Today’s Nobel Prizes
It was announced today that Christopher Sims and Thomas Sargent will be awarded the Nobel Prize in economics. A number of bloggers have discussed their contributions, with MarginalRevolution leading the pack. I don’t keep up with the field enough to provide a comprehensive overview, but I thought I’d provide a few remarks:
1. I was shocked to hear that Sargent won, because I’d assumed he must have already won the award years ago. Sargent and Wallace did a lot of important work integrating rational expectations into monetary economics back in the 1970s and early 1980s. This work may have contributed to Krugman’s paper on expectations traps. I often argue that if we do eventually get high inflation, the cause will most likely be tight money over the past few years. That argument comes directly from this paper by Sargent and Wallace.
2. The Swedish academy provided a short paper explaining some of the contributions of each winner, and I thought I’d make a few comments on impulse response functions and VARs, since those innovations (due mostly to Sims) are being singled out as particularly important:
The difference between forecast and outcome – the forecasting error – for a specific variable may be regarded as a type of shock, but Sims showed that such forecasting errors do not have an unambiguous economic interpretation. For instance, either an unexpected change in the interest rate could be a reaction to other simultaneous shocks to, say, unemployment or inflation, or the interest-rate change might have taken place independently of other shocks. This kind of independent change is called a fundamental shock.
The second step involves extracting the fundamental shocks to which the economy has been exposed. This is a prerequisite for studying the effects of, for example, an independent interest-rate change on the economy. Indeed, one of Sims’s major contributions was to clarify how identification of fundamental shocks can be carried out on the basis of a comprehensive understanding of how the economy works. Sims and subsequent researchers have developed different methods of identifying fundamental shocks in VAR models.
This certainly sounds like a promising approach, and yet I’ve always been skeptical about its practical applicability. To be honest, I don’t know if my objections hold water, perhaps some commenters can let me know.
When impulse response functions are estimated for monetary shocks, they typically show tight money leading to a near term reduction in output, lasting for several years. They also show no near term impact on prices, with a slight decline after about 18 months (although it’s not clear if the results are statistically significant.)
I have several problems with this approach. Researchers often use changes in the monetary base or (more often) interest rates as indicators of monetary shocks. I don’t find these to be reliable indicators. They also use macro data such as the Consumer Price Index, which I view as not only highly inaccurate, but systematically biased over the business cycle. If monetary shocks are misidentified, then you have big problems. For instance, are higher interest rates tight money, or a reaction to higher NGDP growth expectations?
I’ve noticed that when we do have massive and easily identifiable monetary shocks, as in 1920-21, 1929-30, and 1933, output seems to respond almost immediately to the shock, as does prices. This makes me wonder about those impulse response functions. Why would severe monetary shocks immediately impact prices, whereas mild monetary shocks only impact prices after 18 months or more. That doesn’t seem intuitively plausible, but perhaps I’m missing something here.
Perhaps VAR models are misidentifying monetary shocks. I’d argue we saw a severe negative monetary shock in the second half of 2008, and that this caused both prices and output to decline significantly between mid-2008 and mid-2009. What do VAR models show? Do they correctly identify this contractionary monetary shock? If not, is there any way of telling why not? What variables might have given off a misleading reading?
3. Paul Krugman recently made this argument:
Most spectacularly, IS-LM turns out to be very useful for thinking about extreme conditions like the present, in which private demand has fallen so far that the economy remains depressed even at a zero interest rate. In that case the picture looks like this:
Why is the LM curve flat at zero? Because if the interest rate fell below zero, people would just hold cash instead of bonds. At the margin, then, money is just being held as a store of value, and changes in the money supply have no effect. This is, of course, the liquidity trap.
And IS-LM makes some predictions about what happens in the liquidity trap. Budget deficits shift IS to the right; in the liquidity trap that has no effect on the interest rate. Increases in the money supply do nothing at all.
That’s why in early 2009, when the WSJ, the Austrians, and the other usual suspects were screaming about soaring rates and runaway inflation, those who understood IS-LM were predicting that interest rates would stay low and that even a tripling of the monetary base would not be inflationary. Events since then have, as I see it, been a huge vindication for the IS-LM types
I certainly agree about the lack of inflation resulting from the tripling of the base, which I also predicted, but I don’t see it as having much to do with the shape of the LM curve. Indeed Sargent and Wallace (1973) provide a much clearer explanation; the Fed publicly announced that the monetary injections would be temporary (although you could also view the IOR program as an explanation.)
Here’s why I don’t like IS-LM. Suppose the Fed had instead announced that the tripling of the base would be permanent. What does the IS-LM model predict? Notice the LM curve is flat, which means the variable on the vertical axis is the nominal interest rate. But saving and investment depend on real interest rates. A tripling of the base that was expected to be permanent, would lead to a large increase in inflation expectations—probably to double digit levels. This would shift the IS curve far to the right, to where it intersected the LM curve at a positive interest rate. Easy money would make interest rates rise.
So there is no liquidity “trap,” just a promise by the Fed not to allow significant inflation, which they have kept. From the Fed’s perspective, and even more so from the ECB’s perspective, it’s mission accomplished—inflation has stayed low. So IS-LM doesn’t show that monetary policy “doesn’t work,” because it has worked out exactly as the Fed hoped; no breakout in inflation expectations. Some people are under the illusion that the Fed tried to create higher inflation and failed. But Bernanke explicitly indicated that he was very opposed to a 3% inflation target. People need to pay more attention to the Fed’s announced objectives, as those objectives are a major cause of the Great Recession. And Sargent and Wallace help us to understand why.
PS. I do not favor having the Fed announce that monetary injections will be permanent. Rather I favor an announced target trajectory for NGDP (or prices), with level targeting. This would implicitly mean that the Fed was promising enough of the injections would be permanent to hit the nominal target in the future.
Tags:
10. October 2011 at 15:41
One more reason to ban words like “inflation” and “stimulus” from the “stabilization lexicon”!
10. October 2011 at 16:19
A 2010 interview with Sargent:
http://www.minneapolisfed.org/publications_papers/pub_display.cfm?id=4526
From which, I’ve always liked:
‘In early 2009, President Obama’s economic advisers seem to have understated the substantial professional uncertainty and disagreement about the wisdom of implementing a large fiscal stimulus. In early 2009, I recall President Obama as having said that while there was ample disagreement among economists about the appropriate monetary policy and regulatory responses to the financial crisis, there was widespread agreement in favor of a big fiscal stimulus among the vast majority of informed economists. His advisers surely knew that was not an accurate description of the full range of professional opinion. President Obama should have been told that there are respectable reasons for doubting that fiscal stimulus packages promote prosperity, and that there are serious economic researchers who remain unconvinced.’
10. October 2011 at 16:43
Or in other words, the official position of the Fed and ECB is that they don’t want pesky increases in RGDP ruining their “impeccable” track record of disinflation.
10. October 2011 at 16:57
Marcus, I wish it could be done.
Patrick, Yes, that is a good quotation. I’m puzzled by the argument that there was more disagreement about monetary policy. Are we to believe that more economists favored fiscal stimulus than monetary stimulus? Perhaps so, but that would just show the depths to which the profession has fallen.
Shane, That’s right.
10. October 2011 at 17:16
That was an interesting interview, Patrick, particularly his views on labor turbulence, social welfare programs and persistent unemployment. He seems to have Goldbug sympathies.
10. October 2011 at 17:33
The more I look at nominal GDP targeting, the more is appears to solve the issues of the day.
You know, when you think about it, maybe the economics profession is trying to be too clever by half. Fancy models, and arcane rules, sermonettes about inflation, based upon dubious data, and suspect partisan sentiments. Bla-bla-bla.
With nominal GDP targeting, you target what you want—not interest rates, M2, or inflation, on the way to what you want (and that is economic prosperity). What good is zero inflation if you have wrecked the economy?! If you have steady M2 and business is in the toilet, who cares? Target what you want.
With nominal GDP targeting, you say to the world, “We have this huge 450-lb halfback (the printing press), and we are going to run him straight up the middle. And we are going to keep running him until we score.”
Want to bet against the halfback? Make my day—but remember, we get to run him for limitless downs.
Well, football season is upon us. Usually I like baseball analogies, but once in a while a football analogy is necessary to suggest blunt force.
You might say the defense is inflation—but we can get it in the end zone before the inflation defense has time to react and adjust. I bet this is the sort of argument that will win over Fisher of Dallas. Well, nothing else has.
10. October 2011 at 18:12
Scott, I think you have to admit you’re a bit weak on converting NGDP to RGDP.
Every time I talk about the situation where RGDP is real, and it is time to raise rates and slow down growth YOU HIDE.
I mean seriously, it’s a total embarrassing up skirt shot and you really should be better covered.
WHEN during 2002[-2008 IF AT ALL would your level NGDP target have gone high and required a rate raise past what happened???
EVENTUALLY you’ll have to answer this.
Is it that it requires homework and you don’t like me giving assignments?
Is it that you fear saying the answer is never during 2002-2008 would the Fed raised rates?
or do you know when the Fed would have raised them, and you don’t want that period being inspected?
10. October 2011 at 18:14
Benji, that is cute, but realize Scott STILL hasn’t said when exactly month/year his theory would have raised rates when the Fed didn’t.
If it can’t AVERT 2008, it isn’t worth bum squat.
10. October 2011 at 19:33
@Morgan. Logically, there’s no reason Scott needs to show that he would have tightened policy when the Fed wouldn’t have.
It could easily be the case that the Fed procedure has a lot of false positives on tightening policy and very few false negatives.
You see this in statistical hypothesis testing all the time when evaluating Type I vs Type II error rates.
10. October 2011 at 20:41
http://johnbtaylorsblog.blogspot.com/2011/10/congratulations-and-thanks-to-tom.html
Curiously enough John Taylor comes to the exact opposite conclusion regarding the merits of ngdp targeting as a policy rule when looking at vars and impulse functions. Perhaps that’s due to a different interpretation of which indicators were off-base? I find Taylor consistently and dazzlingly out of touch these days, but maybe you could shed some light on his thoughts.
10. October 2011 at 20:51
Morgan-
The nominal GDP targeting adjusts to action on the ground. The market knows it (if the rules are clear and explicit). Lots of self-correcting going on.
Hey, what happened to your boyfriend Perry? He is sinking faster than an anvil in a sump. I hope you were not too tied to him.
10. October 2011 at 20:53
Kevin,
Um, no.
This isn’t about false positive and error rates.
See, 3% level targeted NGDP historically = HARD MONEY.
It means that the Dollar is higher than today, unless say the Euro-block was forced to be even tighter because of our policies.
My point is that Woolsey says 3%:
http://www.themoneyillusion.com/?p=10272
And I say 3%, and so does the Tea PArty.
——–
I’m making the BIGGER argument, and Scott resits it at every turn.
I favor targeting NGDP because it is one number, and it will STILL REFLECT the very conservative goal of ZERO INFLATION.
Since historically RDGP has come in close to 3%…
We set the level NGDP target at 3% and NOW WE SEE THE REAL DEAL.
Scott’s ideas are really best because they PISS ON BOOMS, it means whenever things would really get cooking and say PUBLIC EMPLOYEES soddenly get HUGE pay raises and pensions bumps..
those times never happen.
—
Kevin, I suspect at the end of this, the times when Scott’s policy would be pissing on booms, those are exactly the times when public employees got their biggest pay bumps.
Right when it is soooooo GOOD that nobody is paying attention to public employee salaries, that’s when the Fed lowers the boom, things go tight, and they get nada / zilch / squat.
This is an intuition of mine, a purely organic inductive logic thing, but I trust it.
10. October 2011 at 21:04
Benji, for me it is: Perry > Cain > Romney, because I can’t have Paul.
It’s happy betting though, like laughing at the family football game on Thanksgiving…
Santorum is the only one I’d struggle with putting in over Obama, but I’d probably suck it up even for him just to teach Dems a lesson.
There is no greater sin than people not admitting that taxation is theft. Wars are fought to remind people of that. No one should ever be convinced there is such a thing as a free lunch.
That you need someone else to pay for you is acceptable, it is tolerable, but it sucks and you better talk about it like it sucks. You better be grateful.
This applies to rich poodle children and the 47% torturing us with drum circles – everyone one the minus side should respect those on the positive side, everyone on the minus side should feel shame.
10. October 2011 at 22:03
Scott,
For my own contribution to the ongoing IS-LM debate that currently seems to be permeating the econ blogosphere, I’d like to point out that your observation regarding a permanent increase in base money is not inconsistent with IS-LM (at least my understanding of it).
As you pointed out, it’s absurd to have saving and investment be determined by the nominal interest rate. We can reconcile this with the fact that the nominal interest rate is on the y-axis by using the expectations-augmented fisher equation. The IS curve becomes a function of income, government consumption, and the nominal interest rate minus the expected inflation rate (the real rate of interest). Government spending and expected inflation are exogenous while income and the nominal interest rate are determined endogenously as usual.
This quickly gives the result that a large increase in expected inflation, say through the Fed credibly promising to make the increase in base money permanent, will push the IS curve far to the right. Once forward looking inflation expectations are added, the “trap” part of the zero lower bound disappears, as you observed.
11. October 2011 at 00:15
@Morgan. I’m confused. There are two questions. First what is best target NGDP rate? You say 3% Scott says 5%.
Second, should Scott’s targeting lead to points where he thinks the Fed has too loose a policy and needs to tighten. I say not necessarily if the Fed’s policy generating procedure produces many more tight money errors than loose money errors.
So you criticism on this point fails if the Fed was never in danger of shooting past 5% in 2002-2008.
So it rather seems that a 5% vs 3% target is the true issue here. It would be best to focus on that rather than bringing in spurious challenges.
What’s your list of reasons why average zero inflation with 3% targeting is better than average 2% inflation with 5% targeting?
11. October 2011 at 01:38
“Here’s why I don’t like IS-LM”
Krugman uses that picture of the liquidity trap a lot, so I’m trying to understand this.
As I interpret it, he says that the nominal zero lower bound forces LM to flatten out to the point of intersection with IS and beyond. Therefore, he assumes M policy is ineffective, because nominal rates can’t go lower. He assumes M policy working through interest rates can’t drive the point of intersection with IS further out the GDP axis.
I think you say that monetary policy can drive real rates as negative as desired with sufficiently aggressive M supply. As a result (allowing for the fact that you don’t like ISLM), you say that IS would shift right against a nominal rate axis, and that the ISLM intersection therefore would shift right, under your monetary policy.
However, the IS curve that Krugman draws is probably supposed to be good for all rates. At least that seems to be the way he draw it, since he extends it into nominal negative rate territory. So on that basis, there would be no assumed shift in the IS curve.
But maybe there’s another way of demonstrating your point. Suppose you translate Krugman’s existing graph to (real rate, GDP) space. That’s just a linear translation of nominal to real on the rate axis. Again, assume IS doesn’t change position – only the numbers on the rate axis change.
Against a real rate axis, wouldn’t the LM curve shift down? The nominal zero lower bound is a policy bound. But it is not a real rate policy bound, according to your assumptions about potential M policy effectiveness. The LM curve that is bounded below by nominal rate policy therefore shifts down in real rate policy terms. Presumably it shifts well down into negative real rate territory under your assumptions. Perhaps there is no real rate lower policy bound in theory under your assumptions.
If true, that means that M policy alone under your assumptions will drive the intersection with IS to the right, provided that the degree of real rate easing is deep enough. The point of intersection using ISLM in this way would depend on just how sloped LM would be. And that would depend on how negative real rates could be driven according to your assumptions about M policy effectiveness.
I’m still trying to figure out these ISLM arguments, so this is probably wrong. But maybe the difference with Krugman is more the assumption of M policy effectiveness than the ability to adapt ISLM to either argument about M policy effectiveness. He’s using an ISLM diagram that fits his view.
11. October 2011 at 02:06
Here’s why I don’t like IS-LM. […] Easy money would make interest rates rise.
That’s a strange paragraph. You start by saying you don’t like IS-LM and then use it to show how your preferred policy would work. Your problem isn’t with IS-LM.
11. October 2011 at 02:22
Kevin Donaghue,
If I understand the point correctly, it’s that IS/LM is little better than a language: you can say almost what you like with it. Just like you can use the equation of exchange as part of an arguement either for or against the quantity theory of money.
11. October 2011 at 03:55
W. Peden,
Fair enough but you could say the same about the GE models in a typical intermediate textbook, in fact that’s roughly what the “Anything Goes Theorem” tells us. Yet such models are useful for (1) teaching; (2) sketching a problem as a first step towards creating something more complete; and (3) communicating with people who know the language. I can’t see any good reason why those who deride IS-LM don’t also deride Edgeworth Box models and suchlike.
11. October 2011 at 05:24
I thought IS-LM is in real interest, real income space.
Rather than the horizontal portion of the LM curve being at zero, it is at – expected inflation.
Continue the IS curve to show the equilibrium in at a negative real interest rate.
Higher expected inflation shifts the LM curve down, and the point where it crosses the IS curve to the right. If expected inflation is high enough, then they cross at full employment output.
However, if the IS curve depends positively on future output and income, then this process shifts the IS curve to the right. It isn’t because of higher expected inflation (which is taken care of on the LM curve) but rather higher expected output.
11. October 2011 at 05:29
Scott Sumner wrote:
I often argue that if we do eventually get high inflation, the cause will most likely be tight money over the past few years.
Scott I love you man. If you didn’t exist, we’d have to invent you.
11. October 2011 at 05:34
Kevin, I don’t deal in lists of reasons.
I deal in hegemonic reality.
What do the people who matter want?
The debt holders, the people who are PAYING income taxes get to decide.
The indebted, the people are not paying income taxes do not get to decide.
Look at Japan.
Look at the Bankruptcy laws.
Look at ever decreasing high end tax rates.
Look at America since Reagan.
You can intellectualize pro/con stuff all you want. I’m just concerned with whats going to happen.
11. October 2011 at 05:38
The problem with Krugman’s IS-LM is that it obfuscates nominal vs real interest rates by not labeling its y axis.
IS is much better-understood through real interest rates, so I prefer to have real interest on the Y axis.
His LM curve, though, is flat at zero nominal, not zero real. Therefore, an increase in inflation moves the zero nominal bound lower on the real interest Y axis.
Shifting Krugman’s LM curve downward through exogenous inflation moves the intersection of the two lines to the right, increasing RGDP. (Explanation in words: higher inflation punishes firms more for holding onto cash or zero-nominal-interest bonds, making investment more attractive.)
When Krugman says “increases in the money supply do nothing at all,” I assume he means one of the following:
(1) Increases in the money supply cannot possibly cause inflation.
(2) There is no way to trade inflation for greater employment.
I believe both of these are false. (2) is false by the means I just described. (1) is just obviously false if you argue from the extreme. What if the Fed promised to print unlimited quantities of money and buy unlimited quantities of things until inflation rose to 3%? The end result of this policy would either be (a) inflation of 3%, or (b) the Fed owning every single asset on earth. I think that the former is more likely.
I believe (and I think some other commenters have posited the same) that Krugman fully understands that it would be possible to inflate the dollar to increase employment, but he deliberately avoids discussing it so that he can advocate for government spending instead.
11. October 2011 at 05:45
[…] even if his policies lead to nothing but rising price inflation, he will have no regrets. Yesterday he made his views even more explicit by […]
11. October 2011 at 06:33
John Taylor is more concerned about defending his legacy than creating good policy. He has not said anything of value in years, and his own rule is by admission an “empirical relationship”, which was defined during a non-zero-bound economic environment. He’s more or less useless right now, except as a political tool.
Scott, you write:
“Why would severe monetary shocks immediately impact prices, whereas mild monetary shocks only impact prices after 18 months or more. That doesn’t seem intuitively plausible, but perhaps I’m missing something here.”
Actually, I do think Sargent’s work had a bit to contribute here, although I’ll fully admit I’m not on top of this debate.
Sargent’s work has been credited with informing the decision in the 80s to hike interest rates to “break the back” of inflation expectations. I, personally, would put a simpler game theoretic interpretation on events, however. A large increase in rates is required to breach the separating equillibrium in a signalling game.
The lesson is this – if you want to control expectations, you need to show you mean it in a way that no one can possibly misinterpret, and that may mean paying a price. Dribbling out monetary stimulus a bit at a time does NOT change expectations. The bond markets have called the Fed’s bluff – the Fed doesn’t really mean it.
I think Sargent’s work in a way informs our current dilemma in two ways – first, because of the historical fear of hyperinflations, and the need to create institutions to combat them, current Central Banks are specifically designed to commit to low nominal inflation. In other words, they are designed with an overwhelming fear of the fiscal authority forcing the CB to fund its deficits. Our great mistake was taking Bernanke at his academic word – imagining through 2004 that he would live up to his academic claims enabled the private sector to continue to create leverage (exacerbating the bubble). The 2008 crash was when the markets realized that the institutional underpinnings of the Fed dominated the personal beliefs of Bernanke.
Imagine how much worse it must have been in 1933, though – with the memory of the German hyperinflation (and other major inflationary episodes) so recent in historical memory, and no prior Great Depression to inform current debate.
Second, Sargent notes in the ending of hyperinflations that you needed not only “credible” central bank institutions, but also a debt load that is perceived as manageable. Without the latter, you get an Argentina situation – in essence, monetary deflation as CBs are forced to raise interest rates to control inflation, but interest rates are artifially high due to embedded perceived default risk (because of unmanageable debt load).
It’s possible to position the NGDP target as a solution to Sargent’s dilemma. It permits exactly the amount of inflation that is optimal to escape excess debt loads.
The conservative response (Sargent’s?) is that an NGDP target is looser than an inflation target, and thus gives the government the ability to expand fiscal expenditures more. THIS IS A FALSE CLAIM…
One, it wasn’t govt. debt that triggered the last recession, it was private debt, followed by a secondary deflation – which the GOVT. ABSORBED. So that’s pokey. Spain is an even more extreme example.
Two, an NGDP target is a pass through – yes, govt.s can escape paying back debt, but the cost is immediate and obvious to everyone.
In any case, Scott, it’s probably worth trying to frame the NGDP targeting mechanism in an optimal institutional design framework. But the math is hard, and time consuming.
11. October 2011 at 11:04
@Morgan
“Hegemonic reality” must be a very confusing place to live.
In this realm, it’s apparently impossible to evaluate normative statements.
11. October 2011 at 17:05
bababooey, You mean he supports the gold standard? That seems unlikely to me.
Ben , Yes, NGDP makes a lot of sense.
Morgan, Of course they would have raised rates significantly around 2004-06, otherwise we would have had excessive inflation.
But not in 2002.
shocking, It makes me tremble to think that policy might be based on VARs and impulse response functions. Markets are the best signals.
Robert, I agree, and tried to make that point. But that’s not how people like Krugman use IS-LM. I agree that in theory IS-LM can get things right. My point is that 99% of IS-LM users misuse the model. I oppose it on pragmatic grounds, not theoretical grounds.
JKH, I am pretty sure Krugman would agree with the way I discussed the impact of permanent monetary injections, and how it would look on the graph.
Kevin, A few days ago I did a long post on this, explaining that my objections to IS-LM are purely pragmatic; obviously anything can be shown on the diagram, no one disputes that. It’s also true that anything can be shown with MV=PY.
Bill, Yes, it can be done that way too.
Bob, I steal my ideas form the best–Nobel Prize winners.
Tahtweasal, For some reason whenever Krugman talks about increases in the money supply, he implicitly means increases that are expected to be temporary.
Statsguy, I basically agree with your comments. I’d add that the 1979 interest rate increase was misinterpreted by later economists. It was assumed to have broken the back of inflation with a two year lag. Actually, money wasn’t really all that tight, and only in mid-1981 did the Fed get serious about controlling inflation.
16. October 2011 at 04:39
Ah, see … now that your put your argument in the IS-LM framework, even an old retard like me can follow what you are on about: permanent monetary expansion raises inflation expectations reduces real interest rates/pushed IS out to the right … yes, nice. I know you don’t like IS-LM but please do a bit more of that from time to time, so us only moderately competent 1970s vintage macro oldsters can manage to stay on board!
16. October 2011 at 06:34
bm, I’ll try to oblige. But it’s hard to know how to use it. Nick Rowe is a big IS-LM supporter, and he insists the IS curve should be drawn with a positive slope.