I first became radicalized about 3 years ago when I realized that my fellow economists did not see the seemingly obvious need for greater monetary stimulus.  Here are a few facts:

1.  The number one monetary textbook tells us that monetary policy is still highly effective at boosting nominal spending at the zero bound.

2.  There are many prestigious academic papers discussing how the Fed can boost nominal spending at the zero bound.

3.  American economists were highly critical of Japan’s refusal to boost NGDP growth in the 1990s and 2000s.

4.  I’ve never met a right-of-center economist who worried about “liquidity traps.”

5.  Lots of progressives (Romer/Krugman/DeLong/Yglesias, etc) favor more Fed stimulus.

6.  Ben Bernanke keeps insisting that the Fed is not out of ammunition, a view he’s held from the beginning.

OK, there are some economists who worry about the Fed running out of ammunition.  But rates weren’t even at zero in the fall of 2008, and there was still no pressure on the Fed to ease.  None at all.  And nothing’s changed in the subsequent 3 years.

Clare Zempel sent me a new survey from the National Association of Business Economists:

Given a budget of 10 points, what are the major factors holding back the recovery?  You may allocate all 10 points to one factor or divide the points among them.

16.9% Uncertainty about future economic policies
13.7% Low consumer and business confidence
13.5% Financial headwinds caused by tight credit conditions and balance sheet restructuring
11.0% A tepid housing market
7.4% State and local government spending cutbacks and tax increases
7.3% Uncertainty about economic prospects in the rest of the world.
6.5% The burden of new regulations
6.3% Structural imbalances requiring the reallocation of labor and capital across sectors
6.1% Lack of progress in reducing long-term fiscal imbalances
4.9% The removal of near-term fiscal stimulus
3.1% High and rising commodity prices
1.6% Inadequate monetary stimulus.
1.2% Nothing is holding back the recovery. The economy is poised for a strong rebound.
0.4% Ongoing supply disruptions associated with the earthquake and tsunami in Japan

Just three of the 49 respondents selected “inadequate monetary stimulus” — and just one considered it to be quite important (by allotting 5/10 points to it).

So my fellow economists don’t think we need more monetary stimulus.  And I have no doubt that this is why the Fed isn’t doing more.  If the monetary stimulus choice was 98.4% rather than 1.6%, you can be sure the Fed would be doing all sorts of aggressive stimulus right now.

Here’s the big puzzle; do my fellow economists oppose more monetary stimulus because they don’t think it will work, or because they fear it will work?  In other words, do they want more AD or not?

When I look at all the responses, I see at least a half dozen that implicitly point to AD being a problem.  But in that case why wouldn’t they favor more monetary stimulus?  Is it really possible that 46 out of 49 economists think the Fed is out of ammo?  Or is there some sort of third possibility, which I miss because the model is completely off my radar screen?  I.e. do they think monetary stimulus creates inflation and fiscal stimulus creates real growth?  God only knows.  All I can say is that I am part of a profession that I know nothing about.  I can’t even fathom what is going on in the minds of my fellow economists.

Of course it’s very possible that this whole blog is wrong, and that we don’t have a demand shortfall.  Or that we do, but a more expansionary monetary policy can’t boost nominal spending.  But if I am right then there can be no doubt as to who is to blame for the current crisis (in both America and Europe.)  It’s not politicians.  It’s not bankers.  It’s not voters.  It’s macroeconomists.

PS.  In my view the top 4 choices are mostly a consequence of tight money, of low NGDP.

PPS.  Maybe I should look at the bright side.  Four times as many point to monetary policy being the problem, as compared to the tsunami in Japan.

Marcus Nunes sent me a new Christina Romer paper, which claims that fiscal stimulus is effective.  I’ll argue that she has some good evidence, but also that there are weaknesses in her argument.

Her best evidence is a study that she did with David Romer, which examined two types of tax cuts; those done to boost the economy, and those done for other reasons, which can be viewed as “exogenous.”

What David and I did was to bring in information on the motivation for tax changes. For every legislative tax change, up or down, there is a huge narrative record about why it was passed. This narrative record is contained in Congressional reports, presidential speeches, the Economic Report of the President put out by the Council of Economic Advisers each year, and other documents.

We read all of those documents and classified tax changes into those taken in response to other factors affecting output and those taken for more independent reasons. We identified a number of tax cuts taken because the economy was slipping into a recession. We also found a number of tax increases taken because government spending was rising; for example, policymakers raised taxes dramatically during the Korean War. This is important because spending increases will tend to increase output, while tax increases will tend to reduce it. So in cases where the tax increase is caused by the spending increase, there are systematically factors going in opposite directions.

At the same time, we also found a number of tax changes taken not in response to current or forecasted economic conditions, but for more ideological or long-term reasons. For example, Ronald Reagan cut taxes in the early 1980s because he believed lower tax rates were good for long-term growth. Bill Clinton raised taxes in 1993 because he thought dealing with the deficit would be good for the long-term health of the economy.

We argued that to estimate the impact of tax changes, we should look at the behavior of output following these tax changes made for more ideological reasons. In other words, we dealt with some of the omitted variable bias problem by excluding from the empirical analysis the tax changes taken in response to economic conditions.

They found that the endogenous tax changes had a modest (but positive) effect on output, while the exogenous changes had a large impact on output.

I favor a pragmatic approach to research, so I applaud the Romers for using the narrative approach.  However what’s being tested here isn’t really “stimulus,” it’s tax cuts.  The traditional Keynesian model says fiscal stimulus will boost NGDP, and will also boost RGDP if there is slack in the economy.  Otherwise you get higher prices.  So there are actually two interesting questions worth testing; does Keynesian stimulus boost NGDP (i.e. spending) and does the higher spending lead to more real output.

To make things even more complicated, supply-siders have suggested an alternative channel through which tax cuts might boost RGDP; increasing the incentive to work, save and invest.  The basic supply-side model doesn’t predict claim any impact of tax cuts on NGDP, indeed it was sold in the late 1970s as a tool for boosting output without boosting inflation.  Even so, if the central bank is targeting interest rates, then supply-side effects could easily lead to more NGDP as well.

So let’s accept Romer’s argument that tax cuts boost RGDP.  Is it a problem that we don’t know exactly how or why?  It could be, because if it is due to supply-side effects then lump sum tax rebates and government spending increases wouldn’t necessarily work.

Romer discusses one such event that occurred in the spring of 2008, when the Bush administration issued tax rebates to boost consumption.  John Taylor later pointed out that consumption did not seem to respond to these tax rebates, despite the temporary spike in disposable income.  Romer replied:

The trouble with this analysis is, Professor Taylor wasn’t thinking about what else was going on at the time. Democrats and Republicans didn’t come together to pass the tax rebate for no reason. This was the heart of the subprime mortgage crisis. House prices were tumbling. Mortgage lenders like Countrywide Financial were in deep trouble.

Economists were worried that consumption was about to plummet. For most families, their home is their main asset. When house prices fall, people are poorer, and so tend to cut back on their spending.

Against that background, the fact that consumption held steady around the time of the tax rebate may in fact be a sign of just how well it was working. It kept consumption up for a while, despite the strong downdraft of falling house prices.

Romer’s right that without the rebates aggregate spending and output might have been somewhat lower during mid-2008.  But Romer doesn’t consider whether that might have led the Fed to move much more aggressively in September 2008.  As it is the Fed met two days after Lehman failed and did nothing (which effectively tightened policy sharply as the Wicksellian natural rate was plunging rapidly during this period.)

The Fed cited an equal risk of recession and inflation (i.e. economic overheating) when it left interest rates unchanged at 2% in September.  It seems highly unlikely that the Fed would have been so passive if Romer’s counterfactual had come to pass.  If so, then John Taylor might be right, but for the wrong reason.  The real problem is that the Fed sabotaged Bush’s tax rebate.  The real problem is that in new Keynesian models the fiscal multiplier is precisely zero if the central bank targets either inflation or NGDP.

This is the biggest weakness in Romer’s paper.  When discussing Taylor’s critique she rightfully talks about the omitted variable problem.  But then she basically ignores the problem of monetary policy counterfactuals when considering what would have happened without the Obama stimulus.  The basic problem here is that she seems to hold three contradictory views:

1.  She agrees with Bernanke that the Fed is not out of ammunition.

2.  Elsewhere she praises Bernanke for acting aggressively in 2008-09, making the recession less severe.

3.  Her three million “jobs created or saved” estimate for the Obama stimulus implicitly assumes that if Obama’s stimulus had not passed, then the Fed would have responded to the deeper downturn with almost criminal negligence.

Now I’m perfectly willing to concede that it’s unlikely a counterfactual monetary policy would have exactly offset any fiscal stimulus reductions.  But I would also insist that monetary policy counterfactuals must be addressed in any multiplier estimates.  And I see one Keynesian study after another completely ignoring this problem.

She also cites the study by Nakamura and Steinsson that looked at the cross-sectional effects of defense spending in various regions.  But as I’ve pointed out many times, these multiplier estimates are completely consistent with the national multiplier being zero.  In other words, models that assume no aggregate multiplier effect (such as the monetary policy offset model) would nonetheless predict that regional defense expenditures would impact regional GDP.

She also cites a study of how individual reactions to rebate checks depend on the date they were received (Jonathan Parker, et al.)   This approach is somewhat better, but still fails to fully address the monetary offset problem.  Stimulus might boost NGDP in Q2, and the Fed might take it all back in Q3.

On a more positive note let me acknowledge that the Romers’ tax cut study is very important.  It suggests that we do know, at a minimum, that cuts in marginal tax rates boost RGDP.  I’m willing to support that sort of fiscal stimulus.  But at this point I’d have to say that’s all we know.  In a world where central banks are targeting inflation (and by implication AD), then all multiplier estimates for demand-side stimulus will be highly uncertain, little more that estimates of monetary policy incompetence in the specific period being examined.

John Taylor has a new post criticizing NGDP targeting:

One change is that, in comparison with earlier proposals, the recent proposals tend to focus more on the level of NGDP rather than its growth rate. This removes some of the instability of NGDP growth rate targeting caused by the fact that NGDP growth should be higher than its long run target during the catch up period following a recession. But it introduces another problem: if an inflation shock takes the price level and thus NGDP above the target NGDP path, then the Fed will have to take sharp tightening action which would cause real GDP to fall much more than with inflation targeting and most likely result in abandoning the NGDP target.

I see lots of problems here, but in fairness this may reflect my particular vision of NGDP targeting, which is the “target the forecast” approach.  Under my plan, the Fed would constantly adjust policy so that expected future NGDP (12 or 24 months forward) remained right on target.  Ideally this would involve NGDP futures markets, more likely it would involve an internal Fed NGDP forecast, which also incorporated the consensus private NGDP forecast as well as various asset prices such as TIPS spreads.

Taylor is right that there might be inflation shocks under NGDP targeting, just like there are under inflation targeting.  For instance, the rise in oil prices in 2007-08 caused CPI inflation to rise far above the Fed’s implicit target.  But he’s wrong in assuming these inflation shocks would raise NGDP, indeed NGDP growth slowed to well under 5% during the 2007-08 oil shock.

The deeper problem with this criticism is that wages are not set on the basis of expected inflation, but rather the expected rate of NGDP growth.  That’s why wages in a country like China have been rising at double digit rates for years, despite much lower inflation rates.  It is why wages in the US remained well behaved in 2007-08, even as headline inflation rose to over 5% (as NGDP growth was slowing.)  As long as the Fed keeps targeting NGDP expectations, wage growth will remain anchored.  Workers and employers understand that wages cannot compensate for every spurt in prices at the gas pump.  If actual NGDP does change suddenly, it will be easy to reverse as long as expected future NGDP (and hence wages) remain on track.  (Note; this argument applies best if the Fed targets NGDP per capita, or per working age adult.)

If the Fed had been targeting inflation in 2008 the crisis would have been far worse, as monetary policy in mid-2008 would have been much tighter.  The Fed actually takes both inflation and real growth into account.  But an NGDP target would allow them to do so in a much more explicit fashion, and would have allowed them to ease much more aggressively in late 2008.

Taylor continues:

A more fundamental problem is that, as I said in 1985, “The actual instrument adjustments necessary to make a nominal GNP rule operational are not usually specified in the various proposals for nominal GNP targeting. This lack of specification makes the policies difficult to evaluate because the instrument adjustments affect the dynamics and thereby the influence of a nominal GNP rule on business-cycle fluctuations.” The same lack of specificity is found in recent proposals.

That may be true of Romer and Krugman, but they were basically endorsing the proposals of others.  And certainly no one can claim that my proposal lacks specificity—it is just as rule-based as Taylor’s famous policy rule.  It also has the advantage of being forward-looking, which is a huge plus in a fast moving financial crisis like 2008.  The Fed used Taylor Rule-like reasoning in deciding not to cut rates below 2% in their September 16, meeting, which occurred right after Lehman failed.  They cited a roughly equal risk of recession and inflation.  Incredibly, the risk they saw was excessively high inflation, not excessively low inflation.  How could the Fed have made such a bone-headed mistake?  They were looking in the rear view mirror, at nearly 5% headline inflation over the previous 12 months.  They should have looked down the road as Svensson suggests, as the TIPS spreads that day showed 1.23% inflation over the next 5 years.  Taylor Rule-type thinking caused the Fed to unintentionally leave money way too tight to hit their implicit inflation and employment targets.

I’m sure that today even Ben Bernanke would agree that they erred in not sharply cutting rates at the September 2008 meeting.  During the fall of 2008 the Fed needed to do enough stimulus so that forecasts of 2010 NGDP remained roughly 10% above actual 2008 levels.  They didn’t even come close, which is why the recession was so much worse than it needed to be.  The sub-prime fiasco made a mild recession almost inevitable, but the fall in NGDP (the biggest since the 1930s), made it far worse than it needed to be.  Sharply falling NGDP expectations in late 2008 led to sharply lower asset prices, which dramatically worsened bank balance sheets.  IMF estimates of expected US banking system losses nearly tripled in late 2008 and early 2009, even though the sub-prime fiasco was already well-understood by mid-2008.  What wasn’t predicted in mid-2008 was the catastrophic fall in NGDP over the next 12 months.

At first glance Taylor’s piece looks like a critique of NGDP targeting.  But on close inspection it is something different.  It is a discussion of tactics; level versus growth rate targeting.  Rules versus discretion.  I’ve added the issue of forward-looking versus backward-looking rules.  These are all interesting issues, and I actually agree with Taylor on the importance of policy rules.  He is well aware that some of the most distinguished proponents of NGDP targeting (such as Bennett McCallum) have proposed explicit NGDP policy rules.  He also knows that the dual mandate embedded in NGDP targeting is not that different from the dual mandate embedded in the Taylor Rule.  Readers of critiques by Taylor and Shlaes need to keep in mind that their real target isn’t NGDP targeting, it’s discretion.  I hope John Taylor will consider jumping on board and writing an explicit “Taylor Rule” for NGDP targeting, so that if the Fed does move in that direction they do so in a responsible way.

BTW,  What’s the non-discretionary Taylor Rule suggestion for Fed policy if rates fall to zero and further stimulus is needed?

HT:  Marcus Nunes

Consider the following:

Banks pour huge amounts of money into one particular asset class.  They are encouraged to do this by public policymakers, although there is some dispute about whether that was the main reason for their decisions.  These assets have a long tradition of doing well, although a close look at the evidence would have raised red flags.  The asset market in question suddenly takes a big dive as default risk increases sharply.  This drags down many large banks, forcing policymakers to provide assistance.

What have I just described?  The sub-prime fiasco or the PIGS sovereign debt fiasco?  I’d say both.  I’d say these two crises are essentially identical.  (I should clarify that by “essentially identical” I mean in essence, not in every detail.)

Of course the sub-prime crisis came first, so let’s consider the dominant (progressive) narrative of the sub-prime crisis.  If you read the mainstream media you will see it described as a sort of morality play; the evils of deregulation, which allowed the greedy big banks to take highly leveraged gambles with other people’s money, and then off-load the risk on to both taxpayers and unsuspecting buyers of MBSs.  Or something like that.

Obviously it would be impossible to tell a similar story for the sovereign debt crisis.  No regulator in his right mind would ever contemplate telling big banks not to buy European sovereign debt because it’s too risky.  Indeed the previous attempt at regulation (Basel II) encouraged banks to put funds into those “safe investments.”  Blaming the euro crisis on deregulation doesn’t even pass the laugh test.  The criminals were the regulators themselves.  Is the term ‘criminal’ hyperbole on my part?  Not at all.  Suppose Enron executives had used the same accounting techniques as the Greek government.  They’d all be in jail.  And as for Berlusconi, what can one say about a leader who continually passes laws exempting the Prime Minister from the very crimes he was accused of having committed?  As Keynes said:

Words ought to be a little wild, for they are the assaults of thoughts on the unthinking.

So here’s what I wonder.  Assume the eurozone crisis was obviously not caused by deregulation and greedy bankers.  Then if the sub-prime crisis was basically identical, at least in its essence, how can deregulation be the root cause of the former crisis?  I’m not saying it’s logically impossible, but doesn’t it seem much more likely that there’s a deeper systemic problem, which transcends this glib cliche?  I’m going to leave you with two very different items, which together seem to point to the flaws in our financial system being very deeply ingrained, far too deep to fix with any sort of politically plausible “reforms.”

The first is a heartfelt lament by Steve Waldman, from the recent Kauffman Foundation blogger’s conference.  Steve wonders why after all the outrage in late 2008, nothing fundamental has actually changed.  Even with Obama elected in 2008 and taking office along with a heavily Democratic Congress.

The other item is a very funny Jon Stewart routine (courtesy of Greg Mankiw.)   He shows that one of the progressive political figures who showed the greatest outrage, then left the government, set up his own investment company, used leverage even greater than Lehman Brothers, used political pull to fight off the regulators when they complained, and eventually drove his firm into a messy bankruptcy.

Why is all this so hard to change?  Why didn’t we just adopt the Canadian model, which never has these problems?  I don’t really know, but something tells me that the problems go much deeper than you might imagine when reading cliched morality tales about “deregulation.”

PS.  Of course you and I know that the real problem was (mostly) nominal; tight money turned medium size debt fiascoes into catastrophic financial crises.

Ever since late 2008 I’ve been arguing that we misdiagnosed the crisis.  The main problem was not sub-prime mortgages and banking distress, but rather falling NGDP.  Indeed I’ve suggested that perhaps 2/3 of the banking crisis was due to falling NGDP expectations.

What about the other third?  That’s the obvious part—the subprime loans, the Greek debt, etc.  Now Matt Yglesias has a post that suggest 2/3rds may be an underestimate—we may rapidly be approaching a point where the global debt crisis is 75% or 80% NGDP shortfall:

Robin Wigglesworth covers capital markets for the FT and has a rundown of the ensuing carnage, which I shall summarize for you in bullet points:

“” Italian 10-year yields jumped 32 basis points to 7.02 per cent, which is the level that prompted Berlusconi’s ouster.
“” In Spain a new 12-month bond yielded 5.02 percent (up from 3.6) and 18-month yieled 5.15 percent (up from 3.8).
“” “France’s 10-year notes jumped 20 bps to yield 3.59 per cent – a record 188 basis points above comparable German Bunds.”
“” “The FTSE Eurofirst 300 index tumbled 1.5 per cent, led by the French, Italian and Spanish markets, and have now given up all of last Friday’s gains.”
“” “Belgium, Austria, and Finland’s 10-year benchmark bonds also widened markedly in early trading.”

Now Belgium and Finland aren’t really important countries in the scheme of things but this is a sign that you’ve moved into Total Chaos And Market Panic Mode. You don’t lose faith in Finland’s ability to repay debts based on shady budgeting in Greece or political dysfunction in Italy. You lose faith in Finland’s ability to repay debts when you wake up one day and realize that all European sovereigns no matter how well-run are in a third world fiscal position where they lack a lender of last resort.

It would be nice if the ECB became lender of last resort.  But even that isn’t really essential, and I’m not sure it would be enough.   What we really need is faster NGDP growth in the eurozone, even if the ECB does so by monetizing German debt.  Given the choice of boosting the NGDP growth rate by 5% while purchasing German debt, and acting as lender of last resort to Italy but sterilizing any effects on the monetary base, I’d take the higher NGDP growth.

The great irony of the Depression period is that by 1936 things had gotten so bad that even the French had to devalue.  The French had helped cause the Depression by their obsessive hoarding of gold, and their refusal to help out the weaker countries.  In other words, in monetary terms France was the Germany of the 1930s.  When you see doubts raised about countries like Finland and Austria, you really have to wonder if even the German debt is truly safe.

I still think the policy elite are slightly less pigheaded than in the 1930s, so I doubt things will go that far.  But it would be a lot simpler if they recognized reality right now, instead of dragging out the pain.

Three years ago I argued that falling NGDP was causing the debt crisis to get dramatically larger.  I’d be interesting in hearing whether you think that argument seems more plausible today, November 15, 2011, given the evidence provided by Matt Yglesias.  Or would you prefer to believe that the rising yields on Finnish and Austrian debt represents the market’s sudden realization that Finland and Austria are also run by corrupt governments?