Dylan Matthews on Woodford’s paper

Nicolas Goetzmann sent me a Dylan Matthews post at the Washington Post:

Everyone who’s anyone in monetary policy is in Jackson Hole, Wyo., this long weekend for the annual conference on central banking held there in late summer. The big story every year is the speech by the Federal Reserve chairman, which is often used to signal changes in Fed policy going forward. Sure enough, Ben Bernanke used his platform todefend past quantitative easing measures the bank adopted to fight the economic downturn and to lay the groundwork for similar actions going forward.

But more important than Bernanke’s speech may be an 87-page, highly technical paper released as part of the conference by Columbia University’s Michael Woodford. Although not a household name by any means, Woodford is widely regarded as the greatest monetary economist of his generation. He was in the first class of MacArthur genius fellows, before even finishing his PhD, and his book Interests and Prices, in which he laid out in detail his views on monetary policy, was hailed upon publication as a “landmark treatise” by Harvard professor and former White House chief economist Greg Mankiw and as a “classic” by MIT’s Olivier Blanchard, now chief economist at the International Monetary Fund.

Woodford’s paper is an extended argument for the Federal Reserve to stop targeting a certain level of inflation (about 2 percent annually) and to start targeting a certain level of nominal (that is, not adjusted for inflation) gross domestic product. Woodford is hardly the first person to endorse this idea, commonly known by the not-particularly catchy name of “NGDP level targeting”. Bentley University’s  .  .  .  It has since been endorsed by Christina Romer, who was President Obama’s head economist earlier in his term, Paul Krugman and the economic team at Goldman Sachs.

.   .   .

Woodford’s endorsement adds additional respectability to the NGDP-level targeting proposal, but the paper does much more than that. It answers an important question that the proposal’s critics often bring up: What sort of action, exactly, can the Fed take when its fancy new NGDP target says it should act? When interest rates are at zero, as they are today, you can’t push them much lower. You can print money and use it buy up bonds in hope of increasing in the money supply (quantitative easing). This all misses the point, Woodford contends. The simple act of the Federal Reserve chairman saying he’s going to target NGDP is action enough.

I deleted some unimportant material to save space.

Update:  JimP sent me the following Joe Weisenthal column at Business Insider:

Forget Bernanke: A Paper At Jackson Hole May Have Changed The Future Of Economics

.  .  .

The red line represents the potential nominal GDP for the economy (which is calculated making a few assumptions about stuff like full employment). The blue line is the actual nominal GDP.

What’s defined the crisis, and post-crisis periods is the huge gap that has emerged between total output, and total potential output.

What Woodford concludes is that the Fed ought to say this:

We are going to keep rates low until the blue line comes back and touches the red line.

.   .   .

So this is the idea Woodford’s getting behind. Making a credible promise not to raise rates until a clear moment that will occur well after the recovery has really gathered steam.

It’s worth noting that this isn’t an idea that’s new to Woodford at all. Other economists (notably .  .  . ) have been talking about similar ideas for a long time. Even Goldman has advised the Fed to set a Nominal GDP target.

But this is a major moment, when a top economist at one of the world’s foremost monetary policy settings made this case (and in a very thorough manner).

.   .   .
We’d also point out that Feroli’s note is titled: Don’t forget the undercards at Jackson Hole “” the boxing metaphor is pretty much perfect given that Woodford afford a major rebuke to the big guy.

Bottom line: Ideas that had been buzzy and fringy not long ago are now very close to the center of the profession of monetary policy.

PS.  Sorry for all the ellipses folks; just a little juvenile humor.


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50 Responses to “Dylan Matthews on Woodford’s paper”

  1. Gravatar of Morgan Warstler Morgan Warstler
    3. September 2012 at 17:21

    Has Woody called you yet? Contacted?

    Also, tell me about your new gig with China!

  2. Gravatar of Meegs Meegs
    3. September 2012 at 18:07

    And so it begins.

  3. Gravatar of Jim Crow Jim Crow
    3. September 2012 at 18:18

    I’ll be drinking a beer in your honor, sir. *fist pump*

  4. Gravatar of Greg Greg
    3. September 2012 at 19:21

    Congrats!

  5. Gravatar of Full Employment Hawk Full Employment Hawk
    3. September 2012 at 19:53

    “When interest rates are at zero, as they are today, you can’t push them much lower.”

    That is a demonstratably false statement. SOME INTEREST RATES are at zero and cannot be pushed much lower, but many are not. For example the interest rate on excess reserves and morgage interest rates are not at zero and can be pushed lower.

  6. Gravatar of Full Employment Hawk Full Employment Hawk
    3. September 2012 at 20:00

    “So this is the idea Woodford’s getting behind. Making a credible promise not to raise rates until a clear moment that will occur well after the recovery has really gathered steam.”

    Since there are interest rates that affect aggregate demand that can still be lowered, why not lower them and then make a credible promise not to raise them until a clear moment that will occur well after the recovery has really gathered steam?
    Why would that not be more effective yet?

  7. Gravatar of Full Employment Hawk Full Employment Hawk
    3. September 2012 at 20:18

    “and his book Interests and Prices, in which he laid out in detail his views on monetary policy, was hailed upon publication as a “landmark treatise” by Harvard professor and former White House chief economist Greg Mankiw”

    Clearly Woodford’s paper implies that monetary policy should be more expansionary. So when in Mankiw going to come out and state that Mitt’s criticism of the Fed of following too expansionary a monetary policy is totally wrong? (Sarcasm)

  8. Gravatar of Full Employment Hawk Full Employment Hawk
    3. September 2012 at 20:23

    NGDP targeting may well become established if Obama and the Democrats are reelected. But if Romney and the Republicans win, it will be stimied and killed. Romney and Mankiw may want to support this, but the Republican right wing base in Congress will be inflation hawks who want tighter monetary policy and even a gold standard. And so far Romney has given no indication that he has the guts and backbone to stand up to these people. Once again, he will back down to their demands.

  9. Gravatar of Full Employment Hawk Full Employment Hawk
    3. September 2012 at 20:25

    And, of course, congrats. I learned about the advantages of NGDP targeting from this site.

  10. Gravatar of Jim Glass Jim Glass
    3. September 2012 at 22:08

    Ed Lazear has a paper saying the steep unemployment of the last four years is not structural but cyclical, and so the responsibility of the Fed. (And which reviews how most other analysis says the same.)

    Put this together with Woodford and you get: “Ben, **** it, you broke your promise to Milton, you did it again.”

  11. Gravatar of Benjamin Cole Benjamin Cole
    3. September 2012 at 22:34

    Onwards Market Monetarists.

    More and more, I am hearing buss that the next QE program will be open-ended. A step in the right direction.

    Yes, a few years too late, but welcome nonetheless.

  12. Gravatar of Dirk Dirk
    3. September 2012 at 23:41

    If there’s any justice at all in this world this paper will change the future of economics and make Woodford a household name.

  13. Gravatar of Saturos Saturos
    4. September 2012 at 00:23

    Yayyy for Scott!!!

  14. Gravatar of Saturos Saturos
    4. September 2012 at 00:41

    Hang on a minute! What’s this?

    Interestingly, Woodford ends with an argument for the other policy he thinks could do a lot to boost growth now: fiscal stimulus, such as tax cuts or spending increases. And pairing NGDP targeting with more stimulus would be especially effective, he says, as it would prevent any “crowding out” of private-sector activities or inflation that could result from increased government spending. NGDP targeting, in short, adds more “bang for the buck” to stimulus spending.

    Scott, once again, why is Michael Woodford wrong about fiscal stimulus? I recall you quoting him saying years ago that fiscal stimulus had no place in stabilization policy…

  15. Gravatar of Rajat Rajat
    4. September 2012 at 01:16

    Adding my congratulations to those of others…

    But yes, the point of about fiscal stimulus is puzzling and disturbing.

  16. Gravatar of Ritwik Ritwik
    4. September 2012 at 02:10

    Saturos

    There would be no confusion if you understand that Woodford’s trying to answer the question of ‘what should be the policy goal’ and ‘what are the interactions/how best to achieve it’ rather than saying that central bank omnipotence will take care of it.

    Congratulations to Scott, but it is rather funny to see people fall over themselves trying to show that Woodford believes that communications from central bank are ‘enough’, when he goes to great pains to explain (beginning pg 11) why communications may not be enough. One can agree with Scott/MM that level targeting NGDP is the right policy goal, that a properly communications channel is the most *important* one, and that a certain kind of forward guidance is required, without necessarily believing that any of this would be ‘enough’. That’s basically Woodford’s position.

  17. Gravatar of ssumner ssumner
    4. September 2012 at 04:10

    Saturos, Woodford is a Keynesian, and they all seem to believe fiscal stimulus is useful at the zero bound. They think Fed promise of stimulus might lack credibility, even though Yglesias recently showed once again that it is almost certain NOT to lack credibility.

  18. Gravatar of Doug M Doug M
    4. September 2012 at 06:57

    Is it necessary for the blue line to come back to touch the red line?

    Should the Fed be targeting 5% NGDP, or should they be targeting 10% NGDP for some period to absorb the slack that built up between 2008-2009 and bringing down thereafter. While I have never heard the that veiwpoint expicitly stated, it has been suggested here before.

  19. Gravatar of Full Employment Hawk Full Employment Hawk
    4. September 2012 at 08:17

    “Scott, once again, why is Michael Woodford wrong about fiscal stimulus?”

    Scott, if I understand his position, as he has stated it here, correctly is that any expansionary Fiscal policy would be fully offset by the Fed with a less expansionary or more contractionary Monetary policy that would fully crowd out the effect of the fiscal expansion, so that output would not be affected. To the best of my knowledge there is no generally accepted term for this type of crowding out. I suggest that it be called “monetary policy crowding out.” And what Scott has said indicates that he believes this to be complete. Clearly Woodford does not believe that such monetary policy crowding out would occur and, since it does not, that expansionary monetary policy would actually reinforce expansionary fiscal policy.

  20. Gravatar of Full Employment Hawk Full Employment Hawk
    4. September 2012 at 08:40

    Actually the economy does not have to be in a liquidity trap, and I do not believe it to be in one, for expansionary fiscal policy to be effective. If the central bank believes that aggregate demand requires more stimulus, but for some reason is unwilling to provide it, or as much as is needed, expansionary fiscal policy is effective. The central bank may be reluctant to provide the needed monetary stimulus for fear of political criticism or retribution, for uncertainty of how effective expansionary monetary policy would be with the federal funds rate having reached the zero floor, for fear that an excessively large asset portfolio would cause problems when the Fed has to switch to contractionary monetary policy, or that it might eventually lead to serious inflation, etc. Clearly there are a lot of things that can make a central bank unwilling to act and fail to provide more stimulus even though it recognizes more stimulus is needed. Monetary stimulus would work but is not forthcoming. I suggest calling such a situation a “pseudo liquidity trap.” In such a situation expansionary fiscal policy is effective, and this is exactly the kind of situation we are facing right now.

  21. Gravatar of Bill Ellis Bill Ellis
    4. September 2012 at 09:45

    Scott,

    How does the Fed make its promise credible when the Teapublican controlled congress can be counted on to vilify them for keeping it?

    The Fed is supposed to be politically independent, but we all know, and the market knows that it is not.
    Hair-on-fire Republican fear mongering over inflation and a debased currency will burn credibility in an instant.
    If enough Dems were on board with NGDP targeting… or just Obama… it would be enough to give the Fed cover. The Dems getting behind NGDP targeting is in the realm of possibility.

    Politics matter…in everything.

  22. Gravatar of Costard Costard
    4. September 2012 at 09:47

    The chart of nominal vs. potential nominal GDP is illustrative only of the endpoint used. If NGDPPOT was determined by 1990-2002, rather than 1990-2012, the red and blue lines would have parted ways 12 years ago and the discrepancy today would be more extreme. Whereas this same chart measured in 2022, with 10 more years of data, will most likely show a much smaller divergence. Smoothed averages are always misleading in the context of a cyclical data set; at cyclical extremes, the data and the smoothed average will diverge and neither one will match trend — which can only be measured after the fact.

    I’m open to the idea of nominal GDP targeting but the idea that nominal GDP should “catch up” with potential nominal GDP is worrisome. In practice, this would justify every hyper-investment and asset bubble that follows a downturn. The housing bubble would simply have been NGDP “catching up” from 2000-2002, and the Fed would have been obliged to keep rates low. This sort of policy would tend to favor an increase in inflation during downturns but no reduction in inflation during booms; and an overall increase in inflation (or NGDP, whichever you prefer) will change the “potential” NGDP trend-line that growth is being measured against and require an increase in the the growth rate targeted. You have not created a more responsible monetary policy, merely a more inflationary one, in which there is a feedback mechanism that will, all things equal, result in hyperinflation.

  23. Gravatar of Bill Ellis Bill Ellis
    4. September 2012 at 10:00

    Scott says…

    “They think Fed promise of stimulus might lack credibility, even though Yglesias recently showed once again that it is almost certain NOT to lack credibility.”

    Are you referring to “Is Promising Hard?” http://www.slate.com/blogs/moneybox/2012/09/02/is_promising_hard_.html

    If so, I don’t agree.
    Ygalesias’ case overlooked that it is easy to go back on a promise when your boss tells you you have to. To make a promise credible you have to have juice to make it happen in the first place.
    If the Fed makes the promise to going for a NGDP target, the Market will always be looking for the Boss to cancel the project.

  24. Gravatar of Doug M Doug M
    4. September 2012 at 10:24

    Bill Eillis,

    Politics and the Fed…The Fed doesn’t give a lick what Congress says. They care just a little bit about what the president thinks.

    About the most political that they get, is that the Fed rarely changes policy in the months immediately before an election.

  25. Gravatar of D.Gibson D.Gibson
    4. September 2012 at 10:39

    Perhaps “What is NGDPLT?” will replace “Who is John Galt?” for the right wing crowd. I could see the GOP changing their minds about tight money, if they win and are held responsible for the economy.

    Good work, Scott!

  26. Gravatar of W. Peden W. Peden
    4. September 2012 at 10:58

    What is “potential” nominal GDP anyway?

  27. Gravatar of W. Peden W. Peden
    4. September 2012 at 11:02

    D.Gibson,

    If I were a cynical man, I’d recommend Market Monetarists in the US to push the meme “Why is the Fed allowed to sabotage fiscal responsibility?” if Romney wins and the meme “Why is the Fed forcing fiscal austerity on us?” if Obama wins.

    NGDP targeting would help either a hawkish or dovish approach to the US fiscal deficit.

  28. Gravatar of Bill Ellis Bill Ellis
    4. September 2012 at 11:59

    Doug M,

    So why hasn’t Ben taken Ben’s advice ?

  29. Gravatar of Bill Ellis Bill Ellis
    4. September 2012 at 12:17

    D Gibson says..
    “I could see the GOP changing their minds about tight money, if they win and are held responsible for the economy.”

    I think it is a good thing to be cynical when it comes to politicians…But you would have to be very cynical to believe that congressional repubs could do a 180 on monetary policy…
    They act as if opposition to “easy money” is one of their core beliefs. You would have to believe…that they don’t believe.

    Personally I think there is a large segment of true believers in the GOP ranks, and the base backs them. For the repubs who are not true believers to take on the true believers, would be to risk the wrath of the base in the primaries. They have seen to many “RINOs” get “primaried ” to stick their necks out.

    And Romney is not about to get into a ugly fight with a repub congress over something that does not effect his class. Although if anyone could flip flop it would be him.

  30. Gravatar of John Thacker John Thacker
    4. September 2012 at 12:17

    Contra all the Democratic Party fans here, I’d have to note that Obama and the Democrats have had years to come on board with NGDP targeted, and for all I see, they remain uninterested. They’re far more concerned with the idea of fiscal stimulus.

    Though I could see a good case for NGDP targeting happening if there’s a combination of an Obama Presidency combined with a more firmly Republican Congress. The President, if he cared about monetary policy, can influence that more than he can get fiscal stimulus passed by a hostile Congress.

    I would also caution people to read surveys about inflation. While it’s true that conservatives everywhere tend to be (overly) concerned about inflation, the same is true of Independents. Not just in that Gallup poll, but in other polls. Democrats are less concerned but still quite concerned. Independents are quite close to Republicans in inflation worries.

    Concern about inflation actually tends to be quite popular, more popular than hard core conservative claims. When Republicans appeal to anti-inflation instincts, they’re not (just) pandering to the base– they’re appealing to the center.

    As long as that is true and the politics work that way, dreams of Democrats taking bold action on monetary policy until forced to (by the reality of a Republican Congress refusing fiscal stimulus) are as unlikely to happen as dreams of Democrats actually acting on all those civil liberties planks in the 2008 DNC platform that have vanished from the 2012 platform, as the Obama Administration has ratified Bush Administration policy. Good intentions or not won’t matter, especially if the case isn’t made.

    Only when all alternatives are exhausted will monetary policy finally be turned to. The Democratic Party’s first and most cherished option will always be fiscal stimulus, as a way to achieve policy goals.

  31. Gravatar of Major_Freedom Major_Freedom
    4. September 2012 at 12:26

    It’s extremely disconcerting reading all the “yay!” comments on this blog. Cheering and applauding to a window dressing change to a fundamentally coercive and destructive system, that in the end is going to consist of an acceleration in the rate of money inflation and eventual breakdown of the currency? Good grief. Where is the self-respect?

    This is like the string quartet merrily changing their selected tunes on the deck of the Titanic as it is sinking.

    Well, at least some good will coming out of all this. All your comments are going on the record, for future economists to read and facepalm.

  32. Gravatar of Major_Freedom Major_Freedom
    4. September 2012 at 12:50

    So this is the idea Woodford’s getting behind. Making a credible promise not to raise rates until a clear moment that will occur well after the recovery has really gathered steam.

    It is comments like this that show the incongruity between aggregate Monetarist/Keynesian theory and the market process. There is a sort of inherent faith in the belief of a fuzzy aggregate blob-like conceptualization of aggregates to get moving, which is then interpreted as “recovery” in the micro-level economy. There is however a huge gap between the two. Every Keynesian and Monetarist fades out when the focus is put on future outcomes. “X won’t last forever. It will be removed once the economy “gets going” again. Then we can remove X.” All that needs to occur is for employment and output, indeed any employment and any output, to increase. Once this happens, then “the economy is improved” and the seemingly aggregate only X can be removed.

    The problem with this view is that it does not respect the micro-level significance of interest rates. Interest rates mean something in a market economy. They communicate the temporal preferences of economic agents. In other words, they convey how far into the future economic plans are to be made and thus in what particular relative allocation should scarce resources be put in the present.

    If the Fed is going to raise rates later on, after they gain a flash of revelation from the Gods that the economy is “recovered”, then that raising of rates will expose previous investments dependent on those low rates as no longer economically viable. Longer term projects that were started as if real capital was available, due solely to interest rate manipulation by the Fed, are going to be revealed as malinvestments.

    If this is not to be accompanied by idle resources and unemployment, due to the misguided belief that corrections can be postponed by increasing inflation in order to target NGDP, then the Fed is going to have to once again accelerate the rate that it creates money in the face of a market that “desires” temporary contraction and correction as it is reoriented back to a temporal structure that is more in line with actual consumer preferences, as opposed to the preferences of ivory tower technocrats who arrogantly claim to know what interest rates ought to be. This will of course bring about more malinvestments, and the same process repeats.

    Macro-“economics” is really just a form of mysticism that substitutes for economics. Treating the symptoms, not the causes.

  33. Gravatar of Bill Ellis Bill Ellis
    4. September 2012 at 12:54

    John Thacker,

    It is true that the dems have had a lot of time to get on board with NGDP targeting and that they still back Fiscal stim. But they are recognizing that the fed is important, and at the very least that the Fed’s suborn 2% or less inflation target will blunt our precious, precious fiscal stim.

    Increasingly Dems want both Fiscal stim and Monetary stim. And they will take either if they can’t have both.
    Apart from Market monetarists, the economists voices that support NGDP targeting are mostly on the left. So if there is a hope that economist can influence policy…it is mostly a hope the political left that can be influenced.

    On the other hand the right is Fundamentally opposed to both fiscal and monetary stim. And plenty of economists on the right back them up and paint the M&M’s as kooks…evidence be damned.

    Fans of NGDP targeting don’t have much to get exited about when it comes to the dems…the dems aren’t the NGDP team. But they might become it. They are moving in the right direction.

    But the repubs ARE the Rival Team.
    Why are so many NGDP Fans rooting for their arch rival ?

  34. Gravatar of Bill Ellis Bill Ellis
    4. September 2012 at 13:00

    I meant to say…”it is mostly a hope that the political left can be influenced.”

  35. Gravatar of Greg Ransom Greg Ransom
    4. September 2012 at 14:18

    It sort of looks like Woodford has endorsed the worst possible version of NGDP targeting, the one that Scott Sumner himself rejected (e.g. returning to more than half a decade old NGDP trend line constructed with a grammar school ruler, when the NGDP has been growing for years already at exactly the same NGDP growth rate of past decades.)

  36. Gravatar of Doug M Doug M
    4. September 2012 at 14:54

    So why hasn’t Ben taken Ben’s advice ?

    He has…Committment to zero rates, QE1, QE2, Operation Twist…

    Despite impressions, the US economy is much heathier than the Japanese economy that Bernanke wrote about in his 1999 paper.

  37. Gravatar of CA CA
    4. September 2012 at 15:41

    John Cochrane has posted a lengthy comment on Woodford’s paper:

    “So, in my view, the problem isn’t overly tight monetary policy. The economy’s problems lie elsewhere. Monetary policy is basically impotent. And it’s hard to see that deliberate monetary “stimulus” via expected inflation will help the real economy. We should be telling the Fed to stop pretending to be so all important. You’ve done what you can. Thanks. You’ll do best now by sitting on your hands and letting others cure the real problems. But that kind of advice doesn’t get you (me!) invited to Jackson Hole! The Fed wants to “do more.”

    http://johnhcochrane.blogspot.com/2012/09/woodford-at-jackson-hole.html

  38. Gravatar of Bill Ellis Bill Ellis
    4. September 2012 at 16:04

    Ben has been saying all along he could do more…And only offers lame excuses hinting at unintended consequences…

  39. Gravatar of dtoh dtoh
    4. September 2012 at 19:29

    Scott,
    When are you going to do the post you promised on why OMO do work at the ZLB. You have frequently said expectations have to be about something. Woodford, Krugman and Cochrane are all saying OMO don’t work… i.e. that expectations are about nothing. We are all waiting with baited breath for your post!

  40. Gravatar of Negation of Ideology Negation of Ideology
    4. September 2012 at 20:42

    Bill Ellis –

    “Fans of NGDP targeting don’t have much to get exited about when it comes to the dems…the dems aren’t the NGDP team. But they might become it. They are moving in the right direction.

    But the repubs ARE the Rival Team.
    Why are so many NGDP Fans rooting for their arch rival ?”

    Valid points and good question. As for me, I don’t believe there is any risk of Romney doing any more for the “hard money” nuts than having another Gold Commission – and no serious economist is for the gold standard so we already know the commission will vote against restoring it. But Romney could go for NGDPLT and sell it as a measure to fight inflation and reign in the Fed.

    Or even better, he could have a commission to look at broader Fed reform and make Scott Sumner and Christina Romer co-chairs.

  41. Gravatar of Kevin Johnson Kevin Johnson
    4. September 2012 at 21:38

    How about an attempt to get a question about NGDPLT asked at September 13th’s Bernanke press conference? If enough interested people submitted a mutually agreed question to reporters who’ve previously solicited them, such as Steve Goldstein at Marketwatch (http://goo.gl/gTX5i) and Annalyn Censky at CNNMoney (http://goo.gl/y3PxI) it might get asked during or after the conference.

    Here’s a suggested unbiased question in plain language:
    How would current Fed policy change if its mandate targeted only price stability, and how would Fed policy change if its mandate targeted nominal GDP growth, the sum of the growth of economic output and prices?

  42. Gravatar of Matt Waters Matt Waters
    5. September 2012 at 01:17

    Costard,

    Your argument is a typical one: that the only way to sustain growth of nominal spending is to somehow sustain bubbles. However, we had sustained spending growth in the 50’s and 60’s without bubbles. Sustained spending growth just means incentivizing private spending. Somebody, somewhere out there holds the monetary base and lowering real rates/increasing NGDP expectations unfreezes that money.

    For that new money to go into capital misallocations, private investors would have to do something stupid with their own money. Typically that isn’t case. Most of the times that is the case is due to very poor regulatory structures. In particular, the lack of banking regulation in the 20’s and the 00’s allowed bankers to conjure up safe assets en masse from extremely risky assets.

    Without such capital misallocations, the nominal spending goes instead to consumption or more non-misallocated investments at lower rates. The worst effect such nominal spending increases would have is that they would lead purely to inflation, and no real production growth. This is what we got in the 70’s. But if there is slack in labor markets, then workers cannot bargain for higher wages and the extra spending goes instead to more real production and lower unemployment.

  43. Gravatar of John John
    5. September 2012 at 04:20

    John Thacker,

    The Democrats and Obama are not even advocating fiscal stimulus, they are arguing for higher taxes on the rich, damn what the economists have to say about it.

  44. Gravatar of Bill Ellis Bill Ellis
    5. September 2012 at 08:20

    Arguing against more austerity is arguing for stim.
    Austerity = negative stim.

  45. Gravatar of Costard Costard
    5. September 2012 at 10:15

    @Matt: “For that new money to go into capital misallocations, private investors would have to do something stupid with their own money.”

    You must have a charmed theory of the business cycle, if it begins with the assumption that human beings never do anything stupid. But false expectations are a problem for the intelligent as well as the dumb; no one can predict the future. Half a decade ago, the expectation was that the Federal Reserve would never allow home prices to collapse. Banks leveraged upon this because they, like you, had a boundless faith in the men behind the curtain. Had the Reserve been following a mandate that said NGDP should “catch up” from the dot-com crash, they would have waited even longer to raise rates and the situation been made worse.

    You can blame the banks; or you can blame the accommodative Fed policy that, in both the ’20s and the ’00s, herded both banks and investors into high risk. But to argue for easier monetary policy and tighter bank lending at the same time implies a basic lack of understanding about the position you’ve taken. The world is not stocked with safe investments, and lower interest rates in the recovery and boom parts of the cycle mean greater movement of capital into risk investments — period.

    Your argument is to say that, well, sometimes we don’t have capital misallocations. That’s fantastic — yet sometimes we do. Passing the buck to regulators is disingenuous; their crystal ball is no better than the market’s. You’ve simply made the shortcomings of your theory someone else’s problem.

    A stricter form of NGDP targeting, where a given growth rate is aimed at every year, may be a better option – like I said, I’m open to the idea, particularly since NGDP targeting would be better than inflation targeting at taking into account price movements in capital assets – but this Woodford variant is simply dangerous.

  46. Gravatar of Doug M Doug M
    5. September 2012 at 11:05

    Matt Watters,
    “In particular, the lack of banking regulation in the 20″²s and the 00″²s allowed bankers to conjure up safe assets en masse from extremely risky assets.”

    I would say that you have it completely backward. The presence of increased banking regulations in the 1980’s, lead to regulatory arbitrage. The CDO and its subsets were created to move assets off of the balance sheet / or to relable risky assest as riskless assets and keep them on the ballance sheet. This was a reaction to risk based capital weights.

    The regulatorts turned a blind eye to these exotic derivatives, believing that they surved a purpose to increase transparency, liquidity and efficiency. The great lie of it was, of course, that these exotics exist to do just the opposite. They create arbitrage profits, and allow the banks to hide risk.

    The only reason that a bank’s ballance sheet is so impenatrible is that the bank is trying to stay ahead if its regulators.

  47. Gravatar of dtoh dtoh
    5. September 2012 at 15:24

    Negation – Your Right. The Republicans will just attach an new name and some rhetoric to an expansionary monetary policy and 99.9999% of population and media won’t know they’ve done a 180. What they’re saying now is just politics.

    Costard – You’re wrong. Derivatives do serve a purpose. The reason capital was mis-allocated was because there was a free implicit TBTF guarantee on bank borrowing. Bank managers and traders were rational. All they had to do was get through a couple of bonus cycles to make money on their bets. If the Fed is going to provide a TBTF guarantee, it’s needs to have tighter bank capital rules.

  48. Gravatar of Matt Waters Matt Waters
    5. September 2012 at 15:58

    Costard,

    When you say Fed policy “herded both banks and investors into high risk,” that only makes sense if somehow the Fed put a gun to investor’s head and said “you have to invest in these Tech IPO’s or else.”

    That’s not how it works. In fact, people holding money do not knowingly invest in investments yielding -10% whether the interest rate is 1% or 10%. Interest rates could even be -5%, through penalties on holding money at the Fed, and they still wouldn’t invest in something that yields -10%. No investors are in the business of charity. They invest money only in investments that yield more than the risk-free rate. If needed, the Fed can reduce interest rates to both move forward consumption (since savings earn less interest) and increase volume of investments. Volume is not increased through greater capital misallocation, but because more investments make sense at lower interest rates.

    So why did real private investors with real money invest in Tech IPO’s, subprime CDO’s and derivatives, and Greek sovereign debt. I find zero empirical, logical or intuitive basis in saying that investors were somehow “confused” by low interest rates. The 3-month T-bill rate was 1% in the 60’s, but there was no big crash like the 20’s and the 00’s. In reality, such capital misallocations are mainly due to principal-agent problems. If investors freely put their own money in assets that yield less than the risk-free rate, then there was significant asymmetric information or other issues with that market.

    So, if the Austrian Business Cycle view can be falsified (“low interest rates = bubbles”), then it has been falsified and should be thrown out without modification to explain the 50’s/60’s exception. And if it cannot be falsified, then it really doesn’t say anything. If any sort of economic events can be coerced to explain ABC, then it predicts that any sort of economic events could happen in the future. Furthermore, saying “the Fed somehow confused the private market and therefore the private market should control everything, including currency” strikes me as a terrible logical inconsistency. I just don’t get how the former assertion leads to the latter conclusion.

    Doug,

    It is very odd to argue against regulation by saying a lack of regulation in some area caused the capital misallocation. Whether or not such “regulatory arbitrage” was regulated, real people somewhere freely invested real money into subprime mortgages and their derivatives.

    In other words, if lack of regulation would have been a good thing for the sectors regulated in the 80’s, then how was a lack of regulation in the other capital conduits a bad thing? As Greenspan and many others (including myself) said at the time of the bubble, the people who should have known best about the investments were the people whose money was on the line.

    The explanation of how so much money went into subprime (or Greek debt for that matter) is much more direct and straight forward than people realize. That explanation is that the investment banks essentially passed on most of the subprime paper as collateral to repo agreements. Corporations, Pensions, Insurance Companies and Money Market Funds then treated those as deposits, because they had supposedly AAA collateral. As the collateral declined in value, the depositors demanded higher and higher haircuts until the bank became insolvent. If the banks were all allowed to fail, the main street funds last to the deposit window would have been left holding the bag.

    The repo market and its ultimate conduit to very risky speculation has a good bit of parallel with the way some banks in the late-20’s used depositor money to fund things like extreme margin to speculate on stocks. Panics before the FDIC happened with somewhat regularity as depositors, even uninsured depositors, would eventually forget the last panic and leave money in a bank thinking it was safe. Bankers in theory would focus on reducing operational costs and spread between deposit yields and lending yields. In practice, though, many banks dedicated themselves to finding the highest yielding products which did not run afoul of regulators or alert depositors, regardless of whether it would get those yields in the long-term.

    In 2008, the issue was somewhat different than those old bank runs. We had the same bank runs, but instead our financial intermediaries were running to the banks. The CFO’s of Fortune 500 companies had limited losses if their current asset management resulted in a catastrophic loss, but typically had higher earnings through yielding more than the risk-free rate in the money market/commercial paper market. Same goes for pensions and insurance companies. There was no way shareholders of companies/insurers or the boards of pensions or the foreign bank depositors (like IKB bank) could have policed the make-up of collateral on short-term repo assets. Such market action would have required superhuman action and knowledge on their part.

    All that to say most capital misallocation had relatively simple, direct causes if one is actually open to actually looking at the evidence of why investors, of their own free will, put money in these assets. There’s all sort of rabbit trails and contortions that people do to get around it, but the basic fact is that principal-agent problems were the one, main source of misallocated capital.

  49. Gravatar of Doug M Doug M
    5. September 2012 at 18:23

    Matt,

    “It is very odd to argue against regulation by saying a lack of regulation in some area caused the capital misallocation.”

    No, I am saying that the presence or regulation caused a capital misallocation.

    Banks held toxic “AAA” rated ABS because “toxic waste” had preferential regulatory treatment to non-structured, less toxic but lower-rated debt. AAA assets have minimal haircuts in the repo market, inflating their value over their “economic” value. European banks hold Greek Government debt, because it has 0 risk-based capital weighting.

    I agree, that capital misallocation has some very simple causes. And I agree that investors of their own free will bought those assets. And the people who should have known best what they were buying were ones who were burnt. However, the regulations gave those assets a value in excess of their value as investments. The regulators were “captured” by the entities that they were supposed to be monitoring. I am not against all regulation. I am against bad regulation. And, banking is poorly regulated.

    Agent problems… bankers and traders – they are paid to roll the dice. If they hit their numbers they get a handsome bonus, if they don’t they go across the street and try again. Sr. management – again an asymmetric payoff – they get billions (okay hundreds of millions) if they are right and (fewer) millions if they are wrong. Equity holders – whether they were acting in their own best interests is debatable, but the institutional equity players seemed to be signaling that banks were right to maximize their leverage and short-term profits. Last line of defense – the bond holders — if the government is going to bail out the bond holders, what is their incentive to see that the banks are well run?

    odds and ends…

    Not that much money actually went into sub-prime debt or Greek government debt — about $200 billion into each of them. Yet the losses credited and the bailouts triggered were each several times larger than the markets that were supposedly responsible.

    Repo is to modern banks what depositors used to be. 2008 wasn’t similar to bank runs in the pre-FDIC banking environment — it was exactly a bank run. When creditors demanded larger haircuts or cut their counterparty exposures, it had the exact same effect as line of depositors lined out the door demanding their money back.

  50. Gravatar of Costard Costard
    6. September 2012 at 09:49

    @dtoh: I don’t see how I can be “wrong” about something I never offered an opinion on. Are you really responding to me? If so can you be a little more clear about what you’re disagreeing with?

    @Matt: “Volume is not increased through greater capital misallocation, but because more investments make sense at lower interest rates.”

    This is precisely my point. What do you think will satisfy the demand for “more investments”? T-bills? CDO’s swamped the market for a reason: there was a huge demand for yield and not enough investment-grade assets to satisfy it while maintaining any kind of premium to inflation. So the market innovated. Had capital requirements not been in place, they wouldn’t have bothered to hide the increased risk; as it turns out, all they did was conceal it.

    Conversely, fewer investments make sense at higher interest rates. If you don’t understand that “capital misallocation” is a function of a change in interest rates, then there’s no point in even using the term. What matters is not rates at 1% or at 10%, but a movement from one to the other.

    Profit margins are only one consideration. Asset bubbles are driven also by price appreciation, and as prices go vertical this becomes the dominant factor. They deflate not because they’ve become unprofitable, but because the change in price + yield becomes unfavorable. Mortgage default rates were rising but CDOs would have continued to provide a comfortable income even in a higher interest rate environment, if liquidation hadn’t precipitated a downward spiral. On paper these investments always look good; but a small change in rates can have extraordinary consequences. This is the problem with interest rate volatility, and it’s the problem with Woodford’s notion of “catching up” in the recovery — which, after all, was the reason for this discussion. Had the Fed waited longer to raise rates, inflation would have been a more serious issue, and would have forced a stronge reaction, and the collapse in housing would have been even more spectacular.

    I wasn’t discussing ABC theory, so I see no need to defend it. However I will say that it’s impossible to falsify something you don’t understand. “Low interest rates = bubbles” has never been the Austrian position. What matters to them are interest rates set below what the market would charge. I suspect they would respond to your interpretation of the 60’s by bringing up the 70’s. We didn’t leave gold in ’71 because everything was going splendidly.

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