Connect the dots

Part 1:  A new study by Martin Feldstein estimated that QE2 created an extra $2.5 trillion in stock market wealth for Americans.  It should be noted that foreign markets also rose sharply in anticipation of QE2, so my $5 trillion estimate from last year for world gains may be on the low side.  (US stock wealth is about $17 trillion; world stock wealth is closer to $50 trillion.)

To be sure, there is no proof that QE2 led to the stock-market rise, or that the stock-market rise caused the increase in consumer spending. But the timing of the stock-market rise, and the lack of any other reason for a sharp rise in consumer spending, makes that chain of events look very plausible.

The magnitude of the relationship between the stock-market rise and the jump in consumer spending also fits the data. Since share ownership (including mutual funds) of American households totals approximately $17 trillion, a 15% rise in share prices increased household wealth by about $2.5 trillion.

I conservatively assumed a 10% gain on $50 trillion, whereas Feldstein assumed 15% on $17 trillion.  Either way, the world gained a lot of wealth.

Part 2:  In August (right before rumors of QE2) Paul Krugman argued that pressure from outside pundits was one of the only ways to move that stubborn mule called the Fed:

So why am I even slightly encouraged? Because the critics did, at least, succeed in moving the focal point. Not long ago gradual Fed tightening was the default strategy; but as I said, at this point the Fed realized that continuing on that path would have unleashed both a firestorm of criticism and a severe negative reaction in the markets.

What we need to do now is keep up the pressure, so that at the next FOMC meeting the members are once again confronted by the reality that not changing course would be seen as dereliction of duty. And so on, from meeting to meeting, until the Fed actually does what it should.

I know: it’s a heck of a way to make policy. In a better world, the Fed would look at the state of the economy and do what was right, not the minimum necessary. But wishing for that kind of world is like wishing that Ben Bernanke were running the place.

And it worked!

Part 3:  Last month Ryan Avent published the following observation over at The Economist.com:

I SEE that Scott Sumner is taking a victory lap of sorts””not unearned””over the fact that views of monetary policy have come full circle since the years before the crisis. Once upon a time, the Fed was viewed as having near-absolute power over the path of the economy. Then crisis struck and many argued that the Fed had run out of ammunition and fiscal policy was required. Eventually people began arguing that the Fed could do more and should do more, thanks largely to the efforts of Mr Sumner himself.

“So what you’re saying is . . .”

I’m not saying anything, just reporting news from the blogosphere.

Part 4:  Off topic, but I am complete burned out, and have been for months.  I’ve blogged an average of eight hours a day, seven days a week, for over two years.  I’ve only kept going in recent months out of a sense of obligation to keep pushing these issues.  But now that lots of other people are saying the exact same thing, it’s time for me to take a break.  So I’ll stop blogging for a few months, unless there is some huge news story like QE3, in which case I’ll add a couple posts.  Or if someone does a hit job on my marshmallow post, I may need to briefly respond.  Otherwise I’m done for now, and will return sometime this summer.

I hoped my school would give me some support for blogging, but that’s not how things work in the real world.  Perhaps I could find a way to make some money and buy out a few courses.  I was thinking about ideas like writing a macro version of Freakonomics, or doing speaking engagements, or perhaps even consulting.

Please don’t tell me that so and so does even more blogging than me while teaching; I’m not so and so.   Here are a few reasons I’m taking a break:

1.  Like corrupt politicians resigning under pressure, I need to “spend more time with my family.”  Indeed I might want to spend a few minutes with my 11 year old before she graduates from high school.  And then there is my long-suffering wife.

2.  More time to actually read a few books for pleasure, or see some films.

3.  I do have a job.

4.  The blog has spun off a lot of activities that you don’t see.  I read lots of papers that people send me, do more speaking than before, conferences, etc.  I hope to get my book out this year.  Maybe I can write some papers.

I thought about cutting back, but blogging is like a drug addiction for me—it won’t work.  Better to go cold turkey for a while.

Of course all the other quasi-monetarists (Rowe, Beckworth, Woolsey, Hendrickson, Kantoos, etc) will continue to cover the same sort of topics that I discuss.  On the progressive side, Yglesias is very good on money.  Don’t overlook Marcus Nunes, who contributed greatly to my blog, and also has his own blog now.  His views on monetary policy are quite close to mine.

I suppose I naively thought that if my blog was successful then support would magically turn up somewhere.  But let’s face facts, most people outside the blogosphere view what we do as a cute hobby, like growing miniature Bonsai trees, or raising chinchillas for fun and profit.  For all you young academics out there, the “Wisconsin Idea” is dead; it’s all about the pubs.  But do it anyway; it’s the right thing to do.

PS.  You’re probably thinking Avent exaggerated this blog’s importance by a factor of 100, because he’s a nice guy.  I agree.  So go redo the math and tell me what I’m worth.

PPS.   I’ll occasionally look at the comment section.   Long-time commenters can always ask me questions about current events, and I’ll try to give a quick reaction.

PPPS.  Christina Romer is now my official spokesperson on all matters relating to monetary policy and payroll taxes.

Mankiw and Weinzierl on stabilization policy

Gregory Barr sent me an excellent paper by Greg Mankiw and Matthew Weinzierl :

Conclusion

The goal of this paper has been to explore optimal monetary and fiscal policy for an economy experiencing a shortfall in aggregate demand. The model we have used is in many ways conventional. It includes short-run sticky prices, long-run flexible prices, and intertemporal optimization and forward-looking behavior on the part of firms and households. It is simple enough to be tractable yet rich enough to offer some useful guidelines for policymakers.

One clear implication of the analysis is that how any policy is used depends on which other policy instruments are available. To summarize the results, it is fair to say that there is a hierarchy of instruments for policymakers to take off the shelf when the economy has insufficient aggregate demand to maintain full employment of its productive resources.

The first level of the hierarchy applies when the zero lower bound on the short-term interest rate is not binding. In this case, conventional monetary policy is sufficient to restore the economy to full employment.  That is, all that is needed is for the central bank to cut the short-term interest rate. Fiscal policy should be set based on classical principles of cost-benefit analysis, rather than Keynesian principles of demand management. Government consumption should be set to equate its marginal utility with the marginal utility of private consumption. Government investment should be set to equate its marginal product with the marginal product of private investment.

The second level of the hierarchy applies when the short-term interest rate hits against the zero lower bound. In this case, unconventional monetary policy becomes the next policy instrument to be used to restore full employment. A reduction in long-term interest rates may be sufficient when a cut in the short- term interest rate is not. And an increase the long-term nominal anchor is, in this model, always sufficient to put the economy back on track. This policy might be interpreted, for example, as the central bank targeting a higher level of nominal GDP growth. With this monetary policy in place, fiscal policy remains classically determined.

The third level of the hierarchy is reached when monetary policy is severely constrained. In particular, the short-term interest rate has hit the zero bound, and the central bank is unable to commit to future monetary policy actions. In this case, fiscal policy may play a role. The model, however, does not point toward conventional fiscal policy, such as cuts in taxes and increases in government spending, to prop up aggregate demand. Rather, fiscal policy should aim at incentivizing interest-sensitive components of spending, such as investment. In essence, optimal fiscal policy tries to do what monetary policy would if it could.

The fourth and final level of the hierarchy is reached when monetary policy is severely constrained and fiscal policymakers rely on only a limited set of fiscal tools. If targeted tax policy is for some reason unavailable, then policymakers may want expand aggregate demand by increasing government spending, as well as cutting the overall level of taxation to encourage consumption. In a sense, conventional fiscal policy is the demand management tool of last resort.  (Italics added.)

I agree, and would just add a few observations:

1.  Between the Big Bang and 2011, there has never been a central bank that promised to create inflation, and was not believed.  At least not in the Milky Way.  So there is really no need to go beyond step two.

2.  If we add sticky wages to the model, then I think that the investment tax credit could be augmented with a payroll tax cut–employer share only— as a way of moving the labor market closer to its flexible wage–Walrasian equilibrium level of employment.

As you know, I’d like to eliminate the inflation and the price level from business cycle theory, and use NGDP as my nominal aggregate (where the price level is currently used, such as the Fisher equation and the AS/AD diagram.)  Real wages would be nominal wages over nominal GDP per capita.  A negative nominal shock like 2008-09 would cause (sticky) nominal hourly wage rates to rise as a share of NGDP, causing fewer hours worked. (Hours worked replace RGDP in the AS/AD model.)  Since prices can be affected by both supply and demand shocks, they are an unreliable indicator of nominal shocks.

I just noticed that Paul Krugman commented on this paper:

Now bear in mind that in order to make a commitment to inflation work, central bankers not only have to stand up to the pressure of inflation hawks “” which is much harder when you’re having to testify to Congress than it is if you’re a Harvard professor “” but, even harder, they need to convince investors that they’ll stand up to that pressure, not just for a year or two, but for an extended period.

Now, the thing about fiscal expansion is that people don’t have to believe in it: if the government goes out and builds a lot of bridges, that puts people to work whether they trust the government’s commitment to continue the process or not. In fact, to the extent that there’s some Ricardian effect out there, fiscal policy works better, not worse, if people don’t believe it will continue.

On a personal note: I supported fiscal expansion in 2008-2009 precisely because I didn’t believe that the kind of commitment-based unorthodox monetary policy that works in the models could, in fact, be implemented in practice. Nothing I’ve seen since has changed my views on that subject.

Where does one start?  With the fact that the Dems controlled Congress during the Great Recession and would have welcomed more monetary stimulus?  With the fact that meaningful fiscal stimulus was also not politically feasible (according to Krugman it never happened.)  With the fact that unemployment was 7.8% when Obama took office and 9.8% in November 2010, when QE2 was announced?  With the fact that rumors of QE2 in September and October 2010 affected all sorts of asset prices (including TIPS spreads) in exactly the way us quasi-monetarists predicted?  How can Krugman say nothing he’s seen has changed his views on the relative political feasibility of fiscal and monetary stimulus?  The reason the Fed didn’t do more wasn’t Ron Paul, it was pushback from regional Bank presidents within the Fed.  Oh, and Obama “forget” and left two or three seats empty for over a year.

Krugman seems to misunderstand the role of pundits.  It’s our job to explain what needs to be done, in order to make it more politically feasible.  In early 2009 politicians would have been elated if someone told them there was a way to boost AD without running up big deficits.  But they didn’t know because just about the only people making that point forcefully and loudly were us quasi-monetarists.

In contrast to Krugman, this very wise pundit does understand the role of bloggers is to push the Fed to be more aggressive:

So why am I even slightly encouraged? Because the critics did, at least, succeed in moving the focal point. Not long ago gradual Fed tightening was the default strategy; but as I said, at this point the Fed realized that continuing on that path would have unleashed both a firestorm of criticism and a severe negative reaction in the markets.

What we need to do now is keep up the pressure, so that at the next FOMC meeting the members are once again confronted by the reality that not changing course would be seen as dereliction of duty. And so on, from meeting to meeting, until the Fed actually does what it should.

I know: it’s a heck of a way to make policy. In a better world, the Fed would look at the state of the economy and do what was right, not the minimum necessary. But wishing for that kind of world is like wishing that Ben Bernanke were running the place.

The statement was made in August 2010, just days before the first Bernanke speech hinting that more needed to be done.  Who was this prescient blogger?  Click here and find out.

(And you thought it was going to be me.)

PS.  Neither the Boston Fed nor any local universities have ever asked me to present a paper on how NGDP targeting–level targeting–targeting the forecast, could have greatly reduced the severity of the asset price collapse of late 2008, the associated banking crisis, and the recession itself.  I’ve put together a persuasive group of PowerPoint slides, have honed my presentation at the AEA meetings and elsewhere, and am ready to go if anyone wants an interesting and controversial take on the Great Recession.  I’ve debated countless economists, including some pretty distinguished ones, and found no holes in my logic.  Don’t expect me to be a pushover just because I come from a small school.

Feldstein–>Glasner–>Feldstein

Here’s Martin Feldstein:

Why then the recent revival of interest in fiscal stimulus? By the fall of 2007 it became clear to many economists that the current downturn is different from previous recessions and that monetary policy would not be effective in bringing us back to full employment.

I’ve always wondered how the economic profession could have been so oblivious to the need for the Fed to increase expected NGDP growth in late 2008.  Now we find out that as early as 2007 many economists had made up their minds (for some mysterious reason) that monetary stimulus wouldn’t work in this crisis.  What is that reason?  I haven’t a clue.  We know from 1933 that unconventional monetary stimulus can create fast NGDP growth, even with near zero rates and a completely dysfunctional banking system.

Here’s a recent Financial Times letter where David Glasner (an expert on monetary history and reader of this blog) responded to one of Feldstein’s recent FT essays:

Why then is inflation “unwanted”? Mr Feldstein maintains that it would jeopardise the credibility of the Fed’s long-term inflation strategy. But it is not clear why Fed credibility would be jeopardised more by a temporary increase, than by a temporary decrease, in inflation, or, indeed, why credibility would be jeopardised at all by a short-term increase in inflation to compensate for a prior short-term decrease? The inflexible conception of inflation targeting espoused by Mr Feldstein, painfully articulated in Federal Open Market Committee minutes, led the Fed into a disastrous tightening of monetary policy between March and October 2008, while the US economy was falling into a deepening recession because of a misplaced concern that rising oil and food prices would cause inflation expectations to run out of control.

Feldstein’s worry about inflation seems hard to reconcile with his earlier views.  QE won’t work, because it won’t boost AD.  QE is bad, because it will boost inflation.  How many times have we seen that bizarre dichotomy?  Once again, QE boosts inflation if and only if it boost AD.  Do we want more AD, or not?

Of course QE2 was highly effective at boosting AD.  How do I know?  Because Martin Feldstein just told me so.  (Maybe he read Glasner’s letter.)  Perhaps we ought to have done that highly effective QE back in 2008, when we really needed it.  Instead we had nearly every major macroeconomist saying that monetary policy was out of ammo, and we should either do fiscal stimulus, or do no stimulus at all.  What a sorry period that was for the field of macroeconomics.

How about setting up a blue ribbon AEA panel to investigate why nearly the entire economics profession (excluding a few people like Robert Hetzel and some of my fellow bloggers) had a collective brain freeze between September 2008 and March 2009.

HT:  Statsguy

Yes, QE2 did happen, and it (sort of) worked

I say “sort of” because it was obviously too little, too late.  But it’s now pretty clear that it did have an expansionary impact on both nominal and real aggregates.  Let’s start with the “did it happen” question.  Here’s Arnold Kling:

In the current setting, it appears that economic activity is expanding and inflation is higher than it had been. One may choose to interpret this as resulting from the Fed’s quantitative easing. However, I am not signing onto that one. I recall reading recently that QE 2 was basically canceled out by offsetting changes in Treasury funding operations. That is, as the Fed bought more long-term bonds, the Treasury issued more long-term bonds relative to short-term securities. So we are left with the channel that the Fed announced a higher intended path for nominal GDP, and this was self-fulfilling. Strikes me as a very difficult proposition to prove or disprove.

I also recall reading that QE2 was cancelled out, but as the following graph shows the base is up $300 billion since November:

Of course switching long and short term bonds does almost nothing (this was once called operation twist.)  QE is all about increasing the base.

As far as the effects being “difficult to prove,” nothing could be further from the truth.  Asset markets of all kinds responded very strongly to Fed rumors of QE2 in September and October 2010.  Those sorts of event studies aren’t proof, but they’re the closest we get in macro—far more significant than most econometric studies published in elite journals.

I’m constantly surprised by people’s reluctance to accept the efficacy of monetary stimulus.  When a (fiat) central bank is bound and determined to raise NGDP, it will never fail.

Everyone from Jim Hamilton to Paul Krugman to Martin Feldstein is talking about the recent acceleration of growth.  But when I suggested this was evidence that QE2 might be working, Mark Thoma insisted that this couldn’t be true, as modern macroeconomics has established that monetary policy operates with significant lags.  My initial reaction was “that’s what’s wrong with modern macro.”

Yes, I’m out of the mainstream.  But it’s hard to find a more mainstream economist than Martin Feldstein, and he insists that QE2 is responsible for the recent upswing.  We had a huge stock market rally triggered by rumors of QE2, and then in 2010:4 we saw the most rapid growth in real final sales in more than 2 decades.  (Nominal final sales was also very strong, and is actually the better indicator–but everyone else seems to want to look at real variables.  Note the focus on weak real GDP in the UK during Q4.)

In fact, Feldstein underplays the impact of QE2, as he only considers the impact of higher wealth on consumption.  But the increase in asset prices produced by QE2 also raises investment.  The depreciation of the dollar caused by QE2 raises exports.  Indeed if QE2 produces economic growth, it also slightly reduces cutbacks of state and local government spending.  BTW, it’s now obvious that S&L spending is so endogenous that it might as well be lumped in with the private sector, not treated as a sort of “fiscal policy” that can be waved around like a magic wand.

In addition, Feldstein actually underestimates the evidence in favor of QE2 being the cause of the recent acceleration in growth.  It’s not just that stocks rose at roughly the same time.  As I already noted, stocks clearly were rising in response to specific rumors of QE2 in September and October 2010.

In Kling’s post it’s a bit hard to figure out whether he is skeptical that monetary stimulus can boost nominal variables, or real variables.  He provides this quotation from a Reinhart and Reinhart paper:

 Second, changes in monetary policy can only change real interest rates temporarily.

Yes, some people argue that real interest rates are an important transmission mechanism.  I doubt they matter much, but even if they did, note that 5 year TIPS yields have fallen into negative territory.  In my view monetary policy works by raising expected future NGDP, and current asset prices.  Kling then argues:

The point of the Reinhart and Reinhart paper is to demonstrate empirically that central bankers can only make a big difference if they make really big policy changes.

The important difference isn’t between big and small changes, but between temporary and permanent effects.  We know (from asset market responses) that even quarter point changes in the fed funds target can have a huge impact on the stock market.  These big effects occur precisely when the policy shocks lead to a change in the expected future path of policy.  When they don’t, they have little effect.

In the first Kling quotation I provided he expresses skepticism about merely psychological aspects of Fed policy.  In fact, we know that expectations are far more important than actual changes.  I’ll finish with a couple easy thought experiments that demonstrate why expected future policy matters:

1.  The central banks doubles the monetary base, and the change is expected to be permanent.  Assume it occurred because a new populist government takes power in Bolivia.

2.  The Fed doubles the monetary base right before Y2K hits, and announces that the money will be withdrawn from circulation 4 weeks later.  Their intention is to make sure enough liquidity is available in case ATM machines break down on 1/1/00.

In case 1, nominal asset prices double, in case 2 they hardly budge.  Yet in both cases the monetary base doubles.  Why the difference?  Purely psychological factors; different expectations about future monetary policy.

Case 2 is sort of like what happened in the 2008 crisis.  In this case the Fed could leave this extra money in circulation for quite some time, because of a combination of IOR and near zero rates.  But if Bernanke announced that the Fed was going to permanently abandon IOR, and planned to leave the base at twice its normal level even when T-bill yields rose back up to normal levels, inflation would explode almost immediately.

Commenters:  I beg you not to ask me one more time to explain in a “mechanical” way how QE2 causes NGDP to rise.  Hint: it has nothing to do with banks.

PS.  Just to be clear, I am not expecting miracles from QE2.  At the time I guesstimated that the markets had raised their 2011 NGDP growth forecasts from about 3.5% to 4.0% in the dog days of summer, to about 5.0% to 5.5% after QE2 was announced in early November.  I still think we are in that ballpark, but obviously a collapse of the House of Saud or another euro crisis would shake things up.  I’d still like to see about twice the monetary stimulus that we got, even though (paradoxically) I think we are gradually transitioning from an aggregate demand shortfall to an aggregate supply shortfall.  But I continue to believe that more AD would boost the supply-side of the economy, mostly by speeding the removal of 99 week UI.

PPS.  And no, $1200 billion in QE would not have provided “twice the stimulus.”  It’s all about expectations.

What successful monetary policy looks like

A couple items yesterday got me thinking again about Swedish monetary policy.  Here’s a comment Michael Bordo made at The Economist’s “By Invitation”:

If the central bank is successful in maintaining a stable and credible nominal anchor then real macro stability should obtain. But in the face of real shocks central banks also need to follow short-run stabilisation policies consistent with long-run price stability. The flexible inflation-targeting approach followed by the Riksbank and the Norges Bank seems to be a good model that other central banks like the Federal Reserve, should follow.

I strongly agree, but nevertheless was a bit surprised to see Michael Bordo make this argument.  I recall that he had been somewhat more skeptical about QE2 than I was, and I pegged him as being a bit more conservative, or hawkish on inflation.  In previous posts I argued that the Riksbank engineered a more rapid reconomic recovery precisely because they were more stimulative than the Fed, ECB, and BOJ.  So why do we both agree on Sweden?

I think it was Tolstoy who once said:

Successful central banks are are all alike, every unsuccessful central bank is unsuccessful in its own way.

Or maybe it was Dostoevsky.

At any rate, in previous posts I’ve argued that unsuccessful policy makes the stance of monetary policy very difficult to read.  If you are successful in stabilizing inflation expectations, then interest rates might be able to provide a reasonably reliable indicator of the stance of monetary policy.  The same is true of the monetary base.  On the other hand if you run a highly deflationary monetary policy then interest rates may fall to very low levels.  Tight money might look “easy.”  Deflation can also cause the real (and nominal) monetary base to rise sharply, as people and banks hoard base money.   Thus a deflationary monetary policy might look excessively expansive to some, and excessively contractionary to others.  The policy instruments that economists rely on become much less informative under extreme conditions.

Stefan Elfwing recently sent me the newest monetary policy report from the Riksbank.  Here (p. 30) they contrast recent trends in Swedish and US monetary policy:

In December and January, the Riksbank’s final extraordinary loans to the banks (which totalled SEK 5.5 billion) matured. This meant that all of the extraordinary measures implemented by the Riksbank during the crisis have now been completely wound up. As a result of this, the Riksbank’s balance sheet total has come close to the level prevailing before the crisis in 2008. The remaining difference in the balance sheet total is due to the strengthening of the foreign currency reserve carried out by the Riksbank in 2010.

In conjunction with its monetary policy meeting in November, the Federal Reserve announced that it would start to buy government bonds in an amount of up to USD 600 billion until the end of the second quarter of 2011. These purchases are proceeding as planned and are contributing to the continued increase of the Federal Reserve’s balance sheet total.

In addition, the Riksbank has actually been raising interest rates in recent months, and just announced an intention to accelerate the pace of rate hikes.  So how can I argue that the Riksbank has pursued a more stimulative monetary policy than the Fed?  After all, the Fed is continuing its zero rate policy, and just recently announced another $600 billion in QE, to add onto the roughly trillion dollars of assets purchased in 2008-09.

In my view the more rapid return to normalcy in Sweden reflects the success of Riksbank policy during 2008-09.  But how do we measure the policy stance of the Riksbank, if both interest rates and the monetary base are partly endogenous?  I favor NGDP expectations, but I’m obviously in the minority.  Fortunately there are two other widely accepted indicators that also point to the expansive nature of Riksbank policy.

When the world crisis became severe in late 2008, the Riksbank allowed the krona to depreciate sharply against the euro:

This cushioned the blow from sharply declining world demand for Swedish exports, and helped keep Swedish inflation close to the Riksbank’s 2% target during 2009-10.

And all this was done without any loss in credibility of the Riksbanks’ 2% inflation target, as evidenced by the fact that yields on 10 year Swedish government bonds continue to closely track German yields.

One argument against my hypothesis is that Sweden did suffer a severe recession in 2009, with real GDP falling slightly faster than the eurozone.  However it is important to keep in mind that just as an individual worker or firm cannot shield itself from unemployment via complete wage and price flexibility, the same argument applies to small open economies that are exposed to a severe worldwide demand shock.  Sweden’s goods exports are close to half of GDP, if one counts goods and services they are well over 50% of GDP.  Swedish goods exports plunged more than 15% in late 2008 and early 2009.  There is simply no way Sweden could avoid a severe recession under those world economic conditions, regardless of whether they did NGDP targeting or not.

You might ask why the big depreciation of the krona didn’t prop up Swedish exports.  It may have to some extent, but consider the following example.  Say a casino project in Vegas orders a central air conditioning unit from Sweden.  Now assume that the construction project gets canceled because of economic problems in the US.  How much would Sweden have to cut the price on the AC unit to prevent the sale from being canceled?  Would any price cut be enough?  Sticky wages and prices in the aggregate turn nominal shocks into real recessions.  But unfortunately once that happens, price and wage flexibility at the micro level can only do so much.

Here’s some evidence from the Swedish report that supports the preceding hypothetical:

During the crisis, exports of investment and input goods in particular fell dramatically. These sectors are now primarily responsible for the strong increase in Swedish exports. The [recent] development of exports is connected with the increase of investments we now see in large parts of the world.

The depreciation of the krona might have bought Volvo, Saab and Electrolux a few more sales of cars and vacuums, as those prices fell relative to their German competitors.  But modern sophisticated economies like Sweden and Germany tend to focus on complex capital goods and inputs, which depend less on price than on demand conditions in their export markets.

If Sweden suffered a sharp fall in GDP during 2009 (slightly faster than the eurozone), what evidence do I have that monetary stimulus was successful?  I don’t have any conclusive evidence, but the report does indicate that Swedish GDP is expected to rise 5.5% in 2010 and 4.4% in 2011.  Even Germany, often regarded as the most successful of the eurozone economies, is only expected to grow 3.5% and 2.6%, that’s almost 4% less over two years.  Another interesting comparison is Denmark, which like Sweden suffered a sharp fall in GDP in 2009, and yet has a much slower recovery (2.0% GDP growth in both 2010 and 2011.)

Why did the krona rebound in 2010?  There could be a number of reasons, including sound public finances.  But one additional factor may have been the strong economic recovery in Sweden.  Recall that in late 2008 real interest rates soared in the US, but then plunged in 2009.  The original increase was partly due to tight money, and the later decrease may have reflected the weak economy in 2009.  It wouldn’t surprise me if a similar short- and long run dynamic occurred with the Swedish krona.

The Swedish report is a model of elegance, logic, and transparency.  I couldn’t help wondering why our Fed could not produce similar reports.  They clearly lay out their policy goals (2% inflation and output stability), their expectations for the economy, and the expected path of their policy instrument.  When members dissent, the reasons are clearly laid out and explained (as in the abbreviated report):

Forecasts for inflation in Sweden, GDP and the repo rate

Annual percentage change, annual average

2009 2010 2011 2012 2013
CPI -0.3 1.3 (1.3) 2.5 (2.2) 2.1 (2.0) 2.6 (2.6)
CPIF 1.9 2.1 (2.1) 1.9 (1.7) 1.5 (1.4) 2.0 (1.9)
GDP -5.3 5.5 (5.5) 4.4 (4.4) 2.4 (2.3) 2.5 (2.4)
Repo rate, per cent 0.7 0.5 (0.5) 1.8 (1.7) 2.8 (2.6) 3.4 (3.3)

Note. The assessment in the December 2010 Monetary Policy Update is shown in brackets.
Sources: Statistics Sweden and the Riksbank

Forecast for the repo rate.  Per cent, quarterly averages

Q4 2010 Q1 2011 Q2 2011 Q1 2012 Q1 2013 Q1 2014 
Repo rate 1.0 1.4 (1.4) 1.7 (1.6) 2.5 (2.2) 3.2 (3.1) 3.6

Note. The assessment in the December 2010 Monetary Policy Update is shown in brackets.
Source: The Riksbank

Deputy Governor Karolina Ekholm and Deputy Governor Lars E.O. Svensson entered a reservation against the decision to raise the repo rate by 0.25 percentage points to 1.5 per cent and against the repo rate path of the main scenario in the Monetary Policy Report.They preferred a repo rate equal to 1.25 per cent and a repo rate path that then gradually rises to 3.25 per cent by the end of the forecast period. Such a repo rate path implies a CPIF inflation closer to 2 per cent and a faster reduction of unemployment towards a longer-run sustainable rate.

Sweden shows the importance of focusing on your policy goals, and doing what is necessary to achieve those goals.  Michael Bordo had some very good observations in his aforementioned essay:

BASED on the history of central banking which is a story of learning how to provide a credible nominal anchor and to act as a lender of last resort, my recommendation is to stick to the tried and true””to provide a credible nominal anchor to the monetary system by following rules for price stability. Also central banks should stay independent of the fiscal authorities.  .  .  .

The historical examples of the Wall Street crash of 1929 and the bursting of the Japanese bubble in 1990 suggests that the tools of monetary policy should not be used to head off asset-price booms. Following stable monetary policy should avoid creating bubbles. In the event of a bubble however, whose bursting would greatly impact the real economy, non-monetary tools should be used to deflate it. Using the tools of monetary policy to achieve financial stability (other than lender-of-last-resort actions) weakens the effectiveness of monetary policy for its primary role to maintain price stability.

Thus a strong case can be made for separating monetary policy from financial stability policy. The two should be separate authorities which communicate closely with each other. However if the institutional structure does not allow this separation and requires the FSA to be housed inside the central bank then it should use tools other than the tools of monetary policy to deal with financial stability concerns. The experience of countries like Canada, Australia and New Zealand which largely avoided the recent crisis, shows that some countries got the mix between monetary and financial policy right.

Even if Mike Bordo and I don’t see exactly eye to eye on what went wrong in America, we both recognize successful monetary policy when we see it.  Set a nominal target, and do what is necessary to hit the target.  Let others worry about the financial industry.

PS. As in the UK, interest rate changes distort the CPI in Sweden.  Thus the CPIF is the better indicator, as it removes the effects of interest rates on mortgage costs.