Markets are market monetarists
Stock and Watson have a new paper that provides support for the market monetarist view of the recession:
First, a combination of visual inspection and formal tests using a DFM estimated through 2007Q3 suggest that the same six factors which explained previous postwar recessions also explain the 2007Q4 recession: no new “financial crisis” factor is needed. Moreover, the response of macro variables to these “old” factors is, for most series, the same as it was in earlier recessions. Within the context of our model, the recession was associated with exceptionally large movements in these “old” factors, to which the economy responded predictably given historical experience.
This is what we’ve been saying all along. The massive decline in NGDP after mid-2008 was by far the worst demand-side shock since the 1930s. A severe recession would have occurred after such a shock even if there had been no financial crisis at all. They don’t attribute all of the decline to monetary policy, but that’s probably because of the way they identify monetary policy: the fed funds rate. In 2003 Ben Bernanke pointed out that the fed funds rate is not a reliable indicator of monetary policy, and suggested that aggregates such as NGDP and inflation are “the only” reliable indicators. If you average those two indicators, then 2008-09 was the tightest money since the Great Depression. Had Stock and Watson used that indicator, they would have blamed the Fed for almost all of the Great Recession.
Stock and Watson correctly noted that the slow recovery in RGDP is partly due to a slowdown in labor force growth. However that doesn’t explain the sharp rise in unemployment, which is the distinctive feature of the recovery. In addition, it doesn’t really explain the slow growth in NGDP, another factor in the slow recovery. But they are right that if the labor force was still growing at the peak rates of the 1960s to 1990s period, then the recovery would have been better in RGDP terms (although not in terms of the unemployment rate.)
Here’s Tyler Cowen:
The paper itself can be found here (pdf). By the way, for market monetarists, equity markets seem to agree. Stock and Watson, of course, are two of the most technically accomplished macroeconometricians. This is further evidence “” perhaps the most thorough empirical paper on the topic to date “” that the Great Recession has been about the interaction of cyclical and structural forces.
The second sentence had me a little confused. Tyler had just quoted some material from Stock and Watson pointing to the structural factors in the slow recovery. This is certainly consistent with market monetarism, as we do not think monetary stimulus can magically increase the trend rate of labor force growth. But it has no bearing on the slow recovery in the unemployment rate. In addition, I don’t see the link in the second sentence as providing any meaningful evidence that equity markets agree with Stock and Watson (although I’d guess they do, as Stock and Watson are probably right about the slower trend growth rate.)
Tyler’s link is to a Sober Look post, which shows that current P/E ratios are currently below the 10 year average.
The equity markets are pricing in a significantly slower growth for most of the world than we’ve experienced in the past decade.
A few observations:
1. What is actually being forecast is future expected profit growth, which has been only loosely correlated with economic growth during recent years.
2. FWIW, experts on stock prices such as Robert Shiller argue that stocks are hugely overvalued. I don’t agree, but I find it odd that the experts can’t agree on whether stocks are hugely undervalued or overvalued on a P/E basis
3. The US has experienced roughly 3% trend RGDP growth for more than a century, and wildly volatile P/E ratios. This makes me wonder whether P/E ratios are a useful predictor of changes in trend RGDP growth. I.e., all the previous wild swings in P/E ratios have failed to predict any sustained and significant shift in trend RGDP growth.
4. Having said all of that, I do buy Tyler’s conclusion, but don’t see the connection to market monetarism.
Part 2: Why wasn’t the recession far worse?
I recall that in the past Tyler has argued the recession was about 1/3 nominal shock and 2/3 real shocks (or perhaps monetary/structural, I don’t recall the exact terminology.) It seems like he sees the Stock and Watson paper as providing at least some support for this view. I don’t agree.
Let’s suppose Tyler was right, and that the recession was 2/3 real. In that case the unemployment rate would have risen by about 2/3 as much as it did, even in the absence of any nominal shock at all. Thus if the Fed had kept NGDP from growing at 5% throughout this period, we still would have had a pretty severe recession. At this point some real shock proponents will rebel, insisting that NGDP fell partly as a result of the real shock. That may be true, but it’s beside the point. We are interested in the independent effect of each shock.
Consider a medical analogy. Suppose someone with lung cancer gets pneumonia, and then dies of pneumonia. How could we separate the impact of pneumonia and lung cancer, as cancer often triggers pneumonia? The best way would be to treat a group of lung cancer patients with an antibiotic that prevents pneumonia. If (as I suspect) they would have eventually died of lung cancer in any case, then it’s reasonable to see the lung cancer as the more important factor in the cause of death.
If I’m right that NGDPLT can prevent serious declines in NGDP, then the key counterfactual for the structuralists is to come up with a plausible estimate of how bad the recession would have been with the real estate bust/banking crisis, but without the fall in NGDP. In my view we might not have had any recession at all, or at worst a very mild recession.
Here’s the problem with the structural argument. If 2/3 of the recession was due to real factors, then monetary factors would have caused at worst a very small increase in unemployment, maybe 1.7% points of the roughly 5 percentage point increase. That would be milder that any post-WWII recession. But we know for a fact that the nominal shock was by far the worst since the 1930s. So if we are to take seriously the structural view, we’d have a bizarre situation where a massive negative nominal shock, which by itself should have caused a severe recession, miraculously failed to produce any sort of big increase in unemployment. How did we get so lucky?
Remember, it doesn’t matter why NGDP crashes; falling AD will always reduce short term growth. If it crashes because Mexican drug lords hoard lots of Federal Reserve notes, and the Fed doesn’t increase the monetary base to accommodate that demand, then we get a severe recession. Note that there is no direct real effect of drug lords on our GDP, just the indirect effect of tightening monetary policy. A financial crisis is both a monetary and a real shock. It disrupts credit allocation, hurting credit-intensive industries, and it indirectly causes the Fed to lose control of NGDP (due to their foolish interest rate targeting approach.) Both hurt the economy, but the part of the damage due to lower NGDP is not miraculously less bad just because there are real problems too.
If you are stabbed with a knife soaked in pneumonia bacteria, the direct damage from the knife itself isn’t mitigated by the bacteria on the blade. Suppose the knife wound was of the sort that would normally kill someone. Would we need to even consider the effects of the pneumonia germs in the post mortem? The NGDP shock was a knife wound to the US economy severe enough, all by itself, to cause the current recession. A priori, I’d expect the banking crisis to have made things even worse, but I see almost no evidence that it did. If it did reduce RGDP, why wasn’t the recession far worse? The NGDP decline already explains the severity.
But it’s even worse for the structuralists, far worse. The banking crisis itself was roughly two thirds caused by the fall in NGDP expectations. So if there’s no nominal shock, then the real shock is also much smaller. Thus whatever small part of the recession is real, is itself 2/3rds caused by the fall in NGDP. That makes the real part of the recession extremely small.
The Sober Look post provided one data point for the US recession (of dubious relevance.) Fortunately, there many other stock market data points in support of market monetarism. As David Glasner and others have discovered, the stock market “rooted” for more inflation after 2008, but much less so before 2008. Another study found they rooted against higher inflation during the Great Inflation. All these market responses are consistent with the argument that stocks do best with steady 5% NGDP growth. And recently stocks have responded strongly to even small hints of modest monetary easing, which refutes those who argue monetary policy is ineffective in a liquidity trap.
The stock market hates the RBC model, and it’s equally contemptuous of the post-Keynesians who say the Fed is out of ammo. It’s not surprising that the markets are market monetarist, as my views of macro were largely developed by watching how markets responded to the massive and hence easily identifiable monetary shocks of the interwar period. That’s why I never lose any sleep at night worrying about whether market monetarism will ever be discredited; I know the stock market agrees with me.
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23. March 2012 at 17:02
Of course markets are “market monetarist”: they care about income expectations.
23. March 2012 at 18:22
“If I’m right that NGDPLT can prevent serious declines in NGDP, then the key counterfactual for the structuralists is to come up with a plausible estimate of how bad the recession would have been with the real estate bust/banking crisis, but without the fall in NGDP.”
Pshhaw
If you are right that NGDPLT can prevent serious declines in NGDP, it is BECAUSE first and foremost NGDPLT kept the the Internet Boom, and then kept the Housing Boom from happening.
If the Fed is to be credible, it has been earning that credibility pissing on booms.
YOU YOURSELF go out of your way to remove Fed control (futures market, pc, etc) precisely because you know that follow-through credibility is lacking for a reason.
And as I keep saying, the hard part is not printing money in a crisis….
The hard part is running NGDPLT for the first few years when public employees are being gutted, and drill baby drill is the law of the land.
And that’s what’s required with NGDPLT, a “brutal” enforced cap on growth + inflation that make it perfectly obvious to everyone when non private productivity gains are being called “growth”
Under NGDPLT “fake” growth knowable and is HATED.
You live through that, and everyone will allow the Fed to act aggressively in crisis.
23. March 2012 at 18:37
Scott
Great post.Both David Glasner and George Selgin criticized Bernanke´s first Lecture. I took a stab at the second. Even, as you remind everyone, he talks about NGDP as reflecting the stance of MP, in his second Lecture he never mentions the role of MP, just the conventional “causal” route from house prices to the financial crisis to the Great Recession!
http://thefaintofheart.wordpress.com/2012/03/23/bernanke-gets-it-conveniently-wrong/
23. March 2012 at 18:39
Still not a shred of evidence that it’s possible to divorce capital market dynamics from NGDP. Monetarist malarkey basically boils down to, ‘the patient didn’t die of malaria, it was the fever! QED’
Speaking of which, I think I’ve discovered the monetarist approach to argument. Pick a tautology, any tautology, and argue that it’s existence proves that we should lower marginal tax rates and deregulate everything. QED.
Of course no one could consider the possibility that financial crises themselves are the common thread running through the experience of recessions in capitalist economies with modern financial systems. You don’t want to let that camel’s nose under the tent. Who knows where it could lead!
Course Hyman Minsky, whose ideas by contrast with those of the monetarists haven’t been discredited, convincingly lays out the argument there. But as he’s actually been able to foresee events, he can safely ignored.
23. March 2012 at 18:49
“we caused the recession by not regulating banks then throttling the economy.”
heh, i should live so long to hear the chairman say that.
23. March 2012 at 20:08
OT (sort of) but fun read:
http://www.bis.org/review/r110726b.pdf
This is a governor of the BoJ. He blahs-blahs a lot about structural reforms, but towards the end he indicates the BoJ is going to QE and targeting higher inflation rates.
Not yet Market Monetarism, but getting closer.
Also, does this mean Japan, ECB and Fed are all have tepid growth agendas? Too tepid?
23. March 2012 at 20:19
Excellent post btw.
I liked the part about Mexican drug lords.
I often ask my economically inclined right-wing friends, “Would you mind if overseas drug lords suddenly repatriated the $800 billion in cash offshore?”
No one thinks that would be immoral.
But printing up $800 billion and getting our economy rolling again is immoral.
I consider “moral” the monetary policy that results in higher long-term growth.
23. March 2012 at 20:29
OT again but fun:
http://www.esri.go.jp/jp/workshop/040622/040622mishkin1.pdf
Fredric Mishkin is another who went to Japan, and told them to go to QE hot and heavy and print way more more money.
That makes Friedman, Meltzer, Taylor, Bernanke and Mishkin.
23. March 2012 at 21:56
Majorajam,
“Pick a tautology, any tautology, and argue that it’s existence proves that we should lower marginal tax rates and deregulate everything. QED.”
Deploying strawmen is a very ineffective form of argument when the people caricatured are the people you’re trying to persuade. Put another way, if you’re only willing to argue against the weakest possible interpretation of your opponent’s position, then you can only hope to produce some of the weakest possible arguments.
On the other hand, as a means of venting steam, it’s quite effective. Also-
“Of course no one could consider the possibility that financial crises themselves are the common thread running through the experience of recessions in capitalist economies with modern financial systems.”
No. They’re A common thread, but not THE common thread.
23. March 2012 at 23:04
Scott:
So VAR studies are suspect, except when they support your views?
🙂
Stock and Watson use 198 variables, six “big” shocks (oil prices, monetary policy, productivity, credit spreads, uncertainty, and fiscal policy), and 16 smaller shocks…it’ll take some time for me to wrap my head around this paper.
Interestingly they find that monetary policy shocks contributed negatively to growth; i.e. that on net, during the recession, the Fed was not “leaning against the wind.” That basically matches the MM story.
24. March 2012 at 02:48
“If it crashes because Mexican drug lords hoard lots of Federal Reserve notes, and the Fed doesn’t increase the monetary base to accommodate that demand, then we get a severe recession. Note that there is no direct real effect of drug lords on our GDP, just the indirect effect of tightening monetary policy. ”
Sorry to go off topic here, but why is a drug lord hoarding money contractionary while Apple hoarding money isn’t? If we assume that Apple places its reserves in short term govt bonds yielding 0.25%, they are in effect doing the same thing as the drug lords, monetary policy wise: They park their profits in a piece of paper that has the signature of the US treasury and pays no interest rate.
24. March 2012 at 03:25
In the seventies, stock markets wanted 5% nominal GDP growth?
Rate or path?
They wouldn’t have been equally happy with 6% or 4%?
24. March 2012 at 05:20
Lorenzo, I agree.
Morgan. A target is a target, people ought to be able to understand plain English.
Marcus, Thanks, I’ll take a look.
Majorajam, You said;
“Of course no one could consider the possibility that financial crises themselves are the common thread running through the experience of recessions in capitalist economies with modern financial systems. You don’t want to let that camel’s nose under the tent. Who knows where it could lead!”
Hmmm, let’s see. America’s had about 12 recessions since WWII, and one has involved a financial crisis. Yeah, I’d say that’s a “common thread.”
Benjamin, I heard from a insider in Japan that the government threatened the BOJ, and is basically forcing them to inflate.
And thanks for the Mishkin link.
Integral, Good point, but note that my previous criticism of VAR studies generally involved the identification problem with monetary policy. And I made that criticism here as well. So I’m not totally hypocritical. 🙂
Orionorbit. You asked:
“Sorry to go off topic here, but why is a drug lord hoarding money contractionary while Apple hoarding money isn’t?”
Good question. Drug dealers hoard base money (the medium of account and the stuff the Fed actually produces.) Apple saves by buying financial assets. There may be a tiny indirect affect if Apple depresses market interest rates enough to cause other people to want to hard more base money.
And I’m not objecting to drug dealers hoarding cash, as in the real world the Fed easily and profitably offsets that action.
Bill, I should have said markets wanted less than the 11% actual growth rate of 1972-1981. Obviously it wasn’t exactly 5%, but the point is it was consistent with market monetarism.
24. March 2012 at 06:05
The “common thread”:
http://www.frbsf.org/publications/economics/papers/2011/wp11-27bk.pdf
24. March 2012 at 07:13
[…] not sure I agree with him that monetary policy is entirely useless at the zero lower bound – NGDP targeting? His continued critique of Paul Krugman and Ben Bernanke also comes off as a little childish […]
24. March 2012 at 11:38
relevant factoids supplied from a post-keynesian point of view:
– its a stock market rallying on declining volume, so its not the market as a whole that supports you but an increasingly small number of “fanatics” with the ability to bid up stocks on the basis of credit.
– the endogenous money theory of the post-keynesians you mention would hold that when your NGDP level targeting suggestions are implemented, real interest rates go below zero and give leveraged buyers the ability to bid asset prices to infinity without creating a drawdown on savings (after all, endogenous money theory holds that loans create deposits); in other words the negative real rates are perpetuated. Is a rising market a bullish sign in this context?
24. March 2012 at 12:28
Emperor, clothes Scott. So if Paulson bails out Lehman than no financial crisis at all since WWII? I don’t know Scott, somehow that strikes me as less than robust. Might be something to do with the exponentially increasing size of the bailouts required to keep our financial crisis-less Swiss watch of an economy humming.
Could also be related to the fact that 30 year mortgage rates north of 4% can now be counted on to crush home sales. Or it could have something to do with the financial sector’s coming to represent, whatever it was at it’s zenith, 40% of corporate profits, not including the massive financial operations of non-financial companies, amongst other maladjustments.
While you’re working on definition disclosures in the interest of the discourse, I trust those many questions I have about how the central bank can control NGDP in a systemic meltdown are likewise in the works.
24. March 2012 at 12:45
Scott – If S&W are correct that about half of the weak employment recovery since the 09′ cyclical trough is attributable to structural forces, would we not expect to see that show up in a looser linkage between NGDP and RGDP? In fact, the linkage has been tighter than its historical average. That fact alone decimates the argument that the weak recovery has been largely structural. So does the fact that inflation tied to domestic output has been low (both the NGDP price deflator and average hourly wage rates). The data seems to show something quite different than S&W’s mathematical modeling.
25. March 2012 at 08:47
David Pearson, You linked to a paper whose first sentence is:
“All major landmark events in modern macroeconomic history have been associated with a fi nancial crisis.”
Only one post-WWII US recession has been accompanied by a financial crisis. So I guess recessions aren’t “landmark events.”
Fair enough. But I’m talking about recessions, so this paper has no bearing on my argument.
Rademaker, Asset prices go to infinity while NGDP grows at 5%? How does that happen? Who can afford to pay “infinity” for an assets?
Majorajam, I have no idea what you are driving at, trying speaking in plain English for a change. You said:
“So if Paulson bails out Lehman than no financial crisis at all since WWII?”
Who made that claim? Not I.
Nor do I favor bailouts.
Tommy Good point, but the other side would argue that inflation should have fallen even faster. I’m no expert in this area, but certainly the P/Y split seems fairly conventional, as you say.
25. March 2012 at 17:27
Dumb question: What do the market monetarists say caused the NGDP shock? Is it correct to say there must have been an increase in the demand for money that was not accommodated by the Fed? Why was there a sudden increase in the demand for money?
25. March 2012 at 17:50
Jim:
<i.Dumb question: What do the market monetarists say caused the NGDP shock? Is it correct to say there must have been an increase in the demand for money that was not accommodated by the Fed? Why was there a sudden increase in the demand for money?
This is the question that market monetarists avoid like the black plague, because it invariably and eventually leads to them having to reject their own worldview.
25. March 2012 at 19:16
Scott, your riposte to me was predicated entirely upon what I have no doubt is an absurd definition of the term ‘financial crisis’. So I was inviting you to further expose monetarism for what it is by spelling out that definition. Clear enough for you now? Capiche? Catalavenes?
I’m sorry you can’t understand my comments. Unfortunately for you, I understand yours very well.
25. March 2012 at 19:18
PS I know you ‘do not favor bailouts’ That is but the most delicious part of the fervor with which you advocate bailouts.