Here’s Mayor Bloomberg:

In the wake of the Boston Marathon bombings, Mayor Michael Bloomberg said Monday the country’s interpretation of the Constitution will “have to change” to allow for greater security to stave off future attacks.

“The people who are worried about privacy have a legitimate worry,” Mr. Bloomberg said during a press conference in Midtown. “But we live in a complex word where you’re going to have to have a level of security greater than you did back in the olden days, if you will. And our laws and our interpretation of the Constitution, I think, have to change.”

Mr. Bloomberg, who has come under fire for the N.Y.P.D.’s monitoring of Muslim communities and other aggressive tactics, said the rest of the country needs to learn from the attacks.

“Look, we live in a very dangerous world. We know there are people who want to take away our freedoms.

Sweden has long been a leader in the field of monetary policy.  The homeland of Wicksell and Cassel pioneered the first price level targeting regime, in 1931.  In 2008 they depreciated the krona, which is why Sweden did better than the rest of the Eurozone.  Unfortunately they are now pioneers in a rather unfortunate direction.  But first a bit of context.

A few months ago I pointed out that the view of policymakers tend to be shaped by the key events of their youth.  Thus the 55 year-old policymakers of the 1960s had their views shaped by the Depression, and erred on the side of too much inflation.  Today’s policymakers were shaped by the Great Inflation, and you can see the results all around us.  I speculated that the next generation would be obsessed with stamping out bubbles, because the consensus (wrongly) interpreted the Great Recession as being caused by bursting bubbles, whereas in fact the “Ben Bernanke criterion” for judging the stance of monetary policy makes it very clear that the Great Recession was caused by tight money.

I was sad to hear that Lars Svensson decided to retire from the Riksbank.  He was a lonely voice of reason in a policy environment increasingly dominated by irrationality:

Svensson, who taught together with Bernanke at Princeton University more than a decade ago, has spent the years since the onset of the global financial crisis arguing that Sweden’s failure to spur inflation has killed jobs. Annual headline inflation accelerated to zero in March from minus 0.2 percent a month earlier and has been below target since January 2012. Sweden’s 8.5 percent jobless rate is the highest in Scandinavia.

The departure of the most outspoken member of the Riksbank’s six-member board has added sparks to a global debate on the role of monetary policy. The International Monetary Fund this month urged central banks to do more to stimulate growth, even as record liquidity risks fueling assets bubbles. Ingves, who is also the chairman of the Basel Committee on Banking Supervision, has cautioned against excessive easing, arguing monetary policy can’t ignore household debt growth.

Svensson has again and again pointed out that policy has been too tight, even by the forecasts of the central bank itself.  They have set their target interest rates at a level too high to hit their employment and inflation mandate, under any weighting scheme.  His opponents talk vaguely about the dangers of potential bubbles, even though that’s not the Riksbank’s mandate, and there are no good macro models suggesting that debt is addressed more effectively through monetary policy than regulation.

I’ve frequently done blog posts providing long detailed discussions of the minutes of the Riksbank.  I get the feeling that most readers were uninterested.  But in many ways the Riksbank debate was our clearest most transparent window into modern central banking.  The views of both sides were very clearly explained.  There was no zero bound problem.  Here’s what we have learned:

1.  The “austerian debate” is a phony debate.  There are lots of central banks that are not at the zero bound (Sweden, Canada, Australia, the ECB, etc), and yet even in these cases money is currently too tight.  Recall that even Paul Krugman admits that fiscal stimulus is not needed when central banks are not at the zero bound.  The problem in the world today is not fiscal austerity; it’s tight money.  Today many Fed officials want to scale back on QE.

2.  Despite the fact that our mainstream textbooks tell us that low rates don’t mean easy money, most central bankers cannot shake the suspicion that low rates do mean easy money, and that the current relatively low rates are a danger to the economy.  This irrational bias is driving policy failure in much of the world.  Even central banks at the zero bound (like the Fed) are inhibited in their push for unconventional stimulus by this cognitive illusion.

3.  Recall that despite all the problems noted by Svensson, the Riksbank is still one of the world’s more progressive central banks.  Things are even worse in much of the rest of Europe.

Most of our central banks are ignoring the flexible inflation mandates that derive from modern new Keynesian models taught at elite universities, and instead have an Ahab-like obsession with killing the Great White Bubble. When I think of the tragic mistakes being made by these central bankers I’m reminded of a comment made by John Cochrane a few years back:

Some economists tell me, “Yes, all our models, data, and analysis and experience for the last 40 years say fiscal stimulus doesn’t work, but don’t you really believe it anyway?” This is an astonishing attitude. How can a scientist “believe” something different than what he or she spends a career writing and teaching? At a minimum policy-makers shouldn’t put much weight on such “beliefs,” since they explicitly don’t represent expert scientific inquiry.

I’d say the same about using monetary policy to address financial/debt/bubble issues.  Our models tell us that this is not wise.  The Fed tried to pop a bubble in 1929 and it didn’t end well.  We need to focus on the dual mandate, prices and output.  Yet the “beliefs” of central bankers are so powerful that they don’t seem to be able to block out these cognitive biases, as they plunge the developed world ever deeper into slow NGDP growth, high unemployment, and ballooning public debts.

PS.  Stefan Elfwing sent me some very interesting information, (which includes some of Svensson’s devastating criticisms of Riksbank policies), and allowed me to reprint his email, for those interested in Sweden and/or monetary history:

Stefan Elfwing

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PS I have taken an interest in Swedish monetary policy during the 30s. It is truly fascinating. There was a very intense and high-level debate when Sweden implemented PLT inspired by Knut Wicksell (he was not involved in the debate since he died 1926). The leading op-ed commentators for the three largest newspapers in Sweden were Bertil Ohlin, Eli Heckscher, and Gustav Cassel (He wrote about 1500 op-eds on economic issues during almost 50 years!)

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Here is a summary by Benny Carlsson:
http://www.riksbank.se/Upload/Dokument_riksbank/Kat_publicerat/Artiklar_PV/2011/er_2011_1_carlson.pdf

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Bertil Ohlin summarized the experiment in 1936

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“The paper currency is nowadays regarded as an alternative to the gold currency not only temporarily in times of crisis but permanently. The pioneering work of educating financial opinion, which has been carried out primarily by Wicksell, Cassel and Keynes, is coming to fruition. A rejection of the antebellum gold standard does, however, not necessarily imply that a restoration of an international monetary system is hopeless. However, it seems probable that gold within such a system will play the role of servant rather than “tyrant”. [—] The experience of a rational monetary policy gained during five years of a paper currency system is a precious advantage. A future monetary system will surely combine several elements of the old gold standard and the paper standard of the crisis era.”

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First Wicksell, then Cassel, and placed third, Keynes:-)

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Here are character portraits of Wicksell, Cassel, Heckscher, Ohlin and Myrdal by Carlsson and Jonung:

http://econjwatch.org/file_download/119/2006-09-carlsonjonung-char-issue.pdf

The first four represent the whole liberal spectrum (Wicksell was a hard-core utilitarian).  It is a shame that it was Myrdal who won the war of ideas after W2. http://research.stlouisfed.org/fredgraph.png?g=hKa

We actually caught you in the beginning of 60s:-) Then, 35 years of stagnation due to the closest to real socialism that has been implemented in any western country (and incompetent monetary policy). Tax/ngdp was 25.2% in 1959 and 52.3% in 1991 when the big crisis hit Sweden.

After returning from a family vacation in Mexico (aka a week long upset stomach I’m still trying to recover from) I have been trying to catch up on the blogosphere.  Tyler Cowen directed me to a series of interesting posts by JW Mason, John Cochrane, (and indirectly) Noah Smith.  All these individuals know much more modern macro than I do, but I’ll provide my two cents worth anyway.  My basic approach is as follows:

1.  Like Milton Friedman, I prefer to use simplest model for the problem at hand.

2.  I prefer to use different models for those business cycles that are created by “nominal shocks” (defined below) and everything else, i.e. “real shocks.”  Real shocks include factors that change the natural rate of unemployment (or LFPR), savings preferences, technology shocks, terms of trade, taxes, government output, etc.  All these things would matter even if wages and prices were completely flexible.  Indeed real shocks would be all that matters.  Indeed they are (almost) all that matters in the long run.

3.  The problem of nominal shocks combined with sticky wages/prices is so radically different from the rest of economics that attempts to capture all of macro in a single model leads to DSGE models that simply cannot do what we ask of them—provide reliable policy advice.  Here’s Noah Smith:

Imagine a huge supermarket isle a kilometer long, packed with a million different kinds of peanut butter. And imagine that all the peanut butter brands look very similar, with the differences relegated to the ingredients lists on the back, which are all things like “potassium benzoate”. Now imagine that 85% of the peanut butter brands are actually poisonous, and that only a sophisticated understanding of the chemistry of things like potassium benzoate will allow you to tell which are good and which are poisonous.

This scenario, I think, gives a good general description of the problem facing any policymaker who wants to take DSGE models at face value and use them to inform government policy.

Read the whole thing.

4.  My preferred nominal shock model would focus on explaining movements in nominal aggregates, and also explaining the business cycle.  More specifically, explaining that part of the business cycle that is due to employment fluctuations attributable to wage and price stickiness.  My hunch is that wage stickiness is the key, so I’ll focus on that issue.

5.  Because of wage/price stickiness, we need some sort of indicator of “nominal shocks.”  We do not have such an indicator, although I often talk as if NGDP is the optimal nominal indicator.  Let’s call the optimal nominal indicator “ONI,” and define it as the variable that, if stabilized by the Fed, would leave employment levels closest to their flexible wage equilibrium, i.e. at a level that would obtain if all wages (and prices) were completely flexible.  Thus “nominal shocks” can only be defined in terms of wage stickiness, and the ONI will depend on the precise type of wage stickiness.  Nominal shocks are not self-evident like “oil price shocks”—you need a model.  NGDP is almost certainly not the ONI, as there are presumably monetary policies that would keep employment closer to its flexible wage level than a NGDPLT policy regime.

6.  The term ‘demand’ is a rather unfortunate carry-over from the Keynesian revolution.  Here’s Mason:

People often talk about aggregate demand as if it were a quantity. But this is not exactly right. There’s no number or set of numbers in the national accounts labeled “aggregate demand”. Rather, aggregate demand is a way of interpreting the numbers in the national accounts. (Admittedly, it’s the way of interpreting them that guided their creation in the first place). It’s a statement about a relationship between economic quantities. Specifically, it’s a statement that we should think about current income and current expenditure as mutually determining each other.

I use the term ‘demand’ in order to talk to Keynesians.  However when I use ‘demand’ I have something in mind that is a specific quantity (NGDP, or ONI), and thus I am not really speaking the Keynesian language—I’m talking a close dialect (like Cantonese to Mandarin.)  I’d like macroeconomists to stop talking about “demand” and start talking about their preferred ONI.

7.  It seems to me that most macro models don’t have a ONI, but rather contain factors that might or might not affect the true ONI (i.e. interest rates, fiscal policy, etc.)  And I think that’s part of the problem.  Here’s Cochrane:

All current macroeconomic theories start with the same basic story: when interest rates are higher, people consume less today, save, and then consume more in the future.

Why isn’t this an example of the fallacy of “reasoning from a price change?”  Cochrane clearly understands this issue because in subsequent paragraphs he talks about the NK view that an outbreak of “thrift” triggered both much lower interest rates and much lower consumption.  Aren’t we asking too much of interest rates?  They are a key variable for intertemporal allocation decisions, but the NK models also use them to represent monetary policy.  That’s just one of the reasons I prefer to use an ONI as an indicator of monetary policy.

8.  Later Cochrane discusses the NK view that inflation, even supply-side inflation, can boost real consumption:

Fiscal stimulus, and many of the other seemingly magical properties of new-Keynesian models (see  last post) follow from the idea that inflation is good. Fiscal stimulus raises inflation. Broken windows, hurricanes, pointless public works projects, temporarily lowering the economy’s productive capacity, all raise inflation (how is in other equations of the model), which lowers interest rates.

I’m not sold on this story, as you probably guessed, for a variety of reasons.

I’m also skeptical, but for reasons that Cochrane would probably reject even more vehemently than the NK models he criticizes. The view that disasters boost output violates the undergrad AS/AD approach to macro, which predicts that a hurricane will shift AS to the left, reducing output.  I believe the textbook AS/AD modelers stumbled on something close to the truth, for essentially accidental reasons.  The AD curve is usually drawn with a curvature that looks vaguely like a hyperbola, but not exactly.  That means “demand” is assumed to be loosely related to P*Y, or NGDP.  In other words, “demand” is a sort of loose proxy for the ONI.  There is no actual “ONI” in Keynesian models, but the simple undergrad AD curve is close enough that it produces pretty decent empirical results, indeed better empirical results than NK models featuring weird upward sloping AD curves.

10.  If you insist on a formal model, call the natural rate of employment (in terms of hours worked) “En.”  Then E – En is negatively related to W/ONI, and hourly wages are very “sticky” in the short run, especially when the aggregate rate of hourly wage rate growth approaches zero.  Thus if the central bank can control ONI, it can also influence E in the short run.  The musical chairs model.  The rest of the economy can be modeled using new classical principles.

PS.  It’s probably best to visualize my simple model by using “aggregate wage and salary income” as the ONI, rather than NGDP.

PPS.  I recommend two new Nick Rowe posts on NGDP targeting and the Phillips Curve.

PPS.  I’ll read all the old comments, and answer as many (or few) as I have the energy for.

PPPS.  Did they really close down Boston when I was gone?  If so, why?  Or to me more specific, can someone write down a rule that determines when the authorities should close down large cities?  I’m not trying to be cute, I actually don’t understand the rationale, although I could imagine several different possible explanations.  But I’d be more interested in what you think.  I’m inclined to see this as a harbinger of things to come.  Welcome to the 21st century.

After Hiroshima you’d think we’ve inflicted enough damage on Japan, but now we are trying to force them to abandon their attempt to climb out of deflation:

The Obama administration used new and pointed language to warn Japan not to hold down the value of its currency to gain a competitive advantage in world markets, as the new government in Tokyo pursues aggressive policies aimed at recharging growth.

I’m sure the administration defenders will insist that the target is not monetary stimulus, but rather “competitive devaluation.”  But of course there’s no way Japan can escape from deflation without a large currency depreciation.  Even after cutting the yen from 76 to 99, their long term bond yields still suggest lower NGDP growth expectations than almost anywhere else in the world.  They need significant further currency depreciation.

BTW,  Lots of people confuse policies aimed at nominal exchange rate depreciation (monetary stimulus) with policies aimed at real exchange rate depreciation (high government saving.)  The two policies are so different that they ought not even be covered in the same course.  To say the Japanese government is not engaged in excessive saving would be an understatement.

PS.  I may not have any time for comments over the next week.

One of the frustrations of promoting new ideas is being forced to shoot down the same “zombie” objections over and over again.  In a recent post, Noah Smith seems to have misunderstood the nature of NGDP futures targeting.  (Actually not in the post, but in this comment.)  He implied it was subject to “Goodhart’s Law” because the relationship between NGDP futures prices and future expected NGDP would break down after the Fed started targeting NGDP futures prices.  He compared it to bitcoin.

One obvious problem with applying Goodhart’s Law is that there is currently no NGDP futures market, and hence no relationship to break down.  But the bigger problem is that he is attacking a proposal that is not being made.  He implies that the Fed would look at NGDP futures prices, and adjust policy as needed to keep them close to the target.  But that’s not what people like Bill Woolsey and I are proposing.

Imagine the FOMC increased from 12 to 13 members.  Does Goodhart’s Law predict that policy would become less effective?  Not that I know of.  How about 14 members?  What about 15?  How about 100 million?

And how about compensating each FOMC voter based on the accuracy of their vote.  Let policy be set at the median vote for the instrument setting.  Then pay people more who were “correct” (i.e more hawkish than average when ex post NGDP ends up above target, and vice versa.)  That’s the essence of NGDP futures targeting.  Of course the real world system would be more complex.  I have a paper coming out soon, but until then my 2006 Contributions to Macroeconomics paper will have to suffice, or this blog post.

It’s not about the FOMC looking to the market for advice, indeed the FOMC would in a sense rely solely on their own internal judgment.  They wouldn’t look to any external market.  The difference is that the FOMC would be completely open, anyone could vote.  The FOMC would become the market.  And voters would be held accountable for their mistakes.  That’s what makes it so scary for policymakers.  Most existing members of the FOMC would probably choose not to vote, as they’d have their own money at stake.  That’s good; they’ve been consistently overestimating how fast NGDP would grow, for I don’t know how many years in a row.

We don’t want them voting.

PS.  Evan Soltas had a couple good comments.

PPS.  I presented this idea at the New York Fed back in the 1980s.  They said something like; “Thanks, but no thanks, we know how to keep NGDP on target.  We can forecast better than the markets.”  How’s that arrogance working out for ya?  A comment by Noah Smith suggests that people like Narayama Kocherlakota are just beginning to think about this idea.  I suppose it’s better 25 years late than never, but I can’t help being disappointed that he is only in the early stages of exploring this idea.  Ten to one that he doesn’t yet know the literature.