Archive for July 2018


Martin Feldstein on Fed policy

In a new WSJ piece, Martin Feldstein calls for higher interest rates. I don’t necessarily disagree with the need for somewhat higher interest rates, although I think we need to be very careful not to tighten policy too much.  But I do disagree with his reasoning:

But controlling inflation isn’t the primary reason for the Fed to keep raising the short-term interest rate. Rather, raising the rate when the economy is strong will give the Fed room to respond to the next economic downturn with a significant reduction.

This is wrong.  Raising interest rates reduces the Wicksellian equilibrium interest rate.  That gives the Fed less room to cut rates in the future.  The Fed does monetary stimulus by cutting rates below the equilibrium rate.  The lower the equilibrium rate, the less room there is to use conventional monetary stimulus.

That downturn is almost surely on its way. The likeliest cause would be a collapse in the high asset prices that have been created by the exceptionally relaxed monetary policy of the past decade.

This is wrong.  Downturns cannot be forecast.  Even if they could, they are not caused by high asset prices; they are caused by tight money.  And the recent high asset prices are not caused by easy money, because money has not been easy over the past decade.

It’s too late to avoid an asset bubble: Equity prices already have risen far above the historical trend. The price/earnings ratio of the S&P 500 is now more than 50% higher than the all-time average, sitting at a level reached only three times in the past century. Commercial real-estate prices also are extremely high by historical standards.

This is wrong—bubbles do not exist.  Past P/E ratios are not very useful in predicting asset prices.  If they were, P/E mutual funds would outperform ordinary funds.  Robert Shiller likes to use P/E ratios, and made some predictions about stock prices in 1996 and 2011.  The predictions did not turn out well.  Real estate prices are skewed by NIMBYism, and unusually low interest rates relative to NGDP growth.

The inevitable return of these asset prices to their historical norms is likely to cause a sharp decline in household wealth and in the rate of investment in commercial real estate. If the P/E ratio returns to its historical average, the fall in share prices will amount to a $9 trillion loss across all U.S. households.

Inevitable? If Martin Feldstein wants me to sign a contract to buy San Francisco property in 5, 10 or 15 years, at “historical norms” plus 10%, I’ll sign tomorrow.  Show me where the dotted line is.  Ditto for stocks.  I’ll buy stocks right now, to be delivered in 10 years, at “historical norms” plus 10%.  Does Feldstein want to sell those assets at that price?  After all, if prices fall to historical norms he’d make a 10% profit. Of course I’m not being serious—if I were in his shoes I wouldn’t want to waste time doing a deal with me; my point is for readers to think more deeply about what stuff is worth.

Large drops in household wealth are usually accompanied by declines in consumer spending equal to about 4% of the wealth drop. That rule of thumb implies that a $9 trillion drop in the value of equities would reduce consumer spending by about 2% of gross domestic product—enough to push the economy into recession. The fall in the value of commercial real estate would add to the decline of demand. And with consumer spending down sharply, businesses would cut back on their investment and hiring.

Drops in wealth do not necessarily cause a drop in spending; it depends on why wealth changes.  The stock market crash of 1987 did not impact consumer spending.  Where the two move together, it’s usually because a third factor such as the business cycle is causing both.  But if the Fed keeps NGDP growing at a steady rate (as in 1987), then an asset price drop is not likely to have much impact on consumer spending.  And even if consumer spending does drop, it’s not likely to push the economy into recession as long as the Fed keeps NGDP growing at a steady rate.  What matters is not consumer spending, it’s aggregate spending.

But significant monetary stimulus would be impossible to achieve if the short-term interest rate remains at the current 1.75%. And there is less room than ever for fiscal stimulus, as annual deficits will exceed $1 trillion by 2020 and federal debt will be greater than 100% of GDP by the end of the decade.

This is half wrong.  As Frederic Mishkin used to point out in his best selling monetary economics textbook, monetary policy remains “highly effective” at near zero interest rates.  However, Feldstein is right about fiscal policy.

That’s why it’s important for the Fed to raise the federal-funds rate to 4% over the next two years, which would allow it to cut the rate by at least three points when the next recession begins. Such a rate reduction might not be enough to prevent a recession within the next two years, but it would maximize the Fed’s positive influence on the economy.

It would be a huge mistake to raise rates so sharply (unless the economy got much stronger than I current expect.)  This might well trigger a severe recession, and in that case the equilibrium interest rate would fall sharply.  The Fed would actually have less room to cuts rates than they do right now, not more.

Feldstein’s views are very popular among conservative economists.  But I’m heartened to see that many younger economists and grad students are increasingly moving toward the market monetarist perspective, as events consistently back our interpretation and discredit the standard conservative view.  We are currently behind, but we’ll win in the long run.

PS.  I can’t even imagine what Feldstein would make of the past 27 years in Australia—they must be about to enter an enormous, humongous, stupendous, monumental, colossal, gigantic, titanic, vast, huge, bigly, Great Great Great Depression.  Check out David Beckworth’s post on house prices and debt in Australia, compared to the US.

HT:  Stephen Kirchner


Worst negotiator ever

One of the interesting things about Trump is that his statements are so often the exact opposite of reality.  When he says he’s really smart, or no one respects women more than him, or that press criticism is fake news, the truth is almost always the precise opposite.  Now we find out that not only is Trump not a great negotiator, he might be the single worst negotiator ever to serve as President of the United States.

We’ve seen his inability to get a Republican House and Senate to replace Obamacare.  His inability to get them to put up money for a border wall, even though in other areas Congress has been spending money like a drunken sailor. (Nor has he been able to get Mexico to pay for the wall, as he promised.)  Now this:

When he emerged from his summit with Kim Jong Un last month, President Trump tri­umphantly declared that North Korea no longer posed a nuclear threat and that one of the world’s most intractable geopolitical crises had been “largely solved.”

But in the days and weeks since then, U.S. negotiators have faced stiff resistance from a North Korean team practiced in the art of delay and obfuscation.

Diplomats say the North Koreans have canceled follow-up meetings, demanded more money and failed to maintain basic communications, even as the once-isolated regime’s engagements with China and South Korea flourish. . . .

The lack of immediate progress, though predicted by many analysts, has frustrated the president, who has fumed at his aides in private even as he publicly hails the success of the negotiations.

N. Korea is toying with us, because they knows that Trump’s eager for an agreement. Any agreement.

When Trump showed an almost pathetic eagerness to meet with Kim, he put the US in a very weak negotiating position.  The North Koreans are not dumb; they know that Trump’s only goal is personal success—ideology is secondary.  If Obama had done a nuclear agreement with North Korea and put sanctions on Iran, then Trump would have torn up the Korea agreement and started cozying up to the mullahs.  Trump’s only goal is to do the opposite of Obama, to one up him.  But that makes it hard for people in the Trump administration, some of whom (like Mike Pompeo) actually do have ideological beliefs.

It’s actually good that Trump is so bad at negotiating.  Because he has such bad instincts on policy questions, it’s better if he gets nothing done.  That’s not to say he won’t occasionally luck into a successful policy, like the recent corporate tax cut (something all our competitors did years ago—Obama’s biggest failure was to not see the need.) But Trump will usually be wrong.

In his recent negotiation with Juncker, the EU leader took him to the cleaners.  The Independent explains how:

European Commission chief Jean-Claude Juncker reportedly used brightly coloured flash cards to explain international trade to US president Donald Trump.

The pair met at the White House earlier this week for trade negotiations and Mr Juncker used cards with simple language and easy-to-understand explanations, according to a senior EU official who was at the meeting and spoke to the Wall Street Journal.

Trump agreed to back off on a trade war with the EU in exchange for meaningless promises.  But that’s really good news.

Trump has lots of bad qualities; stupidity, extreme egotism, corruption, dishonesty, cruelty, incompetence, bad taste, bigotry, no sense of humor, cowardice, I could go on and on.  He has no good qualities, unless one views a talent for conning voters to be a positive attribute.  But his complete lack of negotiating skills turns out to be a plus for America, even if it’s just one more of his seemingly endless bad qualities.

PS.  Brightly colored flash cards?  How can you not love that story?

Are the tax cuts affecting growth?

Probably, but it’s too soon to say.  Here is some (annualized) data on RGDP and NGDP growth:

2009:Q4 to 2016:Q4:  NGDP growth averaged 3.8%, RGDP growth averaged 2.1%

2016:Q4 to 2018:Q1:  NGDP growth averaged 4.5%, RGDP growth averaged 2.4%

2018:Q1 to 2018:Q2:  NGDP growth was 7.4%, RGDP growth was 4.1%


1.  Monetary policy has recently become more expansionary, especially in 2018:Q2.  This would be expected to modestly boost RGDP growth, and it did.  But NGDP growth has no effect on long-term trend RGDP growth.

2. There is a small amount of evidence that RGDP growth picked up after 2016, but it’s really only in the last three months where we seem to see significant effects from Trump policies—especially the corporate tax cut.  (I’m not interested in the demand side effects of other tax cuts, which are offset by monetary policy over any significant period of time.) But it’s still not completely clear if this growth surge is any different from 2014-15.

In my view, about 1/2 of the 0.3% initial boost to growth was due to deregulation, and the rest was due to easier monetary policy.

This year I expect a bigger growth surge due to the tax cut.  I predict an extra 1% of RGDP growth, and I also predict this growth burst will fall off sharply in subsequent years, so that the long run effect will be RGDP about 2% higher than otherwise, at most. But 2% more RGDP is a lot–well worth doing. (Here I’m referring to actual RGDP, the tax bill might slightly distort the figures by changing the way corporations report the location of economic activity.  We’ll know that occurred if Ireland’s GDP takes a hit.)

I have not factored in a major (and persistent) international trade war, as I still consider that outcome to be unlikely.

BTW, the 7.4% NGDP growth in Q2 is not likely to be sustained, according to the Hypermind prediction market (which shows 4.6%).   Ditto for real GDP growth.  I recall that RGDP growth averaged over 5% during the second and third quarters of 2014, but that was not sustained.

PS.  Earlier GDP figures were revised downwards, so the NGDP growth under the previous year’s Hypermind market was actually 4.6%, not 4.8%.  Of course the payoffs depend solely on the initial announcement.

PPS.  The employment situation is of course much less impressive.  Job growth has not increased under Trump, despite the fantastic claims of some in the media:

Trump’s policies have produced the best of all economic worlds — surging growth and employment, with little inflation and a rising dollar.

That’s simply not true:

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The China that can say no

I’m not at all a fan of the Chinese government, especially Xi Jinping.  But I do wish the best for the Chinese people, so I’m offering some advice in this spirit.

Right now the Trump administration is pressuring China on a number of fronts.  I believe that China is in a far stronger negotiating position than many people realize, perhaps stronger than they realize.  Here are some factors to take into account:

1. China is a huge country.  It has the world’s biggest economy and the gap with the US gets wider every year.  It has more than 4 times the US population.  It does far more trade than any other country.  Its current account is approaching balance.  Trade with the US is a small share of China’s GDP.  The US does have a big military advantage, but that’s of no use in trade negotiations.

2.  It’s true that China has a large trade surplus with the US, but that cuts both ways.  We could hurt China by cutting off Chinese imports, but that action would hurt the US just as much.  Imagine consumers showing up at Walmart or Target and finding no Chinese goods—the shelves would be almost empty.  Now imagine Walmart’s buying manager calling up their Indian purchaser, and asking how long it will take India to make up for the lost output from just the Pearl River delta.  A decade?  Two decades?  Are American consumers that patient?

3.  The Chinese people have been through much greater hardship than the American people, and are much better positioned to survive the unpleasantness of a trade war.  (BTW, the greater Chinese tolerance for hardship has been noted by historians going way back in history.)  In addition, Trump has little support for his trade war in either the Democratic or Republican Party leadership, whereas the Chinese government is more unified. Trump may lose the House in November, and has to think about the 2020 election as well.  The Chinese should delay, delay, delay. Time is on their side.

Overall I think it’s in China’s interest to stand up to Trump.  Bullies like Trump tend to be cowards, who back down when someone actually puts up a fight.  If the Chinese do want to grant any concessions, they might consider lowering a few trade barriers, which would actually help China and thus not really be a “concession” at all.

What about Chinese rules that force foreign companies to provide intellectual capital as a pre-condition for entering the Chinese market?  It’s hard for me to get worked up about this issue, for a number of reasons:

1. The US does far worse things, such as putting extreme sanctions on companies that do business with Iran, even if those companies are located in countries that have perfectly good relations with Iran, and who support the Iran deal along with 90% of the rest of the world.  The US is a big bully that tries to force the whole world to do as we do.  We also bully smaller countries like Canada in international trade disputes, often ignoring our own agreements.  We are the last people who should be criticizing China for not playing by the rules.

2.  One can make a good case that it’s efficient for foreign companies to be forced to transfer technology to China. Intellectual property laws are too restrictive, and the benefit of the technology to the 1.4 billion people in China probably far exceeds the cost to the companies and their stockholders.  And who are we to complain about a country using its size to get its way?

From a fairness perspective, keep in mind that China’s size is a disadvantage in international trade.  China contains by far the most homogenous large population anywhere; indeed there is nothing else on Earth like the 1.26 million billion strong Han ethnic group.  This means that China is constantly suffering from disadvantageous terms of trade whenever it goes into a new industry.  In contrast, Switzerland can specialize in a few industries without driving prices down to rock bottom.  So from a “fairness” perspective, the forced technology transfers merely offset the huge disadvantage China faces in trade due to its massive size and homogeneity.  (This homogeneity is a gold mine for US corporations—why shouldn’t they have to “pay to play”.)

(It would be different if the job skills in various Chinese regions were as diverse as in Europe, but they are not.)

I didn’t even mention other possible Chinese advantages, such as their strong authoritarian dictatorship, because I’m not convinced dictatorships actually do have more power.  However, others might cite that factor.

PS.  Several commenters asked me about an article claiming that the Chinese thought Trump was a formidable negotiator.  Here’s how I responded:

Trump’s been in office 18 months and done an amazingly bad job of negotiating.  For instance, he desperately needed McCain’s vote to repeal Obamacare, and instead mocked the fact that he was captured by the North Vietnamese (where he was tortured.)  Is that how smart negotiators win people over to their side?  He gave N. Korea the recognition it wanted and got nothing meaningful in return.  He tore up the Iran agreement and failed to negotiate anything better.  The EU president ran circles around him in yesterday’s agreement.  Putin made a fool of him.  He blabbed out top secrets to Russian officials in a White House meeting.  Where is the evidence that he’s a good negotiator?  I know; it’s all a secret master plan that only a select few can understand.

I’m guessing that a few of these glowing comments from the Chinese are a tactic to butter Trump up so that they can more easily use their vastly superior negotiating skills to run circles around him, just as Juncker did yesterday.

The next five years

At the moment, monetary policy is boring.  But the next five years will be very interesting.  Take a look at this graph for the unemployment rate:

Screen Shot 2018-07-25 at 1.32.45 PMThere’s an interesting pattern there.  When the unemployment rate stops falling, we usually have a recession within about 18 months.

One exception is 1966.  During late 1966, it looked like we were entering a recession.  But the Fed put the pedal to the medal and we avoided a recession until the very end of 1969.

I feel fairly confident that the unemployment rate will stop falling within a couple of years.  I doubt it can go below 3%.  If so, we will enter a dangerous period for the economy.  The Fed will try to engineer a “soft landing”, but so far it’s had little luck. (And even if I’m wrong and unemployment falls to 2.5%, it merely puts off the day of reckoning by a year or so.)

In 1967, the Fed got so nervous that they pulled up on the steering wheel and never landed at all, soaring off into the Great Inflation of 1966-81.  In more recent cases we’ve had a hard landing into recession.

So is a low inflation soft landing impossible?  No.  The UK achieved a soft landing in 2001, and Australia hasn’t had a recession since 1991.  While a forecaster looking only at US data might say that a recession is extremely likely within the next 5 years, in my view the odds are closer to 50-50.

[Yes, that’s a wimpy forecast, where I can’t be “wrong”.  But that’s not the point of this post.  I make no claims to be able to forecast recessions.]

Past data is extremely misleading in macro, as the monetary regime is always evolving in response to previous mistakes.  The interwar period was not useful for predicting the postwar period, and the Great Inflation was not useful in predicting the Great Moderation, and the Great Moderation was not useful in predicting the Great Recession.  Subtle changes are always occurring.  Look how the business cycle has started stretching out since the 1950s.

Either of these two outcomes will be great for market monetarism:

1. If a recession occurs we can say, “See, we told you not to let NGDP growth plunge.  We told you inflation targeting was not reliable.”

2. If no recession occurs we can say, “See, we told you that if you keep NGDP growing at a steady rate you could moderate the business cycle.”

Of course if a recession occurs despite stable NGDP growth, then we’re screwed.

(BTW, David Beckworth has a new article in The Hill, on the prospects for Jay Powell adopting a monetary rule.)

Yes, it’s delusional to think our tiny band of MMs will get credit for a 14-year expansion.  Who would get (or “take”) credit?  I’m not quite sure . . .

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PS.  Read this hilarious article about what happened when Melania was caught watching CNN.  This is just 18 months in; imagine how wild things will be after another 6 years!