Does macro need a paradigm shift?

I’ve been giving some thought to how my views of macro are different from those of other economists.  Until this crisis hit, I assumed that I was doing “normal economics,” to use Thomas Kuhn’s terminology.  NGDP targets are different from the Taylor Rule, but they aren’t all that different.  Even Ben Bernanke has talked about targeting the forecast.  You’ve seen me endlessly recite Mishkin’s 4 key concepts from his monetary textbook.  They are a virtual blueprint for my current critique of monetary policy.  So I’ve never thought of my views as being particularly heterodox.

And yet . . . .  You could count on one hand the number of economists who think money was tight last fall.  And you could count on one hand the number of right-wing economists who think that the economy currently needs much more stimulus.  So although my views are not completely unique, there is apparently something rather unusual about my approach to macro.

Kuhn is famous for arguing that scientific revolutions were preceded by a buildup of “anomalies,” or things that were difficult to explain within the standard model.  I’d like to discuss two possible anomalies, although in this case I don’t think that either are currently recognized as such.  I hope to change that.  The discussion will actually be more of a challenge to my fellow economists.  Can you explain these anomalies in a way that is consistent with the standard model?

Anomaly 1:  Economists talk about “monetary policy” without having a coherent idea of what they mean by the term.

Recall that a standard model should have an agreed upon set of terms, so that communication between scientists is possible.  OK, what do we mean by the “stance of monetary policy?”  What do we mean by “easy money?”  How about “tight money?”  Surely if we claim to be a science it’s not good enough to say “it depends” or “I know it when I see it.”  We must have some metric in mind, something in the real world we can point to, beyond our gut instinct.  So let me throw out this challenge:  I say it is impossible to come up with any sort of coherent meaning for terms like ‘easy money’ and ‘tight money’ in the context of the standard model.  Economists use these terms all the time, and yet are really just spouting nonsense.  To make things simpler I’ll offer 6 options, which conform to all of the ways in which I have heard people try to give meaning to the term:

1.  The Joan Robinson interpretation:

As you may recall, I like to mock Joan Robinson’s statement that the German hyperinflation could not possibly have been caused by easy money; after all, nominal interest rates were not low in Germany during the early 1920s.  I think it is fair to say that Joan’s views are no longer part of the standard model.  It is now widely believed that the German hyperinflation was caused by easy money, and hence nominal interest rates cannot be the right indicator for the stance of monetary policy.  When economists say “easy money” they can’t possibly be referring to low nominal interest rates, otherwise they’d have to accept Joan’s rather eccentric views.

2.  How about real interest rates?

When I make the preceding argument to economists, the quick retort is usually “of course what I really meant was that easy money means low real interest rates, and tight money means high real interest rates.”  Fair enough.  So let’s look at the record.  Real interest rates on five year TIPS rose from 0.57% in mid-July 2008 to 4.24% in late November 2008.  If real interest rates are the appropriate indicator of the stance of monetary policy, then this 4 month period was one of the most sudden and aggressive examples of monetary policy tightening in all of recorded history.

So maybe we do have a coherent view of the stance of monetary policy.  It refers to the level of real interest rates.  Except there is just one problem.  When I tell other economists that money became ultra-tight in the second half of 2008, I am met with stares on incomprehension, as if I had just escaped from a lunatic asylum.  So whether or not real interest rates are the “right” indicator (and for what it’s worth I don’t think they are) one thing is perfectly clear—this is not the standard model.  If only a tiny handful of economists think money was tight last fall, most economists obviously are defining “tight” as in terms of much higher real interest rates.

3.  The monetary base:

I used to like this one.  It seems to conform best to what the Fed actually does.  They print money.  And the money they print isn’t M1 or M2, it’s base money.  But again, whether or not this is the best indicator (and I no longer think it is) it’s clear that it hasn’t been the standard view for decades, if ever.  As Friedman and Schwartz showed the base was extremely misleading in the Great Depression, as M1 and M2 fell sharply at the same time as the base was rising rapidly.  Most of the profession now accepts their view that Fed policy was very tight in the early 1930s.  During that period the sharply falling M1 and M2 seemed to be better indicators as we also experienced extreme deflation, not what you’d expect from easy money.  Now of course there are other ways to look at this picture.  Krugman has argued that one could think of money as being easy, but that because we were in a liquidity trap the easy money did no good.  However, the fact that Krugman might make this argument doesn’t mean that he thinks the monetary base is the right indicator of the stance of monetary policy.  I rarely see him (or other Keynesians) pay any attention to the base.  I suppose one could still argue that the base is the right indicator of monetary policy, but that view is certainly not the standard view.  I’ll bet 90% of the economists who claim Greenspan ran an easy money policy in 2003 have never once examined the base data from that year.

4.  How about the broader aggregates?

In some ways M2 is better than the other three.  It certainly gave a more useful indication of monetary policy than either the base or nominal interest rates during the Great Depression.  (And my hunch is that even real rates were misleading, although there is some debate about whether the deflation was anticipated.)  But once again, it is certainly not the standard view that M1 or M2 are the right indicator of the stance of monetary policy.  Indeed, after the early 1980s most economists lost any interest in these variables.  Mike Belongia argues that we can and should come up with much more informative aggregates.  He may be right, but that’s not the issue I am examining here.

This week’s Economist mentioned how M2 has recently been flat, and then a few sentences later asked “whether all this fiscal and monetary stimulus will work.”  Obviously they are assuming that nobody would view M2 as the right indicator of monetary policy.

5.  The Taylor Rule

Lots of economists have argued that the Taylor Rule suggests rates should now be much lower.  I know there is some debate about their interpretation, but I’d like to focus on something different.  Even those economists who say rates need to be much lower according to the Taylor Rule, do not draw the implication that money is currently very tight.  So it is very clear that even economists who use the Taylor Rule don’t generally think it is an indicator of the stance of monetary policy.

6.  The “it depends” view:

Once they’re painted in a corner, and there no longer seems any single coherent definition of monetary policy, some economists will strike a more nuanced pose.  They will argue that it depends on a variety of factors.  You can’t just look at one metric.  It depends on the condition of the economy.  But again, this is not the view within the standard model.  If this were the standard view, then communication on monetary policy issues would look much different.  Suppose we had an English professor go through reams of economics discussions, debates, articles, etc, looking for how economists use terms like ‘easy’ and ‘tight’ money.  I am quite certain that he or she would find the terms used in a fashion that indicated their meaning was clear, and that both the speaker and the listener had the same shared understanding of what these terms mean.  In other words, economists uses these terms in the same way scientists use terms like force and mass.  But there is just one problem; scientists can point to agreed upon metrics (such as kilograms) for measuring their concepts.  So here is my big challenge to the economics profession:

Where is the metric for the stance of monetary policy?

I say we don’t have one.  Even worse, I say we think we have one, we talk as if we have one, but we aren’t even close to having one.  Given how monetary policy moved front and center in macro after the new Keynesian consensus of the 1980s, I’d say that’s a pretty big problem.

Anomaly 2:  Economists who claim to believe in markets, ignore the fact that the markets decisively reject their policy views.

Here’s one Krugman and DeLong would like, in the off chance they read this post.  Lots of economists on the right talk with a high degree of confidence about whether money is too easy, or too tight.  Let’s put aside the problem of defining easy and tight, and pretend there was a consensus.  My reading of history is that more often than not the markets don’t agree with right-wingers, and even worse, those right-wingers who claim to believe in efficient markets and rational expectations just brush off the markets’ rejection of their policy views.

Some examples:  I found that in the Great Depression the Fed mistakes identified by Friedman and Schwartz rarely had any discernable effect on asset prices.  But gold market shocks had a huge impact on asset prices.  Or take the “real business cycle” view, the view that nominal stimulus can’t boost real output, as recessions are caused by real shocks.  In the Great Depression the real value of assets like stocks often soared on news of easier money.  In addition, default risk fell sharply (as the Aaa/Baa yield spread fell on news of easier money.)

And we have seen the same in recent months.  For anyone who pays even the slightest attention to equity markets, it is obvious that during a recession stock prices react extremely positively to even a slightly greater than expected easing of monetary policy.  (And one thing Krugman won’t like, that’s even true when rates are at the zero bound.)

Here’s my favorite example.  I recently saw a graph showing inflation expectations over the next few years.  As I recall the medium forecast was about 2%, which is somewhat above market forecasts.  But here is what was interesting; the distribution of forecasts was much wider than usual.  There were a lot of 1% forecasts, and a lot of 3% forecasts.  The typical distribution is much tighter.  Some of my more astute commenters made this argument to me, after I cited the TIPs markets as evidence that we didn’t need to worry about inflation.  They argued that those buying gold might have a very high inflation forecast, but aren’t participating in the bond market.

So who is right, those in the bond market or those economists forecasting much higher inflation?  The answer is easy, those with money on the line.  Remember how during the Bush years liberals used to make those sarcastic comments about faith-based vs reality-based views?  There is a bit of truth in what they were saying (although of course they have their own biases.)  It seems to me that if you take a “realistic” look at the big picture, inflation is likely to stay low.  But some economists have “faith” in models that say when we have big deficits and double the monetary base then inflation will be just around the corner.  Unfortunately, those models were wrong in Japan and they will be proved wrong here as well.

So my explanation for the wide dispersion of inflation forecasts is quite simple, ideology is driving the forecasts to a much greater extent than during normal times.  And in this particular case the Keynesian model just happens to yield predictions that are closer to “reality.”  Of course that’s not always true, the view that economic “slack” prevents higher inflation didn’t work very well in the 1970s, and performed absolutely horribly in the year after the dollar was devalued, when prices rose rapidly despite 25% unemployment.  Still, right now the right is wrong.

BTW, this example also addresses a question I am often asked:  “If even economists can’t agree on the right model, how could average traders possibly have rational expectations, how could they form expectations consistent with the right model.”  Well I don’t know how the wisdom of crowds comes about, be we are currently seeing a beautiful example of rational expectations in action.  Traders are rationally blowing off simplistic quantity theories of money, which some academic economists continue to cling to.  They are trading TIPS as if they understand that the Fed interest payments on excess reserves changes everything.

I’ve gone on way too long.  I think it makes sense to first see if any economist can meet my challenge, can come up with a coherent metric for measuring the stance of monetary policy that is also consistent with the standard model.  Heck, I’d be happy with any metric that is consistent with the views of any substantial fraction of respected economists, on either the right or the left.  I say there isn’t any.

In my next post I’ll discuss where I think  macro needs to go and explain why we might need new concepts, new metaphors, indeed a completely new paradigm (something I never would have imagined before October 2008.)  It will be a macroeconomics without lags and without multipliers.  A macroeconomics where all important concepts are embedded in parallel asset prices measurable in real times.  Where shocks and have no important macro implications.  A macro free of VARs.



59 Responses to “Does macro need a paradigm shift?”

  1. Gravatar of adrian adrian
    3. November 2009 at 21:01

    Hi, this is the first time I post on this blog (I have been reading it for some time).

    I’ve got a question: Why is expected NGDP growth a better indicator on the monetary policy stance than expected inflation? Could real interest rates or Taylor rules be seen as some sort of second/third best indicators (given that they focus explicitly on the instrument used by most Cental Banks nowadays)?

  2. Gravatar of adrian adrian
    3. November 2009 at 21:02

    Oh, and great blog by the way.

  3. Gravatar of Thorfinn Thorfinn
    3. November 2009 at 21:08

    Lucas (1987) tells us business cycles shouldn’t matter; all we need is better QE and flexible wages and no one will have to worry about the economy again. We could move to nuclear energy and electric cars and get rid of energy shocks too. Capital insurance would eliminate banking problems as well (higher capital controls for banks is like having homeowners save 15% of their income instead of 10% in case of a flood).

    Does anyone else find it odd that Krugman and company spend half their time railing against non-existent proponents of some “price is always right” EMH; and the rest using market prices as a guide to what market participants think–exactly how EMH should be used?

  4. Gravatar of david david
    3. November 2009 at 23:39


    If you’re at all familiar with how EMH has been used in the past, its proponents often perform a delicate two-step where when the EMH comes under attack, proponents claim that they only support the weak EMH, which indeed merely states that market prices reflect systematic market beliefs. Well duh.

    But the moment the attention recedes, suddenly the strong EMH is stealthily reintroduced, especially to make assertions about the realities which prices are claimed to reflect. The claim that (for example) the TIPS market is an accurate and reliable barometer for future inflation is an instance of “price is right” EMH (to borrow the most convenient example. Sorry Sumner), for the context of one market (TIPS). Either hordes of economists are wrong, or hordes of investors are wrong; the “price is right” concept is invoked to suppress the latter.

    Especially prior to the dotcom bubble it was extraordinarily easy to find pundits ‘explaining’ the new and permanently high plateau by describing the intuitive, nearly-tautological weak EMH, then silently switching to the strong EMH thereafter. Now in a chastened environment it’s harder to find such unconditional enthusiasm, but don’t mistake that for non-existence.

  5. Gravatar of Artturi Björk Artturi Björk
    4. November 2009 at 00:29

    david: I think you are seeing a paradox where there is none.

    Weak EMH implies that no one can forecast better than the market consistently. So if someone claims to have superior knowledge of the future that contradicts the market you can hit them on the head with EMH and say, look at the price! it’s more likely that you are wrong than the market.

    This is consistent with the view that markets don’t always price everything according to fundamentals. Even weak EMH implies that if economists agree that the market price is wrong they are more often mistaken than not.

  6. Gravatar of woupiestek woupiestek
    4. November 2009 at 00:39

    If I understand correctly, it doesn’t really matter whether the market gets its inflation predictions exactly right. Future inflation has no influence on what the markets do right now – for that only expectations matter. But the predictions from inside the market are more likely self fulfilling prophecies, than the predictions of economists and politicians on the outside.

  7. Gravatar of Kevin Donoghue Kevin Donoghue
    4. November 2009 at 03:05

    To my mind we can only talk of money as being tight or loose in the context of a model. In Joan Robinson’s cost-push model of inflation, where workers start the inflationary spiral by demanding excessive pay increases, money is tight if the central bank refuses to accommodate the rising level of wages and prices. The Reichsbank reacted passively – that’s her take as I remember it – so monetary policy was neutral in terms of her model, or perhaps we should say that if money is endogenous it makes no sense to describe it as either tight or loose. In the textbook IS-LM model monetary conditions tighten if there is either an upward shift in the demand curve for money, or a shift to the left in the supply of “real” money, M/P. In either case the LM curve shifts to the left. In the rational expectations version of that model only unexpected reductions in the money supply represent tightening. And so on.

    So in my view you can only expect to see agreement on what tight money means when there is agreement on the appropriate model. That seems to be much farther away than it was in the 1970s when students could look at papers by Tobin and Friedman and say, what’s the argument about, the length and variability of lags, is that all? Fine tuning bad, coarse tuning good. There was a mainstream then, with only Austrians and Post-Keynesians and suchlike outside it. There is no mainstream now, not in academia at least; in central banks the NK model seems to be supplanting the beefed-up IS-LM models which were the standard tools until Lucas got people worried about them. So there may be a consensus of sorts among policy-makers. To adapt the old joke about Heisenberg: Taylor probably rules, okay?

    In that regard, I think you’re not quite right here: “Even those economists who say rates need to be much lower according to the Taylor Rule, do not draw the implication that money is currently very tight.” They do say that, in effect; at least Krugman does. Interest rates are stuck against the lower bound. Conventional monetary policy is constrained. That’s why you turn to fiscal policy.

  8. Gravatar of David Ortmeyer David Ortmeyer
    4. November 2009 at 04:49

    When you talk about “monetary stance”, I think you need to be more precise and distinguish between “monetary policy intent” and “monetary impact”. Which do you mean? The Fed’s intent won’t necessarily be reflected in nominal interest rates (for example)because they don’t have policy control over inflationary expectations. If you want a measure of Fed intent, can’t you just look at their balance sheet?

  9. Gravatar of ssumner ssumner
    4. November 2009 at 05:39

    Thanks Adrian. I should do a whole post on NGDP. But some of its advantages are that CPI is badly mismeasured due to sticky prices and a poor proxy for housing (rent equivilent) which is a much larger share of the CPI than GDP. Also it provides more macro stability when there are supply shocks. If oil prices rise temporarily, you don’t want to force down all other prices. Better to let inflation rise a bit when output falls.

    The Fed doesn’t really control real rates as an instrument, but I know what you mean. I agree that the Taylor Rule and real rates are better than nominal rates, but I still think expected growth in NGDP is the best indicator. In addition, the two you mentioned can’t be what economists think of when they think of “tight money” because both signalled very tight money recently, and yet almost no one in the profession (except me and a few others) actually thought money was tight.

    Thorfinn, Those are good points. Given that the Canadian system has been stable for 100 years, I think it’s fair to say that we know how to set up more stable banking systems, but politics gets in the way.

    I think that fixing the business cycle is a bit more complicated than QE, but I do agree with Lucas that we should be able to do far better.

    Yes, I’ve also noticed that about Krugman. Try to imagine teaching a finance course without the hated EMH. When students ask why stocks prices respond suddenly to news announcements, what would you say?

    david, You said;

    “But the moment the attention recedes, suddenly the strong EMH is stealthily reintroduced, especially to make assertions about the realities which prices are claimed to reflect. The claim that (for example) the TIPS market is an accurate and reliable barometer for future inflation is an instance of “price is right” EMH (to borrow the most convenient example. Sorry Sumner), for the context of one market (TIPS). Either hordes of economists are wrong, or hordes of investors are wrong; the “price is right” concept is invoked to suppress the latter.”

    Either you or I don’t understand the EMH. I never said TIPS spreads accurate measure future inflation, I said they are a measure of inflation expectations, and perhaps the best tool for forecasting inflation. But that is very different from saying they accurately reflect future inflation. They are often wrong, indeed almost always wrong.

    Artturi, I agree.

    Woupiestek, I don’t see how they can be self-fulfilling prophecies, as they are usually wrong.

    Kevin, You said;

    “To my mind we can only talk of money as being tight or loose in the context of a model.”

    That is right, but it supports my critique of economics. We talk as if there are objective measures of ease and tightness. That’s why other economists look at me like I’m nuts when I say money was very tight in late 2008. If they agreed with you they’d find nothing at all odd about my assertion. It fits the Taylor Rule characterization.

    I think you are wrong about Krugman. Sure he says it’d be nice if we could get even looser policy, but I think he has said many times recently that the economy is weak despite very loose monetary policy, and indeed he made the same argument against Friedman and Schwartz regarding the 1930s. He’s been arguing that the economy failed to recovery despite monetary ease. If my memory fails me about Krugman, surely at least 95% of economists talk the way I claim they talk.

    Don’t get me wrong, I think you make a great argument. If I wasn’t always met with incredulous stares by other economists (on saying money is tight) I would probably buy your argument.

    So you can call my theory “Sumner’s Paranoia” 🙂

    David, I should have explained that term. By monetary stance I refer to the characteristic of monetary policy that real world mainstream economists are referring to when they use terms like ‘easy money’ and ‘tight money.’ They rarely qualify it in terms of intentions. Thus mainstream economists are always referring to “Greenspan’s ultra-loose monetary policy of 2003,” with no thought that a qualifier is necessary to distinguish between loose in fact, and loose according to Greenspann’s intentions. Thus the clear implications is that policy was objectively loose in some sense.

  10. Gravatar of John Hall John Hall
    4. November 2009 at 07:06

    Just to let you know, there was a huge amount of inefficiency in the TIPs market in Q4 2008. Many firms held collateral in TIPs, which they had to sell to meet margin calls. This pushed down prices of TIPs and pushed up yields. You may ask why this didn’t occur with nominal securities, but the TIPs market is much less liquid than T-Bills or Treasury bond markets.

    Further, TIPs are normally quoted on a 5 or 10 year basis. Not over a time frame that the Fed would be able to control. The breakeven inflation rates embedded in those securities are normally thought of as a longer-term forecast of inflation. Using CPI, real Fed Funds and real 3 month T-bills rates were negative from October 2007 until late 2008. Using the quarterly year ahead inflation forecasts from the Philly Fed’s SPF, these rates turned negative between Q1 and Q2 2008 and are still very negative.

  11. Gravatar of adrian adrian
    4. November 2009 at 07:34

    But in that case, would NGDP growth targeting induce higher inflation (at least CPI inflation) in the future? How can NGDP growth targeting be understood using the Barro-Gordon model? Does it lead to dynamic inconsistency?

  12. Gravatar of David Heigham David Heigham
    4. November 2009 at 08:35

    Scott Sumner,

    A nice and illuminating piece. Thanks. I will re-readit with increased pleasure.

    Since you are looking for a new paradigm in monetary and macro, I strongly recommend that you look carefully at Monetary Economics by Godley and Lavoie – see . Dirk Bezemer noted that this model did foresee the mess we are now in. Good as Wynne Godley’s model is, I think that you may be thinking sufficiently originally to criticise his paradigm fruitfully.

  13. Gravatar of Bill Woolsey Bill Woolsey
    4. November 2009 at 09:22


    No, NGDP targeting doesn’t lead to “more” inflation.

    Positive aggregate supply shocks result in lower inflation or deflation.

    There is more variation compared to a target for the growth paof the CPI. I am not sure about relative to inflation targets from wherever it starts.

  14. Gravatar of Bob Murphy Bob Murphy
    4. November 2009 at 10:26

    Scott, this is another provocative post, as (almost) always. I haven’t finished it yet, but I stumbled on this part:

    “Real interest rates on five year TIPS rose from 0.57% in mid-July 2008 to 4.24% in late November 2008. If real interest rates are the appropriate indicator of the stance of monetary policy, then this 4 month period was one of the most sudden and aggressive examples of monetary policy tightening in all of recorded history.”

    I confess I thought you were just wrong, but I looked up the chart and yep, TIPS yields really did spike that much. Wow, I didn’t realize they had gone up so much by November.

    But hold on a second. I think the conventional economist’s meaning, when he says that the Fed can raise real interest rates, is that he’s saying the Fed hikes up nominal rates higher than inflation expectations are increasing.

    So Joan Robinson was wrong, because the German central bank didn’t raise nominal rates nearly enough to offset the increase in inflation expectations.

    To put it in other words, I think most economists (at least if they’ve never read your blog and so don’t think about this stuff much) would assume that the real interest rate is determined by the market, and that gives you the TIPS yield. And then the Fed comes along and (within reason) can make the nominal interest rate whatever it wants. Sure if the Fed doesn’t something nutty, it can indirectly affect the real economy and hence real interest rates.

    So in your view, what exactly did the Fed do to cause TIPS yield to shoot up? I don’t see how you can explain that. What in the world would make investors demand a 4% return on TIPS securities, except (my own pet theory) that they thought the USG was taking on so much that they were going to quietly renege on the TIPS contracts?

    Let me try it one last way, to make sure you get the distinction I am making. If the TIPS yield had stayed constant throughout the crisis, but inflation expectations collapsed while the Fed only meekly cut nominal rates, *then* you would be able to coherently say, “Aha! You fools made the reverse mistake Joan Robinson did. Yes, the Fed was cutting rates, but not nearly quickly enough. 5-year nominal Treasury yields are collapsing much faster than the Fed’s target rate, which shows that in forward-looking inflation-adjusted terms the Fed’s real target is rising.”

    Am I making sense? I would think all the action in your story would be on nominal Treasury yields falling so that the nominal/TIPS spread falls, and that this fall is bigger than the cuts in the target.

    In contrast, you are pointing to investors apparently demanding a huge increase in the real return on their investments, in the midst of a huge rush to safe assets. Why would they all of a sudden demand a much better return from the USG? That doesn’t make sense to me, unless they actually are not as sure about the airtight TIPS contracts. I don’t see how monetary policy directly causes TIPS yields to spike.

  15. Gravatar of Rafael Rafael
    4. November 2009 at 10:34

    Eugene Fama has a post on the issue of EMH:

    He writes about Justin Fox new book.


    The book is fun reading, but its main premise is fantasy. Most investing is done by active managers who don’t believe markets are efficient. For example, despite my taunts of the last 45 years about the poor performance of active managers, about 80% of mutual fund wealth is actively managed.

  16. Gravatar of Lee Kelly Lee Kelly
    4. November 2009 at 10:43

    Well, for me tight monetary policy can mean only one thing — an decrease in the money supply relative to money demand (or velocity).

    In early ’08, the growth of M2 remained steady while velocity started falling. I think the collapse of the housing market was responsible for the initial fall in velocity. To maintain the NGDP growth the Fed needed to grow M2 more than before, but did they even try to expand the monetary base? It doesn’t look that way to me. Instead they kept to the previous trend which, although suitable for last year’s economic conditions, had become tight monetary policy in the aftermath of a bursting bubble.

    The failure of monetary policy to adapt to the changing market intensified the economic downturn. Then as velocity dropped even further through ’08 the Fed still remained fixed upon its previous course. It wasn’t until the whole thing turned into a financial crisis that the monetary base was actually expanded (and by this point a massive expansion was necessary).

    In any case, accoridng to how I use the phrase “tight money,” the Fed was very tight, because it’s not just about what the Fed does, but what it doesn’t do, too.

  17. Gravatar of Jon Jon
    4. November 2009 at 11:51

    In your post, not once did you use the term ‘natural’ rate. This is _the_ technical definition of an easy-monetary policy: namely that the risk-free rate is below the ‘natural’ rate.

    This roots a concern within a greater body of thought–in this case that there is an equilibrium rate that derives from people’s willingness to defer future consumption.

  18. Gravatar of 123 123
    4. November 2009 at 13:25

    “If I wasn’t always met with incredulous stares by other economists (on saying money is tight)…”

    Words tight and easy have too many meanings depending on the frame of reference (possible frames of reference include policy x months ago, range of previous policies during last ten years, policy required to hit the target, etc; model differences add enother layer of miscommunication). Perhaps other economists would get your point quicker if you told them that monetary policy should be much looser.

  19. Gravatar of David Stinson David Stinson
    4. November 2009 at 13:30

    Hi Scott. Another thought-provoking post.

    It seems to me that, at its core, monetary policy is aimed at achieving some desired gap between the demand for money and the supply of money. Inflation has been seen as an expression of that gap (i.e., excess supply leads to spending and price increases) and therefore it has often been chosen as a measurement and target for the gap. There may be other ways to measure or define the gap but the size and sign of the gap between demand and supply for money fundamentally determines whether monetary policy is easy or tight.

    I’ve been out of school for a longish while but it seems that nowadays mainstream macroeconomists rarely focus on the demand for money in any systematic way. Economists seem to have rediscovered “velocity” since the crisis started and talk about it an informal way but tend to view money demand as some sort of irrational group behaviour (“hoarding”) rather than the result of an individual maximization decision. I’m aware that it is hard to estimate and unstable and that defining a suitable aggregate is problematic, etc., etc. However, from my vantage point, it seems unlikely that we can properly measure monetary stance (as you refer to it) without a better explicit understanding of the demand for money. Therefore, we can’t know what variable to target without that understanding.

    For example, the whole issue as to whether to target asset prices in addition to prices of the components of GDP seems to me to really be a debate about the demand for money and what people do with excess money balances. Another way to frame the discussion would be to ask “what terms do we put on the right hand side of the equation of exchange”? Likewise, what some people dismissively refer to as hoarding is really a response to volatility in other asset markets and changes in the relative risk/return trade-offs of money vs other assets.

    I believe you are right to keep coming back to expectations and rationality. In a post in August you wrote:
    “Many economists were initially skeptical of rational expectations theory. They would ask “if brilliant macroeconomists cannot even agree on what the correct model of the economy is, then how can we possible expect the public to fully understand the model?” McCallum pointed out that this was the wrong way to think about rational expectations. He didn’t even like the term ‘rational expectations,’ insisting the concept should be called ‘consistent expectations.’ McCallum said the real question was whether when you develop a model, you assume that the public has expectations that are consistent with that model. He pointed to the absurdity of developing a model that assumed the world was X, but then assuming that the public believed the world was Y.”
    The thing that strikes me about many rational expectations models is the high level of agreement or consensus assumed in the model and the fact that the consensus is usually a correct interpretation of how the economy works. To address your point in the quote above, the academic writing a paper is working with one model. Individuals the academic is attempting to model recognize however that there is a multiplicity of models and vast uncertainty as to which if any are valid. Learning can take place but only over time and, in any case, misspecified and/or multiple models can be confirmed by particular sets of data. Information collection and analysis are costly. In such a world, expectations can be both rational and heterogeneous. Add in the fact that investors need to not only form expectations about the evolution of fundamentals but about policy-makers’ future responses to those fundamentals and it becomes difficult to decompose the information content of expectations. That seems like it probably matters.

  20. Gravatar of Thorfinn Thorfinn
    4. November 2009 at 13:34

    BTW, Bernanke has stated the circumstances under which he’d raise rates, and the market tanked. That’s another data point for the tight money idea.

  21. Gravatar of D. Watson D. Watson
    4. November 2009 at 14:07

    I trust then you have the book deal in hand, yes? Offering to change the entire macro paradigm for free, without announcing the forthcoming book to explain all the details, seems remarkably ambitious. 🙂

  22. Gravatar of Doc Merlin Doc Merlin
    4. November 2009 at 15:29

    I agree it is time for a paradigm shift. For the record, I am a right-winger in economic theory. However, I don’t believe in EMH in either strong or weak form. I believe something else entirely; that markets are the only way to signal demand and supply. Also that the possibility of failure of market participants is the only way to make sure that bad ideas get cleared out.

    Interest rates should be a signal of both the demand for credit and the supply of investments available for lending. In our world, the fed can arbitrarily create currency, so the supply isn’t limited by anything except what the fed wants to do and what is politically feasible.

    I agree that expectations are important, and that when expectations in a large percent of market participants fails to match reality is when you see market crashes. (You also see them when certain types of legislation is passed or when someone comes along and starts destroys assets, like in war.) I don’t think that this is a problem. I think this is necessary. If you don’t have a way to remove market participants with bad predictive powers from their actions having a market impact in the future, or have them correct their incorrect models, the whole system will suffer. You will trade the occasional crashes for constant increasing badness.

    I had a bunch of other thoughts but I didn’t include them here because there was an included plot. They are at my blog.

  23. Gravatar of rob rob
    4. November 2009 at 16:24

    I tried reading The Economist online today to get a different point of view for a change, but they just linked me back here.

  24. Gravatar of Joe Calhoun Joe Calhoun
    4. November 2009 at 17:45

    You say: “So who is right, those in the bond market or those economists forecasting much higher inflation? The answer is easy, those with money on the line. ”

    Don’t the people buying gold have money on the line? Why isn’t that a good indication of inflation expectations? Why do you always cite the TIPS market but never consider other markets? Don’t commodity markets indicate anything about inflation? Doesn’t the value of the dollar indicate anything about inflation expectations?

    When I judge monetary policy, I look at market indicators too, but I do not confine my view to one market such as the TIPS market. The currency markets and commodity markets provide valuable information too and often react quicker than the TIPS market, which as someone pointed out above isn’t all that large or liquid.

    Judging the stance of monetary policy is a matter of judging the balance of supply and demand for money. If I want to judge that balance in the oil market, I observe the price movements. If I want to judge that balance in the dollar market, I do the same thing.

  25. Gravatar of ssumner ssumner
    4. November 2009 at 19:25

    John, Those are good points, but my impression is that those who think interest rates are important for the macroeconomy (and I’m not one of them), think 5 year rates are much more important than three month rates. The second point I’d make is that those are really the only objective measure we have of real interest rates. People often say the TIPs market is small, but it isn’t any longer. It’s just small compared to the ordinary Treasury securities markets. So here’s the deal, anyone who wanted to could go to their broker on Novermner 2008 and buy TIPS that guaranteed a 4% REAL rate of return over the next 5 years. No default risk and no inflation risk. Under those circumstances what would it take to get you to lend money to commercial firms in an economy going down the toilet? I’d call that tight money.

    I would question your argument that the Fed has no control over the yields on 5 year TIPS. With a much more expansionary monetary policy I’m not sure the yields would have ever approached 4% last November. But I agree it is an open question.

    I am not impressed by real interest rate estimates based on the actual CPI. The CPI is almost worthless as a measure of inflation in a situation where the macroeconomy is changing fast. The measured rate of inflation between mid-2008 and mid-2009 was around negative 1.5% or 2%. But if housing was measured properly the actual deflation would have been much greater.

    Despite all these caveats, I do agree the real yield may have been biased upward somewhat by liquidity issues. But if you compare TIPS to TIPS, the liquidity issue doesn’t seem to explain anywhere near all of the problem. New 5 year TIPS (which can’t be adjusted downward during deflation) had much lower yields at that time. Expected deflation seems the only way to explain that–or did I miss something? After all, why should the liquidity characteristics of a new 5 year TIPS differ THAT MUCH from a 10 year TIPS with 5 years to maturity?

    adrian, Are you referring to a time inconsistency model? I don’t think there is any difference between inflation and NGDP targeting in terms of that model.

    David, Thanks, I’ll take a look at the model. But I should say that it’s ability to predict the crisis is a point against the model in my view. I see the crisis as being unpredictable, and don’t think economists should waste time trying to predict crises. Rather they should try to prevent them. But I’ll reserve judgment until I’ve read it.

    Bill, I agree.

    Bob, No, normal economists think the Fed can control real interest rates, via the liquidity effect. But I agree with you, I also find it odd that real rates rose so much. And I have no explanation.

    Going back to John’s question, which was quite good, there is the problem of what maturity to look at. I had always assumed that because Keynesians see interest rates impacting the economy through investment, they cared more about the 5 year bond yield than the overnight rate. But I’m no Keyneisan so I shouldn’t try to speak for them. If the real overnight rate is key, then what is the transmission mechanism? Inflation over one day is trivial. Sure you could go with the 3 month rate, but that doesn’t even always move in the same direction as the overnight rate when the Fed changes policy (December 2007 the 3 month rate behaved perversely.) So the evidence doesn’t support the view that the fed can even control three month rates in a fast changing economic environment. So I don’t claim to know what I am talking about regarding rates, but I don’t see anyone else talking coherently about how interest rates relate to easy and tight money.

    Have to go to bed now, so I’ll take the rest of the comments in the morning. I’ll leave a short and totally trivial short new post.

  26. Gravatar of adrian adrian
    4. November 2009 at 20:15

    Thank you for your answer, yes I was refering to the dynamic inconsistency model.

    I think I’ll wait for a post on NGDP targeting.

  27. Gravatar of StatsGuy StatsGuy
    4. November 2009 at 20:19

    Bob Murphy writes:

    “What in the world would make investors demand a 4% return on TIPS securities, except (my own pet theory) that they thought the USG was taking on so much that they were going to quietly renege on the TIPS contracts?”

    This is implausible – TIPS is a small fraction of total US debt obligations, and the implied default probability in CDS swaps on US (regular) debt never came close to explaining the difference.

    Here’s another hypothesis for you: Bank deleveraging, which had already started in March of 08. This created an exogenous reduction in the supply of credit, forcing interest rates higher – particularly as the Fed continued to signal a future tight money policy to protect against commodity driven inflation.

    ssumner writes:

    “more often than not the markets don’t agree with right-wingers, and even worse, those right-wingers who claim to believe in efficient markets and rational expectations just brush off the markets’ rejection of their policy views.”

    While this is surely true, there is a defense here: If by “markets” you refer to the stock market, then one could argue that the stock market can go higher simply because it expects inflation (stocks are a better hedge against inflation, particularly if they are more export dependent or produce commodities). The BOND market, however, would react differently.

    If by “markets”, you mean something akin to the sum of all markets, then sure… though that would be difficult to measure. But, perhaps, a worthy metric to build.

  28. Gravatar of Graeme Bird Graeme Bird
    4. November 2009 at 20:28

    George Reisman has already made the paradigm shift. Its just a matter of everyone catching up to him.

  29. Gravatar of Graeme Bird Graeme Bird
    4. November 2009 at 20:43

    “Where is the metric for the stance of monetary policy?”

    The metrics ought to be total sales revenue in the economy, and business-to-business spending. In the Reisman terminology this would be “Gross Domestic Revenue” and “Productive Expenditure.”

    “Economists talk about “monetary policy” without having a coherent idea of what they mean by the term.”

    Aint that a fact. We have to separate brazen bank subsidy and stop calling it “monetary policy”. Stealing on behalf of the banks ought never be called monetary policy.

    Having removed all stealing, then monetary policy becomes raising the reserve asset ratio when you want to stop spending from overshooting your target, and cash injection through debt retirement, when you want more spending.

    We’ve got to stop using GDP for quarter-to-quarter comparisons. This is clearly moronic. Because its a subset to spending. You cannot hope to relate monetary policy to GDP. This follows very closely with the transmission mechanism.

    More money goes into more spending goes into nominal GDR which indirectly affects nominal GDP and there is another step to “real” GDP. Now this is silly to try and go Rainman on us and statistically by trying to relate the money to the GDP. When the two are related only at so many steps.

    We want to relate the money to total sales revenue. Thats where we will get statistical results. Thats where we will build up the database to destroy the Keynesian multiplier delusion for all time and conduct proper monetary policy.

  30. Gravatar of John Hall John Hall
    4. November 2009 at 22:09

    Scott, I hadn’t thought of your response about overnight or three month inflation rates. That’s a good one.

    I got the constant maturity 5-year TIPs and the 10 year TIPs due in 2013 (five years left in Oct. 2008) from the St. Louis Fred. Around the period where there is five years left (July), the two bonds have very close yields. Around October, the spread widens to around 30bps until I believe the constant maturity series switches over to a new bond and the yields go out of whack in December. So relative to each other, there is little evidence of liquidity constraints showing up in on-the-run vs. the off-the-run securities.

    An on-the-run 5 year TIPs bond should have some liquidity advantage relative to a 10 year TIPs bond with 5 years remaining, but more as something that an LTCM-type hedge fund would arbitrage away and not something significant. In addition, TIPs securities have a floor on the premium. If a 10 year TIPs bond builds up its inflation-protected principal until five years are out and then there is a deflation. The 10 year bond will reduce the principal. However, a new 5 year bond cannot go below 100. This might cause some difference, but I’m not sure how it helps explain your point. Because the 10 year bond can lose principal, I would rather be in the 5 year bond, but I’m not sure if I have the math right enough to prove it. The spreads I found might be a lot to a fixed income arb fund, but it might be enough to compensate for this problem if a modest deflation is expected.

    My thesis is more one of margin calls. A hedge fund will hire a cash management firm to manage their short-term debt positions. If the hedge fund needs to dramatically reduce their leverage, they call the cash management firm who then frees up the cash positions. If all these firms are selling Treasuries, there will be an impact on the market, but since it is so much of a larger, deeper market than the TIPs market, there isn’t nearly the impact. I still don’t think you appreciate how much less liquid it is than the nominal Treasury market and its use as collateral.

    I follow what economic forecasters are saying and I just did not see any one of them forecasting the kind of 5 year breakeven inflation rates that we saw in October 2008. Not one was close. So I’m sticking with the margin call story and not the deflation forecasting story.

    To your other point, you could call a Fed intervention to buy TIPS monetary policy, but getting back to points you’ve previously mentioned it depends on what you call monetary policy. I would say that intervening into a specific market to boost liquidity for something that is obviously mispriced is not monetary policy, but that might just be splitting hairs. We would be better off if we just had inflation futures contracts than divining real interest rates from TIPs.

  31. Gravatar of ssumner ssumner
    5. November 2009 at 05:47

    Rafael, Thanks for the tip.

    Lee, I agree, I wish other economists agreed with us.

    Jon, That’s fine. But again, if we use that definition then money was really tight last fall, and almost no economists agree that it was really tight. So most economists are clearly not using the natural rate as a benchmark.

    123, The big problem is not that they can’t understand me. I agree that I can express my thoughts in a way that they can understand. The big problem is that this false reasoning about the stance of monetary policy causes them to make false inferences about policy. Many economists think “money was easy and the economy still declined, that shows monetary policy is ineffective in a liquidity trap.” They’d be much less likely to engage in that sort of false analysis if they understood that money wasn’t easy. So it corrupts their thinking.

    David Stinson, Those are good points. I obviously prefer NGDP as the benchmark of whether money supply growth is exceeding or falling short of money demand (or velocity in my case.) You are right, there are other things that one could put on the right side of the equation of exchange. But even if you put asset prices there, money would still have been very tight last fall. So that problem remains.

    One reason to target expectations is so that we don’t need to model money demand. The market can do that. We just supply the amount of money that the market believes is necessary to offset money demand shocks. Then heterogeneous beliefs don’t cause any problems.

    Thorfinn, Thanks, but are you sure the timing was right? My understanding is that the market initially rose on the Fed announcement, and then tanked later. When did the market find out about the Bernanke statement?

    D Watson, You said;

    “Offering to change the entire macro paradigm for free, without announcing the forthcoming book to explain all the details, seems remarkably ambitious.”

    Thank you for being so polite in calling me “remarkably ambitious.” Some less flattering adjectives would probably be more appropriate. How about “the economics equivilent of cold fusion?”

    Doc merlin, I don’t want to prevent all market crashes, just those crashes due to bad monetary policy.

    rob, Did The Economist link to me?

    Joe, I actually look at two indicators; the TIPS market and CPI futures. Those are direct reads on inflation expectations in the US. Gold prices reflect global conditions, and are affected by things like Asian growth and the value of the dollar which may or may not influence US inflation.

  32. Gravatar of ssumner ssumner
    5. November 2009 at 06:31

    Statsguy, Thanks for that info on the TIPS market, it was very helpful.

    I partially agree with your second point, inflation could raise stock prices. But you’ll notice that in my post I referred not to nominal stock prices, but to real stock prices, and also default risk in corporate bond markets. And those are both real variables. Now I suppose one could argue that if prices are sticky then a purely nominal shock could raise real stock prices until the overall price level had adjusted, but if a New Classical makes that assumption, then they’ve already lost the battle, haven’t they?

    Graeme, I haven’t looked into that theory. But let me say that stablizing either NGDP or total sales revenue would be a vast improvement over what we are now doing.

    John, You said;

    “I follow what economic forecasters are saying and I just did not see any one of them forecasting the kind of 5 year breakeven inflation rates that we saw in October 2008. Not one was close. So I’m sticking with the margin call story and not the deflation forecasting story.

    To your other point, you could call a Fed intervention to buy TIPS monetary policy, but getting back to points you’ve previously mentioned it depends on what you call monetary policy. I would say that intervening into a specific market to boost liquidity for something that is obviously mispriced is not monetary policy, but that might just be splitting hairs. We would be better off if we just had inflation futures contracts than divining real interest rates from TIPs.”

    I suspect you might be right in terms of the measured CPI. BTW, there is a CPI futures market, but I’m not sure how to get historical data. I think the series may be Bloomberg USSWIT5:IND or something like that. Maybe someone can check.

    I still am confused by your reply, but it’s probably my ignorance. You said the difference between on the run and off the run was only about 30 bps. But when the official series changed at the beginning of December the real yield fell 200 bps. Isn’t the only thing that happened in the beginning of December that they went from off the run to on the run? That’s why I assumed deflation must be the explanation. Having said that, 2% per annum deflation over 5 years is a bit implausible, I agree. So here are my other comments on using real rates:

    1. The measured CPI poorly matches actual inflation (or deflation) during severe nominal shocks.

    2. Real rates are a poor proxy for the stance of monetary policy for other reasons. Robert King argued in 1993 that a contractionary monetary shock can reduce real growth expectations, and hence immediately reduce real interest rates. So I will not be surprised if in the end we find that real rates did not rise as much as I assumed.

    3. If we are going to go with short term rates, as you suggest, then fairly rapid deflation becomes much more plausible in late 2008. We know that commodity prices were plunging and even the actual CPI, (which measures housing by using existing long term rent contracts!) was falling during that period. Imagine what a properly constructed CPI would have shown. So substantial expected deflation over one year was very plausble. Also recall that the depression turned out to be less than expected (by markets), as we know from the strong equity market recovery since March. So the expected deflation could have easily exceeded what actually occurred.

    4. A bit off topic, but elsewhere I’ve argued that a better way to adjust nominal interest rates is not to subtract out inflation, but rather to substract out expected NGDP growth. Expected NGDP growth represents the expected nominal income available to repay loans in the future.

    5. No matter how screwed up the TIPS markets were, the rates were what they were. And banks could freely buy TIPS if they wanted. So isn’t there still a sort of “opportunity cost” argument that says banks might have been more tight-fisted with risky borrowers in an environment where they could get a sure 4% on risk-free loans? Or does the points you made in your reply somehow discredit this argument?

    6. I much prefer market forecasts to Fed forecasts. Even if the market is wrong, it is the theoretically appropriate “expected infaltion” in our models.

  33. Gravatar of rob rob
    5. November 2009 at 06:53

    Scott, yes, The Economist linked to you here:

  34. Gravatar of ssumner ssumner
    5. November 2009 at 07:37

    Thanks rob, In the comment section someone named “fundamentalist” says I take the QTM too seriously. That will surprise people who are puzzled my my frequent statements that inflation is not a problem despite rapid growth in the money supply.

    David, The Godley and Lavoie books looks very ambitious. They seem to want to model the whole economy. I think our models need to get much simpler, much more abstract.

  35. Gravatar of D. Watson D. Watson
    5. November 2009 at 09:11

    Just in case the two of you are unaware of each other, a post that mentions how few of us believe you just calls out for me to possibly make an introduction:

    David Beckworth, Asst Prof at Texas State writes, “Tuesday, November 3, 2009
    Global Nominal Spending History

    As someone who believes that stabilizing nominal spending rather than inflation is key to macroeconomic stability,…”

    More here:

  36. Gravatar of rob rob
    5. November 2009 at 10:35

    And now I see The Economist has linked David Beckworth’s chart (via MR:) — and say “Well, Scott Sumner’s argument is that monetary officials aren’t looking at the right indicators, or can’t agree on the right indicators. What they ought to be targeting is nominal GDP, or nominal spending.”

  37. Gravatar of rob rob
    5. November 2009 at 11:00

    Is it at least POSSIBLE that the market simply doesn’t view TIPS as a good inflation hedge and therefore speculators who expect inflation are moving into metals and oil instead? Because if I didn’t know any better (and I don’t) I would look at the metals, oil and equity markets right now think the market is expecting inflation. Imagine for a moment TIPS doesn’t exist. What would you think the market was saying about inflation expectations then?

  38. Gravatar of Doc Merlin Doc Merlin
    5. November 2009 at 12:31

    It would explain why metals and oil are prices far above their extraction costs right now. (especially Gold.)

  39. Gravatar of Don the libertarian Democrat Don the libertarian Democrat
    5. November 2009 at 16:45

    I really don’t have any disagreements with your post. I would simply add that, when talking about the importance of Lehman’s collapse, it seemed to me that some bloggers and commenters didn’t consider what the people with real money were doing that week as empirical evidence for what occurred ( largely by not addressing the point at all ). Consequently, if I pointed out the talk at the Special Trading Session on that Sunday before Lehman’s fall, which was that Merrill would immediately fail and so on and so on, that didn’t seem to matter to many writers. But, hey, if these guys say that they’re pulling their money out come what may, and then they do so, it has real consequences for our economy. I’m not saying that such actions are the only evidence to consider, but isn’t it empirical evidence for what happened?

    As well, if the people with real money say that they’re assuming that they are guaranteed by the govt, as unpleasant as that revelation might have been to some people, then, if there’s a crisis, these same people are likely to panic if you tell them that they’re on their own. And, so, if the govt then guarantees them, the panic eases. That’s the lesson you can see by looking at the bailout of Citi and the VIX. In fact, the QE and Stimulus have worked positively, if not well enough, by altering expectations of some of the people with real money. In my view, the whole point of QE and the reinforcing stimulus is to alter such perceptions and expectations. That’s also what I believe the authors of the Chicago Plan of 1933 meant to accomplish with their plan.

    I’d like to see this system redesigned, but the real world is what matters.

  40. Gravatar of ssumner ssumner
    5. November 2009 at 17:51

    D Watson, Thanks, I’ll leave the same comment I left at David’s site:

    Nice graphs David. It really shows how big the policy error was this time (the biggest drop in NGDP since 1938) Bill Woolsey has done some graphs with levels rather than rates of change. Since the early 1990s NGDP stayed pretty close to the trend line until last year. I would add that the NGDP spurt in 1983-84 wasn’t totally unjustified, as the deep recession of 1982 meant that RGDP could grow fast as we returned to full employment. This meant fast NGDP growth was consistent with 4% inflation. After 1984 they appropriately downshifted to closer to 5% NGDP growth. There is some debate about whether faster than 5% NGDP growth would be appropriate during a similar catch up period right now. I think it would, (as does Woolsey)as long as the Fed carefully spells out an explicit target path for NGDP that would prevent a breakout of high inflation.

    rob, Thanks, that’s the 3rd time in a couple weeks they’ve linked to me.

    rob#2 and Doc, That’s possible, but I’d stake my reputation on at least core inflation (heavily linked to wages) staying very well behaved for many years. And any commodity price spurt have only a modest and very transitory effect on the headline CPI. (oh uh, I may come to regret the ‘reputation’ staking.) I do realize that inflation can occur with slack in the economy; I’m not that stu . . . I mean I’m not that Keynesian. But I think the Keynesians are much closer to the truth on the current inflation risks than most non-Keynesians realize.

    Don, I understand the second part but am a bit hazy on the first part. Could you restate it as if you are talking to a dummy that knows little about investment banking. I don’t even know exactly what a “special trading session” is. Thanks. And I need to know this stuff because in a couple weeks I enter a high level debate with a bunch of elite bloggers who know much more finance than I do. Banking bores me to death, maybe that’s why I think monetary policy is all powerful.

  41. Gravatar of Graeme Bird Graeme Bird
    5. November 2009 at 22:47

    “Graeme, I haven’t looked into that theory. But let me say that stablizing either NGDP or total sales revenue would be a vast improvement over what we are now doing.”

    Let me explain a little bit more about it. Reisman and the Austrians more generally are not big on statistics. Reisman isn’t a straight Austrian. He’s more British-Classical/Austrian synthesis and has done a remarkable job of cleaning up both and synthesising also with modern accounting.

    So the situation is incredibly ripe for someone to come in and start working with more sensible metrics. I feel I can assure you that you will not be looking at dead patterns for long if you did this.

    “But let me say that stablizing either NGDP or total sales revenue would be a vast improvement over what we are now doing.”

    The idea of using total sales revenue including intermediate business sales revenue is intuitively sensible sounding since it is a far better measure of spending itself. And if you relate money growth to something that is pretty close to spending growth you are far more likely to get good results from statistical work.

    But consider this. Total sales revenue in this time period becomes, or is proportional to cost-of-goods-sold in the next time period.

    And a simplification but a good one is to have total sales revenue never falling, since if it falls, then cost of goods sold can overshoot total sales revenue and therefore bring on recessionary conditions. The idea is to have sales revenue growing as slowly as you can manage it but never let it actually fall.

    If you were picking up the reigns now you would find out what was the highest sales revenue figure and you would boost back above that figure and then flatten. You’d ignore inflation, and what have you because you would know if you bounce and flatten then at least some profits would be made, and eventually prices would start falling.

    Now also consider this. Government spending becomes revenue to business that does not lead to cost of goods sold. Doesn’t that throw light on this fake recovery you guys are going through?

    Profits are being artificially boosted, as is GDP, by all this deficit spending. But the spending is being taken out of “productive expenditure”. That is to say “business-to-business spending”. Business spending, is that spending that leads to business costs. One of those business costs is wages. So this deficit spending is causing unemployment and higher profits at the same time.

    Further to this it is only the renovation of business through business spending which can be the source of a real recovery, and authentic productivity growth, with growing employment. Not the fake recovery with synthetic phony productivity growth that your labor department is reporting right now.

  42. Gravatar of Graeme Bird Graeme Bird
    6. November 2009 at 03:30

    “My reading of history is that more often than not the markets don’t agree with right-wingers, and even worse, those right-wingers who claim to believe in efficient markets and rational expectations just brush off the markets’ rejection of their policy ”

    This problem is easily solved. Since in the situations described the economist ought not confuse subsidising Wall street with

    1. getting people back to work

    2.convincing businesses to spend money now to cut recurring costs later.

    3. and to otherwise renovate their businesses. To wind up with better businesses via spending that improves their business and not just for spending that cranks out the goods right away.

    Jazzing the stock market is not really part of the plan here. It might happen as a side-issue. But its not part of any sensible recovery strategy to plan for it.

  43. Gravatar of Current Current
    6. November 2009 at 03:42

    I have read little pieces of Reisman before. But, I’ve never had the time to sit down and read “Capitalism”. But the little pieces I have read offer a tantilizing glimpse into what may be possible.

    I think I’d have to give up the day job and become an economist in order to make more of it. And that’s not on the cards right now.

    I really hope though that someone does it and incorporates it into more mainstream Austrian work, and more mainstream mainstream economics.

  44. Gravatar of ssumner ssumner
    6. November 2009 at 05:57

    Graeme, The reason I went with final sales is that I wasn’t interested in spending as a goal in itself, but rather a means to an end. The goal being more stable output. Again, both final sales and total sales correlate very closely with output, so I don’t want to make a big deal of this distinction. I think in practice his approach would do fine. I’m just explaining why I went with final sales.

    One other issue, the back and forth in commodity markets can create quite a bit of volume. That would not be included in final sales, but I’m not clear whether those transactions get incorporated in the intermediate sales aggregate.

  45. Gravatar of Jon Jon
    6. November 2009 at 08:41

    Scott: I think you’re inferring that money was tight relative to the natural rate by means other than estimating the natural-rate.
    So a priori, we cannot argue that because they thing money is loose, they must not consider the natural rate.

    Despite that, I don’t think the natural-rate has been internalized. Rather, the going idea is often called the neutral-rate, which is a fully nominal concept based in regime of stable inflation expectations. I hear this line of argument quite often. Its the dressing up of low-rates loose, high-rates tight line of reasoning.

    I would argue that part of the problem is economists became apologists for missed inflation targets in recent years. Inflation would drift above target and chorus would break-out explaining how that didn’t matter, the target is a ‘medium-term objective’. The trouble with that sort of reasoning is that it ignores the real effects of violating expectations in the short-term especially when that violation serves to inadvertently tighten policy.

  46. Gravatar of Jon Jon
    6. November 2009 at 09:15


    Nice graphs David. It really shows how big the policy error was this time (the biggest drop in NGDP since 1938) Bill Woolsey has done some graphs with levels rather than rates of change. Since

    Any opinions on which graphing style embodies the better meta-ideas? Bill’s graphs are very explicit about falling below trend in a historic sense: “have we recovered”. But this introduces a concern: how and when do you decide to change the base-line?

    David’s graphs use the very misleading year-over-year numbers–which are useful when the volatility in the index is low but not at other times. Essentially there is an arbitrary embedding of 1-yr time horizon. We saw this recently with some of the year-over-year CPI numbers as we effectively road up last years price-spike in reverse even as Energy prices were trending up this year!

    My next question gets to the ‘physics’ of NGDP targeting. Is it your position that recovery cannot happen until NGDP returns to trend? If so, why?

    I’d be tempted to argue (initially) that the pain has already come and accelerating back to a trend-line is pointless (we’ve already gone through a liquidation phase).

  47. Gravatar of Graeme Bird Graeme Bird
    6. November 2009 at 12:50

    “The goal being more stable output.”

    But what you mean here is not more stable output. You mean more stable GDP and that is not the goal. Yes I think you ought to have more stable output. But that doesn’t mean more stable GDP. The question to ask is “output of what?” Are we really after more stable output of consumer goods and government spending? I don’t think so. So this is about defining ones terms a little bit better.

    People produce producers goods and not just consumers goods. And one wants more stable spending on both. Not just on consumers goods. Because at least on policy grounds one wants less government spending, and less consumer spending and this means, in the medium term at least, a falling GDP.

  48. Gravatar of azmyth azmyth
    6. November 2009 at 15:50

    I’m surprised you didn’t mention expected inflation as something economists use to classify tight/loose monetary policy. The only difference between expected inflation and NGDP targeting is the supply shock side. Supply shocks are hard to predict in advance, so I think most traders will just expect normal trend growth. I also don’t think the central bank should do anything to offset supply shocks. Convincing economists to use inflation expectations as a policy measure will likely be easier than NGDP, since inflation is already something many central banks use as their explicit target.

  49. Gravatar of Graeme Bird Graeme Bird
    6. November 2009 at 19:53

    Thats neither here nor there azmyth. You don’t suck up to these central bankers and try and coax them to do the tenth best thing. You bash them over the head with the truth and attempt to build a coalition to get them all sacked. Then they have to follow better policy to neutralise you. Inflationary expectations or consumer price inflation is an irrational policy target. Nominal GDP is better but still no good. Nominal Gross Domestic Revenue is what you are after.

    The last thing you want to do is appease the fractional reserve welfare queens.

  50. Gravatar of azmyth azmyth
    7. November 2009 at 01:54

    Graeme Bird: I agree with you in spirit, and I agree I’m talking about making a tenth best world a ninth best one. I’ve read Mises and Hayek, but I’ve also read Buchanan and Tullock. I don’t think the government will ever give up fiat currency or fractional reserve central banking because it gives them too much power.

    GDR targeting seems interesting, but I don’t know much about it. Although Scott has banned recommending him Austrian articles after a traumatic experience, could you recommend a Reisman article?

  51. Gravatar of ssumner ssumner
    8. November 2009 at 08:34

    Jon, The problem is that any view such as the “natural rate” approach must be made operational in some fashion. When they try to do so they basically ignore the natural rate theory, (which suggests falling prices are prima facia evidence of tight money), and instead they go with their gut. And that’s the problem.

    Jon#2, Good question. I think each has it’s advantages in certain contexts. If the Fed actually did do level targeting with NGDP, then Bill’s approach would be better. but they don’t, so we need to consider growth rates for reasons that will become apparent when I answer your next question.

    2. No, I agree that we will eventually get a recovery even if we don’t boost AD, or NGDP. Instead wages and prices will adjust downward, causing the SRAS to shift right. It’s just a slower recovery. We will resume 4-5% growth at some point (maybe now) but at a much lower trend line. Bill also recognizes this issue.

    Graeme, I mean all output on a value added basis, as I am interested in minimizing employment fluctuations. That’s why i don’t use expenditure on both intermediate and final goods. For employment purposes that would be double counting. But again, in practice they are very closely correlated, so I think your plan would also work well.

    azmyth, Yes, expected inflation would be fine. But by that criterion money was very tight last fall. Since almost no economists believe money was tight, we can infer they aren’t using expected inflation.

    azmyth, That comment about a traumatic experience was pretty funny.

  52. Gravatar of Graeme Bird Graeme Bird
    8. November 2009 at 16:42

    “Graeme Bird: I agree with you in spirit, and I agree I’m talking about making a tenth best world a ninth best one.”

    Thats where you have come off the beam. You can do nought but harm with that attitude. Leave it to a President or house speaker to sell out at the last moment. This is not for you.

  53. Gravatar of Graeme Bird Graeme Bird
    8. November 2009 at 23:45

    “Graeme, I mean all output on a value added basis, as I am interested in minimizing employment fluctuations”

    Yes I can see what you are saying. Since GDP is also national income, you are saying that to let GDP tank, and focus exlusively on GDR would leave the situation beyond the ability of a President, using moral suasion, to bring wages and prices down quickly enough to maintain employment.

    If you were advising a President, the socio-politico situation would need to be taken into account, since nominal incomes might be constrained to fall only slowly.

    I’m not saying that GDP isn’t part of the picture and does not need to be taken into account at all. But I’ll confuse everyone if I try to nuance matters too much at this point.

    So GDP is important to bring back after you have banished it long enough to allow oneself the mental shift to go from one paradigm to another. No easy matter. But either you are going to have a GDR PRIMARY FOCUS or a GDP primary focus. And the GDR focus is the right one for business stability.

    Supposing your ideal target was 4% GDR growth per year, looking towards the ideal of growth-deflation. And suppose this requires 8% monetary growth at first and 4% monetary growth later. But then the crisis hits. And GDP starts falling faster than wages can hope to fall in order to bring employment down.

    Well I can see in that situation a compromise is in order. To maximise business-to-business spending as a PROPORTION of GDR, but without letting GDP fall by more than one per cent per quarter ……. (for the reason you gave)…

    Well this requires you to:

    1. Bring GDP back into the focus.

    2. It may require a one-off jump in money supply immediately by 5% (lets say)

    3. You’ll need spending cuts, tax cuts and moral suasion to get wages, salaries and prices down faster than 1% per quarter.

    4. Instead of your goal of 4% GDR growth per year, you increase the target temporarily to 8% growth per year to get that good compromise between GDR growth and prevention of natinal income from falling too fast.

    I’m sure I won’t be confusing you with the above. But I wanted to avoid a more nuanced take on this matter when I said that GDR is the right goal. Its the right primary goal. But certainly I can see how a crisis of this sort would force you to bring GDP back into the picture.

  54. Gravatar of ssumner ssumner
    9. November 2009 at 15:19

    Graeme, I agree that you need faster NGDP growth in the short run, as the economy is deeply depressed.

    You might want to get some numbers comparing total revenue and NGDP. Obviously the levels are very different, but I think you might be surprised about how close the growth rates are. When final goods sales drop off, interest intermediate good sales are affected in a roughly proportionate manner.

  55. Gravatar of Graeme Bird Graeme Bird
    9. November 2009 at 17:40

    We are not talking about final goods sales. We are talking about the totality of sales. Intermediate production as well. The plastic that we use to shrink-wrap pallets of offal. The cleaning products and electricity used in industry. The same shrink wrap that we use for pallets of ingredients that are thrown away before they get to the consumer.

    The new wracking that we put up that we may be able to expense in that same year. All intermediate production. I work in a place where we buy stuff from other businesses and we sell stuff to other businesses. We spend real money and lots of it. We have to have a lot of investment to do all this. And yet all our activity is not included in GDP.

    Maybe if we get an accounting profit and we don’t release dividends that will be included in the highly artificial net(I) in GDP. But we want the raw data of Gross (I) to tell us how much activity is going on.

    The smaller the time period the less good is GDP as a measure of the comparative trend in activity and output. Since output means producer and consumer goods. Consider the leadup to Christmas. Few people working and and a lot of buying going on. Fortnight GDP would soar even as GDR was in the tank and labour hours going through the floor. Labour hours goes with intermediate production and not GDP. As the example shows. Labour a business expense which forms part of every firms Income statement and not the income statement just of the retailers.

  56. Gravatar of Scott Sumner Scott Sumner
    11. November 2009 at 08:57

    Graeme, The Christmas issue is not a problem for NGDP, because the numbers are seasonally adjusted. I’d still like to see total revenue numbers.

  57. Gravatar of Graeme Bird Graeme Bird
    15. November 2009 at 17:54

    I was using Christmas as an example. The fact is that GDP is an irrational measure to use, except in the above nuanced way, for quarter to quarter comparisons. Because the basis of employment and growth is how much resources we are funneling back into business renovation. Not into consumption and government splurging. GDP is only relevant in the short-run, insofar as we are limited in terms of how fast we expect nominal income to fall so as to keep everyone employed from a pricing standpoint.

    But the main thing is this:

    I was taught in my formal education to value companies using a wide range of ratios. Now of course the bigshots just make sure they’ve infiltrated their people into government. But back then we used to actually try and assess companies by multiple measures. Never to fall in love with one metric.

    But nowadays we have economists teaching the kids to everything on a GDP basis. More idiotically to try and correlate money growth with GDP, when GDP is an arbitrary subset of spending.

    Serious reform is needed.

  58. Gravatar of Scott Sumner Scott Sumner
    26. November 2009 at 06:44

    Graeme, I still don’t think you follow my argument. I am not interesting in targeting NGDP because it is correlated with money. Even if total revenue was much more closely correlated with money I’d still favor GDP. Instead, I favor GDP because it is correlated with employment, and I see employment stabilization as the prime goal of monetary policy.

  59. Gravatar of TheMoneyIllusion » October 2008: the Taylor Rule vs. NGDP futures targeting TheMoneyIllusion » October 2008: the Taylor Rule vs. NGDP futures targeting
    20. January 2010 at 17:27

    […] If you haven’t read my earlier posts on monetary policy, I should clarify a few things.  I know full well that Taylor and others understand the […]

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