The ECB moved more aggressively than expected to cut IOR and increase QE. Today I will explore the effects, beginning with the banks.  Recall how negative IOR was supposed to be so bad for bank profits.  It seems those theories were wrong:

Banks have warned that negative interest rates are eroding their profitability. The rates cut into banks’ net interest margins as lenders have been reluctant to pass on the cost of negative rates to all but the biggest retail customers.

To offset some of the pain to banks, the ECB will provide cheap loans through targeted longer-term refinancing operations, each with a maturity of four years, starting in June 2016. These loans could potentially be provided at rates as low as minus 0.4 per cent, in effect paying banks to borrow money. Banks will also benefit from a refinancing rate of 0 per cent.

Shares in eurozone banks rallied sharply after the ECB announcement with Deutsche Bank up 6.5 per cent, Commerzbank up 4.9 per cent, Société Générale up 5.4 per cent and UniCredit up 8.2 per cent.

Over the years I’ve pointed out that there are things that central banks could do to offset the hit to bank profits. For instance, they could raise IOR on infra-marginal reserve holdings, while they lowered IOR at the margin. I did not propose the exact offset discussed above, but it seems that the general concept is workable. Negative IOR need not be a problem for banks, if done correctly.

European stocks rose sharply on the more aggressive than expected announcement and the euro fell in the forex markets. Oddly, however, for the 347th consecutive time the “beggar-thy-neighbor” theory was falsified by the market reaction.  Not only did Europe’s actions not hurt the US, our stocks soared higher on the news:

Dow futures added more than 150 points after the ECB cut the deposit rate to negative 0.4 percent from minus 0.3 percent, charging banks more to keep their money with the central bank. The refinancing rate was also cut, down 5 basis points to 0.00 percent.

I warned people to be careful after the Japan announcement; the EMH is not a theory to be trifled with.  As you recall, Japanese stocks soared and the yen fall sharply when negative IOR was announced in Japan.  But then a few days later both markets went into reverse (probably for unrelated reasons).  Many people assumed it was a delayed reaction to the negative IOR.  That’s possible, but markets generally respond immediately to news.  With the European moves today we see yet another confirmation of market monetarism:

1.  Policy is not ineffective at the zero bound.  So do more!!

2.  Reducing the demand for the medium of account (negative IOR) is expansionary.

3.  Increasing in the supply of the medium of account (QE) is expansionary.  I.e. the supply and demand theory is true.

4.  There is no beggar-thy-neighbor effect from monetary stimulus.

Market monetarists were the first to propose negative IOR.  It’s our idea.  When your ideas are correct, they help to explain how the world evolves over time. Things make sense.  In contrast, people with a more “finance view” of monetary policy have been consistently caught flat-footed.  Note that these people are represented on both the right and the left, and they have been consistently wrong in their views of monetary policy at the zero bound.

BTW, James Alexander has a post showing that eurozone growth has nearly caught up with the US:

Notice that at the beginning of 2012, NGDP growth in Europe had been running at less than 1% over the previous 12 months.  That’s the horrific situation that Draghi inherited from Trichet.  Draghi did move much too slowly at first, but at least things are beginning to look a bit better for the eurozone.  Still, Draghi needs to do more, as the eurozone is likely to fall short of its 1.9% inflation target.

Even better, the ECB needs to change its target, and set a new one high enough so that the markets are not expecting near-zero interest rates for the rest of the 21st century:

Take overnight interest rate swaps. They imply European Central Bank policy rates won’t get back above 0.5 percent for around 13 years and aren’t even expected to be much above 1 percent for at least 60 years.

Update:  The euro later reversed its fall.  But note that US stocks soared even after the initial plunge in the euro.  It’s interesting to think about why the euro reversed its losses–perhaps a view that the ECB action will make the Fed less likely to raise rates?  Or because it was expected that the action would lead to stronger eurozone growth?  What do you think?

Update#2:  Commenters HL and GF pointed out that the euro rose in value after Draghi indicated (in a press conference) that the ECB would probably not push rates any lower.

Update:  if you only have time for one post today, read my Econlog post instead.

Here’s Tim Worstall in Forbes, discussing my skepticism about the existence of bubbles:

His example at one point was the housing market. You can go long housing: go buy a house. You can be neither long nor short housing: don’t buy one. But it’s very difficult indeed to go short housing.

And here’s Wikipedia:

John Alfred Paulson (born December 14, 1955) is an Americanhedge fund manager and billionaire^[4] who headsPaulson & Co., a New York-based investment management firm he founded in 1994. He has been called “one of the most prominent names in high finance”^[5] and “a man who made one of the biggest fortunes in Wall Street history”.^[6]

His prominence and fortune were made in 2007 when he earned “almost $4 billion” personally and was transformed “from an obscure money manager into a financial legend”^[6] by using credit default swaps to effectively bet against the U.S. subprime mortgage lending market.

So why didn’t lots of wealthy investors short the market like Paulson?  Because no one knew if it really was a bubble. If you look around the world you’ll see lots of countries where house prices soared between 2000 and 2006.  In some cases they leveled off, in some cases they then fell, in other cases they went still higher.  It’s a crap shoot.

And now for some red meat for Trump haters.  It turns out that yesterday I was too kind to Chris Christie, he was not too cowardly to attack Trump.  Today he endorsed him, as the GOP train wreck spirals ever further out of control.  Some Republicans say Trump must be stopped because he can’t win.  (I made that mistake earlier).  That’s exactly wrong.  Trump must be stopped because the betting markets say he can win, indeed he has a 30% chance of winning, conditional on getting the nomination.

Ezra Klein says the GOP tried to stop Trump and failed.  If they did try, it was a pretty pathetic attempt.  In the future, people are going to look at this in much the way they looked at the Joe McCarthy fiasco—who had the guts to oppose him? (In fairness, Trump’s not as bad as McCarthy, he’s far worse.  Anti-communism is actually an honorable cause, far more honorable than anti-McCarthyism. McCarthy’s sins were recklessness and dishonesty in a good case.  In contrast, Trump is recklessly and dishonestly promoting evil causes like xenophobia.)

In 1964, lots of top Republicans endorsed Johnson.  In 1972, lots of top Democrats endorsed Nixon.  Both Goldwater and McGovern were seen as unacceptable.  Yet they were each paragons of virtue compared to Trump.  If the GOP establishment had truly wanted to stop Trump (instead of just being worried about losing) they would have taken a similar position to the pro-Nixon Dems, and done it months ago.  Congressmen and Senators, Governors, conservative media and pundits, etc., etc., should have almost unanimously indicated that they would vote for Hillary over Trump.  But that assumes these are honorable men and women, which is obviously not the case, as you can tell by Christie’s pathetic attempt to angle for the VP spot.  I will give the National Review credit for criticizing Trump, but that’s not enough, you need to say that the GOP Establishment will vote for Hillary over Trump.  And say it loud.

Some say that doesn’t matter, as the GOP voters hate the Establishment.  Yes, but Trump only gets about 50% in head to head polls against people like Rubio.  He can’t win in the general election without the Establishment voters.

The betting markets say that both Trump and Rubio have a chance of winning in a general election, with Rubio at over 40%.  I believe in the EMH, but I admit to being mystified by this.  When was the last time that a political party won an election after self-immolating just months before?  (Or as Senator Graham puts it; “My party has gone batshit crazy.”)  I can’t imagine any Republican with half a brain voting for a guy that Rubio correctly calls a con man, nor can I imagine Trump telling his people to vote for Rubio, if he somehow got the nomination. This looks like a complete train wreck to me, and yet perhaps I’m missing something.  After all, Berlusconi was elected in Italy, and I’m not sure American voters are any more sensible than Italians.

Some say that Trump’s not that bad on some of the issues, indeed in some cases better than the mainstream candidates.  Talk about missing the point!  This isn’t about what Trump says he favors, it’s about what he is.  It’s comical that people actually believe that Trump’s positions on the issues are anything more than negotiating tactics to “close the deal.”  I actually have commenters telling me to defend my claim that Trump is a demagogue.  I don’t know how to do that.  Nor do I know how to convince you that the sky is blue. If you don’t see it, and apparently tens of millions do not, then there is really nothing to say.  Does he need to sport a little black mustache?

I know what how are thinking, Sumner’s unhinged, next thing you know he’ll compare Trump to Hitler.  No, I have no plans to compare him to “Hitler”, who is the ultimate symbol of evil, due to WWII and the Holocaust.  Instead I’d like to compare him to Mr. Hitler, just another nationalist politician participating in democratic elections in Germany during the early 1930s. This Hitler was a politician that (according to the NYT at the time) would certainly moderate his positions as he got closer to power, in the opinion of most experts.  But (you are thinking) this comparison is absurd, because that politician was contemptuous of democractic principles, like freedom of the press.  In contrast. . . . oh wait, this is hot off the press:

Republican presidential front-runner Donald Trump said on Friday that if elected he would “open up” libel laws to make suing the media easier.

Speaking at a rally in Fort Worth, Texas, Trump said the change was necessary to combat what he described as the “dishonesty” of major American newspapers.

No, Trump’s nothing like the “Hitler” we know and hate.  But he’s a lot like the hundreds of nationalists who started out like Mr. Hitler the politician, asking for your votes, and never ended up becoming “Hitler”.  Like a Juan Peron.  Or perhaps his good buddy Putin (who recently grabbed the Sudetenland, err, I mean Crimea), and even that’s perhaps an overstatement—libel suits are not as bad as being assassinated.

Oh wait, just like Putin he does like jokes about killing journalists :

At a Dec. 23 appearance in Grand Rapids, Michigan, he joked about killing journalists as the crowd thundered applause.

But he certainly doesn’t excuse Putin’s actions. Well, not very much:

After Russian President Vladimir Putin called Donald Trump “very talented,” the GOP frontrunner has defended Putin against suspicions that Putin kills journalists who don’t agree him.

It started on MSNBC’s Morning Joe last month when host Joe Scarborough asked about it.

Trump responded, “He’s running his country, and at least he’s a leader, unlike what we have on this country. I think our country does plenty of killing also, Joe, so you know.”

Yes, we know. But at least he doesn’t favor concentration camps, he’s undecided:

Republican presidential frontrunner Donald Trump told TIME that he does not know whether he would have supported or opposed the internment of Japanese Americans during World War II.

But at least he doesn’t think the IRS favors Jews over Christians.  Or does he?

I’m always audited by the IRS, which I think is very unfair — I don’t know, maybe because of religion, maybe because of something else, maybe because I’m doing this, although this is just recently,” Trump said in an interview with CNN’s Chris Cuomo immediately following the 10th GOP debate on Thursday night.

Cuomo cut in: “What do you mean religion?”

“Well, maybe because of the fact that I’m a strong Christian, and I feel strongly about it and maybe there’s a bias,” Trump said.

Cuomo cut in again: “You think you can get audited for being a strong Christian?”

“Well, you see what’s happened,” Trump said. “You have many religious groups that are complaining about that. They’ve been complaining about it for a long time.

Perhaps the IRS is controlled by “the Jews”.

But at least . . . oh I give up, I’m just persuading more and more people to vote for Trump.  The worse he gets, the more they like him.

I find that when things go bad with the economy, the level of discourse seems to suffer.  Here are a few items I keep bumping up against:

1.  Why not do a helicopter drop?  Because there are no free lunches in economics, and any fiscal stimulus will have to be paid for with future distortionary taxes.  What if they promise to never remove the money injected in the helicopter drop? Then we either get hyperinflation or perma-deflation, neither of which is appealing.  Won’t it help to achieve the Fed’s inflation target?  The Fed already thinks it’s achieved its target, in the sense that expected future inflation is 2%, in the Fed’s view.  That’s why they raised rates in December.  You and I may not agree, but helicopter drops are a solution for a problem that the Fed doesn’t think exists.  If we can convince the Fed that market forecasts are superior to Philips curve forecasts, then the solution is not helicopter drops, it’s a more expansionary monetary policy.

2.  Are negative interest rates good for the economy?  That’s not even a question.  I don’t even know what that means.  For any given monetary base, lower levels of IOR are expansionary (for NGDP), and lower levels of long term bond yields are contractionary. So there is no point in even talking about whether negative rates are good or bad, unless you are clear as to what sort of interest rate you are discussing.

People often debate whether the problem is that interest rates are too high, or whether the problem is that interest rates are too low.  Neither.  The problem is that we are discussing interest rates, which means we are talking nonsense.  We need to talk about whether NGDP growth expectations are too high or too low.  We need to create a NGDP futures market (which I’m trying to do, but not getting much support) and focus on getting that variable right.

Tyler Cowen’s recent post on negative rates is not helpful, because it fails to distinguish between the fact that negative bond yields are bad and negative IOR is mildly helpful.  The eurozone has negative bond yields because it raised IOR in 2011.  That was a really bad move.

3.  If market monetarism is so smart, how come you guys can’t predict recessions?  The point of economics is not to predict recessions (which is impossible, at least for demand-side recessions) the point is to prevent recessions.

4.  What’s the optimal rate of NGDP growth, or the optimal rate of inflation?  It depends.  If the central bank plans to hit the target you can get by with a lower growth rate than if they plan to miss the target.  If they use level targeting then the optimal growth rate is lower than if they target the growth rate.  If capital income taxes are abolished then the optimal rate of inflation/NGDP growth is higher than otherwise. So I can’t give you a specific number, except to say “it depends.”

5.  What do we make of the fact that the yen depreciated when negative IOR was announced, and later appreciated?  The depreciation that occurred immediately after the announcement was caused by the negative IOR.  The later appreciation was caused by other factors.  The EMH says the market responds immediately to new information.  BTW, talk about a new headline not matching the accompanying article, check out this bizarre story from Bloomberg.

6.  Thomas Piketty recently claimed:

Whatever the case, however, the failures to make such [structural] reforms are not enough to explain the sudden plunge in GDP in the eurozone from 2011 to 2013, even as the US economy was in recovery. There can be no question now that the recovery in Europe was throttled by the attempt to cut deficits too quickly between 2011 and 2013—and particularly by tax hikes that were far too sharp in France. Such application of tight budgetary rules ensured that the eurozone’s GDP still, in 2015, hasn’t recovered to its 2007 levels.

No question?  Anyone making that claim has clearly paid no attention to the recent debate over fiscal and monetary policy. His claim is not just wrong, it’s patently absurd.  I question the claim.  Hence there is a question.  QED.

Seriously, Piketty himself points out that the US kept growing during 2011-13.  And the US did even more austerity than Europe.  And the only significant policy difference was that the US monetary policy was much more expansionary than the eurozone monetary policy.  The logical inference is that the eurozone recession was caused by tighter money in Europe. I’m tempted to say that there is “no question” that tight money in Europe caused the double-dip recession, as eurozone fiscal policy was more expansionary than in the US.  But I won’t, because Piketty clearly questions this claim.

Are there any Keynesians out there who are willing to debate me on this point?  I’d love to see the argument as to how fiscal austerity clearly caused a double dip recession in Europe, even though the US did even more austerity and kept growing. It seems to me as if Keynesians live in some sort of intellectual bubble, where they aren’t even aware of the arguments made by people on the other side.  That’s not helpful if you have to debate the other side.

Let’s go back to March 3, 2009.  Here’s Paul Krugman:

As Brad DeLong says, sigh. Greg Mankiw challenges the administration’s prediction of relatively fast growth a few years from now on the basis that real GDP may have a unit root — that is, there’s no tendency for bad years to be offset by good years later.

I always thought the unit root thing involved a bit of deliberate obtuseness — it involved pretending that you didn’t know the difference between, say, low GDP growth due to a productivity slowdown like the one that happened from 1973 to 1995, on one side, and low GDP growth due to a severe recession. For one thing is very clear: variables that measure the use of resources, like unemployment or capacity utilization, do NOT have unit roots: when unemployment is high, it tends to fall. And together with Okun’s law, this says that yes, it is right to expect high growth in future if the economy is depressed now.

But to invoke the unit root thing to disparage growth forecasts now involves more than a bit of deliberate obtuseness.

And here is Greg Mankiw’s reply:

Paul Krugman suggests that my skepticism about the administration’s growth forecast over the next few years is somehow “evil.” Well, Paul, if you are so confident in this forecast, would you like to place a wager on it and take advantage of my wickedness?

Team Obama says that real GDP in 2013 will be 15.6 percent above real GDP in 2008. (That number comes from compounding their predicted growth rates for these five years.) So, Paul, are you willing to wager that the economy will meet or exceed this benchmark?

And here’s what I wrote, 5 years later:

Krugman wisely decided to avoid this bet, which suggests he’s smarter than he appears when he is at his most political. In any case, the actual 5 year RGDP growth just came in at slightly under 6.3%. That’s not even close. Mankiw won by a landslide.

In January 2011, Tyler Cowen wrote a book entitled “The Great Stagnation.”  So far Tyler’s hypothesis has proven correct. (Oddly, the media often refer to Larry Summer’s stagnation hypothesis, which (AFAIK) came much later.)

In 2013 Tyler made a bet with Bryan Caplan, that unemployment would not fall quickly back to 5%:

Tyler just bet me at 10:1 that U.S. unemployment will never fall below 5% during the next twenty years.  If the rate falls below 5% before September 1, 2033, he immediately owes me $10.  Otherwise, I owe him $1 on September 1, 2033.

Readers of my blog know that I would have agreed with Bryan.  Tyler Cowen responded by pointing to reasons why these bets are not a good idea:

Bryan Caplan is pleased that he has won his bet with me, about whether unemployment will fall under five percent.  I readily admit a mistake in stressing unemployment figures at the expense of other labor market indicators; in essence I didn’t listen enough to the Krugman of 2012.  This shows there were features of the problem I did not understand and indeed still do not understand.  I am surprised that we have such an unusual mix of recovery in some labor market variables but not others.  The Benthamite side of me will pay Bryan gladly, as I don’t think I’ve ever had a ten dollar expenditure of mine produce such a boost in the utility of another person.

That said, I think this episode is a good example of what is wrong with betting on ideas.  Betting tends to lock people into positions, gets them rooting for one outcome over another, it makes the denouement of the bet about the relative status of the people in question, and it produces a celebratory mindset in the victor.  That lowers the quality of dialogue and also introspection, just as political campaigns lower the quality of various ideas — too much emphasis on the candidates and the competition.  Bryan, in his post, reaffirms his core intuition that labor markets usually return to normal pretty quickly, at least in the United States.  But if you scrutinize the above diagram, as well as the lackluster wage data, that is exactly the premise he should be questioning.

As I’m the only one in this exchange fessing up to what I got wrong, and what I still don’t understand, and what the complexities are, in a funny way…I feel I’m the one who won the bet.

I agree with Tyler’s skepticism regarding the utility of public bets; they oversimplify a very complex set of issues.  They also subtly imply that greatness is a function of not being “wrong” about particular questions.  I’d argue that one doesn’t become a truly great scientist until one’s views have been partially discredited.  That means people are taking your ideas seriously, and pushing them to the point where they are no longer intellectually progressive.  (Think Copernicus, Newton, Einstein, Darwin, etc.)

However, as someone who agreed with Caplan, I don’t entirely accept the implication of Tyler’s final sentence.  I can’t speak for Bryan, but here are the views I’ve expressed:

1. Cycles in unemployment are largely caused by nominal wage stickiness, and unemployment will usually revert back to the natural rate, which tends to be fairly stable in the US (but not completely stable).

2. The US is entering a Great Stagnation, where 3% NGDP growth will be the new norm, measured RGDP growth will also slow sharply, but of course it’s not clear what RGDP actually is, because it’s not clear what economists mean by the term “price level.”

3. The Labor Force participation rate has historically been unstable, unlike the natural rate of unemployment, responding to demographics, welfare reform, disability insurance, prison incarceration, etc., etc., etc.)  Wage stickiness doesn’t explain this.  But Tyler was also skeptical of how far Bryan and I pushed the wage stickiness concept.  Since our view is that wage stickiness explains changes in the unemployment rate, but not the LFPR, Bryan winning his bet is at least as small point in favor of the sticky wage model.

4. Fiscal austerity would not slow growth in 2013, a claim Paul Krugman contested.  I was right and Krugman was wrong.

5. Repealing the extended unemployment benefits in early 2014 should have modestly increased new job creation, by boosting the supply of labor.  This would be true even if NGDP growth (i.e. AD) did not accelerate.  Paul Krugman also contested this claim.  Again, I was right.  Job growth in 2014 was substantially above the 2010-13 rate, despite very modest growth in NGDP. Of course Krugman has been right about many things, especially when he agreed with market monetarists.  Thus he has criticized the mainstream conservative prediction that “easy money” would lead to high inflation.

6. I’ve consistently predicted that unemployment would fall faster than the Fed thought, and that NGDP growth and inflation would be less than the Fed thought.  That’s actually sort of threading the needle, as faster falling unemployment would normally be associated with faster than normal NGDP growth.

Despite the fact that I’ve recently ended up being right more often than wrong, I think the importance of specific predictions is overrated.  If I had been blogging in 2006-09 I would have been wrong about lots of things, because the market was wrong about lots of things.  The economy is very hard to predict, and hence I’ve been lucky.  More important is the reasoning process used.  Here is how I’ve approached this:

1. For low NGDP growth and inflation predictions I’ve relied on market forecasts, which generally seemed more bearish than Fed forecasts.

2. For the Great Stagnation, early on I noticed a “job-filled non-recovery”, which many people oddly called a jobless recovery.  The unemployment rate fell sharply despite anemic RGDP and NGDP growth (for a recovery period).  So I reasoned that if RGDP growth was only 2.0% to 2.5% during a period of fast falling unemployment, then the trend rate of growth must be really slow.  So far I’ve been correct (and I hope my prediction is soon refuted, for the sake of the economy.)

3. For the unemployment compensation issue I relied on basic theory, and on previous studies of the effect of UI on jobless rates.  Back in 2008, Brad DeLong predicted higher unemployment as a result of a very small increase in benefits under President Bush.  It seemed to me that people like Krugman were abandoning mainstream economics for ideological reasons.

4. Standard theory, pre-2008, also implied that the monetary authority drove AD, and that fiscal policy would only impact growth by shifting the AS curve.  I saw no reason to abandon the standard view.

5. As far as wage stickiness and unemployment, my views were shaped by many factors, including my study of the Great Depression, and the fact of wage stickiness documented by many studies.  I also relied upon the strong theoretical implication that if nominal wages are sticky then nominal GDP shocks will lead to volatility in hours worked.  As far as the unemployment rate recovery predicted by Caplan, I relied on both theory (Friedman/Phelps) and evidence—the fact that the US natural rate seems fairly stable at around 5%. That’s the best I could do, and in this case I was right.  But if I’d lived in Western Europe in the late 1970s and early 1980s, I would have been wrong and Tyler would have been right, as the unemployment rate jumped sharply, and never went back down (except in a few countries like Germany, and even then only much, much later.)

Market forecasts are the best we can do.  I suggest that readers pay less attention to who predicted what, and more on the reasoning process behind their predictions.  Occasionally people will get lucky and nail a prediction that the markets missed (think Roubini, John Paulson, Shiller, etc.)  But when you look at their overall track record it’s clear that luck was involved; no one can consistently predict the macroeconomy. Nor should we focus on who has the most impressive mathematical model. Instead we should focus on who has a coherent explanation for what is occurring, an explanation that is consistent with well established theory, and that can be applied to a wide range of cases.  I hope market monetarism is one of those coherent explanations.

PS.  I just returned from the Warwick Economics Summit, and was very impressed by the Warwick students.  I would especially like to thank Ibraheem Kasujee, who helped arrange the visit.  It was good to get out of the Puritan States of America for a few days, and attend a student ball where drinks are served to 18 year olds.  At Bentley even the faculty can’t drink a glass of wine at the Holiday Party.  And Bentley just banned smoking everywhere—basically telling the smokers (who used to huddle outside in the cold) to go away, we don’t want you here.  This university is only for PC puritan paternalists.  (On the plus side, our students do get good jobs.)

I had planned on being home for dinner on Monday, but instead (due to snow at the Boston airport) I was 30 miles north of Reykjavik (at 11 pm Iceland time), in the middle of nowhere, standing in a cold wind with no hat on, looking straight up at a zillion stars in the sky–and a few northern lights as well.  But now I’m back and have a huge amount of catching up to do. (Here’s my earlier unexpected layover in Iceland.)

For readers who didn’t get their fill of Krugman bashing here, I also have a new Econlog post.

Benn Steil and Emma Smith have a new post on the Big Mac Index:

The Economist magazine’s famous Big Mac Index uses the price of McDonald’s Big Macs around the world, expressed in a common currency (U.S. dollars), to estimate the extent to which various currencies are over- or under-valued. The Big Mac is a global product, identical across borders, which makes it an interesting one for this purpose.

But burgers travel badly.  So in 2013 we created our own index—one that better meets the condition that the product can flow quickly and cheaply across borders.

The Geo-Graphics Little Mac Index compares the price of iPad minis across countries. iPad minis are a global product that, unlike Big Macs, do in fact travel the earth with their owners.

.  .  .

Overall, the Little Mac Index suggests that the dollar has become slightly more overvalued (up from 5 percent) since the beginning of 2015.  The euro is undervalued by 11 percent, and the yen by 10 percent.  Having been fairly valued at the beginning of last year, the renminbi – following on the heels of China’s large devaluation in August – is now 5 percent undervalued.  This compares with an implausible 46 percent undervaluation on the Big Mac Index.  Maybe Congress is Lovin’ It, but we think the Economist needs to hold the mustard.

Given recent events, only a complete moron, or Donald Trump, would claim the yuan is undervalued.  So that’s a point in favor of the Little Mac Index.  But let’s step back and think about what terms like ‘overvalued’ and ‘undervalued’ actually mean.  Do they mean the exchange rate is artificially set at a different level from the black market rate?  Perhaps in cases like Venezuela, but in most cases these are actual market exchange rates, where you can freely buy and sell the currency in question.  So clearly that’s not what the creators of the Big Mac and Little Mac indices have in mind.

But then what does it mean to say an asset price is under or overvalued?  Does it mean the market is in some sense wrong, as when there is a bubble?  Perhaps, but then why would you expect these “Mac” excises to find the right exchange rate? Yes, PPP predicts a certain relationship between prices, but we have very good economic theories, such as Balassa/Samuelson theory, which explain why we should not expect PPP to hold for all goods.  So a deviation from the prediction of PPP actually tells us nothing about under and overvaluation.

Nor is it clear why Steil and Smith think it’s better to use a traded good than a non-traded good.  Let’s take that to the logical extreme, and use a good that is so easily traded that the law of one price holds, say gold.  AFAIK, the price of gold in New York, London, Hong Kong, Tokyo, Zurich, etc., is virtually identical, when measured in a common currency.  So Steil and Smith have picked a good that is more easily traded that Big Macs, but less easily traded than gold.  But why is that optimal? Using gold, PPP would always seem to hold true.  Even worse, a sudden adjustment in the exchange rate (such as Switzerland’s 15% appreciation a year ago), would leave the price of gold in Zurich exactly the same as before, when measured in dollar terms.  In other words, if they had chosen a very easily traded good like gold, instead of Little Macs, Steil and Smith would have found the Swiss franc to be correctly valued right before, and right after, a sudden 15% adjustment.  Does that make sense?

It seems to me that if you really want to look for exchange rates that are out of line with PPP, you’d use non-traded goods like Big Macs, not traded goods like gold. Little Macs fall in between, and offer no obvious advantage over either extreme.

In my view all of these exercises miss the point.  Exchange rates should not be set to make PPP come true. Nor should exchange rates be set to generate a current account balance of zero.  Trying to set rates to make these equalities hold would create a macroeconomic disaster.  Exchange rates should be set at a level that provides macroeconomic equilibrium, something like low and steady growth in NGDP.  The only meaningful sense that an exchange rate can be said to be overvalued is if it leads to below target NGDP growth (or inflation, if you prefer.) For instance, despite falling from 80 to the dollar, to 120 to the dollar, the yen is still overvalued, as most experts forecast about 1% inflation going forward, which is below their 2% target.

This sense in which an exchange rate can be overvalued is exactly the same as saying the short term interest rate is too high, or the TIPS spread is too low, or the nominal price of zinc is too low.  A counterfactual monetary policy that produced on target NGDP growth, would (by assumption) lead to a lower short-term nominal interest rate, a higher TIPS spread, and a higher nominal price of zinc.  And a lower domestic currency value in the forex markets.  That doesn’t mean the market is “wrong” in a “violation of the EMH” sense, rather it means monetary policy is too tight to achieve macroeconomic equilibrium.

So far I’ve talked about nominal exchange rates.  But what about real exchange rates, can they also be overvalued or undervalued?  Elsewhere I’ve argued that real and nominal exchange rates are so different that they should not even be discussed in the same course.  And yet many people foolishly talk about them synonymously. What would it mean to say the China’s real exchange rate is undervalued?  In that case you’d be arguing that China’s government policies encourage too much saving, too little investment, or both.  In other words, the policies encourage too big a S-I gap, which of course is the current account surplus.  I’m not saying that’s true (I doubt it) but that would be the argument.  In that case it would be stupid to adjust the exchange rate (doing so would produce a depression) you’d want to change the saving/investment policies.

Off topic, I love the ambition in this post by C. Harwick, where he derives NGDP targeting from first principles.  I don’t know anything about this blogger, but based on this post he seems much younger and much smarter than I am.  However I disagree with the final two bullet points in item #13.

PS.  I have a new post on IS shocks, over at Econlog.