Today’s Free Exchange post is entitled “Scott Sumner is Wrong.”  I certainly can’t disagree with that claim, but I’m not sure I’m wrong in quite the way that M.C.K. asserts.

LAST Thursday, Jeremy Stein, a governor of the Federal Reserve Board, gave an important speech outlining the ways that monetary policy can inflate””and prevent””deeply destructive debt bubbles. (You can read my summary of his main points here. The speech was not about current policy so much as how the Fed should behave in general.) Scott Sumner, a blogger, was unimpressed by Mr Stein’s analysis, arguing that it was uninformed by history. However, the latest empirical studies support Mr Stein’s thesis that monetary policymakers who care about the long-term well-being of the citizenry should monitor private credit creation and prevent it from growing too rapidly.

.  .  .

Banks and other financial intermediaries usually create credit whenever they can earn what they believe is a risk-adjusted spread between their funding costs and the rates they charge their borrowers, both of which are affected, if not determined, directly by the monetary authority. Tobias Adrian and Hyun Song Shin have shown that the balance sheets of financial firms that mark their assets to market grow and shrink based on changes to the level of short-term interest rates. Meanwhile, Markus Brunnermeier and Yuliy Sannikov have shown that monetary policymakers can alter the willingness of banks to create credit by adjusting the shape of the yield curve. (I wrote a more detailed summary of this new research here.)

I read M.C.K. as assuming that short term rates are a good indicator of the stance of monetary policy.  More specifically, that easy money leads to low short term rates, which leads to extra leverage.  I don’t agree. For simplicity, let’s use Bernanke’s benchmarks for the stance of monetary policy; NGDP growth and inflation.  More specifically, let’s assume the Fed pegs the price of a futures contract linked to a weighted average of NGDP growth and inflation.  So we have a monetary policy that, by construction, is always neutral in Bernankian terms.  It’s never easy and it’s never tight.  But short term interest rates would still move around quite a bit.  And the leverage of financial firms might well be highly correlated with the movements in short term rates.  So it would look like monetary policy is having a big impact on leverage, whereas in reality (by assumption) it would be having no impact at all.

If you don’t like my assumption, change it as you please.  Assume the Fed is targeting M2 growth at 4%/year, as Friedman once advocated.  You get the same result, neutral money and volatile short term rates.

The bottom line is that short term interest rates are a lousy indicator of the stance of monetary policy, even though (paradoxically) on the day of a FOMC meeting a higher than expected setting of the fed funds target is almost always an easier than expected monetary policy.  But over any longer period of time (when a central bank is targeting inflation or NGDP growth), short term rates will reflect conditions in global credit markets.  For instance, we know that the 1% interest rates of 2003 did not represent “very easy money” because it did not lead to particularly high expectations of inflation and/or future NGDP.  If low short term rates lead to a credit bubble (under NGDP targeting) the credit bubble is not caused by the Fed, it’s caused by an inflow of Asian savings, or some other (non-monetary) credit market factor.

The yield curve might be a slightly better indicator of the stance of money policy, but unfortunately it’s also an excellent indicator of changes in expected NGDP growth.  A sharp slowdown in expected NGDP growth can even cause the yield curve to “invert.”  If that leads to deleveraging, it might well be due to fear of recession, not the direct effect of changes in short term rates.

Mr Sumner says that central banks would do better taming the credit cycle solely with regulatory tools, although he does not specify how this would work in practice. Moreover, he asserts that monetary policy is too “blunt” to be helpful. But Mr Stein explained that monetary policy can be a useful supplement to regulatory measures precisely because those can only be applied to areas of the financial system that are being actively monitored by regulators. Unlike regulation and supervision, monetary policy “gets in all the cracks” because all financial intermediaries are exposed to the interest rates under the central bank’s control.

My first best solution (admittedly not realistic today) is to get rid of all government intervention in credit markets.  No Fannie and Freddie, no FHA, no deducting interest on mortgage loans, no FDIC, etc.  Laissez-faire.

My second best solution is to try to regulate to make our system look more like Canada’s.  Unlike 99.99% of bloggers I think small banks are the problem and big banks (like Canada) are the solution.  I also favor bans on making sub-prime loans with taxpayer-insured funds.  Require a minimum of 20% down, unless the lender is not insured by FDIC.  Also change laws on non-recourse loans, etc.  Change tax laws so that debt is not subsidized (as compared to equity.)

I agree that monetary policy “gets in all the cracks” but I disagree with the implications he draws:

Mr Sumner might argue that monetary policy “gets in all the cracks” because it affects the level of nominal output. But the cutting-edge research makes it clear that financial firms operate according to a unique set of incentives different from those of the broader economy. Monetary policy affects those incentives, which I described above, more directly than it affects the incentives of the nonfinancial sector. Regular people and firms in the “real” sector simply do not care about small changes to the level of short-term interest rates to the same extent as commercial banks, investment banks, insurers, the repo market, and all of the other intermediaries responsible for creating money and credit.

File this under “never reason from a price change.”  If the change in short term rates reflects credit market conditions (which is usually the case) then I agree that most people don’t care.  But if it reflects a change in monetary policy then it really does get in all the cracks—Main Street is affected as much or more than Wall Street.  The tight money of late 2008 (not picked up by the short term rate indicator, BTW) was devastating to Main Street.

Thus, the evidence suggests that the Fed and other central banks can in fact use monetary policy tools to restrain credit growth without crushing the economy””if they want to.*

That’s not how I read the evidence from 1929.

My bigger problem with this entire line of analysis is that it’s all (implicitly) based on a giant misconception, that the severe recession was caused by financial turmoil, not tight money.  If the Fed had kept NGDP plugging along at a 5% rate we would have had some very mediocre years—call it stagflation if you wish.  Maybe 1% RGDP and 4% inflation until the excesses were worked off.  But the high unemployment and greatly intensified debt crisis need not have happened.

My view is obviously the minority view, held by neither policymakers nor my fellow academics.  But it does follow from what we’ve been teaching our students in recent decades; that the Fed has both the ability and the duty to keep expected NGDP growth plugging along at a decent rate.  Until we correctly diagnose the real problem, we will not be able to come up with solutions.  Unfortunately, the newly resurgent credit view reflects a basic misconception about what went wrong.

But I’ll give M.C.K. and Stein a lot of credit in one respect.  If my view is wrong and the now standard credit view of 2008 is correct, then there might be a role for monetary policy in this area.  The people who should really be embarrassed here are the professors who continue to teach Sumnerian macroeconomics out of their Mishkin textbooks (Fed never out of ammo—low rates aren’t easy money), but don’t believe a word of what they teach.

PS.  In their paper, Adrian and Shin call for monetary policy to be more forward looking than traditional interest rate targeting rules.  I agree, and believe a policy of targeting NGDP one or two years out would do a lot to prevent the build up of credit excesses, or excessive deleveraging on the other side of the crisis.

PPS.  Karl Smith asks two questions.  Here are my answers:

1.  Maybe; not in a mechanical sense, but perhaps in a signaling sense.  Yes, but it’s probably ineffective.

2.  Yes, as much as required to keep the central bank’s subjective forecast of NGDP growth on target.

PPPS.  This debate reminds me a bit about the debate over utilitarianism.  Some anti-utilitarians believe the world would be a happier place if we abandoned utilitarianism.  Some NGDP opponents believe NGDP would grow at a more stable rate if central banks targeted something other than NGDP.

PPPPS.  Noah Smith recently pointed to the fact that Japan grew at a decent rate from 2000-07 without anything close to 5% NGDP growth:

On the other hand, as we saw above, Japan remained in or very near deflation for the entire period, and ever since (meaning that NGDP didn’t grow anywhere near the 5% that Scott Sumner and others claim is optimal).

Just to be clear, I’ve never claimed Japan needs 5% NGDP growth to have healthy RGDP growth.  Indeed I don’t even think that is true for the US.  In the long run monetary policy doesn’t affect RGDP growth (very much), and in the short run what matters is the NGDP growth rate relative to expectations from a few years back.  I do believe that very low trend NGDP growth rates will slightly reduce the level of RGDP, but that was “priced in” by 2000, and so would not have been expected to impact post-2000 RGDP growth rates in Japan.

Japan did have relatively poor RGDP growth after 1991, but the big problem in Japan since 2000 is excessively low levels of RGDP, relative to the US.  Low productivity.  For people of my generation, who recall the incredible dynamism of the Japanese economy in earlier decades, the big shock is that they have actually grown slightly slower than the US since the bubble burst in 1990.  Not much slower, but I would have expected further convergence.

As an aside, I expect Zimbabwe and North Korea to grow faster than the US over the next 20 years, although I’m not at all positively inclined toward their economic policies.

HT:  Travis V.

A friend of the family is finishing up her BA in economics (at a top three econ department.)  She’s looking for a research assistant position.  Her area is applied micro (especially the economics of law and crime, the economics of education, and experimental econ.)  I would greatly appreciate any information that might be useful to her.  If it’s a specific position, then send me an email at Bentley.  If it’s general advice, please leave it in the comment section.

One of the oddities of the Keynesian model is that although it predicts that saving will fall during recessions, many people assume the model predicts that saving will rise during recessions.  If you don’t see this, start with the easiest version, a closed economy Keynesian cross model.  The famous Keynesian “paradox of thrift” predicts that an attempt by the public to save more will not cause the equilibrium quantity of saving to rise.  Rather income will fall, and then at the lower income level saving will again equal investment.  But it doesn’t stop there.  More sophisticated Keynesian models show that falling income will tend to reduce investment.  Indeed all business cycle models predict investment (and hence saving) will fall during recessions, even as a share of GDP.  So when you are in recession both saving and investment tend to be a relatively low share of national income.

The preceding implies that merely looking at saving as a share of GDP is not very useful.  Yes, it is lower during recessions, but not because reduced saving causes recessions—indeed the Keynesians would claim something closer to the opposite.

The next question is whether saving by sector is a useful variable to look at.  In particular, if one sector has a high saving rate could that sector be causing a recession?  That’s not at all clear.  If aggregate saving tells us very little, it’s not clear why the components of saving (household, business, government, etc.) would be particularly informative.  They might be, but you’d need a model.

Paul Krugman has a suggestive new post:

And another notes to myself post. Below are corporate profits (after tax and inventory valuation adjustment) and nonresidential fixed investment (roughly speaking, business investment), both measured as shares of GDP. These aren’t exactly matched figures, because not all business investment comes from corporations. Still, I think they illustrate an important point. Business investment isn’t actually all that low; you expect it to be relatively weak in a weak economy with excess capacity, but in fact it’s about as high a share of GDP as in the middle Bush years. What’s really out of line with previous experience is the level of corporate profits, which is arguably serving as a kind of sinkhole for purchasing power.

Just when you think Krugman is going to draw some policy implications, he steps back, and lets the facts speak for themselves.  And I think that’s a wise move, as it’s not at all clear what the high level of corporate saving actually means. Krugman points out that investment is about normal for this stage of the business cycle, which suggests that “animal spirits” are not the big problem here.

Are there policy implications for corporate saving rates?  Maybe, but I doubt there are stabilization policy implications.  I doubt that the corporate “sinkhole” is making the recession worse.  It seems to me that to draw policy implications you’d have to construct a bizarre Rube Goldberg-like model of stabilization policy:

1.  Monetary policy should target NGDP or inflation.  There’s your model of AD.

2.  If monetary policy fails to target NGDP or inflation, then fiscal policy should try to cause either M or V to move in such a way as to stabilize the economy. For instance, fiscal stimulus might raise interest rates and thus raise V.  Or if the Fed is targeting interest rates, it might cause the Fed to raise M.

3.  If monetary policymakers fail to do their job, and fiscal policymakers fail to do their job, perhaps some sort of policy directed at corporate saving might affect V or M.

What might that policy be?  An excess profits tax?  No, that’s contractionary.  Relaxing intellectual property laws?  That might redistribute wealth from capitalists to workers, and perhaps might decrease the private sector marginal propensity to save.  However it might also cause a stock market crash, reducing the Tobin q, and hence corporate investment.  More propensity to save, but less animal spirits.

I’d like to see intellectual property rights weakened (although it would reduce stock prices and thus hurt my personal finances.)  But not as a stabilization policy.

To conclude, never reason from a sector of GDP, at least if you are trying to explain changes in GDP.  First analyze monetary policy.  If that policy is dysfunctional, then try to figure out how changes in fiscal policy might change the precise way in which monetary policy is dysfunctional.

And then?  There is no “and then.” Even the second part of the preceding suggestion is probably too difficult for economists to model in the real world; trying to go even further (into various types of private saving) would be completely pointless.

Tyler Cowen responds to Krugman’s “sinkhole” claim:

That seems to be Krugman’s argument here, and here, excerpt:

“So corporations are taking a much bigger slice of total income “” and are showing little inclination either to redistribute that slice back to investors or to invest it in new equipment, software, etc.. Instead, they’re accumulating piles of cash.”

I am confused by this argument.  I would understand it (though not quite accept it) if corporations were stashing currency in the cupboard.  Instead, it seems that large corporations invest the money as quickly as possible.  It can be put in the bank and then lent out.  It can purchase commercial paper, which boosts investment.

Maybe you are less impressed if say Apple buys T-Bills, but still the funds are recirculated quickly to other investors.

I don’t much like either post.  Tyler seems to believe that high levels of corporate saving do not cause depressed levels of AD.  I have no complaints with that broader claim.  But you can’t really make that argument by pointing to the fact that funds saved get recycled into investments.  Yes, increases in realized saving lead to increases in realized investment, at the aggregate level.  But if and when Krugman does draw some policy implications from the “sinkhole” of corporate saving, he’s way too savvy to ignore the saving/investment identity.  He’ll talk about income distribution, propensities to save, and dysfunctional monetary policy.  Or at least imply those assumptions.

BTW, The Krugman quotation provided by Cowen does have one peculiarity.  It actually doesn’t matter very much whether corporations give money back to investors, except second order effects relating to agency problems.  But it was preceded by this paragraph:

So, I’ve had a mild-mannered dispute with Joe Stiglitz over whether individual income inequality is retarding recovery right now; let me say, however, that I think there’s a very good case that the redistribution of income away from labor to corporate profits is very likely a big factor. Here’s corporate profits as a share of GDP:

Krugman shouldn’t use the term “redistribute” in completely different ways in back to back paragraphs.  The argument that higher earnings by capital will lower the MPC is far more powerful than the argument that redistribution within the corporate sector has an effect on the MPC.  After all, capital gains are (effectively) taxed more lightly than dividends, so investors might actually be better off if corporations waited a while before paying out profits to shareholders.

If Krugman wants to make a case that inequality matters for AD (and please God don’t let him become another Stiglitz) then he’d want to make it on the basis of individual income distribution, not redistribution among capitalists.

I’m not happy with my post–but perhaps after getting comments I’ll see where the real issue here is–it’s all too vague for me to grapple with right now.

Although I’m reasonably smart, I don’t have a high enough IQ to understand things like quantum mechanics.  At least I didn’t until I came across David Deutsch’s explanation; it’s all about fungibility. Being an economist, fungible is a concept that I do understand:

It is a rather counter-intuitive fact that if objects are merely identical (in the sense of being exact copies), and obey deterministic laws that make no distinction between them, then they can never become different; but fungible objects, which on the face of it are even more alike, can.  This is the first of those weird properties of fungibility that Leibniz never thought of, and which I consider to be at the heart of the phenomena of quantum physics.

Here is another.  Suppose that your bank account contains a hundred dollars and you have instructed your bank to transfer one dollar from this account to the tax authority on a specified date in the future.  So the bank’s computer now contains a deterministic rule to that effect.  Suppose that you have done this because the dollar already belongs to the tax authority.  .  .  .  Since the dollars in the account are fungible, there is no such thing as which one belongs to the tax authority and which one belongs to you.  So we now have a situation in which a collection of objects, though fungible, do not all have the same owner!  Everyday language struggles to describe this situation: each dollar in the account shares literally all its attributes with the others, yet it is not the case that all of them have the same owner.

.   .   .

The term ‘uncertainty principle’ is misleading.  Let me stress that it has nothing to do with uncertainty or any other distressing psychological sensations that the pioneers of quantum physics might have felt.  When an electron has more than one speed or more than one position, that has nothing to do with anyone being uncertain what the speed is, any more than anyone is ‘uncertain’ which dollar in their bank account belongs to the tax authority.  The diversity of attributes in both cases is a physical fact, independent of what anyone knows or feels.

Nor by the way, is the uncertainty principle a ‘principle’, for that suggests an independent postulate that could logically be dropped or replaced to obtain a different theory.  In fact one could no more drop it from quantum theory than one could omit eclipses from astronomy. (From the multiverse chapter in “The Beginning of Infinity.)

This blew my mind, and so I decided to check with Eliezer Yudkowsky, who most definitely does have a high enough IQ to understand QM:

So let me state then, very clearly, on behalf of any and all physicists out there who dare not say it themselves:  Many-worlds wins outright given our current state of evidence.  There is no more reason to postulate a single Earth, than there is to postulate that two colliding top quarks would decay in a way that violates conservation of energy.  It takes more than an unknown fundamental law; it takes magic.

The debate should already be over.  It should have been over fifty years ago.  The state of evidence is too lopsided to justify further argument.  There is no balance in this issue.  There is no rational controversy to teach.  The laws of probability theory are laws, not suggestions; there is no flexibility in the best guess given this evidence.  Our children will look back at the fact that we were STILL ARGUING about this in the early 21st-century, and correctly deduce that we were nuts.

We have embarrassed our Earth long enough by failing to see the obvious.  So for the honor of my Earth, I write as if the existence of many-worlds were an established fact, because it is.  The only question now is how long it will take for the people of this world to update.

Ha!  So most of those arrogant physical scientists who make fun of how “unscientific” we social scientists are, don’t even follow the scientific method in the supposed “queen of the sciences”—physics.  Modern physicists are no better than the Pope who insisted that Galileo could use his heliocentric theory, but only if he admitted it was merely for prediction, not as a description of “reality.”   “Hey Galileo; shut up and calculate.”  Pathetic.

And it’s not just the physicists; how often have you heard some younger New Keynesian, or New Monetarist, or  New Classical-type prattle on about how “real economists” use mathematical models (preferably DSGE), and that we followers of the old Chicago School (i.e. Milton Friedman) weren’t “serious scientists.”  I can’t wait to tell them what “serious science” says about reality.  Here’s Deutsch:

All fiction that does not violate the laws of physics is fact.

So there are universes where Market Monetarism is true.  Take that you science fascists!

(Unfortunately that also means there are universes where MMT is true.  However I’d wager they are of googleplex orders of magnitude smaller “measure.”)

It’s also good to find out that the multiverse is deterministic.  When I was young I argued with the first guy who told me that QM implied a random universe.  It made no sense to me.  OK, our universe is random, but the multiverse isn’t.  That’s what I meant.

Now let’s try to relate this stuff to NGDP.  Here’s my analogy.  If there is a negative NGDP shock then employment falls in the short run.  But if the NGDP shock is quickly reversed then our universe joins up again with the universe that did not have the negative NGDP shock.  (Imagine the negative shock only occurs in one of the two universes, because Ben Bernanke’s mind is put into a Schrodinger cat-type experiment, where a particle’s behavior determines whether his mind will lose all memory of the need for Rooseveltian Resolve.)

Unfortunately, the NGDP shock may become “entangled” with the other parts of the economy, which could lead to “decoherence.”  I can think of two types of entanglement:

1.  The negative NGDP shock leads to lower nominal wages before NGDP is restored to the old path.  In that case restoring NGDP pushes employment above the natural rate.

2.  More likely the negative NGDP shock leads to bad supply-side policies, such as extended UI benefits.  When NGDP returns to normal, employment remains below the natural rate.

Any other applications of QM to macro?

PS.  If our students can’t understand that money is fungible, how the hell are they going to understand that they themselves are fungible!

PPS.  If you think I’m being modest about not having a high IQ, then consider that even after reading Deutsch and Yudkowsky, I still find it hard to believe there is enough room for all these universes.

PPPS.  My rant against economists’ obsession with models reminds me of this recent Nick Rowe post:

If the real world really were as simple as my simple model, then price controls really would be a good thing, in both the short and long run. But the real world is much more complicated than my ability to model it, so I think that price controls will be a bad thing, at least eventually. But I can’t model it, because it’s too complicated for me to model.

I think that it is thoughts like this that drive Austrian economists to distraction. I sympathise. I think they are right. The, um, medium of modelling biases the message.

Love that last sentence.

PPPPS.  Don’t believe anything is possible?  Read this.

Of course the “Sumner critique” is not really my idea, the standard NK model circa 2007 implied a fiscal multiplier of zero.  At best I expressed the idea a bit more colorfully (fiscal “multipliers” are nothing more than estimates of central bank incompetence), and did so in 2009 when almost everyone seemed to have forgotten NK economics, circa 2007.

Here’s The Telegraph:

“I think there will be quite a few changes,” said Michael Saunders, an economist at Citi, such as a more flexible inflation target, setting clear signals on how long interest rates may remain low, more bond-buying and, possibly, a rate cut.

That kind of approach has raised eyebrows at the Bank of England. Several top officials have said it is not needed for Britain, in part because of concerns it could stoke the country’s persistently above-target inflation.

Mr Carney also stirred controversy in December by saying that, in times of crisis, central banks might consider targeting a mix of inflation and growth rates instead of just inflation.

While Mr Carney speaks in Westminster, Sir Mervyn will be chairing one of the final Monetary Policy Committee meetings of his term. The MPC is not expected to expand its bond-buying programme.

But, the day before the Bank of England’s monetary policy committee announces the outcome of its monthly meeting, the Chancellor put the pressure on the bank to take action, the Financial Times reported.

Mr Osborne said decisive moves by the government on the deficit “means that…monetary policy action by the BoE can and should continue to support the economy”.

He was speaking at the launch of the Organisation for Economic Co-operation and Development’s report on the UK economy, which said the Bank of England may need to carry out more money-printing to stimulate the economy.

The Chancellor hopes that Mr Carney will persuade the Bank to take a more active stance in supporting the recovery.

All the Very Serious People in Britain are reacting with shock and horror at the idea of NGDP targeting.  Here’s a tip as to whether you are reading someone who is absolutely clueless on the subject—they’ll say; “An NGDP targeting regime would force the central bank to estimate the trend rate of RGDP growth.”

So Carney is backing off a bit, and talking about flexible inflation targeting, which is a slightly less effective form of NGDP targeting, without the ugly four letter acronym.

Osborne is hoping that the BoE will offset fiscal austerity.  So does the Labour Party.  So do the Liberal Democrats.  So do most of the British people.  But NGDPLT is one of those ideas that policymakers dare not speak its name.  Thus we have the bizarre situation where Osborne:

1.  Has the duty of telling the BoE exactly what they are supposed to do.

2.  Wants them to do NGDPLT.

3.  Dare’s not tell them he wants them to do NGDPLT.

4.  Hopes that Carney will see the winks and the nods and do it anyway.

After all, when you pay a central banker a million dollars a year you’d expect, at a minimum, that he can recognize when the Chancellor of the Exchequer is winking at him.  The real question is whether Carney can convince his colleagues, who can pretend not to see the winks.