Must-read: Athanasios Orphanages: “The Euro Area Crisis Five Years After the Original Sin”

Must-Read: Athanasios Orphanides: The Euro Area Crisis Five Years After the Original Sin: “Why did Europe fail to manage the euro area crisis?…

…Studying the EU/IMF program… imposed on Greece in May 2010–the original sin of the crisis–highlights both the nature of the problem and the difficulty in resolving it. The mismanagement can be traced to the flawed political structure of the euro area…. Undue influence of key euro area governments compromised the IMF’s role to the detriment of other member states and the euro area as a whole. Rather than help Greece, the May 2010 program was designed to protect specific political and financial interests in other member states. The ease with which the euro was exploited to shift losses from one member state to another and the absence of a corrective mechanism render the current framework unsustainable. In its current form, the euro poses a threat to the European project.

Must-read: Jed Graham: “The Fed’s Historic Rate-Hike Goof–in One Chart”

Must-Read: The very-sharp Jed Graham has… strong views… about the Federal Reserve’s rather counterintuitive decision to raise interest rates in a quarter at which nominal GDP grew at a rate of 1.5%/year, at the end of a year in which nominal GDP grew at 2.9%. The Fed is placing an awful lot of weight on the unemployment rate, and not on either non-labor market indicators or the employment-to-population ratio, in its decision to raise. I don’t think we even have to reach for the (very true and powerful) arguments about asymmetric risks to find the interest-rate increase technocratically incomprehensible, and the failure to roll it back last month technocratically incomprehensible as well:

The Fed s Historic Rate Hike Goof In One Chart Stock News Stock Market Analysis IBD

Jed Graham: The Fed’s Historic Rate-Hike Goof–in One Chart: “Janet Yellen’s Federal Reserve has done something that no other Fed has done since Paul Volcker…

…aimed to quash runaway inflation in the early 1980s, even if it meant a recession–and it did…. Nominal GDP grew at a 1.5% annualized rate in the fourth quarter…. (Inflation-adjusted GDP rose just 0.7% in Q4.) With the exception of Volcker’s interest-rate hike in early 1982 amid a recession, no other Fed has raised rates during a quarter in which nominal GDP grew less than 3%, dating back to the early 1970s. In fact, a rate hike when nominal GDP is growing less than 4%… from 1983 to 2014, it only happened twice, and one of those times (the second quarter of 1986), the Fed cut rates by a half-point before retracting 1/8th of a point of the reduction…. The first quarter of 1995, when nominal GDP grew 3.7%, [is] the only time since Volcker that the Fed had, on net, raised rates in a quarter when nominal growth was running below 4%. After that early 1995 hike, it should be noted, the Fed proceeded to cut rates three times before the next rate hike…. If one looks at the pace of GDP growth from the year-earlier quarter, the Yellen Fed stands alone as the only Fed to hike rates when nominal growth was below 3%.

Skidelsky on “The Two Big Economic Policy Failures That John Maynard Keynes Would Be Disappointed by Today”

I missed this six months ago:

Julie Verhage: The Two Big Economic Policy Failures That John Maynard Keynes Would Be Disappointed by Today: “The famous economist isn’t around for us to ask him…

…but here is probably the next best thing. Robert Skidelsky… said… Keynes would have found two things upsetting. First, he would be frustrated with the lack of  precautions taken to prevent a huge financial crash like the one we saw in 2008. Secondly, Lord Skidelsky believes Keynes… would have wanted a more ‘buoyant response,’ he said.  Specifically, he doesn’t think Keynes would have liked the Federal Reserve’s quantitative easing….

We’ve been for many years in a state of semi-stagnation, and the recovery is still very very weak in the European Union. The actual recovery measures we’ve taken, particularly quantitative easing, have actually skewed the recovery towards asset buying and real estate, thus threatening to recreate the circumstances that led to crash in the first place. I think he would have been disappointed by those policy failures…

Skidelsky is certainly correct in saying that Keynes would be driven raving mad by the failure of central banks and other regulatory agencies to take seriously the task of managing and bounding the illusion of collective liquidity, in order to curb the dangers created by systemic risk. And he is correct in believing that Keynes would be astonished at counterproductive fiscal austerity and incoherent worries about debt burdens at a time of extraordinarily low current and projected future interest rates.

But I am puzzled by Skidelsky’s third. He believes that Keynes would have seen not a second- but a first-order loss in responding to tighter-than-ideal fiscal policy with looser-than-ideal monetary policy in order to hold aggregate demand harmless. Good Belsky does not, and to my knowledge nobody has succeeded in, producing a coherent simple model of what they mean. I am going to have to put this down as yet another example of a case in which smart, sensible people claim to know more and know different then what is in the simple file-and-communications systems that are our standard economic models.

I can see that responding to inappropriately-austere fiscal policy with easier monetary policy and lower interest rates than in the first-best creates a world with too-little government capital, too-low a level of social insurance spending, an inappropriately low level of government-provided safe assets, and on inappropriately-high level of long-duration risky assets.

What I do not see is why all of this is a first-order loss, and why it is worth opening up a significant Okun Gap relative to full employment and potential output in order to prevent these Harburger Triangles.

So, I am once again pleading for an answer, or an explanation, preferably in the form of a simple model I can wrap my brain around.

Crickets…

Must-read: David Glasner: “The Sky Is Not Falling… Yet”

Must-Read: If you think that there is one chance in ten that the sky is falling with respect to the development of deflationary expectations, then you conclude that Federal Reserve policy is not appropriate–that they ought to be straining nerves to make policy looser to diminish that chance.

If you also think that there is one chance in two that in two years an inflationary spiral will have clearly begun… then you also conclude that Federal Reserve policy is not appropriate–that they ought to be straining nerves to make policy looser to diminish the chance of deflation, for there is plenty of policy time and policy space, plenty of sea room, to curb aggregate demand in the future should it attempt to blow us out to sea.

But there is next to no sea room and next to no policy space to boost aggregate demand if needed, for we are on a lea shore right now.

I am kinda thinking these days that only yachtsmen and yachtswomen should be allowed to hold central-banking policy jobs…

David Glasner: The Sky Is Not Falling… Yet: “The 2008 crisis. was caused by an FOMC that was so focused on the threat of inflation…

…that they ignored ample and obvious signs of a rapidly deteriorating economy and falling inflation expectations, foolishly interpreting the plunge in TIPS spreads and the appreciation of the dollar relative to other currencies as an expression by the markets of confidence in Fed policy rather than as a cry for help. In 2008 the Fed at least had the excuse of rising energy prices and headline inflation….

This time, despite failing for over three years to meet its now official 2% inflation target, Dr. Yellen and her FOMC colleagues show no sign of thinking about anything other than when they can show their mettle as central bankers by raising interest rates again…. [But] Dr. Yellen’s problem is now to show that her top–indeed her only–priority is to ensure that the Fed’s 2% inflation target will be met, or, if need be, exceeded, in 2016 and that the growth in nominal income in 2016 will be at least as large as it was in 2015. Those are goals that are eminently achievable, and if the FOMC has any credibility left after its recent failures, providing such assurance will prevent another unnecessary and destructive financial crisis…

Must-read: Lars Svensson: “Two serious mistakes in the Goodfriend and King review of Riksbank monetary policy”

Must-Read: Is it really the case that Goodfriend and King never asked Svensson whether his dissents and calls for lower rates were statements about the direction in which policy tools should move or statements about what the optimal value of policy tools should be? If they never asked him, that seems to me to be quite unprofessional. If they did ask him, then it seems there was, somewhere along the way, a major failure to communicate:

Lars E.O. Svensson: Two serious mistakes in the Goodfriend and King review of Riksbank monetary policy: “Marvin Goodfriend and Mervyn King presented their review of the Riksbank’s monetary policy 2010-2015 on January 19….

…They unfortunately start their evaluation by making two serious mistakes…. When finding the Riskbanks response… ‘not unreasonable’, Goodfriend and King… confuse rates of change and levels…. GDP and exports had started to grow in 2010 (although the year-over-year growth rates in quarter 1 of 2010 were not exceptionally high, 2.9% for GDP and 4.2% for export). However, the more important levels were not high but quite low…. The unemployment rate, a more reliable indicator of slack in the economy, was about 9%… making the unemployment gap about 2.5%. To start a rate hike from 0.25% to 2% in such a situation, with large slack in the economy and inflation not far from its target, is definitely not reasonable…. Just stating that the Riksbank rate hike was ‘not unreasonable,’ ignoring the actual GDP and export level data as well as the unemployment rate known at the time, and not providing a thorough evaluation of the hike, is a first serious mistake….

A second serious mistake of Goodfriend and King [is] to state that the rate hikes were ‘broadly accepted by all members’…. I know for sure that I did not share the view, and this is evidenced in my November 2010 speech and repeatedly in the minutes…. I instead advocated a major redirection of policy. One may also note the headline ‘Disaster path’ (‘Katastrofbana’) on the front page of the Swedish newspaper Svenska Dagbladet on September 27, 2010. This referred to my warning about the dire consequences of the majority’s high policy-rate path in an interview (in Swedish) in the newspaper that day. The headline and interview hardly indicates that I ‘broadly accepted’ the rate hikes. As evidence supporting their conclusion, Goodfriend and King state….

The dissenters on the Executive Board never voted for a level of the current repo rate more than one quarter of a percentage point below that actually set by the majority….

A vote for a slightly lower rate than that adopted by the majority cannot subsequently be used as evidence that a dissenter did not believe that a very different repo rate was optimal…. The repo rate… I voted for was only the first step in the right direction towards an approximately optimal rate and path; it was not a complete step to such a rate and path…. I advocated a stepwise procedure towards a rate and path that would eventually make the corresponding forecasts for inflation and unemployment ‘look good’. Unfortunately, I never gained a majority for even the first step…. Voting for a rate of 1.25% or 2% didn’t mean that it was the best rate, but that it was better than 1.5% and 2.25%, and a first step to a much lower rate…

Must-read: Robert Skidelsky: “The Optimism Error”

Robert Skidelsky: The Optimism Error: “When a slump threatened… a government could stimulate spending…

…by cutting interest rates and by incurring budget deficits. This was the main point of the Keynesian revolution…. In the 1980s… unemployment prevention became confined to interest-rate policy… by the central bank, not the government. By keeping… inflation constant, the monetary authority could keep unemployment at its ‘natural rate’. This worked quite well for a time, but… the world economy collapsed in 2008. In a panic, the politicians, from Barack Obama to Gordon Brown, took Keynes out of the cupboard, dusted him down, and ‘stimulated’ the economy like mad. When this produced some useful recovery they got cold feet….

Why had the politicians’ nerve failed and what were the consequences? The answer is that in bailing out leading banks and allowing budget deficits to soar, governments had incurred huge debts that threatened their financial credibility. It was claimed that bond yields would rise sharply, adding to the cost of borrowing. This was never plausible in Britain, but bond yield spikes threatened default in Greece and other eurozone countries early in 2010. Long before the stimulus had been allowed to work its magic in restoring economic activity and government revenues, the fiscal engine was put into reverse, and the politics of austerity took over. Yet austerity did not hasten recovery; it delayed it and rendered it limp when it came.

Enter ‘quantitative easing’ (QE). The central bank would flood the banks and pension funds with cash. This, it was expected, would cause the banks to lower their interest rates, lend more and, by way of a so-called wealth effect, cause companies and high-net-worth individuals to consume and invest more. But it didn’t happen. There was a small initial impact, but it soon petered out…. Institutions sat on piles of cash and the wealthy speculated in property. So we reach the present impasse…. Monetary expansion is much less potent than people believed; and using the budget deficit to fight unemployment is ruled out by the bond markets and the Financial Times. The levers either don’t work, or we are not allowed to pull them….

How much recovery has there been in Britain?… The OECD’s most recent estimate of this [output] gap in the UK stands at a negligible -0.017 per cent. We might conclude from this that the British economy is running full steam ahead and that we have, at last, successfully recovered from the crash…. But… although we are producing as much output as we can, our capacity to produce output has fallen…. Growth in output per person in Britain (roughly ‘living standards’) averaged 2.25 per cent per year for the half-century before 2008. Recessions in the past have caused deviations downward from this path, but recoveries had delivered above-trend growth…. This time it was different. The recovery from the financial crisis was the weakest on record, and the result of this is a yawning gap between where we are and where we should have been. Output per head is between 10 and 15 per cent below trend….

Why is it that the recession turned spare capacity into lost capacity? One answer lies in the ugly word ‘hysteresis’…. The recession itself shrinks productive capacity: the economy’s ability to produce output is impaired…. Much of the new private-sector job creation lauded by the Chancellor is… in such low-productivity sectors. The collapse of investment is particularly serious, because investment is the main source of productivity. The challenge for policy is to liquidate the hysteresis – to restore supply. How is this to be done?…

On the monetary front, the bank rate was dropped to near zero; this not being enough, the Bank of England pumped out hundreds of billions of pounds between 2009 and 2012, but too little of the money went into the real economy. As Keynes recognised, it is the spending of money, not the printing of it, which stimulates productive activity, and he warned: ‘If… we are tempted to assert that money is the drink which stimulates the system to activity, we must remind ourselves that there may be several slips between the cup and the lip.’ That left fiscal policy… deliberately budgeting for a deficit. In Britain, any possible tolerance for a deficit larger than the one automatically caused by a recession was destroyed by fearmongering about unsustainable debt. From 2009 onwards, the difference between Labour and Conservative was about the speed of deficit reduction…. From 2009 onwards the main obstacle to a sensible recovery policy has been the obsession with balancing the national budget…. ‘We must get the deficit down’ has been the refrain of all the parties….

It is right to be concerned about a rising national debt (now roughly £1.6trn). But the way to reverse it is not to cut down the economy, but to cause it to grow in a sustainable way. In many circumstances, that involves deliberately increasing the deficit. This is a paradox too far for most people to grasp. But it makes perfect sense if the increased deficit causes the economy, and thus the government’s revenues, to grow faster than the deficit…. In our present situation, with little spare capacity, the government needs to think much more carefully about what it should be borrowing for. Public finance theory makes a clear distinction between current and capital spending. A sound rule is that governments should cover their current or recurrent spending by taxation, but should borrow for capital spending, that is, investment. This is because current spending gives rise to no government-owned assets, whereas capital spending does. If these assets are productive, they pay for themselves by increasing government earnings, either through user charges or through increased tax revenues. If I pay for all my groceries ‘on tick’ my debt will just go on rising. But if I borrow to invest in, say, my education, my increased earnings will be available to discharge my debt….

Now is an ideal time for the government to be investing in the economy, because it can borrow at such low interest rates. But surely this means increasing the deficit? Yes, it does, but in the same unobjectionable way as a business borrows money to build a plant in the expectation that the investment will pay off. It is because the distinction between current and capital spending has become fuzzy through years of misuse and obfuscation that we have slipped into the state of thinking that all government spending must be balanced by taxes – in the jargon, that net public-sector borrowing should normally be zero. George Osborne has now promised to ‘balance the budget’ – by 2019-20. But within this fiscal straitjacket the only way he can create room for more public investment is to reduce current spending, which in practice means cutting the welfare state.

How can we break this block on capital spending? Several of us have been advocating a publicly owned British Investment Bank. The need for such institutions has long been widely acknowledged in continental Europe and east Asia, partly because they fill a gap in the private investment market, partly because they create an institutional division between investment and current spending. This British Investment Bank, as I envisage it, would be owned by the government, but would be able to borrow a multiple of its subscribed capital to finance investment projects within an approved range. Its remit would include not only energy-saving projects but also others that can contribute to rebalancing the economy – particularly transport infrastructure, social housing and export-oriented small and medium-sized enterprises (SMEs). Unfortunately, the conventional view in Britain is that a government-backed bank would be bound, for one reason or another, to ‘pick losers’, and thereby pile up non-performing loans. Like all fundamentalist beliefs, this has little empirical backing….

George Osborne has rejected this route to modernisation. Instead of borrowing to renovate our infrastructure, the Chancellor is trying to get foreign, especially Chinese, companies to do it, even if they are state-owned. Looking at British energy companies and rail franchises, we can see that this is merely the latest in a long history of handing over our national assets to foreign states. Public enterprise is apparently good if it is not British….

Setting up a British Investment Bank with enough borrowing power to make it an effective investment vehicle is the essential first step towards rebuilding supply. Distancing it from politics by giving it a proper remit would create confidence that its projects would be selected on commercial, not political criteria. But this step would not be possible without a different accounting system. The solution would be to make use of comprehensive accounting that appropriately scores increases in net worth of the bank’s assets…

Must-read: Simon Wren-Lewis: “The Dead Hand of Austerity; Left and Right”

Must-Read: There is an alternative branch of the quantum-mechanical wave-function multiverse in which we reality-based economists got behind the “safe asset shortage” view of our current malaise back in 2009. Savers, you see, love to hold safe assets. And in 2007-9 the private-sector financial intermediaries permanently broke saver trust in their ability to create and credibility to identify such safe assets. If, then, we seek to escape secular stagnation, the government must take of the task of providing safe assets for people to hold and then using the financing for useful and productive purposes. That could have been an effective counter-narrative to demands for austerity–not least because it appears to be a correct analysis…

Simon Wren-Lewis: The Dead Hand of Austerity; Left and Right: “Those who care to see know the real damage that austerity has had on people’s lives…

…The cost on the left could not be greater. Austerity and the reaction to it were central to Labour losing the election. The Conservatives managed to pin the blame for Osborne’s austerity on Labour, and as the recent Beckett report acknowledges (rather tellingly): ‘Whether implicitly or explicitly (opinion and evidence differ somewhat), it was decided not to concentrate on countering the myth…’ It was also central in the revolution of the ranks that happened subsequently. Austerity is a trap for the left as long as they refuse to challenge it. You cannot say that you will spend more doing worthwhile things, and when (inevitably) asked how you will pay for it try and change the subject. Voters may not be experts on economics, but they can sense weakness and vulnerability….

That dead hand… touches the reformist right… as [well]…. There were genuine hopes on all sides that Universal Credit (UC) might achieve the aim of simplifying the benefit system…. But as a result of austerity, and those cuts to tax credit that the Chancellor was forced to postpone, UC will now be seen as a way of cutting benefits and will be either extremely unpopular and/or be quickly killed…. The years of austerity will be seen as wasted years, when no new progress was achieved and plenty that had been achieved in the past setback. Recovery from recessions need not be like this, and indeed has not been like this in the past. They can be a time of renewal and reform…. In the UK that dead hand continues, seen or unseen, to dominate policy and debate. And with its architect set to become Prince Minister and large parts of the opposition still too timid to challenge it, it looks like another five wasted years lie ahead for us.

Must-read: Olivier Blanchard: “Ten Take Aways from the ‘Rethinking Macro Policy: Progress or Confusion?'”

Must-Read: I think the extremely-sharp Olivier Blanchard misses an important part of my argument here. If g the rate of growth of a government’s taxing capacity > r its cost of funds via borrowing and if the government is risk-neutral then obviously the government should issue more debt: the economy is then dynamically inefficient with respect to the investments taxpayers have made in their “ownership” of the government and its assets. Any argument that such a government should not be frantically running up its debt must hinge on aversion to interest-rate risk caused by fear of the consequences in the event of an interest-rate spike. But in the case of a reserve currency-issuing sovereign, what are those consequences? The consequences are merely that one must then balance the government’s budget constraint, via some combination of higher taxes, inflation, and financial repression. And there is no reason to think that, for reserve currency-issuing sovereigns, the costs of such a balancing are unduly large.

Other policies to get rid of the distortions that produce g > r for government debt may well be better than running up the debt. But in the absence of those other policies, running up the debt is certainly better than the status quo unless the government is near the edge of its financial repression and taxing capacities and the costs of inflation are very large. And for reserve currency-issuing sovereigns those are none of them the case.

Olivier Blanchard: Ten Take Aways from the “Rethinking Macro Policy: Progress or Confusion?: “On the latter, perhaps the most provocative conclusion of the conference…

…was offered by Brad DeLong:  If the rate at which the government can borrow (r) is less than the growth rate (g), then, he argued, governments should increase, not decrease, current debt levels. If people value safety so much (and thus the safe rate is so low), then it makes sense for the state to issue safe debt, and possibly use it for productive investment.  And if the interest rate is less than the growth rate, debt is safe: the debt- to-GDP ratio will decrease, even if the government never repays the debt.
One senses that the argument has strong limits, from the likelihood that r remains less than g (the two letters appear to have become part of the general vocabulary), to the issue of what determines the demand for safe assets, to whether r less than g is an indication of dynamic inefficiency or some distortion, to whether, even if this world, high levels of debt increase the probability of multiple equilibria, rollover crises and sudden stops.

Must-read: Paul Krugman: “Strangely Self-Confident Permahawks”

Must-Read: Paul Krugman: Strangely Self-Confident Permahawks: “An odd thing about permahawks…

…They are, by and large, free-market acolytes who insist that markets know best; yet they also insist that we ignore financial markets that have been telling us that inflation is quiescent and the U.S. government is solvent…. It’s OK to conclude that markets are currently wrong, although if you believe that they make huge errors that should influence your views on policy in general. But your confidence in your dismissal of market beliefs should bear some relationship to your own track record. If you’ve been warning about inflation, wrongly, for six or so years, and markets current show no worries about inflation… I would expect some diffidence….

But I’m not Martin Feldstein.


Marty Feldstein: A Federal Reserve Oblivious to Its Effect on Financial Markets: “The sharp fall in share prices last week was a reminder of the vulnerabilities created by years of unconventional monetary policy…

…t was inevitable that the artificially high prices of U.S. stocks would eventually decline. Even after last week’s market fall, the S&P 500 stock index remains 30% above its historical average. There is no reason to think the correction is finished. The overpriced share values are a direct result of the Federal Reserve’s quantitative easing (QE) policy…. The strategy worked well. Share prices jumped 30% in 2013 alone and house prices rose 13% in that year. The resulting rise in wealth increased consumer spending, leading to higher GDP and lower unemployment. But excessively low interest rates have caused investors and lenders, in their reach for yield, to accept excessive risks…. As the Fed normalizes interest rates these prices will fall. It is difficult to know if this will cause widespread financial and economic declines like those seen in 2008. But the persistence of very low interest rates contributes to that systemic risk and to the possibility of economic instability….

Moreover, the Fed is planning a path for short-term interest rates that is likely to raise the rate of inflation too rapidly…. The danger is that very low interest rates in this environment would lead to a higher rate of inflation and higher long-term rates. The Fed could prevent that faster rise in inflation by increasing the federal-funds rate more rapidly this year and next. Fed officials also make the case that stimulating the economy by continued monetary ease is desirable as protection against a possible negative shock—such as a sharp fall in exports or in construction—that could push the economy into a new recession. That strategy involves unnecessary risks of financial instability. There are alternative tax and spending policies that could provide a safer way to maintain aggregate demand if there is a negative shock. The Fed needs to recognize that its employment goals have essentially been reached and that the inflation rate will reach its target of 2% in the foreseeable future. The economy would be better served by a more rapid normalization of short-term interest rates.

Must-read: Simon Wren-Lewis: “Confidence as a Political Device”

Must-Read: Simon Wren-Lewis: Confidence as a Political Device: “The leap from the statement that ‘in some circumstances confidence matters’…

…to ‘we should worry about bond market confidence in an economy with its own central bank in the middle of a depression’ is a huge one…. For the US and UK in 2009, was there the slightest chance that either government wanted to default?… The answer has to be a categorical no…. The argument goes that if the market suddenly gets spooked and stops buying debt, printing money will cause inflation, and in those circumstances the government might choose to default. But we were in the midst of the biggest recession since the 1930s. Any money creation would have had no immediate impact on inflation…. The Corsetti and Dedola paper is not applicable. (Robert [Waldmann] makes a similar point about the Blanchard paper. I will not deal with the exchange rate collapse idea because Paul already has….

Ah, but what if the market remains spooked for so long that eventually inflation rises?… In Corsetti and Dedola agents are rational, so we have left that paper way behind. We have entered, I’m afraid, the land of pure make believe. So there is no applicable model that could justify the confidence effects that might have made us cautious in 2009 about issuing more debt. There are models about an acute shortage of safe assets on the other hand, which seem to be ignored by those arguing against fiscal stimulus…. When people invoke the idea of confidence… it frequently allows those who represent the group whose confidence is being invoked to further their own self interest…. Bond market economists never saw a fiscal consolidation they did not like…. If the economics point towards a conclusion, and people argue against it based on ‘confidence’, you should be very, very suspicious…