It’s worse than it looks

Every once and a while it’s appropriate to remind readers of the “circularity problem.”  The Fed pays attention to markets when deciding what to do, and markets react to what they think the Fed will do.  The seminal paper on the circularity problem is written by Michael Woodford and Ben Bernanke (JMCB, 1997.)

Right now the markets are mostly likely pricing in further Fed “easing”, something like QE3.  I doubt it’s viewed as 100% certain, but it’s clearly a likely outcome given the rapid deterioration of the global economy.

Now for the bad news, these market prices already reflect QE3; it’s already (mostly) priced in.  That means QE3 will most likely fail, even if undertaken.  I hate to ruin everyone’s weekend, but the markets are telling us that there is actually very little hope that we’ll be able to avoid a massive AD shortfall in future years.  Sober  Look has a post showing that two year TIPS spreads forecasts have fallen below 1%, and Paul Krugman has a post showing plunging inflation forecasts in Germany, the one bright spot in Europe (no longer.)  Sure, it’s possible the Fed will do more than the markets expect, but its equally likely they’ll do less.

On the lighter side, let’s have some fun with recent comments. This is from Liberal Roman:

Today I heard this rather depressing exchange on CNBC involving their main Fed expert, Steve Liesman (and I am paraphrasing):

Anchorman: “Steve do you think the Fed is more likely to do QE3 because of this poor jobs report?”

Steve Liesman: “Maybe, but I don’t really see the point. The market has already done a lot of their work for them. 10 year yields are at record low levels. I don’t really see what else the Fed can accomplish with more QE”

Anchorman: “Yea, you are right Steve”

Liberal Roman: **Throws bowl of cereal at TV screen**

My regular readers know that my previous post was satire, but I’d guess 99% of the general public thought I was serious.  Then CA added:

Yeah, I just heard on CNBC Steve Liesman and Rick Santelli agree that the Fed can do no more (and shouldn’t even try) to improve the economy.

Who says two wrongs don’t make a right?  If it really were true that lower bond yields were the functional equivalent of easier money, then monetary stimulus actually would be a bad idea.  (Apologies to Steve Liesman if he’s been misquoted.  In any case, there are a zillion other reporters who feel the same way.  We are the weirdos over here, insisting money is ultra-tight.)

Commenter Bonnie said:

Romney campaign speeches over the last few weeks have included the words “we need jobs and rising incomes.” I don’t know exactly what he means by “rising incomes,” but it is an interesting choice of words. Too bad, if it means what I think it might, he couldn’t tell us.

This was what Romney was saying before Governor “hang em high” entered the race.  Looks like he’s reverting back to form now that all the neanderthals (plus Huntsman) have been eliminated from the race.  BTW, another term for NGDP is “gross national domestic income.”

Obama contracts fell 4.1% today on Intrade.  To paraphrase St Augustine, Romney’s probably thinking “lets have more jobs and income but not quite yet.”

PS.  All commenter quotes are from the previous post.

PPS.  Readers who want to see what the Keynesians are up to might be amused to find this “proof” that Keynes discovered the “Sumner critique.”  Lots of people discovered it before me, but certainly not Keynes.  The “proof” is based on the proposition that “full employment” means the same thing as “NGDP”.  Not only are the two terms unrelated, but the Sumner critique has nothing to do with whether the economy is at full employment.  BTW, I think it’s appropriate that the Sumner critique be named after me, as economic propositions are never named after their actual inventor.  Thus the name implies that I most certainly am not the first to use the idea.

HT:  Integral, Bob Murphy


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30 Responses to “It’s worse than it looks”

  1. Gravatar of curiouseconomist curiouseconomist
    1. June 2012 at 17:23

    “BTW, another term for NGDP is “gross national income.””

    Scott, I believe you mean Gross *Domestic* Income. Gross *National* Income includes net factor payments from abroad (and is the income equivalent of Gross *National* Product).

  2. Gravatar of johnleemk johnleemk
    1. June 2012 at 17:34

    It’s incredibly frustrating. The political and policy world falls into two camps:

    Those who believe no stimulus is necessary, everything is supply-side
    Those who believe stimulus is necessary but only fiscal stimulus can or should supply it

    It’s like people completely forgot the existence of Milton Friedman, and decided to revert to the stupidest possible version of New Keynesianism, where interest rates are the only lever of monetary policy and the printing press is something that only functions when rates are above zero.

    I feel like to both the centre left and the right, Milton Friedman is too heretical now — too right-wing for the left obviously and too left-wing for the right. Consequently, everything about monetarism has been stripped out of the public consciousness and we are left with vulgar Keynesianism and vulgar Austrianism.

    We truly live in a Dark Age of economics.

  3. Gravatar of Steve Steve
    1. June 2012 at 17:47

    Scott, I argued on Historinhas that the market is pricing in QE3, but only after NGDP approaches 0% and the Fed has a few months to whitewash the record. Thus, QE *IS* expected to work in the sense of keeping us above the Fed’s floor. The problem is that the Fed’s floor is extremely unambitious.

  4. Gravatar of Steve Steve
    1. June 2012 at 17:50

    Also, the latest from our “favorite” central banker, Richard Fisher:

    Fisher pointed out that long-term bond yields are already low as investors flock to the dollar and away from the euro.

    “It helps to be the best looking horse in the glue factory! Monetary policy has done all it can, in my view,”

    http://money.cnn.com/2012/06/01/news/economy/Fed-Fisher/

    Plosser said the same thing: Europe is helping us by driving down interest rates!!!

  5. Gravatar of Evan Soltas Evan Soltas
    1. June 2012 at 17:50

    Hi Scott,

    I think the Bernanke-Woodford paper to which you made reference is here: http://www.nber.org/papers/w6157.pdf?new_window=1. Will read over the weekend.

    Seems like circularity could be problematic, but also just looking at the behavior of equity prices, they seem awfully related to QE. Does that suggest imperfect circularity, or whatever one might call it? http://3.bp.blogspot.com/-2vY5Zf6WAFo/TZue2EMU3EI/AAAAAAAAKHM/EWBaONjtFWc/s1600/SP500QE.jpg

    Also, the 1-year implied breakeven from is 0.37. It fell from 0.58 yesterday alone. In mid-May it was 1 percent. See: http://www.bloomberg.com/quote/USGGBE01:IND/chart. The ten- and twenty- year breakevens, if you change the year code in the URL (the last two digits before the final colon), are about to go sub 2 percent.

    – Evan Soltas

  6. Gravatar of ssumner ssumner
    1. June 2012 at 18:01

    Curiouseconomist, Thanks, I’m showing my age.

    Johnleemk, I agree.

    Steve, The things they say would be comical if the results weren’t so tragic.

  7. Gravatar of Morgan Warstler Morgan Warstler
    1. June 2012 at 18:17

    Romney plays the logic card, Scott agrees:

    “Some of the Fed’s stimulative efforts have fallen on hard times. … I don’t think we’re looking for more QE3. I don’t think that will have any more impact than QE2 did.”

    Read more: http://www.businessinsider.com/romney-thrashed-obama-on-jobs-report-on-cnbc-2012-6?op=1#ixzz1wb8FEGpE

    —–

    The truth is QE3 can’t solve it, it takes a full blown commitment to level target, and that is not in the cards.

    I’m going to say it again:

    Obama had ANOTHER option.

    Romney articulates it clearly: Act like Clinton.

    On Obamacare, Romney says Obama is more “focused on his historic legislative achievements than getting people back to work. … His own team said it would slow the economy, and it has.” Later, he says Obamacare has “scared small business from investing.”

    On energy policy: “His energy policies have put people out of work and have not put them back to work.”

    “Unfortunately, what the president has done is make is less and less likely for people to invest in America.”

    —-

    Spending all the money so Dems don’t get to do anything but make govt. more productive so people like it…

    Is a VALID strategy.

    And if it WORKS, then the left will be forced to stop trying to use economic rhetoric and will be forced to make government work as efficiently as the private sector and devolve power to the state, or they won’t get to matter.

    And if it works, Scott is dedicating his book to me. Something short and sweet. Pithy.

    http://www.businessinsider.com/romney-thrashed-obama-on-jobs-report-on-cnbc-2012-6?op=1

  8. Gravatar of UnlearningEcon UnlearningEcon
    1. June 2012 at 18:18

    Keynes obviously used full employment to mean maximum effective demand at a given level of potential output. It’s hard to deny that you do something very similar.

  9. Gravatar of Morgan Warstler Morgan Warstler
    1. June 2012 at 18:28

    Scott, this is what happens when you don’t explain how NGDPLT shrinks govt. to increase growth.

    It’ll silence this stuff immediately.

  10. Gravatar of Mark A. Sadowski Mark A. Sadowski
    1. June 2012 at 18:36

    Scott,
    I thought I had read something vaguely similar before…

    The Keynes Critique:
    “But if our central controls succeed in establishing an aggregate volume of output corresponding to full employment as nearly as is practicable, the classical theory comes into its own again from this point onwards.”
    (The General Theory – Chapter 24)

    The Sumner Critique:
    “If the Central Bank is targeting expected Nominal GDP then all other macroeconomic effects become approximately classical in nature.”
    (The NKs win when only the RBC model is left standing)

    You’re right, “full employment” does not mean NGDP. Still, the rest of it is eerily similar.

    For those who are interested the 2-year breakevens can be found here:

    http://www.bloomberg.com/quote/USGGBE02:IND/chart

    I check it daily.

    In the last two years it’s gotten to the point where I can tell what time of year it is just by looking at the trend in inflation expectations (no need to go outside at all). It peaks every spring and troughs every fall prior to the announcement of another round of monetary stimulus.

    Thus I’ll know its autumn when the greenbacks fall again.

    @JohnleekM
    When I comment elsewhere I go out of my way not to say anything critical of any form of stimulus. But I find that for whatever reason Keynesians feel deeply threatened by any talk of monetary stimulus, and my general refusal to criticize fiscal stimulus is, as a rule, never reciprocated.

    The austerians may be wrong, but at least they’re honorable.

  11. Gravatar of Morgan Warstler Morgan Warstler
    1. June 2012 at 19:06

    The eery similarity doesn’t end there….

    Just as Keynes ideas are used to grow govt.

    Sumner’s will be used to shrink it.

    Scott doesn’t come into his own, until we first hear someone say, “if govt. gets more productive, we can keep rates low!”

    DeKrugman and Wren Lewis are wrestling with it, but they haven’t seen it yet for what it is.

    Perhaps Scott is Ronald Reagan hiding in a Nixon mask.

  12. Gravatar of StatsGuy StatsGuy
    1. June 2012 at 19:20

    Scott, the Fed’s answer to the circularity problem is uncertainty – they are playing a mixed equilibrium. This is precisely why we get such ridiculous volatility. How else does the 10 year drop from 2.3 to 1.45? Mixed equilibria are not inconsistent with efficient markets.

    In any case, I’ve discovered I’m a better investor when I try not to think too hard. Again, simple revealed preference theory – the Fed is crudely and retroactively targeting headline inflation, largely driven by commodities due to lack of labor pricing power. Theory says this is stupid, Bernanke’s way too smart for that, blah blah. But empirical evidence has given us several straight years of corroboration. I’m making an attempt to stop conflating what is logical, and what appears to actually be true.

  13. Gravatar of johnleemk johnleemk
    1. June 2012 at 19:35

    Mark,

    Indeed. If you replaced Keynes’s “full employment” with the NAIRU, it essentially would be the Sumner critique. Wow.

    I separate the fiscal stimulus crowd into two groups: laypeople, who take their cue from Krugman because they aren’t economists; and the economic professionals like Krugman et al. Not much use talking this with laypeople like Obama, you need to go to the source: Krugman and other left-leaning economists.

    The problem I’ve found is that they’re very politically astute and capable of marshalling all these fantastic political arguments for fiscal stimulus and its workability, lambasting right-wing liquidationists for what they are — but when it comes to monetary stimulus, they retreat to academia and talk in very theoretical terms, as if monetary policy isn’t something which the political sphere can touch.

    Then they get all grumpy about market monetarists criticising Krugman for not supporting monetary stimulus in the politically-loaded terms he uses to marshal support for fiscal stimulus — arguing that they too support monetary stimulus. My rejoinder always is: if that’s so, why the hell did Obama wait two years to even bother filling the empty FOMC seats, and why did he pick people who would be so ineffective at fighting hawks like Plosser? At that point I’ve found nobody can say anything.

    It’s a fact that Obama needs the advice of economists — and the economic profession has given him, pardon my French, totally shit advice on monetary policy. Krugman and his ilk may say they support monetary stimulus, but Obama’s total failure to leverage monetary policy cannot be attributed to anything other than Krugman et al totally failing to get their message across, if monetary stimulus is part of their message at all.

    I am skeptical of fiscal stimulus, but like you, I rarely mention this. Yet criticising Krugman et al for their inconsistencies on monetary stimulus gets me treated as if I’m no better than a liquidationist hawk.

  14. Gravatar of Bonnie Bonnie
    2. June 2012 at 00:35

    “That means QE3 will most likely fail, even if undertaken. I hate to ruin everyone’s weekend, but the markets are telling us that there is actually very little hope that we’ll be able to avoid a massive AD shortfall in future years.”

    I am confused by this. Maybe I’m missing the point somewhere because I don’t see much difference in what the expectation for AD has been over the last few years verses what has been fostered by the Fed anyway. It never has wanted to have more AD than what we’ve had recently.

    What I am very concerned about is if the Fed grossly underestimates the the magnitude of pressures because these guys have their heads in some deep dark place, wringing their hands over inflation, and inflation fighting credibility, like in 2008, and therefore doesn’t do QE3; or if it does do it, it will end up like fighting a raging inferno with a garden hose and not be enough to even maintain the status quo. I truly am no fan of misery, but the current level of misery is highly preferable to further magnification of it.

  15. Gravatar of Peter N Peter N
    2. June 2012 at 03:39

    @statsguy

    “Scott, the Fed’s answer to the circularity problem is uncertainty – they are playing a mixed equilibrium. This is precisely why we get such ridiculous volatility. How else does the 10 year drop from 2.3 to 1.45? Mixed equilibria are not inconsistent with efficient markets.”

    Yes. There’s a balancing act between optimum levels of perceived uncertainty and confidence. This would be an interesting area for some enterprising economist to explore.

  16. Gravatar of Peter N Peter N
    2. June 2012 at 03:57

    I had a weird idea about how to introduce the drachma. The problem is that any system with an involuntary conversion will cause runs and capital flight.

    So how about a voluntary conversion? I don’t see any economic laws that say it’s impossible. My idea is:

    1) The bank of Greece announces the new drachma (ND), with a conversion rate of 2 ND for every tendered euro, but no official conversion the other way. This is voluntary, there’s no obligation to convert.

    2) ND will be accepted as payment by government entities at a rate of maybe 1.5 to 1. Whatever looks to work best.

    3) In particular, ND will be accepted for taxes, electricity bills, licensing fees and university fees.

    4) The VAT will be 3% lower for all transactions verifiably conducted in ND like bank transfers and credit and debit card purchases.

    5) The public can convert ND to euros at any rate it chose.

    6) The Bank of Greece would use the euros it receives to pay down government euro debt.

    7) The ECB would finance this scheme, since it’s the least expensive solution.

    That’s it. I’m sure this is incomplete, but I thought I’d run it by people for them to poke holes in.

  17. Gravatar of Morgan Warstler Morgan Warstler
    2. June 2012 at 04:11

    Peter, where do the ND come from to pay the Greek public employees?

    And I think Tyler would agree with my observation:

    When hippies are angry the chance of QE increases.

  18. Gravatar of StatsGuy StatsGuy
    2. June 2012 at 04:13

    @Peter

    I talked to couple algo programmers a few months back, and it seems most of the pro algo based funds now use regime switching models, which move from high to low volatility modes. Regime switching models are highly binary – they’re essentially move across states of the world with probabilities, and each state of the world has a set of protocols that govern behavior. This means the flip from low to high volatility mode can be very rapid, with periods of low volatility punctuated by periods of extreme volatility. Also, with everyone running similar models and using the same historical training data, we get some wacked behavior.

    Scott – consider the following circularity proposition – if the Fed wanted to, they could reduce the current volatility by simply declaring right now what they are likely to do on June 20th, subject to what conditions. Isn’t Bernanke touting his efforts to “communicate” more effectively? If so, where has the communication effort been in the past 30 days?

  19. Gravatar of StatsGuy StatsGuy
    2. June 2012 at 04:19

    @Morgan

    :Romney plays the logic card, Scott agrees:

    “Some of the Fed’s stimulative efforts have fallen on hard times. … I don’t think we’re looking for more QE3. I don’t think that will have any more impact than QE2 did.”
    ——

    Oh please, Morgan, you are smarter than that. Let me translate Romney for you:

    “Please, please, everyone, let’s do our best to stop the Fed from QE3. QE3 4 months before the election would trigger a 4-6 month reduction in volatility and rise in equities, and election results can be predicted with 90% accuracy based on the movement of the equity markets 3 months prior to the election. If Obama gets QE in June, there’s a good chance he could win this thing… So we’ve got to stop that. I’ve got all my allies out on the news networks telling everyone why QE3 won’t do anything. Sure, we know it’s a lie, but we need to delay it till after I get elected.”

  20. Gravatar of Peter N Peter N
    2. June 2012 at 04:35

    @Morgan

    Peter, where do the ND come from to pay the Greek public employees?

    Good question. Since the idea is voluntary conversion, nobody should be forced to take ND. So payment would be in a mixture of ND and euros chosen by the employee, with the proviso that there was a penalty for changes which decreased the proportion of ND. You can go forward for free and make a profit on it, but you have to pay to go back.

    The tricky bit seems to be the part where you scale back the subsidies and the Bank of Greece starts exchanging euros for ND. after that, we’re done. The rate set will be the average conversion rate of some recent period.

  21. Gravatar of Negation of Ideology Negation of Ideology
    2. June 2012 at 06:11

    About Romney reverting to form after the threat from “hang him high” Perry was gone. I finished Krugman’s book the other day and toward the end he says that it’s not clear Romney believes any of this stuff. While I don’t think Krugman will be voting for Romney, he seemed to be holding out hope that Romney is actually sane.

    I used to think we needed someone really bold to end this crisis, but maybe Romney, who I thought of as the most cautious candidate, could do it. He supposedly cares about “the data”, he’s not ideological, and he knows something about money. Does anybody think he’s going to let a bunch of austerians and gold cranks ruin his Presidency?

    Here’s a scenario – Romney looks at all the options, and checks the data and sees the market monetarists are right. When NDGP stays on a stable path, good things happens. When it goes off, bad things happen – and don’t get better until you return to previous levels. He sells it to the right as an inflation fighting measure, and to the left as rising incomes.

  22. Gravatar of ssumner ssumner
    2. June 2012 at 11:28

    Evan, Thanks for the links. A few comments about Bernanke/Woodford

    1. You are right that control is imperfect, and hence the circularity problem is overrated. But it is a problem, under current procedures.

    2. They made a mistake in applying the circularity problem to Dowd (1994). It does apply to my 1995 paper, but not to my 1989 version. Basically you overcome the circularity problem by having the market forecast the instrument setting that hits the target, rather than directly forecast the NGDP itself. Thus markets forecast what monetary base setting is mostly likely to lead to 5% NGDP growth. Of course we don’t have that system in place, but that’s what I proposed in 1989, and Dowd in 1994.

    Morgan, Romney’s right that QE3 won’t help much.

    Unlearningecon. Full employment plays no role in any of my analysis. None. It has nothing to do with the Sumner critique, which applies at any level of unemployment.

    Mark, There’s no relationsip at all. Keynes is just saying that classical econ applies when you are on the LRAS. That’s obvious. I’m saying it applies when you are off the LRAS, but the Fed is targeting some sort of nominal aggregate.

    Stasguy, That fall in inflation expectations is mostly oil, NGDP expectations have changed far less.

    Johnleemk, Absolutely not–read my reply to Mark.

    Bonnie, Good point, they’d fail even worse if they don’t do QE3

    Peter, Wouldn’t that create panic, as it would make it obvious Greece will leave the euro. People would hoard euro currency and the banks would collapse.

    Statsguy. Bernanke can’t communicate clearly because he doesn’t know what the FOMC will do.

    Negation, Romney is definitely sane, the question is how will he govern?

  23. Gravatar of Wadolowski Wadolowski
    2. June 2012 at 13:47

    About Roomney. Let’s not forget what his main economic advisor once has written 😉 😉

    http://www.nber.org/papers/w4439

  24. Gravatar of Negation of Ideology Negation of Ideology
    2. June 2012 at 16:30

    Wadolowski – That’s encouraging.

    Scott – I read somewhere that Romney learned in one of his early campaigns not to get too specific because it give opponents something to attack. It is a little troubling to me when a candidate says “Vote for me, and you’ll find out what I’m going to do after I’m in office.” But then again, maybe it’s working, because I’m starting to think he’ll go to market monetarism or some form of it. If he came out in favor of it now, I suspect Obama would hammer him for threatening “Fed independence”. Of course, I see no evidence that Obama is interested in monetary policy at all, and I put the odds of us going to market monetarism in an second term at barely higher than zero.

  25. Gravatar of Morgan Warstler Morgan Warstler
    4. June 2012 at 09:40

    “He sells it to the right as an inflation fighting measure”

    That’s nothing

    He’s going to sell it as, “it shrinks govt.”

  26. Gravatar of Brad DeLong Brad DeLong
    4. June 2012 at 10:32

    RE: John Leemk: “It’s incredibly frustrating. The political and policy world falls into two camps: Those who believe no stimulus is necessary, everything is supply-side Those who believe stimulus is necessary but only fiscal stimulus can or should supply it. It’s like people completely forgot the existence of Milton Friedman, and decided to revert to the stupidest possible version of New Keynesianism, where interest rates are the only lever of monetary policy and the printing press is something that only functions when rates are above zero. I feel like to both the centre left and the right, Milton Friedman is too heretical now “” too right-wing for the left obviously and too left-wing for the right. Consequently, everything about monetarism has been stripped out of the public consciousness and we are left with vulgar Keynesianism and vulgar Austrianism. We truly live in a Dark Age of economics.”

    I must say that I don’t know whether you live in a totally different universe from the rest of us, or are simply insane. The center-left extends from people like Jan Hatzius who think that massive quantitative easing–taking the Federal Reserve balance sheet to $5 trillion, or higher if necessary–would almost surely work and we don’t need fiscal policy to people like Paul Krugman who think that massive quantitative easing is unlikely to work, but is nevertheless worth trying.

    I know of nobody on the center-left who is opposed to it…

    Brad DeLong

  27. Gravatar of Saturos Saturos
    4. June 2012 at 10:50

    Brad deLong

    I can name one very important center left person who, if not opposed, is at least patently unaware of the potential and the irresponsibility of the Fed (in his famous words, “shot it’s wad”).

    That person is Barack Obama.

    As Scott never tires of pointing out, 6 0f 7 current members were appointed by him. And he foresook too many opportunities to fill vacancies and get better action.

  28. Gravatar of All linky, no thinky « Blunt Object All linky, no thinky « Blunt Object
    4. June 2012 at 11:53

    […] Tyler Cowen points us to a comment by JohnLeemk that puts into (good) words my mounting frustration with internet econo-commentary: It’s […]

  29. Gravatar of TheMoneyIllusion » Where did Obama get the crazy idea that fiscal stimulus was the only option? TheMoneyIllusion » Where did Obama get the crazy idea that fiscal stimulus was the only option?
    5. June 2012 at 04:43

    […] recently took issue with Johnleemk in the comment section of one of my old posts (a comment replayed by Tyler Cowen.)  Here’s […]

  30. Gravatar of J Mann J Mann
    5. June 2012 at 05:14

    Remarkable — a rare opportunity to respond to Brad DeLong in comments without being deleted.

    Prof DeLong, I think you can imagine why the market monetarists are frustrated with the Krugman left. I think you characterize Krugman accurately, which is basically that in 2008, he supported fiscal stimulus and opined that monetary stimulus was unlikely to work. In 2010, with further fiscal stimulus off the table politically, Krugman now thinks that monetary stimulus is still unlikely to work but is worth trying.

    Assuming that John Leemk is frustrated that no one took monetary stimulus seriously in 08, and that the best you can get from Krugman today is “what the hell, it can’t make things much worse,” then I don’t think insanity is required.

    Thanks.

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