Archive for June 2019


Ha ha ha

It’s easy to ridicule economic ideas. Nathan Lewis did a Forbes piece back in 2016 that ridiculed both traditional and market monetarism. Potential Fed nominee Judy Shelton called Lewis’s article “brilliant analysis”.

Over at Econlog I defended Milton Friedman from Lewis’s attacks. At one point in an earlier Forbes post Lewis wrote the following:

Bitcoin is an entertaining little trading sardine, which might have within it some templates for use in the creation of a much better currency unit. But, to propose this for the U.S. dollar? And make it a Constitutional Amendment?

Ha ha.

Ha ha ha.

Friedman was a dope. It’s funny that decades have gone by, and practically nobody has figured this out.

I think you get the idea. It’s Forbes. 

In the article Shelton praised, Nathan Lewis points to an important and not well understood flaw in NGDP targeting; inflation would move inversely to RGDP growth. (Yes, I’m being sarcastic.)  Perhaps this was the part that Shelton thought was brilliant:

With a stable currency, “real” GDP might be -2.0%. However, the Federal Reserve would – automatically – increase the monetary base such that this is magically turned into an NGDP of 3.65%. In other words, the GDP deflator might be +5.65%. That would be a pretty big move for a broad, slow-moving price index like the GDP deflator. It would probably require a substantial decline in dollar value, on the foreign exchange market for example.

Yup, that’s what happens under NGDP targeting, indeed that’s the whole point of NGDP targeting.  The idea is to allow real shocks to change real GDP, but not magnify the effect unnecessarily by having NGDP change as well, causing lots of unnecessary unemployment.  So what’s wrong with the idea?  Lewis doesn’t say.  He seems to think the fact that inflation would fluctuate is an argument, even though he’s later downright contemptuous of inflation targeting.  Indeed he favors a gold standard, which is a regime that would also allow the inflation to fluctuate, in this case in response to changes in the supply and demand for gold.  In the end, Lewis doesn’t even present any arguments against the claim that NGDP stability is better than price stability, he simply denies it.  

Lewis continues:

Then, there’s the possibility that the “NGDP futures market” could be manipulated by large financial interests. Sumner assures us that this is impossible, because some other academics wrote a paper.

I’ll come back to this later, but first let’s have some fun with Lewis’s preferred policy, the gold standard:

The gold standard has an awesome track record of real-life success over a period of centuries. That’s why conservatives traditionally supported it.

So we are supposed to attach our money to a commodity that has wild swings in price like gold?  Ha ha ha.

This graph shows the ratio of the CPI to gold prices, which is the price of goods in gold terms:

The deflations of the 1970s and the early 2000s are huge. Now in fairness the rise in gold’s value in the 1970s was mostly due to its use as an inflation hedge under fiat money. But the 2000s surge in the value of gold was more likely due to enormous growth in demand in developing countries, a real problem if you are using gold as money.

Lewis might argue that the US returning to gold would miraculously stabilize its value. Why, because some academics wrote a paper?

Ha ha ha.

In fact, to have any chance of stabilizing the value of gold it’s not enough for one country to adopt it as its standard, you’d need to recreate an international gold standard. So future Fed chair Judy Shelton will talk Mario Draghi and Xi Jinping into adopting the gold standard?

Ha ha ha.

Then’s there’s the great deflation of 1929-33, which directly led to the worst depression ever and resulted in the Nazi’s taking power in Germany. Is this part of the “centuries” of real life success?

I know, that interwar gold standard was not “done correctly”; the government messed it up. So let me get this straight. We need a gold standard because the government will mess up fiat money. Under gold, the government will be disciplined, prevented from creating too much money. And then when the gold standard doesn’t work because the government was too disciplined, created too little money, it’s not the fault of the gold standard?

Ha ha ha.

Some will argue that the interwar gold standard wasn’t the real thing, and that only the pre-1914 “classical” gold standard counts. But Lewis goes the other direction, even the pathetically weak post-WWII regime counts as a gold standard in his book:

Stable Money advocates still favor a gold-standard system – the proven method that served as the foundation for prosperity in the U.S. and around the world for nearly two centuries before being abandoned, after two wonderfully prosperous decades, in 1971.

Wait. The inflationary monetary policy under LBJ and Nixon was an example of the success of the gold standard?

Ha ha ha.

Lewis doesn’t seem to realize that even the quasi-gold standard of the post-WWII era was entirely abandoned in March 1968, when market price of gold was no longer pegged at $35/oz. Yes, the official price peg at $35/oz continued until 1971, but that’s meaningless. Indeed last time I looked the official price was still $42.22/oz. So by Lewis’s logic we are still on the “gold standard”.

Ha ha ha.

In fact, while there was a very weak gold standard up until 1968, the gold standard of 1929-33 was far more orthodox, albeit not as orthodox as before 1914. So if Lewis is going to claim the “gold standard” somehow created the post-WWII boom, he’s got to also own the Great Contraction of 1929-33.

Ha ha ha.

My point is not that there aren’t respectable academics advocating a gold standard. But those who do so certainly aren’t advocating the “gold standard” in effect until 1968, much less 1971. Rather they favor a highly decentralized regime where free banks would create private banknotes that are backed by gold. Bretton Woods was a government run system, and the Great Inflation began while it was still in effect.

And why isn’t Lewis worried that “market manipulation” will disrupt the gold market just as he thinks it would disrupt the NGDP futures market? I know, it’s pretty far fetched to believe that someone could manipulate the global market for important precious metal. Oh wait . . .

Silver Thursday: How Two Wealthy Traders Cornered The Market

Ha ha ha!

Now let’s go back to Lewis’s worry about market manipulation under an NGDP targeting regime. Market manipulation only make sense if you are going to extract profits from someone. But at who’s expense will NGDP market manipulators profit from? Not the Fed; I’ve advocated that they avoid taking a net long or short position. Not taxpayers. Not my 93-year old mom, she won’t trade the contracts. So are we to believe that a bunch of Wall Street firms will extract big profits from “manipulating” the NGDP futures market (or other markets in side bets) at the expense of other big Wall Street firms who passively sit back and get taken advantage of?

I actually hope someone manipulates the NGDP market. Then I can get rich taking the opposite bet. After all, market NGDP manipulation requires taking unprofitable bets in one market (NGDP futures) to earn gains in side bets in another. So let’s play!

Seriously, I know I won’t win this argument, which is why I now favor using NGDP contracts as merely a “guardrail”, where the Fed could ignore any attempts at market manipulation. I don’t think this is needed. My original plan would work fine, as no trader could do enough market manipulation to materially impact the path of NGDP. But a guardrails approach is a reasonable compromise if it will reassure people frightened of markets, people like Lewis.

HT: Sam Bell

Should we accept lower than 2% inflation?

Here’s Scott Mather in the Financial Times:

Central banks around the world are pivoting toward easier monetary policy. In pursuit of a 2 per cent target for inflation, major central banks seem willing to exhaust their monetary policy ammunition at a time when economic output is at — or above — potential.

In fact, monetary stimulus does not exhaust ammunition, it adds to ammunition by raising the equilibrium interest rate.

Unfortunately, there is little evidence to suggest that lower policy rates are successfully generating either better real growth outcomes or higher inflation. 

That comment may reflect the fact that lower growth and lower inflation cause lower interest rates. So the correlations are not what one might expect. Nonetheless, Mather worries about the effect of low interest rates:

In some countries, this policy stance has the potential to reduce monetary policy effectiveness, create imbalances that may sow the seeds for the next crisis, and leave central banks powerless to respond to that crisis. It is time to ask whether the 2 per cent inflation target has outlived its usefulness.

But is lowflation really that bad:

Although economic recessions are typically accompanied by disinflationary forces, it is far from clear that disinflation or small negative rates of deflation actually cause economic crises. Japan has had such an environment for much of the past two decades, but its real economic growth per capita looks very similar to that of the US or Europe over the same time period.

One result of this Japanese low inflation policy is extremely low interest rates. But Mather seems to be suggesting that low interest rates are a problem, which can lead to financial excesses. So would higher rates be better? And if so, don’t we need higher rates of inflation? Here’s Mather:

And while likely fuelling these risks and distortions, low rates are clearly not delivering targeted inflation, and they may even be having the opposite effect. It has recently been observed that low rates correlate to low inflation outcomes, perhaps because they cause inflation expectations to fall rather than rise.

This is precisely why so many New Keynesians have recently advocated raising the inflation target to 4%. A higher inflation target would allow for higher interest rates. But Mather seems to go in another direction:

The “natural” rate of inflation may fluctuate over time because of the forces of technology, globalisation, demographics and so on. With potential growth rates that are barely positive and falling in places like Europe and Japan (owing much to challenging demographics), 2 per cent may also not be the natural inflation rate for every region. If this is the case, then inflation targets should be looser, more variable over time, and differ across countries with different economic structures.

There is no “natural” rate of inflation; only real variables have natural rates. One might argue that the “optimal” rate of inflation is different in slow growth countries, but in that case the optimal rate is likely to be higher, not lower. It is fast growing countries that have very low optimal rates of inflation.

HT: Stephen Kirchner

The next 3 years will definitely be interesting

[Before starting, let me point to a very interesting new working paper at Mercatus, by Robert Hetzel.  He was somehow able to preserve his monetarist perspective while working for decades at the Richmond Fed.  Lots of interesting discussion of how the Fed needs to make the rate setting process clearer.  In addition, I have a new piece on the Fed, at The Hill.]

Given that the past 10 years have seen a pretty boring recovery, how can I be sure that the next 3 years will be interesting? Because one of three things must happen:

1. A dramatic change inflation, to a rate far from 2%
2. A recession
3. Continued growth with 1% to 3% inflation

The first two are obviously interesting. But why the third?

It turns out that the US has never had a soft landing. Other countries have, but not us. We’ve never had three years of low inflation growth once unemployment fell to cyclical lows.

Consider the following claims:

1. Inverted yield curves predict recessions.  (True)
2. Tight money causes recessions.   (True)
3. Inverted yield curves show that money is too tight.  (False)

It would seem like if the first two claims were correct, then the third claim would also be true. But that’s not the case.

The 3 month/10 year yield spread inverted slightly in September 1966, May 1989, September 1998 and January 2006. In 2 of those 4 cases a recession occurred within two years.  But in none of those 4 cases was monetary policy clearly too contractionary at the time.  Even in May 1989 and January 2006, the actual policy mistakes occurred a year or more later.

Today the inverted yield curve shows that there is a heightened risk of recession.  That’s true.  But that doesn’t necessarily mean that money is too tight.

Nonetheless, monetary policy is slightly too tight, as a bit easier money would help reduce the risk of recession without causing inflation to overshoot the 2% target.  Policy is not far off course, but it is a bit too tight.

On balance, I believe the most likely outcome over the next three years is a soft landing, although the risk of recession is probably at least 30%.  I view the risk of high inflation as being well under 10%.

This rather optimistic take is based on several factors:

1. Previous recessions were often triggered by tight money policies aimed at restraining inflation.  I see little risk that the Fed will adopt tight money for that reason.  It might adopt tight money for some other reason, like inertia in adjusting the policy rate to the fast moving equilibrium rate.

2. It seems to me that we are nearing a major turning point in the zeitgeist.  Policy was dovish in the 1960s and 1970s, because people thought dovish policy was appropriate.  That view gradually became discredited, and then policy became hawkish in the 1980s.  The hawkish era now seems to be ending, partly because the recent predictions of the doves have been consistently more accurate.  Over time, the hawkish warnings about inflation get tuned out, especially by the younger generation.

James Bullard’s recent dissent is a straw in the wind.  Bullard has taken both dovish and hawkish stances at various points in time.  His recent advocacy of policy easing is one indication that this view is ascendant.

These changes in the zeitgeist are associated with changes in policy, with a lag.  The easy money of the 1960s came several years after President Kennedy called for faster growth, and the tight money of the 1980s came several years after Volcker was appointed.  While monetary policy is inertial, when it turns the new trend often lasts for decades.  I’d expect the next few decades to feature a Fed bias towards dovishness.

I also believe that the Fed learns something from its mistakes.  After WWII, they did not repeat the errors of the post-WWI period.  After the 1970s, they did not repeat the mistakes of the Great Inflation.  I suspect that the Fed has learned some lessons from the Great Recession.  They won’t formally adopt NGDPLT, but they will quietly try to make sure that NGDP follows a path that is not too far from what NGDPLT would call for.  (Just as inflation targeting was adopted informally, long before it was adopted formally.)  Deep down they probably understand that NGDPLT would have done better in 2008-09.  Again, Bullard is ahead of the curve.

The biggest risk of recession comes from a “shock”.  In the past I’ve argued that the housing/banking shock of 2008 did not cause the Great Recession; tight money was to blame.  At the same time, it’s clear that the tight money error would have been much less likely to occur if we had never had a financial crisis.  In this case I see two possible shocks that might cause the Fed to screw up:

1. A Eurozone crisis, probably triggered by Italy leaving the Eurozone.

2. A major trade war (which I do not expect to occur.)

I suppose a war with Iran might qualify, but I have trouble seeing how that could trigger a recession.  They no longer export much oil.

Brexit is also a possible flashpoint. Ironically, I believe the biggest risk here is that Brexit goes well.  If it is seen as going well, it might encourage the Italians to leave.  That would probably destroy the euro.  I just can’t see how the other weaker Eurozone members could withstand a run on their financial systems if Italy left.  In the long run, Europe might be better off without the euro.  But as we saw in 1931, the short run impact is contractionary when one country leaves this sort of regime.

Thus Macron will be very tough with Boris, pour encourager les autres.

PS.  The current ruling party in Italy was founded by a clown.  The new Ukrainian leader is a comedian.  And now another clown looks set to become the new British PM.

And let’s not even talk about the USA . . .

As Marx said; history repeats itself, the first time as tragedy, the second time as farce.  I’m sure glad to be living in the farce era.

Surprising trends in air travel

I’d first like to correct one point from an earlier post on Chinese airline travel. I suggested that Michael Pettis believed the Chinese government was somehow faking the GDP growth data, which is not accurate. Pettis did not question the fact that Chinese statisticians were measuring some sort of economic activity, rather he argued that a substantial portion of this activity had little economic value, due to misallocation of resources. He views reported GDP growth as more of an input into the system, which may or may not be effective at producing useful output.

Tim Peach sent me an interesting article on international air travel:

This is one of those dynamic (moving) graphs that I find kind of mesmerizing. (Like those moving graphs of world history over the past 5000 years.) The top 8 countries were not that surprising; the European big four plus the US, China, Russia and Canada. But where is Japan? The ninth country is South Korea, followed by lowly Ukraine. Sweden makes the list with fewer than 10 million people, while Japan has 126 million. Even worse, airlines are basically the only way for the Japanese to visit other countries, whereas Europeans can travel internationally by train or car.

I hit replay, and tried to take a quick screenshot:

Now Japan’s well up the list at number 7. But no South Korea. Even today, Japan is slightly richer than South Korea, and 2.5 times as populous. Does anyone know what’s going on with Japan?

Perhaps the Japanese did some travel in the boom years, and then decided there was no point in leaving home. When I visited Japan last year I noticed that the people were extremely polite, and things like trains and subways tended to work perfectly. To the Japanese, the rest of the world must seem barbaric. Or perhaps the Japanese worry that their limited skills in speaking English will be a drawback.

Any thoughts?

PS. In the early 1400s, the Chinese sent a huge armada under Admiral Zheng He across the India Ocean, and then decided the rest of the world had nothing of interest. They stopped exploring.

PPS. I presume the UK figures are inflated by London being a stopover point to Europe. And the hub and spoke system might inflate some of the other European countries as well. But five years ago, I flew to Singapore via Tokyo, so even the Japanese figures are a bit inflated. Also note that Japan has recently seen a huge boom in inbound tourism.

Two ways of thinking about the Phillips curve

There are two ways of thinking about the Phillips curve relationship:

1. Falling inflation causes higher unemployment.
2. Higher unemployment causes falling inflation.

Irving Fisher invented the Phillips curve back in the early 1920s, and employed the first interpretation. Milton Friedman also approached it that way, although he refined the model by emphasizing unanticipated changes in inflation. In a world of sticky nominal wages, an unanticipated fall in inflation tends to raise real wages, resulting in more unemployment.

New Keynesians use the second interpretation. In their view, higher unemployment creates “slack”, which drives inflation lower. That’s become the standard approach, although I’ve never liked it for reasons I’ll explain in a moment.

Greg Mankiw has a new post that suggests the Phillips curve is alive and well. Interestingly, he uses nominal wages:

Reading Mankiw’s post I suddenly got a brainstorm. Start with the fact that inflation is obviously not the right variable for the Phillips curve. Every day that goes by, that becomes more and more obvious to me. But what is the right variable? There are two directions one could go, depending on whether one wants to highlight the Fisher/Friedman approach, or the New Keynesian approach.

Mankiw points to a paper that he co-authored with Ricardo Reis to justify the use of nominal wages. I think he’s right that wages are the correct nominal aggregate in the new Keynesian model, not prices. If you want to argue that slack reduce inflation, it’s most likely to show up in wages, as prices reflect both AS and AD shocks. And wages are stickier than prices, and thus a better target for monetary policy.

Using the Fisher/Friedman interpretation of Phillips curve causality (nominal shocks have real effects), NGDP is the right nominal aggregate. Recall that nominal wages are sticky in the Fisher model, and unexpected changes in inflation cause movements in real wages, and hence unemployment. But that’s obviously much more true of NGDP than price inflation. Unexpected NGDP shocks clearly do drive changes in employment when wages are sticky. Again, price inflation reflects both AS and AD shocks.

So we have a world where the true model of the economy is all about NGDP and nominal wages. NGDP shocks in a country with sticky wages create business cycles. But we’ve weirdly decided to use an ambiguous intermediate variable—price inflation—which is sort of like NGDP and sort of like wage inflation. Because it is ambiguous, its causal role in the Phillips curve model can be interpreted in two radically different ways, as either the cause of business cycles or the result of business cycles.

If we dump the ambiguous price inflation from macro and replace it with the very unambiguous NGDP and nominal wages, we get a much clearer sense of what’s going on. Cause and effect are immediately obvious.

PS. I can’t even imagine what our undergraduates make of textbook macro. Taken as a whole, it MAKES NO SENSE. Inflation comes from MV=PY? Or does it come from having less “slack”? If you replace the textbook model with NGDP and wages, everything suddenly becomes clearer. Monetary policy (including velocity shocks) drive NGDP. Real GDP fluctuations are caused by NGDP fluctuations interacting with sticky wages. And once you have growth rates for NGDP and RGDP, then price inflation is simply the difference.

PPS. Sorry for being so long-winded. I wish I could write like Mankiw, a man of few words. Or zero words in the post I linked to, to be precise.

PPPS. If only I could write my own textbook. Oh wait, I did.

. . . If only I could write a textbook without worrying about sales figures.