Welcome to the market monetarist world

We’ve been in a market monetarist world all along, but recent events have made that quite obvious.  I’d like to explain why in a slightly roundabout fashion.

Skeptics like George Selgin have occasionally asked why I think monetary stimulus is still needed.  After all, NGDP has been growing at about 4% rate for nearly 4 years, and you’d think wages and prices would have adjusted by now.

There are actually two different ways of thinking about this question:

1.  Figure out what is the optimal monetary regime, and then judge current Fed policy against that benchmark.

2.  Consider the Fed’s own announced goals, and then judge current policy against those goals.

I don’t have strong views on the optimal monetary regime.  I could see good arguments for a 3% growth NGDPLT regime, or a 5% growth NGDPLT regime.  And I can see good arguments for starting the clock in 2008 or 2013, or something in between.  If we started the clock in 2013, then a 3% NGDPLT regime would call for tighter money right now, and a 5% NGDP regime would call for easier money.

But in some ways it makes more sense to judge policy against the Fed’s own announced goals.  You might wonder why, given the Fed often fails to hit those goals.  The reason is that from 1983 to 2008 the Fed actually did a pretty good job of addressing its dual mandate.  And in the future they may also do a pretty good job.  That suggests that adhering to the mandate right now would reduce uncertainty and macroeconomic instability.   It does no good to tell the Fed to aim for zero inflation, or negative 1%, or positive 6%, if they will soon be aiming for 2% again.  We need stability, predictability.

So that raises the question of why they have recently failed, or indeed if they have recently failed.

And that’s where the recent success of market monetarism comes in.  For 4 years we’ve been battling on two fronts; trying to convince the profession that faster NGDP growth was needed, and trying to convince the profession that the Fed could deliver faster NGDP growth—indeed that the Fed was continuing to steer the economy at the zero rate bound.

And suddenly in the last few weeks it’s as if everything has become clear.  As if we’ve driven out of a dense fog into a sunny uplands, where the air is transparent.  Here’s the first sentence of a typical recent story:

The Federal Reserve almost entirely drove the markets this week.

Yes, and that doesn’t happen when an economy is in a liquidity trap.  But the bigger story was elsewhere.

Let’s start with the question of why we’ve done so poorly since 2008 if the Fed was following the same mandate (stable employment and roughly 2% inflation) as in 1983-2008.  Why is that policy not producing the good results of 1983-2008?  If there was any doubt as to the answer to that question, it’s been definitively dispelled by Bernanke’s recent press conference.  We aren’t getting good results precisely because the Fed is not acting in such a way as to implement their mandate.  Inflation is well under 2%, and likely to stay low, and the unemployment rate is far above the Fed’s estimate of full employment.  That means the Fed should further ease policy, and yet Bernanke just announced that they are likely to tighten policy, even if the economy continues along its current path.  During 1983-2008 they consistently adjusted their instruments in such a way as to hit their mandate.  Now they don’t.  They are failing because they’ve enacted the exact same policy mistakes that Ben Bernanke criticized the BoJ for making in earlier years.

The Fed has us just where they want us to be, and will adjust policy to keep us on the current path.  There were fears (even within the Fed) that monetary policy would be unable to offset the effects of fiscal stimulus.  Bernanke has recently dispelled those fears:

Bernanke said the quantitative-easing program could end in the middle of next year. The chairman was upbeat about the outlook, saying housing was strong and the recovery seemed to be brushing aside any headwinds from fiscal policy.

This is what a market monetarist world looks like.  The Fed is steering the nominal economy, bad outcomes (for AD) are due to bad Fed policy, and fiscal policy is ineffectual.  One of two things will happen over the next few decades:

1.  The Fed will keep NGDP growth fairly stable.

2.  The Fed will allow erratic fluctuations in NGDP growth.

In case one the market monetarists win.

In case two the market monetarists also win.  High NGDP growth will lead to excessive inflation, and we can say; “I told you so.”  A sharp fall in NGDP growth will lead to recession, and we can say; “I told you so.”

Unlike in 2008, the whole world is now watching NGDP.  No more excuses.  (OK, the whole world isn’t watching yet, but Michael Woodford is.)

From a purely selfish perspective, case one is actually the worst case.  If NGDP growth is stable then macro as we conceive it today (which is mostly a demand-side field) will disappear, and that means market monetarism will disappear.  Even worse, the residual problems (and there will be supply-side problems) will appear to be failures of market monetarism.  And we won’t have any useful advice to offer, other than “Money won’t solve that problem, nor will demand-side fiscal stimulus.” 

Why is the Fed adopting policies likely to cause it to fail?  I don’t know.  Commenter “James of London” links to people who spot the sinister influence of Jeremy Stein, who thinks the Fed should consider adding a third policy goal, financial market stability.  That might mean raising rates or ending QE even if other indicators suggest more stimulus is needed.  Who appointed this conservative to the Fed?  The same President who appointed 5 of the other 6 board members.  The President that supposedly thinks the economy needs more AD.  Thank God for regional Fed presidents like Bullard, Dudley, Evans, Rosengren, Kocherlakota, Williams, etc.

And where is Brad DeLong’s vitriolic ridicule when we need it most?

And sometimes the people are smarter than I am and done their homework. Then I have a very hard task indeed–and readers should understand that for them to bet on the correctness of my conclusions would not be to maximize expected value. Jeremy Stein is such a case.

As I understand Jeremy Stein’s view, it goes more or less like this:

[DeLong then presents Stein’s argument] . . .

It is Stein’s judgment that right now whatever benefits are being provided to employment and production by the Federal Reserve’s super-sub-normal interest rate policy and aggressive quantitative easing are outweighed by the risks being run by banks that are reaching for yield.

I do not know why this is Stein’s judgment. I do not know how I would go about making such a judgment.

Perhaps DeLong is saving up his insults for stupid conservatives that worry about bubbles and hence oppose monetary stimulus.  Conservatives that don’t teach at Harvard.  (Sorry if this is too snarky, the angel in my other ear is telling me I should praise DeLong for being civil.  And DeLong is smarter than he seems to think, certainly smarter than me.)

Even more amusing is that the same day Obama picked Stein he also nominated a former GOP administration official, to provide “balance” in order to get the two picks through the Senate.  And who is the blogger that has been talking about President Obama’s incompetence on monetary policy ever since 2009?

PS.  In the comment section there was lots of discussion of why real interest rates have recently risen sharply.  I find this issue to be really puzzling, but I think some people may have failed to pick up on the fact that I’ve always found this issue to be mystifying.  Consider that some of the previous US QE announcements seemed to lower bond yields, but later on bond yields rose during the actual QE program, as the economic outlook improved.  Or consider that the recent Japanese QE announcement seemed to initially lower bond yields, but then they rose sharply as the program raised inflation expectations.  Indeed you now have the following conventional wisdom:

1.  Japanese QE is raising inflation fears and raising bond yields.

2.  Fear of an end to US QE is raising bond yields.

Can both be right?  Do you see why I find this confusing?  Then add in the fact that some of the increase in US yields did occur after news of stronger than expected economic growth, but not all.  Some occurred after more contractionary than expected monetary policy announcements.

Some market monetarists are less enamored with the EMH than I am, and this sort of situation certainly works in their favor.  They can claim that the fall in bond prices is a due to a market failure, as investors don’t yet see that the tight money policy will slow growth, and eventually lead to lower bond yields.  Maybe, but then why call it “market” monetarism?

Of course if we had a NGDP futures market then all of these puzzles would be easily resolved.  No more mystery.  No need to speculate as to the possible existence of positive supply-shocks, etc.  But we aren’t willing to spend a few $100,000 on a prediction market that would vastly improve our knowledge base, our ability to conduct effective monetary policies.  And that’s the real mystery.


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42 Responses to “Welcome to the market monetarist world”

  1. Gravatar of 123 123
    22. June 2013 at 13:30

    Some people at the Fed think that the Evans Rule will automatically provide the monetary offset and neutralize the impact of smaller QE.

  2. Gravatar of Rajat Rajat
    22. June 2013 at 14:56

    “We aren’t getting good results precisely because the Fed is not acting in such a way as to implement their mandate. ”

    And they’re doing that because out there in commentator/pundit land and in the wider world, people continue to disbelieve Friedman’s view on the confusion between the level of interest rates and the stance of monetary policy. The current generation of policy people and commentators have been reared on IS-LM and will not abandon it. That is the only possible explanation. As you often say, if the FF rate were at 5% right now, the Fed would be cutting. Here in Australia, even quite switched-on commentators continue to describe monetary policy in the US as ‘super stimulatory’. Some of them are starting to realise that our own record-low cash rate of 2.75% cash rate is not as stimulatory as it may have been in other (previous) circumstances. But they attribute that to the high AUD – as in, if the dollar were lower (where it ought to be), then we’d be fine; they don’t judge the stance of policy by looking at inflation or NGDP. We have a long way to go before people break the nexus between levels of interest rates and policy stance.

  3. Gravatar of Conspiracy? Conspiracy?
    22. June 2013 at 15:16

    http://www.bloomberg.com/news/2013-06-21/u-s-weighs-doubling-leverage-standard-for-biggest-banks.html

    Maybe this is why interest rates going up…banks will want better returns if they are forced to hold treasuries. Link above.

  4. Gravatar of Geoff Geoff
    22. June 2013 at 17:18

    “There are actually two different ways of thinking about this question:”

    “1. Figure out what is the optimal monetary regime, and then judge current Fed policy against that benchmark.”

    “2. Consider the Fed’s own announced goals, and then judge current policy against those goals.”

    So the only two ways of thinking about money, is top down management (i.e. socialist) thinking A, and top down (i.e. socialist) thinking B.

    Wow.

    How about thinking about a free market in money, and judging Fed activity relative to that benchmark? Crickets…

    ———————

    “One of two things will happen over the next few decades:”

    “1. The Fed will keep NGDP growth fairly stable.”

    “2. The Fed will allow erratic fluctuations in NGDP growth.”

    “In case one the market monetarists win.”

    “In case two the market monetarists also win. High NGDP growth will lead to excessive inflation, and we can say; “I told you so.” A sharp fall in NGDP growth will lead to recession, and we can say; “I told you so.””

    In both cases liberty and maximum prosperity lose.

    —————-

    “In the comment section there was lots of discussion of why real interest rates have recently risen sharply. I find this issue to be really puzzling, but I think some people may have failed to pick up on the fact that I’ve always found this issue to be mystifying.”

    When one grounds their economics on subjective value theory, then the “mystification” can be learned to just be an effect of inconsistencies in objective value theorizing, under which MM falls.

    Subjective value theory is much more useful.

  5. Gravatar of Geoff Geoff
    22. June 2013 at 17:32

    Given that interest rates (30 year yields) significantly rose after the Fed announced it would scale back its purchases, does this imply that the Fed’s QE has been suppressing interest rates thus far?

  6. Gravatar of J J
    22. June 2013 at 18:19

    Geoff,

    Can you do the comparison with a free market in money?

  7. Gravatar of kebko kebko
    22. June 2013 at 19:15

    I don’t understand why the conventional wisdom is that the Fed just tightened. My reading is that as recently as the last few weeks, there was some doubt that QE would even last through summer, but that the fed is promising not to taper at least until late in the year. I run a model that tracks the expected date of short term rate increases, and uncertainty around that. It looks to me like the date of the rate hike has moved up slightly, the rate of change in subsequent rate hikes has increased slightly, and there is much more certainty that the rate hikes will begin within a quarter or two around the end if 2014. I think much of this certainty comes from relief that the fed will not pull back on QE too early.

  8. Gravatar of Marcos Marcos
    22. June 2013 at 19:17

    If the FED doesn’t ease more monetary policy in response of a positive supply shock what would be the consequences?

  9. Gravatar of Benjamin Cole Benjamin Cole
    22. June 2013 at 19:22

    Excellent blogging.

    Why do “cpnservatives” always devise reasons for tighter money?

    I think it just a social norm. They start from the premise—tight money is always the answer, and zero inflation is the primary goal, and liberal flaccid weenies want to print a lot of money—and reason backwards from that, inventing moralistic or even rational-sounding arguments for tighter money.

    But, in light of the current dead inflation, but low interest rates and QE, “conservatives” are reaching ever-more exotic and less-persuasive reasons for tighter money. Stridently peevish is the new conservative.

    What is sad is that money is in fact tight now—and that may be another reason for the failure of conservatives to embrace Friedmanesque policies now. Low interest rates are associated with “easy” money. They cannot fathom that money can be tight even at ZLB. See Japan.

    With 50 percent of the world’s economy—Japan, USA and Europe—under effective tight money regimes, a chance for a robust recovery is dim.

  10. Gravatar of John John
    22. June 2013 at 19:38

    There was nothing of substance in what Bernanke said. To the extent that he talked about tapering, he said something like “if the economy hits our targets for output and employment quicker than we expect we’ll begin the taper sooner.” In other words he said nothing. Traders on Wall Street have been waiting four months for a pull back and this gave them the excuse to do so.

  11. Gravatar of John John
    22. June 2013 at 19:39

    Thursday was probably a good dip buying opportunity by the way.

  12. Gravatar of W Raftshol W Raftshol
    22. June 2013 at 19:48

    The effect of below market interest rates since just after Volcker has brought the velocity to near one. The reason all the printing and spending produces no inflation is because there is no velocity. Velocity is demand for money.

    Even were the Fed to abandon ZIRP, velocity would remain low for decades. If the FED were to do something extreme such as raise the fed funds rate to 8%, it would be 2016 before the velocity increased to a non-robust level of 2.

    Perhaps the only immediate fix would be Gisellian stamp money with a negative interest rate of say 12% per year. People would use it to pay off their debts. Students would dump it on loan creditors. Credit card debtors would pay off their cards. Meanwhile, this high velocity currency would consume the national debt as stamp revenues poured into the US Treasury.

    Velocity would be restored. The Fed would be no more.

  13. Gravatar of Steve Steve
    22. June 2013 at 21:12

    The liquidity effect dominates the expectations effect in the very short run. Especially if the Fed announces “We are going to tighten and but we insist tightening is not really tightening.”

    There are lots of players who need to make room in their portfolios for bonds that the Fed won’t be buying. Then there are issues like convexity; everyone’s duration just got longer last week, without making a single trade.

    Besides, stocks dropped 5% and long bonds dropped 2%, so every player has just upped his weighting in bonds relative to stocks. That’s usually what happens when people de-risk.

    If the Fed had said no change to QE, but we are now shooting for 1% inflation since we’re already there, stocks would have tanked and bonds would have rallied — expectations would have dominated.

    Since the Fed said we’re cutting QE, but please don’t read anything into it, everything tanked. Liquidity dominated. We don’t know what to expect because the Fed isn’t clear. We have to see how much the higher rates hurt the economy, and then reset expectations according to whether the Fed cares.

    We know the Fed claims it is not tightening, but we also know the Fed is now more likely to show passive indifference to negative shocks. So a new set of expectations needs to be built around the likelihood of negative shocks. Volatility up.

  14. Gravatar of Benjamin Cole Benjamin Cole
    22. June 2013 at 21:47

    OT but interesting:

    Thailand now has an unemployment rate of…0.7 percent, reports The Economist.

    I live in Thailand now, and I can confirm that construction companies and others are complaining about the lack of workers, and that Burmese and Cambodians, here illegally, are getting harder to find as their nations’ economies improve as well. Many companies say they could take on more jobs if only they could get the workers—and not just skilled workers, construction workers, farm labor, etc

    Inflation is in low single digits, btw.

    Now, Thailand pegs the baht to the dollar. I am not sure what that means.

    But interesting. Can an economy have 0.7 percent unemployment and low inflation? So far, yes.

    Oddly enough, no one talks about the “Thai miracle” etc.

  15. Gravatar of Jim Crow Jim Crow
    22. June 2013 at 21:49

    This may be the dumbest of the dumb questions I tend to ask (makes me proud in a way) but is the US treasury market really efficient in the way one would expect from other markets? The US dollar is a reserve currency that a lot of Central Banks in Asia and the Middle East play around with to manage their own monetary policy. Is that good, bad, or irrelevant for price signalling?

  16. Gravatar of Negation of Ideology Negation of Ideology
    22. June 2013 at 23:56

    It seems strange that the government would worry about government-backed and government-regulated banks would “reach for yield”. If we’re worried about them taking imprudent risks with backed accounts, why would our regulations allow it?

    So the rest of us are going to have to live with sub-par growth and sub-par living standards because we’re afraid the banks are going to do something we allow them to do and then we’ll have to bail them out. It would be much better if we let prudent regulation deal with bank risk, and let monetary policy deal with AD.

  17. Gravatar of Dtoh Dtoh
    23. June 2013 at 02:32

    Scott
    As I have noted before an NGDP indexed note would be more practical than a futures market.

    In the meantime if someone can run a correlation between corporate profits and NGDP you have enough info to calculate expected NGDP.

  18. Gravatar of Orn Gudmundsson Jr Orn Gudmundsson Jr
    23. June 2013 at 05:05

    1. Japanese QE is raising inflation fears and raising bond yields.

    The market is anticipating that BOJ QE will actually create inflation, i.e., the expanded monetary base will be put through the banking system and, with the money multiplier, will have a greater impact on bond prices than the purchases. The inflationary impact on bond prices is greater than a few large purchases in the vast sea of Japanese government debt.

    2. Fear of an end to US QE is raising bond yields.

    The US QE isn’t creating inflation because a large part of it has not been released through the banking sector, it is still mostly sitting as excess reserves. The yield increase is not due to inflation fears, but rather what is anticipated to be slack demand after the large buyer exits the market.

  19. Gravatar of Marcos Marcos
    23. June 2013 at 05:24

    If the FED doesn’t ease more monetary policy in response of a positive supply shock what would be the consequences??

  20. Gravatar of ssumner ssumner
    23. June 2013 at 06:15

    123, It might, but with the Fed behaving so irrationally it’s hard to say.

    Rajat, Interesting, of course the strong dollar may reflect tight RBA policy, although I haven’t followed it closely enough to have an informed opinion.

    Conspiracy, But bank desires don’t determine interest rates.

    kebko, If you were right then stocks would not have fallen sharply last week.

    Marcos, Inflation would fall and output would rise, which is what you want.

    Ben, But why were conservatives silent during the Bush administration?

    John, EMH?

    Steve, I find the liquidity effect to be endlessly confusing. At times it seems strong, at other times very weak. Your hypothesis requires two instruments of Fed policy (QE and signaling.) Perhaps that’s it, but I can’t develop a plausible model.

    Ben, That sounds hopeful.

    Jim Crow. Yes, it’s pretty efficient. And is that your real name?

    dtoh, The correlation is time-varying, that’s the problem. It’s not stable.

    Orn, Maybe, but that theory requires we stay at the zero bound. But markets are saying they now expect a quicker exit from the zero bound. So it’s not “nothing” in a macro sense. It should affect inflation.

  21. Gravatar of J J
    23. June 2013 at 07:07

    Professor Sumner,

    Of course, over some horizon the liquidity effect can dominate, particularly in a ZLB situation. If markets believe that, under most likely scenarios, the Fed will not enact enough QE to be able to safely raise interest rates for five years, then any sign of tighter money over the next five years may raise expected five-year interest rates. There may be some spot in the middle of the tight-loose spectrum at which expected five-year rates are zero and they go up as expected policy gets either tighter or looser.

  22. Gravatar of Matt Waters Matt Waters
    23. June 2013 at 10:32

    As a market monetarist somewhat less enamored with the EMH, I would just say to not get too involved with every little movement in interest rates, especially in less liquid markets like TIPS. The TIPS market in 2008 did suggest very high real interest rates with deep deflation on the horizon, but bond market participants attributed much of this increase in real rates to lack of liquidity in TIPS. Similarly, LTCM existed to capitalize on differences between 30 year and 29.5 year Treasuries which shouldn’t exist, but the market for on the run Treasuries was higher due to their liquidity. As investors searched for liquidity after Russia’s default, the spread between on the run and off the run Treasuries went very high.

    As far as how I could then favor “market” monetarism, I will say that I generally think liberal economists think too little of the market, and many conservative economists as well when it suits their interests. The “financial instability” argument from conservatives makes no sense it markets are efficient. The “reaching for yield” and other arguments assume that somehow, some way investors would misallocate their own money. Even if that’s true, how could investors making mistakes with their money trump unemployment? It makes no sense.

    Also, the extent of the bubble in housing is vastly overstated by these economists. Most of the bubble that did exist was driven by regulatory and principal-agent issues with banks. Most of the funding for non-conforming mortgages came from AAA tranches, which were very advantageous from a leverage perspective. The only people who lost from the bank’s perspective were equity holders. The managers did very well, with their compensation resembling a call option. The leverage providers outside of Lehman did well, with their assumption that they would be bailed out proving correct. The mortgage brokers maximized their compensation and home buyers maximized their profit by also taking advantage of a cheap call option. From most perspectives, markets were indeed quite efficient.

    There are some cases of small inefficencies, such as liquidity premiums, and big inefficiencies such as the Tech bubble, which can only really be explained by irrationality, but in general people wise up with their own money. But I do think more inefficiencies exist than Scott generally admits.

  23. Gravatar of Matt Waters Matt Waters
    23. June 2013 at 11:22

    “How about thinking about a free market in money, and judging Fed activity relative to that benchmark? Crickets…”

    “Free marking in money” has been done once before, during the free banking era in the 1800’s. It was an absolute disaster. An analogy today would be finding yourself in 2008 stuck with a bunch of Washington Mutual and Lehman Brothers money. It would be redeemable for gold at those banks, but that’s useless once they went out of business. People knew this ahead of time and all money had some nominal discount depending on the issuer.

    It’s tough to acknowledge, but no argument ever in economics is won by saying “free markets!” Free markets are not axiomatically better. There has to be evidence to show them to be better. And the evidence shows that free market in money was a disaster. Furthermore, since the government does control the money supply, deflation due to a gold standard or due to low market real interest rates is also a disaster. Even though a perfect free market would not care about the nominal value of money, the real world evidence shows much more utility from a nominal value of money that results in constant NGDP growth.

  24. Gravatar of Negation of Ideology Negation of Ideology
    23. June 2013 at 11:55

    Matt Waters –

    You’re right, that free banking was a disaster. But I’d go further and say that era wasn’t any more a free market in money than now, and in fact a free market in money has never existed because it is logical contradiction, thus impossible.

    In one sense we already have a free market in money. People are free to trade anything they use as money right now. I have discussed this ad naseum with Geoff before (more so when he still called himself Major Freedom). His contention is that since we pay our taxes in the government currency that favors the government currency. Thus he wants a Rube Goldberg scheme where every taxpayer pays taxes in the currency of their own choosing. Obviously, this is rediculous, but it clarifies the issue. Once the government accepts something for payment, it has an effect on the market for that thing. Using the government to favor gold and banknotes based on gold, as in the 1800’s isn’t any more free market than any alternate monstary system. And using the government to subsidize competing currencies, as Major Geoff advocates, is no more free market either.

    So I’m in agreement with you. We should just admit that there is no free market in money in that sense, and pick the best system for the money issued and used by the government. The government should just issue a stable currency based on NGDPLT, let it float freely against anything else people want to trade it for, and let people do business in whatever they choose. But the government should only do business in its own currency, and not give any legal status to any other currency.

  25. Gravatar of John John
    23. June 2013 at 12:31

    Scott,

    As much as I think the EMH is a cool idea and can be useful at times (99% of investors should by index funds as I do myself). The theory seems to have more holes than Swiss cheese at this point. Here are my objections.

    1. Those who actually have money on the line do not act as if it were true. For instance, every major investment bank does proprietary trading. If markets were efficient, why would they have prop trading currency desks? It should be impossible to make money that way if the EMH were true, yet these are very large profitable companies. If they believed in EMH there is no way they would be involved in trading money they earned in the market outside of buying the total market. The people with the most at stake don’t believe it and that says a ton.

    2. Crappy companies that issue junk grade debt actually perform much worse than the index. Ditto for penny stocks. If EMH and the risk premium were true, investors willing to take the risk of buying these things would outperform overall but they don’t. There’s a similar phenomenon with gambling; long shots lose you much more money overall than just betting on the favorite every time (something like -65% to -5%). Read Eric Falkenstein’s interesting book “The Missing Risk Premium.”

    3. Prices movements over time move in more or less a random fashion as the model suggests except for large downward movements. These market crashes are clearly products of psychology. The EMH would predict prices moving in a brownian motion random fashion which follows a standard deviation. Instead they move in a distribution that is very fat-tailed to the downside. Read Benoit Mandlebrot’s interesting book “The Misbehavior of Markets.” I got the first argument from that book as well.

    4. You and Fama yourselves don’t believe it. You invested heavily in China because you thought you had an advantage by knowing about culture and economic growth that wasn’t priced into the market. Fama runs a fund that charges fees and invests in small caps and value companies. If markets were efficient, they would give higher multiples to small and value type companies that have historically outperformed.

    The EMH is a neat idea and I think it’s a little bit like Newtonian physics. It’s not true per say and better theories will come along the way the Einstein’s relativity and quantum mechanics allowed more precise calculations.

  26. Gravatar of Justin Justin
    23. June 2013 at 13:11

    –“Indeed you now have the following conventional wisdom:

    1. Japanese QE is raising inflation fears and raising bond yields.

    2. Fear of an end to US QE is raising bond yields.

    Can both be right? Do you see why I find this confusing? Then add in the fact that some of the increase in US yields did occur after news of stronger than expected economic growth, but not all. Some occurred after more contractionary than expected monetary policy announcements.”–

    I think both can be right.

    I generally view long term interest rates (at least in the US and other fiat money economies) as reflecting expectations for the path of short term interest rates. If that were not so then there would be consistently profitable arbitrage opportunities.

    It makes sense that if the Fed were to adopt a very tight monetary policy (say, an explicit move to a 0% inflation level target) that long term rates would fall substantially. This would be so because a 0% inflation targeting regime would generally mean that the short rate would not be as high as it would be under a 2% inflation targeting regime over any significant length of time.

    It also makes sense for long term interest rates to rise if the market expects the Fed to tighten by raising the short term interest rate in a more aggressive manner than previously thought. While the impact of tightening is noted in inflation expectations (i.e. inflation break evens falling), long term rates still rise due to a jump in the expected time path for short term interest rates. The net effect is a jump in ex-ante real long term interest rates.

    As an example, if the Fed came out tomorrow and declared that it was hiking the Federal Funds Rate to 5% and promised to hold it there indefinitely, I would expect the whole yield curve to jump to 5% give or take even as the economy crashes.

  27. Gravatar of J J
    23. June 2013 at 13:16

    Negation of Ideology,

    I like what you say, but the “not give any legal status to any other currency” should be removed. Part of your point is that people can use whatever currency they want; the only limitation is that the government collects dollars (for the US government) as payment for taxes. Other than that, dollars have no ‘legal status’. A $10 bill says ‘this must be accepted for all debts public and private…’ but that only applies if the debts are denominated in dollars. That statement means the bill is an official dollar, not that I am required to accept dollars as payment for what I am selling. I am certainly allowed to open a store and only accept gold as payment.

  28. Gravatar of TallDave TallDave
    23. June 2013 at 13:17

    why real interest rates have recently risen sharply.

    Springiness at ZLB? Too-tight monetary policy affects real rates of return/growth as well as nominal, that’s why we stopped allowing deflationary spirals.

  29. Gravatar of TallDave TallDave
    23. June 2013 at 13:29

    John,

    It seems like everyone always argues against strong EMH, but hardly anyone actually argues for strong EMH — much harder to argue markets are so inefficient that future prices can be predicted by analyzing prices from the past with a formula anyone could use.

    I’d say EMH is more like the anthropic principle — the weak version is very powerful, but it’s very hard to define exactly how powerful, and there are lots of applications on small scales where it doesn’t apply at all.

  30. Gravatar of George Selgin George Selgin
    23. June 2013 at 14:39

    “”Free marking in money” has been done once before, during the free banking era in the 1800″²s.” Like many before you, Matt, you have the history very wrong. You confuse so-called U.S. “free banking” arrangements, in which (among other things) banks could neither branch nor choose the assets backing their notes–no minor interventions, those!) with systems like those of Scotland and Canada that better approximated the sort of system that those of us who have tried to encourage people to take “free banking” seriously have in mind. U.S. “free banking<" though not actually disastrous everywhere (as you suppose) did prove disastrous in several instances, and in those cases the main cause of bank failures appears to have been the depreciation of the very note collateral that state banking regulations forced the banks in question to load up on. (Unit banks of all stripes have, of course, always been relatively failure prone.)

    The Scottish and Canadian arrangements, which also involved competitive note issuance but which imposed no restrictions on either branching or bank's portfolio decisions, were remarkably successful while they remained free. And by remarkably better I mean much, much better than their more regulated counterparts, both during the 18th century and today.

    If, Mr. Waters, you will consider reading about the actual experiences of Canada and Scotland, I am happy to point you to the relevant literature on those, and also on the true nature of the antebellum U.S. "free banking" episodes.

  31. Gravatar of Geoff Geoff
    23. June 2013 at 17:31

    J:

    “Can you do the comparison with a free market in money?”

    Depends on what you mean by compare. If you mean observable comparison, then no. If you mean theoretical comparisons, then yes.

  32. Gravatar of Geoff Geoff
    23. June 2013 at 17:53

    Negation of Ideology:

    “You’re right, that free banking was a disaster.”

    Define “free banking.” Do you mean the 19th century events with two central banking experiments, artificial bi-money standards imposed by the silver and gold banking houses, the upper east monopolization/cartelization privileges brought about by state law, the fractional reserve banking with partial state backing, and other hampered market activities in banking?

    Or do you mean some imaginary free market in banking system?

    “But I’d go further and say that era wasn’t any more a free market in money than now, and in fact a free market in money has never existed because it is logical contradiction, thus impossible.”

    A free market in money is not a “logical contradiction.” What a ridiculous claim. A free market in money is just another name used for the monetary system that would prevail on in a society where private property rights are protected and held as absolute. There is no “logical contradiction” in this whatsoever.

    “In one sense we already have a free market in money. People are free to trade anything they use as money right now. I have discussed this ad naseum with Geoff before…His contention is that since we pay our taxes in the government currency that favors the government currency. Thus he wants a Rube Goldberg scheme where every taxpayer pays taxes in the currency of their own choosing. Obviously, this is rediculous, but it clarifies the issue.”

    It is not ridiculous if you realize that you just smuggled in an assumption that contradicts free markets, namely, mandatory taxation to a coercive territorial monopoly on final jurisdiction!

    Of course if you have in your mind that the state should exist, and should collect taxes against the consent of those who are forced to pay them, then it should not be surprising that you have trouble reconciling that with a free market in money. For how difficult would it be for those calling themselves statesmen to leech off of productive property owners if they had to figure out what they’re producing first, before they demand what to be paid!

    I am not in that contradictory position that you are in, because contrary to you, I do not advocate for violations of property rights. Security and protection should be offered on the open market just like every other service. This means customers and protection providers, on a case by case basis, come to their own terms of trade.

    But more importantly, you seem to be totally clueless about the economics of money. A free market in money does not necessarily imply that “money”, the generally accepted medium of exchange, will consist of hundreds or thousands of different commodities, such that you have in your mind such silly “Rube Goldberg” hands in the air fake defeatism that seems to be the only way you can justify coercive monopolies in money.

    A free market in money would likely entail at most two or three different commodities, with one being widely accepted. Money is by definition the generally accepted medium of exchange. The reason it is defined this way is because on the open market, it has historically been the case that one commodity outcompetes all other commodities in terms of general acceptance. Gold and silver have traditionally been the most widely accepted, for many reasons, but there have also been instances of nails, copper, salt and other commodities being money.

    If more than one money makes it harder for territorial gangs to finance their activity, then how in the world can that possibly stand as any real argument against a free market in money, unless you have already sanctioned such coercive gang behavior? I’m not going to lose any sleep over your inability to think honestly and creatively on how a free society could work.

    We’ve gone over this ad nauseum yes, but you don’t seem to be able to learn, because you refuse to think creatively about different ways that human society can be organized, other than the one you were born into, brought up in, and have come to accept without serious reflection or analysis.

    Taxes are not, contrary to what you may believe, some kind of law of nature like gravity or electromagnetism. It is a human choice, specifically, a human choice consisting of a violation of private property rights.

    “Once the government accepts something for payment, it has an effect on the market for that thing. Using the government to favor gold and banknotes based on gold, as in the 1800″²s isn’t any more free market than any alternate monstary system.”

    Agreed, which is why a free market in money makes states much more difficult to maintain, and that’s a good thing, for those of us who value individual liberty.

    “And using the government to subsidize competing currencies, as Major Geoff advocates, is no more free market either.”

    I do not advocate that at all you liar. I don’t advocate for the state to subsidize anything, let alone competing currencies. Only for them to stay out of the way, i.e. refrain from initiating threats of violence and acts of violence. This is not “subsidizing” anything. It is retreating and leaving people alone. Laissez-faire.

    “So I’m in agreement with you. We should just admit that there is no free market in money in that sense, and pick the best system for the money issued and used by the government.”

    No, we should not settle for this. We should put our energy towards advocating for a free market in money, not the best state money.

    “The government should just issue a stable currency based on NGDPLT, let it float freely against anything else people want to trade it for, and let people do business in whatever they choose.”

    No, the government should cease taxing people, cease demanding payment in dollars.

    “But the government should only do business in its own currency, and not give any legal status to any other currency.”

    No, the government should cease doing business altogether.

  33. Gravatar of Geoff Geoff
    23. June 2013 at 17:55

    George Selgin:

    Thank you for providing some incredibly important facts and information on 19th centiry banking. Much needed on this blog!

  34. Gravatar of ssumner ssumner
    23. June 2013 at 18:28

    J, Yes, but I still wonder about the very long term bonds.

    Matt, That’s a very good defense of your version of MM. Let 1000 flowers bloom.

    John, I agree that it’s true in the exact sense that Newtonian physics is true. Not quite true, but a very useful approximation for some purposes.

    Justin, The puzzle is that tight money should raise expected future rates for a few years out, but then depress them longer term.

    Everyone, I’ll let George defend free banking, as he knows far more about it that I do. I tend to think that free banking got a bum rap in the textbooks, based on what I know.

  35. Gravatar of Negation of Ideology Negation of Ideology
    23. June 2013 at 19:33

    J,

    I agree with your reponse, that phrase was worded poorly. By “not give an legal status to any other currency”, I was trying to indicate that the government should not give any special privileges to any other currency. I was thinking of proposals by Ron Paul and others to eliminate taxes on gold and silver. I was not advocating making other currencies illegal. I agree that you should be free to open a store and only accept gold as payment.

  36. Gravatar of dtoh dtoh
    23. June 2013 at 19:44

    Scott,
    We know TIPs > we know expected inflation. We know nominal yields so we also know real expected yields. Assuming the risk differential between stocks and Treasuries is unchanged, then we know expected corporate profits (or maybe free cash flow). There are enough companies where sales/profits correlate pretty closely to NGDP (and they should be easy to identify by seeing which stocks most consistently track Fed announcements) that we ought to be able to get a pretty good estimate on NGDP expectations. If not perfect it would at least tell us direction and give us a good indication of magnitude.

    At a minimum it would stop all this speculation about why stocks moved this way and bonds moved this way by reducing it to simple mathematics so you pundits can just say this is a math problem we don’t have the data to solve.

  37. Gravatar of Scott Freeland Scott Freeland
    24. June 2013 at 00:01

    Scott,

    I’m curious about what you think the effect of Fed offset would be on employer side payroll tax cuts. Let’s say Congress and Obama took your advice and cut or eliminated the employer side of the payroll tax and the Fed cut back on monetary stimulus to exactly offset the effects on NGDP. Specifically, how would employment be affected?

    And contrast this to a fiscal stimulus effort that involved direct recruitment of the unemployed by the government, with a job guarantee for any future unemployed, such that monetary policy offset couldn’t necessarily affect the employment rate(or at least affect it less).

    Which do you guess is superior in this context of Fed offset? I assume you think the employer side of the payroll tax is superior, but why?

    And why not simply eliminate both sides of the payroll tax?

  38. Gravatar of Scott Freeland Scott Freeland
    24. June 2013 at 00:06

    Scott,

    On the rise in Treasury rates, perhaps it reflects more complex compound/conditional expectations than is widely realized, and/or reflects expected future liquidity drying up.

  39. Gravatar of ssumner ssumner
    24. June 2013 at 06:42

    dtoh, Yes, but NGDP futures would still be much better. Stocks have risen a lot since 2009, despite low NGDP growth.

    Scott, A lower employer-side payroll tax doesn’t boost NGDP, and hence is not offset. It boosts RGDP for any given NGDP. It is supply-side.

  40. Gravatar of John John
    24. June 2013 at 08:55

    Tall Dave,

    I believe in EMH enough to think that chart readers are like astrologers if that’s what you were getting at. They’re like astrologers for the reason that they both make a connection without having a direct causal framework in place.

  41. Gravatar of Justin Justin
    24. June 2013 at 18:14

    –“The puzzle is that tight money should raise expected future rates for a few years out, but then depress them longer term.”–

    I don’t see why tight money should *always* lead to lower long term rates via the mechanism you describe. I think it’s plausible for the market to raise its tightening expectations such that there is a increase in the average expected real short term interest rate, and thus higher long term rates despite tighter monetary policy. As an implausible example, if the Fed set the Fed Funds rate at 7% and credibly pledged to keep it there indefinitely, I would expect the yield curve to migrate to 7% despite the ultra-tight monetary policy that would entail.

    That’s what I think is happening in this situation. The market is currently expecting a higher time path of nominal short term interest rates in the US, leading to lower stock prices, lower inflation expectations, but higher nominal longer term interest rates.

    I don’t know why the FOMC bothers with this madness. Just saying that they will shoot for 5% NGDP growth and leaving it at that would be a heck of a lot easier than trying to communicate how the QE taper will (or rather might) play out.

  42. Gravatar of ssumner ssumner
    25. June 2013 at 05:54

    Justin, But that’s the problem, the Fed can’t credibly promise to keep rates at 7%, because it would quickly destroy the economy–within months.

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