Category: Equitablog

The baseline New Keynesian model was not, originally, intended to become a workhorse.

It was intended as a proof-of-concept: to demonstrate that introducing very small market-imperfection frictions into a DSGE framework generated very Keynesian-monetarist conclusions. But the extraordinary shortcuts needed for tractability were and are a straitjacket that makes it extremely hazardous for policy analysis. It cannot fit the time series. And when it does fit the time series, it does so for the wrong reasons.

So why require everything to fit in this Procrustean Box?
This is a serious question–closely related to the question of why models that are microfounded in ways we know to be wrong are preferable in the discourse to models that try to get the aggregate emergent properties right.

Over at Project Syndicate: The Monetarist Mistake:

Two months ago here, I briefly noted that I had found the best explanation for why the collective economic policymakers of the North Atlantic have left and continue to leave the job of fighting and guiding recovery from our Lesser Depression at most half-done. The best explanation is to be found in my friend, teacher, and patron, Barry Eichengreen’s Hall of Mirrors.

But I have short shrift to both the argument of the book, and to its praise. It is the best book on 2008-present that has yet been written. And Eichengreen’s book’s central argument deserves to be the centerpiece of a much larger discussion. READ MOAR

So let me try to launch one piece of that discussion today:

Hall of Mirrors traces our tepid and inadequate response to the crisis in 2007-2009 to the triumph of monetarism. In the 1960s and 1970s monetarist economists advanced their particular economyc-historical interpretation of the causes of the 1930s Great Depression. And the sometime disciples of Milton Friedman overwhelmed their Keynesian and Minskyite peers.

The Great Depression, Friedman and his co-author Anna Jacobson Schwartz had argued in their 1963 Monetary History of the United States, was a failure of government. It was due solely and completely to the failure of the 1929-1933 Federal Reserve to properly and aggressively expand the monetary base in order to keep the economy’s money stock on a stable growth path. No decline in the money stock, no Great Depression. The government’s failure to follow a “neutral” monetary policy–the active disturbance by government incompetence of what was by nature a stable full-employment market economy–was the only reason for the Great Depression.

This interpretation made a certain kind of coherent sense. However, it could be sustained the so-called velocity of money, the speed with which people spent the cash in their pockets and the demand deposits in their banking accounts, varied little with changes in interest rates. And it involved some fast talk and fast dancing as to what a “neutral” monetary policy was.

But suppose the velocity of money was interest-elastic. Then the open-market operations undertaken to expand the money supply would have pushed down interest rates. They would so cause a further fall in monetary velocity. And so that would have made Freedman and Schwartz’s cure impotent.

And, it turned out, what Friedman and Schwartz called a “neutral” monetary policy in the Great Depression would have required that the Federal Reserve flood the zone with liquidity and buy bonds and print cash at a rate never before imagined.

If money demand were, contrary to what Friedman and Schwartz supposed, highly interest-elastic, then to have successfully stopped the Great Depression in its tracks would have required Keynesian expansionary fiscal and Minskyite supportive credit-market policies. And the argument that a “neutral” monetary policy is government hands-off as opposed to activist Keynesian fiscal and Minskyite credit policies was never fully credible.

The monetarists won the economic-historical and ma beat in the 1960s and 1970s. Peter Temin’s Did Monetary Forces Cause the Great Depression pointed out convincingly that there was no surprise in anything the Federal Reserve did–no place where interest rates jumped up as it deviated from what people were expecting–and at most minor and irregular downward pressure on liquidity. But that didn’t matter. Why not? Because the debate wa really two debates:

At one level, the debate between monetarists, Keynesians, and Minskyites was a simple empirical matter of reading the evidence: Was the interest-elasticity of money demand in a serious downturn low, as Milton Friedman claimed, or high, as in John Maynard Keynes’s and John Hicks’s liquidity trap? Were financial markets a near-veil because the money stock was a near-sufficient statistic for predicting total spending, as Milton Friedman claimed, or was the credit channel and its functioning of decisive importance, as Minsky warned?

At the second level, however, the debate was over whether market failure or government failure was the bigger threat. The Great Depression had, before Friedman and Schwartz’s Monetary History, been seen as an unanswerable argument that market failure was potentially so dire as to require the government to take over direction of the whole economy. And that created a presumption that there might be other, smaller market failure might require a government to be interventionist indeed not just in macro but in micro as well. But if the Great Depression could be understood as a failure of government, then the cognitive dissonance between its reality and right-of-center economists’ presumption that government failure was always the bigger threat could be erased.

Of course, the textbook Friedmanite cure was tried á outrance over 2008-2010 and proved insufficient. That is decisive evidence that Friedman and his monetarists were wrong about the Great Depression as well. There are thus no people today who have properly done their homework who would say, as Ben Bernanke said to Milton Friedman and Anna Schwartz in 2002:

You’re right, we did it. We’re very sorry. But thanks to you, we won’t do it again.

But, even in the 1970s, the empirical evidence did not weigh strongly enough on the monetarist side to account for its decisive victory.

The completeness of the victory must, I think be attributed to the fact that political economy is always polluted by politics: so polluted that, as John Stuart Mill lamented back in the 1800s, there is no position so absurd that it has not been advanced by some political economist of note and reputation, and I would add because it is convenient to their intellectual-political commitments.

To admit that the monetarist cure was inadequate would be to admit that the Great Depression had deeper roots then a failure of technocratic management on the part of central banks charged with maintaining a neutral monetary policy and a stable money supply growth rate. Such deeper roots in severe market failures would not be consistent with a belief that social democracy had been oversold, and that government failure was almost invariably a worse danger than market failure. There was thus an extremely strong elective affinity between a mainstream economics profession caught up in the gathering neoliberal currents of the age and the Friedmanite interpretation of the Great Depression.

It was the completeness of the victory that made policymakers in 2008-2010 unwilling to apply the Keynesian and Minskyite cures to severe downturns enthusiastically enough and on a large enough scale to adequately deal with the problems that emerged.

And so when 2008 came, the economists advising the North Atlantic’s governments and central banks were not ready.

It is always instructive to look at the materials that the Federal Reserve’s Federal Open Market Committee pumps out, especially their semi-anonymized (hi, Charlie Evans, with your 3% longer-run value) estimates of what the appropriate federal funds rate would be.

Thus we can see, comparing January 2012 when the Federal Reserve began publishing its dot-plots to today, the Federal Reserve collectively and slowly come to recognize current reality. Back at the start of 2012 the FOMC participants all thought that in the “longer run”–which at the beginning of 2012 I take to be next year, 2016–the federal funds rate ought to be back at its normal mid-expansion level, which they all took to be in the 3.75%-4.5% per year range. Today, of course, only one participant (Charles Plosser?) still thinks the federal funds rate ought to be in that range next year, and at the very bottom of it.

And we can see, comparing November 2013 to today, the Federal Reserve stick to its guns as to the anticipated pace of policy tightening set in motion with Ben Bernanke’s mid-2013 announcement that it was time to stop searching for further extraordinary monetary policy actions to boost the economy. The median FOMC participant in November 2013 thought that by the end of 2015 the federal funds rate should by 0.75%, and by the end of next year 1.75%. The median FOMC participant today thinks that by the end of 2015 the federal funds rate should be 0.5-0.75%, and by the end of next year 1.75%-2.00%.

This staying-the-course on the pace of tightening is interesting and somewhat surprising because of two facts. First, only one of the three key cyclical indicators–only the unemployment rate of the triple that is unemployment, labor-force participation, and production relative to projected past trends–has improved at anything like the rate expected. Second, the FOMC’s view of the Wicksellian “neutral” or “natural” nominal short-term safe rate of interest has fallen from a medium value of 4.25% in January 2012 to 4.0% in November 2013 to 3.75% today. If one thinks, as one should, of monetary ease or tightness as deviations from the Wicksellian “neutral” rate, an 0.75% rate as of today is thought to be about the same as a 1.25% rate back three and a quarter years ago.

And, of course, back in 2007 we firmly believed that for a healthy economy near but not beyond full employment, with a 2% per year target inflation rate, the appropriate federal funds rate would be 5%–as it as in 2996-7, as it had been from 1995-1998, before the 1998 decision to ease and the 2000 decision that the economy was overheated. 3.75% is far below that level.

Yet I find myself frustrated by one lack: the meeting participants fail to give their estimates of what the 10-year Treasury bond yield associated with their preferred funds path would be. I don’t know how they think the shifts since 2007 both in the economy and in how we view the economy have affected the “neutral” or “natural” long-term safe interest rate in relation to the short-term rate. So the thinking of FOMC participants remains more opaque to me than I would wish. What is their expectation of the gearing from the short to the long-term interest rate? And at what short-term interest rate do they expect the yield curve to invert? (Of course, even if I knew their implicit appropriate 10-year bond yield forecasts, much of their thinking would still remain opaque–only less opaque).

Must- and Should-Reads:

• Evening Must-Read: Michael Strain: How to Cut Taxes and Help the Poor
• Kenneth Thomas: Wikileaks Releases Trans-Pacific Partnership Investment Chapter
• Today’s Must-Must-Read: Ilyana Kuziemko et al.: What Do Americans Think Should Be Done About Inequality?
• Nick Bunker: Risk-Sharing and Student Loans

Might Like to Be Aware of:

• Jan Ebbeler: Felicior Augusto, Melior Traiano
• Joe Nye**: The American Century Will Survive the Rise of China

…the U.S. economy will have grown at a rate of:

• 2.8%/year over the past four quarters.
• 2.5%/year over the past eight quarters.
• 2.2%/year over the past twelve quarters.

If you think that the growth rate of potential output post-2009 is 2.2%/year, we are in exactly the same position relative to potential output that we were in March of 2012. And thus monetary and fiscal policy looking forward should be the same now as they should have been in March of 2012.

And if you think that the growth rate of potential output post-2009 has been less than 2.2%/year, you need to explain why–and you need to explain why it has not been due to low-pressure-economy policies, and why given that high-pressure economy policies right now are not a no-brainer.