In philosophy the “god of the gaps” hypothesis suggests that while science can explain most phenomena, certain seemingly inexplicable events (the origin of life, the universe, the laws of nature, Morgan’s comments, etc) must be attributed to a deity.  In this recent post, I argued Keynesians were using a similar argument for fiscal stimulus.

By the 1990s, most macroeconomists attributed changes in the expected level of nominal spending to monetary policy, and this made fiscal stabilization policy redundant, a sort of 5th wheel.  During the recent crisis, some Keynesians have attempted to revive the arguments for fiscal stimulus, arguing that monetary policy was ineffective at the zero rate bound.  When a group of quasi-monetarists reminded them that there are all sorts of unconventional monetary policy tools, the Keynesians argued that these tools would only be effective if credible, and it was unlikely that markets would believe central bank promises to inflate.  Then the quasi-monetarists showed that markets did react to rumors of QE2 in a way that implied the policy was credible.  Once again, Keynesian fiscal stimulus would seem to have no role to play.

Keynesian were not going to give up easily.  The next argument was that while monetary stimulus can be effective, central banks were afraid to aggressively pursue this sort of policy.  In that case a “gap” would open up between the central bank’s forecast of NGDP, and their implicit target.  Fiscal policy can fill that gap.  In essence, they argue that fiscal policy is useful in direct proportion to the degree to which monetary policy is incompetent (in the Svenssonian sense of failing to equate the policy forecast and policy goal.)  And to give credit where credit it is due, monetary policy has been strikingly incompetent over the past 30 months.

[As an aside, this explains why back in 2009 both the right and left thought the other side was returning to the dark ages.  The right recalled that Keynesian fiscal stimulus had been expunged from graduate education for nearly 30 years, as the fiscal multiplier is zero under an inflation targeting regime.  The left couldn’t understand why the right denied that fiscal stimulus could be effective in a world where the central banks had obviously allowed inflation to fall below target.]

Before addressing some questions by Ryan Avent, I’d like to tell a brief story that might help explain why I think Keynesians are putting too much weight on the “gaps” argument.  Not that the argument is wrong, but rather that it is much less right than it seems at first glance.

Years ago I used to get into arguments with our dean, who insisted that the marginal cost of admitting an extra student to Bentley was essentially zero.  He relied on the common sense notion that most classes had at least a few empty seats, and hence one extra student could be squeezed in at virtually no additional cost.  Here’s why I think that argument is wrong.  Bentley caps classes at 35.  For simplicity, assume it costs $35,000 in salary and benefits for each professor-taught course.  (I.e. profs earn $140,000 in total comp., and teach 4 sections.)  For each student added by Bentley, there is a 1/35 chance that the admission will trigger the need for an extra section.  In that sense the dean was right.  It’s quite likely that the marginal cost would be zero.  On the other hand, if an extra class was needed the cost would be $35,000.  Since we have no idea when and where students will trigger an extra section being offered, the expected cost of an extra student is (1/35)*$35,000, which equals $1000.  And that’s also the average cost.  There’s no “expected gap” to be filled, even if there are occasionally some actual gaps that can be filled at no cost.

The Keynesian gap argument is not as weak, because we may be able to observes gaps in the aggregate economy more easily than in class size.  But I still think they are making an analogous mistake.  For instance, let’s go back to the argument (which I agree with) that the Fed has recently allowed the forecast NGDP growth rate to fall below their policy goal.  For simplicity, assume the Fed’s goal is 6% NGDP growth during the recovery, and the forecast is 4.5%.  So there is a 1.5% gap that might be filled by fiscal stimulus.  And furthermore (so the Keynesians argue) if fiscal stimulus does try to fill this gap, the Fed won’t take affirmative steps to neutralize the stimulus.

Now let’s ask why the Fed allows this 1.5% growth gap.  Perhaps it is fear that unconventional stimulus is a dangerous weapon, and that we might overshoot to high inflation.  (Recall the monetary base has more than doubled.)  The next question is; how should we interpret that caution?  Does that mean the Fed has a de facto 4.5% NGDP target?  When I talk to Keynesians, I get the feeling that they differentiate between situations where the Fed is “doing nothing” and where the Fed is “doing something.”  Thus the Fed would not do unconventional stimulus to push NGDP growth above 4.5%, but if fiscal stimulus pushes it above 4.5% (but below 6%) the Fed would not pull back to slow the economy.  They will allow faster growth, but they won’t try to cause faster growth.

This is where I begin to part company with the Keynesians.  I believe it’s better to think in terms of the Fed always “doing something.”  This is probably easier to explain with an example.  During the spring of 2010 NGDP growth slowed, perhaps due to dollar hoarding following the Greek/euro crisis.  Keynesians argued for more fiscal stimulus, and made the quite plausible assumption that the Fed would not try to offset the effects of fiscal stimulus.  One particularly sophisticated argument was that Bernanke didn’t have enough support (at that time) to push for more stimulus, but that the inflation hawks also lacked enough power to tighten policy after a fiscal boost.  Monetary policy was adrift in the gap.

How do things look today?  If the Keynesians had gotten their way in the spring and early summer of 2010, then Congress would have debated a new fiscal stimulus for a few months, and passed it during the second half of 2010.  Would this have boosted NGDP growth in 2011?  I’m skeptical, as it turns out that the monetary policy “gap” wasn’t that big.  The Fed did move aggressively in November, and indeed moved in September, if you recall that expectations of monetary stimulus are the same thing as actual monetary stimulus, even in the new Keynesian model.  If Congress had done another $400 billion stimulus, it seems unlikely that the Fed would have moved until they had a chance to see whether the fiscal boost would do the trick.  In that case the argument for a positive fiscal multiplier is essentially that fiscal stimulus is more powerful than monetary stimulus.  But in the famous cases where fiscal and monetary stimulus worked in opposite directions (1968-69 and 1981-82), monetary stimulus seemed much stronger.

Here’s my point.  In the spring of 2010 even I had trouble coming up with persuasive arguments against the Keynesian proposals for fiscal stimulus.  Even I had to admit that it was unlikely that the Fed would try to sabotage fiscal stimulus when the recovery was so weak.  But as things played out in reality, it seems unlikely that a fiscal boost would have helped all that much, not because it would have been intentionally sabotaged, but because it would have taken the Fed off the hook, allowing them to do nothing in the fall of 2010.

It’s a mistake to think the Fed is ever really in a situation of “doing nothing.”  We’ve seen them do several mid-course corrections (March 2009 and November 2010) when the recovery was unacceptably weak.  During early 2010 policy was de facto contractionary, as lots of Fed officials talked about “exit strategies.”  If, as seems plausible, these back and forth swings of monetary policy are reactions to expected NGDP growth, then it would be more accurate to say that there is no significant policy gap, but rather the Fed is (for whatever reason) targeting NGDP at a lower level than they would if they could rely on their tried and tested fed funds targeting approach.  They are like that 85 year old lady driving her Camry very slowing, with one foot on the brake, because she read scary news reports of “sudden acceleration” problems in Toyotas.  If Morgan Warstler gets right on her tail with his big SUV, and starts honking, she’ll get even more nervous and drive even slower.  (Sorry Morgan, I’m using you as a symbol of fiscal stimulus.)

In this comment section, Andy Harless presented one of the best arguments for fiscal stimulus:

I still believe the “god of the gaps” argument. (In fact, I may be the only one who has made the argument explicitly. Krugman and others kind of dance around it but don’t quite come out and say it.) Moreover, I believe that we are seeing it in action, although it will never be possible to prove counterfactuals about what Fed would have done. But we saw the tax compromise last year, and we saw that forecasters revised their forecasts as a result and that subsequent economic reports were consistent with that increased optimism, and a lot of people thought that the Fed would cut QE2 short because of the improvement. But subsequent Fedspeak makes it clear that such a cutting short is highly unlikely. I’d say that we are in a gap and that Almighty Fiscal Policy is filling part of it.

I’m not going to argue Andy is wrong, rather I’ll argue he is less right than he thinks.  First, Tyler Cowen often notes that the Fed is normally the “last mover” in the stabilization game.  Congress acts infrequently, whereas the Fed meets every 6 weeks.  In the case Andy discusses, Congress became the last mover for a variety of unusual reasons:

1.  QE2 occurred around election day.  This was partly because the recovery had stalled, and partly because Bernanke was waiting for more support (from the new Obama appointees) on the Board of Governors.

2.  The GOP made huge gains, necessitating a compromise to prevent a huge tax increase in 2011.  Obama was forced to give in on tax cuts for the rich, and in exchange was able to secure more fiscal stimulus via a payroll tax cut.

3.  Because the fiscal stimulus happened to occur right after QE2, and because the Fed likes to “wait and see” after a dramatic policy shift, we can be reasonably sure the Fed won’t immediately negate the tax cuts.

I would also agree that the fiscal stimulus has been somewhat effective.  But the reasons I’d give are a bit different from those of the Keynesians.  I believe cuts in MTRs boost the supply-side of the economy, which slightly raises the Walrasian equilibrium real interest rate.  This effectively makes monetary policy (even at the zero bound) slightly more expansionary.  I don’t believe spending increases have any supply-side boost, and I think their effect on the Walrasian real rate is smaller.  Hence part of the higher expected growth is a direct supply-side effect, part is the indirect effect on monetary policy, and perhaps another part is that if we exit the liquidity trap more quickly, the Fed will be more comfortable with slightly higher NGDP growth, as they can then use conventional tools.  No more 85 year-old lady driving the economy.

And if Keynesians insist on defining “monetary policy” as changes in interest rates, then the tax cuts probably did lead to tighter money.  Woodford argued the Fed should promise to hold rates at zero for an extended period.  But the fiscal boost seems to have moved the expected date of Fed rate increases closer to the present.  Unlike Woodford, I don’t necessarily see that as bad news, as it also indicates that markets think the economy will recover more quickly.  So I’m not going to argue against this particular fiscal stimulus.  All I’ll say is that there was a bit of luck (avoiding the usual last mover problem) and that it was effective partly for supply-side reasons.  (I won’t even attempt to defend that argument here, as it’s already an over-long post.)

This post was motivated by a Ryan Avent post, which asked me to respond to three arguments for fiscal stimulus.  I’ve responded to his second argument.  Here’s his third:

Finally, American government debt is extremely cheap during some severe recessions (like this one), and useful as a monetary tool. Resources and labour are also quite cheap during a downturn and slow recovery. If we’re anxious to minimise the cost of public investments, there seems to me to be a strong case for building a public investment project pipeline that can be accelerated during periods of economic weakness. Save the taxpayers money by borrowing and hiring when the demand for loans and labour is low.

I agree with this argument.  Projects such as infrastructure should meet a cost/benefit test.  Because real rates are lower during recessions, more infrastructure will pass that test during recessions.  But this isn’t how American states behave.  California spends money like a drunken sailor when the capital gains revenues pour in from Silicon Valley, and everything gets put on hold when the bubble collapses.  (BTW, for all you leftists who think the housing bubble shows capitalism doesn’t work, note that our governments are just as irrationally exuberant.)  Yes, I’d love to see our fiscal regime become more like Singapore, but it would be far easier to reform our monetary regime to make fiscal stimulus superfluous, then it would be to reform our dysfunctional fiscal regime.  I agree with Ryan’s logic; I just don’t see it happening.

If the states don’t save money in the good years, they have nothing to spend in the bad years.  At this point fiscal advocates call on the deus ex machina of federal spending.  But the federal government’s not good at quickly implementing shovel-ready projects; in our system that’s mostly done at the state level.  Plausible federal projects, like high speed rail, are far from being shovel-ready.  (There was a proposal to build high speed rail from Madison to Milwaukee, now cancelled.  Having grown up in Madison I can assure you no one would have used that high speed rail service.  Normal people do the very easy 75 minute trip by car, and poor people take Badger Bus, much cheaper than high speed rail.)

Ryan Avent also argued:

Mr Sumner suggests that the Fed controls the glide path, such that any fiscal boost will be offset by monetary policy and will therefore have a multiplier of zero. I don’t quite agree, for a few reasons. First, sometimes the Fed messes up, as it did in 2008. If Congress had passed a massive, immediate stimulus measure to go along with TARP, I believe Mr Sumner would agree that it would have done some good. He would prefer the Fed not to mess up, but given that the Fed will sometimes mess up, strong automatic stabilisers strike me as a very nice thing to have.

The honest answer is I don’t know, but here’s a few reasons I am skeptical:

1.  Fiscal stimulus is slow.  It wouldn’t prevent the initial slump, and the actual date of passage (early 2009) is about as fast as thing happen in the US.  But by that time it was obvious monetary policy had also failed.  The Fed knew it was behind the curve.  So Avent’s argument is that fiscal authorities were willing to act more aggressively than monetary authorities in early 2009.  The argument is (presumably), that a bigger fiscal stimulus bill would not have led the Fed to forgo QE1 in March 2009.  Maybe.  The argument is that no stimulus bill would not have forced Bernanke to pull out the nuclear option, level targeting, which is likely to be highly effective.  Maybe.  The argument is that the actual fiscal stimulus produced benefits in the form of faster recovery, which outweighed its costs (a big future deadweight burden on the economy, through higher taxes.)  Maybe.

2.  Given all this uncertainty, I can’t argue Avent is definitely wrong.  If I had my way the fiscal stimulus would have involved the elimination of the employer share of payroll taxes in 2009.  That’s effectively a 7.65% wage cut that doesn’t affect worker-take-home pay at all.  It essentially neutralizes the negative impact of falling NGDP combined with sticky wages.  Then I’d tell the Fed to get its act together and make sure it had enough monetary expansion in place to take over in 2010, once the taxes went back to normal.  I seem to recall that Singapore and also a few European countries do this sort of thing.

3.  I hope people reading this post will understand why even if I am wrong, we’ve got to stop building models of fiscal stimulus that rely on ever more epicycle-type arguments, and just get on with implementing a simple monetary regime of targeting the &%$@#%$ nominal GDP forecast, level targeting.

PS.  Readers who skip my comment sections can sample Morgan here at 2/10, 7:07am and 2/10, 13:23pm.  If only I could combine Morgan’s Hunter S. Thompson-like gonzo style with my knowledge of macro, I could be the Krugman of right-wing blogging.

Here’s what Tyler Cowen had to say back on November 10th, a week after QE2 was announced:

I’m unhappy with claims that “we’re not doing enough” and that therefore this is no test of the idea of monetary stimulus.  This is what QEII looks like, filtered through the American system of political checks and balances.  And if it looks small, compared to the size of our problems, well, monetary policy almost always looks small compared to its potential effects.  I’m willing to consider this a dispositive test and I am very curious to see the results.

Is it too soon to see the results of this “dispositive test?”  In one sense it’s far too late.  Monetary policy should target NGDP growth expectations, and we saw in the run-up to QE2 that growth expectations were rising rapidly on hints of QE2.  We don’t have NGDP futures markets, but based on things like stock and commodity prices, and TIPS market inflation expectation, I’d guess expected NGDP growth for 2011 rose from around 3.5% to 4.0% in August to around 5.0% to 5.5% in November.  At the time I argued that this was quite good news, although we actually needed about twice as much monetary stimulus.  Unfortunately, I’m just about the only person in the world (with the possible exception of Robin Hanson) who evaluates macro policy on that basis.  Most want to see how it plays out in the real world.

Some would argue it is too early to see the effects in the real world, citing “long and variable lags” in monetary policy.  As you know, I don’t entirely buy the lag argument.  I think it reflected misidentification of monetary shocks by the monetarists (and Keynesians as well.)  And the asset markets seem to agree with me.  For instance, when policy was very volatile during the 1930s, monetary shocks led to movements in asset prices that were highly correlated with contemporaneous movements in industrial production.  That shouldn’t happen with long and variable lags.

Of course there is a distributed lag, as output such as the construction of new office buildings requires careful planning.  Asset prices respond immediately to monetary shocks, whereas some types of output respond almost immediately, but the peak impact may be many months out into the future.  So we don’t have enough data yet to see the peak impact.  Here’s what we do know; starting with bad news, then the good news:

Bad news:

1.  Real and nominal GDP growth was disappointing in 2010:4.  The media called the 3.2% RGDP growth a slightly positive development, but the 3.5% NGDP growth was very disappointing.

2.  The payroll numbers have been disappointing; although it’s possible the snowstorms impacted the data.

Good news:

1.  The final sales number (both real and nominal) was quite strong, somewhere around 7% in 2010:4.  The real number was the strongest since the 1980s.

2.  The unemployment rate fell by 0.8 percentage points in the two months after QE2 was announced, the sharpest two month fall since 1958.  As with the payroll number, there are questions about the accuracy of this data.

3.  The ISM manufacturing activity number for January was the highest since 2004.

4.  The ISM manufacturing employment number for January was the highest since 1973.

5.  The ISM exports number for January matched May 2010, and was otherwise the highest since 1988.

6.  The ISM services number for January showed the fastest growth since August 2005.

My hunch is that the truth is somewhere between the two extremes, and we are still on course for 5.0% to 5.5% NGDP growth.  BTW, NGDP growth (or nominal final sales growth) is of course the only test of the efficacy of monetary stimulus at the zero bound.  RGDP growth is useful for a different question; to decide whether stimulus of any kind was needed.  If the NGDP growth is mostly inflation and not much RGDP growth, it would suggest that neither monetary nor fiscal stimulus was appropriate, rather labor market and tax reforms would have been called for.  So far the data shows mostly real output gains, and relatively low inflation.

Please remind me to do this test about every three months.  I may forget because I don’t think it is important.  I already know the only answer that matters to me.  But it is obviously important in terms of how the rest of the world will evaluate the ideas we quasi-monetarists have been peddling for the last few years.  So far so good; keep your fingers crossed.

As you may know, both real and nominal GDP growth were a bit disappointing in the fourth quarter, especially nominal growth.  On the other hand real final sales rose at the fastest rates in more than 20 years.  This led David Beckworth, Bill Woolsey and Marcus Nunes to suggest QE2 was already working (recall it started strongly raising stock prices and reducing the value of the dollar as early as September.)

I was a bit skeptical about the final sales numbers, partly due to issues raised by Jim Hamilton and his commenter “rootless” (at 3:49pm.)  I see the optimists as making an implied prediction that production would rise strongly in 2011:1, as firms restock depleted inventory.  And now we have the first indication that the optimists may be right:

WASHINGTON (AP) — Factory activity expanded in January at the fastest pace in nearly seven years, as manufacturers reported a sharp jump in new orders.

Still, builders spent less on projects in December, pushing annual construction spending down to a decade low.

The Institute for Supply Management, a private trade group, said Tuesday that its index of manufacturing activity rose last month to 60.8, from 58.5 in December. The sector has expanded for 18 straight months, and January’s reading was the highest since May 2004. Any reading above 50 indicates expansion.

People who have brains that are “wired Keynesian” often ask me where will the extra demand (from QE2) come from.  Businesses have lots of slack and don’t need to invest, and without more investment how will cash-strapped consumers have enough income to spend?

They are essentially arguing an economy can’t be raised up by its bootstraps.  This is because they don’t understand how nominal shocks can have real effects.  There’s an old movie line “build it and they will come.”  In this case it’s more like “provide the extra NGDP, and the RGDP will come” (when there’s lots of slack.)  The transmission mechanism is asset prices.  Here’s some more info from the article, which explains where the demand is coming from:

Consumers are spending more on autos, appliances and other goods, while businesses have invested in more industrial machinery and computers. Those trends boosted economic growth to a 3.2 percent pace in the October-December quarter, the Commerce Department said last week.

Duesterberg said orders for mining and drilling equipment and for airplanes and airplane parts are also rising.

Factories’ healthy pace of expansion is likely to continue in the coming months. Manufacturing firms surveyed by ISM said their backlog of orders jumped in January, pushing an index measuring that activity to 58 from 47.

U.S. factories are also benefiting from rising overseas sales. The index of export orders jumped to 62 in January, from 54.5 the previous month. That matches a recent peak reached in May and is otherwise the highest level for that index since December 1988.

The employment index rose to its highest level since 1973, a sign that manufacturing companies are hiring more workers. But Duesterberg cautioned that the ongoing boom in productivity in manufacturing would likely limit hiring.

We’ll need a few months more data, but so far it looks like the recovery is going from almost nonexistent during May through August, to moderate.  That’s progress.

PS.  Does anyone know how meaningful this index is?  That phrase “highest level since 1973” certainly caught my eye.  And it also seems to have caught Wall Street’s eye.

A few months back a great deal was made of a letter signed by 24 mostly conservative intellectuals.  Some people drew the conclusion that conservative economists were opposed to QE2.  Undoubtedly many are, including some that did not sign the letter.  But the letter itself shows almost nothing.  Many of the signers were not economists.  A grand total of 5 had jobs at American universities.  One more taught at a college.  Four were at Stanford, meaning a total of one American economist teaching at a university not named Stanford signed the letter.  Let’s take a look at that one, the distinguished monetary economist Charles Calomiris, who teaches at Columbia University.

Noah Kristula-Green emailed Calomiris to ask him why he opposed QE2:

Charles W. Calomiris of the Columbia University Graduate School of Business told FrumForum in an email that he favored keeping interest rates were they currently were:

“There are many reasonable alternative views on how to target monetary policy. I favor Ben McCallum’s proposal to target nominal GDP growth at about 5%. Since we were on track with that target before QE II, at least for the moment, I would neither be raising or lowering interest rates.”

Though he also stated that he would be in favor of a looser monetary policy if the evidence could convince him the circumstances warranted it:

“If there were evidence of a need for further loosening to raise the growth of nominal GDP to that target rate, then some quantitative easing might be a reasonable proposal.”

This puzzled me on several levels.  First, I also support 5% NGDP growth targeting, and I thought QE2 was far too weak.  The easiest way to explain this discrepancy is that I favor level targeting, which requires us to make up for at least some of the previous NGDP shortfall, whereas Calomiris may support a sort of “memory-less” growth rate targeting.  Let bygones be bygones.  I feel pretty strongly that level targeting is better after a serious slump, and also when monetary policy is up against the zero bound, but let’s put that issue aside.

What I find most perplexing about Calomiris’s statement is that even if you accept growth rate targeting, and even if you buy his argument that QE2 should only be adopted if there were signs that NGDP growth was likely to be inadequate, there is no logical reason why Charles Calomiris should have opposed QE2.

A few weeks ago I suggested that the early indications are that QE2 had raised NGDP growth expectations up from about 3.5% to 4.0% in late summer, to around 5.0% to 5.5% today.  Isn’t that what Calomiris wants?  But those were just my hunches, from reading various news stories.  So I looked for a table that averages the various forecasts.  The Economist  magazine provides monthly estimates of the consensus forecasts for RGDP and inflation.  They don’t provide separate NGDP forecasts, but NGDP growth is usually similar to the sum of RGDP growth plus CPI inflation, if not slightly lower (as the GDP accounts use a more conservative technique for estimating inflation.)

Here are the numbers for the last 8 months of The Economist:

Issue date     RGDP growth        CPI inflation    Sum of growth plus inflation

June 3                   3.0%                   1.8%                              4.8%

July 8                    2.9%                   1.5%                              4.4%

Aug. 5                   2.8%                    1.5%                             4.3%

Sept. 9                  2.4%                    1.5%                             3.9%

Oct.  7                  2.4%                     1.5%                             3.9%

Nov.  4                 2.3%                     1.5%                             3.8%

Dec.  9                  2.6%                     1.5%                             4.1%

Jan. 6                   3.0%                     1.5%                             4.5%

A few comments on the numbers.  The date refers to the issue of the Economist magazine.  Because these changes lag a couple months behind changes in many market indicators, my hunch is that the actual forecasts were made somewhat earlier.  The Economist may have surveyed forecasts that had already been published elsewhere by professional forecasters.  But either way, whether you think NGDP growth forecast hit bottom at the time QE2 was announced, or whether you believe (as I d0) that they hit bottom right before the intense flurry of QE2 rumors in September and October, it is clear that NGDP growth expectations were falling well below 5%, and QE2 seems to have raised them back up closer to Calomiris’s target.

I don’t know about you, but even if these numbers are slightly off, I don’t see any reason for someone who favors 5% NGDP targeting to write a highly public letter complaining about Fed policy on the basis of this sort of pattern.  Perhaps Calomiris looked at actual NGDP growth.  But NGDP growth had only averaged about 4% during the recovery, and if anything was slowing slightly in the summer of 2010.

Now it may be that actual NGDP growth in 2011 will come in at a tad more than 5%.  Perhaps we’ll get 4% RGDP growth and 1.8% inflation.  And Calomiris can claim that vindicates his opposition.  But even in that case I don’t think I’d write a letter complaining about Fed policy being too easy, particularly if I had not signed any letters complaining it was too tight from mid-2008 to mid-2009, when growth was 8% below trend, or mid-2009 to mid-2010 when it was 1% below trend.  Indeed I don’t recall any letters from conservatives complaining about tight money, unless you count us quasi-monetarists as “conservatives.”

My hunch is that Calomiris was asked to sign the letter, had recalled reading someone forecast roughly 3% growth, added on an assumption of 2% inflation, and thought “things are fine, we don’t need that.”  I think if he had looked closely at the data, and noticed that the recent increases in forecasts for 2011 occurred precisely when QE2 rumors began swirling around, and precisely because of QE2 rumors, he might not have signed the letter.  I hope he provides more clarifying remarks.

PS.  I notice Ben McCallum did not sign the letter.

With all the grading I have to do I shouldn’t be posting.  But life doesn’t provide many opportunities, and my National Review piece has led a number of very smart bloggers to mull over my ideas, including Brad DeLong, Tyler Cowen and Ryan Avent.  So grading will have to wait.

I’ve noticed is that it’s easier to see flaws in others than to see one’s own flaws.  For instance, I think I can see flaws in Paul Krugman’s analysis of China’s predatory trade policy, or his analysis of why Japan got stuck in a liquidity trap.  But strangely enough, I have trouble find major flaws in my own arguments (although I certainly see some modest weaknesses.)

If I try to crawl out of my own ego and look at things dispassionately, then I need to take seriously an issue raised by not one but two highly respected bloggers.  I’m referring to a recent Ryan Avent post that favorably quoted a question Tyler Cowen recently asked me.   Here’s Ryan Avent, followed by the Tyler Cowen question:

At a recent dinner here in Washington, Mr Sumner discussed his views and took questions. One, from Tyler Cowen, struck me as more psychological than economic, and also as one of the most potent criticisms of the Sumnerian approach:

“Let’s say that at the peak of a financial crisis, the central bank announces a firm intention to target a path or a level of nominal GDP, as Scott suggests.  If everyone is scrambling for liquidity, and panic is present or recent, and M2 is falling, I wonder if the central bank’s announcement will be much heeded.  The announcement simply isn’t very focal, relative to the panic.  A similar announcement, however, is more likely to work in calmer times, as the recent QEII announcement has boosted equity markets about seventeen percent.  But for the pronoucement to focus people on the more positive path, perhaps their expectations have to be somewhat close to that path, or open to that path, to begin with.

(Aside: there is always a way to commit to a higher NGDP path through currency inflation, a’la Zimbabwe.  But can the central bank get everyone to expect that the broader monetary aggregates will expand?)

The question is when literal talk, from the central bank, will be interpreted literally.”

And here’s what Ryan Avent said immediate after the quotation:

Had the Fed said, in the thick of the financial crisis, that it would maintain NGDP growth at 5%, who would have listened? There was a palpable sense at the time that the economy was in need, first and foremost, of serious repair to the banking system. A bit later, op-ed pages rang with calls for fiscal stimulus, as pundits explained that in an atmosphere of panic monetary policy was impotent since no one would borrow at any interest rate.

After that, Avent becomes supportive of my critique of Fed policy.  And Tyler Cowen has also said some good things.  Nevertheless, I need to address an issue that two sympathetic critics see as one of the least persuasive parts of my message.  How can I overcome the fact that others see our flaws more clearly?  By relying on the fact that others also see our models less clearly.  My argument is sort of like a jigsaw puzzle, with many interconnected pieces in areas such as monetary theory, efficient markets, economic history, policy constraints, monetary transmission mechanisms, unconventional monetary instruments, reverse causation, etc, etc.  An outsider will usually fixate on a few notable aspects of the argument, and may not see the entire picture as a unified whole.  OK enough navel gazing, so how do I respond?  Let’s assemble some pieces:

1.  The NGDP and RGDP collapse, (at estimated monthly frequencies) occurred almost entirely between June and December 2008.  I argue that NGDP targeting could have prevented that collapse.

2.  I argue that the dramatic worsening of the banking crisis after Lehman was mostly endogenous, as sharply falling NGDP expectations one, two, and three years out reduced current asset prices, and made bank balance sheets deteriorate sharply.

3.  I argue that NGDP growth targeting might not have been able to arrest the sharp fall in forward estimates of NGDP, but that NGDP level targeting could have done so.

4.  I argue that the crucial errors were made before we were in a liquidity trap (i.e. when rates were still 2% in September and early October.)

5.  I argue that the financial crisis of September 2008 did not cause a stock market crash, as the markets expected the Fed to continue its multi-decade policy of keeping NGDP growing at about 5%/year.  If the markets had given up on the Fed in September 2008, they wouldn’t have waited until October to crash.

6. I argue that stocks crashed 23% in early October on little financial news.  Instead, there were ominous reports of rapidly falling orders all over the industrial world.  Markets then sniffed out Fed passivity, a failure of the Fed to do what it takes to maintain the Great Moderation.  They became demoralized.

7.  I argue that the only significant Fed policy during the October crash was the IOR program, which was termed contractionary by leading monetary economists such as Robert Hall and Jim Hamilton.

8.  I argue that the Fed has many powerful tools even when rates hit zero, and even when the banking system is near collapse.  I cited FDR’s 1933 policies as a precedent.

9.  I argued that the recent market response to QE2 shows that monetary policies are powerful at the zero bound, and work through expectations channels.

10.  I argued that the failures of Fed policy in September 2008 were a clear example of the superiority of forward-looking monetary policy over backward-looking monetary policy.

11.  I argued that the Fed could have prevent the extraordinary increase in real interest rates on 5-year TIPS during July to November 2008 (from 0.6% to 4.2%) if it had moved aggressively.  This would have also prevented the sharp increase in the foreign exchange value of the dollar, something almost unprecedented in a financial crisis.

12.  I noted that many contemporaneous observers felt the Fed was powerless to arrest the 50% fall in NGDP during the early 1930s, because of financial panic.  Today much of the profession (including Bernanke) has accepted Friedman and Schwartz’s revisionist view that it was possible for the Fed to arrest that decline in NGDP.  But they don’t think the Fed could have done much in late 2008, under very similar circumstance.

13.  I’ve pointed out that cutting edge research in macro (i.e. Woodford) suggests that the most powerful determinant of current movements in AD is future expected movements in AD.  So if the Fed could credibly commit to boost AD when the banking crisis was over, it would have sharply boosted AD while the banking crisis was still going on.

14.  I’ve argued that even if banking problems are a real problem, and could not be papered over with more money; falling NGDP was also most certainly something that would reduce RGDP, above and beyond any decline due to banking.  Sharp declines in NGDP don’t suddenly become harmless when the economy has other problems, just as a knife wound doesn’t become harmless just because the patient also has pneumonia.

15.  I’ve argued that the banking problems of 2007 morphed to a NGDP crisis (needing different treatment) without the profession knowing it.  Just as my cold of last week morphed into bronchitis this week (again needing different treatment.)

16.  I’ve argued the Fed can tell right away if its policy has worked (in the TIPS markets) or if more is needed.  Contrary to what 99.9% of economists believe, there is no “we need to wait and see if it’s working” problem in monetary and fiscal stimulus.

I guess 16 is enough for now.  Now let’s see how this relates to Tyler’s argument.  Tyler asks how we can realistically expect markets to be convinced by aggressive Fed action in the midst of the banking crisis.  One response is that the banking crisis was caused by tight money.  Another response is that markets didn’t need to be convinced in the midst of the banking crisis (when stocks weren’t falling that sharply), but rather in the first 10 days of October, when the stock market did crash.  And I am arguing that the stock market crashed in part because of a growing realization that policymakers would not do anything to arrest the decline.  This does not mean each trader has a fully formed model of monetary policy in his or her head, much less my model.  That’s not how markets aggregate information.

Here’s an analogy.  I’ll bet you’d find more people on Wall Street who disagree with my views on the miraculous ability of QE2 to boost asset prices, than you would people who agree with my views (if you interviewed them.)  But in September and October the markets acted as if I am right.  FDR was hated by Wall Street, and all the business press thought the 1933 dollar devaluation was a horrible idea.  But asset markets soared on the news.  Money talks, and very loudly.

It’s hard to emphasize enough how un-radical the Fed’s QE2 policy really is.  It’s ultra-cautious.  They are buying some T-notes, with modest price risk.  That’s an open market operation.  They deliberately passed over all sorts of “nuclear options,” including a higher inflation target, or level targeting, or negative IOR.  And yet the markets still became totally obsessed with Fed rumors during September and October of this year.  Admittedly the news backdrop was more intense in late 2008, but not all the time.  Here’s Ryan Avent:

People remember the sharp decline in share prices in September and October of 2008, but from the end of 2008 until March of 2009, the Dow fell by a third. Ben Bernanke didn’t need to get everyone’s attention on September 15, 2008, or even that particular week.

I’d go further, there were plenty of slow news days in October when the Fed could have electrified the markets.  I know I’m going to be ridiculed for this, but what the heck.  I recall seeing Jim Cramer on TV one morning (in October 2008 I believe) and he was utterly despondent.  Why?  Because the Brits had cut rates sharply, initially leading to hopes on Wall Street that the ECB would do the same later in the morning.  But then the ECB made  a weak move, and US markets fell sharply on dashed hopes.  Cramer seemed forlorn, and berated the ECB.  If even Jim Cramer is grasping for straws from ECB rate decisions on national TV, just imagine the reaction to the United States Federal Reserve doing something bold.

If I were to critique my argument it would be as follows.  The Fed is what it is, a large bureaucratic institution.  I naively thought they could handle this sort of crisis.  Krugman correctly predicted they could not.  So there is a sense in which Tyler in right.  I may have been asking for something that the Fed simply wasn’t set up to do.

My response would be to go back and look at the 1930s.  You could argue that the Fed of the early 1930s wasn’t institutionally set up to prevent the sort of fiasco that we actually observed.  But we learned from that mistake.  And the Fed changed in ways that make another 50% fall in NGDP almost inconceivable.  So that’s progress, and we have Friedman and Schwartz to thank for that progress.

So maybe I was wrong that the Fed was implicitly targeting NGDP during the Great Moderation at roughly 5% growth.  And maybe Tyler’s right that it would not have been credible for them to suddenly start doing so in the midst of the banking crisis.  I’m still not convinced, but maybe he’s right.  Then my fallback is that I’m already fighting the next battle, we need to learn lessons from this fiasco that are analogous to the lessons we learned from the 1930s.  So that next time we’re near the zero bound everyone knows the Fed plans to immediately shift to NGDP targeting, level targeting, with a catch up for any near term undershoot.  Even better, let’s shift before the next crisis.  If we can learn that lesson from this crisis, we can make the next crisis even smaller.  (All battles over economic history are disguised battles over current and future policy.)

PS.  When I saw Jim Cramer I said to myself; “Even he gets it.  He understands the need for more monetary stimulus.  Why can’t Bernanke and all the other elite macroeconomists see the same thing?”  (I hope the term ‘even’ didn’t come across as condescending, but you know how academics look down on the shouters and the showman.)

PPS.  I still plan to say something more about Tyler Cowen’s longer critique, when I have more time.

HT:  Marcus Nunes