Archive for December 2012


Recognizing easy money

People who pay attention to monetary policy know that easy money often raises long term interest rates.  We have lots of high frequency data showing this (expansionary monetary surprises often raise long term bond yields) and low frequency data (long periods of accelerating M2 growth usually result in higher inflation and higher bond yields.)

But most people don’t understand this, probably because they equate the terms ‘easy money’ and ‘low interest rates.’  So the claim that easy money raises rates leads to one of the “that does not compute” moments of puzzlement.

Commenter Brendan recently directed me to a blog post that had some fun with some predictions by a Wall Street commentator named John Hussman.  Here’s Brendan commenting on a quotation from a Hussman post:

It’s June 28th, 2010. The S&P 500 has declined from a high of 1220 in April to 1,011 in late June, a plunge of 18% in just two months. The economic expansion and bull market is barely more than a year old and people are skittish. Here is what John Hussman had to say at the time (emphasis mine):

“Based on evidence that has always and only been observed during or immediately prior to U.S. recessions, the U.S. economy appears headed into a second leg of an unusually challenging downturn.”

Then Brendan goes on to report some follow-up information:

Two months later Ben Bernanke, speaking at Jackson Hole, hinted that further Fed stimulus could be coming. And a bit more than a two months later QE2 was officially announced.

Since monetary policy works primarily through shaping expectations, it makes sense to consider the QE2 hints at Jackson Hole as the functional start date for QE2. . . .

The S&P, which was at 1100 when QE2 was hinted at, rose to 1330 in the next six months, a gain of 21%. And over that same time frame 10-year inflation expectations rose from an anemic 1.7% to a healthier 2.6%.

By late 2010 or early 2011, economic data was firming and statistical recession forecasting models were no longer predicting recession. Human nature being what it is, bears who had been predicting recession and predicting the futility of QE2 refused to admit that the policy may have successfully averted recession.

Here’s Hussman in late December 2010:

“As for the notion that the Fed’s targeted Treasury purchases have directly aided the economy, the argument requires bizarre logical gymnastics. It demands one to believe that although the purchases were intended to stimulate the economy by lowering rates, they have been successful without lowering them, and in fact by raising them, because the expectation of lower rates was so stimulative that it caused rates to rise, so that the higher rates can be taken as evidence that lowering rates without lowering them was a success. Oh, brother.”

Yes, the Fed says it’s trying to lower bond yields.  Don’t believe them.  They are trying to raise the yields; they just don’t know it.

PS.  I added the Hussman links to the Brendan quotes, to make it easier for readers to follow the threads.

NGDPLT will not eliminate recessions

Noah Smith responded to my recent post:

Update 6: Scott Sumner comments. He disagrees with my observation that the freshwater/saltwater conflict has waned. His answer to the question of “what causes recessions” is “aggregate demand shocks”, but this doesn’t really answer the question of what is causing those shocks (of course, Scott Sumner thinks NGDP targeting can perfectly cancel out any aggregate demand shocks, so maybe he doesn’t even care where the shocks come from). He agrees that modern macro methods (DSGE models) have given us no useful technology of any kind. And he endorses replacing the current mainstream macro profession with “Market Monetarists” like himself and David Beckworth.

Yikes!  Just to clarify:

1.  I’ve done many posts answering the question of “what is causing those shocks.”  Demand shocks are caused by changes in either the supply or demand for the medium of account—and they occur for a reason.  Or one can think of them being caused by bad monetary policy, if you think (as I do) that it’s the central bank’s job to deliver a stable growth path for expected future NGDP.  But outside factors obviously impact the demand for base money.  In late 2007 and early 2008 a slowdown in base growth was the main culprit.

2.  I do not think all recessions are caused by demand shocks, nor did I say so.

3.  I do not think NGDPLT can perfectly stabilize demand, nor did I say so.

4.  The suggestion that Beckworth replace Bernanke was sort of half-joking, in response to a point by Noah Smith.  I know that won’t happen.  The serious point is that I’d like to see market monetarism replace the current standard model in macro.  I don’t seriously expect a handful of market monetarists at small schools to replace the entire establishment, if one is thinking in terms of bodies, not ideas.

I would add that if NGDPLT is adopted, there will come a time when it will be perceived to have failed, because it can’t perfectly stabilize AD, and there are also real shocks.  So there will still be occasional business cycles, although I’d expect them to be milder.  When they occur, people will say that NGDPLT “failed,” just as when China finally has a recession, they’ll claim the mythical “China bubble” has collapsed.

However it’s important to realize that even mild recessions like 1991 or 2001 did not seem mild at the time.  I recall articles in both years about how “this one is different” perhaps “heralding the end of the American dream, blah blah, blah.”  People always tend to overreact to current events.  Remember after 9/11 how all the experts assured us that we were in a new world, a “war on terror.”  (And then the other side never showed up for the war.)  So perhaps the adoption of NGDPLT would not be the end of history that I’ve claimed it would be, but I do think it would help to gradually unite macro and micro, leaving only RBC analysis on the macro side.

And I do think NGDPLT can prevent severe slumps like 1921, 1930, 1938, 1982, 2009, etc.

PS.  Merry Christmas!

PPS.  Because of the holidays I won’t have time for much blogging, but may post a few from my queue.

Money well spent

Back in 2009 I argued that only elite monetary economists should sit on the FOMC. Some of its current members are not even monetary economists, elite or otherwise. They are unqualified people serving in the most important economic policy position on the planet. I also argued that we should do whatever it takes to attract the best:

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.

Three years later Matt O’Brien made an even better case:

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.

A trillion dollars . . . a billion dollars . . . and now the Financial Times is quibbling over a lousy million dollars:

Mark Carney took some persuading to become the next governor of the Bank of England. We know that he initially resisted George Osborne’s blandishments, only agreeing to apply when the term of the appointment was reduced from eight years to five.

But the full price paid by the chancellor has only this week emerged with news that on top of the £624,000 in salary and pension contributions Mr Carney negotiated for himself, the next governor will also receive a housing allowance worth £250,000 a year. This number was computed, we are told, on the basis that it would, after tax, give Mr Carney enough money to rent a house for his family in one of London’s smarter neighbourhoods. It also makes him, when all the cash amounts are totted up, among the best-paid central bankers in the world.

No one doubts that the governorship is an extremely challenging job, or that Mr Carney is a very able candidate. But Mr Osborne’s willingness to bend over backwards to secure the Canadian’s services still raises questions.

At a time of austerity and calls for public-sector pay restraint, it runs against the grain to raise the governor’s pay so dramatically. Sir Mervyn King, the present incumbent, is on just £305,000 a year. And while a bit of the increase can perhaps be explained by the need to make up for the loss of some extremely generous pension rights, even this is an odd message to send when the government is bearing down on far less generous public-sector pensions elsewhere – to the point that many talented, middle-ranking civil servants are quitting for the private sector.

The liberality extended to Mr Carney cannot be blamed on a lack of alternative candidates. The chancellor had other credible choices to hand, including Paul Tucker, the current deputy governor. Moreover, had he publicised his willingness to entertain five-year governorships, or to pay nearly £1m a year to the successful candidate, other figures of merit might have stepped forward.

By breaching both the government’s pay policies and the terms of his own job search, Mr Osborne has attached too much weight to “star power”. The governorship of the BoE is a great public office and should not need to command private sector premiums.

I know nothing about Mr. Tucker, but given the fact that the BOE has failed to provide enough growth in nominal spending to offset the drag of fiscal austerity, or should I say “austerity”, I’m not surprised that Osborne looked elsewhere.  I do agree that the BOE is a “great public office” and that it’s unfortunate they needed to pay extra to attract Carney.  But facts are facts, and right now a sound monetary policy is 100 times more important than whether our top civil servants are excessively motivated by monetary considerations.  Make that 1000 times more important.  Maybe even a million times.

Nicolas Goetzmann sent me another FT article, which correctly notes that it is NGDP growth, not inflation, that determines nominal interest rates:

In reality, bond markets are reflecting economic fundamentals. Risk-free rates should approximate nominal GDP growth, which has been in sharp decline globally. With governments caught between stimulus and austerity, and monetary policy achieving little traction, bonds have looked the safest bet.

The great investment question for 2013 is whether change is in the air and the deflation trade is over.

In Japan, the election victory of Shinzo Abe means the last bastion of hard money has fallen. The next governor of the Bank of Japan, to be appointed in the spring, will be a dove. A shift towards inflation targeting is likely. There will also be less enthusiasm for driving the economy off a fiscal cliff, as Yoshihiko Noda, the outgoing prime minister, risked with planned tax rises.

Globally, the move to soft money is gathering impetus – as seen in the US Federal Reserve’s move to tie monetary policy to unemployment and by favourable talk of nominal GDP targeting by the Bank of England’s governor-designate.

Noah Smith on the state of macroeconomics

Noah Smith’s recent post on the state of macroeconomics has gotten a lot of attention.  Paul Krugman criticizes Noah’s claim that the saltwater and freshwater schools of thought aren’t that far apart.  I think Krugman’s right, and I also agree that the freshwater saltwater school is basically correct on the key issue of demand shortfalls.  But while Krugman might seem pessimistic about the state of macro, he’s a Pollyanna compared to me. I see the field of macro as being completely adrift.

Noah Smith asks some very good questions:

So if collegiality and similarity of technique are measures of a field’s health, then macro is doing quite well. But I feel like there’s a larger question: What has macro done for the human race in the last 40 years? How are we better off as a result of all this macro research effort?

(This is the more general version of the question asked by the Queen of England, when she asked why (macro)economists didn’t see the financial crisis coming. Sure, some people argue that “financial crises” are inherently unpredictable because of the EMH. But there’s no obvious reason why recessions shouldn’t be predictable in advance.)

Today, in 2012, do we know much more about the “shocks” that cause recessions than we knew in 1972? I’m not sure we do. The question of whether these shocks are mainly “real” or mainly “monetary” is not settled within the field (as Bob Lucas mentioned in a recent interview). Nor do we seem to know much about how the shocks actually work – usually, macroeconomists just assume the shocks follow a simple random process like an AR(1).

What this means is that the actual cause of recessions is basically still one huge mystery.

What about the question of how the economy responds to the shocks? Even if we don’t know much about the cause(s) of recessions, do we understand how recessions play out? I’m not sure we do. We have some empirical observations, of course – we know how much investment tends to vary with swings in GDP, etc. But in terms of impulse responses – i.e. the way the economy would move if all the noise were cleared out of the data – we have as many different guesses as we have macro theory papers. And macro theory papers are as numberless as the stars in the night sky.

What about the question of policy? Do we know how governments can damp out the swings in the business cycle? Here there seems to be very little agreement. Even if macro isn’t divided into warring camps shouting at each other, there is nevertheless a huge diversity of opinion on both the efficacy and the proper conduct of monetary policy, fiscal policy, and other recession-fighting measures. That there is no consensus means that the question is still unanswered. Useful technology has not been delivered. It doesn’t take an expert to realize that fact. (Update: Well, actually not quite. Constantine Alexandrakis comes up with a couple of important counterexamples; see below.)

So macro has not yet discovered what causes recessions, nor come anywhere close to reaching a consensus on how (or even if) we should fight them.

Actually mainstream macro does know what causes most recessions in big highly diversified economies—-aggregate demand shocks.  And mainstream macro concluded years ago that it was the central bank’s job to steer AD.  And mainstream macro has all sorts of ways of making monetary policy effective at the zero bound.  Indeed all this stuff is taught to our undergraduates in mainstream textbooks like Mishkin’s money text.

The real problem with mainstream macroeconomists is that they are too influenced by “framing effects” and had a giant brain freeze in late 2008.  Virtually the entire profession forgot that the central bank has the ability and responsibility to provide an adequate level of AD.  Only a fringe group of Aspergy-types looked beyond the framing effects, saw the real problem, and saw what needed to be done.  But the profession (freshwater and saltwater) failed us.  The central banks do pretty much what a consensus of elite macroeconomists think they should be doing. The profession “owns” the Great Recession, or at least that portion of it caused by inadequate AD. The profession has had the tools all along, but doesn’t seem to know how or when to use them.  Only 4 years later is it starting to wake up.

Noah continues:

(As an aside, modern macro models – at least, the DSGE variety – are basically not regarded as useful by private industry, although time-series methods developed for macro, such as vector autoregressions, have seen wide application.)

Of course private industry doesn’t use DSGE models, they are useless.  The macroeconomy is incredibly complex; I recall McCallum once listing 10 types of wage/price stickiness.  Most models assume one type.  And most models fail to incorporate AD/AS interaction, as when adverse demand shocks reduce AS by leading policy-makers to extend unemployment insurance from 26 weeks to 99 weeks.  Most don’t know how to identify monetary policy shocks.  The DSGE models are incredibly simplistic.  I basically “retired” from mainstream macro several decades ago when I saw where things were going, and pursued my own research interests.

There are two possible uses for DSGE type models; identify the costs of macro instability, so that central banks can pick the optimal target, and identify the stance of monetary policy most likely to hit the policymaker’s target.  But the DSGE models cannot do either.  The optimal monetary policy stance is most efficiently resolved by targeting market forecasts of the goal variable.  And given the complexity of the macroeconomy, any attempt to use DSGE models to identify the optimal monetary policy goal will depend entirely on what assumptions are built into the model.

All we really know is what Milton Friedman knew, with his partial equilibrium approach. Monetary policy drives nominal variables.  And cyclical fluctuations caused by nominal shocks seem sub-optimal.  Beyond that it’s all conjecture.  The reason NGDPLT caught on recently is that in this recession (and many others I’d add) fluctuations in NGDP seemed to do better than inflation at identifying what most economists saw as suboptimal levels of demand.

Noah continues:

Given this state of affairs, can we conclude that the state of macro is good? Is a field successful as long as its members aren’t divided into warring camps? Or should we require a science to give us actual answers? And if we conclude that a science isn’t giving us actual answers, what do we, the people outside the field, do? Do we demand that the people currently working in the field start producing results pronto, threatening to replace them with people who are currently relegated to the fringe?

Not all fringe groups are created equal.  Replace the establishment with the one fringe group that correctly anticipated where mainstream macro opinion would end up in December 2012 (i.e. NGDPLT, and “target the forecast”), and did so in late 2008 and early 2009.  Replace Ben Bernanke with David Beckworth.

PS.  My nightmare scenario is nicely described by a recently commenter named John Brown:

I am an 18 year old college student with a strong interest in economics. With regret, I have to say that, based on what I’ve seen, you are totally correct in your assessment of our generation.

When I talk to other people in my age group about economics, there seem to be two groups. One group sees easy money as the root of all economic problems. These are the Ron Paul supporters who talk about gold all the time. They read Mises on a regular basis and constantly use the world “fallacy” (usually accompanied with something about a broken window).

The other group reads Krugman on a daily basis. In their view, the ultimate problem with our economy is that the government isn’t running large enough deficits and that underregulation of the banking industry was the only major cause of the financial troubles in 2008. On top of this, this group scoffs at the thought that high marginal tax rates, overregulation, and even trade protectionism have any negative effect on long term GDP. According to them, the large tax/transfer systems and tightly regulated labor markets had nothing to do with the relative decline of GDP in Western Europe.

There are very few, if you will, centre-right or centre-left economists. I would consider myself centre to centre-right, all things considered. I am a staunch believer in free trade and free markets, but I also support NGDP targeting. Like you, Mr. Sumner, I am of the view that we should have the fed boost AD while we continue to partake in pro growth, neoliberal reforms in the rest of our economy.

Unfortunately, if nothing changes, I would predict we will have a generation of economic policy managed by goldbugs who want to abolish the fed (or peg it to gold) and hard left statists who think 90% tax rates are good and free trade is bad.

But perhaps I should be optimistic that there are people like Brown and Soltas and Wang coming along.

Generation Depression –> Generation Inflation –> Generation Bubble

People form their views of politics and economics when they are young, and are given the reins of power when in their late fifties.  Any thoughtful person in the 1930s could have easily predicted what would go wrong in the 1960s.  The generation that grew up in the Great Depression would have a single-minded obsession with boosting AD to prevent mass unemployment.  They would see everything as a demand issue, and ignore the supply side.  Thus the “Liberal Hour” of 1961 turned into the Great Inflation.

Any thoughtful person in the 1970s could have easily predicted the policy mistakes of the 2000s.  The generation that came of age during the 1970s would be obsessed with the threat of inflation—seeing it just around the corner whenever there was a spike in the money supply, a dip in interest rates, or a blip in the CPI from commodity prices.  The 1970s generation (including me) would overreact until NGDP growth was driven so low that interest rates fell to zero, making conventional monetary policy impotent.  The inflation targeting consensus turned into the Great Recession.

The young people today have grown up in a world dominated by two giant bubbles.  To see how strange this is, consider that as late as 1998 the economics profession paid almost no attention to bubbles.  After all, the EMF said markets were efficient, and the policymakers of 1998 had experienced exactly zero real estate bubbles in the past 60 years, and the only stock market bubble (1987) crashed without even a tiny blip in GDP growth.  Bubbles?  Who cares?

Any thoughtful person today can predict that the macroeconomics policy failures of 2040 will be produced by a generation of late middle-aged policymakers obsessed with preventing bubbles.  And boy will they have lots of bubbles to worry about!  The coming Asian century will produce a tsunami of savings and a crash in population growth, which will drive real interest rates to ultra-low levels. Perfect for endless bubble formation. (Of course I still believe in the EMH, so whenever I say ‘bubble’, I actually mean “bubble” with scare quotes.) Yes, bubbles don’t actually cause macro instability, but what matters is that they appear to.

Right now that future generation of mischievous policy-makers are still young—in a sort of embryonic state—studying in our graduate schools.  But someday they’ll be in power.  And then watch out!

What strange beast slouches . . .

PS.  Many commenters have sent me a post by M.C.K. at Free Exchange.  Some perceive it to be critical of NGDP targeting.  I see it as supportive, pointing out that NGDP targeting during the late 1990s might well have been preferable to Greenspan’s actual (inflation targeting) policy.  But the post does express some concern that central banks might refrain from implementing NGDP targeting during a period of strong productivity growth.  I don’t happen to share that fear.  If they decide that NGDPLT is to be the target, they’ll do a pretty good job of hitting the target.

PPS.  Imagine a sci-fi movie with hoards of young Austrian economics in giant test tubes . . . waiting for their chance.

Or will it be MMTers?