Larry Summers has an article in the FT where he admits that the Phillips curve hasn’t worked very well recently, and then advocates keeping interest rates near zero until inflation rises significantly.  Summers likes discretionary monetary policy, whereas I believe that’s how we got into this mess.  Stephen Williamson is also not a fan.  Here he comments on Summers:

If the Phillips curve doesn’t explain what’s going on, how do we get more inflation with continued ZIRP except through a Phillips curve mechanism? Further, Summers seems worried about the “next recession.” Presumably if the Fed still has ZIRP at that point, it’s powerless (except perhaps with unconventional tools) to do anything about it.

Next, we enter the realm of the bad analogy:

…a plane that accelerates too rapidly as it takes off may cause passengers discomfort while a plane that accelerates too slowly may crash at the end of the runway. Historical experience is that inflation accelerates only slowly so the costs of an overshoot on inflation are small and reversible with standard tightening policies. In contrast, aborting recovery and risking a further slowing of inflation is potentially catastrophic “” as Japan’s experience demonstrates. So in a world where economic forecasts are highly uncertain, prudence in avoiding the largest risks counsels in favour of Fed restraint in raising rates.

His assumption, again, is that continued ZIRP will make the inflation rate go up. But “as Japan’s experience demonstrates,” 20 years of ZIRP just serves to produce low inflation.

Of course I think that neo-Fisherians like Williamson get the causation exactly backwards—20 years of low inflation “serves to produce” the zero interest rates.  But Williamson is right to sense something is wrong with the standard Keynesian remedies.  Actually two things:

1.  The inflation targeting approach favored by new Keynesians doesn’t work well today because inflation is no longer closely correlated with output gaps.  In contrast, NGDP is closely correlated with output gaps, and hence central banks should target NGDP, not inflation.

2.  Interest rates are not a good policy instrument, as they can get stuck at zero for years, even decades.  We need a policy instrument with no zero bound (the base, forex rates, or my favorite, NGDP futures prices.)

The Fed thinks that monetary policy can go back to normal in the near future, and that they can return to something like a Taylor Rule approach.  Here’s who disagrees with the Fed:

1.  Me

2.  The 30-year bond market

3.  Stephen Williamson

4.  Paul Krugman and Larry Summers

I’d like to see NGDPLT, Krugman wants fiscal stimulus or a 4% inflation target, and Summers wants fiscal stimulus.

Perhaps it’s inevitable that big institutions like the Fed are reactive rather than creative.  It’s really hard to believe that they don’t see that interest rate targeting just won’t work in the future—that rates will go right back to zero in the next recession (assuming they rise above zero before it occurs.)  Or that IT is far inferior to NGDP targeting.

PS.  I have a piece in the Telegraph, and there’s also another Telegraph article that quotes Lars Christensen and me.

PPS.  Check out my new Econlog post.

PPPS.  Eggs are fine!

HT:  Michael Byrnes, TravisV

In the standard national income accounting, gross domestic income equals gross domestic output.  In the simplest model of all (with no government or trade) you have the following identity:

NGDI = C + S = C + I = NGDP  (it also applies to RGDI and RGDP)

Because these two variables are identical, any model that explains one will, ipso facto, explain the other.  Nonetheless, I think if we focus on NGDI we are more likely to be able to think clearly about macro issues.  Consider the recent comment left by Doug:

Regarding Investment, changes in private investment are the single biggest dynamic in the business cycle. While I may be 1/4 the size of C in terms of the contribution to spending, it is 6x more volatile. The economy doesn’t slip into recession because of a fluctuation in Consumption. Changes in Investment drive AD.

This is probably how most people look at things, but in my view it’s highly misleading. Monetary policy drives AD, and AD drives investment.  This is easier to explain if we think in terms of NGDI, not NGDP.  Tight money reduces NGDI.  That means the sum of nominal consumption and nominal saving must fall, by the amount that NGDI declines.  What about real income?  If wages are sticky, then as NGDI declines, hours worked will fall, and real income will decline.

So far we have no reason to assume that C or S will fall at a different rate than NGDI. But if real income falls for temporary reasons (the business cycle), then the public will typically smooth consumption.  Thus if NGDP falls by 4%, consumption might fall by 2% while saving might fall by something like 10%.  This is a prediction of the permanent income hypothesis.  And of course if saving falls much more sharply than gross income, investment will also decline sharply, because savings is exactly equal to investment.

[Update:  Lorenzo directed me to an excellent post by Andy Harless, explaining why S=I.]

This is where Keynesian economics has caused endless confusion.  Keynesians don’t deny that (ex post) less saving leads to less investment, but they think this claim is misleading, because (they claim) an attempt by the public to save less will boost NGDP, and this will lead to more investment (and more realized saving.)  In their model when the public attempts to save less (ex ante), it may well end up saving more (ex post.)

The Keynesian model probably works best in a gold standard world.  An attempt to save more will depress nominal interest rates.  If the stock of gold is approximately fixed in the short run, then the lower nominal interest rates will boost the demand for gold, and increase the value of gold.  If gold is the medium of account then this will be deflationary.  NGDI will decline, and if wages and prices are sticky this will ultimately lead to less saving and less investment.  So there is a grain of truth in the Keynesian model, if you are in a gold standard world (as Keynes was when he developed the model.)

But we no longer live in a gold standard world, and today it makes more sense to view NGDI (and NGDP) as being determined by the central bank.  In that world monetary shocks create (or worsen) investment volatility.

Here’s another example.  Recent posts by Simon Wren-Lewis and Nick Rowe criticize new Keynesian models that feature a sort of “divine coincidence.”  In these models (assuming Calvo pricing) when the central bank stabilizes inflation it also keeps output at potential.  They kill two birds with one stone—price stability and no output gaps. This result follows from the NGDP (expenditure) approach–focusing on sticky prices and aggregate purchases of consumption and investment goods.

Both Wren-Lewis and Rowe rightly point out that these models did poorly in the Great Recession.  Nick wants to shift to NGDP targeting (as do I.)  But it might be easier to explain the advantages with the NGDI approach.  Unlike the sticky-price NK model, the “musical chairs model” did beautifully during the Great Recession.  In this model, when there is a sudden fall in NGDI, there is less income to allocate to workers. Because hourly wages are extremely sticky, this means many fewer hours worked. If the major central banks had kept inflation stable during the Great Recession, it probably would have been a bit milder, but we still might have experienced a pretty big recession.

In contrast, a stable path of NGDI would have led to fairly stable hours worked (unless hourly wages did something truly bizarre in response.)  What about the Lucas Critique? If it applies at all (and I’m not sure it does), then I’d guess workers would respond to NGDI targeting with even stickier wages.  Output gaps would probably be much smaller, but might be longer lasting.  Indeed it’s quite possible that the “Great Moderation,” which produced results not too unlike NGDP targeting, has already made wages a bit stickier (especially when compared to the 1865-1929 period.)  If so, that’s a price I am more than willing to pay.

PS.  We finally succeeded in embedding the NGDP futures price at Hypermind in the right column of this blog.  Please look for it when you tune in each day.  And trade some contracts—you can win but you can’t lose.  The specific price shown (about 4.2% last time I checked) is for 2014:Q4 to 2015:Q4.

The iPredict market is still progressing, but these things always take longer than I expect.  It took us several weeks just to get the NGDP price embedded.

PPS.  The winter from hell continues.  Boston has gotten about 70 inches of snow in the past 17 days.  Before that we had only gotten 5.5 inches all winter.  In 17 days we’ve gone from a winter with almost no snow, to the 10th snowiest ever.  And there are two months to go, with more snow on the way.  To put that 70 inches in 17 days into perspective, the previous record was 31 inches in a week.  So it’s roughly like we had 2 1/2 weeks in a row of snow intensity at the level of the very worst week in all of Boston history.  A stock market analogy would be 17 days of decline at the rate of the worst week in NYSE history.  Ouch.

If you start to see me endlessly typing:

All work and no play . . .

Or:

Here’s Scottie!

You’ll know that cabin fever has set in.  Schools are closed as often then they are open, 6 days missed in the past 2 1/2 weeks.

Probably shouldn’t have watched Twin Peaks with my teenage daughter—definitely won’t be renting The Shining.

From the New York Times:

Guy Morin, the mayor of Basel, acknowledged news of the sale of the Gauguin and bemoaned its loss. On Tuesday, The Baer Faxt, an art world insiders’ newsletter, said Qatar was rumored to be the buyer of the Gauguin at $300 million, which would exceed the more than $250 million that Qatar reportedly paid for Paul Cézanne’s “The Card Players” in 2011.

So what do we make of all this?

1.  Economics is about choices, mutually beneficial trades.  The developed countries (I’ll call them “the West,” even though East Asia buys lots of the gas) swap art for gas.  This is probably a good deal for the West from a utilitarian perspective, as the gas is worth far more than the difference in utility from looking at these paintings, as compared to other paintings that will replace them on the wall (and I’m saying this as a huge Cézanne fan.)

2.  Or you can look at the labor involved in producing those 2 paintings, compared to the labor required to mine millions of tons of coal that would be burned, if we didn’t buy natural gas from Qatar.

3.  On the other hand the labor criterion may be misleading.  Suppose 10,000 artists each try to produce great paintings, knowing that each has a 1/10,000 chance of being the next Jeff Koons.  All the failures earn zero, and the one success (Koons) makes $1 billion dollars.  Ex ante, each artist might be willing to devote a lot of time on that lottery ticket to success.  Yes, there is risk aversion to consider, but also the utility to be derived from the romanticism of struggling artistry.

4.  So the huge expenditures on art by contemporary masters have a very large labor cost.  But surely this doesn’t apply to dead artists?  I’m afraid it does.  While they were alive people were buying their art, hoping they’d be the next Van Gogh. Oil paintings are near infinite-lived assets.  Even the purchase of paintings by dead artists is a spur to the contemporary art industry, just as the success of Facebook is a spur to the venture capital market of new social media companies trying to get going.

5.  Does this trade increase inequality in the West?  After all, millions pay gas bills to Qatar, and the money is then sent back to one rich guy in Switzerland.  Yes, the refined taste of Middle Eastern royalty is making income in the West more unequal. In contrast, if Qatar had purchased 10,000 Mercedes with the $550,000,000, to be distributed to Qatari public employees, then lots of the money would have gone to workers in Germany—a more equal distribution.

6.  But wait, those Mercedes have an opportunity cost.  Western consumers don’t get to enjoy them.  Measured consumption would be higher in the West if they swapped the paintings rather than the cars.

7.  On the other hand, argument #6 is refuted by my earlier observation that the spur to the art market caused by this purchase leads young Germans into the art industry, instead of the technical schools training future Mercedes employees. Either way, roughly the same quantity of consumer goods is produced in the long run.  The difference is that income inequality is greater if consumption tastes shift from a constant cost industry (cars) to a winner-take-all industry (art.)

PS.  The Gauguin was on a semi-permanent loan to a Swiss museum, while the Cézanne was sold out of a private collection in Greece.  Does that matter for equality?  It depends what the Swiss seller does with the money.  Do they spend it on something equally charitable to the loan of the painting?

HT:  Lorne Smith

Noah Smith is generally an excellent blogger, but when he switches over to Bloomberg.com, he . . . well let’s be charitable and assume the editors forced him to dumb things down.  Waaaaay down:

One crowd-pleaser is Scott Sumner, a professor at Bentley University, who is the champion fighter of a team that calls itself the market monetarists. They believe that it’s the Federal Reserve’s job to fight recessions, doing whatever it takes in the way of monetary easing in order to get nominal gross domestic product (click on the link for a full explanation) back to a healthy trend.

Just for the record, I don’t think the Fed should fight recessions, and indeed I believe they should ignore RGDP entirely.  I believe the Fed should prevent NGDP shortfalls (and overshoots.)  Aren’t they the same thing (some commenters always ask me?) Check out NGDP during Zimbabwe’s 2008 recession.  Or the 1980 recession (which Volcker did “fight,” and was wrong to do so.)

The basic market monetarist case against the Keynesians is that U.S. federal government spending, and deficits, have both been decreasing relative to GDP in recent years, and that this hasn’t brought us to economic ruin.

Readers of this blog know that this is not the “basic market monetarist case.”  They know that monetary offset was the consensus Keynesian view in 2007.  They know that MMs believe there is no reason to abandon that consensus.  They know that the deficit fell by an astounding $500 billion in calendar 2013.   They know that $500 billion is an extraordinary amount of austerity.  They know that Paul Krugman and Mike Konczal called this a “test” of market monetarism.   They know that 350 Keynesians signed a letter warning of recession if just a bit more than $500 billion in austerity were to occur. They know that RGDP growth in calendar 2013 nearly doubled over 2012. But of course readers of Bloomberg learn none of this.

Yes, if it were just a matter of the deficit decreasing in “recent years” then I’d entirely agree with Smith, it would tell us nothing.  Smith makes it seem like we have no good reason to dismiss Keynesianism:

As you can see, government spending flatlined for about four years (and deficits declined) but GDP kept right on growing. In the mind of the market monetarists, that’s case closed — Keynesianism is dead.

That’s not my “mind.”  Smith continues:

Others might claim that what matters is total government spending, including state and local governments, which boosted outlays quite a bit in 2013. Sumner, in his post, waves away these objections, accusing Keynesians of a “shell game” in which they claim to care about whichever method supports their thesis.

This is like those headlines stating, “Is the earth flat?  Opinions differ.”  I mean seriously, is there any Keynesian model that treats state and local spending differently from investment?  If you are going to add S&L spending to Federal spending, then why the hell don’t you add investment too?  They both have a multiplier effect.  Neither are controlled by fiscal policymakers. This is why I use offensive language like “shell games.”  It fits.  And by the way, adding S&L spending to the 2013 experiment doesn’t significantly change anything, even if it should be included—which of course it shouldn’t.

Market monetarists have it even easier. Their credo is that the Fed is basically omnipotent, and so everything that happens is a result either of A) Fed actions, or B) expectations of Fed actions. If government spending goes up and GDP goes up, the market monetarists can say that it wasn’t because of fiscal stimulus, but because the Fed decided to be more dovish, and people realized that.

Obviously this is false.  For instance, I don’t believe the Fed can prevent Noah from writing misleading opinion pieces.  Or cure cancer.  I do believe what almost all respectable economists believed in 2007, that central banks can and should target nominal aggregates like inflation or NGDP.  I still believe that.  Why so many other economists have changed their minds is an interesting question that Smith doesn’t address.

To make things worse, all the gladiators in this combat are looking at noisy time series data with very short samples, and making inferences about policy that might or might not operate with a lag, in an environment in which everything is changing at once. And the gladiators are free to pick out any data point that supports their thesis, and ignore the others.

A time-series econometrician would blanch if you presented her with that kind of analysis. She wouldn’t even give it the time of day. Instead, she’d do a historical study, using data as far back as she could go, instead of picking one or two recent points. She would have to use some theory to guide her along, too. And even then, her conclusions would come with huge uncertainty.

I’ve spent most of my life studying older historical examples. And as far as I can tell it’s the Keynesians who favor making sweeping claims based on one or two data points.  All I did is call them on it.

So who’s right? The answer is that we can’t really know. Chris Sims, winner of the 2011 Economics Nobel Prize, has found lots of evidence that monetary policy has an effect on the economy. Prestigious macroeconomists such as Robert Hall have found that fiscal policy has an effect as well. Maybe the market monetarists and the Keynesians are both a little bit right and a little bit wrong.

Of course Hall found that fiscal policy can affect the economy.  There are lots of ways that can occur, even within the MM model.  Sharply higher government spending can depress consumption, and make people work harder, as in the early 1940s.  Lots of types of tax cuts can shift the AS curve.  If the central bank is targeting inflation then lower VATs or employer-side payroll taxes will cause the central bank to boost AD.  Then there is fiscal policy in scenarios with no monetary offset (fixed exchange rates, members of the euro, etc.)

Unfortunately a reader of this Bloomberg column would learn essentially nothing about market monetarism.  But I’m less pessimistic than Smith.  In the 1960s most economists believed that fiscal policymakers could and should try to do stabilization policy, even when interest rates are positive.  By 2007 Milton Friedman had convinced the profession (including Krugman) that the Fed should steer the nominal economy when rates are positive.  Now we just have to convince the profession that they should also do so at zero rates. And that’s what I’m trying to do.

HT  Saturos, Travis

Lots of people favor monetary stimulus, lots of people favor austerity, and lots of people favor structural reform.  But outside the market monetarist community you won’t find many that favor all three.

Except in Japan:

The Abe administration nominated a proponent of reflationary monetary policy to the central bank’s board, buttressing Governor Haruhiko Kuroda’s effort to end a two-decade slump in the world’s third-biggest economy.

The government proposed economist Yutaka Harada to replace Ryuzo Miyao, whose term ends March 25, according to a document distributed to reporters at parliament Thursday. The Waseda University professor, who has said Japan can beat deflation by printing money, co-edited a 2013 book “Reflationary Policy Revives Japan’s Economy” with Deputy Governor Kikuo Iwata and Koichi Hamada, an adviser to Abe on monetary policy.

The pick would give Kuroda another ally on the board after a decision in October to increase already unprecedented easing was carried by the narrowest margin since 2008. Prime Minister Shinzo Abe will have another chance to bolster Kuroda’s sway on the board when an opponent of the extra stimulus steps down in June.

“The nomination is a good news for Kuroda,” said Junko Nishioka, an economist at Sumitomo Mitsui Banking Corp. and a former BOJ official. “He will keep a majority on the board and win what he wants. But the 2 percent inflation target is still out of reach. Kuroda’s struggle will continue.”

.  .  .

In an interview with Bloomberg News in 2002, Harada said the central bank held the key to ending deflation, which began to grip the economy in the late 1990s as Japan stumbled into a recession amid a banking crisis.

“We just need to print money,” said Harada, who was a deputy director at the finance ministry’s Policy Research Institute at the time.

“If the BOJ buys all of the bonds from Japan’s debt market, that will create inflation without a doubt. That’s it,” Harada said. “Deflation will be over if the BOJ buys them under the condition that it would continue the purchases until 2 or 3 percent of inflation is achieved.”

In 2012 paper published before Abe took office pledging to shake Japan out deflation with Abenomics, Harada said the “absence of any real monetary policy” had contributed to Japan’s two decades of stagnation.

Bond Purchases

The BOJ has room to buy more government bonds and should boost stimulus to accelerate inflation, Harada said in an interview with the Asahi newspaper posted on Jan. 21.

“Harada has been a well-known monetarist and a strong supporter on quantitative easing,”Masaaki Kanno, an economist at JPMorgan Chase & Co., wrote in a note.

Miyao was a professor at Kobe University before taking up his post on the board. The term of Yoshihisa Morimoto, an executive at Tokyo Electric Power Co. before he joined the BOJ, is set to end on June 30. Morimoto dissented in October’s 5-4 vote to increase stimulus, which gives the central bank room to buy every new bond issued by the finance ministry.

The openings on the board comes as the BOJ approaches the two-year mark after Kuroda introduced the asset purchase program in April 2013. The plunge in oil prices is challenging Kuroda’s effort to spur 2 percent gains in consumer price that he said at the time the BOJ could achieve in about two years.

JPMorgan is among banks forecasting consumer prices will decline in coming months due to the effects of cheaper oil. The BOJ’s main inflation gauge slowed to 0.5 percent in December.

Easing Expansion

A majority of economists see the BOJ adding to easing by October this year as inflation slows.

Etsuro Honda, another adviser to Abe, said policy board selections are crucial to give Kuroda flexibility as he seeks to revive the economy.

In Harada, Kuroda would also find support for his case that Japan’s government must tackle its debt problem to put the economy on a long-term stable footing.

“Harada isn’t just a reflationist,” said Hamada. “He understands the importance of fiscal consolidation and he’s very serious about it.”

In a book published in 2013, Harada advocated Japan’s participation in the Trans-Pacific Partnership, a U.S.-led free-trade initiative that Abe is negotiating to join as part of his effort to revive the economy.

Paul Krugman likes to point out that market monetarists don’t have much influence.  Perhaps not, but our ideas do seem increasingly popular in the world’s 3rd largest economy.

Now if only we could convince them to do price level targeting, or better yet NGDPLT.

HT:  James in London