Once Paul Krugman has reaching a firmly held policy view, it can be costly to express a contrary opinion.  Just ask Ken Rogoff or Tyler Cowen.  On the other hand he can be very supportive to those who toe the party line:

Joe Gagnon Is Right

He calls on the Fed to implement a plan based on the ideas of someone the central bank seems to have been ignoring “” a macroeconomist by the name of Ben Bernanke.

Of course Krugman has recently been calling on the Fed to ease monetary policy, having basically given up on Congress providing more fiscal stimulus.  Gagnon called for eliminating the interest rate on reserves, and suggested that the Fed buy Treasury bonds.  There was no mention of Krugman’s favorite idea, higher inflation targets.

But what happens if you call for monetary stimulus before Krugman is ready, while he is still pinning his hopes on fiscal stimulus?  On March 1, 2009, I wrote an open letter to Krugman calling for a three-pronged attack on deflation; elimination of IOR, having the Fed buy Treasury bonds, and Krugman’s favorite idea, inflation targeting.  So he must have liked my proposal even more that Gagnon’s, right?   Ummm . . .  actually not:

A quick response to Scott Sumner OK, I see that Scott Sumner has written an open letter to me. But I’m puzzled. He writes:

“I think you have acknowledged that there is some level of quantitative easing that would boost demand. If I am not mistaken you are concerned that if such a policy boosted inflation expectations sharply, the Fed would have to quickly sell off these assets, suffering massive capital losses.”

Um, you are mistaken. I’ve never said such a thing. Did you mean to address this letter to someone else?

Very funny.  Why the negative reaction?  Here was my concluding paragraph:

To conclude, I ask you to reconsider your position on monetary policy.  If you did change your view, some people might accuse you of inconsistency. But remember what your hero once said:

“When the facts change, I change my mind “” what
do you do, sir?”

The Obama administration is obviously struggling in coming up with an effective solution to the banking crisis.  The stimulus package seems inadequate, either because (as you believe) it is too small, or (as I believe) the multiplier may be less than we think.  The economic data seems to be consistently worse than expected.  The facts have changed.

In early March, 2009, Krugman wasn’t ready to hear this message, especially from a right wing economist.   Now he is.

Part 2.  The Fedfail index

I suppose I should include something a bit less petty and self-indulgent in this post, so let’s consider Krugman’s Fedfail index:

But forecasts aside, we really have to bear in mind that the Fed is failing in fulfilling its dual mandate, price stability and full employment. I thought it might be convenient to have a simple measure of just how big the failure is; let’s call it the Fedfail Index. It’s related to the Taylor rule, but instead of offering a rule of thumb for the Fed funds rate, it measures how far unemployment and inflation are from their presumed targets.

The rule I’ve chosen takes its coefficients from the Rudebusch version of the Taylor rule; 1.3 times the deviation of unemployment from 5 percent + 2 times the deviation of core inflation (CPI) from 2 percent. So it’s 1.3* ABS(unemployment – 5) + 2* ABS(core inflation – 2). You can make up your own version; I don’t think it will look very different.

I don’t have any big problem with this index, but I prefer to use NGDP deviations from trend for two reasons.  First, I’d rather not try to estimate the natural rate of unemployment.  So I prefer NGDP (which includes real output) rather than unemployment.  Of course the closest parallel would be to use deviations from the natural rate of real output, which is equally hard to estimate.  But I favor simply targeting NGDP, as most of the problems (wrongly) attributed to inflation instability are actually associated with instability in NGDP growth.

More importantly, my Fedfail index treats supply shocks very differently from Krugman’s index.  In Krugman’s index each term is calculated as an absolute value.  Thus if a supply shock causes both unemployment and inflation to rise above normal, the Fedfail index gets worse.  But in my view that’s not really a monetary policy failure, as the Fed can’t do much about supply shocks.  So I’d prefer to use a steady 5% NGDP growth track as my benchmark for success, even if a supply shock causes inflation to rise above 2% and real growth to fall below 3%.  In a sense, Krugman’s index shows how poorly the economy is doing, not how much AD is deviating from its appropriate level.

[Note, please let me know if I misinterpreted Krugman’s index, especially the absolute value expression.]

PS.  The snarky “party line” comment wasn’t aimed at Gagnon, he’s been saying these things for a long time—indeed arguably helped created the “party line.”  Instead, it was aimed at Krugman.  And a note to Krugman-lovers:  I hope it goes without saying that the whole thing was meant to be humorous, I am quite aware that Krugman has held some of these views for quite a long time, it’s just that recently he is giving them more emphasis.

I recently came across a very interesting essay written by Paul McCulley (of PIMCO) in 2001.  At one point he discusses a bizarre idea that got a foothold at the Fed in 1989:

For the last decade, the Fed has played something called “opportunistic disinflation,” and it, too, has worked.

The term actually entered the public arena on July 10, 1996, when the Wall Street Journal leaked an internal Fed report by staff economists Orphandies and Wilcox, detailing the Fed’s “new” approach to inflation-fighting: the Fed should not take deliberate action to reduce inflation, but rather “wait for external circumstances – e.g., favorable supply shocks and unforeseen recessions – to deliver the desired additional reduction in inflation.”

Simply put, the theory said, the Fed should not deliberately induce recessions to reduce inflation, but rather “opportunistically” welcome recessions when they inevitably happen, bringing cyclical disinflationary dividends. A corollary of this thesis was that the Fed should pre-emptively tighten in recoveries, on leading indicators of rising inflation, rather than rising inflation itself, so as to “lock-in” the cyclical disinflationary gains wrought by recession. While the label “opportunistic disinflation” was a clever one, the Fed had actually been practicing the policy for a long time. Indeed, former Philadelphia Fed President Edward Boehne elegantly described the approach at a FOMC meeting in late 1989:

“Now, sooner or later, we will have a recession. I don’t think anybody around the table wants a recession or is seeking one, but sooner or later we will have one. If in that recession we took advantage of the anti-inflation (impetus) and we got inflation down from 41/2 percent to 3 percent, and then in the next expansion we were able to keep inflation from accelerating, sooner or later there will be another recession out there. And so, if we could bring inflation down from cycle to cycle just as we let it build up from cycle to cycle, that would be considerable progress over what we’ve done in other periods in history.”

Before discussing the Boehne quotation, think for a moment about just how strange this “opportunistic disinflation” idea really is.  Suppose you are trying to lose weight.  You notice that extremely ill people often lose weight.  Voila!  A cancer diagnosis is a perfect “opportunity” to lose some weight.  Of course you don’t want to go on a diet when suffering from cancer, (that would be going too far), but on the other hand don’t go out of your way to eat food either.   Just enjoy the weight loss.

There are basically two types of macroeconomists in academia.  Those (mostly right-wing) who favor a strict inflation target.  In that case inflation would be the same whether we are in a recession or boom.  Others favor some sort of flexible inflation target.  NGDP targeting is a good example.  When real growth falls, you allow inflation to rise a bit.  This reduces the severity of the business cycle during supply shocks.

But within the halls of the Fed a third and very dangerous idea took hold during the 1980s and 1990s, opportunistic disinflation.  This ideas suggests that the fall in inflation rates often observed in recessions is not a failure of demand management, not a highly procyclical monetary policy, but something to be welcomed.

Now at this point I know my more sensible readers are starting to roll their eyes.  “Yes, a few oddballs at the Fed put forth this theory, but you don’t mean to seriously suggest that such a wacky idea, with almost no support in academia, would be embraced by the Fed itself?”

Go back and read the Boehne quotation.  As of 1989, inflation had average about 4.5% over the previous 7 years.  The bond markets clearly indicated that inflation was likely to stay high, indeed go even higher.  But Boehne had inside information, he worked at the Fed and understood that in the next recession the Fed was determined to reduce inflation to 3% and keep it there until the following recession.  And in the following recession they would reduce it a bit further, and so on.  And that is what happened.  Inflation fell to 3% percent in the 1990s.  The next cycle didn’t see much further reduction, but only because of the huge 2006-08 oil shock.  If not for Asian oil demand, the Fed would have delivered a further reduction in inflation.  Now that oil prices are down, we have inflation falling to about 1% in this cycle.

Boehne was very accurately predicting a Fed policy that would almost inevitably drive the economy off the cliff, only he didn’t realize it.  Opportunistic disinflation means that inflation falls at the same time that RGDP is falling.  If you start from a position of already minimal inflation, and have a steep recession, and the Fed does nothing to offset the fall in inflation typically associated with steep recessions, then you can get a fall in NGDP.  As I keep pointing out, NGDP in 2009 fell at the sharpest rate since 1938.  And both 1938 and 2009 saw near-zero interest rates.  Boehne did not recognize that this sort of policy could drive the economy into a liquidity trap.  But he can be forgiven for that oversight, after all, with Treasury-bill rates up around 8% in 1989, few people even considered the possibility of 1930s-style liquidity traps returning.

Bernanke and Greenspan saw what happened in Japan in the 1990s, however, and that ‘s why the Fed seemed to ease aggressively in 2002.  In fact, monetary policy was not very expansionary, but at least they understood the problem.  Unfortunately, they didn’t recognize just how dangerous the Fed’s opportunistic disinflation policy had become.

The following graph shows that the jobless recovery of 2010 is nothing new, the previous two cycles had the same problem, it’s just that they were much milder, so fewer people noticed.

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I found this graph in Erik Brynjolfsson’s blog, which also contained this provocative post:

As growth resumes, millions of people will find that their old jobs are gone forever. The jobless recovery is one symptom.

Two points.  There are no jobless recoveries.  If you don’t generate jobs, you have no recovery—regardless of whether RGDP is growing.  And second, people normally don’t get their old jobs back, in this recession or in any other recession.  How many people return to their old jobs after being laid off?  I read somewhere that during a typical year there are about 32 million jobs lost and about 33 million jobs created.  I’d wager that very few of those jobs created are people getting their old jobs back.

The post was entitled “The Great Recalculation.”  But if the Fed is doing its job then recalculation should produce stagflation.  Lower output should mean higher inflation.  But that’s not what we are seeing.  It is possible that there is an unusually large amount of recalculation going on, although in my view that mostly occurred before the severe phase of the recession began in August 2008, but in any case it is observationally indistinguishable from opportunistic disinflation.

I recall reading about opportunistic disinflation in the 1990s, and making a mental note that it was a silly idea, obviously procyclical, and that surely the Fed would not take the idea seriously.  Shame on me.  The Fed warned us what they planned to do as far back as 1989.  We ignored them.  Then they went ahead and did it.  And they are still doing it.  This expansion will have even lower inflation that the last one.

PS.  Paul Krugman deserves some credit for anticipating this problem.

Here is a good post from Paul Krugman:

In past releases, the Fed has been clear that the long-run unemployment projection represents Fed views on the NAIRU, the unemployment rate consistent with stable inflation, and that the long-run inflation projection should be viewed as a target. Also, the Fed generally looks at core inflation rather than the headline number.

With that in mind, here’s what the Fed expects: unemployment far above normal, core inflation well below target, for years to come.

I’d quarrel with those projections, a bit: I have no idea why Fed presidents expect core inflation to rise over the next two years. Historically, high unemployment has been associated with falling, not rising inflation. In fact, my bet is that we will be near or into deflation by 2012.

But even given the Fed’s own projections, it’s not doing its job, it’s missing its targets. Yet it apparently sees no need to act.

Bonus question:  Estimate (to the nearest 100) the number of times I have complained (since October 2008) that the Fed is not targeting the forecast.

HT:  Niklas Blanchard

Update:  Get your NGDP targeting T-shirts here.

HT:  William Luther.

I learned an important lesson by reading newspapers from 1933 showing Wall Street’s reactions to FDR’s New Deal policies.  They were sort of OK with his outrageously statist NIRA, which had the government herd companies into cartels in order to raise prices (although interestingly they weren’t too crazy about the later high wage add-on.)  But Wall Street was absolutely apoplectic about the one FDR policy that actually worked–dollar depreciation.  Tinkering with the value of the dollar–which had been fixed to gold for 54 years–was considered an outrage.  But then I noticed something interesting; every time the dollar fell a bit more after some sort of action and/or signal from the Administration, stock prices soared.  Wall Street was like some sort of masochist.  Ow! . . . hmmm, I like that, hit me again.

This all made me think of some recent Krugman posts (and no, not for the reasons you are thinking.)  If you read Brad DeLong, you probably notice that he is a bit in awe of Krugman’s ability to be right about everything.  Actually, Krugman isn’t right about everything, but he tends to be wrong about exactly the same things that DeLong is wrong about, and so DeLong wouldn’t notice those things.  But to give the devil his due, he is right about an awful lot of things.  Why is that?  My conservative readers may assume that Krugman sold his soul to the devil, but I have a more plausible explanation.

Think about all his recent posts mocking the conservative fear that big deficits will lead to higher interest rates.  What evidence does Krugman use?  He cites the low and falling 10 year bond yields.  In other posts he has used TIPS spreads to explain why inflation is the last thing we should be worried about.  Now flash back to March 2009, when Krugman warned that $780 billion in stimulus would not be enough to get the job done.  Did he know this from his models, as he claimed?  Or did he cheat, did he peek at the equity, commodity and bond markets, and notice that all were predicting a severe recession with lots of disinflation, if not outright deflation?  I think he peeked.

My theory is there are two kinds of economists:

1.  Those who look smarter than they really are, because they rely on the EMH to predict

Paul Krugman

Scott Sumner

etc

2.  Those who look dumber than they really are because they rely on their own models to predict:

Conservatives predicting inflation based on Quantity Theory models or Fiscal Theory models.

etc

I bet you never thought you see a list that had Paul Krugman in the pro-EMH camp.  But just as with Wall Street in 1933, look at what people do, not what they say.  Just as I am a pro-EMH guy who occasional tries market timing in my personal investments, Krugman is an anti-EMH guy who forecasts as if he believes in the EMH.  And that makes him a very good forecaster, and very dangerous to us right-wingers.  We underestimate him at our peril.

Here is an example of a conservative who wasn’t careful.  The passage is a Greenspan quotation, cited by Krugman:

Despite the surge in federal debt to the public during the past 18 months””to $8.6 trillion from $5.5 trillion””inflation and long-term interest rates, the typical symptoms of fiscal excess, have remained remarkably subdued. This is regrettable, because it is fostering a sense of complacency that can have dire consequences.

And here is Krugman’s reply:

You know, some people might take the fact that what’s actually happening is exactly what people like me were saying would happen “” namely, that deficits in the face of a liquidity trap don’t drive up interest rates and don’t cause inflation “” lends credence to the Keynesian view. But no: Greenspan KNOWS that deficits do these terrible things, and finds it “regrettable” that they aren’t actually happening.

Ouch!  Actually, deficits are bad because they lead to higher future taxes, not higher inflation.  Inflation is determined by monetary policy, but perhaps Mr. Greenspan forgot that.

BTW, it seems like half the time Krugman is pushing fiscal stimulus, and the other half of the time he is showing how countries with more stimulative policies (such as Iceland and Britain) are doing slightly less bad.   But has anyone noticed that the successful policy examples that he cites relate to monetary policy, not fiscal policy.  Just saying.

Last year I spent a lot of time emphasizing that the real problem was the profession, not the Fed.  The Fed represents the consensus of opinion among economists.  Unless we can change that consensus, it is unlikely that we can change Fed policy.

Paul Krugman is also pulling his hair out over attitudes toward monetary stimulus.  He recently linked to a 2008 post that criticized Ken Rogoff for advocating tight money to slow the commodity price boom of 2008.  Krugman responded (in 2008):

Um, why? Basically, the world is employing rapidly growing amounts of labor and capital, but faces limited supplies of oil and other resources. Naturally enough, the relative prices of those resources have risen “” which is the way markets are supposed to work. Since when does economic analysis say that the way to deal with limited supplies of one resource is to reduce employment of other resources, so that the relative price of the limited resource returns to “trend”?

Presumably there’s some implicit argument in the background about why a sharp rise in the relative price of oil is more damaging than leaving labor and capital underemployed. But that argument isn’t there in Ken’s recent pieces. Model, please?

I agree that

“Dollar bloc countries have slavishly mimicked expansionary US monetary policy”

and that’s a real issue: the Fed is pursuing very loose policy to deal with a US financial crisis, and that’s inflationary in countries that are pegged to the dollar without facing our problems. But that’s an argument for breaking up Bretton Woods II; it’s not an argument for tighter Fed policy.

Several points.  If the CPI is a much worse indicator than NGDP, then the price of oil and other commodities are far worse than even the CPI.  Krugman’s also right about the exchange rate issue.  BTW, China sharply revalued the yuan between 2005-08, and thus avoided high inflation.

On July 29, 2008, the very same day that Rogoff penned his infamous call for tighter money, I received a rejection letter for a paper I had submitted to Contemporary Economic Policy.  (Please don’t take this as a criticism of that journal, two other journals didn’t even think my paper was worth evaluating.)  Here is one of the two referees who didn’t like the paper (a third loved it):

The author assumes that the Fed will not repeat the mistakes of 1979-80.  The current environment looks very much like 1980.  The monthly CPI rose 14 a.r. in June and expectations in the Michigan survey rose from 4 to 7% for the year inflation with the June report.  The dollar is at all time lows and commodity prices are soaring to record heights.  With the fed funds rate negative the New Keynesian model is predicting a rapid rise in inflation.

Hey Mr. Anonymous referee; how’s that New Keynesian model prediction working out for yah?

So that’s where we were on July 29th, 2008, on the eve of the Fed’s Great Mistake.  With mindsets like those being the norm, is it really at all surprising that we ended up where we did?  If you are wondering what they should have been focusing on in 2008, my answer is NGDP forecasts for the US inferred from various real output indicators plus TIPS spreads.  This might not have called for easier money yet, but certainly not tighter money.

Part 2.  Krugman and Thoma vs. Rajan.

Krugman (and Mark Thoma) also criticize Raghuram Rajan’s recent article calling for tighter money.  Although I agreed with Rajan in his recent dispute with Krugman about Fannie and Freddie (and prefer his more polite writing style to Krugman’s), I’m afraid I find this column even more discouraging than do Krugman and Thoma.  Here is Rajan:

Regardless of the true explanation, the US is singularly unprepared for jobless recoveries. Typically, unemployment benefits last only six months. Moreover, because health-care benefits are often tied to jobs, an unemployed worker also risks losing access to affordable health care.

Short-duration benefits may have been appropriate when recoveries were fast and jobs plentiful, because the fear of losing benefits before finding a job may have given workers an incentive to look harder. But, with few jobs being created, a positive incentive has turned into a source of great anxiety. Even those who have jobs fear that they could lose them and be cast adrift.

Then he criticizes fiscal stimulus, before turning to monetary policy:

Equally deleterious to economic health is the recent vogue of cutting interest rates to near zero and holding them there for a sustained period. It is far from clear that near-zero short-term interest rates (as compared to just low interest rates) have much additional effect in encouraging firms to create jobs when powerful economic forces make them reluctant to hire. But prolonged near-zero rates can foster the wrong kinds of activities.

For example, households and investment managers, reluctant to keep money in safe money-market funds, instead seek to invest in securities with longer maturities and higher credit risk, so long as they offer extra yield. Likewise, money fleeing low US interest rates (and, more generally, industrial countries) has pushed up emerging-market equity and real-estate prices, setting them up for a fall (as we witnessed recently with the flight to safety following Europe’s financial turmoil).

Moreover, even if corporations in the US are not hiring, corporations elsewhere are. Brazil’s unemployment rate, for example, is at lows not seen for decades. If the Fed were to accept the responsibilities of its de facto role as the world’s central banker, it would have to admit that its policy rates are not conducive to stable world growth.

Policy would still be accommodative if the Fed maintained low interest rates rather than the zero level that was appropriate for a panic. And this would give savers less of an incentive to search for yield, thus avoiding financial instability.

Politicians will not sit quietly, however, if the Fed attempts to raise rates. Their thinking – and the Fed’s – follows the misguided calculus that if low rates are good for jobs, ultra-low rates must be even better.

Emerging studies on the risk-taking and asset-price inflation engendered by ultra-low policy rates will eventually convince Fed policymakers to change their stance. But, if politicians are to become less anxious about jobs, perhaps we need to start discussing whether jobless recoveries are here to stay, and whether the US safety net, devised for a different era, needs to be modified.

Another even more famous University of Chicago professor (Milton Friedman) pointed out that low interest rates are usually a sign of tight money, not easy money.  Tight money produces a weak economy and disinflation.  That drives nominal and real rates to very low levels.  Second, Brazil is not even in the dollar bloc.  So I don’t see how one can imply that easy money in the US is making economies like Brazil overheat.  They can revalue.  And the proposal to extend unemployment benefits seems puzzling for two reasons.  First, I thought it had already been done.  Maybe Rajan thinks even the extended benefits are not enough.  But second, studies show that this sort of policy creates more unemployment.

Hoover’s Fed raised interest rates from very low levels to somewhat less low levels in 1931.  FDR made labor markets much more rigid.  Between the two of them they produced a 12 year depression.  Rajan’s proposals obviously wouldn’t be anywhere near as harmful, but I still think it would be a step in the wrong direction.

Part 3:  Paging Banksy and Fairey

Maybe we need some sort of guerrilla street art campaign to change attitudes through subliminal indoctrination.  Outside of every economics conference, FOMC meeting, G-20 meeting, etc, we need street artists to plaster enigmatic images like this one, but with ‘obey’ replaced by 9/08+2%.  Then people might start asking what it means.

(I.e., target the core price level on a 2% growth track from Sept. 2008.)