Well that’s certainly something I’d never expected to see, some prominent pundits talking about my ideas on Bloggingheads.tv.

Brink Lindsey is sympathetic to my argument.  Brad DeLong suggests that my plan would require the Fed to do twice as much bond buying as under QE2, and keep doing it month after month.  (I.e. about $200 billion/month in bond purchases.)  I’m not sure where he got those figures, but I won’t criticize him.   After all, right after QE2 I said it was roughly half of what the Fed needed to do.  He may have been referring to that comment, or perhaps that’s just his own take on what would be needed.  Brad made the quite reasonable point that it’s politically difficult for the Fed to do enough to end the recession.   I agree; if it weren’t difficult they probably would have already done it.

And yet, I’m not willing to give up so easily.  Here’s a few other possibilities.

1.  There are things the Fed could try that don’t involve printing money, and hence might be less controversial.  The most obvious is a lower IOR.  Interest on reserves is seen as a subsidy to fat cat bankers, and it’s opposed by many on both the left and the right.  Of course if you believe the banks control the Fed, you will tell me this can never happen.  But if the banks control the Fed, why would they let NGDP expectations fall so sharply in 2008, and again recently, badly hurting bank balance sheets.

2.  The Fed could try Greg Mankiw’s suggestion of level targeting.  That’s not a cure-all.  But I’m convinced core inflation is likely to remain below 2% for some time.  And 2 and 1/2 year TIPS spreads are only 1.3%.  This would give the Fed room to ease.  It would provide even more room if that started the level targeting from the point at which rates hit zero—which is the theoretically appropriate point in time, according to Woodford, et al.  We are now well below that trend, according to either the core or headline rate.

3.  The Fed could try for 5% NGDP targeting.  This might be acceptable to the right, as it would take “hyperinflation” off the table.  In addition, throughout history I’d guess that at least 75% of the economists who advocated NGDP targeting were right of center (Hayek, McCallum, quasi-monetarists, etc.)  They could tell Barney Frank that unlike a strict inflation target it addresses the Fed’s dual mandate.  I’d actually prefer slightly higher than 5% during the catch-up period.  But things are so bad now that even 5% would be an improvement.

DeLong might argue that those alternative policies would also require the Fed to buy up lots of bonds.  But that isn’t necessarily the case.  Indeed if the policy were credible, it’s very possible that we could get by with a reduction in the currently bloated base, which includes trillions of excess reserves that are doing nothing.

So even though Brad DeLong’s skepticism about the politics of monetary stimulus is quite persuasive, I’m not willing to throw in the towel.  There are things the Fed can do that are less controversial than QE2 on steroids, and surprisingly, might be even more effective.

HT:  Dennis and Brito

Stephen Williamson has an excellent observation about the Fed’s new commitment to hold rates near zero for 2 years:

Further, it seems the outcome the Fed would hope for is one where inflation increases, the interest rate on reserves increases commensurately, and the Fed proceeds to sell off assets so as to normalize the state of its balance sheet, with zero excess reserves. Committing to IROR = 0.25 for two years risks two outcomes that seem equally bad (if we believe that 2% inflation is optimal). One is the too-high-inflation outcome: People anticipate high inflation, reserves start to look much less desirable, and the high inflation is self-fulfilling. The other is too-low-inflation: People anticipate low inflation, the reserves look more desirable, and low inflation is self-fulfilling. The first scenario is something that I have been worried about. The second scenario was a concern of Jim Bullard, and Narayana Kocherlakota.I think both are possibilities, i.e. there are multiple equilibria.

Fed officials like to talk about “anchoring expectations.” In this circumstance, the kind of FOMC statement that would anchor expectations would be something like: “We anticipate raising the fed funds rate target (actually the IROR target, but what the heck) as observed and anticipated inflation warrants. Currently, we think we are on a path on which inflation will increase.”

George Selgin made some similar criticisms in the comment section of this post and this post (where Nick Rowe also makes comments.).  I completely accept their analysis.  Interest rate pegging is a really bad idea.  But I am not particularly worried that the high inflation outcome will occur, for two reasons:

1.  Consider Stephen’s comment “Currently, we think we are on a path on which inflation will increase.”  You would think that is the view of the Fed.  That would certainly be their view if Lars Svensson (of targeting the forecast fame) were running the place.  But alas, Svensson is in Sweden, the land of negative IOR (and the only western European country expected to achieve rapid growth during 2009-12.)  The Fed probably expects core inflation to slow a bit over the next year.  Why don’t they adjust one of their policy levers?  Why not more QE, or lower IOR?  Your guess is as good as mine.

2.  The Fed still has plenty of anti-inflation credibility.  And thus it’s widely understood that if inflation exceeded the Fed’s comfort zone, they’d slam on the brakes in mid-2013.  But what about the period before mid-2013?  It turns out that many New Keynesian models suggest that current NGDP is strongly affected by future expected NGDP.  Although I’m not exactly a NK economist, my intuition tells me they are correct on this point.

Consider the following analogy.  Suppose the Fed said it would let the dollar/euro exchange rate float for two years, and then peg it at 1.40.  Also suppose this announcement was credible.  In practice, the spot rate would show very little variation over the next two years, even though the Fed was taking no explicit actions to stabilize rates (until mid-2013.)  The same intuition applies to NGDP.

Keynes understood this at an intuitive level, which is why he always talked about the importance of business “confidence.”  Whenever reading Keynes, just substitute the term “expected NGDP growth” for “confidence” and the meaning will be much clearer.  Of course other factors such as regulation can also affect business confidence, but Keynes focused on AD.

So although I agree with the criticism of Williamson and Selgin, as a practical matter I focus on the fact that the Fed’s action is almost certainly going to be too little, not too much.  (And obviously the 3 year T-note market agrees.)  I hope I’m wrong, as I’d much rather see the Fed trying to rein in 4% inflation in 2013, than trying to boost up 0% inflation in 2013

Selgin and Williamson are also correct that what the Fed really needs to do is commit to a nominal target, and let interest rates move as necessary to hit that target.  Because they failed to do so, a two year interest rate commitment is likely to be meaningless.

Bruce Bartlett sent me a new paper by Peter Ireland.

This paper uses a New Keynesian model with banks and deposits, calibrated to match the US economy, to study the macroeconomic effects of policies that pay interest on reserves. While their effects on output and inflation are small, these policies require important adjustments in the way that the monetary authority manages the supply of reserves, as liquidity effects vanish and households’ portfolio shifts increase banks’ demand for reserves when short-term interest rates rise. Money and monetary policy remain linked in the long run, however, since policy actions that change the price level must change the supply of reserves proportionately.

I found the long run neutrality of monetary policy to be quite interesting, as I’d assumed that relationship broke down with interest on reserves.  The fact that IOR has little effect on inflation and growth is also interesting, but I would caution that this sort of finding needs to be interpreted with caution.

In December 2007 the Fed was trying to decide between cutting rates by 1/4 and 1/2 point.  They actually cut them by 1/4 point, and the Dow promptly fell by 300 points.  Because fed funds futures showed a 58% chance of a 1/4 point cut and a 42% chance of a 1/2 point cut, we can infer that the Dow would have risen about 400 points with a 1/2 point cut.  (One of the few things even anti-EMH types accept is that the expected return on the Dow over any 2 hour period is roughly zero.)

Are there any models that predict that a 1/4 swing in the fed funds target would mean 700 points on the Dow?  I doubt it, because most models look at these things rather mechanically.  But in the real world the effect of a change in almost any monetary policy variable (fed funds rate, the base, IOR, M2, etc) depends almost entirely on how the change impacts the expected future path of policy.

I agree with Peter Ireland that a decision to pay IOR will have very little macroeconomic impact, ceteris paribus.  On the other hand, ceteris is rarely paribus.  It’s possible that an IOR decision might lead to changes in the expected path of monetary policy.  For instance, it might lead to fears that future QE would be less effective, as banks would have an incentive to hoard any extra cash.  Or markets might have already been expecting QE (to provide liquidity during a banking crisis) and the additional step of IOR might lead them to think the QE will not immediately drive short term rates to zero.

Since the impact of a policy depends on its impact on the expected future path of policy, it is almost impossible to model these effects.  They are highly contingent on the economic situation in which they occur.  For instance, the December 2007 quarter point cut would normally have had little market impact, but coming on the edge of the Great Recession, its impact was greatly magnified.  It made investors far more pessimistic about future Fed policy (correctly pessimistic, I might add.)

Does this mean there is no hope of ever being able to estimate the impact of policy decisions?  Far from it.  Louis Woodhill looked at the only three IOR decisions in the Fed’s 98 year history.  In each case stocks fell very sharply around the time of the decision:

At the time of the Fed’s IOR announcement, the S&P 500 was down by a total of 12.18% from its pre-Lehman close, 15 trading days earlier. However, the day that the Fed announced IOR, the S&P 500 fell by 3.85%, and it was down by a total of 17.22% three days later.

On October 22, 2008, the Fed announced that it would increase the interest rate that it paid on reserves. The S&P 500 fell by 6.10% that day, and it was down by a total of 11.11% three days later. On November 5, 2008, the Fed announced another increase in the IOR interest rate. The S&P 500 fell by 5.27% that day, and it was down by a total of 8.60% three days later.

To play it safe it’s probably better to go with the single day returns, as the EMH suggests the effect on asset prices should be immediate.  On the other hand, the concept of IOR was fairly unfamiliar to Wall Street, so arguably there might have been some delay as the program was discussed and explained.  But even using the more conservative one day window, what are the odds of three drops like that occurring on the only three days in history when the IOR was raised?  I’d guess no more than 1 in 10,000.  Economists get published with results no more unlikely than 1 in 20, and yet I am so skeptical of statistical significance that even 1 in 10,000 seems merely suggestive to me.  I think IOR might have had a significant contractionary impact, but I am not certain.

Whenever the model says one thing and the markets say another, I always go with the markets.  The markets seemed to think the IOR program was a big mistake, and the QE2 program was an important step in the right direction.  That’s all we know right now, and probably all we’ll ever know.

PS.  After the third and final increase in IOR, the S&P500 actually fell 10% in just two days.  Thus the market declined over 38% in 10 trading days–October 6, 7, 8, 9, October 22, 23, 24, 27, and November 5, 6.  Think about what it means for US equities to lose 38% of their total value in 10 trading days.  Coincidence?  Maybe, but a pretty unlikely one.  Using 2 day windows the total drop was about 24%.  Even the three single day drops add up to more than a 15% decline.

And then there is Sweden, with its negative IOR and record RGDP growth.  Hmmm . . .

Memo to Bernanke:  Cut the IOR to 0.15%.  It will give banks a bit less incentive to just sit on all the QE you’re sending their way.  But it will still be high enough to prevent the MMMFs from going belly up.  And you guys at the BOG can do it on your own–no pesky regional bank presidents to deal with.  Even Ron Paul will approve—less subsidy to fat cat bankers.  Git er done.

Here’s Matt Yglesias and Brad DeLong touting the success of Sweden’s negative IOR program.  Ryan Avent also links.

I published the idea back in early 2009.  And I blogged on Sweden’s policy move back in mid-2009.  At the time, I was frequently criticized for talking about IOR.  “Surely it can’t matter that much, just a quarter point.”

If you want to read what other bloggers will be talking about in 2011, be sure to read my blog in 2009.

PS.  I doubt that negative IOR played a significant role in Sweden’s success; although it’s hard to know for sure because so much of monetary policy is about signaling.  But monetary stimulus did speed up Sweden’s recovery.

PPS.  DeLong’s post is entitled “Matthew Yglesias Makes a Good Catch”  Matthew knows where the fishing is good.  🙂

With all the grading I have to do I shouldn’t be posting.  But life doesn’t provide many opportunities, and my National Review piece has led a number of very smart bloggers to mull over my ideas, including Brad DeLong, Tyler Cowen and Ryan Avent.  So grading will have to wait.

I’ve noticed is that it’s easier to see flaws in others than to see one’s own flaws.  For instance, I think I can see flaws in Paul Krugman’s analysis of China’s predatory trade policy, or his analysis of why Japan got stuck in a liquidity trap.  But strangely enough, I have trouble find major flaws in my own arguments (although I certainly see some modest weaknesses.)

If I try to crawl out of my own ego and look at things dispassionately, then I need to take seriously an issue raised by not one but two highly respected bloggers.  I’m referring to a recent Ryan Avent post that favorably quoted a question Tyler Cowen recently asked me.   Here’s Ryan Avent, followed by the Tyler Cowen question:

At a recent dinner here in Washington, Mr Sumner discussed his views and took questions. One, from Tyler Cowen, struck me as more psychological than economic, and also as one of the most potent criticisms of the Sumnerian approach:

“Let’s say that at the peak of a financial crisis, the central bank announces a firm intention to target a path or a level of nominal GDP, as Scott suggests.  If everyone is scrambling for liquidity, and panic is present or recent, and M2 is falling, I wonder if the central bank’s announcement will be much heeded.  The announcement simply isn’t very focal, relative to the panic.  A similar announcement, however, is more likely to work in calmer times, as the recent QEII announcement has boosted equity markets about seventeen percent.  But for the pronoucement to focus people on the more positive path, perhaps their expectations have to be somewhat close to that path, or open to that path, to begin with.

(Aside: there is always a way to commit to a higher NGDP path through currency inflation, a’la Zimbabwe.  But can the central bank get everyone to expect that the broader monetary aggregates will expand?)

The question is when literal talk, from the central bank, will be interpreted literally.”

And here’s what Ryan Avent said immediate after the quotation:

Had the Fed said, in the thick of the financial crisis, that it would maintain NGDP growth at 5%, who would have listened? There was a palpable sense at the time that the economy was in need, first and foremost, of serious repair to the banking system. A bit later, op-ed pages rang with calls for fiscal stimulus, as pundits explained that in an atmosphere of panic monetary policy was impotent since no one would borrow at any interest rate.

After that, Avent becomes supportive of my critique of Fed policy.  And Tyler Cowen has also said some good things.  Nevertheless, I need to address an issue that two sympathetic critics see as one of the least persuasive parts of my message.  How can I overcome the fact that others see our flaws more clearly?  By relying on the fact that others also see our models less clearly.  My argument is sort of like a jigsaw puzzle, with many interconnected pieces in areas such as monetary theory, efficient markets, economic history, policy constraints, monetary transmission mechanisms, unconventional monetary instruments, reverse causation, etc, etc.  An outsider will usually fixate on a few notable aspects of the argument, and may not see the entire picture as a unified whole.  OK enough navel gazing, so how do I respond?  Let’s assemble some pieces:

1.  The NGDP and RGDP collapse, (at estimated monthly frequencies) occurred almost entirely between June and December 2008.  I argue that NGDP targeting could have prevented that collapse.

2.  I argue that the dramatic worsening of the banking crisis after Lehman was mostly endogenous, as sharply falling NGDP expectations one, two, and three years out reduced current asset prices, and made bank balance sheets deteriorate sharply.

3.  I argue that NGDP growth targeting might not have been able to arrest the sharp fall in forward estimates of NGDP, but that NGDP level targeting could have done so.

4.  I argue that the crucial errors were made before we were in a liquidity trap (i.e. when rates were still 2% in September and early October.)

5.  I argue that the financial crisis of September 2008 did not cause a stock market crash, as the markets expected the Fed to continue its multi-decade policy of keeping NGDP growing at about 5%/year.  If the markets had given up on the Fed in September 2008, they wouldn’t have waited until October to crash.

6. I argue that stocks crashed 23% in early October on little financial news.  Instead, there were ominous reports of rapidly falling orders all over the industrial world.  Markets then sniffed out Fed passivity, a failure of the Fed to do what it takes to maintain the Great Moderation.  They became demoralized.

7.  I argue that the only significant Fed policy during the October crash was the IOR program, which was termed contractionary by leading monetary economists such as Robert Hall and Jim Hamilton.

8.  I argue that the Fed has many powerful tools even when rates hit zero, and even when the banking system is near collapse.  I cited FDR’s 1933 policies as a precedent.

9.  I argued that the recent market response to QE2 shows that monetary policies are powerful at the zero bound, and work through expectations channels.

10.  I argued that the failures of Fed policy in September 2008 were a clear example of the superiority of forward-looking monetary policy over backward-looking monetary policy.

11.  I argued that the Fed could have prevent the extraordinary increase in real interest rates on 5-year TIPS during July to November 2008 (from 0.6% to 4.2%) if it had moved aggressively.  This would have also prevented the sharp increase in the foreign exchange value of the dollar, something almost unprecedented in a financial crisis.

12.  I noted that many contemporaneous observers felt the Fed was powerless to arrest the 50% fall in NGDP during the early 1930s, because of financial panic.  Today much of the profession (including Bernanke) has accepted Friedman and Schwartz’s revisionist view that it was possible for the Fed to arrest that decline in NGDP.  But they don’t think the Fed could have done much in late 2008, under very similar circumstance.

13.  I’ve pointed out that cutting edge research in macro (i.e. Woodford) suggests that the most powerful determinant of current movements in AD is future expected movements in AD.  So if the Fed could credibly commit to boost AD when the banking crisis was over, it would have sharply boosted AD while the banking crisis was still going on.

14.  I’ve argued that even if banking problems are a real problem, and could not be papered over with more money; falling NGDP was also most certainly something that would reduce RGDP, above and beyond any decline due to banking.  Sharp declines in NGDP don’t suddenly become harmless when the economy has other problems, just as a knife wound doesn’t become harmless just because the patient also has pneumonia.

15.  I’ve argued that the banking problems of 2007 morphed to a NGDP crisis (needing different treatment) without the profession knowing it.  Just as my cold of last week morphed into bronchitis this week (again needing different treatment.)

16.  I’ve argued the Fed can tell right away if its policy has worked (in the TIPS markets) or if more is needed.  Contrary to what 99.9% of economists believe, there is no “we need to wait and see if it’s working” problem in monetary and fiscal stimulus.

I guess 16 is enough for now.  Now let’s see how this relates to Tyler’s argument.  Tyler asks how we can realistically expect markets to be convinced by aggressive Fed action in the midst of the banking crisis.  One response is that the banking crisis was caused by tight money.  Another response is that markets didn’t need to be convinced in the midst of the banking crisis (when stocks weren’t falling that sharply), but rather in the first 10 days of October, when the stock market did crash.  And I am arguing that the stock market crashed in part because of a growing realization that policymakers would not do anything to arrest the decline.  This does not mean each trader has a fully formed model of monetary policy in his or her head, much less my model.  That’s not how markets aggregate information.

Here’s an analogy.  I’ll bet you’d find more people on Wall Street who disagree with my views on the miraculous ability of QE2 to boost asset prices, than you would people who agree with my views (if you interviewed them.)  But in September and October the markets acted as if I am right.  FDR was hated by Wall Street, and all the business press thought the 1933 dollar devaluation was a horrible idea.  But asset markets soared on the news.  Money talks, and very loudly.

It’s hard to emphasize enough how un-radical the Fed’s QE2 policy really is.  It’s ultra-cautious.  They are buying some T-notes, with modest price risk.  That’s an open market operation.  They deliberately passed over all sorts of “nuclear options,” including a higher inflation target, or level targeting, or negative IOR.  And yet the markets still became totally obsessed with Fed rumors during September and October of this year.  Admittedly the news backdrop was more intense in late 2008, but not all the time.  Here’s Ryan Avent:

People remember the sharp decline in share prices in September and October of 2008, but from the end of 2008 until March of 2009, the Dow fell by a third. Ben Bernanke didn’t need to get everyone’s attention on September 15, 2008, or even that particular week.

I’d go further, there were plenty of slow news days in October when the Fed could have electrified the markets.  I know I’m going to be ridiculed for this, but what the heck.  I recall seeing Jim Cramer on TV one morning (in October 2008 I believe) and he was utterly despondent.  Why?  Because the Brits had cut rates sharply, initially leading to hopes on Wall Street that the ECB would do the same later in the morning.  But then the ECB made  a weak move, and US markets fell sharply on dashed hopes.  Cramer seemed forlorn, and berated the ECB.  If even Jim Cramer is grasping for straws from ECB rate decisions on national TV, just imagine the reaction to the United States Federal Reserve doing something bold.

If I were to critique my argument it would be as follows.  The Fed is what it is, a large bureaucratic institution.  I naively thought they could handle this sort of crisis.  Krugman correctly predicted they could not.  So there is a sense in which Tyler in right.  I may have been asking for something that the Fed simply wasn’t set up to do.

My response would be to go back and look at the 1930s.  You could argue that the Fed of the early 1930s wasn’t institutionally set up to prevent the sort of fiasco that we actually observed.  But we learned from that mistake.  And the Fed changed in ways that make another 50% fall in NGDP almost inconceivable.  So that’s progress, and we have Friedman and Schwartz to thank for that progress.

So maybe I was wrong that the Fed was implicitly targeting NGDP during the Great Moderation at roughly 5% growth.  And maybe Tyler’s right that it would not have been credible for them to suddenly start doing so in the midst of the banking crisis.  I’m still not convinced, but maybe he’s right.  Then my fallback is that I’m already fighting the next battle, we need to learn lessons from this fiasco that are analogous to the lessons we learned from the 1930s.  So that next time we’re near the zero bound everyone knows the Fed plans to immediately shift to NGDP targeting, level targeting, with a catch up for any near term undershoot.  Even better, let’s shift before the next crisis.  If we can learn that lesson from this crisis, we can make the next crisis even smaller.  (All battles over economic history are disguised battles over current and future policy.)

PS.  When I saw Jim Cramer I said to myself; “Even he gets it.  He understands the need for more monetary stimulus.  Why can’t Bernanke and all the other elite macroeconomists see the same thing?”  (I hope the term ‘even’ didn’t come across as condescending, but you know how academics look down on the shouters and the showman.)

PPS.  I still plan to say something more about Tyler Cowen’s longer critique, when I have more time.

HT:  Marcus Nunes