Kevin left this comment after my last post:

I will just add that if we asked someone to point out where reckless monetary policy led to a demand-side housing bubble, nobody looking at those last two graphs would pick the 2000s. Nobody. The entire public discussion of finance over the past 15 years has been a massive exercise in reasoning from a price change. It’s not even like there is a point to it but some people take it too far. There is simply nothing there besides reasoning from a price change.

NGDP growth at the peak in the 2000s barely even reached the average growth rate of post WW II, yet the description that is considered above a burden of proof is the one that sees this period as some sort of crazed bubble where debt and money were flowing out of control.

Marcus Nunes also made a good point:

Scott, I think there are several things wrong in this post!
You should reread your early Feb 09 post: GDP=Y+C+I+NX=Gross Deceptive Partitioning!

If we use that earlier post as a starting point, we’d begin by looking at NGDP instability.  Then we’d ask why RGDP instability deviated from that level during certain periods, such as the 1970s.  And almost by definition it would have to be due to non-procyclical prices, such as the oil shocks, or price controls, or perhaps AS shifting due to changes in expected inflation.  All three occurred during the Great Inflation.  In other words, the analysis of components was a sort of dead end in Marcus’s view, and he’s probably right.

Caroline Baum sent me a NYT story with “reasoning from a price change” implications. It is entitled “A Global Chill in Commodity Demand Hits America’s Heartland.”  To its credit they do also mention the previously popular “tax cut” theory:

The 37 percent drop in gasoline prices since the summer of 2014 is the equivalent of a $100 billion tax cut, providing much-needed relief while wages remain stuck.

Certainly falling commodity prices have different effects on different sectors, but as for overall RGDP?  That would be reasoning from a price change.

And finally, someone needs to tell Greg Mankiw that “objects in his rear view mirror may be closer than they appear”.  (And for the first and last time in my life I’m one ahead of Krugman on a list.)

Yes, I know, it’s not textbook season.

Always dangerous to speculate when the market is changing minute by minute, but a few observations:

1.  Over at Econlog I did a post earlier this morning, suggesting that the China slowdown is reducing the Wicksellian equilibrium global interest rate.  Since central banks foolishly target interest rates rather than NGDP, this makes monetary policy more contractionary.

2.  Why does this seem to affect foreign markets more than the US market?  One possibility that that economies like Germany and Japan are more exposed to a global slowdown, as manufacturing exports are a bigger part of their economies. But that suggests the yen and euro should be falling against the dollar, whereas they are actually appreciating strongly.  Indeed the appreciation is so strong that one could easily attribute much of the recent stock market decline in Europe and Japan to their strengthening currencies.  Now of course I always say “never reason from a price change,” so let me emphasize that I am implicitly assuming the stronger yen and euro reflect tighter money, not surging growth expectations in Europe and Japan.  I don’t think anyone in their right mind believes global growth prospects have been rapidly improving in the last week, especially when you look at commodity and stock prices.

3.  The falling TIPS spreads and real interest rates suggest that AD expectations are falling in the US, but not anywhere near to recession levels.  After all, did anyone expect a recession last time the S&P was at this level?  Obviously not.  The tighter money in Europe and Japan suggests those economies will be hit harder than the US.

4.  If Europe and Japan are facing tighter money than the US, why would that be? Probably because markets think it would be easier for the Fed to at least partially offset this shock, via a delay in the interest rate increase.  Areas already at the zero bound would have to be more creative, and history has shown that central banks tend to be slower to react at the zero bound, especially when there are sudden and unanticipated shocks like this.  (It’s easier to offset anticipated shocks, like 2013’s fiscal austerity.)

This is all very speculative, and I don’t have a lot of confidence on my analysis. And as always, I don’t forecast asset prices, I merely try to ascertain what the market is forecasting.  Unfortunately the Hypermind market is still not very efficient.  It opened this morning at 3.6%, which was actually up slightly in the past few days.  I don’t think that reflects actual NGDP expectations.  Last I looked it was down to 3.4%, but of course efficient markets respond immediately to shocks.  This tells me that while the market is a nice demonstration project, there is no substitute for a very deep and liquid NGDP prediction market subsidized by Uncle Sam.  If it’s not the biggest $100 bill on the sidewalk, it’s right up there.

One other point.  I’m much more concerned by falling TIPS spreads and falling 30-year bond yields, than I am by falling equity prices.  Stocks often show large price breaks, without there being any change in the business cycle.

PS.  I agree with Lars Christensen’s analysis (except the part about China not becoming the biggest economy.  We face this problem because they already are the biggest.)  I think Lars is right about the two key mistakes being the Chinese yuan/dollar peg and Yellen’s tight money policy.

The Neo-Fisherian debate continues, and continues to miss the point.  The debate is framed in terms of whether a higher interest rate causes higher inflation.  But that’s not even a question.  Or at least it’s meaningless unless you explain whether the higher interest rate is produced by an expansionary monetary policy or a contractionary monetary policy. Central banks have the tools to do it either way.  On the other hand I am increasingly getting the impression that the New Keynesian model is incapable of handling that distinction.  Here’s John Cochrane responding to a recent Woodford talk on the issue:

This is a particularly important voice, as it seemed to me that standard New-Keynesian models produce the new-Fisherian result. i = r + Epi is a steady state in all models. In old-Keynesian models, it was an unstable steady state, so an interest rate peg leads to explosive inflation or deflation. But in new-Keynesian models, an interest rate peg is the stable/indeterminate case. There are too many equilibria, but if you raise interest rates, inflation always ends up rising to meet the higher interest rate.

What I can glean from the slides is that Garcia Schmidt and Woodford agree: Yes, this is what happens in rational expectations or perfect foresight versions of the new-Keynesian model. But if you add learning mechanisms, it goes away.

My first reaction is relief — if Woodford says it is a prediction of the standard perfect foresight / rational expectations version, that means I didn’t screw up somewhere. And if one has to resort to learning and non-rational expectations to get rid of a result, the battle is half won.

But that’s only preliminary relief. Schmidt and Woodford promise a paper soon, which will undoubtedly be well crafted and challenging.

If that’s true, then the NK model is obviously very, very flawed.  Noah Smith seems to agree that rational expectations is the key assumption:

The question of whether interest rates affect inflation in a Woodfordian way or a Neo-Fisherian way depends on whether people’s expectations are infinitely rational. Woodford’s new idea – which will certainly be a working paper soon – is that people don’t adjust their expectations to infinite order. He essentially puts bounded rationality into macro. He posits a rule by which expectations converge to rational expectations.

I have one small quibble here.  When Smith writes:

The question of whether interest rates affect inflation in a Woodfordian way or a Neo-Fisherian way depends on whether people’s expectations are infinitely rational.

He seems to imply that he is discussing the real world.  Like it would actually matter whether people had ratex. My hunch is that you can easily get either result with or without ratex, if you don’t restrict yourself to the NK model.  The liquidity effect from easy money should be able to be derived with simple sticky prices, even with ratex.  I’d rather Smith had said:

The question of whether interest rates affect inflation in a Woodfordian way or a Neo-Fisherian way in the NK model depends on whether people’s expectations are infinitely rational.

BTW, in this post I showed how you could get a Neo-Fisherian result.  That doesn’t mean I think they are “right”, just the opposite.  But I am increasingly confident that they have stumbled on something important, a serious flaw in the NK model. I’d rather people continue to assume rational expectations, and fix the model in some other way—like defining monetary policy in terms of something other than interest rates.  Stop assuming that “the central bank raises interest rates” is a meaningful statement.  It isn’t.

PS.  I wrote this a couple days ago but wasn’t sure if I was missing something, so I didn’t post until today.  Nick Rowe’s new post convinced me that I’m not missing something obvious.

HT:  Tyler Cowen

1.  For a guy who has been right about everything, Paul Krugman sure is wrong about an awful lot of things.  Bob Murphy has an excellent new post which digs up lots of Krugman claims that turned out to be somewhat less then correct.

Krugman, armed with his Keynesian model, came into the Great Recession thinking that (a) nominal interest rates can’t go below 0 percent, (b) total government spending reductions in the United States amid a weak recovery would lead to a double dip, and (c) persistently high unemployment would go hand in hand with accelerating price deflation. Because of these macroeconomic views, Krugman recommended aggressive federal deficit spending.

As things turned out, Krugman was wrong on each of the above points: we learned (and this surprised me, too) that nominal rates could go persistently negative, that the US budget “austerity” from 2011 onward coincided with a strengthening recovery, and that consumer prices rose modestly even as unemployment remained high. Krugman was wrong on all of these points, and yet his policy recommendations didn’t budge an iota over the years.

Far from changing his policy conclusions in light of his model’s botched predictions, Krugman kept running victory laps, claiming his model had been “right about everything.” He further speculated that the only explanation for his opponents’ unwillingness to concede defeat was that they were evil or stupid.

Read the whole thing.

2.  Caroline Baum has a very nice post on “never reason from a price change.”  She’s one of the relatively small number of journalists that seem to really get this idea.

The Fed is equally confused when it comes to long-term rates. If you were to ask policy makers if interest rates move pro-cyclically, they would all answer yes. But when rising market rates become a reality, the cries go out that higher rates will damage the economic growth. At the same time, a decline in long rates is automatically assumed to provide economic stimulus. Alas, the expectation that the 100-basis-point decline in 10-year Treasury yields last year would boost investment was mugged by reality.

Getting back to oil prices, economists are still waiting (hoping?) for the oil-price-tax-cut to materialize. Bad weather is getting old as an excuse.

Read the whole thing.  Moving from the sublime to the ridiculous:

3.  John Tamny has a post entitled:

Baltimore’s Plight Reveals the Comical Absurdity of ‘Market Monetarism’

In case you are wondering who John Tamny is, in an earlier post he explained that Bernanke’s inflation targeting idea was unwise, as it would imply that each and every price was stable, not just the overall price level.  Flat panel TV prices could no longer decline.

I’m too busy to do a post mocking all of Tamny’s more recent claims, but he was polite enough to write it in such a way that all I really need to do is quote him.  It’s self-mocking:

‘Market monetarists’ believe that economic growth can be managed by the Federal Reserve.  .  .  .

Market monetarists’ believe the Fed can achieve the alleged nirvana that is planned GDP growth and national income through money supply targets set for the central bank by members of the right who’ve caught the central planning bug.  .  .  .

In fairness to the neo-monetarists, they would all agree that Baltimore has problems that extend well beyond money supply. Still, if money supply planning is the alleged fix for the broad U.S. economy, presumably it would have a positive impact locally.  .  .  .

Specifically, ‘market monetarists’ seek consistent money supply growth, and then when the economy is weak, a bigger increase in the supply of money to boost GDP. . . .

It’s kind of simple. Money supply once again can’t be forced. . . .

It can’t be repeated enough that production is money demand, and is thus the driver of money supply. Money supply shrank in the 1930s not because the Fed decreased it (if it had, alternative sources of money would have quickly revealed themselves), but because the federal government erected massive tax, regulatory, and trade barriers to production. All that, plus FDR’s devaluation of the dollar from 1/20th of an ounce of gold to 1/35th of an ounce in 1933 further put a damper on the very investment that powers new production. It’s forgotten by economists today, but when investors invest they’re tautologically buying future dollar income streams.

If you are looking for a few laughs, the Tamny piece is highly recommended. Indeed I’d call it “tautologically funny.”

PS.  Over at Econlog I have a new post that indirectly addresses some of the confusion in the Tamny post.

HT:  David Beckworth

Update:  Well I may not have gotten the ECB to adopt NGDPLT, but consider this comment from yesterday’s post:

Must be nice to be the sort of rich hedge fund manager that gets this “critical” information before the rest of us.

And from today’s WSJ:

The ECB will post speeches of its board members on its website when they are scheduled to begin, without making them available to journalists ahead of time under embargo as the ECB had done for many years.

The decision, which takes effect immediately, came one day after the public release of comments by executive board member Benoit Coeuré caused a stir in financial markets. Mr. Coeuré  said the ECB would front load bond purchases under its €1.1 trillion ($1.2 trillion) quantitative easing program in May and June to account for a summer lull in bond markets.

HT:  lysseas

Back in late 2014, many pundits assured us that falling oil prices were bullish for the economy.  I countered that one should never reason from an oil price change.  The net effect is ambiguous.  As the following graph shows, industrial production had been rising fast in the period leading up to November 2014, but has been falling ever since.  GDP was almost flat in Q1, and the Atlanta Fed says growth will also be slow in Q2.

That does NOT mean falling oil prices hurt the economy, an equally unjustified assumption.  Rather it is monetary policy (NGDP growth) that drives short run changes in output.  NRFPC!