Tyler Cowen asks:

Why are bank stocks falling so rapidly?

I can’t be sure, but my hunch is that bank stock prices are weakening for the same reason they crashed in the second half of 2008.  Falling NGDP expectations led to falling asset prices, which weakened the balance sheets of banks.

Many people assume low interest rates help banks.  Sometimes that’s true.  But not always.   Never reason from a price change . . .

I almost always agree with Paul Krugman’s views on inflation.  We’ve both been skeptical of claims that US monetary and fiscal policy will produce high inflation.  Krugman points to the economic slack in the economy, I focus on TIPS spreads.    In a recent post, Krugman made the following observation:

. . . if we think of wages as the ultimate core price, I don’t see any mechanism in today’s America whereby rising commodity prices translate into higher wage contracts.

But what does the historical record say? It depends on which era you’re looking at.  . . .

The two big commodity price shocks of the 70s did, in fact, feed quickly into core inflation. Since then, however, nada.

Why the difference? The obvious point is that back in the 70s many labor contracts included cost of living adjustments (COLAs). This in turn partly reflected stronger worker bargaining positions and also real doubts about whether monetary policy would contain inflation. Today, none of that: COLAs are rare, and commodity-price fluctuations don’t feed into wages at all.

My only observation here is that we don’t even need to bring COLAs into the picture.  Wages respond to trend NGDP growth, and those growth rates were extremely high during the 1970s, even during recession years.  For instance, NGDP grew at an 11% rate between 1971:4 and 1979:4, and then grew another 9.6% in 1980, despite a mild recession.  Since monetary policy determines the trend rate of NGDP growth, this analysis is consistent with Krugman’s observation that in the 1970s there were “real doubts about whether monetary policy would contain inflation.”  But the phrase “contain inflation” is a tad misleading—suggesting that inflation was like a wild animal on the loose and needed to be reined in by the Fed.  The Fed caused the Great Inflation.

As you know, I often say “never reason from a price change.”  I think we’d be better off talking about the impact of NGDP on wages, which is fairly stable, rather than the impact of prices on wages, which is highly dependent on whether prices are rising because of more demand, or because of supply-shocks.  As we saw in mid-2008, high headline inflation doesn’t translate into big pay increases if not associated with fast NGDP growth.  The Economist made a similar observation for Britain:

But a jump in inflation caused by higher commodity prices and a rise in VAT””in an economy with spare capacity””is quite different from one caused by excess demand and a pay-price spiral. It intensifies the squeeze on households from other tax rises and curbs consumer spending.  Although the central bank is facing calls to tighten monetary policy soon, that would be warranted only if there were signs of inflation getting embedded into expectations and feeding through to higher wages.

Unsurprisingly, households are now expecting inflation to be higher over the coming year. But other official figures published this week showed no sign of a pay-price spiral. Average earnings are rising by just 2.1%, a very muted rate by historical standards. It is difficult to envisage wages taking off when the public sector is shedding jobs and facing a two-year pay freeze and there are 2.5m people unemployed, close to 8% of the labour force. Indeed the youth-unemployment rate has reached 20.3%, the highest since comparable records began in 1992.

The economy clearly retains quite a bit of spare capacity””the main reason why the Bank of England has insisted that the flare-up in inflation will be temporary. The bank has lost credibility as the inflation overshoot has persisted and its forecasts have proved incorrect.

[there was a rogue paragraph in the original version, which I deleted]

Keynesians often focus on economic slack as a determinant of wage gains.   That’s a bit too simple (as we saw in the 1970s); the more sophisticated Keynesian models now account for expected inflation.  And in fairness, the “slack” model of wages does seem to outperform the NGDP growth rate model during recoveries, when wage gains are often quite moderate, despite fast NGDP growth.

But there’s a good reason why wage gains often trail NGDP growth during a recovery—wage cuts trail declines in NGDP during most contractions.  Thus wages are still adjusting to the previous drop in AD during the early stages of a recovery.  The Keynesian model is good at explaining cyclical variations in wages, but not so good at explaining long run changes in trend wage growth, and trend NGDP growth.  For that you need the quantity of money.

Britain is facing an interesting dilemma.  The BOE clearly understands that NGDP, not prices, are the best indicator of demand.  They understand that it would be a mistake to react to the 3.7% headline inflation in December (yoy), by tightening monetary policy.  But they are constrained by the fact that almost everyone (wrongly) thinks it’s the central bank’s job to control inflation.

In contrast, fiscal policy is almost always evaluated in terms of real GDP growth.  This dichotomy makes no sense.  There is no macro model of any school of thought that says monetary policy controls inflation by shifting demand, and fiscal policy controls RGDP by shifting demand.  Yet when RGDP growth in Britain came in at a disappointing minus 0.5% in Q4, almost all the reports pointed not to the BOE, but to the fiscal austerity of the new British government. Even Brad DeLong, who devoted much of his talk at the recent AEA meetings to emphasizing the importance of NGDP, quotes an article giving a RGDP number for Britain.  RGDP numbers tell us nothing about whether demand stimulus is succeeding.  In fairness, I believe the UK NGDP numbers come out with a lag, but the problem is much deeper than that.  The media overwhelmingly sees fiscal policy as a RGDP issue and monetary policy as an inflation issue.  Until both are seen as NGDP issues we will not be able to come up with coherent policy regimes, which assign fiscal and monetary policy their appropriate roles.

There are two ways British policy might fail.  First, the BOE might fail to hit its implicit NGDP target.  Why would that occur?  Not because Britain is in a liquidity trap.  They are actually expected to tighten policy this summer.  And Britain can always depreciate its currency if it wants to.  It could even cut rates another quarter point.  No, with 3.7% inflation it’s madness to even talk about liquidity traps.  If they fail it will be because fear of politically embarrassing headline inflation numbers caused BOE officials to take their eye off the ball (NGDP.)  However if BOE policy does fail to boost NGDP, I predict fiscal austerity will be blamed.

Alternatively, policy might fail because the Gordon Brown government did significant damage to the supply-side of the UK economy, by increasing the size of the state.  A supply-side failure would show up as stagflation, i.e. appropriate NGDP growth but high inflation and slow RGDP growth.  Although we saw a bit of stagflation in the 4th quarter, it’s too soon to draw any conclusions.  Inflation will probably slow over the next few years.

I predict that if policy does fail for supply-side reasons, the failure will be widely attributed to demand-side factors, especially fiscal austerity.  That’s because everyone focuses on RGDP, and almost no one pays any attention to NGDP.

This past May I pointed out that the euro debt crisis was increasing the demand for dollars and depressing AD in the US.  One sign was the dollar appreciating as investors fled to safety.  As I expected, this slowed the US economy in the second and third quarters, necessitating the Fed’s QE2 program.  QE2 did “work,” at least to a limited extent.  It raised the prices of assets such as stocks and foreign exchange.   Rumors of QE2 may have roughly offset the effects of the euro crisis, putting the dollar and expected NGDP growth back where they were in April.

Unfortunately, the euro crisis seems to be flaring up again.  Look at how the euro has recently slipped from 1.40 to 1.35.  As the dollar rises again, stocks start declining.  Let’s hope this is just a temporary blip; if the euro crisis became severe it could have a deflationary impact on the US economy–requiring still more QE (or better yet something more effective like level targeting or much lower IOR.)  Ironically all this occurs against a backdrop of relentless criticism of the Fed’s “inflationary” policies.

Readers of this blog might recall I often say “never reason from a price change.”  So why am I making such a big deal about changes in exchange rates?  In fact, it is very dangerous to draw conclusions from exchange rates alone.  You need to look at the news events that cause the changes, and look for confirmation in other asset markets such as stocks, commodities, commercial real estate and TIPS spreads.

The ECB doesn’t seem to realize that its policy is far too tight for most eurozone members; not just the PIIGS, but also major economies like France.  This is making the eurozone debt crisis even worse, although in my view they also face serious long term fiscal imbalances that go beyond the current recession.

The tight money policy in Europe causes the debt crisis to flare up and the euro itself depreciates as there is a flight to safety.  And guess which major exporter of machinery benefits from the weaker euro?  My Canadian readers might like this analogy: Suppose commodity prices plunge.  This might weaken the Canadian dollar, as Canada is a major commodity exporter.  But it might also help the manufacturing exporters in the Ontario region.

Currencies are not a zero sum game.  The tight money policy of the ECB makes eurozone NGDP growth decline, even if the euro depreciates during a debt crisis.  An exchange rate of 1.35 could represent easy money in both the US and Europe, or tight money in both regions.  With all the focus on exchange rates let’s not lose sight of the underlying monetary policies, which show up in expected NGDP growth rates in each region.  Get those right, and it makes little or no difference what happens to exchange rates.

PS:  A few posts back I linked to an amusing anti-QE video.  A commenter named “wkw ” animated it for me, and Greg Ransom was nice enough to colorize the animation.  (He doesn’t know that I prefer watching classic film is the original B&W version.)  If I knew people were going to be speaking my lines, I wouldn’t have used ungainly phrases like NGDP.

Paul Krugman continues his habit of assuming the worst about those with whom he disagrees.  In a new post, entitled “The Worst Economist in the World” he discussed the following quotation from the WSJ:

When one country devalues its currency, others tend to follow suit. As a result, nobody achieves trade gains. Instead, the devaluations put upward pressure on the prices of commodities such as oil. Higher commodity prices, in turn, can cut into global economic output. In one ominous sign, the price of oil is up 8.7% since August 27.

OK, it’s not the best thing I’ve ever read.  There are two possible interpretations, neither of which are entirely satisfactory.  First, he might have been referring to the fact that all currencies could simultaneously depreciate against goods and services.  Unfortunately, it seems extremely unlikely that a modern journalist would refer to inflation as “devaluation.”  More likely, he had the following scenario in mind:  The US depreciates first by using QE, then other countries do the same.  This would bring dollar exchange rates back to their original equilibrium, but leave all prices higher.

Does Krugman have any idea, any clue, as to how difficult it would be to win the title of most economically illiterate journalist?  With all due respect to Mr. Krugman, I don’t think the WSJ quotation even comes close.  By analogy, I was always the last person picked for basketball in high school, despite being 6′ 4”.  But was I the worst player in the world?  After all, there are people who are blind, or 105 years old, or in comas.  I expect better, er I mean worse, from Mr. Krugman next time.

I prefer Matt Yglesias’s take on the same quotation.  He senses what the WSJ was trying to get at, but points out that right now higher oil prices might be a positive sign:

If you try to reason in this direction, you end up tying yourself into knots. Is a higher price of oil “ominous.” Well it depends why it’s going up. If a bunch of equipment in the North Sea breaks, then the price of oil is increasing because the quantity of oil available to the world economy has declined. That’s bad because oil is useful. But conversely, if the US economy were to start growing rapidly that would increase the demand for oil and lead to a price increase. That, however, would be a good thing. If the world’s central banks engage in coordinated monetary stimulus, that will result in some inflation (and hence higher nominal oil prices) but some inflation would be helpful at the moment. But if Israel and Iran go to war, that will also increase the price of oil and it’ll be terrible.

In general, higher supply of useful commodities is good (and leads to lower prices) and higher demand for useful commodities is a side-effect of good things (and leads to higher prices) so you can’t just look at commodity prices and draw any conclusions about what’s happening.

That’s right.  Never reason from a price change.  That’s the real problem with the WSJ quotation.

The following is related to my most recent essay at The Economist.

I suppose it’s presumptuous for me to pontificate on Bretton Woods II, given I found out the meaning of the term only a few weeks ago.  But heh, that’s never stopped me before.  Here’s Wikipedia:

Bretton Woods II was an informal designation for the system of currency relations which developed during the 2000s. As described by political economist Daniel Drezner, “Under this system, the U.S. is running massive current account deficits to be the source of export-led growth for other countries. To fund this deficit, central banks, particularly those on the Pacific Rim, are buying up dollars and dollar-denominated assets.”

Well at least I was aware of the phenomenon.

There’s been a lot of recent discussion of whether Bretton Woods II is about to fall apart, with this post by Tim Duy being perhaps the most authoritative:

The inability of global leaders to address global current account imbalances now truly threatens global financial stability.  Perhaps this was inevitable – the dollar has not depreciated to a degree commensurate with the financial crisis.  Moreover, as the global economy stabilized the old imbalances made a comeback, sucking stimulus from the US economy and leaving US labor markets crippled.  The latter prompts the US Federal Reserve to initiate a policy stance that will undoubtedly resonate throughout the  globe.  As a result we could now be standing witness to the final end of Bretton Woods 2.  And a bloody end it may be.

I don’t know whether Bretton Woods II is about to collapse or not.  But I am skeptical of much of the discussion of global imbalances, which in my view focuses far too much on currency/trade questions, and far too little on savings/investment imbalances.  Before considering Duy’s views, I’d first like to address an argument recently made by Michael Pettis:

For that reason I am always puzzled by people who say that devaluing the dollar will have no impact on the US trade deficit because the problem is low savings relative to investment.  No, that is not the problem.  That is simply one of the definitions of a current account deficit.  But if the dollar devalues, and consumer prices rise, US consumption is likely to decline.  In addition, to the extent that any of the stuff Americans used to import before the devaluation is now produced domestically (not all, but any), then US production must rise.  Since savings is equal to production minus consumption, the US savings rate must automatically rise.

As you may know, I’ve never liked arguments that “reason from a price change”:

1.  Next year the price of oil will be higher, therefore we can expect consumers to . . .

2.  Interest rates will fall therefore we can expect investment to . . .

3.  The dollar will fall therefore we can expect exports to . . .

This is often a misuse of basic supply and demand theory.  There is no necessary correlation between a price change and a quantity change; it entirely depends on why the price changed.  Was it more supply, or more demand?  Now that doesn’t mean Pettis is wrong here, he probably assumed a particular cause of the price change in the back of his mind.  But we need to start with that fundamental cause.

Often when people talk about the need for the US to devalue the dollar, they imagine it occurring through an expansionary monetary policy.  But monetary policy doesn’t have real effects in the long run, so it can’t solve secular problems.  There is no particular reason to expect that having the Fed devalue the dollar would “improve” the US trade balance:

1.  In the long run money is neutral; hence the real exchange rate is unaffected.

2.  In the short run the trade balance might get worse due to the J-curve effect.

3.  If monetary stimulus has a business cycle effect, then the trade balance might get worse if the stimulus creates a boom in the US.

So while Pettis might be right, I don’t have much confidence that the sort of dollar depreciation people are currently discussing would materially affect the US trade balance.  The most “beggar-thy-neighbor” policy in American history was probably the massive devaluation of 1933, and the trade deficit initially got worse.

Of course it may be the case that a country adjusts its currency value by altering the savings/investment equation.  For instance, many people are calling on China to revalue it’s yuan by purchasing fewer foreign bonds.  That doesn’t necessarily reduce Chinese saving (it depends what else the Chinese government does) but there are certainly scenarios where it might.

On the other hand I don’t have much confidence that a laissez-faire attitude in China would materially affect the US trade balance in the long run.  Remember that if China removed all currency controls, it would also be much easier for Chinese citizens to invest overseas.  I think we need to see China in a broader East Asian context.  One reason I could foresee Bretton Woods II being around for a long time is that East Asia is very different from the West, and those differences will become much more important over time, as East Asian wealth skyrockets.  (The term “skyrocket” is not hyperbole, Chinese wealth is set to rise dramatically.)  All of East Asia seems to be moving toward ultra-low birth rates and economies that are structured to produce high saving rates.  I don’t know if Singapore intervenes to weaken their currency, but given the extraordinary high savings rates there you’d expect a big CA surplus even if the government wasn’t accumulating foreign reserves.  The exact same thing occurs if the Singapore public buys the assets, and puts them in retirement accounts.

Over the next few decades China will get much richer.  As it does so, I’d expect its economy to resemble other East Asian countries more than the US.  And that will be true even if their government ends its weak yuan policy.  To take just one trivial example, I’d expect far more Chinese citizens to be speculating in property in LA, Vancouver and Sydney, than Westerners buying vacation homes in Shanghai or Hainan.

The East Asian economy is set to become extremely large in 20 or 30 years.  Given the enormous structural differences from our economy, I think it quite likely that the imbalances will become even larger in absolute terms.  When I lived in Australia in 1991, many Aussies were worried that their huge CA deficits were unsustainable, and also the cause of their recession.  They haven’t had a recession since, and they have continued to run very large deficits.  I see no reason why this “unsustainable” trend cannot continue for many more decades.

This is not to suggest that I disagree with Pettis’ policy recommendations, indeed I think his views on restructuring the Chinese economy make a lot of sense.  He also seems to share my view that while moderate yuan appreciation would be desirable, a sudden and sharp appreciation might be counterproductive:

This is why I worry that we are putting too much pressure on the renminbi.  There are many ways for China to rebalance, and they all involve the same process of transferring income from producers to households.  Raising the value of the renminbi, for example, increases the real value of household income in China by reducing the cost of imports.

It balances this by lowering the profitability of exporters.  The net result is that if it is done carefully, the household income share of China’s GDP rises when the renminbi is revalued, and with it consumption rises too.  Since China must export the difference between what it produces and what it consumes or invests, raising the value of the currency also reduces China’s trade surplus.

But what would happen if China were to raise the currency too quickly?  In that case the profitability of the export sector would decline so quickly that exporters would be forced either into bankruptcy or into moving their facilities abroad to lower-wage countries.  Either way, they would have to fire local workers.

Tim Duy also seems skeptical of those who put all the focus on Chinese surpluses:

But I don’t want to make this piece about China.  It is more than China at this point.  It became more than China the instant US Federal Reserve policymakers woke up one morning and decided they needed to take the dual mandate seriously.  And seriously means quantitative easing.  Brad DeLong suggests that when the Fed actually acts on November 3, it will be too little too late.  But if it is too little, more will be forthcoming.

Put simply, the Federal Reserve is positioned to declare war on Bretton Woods 2.  November 3, 2010.  Mark it on your calendars.

So perhaps Bretton Woods does not end because foreign governments are unwilling to bear ever increasing levels of currency and interest rate risk or due to the collapse of private intermediaries in the US, but because it has delivered the threat of deflation to the US, and that provokes a substantial response from the Federal Reserve.  A side effect of the next round of quantitative easing is an attack on the strong dollar policy.

Even if we could boost US demand by bashing China (and I doubt we could) there is a much better way; boost NGDP with a more expansionary monetary policy.  Where I differ with Duy is that I don’t think it will permanently end Bretton Woods II.  Yes, there may be some short term reduction in imbalances, but once the US recovers I have trouble seeing why we would not revert to running large deficits.  In my view there are only two permanent ways to address the US CA deficit; raise the US saving rate through fiscal reforms, or depress investment by adopting demand and supply-side policies that impoverish the country.  I think you know which approach I prefer.

BTW, David Beckworth posted on this earlier, and he shares my skepticism about the end of BWII.  Bill Woolsey also has a good post on exchange rates.

HT:  Marcus Nunes