October 2008: the Taylor Rule vs. NGDP futures targeting

The Big Think has just posted an interview with John Taylor, and he provides some very interesting answers to my questions on monetary policy.  Before I try to systematically demolish his response, let me first say that I agree with John Taylor on most things, including most of his answers to questions raised by others:

1.  Fiscal stimulus was not very effective, and led to a counterproductive increase in the national debt.

2.  The Fed should focus on monetary policy, rather than supporting the housing market.

3.  The big mistake was not the failure to bail out Lehman, but rather policy errors a few weeks later.

4.  The State of California needs to curb the growth rate of spending.

5.  The Fed should not focus on asset bubbles.

So we agree on most things.  But with all due respect I think his attachment to a backward-looking Taylor Rule has led him into all sorts of blind alleys.

Taylor responded to two of my questions.  I will quote in full, breaking occasionally to interject my own views:

Question: Is it better to have price level targeting or inflation targeting in a liquidity trap? (Scott Sumner, The Money Illusion)

John Taylor: I think the distinction between price level targeting and inflation targeting, which has had a huge amount of attention in the academic literature and has been referred to in the past, such as Ben Bernanke before he became Chairman. I think those distinctions in practice get blurred by the realities, quite frankly. It of course would be good to have a price level targeting other things equal that would sometimes require deflation, however, and a lot of evidence that that’s not such a good thing to have; even occasionally.

So, I’ve always been of the view that an inflation target makes more sense, it’s easier for people to understand, we’ve had a lot of practice with it. And while there is this problem of lack of a drift, the drift of the price levels sometimes called base drift, overall seems to me if we were able to keep the inflation rate at a very low level, then we would effectively get similar results to price level targeting.

What do you think?  It doesn’t seem to me that he addresses any of the reasons Woodford puts forth for price level targeting in a liquidity trap.  Just to review, Woodford argues that with an inflation target, monetary policy has no traction in a liquidity trap.  Assume the inflation target is 2%, but also suppose inflation keeps coming in under 2%.  How does the Fed react?  Under inflation targeting the only answer is “try the same thing again, and hope for better luck next time.”  With price level targeting, if you undershoot the 2% price level growth trajectory the target inflation rate automatically rises.  If nominal rates are stuck at zero, sub-target inflation automatically lowers the real rate.  Does Taylor’s response address Woodford’s argument?  Maybe I missed something, but it seems to me that Taylor’s answer referred to the opposite situation, where inflation has exceeded the target.  Next question . . .

Question: Should the Fed have been more aggressive with monetary stimulus in September-November 2008? (Scott Sumner, The Money Illusion)

John Taylor: I think the Fed cut interest rates during that period just about right. I think it was basically coming down, it could have been a little faster at that point, and of course, GDP did fall tremendously. But I think if they had kept the interest rates along the same path it would have been fine.

Now stop right there.  I didn’t ask whether the Fed should have had lower interest rates, I asked whether their policy should have been more stimulative.  Of course Joan Robinson would say that nominal interest rates and monetary policy are one and the same.  Joan Robinson would say that monetary policy was not easy during the German hyperinflation, after all nominal rates weren’t very low.  Am I being unfair to John Taylor?  In one sense yes.  The inventor of the Taylor Principle clearly understands the distinction between nominal and real interest rates as well as any person alive.  But then when I asked about the stance of monetary policy, why did Taylor not criticize the Fed for dramatically raising real rates between July and November 2008?  Why did he merely talk about changes in nominal interest rates, as if they provided meaningful information about changes in the stance of monetary policy?

A few months ago I had a series of posts basically calling out the entire monetary economics establishment.  I accused them of throwing around terms like ‘easy money’ and ‘tight money’ without assigning any coherent meaning to the terms.  Taylor’s answer is a perfect illustration of what I was complaining about.  I still await an answer as to what these terms mean.  I might have to offer a $200 reward as a cheap stunt, just to generate some interest.  How hard can it be to define the stance of monetary policy?  How hard can it be to explain what we mean by ‘easy money’ and ‘tight money?’  Apparently it’s pretty hard, because no one has yet been able to answer my question.

Taylor continues . . .

The problems I see at that period was the tremendous amount of uncertainty added by these new effects, if you like, the quantitative ease, and sometimes I’ve called somewhat **** industrial policy to where the actions went well beyond the usual interest rates. And I don’t think they were appropriate. We’re still studying them. Some of them were inappropriate. I just finished a study on mortgage interest rates.

I agree that we wasted precious time focusing on non-monetary issues during September-October 2008.  Taylor continues . . .

So, the question about whether the policy could have been even easier going into the panic, it is certainly something to examine, but I think basically, it’s about all it could do at that point. The problems I saw were not so much a monetary policy at that stage, but the really ad hoc chaotic interventions that occurred around the time of the rollout of the TARP, not clear kind of actions with respect to what happened to Lehman Brothers. So, a lot of surprises and ultimately a lot of panic. And I think that panic was induced as I’ve argued in other places by government actions. I think some of the actions of the Fed after the panic began were constructive to be sure. But I don’t see that in terms of a faster reduction in interest rates.

I absolutely agree that the government was creating a lot of panic.  If I was running a highly leveraged commercial or investment bank, and I saw NGDP growth expectations rapidly plunging into negative territory, and I saw the Fed making no effort to adopt a more stimulative policy, but instead adopt an interest on reserves program to prevent reserve injections from having any effect, well then I’d panic too.  But those aren’t the actions that Taylor thinks created the panic.  Rather it was Bernanke and Paulson’s admittedly clumsy efforts to save the banking system.  The reason we both felt that late September and early October was important was that it was during this period that asset markets showed panic.  And we even agree that it was related to Fed actions.  But Taylor (and Cochrane) seem to think it was what they said that was causing panic, whereas I think it was the fact that they got distracted from monetary stimulus.  Throughout history there are many examples of tight money policies severely depressing the stock market.  I simply don’t think it is plausible that a few clumsy regulatory moves that were quickly reversed under political pressure could have severely depressed equity prices.  There’s no precedent for that.  That’s not how the stock market works.  It is not that sensitive.  Oddly, on this point I agree with Paul Krugman (as does Tyler Cowen.)

Taylor continues . . .

In fact, if I could just add. One thing I think people should recognize is that while the federal funds rate target of the FOMC came down gradually in the fall of 2008, the actual rate came down quite a bit more rapidly. In fact, each of the FOMC decisions effectively ratified what the rate was already at. And that rate came down so rapidly because of the large expansion in the reserves. So, it’s hard to see how measured in terms of interest rates policy could be much easier in the October, November, December period.

The fact that the Fed was scrambling to catch up to market rates is one indication of just how far behind the curve it was in the fall of 2008.  But the last sentence was a big disappointment.  Taylor previously indicated that policy was fairly expansionary in late 2008, and ended his answer by suggesting that there wasn’t much more the Fed could have done.  In contrast, I think monetary policy was highly contractionary, and that the Fed could have and should have been much more stimulative.

So how does the Taylor Rule hold up in the crisis of 2008?  The first question to be answered is which version of the Taylor Rule?  I seem to recall that Taylor likes to cite the “Marshall McLuhan” scene in the old Woody Allen movie, so I’ll assume the Taylor Rule is whatever the hell John Taylor says it is.  Here’s how I see things:

1.  In October 2008 I was running around calling for a much more expansionary monetary policy.

2.  John Taylor seems satisfied with the stance of monetary policy in October 2008.

3.  In 2009 NGDP fell at the fastest rate since 1938.

In retrospect, would you say I was right in calling for more monetary stimulus, or was Taylor right?

I do think the Taylor Rule works reasonably well when you are not in a liquidity trap, although even in that case I think NGDP futures targeting is superior.  But if there is one thing we have learned in the past two years it is that the Taylor Rule provides absolutely no guidance to policymakers when interest rates approach zero.  Indeed I believe it quite likely that the “panic” Taylor refers to in early October 2008, which was very real, was caused precisely by the fear that the Fed would adhere to the Taylor Rule, and would not adopt the sort of policies that Bernanke had recommended the Japanese try once their rates hit zero.

PS.  If you haven’t read my earlier posts on monetary policy, I should clarify a few things.  I know full well that Taylor and others understand the distinction between real and nominal rates.  But they insist on continuing to discuss the stance of monetary policy with reference to nominal rates.  As long as they keep doing so, I will keep needling them with my insulting Joan Robinson comparisons.

I am not saying that real interest rates are a good indicator of monetary policy.  Rather that’s what others often say when I point to the flaws with nominal rates.  My point is “OK, if real rates are the right indicator, then why no criticism of the Fed’s extraordinarily contractionary policy during July to November 2008, when 5-year real rates jumped from 0.5% to 4.2%?”

In my view the only meaningful indicator of monetary policy is the expected growth in the policy target variable, which I think should be NGDP.


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52 Responses to “October 2008: the Taylor Rule vs. NGDP futures targeting”

  1. Gravatar of Marcus Nunes Marcus Nunes
    20. January 2010 at 18:17

    Two years ago next March I sent J Taylor a piece I wrote while working as an economist for Cargill´s Financial Markets Division in the mid 1990´s. I wrote the piece in late 1995 and (I think) it was the first to discuss what Bernanke in 2005 called “The Great Moderation”. I think Taylor was the second to discuss it in his “The Long Boom” in the April 1998 issue of the St Louis Fed Review. The reduction in macroeconomic volatility became a frequent topic of discussion after 1999/00.
    These days the discussion is still on as can be gleaned from 3 recent articles:
    http://news.ino.com/headlines/?newsid=689686647769790
    http://www.kc.frb.org/PUBLICAT/ECONREV/pdf/09q4Clark.pdf
    http://artsci.wustl.edu/~morley/great_moderation.pdf
    Taylor came up with the “Rule” in 1993. For a time it was used as a good Description of the Fed´s policy since the mid 1980´s. Troubles with alternative incarnations of the “Rule” appear when it is tried as a Prescriptive tool.
    Now we have the “feeling” (Scott´s “certainty”) the the GM was the result of the fact that until early or mid 2008 NGDP was kept stable, growing along a path around 5.x%. With that the market crash of 1987, the S&L problems of the late 80´s early 90´s, the Asia/Russia crises of 97/98 and the Tech “bubble” of 98/00 had no lasting or deep effect on the broader economy.But in late 08 NGDP growth “melted” and all sorts of nasty things happened. It does no good to appeal to the fact that the “miscief” is closely linked to the Fed having abandoned the TR Prescriptions during 2002-04!
    Like the Phillips Curve, the Taylor Rule has become a “household word”, so very difficult to substitute.

  2. Gravatar of Marcus Nunes Marcus Nunes
    20. January 2010 at 18:24

    Oops, forgot to say that J Taylor e-mailed me the same day with nice comments on the article.

  3. Gravatar of David Pearson David Pearson
    20. January 2010 at 18:51

    Seems to me Taylor was arguing that price-level targeting is difficult when the Fed overshoots, not undershoots. That is, he cites “deflation” as being necessary, presumably when the price level exceeds the target. By “deflation” I think he envisions the Fed seeking to make the price level FALL to the target. If you believe that the Fed can fine-tune NGDP with no policy lag, then overshooting should never be an issue. I guess Taylor does not believe that.

    I wonder if Taylor is really saying that level-targeting policy is by nature asymmetric, and that a target requires symmetry, which in turn requires the Fed to do something politically infeasible.

  4. Gravatar of David Pearson David Pearson
    20. January 2010 at 18:53

    Sorry, the last paragraph was confusing. What I meant to say is that in theory level-targeting is symmetric, but Taylor may be saying in practice it will end up being asymmetric. If true, that policy would result in serious inflation overshooting.

  5. Gravatar of Marcus Nunes Marcus Nunes
    20. January 2010 at 19:03

    David
    The fed, Bernanke in particular (see his 2002 presentation) is pretty horrified by the prospect of deflation (or even inflation lower than 2%). NGPP targeting (as opposed to prie level targeting) would take care of that problem.

  6. Gravatar of Don the libertarian Democrat Don the libertarian Democrat
    20. January 2010 at 19:12

    “3. The big mistake was not the failure to bail out Lehman, but rather policy errors a few weeks later.”

    In order to believe that, you have to believe that the VIX would have stayed the same or gone down the week of Lehman if the Fed and Treas not intervened. Do you believe that? His timing arguments don’t even make sense. The VIX turned down the day after Citi was saved and the “No More Lehmans” policy was made apparent.The only uncertainty was whether or not the Fed and Govt were going to act as a LOLR. You say the panic was “Uncertainty”. Can you give me any evidence of investors, people with actual money involved, who say that if it was obvious that the Govt and Fed weren’t going to save Merrill, save AIG, let the MMFs spiral downward, then the markets would have rallied and things would have been fine?

    On the stimulus, what were you expecting the stimulus to do? If it failed, you must have a measure that it didn’t live up to. What was that measure? In my view, one measure would be investment in corp bonds, since that would show a marked decrease in the Fear and Aversion to Risk. How have Junk Bonds done recently? The stimulus is meant to alter expectations. I believe it has done that, even though my preferences for what to do with the Govt Borrowing were different than what has been done.

  7. Gravatar of Justin D Justin D
    20. January 2010 at 20:40

    Scott,

    I’m wondering if Taylor concerns about overshooting are justified. What happens if the targeted variable significantly overshoots the target, for whatever reason?

    As an example, suppose some large negative shock occurs which convinces investors that the Fed will have trouble keeping NGDP precisely along the 5% growth path. Let’s say that as a result of those fears there is enough trading action in the NGDP futures market to generate a huge increase in the monetary base – an increase which proves unnecessary – and NGDP ends up 5% above trend. Should the Fed continue to target the trend one year out – or 0% NGDP growth for the coming year – or does the Fed use discretion and shift the target out 2-3 years, so that several years of 3%-4% NGDP growth bring NGDP back to target? If discretion is allowed, with shifting time frames and perhaps shifting target growth rates, could that undermine the credibility and effectiveness of the NGDP futures targeting approach?

    Or would your view be that under a credible NGDP targeting regime, excess growth in the monetary base shows up in asset prices first and only gradually bleeds its way into excess NGDP growth, which is more easily offset without a need for the central bank to adjust its target growth rate or growth period?

    I apologize if you’ve already discussed this somewhere but I only discovered your blog recently. Very enjoyable reading I must say, and good luck on getting the Fed (or any central bank for that matter) to give NGDP futures targeting a try.

  8. Gravatar of David Pearson David Pearson
    20. January 2010 at 21:14

    Marcus,

    I think you misunderstand. Taylor is talking about the need to deflation when the Fed overshoots the target. Take and arbitrary target of “200”. Should the price level move to “204”, the Fed would have to engineer a 4% fall in prices to return to the target. Alternatively, it could let the target be reached over a number of years by holding down the inflation rate (in which case, policy would be “time-asymmetric”, as the Fed is quick to remedy undershoots and slow to remedy overshoots). So by “deflation” Taylor, I think, is talking about the need to reduce the price level when it overshoots.

  9. Gravatar of Jon Jon
    20. January 2010 at 21:48

    Maybe I missed something, but it seems to me that Taylor’s answer referred to the opposite situation, where inflation has exceeded the target. Next question . . .

    Taylor appears to be claiming that because price-level targeting would induce deflations per-se, and as such, it is not worth whatever benefits Woodward claims. This is some sense a response. He’s saying that its not worth considering the point you raise because the method is wrong for other reasons if adopted as a general rule.

    The man clearly prefers consistent rules. So I don’t think he sees it as switching to level targeting when appropriate. He sees it as either level targeting always or inflation targeting always. In that context, he makes a coherent response–which includes first rejecting your premise.

    Scott you comment:

    The fact that the Fed was scrambling to catch up to market rates is one indication of just how far behind the curve it was in the fall of 2008.

    I think you’ve mistaken Taylor at this point. His claim is not about a difference between the FF rate target and market-rates. His (true) statement is that the chairman and the NYFED abused their administrative power to set the FF rate below the level approved by the FOMC by purposefully failing to sustain the FF target.

    Scott then you comment:

    If I was running a highly leveraged commercial or investment bank, and I saw NGDP growth expectations rapidly plunging into negative territory, and I saw the Fed making no effort to adopt a more stimulative policy, but instead adopt an interest on reserves program to prevent reserve injections from having any effect, well then I’d panic too.

    In his recent book, Taylor’s narrative is a bit more complete. He argues:
    0) The Libor-OIS spread widened. i.e., the difference between nominal market-rates and the FF rate increased. Rates tightened in the loan-market despite the FF rate below low–much as if the Fed had suddenly RAISED rates in mid-September.
    1) The Fed interpreted this as a liquidity crisis, but an identical spread held between secured and unsecured lending. Consequently, Taylor argues, the spread was not due to liquidity but rather due to the “queen of spades” problem. Taylor also cites that the spread did not respond to subsequent liquidity extensions by CBs.
    2) Bernanke and Paulson propose “TARP” which is a liquidity program. The market reacts negatively because of the perception that this is so large as to be the last bullet. A bullet being fired to solve a nonexistent problem. i.e., the lack of liquidity.
    3) TARP is recast as a bank-capital injection. This directly addresses the queen-of-spades problem. Rates finally start to decline. But this is now a month or more later. Businesses have already begun reduce output and lay-off staff. e.g., a firm I consult for laid-off substantial staff at this time and curtailed expenses 10%, including immediate pay-cuts. Customers canceled orders, cut lead-time, and pushed out delivery dates by similar amounts. i.e., by the time market rates dropped back down, deflation had already set in by December.

    His meta-point though is that policy was very loose in September-November but ineffectively so. Now you can claim that means it needed to be even looser, but I think his argument is that it would have been more effective to address the problem directly rather than loosen policy further.

  10. Gravatar of Don the libertarian Democrat Don the libertarian Democrat
    20. January 2010 at 23:54

    “John Taylor: This is a question about the timing of the panic and whether it was associated with the Lehman Brothers bankruptcy, or with the responses of the government more generally. Basically, as soon as that occurred, I looked at the data and I saw much more evidence that the panic in the markets were associated with the government’s responses a week or ten days later. That’s the time that say, the S&P 500 fell by nearly 30%, 10 times greater than what happened at the time of Lehman. The S&P 500 was higher the Friday after the Lehman bankruptcy than the Friday before.”

    That’s because the Govt intervened and investors thought that everything might be guaranteed. Here’s my view from another post:

    “On Sept. 15th, there’s a big jump. That week peaks on Wed. On Friday, it’s gone down a bit, but it’s still way up from the previous week. On the 24th of Sept. it’s up, but lower than the previous Wed. On the 29th, it shoots up. It peaks on Nov. 20th, and then starts to decline.

    My story is that the govt allowing Lehman to fail caused it to shoot up. On Thurs., there’s a brief rally, based upon the govt bailout out AIG, getting the B of A to buy Merrill, and MMFs are guaranteed by the govt. Following WaMu bondholders getting wiped out on the 26th, or the expectation of that, and the govt guarantees being doubted again, it shoots up on the following Mon. On Nov. 23rd, Citi is saved, and the policy of No More Lehmans is understood, meaning that the govt will bailout whomever it needs to, and the VIX begins its descent.

    Now, the alternative argument is based on the fact that the VIX rallied on Thurs. of Lehman week. Hence, that week doesn’t look like the worst week. So, the question is: Would the VIX have gone much higher if AIG wasn’t saved, Merrill wasn’t bought, and MMFs were guaranteed. In order for the Taylor, Zingales, and Cochrane view to be correct, the actions of the govt could not have averted a major jump in the VIX. In fact, they have to believe that either the govt’s actions had no influence on the VIX, or they believe that the VIX would have gone down if the govt allowed AIG and Merrill to fail, and MMFs to break the buck. So this view must be wrong:

    “The panic was averted only after the Treasury Department on Sept. 19 stepped in and announced it would backstop money-fund assets, in a series of measures that slowly restored investor confidence. But industry officials are under no illusions about what might have happened.”

    So, who are the people that believe that allowing AIG and Merrill to fail, and the MMFs to break the buck, would have had no influence on the VIX that week or believe that it would have gone down?”

  11. Gravatar of DanC DanC
    21. January 2010 at 04:26

    I think Sumner is too quick to discount the fear that Fed and Treasury was introducing into the markets.

    I, like many people, thought that housing expenditures had gone crazy. I expected a market correction. However a spike in oil prices (which may have started a small recession, especially because of it’s impact on a weak auto industry), the Fed raising rates (I assume to combat an inflation risk they saw form oil prices), and a big jump in LIBOR at the same time a record number of adjustable rate mortgages were resetting, all created severe problems for the economy. Subprime lenders were hit especially hard by these events.

    However I thought, like many others, that the banks had prepared, at least in part, for the coming housing correction. Most knew, I would argue, that in an economic downturn housing would suffer. As it turns out the safety nets that the financial markets had created were an illusion.

    Enter the Fed and Treasury with a story designed to scare the hell out of people. “The banks are collapsing, the banks are collapsing. We need billions of dollars to bail them out!” I suddenly have the government telling me that the risks I was taking were much greater then any thing I had dreamed. Of course the value of assets I hold have to adjust downward.

  12. Gravatar of q q
    21. January 2010 at 04:46

    it wasn’t just the two weeks following Lehman. the Fed / FDIC / Treasury pursued a policy of complete non-transparency and inconsistency in the months between the expropriation of fannie and freddie on 7 september and the saving of Citibank on 23 november. among other things, there was fannie/freddie, WAMU, the run and guarantee on money market funds, Lehman, AIG, the paulson/bernanke TARP scare and complete inconsistency about how the TARP funds would be used. i don’t have time to write a big essay right now but these disrupted international trade, sparked forced deleveraging and flight to cash, and broke the wholesale funding model of the banking sector, making it a ward of the state for a while.

    here’s an interesting post on lehman:
    http://brontecapital.blogspot.com/2008/10/why-lehman-mattered.html. john hempton also writes convincingly about the seizure of WAMU.

    for a view of how international trade was effected, the best document i know is brad setzer’s blog in september-december 2008.

  13. Gravatar of StatsGuy StatsGuy
    21. January 2010 at 05:20

    Wow. Taylor has just subscribed to the emerging anti-Fed narrative that everything would have been alright if not for Bush going on TV and starting a panic. The defense goes like this:

    “My backwards looking rule was just fine, if not for Bush/Paulson needlessly scaring everyone.”

    Darn those animal spirits!

    So Taylor is resorting to animal spirits to defend his theories, which he says work because they are “simpler” than price level targeting (REALLY?) because the common person understands steady inflation better than steady price level growth (REALLY?).

    Meanwhile we have all those revisionist hedge fund managers and retail investors saying: “We were not really scared out of our wits! We only acted like we were scared because Bush/Paulson were playing chicken little on TV!”

    That’s some real sophistimucation there, folks.

    I do have one question for Taylor (and you, since you indicate agreement) – once ZIRP was hit, and quantitative action was necessary, exactly what assets should have been purchased first?

    MBS seems like a reasonable start, since that market lost the most liquidity and assets therein seemed the cheapest. I suppose the question was how much should the Fed be willing to pay? And I guess there was a big debate that lasted from October through May about trying to get “private equity” actors to co-bid on assets in order to “discover” the “market value” of the assets being purchased. Because private actors with special privileges somehow creates a “market”.

    http://online.wsj.com/article/SB123854120033275659.html

    What were these guys smoking? How does the creation of an exclusive club of a dozen hedge funds with the privileged opportunity to bid on massively subsidized assets facilitate “price discovery”? And why couldn’t the Fed or Treasury just open up the books of these banks and estimate their own darn value, given that the FOMC ought to have a decent idea of projected loan asset values?

  14. Gravatar of DanC DanC
    21. January 2010 at 06:09

    to StatsGuy

    How is new information, a Federal Government screaming the sky is falling, animal spirits? This wasn’t a rumor started by a shoeshine boy.

    New information entered the market place. The safety nets, the risk management tools, financial institutions had in place were failing. The true value of a variety of contracts were now unknown. Uncertainty was skyrocketing based on government comments.

    Some, like StatsGuy, seem to believe that the government has greater access to inside information or are better able to understand the data. If you share such a believe why wouldn’t you react strongly to government screaming?

    Even if the financial markets had adequate reserves the economy was going into a recession from the oil price shock and the accelerating decline in the auto industry (and to a lesser degree tourism and travel).

    Much of the economy was seeing a downturn, people were already smelling smoke when the government yelled fire.

    Not to mention how mismanaged the economies of California and Illinois were going.

    I do think their was some regulatory capture in the way the Fed and Treasury reacted to the crisis.

  15. Gravatar of scott sumner scott sumner
    21. January 2010 at 06:17

    marcus, That’s quite interesting that you spotted the pattern in the mid-1990s. I suppose there may be non-monetary factors that play some role. Perhaps the rise of the service sector, and better inventory control. But the break is so dramatic that something else must be at work. Probably monetary policy.

    David Pearson, Yes, I understand what Taylor said, but it certainly didn’t answer my question. He talked as if I had simply asked him about the pros and cons of price level targeting. But I very specifically asked him to consider it as a solution to the liquidity trap. This means you shift to price level targeting when rates hit zero. This is the context that Woodford made the proposal. I really don’t see how he addressed Woodford’s arguments at all. If I was Woodford, and Taylor responded that way to my question, I be even more convinced I was right. My reaction would be “is that all you got?”

    In practice, it is inflation targeting that leads to asymmetry (as we see now) and price level targeting is a solution to the asymmetry problem. It is a way of insuring that the average inflation rate is 2%. Inflation targeting doesn’t do that, price level targeting does.

    Don, You said;

    “In order to believe that, you have to believe that the VIX would have stayed the same or gone down the week of Lehman if the Fed and Treas not intervened. Do you believe that? His timing arguments don’t even make sense. The VIX turned down the day after Citi was saved and the “No More Lehmans” policy was made apparent.The only uncertainty was whether or not the Fed and Govt were going to act as a LOLR. You say the panic was “Uncertainty”. Can you give me any evidence of investors, people with actual money involved, who say that if it was obvious that the Govt and Fed weren’t going to save Merrill, save AIG, let the MMFs spiral downward, then the markets would have rallied and things would have been fine?”

    I never said anything even close to what you are asserting here. When did I ever say things would be fine if these firms hadn’t been bailed out? I blamed the recession on tight money. If money was tight we would have had a recession whether or not Lehman and the others were bailed out. Indeed it is possible the recession might have even been a bit milder if Lehman had been bailed out. I said the “big mistake” was monetary policy. I do think bailing out banks is a mistake, as it makes out financial system more unstable by encouraging excessive leverage among the bigger banks. Unfortunately we learned the wrong lesson from Lehman. The lesson should have been to use monetary policy to maintain AD during a crisis, instead we are actually increasing the number of bailouts, as compared to before Lehman. Even extending bailouts to AIG, auto companies, etc.

    You said;

    “On the stimulus, what were you expecting the stimulus to do? If it failed, you must have a measure that it didn’t live up to. What was that measure? In my view, one measure would be investment in corp bonds, since that would show a marked decrease in the Fear and Aversion to Risk. How have Junk Bonds done recently? The stimulus is meant to alter expectations. I believe it has done that, even though my preferences for what to do with the Govt Borrowing were different than what has been done.”

    I suppose the easy answer is to point to Obama administration forecasts of what would happen with no stimulus; we have actually done far worse than the no stimulus scenario. Another would be to compare this recovery to the only similar recession in my lifetime, 1981-82. In this case the fiscal stimulus has been far, far bigger (deficits of 12% of GDP vs. 6%) and yet the recovery from 1982 was much more rapid. Not very much evidence that fiscal stimulus helped.

    Yes, things are getting better and the 4th quarter will be good, but recessions eventually end with or without fiscal stimulus. And 2010 is still not looking very good. Most people expect unemployment to stay high.

    Justin, That question comes up a lot. People forget that major business cycles are produced by changes in the expected rate of GDP (or inflation) not just the actual. As long as expected NGDP remains on target, then wages will remain well-behaved, as will core inflation. Wages are set based on expected NGDP (as are sticky prices.) This means that any under or overshooting will be transitory, and will not have any major effect on employment. The problem in late 2008 was that not just actual, but also expected NGDP was falling fast. The markets knew this and they were right. Indeed I think the Fed also knew it, but for some reason remained passive.

    Current NGDP is closely linked to future expected NGDP. (As an analogy, changes in spot gold prices are closely linked to changes in one year forward gold prices.) So as a practical matter, if one year forward NGDP is always expected to be on target, then current spot NGDP won’t fluctuate very much.

  16. Gravatar of David Pearson David Pearson
    21. January 2010 at 06:28

    Scott,

    I think in theory level targeting is symmetrical. The problem occurs when the real growth trajectory of the economy is overestimated by the Fed. At that point, symmetrical policy results in higher unemployment starting from a high base. This is politically infeasible. So in practice, unless 1) the Fed pegs the real growth trend right; 2) the output gap constrains inflation when the Fed is trying to correct an undershooting; and 3) the Fed can fine-tune without lags and never produce an overshoot — unless those things are true, policy will not be symmetrical in practice.

  17. Gravatar of DanC DanC
    21. January 2010 at 06:30

    BTW
    Nothing a said directly disagrees with Professor Sumner’s view that the solution to the problem was the monetary policy path he suggests.

    Most of the time I would have agreed with Professor Taylor. I’m not sure if the Sumner option may have been the better path this time. I find the Sumner views interesting and often compelling

  18. Gravatar of Dan Carroll Dan Carroll
    21. January 2010 at 06:50

    A lot of this speculation over what the market was thinking at the time (September-October 2008) seems a little, well, speculative. Here is my perspective:

    1. Until October, no one knew exactly what the bankruptcy policy of the government was. Before Lehman, the Bernanke-Paulson doctrine was emerging where the government would provide an assist to stronger banks to buy out weaker banks (a model with at least a hundred year tradition), though the details of that policy were not yet clear. Lehman blew that up.
    2. Lehman triggered a crisis in confidence in the credit markets that quickly spiraled out of control, bringing down other weak financial institutions and shutting off access funding.
    3. The financial institutions then shut off access to funding where they could, including leveraged investors, trade finance, and working capital finance.
    4. However,this triggered a response from businesses: Lines of credit that usually went untapped were suddenly tapped, further stressing the already illiquid financial system.
    5. The following weeks saw extensive forced liquidation first in equity markets, then in trade and business working capital, then finally in labor markets.
    6. A relief rally in December marked the end of the forced liquidation in stocks.
    7. The March bottom was more of a pure panic over the future of the financial system (nationalization or not?) and fears of a Depression. There was probably additional forced liquidation resulting from lag effects. Retail investors were liquidating assets and buying bomb shelters in the hills. Ironically, the seeds of an economic rebound had already been sown.

    I think in November the markets recognized that the government would move the heavens and the earth to save the financial system after Lehman, even if the government’s responses were haphazard and clumsy. However, a rapid and chaotic unraveling of the financial system forced a rapid selloff accross all markets as liquidity vanished.

    That said, Lehman was a catalyst. It is likely that if Paulson had saved Lehamn, the crisis would have happened anyway – the catalyst would have been AIG.

    While I agree with Scott that the effective monetary policy was tight due to a spike in interest rates, I don’t beleive that the Fed was really in control of monetary policy at the time: it was dictated by the markets. Indeed, I think the Fed had begun to lose control over monetary policy in 2004 when he raised rates with little effect on yields.

    Could he have done more? Certainly. But he was faced with a complex rapidly changing crisis and surrounded by an extremely volatile political climate. Did he make mistakes? Absolutely. Would the “perfect” response have averted the crisis? Maybe, maybe not. It’s easy to shoot missles when you are not the one who is accountable.

  19. Gravatar of scott sumner scott sumner
    21. January 2010 at 07:05

    David, My previous answer to Justin relates to this point. Changes in the price level don’t create significant macro instability unless they bleed into wages. And wages are based on inflation expectations, not actual inflation. That’s why changes in the CPI due to commodity price shocks don’t have much impact on core inflation, or wages. The problem (as we are now seeing), is when there is a sharp break in the price level trend line, and more importantly, the NGDP trend line. That doesn’t occur under level targeting. Blips don’t create crises, shifts in trend lines do.

    Prices fell in 2009 as compared to 2008, and yet the Fed seems to be targeting only about 1% inflation in 2010 and 2011. That’s why we need level targeting.

    Jon, You said;

    “Taylor appears to be claiming that because price-level targeting would induce deflations per-se, and as such, it is not worth whatever benefits Woodward claims. This is some sense a response. He’s saying that its not worth considering the point you raise because the method is wrong for other reasons if adopted as a general rule.”

    This isn’t right. His answer is addressing the situation where you are having high inflation, and then need deflation to return to the price level trend. But high inflation is not the problem you face in a liquidity trap, it is low inflation.

    You said:

    “I think you’ve mistaken Taylor at this point. His claim is not about a difference between the FF rate target and market-rates. His (true) statement is that the chairman and the NYFED abused their administrative power to set the FF rate below the level approved by the FOMC by purposefully failing to sustain the FF target.”

    I understand that, my point was that the Fed was trying to set an official rate too high. Yes, they partially failed, but this question is complicated by a dual fed funds market, which involved entities which received interest on reserves, and those that didn’t. So the market fed funds rate was somewhat misleading, as commercial banks were earning higher interest on their reserves, and thus had a higher opportunity cost of funds. I do see you point, and I would have had to say much more to have made my point clearer.

    You said;

    “His meta-point though is that policy was very loose in September-November but ineffectively so. Now you can claim that means it needed to be even looser, but I think his argument is that it would have been more effective to address the problem directly rather than loosen policy further.”

    People keep saying that policy was loose, but no one gives even one shred of evidence to back up this assertion. I have all sorts of evidence that money was tight; soaring real rates, a soaring dollar, crashing commodity prices, a downturn in non-sub prime real estate markets, stock crashes, etc. All this points to tight money. What tells Taylor that money was loose? I just don’t see any evidence. Is it the nominal fed funds rate? Well that also fell sharply in the early 1930s.

    Don#2, Again, I think what needs explaining is the first 10 days of October. That is when the stock market crashed. I don’t see you even mention that period.

    DanC, I suppose that is possible, but didn’t the stock market already know the banks were in trouble by late September? So why did the stock crash occur in the first 10 days of October? My argument is that that is when the market lost confidence in monetary policy. If we had had an NGDP futures market, I think it would have crashed during that period.

    But I don’t mean to suggest you are wrong, the statement you point to probably contributed somewhat to the general loss of confidence. On the other hand Herbert Hoover used to go around saying “all is well” and the markets crashed anyway, as they didn’t believe him.

    q, I view those factors as leading to a velocity shock. But that doesn’t explain the sharp fall in NGDP. If the Fed is doing its job, it will offset any fall in expected future velocity. It did not do so.

    My other point is that we should not expect government competence in an emergency. That’s not what government’s are good at. This was uncharted waters. Ex ante, why would markets expect a rational government response to a banking crisis, when even the best and the brightest private sector economists were all over the map on what should be done.

    However the government ought to be good at preventing deflation. The last time we had deflation (before 2009) was 1955. It’s easy to prevent deflation, but they even failed at that simple task. That was the big surprise, and you saw it in the TIPS markets, which closely correlated with the stock crash.

    Statsguy, You said:

    “I do have one question for Taylor (and you, since you indicate agreement) – once ZIRP was hit, and quantitative action was necessary, exactly what assets should have been purchased first?

    MBS seems like a reasonable start, since that market lost the most liquidity and assets therein seemed the cheapest.”

    I agree with your earlier comment that Taylor is avoiding the problems with his Rule by discussing adminstration statements. Regarding QE, I’d make several points:

    1. Under NGDP targeting QE would probably not have been necessary.

    2. If it was I’d have the Fed buy T-bills and shorter term notes, to avoid too much risk of capital losses. I’m not too fond of MBS purchases, as I don’t think they should be trying to prop up housing. But if the choice is between MBSs and nothing, I’d go with MBSs.

    But with 5% expected NGDP growth, I don’t think the public would have been hoarding much cash, so I don’t think anywhere near as much QE would have been needed as what actually occurred. Instead of doubling the base, the Fed might have merely had to raise it 5% or 10%.

    Also recall that rates were not at the ZIRB during the July November period I discussed.

    DanC, Again, I don’t dispute that you are partly right. But you said this:

    “Some, like StatsGuy, seem to believe that the government has greater access to inside information or are better able to understand the data. If you share such a belief why wouldn’t you react strongly to government screaming?”

    Unlike many liberals, I am pretty sure that the government does not have access to better data, and that is why I don’t think the government bearishness could have had a massive effect, unless correlated with a non-response on the monetary policy front. The markets had to know the banks were in trouble–all sorts of risk spreads were rising.

  20. Gravatar of scott sumner scott sumner
    21. January 2010 at 07:25

    David Pearson, You said;

    “I think in theory level targeting is symmetrical”

    Anything that is true in theory is true in practice. If it isn’t true in practice, then tell me what is wrong with the theory. The example you provide doesn’t tell me what is wrong with the theory. If we target 2% price level growth over the next 100 years, then (ignoring compounding) 100 years from now the price level will be 200% higher. If we do 2% inflation targeting for 100 years, we have no idea where the price level will be in 100 years. Do you disagree with this statement? If not, why aren’t the errors with price level targeting symmetrical? I don’t follow your example at all. What does real GDP have to do with inflation targeting?

    DanC, Thanks.

    Dan Carroll, You said;

    “While I agree with Scott that the effective monetary policy was tight due to a spike in interest rates, I don’t believe that the Fed was really in control of monetary policy at the time: it was dictated by the markets. Indeed, I think the Fed had begun to lose control over monetary policy in 2004 when he raised rates with little effect on yields.

    Could he have done more? Certainly. But he was faced with a complex rapidly changing crisis and surrounded by an extremely volatile political climate. Did he make mistakes? Absolutely. Would the “perfect” response have averted the crisis? Maybe, maybe not. It’s easy to shoot missiles when you are not the one who is accountable.”

    Prior to 2008 I had virtually never criticized the Fed in the previous 15 years. So I don’t make a practice of shooting missiles. But by October 2008 it was patently obvious that policy was far too contractionary. I don’t see how anyone can contest that point. The expected growth in P and NGDP were far below the Fed’s implicit targets. The Fed was even asking for fiscal stimulus–if that isn’t an admission that policy is too tight, then what is it?

    I don’t agree at all with your reading of 2004. Monetary policy doesn’t work by moving short rates in order to move long rates. When monetary policy is effective the long rates should move in the opposite direction from the short rates (as they have on many occasions.) This is due to the longer term income and inflation effects overwhelming the short term liquidity effect. An expansionary monetary policy that is expected to be effective will generally raise long rates.

  21. Gravatar of StatsGuy StatsGuy
    21. January 2010 at 07:49

    DanC:

    “Much of the economy was seeing a downturn, people were already smelling smoke when the government yelled fire.”

    That is precisely the point. Taylor blames Bush/Paulson for creating the crisis (when the crisis would allegedly not have existed or not have been that bad). But you are arguing that the crisis WAS that bad, and Bush/Paulson were merely admitting that fact publicly. I agree with you – the crisis WAS that bad, and therefore Taylor is putting up a smoke screen.

    So either:

    1) The government does not have good information (which Taylor seems to think), and everything was caused by the spread of faulty information/beliefs (which I would call animal spirits).

    OR

    2) The government does have good information, and the introduction of this information causes markets to respond rationally.

    Taylor/Zingales’ rebuttal seems to be the timing of the crash, arguing that markets responded to Paulson’s speech, but that’s utterly bogus and self-serving. The timing does not align.

    https://www.themoneyillusion.com/?p=2810#comment-9547

  22. Gravatar of m. belongia m. belongia
    21. January 2010 at 07:59

    Scott — Beyond your call to define “tight” or “easy” monetary policy, you need to be specific about the implications of a “liquidity trap.” Presumably, the Fed only has leverage by manipulating the federal funds rate, which is an extremely narrow view of the world — irrespective of whether the funds rate is viewed as an instrument or intermediate target. If the perspective is widened to allow for influence through a standard monetary transmission mechanism, whereby changes in the quantity of reserves affect the quantity of money and that affects spending directly, the liquidity trap issue is irrelevant. Of course, this hypothesis cannot be examined because meaningful data are not constructed or published by the Fed. But it seems rather limiting to view the world through the narrow lens of Woodford’s model in which money is irrelevant.

  23. Gravatar of David Pearson David Pearson
    21. January 2010 at 08:06

    Scott,

    Between theory and practice is politics.

    If the Fed can’t correct its overshoots, then the price level target will be exceeded.

    Rules-based policy is symmetrical as long as the rules are followed.

    What I have a problem with is the attitude, “don’t worry, the Fed will never have to tighten with unemployment at 9%, because with level-targeting unemployment will never get that high.” If you assume away the tail-risk of overshooting, of course the any inflation targeting (level or rate) policy looks absolutely wonderful.

    BTW, I think the practical effect of the MA election is that the Fed has to become more rules based: the populists are angry over ad-hoc, untransparent policy and “back room deals”. If the economy dips, picture the Fed saying in March: “we’ll just buy another $1tr of MBS, plus other stuff, with no audit”. It won’t fly.

    So, the probability of level targeting being adopted just went up considerably, in my view.

  24. Gravatar of DanC DanC
    21. January 2010 at 08:32

    Scott

    Yes the markets knew problems were coming. Most of the world expected some correction in the market: the crow can only fly so high.

    I think the government increased the fear and uncertainty and they may have been the root cause of the problem. However, the response of the government did little, I think, to encourage confidence. Plus the changing political climate, a rather big shift in the political polls also started to occur. Was it bad? It was different from what people had anticipated.

    My comment to StatGuy was based on his past comments that he doesn’t have much faith in markets and seems to have more faith in government. If you have such views, why would he ignore a government yelling fire?

    So I agree with you that the government rarely knows more then the general public. But they are in a position to do much damage if you think they are wrong or confused. And that can scare you.

    BTW Once upon a time I had a conversation with the late Senator Fulbright. I asked him if government didn’t really have more information on national security issues. He told me that in general no. That private briefings often included more information about the private life of adversaries but rarely added much substance to the core issues.

  25. Gravatar of Doc Merlin Doc Merlin
    21. January 2010 at 09:15

    “So I agree with you that the government rarely knows more then the general public. But they are in a position to do much damage if you think they are wrong or confused. And that can scare you.”

    This is what I see as the main problem of the 20th century. The belief that people with power knew more than the populace at large about big issues lead to undue trust in people with power, and then to abuse of that trust.

  26. Gravatar of Joe Calhoun Joe Calhoun
    21. January 2010 at 09:46

    Scott,

    When you say that it was the first ten days of October that the market lost confidence in monetary policy, I think you give way too much credit to the investors and traders who populate the markets. As you know I’m an investment advisor and I talked with a lot of investors and traders (some of them wealthy individuals, some not so wealthy individuals, some hedge fund traders, some prop traders) during that time and not one of them mentioned monetary policy. What I heard most often was:

    1. Good lord man, these people (Paulson, Bernanke, Bush) don’t have clue what they are doing.
    2. This TARP plan is going to take forever to implement.
    3. We’re going to have another great depression (this one was mostly from smaller individual investors)
    4. McCain is toast; what the hell is Obama going to do?

    I started hearing this in mid to late September when TARP was first proposed and the volume increased when TARP failed the first vote in the House. It really ramped up after TARP passed because….NOTHING HAPPENED. People had this idea that once it passed, Treasury would immediately start doing something, but that didn’t happen. That’s when people rally panicked because that’s when it dawned on them that even with a plan this wasn’t going to be over anytime soon.

    Traders and investors just were not concentrating on monetary policy at that time. It wasn’t even on their radar screen. It was the uncertainty that killed the market and that only got worse after the election because no one knew exactly what Obama’s policies would be.

    I’m not sure if monetary policy could have overcome all the fear and uncertainty in the fall, but it is interesting that the market bottomed when the Fed announced their “credit easing” policy in early March. Of course the fear and uncertainty had eased considerably by then so I’m not sure that tells us what would have happened if they tried it a few months earlier.

  27. Gravatar of Bill Woolsey Bill Woolsey
    21. January 2010 at 09:58

    I find much of the discussion here regarding inflation vs. price level to be puzzling. If there is a decrease in the supply of some important product, say oil, the the price of oil rises as does the price level as a matter of arithmetic. This implies inflation. If there is an inflationary trajectory, the price of oil and the price level rise more than usual, and inflation is higher than usual.

    A price level target requires that the Fed impose “tight” money to force the price level back down. The price of oil falls a bit from its peak, and other prices must fall (really rise more slowly,) and so the price level returns to target.

    With inflation targeting, the higher price level and past inflation is ignored, and the plan is for price to continue rising from where they already are. The price of oil goes to rising at the planned rate from its high level, and all the other prices just keep on rising. The Fed doesn’t need to interve to reverse the increase in the price level.

    All of this should work in reverse. Lower oil prices, lower inflation, and then Fed does nothing to raise other prices up to keep the price level on target. Prices just go back to rising at the old rate after falling, or growing more slowly.

    Nominal expenditure targeting doesn’t require this sort of Fed intervention to reverse changes in the price level (growth path of prices) generated by price level deviations.

    “Supply shocks” impact both the price of the good and the output, and the impact on nominal expenditure and nominal output depends on demand elasticity for the goods with the shocks. There is not some automatic disruption of the rest of the economy to hit an artificial target. If the good with the shock isn’t unit elastic, then the impacts on the rest of the economy needed to return aggregate expenditure to target are broadly coordinating. Resources do need to shift.

    Further, it is the impact of changes in expenditure on output, prices, and wages that are sticky, not the changes in expenditure themselves. Reversing changes in expenditure before they have created persistent impacts on nominal wages, sticky prices, or even output are possible.

  28. Gravatar of DanC DanC
    21. January 2010 at 11:07

    To Bill
    My macro classes were long ago so please forgive my rather basic approach to such issues.

    I was taught that inflation is always and everywhere a monetary issue. I know that this view has changed somewhat. But still, for me, price targeting is a waste of time.

    Rather if the price of oil goes up, and the change is viewed as permanent, then people must adjust their budget and the economy reallocates resources.

    The shock to the economy depresses output below full employment as the economy shifts. The more flexible the inputs, the more rapid the change.

    The Fed could intervene with monetary stimulus but the benefits occur with a lag and you risk introducing inflation. Left on their own, if they are flexible enough, markets will return to full employment.

    If you have a substantial shock to the economy or you think markets are too sticky, who could introduce inflation to deflate wages in real terms to spur a return to full employment.

    Most of the time you just want steady growth in the money supply.

    Most shocks are absorbed by a healthy economy. Oil shocks tend to act as a giant tax on the entire economy. I suppose you could argue that it is an inelastic tax placed on the economy: a shock that few can avoid.

    Professor Sumner offers an alternative path if the economy is stuck.

  29. Gravatar of StatsGuy StatsGuy
    21. January 2010 at 13:34

    DanC:

    “My comment to StatGuy was based on his past comments that he doesn’t have much faith in markets and seems to have more faith in government.”

    To more accurate, I have no faith in anything, and quibble with those who rely on markets due to faith.

    Regarding the specific issue at hand – Fed awareness of bank books circa May 09 – Fed/Treasury has the ability to audit, and far more legal access than anyone in the private sector. One would imagine that by September 08 (long long after Bear Stearns failed), they’d have acquired a bit of info. Certainly by May 09… Had they not just executed well publicized “stress tests”? Why, then, would one want to bring in a privileged, hand-picked cadre of hedge funds to bid on assets (in closed auctions, with asymmetric buyer/seller information) with govt. financing in order to “discover” a “market price”? Do you believe this sort of “market” has any real advantages? (Is it really even a “market”?)

    Or are you arguing about Bush/Paulson? Let me repeat the two scenarios above, and add one more:

    1) The government does not have good information (which Taylor seems to think), and everything was caused by the spread of faulty information/beliefs (which I would call animal spirits). In other words, Paulson (former head of Goldman) really had no clue about threats to the financial system, but everyone believed he did because they put too much faith in govt, and therefore this started a panic.

    2) The government does have good information, and the introduction of this information causes markets to respond rationally. (But in that case, the crisis was real – and Paulson’s speech was not causal, merely symptomatic.)

    3) Paulson knew everything was fine, but deliberately started a panic due to a Goldman Sach’s conspiracy?

    So which is it? And if you pick #1, how does this align with the timing (which Zingales completely mischaracterizes, as noted in the link above)? And why would the market (with its great wisdom) believe Paulson if they did not think he was worth believing?

  30. Gravatar of Doc Merlin Doc Merlin
    21. January 2010 at 13:48

    @DanC
    Two ways to fix the oil shock issue are:
    1. Technological: Electric cars, micro nuclear generators for large shipping, etc will in part help. Technologies for oil recovery, etc. Better exploration techniques, ect.

    2. It needs to be easier to adjust the output of oil so when prices rise, production can increase as well. What I mean is we need to reduce governmental transaction costs in oil production, so that the oil supply curve is more price elastic.

    @StatsGuy

    I’d say a combination of #2 and #1.
    I don’t think #1 was caused by too much faith in government, but rather the rational reaction to government behavior. At the time, the market was rationally reacting to a shock, and had been since ARMs started failing in early 2007 in response to the rate increases in 2006. When the government got involved, people were rationally frightened away from the market due to uncertainty, so it made a bad situation worse.

    For #2, The market already knew what the government did, but the involvement still caused a rational panic, because it changed the micro incentives.

    (This also takes care of the timing)

  31. Gravatar of Doc Merlin Doc Merlin
    21. January 2010 at 13:58

    As a note, with the whole supply/demand for credit:

    I feel its time to change the way economics talks about credit. In the micro, supply and demand are /almost/ symmetrical (i.e. one persons supply is another’s demand.) But the symmetry is broken, because demands are unlimited while supplies are limited. Credit however, doesn’t work this way. The supply of credit is really, basically, unlimited. The limited supply is of future earnings over a unit of time (what we trade for credit).

    So instead of talking about the demand/supply of credit, which obscures a lot, and leads to confusion between money and credit. We should talk about demand for future money.

  32. Gravatar of Doc Merlin Doc Merlin
    21. January 2010 at 14:06

    The last sentence should read: “We should talk about supply of future money.” Not demand.

  33. Gravatar of Dan Carroll Dan Carroll
    21. January 2010 at 14:43

    Scott,
    “I don’t agree at all with your reading of 2004. Monetary policy doesn’t work by moving short rates in order to move long rates. When monetary policy is effective the long rates should move in the opposite direction from the short rates (as they have on many occasions.) This is due to the longer term income and inflation effects overwhelming the short term liquidity effect. An expansionary monetary policy that is expected to be effective will generally raise long rates.”

    I was referring more generally to the fact that the world continued to be flooded with liquidity and yield spreads compressed, despite the fact that the Fed was trying reign it in. The Fed started losing control over monetary policy because other large players were flooding the market, and depending on which model and interpretation of that model one uses, velocity accelerated. In other words, the debt binge was not necessarily fueled by the Fed’s low interest rates in 2003 (notice I used the word “binge” instead of “bubble” to avoid getting you riled up).

    This lack of control over monetary policy was a function of the Fed limiting itself to short-term treasuries as its only tool to manage the money supply. I would also argue that the Fed doesn’t take a broad enough read of the money supply and its impact on liquidity.

  34. Gravatar of azmyth azmyth
    21. January 2010 at 14:54

    “1. Fiscal stimulus was not very effective, and led to a counterproductive increase in the national debt.”

    I agree with the first part, but not the second. Fiscal stimulus involves two parts – reallocating spending from private uses to public uses and issuing debt to the people you took the spending power from. Imagine a world where instead of selling bonds and using the money to buy governmental goods, the government simply handed out the bonds for free. Although bonds are difficult to spend on small purchases, they satisfy people’s desire to hold currency for future use and can be used by banks as collateral.

    Issuing bonds is similar to a temporary monetary injection. When the bonds come due, the government shuffles money around (by taxing those who do not have bonds and paying people who do) and destroys the bond. I suppose you could add another layer and say that bonds are only temporary if people expect them not to be monetized. If people expect bonds to be monetized when they come due, injecting cash is equivalent to injecting bonds. In either case, the increase in government debt is the cause of the stimulus, not the shuffling around of resources that follows it.

  35. Gravatar of Bill Woolsey Bill Woolsey
    21. January 2010 at 17:12

    Dan C:

    The price level depends on the quantity of money and the demand to hold it. If the price of oil rises (because a decrease in supply leads to a shortage at the current market price, then the price level rises. This reduces the real quantity of money. If the real demand for money was unchanged, there is a shortage of money. People reduce expenditures to rebuild money balances. The prices of all goods fall, including oil. In the end, oil prices are higher, but the increase is dampened. The prices of everything else is lower. Resources are shifted to oil from everything else.

    But, the demand for money falls. The decrease in the supply of oil is and leads to a decrease in the production of goods and services. There is less real output and so less real income. The demand for money is positively related to real income.

    So, the higher price of oil raises the price level, which reduces the real quantity of money, and the real demand for money has fallen, because of the decrease in the quantity of oil.

    If the Fed targets the price level, then it must reduce the quantity of money so that the price level falls again (as would happen if the real demand for money didn’t fall.

    If the Fed is aiming at inflation, then the same thing happens but with some complications which I described in the other version.

  36. Gravatar of thruth thruth
    21. January 2010 at 17:35

    I’m still completely befuddled about how “conventional” macroeconomists think about TARP (and bailing out the GSEs). By the narrow definitions of said macroeconomists it’s neither fiscal nor monetary policy, yet it has the side effects of both (affecting expectations, prices and output to varying degree, depending on your religion). I regularly see discussion of both monetary and fiscal policies that basically assume TARP away as if it’s impact is orthogonal… What am I missing?

  37. Gravatar of thruth thruth
    21. January 2010 at 17:49

    scott sumner said “Unlike many liberals, I am pretty sure that the government does not have access to better data, and that is why I don’t think the government bearishness could have had a massive effect, unless correlated with a non-response on the monetary policy front. The markets had to know the banks were in trouble-all sorts of risk spreads were rising.”

    They do have exclusive access to one important piece of information and that’s the bank supervisory ratings, which to some extent (especially in crisis) are at their discretion. Markets probably do a reasonably good job of divining the ratings, but government bearishness could be read as a signal that they were planning to start closing banks en masse, which could easily become self-fulfilling under mark-to-market capital rules.

  38. Gravatar of Jon Jon
    21. January 2010 at 18:08

    Scott you write:

    People keep saying that policy was loose, but no one gives even one shred of evidence to back up this assertion. I have all sorts of evidence that money was tight; soaring real rates, a soaring dollar, crashing commodity prices, a downturn in non-sub prime real estate markets, stock crashes, etc. All this points to tight money. What tells Taylor that money was loose? I just don’t see any evidence. Is it the nominal fed funds rate? Well that also fell sharply in the early 1930s.

    Your evidence and his are the same. He claims that the fed attemped to respond to rising rates in the interbank market by liquidating the ff market. It’s this liquidation that he deems loose but chastises for failing to constitute easing in the interbank market. In this sense he views further loosing of the ff market as pointless. I.e. The policy failed because the interbank market remained tight.

    He alleges that Libor was more important than the availability of reserves because of it role as an index variable in existing contracts.

    The Feds policy in the fall of 2008 was indeed to tighten the libor market and liquidate the ff market—by selling treasuries in one market and liquidifuing the other via TAF. Legal strictures on access to the rserves market and the queen of spades problem sustained a risk primia between the rserves market and the public and thus the loosening actually tightened the public market.

    So indeed to the extent that loosen refers in the public mind to the ff target not market rates more broadly—it was that loosening that we needed less of. Even as a loosening of a different sort was necessary.

  39. Gravatar of Don the libertarian Democrat Don the libertarian Democrat
    21. January 2010 at 19:28

    Scott,

    The picture is the same whether you use the VIX or DJIA:

    On the 12th of Sep. 08, the DJI is 11,400
    On the 17th of Sep. 08, the DJI is 10,600
    That’s an 800 pt difference.

    On the 12th of Sep.08, the VIX is 25
    On the 17th of Sep.08, the VIX is 35

    So, that’s on Wed. of Lehman week. Then the Fed & Treasury intervene, and the markets rally. They don’t panic and get worse. That tells me that investors want and expect the Fed & Treasury to intervene. And, of course, there’s a big fall in both from the Friday before the Monday, signaling that Lehman is a huge negative. All you have to do is compare the Friday before and the Wed. after, prior to govt intervention.

    Then both markets tread water.

    On the 26th of Sep., the DJI is at 11,100
    on the 29th of Sep., the DJI is at 10,300

    That’s a 700 pt difference.
    On the 26th of Sep., the VIX is at 24
    on the 29th of Sep., the VIX is at 46

    I did explain what happened. As John Hempton said on the 28th of Sep. 2008:

    http://brontecapital.blogspot.com/2008/09/reckless-irresponsible-seizure-of.html

    “The Government did this seemingly capriciously. It changed the order of creditors and the basis on which banks all across America raise wholesale funds.

    Now there is not much raising of wholesale funds by banks at the moment. But after this deal there is likely to be less. It is simply the case that there is now a new risk for people who provide wholesale funding – and that risk is that the government will unilaterally abrogate their rights – without appeal, without due process and without accountability.

    In the process the OTS and the FDIC have effectively removed the main low-cost source of funds of pretty well all banks in America. They will have put the fear-of-Government into such people globally. This is the opposite of moral hazard. In the Moral hazard case people take too many risks because they believe the government will reimburse their losses. But in this case people are going to take too few risks because they know that government might unilaterally remove their rights and property.”

    In other words, they caused panic by letting Lehman fall, frightening investors that the govt wouldn’t intervene to help them. When the govt stepped in, the markets remained stable. When WaMu was seized, the govt caused a panic by signaling that, once again, the govt was not in the business of supporting their investments. Hence, you had another panic.

    Then the markets do very poorly until the end of Nov.08:

    On Nov. 20th of 08, the DJI is at 7500.
    On Nov. 21st of 08, the DJI is at 8000 and continues to rise.

    On Nov. 20th of 08, the VIX is at 80.
    On Nov. 21st of 08, the VIX is at 72 and continues to go down.

    What happened? Citi was bailed out, and the policy of “No More Lehmans” was put into place.

    I agree that the cause of these two panics was uncertainty. But it’s not a general or unspecific uncertainty. It’s uncertainty about whether or not the Fed & Treasury will honor the Implicit Guarantees that investors have been investing upon.

    Now, I’m just describing what happened and why. I’m trying to explain why I feel that the govt needed to honor these obligations in this instance. In no way am I endorsing the system that produced this tragedy. That system was an unholy union between the private sector and the govt, and they are both to blame. My own views are inimical to the current system, but I recognize this it is a very resilient system that will take a long time to meaningfully change.

  40. Gravatar of Bill Woolsey Bill Woolsey
    22. January 2010 at 06:28

    Don:

    I think you have a problem with partial analysis.

    Who was providing funds on the wholesale market, and when they lose their implicit guarantee, what do they do with the funds instead?

    To me, your analysis is, the loss of the implicit guarantee resulted in the removal of those funds, and whoosh, they are gone. Well, they are gone from the partial analysis. But where did they go?

    Immediately, they end up in a checking account. That means they are providing funds for some bank or other. Of course, if the quantity of checkable deposits is given, there cannot be an increase in the total amount held. The quantity of money needs to increase.

    I think there was a move to T-bills. And when the yields on T-bills got really low, this interacted with the Fed’s interest rate targeting scheme to generate disaster. The Fed tried to “fix” the problem by getting people to move back out of T-bills by “fixing” the securitization market.

    They needed to start purchasing longer term government bonds in a really big way.

    I just don’t see the connection between broker dealers in New York can’t borrow money cheap on the wholesale market, so businesses will lose a lot of money and so their stocks should be worth less.

    I am more and more thinking that the crazed theory of our leaders is that people hold stock to make short term trading gains. If stock markets are not liquid enough to make large trades quickly, then this is not possible. And so, people won’t hold stocks. The NY broker dealers must be be able to borrow money short term to be able to buy and sell large amounts of securities without having the securities or the money. If they don’t have sufficient net worth as shown by their market capitalization, they won’t be able to trade without having the money or the securities, the markets will slow down, speculators won’t be able to trade. Who wants to hold securities if you can’t day trade, no one will want to hold stocks and bonds. The markets crash. Regular business cannot find financing.

    Crazy.

  41. Gravatar of StatsGuy StatsGuy
    22. January 2010 at 08:57

    Bill:

    “If they don’t have sufficient net worth as shown by their market capitalization, they won’t be able to trade without having the money or the securities, the markets will slow down, speculators won’t be able to trade. Who wants to hold securities if you can’t day trade, no one will want to hold stocks and bonds. The markets crash. Regular business cannot find financing.”

    Yep, something like that. It’s gotten worse because large debt ratios, compensation structures, and computer trading have shortened time frames. The value of stocks & bonds, like that of money, is dependent on peoples’ willingness to hold them.

    There are two classes of investors, value investors and momentum investors. The latter, a large portion of heavily leveraged funds, support asset prices by holding them for short term gains (or harm prices by shorting them). The support is capricious. The use of money market provided short term liquidity, for instance, reinforces this dynamic.

    The ultimate source (symptom?) of this is lack of cash in the system and the reliance on credit to support asset prices. Long term financing is expensive, short is “cheap” – the yield curve just set a record, so no one wants to borrow long to hold long. Asset prices are thus very volatile as they are dependent on short term debt costs (and expectations thereof). And M3 is clearly decreasing as deleveraging continues (especially by consumers), so the primary source of asset price support is money injected through financial institution lending.

    This is why back in Oct 08, the key indicator everyone was watching was LIBOR. Interbanc lending allowed recycling of asset sales by bank trading subsidiaries back into the system to facilitate more asset purchases in a great big credit circle (which, because reserve ratios were nigh meaningless, was only constrained by the capital ratios – except you could buy insurance on capital ratios and get AAA status, or buy higher CDO traunches for AAA status, which had even lower cap ratios). Effectively, it was a money-manufacturing scheme.

    The Bush/Obama response was to reflate asset prices by rebuilding the short term debt financed intertemporal aribtrage – more capital, cheap access to credit. Hence, the massive trading profits for banks in the last year. But they haven’t addressed the core problem, and this left asset markets still vulnerable (see the market’s response to Obama’s speech promising breaking up TBTF).

    This is why I have argued, many times, that an NGDP targeting scheme like ssumner’s would be more effective with much stronger cap/asset ratios and regulation (to prevent credit from being poured into short term asset markets at the expense of more material investments). Meanwhile, regulation would be more politically palatable and effective with an NGDP targeting scheme.

    But the pro-regulation folks can’t seem to decide if they are or are not populists, and so want to kill the Fed while regulating banks. It’s a great recipe for an Uber Depression.

    Any significant amount of regulation is going to slow the short term money carousel, which means we need more long term money (“real” money, whatever that is) in the system to compensate. Bigger base, lower multiplier. To prevent inflation expectations from soaring, these two legs need a third – which is a credible commitment not to use newly created printed money to increase the deficit even more. If the Federal Govt. could just hold nominal fiscal spending flat, regulate cap asset ratios and prevent end-runs via financial “innovation”, and start covering a portion of the current deficit with printed money, we’d be OK.

    We aren’t going to get it. It seems that we’re either going to get deflationary hell (followed by default), or keynesian fiscal policy followed by default.

    Treasury’s original objective with TARP

  42. Gravatar of Bababooey Bababooey
    22. January 2010 at 16:44

    Scott- Why do you think so other prominent economists have not been convinced? Is it (1) they haven’t seriously and thoughtfully considered targeting NGDP instead of inflation, but once they give it a fair study, they will agree? Or, have they thought about targeting NGDP but dismissed it (if so, what reasons caused them to dismiss it)?

    I ask because I follow this debate as a mere dilettante and it would help me to understand why your sustained advocacy hasn’t caught on with the Fed, Taylor, Volcker, Becker and the celebrity economists.

    Thanks.

  43. Gravatar of scott sumner scott sumner
    22. January 2010 at 19:57

    Michael B., You said;

    “Scott “” Beyond your call to define “tight” or “easy” monetary policy, you need to be specific about the implications of a “liquidity trap.” Presumably, the Fed only has leverage by manipulating the federal funds rate, which is an extremely narrow view of the world “” irrespective of whether the funds rate is viewed as an instrument or intermediate target.”

    I completely agree, there are all sorts of ways monetary policy can be implemented once rates hit zero. I would turn things around, the fact that rates hit zero is the market expressing no confidence in the Fed, no confidence that it will use alternative procedures.

    David Pearson, I just have no sympathy with the view that we can’t do the correct monetary policy because it would be politically unacceptable. In fact, it would be far more acceptable that what we are doing now. The Fed just let NGDP fall 8% below trend, and unemployment is 10% and Bernanke was named man of the year! So how can you say the Fed would be unable to tighten if unemployment were 9%? They are running a tight money policy right now, but they’d run an easy money policy under my plan.

    In that long 25 year period where NGDP growth ran 5% or a bit higher, the Fed was very popular, I’d like to go back to that.

    DanC, I completely agree with you about foreign policy. The recent Iraq War is just one more sorry example showing that the CIA doesn’t know any more than you or I. All the CIA knows is what they read in the press, and that’s also all I know.

    Joe, You said;

    “When you say that it was the first ten days of October that the market lost confidence in monetary policy, I think you give way too much credit to the investors and traders who populate the markets. As you know I’m an investment advisor and I talked with a lot of investors and traders (some of them wealthy individuals, some not so wealthy individuals, some hedge fund traders, some prop traders) during that time and not one of them mentioned monetary policy. What I heard most often was:

    1. Good lord man, these people (Paulson, Bernanke, Bush) don’t have clue what they are doing.
    2. This TARP plan is going to take forever to implement.
    3. We’re going to have another great depression (this one was mostly from smaller individual investors)”

    This is a very common mistake you made. In trying to refute my argument, you actually proved it. What you describe here is people losing trust in monetary policy. Of course most people in the private sector don’t think in terms of “monetary policy” and if they did they’d think about interest rates, which aren’t monetary policy at all. There are probably not more than a few hundred people in the entire world who understand how monetary policy works. Indeed many economists still think monetary policy is changes in interest rates. But businessmen do understand the effects of monetary policy. Your comment about fear of a Depression is just another way of saying “sudden expectation of a sharp fall in NGDP.” And changes in expected NGDP are precisely what I mean by monetary policy. The asset markets respond powerfully to Fed policy surprises, so there is no doubt that investors pay a lot of attention to the Fed.

    You said;

    “I’m not sure if monetary policy could have overcome all the fear and uncertainty in the fall, but it is interesting that the market bottomed when the Fed announced their “credit easing” policy in early March. Of course the fear and uncertainty had eased considerably by then so I’m not sure that tells us what would have happened if they tried it a few months earlier.”

    I see no evidence that the fear had eased by March. Stocks were hitting new lows almost everyday, and there was lots of talk of depression.

    Bill, I agree with you that NGDP targeting is much better than price level targeting. Because almost no one supports NGDP targeting, I thought I’d ask Taylor about price level targeting vs inflation rate targeting. In a liquidity trap price level targeting is clearly much better, but for some reason he didn’t see it that way. I can’t make heads or tails of his answer.

    Doc Merlin, How is the supply of credit unlimited?

    Dan Carroll, You said;

    “I was referring more generally to the fact that the world continued to be flooded with liquidity and yield spreads compressed, despite the fact that the Fed was trying reign it in.”

    I completely disagree. Most people seem to assume the world was flooded with liquidity because interest rates were low in 2004. But interest rates have nothing to do with liquidity. Interest rates were very low in late 2008 when monetary policy was very tight.

    Azmyth, The problem is that people don’t expect the debt to me monetized. That is why it didn’t stimulate the economy, and its why it will be a huge burden on future taxpayers. But I agree with you that if it had been expected to be monetized, it would have stimulated the economy.

    thruth, I don’t know if I can give you a good answer. I think of TARP as fiscal policy, but it is different from other types of fiscal policy, hence is often put in a third category.

    thruth, Regarding your second point, there is evidence in the Vernon Smith interview that the government was completely clueless about the banking crisis three days before in blew up in August 2007. And they only found out about it when the markets panicked.

    Jon, What Taylor doesn’t seem to realize is that the liquidity added by the Fed meant nothing once they started paying interest on excess reserves. I hope to discuss that issue again tomorrow in a post.

    Don the libertarian democrat. I agree with part of what you say. The stock market fell about 5% right after Lehman failed. If it had been bailed out the market would have done better that week. My point was that the big damage was done in early October, and I don’t see many people trying to explain why stocks crashed 23%. What news hit the market, other than the fact that monetary policy was paralyzed?

    Bababooey, Most prominent economists have never given it much thought. In addition, they put way too much faith in the concept of inflation. They seem to think that the inflation number generated by the federal government bears some resemblance to the concept of inflation in their theoretical models. In fact, the growth rate of NGDP is a better proxy for the variable represented by inflation in many of these models. The inflation numbers are worse than worthless, they are positively dangerous. But prominent economists said we had no deflation using the core CPI, as if the core CPI number had any relationship to what was going on in the real world. The core CPI showed the cost of housing rising in the midst of the greatest housing price collapse in American history.

    Sorry for the short replies tonight, I am getting way behind on things.

  44. Gravatar of Jon Jon
    22. January 2010 at 22:15

    Scott: yes that may explain the failure of transmission on its own. But how does “the evidence” differentiate between his queen of spades narrative and your narrative?

  45. Gravatar of ssumner ssumner
    23. January 2010 at 06:49

    Jon, I am afraid that I don’t know what “the queen of spades narrative” refers to, could you spell it out?

  46. Gravatar of TheMoneyIllusion » Woolsey comments on John Taylor TheMoneyIllusion » Woolsey comments on John Taylor
    23. January 2010 at 08:58

    […] already discussed John Taylor’s appearance on the Big Think.  Today I’d like to do two more posts […]

  47. Gravatar of TheMoneyIllusion » John Taylor on the Big Think (part three) TheMoneyIllusion » John Taylor on the Big Think (part three)
    23. January 2010 at 11:19

    […] an earlier post I discussed John Taylor’s answers to two questions I asked about monetary policy in late […]

  48. Gravatar of Joe Calhoun Joe Calhoun
    23. January 2010 at 16:13

    Scott,

    I am not trying to refute anything at all. Unlike some, I don’t come here to argue; I come here to learn and hopefully translate what I learn here (and elsewhere) into better investment results. All I was trying to do was give you some feedback about what I was experiencing on the ground at the time in question. And apparently it was useful since my experience is exactly what you expected. I must admit it is hard for me to see how what I heard from clients/traders/investors translates into a loss of confidence in monetary policy but if that is what you get from it and it is helpful, well, okay.

    Also, just for the record, I learned a long time ago in a decade far, far away that monetary policy isn’t about interest rates. In fact, what I learned was that the Fed often uses interest rate policy to send one signal to the market while doing something entirely different with actual monetary policy. I’ve also discovered over the years that, apparently, there are times when the Fed believes policy is one thing when it is actually something entirely different because a lot of the people who end up at the Fed are just as clueless about monetary policy as the rest of the world. I judge monetary policy by its effects on the market. I have some differences with you about what indicators to watch, but we certainly agree that the market is how to judge policy. (By the way, in case you are interested, the person who taught me about how to judge monetary policy was Jude Wanniski. He was eccentric as hell and wasn’t an economist but he taught me a lot about how things really work).

    Anyway, I agree with you that policy was tight in the Fall of 2008. The rapid rise in the dollar and drop in commodity prices that started in July/August was evidence of that. What I was trying to say in my comment though is that market participants did not recognize these market price movements to be a consequence of monetary policy. And I don’t think their later fear in early October was just a function of the changes in these market prices and therefore was not just a function of monetary policy. The loss of confidence to me was a loss of confidence in the individuals involved (primarily Paulson and Bush by the way) and I wonder if a monetary response sufficient to move market prices would have been possible without having other effects. Also, the drop in NGDP expectations, as you term it, was to me a massive reduction in current economic activity as a result of the uncertainty created by TARP and the election. There was a drop in long term NGDP expectations but I don’t think it was sufficient to explain the drop in activity in Q4 08 and Q1 09. I think we had a one time drop in activity (due to the uncertainty) to a new level from which a lower NGDP path was expected. Is it possible that we could have had the same depth of crash due to the uncertainty but a more rapid recovery if monetary policy had successfully raised future NGDP expectations? It seems that would be true if the Fed were targeting a level of NGDP rather than a rate of growth (or a level of inflation versus a rate).

    As for your contention that the fear had not ebbed any by early March, my notes show that starting in late January and early February, I started hearing a lot of clients express interest in starting to take on risk again. (This was primarily expressed as the observation that some blue chip stocks were incredibly cheap and were good long term buys.) Basically the panic was over although there was still concern about the depth of the recession and people (or at least the ones I talked to) were starting to look past the valley to the recovery. I was seeing enough positive market signs (gold, oil and copper prices) that I wrote a client note titled “Bottom?” on March 11th a full week before the Fed announced the credit easing program. So unless my experience was unique, the fear had definitely eased by March. Again, not trying to argue or refute just providing feedback.

  49. Gravatar of Marcus Nunes Marcus Nunes
    23. January 2010 at 17:41

    Scott
    The player holding the Queen of Spades at the end of the game (I forget the name) looses.

  50. Gravatar of Marcus Nunes Marcus Nunes
    23. January 2010 at 17:49

    In the Game of Hearts if you get stuck with the Queen of Spades you loose. The “Queens” of Spade were the securities with the bad mortgages in them and no one knew where they were.

  51. Gravatar of Doc Merlin Doc Merlin
    24. January 2010 at 02:09

    “Doc Merlin, How is the supply of credit unlimited?”

    One way of describing why:
    Because credit creation also creates assets which can then be used to expand the possible credit available to banks. Many of these assets have no reserve requirements. The trivial example is two banks buying time deposit assets from each other. In short, in the aggregate banks can infinitely expand their ability to create new credit.
    ————

    Another way of describing it:
    For a single bank, credit demand creates new credit up to the limit imposed by reserve requirements, but for multiple banks they can shift the structure of their debt to expand credit as people demand more credit.
    ————

    Basically, as demand for credit increases, the quantity supplied can always increase, even if the monetary base does not. I am trying to argue that credit is demand driven not supply driven, and hence why I like using “demand for expected future money now” instead of “supply of credit.”

  52. Gravatar of scott sumner scott sumner
    24. January 2010 at 08:55

    Joe, Sorry if I seemed to argumentative. You said;

    “I judge monetary policy by its effects on the market. I have some differences with you about what indicators to watch, but we certainly agree that the market is how to judge policy. (By the way, in case you are interested, the person who taught me about how to judge monetary policy was Jude Wanniski. He was eccentric as hell and wasn’t an economist but he taught me a lot about how things really work).”

    I agree, I judge policy by the expected growoth rate of NGDP. This is why we really need a NGDP futures market. If we had one, I thinks it would be closely watched on Wall Street. I read one of Wanniski’s books on supply side economics. It was provocative.

    You said;

    “Also, the drop in NGDP expectations, as you term it, was to me a massive reduction in current economic activity as a result of the uncertainty created by TARP and the election. There was a drop in long term NGDP expectations but I don’t think it was sufficient to explain the drop in activity in Q4 08 and Q1 09.”

    The current view in macro is that the most powerful factor causing changes in near term NGDP is expected future change sin longer term NGDP. If one year forward expected NGDP hadn’t fallen sharply in late 2008, the recession would have been far milder. This is because today’s decisions are powerfully shaped by what we think the world will look like in 12 months.

    You said:

    “So unless my experience was unique, the fear had definitely eased by March. Again, not trying to argue or refute just providing feedback.”

    I think it was unique. If it had been widespread, stocks would not have declined between January and March.

    Thanks Marcus.

    Doc, OK, I’d have to see some applications to comment.

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