My views on money/macro

Update:  Here’s my EconTalk with Russ Roberts, where I describe my views on macro.

A few weeks back someone suggested that I describe how my views differ from the mainstream.  A few days ago I did a post describing what I thought was wrong with the standard models of monetary economics.  I ended up with a call for a new paradigm and left the impression that I’m about to provide it.  One commenter said my last paragraph was “remarkably ambitious,” which is a polite way I suggesting it’s crazy for a Bentley professor to be talking about new paradigms.  And he’s right.  So I’ll just list some of the areas where my views differ from others, provide lots of links, and then let others decide whether there is anything coherent in my approach.

1.  How I think about the stance of monetary policy:

I use three ingredients here.  One is Svensson’s notion that monetary policy should target the forecast.  Policy should be set in such a way as to equate the forecast of NGDP or inflation, with the target.  The second ingredient is Michael Woodford’s argument that AD is not so much influenced by the current setting of monetary policy, as by changes in the entire expected future path of policy.  (This post applies the idea to the Great Depression.)  Monetary policy actions that are expected to be temporary have almost no impact on AD.  And the third ingredient is Robert King’s insight that in a forward-looking IS-LM model an expansionary monetary policy can increase inflation and growth expectations so much that both nominal and real interest rates actually move “perversely.”  This means tight money can cause lower nominal and real rates and easy money can cause higher nominal and real rates.  And this is not just a theoretical curiosity; this postdiscusses evidence that a contractionary surprise in December 2007 actually caused 3 month T-bill yields to decline.

Now let’s put the ingredients together.  Woodford argues that in a liquidity trap you need to promise to hold rates low for a long time.  The problem with that recommendation is it confuses low rates with easy money.  Woodford is right that in a liquidity trap you need to promise easy money for an extended period of time.  But as we saw in Japan low nominal rates may merely reflect weak NGDP growth expectations, not an easy money policy.  Milton Friedman pointed out in 1997 that near zero interest rates are more likely to reflect tight money rather than easy money.  So although Woodford is right to recommend a credible and sustained policy of monetary ease in a liquidity trap, low interest rates aren’t the way to implement that policy.  (In fact, the tightest monetary policy imaginable would actually produce zero interest rates forever.)  Instead, we need a credible policy of targeting the future path of the price level or NGDP.  Later I’ll explain why level targeting is appropriate.

There are several ways to recognize the stance of monetary policy, but the best way is to try to infer the market expectation of the future path of the goal variable, and compare it to the policy goal.  Svensson recommended using the central bank’s internal forecast to avoid the circularity problem, but I prefer the market forecast.  Thus policy is “tight” if next year’s expected NGDP is 14.6 trillion, while the target is $15 trillion. 

Now let’s think about how this approach to monetary policy forces us to rethink some of our basic concepts.  The textbooks have traditionally taught demand management by considering fiscal and monetary stimulus.  Under a futures targeting approach that no longer makes any sense.  Monetary policy is set at the level expected to produce on-target growth in NGDP, leaving fiscal policy with no role to play. 

Under this sort of approach many of the metaphors that we traditionally employ would become wildly inappropriate.  For instance, how much of the “heavy lifting” should we leave to the Fed?  This metaphor suggests that monetary stimulus requires more effort that not doing monetary stimulus.  In fact, exactly the opposite is true.  The more monetary stimulus we do, the smaller the national debt, and hence the smaller the burden on the next generation of taxpayers.  In addition, under a fiat money regime we can create more money at almost zero cost.  Even better, we earn seignorage from money creation, so the less “effective” is monetary stimulus, the more we should want to do it.  Of course I am being a bit simplistic here.  The more serious argument is that a bloated monetary base and near-zero interest rates are the result of falling NGDP, not on-target NGDP.  When NGDP is on-target, interest rates and demand for base money return to more normal levels.  Thus a truly effective policy of monetary stimulus would not look anything like what Woodford suggests—it would quickly raise nominal interest rates above liquidity trap levels, and also reduce the bloated demand for excess reserves. 

The right metaphor isn’t “heavy lifting,” it’s turning the steering wheel to the proper setting.  When piloting a ship it’s no harder to turn a steering wheel to ENE, then to set it at NNE.  We need to stop thinking about how much burden we should put on the Fed, and simply think in terms of what an optimal monetary policy setting would look like.

Here is one of the great ironies of our current predicament.  A central bank that truly had a credible “we’ll do whatever it takes” attitude would never have to do very much at all; but a timid central banks that is hamstrung by inflation hawks will have to engage in endless seemingly reckless policies such as zero rates, extreme QE, bailing out banks.  Australia had the world’s best monetary policy during the recent crisis.  They haven’t had a recession since 1991.  They keep their NGDP growing.  And yet by conventional standards they look like one of the most “conservative” central banks.  They never cut their interest rates to zero, and they were first out of the box raising them in the recovery.  That’s what effective central banking looks like.  (Of course those who follow central banking know that the Bank of Australia is actually one of the least conservative of the major central banks.)

You may find this analogy completely off the wall, but it reminds me of self-confidence.  The self-confident person can have lots of fun at a party without trying very hard.  The shy guy is working really hard, but just spinning his wheels.  If he were to do the right thing—go to the party with an “I don’t give a s*** what other people think of me” attitude, other people would find him more interesting and he’d have a much better time.  And it wouldn’t really require more effort, it would require less.  It just seems like it’d take more effort, before you take the plunge.  Australia is like the self-confident guy.  The Fed, ECB and BOJ are the nerds. 

[As an aside, this whole post might make more sense if you first read Alice in Wonderland or Through the Looking Glass.]

Recently I’ve become more interested in the way Bill Woolsey frames the issue; rather than using the “targeting” metaphor he uses the gold standard metaphor.  Index futures convertibility.  The reason I like this is because it helps us better understand what is going on with the money supply and interest rates.  You make a NGDP futures contract into the medium of account, and make currency redeemable into that asset at a fixed price.  Now both interest rates and the money supply become endogenous, just as under a gold standard.  But whereas under a gold standard NGDP can move all over the place despite a fixed nominal price of gold, the ability of current NGDP to fluctuate with a fixed 12-month future expected NGDP is constrained by a complex set of macroeconomic forces.  I’ll talk about those in the next section, but for now just think about how interest rates would behave in a world where expected NGDP was always on target.  Expected future NGDP is the most powerful force affecting nominal interest rates; both the inflation component and the real component.  Under NGDP targeting both the money supply and nominal interest rates would probably be far more stable than under current policy.

2.  Recognizing the nature of the macro problem

I use a fairly mainstream AS/AD model when thinking about macro problems.  I also find it convenient to define ‘aggregate demand’ as simply aggregate nominal expenditure (which makes the AD curve a hyperbola.)  As with many other economists, I believe that dramatic cyclical movements in RGDP are often caused by AD shocks, as NGDP and RGDP tend to move in the same direction in the short run.  Over longer periods of time AD has almost no effect on RGDP, only prices are affected.  None of this is particularly controversial. 

I think that one thing that separates me from other macroeconomists is that I see short run changes in NGDP as being powerfully impacted by changes in future expected NGDP.  Thus if the expected level of NGDP one, two and three years out falls sharply, then current NGDP will tend to fall sharply.  But the reverse is also true.  If future NGDP stays on target, then it is very difficult to envision how near term NGDP could fall sharply.  Most people I talk to disagree with me on this.  They say that once the post-Lehman financial crisis hit it was too late to prevent the severe fall in NGDP over the next 6 months.  Money affects the economy with a long lag.   I disagree.  I think near term NGDP can be propped up by a credible policy to make up for any deviations from the target path within a year or two.    I don’t think people have clearly thought about the implications of their views, as we are so used to declines in current NGDP being associated with concurrent declines in expected future NGDP that we don’t think through what this actually means.  (Perhaps someone familiar with the “unit root” literature could provide some evidence that has a bearing (either way) on my argument.) 

 As an analogy (and I know it’s not perfect) once the US stopped pegging the price of gold in April 1968, both the nominal and real price of gold became far more volatile, indeed several orders of magnitude more volatile.  If we went back to pegging the price of gold (which I don’t recommend) both the nominal and real price of gold would become much more stable.  When you target NGDP along a given trajectory, both real and NGDP will become more stable.  In addition, all sorts of asset prices will also be much more stable.  Why?  Because changes in NGDP have a dramatic impact on asset prices, as we’ve recently seen.  And since asset markets are forward-looking, the mere expectation that NGDP will return to target in a year or two means that (due to intertemporal arbitrage) asset prices will never stray far from a level consistent with on-target NGDP.  Put simply, the DOW never would have crashed into the 6000s if it was understood that NGDP was going to return to its target growth trajectory in 2010.  The market crashed because investors saw (correctly) that the Fed has no plans to offset the negative nominal shock.  Indeed we continue to fall further and further behind; although thankfully things are getting worse at a slower rate than was expected last March, so the DOW has bounced part way back to 14,000.

Why would it help to have more stable asset prices?  Here’s another area where I differ from my colleagues.  Imagine a forward-looking model like Woodford’s, but make it monetarist.  Unlike traditional monetarism, we use Woodford’s emphasis on changes in the expected future path of monetary policy.  As with monetarism, I assume an excess cash balance transmission mechanism, but only in the long run.  This means an expansion in the money supply that is expected to be permanent will cause future expected NGDP to rise via the excess cash balance effect.  This will immediately increase the prices of assets like stocks, commodities and real estate.  And this will increase current AD.  Because wages are sticky, the higher prices of these assets will boost output of corporate assets, commodities and real estate.  And since employment and wealth rise, so does consumption.  So policies that are expected to have a major effect on future NGDP also have a powerful effect on current NGDP, just as in Woodford.  And that brings us to the issue of policy lags.

3.  Policy lags aren’t what they seem.

The standard view of macro is that there are a set of monetary and fiscal policy tools that affect the broader macroeconomy with “long and variable lags.”  The transmission mechanism lies in some sort of “black box” that is poorly understood.  So policy actions go into this mysterious black box, and a year later out pop some macroeconomic outcomes.  And we can use VAR models to estimate the effects of policy.  I don’t buy this view of things, as I think it implicitly assumes that asset markets are inefficient.  Any expected long run effect on inflation should be reflected immediately in TIPS spreads and CPI futures prices.  That’s how we should evaluate policy.

In my research on monetary history I discovered again and again that the policies that economists focused on often had little or no impact on asset prices, even though economic theory suggests that if they were expected to have important macro effects, asset prices should have been strongly impacted.  And we know this because when there is a sudden and unexpected change in prices or output, the effect on the stock market is often very dramatic. 

So I’d like to see us reconstruct macro in a way that eliminates lags.  The basic units of analysis would no longer be inflation and real growth, but rather expected inflation and expected real growth.  No more “depression economics,” it would be replaced with “expected depression economics,” aka bad economic policy economics.  Now analysis could operate in “real time.”  There would be no lags between changes in policy and changes in expected NGDP or inflation.  You might ask “but isn’t it actual growth and actual inflation that we really care about?”  Actually, I’m not the only one who thinks expectations may be more important.  Many new Keynesian-type models emphasize the importance of keeping expected inflation under control, in order to prevent a change in expected inflation that would feed into wages and core inflation.  And I think this view is correct.  Where I differ from my fellow economists is that I think that with the right approach to macro policy, with a policy of targeting the forecast, this is surprisingly easy to do.  Indeed I think it is so easy that if and when we do start targeting the forecast in a serious way, VAR models of policy will almost instantly become just as obsolete as old money demand models from the 1970s.  The market has the only structural model that matters.  It doesn’t matter whether some model at MIT tells us NGDP is likely to rise too fast, it only matters whether bond investors, and commodity markets, and labor unions think inflation will rise, as NGDP growth expectations are only destabilizing to the extent that they effect financial markets, goods markets, and labor markets.  What if an “accident” happens where MIT is right and all the normal people are wrong?  Very little, because if we assume a policy where next period’s NGDP will always be expected to return to target, then any short run deviations won’t cause significant macroeconomic instability—for the simple reason that they won’t have been reflected in wage and debt contracts. 

Sure there are some lags.  The economy is full of sticky wages and prices.  But that just means we need to choose a medium of account which has properties consistent with macro stability, given that price stickiness.  And I think expected NGDP comes closest.  A low and stable expected NGDP growth path will definitely anchor long run inflation expectations; it will also minimize demand-side business cycles and will reduce the impact of supply shocks (when compared to a strict price level target.)  And targeting expected future NGDP will do this far more effectively than a backward-looking regime that responds to past deviations of NGDP from target.

4.  Markets are smarter than great economists (and also lesser ones like me.)

You’ve heard about how if a tree falls in the forest and nobody hears it then it doesn’t really make any sound.  (Perhaps it would be more accurate to say it doesn’t make sound as people think of the term ‘sound’ but it still does make vibrations in the air.)  I’d say the same about major policy errors.  If a catastrophic policy error is alleged to have occurred, and the markets don’t care, then I say it didn’t occur.  Was Greenspan’s decision to lower rate to 1% the root cause of our current crisis?  Who’s to say?  But for all practical purposes the answer is no.  We should not go around acting like a bunch of Sherlock Holmes’s; searching for the secret key to our predicament.  It is right in front of us.  The policy errors occurred when the asset markets crashed.  We don’t have an NGDP futures market, but if you look at CPI futures, as well as indirect measures of real growth expectations such as commodity and stock prices, there can’t be much doubt that NGDP growth expectations plunged precipitously between July and November 2008.  Case closed.  There’s your smoking gun.  No need for an Oliver Stone movie.

Policymakers can’t outsmart markets, and shouldn’t be expected to.  If investors didn’t see a crash coming 5 years down the road, then there is no reason to expect policymakers to have seen the crash.  (And of course they didn’t.)  Experts aren’t superman, although they often claim to be as Einzig suggested in this brilliantly devastating skewering of Cassel from 1937 (a crisis with some interesting similarities to our recent crisis):

 “On June 9, 1937, this veteran monetary expert [Cassel] published a blood-curdling article in the Daily Mail painting in the darkest colours the situation caused by the superabundance of gold and suggesting a cut in the price of gold to half-way between its present price and its old price as the only possible remedy.  He took President Roosevelt sharply to task for having failed to foresee in January 1934 that the devaluation of the dollar by 41 per cent would lead to such a superabundance of gold.  If, however, we look at Professor Cassel’s earlier writings, we find that he himself failed to foresee such developments, even at much later dates.  We read in the July 1936 issue of the Quarterly Review of the Skandinaviska Kreditaktiebolagetthe following remarks by Professor Cassel:  ‘There seems to be a general idea that the recent rise in the output of gold has been on such a scale that we are now on the way towards a period of immense abundance of gold. This view can scarcely be correct.’ . . . Thus the learned Professor expected a mere politician to foresee something in January 1934 which he himself was incapable of foreseeing two and a half years later.  In fact, it is doubtful whether he would have been capable of foreseeing it at all but for the advent of the gold scare, which, rightly or wrongly, made him see things he had not seen before.  It was not the discovery of any new facts, nor even the weight of new scientific argument that converted him and his fellow-economists.  It was the subconscious influence of the panic among gold hoarders, speculators, and other sub-men that suddenly opened the eyes of these supermen. This fact must have contributed in no slight degree towards lowering the prestige of economists and of economic science in the eyes of the lay public.” (1937, pp. 26-27.)

Sound familiar?

So I don’t agree with the way my fellow economists go about their Monday morning quarterbacking.  I look for the market crash, and infer that that is probably where the policy error occurred.  And at least in the Great Depression, I found that it often did occur at that point.  BTW, I don’t mean to suggest that Monday morning quarterbacking is always wrong; Smoot-Hawley did cause a stock market crash in mid-1930, as did the National Industrial Recovery Act in mid-1933.  My point is that it isn’t fair to blame policymakers for mistakes that were invisible to the markets.  Hoover and FDR are certainly fair game.

5.  Expected NGDP growth is more meaningful than expected inflation:

a.  Inflation is an arbitrary concept that has never been clearly defined, or at least defined in a way that relates to how it is actually measured.

b  Where expected inflation is alleged to be important  (i.e. nominal interest rates, nominal wage negotiations, etc.) then expected NGDP growth is more useful than expected inflation.

c.  When there is a sudden nominal shock hitting the economy then the size of the shock is much more accurately proxied by NGDP than by the CPI.

d.  NGDP targeting will provide greater macro stability that inflation targeting.

Some of these issues are discussed here.

6.  Recessions should be unpredictable, if we are doing our jobs.

As James Hamilton once argued:

 “You could argue that if the Fed is doing its job properly, any recession should have been impossible to predict ahead of time.”

Unfortunately, he then went on to talk about how we might better forecast recessions in the future.  To the extent that economists cannot forecast recessions, we should wear that failure like a badge of honor.  Would you want to fly on an airline that could forecast its own fatal accidents?  The search for a recession forecasting formula is like the search for the Holy Grail.  We’ll never find it.  If we could forecast recessions we could (and would) prevent them.  But we will eventually develop formulas that are capable of “retrocasting” past recessions, if that makes anyone feel better.

 7.  I also differ from most economists in the way I interpret the stylized facts of macro history:

a.  In 1929 a policy of tight money among all the big central banks led to expectations of sharply falling NGDP, and this caused the stock market crash.  Stock crashes of equal size that are not associated with falling NGDP expectations (i.e. 1987) don’t result in recessions, much less depressions.

b.  The was no liquidity trap in 1932.  The aggressive open market operations did fail (as Keynes argued.)  So Friedman and Schwartz were wrong about that.  But Keynes was wrong about the reason why.  They failed because of the constraints of the gold standard prevented the OMOs from affecting the expected future path of monetary policy.

c.  In 1933 neither liquidity trap-type conditions nor an almost completely dysfunctional banking system prevented extremely fast NGDP (and RGDP) growth.  FDR did what Krugman says can’t be done now.

d.  In 1933 inflation rose sharply, despite the most “slack” that we’ve ever had in our entire history.  So much for the NAIRU model.  (Finally a point my Austrian readers will like.)

e.  After the BOJ adopted QE, it hit its zero percent CPI target almost perfectly.  Mission accomplished (contrary to what you read in 99% of the discussions of Japan.)  Policy was “effective.”

f.  And of course my claim to (minor) fame, it was tight money that caused NGDP expectations to fall sharply between July through November 2008.  All the other things we observed (discussed here, here and here) were symptoms of that tight money.  That includes the second and much more severe part of the financial crisis, as well as the second half of the housing collapse, as well as the entire collapse in the commercial property market.  Not to mention a severe world-wide recession, high real interest rates, a soaring dollar, and a good portion of the fall in commodity prices.

g.  One area where I do agree with many economists is that I think most recessions are due to demand shortfalls, and hence monetary policy errors.  But even here my views are slightly different.  I think most economists only understand this about earlier recessions, and they continually misdiagnose each new recession as being due to special factors.  When they are “in the moment” they are too mesmerized by the froth on top of the waves, and are missing the powerful currents below the surface that are creating all this turbulence.

8.  Escaping from a liquidity trap.   (Arnold Kling said I needed this section.) 

First adopt the attitude of Peter Pan.  (If I think I can, then I can.) 

Seriously, there are several options, none ideal:

1.  Target the price of NGDP future contracts.  Too radical in today’s policy environment.

2.  FDR’s strategy—currency depreciation.  It worked, but is politically problematic (although it isn’t the beggar-thy-neighbor policy most assume it is.)

3.  Unfortunately we are left with the least attractive option.  First create an explicit NGDP target.  Use level targeting, which means you promise to make up for under- or overshooting.  If excess reserves are a problem, get rid of most of them with a penalty rate.  Commit to doing QE until various asset prices show (in the view of Fed officials) that NGDP is expected to hit the announced target one or two years out.  If necessary buy up all of Planet Earth.  In practice, if you forced banks to disgorge their bloated excess reserves, then the monetary base would probably fall from $1.5 trillion to under $1 trillion, even as NGDP growth expectations rose sharply.  So you’d being doing open market sales.  That’s because banks would hold very few excess reserves if penalized (they’d substitute T-securities) and the public’s demand for cash to put under beds would not be very high if asset prices showed expected NGDP to be at the policy target.

9.  What would macro texts look like if I had my way?

By “my way” I don’t just mean if I wrote the textbooks, I mean if I was monetary dictator of the world.  OK, so let’s say expected future NGDP is pegged along a 3% or 5% growth trajectory with index futures.  What’s left to talk about?  Certainly not fiscal stimulus, or multipliers for investment spending.  (Indeed, even the current multiplier debate is incoherent.)  No more paradox of thrift or liquidity traps.  Banking instability no longer affects the broader economy.  Fiscal policy becomes a long run topic, focused on issues like savings, investment and the current account.  Interest rates would no longer be very interesting, nor would the money supply.  There would be increasing emphasis on supply-side problems.

Notice that with the exception of interest rates my dream scenario pretty well describes what was already beginning to occur in higher level new Keynesian textbooks during the Great Moderation.  So let’s finish the job.

Of course there is that one glaring exception; nominal interest rates continued to be the center of attention during the Great Moderation, and this proved to be the Achilles heel of the whole system.  It turns out that interest rates are about the worst possible “instrument” of policy.   Why?  Because they fail you just when you most need them.  When the economy is in danger of falling into a depression the nominal interest rate will hit zero, and interest rate targeting becomes ineffective.  And so here we are, spinning our wheels while the nominal economy falls far short of policy goals.  Meanwhile our libraries are full of academic papers with various “foolproof” escapes from liquidity traps, all of which sit on the shelf collecting dust:

Currency depreciation in Japan?  The BOJ let the yen soar in value last year.

Inflation or NGDP targets in the US?  The Fed has refused to make any, and instead keeps insisting that their goal is low inflation. 

In Europe they do have an explicit target, but when they undershot it the ECB refused to take any actions to remedy the situation.

If this doesn’t call for a new paradigm, I don’t know what does.



52 Responses to “My views on money/macro”

  1. Gravatar of Thorfinn Thorfinn
    8. November 2009 at 20:14

    Cochrane and Zingales use a similar “when did the market crash” to blame the instability in 2008 to Paulson’s speech rather than Lehman’s collapse:

  2. Gravatar of Doc Merlin Doc Merlin
    8. November 2009 at 21:28

    Hrm, I like a lot about this. I don’t think you can get perfect conversion into an expectation based realm of thinking, just due to the impossibility of making good real measurements. However, I agree that expectations matter a lot more than they are given credit for in current theory.

    Although, I tend to be somewhat more Austrian in my views, we are completely in agreement on this. Expectations matter; expectations decide current behavior. This is something that most current economics misses with its reliance on equilibria and perfect knowledge.

  3. Gravatar of Doc Merlin Doc Merlin
    8. November 2009 at 21:42

    Hrm, that confirms my initial feeling that the crash felt like a panic rather than an actual crash. Maybe the institutions were actually in bad shape, and the panic put them over the edge?

  4. Gravatar of Coray Coray
    8. November 2009 at 22:54

    if the tree doesn’t make a sound, which is the perception of what you’re calling vibrations, then neither does the tree make “vibrations.” vibrations are a scientific model that explains the originating conditions of sound. such a model has no meaning in the absence of a perceiver. that’s the point of the question. otherwise it’s kind of an anodyne question, no?

  5. Gravatar of Graeme Bird Graeme Bird
    8. November 2009 at 23:03

    “which is a polite way I suggesting it’s crazy for a Bentley professor to be talking about new paradigms.”

    What? Chicago aside, nothing worthwhile has comes out of those Ivy League setup for some time. Actually Chicago is nothing like it was either. You know that. Lets us not hear any of this talk again. From here on in the only worthwhile stuff is likely to come out of the fringes.

    The whole point of scientific enquiry is not to be primarily building WITHIN approved paradigms. But to be judging BETWEEN paradigms that are out there. Progress will be measured “one funeral at a time” until this realisation becomes general.

  6. Gravatar of Graeme Bird Graeme Bird
    8. November 2009 at 23:12

    My goodness man. I just read your bio. You were studying at the right University at the right time. Just past the peak of Chicago vibrancy. If YOU aren’t qualified in the FORMAL sense to push forward then almost no-one is. You would have known Friedman, Buchanan, Coase, maybe Hayek. Maybe knocked around with the incredible Tom Sowell.

    “which is a polite way I suggesting it’s crazy for a Bentley professor to be talking about new paradigms.”

    Your country is heading for a breakdown. And misinformation in monetary economics is a big part of this story. Its time to push aside old inhibitions and cast off these shackles. Anybody who has seen the sort of genius of Buchanan and the warrior spirit of Friedman doesn’t need to play second fiddle to this recent coterie of Nobels know-nothings, or anyone else for that matter.

  7. Gravatar of Bill Woolsey Bill Woolsey
    9. November 2009 at 04:25


    Very good presentation.

    While I think that the most likely scenario for zero short term and safe interet rates is expecations of falling and low nominal expenditure, other scenarios are possible. In particular, a large shift in the risk premium. Even if nominal expenditures are expected to remain on target, fear of falling asset prices results in a increase in the demand for short and safe assets.

    Just recently, I was listing to some economist explaining who employment wasn’t increasing even though production was increasing. I think he also mentioned the increase in temporary workers. Anyway, supposedly, firms are waiting to see if the increase in sales last quarter is going to persist before they hire anyone. Interseting….

    At least among Keynesians, consumer expectations drive consumption and aggregate demand. We hear reports about poll results on consumer feelings about the future.

    We all know that real investment expenditure is the most volatile element of expenditure. Surely that is forward looking.

    In my view, the is a supply-side problem now. I know that you suggets that we had already turned the corner on that. Perhaps. While you mention these things in a general way–textbooks will focus on supply side issues. You, like most macro economists focus on demand shocks. But too many free market economists seem unable to see even more explicit mentions that there is or was a simultaneous supply side problem and that the demand side crash was overlayed on top of it.

  8. Gravatar of Bill Woolsey Bill Woolsey
    9. November 2009 at 04:40

    Check out Nick Rowe.

    Interest rate targeting is a disaster waiting to happen, and it just happened.

  9. Gravatar of David Heigham David Heigham
    9. November 2009 at 08:17

    This is going places. Like the Alice books, this post displays a lot of clear perception and uncommon sense.

    A question that may be sneaky: Is targetting the forecast what the Chinese do right?

  10. Gravatar of StatsGuy StatsGuy
    9. November 2009 at 08:55


    Cochrane & Zingale’s timing of the “Panic” phase is entirely self-serving and wrong. They write:

    “The nearby chart shows that the main risk indicators only took off after Treasury Secretary Henry Paulson and Fed Chairman Ben Bernanke’s TARP speeches to Congress on Sept. 23 and 24″”not after the Lehman failure.”


    “On Sept. 25, Washington Mutual, the nation’s sixth-largest bank, was seized by the FDIC. On Sept. 29, Wachovia, the nation’s seventh-largest bank, was sold to avoid a similar fate. All this would have happened without Lehman.”

    The timing is very explicit, ALMOST ALL of the move was on the 25th. (NONE of it was on the 23rd, and financial markets move very fast – are you telling me that NONE of the effect of the TARP announcement was felt on the day it was first announced in specifics, but that ALL of it was felt 2 days later?)


    Quite the contrary, almost all of the movement occurred on the 25th, AND some of this was _anticipated_ on the 24th. Notably, S&P severely downgraded WaMu _bond_ status on the 24th.

    I am fairly familiar with this because I was actively trading WaMu around that time, and made a nice bit of money. But I saved myself a couple month’s salary by _not_ jumping back in when it dived on the 24th. Why did I not jump in? See above.

    The “It’s Paulson and Bernanke’s fault” argument is a convenient excuse to absolve the markets and blame an attempted government intervention for making things worse. Cochrane/Zingales’ implied argument – that the markets were taking everything in good stride until the government blew things out of proportion and created the panic – is full of puckey.

    In truth, the Panic occurred when the markets figured out that WM was going down hard – in other words, that the crisis was NOT limited to investment banks, but was endemic in commercial banks, AND that the Fed/FDIC was going to close them down rather than bail them out. AND, that as part of the close down, bondholders would take a big hit.

    The WaMu shutdown had a LOT more to say about CITI swaps than Lehman, because WaMu was a large commecial bank.

    Immediately thereafter, Libor blew through the roof. Interbanc lending stopped. Short term financing (which is largely supported by money markets to roll over short term debt) collapsed. Astute traders realized the impact this would have on any company dependent on short term debt, and to borrow a phrase at the time “shorted the sh!t” out of every company that had a lot of debt. This created a downward demand shock on an economy dependent on consumer sales going into the Christmas season (right before Black Friday), the media amplified this, the public saw their asset holdings plummet in value (and reacted by contracting demand even faster).

    The credit crisis – and, more importantly, the bank _solvency_ crisis – was very real. Did Paulson make things worse? (Did Treasury/Fed really need the authority beforehand?) I have no idea. My beefs (other than the many structural/regulatory problems that led up to the crisis) have always been the Fed’s failure to use monetary policy to compensate, and (after reading ssumner) the Fed’s tight policies going into late summer (which I believe was an attempt to control carry-trade driven commodity prices). And I believe that huge failure was because the Fed _continued_ to believe in the myth that they were dealing with a liquidity crisis, not a solvency crisis (which quickly turned into a demand crisis). Moreover, the Fed deliberately focused on inflation (even as expectations plummeted) and ignored the role of asset prices.

    So there are lots of legitimate things to argue about, but Cochrane/Zingales’ argument is (at best) very frail.

  11. Gravatar of Thorfinn Thorfinn
    9. November 2009 at 10:33


    Those are fair arguments to make. My only point is that it’s more productive to have an argument along those lines, rather than blaming it on ’70s era policies like bank deregulation or the CRA.

  12. Gravatar of ssumner ssumner
    9. November 2009 at 11:13

    Thorfinn, Not just C&Z, Taylor makes a similar argument. My view partly overlaps. I do believe that it was not Lehman, but rather post-Lehman policy failures that caused the crash. But rather than focus on the details of the banking bailout (which were obviously not significant enough to cause a major crash), I focus on the Fed errors of omission, the fact that the Fed paid no attention to the need for aggressive monetary stimulus at the very moment the world economy was going into free fall.

    Doc Merlin, Yes, we desperately need better measures of expectations. The Fed needs to set up and subsidize trading in a NGDP future market. Then never allow the equilibrium price to stray more than 1% from the policy target. If they do that we’ll be fine.

    Coray, You may be right about the intent. I didn’t know whether they allowed for observers to go into the forest later to look for evidence like nearby squirrels with ear damage. I agree there is no sound at all without observers. Indeed without observers there is no anything at all. A universe without observers is observationally equivalent to an empty universe. Isn’t philosophy easy when you rely on tautologies!

    Graeme, You and I share an interest in overturning the establishment, so I am sympathethic to your comment. Thanks for the support.

    I was also struck by your very perceptive comment about Chicago, saying I was there just past its peak. I always wished I could have gone there a couple years earlier, having many of the same professors plus Friedman, Johnson and a few others (I don’t recall when Hayek, Coase and and Barro were there, but I missed them.)

    Bill, You said;

    “While I think that the most likely scenario for zero short term and safe interet rates is expecations of falling and low nominal expenditure, other scenarios are possible. In particular, a large shift in the risk premium. Even if nominal expenditures are expected to remain on target, fear of falling asset prices results in a increase in the demand for short and safe assets.”

    Good point. On a related note I sometimes think back to 1929-41. During those years T-bill yields were very low, despite fast NGDP growth. I don’t have an answer. One possibility is that the level of NGDP relative to trend also matters. It’s easier to talk about “expected NGDP growth” rather than “growth expected to produce on-target NGDP,” so I sometimes forget that the later term may be more appropriate for the claims I am making about interest rates. I.e., in this recovery interest rates may remain low despite rising NGDP, if the level of NGDP is still too low. And risk is a related factor. Low levels of NGDP makes many alternative assets have higher default risk.

    You said;

    “At least among Keynesians, consumer expectations drive consumption and aggregate demand. We hear reports about poll results on consumer feelings about the future.”

    When I wrote the transmission mechanism section I tried to make it accessable to Keynesians by listing many factors, stock prices, jobs, wealth, etc. But I also had non-Keynesian mechanisms, such as rising commodity prices causing producers to slide up and to the right along their supply curves.

    Regarding supply-side: Before this crisis I was focusing on supply-side. I am much more of a supply-sider than the average economist. By 2007 I thought we had solved demand-side problems (or at least reduced them to tolerable levels.) I was wrong. I do think we have a lot of supply-side problems independent of the demand shock (energy and the environment, health care, etc.) And some supply-side problems partly created by the demand shorfall (banking turmoil, higher real minimum wage rates, etc.)

    Bill#2, Thanks, I commented over there.

    David, I think people over-rate the Chinese success. I am a China booster, but it must be understood in context. Mao made China as poor as India in 1976 (when he died.) Or as poor as central Africa. This is hard for many people to imagine because we view China today as a great power that is rising rapidly. And it is. But much of their growth is just by dropping horrible inefficient policies and moving from a third world country to a second world country. China is still poorer than Mexico.

    On the other hand (there’s always an other hand with China) I do think the government is reasonably competent in macro. But much of China’s success has been on the backs of the farmers they unleashed in the 1980s, and the small entrepreneurial exporters. Countries that go a long time without recessions are usually countries with a high trend rate of growth.

    China does have NGDP fluctuations as well, just from a much higher growth rate. So even in recessions they are still growing. But 10s of millions have lost jobs in this crisis.

    Statsguy, You make some very good points. In my Great Depression manuscript I am very careful about timing issues. If the policy news breaks in the morning, and the NYT says “stocks broke sharply late in the day” I don’t count it, even though 99% of my readers would never check, and never notice the difference.

    In general there was a lot of news in September, and a significant decline in stock prices. In the first 10 days of October there was little news (except monetary errors of omission, and reports of sharply falling AD all over the world) but a huge stock market crash. I think that is the period when markets realized the Fed wasn’t going to come to the rescue this time. Either because they couldn’t (as Krugman argues) or they were not willing to be bold enough (as I argue, but in a sense Krugman also makes this argument sometimes.)

    To use my metaphor from the essay, there are too many economists trying to be amateur Sherlock Holmes’s. I think you might have uncovered evidence that economists are not very good detectives, because they lack Sherlock’s open mind. They have prior beliefs that lead them to look for pro- or anti-market answers.

    BTW, on the other side of the coin, Henderson had an amazing quotation from a Stiglitz paper from 2002 over at Econlog. Everyone should take a look at that quotation and think about it everytime Stigliz says it was not enough regulation that caused the crisis. Yeah I’d say so. Bush was trying to rein in Fannie Mae and he was writing papers saying there’s no need to worry, Fannie Mae has almost no chance of ever defaulting. Of course Bush was doing other things to make the crisis worse. Like Murder on the Orient Express, just about everyone has blood on their hands.

  13. Gravatar of JimP JimP
    9. November 2009 at 13:16

    A paper from the NY Fed footnoting Scott

  14. Gravatar of JimP JimP
    9. November 2009 at 13:53

    Mishkin on price level targets (pp 209)

  15. Gravatar of Doc Merlin Doc Merlin
    9. November 2009 at 14:26

    I don’t think we will be able to fix supply side any time soon, it is too easy for the government to change regulations create supply side shocks through legislation.

  16. Gravatar of ssumner ssumner
    9. November 2009 at 14:43

    Thanks JimP, I have seen the NYFed paper. The Mishkin paper was new to me. I like the fact that he says level targeting is better than rate targeting, especially during deflation. I think this crisis shows the need for an explicit NGDP growth path, and a commitment to catch up if we fall short. And we aren’t getting that yet, although perhaps the weak dollar will help somewhat (at the least the stock market was up today.)

    Doc merlin, I am also pessimistic short term. Long term I am more optimistic

  17. Gravatar of Declan Trott Declan Trott
    9. November 2009 at 16:01

    Great post, and great blog. But as an Aussie I don’t feel like I can vicariously accept the amount of praise you’re showering on us. I think our Reserve has done a good job, but we have had an easy ride for a number of fortuitous reasons:

    1. We were growing really strongly before the crisis hit (thanks partly to China, which has also stayed solid during it). So we had rates peak at 7.25% and cut them to a minimum of 3%. The size of the cut was not much different from the Fed or the ECB, we just started from a higher level.

    2. We have this weird housing market where prices can go nuts but construction stays about the same (people blame this on state and local govt zoning & tax policy). So there is still strong demand for new housing (thanks also to high immigration).

    3. Our banks didn’t get in trouble. Some of this might be good regulation, some might just be the fact that we have a big CA deficit, and our banks were looking for new ways to borrow money not crazy new assets to invest in (since they could earn high interest rates on standard investments).

    I read your earlier post on this too, but I’m not convinced we were doing anything qualitatively better as far as monetary policy was concerned. (We are also having the exact same argument about fiscal stimulus as you are, it just feels a lot less urgent!)

  18. Gravatar of ssumner ssumner
    9. November 2009 at 17:16

    Declan, I partly agree and my comments were half tongue in cheek. I also think you left out one of the most important factors–Australia has a slightly higher trend rate of inflation and a significantly higher trend NGDP growth rate than most other industrial countries–far higher than Japan.
    The higher trend rate of NGDP growth meant Australia had higher nominal interest rates than other developed economies, so they were farther from a liquidity trap. (As you correctly pointed out.) When things slowed down they were able to cut rates without the markets worrying they’d fall into a liqudity trap. In addition, they could devalue, something many small European countries couldn’t do. And they aren’t joined at the hip to the US, as Canada is.

    I mention these factors because even after our real estate bubble burst in mid-2006, we did not have a severe recession. Unemployment only began rising sharply in late 2008 when NGDP fell sharply. So while I agree that real factors like Aussie commodity exports to Asia, and a better housing/banking sector, made the Australian real economy stronger prior to mid-2008, it remains true that commodities were hit hard by the recession, and if Australia had been part of the euro I think it might well have slipped into recession.

    To conclude, I do understand that there was a bit of luck involved. The connection to Asia. High rates of immigration (but contrast Spain, which greatly overbuilt housing.) The higher trend NGDP growth rate (which is normally a flaw, but is an advantage if central banks don’t know how to handle liquidity traps.) Obviously Aussies aren’t that different from anyone else, but at least they’ve shown that the business cycle can be tamed somewhat.

    One of my first posts was on the Puritan ethic or mentality, which makes central bankers think we must suffer for our sins. When I lived in Australia it seemed like the Aussies were less affected by that negative approach toward life.

    It’s kind of weird that it’s so hard to build in Australia–you guys have so much land. Are more conservative states like Queensland more pro-development?

  19. Gravatar of Greg Ransom Greg Ransom
    9. November 2009 at 17:22

    Excellent conversation with Russ Roberts.

    Macro is hard and conversation helps.

  20. Gravatar of Bill Woolsey Bill Woolsey
    9. November 2009 at 18:12

    Did you see Beckworth’s post on Nominal Expenditure targets.

    The paper by Hall and Mankiw he cites is worth a careful review.

  21. Gravatar of johnleemk johnleemk
    9. November 2009 at 18:54

    Declan, “So there is still strong demand for new housing (thanks also to high immigration).” Incidentally, around the time when the present financial crisis broke, someone mooted in jest on Marginal Revolution the idea of the US opening the immigration floodgates to prop up the housing market there.

  22. Gravatar of Bill Woolsey Bill Woolsey
    9. November 2009 at 19:37

    Good interview.

    Very good on sticking to nominal income targeting. You didn’t sound like an inflationist.

    We need to think about this corrupt Fed that intentionally causes a recession to make money at the expense on the long positions of the inflation hawks. (Or the opposite).

    I don’t hink it is a problem. The diabolitical effort to cause a deviation in the opposite direction is going to leave NGDP away from target and result in losses during the next period from speculators seeing this behavoir.

    Roberts ignored that we continue to trade the contracts.

    But, if this is a problem, a requirement that the Fed keep its net position as close to zero as it can would solve it. (You put them all in jail for this manipulation scheme.)

    Anyway, the reason you trade isn’t to make money from the Fed, but rather from speculators who have a different view.

    By the way, free banking with index futures redeemability. That’s the ticket.

  23. Gravatar of rob rob
    9. November 2009 at 20:07

    My problem with a a currency backed by ngdp is it doesnt go far enough. how about a currency backed by units of happiness? how about national happiness futures?

    of course the problem with a currency backed by happiness is that, as nietzsche says: “only an Englishman wants that.”

  24. Gravatar of rob rob
    9. November 2009 at 20:15

    sucks not being able to edit your comments. scott, the 90% of bloggers that would think i was drunk would be right. you are too open minded.

  25. Gravatar of Graeme Bird Graeme Bird
    9. November 2009 at 21:45

    “We need to think about this corrupt Fed that intentionally causes a recession to make money at the expense on the long positions of the inflation hawks. (Or the opposite).”

    The Fed must go. Its an exploitive organisation and its also an example of public private partnership. Which is fascism in economic life. Worse even then retaining some socialism for a small part of the economy. In Australia our central bank needs to go as well. But we are luckier than you Americans in that it is a wholly public bank, though it does do the banking sectors bidding at an institutional level.

    All this talk about central bank independence has missed the mark since the question wasn’t asked “Independent from whom”

    If we were to keep a central bank we would have to work harder keeping it independent of the bankers than of the politicians. But since this is impossible it must be trashed. And since it is unwise to have fractional reserve without a central bank then fractional reserve has to go as well.

    In my country the bankers and the government aren’t yet quite the one entity. Though our banks take two thirds of the direct benefit of new money creation whereas the government only takes one third. Still despite this imbalance suggesting they are the senior partner in the counterfeiting racket, to suggest that the government is in fact the junior partner in crime, doesn’t quite seem realistic in the case of Australia.

    But in your country it is no more a material thing to differentiate banks from government any more than it was under the Medicis. Your Republic is on the way out unless everyone pins their ears back to save it. And its not only Soetoro’s Marxist crew. Since it must be remembered that the insane Paulson, in practice set up a smooth glide-path for Soetoro, and his coterie, when it came to the wholesale raiding of the treasury, and the scuttling of the nation.

  26. Gravatar of rob rob
    9. November 2009 at 22:47

    I listened to the interview and thought it came off very well. The strange thing from my perspective is that you say your point of view is both radical and textbook at the same time. I think I am learning something about monetary policy from this radical textbook point of view, and now talk to my friends about it as if I knew something. So I hope you are not making a fool of me…

    Question I have now is this: so falling AD was the proximate cause of the crisis. My guess is that falling AD was due to the first housing/banking crisis causing more people to want to hold onto money due to insecurity. Is this approximately correct in your view? As a non-economist, I want to be able to explain these things to myself and others in layman terms. So as I understand it, the housing crisis caused more people to want to hold on to money instead of exchanging it for new TV’s etc., and banks to hold on to it instead of trusting businesses to make new investments with it… but if they could have gotten the money they demanded after the initial crisis, they wouldn’t have freaked out and horded everything around Oct 08???? Is this an apt description? Or is this layman still missing something??

  27. Gravatar of rob rob
    9. November 2009 at 23:07

    Also, I am always curious to get your most up-to-date read on the economy. The dollar keeps dropping, equities and commodities rallying. I am less sophisticated at following bonds. What is your take on the status of monetary policy today? My guess is that the demand for money is a lot less now. No? So where is AD now? What sort of scenario is it if TIPS say one thing and commodities another? I understand that commodity prices are volatile and thus shouldn’t be over-weighted — but there seems to be something to the qualitative nature of commodity prices right now. Oil prices,for instance, don’t make much sense in terms of inventory numbers. Most people in the oil patch are forced to give macro explanations for why oil continues so high. Gold… you have mentioned that gold can rise yet be deflationary – but wasn’t that during the years of the gold standard? what does it mean for gold to rise so much now? is it all those commercials on AM radio? is gold simply an Armageddon play? Should we rationally expect Armageddon based upon gold futures?

  28. Gravatar of vimothy vimothy
    10. November 2009 at 03:26

    Great podcast. I have been pestering Russ to try to get him to interview you, so I consider this a job well done!

    I think that you lost him with the futures peg though. Hetzel’s idea of targeting indexed bonds sounds a lot simpler and may be more appropriate for occasions like these. He called it a “scheme”. That’s quite a dismissal from Russ. But then he went on to suggest the gold standard as an alternative, so it’s not clear that he really understood your suggestion.

  29. Gravatar of StatsGuy StatsGuy
    10. November 2009 at 06:34

    Joe Gagnon comments on EconBrowser:

    He ends with: “A good definition of expansionary monetary policy is the printing of money to purchase financial assets. Expansionary fiscal policy is the selling of financial assets to purchase goods and services, to cut taxes, or to increase transfers. On these definitions, both monetary and fiscal policy can be effective when short-term interest rates are zero.”

    And since A/B * B/C = A*C, we get: monetary/fiscal cancelling out, and:

    “A good definition of expansionary … policy is the printing of money … to purchase goods and services, to cut taxes, or to increase transfers.”

    Just one missing piece. Merely creating the _expectation_ is probably sufficient, as long as the authorities _actually mean it_. Merely announcing a credible plan to do the above on sufficient scale would fix any “liquidity trap” insta-frickin-taneously, without any arguments about cash/asset holding substitutability and M/V equivalence.

    On Krugman’s good days, this is what I think he means (but he hasn’t had any good days for a few months). I am TOTALLY baffled by the nonsensical debate in which one side argues that (pure) fiscal policy is required and (pure) monetary policy cannot possibly work. (aka, recent Brad DeLong post…)

    Or vice versa, that “pure” monetary policy can work but “pure” fiscal policy can’t. When, frankly, there ain’t no such thing as “pure” anything.

    Really? No such thing as “pure” monetary policy, some may ask?

    Believes can live with the illusion that pure monetary policy is less intrusive into the economy than fiscal policy, but that it’s still intrusive… In that, Bill W. is correct – the Fed is just as guilty of picking winners (e.g. debtors/creditors) as the fiscal authority.

    Even worse, what about the especially low cost to borrow funds for banks that enjoy implied federal backing?

    We talk about the Money Illusion. We should be talking about the Many Illusions.

  30. Gravatar of caveat bettor caveat bettor
    10. November 2009 at 13:00

    Scott: I’ve had some limited success listing contracts on Intrade in the past. Could you email me on how you see NGDP futures being constructed, in terms of underlying spot source(s) of data and expiries? Thanks.

  31. Gravatar of ssumner ssumner
    10. November 2009 at 15:37

    Thanks Greg,

    Bill, I will look at it. I’ve been working on a new post today (just posted.) I think Mankiw and Hall are too pessimistic about how much NGDP targeting would stabilize real GDP. Do they contemplate rate or level targeting?

    Johnleemk, The crackdown on immigration contributed (modestly) to the housing bust. Hispanic neighborhoods were ground zero of the crash–fast population growth projections did not pan out.

    more to come . . .

  32. Gravatar of ssumner ssumner
    10. November 2009 at 17:07

    Bill, Thanks, I agree with your comments about the interview. It is hard to get in subtle points about index targeting, but I did my best. Russ seemd to think I got my points across.

    ron, If happiness were as “sticky” as wages, maybe I’d want to target happiness. Neitzsche’s right that people don’t want to maximize happiness, they want to maximize utility, where ‘utility’ is defined as “that which people maximize.”

    Graeme, It is a neverending battle to struggle against excessive government power, and its entanglement with special interest groups.

    ron, In this crisis I found out that what I thought were textbook views, what I had been teaching, was in fact radical. (Zero rates don’t mean easy money, monetary policy is still highly effective at zero rates. Etc.)

    regarding AD. The housing crisis had little affect on AD. Base velocity didn’t fall in late 2007 and early 2008. The problem came later. As the economy gradually slowed in August and the banking crisis got worse the equililbrium real interest rate fell toward zero, and then the market gradually lost confidence in the Fed’s ability to stimulate the economy at zero rates. When that happened everything crashed quickly (late September to November 2008.)

    rob, I don’t predict markets, but I’ll make a few observations. Never try to predict oil prices based on quantities. Oil inventories don’t mean anything about the direction of prices. Don’t assume that because a price movement looks “funny” it will reverse. I thought gold was high at 900, and now it’s 1100. I doubt gold has much to say about inflation, but don’t know what it is saying. I’m not sure where to invest. I generally like Asian markets (except Japan), but they’ve almost doubled since March, so who knows where they will go from here.

    vimothy, Thanks, it’s hard to explain these ideas over the telephone. I probably need to work on alternative ways of describing the idea. But issues like the circularity problem are not easy to discuss. Russ was very nice, although he is obviously more skeptical of central banking that I am. And even I would like to curtail Fed discretion quite a bit.

    Stastguy, All good points:

    Thanks for the econbrowser tip. I left a comment there.

    DeLong is too dismissive of monetary policy. Even without going as far as I’d like, they can do more just by signaling more determination to not let the economy stagnate for years.

    Some of the populists on both the right and left are correct about banking having too much power. It’s an issue that I lack the time and expertise to address.

    Caveat bettor, It depends how Intrade wants to set things up. Ideally you’d want a point estimate. I recall the Iowa electronic markets once set up election contracts that way. The payoff value was proportional to the vote share. To get some leverage you need something like actual NGDP minus $14 trillion.

    More often the contracts are all or nothing. You could have nominal GDP estimates for Q3 2010 that are 3%, 5% and 7% above 2009 Q3 numbers. Then they would be all or nothing contracts. People would bet long or short. Comparing the various market values could still allow you to infer a reasonably good estimate, if you had at least three contracts spaced at plausible intervals (I think 3%, 5%, 7% would be most informative, as I think the point estimate is somewhere in that range.

    I think it would be a great idea, it would help this blog a lot to have something to point to other than TIPS spreads. They’re going to try to talk you into doing shorter contracts, but try to go out as far as possible Three more for 2011 Q3 would also be nice, but may be too much to ask.

    It doesn’t matter whether the payoff is based on the preliminary number or the final number, it just matters that it be clearly spelled out in the contract, so both sides understand what they are betting on. I think Intrade is good at doing that.

    Tell them economics teachers may have great interest in this contract, and use it in their classes. That’s free advertising for Intrade.

  33. Gravatar of rob rob
    10. November 2009 at 17:49

    RE Intrade contracts — this is my opinion as a speculator/gambler, but I’m no economist — I think the contracts would get a LOT more liquidity if they traded based upon an expected value of NGDP instead of the all-or-nothing, over/under sort. With over/under we are back at the problem of: why wouldn’t people wait until the last moment of contract expiration to trade? If traded by price/value speculators would be motivated to buy/sell whenever they wanted to and try to make money on the fluctuations instead of merely the final outcome. This is how S&P futures contracts work, so why should this be any different? Don’t the election prediction markets get liquidity because you can make a profit/loss on the fluctuations without having to wait until election night?

  34. Gravatar of rob rob
    10. November 2009 at 17:58

    RE Intrade (cont) But now I see a problem with final settlement of contracts in my above. I can’t think of a solution right now, but I think the solution does need to allow for trading fluctuations in order to get good liquidity throughout the year. Maybe the %s Scott mentions but traded as % likelihoods like election prediction contracts.

  35. Gravatar of rob rob
    10. November 2009 at 18:01

    Yes, looking at Intrade now I’m sticking with my last suggestion. It could be exactly like the contract now reading:
    “US Unemployment Rate in Dec 2009 to be greater than 10.00%”

  36. Gravatar of rob rob
    10. November 2009 at 18:05

    But I guess that was exactly what Scott had in mind in the first place. Um, please ignore all my above comments…

  37. Gravatar of David Stinson David Stinson
    10. November 2009 at 19:08

    Hi Scott. Another interesting post and good interview with Russ Roberts.

    Sometimes I wonder whether macroeconomics should be renamed “The Study of the Demand for Money (and related issues)”.

    I like how you take a more nuanced approach to determining whether money is loose or tight. I also like how your approach is driven by market expectations and doesn’t require that the central bank actually model (or even understand?) the economy. It reminds me of Hayek’s comment that market outcomes are the result of human action but not human design (or something like that).

    The difficulty I have with NGDP targeting (and inflation targeting for that matter) is that it seems to me to based on one of four ideas or assumptions:

    a) People only spend excess money balances on components of GDP; or

    b) People spend excess money balances on components of GDP and existing assets in fixed proportion; or

    c) As long as the NGDP target is hit, asset prices can’t become disconnected from NGDP growth or otherwise form a bubble (perhaps because of b)?); or

    d) If asset prices do become disconnected, it’s not a problem as long as the NGDP target is hit – i.e., there’s no cluster of entrepreneurial or investor error and the pattern of real output is not affected.

    The experience of the last few years suggests that a) and c) (and therefore presumably b)) are not valid, i.e., we had low inflation and an asset bubble (didn’t we?). As far as c) goes, EMH doesn’t t get you there if one considers that, from a trader’s perspective, money supply in excess of demand is a fundamental valuation factor, at least in the short/medium term. In that regard, if I recall correctly, I think Vernon Smith found in trading experiments that even once traders fully understood that excess liquidity caused price bubbles, the bubbles still occurred, they were just smaller and popped earlier. I’m not sure why one would rely on d) as being true in general, although perhaps that might depend on the level of NGDP growth implicit in the target.

  38. Gravatar of Scott Sumner Scott Sumner
    11. November 2009 at 08:32

    rob, Yes, people trade all or nothings because the odds change over time.

    Thanks David, Actually, NGDP targeting does not depend on where people spend money. The market develops a forecast of future NGDP, conditional on money growth, which is based on a model that already takes into account the fraction of new money injections that are likely to be spent on goods and services. It doesn’t have to be one for one. So that’s not a problem at all.

    Yes, bubbles could still occur, and yes, they could do moderate damage to the economy, but nothing like we have recently seen. Monetary policy can’t do everything, and shouldn’t be expected to. If there is something wrong with our housing market you need to look at regulations or deregulation targeted at those specific problems.

    Lab experiments are very different from real world markets where experienced traders have lots of money on the line. If a lab experiments suggest a way to get rich quick, they are wrong. Anyone who predicted the housing bubble fiasco could have made a lot of money.

  39. Gravatar of jsalvatier jsalvatier
    11. November 2009 at 11:51

    I am reading the Mishkin paper linked to in one of the comments and I am curious if anyone can respond to Mishkin’s assertion on p. 212 that the evidence does not support forward looking inflation expectations:

    One strand
    in the literature suggests that it is optimal to cont inue with the target.
    In models with a high degree of forward-looking behaviour (for example,
    Clarida, Galí, and Gertler 1999; Dittmar, Gavin, and Kydland 1999; Dittmar
    and Gavin 2000; Eggertsson and Woodford 2003; Svensson 1999; Svensson
    and Woodford 2003; Vestin 2000; Woodford 1999, 2003), a price-level
    target produces less output variance than an inflation target. However,
    empirical evidence (for example, Fuhrer 1997) does not clearly support
    forward-looking-expectations formation, and models with forward-looking
    behaviour have counterintuitive properties that seem to be inconsistent with
    inflation dynamics (Estrella and Fuhrer 1998).

  40. Gravatar of D. Watson D. Watson
    11. November 2009 at 13:46

    Another excellent post (not that you were waiting for me to say that). Although I laughed heartily when I saw my quotation in there, I would like to say that that’s as far as I meant it. I did not and do not think you are crazy, nor imply any slight to Bentley, to Chicago graduates, or any other demographic you’d like. There have been an awful lot of people throwing around the need for a change in the paradigm, and all of them have merely been a “return to first principles” back-to-Keynes or back-to-Hayek. This is the first call I’ve read that’s actually backed by something reasonably new, and I expected it would be. Since you said there was a misunderstanding, I went back, reread the language, and saw where I misunderstood. This is an excellent summary piece of many of your arguments. The one part I am still serious about is that you ought to consider some formal, longer-lasting medium than the blog so that your policy recommendations become a little less radical in the future.

    One of the potentially trickier parts I see here is a need to pin down the term expectations. There are expectations of individual market participants (traders, bankers, Warren Buffett), expectations of the Fed, expectations from the market’s emergent order, expectations of mattress-stuffers generated by the media who have some of the worst understanding of what’s going on of any profession. Getting all of them lined up in properly rational terms is going to be mighty difficult.

  41. Gravatar of Declan Trott Declan Trott
    11. November 2009 at 19:59


    We seem to be in furious agreement then . . .

    “One of my first posts was on the Puritan ethic or mentality, which makes central bankers think we must suffer for our sins. When I lived in Australia it seemed like the Aussies were less affected by that negative approach toward life.”

    As far as central banking goes, we got burned by tight money in the early 90s (which for us was like the Volcker disinflation, except we took a lot longer to bounce back). But I don’t know how much that has affected the current response – we’ve raised rates by 0.5% already.

    “It’s kind of weird that it’s so hard to build in Australia-you guys have so much land. Are more conservative states like Queensland more pro-development?”

    Not an expert on this, but I don’t think there’s anything like the difference you have between states in the US (California and Texas, say). In general, Queensland is not as different as it used to be. And yes, it does seem kind of weird that blocks of land on the fringes of our major cities are more expensive than established houses were 10 years ago.

  42. Gravatar of ssumner ssumner
    12. November 2009 at 06:50

    jsalvatier, I can’t answer that question, but I do know their is evidecne of forward-looking inflation expectations. Because ift is hard to forecast inflation, it often makes sense to just extrapolate from past rates, but when things change dramtically (such as last september, there is evidecne that forward-looking inflation expectations change quickly as well. Also, when the Bank of England was made independent in May, 1997, there was a sudden drop in UK inflation expectations. That is also consistent with forward-looking inflation expectations.

    D Watson, Yes, I knew you didn’t mean it as criticism, but it made me realize that I was implying that I had some grand new paradigm, whereas it is more a serious of perspectives on different issues. So I put that in to add some levity.

    I think you need soem sort of market expectation. Ther eis no perfect way to measure that, (as we’ve been discussing in the comment section discssion on the real intereat rate post.) But i tend to favor the expectations embedded in asset prices, compared to surveys of the public or economists.

    Declan, Yes, I lived in the Gold Coast in 1991. Had a beautiful oceanfront apartment which cost very little to rent, and the AUS$ was cheap so the cost of living seemed very low. I do recall the deep concern people had then about Australia’s future, which is one reason I find it so interesting that they have avoided any (technical) recessions ever since.

  43. Gravatar of caveat bettor caveat bettor
    12. November 2009 at 14:26

    Scott: What would be appropriaate source data for settling the NGDP contracts? For instance, I used NASA’s GISS data for settling global warming contracts. Once I get this, I can start the process with Intrade. Thanks!

  44. Gravatar of Graeme Bird Graeme Bird
    15. November 2009 at 20:20

    NGDP contracts? Now there is an excellent idea. Absolutely superb. Because increasing savings and the surplus, and retained earnings in the context of a slowly growing GDR could have GDP collapsing by 20%. Even although the rate at which the economy would be progressing would be massively increased, so long as you could keep everyone employed.

    And so NGDP contracts would work like a charm. Because it would deliver the nominal pay cuts to maintain employment even as real pay was increasing. Profitability would be maintained and more resources could be funneled into long-term investment as firms realised they would have to invest to be able to deliver better value for money.

    This is the best idea I’ve heard in years. I’m going to steal it and run like a thief in the night.

  45. Gravatar of Scott Sumner Scott Sumner
    17. November 2009 at 09:17

    Caveat bettor, BEA does NGDP estimation.

    Graeme, Be my guest.

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