You want concrete? I’ll show you concrete!

Nick Rowe often talks about “The People of the Concrete Steppes;” commenters who don’t like explanations based on central banks steering expectations, and demand to know what “concrete steps” the central bank should take.  Of course Nick’s right that in the short run central banks steer the nominal economy by setting expectations.  But expectations have to be about something.  In my view (and I think Nick’s as well) money matters; an increase in the money supply will raise nominal aggregates in the long run via something like the “hot potato effect.”  Indeed this effect is the only transmission mechanism capable of explaining why the price level is not currently 1000 times higher, or 1000 times lower than it is.  Pure interest rate models can’t do that.

But my bigger problem with the people of the concrete steppes is that they don’t seem to practice what they preach.  They want to know what concrete steps were taken by policymakers, but don’t seem to have bothered to look at the data.

Most of these people want a concrete step in terms of one of two variables, interest rates or the money supply.  Did the Fed raise rates or cut the money supply growth rate, or not?  And if not, how can the Fed be said to have caused the 2008 recession?

In this post I’m going to combine two older posts, hoping that the combination with be more persuasive.  I’m going to try to show the Fed did both, they tightened policy in very concrete ways, no matter how it is defined.

Let’s start with the money supply.  One of the most famous concrete steps arguments was put forth by Paul Krugman, who criticized Milton Friedman’s claim that the Fed reduced the money supply during the Great Depression.  Krugman pointed out that only the broader aggregates fell, and that the base actually rose sharply.  So the Fed didn’t directly reduce the money supply, but rather pumped in lots of money, but this extra money failed to boost the broader aggregates (due to banks hoarding excess reserves and people hoarding currency.)  So let’s assume that changes in the base are the most concrete of all possible concrete steps.  Can that tell us why a mild recession began in December 2007?

Yes!

Notice that between early 2003 and the summer of 2007, the base rose from 720 to 860 (billions of dollars.)  Then just when the sub-prime crisis began to hit the US banking system, the Fed tightened policy, and base growth came to a standstill for nearly a year.  Fortunately, base velocity continued to grow a bit, so the initial recession was fairly mild.  The growth rate of NGDP slowed sharply, but did not completely halt.  But if you insist on looking at things from a “concrete steps” perspective, then the Fed took a big enough concrete step to create a recession in late 2007 and early 2008, and the only real mystery is why the recession wasn’t even worse.

Of course we all know that the base did increase a lot in the more severe phase of the recession, but that’s obviously because the demand for base money grows sharply when rates are near zero.  Indeed that would have occurred even without the infamous “interest on reserves program.”

The near zero interest rates brings me to the second objection by the concrete steppes people.  It didn’t seem like tight money, because the Fed wasn’t raising interest rates.  Oh really?  Are you sure about that?  I often point out to people that high interest rates can’t be tight money, because interest rates are never higher than during hyperinflation.  And I always get the following reply:

“Well, of course, but I mean real interest rates.  The Fed tightens monetary policy by raising real interest rates.”

Fine, so let’s call higher real rates a tight money policy in the eyes of the people of the concrete steppes.  Did monetary policy become far tighter in the second half of 2008?

Yes!

I defy anyone to show me another period of US history when the risk-free, ex ante, real interest soared 3.5% in the space of less than six months.

You want concrete steps?  The Fed provided enough concrete in 2008 to entomb 1000 Jimmy Hoffas.

Commenter Steve provided some very interesting links, which shed further light on the mistakes of 2008.  In earlier posts I pointed out that after the infamous (post-Lehman) September 16 2008 Fed meeting, the Fed refused to cut rates, citing an equal risk of inflation and recession.  This despite the fact that TIPS spreads showed only 1.23% inflation over the next 5 years (roughly correctly, as we now know.)  I had assumed that the Fed’s mistake was being backward-looking, but Steve’s link showed they also might have been getting their inflation forecasts from USA Today, as the big story that day was Hurricane Ike:

As much of the Gulf remained in darkness, gasoline prices jumped nationwide. Ninety-eight percent of the Gulf’s natural gas and crude production was halted.

And the WSJ had the same view:

“September 15, 2008, 10:34 AM
Ike Watch: Hurricane Didn’t Slam Refining, But Gas Prices Will Rise”

“So even if Ike’s wrath was less than many feared, the storm will still leave some scars on the U.S. economy at a vulnerable time.”

Then Steve made this interesting observation:

I’m not trying to spam this blog but I have fire in my belly this Friday eve.

My rationale for posting Hurricane Ike stories is that few people appreciate the magnitude of the short-term supply side shock that struck at the same time Lehman failed. Shutting down Refinery Row was huge, and it definitely affected the Fed.

Then there’s the ECB in April 2011. Krugman demonstrated in an event study that the GIPSI sovereign spreads began to blow out on exactly the same day the ECB raised rates in April 2011. What happened between April 2011 and the prior ECB meeting? Well, a civil war in Libya and a tsunami in Japan. Basically Ghadafi did to Europe what Napoleon wasn’t capable of.

The point is that SUPPLY SHOCKS ARE ABSOLUTELY ***FATAL*** TO AN INFLATION TARGETING REGIME!!! It’s painfully obvious, Hurricane Ike swamped the entire US economy and Libya conquered the entire European continent all thanks to inflation targeting.

I notice that the commenters who apologize are never the commenters who should apologize.

It seems the world’s major central banks have been very naughty.  They are supposed to focus on core inflation, and ignore commodity price spikes.  But they peeked. They’ve behaved like they are afraid of being blamed for high headline inflation.  Time to change the target?  What sort of target might work better during periods of supply disruption?

PS.  I’m not claiming that either slow base growth or high real interest rates are good indicators of tight money.  They aren’t.  I agree with Ben Bernanke that the “only” good indicators of the stance of monetary policy are nominal aggregates like inflation, or even better NGDP.  Of course both of those fell in 2008-09, as money was tighter than any periods since the 1930s.  I’m simply saying that if one thinks those sorts of concrete steps are what matters, then money was really, really tight.

PPS.  In this post I discussed Krugman’s criticism of Friedman.


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29 Responses to “You want concrete? I’ll show you concrete!”

  1. Gravatar of orionorbit orionorbit
    10. March 2012 at 09:43

    Oh well, this must be the thread where ’08 veterans exchange war stories. Mine includes a slightly different interpretation of the figure 2 above.

    My take at the time was that the market was seriously irrational in expecting a very very high rate of inflation (this was an illusion that i speculate was brought upon because, in trading floors inflation expectations don’t matter too much, it’s the nominal earnings of your trades that determine your bonus, not the real ones). Traders were -for a while- still in great moderation mode and a nominal return of 3-4% was considered “low”. Of course this was wrong; it’s just a matter of time until you realize that it’s the pension funds and the like that determine the long run equilibrium rate, not 23 year old traders and pension funds care about the real return they pay. Traders’ job is to try and “guess” what the real demand for yield will do. And in this case most traders got it very wrong for very long. Two kind of people got it right:

    – ISLM kind of guys like Krugman and monetarists (new and old) like Scott who understand that in the zlb real returns are likely HIGHER than nominal and also understand that when base money growth is squeezed you buy long term bonds like there is no tomorrow.

    – Finance/asset pricing guys like myself who knew that in Japan, nominal rates were very low but real rates very high, something which we knew kind of like a stylized fact, from the horror stories of old traders who got burned shorting japan bonds some years ago. The reason I got this one right was that I simply realized that the real interest rate on government bonds should incorporate only convexity risk (credit risk assumed zero) so you could simply make lots of money buy buying 5-year bonds where the convexity risk is really really low.

    so I tend to think of chart 2 as evidence of market failure to price in deflation, something that the fed could not have known at the time. So when you are saying that “monetary policy was tight”, are you essentially saying:

    “The fed should have realized that the market was not properly pricing pending deflation and should have bought government bonds to bring their prices back in line.”?

  2. Gravatar of Negation of Ideology Negation of Ideology
    10. March 2012 at 10:47

    I think the reason people want “concrete steps” is because there are two goals of monetary policy, as I see it anyway.

    1. Efficiency – The effectiveness of the monetary itself, basically the idea that currency in and of itself is not destablizing. So people can be experts on their own business and not worry about the currency.

    2. Equity – The idea that everyone benefits equally from the issuance of money.

    I think setting expectations deals with the first goal, concrete steps deals with the second. Assuming NDGP targeting is the best way to deal with the first (and I believe that you’ve proven that from the data), it’s still possible that the second could be thrown of by the concrete steps. I think that’s where the emotionalism comes from – people perceive that bankers or Wall Street insiders are getting the profits. That’s an issue no matter what target you use.

    The second goal might be more of a political issue than an economic one, so it may be outside the scope of your blog.

  3. Gravatar of Jon Jon
    10. March 2012 at 11:13

    Scott, I’m your past several posts you’ve been discussing a certain model of inflation targeting. Allow me the presumption of translating your implicit model into a policy rule. You’ve presented inflation targeting as if the fed would take the daily TIPS spread and set the overnight rate accordingly.

    No one seriously discusses such a regime. Inflation targeting as practiced is not a mechanical rule but requires the CB to reason about whether inflation variations are supply-side or demand-side effects.

    Once you concede that model, just about all of your hypothetical parallels about the harm of inflation targeting collapse as the sophistry that they are.

    If you had been trying to steer your readers to this idea, I’d respect your rhetorical device but that is not what I see you doing. Rather you’ve hooked on to this meme that the dual mandate is a vehicle for the fed to adopt ngdp targeting. Sorry Scott but your quest to win the long game is compromising you.

  4. Gravatar of M.R. M.R.
    10. March 2012 at 11:25

    Hi Scott, you may be right about this. One question: does the relative illiquidity of the TIPS market pose any problems for your analysis? See e.g. this piece from the San Francisco Fed:

    http://www.frbsf.org/publications/economics/letter/2011/el2011-12.html

    They estimate that TIPS liquidity risk premiums spiked dramatically during the market disruptions of late 2008.

    Similarly, in Figure 3 of that piece, they show that off-the-run Treasury yields spiked dramatically compared with comparable on-the-run Treasuries in late 2008.

    This seems to provide evidence that liquidity considerations should be factored into an analysis of TIPS yields during that time period.

  5. Gravatar of Jason Jason
    10. March 2012 at 11:44

    Nice post. An aside on theoretical models; you said:

    “… explaining why the price level is not current 1000 times higher, or 1000 times lower than it is. Pure interest rate models can’t do that.”

    An interesting analogy (to me at least) are the theories of the (non-gravitational) forces in physics. In those, the theory does not explain why the strength of say the strong force is not 1000 times higher or lower. The theory (via renormalization group equations) shows how the strength changes with energy and you have to measure it at one point (at least) to determine the level.

    Physicists believe that there is a theory that explains the level but we don’t know what it is or how it works yet.

    A possible take-away: just because a theory is the only one that explains the price level doesn’t mean it is right and pure interest level theories could work just fine if you incorporate an empirical measurement. Being unable to explain the level is a defect, but not an insurmountable one.

  6. Gravatar of Major_Freedom Major_Freedom
    10. March 2012 at 12:04

    ssumner:

    In my view (and I think Nick’s as well) money matters; an increase in the money supply will raise nominal aggregates in the long run via something like the “hot potato effect.”

    That’s better.

    Except it’s still incomplete. An increase in the money supply will only increase interest rates in the long run if the Fed inflates…but then stops. But because the Fed more or less continually inflates into the banking system, they can, for long periods of time, keep short term interest rates low, via what you call the liquidity effect (e.g. 2001 – 2006, and 2008 – present). They do this not just by inflating into the banking system, but by accelerating the rate of money inflation. That is how they counter-act the building tendency for interest rates to rise, and why keeping rates low, such as mortgage rates, all the way to 2005, required accelerating money inflation.

    However, a policy of accelerating money growth will eventually result in too high of price inflation in consumers goods, and so at some point, the Fed has to reduce its rate of inflation. This results in higher short term interest rates (which is what happened in 2005-2006), and this reveals all the malinvestments that depended on cheap money.

    We can’t talk about long run interest rates on the basis of the Fed inflating into the banking system, if we are always in the short term on the basis that the Fed is almost always inflating into the banking system and we are therefore consistently in the “liquidity effect” stage of low interest rates.

  7. Gravatar of M.R. M.R.
    10. March 2012 at 12:27

    Following up on my comment above, see also this GAO report: http://www.gao.gov/new.items/d09932.pdf

    The relevant portion is on page 30:

    “The sharp decline in breakeven inflation rates in late 2008 can be attributed to a combination of liquidity and technical market factors. Strong flight-to-liquidity flows during the market upheaval boosted the demand for nominal Treasury securities. Because TIPS markets are less liquid than nominal Treasury markets, this reduced the breakeven inflation rate.

    In addition, technical market factors closely linked to liquidity effects appear to have contributed to the decline in breakeven inflation rates. Lehman Brothers owned TIPS as part of repo trades or posted TIPS as counterparty collateral. Because of Lehman’s bankruptcy, the court and its counterparty needed to sell these TIPS, which created a flood of TIPS on the market. There appeared to be few buyers and distressed market makers were unwilling to take positions in these TIPS. As a result, the TIPS yields rose sharply. …

    Some financial economists view the experience with TIPS yields after the Lehman bankruptcy as a highly abnormal market situation where liquidity issues suddenly created severe financial anomalies. They suggest that this was an unrepresentative episode and that observations from this period could be ignored.”

  8. Gravatar of ssumner ssumner
    10. March 2012 at 13:36

    orionorbit. I’m afraid your comment went right over my head–I have no idea what you are trying to say. My point in showing figure 2 was quite simple:

    People deny the Fed made bad concrete steps in 2008.

    People claim monetary policy is about real interest rates.

    Real interest rates (risk free ex ante) soared in late 2008.

    Which of those three do you disagree with? If none, then what exactly is your point?

    The market began to forecast deflation in late 2008, just when it became rational to forecast deflation. So I have no idea what you mean by the market failing to forecast deflation.

    Negation, If it were true that insiders were getting big profits it would not be outside the scope of my blog. But I see no evidence it’s true. The Fed buys bonds at market prices. You can sell your own Treasury bond at essentially the same price as others sell their bonds to the Fed (perhaps minus a very small commission.)

    Jon, You said;

    “You’ve presented inflation targeting as if the fed would take the daily TIPS spread and set the overnight rate accordingly.”

    No I haven’t. I realize they don’t operate that way, nor would I want them to.

    You said:

    “Inflation targeting as practiced is not a mechanical rule but requires the CB to reason about whether inflation variations are supply-side or demand-side effects.”

    Isn’t that exactly what I said here? That’s why I said the central banks were “naughty.” They were not ignoring commodity price spikes, and focusing on demand side inflation like they are supposed to.

    You said:

    “Once you concede that model, just about all of your hypothetical parallels about the harm of inflation targeting collapse as the sophistry that they are.”

    I’ve discussed many reasons why inflation targeting is a bad idea, not just the one’s you mention here. Google my National Affairs piece for some other problems.

    M.R., Those studies have things exactly backward. The TIPS market is quite liquid, just not as liquid as the conventional T-bond market. Banks would find TIPS to be just as liquid as a corporate bond, and much more liquid that a commercial loan. The “distortion” in late 2008 had to do with conventional bonds, which saw their yields fall to very low levels due to the search for liquidity.

    TIPS yields were not distorted, they were quite representative of risk-free rates of return on debt of average liquidity. Any bank could earn 4% real rate of return by buying TIPS in late November 2008, so the opportunity cost of funds used in a commercial loan was quite high. If you believe real interest rates are an indicator of monetary policy (I don’t) then money was really really tight.

    The other problem I have is that those who denigrate the usefulness of real rates as an indicator of the stance of monetary policy don’t seem to offer any alternatives. Exchange rates? The trade weighted dollar soared 15% in late 2008. Commodity prices? They fell in half. Everything was pointing to tight money.

    Major, You said;

    “An increase in the money supply will only increase interest rates in the long run if the Fed inflates…but then stops.”

    Just the opposite. A one time increase in M has no long run effect, and increase in the money supply growth rate increases inflation, and hence nominal interest rates.

    M.R. See my previous answer. I’d add that if this were true, if liquidity had completely dried up, doesn’t that point to money being excessively tight?

    We should not be surprised that when monetary policy goes off course you’ll see lots of weird things going on with the economy. The Fed isn’t a bunch of sadists, they are not intentionally trying to inflict harm. So Fed errors will occur during periods where things look confusing. People might say we should ignore the falling TIPS spreads from that era, but the markets were correct, weren’t they?

  9. Gravatar of ssumner ssumner
    10. March 2012 at 13:47

    Jason, I agree.

  10. Gravatar of 123 123
    10. March 2012 at 14:00

    Scott, Orionorbit says nominal yields were insanely high in Oct 2008. And high nominal 5yr yields have were misinterpreted by some at the fed as an evidence of absence of deflationary pressures.
    Well, I’d say the ultra-tight policy has caused high levels of nominal yields.

  11. Gravatar of M.R. M.R.
    10. March 2012 at 14:45

    Scott, you said: “The TIPS market is quite liquid, just not as liquid as the conventional T-bond market. Banks would find TIPS to be just as liquid as a corporate bond.”

    Yes, I should have been clearer. When I referred to the “relative” illiquidity of TIPS, I meant relative to normal Treasury bonds.

    You said: “If liquidity had completely dried up, doesn’t that point to money being excessively tight?”

    At the risk of stating the obvious: In this case, it points to an epic run in the short-term funding markets. If that’s equivalent to “tight money,” then we’re in agreement.

    I’ve only followed this blog intermittently (to my regret), but I’ve gathered in the past that you don’t ascribe much importance to the financial crisis (by “financial crisis” I mean the run in the short-term funding markets). Maybe I have this wrong …

  12. Gravatar of Negation of Ideology Negation of Ideology
    10. March 2012 at 15:11

    I agree with your point on the Treasury bonds. That’s what I undertood as “concrete steps” (which was perhaps different than how you meant it). I’m thinking the decision of whether to buy Treasuries, lend directly to banks, or buy private securities as a concrete step. Maybe that’s more of an implementation detail. My understanding is the Fed mostly buys Treasuries, and the ECB mostly lends to banks. I think our way is better.

    I do have a concern on the NGDP futures though – mainly because I think sophisticated investors would be the primary buyers, unlike Treasuries, which are probably the most broadly owned asset in the country. Maybe the winners and losers on the futures would balance out so it wouldn’t matter.

  13. Gravatar of M.R. M.R.
    10. March 2012 at 15:17

    Looking at my most recent post, I’m afraid the phrase “At the risk of stating the obvious” may be taken the wrong way; I should have said “It seems to me that …”

  14. Gravatar of Steve Steve
    10. March 2012 at 15:39

    Scott,

    I have some interesting graphs filed away somewhere. Oil and gas production, domestically, hit generational lows the Week That Lehman Died. I believe for oil, the lowest since around 1950. And it’s been higher and uptrending ever since.

    Also, retail gasoline prices actually did hit all-time record highs across a number of Southern state from North Carolina to Texas during the Week That Lehman Died. Elsewhere, they were already in steep remission, but the Fed meeting of September 2008 saw the highest price ever for retail gasoline in a number of states.

    That week was historical for so many reasons. It will probably end up being a 100-year low for domestic oil production, and an inflation-adjusted record high for gasoline prices in the Atlanta and Charlotte areas.

    Lots of people now accuse Greenspan of panicking in 2003 by keeping rates too low. But it’s even more clear that the Fed suffered a Hurricane Ike gasoline panic in September 2008. The minutes from that meeting will be worth the wait.

  15. Gravatar of Just when the sub-prime crisis began to hit the US banking system, the Fed tightened policy, and base growth came to a standstill for nearly a year « Economics Info Just when the sub-prime crisis began to hit the US banking system, the Fed tightened policy, and base growth came to a standstill for nearly a year « Economics Info
    10. March 2012 at 17:00

    […] Source […]

  16. Gravatar of Rien Huizer Rien Huizer
    10. March 2012 at 18:04

    Scott,

    “Concrete steps” are important elements of an expectations formation process. Apparently the concrete steps here were the wrong ones at the time and maybe that resulted in (a) bad/wrong expectations (i.e. unlikely to lead to outcomes consistent with a Fed acting in accordance with both elements of its mandate) and (b) those expectations may have led to the outcomes we can observe.

    If we just assume that the bad expectations did exist and were indeed resulting (only) from Fed actions, would the Fed have been aware of that happening while it happened? Would they have been able to correct if they had observed they were growing in the wrong direction? Mechanics of correction??

  17. Gravatar of Jeff Jeff
    10. March 2012 at 19:07

    @Jason,

    Some of us have taken to heart the criticism that economics suffers from physics envy.

    And I guess some of us haven’t.

  18. Gravatar of Greg Ransom Greg Ransom
    10. March 2012 at 22:59

    Scott,

    I still don’t get the economics of your account of what has happened between 2006 and today.

    You’ve said a million things in a million different directions, but I’ve never seen from you a clear step by step account of the economics of how we can go from everything essentially being OK in 2007 (as you tell it), to what we had in 2009.

    I’m not understanding what you are putting on the table that can account for that, or for all of this going on and on for half a decade.

    I get NGDP targeting (well enough).

    I don’t get your boom-bust story. And I confess I really don’t see it even in all that you have written.

    What is it that I should be looking for? Can you say it clearly and simply and step by step? Pretend I’m a Bentley freshman.

  19. Gravatar of Tommy Dorsett Tommy Dorsett
    11. March 2012 at 05:32

    Scott — What do you think of this chart:

    http://research.stlouisfed.org/fredgraph.png?g=5Cp

    Inflation-adjusted base growth has turned negative just ahead of every recession since 1959 with no false positives. There was a ‘near miss’ in 1996 when real base growth temporarily fell to nearly zero.

    The broader aggregates don’t do nearly as good a job over this period.

  20. Gravatar of Tommy Dorsett Tommy Dorsett
    11. March 2012 at 05:33

    P.S. I removed excess ERs from the calculation of real base growth.

  21. Gravatar of Bill Woolsey Bill Woolsey
    11. March 2012 at 06:11

    Scott:

    Major Friedman is just repeating the Misean old time religion.

    Start with the assumption that all central banks are always trying to reduce real interest rates. That is their fundamental goal.

    Clear your head of any intuition that the central bank is setting a growth rate for base money (or currency, or M2.)

    Clear your head of any notion that we are thinking about how a new growth rate will play out over time. Don’t worry about whether it is expected or unexpected, but there is not defined growth rate. That isn’t the thought experiment.

    Now,this is wierd. Inflation _is_ using money creation to push real interest rates lower.

    With equilibrium reasoning, this policy is explosive. With the Miseans, this explosive effect is about to show up any day now.

    With money supply growth targeting, real interest rates just adjust and the money supply keeps on growing.

    With nominal GDP or inflation targeting, real interest rates just adjust, and the price level or nominal GDP just keep on growing.

    With this Misean business, the inflation is identified with keeping real interest rates low.

    Of course, many Austrians and Miseans understand about real interst rates adjusting, but the amateur internet ones don’t. But even the best are someone infected by this framing. And, by the way, _you_ could use a bit of infection by way of balance. I see way to much of the constant growth rate of base money, worse, coming down like manna from heaven, thought experiement.

    Endogenous base money by open market operations with a NGDP growth path target is in some ways a special regime. Exogenous changes in base money, and even inflation targeting, can lead one astray.

  22. Gravatar of ssumner ssumner
    11. March 2012 at 07:02

    123. I don’t recall nominal yields being high in October 2008.

    M.R. I think the recession was caused by a sharp fall in NGDP, i.e. what Bernanke and I call “tight money.” I agree that the high real yields can be interpreted in many ways, and as I said they are not a good indicator of the stance of monetary policy. But what I can’t understand is how those high TIPS yields in late 2008 were not signaling excessively tight money. If it was a signal of a strong liquidity effect on interest rates, then money was way too tight in the conventional sense. If it was a signal of a liquidity crisis, then money was way too tight in an unconventional sense. I’m trying to think of an interpretation that wouldn’t have meant money was tight.

    When I wrote this post I was apprehensive that people might take it too literally, that they might see this as me arguing these indicators are useful. I agree they aren’t, it’s others that find them useful, but only apparently when the data agrees with their perceived prejudices. Otherwise they dismiss the data as “distorted.” (By the way these last comments are not directed at you–I think you did understand what I was saying, but people tend to misinterpret the argument.)

    Negation, I strongly agree with the final sentence of your comment.

    Steve, Thanks for that data.

    Rien, I was certainly aware, the TIPS markets were certainly aware, so I think it’s reasonable to expect the Fed to have been aware.

    But I think there is a better answer, that doesn’t hold effective monetary policy hostage to the skill of the central bank—level targeting. Under that system the markets will automatically tend to correct Fed errors, by moving in anticipation of future corrections.

    Greg, I don’t have a boom-bust story, if you are referring to real estate. (Obviously NGDP explains the broader economic bust, which affected almost all sectors.) Indeed there are lots of things I don’t know about the world around me. If I had a boom bust story for real estate, I’d be as rich as John Paulson. And I’m not.

    Tommy Dorsett, That’s quite impressive (although there is a false positive in 2006.) But I’d be interested in why you removed ERs. What does it look like with ERs put back in?

    Bill, I’ve given up trying to understand the Major.

  23. Gravatar of Major_Freedom Major_Freedom
    11. March 2012 at 07:57

    ssumner:

    “An increase in the money supply will only increase interest rates in the long run if the Fed inflates…but then stops.”

    Just the opposite. A one time increase in M has no long run effect, and increase in the money supply growth rate increases inflation, and hence nominal interest rates.

    You’re wrong. A one time increase in the money supply will have the long run effect of raising nominal interest rates, but of course not permanently raising them, by the following mechanism:

    A one time increase in M will, by the process of what you call the spending multiplier, increase aggregate nominal incomes over time as new money is spent and then respent. This will have the effect of raising long run nominal net incomes, and most importantly the average rate of profit. The connection to interest rates is realizing that interest rates are determined by the rates of profit.

    Once people’s time preferences for consumption and investment reassert themselves, and investment continues to be made in the original proportions, costs will once again rise, and that will then decrease the rates of profit and hence decrease the rates of interest. I think of it like a wave. A one time increase in M will like a wave spread throughout the economy, and over time raise nominal incomes and nominal profits and hence nominal interest rates. Once the old investment/consumption ratio reasserts itself, nominal profits and hence nominal interest rates come back down. When I said “interest rates in the long term”, I do not think of that in terms of a rigid concept that persists, as I am sure you did when you thought of interest rates “in the long run.” No, by “in the long run” I meant it as a wave as it moves throughout the economy, bidding up demands and nominal incomes as the increase in M spreads.

    Yes, in the VERY long term, after enough time has elapsed, a one time inflation of M cannot possibly permanently increase interest rates. If that is what you thought I meant by “in the long run”, as a permanent concept, then that is not what I intended to convey, and you’d be right to say that is totally wrong.

  24. Gravatar of Major_Freedom Major_Freedom
    11. March 2012 at 08:16

    Bill Woolsey:

    Major Friedman is just repeating the Misean old time religion.

    It’s not a religion Bill.

    Start with the assumption that all central banks are always trying to reduce real interest rates. That is their fundamental goal.

    But my assumption is that central banks can only reduce nominal interest rates, and cannot affect real interest rates directly, but only indirectly through the economic destruction they unleash and the resulting change in time preferences.

    Clear your head of any intuition that the central bank is setting a growth rate for base money (or currency, or M2.)

    Clear your head of any notion that we are thinking about how a new growth rate will play out over time. Don’t worry about whether it is expected or unexpected, but there is not defined growth rate. That isn’t the thought experiment.

    Now,this is wierd. Inflation _is_ using money creation to push real interest rates lower.

    With equilibrium reasoning, this policy is explosive. With the Miseans, this explosive effect is about to show up any day now.

    No, that’s false. Misesianism does not contain any theory or principles for time based predictions. It’s quite the opposite. It is only Misesians who recognize that there are no constant causal factors in the sphere of human action that are required in order to make such time dependent predictions on “when” things are going to happen.

    With money supply growth targeting, real interest rates just adjust and the money supply keeps on growing.

    With nominal GDP or inflation targeting, real interest rates just adjust, and the price level or nominal GDP just keep on growing.

    With this Misean business, the inflation is identified with keeping real interest rates low.

    No, it’s the opposite. You know it will help your case in your criticism of Misesian economics to at least grasp what it is about. The Fed inflating into the banking system (temporarily) reduces nominal interest rates. The inflation is not “identified with keeping real interest rates low.” It is precisely because the Fed brings about nominal rates that would differ from unhampered market rates that are a function of real savings and real time preferences, that causes the business cycle. Investors (and consumers) have to coordinate their plans by utilizing nominal rates, not real rates which cannot be observed. Nobody can observe what the real rates are precisely because the Fed isn’t letting them be reflected in nominal interest rates.

    No, we cannot know what the real rates are by simply subtracting an index rate of inflation from nominal rates, because A. there is no single rate of inflation in the economy, there are inflation rates, and B. the rate of interest on loans isn’t even where the true Misesian time preference resides. The Misesian time preference resides in the difference between demand for output and demand for input factors. The interest rates on loans is but a derivative of this.

    Of course, many Austrians and Miseans understand about real interst rates adjusting, but the amateur internet ones don’t. But even the best are someone infected by this framing. And, by the way, _you_ could use a bit of infection by way of balance. I see way to much of the constant growth rate of base money, worse, coming down like manna from heaven, thought experiement.

    Amateur internet Austrian critics don’t understand that Austrians don’t speak of inflation affecting real interest rates, but rather nominal interest rates that make certain marginal investment opportunities turn from unprofitable to profitable, which then redirects scarce resources into unsustainable projects. Austrians don’t hold that central banks can manage real interest rates.

    Endogenous base money by open market operations with a NGDP growth path target is in some ways a special regime. Exogenous changes in base money, and even inflation targeting, can lead one astray.

    That’s why I made it clear that it is not changes in base money that are important, but changes in aggregate money like M2, which you sloppily said should be “gotten out of people’s heads.”

    Every time someone criticizes Austrian economics, 99/100 the critic is not even knowledgeable of it.

  25. Gravatar of M.R. M.R.
    11. March 2012 at 08:21

    Scott, you wrote: “If it was a signal of a liquidity crisis, then money was way too tight in an unconventional sense. I’m trying to think of an interpretation that wouldn’t have meant money was tight.”

    I actually agree with this. So now I think I can pinpoint where you lose me.

    When you look at late 2008, you see a policy failure. When I look at late 2008, I see an institutional design failure.

    At the risk of oversimplifying: You don’t think there’s a big problem with the *design* of our monetary institutions (money & banking, broadly speaking). You think the central bank just needs to credibly commit to a policy of buying enough stuff to achieve an NGDP path, level-targeted. I hope I have this right.

    I, on the other hand, would say that the core problem is a flawed institutional design. Mine would be a variant of the “shadow banking”/liquidity crisis story. Policies matter, but so do institutions.

    This also goes to the tricky question of “causation.” You think that bad policies, undertaken within our existing institutional structure, “caused” the economic crisis. Whereas I would say that an unsound institutional structure “caused” the economic crisis.

  26. Gravatar of M.R. M.R.
    11. March 2012 at 09:11

    By the way, I agree with you that the problem is essentially monetary in character. But there’s a useful distinction to be made between (i) monetary institutions per se and (ii) monetary policies undertaken within a given institutional context.

  27. Gravatar of RebelEconomist RebelEconomist
    11. March 2012 at 09:42

    I am with M.R. It does seem that financial turmoil plays havoc with TIPS. Scott’s extract from the time series of real yield is selective. The real yield on that bond had fallen by about 2% in the six months before the extract (from the beginnings of the financial crisis in summer 2007), and fell very steeply after the extract back to about 1.5% in early 2009. In fact, Scott’s extract shows typical signs of illiquidity post-Lehman, being smoother (ie traders are not sure where to mark their bonds) with more missing observations. Moreover, I believe that, by convention, traders mark their bonds on the bid side, meaning that to some extent the post-Lehman rise in real yield in Scott’s chart may represent ballooning bid-ask spreads on TIPS.

    As an alternative to TIPS as a financial market indicator of inflation expectations, I would suggest gold. The price of gold rose by about $100 in the week following the collapse of Lehman (though it did fall back later in the year).

  28. Gravatar of 123 123
    12. March 2012 at 06:04

    Scott, compared to the future NGDP growth, nominal yields were insanely high in Oct 2008. Orionorbit’s point was that not many have noticed this in real time.

  29. Gravatar of ssumner ssumner
    12. March 2012 at 18:06

    MR, I agree that basic policy changes are needed in both monetary policy and regulatory policy. I’d like to have the market determine the money supply and interest rates, not the Fed.

    And I’d abolish FDIC, the GSEs, TBTF, etc. So you can’t say I oppose systemic changes.

    rebeleconomist. Those “missing observations” are just holidays. I don’t recall the bid/asked spread as being large, it’s generally tiny in the TIPS markets. If you don’t like TIPS, I’d use CPI futures prices, not gold. The point is that it was obvious market inflation expectations were plunging, whichever measure you use.

    123, OK, I thought you meant high in absolute terms.

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