In the physical sciences, researchers identify empirical facts, and try to model them.  In economics, we observe empirical facts, and then create models to explain why these facts cannot possibly actually occur.  Consider:

U.S. stock futures pointed to another strong session for Wall Street on Friday, as oil prices continued to climb and investors were encouraged by signals of potential central-bank stimulus, at the end of a tough week for global markets.

Dow Jones Industrial Average futures YMH6, +1.29% leapt 210 points, or 1.3%, to 15,997, while S&P 500 futures ESH6, +1.46% jumped 27.25 points, or 1.3%, to 1,888.75. Nasdaq-100 futures NQH6, +1.86% gained 72 points, or 1.8%, to 4,202.75.

Friday was looking like a repeat of Thursday, when oil led the market higher. Then, U.S. crude prices CLH6, +5.22% rose $1.58, or 5.3%, to $31.10 a barrel, while Brent crude LCOH6, +6.36% jumped $1.88, or 6.4%, to $31.10 a barrel.

Oil and global stocks got a boost after European Central Bank President Mario Dragi dropped heavy hints on Thursday that more stimulus could be in store when the ECB meets in March. The Stoxx Europe 600 index SXXP, +3.18% was up 2.6% on Friday, while Asian markets finished with solid gains, including a nearly 6% rise for the Nikkei 225 index NIK, +5.88%

The Nikkei got a boost after an aide to Prime Minister Shinzo Abe said Thursday that “conditions for additional easing have fallen into place,” according to The Wall Street Journal. The Bank of Japan will meet on Jan. 28-29, and some expect the central bank’s asset-purchasing program could be increased.

So the expectations fairies are causing wild stock and commodity price movements, even though both Japan and the eurozone are at the zero bound.  And yet in the comment section I’ll have people “proving” this cannot be so, because in highly unrealistic New Keynesian DSGE models, monetary policy is totally ineffective at the zero bound.

Or they’ll say it worked, but through the expectations channel, so that “doesn’t count.”  Oh really, don’t New Keynesians believe the highly expansionary monetary policy of the 1960s sharply raised NGDP growth?  Isn’t that the standard NK explanation?  But interest rates rose during the 1960s, so how can that be?  They respond, “yes but that’s because inflation expectations rose sharply, real interest rates actually fell.”  Oh, so you are saying the 1960s monetary stimulus worked by lowering real interest rates, and that only occurred because inflation expectations rose?  So even when not at the zero bound, it’s all about the expectations channel? Then what makes the zero bound special?

Meanwhile Narayana Kocherlakota has a new post entitled:

It’s Time to Make a Hard U-Turn

It’s very short, so rather than try to excerpt it, and not do it justice, I’ll just ask you to read the whole thing.  Can we all agree now that Kocherlakota was not crazy last fall, as so many people assumed?  “Hey, there’s one FOMC member who wants to cut rates”   “Ha ha ha”

Yeah, who got the last laugh?

Update:  Update, I also recommend this blog post by Lars Svensson, another central bank dissenter who turned out to be absolutely correct.

Just imagine if Kocherlakota and Svensson were made chair and vice chair of the Fed (in either order.)

HT:  Julius Probst,  Marcus Nunes

Back in early 2009, many economists seemed to move away from New Keynesian ideas, back to the so-called “vulgar Keynesianism” of the 1950s and 1960s.  Recall that by the 1990s, the NKs accepted many ideas from the monetarists:

1.  Monetary policy determines the path of NGDP, and thus fiscal countercyclical policy is useless.

2. Wages and prices are flexible in the long run, and hence the economy eventually adjusts back to LRAS curve.  Demand side policies only have a short-term impact on output.

3.  Sluggish growth in productivity and/or the size of the labor force reflects structural problems, and cannot be remedied by demand stimulus (which can reduce high unemployment).

In 2009, economists like Paul Krugman assured us that the abandonment of NK orthodoxy was temporary, that “everything’s different” at the zero bound.  Fiscal policy can be effective when the Fed is out of ammo.

I was skeptical that this would be temporary, and thus I’m not surprised that the old-style Keynesian revival has survived into the post-zero bound period.  Here’s Alan Blinder in the WSJ:

Let’s look at some of the agreement’s main provisions. The budget for fiscal year 2016 and beyond blows through the spending caps put in place in 2013. (Remember the fiscal cliff and the sequester?) Furthermore, Congress extended more than 50 special tax breaks, often called “extenders,” without paying for them. So if your Christmas wish was further deficit reduction, you ended up with a lump of coal.

But the federal deficit that President Obama proposed for fiscal 2016 was merely 2.5% of GDP—a number in line with historical norms. There was no need to shrink it. Furthermore, with a still sluggish economy and the Federal Reserve beginning to raise interest rates, a little fiscal stimulus is welcome, even if the agreement provides very little. The big bucks in the budget deal come in the tax extenders, which everyone knew would be extended regardless. So making some of them permanent does not provide stimulus, nor does it really raise future deficits.

Blinder seems to defend some outrageous and inefficient (GOP) tax breaks, on the grounds that they provide fiscal stimulus.  But how can that be?  The inflation targeting Fed would simply raise rates more quickly, to prevent inflation from rising above their preferred target path (which calls for restoring 2% inflation in about 2 years.)  Keynesians used to argue that monetary offset doesn’t hold at the zero bound. I don’t agree, but that’s a defensible argument.  The current claims being made by Blinder don’t even seem defensible, or at least I’ve never seen a plausible defense.  In any case, it’s now clear that Krugman was wrong; the end of the zero bound would not bring an end to calls for fiscal stimulus.  Instead of “everything’s different” we find out that “nothing’s different.”

And Krugman himself seems to be jumping on the old Keynesian bandwagon, claiming that slow long-term growth reflects deficient demand, even though demand deficiencies would slow growth by raising the unemployment rate (in the Keynesian model), not by reducing productivity.  And this claim is being made even though unemployment has fallen from 10% in 2009 to 5% today.  Whatever this is, it’s not New Keynesian economics.  It almost seems like economists have decided they want more fiscal stimulus, and then simply assume there must be a model that endorses their policy preferences.

You might complain that it’s unfair to tie Keynesians to the 1990s version of their model.  Things change, and new hypotheses are dreamed up.  Maybe there are mysterious “hysteresis effects” that allow demand stimulus to boost long-term growth.  It didn’t work in Brazil, but hey, maybe it could work here.  So shall we treat Krugman’s recent musings as an interesting new hypothesis, something to study and discuss?  I’d be happy to, but Krugman himself won’t allow it.  In a mind-boggling tone-deaf post he trashes Timothy Taylor (a moderate who supports fiscal stimulus during recessions). Here’s Taylor’s response:

Paul Krugman was “quite unhappy” with a paragraph in my blog post last Monday concerning “Secular Stagnation: An Update.”  In his characteristic high-decibel mode, Paul manages in a single post to use the phrases “both wrong and, to some extent, cowardly,” “change the subject,” “actually engaged in an act of evasion,” “refusing to take sides is a dereliction of responsibility,” and more.

If that’s how he reacts to Taylor, I sure hope he never reads my posts.  Unlike Taylor, I don’t even think that what Taylor calls the “2009-2012” fiscal stimulus helped, and can’t help noticing that GDP growth accelerated slightly immediately after it ended.

So Paul Krugman creates a new demand-side theory of secular stagnation, and then trashes the character of anyone who doesn’t immediately buy into his model.  A model Krugman himself would have scoffed at in the 1990s.  Indeed did scoff at, even a year after he had written his famous 1998 “Road to Damascus” revisionist model of the liquidity trap:

What continues to amaze me is this: Japan’s current strategy of massive, unsustainable deficit spending in the hopes that this will somehow generate a self-sustained recovery is currently regarded as the orthodox, sensible thing to do – even though it can be justified only by exotic stories about multiple equilibria, the sort of thing you would imagine only a professor could believe. Meanwhile further steps on monetary policy – the sort of thing you would advocate if you believed in a more conventional, boring model, one in which the problem is simply a question of the savings-investment balance – are rejected as dangerously radical and unbecoming of a dignified economy.

Will somebody please explain this to me?

So apparently the Paul Krugman of the 1980s and 1990s, the one who did research that later resulted in a Nobel Prize, was also a “cowardly” and “evasive” person who refused to take responsibility for demanding fiscal stimulus.   Just like poor Timothy Taylor.  Should the Nobel Prize be returned?  Or was it awarded in anticipation of his later heterodoxy, just as President Obama’s 2009 Nobel Peace Prize was awarded for all the drone strikes, Libyan bombings, Syrian bombings, etc., that he was undoubtedly going to avoid doing during his Presidency.

HT:  TravisV

Here’s an interesting graph in The Economist, showing the extent of negative interest rates, by country and by maturity:

Not only are interest rates negative on 10-year Swiss government bonds, they are significantly negative, minus 41 basis points according to the FT.  Here are some observations:

1.  The differences within the eurozone mostly reflect default risk.  But notice that despite the default risk, even Spain and Italy have lower government bond yields than the US.

2.  The differences between the eurozone (especially Germany) and Switzerland relate to expected exchange rate changes.  The Swiss franc is expected to gradually appreciate against the euro.  Why is that?  Perhaps because the Swiss National Bank (SNB) has pursued contractionary policies in the past, especially when it (foolishly) allowed the SF to sharply appreciate at the beginning of the year.  Traders naturally expect more of the same.  The Danes sensibly kept their currency pegged to the euro.

3.  OK, but then why are eurozone rates lower than in the US?  The euro has recently depreciated.  Here you need to distinguish between levels and rates of change.  (And this is something that lots of people miss.)  An expansionary monetary policy can be thought of as reducing the value of the currency, or reducing the expected growth rate in the value over time (or both).  But those are actually two radically different kinds of expansionary policy.  The recent ECB policy has resulted in a one-time reduction in the value of the euro, but from this point forward it is expected to appreciate against the US dollar.  Why?  Probably because the ECB’s inflation target is a little lower than the Fed’s inflation target, although low eurozone rates may also be related to ECB credibility problems.

4.  As far as the low level of interest rates in all developed economies, I attribute that partly to slow NGDP growth, but there also have to be other factors involved.  And always remember that a low interest rate is not a monetary policy, it might reflect either easy money (liquidity effect) or tight money (NeoFisherian view.)  Keynesians and NeoFisherians both make a mistake in assuming that a low interest rate policy can deliver some sort of desired result.  (Oddly they make exactly opposite errors on what sort of results.)  Low rates are not a policy.

5.  Tyler Cowen linked to Matt Rognlie’s research papers.  (Any top university not making him a job offer should have their head examined.)  He has a paper on the zero bound that is full of interesting stuff.  I particularly liked the analysis of the welfare costs of negative interest. Friedman showed that positive interest rates were a tax on money, and hence inefficient, but I had never given much thought to the costs of a subsidy on currency use.  Rognlie also notes (correctly in my view) that before currency is withdrawn from circulation the government should first withdraw high denomination notes.

6.  Although most have us have been surprised that currency demand near the zero bound is less elastic than we expected, I still think it might be more elastic in the long run than in the short run, due to the cost of adjusting currency stocks.  I’d note that US currency demand seems to be moving upward with a lag, after short term rates fell close to zero in late 2008.  On the other hand the negative 41 basis point yield on long-term Swiss bonds suggests that investors expect the SNB to maintain significantly negative rates for an extended period of time.  So even in the long run, demand can’t be perfectly elastic at the zero bound.  I recall reading that the SNB was informally discouraging currency use, by telling banks not to pay out large sums of currency to depositors. (Unfortunately I forgot where I read that.)  Of course the US government has been trying to criminalize the use of significant sums of currency.

7.  The Economist article has some interesting speculation on the future of currency at the zero bound:

As interest rates creep further into the red, economists’ prescriptions have become bolder. In a speech in September Andy Haldane, the chief economist of the Bank of England, outlined a range of options to allow rates to go lower still. The most radical would be to get rid of the mattress option by abolishing cash altogether. Ken Rogoff of Harvard University calculates that there is $4,000 of currency in circulation for every person in America. Much of it is used to hide transactions from tax authorities or the police. Abolishing it would curb such activities, as well as helping central bankers.

Yet depositors might still find ways to safeguard their savings. Switching to foreign currency or precious metals would be an obvious option. As Kenneth Garbade and Jamie McAndrews of the Federal Reserve Bank of New York point out, taxpayers could make advance payments to the taxman and subsequently claim them back. Depositors could withdraw funds in the form of bankers’ drafts (certified cheques) to use as a store of value. Such drafts might even become a form of parallel currency, since they are transferable. Any form of pre-paid card, such as urban-transport passes, gift vouchers or mobile-phone SIMs could double up as zero-yielding assets. If interest rates became deeply negative, it would turn business conventions upside down. Companies would seek to make payments quickly and receive them slowly. Their inventories would grow fatter.

Note that even if depositors found a way to avoid sharply negative interest rates after the abolition of currency (say by holding foreign currency, or pre-paying taxes), the central bank could still use negative rates to reduce the demand for bank reserves (make it a hot potato), and hence boost NGDP.  But as always they need to be aware of where the Wicksellian rate is, and not just chase the Wicksellian rate lower in a futile attempt to jump-start NGDP growth.  They need to get ahead of the curve.

BTW, I strongly oppose the abolition of cash.  Like high taxes on cigarettes, it’s a highly regressive policy that seems to have support among progressives.

PS.  Marcus Nunes sent me an excellent Jim Pethokoukis interview of Tino Sanandaji, discussing the Swedish economy.  Lots of interesting info on Swedish history, the current immigration crisis, etc.

The view that QE is ineffective is pretty widely held—except in the asset markets. Earlier today, Mario Draghi hinted than another round of QE might be coming later in the year, if the global economy continues to be weak.  The euro fell 2% against the dollar, and European stock indices rose sharply.  Even Wall Street rallied on the news (so much for “beggar-thy-neighbor” theories.)  For an ineffective policy QE sure has a big effect on asset prices.  (And note that the big move down in the euro means that imported oil, and other commodities, are immediately more expensive, and hence the eurozone cost of living rose a few basis points today.)

At the same time these steps are much too weak to solve “the problem”, they merely make the eurozone economy a bit less weak.  The ECB should do much more.  One possible step is a further cut in interest rates:

“The ECB will almost certainly be delivering an early Christmas present this year,” said Nick Kounis, head of macro and financial markets research at ABN Amro.

“This could include an adjustment of the QE programme but also further policy rate cuts, something which had been ruled out before.”

Analysts at Barclays said: “We do not rule out the possibility of a deposit rate cut in December, although this is not our baseline. The likely trigger for a deposit rate cut, in our view, would be a further material appreciation of the euro, possibly in a scenario where the Fed remains on hold for longer.”

Wait, I thought the zero bound was the lowest that rates can fall.  I guess not. Lower interest rates will help, but what they really need is a better policy target, as explained by James Alexander:

Nominal GDP growth and thus Real GDP growth cannot get that much better in the Eurozone as a whole while the overarching target remains the self-defeating one of the <2% inflation ceiling. Draghi can prevent tail risks with the QE programme, lower rates for longer and even more negative rates. But it will never be enough to see healthy growth. The inflation ceiling offsets almost of the good work from the other policies.

Overall, monetary policy is just not that accommodative. Draghi says he and his fellow governors and their staff are working hard:

“the strength and persistence of the factors that are currently slowing the return of inflation to levels below, but close to, 2% in the medium term require thorough analysis.”

Please, Mr Draghi, it is the mandate itself that is the obstacle. In the UK we may be looking soon at the mandate  and there were hints that the European Parliament is also looking into the mandate. At least talk about NGDP Targeting and you can then “Feel The Power” in time for the pre-Christmas release of Star Wars 7.

Amen.

I’m certainly an optimist.  I think the expected interest rate increase is a mistake, but on balance I don’t think it will push the US back into recession.  I suppose I’d say I’m 80-20 growth in 2016.   But even that is an unnecessary risk in my view, with essentially no upside from raising rates:

1.  It will hurt the unemployed.

2.  It will move the Fed further from its 2% PCE inflation target.

3.  If you are worried about savers (I’m not) it will lead to lower interest rates in years 2 through 20 than would an easier money policy that led to faster NGDP growth.

The only argument in favor seems to be that rates for savers would be 1/4% higher for a year or two.  And that gain is worth all the downsides?

I’m 80% sure this will not push us into a double dip recession, despite the fact that history shows exactly the opposite.  Of the 5 previous attempts to exit the zero rate bound (or perhaps I should say what Keynesians regard as the zero bound) 4 were failures, which pushed the economy back into recession and/or deflation.  The failures were the US in 1937, Japan in 2000 and 2006, and the ECB in 2011.  (That 2011 rate increase wasn’t quite at the zero bound, but generally regarded as close.)  In three cases it was a 1/4% increase, and in 2011 a 1/2% increase.  The only success was in 1951, when the Treasury-Fed Accord ended the low interest rate pegging policy.

And yet despite all of this history, Alan Greenspan is “baffled”:

Greenspan also said he’s “baffled” that a 25 basis point hike by the Fed would have a major impact on economic conditions around the world.

So almost every previous time central banks do a tiny interest rate increase at the zero bound, it blows up in their face.  And yet we are shocked that markets might be a tad worried?

What’s the downside of waiting until the Fed actually needs to raise rates to achieve its target path?

It’s really very simple.  Basic monetary theory says that interest rate pegging makes the price level indeterminate.  A peg slightly above the natural rate eventually sends you into deflation.  A peg slightly below the natural rates starts a cumulative process that sends the economy into hyperinflation. Monetary theory says that a 1/4% can make a massive difference, or it might make very little difference at all (it depends what happens next).  If you read any news or opinion articles where the writer wonders how a 1/4% change can be such a big deal, just stop reading.  You are wasting your time.

PS.  Just as I am a US economy optimist, perceived as a pessimist, I’m a China pessimist perceived as an optimist.  I’m currently more pessimistic about China’s growth prospects for 2016 than every single member of The Economist’s expert panel.  Every one of them expects at least 6.3% growth for China in 2016.  What a bunch of pollyannaish apologists for the Chinese Communist Party!