On June 8th Larry Kotlikoff did a bloggingheads discussion of Thomas Piketty with Glenn Loury. Kotlikoff pointed out many important flaws with both the theory and data in Piketty’s new book. Unfortunately, the discussion was somewhat marred by Kotlikoff’s personal attacks on Piketty:

This guy is a fraud. 

Kotlikoff suggested that Piketty knew that his model was wrong, and was intentionally misleading in order to create a sensation.  But again, I agree with most of the substantive economic points made by Kotlikoff.

Now Kotlikoff has a new column at Forbes criticizing Krugman:

I think public intellectuals, like Paul Krugman, have a responsibility to act like grownups in speaking with the public. If they start calling people with different views “stupid,” they demean themselves and convey the message that name calling rather than respectful debate is appropriate conduct. It certainly is not.

Economists who are engaging with the public have a special responsibility in this regard. First, none of we economists know anything for dead sure. Second, understanding the economy and our various theories of the economy is really difficult for people who haven’t spent years seeped in the subject. So a key job economists have is to explain the different views we have about how the economy works before explaining why we prefer our view. .

Simply saying “You’re wrong, I’m right, and, furthermore, you’re stupid for not agreeing with me.” is something you’d expect from a child, not a grown up and certainly not from a columnist for the New York Times who sports a Nobel Prize.

PS.  Fortunately I never overlook my own faults when criticizing others.  The Pied Piper remark? That was meant as a compliment.  🙂

HT:  Marcus Nunes

A big demand slump isn’t just an economic disaster; it’s also a prediction of an economic disaster. And that means it’s a prediction of policy failure.   At least that’s the implication of the Woodfordian view of macro (which I accept.)  Changes in current AD are mostly driven by changes in the future path of AD.  Changes in near-term NGDP are mostly driven by changes in expected NGDP 1, 2, 5 and 10 years out in the future.  Call it the term structure of NGDP.  And those are driven by the future expected path of monetary policy.

And of course whenever we have crashes like 1920-21, 1929-30, 1937-38, 2008-09, we also tend to have asset market crashes.  Asset markets aren’t perfect (1987) but when there’s a very big economic slump on the way they are pretty good at sniffing it out.

So here’s the problem for macro policy.  It’s good at preventing disasters, as we saw with the Great Moderation.  But when it fails, it’s really, really hard to fix the problem, because doing so requires policymakers to be more effective than the markets predict.  I won’t say that things are hopeless when markets predict disaster, but I wouldn’t put much hope on stabilization policy.  In the textbooks, the purpose of stabilization policy is to “fix problems.”  In reality it will usually fail at that.  Rather it’s good at preventing problems.  If you’ve got a problem, you’ve already failed.  Like the old joke—“if you are headed there, I wouldn’t start from here.”

I was reminded of all this while reading a Brad DeLong post that discusses a debate between Nick Rowe and Simon Wren-Lewis.  DeLong looks at the possibilities offered by monetary and fiscal stimulus when you have a “deficiency in demand.”

Let’s look at this from a different perspective.  The problem is not “demand deficiency” it’s expected demand deficiency.  Policymakers try to steer the nominal economy, they implicitly or explicitly target NGDP one or two years out in the future.  If 12 month forward expected NGDP is right on target, then no policy changes are needed.  And if 12 month forward NGDP is below target, then the markets have predicted policy will fail, and their forecast counts for far more than the views of any academic economist or government policymaker.  At that point, we really shouldn’t expect much from macro policy.  It’s likely to fail.  No wonder people are so pessimistic about monetary policy! Markets have observed the behavior of the relevant central bank (Fed, ECB, etc.) and come up with the optimal forecast of the result.  If there’s an expected demand shortfall, markets have already given a vote of no confidence to the policymaking apparatus.

From that perspective, DeLong is asking the wrong question.  It’s not, “how do we fix this problem?”  It’s, “how to we make it so that Brad DeLong and Simon Wren-Lewis never ask, ‘how do we fix this problem.'”  I see two ways, and only two ways of doing that.  Both methods involve abandoning the Keynesian policy of interest rate targeting.  Interest rate targeting doesn’t work at the very moment when good monetary policy is most essential—in a very deep demand slump. Would you buy a car that had a brake that failed just 1% of the time—only on twisty mountain roads with no guardrail? Then why do you (Keynesians) buy interest rate targeting as the appropriate policy instrument?

1.  One method would have the central bank peg the price of one year forward NGDP futures, and do OMOs until the market price is right on target.  Now you don’t have to worry about what to do if there is an expected demand deficiency, because there never is an expected demand deficiency.  At least not one expected by the market.  There may be a current demand deficiency, but if it isn’t expected to persist, then stabilization policy is right on target.

2.  Let’s say you don’t buy the “market” part of market monetarism.  You think markets are irrational.  “Better leave this to the wise mandarins who will control policy in the optimal fashion.” What then?  It’s very simple, you do what Lars Svensson suggested, you set the monetary instrument at a position where the central bank’s internal forecast is equal to the policy target.  But which instrument?  Recall that we have abandoned interest rate targeting.  Don’t ask me, I’m the NGDP futures market guy–ask the mandarins.  Anything with no zero bound.  It might be the monetary base, it might be the trade-weighted exchange rate, it might be the nominal price of zinc. There is an infinity of possible choices.  (Now do you see why I’d rather let the markets set policy?)

In his post, DeLong cites Wren-Lewis saying he’s heard the MM arguments, but doesn’t buy them. Then he goes on to conclusively show he has not heard the MM arguments, by using the metaphor of employing both a regular brake and an emergency brake in a car careening down a hill.  This metaphor is supposed to provide justification for using fiscal stimulus “just in case” to back up monetary stimulus.

But that won’t work if you have monetary offset.

In any case, monetary policy is a brake that never fails, and if it does fail you don’t end up crashing, you end up with the Bank of England owning the entire world.  A level of global domination that makes Victorian-era Britain seem like a 98 pound weakling by comparison.  Global GDP is around $100 trillion.  So Piketty would say that global wealth must be around $500 trillion.  Could the Brits live on 5% of that?  I think so.  But wait until the Scots secede, those ingrates don’t deserve any of it.

As Dylan said on his greatest album:

.  .  . there’s no success like failure . . .

The economics profession made a serious mistake a few decades ago when they latched onto “inflation” as a key macroeconomic indicator.  People were very upset about inflation during the Great Inflation of 1966-81, for reasons totally unrelated to the reasons macroeconomists think inflation is important.  Since everyone was talking about inflation, macroeconomists wanted to put it into their models.  Nobody was talking about nominal GDP.

[As an analogy, macroeconomists put short-term interest rates in their monetary models because central banks usually target that variable.  In the 1930s George Warren was mocked for saying that the price of gold is “the” indicator of monetary policy.  But how’s that different from new Keynesians?  After all, when Warren was alive central banks did target the price of gold.]

In any case, it’s become increasing clear that inflation is not the right variable–it does not describe the nominal shocks hitting economies.  And Europeans in particular are paying a heavy price for this mistake, as when the ECB sharply tightened monetary policy in 2011 because a completely meaningless headline inflation number (including “austerity” VAT increases and imported oil) had briefly risen above their 2% target.

As inflation becomes more and more discredited, pundits try ever more clever techniques to make it seem relevant again.  Here’s a recent article from The Economist:

Against this background, it is unsurprising that inflation is stuck at just 0.5%. Although the European Central Bank (ECB) took steps to counter “lowflation” in early June, the worry is that it has still not done enough. In a survey of the euro-zone economy published on July 14th the IMF urged the ECB to adopt quantitative easing””creating money to buy assets including sovereign bonds””if inflation remains too low.

Lowflation represents a particular threat to highly indebted countries like Portugal.

It’s amazing the lengths to which pundits will go to NOT mention nominal GDP.

Let’s compare Portugal and Switzerland.  Over the past 6 years both have seen inflation fall from the low single digits, to near zero.  But look at the nominal GDP numbers (World Bank) for the two countries:

Year       Portugal   Switzerland

2007       169.3          540.8

2008       172.0          567.9

2009       168.5          554.3

2010       172.9          572.1

2011      171.1           585.1

2012      165.1          591.9

2013      165.7          603.2

Portugal’s NGDP is down over 2%, while Switzerland’s is up over 11%.  Not surprisingly, although both countries suffer from “lowflation,” Switzerland has seen RGDP grow 8% over this period, while Portugal’s RGDP has fallen by 7%.

And NGDP isn’t just the right metric for nominal shocks and the business cycle, it’s also the right variable for the debt crisis.  Nominal income is the resource that individuals, business, banks and governments have to repay nominal debt.  Why in the world would someone talking about a debt crisis mention “inflation?”  What does that have to do with debt?  What if a country has 0% inflation and 10% RGDP growth?

That’s not to say inflation is never correlated with demand shocks–most of the time it is.  But NGDP is 100% correlated with demand shocks.  So if you are worried about nominal shocks hitting the economy, why not use an accurate nominal shock measure like NGDP?  Why use a metric that is correlated with NGDP when the economy is hit by demand shocks, but not supply shocks?

Of course even NGDP isn’t going to explain all the movements in RGDP (but it will do better than inflation.)  Switzerland has better supply-side fundamentals, so even if the ECB had done enough monetary stimulus to cause Portugal’s NGDP to rise by the same 11% as in Switzerland, their RGDP performance might well have lagged Switzerland.  Nonetheless, Portugal would have done somewhat better in terms of growth, and their debt crisis would have definitely been much milder.

You want to see “lowflation?” China’s inflation rate (GDP deflator) averaged 0.75%/year between 1996 and 2003—pretty close to Japan.  Now check out the NGDP numbers for the two countries.

I’m begging the economics community.  Stop talking about inflation when you really mean nominal income.  And stop coining terms like ‘lowflation’ in a pathetic attempt to add epicycles to the obsolete inflation-oriented models of macroeconomics.

Inflation, interest rates, income inequality—the “i-words” don’t matter.  NGDP, nominal wages, consumption are what matter.  BTW, the current account deficit also doesn’t matter, as I point out in my newest Econlog post.

Tyler Cowen has a new post discussing the very low inflation rate in the eurozone:

What is the most economical model here?  The ECB invested in building up a lot of credibility in some areas, such as price level stability, but that means less credibility when it comes to pushing higher inflation.  So to get two percent inflation, perhaps the ECB has to genuinely and truly seek four percent inflation, because a big chunk of the market won’t believe they really want four percent.  Four will get them to two.

The ECB in fact may be wishing for two percent price inflation and getting…less than that.  Which in turn conditions market participants to doubt the commitment of the ECB to the rates of price inflation which it claims to be seeking.  The ECB and the citizenry can get stuck in a self-fulfilling prophecies equilibrium, yet without requiring a standard liquidity trap.

I see a simple explanation, the ECB really is as stupid as they seem.  Over the last 5 years everyone from market monetarists to Keynesians have been absolutely incredulous at the statements made by ECB officials, and the actions taken by the ECB.  They often seem incomprehensible.  “Surely they can’t really be this stupid, there must be a dark conspiracy somewhere.”  Call me naive, but I’m inclined to actually believe that they believe what they say:

1.  When eurozone inflation briefly rose above 2% in 2010-11, due to obviously temporary factors like VAT and oil price increases, they sharply tightened policy, insisting that unemployment didn’t matter.  They needed to focus like a laser on inflation.

2.  When inflation fell far below 2%, and indeed into deflation in several countries, we were told that falling prices are actually good, as they help restore competitiveness in the PIIGS.

I don’t think there is a model, just atavistic urges.  Yes, Paul Krugman and I pull our hair out when we read these comments, but I see no reason to disbelieve them.  Their words are backed up with actions.  For 6 years they have acted exactly like a central bank that wanted to push inflation far below 2%.  Keep in mind that eurozone NGDP is up less than 5% in the last 6 years—does anyone think that will lead to 2% trend inflation?

The ECB does not need to shoot for 4% inflation to get 2% inflation, they need to shoot for 2% inflation to get 2% inflation.  I might add that the ECB has NOT been at the zero bound throughout the vast majority of the past 6 years.  They’ve been doing “normal” monetary policy–raising and lowering their interest rate target.  So one cannot point to the zero bound issue as an excuse for the ECB’s policy failure.  They can’t even do normal monetary policy correctly.   Outsiders have consistently pointed out that the ECB would fail to hit their target, and we’ve been consistently right.  Second guessing the ECB is like taking candy for a baby, not even a fair contest.  Look, everyone from Paul Krugman to Milton Friedman knew this wasn’t going to work.  Here’s a Friedman interview back in 1999 in the Hoover Digest:

EPSTEIN: Do you think the European Monetary Union will be a success?

FRIEDMAN: I hope so, but I am very dubious.

EPSTEIN: Why so?

FRIEDMAN: Because the European Union is not an appropriate area for a single currency. There are some cases where a single currency is desirable and some where it is not. It is most desirable where you have countries that speak the same language, that have movement of people among them, and that have some system of adjusting asymmetric effects on the different parts of the country. The United States is a good area for a common currency, for all those reasons.

But Europe is the opposite in all these respects. Its inhabitants speak different languages, have different customs. And there is limited mobility between countries. The exchange rate between different currencies was a mechanism by which they could adjust to shocks that hit them asymmetrically””that hit one area differently from another. The Europeans have, in effect, entered into a gamble in which they have thrown away that adjustment mechanism. It may work out all right. But on the whole, I think the odds are that it will be a source of great trouble.

EPSTEIN: What kind of trouble?

FRIEDMAN: The trouble will not be for all of them. Some among them will be affected by developments that would have called in the past for a depreciation of their currency. But given that they are locked into a single currency, the alternative will be a recession.

The only mystery is why the Europeans are confused about why the euro has failed.

PS.  Rereading Tyler’s post after writing this I’m not sure I actually disagree with him.  I suppose aiming for 4% to get 2% might be consistent with incompetence.  I’m not quite sure if I’m arguing that they don’t have a coherent policy, or that they wouldn’t know how to achieve it if they did, or both.  All I know is that there is no technical mystery—if the steering wheel is set for ENE, don’t be surprised if the ship moves in a ENE direction.  Even if the announced target is ESE.

PPS.  Just saw the employment report.  Wages flat in July, up just 2% in 12 months.  We still have slack–we are in recovery mode.  Unemployment can and will decline further.