The ECB moved more aggressively than expected to cut IOR and increase QE. Today I will explore the effects, beginning with the banks.  Recall how negative IOR was supposed to be so bad for bank profits.  It seems those theories were wrong:

Banks have warned that negative interest rates are eroding their profitability. The rates cut into banks’ net interest margins as lenders have been reluctant to pass on the cost of negative rates to all but the biggest retail customers.

To offset some of the pain to banks, the ECB will provide cheap loans through targeted longer-term refinancing operations, each with a maturity of four years, starting in June 2016. These loans could potentially be provided at rates as low as minus 0.4 per cent, in effect paying banks to borrow money. Banks will also benefit from a refinancing rate of 0 per cent.

Shares in eurozone banks rallied sharply after the ECB announcement with Deutsche Bank up 6.5 per cent, Commerzbank up 4.9 per cent, Société Générale up 5.4 per cent and UniCredit up 8.2 per cent.

Over the years I’ve pointed out that there are things that central banks could do to offset the hit to bank profits. For instance, they could raise IOR on infra-marginal reserve holdings, while they lowered IOR at the margin. I did not propose the exact offset discussed above, but it seems that the general concept is workable. Negative IOR need not be a problem for banks, if done correctly.

European stocks rose sharply on the more aggressive than expected announcement and the euro fell in the forex markets. Oddly, however, for the 347th consecutive time the “beggar-thy-neighbor” theory was falsified by the market reaction.  Not only did Europe’s actions not hurt the US, our stocks soared higher on the news:

Dow futures added more than 150 points after the ECB cut the deposit rate to negative 0.4 percent from minus 0.3 percent, charging banks more to keep their money with the central bank. The refinancing rate was also cut, down 5 basis points to 0.00 percent.

I warned people to be careful after the Japan announcement; the EMH is not a theory to be trifled with.  As you recall, Japanese stocks soared and the yen fall sharply when negative IOR was announced in Japan.  But then a few days later both markets went into reverse (probably for unrelated reasons).  Many people assumed it was a delayed reaction to the negative IOR.  That’s possible, but markets generally respond immediately to news.  With the European moves today we see yet another confirmation of market monetarism:

1.  Policy is not ineffective at the zero bound.  So do more!!

2.  Reducing the demand for the medium of account (negative IOR) is expansionary.

3.  Increasing in the supply of the medium of account (QE) is expansionary.  I.e. the supply and demand theory is true.

4.  There is no beggar-thy-neighbor effect from monetary stimulus.

Market monetarists were the first to propose negative IOR.  It’s our idea.  When your ideas are correct, they help to explain how the world evolves over time. Things make sense.  In contrast, people with a more “finance view” of monetary policy have been consistently caught flat-footed.  Note that these people are represented on both the right and the left, and they have been consistently wrong in their views of monetary policy at the zero bound.

BTW, James Alexander has a post showing that eurozone growth has nearly caught up with the US:

Notice that at the beginning of 2012, NGDP growth in Europe had been running at less than 1% over the previous 12 months.  That’s the horrific situation that Draghi inherited from Trichet.  Draghi did move much too slowly at first, but at least things are beginning to look a bit better for the eurozone.  Still, Draghi needs to do more, as the eurozone is likely to fall short of its 1.9% inflation target.

Even better, the ECB needs to change its target, and set a new one high enough so that the markets are not expecting near-zero interest rates for the rest of the 21st century:

Take overnight interest rate swaps. They imply European Central Bank policy rates won’t get back above 0.5 percent for around 13 years and aren’t even expected to be much above 1 percent for at least 60 years.

Update:  The euro later reversed its fall.  But note that US stocks soared even after the initial plunge in the euro.  It’s interesting to think about why the euro reversed its losses–perhaps a view that the ECB action will make the Fed less likely to raise rates?  Or because it was expected that the action would lead to stronger eurozone growth?  What do you think?

Update#2:  Commenters HL and GF pointed out that the euro rose in value after Draghi indicated (in a press conference) that the ECB would probably not push rates any lower.

James Bullard is perhaps the most data-driven member of the Fed, and thus one of my favorite FOMC members.  His only agenda is getting policy right; he’s perfectly willing to shift his views as new data comes in. However in the past I’ve occasionally been critical of his attempts to second-guess the markets.  This is from a post from 3 years back (beginning with a CNBC article):

But the St. Louis Fed president said in Friday’s “Squawk Box” interview, “I think policy is much easier than it was last year because the outright purchases are more potent tool than the ‘Twist’ program was …

Yes, but only because Twist was very weak.

. . . I don’t think markets have fully absorbed that switch.”

That’s not Bullard’s job.  He hasn’t been hired to outguess the markets.  If he wants to do that he should go run a hedge fund.  His job is to be led around by the markets like a stupid ox with a steel nose ring being dragged along by a farmer.

For the year, Bullard predicted gross domestic product (GDP) growth at 3.0 percent.

It’s not going to happen.  Ironically one of the reasons it’s not going to happen is because James Bullard thinks it is going to happen.

For the 100th time: No subsidized NGDP futures market = criminal negligence.

Yikes, that sounds too negative today, I certainly didn’t mean to suggest Bullard is a stupid ox; I just want him to behave like one.  No, that doesn’t sound right either.  Anyway, TravisV sent me to an article that makes me more hopeful about future Fed policy:

One of the U.S. Federal Reserve’s most prominent advocates of higher interest rates on Wednesday declared it “unwise” to move any further in light of weak inflation and global volatility, suggesting the Fed is stepping further away from plans to continue to hike rates.

St. Louis Fed President James Bullard argued steadily last year for the U.S. central bank to tighten policy and sounded alarms over the risk that continued low rates would create dangerous asset bubbles.

But on Wednesday he said the steady drop in U.S. inflation expectations is now his chief worry and said he will not be comfortable with further hikes until the trend reverses. . . .

Bullard is a voting member of the Fed’s rate-setting committee this year. . . .

“I regard it as unwise to continue a normalization strategy in an environment of declining market-based inflation expectations,” Bullard said. One other “pillar” of the Fed’s decision to hike rates in December has also weakened, he said, because falling equity prices and other tightened financial conditions have made the risk of asset bubbles “less of a concern.”

The Fed, he said, now has “more leeway” to take its time with rate hikes. Bullard said he in particular won’t be ready to move again until inflation-linked bonds signal that investors expect prices to rise at the Fed’s target 2 percent rate.

In a presentation to a group of financial analysts here, Bullard noted that the expected rate of inflation built into some bond prices has fallen as much as 50 percent since mid-2014. Bullard said he at first dismissed the slide as likely linked to the falling price of oil, but now views it as more endemic.

To hike rates in that situation, he said, would put the central bank’s credibility at risk because the Fed remains far from reaching its 2 percent inflation target, considered an important sign, alongside low unemployment, of the U.S. economy’s health.

“Central banks need to defend their credibility. That is why this is worrisome,” Bullard said. [Emphasis added]

The Fed taking its marching orders from the markets?  Does that remind you of a small heterodox school of thought?

India pushes into Asia one inch at a time.  But eventually you see that these incremental shifts have created the world’s highest mountains.  The role of expectations seeps into macro a little bit at a time.  How long before we wake up into a market monetarist world?

PS. I can’t believe I thought I could win friends and influence people with that sort of post back in 2013.  Replace “stupid ox” with “a man so wise that he understands that nothing exceeds the wisdom of crowds.”

Update:  TravisV pointed to this comment, from Bullard’s Powerpoint presentation:

Modern theory suggests that inflation expectations are a more important determinant of actual inflation than traditional “Phillips curve” effects.

Great stuff.

In a recent post I discussed 4 possible interpretations of Tyler Cowen’s post on risk-based recessions:

Perhaps the claim is that we might have a recession this year due to risk, despite 3% plus NGDP growth.  If so, I very strongly disagree.  (This could be viewed as a version of real business cycle theory.)

Perhaps the claim is that if there is a recession, then NGDP growth will slow, but that this will not be the cause.  In other words, even in a counterfactual world where the Fed kept NGDP growing at 3% plus, there would still be a recession for non-monetary reasons.  If so, I very strongly disagree.  (Again, an RBC-type claim.)

Perhaps the claim is that falling NGDP growth is a necessary condition for a recession this year, but it will be caused by growing risk and there is nothing that monetary policymakers can do about it.  If so, I strongly disagree.  (A traditional Keynesian claim)

Perhaps the claim is that falling NGDP growth is a necessary condition for a recession this year, but it will be caused by growing risk that monetary policymakers are too cautious to do anything about.  If so, I mildly disagree.  (A New Keynesian claim.)

Tyler has a new post that discusses some of these issues.  He does not refer to this list, but as far as I can tell he has a fairly eclectic view of business cycles, and thus probably doesn’t want to get pinned down to any single hypothesis.  I’ll go further and speculate that he believes both the RBC and the Keynesian explanations may each apply in some cases.  That is, sometimes recessions are caused by real shocks, and could not be prevented even if the Fed were able to stabilize NGDP growth.  And sometimes there are shocks that it is more useful to think of as “non-monetary” even though they work at least partly through the channel of causing NGDP changes that destabilize the economy.  Perhaps because of some problem such as policy lags or the zero bound, the central bank may not be able to prevent those NGDP shocks, and if they are ultimately caused by some other factor, such as financial distress, then it makes more sense to see the recession as being caused by the financial distress, not the “tight money” label that MMs pin on falling NGDP.

I’m not certain I’ve interpreted his views exactly right, but I’ve tried to state them in a way that I think is quite defensible.

The post also has an extensive critique of areas where market monetarism may overreach, i.e. make claims that are unsupported by evidence, if not borderline tautological.  As I read though this criticism I kept coming back to an observation that seems central to me, but perhaps not to Tyler.  I see his strongest criticism as boiling down to something like “Market monetarism is flawed because we lack a real time indicator of NGDP expectations.”  (My words not his.)  That is we lack a NGDP futures market.  And that is indeed a big flaw.

Right now lots of smart market analysts, like Jan Hatzius, suggest that financial conditions have recently tightened enough to slow growth by 1% to 1.5%.  But it would be better if we had a NGDP futures market.  Indeed even last year at this time we had the Hypermind prediction market, which although flawed, was good enough to give ballpark NGDP estimates.  It showed that no recession was expected in 2015. But now we lack even that.

This is important because MM theory says NGDP expectations are the proper measure of the stance of monetary policy. Lacking that market, we sometimes fall back on actual NGDP.  And Tyler points out that if the central bank targets inflation, then NGDP and RGDP shocks would be perfectly correlated, even if there were no causal link.

So far I’ve been trying to describe his argument in as positive a way as possible.  Now I will start disagreeing:

Here is a recent Scott Sumner post, mostly about me.  It’s basically taking the other side of what I have been arguing, and I would suggest simply disaggregating the ngdp terminology into a more causal language of nominal and real shocks.  Surely there are other independent, ex ante signs for judging the tightness of monetary policy, rather than waiting for ngdp figures to come in, which again is citing a transform of the real gdp growth rate as a way of explaining real gdp.

I find these issues come up many, many times in market monetarist writings.  I think they have basically the right policy prescription, and could provide the world with billions or maybe even trillions of dollars of value, if only policymakers would listen.  But I also think they are foisting a language of causality on the business cycle problem which the rest of economic discourse does not easily absorb, and which smushes together real and nominal shocks into a lower-information accounting variable, namely ngdp, and then elevating that variable into a not entirely deserved causal role.  We ought to talk in terms of ex ante, independent measures of monetary policy looseness, not ex post measures which closely resemble indirect transforms of real gdp itself.

My focus when estimating the stance of monetary policy has generally been NGDP forecasts, not actual NGDP. And NGDP forecasts are available in real time, and hence not subject to the “waiting for ngdp figures to come in” critique above.  This point can be made much more effectively by focusing on the past two months.  Tyler says money is not that tight:

I say [monetary policy is] “not that tight,” while leaving room open for the possibility that it should be looser.

What metrics might we look at?  Federal funds futures no longer expect imminent further rate hikes from the Fed.  Expected rates of price inflation have been very close to two percent.  No matter what you think about the structural component of labor supply, cyclical unemployment has recovered a great deal over the last few years.  And that is through the period of “taper talk” of almost two years ago.  Consumer spending is doing OK, not spectacular but not cut off at the knees.  And while in very recent times price expectations are headed downwards away from two percent, this seems to stem from negative real shocks, to which the Fed has responded passively (perhaps unwisely).  That’s different than the Fed tightening.  There was a quarter point rate hike from December, which is a small tightening for sure, but I don’t see much more than that.

Here’s where I strongly dissent from the thrust of Tyler’s argument.

1. The fact that markets now expect zero Fed funds rate increases this year, not the two expected (or 4 promised) in December, is not a sign that money is getting looser, it’s more likely a sign it’s getting tighter.  While on any given day a rate increase is tighter than not increasing rates, over a 12-month period policy is highly endogenous.  If a crystal ball told me rates would be at zero for another 20 years, I’d take that as evidence that money is currently way too tight.

2. Tyler’s claim that expected inflation is 2% is linked to an earlier post, which discusses not market forecasts, but the forecasts of economists.  Two months ago the consensus of economists called for about 1.8% to 1.9% PCE inflation over the next few years.  But even then, 5 year TIPS spreads showed about 1.2% to 1.3% CPI inflation, which is about 1.0% PCE inflation.  And as the following graph shows, market inflation forecasts have fallen much further in the past two months, so even if policy was roughly on target in December 2015, it’s too tight now.

3. A quarter point rate increase in December may or may not be a “small tightening”.  The size of the rate increase is not a reliable gauge of the degree of tightening, because monetary policy affects rates in two partially offsetting ways (the liquidity effect vs. the income/Fisher effects).  Important recessions (US 1937, Japan 2001, eurozone 2011) have been caused by very small rate increases.

4. The recovery in the labor market doesn’t tell us much about the risk of recession, other than that we aren’t in one yet.

5.  Any “real shock” that reduces NGDP expectations because the Fed responded passively is also a monetary shock.  It could be both monetary and real.  If frightened Venezuelans started hoarding US currency and the Fed didn’t print any more currency, and NGDP fell, I’d call that a tight money policy even if it was “passive.”  In any case “passive” is a meaningless concept in monetary policy, as change can occur along many dimensions; fed funds target, reserve requirement, the monetary base, IOR, exchange rates, price of gold, TIPS spreads, etc., etc.  At any give moment, policy will be active along some dimensions and passive along others.

My views on current business conditions are pretty similar to those of Tyler, AFAIK.  I think we both see a modest risk of recession this year, but less than 50-50.  So suppose there is a recession this year—can I say, “I told you so”?  I certainly didn’t think the rate increase in December would lead to recession (although some other MMs were more pessimistic.)  But that misses the point.  Sorry to be so long winded, but wake up here, this is the key point.

The Fed needs to always keep the “shadow NGDP futures price” close to target.  If at any time they let it slip, as they did in September 2008, and if MMs point out that it is slipping, and if the Fed does not take aggressive actions that it clearly could take to prevent if from slipping, then yes, it’s the Fed’s fault.

That italicized statement does not involve any Monday morning quarterbacking.  I’m not going to blame them for anything that they cannot prevent in real time.  But recall that currently they are not even at the zero bound.  Let’s explain this with a simpler example.  We do have TIPS spreads, so we don’t need shadow prices for inflation expectations.  MMs claim that even with the liquidity bias in TIPS spreads, the current ultra-low 5-year spread suggests money is too tight for the Fed’s 2% inflation target.  That doesn’t mean we’ll have a recession, but if the Fed wants to hit their 2% inflation target they need to ease policy.  If they don’t, and if they fall short of their inflation target, then MMs will have been right.

Now I think it’s possible that the Fed will luck out here, and perhaps even hit their inflation target.  But on balance I believe markets are right more often than not, and the Fed will once again fall short.

Note that if we had a good NGDP futures market I could have reduced the length of this post by 80%.  It would be easy to address Tyler’s various points by referring to NGDP futures prices.  Either they predict recession or they don’t.  Either they are controllable at the zero bound or they are not.  They would be real time indicators, with no Monday morning quarterbacking involved.  But we don’t have that market, so the best we can do is estimate a shadow price of NGDP futures by looking at TIPS spreads, bond yields, stock indices, commodity prices, and a zillion other factors, and construct the best estimate we can of the current market NGDP forecast.  That’s the key variable for me, not actual NGDP.

Actual NGDP comes in to play when we consider level targeting.  MMs believe not just that level targeting would make recessions shorter, we also think it would make them less likely in the first place.  So the one area where we are justified in criticizing the Fed based on actual NGDP numbers is the level targeting issue; are they trying to get us back to the trend line?  If they don’t level target, then recessions are more likely to occur, and will be deeper.

PS.  I’m not sure what Tyler means by saying NGDP is a transform of RGDP.  Does this mean NGDP * (1/p) = RGDP?  If so, isn’t that true of any variable?

M * (V/P) = RGDP

In general,

X * (RGDP/X) = RGDP, where X is the price of a can of tomato paste.

Nor do I understand the “tautology” remark attributed to Angus.  Obviously it’s not a tautology for Zimbabwe. The only way I can make sense of this complaint is that the Fed actually does target inflation, so it makes sense to assume P is stable, whereas it doesn’t make sense to assume V/P or (RGDP/X) is stable.  And if we assume P is stable then NGDP and RGDP become highly correlated.  Fair enough.  But as Nick Rowe recently point out, what matters is the counterfactual where NGDP is kept stable.  Which brings us back to the list at the top of this post.  I think MM critics need to think long and hard about exactly which of those four critiques is the most important, and what sort of empirical evidence we’d use to evaluate that critique.

PPS.  I also have a new post over at Econlog.

PPPS.  I will be doing a “Reddit” on the 23rd at 1 pm, whatever the heck that is.  “Ask me anything.”

[Fourth city in 5 nights.  Tired.  I wrote this a few weeks ago to post while traveling. I hope to respond to comments for this post and earlier posts on Sunday.]

So I started rereading the General Theory, just for the heck of it, and noticed something very interesting.  Early in the book Keynes lays out the musical chairs model of the business cycle.

The General Theory begins with an appalling caricature of “classical economics”. Keynes says that the classical economists believed that unemployment was caused by sticky wages.  This is true.  Then Keynes suggests that the classical economists believed all unemployment was “voluntary”.  The idea was (according to Keynes) that the classical economists believed that full employment could be reached at a sufficiently low wage level, and hence if there were unemployment then it must be voluntary—workers refused to take the pay cuts that would restore full employment.

This makes no sense to me, as it seems to confuse collective action and suffering at the individual level.  No single automobile factory worker can regain a job by cutting his or her wages, and thus their unemployment is every bit as involuntary as if the sticky wages were caused by an Act of God. But that’s not how Keynes looked at it.  Then we come to a sentence that reminds me of the style of a certain famous NYT columnist:

Obviously, however, if the classical theory is only applicable to the case of full employment, it is fallacious to apply it to the problems of involuntary unemployment—if there be such a thing (and who will deny it?).

Who will deny it?  Keynes has just told us that the classical economists deny the existence of involuntary unemployment. Then why say, “Who will deny it?”  Keynes wants the readers to nod their heads, and note that there’s clearly lots of involuntary unemployment 1936, it’s just that the classical economists are too dense to see the obvious.

But what is so obvious about involuntary unemployment, as defined by Keynes? We all agree that there were lots of people without jobs. We all agree that lots of them wanted to be working.  We all agree that lots of them were miserable.  I call that “involuntary unemployment.”  But I think they were unemployed because of sticky wages, and that if workers collectively accepted lower wages then we would have had full employment in 1936.  And Keynes tells us that if we hold the belief that I hold, and that many interwar economists also held, then we are not entitled to say we think there is such a thing as involuntary unemployment.

OK, so what is Keynes’s theory of unemployment?  Brace yourself.

Sticky wages!

The only difference is that Keynes also believes that if workers did accept wage cuts, it would not solve the problem.  Prices would also fall in response, and hence real wages would not fall.  I don’t think he’s right, but the key point is that he thinks that assumption somehow magically turns “voluntary unemployment” into “involuntary unemployment.”  I can’t imagine that the unemployed workers even understand that distinction, or care.  Nor do I understand how the reader is supposed to think it’s “obvious” that there is one type of unemployment and not the other.  Does a miserable unemployed worker look different if his plight is “voluntary” at a level that he has no control over?

It might seem I’m nitpicking, but Keynes’s entire critique of the “classical model” of unemployment falls apart once you allow for the fact that sticky wages can cause involuntary unemployment.  The interwar economists had perfectly fine theories of the business cycle, and Keynes doesn’t lay a glove on them.  So much for chapter 2.

In chapter 3 he argues that demand shocks cause changes in employment, and says that the “classical” economists did not realize this.  The classical economists (supposedly) assumed Say’s Law held true.  And yet during the interwar years the standard model of business cycles was essentially a demand shock model, although economists used different terminology in those days. Fisher did early Phillips Curve models.  Pigou, Hawtrey, Cassel, and the others certainly understood that demand shocks (monetary shocks) affected employment.

I must say that Chapter 3 is beautifully written, especially section 3.  But that must have infuriated the interwar economists all the more.  I can’t even imagine what it would be like to be unfairly attacked by a brilliant economist with a devastating wit. Oh wait . . .

In book II things get much better.  Recall that I often argue that inflation is a vague and undefined concept, which makes real GDP also hard to pin down.  On the other hand I do grudgingly concede that the CPI provides a ballpark estimate of inflation.  I certainly don’t think the actual rate is 8%, as some claim.  Inflation estimates are accurate enough so that we know China has grown faster than Zimbabwe, despite the higher NGDP growth in the latter country.  On the other hand I’ve also suggested that macroeconomists should discard inflation and real GDP, and focus on more easily measured concepts, such as NGDP, wages, and employment.  Now let’s look at Keynes:

But the proper place for such things as net real output and the general level of prices lies within the field of historical and statistical description, and their purpose should be to satisfy historical or social curiosity, a purpose for which perfect precision “” such as our causal analysis requires, whether or not our knowledge of the actual values of the relevant quantities is complete or exact “” is neither usual nor necessary. To say that net output to-day is greater, but the price-level lower, than ten years ago or one year ago, is a proposition of a similar character to the statement that Queen Victoria was a better queen but not a happier woman than Queen Elizabeth “” a proposition not without meaning and not without interest, but unsuitable as material for the differential calculus. Our precision will be a mock precision if we try to use such partly vague and non-quantitative concepts as the basis of a quantitative analysis.

.  .  .

In dealing with the theory of employment I propose, therefore, to make use of only two fundamental units of quantity, namely, quantities of money-value and quantities of employment. . . .

We shall call the unit in which the quantity of employment is measured the labour-unit; and the money-wage of the labour-unit we shall call the wage-unit.

.  .  .

It is my belief that much unnecessary perplexity can be avoided if we limit ourselves strictly to the two units, money and labour, when we are dealing with the behaviour of the economic system as a whole; reserving the use of units of particular outputs and equipments to the occasions when we are analysing the output of individual firms or industries in isolation; and the use of vague concepts, such as the quantity of output as a whole, the quantity of capital equipment as a whole and the general level of prices, to the occasions when we are attempting some historical comparison which is within certain (perhaps fairly wide) limits avowedly unprecise and approximate.

Right on!!  That’s exactly my view. (I did a similar post on this a year ago, with a much longer section of quotations, in case you want more context. Here I’ll explore different implications.)

So Keynes basically has a model with three components:

1.  Aggregate demand shocks (NGDP shocks)

2.  Sticky wage-units  (sticky nominal wages)

3.  Labour unit fluctuations  (employment fluctuations)

Wait, that’s my musical chairs model!

This is all explained by the end of chapter 4, on page 45 of a nearly 400 page book. If I were writing the General Theory, I would have merely added that NGDP is determined by monetary policymakers, and then called it a day after 50 pages.

I probably won’t read any more, because I know what’s coming next.  There will be hundreds of pages explaining what causes demand shortfalls, and monetary policy plays only a modest role in the model.  Why did Keynes and I reach such different conclusions?  Because I am living in a fiat money world where central banks really do determine NGDP.  Indeed if they didn’t then the entire concept of inflation targeting would be nonsensical.  The 2% inflation rate since 1990 would be an amazing coincidence, almost a miracle.

In contrast, Keynes lived in a gold standard world or at least in a world where countries were expected to soon return to a gold peg.  In that sort of world monetary policy was much more constrained.  If you go to the extreme and assume M was fixed, then explaining NGDP is all about explaining velocity.  And what explains velocity?  Things like interest rates and uncertainty.  Here are some things that would lower V when M is fixed:

1.  The public decides to save more–lowering interest rates, which lowers V.

2.  Less animal spirits among businessmen, which leads to less investment, less demand for credit, lower interest rates and lower V.

3.  Fiscal austerity, which lowers government borrowing, lowering interest rates and V.

4.  A big inflow of foreign saving from surplus countries like Germany and China, which depressed interest rates and lowered V.

5.  Wage cuts would transfer income to capitalists, which would boost saving, reduce interest rates, and reduce V.

But Keynes did not build the General Theory around the Equation of Exchange—that would not have been revolutionary.  Instead he created the Keynesian cross and hinted at IS-LM.  Instead of pointing out that shocks to V affect NGDP and hence (because of sticky wages) also employment, he made it seem like thrift, and bearish expectations, and austerity, and beggar-thy neighbor trade policies directly caused unemployment.  He appealed to the prejudices of what he calls the “uninstructed.”  These are, after all, the common sense views of most people, even politically conservative people who are not well versed in economics.  Here’s Keynes:

That it [classical theory] reached conclusions quite different from what the ordinary uninstructed person would expect, added, I suppose, to its intellectual prestige.

The General Theory screams out that the uninstructed people were correct, and then whispers that they were correct for the wrong reason, and not at all when monetary offset applies.  The problem here is that he was too successful.  We now have several generations of reporters and politicians who think this these bearish factors are always contractionary, even when not at the zero bound.

Of course Keynes did talk about the possibility of monetary stimulus, and was pessimistic that it would be sufficient in a deep depression, for standard liquidity trap reasons (actually its more complicated, but the liquidity trap is still a necessary condition for complete monetary policy ineffectiveness.)  And even if there was not a complete liquidity trap, under a gold standard the ability to print money was limited.

To summarize, Keynes started with the same basic business cycle model as I use—the musical chairs model.  Combine deficient nominal spending with sticky wages and you end up with high unemployment.  But he did not become a market monetarist, for two reasons:

1.  He did not think that wage cuts would help, they would merely lead to further cuts in AD.

I think that’s wrong, but I also think it’s a pretty minor dispute.  As a practical matter I don’t think wage cuts are a very effective solution to a collapse in NGDP. The big difference is the second distinction:

2.  He did not think the monetary authority could provide adequate levels of AD (NGDP) during a depression.

There’s an interesting similarity between these two points.  Keynes was very clear that excessively high real wages were a root cause on unemployment, but didn’t think nominal wage cuts would help.  Keynes was very clear that inadequate spending in money terms was the root cause of labor markets being out of equilibrium, but didn’t think printing more money would (necessarily) solve the problem.  So in both cases he correctly diagnosed the problem, but drew back from the obvious solution.

However I do think we need to cut him some slack here.  Things looked very different in a gold standard world, and most other economists were just as confused as he was.  A few such as Fisher, Hawtrey and Cassel saw the true nature of the (monetary) problem more clearly than Keynes did, but they were the exception.

I’m a bit skeptical about the utility of the Keynesian model, even in a world of constrained monetary policy.  But here I need to admit that an awfully lot of very smart people see things differently than I do, so it’s at least plausible that the Keynesian model has merit as a sort of backdoor way of explaining movements in V when M is fixed, and hence as a theory of demand side business cycles under certain types of monetary regimes.

But I don’t think I’ll read anymore.  I can’t bear to work though 100s of pages of convoluted (implicit) explanations for why certain shocks might impact V.  If only Keynes had stopped at page 45 and said:

“So the central bank should create a NGDP futures market and target the futures price along a track rising at 4%/year.  That makes the world safe for classical economics.

The end.”

I define monetary policy in terms of NGDP growth.  So tight money occurs when NGDP (or expectations of NGDP) are falling.  I also claim that tight money causes most recessions.  Some commenters argue this is a tautology.  That complaint is actually really stupid.  Just think about Zimbabwe, where RGDP plunged as NGDP rose by zillions of a percent.  But it’s also an unintentional compliment, as we’ll see.

I frequently point out that the unemployment rate is strongly correlated with the ratio of wages to NGDP.  Some people argue that this is a tautology.  That’s actually a somewhat more reasonable complaint, although it’s not accurate.  I say reasonable, because a slightly different version of the “musical chairs model” (MCM) would be a tautology. This version:

1/employment (in hours) = W/Aggregate nominal labor income.

I replaced unemployment with 1/employment (in hours), and I replaced NGDP with total labor compensation, which is well over half of NGDP, and highly correlated with NGDP.

So what’s going on here?  Is this a model or a tautology?  And if it is a model, how do we falsify it?

Here it would be helpful to think about how a real business cycle (RBC) economist, AKA “new classical” economist, would criticize the MCM, if one of them actually took the time to examine my pathetic little model.

They’d clearly accept the fact that NGDP and RGDP growth are highly correlated in the US, and that unemployment is highly correlated with W/NGDP.  That’s not the issue. The issue is the policy counterfactual.  We observe that NGDP is often more volatile than W, especially during periods like 2008-09, where NGDP suddenly fell by 3%, or roughly 8% below trend, and wage growth only slowed very slightly.  So W/NGDP rose sharply, as did unemployment.

My counterfactual is that had NGDP kept growing at 5% in 2008-09, then RGDP would have also kept growing (although it would have slowed slightly for supply-side reasons) and I claim that wages would have continued growing at about 4%.  An RBCer would not agree.  In their view the counterfactual result would be high inflation and high nominal wage growth, indeed wages soaring at perhaps 10%/year, or something like that. And because wages would have soared by 10%, the stable 5% NGDP growth would lead to 5% fewer hours worked, and the unemployment rate would soar from 5% to 10%. RBCers don’t believe than nominal shocks have real effects.  The Great Recession was caused by real factors, in their view.

The math fits, but how plausible is that counterfactual?  And keep in mind, BTW, this is the ONLY possible counterfactual to my claim that stable NGDP growth would have maintained high employment in 2008-09, (or at least that stable growth in nominal aggregate labor income would have worked, if you want to be picky.)  Even if you are not a RBCer, but blame it on “reallocation”, this HAS TO BE your theory.  For the RBCers to be right:

1.  Wages must be highly flexible, and that flexibility is cleverly hidden by Fed policies that, de facto, keep equilibrium nominal wage growth fairly stable.

2.  It must be true that with a 5% NGDP growth counterfactual, wage growth would soar much higher in a period of fast rising unemployment like 2008-09, all because, well because fast rising wages are mathematically required to produce the big drop in hours worked that the RBCers insist is the “equilibrium” outcome of some mysterious hard to identify technology shock that causes workers to want to take long vacations. Or something like that.

Can you tell that I don’t find the RBCers counterfactual to be particularly plausible?

Other possible flaws in the musical chairs model?  There really aren’t any.  When we get to the policy implications, you can certainly question my claim that:

NGDP = stance of monetary policy,

or that the Fed is capable of stabilizing NGDP growth at 5%, or ask whether fiscal policy is needed too.  But those policy issues are entirely separate; here I’m just trying to figure out what causes business cycles.

And basically it’s fluctuations in W/NGDP.  Which are mostly caused by NGDP shocks. Period, end of story.  It’s a really ugly model, and kinda stupid.  I wish it weren’t true. But it’s also incredibly robust, just unbelievably robust.  Unlike New Keynesians who utilize the Phillips Curve, I can go to sleep at night with serene confidence that I won’t wake up to Bob Murphy or Arnold Kling, or anyone else having some sort of empirical evidence that refutes the model.  At best someone might find an episode where it doesn’t fit it quite as well as usual.

The more interesting question is whether the rest of the profession should take this seriously as a model.  I’m too close to give an objective answer.  Take a look at these graphs, in a blog post by “Robert“:

Now take a look at the bottom graph.  See that spike at zero?  The RBC model predicts no spike there at all, because there in no money illusion allowed in the RBC model.  So immediately we know that the RBC model is wrong.  But all models are wrong, even mine.  The real question is how wrong.  Maybe they are wrong in assuming no wage stickiness, but in fact there’s only a small amount of wage stickiness, and the RBC model is almost true.

Fair enough.  But then they need to convince the rest of the profession on empirical grounds.  And go back and read my points #1 and #2 above.  Good luck convincing the rest of the profession that those counterfactuals are even remotely plausible.

If we can dismiss the RBC critique of the musical chairs model (which no one has made, AFAIK, but it’s the critique that would be made, by anyone who believed the RBC model) then what’s left for me to defend?  Mostly monetary policy.

So let’s say we agree that NGDP shocks cause recessions.  OK, that’s not very controversial; indeed it’s pretty much Keynes’s General Theory (I’ll do a post soon explaining why the General Theory is basically the musical chairs model.)  So I can’t really claim to have invented anything here.  But somehow we’ve drifted away from the General Theory, which focused on NGDP and average hourly wages and employment, to NK models that focus on interest rates and inflation and output.  And that’s obscured Keynes’s musical chairs model.  Instead of using NGDP shocks to explain employment fluctuations, we use interest rates and government output and technology shocks and price shocks to explain output.  It all becomes very confusing, when in fact demand-side recessions are very simple—not enough NGDP to pay the workers.

Maybe if we had an NGDP futures market we could start thinking of NGDP as a policy choice for the central bank, a tool, a lever, and then the musical chairs model would be right in front of us, staring us in the face.  Unavoidable.

No matter how hard you try to focus on something else like price stickiness or technology or investment shocks or whatever, W/NGDP is right there, right in front of you. It’s the sine qua non of demand side macroeconomics.  If the causation doesn’t go from NGDP, to W/NGDP, to employment, then the RBCers are right.  And they ain’t right.

PS.  Robert relied on this paper by Mary Daly and Bart Hobijn.