Archive for April 2013


Mark Carney on the (zero?) fiscal multiplier

Daniel sent me to this interesting FT article:

Questioned whether his call for true fiscal adjustment put him out of line with the fund’s call for the UK authorities to consider easing up the pace of deficit reduction while demand remained weak, Mr Carney made it clear that he did not see the level of fiscal austerity as a major constraint on the BoE’s ability to stabilise the economy.

“Central banks take fiscal policy as given and treasuries take monetary policy as given – that’s the separation,” Mr Carney said. “I’m not going to wade in [on fiscal policy] positively or negatively”‰.”‰.”‰.”‰except in the most extreme circumstances when growth threatens financial stability”.

That’s not quite a zero multiplier (because of the term ‘major’), but it’s pretty close.

And then there’s this:

One likely change of policy is that the BoE will start to steer individuals and markets towards an understanding that interest rates will probably stay exceptionally low until a threshold on unemployment or growth has been achieved. This guidance would aim to encourage spending.

Mr Carney is an advocate of such tools and dismissed fears that guidance might be counter-productive if the central bank subsequently found that the underlying health of the economy was worse and had to raise interest rates before the threshold had been reached. The incoming governor said it would be clear to individuals that inflation “is an element of the reaction function” and so such fears would not arise.

Sir Mervyn King, the departing BoE governor, expressed just such concerns this week. He told an IMF conference: “In a model it’s very simple to give guidance. But what happens if the structural interpretation of given level of unemployment changes? Then you have to backtrack and you don’t want to backtrack on conditional guidance.”

Of course there’s some truth to King’s criticism.  But on balance I support Carney’s proposal to adopt a sort of “Evan’s Rule.”  It’s not NGDPLT, but it’s a small step in that direction, and hence is better than current policy.  Of course he still has to get the BoE to go along:

Playing down expectations stoked up by Mr Osborne that his arrival would see the pace of economic growth move up a gear, Mr Carney pointed out that the governor’s power “can be overplayed” and policy could not change without the support of others in the central bank.

“I am a member of the [Monetary Policy] Committee, so any decision is not mine – but a decision of the MPC as a collective,” he said.

Still very busy today–will get to comments tomorrow.  Strong 3.2% consumption boost in Q1–that payroll tax increase sure hammered consumption! 

Why the Keynesian model cannot explain Britain

Lots of Keynesians think recent events in Britain support the Keynesian model—particularly the Keynesian critique of “austerity.”  Put aside the fact that Britain clearly isn’t “stuck” in a liquidity trap, rather the BoE simply does not want to push inflation even higher.  Let’s say my monetary offset theory is wrong.  Does this rescue the anti-austerity thesis?  Unfortunately no.

Step 1.  The Economist magazine reports (in the back) that Britain has the third largest budget deficit in the world, significantly bigger than the US as a share of GDP.  So fiscal policy is obviously expansionary using a simplistic metric that doesn’t adjust for the business cycle.

Step 2.  Then Keynesians point to the cyclically-adjusted deficit, which is presumably much smaller in Britain, and has been shrinking.  Unfortunately this won’t work either, but the reasons are more subtle.  Just how far below potential is the UK economy?  The honest truth is that no one has a clue.  But let’s use the sorts of measures that Keynesians would rely on.  The unemployment rate is roughly the same as in the US.  So by that measure the output gap is similar, although a bit smaller in the UK because they have a slightly higher natural rate of unemployment.  But almost all economists think that no single labor market indicator is perfect.  And all the other measures show the UK doing far better than the US, especially total employment, which hits record levels in the UK month after month, while lagging 3 million below early 2008 levels in the US (a country with a faster growing population.)  Here’s the bottom line: The UK has a smaller output gap than the US using any plausible set of labor market metrics.  This means that the cyclically-adjusted budget deficit in Britain isn’t just modestly larger than the in the US, but a great deal larger.  And yet the US has not experienced the near zero growth of the UK.  Why not?

Step 3.  Then the Keynesians point to the low RGDP growth in Britain, and claim this somehow proves Britain has a massive output gap, and hence fiscal policy is actually quite austere.  I hope everyone can see the problem with this argument.  It makes the Keynesian theory almost impossible to refute.  Indeed demand-side explanations would appear correct even if Britain’s problems were 100% supply-side.  Here’s why.  If growth slowed sharply for supply-side reasons, the government officials would likely sense that they had a structural deficit problem and cut back on spending.  The alternative would be an exploding debt ratio.  If Keynesians (wrongly) assumed the slowdown was demand-side driven, and that the output gap was huge, they would severely overestimate the amount of austerity, assuming the cyclically-adjusted deficit to be much smaller than it actually was.  All economic slowdowns would contain stylized facts that seemed to confirm the Keynesian, demand side, anti-austerity view, even if (by assumption) the slowdown was structural.

Step 4.  So is this simply a “he said, she said?”  No, we have powerful evidence of supply-side problems in Britain.  Recall that the Keynesian model doesn’t just predict that fiscal austerity reduces output, they have a specific mechanism—lower employment.  The Keynesian model has no explanation for a slowdown that occurs when employment is hitting record levels but productivity is awful.  Thus the stylized facts fit the supply-side model at least as well as the Keynesian model, if not better.  And then there’s that British inflation problem . . .

But I don’t want to overstate things.  The UK unemployment rate is somewhat elevated, and hence they probably have both supply and demand-side problems.  It’s OK for Keynesians to blame the elevated UK unemployment rate on fiscal austerity, but they cheat when they blame the horrible RGDP numbers on austerity, which look dramatically worse than the unemployment figures, much less the employment figures.  Indeed they shouldn’t use RGDP at all; NGDP is a better measure of demand, the P/RGDP split reflects supply-side factors.

Step 5.  Keynesians that are not yet convinced need to think really hard about the implications of the famous Krugman/Mankiw debate over trend reversion, which occurred at the beginning of the recovery.  Mankiw suggested that RGDP would not return to the old trend line, and Krugman got outraged, suggesting that if the labor market improved then RGDP would grow faster than trend during the recovery.  (And insulted Mankiw in the process.)  Well guess what, both the US and the UK have seen some improvement in the labor market, and yet both countries have seen no reversion to trend, indeed in Britain RGDP growth has been dramatically below trend rates of 2.5%.  Mankiw wasn’t just a bit more correct than Krugman, he was overwhelmingly more accurate.

PS.  For those who think NGDP is a better measure than employment, consider that the second biggest budget deficit in the world is in Japan, a country whose NGDP is lower than 20 years ago.

PPS.  And I haven’t even mentioned the major embarrassment of the most influential Keynesian policymaker in Britain, Ed Balls, insisting that the BoE should maintain its 2% inflation target.  Why not 3% Mr. Balls?  Would that lead to too much demand?  Do you want more demand or not?

PPPS.  Evan Soltas has a post that is generally sympathetic to the anti-austerian view, but also makes this observation:

The data don’t support the thesis that Europe is suffering because it’s doing more austerity than the U.S. It seems, at least from these data, comparable. The story I look to instead is the differing degrees of monetary-policy offset for fiscal austerity.

Also check out his excellent recent posts (here and here) on the euro-disaster.  I’ll have more to say on the ECB when Q1 data is out.

PPPPS.  Here’s the wrong (and offensive) Krugman comment:

I always thought the unit root thing involved a bit of deliberate obtuseness “” it involved pretending that you didn’t know the difference between, say, low GDP growth due to a productivity slowdown like the one that happened from 1973 to 1995, on one side, and low GDP growth due to a severe recession. For one thing is very clear: variables that measure the use of resources, like unemployment or capacity utilization, do NOT have unit roots: when unemployment is high, it tends to fall. And together with Okun’s law, this says that yes, it is right to expect high growth in future if the economy is depressed now.

But to invoke the unit root thing to disparage growth forecasts now involves more than a bit of deliberate obtuseness. How can you fail to acknowledge that there’s huge slack capacity in the economy right now? And yes, we can expect fast growth if and when that capacity comes back into use.

That’s an implied prediction that a falling unemployment rate in the US would be associated with above 3% RGDP growth.  Since Krugman likes pop music embeds:

something is going on here,

but you don’t know what it is,

do you?

Mr. Jones

HT:  Geoff

I’ll be too busy to do much over the next few days.  Check out Beckworth’s latest, and Nick Rowe’s reply.

Heh Noah, what superhero am I?

Noah Smith has called Paul Krugman a superhero (KrugTron) for out-forecasting his opponents.  What was Krugman’s great achievement?  He parroted market forecasts that inflation and interest rates would stay low.  But I’m not whining . . . in the profession of the blind the one-eyed forecaster truly is the king.

OK I am complaining, I’m green with envy.  But how about a bit of hero worship for those economists who predicted inflation and interest rates would remain low, and who also predicted that the Swiss National Bank and the Bank of Japan could depreciate their currencies if they tried?  Even at the zero bound.

And who also predicted that NGDP targeting would be the next big idea.  If I can’t be Batman, can I at least be Robin?  Even the cheesy Robin of the TV series?

HT:  Saturos.

Miles Kimball on Market Monetarism

Marcus Nunes sent me a piece by Miles Kimball on market monetarism, clearly aimed at readers who are non-specialists.  I like the article, but I’ll focus on a few areas where I at least slightly disagree:

One constant in all of these textbooks is an equation as famous for economics as E=MC2 is for physics””an equation suitable for an economist’s vanity license plate: MV=PY.

As E=MC2  is the key to understanding nuclear weapons and nuclear power, the “equation of exchange” MV=PY is the key to understanding monetary policy.

This caught my attention.  While certainly a defensible argument, I believe it does more to confuse than enlighten.  E=MC2 is a theory positing a specific relationship between three well-defined variables.  MV=PY is essentially a definition of one variable (V), in terms of three other well-defined variables (M, P, Y).  Actually not all that well defined, but at least capable of being measured independently of the other variables in the equation.  I fear the average reader might assume MV=PY is a theory, just like E=MC2.

In my view people make one of two mistakes with the equation of exchange.  One mistake is to assume it provides some sort of mysterious support for the Quantity Theory of Money.  It doesn’t.  Those that don’t like the QTM often tend to have a visceral distaste toward the equation, calling it a “mere tautology.”  They often prefer C+I+G+NX=Y, which they think has profound implications for how the world works.  It doesn’t either.

If one is to explain monetarism to the average reader, I think the best approach is to walk them through the “hot potato effect.”  It’s not easy for people to comprehend this idea, but it’s the only real hope one has of giving actual insight into the motivating idea behind monetarism.

But what if new technology makes the natural level of output go up faster, as the digital revolution did from at least 1995 to 2003? Then real GDP should be going up faster to keep inflation steady. And that means that nominal GDP should also be going up faster.

.  .  .

Even if I can bring my market monetarist friends around to adjusting the nominal GDP target for what is happening with technological progress, I differ from them in thinking that the tools currently at the Fed’s disposal plus clearly communicating a nominal GDP target are not enough to get the desired result.

I have two objections to these two paragraphs.  Let’s start with “Even if I can bring . . .”  If Miles Kimball wants to bring us over to his side (and I’m perfectly willing to be convinced, as I don’t view NGDPLT as the absolute optimal policy, but only a close approximation), he first needs to do two things:

1.  Discuss the many, many arguments that market monetarist have made for why steady NGDP growth is superior to steady inflation.  We know that many new Keynesian models suggest that a flexible inflation target is preferable to an NGDP growth rate target.  We reject those models and have provided many reasons for doing so.  A recent example is this Nick Rowe post, although there are numerous other arguments as well.  I’m working on a paper entitled “Seven unconventional arguments for NGDP targeting” (in addition to the conventional arguments.)

2.  Then explain to us why all these arguments are wrong.  He hasn’t done that.

As far as the adequacy of the Fed’s tools, here’s how I look at it.  What is the demand for base money when NGDP rises at 5% per year, and there is no IOR?  It’s about 6% of GDP.  What is the national debt held by the public?  About 75% of GDP?  That’s a lot of ammunition.  But it’s even worse for Kimball, as the current monetary base is about 20% of GDP, despite NGDP growth of less than 3% per year since 2008, and even with IOR at a rate higher than T-bill yields!  Recall that slower NGDP growth leads to lower nominal rates, and hence higher demand for base money.  And of course IOR increases demand for excess reserves.  So it’s very likely that with a higher NGDP growth rate, and level targeting, and no IOR, nominal interest rates would be considerably higher today, and base demand would be smaller.  Australia is a good example.

This may be confusing, so let me state it another way.  We have a base that’s about 20% of GDP.  Miles is worried that the Fed might run out of ammo trying to hit a 5% NGDP target, whereas I’m claiming that if they do it the right way (no IOR, level targeting, etc) the base is more likely to fall to 6% of GDP, than rise above 75% of GDP.   (And I didn’t even included Treasury-backed agency debt, which is Treasury debt in all but name only.  The Fed can and does buy that debt as well.) 

Even if I’m wrong, there’s several steps I’d take before throwing in the towel and endorsing Kimball’s radical currency proposal.  I’d try a negative 2% yield on all excess reserves, including vault cash.   But not cash held by the public.  Then I’d raise the trend rate of NGDP growth to 6%.  Are you worried that would create too much inflation?  Then recall that far and away the biggest welfare cost of inflation is higher nominal returns on capital, and hence a higher real tax rate on capital.  But the 6% GDP option assumes that nominal yields are stuck at zero!  Why do you never see me mention 6%?  Because I find it extremely unlikely that it would ever be necessary.

Overall I like Kimball’s article a lot.  But I think he misjudged two key issues.  Stable NGDP growth is preferable to stable inflation, and the Fed doesn’t need to resort to radical currency proposals—it’s not even close to being out of ammo.

PS.  Marcus Nunes has a good critique of Kimball’s technology argument.

All hail Bryan Caplan

Read the whole thing.