Archive for May 2015


Recommended reading

1.  For a guy who has been right about everything, Paul Krugman sure is wrong about an awful lot of things.  Bob Murphy has an excellent new post which digs up lots of Krugman claims that turned out to be somewhat less then correct.

Krugman, armed with his Keynesian model, came into the Great Recession thinking that (a) nominal interest rates can’t go below 0 percent, (b) total government spending reductions in the United States amid a weak recovery would lead to a double dip, and (c) persistently high unemployment would go hand in hand with accelerating price deflation. Because of these macroeconomic views, Krugman recommended aggressive federal deficit spending.

As things turned out, Krugman was wrong on each of the above points: we learned (and this surprised me, too) that nominal rates could go persistently negative, that the US budget “austerity” from 2011 onward coincided with a strengthening recovery, and that consumer prices rose modestly even as unemployment remained high. Krugman was wrong on all of these points, and yet his policy recommendations didn’t budge an iota over the years.

Far from changing his policy conclusions in light of his model’s botched predictions, Krugman kept running victory laps, claiming his model had been “right about everything.” He further speculated that the only explanation for his opponents’ unwillingness to concede defeat was that they were evil or stupid.

Read the whole thing.

2.  Caroline Baum has a very nice post on “never reason from a price change.”  She’s one of the relatively small number of journalists that seem to really get this idea.

The Fed is equally confused when it comes to long-term rates. If you were to ask policy makers if interest rates move pro-cyclically, they would all answer yes. But when rising market rates become a reality, the cries go out that higher rates will damage the economic growth. At the same time, a decline in long rates is automatically assumed to provide economic stimulus. Alas, the expectation that the 100-basis-point decline in 10-year Treasury yields last year would boost investment was mugged by reality.

Getting back to oil prices, economists are still waiting (hoping?) for the oil-price-tax-cut to materialize. Bad weather is getting old as an excuse.

Read the whole thing.  Moving from the sublime to the ridiculous:

3.  John Tamny has a post entitled:

Baltimore’s Plight Reveals the Comical Absurdity of ‘Market Monetarism’

In case you are wondering who John Tamny is, in an earlier post he explained that Bernanke’s inflation targeting idea was unwise, as it would imply that each and every price was stable, not just the overall price level.  Flat panel TV prices could no longer decline.

I’m too busy to do a post mocking all of Tamny’s more recent claims, but he was polite enough to write it in such a way that all I really need to do is quote him.  It’s self-mocking:

‘Market monetarists’ believe that economic growth can be managed by the Federal Reserve.  .  .  .

Market monetarists’ believe the Fed can achieve the alleged nirvana that is planned GDP growth and national income through money supply targets set for the central bank by members of the right who’ve caught the central planning bug.  .  .  .

In fairness to the neo-monetarists, they would all agree that Baltimore has problems that extend well beyond money supply. Still, if money supply planning is the alleged fix for the broad U.S. economy, presumably it would have a positive impact locally.  .  .  .

Specifically, ‘market monetarists’ seek consistent money supply growth, and then when the economy is weak, a bigger increase in the supply of money to boost GDP. . . .

It’s kind of simple. Money supply once again can’t be forced. . . .

It can’t be repeated enough that production is money demand, and is thus the driver of money supply. Money supply shrank in the 1930s not because the Fed decreased it (if it had, alternative sources of money would have quickly revealed themselves), but because the federal government erected massive tax, regulatory, and trade barriers to production. All that, plus FDR’s devaluation of the dollar from 1/20th of an ounce of gold to 1/35th of an ounce in 1933 further put a damper on the very investment that powers new production. It’s forgotten by economists today, but when investors invest they’re tautologically buying future dollar income streams.

If you are looking for a few laughs, the Tamny piece is highly recommended. Indeed I’d call it “tautologically funny.”

PS.  Over at Econlog I have a new post that indirectly addresses some of the confusion in the Tamny post.

HT:  David Beckworth

Update:  Well I may not have gotten the ECB to adopt NGDPLT, but consider this comment from yesterday’s post:

Must be nice to be the sort of rich hedge fund manager that gets this “critical” information before the rest of us.

And from today’s WSJ:

The ECB will post speeches of its board members on its website when they are scheduled to begin, without making them available to journalists ahead of time under embargo as the ECB had done for many years.

The decision, which takes effect immediately, came one day after the public release of comments by executive board member Benoit Coeuré caused a stir in financial markets. Mr. Coeuré  said the ECB would front load bond purchases under its €1.1 trillion ($1.2 trillion) quantitative easing program in May and June to account for a summer lull in bond markets.

HT:  lysseas

What happened to the QE skeptics?

I don’t hear much anymore from people denying that printing money boosts NGDP. Perhaps this story from yesterday morning explains why:

The comments from Benoit Coeure, initially made in private on Monday at a conference attended by one of Britain’s richest hedge fund managers Alan Howard, some of his peers and academics, sent markets into a flurry when they were published on Tuesday.

Anticipating a flood of yet more euros onto the market, the single currency tumbled when the ECB released its Executive Board member’s remarks, sending European shares rising to near multi-year highs.

Coeure said the speed of the recent spike in bond yields, was worrisome and that the ECB could “moderately” increase its buying in May and June so that it did not fall below its monthly buying target. He said, however, that the two were not linked.

Other central bankers chimed in with support for the ECB’s fledgling scheme to buy 60 billion euros a month of chiefly government bonds, a programme known as quantitative easing.

“The Eurosystem is ready to go further if necessary …,” Christian Noyer, who as governor of the Bank of France also sits on the ECB’s decision-making Governing Council, said in Paris.

The excitable market reaction, pulling the euro down below $1.12 and paring back the returns or yields on government bonds, illustrates how critical money printing is to confidence.  (emphasis added)

Two comments:

1.  Yes, the markets are right that money printing is critical.

2.  Must be nice to be the sort of rich hedge fund manager that gets this “critical” information before the rest of us.

Then there are those who are agnostic on the real economy, but insist that QE is blowing up bubbles:

Academics will no doubt be discussing the effectiveness of QE in lifting the real economy for a couple of generations at least, and probably not reaching any definitive conclusions. Perhaps it pulls countries out of a recession, or perhaps they would have eventually started to grow again anyway? One thing we can say for sure, however, is that it boosts asset prices.

In fact, it is already happening. A series of Mario Draghi bubbles are already inflating across the eurozone. Where exactly? Well, Spanish construction is booming, Dublin house prices are soaring, German wages are accelerating, Malta is riding a wave of hot money, and Portuguese equities are among the best performers in the world. For a lucky few investors, QE is already working its magic.

In the 21st century, pundits will be unable to see anything other than recessions and “bubbles.”  There will no longer be periods of stable growth without “bubbles,” like the 1960s.  Of course bubbles don’t actually exist, but low interest rates as far as the eye can see means that asset prices will look bubble-like unless artificially depressed by a tight monetary policy that drives the economy into recession.

By the way, the rest of the article has data that supposedly supports the claims in the quote above, but they aren’t even close to being adequate.  Spanish construction is booming”?  How would we know?  They support that claim by pointing to a recent 12% rise in construction.  They don’t tell you whether that’s from a highly depressed level. Didn’t Spanish construction fall something like 60% or 80% during the Great Eurozone Depression? German wages accelerating?  We are told one German union got a 3.4% wage increase. That’s it. Malta’s property prices are up 10%.  Portuguese stocks are up 25%.  Snippets of information that provide essentially no support for the bubble claims being made.  But when you are sure that QE is blowing up “bubbles”, I guess that’s all you need.  After all, there could not possibly be any rational explanation for Malta’s property prices rising 10%, could there?

Neo-Fisherism, missing markets, and the identification problem

I’ve done recent posts on Neo-Fisherism, and the problem of identifying the stance of monetary policy.  I’ve also pointed out that if we can’t identify the stance of monetary policy, we can’t identify monetary shocks.

This is going to be a highly ambitious post that tries to bring together several of my ideas, in a Grand Theory of Monetary Policy.  Yes, that’s means I’m almost certainly wrong.  But I hope that the ideas in this post might trigger useful insights from people who are much smarter than me and/or better able to handle macro modeling.

NeoFisherians argue that if the Fed switches to a policy of low interest rates for the foreseeable future, this will lead to lower inflation rates.  Their critics claim this is not just wrong, but preposterous—and undergraduate level error.  I think both sides are right, and both sides are wrong.

All of mainstream macro (including the IS-LM model) is built around the assumption of a “liquidity effect”.  That is, because wages and prices are sticky in the short run, a sudden and unexpected increase in the money supply will lower short-term nominal interest rates. Interest rates must fall in the short run so that the public will be willing to hold the larger real cash balances (until the price level adjusts and the real quantity of money returns to its original equilibrium.)

One thing that makes this theory especially persuasive is that it’s not just believed by eggheads in academia.  Pragmatic real world central bankers often see nominal interest rates fall when they inject new money into the economy.  It’s pretty hard NOT to believe in the liquidity effect if you see it in action after you make a policy move.

So the NeoFisherians have both the eggheads and the real world practitioners against them.  And yet not all is lost.  Over any extended period of time the nominal interest rate does tend to track changes in trend inflation (or better yet trend NGDP.)  If I had a perfect crystal ball and saw the fed funds rate rise to three percent and then level off for twenty years, I’d expect a higher inflation rate than if my crystal ball showed rates staying close to zero for the next 20 years.  NeoFisherians are smart people, and they wouldn’t concoct a new theory without some good reason.

In previous posts I’ve found it useful to illustrate where NeoFisherism works with a thought experiment.  I’ll repeat that, and then I’ll take that thought experiment and use it to develop a general model of monetary policy.  Here’s the thought experiment:

Suppose Japan wants to raise their inflation rate to roughly 8%/year.  How do they do this?  This requires two steps.  They need a monetary regime that produces 8% steady state trend inflation, and they need to make sure that the price level doesn’t undergo a one-time jump upwards or downwards at the point the new regime is adopted.

To get 8% trend inflation, they’d need to shift the trend nominal interest rates to a much higher level.  To make things as simple as possible, suppose the US Federal Reserve targets inflation at 2%, and the BOJ has confidence that the Fed will continue to do so.  In that case the BOJ can peg the yen to the dollar, and promise to depreciate it at 6%/year, or 1/2%/month.  The interest parity theory (IPT) assures us that Japanese interest rates will immediately rise to a level 6% higher than US interest rates.  (Note, I’m using the near perfect ex ante version of the IPT, not the much less reliable ex post version.)

We’ve already gotten a very NeoFisherian result.  Currency depreciation is an expansionary monetary policy, and the IPT assures us that this particular expansionary monetary policy will also produce higher interest rates.  And not just in the long run, but right away. Although Purchasing Power Parity is widely known to not hold very well in the short run, expected inflation differentials do tend to reflect the expectation than PPP will hold.  So under this regime not only will Japanese nominal interest rates rise almost exactly 6% above US levels, Japanese expected inflation rates will also rise to roughly 6% above US levels.

Of course actual PPP does not hold all that well (although it does far better under fixed exchange rate regimes, or even crawling pegs like this system, than floating rates.)  But that doesn’t really matter in this case; just getting 6% higher expected inflation is enough to pretty much confirm the NeoFisherian result.

Unfortunately, the immediate rise in interest rates might reduce the equilibrium price level in Japan.  But even that can be prevented with a suitable one-time currency depreciation at the point the regime is adopted.  How large a currency depreciation? Let the CPI futures market tell you the answer.  Make your change in the initial exchange rate conditional on achieving a 1 year forward CPI that is 8% higher than the current spot CPI.  Thus the CPI futures market might tell you that the yen should immediately fall to say 154.5 yen/dollar, and then depreciate 1/2% a month from that level going forward.  Whatever amount of immediate currency depreciation offsets the immediate impact of higher interest rates.

Notice that monetary policy has two components, a level shift and a growth rate shift. This idea will underpin my grand theory of monetary policy.  In this case the level shift was depreciating the yen from 120 yen/dollar to 154.5 yen/dollar.  The growth rate shift was going to a regime where the yen is expected to gradually appreciate against the dollar, to one where it is credibly expected to depreciate at 1/2%/month.

Now think about the expected money supply path that is associated with that new policy regime for the yen.  My claim is that if the BOJ simply adopted that expected money supply path, all the other variables (exchange rates, interest rates, inflation, etc.) would behave just as they did under my crawling peg proposal.

So far I’ve been supportive of the NeoFisherians, but of course I don’t really agree with them.  Their fatal flaw is similar to the fatal flaw of Keynesian and Austrian macro, using the interest rate to identify the stance of monetary policy.  But in some ways it’s even worse than the Keynesian/Austrian view.  Those two groups correctly understand that a Fed rate cut is a signal for easier money ahead.  The NeoFisherians implicitly assume the opposite.

People say that the longest journey begins with a single step.  But what the NeoFisherians don’t seem to realize is that central banks generally signal an intention to go 1000 miles to the west by taking their very first step to the EAST.  (Nick Rowe has much better analogies.)  Thus when Paul Volcker decided that he wanted the 1980s to be a decade of much lower inflation and much lower nominal interest rates, the very first thing he did was to raise the short term interest rate by reducing the growth rate of the money supply.

As soon as you realize that central banks usually use changes in short term nominal interest rates achieved via the liquidity effect as a signaling device, then the NeoFisherian result no longer makes any sense.

But now I’m being too hard on the NeoFisherians.  Look at my crawling peg for the yen thought experiment.  And what about the fact that low rates for an extended period do seem associated with really low inflation, in places like Japan.  That suggests there’s at least some truth to the NeoFisherian claim, and at least some problem with the Keynesian/Austrian view.

In my view the two views can only be reconciled if we stop viewing easy and tight money as points along a line, but rather as multidimensional variables:

Monetary policy stance = S(level, rate)

A change in monetary policy reflects a change in one or both of these components of the S function.  You can have a rise in the price level, but no change in the trend rate of inflation.  You can have a rise in the trend rate of inflation, with no change in the current (flexible price) equilibrium price level.  The beauty of the thought experiment with the yen is that it makes it much easier to see this distinction.  You can imagine once and for all change in the exchange rate, as when the dollar went from $20.67 an ounce to $35.00 an ounce in 1933, and then stayed there for decades.  Or you can imagine a change in the trend rate of the exchange rate, as in my crawling peg example.  Or you can imagine both occurring at once.

When NeoFisherians are talking about higher interest rates leading to higher inflation, they are (implicitly) changing the “rate” component of my monetary policy stance function.  Keynesian and Austrians tend to (implicitly) think in terms of changes in levels, once and for all increases in the money supply that depress short-term interest rates and have relatively little effect on long-term interest rates or long run inflation.

In previous posts I’ve expressed puzzlement as to why easy money surprises lower longer-term interest rates on some occasions, and at other times they raise long-term interest rates.  The “perverse” latter result occurred in January 2001, September 2007, and (in the opposite direction) December 2007.

Indeed the December 2007 FOMC meeting produced the most NeoFisherian (i.e. “rate”) shock that I have ever seen in my entire life.  A smaller than expected rate cut (contractionary shock) led to a huge stock market sell-off (no surprise) but also lower bond yields for 3 months to 30 years T-securities (a big surprise.)  This policy announcement had an unusually large “rate shift” component, whereas most US policy announcements are primarily “level shifts”.  The markets (correctly) saw the Fed’s passivity in December 2007 as indicating that inflation and NGDP growth might be lower than normal going forward.  And not just in 2008, but indefinitely.

Unfortunately, while exchange rates nicely capture the rate/level distinction, they are not ideal for developing a general monetary policy theory, as the real exchange rate is too volatile.  And that brings me to the missing market, NGDP futures.  If this market existed we would have all the tools required to describe the stance of monetary policy in the multidimensional way necessary to sort through this messy NeoFisherian/conventional macro debate.  Suddenly we could clearly see the distinction between level shifts and rate shifts.

Unlike exchange rates, NGDP responds to monetary policy with a lag.  But we could use one-year forward NGDP as a proxy for levels.  Thus if one year forward NGDP rose and longer-term expected NGDP growth rates were unchanged then you’d have a level shift.  If the opposite occurred, you’d have a rate shift.  Or you might have both.  The response of interest rates to the monetary policy shock would largely depend on the response of NGDP futures to the monetary policy shock.

In a richer model there would be more than two dimensions, indeed the expected future NGDP at each future date would tell us something distinct about the stance of monetary policy, and thus more fully characterize any monetary shocks that occurred. But I see great benefits of using the simpler two variable description, levels and growth rates.  This simpler version is enough to address many of the perplexing features of monetary policy, such as why economists can’t seem to come up with a coherent metric for the stance of monetary policy, and why the NeoFisherians reach radically different conclusions than the Keynesians.

Ideally we’d create highly liquid NGDP and RGDP futures market, and then we could easily identify the stance of monetary policy, in both dimensions.  This would also allow us to ascertain the impact of policy shocks on both NGDP and RGDP. NeoFisherians could say, “A monetary policy that raises expected inflation rates and/or expected NGDP growth rates will usually raise nominal interest rates.”  That’s a much more sensible way of making their claim than “Raising interest rates will raise expected inflation and/or expected NGDP growth.

PS.  I’ve benefited greatly from discussions with Daniel Reeves (a Bentley student), and Thomas Powers (a Harvard student).  They understand NK models better than I do, and bouncing ideas off them has helped me to clarify my thinking.  Needless to say they should not be blamed for any mistakes in this post.

The most underpaid profession on Earth

Britmouse is back blogging with lots of interesting new posts.  A short one that caught my attention discussed this story from 2010:

I saw the governor of the Bank of England [Mervyn King] last week when I was in London and he told me whoever wins this election will be out of power for a whole generation because of how tough the fiscal austerity will have to be,” Hale said in an interview on Australian TV reported by Reuters.

Of course the Conservatives were recently re-elected, and indeed slightly improved their standing because they no longer rely on support from the Liberal Democrats. BTW, I agree with this comment from Britmouse:

.  .  . sad to see so many true liberal voices leaving Parliament.  You’ll be missed, Vince.

King headed the Bank of England in 2010.  So why was his political forecast incorrect? Perhaps he thought the economy would do poorly during the period of austerity.  But why would he think that?  Perhaps because he’s a Keynesian, like Ben Bernanke and most other central bankers.  Maybe he doesn’t believe in monetary offset.

Of course there are other possibilities, maybe he thought austerity would be unpopular even if the economy did fine.  But I think it more likely that he was making an implied forecast of slow growth and a weak job market.  In fact growth was weak, but during 2013 the job market began improving dramatically:

Screen Shot 2015-05-18 at 10.53.05 AM

Notice that British unemployment was at about 8% at the time of the May 2010 election, and still at about 7.8% in the spring of 2013.  Not much progress in three years.  But then the rate began falling sharply, and was at 5.5% in March, 2015, the same as the US and just slightly above Germany’s 4.9%.  Total employment numbers did far better than the US.  What happened?  There are lots of possibilities:

1.  Maybe the Keynesians are right and monetary offset was impossible in the UK.  Austerity hurt.  Recovery only occurred in 2013 because wage moderation finally allowed for the natural recovery forces in the economy to take hold.

2.  More likely, the BoE felt additional monetary stimulus was risky, due to high inflation during 2010-13, often running at close to 4%.  In that case the fiscal austerity had no impact on growth and employment, as the BoE was unwilling to tolerate higher inflation.

3.  The most interesting hypothesis is that King failed to forecast that he would be replaced in 2013 by a more competent central banker, from Canada of all places.  Mark Carney was appointed in late 2012, but didn’t formally join the BoE until June 2013, so it’s not quite clear where we should see his appointment impacting the economy.

Here’s Carney’s record at the Bank of Canada, from Wikipedia:

Carney’s actions as the Bank of Canada’s governor are said to have played a major role in helping Canada avoid the worst impacts of the financial crisis that began in 2007.[14][15]

The epoch-making feature of his tenure as governor remains the decision to cut the overnight rate by 50 basis points in March 2008, only one month after his appointment. While the European Central Bank delivered a rate increase in July 2008, Carney anticipated the leveraged-loan crisis would trigger global contagion. When policy rates in Canada hit the effective lower-bound, the central bank combated the crisis with the nonstandard monetary tool: the “conditional commitment” in April 2009 to hold the policy rate for at least one year, in a boost to domestic credit conditions and market confidence. Output and employment began to recover from mid-2009, in part thanks to monetary stimulus.[16] The Canadian economy outperformed those of its G7 peers during the crisis, and Canada was the first G7 nation to have both its GDP and employment recover to pre-crisis levels.

The Bank’s decision to provide substantial additional liquidity to the Canadian financial system,[17] and its unusual step of announcing a commitment to keep interest rates at their lowest possible level for one year,[18] appear to have been significant contributors to Canada’s weathering of the crisis.[19]

Canada’s risk-averse fiscal and regulatory environment is also cited as a factor. In 2009 a Newsweek columnist wrote, “Canada has done more than survive this financial crisis. The country is positively thriving in it. Canadian banks are well capitalized and poised to take advantage of opportunities that American and European banks cannot seize.”[20]

Carney earned various accolades for his leadership during the financial crisis. He was named one of the Financial Times ‘s “Fifty who will frame the way forward”,[21] and of Time Magazine ‘s “2010 Time 100”.[22] In May 2011, Reader’s Digest named him “Editor’s Choice for Most Trusted Canadian”.[23]

In October 2012, Carney was named “Central Bank Governor of the Year 2012” by the editors of Euromoney magazine.[24]

So he’s a talented central banker.  But how do we know the UK wouldn’t have improved even if King had stayed on?  We don’t, and indeed I think the UK would have improved, but not as fast as with Carney.  Mark Carney did take some aggressive forward guidance steps in 2013, and the markets took notice.  Just as in Canada, he got better job market results than his peers at other central banks.  That’s not proof, but I believe the balance of evidence suggests that Carney modestly boosted the speed of the UK recovery.

Years ago I did a post arguing that central bankers are grossly underpaid, and that we should pay whatever it takes to make sure that the FOMC has people like Michael Woodford, not community bankers from Hawaii.  Even if it takes a billion dollars.  Of course a billion dollar salary is not politically feasible, but it’s also not necessary. Carney was reluctant to take the BoE job for family reasons, and the British government eventually lured him over with a fairly generous pay package, including that all-important London housing allowance.  It did get some attention in the press, which points to the difficulty of paying central bankers their marginal product.

BTW, you might wonder why I say central bankers are the most underpaid profession. What about the President, who only makes $400,000, and yet is even more powerful and consequential?  Yes, but have you checked the non-monetary compensation of being President?  Even Bill Gates can’t have state dinners in the White House with a glittering international set of celebrities, or fly in Air Force One with a military escort. The total compensation of being President is plenty high enough to attract talented people.  Unfortunately, the close call on whether Carney was willing to take the BoE job, and the frequency with which Federal Reserve Board members resign before their term is up, suggests that central bankers are grossly underpaid.  I’ve never seen a President resign after 2 years to take a more lucrative job with Goldman Sachs.

PS.  I chose Michael Woodford precisely because he is not a MM.  We need to get best people possible, and this has nothing to do with whether they agree with me, or they don’t.  John Taylor is another person I sometimes disagree with, who is obviously extremely well qualified for being a central banker.

PPS.  Check out Britmouse’s longer new posts, which are also quite interesting.

Jonathan Pedde on the UK election and fiscal policy

Tyler Cowen directed me to an excellent new paper by Jonathan K. Pedde:

Standard zero-lower-bound New Keynesian models generate large fiscal multipliers and expansionary negative supply shocks. Thus, according to these models, a political party that implements fiscal contraction coupled with policies to increase aggregate supply should unambiguously cause economic contraction, compared to a party that implements the opposite policies. I test this prediction using high-frequency prediction- and financial-market data from the night of the 2015 U.K. election, which featured two such parties. By analysing financial-market movements caused by clearly exogenous changes in expectations about the election winner, I find that market participants expected higher equity prices and a stronger exchange rate under a Conservative Prime Minister than under a Labour P.M. There were little to no partisan differences in interest rates, expected inflation, or commodity prices. These results cast doubt on the empirical validity of zero-lower-bound New Keynesian models.

Some initial reactions:

1.  Wow, was that fast!  The election occurred on May 7th and a fully done research paper was at SSRN on May 12th

2.  The paper has a rather MM feel to it.  Fiscal stimulus doesn’t affect growth, no paradox of toil, use market price changes to identify the effects of policy shocks, etc. It’s a much more formal treatment of what I do informally in this blog.

[Update: Jonathan Pedde pointed out that I misinterpreted his fiscal policy claim. Here’s the more nuanced claim he actually made:

Of course, these results do not necessarily imply that the fiscal multiplier is zero. Perhaps a Conservative (rather than a Labour) P.M. leads to less expansionary fiscal policy as well as higher stock prices and exchange rates, but the higher stock prices and exchange rates happen in spite of the less expansionary fiscal policy, not because of it. But in order for this to be true, then something else about a Conservative P.M. must have been responsible for the higher stock prices and exchange rates. But, in the context of a ZLB NK model, that “something else” would probably have to be a policy relating to aggregate supply. So this argument requires that policies to increase aggregate supply actually increase GDP – which, of course, is at odds with the predictions of the ZLB NK model.

So he’s testing the overall ZLB NK model, not just fiscal policy.]

My only reservation is that one must be careful in interpreting stock market reactions. Pedde claims that the rise in stock prices reflects higher growth expectations after the Conservative victory.  I think that’s right, but it’s also possible that higher stock prices reflect lower expected future taxes on capital income in the UK.  In that sense elections are different from something like Fed announcements.

In fairness, Pedde’s growth hypothesis is confirmed by the concurrent move upward in the UK pound, which also signals faster growth ahead.  But this still shows the desperate need for more and better macro predictions markets, with higher levels of liquidity.

Interestingly, the paper relied on the Hypermind prediction market for the election probabilities.  This market also contains a set of NGDP futures markets, but with only $10,000 in prize money this year.  Think about the following.  If we boosted the prize money 50-fold to $500,000 per year, the market would be much more liquid, much more efficient.  That’s a lot of money for you and I, but for the Treasury or the Fed it’s like the coins that slip down between the cushions on your couch.  It’s nothing.  And it would open the door to a new golden age of macro research.  We could identify the stance of monetary policy in real time.  VAR studios would immediately by 100 times better.

Why hasn’t it happened yet?  Good question.  All I can say is that I’m doing my part; now I’d like to see some bigger name economists make a push for these markets.

PS.  My admittedly unscientific sense of Hypermind is that the NGDP market is now pretty accurate at identifying NGDP market forecasts, and also the gradually fall in the growth forecast over recent months.  But I don’t think it’s liquid enough at this point to do event studies.  Trading volume is too low.

On the other hand if traders knew that the most successful trader would walk away with $100,000, the second most with $75,000, the third most with $60,000, the 4th most with $50,000, etc., etc., even after having to put up none of their own money, well then I’m pretty sure that trading volume would get much, much higher.

On the plus side, even the very small Hypermind NGDP market is yielding interesting results.  I’ve argued that the current 3.4% NGDP growth forecast during a recovery year is consistent with the hypothesis that we are in a NGDP Great Stagnation, with a trend rate of 3% NGDP growth.

PPS.  Glad to see David Andolfatto and Noah Smith saying many of the same things that we (market monetarists) have been saying about Britain.