Paul Krugman has weighed in on my “never reason from a price change” argument.

[And of course NRFPC it isn’t my idea; it’s a part of EC101 that many economists never learned, or forget on occasion.  Over at Econlog I cited a great Krugman essay where he claimed that one reason he became successful is that he took the stance of a rebel, while using arguments out of standard econ textbooks.  I suggested someone else who had modest success doing exactly that.]

Here’s Krugman:

Sumner says that you can’t reason from a price change; the dollar doesn’t just move for no reason, so you have to go back to the underlying cause and ask what effect it has. Actually, asset price moves often have no clear cause “” they’re bubbles, or driven by changes in long-term expectations, so you really do want to ask about the effects of price changes you can’t explain very well.

Obviously I don’t agree about the existence of bubbles–Fama shoots that idea down in his Nobel lecture.  But even if I’m wrong about bubbles, Krugman is wrong about the relevance of never reason from a price change to bubbles.  It matters very much why prices change, even if those reasons are irrational.  For instance, stock prices may be driven to irrational heights because:

A.  People are irrationally pessimistic about NGDP growth, and this depresses bond yields to unreasonably low levels, and this discounts a given flow of earnings at a higher valuation.

B.  People are unreasonably optimistic about the economy, and expect a highly implausible rate of growth in NGDP and profits.

Surely you can’t argue that it doesn’t matter which of those two types of irrationality cause the stock price “bubble”?  And surely you can’t have confidence that something is a bubble without having some sort of view as to what market thinking is leading to the excessive price movements?

Krugman continues:

More specifically, Sumner is right that if the euro’s fall is being driven by expansionary monetary policy, this affects the U.S. through the demand channel as well as competitiveness, so it may be a wash. But I’ve already argued that the fall in the euro is much bigger than you can explain with monetary policy; it seems to reflect the perception that Europe is going to be depressed for the long term. And if that’s what drives the weak euro/strong dollar, it will hurt US growth.

I agree with the reasoning process in the last sentence.  But I don’t think it applies to the current case, as it seems very unlikely that lower growth expectations are what is depressing the euro.  Here’s what we do know:

1.  Eurozone growth expectations have been in the toilet for years.

2.  The euro was valued at about $1.35 for years, and then gradually fell to about $1.05 over the past few months.

3.  During the past few months the growth forecasts of the eurozone have been revised upward, as the euro has been falling.

You don’t need to be an EMH fanatic like me to see a problem with Krugman’s argument. Kudos to him for not reasoning from a price change, for not lazily assuming that a weaker euro meant more growth.  But I think’s he’s gone too far in the other direction, in assuming that the cause of the weaker euro was lower growth expectations.

Having said that, I’ll admit I’m a bit puzzled by the timing of the euro’s fairly steady decline.  Some of that was associated with easy money statements coming out of the ECB, but not all. So there may be some other factor depressing the euro that I don’t see. I just don’t see any evidence that slower growth in the eurozone is that mysterious X factor.  It’s not new information.  On the other hand Krugman’s right that weaker growth might be the cause, so I’m willing to revise my views as new information comes in, such as another growth pause in Europe.  There is no theoretical issue at stake here, separating our two views.

Off topic, don’t read too much into my statements on Fed policy over the next few years.  Unlike in past years, when the Fed was clearly much too tight, I don’t think they are far off course.  Some of my statements might suggest I think policy is not far off course, others might suggest I think policy is a bit too tight to hit the Fed’s dual mandate.  There is no contradiction between those statements.  It’s hard to evaluate current policy without knowing where the Fed wants to go, and they refuse to tell us where they want to be in 10 years, either in terms of the price level or NGDP.  If they would tell us, I’d recommend they go there in the straightest path possible.

Also, I see people talking like it’s perfectly obvious that Fed policy is now much tighter than ECB policy.  That’s not at all obvious.  What causes that perception?

1.  The ECB has recently loosened, and the Fed may have slightly tightened.

2.  Rates are lower in Europe, and they are doing QE.

Neither of those are good reasons.  During 2011-14 ECB was far tighter than in the US. So even though they have loosened, it doesn’t mean that ECB policy is looser in absolute terms. The deeper into a liquidity trap you fall, the more “concrete steppes” you need to achieve a given policy stance.  And the eurozone has fallen very, very deeply into their liquidity “trap.”  Of course neither interest rates nor the monetary base are good indicators of the stance of policy, unless you want to argue that the Fed’s highly deflationary policy of 1932 was actually easy money because rates were near zero and the Fed was doing QE. That claim would have been viewed as wacky 10 years ago, although I admit that many economists now seem hopelessly confused about how to define the stance of monetary policy.

As always, NGDP futures markets in the two regions would best establish the relative stances of monetary policy.  TIPS markets suggest the ECB is still effectively tighter.

HT:  Foosion, Edward

That’s the conclusion of a new paper that Tyler Cowen has linked to.  And I think that’s right.  Many stimulus advocates (including me and Lars Svensson) have pointed out that currency depreciation caused by monetary stimulus would not be expected to boost net exports, as the substitution effect will often be dominated by the income effect (a booming economy sucking in more imports.)

Unfortunately, the paper (by Alberto Bagnai and Christian Alexander Mongeau-Ospina) starts off with a misleading summary of the results:

It is frequently claimed that the current EUR/USD exchange rate is too high and that a depreciation of the EUR against the USD would contribute to relieve the Eurozone economy from the current state of persistent crisis. Evidence provided by the a/simmetrie annual econometric model suggests that this claim is unsupported by the data, at least as far as the Italian economy is concerned. In fact, the size and sign of the trade elasticities show that the increases in net exports towards non-Eurozone countries, brought about by the depreciation of the euro, would be offset by an increase in net imports towards Eurozone countries, brought about by the increase in Italian domestic demand.

And indeed Tyler also assumed that this pessimistic conclusion was their key finding, in his quick summary of the results.  But in fact that’s not at all what the paper says. Here’s the key paragraph:

Before presenting the results, it is worth noting that the simulations proposed were performed using only the foreign trade block of the model, supplemented with the national income identity and the price deflators equations. As a consequence, the results presented have only a partial equilibrium meaning and are still preliminary. In particular, they take into account the feedback on imports following from the expansion of aggregate demand caused by the increase in exports, as well as the inflationary effects following from the increase in import prices determined by the nominal exchange rate devaluation, but they do not take into account the “second round” inflationary effects determined via Phillips curve by the decrease in unemployment, which could possibly offset in the longer run the effect of a nominal realignment.

So if you ignore the fact that monetary stimulus that depreciates the euro will also boost NGDP, and that this will boost RGDP and employment via the “Phillips curve” mechanism, and only focus on the fact that a faster growing Italian economy will suck in more imports and hence stimulus will not improve the trade balance, then it appears a weaker euro will not help Italy.  And I certainly can’t disagree with that!

However I certainly don’t agree with this:

These results have important policy implications.

Ramesh Ponnuru has a very good article pushing back against Robert Samuelson’s criticism of Fed bashers.  While Mr. Samuelson is certainly right that much of the criticism is a bit nutty, sometimes I think there is a tendency for what Paul Krugman calls “Very Serious People” to be overly protective of institutions such as the Fed.  I am perfectly willing to accept the claim that the Fed is an institution full of very talented people.  I believe that its leadership is well intentioned. I believe Fed policy partly explains why the US has done better than the eurozone in the past 4 years.  I believe that, on average, Fed policy has improved over time.

But . . . no institution should be immune from criticism, as there is always room for improvement.  Today I’d like to talk about the biggest Fed basher of them all: Ben Bernanke.  Here’s Bernanke blaming the Fed for the Great Inflation:

Monetary policymakers bemoaned the high rate of inflation in the 1970s but did not fully appreciate their own role in its creation.

And here’s Bernanke attributing the performance of the Fed during the Great Moderation to improved Fed policy:

With this bit of theory as background, I will focus on two key points. First, without claiming that monetary policy during the 1950s or in the period since 1984 has been ideal by any means, I will try to support my view that the policies of the late 1960s and 1970s were particularly inefficient, for reasons that I think we now understand. Thus, as in the first scenario just discussed (represented in Figure 1 as a movement from point A to point B), improvements in the execution of monetary policy can plausibly account for a significant part of the Great Moderation. Second, more subtly, I will argue that some of the benefits of improved monetary policy may easily be confused with changes in the underlying environment (that is, improvements in policy may be incorrectly identified as shifts in the Taylor curve), increasing the risk that standard statistical methods of analyzing this question could understate the contribution of monetary policy to the Great Moderation.

And here’s Bernanke blaming the Fed for the Great Depression:

Let me end my talk by abusing slightly my status as an official representative of the Federal Reserve. I would like to say to Milton and Anna: Regarding the Great Depression. You’re right, we did it. We’re very sorry. But thanks to you, we won’t do it again.

That’s a pretty serious charge, given that the economic collapse of 1929-33 turned the Nazis from a small fringe party to the dominant political force in Germany.  And Bernanke is not just a Fed basher; he lashes out at any other central bank that doesn’t do what he thinks they should be doing:

Japan is not in a Great Depression by any means, but its economy has operated below potential for nearly a decade. Nor is it by any means clear that recovery is imminent. Policy options exist that could greatly reduce these losses. Why isn’t more happening? To this outsider, at least, Japanese monetary policy seems paralyzed, with a paralysis that is largely self-induced. Most striking is the apparent unwillingness of the monetary authorities to experiment, to try anything that isn’t absolutely guaranteed to work. Perhaps it’s time for some Rooseveltian resolve in Japan.

So the Fed is to blame for the Great Depression, deserves praise for producing low inflation during the 1950s and early 1960s, deserves praise for producing a stable macroeconomy during the Great Moderation (1984-2007), and is to blame for the Great Inflation of 1966-81.  In this set of PowerPoint slides Bernanke blames the Fed for the severe 1981-82 recession.  Are we to assume that beginning in 2008 the Fed suddenly stopped being responsible for macroeconomic outcomes?  After being to blame or deserving credit for virtually every single major macroeconomic twist and turn since it was created in 1913?

Not according to William Dudley, current New York Fed President and close Bernanke ally.  He argues the Fed continued to make mistakes after 2008:

I would give each of these four explanations some weight for why the recovery has been consistently weaker than expected. But I would add a fifth, monetary policy, while highly accommodative by historic standards, may still not have been sufficiently accommodative given the economic circumstances.  .  .  .

My conclusion is that the easing of financial conditions resulting from non-traditional policy actions has had a material effect on both nominal and real growth and has demonstrably reduced the risk of particularly adverse outcomes.  Nevertheless, I also conclude that, with the benefit of hindsight, monetary policy needed to be still more aggressive. Consequently, it was appropriate to recalibrate our policy stance, which is what happened at the last FOMC meeting.

As I argued in a recent speech, simple policy rules, including the most popular versions of the Taylor Rule, understate the degree of monetary support that may be required to achieve a given set of economic objectives in a post-financial crisis world. That is because such rules typically do not adjust for factors such as a time-varying neutral real interest rate, elevated risk spreads, or impaired transmission channels that can undercut the power of monetary policy.  [emphasis added]

So from the vantage point of October 2012, William Dudley suggests that monetary policy over the previous 4 years was insufficiently expansionary.  He’s “bashing” the Ben Bernanke Fed, and he’s almost a clone of Bernanke in his policy views!

I wonder if Dudley is also admitting that, in retrospect, a certain group of monetary cranks that were bashing the Fed in 2008 and 2009 for inadequate nominal growth might have been right.

I don’t know if “Fed basher” is the right term to apply to Ben Bernanke.  All I can say is that if Bernanke is a Fed basher, then I’m proud to be one too.

The title of this post does not refer to the exchange rate, the importance of which is overrated.

Tyler Cowen has a new post on the euro.  Here’s his conclusion:

All in all, the weaker euro is likely to prove a net benefit to the eurozone, all the more so if monetary policy can drum up some expansionary domestic benefits above and beyond the exchange rate effect.  Still, if you deliberately engineer a depreciation of your currency out of weakness and desperation, the long-run benefits usually don’t match up to that immediate feeling of short-run juice.

This is correct.  There are many examples of Latin American or Mediterranean countries devaluing their currency, and merely ending up with higher inflation in the long run.  But it’s also important to point out that the euro is still far too strong. Unfortunately there is no single measure of the strength of a currency, but surely it is more meaningful to talk about it’s ability to purchase a basket of all goods and services, as compared to its ability to purchase a pound of zinc, a share of Apple stock, a US dollar, an Australian dollar, or a Zimbabwean dollar.  I’d argue that a still better measure would be the fraction of a year’s eurozone NGDP that can be bought with a single euro.

In any case, whether you use the price level or NGDP as your metric, the euro is far too strong.  So while there are many examples throughout history of countries debasing their currency, the eurozone is not currently one of those examples.

PS.  If in fact the ECB has engineered a weaker euro in the forex markets, then ipso facto it has engineered “some expansionary domestic benefits above and beyond the exchange rate effect” relative to a tighter monetary policy stance. When using monetary policy, you can’t have one without the other.

Update:  Marcus Nunes has a related post on the yen.  Yes, there are actually people claiming the yen is too weak (not Marcus!)  Isn’t the yen right up there with the Swiss franc, vying for the title of the strongest fiat currency in the history of the world?

Here’s a new headline from the Washington Post:

U.S. economy’s surprise risk: The dollar’s surge could weaken growth

The surging value of the U.S. dollar promises new bargains for American consumers and travelers but also presents big threats to the U.S. economy “” in a trend that is shaping up to be one of the most unexpected and significant factors driving the global economy this year.

This is wrong, one should never reason from a price change.  There are 4 primary reasons why the dollar might get stronger:

1.  Tighter money in the US (falling NGDP growth expectations.)

2.  Stronger economic growth in the US.

3.  Weaker growth overseas.

4.  Easier money overseas.

In my view the major factor at work today is easier money overseas.  For instance, the ECB has recently raised its growth forecasts for 2015 and 2016, partly in response to the easier money policy adopted by the ECB (and perhaps partly due to lower oil prices—but again, that’s only bullish if the falling oil prices are due to more supply, not less demand–see below.) That sort of policy shift in Europe is probably expansionary for the US.

However NGDP growth forecasts in the Hypermind market have trended slightly lower in the past couple of months. Unfortunately, this market is still much too small and illiquid to draw any strong conclusions.  Things will improve when the iPredict futures market is also up and running, and even more when the Fed creates and subsidizes a NGDP prediction market.  But that’s still a few years away.  Nonetheless, let’s assume Hypermind is correct.  Then perhaps money in the US has gotten slightly tighter, and perhaps this will cause growth to slow a bit.  But in that case the cause of the slower growth would be tighter money, not a stronger dollar.

Does that mean exchange rate changes are never informative?  Not at all.  When we observe exchange rates change in response to monetary policy actions, then we can pin down the direction of causality.  Thus the dollar fell 6 cents against the euro on the day QE1 was announced in March 2009.  We’ve also seen falls in the yen and euro on QE announcements in Japan and Europe.  But you need to know why the exchange rate has moved before drawing any conclusions about causality.

As an aside, late last year there was talk that the huge fall in oil prices would be “like a tax cut,” boosting growth in the US. I was skeptical, and still am skeptical. It’s worth noting that falling oil prices did not raise the consensus forecast for RGDP growth during 2015, indeed forecasts fell slightly between last fall and early 2015, “despite” the huge plunge in oil prices: