How to prevent an epidemic of Reckless Lending

Here is Free Exchange:

SLOVENIA’s banking bail-out announced on December 12th followed a familiar pattern. Having driven over the edge thanks to reckless lending, the country’s three big banks are being hauled back onto the road by taxpayers.

Now this is certainly an interesting coincidence.  At the same time that Atlanta and Phoenix banksters were engaging in Reckless Lending in America, the same thing was occurring in small far-away formerly communist country, with a very different economic system.

And in an even more shocking coincidence, the same thing was going on in Greece.

And in Latvia.

And in Spain.

And in Britain.

And in Iceland.

And in Cyprus.

And in Ireland.

.  .  .

.  .  .

etc, etc.

Or perhaps this is a lazy explanation.  Could there be some sort of common external shock that economic theory predicts would cause Reckless Lending in a large group of countries?  Yes, the biggest fall in NGDP since the Great Depression.

“So are you saying . . .”

Here’s precisely what I’m saying:

1.  There was some reckless lending (no caps) in America and a few other places.  Nothing catastrophic.

2. When oil prices soared in 2007-08, central banks responding to rising headline CPI inflation with tight money, which slowed NGDP growth sharply in the first 9 months of 2008.

3.  The sharply falling NGDP growth made the banking crisis much worse, driving the Wicksellian real equilibrium rate so low that even with a 2% inflation target equilibrium nominal rates fell to zero.

4.  Central bank error #2, they cut rates far too slowly during this period.  Especially in Europe.  Now NGDP plunged sharply in late 2008 and the financial crisis became much more intense.  Suddenly even more Reckless Lending was exposed.

5.  When rates finally hit zero at the end of 2008 in the US (but not in Europe), the Fed had no backup plan to maintain NGDP growth.  They did not do what Bernanke had told the Japanese they must do. Now NGDP fell even further, the financial crisis got even worse.  More Reckless Lending was exposed.

6.  Because the eurozone budget deficits got much worse, fiscal strains appeared in places like Greece, which really had done some (sovereign) reckless borrowing.  Or should we call that reckless lending by the Germans, in order to be consistent?

7.  Time to raise those VATs, so that the sovereign debt crisis doesn’t get even worse.

8.  Higher VATs raise inflation in the eurozone.  The ECB must focus like a laser on keeping inflation around 1.9%, unless of course it is lower than 1.9%, in which case inflation should be ignored and attention should switch to stopping “bubbles,” which are of course easy for government bureaucrats to spot.  But I’m getting ahead of myself.

9.  The higher VATs raise headline inflation, and the ECB in its infinite wisdom decides to target inflation inclusive of VAT at a time of fiscal austerity.  They raise interest rates twice in 2011, and a double-dip recession ensues.  Right out of the 1937 playbook—tight fiscal and tight money.

10.  Now the debt crisis gets even worse, as it always does when NGDP growth plunges.  Even more Reckless Lending by the Germans.  And they didn’t just Recklessly Lend to Greece, they Recklessly Lent to Spain and Italy and Portugal and Ireland.  No bailouts for governments (that creates moral hazard) but Irish banks that borrowed from the Germans must of course be bailed out.

10.  And now Slovenia.  And we are asked to believe the explanation is simply Reckless Lending.  A bizarre epidemic of Reckless Lending suddenly appeared all over the world at roughly the same time.  Wildcat banks in the American sunbelt.  Sober German banks.  British banks.  Irish banks.  Spanish banks.  Cypriot banks.

And now Slovenian banks.  And all this at a time when NGDP plunged.  And economic theory predicts that plunging NGDP would cause a big increase in debt defaults.  And economic theory suggests that central banks are supposed to prevent NGDP from plunging.

Especially when not at the zero bound.

And the ECB has been above the zero bound for more than 95% of the time over the past 5 years.

So how do you prevent reckless lending from occurring?  It’s impossible, but a reduction in regulations generating moral hazard would help.  How do you prevent an epidemic of Reckless Lending?  Simple, a 5% trend growth target for NGDP, level targeting.

PS.  The snark is not aimed at P.W., who is only expressing the conventional wisdom.

PPS.  Just to be clear, when I say tight money causes “Reckless Lending,” I mean tight money causes NGDP to fall, which causes defaults, which causes loans that were not reckless at the time to later be perceived as reckless.


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88 Responses to “How to prevent an epidemic of Reckless Lending”

  1. Gravatar of JoeMac JoeMac
    16. December 2013 at 08:57

    Pursuant to my questions in your previous post, when you say… “I mean tight money causes NGDP to fall, which causes defaults, which causes loans that were not reckless at the time to later be perceived as reckless.”

    … how could we empirically test this?

  2. Gravatar of Morgan Warstler Morgan Warstler
    16. December 2013 at 09:06

    Except, as oil prices soared, the Saudi Oil Minister was saying “look they keep printing money, we’re going to charge more for the oil”

    Well he didn’t say that he said that as the value of dollar fell, oil cost more money.

    Jan 16, 2008:

    http://www.boston.com/news/world/articles/2008/01/16/analysts_say_production_just_one_factor_in_oil_price/?camp=pm

    “A. Oil is priced in dollars on the world market and analysts say the falling value of the US currency has contributed to rising prices. Assuming the value of a barrel of oil is fixed, as the dollar declines, the price of oil must increase to make up for lost value.”

    Then after the crash in late 2008, the fed tight money, we could buy gas for $2 a gallon.

    So the question is, why do you assume that as the Fed pours money into system, the price of gas doesn’t keep rising to $6 a gallon?

    Because it would.

    Eventually, you HAVE to tellt he real story,:

    MILLIONS OF mortgages couldn’t be paid, which caused the overnight lending to seize up.

    And Scott, the mortgages STILL WOULDN’T be paid, because gas cost $6 a gallon.

    NGDPLT works, but it’s a better story to explain how it stops the mortgages in the first place.

  3. Gravatar of Dan W. Dan W.
    16. December 2013 at 09:12

    Scott,

    So you do not believe it is risky to lend 100% of an assets current market value to a stranger with no documented income?

    Really?

    “The F.B.I. warned in September 2004 that mortgage fraud was “epidemic” and predicted that it would cause an “economic crisis.” In 2006, the mortgage industry’s own anti-fraud experts warned that liar’s loans had a fraud incidence of 90 percent because they were “an open invitation to fraudsters.” The lenders reacted to the warning by greatly increasing the number of liar’s loans.

    Credit Suisse reported in early 2007 that 49 percent of new mortgage originations in 2006 were liar’s loans. That means that more than a million fraudulent loans were being made each year and that liar’s loans were causing the bubble to hyper-inflate. Federal regulators and the Securities and Exchange Commission also could have stopped liar’s loans and toxic derivatives supposedly backed by liar’s loans. But the Bush administration appointed senior anti-regulators who did not believe that fraud could be a serious problem, so the regulators refused to act.”

    http://www.nytimes.com/roomfordebate/2011/01/30/was-the-financial-crisis-avoidable/when-liars-loans-flourish

  4. Gravatar of Daniel Daniel
    16. December 2013 at 09:14

    Dan,

    Nobody says moral hazard in the banking sector is a good idea. We’re saying it does not result in increased unemployment.

  5. Gravatar of Dan W. Dan W.
    16. December 2013 at 09:50

    Daniel,

    Between 2000 and 2006 the mortgage industry added two hundred thousand workers. As well documented a significant percentage of the mortgage business in 2004 – 2006 was based on fraud. Now the industry has retreated to 2000 levels. Two hundred thousand mortgage workers had to find new jobs.

    What jobs?

    The housing bust not only meant less mortgages it meant less houses being constructed. It also meant less disposable income as home owners no longer could tap home equity to buy boats, trips, furniture and other luxuries. What jobs could displaced mortgage workers find?

    The housing bubble created an economic distortion that is still unwinding. The economic loss of this boondoggle is huge and most certainly non-zero. When you write “we’re saying it does not result in increased unemployment” who is the we? Is denial of bubbles and busts an article of faith of macro-economists? How does an ideology of frictionless, homogenous, economic activity square with real world observations?

    http://www.statista.com/statistics/275752/mortgage-industry-employment-in-the-us/

  6. Gravatar of Mike T Mike T
    16. December 2013 at 09:56

    Daniel –

    “Nobody says moral hazard in the banking sector is a good idea. We’re saying it does not result in increased unemployment.”

    >> Was moral hazard a contributing factor in Bear Stearns taking excessive risks they would have otherwise not taken? When those risks turned into massive losses, how did that impact employment at Bear?

  7. Gravatar of 123 123
    16. December 2013 at 09:56

    “Central bank error #2, they cut rates far too slowly during this period. Especially in Europe”

    According to TIPS spreads, monetary policy was less tight in the eurozone at that time.

  8. Gravatar of Morgan Warstler Morgan Warstler
    16. December 2013 at 10:28

    Guys, if we had NGDPLT at 4.5% since 2000….

    We’d never had gotten subprime mortgages.

    If you draw that line from 2000, basically the silliest ideas after 2004 all end.

  9. Gravatar of Ben Ben
    16. December 2013 at 10:33

    Dan W great post. Housing increases feed into jobs, malinvestment and wasted unearned “income” that makes the whole economy look great. So GDP is above the true level then lending stops and it falls below the true level as we unwind and the malinvestment kicks in.

  10. Gravatar of ssumner ssumner
    16. December 2013 at 10:37

    JoeMac, The first test is whether theory predicts that tight money leads to more defaults. The answer is clearly yes. Then you’d look to see whether epidemics in defaults are associated with periods of tight money. I think the answer is yes, but have not done a formal test.

    Morgan, The Fed should pay no attention to oil prices.

    Dan, You said;

    “So you do not believe it is risky to lend 100% of an assets current market value to a stranger with no documented income?”

    Of course I believe it is risky. But that has no bearing on the argument I am presenting in this post. Please read it again.

    Do you really believe that if people in aggregate have far less nominal income than expected, it has no bearing on their ability to repay nominal debts? Really?

    None of the information you present has any bearing on the Slovenia quotation I discuss.

    And of course the US housing bust had almost no impact on the unemployment rate, which rose from 4.7% in January 2006 to 5.0% in April 2008. The data simply do not support your argument. The data support the claim that NGDP is the key problem.

    123, Less tight, but still way too tight.

  11. Gravatar of ssumner ssumner
    16. December 2013 at 10:38

    Ben, There is no such thing as the “true level” of GDP.

  12. Gravatar of TravisV TravisV
    16. December 2013 at 10:38

    Morgan,

    You’re expressing a very interesting disagreement here. I’m not totally grasping what you’re saying yet, though…..

  13. Gravatar of Patrick R. Sullivan Patrick R. Sullivan
    16. December 2013 at 10:40

    ‘A bizarre epidemic of Reckless Lending suddenly appeared all over the world at roughly the same time.’

    Basel II.

    Predicted in 2006 by Peter Wallison;

    http://www.aei.org/files/2006/11/09/20061108_200611FSOg.pdf

    ‘The international bank capital accord proposal known as Basel II is a statistical and probabilistic effort to replicate
    what the market would do if government regulation had not interfered with market discipline. The proposal has many flaws, and a recent test suggested that it would reduce bank capital requirements substantially below current U.S. levels.’

    Seems to be confirmed by;

    http://www.voxeu.org/article/basel-risk-weights-can-t-be-trusted

    ‘Recent research shows that capital requirements are only loosely related to a market measure of bank portfolio risk. Changes introduced under Basel II meant that banks with the riskiest portfolios were particularly likely to hold insufficient capital. Banks that relied on government support during the crisis appeared to be well-capitalised beforehand, suggesting they engaged in capital arbitrage. Until the regulatory concept of risk better reflects actual risk, the proposed increases in risk-weighted capital requirements under Basel III will have little effect.’

  14. Gravatar of Doug M Doug M
    16. December 2013 at 10:46

    Money is asymmetric.

    When money grows, liquidity grows, lending grows, and the economy grows.
    When money contract, what begins as a liquidity crisis turns into a solvency crisis. You could call this a negative feedback loop or a “viscous cycle.”

    This asymmetry of money exists because debt is not destroyed at the same pace that money is destroyed in the market crash. It takes hours for the market crash, and it takes years for debt to either be paid-off, or written-off via bankruptcy or forgiveness.

    While it appears that banks engaged in “reckless lending” after the fact. Had the cycle not begun, it wouldn’t have appeared so reckless.

  15. Gravatar of Vivian Darkbloom Vivian Darkbloom
    16. December 2013 at 10:54

    Daniel
    16. December 2013 at 09:14
    “Dan,

    Nobody says moral hazard in the banking sector is a good idea. We’re saying it does not result in increased unemployment.”

    Dan W.
    16. December 2013 at 09:50

    “Daniel,

    Between 2000 and 2006 the mortgage industry added two hundred thousand workers. As well documented a significant percentage of the mortgage business in 2004 – 2006 was based on fraud. Now the industry has retreated to 2000 levels. Two hundred thousand mortgage workers had to find new jobs.”

    So, “reckless lending” added 200K jobs and then later subtracted the same number. Isn’t the net result zero? Is it better to add jobs temporarily to have them later subtracted, or not at add them at all? Or is this merely a timing issue?

    I’m looking for an explanation that productive output was on net either permanently increased or decreased as a result of this “reckless” lending. So far, neither argument seems convincing.

    One thing I am pretty sure about, though: We should not be giving tax incentives for home equity loans.

  16. Gravatar of Dan W. Dan W.
    16. December 2013 at 11:13

    Scott,

    NGDP fell because the flow of income from the housing bubble stopped. Is it your position that the Federal Reserve goofed by not ensuring a perpetual increase in home prices?

  17. Gravatar of Randy W Randy W
    16. December 2013 at 11:14

    “PPS. Just to be clear, when I say tight money causes “Reckless Lending,” I mean tight money causes NGDP to fall, which causes defaults, which causes loans that were not reckless at the time to later be perceived as reckless.”

    Scott – in light of credit standards pre-2007, might it be accurate to say instead:

    “PPS. Just to be clear, when I say tight money causes “Reckless Lending,” I mean tight money causes NGDP to fall, which causes defaults, which causes loans that were not reckless at the time to later be perceived as reckless and, along with loans that were actually reckless at the time, to be perceived as the cause of the recession.”

  18. Gravatar of Morgan Warstler Morgan Warstler
    16. December 2013 at 11:18

    Scott I’m not saying the fed should pay attention to oil prices.

    I’m saying in your narrative about 2008, where the fed takes action to stay on NGDPLT:

    1. “Every one percent decline in the dollar’s value, OPEC estimates, increases the price of crude by $4 a barrel.’

    http://www.rediff.com/money/2008/may/22oil1.htm

    2. There’s some kind of knowable formula on Barrel of Oil to Gallon of gas:

    http://blogs.mprnews.org/newscut/2011/03/what_does_the_price_of_oil_mea/

    3. for each cent that gas prices increase, spending declines by $1 billion in other consumer spending areas.

    http://www.ehow.com/info_7745819_fuel-prices-affecting-family-budgets.html#ixzz2nfNCyWHL2.

    So if fed pays no attention to anything but pumps in Sept / 2008:

    8/2008 Oil is: $119.05 Gas is: $3.96

    So Fed drives down dollar 25%

    Opec raises cost of oil $100.

    This calculator says Oil is at $220 is $7.22

    http://gascalc.appspot.com/

    So that’s a $3.27 increase in price of gas

    Which puts the slow down to US consumer at: -$3.27 BILLION in consumer slowdown.

    Which of course, the Fed has to stay on target for….

  19. Gravatar of 123 123
    16. December 2013 at 11:18

    “Less tight, but still way too tight.”

    Yes.
    The interesting question is why the policy was less tight despite higher rates. The answer was IOR plus unlimited liquidity via full allotment.

  20. Gravatar of Morgan Warstler Morgan Warstler
    16. December 2013 at 11:19

    $327BILLION

  21. Gravatar of Morgan Warstler Morgan Warstler
    16. December 2013 at 11:22

    I’d argue that since we can’t print money to buy gas without raising the cost of gas DIRECTLY, that perhaps OIL is the real global currency.

  22. Gravatar of Dan W. Dan W.
    16. December 2013 at 11:32

    Vivian,

    As documented a significant percentage of mortgage activity from 2004 to 2007 was fraudulent. It was a fantastic fraud as it allowed everyone to get what he or she wanted. Buyers got fancy homes, brokers got commissions, industry chieftains cashed out millions in stock options and politicians bragged about the booming economy. Ignored in the process was that the homes were purchased by debt that was supposed to be paid by the house buyer. Well, the fraud was that millions of these house buyers were not going to pay that debt.

    Oops.

    So now you have realtors with nothing to sell, brokers with nothing to broker and consumers with mortgages they cannot pay.

    How in the world is such a process supposed to “net to zero”? Money wasted on homes built in the Arizona desert is wasted and no amount of chalkboard arithmetic will change that reality.

  23. Gravatar of Vivian Darkbloom Vivian Darkbloom
    16. December 2013 at 11:44

    Dan W.,

    I’ve no doubt that much of the lending for mortgages was fraudulent, particularly from 2000-2007 (and, to a lesser extent, still is). But, I’m focusing on your own logic and numbers, which I think you’d have to admit do net to zero (plus 200K minus 200K).

    You say “money wasted on homes built in the Arizona desert”. I don’t want to sound like PK, but per your logic that “wasted money” (temporarily) created 200K jobs.

    What I am looking for from you is a better argument.

  24. Gravatar of Dtoh Dtoh
    16. December 2013 at 12:00

    Scott,
    Excellent post. Spot on.

  25. Gravatar of Steven Kopits Steven Kopits
    16. December 2013 at 12:25

    You’re the first widely-quoted economist to state that reckless lending did not cause the global recession. I agree, as it affected a broad range of disparate countries.

    Then you ask, “Could there be some sort of common external shock that economic theory predicts would cause Reckless Lending in a large group of countries?”

    So now we’re looking for a large external shock, one not related to country-specific lending practices.

    What is that? Well, you state the culprit is the “biggest fall in NGDP since the Great Depression.” But what caused that? You state this: “When oil prices soared in 2007-08, banks responding to rising headline CPI inflation with tight money, which slowed NGDP growth sharply in the first 9 months of 2008.” So 2008 was an oil shock? So are we talking about a misconceived monetary response to an oil shock?

    But what was the nature of this oil shock? Not only did the mature economies as a group go down together; the fast growing economies as a group did not go down together. It was not only a crisis of the OECD, it was only a crisis of the OECD. This is entirely counter-intuitive. Normally, it’s the emerging countries that see financial crises, for example, as in 1998.

    So why did this oil shock affect only the mature, slow growing economies? Did the emerging economies all have accommodative policies which maintained higher NGDP levels? Why this differentiation?

    (You can see my take on slide 16 of my Princeton presentation.)

  26. Gravatar of DanC DanC
    16. December 2013 at 12:47

    I agree Scott except that I would flush out the definition of reckless lending. i.e. oil shock leads to tight money at a time when a record number of adjustable rate loans were coming due. The unforeseen rate increase exposed the degree to which so many loans had grown dependent on overly optimistic expectations of low interest rates. Many loans were risky because they only worked if rates stayed low.

    Also the combination of hire oil prices and tighter money hurt the auto and travel industry. The auto industry was already limping and this led to major problems in the Midwest. Florida and Nevada were hit with a reduction in tourism then a hit to housing. California was a growing problem due to local political problems.

    A couple of sectors of the economy were in trouble, made worse by tight policies.

    Corrections in auto and housing were going to happen, many loans were reckless given that they didn’t assume the troubles the economy could hit.
    Expectations of the worst case on future interest rates and the timing of the reset on loans were contributors to the collapse.

  27. Gravatar of Edward Edward
    16. December 2013 at 12:54

    Morgan,

    If, as you say, loose money drives the price of oil extraordinarily high, it would also drive the price of oil stocks extremely high as well, giving retirees and people on fixed incomes something to invest in. Oil would be the theoretical bull market that replaces the housing bubble as jobs in oil multiply, many people enter the producing market, supply increases, and north dakota booms, which already seems to be happening.

  28. Gravatar of ssumner ssumner
    16. December 2013 at 13:02

    Patrick, When was Basel II implemented?

    Dan, You said:

    “NGDP fell because the flow of income from the housing bubble stopped.”

    No, NGDP kept growing from January 2006 to April 2008, even as housing construction fell by more than 50%. The data rejects a “housing” explanation of the slump. In any case, you are confusing nominal and real shocks. A housing slump could conceivably affect RGDP, but what matters for debt is NGDP, which is controlled by the Fed.

    Morgan, Why should I care if oil prices soar? (And I’m not in any way assuming you are right–no one knows where oil prices would have gone under a sound monetary policy.)

    123, Why not compare NGDP growth to the US to see how tight policy was?

    Steven, An oil shock affects RGDP, and may reduce output. But NGDP is what matters for debt. Oil shocks don’t affect NGDP, the Fed controls NGDP.

    The developing countries did better for the same reason that developed countries like Australia and Israel did better–sound monetary policy.

    DanC, Those factors explain RGDP, not NGDP. And they are US factors, I want to know what went wrong in Slovenia.

  29. Gravatar of 123 123
    16. December 2013 at 13:20

    “Why not compare NGDP growth to the US to see how tight policy was?”

    Because it is best to use real time market prices to evaluate policy.
    At some moment in 2010-11 eurozone policy became tighter than the US policy.

  30. Gravatar of Dan W. Dan W.
    16. December 2013 at 13:49

    Scott,

    What do you mean the Fed controls NGDP? Can you clarify what the Fed controls and the effectiveness of those controls to improve the economic standing of the nation’s citizens?

    I do not see how NGDP forcing can be a substitute for billions and billions of dollars of bad economic decisions. Someone must pay the piper. Who?

  31. Gravatar of kebko kebko
    16. December 2013 at 13:55

    Patrick, that is interesting timing.

    Scott, I think that’s another one for your freak show list:

    The only industry that is predictably overleveraged is the banking industry – the industry that is highly regulated concerning leverage.

    Firms spanning the entire remaining portion of the economy are much less leveraged, even though they generally have no leverage-related regulations.

    Our conclusion: We must regulate bank leverage, because if we don’t regulate it, they will become predictably overleveraged.

  32. Gravatar of Michael Byrnes Michael Byrnes
    16. December 2013 at 14:06

    Dan W wrote:

    “I do not see how NGDP forcing can be a substitute for billions and billions of dollars of bad economic decisions. Someone must pay the piper. Who?”

    In an ideal world, the people who made bad decisions should pay the piper, while those who did not make bad decisions shouldn’t. That isn’t what happened in 1929 or 2009. When NGDP falls, EVERYONE suffers the consequences.

  33. Gravatar of Steven Kopits Steven Kopits
    16. December 2013 at 14:40

    I agree, Scott.

    But which is the greater order effect? The oil shock or the poor monetary response to the oil shock? Is it the collision or the rebound?

    You seem to be saying its the consequential effects, the follow-on monetary policy, which is the bigger problem. How do we know that?

  34. Gravatar of Doug M Doug M
    16. December 2013 at 15:16

    kebko,

    “Our conclusion: We must regulate bank leverage, because if we don’t regulate it, they will become predictably overleveraged.”

    I don’t entirely disagree with you… but, it is a theory that it becomes over-leveraged because of the regulation. Once the regulator suggests a cap the cap becomes the standard.
    When exposure to one risk factor becomes capped, banks extend risk toward those risk factors that remain uncapped. The bank takes the same amount of risk, but likely in a less efficient, less transparent or less hedged way.
    Once the government starts to regulate the government shares responsibility for any failures.
    Bad regulation is often worse than no regulation.

  35. Gravatar of Doug M Doug M
    16. December 2013 at 15:19

    On oil shock… there are many Wall St. types who will say an oil shock is a tax. The appropriate response is to ease into it. This is actually the majority view of economists I read.

    There is another school that sees it as inflationary and the fed should tighten.

    The minority view is that oil shocks should simply be ignored. The inflationary impact will be transitory.

  36. Gravatar of Negation of Ideology Negation of Ideology
    16. December 2013 at 15:27

    Dan W –

    “What do you mean the Fed controls NGDP? ”

    The key letter in the acronym is N – Nominal. The Fed has 100% control over the supply of the monetary base, therefore it had 100% control over the value of the monetary unit. The demand is determined by the public (though it is influenced by the Fed through reserve requirements and IOR), so the Fed’s job is simply to base the supply of monetary base to the public’s demand for it.

    I think you may have an easier time if you turn it around. Instead of thinking of it as controlling NGDP, think of it as controlling the value of the dollar. Let’s say NGDP per adult is $80,000 and the target is $84,000 – that implies that the Fed must devalue the dollar by 5% to hit its target. Or if it goes over the target, the Fed must strengthen the dollar. Then the Fed simply bases it’s decisions on the market.

    Scott even has a plan to use futures to do this automatically. It’s described on the right under “Quick Intro to My Views” – “NGDP Futures Targeting”. It’s a quick and interesting read, and I recommend it highly.

  37. Gravatar of Geoff Geoff
    16. December 2013 at 16:22

    Reckless lending is just another way of saying giving credit unworthy borrowers more credit at lower interest rates, which is caused by central banks, which means reckless lending is caused by reckless monetary policy.

    Inflation of reserves actually raises prices and NGDP by way of more credit in the economy. That’s the form the additional money enters the economy.

    To complain about reckless lending while at the same time advocating for more inflation, is like a drunk complaining about headaches while at the same time advocating for more alcohol.

  38. Gravatar of Geoff Geoff
    16. December 2013 at 16:40

    Negation of Ideology:

    “The Fed has 100% control over the supply of the monetary base, therefore it had 100% control over the value of the monetary unit. The demand is determined by the public (though it is influenced by the Fed through reserve requirements and IOR), so the Fed’s job is simply to base the supply of monetary base to the public’s demand for it.”

    You have things backwards. The Fed isn’t responding to the public’s demand for holding money when it targets NGDP. The public is responding to the Fed’s activity by holding money for longer or shorter periods of time given what the Fed is doing. The public is “simply basing their waiting times on the rate of growth in the money supply.”

  39. Gravatar of Morgan Warstler Morgan Warstler
    16. December 2013 at 17:20

    Scott,

    Why should you care if oil prices soar?

    Because “for each cent that gas prices increase, spending declines by $1 billion in other consumer spending areas.”

    And consumers buying $327B less in junk because they have $7 a gallon gas – is believable – peeps are super aware of gas prices.

    “So how does a falling dollar contribute to rising oil prices?

    It’s a little bit complicated. Oil is priced in dollars on the world market. When the dollar is weaker, foreign currencies are stronger, by definition. That means people in other countries can buy more oil for the same amount of money. So let’s assume oil is $100 per barrel, and $100 is equal to 70 euros. If the euro appreciates against the dollar by 10 percent, then instead of 70 euros it will take only 63 euros to buy one barrel of oil. So that oil becomes cheaper to foreigners, and they can buy more.”

    http://money.usnews.com/money/blogs/flowchart/2008/03/10/why-gas-prices-rise-as-the-dollar-falls

    —–

    Look, NGDPLT tells a better story than the status quo.

    it certainly can help keep FDR and Obama from happening.

    BUT IT CAN DEFINITELY KEEP SUBPRIME MORTGAGES FROM HAPPENING.

    And at 4.5% it WOULD.

    There is no universe where have adopt 4.5% NGDPLT in 2000, and Barney Frank is still giving bartenders loans for 5 homes.

    Under a hard cap: FRAUD that boosts NGDP gets hunted down and killed BECAUSE OTHER GUYS can’t get loans for real stuff.

    Look in your hearts people, imagine there is a HARD CAP on anything, a fixed supply of growth next month…

    Every one of you will become SUPER FOCUSED on what the growth “got to be.”

    Under a hard cap, the “planned” part of our economy gets investigated with daily anal probes.

    Barney Frank and Obama would be MISERABLE under a 4.5% HARD CAP ON GROWTH.

    Why?

    Because govt. spending isn’t productive, which means it is the inflation part of NGDP.

    Again:

    Paying public employees more money = INFLATION

    Reducing size of factory workforce and producing 14% more = REAL GROWTH

    NGDP teaches everybody WHAT in our economy is unproductive and what is productive.

  40. Gravatar of Geoff Geoff
    16. December 2013 at 18:00

    “[T]he sharply falling NGDP growth made the banking crisis much worse”

    What caused the banking crisis in the first place, before even more corrections took place later in a context of falling NGDP?

  41. Gravatar of Dustin Dustin
    16. December 2013 at 18:16

    Negation of Ideology,

    “The Fed has 100% control over the supply of the monetary base, therefore it had 100% control over the value of the monetary unit.”

    I really do not understand this. Sure the Fed has significant influence, but certainly not 100%. If we all sit on our behinds for a year, NGDP is 0, Fed wishes be damned. Not realistic, but clearly demand for money and credit is what controls the value of the dollar and NGDP.

    To claim the Fed has 100% control is also to claim that people’s behaviors are 100% constant, which is as realistic as us all sitting on our behinds for a year.

  42. Gravatar of Don Geddis Don Geddis
    16. December 2013 at 18:39

    Dan W.: “Is it [Sumner’s] position that the Federal Reserve goofed by not ensuring a perpetual increase in home prices?

    No. The Fed has no business preferentially supporting one industry over another. The Fed’s job ought to be to stabilize NGDP as a whole. It is up to the free market, to decide which industries have which relative preferences throughout the economy. The Fed should have no opinion on the path of home prices in particular.

    Money wasted on homes built in the Arizona desert

    Those home are not unwanted, nor was that construction wasted. The builders are merely having trouble selling them at high enough prices. In other words, the problem is purely nominal, not real. There remains real demand for the houses. There simply isn’t enough nominal income for buyers to pay enough for them, so that builders can have a nominal profit.

    Someone must pay the piper.

    This happens easily, by making the real return to the investment be negative. Or at least lower than the return for most other investments. But there’s nothing that requires a negative real return, to also be a negative nominal return. You keep confusing nominal and real. Nothing is gained by having nominal GDP fall below trend. And NGDP is essentially unrelated to the path of real GDP.

  43. Gravatar of Don Geddis Don Geddis
    16. December 2013 at 18:44

    Dustin: “To claim the Fed has 100% control is also to claim that people’s behaviors are 100% constant

    Completely false. Velocity changes all the time. But the Fed easily has enough power to change the monetary base, to more than compensate for changes in velocity.

    Yes, the change in demand for money provides pressure on NGDP. Just the way that changes in ocean currents provide pressure on ocean liners. But the Fed has engines and a rudder, and can still land at whatever port it wishes, regardless of what changes happen in the local currents.

  44. Gravatar of benjamin cole benjamin cole
    16. December 2013 at 18:47

    Excellent blogging.

  45. Gravatar of Michael Byrnes Michael Byrnes
    16. December 2013 at 19:03

    Dustin wrote:

    “I really do not understand this. Sure the Fed has significant influence, but certainly not 100%. If we all sit on our behinds for a year, NGDP is 0, Fed wishes be damned. Not realistic, but clearly demand for money and credit is what controls the value of the dollar and NGDP.

    To claim the Fed has 100% control is also to claim that people’s behaviors are 100% constant, which is as realistic as us all sitting on our behinds for a year.”

    The public wants to hold some amount of money. There are plenty of alternatives to holding money, ranging from consumption goods to stocks, bonds and other assets. In comparison to those other options, money has some definite advantages and some definite disadvantages. Not every individual or institution (such as a bank) will have the same preferences… some will want more money relative to their other alternatives, and others less. But if you add it all up you get the total amount of money demanded by the public.

    But, in the US, the Fed supplies the money, and ultimately, the public has no choice but to hold the amount of money supplied by the Fed – it can’t hold more or less money than the Fed has chosen to supply.

    What happens if the Fed supplies more money than the public wants to hold? The public is stuck with it. An individual can choose to hold less money – by buying stuff with money, or by not selling stuff for money, but the public as a whole cannot. (Individuals/institutions “get rid of” money by passing it on to other individuals in various exchanges – but the money so exchanged continues to exist, it just has a different owner.) If the Fed produces money, and the public doesn’t want the money but cannot get rid of it, something must give. And the Fed wins – something in the real economy must change such that the public is now willing to hold the money. What changes? Prices change. People spend the money they don’t want, more money chases the same supply of goods, and prices rise. Eventually, the price level will rise to a point where the public is willing to hold the money supplied by the Fed. The public must hald a higher nominal quantity of money to retain the same *real* purchasing power. Look back at the 70s and early 80s for an example of how this works.

    Alternatively, say the Fed provides less money than the public wants to hold. Again, the Fed wins – the public cannot hold more dollars than the Fed has provided. An individual can hold more money by selling assets or cutting back on consumption, but on net across the whole economy this won’t work, because it will reduce incomes. This could theoretically be resolved by falling prices, but prices tend to be sticky for various reasons. In the short run, sales fall off, producers cut back on production, lay people off, etc. Also, debts are usually defined in nominal terms – if prices and incomes fall, the real burden of debt rises, as does the rate of default on debt.

    The Fed controls the supply of base money, and through that controls nominal income. It doesn’t control real income.

  46. Gravatar of Dustin Dustin
    16. December 2013 at 20:04

    Don Geddis,

    “Completely false. Velocity changes all the time. But the Fed easily has enough power to change the monetary base, to more than compensate for changes in velocity.”

    But doesn’t the velocity simply decrease when more base money is introduced? Anyway, as I said, I believe it is defensible to say the Fed has significant control (ie, 95% – ish as an example), perhaps I am wrong, but the notion of 100% absolute control is difficult to agree with.

    As I stated, if we all sit on our behinds the next year, NGDP is 0. If this is true, which it is, then the Fed doesn’t have absolute control.

    Michael Byrnes,
    Thank you for the lengthy, illustrative write-up. I learned some things; there is a lot there, I should think on it some more. 🙂

  47. Gravatar of Don Geddis Don Geddis
    16. December 2013 at 21:21

    Dustin: “But doesn’t the velocity simply decrease when more base money is introduced?

    No. At least, not if you mean in a way to completely negate any possible impact of the change in base money. Base money quantities can change at far greater magnitudes than typical velocity changes.

    I believe it is defensible to say the Fed has significant control (ie, 95% – ish as an example) … NGDP is 0

    Your ability to imagine an unrealistic scenario, is not helpful. The problem is, if we agree that in an absurd scenario that the Fed cannot pick an NGDP, and then label that as “95% control”, but then return to the real world where we ask for a 5% NGDPLT growth rate, but the Fed only manages 3% … then it’s a mistake to think that “95% effective” means that they have an excuse to fall short of their target in the real world.

    In the real world, for any reasonable economic conditions, the Fed can name essentially any NGDP target, and it has the power to hit the target. If it fails to hit the target, the cause is Fed mismanagement. We don’t have to look anywhere else.

    The fact that you can imagine a scenario, where people choose never to use dollars for any transaction for a year (and thus likely the entire population goes to jail for failure to pay taxes, for example), is kind of irrelevant to any practical policy choices.

  48. Gravatar of kebko kebko
    16. December 2013 at 21:47

    Doug M.,

    I think we agree and I just wrote poorly. I absolutely believe it is the regulatory framework that creates the leverage. I meant to say that conventional wisdom on the matter is nuts.

  49. Gravatar of JN JN
    17. December 2013 at 02:33

    Scott,

    I think you’re missing a part of the picture here.
    All the markets you mentioned experienced almost simultaneous housing “bubbles”.

    While there have been local differences in terms of timing, implementation, local economic performance, etc, this is no coincidence: banks have been incentivised to lend to households (mortgages) and related corporates since Basel regulations have been put in place at the end of the 1980s/early 1990s (Basel 1) and mid-2000s (Basel 2).

    http://spontaneousfinance.com/2013/11/05/banks-risk-weighted-assets-as-a-source-of-malinvestments-booms-and-busts/

  50. Gravatar of Lorenzo from Oz Lorenzo from Oz
    17. December 2013 at 02:41

    Lending is based on expected income. If expected income crashes, a lot more lending becomes problematic, how is this hard?

  51. Gravatar of Lorenzo from Oz Lorenzo from Oz
    17. December 2013 at 02:44

    JN

    Australia also had housing “bubbles”. Somehow, there was not an epidemic of “reckless lending”. Why not? Guess what Australian NGDP didn’t do?

  52. Gravatar of Dustin Dustin
    17. December 2013 at 04:25

    Don Geddis,

    “Your ability to imagine an unrealistic scenario, is not helpful.”

    One man’s unrealistic scenarios is another man’s boundary condition (a powerful tool for reasoning, BTW). The logical implication is enormous. It follows that either their exists 1) a spectrum of Fed control that is impacted by actions of economic agents or 2) two discrete, binary states of economic agents (ie, all or nothing).

    Needless to say the 2) option is as absurd and unrealistic as a year of vacation for all. It is also as unrealistic as, oh say, every properly sailing vessel can withstand every current every time. Continuing, my intuition is that the probable range of actions by economic agents is quite narrow, though they do become extreme at times, and the absoluteness of Fed control is impaired proportional to that range.

    Maybe it is imperfect information on the Fed’s part relative to the economic agents? Other? But to think the Fed could dial in NGDP to 5.000000000% forever (as an example) is really no less absurd than anything I have stated. I mean, what in life is 100% guaranteed if not the Fed’s control huh?

    If NGDP is part RGDP and part inflation, can we agree that 100% Fed control of NGDP = 100% Fed control of inflation? Quoted in Scott’s newest post: “”The idea that central banks can always get the inflation rate they want is something that’s going to pass away,” Peter Fisher, the former Fed official and undersecretary for domestic finance at the U.S. Treasury”

  53. Gravatar of JN JN
    17. December 2013 at 04:54

    Lorenzo,

    Australia benefited from a commodities boom during the financial crisis. That helps.
    It doesn’t mean that house prices won’t crash when the economy starts experiencing problems. Same applies to Canada.

    It also doesn’t mean that it was ‘reckless’ lending. It was regulatory-incentivised lending.

  54. Gravatar of Dan W. Dan W.
    17. December 2013 at 05:10

    This is a fantastic blog as it is extremely successful at revealing the fantastic ideas that permeate macroeconomics. Best yet is the claim that the Fed can make NGDP be whatever it wants. In theory yes. But does Ben Bernanke actually have knowledge of every economic transaction? No he does not.

    First and foremost there is the black market where a real percentage of economic activity occurs and income is acquired that is not directly reported to the government. Second there is debt in all its various forms, including loans, lender financing, accounts payable, IOUs and so on. The government has oversight on some of this activity but it controls very little of it! Third there is the non-monetary economy where individuals exchange goods & services and no “money” is involved.

    Consider what has happened as millions of dual income households transition to single income households. The paid work of one partner becomes unpaid work. Where does the value of that work show up in Ben Bernanke’s spreadsheets? NGDP will never be zero but it is perfectly reasonable that measured NGDP could decrease while economic exchange increases.

    NGDP and GDP and M1, M2, etc are government measures of economic activity that provide a 30,000 foot view of the nation’s economy. The data is meaningful in the context by which it is obtained but it is hubris to assume that manipulation of these measures gives one control. What these measures especially fail at is in providing any clarity on the micro-economic factors that are driving the economy.

    Lastly, if monetarists claim that debt accumulation is innocuous (because it can simply be devalued) then are they not actually defending modern Keynesian ideology? In Krugman vs Sumner I am going to side with Krugman. At least when the government spends or hands out money it enters the economy! Changing the composition of bank reserves means nothing unless actual economic opportunity presents itself. If the point is to increase measured NGDP Krugman’s methods get there with a lot less imagination than do Scott’s.

  55. Gravatar of Daniel Daniel
    17. December 2013 at 05:30

    the Fed can make NGDP be whatever it wants. In theory yes. But does Ben Bernanke actually have knowledge of every economic transaction? No he does not.

    http://en.wikipedia.org/wiki/Obscurantism

  56. Gravatar of Tom Tom
    17. December 2013 at 05:48

    #2 “central banks responding to rising headline CPI inflation with tight money,”

    Scott, you are being intellectually inconsistent to claim that the Fed had “Tight money” in 2007, without saying what that tight money was. Was it interest rates? (what were the rates, when did they change?) Or something else?

    If interest rates mean money was “tight” then, at this time when rates are almost 0, it must mean that money is “easy”.
    But you claim, today, money is “tight”.

    Too tight today is a critique I agree with, but don’t accept that interest rates are the right measure, rather bank lending should be noted — and there was still plenty of bank lending in 2006-2007.

    Second issue is in comments talking about the Fed controlling base money.

    Yet “base money” remains vague, when comparing an economy of 2000-2006 where homeowners were using equity loans as “money in the house bank”, to withdraw at will for whatever purchases struck their fancy. When house prices stopped rising, such house equity loans went down dramatically.
    Where is the base money calculation that compares a $400k house with $100k of equity-loan available to the same house valued at $300k with no equity-loan available.
    Real world “money in the house-bank” has disappeared, thus money is tighter, yet I see no calculations including this — and the Fed doesn’t control house-equity.

    It’s mostly banks that get money from the Fed; until QE, only banks. If the Fed was actually doing helo drops of cash, or more efficiently sending electronically to every US taxpayer $1000 into their bank account, then I would agree that the Fed can quickly increase the monetary base. (or 100% of the income tax paid up to some 1,2, … or 10 $k cap — a Fed based “monetary tax cut” QE to the workers).

    As Don G notes, we should spend most of our time discussing reality, as well as realistic possible changes. I’d prefer a QE regime of cash to taxpayers more than the Fed continuing to give cash to the rich, as they now do; but such would only be realistic if more economists called for it. Perhaps as part of NGDP targeting? (Scott, why not this idea?)

    Third, after the house construction boom bubble popped in 2006, there were some millions of illegals who had been working in the US directly or indirectly in construction, including services for the construction workers. They began losing jobs/ stopped getting hired in 2006 — but neither their employment nor unemployment were part of the official statistics. Thus the unemployment really did start increasing then, but the data is not reliable. During the bubble years, there was actually MORE money and economic productivity (unreported cash services to illegals working for cash off the books) than the data shows.

    There was over-employment and mal-investment for years, perhaps since 2002 – 2006, and this malinvestment means that small business entrepreneurs had big losses and big Net Wealth reductions. Plus those rich banks which also malinvested in MBS and especially CDOs and derivatives of the house loans (while collecting fat fees for liar’s loans to which they turned a blind eye).

    The post 2007 reduction of Net Wealth as house prices drop, below the individually desired amount, means there is a natural increase in savings / debt reduction, and a reduction in purchases as well as money velocity.

    The malinvestment was caused by banks using bad financial models created by Nobel prize winning quality economists and rocket scientists to forecast the future based on the past. (Similar model weakness is seen in the Global Warming alarmism, despite CO2 rising). Such models are used by regulators and banks all over the world, so it should be no surprise that if there are bad assumptions in the models, all the similar models have similar bad results.

    The Slovenian article notes that there have been long-festering problems in the banks — probably since the 2007/2008 drying up of speculative real estate investment in Slovenia.

    Let’s also remember that Japan had a huge 1989 real estate bubble crash — and its banks have still not fully written off the bad loans and revalued Tokyo real estate at more realistic market values. 24 years later of denial — to avoid needing bailouts or bankruptcy.

    It’s better to clean up the junk now, but no “monetary policy” is going to work well if it depends on banks as the transmission actors yet the banks remain weak.

  57. Gravatar of ssumner ssumner
    17. December 2013 at 05:58

    123, Fair enough, so let’s suppose money was way too tight in both places, but slightly less tight in Europe. What does that imply?

    DanC, Check out my short course on money in the right column. I’m not advocating the use of monetary policy to cover up bad lending practices. Not sure where you get that idea. I believe monetary policy should be stable, and should completely ignore housing/banking/debt/bubbles/etc.

    kebko, Good point.

    Steven, You asked:

    “But which is the greater order effect? The oil shock or the poor monetary response to the oil shock?”

    Monetary policy is far more important. BTW, I just saw an article that Mexico may produce another 2.5 million bpd based on the recent reforms (not right away of course.) There’s a lot of oil in the world if countries were to become slightly less incompetently ruled.

    Doug, The Fed should ignore the oil market, it plays no role in optimal monetary policy. Focus on NGDP.

    Morgan, Why do I care about consumer spending? I care about NGDP, not consumer spending.

    JN, I’m not at all convinced by your bubble claim. How would you know that? A sharp rise in house prices is NOT, and I repeat NOT, a housing bubble. The price must also collapse. And it must collapse predictably, not unpredictably. House prices have not collapsed in most countries where they rose sharply, hence no bubbles. Where they did collapse it was unpredictable. Most countries have housing markets that look like Australia, not the US. And most countries did not have commodity booms. The common denominator is NGDP, not lending.

    Dan W, You said;

    “Lastly, if monetarists claim that debt accumulation is innocuous (because it can simply be devalued) then are they not actually defending modern Keynesian ideology?”

    Fortunately neither monetarists nor Keynesians hold that view.

    Measurement issue for NGDP are not a serious problem. I’m talking about targeting measured NGDP, NOT actual NGDP.

    Everyone, The Fed should target NGDP expectations. Yes, it can precisely control those expectations (via a NGDP futures targeting regime, for example) And yes, there will still be small fluctuations in actual NGDP, but those will not be macroeconomically significant.

  58. Gravatar of ssumner ssumner
    17. December 2013 at 06:05

    Tom, You said;

    “Scott, you are being intellectually inconsistent to claim that the Fed had “Tight money” in 2007, without saying what that tight money was. Was it interest rates? (what were the rates, when did they change?) Or something else?”

    You must be new to this blog. I’ve always argued interest rates are a lousy indicator of the stance of monetary policy. I favor NGDP growth expectations.

    As for the Fed not being able to control the base, I don’t understand that argument. They can control it very precisely via OMOs, if they choose to do so. Perhaps you mean they should not target the base, as base demand is erratic. In that case I agree. Or that they cannot control the base if they are pegging exchange rates, interest rates, etc. That’s also true. But they certainly can control the base, that’s not even debatable.

    There are lots of other mistakes in your comment, for instance the Fed doesn’t give cash to the rich.

  59. Gravatar of Andrew Andrew
    17. December 2013 at 06:14

    Were there Central Bank policy decisions that led to the oil shock?

  60. Gravatar of JN JN
    17. December 2013 at 06:41

    Scott,

    I am not saying that those were bubbles in the traditional sense. Hence the “”.

    However, house price increases have been (at least partially) driven by regulatory incentives. Prices peaked and started to fall, but as soon as the economy and the banking sector stabilised, mortgage lending restarted again as regulation had not changed in the meantime. This probably put some sort of floor under house prices in many countries.

    Saying that house prices have been (temporarily or permanently) artificially inflated by regulatory incentives is not incompatible with saying that a fall in NGDP once prices peaked caused, or worsened, the crash.

  61. Gravatar of 123 123
    17. December 2013 at 06:49

    “Fair enough, so let’s suppose money was way too tight in both places, but slightly less tight in Europe. What does that imply?”

    Maybe this is one of the reasons why deviations from the Okun’s law were to the oposite directions in the US and Eurozone in 08-09.

  62. Gravatar of Patrick R. Sullivan Patrick R. Sullivan
    17. December 2013 at 06:54

    To the question of when Basel II was implemented, sometime between 1999 and the mid-2000s, depending on the country. Wallison’s paper says;

    ‘In the Fourth Quantitative Impact Study, the results of which were made available in 2005, there were major reductions in capital from current requirements for the twenty-six banks that participated.’

    So maybe I should have said, Basel I and II.

  63. Gravatar of Steven Kopits Steven Kopits
    17. December 2013 at 09:24

    Scott, you write: “Monetary policy is far more important” than the primary oil shock. This is merely asserted, not demonstrated.

    Just cause you say it, don’t make it so.

  64. Gravatar of Don Geddis Don Geddis
    17. December 2013 at 09:31

    Dustin: “If NGDP is part RGDP and part inflation, can we agree that 100% Fed control of NGDP = 100% Fed control of inflation?

    Well, the Fed doesn’t control RGDP. But yes, the Fed can control either NGDP, or inflation (but not both at the same time).

    Fisher is mistaken in his claim that central banks cannot control inflation. They can. (They just aren’t.)

  65. Gravatar of Don Geddis Don Geddis
    17. December 2013 at 09:36

    Dan W.:”it is perfectly reasonable that measured NGDP could decrease while economic exchange increases.

    You don’t even need your black-market or under-the-table activity to cause this. This is essentially the critical difference between RGDP and NGDP. The point is that the central bank has the ability to stabilize NGDP, and keep it on a predictable path. Even if it does, the path of RGDP would be far less stable, and is not under the control of the central bank in any case. “Real economic exchange” might do almost anything. You need to clearly separate that, from the essentially unrelated problem of keeping NGDP on trend.

  66. Gravatar of Steven Kopits Steven Kopits
    17. December 2013 at 09:55

    As for Mexico, I think the reforms are welcome. One analysis I saw suggested that the country might produce another 1 mbpd by 2025. US shales will produce another 1 mbpd by October, just as a point of comparison.

    But we’re seeing govt take coming down and openness increasing, not only in Mexico, but also in places like Russia, Argentina–and Alaska. (See my article in Oil and Gas Journal on Alaska: http://www.ogj.com/articles/print/volume-111/issue-11/exploration-development/alaska-s-oil-crossroads-lucrative-ocs-prize-and-taps.html) If you look at my Princeton presentation on slide 49, it alludes to the government take issue. If costs are rising and oil prices are not, then governments will look to increase production to maintain net revenues. So that’s a positive, but not a panacea, I think.

    Argentina is all YPF, and they’re the only ones really doing anything there. For deepwater–and Mexico is likely to have some big deepwater plays–the time from discovery to production is 8-10 years. It’s not a near-term thing, but it could help a bit along the way. Russia is struggling to hold production, and they’re moving farther east in Siberia and north central Arctic Russia. No doubt, if US oilmen ran Russia’s oil business, it could produce 5 mbpd more, but they don’t and they won’t. Still, Russia could perk up a bit.

    I think Saudi is tapped out. If Saudi is looking for unconventionals–and they are–then it says something about their conventional resources. There is downside risk in Saudi at the 5-10 year horizon, I think, and I don’t anticipate much upside from here. You’re left with Iraq, just as you have been for the last several years. It’s not been enough to offset conventional declines elsewhere.

    But flat oil prices will lead to greater openness to be sure.

    I would note that all the oil majors except Exxon are cutting capex in 2014–and this at $108 Brent. (See p. 50 of the Princeton presentation.)

    Here’s an article on Statoil today which I think lays out the issues pretty starkly. http://www.upstreamonline.com/epaper/article1346822.ece
    And here’s my recent article from World Oil, where I predict Statoil will do what it just did: http://www.worldoil.com/November_2013_Regional_Report_The_Arctic.html

    Also, here’s an article on Hess, now the poster boy for capex compression and the very embodiment of the Houston versus New York war which is escalating around us in the industry. http://www.upstreamonline.com/live/article1346765.ece

    Also, keep in mind that the Chinese are not in the oil markets is a serious way right now. In the last year, China’s demand is up a paltry 270 kbpd (2.6%–absolutely not consistent with 7% GDP growth), while the US is up 570 kbpd (3.1%) and “Other non-OECD” is up 550 kbpd (3.2%).

    Meanwhile, US and Canadian incremental production is up an astounding 2 mbpd in the last twelve months.

    We’re seeing very high prices even with very substantial unconventional production growth and, and best, uninspiring demand growth. And why is that? Because with all of these things together, demand is still outstripping supply by 500 kbpd.

  67. Gravatar of Don Geddis Don Geddis
    17. December 2013 at 10:00

    Tom: “I…don’t accept that interest rates are the right measure [of whether monetary policy is tight]

    Welcome to Sumner’s blog! He has been the leading public proponent of the idea that interest rates are a terrible indicator of the stance of monetary policy, for some years now. You probably should get up to speed by reading one of Sumner’s overviews, like his “quick intro to my views” linked on the right-hand side of the blog, or perhaps his Re-Targeting the Fed paper.

    “base money” remains vague

    “Base money” means currency (plus maybe demand deposit checking accounts?). You can argue whether that is a useful concept, but that’s the concept Sumner refers to.

    mostly banks that get money from the Fed … the Fed continuing to give cash to the rich

    Nope, that’s not how it work. The Fed doesn’t give cash to anyone. It buys T-bills on the open market, at market prices. The transmission effect is not via Cantillon effects from who gets “new” money “first”; it is instead from the Hot Potato Effect due to the increase in the monetary base, which affects the entire economy simultaneously.

    no “monetary policy” is going to work well if it depends on banks as the transmission actors

    Fortunately, the banks are not the transmission actors, so your concern is unwarranted, and monetary policy works just fine.

  68. Gravatar of Dan W. Dan W.
    17. December 2013 at 11:51

    Don,

    I have read Scott’s paper and it is well written. It also contains several moments of hand waving that suggest its purpose is more to sell the politics of NGDPLT than to convince the learned skeptic.

    For example, Scott perpetually assumes that NGDP is both an output and an input. I doubt anyone disputes NGDP can be measured according to some government defined standard. But it begs the question of how what is being measured can also be a dependent variable.

    Consider that one can measure the temperature of a room but one does not directly control the temperature in a room. Rather, the system controls heat exchangers and THEY are controlled to reach the desired temperature. But if the windows and doors are open it may be that no amount of “control” can move the temperature to the desired level.

    Now it seems what Scott is arguing is that the way to make the room temperature what one wants is to change the unit of temperature. Instead of 1 degree being 1 degree make it 1.2 degrees or make it 0.8. I agree that through this manipulation one can then make the temperature whatever value one wants. But what’s the point? You can claim the room temperature is 72 degrees* but it may not be comfortable if the degrees* are greatly distorted from standard degrees.

    What NGDPLTers need to show is how their monetary manipulations will actually promote economic activity. There is no dispute that manipulating the price of one financial asset will change the demand for other financial assets. I fully believe the central bank can blow bubbles to the sky in stocks, bonds, debt, real-estate or whatever asset it wishes. What remains to be shown is that the central bank has anything more than a weak influence on encouraging real economic activity.

    When pressed Scott admits that structural reform matters. Truth is that structural reforms matter a whole lot more than monetary policy. The reason for this is that economic activity hinges on the existence of consumer surplus. Both the buyer and the seller must believe he is getting a good deal. Yet when monetary manipulation distorts the cost of assets the market’s confidence that prices reflect true economic opportunity is hindered. The rate of economic exchange slows and consequently the measure of economic activity is lessened. And this happens despite the best intentions of central bankers to have it be otherwise.

  69. Gravatar of ssumner ssumner
    17. December 2013 at 14:08

    Andrew, No.

    JN, Ok, I misunderstood your meaning. Yes, regulation can boost the level of prices. But it doesn’t explain the crisis.

    123, I don’t follow the logic.

    Patrick, Thanks for the info.

    Steven, That’s right. This blog is supposed to demonstrate the point, but I can’t expect anyone to read all the posts. So I try a little bit each day.

    On interesting fact is that unemployment did not soar during the oil shock, nor did it cause the consensus of economists to predict a deep recession. Falling NGDP did cause RGDP to fall sharply, causing a severe recession.

    In your second post you forgot Kazakstan and Africa. They have lots of oil.

  70. Gravatar of Steven Kopits Steven Kopits
    17. December 2013 at 15:53

    Scott, I am not arguing against market monetarism. I do get it, or at least some of it.

    But you would agree, no, that if we took away 100% of US oil consumption overnight, the economy would collapse no matter what NGDP number you cared to target, no matter how many helicopter drops Ben or Janet might care to make? Or would you?

    At some point, there is a real economy, no?

  71. Gravatar of Don Geddis Don Geddis
    17. December 2013 at 16:00

    Dan W., re: temperature. Sure, the Fed doesn’t control NGDP directly. But it does control the monetary base directly (OMOs directly add or subtract from the total size of the base), and via the Hot Potato Effect that is sufficient to guide NGDP to any (reasonable) level that you want it to be at.

    I agree that…one can then make the temperature [NGDP] whatever value one wants.

    That’s great! Because there are many people who still don’t accept this, so Sumner needs to address that audience as well. But it’s super that you are in agreement on this particular issue.

    What NGDPLTers need to show is how their monetary manipulations will actually promote economic activity.

    You really haven’t been able to find this discussion? It mostly comes down to: wages and (somewhat less so) prices are (observed to be) sticky (esp. downward), and most debts (e.g. mortgages) are contracted nominally, with no correction for inflation … thus an unanticipated change in nominal national income (about the same as NGDP) results in a tremendous change in debt burden and significant unemployment, because wages and debts are unable to have flexible enough prices to maintain efficient allocation, unlike the usual price-adjustment way that most markets work.

    I fully believe the central bank can blow bubbles to the sky in stocks, bonds, debt, real-estate or whatever asset it wishes.

    No, the Fed manipulates the overall money supply, but that doesn’t favor any particular industry. “Bubbles” (if they even exist) are not a function of monetary policy; certainly not within specific industries.

    Truth is that structural reforms matter a whole lot more than monetary policy.

    They’re both very important. Structural reforms impact RGDP directly. Bad monetary policy (because nominal shocks can have real effects) can cause the economy to significantly underproduce (e.g. due to excessive unemployment). You are correct, that “good” monetary policy only has weak influence on long-term economic growth.

    You’re asking for too much. Market Monetarists are only trying to avoid unnecessary self-inflicted economic damage. But you’re right that there is far more to macroeconomics than only monetary policy. Still, broken monetary policy can do far more macro damage than structural reforms have the power to fix.

    monetary manipulation distorts the cost of assets

    Monetary policy does not distort the cost of assets, so this concern is unnecessary.

  72. Gravatar of Don Geddis Don Geddis
    17. December 2013 at 16:05

    Steven Kopits: As I just said to Dan W., there is more to macroeconomics than just monetary policy. But that doesn’t make oil “more important” than monetary policy. Surely the only reasonable meaning of “more important” would have to do with how large the consequences are, when there are small changes in input. What impact on overall US macro have we seen from oil volatility? What impact from Fed monetary choices?

    Monetary policy is very, very important to macro. But it’s not all there is, sure. So what?

  73. Gravatar of Steven Kopits Steven Kopits
    17. December 2013 at 16:10

    As for oil production, in 2009 non-OPEC Africa (Egypt, Guineau, Gabon, Sudans) was producing 2.6 mbpd, currently producing 2.55 mbpd, four years later. Not a large quantity, no material growth. Less than 3% of global supply.

    OPEC Africa (Algeria, Nigeria and Angola): Nov. 2009, 5.21 mbpd; Nov. 2013, 4.65 mbpd. Algeria has some modest upside. Angola’s deepwater looks like it’s reaching its limits. Nigeria has a good bit of oil, with a trend line going in the wrong direction. Collectively, this is a material part of supply, about 5%. Upside is maybe 1-2 mbpd, depending on how you want to think about Nigeria.

    Kazakhstan: Nov. 2009, 1.64 mbpd; Nov. 2013, 1.66 mbpd. Kazakhstan’s Kashagan field is currently shut in. It’s been the project from (and arguably in) hell. Production from the first two phases is hoped to be around 550 kbpd, rising eventually to 1.5 mbpd. It’s a material project, worth about six months of US shale oil growth. The field was discovered in 2000, development consortia date from 2001 (12 years ago); project cost is estimated at $110 bn.

    That’s a lot of money, $110 bn, to be betting on the goodwill of Nursultan Nazarbayev.

    But you’re pulling my chain, aren’t you?

  74. Gravatar of Steven Kopits Steven Kopits
    17. December 2013 at 16:35

    Don – You write: “What impact on overall US macro have we seen from oil volatility? What impact from Fed monetary choices?”

    If you are using a constrained oil supply model (and I do), then you get very little price volatility with the oil price tending to revert to the global carrying capacity price. If the oil price falls, demand quickly recovers, GDP grows, and the price reverts to carrying capacity price. This is what we saw in the US data, I believe, in October and November.

    If the supply declines (modestly), then the oil price rises, demand falls off quickly (no price inelastic behavior), and the price reverts to the carrying capacity price from the top.

    Thus, you should not see much price volatility in a supply-constrained system barring a significant supply outage, and the price should tend to hover around the carrying capacity price. The data has been supportive of this thesis.

    Now, if demand is price elastic, then the damage will be done by volumes, not prices. Has demand been price elastic? Well, oil prices have been falling modestly for the last two years, and OECD oil consumption has been falling for the last two years (excepting the US in the last two quarters). Falling consumption in the face of falling prices…why don’t you give me the price elasticity interpretation of that, Don.

    Now, if oil consumption is falling even as prices are falling, then clearly a price spike cannot be hurting the economy, because there is no spike. But can falling consumption hurt an economy? Well, that depends on how fast the economy can adjust.

    The Fed, by the way, knows nothing of this. They are purely price, not volume, focused. They have no idea what terms like supply-constrained or carrying capacity mean in terms of analytics or policy. (Not that I haven’t presented at the Fed. I have.)

    As for broader Fed policy. I agree with Scott (assuming I understand him correctly), that you want an accommodative monetary policy to facilitate as fast an adjustment in the real economy as possible. But the adjustment of the real economy has a speed limit. It’s not infinite.

    By the way, this whole thesis was the topic of my Woodrow Wilson School presentation to which I alluded in comments above.

  75. Gravatar of Dustin Dustin
    17. December 2013 at 18:57

    Don Geddis
    “Well, the Fed doesn’t control RGDP.”
    Correct and agreed

    “But yes, the Fed can control either NGDP, or inflation (but not both at the same time).”
    Lost me here. Controlling NGDP is done by controlling inflation, a both or none concept.

    Scott, in a recent post: “…central banks control inflation, and by implication NGDP growth….”
    https://www.themoneyillusion.com/?p=25417

  76. Gravatar of Lorenzo from Oz Lorenzo from Oz
    17. December 2013 at 21:37

    JN: No recession since 1991-2 is not just about commodity prices. But yes, land use regulation has a great deal to do with Australian housing prices. As it did about which parts of the US has housing prices surges and which did not. And UK price surges. But why Germany, not so much.

  77. Gravatar of Don Geddis Don Geddis
    17. December 2013 at 21:40

    Dustin: The Fed has actions/instruments, and it has targets. An action might be something like an Open Market Operation (buying Treasuries on the open market). A target might be 5% annual NGDP growth. The Fed would continue to perform the action, until the target is (expected to be) achieved.

    A different instrument might be the interbank overnight lending rate. A different target might be 2% inflation. The Fed would adjust the short-term interest rate, until (its expectation of future) inflation is around 2%.

    Those are two different possible Fed policies. The Fed can either choose to target (and thus control) NGDP, or choose to target (and thus control) inflation. But it can’t target both at the same time.

    Controlling NGDP is done by controlling inflation

    Nope. A policy of NGDPLT would be expected to result in highly variable inflation. If NGDP were to be controlled, then inflation would not be controlled. Inflation would change each year, depending on what kind of real (RGDP) growth happened that year.

    Sumner’s point was that, if you have the power to control inflation, then NGDP growth is also determined by those same choices that you make (in controlling inflation). Each Fed action affects both inflation, and also NGDP.

    But it doesn’t make any sense to say that controlling NGDP “is done” by controlling inflation. Nobody would use inflation as an intermediate target, if their intention was to control NGDP. They’d just target NGDP directly.

  78. Gravatar of JN JN
    18. December 2013 at 01:58

    Lorenzo,

    Even in Germany, there are now warnings of overheating house prices, though not yet to the extent of what has been seen in other countries.
    http://www.theguardian.com/business/2013/oct/22/bundesbank-warns-german-house-price-boom

  79. Gravatar of Dustin Dustin
    18. December 2013 at 04:26

    Don Geddis.

    To control inflation is to control NGDP
    To control NGDP is to have controlled inflation

    The only way the Fed can affect NGDP growth or NGDP growth expectations is to affect price levels or price level expectations. This is *implicit* in any NGDP target. No, the Fed doesn’t *target* inflation, but it absolutely must control inflation expectations that are exactly equal to the differential of NGDPLT expectations and RGDP expectations.

    And just because the differential is fluid and constantly changing doesn’t mean anything. NGDPLT is about expectations. Assume a moment that we are on a 5% NGDP growth trajectory. If expected NGDP increases, the Fed must act to decrease inflation expectations by an amount equal to to the NGDP increase expectation, and vice versa, to maintain the 5% NGDPLT.

    To say it another way, my expectations about NGDP growth are a function of precisely my expectations of real growth and my expectations of inflation. Full stop. The Fed cannot impact my expectations of real growth, at all, so if the Fed wants to increase my expectation of NGDP growth, it must increase my expectation of inflation.

  80. Gravatar of Steven Kopits Steven Kopits
    18. December 2013 at 04:55

    And Libya: Nov. 2009, 1.65 mbpd; Nov. 2013: 0.22 mbpd. (Currently a minimal share of global supply.)

    Libya should be able to produce 1.65 mbpd. The capacity is there, if they can resolve labor and internal political issues. This is the major wildcard in short term supply.

    I wouldn’t expect them to produce much more than their current capacity–it’s not clear that they need to for domestic budget purposes. I don’t know too much their upside potential, but I would imagine it might be possible to increase it by 1 mbpd if the intent were there. However, 1.65 mbpd would be the max production I would expect to see there in the intermediate term.

  81. Gravatar of ssumner ssumner
    18. December 2013 at 06:13

    Steven, If we took away 100% of nails (including those installed in the walls of houses) the economy would collapse. That doesn’t make the nail industry important. But seriously, yes the real side of the economy is much more important than the monetary side. But the monetary side is really important for two specific issues:

    1. Inflation.

    2. Business cycles.

    Oil matters more than most goods for those two variables, but still much less than money.

    On oil production, I think you’ll be surprised by how much it rises over time. As oil prices rise due to Asian demand the level of production is likely to respond. The oil is clearly there, and the higher the price the more intensively it will be produced. BTW, I see articles claiming Libya could produce far more oil if it had political stability.

    JN, Aren’t house prices in Germany lower than 20 years ago?

  82. Gravatar of JN JN
    18. December 2013 at 08:46

    Scott,

    Possibly. I don’t have precise data and it depends on the indicator. Overall it looks like they only just started rising over the last couple of years.
    I only started covering this country recently as part of my job and so aren’t sure of what happened there exactly.

    Let’s not forget that Germany went through a reunification period post-1989, and that the East German region was much poorer. There were possibly a lot of housing starts during the period, although I don’t have any data to back this.

    Germany’s population is also in relative decline, which doesn’t help pushing house prices higher. If anything, house prices should go down rather than up or stable. Demographics could offset the impacts of regulation.

  83. Gravatar of Don Geddis Don Geddis
    18. December 2013 at 09:12

    Dustin: this comment thread has probably reached the end of its productive life. On a very precise level, of course we agree: yes, NGDP = RGDP + inflation. And the Fed has very little influence over RGDP.

    But you’re too dogmatic about it. You say: “my expectations about NGDP growth are a function of precisely my expectations of real growth and my expectations of inflation.” That’s actually not quite true. Your estimate of real growth will have some errors around it; your estimate of inflation will also have some errors. Using your logic, your estimate of NGDP would have to include the sum of those two errors.

    But it actually doesn’t. You can have a more precise estimate of NGDP expectations directly, without needing to add two different uncertain estimates. You may know, for example, that the revenues of Dell selling PCs is going up by 5% this year, without being completely sure what fraction of that increase is RGDP, and what fraction is inflation.

    So it’s highly misleading to claim that NGDPLT works by “controlling inflation”. If people believed you, they would expect to be able to ask the Fed, “what is your current estimate of future inflation?”, and they would be very confused if the Fed responded “we have no idea … we no longer track inflation as a separate measurement.”

    To put it another way: NGDP, directly, is the thing that is most precise and easiest to measure. RGDP and inflation are mere estimates, derived from NGDP measurements via some approximating theory, and with significant uncertainty and errors. If you want to control NGDP, you just do it directly. You don’t bother with the much fuzzier concepts of RGDP and inflation.

  84. Gravatar of Dan W. Dan W.
    18. December 2013 at 12:42

    Don Geddis,

    The power to manipulate the cost of debt (which NGDP implicitly aims to do) is the power to manipulate the cost of leveraged assets.

    Your claim that fed policy does not favor any particular industry is demonstrably wrong. Banks are first in line and after that is every institution that benefits from leveraged capital and cheap debt.

    Dustin gets to the point. Pining for NGDP sounds better than shouting for inflation but inflation is what NGDP is all about.

  85. Gravatar of Don Geddis Don Geddis
    18. December 2013 at 12:54

    Dan W: NGDPLT is about the value of money, not about the cost of debt. They aren’t the same thing. Interest rates would not be targeted or controlled; they would be free to float to their fair market values.

    NGDPLT would result in the same average long-term inflation (2%), that the Fed has maintained since the 1980’s. Perhaps you are unhappy with US macroeconomic performance during the 2 1/2 decades of the Great Moderation. Perhaps there is some other policy that you prefer. But can you at least agree that 5% NGDPLT would be superior to the last decades of the Fed’s 2% inflation targeting policy?

  86. Gravatar of Dustin Dustin
    18. December 2013 at 13:24

    Don Geddis:

    Estimate errors are entirely irrelevant and the idea ignores the basic function of markets. A minimally sophisticated investor uses estimated value ranges, that when combined with other investors’ estimated value ranges, yield a very specific value at time T.

    NGDPLT (using the futures market) is the exact same as any other securities market in this regard. Individuals place bets based upon estimate ranges that in aggregate form specific values, in this case a specific NGDP(e) at time T+n.

    Fed would need to adjust policy to move the price level expectations needle to drive NGDP(e) back to the target. The Fed won’t care what price level expectations are, just that they offset the NGDP(e) – RGDP(e) differential. In summary, it is absolutely essential that the Fed control inflation expectations (ie, change in price level expectations) to keep NGDP(e) on target.

  87. Gravatar of Dan W. Dan W.
    18. December 2013 at 16:06

    Don Geddis:

    What should appall us is the fragility of our nation’s financial institutions and the resulting permanent intrusion of the central bank in our economy and financial markets. This volatility can be directly attributed to financial leverage, a condition that the Federal Reserve not only accommodates but encourages.

    NGDP targeting strikes me as nothing special. NGDPLT scares me to death and I question the common sense of anyone that proposes it. Such a policy would create huge economic instability as inherent delays in measurement feedback would invariably result in the Bullwhip Effect.

    In fact, the argument for NGDPLT strikes me as the same foolish strategy of winning in gambling by doubling down on losing bets under the premise that eventually one will have a winning hand that will recoup all losses. Not only does this strategy not work in practice but it is a recipe for personal financial ruin.

    As with most of our government institutions the charter of the central bank has drifted from its original purpose. It is good to ensure a sound banking system. It is not good to promote policies that cover up bad banking practices or that encourage such. But that is exactly what the Federal Reserve is doing. Meanwhile it sticks the citizenry with the bill via inflated prices and ever diminishing returns on savings all while claiming it is doing us a favor.

  88. Gravatar of Floccina Floccina
    20. December 2013 at 12:35

    Morgan Warstler, If gasoline prices rise sharply but NGDP continues to go up, don’t people buy cars that get better mileage, drive less, car pool, etc. creating jobs? Doesn’t investment in petroleum production rise creating jobs?

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