Archive for December 2016


Banana republic watch

How do you know when your country is becoming a banana republic?  Let’s call our imaginary banana republic “Costaguava”.

1.  Voter do not judge foreign leaders on the basis of whether they are mass murderers, but rather on how they get along with the leader of Costaguava:


2.  When political parties lose an election in Costaguava, they try to change the rules to invalidate the will of the voters:

RALEIGH, N.C. — Amid a tense and dramatic backdrop of outrage and frustration, North Carolina’s Republican-controlled legislature on Friday approved a sweeping package of restrictions on the power of the governor’s office in advance of the swearing in of the Democratic governor-elect, Roy Cooper.

Protesters spent a second day chanting and disrupting debate, as some were arrested and led away from the state legislative building in plastic wrist restraints.

3.  In Costaguava, it’s difficult to discern the line between the leader’s official duties, and the ruling family’s far-flung business empire:


4.  It’s hard to draw the line between real news and fake news in Costaguava.

screen-shot-2016-12-17-at-3-48-04-pmPart 2:  Trust the process.

Lots of people totally miss the elephant in the room, debating minor issues like whether Russia hacked the election.  Trump said the CIA’s claim was ridiculous, but could offer no reason other than that, if true, it would make Trump’s win look less impressive. The problem with Trump’s claim has nothing at all to do with whether Trump is right or wrong, rather it reflects a deep flaw in his thinking process.  Indeed Trump would be equally culpable for his remarks even if it turned out the CIA had been mistaken.

The problem here is that if you degenerate into a banana republic, decision-making will suffer, and eventually there will be a price to pay in terms of policy screw-ups.  For a time, you might get lucky with economic policy, as when Pinochet stumbled into the Chicago Boys.  But that’s a weak reed to lean on.  In the long run, well-governed countries will do well, and banana republics will do poorly.  Chile graduated from banana republic status in 1989. Venezuela never did.  The US seems to be falling back into that category today.

PS.  I just saw this item:

Earlier Saturday, he announced the nomination of South Carolina Rep. Mick Mulvaney to head the Office of Management and Budget, choosing a tea partyer and fiscal conservative with no experience assembling a government spending plan.

No experience?  Isn’t that unpresidented?  What could go wrong?


Monetary policy counterfactuals are tricky

Rajat asked one of his characteristically probing questions, in the previous post:

As you’ve often said with monetary policy, it all depends on the yardstick or counterfactual. With your examples, because you’ve put the focus on interest rates, the reader naturally assumes that the counterfactual is no change in official interest rates. For example, in (1), surely the cut in the Fed Funds rate from 5.25% to 2% was less contractionary than if the Fed did not lower the rate? The money supply may not have risen in 2007-08, but wouldn’t it have fallen if rates were kept at 5.25%, as the market devoured the short-term securities the Fed offered at that yield? I understand that the reduction in official rates was not expansionary in any meaningful sense (ie against a benchmark of ideal monetary policy under inflation or NGDP targeting).

This is probably correct, but I’d argue that it could also be misleading, resulting in too much reassurance that interest rates aren’t that bad an indicator after all.  Rajat’s point is that if the Fed never even began cutting rates, then they would have had to reduce the money supply rather dramatically.  So much so that NGDP would have done even worse than with cut from 5.25% to 2.0%.  So does that mean the interest rate cut was expansionary after all?  Not quite.

Consider the two following hypotheticals:

A.  No change in the base from August 2007 to May 2008, rates fall from 5.25% to 2.0% (actual policy)

B.  The base rises by 5%, while rates move from 5.25% in August 2007 to 5.25% in May 2008.

I would claim that policy B is almost certainly more expansionary.  Rajat might reply that policy B was not an option.  If the monetary base had risen by 5%, then interest rates would have declined even more rapidly than they actually did.

I don’t quite agree, although for any given day I’d agree with that claim.  Thus on any given day, a lower fed funds target requires a larger base than otherwise (at least before IOR was instituted in October 2008).  But that true fact leads many Keynesians to jump to a seemingly similar, but unjustified conclusion.  Many people assume that over a 9-month period a more expansionary monetary policy implies a faster decline in interest rates.

In fact, option B probably was available to the Fed, but only if they moved much more aggressively in the early part of this period and/or if they changed their policy target.  Thus there are two possible ways the Fed might have achieved policy option B:

B1.  Cut rates sharply enough in August 2007 to dramatically boost NGDP growth expectations, and then gradually raise rates enough over the next few months to get them back to 5.25% by May 2008.  In that case, NGDP growth would have held up well, and yet the path of interest rates over that period would have ended up higher than otherwise.

B2.  Adopt a policy of 5% NGDPLT, which would have radically changed expectations, and hence boosted the Wicksellian equilibrium rate.

Rajat might view option B2 as cheating, so let me make a case for option B1.  I’d argue that the Fed did almost exactly what I describe in option B1 during 1967.  Just to set the scene, the economy was slowing sharply during early 1967, and some people worried that we might enter a recession.  The Fed moved quite aggressively, and their move was so successful that over a period of 10 months there was no rate cut at all.

3 month T-bill yields:

January 1967:  4.72%

June 1967:  3.54%

November 1967:  4.73%

So interest rates were basically unchanged over this period, and yet I’d argue that policy was far more expansionary than during August 2007 to May 2008, when rates fell sharply.  The monetary base grew by over 5% in just 10 months, and this allowed the US to avoid recession.

(BTW, in retrospect, a mild recession would have been preferable in 1967, as a way of avoiding the Great Inflation.  Instead, the US left the gold standard in April 1968, Bretton Woods blew up 3 years later, and the rest is history.  But since policymakers didn’t know all of this would occur, the mistake of the 1960s was sort of inevitable—just a question of when.)


In 1967, the expansionary policy early in the year boosted NGDP growth expectations enough so that they could raise rates back up later in the year, and still see robust NGDP growth.  In 1968, interest rates rose still higher, but this was expansionary because the base was also rising briskly.  So you have both rising base velocity (from higher rates) and a rising monetary base.

There’s a grain of truth in Rajat’s comment, but it’s best thought of as applying to a given day, where a lower interest rate implies a faster growth in the money supply, and easier money.  Over a more extended period of time things become much dicier.  Those who focus on interest rates are more likely to be led astray, the longer the period being examined.

Nick Rowe on the New Keynesian model

Here’s Nick Rowe:

I understand how monetary policy would work in that imaginary Canada (at least, I think I do). Increasing the quantity of money (holding the interest rate paid on money constant) shifts the LM curve to the right/down. Increasing the rate of interest paid on holding money (holding the quantity of money constant) shifts the LM curve left/up. Done.

It’s a crude model of an artificial economy. But it’s a helluva lot better than a simple New Keynesian model where money (allegedly) does not exist and the central bank (somehow) sets “the” nominal interest rate (on what?).

I think this is right.  But readers might want more information.  Exactly what goes wrong if you ignore money, and just focus on interest rates?  Let’s create a simple model of NGDP determination, where i is the market interest rate and IOR is the rate paid on base money:

MB x V(i – IOR) = NGDP

In plain English, NGDP is precisely equal to the monetary base time base velocity, and base velocity depends on the difference between market interest rates and the rate of interest on reserves, among other things.  To make things simple, I’m going to assume IOR equals zero, and use real world examples from the period where that was the case.  Keep in mind that velocity also depends on other factors, such as technology, reserve requirements, etc., etc.  The following graph shows that nominal interest rates (red) are positively correlated with base velocity (blue), but the correlation is far from perfect.


[After 2008, the opportunity cost of holding reserves (i – IOR) was slightly lower than shown on the graph, but not much different.]

What can we learn from this model?

1.  Ceteris paribus, an increase in the base tends to increase NGDP.

2.  Ceteris paribus, an increase in the nominal interest rate (i) tends to increase NGDP.

Of course, Keynesians often argue that an increase in interest rates is contractionary.  Why do they say this?  If asked, they’d probably defend the assertion as follows:

“When I say higher interest rates are contractionary, I mean higher rates that are caused by the Fed.  And that requires either a cut in the monetary base, or an increase in IOR.  In either case the direct effect of the monetary action on the base or IOR is more contractionary than the indirect effect of higher market rates on velocity is expansionary.”

And that’s true, but there’s still a problem here.  When looking at real world data, they often focus on the interest rate and then ignore what’s going on with the money supply—and that gets them into trouble.  Here are three examples of “bad Keynesian analysis”:

1. Keynesians tended to assume that the Fed was easing policy between August 2007 and May 2008, because they cut interest rates from 5.25% to 2%.  But we’ve already seen that a cut in interest rates is contractionary, ceteris paribus. To claim it’s expansionary, they’d have to show that it was accompanied by an increase in the monetary base.  But it was not—the base did not increase—hence the action was contractionary.  That’s a really serious mistake.

2.  Between October 1929 and October 1930, the Fed reduced short-term rates from 6.0% to 2.5%.  Keynesians (or their equivalent back then) assumed monetary policy was expansionary.  But in fact the reduction in interest rates was contractionary.  Even worse, the monetary base also declined, by 7.2%.  NGDP decline even more sharply, as it was pushed lower by both declining MB and falling interest rates.  That’s a really serious mistake.

3.  During the 1972-81 period, the monetary base growth rate soared much higher than usual.  This caused higher inflation and higher nominal interest rates, which caused base velocity to also rise, as you can see on the graph above.  Keynesians wrongly assumed that higher interest rates were a tight money policy, particularly during 1979-81.  But in fact it was easy money, with NGDP growth peaking at 19.2% in a six-month period during late 1980 and early 1981.  That was a really serious error.

To summarize, looking at monetary policy in terms of interest rates isn’t just wrong, it’s a serious error that has caused great damage to our economy.  We need to stop talking about the stance of policy in terms of interest rates, and instead focus on M*V expectations, i.e. nominal GDP growth expectations.  Only then can we avoid the sorts of policy errors that created the Great Depression, the Great Inflation and the Great Recession.

PS.  Of course Neo-Fisherians make the opposite mistake, forgetting that a rise in interest rates is often accompanied by a fall in the money supply, and hence one cannot assume that higher interest rates are easier money.  Both Keynesians and Neo-Fisherians tend to “reason from a price change”, ignoring the thing that caused the price change.  The only difference is that they implicitly make the opposite assumption about what’s going on in the background with the money supply. Although the Neo-Fisherian model is widely viewed as less prestigious than the Keynesian model, it’s actually a less egregious example of reasoning from a price change, as higher market interest rates really are expansionary, ceteris paribus.

PPS.  Monetary policy is central bank actions that impact the supply and demand for base money.  In the past they impacted the supply through OMOs and discount loans, and the demand through reserve requirements.  Since 2008 they also impact demand through changes in IOR.  Thus they have 4 basic policy tools, two for base supply and two for base demand.

PPPS.  Today interest rates and IOR often move almost one for one, so the analysis is less clear.  Another complication is that IOR is paid on reserves, but not currency.  Higher rates in 2017 might be expected to boost currency velocity, but not reserve velocity.  And of course we don’t know what will happen to the size of the base in 2017.

Larry Kudlow to head the Council of Economic Advisors?

Here’s an interesting news report:

President-elect Donald Trump’s administration is planning to nominate political commentator and economic analyst Larry Kudlow to chair the Council of Economic Advisers.

Stephen Moore, a conservative economist who advised Trump’s presidential campaign, said at a luncheon in Michigan that Trump was set to choose Kudlow to be next chair of the council, a source who was in attendance told Business Insider.

In a follow-up conversation with Business Insider, Moore clarified that Kudlow is the leading candidate for the job but was not selected yet. Moore also said the selection would come in “the next week or so.”

“He’s a fantastic pick for the role, a great pick,” Moore told Business Insider.

Kudos to Donald Trump for reaching out to someone who’s been willing to criticize Trump on occasion:

Kudlow was an early advocate for Trump, saying his proposals to lower taxes would benefit the US economy. Later in the campaign, Kudlow broke with Trump on his more protectionist trade policies — Kudlow has advocated the Trans-Pacific Partnership — and anti-immigration policies.

It will be interesting to see how influential Larry Kudlow will be.  Normally I might prefer a traditional academic in the Mankiw/Hubbard vein, but in this case I think Kudlow is a very good pick.  I see a looming fight between populism and supply-side economics, and Kudlow will ably defend the supply-side view.  Kudlow will speak Trump’s language more effectively than a pure academic would.  (Academics don’t like Trump, and I’m pretty sure the feeling is mutual.)

I view myself as a moderate supply-sider, sort of like Miles Kimball.  Even though I think some supply-siders are a bit too optimistic about the growth impact of tax cuts, at least Kudlow will be fighting for the right causes.

I know what you are all thinking; who will Kudlow recommend as Yellen’s replacement?  It just so happens that Kudlow mentioned 5 names a few years back:

Kevin Warsh, John Taylor, Steve Forbes, Paul Ryan and Richard Fisher.

I’d guess that Warsh and Taylor are the more likely choices.

PS.  Actually Kudlow mentioned 6 names, but the last person has spent the past 12 months using his blog to relentlessly attack Trump in a total unhinged manner.  At this point he has more chance of becoming the next Pope than the next Fed chair.

screen-shot-2016-12-15-at-4-25-49-pmAmazing what you can do with Photoshop.

PPS.  Morgan Warstler mentioned that Kudlow is a fan of NGDPLT, and also Morgan’s proposed replacement of the welfare system


Japan’s lucky break

Just a couple of months ago, pundits were writing off the Bank of Japan, and particularly Kuroda’s policy of 2% inflation.  Now things are looking much more positive for the BOJ.  Since plunging on the night of the Trump election, the Japanese stock market has taken off like a rocket.

It’s not hard to understand why—the yen has been in almost free fall, down from about 100 to the dollar to 118 today.  To put that into perspective, back in April 1995, the yen was at 84 to the dollar.  As recently as September 2012, right before Abenomics was announced, it was at 78 to the dollar.

But those numbers don’t even come close to showing what’s going on with the yen. What really matters is the real exchange rate.  And since 1995, Japan has had an inflation rate that ran almost 2% a year lower than in the US.  The US CPI is up by more than 57% since 1995, while the Japanese CPI is barely changed.  Thus the real exchange rate for the yen has gone from 84 in 1995 to something like 180 or 185 today.  At these levels, the exchange rate is a gold mine for Japanese exporters, which explains why the Japanese stock market is doing so well.

The big puzzle here is why PPP is failing so abysmally in terms of explaining the dollar/yen exchange rate.  Generally when a country has persistently lower inflation than the US, its exchange rate tends to appreciate of time, and vice versa.  Thus the Swiss have low inflation and the Swiss franc trends upwards.  The Brazilians have high inflation and the Brazilian real trends downwards.  And over the very long run that’s true of Japan as well.  I recall when the yen was 350 to the dollar.

But since 1995 the yen has depreciated dramatically, even while Japan has had inflation rates that are roughly two percent less than the US.  Of course during this period Japan has had much lower nominal interest rates than the US (at least the Fisher effect works!), and the yen has generally been expected to appreciate (due to the interest parity condition).  Thus we’ve had a 21-year period where investors expected steady appreciation in the yen, and (on average) they got the exact opposite.

Going forward, one of two things will happen.  Either the BOJ will persist with its inflation policies, or it will not.  If it does persist, eventually investors will have to throw in the towel and admit that they were wrong about Kuroda.  The yen will no longer be expected to appreciate, and the level of Japanese interest rates will be much closer to US rates.

Or, the BOJ will abandon it goal of 2% inflation, and the yen will start appreciating, just as investors have been predicting for 21 years.  In that case, interest rates in Japan may stay close to zero.

It’s entirely up to the BOJ which road they prefer to take.  A few months ago, many people thought they had given up.  Today that’s much less clear. The higher global interest rates following Trump’s election, combined with the BOJ policy of pegging the 10-year bond yield at zero, has caused the yen to plunge in value.  PPP is elastic, but not infinitely elastic.  The yen can’t stay here indefinitely without generating serious inflation.  Otherwise at some point a Lexus 430 would be as cheap as a candy bar.

My instincts tell me that this weird discrepancy between market predictions and actual outcomes can’t go on much longer.  Within the next decade it will be clear whether Japan is seriously committed to a 2% inflation target.  At that point, either Japanese interest rates will rise sharply (success), or the yen will appreciate sharply (failure).

PS.  At Econlog, I have a post on Nick Rowe’s reply to John Cochrane, which might be seen as loosely relating to this post.