Patrick Horan and I have a new piece over at The Bridge, which criticizes the increasingly popular “Modern Monetary Theory” of inflation:

Market monetarists argue that nominal GDP (total dollar spending on all goods and services in the economy) is the best way to determine whether monetary policy is too tight (leading to a recession) or too loose (leading to high inflation). During the recovery from the Great Recession, nominal GDP growth has averaged only four percent per year, which largely explains the low inflation rate.  The 1980s was also a period of expansionary fiscal policy and rising government debt, and inflation also fell during this period, as the Fed reduced the growth rate of the money supply.  And contrary to the predictions of MMT, the expansionary monetary policy of the 1960s and 1970s pushed inflation sharply higher, even though government spending and deficits were not unusually large.  While the market monetarist model (as well as some other conventional models) can explain why inflation has remained near two percent since 1990, MMT has no clear explanation for the relative success of inflation targeting.

Previously, whenever I criticized MMT I was told that I had gotten it all wrong, so we’ll see what sort of feedback this gets.  Brad DeLong also seemed a bit confused by their “theory”:

I think I am beginning to understand what had confused me: MMT is not M, or M, or T.

It seems to me that MMT argues that inflation is caused by excessively expansionary fiscal policy that pushes the economy past full employment, and that the cure for inflation is higher taxes.  If so, the theory is false.  They also seem to be arguing that central banks cannot control the price level by adjusting the money supply through open market operations.  Again, this is false.  Central banks control the price level through policies that affect the supply and demand for base money.

PS. Mark Sadowski expanded on DeLong’s remark:

I’ll get grief for this but like DeLong, I regard Modern Monetary Theory as none of the above. It’s more Ancient Fiscal Tautology.

1) Ancient
Chartalism, which is the intellectual foundation of MMT, was developed by G.F. Knapp in the 1920s, with contributions by Alfred Mitchell-Innes and Abba P. Lerner over 60 years ago. Not much of substance has happened since.

2) Fiscal
Exchanging money for goods or services is called “spending”. Issuing bonds in exchange for goods or services is called “borrowing.” Funding the difference via taxation is called “taxing.” Spending, borrowing, and taxing together make up fiscal policy, not monetary policy.

3) Tautology
Unless the proponents of a point of view, like MMT or Austrian Praxeology, admit that it is a set of assumptions that is falsifiable, then they don’t have a theory, they have a tautology.

Commenter Michael Sandifer left this comment:

One key difference between the current period and ’66 is that inflation is tame.

He’s referring to our relatively low inflation:

Over the previous 6 years, unemployment has fallen from 8% to 3.7%.  Inflation has mostly stayed in the 1% to 2% range, occasionally dipping below 1%, and recently rising above 2%.

In contrast, here’s the picture as of mid-1966:

In this case, unemployment rose to a peak of 7% in 1961, then gradually trended down to 3.8% in mid-1966.  Inflation mostly stayed in the 1% to 2% range, occasionally dipping below 1%, and recently rising above 2%.

Hmmm, that sounds familiar.

I don’t expect the next 3 years to look anything like the late 1960s.  But if we are to avoid a repeat of the 1960s, it will not be because the current situation is radically different from 1966, it will be because we take steps right now to make sure than the future situation is radically different.  And that requires a dramatically less expansionary monetary policy that what the Fed adopted in 1966-69.

In the 1960s, the Fed tried to use monetary policy to drive unemployment to very low levels.  Let’s not make that mistake again.  Better to produce stable NGDP growth, and let unemployment find its own natural rate.

Stocks dropped sharply this morning.

In don’t view today’s decline in stock prices as being important.  In recent years, stocks have often plunged for a few days, and then recovered.  I put more weight on the level of stock prices, which is still quite high.  Thus I believe the macroeconomy is still in very good shape.

But there’s also something more interesting going on—bond prices have also been falling (i.e. higher yields):

“It’s always hard to judge at what point you hit an inflection point where the correlation between yields and stocks goes into reverse,” says Liz Ann Sonders, chief investment strategist at Charles Schwab & Co. “One of the markers to when that happens is typically when you move from a deflationary era or at least a deflationary mindset to more of an inflationary mindset.”

It’s potentially a big deal.

An enduring rupture in positive correlations — yields moving up along with stocks — would signal a break in the weak-growth, low-interest regime seen over much of the past decade. Markets driven by negative tandem moves — yields up, shares down — have tended to be in the grip of inflationary pressure or potential economic over-heating.

David Glasner did a very important study that found stock prices became positively correlated with TIPS spreads (inflation expectations) during the Great Recession, but not before.  This may have reflected the fact that market participants thought the US economy would benefit from a more expansionary monetary policy during the period of high unemployment and near-zero interest rates.  That assumption was correct in my view. If long-term bond yields and TIPS spreads start becoming negatively correlated with stocks, then presumably excessively tight money is no longer much of a problem.

That doesn’t mean money is now too easy.  In my view we are so close to optimal that it’s hard to be sure whether policy is appropriate or a tad too expansionary.  We’ll know better in a few years.  But certainly most of the data looks pretty good from a dual mandate perspective.

I’d encourage people not to think in terms of binaries, rather shades of grey.  Monetary policy has been gradually moving from much too tight, to slightly too tight, to about right.  We don’t know precisely where we are on the spectrum, but the trend it clear.  It’s also clear that current monetary policy is far more appropriate than policy in 2009, or 1979, or 1930.

We used to think that the shape of a man’s skull correlates with his character.

Then we discovered that that’s actually not true; phrenology is fake science.

Then we discovered that the shape of a man’s skull actually does correlate with his character:

The new Caltech study is the first to show that observers have a knack for picking out corrupt politicians based on just a portrait and that observers perceive politicians with wider faces as more corruptible.

All knowledge is provisional.  As Richard Rorty observed, truth is that which we regard as true.

Of course no good blog post is complete until it includes an appropriate picture:

PS.  How about me? I think I’m a bit more corrupt than Obama, but less corrupt than Trump, but it’s hard to judge one’s own face.  Any thoughts?

PPS:  Yikes!

PPPS:  Lighten up everyone, this entire post is meant to be a joke.  I know that the correlation is quite small and only shows up with large data sets.

HT:  Scott Alexander

Here’s Noah Smith at Bloomberg:

Instead, the U.S.’s best bet is to concentrate on a key Chinese government intervention that can be measured easily — currency manipulation. Though China no longer pegs its currency to the U.S. dollar, it still closely manages the yuan’s value and maintains an extensive system of capital controls. In recent years, China usually hasn’t had to intervene in order to keep its currency cheap, since the yuan has fallen:

But the threat of intervention is still there, which undoubtedly keeps a lid on the currency’s value. Meanwhile, measures like the Economist’s Big Mac Index show that the yuan is undervalued against the dollar by about 44 percent. This effectively provides a subsidy to all Chinese exporters, and a tax on U.S. goods sold in China, thus distorting the global economy and the patterns of world trade.

As his main goal in the trade war, Trump should push for a large upward valuation in the yuan, followed by a much freer float of that currency against the dollar.

Actually, that would be a disastrous policy for China, which (fortunately) they are unlikely to adopt.  The Chinese economy is already struggling with a slowdown due to a crackdown on debt and a looming trade war with the US.  A sharp revaluation in the yuan could easily push them into a depression.  Think about it.  A rising power in the East, with a history of being humiliated by Western powers, and with a prickly nationalistic public that is intensively resentful of these past actions, is pushed into depression by a combination of a rabidly anti-Chinese American administration and some really bad exchange rate advice by Western experts.  What could go wrong?

[BTW, even if the yuan were undervalued, which it isn’t, it would not constitute a “subsidy” to Chinese firms or a “tax” on US exporters.  Words matter.  Taxes and subsidies are inefficient because they drive wedges between the prices faced by buyers and sellers.  Undervalued currencies do not do this.  If you want to argue an undervalued currency is inefficient, you need a completely different argument centered on saving rates.]

So what’s my solution?  Simple.  Have the Chinese government order McDonalds to raise Beijing Big Mac prices by 44%.  Problem solved, no more undervalued currency.  Seriously, the Big Mac index tells us absolutely nothing about whether a currency is undervalued or overvalued.  If it did, then the Swiss and Norwegians should demand that the US massively revalue the dollar, so that Big Macs over here are as expensive as in Oslo and Zurich.  In fact, all the Big Mac index illustrates is the Balassa-Samuelson theorem, which says that lower wage countries tend to have lower price levels because their comparative advantage lies in non-traded goods.  (I.e. rich countries are much more productive at building complex products, but not much more productive at cutting someone’s hair or cooking Big Macs.)

Outside the Trump administration, I doubt you’d find many international economists who think PPP should determine the proper exchange rate between any two countries.  And even within the Trump administration they’d be more likely to use “trade imbalances” as an excuse for demanding that China revalue.  The problem, of course, is that China now has the most balanced trade of any major economy in the world, with a current account surplus estimated to be 0.5% of GDP this year and 0.3% next year.  So it’s not clear what sort of “distortions” Smith is referring to.  Many of the same people who a decade ago insisted that China needed to revalue because of its current account surplus (which really was large at that time) now seek out some other reason for demanding Chinese revaluation.  I guess cheap hamburgers are as good as any, as the importance of maintaining PPP and “balanced trade” are roughly equally invalid arguments.

There is one economy that does have a massive CA surplus, the Eurozone.  And to his credit, Smith does not advocate that we demand a sharp euro appreciation (which would also be a disaster—ciao Italia):

Trump has also turned his attention away from Europe, avoiding the mistake of getting into a harmful spat with allies he should persuade to form a trading bloc and a unified front.

This also caught my eye:

There’s no way to measure the amount of state interference that China is using to shut out foreign companies. And IP theft, by definition, happens in secret and is thus difficult to detect or to prove. China’s entire economy is centered around pervasive state intervention and skullduggery — even if it made some moves to change that model, the U.S. couldn’t verify that changes had really been made.

If it can’t be measured, how can we be confident that China’s entire economy is centered around this intervention and “skullduggery”?  You might say, “it’s obvious”.  No, it’s obvious that these things happen pretty often in China, but it’s not obvious how big a problem it is.  If it were, then Smith would be wrong in claiming we can’t measure it.  How do we know that the “center” of their economy is not growing rice, or building subways, or selling life insurance?  For instance, China’s goods imports are about 15% of their GDP.  The same is true of the US, but because the US figure is for both goods and services, I presume China’s total imports are actually a larger share of GDP than in the US.  So how important are their barriers to imports? Who knows?

I am not claiming that China has fewer trade barriers than the US, indeed I believe the opposite is true; my point is that the data doesn’t provide any way of knowing how much of this is anecdotal, and the extent to which China really is much more closed than other countries like the US.  Let’s not forget that the US also does lots of “skullduggery”, like “Buy America”.

Note that if Smith is right that it’s hard to measure this stuff, then Trump may be wasting his time.  How would we even know if they adhered to any trade agreement?  That’s why Smith suggests that we instead press for yuan revaluation.  But that won’t work either.  China could simply stop having a crawling peg with the dollar, and instead have a crawling peg with the euro, yen or pound.  When you have a crawling peg, it really doesn’t matter which currency you choose.  And there is near-zero chance that China will agree to set their exchange rate according to PPP.

Smith also seems confused about the implications of what’s often called the “China shock”:

And Chinese import competition has been much more harmful to American workers than competition from Mexico, Europe or any other country. Even some Democrats support pushing back against China.

He’s referring to a study that showed the import surge from China had depressed a number of industrial towns in the US.  But then he advocates a Chinese policy that would cause an even bigger China shock:

What would constitute a win in a trade war against China? A simple goal would be to get that country to cut tariffs on U.S. imports. Indeed, China’s leaders have already offered some tariff cuts, suggesting that they’re in a mood to deal. But although tariff cuts are good, they don’t form the bulk of China’s unfair trade practices. The government underwrites its industries in a variety of ways, from cheap loans from state-owned banks to energy subsidies to export subsidies. Costs are held down because of lax environmental regulations and low labor standards — China crushes independent labor unions, for example. The U.S. government could demand that the Chinese reduce subsidies, do more to protect the environment, or improve worker rights.

Chinese tariff cuts would cause the US to export more movies and food and high tech stuff to China, and also cause China to export more “mid-tech” industrial goods to America.  If you thought the China shock hurt America (I don’t), you should not advocate an even more open China, an even bigger China shock.  You should advocate they go back to Mao’s policies, when China was closed to the world and American workers were not “threatened” at all.  Of course I don’t worry about China shocks, and thus agree with Smith that fewer Chinese tariffs would be a good thing.

Some might argue that lower Chinese tariffs would reduce America’s trade deficit.  They won’t.  But what is true is that Trump’s policies are likely to raise our deficit.

At a deeper level, all of this focus on the domestic policies of other nations is deeply misguided.  I agree that better economic policies in China would benefit the US.  However that same argument is even more true of India, Africa and lots of other places, which buy far fewer US goods than they would with more sensible policies.  But that’s because with better policies they’d be richer, not because they would no longer be “cheating” at trade.  Since the time of Ricardo, we’ve known that factors such as subsidies, weak environmental laws and low wages do not give countries any competitive advantage of international trade.  Paul Krugman demolished all those arguments a second time back in the 1990s.  Read Pop Internationalism.

I hope this post doesn’t come across as too negative, but I get frustrated reading the same misconceptions about trade, over and over again.  In fairness, there are also things I agree with in Smith’s article:

That doesn’t mean a trade war with China is without downsides and risks. Chinese retaliation against U.S. agriculture has already forced many farmers to accept handouts from the government in order to stay afloat. Disrupting the cozy economic symbiosis that has developed between the U.S. and China will cause painful adjustment, and will also increase the risk of military conflict. If Trump decided to call off his trade war against China right now, it would certainly be a safe course of action.

He’s rightfully skeptical of the Trump approach, and opposes some of the current protectionist policies:

President Donald Trump’s trade war is less bad than it was just a short time ago. After some tense negotiations, the North American Free Trade Agreement has been replaced with a new, very similar arrangement, meaning the disruption to trade — and to U.S. relations with Canada and Mexico — will be contained. The agreement might even ease the damage from the president’s misguided steel and aluminum tariffs.

Unfortunately, China pushes people to advocate policies that are highly counterproductive.  Perhaps it’s partly due to the fact that China is an increasingly powerful and successful country that really does have lots of bad public policies, especially in terms of repressing free speech, minority rights, etc.  That’s frustrating—I really wish they had better policies (Ditto for Myanmar, Vietnam, Venezuela, Saudi Arabia, Russia, Cuba, Iran, Nigeria, and 100 other countries.)  But when I read the arguments for focusing our trade war on China, none of them make any sense.  Whether it be “undervalued currencies”, trade imbalances, or domestic policies that discourage US exports, you can always find much worse offenders than China.

So what’s my solution for bad Chinese policies?  Push China to high income status as quickly as possible and hope for the best.  It worked pretty well in the rest of East Asian, where it was tried. It may not work with the mainland, but going back to the 1930s is even less likely to work.