Is Bernanke too melancholy?

Nick Rowe continues to provide interesting feedback.  This is the tail end of a much longer comment he left at the end of my Richard Rorty post from a few days back:

Here’s another one, that’s both fun, and deadly serious in current contexts:

Horizontal axis: belief that monetary policy is interest rate policy.
Vertical axis: truth that monetary policy is interest rate policy.
Here we have a positive feedback system. There are probably two (stable) equilibria: one in which monetary policy *is* interest rates, and we can get stuck in liquidity traps; and a second in which it isn’t, and we don’t get stuck. Social construction of reality, again, which is just an extreme form of a convention, which not only affects how we behave, but how we see the world. It defines the “social facts” of what central banks “do”.

Question: if this (above) view is correct, what exactly is it that Scott Sumner is *doing* (on this blog)? What *is* he? Not a policy advocate, in the standard sense.

And, if this view is correct, forget about trivia like cutting the overnight rate by 0.25%. Banning all public mention of the overnight rate would be a more effective policy!

I think I may have jumped the shark. Never mind.

He is being too modest; this raises all sorts of interesting issues.  Yes, other economists have discussed somewhat similar ideas.  I seem to recall Krugman used the “Peter Pan” analogy at one point.  Something to the effect of “if we think monetary stimulus can work in a liquidity trap, then it can work.”  But Nick’s comment raises some deeper issues.

In another post one commenter contested my view that investors were paying a lot of attention to Fed policy in October 2008, the period when I alleged that policy was too tight.  He argued that investors were focusing on falling GDP.  I replied that expectations of falling NGDP is exactly what I mean by tight money.  At this point you might say “but for the Fed to have been able to prevent this, they would have had to have been able to change NGDP growth expectations with their policy tools.  Unless investors see the connection, they won’t be able to do that.”

Normally it would be easy for me to swat away that objection, as stock prices often rise or fall 2% or 3% minutes after the 2:15 Fed policy announcements.  So clearly Fed policy has a powerful effect on expectations.  And I think my argument even applies to early October 2008, when the Fed funds target was still 2%.  But what about later, when there was a widespread sense that rates could be cut no further.  Was the Fed no longer able to affect market expectations of NGDP growth?

That is where Nick’s observations come in.  Nick and I have both argued that there are a variety of policy levers by which the Fed can impact nominal spending.  But suppose everyone else thinks the fed funds rate is the only possible tool?  Does that make the Fed powerless?  I am going to argue that the answer is no.  But first suppose that the answer were yes.  Then Nick is arguing that my blog (and by implication blogs like his and Bill Woolsey’s as well) are providing a valuable public service.  We are like those slightly ridiculous 60s hippies that were “trying to blow people’s minds, to get them to see reality in a new way.”  And if people can see there are other ways out of the liquidity trap, then they will be more optimistic that the Fed can avoid the worst case of another Great Depression.

[BTW, my blog started in February 2009, and caught on in March 2009.  Just saying . . . ]

Well this is all very flattering, but I don’t think it is that simple.  It’s up to the Fed to decide what sort of policy tools they want to use.  In the early 1980s the Fed announced it was targeting M1, and almost immediately the various Wall Street markets started reacting strongly to the unanticipated part of the money supply announcement.  When they stopped a few years later, the markets stopped reacting to M1 announcements.  In 1933 FDR announced he was using the price of gold as the level to move prices higher, and the markets immediately started responding to changes in the price of gold.  It’s really all up to the Fed.  Whatever tools they choose to use, the public will follow.  In my view the tool should have been NGDP futures prices.  If they had done so, the public would have followed these prices as closely as they now follow changes in the fed funds rate.

So I don’t buy versions of the Peter Pan argument that make success seem very iffy, very contingent on luck, on whether the well-intentioned Fed is able to convince to the narrow-minded public of their wisdom.  That’s getting the problem backward; the public knows exactly what is going on, it is the Fed that needs to wake up and “have its mind blown.”

But given where we are, stuck with a Fed that can’t think beyond interest rates, what would be the best type of Fed chairman?  In the 1980s and 1990s, when most academics thought the “time inconsistency problem” biased us toward excessively fast NGDP growth, there was a view that we needed a sober, conservative central banker.  Maybe even someone a bit heartless.  Someone who could hold down inflation expectations.  Of course macroeconomists are exactly like the generals who are always fighting the last war, and this was all an attempt to build models out of a single observation—the 1970s.  In retrospect the models were wrong.  So if we are stuck with interest rate targeting, what sort of central banker do we need?

During most times a sober, responsible figure like Volcker/Greenspan/Bernanke is fine.  They can use their Taylor Rules to try to keep NGDP growing at a low and stable rate.  But the minute interest rates hit zero (or even close to zero) there should be a provision that the entire FOMC is replaced with a new FOMC.  And who should be on the new FOMC?  Sit down before you read this . . .

I’m thinking of people like Jim Cramer and Larry Kudlow.  When I say “like them,” I don’t mean people with similar views on monetary policy, I mean people with similar personalities.  People who are optimistic about America, strongly pro-growth, people that are not passive, but rather want to make things happen.  You get the idea.  The point is to instill the public with a feeling that good times are just around the corner, and that they will pull out all the stops to make it happen.  The last thing we need right now is a central banker with shoulders hunched over, who solemnly intones about the looooong difficult period America has ahead if it.  Who keeps talking about how we need to tighten our belts, and get used to a lower standard of living.  Come to think of it, I’d like to nominate my commenter JimP to the FOMC.

Back to reality, I have two serious points in this post.  One is that Nick has correctly pointed to the key role played by beliefs in the transmission of monetary policy.  Academic economists have an enormous responsibility to make people understand that liquidity traps do not limit the effectiveness of monetary policy.  Unfortunately among the people who need to be educated are Fed Presidents like Janet Yellen, and what Krugman calls the “economic analysts” who advise them.  But my second point is that this “expectations” issue should not be misunderstood.  The previous examples of monetary policy at the zero rate bound (US in the 1930s, Japan more recently) make it crystal clear that (contrary to Krugman) there is no such thing as an expectations trap.  No central bank has ever tried but failed to reflate.  Central bankers set the agenda, it is up to them to provide leadership, if they wish to do so.  But right now the leaders of the Fed, ECB, and BOJ, have absolutely no desire to raise NGDP growth expectations.  And that’s a shame.

PS.  Regarding Nick’s proposal for no more discussion of the short term policy rate; my dream is a macroeconomics with no discussion of either interest rates or inflation.  Just aggregate hours worked for the real (cyclical) variable, and NGDP for the nominal variable.  Monetary policy targets NGDP expectations rather than the short term rate.


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28 Responses to “Is Bernanke too melancholy?”

  1. Gravatar of JimP JimP
    26. January 2010 at 09:55

    quote from above
    I’m thinking of people like Jim Cramer and Larry Kudlow. When I say “like them,” I don’t mean people with similar views on monetary policy, I mean people with similar personalities. People who are optimistic about America, strongly pro-growth, people that are not passive, but rather want to make things happen. You get the idea. The point is to instill the public with a feeling that good times are just around the corner, and that they will pull out all the stops to make it happen.
    end quote

    Exactly my point. Its not so much that Bernanke is too sad and pessimistic – though he sure is. But it is really that Obama, and everyone around him, are too sad and pessimistic.
    They think they are managing America’s decline.

    Where is our Roosevelt? Thats what we need. The big smile, and that cigarette holder. Class, and confidence. Confident that our best days are in front of us. Obama simply does not believe that this is true. That is really what is going on here. The man is a real disaster. Sad and glum and blue.

    And that fits right into the Austrian, deflationist, cyclical view of all of this. We invaded Iraq. We don’t have national health care. We are not vegetarians. We are getting exactly what we deserve. Read the blog Naked Capitalism. The woman on there says stuff like this all the time. America deserves deflation – and that is what we are going to get. And she says it with such joy. Or Mish. Or Cluterstock. They are all over the place. The moralists and the deflationists.

  2. Gravatar of Marcus Nunes Marcus Nunes
    26. January 2010 at 10:37

    “Pessimism is infectious” Optimism is contagious” I just made this up, but from reading JimP comment I think it makes sense.
    To abuse, I find the intro to Krugman´s 1998 Slate article (where he argues that MP can “bulldoze” trough any “liquidity trap”) enlightening about the promise of optimism (that unfortunately he let fade away):
    “Twenty years ago I read a story that changed my life. I think about that story often; it helps me to stay calm in the face of crisis, to remain hopeful in times of depression, and to resist the pull of fatalism and pessimism”…
    http://www.slate.com/id/1937/

  3. Gravatar of David Pearson David Pearson
    26. January 2010 at 11:13

    Scott,

    We don’t have NGDP futures. The closest we can come is the stock market. As someone close to the markets, I can assure you that the expectations embedded in them (what we call “consensus”) is probably above 5% NGDP growth for 2010.

    Now, you might say that using NGDP level targeting, we should have an even higher NGDP expectation in order to reach target more quickly. Fine. But assuming an NGDP rate targeting regime, the Fed would probably be tightening policy about now, with unemployment at 10%.

    I say this because much of the discussion around targeting is theoretical because there is no clear measure of expectations. If you accept that the stock market is the best one we have, then expectations are fairly robust at this point in time, and Bernanke need not do anything except, perhaps, tighten until the stock market fell.

    You see where I’m going with this? Substitute “stock market” for “NGDP futures”, and all kinds of interesting things happen. The stock market would go up in a relatively straight line: no more zig-zags. Oh, but since it goes up in a straight line from now on, then there should be a one-time gap up in the price (of the S&P) to account for the decline in volatility. So, as soon as NGDP targeting is adopted, the S&P goes to, say 2,000, and proceeds from there to rise, literally like clockwork, by the growth rate in NGDP. The jokers that wrote “Dow 36,000” (and still advise GOP leaders) would finally win their bet!

    So the Fed can magically create, at the stroke of a pen, enourmous value in the stock market. Given the low volatility, firms would be rewarded for buying back stock and replacing equity with debt. Leverage ratios would go through the roof. Collateralized lending — like 100% mortgages — would explode as nominal asset prices would be virtually never guaranteed to fall.

    Sounding familiar? Like maybe what Greenspan set in motion back in 2002?

    Eventually some limit of leverage would be reached, despite feeble attempts t corral optimism and enforce lending standards. Because if you tighten standards in one place, the market will find a way to use leverage in others. This is exactly what happened in the CRE space, where new lending standards put in place after the S&L crisis were not so much shredded as circumvented.

    Scott, how does the no-volatility world you envision NOT lead to a Minsky moment?

  4. Gravatar of Doc Merlin Doc Merlin
    26. January 2010 at 11:36

    @JimP
    “Exactly my point. Its not so much that Bernanke is too sad and pessimistic – though he sure is. But it is really that Obama, and everyone around him, are too sad and pessimistic.
    They think they are managing America’s decline.”

    This is progressive ideology. Its bazaar to those of us who are pro growth, but this is actually what they believe, and worse than that, it is what they think should happen.

    “And that fits right into the Austrian, deflationist, cyclical view of all of this. We invaded Iraq. We don’t have national health care. We are not vegetarians. We are getting exactly what we deserve. Read the blog Naked Capitalism. The woman on there says stuff like this all the time. America deserves deflation – and that is what we are going to get. And she says it with such joy. Or Mish. Or Cluterstock. They are all over the place. The moralists and the deflationists.”

    HEY HEY! don’t be equating us who have Austrian views with blogs like Mish’s or Clutterstock, or Naked Capitalism. Hell no!

    And as to your argument that we need a Roosevelt, his election didn’t exactly improve things.

  5. Gravatar of StatsGuy StatsGuy
    26. January 2010 at 12:10

    Comment on ssumner’s NGDP targeting regime (of which futures is just one case): One beauty of the system is that it’s a NEGATIVE FEEDBACK LOOP, which is inherently self-stabilizing. It inherently coordinates reaction functions.

    ssumner:

    “But right now the leaders of the Fed, ECB, and BOJ, have absolutely no desire to raise NGDP growth expectations.”

    You have to ask why… Unless you believe it’s all just a mis-understanding (perhaps it is). I suspect the central bankers fear a short term maturity squeeze (raise rates, and they can’t rollover federal debt) and commodity push inflation. They feel the magnitude of debt overhang + import (energy) dependence limits options. Plus, perhaps, fighting for reserve currency status. All very bad reasons. But as I said, I predict we’ll see inflation when Treasury has successfully lengthened its average maturity.

  6. Gravatar of Joe Calhoun Joe Calhoun
    26. January 2010 at 13:05

    Scott,

    Just to clarify a bit. The investors I spoke with during the crisis did not have an iron clad belief that GDP would fall; it was just that the uncertainty surrounding the outcome of TARP and the election made it too risky to wait around and find out. They didn’t say, “The economy is going to hell so I’m getting out”. They said, “I have no idea how this is going to play out but I can’t afford to be wrong if things really do go to hell.” They were afraid that TARP wouldn’t work; they were afraid of what Obama might do. There was an overwhelming fear of the future. I would say that the fear of a fall in GDP was largely responsible for the fall in GDP. Is that the same thing you said? I don’t know but it seems very relevant to this post.

    I would like to comment on the issue of pessimism and expectations. This is a theme I’ve been talking about for a number of months now. In one of my weekly client letters from August called The Triumph of Pessimism: “Unfortunately, despite the rhetoric of hope and change, the new administration displays a pessimism about the resilience of the US economy that prevents the real changes needed to ensure our future prosperity.”

    And then:

    “In a recent article for The New Republic, Noam Scheiber makes the pessimists’ case:

    “So far as I can tell, the only solution to the underlying economic problem is something that’s been a dirty word in Washington the last generation or two: industrial policy (that is, an active government role in the development of certain industries.) In his LSE lectures, Krugman quipped that “if someone could invent the 21-st century moral equivalent of the railroad, or actually even the moral equivalent of IT in the ’90s, that would help a lot.” I agree-that would help a lot. But waiting around for this to happen seems risky when the alternative is a decade of stagnation.

    If, on the other hand, the government were to place some massive bets on R&D, we might substantially increase our chances of stumbling onto a major technological breakthrough-or at least accelerate the process.” Noam Scheiber, TNR

    We have millions of companies and individuals across the country and around the world, but Mr. Scheiber and his fellow central planners apparently believe the best way to enhance the odds of innovation is to employ fewer minds in the pursuit of it. I’m not sure which is more disconcerting; the utter lack of logic in that thought process or the stunning lack of faith in the abilities of the American people. How does this work? Is there something in the DC water supply that endows politicians with a foresight not available to the rest of us? Do dollars attain some kind of magical quality that ensures success when they are passed out by government agencies? President Obama obviously understands the power of the network; he used his own grass roots network very effectively to get elected. What is the value of a network? To put it in the language of mathematics; as the number of nodes in the network increases arithmetically, the value of the network increases exponentially. We have a network of millions; all the government needs to do is make sure the network continues to function and remains accessible. Economic policy should focus on accelerating the accumulation of new pools of capital so it is available to fund the good ideas that emerge naturally. What seems more likely to be successful? Allowing politicians to make a few large bets or encouraging millions to make the investments of their choice?”

    Sorry to quote so liberally from my own stuff, but I think this is incredibly important. Do the problems we face really require years of weak growth? Are things really so much worse now than they were when Reagan took office? We turned things around pretty quickly back then; why can’t we now? Is our only hope really that Obama will pick the right technology to bet on? God help us, I hope not. Scott focuses on monetary policy here and how that could affect the rate of recovery but it also extends to other policy and just the general demeanor of the administration.

    I don’t believe the problems facing our economy are really all that difficult to solve and I don’t believe we have to suffer through years of lousy growth to do it. Scott laid out some ideas for changing tax policy a few posts back that would lead to higher growth even while maintaining a new higher level of government spending. I would prefer, like many of the commenters on that post, to reduce spending but if you believe Scott was right in that post (and I do), the message needs to be spread far and wide. Most people do not believe that we can recover quickly and until they do, it won’t happen.

    Rahm Emmanueal was right; a crisis is a terrible thing to waste. This crisis offered an opportunity to make major changes to things like tax, spending and monetary policy and we are letting it slip away in favor of some kind of Japanese malaise. What a shame. Again, sorry for being long winded….

  7. Gravatar of 123 123
    26. January 2010 at 13:16

    DeLong says that Bernanke is an optimist and a fan of monetary stimulus, but the only way he can steer the FOMC is by playing the role of a sober, responsible median FOMC member in public. And then in private he can subtly nudge FOMC. Delong even proposes two new FOMC members so that Bernanke can work his behind the scenes magic easier. What do you think?

  8. Gravatar of Mr. E Mr. E
    26. January 2010 at 13:33

    Here here!

    Your last paragraph might be the most inspiring thing I’ve ever read from an economist.

    Really all that matters is that people are working and the economy is growing. Everything else is just so much detail.

    Nice one Scott.

  9. Gravatar of TA TA
    26. January 2010 at 14:17

    I need some help with the expectations mechanism.

    Let’s say I’m a guy, whom I will describe in just a moment, and you are the czar of money — you can do whatever you want to target NGDP.

    Here’s me: I run a small, very promising corporation, in which I own a lot of stock. Right now, because our particular market is way down in the recession, we are tight on cash flow, and concerned about that if this keeps up, so we’re not investing much, although we will need to do so at some point — lots, if we’re going to have the success we should. Also, I have a family. We have a fair amount of savings apart from the stock in the company, invested conservatively.

    Here are my questions: What are you going to do to target NGDP? As a normal human being, what data will I be looking at that might change as a result? What will I do in response, and why?

  10. Gravatar of Matthew Yglesias » Endgame Matthew Yglesias » Endgame
    26. January 2010 at 15:16

    […] “” FOMC needs optimists. […]

  11. Gravatar of JimP JimP
    26. January 2010 at 17:11

    Yglesias

    Exactly right.

  12. Gravatar of JimP JimP
    26. January 2010 at 17:14

    I said this once before……….a long time ago.

    It is not the job of the Fed to give us their sad and blue expectations – of 10% unemployment and 17% underemployment from now to the end of time.

    It is their job to SET expectations. And in an optimistic way I would hope.

  13. Gravatar of scott sumner scott sumner
    27. January 2010 at 06:42

    JimP, You have the best psychological diagnosis of the crisis.

    marcus. please stop! You keep forcing me to do new posts.
    🙂

    David Pearson. I can never make heads or tails of the argument you are making. I must be misinterpreting it somehow, as you seem to be saying occasional recessions are a good thing because they instill fear in the markets, and keep stock prices lower. Why would we want to do that?

    I haven’t studied Mnisky. But I gather he thinks recessions are caused by financial bubbles, not tight money causing falling NGDP. If so, then I have no concern about “Minsky moments” which seem to violate the EMH in any case.) We had one in October 1987, so what?

    A few minutes ago I argued that the Fed probably wants about 5% NGDP growth, going forward. In other words, they don’t think there is any “problem” of demand shortfall that needs to be “solved.” If they did, they’d adopt an easier monetary policy. I do think some catchup is appropriate, as do most economists. If you polled economists and asked whether it would be better to have 7% NGDP growth or 5% NGDP growth over the next two years, most would probably say 7%. (If not, then what the hell were most economists doing supporting fiscal stimulus?)

    BTW, I think the Consensus forecast for 2010 NGDP growth is about 4%. But that is year over year, and perhaps from January to December the rate is 5%, I don’t know.

    Doc, I’d say we need FDR’s monetary stimulus and optimism, but not the New deal.

    Statsguy, You said;

    “They feel the magnitude of debt overhang + import (energy) dependence limits options. Plus, perhaps, fighting for reserve currency status. All very bad reasons.”

    Yes, bad reasons, partly because much of the debt overhang was created by falling NGDP, which was created by . . .

    Joe, The markets showed that NGDP expectations were plunging at that time, for two reasons. TIPS spreads showed much lower inflation, as did commodity prices. And the stock market indicated RGDP expectations were falling fast, as did indicators like plunging prices of renting tankers to ship goods around the world (which fell 90% in the fall of 2008.)

    The rest of your comment makes some great points. The left’s problem is that they think falling NGDP is a failure of capitalism, and requires big government. The right’s problem is that they don’t understand that falling NGDP opens to the door to the left.

    123, Yes, I linked to DeLong’s post and praised it. (Even though he dissed me earlier.)

    Thanks Mr. E.

    TA, That’s why I love monetary economics, it is impossible to give an intuitively appealing explanation of how monetary policy works. That is why almost no one understands it. I have long posts like this one to explain it:

    http://blogsandwikis.bentley.edu/themoneyillusion/?p=461

    Monetary theory works through something called the “fallacy of composition” what is true for the group isn’t true for the individual. When you give individual people more cash, it has little impact on their behavior. They try to get rid of it, if it is more than they want to hold. But in aggregate they can’t, you only get rid or your cash by giving it to someone else, or a bank. In aggregate if there is too much cash, and people try to get rid of it, raising AD and prices. Since wages are sticky, that boosts output. But the individual cannot see this process play out, your attempt to get rid of cash seems a trivial thing, unable to spur the economy. But in aggregate, if people customarily carry $100 in their wallets, and then the Fed doubles that to $200 per capita, then NGDP will double, even though the average person will view the extra cash as a momentary inconvenience, quickly gotten rid of.

  14. Gravatar of David Pearson David Pearson
    27. January 2010 at 08:14

    Scott,

    You are right. I believe recessions are a necessary part of capitalism, and that their severity is dictated mostly by the amount of leverage and the level of savings going into them. Without a recession, near-clockwork NGDP growth of 5% would drive leverage to sky-high levels. This is a point which you did not address: what is the natural cap on leverage in an economy with as little volatility as you envision under NGDP targeting? My point is that even if the Fed were successful in fine-tuning the economy to that extent, the amount of leverage would cause the system to be extraordinarily vulnerable to any shock. In fact, we such fine-tuning under the “Great Moderation” and asymmetric monetary policy, and it has led us to the present juncture.

    One thing to think about Scott. The market is a discounting mechanism. Guarantee it 5% nominal growth and it will mark up asset prices dramatically — right away. This would result in extremely high fixed capital investment levels in certain sectors (namely real estate). The distortions caused by that investment (made with extreme leverage) would plague the economy. Again, this is what happened in 1998-2008 with asymmetric policy, and NGDP targeting would make an even bigger bubble in the future.

    BTW, I think NGDP targeting at all cost is essentially the policy of the PBOC. That is why they flushed 2/3 of GDP (annualized) in lending into the economy in the fist half of 2009. Talk about controlling velocity! The result is obviously going to be dramatic loan losses in the future.

  15. Gravatar of TA TA
    27. January 2010 at 08:25

    Bah! That’s no explanation at all. The reason why I specified my hypothetical self the way I did was to elicit your view of what the transmission mechanisms to the real economy would be. If you can say it, I can probably understand it.

    You make a lot out of targeting (NGDP in your case). To me that implies some role for expectations. I don’t see any expectations at all in your response to me. In that simple model, I assume the FRB would buy securities. People who previously held securities would now have money, but want securities. And so on and so on until lower interest rates made people spend more, or they just gave up and spent the cash, or something. If that’s it, why target at all? Just buy securities until you get the result you want.

    That’s why I hate monetary economics. Most of the time, it just sounds like some vague collective action theory, in which nobody knows why anybody does anything, except they do it because everybody else does it.

  16. Gravatar of David Pearson David Pearson
    27. January 2010 at 08:26

    One other thing: this is where the libertarian vs. command/control argument comes into play.

    If I can paraphrase your thesis:

    “Free markets are responding, correctly, to price signals that are artificially created by the Fed, which is keeping NGDP, by fiat, below its “natural” level.”

    My thesis:

    “Free markets are responding, correctly, to price signals that reflect reality, whereas before they were responding to artificial signals created by the Fed, which kept, by fiat, NGDP above its natural level.”

  17. Gravatar of Marcus Nunes Marcus Nunes
    27. January 2010 at 08:54

    David P
    You said: “The market is a discounting mechanism”. It sure is, but you can also phrase it as: The market is the field where expectations confront. The more uncertain the environment, the scope of expectations is wide (which lead to very different discount values) and the economy is more volatile. If you want to keep people “on their toes”, use a mixed strategy, so everyone will be extremely “conservative” (leverage will be small), but outcomes will still be widely variable. Surely, that´s not “Pareto Optimal”!
    The US had 24 (84-08) years of Great Moderation during which it went through 2 brief and shallow recessions (in 2001 not even RGDP growth turned negative yoy). Towards the end of that period leverage skyrocketed, but that is not a necessary consequence of “tranquility”. In fact it shouldn´t be difficult to keep leverage “bounded”. In the housing market, just to give an example, down payment could be closer to 20% (or even 30%) than to 0%.

  18. Gravatar of thruth thruth
    27. January 2010 at 09:20

    Marcus Nunes said “The US had 24 (84-08) years of Great Moderation during which it went through 2 brief and shallow recessions (in 2001 not even RGDP growth turned negative yoy) Towards the end of that period leverage skyrocketed, but that is not a necessary consequence of “tranquility”. […] In the housing market, just to give an example, down payment could be closer to 20% (or even 30%) than to 0%.”

    I see a lot of people say that we need (more) leverage restrictions, but I’m not convinced it’s a freebie or that there’s an obvious leverage limit. Part of the great moderation was the freeing up of credit. It’s not unreasonable to say credit became too free, but then how much lower would real GDP have been in 2007 without it? Why is a 20% or 30% downpayment appropriate? Would you prefer a nation with a larger share of renters? Or should the government hand out $40,000 first home buyer grants and get rid of all the other forms of housing support? (presumably the voters’ demand for govt supported housing isn’t going away). What about leverage at the institutional level?

    I’d prefer to see a system where acceptable leverage levels are determined in the market place. Unfortunately, the incentives to take on leverage are screwed up by massive creditor bailouts, a financial regulatory system that encourages herd behavior etc…

  19. Gravatar of David Pearson David Pearson
    27. January 2010 at 09:24

    Marcus,

    You could require 20% down. You would also have to prohibit all 2nd liens and home-equity lines. Also, you would have to make option arms illegal, along with any kind of equity participation certificate (which would allow the homeowner to sell equity). That would not be enough, however. You would also need to prohibit equity extraction upon refinancing.

    Then, even if you did all that, here’s what would happen: hedge funds would use extreme leverage to increase the returns on plain-vanilla, 80% LTV MBS. When I say extreme, I mean above 20:1 — more like 100:1. These hedge funds would attract enourmous amounts of capital, driving mortgage rates down and house prices further up. If these hedge funds got into trouble because of leverage, they would spike mortgage rates, tank housing prices, and cause a financial crisis.

    So you would have to regulate hedge funds and the prop desks of banks; prohibit derivatives as a way of gaining leverage; and prohibit any product that could increase leverage in housing finance. Even then, you would be working against the best minds in the U.S., all being paid enormous sums of money to circumvent regulations in search of leverage on assets that are virtually guaranteed to increase in price.

    Good luck with that.

  20. Gravatar of jj jj
    27. January 2010 at 10:33

    Here’s a question I’ve had brewing for a while. NGDP dropped precipitously, creating slack in the economy. As I understand it, the economy should then be able to grow rapidly without causing inflation, until the slack is taken up. If the fed was targeting inflation rate expectations (instead of backwards-looking Taylor), wouldn’t a huge monetary base increase be called for to achieve the desired 2% inflation rate? This would make inflation rate targeting effectively equivalent to price level targeting.

    I don’t know if that’s clear enough to follow; the main thrust is that due to all the slack, additional money won’t create inflation until NGDP reaches its former level, therefore an inflation rate expectations rule would pump enough money in to bring the NGDP back up. In this scenario does price level targeting have any advantage?

  21. Gravatar of JimP JimP
    27. January 2010 at 11:24

    Scott

    I think thats right. I do have a good grasp of the psychology of all this. It is really fascinating.

    Early last year the US stock market was falling faster even than it had during the depression. It was amazing to watch the pro-cyclical behavior of “everyone” – from tv commentators to investment advisors to investors. Everyone was running is the same direction, as fast as they could go. Market efficiency? Only if a person has a time horizon of two seconds, or is leveraged 50:1. It was a pure and simple liquidity panic.

    We were on the other side of those trades. Buying into the panic.

    Contra-cyclical behavior – provided by long term investors, and by governments. To do that one has to have one’s psychological ducks in a row.

  22. Gravatar of JimP JimP
    27. January 2010 at 11:48

    And the only “contra” blog I could find with intelligent arguments was yours.

  23. Gravatar of Doc Merlin Doc Merlin
    27. January 2010 at 12:26

    @JimP
    “Contra-cyclical behavior – provided by long term investors, and by governments. To do that one has to have one’s psychological ducks in a row.”

    I completely disagree with your characterization of governments. G is a pro cyclical variable, and actually grows faster than C during the boom phase.

  24. Gravatar of scott sumner scott sumner
    29. January 2010 at 05:45

    David Pearson, You said;

    “BTW, I think NGDP targeting at all cost is essentially the policy of the PBOC. That is why they flushed 2/3 of GDP (annualized) in lending into the economy in the fist half of 2009. Talk about controlling velocity! The result is obviously going to be dramatic loan losses in the future.”

    No, that’s socialism, not NGDP targeting.

    I presume you think Australia, which hasn’t had a recession since 1991, is headed for a Great Depression?

    The cause of our financial crisis was FDIC and TBTF. That should be addressed through regulation (requiring lots of collateral) not monetary policy.

    TA, I can’t teach a whole course in monetary economics in a single post. If you are so skeptical about monetary economics, explain why countries where money supply growth averaged 50% over decades, saw 50% inflation, and countries where money supply growth averaged 70%, saw 70% inflation. Try explaining that key empirical observation without the fallacy of composition. Good luck.

    David Pearson, You said;

    “Free markets are responding, correctly, to price signals that reflect reality, whereas before they were responding to artificial signals created by the Fed, which kept, by fiat, NGDP above its natural level.”

    This is a very common mistake. Although there is a natural rate of RGDP, there is no such thing as a natural rate of NGDP. NGDP depends entirely on monetary policy.

    Marcus, I agree.

    Thruth, You said,

    “I’d prefer to see a system where acceptable leverage levels are determined in the market place. Unfortunately, the incentives to take on leverage are screwed up by massive creditor bailouts, a financial regulatory system that encourages herd behavior etc…”

    Exactly.

    David Pearson, That is a common mistake. The size of any financial crisis is caused by the amount of underlying loan losses. Leverage by banks and or derivatives don’t change that fact at all, they merely move the losses around. The world financial system got in trouble because of more than $3 trillion in loan losses. Collateral would take care of that problem, you don’t need to worry about hedge funds that are leveraged. If they lose money no one cares. Did the government bail out any hedge funds in the worst crisis in 100 years? No.

    jj, JJ the advantage of price level targeting is that it helps prevent the initial fall in the price level. Furthermore it allows for a higher inflation target once prices have fallen (say a 3% target.) But I agree, even a 2% inflation target over the next two years would require a far more expansionary monetary policy than we have right now. I expect 1% inflation over the next two years, as do the markets, BTW.

    JimP and Doc, I think Jim is saying government should be countercyclical, not necessarily that it always is. I’m doubtful whether fiscal stimulus can be times right, but monetary stimulus can.

  25. Gravatar of Doc Merlin Doc Merlin
    29. January 2010 at 21:34

    Re: Cyclicality of government
    Fair enough, but I am not sure that government can actually be pro-cyclical. Its too easy to just spend the money when its available, and to increase spending as more money comes in. California’s recent budget mess is an example of this, during the boom times they increased their budget much faster than the state was growing, and now that they are in recession, they are in trouble.

  26. Gravatar of scott sumner scott sumner
    31. January 2010 at 08:12

    Doc, I agree about state governemtns. Our only hope is if the Fed can be countercyclical.

  27. Gravatar of TA TA
    7. February 2010 at 10:21

    You misread me. I’m actually not so skeptical — just agnostic. What prompted my first post is — I want to know what you think the transmission mechanisms are from monetary policy to aggregate demand. But you just keep patting me on the head with this stuff about fallacy of composition.

  28. Gravatar of Scott Sumner Scott Sumner
    11. February 2010 at 11:02

    TA, There are lots of “transmissions mechanisms.” The excess cash balance mechanism. That impacts future expected NGDP. Then there is the effect of changes in future expected NGDP on flexible asset prices like stocks commodities and real estate.

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