I know, you are gagging on the title of the post.  I hate commissions too.  But there’s already a lot of discussion about a commission to re-evaluate the Fed’s goals and tactics.  And the current proposals are both too much and too little.  Too much because there are some tactical questions that the Fed itself can resolve better than any commission.  But there are also some questions that the Fed currently cannot answer, and where a commission could be very useful to the Fed. I believe the biggest issue now is what to do about stabilization policy in a world that frequently hits the zero bound during recessions. That’s not the world of the past 50 years, but I believe it’s quite likely to be the world of the next 50 years.

Although I don’t recall doing so, it’s quite possible that at some point in the past 6 years I insinuated that Paul Krugman favors fiscal policy because he likes big government.  Perhaps there’s even a grain of truth in that statement.  But there’s also one really big problem with that claim.  Consider:

1.  Paul Krugman strongly supports raising the inflation target to 4%

2.  There is only one justification for raising the inflation target to 4%; it makes it possible for the Fed to handle 100% of the responsibility for stabilization policy.

And it’s not just Krugman; lots of other liberal economists have also favored raising the inflation target to 4%.  Why do I bring this up now?  Because I can just hear commenters saying how naive I am; “liberals will never agree to a plan that eliminates the need for fiscal policy.”  Then why do so many favor 4% inflation target?  And why does Paul Krugman say fiscal policy is pointless when nominal interest rates are positive?

Now I don’t happen to favor a 4% inflation target, and I doubt that this would be the outcome of the commission.  But I do believe the commission’s output would be very useful, even if I don’t “get my way” on fiscal policy.

Both liberal and conservative economists agree on these basic facts:

1.  When trend NGDP growth rates are lower, the economy will hit the zero bound more often.  One option is to raise the inflation target.  The Paul Krugman solution.

2.  Another option is to do something like NGDPLT.  My preferred solution.

3.  Another option is to keep the Fed’s current policy framework, 2% PCE inflation, growth rate targeting, and unemployment near the natural rate.

Economists also agree that option three may require some hard choices.  These include:

a.  Pursuing QE to the limit in a liquidity trap.  Allowing the Fed to buy whatever it takes, even if they have to move beyond Treasury debt.  Telling the Fed not to worry about capital risk, the Treasury has them covered.  My second preference.

b.  Constraining the Fed to buy securities of no more than a specific amount, say 50% of GDP, to avoid excessive risk.  Other options are also possible here, such as more aggressive cuts in IOR, perhaps to negative levels.  Then just live with a slow recovery.  Similar to current policy.

c.  Same as option b, but have an implicit agreement that once the Fed hits its QE limit, fiscal stimulus will take over.  The Larry Summers solution, Krugman’s second preference.

Policy is currently hindered by the fact that the Fed doesn’t know exactly how aggressive it should be, partly because Congress is not even aware of these “hard choices.”  So we don’t have any sort of clear policy regime, rather we drift in a sort of limbo, where the Fed doesn’t really know how much others want it to do.  Or whether it would be scolded for large capital losses on its balance sheet if rates rose sharply.  Or whether Congress would support the Fed if it shifted its target higher in order to keep interest rates above zero.  The Fed knows that politicians are concerned that rates are low for savers, but doesn’t know if that concern implies they’d favor higher interest rates that are caused by higher inflation.

I don’t think this commission is politically feasible until January 2017, but at that time it just might work. I’m assuming the Dems will again win the presidency and the GOP will retain the House.  Gridlock will make fiscal policy impossible unless an agreement can be reached.  If you put sensible conservatives like Taylor, Mankiw and Hubbard on the committee, with sensible Keynesians, they are all going to understand the trade-offs I discussed above.  The GOP economists can explain to GOP politicians “look, it’s inflation or socialism, take your choice.  If we don’t have a bit more inflation then interest rates will fall to zero, and the Fed will keep expanding its balance sheet, bigger and bigger.”  Or we’d get fiscal stimulus, another option the GOP doesn’t like.  The liberal members of the commission can explain to Democrats “look, it’s better if the Fed handles stabilization policy, and fiscal resources are utilized for pressing social needs, not economic stabilization. And in any case, the GOP will never let us do the amount of fiscal stimulus we need, or they’ll insist on tax cuts that ‘starve the beast’.”

Krugman and I may not get our way.  Maybe the commission will compromise on a monetary/fiscal mix, where the Fed takes the lead, but the fiscal authorities act if the Fed ‘s balance sheet hits X% of GDP.  If I lose the battle I’ll stop objecting to fiscal stimulus.  I’ll stop claiming the multiplier is zero.  I’ll stop claiming there is monetary offset.  If that’s clearly the regime, and it’s all spelled out, then so be it. At that point I’ll argue that payroll tax changes are the best form of stimulus.

But right now there is great uncertainty about who is in charge, and what is expected of the Fed.  This stuff really needs to be clarified for the zero bound environment.  Or at least discussed.  I’ll bet the Fed would be thrilled if Congress told them exactly what their responsibilities were in terms of capital losses, instead of leaving it quite vague.

What would Congress decide in the end?  One possibility is keeping the 2% inflation target, and a continual role for fiscal policy.  That’s very possible.  Or Congress might ask the Fed to study options for preventing the zero rate bound from hamstringing monetary policy, and they might buy into a technical fix like level targeting and/or NGDP targeting. I don’t know.  But politics goes in cycles.  After so many years of gridlock, 2017 might be a good time for a compromise.  To make this happen we all have to starting talking up the idea right now—assuming anyone agrees with me.

Jason Smith is trained in physics, and has recently tried his hand at economics blogging.  Perhaps inspired by Matt Yglesias and Britmouse, Jason noticed that an economics degree is not required to do good economic analysis.  But he went even further than the other two, creating a revolutionary new type of economics called “Information Transfer Economics.”  Although I’ve tried to understand his model, it’s all way over my head. He knows a lot more math than I do.

Jason is now discovering just how macro research is done, and as a result Mark Sadowski and I are in his doghouse. Literally:

And that picture is one of the nicer things he had to say.  The dog is more handsome than I am, and probably more skilled at time series analysis.  But this isn’t too nice:

This is just garbage analysis.

Basically we did not provide the best possible study of austerity. For instance, we did not distinguish between countries at the zero bound, and those not at the zero bound. Guilty as charged.

So what’s my defense?  Here’s how I look at it.  The Keynesians did several studies of the relationship between austerity and growth that were highly flawed, for too many reasons to mention.  Confusing real and nominal GDP.  Mixing countries with and without an independent central bank.  Wrongly assuming correlation implied causality.  Mixing countries at the zero bound with countries not at the zero bound. Just a big mess.

And then the Keynesians did blog posts suggesting that these studies provided some sort of scientific justification for the claim that austerity slows growth.  Mark and I thought it would be interesting to at least separate out the countries with an independent central bank, from those that lacked the ability to do monetary offset (i.e. the eurozone countries.)

I find it interesting that our critics are outraged that we included some non-zero bound countries, when the Keynesians did as well.  For instance, the 18 eurozone countries were certainly not at the zero bound for the vast majority of this period. Their main interest rate fluctuated between 0.75% and 1.50% between early 2009 and 2013.  (It’s now roughly zero)  And yet all that time Keynesians were squawking about how “austerity” was slowing growth in Europe.  It seemed logical to assume that if the Keynesians were making this claim, then they were assuming that their model also applied to countries with low but positive interest rates.  Indeed that they assumed it even applied to countries where the central bank was in the process of raising interest rates to reduce inflation.  I’m happy throwing out the 18 eurozone countries. But of course if you do so then the empirical support for their austerity theory collapses.  Is that what my critics want?

Mark improved on previous studies by looking at both NGDP and RGDP, and by separating out countries with independent monetary policies from those that lack independent monetary policies.  He showed that if you do so then the Keynesian results go away.  Maybe even further improvements could resurrect the Keynesian model.  If so, I’ll take a look at the results. But as of now I don’t know of any credible support for Keynesian interpretation of the effects of austerity during the Great Recession.

PS.  Mark has another good post over at Marcus Nunes’ blog.

PPS.  The graph below shows ECB rates, with the middle one usually cited as the policy rate.  The lower (deposit) rate did hit zero in 2012, but there is no zero bound on the deposit rate.  The increase in rates during 2011 was done to control inflation, and eventually caused a double dip recession.  Doing fiscal stimulus when a central bank is trying to reduce inflation is about as effective as slamming your foot on the accelerator when the transmission is in neutral.

Marcus Nunes pointed me to a Stephen Williamson post.

On the other hand, suppose I am an empirical macroeconomist, and I’m trying to understand the Great Recession. I have coffee with Paul Krugman, and he tells me not to worry. This looks pretty much like other recessions – just an insufficiency of demand. As an empirical macroeconomist, I may not know what Paul is talking about, as there now exist practicing macroeconomists who have never seen AD/AS, IS/LM. But, for example, Christiano, Eichenbaum, and Trabandt know AD/AS, IS/LM (at least I’m pretty sure the first two do). They’re well-known empirical macroeconomists, and they’re not coming out and saying the Great Recession is about aggregate demand deficiency. They have a model, and the model has stochastic shocks which they give names to, and none of those shocks appear to have the name “aggregate demand.” They have taken the time to write a whole paper in which they try to figure out how the shocks account for the Great Recession, and what the propagation mechanism is. Conclusion:

We argue that the vast bulk of movements in aggregate real economic activity during the Great Recession were due to financial frictions interacting with the zero lower bound.

Sorry, but that’s not in AD/AS, IS/LM.

So I took a look at the abstract to their paper:

We argue that the vast bulk of movements in aggregate real economic activity during the Great Recession were due to financial frictions interacting with the zero lower bound. We reach this conclusion looking through the lens of a New Keynesian model in which firms face moderate degrees of price rigidities and no nominal rigidities in the wage setting process. Our model does a good job of accounting for the joint behavior of labor and goods markets, as well as inflation, during the Great Recession. According to the model the observed fall in total factor productivity and the rise in the cost of working capital played critical roles in accounting for the small size of the drop in inflation that occurred during the Great Recession.

That sounds an awful lot like an AD paper to me.  But I’ve only read the abstract. Perhaps someone else can read the paper, and tell me why they used a NK model with liquidity traps and sticky prices, if it’s not an AD-oriented model.

Returning to the Williamson post:

Now, consider another person. This one is older than the average undergraduate – old enough to actually care about the Great Recession, and not think of this as ancient history. This person is, say, 30, and worked on Wall Street during the financial crisis. She saw a lot of stuff. Volatile financial market activity, unemployed people, large financial institutions in trouble, etc. Now she’s motivated to go back to school and take some economics so she can understand all that stuff. She takes an intro-to-macro course, learns AS/AD, and is told that the Great Recession is just like all the other recessions – AD shifts left. Given her experience in the world does this get her excited? Does this information somehow put all her practical experience into perspective? I don’t think so.

I can’t speak for her, but it would sure get me excited.  If I’d run up huge debts and then found myself unable to pay them off, I’d double down and work harder. The fact that Americans, on average, decided to take lots of vacations in late 2008 is a big puzzle.  Especially in industries that had nothing to do with subprime mortgage debt, like autos and services.  Why did so many autoworkers stop working when the mortgage crisis occurred in 2008? Why didn’t creative destruction work, with labor moving from overbuilt housing to other areas? Why did output fall in almost all industries? I’d want to take a course in macro to find out.

And suppose I was told that there are competing theories:

1.  Technological regress in autos, people forgot how to make them.

2.  An earthquake destroyed most of America’s auto-making facilities.

3.  Autoworkers were tired of working, and decided it was time for a long vacation.

4.  The government raised the minimum wage to $30/hour, making the industry uncompetitive

5.  AD fell, and Americans cut back on spending on cars.

Which of those theories, or any other you’d like to mention, might that hypothetical stock trader find plausible?  If she was really smart she might ask why a decline in spending would reduce real output.  And you’d answer that prices are sticky.  And then she’d ask why AD fell, and you’d mention the financial crisis.  And then she’d ask why the Fed didn’t offset the effect of the financial crisis on AD by easing monetary policy.  And you’d mention the zero bound, and their reluctance to pursue unconventional techniques to the max.

Hmmm, sticky prices, financial crisis, the zero bound problem, isn’t that the abstract to the paper Williamson said was not AS/AD?

I actually enjoyed reading Williamson’s post.  Lots of good observations about Krugman and Meltzer.  A nice critique of Phillips curve thinking.  But I’m far less impressed by modern modeling techniques than he is.  For me the proof is in the pudding.  If modern macro really is making progress, then we ought to hear its practitioners make useful observations during a major crisis.  Or at least make observations as astute as someone like Milton Friedman would have made in 1997:

Low interest rates are generally a sign that money has been tight, as in Japan; high interest rates, that money has been easy.

.   .   .

After the U.S. experience during the Great Depression, and after inflation and rising interest rates in the 1970s and disinflation and falling interest rates in the 1980s, I thought the fallacy of identifying tight money with high interest rates and easy money with low interest rates was dead. Apparently, old fallacies never die.

Instead we’ve regressed, and most of what I’ve read since 2008 has been utter nonsense, starting with claims that the Fed has been conducting an “easy money” policy.  In fairness to Williamson, he and David Andolfatto are among the extremely tiny number of macroeconomists who don’t equate low interest rates with easy money.

PS.  I have a new post on Iceland over at Econlog.

By “this” I mean sluggish growth, very low inflation, and especially near-zero interest rates.  Paul Krugman has repeatedly said “yes” and mocked people like Martin Feldstein, who expected a more conventional recovery with rising inflation and rising interest rates.  But Brad DeLong says he’s too tough on Feldstein:

Unlike Paul, I get why moderate conservatives like Feldstein didn’t find “all this convincing” back in 2009. I get it because I only reluctantly and hesitantly found it convincing. Feldstein got the Hicksian IS-LM and the Wicksellian S=I diagrams: he just did not believe that they were anything but the shortest of short run equilibria. He could feel in his bones and smell in the air the up-and-to-the-right movement of the IS curve and the upward movement of the S=I curve as investors, speculators, and businesses took look at the size of the monetary base and incorporated into their thinking about the near future the backward induction-unraveling from the long run Omega Point. My difference with Marty in 2009 is that he thought then that the liquidity trap was a 3 month-1 year phenomenon-that that was the duration of the short run-while I was much more pessimistic about the equilibrium-restoring forces of the market: I thought it was a 3 year-5 year phenomenon.

I’m somewhere in between, and also a bit off to the side.  DeLong has by far the best argument, and if you are only going to read one post, stop reading mine and read his instead.  But I’ll put in my 2 cents, FWIW.

I have a very low opinion of the IS-LM model; indeed I blame a lot of our policy failures on that model.  I think it led too many economists to write off monetary policy in late 2008, right when we desperately needed monetary stimulus.  But I reached the same conclusions as Krugman, for somewhat different reasons.

Since late 2008, I’ve consistently wanted more, more and more, but not for IS-LM reasons.  Rather I’m a market monetarist, and in my view the markets have been signaling a need for more, more and more.  I’m also a Lars Svensson-style, “target the forecast” guy, which means I always, at every single moment, want the instruments of monetary policy set at a position where expected NGDP growth equals desired NGDP growth.  Since 2008 we’ve consistently fallen short.

In contrast, Paul Krugman is much more skeptical of the market view:

Kevin O’Rourke has a post, What do markets want, raising the same issues I’ve been discussing about debt, austerity, etc.

But never mind all that: read the comments, specifically this one:

The markets want money for cocaine and prostitutes. I am deadly serious.

Most people don’t realize that “the markets” are in reality 22-27 year old business school graduates, furiously concocting chaotic trading strategies on excel sheets and reporting to bosses perhaps 5 years senior to them. In addition, they generally possess the mentality and probably intelligence of junior cycle secondary school students. Without knowledge of these basic facts, nothing about the markets makes any sense””and with knowledge, everything does.

That’s about as far from my view of markets as it’s possible to get, although I suspect that Krugman himself doesn’t really quite believe it.  Maybe it’s just my imagination, but on occasion I think I see him “peeking” at markets, to confirm his (often excellent) intuition about where things are going.  And when he fails to do so, as in early 2013, he pays a heavy price in lost prestige.

OK, so Krugman and I were right in 2009, but did we just get lucky?  Even now it’s hard to say.  DeLong spends a lot of time explaining why in a traditional macro model, even a traditional Keynesian macro model, you would not expect a recession to lead to 7 years of near-zero interest rates.  Not even a deep recession like 1982, when unemployment peaked at 10.8%.  So what happened this time?

On the other hand Krugman’s right that this isn’t actually unprecedented, we had near-zero rates from 1932 to 1951, and then again in Japan beginning in the late 1990s, and still ongoing.  So (he asks) why is anyone surprised?

In my view we had a perfect storm of shocks that just barely added up to zero rates for 7 years in the US, but not enough for Australia, and more than enough for Japan (and perhaps going forward, Europe.)  These included:

1.  A big negative AD shock.  Both a big NGDP drop in 2008-09, and an unprecedentedly slow recovery.  DeLong might argue that I am assuming the conclusion, that I need to explain this slow NGDP recovery.  I don’t quite agree, but I’ll circle back to this issue later.

2.  Bad supply-side factors.  In the US we have boomers retiring, fewer young people choosing to work, more people going on disability, and a crackdown on immigration. Then we had a 40% rise in the minimum wage right at the onset of the recession, and an unprecedentedly long extension of unemployment benefits (which DeLong correctly predicted (in 2008) would raise unemployment.)  By themselves, these factors weren’t that important, but together they had some impact.  For instance, after unemployment compensation returned to the usual 26 weeks in early 2014, job growth accelerated.

3.  A 30-year downtrend in the Wicksellian equilibrium real interest rate.  And the last step down after 2008 was aided by a structural shift in the US and Europe from investment to consumption, as an after effect of the housing bust and tighter lending standards.

In my view the weak NGDP growth is monetary policy.  Period, end of story.  But DeLong would want something more:

In the long run… when the storm is long past, the ocean is flat again.

At that time-or, rather, in that logical state to which the economy will converge if values of future shocks are set to zero-expected inflation will be constant at about the 2% per year that the Federal Reserve has announced as its target. At that time the short-term safe nominal rate of interest will be equal to that 2% per year of expected inflation, plus the real profits on marginal investments, minus a rate-of-return discount because short-term government bonds are safe and liquid. At that time the money multiplier will be a reasonable and a reasonably stable value. At that time the velocity of money will be a reasonable and a reasonably stable value. Why? Because of the powerful incentive to economize on cash holdings provided by the sacrifice of several percent per year incurred by keeping cash in your wallet rather than in bonds. And at that time the price level will be proportional to the monetary base.

So you can’t explain why the massive QE didn’t lead to a big growth in NGDP unless you can explain how interest rates stayed near zero for 6 years after the recession, holding down velocity.

My response is that, yes, back in 2009 it would have been hard to predict near-zero rates in 2015.  The markets didn’t expect that and neither did I.  We had that perfect storm described above.  But that doesn’t matter.  You take policy one step at a time.  The markets were also telling us that the policies that so many thought “extraordinarily accommodative” were in fact woefully inadequate.  That’s all we knew in 2009, but it’s also all that we needed to know in 2009.

Krugman sees traders as drug-crazed yuppies.  I see economists and Fed officials as stupid bulls that need a ring in their noses.  Then you attach the rings to the markets, and let those 22-27 year old drug-addled traders lead us to a glorious world where expected NGDP growth is always on target and where bailouts and fiscal stimulus aren’t needed.  A world where Say’s Law is true even though it’s not really true (I stole that last one from Brad DeLong.)

HT:  Marcus Nunes

More than three years ago Marcus Nunes did a post taking on two of my favorite macroeconomists, Robert Hall and Greg Mankiw.  It hardly seems like a fair fight, as Marcus is merely an amateur market monetarist down in Brazil.  And yet, I’ll show that Marcus was correct in both disputes.  In a January 2012 post, Marcus quotes from a Ryan Avent post.  Here’s Ryan:

This time around, Mr Hall addressed the point head on. He noted that in a liquidity trap, the real rate of interest was simply equal to the negative inflation rate. In other words, if the Fed’s nominal rate is at 0% and the inflation rate is 2%, then the real rate of interest is -2%. If a -3% real interest rate is necessary to clear the economy, then all that’s needed is a higher rate of inflation””3% rather than 2%. Mr Hall noted that this was an important point because potentially the Fed could have an enormously helpful impact on the economy simply by raising inflation just a little. And here’s where things got topsy-turvy. Mr Hall argued that (my bold):

1. A little more inflation would have a hugely beneficial impact on labour markets,
2. And a reasonable central bank would therefore generate more inflation,
3. And the Federal Reserve as currently constituted is, in his estimation, very reasonable; therefore
4. The Federal Reserve must not be able to influence the inflation rate.

Both Ryan Avent and Marcus Nunes thought Hall was wrong.  So did I.  I could have given dozens of reasons.  Bernanke said the Fed could do more.  The Fed had not done the things Bernanke recommended the Japanese do.  The market response to QE rumors. The difference between central banks that did QE and those that didn’t.  Since this time we have lots more evidence, such as the Abe policy in Japan, which has pushed the yen from 80 to 125/dollar.  Despite the recent dip due to falling oil prices, Japanese inflation since 2013 is significantly higher than before.

But even if that was all wrong, we can still be 100% certain that Hall was completely incorrect.  Indeed it’s not even a debatable point anymore.  Why?  I hope it’s obvious to everyone by now.  Hall is wrong because the Fed plans to raise interest rates later this year, even though they expect inflation to continue running below 2%.  So the Fed does not want to raise its inflation target to 3%.  Period. End of debate.

[Isn’t it wonderful when economic debates get resolved with 100% certainty!  It happens so rarely.]

Now on to the next victim, Greg Mankiw.  Here he quotes Mankiw discussing the condition of the economy in early 2012, in light on Mankiw’s own version of the Taylor Rule:

Not surprisingly, the rule recommended a deeply negative federal funds rate during the recent severe recession.  Of course, that is impossible, which is why the Fed took various extraordinary steps to get the economy going.  But note that the rule is now moving back toward zero.  As Eddy points out, “At the current inflation rate, the unemployment rate needs to drop to 8.3% from the current 8.5% for the model to signal positive rates. We’re getting close.”

To be fair to Mankiw, he doesn’t explicitly say the Fed should raise rates when unemployment falls to the low 8% range, even if inflation stayed about the same. There’s some wiggle room.  So let me just say that I think the vast majority of readers would have assumed that Mankiw was stating that policy implication with approval.

In any case, we now know that tightening monetary policy in early 2012 would have been a big mistake.  Actual unemployment has fallen rapidly to 5.4%, and inflation remains well below the 2% target.  Furthermore, inflation is expected to remain below target for an extended period, while unemployment is expected to keep falling. Tightening policy in 2012 would have been a mistake, even if you were a hawkish Fed policymaker who would prefer to ignore unemployment and focus like a laser on their 2% inflation target.

In contrast, the ECB did raise rates a few months before the Nunes post, and we now know that the result was disastrous.

The bottom line here is that the Taylor Rule (in any form) is not a reliable instrument rule.  That’s not to say that the Taylor Principle is without value—I think it contributed to the successful Fed policy of the Great Moderation period.  But as a rigid instrument rule it simple doesn’t work.

PS.  In my tradition of “burying the lede”, let me point to a comment left by Julius Probst:

Yesterday, Larry Summers held a speech at DIW Berlin here in Germany, talking about secular stagnation.
He mentioned that bond markets expect low trend real growth rate in the years to come, low inflation rates and low interest rates – all of that is true in my opinion and I think that the FED is much too optimistic expecting long-term interest rates at 4% in a few years. It won’t happen.

I got to ask Larry Summers a question whether he favors more aggressive monetary stimulus – he does – and whether he favors a different monetary target.

He was against a 4% inflation target, but he favored a NDGP target !!!! I think that might have been the first time he did so in public ? At least the first time I know about it.

The same with me, I’d never heard that he favored NGDP targeting.  Maybe I backed the wrong horse in the Fed race last year.  Oh well.  I’d appreciate it if someone could send a link as soon as possible.  With endorsements by Woodford, Romer, McCallum, Frankel, DeLong, Krugman (sort of), Bullard, and now Summers, there is obviously strong momentum toward NGDP targeting among the macro elite.  So much for the silly view that MM ideas are becoming less popular.  (Of course I’m not claiming that our blog posts actually caused any of these conversions, just that our policy ideas are getting more popular.)