Archive for July 2012


A graceless and petty reply to Tyler Cowen

No, I’m not referring to Krugman’s latest, that’s a dog bites man story. I’m referring to this post, which relentlessly nitpicks a Tyler Cowen argument with which I sort of agree.

It’s not very glorious or motivational, but here goes: the costs of inflation, within reasonable ranges, are not very high.

There are no costs of inflation.  What is widely believed to be the costs of inflation is actually the cost of excessive NGDP growth.  (Otherwise I agree.)

I am more agnostic about the gains from monetary expansion than are many of its advocates.  I think we do not know where the point of “potential output“ lies, I think sticky nominal wages (especially for new labor market entrants and the unemployed) are overrated as a problem, I doubt the ability of the Fed to make credible commitments at this point, and often I view “hiring” as more of an multi-dimensional investment and longer-term commitment, which requires various variables to be set at the right places, not just the short-run real wage in spot markets.

I agree that we don’t know where potential output is, but I don’t think that has any bearing on monetary policy, which should promote 5% NGDP growth regardless of potential output.  I also agree that sticky wages for the unemployed and new market entrants are not much of a problem (although as Paul Krugman showed with his $160,000 lawyer example a few days ago, they are a bit of a problem even for new entrants.)  But even if there was zero wage stickiness for the unemployed, aggregate wage stickiness would be a huge problem.  It’s a game of musical chairs, and given the current level of NGDP all the chairs are currently occupied by “insiders.”  As far as credibility, no fiat money central bank has ever tried to inflate and fail.  Given the massive market responses to trivial Fed and ECB signals, imagine how markets would react if they did something bold.

A bit more personally or perhaps psychologically, the contrarian in me gets nervous when I read the ongoing ritual excoriation of Ben Bernanke in the blogosphere, every time the Fed decides to take no further major action.

I get very nervous when I read the ongoing ritual excoriation of Ben Bernanke in the stock market, every time the Fed decides to take no further major action.  That’s because I believe the stock market is much smarter than me, and even a bit smarter than the wisest economist in the blogosphere.

Still, at the end of the day if we try further monetary expansion and it fails to stimulate employment, I don’t see a huge social cost to having a three or four percent rather than a two percent inflation rate.

If we’d had 2% inflation over the past 4 years, I believe the recession would have been far milder.   I don’t favor a 2% target, but we aren’t failing because the Fed is targeting inflation at 2%, we are failing because they are running 1.1% inflation at a time when the dual mandate and the Taylor Principle suggest they should be temporarily overshooting their 2% flexible inflation target.

How’s that for ingratitude!  Seriously, I believe that nitpicking over even small points is a good way of advancing the discussion.

Off topic:  Tyler complained about the following:

Let’s put it this way.  Paul Krugman is a great economist.  But of all the people in my RSS feed, in terms of his quality and skill as a reader, he is not in the top 90 percent.

It seems to me that Krugman is sort of sitting up on Mt. Olympus, occasionally throwing clever barbs at the rest of us.  The usual pattern is that we say something and then he misinterprets what we say and mocks what he thinks we said.  Then we have a rejoinder and essentially win the debate.  And then he ignores the rejoinder.  I’m not quite sure why he operates this way.  He’s a very talented debater and would win most debates.  It would be interesting to see him get off Mt. Olympus and actually engage with the blogosphere, instead of taking potshots at caricatures of the argument actually being presented.  But that’s for him to decide.

PS.  Arnold Kling has the following to say:

It would be much better if the Fed were buying less debt. But the inflationary threat, in my view, is the amount of debt being issued. What worries me is not the debt that the Fed buys today, but the debt that the Fed will be forced to buy in the future, even if inflation picks up. Eventually, the government is going to find a way to default, and high inflation is one way to do it.

I would add that if the Fed bought much more debt, then the Treasury would be issuing much less debt.  So easier money today greatly reduces the long term risk of high inflation generated by monetizing the excessive Treasury debt.

PPS.  Ryan Avent has a great post on the central importance of NGDP. Ed Dolan also chimes in.  It seems to me that NGDP is gradually becoming more widely accepted as a useful indicator of Fed policy.  As I noted in my previous post, even Krugman is now using NGDP as a way of explaining the problem.  Maybe I was unfair when suggesting he doesn’t read my blog carefully.

PPPS.  I didn’t realize until now that today would have been the 100th birthday of my favorite economist.  So I don’t have a post prepared.  My favorite Friedman comment was in response to someone asking him what sort of schools would be provided under a voucher system.  I believe he replied something to the effect; “If I knew the answer, I wouldn’t favor vouchers, I’d just instruct the public schools to operate that way.”  Sometimes people ask me what sort of QE would be necessary to hit my NGDP target.  My response is that if I knew the answer I wouldn’t favor NGDP futures targeting, I’d just instruct the central bank to set the base at that level.

Will Krugman ban the term ‘inflation?’ Let’s hope so.

Three years ago I did a post suggesting that we stop using the term ‘inflation,’ as it just causes confusion.  People wonder how higher inflation could help us.  “How are Americans better off if we have to pay $4.50 for gas?”  The problem is that there is both AS and AD driven inflation, and most people instinctively think of the supply-side inflation, which reduces the real incomes of Americans, not the demand side inflation (that Paul Krugman and I want) which raises the real income of Americans (when there is slack in the economy.)

So I prefer to talk about NGDP as my nominal/AD indicator.  Indeed if I had my way I would ban the term “aggregate demand,” and just talk about nominal and real shocks.  What we call the “AD curve” would be a rectangular hyperbola relabeled the “nominal spending curve” or NS curve.  This isn’t just more understandable, it’s also more accurate.  Krugman and I don’t want more inflation, we want more NGDP, and for any given increase in NGDP that the Fed or ECB is able to engineer, we’d actually prefer to see more real growth and less inflation.

Maybe I’m reading too much into this, but it seems to me that Paul Krugman is accepting the logic of my “ban inflation” argument, at least as a pedagogical device.  (BTW, I don’t claim that Krugman now views his inflation-centered models as theoretically unsound, just confusing to average readers.)  See what you think:

I’ve been writing for a long time about how the euro area needs more inflation. But I suspect that many readers don’t quite see how this ties into the macro story.

.   .   .

So, imagine a currency area with just two countries, Spain and Germany, which I’m going to represent in an aggregate supply-aggregate demand framework.

On demand, I’ll make two assumptions I don’t believe. The first is that the ECB can determine nominal GDP for the euro area. Under liquidity-trap conditions, this is a very problematic assumption, and I don’t mean to drop my skepticism for other purposes. For right now, however, it’s useful, I think, to use nominal GDP as a proxy for the whole range of possible expansionary policies the ECB might follow.

By assuming that the ECB chooses nominal GDP, we get an aggregate demand curve for the euro area as a whole: Py = Y, where P is the price level, y is real GDP, and Y is the target nominal GDP.

At least we’ve nudged him to start talking in terms of models he “doesn’t believe.”  Now if only we can get him to believe those models.

HT:  Mark Sadowski, who provides some other comments that are quite persuasive.

A defense of interwar macroeconomics

Gauti Eggertsson makes the following claim:

As a discipline, macroeconomics was born in response to the Great Depression, giving rise to Keynesianism; the rational-expectations revolution in macroeconomics was born in response to the great inflation on the 1970s.

I don’t wish to contest this claim, at least not directly.  I agree that the Depression led to Keynesian economics and that the Great Inflation led to the rise of monetarist/Lucasian ideas.  And there is a sense in which macro was born in the Depression.  It became a separate field with highly specialized practitioners.  But there’s also a sense in which that claim is misleading, and misleading in an interesting way.

Interwar (pre-General Theory) economists had all sorts of recognizable models of the macroeconomy.  Today many look ad hoc, but I’d argue they were appropriately ad hoc.  Here’s a couple models that form my vision of macro:

MB*V(i) = NGDP, where V is positively related to the 5 year bond yield.

I think it’s a pretty good model, even though other variables like marginal tax rates also impact V.  And I think most of the better interwar economists had a model something like this in the back of their minds.  Or take this model:

(Hours worked)/ (natural rate of hours worked) = f(W/NGDP), where high relative (not real!) wages reduce hours worked.

Again, many interwar economists assumed a similar sort of sticky-wage model.  Fisher was the most advanced; he created a Phillips Curve model in the early 192os.

In my view lots of modern macroeconomists overlook these models, as their vision of a macro model uses a general equilibrium approach, where monetary policy works through the liquidity effect and sticky prices are more important than sticky wages.  Something like IS-LM.

Because my preferred approach is similar to that of the interwar economists, I am naturally more likely to treat these early models with respect.

Evan Soltas makes the following claim about improvements in data:

In the beginning, there was no economics data. Greats like Adam Smith wrote treatises on political economy in the equivalent of near-total darkness. Later economists such as Vilfredo Pareto and Alfred Marshall introduced mathematical foundations, changing the direction of what had been a very qualitative philosophical endeavor. After the Great Depression, Paul Samuelson and John Hicks consolidated Keynes’ work into the modern field of macroeconomics — and they received critical (and I might argue significantly under-appreciated) support from econometricians and statisticians like Simon Kuznets.

Kuznets developed the United States’ program of national income accounting — from which the ubiquitous measure of GDP comes — and more broadly, he put heavy emphasis upon data collection.  That enabled empirical analysis and complemented economics’ ever more quantitative bent.

Call Kuznets’ revolution the First Generation of economics data. Much of it was low-frequency, with figures released on yearly and quarterly bases. Only some data, largely from labor markets and prices, came out with greater frequency. In large part, data was supplied from government bureaus of statistics and industry groups — a highly centralized model of collection and distribution. And the supply of data was scarce, with each figure an expensive undertaking.

I think we are approaching a Second Generation of economics data. The model is changing, a trend driven by information technology.

I spent several decades immersed in interwar macroeconomic data.  And what surprised me most was the high frequency nature of the data, and the fact that it was much more available in “real time” than modern data.  I recall during the first quarter of 2011 and the first quarter of 2012 that there was a lot of uncertainty about the macroeconomy.  Some data such as ISM numbers and employment numbers showed strong growth.  But the actual real GDP numbers (released in late April) were quite disappointing (and later revised.)  That wouldn’t have happened in the interwar period.

Christopher Hanes has shown that the interwar economy was very heavily dominated by commodities, and by manufactured goods that are not highly finished (things like steel.)  It’s not at all difficult to ascertain the contemporaneous prices of these goods, as they are often traded in auction-style markets, or at the very least (in the case of steel) are relatively homogeneous, and hence the law of one price is approximately true.  The WPI (forerunner of the PPI) was actually reported weekly, with very little lag.  Admittedly it didn’t include all prices, but it did include the most volatile prices.  Hence it did a good job of picking up surges of inflation or deflation.

The data for real output was dominated by agriculture and manufacturing.  That’s a weakness in that it ignores services, however:

1.  Agricultural and manufacturing comprised a far larger share of GDP during the interwar years.

2.  Manufacturing (including mining and utilities) was by far the most volatile part of GDP.

Put those two together and the monthly industrial production numbers gave a pretty good read on the business cycle, far better than the modern IP numbers.  And of course they were available much more frequently than our modern GDP figures.  And there was even more data available at weekly frequencies, which were highly correlated with the macroeconomy.  Steel production, and even more importantly rail shipments (at a time when most goods were shipped by rail.)

Today we are dominated by sectors like finance, consulting, health care, education, software, online journalism, law, accounting, etc, where I don’t even have a clue as to how we should measure “real output” and I don’t think anyone else does either.  Under those circumstances the monthly employment data is probability our best cyclical indicator.  Unfortunately we have two employment series, and they often diverge sharply.

When I was young I also had a sort of “Whig view of history.”  Now that I am a grumpy old reactionary, I no longer think we are evolving toward the right model of the macroeconomy, or the perfect data set.  Indeed in both areas I see us regressing, moving ever further away from the golden age of Calvin Coolidge.

The only thing that gives me hope is people like Evan Soltas and Yichuan Wang.

Let’s create a world where Cochrane, Mulligan, et al, are always right

So macroeconomics is a complete mess.  One third of all macroeconomists think the problem with the economy is structural, and more AD won’t help.  Another third think it’s an AD shortfall and that the Fed needs to fix it.  And another third also thinks there’s an AD shortfall, but doesn’t blame the Fed and/or doesn’t think the Fed is capable of fixing the problem.  I’m leaving out those who overlap, or who can’t tell us what they really think.

So what do we do when we don’t know what the hell we are doing?  The answer is pretty obvious, isn’t it?

Folks, this isn’t rocket science. . . .

We stabilize AD.  Then all the problems in society will be AS problems.  The only macroeconomists we’ll need are supply-siders.  And of course we do that by having NGDP grow at a steady rate of 5% per year.  I should be more specific, we’ll have expected NGDP grow at a 5% rate each year.  Then there will be no expected demand-side problem, hence nothing to debate.

To put it another way, we need 5% NGDP targeting to better understand our own field.  Yes, that’s right, I’m calling for experimenting with the economy, to improve the science of economics.  And I’m claiming that if we do so all the vicious fights will end.  The lions will lie down with the lambs, and the hawks and doves will stop squabbling.

How can I entertain such a utopian vision?  Because we basically did it for several decades before 2008.  And it worked fine.  The left and right stopped debating stabilization policy, and focused on long run structural issues.  I’m calling for a return to that policy; you know, the one that worked.

We need 5% NGDP targeting to fix the economy.  And we need 5% NGDP targeting to fix the economics profession.  I’m not sure which is in worse shape.

Oh yeah, I forgot about the one third who worry that fiat money central banks might not be able to debase their currencies.  The people who fear the mysterious zero bound.  OK, target NGDP futures contracts; there is no zero bound in the price of that financial asset.  Then we are done.  Economics can resume being a science, and stop being a soap opera.

I suspect we also have a Great Stagnation, and that in the future we’ll wonder why we wasted so much time on easy to solve problems like AD, and didn’t address the really hard problems like long run fiscal imbalances and tax reform.

PS.  Since Casey Mulligan was severely (and justifiably) criticized for his recent post, let me point out one criticism by Brad DeLong that went overboard:

The third joke is the entire third paragraph: since the long government bond rate is made up of the sum of (a) an average of present and future short-term rates and (b) term and risk premia, if Federal Reserve policy affects short rates then–unless you want to throw every single vestige of efficient markets overboard and argue that there are huge profit opportunities left on the table by financiers in the bond market–Federal Reserve policy affects long rates as well. Note the use of the weasel word “largely”.

This criticism addressed the following paragraph by Mulligan:

Eugene Fama of the University of Chicago recently studied the relationship between the markets for overnight loans and the markets for long-term bonds…. Professor Fama found the yields on long-term government bonds to be largely immune from Fed policy changes…

DeLong seems to suggest that the EMH tells us that a cut in short term rates should also reduce long term rates.  But that’s not true.  Monetary stimulus reduces short term rates via the liquidity effect, and raises future expected short term rates via the income and inflation effects.  There are numerous cases where a Fed announcement moves short and long rates in the opposite direction.  So it might be the case that long rate is largely unaffected by Fed engineered changes in the fed funds rate.  I haven’t studied the issue, but the claim certainly doesn’t violate the EMH.

Of course the Mulligan piece is still almost complete wrong, for all sorts of reasons.  Nick Rowe has a nice critique.

A green and pleasant land

According to Wikipedia, the Atlanta metro area has about 5.3 million people (a bit more or less depending on where you draw the boundary line.)  The population density is 243 per square kilometer (630/sq. mile.) I’d like you to contemplate the following thought experiment. Suppose Atlanta adopted a Portland-style land use plan, and didn’t allow any growth beyond the current perimeter. Let’s also suppose that over the next few decades Atlanta’s population grew from 5.3 million to 8.3 million, with all of the new residents packed into the current area.

Sounds like nightmarish hell, doesn’t it?  And yet England is not just more crowded than Atlanta today, with 1053 people per square mile it’s more crowded than Atlanta would be with 3 million more residents packed into the current metro area. And yet whenever I visit England it doesn’t seem like it’s crowded at all. Yes, London seems quite crowded, but only 8 million of the 53 million Englishmen live in London.  The rest of the country seems to be a charming set of rolling green hills, country houses, quaint villages, etc.  So what’s going on here?

One answer is that “overpopulation” is a state of mind.  England is more densely populated than China; indeed even more densely populated than the eastern half of China (where most of the people live.)  It’s more densely populated than Japan, or the Netherlands.  It just doesn’t seem that way.

Outside of Africa, the world’s population has nearly peaked (it’s 6 billion non-Africans, whereas in 100 years it’s expected to be 6.5 billion.)  Since most places are far less crowded than England, it looks like the world as a whole will never end up being particularly densely populated.  So why does it seem like it is?  Here are a few theories:

1.  Terrain:  In places that are very mountainous (China and Japan) the population will seem denser, as people will be squeezed into the lowlands.  In flat places like the Netherlands the crowding will seem worse because you will see the country in two dimensions, not three.  The ideal is a green and gently rolling countryside, which provides views in three dimensions, allowing you to see the actual size of places much more easily.  England is really big; one could spend a lifetime exploring its 50,000 sq. miles.  Instead, it is flat places the size of England (Illinois, Bangladesh, etc.) that seem much smaller than they actually are.

2.  Compact cites:  Prevents the sprawl that makes the Atlanta metro area seem more crowded than England.

3.  Wealth:  Wealth allows people more elbow room.  It’s why a one story high third world shanty town seems much more densely populated than Paris or London.  When I first visited China, the train stations seemed like the black hole of Calcutta.  Their new ones are big and spacious and airy and seemingly uncrowded.

4.  Good infrastructure:  America’s infrastructure is not quite as good as you’d expect for a country as rich as we are, and the resulting traffic makes it seem a bit more crowded than it is.

5.  Low pollution.  When there’s lots of air and water pollution (and litter) it makes the place seem overcrowded, even if only subconsciously.  That’s one reason China seems more crowded than England, which benefits from both better technology and favorable ocean breezes.

I suppose this is just a longwinded way of saying that Yglesias and Avent are right about urban policy.  Or that Europe is best.  But I’m not really anti-suburb.  There are few places on earth that offer more attractive living conditions than my current place of residence, the suburb of Newton, Massachusetts.  And I don’t think this model is unsustainable.  Suppose a carbon tax doubles the price of gasoline.  Does that force Newton residents back into the city?  You’ve got to be kidding; that’s just pocket change for them (I mean for us.)  And even if it wasn’t, most suburban residents would prefer to adapt by getting a hybrid car with double the miles per gallon, rather than give up their nice suburban neighborhoods and be squeezed into some urban apartment building.  Yes, a carbon tax would make a difference in land use at the margin, but it’s not going to be a game changer.

All this was motivated by the new English census:

PEOPLE in Britain are living longer and having more babies””and more foreigners are joining them. That is the main finding from the 2011 census results released on July 16th. The population of England and Wales is growing faster than most demographers thought, at 7.1% for the decade, thanks mainly to immigration and a rise in fertility fuelled by the newcomers. But there is another, still less expected, change: big cities that were shedding people a decade ago are growing at a terrific rate. . . .

Manchester’s population grew by 19% in the ten years to March 2011, much faster than its surroundings (see map). . . .

Are urban populations growing because people want to live in cities again or because they have to? It is a mixture of the two, says Tony Travers of the London School of Economics. Moving to London generally enhances a career because so many companies are based there and people change jobs a lot””the so-called “elevator effect”. This may just about be true of Manchester. Lately sticky jobs and housing markets have glued urbanites in place. But supply makes a difference, too. As big cities have welcomed growth in their centres, many small towns have resisted it.

This is quite different from America, where small towns are usually more welcoming of growth than big cities.  Perhaps not surprisingly New England is the area most similar to old England in this regard; many small Massachusetts towns resist growth, and Boston is growing faster than many of its suburbs.  But even Boston severely restricts growth.

PS.  The English decennial population growth wasn’t that much lower than our 9%.  Perhaps we need to revise our (American) assumptions about demographic decline in Europe.

PPS.  It’s an interesting coincidence that I grew up in an area of rolling green hills, and I spent my youth bicycling over them.  Is it actually the ideal?  Or just nostalgia on my part?  BTW, my home state (Wisconsin) is the same size as England, but has 1/10th the population.  England is actually more attractive, although I’m not sure exactly why.

PPPS.  I excluded Africa because I have doubts about the population forecasts for that continent.