those who get it first and is detrimental to those who get it last.

This is not correct. If I sold some bonds to the Fed at market prices, I would not benefit.  An unanticipated monetary injection helps debtors and hurts creditors, by raising the price level and NGDP.  However, during the past 3 and 1/2 years inflation has been lower than any time since the mid-1950s, and NGDP has grown at the slowest rate since the 1930s, so obviously that’s not an issue right now.

As Mises protégé Murray Rothbard explained, monetary inflation is akin to counterfeiting, which necessitates that some benefit and others don’t. After all, if everyone counterfeited in proportion to their wealth, there would be no real economic benefit to anyone. Similarly, the expansion of credit is uneven in the economy, which results in wealth redistribution. To borrow a visual from another Mises student, Friedrich von Hayek, the Fed’s money creation does not flow evenly like water into a tank, but rather oozes like honey into a saucer, dolloping one area first and only then very slowly dribbling to the rest.

It is akin to counterfeiting, but the counterfeiter is the federal government, who earns inflation tax revenue, and the victims are the holders of non-interest bearing currency, who see its purchasing power fall.  But the recent injection of “money” is mostly interest-bearing reserves, so the government is not gaining from “counterfeiting,” rather it is exchanging one interest-earning asset for another.  In any case, Rothbard’s point actually disproves the previous assertion.  It’s not who gets it first that gains; it’s who sells it first, after producing the currency at near-zero cost.

The Fed doesn’t expand the money supply by uniformly dropping cash from helicopters over the hapless masses. Rather, it directs capital transfers to the largest banks (whether by overpaying them for their financial assets or by lending to them on the cheap), minimizes their borrowing costs, and lowers their reserve requirements. All of these actions result in immediate handouts to the financial elite first, with the hope that they will subsequently unleash this fresh capital onto the unsuspecting markets, raising demand and prices wherever they do.

Here the author is confusing increases in the monetary base that accommodate increases in the demand for liquidity, with exogenous increases in the money supply that drive up prices via the hot potato effect.

The Fed, having gone on an unprecedented credit expansion spree, has benefited the recipients who were first in line at the trough: banks (imagine borrowing for free and then buying up assets that you know the Fed is aggressively buying with you) and those favored entities and individuals deemed most creditworthy. Flush with capital, these recipients have proceeded to bid up the prices of assets and resources, while everyone else has watched their purchasing power decline.

Milton Friedman said ultra-low rates were a sign that money has been tight.  Spitznagel suggests monetary policy has been very expansionary.  Given the very low inflation over the past three and a half years, it’s pretty obvious who’s right.  It’s too bad the Wall Street Journal has abandoned the ideas of Milton Friedman.  In a few years their predictions will look rather silly.

HT:  Dilip.   Paul Krugman also has some comments.

Market monetarism goes mainstream

Back in early 2009 two key market monetarist ideas were very much out on the fringe.  One is the claim that the huge output gap was due to excessively tight money, caused by Fed incompetence.  The second was the claim that interest rate targeting is fatally flawed, and is part of the problem.  Consider this recent article written by Matt O’Brien at the Atlantic:

It got me thinking: How much is a good central banker worth? Consider this chart. The blue line shows where our economy could, and should, be if it had kept growing at its long-term trend since 2008. The red line shows where we actually are. The difference between the two is the so-called output gap. (Note: These dollar figures are not adjusted for inflation).

We’re in about a trillion-dollar hole. And that’s a trillion dollars every year. Even if we get “Morning in America: The Sequel” and the economy rapidly reverts to its long-term trend, we’ll forever be $4 trillion poorer than we would have otherwise been.

Let’s try a thought experiment. Say that Lars Svensson — one of the world’s top monetary economists and the current deputy governor of Sweden’s central bank, the Riksbank — could get our economy back to trend in half the time Ben Bernanke could. It’s actually plausible-ish. Like Bernanke, Svensson spent his academic career championing unconventional monetary policy as a “foolproof” way to escape a liquidity trap. (Coincidentally, they were colleagues at Princeton). But unlike Bernanke, Svensson’s Riksbank has been much more willing than Bernanke’s Fed to experiment with these kind of heterodox policies. Perhaps unsurprisingly, Sweden’s recovery has been the envy of the developed world. So I ask again: How much is a good central banker worth? Put simply, how much cash should we throw at Svensson to steal him away from Sweden?

That’s another way of asking how long it will take the economy to return to trend. Here’s where things get really depressing. According to Fed Vice Chair Janet Yellen, we won’t get back to full employment until after 2018. If we assume the output gap will steadily shrink until then, that leaves us with roughly another $4 trillion in lost income. Maybe more. If Svensson really could double our recovery speed, he’d be worth $2 trillion to us. Even if that’s being wildly optimistic, something on the order of hundreds of billions of dollars probably isn’t. Tell me that wouldn’t be worth paying Svensson a billion dollars a year. Maybe more.

Here’s what I said three years ago:

So let’s imagine an FOMC with the above 4 members [Bernanke, Svensson, Woodford, Krugman], plus a bunch of other distinguished monetary economists; say people like Mishkin, Mankiw, Rogoff, Hall, McCallum, James Hamilton, etc.  I don’t want any inflation hawks or inflation doves; I want people who call for tight money when tight money is needed and easy money when easy money is needed.  And most importantly, nobody who believes monetary policy is ineffective in a liquidity trap.  (Yes, I’m talking about Janet Yellen.)

Here’s my hypothesis.  A committee made up of these 10 people would have been far more likely to adopt a highly expansionary monetary policy once the scale of last fall’s crash became apparent.  There’s enough intellectual firepower there to understand the threat of rapidly falling NGDP, and also the need for policy credibility.  I think they would have been able to coalesce around something like the 3% inflation trajectory (level targeting) proposed by Mankiw in his blog.

Monetary policy is incredibly complex.  You have to look at issues from a lot of different perspectives.  My fear is that even fairly bright people may get stuck in an intellectual rut, looking at policy from just one perspective.  Good isn’t good enough, bright isn’t bright enough, we need people who are extremely bright, but also have the kind of mind that allows them to see the problem from different angles.

And here’s another hypothesis.  Monetary policy may be the only important policy area where this is true.  In other areas like health care, we don’t let a bunch of “wise men” (and women) make important decisions, rather we let Congress and the President decide.  (Go ahead, insert a joke here.)  The Supreme Court might be the closest parallel, but a mistake by the Supreme Court generally won’t create a worldwide recession, or depression.

.   .   .

I don’t care how much is costs, even if we have to pay FOMC members a billion dollars a year, we will save much more money in the long run if we can get “strong” central bankers (pun intended) who have the vision to see what needs to be done, and who understand that effective policies require explicit target paths for macro aggregates.

When I wrote that I never expected this sort of idea to go mainstream.

Nick Rowe sent me a recent Matt Yglesias post from

I say all this, I note, not to argue that we need to scrap paper money. The point is that it’s very bad for the Fed to have a policy rule [interest rate targeting] that breaks down in moments of severe crisis. It’s like having an umbrella that dissolves in water. We either need to run a background level of inflation that’s high enough to avoid zero bound episodes, or else shift the policy lever to something that’s not effected by these issues.

And here’s what I wrote a few days ago:

But interest rate targeting (which underlies all of New Keynesian economics) has been an unmitigated disaster for American workers.  And given that rates are likely to frequently hit the zero bound in future recessions (as trend productivity growth and population growth both slow) NK policy will fail us again and again in future recessions, i.e. when we most need it to be effective.  Our current monetary regime is roughly like a car with a steering wheel that works fine””except when driving on twisting mountain roads with no guard rail.  (emphasis added.)

I like the steering wheel metaphor better, as I see the Fed steering the nominal economy.

In three years market monetarism has moved from the fringes to mainstream publications like The Atlantic and Slate.

PS.  If this keeps up Lars Svensson’s going to start asking “where’s my billion dollars?”  If the titans of finance deserve the big bucks for efficiently allocating capital, what about the people who actually steer the macroeconomy?