Archive for the Category Keynesianism


We need to unify monetary theory and monetary policy

Before today’s post, a few quick comments.  I have a piece on Trump’s “deregulation” policies at MarketWatch.  I have a Ted talk on public opinion at Econlog.

It’s clear to me that there is something seriously wrong with the field of monetary economics.  The profession got 2008-09 almost entirely wrong.  But it’s hard to pin down exactly where the problem lies.  After all, there are increasingly sophisticated models being developed by economists who are much smarter than me.  These models feature rational expectations, and all the other bells and whistles you might want. I regret their focus on interest rates and inflation, but that doesn’t fully explain the problem.  While I prefer to talk about money and NGDP, anything that I believe can be translated into New Keynesianism by referring to the gap between the natural rate of interest and the market rate.  So where’s the problem?

In my view, the problem lies in the interface between sophisticated theoretical models and a very crude discourse on monetary policy.  This monetary policy discourse is little changed from 90 years ago, and not at all informed by recent developments in theory.

John Hall directed me to a James Hamilton post that included this remark:

Zhang’s suggested solution begins with the observation by Gurkaynak, Sack and Swanson (2005) that the news revealed by a typical FOMC announcement is multidimensional. The Fed is typically both changing the current interest rate and signaling the changes that are in store for the future.

Here’s my hypothesis.  Monetary models suggest that monetary policy actions are multidimensional, while most of the discourse on real world monetary policy treats policy as one dimensional—easier or tighter money, lying along a single line.  This has led to the confusing debate between Keynesians and NeoFisherians, which I’ll return to later.

Once monetary theorists understood that monetary policy actions affected the entire future path of policy, the modeling problem became more difficult.  At this point they should have stopped basing their models on interest rates, as this variable creates all sorts of indeterminacy issues, or perhaps I should say makes these issues even harder to grapple with—they can also occur when using money itself.

To make things simpler, I’m going to boil the multidimensional theoretical models down to two dimensions—levels and growth rates.  Obviously things are more complicated than that, but it’s enough to make my point about the disconnect between monetary theory and the modern discourse on monetary policy.  I’m also going to work with some alternative monetary instruments, that is, alternatives to interest rates.

Let’s start with the monetary base.  Any change in monetary policy has two dimensions, a level shift and a growth rate shift.  Thus the Fed might immediately increase the base by 3%, but not change its expected growth path going forward, or they might keep the level of the base as is, but announce a faster growth path for the base.  In practice, most monetary policy shocks probably involve a bit of each.  You could plot them using a graph with the X axis being the immediate change in the level of the base, and the Y axis being the change in the expected growth rate of the base.

Elsewhere I’ve argued that Keynesian economics is basically about level shifts, and monetarism is basically about growth rate shifts.  But old monetarism is mostly gone, so I’ll instead describe these two dimensions of monetary policy as “Keynesian” and “Fisherian”.  No “neo” is necessary in front of Fisherian, for reasons that will later become clear.

Thus if the Fed suddenly announces a 3% rise in the base, and also announces that henceforth the growth rate of the base will be reduced by 1.8%/year, then the policy would be described as “Keynesian monetary stimulus and Fisherian monetary contraction.”  Terms like “easy money” and “tight money” are no longer sufficient in this multidimensional world.  And keep in mind that this multidimensional approach comes right out of modern monetary theory.  (Not “MMT”, I mean actual cutting edge monetary theory.)

Unfortunately, money demand shocks leave money as an unsuitable instrument for policy analysis.

I eventually plan to link this up to the Keynesian/NeoFisherian debate.  To do so, we’ll run through the exact same exercise, but this time using the exchange rate as the policy instrument.  (As is the case in Singapore, for instance.)  A Keynesian policy change is a one time adjustment in the exchange rate.  A Fisherian policy change is a change in the expected growth rate of the exchange rate.  In the Dornbusch overshooting model, an increase in the money supply causes a fall in interest rates (to levels below the alternative currency.) This leads to a one-time depreciation in the exchange rate.  But the interest parity condition implies that (with lower interest rates) the exchange rate is expected to appreciate relative to the alternative currency.   With Dornbusch overshooting the currency still depreciates in the long run; the Keynesian effect outweighs the Fisherian effect. But that need not be true in all cases.

In January 2015, Switzerland simultaneously appreciated its currency sharply, and dramatically cut interest rates.  The effect was a policy that was contractionary in both the Keynesian and Fisherian sense.  The Swiss franc immediately appreciated sharply, and was expected to continue appreciating over time (due to the low rates).  In a few cases, exactly the opposite occurs, usually in developing countries experiencing a crisis.  Thus places like Argentina or Indonesia might see their currency sharply depreciate in a crisis, and also see a huge rise in interest rates—which is a forecast of further depreciation (according to the interest parity condition.)  BTW, the interest parity condition does not hold perfectly true in the real world, but that’s not important for the points I’m making.  No macro model holds perfectly true—it’s a model, a stylized picture of reality.

When the US announced the QE of March 2009, the dollar plunged sharply and interest rates fell.  That was an example of Dornbusch overshooting, Keynesian monetary stimulus dominating Fisherian monetary contraction.  By “dominating”, I mean that in the long run the exchange rate ends up lower than before the shock, despite appreciating after the original overshoot lower.  It was easier money, in net terms.

Now let’s imagine the X/Y policy graph I described as a vast plain, with economists living on that featureless surface.  Some economists are only able to see things along the X-axis direction.  We’ll call these economists “Keynesians”.  They think lower interest rates represent easier money.  Others only see things along the Y-axis.  We’ll call these economists “NeoFisherians.”  They believe lower interest rates represent tighter money.   Others can see in two dimensions, we’ll call them “monetarists”.  They do not believe that interest rates tell us anything useful about the stance of monetary policy.

Comments and suggestions are welcomed.

PS.  I’d rather not use money or exchange rates as a monetary indicator, rather I’d prefer to rely on NGDP futures prices.  The level/growth rate distinction also applies there, but is complicated by the fact that NGDP responds slowly to shocks.  Thus unlike with exchange rates, “level shifts” actually take a bit of time.  Recall mid-2008 to mid-2009, which was a sort of level shift down in NGDP, of roughly 8% below trend.  Then the growth rate going forward also fell by about 1%, from 5% to 4%.

Natural interest rate bleg

I suppose I should know what the natural rate of interest is, given that I’m a monetary economist.  But I see the term used in two radically different ways, and am not sure which version is correct:

1.  The real interest rate that would exist if the economy were at full employment and stable prices (or on-target inflation).

2.  The real interest rate that would be expected to push the economy back to full employment and stable prices (or on-target inflation).

A recent NY Fed piece used the first definition:

The Laubach-Williams (“LW”) and Holston-Laubach-Williams (“HLW”) models provide estimates of the natural rate of interest, or r-star, and related variables. Their approach defines r-star as the real short-term interest rate expected to prevail when an economy is at full strength and inflation is stable.

The accompanying graph shows their estimate of the natural real rate for the US:

Screen Shot 2018-12-10 at 3.22.38 PMObviously, it would have been a disaster if the Fed had set the real rate at that level during the Great Recession.  Rather the authors are showing the real rate that would be appropriate in the counterfactual case where the economy was at full employment.

In contrast, an article by Vasco Cúrdia at the San Francisco Fed uses a very different concept when describing the natural rate:

The natural rate of interest is the real, or inflation-adjusted, interest rate that is consistent with an economy at full employment and with stable inflation. If the real interest rate is above (below) the natural rate then monetary conditions are tight (loose) and are likely to lead to underutilization (over-utilization) of resources and inflation below (above) its target.

At first glance, that sounds similar to the New York Fed’s definition, but he later clarifies that this is the rate expected to lead to full employment, and that the natural rate will fall when the economy is depressed:

During the economic recovery, the natural rate was kept low by weak demand due to a larger propensity to save in the aftermath of the financial crisis.

As a result, Cúrdia’s estimate of the natural rate is dramatically lower than the NY Fed estimate:

Screen Shot 2018-12-10 at 3.28.14 PM

I like Cúrdia’s definition better, and it’s the one I’ve always used.  During the Great Recession, the Fed would have had to initially cut real rates to very low levels to push the economy back to full employment.  But if a magic wand (say a quick adjustment of wages and prices by God) had suddenly gotten us back to full employment, then the equilibrium interest rate would be much higher, as is normally the case during booms.  That’s the NY Fed estimate.

Alternatively, if monetary policy had been expansionary enough to prevent a Great Recession, the natural rate would not have fallen as sharply.

Here’s the problem.  I see each version of the natural rate being used by various economists, and I don’t know which use is conventional.  This makes it hard to communicate with other macroeconomists.

Personally, I don’t like speaking Spanish or Keynesianism. But when speaking with Mexicans I at least try to use a bit of Spanish, and when speaking with Keynesians I at least try to use a bit of Keynesianism.  But if I don’t know the proper meaning of the terms, then it’s hard to communicate.

Can someone please help me?

Cúrdia explains the difference this way:

Williams (2015) estimates the natural rate to be low by historical standards, but not nearly as low as those shown in Figure 1. The main difference is that Williams uses the statistical model of Laubach and Williams (2003), which is better suited to determine the longer-run level of the natural rate. By contrast, my analysis is suited to find short-term fluctuations in the natural rate.

But that doesn’t seem adequate to me; it seems like they are describing entirely different concepts.  And even if it’s correct, it suggests that economists should never refer to the term ‘natural rate of interest’ without first specifying whether it is the short or long run version.  Indeed Cúrdia hints at this inadequacy when describing how one could draw incorrect policy implications from the alternative definition:

This distinction is important in evaluating monetary conditions. In contrast to my results, the interest rate gap using the Laubach-Williams measure of the natural rate has been negative since the recession. According to their estimate, the Fed response to the crisis was expansionary because it lowered the real interest rate below its longer-run natural level.

Obviously, if the natural rate is defined as the rate that would prevail if the economy actually were at full employment, it’s of zero value in determining whether monetary policy is expansionary in an economy that is far from full employment.  So this isn’t just “semantics”, there are important policy issues at stake here.

Nor can the natural rate of interest be described as the appropriate real interest rate on long-term bonds, as that rate will itself depend on the future path of monetary policy.

Update:  Commenter Judge Glock left the following comment, which seems correct to me:

Maybe this isn’t helpful, but I think it just has to do with referring to different parts of the Taylor Rule. For the “long-term” natural rate, people mean the r* as in r* + a1(infl – desired inflation) + a2(output gap – desired output)= i, or, in other words, the intercept of the Taylor Rule, or its equivalent. Other people seem to refer to the natural rate as the final i, the dependent variable of the Taylor Rule, or the output of the equation, which represents the short-term rate when factoring in output and inflation gaps. It may be mere preference or semantics, but it seems to me the i more closely approximates the original Wicksellian understanding of the “natural rate,” or the rate that will keep the economy at equilibrium, while the r* more closely approximates the combination of growth rate and time preference. The confusion, though, could be emerging from the original Laubach-William paper, which, if I’m reading it correctly, estimates the “natural rate” or “r*” by looking at output gaps and real interest rates over time, thus treating the r* as something like the Taylor Rule’s i, even while they also refer to r* as the combination of the economic growth rate and household time preference not dependent on output gaps.

Update#2:  Rayward directed me to an excellent 2015 Tyler Cowen post on the topic.

Cowen and Smith on monopoly and stimulus

In a recent Bloomberg debate, there was an interesting exchange.  First, Tyler Cowen:

But Noah, I have a question for you. You’ve written several columns about how the American economy is becoming more monopolistic. If true (and it is not exactly my view), that implies output could be much higher with current resources, even at full employment. A boost in demand could spur firms to produce more, rather than restricting output so much. So are you now a fan of these Trumpian deficits? They may not be your preferred form of deficit spending, but do you see them still as a net positive?

Then Noah Smith:

As you say, monopoly power could potentially increase the case for stimulus in bad times.

Actually, that’s not what Tyler said, nor is what Tyler said true.  (Now everyone will be annoyed at me.)

One of the fundamental principles of modern macro is that demand-side stimulus cannot solve real problems.  It can overcome problems such as high unemployment caused by sticky wages and prices combined with inadequate spending, but that’s all it can do.  Inefficiencies associated with monopoly are a real problem, and cannot be solved by printing money.  There are actually a number of issues here that need to be disentangled, some of which are quite subtle.

1.   Monopoly is a microeconomic problem, not a macroeconomic problem.  Thus it’s quite possible to have low unemployment rates and high levels of monopolization.  Indeed, I’d argue that’s true in America right now.  Employment in the monopolistic sector is indeed lower than we’d like, but the result of this is not unemployment, it’s workers being employed in the less efficient competitive sector of the economy.  This is important, because the mechanism by which demand stimulus creates growth is by encouraging more employment (not moving workers between sectors).  But we are already at full employment.

2.  Suppose I’m wrong, and monopolization causes the natural rate of unemployment to be higher than otherwise. Say America’s natural unemployment rate rises to French levels, due to monopolization.  Is Tyler correct in that case?  No, demand stimulus is still not called for even if monopolization causes the natural rate of unemployment to be higher than otherwise.  That’s because when you are at the natural rate, demand stimulus basically tricks workers and firms into producing more output than they’d like, by pushing up nominal spending in the face of sticky wages and prices.

So doesn’t that make us better off?  In the short run yes, but only at the cost of being worse off in the long run.  When prices are sticky, demand stimulus can reduce a monopoly’s real price, which is its price relative to NGDP.  But once the monopoly catches on to the higher NGDP, it will raise the real price again.  That might not sound so bad, but it leads to cyclical instability.  Ditto for wage stickiness.  Demand stimulus will give monopolies an incentive to hire more workers, as long as nominal wages are sticky.  That will indeed make the economy more efficient for a short time (this may have been Tyler’s intuition), but at a cost of future instability.

This is why we have independent central banks.  Because our economy is riddled with inefficient policies such as minimum wage laws and taxes on labor, our natural rate of output is suboptimal.  Demand stimulus tricks us into producing more, and we move closer to the optimal position for the economy.  But it’s not sustainable. It’s a sugar rush.  Minimum wages eventually get increased with NGDP, and workers renegotiate contracts.  In the short run, the stimulus really does make us better off as a country (with or without monopoly), but it overheats the economy and leads to a painful recession in future years.  Once mainstream monetarist and New Keynesian economists understood this problem, they decided the best we could do was to keep the economy close to the natural rate of unemployment, and then advocated setting up independent central banks that would be immune from pressure by a corrupt future president that might have a big ego and a short attention span.  (Hmmm . . . . )

Unless I’m mistaken, there is nothing particularly controversial about this post.  Think about a standard NK model, which produces an optimal policy of 2% inflation.  How would the existence of monopoly change the optimal policy?  Make it more expansionary?  But what does that even mean?  In the standard model, money is neutral in the long run.  Going to 3% inflation doesn’t have any long run benefit.  I suppose you could advocate steadily rising inflation, ending up in hyperinflation, but that won’t work if there are any welfare costs of inflation.  In fact, the optimal policy under a NK model is no more expansionary with monopoly than without.

Now I suppose there might be models where the optimal policy is more countercyclical if there is monopoly, and this seems to be what Noah is hinting at.  But that doesn’t help Tyler’s argument, as in that case policy should actually be more contractionary when unemployment is 4.1%.  And I’m not even sure that claim is true; do NK models imply that more weight should be put on output, and lesson inflation, when the economy is more monopolistic? Are there any models that do so?

PS.  Tyler might argue that the monopoly argument was not his view, just the implication of Keynesian models with which he does not agree.  But I’m saying even that’s not true.  The argument he makes is not even an implication of any sound Keynesian model that I’m aware of.

PPS.  I have a new post criticizing proposals to “experiment” with a hot economy, over at Econlog.


Keynes was wrong; animal spirits do not drive growth

Here is Neil Irwin:

After Donald J. Trump won the presidential election, Americans’ optimism about the economic future soared. But midway through the year, that optimism has not translated into concrete economic gains.

This seeming contradiction exposes a reality about the role of psychology in economics — or more specifically, how psychology is connected only loosely to actual growth. It will take more than feelings to fix the sluggishness that has been evident in the United States and other major economies for years. Confidence isn’t some magic elixir for the economy: Businesses will hire and invest only when they see concrete evidence of demand for their products, and consumers intensify their spending only when their incomes justify it.

Long run growth is driven by fundamentals: free markets, property rights, sensible taxes, low corruption, human capital, technology, peace, etc. Short run growth is driven by aggregate demand, i.e. monetary policy.

That’s why I prefer monetarism to Keynesianism, despite all its faults.  At least monetarists understand that monetary policy drives AD.

PS.  Off topic, I found this NYT story to be of interest:

Jason Kenney, then a Conservative member of Parliament, convinced Prime Minister Stephen Harper that the party should court immigrants, who — thanks to Mr. Trudeau’s efforts — had long backed the Liberal Party.

“I said the only way we’d ever build a governing coalition was with the support of new Canadians, given changing demography,” Mr. Kenney said.

He succeeded. In the 2011 and 2015 elections, the Conservatives won a higher share of the vote among immigrants than it did among native-born citizens.

The result is a broad political consensus around immigrants’ place in Canada’s national identity.

That creates a virtuous cycle. All parties rely on and compete for minority voters, so none has an incentive to cater to anti-immigrant backlash. That, in turn, keeps anti-immigrant sentiment from becoming a point of political conflict, which makes it less important to voters.

In Britain, among white voters who say they want less immigration, about 40 percent also say that limiting immigration is the most important issue to them. In the United States, that figure is about 20 percent. In Canada, according to a 2011 study, it was only 0.34 percent.


Keynesianism as religion

If there is any intellectual framework that should have been discredited over the past decade it is old-style Keynesianism.  Unfortunately, just the opposite has happened.  Marcus Nunes directed me to a Noah Smith post that discusses the revival of old Keynesian ideas:

Another way of putting this is that Paul Krugman was right. Krugman has long advocated that macroeconomists learn to once again think in terms of simple simple Keynesian theory. And when more fully developed, complex models are needed, Krugman uses the kind of models that Christiano endorses.

As Christiano mentioned, the New Keynesian revolution isn’t so new. Even in the 1990s, economists like Greg Mankiw and Olivier Blanchard were arguing that monetary policy had real effects on demand. And at the same time, international macroeconomists were realizing that Japan’s post-bubble experience of slow growth, low interest rates and low inflation implied that demand shortages could last for a very long time unless the government rode to the rescue. Krugman, Adam Posen, Lars Svensson, and others were already referring to a Japan-type stagnation as a liquidity trap in the late 1990s, and warning that standard monetary policy of cutting interest rates wouldn’t work in that sort of situation. .  .  .

If economists gravitated toward anti-Keynesian theories, it was at least in part because evidence wasn’t strong enough to push them in the right direction. It’s just very hard to assess the impacts of fiscal stimulus. For example, Japan’s tremendous government spending binge in the 1990s looks to a casual observer like it had no effect, since the economy didn’t recover until years later — but government spending might have been the only thing saving the country from a deeper recession.

I certainly agree that Japan tells us a lot about the validity of old Keynesian thinking.  Here are some things it tells us:

1.  Depreciating the yen is a foolproof way of creating inflation.  Thus Keynes was wrong about monetary policy being ineffective at the zero bound.

2.  From 1993 to 2013 Japan ran up by far the largest peacetime fiscal deficits ever seen by a major economy.  And all that “stimulus” led to by far the worst growth in AD over 20 years ever seen by a major economy.  Roughly zero growth in NGDP over two decades.  And the Keynesian takeaway is that this was a great success, as it prevented an even more record-breaking fall in NGDP.  This is like a religious person who believes in the efficacy of prayer, prays for peace in 1939, and then later argues that his prayers prevented an even bigger war and Holocaust. Okaaaay . . .

3.  Then in 2013 Abe takes office and raises consumption taxes.  This fiscal tightening causes the debt to GDP ratio to level off at 250%.  Instead Abe relies on monetary stimulus, raising the inflation target.  And both inflation and NGDP growth actually increase, the opposite of the prediction of the old Keynesian model.

Of course I could go on and on.  There’s the letter signed by 350 Keynesians warning that the fiscal austerity of 2013 risked recession (growth actually sped up.) Or the fact that Keynesians don’t even know how to estimate the multiplier (as documented recently by Ryan Murphy.)

Smith points out that Paul Krugman realized in the late 1990s that the standard policy of cutting interest rates would no longer work at zero.  But he doesn’t tell you that everyone already knew that, even Milton Friedman.  AFAIK, not one economist in the entire world in the late 1990s thought that cutting interest rates when they were already zero would work. Perhaps you think I’m being too picky; what Smith really meant is that Krugman discovered that monetary stimulus no longer worked in Japan, and that fiscal stimulus was needed. Except that’s not true, in the late 1990s and early 2000s Krugman ridiculed the idea of using fiscal stimulus in Japan, and suggested that monetary stimulus was the obvious solution. Whatever “new facts” caused Krugman to revert to old Keynesianism more recently; it certainly wasn’t his famous 1998 study of Japan’s liquidity trap.  So what caused Krugman to change?  I’m not sure, but Smith hints at one possibility:

When evidence is sparse or inconclusive, things like sociology and politics often fill the gap.