Karl Smith recently quoted me and then responded:

Scott writes

“The new GDP figures offer a reminder that one can’t analyze movements in GDP by looking at components of GDP.  We saw huge increases in spending on cars (pushing consumer durables up by 15.3%) and houses (up 19.1%.)  And yet overall RGDP growth fell to only 2.2%.  Why didn’t the spending on cars and houses help?  Because in the short run it’s NGDP growth that drives RGDP.  And the Fed continued its tight money policy by allowing only 3.8% NGDP growth, same as the previous quarter.”

If the Fed had a strict NGDP target and everyone knew what it was the Scott would be correct. However, if either the Fed doesn’t have a strict target or we don’t know what it is then Cars and Houses are causal or informative, respectively.

This is because Cars and Houses pull harder on NGDP more than most sectors of the economy. If we think of the Fed trying to influence NGDP indirectly – through the interest rate or some other mechanism – then this would imply that an exogenous negative shock to the purchase of cars and houses would tend to lower the demand side pressure on NGDP and so the Fed would need to loosen its indirect target to keep NGDP growth constant. Conversely and exogenous positive shock would raise demand side pressure on NGDP and the Fed would need to tighten its indirect target to keep NGDP growth constant.

In the comment section Matt Rognlie agreed:

Indeed. I love Scott Sumner, but sometimes the fixation on NGDP goes overboard. It’s true that an NGDP level target might be a very good rule for the Fed to follow, but unfortunately we’re not operating under an NGDP level target or anything close to it. In practice, we’re close to a barely-flexible inflation targeting framework.* And in that environment, the dynamics of consumer spending matter a great deal.

I love Matt and Karl too, but I don’t quite agree with this.  I actually wasn’t assuming the Fed was targeting NGDP, although I can see how they would have made that assumption.  Rather I assumed that Fed policy determined NGDP, if only through errors of omission.

Now I suppose you could make an argument that car and house output would have an impact on NGDP, given the Fed’s operating procedure.  But I think that very unlikely.  For instance suppose they target inflation, which is probably not all that far from current policy.  In that case the Fed shifts AD to offset any change in AS, and hence car and house output only boosts NGDP if it shifts AS to the right.  That could happen, but it seems unlikely to me.

Suppose we make an even weaker assumption, such as money supply targeting.  Now it’s much easier to tell a story where car and house output boosts NGDP.  These products are usually bought on credit, as they are essentially investment goods.  So more demand for these products tends to raise interest rates, and also velocity.  That would boost NGDP under money supply targeting (or interest rate pegging–via a bigger money supply.)

But even then I’d defend the broader point I was trying to make here.  In Q1 we saw big increases in cars and houses, and yet very little growth.  So either the effect didn’t occur at all, or these sectors prevented what would have otherwise been a big fall in NGDP.  In either case, I don’t see where those sectors help us to predict where we go next.

On this point I’m quite prepared to backtrack, if the evidence cuts the other way.  We have a thriving industry in “leading indicators.”  I’m pretty sure that stocks and the yield spread have been shown to have significant predictive power.  I doubt the various sectors of GDP have much power, once you account for overall growth in GDP.  Thus I doubt that a prediction of future growth based on current growth in GDP can be substantially improved by looking at output by sector, with the possible exception of inventories.  But the evidence is out there.  If sectors are predictive, then I’m sure we would have discovered it, and they’d be in leading indicator models.

This link suggests that housing doesn’t predict GDP, but building permits do.  That makes sense to me, as I’d expect growth in building permits to be correlated with future growth in construction.

PS.  Yes, I have an unhealthy obsession with NGDP.  But our profession has the exact opposite problem, and my goal is to fix that oversight.

Matt Yglesias is back from his honeymoon, and better than ever.  But I’m not completely sold on this argument:

Here’s a fun Intrade price anomaly that showed up this morning. The markets indicate that there’s more than a 3 percent chance that neither Barack Obama nor Mitt Romney will win the presidential election. That’s clearly way too high.

Maybe, but is it possible that we underestimate the chance of something unusual happening?

1.  One of the two major candidates is assassinated, and the replacement is elected (as in Mexico’s 1994 election.)

2.  Ditto, except one pulls out due to health problems, or scandal.

3.  A third party candidate comes out of nowhere to get elected.

To be sure, I view all of these as being very unlikely.  But 3% is low odds.  It’s basically saying once in ever 130 years you’d expect something really weird to happen in US presidential politics during an election year.   That’s a long time!  Given all the weird things that have happened, how unlikely is it?  Some might counter that none of the three scenarios I’ve outlined have occurred in the US during an election year (my history is weak so I’m not certain.)  But mind-bogglingly unusual things have happened on occasion.  On November 10, 1972, what kind of odds would Intrade have given on neither Nixon nor Agnew being President on January 1 1975?

And no, I don’t plan on putting my money where my mouth is—I’ve already placed my wager on the same candidate I bet on in 2008.

In my study of the Great Depression, I argued that the Depression could be seen as resulting from governments doing too little, or too much.  In a laissez-faire world the Great Depression would not have happened, nor would it have happened if governments took as much responsibility for AD stabilization as they do today (and even that’s a really low bar!)

In blog posts on the Great Banking Crisis I argued it wouldn’t have happened if the government had done much more regulation, or much less regulation.  If they had abolished FDIC, TBTF, and the GSEs, banks would have taken far smaller risks.  But given they didn’t abolish those generators of moral hazard; they should have banned mortgages with less than 20% downpayments made with funds from FDIC-insured banks.

Tyler Cowen quotes this comment from Ryan Avent:

The euro-zone must recognise that it is the failure to build appropriate euro-zone-wide institutions””equal in scope to the considerations and resources of the central bank””that is contributing to soaring yields around the periphery and creating the illusion of the need for dramatic austerity in places that could do without it.

Maybe, but I’d argue exactly the reverse.  It was the success in building inappropriate euro-wide institutions, specifically a central bank, that created the crisis.  Ryan might agree, but then the question becomes how to get out of this mess.  Matt Yglesias says the solution is easy.  I only see one easy solution, monetary stimulus.  And even that won’t really solve the problem, just make it much smaller.  The other solutions, breaking up the euro or fiscal union (i.e. much more centralization or much less), are currently politically impossible.  Of course, one must be careful in dismissing ideas as politically infeasible, as the current path of Europe is likely unsustainable, which means  in the future they may well adopt a policy that is currently “politically infeasible.”

After commenting on Avent, Tyler discussed the ECB, and then made the following observation:

On top of all that, arguably the deflationary pressures in Greece, and possibly Spain, are already past the point of control from the ECB side, given the ongoing collapse in private lending.

The most recent inflation rate in Greece is 1.7%, whereas Spain has 1.9% inflation.  I don’t know about you, but I find those figures to be astounding.  That’s not deflation, and yet Tyler’s clearly right that they are being buffeted by powerful deflationary forces.  I’d make several observations:

1.  This shows the poverty of our language.  Economics lacks a term for falling NGDP, even though falling NGDP is arguably the single most important concept in all of macro, indeed the cause of the Great Depression.  So we call it “deflation” which is actually an entirely different concept.  I wouldn’t be the first to find connections between the poverty of our language and the poverty of our thinking.

2.  Through experience I’ve learned that whenever a data point seems way off, there are probably multiple reasons.  Thus Greece and Spain probably have less price level flexibility due to structural rigidities in their economies.  And the inflation might be partly due to special factors like increased VAT or higher oil prices.  Nonetheless, these sorts of depressions would have been associated with falling prices in the 1930s, so it’s not your grandfather’s business cycle.

Tyler has a new post:

Recently accepted wage cut for new project, ngdp will go up not down. I am helping to manufacture ngdp, people get with the program.

What did *you* do for nominal gdp today? Just asking.

In a recent post I argued that falling wages were a really bad sign.  Some commenters thought I opposed wage cuts.  Just the reverse, if we are stupid enough to let NGDP fall, wage cuts are an excellent idea.  I want wage flexibility at the micro level, and a monetary policy that produces stable wage growth at the macro level.  If the central bank targets inflation, wage cuts will even boost NGDP.

And what did I do for NGDP today?  I used blogging to press more FOMC members to support NGDP targeting.  Thanks for asking.

At least I think that’s what Raghuram Rajan is saying:

In fact, today’s economic troubles are not simply the result of inadequate demand but the result, equally, of a distorted supply side. For decades before the financial crisis in 2008, advanced economies were losing their ability to grow by making useful things. But they needed to somehow replace the jobs that had been lost to technology and foreign competition and to pay for the pensions and health care of their aging populations. So in an effort to pump up growth, governments spent more than they could afford and promoted easy credit to get households to do the same. The growth that these countries engineered, with its dependence on borrowing, proved unsustainable.

Rather than attempting to return to their artificially inflated gdp numbers from before the crisis, governments need to address the underlying flaws in their economies.

So it’s 50% demand shortfall. Given that NGDP growth since mid-2008 has been the lowest since Herbert Hoover was president, I’d say it’s more like 70% demand-side, at least in the US.  But let’s put that issue aside.  I agree with Rajan that we have a huge demand-side problem.  The question is what to do about it.  Rajan seems to be saying “nothing.”

1.  No one I know is claiming that we should target the pre-2008 RGDP trend line.

2.  If borrowing is the problem, leisure (i.e. unemployment) isn’t the solution. Rather we need to work harder in sectors determined by market forces, not governments.

3.  Elsewhere Rajan focuses on how attempts to reflate spending might lead to wasteful projects.  That argument may apply to fiscal stimulus, but I can’t see how it would apply to monetary stimulus aimed at boosting NGDP, which did not involve buying unconventional assets.

I’m not as negative on this piece as some on the left.  I agree that recessions are great times to do long term structural reforms.  But millions are needlessly unemployed right now due to the demand shortfall that both Rajan and I think is massive.  Why leave them hanging while we are going about our structural reforms?  I read the entire essay and could find no persuasive answer to that question.

PS.  I also find it interesting that Tyler Cowen says we need some additional monetary stimulus, but keeps raving about essays that take the opposite position.  In one sense that reflects well on him, he is well known for having the unusual ability to look past things that annoy him and find gems of wisdom in papers that may also be highly flawed.  But I’m not going to let him off the hook on this one:

Every paragraph of his piece is excellent,”

Does that include the paragraphs where he argues against monetary stimulus, despite the demand shortfall?

PPS.  There are times where Rajan seems to equate easy money and easy credit.  And he teaches at the school that Milton Friedman made famous!

Right before I got into blogging I started reading James Hamilton.  He was a sort of inspiration to me; he kept his head as the world around him seemed to be losing its mind.  My favorites were his posts mocking the idea of a “liquidity trap” the idea that a fiat money central bank would somehow be unable to “debase it’s currency” when rates hit zero.  Now he seems to have gone over to the other side, as his new post is very skeptical of whether the Fed could hit a higher inflation or NGDP target.  And yet the reasons provided seem based on macro theory that was discredited long ago.  More specifically, he seems to have become one of what Nick Rowe calls “the people of the concrete steppes.”

These academic critics would like to see the Fed announce more aggressive targets in the form of either higher rates of inflation or faster growth of nominal GDP. I will get to the issue of these targets in a moment, but first would like to discuss the mechanical details of what, exactly, the Fed is supposed to do in the way of concrete actions in order to ensure that any such announced target is achieved.

Recall that current Fed actions that are mechanical in nature have almost no impact on prices, output, or any other macro aggregate.  The effect of monetary policy, if it is effective at all, comes mostly from signaling future policy intentions.  In the comment section Nick raises this very point:

If a (say) 5% NGDP level path target (with a catch-up step) were credibly communicated, all those “mechanical” and “concrete” “logistics” would have to be implemented very quickly, only in the exact reverse direction. The Fed’s balance sheet is far larger than it would need to be if people expected 5% NGDP level path. The more ambitious the target, the easier the logistics.

And here’s how Hamilton responds:

Nick Rowe: Not sure I’m following your argument. I gather your claim is that the announcement itself would solve the problem. If so, I’m skeptical about that assumption. I am just looking at the mechanics of what the Fed would do right now, with numbers and the situation such as we have, in order to boost nominal GDP growth. And my answer is, it would have to do more buying of securities, leaving bigger concerns than those we have right now as to how later the Fed is going to go about undoing those positions.

Hamilton has it exactly backwards.  Countries with lower expected NGDP growth than the US (like Japan) have higher base to GDP ratios.  Countries like Australia which have faster expected NGDP growth (and thus avoided the zero rate bound) have lower base to GDP ratios (indeed only about 1/4th US levels.)  Nick’s right that a policy of faster NGDP growth would require the Fed to reduce the monetary base.  I’m surprised that Hamilton finds this a novel argument.  He’s one of the best scholars of the Great Depression, and is well aware of what happens to base demand in a depressed economy with near zero interest rates.

In the comment section a number of commenters confronted him with his earlier quotations mocking the idea that the Fed would be unable to boost inflation.  (Read comments by Anon1, and Andy Harless.)  And his response was as follows:

Anon1: Not sure I understand your point, either. I claimed then and still claim today that the Fed has the power to prevent deflation.

But the quotation provided by Anon1 doesn’t just say the Fed has the power to prevent deflation, he also claims it has the power to create inflation.  If Hamilton is right that there is no contradiction, then I humbly suggest that almost everyone must be completely misinterpreting his current message.  (It would be interesting to know how Tyler Cowen interprets the post, which he calls “superb.”)

Let me first acknowledge that it is very possible I have misinterpreted either Hamilton’s earlier posts or his current post.  And yet I can’t help thinking about the large number of  elite monetary theorists who seem to have changed their views since before the recession, while strongly denying any change.  The most famous example is of course Ben Bernanke.  The most amusing example is Frederic Mishkin, who keeps changing his textbook in ways that make current Fed policy look less bad.  Why the changes?  What scares me is that I fear some economists think that recent events in the US cast doubt on the effectiveness of monetary stimulus, whereas in fact they confirm that effectiveness.

Hamilton also makes this odd claim:

And the way I see current U.S. monetary policy is exactly as Bernanke defended it at a recent press conference. I believe the Fed has effectively and credibly communicated that it is not going to allow the U.S. to repeat Japan’s experience of deflation or extremely low inflation. Deflation is the exact opposite of the potentially chaotic flight from dollars that I described above, and deflation would unquestionably be counterproductive for the U.S. By drawing a line at keeping inflation above 2%, I think the Fed can use its limited available mechanical tools in a credible way to achieve an appropriate goal.

This seems to imply that Bernanke is promising to keep inflation above 2%, but the reverse is more nearly correct.  Headline inflation has averaged well below 2% since mid-2008, the slowest rate since the mid-1950s.  This tight money policy has of course made the debt crisis much worse.  By mid-2010 the core inflation rate had fallen to 0.6%.  Their current forecast calls for 1.9% inflation over the next few years, suggesting 2% is more like a ceiling than a floor.  If we’d had a 2% floor the recession would have been much milder.  But it’s actually much worse than that.  Both core and headline inflation are dominated by housing costs.  The BLS numbers show housing up by about 8% since early 2006, whereas the Case-Shiller index shows prices down 32%.  Obviously the actual fall in all housing costs (including rental units) is far less than the Case-Shiller number, but nonetheless the actual CPI number is hugely distorted by mis-measured housing prices

Based on his late 2008 writings that helped inspire me to get into blogging, I’d expect Hamilton to be outraged by Bernanke’s recent statements.  The US clearly has a nominal spending shortfall.  Bernanke says the Fed can fix it, but that it doesn’t need fixing because they are close to their 2% inflation target.  What about the dual mandate?   I’m confused and somewhat dismayed by Hamilton’s support for Bernanke, and can’t find anything in this new post that would justify it.