Tim Duy’s Five Questions for Janet Yellen

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A very nice piece here from the very-sharp Tim Duy:

Tim Duy: Five Questions for Janet Yellen

Next week’s meeting of the Federal Open Market Committee (FOMC) includes a press conference with Chair Janet Yellen. These are five questions I would ask if I had the opportunity to do so in light of recent events.

(1) 1. What’s the deal with labor market conditions? You advocated for the creation of the Federal Reserve’s Labor Market Conditions Index (LMCI) to serve as a broader measure of the labor market and as an alternative to a narrow measure such as the unemployment rate. The LMCI declined for five consecutive months through May, the most recent release…. On June 6, however, you said that:

the job market has strengthened substantially, and I believe we are now close to eliminating the slack that has weighed on the labor market since the recession.

The LCMI signals that although the economy may be operating near full employment, it is now moving further away from that goal. Is it appropriate for the Fed to still be considering interest rate hikes when your measure is moving away from the goal of full employment? Or have you determined the LMCI is not a useful measure of labor market conditions?

(2) Has the effect of QE been underestimated? Since the Fed began and completed the process of ending quantitative easing (QE), the dollar has risen in value, the stock market rally has stalled, the yield curve has flattened, broader economic activity has slowed, and now we are experiencing a slowing in labor market activity. These are all traditionally signs of tighter monetary policy, but you have insisted that tapering is not tightening and that policy remains accommodative. Given these signs, is it possible or even likely that you have underestimated the effectiveness of QE and hence are now overestimating the level of financial accommodation?

(3) Optimal control or no? The Fed appears determined to hit its inflation target from below. In other words, the central bank is positioning policy to tighten despite inflation currently running below the 2 percent target in order to avoid an overshoot at a later date. In the past, however, you argued for an ‘optimal control’ approach that anticipated an explicit overshooting of the inflation target in order to more rapidly meet the Fed’s mandate of full employment. Under optimal control, it seems that given stalled progress on reducing underemployment, coupled with deteriorating labor market conditions, the Fed should now be explicitly aiming to overshoot the inflation target by keeping policy loose. Do you believe the optimal control approach you previously advocated is wrong? If so, what caused you to change your mind?

(4) An Evans Rule for all? Chicago Federal Reserve President Charles Evans remains concerned about asymmetric policy risks. Persistently below target inflation risks undermining the public’s belief that the Fed is committed to reaching its target. Such a loss of credibility hampers the ability to subsequently meet the central bank’s target. In contrast, the well-known effectiveness of traditional policy tools means there is less upside risk to inflation. Consequently, he argues for an updated version of the Evans Rule (or an earlier commitment to not hike rates as long as unemployment exceeded 6.5 percent and inflation was below 2.5 percent).
Specifically, Evans said:

In order to ensure confidence that the U.S. will get to 2 percent inflation, it may be best to hold off raising interest rates until core inflation is actually at 2 percent. The downside inflation risks seem big — losing credibility on the downside would make it all that more difficult to ever reach our inflation target. The upside risks on inflation seem smaller.

Recall that in your most recent speech you indicated unease with inflation expectations and — at least implicitly — recognized the asymmetry of policy risks:

It is unclear whether these indicators point to a true decline in those inflation expectations that are relevant for price setting; for example, the financial market measures may reflect changing attitudes toward inflation risk more than actual inflation expectations. But the indicators have moved enough to get my close attention. If inflation expectations really are moving lower, that could call into question whether inflation will move back to 2 percent as quickly as I expect.

This — especially when combined with your past support for an optimal control approach to policy — suggests that you should be amenable to adopting Evans’ position. Do you support Evans’ proposal that the Fed should stand down from rate hikes until the inflation target is reached? Why or why not?

(5) Just how much do you care about the rest of the world? Earlier this year, Federal Reserve Governor Lael Brainard suggested that the many developed economies operating at or below zero percent interest rates reduces the central bank’s capacity for raising rates:

‘Financial tightening associated with cross-border spillovers may be limiting the extent to which U.S. policy diverges from major economies…

At last September’s FOMC press conference, you said that you thought the global forces were insufficient to restrain the path of U.S. monetary policy. In response to a question about ‘global interconnectedness’ preventing the U.S. from ever moving away from zero percent interest rates, you said:

I would be very surprised if that’s the case. That is not the way I see the outlook or the way the Committee sees the outlook. Can I completely rule it out? I can’t completely rule it out. But, really, that’s an extreme downside risk that in no way is near the center of my outlook.

Given the events of the past six months — especially the refusal of longer-term U.S. Treasury yields to rise despite repeated hints of monetary tightening — have you reassessed your opinion? Do you view the risks of such an outcome as greater or lower than your assessment made last September?

Bottom Line: Most of these questions try to push Yellen to explain her past positions in light of the current data and actions. I think understanding how and why her positions change is critical to understanding how the Fed reacts to the conditions facing it. Making the so-called ‘reaction function’ clear remains the most important piece of the Fed’s communication strategy.

These five questions–“What’s the deal with labor market conditions?… Has the effect of QE been underestimated?… Optimal control or no?… An Evans Rule for all?… Just how much do you care about the rest of the world?”–are the right questions to ask. And Tim’s bottom line–“Push Yellen to explain her past positions in light of the current data and actions. I think understanding how and why her positions change is critical…. Making the so-called ‘reaction function’ clear remains the most important piece of the Fed’s communication strategy”–is the right bottom line.

After all, does this look like an economy crossing the line of potential output in an upward direction with growing and substantial gathering inflationary pressures to you?

Change in Labor Market Conditions Index FRED St Louis FedNewImage
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The Federal Reserve is simply not doing a good job of communicating its reaction function. It is not doing a good job of linking its model of the economy to current data and past events. Inflation, production, and employment (but not the unemployment rate) have been disappointingly low relative to Federal Reserve expectations for each of the past nine years. These events should have led to substantial rethinking by the Federal Reserve of its model of the economy. And yet the model set forward by Yellen and Fischer (but not Evans and Brainard) appears to be very much the model they held to in the late 1990s, which was the model they believed in in the early 1980s: very strong gearing between recent-past inflation and expected inflation, and a Phillips Curve with a pronounced slope, even with inflation very low.

Unless my Visualization of the Cosmic All is grossly wrong along the relevant dimensions, this is not the right model of the current economy. There was never good reason to think that the bulk of the runup in inflation in the 1970s was due to excessive demand pressure and unemployment below the natural rate–it was, more probably, mostly due to supply shocks plus the lack of anchored expectations. Only if you highball the estimate of the Phillips Curve’s slope for the 1970s can you understand the fall in inflation in the early 1980s as due overwhelmingly to slack, rather than ascribing a component to the reanchoring of inflation expectations. Thus the way to bet is that the economy on its current trajectory will produce less upward pressure on current inflation and also on inflation expectations than the Federal Reserve currently projects.

But how will it react when the data once again disappoints Federal Reserve expectations–as it has? In June 2013, the Fed was predicting that annual GDP growth during the 2013-2015 period would average 2.9%, with longer-run growth of real potential GDP averaging 2.4%. Instead, annual growth has averaged 2.3% (or 2.2%, if estimates for the first half of 2016 are correct). Nor did it perform better on other measures. The Fed predicted an annual inflation rate, based on the personal consumption expenditures index, of 1.9% for 2015. The true number was 1.5%. Similarly, its average projection of the federal funds rate for 2015 was 1.5%. The figure is currently 0.25%. This three-year period, starting in 2013, in which the economy undershot the Fed’s expectations, follows a three-year period in which the economy likewise fell short of the Fed’s forecast. And that period followed a three-year period, starting in 2007, in which the Fed massively understated downside deflationary risks.

Yet the prevailing model does appear to be the model of the early 1980s. It continues to gear inflation expectations at unrealistically high levels based on past inflation. And it continues to rely on the unemployment rate as a stand-in for the state of the labor market, at the expense of other indicators. So the big questions are: Will that commitment break? What would make them revise their models of the economy? And how will those model revisions affect their policy reaction function map from data to interest rates?

In an environment of economic volatility like the one in which we find ourselves today, a prudent central bank should do everything it can to raise expected and actual inflation, in order to gain the ability to stabilize the economy in any direction. If interest rates were well above zero, the Fed would have scope to raise them further in case of overheating or to lower them in response to adverse demand shocks.
But the Fed continues to neglect asymmetry, considering it only a second- or third-order phenomenon. It is not pushing for inflation at or above its target, even as optimal-control doctrines that themselves neglect asymmetry call for such a trajectory. Instead, by tightening policy by an amount that it cannot reliably gauge, it is narrowing its room for maneuver.

Looking at the current composition of the FOMC does not add to confidence:

  • On the left, Lael Brainard and Charles Evans certainly understand the situation–and have been right about almost everything they have opined on over the past eight years. Dan Tarullo shares their orientation, but these are not his issues.

  • On the right, Robert Kaplan and Patrick Harker replace hawks who were always certain, often wrong, and never open-minded–and are the products of failed searches: a job search is not supposed to choose a director of the search-consultant firm or the head of the search committee. Jeffrey Lacker and James Bullard and their staffs have been more wrong on monetary policy than the average FOMC member over the past eight years, but do not appear to have taken wrongness as a sign that their views of the economy might need a rethink. Esther George and Loretta Mester and their staffs feel the pain of a commercial banking sector in the current interest-rate environment, but I have never been convinced they understand how disastrous for commercial banks the medium- and long-term consequences of premature tightening and interest-rate liftoff would be.

  • In the neutral center, Jerome Powell does not appear to have views that differ from those of the committee as a whole. These are not Neel Kashkari’s issues: he is too good a bureaucrat to want to dissent from any consensus or near consensus on issues that are not his. And I simply do not have a read on Dennis Lockhart and his staff.

  • The active center is thus composed of Janet Yellen, Stanley Fischer, Bill Dudley, Eric Rosengren, and John Williams. Market risk and confusion is generated by uncertainty about their models of the economy, uncertainty about how they will revise their models as the data comes in, and uncertainty as to how they will react in committee, with six voices to their right calling for rapid interest-rate normalization and only three voices to their left worrying about asymmetric risks and policy traction.

When I listen to this center, one vibe I get is that the asymmetries are really not that great. Janet Yellen this March:

One must be careful, however, not to overstate the asymmetries affecting monetary policy at the moment. Even if the federal funds rate were to return to near zero, the FOMC would still have considerable scope to provide additional accommodation. In particular, we could use the approaches that we and other central banks successfully employed in the wake of the financial crisis to put additional downward pressure on long-term interest rates and so support the economy–specifically, forward guidance about the future path of the federal funds rate and increases in the size or duration of our holdings of long-term securities. While these tools may entail some risks and costs that do not apply to the federal funds rate, we used them effectively to strengthen the recovery from the Great Recession, and we would do so again if needed…

Another vibe I get is more-or-less what Bernanke said back in 2009:

The public’s understanding of the Federal Reserve’s commitment to price stability helps to anchor inflation expectations and enhances the effectiveness of monetary policy, thereby contributing to stability in both prices and economic activity…. A monetary policy strategy aimed at pushing up longer-run inflation expectations in theory… could reduce real interest rates and so stimulate spending and output. However, that theoretical argument ignores the risk that such a policy could cause the public to lose confidence in the central bank’s willingness to resist further upward shifts in inflation, and so undermine the effectiveness of monetary policy going forward. The anchoring of inflation expectations is a hard-won success that has been achieved over the course of three decades, and this stability cannot be taken for granted. Therefore, the Federal Reserve’s policy actions as well as its communications have been aimed at keeping inflation expectations firmly anchored…

I cannot help but be struck by the difference between what I see as the attitude of the current Federal Reserve, anxious not to do anything to endanger its “credibility”, and the Greenspan Fed of the late 1990s, which assumed that it had credibility and that because it had credibility it was free to experiment with policies that seemed likely to be optimal in the moment precisely because markets understood its long-term objective function and trusted it, and hence would not take short-run policy moves as indicative of long-run policy instability. There is a sense in which credibility is like a gold reserve: It is there to be drawn on and used in emergencies. The gold standard collapsed into the Great Depression in the 1930s in large part because both the Bank of France and the Federal Reserve believed that their gold reserves should never decline, but always either stay stable of increase.

And I cannot help but be struck by the inconsistency between the two vibes. The claim that we need not worry about asymmetry because we are willing to undertake radical policy experimentation fits very badly with the claim that we dare not rock the boat because the anchoring of inflation expectations on the upside is very fragile. Combine these with excessive confidence in the current model–with a tendency to make policy based on the center of the fan of projected outcomes with little consideration of how wide that fan actually is–and I find myself with much less confidence in today’s Fed than I, four years ago, thought I would have today.

Must-Read: Paul Krugman: Germany Austerity Policy

Must-Read: Paul Krugman: Germany Austerity Policy: “Once the bubble burst, there was going to be a difficult time for the Euro, regardless…

…But it’s been far worse than it needed to be and Germany bears some of the responsibility because of turning what should have been viewed as essentially a technical economic problem into a morality play. That has been a very unfortunate story…. Austerity policies have taken what was fundamentally a story about excessive private capital flows and housing bubbles and turned it into lectures of fiscal responsibility that have ended up doing a lot of damage….

Greece was going to have to do a fair amount of austerity but not this much. In the end it would still have been ugly, but not on this level. What could have mitigated the damage? The thing is that what has actually happened has not worked. Greece is still in the Euro. There’s a little bit of economic growth but at the cost of an incredible slump. The ratio of debt to GDP is higher than ever. All of this austerity has not only not resolved the fiscal problem, it hasn’t even moved it in the right direction…

Must-Read: Olivier Blanchard: How to Teach Intermediate Macroeconomics after the Crisis?

Must-Read: Am I allowed to say that nearly all of this is in Paul Krugman’s 1998 The Return of Depression Economics?

Olivier Blanchard: How to Teach Intermediate Macroeconomics after the Crisis?: “The IS relation remains the key to understanding short-run movements in output…

…In the short run, the demand for goods determines the level of output. A desire by people to save more leads to a decrease in demand and, in turn, a decrease in output. Except in exceptional circumstances, the same is true of fiscal consolidation. I was struck by how many times during the crisis I had to explain the ‘paradox of saving’ and fight the Hoover-German line, ‘Reduce your budget deficit, keep your house in order, and don’t worry, the economy will be in good shape.’ Anybody who argues along these lines must explain how it is consistent with the IS relation. The demand for goods, in turn, depends on the rate at which people and firms can borrow (not the policy rate set by the central bank, more on this below) and on expectations… animal spirits… largely self-fulfilling. Worries about future prospects feed back to decisions today….

The LM relation… is the relic of a time when central banks focused on the money supply…. The LM equation must be replaced, quite simply, by the choice of the policy rate by the central bank, subject to the zero lower bound. How the central bank achieves it… can stay in the background…. Traditionally, the financial system was given short shrift in undergraduate macro texts. The same interest rate appeared in the IS and LM equations…. This is not the case and that things go very wrong. The teaching solution, in my view, is to… discuss how the financial system determines the spread between the two….

Turning to the supply side, the contraption known as the aggregate demand–aggregate supply model should be eliminated…. One simply uses a Phillips Curve…. Output above potential, or unemployment below the natural rate, puts upward pressure on inflation. The nature of the pressure depends on the formation of expectations…. If people expect inflation to be the same as in the recent past, pressure takes the form of an increase in the inflation rate. If people expect inflation to be roughly constant… pressure takes the form of higher—rather than increasing—inflation. What happens to the economy, whether it returns to its historical trend, then depends on how the central bank adjusts the policy rate in response to this inflation pressure…. This… is already standard in more advanced presentations and the new Keynesian model (although the Calvo specification used in that model, as elegant as it is, is arbitrarily constraining and does not do justice to the facts). It is time to integrate it into the undergraduate model…. These modified IS, LM, and PC relations can do a good job….

I consider two extensions… expectations… openness. Here, also, there are important lessons from the crisis…. The long interest rate… as the average of future expected short rates, with a fixed term premium. Quantitative easing… can affect this premium…. Deriv[ing]… exchange rates from the uncovered interest rate parity condition… assumes infinitely elastic capital flows. The crisis has shown… capital flows have finite elasticity and are subject to large shocks beyond movements in domestic and foreign interest rates. Periods of ‘risk on-risk off’ and large movements in capital flows have been an essential characteristic of the crisis and its aftermath…

Must-Read: Simon Wren-Lewis: Greece Under Troika Rule

Must-Read: Simon Wren-Lewis: Greece Under Troika Rule: “‘The repayment of foreign loans and the return to stable currencies…

…were recognized as the touchstones of rationality in politics; and no private suffering, no infringement of sovereignty was considered too great a sacrifice for the recovery of monetary integrity. The privations of the unemployed made jobless by deflation; the destitution of public servants dismissed without a pittance; even the relinquishment of national rights and the loss of constitutional liberties were judged a fair price to pay for the fulfilment of the requirements of sound budgets and sound currencies, these a priori of economic liberalism. — Karl Polanyi (1944), ‘The Great Transformation’ (p142)

This quote (HT Jeremy Smith) could almost be written today about Greece. I had once thought that the lessons of the interwar period and Great Depression had been well learnt, but 2010 austerity showed that was wrong…. The Greek government borrowed too much… the scale… meant default was pretty inevitable. But Eurozone leaders, worried about their banking system (which held a lot of Greek debt), first postponed default and then made it partial. The real ‘bailing out’ was for the European banks and others who had lent to the Greek government…. Nothing… obliged Eurozone leaders to lend their voters money to bail out these creditors…. If European leaders felt their banking systems needed support, they could have done this directly….

They convinced themselves that Greece could pay them back. It was a mistake they will do anything to avoid admitting. To try and ensure they got their money back, they along with the IMF effectively took over the running of the Greek economy. The result has been a complete disaster. The amount of austerity imposed caused great hardship, and crashed the economy…. The Troika wants 3.5% primary surpluses by 2018… to start getting their money back sooner… an absurd demand…. Right now Greece needs more aggregate demand not structural reform, yet the Troika insists on taking more demand out of the economy….

Despite Martin Sandbu’s optimism, the recent deal is essentially more of the same. The IMF, which knows it makes no sense to ‘extend and pretend’, has again capitulated. The reaction to the IMF’s paper on neoliberalism has generally missed the key point. It is not fanciful to believe that the paper is directed at those within the IMF like Poul Thomsen, the head of their European department. Falling GDP will continue to be blamed on the Greek government, even without its former finance minister. Of course one day the Greek economy will recover, just as the Irish famine came to an end. But history, as taught in Britain as well as Ireland, does not remember the British troops guarding the shipments of grain leaving Ireland during the famine as heroic upholders of the rules of law and contract. Nor will it do the same for the members of the Troika that keep Greece in poverty.

Must-Read: Alan Shipman: Iceland’s Economy Miracle

Must-Read: Alan Shipman: Iceland’s Economy Miracle: “The country that suffered proportionally the world’s biggest financial collapse in 2008 is now set to boom again…

…Its overgrown banks were one of the causes of the global financial crisis, Iceland responded to their meltdown… allowed its currency to fall in value… nationalised the big banks… rescuing only the fraction that served the domestic economy. It imposed capital controls… tightened monetary policy… allowed fiscal policy to take the economic and social strain. In particular, public money was used to relieve households of the debt that would otherwise stop any spending recovery….

Until now, critics had one powerful riposte to this improbable ray of Nordic sunshine. They said it was a false dawn…. When the controls lift, the whole fairy-tale escape story will unravel…. Iceland’s currency (the kronur) will plunge as foreign funds flee, never to return. Interest rates will rise even higher to rescue the exchange rate, choking-off investment, without stopping the runaway inflation sparked by imports getting more expensive. The weaker kronur will leave the country struggling to service its remaining foreign debt, despite its recent reduction….

[But] the current account surpluses permitted by the devaluation, and the nationalised bank assets that regained value… have enabled the repayment of so much foreign debt that the rest will be manageable…. It’s a stark contrast to the eurozone and especially Greece, which had to ask its creditors for debt relief that will not begin until 2018. The chances of a kronur crash have diminished because the current account is back in surplus… foreign investors are again being attracted… [by] high interest rates, growth prospects and investment opportunities…. A remote island with a population of 300,000 and unique natural resources could be dismissed as a special case, Iceland’s remarkable renaissance make its remedies a serious challenge to the orthodoxy…

Whose are the ruling macroeconomic ideas?

It is now six years since Olivier Blanchard called for “outlining the contours of a new macroeconomic policy framework”. Yet what is that framework? Where is it? Who outlines it? And what processes will give it political traction?

Looking back to 2010:

Olivier Blanchard et al. (2010): Rethinking Macro Policy: “The global crisis forced economic policymakers…

…to react in ways not anticipated by the pre-crisis consensus…. Here the IMF’s chief economist and colleagues (i) review the main elements of the pre-crisis consensus, (ii) identify the elements which turned out to be wrong, and (iii) take a tentative first pass at outlining the contours of a new macroeconomic policy framework…

You can argue that the elements of such a framework are there. But they are disassembled, lying on the ground, disconnected. And as far as political traction, they are next to nowhere.

I am ending my invited lectures these days with this:

It is traditional to close lectures like this with Keynes’s “madmen in authority” quote:

Is the fulfilment of these ideas a visionary hope? Have they insufficient roots in the motives which govern the evolution of political society? Are the interests which they will thwart stronger and more obvious than those which they will serve?

I do not attempt an answer in this place…. But if the ideas are correct… it would be a mistake, I predict, to dispute their potency over a period of time…. The ideas of economists and political philosophers, both when they are right and when they are wrong, are more powerful than is commonly understood. Indeed the world is ruled by little else. Practical men, who believe themselves to be quite exempt from any intellectual influences, are usually the slaves of some defunct economist. Madmen in authority, who hear voices in the air, are distilling their frenzy from some academic scribbler of a few years back. I am sure that the power of vested interests is vastly exaggerated compared with the gradual encroachment of ideas….

There are not many who are influenced by new theories after they are twenty-five or thirty years of age, so that the ideas which civil servants and politicians and even agitators apply to current events are not likely to be the newest. But, soon or late, it is ideas, not vested interests, which are dangerous for good or evil.

Yet when I look around, I see lots of ideas with a potency that is extremely great but with influence that is nowheresville.

The ruling ideas are not those of “academic scribblers”. They are, rather, much simpler. At the moment I count five:

  1. The bankers have us by the plums…: Thus it is important to cosset, coddle, and enrich our bankers, because only if they are confident will the engine of financial intermediation that is the only thing that can create a booming full-employment economy run smoothly.

  2. Debt is bad (except when it is used to fund tax cuts for “job creators”)…: Hence it is important to cut Social Security and make sure that not an extra drop is spent on public infrastructure.

  3. Today’s extremely low interest rates must be unnatural…: Hence they need to be reversed and monetary policy “normalized” as quickly as normalization can be accomplished without renewed recession.

  4. Only pain can drive reform…: Hence boosting employment and restoring fast growth would be bad as it would impeded the essential process of actually undertaking the badly-needed “structural reforms”.

  5. We couldn’t have done any better…: The most urgent economic problems of the North Atlantic aren’t the standard ones of too-little “money” (of various kinds) chasing a normal amount of goods, but are complicated and irresolvable.

If the ruling ideas were those of Bagehot, Kindleberger, Keynes, Friedman–even a Hayek–we could do something, although in the last case it would take a lot of intellectual ingenuity to make a silk purse out of that particular sow’s ear. But the ruling ideas are barely ideas–they are, rather slogans. The bipartisan technocratic policy center of politicians who listen to arguments about what policies might actually work is gone–or at least paralyzed. And too many key levers of power are held by a right–in Germany, in Britain, and in the U.S.–that appears profoundly uninterested in argument abut policy effectiveness, if not uninterested in policy effectiveness itself.

Must-read: Olivier Blanchard: “Rethinking Macro Policy”

Must-Read: It is now six years since Olivier Blanchard called for “outlining the contours of a new macroeconomic policy framework”. Yet what is that framework? Where is it? Who outlines it? And what processes will give it political traction?

Olivier Blanchard et al. (2010): Rethinking Macro Policy: “The global crisis forced economic policymakers…

…to react in ways not anticipated by the pre-crisis consensus…. Here the IMF’s chief economist and colleagues (i) review the main elements of the pre-crisis consensus, (ii) identify the elements which turned out to be wrong, and (iii) take a tentative first pass at outlining the contours of a new macroeconomic policy framework.

Must-read: Paul Krugman: “Robber Baron Recessions”

Must-Read: But… but… but…

Is this the wrong graph somehow?:

FRED Graph FRED St Louis Fed

Yes, investment spending is weak relative to its past business-cycle peak values. But all of the relative weakness is in residential construction:

FRED Graph FRED St Louis Fed

You can say that business investment should be even stronger–high profits, high profit margins, depressed wage costs mean that capital’s complement labor is cheap, very low financing costs (if you can borrow risk-free). But business investment is also a function of capacity utilization, and you would not expect it to be high in a low-pressure economy, especially one in which confidence is low that the trend growth of nominal GDP will be sustained.

Why is this the wrong graph?

Paul Krugman: Robber Baron Recessions: “Profits are at near-record highs…

…thanks to a substantial decline in the percentage of G.D.P. going to workers. You might think that these high profits imply high rates of return to investment. But corporations themselves clearly don’t see it that way: their investment in plant, equipment, and technology (as opposed to mergers and acquisitions) hasn’t taken off, even though they can raise money, whether by issuing bonds or by selling stocks, more cheaply than ever before….

Suppose that those high corporate profits don’t represent returns on investment, but instead mainly reflect growing monopoly power… [with] corporations… able to milk their businesses for cash, but with little reason to spend money on expanding capacity or improving service… an economy with high profits but low investment, even in the face of very low interest rates and high stock prices.

And such an economy wouldn’t just be one in which workers don’t share the benefits of rising productivity; it would also tend to have trouble achieving or sustaining full employment. Why? Because when investment is weak despite low interest rates, the Federal Reserve will too often find its efforts to fight recessions coming up short. So lack of competition can contribute to ‘secular stagnation’ — that awkwardly-named but serious condition…. If that sounds to you like the story of the U.S. economy since the 1990s, join the club.

Must-read: Simon Wren-Lewis: “Can Central Banks Make Three Major Mistakes in a Row and Stay Independent?”

Must-Read: Simon Wren-Lewis: Can Central Banks Make Three Major Mistakes in a Row and Stay Independent?: “Mistake 1: If you are going to blame anyone for not seeing the financial crisis coming…

…it would have to be central banks. They had the data that showed a massive increase in financial sector leverage. That should have rung alarm bells, but instead it produced at most muted notes of concern about attitudes to risk. It may have been an honest mistake, but a mistake it clearly was.

Mistake 2: Of course the main culprit for the slow recovery from the Great Recession was austerity, by which I mean premature fiscal consolidation. But the slow recovery also reflects a failure of monetary policy…. Monetary policy makers should have said very clearly… that fiscal stimulus would have helped them do that job….

What could be mistake 3: The third big mistake may be being made right now in the UK and US… supply side pessimism. Central bankers want to ‘normalise’ their situation… writing off the capacity that appears to have been lost as a result of the Great Recession…. In both cases the central bank is treating potential output as something that is independent of its own decisions and the level of actual output. In other words it is simply a coincidence that productivity growth slowed down significantly around the same time as the Great Recession. Or if it is not a coincidence, it represents an inevitable and permanent cost of a financial crisis. Perhaps that is correct, but there has to be a fair chance that it is not…. What central banks should be doing in these circumstances is allowing their economies to run hot for a time….

If we subsequently find out that their supply side pessimism was incorrect (perhaps because inflation continues to spend more time below than above target, or more optimistically growth in some countries exceed current estimates of supply without generating ever rising inflation), this could spell the end of central bank independence. Three counts and you are definitely out?

Notes on the global economy as of early April 2016

A Note on the Likelihood of Recession: With global inflation currently more than quiescent, there is no chance that global recovery will be—as Rudi Dornbusch used to say—assassinated by inflation-fighting central banks raising interest rates.

As for recovery being assassinated by financial chaos, we face a paradox here: Financial risks that policymakers and economists can see are those that bankers can see and hedge against as well. It is only the financial risks that policymakers and economists do not see that are truly dangerous. Many back in 2005 saw the global imbalance of China’s export surplus and feared disaster from a fall in the dollar coupled with the discovery of money-center institutions having sold massive amounts of unhedged dollar puts. Very few, if any–even among those who believed US housing was a massive bubble likely to pop—feared that any problems created thereby would not be rapidly handled and neutralized by the Federal Reserve.

The most likely danger of recession is thus absent, and the second most likely danger is unknowable.

That leaves the third: a global economy that drifts into a downturn because both fiscal and monetary policymakers sit on their hands and refuse to use the stimulative demand management tools they have.

Here there is, I think, some reason to fear. A passage from a recent speech by the nearly-godlike Stan Fischer was flagged to me by Tim Duy:

If the recent financial market developments lead to a sustained tightening of financial conditions, they could signal a slowing in the global economy that could affect growth and inflation in the United States. But we have seen similar periods of volatility in recent years–including in the second half of 2011–that have left little visible imprint on the economy, and it is still early to judge the ramifications of the increased market volatility of the first seven weeks of 2016. As Chair Yellen said in her testimony to the Congress two weeks ago, while “global financial developments could produce a slowing in the economy, I think we want to be careful not to jump to a premature conclusion about what is in store for the U.S. economy”…

And Tim commented:

This… again misses the Fed’s response to financial turmoil…. I really do not understand how Fed officials can continue to dismiss market turmoil using comparisons to past episodes when those episodes triggered a monetary policy response. They don’t quite seem to understand the endogeneity in the system…

However, anything that could be called a “global recession” in the near term still looks like a less than 20% chance to me. But that is up from a 5% chance nine months ago.


A Note on China: I do not understand China. And I know I do not understand China. Perhaps that gives me an advantage in analyzing China, perhaps not. The relevant long-run fundamentals of China seem to me to be two:

  1. Your typical wealthy Chinese plutocrat-political clan seeks in the long run to have perhaps 1/3 of its wealth outside of China as insurance against political risks, and thus seeks an opportunity to export capital from China.
  2. Your typical North Atlantic business or investment group sees returns from further massive investments in China as uncertain and sees political risks as large but as capable of resolution over the next decade, and so will delay investing in China.

That means renminbi weakness as a background trend behind shorter-term financial- and political-business cycles. And that has to shape what the real risks are (large) and opportunities (smaller).

A Note on the Non-Need for a New Plaza Accord: I would say that international monetary affairs in the Global North high now need not an accord but, rather, the right kind of discord.

At my Berkeley office I dwell in the zone of influence of the truly formidable Barry Eichengreen. His strongly, and I believe correctly, argued view is essentially that he set out in Eichengreen and Sachs (1986): that what we need is not an accord but a currency war. Global North blocs—the U.S., Britain, the Eurozone, Japan—leapfrogging each other with aggressive competitive devaluations every four months or so are likely to produce positive monetary spillovers as large as anything that monetary policy could now produce.

But what could monetary policy now produce?

My career analytical nadir was my memo to my Treasury bosses in 1993 that NAFTA was likely to put upward pressure on the peso. My second-worst was my confident prediction at the end of 2008 that within three years North Atlantic nominal demand would be back to its pre-2008 trend. My third has been my prediction that Abenomics would be an obvious and substantial success. That third prediction was based on my reading of the 1930s, in which four aggressive reflationary régime changes—that of Neville Chamberlain as Chancellor of the Exchequer in 1931, that of Takahashi Korekiyo as Finance Minister in 1932, that of Hjalmar Horace Greeley Schacht as Reichsbank President in 1933, and that of Franklin Delano Roosevelt as President in 1933—had been substantial successes. The mixed success of Abenomics thus tells me that my views of what monetary policy tools would work and how well they would work are almost surely wrong, and that I need to rethink.

Thus as far as monetary policy is concerned I am at sea.

With respect to fiscal policy, however, I am much more confident: Blanchard and Leigh (2013) is convincing. DeLong and Summers (2012) is correct. Coordinated North Atlantic fiscal expansion—unless the money is spent in a truly perverse fashion—is highly likely to boost production with North Atlantic-wide multipliers of around 3 and to reduce debt-to-GDP ratios. Whether it will generate enough inflation to be unwelcome hinges on the state of aggregate supply in the North Atlantic. And there we are so far outside the bounds of previous experience that I do not think anyone can or should speak with confidence.

A Note on Negative Interest Rates: Cash should be a very attractive asset vis-a-vis Treasury bonds at any negative or, indeed, slightly positive interest rate. Containers full of durable, storable commodities should be a very attractive asset vis-a-vis cash—and more so vis-a-vis Treasury bonds and even cash at a wider range of interest rates up to nearly the long-term expected rate of inflation. The only way I can understand current strong demand for the interest-bearing securities and, indeed, the cash of reserve currency-issuing sovereigns possessing exorbitant privilege is that 2008-9 and the political reaction thereto has cast the existence of the Bagehot lender-of-last-resort into grave doubt. Thus we not only have East Asian and other sovereigns desperate for reserves to avoid another 1998, we have every major financial institution desperate to avoid another fall of 2008. These economic agents seem to me to be no longer pursuing sensible risk-return optimization strategies. Instead, they seem to seek enough reserves to surmount any possible future crisis so that they can stay in the game and then earn profits whenever normalization and the future come.

As to dysfunctionalities—so far I see no signs of massive malinvestments in physical or organizational capital that will pay large negative societal returns, and I see no taking of extraordinarily risky large positions by too-big-to-fail entities. I feel that dysfunctional asset prices that produce dysfunctional investments and dysfunctional portfolios. But I cannot see what they are…