Archive for December 2012


Dear Ben, Please surprise us with a policy regime that never again surprises us

“Left Outside” recent left the following two comments:

It’s all getting quite exciting isn’t it?


That’s a bad sign, of course, monetary policy should never be exciting. If it’s exciting you’re doing it wrong.

That’s right.  The central bank is doing its job when monetary policy is incredibly boring.

Then Saturos pointed me to an Arnold Kling post, which starts off quoting one of Arnold’s readers:

if an economist comes up with a novel and correct theory that makes predictions about macroeconomic variables, shouldn’t this theory enable him to beat the markets using these predictions?…

Therefore, it seems that if we accept both the EMH and the basic validity of macroeconomics, the latter must be about predictions that are somehow novel, correct, and non-trivial, but at the same time provide no new information about future market prices, even in terms of crude probabilities. But what would be some examples of these predictions, and what principle ensures their separation from market-relevant information?

Then Arnold adds the following:

Consider financial variables, such as the long-term interest rate or the price-earnings ratio of the overall stock market. According to the efficient markets hypothesis, these are not predictable on the basis of known information. To put this another way, you cannot beat the market forecast for these variables.

On the other hand, in conventional macroeconomics these variables can be predicted using models and controlled using policy levers. Reconciling this with the EMH has challenged economists for decades. Here are various alternative ways of doing so:

1. Policy has no effect. Markets do what they will do, regardless. The market uses the best prediction model, so economists’ macro models can, at best, replicate the market’s implicit model.

2. Policy has an effect, but markets try to anticipate policy. The expected component of policy has no effect. Only policy surprises have an effect.

It seems to me that the market monetarists (e.g., Scott Sumner) believe something closer to (2) than to (1). But (2) can get you into some strange conundrums. Does the Fed have free will? That is, does it have the ability to surprise markets, other than by acting randomly? If its actions are not random, they should be anticipated by markets. If they are anticipated by markets, then they should have no effect. etc.

Here’s what I would say:

1.  The expected part of monetary policy has no impact on financial markets.  It can still impact goods and labor markets, depending on when the policy became expected, and the duration of wage and price stickiness.

2.  Because the expected part of monetary policy cannot move markets, any systematic monetary policy should not involve Fed “surprises” moving asset prices.  If they do, then the policy regime is non-optimal.

3.  If policy is already non-optimal, and expected to remain non-optimal, then markets may be pleasantly surprised if an obscure blogger is able to make the world’s major central banks see the light and “target the forecast.”  That’s a good surprise, but can only occur once—during the transition from a bad to a good policy regime.  After than, no more surprises.  Please.

PS.  I’ll be very busy over the next few days, and may not be able to get to comments.

The latest on NGDP targeting from the WSJ

Here’s Simon Nixon writing in the WSJ:

Excessive praise for central bankers from politicians is rarely a healthy sign. The whole point of making these guardians of monetary policy independent was so that they could be a restraint on the inflationary tendencies of politicians.

So when the U.K. Treasury referred to Mark Carney last week as “the outstanding central banker of his generation” “”before the Bank of Canada chief has even taken up his new post as Governor of the Bank of England””alarm bells rang in some quarters of the City of London.

After all, politicians used to say similar things about the Federal Reserve’s Alan Greenspan until his reputation collapsed along with the global economy. These days, it’s his predecessor, Paul Volcker, who stood up to politicians as he stamped out inflation in the 1980s, whose reputation now stands tall. Meanwhile Bank of Japan governor is expected to lose his job following Sunday’s election having resisted political demands to be more aggressive at inflating the economy.

Paul Volcker tried to reduce inflation in late 1979 and early 1980, and then gave up when a small recession hit the US in the first half of 1980.  He then slashed short term interest rates sharply, and NGDP growth surged to a 19% rate in late 1980 and early 1981.  Next time he tried he stuck with it, and inflation was running about 4% by 1982.  But then Volcker got complacent—mission accomplished.  Inflation stayed close to 4% all the way up to 1987 when Greenspan took over.  But Greenspan wasn’t content with 4% inflation, and drove the rate down to 2%.  And from this Nixon infers that Volcker is an anti-inflation hero, and Greenspan a villain?

Then there’s his comment on Japan.  I thought the one thing all economists agreed on, both liberals and conservatives, was that the BOJ’s deflationary policy was utter madness.  Even Japan’s NGDP has been falling in recent decades.   And now Nixon criticizes those who favor a more expansionary monetary policy in Japan.  Is Japan the new model for the WSJ editorial page?

Sure, a nominal GDP is superficially beguiling because it forces central banks to weigh their decisions explicitly through the prism of growth. It allows them to look through periods of high inflation when real economic growth is low.

But it is a dangerous path. Gross domestic product is hard to measure and prone to substantial revisions. Choosing an appropriate nominal-GDP target is problematic. It depends on assumptions about how fast output can grow without causing inflation.

Yes, NGDP is hard to measure, although NGDI is somewhat easier and is exactly the same concept.  So the problem with revisions is not as severe as it first seems.  But if NGDP is hard to measure, what are we to make of the CPI?  Economists cannot even agree as to what the CPI is supposed to measure.  Is it the size of a raise the average person would need to maintain constant utility?  If not, what is it, and how could we possible measure it in the era of Facebook and smart phones?

And no, the NGDP target does NOT depend on estimates of how fast output can grow.  We target NGDP because it is NGDP that matters for maximizing social welfare, and inflation does not matter.  The problems that are assumed to represent the welfare costs of inflation; actually represent the welfare costs of high and volatile NGDP growth.

If the public sees prices rising, it may simply assume the central bank has lost control and react accordingly. The idea that central banks will act to dampen growth during a boom if inflation is low will strike many as particularly unrealistic.

No they won’t react accordingly, because wage demands depend on expected NGDP growth, not expected inflation.  And the second sentence makes no sense at all.  I thought the entire objection to Greenspan’s bubble era policy was that he targeted inflation during the housing bubble, and didn’t try to tighten enough to prevent overheating.  That’s inflation targeting.  But a few sentences back Nixon just bashed Greenspan’s policy.  Does Nixon favor inflation targeting, or not?  If he thinks Greenspan was too inflationary, then why not advocate NGDP targeting, as Friedrich Hayek did?

Besides, many suspect the BOE has already been covertly targeting nominal GDP, given it continued printing money even when inflation rose above 5% in 2011. The only reason for making the change is if one believes the central bank has somehow been excessively cautious in spending the mere equivalent of 30% of GDP to fund the purchase of 40% of the U.K. government bond market.

I don’t follow this at all.  Central banks tend to run large balance sheets as a share of GDP when interest rates and inflation are low, not high.  Look at the Bank of Japan, which has also monetized vast quantities of government debt.  And the BOJ actually did so, using non-interest bearing base money (until 2008), unlike the BOE, which didn’t really monetize debt, it just exchanged one form of interest-bearing government debt for another.  If Mr. Nixon wants smaller central bank balance sheets as a share of GDP, he should favor higher nominal interest rates and inflation, not lower.

Mr. Carney’s openness to further large-scale money printing will disappoint those who blame the lackluster U.K. economy on the inaction of politicians in facing up the U.K.’s deep structural problems. These supply-side challenges include an unproductive public sector that accounts for more than 50% of GDP; a welfare system that undermines labor mobility; a deficit reduction strategy that is barely reducing the deficit; and dysfunctional banking and planning systems.

Yes, Britain’s biggest problems are structural, but I favor more monetary stimulus because those structural problems are easier to address when the economy in not suffering from a lack of AD.  As we saw in the US during the 1930s, Argentina in the 2000s, and much of the world today, bad demand-side policies lead to bad supply-side policies.  Nothing discredits conservative economics so thoroughly as a demand shortfall, which looks like the “failure of capitalism” to the average person.  Boost employment and the US will cut back on the excessive duration of unemployment benefits (which were boosted from 26 weeks to 99 weeks in the US during the current recession, before being reduced to 73 weeks.)  It will be easier for Cameron to reduce the excessive taxes if Britain’s budget deficits are not bloated by the recession, and it will be easier to reduce excessive welfare spending if the public believes the economy can offer a job to any willing able-bodied worker.  Was it a coincidence that America’s welfare reform was passed in 1996?

Matt O’Brien pointed me to another WSJ article on monetary policy.  This one suggests that Poland avoided the Great Recession with a tight money policy (Mark Sadowski just had a heart attack, and is spinning in his grave.)  Here’s how Matt responds:

What’s the secret of Poland’s mini-economic miracle? Matthew Kaminski of the Wall Street Journal interviewed former Polish central banker Leszek Balcerowicz to find out just how exactly the country managed to avoid a recession back in 2009. The answer is … well, it’s completely wrong. Kaminski says Poland’s “hard-money policies” from 2001 to 2007 deserve the credit, but doesn’t say a word about what happened afterward. That’s curious, because the global financial crisis was an equal opportunity destroyer of economies. Avoiding a bubble hardly guaranteed avoiding a recession. So, again, what did Poland do?
You probably know where this is going. It wasn’t hard money that saved Poland. It was really, really, really easy money that saved Poland. Just look at the chart below of the exchange rate between the Polish zloty and the euro the past five years. That’s a 33 percent drop starting in late 2008.

Throughout much of the WSJ article low interest rates are equated with easy money.  Now Milton Friedman is spinning in his grave.

HT:  David Gulley

Three political nudges

It occurred to me that we are finally seeing the voters begin to influence monetary policy.  The most obvious case is Japan, where monetary stimulus was a major issue in the recent election.  But it’s also worth noting that the GOP tied its mast to hard money arguments that would have reduced our already anemic NGDP growth even further.  Obviously monetary policy was not a major issue, but I think it’s fair to say that this was part of a set of policy positions that turned off thoughtful moderates.  And like the Supreme Court, the Fed can read the election returns.

The British case is slightly different.  There has been no recent election, but it’s hard to avoid the suspicion that the Coalition government moved decisively to get someone like Mark Carney because they fear the wrath of voters if fiscal austerity is not offset by monetary stimulus.

That leaves the ECB.  I suppose one could argue that politics plays a role in the policy shift after Draghi took over from Trichet.  But I’m inclined to think that this showed up more in the form of debt bailouts, not easier money.  NGDP growth is still almost nonexistent in the eurozone.  The ECB may be starting to find out what the Fed learned in late 2008 and early 2009, solving a debt crisis doesn’t automatically cure an AD shortfall.

In 2001 Argentine fans of the “currency board” learned that their policy regime was not as impregnable as they’d assumed.  And in 1933 American supporters of the gold standard found that even the world’s largest monetary gold stock couldn’t prevent a devaluation under duress.  The reason was the same in both cases—voters get the last word.

PS. Notice that the eurozone, which lags the other three central banks, is the one currency area that lacks an effective method for voters to voice their opinions.  Of the four systems, it’s the one closest to a technocracy.  Shows we can’t trust those ignorant voters, doesn’t it?  Better leave this stuff to the “experts.”

About those Japanese inflation-phobes

We bloggers get all kinds in our comment sections.  One of my favorites are those sophisticated folks who assure us that we just don’t understand how politics works in the real world.  You know the type, the one’s who say central bankers could never go for an idea as crazy as NGDPLT.  Or the ones who lecture us about how the Japanese are different;  “They are a bunch of elderly savers.  They don’t want inflation, and are happy in their deflationary paradise.”  Yes, with a national debt equal to 240% of GDP and rising steadily.

Now it looks like the Japanese have elected a new government, which won by a landslide.  And that government ran on a platform of higher inflation.  Lars Christensen points us toward an article by Ambrose Evans-Pritchard:

“Its very rare for monetary policy to be the focus of an election. We campaigned on the need to beat deflation, and our argument has won strong support. I hope the Bank of Japan accepts the results and takes an appropriate decision,” he said.

The menace behind his words did not have to be spelled out. He has already threatened to change the Bank of Japan’s governing law if it refuses to comply. “An all-out attack on deflation is on its way,” said Jesper Koll, Japanese equity chief at JP Morgan.

Mr Abe plans to empower an economic council to “spearhead” a shift in fiscal and monetary strategy, eviscerating the central bank’s independence.

The council is to set a 3pc growth target for nominal GDP, embracing a theory pushed by a small band of “market monetarists” around the world. “This is a big deal. There has been no nominal GDP growth in Japan for 15 years,” said Mr Christensen.

The yen depreciated sharply to Y84.48 against the dollar on Monday, the weakest in nearly two years, as traders bet that the LDP will this time bend the Bank of Japan to its will.

I’ve never been much interested in whether or not my ideas are “politically realistic.”  I’m sure that when the first Swedish intellectual proposed a system of universal education vouchers, including for-profit schools, they told him or her that it would never work in socialist Sweden.  Political reform proposals are always politically unrealistic, right up until the time when they are adopted.

So the next time you tell me that one of my ideas is not “politically realistic,” don’t be offended if I brush off your warning.

PS.  Lars adds the following warning:

PS a friend of mine who once spend time at the BoJ is telling me not to get overly optimistic…

I think that’s right.  The yen has fallen, but only to 84/$.  Stocks have risen, but only about 12%.  The market loves MM, as do the Japanese voters.  But Japanese bureaucracies are very powerful, and change may be incremental, not radical.

PPS.  I’m not certain about the NGDP target; some have told me that the correct translation was a 2% to 3% inflation target.  Time will tell.

Are we too cheap to test macro theories, or afraid of the answers we’d get?

David Glasner recently began a post with the following observation:

In my previous post, I suggested that Stephen Williamson’s views about the incapacity of monetary policy to reduce unemployment, and his fears that monetary expansion would simply lead to higher inflation and a repeat of the bad old days the 1970s when inflation and unemployment spun out of control, follow from a theoretical presumption that the US economy is now operating (as it almost always does) in the neighborhood of equilibrium. This does not seem right to me, but it is the sort of deep theoretical assumption (e.g., like the rationality of economic agents) that is not subject to direct empirical testing. It is part of what the philosopher Imre Lakatos called the hard core of a (in this case Williamson’s) scientific research program.

I’m going to stay away from the “equilibrium” dispute, mostly because I don’t know what people mean by the term, and also because I think many of these debates are merely about semantics, of no practical importance.  But the question of whether monetary policy can reduce unemployment is of great practical importance, and also incredibly easy to test.

If we had any serious interest in finding out the impact of monetary policy on real variables, we’d have the Federal government create NGDP and RGDP futures markets, and subsidize trading at a high enough level to create a deep and highly liquid market.  Then we’d watch NGDP and RGDP futures contract prices rise in response to new information on QE1, QE2, and QE3.  Because skeptics about the ability of monetary policy to lower unemployment are usually the same people who believe markets are efficient, we’d have that debate resolved very quickly and we could move on to more important things, like whether NGDP targeting or inflation targeting are superior.  (I think NGDP targeting is better, even if nominal shocks don’t impact real output.)

Instead we have an FOMC made of up people who agree with Williamson, and others who disagree.  And that committee makes decisions that move global real equity prices by TRILLIONS of dollars in a single day.  And they do so in complete ignorance of the answer to Glasner’s question, even though a few MILLION dollars spent on a prediction market (Robin Hanson could design it) would quickly answer this question, and allow for much more effective monetary policy.