Matt Yglesias recently made the following comments on the Chicago teacher strike:

“Pay is also an issue. However, the union said the two sides are close to a pay agreement after school officials offered a deal that would increase salaries 16% over four years. The average teacher salary in Chicago was $74,839 for the 2011-2012 school year, according to the district.”

.   .   .

I take it that both sides are assuming that the Federal Reserve will persist in its policy of keeping inflation at close to but less than 2 percent per year, but there’s no guarantee of this. And yet that’s exactly how people negotiate deals””whether it’s an apartment lease or a two-year cell phone commitment or a teacher’s salary deal. We’re all enmeshed in a vast web of implicit and explicit nominal agreements, and in practice we tend to think in nominal terms.

In a sensible world it would be relatively easy to work through monetary policy options.  The first step would be to ask where the central bank wants to go.  Everything else would hinge on that strategic decision.  Thus if they want 5% expected NGDP growth, level targeting, you can pretty easily work out some tactics to achieve that target.  One such policy would be to have the NGDP futures market determine the monetary base and the fed funds rate.

Under that sort of policy regime there’d be much less reason to worry about a collapse of a major bank.  That’s partly because the NGDP target would help prevent the bank failure from affecting output, but much more importantly it would make it much less likely that a major bank failure would have a contagion effect.  Because bank bailouts are really, really, undesirable, that’s a huge advantage of NGDP level targeting.  Even so, this doesn’t mean the Fed necessarily made a mistake in bailing out the banking system in late 2008.  After all, the Fed does not engage in level targeting, at least when the nominal interest rate falls to zero.  So it’s hard to be certain that a banking crisis would not lead to lower NGDP.  And in a world of sticky wages, falling NGDP is a really, really, really bad thing (that’s one more ‘really’ than for bank bailouts.)  Given that policymakers are risk averse, I’m not surprised that they didn’t want to take any chances.

Cardiff Garcia has a long article on IOR that indirectly illustrates this problem.  A sensible central bank would do the following:

1.  First decide where it wanted to go (i.e. set an NGDP target.)

2.  Then provide the level of base money (and hence the fed funds rate) that is expected to hit that target.  The Lars Svensson approach.

3.  If the equilibrium fed funds rate is near zero when expected NGDP growth is on target (not likely), then decide whether that level of rates is likely to bankrupt the money market mutual fund industry, and also whether that sort of bankruptcy is systemically important.  (An issue I’m not qualified to address.)  If so, set an IOR at 0.25%, and recalculate the level of base money required to produce on-target expected NGDP growth.

4.  Then radically reform the MMMF industry so that it can never again hold our monetary policy hostage.

Unfortunately our policymakers only do step 3, and ignore steps 1, 2 and 4.  That’s why Garcia has such a hard time sorting through the options, (although he, Yichuan Wang, David Beckworth, et al, do an excellent job of trying.)

This column in Free Exchange shows how badly we botched the regulation of MMMFs:

After the crisis was over, the money markets were an area that seemed worthy of further scrutiny. Like asset-backed securities before them, they had appeared boring and safe when they were actually a large source of hidden risk. The industry, however, put up an unprecedented lobbying campaign against the SEC. As a result, it was able to avoid anychanges the existing rules, even though they had proven so hopelessly inadequate prior to the crisis. How could this have happened? An excellent and detailed investigative report by Bloomberg provides an answer: the SEC is a captured organization whose employees regularly alternate between government and lobbying on behalf of the firms the SEC is meant to keep in line. It is not right to call this a “revolving door,” since that implies some kind pause while going from one side to the other.

Let’s be clear. If the events described in the Bloomberg article happened in China, everyone would immediately (and rightly) decry cronyism and corruption. Why not do the same here?

This is just the tip of the iceberg.  After the 2008 financial fiasco there were lots of calls for “re-regulation,” especially by the Democrats.  Then in early 2009 they seized the House, Senate and the Presidency.  They needed to address 4 basic weaknesses in our financial system:

1.  A deeply flawed FDIC system that allowed (mostly smaller) banks to lend insured deposits to developers undertaking highly risky projects.

2.  A deeply flawed FDIC system that allowed (mostly smaller) banks to lend insured deposits to people taking out subprime mortgages, i.e. mortgages with less that 20% down.

3.  Fannie and Freddie, which needed to be blown up.

4.  The MMMF industry.

And in its infinite wisdom the Congress succeeded in writing a 1000 page bill that addressed none of these key problems.  Which means the crisis is likely to happen all over again.  Just as the post-1980s S&L fiasco “re-regulation” solved nothing.  As far as Congress is concerned moral hazard isn’t a bug, it’s a feature.  Of course things are no different in Europe or China, so we shouldn’t be shocked by any of this.  And I doubt the GOP would have done any better in addressing these issues.

It’s a messy world, which makes it hard to evaluate monetary policy tactics.  On the other hand NGDP level targeting would clarify a lot of things.  The biggest advantage may not be better macroeconomic stabilization, but rather better policy in other areas.  Just as the Great Moderation made the world safe for neoliberalism, NGDP targeting would make the world safe for sensible financial regulation.

PS.  It’s frustrating to see people focusing on the effect of lower IOR on lending.  The goal isn’t more lending; it’s a lower demand for base money.

I can’t see any logical reason to connect these two variables, but lots of people seem to think they are connected.  So I thought I’d look at the evidence.  I found an OECD study that looks at income growth for the top 10% and the bottom 10%, between the mid-1980s and the late 2000s.  It seems reasonable to assume that if the income of the rich is growing much faster than the income of the poor, then inequality is increasing, and vice versa.  So rather than look at all countries, let’s focus on those where the difference is significant, say more than 1% per annum.  There are 8 countries where the rich did much better than the poor, headed by Sweden:

Country  Top 10%  Bottom 10%  Gap

Sweden       2.4%         0.4%         2.0%

Britain         2.5%        0.9%         1.6%

Germany     1.6%         0.1%         1.5%

New Zealand  2.5%      1.1%          1.4%

USA             1.5%        0.1%         1.4%

Norway        2.7%        1.4%          1.3%

Finland         2.5%       1.2%          1.3%

Holland        1.6%       0.5%          1.1%

And there were four countries where income got much more equal:

Portugal     1.1%        3.6%        (2.5%)

Greece       1.8%       3.4%        (1.6%)

Spain         2.5%       3.9%        (1.4%)

Ireland       2.5%       3.9%        (1.4%)

Comments?

Update:  Commenter Declan pointed out that I missed 4 countries in the increasing inequality camp:  Australia, Israel, Czech Republic and Luxembourg.  That’s because I originally got the list from a source with a smaller number of countries, and later linked to OECD.

Here’s Yichuan Wang on Chinese saving options:

What I think is sometimes forgotten is that Chinese citizens face a severe shortage of effective ways to save money to ä¿å€¼, or preserve value. Bank deposit rates consistently run below the rate of inflation. When better investment opportunities come along, those deposit rates don’t necessarily rise. There are securities companies, but it’s very difficult for the people to trust them. Moreover, given the recent explosion in these companies, it’s not hard to imagine that any risk-adjusted excess returns on securities should quickly go to zero. The stock market is seen as a capricious creature, and given past stock crazes involving nannies and farmers, people are right to be suspicious of investing in stocks as a way to secure wealth.

Let’s say that’s all true.  Does it suggest a market failure?  Does it suggest that the Chinese are putting “too much” money into housing?  Maybe, but that’s not clear to me.

Suppose there were no capital controls distorting the Chinese economy.  Would the Chinese people be able to earn positive real rates of return on bank savings accounts?  I don’t see how.  The interest parity condition says Chinese rates should be the same as US rates, after adjusting for the expected change in the value of the yuan.  Since the yuan is unlikely to depreciate significantly over time, Chinese rates on risk free bank accounts should be no higher than the roughly zero percent earned on US bank accounts.

Of course if China was a laissez-faire paradise then it would be growing much faster, and it’s possible that the Chinese could earn higher rates of return in investments such as equities.  But it isn’t.  Given the nature of the actual Chinese economy, where returns on non-residential investments are not all that high, housing might not be a bad option.

BTW, regarding the earlier discussion of vacant Chinese apartments by Christopher Balding, I found this interesting data on Chinese apartment vacancies:

Beijing’s New Home Inventory Hits Four-year Low

Source

: The Beijing News, ChinaScope Financial (Data)

Data from the Beijing Municipal Commission of Housing and Urban-rural Development shows that as of September 2, Beijing’s new residential properties available for sale hit a new low since 2009, totaling 77,104 units. 50,879 units of the total inventory were pre-sale homes. Based on the home transaction volume last month, real estate developers needed only five months to clear out the inventory.

ZHANG Dawei, Director of the Market Research Department at Beijing Centaline, believes that more than 10,000 new homes were sold in each of the four months since May, which has helped shorten the destocking cycle. Meanwhile, the low inventory was due to the decrease in residential housing and land supply.

Beijing Properties’s destocking cycle is shortening as transaction volumes have picked up in 2012 and developer supply has decreased.

Note that while 77,000 sounds like a lot of unsold units, Beijing’s population is over 20 million.  Of course units can remain vacant even after being purchased.  Nonetheless, Chinese housing prices are edging upward again, after a pullback during 2011 and early 2012.  Commenter Ben Zhan pointed out that if Beijing had 3.8 million vacant apartments, then the other 3.8 million units would contain Beijing’s entire population.  Which doesn’t seem very likely given that Beijing families are generally quite small.  He also pointed out (in a subsequent comment) that Beijing’s per capita GDP is more than $1000/month, not the $435 figure cited by Balding.

Here’s Stephen Roach on the “overbuilding” theory:

Shanghai Pudong is the classic example of how an “empty” urban construction project in the late 1990s became a fully occupied urban center, with a population today of roughly 5.5 million. A McKinsey study estimates that by 2025 China will have more than 220 cities with populations in excess of one million, up from 125 in 2010, and that 23 mega-cities will have a population of at least 5 million.

China cannot afford waiting to build its new cities. Instead, investment and construction must be aligned with the future influx of urban dwellers. The “ghost city” critique misses this point entirely.

All of this is part of China’s grand plan. The producer model, which worked brilliantly for 30 years, cannot take China to the promised land of prosperity. The Chinese leadership has long known this, as Premier Wen Jiabao signaled with his famous 2007 “Four ‘Uns'” critique – warning of an “unstable, unbalanced, uncoordinated, and ultimately unsustainable” economy.

Two external shocks – first from the US, and now from Europe – have transformed the “Four Uns” into an action plan. Overly dependent on external demand from crisis-battered developed economies, China has adopted the pro-consumption 12th Five-Year Plan (2011-15), which lays out a powerful rebalancing strategy that should drive development for decades.

The investment and construction requirements of large-scale urbanization are a key pillar of this strategy. Urban per capita income is more than triple the average in rural areas. As long as urbanization is coupled with job creation – a strategy underscored by China’s concomitant push into services-led development – labor income and consumer purchasing power will benefit.

Contrary to what China doubters say, urbanization is not phony growth. It is an essential ingredient of the “next China”, for it provides China with both cyclical and structural options. When faced with a shortfall of demand – whether owing to an external shock or to an internal adjustment, such as the housing-market correction – China can tweak its urbanization-led investment requirements accordingly.

This long paper by Credit Suisse provides a detailed examination of the Chinese housing market, in case anyone is still interested.

Michael Woodford is hell bent on creating a monetary economics that revolves around interest rates, with no role for base money.  That makes him the opposite of me, as I’d like to get rid of interest rates, and focus entirely on the supply and demand for base money.  We both have our thought experiments.  He has a “money-less economy” model (which actually has money–reserve balances.)  And I have a model with no interest rates (which actually has interest rates–the return to real capital.)

I’m working through Woodford’s paper, and it’s a brilliant piece.  But there’s one big flaw. In his zeal to brush aside the monetarist approach, he uses the Japanese QE example to try to discredit monetarism.  In doing so he attacks a straw man.  He attacks a position that (AFAIK) no monetarist has ever taken.  Here’s the proposition that he claims (pp. 55-56) monetarists believe in:

Suppose a central bank injects a lot of cash in the economy.  The central bank simultaneously announces that the injection is temporary, and that the cash will be removed the minute prices start to rise.  Woodford seems to believe that the quantity theory predicts that the large monetary injection will cause a large increase in prices and NGDP.  He doesn’t say so, but presumably he also believes that the quantity theory predicts a big fall in the price level when the money is withdrawn from circulation.

I went to the University of Chicago, and I don’t ever recall learning any theory like that.  I’ve read lots of articles by Friedman, Schwartz, Brunner and Melzter, but I don’t recall any of them making that claim.  And there’s good reason why no monetarist would make this argument, it would imply completely bizarre fluctuations in the real interest rate.  Back in 1993 I published an article that explained this with a simple thought experiment:

The Fed doubles the money supply from $1 trillion to $2 trillion, and simultaneously announces that a year from today the money supply will be cut in half, back to $1 trillion.  Suppose the price level doubled, and was expected to fall in half next year.  Then the real return from holding cash would be 100% over the next year.  Since risk free interest rates are usually around 2%, not 100%, this would mean that money would be wildly non-neutral.  But that makes no sense, as the neutrality of money is one of the central tenets of monetarism.  Something’s wrong here.

Here’s what monetarists actually believe.  A one-time, once-and-for-all, doubling of the money supply will cause a sharp rise in prices.  That true whether interest rates are zero or positive.  As far as I can tell, Woodford accepts this view.  So it’s actually not at all clear where he disagrees with the monetarists.

It seems like Woodford wants to divide the classic monetarist experiment into two parts; the initial injection, and then the permanent increase in the money supply.  (Krugman does this too.)  The second part (the permanent increase) is then viewed as non-monetarist policy, a sort of signaling issue.  The first part by itself has almost no effect, and hence monetarist stimulus ideas are labeled ineffective at the zero bound.  But of course by that logic they’d also be almost ineffective at positive rates. If you inject money and pull it out a year later, NGDP won’t change (very much) even if rates are positive at the time of the initial injection.

The problem with this framing technique is that the same could be done with the 2001 interest rate cut I described in this post a couple days ago, which immediately boosted stock prices by 5% and helped prevent a deep post-tech bubble slump.  That Fed action could be divided into the initial rate cut, and then expectations of lower future rates (relative to the Wicksellian equilibrium, as longer term interest rate expectations actual rose on the income and inflation effects.)  The initial cut did almost nothing.  So by that logic the classic Keynesian thought experiment  (cutting rates) is nearly as ineffective as the classic monetarist policy.  But somehow it worked.  To be clear, I’m not contesting Woodford’s claim that the long run trajectory of policy is the key, rather I’m contesting how he interprets that fact.

Woodford then makes some odd assertions, which suggest he thinks Japan’s QE of 2001-06 was a failure.

And as the theoretical models would predict “” but contrary to the quantity- theoretic reasoning that had provided the basis for the policy proposal “” there was little effect of the policy on [Japanese] aggregate nominal expenditure. As shown in Figure 14, the increased supply of bank reserves raised the total monetary base by 60 percent over the first two years of the policy, and eventually by nearly 75 percent. Yet there was no corresponding increase in aggregate nominal expenditure: nominal GDP was only six percent higher after five years of QE than it had been in the first quarter of 2001, despite a massive increase in the monetary base. And as the figure also shows, deflation (here measured by the GDP deflator) continued unabated.

.   .   .

The BOJ itself appears no longer to put great stock in pure QE as a policy. Its “comprehensive monetary easing” policy, introduced in October 2010 in response to continuing concerns about the economic outlook, has again resulted in a significant increase in the size of the BOJ’s balance sheet, but does not involve quantitative targets for current account balances.

And yet by his own account the BOJ discontinued QE because it had succeeded in boosting the CPI by a small amount:

As Figure 14 shows, most of the increase in current account balances was reversed, in the space of a few months, after the policy was suspended in March 2006, as a result of CPI inflation that had been measured to be slightly above zero.

So by the BOJ’s criteria it worked.  That’s why it was discontinued, that’s why much of the money was pulled out of circulation, and that’s why interest rates were raised in 2006.  I think people like Woodford and Krugman misinterpret the Japanese case because by their criteria (and by mine) it failed.  Japan shouldn’t have been shooting for zero CPI inflation, but rather a slightly higher number.  But QE did what they wanted it to do.  Then Woodford suggests the BOJ reacted to this failed experiment by abandoning “QE as a policy.”  But in fact they still use it.  Yes, it used in conjunction with other tools such as a new and more explicit 1% inflation target, but that’s perfectly consistent with monetarism, broadly defined.

I do think it’s fair to criticize the older monetarists for not putting enough weight on managing expectations (that’s the big contribution of Krugman/Woodford/Eggertsson), but that may be partly due to their advocacy of level targeting monetary aggregates, which avoids some of the pitfalls of purely “forward-looking” policy regimes.

Here’s how I see things:

1.  There are no known cases of fiat money central banks trying to inflate and failing.

2.  Markets have often responded strongly to slight easing by the Fed, ECB, and BOJ, even though these moves weren’t even 10% of what was needed.  Imagine how strongly they’d react to something serious!  So the markets certainly don’t think central banks have run out of ammunition.  This is important because new Keynesian models suggest that the key to success is raising market expectations of NGDP growth.

3.  Everyone agrees that if the Fed bought up all of planet Earth, NGDP would rise sharply.  So the “worst case” is that the Fed needs to engage in “unconventional purchases.”

4.  Even though it’s extremely unlikely the Fed would ever have to engage in unconventional purchases, even that option is 100 times better than grotesquely inefficient fiscal stimulus.

So if the Keynesians are going to get us market monetarists to abandon our monomaniacal obsession with relying solely on monetary policy to steer NGDP, they’ll have to come up with far better arguments than what I see in Woodford’s paper.  It’s a brilliant paper, but nowhere near good enough.

PS.  After being blacked out for a month (in China) I have regained access to many of my favorite blogs.  Here are posts from David Glasner and Bill Woolsey commenting on Cochrane.  Marcus Nunes has an illuminating post showing that the Fed was leaning toward raising rates in July 2008, 7 months into the recession, and despite very slow NGDP growth.

And Josh Hendrickson finds a great quotation from Walter Bagehot:

To lend a great deal, and yet not give the public confidence that you will lend sufficiently and effectually, is the worst of all policies; but it is the policy now pursued.

Hmmm, I wonder what Bernanke would make of that quotation?  Here’s Tim Duy discussing the effects of GOP attacks on the Fed:

If in fact this is true, then Federal Reserve Chairman Ben Bernanke made a disastrous tactical error.  By not responding even more aggressively, as he now appears to be headed, he opened the Fed up to additional attacks because monetary policy looked ineffective at supporting the economy.  As they say, the best defense is a good offense.  If the economy looked to be returning to the pre-recession path of nominal GDP, the Fed’s detractors from both the left and the right would have less ammunition for criticizing monetary policymakers.

For more than three years I’ve been arguing that it’s easier for central banks to succeed than fail.  Failure requires far more “effort.”  Lazy central banks like the RBA succeed.  Calvinist central banks like the BOJ fail.