Help, I’m surrounded!

I just got back from a very satisfying trip to GMU, where I met a lot of my favorite economists.  I’ll say more about the trip when I have time, but upon returning I found I was being bombarded on all sides.  I feel like I am in a boat that has more holes in the hull than I have fingers to plug them.  Interested readers might want to check out my ongoing debate on Cato Unbound, where I fend off several reviewers.  You’ll see all the replies in the right margin.

After responding on Cato Unbound, I started to catch up by going back over Econlog, and found this passage by Arnold Kling:

Suppose that the Fed had decided to print a lot more money at some point last year. The Scott Sumner thesis is that this would have raised nominal GDP. In my view, the fall in nominal GDP was due to the fact that real GDP had to fall. Real GDP had to fall, because the economy was beginning a Great Recalculation. The Great Recalculation was mostly due to the end of the housing bubble and the shrinking of the financial sector.

First let me emphasize that this is not my view of monetary policy, it is the monetarist view.  If it was my view I’d be lumped in with Alan Meltzer and Anna Schwartz, and you’ve certainly seen me criticize their view of monetary policy.  I have argued that a more expansionary monetary policy would have boosted NGDP.  A more expansionary monetary policy is one that raises the expected rate of NGDP growth over time.  That might involve more base money, but last fall it almost certainly would have involved much less base money.  The reason the base was so bloated was that people expected deflation, and hoarded money.   (And because interest was paid on reserves.)   Yes, there is probably some level of base money that would have been large enough to prevent NGDP from falling, but I certainly don’t think that is a useful way of describing what was needed.

Second, if it is true that nominal GDP had to fall because real GDP fell, doesn’t that mean monetary policy was powerless to affect prices?  So is Arnold Kling arguing that monetary policy is ineffective at raising prices once interest rates hit zero?  Even Paul Krugman doesn’t believe that.  Krugman believes that inflation targeting would still work at the zero bound.  I would be interested in hearing why inflation targeting would not work at the zero bound.

Consider a permanent increase in the money supply.  If it were not inflationary, that would mean it caused a permanent rise in real money demand.  But does that make sense?  Do you let Bernanke tell you how much purchasing power to hold in your wallet?  If he permanently raised the base by 10%, would you permanently hold 10% more non-interest-bearing cash in real terms?    Perhaps Kling is arguing that a monetary injection would not be viewed as permanent.  In that case I’d agree, but I can’t imagine why people wouldn’t regard it as permanent if the Fed had an explicit inflation target.

Third, I’ve never understood this “Great Recalculation” story.  I can see why it would cause people to lose their jobs in the housing and financial sectors.  But what I don’t understand is why those people wouldn’t look for jobs in other sectors.  Why wouldn’t employment gradually rise in other sectors?  Yes, frictional unemployment would rise during the transition, but that’s what happened in 2007, not 2008.  In late 2008 NGDP started falling fast and millions lost jobs in industries unrelated to the housing bubble.  I don’t understand why that occurred, if the negative nominal shock is not the explanation.  One can hardly claim that all industries were bubbles; that would imply the public was in the mood for a “Great Vacation.”   So why the massive collapse of jobs all of a sudden in manufacturing and services unrelated to finance?  Is it possible that there was less nominal demand for those “other goods?”  And why might that have occurred?

In a follow-up post Arnold made the following claim:

Think of monetary policy as being like currency intervention. It seems as though it is very difficult for a government to maintain a currency at a value that the market views as unrealistic. Similarly, it is very difficult for the government to maintain an interest rate at a level that the market views as unrealistic.

First of all, this is only true of contractionary monetary policies; no one disputes the government’s ability to set the exchange rate at a lower level.  So if it can always depreciate its currency, why can’t it always inflate the price level?  The US is a good example.  The price of gold was pegged at $20.67 an ounce for 54 years.  Did this always happen to be the “realistic” price?  Then under no pressure from speculators at all, it raised the price between April 1933 and January 1934 to $35 dollars and ounce, and held it there for another 34 years (in terms of free market gold prices in Europe, I know the US gold market was closed.)  Did the public suddenly decide that this was the new “realistic” price?  I may have misunderstood Kling’s argument; but that would make us even, as he also said this about my views:

Sumner’s view of the causal ordering of the current recession is that the Fed cut M, which reduced nominal GDP, which reduced real GDP. My view is that the Recalculation reduced real GDP, which also slowed the rate of price increase. The standard view is that there was a huge increase in the demand for M, which lowered nominal GDP. An interesting question is whether it is possible to use data to evaluate these differing explanations.

Ouch!  I hope I don’t believe that, as every single definition of “M” I have ever seen rose last year, and the one I used doubled.  At first I tried to be generous and assume that by “cut M” Arnold meant “adopt a tight monetary policy.”  But then look how he uses the term “M” two sentences later.

In the third round of his debate with Bryan Caplan, Arnold makes this claim:

In classical monetary theory, the helicopters have the same sort of effect as the elves (at least in the “long run”). Relative prices will be unchanged, real economic activity will be unchanged. Only the price level will be different.

However, in my view, classical monetary theory is wrong. The change in the store of value is not neutral. The helicopter drop will disrupt people’s habitual behavior. Initially, with prices unchanged, some people will feel wealthier. However, that will change as they realize that prices are rising. As they see prices rising, people will realize that money is depreciating faster than it was before, and they will try to economize on cash balances. All sorts of relative wealth effects and relative price changes will take place. We will not end up with the same real activity as before.

But that is exactly the classical view, exactly the view of David Hume.  More money is expansionary in the short run and neutral in the long run. So why is classical monetary theory “wrong.”  Then there is another misinterpretation of my views:

Let me return this discussion to Scott Sumner’s thesis. As I understand it, he wants to say that the Fed should have looked around in the second half of 2008, seen that nominal GDP was looking bad, concluded that velocity was falling, and sent the helicopters out to drop money in order to offset this. I am willing to grant that a big helicopter drop would eventually have raised prices above what they otherwise would have been.

This is misleading.  I do not think the Fed should have “looked around” and seen nominal GDP was falling.  I think they should have looked at market forecasts of NGDP one or two years out.  And I don’t think they should have dropped money from helicopters, I think they should have set an explicit NGDP target, which probably would have required a reduction in the money supply, as the target would have almost certainly have raised base velocity sharply.

Then on Econlog I ran into a post by Bryan Caplan that quotes me talking about Denmark.  After the quotation he says:

Friends of Scandinavia often go on to suggest that perhaps libertarians should ignore welfare states.  If they’re economists, they’ll emphasize that industrial policy and state-owned enterprises create large deadweight costs, while redistribution is a mere transfer.

In this case there is no smoking gun showing he misunderstood my views, but I am worried that readers will infer that he is talking about me.  After all, this passage directly follows the long quotation of me praising Denmark.  Let me assure Bryan that I haven’t gone soft.  I remain opposed to the welfare state on supply-side grounds.  I favor the small government/flat income tax/no tax on capital policies of Singapore.  (BTW, Bryan is a great guy; I finally met him in person.  Indeed I really liked all the GMU economists I met—they aren’t just incredibly smart, they were also very kind and supportive to me.)

OK, back to Arnold Kling, round 4.  This time in a discussion of Tyler Cowen’s views:

Suppose we measured GDP on a weekly basis. What can the Fed do this week that would affect nominal GDP next week? I say “nothing.”

All I can say is that I hope Kling isn’t serious here.  There is massive evidence that monetary policy surprises immediately impact asset prices.  Ever looked at the stock market at 2:15 in the day of an unexpected Fed announcement?  And among those asset prices are things like commodities, which trade in auction-style markets.  An expansionary monetary shock will immediately raise commodity prices and perhaps commercial real estate as well.  If Kling is going to argue that NGDP is not affected at all, he’d have to argue that coal output falls just as rapidly as coal prices rise.  If you look at the data from 1933 you can see indirect evidence of NGDP rising week by week (of course no explicit data was available, but all sorts of output indices like steel and rail shipments were available weekly.)  How did they do it?  Not by dumping cash from helicopters–I agree that would be a terrible idea.  Rather they set an explicit inflation target, which raised prices and NGDP right away.  RGDP also rose sharply, even though the banking industry was in even worse shape than 2008.  Funny how the Great Recalculation of 1933 turned around on a dime as soon as easy money was adopted; and output started soaring upward.

And then there is MarginalRevolution .  .  .  Et tu, Tyler?

Tyler Cowen found 7 fundamental flaws in my argument that tight money caused the crisis.  It could have been worse, he might have found 8.  I already commented on his blog (I think around the fifth comment), so I won’t repeat the comments over here.

Of course I am kidding about being beleaguered by criticism.  Like a true monetary crank I remain serenely convinced of my omniscience, no matter how much criticism I get.   I am actually happy that so many people are commenting, it means people are paying attention to the blog.

But I am beleaguered in the sense of being overwhelmed with stuff to do.  I have not even had a chance to catch up on dozens of emails.  And of course I am way behind in answering comments.  Usually I catch up on comments before a new post, but I just couldn’t let all these outrageous, oops, I mean all these insightful comments go unanswered.  I promise I will eventually get to every comment from a week back.  I just don’t know when.

PS.   Tyler’s cryptic comment on my views on India refers to a prediction that it would have the world’s largest economy in 100 years.  If you think this sounds absurd, you should know that Tyler specifically asked me for my most absurd belief.  Please hold off telling me why I’m nuts, I will defend this view in a later post.  It’s far more plausible than you might think.


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73 Responses to “Help, I’m surrounded!”

  1. Gravatar of rob rob
    25. September 2009 at 17:08

    Scott,

    Sounds like a pretty cool situation to be in. After all, when there is a confederacy of geniuses against you.. oh. Maybe I am paraphrasing….

  2. Gravatar of Bob Montgomery Bob Montgomery
    25. September 2009 at 17:15

    Glad you’re back blogging again!

  3. Gravatar of rob rob
    25. September 2009 at 17:15

    India. Let me guess. they dont have the demographic nightmare china, not to mention europe face. But i’m going to put my money on the Persians, if you give me odds.

  4. Gravatar of Current Current
    25. September 2009 at 17:55

    Rob, read up on the demography of India!

  5. Gravatar of marcus nunes marcus nunes
    25. September 2009 at 17:57

    Scott
    It is actually good to be “surrounded”. It means you´re saying something that get people to jump off their confortable chairs.
    Take C. Romer in her last speech, for example: For her the economic crisis only began in earnest last fall – and it had nothing to do with the conduct of MP in the previous 10 months!
    Or take Charles Bean who concludes, like Poirot in Agatha Christy´s Murder on the Orient Express,that “everyone had a hand in it” (caused the crisis, or “murdered the economy”). As for all the talk about “recalculation”, how come the system did a pretty good job in “recalculating” (or relocating) the resources needed to satisfy the large increase in house demand in the US from 1998 onwards?
    With the “panic” and the “great contraction” many say that the 25 years of Great Moderation was just a mirage. The GM happened exactly because policy was effective in containing the propagation of shocks. When policy failed the initial shocks “just rolled on” with nothing to stop them. So, why not blame distorting compensation schemes adpoted by “greedy” bankers? A topic that will certainly be a favorite in the G20 Pittsburg meeting this weekend.

  6. Gravatar of happyjuggler0 happyjuggler0
    25. September 2009 at 18:02

    I’m guessing that Scott’s argument goes something like:

    China has both higher per capita GDP and a higher population than India does right now. India will likely have a huge GDP (RGDP!) growth rate similar to China’s, but thanks to China’s alleged one child policy, India’s population will surpass China’s. Take a higher population (for India) and combine it with the same per capita GDP growth rate, and it mathematically ought to surpass China’s overall GDP total.

    Note that I don’t think there will be convergence issues on a per capita basis for GDP the way there will be contrasted with China/US or India/US.

    Welcome back Scott. I was going through withdrawal symptoms. 🙂

  7. Gravatar of Blackadder Blackadder
    25. September 2009 at 18:56

    Rob and Happyjugler0,

    What you’re missing on India is that it is more democratic than China. Hence, on Prof. Sumner’s views, it is more likely to have better policies over the next 100 years.

    I’m not sure why this would count as an absurd belief, actually. India and China have the largest populations, so having the largest economies in 100 years makes sense. If he’d said the largest economy in 100 years would be Albania, that would be a different story.

  8. Gravatar of Greg Ransom Greg Ransom
    25. September 2009 at 20:14

    Scott, you forgot to include the auto industry — identified by Hayek as a capital good for purposes of macro / capital theory / trade cycle theory.

    Or consider what I’m seeing in Orange County, CA.

    I know folk who 3 years ago worked as realtors, computer programmers for builders, finance guys, etc. — today they are working for cashing arranging closets, trying to sell used cars in a start up, or they’ve become stay at home dad’s, etc.

    And talking with construction and gardening labor here — many in those industries have gone home to Mexico or Central America. At the Home Depot one day I counted over 100 day laborers looking for work ..

    I don’t think you’ve thought carefully at all about the time structure of the production and consumption economy — or the massive “recalculation” problem involve in dramatic shifts in that time structure. So I ask, have you spend _any_ time trying to imagine this.

    Scott writes:

    “can see why it would cause people to lose their jobs in the housing and financial sectors. But what I don’t understand is why those people wouldn’t look for jobs in other sectors. Why wouldn’t employment gradually rise in other sectors?”

  9. Gravatar of Greg Ransom Greg Ransom
    25. September 2009 at 20:16

    I forgot to add. Unemployment is over 12% in California, in many mostly immigrant / laborer cities it’s more like 25% – 35%.

  10. Gravatar of Greg Ransom Greg Ransom
    25. September 2009 at 20:26

    Scott, during the housing boom in OC, you ran into people all the time who were moving from medium & low pay jobs selling toasters, vacuums, ovens and cars to high pay jobs originating home loans.

    And similarly folks making much better money in real estate, or better money showing homes, or staging homes or doing customer service, etc. — moving from jobs that had payed less (e.g. moving from fast food manager to real estate agent).

    All sorts of high end discretionary shops were opening — people where spending the money gained from 2nd mortgages on their inflated houses — dozens of these are now shutters. I’ve known small business owners who’ve ridden this boom and bust up and down.

    The downturn started here in late 2006 and early 2007 — and it has never let up. Stores and restaurants continue to close and houses continue to foreclose.

    This is the real world out here, Scott. Instead of reading the NY Times from the 1930s, spend a month reading the OC Register between 2003 and 2009 ….

  11. Gravatar of Greg Ransom Greg Ransom
    25. September 2009 at 20:29

    Scott, I feel like simply saying, come to Orange County and tell me you don’t understand the “recalculation” story.

    Talk to _my_ friends and neighbors.

  12. Gravatar of Greg Ransom Greg Ransom
    25. September 2009 at 20:34

    “One can hardly claim that all industries were bubbles”

    Scott, this can’t be considered a serious attempt to understand the systematic distortion of _all_ relative prices and all capital investments and all consumption & savings plans across the dimension of time. The word “bubble” doesn’t really capture the reality of this system-wide mal-coordination of the complete system across time, distorting _all_ production processes and _all_ consumption & savings plans.

  13. Gravatar of Greg Ransom Greg Ransom
    25. September 2009 at 20:37

    Scott, I know a number of people now in foreclosure or who have lost their homes who in fact _literally_ took “great vacations” using money acquired during the housing & auto boom, either via big pay checks or via refinance.

    Scott writes:

    “That would imply the public was in the mood for a “Great Vacation.””

  14. Gravatar of Greg Ransom Greg Ransom
    25. September 2009 at 20:46

    Scott writes:

    “that is exactly the classical view, exactly the view of David Hume. More money is expansionary in the short run and neutral in the long run.”

    And if you include the money injections effects on the time structure of production (and the distortions upon both savings and consumption plans) what you have in-between is an artificial boom and inevitable bust on the way to the “long term”.

    Between Hume’s short run and Hume’s long run stands Hayek’s monetary / trade cycle theory like a colossus.

    If you just do Marshall short run and you just do Marshall long run, and you do nothing else — you leave out the marginalist / causal theory taking you from one to the other — the great fallacy of the British Cambridge economists which Americans began to ape in the 1940s.

  15. Gravatar of Thorfinn Thorfinn
    25. September 2009 at 21:27

    Your “absurd belief” is pretty reasonable. In the maltusian world where everyone has a similar standard of living, China and India had about half of the world’s economy between them. After convergence, probably the same will be true.

    There will probably be huge geographic disparities for some time though. Gujarat and Guangzhou will look like Japan; Uttar Pradesh and Qinghai not so much.

  16. Gravatar of Lorenzo (from downunder) Lorenzo (from downunder)
    26. September 2009 at 01:43

    If you are betting on India more than China, it just shows (yet again) what a rational fellow you are.

    China is a Brazil with nuclear weapons: a country with a great future ahead of it and always will be. India is democratic, more decentralised, speaks English, has more cultural diversity and lacks the institutional baggage of Leninism. And, btw, already has considerably more (military)) power projection capacity than China.

  17. Gravatar of 123 123
    26. September 2009 at 03:20

    In Cato Unbound discussion Hamilton wrote this about NGDP futures targeting scheme:

    “One can write down more complicated models with heterogeneous beliefs, risk aversion, and liquidity constraints, that do have particular implications for the quantities of contracts held in equilibrium, but I am most doubtful that a tight argument can be made relating the volume of positions taken on one side to a specific targeted economic objective.”

    In the comment section of your post “Spot the flaw in nominal index futures targeting” we had a long discussion about the issue that Hamilton has raised again. So let me repeat again that I agree with Hamilton on this narrow issue of specific implementation of targeting regime. I believe that your targeting scheme is less stable than than other possible alternative implementations. So while the basic idea to use market information for driving monetary policy is sound, I think that technical implementations that fully incorporate insights of auction design theory and market design theory have more chances of success.

  18. Gravatar of Current Current
    26. September 2009 at 03:25

    See also the discussion between Bill Woolsey and Arnold Kling

    http://monetaryfreedom-billwoolsey.blogspot.com/

  19. Gravatar of Bill Woolsey Bill Woolsey
    26. September 2009 at 03:31

    Scott:

    Welcome back. Great job in promoting the monetary disequilibrium perspective and index futures convertibility.

    As for Kling, I have been thinking that he has the remarkable theory that real income always equals potential output (so that monetary disequilibrium is not disruptive,) and somehow, nominal expenditure always adjusts to the productive capacity of the economy at the existing growth path of prices. In other words, there is some market process such that the demand to hold money always adjusts enough so that there is monetary equilibrium at the current trajectory of the price level and the productive capacity of the economy. Efforts by the foolish central bank to disrupt this happy occurance will be offset by the market system–through changes in the demand to hold money. If the central bank is really evil and persistent, yes, it can disrupt the market, and create a new growth path of prices, but real income will remain equal to productive capacity the entire time.

    The Klingonian invisible hand works much better than “ours.”

    My view, anyway, is that changes in the price level gradually correct monetary disequilibrium so that real expenditure adjusts to the productive capacity of the economy. I don’t see the nominal demand for money changing so that nominal expenditure changes, so real expenditure changes, so it remains equal any change in the productivce capacity of the economy.

    I have several posts on Klingonomics on my blog.

  20. Gravatar of Current Current
    26. September 2009 at 03:51

    There are two main problems what people are saying here.

    Firstly, Scott has a problem with distortions of production by money supply. He doesn’t like the Austrian account of how booms occur and why they can’t last, this is what Brian Caplan is talking about. He is wrong here. If like Hume thought a permanent increase in the money supply is expansionary in the short term then it is clear that this expansion must result in a different capital structure than otherwise. During the expansion people will buy capital goods differently than they did before it.

    Secondly, the others don’t understand very well that money is a fund of purchasing power. In a money economy like ours if I were perfectly sure what I would do in the next few weeks then I would make all the payments for that time now. Doing so would protect me against price changes and give me the services of the good faster. I hold money exactly because I am not sure. That is the reason we all hold it. So, if things become more uncertain the demand for money increases. It is best if the banking system fulfill that demand at a price. So, what we should see in a period of recession is monetary expansion for this purpose.

    In the discussion on CATO people keep mentioning Hume and his chest. Hume was wrong about his chest. Money that is locked up in chests provides a source of purchasing power that can be used at any time. It does affect money prices because if a person didn’t have their chest (or wallet) they would have to sell something to obtain it, or work.

  21. Gravatar of ssumner ssumner
    26. September 2009 at 07:31

    Thanks for your support everybody. I won’t take the bait and defend my India statement until I’ve had a chance to lay out the evidence in a post. I guess I better do that soon.

    Marcus, I entirely agree. Well put.

    Greg, No I did not forget the auto industry. I specifically pointed out that manufacturing was doing well until NGDP started falling sharply. I suppose autos were also affected by high oil prices, but that problem went away last fall. So it was mainly falling AD that killed sales, not some spillover form the housing crisis.

    You said;

    “I know folk who 3 years ago worked as realtors, computer programmers for builders, finance guys, etc. “” today they are working for cashing arranging closets, trying to sell used cars in a start up, or they’ve become stay at home dad’s, etc.

    And talking with construction and gardening labor here “” many in those industries have gone home to Mexico or Central America. At the Home Depot one day I counted over 100 day laborers looking for work ..”

    Both of these points strongly support my argument. When tons of builders and finance guys lost jobs after the housing bubble burst in 2006, there was only a small rise in unemployment. So that cannot have been the cause of the severe recession late last year. And the losses had even less impact on the 9.7% unemployment than if the Mexican labor stayed in the US. So that makes it even more surprising that unemployment went from a bit over 5% to 9.7%. Only a nominal shock could do that, real shocks have been shown over and over again to have a modest impact on unemployment, as long as NGDP is well behaved.

    You describe labor moving into other industries like selling cars. Indeed that is what should have happened if the Great Recalculation story was right. But it is wrong, hence the non-bubble industries have also suffered massive employment losses.

    Regarding your second point, I’m a macroeconomist, and hence not interested in the OC economy. I know it was hit harder than the national average. I am trying to explain the national economy. What you are doing is analogous to those who tried to explain inflation in the 1970s by explaining why some produce prices (like oil) went up faster than average.

    You said;

    “Scott, I know a number of people now in foreclosure or who have lost their homes who in fact _literally_ took “great vacations” using money acquired during the housing & auto boom, either via big pay checks or via refinance.”

    I think the vast majority of unemployed would rather be working, but are suffering from involuntary unemployment because of sticky wages.

    In general, I don’t think you have answered my question as to why the Great Recalculation doesn’t cause employment to rise in the industries that were not overbuilt. I.e. why doesn’t employment rise in the aggregate of all industries excluding housing and finance. Instead it plunged. Why? Until someone can answer that question I won’t understand the theory, as it seems to imply that this should happen.

  22. Gravatar of ssumner ssumner
    26. September 2009 at 07:55

    Thorfinn, So many people agree that I guess I need a new absurd belief. I thought my belief that the financial crisis caused the recession was sufficiently absurd, but the GMU guys didn’t agree.

    Lornenzo. I am not that optimistic about India—I don’t think it is likely to be as rich as China, just that it will have a bigger economy.

    123, Hamilton didn’t understand my proposal. He thought that with homogeneous beliefs the money supply would be indeterminate. He didn’t realize that each transaction changed the money supply, and hence the expected NGDP growth rate. See my reply to him. With homogeneous beliefs the money supply will go the the point where expected NGDP is right on target, given the uniformity of beliefs about velocity. Thus if target NGDP is 14 trillion, and the consensus velocity estimate is 7, then trading will only occur until the base goes to 2 trillion.

    With heterogeneous beliefs trading occurs until both sides of the market are equally balanced, the number of dollar votes that expected more than 14 trillion NGDP balances out with the number that expected less than 14 trillion NGDP.

    Bill, Thanks. I agree with you, especially with your criticism of Nick. I will comment when I get caught up.

    Have you ever seen Kling talk about the impact of NGDP falling in half between 1929 and 1933? What’s his story about the Great Depression? I hope it isn’t some sort of housing bubble type story, as there is no evidence at all that there were major sectoral imbalances in 1929.

    Current: You said;

    “Firstly, Scott has a problem with distortions of production by money supply. He doesn’t like the Austrian account of how booms occur and why they can’t last, this is what Brian Caplan is talking about. He is wrong here. If like Hume thought a permanent increase in the money supply is expansionary in the short term then it is clear that this expansion must result in a different capital structure than otherwise. During the expansion people will buy capital goods differently than they did before it.”

    I don’t follow this. I do agree that easy money causes booms, and causes too much capital to be built. And I agree that this causes a relapse, a decline in the overbuilt industries, and of course a rise in other industries. I just think the relapse is of minor importance compared to a secondary deflation, which makes all industries contract. The capital structure problem merely causes a bit of frictional unemployment—except in Orange County, and other places especially severely overbuilt. In those areas you can have recession-level unemployment even while the national rate is doing fine.

    Hume is merely saying that a decline in velocity has the same effect as a decline in M. I think he is right. You seem to be saying that if money is locked up in chests, then people will feel more confident, and that that portion of money that is not locked up will have a faster velocity. If you are not saying this then you are wrong, as the equation of exchange is a tautology.

  23. Gravatar of Current Current
    26. September 2009 at 09:08

    Scott: “I don’t follow this. I do agree that easy money causes booms, and causes too much capital to be built. And I agree that this causes a relapse, a decline in the overbuilt industries, and of course a rise in other industries. I just think the relapse is of minor importance compared to a secondary deflation, which makes all industries contract. The capital structure problem merely causes a bit of frictional unemployment””except in Orange County, and other places especially severely overbuilt. In those areas you can have recession-level unemployment even while the national rate is doing fine.”

    In that case, I don’t think we disagree much. The problem is not so much that too much capital is built. It is rather that the capital built is not complementary to the needs of the future. I agree that there are specific local problems.

    I still don’t quite agree with you about unemployment. You write replying to Greg….

    Scott: “In general, I don’t think you have answered my question as to why the Great Recalculation doesn’t cause employment to rise in the industries that were not overbuilt. I.e. why doesn’t employment rise in the aggregate of all industries excluding housing and finance. Instead it plunged. Why? Until someone can answer that question I won’t understand the theory, as it seems to imply that this should happen.”

    Now, bad monetary policy may have caused the situation in late 2008. But it isn’t the only possible cause of such a decline. There is another explanation, all jobs require different skills. Few are unskilled today, most require very specific skills. So, workers entering the employment market from failing industries aren’t necessarily useful to other industries. Or at least, they are not immediately useful. Many industries can be setup for more or less skilled workers. If the supply of less skilled workers increases it takes some time for businesses to change their practices.

    Our knowledge, what neoclassicals call “human capital” is hugely important. It is complementary to the physical capital we use. But the two are deeply intertwined.

    Scott: “Hume is merely saying that a decline in velocity has the same effect as a decline in M. I think he is right. You seem to be saying that if money is locked up in chests, then people will feel more confident, and that that portion of money that is not locked up will have a faster velocity.”

    Yes, that last sentence is fairly much what I mean.

    What I’m saying is something I think you’ve said before. That the problem of monetary policy is people having confidence that they can turn one asset into another.

    V is 1/k in the Cambridge equation. That k is the ratio of the demand to hold money to the stock of money. The important thing is that this (very dispersed) market clears. It may be that people demand more money to put in their wallets. Once that money is there it may not be spent immediately because the uncertainty that provoked it vanishes. However, that doesn’t mean it served no purpose. Because if the money demand increase hadn’t have been accomodated people would have had to have cut their expenditures to meet it.

  24. Gravatar of rob rob
    26. September 2009 at 09:54

    Scott, since you brought it up, I want to know the answer to this: What caused inflation in the 70’s? I’ve always heard it was due to the oil supply shock, though I have never understood how that affected much more than just the price of oil (and things with oil inputs) or why the inflation wouldn’t have therefore reversed when the oil supply returned.

  25. Gravatar of Greg Ransom Greg Ransom
    26. September 2009 at 09:57

    Scott, two things.

    How do you define a non-bubble industry? (I.e are you simply avoiding thinking of the systematic distortion of ALL production processes and consumption plans across time).

    And a simple reminder. Once the artificial boom and inevitable
    bust are underway all sorts of other causal processes can contibute
    to further downturn, e.g. regime uncertainty, secondary deflation and Fed monetary mismanagement, government incompetence, fear caused by the leftist lurch of the political class and elite, etc., etc. The inability of economists and politicians to
    imagine the domain of the coordination of production decisions over time interrelated with consumption and savings decisions created greater chaos and discoordination as they push policies that make the discoordination WORSE.

    So economic ignorance and error must be included as a force multiplier in the recalculation story.

  26. Gravatar of Greg Ransom Greg Ransom
    26. September 2009 at 10:40

    Scott, you seem ignore the leverage / securitization and insolvency proble
    and how the great recalculation slammed into Wall Street, and upended the plans of everyone from Madoff to AIG to investor in Iceland.

    And you seem to think everything would have been ok if only we’d have continued to accelerate he expansion of money and credit into Wall Steet and into home finance, so that Madoff and AIG and Freddie and the Icelanders and Lehman could have gone on another year doubling down on their leverage / securitization and insolvency trajectory.

    If that isn’t what you are saying, explain how you aren’t — and why things would have been delayed and made an even more massive mess on down the road, e.g. Madoff
    stealing 100 billion and not 50, AIG soaking the taxpayer for 600 billion and not 130
    billion, etc. etc. etc

  27. Gravatar of rob rob
    26. September 2009 at 12:02

    Greg,

    I’m trying to follow all sides of this debate as best I can, and I can say that your lurid tone makes it difficult for one to take your points as seriously as one might otherwise. I believe there is usually a correlation between tone and reason.

  28. Gravatar of 123 123
    26. September 2009 at 12:30

    I think that Hamilton has understood your proposal, let’s wait for his response in Cato discussion.

    In any case, I agree with a specific Hamilton’s statement that I cited above, because I think that the quantity of NGDP contracts held by market participants is not the optimal indicator of market forecast, and alternative market based targeting schemes would function more smoothly.

  29. Gravatar of 123 123
    26. September 2009 at 12:33

    Scott,
    you wrote:
    “Have you ever seen Kling talk about the impact of NGDP falling in half between 1929 and 1933? What’s his story about the Great Depression? I hope it isn’t some sort of housing bubble type story, as there is no evidence at all that there were major sectoral imbalances in 1929.”

    The usual story about imbalances in 1929 is that there was too much margin debt, and equity risk premia were unsubstainably low.

  30. Gravatar of Greg Ransom Greg Ransom
    26. September 2009 at 19:29

    Rob — I prefer the word “vivid”. If folks can’t see or even imagine things right there in the real world because of the math goggles / unreal constructs they’ve been wearing and playing with for 30 years, you don’t keep things on “dim” and on pastel and on camouflage — you turn on the spotlights.

  31. Gravatar of StatsGuy StatsGuy
    27. September 2009 at 05:01

    Some of the folks are meeting you in the middle – Tyler Cowen concedes it would have decreased the impact on the real economy by a third and calls it the best free lunch in years (that’s still vastly better than where we are now). Your reply that he underestimates the secondary effects from an exacerbated banking crisis and other problems is right on the money – but at least you and he are arguing about how big the improvement would be, NOT whether the Fed should have we would be better off if the Fed officially endorsed liquidationism.

    Selgin and Hamilton’s initial replies seemed very reasonable, and your responses well considered. Hummel’s seemed rather ideological and dismissive. It seems there are two groups of people, those who are treating your arguments legitimately and arguing about magnitudes, and those who are setting up a straw man (e.g. arguing that you are claiming we could have avoided any adjustment costs completely, rather than that NGDP futures targeting would accelerate the adjustment process). Your empirical datapoint that employment dropped IN ALL SECTORS in the October08/March09 time frame, even growth sectors, is a very strong point. I have yet to see anyone on the other side who has a real response to that. Maybe it’s worth putting a chart from BLS on that data as a blog post and asking for the “it was all real” folks to explain that.

    Hamilton’s arguments, IMOH, are somewhat more practical and specific to this cycle – and have to do with how structural problems (like regulatory challenges – which I take to imply things the like lack of credit instrument transparency and misaligned incentives for ratings agencies) created real misallocations and effectively constrained the effectiveness of monetary policy. While your responses are quite strong, I think he’s got a point – but again, he doesn’t seem to be arguing against your proposal, but rather the magnitude it could have had. In essence, he seems to be arguing that even if we’d avoided an output gap in the normal sense (capacity utilization below neutral inflation level) the capacity utilization still would have been much lowered due to frictional problems because of the scale of malinvestment. Hamilton may be right, but that’s a counterfactual we will never know.

    In any case, I think those are very positive responses – they seem to primarily be arguing against your statement that the Fed could have achieved an unemployment rate of not-much-worse than 5% or so. But right now, an unemployment rate of 7-8% (and a lower fiscal deficit as a result) would be a great thing. Even getting this much of a concession from mainstream economics is a big win. Congratulations.

  32. Gravatar of ssumner ssumner
    27. September 2009 at 09:42

    Current, You said;

    “Now, bad monetary policy may have caused the situation in late 2008. But it isn’t the only possible cause of such a decline. There is another explanation, all jobs require different skills. Few are unskilled today, most require very specific skills. So, workers entering the employment market from failing industries aren’t necessarily useful to other industries. Or at least, they are not immediately useful. Many industries can be setup for more or less skilled workers. If the supply of less skilled workers increases it takes some time for businesses to change their practices.”

    You didn’t read what I wrote carefully. I agree that the unemployment rate would rise because laid-off construction workers are a bad fit for other industries–that’s called frictional unemployment. But it doesn’t explain why millions of workers who were already employed in other industries lost their jobs. Those industries should have gradually increased employment.

    I agree with your final point about V and k, if hoarding demand was not partially accommodated, things would have been even worse.

    rob, The inflation of the 1970s was not due to supply-shocks. Supply shocks cause inflation by reducing real output, but real GDP grew at a fairly normal rate during the 1970s. It was an expansionary monetary policy caused by:

    1. Leaving the (de facto) gold standard in April 1968
    2. Trying to target real output above its natural rate
    3. Confusion over monetary policy indicators (assuming high nominal rates meant easy money.) Hmmm, where has that confusion popped up recently?

    Greg; You said;

    “How do you define a non-bubble industry? (I.e are you simply avoiding thinking of the systematic distortion of ALL production processes and consumption plans across time).

    And a simple reminder. Once the artificial boom and inevitable bust are underway all sorts of other causal processes can contribute to further downturn, e.g. regime uncertainty, secondary deflation and Fed monetary mismanagement, government incompetence, fear caused by the leftist lurch of the political class and elite, etc., etc. The inability of economists and politicians to imagine the domain of the coordination of production decisions over time interrelated with consumption and savings decisions created greater chaos and discoordination as they push policies that make the discoordination WORSE.”

    Non-bubble industries are industries where output would not contract sharply in the absence of falling NGDP, that is, in the absence of a negative monetary shock.

    Sorry, but your model is just to vague for me. I wouldn’t even know how to identify some of the problems you mention. At least the housing bubble theorists can point to one fact—housing started contracting sharply even when the national unemployment rate was low. I don’t know how to test your model, or use your model. In contrast my NGDP model has definite measurable implications; when NGDP growth falls sharply below its expected path, unemployment rises sharply. And monetary policy can control NGDP. I don’t claim my model is perfect—we had a bad recession in 1974 despite rapid NGDP growth, but I think it’s pretty good. And nothing Austrians tell me is enticing me to move.

    Greg#2: You said;

    “If that isn’t what you are saying, explain how you aren’t “” and why things would have been delayed and made an even more massive mess on down the road, e.g. Madoff
    stealing 100 billion and not 50, AIG soaking the taxpayer for 600 billion and not 130”

    I don’t know how you can say this. From the very beginning I said the Fed should not have tried to prevent the housing bubble from bursting. I said it was appropriate that housing contracted sharply between mid-2006 and mid-2008. I opposed the Bear Stearns bailout. I oppose even the existence of Fannie Mae and Freddie Mac. I do want NGDP to grow at a steady rate forever, and I believe monetary policy can make that happen. But even if it does there will be booms and busts in specific industries, and I don’t want bad investments bailed out. Madoff would have failed eventually. BTW, I had no blog back then, but I opposed the LTCM bailout in 1998, as that led to over-confidence about “too big to fail.” So I agree with Austrian economists on many points, I just don’t like (some of) their views on the post-August 2008 time period. But also note that some Austrians agree with me that money was too tight late last year (Selgin said it was too tight after September.)

    123, You said;

    “I think that Hamilton has understood your proposal, let’s wait for his response in Cato discussion.”

    Didn’t he say that if growth was expected to be below target, and if beliefs were homogeneous, there would be an infinite demand for futures contracts? That ignores the impact of trading on expectations. Perhaps I misunderstood his comment. I hope not.

    The number of contracts (in net terms of course) held by traders is not supposed to be a forecast of NGDP, it is supposed to be a forecast of the change in the monetary base required to equate NGDP growth expectations and target NGDP.

    123; you said;

    “The usual story about imbalances in 1929 is that there was too much margin debt, and equity risk premia were unsubstainably low.”

    That might explain why the stock market crashed, but not the real economy. Were you the one I debated about the 1987 comparisons? If not, I make that comparison here. If you were the one, I withdraw the argument because we already had a long debate.

    In every economic model that I know about sunk losses don’t affect, at the margin, the incentive to produce more output as long as the AD is there.

    Statsguy, You said;

    “Some of the folks are meeting you in the middle – Tyler Cowen concedes it would have decreased the impact on the real economy by a third and calls it the best free lunch in years (that’s still vastly better than where we are now).”

    Hey, 1/3 is not the middle! Seriously, I think you are right, I hope my response didn’t sound too defensive as Tyler obviously is a very reasonable guy, and doesn’t have any ax to grind. I’ll admit that since I have invested my whole career into developing a specific worldview, I do have an ax to grind–I think NGDP forecasts are the key.

    You said;

    “Maybe it’s worth putting a chart from BLS on that data as a blog post and asking for the “it was all real” folks to explain that.”

    That’s a good idea. What’s the best way? Should I take the change in total employment, and subtract out housing and finance job losses? I suppose some could argue home furnishings should be included, or the share of home furnishings that goes into brand new homes. Does anyone know the approximate share by mid-2008?

    I appreciate you supportive comments on the Hamilton response. Here’s my take on the key difference. It’s not the whole regulation issue. I agree those issues are important, but I think Hamilton thinks they are more important that I do, precisely because he thinks the sharp drop in NGDP was unavoidable once the financial system froze up after Lehman failed. I think he misses two points:

    1. The balance sheets of banks worsened rapidly because of sharply lower NGDP forecasts going several years out.

    2. Near term NGDP is much more influenced by 1 2 and 3 year forward NGDP expectations that Hamilton thinks. If the Fed had supported those expectations, near term NGDP would have held up better in the 4th quarter. I see an analogy to markets like commodities and foreign exchange. If the government has a credible policy to support commodity prices or the exchange rate a year or two out, then through intertemporal arbitrage it is hard for the current commodity prices or exchange rate to fall sharply. I’m not saying the analogy to NGDP works perfectly, but there’s something to it, and I think Hamilton either overlooks it, or understands my argument and simply disagrees.

  33. Gravatar of Greg Ransom Greg Ransom
    27. September 2009 at 18:06

    I’ve insisted for some time that is you scratch an economist what you’ll find at his core is a philosophers of science using a debunked picture of science borrowed from
    a discredited philosophical fashion of the distant past — than the folks prociding powerful causal explanations:

    The stipulated demands you assert here are exactly those Hayek debunked in his 1974 Nobel lecture.

    http://nobelprize.org/nobel_prizes/economics/laureates/1974/hayek-lecture.html

    Bad philosophy of science does not trump explanatory power.

    The arguments you provide here are on the same order as the arguments of the creationists against Darwinian biology — Darwin himself said we can’t measure
    and test the theory in the manner demanded by the working under false
    philosophers pictures science and knowledge.

    Bad philosophy does not guarantee good science — and it often rules
    it out.

    By the way, several econometric studies have verified the basic
    empirical elements of the Austrian causal picture (even using data constructed according to Keynesian theory) — and I expect as much again looking at
    current data.

    Scott writes:

    “Sorry, but your model is just to vague for me. I wouldn’t even know how to identify some of the problems you mention. At least the housing bubble theorists can point to one fact””housing started contracting sharply even when the national unemployment rate was low. I don’t know how to test your model, or use your model.”

  34. Gravatar of Greg Ransom Greg Ransom
    27. September 2009 at 18:08

    Sorry. Time to admit the iPhone doesn’t cut is for this kind of thing.

  35. Gravatar of Greg Ransom Greg Ransom
    27. September 2009 at 18:12

    You can’t test Darwin’s “model” in the way demanded.

    In my mind that cuts against your philosophy of science, not Darwin.

    Ditto with Hayek / Garrison / Horwitz capital based macro.

  36. Gravatar of Current Current
    28. September 2009 at 01:15

    Scott: “You didn’t read what I wrote carefully. I agree that the unemployment rate would rise because laid-off construction workers are a bad fit for other industries-that’s called frictional unemployment. But it doesn’t explain why millions of workers who were already employed in other industries lost their jobs. Those industries should have gradually increased employment.”

    I see what you mean now. I don’t think though that those other industries would have necessarily increased employment though.

    As I mentioned some time ago, in these situations there are *three* different sorts of loss. Firstly, there is the misallocation loss in the industries where there was too much long-term investment, housing in this case. As Greg mentions above though, others relied upon these investments, they expected profits from them. After the initial crisis occurs they must retrench and live more frugally. This second effect could be called the “derived demand” misallocation. This affects all the industries in which these people were buying.

    Then, thirdly, we have the “secondary recession” caused by how the rigidities interact with the two effects I’ve described above. I agree that in this case this effect was very important. But, whenever a crisis like this happens there will be an increase in unemployment across many sectors, because of the second form of misallocation I describe above. This is what Greg means when he talks about the distortion of “ALL production and consumption plans”.

    What points to the secondary recession being the chief culprit in this recession is the contraction of MV you often point to.

  37. Gravatar of ssumner ssumner
    28. September 2009 at 06:39

    greg, I think I have the same philosophy as Darwin. I want an explanation that helps me makes sense of the world around me. NGDP shocks plus sticky wages does that for me. I don’t see any other models that work as well. So I will go with the most powerful explanation. The Austrian view just doesn’t seem very powerful to me. They claim the Fed created bubbles in the 1920s, but then why weren’t there bubbles in the much more inflationary 1960s?

    Current; You said;

    “I see what you mean now. I don’t think though that those other industries would have necessarily increased employment though.
    As I mentioned some time ago, in these situations there are *three* different sorts of loss. Firstly, there is the misallocation loss in the industries where there was too much long-term investment, housing in this case. As Greg mentions above though, others relied upon these investments, they expected profits from them. After the initial crisis occurs they must retrench and live more frugally. This second effect could be called the “derived demand” misallocation. This affects all the industries in which these people were buying.”

    This is exactly what I keep complaining about. If people need to live more frugally then they need to work harder, but people are working much less hard right now. I don’t see where the recalculation model has any explanation for sharply higher unemployment in non-bubble industries. When you say the demand for other goods fell, you are just repeating my explanation, which is that the problem was too little aggregate demand for all other goods outside housing. So if you really think that is why employment fell in other industries, then you and I completely agree. The problem was a fall in AD. That’s what I’ve been saying since October last year.

  38. Gravatar of Current Current
    28. September 2009 at 07:30

    Scott: “This is exactly what I keep complaining about. If people need to live more frugally then they need to work harder, but people are working much less hard right now. I don’t see where the recalculation model has any explanation for sharply higher unemployment in non-bubble industries. When you say the demand for other goods fell, you are just repeating my explanation, which is that the problem was too little aggregate demand for all other goods outside housing. So if you really think that is why employment fell in other industries, then you and I completely agree. The problem was a fall in AD. That’s what I’ve been saying since October last year.”

    I see what you mean, I mostly agree. But, I’ll try to explain more clearly what I mean.

    Because of the initial misallocation future incomes will be lower than expected. So, future spending plans will be different than expected. People may plan to save more than before. All this causes discoordination that is quite separate from the aggregate demand fall, it would happen without contractual obligations and wage stickiness. It is brought about only by the specificity of knowledge and capital. Some Workers/Consumers expect lower incomes in future months, so, they save more and spend less*. The saving supports investment, whereas before the crisis the same money had been spent on consumption. That means that some portion of resources in the industries that directly produce consumption goods will be unemployed. In some case the industries where new investment is occurring will take up the slack, but, because of the specificity of skills and capital that won’t be the general case. Resources must travel from serving near the front of Hayek triangle to further back. This is causes frictional unemployment.

    In the real world with it’s rigidities this effect will be intermingled with the effect of the secondary recession. But, my main point here is that an episode of misallocation will cause effects that are quite widespread even if banks keep up with money demand. Of course just because it’s widespread doesn’t mean that it will be anything like as bad as what we have today.

    * Confusingly Hayek proposed that sometimes opposite may be true. This brings us into a confusing part of Austrian capital theory which I won’t bother with because it probably has no practical bearing.

  39. Gravatar of Greg Ransom Greg Ransom
    28. September 2009 at 07:33

    Scott, I can accept this:

    “greg, I think I have the same philosophy as Darwin. I want an explanation that helps me makes sense of the world around me. NGDP shocks plus sticky wages does that for me. I don’t see any other models that work as well. So I will go with the most powerful explanation. The Austrian view just doesn’t seem very powerful to me.”

    You add:

    “[The Austrians] claim the Fed created bubbles in the 1920s, but then why weren’t there bubbles in the much more inflationary 1960s?”

    The structural distortion picture doesn’t by necessity have to create a one-industry bubble. The picture is really about system wide discoordinations across all consumption plans, all savings plans, and all production plans. There has been a bit of work showing how the causal elements of the Hayek explanation fit the empirical data of this and other periods, and you’d have to look at that for richer empirical basket useful for thinking about these causal elements.

    Note that the collapse of Keynesianism occurred in the very early 1970s — famously Hicks himself rejected the theory at this time. The inflation of the 1960’s became the economic pathologies of the 1970s (remember wage and price controls, etc.?).

    It is perhaps not a coincidence that this period of the collapse of the Keynesian dominance — the early 1970s — also marked the “Austrian revival”. (And note well, Friedman in the late 1960s was casting many Mises / Hayek insights into the language of of post-Keynesian macro and what Friedman call “monetarism”).

    Hayek won the Nobel Prize at this time, Hicks began work on “neo-Austrian” capital theory, Hayek’s _A Tiger by the Tail_ became an influential book in Britain, and Hayek once again became an anti-inflation figure of controversy on Meet the Press, and in policy conferences at the AEI in Washington, and the new America generation of Austrians began meeting and building their small but influential movement in the economics departments.

  40. Gravatar of 123 123
    28. September 2009 at 12:17

    Scott, you said:
    “Didn’t he say that if growth was expected to be below target, and if beliefs were homogeneous, there would be an infinite demand for futures contracts? That ignores the impact of trading on expectations. Perhaps I misunderstood his comment. I hope not.

    The number of contracts (in net terms of course) held by traders is not supposed to be a forecast of NGDP, it is supposed to be a forecast of the change in the monetary base required to equate NGDP growth expectations and target NGDP.”
    Hamilton has replied, and he said “I do not think it is workable to implement a plan that is geared to the quantity of contracts written.”, so I think that he sees the same problems that you and I debated some months ago. I think targeting of NGDP treasury security spread would work much better.

    you said;
    “”The usual story about imbalances in 1929 is that there was too much margin debt, and equity risk premia were unsubstainably low.”
    That might explain why the stock market crashed, but not the real economy. Were you the one I debated about the 1987 comparisons? If not, I make that comparison here. If you were the one, I withdraw the argument because we already had a long debate. ”

    To avoid misunderstandings I will clarify that I believe that monetary shock has caused ~80-100% of the Great Depression, and supply shocks have caused the remaining 0%-20% of damage, and change in equity risk premium is one plausible candidate for supply shock (of course part of change in equity risk premium was caused by monetary policy).

    Yes, we have already debated the 1987 (I have argued that 1987 bubble could not have caused a supply side shock because according to Shiller’s P/E 1987 overvaluation was much milder than 1929 and overvaluation lasted only 6 months in 1987), so there is no need to repeat that here. But you have said somewhere that you were persuaded by a study that said stocks were not overvalued in 1929. If you are interested you could tell me the names of the study authors so I could find out why they have a result that differs from Shiller.

    “In every economic model that I know about sunk losses don’t affect, at the margin, the incentive to produce more output as long as the AD is there.”
    This is true only in frictionless models that ignore bankruptcy costs etc.

  41. Gravatar of Current Current
    29. September 2009 at 01:36

    Regarding Free Banking….

    I think the Free Bankers are right that Free Banking is needed in the long run. In the short run the central banks may be able to employ a monetary equilibrium policy that would be successful in recessions and in periods of growth.

    However, most of the major developed countries have huge outstanding debts. The governments would very much like to monetize these debts because electorates would not blame them as much for higher inflation as they would for higher taxation. They would blame higher prices on big corporations forcing prices higher. Also, the effect of higher inflation leans heavily on those who hold dollar denominated assets, who are often foreigners and don’t have much political power. The US has so far done little of this inflationary repudiation of debt recently except for the episode in the 70s. However, this sort of simple examination of the interests of the parties involved indicates that in the future governments of all of the heavily indebted developed countries will do this. They will find some sort of ruse to cover up their actions.

    When they do the public and the economics profession are unlikely to support monetary inflation. Even increasing the money supply in a recession will be treated with suspicion. Also, because speculators will suspect that money supply increases will be permanent they will spend them rather than holding them, causing price inflation.

    So, in the long term I don’t think any sort of policy (no matter how effective) from the Federal Reserve will work.

  42. Gravatar of ssumner ssumner
    29. September 2009 at 17:39

    Current, I can accept most of that. You agree demand was a problem, and I probably don’t understand the whole mis-allocation story as well as I could.

    Greg, Just to support your point about Hayek; David Glasner mentioned that Hayek came up with the key insight in the natural rate hypothesis before Friedman.

    123, Hamilton’s newest post implies that he thinks investors might expect 6% NGDP growth even if the money supply fell to zero. I consider that highly unlikely, to put it mildly.

    I think those percentages are reasonable, but I’d say the supply shocks were mostly Smoot-Hawley and the huge tax increases. Plus Hoover’s high wage policy.

    The paper I referred to was “Irving Fisher was Right” by McGrattan and Prescott (2004)

    I don’t think bankruptcy costs are even close to being big enough to have a cyclical impact. Even Katrina, with $10s of billions in damages didn’t create a business cycle.

    Current, It is important to note that while US debts were repudiated in the 1970s, that definitely was not a motivation for the high inflation, as the US national debt was reasonably low before the decade even began.

  43. Gravatar of Current Current
    30. September 2009 at 07:12

    Scott: “I can accept most of that. You agree demand was a problem, and I probably don’t understand the whole mis-allocation story as well as I could.”

    Fair enough, as long as you see what I mean.

    Scott: “It is important to note that while US debts were repudiated in the 1970s, that definitely was not a motivation for the high inflation, as the US national debt was reasonably low before the decade even began.”

    You’re right about that case. But, governments have chosen this path deliberately before. The Germans and Austrians after the first world war, for example, and many governments outside of Europe and America.

  44. Gravatar of 123 123
    30. September 2009 at 11:02

    Scott,
    I believe you are misuderstanding Hamilton – from a mechanism design perspective (subject of 2007 Nobel) he is (and always was) arguing that price, not volume is the best indicator of information held by market participants. In order to highlight the risk of instability in your scheme in his first post Hamilton said that under idealized conditions volume would explode to infinity, and while under more realistic conditions your scheme might accidentally work, it wouldn’t be “tight”. You are engaging in an obscure debate about optimal mechanism design and you are just wasting a valuable opportunity to ask him if he thinks that Fed targeting based on the price of a contract (for example NGDP bond spread) would work.

    By the way Buiter has proposed that governments should issue NGDP bonds:
    http://blogs.ft.com/maverecon/2009/09/is-there-a-case-for-a-further-co-ordinated-global-fiscal-stimulus-part-4-ultima/

    I will answer Great Depression related topics later.

  45. Gravatar of Scott Sumner Scott Sumner
    1. October 2009 at 10:13

    Current, I agree, but right now we aren’t even close to that sort of scenario. Let’s hope our fiscal authorities see reason before we do end up there.

    123, A couple points. My next reply to Selgin and Hamilton was influenced by your earleir comment. Did you check it out? I’m afraid I waited to long to explain why a price approach won’t work. Hamilton doesn’t seem familiar with Bernanke and Woodford’s circularity problem.

    People thought my “abolish inflation” post was nutty. But now we have Buiter saying that bonds shouldn’t be indexed to inflation, but rather NGDP growth. I entirely agree. Just one more reason why when people talk about inflation they should be talking about NGDP growth.

  46. Gravatar of 123 123
    6. October 2009 at 02:48

    Scott, you wrote:

    “The paper I referred to was “Irving Fisher was Right” by McGrattan and Prescott (2004)”

    McGrattan and Prescott paper has many problems:
    – it assumes that equity risk premium is zero and cost of equity is equal to Aaa long term corporate yield (the same mistake was made by Dow 36,000 guys)
    – it ignores the depreciation of intangible capital
    – it uses Gordon growth model – this model is very sensitive to slightest estimation errors in data when cost of capital is near the growth rate
    Shiller’s analysis avoids all these problems and it indicates that stocks were overvalued in 1929.

    You said:
    “I don’t think bankruptcy costs are even close to being big enough to have a cyclical impact. Even Katrina, with $10s of billions in damages didn’t create a business cycle.”
    Lehman bankruptcy process was very inefficient – bondholders will get only cents on the dollar after three years. Panic of 2008 can be described as a fear of huge bankruptcy costs in the financial system. I don’t know if this was important in the Great Depression, perhaps you know if bankruptcy of Creditanstalt and other big institutions was efficient?

    “A couple points. My next reply to Selgin and Hamilton was influenced by your earleir comment. Did you check it out? I’m afraid I waited to long to explain why a price approach won’t work. Hamilton doesn’t seem familiar with Bernanke and Woodford’s circularity problem.”
    Your last comment at Cato really clarified the issues. I think that Bernanke and Woodford’s circularity effect would not be important in practice if FOMC had NGDP corridor targeting approach, with different members giving greater weights to different maturities of contracts. NGDP corridor approach would also lead to lower volatility of short term interest rates.

    “People thought my “abolish inflation” post was nutty. But now we have Buiter saying that bonds shouldn’t be indexed to inflation, but rather NGDP growth. I entirely agree. Just one more reason why when people talk about inflation they should be talking about NGDP growth.”
    If NGDP stability problem is solved, we will be able to focus on the real issues – for example if country A and B have both 5% NGDP, they can compete which has larger real growth.

  47. Gravatar of ssumner ssumner
    6. October 2009 at 17:26

    123, You may be right about the weaknesses, but I did provide a study as I promised, and one of the authors is a Nobel Prize winner.

    I recall seeing a bunch or papers now arguing that the equity risk premium is near zero. Is my memory wrong? (It might be, as I don’t follow this area closely.)

    The problem in the Great Depression was almost entirely nominal, NGDP fell in half. So whatever bankruptcy costs there were, they were trivial compared to the nominal shock.

    I agree with your other points.

  48. Gravatar of Current Current
    6. October 2009 at 23:46

    Scott: “I recall seeing a bunch or papers now arguing that the equity risk premium is near zero. Is my memory wrong? (It might be, as I don’t follow this area closely.)”

    You are probably thinking off “What Risk Premium is Normal” by Arnott and Bernstein.

    http://papers.ssrn.com/sol3/papers.cfm?abstract_id=296854

    When I first read that I was very impressed, however I understand that problems have been found with the data.

  49. Gravatar of 123 123
    7. October 2009 at 12:26

    Scott,

    you are the master of the Nobel winner’s game called Krugman vs. Krugman. I have a case of Prescott vs. Prescott. In 2004 Prescott assumes equity risk premium is zero. But why did Prescott write in 1985 that equity risk premium is 6 percent?
    More seriously, there were many surveys of market participants asking an estimate of equity risk premium. Depending on the date of the survey, the answers are in the range of 3-8 percent. When stock prices are so high that actual equity risk premium is zero market participants think that risk premium is actually very high, indicating a bubble and not a rational expectations equilibrium.

    Equity risk premium is just one of the problems in Prescott paper. There are many more. Do you know that real price of S&P 500 index was no higher in 1985 than in 1929? (note that dividend yield in 1929 was just 3 percent and actual dividend payout in 1985 was just 50% higher in 1985 than in 1929 in real terms). Source here:
    http://www.econ.yale.edu/~shiller/data.htm

  50. Gravatar of TGGP TGGP
    7. October 2009 at 12:54

    Eric Falkenstein has written a book claiming there is no equity risk premium.
    http://www.overcomingbias.com/2009/08/no-risk-premium.html

  51. Gravatar of 123 123
    7. October 2009 at 13:02

    Scott, you wrote:
    “The problem in the Great Depression was almost entirely nominal, NGDP fell in half. So whatever bankruptcy costs there were, they were trivial compared to the nominal shock. ”

    I believe that monetary shock has caused ~80-100% of the Great Depression, but I am also interested in the remaining 0-20 percent. Bankruptcy costs and increase in risk premia caused by the fear of bankruptcy costs is a plausible candidate.

  52. Gravatar of 123 123
    8. October 2009 at 07:22

    Scott, you wrote:
    “I recall seeing a bunch or papers now arguing that the equity risk premium is near zero.”

    The best authority for equity risk premium is the father of EMH Eugene Fama. He says on his blog : “The simplified model that produces the equity premium puzzle, says that the premium (the difference between the expected returns on stocks and bills) should be about 1% per year (or even less). If the premium were this small, the required holding period to be relatively sure of getting a positive premium would be about 1600 years. Who would be willing to hold equity on these terms?”

    Source:
    http://www.dimensional.com/famafrench/2009/04/qa-equity-premium-puzzle.html

  53. Gravatar of ssumner ssumner
    8. October 2009 at 12:04

    Current: I think it was more than just one recent paper, but I could be wrong.

    123, I recall a few years ago reading lots of articles talking about the huge rate of return in stocks since 1926. I think it was about 11% per year, vs 3% for T-bills. Is that right? I was under the impression that stocks had massively outperformed other assets, and that this strong performance was a real problem for the EMH. Now you tell me that stocks have done so poorly that it is a problem for the EMH. Admittedly you use 1929 as a starting point, but can that really make that much difference over so many years? If so, then all we have really established is that stocks are very volatile, but we already knew that. Keep in mind that the US economy was in much better shape in 1929 than 1985, so you would expects stocks to have been somewhat stronger on that basis. What if you compared 1929 and 2000?

    In general, I’m not sure what we learn by selecting unusual dates as our starting and end points. The return on gold investments was 0% between 1934 and 1968, and then more than 2000% in the next 12 years. That’s far more erratic than the stock market. Ex post, a lot of wild and crazy things happen. Wouldn’t it be nice if we could predict them. Shiller claims he can. Good for him. I have no such confidence in my own ability.

    In 1974 my econ professor said gold was overpriced at $42 dollars, and would probably fall. I recall many such predictions from economics professors.

    I also have this question, if the S&P had such a low rate or return, doesn’t that support the idea of no risk premium?

    TGGP, Ah, so my memory isn’t so bad, lots of experts now say there is no risk premium. So it looks like lots of people support Prescott’s assumption. I understand there is a debate about 1929, but it is far from resolved.

    123, I think you mean 80-100% of the Great Contraction. I believe nominal shocks caused 80% to 90% of the Great Contraction, with the other bit being supply shocks like Smoot-Hawley and higher MTRs. As far as the Great Depression, only about 40-50% was caused by falling NGDP. The rest was caused by New Deal policies like the NIRA, the Wagner act, and the minimum wage laws

  54. Gravatar of rob rob
    8. October 2009 at 12:51

    The more people believe in the EMH the more imaginary it becomes. The EMH lead to the buy and hold mantra, which reduced the equity risk premium. Markets are most efficient when people don’t believe that they are.

  55. Gravatar of TGGP TGGP
    8. October 2009 at 14:12

    rob, Fama & French discuss just that concern in another post from the site 123 linked:
    http://www.dimensional.com/famafrench/2009/09/qa-what-if-everybody-indexed.html

  56. Gravatar of Current Current
    9. October 2009 at 01:17

    Scott: “I think it was more than just one recent paper, but I could be wrong.”

    There probably are I’m not that interested in the subject. I understand the Arnott & Bernstein paper won an award though.

  57. Gravatar of ssumner ssumner
    11. October 2009 at 07:26

    rob, That’s a good point, fortunately we don’t have that problem as almost no one believes in the EMH. I don’t even invest that way.

    TGGP, Thanks, I agree with their point in the abstract.

    Current, In another thread at least three such papers were identified.

  58. Gravatar of 123 123
    15. October 2009 at 12:44

    Long term stockmarket returns were great from 1926, but from 1929 peak to 1985 stocks have gone nowhere in real terms. This all means that equity risk premium was reasonable in 1926, but negative in 1929. Ex ante negative risk premium is a big problem for EMH.
    Year 1985 is just an illustration that even for investors with 50+ year horizons stocks were too risky in 1929. If you don’t like 1985 you can choose any year from 1977 to 1985.

  59. Gravatar of 123 123
    15. October 2009 at 12:50

    Your example about gold is not relevant, as gold is just a single undiversified commodity. Gold price peak in 1980 (1981?) was just a bubble.

  60. Gravatar of rob rob
    15. October 2009 at 13:32

    I think it would help if we defined what is meant by the statement “the market is always right”. What does “right” mean? Does right mean that the market correctly forecasts the future 100% of the time? i.e., in the case of equities does it mean that when stocks go up they will always be followed by a rise in earnings? Or by “right” do we merely mean that the market is positively correlated with future earnings, even if it isn’t right 100% of the time? I think we mean the latter, not the former.

    For example, people made a big deal about the prediction markets being “wrong” about predicting who would get the olympics. But prediction markets only give you odds, that is all. In fact, prediction markets would be “wrong” if the favorite always won, unless the favorite’s odds were always 100%. Similarly, financial markets are merely yielding the most likely odds of what will happen. If equities predict future earnings better than 50% of the time, that may be enough for the EMH.

    Who was it that said the stock market had correctly predicted 9 out of the last 5 recessions?

  61. Gravatar of ssumner ssumner
    17. October 2009 at 07:36

    123, I don’t think you understood my point. people in both 1926 and 1929 had absolutely no idea what the future was going to look like. By 1933 many thought we were headed toward socialism. It is not surprising that stock prices swung all over the place. If people had known the US was go to grow at 3% a year for 100 years, and was going to stay capitalist, and was going to have a Great Depression, but was also going to recover from the Great Depression, then prices would not have swung anywhere near that wildly. But people didn’t know that ex ante, and abstrack models can’t pick up that sort of deep uncertainty.

    123#2, Saying something was a bubble is simply saying the price rose a lot and fell a lot. Nothing less and nothing more. In other words the term “bubble is purely descriptive in practice. I know people intend it to mean “irrational peaks” in prices, but as a practical matter there is no way to distinguish between a price that soars and collapses due to changes in something like inflation expectations (i.e gold in 1980) and because of purely psychological factors like fear and greed.

    rob. I agree. I was watching bloggingheads recently and one speaker mentioned that there is nothing odd about flipping a coin 100 times in a row and getting heads each time. That sequence is equally probable to any other specific sequence. People have this urge to look backward and draw conclusions about unlikely events, even though they have no basis for those conclusions. The EMH says prices follow a random walk. That means there will be some really weird patterns once and a while. But where we have a long time series, like betting on who will win the Oscars, the markets do pretty well.

    I agree with 123 that when looks backward one sees a lot of things that seem superficially to violate the EMH. But when I look forward I am somehow never able to see the future. I never have confidence that a particular asset is over or undervalued. At most I have hunchs, which sometimes are right (Vegas houses overvalued in 2006) and sometimes are wrong (Boston houses overvalued in 2001.)

  62. Gravatar of 123 123
    17. October 2009 at 11:52

    Scott, you said:
    “I don’t think you understood my point. people in both 1926 and 1929 had absolutely no idea what the future was going to look like. By 1933 many thought we were headed toward socialism. It is not surprising that stock prices swung all over the place. If people had known the US was go to grow at 3% a year for 100 years, and was going to stay capitalist, and was going to have a Great Depression, but was also going to recover from the Great Depression, then prices would not have swung anywhere near that wildly. But people didn’t know that ex ante, and abstrack models can’t pick up that sort of deep uncertainty.

    I agree with you that 1933 price was rational, but this has nothing to do with the question of rationality of 1929 prices. Stocks are a long term asset, so it is better to look to longer periods. During the period of 1929-1985 the total performance of American economy was top quintile, but ex dividends real returns of stocks was zero. This strongly supports the idea that prices in 1929 were irrational.

    One lucky investor called Warren Buffet had two grandfathers. One of them was optimist like Prescott, and he thought that stock prices were too low in 1929. Another had Roubini’s views, and thought that stockprices were crazy in 1929. These two grandfathers taken together represented the wisdom of crowds. The problem was that in 1929 one grandfather was massively long the stockmarket, but another did not go short, and prices did not reflect the wisdom of the crowds.

    You said:
    “Saying something was a bubble is simply saying the price rose a lot and fell a lot. Nothing less and nothing more. In other words the term “bubble is purely descriptive in practice. I know people intend it to mean “irrational peaks” in prices, but as a practical matter there is no way to distinguish between a price that soars and collapses due to changes in something like inflation expectations (i.e gold in 1980) and because of purely psychological factors like fear and greed.”

    Just one quick glance at the chart of gold would tell you that volatility of gold prices was orders of magnitude larger than volatility of inflation expectations. Look, I have no idea if gold was in bubble in 1980, or if it was anti-bubble in 1977 when prices of gold were much lower. All I can say that both prices cannot be be rational.

    You said
    “I was watching bloggingheads recently and one speaker mentioned that there is nothing odd about flipping a coin 100 times in a row and getting heads each time. That sequence is equally probable to any other specific sequence. People have this urge to look backward and draw conclusions about unlikely events, even though they have no basis for those conclusions. The EMH says prices follow a random walk. ”

    What is odd that 100 heads in a row sequences happen much too often in markets.

  63. Gravatar of ssumner ssumner
    18. October 2009 at 10:22

    123, As usual, those are good arguments. But here’s my reply for what it’s worth. In 1929 investors had no idea we were going to have a Great Depression, or that federal spending would rise from 3% of GDP to 20%, or that inflation would later run wild, causing real taxes on capital to skyrocket. The fundamentals of the economy (from a right wing investor perspective) were way better in 1929 than 1985.

    By the way, the horrible problem of overtaxation of capital was partially corrected after 1985, although we certainly didn’t get back to 1929. (Lower inflation expectations and low tax rates on cap. gains) And when that correction occurred, the post 1929 returns started to look much better. If you do peak to peak (1929-2000), I think stocks did pretty well, even in real terms.

    On the gold question, people often tell me that expectations are double-humped. (this is done to criticize my use of TIPS spreads.) If so, I’d argue that some investors were almost panicky about the dollar by 1980. In addition, I don’t know if theory predicts the link between gold prices and inflation expectations must be proportional. Gold supplies are very inelastic, if everyone piles into a limited commodity at some tipping point where it becomes more desirable than alternatives, can’t the model allow for dramatic price moves? I’m just thinking out loud, but I think there might be rational models where this is possible.

  64. Gravatar of 123 123
    18. October 2009 at 11:58

    Share of federal spending is important and lowered returns on stocks. Inflation of 70s maybe confiscated profits of a year or two. But excessive margin debt is much more important explanation. In fact, I’d say that market returns from 1985 to 2000 were great because post 1929 margin debt regulations were circumvented by using derrivative contracts.

    I certainly don’t agree with those who use gold to criticize TIPS spreads. First of all, noise trader models imply that bubbles are much more important for long duration assets like gold and stocks, and should be rare in short duration assets like TIPS. There are also some EMH compatible things to mention – TIPS measure American inflation, but gold is sensitive to global inflation, TIPS measure inflation expectations for specific time frame, but gold is sensitive to very long term inflation expectations. Physical gold is also a hedge for confiscatory taxation.

    I don’t think that there is a big difference in elasticity of supply of gold and TIPS.

  65. Gravatar of rob rob
    19. October 2009 at 16:48

    123,

    Bubbles are not a flaw in the EMH: they are a feature. It is sometimes worthwhile to think of the market in terms of 2 person game theory. For the market to remain unpredictable, it must do what seems like strange things from time to time. Like a smart pitcher in baseball should sometimes throw 6 sliders in a row, so should the market.

    You said: “What is odd that 100 heads in a row sequences happen much too often in markets.”

    This is hard to be sure of, if you consider non-stationary volatility. The so-called “long tails” in the normal distribution may merely be artifacts of wandering volatility.

  66. Gravatar of ssumner ssumner
    20. October 2009 at 04:40

    123, Those are good points about gold. i still think the lower real taxes on capital were pretty important in the 1980 to 2000 period, although I don’t really have a sense of exactly how important. The increasing weakness of the labor movement might have been another factor. And the strong globalization push in places like Asia and Mexico might have boosted multinational profits.

    rob, You and 123 both know more about the EMH than I do, so I’ll just enjoy learn from your debate. You both have good arguments.

  67. Gravatar of 123 123
    31. October 2009 at 01:08

    I don’t agree with Rob that bubbles are a feature of EMH. Game theory is relevant for an individual trader if he wants to trade without moving the market, but add together all the traders and you get pure noise that should not create bubbles.

  68. Gravatar of 123 123
    31. October 2009 at 01:11

    Scott,

    factors you mentioned are important, but only taxation on capital are relevant for the puzzle of increased PE multiples, and it might explain some part of it but not whole.

  69. Gravatar of ssumner ssumner
    31. October 2009 at 07:27

    123, Doesn’t it depend on how you define “bubbles?” According to the usual definition in finance, bubble are not consisten with the EMH. But some people just mean a price spike and collapse, which of course is consistent with the EMH.

    I don’t quite agree that the other two factors I mentioned don’t matter. They might not merely affect the level of profits, but also the expected growth rate, if globalization and is expected to continue and labor is expected to get still weaker (which is not improbably given the steady trend since the 1960s for unions to decline as a share of the private workforce.)

  70. Gravatar of 123 123
    8. November 2009 at 05:42

    Price spike and collapse are consistent with EMH only when fundamentals also spike and collapse. Often this is not the case.

    Other two factors also matter, but their impact is more limited than the effect of the dramatic decline of tax burden.

  71. Gravatar of ssumner ssumner
    9. November 2009 at 15:33

    123, I agree with your first point, although technically it is “rationally expected fundamentals” which of course is harder to pin down than fundamentals.

  72. Gravatar of 123 123
    21. November 2009 at 13:55

    Events of last decade will cause many people to abandon EMH. Let’s hope they will be attracted by austrians, not by Krugman. On Landsburg’s blog I saw a link where Robert Murphy laughs at EMH from austrian perspective:
    http://mises.org/daily/3835

  73. Gravatar of Scott Sumner Scott Sumner
    26. November 2009 at 07:08

    123, I read Bob’s post, and fail to see the humor. The EMH said it is hard to predict financial crises, almost no one predicted this financial crisis. What’s so funny about that? I don’t get it.

    EMH types don’t defend our current economic system as being optimal. I oppose many of the government policies that helped blow up the housing bubble.

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