Everyone from Paul Krugman to Steve Waldman to Yichuan Wang is giving their spin on the plunging nominal interest rates.

It’s beginning to look like Keynes was wrong about liquidity traps, at least when he argued that there’s a certain minimum nominal yield that government bond investors demand, and that long term rates can be reduced no further.  Wherever people draw a line, bond yields just seem to plunge right through, to one record low after another.  And we know from Japan that they can go even lower.  But what does this mean?

It probably means multiple things.  For instance it suggests that the Keynesian/market monetarist AD pessimists and the Great Stagnation AS pessimists are both right.  We are looking at BOTH low inflation and low real GDP growth for many years to come.  Why don’t I think AD explanations are enough?   Partly because even the 20 year T-bond now has a negative real yield. Indeed it suggests the Bernanke “global savings glut” hypothesis is also correct, a point I’ve argued previously.  Japan is the future of the world.

But I’m more interested in what it means for Fed policy.  Even if the Fed does something semi-bold on August 1st, it most likely won’t be enough to change the underlying dynamic.  And the reason is pretty basic; the Fed simply doesn’t have a grip on what went wrong.  They had a policy regime that targeted short-term interest rates as a way of targeting inflation.  Both of those decisions were flawed, and now the regime has collapsed.  Markets are saying that the Fed may never again be able to using its preferred interest rate targeting mechanism.  Let me emphasize that I still believe interest rates are more likely than not to eventually rise above zero.  But these low yields are consistent with a non-zero probability of the US essentially becoming Japan.

This reminds me a lot of the end of Bretton Woods.  When Bretton Woods collapsed the central banks of the world were in a completely new policy environment, with the price level having no nominal anchor.  It took them a decade to figure this out, and come up with a new policy regime that could operate in a world with no gold price peg.  When they finally did it was something close to the Taylor Rule.  And its was actually a pretty decent monetary policy regime, as long as short term nominal rates were not zero.

But if they were zero, then things got much trickier.  Now it was only a workable policy regime if the rate was expected to rise above zero in a reasonable period of time.  In that case, the Fed could do a sort of Woodfordian policy, steer the economy by making explicit or implicit promises about what circumstances would lead them to raise interest rates.

Unfortunately, it turns out the Fed was too conservative, too cautious, to adopt the Woodfordian policy.  They weren’t willing to commit to a future path of the price level or NGDP.  Instead they simply hoped that things would somehow get better.  And although I’ve been pretty harsh in my criticism, let me express a tiny bit of sympathy.  The rate of nominal GDP growth in the US over the past 3 years has been above 4%, which is considerably higher than in Japan.  I would have thought that might well be enough.  (The fact that it wasn’t makes me think Japan is light years away from exiting the zero bound.)

But things didn’t turn out as the Fed hoped.  Instead of gradually approaching the date when we would exit the zero bound, and resume normal monetary policy, that date is receding ever further out into the future.  Indeed the bond markets are now signaling that there’s a non-zero risk that we’ll never exit.  Again, I think that unlikely.   But the difference between “never” and “in 27 years” is actually pretty unimportant here.  If we don’t exit for 27 years, then we are in big trouble . . . unless . . .

The Fed really needs to face up to the fact that their policy regime has failed.  It’s crashed and burned.  They are like a ship captain holding steering wheel that is detached from the rudder, blandly assuring the passengers that all is well.  In fact all is not well.  There is no steering mechanism for the US nominal economy, and no sign that there will be one for the foreseeable future.

Yichaun Wang argues that NGDP futures contracts are our only hope:

However, one form of nominal GDP targeting seems to sidestep these problems:nominal GDP futures targeting. This would allow market participants to instantly improve estimates of future inflation by bidding on futures contracts. Their bidding one way or another would immediately translate into changes in central bank open market operations such that nominal GDP always stays on track. This approach sidesteps the non-linearity of expectations because it allows the market to aggregate all the necessary information and automatically has the central bank adapt to the new found information. Even if expectations did shift in response to unforecasted shocks, the policy response would be immediate and taken in decentralized steps as individual investors bid on futures contracts. In this case, mechanics-credibility theorem is satisfied because the mechanic by which the Fed earns its nominal GDP credibility directly interacts with market expectations while avoiding the circularity problem. Market expectations of nominal GDP feed into futures market volumes, which directly changes the monetary base. The market answers the questions of “how much” with the level it thinks is “just right”.

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This is one of the key advantages of an nominal GDP futures targeting regime relative to a conventional “wait-and-see” regime. It cements in credibility, and rolls with the waves of external volatility. In a sense, it floats like a butterfly and stings like a bee. It takes monetary policy from the world of “Bernanke Smash” to “Sumner Slice”, and allows for greater accuracy and precision in the control of a central nominal aggregate: nominal GDP.

I’m more optimistic.  We aren’t going to see futures targeting in the near future, but if things get bad enough I see a slim possibility that a consensus might develop in favor of level targeting.  Then the key questions become:

1.  How much base money does the public want to hold if the future expected price level or NGDP is on target?

2.  And is the Fed willing to supply that much base money, or do they consider it too risky?

The key question is not whether some desultory gesture by the Fed will “work.”  It won’t.  We already know that.  It’s a question of how long it now takes the Fed to figure out that its entire policy regime has collapsed.  So far I have not seen a single comment by any Fed official that suggests they have even a clue as to how far off course they’ve drifted, and the challenges they face ahead.

Indeed many don’t even seem to understand that the Fed steers the nominal economy, and that the steering mechanism is broken.  They are like a ship captain complaining that he constantly has to “rescue” the ship by nudging the steering this way and that.  Why can’t the ship steer itself!  Why do I always have to intervene?  Um, because that’s your job?

[Or to use more technical language:  Because NGDP moves inversely to 1/NGDP.  And 1/NGDP is the share of national income than can be purchased with a single dollar, one definition of the value of money.  And because the share of national income that can be purchased with a single dollar is going to be strongly influenced by a monopoly supplier of dollars that has nearly unlimited ability to print money.  Deal with it.]

During and after WWI the world’s central banks went on an orgy of money printing, leading to a hyperexpansion of NGDP in many economies.  This so discredited expansionary monetary policy that the hard money types were put in charge.  After 8 years of stable NGDP growth we went overboard the other way, as NGDP fell in half between 1929 and 1933.  Now the hard money types were completely discredited.  So we started seeing fast growth in NGDP.  Except for a few sweet spots like 1953-63, the growth was mostly too fast, culminating in the Great Inflation of 1966-81.  This so discredited the doves that the hard money types were again put in charge.  Now we had a long sweet spot lasting from 1985 to 2007.  Then the inevitable happened.  Hard money types always worry more about too much inflation than too little, and so when they screwed up they did so in the only way they know how–falling NGDP.

And that’s where we are today.  Ironically the hard money types are currently worried about inflation, even though it could only come about if they screw up so badly that people turn to the inflation-mongers out of desperation.  During the sweet spot of 1985-2007 there was almost no pressure on the Fed from the left, as NGDP growth was just over 5% and fairly stable.  And there was almost no pressure from the right either, because inflation was fairly low and stable.

It would be nice if we had central bankers that understood the dangers of both too much NGDP growth and too little.  Perhaps that’s simply beyond the ability of the human mind.  It would be an amazing feat, on par with walking and chewing gum at the same time.  So far the Australian central bank seems to be about the only major one that has mastered this subtle art.

Last month I did a post describing a program that was far from optimal, but the best I thought we could hope for given the current make-up of the Fed:

The New York Fed will be instructed to buy $30 billion a week in T-securities of various maturities, until the Fed’s forecasting department is able to forecast a path of unemployment and inflation over the next 5 years that minimizes the sum of the deviation of inflation from 2% and unemployment from its long run average (or estimated natural rate.)  At that point it will stop.  If forecasts of inflation and unemployment change in such a way as to under or overshoot the previous expectation, the New York Fed will either buy or sell T-securities, as appropriate.

Lots of people sent me a FT column discussing a recent speech by San Francisco Fed President Williams:

If the Fed launched another round of quantitative easing, Mr Williams suggested that buying mortgage-backed securities rather than Treasuries would have a stronger effect on financial conditions. “There’s a lot more you can buy without interfering with market function and you maybe get a little more bang for the buck,” he said.

He added that there would also be benefits in having an open-ended programme of QE, where the ultimate amount of purchases was not fixed in advance like the $600bn “QE2″ programme launched in November 2010 but rather adjusted according to economic conditions.

Here’s a few observations that might be loosely viewed as responses to thoughtful conservatives who are skeptical of the need for monetary stimulus:

1.  Three times

Consider the following three dramatic declines in NGDP growth:  1929-30, 1981-82, and 2008-09.

Now think about what the sticky wage model would predict in each case.  I’d say a sharp fall in RGDP.  And that’s what happened in all three cases.  Then what?  Here’s where things get interesting.  The 1929-30 NGDP decline was followed by an even bigger plunge, so that by early 1933 NGDP was at less than 1/2 of its 1929 peak.  In 1983 and 1984 NGDP soared, rising at an 11% rate in the first 6 quarters of recovery.  After mid-2009, NGDP grew below trend, roughly 4.2%/year.

Now let’s think about what kind of recovery you’d expect in each case if the sticky wage model was true.  I’d expect a further fall in RGDP after 1930.  I’d expect very rapid growth in RGDP in 1983-84, and I’d expect modest growth in RGDP in the period after mid-2009.

And that’s exactly what happened!  If you are a sticky wage skeptic, tell me what sort of RGDP path you think the sticky wage model would have predicted in each case.

2.  Don’t solve problems

We should not use monetary policy to solve problems.  I believe we should have stable NGDP growth at about 5% per year, in order to avoid creating problems.  If NGDP growth had averaged 5% over the past 4 years, and unemployment was now 11%, I would not be calling for monetary stimulus.  Indeed even if it had averaged 4% I would not be making any great effort to promote monetary stimulus (although I wouldn’t oppose a bit in that case.)  But in fact NGDP growth since 2008 has been the slowest since Herbert Hoover was President, about 2%.  I don’t want monetary policy to be used as a tool to solve problems.  I want to avoid creating them with stable policy.

3.  Now more than ever

One often hears people using a crisis, especially one where the cause is rather murky, as an excuse to press for something they’ve favored all along.  High speed rail.  Break up the big banks.  Radical liberalization of the eurozone economy.  Lower tax rates on capital.  Less restrictions on occupational entry.  I favor some of these proposals.  But that’s not the problem we face.  I’ve followed the US business cycle since LBJ was president and I don’t recall there being even a hint of evidence that 8.2% unemployment in the US is caused by regulations, taxes, lack of high speed rail, big banks, or anything else other than tight monetary policy.  In 1982 the tight money was justified because inflation was a big problem.   It wasn’t “overly” tight. That’s clearly not true today.

4.  Johnny come lately

I hear people say; “Yes, we all agree that money was too tight in 2008-09 when NGDP fell 4% peak to trough, but it’s no longer too tight.”  It’s interesting that “we all agree” because when I was running around like a chicken with its head cut off in late 2008 I don’t recall anyone agreeing with me (that tight money by the Fed was creating a disastrous fall in NGDP.)  I recall attending an economics convention in late November 2008, and there was a 5 person panel that was dismissive of the need for easier money.  And that was during the worst of the crisis, when markets clearly showed the global economy falling off a cliff.  Even if I remembered who they were it wouldn’t matter, as there’s no reason to single them out.

Progressives often say; “at least we weren’t opposing monetary stimulus.”  Yes, but silence turned out to be just as damaging.  It would be interesting for someone to go back and investigate how many op eds were written by academic economics in the second half of 2008, and early 2009, castigated the Fed for driving NGDP much lower with tight money.  Op eds in an any major publication (NYT, FT, WSJ, WaPo, The Economist, etc.)  I predict roughly zero.  The first articles I do recall reading we in 2009 and were written by:

1.  Robert Hetzel.

2.  The late Earl Thompson

3.  Tim Congdon

All somewhat conservative economists.  And of course out of the limelight were market monetarists like Beckworth, Hendrickson, etc.  I wasn’t even reading many blogs in late 2008, so I may have overlooked a few voices.

My point here is this:  If now “we all agree” money should have been much easier in late 2008, and virtually 100% of the very few people who realized that at the time were market monetarists and their fellow travelers, doesn’t that suggest our current policy views ought to be taken pretty seriously?

5.  And if that’s not enough

The US and global economies appear to be deteriorating (we’ll have better data by Friday.)  It’s likely that we need additional monetary stimulus just to keep NGDP growing at the current pathetic 4% rate.  Any good arguments for not doing at least that much?

PS.  “Three Times” is one of the great films of this young century.  Earlier this evening I saw a Korean film called “The Day He Arrives.”  When Woody Allen sees this movie he’ll probably say to himself; “If only I could make a film like that.”  And yet his newest will draw 100 times more viewers.

The Economist has an interesting article on the gas boom in America:

Gas has wrought some remarkable changes. Over the past five years America has recorded a decline in greenhouse-gas emissions of 450m tonnes, the biggest anywhere in the world. Ironically, given its far greater effort to tackle climate change, the European Union has seen its emissions rise, partly because its higher gas prices (linked to oil) have led to an increase in coal-fired power generation.

So let’s review the facts:

1.  America is reducing greenhouse gas emissions faster than anywhere else because Bush/Cheney ignored environmentalists and went with the “drill baby drill” strategy.

2.  Europe is switching to coal because gas is too expensive.  But wait; doesn’t Europe also have lots of shale gas? They do. But they listened to the environmentalists, and have all but banned fracking.

3.  But wait; doesn’t Europe have lots of carbon-free nuclear power plants?  Yes, but countries like Germany have decide to close them all down, on the recommendation of environmentalists.  Other countries are also leaning that way.  I can sort of understand Japan, but when was the last time you heard about an earthquake in Germany or Sweden?

Now it’s true that the US still has a worse record than Europe, especially in high energy consuming states like Texas.  But the same issue of The Economist has another article with this interesting tidbit:

At a casual glance, Houston looks much as it ever did: a tangle of freeways running through a hodgepodge of skyscrapers, strip malls and mixed districts. A closer inspection, though, shows signs of change. The transport authority, which branched into light rail in 2004, is now planning three new lines, adding more than 20 miles of track. Most of the traffic lights now boast LED bulbs, rather than the incandescent sort. More than half the cars in the official city fleet are hybrid or electric, and in May a bike-sharing programme began. Every Wednesday a farmers’ market takes place by the steps of city hall.

Other changes are harder to see. The energy codes for buildings have been overhauled and the city is, astonishingly, America’s biggest municipal buyer of renewable energy; about a third of its power comes from Texan wind farms.

But are windmills actually that good for the environment?  Still another article in the same issue has this to say:

By 2009 Inner Mongolia had become China’s largest producer of coal. It is the biggest source of the world’s supply of rare earths. The coal bed around Xilinhot, the capital of Xilin Gol, boasts 38% of global reserves of germanium, a rare earth used in the making of circuitry for solar cells and wind turbines. Ripping up the grasslands and sucking up scarce water for thirsty mines has been part of the price of these “green energy” products.

Here are some comparisons between Inner Mongolia and Texas:

Texas is a state with 25.7 million people.  It started out as a ranching state and is now dominated by energy production.  It’s mostly hot and flat, and is growing much faster than the rest of the US.

Inner Mongolia is a province with 24.7 million people.  It started out as a herding state and is now dominated by energy production.  It’s mostly hot and flat, and is growing much faster than the rest of China.

Much faster?  How’s that possible given that China has grown at 10% per year for decades?  Because Inner Mongolia has grown at 17% per year since 2001.  Even Texans can’t say that.

PS.  People trying to convince you that China’s a bubble often show a video of Ordos, the almost uninhabited new city.  Ordos is in Inner Mongolia, and is hosting the Miss World pageant next month.  Let’s see what Ordos looks like in 10 years before we jump to conclusions.

PPS.  Do you recall that America’s had two Presidents named Bush, the second of which was governor of Texas?  China’s current President is named Hu, and another Hu is being touted as a possible future president.  He’s now the governor of Inner Mongolia.

PPPS.  Think about Mercedes, BMW and Audi.  Then think about the quality of the stuff you buy that’s made in China.  Do you sleep better at night knowing that Germany is shutting down its entire nuclear industry, and China is building nuclear plants at a rapid pace.

PPPPS.  Please don’t ask me what the point of this post is.  It’s Sunday. There is no point.