I can’t say I am surprised by what people are writing.  But it’s still disappointing.  Let’s review the past 6 months:

1.  The Fed sees fiscal austerity on the horizon in late 2012, and tries to offset it with several monetary initiatives.  They even say they are doing the stimulus with the intention of shielding the economy from austerity.  Monetary offset.

2.  The fiscal austerity that the Fed was worried about does happen.

3.  The Fed forecasts 3% to 3.5% RGDP growth over the next couple of years, knowing full well that fiscal austerity was on the way.

4.  Over here at TheMoneyIllusion I am skeptical that we’ll get 3% to 3.5% RGDP growth, based on market indicators.  I claim that the Fed actions are a modest plus (again based on market reactions) but anticipate that it will probably just roughly offset the fiscal austerity, leaving RGDP and NGDP growth in 2013 about the same as 2012.

5.  So far it looks like I was right and the Fed was wrong.  Admittedly things could change, but Fed officials are already in full CYA-mode, blaming fiscal austerity for the slowdown, despite the fact that they anticipated fiscal austerity when they made their forecasts in late 2012.  You don’t hear them say; “Sumner was right, we never should have forecast such robust RGDP growth in the first place.”

6.  Meanwhile the anti-austerians predicted a 1.5% hit to RGDP, some even mentioned 2%, and yet those predictions also look off base so far, as 2013 will look much like 2012.  Yet the press has an overwhelming Keynesian bias, so any facts are assumed to support the Keynesian model, no matter how much at variance. For instance, the US is doing more fiscal austerity that Europe, and yet David Beckworth showed that it’s Europe that has the big slowdown, not the US.  And let’s not even talk about the fact that the biggest surge in public debt in global history—-Japan since 1993, has been associated with FALLING NGDP!!!!  That’s right, the biggest surge in public debt is associated with the worst 20-year performance for AD in all of global history.  Of course “correlation doesn’t prove causation,” unless it supports the Keynesian model.

Karl Smith quotes Jeremy Stein, showing that it takes a PhD in economics from an elite school to concoct a theory that a central bank with a monopoly on the printing of money is somehow unable to debase its own currency:

Moreover, . . , absent policy action, progress on reducing unemployment will likely be slow for some time. Meanwhile, inflation is subdued, running at or below our long-run objective of 2 percent, while inflation expectations remain well anchored. If the federal funds rate were at, say, 3 percent, we would have, in my view, an open-and-shut case for reducing it.

The complication, of course, is that the federal funds rate is essentially at its lower bound, which means that we cannot do more simply by turning that dial further. Instead, we have to use unconventional tools, such as LSAPs and guidance about the future path of the federal funds rate.

OK not unable, just afraid that a policy that produces a million new jobs for the desperately unemployed might lead to a trillion dollar capital gain for the Federal government.  Why would that be a problem?  Because it might be composed of a $200 billion loss to the Fed, and a $1.2 trillion gain to the Treasury, and we all know that the Fed is an independent part of the government, which must never, ever incur a loss, no matter how vast its profits have been in recent years.  (Yes, I’m being sarcastic.)

Here’s what Stein is actually saying, if you translate:

We are going to allow a million workers to remain unemployed, because we are too timid to switch from growth rate targeting to level targeting.

This requires some explanation.  Under growth rate targeting it’s perfectly possible to miss your implied NGDP target of 5.5% by 1.5% each year, leading to 4.0% growth, year after year.  That’s not far from what’s happened since 2009.

Under level targeting (5.5% trend line) if you miss your target by 1.5% each year, the actual NGDP growth rate will still be exactly 5.5%, in all but the first year.  (Think about it.)

Why is this crucial?  Because the demand for base money is negatively related to the NGDP trend growth rate.  So under NGDPLT, a more expansionary policy (higher target NGDP growth) actually leads to less monetary base as a share of QE (Australia’s a good example here) and thus less of that QE that the Fed is so afraid of doing.

Here’s the great irony; the Fed thinks easy money is too risky, and yet the things it (falsely) thinks are risky about easy money (a bloated base) are actually associated with the low NGDP policies of the US and Japan, not the high trend NGDP policy of Australia (6.5% per year since 1996.)

When I think of all the damage being done by these conceptual errors it makes me want to cry.  

PS.  Leaving “rant mode” for a minute; I do concede the Fed didn’t forecast 100% of the recent sequester, and hence Q2 NGDP growth will likely fall a bit below “Sumner Critique” predictions.  I address that issue in this recent post, which some commenters seemed to misinterpret as support for fiscal stimulus.

PPS.  Why is the Fed afraid of level targeting?  Because it’s a powerful tool.  Here’s an analogy.  I’ve got gangrene throughout my left leg.  I ask the doctor for advice.  He suggests a large axe.  I say “how about some drug therapy instead?”  Why am I afraid of the axe?  Because it really will work, it really will get rid of my gangrene leg.

PPPS.  Nick Rowe has a great post, which is loosely related to the “monetary stimulus is risky” idea that I’ve tried to refute here.  Ryan Avent also has an excellent post on a similar theme.

PPPPS.  Is there anyone out there who has drunk so much Keynesian Koolaid that they think that, in the absence of fiscal austerity, in late 2012 the Fed would have been predicting 5% RGDP growth going forward?

[Update:  I initially read the Steil/Walker post as opposing NGDP targeting.  But the actual target of their post was the bad weather fans of NGDP targeting, who would abandon it when they didn’t think it was needed.  Obviously I don’t disagree with their view that the policy should not be an expedient.  Here’s a longer version of their argument.]

I’ve been meaning to comment on a recent post by Benn Steil and Dinah Walker, but Jeff Frankel has just made the argument that I was going to make:

I have in mind, especially, the views of Benn Steil and Dinah Walker of the Council on Foreign Relations, as expressed in “Why  Nominal GDP Targeting is a Fad“: 

“NGDP targeting having once been the intellectual stomping ground of economists on the right (notably Scott Sumner), its newest supporters come overwhelmingly from the left (such as Christy Romer)…. We think the rage will be short-lived. The reason is that NGDP targeting’s newest supporters are bad-weather fans. That is, they like it now, when NGDP is well below its 2007 “trend” line, meaning that the policy implies extended and more aggressive monetary loosening. But what happens when NGDP goes above its target, as it eventually will? NGDP targeting then requires tightening….”

Let’s consider the analytics first, and hold off awhile on the less edifying political labels.   The nominal GDP proposal was originally studied and supported by many prominent economists in the 1980s.  The problem at the time was a need for monetary discipline, anchoring expectations, and reducing inflation.   Nominal income targeting was not designed as a way of getting easier monetary policy, but rather the opposite.   It is equally good for either purpose:  the target can be set high or low, depending on the times.

Originally, the leading competitor for the role of monetary anchor was money supply targeting (monetarism).  This was the regime that was adopted in the early 1980s by the central banks of the largest economies. But they were forced to abandon it subsequently.  Later on, the leading competitor became Inflation Targeting; but it too ran into difficulties in the 2000s.   The general argument for nominal GDP throughout has been that it is robust to a variety of shocks, positive and negative.   It dominates money targeting in that it is robust with respect to velocity shocks.  It dominates inflation targeting in that it is robust to supply shocks.

In other words, Nominal GDP Targeting is not a short-term expedient but is fit precisely for the long run.

.  .  .

Steil and Walker support their argument that the proposal is not fit for the long run with an attractive graph.  It shows that in many of the years since 1981 when the rate of growth of nominal GDP was above 4 ½ %, which they claim would imply monetary tightening under the proposed regime, unemployment was above 5 ½ %, prompting the Fed to loosen (wisely, in the authors’ view, if I understand them right).

The problem with this argument is that of those eight years when the Fed is shown loosening  in response to unemployment above 5 ½ % (by my count), seven of the years came during the first part of the sample: 1983, 1985, 1986, 1987, 1990, 1992, 1993.   (The only year from the more recent half of the sample is 2003.)  Why is this a problem for the argument?  In the 1980s and even the 1990s, it seems to me that nobody would have set a target so aggressive as to require monetary tightening when nominal GDP reached 4 ½ %.   Back then we were coming down from high levels of inertial inflation and this process was understood to be gradual.   Furthermore, the rate of growth of potential output was higher than today as well.   Thus the numbers chosen for the nominal GDP target would have been higher than today.  They would not have forced the Fed to tighten when unemployment was 7%.

During the Great Moderation liberal economists were quite willing to go along with higher interest rates, when needed to keep inflation on-target.  After 2008 many liberals began questioning the 2% inflation target, but so did lots of moderates and conservatives who saw a need for more aggregate demand (and who opposed fiscal stimulus.)  This is how things should work.  Inflation targeting was an improvement on previous regimes such as the gold standard and the unanchored discretion of the 1965-81 period.  And NGDP would be an improvement on IT.  Despite my half-joking comments about NGDPLT being “the end of (macro) history” I do understand that at some point a consensus might develop that an alternative regime is even better than NGDPLT.  Indeed I’ve mentioned that an index of NGDP excluding indirect business taxes might be superior.

But the key point is that when this occurs, the new consensus should not reflect the fact that some policy would be superior at the moment, but rather that it would be superior in the long run.  I think that’s how NGDP proponents feel.  We don’t just think it would have been better since 2008, but rather that NGDPLT over the past 100 years would have outperformed IT.

PS.  One slight quibble with the Frankel post.  He mentions how it might be wise to adjust the NGDP target occasionally, presumably to reflect changes in trend RGDP growth.  Elsewhere I’ve argued that that’s not really necessary (except for population growth), although I’ve also argued it would be a price worth paying to get an NGDP targeting regime in place.  Over time I believe people would start viewing NGDP (per capita) as the relevant nominal aggregate (appropriate for questions relating to the “welfare costs of inflation”) rather than the price level.

Ken Rogoff and Carmen Reinhart have an excellent new column in the FT:

The recent debate about the global economy has taken a distressingly simplistic turn.

Actually, it’s been simplistic from the beginning.  The real problem in the developed world is tight money.   Or should I say the nominal problem. Here’s more:

One of us [Rogoff] attracted considerable fire for suggesting moderately elevated  inflation (say, 4-6 per cent for a few years) at the outset of the crisis.  However, a once-in-75-year crisis is precisely the time when central banks  should expend some credibility to take the edge off public and private debts,  and to accelerate the process bringing down the real price of housing and real  estate.

Structural reform always has to be part of the mix. In the US, for example, the bipartisan blueprint of the Simpson-Bowles commission had some very  promising ideas for simplifying the tax codes.

A few comments:

Rogoff is right that higher inflation would have been desirable back in 2008-09.  But today wage growth has fallen so low that even 2% inflation would promote a robust recovery.  We don’t need to clobber savers with high inflation.  And we won’t.

Over the past year NGDP growth has been running around 3.5%; 2% real and 1.5% inflation.  Given the slack in the economy, if the Fed bumped that up to 5.5% NGDP growth for 2 years, we’d get around 2% inflation and 3.5% RGDP growth.  At worst it would be 2.5% inflation and 3% RGDP growth.  In either case the unemployment rate would quickly fall back to the natural rate (whatever it is.)

Unfortunately there is very little chance that the Fed will achieve 5.5% NGDP growth.  Some have argued that fiscal austerity is slowing the recovery.  Indeed the Fed has argued that fiscal austerity is slowing the recovery.  And that’s because fiscal austerity is slowing the recovery.  RGDP growth in Q2 will likely be lower than if the sequester had not taken effect.  So why do I keep prattling on about  “zero fiscal multiplier?”

This is a hard concept to explain, so let me use the analogy of Lucas’s critique of discretionary monetary stimulus.  Lucas argued that discretionary monetary policy was undesirable.  He argued that monetary stimulus was ineffective if anticipated, as it would already be factored into wages and prices.  Then people would ask Lucas why unanticipated stimulus would not work.  He replied that one had to think in terms of systematic policy rules that one could write down on a piece of paper, otherwise there was little hope of producing a welfare-enhancing monetary regime.  Suppose you wrote down “Every time unemployment rises above 7% we’ll do an unexpected monetary stimulus.”   Then it would no longer be unexpected!  In other words, the monetary authority could only surprise the public by doing “wild and crazy” things which people had no reason to expect.  How likely is that to work?

I think wages and prices are stickier than Lucas believes, so I think even systematic monetary policies will have some real effects.  But the logic of his argument applies pretty well to the monetary offset issue.  The claim today seems to be “fiscal stimulus can work if it catches the Fed off guard, as with the April 2013 sequester.” Yes, but now think about this game from a “timeless perspective,” (not a 2013:2 perspective) where you don’t know the starting point.  Over time, there will be equal number of cases where fiscal stimulus is greater than expected, and less than expected.  Thus on average fiscal stimulus will have no effect.  Since 2009 there have certainly been some quarters of greater than expected stimulus and some quarters where it was less than the Fed expected. But it’s absurd to think we can have long run success from fiscal stimulus via a policy of Congress continually fooling the Fed.  It’s hard to imagine a less nimble organization than Congress.

I’ve emphasized that estimates of fiscal multipliers are nothing more than estimates of central bank incompetence.  When the Fed took some aggressive steps late last year, they said that one purpose was to offset fiscal austerity.  They said their actions, combined with the expected results of the fiscal cliff, would lead to 3% to 3.5% RGDP growth.  They will probably fall short, but why?

1.  Faulty model; over-estimating expansionary effect of the Evan Rule, or the very low rates, or QE?

2.  A worsening global environment?

3.  More fiscal austerity than expected?

4.  All three?

Who knows? But I’m still not seeing any evidence that RGDP growth will slow by 1.5% as compared to recent years, as the anti-austerians predict.  However I do see evidence of central bank incompetence.  So I’ll re-iterate that the zero multiplier is a baseline for starting to think about the problem, or as the average effect over long periods of time, not a precise estimate of the effect of fiscal stimulus in each and every case.

Here’s the question that should be of interest to serious macroeconomists (as opposed to ideologues.)  If the fiscal contraction of 2013 had not been expected, what would the Fed have done in late 2012?  And what would their forecast for RGDP growth have been?  I’m not certain exactly what the Fed would have done, but I’m pretty sure their forecast for 2013 growth would have been around 3% to 3.5%.  Maybe a tad higher than otherwise, but nothing close to the 1.5% extra RGDP growth predicted by the anti-austerians.

HT:  Nicolas Goetzmann

Paul Willen recently presented a paper on the housing crisis here at Bentley University.  It might be the best paper I’ve read on the subject.  Since it’s not my area, I don’t know if their ideas have already been discussed on the internet, but if not I strongly recommend people take a look.  The paper is too long and exhaustively documented to present in a short blog post, but their “12 facts about the mortgage market” provide a hint:

Fact 1:  Resets of adjustable rate mortgages did not cause the foreclosure crisis.

Fact 2:  No mortgage was “designed to fail.”

Fact 3:  There was little innovation in mortgage markets in the 2000s.

Fact 4:  Government policy toward the mortgage market did not change much from 1990 to 2005.

Fact 5:  The originate-to-distribute model was not new.

Fact 6:  MBSs, CDOs, and other “complex financial products” had been widely used for decades.

Fact 7:  Mortgage investors had lots of information.

Fact 8:  Investors understood the risks.

Fact 9:  Investors were optimistic about home prices.

Fact 10:  Mortgage market insiders were the biggest losers.

Fact 11:  Mortgage market outsiders were the biggest winners.

Fact 12:  Top-rated bonds backed by mortgages did not turn out to be “toxic.” Top-rated bonds in collateralized debt obligations (CDOs) did.

Each assertion is fully documented.  There is lots of fascinating information:

A focus on mortgage companies alone understates the role of the OTD model, however. Starting in the 1970s, the OTD model was adopted by other financial institutions, most importantly savings and loans (S&Ls), which financed the majority of U.S. residential lending in the postwar period. S&L’s had historically followed an originate-and-hold model. By the late 1970s, however, rising interest rates had generated a catastrophic mismatch between the low interest rates that S&Ls received on their existing mortgages and their current costs of funds. This mismatch, which would eventually render more than half of S&Ls insolvent, encouraged thrifts either to turn to adjustable-rate mortgages or to sell the mortgages they originated to the secondary market.

Wait, I thought Paul Krugman told us that the pre-1980 period was the golden age of “regulation.”  And then there’s this:

Consider the Dodd-Frank requirement that loan originators retain 5 percent of the credit risk of certain mortgages. During the housing boom, would this requirement have stopped lenders from making bad loans? In 2006 and 2007, lenders originated $791 billion subprime loans. Had Dodd-Frank existed, lenders would have retained 5 percent of that amount or $40 billion of subprime credit. Overall loss rates of 35 percent would have saddled them with $14 billion in losses.54 Inspection of Table 4 shows that mortgage-related losses exceeded that amount for no fewer than eight firms individually. In other words, if every one of those ï¬rms had followed the Dodd-Frank requirement and originated the entire subprime mortgage market, they would have suffered smaller losses than they actually did.

I knew Dodd-Frank missed the boat, but it was even worse than I assumed.  And the reason why is simple.  The cheerleaders for the “deregulation” explanation of the crisis, such as the NYT, don’t actually want effective regulation, because that would make it harder for low-income people to buy homes.  Here’s the NYT:

It seemed an easy fix to prevent the excesses of the housing market: make home buyers put more money down.

But as the housing market starts to return and the subprime mess fades from memory, the issue is up for debate.

Lenders and consumer advocates “” rarely on the same side of the issue “” are now cautioning against down payment requirements. They argue that such restrictions could limit lending, and prevent lower-income borrowers from buying homes. They also contend that the new mortgage rules put in place this year will do enough to limit foreclosures, making down payment requirements somewhat superfluous.

The arguments seem to run contrary to long-standing beliefs about homeownership. For decades, experts have emphasized the need for a sizable down payment “” a rule of thumb being 20 percent “” on the premise that borrowers with a sizable chunk of equity in a home are less likely to walk away when things get bad.

“If our goal is to prevent foreclosures, I can’t think of anything more effective than requiring a down payment,” said Paul S. Willen, a senior economist and policy adviser at the Federal Reserve Bank of Boston.

The issue may not be so black and white. Regulators want to protect borrowers and promote homeownership. But they also want to encourage lending and insulate the financial system from future shocks.

Why am I not surprised?  The NYT wants ineffective regulation, like having to rapidly sign 50 meaningless “disclosure” forms when you refinance, instead of the current 25 meaningless disclosure forms.

PS.  My only suggestion to Foote, Gerardi, and Willen would be to focus on the Fed’s catastrophic policy failure, which allowed NGDP to plunge 9% below trend in 2008-09, as a key unforeseen factor that contributed to the severity of the housing debacle.  But that’s easy for me to say, they work at the Fed!