Archive for November 2013


Comments on Arnold Kling on Larry Summers

As usual, I’m in a sort of triangle, where I don’t agree with either side.  But FWIW, here’s how I’d respond to Arnold Kling’s new post:

Cowen’s stagnation story is that the pace of innovation has slowed, resulting in declining growth in aggregate supply. In contrast, Summers’ story is one of a permanent shortfall of aggregate demand, due to an excess of desired saving over desired investment, which can only be eliminated at a negative real interest rate.

The stories complement each other.  Summers claims that some sort of exogenous shock has reduced the long run real interest rate on safe assets.  Slower growth in RGDP (due to supply-side factors) is one likely explanation.

Here are some criticisms that come to mind.

1. If “the” full-employment real interest rate is negative, then why do we need quantitative easing? Why does not the excess of saving over investment not by itself drive long-term rates to zero?

Because nominal yields are expected to rise above zero in the long run.

2. Summers wants to claim that full employment has been achieved in recent years because of asset bubbles. However, in a world of negative real interest rates, there is no such thing as an asset bubble. Real assets have infinite value in such a world.

Most assets are riskier than T-bills, and long term rates are not negative.

3. As Tyler points out, it is hard to reconcile positive economic growth with negative real interest rates. We have had positive economic growth, even since 2008.

And real T-bill yields have been negative since 2009.  It’s not a question of whether you can “reconcile” the negative rates with growth; they are a fact.  The question is what’s causing them?

4. As Tyler also points out, we observe higher interest rates for risky assets. In fact, if you want to understand the low interest rates that Summers and Krugman are talking about, then my suggestion is to “follow the guarantees.” In one way or another, the U.S. government has provided a guarantee on many investments. Government bonds are one example. Mortgages are another.

I think everyone agrees that one of the reasons why T-bill yields are so low is that they are risk-free. But they were risk free before 2008, and had positive yields.  The fact that the rates on various safe assets are low only because of a government guarantee has no bearing on Summers’ argument.

5. The prime rate at banks averaged 5 percent from 2001-2004, almost 7 percent from 2005-2008, and 3.25 percent from 2009-2012. Inflation over these periods averaged 2.3 percent, 3.4 percent, and 1.5 percent respectively, so that the real rate of interest has been positive throughout.

Yes, but these are not risk free assets, so their positive yield has no bearing on Summers’ argument.  He’s making a claim about risk free assets.

6. Summers’ revival of the secular stagnation hypothesis has not been broadly peer reviewed. Before people jump on the bandwagon, I would wait until it has been evaluated by a broader range of economists.

The best peer review is the markets.  The long term bond markets suggest that Summers is partly right, but overstates his case.  The 30 year T-bond yields 3.81%, which is low, but well above the 1.64% in Japan.  The market probably see rates hitting zero in future recessions and initial recoveries, but not otherwise.

PS.  The Keynesian liquidity trap model suggests that monetary stimulus is mostly ineffective if T-bill yields are zero, regardless of the level of other interest rates.  I don’t buy this model (especially with the ad hoc “bubble” addendum), but the arguments used by Kling are not going to convince any Keynesian, as their model allows for other assets to have positive yields.

Rick Santelli explains the real reason for QE3

I usually disagree with Rick Santelli, who’s a monetary hawk right now.  But in this interview he clearly explains why the Fed needs to do so much QE: the money market industry.

Back in late 2008 a few money market funds got into trouble and were in danger of “breaking the buck.” That’s due to their policy of pricing each share at $1.  The solution is to allow the price to fluctuate.  The Fed should have given the industry 6 months to prepare for negative interest rates.  Instead they bailed them out and propped up interest rates at 25 basis points, in order to insure they would never break the buck.

If not for the money market industry the Fed could have already cut the fed funds target to around negative 0.25%, and the same for the interest rate on reserves.  In that case (and assuming the IOR also applied to vault cash) it’s likely that most of the ERs would exit the banking system and end up in safety deposit boxes.  But three trillion dollars is a lot of Benjamins, and despite the cash hoards you observe in places like Japan, a more likely outcome would have been hyperinflation.  Obviously that would not be allowed, so what this thought experiment really shows is that with that sort of negative IOR the Fed could have gotten the stimulus it wanted with much less QE.

Santelli is one of the few people who understands the real reason for the massive QE program.  Kudos to CNBC. (Louis Woodhill also frequently discusses IOR.)

PS.  On balance I’d prefer the old policy of no IOR, rather than negative IOR.  But negative IOR is preferable the current sluggish recovery in NGDP.

If only the ECB had paid attention to market monetarism 5 years ago

Ambrose Evans-Pritchard suggests that the ECB might be moving toward easier money:

The doves are seizing control of the European Central Bank. They are already laying the ground work for a blitz of Anglo-Saxon QE, whatever the Germans, Dutch, Austrians, and Finns (?) have to say about such wicked Latin conduct.

Welcome to the next fascinating phase of the EMU opera buffa, opera tragica.

The ECB’s Peter Praet – the board member in charge of setting economic policy debates – has given an astonishing interview to Brian Blackstone at The Wall Street Journal, opening the floodgates for bond purchases.

It is clear that the slide towards deflation and Euroland’s fizzling recovery have caused a revolt at long last. The ECB’s Latin (plus) majority simply refuses to accept Bundesbank orders any more.

“If our mandate is at risk we are going to take all the measures that we think we should take to fulfil that mandate. That’s a very clear signal,” said Mr Praet.

“The balance sheet capacity of the central bank can also be used. This includes outright purchases that any central bank can do. The rules do not exclude that you intervene in the markets outright.”

“For some decisions it’s easier than others [to gain consensus]. One thing is clear: the Governing Council has been able to decide. That’s really the message.”

So there you have it. This had to happen since deflation in southern Europe is causing debt dynamics to go berserk, defeating any of the alleged gains from the rest of EMU policy. Nations have to protect themselves.

“That is a radical change of position for the ECB and a very welcome one in our view,” said Ken Wattret from BNP Paribas.

“This is the most explicit signal yet from an ECB official that balance sheet expansion via asset purchases is on the radar.”

“The patience of the majority of Council members towards the ‘blocking minority’, which has led to a worryingly slow policy response to persistent below-objective inflation to date, has been exhausted. The plunge in inflation in October has been the trigger.”

Memo to FT editors: Be as crazy as you like, but give us an explanation.

There seems to be no end to the creative ways by which people justify outrageously contractionary monetary policies.  First we were told that monetary stimulus was unacceptable because the ECB needed to focus like a laser on 2% inflation.  Now we are told that 2% inflation is unacceptable because the ECB must allow the peripheral countries to experience the wonders of beneficial deflation.  I guess I should be happy that people finally recognize that inflation is the wrong target, but I somehow expected something better to replace it. Here’s the Michael Heise in the Financial Times:

Nonetheless, bank lending has been on the retreat, bankruptcies have soared and disposable incomes have fallen. This is the kind of demand shock that fosters bad deflation: a financial crisis causes aggregate demand to shrink faster than supply, resulting in falling prices.

However, looking through the lens of aggregate supply, the difficulties of the eurozone’s periphery bear only a superficial resemblance to those plaguing Japan. In this case, falling prices are the result of a supply shock, through improved productivity or real wage reduction.

Low inflation or even deflation is testament to the fact that (painful) adjustment through structural reforms is finally working.

Actually the situation in the periphery is a lot like Japan, if not worse.  After all, Japan does not have 12% to 27% unemployment (even accounting for mismeasurement in Japan.)

When AD declines you see a decline in both output and inflation.  Then the self-correcting mechanism takes over.  Heise seems to be suggesting that we are now seeing the self-correcting phase.  But that’s clearly not the case; if it were then RGDP growth in the periphery would be above trend.

The mistake is to look at the inflation rate, which tells us nothing of interest.  Rather the key variable is NGDP, where growth has slowed sharply since 2010, pushing the eurozone into a double-dip recession. That’s a demand shock, pure and simple.  If the ECB raises the NGDP growth rate (and there are a few signs it may be shifting toward easier money) then the self-correcting mechanism will kick in.  For any given growth rate of NGDP, more deflation is better. But first you need the NGDP growth.

The eurozone periphery is regaining competitiveness via internal devaluation. This could even be called “good deflation”, and is a world away from Japan, which slipped into deflation because it was able to duck structural reforms for too long with the help of expansionary fiscal policies.

So in Japan bad supply-side policies and fiscal stimulus cause deflation?  I’m lost; I thought both were inflationary.  I’m hoping that commenters can help me here, because this also seems crazy:

In the eurozone, both reasons for deflation – good and bad – interact. On the one hand, low inflation or deflation is a welcome reaction to structural reforms as they accelerate the restoration of (cost) competitiveness; on the other, it is a troubling sign of economic depression as it aggravates the problem of excessive debt.

It is not at all clear whether the ECB’s response addresses the good or bad sort of deflation. The ECB could easily end up killing the wrong guy.

So now it’s not clear whether easy money boosts AD or reduces AS?  Really?

I’m all for wacky unconventional theories, this blog is full of statements that seem crazy to others.  But I never insult the intelligence of my readers.  I assume all my readers know the basic AS/AD model, and I assume that the FT’s readers also understand that model. It’s fine if you want to say things that seem totally strange on the surface, but if you do so then please provide us with an explanation.  I always do so, and expect no less from the world’s leading financial newspaper.

PS.  Everything in this post is doubly true when you considered that Heise’s article is saturated with the language of AS/AD, so he certainly can’t claim those concepts are irrelevant to his analysis.

PPS. Ryan Avent has a much better piece, which ends up by pointing to the similarities between inflation targeting and the gold standard:

The belief in the critical importance of low and stable inflation is more flexible than the gold standard was, and it is born of a better understanding of the workings of the macroeconomy. But it is a binding constraint on recovery and prosperity all the same. And the unwillingness to question its continued utility in the face of evidence that it is doing real harm looks all too similar to the intellectual fetters that led central bankers to persist in foolish policy in the early 1930s.

Pegging the price of gold failed to stabilize US national income, which fell in half from 1929 to early 1933. Targeting inflation failed to stabilize US national income, which fell 4% between 2008:2 and 2009:2.  If we want to stabilize national income, why not target national income?

Ryan mentions a higher inflation target, but that’s not needed.  The reason so many Keynesians keep returning to that assumption is that they rely on the wrong model, IS/LM with a downward-sloping IS curve.  If they could somehow absorb Nick Rowe’s insight that the IS curve is often upward-sloping (especially for large monetary policy shifts), then they’d realize that NGDPLT is enough, no need for a higher inflation target.  Easy money creates faster NGDP growth, which raises nominal interest rates.  The zero bound is not a factor preventing monetary stimulus, it’s the result of an excessively low (implicit) NGDP target.

HT:  Nicolas Goetzmann

China: The glass is now 51% full

For those who have trouble with framing effects, let’s get this out of the way up front:

1.  China has very bad economic policies

2.  China has very bad human rights policies

3.  China has very bad environmental policies

Now can we talk about the more interesting first derivative?

China is improving in all three dimensions and the new reform package accelerates the pace of change, particularly in the area of human rights.  The Hang Seng index soared today on the news:

China’s broad-based reform plans got a thumbs-up from the markets, with Hong Kong and mainland shares climbing Monday, leading regional gains, with positive cues from Wall Street Friday providing a fillip.

Hong Kong’s Hang Seng Index jumped 2.7 percent to end at 23,660.1, its highest close since February, while China’s Shanghai Composite tacked on 2.9 percent to end at 2197.22.

China will avoid the middle income trap because the Chinese government’s overriding objective is to avoid the middle income trap.  Brazil did not avoid the middle income trap because that wasn’t the overriding objective of the Brazilian government.  If avoiding the trap meant shifting 10% of Brazilian GDP from public employee pensions to infrastructure, then it was not worth the price.

The best way to analyze China is to ignore levels and focus on first derivatives. Pay no attention to the current structure of China (political/economic/cultural/etc), as China will be totally different in 30 years, just as the current China is totally different from the China of 1983.  The current Chinese government has no say in what the China of 2043 will look like, because it will be ruled by completely different people, living in a completely different world, with completely different attitudes.  That’s the price the CCP will pay for making China into a great power.

PS.  Check out Shenzhen’s new airport:

Screen Shot 2013-11-05 at 2.14.42 PM

Terminal Paradiso.  A mile long. Lots of larger pics at the link.

Prediction:  When Shenzhen and Hong Kong merge in 2047, Shenzhen won’t be stuck in a middle income trap.