Tyler Cowen recently had the following to say about QE:

I’m unhappy with claims that “we’re not doing enough” and that therefore this is no test of the idea of monetary stimulus.  This is what QEII looks like, filtered through the American system of political checks and balances.  And if it looks small, compared to the size of our problems, well, monetary policy almost always looks small compared to its potential effects.  I’m willing to consider this a dispositive test and I am very curious to see the results.

Of course I am one of those claiming that we aren’t doing enough, but I’d like to focus on Tyler’s curiosity about the results.  I think there are more layers to this question that most people assume—many more.

Let’s start with the distinction between real and nominal GDP.  What would count as success?  Should we focus on real GDP, nominal GDP, or both?  That depends.  I think most economists would say that the whole point is to raise RGDP, and that a rise in NGDP that was not accompanied by an increase in RGDP would constitute failure.  But what happens if both RGDP and NGDP rise at rather modest rates, (which is quite likely.)  In that case, would monetary stimulus have been shown not to work?  Tyler Cowen has argued that much of the recession is real, and he has also expressed skepticism about “liquidity trap” models that say monetary policymakers cannot create inflation (or higher NGDP) at the zero rate bound.  So perhaps Tyler is interested in whether a given increase in NGDP translates into higher RGDP.

For instance, let’s assume NGDP grows at 3%, RGDP at 2% and prices at 1%.  I’d say monetary stimulus hasn’t really been tried.  On the other hand if we had 6% NGDP growth accompanied by only 2% RGDP growth I’d say monetary stimulus had been tried, and failed to produce the predicted growth in RGDP.  Does that mean it never should have been tried?  Not necessarily, it depends on the Fed’s policy goals.  I favor 5% NGDP targeting, level targeting, regardless of what is happening on the supply side of the economy.

On the other hand, as I read Tyler’s comment above, he’s setting the bar where 3% NGDP growth would constitute failure.  Even if monetary stimulus, pursued a outrance, would certainly boost inflation and NGDP, he suggests that the recent QE announcement is about all that is politically feasible in the US.  This is an argument that Krugman has made as well, and at some level I think he’s right.  But that sort of failure would not change my message, because whereas Tyler views QE2 as a partially endogenous response from real world monetary policymakers, I consider TheMoneyIllusion.com to be a sort of exogenous shock, aimed at convincing policymakers that monetary stimulus that seems highly aggressive is actually quite modest.  I’m trying to make more expansionary policies become more politically acceptable.  Yes, that’s a rather grandiose objective, and I don’t realistically think I can have more than a tiny impact on the zeitgeist, but (as I argued earlier) even a tiny impact is important when the stakes are high.

We’ve considered the distinction between real and nominal GDP, and the distinction between what’s politically feasible and what is not.  And yet we’ve haven’t really addressed the most important implications of Tyler’s curiosity.  For instance, what would be the policy implications of failure?  If NGDP rises fast, but unemployment stays high, then maybe we shouldn’t be trying to boost AD at all.  If NGDP doesn’t rise, then maybe we should have tried fiscal policy.  Or maybe not.  It’s clear to me (from market reactions) that QE2 has already raised the expected rate of NGDP growth.  I also think QE1 slightly boosted AD in 2009.  Those who claim that fiscal stimulus should have been $1.3 trillion would have to show that the Fed would not have simply offset the effect of more fiscal stimulus by doing less monetary stimulus.  Perhaps QE1 and QE2 never would have happened.  After all, the Fed’s two forays into QE both seemed motivated by a macroeconomy that was under-performing in the months immediately preceding the policy initiatives.

Most importantly, I would argue that Tyler Cowen has no reason to be curious.  We already know whether QE2 will work, we know the only effects that matter—the impact on NGDP growth expectations.  OK, that’s slightly overstating things; we know it boosted 5 year inflation expectations by about 0.5%.  Again, this shows the urgent need for a NGDP futures market.  For the moment, let’s assume an NGDP futures market did exist–my hunch is that Tyler Cowen might still have been “curious” to see the effect of QE.  Obviously I think that would be a mistake, and the only thing we will learn from observing the macroeconomy over the next 5 years is that part of NGDP growth that was not caused by QE.

Think of the TIPS market response as not just the optimal forecast of the effect of QE, but also the optimal estimate of the effect of QE.  And not just the optimal ex ante estimate, but the optimal ex post estimate.  How can that be?  Surely we will eventually know much more about how much inflation was created than our current rather crude forecasts?  Actually no.  We still don’t know how much good Obama’s $800 billion fiscal stimulus did, because we don’t know the relevant counterfactual growth path.

Economics is all about the effect of X on Y, ceteris paribus.  The TIPS market gives us the optimal forecast of inflation, ceteris paribus.  The actual inflation rate that we observe over the next 5 years will differ from that forecast, but we have no way of knowing whether it differs because “other things weren’t equal” or because our original forecast was flawed.  Without such knowledge, we have no reason to revise our estimate of how much QE2 raised 5 year inflation expectations.  There’s no need to be curious Tyler; we know how much good QE2 did, about 0.5%/year more inflation over 5 years.  Yes, we don’t know how much that will raise RGDP growth, but only because of the bizarre anomaly that the US government has never bothered to create an NGDP future market.  Now are you guys seeing why I think this market is so important?  If we had one, the market response (TIPS vs. NGDP futures) over the past 2 months would have basically settled the dispute between Tyler and myself about whether the recession is mostly nominal or mostly real.

I seem to recall Robin Hanson complaining that we won’t spend the money needed to redo the Rand health insurance experiment—the only one that really solves the identification problem.  This is even worse, we are making enormous macroeconomic policy errors because we won’t create and subsidize trading in a simple NGDP futures market.

Update:  Here is the Hanson post.  Second update:  Oops, TGGP pointed out it should be this link:

Let’s go one year forward and consider how my reputation will fare under different outcomes:

1.  NGDP grows at only about 3-4%, and RGDP grows by only about 2%.  I think QE2 will be seen as not working, and my reputation will suffer.

2.  NGDP grows about 5%, and RGDP grows a bit over 3%.  I think I’ll do alright.  I said it was better than nothing and would slightly boost growth.

3.  NGDP grows 7% and RGDP grows at 4-5%.  I think people will see the result as strongly vindicating my policy proposals.

4.  NGDP grows 7% and RGDP grows only 3%.  I think people will think I was right about the potency of monetary policy, but wrong in assuming the recession was an AD problem.  Tyler Cowen wins twice. Krugman loses twice.  Kling wins on structural problems, but loses on the potency of QE.

But that’s not how I see things.  I hope outcome #3 occurs, but I also think the credit that I predict I’d receive would be undeserved.  I’m a “target the forecast” guy.  The markets are saying QE2 helped, but nothing too dramatic.  Outcome #3 would be more than I think the markets are forecasting, and hence would not be evidence in support of forecast targeting.  My sense is that other people don’t particularly focus on the forecast targeting part of my message, however, and that they’d see it as vindicating my constant arguments for monetary stimulus.  What do you think?

I bet you never realized there was so much complexity embedded in Tyler Cowen’s innocuous sounding comment “I am very curious to see the results.”  I’m very curious to see how Tyler interprets the results that actually occur, but I have no curiosity at all about the nominal effects of QE2.  The markets have already answered that question to my satisfaction, ceteris paribus.  But I am curious to see the NGDP/RGDP split, if NGDP rises dramatically.

Paul Krugman frequently notes that he has been consistently right in claiming that our fiscal and monetary policies would not lead to high inflation and high interest rates.  I can’t say I blame him (which is not surprising, given that I have made identical predictions.)  At the same time, I feel a bit uneasy about judging the merits of an economic theory based on the forecasting skill of its leading proponents.  I believe markets are relatively efficient, and thus that it is hard for even a brilliant economist to forecast shocks that the markets don’t see.  I am far more impressed by the fact that Irving Fisher’s Phillips curve model explains the Great Contraction of 1929-33, then I am worried by the fact that he failed to predict it before it happened.  But I’m the exception.

I was reminded of this issue when I read a great post by Ryan Avent entitled “What Happened over the Summer?”  Ryan dismisses several theories of the economic slowdown, before settling on the following explanation:

So let me tell you a story. In late April, fears of a serious European debt crisis began to emerge. These fears sparked a mild panic and a renewal in the flight to safety. This flight manifested itself, in part, as a rush to buy American government debt. Treasury yields had been rising in the months prior to the crisis, but plunged from April through the summer. The dollar shot up; the trade-weighted dollar rose nearly 5% from late April to early June. In response to the pressure within markets, the Fed reopened currency swap lines it had used in previous stages of the crisis. It did not, however, take steps to offset the impact of the financial hiccup on growth expectations.

Markets reacted. The Dow fell over 13% from late April to early July, and was still 10% off its April peak in late August. From January to April, 10-year inflation expectations were stable at around 2%. These began falling sharply, and were down to around 1.5% by the end of the summer. Every signal available began flashing a decline in economic expectations starting in late April. But the Fed didn’t act. Not until late August did Ben Bernanke hint at a course change, and matters improved almost immediately. The Dow has risen by nearly 13% since then. Inflation expectations leveled off in October. And the pace of private hiring has returned to early spring levels.

You may not buy this story. We obviously can’t be sure one way or another. It strikes me as fairly compelling, however. And if we do accept it, the story implies that the Fed, by waiting until August to signal a policy change, cost the economy between 100,000 and 200,000 jobs a month for four months.

Of course people could argue that “hindsight is 20-20” and that the Fed had no way of knowing last spring that the euro crisis would end up hurting the US more than Germany.  Unless, of course, they read TheMoneyIllusion.  The following essay was published by the online Economist in August, but note the embedded quotation that was published in my blog back in May:

Back in May and June there was a lot of talk about the bleak outlook for the euro zone. Recall that the problems in Greece, and more broadly all the so-called “PIIGS”, had created doubts about the soundness of banks in France, Germany, and the Netherlands. In late May I made this observation in my blog:

“So stocks in the heart of the eurozone, the area with many banks that are highly exposed to Greek and Spanish debts, are actually down a bit less (on average) than the US. Perhaps the strong dollar is part of the reason. Perhaps monetary policy has become tighter in the US than Europe.”

The loss of confidence in the euro led to a rush for safety, and the demand for dollars rose sharply in the spring of the year. Because the interest rate in America is stuck at 0.25%, and the Fed is reluctant to use unconventional policy tools, there was no policy action taken to offset the increase in the demand for dollars. Monetary policy became effectively tighter.

The results were predictable. Whereas the euro had traded in the range of 1.35 to 1.45 to the dollar in the first four months of 2010, the exchange rate has dropped to the 1.20 to 1.32 range since the beginning of May. Because Germany has an export-based economy, this contributed to a fast rise in output. Just the opposite happened in the US, where a recovery that looked on track in the first quarter of 2010, suddenly stalled in May and June. Some have argued that the winding down of fiscal stimulus caused the recovery to weaken in the US. But spending rose briskly in the second quarter; the problem was a widening of the trade deficit.

Many economists overestimate the importance of real shocks in the business cycle of large diversified economies, and underestimate the importance of monetary shocks.

Let me first clarify one point.  I am not trying to claim to be some sort of Nostradamus.  I simply try to infer market expectations from indicators such as stock, forex and TIPS prices.  Some indicators, such as a strong dollar, can be ambiguous.  It might indicate a strong real economy, or it might indicate a tight money policy (including an increase in money demand.)  In those cases I look at other markets for confirmation.  In the long run I’ll predict no better than markets.  Where there are unexpected shocks (like bubbles bursting) I will fail to predict them.  But consider how much I was able to predict, just buy using market indicators:

1.  In late 2008 I warned that all sorts of market indicators were predicting a severe fall in AD, and that trying to fix banking was merely treating the symptom.  I said much easier money was needed.  We now know that NGDP began plunging two months before the banking crisis of September.

2.  In late 2008 and early 2009 I said fiscal stimulus would not even come close to solving the AD problem, and that monetary stimulus was the key.

3.  On the day after the March 2009 QE I said it would provide a slight boost, but was nowhere near enough to solve the problem.  The economy did do a little bit better after March.

4.  Like Krugman, I said the right-wingers predicting high inflation (because of QE and ultra-low rates) were totally off base, and that inflation would stay very low.

5.  In May 2010 I suggested that the euro crisis might well hurt the US more than Europe.  That was before we had any second quarter GDP data showing the sharp slowdown in the US and the robust growth in Germany.  Ryan Avent is right, the Fed had the market signals it needed to act in the spring and cost hundreds of thousands of jobs by waiting until November (or late August for the verbal easing.)

6.  Back in early March 2009 I suggested that the Fed needed to do three things; QE, lower IOR, and level targeting and/or NGDP targeting.  Recently they began discussing all three options, and adopted QE.  The talk of QE and the other options clearly boosted stocks and foreign exchange prices in September-October, which confirmed my prediction that monetary policy is not impotent at the zero bound (as had been widely assumed in late 2008 and early 2009.)

7.  My prediction that the slowdown that began around May was due to an increase in the demand for dollars implied that monetary easing should reverse the slowdown.  It’s too soon to say for sure, but Avent’s right that the early indications are that the economy picked up a bit in October.  Certainly QE has already moved asset prices in a direction that should (ceteris paribus) lead to more NGDP growth.

This does not mean prosperity is just around the corner.  Markets seem to be indicating that inflation will be a little bit higher, and that the odds of a double dip recession have receded.  But the recovery is still likely to be slow, albeit a bit less slow than forecast in mid-August.

I don’t have any spectacular predictions that other missed.  I’m no Roubini.  But at the same time I think it’s fair to say that if monetary policymakers had paid more attention to market signals after mid-2008, we would have had a more expansionary policy.   And even those who are skeptical of the current QE policy can hardly deny that more AD would have been beneficial in late 2008.

Rather than look for spectacular predictions (something we can never expect from policymakers anyway) it makes more sense to look back at what models were telling us, and whether in retrospect the advice now seems wise.  In 1930 no one knew for sure that easier money was needed.  And in 1966-68 no one knew for sure that tighter money was needed.  Now almost everyone agrees about what went wrong in those two episodes.  I’m impressed by models that would have told us that at the time.  I’m claiming that the target the forecast approach that relies on market forecasts of NGDP indicators would have led to better monetary policy over the past 3 years, indeed the last 100 years.

Paul Krugman occasionally predicts things markets don’t see coming.  When he’s right, he racks up successes that I miss.  Often we have the same prediction.  But like the tortoise in Aesop’s fable, I believe that methodically inferring market forecasts of the effect of monetary policy will win out in the long run.  Indeed I think that markets have recently exposed some weaknesses in his view of the relative potency of fiscal and monetary policy at the zero bound.

There’s still a long way to go, and markets will continue to make mistakes on occasions.  But if we’ve learned anything over the past three years it’s that monetary policymakers ignore market signals at their peril.

PS.  I just noticed a German blog called Kantoos Economics, which seems to also favor stable NGDP growth.  I can’t read German, but the graph is worth 1000 words.

PPS.  I just noticed The Atlantic picked up Avent’s post, perhaps the press will discover my blog someday.  🙂

Ben Bernanke recently used a golf metaphor to describe monetary policy:

In remarks simply titled “Gradualism,” then-Governor Bernanke explained the case for policymakers “to move slowly and cautiously” when they can’t be sure about the consequences. He cited a classic 1967 article by Brainard, a Yale economist, who “showed that when policymakers are unsure of the impact that their policy actions will have on the economy, it may be appropriate for them to adjust policy more cautiously and in smaller steps than they would if they had precise knowledge of the effects of their actions.”

Then he gets into miniature golf:

“Imagine that you are playing in a miniature golf tournament and are leading on the final hole. You expect to win the tournament so long as you can finish the hole in a moderate number of strokes. However, for reasons I won’t try to explain, you find yourself playing with an unfamiliar putter and hence are uncertain about how far a stroke of given force will send the ball. How should you play to maximize your chances of winning the tournament?

“Some reflection should convince you that the best strategy in this situation is to be conservative. In particular, your uncertainty about the response of the ball to your putter implies that you should strike the ball less firmly than you would if you knew precisely how the ball would react to the unfamiliar putter. This conservative approach may well lead your first shot to lie short of the hole. However, this cost is offset by the important benefit of guarding against the risk that the putter is livelier than you expect, so lively that your normal stroke could send the ball well past the cup. Since you expect to win the tournament if you avoid a disastrously bad shot, you approach the hole in a series of short putts (what golf aficionados tell me are called lagged putts). Gradualism in action!”

That’s way too gradual.  Bernanke is playing something closer to electronic golf.  After each practice swing in Wii, the likely distance the ball will travel is shown on the computer screen.  The practice swings are the recent policy statements by Fed officials.  The reactions of markets (everything from stocks to TIPS spreads) show us the likely effects.  Yes, there is a circularity problem here–but at least it gives us a ballpark estimate.  And the Fed’s still not swinging hard enough.

Target the forecast!  Set monetary policy at a level expected to produce desired growth in AD.  We’re still far from that level.  I hope Bernanke doesn’t choke under the pressure.  I hope he remembers what he told the Japanese a few years back:

Needed: Rooseveltian Resolve

Franklin D. Roosevelt was elected President of the United States in 1932 with the mandate to get the country out of the Depression. In the end, the most effective actions he took were the same that Japan needs to take””-namely, rehabilitation of the banking system and devaluation of the currency to promote monetary easing. But Roosevelt’s specific policy actions were, I think, less important than his willingness to be aggressive and to experiment””-in short, to do whatever was necessary to get the country moving again. Many of his policies did not work as intended, but in the end FDR deserves great credit for having the courage to abandon failed paradigms and to do what needed to be done.

Japan is not in a Great Depression by any means, but its economy has operated below potential for nearly a decade. Nor is it by any means clear that recovery is imminent. Policy options exist that could greatly reduce these losses. Why isn’t more happening? To this outsider, at least, Japanese monetary policy seems paralyzed, with a paralysis that is largely self-induced. Most striking is the apparent unwillingness of the monetary authorities to experiment, to try anything that isn’t absolutely guaranteed to work. Perhaps it’s time for some Rooseveltian resolve in Japan.

Caroline Baum of Bloomberg recently suggested that Milton Friedman would have been appalled by the many top economists arguing the Fed is out of ammunition:

Milton Friedman, Nobel Laureate in Economics, died in 2006. Monetarism, the school of thought he founded, seems to have died with him, judging from recent comments.

Academics, such as Princeton’s Alan Blinder and Harvard’s Martin Feldstein, are claiming there’s very little the Federal Reserve can do to stimulate the U.S. economy. Newspaper headlines deliver the same message: the Fed is “Low on Ammo.” The public is feted with explanations — couched in technical terms, such as the “zero-bound” and a “liquidity trap” — as to why the Fed’s hands are tied.

What planet are these people on?

They’re clearly not on planet monetarism.  On the other hand John Taylor thinks Friedman’s message still resonates, but that he would have been opposed to additional monetary stimulus:

I see neither those ideas nor their adherents going to the grave. Indeed, the experience of this crisis is proving that Milton Friedman’s ideas were right all along, and I can see them gaining favor.

Two of Friedman’s most famous ideas in the macroeconomic sphere were (1) that monetary policy should follow a simple policy rule and (2) that discretionary fiscal policy is not useful for combating recessions, and indeed could make things worse. Both ideas have been reinforced by the facts during the recent crisis.

The first idea is reinforced by the evidence that the crisis was brought on by the failure of the Fed to keep following the rules-based monetary policy that had worked well for 20 years before the crisis. Instead, it deviated from such a policy by keeping interest rates too low for too long in 2002-2005. But Caroline Baum wonders whether the Fed should now just print a lot more money and buy more mortgages or other securities. That might sound like a monetarist solution, but Friedman did not believe in big discretionary changes the money supply. Rather, he advocated a constant growth rate rule for the money supply. I doubt that he would have approved of the rapid increase in the money supply last year, in part because he would have known that it would be followed by a decline in money growth this year. He always worried about monetary policy going from one extreme to the other and thereby harming the economy. That is why the Fed should be clear and careful as it brings back down the size of its balance sheet, which exploded during the crisis.

While Taylor’s argument is defensible (and I agree with him on fiscal policy), I believe the weight of evidence supports Baum’s interpretation.  Let’s look at what Milton Friedman had to say about Japan in December 1997.  The subtitle is as follows:

Nobel laureate and Hoover fellow Milton Friedman gives the Bank of Japan step-by-step instructions for resuscitating the Japanese economy. A monetary kiss of life.

And here’s Friedman’s argument:

The surest road to a healthy economic recovery is to increase the rate of monetary growth, to shift from tight money to easier money, to a rate of monetary growth closer to that which prevailed in the golden 1980s but without again overdoing it. That would make much-needed financial and economic reforms far easier to achieve.

Defenders of the Bank of Japan will say, “How? The bank has already cut its discount rate to 0.5 percent. What more can it do to increase the quantity of money?”

The answer is straightforward: The Bank of Japan can buy government bonds on the open market, paying for them with either currency or deposits at the Bank of Japan, what economists call high-powered money. Most of the proceeds will end up in commercial banks, adding to their reserves and enabling them to expand their liabilities by loans and open market purchases. But whether they do so or not, the money supply will increase.

There is no limit to the extent to which the Bank of Japan can increase the money supply if it wishes to do so. Higher monetary growth will have the same effect as always. After a year or so, the economy will expand more rapidly; output will grow, and after another delay, inflation will increase moderately. A return to the conditions of the late 1980s would rejuvenate Japan and help shore up the rest of Asia.

The Interest Rate Fallacy

Initially, higher monetary growth would reduce short-term interest rates even further. As the economy revives, however, interest rates would start to rise. That is the standard pattern and explains why it is so misleading to judge monetary policy by interest rates. Low interest rates are generally a sign that money has been tight, as in Japan; high interest rates, that money has been easy.

In the article, Friedman presents data showing Japanese monetary growth slowing sharply in the 1990s.  He also notes that RGDP growth slowed from 3.3% during what he calls the “Golden Age” of 1982-87 to only 1.0% during 1992-97.  Inflation slowed from 1.7% to 0.2%.  From this we can infer:

1.  Friedman does not seem to agree with Fed hawks who think price stability is a good thing.  After all, Japanese prices were very stable during the 5 year period when he thinks money was far too tight.  Admittedly, some at the Fed define price stability as 2% inflation, but the hawks clearly don’t agree, as inflation is 1% and falling, yet the hawks still oppose stimulus.

2.  Friedman thinks near-zero interest rates are a sign that money has been too tight.  And he suggest that QE is the proper response.

3.  Friedman cites data showing that Japanese NGDP growth has slowed from 5% during the golden age to 1.3% in 1992-97.  Of course 5% NGDP growth is quite close to the US experience from 1992-2008, another “golden age.”  But then US NGDP fell 3% between mid-2008 and mid-2009, nearly 8% below trend.  And it continues to grow at well under trend during the “recovery.”  Friedman would have seen that as a warning sign.

4.  Friedman advocates raising money growth rates in Japan (M2) up much closer to the 8.2% of Japan’s Golden age.

5.  In the US monetarists tend to look at broader aggregates like M2 and MZM (although unfortunately we lack the ideal divisia index that monetarists like Mike Belongia say is needed.)  For what it’s worth, here are the growth rates of M2 and MZM from mid-2008 to mid-2009, and then from mid-2009 to mid-2010:

2008-09:   M2 grew 8.8%,  MZM grew 10.2%

2009-10:  M2 grew 2.1%, MZM fell 1.8%

So on average the aggregates grew around 9-10% during the financial turmoil, and then barely changed over the following 12 months.  It is difficult to know what Friedman would say about the increase in the money supply between 2008 and 2009.  Obviously the facts don’t exactly fit either my interpretation or Taylor’s.  But if we take a more expansive view of Friedman’s approach to macroeconomics, then I believe there is even more reason to believe that he would now favor monetary stimulus, just as in Japan:

1.  In the Monetary History, Friedman and Schwartz decided not to use the monetary base as their indicator of the stance of monetary policy.  In my view, this was partly because the base increased sharply between 1929 and 1933.  Friedman understood that NGDP had fallen in half during those four years, and thus monetary policy had obviously been too contractionary for the needs of the economy.  He also understood that the increase in the base reflected hoarding of cash and reserves during the banking panics.  Thus the most natural monetary indicator for a libertarian, the one directly controlled by the government, was not going to work.  Instead he and Anna Schwartz focused on broader aggregates, which declined sharply between 1929 and 1933.

2.  Now consider the 2008-09 increase in the broader aggregates.  Because we now have FDIC, people no longer hoard cash during a liquidity crisis; instead they hoard the very liquid and safe assets that make up MZM.  Friedman would have understood that the financial crisis was a special situation, and hence required economists to look past the temporary blip in MZM, just as he had overlooked the rise in the base during 1929-33.  He understood that money was actually tight during 1929-33, despite the increase in the base and the low interest rates.  (And he’d understand that the bloated base since 2008 largely reflects interest-bearing excess reserves, where yields exceed the rate on T-bills.)

3.  Friedman also understood that in uncertain times markets can provide an indication of whether money is too tight.  Recall his defense of speculators, and also floating exchange rates.  He clearly thought market signals were meaningful.  In 1992 [Money Mischief] he endorsed Robert Hetzel’s idea of having the Fed directly target expected inflation, by trying to peg the spread between nominal and indexed bonds.  Now recall that the TIPS spread briefly went negative in late 2008, and even today is only about 1% for one and two year T-bonds.  So if Friedman thought Hetzel’s proposal was a good idea, I think it unlikely he would brush off the message in the TIPS markets, as many conservatives seem to do.  The markets are clearly indicating both inflation and output will remain below the Fed’s implicit target for quite some time.  Friedman would have seen the importance of those market signals.

4.  There are some modern monetarists, such as Tim Congdon  (and this), who have made many of the same arguments that I’ve used in this post.

To summarize:

1.  In 2009 NGDP fell at the sharpest rate since 1938.  And NGDP growth is expected to remain very weak.   If M*V is that weak, something must be wrong.

2.  Friedman argued the low rates in Japan were actually evidence of tight money.

3.  Friedman would have been concerned by the abrupt slowdown in the growth rates of the monetary aggregates since mid-2009.

4.  Some modern monetarists like Tim Congdon think money is way too tight.

The burst of M2 and MZM in 2008-09 does point slightly in John Taylor’s favor, but overall I believe the evidence supports Baum’s view.

Of course neither John Taylor nor I hold identical views to Friedman.  He supports the Taylor Rule (why not, he invented it!)  I give him a lot of credit, as the Taylor principle is the primary factor behind the Great Moderation.  However I believe a Svenssonian “targeting the forecast” approach is even better.  In September 2008 the Fed failed to cut rates below 2%, looking backward at the high rates of headline inflation during the summer of 2008.  But forward-looking real growth and inflation indicators were already slowing rapidly, indeed the TIPS spread on 5 year bonds fell to 1.23% just before the post-Lehman Fed meeting.  I think almost everyone would now agree the Fed should have moved much more aggressively in September 2008, before rates had fallen to zero.  A forward-looking approach would have allowed them to do so, but instead they relied on historical data that seemed to suggest the risks of inflation and recession were equally balanced.  They did nothing.

I suppose the fight over Friedman’s legacy is related to the fact that he is the one right-wing macroeconomist who is almost universally respected by conservative/libertarian economists.  Even though I’m not a strict monetarist, I’d like to think he would support my view of the current crisis.  I’m guessing Taylor feels the same way.

HT:  DanC, Benjamin Cole, David Pearson, Richard W.

PS:  After 16 months of leisure frantic blogging activity, school starts tomorrow.  Unfortunately, posting and comment replies will have to slow down.

One of my commenters (John Salvatier) is thinking about using his own money to set up some NGDP contracts on Intrade.  He sent me an email with this information, and asked for suggestions:

Each contract would be based on the BEA final estimate of NGDP for the specified quarter and the quarter two quarters before (i.e. 6 months before). The formula for the contract payout would be

payout = ln(NGDPend/NGDPstart) * periodsInYear * 1000
if payout > 100: payout = 100
if payout < 0: payout = 0.

This specification has the nice property that payout/10 = continuously compounded annual growth rate of NGDP during that period (in %). However, the drawback of this specification is that 2008q4, 2009q1 and 2009q2 would all have had negative payouts so they would have paid out 0 instead, which means  you would have had trouble gauging expected the severity of the downturn.

An alternative specification is

payout = ln(NGDPend/NGDPstart) * periodsInYear * 500 + 50
if payout > 100: payout = 100
if payout < 0: payout = 0

This specification would have had positive payouts even during the most severe phase of the downturn, but it makes the contract prices more difficult to interpret and reduces the variation in contract payouts.

I would have contracts for the 6 month intervals between now and 2.5 years from now. When one contract expired, another one would be started for 2.5 years from now. I would consider using quarterly contracts instead of semi-annual contracts if people thought that was important.

I will be making markets in these contracts, ensuring a small spread. This will effectively subsidize informed traders by giving them the option to trade a little cost. I may do this manually at first, but I hope to be able to build an automated market maker to do this for me.

A few comments:

1.  I strongly favor NGDP futures markets, and thus am obviously happy to see one being set up.  But I fear that without government subsidies, there will be very low volume.  That’s why I favor having the Fed subsidize trading in an NGDP futures market (by paying higher than market rates on the margin accounts.)  Nevertheless, I greatly appreciate John’s willingness to put his money on the line.

2.  I am not an expert on futures markets, so John and I would appreciate any advice on how best to set up the contracts.  We’d like to make them customer friendly, but also able to provide point estimates of expected NGDP growth.  And I believe John’s proposal does that.   I believe there are currently some RGDP contracts that merely involve binary outcomes, such as whether growth will be higher or lower than 3%.

3.  If this is set up I am going to ask all my readers to please consider trading a few contracts.  The price of the contracts are pretty low (I believe $10), and since NGDP is somewhat predictable it’s unlikely you’d lose more than a few dollars on each contract.  Is that too high a price to pay to show solidarity with the entire Money Illusion project?   I will certainly buy some contracts.   If no one trades the contracts I might just go on strike and not post for a while.    🙂

I’ll keep you posted.