How did Don Luskin get so smart?

Josh Hendrickson sent me this Youtube video on Don Luskin defending QE2.  I won’t say; “I couldn’t have put it better myself,” the fact is that I couldn’t even have put it as well myself.  If you are not interested in his defense of supply-side economics, skip ahead to the 5 minute point.

Luskin nails one point after another:

1.  QE2 was needed as the economy showed all sorts of signs of sluggishness in the summer.

2.  QE2 is working because asset prices (stocks, TIPS spreads) responded strongly to rumors of QE2 that began in late summer.

3.  The rise is interest rates is actually a good sign, indicating that inflation expectations are moving closer to an appropriate level, and real growth expectations are increasing.

4.  Money was actually too tight during the summer, despite near zero rates.

5.  Milton Friedman pointed out that nominal rates were an unreliable indicator of the stance of monetary policy.

6.  Luskin said you must look at other indicators, and they all showed money was too tight.

7.  QE2 is very consistent with laissez-faire economics, as we don’t want the Fed to maintain a steady interest rate or money supply, but rather to provide enough money to generate a stable macro environment (dare I say NGDP) for companies to operate in.

Back in late 2008 I never heard that sort of talk on TV.  Indeed that’s the main reason I got into blogging; frustration over the conversation of pundits, which seemed to be ignoring the elephant in the room.  If I knew pundits were going to get so smart I might have stayed out of blogging.  It turns out I wasn’t needed.

PS.  It took me one year to figure out how to post graphs on my blog.  Perhaps in another year I’ll learn how to directly post YouTube videos.

PPS.  Tyler Cowen has a very generous post on my NGDP targeting talk.  I will definitely comment at some point, but am too busy with grading right now to give it the attention it deserves.  Meanwhile, help me think up titles;  “Wittgenstein and me”?  I will also eventually comment on his recent inequality article, but that may take even longer.

PPPS.  Luskin also supports the “tax cut.”  I get annoyed by progressives always talking about how the Clinton-era top rate (39.6%) was fine.  Maybe so, but then why don’t they support this “tax cut,” which will return the top rate to 38.8%, once the health care tax kicks in?

Good news: lower interest rates. . . . Even better news: higher interest rates.

It seems like lots of commenters are insisting that QE2 is failing because interest rates have risen since the November 3rd announcement.  If course most of the interest rate effect was already priced in by November 3rd.  But they are also missing a more important distinction—higher rates can be good news, or more specifically a reflection of good news.

Take yesterday’s big move in the bond markets.  Five year T-note yields jumped 17 basis points, from 1.47% to 1.64%.  But the yield on 5 year TIPS only rose by 10 basis points, from -0.22% to -0.12%. Thus 5 year inflation expectations rose 7 basis points, from 1.69% to 1.76%.  That’s good news folks.

Now some people might say; “Sumner, you can’t have it both ways.  The QE2 proponents have been arguing that the falling rates of September and October showed QE2 was working.”  Actually I can have it both ways.  In the months before QE2 was announced TIPS yields fell much more sharply than nominal yields and thus 5 year inflation expectations rose from about 1.2% to 1.7%.

Message to QE critics (and proponents); stop focusing on interest rates.  Here’s what Milton Friedman had to say in 1997:

After the U.S. experience during the Great Depression, and after inflation and rising interest rates in the 1970s and disinflation and falling interest rates in the 1980s, I thought the fallacy of identifying tight money with high interest rates and easy money with low interest rates was dead. Apparently, old fallacies never die.

The stock market understands that message; they brushed of the higher interest rates and rose 2% yesterday.  And stocks also rose when rates fell on earlier rumors of QE2.

Then there is the argument that the rising dollar (against the euro) shows QE2 isn’t working.  I admit to arguing that the strong dollar was a sign of tight money in the spring of 2010.  But I wasn’t basing that argument solely on the movements in the exchange rates, which are always an ambiguous signal.  A rising dollar can reflect tighter money here, or easier money in Europe.  In the spring it seemed to reflect tight money in the US, as other asset prices were confirming that signal.  And my initial reaction was that the same was occurring in response to renewed problems in the eurozone.  But a good macroeconomist will never fall in love with an explanation.  It seems like the eurozone troubles may be becoming so severe that the ECB will have to become more accommodative.  If there is anything the ECB hates more than easier money, it would be a crisis that ripped the eurozone apart.  Here’s a recent story hinting that ECB easing may be necessary to save the euro:

NEW YORK (AP) — U.S. stock futures are rising, building on gains overseas as the European Central Bank meets to discuss its plans to support the euro zone.

Investors are hoping that the bank will take additional steps to prevent the European financial crisis from spreading to Spain and Italy.

I’m not saying I have high confidence in this explanation, but rather that one must always remember to look at a wide variety of variables when analyzing a situation.  Even the very best macroeconomists can become a little too obsessed with one variable, Milton Friedman with the money supply, Robert Mundell with exchange rates.  But where they differ from their followers is that they generally knew when to look beyond that one variable, and which other variables were relevant to the problem at hand.

Yesterday a commenter named Leo made this interesting observation:

Readers should not (as I’m sure you don’t) confuse Hayekian pragmatism for Misesian logic.

I can’t comment on Mises, but I do consider myself a pragmatist.  In any given macroeconomic situation there are at least 10 models and variables that need to be considered.  Some people will ignore 9 of the 10, and then methodically apply Cartesian logic to the one variable that they consider “the real problem.”  That’s not my style.

PS.  What am I monomaniacally focused on?  NGDP expectations?

Update:  This article has a bit more info on the ECB:

LONDON (AP) — The European Central Bank stepped up efforts to contain the continent’s government debt crisis, as bank president Jean-Claude Trichet announced it would prolong measures to provide ready cash to banks and steady the financial system.

Markets were initially disappointed Thursday when Trichet did not say the bank would go even further and increase its purchases of government bonds. The euro sagged almost a cent during his news conference.

But it quickly bounced back, trading higher on the day on market chatter that the bank might in fact be quietly buying bonds of financially troubled eurozone countries — despite Trichet’s reticence on the issue.

We don’t need a higher fed funds target, we need to need a higher fed funds target

This post is partly in response to a long conversation I’ve been having with Rodney Everson.  He appears to be the first person to mention the negative interest rate on reserves idea, but I am less enthused about his argument that raising the fed funds target above zero can actually be expansionary:

Alternatively, they could raise the rate of overnight money to 1 or 2 percent which, of course, is impossible under current theory because it would be considered a “tightening.”  If you, the reader, now understand why such a “tightening” is necessary before an “easing” can be effected, then you have grasped the essence of this monograph.  You also should then understand the immediate danger we face under the current Federal Reserve policy of steadily driving the federal funds rate lower.

It is true that a zero fed funds rate promotes massive hoarding of base money, and also that base money hoarding is, ceteris paribus, highly contractionary.  But the Fed cannot solve this problem by raising the fed funds target.  Markets would interpret that action as being contractionary, as a signal that the Fed plans to withdraw funds to make the new target stick.

How can we reconcile the following two facts:

1.  Near-zero short term rates are almost always associated with disinflation and low output, not a booming economy.

2.  In the short run, a cut in the fed funds rate target is an expansionary action.

The answer is that (as Milton Friedman said in 1997) near-zero rates are a sign that money has been tight.

So how do we solve this problem?  Some Keynesians argue that we need to promise to hold rates near zero for an extended period.  But that’s not really a satisfactory answer.  The Japanese case shows that an extended period of near-zero rates may accomplish nothing; rather it may simply reflect a period of continual NGDP stagnation.

Instead, the Fed needs to raise inflation using a different policy tool, some tool other than the fed funds target.  This might involve QE, or it might involve cutting the IOR, perhaps to negative levels.  Or it might involve a target rate for the trade-weighted exchange rate.  But the best option is to use level targeting as a policy tool.  Set a much higher price level or NGDP target trajectory than the market currently expects, and then promise to make up for any future shortfalls.

Higher rates are associated with prosperity.  But we can’t get to prosperity by having the Fed raise rates.  The Fed must use other steps to raise NGDP growth expectations so high that the Fed will need to raise the fed funds target in order to prevent the economy from overshooting its target.  We need to whip the horse so hard that we need to pull back on the reins to keep it from running too fast.  But pulling back on the reins, by itself, will simply slow the horse down.

We don’t need higher short term rates right now, we need to do other things that will result in the Fed needing to raise short term rates in the future.  And the sooner the Fed needs to raise short term rates the better.  Promising to hold rates near zero for an extended period is not that answer, as the Japanese have learned over the past 15 years.

PS.  Would my grammar teacher have approved of the phrase “need to need?”

PPS.  I’m actually not that far from Everson, if the Fed did the right thing with its other policy tools then it would soon be able to raise the fed funds target a bit above zero.

Milton Friedman, Ben Bernanke and me

My extremely annoying victory lap continues.  David Beckworth recently had this to say about the debate over what Friedman would have thought about QE:

So the debate over what Milton Friedman would say continues to be debated  by policymakers and other monetary luminaries. This debate started with an Op-Ed I coauthored with Will Ruger in the Investor’s Business Daily, received more attention from a similar article by David Wessel in the Wall Street Journal, and was further promoted by Terence Corcoran in the Financial Post.  These articles upset the old school monetarists and apparently were discussed at a recent  Karl Brunner conference where they were gathered.

BTW, I wasn’t the leak.  David’s right that his article touched off the debate, but not the analysis.  Here are four earlier posts I did suggesting Friedman would have favored monetary stimulus:

July 31, 2009

August 2, 2009

August 24, 2010

Sept. 16, 2010

For the past several years I’ve been using this argument to criticize the Fed.  Now Bernanke has made the same argument to defend the Fed:

In an essay in The Wall Street Journal on Thursday, Allan H. Meltzer, an economist at Carnegie Mellon University and the pre-eminent historian of the Fed, said that the Fed was stoking inflation to stimulate the economy, and that Mr. Friedman would never have supported such an effort.

That drew an emotional retort from Ben S. Bernanke, the Fed chairman and a scholar of the Depression.

“I grasp the mantle of Milton Friedman,” Mr. Bernanke told his colleagues on Saturday. “I think we are doing everything Milton Friedman would have us do.”

Mr. Bernanke said Mr. Friedman would have agreed that the Fed had a mandate to promote price stability and that “you don’t want inflation to be too high, but you also don’t want inflation to be too low.”

Because inflation, at just more than 1 percent, is too low, and because the economy and the money supply are growing very slowly, “even from a strict monetarist perspective, we need to do more,” Mr. Bernanke said.

Of course I can’t be sure that Friedman would favor monetary stimulus.  But there is one thing I am confident of; he would not have opposed monetary stimulus in late 2008 and 2009, and supported it in 2010.  He was a very logical thinker, and the case for monetary stimulus was clearly much stronger when prices and NGDP were falling in late 2008, than it is today.  And Bernanke thinks we need more stimulus right now.

In 2009 I was using Friedman’s quotations to show why the Fed needed to ease.  In 2009 those posts were used to bash the Fed.  Now those same posts are seen as supporting the Fed.  And I haven’t moved one bit.  So what’s changed?

PS.  The term ‘victory lap’ was ill-chosen; we are a long way from having adequate NGDP growth expectations.

Laidler on Friedman’s puzzling views on the Phillips Curve

Last weekend I attended a conference on Karl Brunner.  It was a treat meeting a number of famous monetarists, particularly Bennett McCallum, who I described last year as my favorite monetary economist.  One of the conference readings was written by David Laidler, an outstanding monetary historian.  Anyone interested in learning about the development of macro theory between 1900 and 1940 should read his two books on the subject.

I was struck by the following passage in the Laidler article, which describes an inconsistency in Friedman’s view of the Phillips Curve (or aggregate supply curve.)  The passages in quotation marks were written by Friedman, the other portions are Laidler:

Once inflation got going in response to monetary expansion,

“Employees will start to reckon on rising prices of things they buy and to demand higher nominal wages for the future. ‘Market’ unemployment is below the ‘natural’ level.  There is an excess demand for labor so real wages will tend to rise toward their initial level.” (1968, p. 104, italics added.)

This story of a market out of equilibrium is of course quite compatible with Friedman’s earlier observation that, after an unanticipated monetary shock, “To begin with, much or most of the rise in income will take the form of an increase in output and employment rather than prices.”  (1968 p. 103), but less so with another remark that occurs in an intervening paragraph.

“Because selling prices of products typically respond to an unanticipated rise in nominal demand faster than prices of factors of production, real wages received have gone down — though real wages anticipated by employees went up . . . Indeed, the simultaneous fall ex post in real wages to employers and rise ex ante to employees is what enable employment to increase.”  (1968 pp. 103-104, italics added)

Here the behaviour of a key real variable, employment, is presented as an equilibrium response to price changes that have already occurred, but have been perceived differently on different sides of the market.  It is hard to see how the employment change in question could simultaneously have precededthose same price changes.  What we have in this passage, then, is not an alternative description of a disequilibrium interpretation of the Phillips curve augmented by the idea of inflation expectations, but something rather closer to Lucas’s alternative aggregate supply curve interpretation, albeit without the idea of rational expectations.

This sounds like Irving Fisher’s view of the Phillips curve, which I have always preferred to the NAIRU approach.  A few lines later, Laidler quotes another passage that confirms this is what Friedman had in mind.

“There was, however, a crucial difference between Fisher’s analysis and Phillips’, between the truth of 1926 and the error of 1958, which had to do with the direction of causation.  Fisher took the rate of change of prices to be the independent variable that set the process going.”  (1975 p. 12 italics in original)

I think both Friedman and I visualize the process in terms of nominal shocks having real effects.  In contrast, many Keynesians see inflation as resulting from an overheated economy.  So who’s right?  I do see why Laidler is critical of Friedman; he also claims that demand shocks initially produce higher output, and only later do prices rise.

I see a three step process.  A monetary shock (money supply or demand) causes flexible asset prices to change immediately (stocks, commodities, exchange rates, etc.)  This causes output to rise, and consumer prices and wages respond with a lag.

Recently I seem to see advantages to NGDP almost everywhere I look.  (Yes, I know; confirmation bias.)   I think Friedman made a mistake focusing on inflation.  His nominal aggregate should have been NGDP, not the price level.  In that case the nominal shock is an unexpected change in NGDP, and the real effect is a change in employment.  Inflation doesn’t have to play any causal role in the story.  This avoids the inconsistency of claiming prices are slow to rise, yet rising prices cause employment to change.  NGDP can rise almost immediately, even if many prices are sticky.  And we can model wages as responding with a lag to NGDP, not to prices.  Of course this is exactly what happens in the real world—otherwise we would have seen wages soaring in 2007-08, when inflation shot up, but NGDP growth remained subdued.

So unexpected changes in NGDP are the nominal shock and (because wages and prices are sticky) employment responds to these nominal shocks in the short run, and then moves back to the natural rate in the long run.  A very Fisherian approach, which does not need to rely on awkward assumptions about inflation only occurring at full employment, and which avoids the logical inconsistencies involved in using the price level as the indicator of nominal shocks.

In the next post I’ll use these ideas to address an issue raised in a recent Krugman post; is it possible to produce moderate inflation expectations in a liquidity trap?

PS.  The Laidler and Friedman quotations were from “Some Aspects of Monetarism Circa 1970: A View from 1994.”  In Macroeconomics in Retrospect: The Selected Essays of David Laidler.